Table of Contents
I
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2021
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 000-10537
(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 every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) 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☐
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 ☒
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common Stock
OSBC
The Nasdaq Stock Market
As of November 2, 2021, the Registrant has 28,707,737 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
5
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
39
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
64
Item 4.
Controls and Procedures
65
PART II
Legal Proceedings
Item 1.A.
Risk Factors
66
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosure
Item 5.
Other Information
Item 6.
Exhibits
67
Signatures
68
2
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report and other publicly available documents of the Company contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act, including with respect to management’s expectations regarding future plans, strategies and financial performance, including regulatory developments, industry and economic trends, our proposed merger with West Suburban Bancorp. Inc. (“West Suburban”) 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,” “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 materially from those described in such forward-looking statements due to numerous factors, including:
3
We caution readers that the foregoing list of factors is not exclusive, is not necessarily in order of importance and readers should not place undue reliance on any forward-looking statements. 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, except as required by applicable law.
4
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except share data)
(unaudited)
September 30,
December 31,
2021
2020
Assets
Cash and due from banks
$
26,705
24,306
Interest earning deposits with financial institutions
492,548
305,597
Cash and cash equivalents
519,253
329,903
Securities available-for-sale, at fair value
715,188
496,178
Federal Home Loan Bank Chicago ("FHLBC") and Federal Reserve Bank Chicago ("FRBC") stock
9,917
Loans held-for-sale
3,009
12,611
Loans
1,867,942
2,034,851
Less: allowance for credit losses on loans
26,949
33,855
Net loans
1,840,993
2,000,996
Premises and equipment, net
44,120
45,477
Other real estate owned
1,912
2,474
Mortgage servicing rights, at fair value
5,320
4,224
Goodwill and core deposit intangible
20,433
20,781
Bank-owned life insurance ("BOLI")
64,265
63,102
Deferred tax assets, net
7,335
8,121
Other assets
43,387
47,053
Total assets
3,275,132
3,040,837
Liabilities
Deposits:
Noninterest bearing demand
1,037,638
909,505
Interest bearing:
Savings, NOW, and money market
1,366,138
1,202,134
Time
310,553
425,434
Total deposits
2,714,329
2,537,073
Securities sold under repurchase agreements
42,962
66,980
Junior subordinated debentures
25,773
Subordinated debentures
59,190
-
Senior notes
44,454
44,375
Notes payable and other borrowings
20,155
23,393
Other liabilities
47,037
36,156
Total liabilities
2,953,900
2,733,750
Stockholders’ Equity
Common stock
34,957
Additional paid-in capital
121,074
122,212
Retained earnings
262,513
236,579
Accumulated other comprehensive income
12,249
14,762
Treasury stock
(109,561)
(101,423)
Total stockholders’ equity
321,232
307,087
Total liabilities and stockholders’ equity
September 30, 2021
December 31, 2020
Common
Stock
Par value
1.00
Shares authorized
60,000,000
Shares issued
34,957,384
Shares outstanding
28,707,737
29,328,723
Treasury shares
6,249,647
5,628,661
See accompanying notes to consolidated financial statements.
Consolidated Statements of Income
(In thousands, except per share data)
Three Months Ended September 30,
Nine Months Ended September 30,
Interest and dividend income
Loans, including fees
21,315
21,980
64,337
67,924
95
132
241
Securities:
Taxable
1,835
1,458
5,282
5,315
Tax exempt
1,285
1,327
3,851
4,178
Dividends from FHLBC and FRBC stock
114
118
342
366
Interest bearing deposits with financial institutions
203
432
185
Total interest and dividend income
24,791
25,046
74,376
78,209
Interest expense
Savings, NOW, and money market deposits
209
299
667
1,319
Time deposits
330
1,084
1,239
4,292
15
28
167
Other short-term borrowings
24
286
285
850
1,932
547
1,064
673
2,019
113
144
355
439
Total interest expense
2,173
2,537
6,261
10,335
Net interest and dividend income
22,618
22,509
68,115
67,874
(Release of) provision for credit losses
(1,500)
300
(8,000)
10,413
Net interest and dividend income after (release of) provision for credit losses
24,118
22,209
76,115
57,461
Noninterest income
Wealth management
2,372
1,889
6,912
5,793
Service charges on deposits
1,368
1,322
3,784
4,168
Secondary mortgage fees
240
492
834
1,267
Mortgage servicing rights mark to market loss
(282)
(160)
(202)
(2,739)
Mortgage servicing income
572
521
1,646
1,447
Net gain on sales of mortgage loans
2,186
5,246
7,802
12,123
Securities gains (losses), net
244
(1)
246
(25)
Change in cash surrender value of BOLI
406
459
1,163
942
Death benefit realized on BOLI
(2)
57
Card related income
1,624
1,499
4,737
4,097
Other income
610
420
1,637
1,572
Total noninterest income
9,340
11,685
28,559
28,702
Noninterest expense
Salaries and employee benefits
12,964
12,586
39,366
36,846
Occupancy, furniture and equipment
2,418
2,003
7,188
6,239
Computer and data processing
1,477
1,226
4,079
3,808
FDIC insurance
211
191
604
403
General bank insurance
301
281
854
764
Amortization of core deposit intangible
122
348
374
Advertising expense
107
62
262
228
Card related expense
662
566
1,881
1,612
Legal fees
455
169
645
476
Other real estate expense, net
25
125
138
505
Other expense
3,396
2,935
9,903
8,909
Total noninterest expense
22,129
20,266
65,268
60,164
Income before income taxes
11,329
13,628
39,406
25,999
Provision for income taxes
2,917
3,363
10,295
6,221
Net income
8,412
10,265
29,111
19,778
Basic earnings per share
0.30
0.35
1.01
0.67
Diluted earnings per share
0.29
0.34
0.99
0.65
Dividends declared per share
0.05
0.01
0.11
0.03
6
Consolidated Statements of Comprehensive Income
(In thousands)
Net Income
Unrealized holding (losses) gains on available-for-sale securities arising during the period
(3,007)
5,812
(4,483)
10,455
Related tax benefit (expense)
841
(1,633)
1,277
(2,932)
Holding (losses) gains, after tax, on available-for-sale securities
(2,166)
4,179
(3,206)
7,523
Less: Reclassification adjustment for the net gains (losses) realized during the period
Net realized gains (losses)
Related tax (expense) benefit
(69)
(70)
7
Net realized gains (losses) after tax
175
176
(18)
Other comprehensive (loss) income on available-for-sale securities
(2,341)
4,180
(3,382)
7,541
Changes in fair value of derivatives used for cash flow hedges
218
615
1,207
(1,472)
(62)
(173)
(338)
413
Other comprehensive income (loss) on cash flow hedges
156
442
869
(1,059)
Total other comprehensive (loss) income
(2,185)
4,622
(2,513)
6,482
Total comprehensive income
6,227
14,887
26,598
26,260
Accumulated
Total
Unrealized Gain
Accumulated Other
(Loss) on Securities
(Loss) on Derivative
Comprehensive
Available-for -Sale
Instruments
Income/(Loss)
For the Three Months Ended
Balance, June 30, 2020
10,188
(3,766)
6,422
Other comprehensive income, net of tax
Balance, September 30, 2020
14,368
(3,324)
11,044
Balance, June 30, 2021
16,372
(1,938)
14,434
Other comprehensive (loss) income, net of tax
Balance, September 30, 2021
14,031
(1,782)
For the Nine Months Ended
Balance, December 31, 2019
6,827
(2,265)
4,562
Other comprehensive income (loss), net of tax
Balance, December 31, 2020
17,413
(2,651)
Consolidated Statements of Cash Flows
(Unaudited)
Cash flows from operating activities
Adjustments to reconcile net income to net cash provided by operating activities:
Net premium / discount from amortization on securities
1,736
1,712
Securities (gains) losses, net
(246)
Originations of loans held-for-sale
(191,679)
(296,388)
Proceeds from sales of loans held-for-sale
207,339
300,045
Net gains on sales of mortgage loans
(7,802)
(12,123)
202
2,739
Net discount from accretion on loans
(618)
(841)
Net change in cash surrender value of BOLI
(1,163)
(942)
Net gains on sale of other real estate owned
(40)
(188)
Provision for other real estate owned valuation losses
264
Depreciation of fixed assets and amortization of leasehold improvements
2,286
2,075
Amortization of core deposit intangibles
Change in current income taxes receivable
329
(781)
Deferred tax expense (benefit)
1,796
(693)
Change in accrued interest receivable and other assets
2,973
(19,144)
Amortization of purchase accounting adjustment on notes payable and other borrowings
(3)
Amortization of junior subordinated debentures issuance costs
643
Amortization of subordinated debentures issuance costs
42
Amortization of senior notes issuance costs
79
Change in accrued interest payable and other liabilities
12,898
8,060
Stock based compensation
1,113
1,623
Net cash provided by operating activities
50,766
16,755
Cash flows from investing activities
Proceeds from maturities and calls, including pay down of securities available-for-sale
91,931
41,645
Proceeds from sales of securities available-for-sale
35,075
18,006
Purchases of securities available-for-sale
(352,236)
(14,681)
Net change in loans
168,551
(100,370)
Proceeds from claims on BOLI, net of claims receivable
483
Proceeds from sales of other real estate owned, net of participations and improvements
607
3,140
Net purchases of premises and equipment
(929)
(2,635)
Net cash used in investing activities
(57,001)
(54,412)
Cash flows from financing activities
Net change in deposits
177,256
352,494
Net change in securities sold under repurchase agreements
(24,018)
10,575
Net change in other short-term borrowings
(42,375)
Redemption of junior subordinated debentures
(32,604)
Issuance of subordinated debentures, net of issuance costs
59,148
Issuance of term note
20,000
Repayment of term note
(3,000)
(2,000)
Net change in notes payable and other borrowings, excluding term note
(235)
(229)
Dividends paid on common stock
(3,177)
(893)
Purchase of treasury stock
(10,389)
(4,803)
Net cash provided by financing activities
195,585
300,165
Net change in cash and cash equivalents
189,350
262,508
Cash and cash equivalents at beginning of period
50,632
Cash and cash equivalents at end of period
313,140
8
Consolidated Statements of Changes in
Additional
Other
Paid-In
Retained
Treasury
Stockholders’
Capital
Earnings
Income (Loss)
Equity
121,437
218,856
(99,156)
282,516
Dividends declared and paid, ($0.01 per share)
(296)
309
Purchase of treasury stock from stock repurchase program
(1,148)
121,746
228,825
(100,304)
296,268
120,572
255,536
315,938
Other comprehensive loss, net of tax
Dividends declared and paid, ($0.05 per share)
(1,435)
502
34,854
120,657
213,723
(95,932)
277,864
Adoption of ASU 2016-13 (CECL)
(3,783)
Dividends declared and paid, ($0.03 per share)
Vesting of restricted stock
103
(534)
431
Purchase of treasury stock from taxes withheld on stock awards
(423)
(4,380)
Dividends declared and paid, ($0.11 per share)
(2,251)
2,251
(577)
(9,812)
9
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share data, unaudited)
Note 1 – Basis of Presentation and Changes in Significant Accounting Policies
The accounting policies followed in the preparation of the interim consolidated financial statements are consistent with those used in the preparation of the annual financial information. The interim consolidated financial statements reflect all normal and recurring adjustments that are necessary, in the opinion of management, for a fair statement of results for the interim period presented. Results for the period ended September 30, 2021, are not necessarily indicative of the results that may be expected for the year ending December 31, 2021. 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, 2020. Unless otherwise indicated, dollar 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.
Recent Accounting Pronouncements
In June 2016, the Financial Standards Board, or FASB, issued Accounting Standards Update (ASU) No. 2016-13, “Financial Instruments – Measurement of Credit Losses on Financial Instruments (Topic 326),” also known as Current Expected Credit Losses, or CECL. 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 reflects 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 also requires available-for-sale debt securities to have a credit loss recorded through an allowance rather than write-downs through an other than temporary impairment analysis. In addition, an allowance must be established for the credit risk related to unfunded commitments. ASU 2016-13 is effective for financial statements issued for fiscal years beginning after December 15, 2019, and was adopted as of January 1, 2020, by the Company. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” and Note 1 – Summary of Significant Accounting Policies, both found in our Annual Report on Form 10-K for the year ended December 31, 2020 for further discussion of our Allowance for Credit Losses methodology and assessment as a critical accounting policy.
Change in Significant Accounting Policies
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, 2020. 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. During the third quarter of 2021, the Company had no changes to significant accounting policies.
10
Subsequent Events
On October 19, 2021, the Company’s Board of Directors declared a cash dividend of $0.05 per share payable on November 8, 2021, to stockholders of record as of October 29, 2021; dividends of $1.4 million are scheduled to be paid to stockholders on November 8, 2021.
Note 2 – Proposed Merger with West Suburban Bancorp, Inc.
On July 25, 2021, the Company and West Suburban Bancorp, Inc. (“West Suburban”) entered into an Agreement and Plan of Merger and Reorganization (the “Merger Agreement”), under which West Suburban will merge with and into Old Second, with Old Second as the surviving corporation.
The merger is expected to close in December 2021, subject to the satisfaction of customary closing conditions, including approval by the stockholders of the Company and the shareholders of West Suburban. Subject to the terms and conditions of the Merger Agreement, if the merger closes, each West Suburban shareholder will receive 42.413 shares of Company common stock and $271.15 in cash, without interest, for each share of West Suburban common stock owned by the shareholder.
Based on the number of outstanding shares of Company common stock and West Suburban common stock as of September 30, 2021, and based on the exchange ratio of 42.413, it is expected that the Company’s stockholders will hold approximately 64% and West Suburban’s shareholders will hold approximately 36% of the issued and outstanding shares of Company common stock immediately following the closing of the merger.
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.
Federal Home Loan Bank of Chicago (“FHLBC”) and Federal Reserve Bank of Chicago (“FRBC”) stock are considered nonmarketable equity investments. FHLBC stock was recorded at $3.7 million at September 30, 2021, and December 31, 2020. FRBC stock was recorded at $6.2 million at September 30, 2021, and December 31, 2020.
The following tables summarize the amortized cost and fair value of the securities portfolio at September 30, 2021, and December 31, 2020, and the corresponding amounts of gross unrealized gains and losses:
11
Gross
Amortized
Unrealized
Fair
Cost1
Gains
Losses
Value
Securities available-for-sale
U.S. Treasury
4,017
53
4,070
U.S. government agencies
33,915
(340)
33,575
U.S. government agencies mortgage-backed
17,269
(215)
17,818
States and political subdivisions
222,833
16,758
(639)
238,952
Corporate bonds
5,000
(8)
4,992
Collateralized mortgage obligations
163,756
1,966
(308)
165,414
Asset-backed securities
187,825
(133)
189,338
Collateralized loan obligations
61,085
18
(74)
61,029
Total securities available-for-sale
695,700
21,205
(1,717)
4,014
4,117
6,811
(154)
6,657
16,098
1,112
17,209
229,352
21,269
(1,362)
249,259
53,999
2,866
(280)
56,585
130,959
1,370
(511)
131,818
30,728
(210)
30,533
471,961
26,735
(2,518)
1 Excludes accrued interest receivable of $2.8 million and $2.7 million at September 30, 2021 and December 31, 2020, respectively, that is recorded in other assets on the consolidated balance sheet.
The fair value, amortized cost and weighted average yield of debt securities at September 30, 2021, by contractual maturity, are listed in the table below. Securities not due at a single maturity date are shown separately.
Weighted
Average
Cost
Yield
Due in one year or less
4,227
1.87
%
4,281
Due after one year through five years
36,288
0.79
36,240
Due after five years through ten years
28,159
2.35
29,387
Due after ten years
197,091
3.01
211,681
265,765
2.62
281,589
Mortgage-backed and collateralized mortgage obligations
181,025
1.73
183,232
1.14
1.40
1.88
At September 30, 2021, the Company’s investments included $154.5 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
12
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 $15.6 million, or 10.03% of outstanding principal.
At September 30, 2021, the Company had invested in securities issued from one originator that individually amounted to over 10% of the Company’s stockholders’ equity. Information regarding this issuer and the value of the securities issued follows:
Issuer
Towd Point Mortgage Trust
32,836
34,339
Securities with unrealized losses with no corresponding allowance for credit losses at September 30, 2021 and December 31, 2020, 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
229
28,066
111
5,509
340
215
6,084
23
1,490
1
616
4,085
639
5,575
63,495
7,531
308
71,026
35,048
54
3,270
133
38,318
27
20,386
47
10,625
74
31,011
29
825
159,561
892
31,020
38
1,717
190,581
154
141
1,362
3,433
279
8,142
146
280
8,288
251
509
49,572
511
49,823
31
7,468
179
21,477
210
28,945
313
16,002
13
2,205
81,285
20
2,518
97,287
Each quarter we perform an analysis to determine if any of the unrealized losses on securities available-for-sale are comprised of credit losses as compared to unrealized losses due to market interest rate adjustments. Our assessment includes a review of the unrealized loss for each security issuance held; the financial condition and near-term prospects of the issuer, including external credit ratings and recent downgrades; and our ability and intent to hold the security for a period of time sufficient for a recovery in value. We also consider the extent to which the securities are issued by the federal government or its agencies, and any guarantee of issued amounts by those agencies. No credit losses were determined to be present as of September 30, 2021, as there was no credit quality deterioration noted. Therefore, no provision for credit losses on securities was recognized for the third quarter of 2021.
The following table presents proceeds from sale and net realized gains (losses) on securities available-for-sale for the three and nine months ended September 30, 2021 and 2020:
Three Months Ended
Nine Months Ended
Proceeds from sales of securities
26,873
Gross realized gains on securities
267
17
Gross realized losses on securities
(21)
(42)
Income tax (expense) benefit on net realized gains (losses)
Effective tax rate applied
28.3
0.0
28.5
28.0
As of September 30, 2021, securities valued at $353.2 million were pledged to secure deposits and borrowings, and for other purposes, an increase from $335.8 million of securities pledged at year-end 2020.
Note 4 – Loans and Allowance for Credit Losses on Loans
Major segments of loans were as follows:
Commercial 1
321,548
407,159
Leases
162,444
141,601
Commercial real estate - Investor
535,506
582,042
Commercial real estate - Owner occupied
330,648
333,070
Construction
108,690
98,486
Residential real estate - Investor
45,497
56,137
Residential real estate - Owner occupied
108,343
116,388
Multifamily
160,798
189,040
HELOC
69,651
80,908
HELOC - Purchased
12,370
19,487
Other 2
12,447
10,533
Total loans
Allowance for credit losses on loans
(26,949)
(33,855)
Net loans3
1 Includes $34.7 million and $74.1 million of Paycheck Protection Program (“PPP”) loans at September 30, 2021 and December 31, 2020, respectively.
2 The “Other” segment includes consumer and overdrafts in this table and in subsequent tables within Note 4 - Loans and Allowance for Credit Losses on Loans.
3 Excludes accrued interest receivable of $6.1 million and $7.0 million at September 30, 2021 and December 31, 2020, respectively, that is recorded in other assets on the consolidated balance sheet.
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 seeks to assure access to collateral, in the event of borrower default, through adherence to lending laws, the Company’s lending standards and credit monitoring procedures. Although the Bank makes loans primarily 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. The real estate related categories listed above represent 73.4% and 72.5% of the portfolio at September 30, 2021, and December 31, 2020, respectively, and include a mix of owner and non-owner occupied, residential, construction and multifamily loans.
14
The following tables represent the activity in the allowance for credit losses for loans, or the ACL, for the three and nine months ended September 30, 2021 and 2020:
Provision for
Beginning
(Release of)
Ending
Allowance for credit losses
Balance
Credit Losses
Charge-offs
Recoveries
Three months ended September 30, 2021
Commercial
2,601
82
2,685
3,388
(41)
3,343
10,437
(890)
101
9,464
1,086
99
1,187
3,048
(175)
2,873
975
(287)
695
1,866
(116)
1,768
3,266
(121)
183
2,962
1,604
1,645
(36)
193
139
19
134
Ending Balance, September 30, 2021
28,639
(1,453)
369
Nine months ended September 30, 2021
2,812
43
232
3,888
(513)
32
9,205
302
58
(1,250)
225
4,054
(1,181)
1,740
(1,328)
283
2,714
(1,074)
128
3,625
(480)
1,749
(216)
129
199
(6)
1,618
(1,483)
108
(7,186)
712
992
Impact of
Adopting
ASC 326
Three months ended September 30, 2020
2,292
98
2,397
2,012
1,965
119
3,858
7,725
783
102
8,610
2,521
(535)
145
565
2,406
4,431
60
4,778
2,217
(290)
1,942
3,204
(508)
2,721
3,518
(301)
3,217
2,255
(359)
52
1,948
398
(43)
289
700
41
752
Ending Balance, September 30, 2020
31,273
1,280
451
816
32,918
Nine months ended September 30, 2020
3,015
(292)
(250)
124
48
1,262
501
2,214
6,218
(741)
3,678
(848)
556
1,546
513
1,334
2,990
601
740
564
45
1,257
1,320
30
157
1,444
1,732
1,161
1,526
(902)
85
248
640
(433)
192
130
19,789
5,879
8,174
2,258
The ACL on loans excludes $2.2 million, $3.0 million and $4.0 million of allowance for unfunded commitments, recorded within Other Liabilities, as of September 30, 2021, December 31, 2020 and September 30, 2020, respectively.
The following tables presents the collateral dependent loans and the related ACL allocated by segment of loans as of September 30, 2021 and December 31, 2020:
Accounts
ACL
Real Estate
Receivable
Equipment
Allocation
195
3,413
546
3,959
661
6,070
2,290
4,373
2,523
6,896
4,898
988
998
3,945
90
181
23,249
3,071
29,733
4,233
1,070
55
1,125
56
2,377
597
2,974
880
84
9,726
1,891
952
928
3,535
3,838
378
1,053
78
25,150
656
29,253
2,637
16
Aged analysis of past due loans by segments of loans was as follows:
90 days or
90 Days or
Greater Past
30-59 Days
60-89 Days
Total Past
Due and
Past Due
Due
Current
Total Loans
Accruing
778
220
320,550
160,807
239
269
535,237
812
672
3,742
326,906
2,665
106,025
882
44,615
322
1,853
2,175
106,168
741
876
437
1,345
159,453
344
77
421
69,230
12,189
12,446
2,811
1,265
10,240
14,316
1,853,626
1,233
December 31, 2020 1
407,107
613
59
316
140,613
163
1,439
1,108
2,547
579,495
1,848
958
7,309
10,115
322,955
1,237
97,249
1,022
484
54,611
859
717
1,862
114,526
3,282
467
3,749
185,291
549
50
206
805
80,103
19,440
10,513
10,916
1,840
10,192
22,948
2,011,903
434
1 Loans modified under the CARES Act are considered current if they are in compliance with the modified terms.
There were 506 loans which totaled $237.8 million modified under the CARES Act. As of September 30, 2021, 12 loans of the original 506 loans deferred, or $8.8 million, had an active deferral request and were in compliance with modified terms; 494 loans which totaled $229.0 million had resumed payments or paid off. Details of loans in active deferral is below:
1st Deferral
2nd Deferral
3rd Deferral
Loans modified under CARES Act, in deferral
6,752
2,077
8,829
Loans modified under CARES Act, in nonaccrual, within deferral above
2,524
4,601
The table presents all nonaccrual loans as of September 30, 2021, and December 31, 2020:
Nonaccrual loan detail
2,638
1,632
9,262
2,958
3,206
2,437
1,052
27,520
22,280
The Company recognized $243,000 of interest on nonaccrual loans during the three months ended September 30, 2021.
Credit Quality Indicators
The Company categorizes loans into credit risk categories based on current financial information, overall debt service coverage, comparison to 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. The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Credits that are not covered by the definitions above are pass credits, which are not considered to be adversely rated.
Credit quality indicators by loan segment and loan origination date at September 30, 2021 were as follows:
Revolving
Converted
To Term
2019
2018
2017
Prior
Pass
64,298
24,032
26,420
11,445
4,172
2,184
186,201
318,811
Special Mention
287
357
177
1,449
2,270
Substandard
233
200
34
Total commercial
64,818
24,589
26,597
11,479
187,650
59,361
47,677
36,332
10,311
1,752
2,588
158,021
2,918
664
35
806
4,423
Total leases
39,250
10,975
1,787
3,394
109,776
146,497
107,124
62,359
44,644
42,916
2,697
516,013
10,607
168
10,775
2,107
448
5,948
8,718
Total commercial real estate - investor
111,883
118,179
62,544
50,592
43,114
85,407
67,186
42,218
41,444
38,798
45,990
2,179
323,222
3,493
1,686
1,008
1,024
7,211
Total commercial real estate - owner occupied
70,679
43,904
40,021
47,014
30,362
44,396
16,992
1,671
514
1,258
7,511
102,704
1,088
174
2,784
1,940
Total construction
30,536
20,864
3,611
1,877
6,148
10,909
6,383
6,867
10,229
1,930
44,343
388
1,154
Total residential real estate - investor
6,539
7,255
10,839
16,322
16,625
19,433
6,892
11,045
30,816
2,022
103,155
253
427
680
46
399
178
3,821
4,508
Total residential real estate - owner occupied
16,639
16,671
7,291
11,223
34,637
20,071
29,014
28,374
45,325
21,745
6,362
69
150,960
6,901
1,580
747
2,327
Total multifamily
35,275
47,515
22,492
503
1,918
2,018
1,132
1,576
1,023
60,339
68,509
259
683
1,034
Total HELOC
1,946
1,162
1,610
1,282
61,130
Total HELOC - purchased
3,772
575
112
223
6,095
12,445
Total other
180
391,749
384,983
290,395
187,140
131,225
155,778
269,043
1,810,372
540
18,773
1,557
22,647
2,578
3,767
7,836
4,990
8,338
6,731
34,923
394,867
389,107
317,004
192,740
139,778
162,677
271,283
486
Credit quality indicators by loan segment and loan origination date at December 31, 2020, were as follows:
2016
101,796
42,294
14,519
6,265
1,825
1,691
230,388
398,778
5,130
425
76
5,702
273
1,524
830
2,679
107,199
42,771
16,111
1,828
231,294
56,605
52,168
16,830
6,545
5,242
651
138,041
338
1,434
798
450
481
3,222
56,780
53,765
17,628
6,604
5,692
173,781
158,677
92,156
66,762
55,963
15,966
564,624
2,394
9,592
12,301
2,709
1,126
71
871
5,117
178,884
169,395
92,447
56,398
16,837
72,605
52,809
73,719
45,315
50,000
25,507
1,324
321,279
1,564
2,154
1,780
1,664
3,524
11,187
74,773
54,963
75,499
46,979
50,501
29,031
50,170
24,163
7,203
539
1,261
9,702
93,256
3,135
2,057
5,192
50,208
27,298
9,260
9,371
14,194
8,522
7,775
2,431
11,184
1,144
54,621
349
91
466
1,516
9,720
9,132
2,522
11,650
18,308
23,450
10,808
15,409
10,394
31,325
2,654
112,348
412
219
526
2,836
4,040
18,355
11,220
15,628
10,920
34,161
40,671
30,849
44,301
38,133
12,147
7,735
197
174,033
548
7,449
4,254
927
2,190
7,558
40,740
37,750
48,555
39,608
12,265
9,925
2,511
2,174
1,679
2,120
504
803
69,483
79,274
94
86
37
271
1,055
1,540
1,765
2,157
775
894
70,632
1,555
574
569
559
341
6,702
10,529
573
527,373
401,352
270,306
189,092
139,283
115,951
322,913
1,966,270
8,341
17,081
288
170
26,526
5,011
7,901
11,596
2,906
2,297
10,459
1,885
42,055
540,725
426,334
282,190
192,546
141,678
126,410
324,968
21
The Company had $572,000 and $546,000 in residential real estate loans in the process of foreclosure as of September 30, 2021, and December 31, 2020, respectively.
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. Additionally, in accordance with interagency guidance, short-term deferrals granted due to the COVID-19 pandemic are not considered TDRs unless the borrower was experiencing financial difficulty prior to the pandemic.
The specific allocation of the allowance for credit 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 credit 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 credit 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.
There was no TDR activity for the three and nine months ended September 30, 2021.
TDRs that were modified during the period are as follows:
TDR Modifications
Three Months Ended September 30, 2020
Nine Months Ended September 30, 2020
# of
Pre-modification
Post-modification
contracts
recorded investment
Troubled debt restructurings
HAMP1
153
410
404
1 HAMP: Home Affordable Modification Program
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 periods ended September 30, 2021, and September 30, 2020, for loans that were restructured within the prior 12 month period.
22
Note 5 – Other Real Estate Owned
Details related to the activity in the other real estate owned (“OREO”) portfolio, net of valuation allowance, for the periods presented are itemized in the following tables:
Balance at beginning of period
5,082
5,004
Property additions, net of acquisition adjustments
70
314
898
Less:
Proceeds from property disposals, net of participation purchase and of gains/losses
2,664
567
2,952
Period valuation (write-up)/write-down
Balance at end of period
2,686
Activity in the valuation allowance was as follows:
1,296
6,464
1,643
6,712
Provision for unrealized losses
Reductions taken on sales
(129)
(4,897)
(543)
(5,363)
1,165
1,613
Expenses related to OREO, net of lease revenue includes:
Gain on sales, net
(5)
(165)
Operating expenses
117
460
Lease revenue
Net OREO expense
Note 6 – Deposits
Major classifications of deposits were as follows:
Savings
457,900
399,057
NOW accounts
537,547
486,612
Money market accounts
370,691
316,465
Certificates of deposit of less than $100,000
173,595
200,107
Certificates of deposit of $100,000 through $250,000
98,496
164,982
Certificates of deposit of more than $250,000
38,462
60,345
Note 7 – Borrowings
The following table is a summary of borrowings as of September 30, 2021, and December 31, 2020. Junior subordinated debentures are discussed in more detail in Note 8:
Total borrowings
192,534
160,521
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 $43.0 million at September 30, 2021, and $67.0 million at December 31, 2020. The fair value of the pledged collateral was $113.8 million at September 30, 2021, and $94.4 million at December 31, 2020. At September 30, 2021, there were no customers with secured balances exceeding 10% of stockholders’ equity.
The Company’s borrowings at the FHLBC require the Bank to be a member and invest in the stock of the FHLBC. Total borrowings are generally limited to the lower of 35% of total assets or 60% of the book value of certain mortgage loans. As of September 30, 2021, and December 31, 2020 the Bank had no short-term advances outstanding under the FHLBC. The Bank also assumed $23.4 million of long-term FHLBC advances with the ABC Bank acquisition in 2018. At September 30, 2021, one advance remains in long-term status, with a total outstanding balance of $6.2 million, at a 2.83% interest rate, and is scheduled to mature on February 2, 2026. FHLBC stock held at September 30, 2021 was valued at $3.7 million, and any potential FHLBC advances were collateralized by loans with a principal balance of $553.6 million, which carried a FHLBC-calculated combined collateral value of $402.1 million. The Company had excess collateral of $269.7 million available to secure borrowings at September 30, 2021.
The Company also had $44.5 million and $44.4 million of senior notes outstanding, net of deferred issuance costs, as of September 30, 2021 and December 31, 2020. The senior notes were issued in December 2016 with a ten year maturity, 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 September 30, 2021, and December 31, 2020, unamortized debt issuance costs related to the senior notes were $546,000 and $625,000, 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.
On February 24, 2020, the Company originated a $20.0 million term note, of which $14.0 million is outstanding as of September 30, 2021, with a correspondent bank related to the Company’s redemption of the 7.80% cumulative trust preferred securities issued by Old Second Capital Trust I and related junior subordinated debentures. See the discussion in Note 8 – Junior Subordinated Debentures. The term note was issued for a three year term at one-month LIBOR plus 175 basis points, requires principal and interest payments quarterly, and the balance of this note is included within Notes Payable and Other Borrowings on the Consolidated Balance Sheet. The Company also has an undrawn line of credit of $20.0 million with a correspondent bank to be used for short-term funding needs; advances under this line can be outstanding up to 360 days from the date of issuance. This line of credit has not been utilized since early 2019.
On April 6, 2021, we sold and issued $60.0 million in aggregate principal amount of our 3.50% Fixed-to-Floating Rate Subordinated Notes due April 15, 2031 (the “Notes”). The Notes were offered and sold to eligible purchasers in a private offering in reliance on the exemption from the registration requirements of Section 4(a)(2) of the Securities Act of 1933, as amended and the provisions of Regulation D promulgated thereunder. The Company intends to use the net proceeds from the offering for general corporate purposes, which may include, without limitation, the redemption of existing senior debt, common stock repurchases and strategic acquisitions. The Notes bear interest at a fixed annual rate of 3.50%, from and including the date of issuance to but excluding April 15, 2026, payable semi-annually in arrears. From and including April 15, 2026 to, but excluding the maturity date or early redemption date, the interest rate will reset quarterly to an interest rate per annum equal to Three-Month Term SOFR (as defined in the Note) plus 273 basis points, payable quarterly in arrears.
Note 8 – Junior Subordinated Debentures
On March 2, 2020, the Company redeemed the 7.80% cumulative trust preferred securities issued by Old Second Capital Trust I (“OSBCP”) and related junior subordinated debentures, which totaled $32.6 million. These debentures were originally issued in 2003 for a term of 30 years at 7.80%, and subject to regulatory approval, were able to be called in whole or in part by the Company after June 30, 2008. The Company received regulatory approval to redeem the debentures in early 2020, and notified OSBCP stockholders of the redemption in late January 2020. Cash disbursed for the redemption, including accrued interest on the debentures, totaled $33.0 million, or $10.13 per OSBCP share. The OSBCP redemption was funded by cash on hand and the $20 million term note discussed in Note 7 – Borrowings. Upon redemption of the junior subordinated debentures related to OSBCP in March 2020, the Company recognized the remaining unamortized debt issuance costs of $635,000.
The Company issued $25.0 million of cumulative trust preferred securities through a private placement completed by another 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. Upon conversion to a floating rate, a cash flow hedge was initiated which resulted in the total interest rate paid on the debt of 4.40% for the quarters ended September 30, 2021 and September 30, 2020. 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.
The junior subordinated debentures issued by the Company are disclosed on the Consolidated Balance Sheet, and the related interest expense for each issuance is included in the Consolidated Statements of Income. As of September 30, 2021, and December 31, 2020, the remaining unamortized debt issuance costs related to the junior subordinated debentures were $1,000 and are included as a reduction to the balance of the junior subordinated debentures on the Consolidated Balance Sheet. The remaining deferred issuance costs on the junior subordinated debentures related to the issuance of Old Second Capital Trust II will be amortized to interest expense over the remainder of the 30-year term of the notes and are included in the Consolidated Statements of Income.
Note 9 – Equity Compensation Plans
The Company’s 2019 Equity Incentive Plan, which authorized 600,000 shares for issuance under the plan, was approved at the May 2019 annual stockholders’ meeting. Following approval of such plan, no further awards will be granted under any other prior Company equity compensation plan. At the May 2021 annual stockholders’ meeting, the Company obtained stockholder approval to amend and restate the 2019 Equity Incentive Plan to increase the number of shares of common stock authorized for issuance under the plan by 1,200,000 shares, from 600,000 shares to 1,800,000 shares (the “2019 Plan”).
The 2019 Plan authorizes the granting of qualified stock options, non-qualified stock options, restricted stock, restricted stock units, and stock appreciation rights (“SARs”). Awards may be granted to selected directors, officers, employees or eligible service providers under the 2019 Plan at the discretion of the Compensation Committee of the Company’s Board of Directors.
As of September 30, 2021, 1,418,520 shares remained available for issuance under the 2019 Plan.
Under the 2019 Plan, unless otherwise provided in an award agreement, upon the occurrence of a change in control, all stock options and SARs then held by the participant will become fully exercisable immediately if, and all stock awards and cash incentive awards will become fully earned and vested immediately if, (i) the 2019 Plan is not an obligation of the successor entity following a change in control or (ii) the 2019 Plan is an obligation of the successor entity following a change in control and the participant incurs a termination of service without cause or for good reason following the change in control. Notwithstanding the immediately preceding sentence, if the vesting of an award is conditioned upon the achievement of performance measures, then such vesting will generally be subject to the following: if, at the time of the change in control, the performance measures are less than 50% attained (pro rata based upon the time of the period through the change in control), the award will become vested and exercisable on a fractional basis with the numerator being equal to the percentage of attainment and the denominator being 50%; and if, at the time of the change in control, the performance measures are at least 50% attained (pro rata based upon the time of the period through the change in control), the award will become fully earned and vested immediately upon the change in control. 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 of restricted stock 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. Awards of 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 224,464 and 137,944 restricted stock units issued under the 2019 Plan during the nine months ended September 30, 2021 and September 30, 2020, respectively. Compensation expense is recognized over the vesting period of the restricted stock units based on the market value of the award on the issue date. Total compensation cost that has been recorded for the Plan was $1.2 million in the first nine months of 2021 and $1.6 million for the first nine months ended of 2020.
A summary of changes in the Company’s unvested restricted awards for the nine months ended September 30, 2021, is as follows:
Restricted
Stock Shares
Grant Date
and Units
Fair Value
Unvested at January 1
532,609
13.15
Granted
224,464
11.38
Vested
(191,653)
13.95
Forfeited
(42,111)
14.15
Unvested at September 30
523,309
12.01
Total unrecognized compensation cost of restricted awards was $3.1 million as of September 30, 2021, which is expected to be recognized over a weighted-average period of 1.88 years.
26
Note 10 – Earnings Per Share
The earnings per share, both basic and diluted, are as follows:
Basic earnings per share:
Weighted-average common shares outstanding
29,559,026
28,925,612
29,708,239
Diluted earnings per share:
Dilutive effect of unvested restricted awards 1
522,543
543,275
533,194
553,482
Diluted average common shares outstanding
29,230,280
30,102,301
29,458,806
30,261,721
1 Includes the common stock equivalents for restricted share rights that are dilutive.
Note 11 – 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 risk-based capital regulatory guidelines, the Bank’s Board of Directors has established an internal guideline requiring the Bank to maintain a Tier 1 leverage capital ratio at or above eight percent (8%) and a total risk-based capital ratio at or above twelve percent (12%). At September 30, 2021, the Bank exceeded those thresholds.
At September 30, 2021, the Bank’s Tier 1 capital leverage ratio was 10.83%, an increase of 9 basis points from December 31, 2020, but is well above the 8.00% objective. The Bank’s total capital ratio was 16.69%, an increase of 168 basis points from December 31, 2020, and also well above the objective of 12.00%.
Bank holding companies are generally required to maintain minimum levels of capital in accordance with capital guidelines implemented by the Board of Governors of the Federal Reserve System. The general bank and holding company capital adequacy guidelines are shown in the accompanying table, as are the capital ratios of the Company and the Bank, as of September 30, 2021, and December 31, 2020.
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. The Basel III Rules are applicable to all banking organizations that are subject to minimum capital requirements, including federal and state banks and savings and loan associations, as well as to bank and savings and loan holding companies, other than “small bank holding companies” generally holding companies with consolidated assets of less than $3.0 billion. The Company is currently considered a “small bank holding company.” As we had total assets in excess of $3.0 billion as of June 30, 2021, we will no longer be considered a small bank holding company in March of 2022. 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, 2020, under the heading “Supervision and Regulation.”
At September 30, 2021, and December 31, 2020, the Company, on a consolidated basis, exceeded the minimum thresholds to be considered “well capitalized” under current regulatory defined capital ratios.
Capital levels and industry defined regulatory minimum required levels are as follows:
Minimum Capital
Well Capitalized
Adequacy with Capital
Under Prompt Corrective
Actual
Conservation Buffer, if applicable1
Action Provisions2
Amount
Ratio
Common equity tier 1 capital to risk weighted assets
Consolidated
292,767
12.99
157,765
7.00
N/A
Old Second Bank
351,663
15.65
157,293
146,058
6.50
Total capital to risk weighted assets
401,027
17.80
236,561
10.50
374,923
16.69
235,871
224,639
10.00
Tier 1 capital to risk weighted assets
317,767
14.10
191,562
8.50
190,999
179,764
8.00
Tier 1 capital to average assets
9.81
129,569
4.00
10.83
129,885
162,356
5.00
277,199
11.94
162,512
318,466
13.75
162,128
150,548
331,178
14.26
243,855
347,408
15.00
243,186
231,605
302,199
13.01
197,440
196,870
185,289
10.21
118,393
10.74
118,609
148,262
1 Amounts are shown inclusive of a capital conservation buffer of 2.50%. Under the Federal Reserve’s Small Bank Holding Company Policy Statement, the Company is not subject to the minimum capital adequacy and capital conservation buffer capital requirements at the holding company level, unless otherwise advised by the Federal Reserve (such capital requirements are applicable only at the Bank level). Although the minimum regulatory capital requirements are not applicable to the Company, we calculate these ratios for our own planning and monitoring purposes.
2 The prompt corrective action provisions are only applicable at the Bank level. The Bank exceeded the general minimum regulatory requirements to be considered “well capitalized.”
As part of its response to the impact of the COVID-19 pandemic, in the first quarter of 2020, U.S. federal regulatory authorities issued an interim final rule that provided banking organizations that adopted CECL during the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital relative to regulatory capital determined under the prior incurred loss methodology, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during the initial two-year delay (i.e., a five-year transition in total). In connection with our adoption of CECL on January 1, 2020, we elected to utilize the five-year CECL transition. The cumulative amount that is not recognized in regulatory capital, in addition to the $3.8 million
Day 1 impact of CECL adoption, will be phased in at 25% per year beginning January 1, 2022. As of September 30, 2021, the capital measures of the Company exclude $4.2 million, which is the modified CECL transition adjustment.
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, and were fully phased in as of January 1, 2019, the Bank must keep a capital conservation buffer of 2.50% above the new regulatory minimum capital requirements, which must consist entirely of Common Equity Tier 1 capital in order to avoid additional limitations on capital distributions and certain other payments.
Stock Repurchase Program
In September 2019, our board of directors authorized the repurchase of up to 1,494,826 shares of our common stock (the “Repurchase Program”). The Repurchase Program expired on September 19, 2020, however, on October 20, 2020, the Company received notice of non-objection from the Federal Reserve Bank of Chicago to extend the Repurchase Program through October 20, 2021. Repurchases by us under the Repurchase Program may be made from time to time through open market purchases, trading plans established in accordance with SEC rules, privately negotiated transactions, or by other means. During the third quarter of 2021, we repurchased no shares of our common stock pursuant to the Repurchase Program. As of September 30, 2021, 1,485,307 shares had been repurchased since the program’s inception, and 9,519 shares remained available for repurchase under the Repurchase Program. The Repurchase Program expired on October 21, 2021.
Note 12 – 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:
Assets and Liabilities Measured at Fair Value on a Recurring Basis:
The tables below present the balance of assets and liabilities at September 30, 2021, and December 31, 2020, respectively, measured by the Company at fair value on a recurring basis:
Level 1
Level 2
Level 3
Assets:
233,392
5,560
Mortgage servicing rights
Interest rate swap agreements
5,292
Mortgage banking derivatives
875
714,734
10,880
729,684
Liabilities:
Interest rate swap agreements, including risk participation agreements
7,798
244,940
4,319
9,388
840
510,581
8,543
523,241
13,159
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are as follows:
Nine Months Ended September 30, 2021
States and
Mortgage
Political
Servicing
Subdivisions
Rights
Beginning balance January 1, 2021
Total gains or losses
Included in earnings
(7)
Included in other comprehensive income
Purchases, issuances, sales, and settlements
Purchases
748
Issuances
1,298
Settlements
(312)
(1,042)
Ending balance September 30, 2021
Beginning balance January 1, 2020
5,419
5,935
(16)
(2,463)
12,900
1,813
(13,297)
(275)
Ending balance September 30, 2020
4,790
5,010
The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of September 30, 2021:
Measured at fair value
Unobservable
on a recurring basis:
Valuation Methodology
Inputs
Range of Input
of Inputs
Discounted Cash Flow
Discount Rate
11.0 - 15.0%
11.0
Prepayment Speed
0.0 - 49.6%
15.5
The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of December 31, 2020:
5.5 - 59.1%
19.5
In addition to the above, Level 3 fair value measurement included $5.6 million for state and political subdivisions representing various local municipality securities at September 30, 2021. These securities were classified as securities available-for-sale, and were valued using a discount based on market spreads of similar assets, but the liquidity premium was an unobservable input. The state and political subdivisions securities balance in Level 3 fair value at September 30, 2020, was $4.8 million. These securities 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 individually evaluated (formerly, impaired) loans and OREO. For assets measured at fair value on a nonrecurring basis at September 30, 2021, and December 31, 2020, respectively, the following tables provide the level of valuation assumptions used to determine each valuation and the carrying value of the related assets:
Individually evaluated loans1
7,187
Other real estate owned, net2
9,099
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 $11.0 million and a valuation allowance of $3.8 million resulting in an increase of specific allocations within the allowance for credit losses on loans of $1.2 million for the nine months ended September 30, 2021.
2 OREO is measured at fair value, less costs to sell, and had a net carrying amount of $1.9 million at September 30, 2021, which is made up of the outstanding balance of $3.1 million, net of a valuation allowance of $1.2 million.
9,675
12,149
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 $12.3 million and a valuation allowance of $2.6 million resulting in an increase of specific allocations within the allowance for credit losses on loans of $1.4 for the year December 31, 2020.
2 OREO is measured at fair value, less costs to sell, and had a net carrying amount of $2.5 million at December 31, 2020, which is made up of the outstanding balance of $4.1 million, net of a valuation allowance of $1.6 million.
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 13 – 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. September 30, 2021 and December 31, 2020, the fair values of loans and leases are estimated on an exit price basis incorporating discounts for credit, liquidity and marketability factors. 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:
705,558
FHLBC and FRBC stock
1,849,933
Interest rate lock commitments and forward contracts
Interest receivable on securities and loans
8,956
Financial liabilities:
Noninterest bearing deposits
Interest bearing deposits
1,676,691
1,677,796
18,557
60,390
44,724
Note payable and other borrowings
20,600
7,767
Interest payable on deposits and borrowings
1,920
487,742
2,009,773
9,698
1,627,568
1,630,109
14,658
44,600
24,043
13,071
418
Note 14 – 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 these objectives, 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. In December of 2019, the Company also executed a loan pool hedge of $50 million to convert variable rate loans to a fixed rate index for a five year term.
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 income/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 $189,000 will be reclassified as an increase to interest income and an additional $175,000 will be reclassified as an increase 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 with financial counterparties are recognized directly in earnings.
The Company also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan interest rate lock commitments is managed with contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts. Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward MBS contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking revenue. Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.
Disclosure of Fair Values of Derivative Instruments on the Balance Sheet
The Company entered into a forward starting interest rate swap on August 18, 2015, with an effective date of June 15, 2017. This transaction had a notional amount totaling $25.8 million as of September 30, 2021, was designated as a cash flow hedge of certain junior subordinated debentures and was determined to be fully effective during the period presented. As such, no amount of ineffectiveness has been included in net income. Therefore, the aggregate fair value of the swap is recorded in other liabilities with changes in fair value recorded in other comprehensive income, net of tax. The amount included in other comprehensive income would be reclassified to current earnings should all or a portion of the hedge no longer be considered effective. The Company expects the hedge to remain fully effective during the remaining term of the swap. The Bank will pay the counterparty a fixed rate and receive a floating rate based on three month LIBOR. The trust preferred securities changed from fixed rate to floating rate on June 15, 2017. The cash flow hedge has a maturity date of June 15, 2037.
In December 2019, the Company also executed a loan pool hedge of $50.0 million to convert variable rate loans to a fixed rate index for a five year term. This transaction falls under hedge accounting standards and is paired against a pool of the Bank’s LIBOR-based loans. Overall, the new swap only bolsters income in down rate scenarios by a modest degree. We consider the current level of interest rate risk to be moderate but intend to continue looking for market opportunities to hedge further. The Bank held $740,000 and $1.4 million of cash collateral related to one correspondent financial institution to cover the loan pool hedge mark to market valuation at September 30, 2021, and December 31, 2020, respectively.
The Bank also has interest rate derivative positions to assist with risk management that are not designated as hedging instruments. These derivative positions relate to transactions in which the Bank enters an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution. The Bank had $17.2 million of cash collateral held by one correspondent financial institution to support interest rate swap activity and no investment securities were required to be pledged to any correspondent financial institution at September 30, 2021 and December 31, 2020. At September 30, 2021, the notional amount of non-hedging interest rate swaps was $167.2 million with a weighted average maturity of 4.1 years. At December 31, 2020, the notional amount of non-hedging interest rate swaps was $189.1 million with a weighted average maturity of 4.7 years. The Bank offsets derivative assets and liabilities that are subject to a master netting arrangement.
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 September 30, 2021 and December 31, 2020.
36
Fair Value of Derivative Instruments
No. of Trans.
Notional Amount $
Balance Sheet Location
Fair Value $
Derivatives designated as hedging instruments
75,774
Other Assets
1,567
Other Liabilities
4,042
Total derivatives designated as hedging instruments
Derivatives not designated as hedging instruments
Interest rate swaps with commercial loan customers
167,218
3,725
46,753
Other contracts
17,297
Total derivatives not designated as hedging instruments
4,600
3,756
6,380
189,126
6,691
205
84,472
26,523
88
6,779
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 loss recognized in AOCI on derivatives totaled $1.8 million as of September 30, 2021, and $3.3 million as of September 30, 2020. The amount of the gain or (loss) reclassified from AOCI to interest income or interest expense on the income statement totaled $40,000 and ($72,000) for the nine months ended September 30, 2021, and September 30, 2020, 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):
The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as that involved in extending loan commitments to our customers. In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO. The following table represents the Company’s contractual commitments due to letters of credit as of September 30, 2021, and December 31, 2020.
The following table is a summary of letter of credit commitments:
Fixed
Variable
Letters of credit:
Borrower:
Financial standby
8,446
8,775
9,051
9,380
Commercial standby
Performance standby
532
6,836
7,368
356
4,517
4,873
861
15,282
16,143
685
13,568
14,253
Non-borrower:
Total letters of credit
15,349
16,210
13,635
14,320
Unused loan commitments:
126,753
330,934
457,687
88,883
316,298
405,181
As of September 30, 2021, the Company evaluated current market conditions, including the impacts related to COVID-19 and market interest rates during the third quarter of 2021, and based on that analysis under the CECL methodology, the Company determined credit losses related to unfunded commitments totaled $2.2 million. The decrease in the ACL for unfunded commitments of $47,000 for the third quarter of 2021, compared to the prior quarter end, is primarily related to a decrease in the commercial unfunded commitments funding rate assumptions based on our analysis of the last 12 months of utilization. The Company will continue to assess the credit risk at least quarterly, and adjust the allowance for unfunded commitments, which is carried within other liabilities on our Consolidated Balance Sheet, as needed, with the appropriate offsetting entry to the provision for credit losses on our Consolidated Statements of Income.
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The following discussion provides additional information regarding our operations for the three and nine months ended September 30, 2021, compared to the three and nine months ended September 30, 2020, and our financial condition at September 30, 2021, compared to December 31, 2020. This discussion should be 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, 2020. The results of operations for the three and nine months ended September 30, 2021, are not necessarily indicative of future results. Dollar amounts presented in the following tables are in thousands, except per share data, and September 30, 2021 and 2020 amounts are unaudited.
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 bank 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, DeKalb, DuPage, Kane, Kendall, 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.
Proposed Merger with West Suburban Bancorp, Inc.
The Company and West Suburban Bancorp, Inc. (“West Suburban”) have entered into an Agreement and Plan of Merger and Reorganization, dated as of July 25, 2021 (the “Merger Agreement”). Under the Merger Agreement, West Suburban will be merged with and into the Company, with the Company continuing as the surviving entity. Immediately following the merger or at such later time as the parties may mutually agree, West Suburban Bank will merge with and into the Bank, with the Bank as the surviving bank. The Merger Agreement was approved by the boards of directors of the Company and West Suburban, and bank regulatory approval was received from the Office of the Comptroller of the Currency on September 30, 2021, and the Federal Reserve Bank of Chicago on October 8, 2021. The merger is subject to stockholder approval of each company and satisfaction of other customary closing conditions. The transaction is anticipated to close in December 2021. The transaction is discussed in more detail in Note 2 to our Consolidated Financial Statements included in this Quarterly Report.
COVID-19
The COVID-19 pandemic and variants of the virus continue to create disruptions to the global economy and financial markets and to businesses and the lives of individuals throughout the world. The impact of the COVID-19 pandemic and its related variants is fluid and continues to evolve, adversely affecting many of our clients. Our business, financial condition and results of operations generally rely upon the ability of our borrowers to repay their loans, the value of collateral underlying our secured loans, and demand for loans and other products and services we offer, which are highly dependent on the business environment in our primary markets where we operate and in the United States as a whole. The unprecedented and rapid spread of COVID-19 and its variants and their associated impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending, and other economic activities have resulted and continue to result in less economic activity, and volatility and disruption in financial markets. In addition, due to the COVID-19 pandemic, market interest rates declined to historic lows. These reductions in interest rates and the other effects of the COVID-19 pandemic have had, and are expected to continue to have, possibly materially, adverse effects on our business, financial condition and results of operations. The ultimate extent of the impact of the COVID-19 pandemic on our business, financial condition
and results of operations is currently uncertain and will depend on various developments and other factors, including the effect of governmental and private sector initiatives, the effect of the continued rollout of vaccinations for the virus, whether such vaccinations will be effective against any resurgence of the virus and its variants, including any new strains, and the ability for customers and businesses to return to, and remain in, their pre-pandemic routines. In addition, it is reasonably possible that certain significant estimates made in our financial statements could be materially and adversely affected in the near term as a result of these conditions.
Results of Operation and Financial Condition
We continue to monitor the impact of the COVID-19 pandemic on our results of operation and financial condition. To date, the COVID-19 pandemic has not significantly impacted the health of the overall real estate industry in our markets, which have reflected relative stability over the past three years. In addition, we have not experienced significant incurred losses on loans or received communications from our borrowers that significant losses are imminent. While management does not currently expect the next year to result in the precipitous decline in the value of certain real estate assets similar to the declines seen in 2009 to 2010, our forecast includes assumptions for certain loss scenarios that may occur due to the exhaustion of federal stimulus funds or a decrease in market valuations. Accordingly, we determined it prudent to increase our allowance for credit losses to $33.9 million as of December 31, 2020, driven by both our adoption of the new CECL methodology and the expected impact of the COVID-19 pandemic and market interest rate reductions in anticipation of continued market risk and uncertainty. During the first nine months of 2021, unemployment expectations and other market indicators reflected an improving economic outlook, which resulted in a $3.0 million release of our provision for credit losses in the first quarter of 2021, a $3.5 million release of provision for credit losses in the second quarter of 2021, and a $1.5 million release of provision for credit losses in the third quarter of 2021. The total release of credit losses for the first nine months of 2021 of $8.0 million is comprised of a $7.2 million reserve release on loans and an $813,000 release of expense in our provision for credit losses on unfunded commitments.
We also adjust our investment securities portfolio to fair value each period end and review for any impairment that would require a provision for credit losses. At this time, we have determined there is no need for a provision for credit losses related to our investment securities portfolio. Because of changing economic and market conditions affecting issuers, we may be required to recognize impairments in the future on the securities we hold as well as experience reductions in other comprehensive income. We cannot currently determine the ultimate impact of the pandemic on the long-term value of our portfolio.
As of September 30, 2021 and December 31, 2020, we had $18.6 million of goodwill. At November 30, 2020, we performed our recurring annual review for any goodwill impairment. We determined no goodwill impairment existed, however, continued delayed recovery or further deterioration in market conditions related to the general economy, financial markets, and the associated impacts on our customers, employees and vendors, among other factors, could significantly impact the impairment analysis and may result in future goodwill impairment charges that, if incurred, could have a material adverse effect on our results of operations and financial condition.
Lending Operations and Accommodations to Borrowers
To more fully support our customers during the pandemic, we established client assistance programs, including offering commercial, consumer, and mortgage loan payment deferrals for certain clients. As of September 30, 2021, we have executed 506 of these deferrals on loan balances of $237.8 million since March 31, 2020. In accordance with interagency guidance issued in March 2020, these short term deferrals were not considered troubled debt restructurings. As of September 30, 2021, 494 loans previously in deferral status, representing loan balances of $229.0 million, had resumed payments or paid off, and 12 loans totaling $8.8 million remained in active deferral status, of which $4.6 million were in nonaccrual status. We also suspended late fees for consumer loans through June 30, 2020, and, although consumer late fees have been reinstated, we will continue to evaluate any late fee suspension based on the borrower’s financial situation and prior payment history. In addition, we paused new foreclosure and repossession actions through October 3, 2021, and will continue to re-evaluate these activities based on the ongoing COVID-19 pandemic. These programs may negatively impact our revenue and other results of operations in the near term and, if not effective in mitigating the effect of COVID-19 on our customers, may adversely affect our business and results of operations more substantially over a longer period of time. Future governmental actions may require these and other types of customer-related responses.
During 2020, as part of the first round of the SBA Paycheck Protection Program (“PPP”), we processed 746 PPP loan applications, representing a total of $136.7 million. In January through May 2021, we processed an additional 574 PPP loans, totaling $62.3 million, as part of the second round of the program, before the program expired on May 31, 2021. We started the application process for loan forgiveness for the first round of PPP loans in October 2020, and we continued to receive funds for forgiven loans from both the first and second round of PPP loans during the first nine months of 2021. As of September 30, 2021, we had 260 loans, which totaled $34.7 million, still outstanding under the PPP program. We expect the application process for loan forgiveness to continue through the first quarter of 2022, with funds to be received from the SBA for the forgiven loans through March 2022. We recorded $1.1 million of net
40
fee and interest income on PPP loans in the third quarter of 2021, and $2.7 million of net fee and interest income on PPP loans in the first nine months of 2021. As of September 30, 2021, unearned net fee income on both first and second round PPP loans totaled $1.3 million. In addition, as of September 30, 2021, we had one loan with a total outstanding balance of $87,500 under the Main Street Lending Program.
Capital and Liquidity
As of September 30, 2021, all of our capital ratios were in excess of all regulatory requirements. While we believe that we have sufficient capital to withstand an extended economic recession brought about by the COVID-19 pandemic, our reported and regulatory capital ratios could be adversely impacted by credit losses.
We believe there could be potential stresses on liquidity management as a result of the COVID-19 pandemic. For instance, as customers manage their own liquidity stress, we could experience an increase in the utilization of existing lines of credit. However, to date, due in part to federal government stimulus funds received by our customers, as well as a higher volume of loan paydowns than periods prior to COVID-19, our liquidity has increased.
We have developed new processes to monitor our liquidity on a daily basis, and have run stress testing based on various economic assumptions under stress and severe stress scenarios. In addition, management continued to communicate as needed throughout 2021 in structured meetings with key staff to ensure all current events related to the COVID-19 pandemic, such as federal government stimulus check receipt, PPP loan fundings and the forgiveness application process, are managed appropriately.
Financial Overview
Our community-focused banking franchise experienced a decrease in total loans in the third quarter of 2021, compared to the year ended December 31, 2020, and a decrease in total loans compared to the third quarter of 2020, but we believe we are positioned for moderate loan growth for the last quarter of 2021 and into 2022, as we continue to serve our customers’ needs in a competitive economic environment. Given the unprecedented nature of the COVID-19 pandemic and any potential related variants, it is difficult to predict the full impact the pandemic will have on our business. 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, while ensuring the safety and soundness of our Bank, our customers and our employees during the COVID-19 pandemic.
The following provides an overview of some of the factors impacting our financial performance for the three month period ended September 30, 2021, compared to the like period ended September 30, 2020:
Critical Accounting Policies
Our 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 our future financial condition and results of operations.
Of the significant accounting policies used in the preparation of our consolidated financial statements, we have identified certain items as critical accounting policies based on the associated estimates, assumptions, judgments and complexity. See “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, 2020. There have been no material changes to our critical accounting policies or the estimates made pursuant to those policies during the most recent quarter from those disclosed in our 2020 Annual Report in Form 10-K.
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 margin on a tax equivalent (“TE”) basis, our adjusted efficiency ratio, our tangible common equity to tangible assets ratio, and our core net interest margin on a TE basis. 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 September 30, 2021 and 2020
Our income before taxes was $11.3 million in the third quarter of 2021 compared to $13.6 million in the third quarter of 2020. This decrease in pretax income was primarily due to a $2.3 million decrease in noninterest income, primarily due to a $3.4 million decline in residential mortgage banking income year over year, and a $1.9 million increase in noninterest expense, primarily due to an increase in salaries and employee benefits, occupancy, furniture and equipment expense, computer and data processing expense and legal expense. These decreases to pretax income were partially offset by a $1.5 million release of provision for credit losses expense in the third quarter of 2021, compared to provision for credit losses of $300,000 in the like quarter of 2020. Our net income was $8.4 million, or $0.29 per diluted share, for the third quarter of 2021, compared to net income of $10.3 million, or $0.34 per diluted share, for the third quarter of 2020.
Net interest and dividend income was $22.6 million in the third quarter of 2021, compared to $22.5 million in the third quarter of 2020. The $109,000 increase was primarily driven by a $377,000 increase in taxable securities income, as well as a $754,000 decrease in interest expense on time deposits due to higher yielding deposits running off year over year. Partially offsetting this increase was a $665,000 decrease in loan interest income in the third quarter of 2021, compared to the third quarter of 2020, primarily due to a decrease in interest rates and loan volume reductions.
Management has remained diligent in reviewing our loan portfolio to analyze and determine if charge-offs are required. Average loans, including loans held for sale, decreased $159.3 million in the third quarter of 2021, compared to the third quarter of 2020, stemming primarily from $164.3 million of PPP loans forgiven or repaid in the past nine months, and loan paydowns due to growth in our borrowers’ liquidity year over year.
Nine months ended September 30, 2021 and 2020
Our income before taxes was $39.4 million for the nine months ended September 30, 2021, compared to $26.0 million for the nine months ended September 30, 2020. This $13.4 million increase in pretax income was primarily due to a $8.0 million release of provision for credit losses expense for the nine months ended September 30, 2021, compared to a $10.4 million provision for credit losses for the like period in 2020, due both to our adoption of the new CECL methodology effective January 1, 2020 and the expected impact, as of September 30, 2020, of the COVID-19 pandemic and related market interest rate reductions. Due to an improved unemployment forecast and our charge-offs recorded to date, our projected credit losses have decreased over the past year, resulting in the reversal in 2021 of a portion of our reserves recorded in 2020. Our net income was $29.1 million, or $0.99 per diluted share, for the nine months ended September 30, 2021, compared to net income of $19.8 million, or $0.65 per diluted share, for the nine months ended September 30, 2020.
Net interest and dividend income was $68.1 million for the nine months ended September 30, 2021, compared to $67.9 million for the same period of 2020. While net interest and dividend income remained relatively flat, interest and dividend income decreased $3.8 million year over year, due to the reduction in interest rates and a decline in loan volumes. This decrease was offset by a reduction in interest expense for the nine months ended September 30, 2021, compared to the like 2020 period, due to the reduction in interest rates on interest-bearing deposits, as well as our redemption of the Old Second Capital Trust I trust preferred securities and related subordinated debentures in the first quarter of 2020, which was partially offset by the issuance of $60.0 million of subordinated debentures in April 2021.
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.
Our net interest and dividend income increased by $109,000 to $22.6 million, for the third quarter of 2021, from $22.5 million for the third quarter of 2020. This increase was primarily attributable to a $754,000 decline in time deposit interest expense due to the decrease in interest rates and volume reductions year over year, and a $377,000 increase in taxable securities income due to an increase of $225.2 million in average taxable securities. Partially offsetting this increase in net interest and dividend income was a decrease of $665,000 in
loan interest and fees income, primarily due to a reduction in loan volumes and continuing low interest rates year over year. Net interest and dividend income for the third quarter of 2021 reflected an increase of $664,000, or 3.0%, compared to the second quarter of 2021.
Average earning assets for the third quarter of 2021 totaled $3.09 billion, reflecting an increase of $32.1 million, or 1.1%, compared to the second quarter of 2021, and an increase of $316.1 million, or 11.4%, compared to the third quarter of 2020. Average interest earning deposits with financial institutions totaled $523.6 million for the third quarter of 2021, which reflected an increase of $24.0 million compared to the second quarter of 2021, and an increase of $260.4 million compared to the third quarter of 2020. The yield on average interest earning deposits was 15 basis points for the third quarter of 2021, five basis points more than the third quarter of 2020. Securities reflected an increase in interest income year over year, due to growth in volumes. Total average securities for the third quarter of 2021 increased $49.4 million from the second quarter of 2021, and increased $215.0 million from the third quarter of 2020. The yield on average securities declined to 2.07% for the third quarter of 2021, compared to 2.24% for the second quarter of 2021 and 2.78% for third quarter of 2020. Total average loans, including loans held-for-sale, totaled $1.89 billion in the third quarter of 2021, which reflected a decrease of $41.3 million compared to the second quarter of 2021, and a decrease of $159.3 million compared to the third quarter of 2020. The decline in average loan balances year over year was primarily due to a decrease in commercial loans related to PPP loan payoffs, net of originations, and early payoffs on other commercial loans due to higher levels of borrower liquidity. This decline in loan volumes resulted in a decrease in loan interest and fee income of $665,000 in the year over year period. For the third quarter of 2021, the yield on average loans increased to 4.48%, compared to 4.33% for the second quarter of 2021, and 4.29% for the third quarter of 2020.
Average interest bearing liabilities decreased $7.4 million, or 0.4%, in the third quarter of 2021, compared to the second quarter of 2021, but increased $137.7 million compared to the third quarter of 2020. The year over year increase in average interest bearing liabilities was primarily driven by a $98.9 million increase in interest bearing deposits, and a $59.2 million increase in subordinated debentures. The cost of interest bearing liabilities for the third quarter of 2021 decreased by two basis points from the second quarter of 2021, and decreased 12 basis points from the third quarter of 2020. Growth in our average noninterest bearing demand deposits of $136.9 million in the year over year period has assisted us in controlling our cost of funds stemming from average interest bearing deposits and borrowings, which totaled 0.30% for the third quarter of 2021, 0.31% for the second quarter of 2021, and 0.38% for the third quarter of 2020.
In the second quarter of 2021, we entered into Subordinated Note Purchase Agreements with certain qualified institutional buyers pursuant to which we sold and issued $60.0 million in aggregate principal amount of our 3.50% Fixed-to-Floating Rate Subordinated Notes due April 15, 2031 (the “Notes”). We sold the Notes to eligible purchasers in a private offering, and the proceeds of this issuance are intended to be used for general corporate purposes, which may include, without limitation, the redemption of existing senior debt, common stock repurchases and strategic acquisitions. The Notes bear interest at a fixed annual rate of 3.50% through April 14, 2026, payable semi-annually in arrears. As of April 15, 2026 forward, the interest rate on the Notes will generally reset quarterly to a rate equal to Three-Month Term SOFR (as defined by the Note) plus 273 basis points, payable quarterly in arrears. The Notes have a stated maturity of April 15, 2031, and are redeemable, in whole are in part, on April 15, 2026, or any interest payment date thereafter, and at any time upon the occurrence of certain events.
Due to the significant increase in cash and due from banks stemming from federal stimulus funds received and PPP loan forgiveness, we had no average other short-term borrowings, which consist of FHLBC advances, in the third quarter of 2021, compared to minimal average balances in the second quarter of 2021, and $8.2 million in the third quarter of 2020. As of September 30, 2021, notes payable and other borrowings consisted of one long-term FHLBC advance of $6.2 million, and $14.0 million outstanding on a term note with a correspondent bank originated in the first quarter of 2020.
Our net interest margin (GAAP) increased three basis points to 2.91% for the third quarter of 2021, compared to 2.88% for the second quarter of 2021, and decreased 32 basis points compared to 3.23% for the third quarter of 2020. Our net interest margin (TE) increased two basis points to 2.95% for the third quarter of 2021, compared to 2.93% for the second quarter of 2021, and decreased 33 basis points compared to 3.28% for the third quarter of 2020. Our core net interest margin (TE), a non-GAAP financial measure that excludes the impact of our PPP loans, was 2.85% for the third quarter of 2021, compared to 2.91% for the second quarter of 2021 and 3.34% for the third quarter of 2020. The reductions year over year were due primarily to the lower level of market interest rates over the majority of the past twelve months, the related rate resets on loans and securities during the past year, and the increase in liquidity on the balance sheet.
Our net interest and dividend income increased by $241,000, to $68.1 million for the nine months ended September 30, 2021, compared to $67.9 million for the nine months ended September 30, 2020. This increase was attributable to a $4.1 million decrease in total interest expense, which was materially offset by a $3.8 million decrease in interest and dividend income for the nine months ended September 30, 2021, compared to the nine months ended September 30, 2020. The reduction in market interest rates year over year drove the
44
decrease in interest income on loans and securities, as well as the decrease in rates paid on interest bearing deposits, specifically impacting time deposits as both rate and volume declines occurred year over year.
Average earning assets for the nine months ended September 30, 2021 were $3.02 billion, reflecting an increase of $386.8 million, or 14.7%, compared to the nine months ended September 30, 2020. The yield on average earning assets for the nine months ended September 30, 2021 was 3.34%, compared to 4.02% for the nine months ended September 30, 2020. Total average loans, including loans held-for-sale, totaled $1.94 billion for the nine months ended September 30, 2021, which reflected a decrease of $70.9 million, compared to the nine months ended September 30, 2020. The decline in average loan balances and market interest rate reductions resulted in a $3.7 million decrease in loan interest income for the nine months ended September 30, 2021, compared to the like period in 2020. For the nine months ended September 30, 2021, yields on average securities decreased by 84 basis points and yields on average loans decreased by nine basis points, each as compared to the nine months ended September 30, 2020, due primarily to the falling interest rate environment and rate resets on those assets. Average interest earning deposits with financial institutions increased $312.8 million in the nine months ended September 30, 2021, compared to the prior year like period, as payoffs related to forgiven PPP loans were received from the Small Business Administration (“SBA”) over the past twelve months, in addition to federal stimulus funds received by certain of our depositors, both of which increased our liquidity.
Average interest bearing liabilities increased $162.9 million, or 9.6%, in the nine months ended September 30, 2021, compared to the nine months ended September 30, 2020. The increase was primarily due to growth in average interest bearing deposits of $128.4 million due to federal stimulus funds received by certain of our depositors. In addition, securities sold under repurchase agreements increased $16.0 million, and average subordinated debt increased $38.6 million, due to the $60.0 million of Notes issued in April 2021, as discussed above. Partially offsetting these increases to interest bearing liabilities was a decrease in average other short-term borrowings, which primarily consist of FHLBC advances, of $13.2 million, and a decrease in average junior subordinated debentures of $7.1 million due to the redemption of the trust preferred securities issued by Old Second Capital Trust I and the related $32.6 million of subordinated debentures in March 2020. The rate on our junior subordinated debentures was 7.85% for the nine months ended September 30, 2020, as $635,000 of deferred issuance costs was expensed upon the redemption in 2020. Average noninterest bearing deposits increased $185.0 million in the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020, primarily due to federal stimulus funds received from certain of our depositors. The cost of interest bearing liabilities decreased 37 basis points, to 45 basis points, for the nine months ended September 30, 2021, from 82 basis points for the nine months ended September 30, 2020.
Our net interest margin (GAAP) for the nine months ended September 30, 2021 was 3.02% compared to 3.44% for the nine months ended September 30, 2020, reflecting a 42 basis point decrease. Our net interest margin (TE) for the nine months ended September 30, 2021 was 3.06% compared to 3.50% for the nine months ended September 30, 2020, reflecting a 44 basis point decrease. The decrease in net interest margin for the nine months ended September 30, 2021, compared to the nine months ended September 30, 2020, was due primarily to reductions in the market interest rates, a decline of $70.9 million in average loans and loans held for sale, and the growth of our liquidity with an increase in cash and due from banks, which were not yet reinvested into higher yielding assets. These reductions to the net interest margin were partially offset by reductions in rates paid on deposits, additional securities purchases, and growth in noninterest bearing deposits, which drove down our overall cost of funds.
We continue to observe competitive pressure to maintain reduced interest rates on loans retained at renewal. While our loan prices are targeted to achieve certain returns on equity, significant competition for commercial and industrial loans 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 table sets forth certain information relating to our average consolidated balance sheet 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 TE basis using a marginal rate of 21% in 2021 and 2020 to more appropriately compare returns on tax-exempt loans and securities to other earning assets.
Analysis of Average Balances,
Tax Equivalent Income / Expense and Rates
(Dollars in thousands - unaudited)
Quarters Ended
June 30, 2021
September 30, 2020
Income /
Rate
Expense
523,561
0.15
499,555
137
263,199
0.10
476,935
1.53
425,785
1,832
251,760
2.30
Non-taxable (TE)1
186,515
1,627
3.46
188,281
1,594
3.40
196,648
1,680
Total securities (TE)1
663,450
3,462
2.07
614,066
3,426
2.24
448,408
3,138
2.78
Dividends from FHLBC and FRBC
4.56
4.57
4.73
Loans and loans held-for-sale1, 2
1,889,696
21,358
4.48
1,930,965
20,857
4.33
2,048,968
22,078
4.29
Total interest earning assets
3,086,624
25,137
3.23
3,054,503
24,533
3.22
2,770,492
25,402
3.65
29,760
29,985
31,354
(28,639)
(31,024)
(31,518)
Other noninterest bearing assets
185,415
185,368
185,228
3,273,160
3,238,832
2,955,556
Liabilities and Stockholders' Equity
534,056
96
0.07
531,804
105
0.08
470,474
106
0.09
355,651
330,536
306,763
0.12
Savings accounts
451,829
0.04
439,104
378,957
331,482
0.39
359,635
409
0.46
417,952
1.03
1,673,018
0.13
1,661,079
626
1,574,146
1,383
46,339
67,737
54,313
0.21
8,204
1.16
4.40
284
4.42
59,180
3.67
56,081
517
3.70
44,441
6.01
44,415
6.08
44,337
6.04
21,171
2.12
22,250
2.15
25,482
2.25
Total interest bearing liabilities
1,869,922
1,877,336
2,240
0.48
1,732,255
0.58
1,029,705
1,012,163
892,811
53,370
36,553
39,589
Stockholders' equity
320,163
312,780
290,901
Total liabilities and stockholders' equity
Net interest income (GAAP)
21,954
Net interest margin (GAAP)
2.91
2.88
Net interest income (TE)1
22,964
22,293
22,865
Net interest margin (TE)1
2.95
2.93
3.28
Core net interest margin (TE - excluding PPP loans)1
2.85
3.34
Interest bearing liabilities to earning assets
60.58
61.46
62.53
1Represents a non-GAAP financial measure. See the discussion entitled “Non-GAAP Presentations” below that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent. Tax equivalent basis is calculated using a marginal tax rate of 21% in 2021 and 2020.
2 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 50, and includes fees of $1.8 million for the third quarter of 2021, $1.3 million second quarter of 2021, and $975,000 for the third quarter of 2020. Nonaccrual loans are included in the above-stated average balances.
461,498
148,660
0.17
415,029
1.70
257,664
2.76
188,700
4,875
3.45
201,242
5,289
3.51
603,729
10,157
458,906
10,604
3.09
4.61
4.93
Loans and loans held-for-sale 1 , 2
1,944,687
64,480
4.43
2,015,592
68,174
4.52
3,019,831
75,411
2,633,075
79,329
4.02
29,407
31,498
(31,380)
(28,601)
186,083
181,762
3,203,941
2,817,734
520,556
295
450,178
468
0.14
338,510
289,219
0.19
434,702
353,737
363,227
435,419
1.32
1,656,995
1,906
1,528,553
5,611
0.49
65,385
49,358
0.45
13,205
1.69
4.41
32,889
7.85
38,637
3.68
Senior note
44,416
44,310
6.09
22,243
2.13
22,277
2.63
1,853,449
1,690,592
0.82
993,308
808,273
42,632
35,911
314,552
282,958
3.02
3.44
69,150
68,994
3.06
3.50
3.54
61.38
64.21
2 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 50, and includes fees of $4.4 million and $2.0 million for the third quarter of 2021 and the third quarter of 2020, respectively. Nonaccrual loans are included in the above-stated average balances.
Reconciliation of Tax-Equivalent Non-GAAP Financial Measures
Net interest and dividend income (TE) and net interest income (TE) to average interest earning assets are non-GAAP measures that have been adjusted on a TE basis using a marginal rate of 21% for 2021 and 2020 to more appropriately compare returns on tax-exempt loans and securities to other earning assets. The table below provides a reconciliation of each non-GAAP (TE) measure to the GAAP equivalent for the periods indicated:
June 30,
Net Interest Margin
Interest income (GAAP)
24,194
Taxable-equivalent adjustment:
335
353
1,111
Interest and dividend income (TE)
Interest expense (GAAP)
Net interest income (TE)
Paycheck Protection Program ("PPP") loan - interest and net fee income
1,138
832
736
2,711
1,339
Net interest income (TE) - excluding PPP loans
21,826
21,461
66,439
67,655
Average interest earning assets
Average PPP loans
53,562
91,948
136,281
78,288
77,302
Average interest earning assets, excluding PPP loans
3,033,062
2,962,555
2,634,211
2,941,543
2,555,773
Net interest margin (TE)
Core net interest margin (TE - excluding PPP loans)
Noninterest Income
The following table details the major components of noninterest income for the periods presented:
3rd Quarter 2021
Percent Change From
(Dollars in thousands)
2,389
(0.7)
25.6
1,221
12.0
3.5
Residential mortgage banking revenue
272
(11.8)
(51.2)
(1,033)
(72.7)
76.3
507
12.8
9.8
1,895
15.4
(58.3)
Total residential mortgage banking revenue
2,716
1,641
6,099
65.5
(55.5)
N/M
423
(4.0)
(11.5)
(100.0)
1,666
(2.5)
8.3
577
5.7
45.2
7,919
17.9
(20.1)
N/M - Not meaningful
Noninterest income increased $1.4 million, or 17.9%, in the third quarter of 2021, compared to the second quarter of 2021, and decreased $2.3 million, or 20.1%, compared to the third quarter of 2020. The increase from the linked quarter was primarily driven by a $1.1 million increase in residential mortgage banking revenue, primarily attributable to a $751,000 decrease in mark to market losses on mortgage servicing rights (MSRs) stemming from market interest rate changes and a $291,000 increase in net gain on sales of mortgage loans in the third quarter of 2021, compared to the second quarter of 2021. In addition, increases were noted compared to the linked quarter of $242,000 in securities gains, net, and $147,000 in service charges on deposits.
The decrease in noninterest income in the third quarter of 2021, compared to the third quarter of 2020, is primarily due to a $3.4 million decrease in residential mortgage banking revenue, which included a $3.1 million decrease in net gain on sales of mortgage loans and a $252,000 decrease in secondary mortgage fees from the 2020 like period. Partially offsetting these decreases was a $483,000 increase in wealth management income and a $125,000 increase in card related income in the third quarter of 2021, compared to the third quarter of 2020. The increase in card related income in the third quarter of 2021, compared to both the linked quarter and prior year quarter, resulted from reductions in COVID-19 related restrictions and the resultant increase in consumer spending. An increase of $245,000 in the third quarter of 2021, compared to the like quarter in 2020, was also noted in securities gains, net, due to securities sold in the third quarter of 2021.
YTD
Percent
Change
19.3
(9.2)
(34.2)
92.6
13.8
(35.6)
10,080
12,098
(16.7)
Securities gains (losses) , net
23.5
49
15.6
4.1
(0.5)
Noninterest income for the nine months ended September 30, 2021 decreased $143,000, or 0.5%, compared to the nine months ended September 30, 2020. This decrease was primarily driven by a $2.0 million decrease in total residential mortgage banking revenue primarily stemming from a $4.3 million decrease in net gain on sales of mortgage loans, partially offset by a $2.5 million decrease in mark to market losses on MSRs. Wealth management income increased $1.1 million for the nine months ended September 30, 2021, compared to the like period in 2020, primarily due to an increase in customer liquidity and the resultant assets under management. In addition, card related income increased $640,000 for the nine months ended September 30, 2021, compared to the like period in 2020, as customers are starting to spend more as COVID-19 restrictions ease. The change in cash surrender value of BOLI also increased by $221,000 for the nine months ended September 30, 2021, compared to the like period in 2020, due to market rate changes and an increase in BOLI asset balances year over year. Securities gains, net, totaled $246,000, compared to securities losses, net of $25,000 for the like period in 2020, due to sales of $35.1 million during the nine months ended September 30, 2021 compared to sales of $18.0 million in the like period in 2020.
Noninterest Expense
The following table details the major components of noninterest expense for the periods presented:
Salaries
9,630
9,435
9,731
2.1
(1.0)
Officers incentive
1,212
1,194
968
1.5
25.2
Benefits and other
2,122
2,267
1,887
(6.4)
12.5
Total salaries and employee benefits
12,896
0.5
3.0
Occupancy, furniture and equipment expense
2,303
5.0
20.7
1,304
13.3
20.5
9.9
10.5
277
8.7
7.1
Amortization of core deposit intangible asset
115
(1.7)
(7.4)
12.6
72.6
5.8
17.0
135
237.0
169.2
Other real estate owned expense, net
(67.5)
(80.0)
3,381
0.4
15.7
21,401
3.4
9.2
Efficiency ratio (GAAP)1
68.73
68.63
58.27
Adjusted efficiency ratio (non-GAAP)2
66.46
67.64
57.47
1 The efficiency ratio shown in the table above is a GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income and total noninterest income less any BOLI death benefit recorded, net gains or losses on securities and mark to market gains or losses on MSRs.
2 The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits, OREO expenses and merger-related costs, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains or losses on securities and mark to market gains or losses on MSRs, and includes a tax equivalent adjustment on the change in cash surrender value of BOLI. See the section entitled “Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures” on page 52 for a reconciliation of this non-GAAP measure to the most comparable GAAP equivalent.
Noninterest expense for the third quarter of 2021 increased $728,000, or 3.4%, compared to the second quarter of 2021, and increased $1.9 million, or 9.2%, compared to the third quarter of 2020. The linked quarter increase is primarily attributable to a $195,000 increase in salaries primarily due to a reduction of salary-related loan cost deferrals due to the decrease in PPP loan originations, a $173,000 increase in computer and data processing expense and a $320,000 increase in legal fees attributable to merger-related costs incurred related to our pending merger with West Suburban. In addition, occupancy, furniture and equipment expense increased $115,000 in the third quarter of 2021 compared to the linked quarter due to an increase in planned building maintenance. These increases were partially offset by a decrease in other real estate owned expenses.
The year over year increase in noninterest expense is primarily attributable to a $378,000 increase in salaries and employee benefits in the third quarter of 2021 compared to the third quarter of 2020. Officer incentive compensation increased $244,000 in the third quarter of 2021, compared to the third quarter of 2020, as incentive accruals in 2021 were at a higher rate than the prior year. Employee benefits expense increased $235,000 in the third quarter of 2021, compared to the third quarter of 2020, due to an increase in employee insurance costs as more employees returned to routine medical appointments, many of which were on hold during the first six months of the COVID-19 pandemic. We also had increases in the year over year period in occupancy, furniture and equipment of $415,000 due to an increase in planned building repairs, an increase in computer and data processing expense of $251,000, and an increase in legal fees of
51
$286,000, primarily due to merger-related costs incurred. Finally, other expense increased $461,000 primarily due to growth in management and consulting fees, commercial loan non-legal expense, and company events due to our 150th anniversary celebration during the third quarter of 2021.
28,280
28,080
0.7
4,060
2,894
40.3
7,026
5,872
19.7
6.8
15.2
49.9
11.8
(7.0)
14.9
16.7
35.5
11.2
8.5
67.04
59.71
65.69
58.89
Noninterest expense for the nine months ended September 30, 2021, increased $5.1 million, or 8.5%, compared to the nine months ended September 30, 2020, primarily due to an increase in salaries and employee benefits due to annual merit increases in March 2021, as well as payout of officer incentives in early 2021 at a rate higher than that accrued for 2020 performance, and the resultant increase in accruals in 2021 to be paid out in 2022. In addition, occupancy, furniture and equipment expense increased $949,000, stemming from planned building repairs and maintenance, FDIC insurance increased $201,000 due to assessment credits received in early 2020 not repeated in 2021, card related expense increased $269,000, primarily due to a return to pre-COVID-19 customer spending levels in 2021, and other expense increased $994,000, primarily due an increase in management and consulting fees due to the pending merger with West Suburban, and directors fees due to growth in the number of our directors year over year. Partially offsetting these increases was a $367,000 decrease in other real estate owned expense, net, as property holdings have decreased $774,000 year over year, due to continued remediation of credits prior to foreclosure, and the COVID-19 foreclosure moratorium in effect during most of 2021.
Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures
GAAP
Non-GAAP
Efficiency Ratio / Adjusted Efficiency Ratio
Less amortization of core deposit
Less other real estate expense, net
Less merger related costs
Noninterest expense less adjustments
21,991
21,209
20,019
21,566
Net interest income
Net interest income including adjustments
Less death benefit related to BOLI
Less securities gains (losses), net
Less MSRs mark to market losses
Noninterest income (less) / including adjustments
9,378
8,950
11,848
9,486
9,062
11,970
Net interest income including adjustments plus noninterest income (less) / including adjustments
31,996
30,904
34,357
32,450
31,355
34,835
Efficiency ratio / Adjusted efficiency ratio
64,782
59,285
64,357
266
28,515
31,409
28,824
31,675
96,630
99,283
97,974
100,669
Income Taxes
We recorded income tax expense of $2.9 million for the third quarter of 2021 on $11.3 million of pretax income, compared to income tax expense of $3.2 million on $12.0 million of pretax income in the second quarter of 2021, and income tax expense of $3.4 million on $13.6 million of pretax income in the third quarter of 2020. The effective tax rate was 25.8% for the third quarter of 2021, 26.3% for the second quarter of 2021, and 24.7% for the third quarter of 2020.
Income tax expense reflected all relevant statutory tax rates and GAAP accounting. There were no significant changes in our ability to utilize our deferred tax assets during the quarter or nine months ended September 30, 2021. We had no valuation reserve on the deferred tax assets as of September 30, 2021.
Financial Condition
Total assets increased $234.3 million to $3.28 billion at September 30, 2021, from $3.04 billion at December 31, 2020, due primarily to an increase in cash and cash equivalents of $189.4 million and securities available-for-sale of $219.0 million, partially offset by a reduction in loans of $166.9 million. We continue to actively assess potential investment opportunities for our excess liquidity. Total deposits were $2.71 billion at September 30, 2021, an increase of $177.3 million from December 31, 2020, primarily due to increases in noninterest bearing demand accounts, savings, money market and NOW accounts due to lower interest rates on time deposits in 2021, and federal stimulus funds received by many depositors.
As of
U.S. Treasuries
4,134
(1.1)
(1.5)
7,005
404.4
379.3
18,219
(2.2)
249,777
(4.1)
(4.3)
57,013
192.3
190.1
81,585
43.6
132.1
30,688
99.9
98.9
Total securities
448,421
44.1
59.5
Securities available-for-sale increased $219.0 million as of September 30, 2021, compared to December 31, 2020, and increased $266.8 million compared to September 30, 2020. Available-for-sale security purchases during the quarter ended September 30, 2021, totaled $189.6 million and consisted of $28.3 million of U.S. government agencies, $73.0 million of collateralized mortgage obligations, $48.3 million of asset-backed securities, and $39.4 million of collateralized loan obligations. These purchases were partially offset by $23.8 million of calls, maturities and paydowns during the third quarter of 2021, and $26.9 million of security sales, as well as an unrealized mark to market loss adjustment of $3.3 million and net premium amortization of $641,000. During the third quarter of 2021, $244,000 of security gains, net, were recorded, compared to $1,000 of security losses, net, in the third quarter of 2020.
436,277
(21.0)
(26.3)
133,676
14.7
21.5
548,970
(8.0)
335,978
(1.6)
91,856
10.4
18.3
61,923
(19.0)
(26.5)
114,283
(6.9)
(5.2)
188,398
(14.9)
(14.6)
85,882
(13.9)
(18.9)
22,312
(36.5)
(44.6)
Other (1)
10,772
18.2
2,030,327
(8.2)
1 The “Other” segment includes consumer and overdrafts.
Total loans were $1.87 billion as of September 30, 2021, a decrease of $166.9 million from December 31, 2020. The decrease in total loans in the first nine months of 2021, compared to December 31, 2020, was due primarily to forgiveness or payoff of 1,060 PPP loans that totaled $164.3 million within commercial loans, as well as reductions in the majority of our loan categories due to paydowns as commercial and consumer liquidity increased primarily due to the receipt of federal stimulus funds and capital expenditures decreased due to the COVID-19 pandemic. Total loans decreased $162.4 million from September 30, 2020 to September 30, 2021, primarily due to PPP loans forgiven, net of originations, as well as reductions in organic commercial loans due to payoffs related to borrower liquidity. As required by CECL, the balance (or amortized cost basis) of purchased credit deteriorated loans, or PCD loans (discussed below) are carried on a gross basis (rather than net of the associated credit loss estimate), and the expected credit losses for PCD loans are estimated and separately recognized as part of the allowance for credit losses, or ACL.
The quality of our loan portfolio is impacted not only by our 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 real estate, construction, residential, multifamily, and HELOCs) has been and continues to be a sizeable portion of our portfolio. These categories comprised 73.4% of the portfolio as of September 30, 2021, compared to 72.5% of the portfolio as of December 31, 2020. We continue to oversee and seek to manage our loan portfolio in accordance with interagency guidance on risk management.
Asset Quality
Nonperforming loans consist of nonaccrual loans, performing restructured accruing loans and loans 90 days or greater past due. Remediation work continues in all segments. Nonperforming loans increased by $5.9 million to $29.0 million at September 30, 2021 from $23.0 million at December 31, 2020. Purchased credit deteriorated loans, or PCD loans, are purchased loans that, as of the date of acquisition, we determined had experienced a more-than-insignificant deterioration in credit quality since origination. PCD loans and their related deferred loan costs are included in our nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan. Management continues to carefully monitor loans considered to be in a classified status. Nonperforming loans as a percent of total loans were 1.5% as of September 30, 2021, 1.1% as of December 31, 2020, and 1.0% as of September 30, 2020. The distribution of our nonperforming loans is shown in the following table.
Nonperforming Loans
1,605
(80.4)
(86.3)
2,801
2,079
41.3
90.4
6,100
2,021
273.8
201.8
8,635
(25.5)
1,085
935
6.7
4,885
3,561
3,516
37.2
38.9
2,055
895
(15.7)
129.6
1,142
1,140
(38.7)
(38.6)
Other 1
Total nonperforming loans
28,952
23,045
20,832
39.0
The components of our nonperforming assets are shown in the following table.
Nonperforming Assets
(Dollars in Thousands)
Nonaccrual loans
20,076
37.1
Performing troubled debt restructured loans accruing interest
331
334
(39.9)
(40.4)
Loans past due 90 days or more and still accruing interest
422
184.1
192.2
(22.7)
(28.8)
Total nonperforming assets
30,864
25,519
23,518
20.9
31.2
30-89 days past due loans and still accruing interest
2,829
11,326
5,511
Nonaccrual loans to total loans
1.1
1.0
Nonperforming loans to total loans
Nonperforming assets to total loans plus OREO
1.7
1.3
1.2
Allowance for credit losses to total loans
1.4
1.6
Allowance for credit losses to nonaccrual loans
97.9
152.0
164.0
Loan charge-offs, net of recoveries, for the current quarter, prior linked quarter and year over year quarter are shown in the following table.
Loan Charge-offs, Net of Recoveries
% of
Total1
(0.8)
190
292.3
1.9
43.1
(32.6)
83
35.0
(20)
(30.8)
(102)
27.9
32.3
(420)
115.1
(16.2)
(3.0)
(10)
(15.4)
(15)
(7.6)
(61)
(93.8)
77.2
(28)
(72)
(110.8)
(52)
14.2
(18.1)
10.1
(11)
(16.9)
(3.1)
Net (recoveries) charge-offs
237
100.0
(365)
1 Represents the percentage of net charge-offs attributable to each category of loans.
2 The “Other” segment includes consumer and overdrafts.
Net charge-offs of $237,000 were recorded for the third quarter of 2021, compared to net charge-offs of $65,000 for the second quarter of 2021, and net recoveries of $365,000 for the third quarter of 2020, reflecting continuing management attention to credit quality and remediation efforts. The net charge-offs for the third quarter of 2021 were primarily due to one multifamily charge-off. We have continued our conservative loan valuations and aggressive recovery efforts on prior charge-offs.
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 we will sustain some loss if deficiencies remain uncorrected.
The following table shows classified assets by segment for the following periods.
Classified Assets
5,992
(82.6)
(92.2)
37.3
35.3
5,596
70.4
55.8
9,658
(35.5)
(25.3)
5,108
(5.7)
(23.9)
(24.4)
3,836
11.6
17.5
5,833
(69.2)
(60.1)
1,566
(32.9)
(34.0)
(50.0)
(99.3)
Total classified loans
42,657
(17.0)
Total classified assets
36,835
44,529
45,343
(17.3)
(18.8)
Total classified loans and classified assets decreased as of September 30, 2021, from the levels at both December 31, 2020 and September 30, 2020, primarily due to continued remediation efforts and the high level of paydowns and payoffs we have experienced due to increased borrower liquidity stemming from federal stimulus funds received by borrowers and other COVID-19 relief funding, such as PPP loans. Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the ACL on loans 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 9.73% for the period ended September 30, 2021, compared to 12.64% as of December 31, 2020, and 12.86% as of September 30, 2020. The decrease in the classified assets ratio for the period ended September 30, 2021, compared to September 30, 2020, is also due to the remediation efforts and borrower liquidity noted above, as well as growth in our capital level over the past year.
Allowance for Credit Losses on Loans
The provision for credit losses, which includes a provision for losses on unfunded commitments, is a charge to earnings to maintain the ACL at a level consistent with management’s assessment of expected losses in the loan portfolio at the balance sheet date. As of January 1, 2020, we adopted ASU 2016-13, or CECL.
We recorded a net release of $1.5 million in our provision for credit losses due to a reserve release for the third quarter of 2021, comprised of a $1.5 million reserve release related to loans and a $47,000 reserve release related to unfunded commitments. We recorded a release of $3.5 million in our provision for credit losses for the second quarter of 2021, comprised of a $2.3 million reserve release related to loans and $1.2 million of additional provision expense for credit losses on unfunded commitments, compared to a provision for credit losses recorded in the third quarter of 2020 of $300,000. In the third quarter of 2021, we determined a reserve release on loans was appropriate, after considering our low level of net charge-offs for the quarter of $237,000, and net recovery position of $280,000 year to date, as well as the impact of changes to our future loss rate assumptions based on a decrease to the unemployment factor projected for the life of the loans over the one year forecast period. In addition, we recorded a $47,000 release to the provision for credit losses on unfunded commitments in the third quarter of 2021, primarily due to an updated analysis of line utilization rates over the past twelve months, as well as the roll off of prior historical periods with lower losses within the CECL model.
Management estimates the amount of provision required on a quarterly basis and records the appropriate provision expense, or release of expense, to maintain an adequate reserve for all potential and estimated credit losses on loan, leases and unfunded commitments. Our ACL on loans to total loans was 1.4% as of September 30, 2021, compared to 1.7% at December 31, 2020. See Item 7 – Critical Accounting Policies in the Management Discussion and Analysis in our 2020 Annual Report in Form 10-K for discussion of our ACL
methodology on loans. Allocations of the ACL may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off.
Below is a reconciliation of the activity in the allowance for credit losses on loans for the periods indicated (dollars in thousands):
Allowance at beginning of period
30,967
Charge-offs:
207
Total charge-offs
Recoveries:
61
Total recoveries
236
Net charge-offs (recoveries)
924
Adoption of ASC 326
(Release of) provision for credit losses on loans
(2,263)
Allowance at end of period
Average total loans (exclusive of loans held-for-sale)
1,884,788
1,926,105
2,035,584
1,938,573
2,005,253
Net charge-offs / (recoveries) to average loans
0.00
(0.02)
(0.01)
Allowance at period end to average loans
1.43
1.49
1.62
1.39
1.64
The coverage ratio of the ACL on loans to nonperforming loans was 93.1% as of September 30, 2021, which was a decrease from the coverage ratio of 123.9% as of June 30, 2021 and a decrease from 158.0% as of September 30, 2020. When measured as a percentage of average loans, our total ACL on loans was 1.39% for the nine months ended September 30, 2021, and 1.64% for the like period of September 30, 2020
In management’s judgment, an adequate ACL has been established to encompass the current lifetime expected credit losses at September 30, 2021, and general changes in lending policy, procedures and staffing, as well as other external factors, such as the impacts of the COVID-19 pandemic. 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. Further delayed recovery or further deterioration in market conditions related to COVID-19 and the associated impacts on our customers,
changes in business climates and the condition of collateral at the time of default or repossession may revise our current expectations of future credit losses in future reporting periods.
Other Real Estate Owned
As of September 30, 2021, OREO totaled $1.9 million, reflecting a $562,000 reduction from the $2.5 million at December 31, 2020, and a $774,000 reduction from the $2.7 million at September 30, 2020. There was one property disposal of $37,000 net book value and one transfer to OREO for $70,000 recorded in the third quarter of 2021. There was one property addition for $314,500 in the third quarter of 2020. There were seven property disposals for a total of $2.7 million in the third quarter of 2020. There were two valuation adjustments which occurred in the third quarter of 2021 for a net write-up of $2,000, compared to $93,000 of OREO valuation write-downs in the fourth quarter of 2020, and $46,250 of valuation write-downs recorded in the third quarter of 2020.
OREO
(30.1)
(63.1)
(77.7)
(68.9)
(98.6)
93
(102.2)
(104.3)
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 $1.1 million, or approximately 56.4% of total OREO at September 30, 2021, 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
519
430
Lots (single family and commercial)
1,078
1,387
1,461
Vacant land
315
352
351
Commercial property
305
424
Total other real estate owned
100
Deposits and Borrowings
Deposits
889,085
14.1
382,711
19.6
492,407
310,613
17.1
208,570
(13.2)
(16.8)
129,522
(40.3)
(24.0)
66,335
(36.3)
(42.0)
2,479,243
7.0
9.5
Total deposits were $2.71 billion at September 30, 2021, which reflects a $177.3 million increase from total deposits of $2.54 billion at December 31, 2020, and an increase of $235.1 million from total deposits of $2.48 billion at September 30, 2020. The increase in deposits at September 30, 2021, compared to both December 31, 2020 and September 30, 2020, was due to increases in noninterest bearing demand, savings, NOW, and money market accounts, with decreases noted in all maturity categories of certificates of deposit. These total deposit increases in the linked quarter as well as the year over year periods were primarily due to federal stimulus funds received by certain depositors due to the COVID-19 pandemic.
In addition to deposits, we obtained funding from other sources in all periods presented. Securities sold under repurchase agreements totaled $43.0 million at September 30, 2021, a $24.0 million, or 35.9%, decrease from $67.0 million at December 31, 2020. Our notes payable and other borrowings is comprised of one remaining $6.2 million long-term FHLBC advance, which matures on February 2, 2026, and $14.0 million outstanding on a $20.0 million term note originated with a correspondent bank in the first quarter of 2020, to facilitate the redemption of our Old Second Capital Trust I trust preferred securities and related junior subordinated debentures, completed on March 2, 2020. Notes payable and other borrowings of $20.1 million as of September 30, 2021, decreased $3.2 million from December 31, 2020, and decreased $4.3 million from September 30, 2020.
The Company is indebted on senior notes originated in December 2016, totaling $44.5 million, net of deferred issuance costs, as of September 30, 2021. 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 $25.8 million, net of deferred issuance costs, of junior subordinated debentures, which are related to the trust preferred securities issued by its statutory trust subsidiary, 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 4.41% as of September 30, 2021, as compared to 6.77%, which was the rate paid during the period prior to the June 15, 2017, rate reset.
As of September 30, 2021, total stockholders’ equity was $321.2 million, which was an increase of $14.1 million from $307.1 million as of December 31, 2020. This increase is attributable to an increase in retained earnings of $25.9 million, comprised of net income year to date of $29.1 million, less a reduction to retained earnings of $3.2 million for payment of dividends to our common stockholders in the first nine months of 2021. In addition, a decrease to accumulated other comprehensive income of $2.5 million was recorded due to a net decrease in unrealized gains on available-for-sale securities, net of unrealized losses on swaps. Total stockholders’ equity was reduced by an increase of $8.1 million to our treasury stock in the first nine months of 2021, primarily due to repurchases of our common shares pursuant to our stock repurchase program.
In the third quarter of 2019, our Board of Directors authorized a stock repurchase program, under which we were authorized to repurchase up to approximately 1.5 million shares (or approximately 5%) of our outstanding common stock through open market purchases, trading plans established in accordance with U.S. Securities and Exchange Commission rules, privately negotiated transactions, or by other means. The stock repurchase program expired on September 19, 2020; however, we received a notice of non-objection from the Federal Reserve Bank of Chicago to extend the previously authorized stock repurchase program through October 20, 2021. The actual means and timing of any repurchases, quantity of purchased shares and prices will be, subject to certain limitations, at the discretion of management and will depend on a number of factors, including, without limitation, market prices of our common stock, general market and economic condition, and applicable legal and regulatory requirements. These share purchases were funded by our cash on hand. During the third quarter of 2021, we did not repurchase any shares pursuant to our stock repurchase program. For the nine months ended September 30, 2021, we repurchased 766,034 shares at a weighted average share price of $12.81 per share. To date, we have repurchased 1,485,307 shares of our common stock at a weighted average price of $10.31 per share, under our stock repurchase program. As of September 30, 2021, we had substantially completed the stock repurchase program, which expired on October 21, 2021.
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:
Adequacy with
Under Prompt
Capital Conservation
Corrective Action
Buffer, if applicable1
Provisions2
The Company
Common equity tier 1 capital ratio
11.97
Total risk-based capital ratio
14.33
Tier 1 risk-based capital ratio
13.08
Tier 1 leverage ratio
10.07
The Bank
14.24
15.49
10.90
2 The prompt corrective action provisions are only applicable at the Bank level.
As part of its response to the impact of the COVID-19 pandemic, in the first quarter of 2020, U.S. federal regulatory authorities issued an interim final rule that provided banking organizations that adopted CECL during the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital relative to regulatory capital determined under the prior incurred loss methodology, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during the initial two-year delay (i.e., a five-year transition in total). In connection with our adoption of CECL on January 1, 2020, we elected to utilize the five-year CECL transition. The cumulative amount that is not recognized in regulatory capital, in addition to the $3.8 million Day One impact of CECL adoption, will be phased in at 25% per year beginning January 1, 2022. As of September 30, 2021, the capital measures of the Company exclude $4.2 million, which is the modified CECL transition adjustment.
As of September 30, 2021, the Company, on a consolidated basis, exceeded the minimum capital ratios to be deemed “well capitalized” and met the now fully phased-in capital conservation buffer requirements. In addition to the above regulatory ratios, our GAAP common equity to total assets ratio, which is used as a performance measurement for capital analysis and peer comparisons, decreased from 10.10% at December 31, 2020, to 9.81% at September 30, 2021. Our GAAP tangible common equity to tangible assets ratio was 9.24% at September 30, 2021, compared to 9.48% as of December 31, 2020. Our non-GAAP tangible common equity to tangible assets ratio, which management also considers a valuable performance measurement for capital analysis, decreased from 9.49% at December 31, 2020, to 9.25% at September 30, 2021, due to the growth in total tangible assets.
In November 2019, the federal banking agencies published final rules to provide an optional simplified measure of capital adequacy for qualifying community banking organizations, which we refer to as the community bank leverage ratio (“CBLR”) framework. Generally, under the CBLR framework, qualifying community banking organizations with total assets of less than $10 billion, and limited amounts of off-balance-sheet exposures and trading assets and liabilities, may elect whether to be subject to the CBLR framework if they have a CBLR of greater than 9%. Qualifying community banking organizations that elect to be subject to the CBLR framework and continue to meet all requirements under the framework would not be subject to risk-based or other leverage capital requirements and, in the case of an insured depository institution, would be considered to have met the well capitalized ratio requirements for purposes of the FDIC’s Prompt Corrective Action framework. The final rule became effective on January 1, 2020. We do not have any immediate plans to elect to use the community bank leverage ratio framework, but may make such an election in the future.
Reconciliation of Tangible Common Equity to Tangible Assets Ratio Non-GAAP Measure
Tangible common equity
Total Equity
Less: Goodwill and intangible assets
Add: Limitation of exclusion of core deposit intangible (80%)
435
Adjusted goodwill and intangible assets
20,067
20,346
300,799
301,165
286,306
286,741
Tangible assets
Less: Adjusted goodwill and intangible assets
3,254,699
3,255,065
3,020,056
3,020,491
Common equity to total assets
10.10
Tangible common equity to tangible assets
9.24
9.25
9.48
9.49
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 us when reviewing risk based capital ratios and equity performance metrics.
Liquidity
Liquidity is our ability to fund operations, to meet depositor withdrawals, to provide for customers’ credit needs, and to meet maturing obligations and existing commitments. Our liquidity principally depends on our cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and our ability to borrow funds. We monitor our borrowing capacity at the FHLBC as part of our liquidity management process as supervised by our Asset and Liability Committee (“ALCO”) and reviewed by our Board of Directors. In addition, due to the potential impacts on our liquidity stemming from the COVID-19 pandemic, our senior management team monitors cash balances daily to ensure we have adequate liquidity to meet our operational and financing needs. As of September 30, 2021, our cash on hand liquidity totaled $519.3 million, an increase of $189.4 million over cash balances held as of December 31, 2020.
Net cash inflows from operating activities were $50.8 million during the first nine months of 2021, compared with net cash inflows of $16.8 million in the same period of 2020. Funds used to originate loans held-for-sale, net of proceeds from sales of loans held-for-sale, were a source of inflows for both the first nine months of 2021 and the like period of 2020. Interest paid, net of interest received, combined with changes in other assets and liabilities were a source of inflows for the nine months ended September 30, 2021, and outflows for the like period of 2020. The management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows. Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, as part of the balance sheet management process.
Net cash outflows from investing activities were $57.0 million in the nine months ended September 30, 2021, compared to net cash outflows of $54.4 million in the same period in 2020. In the first nine months of 2021, securities transactions accounted for net outflows of $225.2 million, and the principal change on loans accounted for net inflows of $168.6 million. In the first nine months of 2020, securities transactions accounted for net inflows of $45.0 million, and net principal on loans funded accounted for net outflows of $100.4 million. Proceeds from sales of OREO accounted for $608,000 and $3.1 million in investing cash inflows for the nine months ended September 30, 2021 and 2020, respectively.
Net cash inflows from financing activities in the nine months ended September 30, 2021 were $195.6 million, compared with net cash inflows of $300.2 million in the nine months ended September 30, 2020. Net deposit inflows in the first nine months of 2021 were $177.3 million compared to net deposit inflows of $352.5 million in the first nine months of 2020. Other short-term borrowings had no net cash outflows in the first nine months of 2021, compared to $42.4 million of outflows in the first nine months of 2020. Changes in securities sold under repurchase agreements accounted for outflows of $24.0 million and inflows of $10.6 million for the nine months ended September 30, 2021 and 2020, respectively. The redemption of our Old Second Capital Trust I trust preferred securities and related junior subordinated debentures resulted in cash outflows of $32.6 million in the first quarter of 2020, which was partially offset by a $20.0 million term note cash inflow which was originated to partially fund this trust preferred redemption; $14.0 million of this term note
63
remains outstanding as of September 30, 2021. In the second quarter of 2021, we issued $59.1 million of subordinated debentures, net of issuance costs; this cash is anticipated to be used for general corporate purposes, which may include, without limitation, the redemption of existing senior debt, common stock repurchases or strategic acquisitions.
Cash and cash equivalents for the nine months ended September 30, 2021, totaled $519.3 million, as compared to $313.1 million as of September 30, 2020. In addition to cash and cash equivalents on hand or held as deposits with other financial institutions, we rely on funding sources from customer deposits, cash flows from securities available-for-sale and loans, and a line of credit with the FHLBC to meet potential liquidity needs. These sources of liquidity are immediately available to satisfy any funding requirements due to depositor or borrower demands through the ordinary course of our business. Additional sources of funding include a $20 million undrawn line of credit held by the Company with a third party financial institution, as well as unpledged securities available-for-sale.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Risk
As part of our normal operations, we are subject to interest-rate risk on the assets we invest in (primarily loans and securities) and the liabilities we fund (primarily customer deposits and borrowed funds). Fluctuations in interest rates may result in changes in the fair market values of our financial instruments, cash flows, and net interest income. Like most financial institutions, we have an exposure to changes in both short-term and long-term interest rates.
The Federal Reserve has kept the target Fed Funds range of 0% to 0.25% since the first quarter of 2020, the latest Fed Funds Futures implies a rate hike in the third quarter of 2022. The Fed has been aggressively purchasing assets in the open market since March 2020, increasing its balance sheet to $8.5 trillion by the end of September 2021. Given that inflation has been more persistent than initially thought, the Fed announced that it will start tapering its asset purchases this year and conclude such purchases by the middle of 2022. We manage interest rate risk within guidelines established by policy which are intended to limit the amount of rate exposure. In practice, we seek to manage our interest rate risk exposure well within our guidelines so that such exposure does not pose a material risk to our future earnings.
We manage various market risks in the normal course of our 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 our business activities and operations. In addition, since we do not hold a trading portfolio, we are not exposed to significant market risk from trading activities. Our interest rate risk exposures at September 30, 2021 and December 31, 2020 are outlined in the table below.
Our 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. Our asset-liability committee seeks to manage interest rate risk under a variety of rate environments by structuring our balance sheet and off-balance sheet positions, which includes interest rate swap derivatives as discussed in Note 18 of our consolidated financial statements found in in our Annual Report on Form 10-K for the year ended December 31, 2020. We seek to monitor and manage interest rate risk within approved policy guidelines and limits.
We use simulation analysis to quantify the impact of various rate scenarios on our net interest income. Specific cash flows, repricing characteristics, and embedded options of the assets and liabilities held by us are incorporated into the simulation model. Earnings at risk are 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 September 30, 2021, we had notable amounts of earnings gains (in both dollars and percentage) should interest rates rise. The projected increases in income across all up rate interest rate shock scenarios as of September 30, 2021 were notably higher than December 31, 2020, primarily due to the increase in Fed Funds from high deposit levels and repricing on short term rates.
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%, 1.0%, and 2.0% and no change in the slope of the yield curve. Due to relatively low current market interest rates, it was not possible to calculate any down rate scenarios because many of the market interest rates would fall below zero in that scenario.
Analysis of Net Interest Income Sensitivity
Immediate Changes in Rates
(2.0)
2.0
Dollar change
5,343
10,854
22,180
Percent change
6.4
12.9
26.5
3,405
6,879
13,145
3.9
7.8
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.
Effects of Inflation
In management’s opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not change at the same rate or in the same magnitude as the inflation rate. Rather, interest rate volatility is based on changes in the expected rate of inflation, as well as on changes in monetary and fiscal policies. A financial institution’s ability to be relatively unaffected by changes in interest rates is a good indicator of its capability to perform in today’s volatile economic environment. We seek to insulate the Company from interest rate volatility by using our best efforts to ensure that rate sensitive assets and rate sensitive liabilities respond to changes in interest rates in a similar time frame and to a similar degree.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of September 30, 2021. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2021, the Company’s internal controls were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified.
There were no changes in the Company’s internal controls over financial reporting during the quarter ended September 30, 2021, 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
Investing in shares of our common stock involves certain risks, including those identified and described in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as well as cautionary statements contained in this Quarterly Report, on Form 10-Q, including those under the caption “Cautionary Note Regarding Forward-Looking Statements,” and set forth in Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2021.
Except as set forth in Part II, Item 1A of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2021 and filed with the SEC on August 6, 2021, which is incorporated herein by this reference, there have been no material changes to the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020 filed with the SEC on March 8, 2021.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Stock Repurchases
In September 2019, our board of directors authorized the repurchase of up to 1,494,826 shares of our common stock (the “Repurchase Program”). The Repurchase Program expired on September 19, 2020. However, on October 20, 2020, the Company received notice of non-objection from the Federal Reserve Bank of Chicago to extend the Repurchase Program through October 20, 2021. We made no repurchases under the Repurchase Program in the third quarter of 2021. The Repurchase Program expired on October 21, 2021.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Mine Safety Disclosures
Not applicable
Item 5. Other Information
Item 6. Exhibits
Exhibits:
Agreement and Plan of Merger between Old Second Bancorp, Inc. and West Suburban Bancorp, Inc. dated as of July 25, 2021 (incorporated by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K filed on July 26, 2021).
31.1
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).
32.1
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.
32.2
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets at September 30, 2021, and December 31, 2020; (ii) Consolidated Statements of Income for the three months ended September 30, 2021 and 2020; (iii) Consolidated Statements of Stockholders’ Equity for the three months ended September 30, 2021 and 2020; (iv) Consolidated Statements of Cash Flows for the three months ended September 30, 2021 and 2020; and (v) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail.*
104
Cover Page Interactive Data File (the cover page XBRL tags are embedded within the Inline XBRL document).
* As provided in Rule 406T of Regulation S-T, these interactive data files shall not be deemed “filed” for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934 as amended, or otherwise subject to liability under those sections.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
BY:
/s/ James L. Eccher
James L. Eccher
President and Chief Executive Officer
(principal executive officer)
/s/ Bradley S. Adams
Bradley S. Adams
Executive Vice President and Chief Financial Officer
(principal financial and accounting officer)
DATE: November 5, 2021