Old Second Bancorp, Inc. (OSBC) Q2 2013 Earnings Report, Transcript and Summary

Greetings and welcome to the Old Second Bancorp’s Second Quarter 2013 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Doug Cheatham, from Second Bancorp. Thank you Mr. Cheatham, you may begin.

Thank you. Good morning everyone and thank you for joining us. I will start with a reminder that our comments today may contain forward-looking statements which are based on management’s existing expectations in the current economic environment. These statements are not a guarantee of future performance, and results may differ materially from those projected. I ask you to refer to our SEC filings for a full discussion of the Company’s risk factors. With me this morning are Bill Skoglund, President, Chairman and CEO of Old Second Bancorp, President and CEO of Old Second Bank, and Chief Operating Officer of Old Second Bancorp, Jim Eccher, and Executive Vice President and Chief Credit Officer Joe Marchese. And I am Doug Cheatham, Executive Vice President and CFO. And now, I will turn it over to Bill to get things started.

Good morning. Thank you Doug and thank you for your interest in our stock and in the bank and for joining us this morning. As we stated in the past, we really have four main goals this year and they are one to continue to reduce private loans and assets, achieve consistent profitability at both the Bank and the Bancorp, three maintain and grow the capital and new in 2013 to start growing loans and deposits. And I am pleased to report that we continue to see good progress in all these areas this quarter. On the classified asset goal, this is the tenth consecutive quarter that we’ve had a reduction in our classified assets and are now down to levels I’ve seen since early 2008. Classified assets, which are made up of classified loans, loans accrual, both not accrual and substandard accruing and OREO were down $27 million from the first quarter and were down $48 million for the year. The ratio that our regulators follow closely is our total classified assets to Tier-1 plus allowance for loans and this ratio is now at 59.63% at the end of the quarter and it’s down from a peak of 180% in 2010. Because of the continued reduction in classified loans, we were able to take $1.8 million out of the reserve this quarter and put into income, our reserve is now at $35.4 million and it’s now $3.2 million from the year-end, but our classified loans are down about $35 million from the year end. Regarding our second goal, earnings, this quarter we are again happy to report earnings at both the Bank and the Bancorp. This is the fifth consecutive quarter of earnings at both the bank and the Bancorp. At the Bancorp we earned $3.5 million in net…

Okay, thanks Bill. Yesterday, we reported second quarter earnings of $0.15 per share on net income of $3.5 million and net income available to common stockholders of $2.2 million. This compares with $0.30 per share in the first quarter of this year and a slight profit a year ago. For the first half of 2013, we had earnings of $0.45 per share on net income of $8.9 million and net income available to common stockholders of $6.4 million. In comparing the first quarter and second quarters of this year, the major changes were the smaller reserve release, which Bill mentioned from $2.5 million in the first quarter to $2.8 million in the second quarter, reduced gains on securities sale and a decline of about $500,000 in net interest income. The net interest income reduction is the result of a slightly smaller loan portfolio offset impart by increases in securities. The net interest margin ratio declined from 3.18% in the first quarter to 3.07% in the second quarter, in 2012, the ratio was 3.65% in the second quarter and 3.57% for the first half of the year. The average yield on earning assets declined from 4.46% in the first half of 2012 to 3.89% in the first half of 2013. However the 2012 first half earning asset yield received benefit from a collection of previously reversed or unrecognized interest on loans that returned to performing status. The first half of 2012 earning assets yield would have been 4.35 without that benefit. The average cost of interest-bearing liabilities was 1.13% in the first half of 2012 compared to 0.96% in the first half of 2013. Non-interest income was $10.5 million in the second quarter and $21.1 million for the year-to-date. This compares with 1$10.4 million and $20.9 million in the quarter and year-to-date periods in 2012. Security gains were down compared with the first quarter as I mentioned. We also had increased servicing income including a $300,000 increase in the fair value of servicing rights and we recorded a BOLI death benefit of $375,000. Trust income was the highest it has been in two years at $1.7 million compared to $1.5 million both in the first quarters of 2012 and 2013. For both the quarter and year-to-date, expenses were down compared to a year earlier. Non-interest expenses were $22.2 million in the second quarter of 2013, compared to $24.6 million in the second part of 2012. For the first half, expenses were $43.7 million in 2013 and $47.1 million in 2012. In each case, the single largest expense decline was in other real estate expenses. Non-interest expenses of $22.2 million in the second quarter were up when compared to $21.5 million in the first quarter of 2013. Increased costs included salaries and benefits, advertising and other real estate expenses. And with that run down on earnings, I’ll now turn it over to Jim.

Okay, thank you. My comments this morning will be brief. The quarter was highlighted by continued improvement and credit quality. Non-performing loans, OREO and classified assets all declined once again. The loan portfolio metrics continued to improve. Our momentum remains very strong in reaching resolutions at our distressed asset area. All criticized asset categories improved in the quarter and early stage pass due loan levels are now at their lowest levels since pre-cycle 2007 levels. With early stage delinquencies at relatively low levels, we are optimistic that credit costs will continue to abate in future quarters. As Bill mentioned classified assets declined for the tenth consecutive quarter on the strength of continued reductions in our OREO portfolio of classified loans. Classified assets declined 16% in the quarter and are now down 42% from a year ago. After loan portfolio did see somewhere shrinkage this quarter and after decline $58 million and $37 million, the prior two quarters the portfolio showed some stabilization and declined $11 million in the quarter. A $7 million of this reduction was due to the decrease in non-accrual loans. Only $4 million really relative to normal organic shrinkage. The portfolio is beginning to show early signs of stabilization and we expect the second half of the year to yield moderate organic growth and while overall loan demand remains relatively weak in our core markets, still we are beginning to experience slightly higher line of credit utilization from existing borrowers. Loan pipelines are beginning to build slowly and while growth remains elusive, we are optimistic that our business development efforts and our recruiting efforts will lead to positive loan growth in coming quarters. Our residential banking division posted another strong quarter and continues to be a strong source of non-interest income and our loss management group continues to deliver healthy profit margins while growing its client base. At this point, I will turn it back over to the moderator and we can open it up to any questions.

Thank you. (Operator Instructions) Our first question comes from the line of (Inaudible) Please proceed with your question.

Good morning guys. Thanks for taking my question. I had two quick questions actually. The first is and you guys kind touch on this, that given the recent ongoing improvement in the bank’s financials, how far along with discussions or in discussions are you with regulators and what’s the timeline for taking out those securities look like?

Well, with regulators, we are in discussions with them on a regular basis. I think from our perspective, two things happen to take out to look at possibilities of the TARP or where our options are there. One we need to get out of the consent order and the other is we need to get the DTA back. I think both of those are possible to get done this year. Nothing is guaranteed with old groups. But I think both of those are possible. At that point, we would look at all of our strategic options. I think that would be a good time to look at it and one of them could be raising capital. One of them could be talking with the TARP holders at that point about what they would need to be paid. So that’s we are a little bit away from that yet but we are making good progress and we are hopeful we can get a lot of that done this year.

Sounds great. And then the second question was, on the OREO front, are the remaining assets in that pocket, are those the assets that couldn’t be sold at a reasonable price or those assets that you believe are going to rebound in value and so you are holding on to those assets?

Currently, we are not experiencing too much sluggishness in marketing these and finding buyers that the market has recovered substantially from where it was this time a year ago. We’ve seen since the fourth quarter of last year, we’ve seen slow improvements in all sectors of real estate, including for the first time in the last few quarters, our retail environment and our book has improved. So the most market improvement is in residential houses and lots for residential development where these sales were relatively stagnant in our OREO portfolio last year. We’ve seen quite an acceleration of interest in land for developments for residential, properties, single lots and of course consumer demand is coming back strong for individual residential homes as well. So, to add to your question, we don’t really see any sluggish sectors in the OREO portfolio right now. We continue to make excellent progress there and for the foreseeable future we think that shrinkage of that portfolio through sales will continue. By the way, our liquidations at those properties have been pretty close to or even higher than our book value.

Excellent, thank you guys very much. That’s it for me.

The next question comes from the line of Andrew Liesch of Sandler O'Neill. Please proceed with your question. Andrew Liesch – Sandler O'Neill: Hi gentlemen. Good morning. I just want to follow-up on the OREO question. Just curious it sounds like property valuations are rebounding or stabilizing. And can you just go over the $2.6 million in OREO valuation expense in the quarter?

Well this is Jim and I’ll let Joe chime in. We’ve got a continued consistent process where we are currently reappraising properties on an annual basis. We typically have a high level of appraisals in the second and fourth quarters. It shows devaluation adjustment to prior combination of lower value of some construction assets or a devaluation that is tied to the contract sale price of a property that was set for closing. So, while we don’t like to see further devaluation. Those levels are – devaluation expenses was as low as we’ve seen in the second quarters in some time. So, to Joe’s point, we are seeing stabilization in many areas, construction related assets are still under some stress but nowhere near the stress we’ve seen in prior years. We’ve only got about $35 million now in the construction portfolio performing and other OREO portfolio maybe about 40% of our OREO portfolios in construction assets. Our cost to carry on those assets is relatively low. So while we are eager to move on, the expense is tied to holding are very material.

I would just throw in other comment. As you bring the OREO down, you get some across the year stuff that sings in there and surprisingly this quarter and maybe last, we’ve been getting offers on some of the things we would consider to be kind of dog properties. In other words if we have a retail property completely vacant, it’s difficult to know what that’s worth and to write it exactly what you think it might sell for. And lately we’ve been getting offers on some of what we would call a dog stuff. And last quarter we took some of those, just because we know we need to move this classified asset ratio down in order to get out of the consent order. So we’ve been a little more aggressive on wanting to sell even stuff that comes in at a kind of a lower market price and we think it should. But on the other hand it’s a dog property and we can move it and get this classified ratio and get out of the consent order what we’ve been wanting to take. So, and more so the reason for the write-down as Jim said, is again, a lot of our prior times we’ve got a few dogs that we wanted to get rid of and we took them. Andrew Liesch – Sandler O'Neill: Okay, I guess that’s reflected in that in net OREO aging table that you provided at some of the – it looks like some of the stuff that you’ve held for longer has declined. Just moving to the margin real quickly, it came down about a 11 basis points reflects the loan yield fell. I was curious, if there is anything specific driving that or just new loans coming on at lower rates and higher loans maturing and what’s your outlook for further loan yields and then possibly could we see the margin rise and here if you do get some warm results in the second half of the year.

I’ll touch on the loan side, maybe Doug can touch on cost of funding side. We are seeing continued pressure to – the cut rates on renewals as loans come up for maturity in the normal renewal cycle as well as new loan origination. Competition remains pretty fierce. Really it’s that something what we are seeing a lot of loans just renewing this time a year that we are having to get rate concessions to keep the business.

On the expense side of that, with this extended period low rates we are continuing to see the average cost of funds were down. Because we don’t have a need to grow our deposit at this point we have a real strong deposit base but we don’t need to grow that real soon to meet loan demand. We are able to price those pretty reasonably. We still have some longer term CDs that are rolling off and continue to roll off. So, we’ll see some continued benefit on the cost of fund side I would expect. We’ve got; obviously, we’ve put a lot into the securities now. We have $185 million in securities at the end of the quarter. We are picking up some decent yields there, but still keeping the duration relatively short compared to what I am hearing in the marketplace. So, we are managing the balance sheet I think pretty well and as loan demand picks up, we’ll be able to cover that with securities sales maturities rather than having to go out and pay up for deposits. Andrew Liesch – Sandler O'Neill: Thanks. That’s helpful. Thanks for taking my question.

(Operator Instructions) The next question is coming from the line of John Barber with Keefe Bruyette & Woods. Please go ahead with your question. John Barber – Keefe Bruyette & Woods: Good morning guys. Jim, you mentioned that there were two larger relationships deferred into non-accrual status this quarter. I was wondering if you could give us a little bit more color on those relationships with FAS AR and what types of credits they are? Thank you.

Yeah, the largest was a struggling multi-family proprietor near one of the local universities; it has experienced higher vacancies than it has in prior years. And we are hearing the reason for that is mainly because universities actually put up a lot of dormitory and student housing on campus that’s putting pressure on some of the independent investors out there. That was fairly sizable downgrade to non-accrual cost of $6 million. We feel, we got it allocated for – already. We are optimistic part of that will be refinanced elsewhere. The other one is a mixed use properties, about $3 million. That also suffered from higher vacancies and tight cash flows. So, those are two main ones. Other than that, we really didn’t see anything material migrate downward in the portfolio.

Yeah, in addition to that, we had a number of upgrades as a 6.30 as well, I think it was three or four significant numbers that Doug got upgraded out of non-accrual to growing. John Barber – Keefe Bruyette & Woods: Okay, thanks. And Doug, I just want to make sure, I heard you correctly. Do you say there was a $300,000 MSR write-up this quarter?

That’s correct. John Barber – Keefe Bruyette & Woods: Okay, thanks. With the steepening of the curve, OCI taken to have swings this quarter. I was wondering if you are looking into any potential strategies to mitigate further negative impacts on unrealized losses and securities book. Thanks.

Well, we had the real spikes in rates in the end of the quarter, that was, we’ve had plenty of quarters, just back on the MSR, we have had plenty of quarters where we were negative write-downs on the MSR this quarter, it spiked up and we took back some of the previous losses. I think the same thing on unrealized gains and losses on securities. There was a real spike there. At quarter end, it’s reflected in the market value. So on securities at quarter end, I struggle with that issue a little bit because economically speaking we don’t mark the rest of our balance sheet to market, through equity deposits on the liability side or loans or anything else on the asset side. So, I mean, the interest rate risk respective from an economic standpoint we’re very well positioned or an increase in rates I am very comfortable with our interest rate risk position. So do you sacrifice an economic position in the interest of an accounting position? I don’t think that’s necessarily the way to go. So, I guess that’s a longer answer than maybe you expect it. But I would say no, we are probably not going to do a whole lot to try to address out that number.

The only thing we do and this builds go over this add then on the investment is, half of our investments are floating rate securities and we switch to that last year all through early this year and last year have been trying to shorten the duration of the portfolio and I think it’s around the 2.5 to three years.

And, yes, probably we got two, three quarters now.

That’s not the pretty short duration and that’s how we’re kind of managing or we are not locking in long-term rates or haven’t locked in long-term rates in fact has done just the opposite what the floating rate government lot of this through loan paper. John Barber – Keefe Bruyette & Woods: Okay, thank you. And just the last one I had, Bill, it’s been profitable for five straight quarters of the Bank in hold. Just wondering the $75 million valuation for allowance into DTA, what additional evidence do your auditors need to see. I know this is not a brake line test, but kind of where they’ve been telling you they need to see before you can reverse that? Thanks.

I’ll let Doug answer that. But we are talking to them continually about that and about what we can do to get that back. So we are on that pretty heavily, but Doug, you can maybe speak to what specifics we would look towards?

Yeah, I think, we can’t give you an exact timeframe here. But, obviously with another quarter of profitability, we are one step closer. A lot of it relates to not historical earning. The rule of thumb that you need a trend of positive earnings is really all about establishing that you can expect positive earnings in the future which we do. And so, we, as part of documenting the recovery of the valuation allowance, we will document our expected future earnings with the auditors. We’ll put in our position paper on that when the time comes. A lot of objectives, concrete evidence, such as economic trends and all sorts of things, but we also have subjective indicators too. If the regulators provide relief on the consent order, that’s not formally a part of the process, but it’s just one more subjective piece of evidence that the trends are positive. So we’ll put a lot of information into that report package and share that with our auditors. But mostly it rests expectations of future earnings. John Barber – Keefe Bruyette & Woods: Great, thank you very much.

We have reached the end of our question and answer session for today. I will now turn the floor back to management for closing comments.

Okay, well we appreciate everyone’s calling in today and although we know we got some work to do, things are definitely getting better and I think I mentioned earlier our four goals. We do look towards getting, hopefully getting the removal of the consent order and the recovery of the DTA is two of our primary goals and we are optimistic about getting those done. But, certainly they are not necessarily all in our hands. And so, we look forward to getting better in 2013 and continuing to grind it out. So we think it’s definitely getting better and things are improving. So again, thank you for calling and we appreciate your interest.

This concludes today’s teleconference. You may disconnect your lines at this time. We thank you for your participation.