Old Second Bancorp, Inc. (OSBC) Q3 2013 Earnings Report, Transcript and Summary

Greetings and welcome to the Old Second Bancorp’s Third 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 call is being recorded. It is now my pleasure to introduce your host, Doug Cheatham, Executive Vice President and CFO. Thank you. Mr. Cheatham, you may now 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 disclosure of the company’s risk factors. I am Doug Cheatham, Executive Vice President and CFO of Bancorp. With me this morning are Bill Skoglund, President, Chairman and CEO of Old Second Bancorp; President and CEO of Old Second National Bank and Chief Operating Officer of Old Second Bancorp, Jim Eccher; and the Executive Vice President and Chief Credit Officer, Joe Marchese. And now, I will turn it over to Bill to get things started.

Good morning. This is Bill Skoglund and I would like to thank you again for joining us this morning. I am proud to say that the third quarter showed significant continued progress in a number of areas resulting in two major events. First was the OCC terminating of the consent order for the bank that had been in place since May 16, 2011. And secondly, the Bancorp benefited from the reversal of a large part of the valuation allowance against deferred tax assets creating that $70 million benefit, but in addition, we continue to have success for our four main goals this year. On the classified asset goal, we reduced classified assets by $23 million this quarter and this is the 11th consecutive quarter of reductions. Classified assets now stand at $218 million, down from the peak of $470 million in December of 2010. Our total classified assets to Tier 1 capital plus the allowance ratio with the regulators follow closely is now 49.76%. Regarding earnings this quarter, we reported quarterly net income of $72.9 million after the $70 million benefit from the reversal of the valuation allowance against deferred tax asset. With the reversal, the Bancorp reported net income of $81.9 million for the first nine months of 2013 compared to a loss of $1.6 billion in the same period of 2012. On capital at the bank, we have a Tier 1 leverage ratio of 11.08% and a total capital ratio of 17.08%. In connection with the current economic environment, the bank’s current level of non-performing assets and risk-based capital guidelines, the Bank’s Board of Directors has determined that the bank should maintain the Tier 1 leverage capital ratio at or above 8% and a total risk-based capital ratio at or above 12%. As you can see, the bank…

Okay, thanks Bill. In yesterday’s announcement, we reported net income available to common shareholders of $71.6 million, or $5.08 a share in the third quarter. This equates to earnings per share of $0.11 per share a quarter, excluding the reversal of valuation allowance against the deferred tax assets. For the year-to-date, net income available to common shareholders was $78 million, or $5.52 per share. Excluding the DTA reversal, net income before taxes was $11.9 million, or $0.56 per share of the year-to-date. Regarding the DTA valuation amount, we reversed $53.2 million in federal DTA valuation and $18 million in state DTA valuation allowance, $2.4 million in state-related valuation reserve remains. Third quarter net income before taxes was $2.9 million compared to $120,000 in the third quarter of 2012. The increase was primarily due to release of $1,750,000 in loan loss reserves and reviewed other real estate expenses. The net interest margin was 3.25% in the third quarter of 2013 compared to 3.44% in the third quarter of 2012. However, the third quarter margin was 18 basis points higher than the second quarter of 2013. There were several reasons for the quarterly increase in the margin ratio. Fees on loans were $793,000 in the third quarter compared to $551,000 in the second quarter. The average yield of securities increased from the second quarter to the third quarter of 2013 and the cost of deposit continues to decline slightly. We provide a detail schedule of non-interest income in the release. Two items account for the bulk of the change when comparing the third quarter of 2013 to the third quarter of 2012 or to the second quarter of 2013. Residential lending income account about $1.5 million compared to the third quarter of 2012 and it was down about $1.6 million compared to…

Thanks Doug. The loan portfolio was highlighted again by continuous improvement in credit quality as non-performing loans, OREO and classified assets all declined meaningfully in the quarter. Loan portfolio overall continue to show improving metrics as momentum remained strong and reaching resolutions in our dispensed asset areas. All criticized asset categories improved in the quarter and early stage past due levels are in their lowest levels since the pre-cycle stage in 2007. With early stage delinquencies at relatively low levels, we continue to be optimistic that credit costs will continue to abate in future quarters. As Bill mentioned, classified assets declined for the 11th consecutive quarter on the strength of continued reductions in our OREO portfolio and classified loans. Classified assets declined $0.3 million or 16% in the quarter and over 46% lower now from a year ago. The non-accrual loans are those not earning interest dropped sharply in the quarter falling 25% and have declined over 53% from a year ago. More importantly non-accrual inflows were nearly $1 million in the quarter, mostly the results of a few small relationships. Non-accrual outflows outpaced inflows by a wide margin at several relationships either paid off or upgraded or migrated to OREO. Similar trends in our special mentioned category as we experienced $3.6 million in inflow and almost $14 million in outflow as several relationships were upgraded and reported stronger operating results. Prospecting for new loan growth is now becoming a focal point. And as Bill noted our competition and our market footprint remains very competitive. We are seeing significant pressure on pricing and loosening of some loan terms by our competitors, general weakness and overall loan demand. And while we remain competitive from a pricing perspective for the right relationship, we are now going to give in our loan structures. We are beginning to see construction and development activity in some areas of our market. So we have remained on the side lines at this point as we look to focus on traditional commercial industrial business and owner occupied commercial real estate opportunities. And while loan footings declined $25 million in the quarter, $14.5 million of this reduction was due to declines in the non-accrual loan categories and $3 million migrated to OREO. OREO totals declines by over 17% in the quarter, which represents the sixth consecutive quarter reductions in that category. Our special assets group continues to be very effective and reaching resolution to sell properties at near carrying values. The overall loan portfolio is beginning to show early signs of stabilization. And we are nearing the point where we can expect moderate organic growth. Loan pipelines are beginning to build slowly and while growth remains elusive at this point, we are optimistic that our business development efforts will lead to positive loan growth in coming quarters. And that concludes my comments and I will now turn over to the moderator and we can open up to questions.

Thank you. We will now be conducting the question-and-answer session (Operator Instructions) Our first question is from the line of Andrew Liesch of Sandler O'Neill. Please proceed with your question.

Hi guys, congratulations on the consent order and DTA evaluation.

Thank you, Andrew. Hi.

I just wanted to focus a little bit here on loan growth origination activity. I am just kind of curious like where does the pipeline stand from where it was a quarter ago. How much origination activity do you have in the third quarter compared to the fourth quarter obviously it continued to look – the portfolio continued to pay down, but almost I am curious where our production activity is?

We are seeing moderate pick ups in each quarter. Its nowhere near the level if we need to say for averaging about roughly $15million in new and closed business quarter we need to get up to $20 million to $25 million I think to offset run off and the claims in the non-accrual bucket that – as that continues to delay, then we will see more organic growth. Construction activity is starting to pick up and in some of our markets to the west and I wouldn’t say it’s robust, permits are up and we are beginning to feel lot more activity.

Okay, thanks. And then I guess now that you have the – we have the valuation allowance, what tax rates should we be looking at going forward?

That’s a good question. I think probably we have shed ourselves most of our tax exempts, tax incurred assets with a few succession. Over the last couple of years, you can probably calculate and find that a blended state and federal rates and (indiscernible).

Got it. Thanks taking my questions. I’ll get back.

Thanks.

Our next question comes from the line of (indiscernible). Please proceed with your question.

Good morning, guys. Thanks for taking my question. My focus is on the TARP securities and the trough, so you have said it number of times in your press release is that you believe that you will be able to repurchase the TARP preferreds at a discount, but we have seen over the last few months, we have seen the price of your TARP securities move up substantially. And so I am interested in your perspective on the discount that you think you would be able to capture?

Well, I guess it’s – we are jumping a little bit ahead of the game here, but right now, we firstly wanted to get things right at the bank. And so step one was to get the consent order off, get the DTA off. And as the long-term strategy, we want to take care of our obligations. So we are working – looking at all our options right now and that’s one of them that we could consider. We don’t have the cash in the Bancorp to do that now. Although we may have some ability to dividend up from the Bancorp in the future and it’s just something we are looking at our options. So I really can’t tell you what the discount is or we are doing that, but we just need to look at our options and we are interested in bringing – taking care of our obligations, so more to come on that I guess.

Excellent. Then just a quick question on the health maturity portfolio, what would you say the blended duration of that is?

The duration of the held in the trade portfolio is around 530, 535 and a range of the duration on the available per sale is about one-third by the range and we have got a blended rate of (disturbances).

Excellent, that’s it from me guys. Thank you.

Thank you. Our next question is from the line of John Barber with KBW. Please proceed with your question.

Good morning.

Good morning, John. John Barber – KBW: Just as a follow-up to Andrew’s question, the tax rate so we should about that is return to a normal rate for full year ‘14, is that also the case for the fourth quarter of ‘13?

Yes, yes.

Okay, okay, just want to clarify, thank you. And also whether the DTA being protected are there any strategies that you guys can enact that will create an excellence and maybe help you use up that DTA to help build regulatory capital ratios even faster?

Well, the first strategy is to make more money, I think we are trying to do that. So that’s really just frankly, get the bank back to updating more profitable. There is no particular targeted strategy you described, but the best way we can do that is being profitable as we can. John Barber – KBW: Okay. And maybe you guys could talk for a minute more just about to decline in the gain on sale of loans this quarter was held for the industry in general, that line item comes down, but maybe you just talk about your pipeline now at the end of the third quarter and how that compared to the pipeline at the end of the second quarter?

John, I heard the second part of your question regarding about longer haul with the first part about gains. John Barber – KBW: Sorry, I was asking about the gain on sale of loans, fee income line items and just if you could talk about the pipeline at the end of the third quarter compared to the pipeline at the end of the second quarter.

That’s more of the residential real estate part, yes. John Barber – KBW: Yes, what you are selling to secondary markets?

Yes, I asked our head of our mortgage area and the pipeline is down from that by half of what it was earlier in the year. So there is – well, it’s starting to build almost all purchased money and not much refinance going on. So we are probably down 40% to 50% in the pipeline on where we were and Doug, I don’t know if he will talk about gain on sales.

Well, it’s mostly volume driven. We kept – I think it’s the pipeline is essentially move through these – purchases move through the pipeline a little quicker than the replay of news, so that’s a little silver lining there, but the volume is definitely down from the first half. John Barber – KBW: Okay. And then actually I had two more. One on credit, it looks like most probably trends remain favorable and the non-accrual inflows declined versus the second quarter. So just going back to the weekend close in the second quarter last conference call you mentioned it was related to larger relationships. Were those originated more recently or were those more legacy pre-cycle relationships that were previously identified?

Okay. Those, I know, I think they are related to multifamily property outside and are what sort of market they depend on a portfolio for a number of years, local university has experienced a calendar apps and enrollment. Also put some housing on campus that’s affected some of the multifamily subscribers in the market that was really the largest REIT for the inflow of that property will becoming end of our OREO portfolio relatively shortly. John Barber – KBW: Okay, thanks for the color. Last one I had, in your opinion what do regulators need to see before the list the written agreement?

Do you mean at the Fed level? John Barber – KBW: Yes.

Well, it’s certainly they follow the bank. What happens in the bank and we are talking to them now, but we have a different capital structure in the Bancorp that as a bank, I am sure they would like to see that changes a little bit. But they do follow closely with the bank and they are encouraged and are seem to be responding favorably with the credit features that are there. So we are not 100% sure on the Fed yet although we are talking to them, but I am sure they would like to see the capital structure of the Bancorp a little different. John Barber – KBW: Okay, thank you.

Thank you. Our next question is from the line of David Caruso, a Private Investor. Please proceed with your question.

Yes, how are you doing folks?

Good Dave. How are you doing?

Okay. I want to ask you a question, this relates back to the first quarter. In your first quarter of 2013 how much we are from actual earnings and how much was as you call it litigation that you have bank cash and where you are internally that I could breakdown?

Of this quarter you mean?

I am talking about the first quarter of 2013 with the bank run $0.30 EPS I want to know like how much part of that was actual earnings how much what you call litigation case versus the Bancorp?

That’s we are going back a couple of quarters I will have hard time remember few quarters. So maybe we could maybe if you give us or give me a call later we could dwell into that a little bit more but I have to do a little bit research on that.

Okay.

Just to know what happened in the prior quarters.

You are talking about credit remediation where maybe we have some successes I would (indiscernible) on that. We have a line item in our income statement called litigation related income and it was only $11,000 varied on a fund and a little bit of a lock down for the questions I have therefore the reference to the loan related issues. Out of context I can’t relate.

We had some recoveries, I know in the first quarter we did have one borrower for the $1.5 million on a guarantee that we recovered. And that went into the loan loss reserve so that helps some of the money come out of the loan locked reserve. I think we took out $2 million if I am correct in the first quarter out of the reserve, so that part the $2 million would have come out of the credit remediation. I am not sure if that’s what you are talking about, but if he is likely to be happy to discuss as to more Dave if you want.

Okay. And actually to follow up on that first question is there any more litigation standalone let’s say the next quarter?

The nice part of our litigation is it takes a long time that’s the – the good part is we have been into the long time. So we are starting to see some of the people that were hard cases are actually starting to win. So we are optimistic that we can get some guarantors still to pay. And yes, I think that we will start seeing the results of some of that litigation, let’s say, sometimes takes a year and a half, two years to get through, some people fighting pretty hard, the time is running out. So it’s been a year and a half, two years and they are going to have to pay if they can so.

It’s actually running out of them.

Yes.

I understand that. Okay, I had another question if I start right with you, is this bank considered a regional bank or a community bank?

Or what bank?

On the Old Second Bancorp actually is considered what you call a regional bank or is considered what you call a community bank?

Well, I like to think of this as a community bank, but large enough to we call it be the right size. So we operate as a community bank, but we have a lot of the products and services that a regional bank would have. So we are setup that way, but I would still say we are more of the community bank.

Bill thanks for the color in that matter, if you might have less (indiscernible), okay.

Okay.

When does the company expect to receive the $75 million from the government regulators, I was going to get done when you back from them?

When do we expect to pay that?

Yes. No, no, no when do they expect to get that money, which the government regulators are holding from the bank. Was that the top firm holding about $75 million, $76 million of the bank’s money which the regulators are holding?

There is not $75 million that they are holding. We had $73 million in TARP money, which the Treasury auctioned off.

$73 million, alright.

That is another investor sense right now.

That was not in the bank’s hands and alright, it’s still being considered in other words, right. It’s out of the bank’s hands in other words.

We have preferred stock investors that hold that preferred stock that was issued by the company.

So everything is still pending on that particular matter in other words right?

Well, we still hold the money kind of livid, it’s still pending, but it’s not owed by the government, so it’s not something that they owe us, we owe them.

You owe them to $73 million, oh, I thought it was the other way around. I thought you are supposed to get this $20 million back to the government.

No, at risk.

Obviously, the other way around.

Right. The DTA was a tax reversal that we have that in future that’s taxes that we have already to offset future taxes with.

Thanks for your call.

Obviously, it sounds like that the bank owes the government $73 million now?

So we are no longer on the government because other investors bought it.

The investors bought the $73 million already.

We’ll be happy to – why don’t we talk offline on that Dave. We will explain that in more detail to you.

Okay, okay, thank you very much for your time. Anyway, I have done these questions.

Thanks.

Thank you. (Operator Instructions) The next question is from the line of Brian Conrad, a Private Investor. Please go ahead with your question.

Yes. My question is on the deferred dividends on the trust preferreds, what restrictions are there and paying just the deferred dividends and you think you would be able to do that before the end of the year?

Well, the restrictions on the paying the deferred dividends are we have to have the cash in the Bancorp to do that. We don’t have enough ye. We have a couple of sources. One could be to as the bankers’ money, we could begin the dividend up money to the Bancorp now with the – because of the consent order coming off or we could go out and look for capital or some other type of capital to do that. So we do have the right to hold off until the fall of 2015, but it’s not our intention to do. We’d like to get – we’d like to have – like to fulfill our obligations, but we are still looking at our options in order to do that. Brian Conrad – Private Investor: Because I thought last quarter, you indicated you were hoping to do that by the end of the year.

No, I don’t know that we’ve – I would like to do it as soon as I can. But it’s I don’t think we ever said by when so no – it’s really we are looking at our options and we would like to do it as soon as it’s in the best interest of everybody to do that. Brian Conrad – Private Investor: So are you permitted to dividend that money up now?

Now that would permit us to dividend money up to based on our percentage of earnings, but we are also because we are just out of the concerned order, we would probably be a little cautious on just doing that right now. I mean we have to watch the bank capital ratios and be careful with a lot of things. So again the answer is we are looking at our options and we would like fulfill all our obligations when the time is right. So that’s a – that is a priority for us and we are looking at it. Brian Conrad – Private Investor: Okay, thank you.

Your next question is coming from the line of Brian Martin with FIG Partners. Please proceed with your question.

Hi guys. Congrats on the news this quarter. Just one question, Bill you talked about kind of running at a more optimal there are some capital ratios that are still not optimal I guess kind of is at the lower risk profile that’s what you guys have done on the credit front. What is kind of the optimal capital structure it’s just the kind of capital level you guys would like to be running with today or kind of see yourself perceptively going to?

As the bank our capital levels are adequate. As the Bancorp our levels are also adequate, but there are some new rules coming out as you know Brian under Basel 3.

Yes.

So we don’t know for a holding company the bank is fine with all of those ratios. For the holding company, we don’t know if they have set those yet. But we would also have a tangible capital ratio that’s a little lower than we would like to see. So we are still waiting to see what some of the rules come out under Basel 3 and we would like to increase that tangible equity ratio at the bank, but we are looking at our options that we have in order to do that and we are interested in doing that.

Okay, alright. That’s really what I want to. All the other questions have been answered, but thank you.

Okay, Brian. Thanks.

Thank you. And there are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Okay, well thank you again for calling in. We think this is an exciting time for the bank and it’s nice to be back to talking about growth and profitability and those kind of things that are normal for banking and hopefully not so much on problem loans and how we are going to get out of that. So we are encouraged by these results and I would like to thank you for your loyalty and our staff and preservations and our interest in getting through this. And again, thank you for calling in.

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