Old Second Bancorp, Inc. (NASDAQ:OSBC) Q3 2022 Earnings Conference Call October 27, 2022 11:00 AM ET
Company Participants
James Eccher – CEO
Brad Adams – CFO
Gary Collins – Vice Chairman
Conference Call Participants
David Long – Raymond James
Chris McGratty – KBW
Manuel Navas – D.A. Davidson
Nathan Race – Piper Sandler
Operator
Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc.’s Third Quarter 2022 Earnings Call. On the call today is Jim Eccher, the company’s CEO; Gary Collins, Vice Chairman of our Board; and the company’s CFO, Brad Adams.
I will start with a reminder that Old Second’s comments today may contain forward-looking statements about the company’s business, strategies and prospects, 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.
Management would ask you to refer to the company’s SEC filings for a full discussion of the company’s risk factors. On today’s call, we will be discussing certain non-GAAP financial measures. These non-GAAP measures are described and reconciled to their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com on the homepage and under the Investor Relations tab.
Now I will turn the floor over to Jim Eccher.
James Eccher
Good morning, and thank you for joining us. I have several prepared opening remarks and will give my overview of the quarter and then turn it over to Brad for additional details. I will then conclude with some summary comments, few thoughts about the future before we open it up for questions.
Net income was $19.5 million or $0.43 per diluted share in the third quarter of 2022. Net income adjusted to exclude West Suburban acquisition-related costs, net losses from branch sales and gains from the sale of our VISA portfolio and land trust portfolio was $19.6 million or $0.43 per share in the third quarter.
On the same adjusted basis, return on assets was 1.30%. Return on tangible equity was 21.97% and the efficiency ratio was 51.87%. Earnings this quarter were obviously favorably impacted by an increase in net interest income of $10.3 million from increasing asset yields across the balance sheet.
The third quarter of 2022 continue to reflect the positive impacts of the West Suburban acquisition in our financial statements. We continue to outperform our own expectations on cost saves, loan growth and revenue that we had set for ourselves internally as we plan the first year following the close.
I think we’ve been very successful in bringing in new sales teams that make us a better company today, and we weren’t close. As we’ve mentioned, we set out to double our loan origination capacity through the first three quarters this year. We are at three times from where we were last year at this time. These new teams are adding substantially to our results.
We haven’t spoken about it as much, but we have been investing in people and processes in the back office that will allow us to more effectively manage a growing organization. Overall, we could not be more pleased with where the Bank stand today from both a balance sheet positioning and operational standpoint.
The third quarter again represents the highest quarterly net loan growth we have ever produced, excluding acquisition impacts. We had $244.3 million or 6.7% of net loan growth quarter-over-quarter or approximately $245.3 million exclusive of PPP runoff.
Prepayments have slowed meaningfully and allowed continuing strong origination activity to impact the balance sheet. Activity within Loan Committee remained robust and line utilization trends increased modestly during the quarter. Recent hires are hitting their stride and the cultural fit is fantastic.
The net interest margin expanded substantially this quarter with loan yields at last beginning to reflect recent increases in market interest rates. Overall, the tax equivalent net interest margin was 3.96% for the third quarter compared to 3.18% in the second quarter of 2022. The margin benefit resulted from balance sheet mix improvement, the impact of rising rates on the variable portion of the loan portfolio and strong loan growth for both the second and third quarter. Loan-to-deposit ratio is now 73%. And here, too, we consider ourselves far ahead of the schedule that we had set for ourselves.
The focus now for us has shifted to balance sheet optimization from straight liquidity deployment. I’ll let Brad talk about that in a minute. We recorded nominal charge-offs of $67,000 in the third quarter compared to $250,000 of net charge-offs in the second quarter. Total classified loans ticked up $10.6 million to $113.7 million from $103.2 million last quarter. Other real estate owned decreased $63,000 in the third quarter due to 1 property sale. We remain confident in the strength of our portfolios.
The allowance for credit losses increased to $48.8 million as of September 30 from $45.4 million at the previous quarter, which is 1.26% of the total loans and consistent with total ACL to gross loans as of June 30. At quarter end, $3.5 million of provision for credit losses on loans was recorded as well as $973,000 of provision for unfunded commitments, and increases were driven by loan growth and are based on a review of line utilization trends.
Our outlook is cautiously optimistic as the underlying economy appears strong, albeit with significant uncertainties. We believe that we are more than adequately reserved under base case scenarios, but continue to overweight more pessimistic scenarios given the high degree of uncertainty. Recession probabilities increased relative to last quarter in our estimation. The credit remains very well behaved, though we remain mindful and diligent in monitoring trends both within the portfolio and more broadly.
A gain on the sale of our VISA credit card portfolio of $743,000 and a gain on the sale of our land trust book of business of $180,000 were recorded in the third quarter. Both of these lines of business were acquired with the West Suburban acquisition. Expense discipline continues to be strong, and we are far ahead of schedule on cost saving targets announced with the acquisition.
Total merger-related costs of $650,000 were recorded in the third quarter of 2022, which were increased by net losses of branch sales of $411,000 all pretax. The branch sale losses are recorded as occupancy expense. The sum total of these nonrecurring noninterest income and expense items discussed totaled $101,000 net after tax, which did not impact the $0.43 earnings per diluted share.
As we look forward, we are focused on doing more of the same, managing liquidity, building commercial loan origination capacity for the long term and making prudent investments in the securities portfolio in the short term that do not carry excess spread or credit risk. The goal is obviously to build back towards an 80% plus loan-to-deposit ratio in order to drive the returns on equity commensurate with our recent historical performance.
With that, I’ll turn it over to Brad for more color.
Brad Adams
Thanks, Jim. Net interest income increased $10.3 million relative to last quarter and $33 million from the year ago quarter. Margin trends increased due to loan portfolio growth as well as due to increases in security and loan yields due to market interest rate increases. Total yield on interest-earning assets increased 80 basis points to 413 basis points offset by an overall 4 basis point increase to interest-bearing liabilities.
Third quarter continued to see a significant move in rates in addition to widening of credit spreads all along the curve, but none more dramatic than in the under three-year portion of the curve. Longer portfolios in Old Second’s have seen relative outperformance stars given the sharp inversion from the two-year portion of the curve. The mark on the securities portfolio recognized through AOCI went from $11.1 million gain at December 31 to $94.3 million unrealized loss at September 30. The decrease in portfolio value of approximately 8% since year-end 2021.
Certainly challenging given the explosion of liquidity immediately preceding such a massive movement in rates. I’d like to remind investors that we have actually been very cautious here. We have navigated the interest rate portion of this quite well, but a significant portion of our marked losses in the portfolio are actually the result of spread widening in the face of very strong credit. Regardless, the portfolio duration was 2.65 years. The weighted average life was 4.5 years and a little less than one third of the entire portfolio was variable at September 30.
I would also remind that Old Second has not moved anything to held to maturity. So what you’re seeing is likely not directly comparable to others. It’s not fun to stare at this whole day, the market move we’ve seen is exactly what we were preparing for. We had looked to build a portfolio that can reprice and continue to be a source of liquidity for the Bank even in the event of a massive spike in rates. This is the case today.
The yield on the portfolio increased by 63 basis points during the quarter, and we are projecting a little less than $75 million per quarter in cash flow from the portfolio quarterly. If necessary, we can quickly sell several hundred million dollars at a loss of only a few million.
The under two-year portion of the curve gaps like it has, even extremely cautious portfolios can initially look dislocated, but this impact should lessen quickly. If the curve remains stable from here and spreads remain unchanged, we will recapture roughly half of the reported loss position inside of 2.5 years in our estimation.
The end result of that is I don’t think it gets a whole lot worse. Tangible book value declined by a little more than 4% this quarter. I think we are turning the corner on book value growth at this point. The rest of the balance sheet looks fantastic. The deposit base, as many of you know, is extremely granular and insensitive to rates.
On the loan side, we do have some latency, but existing balances feature high concentrations of variable rate structures and relatively short duration. Barring a change in current macro expectation, Old Second is transitioning quickly into a higher rate world with rapidly improving profitability.
On the expense front, not much to say, we are performing far better than I expected, but wage pressure remains very real in our markets. We have increased wages significantly across our retail network and believe we have begun to stabilize after a long period of being understaffed, remains difficult to hire, but we are having far more success on the recruiting front than we have ever had.
In many important ways, Old Second is a much different and much better bank than it was just a few short years ago. Bonus accruals are running very high this year given the significant growth in sales volumes we have seen. I’m very pleased with the way the team has come together and identifying the improvements we need to make to transition into a larger and more dynamic company. We’ve done a fantastic job exiting excess real estate within our portfolio. Just a few properties remain that are targeted for closure and liquidation.
We probably need to expand our footprint just a little bit in terms of office space as we look to bring people together and close the gap culturally with our recent acquisition. I’ll let you know more about that in the future as we get closer to that being a reality. There won’t be anything jaw dropping by any stretch of the imagination.
Deposits declined a bit from second quarter levels, primarily from tax payment, seasonality as some parked funds exited, and we also had a modest impact from rate-sensitive acquired accounts. In aggregate, though, trends were stable throughout the quarter. The resulting remix and improvement in the loan-to-deposit ratio clearly benefited the margin. Margin trends from here will be a function of loan portfolio repricing, which we expect to continue following the most recent 75 basis point hike and the potential for more in November.
As Jim mentioned, we do feel good on the loan growth side of things, but I would not expect to repeat at this quarter’s performance. Deposits will be a tougher game from here as well with a couple of local banks going very big on the time deposit and teaser rate front here in the last few weeks. I believe that Old Second will perform as well or better than it did during the last tightening cycle. The end result is that margin trends are expected to continue to trend in the right direction.
Noninterest income increased from last quarter by $2.3 million, driven by a $1.1 million net increase in mortgage banking, including an increase of $711,000 in net gain on sale of mortgage loans and a $466,000 increase in the fair value of MSRs. Additionally, the gain on the sale of our VISA credit card portfolio provided $743,000. Wealth management service charges and card-related income remained strong and stable.
Provision for credit losses of $3.5 million was recorded during the quarter and our economic outlook declined slightly quarter-over-quarter. With an unemployment rate projection increasing to approximately 4.5% to 5.75% through September 30, 2023, and over the remaining average life of the loans, this is an increase from 4% to 5.50% from last quarter.
I would expect loan growth to continue to outpace provision growth over the near term, where that could change with significant worsening in the macro environment. We recorded a provision for credit losses of approximately $973,000 in unfunded commitments due to review of utilization rates and on commitments.
Nonaccrual loans declined a bit this quarter, but 90 days past due ticked up $20 million on two administrative issues. One has already been renewed at the time of this call and is expected to be paid off in the fourth quarter. The other is a participation that we expect to be renewed by the lead bank and does not represent a new risk to us previously being in classified assets.
Classified loans increased modestly, as Jim noted, but I would add that a couple of the credits that were downgraded last quarter are progressing quite nicely at this point. Overall, we are pleased with how credit has performed and continue to consider credit metrics as both stable and excellent. Expenses are difficult to manage this year and into 2023 with mid-single-digit increases in salaries and double-digit increases in benefits, reflecting wage inflation and a difficult environment to hire.
We are managing through this and are thankful for the flexibility and opportunities for synergies that exist for us right now. Our efforts in the coming quarters will be continuing to bring on additional talent, helping our customers in finding quality loan growth with the expectation of an improving margin. We’re continuing to look to build capital back a bit following our investment in West Suburban and think we have turned the corner on building tangible book value again.
With that, I’d like to turn the call back over to Jim.
James Eccher
Thanks, Brad. In closing, we remain confident in our balance sheet and the opportunities that are ahead for our company. Rising interest rates will certainly be beneficial to our bank profitability, and we are paying close attention to both credit and expenses. We believe our underwriting has remained disciplined and our funding position is strong. Today, we have the balance sheet and liquidity to take advantage of a rising rate environment and have the financial strength to wait for this to occur.
This concludes our prepared comments this morning. So I will turn it over to the moderator to open it up for questions.
Question-and-Answer Session
Operator
[Operator Instructions] And the first question is coming from David Long from Raymond James. David, your line is live.
David Long
Jim, I hope you’re watching closely how well Brad has been managing the balance sheet, especially relative to some of your peers. So kudos to you guys for that. But — and with the balance sheet, with the cash, amount of cash down, and I think you said $75 million of securities, cash flowing per quarter, does that impact your appetite to lend? And if the deposit growth does not keep up, how will you fund excess loan growth?
Brad Adams
So I think our — what we do probably is I would probably have a tolerance depending on — so it’s difficult. I would say that the one thing that really bugs me is a couple of the issues that we bought, thinking that they would be basically at par in a rate environment such as this, namely government guaranteed credit, the vast majority of the principal and fully variable in structured with rapid repricing, it should be where we bought it at right now.
But because it is what you would consider a typical bank buyer paper or insurance company buyer paper, the bid on these has largely gone away as people have starting to see the liquidity strength. So the bid ask has gotten wide. Is it wider than it should be? In my estimation, yes. And I would love to be a buyer here, but obviously, that doesn’t make sense because loans are a better investment for us, and that’s what we do.
But if it comes to it and if it makes sense versus borrowing overnight, if that spread tightens, we would probably look to fund out of the securities portfolio. It is probably about two points underwater on what I had anticipated being able to fund out of. If that gets to 1 point or 0.5 point, it probably becomes more compelling to fund out of the bond portfolio.
But we’ll keep you posted on that. We’ll be granular with what we’re up to. I do think deposits will be a tougher game going forward. Nobody is going to grow deposits in this environment unless they pay up for it. That’s where we are at the margin. And people are starting to do that.
David Long
Okay. And it sounds like then there’s no hesitation if you have a good credit to make, you’re going to make that loan, there’s no change to your appetite to lend at this point?
James Eccher
Yes, David, that is correct. I would point out the second and third quarters are traditionally very strong origination quarters for us with the fourth and first, a little softer. But I will say, pipelines are better today historically than they have been in the fourth quarter of prior years. But I would not expect a $200 million-plus origination quarter like we’ve had in 2Q and 3Q. But yes, we are still looking to actively redeploy securities in the loans.
David Long
Got it. Cool. Okay. And then on the hiring front, it still seems like there’s a lot of disruption in Chicago from several transactions that have happened over the last few years. What is the backdrop for hiring? Are there still opportunities to bring in veteran bankers? And do you still have an appetite to do that? And if so, is there any particular areas you’d be looking at closely or any lenders as particular backgrounds that you’d prefer?
James Eccher
Yes. I think we’re always open-minded, David, about bringing on new talent. We — as I mentioned on the call, we did set out to increase the origination capacity by twofold and we’ve done that. And given the disruption of the market, we will be budgeting for increased as to staff if they become available.
Operator
And the next question is coming from Chris McGratty from KBW. Chris, your line is live.
Chris McGratty
Brad, maybe a couple of housekeeping items into the quarter. Do you have spot rates for your interest bearing deposit costs, your loan yields and really what your margin was in September?
Brad Adams
Yes. So on the loan side, loans were at 5.07% for the month of September and the margin itself was at 4.12%. At the end of September, as you can see, we had to move deposit rates. So it’s pretty much consistent with what you see on that report. In the month of October, we did take deposit rates up modestly. We went to 5 basis points on low balance now accounts and all the way up to 15 basis points on very high balance interest-bearing money market and now accounts.
So you will see a little bit of a movement from us outside of the teaser rate phenomenon, which is really its ugly head again in this world, that would put us actually slightly above the median. We do operate in a market where Jamie Dimon controls the world. So I guess we all do for that matter. But — so you will see a tick up, they won’t be 0 going forward. But as I said, I think we’ll outperform what we did in last cycle.
Chris McGratty
Okay. So 4.12%, that’s the — that’s an all-in margin, right? That’s including the accretion sub?
Brad Adams
That’s correct.
Chris McGratty
Okay. So I think I asked you last quarter, and you said 4% was reasonable based on our last cycle. We’re getting asked a lot about just the rate of change from here if the Fed continues to go, but it would seem like you’ll still get expansion in the first half of the year. But interested maybe what you’re thinking kind of higher level if the Fed is done in January, how do we lock in this really high margin to some degree. We’ve seen some banks do swaps and hedges and just kind of getting your head a little bit about how you’re going to reposition this balance sheet?
Brad Adams
So let me do a big thought piece on this, but I won’t. We have started. We’ve done about $200 million of received fixed swaps at this point. Those are wildly underwater and not beneficial to the margin. I think you’ve seen some people that have tried to start to lock this in. You can pick out the big banks that obviously saw big decreases in book value and massive AOCI margin, you can see that, that’s what they were attempting to do.
To some extent, we will never be able to hedge out what we are, which is a good deposit base. And I don’t think anybody pays us to be a hedge fund betting on the path to interest rates. So we’re not going to try and mute it. It doesn’t make any sense.
The goal is, hopefully, we’re learning not to swing wild interest rates on a pendulum and believe that money actually has a cost going forward. And it’s not going to be a swing from four to zero and zero to four and that being a good bank will be worth something again over time consistently. But we are what we are. And we will increase — decrease asset sensitivity.
The reality is, is that in order to prepare for what’s happened, you had to go outside of your risk tolerances and take on variable rate structures at a percentage that you wouldn’t otherwise do in order to not expose yourself to massive risk to this very event. We will be taking that back down, but we’re not going to lurch at it.
Chris McGratty
Okay. And just on the last one on the bond strategy. You guys obviously had managed that very well. The — did you say the $75 million of cash flows a month out of the bond book out of the quarter?
Brad Adams
Yes.
Chris McGratty
And so the view would be perhaps shrink somewhat less than that, that shrink it altogether?
Brad Adams
Yes. The bond portfolio is bigger than it needs to be for our purposes, and that was just a function of all the liquidity that came into the systems. So longer term, it will be smaller. It also doesn’t need to be this variable given how little duration we have elsewhere on the balance sheet on the asset side.
So what I’d like to do is slowly transition that down, take out some of the variable rate structures and decreasing the overall size of the portfolio, grow more relationships and then maybe if I do, I can continue to get positive shout-outs on the earnings call.
Chris McGratty
Not from me. You’ll not get one from me.
Brad Adams
I don’t expect much from you, Chris. I live for your respect. We can talk about that.
Chris McGratty
All good. I mean I guess, allocating aside, the — I mean this isn’t a fourth quarter restructuring event. Is this more gradual?
Brad Adams
Oh, yes. No, no. Forgive me if I’ve given anything approaching that expectation.
Chris McGratty
No, no. I just want to make sure I’m clear.
Operator
[Operator Instructions] The next question is coming from Manuel Navas from Davidson. Manuel, your line is live.
Manuel Navas
How high do you think the NIM could go? What could it peak now that we’re already at 4.12% in September?
Brad Adams
I don’t know. I don’t — I didn’t think we were going to do this. We protect it against it. In terms of rates, I mean, obviously, we have the advantage of a very good deposit base. And I’m not going to tell you this isn’t the 1970s, but I’m not going to tell you it is either.
Certainly, the potential for rates to go higher, is there anybody who thought differently before this point was wrong. I’d say chances are they come down. But even in that scenario, well, I mean the Fed doesn’t. As long as Fed cares about inflation and doesn’t rapidly move short rates, then the margin will continue to go up that’s just how it works.
James Eccher
Yes. Manuel, I would say our margin is still very receptive to rate tailwinds given that over half of the loan portfolio is floating and 30% of the securities portfolio is floating. We feel pretty good about our positioning.
Manuel Navas
Okay. That’s helpful. And is this kind of the bottom of where cash is going to sit that there’s really not much more deployed?
Brad Adams
No, cash is — we’re going to hold cash where it is. You need some to operate. So yes.
Manuel Navas
Perfect. That makes sense. Switching over, when you look at the loan pipeline, where are you seeing the most opportunity and the most growth here near term?
James Eccher
Yes. The pipeline remains fairly healthy, not certainly as strong as the last couple of quarters as we’ve closed a lot of new business. But it is fairly broad-based in commercial real estate, health care sponsored finance, investment in equipment leasing and our legacy community bank. All their pipelines are pretty solid today.
Manuel Navas
Okay. So kind of like a similar mix, but maybe just a little bit lower, ultimate output.
James Eccher
Correct.
Manuel Navas
Okay. And then can we just switch over, I appreciate your comments on expenses. This is a good run rate to grow from, you think, this current third quarter, $35 million level.
Brad Adams
Yes. This is where we’re at. I mean there’s going to be the normal fits and starts from here, right? So FICO is pretty much full for the year at this point, and that will come back in Q1 and bonus accruals are running very high, and those will step down next year as we don’t accrue at the level that we are right now.
So there are some fits and starts, but this is a pretty good core number. I do expect occupancy expense to tick up a little bit. It’s not a ton. It’s a couple of hundred a quarter probably. Yes, good baseline, pretty clean from us other than a small gain and a small loss, and that’s what it looks like.
Operator
And the next question is coming from Nathan Race from Piper Sandler. Nathan, your line is live.
Nathan Race
A question just on kind of the deposit growth expectations going forward. Obviously, some shrinkage in core deposits this quarter, but it sounds like you guys are being a little bit more defensive in your deposit pricing these days relative to the competitive pressures that take across the Chicago land area. So just curious, are you guys expecting some additional deposit outflows reaching into fourth quarter? Or concise just think about your overall deposit base?
Brad Adams
Our goal is to be stable here. We may have plus or minus $40 million or $50 million in any given time, but that’s what we’re looking to achieve. Growth in this type of environment requires a lot of rate. So we’re looking to hold the line. We delivered good service, and we’ll be at the median in terms of pricing that doesn’t involve these areas and games and whatnot.
Nathan Race
Got it. And then just on the increase in deposit service charges versus the second quarter, is that kind of sustainable going forward?
Brad Adams
Yes, I think so.
Nathan Race
Okay. Great. And then just one last one, going back to the loan growth discussion. Are you guys seeing any moderation payoffs that occur in the third quarter? Is that continuing in the fourth quarter, whether it’s West Suburban related or against the legacy portfolio, which may help loan growth remain pretty solid at least in the fourth quarter?
James Eccher
I’d say since rates started heading north the last couple of quarters, payoffs and prepayments have moderated, and we expect more of the same in the fourth quarter.
Operator
And there are no further questions in queue. I would now like to hand the call back to Jim Eccher for some closing remarks.
James Eccher
Okay. Thanks, everyone, for joining us this morning, and we look forward to speaking with you again next quarter. Goodbye.
Operator
Thank you, ladies and gentlemen. This does conclude today’s conference. You may disconnect your lines at this time, and have a wonderful day. Thank you for your participation.
Be the first to comment