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 June 30, 2018
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 August 3, 2018, the Registrant had 29,747,078 shares of common stock outstanding at $1.00 par value per share.
OLD SECOND BANCORP, INC.
Form 10-Q Quarterly Report
Cautionary Note Regarding Forward Looking Statements
PART I
Page Number
Item 1.
Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Item 4.
Controls and Procedures
PART II
Legal Proceedings
Item 1.A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosure
Item 5.
Other Information
Item 6.
Exhibits
Signatures
2
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report and other publicly available documents of the Company, including the documents incorporated herein by reference, contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act, including, but not limited to, statements regarding management’s belief that we are positioned for future growth, expectations regarding future plans, strategies and financial performance, regulatory developments, industry and economic trends, and other matters. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, can be identified by the inclusion of such qualifications as “expects,” “intends,” “believes,” “may,” “will,” “would,” “could,” “should,” “plan,” “anticipate,” “estimate,” “seeks,” “possible,” “likely” or other indications that the particular statements are not historical facts and refer to future periods. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and may be outside of the Company’s control. Actual events and results may differ significantly from those described in such forward-looking statements, due to numerous factors, including:
·
negative economic conditions that adversely affect the economy, real estate values, the job market and other factors nationally and in our market area, in each case that may affect our liquidity and the performance of our loan portfolio;
defaults and losses on our loan portfolio;
the anticipated benefits of the Company’s recent merger with Greater Chicago Financial Corp., including estimated cost savings and anticipated strategic gains, may be significantly harder or take longer to achieve than expected or may not be achieved in their entirety as a result of unexpected factors or events;
the integration of Greater Chicago Financial Corp.’s business and operations into the Company, which included conversion of Greater Chicago Financial Corp.’s operating systems and procedures, may have unanticipated adverse results relating to the Company’s existing businesses;
the Company’s ability to achieve anticipated results from the Greater Chicago Financial Corp. transaction is dependent on the state of the economic and financial markets going forward. Specifically, the Company may incur more credit losses than expected, cost savings may be less than expected and customer attrition may be greater than expected;
the financial success and viability of the borrowers of our commercial loans;
market conditions in the commercial and residential real estate markets in our market area;
changes in U.S. monetary policy, the level and volatility of interest rates, the capital markets and other market conditions that may affect, among other things, our liquidity and the value of our assets and liabilities;
competitive pressures in the financial services business;
any negative perception of our reputation or financial strength;
ability to raise additional capital on acceptable terms when needed;
ability to use technology to provide products and services that will satisfy customer demands and create efficiencies in operations;
adverse effects on our information technology systems resulting from failures, human error or cyberattacks;
adverse effects of failures by our vendors to provide agreed upon services in the manner and at the cost agreed, particularly our information technology vendors;
the impact of any claims or legal actions, including any effect on our reputation;
losses incurred in connection with repurchases and indemnification payments related to mortgages;
the soundness of other financial institutions;
changes in accounting standards, rules and interpretations and the impact on our financial statements;
our ability to receive dividends from our subsidiaries;
a decrease in our regulatory capital ratios;
legislative or regulatory changes, particularly changes in regulation of financial services companies;
increased costs of compliance, heightened regulatory capital requirements and other risks associated with changes in regulation and the current regulatory environment, including the Dodd-Frank Act;
the impact of heightened capital requirements; and
each of the factors and risks under the heading “Risk Factors” in our 2017 Form 10-K and Form 10-Qs filed with the SEC.
Because the Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain, there can be no assurances that future actual results will correspond to any forward-looking statements and you should not rely on any forward-looking statements. Additionally, all statements in this Form 10-Q, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.
3
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except share data)
(unaudited)
June 30,
December 31,
2018
2017
Assets
Cash and due from banks
$
34,161
37,444
Interest bearing deposits with financial institutions
31,147
18,389
Cash and cash equivalents
65,308
55,833
Securities available-for-sale, at fair value
543,644
541,439
Federal Home Loan Bank Chicago ("FHLBC") and Federal Reserve Bank Chicago ("FRBC") stock
9,093
10,168
Loans held-for-sale
5,206
4,067
Loans
1,849,162
1,617,622
Less: allowance for loan and lease losses
19,321
17,461
Net loans
1,829,841
1,600,161
Premises and equipment, net
42,532
37,628
Other real estate owned
8,912
8,371
Mortgage servicing rights, net
7,812
6,944
Goodwill and core deposit intangible
22,074
8,922
Bank-owned life insurance ("BOLI")
61,159
61,764
Deferred tax assets, net
27,812
25,356
Other assets
26,355
22,776
Total assets
2,649,748
2,383,429
Liabilities
Deposits:
Noninterest bearing demand
620,807
572,404
Interest bearing:
Savings, NOW, and money market
1,058,295
967,750
Time
482,749
382,771
Total deposits
2,161,851
1,922,925
Securities sold under repurchase agreements
54,038
29,918
Other short-term borrowings
76,625
115,000
Junior subordinated debentures
57,662
57,639
Senior notes
44,108
44,058
Notes payable and other borrowings
23,496
-
Other liabilities
22,154
13,539
Total liabilities
2,439,934
2,183,079
Stockholders’ Equity
Common stock
34,717
34,626
Additional paid-in capital
118,082
117,742
Retained earnings
157,796
142,959
Accumulated other comprehensive (loss) income
(4,487)
1,479
Treasury stock
(96,294)
(96,456)
Total stockholders’ equity
209,814
200,350
Total liabilities and stockholders’ equity
June 30, 2018
December 31, 2017
Common
Stock
Par value
1.00
Shares authorized
60,000,000
Shares issued
34,716,589
34,625,734
Shares outstanding
29,747,078
29,627,086
Treasury shares
4,969,511
4,998,648
See accompanying notes to consolidated financial statements.
4
Consolidated Statements of Income
(In thousands, except per share data)
Three Months Ended June 30,
Six Months Ended June 30,
Interest and dividend income
Loans, including fees
22,512
17,385
41,248
33,994
35
37
55
61
Securities:
Taxable
2,392
2,607
4,562
5,570
Tax exempt
2,114
1,648
4,175
2,560
Dividends from FHLBC and FRBC stock
111
92
217
177
97
31
146
54
Total interest and dividend income
27,261
21,800
50,403
42,416
Interest expense
Savings, NOW, and money market deposits
501
233
845
456
Time deposits
1,444
1,025
2,619
2,004
104
183
6
276
605
252
927
1,059
1,854
2,143
672
1,344
1,345
95
Total interest expense
4,019
3,139
7,545
6,206
Net interest and dividend income
23,242
18,661
42,858
36,210
Provision for loan and lease losses
1,450
750
728
Net interest and dividend income after provision for loan and lease losses
21,792
17,911
42,130
35,460
Noninterest income
Trust income
1,645
1,638
3,140
3,096
Service charges on deposits
1,769
1,615
3,361
3,233
Secondary mortgage fees
195
223
357
399
Mortgage servicing rights mark to market (loss) gain
(105)
(429)
200
(562)
Mortgage servicing income
627
444
1,079
879
Net gain on sales of mortgage loans
1,240
1,473
2,157
2,620
Securities gains (losses), net
312
(131)
347
(267)
Increase in cash surrender value of BOLI
351
350
599
709
Death benefit realized on bank-owned life insurance
1,026
Debit card interchange income
1,132
1,081
2,144
2,056
Gain on disposal and transfer of fixed assets, net
12
10
Other income
1,366
1,041
2,627
2,172
Total noninterest income
8,532
7,317
17,037
14,345
Noninterest expense
Salaries and employee benefits
12,355
10,545
22,562
21,118
Occupancy, furniture and equipment
1,652
1,462
3,210
3,028
Computer and data processing
2,741
1,112
4,085
2,202
FDIC insurance
165
321
313
General bank insurance
299
264
550
534
Amortization of core deposit intangible
25
118
50
Advertising expense
492
452
833
838
Debit card interchange expense
301
582
748
Legal fees
286
184
445
288
Other real estate expense, net
429
539
602
1,248
Other expense
3,469
2,839
6,332
5,673
Total noninterest expense
22,286
17,986
39,640
36,040
Income before income taxes
8,038
7,242
19,527
13,765
Provision for income taxes
1,777
2,096
3,777
4,192
Net income available to common stockholders
6,261
5,146
15,750
9,573
Basic earnings per share
0.21
0.17
0.53
0.32
Diluted earnings per share
0.52
5
Consolidated Statements of Comprehensive Income
(In thousands)
Net Income
Unrealized holding (losses) gains on available-for-sale securities arising during the period
(1,391)
6,596
(10,199)
10,827
Related tax benefit (expense)
392
(2,650)
2,876
(4,325)
Holding (losses) gains after tax on available-for-sale securities
(999)
3,946
(7,323)
6,502
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)
(88)
52
(98)
106
Net realized gains (losses) after tax
224
(79)
249
(161)
Other comprehensive (loss) income on available-for-sale securities
(1,223)
4,025
(7,572)
6,663
Changes in fair value of derivatives used for cash flow hedges
515
(613)
1,794
(464)
Related tax (expense) benefit
(145)
245
(507)
Other comprehensive income on cash flow hedges
370
(368)
1,287
(280)
Total other comprehensive (loss) income
(853)
3,657
(6,285)
6,383
Total comprehensive income
5,408
8,803
9,465
15,956
Consolidated Statements of Cash Flows
(Unaudited)
Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation of fixed assets and amortization of leasehold improvements
1,142
1,193
Change in fair value of mortgage servicing rights
(200)
562
Provision for deferred tax expense
3,468
4,052
Originations of loans held-for-sale
(72,820)
(75,079)
Proceeds from sales of loans held-for-sale
73,187
76,649
Net gains on sales of mortgage loans
(2,157)
(2,620)
Net premium amortization/discount (accretion) of purchase accounting adjustment on loans
(776)
(680)
Change in current income taxes receivable
197
(89)
(599)
(709)
Change in accrued interest receivable and other assets
(1,075)
1,665
Change in accrued interest payable and other liabilities
8,195
16,894
Net premium amortization/discount (accretion) on securities
1,388
773
Securities (gains) losses, net
(347)
267
Amortization of junior subordinated debentures issuance costs
23
24
Amortization of senior notes issuance costs
Stock based compensation
1,098
625
Net gains on sale of other real estate owned
(104)
(178)
Provision for other real estate owned valuation losses
366
710
Net losses on disposal and transfer of fixed assets
(11)
Loss on transfer of premises to other real estate owned
1
Net cash provided by operating activities
27,632
34,474
Cash flows from investing activities
Proceeds from maturities and calls including pay down of securities available-for-sale
20,136
78,564
Proceeds from sales of securities available-for-sale
92,746
100,856
Purchases of securities available-for-sale
(54,550)
(205,755)
Net disbursements/proceeds from sales (purchases) of FHLBC stock
2,624
(675)
Net change in loans
(4,418)
(64,755)
Proceeds from claims on BOLI, net of premiums paid
1,204
Improvements in other real estate owned
(59)
Proceeds from sales of other real estate owned, net of participation purchase
2,068
3,280
Proceeds from disposition of premises and equipment
13
Net purchases of premises and equipment
(710)
(375)
Cash paid for acquisition, net of cash and cash equivalents retained
(35,711)
Net cash provided by (used in) investing activities
23,330
(88,847)
Cash flows from financing activities
Net change in deposits
(9,587)
43,360
Net change in securities sold under repurchase agreements
18,497
10,646
Net change in other short-term borrowings
(49,298)
5,000
Payment of senior note issuance costs
(42)
Dividends paid on common stock
(594)
(592)
Purchase of treasury stock
(505)
(236)
Net cash (used in) provided by financing activities
(41,487)
58,136
Net change in cash and cash equivalents
9,475
3,763
Cash and cash equivalents at beginning of period
47,334
Cash and cash equivalents at end of period
51,097
7
Consolidated Statements of Cash Flows - Continued
Supplemental cash flow information
Income taxes paid, net
100
230
Interest paid for deposits
3,295
2,448
Interest paid for borrowings
3,960
3,787
Non-cash transfer of loans to other real estate owned
2,380
3,525
Non-cash transfer of premises to other real estate owned
8
Consolidated Statements of Changes in
Accumulated
Additional
Other
Total
Paid-In
Retained
Comprehensive
Treasury
Stockholders’
Capital
Earnings
Income (Loss)
Equity
Balance, December 31, 2016
34,534
116,653
129,005
(8,762)
(96,220)
175,210
Other comprehensive income, net of tax
Dividends declared and paid
Vesting of restricted stock
(92)
Balance, June 30, 2017
117,186
137,986
(2,379)
190,963
Balance, December 31, 2017
Other comprehensive loss, net of tax
91
(758)
667
Reclassification of stranded tax effects
(319)
319
Balance, June 30, 2018
9
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share data, unaudited)
Note 1 – Summary of Significant Accounting Policies
The accounting policies followed in the preparation of the interim consolidated financial statements are consistent with those used in the preparation of the annual financial information. The interim consolidated financial statements reflect all normal and recurring adjustments that are necessary, in the opinion of management, for a fair statement of results for the interim period presented. Results for the period ended June 30, 2018, are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. 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, 2017. Unless otherwise indicated, amounts in the tables contained in the notes to the consolidated financial statements are in thousands. Certain items in prior periods have been reclassified to conform to the current presentation.
The Company’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.
Significant accounting policies are presented in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. 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.
In addition to the significant accounting policies presented in our Form 10-K, as noted above, as a result of our acquisition of Greater Chicago Financial Corp. (“(GCFC”), and its wholly-owned subsidiary, ABC Bank, that closed in the second quarter of 2018, the Company has implemented accounting policies regarding purchased loans. Loans purchased as a result of a business combination are recorded at estimated fair value on the acquisition date, with no carryover of the related allowance for loan and lease losses recorded by the acquiree at the time of purchase. These loans are segregated into two classifications upon purchase:
1)
purchased non-credit impaired (“non-PCI”) loans, accounted for in accordance with FASB ASC Subtopic 310-20 “Nonrefundable Fees and Costs” (“ASC 310-20”), which have a discount attributable in part to credit quality. Premiums and discounts created when ASC 310-20 loans are recorded at their fair values at acquisition are amortized over the remaining terms of the loans as an adjustment to the related loan’s yield; and
2)
purchased credit impaired (“PCI”) loans, accounted for under FASB ASC Subtopic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality” (“ASC 310-30”) as they display signs of credit deterioration. Interest income, through accretion of the difference between the carrying value of the loans and the expected cash flows, is recognized on the acquired loans accounted for under ASC 310-30.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“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,” which deferred the effective date of ASU 2014-09 for an additional year. ASU 2015-14 was effective for annual reporting periods beginning after December 15, 2017. The amendments could 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 was 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 performed an analysis of the impact of adoption of this ASU, reviewing revenue recorded from service charges on deposit accounts, asset management fees, gains (losses) on other real estate owned, and debit card interchange fees. Certain revenue received, such as service charges on deposit accounts and interchange fees, is recorded immediately or as the service is performed. Asset management fees recorded by the Company take the form of wealth management income and brokerage income, and both types of fees are recorded after services are rendered, with no contractual requirement of refund to a customer based on non-achievement of fund performance objectives. Finally, the methodology used to record revenue from gains (losses) due to the sale of other real estate owned is not anticipated to change, as the Company currently records income or expense only upon consummation of the sale, and any revenue recorded stemming from seller financed transactions is reviewed for deferral, as appropriate. The Company adopted ASU 2014-09 and related issuances on January 1, 2018, with no cumulative effect adjustment to opening retained earnings required upon implementation of this standard.
In January 2016, the FASB issued ASU No. 2016-01 “Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” The objective of the issuance is to provide users of financial statements with more decision–useful information, by making targeted improvements to GAAP. These targeted improvements included revisions to the methodology of accounting for equity investments, eliminating certain disclosures on fair value assumptions for financial instruments measured at amortized cost, and requiring public business entities to use the exit price notion, as defined in ASC 820, for the measurement of the fair value of financial instruments. This standard was effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company adopted this standard as of January 1, 2018. Adoption of this standard resulted in the Company’s use of an exit price rather than an entrance price to determine the fair value of loans and deposits not already measured at fair value on a non-recurring basis in the consolidated balance sheet disclosures; see Note 14–Fair Value of Financial Instruments for further information regarding the valuation processes.
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 in the process of identifying all lease arrangements, methodology of tracking, and practical expedients that may be applied, such as the cumulative effect adjustment in equity upon adoption as of January 1, 2019, compared to a retroactive adoption. We will continue to assess the impact of ASU 2016-02 on our accounting and disclosures.
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 historical data by loan pools and collateral classifications, and completing model option evaluations 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 will continue to decrease future quarterly net interest income over the call period until the premium 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 2017 earnings. Net interest income, net income and diluted earnings per share (“EPS”) were previously reported as $22.1 million, $5.5 million, and $0.18 for the quarter ended June 30, 2017, and $42.9 million, $10.0 million, and $0.33 for the six months ended June 30, 2017. The effect of the adoption of ASU 2017-08 resulted in the currently reported totals of net interest income, net income and diluted EPS of $21.8 million, $5.1 million, and $0.17 for the quarter ended June 30, 2017, and $42.4 million, $9.6 million, and $0.32 for the six months ended June 30, 2017.
11
In August 2017, the FASB issued ASU No. 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 adopted ASU 2017-12 on January 1, 2018, on a modified retrospective basis. FASB ASC 815, Derivatives and Hedging (“ASC 815”), provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Further, qualitative disclosures are required that explain the Company’s objectives and strategies for using derivatives, as well as quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.
As required by ASC 815, the Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives may also be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.
In accordance with the FASB’s fair value measurement guidance in ASU 2011-04, the Company made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio. As the Company does not currently have any derivative financial instruments subject to master netting agreements, there was no impact to the balance sheet.
In February 2018, the FASB issued ASU No. 2018-02, “Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income.” This ASU was issued in response to the enactment of tax bill H.R.1 “Tax Cuts and Jobs Act”, which resulted in “stranding” the tax effects of items within accumulated other comprehensive income related to the adjustment of deferred taxes due to the reduction of the federal corporate income tax rate. The amendments proposed allow the reclassification of these stranded tax effects to retained earnings, and were effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted, and should be applied either in the period of adoption or retrospectively to each period in which the effect of the change in the U.S. federal corporate tax rate is recognized. The Company adopted ASU 2018-02 as of January 1, 2018, and a reclassification of $319,000, net, was recorded, which increased accumulated other comprehensive income and reduced retained earnings with the adoption of the accounting standard.
Subsequent Events
On July 17, 2018, the Company’s Board of Directors declared a cash dividend of $0.01 per share payable on August 6, 2018, to stockholders of record as of July 27, 2018; dividends of $297,000 were paid to stockholders on August 6, 2018.
Note 2 – Acquisitions
On April 20, 2018, the Company acquired Greater Chicago Financial Corp. (“GCFC”), and its wholly owned subsidiary, ABC Bank, which operates four branches in the Chicago metro area. In addition to the acquisition price of $41.1 million, the Company retired the convertible and nonconvertible debentures held by GCFC upon acquisition, which totaled $6.6 million, including interest due. The purchase and the debentures’ retirement were funded with the Company’s cash on hand, and all GCFC common stock was retired and cancelled simultaneous with the close of the transaction. The Company acquired $227.6 million of loans, net of purchase accounting adjustments, and $248.5 million of deposits, net of purchase accounting adjustments for time deposits. Purchase accounting adjustments recorded in the second quarter of 2018 include a loan valuation mark of $11.2 million, a core deposit intangible of $3.1 million, a fixed asset valuation adjustment of $1.5 million, and goodwill of $9.9 million. In addition, a deferred tax asset of $3.5 million was recorded as of the date of acquisition based on analysis of the fair value of assets acquired, less liabilities assumed. None of the $9.9 million recorded as goodwill is expected to be deductible for tax purposes. Acquisition related costs incurred by the
Company for the six months ended June 30, 2018, totaled $3.4 million, pretax, and included $1.2 million of salaries and employee benefits related expenses, and $1.8 million of data processing, computer and ATM related conversion costs.
The assets and liabilities associated with the acquisition of GCFC were recorded in the Consolidated Balance Sheets at estimated fair value as of the acquisition date. In many cases the determination of these fair values required management to make estimates about discount rates, future expected cash flows, market conditions and other future events that are highly subjective in nature and subject to change, as noted below. The following allocation is based on the information that was available to make preliminary estimates of the fair value and may change as additional information becomes available and additional analyses are completed. While the Company believes that information provided a reasonable basis for estimating the fair values, it expects that it could obtain additional information and evidence during the measurement period that may result in changes to the estimated fair value amounts. This measurement period ends on the earlier of one year after the acquisition date or the date we receive the information about the facts and circumstances that existed at the acquisition date. Subsequent adjustments are, and if necessary, will be prospectively reflected in future filings, and may impact loans, other assets, notes payable and other borrowings, deferred tax assets, net, and goodwill.
The below table summarizes the assets acquired, less the liabilities assumed, related to the GCFC/ABC Bank acquisition. All amounts are listed at their estimated fair values as of date of acquisition, and have been accounted for under the acquisition method of accounting.
GCFC/ABC Bank Acquisition Summary
As of Date of Acquisition
April 20, 2018
6,669
500
72,091
Federal funds sold
4,300
FHLBC stock
1,549
227,594
Premises and equipment
5,339
432
12,957
3,456
2,083
336,970
58,005
Savings, NOW and money market
91,494
98,999
248,498
5,624
10,875
23,544
1,249
289,790
Cash consideration paid
47,180
Total Liabilities Assumed and Cash Consideration Paid for Acquisition
Loans acquired in the GCFC acquisition were initially recorded at fair value with no separate allowance for loan losses. The Company reviewed the loans at acquisition to determine which should be considered PCI loans, defining impaired loans as those that were either not accruing interest or exhibited credit risk factors consistent with nonperforming loans at the acquisition date, or non-PCI loans, as addressed in the Company’s significant accounting policies.
The following table represents the acquired loans as of date of acquisition and as of June 30, 2018:
ABC Bank Acquired Loans
PCI
Non-PCI
Fair Value
11,360
216,306
11,214
208,929
Contractually required principal and interest payment
19,447
219,488
18,989
211,341
Best estimate of contractual cash flows not expected to be collected
6,537
2,511
6,402
2,119
Best estimate of contractual cash flows expected to be collected
12,910
216,977
12,587
209,222
Note 3 – Securities
Investment Portfolio Management
Our investment portfolio serves the liquidity needs and income objectives of the Company. While the portfolio serves as an important component of the overall liquidity management at the Bank, portions of the portfolio also serve as income producing assets. The size and composition of the portfolio reflects liquidity needs, loan demand and interest income objectives. Portfolio size and composition will be adjusted from time to time. While a significant portion of the portfolio consists of readily marketable securities to address liquidity, other parts of the portfolio may reflect funds invested pending future loan demand or to maximize interest income without undue interest rate risk.
Investments are comprised of debt securities and non-marketable equity investments. Securities available-for-sale are carried at fair value. Unrealized gains and losses, net of tax, on securities available-for-sale are reported as a separate component of equity. This balance sheet component changes as interest rates and market conditions change. Unrealized gains and losses are not included in the calculation of regulatory capital.
FHLBC and FRBC stock are considered nonmarketable equity investments. FHLBC stock was recorded at $4.3 million at June 30, 2018, and $5.4 million at December 31, 2017. FRBC stock was recorded at $4.8 million at both June 30, 2018, and December 31, 2017.
14
The following table summarizes the amortized cost and fair value of the securities portfolio at June 30, 2018, and December 31, 2017, 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
4,004
(128)
3,876
U.S. government agencies
12,369
(153)
12,216
U.S. government agencies mortgage-backed
14,011
(604)
13,407
States and political subdivisions
279,007
1,640
(4,535)
276,112
Corporate bonds
685
21
(6)
700
Collateralized mortgage obligations
63,778
60
(2,406)
61,432
Asset-backed securities
110,053
1,011
(1,801)
109,263
Collateralized loan obligations
66,489
(74)
66,638
Total securities available-for-sale
550,396
2,955
(9,707)
U.S. Treasury
4,002
(55)
3,947
13,062
(9)
13,061
12,372
(165)
12,214
272,240
7,116
(1,264)
278,092
823
66,892
202
(1,155)
65,939
113,983
862
(1,913)
112,932
54,271
251
(101)
54,421
537,645
8,467
(4,673)
The fair value, amortized cost and weighted average yield of debt securities at June 30, 2018, 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
10,550
2.10
%
10,540
Due after one year through five years
4,689
2.20
4,576
Due after five years through ten years
5,343
3.27
5,413
Due after ten years
275,483
2.98
272,375
296,065
2.94
292,904
Mortgage-backed and collateralized mortgage obligations
77,789
3.11
74,839
3.23
4.34
3.19
At June 30, 2018, the Company’s investments included $92.5 million of asset-backed securities that are backed by student loans originated under the Federal Family Education Loan program (“FFEL”). Under the FFEL, private lenders made federally guaranteed student loans to parents and students. While the program was modified several times before elimination in 2010, FFEL securities are generally guaranteed by the U.S Department of Education (“DOE”) at not less than 97% of the outstanding principal amount of the loans. The guarantee will reduce to 85% if the DOE receives reimbursement requests in excess of 5% of insured loans; reimbursement will drop to 75% if reimbursement requests exceed 9% of insured loans. In addition to the DOE guarantee, total added credit enhancement in the form of overcollateralization and/or subordination amounted to $10.9 million, or 11.44%, of outstanding principal.
15
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
27,685
26,754
Towd Point Mortgage Trust
28,966
28,080
Student Loan Marketing Association
25,780
26,176
Securities with unrealized losses at June 30, 2018, and December 31, 2017, 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
128
153
356
8,968
248
4,439
604
43
3,264
141,455
1,271
3,849
45
4,535
145,304
198
20,353
2,007
37,782
2,406
58,135
65
8,451
1,736
56,539
1,801
64,990
17,364
7,986
74
25,350
64
4,425
212,683
5,282
110,793
88
9,707
323,476
6,550
5,501
141
4,843
10,344
1,237
45,985
27
1,512
1,264
47,497
332
11,534
1,124
40,219
1,155
51,753
1,913
61,745
101
29,313
26
1,457
102,830
22
3,216
108,651
48
4,673
211,481
Recognition of other-than-temporary impairment was not necessary as of the three and six months ended June 30, 2018. The changes in fair value related primarily to interest rate fluctuations. Our review of other-than-temporary impairment determined that there was no credit quality deterioration.
The following table presents net realized gains (losses) on securities available-for-sale for the three and six months ended June 30, 2018 and 2017.
Three Months Ended
Six Months Ended
Proceeds from sales of securities
90,224
36,468
Gross realized gains on securities
71
437
Gross realized losses on securities
(202)
(704)
Securities realized gains (losses), net
The majority of the net realized losses in the prior year were incurred as the portfolio was repositioned during 2017 to invest in higher yielding tax exempt municipal securities.
Securities valued at $311.4 million as of June 30, 2018, an increase from $301.0 million at year-end 2017, were pledged to secure deposits and borrowings, and for other purposes.
16
Note 4 – Loans
Major classifications of loans were as follows:
Commercial
299,536
272,851
Leases
66,687
68,325
Real estate - commercial
808,264
750,991
Real estate - construction
115,486
85,162
Real estate - residential
404,908
313,397
Home equity lines of credit "HELOC"
127,986
112,833
Other 1
13,969
13,384
Total loans, excluding deferred loan costs and PCI loans
1,836,836
1,616,942
Net deferred loan costs
680
Total loans, excluding PCI loans
1,837,948
PCI loans, net of purchase accounting adjustments
Total loans
1 The “Other” class includes consumer and overdrafts.
It is the policy of the Company to review each prospective credit prior to making a loan in order to determine if an adequate level of security or collateral has been obtained. The type of collateral, when required, will vary from liquid assets to real estate. The Company’s access to collateral, in the event of borrower default, is assured through adherence to lending laws, the Company’s lending standards and credit monitoring procedures. With selected exceptions, the Bank makes loans solely within its market area. There are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector, although the real estate related categories listed above represent 78.8% and 78.0% of the portfolio at June 30, 2018, and December 31, 2017, respectively. The PCI loans, net of purchase accounting adjustments, reflect purchase credit impaired loans as of June 30, 2018, related to the Company’s second quarter acquisition of ABC Bank.
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
210
299,326
Owner occupied general purpose
903
450
1,353
172,922
175,098
477
Owner occupied special purpose
1,981
194,604
426
197,011
Non-owner occupied general purpose
3,282
174
279,599
39
283,094
178
Non-owner occupied special purpose
87,704
3,099
90,803
Retail properties
47,582
Farm
14,676
Homebuilder
7,649
Land
9,168
Commercial speculative
39,730
All other
59
442
58,245
193
58,939
475
Investor
466
108
38
612
72,896
371
73,879
40
Multifamily
232
191,883
192,115
Owner occupied
208
918
134,265
3,731
138,914
HELOC
172
49
820
126,443
723
15,026
15,081
Total, excluding PCI loans
8,481
488
1,153
10,122
1,818,405
9,421
1,220
387
7,850
2,977
8,868
10,509
1,826,255
12,398
17
995
275
1,270
271,581
68,147
1,136
144,267
455
145,858
226
170,546
342
171,114
593
273,203
1,163
274,959
92,923
93,171
254
49,538
50,619
15,270
129
2,221
2,350
1,319
2,443
32,028
48,140
201
48,341
55,248
372
55,620
125,049
4,723
129,772
123,257
4,674
128,005
491
278
769
110,872
1,192
14,019
14,063
4,212
1,146
5,606
1,597,628
14,388
1 The “Other” class includes consumer, overdrafts and net deferred costs.
Credit Quality Indicators
The Company categorizes loans into credit risk categories based on current financial information, overall debt service coverage, comparison 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 Bank 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.
18
Credit Quality Indicators by class of loans were as follows:
Special
Pass
Mention
Substandard 2
Doubtful
298,512
631
393
66,148
166,962
4,915
3,221
195,009
1,748
275,728
4,899
2,467
Retail Properties
45,755
1,827
13,428
56,443
2,130
72,759
1,029
188,813
3,302
133,485
5,428
126,353
1,633
15,063
1,798,709
12,921
26,318
37,532
270,889
1,962
67,500
825
142,843
1,927
1,088
169,621
1,152
341
271,731
2,065
89,582
3,589
48,321
1,217
11,755
2,486
46,913
1,052
376
55,172
448
122,178
561
5,266
110,934
1,899
14,043
20
1,583,352
10,965
23,305
2 The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.
The Company had $942,000 and $1.3 million in residential real estate loans in the process of foreclosure as of June 30, 2018, and December 31, 2017, respectively.
19
The following tables set forth the recorded investments, unpaid principal balance and related allowance, excluding purchased credit-impaired loans, by class of loans for the June 30, 2018, periods:
As of June 30, 2018
Unpaid
Interest
Principal
Related
Income
Balance
Allowance
Recognized
With no related allowance recorded
89
Commercial real estate
911
985
683
546
384
81
601
541
Construction
Residential
468
2,362
4,244
5,769
4,726
741
860
933
Total impaired loans with no recorded allowance
6,941
8,951
10,898
With an allowance recorded
3,575
419
1,550
815
822
3,646
3,544
73
1,321
Total impaired loans with a recorded allowance
8,884
9,360
498
7,071
119
Total impaired loans
15,825
18,311
17,969
Impaired loans by class of loans as of December 31, 2017, and for the six months ended June 30, 2017, were as follows:
As of December 31, 2017
June 30, 2017
213
293
495
1,170
1,538
1,443
507
1,177
1,161
72
229
180
676
1,708
4,965
2,412
5,208
6,680
9,016
1,125
1,313
2,227
105
14,855
17,792
20,798
120
123
829
3,443
402
5,257
144
645
20,112
23,049
21,443
Troubled debt restructurings (“TDRs”) are loans for which the contractual terms have been modified and both of these conditions exist: (1) there is a concession to the borrower and (2) the borrower is experiencing financial difficulties. Loans are restructured on a case-
by-case basis during the loan collection process with modifications generally initiated at the request of the borrower. These modifications may include reduction in interest rates, extension of term, deferrals of principal, and other modifications. The Bank participates in the U.S. Department of the Treasury’s (the “Treasury”) Home Affordable Modification Program (“HAMP”) which gives qualifying homeowners an opportunity to refinance into more affordable monthly payments.
The specific allocation of the allowance for loan and lease losses for TDRs is determined by calculating the present value of the TDR cash flows by discounting the original payment less an assumption for probability of default at the original note’s issue rate, and adding this amount to the present value of collateral less selling costs. If the resulting amount is less than the recorded book value, the Bank either establishes a valuation allowance (i.e., specific reserve) as a component of the allowance for loan and lease losses or charges off the impaired balance if it determines that such amount is a confirmed loss. This method is used consistently for all segments of the portfolio. The allowance for loan and lease losses also includes an allowance based on a loss migration analysis for each loan category on loans and leases that are not individually evaluated for specific impairment. All loans charged-off, including TDRs charged-off, are factored into this calculation by portfolio segment.
TDRs that were modified during the period are as follows:
TDR Modifications
Three Months Ended June 30, 2018
Six Months Ended June 30, 2018
# of
Pre-modification
Post-modification
contracts
recorded investment
Troubled debt restructurings
Other1
110
56
HAMP2
Rate3
305
287
523
503
464
382
706
622
Three Months Ended June 30, 2017
Six Months Ended June 30, 2017
155
147
388
1 Other: Change of terms from bankruptcy court.
2 HAMP: Home Affordable Modification Program.
3 Rate: Refers to interest rate reduction.
TDRs are classified as being in default on a case-by-case basis when they fail to be in compliance with the modified terms. There was no TDR default activity for the June 30, 2018, and June 30, 2017, for loans that were restructured within the 12 month period prior to default.
The following table details the accretable discount on all of the Company’s purchased loans, both non-PCI loans and PCI loans as of June 30, 2018.
Accretable Discount - Non-PCI Loans
Accretable Discount - PCI Loans
Non-Accretable Discount - PCI Loans
Beginning balance, April 1, 2018
694
Purchases
3,182
1,551
6,536
11,269
Accretion
(881)
(176)
(1,057)
Transfer1
(2)
(133)
(135)
Ending balance, June 30, 2018
2,995
1,373
6,403
10,771
1 Transfer was due to loans moved to OREO.
Note 5 – Allowance for Loan and Lease Losses
Changes in the allowance for loan and lease losses by segment of loans based on method of impairment for the three and six months ended June 30, 2018, were as follows:
Real Estate
Allowance for loan and lease losses:
Three months ended June 30, 2018
Beginning balance
2,604
617
9,565
1,143
1,535
870
18,188
Charge-offs
504
102
699
Recoveries
(Release) Provision
(5)
1,455
255
(136)
(171)
Ending balance
2,676
634
10,537
1,398
1,818
1,390
868
Six months ended June 30, 2018
2,453
692
9,522
923
1,846
1,446
579
408
(16)
674
109
1,016
138
152
1,806
Provision (Release)
145
(45)
1,035
(1,099)
(102)
338
Ending balance: Individually evaluated for impairment
Ending balance: Collectively evaluated for impairment
10,118
1,763
18,823
Ending balance: Acquired and accounted for ASC 310-30
Total ending allowance balance
Loans:
Ending balance: Individually evaluated for Impairment
4,475
11,138
803,789
115,293
393,770
15,062
1,822,123
4,146
1,556
5,509
Total ending loans balance
299,538
812,410
117,042
410,417
15,082
Changes in the allowance for loan and lease losses by segment of loans based on method of impairment for the three and six months ended June 30, 2017, were as follows:
Three months ended June 30, 2017
1,672
603
7,831
978
2,438
1,340
15,741
946
30
80
1,066
46
139
51
411
479
188
234
(181)
270
(304)
2,150
791
8,107
857
1,872
1,513
15,836
Six months ended June 30, 2017
1,629
633
9,547
389
2,178
1,331
451
16,158
117
977
194
1,757
78
238
521
(1,243)
394
518
98
693
15,738
216
460
3,113
220
14,609
1,971
20,598
256,544
69,678
702,990
93,441
267,509
114,081
14,806
1,519,049
Total ending loan balance
256,760
70,138
706,103
93,661
282,118
116,052
14,815
1,539,647
Note 6 – Other Real Estate Owned
Details related to the activity in the other real estate owned (“OREO”) portfolio, net of valuation reserve, for the periods presented are itemized in the following table:
Balance at beginning of period
7,063
13,481
11,916
Property additions
2,812
204
3,620
Property improvements
Less:
Proceeds from property disposals, net of participation purchase and of gains/losses
1,569
1,964
3,102
Period valuation adjustments
Balance at end of period
11,724
Activity in the valuation allowance was as follows:
8,099
9,659
8,208
9,982
Provision for unrealized losses
Reductions taken on sales
(1,747)
(226)
(2,388)
Other adjustments
8,348
8,304
Expenses related to OREO, net of lease revenue includes:
Gain on sales, net
(24)
Operating expenses
369
816
Lease revenue
42
29
Net OREO expense
Note 7 – Deposits
Major classifications of deposits were as follows:
Savings
301,832
262,220
NOW accounts
435,514
429,448
Money market accounts
320,949
276,082
Certificates of deposit of less than $100,000
249,049
216,493
Certificates of deposit of $100,000 through $250,000
175,174
122,489
Certificates of deposit of more than $250,000
58,526
43,789
Note 8 – Borrowings
The following table is a summary of borrowings as of June 30, 2018, and December 31, 2017. Junior subordinated debentures are discussed in detail in Note 9:
Other short-term borrowings 1
Total borrowings
255,929
246,615
1 Includes short-term FHLBC advances and the outstanding portion of an operating line of credit.
The Company enters into deposit sweep transactions where the transaction amounts are secured by pledged securities. These transactions consistently mature overnight from the transaction date and are governed by sweep repurchase agreements. All sweep repurchase agreements are treated as financings secured by U.S. government agencies and collateralized mortgage-backed securities and had a carrying amount of $54.0 million at June 30, 2018, and $29.9 million at December 31, 2017. The fair value of the pledged collateral was $73.9 million at June 30, 2018, and $40.0 million at December 31, 2017. At June 30, 2018, there was one customer with secured balances exceeding 10% of stockholders’ equity.
The Company’s borrowings at the FHLBC require the Bank to be a member and invest in the stock of the FHLBC. Total borrowings are generally limited to the lower of 35% of total assets or 60% of the book value of certain mortgage loans. As of June 30, 2018, the Bank had $72.6 million in short-term advances outstanding under the FHLBC compared to $115.0 million outstanding as of December 31, 2017; $70.0 million of the June 30, 2018, balance was issued at 2.01%, and $2.6 million was issued at 1.40%. The additional $4.0 million in other short-term borrowings as of June 30, 2018, was the outstanding portion of a $20.0 million line of credit the Company has with a correspondent bank for short-term funding needs, paying 3.73% as of the current quarter end; advances under the line can be outstanding up to 360 days from date of issuance. The Bank also assumed $23.5 million of long-term FHLBC advances
with the ABC Bank acquisition, with maturities scheduled over the next 7.75 years and paying interest at rates in the range of 1.40% to 2.83 % as of June 30, 2018.
FHLBC stock held was valued at $4.3 million, and any potential FHLBC advances were collateralized by securities with a fair value of $76.7 million and loans with a principal balance of $296.3 million, which carried a FHLBC calculated combined collateral value of $295.5 million. The Company had excess collateral of $150.1 million available to secure borrowings at June 30, 2018.
The Company also has $44.1 million of senior notes outstanding, net of deferred issuance costs, as of June 30, 2018 and December 31, 2017. 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. As of June 30, 2018 and December 31, 2017, unamortized debt issuance costs related to the senior notes were $892,000 and $942,000, respectively, and are included as a reduction of the balance of the senior notes on the Consolidated Balance Sheet. These deferred issuance costs will be amortized to interest expense over the ten year term of the notes and are included in the Consolidated Statements of Income.
Note 9 – Junior Subordinated Debentures
The Company completed the sale of $27.5 million of cumulative trust preferred securities by its unconsolidated subsidiary, Old Second Capital Trust I, in June 2003. An additional $4.1 million of cumulative trust preferred securities were sold in July 2003. The trust preferred securities may remain outstanding for a 30-year term but, subject to regulatory approval, can be called in whole or in part by the Company after June 30, 2008. 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 4.34% as of June 30, 2018, compared to the rate paid prior to June 15, 2017 of 6.77%. The Company issued a new $25.8 million subordinated debenture to Old Second Capital Trust II in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.
Both of the debentures issued by the Company are disclosed on the Consolidated Balance Sheet as junior subordinated debentures and the related interest expense for each issuance is included in the Consolidated Statements of Income. As of June 30, 2018, and December 31, 2017, unamortized debt issuance costs related to the junior subordinated debentures were $716,000 and $739,000 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, as amended (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 June 30, 2018, 169,791 shares remained available for issuance under the 2014 Plan.
There were no stock options granted or exercised in the six months ended June 30, 2018 and 2017. All stock options are granted for a term of ten years. There is no unrecognized compensation cost related to unvested stock options as all stock options of the Company’s common stock have fully vested.
A summary of stock option activity in the Plans for the six months ended June 30, 2018, is as follows:
Weighted-
Remaining
Exercise
Contractual
Aggregate
Shares
Price
Term (years)
Intrinsic Value
Beginning outstanding
9,000
7.49
Canceled
Expired
Ending outstanding
0.6
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 254,281 restricted awards issued under the 2014 Plan during the six months ended June 30, 2018, which included 140,000 shares granted under a new performance restricted stock unit agreement for select officers and all directors. The performance period covers January 1, 2018 through December 31, 2020, and vesting will be based upon the achievement of certain key Company performance metrics, such as total shareholder return, earnings, and corporate efficiencies. There were 170,000 restricted awards issued during the six months ended June 30, 2017. 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 $1.1 million and $645,000 in the first six months of 2018 and 2017, respectively.
A summary of changes in the Company’s unvested restricted awards for the six months ended June 30, 2018, is as follows:
Restricted
Stock Shares
Grant Date
and Units
Unvested at January 1
465,000
7.79
Granted
254,281
13.98
Vested
(155,500)
5.14
Forfeited
Unvested at June 30
563,781
11.31
Total unrecognized compensation cost of restricted awards was $4.1 million as of June 30, 2018, which is expected to be recognized over a weighted-average period of 2.22 years.
Note 11 – Earnings Per Share
The earnings per share – both basic and diluted – are included below as of June 30 (in thousands except for share and per share data):
Basic earnings per share:
Weighted-average common shares outstanding
29,587,095
29,703,508
29,573,881
Diluted earnings per share:
Dilutive effect of unvested restricted awards1
539,166
426,264
506,234
400,232
Dilutive effect of stock options and warrants
51,038
2,546
43,698
2,431
Diluted average common shares outstanding
30,337,282
30,015,905
30,253,440
29,976,544
Number of antidilutive options and warrants excluded from the diluted earnings per share calculation
900,839
1 Includes the common stock equivalents for restricted share rights that are dilutive.
The above earnings per share calculation also includes a warrant for 815,339 shares of common stock, at an exercise price of $13.43 per share, that was outstanding as of June 30, 2018, as it is considered dilutive. The same warrant was not included as of June 30, 2017, because the warrant was anti-dilutive. The ten-year warrant was issued in 2009, and was sold at auction by the U.S. Treasury in June 2013 to a third party investor.
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 June 30, 2018, the Bank exceeded those thresholds.
At June 30, 2018, the Bank’s Tier 1 capital leverage ratio was 10.75%, an increase of 4 basis points from December 31, 2017, and is well above the 8.00% objective. The Bank’s total capital ratio was 13.51%, an increase of 27 basis points from December 31, 2017, and also well 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 June 30, 2018, and December 31, 2017.
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, 2017, under the heading “Supervision and Regulation.”
At June 30, 2018, and December 31, 2017, the Company, on a consolidated basis, exceeded the minimum thresholds to be considered “well capitalized” under current regulatory defined capital ratios.
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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
185,044
8.49
138,946
6.375
N/A
Old Second Bank
273,950
12.62
138,386
141,099
6.50
Total capital to risk weighted assets
258,854
11.87
215,348
9.875
293,266
13.51
214,360
217,073
10.00
Tier 1 capital to risk weighted assets
239,538
10.99
171,643
7.875
170,947
173,661
8.00
Tier 1 capital to average assets
9.37
102,257
4.00
10.75
101,935
127,419
5.00
179,853
9.25
111,801
5.750
249,417
12.88
111,347
125,870
251,383
12.93
179,837
9.250
266,873
13.78
179,142
193,667
233,927
12.03
140,978
7.250
140,394
154,917
10.08
92,828
10.79
92,462
115,578
1 As of June 30, 2018, amounts are shown inclusive of a capital conservation buffer of 1.875%; as compared to December 31, 2017, of 1.25%.
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 and lease losses is essentially based on recent real estate appraisals or the fair value of the collateralized asset. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are made in the appraisal process by the appraisers to reflect differences between the available comparable sales and income data. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
Nonrecurring adjustments to certain commercial and residential real estate properties classified as OREO are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.
Assets and Liabilities Measured at Fair Value on a Recurring Basis:
The tables below present the balance of assets and liabilities at June 30, 2018, and December 31, 2017, respectively, measured by the Company at fair value on a recurring basis:
Level 1
Level 2
Level 3
Assets:
257,663
18,449
59,661
1,771
Mortgage servicing rights
Interest rate swap agreements
2,287
Mortgage banking derivatives
261
527,302
28,032
559,210
Liabilities:
263,831
14,261
63,671
2,268
727
525,995
23,473
553,415
2,014
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, 2018
Transfers into Level 3
Transfers out of Level 3
Total gains or losses
Included in earnings (or changes in net assets)
520
Included in other comprehensive income
(551)
Purchases, issuances, sales, and settlements
19,934
Issuances
668
Settlements
(554)
(15,195)
(320)
Sales
Ending balance June 30, 2018
Beginning balance January 1, 2017
3,119
22,226
6,489
(1)
(289)
10,456
(463)
(12,045)
(282)
Ending balance June 30, 2017
2,678
20,348
6,528
The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of June 30, 2018:
Measured at fair value
Unobservable
on a recurring basis:
Valuation Methodology
Inputs
Range of Input
of Inputs
Discounted Cash Flow
Discount Rate
10.0 - 417.6%
10.2
Prepayment Speed
7.0 - 68.4%
8.2
32
The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of December 31, 2017:
10.0 - 34.3%
9.6
In addition to the above, Level 3 fair value measurement included $18.4 million for state and political subdivisions representing various local municipality securities and $1.8 million of collateralized mortgage obligations at June 30, 2018. 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 June 30, 2017, was $20.3 million and collateralized mortgage obligation balance in Level 3 was $2.3 million at December 31, 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.
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis:
The Company may be required, from time to time, to measure certain other assets at fair value on a nonrecurring basis in accordance with GAAP. These assets consist of impaired loans and OREO. For assets measured at fair value on a nonrecurring basis at June 30, 2018, and December 31, 2017, 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
8,386
Other real estate owned, net2
17,298
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 $8.9 million and a valuation allowance of $498,000 resulting in an increase of specific allocations within the allowance for loan and lease losses of $90,000 for the six months ended June 30, 2018.
2 OREO is measured at the lower of carrying or fair value less costs to sell, and had a net carrying amount of $8.9 million, which is made up of the outstanding balance of $18.2 million, net of a valuation allowance of $8.3 million and participations of $937,000 at June 30, 2018.
5,113
13,484
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 $5.3 million and a valuation allowance of $144,000, resulting in an increase of specific allocations within the allowance for loan and lease losses of $856,000 for the year December 31, 2017.
2 OREO is measured at the lower of carrying or fair value less costs to sell, and had a net carrying amount of $8.4 million, which is made up of the outstanding balance of $17.5 million, net of a valuation allowance of $8.2 million and participations of $937,000, at December 31, 2017.
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
33
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. For June 30, 2018, the fair values of loans and leases are estimated on an exit price basis incorporating discounts for credit, liquidity and marketability factors. This is not comparable with the fair value disclosures for December 31, 2017, which were estimated using an entrance price basis. For December 31, 2017, fair values of variable rate loans and leases with no significant change in credit risk were based on carrying values. The fair values of other loans and leases were estimated using discounted cash flow analyses which used interest rates being offered for loans and leases with similar terms to borrowers of similar credit quality. The fair value of time deposits is estimated using discounted future cash flows at current rates offered for deposits of similar remaining maturities. The fair values of borrowings were estimated based on interest rates available to the Company for debt with similar terms and remaining maturities. The fair value of off balance sheet volume is not considered material.
The carrying amount and estimated fair values of financial instruments were as follows:
Carrying
Financial assets:
519,548
20,220
FHLBC and FRBC Stock
Loans, net
1,816,393
Accrued interest receivable
10,244
Financial liabilities:
Noninterest bearing deposits
Interest bearing deposits
1,541,044
1,534,109
59,471
33,267
26,204
46,743
Note payable and other borrowings
Borrowing interest payable
192
Deposit interest payable
800
34
520,963
16,529
1,586,722
8,595
1,350,521
1,346,339
Subordinated debenture
140
Note 15 – Derivatives, Hedging Activities and Financial Instruments with Off-Balance Sheet Risk
Risk Management Objective of Using Derivatives
The Company is exposed to certain risk arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s loan portfolio.
Cash Flow Hedges of Interest Rate Risk
The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. During 2018, such derivatives were used to hedge the variable cash flows associated with existing variable-rate borrowings.
For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in Accumulated Other Comprehensive Income and subsequently reclassified into interest expense in the same period(s) during which the hedged transaction affects earnings. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are received on the Company’s variable-rate borrowings. During the next twelve months, the Company estimates that an additional $59,000 will be reclassified as a reduction to interest expense.
Non-designated Hedges
Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this
program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.
Disclosure of Fair Values of Derivative Instruments on the Balance Sheet
The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet as of June 30, 2018 and December 31, 2017.
Fair Value of Derivative Instruments
Asset Derivatives
Liability Derivatives
Number of Transactions
Notional Amount $
Balance Sheet Location
Fair Value $
Derivatives designated as hedging instruments
Interest Rate Products
25,774
Other Assets
Other Liabilities
Total derivatives designated as hedging instruments
Derivatives not designated as hedging instruments
51,548
Other Contracts
15,857
Total derivatives not designated as hedging instruments
512
1,301
Disclosure of the Effect of Fair Value and Cash Flow Hedge Accounting
The fair value and cash flow hedge accounting related to derivatives covered under ASC Subtopic 815-20 impacted Accumulated Other Comprehensive Income (“AOCI”) and the Income Statement. The gain recognized in AOCI on derivatives totaled $473,000 as of June 30, 2018, and a loss in AOCI of $632,000 as of June 30, 2017. The amount of the gain (loss) reclassified from AOCI to interest income on the income statement totaled ($42,000) and ($18,000) for the three months ended June 30, 2018, and June 30, 2017, respectively. The amount of the gain (loss) reclassified from AOCI to interest income or interest expense on the income statement totaled ($116,000) and ($18,000) for the six months ended June 30, 2018, and June 30, 2017, respectively.
Credit-risk-related Contingent Features
For derivative transactions involving counterparties who are lending customers of the Company, the derivative credit exposure is managed through the normal credit review and monitoring process, which may include collateralization, financial covenants and/or financial guarantees of affiliated parties. Agreements with such customers require that losses associated with derivative transactions receive payment priority from any funds recovered should a customer default and ultimate disposition of collateral or guarantees occur.
Credit exposure to broker/dealer counterparties is managed through agreements with each derivative counterparty that require collateralization of fair value gains owed by such counterparties. Some small degree of credit exposure exists due to timing differences between when a gain may occur and the subsequent point in time that collateral is delivered to secure that gain. This is monitored by the Company and procedures are in place to minimize this exposure. Such agreements also require the Company to collateralize counterparties in circumstances wherein the fair value of the derivatives result in loss to the Company.
Other provisions of such agreements include the definition of certain events that may lead to the declaration of default and/or the early termination of the derivative transaction(s):
if the Company either defaults or is capable of being declared in default on any of its indebtedness (exclusive of deposit obligations), then the Company could also be declared in default on its derivative obligations.
if a merger occurs that materially changes the Company's creditworthiness in an adverse manner.
36
If certain specified adverse regulatory actions occur, such as the issuance of a Cease and Desist Order, or citations for actions considered Unsafe and Unsound or that may lead to the termination of deposit insurance coverage by the Federal Deposit Insurance Corporation.
As of June 30, 2018, there were no derivatives in a net liability position. As of June 30, 2018, the Company has not posted any collateral related to derivatives agreements.
The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as that involved in extending loan commitments to our customers. In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO. The following table represents the Company’s contractual commitments due to letters of credit as of June 30, 2018, and December 31, 2017.
The following table is a summary of letter of credit commitments (in thousands):
Fixed
Variable
Letters of credit:
Borrower:
Financial standby
2,017
5,320
7,337
3,770
Commercial standby
395
354
Performance standby
914
6,676
7,590
241
7,594
7,835
2,931
12,391
15,322
418
11,718
12,136
Non-borrower:
67
142
Total letters of credit
12,458
15,389
11,860
12,278
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The following management’s discussion and analysis presents information concerning our financial condition as of June 30, 2018, as compared to December 31, 2017, and our results of operations for the three and six months ended June 30, 2018 and June 30, 2017. 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, 2017. The results of operations for the quarter and six months ended June 30, 2018, are not necessarily indicative of future results.
In this report, unless the context suggests otherwise, references to the “Company,” “we,” “us,” and “our” mean the combined business of Old Second Bancorp, Inc. and its subsidiary bank, Old Second National Bank (the “Bank”).
We have made, and will continue to make, various forward-looking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” on page 3 of this report.
Business Overview
The Company is a banking holding company headquartered in Aurora, Illinois. Through our wholly-owned subsidiary bank, Old Second National Bank, a national banking organization also headquartered in Aurora, Illinois, we offer a wide range of financial services through our 29 banking centers located in Cook, Kane, Kendall, DeKalb, DuPage, LaSalle and Will counties in Illinois. These banking centers offer access to a full range of traditional retail and commercial banking services including treasury management operations as well as fiduciary and wealth management services. We focus our business on establishing and maintaining relationships with our clients while maintaining a commitment to provide for the financial services needs of the communities in which we operate. We emphasize relationships with individual customers as well as small to medium-sized businesses throughout our market area. We also have extensive wealth management services, which includes a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts and employee benefit plan administration services.
Financial Overview
Our community-focused banking franchise experienced total asset and overall market growth in the second quarter of 2018, as compared to the fourth quarter and second quarter of 2017, and we believe we are positioned for further growth as we continue to serve our customers’ needs in a competitive economic environment. While industry and regulatory developments in the past few years have made it challenging to attain the levels of profitability and growth reflected prior to the economic recession of 2007-2009, we are continuing to seek to provide value to our customers and the communities in which we operate, by executing on growth opportunities in our local markets and developing new banking relationships.
The following provides an overview of some of the factors impacting our financial performance for the three and six month period ending June 30, 2018:
This is the first quarter of results of operations that included our recent acquisition of Greater Chicago Financial Corp., and its wholly-owned subsidiary bank, ABC Bank, which closed on April 20, 2018.
Net income for the second quarter of 2018 was $6.3 million, or $0.21 per diluted share, compared to $5.1 million, or $0.17 per diluted share, for the second quarter of 2017. Net income for the six months ended June 30, 2018, totaled $15.8 million, or $0.52 per diluted share, compared to $9.6 million, or $0.32 per diluted share for the six months ended June 30, 2017.
Net interest and dividend income was $23.2 million for the second quarter of 2018, compared to $18.7 million for the quarter ended June 30, 2017. Net interest and dividend income was $42.9 million for the six months ended June 30, 2018, compared to $36.2 million for the like period in 2017.
Noninterest income was $8.5 million for the second quarter of 2018, which reflects an increase of $1.2 million, or 16.6%, compared to the second quarter of 2017. Noninterest income was $17.0 million for the six months ended June 30, 2018, which reflected an 18.8% increase over the like period in 2017.
Noninterest expense was $22.3 million for the second quarter of 2018, which reflects an increase of $4.3 million, or 23.9%, from the second quarter of 2017. For the six months ended June 30, 2018, noninterest expense totaled $39.6 million, an increase of $3.6 million, or 10.0%, over the like period in 2017.
Asset quality remained consistent, with nonperforming loans as a percent of total loans declining to 0.6% as of June 30, 2018 from 1.0% as of June 30, 2017. We added $11.2 million of purchase credit impaired loans (“PCI loans”), net of purchase accounting adjustments, in our acquisition of ABC Bank in the second quarter of 2018. PCI loans, net of purchase accounting adjustments, to total loans were 0.6% as of June 30, 2018. We had no PCI loans before our acquisition of ABC Bank.
Income tax expense declined due to the enactment of the “Tax Cuts and Jobs Act,” which was effective as of January 1, 2018, and lowered the Federal corporate income tax rate to 21%, as well as income tax credits that were recorded in the first quarter of 2018 due to the vesting of restricted stock awards.
Recent Developments
On April 20, 2018, we completed our previously announced acquisition of Greater Chicago Financial Corp., and its wholly-owned bank subsidiary, ABC Bank. In connection with the merger, Greater Chicago Financial Corp merged with and into the Company, with the Company as the surviving company in the merger. Immediately following the merger, ABC Bank, an Illinois state-chartered bank and wholly owned subsidiary of Greater Chicago Financial Corp., merged with and into the Bank, with the Bank as the surviving bank. With the acquisition of ABC Bank, we acquired four branches in the Chicago, Illinois, metropolitan area. We acquired $227.6 million of loans, net of purchase accounting adjustments, and $248.5 million of deposits, net of purchase accounting adjustments for time deposits, in the acquisition.
Critical Accounting Policies
The Company’s consolidated financial statements are prepared based on the application of accounting policies in accordance with generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. These policies require the reliance on estimates and assumptions, which may prove inaccurate or are subject to variations. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements. Changes in underlying factors, assumptions, or estimates could have a material impact on the Company’s future financial condition and results of operations. The most critical of these significant accounting policies are the policies related to the allowance for loan and lease losses, fair valuation methodologies and income taxes. In addition, as a result of our acquisition of Greater Chicago Financial Corporation and its wholly-owned subsidiary, ABC Bank, that closed on April 20, 2018, the Company has implemented accounting policies regarding loans purchased in a business combination, as discussed below and more fully described in Note 1 to our unaudited consolidated financial statements contained in this Quarterly Report on Form 10-Q.
Loans Acquired in Business Combinations
We record purchased loans at fair value at the date of acquisition based on a discounted cash flow methodology that considers various factors, including the type of loan and related collateral, classification status, whether the loan has a fixed or variable interest rate, its term and whether or not the loan was amortizing, and our assessment of risk inherent in the cash flow estimates. These cash flow evaluations are inherently subjective as they require material estimates, all of which may be susceptible to significant change. Purchased loans are segregated into two categories upon purchase: (1) loans purchased without evidence of deteriorated credit quality since origination, referred to as purchased non-credit impaired (“non-PCI”) loans, and (2) loans purchased with evidence of deteriorated credit quality since origination for which it is probable that all contractually required payments will not be collected, referred to as purchased credit impaired (“PCI”) loans.
We account for and evaluate PCI loans for impairment in accordance with the provisions of ASC 310-30. We estimate the cash flows expected to be collected on purchased loans based upon the expected remaining life of the loans, which includes the effects of estimated prepayments. Cash flow evaluations are inherently subjective as they require material estimates, all of which may be susceptible to significant change. We will perform re-estimations of cash flows on our PCI loan portfolio on a quarterly basis. Any decline in expected cash flows as a result of these re-estimations, due in any part to a change in credit, is deemed credit impairment, and recorded as provision for loan and lease losses during the period. Any decline in expected cash flows due only to changes in expected timing of cash flows is recognized prospectively as a decrease in yield on the loan and any improvement in expected cash flows, once any previously recorded impairment is recaptured, is recognized prospectively as an adjustment to the yield on the loan.
Non-PCI loans outside the scope of ASC 310-30 are accounted for under ASC 310-20. For non-PCI loans, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value and the discount is accreted to interest income over the life of the loan. Subsequent to the purchase date, the method used to evaluate the sufficiency of the credit discount is similar to organic loans, and if necessary, additional reserves are recognized in the allowance for loan and lease losses.
No Other Material Changes in Significant Accounting Policies
The Company’s significant accounting policies are more fully described in Note 1 to the audited consolidated financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2017, and the more significant assumptions and estimates made by management are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in our Annual Report on Form 10-K for the year ended December 31, 2017. Other than as described above, there have been no material changes to the Company’s significant accounting policies or the estimates made pursuant to those policies from those disclosed in our 2017 Annual Report on Form 10-K during the most recent quarter.
Non-GAAP Financial Measures
This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of net interest income and net interest income to interest earning assets on a tax equivalent (“TE”) basis, our adjusted efficiency ratio and our tangible common equity to tangible assets ratio. Management believes that the presentation of these non-GAAP financial measures (a) provides important supplemental information that contributes to a proper understanding of our operating performance, (b) enables a more complete understanding of factors and trends affecting our business, and (c) allows investors to evaluate our performance in a manner similar to management, the financial services industry, bank stock analysts, and bank regulators. Management uses non-GAAP measures as follows: in the preparation of our operating budgets, monthly financial performance reporting, and in our presentation to investors of our performance. However, we acknowledge that these non-GAAP financial measures have a number of limitations. Limitations associated with non-GAAP financial measures include the risk that persons might disagree as to the appropriateness of items comprising these measures and that different companies might calculate these measures differently. These disclosures should not be considered an alternative to our GAAP results. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is presented below or alongside the first instance where each non-GAAP financial measure is used.
Results of Operations
Three months ended June 30, 2018 and 2017
Our net income before taxes was $8.0 million in the second quarter of 2018 compared to $7.2 million in the second quarter of 2017. Net interest and dividend income increased $4.6 million, and noninterest income increased $1.2 million in the second quarter of 2018 compared to the second quarter of 2017. These increases to income were partially offset by an increase in provision for loan and lease losses of $700,000, and an increase of $4.3 million in noninterest expense due primarily to acquisition related costs incurred in 2018, which totaled $3.3 million, pretax, for the quarter.
The increase in net interest and dividend income stems from the rising interest rate environment, as well as loan growth due to the ABC Bank acquisition. Loans acquired, net of the purchase accounting adjustments, totaled $227.6 million in the second quarter of 2018. Loans and loans held for sale yielded 5.0% in the second quarter of 2018, compared to 4.57% in the second quarter of 2017.
Management has remained diligent in reviewing our loan portfolio to analyze and to determine if charge-offs are required. In the second quarter of 2018, management’s review of the loan portfolio concluded that additional provision expense of $1.5 million was appropriate, based on analysis of the allowance and loan portfolio held. The analysis methodology incorporated an adjustment in the second quarter of 2018 to include minimal charge-off assumptions for the five year historical look back period, as the Company has experienced a high rate or recoveries in the last few years, and management does not believe this recovery rate is sustainable in the long term. In addition, management assigned a slightly elevated qualitative factor to variable rate commercial and HELOC loans due to the rising interest rate environment. Management determined an additional provision for loan and lease losses of $750,000 was appropriate for the quarter ended June 30, 2017.
Earnings for the second quarter of 2018 were $0.21 per diluted share on $6.3 million of net income, as compared to $0.17 per diluted share on net income of $5.1 million for the second quarter of 2017. Earnings in the 2018 period, compared to the like 2017 period, were positively impacted by increased loan volumes due to the ABC Bank acquisition, as well as the favorable impact of a rising interest rate environment and the federal income tax rate reduction to 21% from 35% stemming from the “Tax Cuts and Jobs Act” passed in late 2017.
Six months ended June 30, 2018 and 2017
Our net income before taxes was $19.5 million for the six months ended June 30, 2018, compared to $13.8 million for the six months ended June 30, 2017. Net interest and dividend income increased $6.7 million, and noninterest income increased $2.7 million for the six months ended June 30, 2018, compared to the like period in 2017. The increase in net interest income was driven by rising interest rates and the ABC Bank acquisition, while the increase in noninterest income was primarily due to a $1.0 million death benefit received on a BOLI claim in the first quarter of 2018, as well as increases in mortgage servicing rights interest rate driven mark to market adjustments. These increases to income were partially offset by a $3.6 million increase in noninterest expenses in the 2018 period due primarily to acquisition related costs incurred year to date of $3.4 million, pretax.
Earnings for the six month period ending June 30, 2018, were $0.52 per diluted share on $15.8 million of net income, as compared to $0.32 per diluted share on net income of $9.6 million for the six month period ending June 30, 2017. Earnings in the 2018 period, compared to the like 2017 period, were positively impacted by increased loan volumes due to the ABC Bank acquisition, recoveries on a few nonperforming credits and the BOLI death benefit in the first quarter of 2018, as well as the favorable impact of a rising interest rate environment and the federal income tax rate reduction to 21% from 35% stemming from the “Tax Cuts and Jobs Act” passed in late 2017. The performance of our loan portfolio, the impact of the restructuring of our securities portfolio into higher yielding instruments and organic loan growth in the year over year period also contributed to the increase in earnings for the 2018 period
Net Interest Income
Net interest income, which is our primary source of earnings, is the difference between interest income earned on interest-earning assets, such as loans and investment securities, as well as accretion income on purchased loans, and interest incurred on interest-bearing liabilities, such as deposits and borrowings. Net interest income depends upon the relative mix of interest-earning assets and interest-bearing liabilities, the ratio of interest-earning assets to total assets and of interest-bearing liabilities to total funding sources, and movements in market interest rates. Our net interest income can be significantly influenced by a variety of factors, including overall loan demand, economic conditions, credit risk, the amount of nonearning assets including nonperforming loans and OREO, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities, early withdrawal of deposits, exercise of call options on borrowings or securities, a general rise or decline in interest rates, changes in the slope of the yield-curve, and balance sheet growth or contraction.
Net interest and dividend income increased by $4.6 million from $18.7 million for the quarter ended June 30, 2017, to $23.2 million for the quarter ended June 30, 2018. Our interest and dividend income increased $4.1 million, or 17.8%, for the quarter ended June 30, 2018 compared to the first quarter of 2018, and reflected an increase of $5.5 million, or 25.1%, compared to the second quarter of 2017. Tax equivalent interest and dividend income increased by $5.1 million from $22.7 million for the quarter ended June 30, 2017, to $27.8 million for the quarter ended June 30, 2018. Average earning assets for the quarter ended June 30, 2018, were $2.39 billion reflecting an increase of $217.2 million compared to the first quarter of 2018, and an increase of $276.5 million compared to the second quarter of 2017. Total average loans, including loans held-for-sale, totaled $1.81 billion in the second quarter of 2018, which reflected an increase of $206.1 million compared to the first quarter of 2018, and an increase of $299.9 million compared to the second quarter of 2017. The growth in average balances and resultant interest income was primarily due to $227.6 million of loans acquired, net of purchase accounting adjustments, in our acquisition of ABC Bank on April 20, 2018. In addition, the rising interest rate environment in the 2018 period and the repositioning on our securities portfolio over the past year has driven higher yields and growth in interest and dividend income. Total securities yields have increased by 15 basis points for the quarter ended June 30, 2018, compared to the quarter ended June 30, 2017, due to the repositioning of our portfolio into higher yielding tax exempt securities. Our average tax exempt securities portfolio increased by $61.4 million in the second quarter of 2018 compared to the second quarter of 2017; yields have declined in the portfolio on a tax equivalent basis due to the lower federal income tax rate effective in 2018.
Quarterly average interest bearing liabilities increased $162.1 million, or 10.2%, as of June 30, 2018, compared to March 31, 2018, and increased $178.5 million, or 11.4%, compared to June 30, 2017. Growth from the prior periods was primarily due to deposits of $248.5 million, net of purchase accounting adjustments, recorded in our acquisition of ABC Bank in the second quarter of 2018. In addition, an increase in the average balances of securities sold under repurchase agreements, as well as other short-term borrowed funds, which primarily consist of FHLBC advances, was reflected. The short-term FHLBC advances were impacted by the higher interest rate environment in the second quarter of 2018, reflecting a cost of funds of 1.90% compared to 1.53% for the first quarter of 2018, and 0.99% for the second quarter of 2017. The rate on our junior subordinated debentures declined in the second quarter of 2018, compared to the second quarter of 2017, due to the rate conversion on the debt from fixed to floating rate at three month LIBOR plus 150 basis points on June 15, 2017. Upon conversion to a floating rate, we initiated a cash flow hedge that resulted in a reduction in the total interest rate paid on the debt from 6.77% prior to June 15, 2017, to 4.34% as June 30, 2018. This rate conversion and hedge resulted in a reduction of $132,000 of expense related to our interest on our junior subordinated debt in the second quarter of 2018 compared to the second quarter of 2017.
41
Our net interest margin (on a tax-equivalent basis), expressed as a percentage of average earning assets, was 3.99% in the second quarter of 2018, reflecting a 23 basis point increase from the first quarter of 2018, and an increase of 28 basis points from the second quarter of 2017. The average tax-equivalent yield on earning assets increased to 4.67% for the second quarter of 2018, compared to 4.42% for the first quarter of 2018 and 4.26% for the second quarter of 2017. Increases in net interest margin and yield on average earning assets for the second quarter of 2018 compared to the second quarter of 2017 was attributable to growth in loan volumes and rates, as well as the restructuring of our securities portfolio into higher yielding tax exempt holdings, as discussed above. The cost of funds on interest bearing liabilities was 0.92% for the second quarter of 2018, 0.90% for the first quarter of 2018, and 0.80% for the second quarter of 2017. The increase in our cost of funds in each period was driven by the rising interest rate environment, specifically impacting the rates on newly issued time deposits and FHLBC advances.
Net interest and dividend income increased by $6.6 million from $36.2 million for the six months ended June 30, 2017, to $42.9 million for the six months ended June 30, 2018. Our interest and dividend income increased $8.0 million, or 18.8%, for the six months ended June 30, 2018 compared to the six months ended June 30, 2017. Tax equivalent interest and dividend income increased by $7.7 million from $43.8 million for the six months ended June 30, 2017, to $51.5 million for the six months ended June 30, 2018.
Our net interest margin (on a tax equivalent basis) for the six months ended June 30, 2018, was 3.88% compared to 3.63% for the like 2017 period, reflecting a 25 basis point increase. Average earning assets for the six months ended June 30, 2018, were $2.28 billion, reflecting an increase of $190.7 million compared to the six months ended June 30, 2017. The yield on average earning assets for the six months ended June 30, 2018, was 4.55%, compared to 4.17% for the six months ended June 30, 2017. Average interest bearing liabilities for the six months ended June 30, 2018, increased $105.3 million, or 6.8%, compared to the six months ended June 30, 2017. The cost of funds for the six months ended June 30, 2018, was 91 basis points, compared to the cost of funds of 80 basis points for the like 2017 period. Growth in volumes and rates has resulted in an increase for all line items presented, excluding the junior subordinated debentures. The rate on our junior subordinated debentures declined 95 basis points in the six months ended June 30, 2018, compared to the like 2017 period, due to the rate conversion on the debt from fixed to floating rate at three month LIBOR plus 150 basis points on June 15, 2017, as described above.
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 in the following tables have been adjusted to a non-GAAP tax equivalent (“TE”) basis using a marginal rate of 21% in 2018 and 35% in 2017 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)
Quarters Ended
March 31, 2018
Rate
19,161
2.03
13,819
1.44
11,938
1.03
268,591
3.57
269,330
2,170
361,504
2.88
Non-taxable (TE)
286,611
3.74
279,831
2,609
3.78
225,182
2,536
4.50
Total securities
555,202
5,068
3.66
549,161
4,779
3.53
586,686
5,143
3.51
Dividends from FHLBC and FRBC
8,619
5.17
8,920
4.82
7,699
4.78
Loans and loans held-for-sale1
1,809,077
22,552
1,602,947
18,767
4.75
1,509,188
17,445
4.57
Total interest earning assets
2,392,059
27,828
4.67
2,174,847
23,701
4.42
2,115,511
22,711
4.26
36,720
29,776
39,425
Allowance for loan and lease losses
(18,494)
(18,263)
(15,779)
Other noninterest bearing assets
176,608
166,507
189,928
2,586,893
2,352,867
2,329,085
Liabilities and Stockholders' Equity
443,586
0.22
429,301
176
432,248
107
0.10
317,775
0.24
275,334
0.16
280,482
86
0.12
Savings accounts
298,240
70
0.09
266,363
265,066
0.06
460,909
1.26
382,422
1,175
1.25
392,779
1.05
1,520,510
1,945
0.51
1,353,420
1,519
0.46
1,370,575
1,258
0.37
44,655
0.93
40,275
79
0.80
35,652
0.05
58,199
1.90
87,444
329
1.53
58,572
0.99
57,657
6.45
57,645
6.52
57,609
7.35
44,096
6.11
44,071
6.18
43,995
19,795
1.92
Total interest bearing liabilities
1,744,912
0.92
1,582,855
3,526
0.90
1,566,403
618,765
554,624
557,265
15,679
18,047
Stockholders' equity
207,537
201,419
187,370
Total liabilities and stockholders' equity
Net interest income (TE)
23,809
20,175
19,572
to total earning assets
3.99
3.76
3.71
Interest bearing liabilities to earning assets
1 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 45, and includes fees of $233,000, $182,000 and $573,000 for the second quarter of 2018, the first quarter of 2018, and the second quarter of 2017, respectively. Nonaccrual loans are included in the above-stated average balances.
Analysis of Average Balances,
Tax Equivalent Interest and Rates
Six Months Ended June 30, 2018, and 2017
16,505
1.78
12,029
0.89
268,959
3.42
391,646
2.84
283,240
5,285
183,708
3,939
4.29
552,199
9,847
3.60
575,354
9,509
3.31
8,769
4.99
7,657
4.62
1,706,581
41,319
4.88
1,498,268
34,100
4.53
2,284,054
51,529
4.55
2,093,308
43,840
4.17
36,521
(18,379)
(16,034)
171,585
191,374
2,470,527
2,305,169
436,483
414
0.19
429,443
296,672
302
282,042
169
282,390
262,240
421,882
393,579
1,437,427
3,464
0.49
1,367,304
2,460
0.36
42,477
0.87
32,745
0.04
72,741
1.68
57,348
57,651
6.49
57,603
7.44
44,084
6.15
43,987
6.12
9,952
1,664,332
0.91
1,558,987
586,871
541,447
14,829
21,535
204,495
183,200
43,984
37,634
Net interest income (TE) to total earning assets
3.88
3.63
1 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 45, and includes fees of $414,000 and $1.1 million for the first six months of 2018 and 2017, respectively. Nonaccrual loans are included in the above-stated average balances.
44
Reconciliation of Tax-Equivalent Non-GAAP Financial Measures
Net interest income and net interest income to earning assets have been adjusted to a non-GAAP TE basis using a marginal rate of 21% for 2018 and 35% for 2017 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:
March 31,
Net Interest Margin
Interest income (GAAP)
23,142
Taxable-equivalent adjustment:
548
888
1,110
1,379
Interest income (TE)
Interest expense (GAAP)
Net interest income (GAAP)
19,616
Average interest earning assets
Net interest margin (GAAP)
Net interest margin (TE)
Noninterest Income and Expense
The following table details the major components of noninterest income for the periods presented:
2nd Qtr 2018
Noninterest Income
Percent Change From
(dollars in thousands)
1,495
10.0
0.4
1,592
11.1
9.5
Residential mortgage banking revenue
162
20.4
(12.6)
N/M
38.7
41.2
917
35.2
(15.8)
Total residential mortgage banking revenue
1,957
1,836
1,711
6.6
14.4
Securities gain (loss), net
791.4
338.2
41.5
0.3
Death benefit realized on BOLI
1,012
11.9
4.7
Gain on disposal and transfer of fixed assets
1,261
8.3
31.2
8,505
16.6
N/M - Not meaningful
Noninterest income for the second quarter of 2018 increased $27,000, or 0.3%, compared to the first quarter of 2018, and increased $1.2 million, or 16.6%, compared to the second quarter of 2017.
The increase in noninterest income in the second quarter of 2018, compared to the first quarter of 2018, was driven primarily by increases in trust income, service charges on deposit accounts, total residential mortgage banking revenue, securities gains and debit card interchange income, partially offset by a decrease in death benefit realized on BOLI. Securities gain (loss), net, experienced the most significant positive fluctuation, as a percentage of total change on a linked quarter basis, as we repositioned our securities portfolio over the past year. Mortgage servicing income and net gain on the sale of mortgage loans contributed the majority of total residential mortgage banking revenue growth in the second quarter of 2018 compared to the prior linked quarter, due to volume increases in the rising rate environment. The $1.0 million of death benefit realized on BOLI in the first quarter of 2018 was due to the death of a covered employee in February 2018.
The increase in noninterest income in the second quarter of 2018 compared to the second quarter of 2017 was driven primarily by increases in service charges on deposit accounts, total residential mortgage banking revenue, securities gains and other income. Securities gain (loss), net, experienced the most significant positive fluctuation, as a percentage of total change on a year over year basis, as we repositioned our securities portfolio over the past year. Mortgage servicing income and mortgage servicing rights mark to market adjustments contributed to the total residential mortgage banking revenue growth in the second quarter of 2018 compared to the second quarter of 2017, due to volume increases in the rising rate environment. The increase in other income was primarily attributable to an increase in commercial swap fee income of $186,000 in the second quarter of 2018 compared to the second quarter of 2017.
The following table details the major components of noninterest expense for the periods presented:
Noninterest Expense
Salaries
9,703
7,335
7,972
32.3
21.7
Officers incentive
740
787
854
(6.0)
(13.3)
Benefits and other
1,912
2,085
1,719
(8.3)
11.2
Total salaries and employee benefits
10,207
21.0
17.2
Occupancy, furniture and equipment expense
1,558
6.0
13.0
103.9
146.5
156
5.8
19.1
13.3
Amortization of core deposit intangible asset
361.9
288.0
44.3
8.8
281
7.1
(24.6)
159
79.9
55.4
Other real estate owned expense, net
173
148.0
(20.4)
2,863
21.2
22.2
17,354
28.4
23.9
Efficiency ratio (GAAP)
69.16
63.41
66.73
Adjusted efficiency ratio (non-GAAP)1
57.88
60.50
62.95
1 The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding OREO expenses, amortization of core deposits and acquisition costs, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains and losses on securities and includes a tax equivalent adjustment on the increase in cash surrender value of BOLI and the BOLI death benefit recorded.
See the section entitled “Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures” on page 47 for a reconciliation of this non-GAAP measure to the most comparable GAAP equivalent.
Noninterest expense for the second quarter of 2018 increased $4.9 million, or 28.4%, compared to the first quarter of 2018, and increased $4.3 million, or 23.9%, compared to the second quarter of 2017.
The increase in noninterest expense in the second quarter of 2018, compared to the first quarter of 2018, was primarily attributable to ABC Bank acquisition-related costs incurred in the second quarter of 2018, which included $1.2 million of salaries and employee benefit expense, $1.6 million of computer and data processing expense, $114,000 of legal expense, and $76,000 of core deposit intangible amortization. Other expense for the second quarter of 2018 reflects an increase from the prior linked quarter due to various acquisition related costs such as appraisals, audit fees, and consulting expenses.
The increase in noninterest expense in the second quarter of 2018 compared to the second quarter of 2017 was primarily attributable to ABC Bank acquisition-related costs incurred in the second quarter of 2018, which included $1.2 million of salaries and employee benefit expense, $1.6 million of computer and data processing expense, $114,000 of legal expense, and $76,000 of core deposit intangible amortization. The increase in noninterest expense in the second quarter of 2018 was partially offset by reduced OREO related costs in 2018, compared to the second quarter of 2017, as our OREO portfolio balance continued to decline.
Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures
Efficiency Ratio
Less amortization of core deposit
Less other real estate expense, net
Less transition related executive costs
294
Less acquisition related costs
3,168
246
Adjusted noninterest expense
18,592
16,914
17,128
Increase in cash surrender value of BOLI (TE)
93
339
Noninterest income (TE)
8,625
8,844
7,505
Less death benefit related to BOLI
Less securities gain (loss), net
Adjusted noninterest income, plus net interest income (TE)
32,122
27,958
27,208
Adjusted efficiency ratio (non-GAAP)
Income Taxes
The Company recorded a tax expense of $1.8 million on $8.0 million of pre-tax income for the second quarter of 2018, compared to an income tax expense of $2.0 million in the first quarter of 2018 and $2.1 million of income tax expense in the second quarter of 2017. The effective tax rate for the second quarter of 2018 was 22.1%, an increase from 17.4% for the first quarter of 2018, but a decrease from 28.9% in the second quarter of 2017. Lower tax rates were effective in 2018 due to the “Tax Cuts and Jobs Act” which was signed into law in December 2017, and resulted in the federal corporate tax rate being reduced to 21% from 35%. We recorded an income tax expense credit of $483,000 in the first quarter of 2018 related to the vesting of restricted stock awards; this credit also contributed to the reduction of the effective tax rate for the first quarter. The first quarter of 2018 was also favorably impacted by the receipt of a $1.0 million death benefit realized on BOLI, which is not taxable. Income tax expense reflected all relevant statutory tax rates and GAAP accounting.
There were no significant changes in the Company’s ability to utilize the deferred tax assets during the quarter ended June 30, 2018. The Company has no valuation reserve on the deferred tax assets as of June 30, 2018.
Financial Condition
Total assets increased $266.3 million from $2.38 billion as of December 31, 2017, to $2.65 billion at June 30, 2018, due primarily to the Company’s acquisition of ABC Bank in the second quarter of 2018. Total loans as of June 30, 2018, increased $231.5 million, or 14.3%, compared to December 31, 2017. The securities portfolio totaled $543.6 million at June 30, 2018, an increase of $2.2 million from $541.4 million at December 31, 2017. Total deposits also reflected an increase in the second quarter of 2018, ending at $2.16 billion, compared to $1.92 billion at December 31, 2017, due primarily to the ABC Bank acquisition which contributed $248.5 million, net of purchase accounting adjustments, of deposit growth.
47
As of
(in thousands)
(1.8)
(6.5)
20,846
9.8
(35.7)
225,518
(0.7)
22.4
12,616
(16.0)
(94.5)
100,913
(6.8)
(39.1)
140,385
(3.2)
(22.2)
67,949
(1.9)
568,227
(4.3)
Available-for-sale security purchases during the second quarter of 2018 consisted primarily of collateralized loan obligations, whereas purchases during the year over year period were primarily tax exempt state and political subdivisions securities. We immediately liquidated the securities portfolio acquired with our acquisition of ABC Bank in the second quarter of 2018 as the holdings were not considered consistent with our investment strategies. This liquidation resulted in a cash inflow of approximately $72.1 million. During the second quarter of 2018, security sales resulted in net realized gains of $312,000, as compared to net realized gains of $639,000 for the fourth quarter of 2017 and net realized losses of $131,000 for the second quarter of 2017.
Total loans were $1.85 billion as of June 30, 2018, an increase of $231.5 million from total loans as of December 31, 2017. The increase in total loans was due primarily to our acquisition of ABC Bank in April 2018, which resulted in $227.6 million of loans recorded, net of purchase accounting adjustments. Significant loan payoffs continued to occur in the second quarter of 2018, including payoff of one large commercial relationship of approximately $21.5 million. We continued to diversify our loan portfolio driving organic growth in commercial loans in the second quarter of 2018 compared to December 31, 2017, and June 30, 2017. We also purchased $21.8 million of high grade multifamily real estate loans in the second quarter of 2018, which contributed to the total residential real estate growth, excluding PCI loans, of $91.5 million from December 31, 2017, to June 30, 2018.
Total loans increased $309.5 million from June 30, 2017, to June 30, 2018, due primarily to our acquisition of ABC Bank, as discussed above, as well as organic loan growth in commercial, real estate-construction, leases, and real estate-residential loans, the high grade multifamily real estate loan purchase of $21.8 million in June 2018, and the home equity portfolio purchase from TCF Bank in the first quarter of 2018 of $20.0 million.
16.7
(2.4)
(4.9)
7.6
14.5
35.6
23.3
29.2
43.5
13.4
10.3
13,383
14,137
4.4
(1.2)
1,538,969
13.6
19.4
678
63.5
64.0
14.3
20.1
The quality of our loan portfolio is impacted not only by the Company’s credit decisions but also by the economic health of the communities in which we operate. Since we are located in a corridor with significant open space and undeveloped real estate, real
estate lending (including commercial, construction, residential, and HELOCs) have been and continue to be a sizeable portion of our portfolio. These categories comprised 78.8% of the portfolio as of June 30, 2018, compared to 78.0% of the portfolio as of December 31, 2017. We continue to oversee and manage our loan portfolio in accordance with interagency guidance on risk management.
Asset Quality
The Company recorded a provision for loan and lease losses of $1.5 million as of June 30, 2018, compared to a provision of $750,000 as of June 30, 2017. On a quarterly basis, management estimates the amount required and records the appropriate provision expense or release to maintain an adequate reserve for all potential and estimated loan and lease losses.
Nonperforming loans consist of nonaccrual loans, performing restructured accruing loans and loans 90 days or greater past due. PCI loans with an accretable yield are considered current, and are not included within nonperforming loans. Remediation work continues in all segments. Nonperforming loans decreased by $3.8 million at June 30, 2018, from $15.6 million at both December 31, 2017, and June 30, 2017. Credit metrics continue to be relatively stable regarding nonperforming loan levels, and management is carefully monitoring loans considered to be in a classified status. Nonperforming loans as a percent of total loans decreased to 0.6% as of June 30, 2018, from 1.0% as of December 31, 2017, and June 30, 2017. The distribution of the Company’s nonperforming loans is shown in the following table.
Nonperforming Loans
(100.0)
Real estate-commercial, nonfarm
5,012
3,289
3,055
52.4
64.1
Real estate-construction
635
215.9
188.6
Real estate-residential:
409
686
9.9
(40.4)
4,824
4,278
4,964
4,285
(13.8)
(0.2)
1,524
1,890
1,863
(19.4)
(18.2)
128.6
77.8
Total nonperforming loans
11,874
15,624
15,618
(24.0)
Loan Charge-offs, net of recoveries
% of
Total1
(77)
(24.3)
0.1
0.2
2.5
(0.3)
Owner general purpose
8.5
(41)
2.8
Owner special purpose
(21)
1.4
(0.9)
Non-owner general purpose
(20)
(6.3)
(313)
21.6
(39)
Non-owner special purpose
476
150.2
(87)
Total real estate-commercial, nonfarm
483
152.4
31.9
(0.1)
(0.6)
(4)
(48)
(7.3)
(18)
1.2
(1.7)
Total real estate-construction
(19)
1.3
(60)
(9.2)
Real estate-residential
(63)
(19.9)
(30)
2.1
(3.5)
(175)
12.1
19.7
(26)
(8.2)
(766)
52.9
110.4
Total real estate-residential
(100)
(31.6)
(971)
67.1
836
127.7
(109)
(16.6)
Other 2
9.2
(1.5)
Net charge-offs / (recoveries)
317
100.0
(1,449)
655
1 Represents the percentage of net charge-offs attributable to each category of loans.
2 The “Other” class includes consumer and overdrafts.
Net charge-offs for the second quarter of 2018 were $317,000, compared to net recoveries of $1.4 million for the first quarter of 2018 and net charge-offs of $655,000 for the second quarter of 2017, reflecting continuing management attention to credit quality. We have continued our conservative loan valuations and aggressive recovery efforts on prior charge-offs.
The following table shows classified assets by segment for the following periods.
Classified Assets
54.1
610
(11.6)
12,362
6,098
7,494
102.7
65.0
Real estate-commercial, farm
2,439
1,305
(48.8)
(4.4)
397
(1.3)
(7.8)
436
843
136.0
22.1
5,476
4,935
2,038
1,963
(16.8)
Total classified loans
17,486
22,485
50.5
17.0
6.5
Total classified assets, excluding PCI loans
35,230
25,857
34,209
36.2
3.0
PCI, net of purchase accounting adjustments
Total classified assets
46,444
79.6
35.8
Classified loans include nonaccrual, performing troubled debt restructurings and all other loans considered substandard. Classified assets include both classified loans and OREO. Loans classified as substandard are inadequately protected by either the current net
worth and ability to meet payment obligations of the obligor, or by the collateral pledged to secure the loan, if any. These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and carry the distinct possibility that the Company will sustain some loss if deficiencies remain uncorrected.
Total classified loans and total classified assets both increased as of June 30, 2018, from the levels at December 31, 2017 and June 30, 2017 due to loans purchased in our acquisition of ABC Bank in the second quarter of 2018. Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the allowance for loan and lease losses as another measure of overall change in loan related asset quality, which is referred to as the “classified assets ratio.” The classified assets ratio was 12.01% for the period ended June 30, 2018, compared to 11.87% as of December 31, 2017, and 13.66% as of June 30, 2017.
Allowance for Loan and Lease Losses
Below is a reconciliation of the activity for loan losses for the periods indicated (in thousands):
Allowance at beginning of period
Charge-offs:
(96)
99
Total charge-offs
(25)
Recoveries:
367
Total recoveries
1,424
(1,132)
1,072
Provision (release) for loan and lease losses
(722)
Allowance at end of period
Average total loans (exclusive of loans held-for-sale)
1,806,209
1,600,594
1,505,572
1,703,969
1,495,122
Net charge-offs / (recoveries) to average loans
0.02
(0.09)
(0.07)
0.07
Allowance at period end to average loans
1.07
1.14
1.13
1.06
588
17,600
Net charge-offs for the quarter ended June 30, 2018, totaled $317,000, compared to $655,000 of net charge-offs for the quarter ended June 30, 2017. Net recoveries for the six months ended June 30, 2018 were $1.1 million, compared to net charge-offs of $1.1 million for the six months ended June 30, 2017. The coverage ratio of the allowance for loan and lease losses to nonperforming loans was 162.7% as of June 30, 2018, which was an increase from the coverage ratio of 111.8% as of December 31, 2017, and 101.4% coverage ratio as of June 30, 2017. When measured as a percentage of average loans as of June 30, 2018, our total allowance for loan and lease losses decreased to 1.07% of quarterly average loans from 1.14% as of March 31, 2018, but increased compared to 1.05% as of June 30, 2017. The total allowance for loan and lease losses as a percent of total period end loans was 1.22% as of June 30, 2018, excluding the loans purchased from the ABC Bank and Talmer branch acquisitions. Total charge-offs for the quarter ended March 31, 2018, reflected a negative balance due to the unearned net loan fees on loans charged off in prior periods being taken as a charge-off reduction in the first quarter of 2018.
In accordance with the accounting guidance for business combinations, there was no allowance brought forward on any of the acquired loans in our acquisition of ABC Bank or our Talmer branch purchase. For non-PCI loans, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value and the discount is accreted to interest income over the life of the loan. Subsequent to the purchase date, the method used to evaluate the sufficiency of the credit discount is similar to organic loans, and if necessary, additional reserves are recognized in the allowance for loan and lease losses. The aggregate non-PCI loans related to our acquisition of ABC Bank and the Talmer branch purchase totaled $332.8 million as of June 30, 2018, net of purchase accounting adjustments, which included $2.3 million of credit discounts. At June 30, 2018, of our $19.3 million allowance for loan and lease losses, $1.2 million related to non-PCI loans. In management’s judgment, an adequate allowance for estimated losses has been established for inherent losses at June 30, 2018, and general changes in lending policy, procedures and staffing, as well as other external factors. However, there can be no assurance that actual losses will not exceed the estimated amounts in the future, based on unforeseen economic events, changes in business climates and the condition of collateral at the time of default and repossession.
We recorded PCI loans in our acquisition of ABC Bank, which totaled $11.2 million, net of purchase accounting adjustments, which included $6.4 million of credit discounts as of June 30, 2018. We will perform re-estimations of cash flows on our PCI loan portfolio on a quarterly basis. Any decline in expected cash flows as a result of these re-estimations, due in any part to a change in credit, is deemed credit impairment, and recorded as provision for loan and lease losses during the period. Any decline in expected cash flows due only to changes in expected timing of cash flows is recognized prospectively as a decrease in yield on the loan and any improvement in expected cash flows, once any previously recorded impairment is recaptured, is recognized prospectively as an adjustment to the yield on the loan.
Other Real Estate Owned
As of June 30, 2018, OREO increased to $8.9 million, compared to $8.4 million at December 31, 2017 and $11.7 million at June 30, 2017. There were eight additions to the OREO portfolio in the second quarter of 2018. The increase of $2.8 million in OREO for the quarter ended June 30, 2018, compared to the quarter ended June 30, 2017, was a result of our acquisition of ABC Bank. The $709,000 in property disposals in the second quarter of 2018 was due to four property sales. Valuation write-downs continued with an expense of $254,000 recorded on six properties in the second quarter of 2018, compared to $78,000 of valuation write-downs recorded in the fourth quarter of 2017, and $392,000 of valuation write-downs recorded in the second quarter of 2017.
OREO
9,024
(21.7)
(47.6)
Property disposals
575
(54.8)
225.6
(35.2)
Total other real estate owned
In management’s judgment, the property valuation allowance as established presents OREO at current estimates of fair value less estimated costs to sell; however, there can be no assurance that additional losses will not be incurred on disposals or upon updates to valuations in the future. Of note, properties valued in total at $4.7 million, or approximately 52.2% of total OREO at June 30, 2018, 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
900
986
Lots (single family and commercial)
4,395
5,329
6,305
Vacant land
470
Multi-family
Commercial property
1,587
1,663
3,717
Total OREO properties
Deposits and Borrowings
Deposits
546,463
265,643
15.1
429,205
1.5
276,867
16.3
15.9
221,806
15.0
12.3
115,279
43.0
52.0
54,882
33.7
1,910,145
12.4
13.2
Total deposits were $2.16 billion as of June 30, 2018, which reflects a $238.9 million increase from total deposits of $1.92 billion as of December 31, 2017, and an increase of $251.7 million over the $1.91 billion as of June 30, 2017. The growth in deposits was primarily due to our acquisition of ABC Bank, as $248.5 million of deposits were recorded, net of purchase accounting adjustments. Total noninterest bearing demand accounts increased $48.4 million, or 8.5%, to $620.8 million as of June 30, 2018, compared to noninterest bearing demand accounts of $572.4 million as of December 31, 2017. Certificates of deposit reflected an increase of $100.0 million, or 26.1%, for the six months ended June 30, 2018, and savings and money market accounts reflected growth of 15.1% and 16.3%, respectively, for the same period. In addition to deposit growth experienced related to the ABC Bank acquisition, an increase in deposits in the second quarter of 2018 compared to the prior year end and year over year periods was attributable to strong commercial demand deposit growth stemming from operational fund increases as well as growth in commercial loan clients over the past year.
In addition to deposits, the Bank obtained funding from other sources in all periods presented. Securities sold under repurchase agreements totaled $54.0 million at June 30, 2018, an increase from $29.9 million at December 31, 2017. The Bank also recorded a short-term advance of $72.6 million from the FHLBC at June 30, 2018, as compared to $115.0 million in short term borrowings outstanding from the FHLBC as of December 31, 2017. The Bank also assumed $23.5 million of long-term FHLBC advances with the ABC Bank acquisition, with maturities scheduled over the next 7.75 years and paying interest at rates of 1.40% to 2.83 %.
The Company is indebted on senior notes totaling $44.1 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 semi-annually at 5.75% for five years. Beginning December 2021, the interest becomes payable quarterly at three month LIBOR plus 385 basis points. The Company is also indebted on $57.7 million, net of deferred issuance costs, of junior subordinated debentures, which are related to the trust preferred securities issued by its two statutory trust subsidiaries, Old Second Capital Trust I and Old Second Capital Trust II (“Trust II”). The Trust II issuance converted from fixed to floating rate at three month LIBOR plus 150 basis points on June 15, 2017. Upon conversion to a floating rate, we initiated a cash flow hedge which resulted in the total interest rate paid on this debt of 4.34% as of June 30, 2018, as compared to 6.77%, which was the rate paid during the period prior to the June 15, 2017 rate reset.
As of June 30, 2018, total stockholders’ equity was $209.8 million, which was an increase of $9.5 million from $200.4 million as of December 31, 2017. This increase is directly attributable to net income of $15.8 million for the first six months of 2018, partially offset by an accumulated other comprehensive net loss of $6.0 million, and $594,000 of dividends paid to common shareholders in 2018 year to date.
The Company’s total stockholders’ equity continues to include $4.8 million related to the value of a ten-year warrant to purchase shares of its common stock, with an exercise price of $13.43 per share. This warrant was issued in January 2009 as part of the Company’s Series B preferred stock issuance; all preferred stock issued was redeemed as of September 30, 2015. 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, 2017, under the heading “Capital”.
53
The following table shows the regulatory capital ratios and the current well capitalized regulatory requirements for the Company and the Bank as of the dates indicated:
Well-Capitalized1
The Bank's common equity tier 1 capital ratio 1
12.46
The Company's common equity tier 1 capital ratio
8.55
The Bank's total capital ratio 1
13.30
The Company's total capital ratio
12.14
The Company's tier 1 leverage ratio
9.09
1 Prompt corrective action provisions are only applicable at the Bank level.
The Company, on a consolidated basis, exceeded the minimum capital ratios to be deemed “well capitalized” as of June 30, 2018, pursuant to the capital requirements in effect at that time. All ratios conform to the regulatory calculation requirements in effect as of the date noted. In addition to the above regulatory ratios, the Company’s GAAP common equity to asset ratio, which is used as a performance measurement for capital analysis and peer comparisons, decreased from 8.41% at December 31, 2017 to 7.92% at June 30, 2018, due to the ABC Bank acquisition. The Company’s non-GAAP tangible common equity to tangible assets ratio, which management also considers a valuable performance measurement for capital analysis, decreased from 8.07% at December 31, 2017, to 7.19% at June 30, 2018; the reduction was due to intangibles of $13.0 million recorded related to the Company’s acquisition of ABC Bank in the second quarter of 2018.
Reconciliation of Tangible Common Equity to Tangible Assets Ratio Non-GAAP Measure
The Company’s GAAP tangible common equity to tangible assets ratio was 7.14% at June 30, 2018, compared to 8.06% as of December 31, 2017.
GAAP
Non-GAAP
Tangible common equity
Total Equity
Less: Intangible assets
20,692
8,813
187,740
189,122
191,428
191,537
Tangible assets
Less: Goodwill and intangible assets
2,627,674
2,629,056
2,374,507
2,374,616
Common equity to total assets
7.92
8.41
Tangible common equity to tangible assets
7.14
7.19
8.06
8.07
The non-GAAP intangible asset exclusion reflects the 80% core deposit limitation per Basel III guidelines within risk based capital calculations, and is useful for the Company when reviewing risk based capital ratios and equity performance metrics.
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 $27.6 million during the first six months of 2018, compared with net cash inflows of $34.5 million in the same period in 2017. 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 six months of 2018 and 2017. Interest paid, net of interest received, combined with changes in other assets and liabilities were a source of inflows for the first six months of 2018 and 2017. The management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows. Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, as part of the balance sheet management process.
Net cash inflows from investing activities were $23.3 million in the first six months of 2018, compared to net cash outflows of $88.8 million in the same period in 2017. In the first six months of 2018, securities transactions accounted for net inflows of $61.0 million, and the principal change on loans accounted for net outflows of $4.4 million. Proceeds from claims on BOLI, net of premiums paid, accounted for net inflows of $1.2 million. In the first six months of 2017, securities transactions accounted for net outflows of $27.0 million, and net principal disbursed on loans accounted for net outflows of $64.8 million. Proceeds from sales of OREO accounted for $2.1 million and $3.3 million in investing cash inflows for the first six months of 2018 and 2017, respectively. Cash outflows for the six months ended June 30, 2018, included cash paid for the Company’s purchase of ABC Bank of $35.7 million, net of cash and cash equivalents retained.
Net cash outflows from financing activities in the first six months of 2018 were $41.5 million, compared with net cash inflows of $58.1 million in the first six months of 2017. Net deposit outflows in the first six months of 2018 were $9.6 million compared to net deposit inflows of $43.4 million in the first six months of 2017. Other short-term borrowings had net cash outflows of $49.3 million in the first six months of 2018 and inflows of $5.0 million in the first six months of 2017. Changes in securities sold under repurchase agreements accounted for $18.5 million and $10.6 million in net inflows in the first six months of 2018 and 2017, respectively.
Cash and cash equivalents for the six months ended June 30, 2018, totaled $65.3 million, as compared to $51.1 million as of June 30, 2017.
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 2018, 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 interest rates higher during 2018 and potentially into 2019. 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 in October 2017 which result in increases in long-term rates. The Company manages interest rate risk within guidelines established by policy which limits the amount of rate exposure. In practice, we seek to maintain interest rate risk exposure well within those guidelines and we do not believe such risks pose a material risk to the future earnings of the Company.
The Company manages various market risks in its normal course of operations, including credit, liquidity risk, and interest-rate risk. Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of 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 at June 30, 2018, and December 31, 2017, 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 includes 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 a different interest rate environment in order to determine the percentage change. As of December 31, 2017, the Company had modest amounts of earnings gains (in both dollars and percentage) should interest rates rise, and limited earnings reductions should interest rates fall. The changes in income across the various interest rate scenarios as of June 2018 were similar to those of December 2017, with somewhat lower rising-rate earnings gains. Earnings reductions in the 0.50% and 1.00% falling rate scenarios were slightly lower, while somewhat greater in the 2.00% falling-rate scenario. Although significant loan and deposit growth occurred during the quarter due to the acquisition of ABC Bank, the overall impact on the interest rate risk of the combined company was nominal. Overall, management considers the current level of interest rate risk to be moderate, but intends to continue closely monitoring changes in that risk in case corrective actions might be needed in the future. The Federal Funds rate and the Bank’s prime rate increased by 0.25% during the quarter to 2.00% and 5.00%, respectively.
The following table summarizes the effect on annual income before income taxes based upon an immediate increase or decrease in interest rates of 0.5%, 1%, and 2% and no change in the slope of the yield curve.
Analysis of Net Interest Income Sensitivity
Immediate Changes in Rates
(2.0)
(1.0)
(0.5)
0.5
1.0
2.0
Dollar change
(10,532)
(4,749)
(1,958)
1,362
2,650
4,961
Percent change
(11.3)
(5.1)
(2.1)
5.3
(9,447)
(5,272)
(2,382)
1,375
2,764
5,273
(12.0)
(6.7)
(3.0)
1.7
3.5
6.7
The amounts and assumptions used in the simulation model should not be viewed as indicative of expected actual results. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies. The above results do not take into account any management action to mitigate potential risk.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of June 30, 2018. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of June 30, 2018, 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.
As a result of the Company’s acquisition of GCFC, and its wholly-owned subsidiary, ABC Bank, which closed on April 20, 2018, additional controls were added to the Company’s internal controls over financial reporting related to the accounting for purchased loans, including the methodology used to monitor and report purchased loans, specifically PCI loans. There were no other changes in the Company’s internal controls over financial reporting during the quarter ended June 30, 2018, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The Company and its subsidiaries, from time to time, are involved in collection suits in the ordinary course of business against its debtors and are defendants in legal actions arising from normal business activities. Management, after consultation with legal counsel, believes that the ultimate liabilities, if any, resulting from these actions will not have a material adverse effect on the financial position of the Bank or on the consolidated financial position of the Company.
Item 1.A. Risk Factors
There have been no material changes from the risk factors set forth in Part I, Item 1.A. “Risk Factors,” of the Company’s Form 10-K for the year ended December 31, 2017.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
Item 4. Mine Safety Disclosures
Not applicable
Item 5. Other Information
Item 6. Exhibits
Exhibits:
Form of Performance-Based Restricted Stock Unit Agreement (incorporated by reference to Exhibit 10.1 of our Current Report on Form 8-K filed on April 18, 2018).
Form of Director Performance-Based Restricted Stock Agreement.
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 June 30, 2018, and December 31, 2017; (ii) Consolidated Statements of Income for the six months ended June 30, 2018 and 2017; (iii) Consolidated Statements of Stockholders’ Equity for the six months ended June 30, 2018 and 2017; (iv) Consolidated Statements of Cash Flows for the six months ended June 30, 2018 and 2017; 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.
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SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
BY:
/s/ James L. Eccher
James L. Eccher
President and Chief Executive Officer
(principal executive officer)
/s/ Bradley S. Adams
Bradley S. Adams
Executive Vice President and Chief Financial Officer
(principal financial and accounting officer)
DATE: August 7, 2018
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