Q3 2022 Old Second Bancorp Inc Earnings Call
Good morning, everyone and thank you for joining us today for old Second Bancorp, Inc. Third quarter 2022 earnings call.
On the call today is Jim <unk>, 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 and 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 Companys SEC filings for a full discussion of the Companys 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 counterpoints counterparts in our earnings release, which is available on our website.
At old second Dot com on the homepage under the Investor Relations tab.
Now I will turn the floor over to Jim <unk>.
Hey, good morning, and thank you for joining us.
Several prepared opening remarks give my overview of the quarter and then turn it over to Brad for additional details.
We'll then conclude with some summary comments and thoughts about the future before we open it up for questions.
Net income was $19 5 million or <unk> 43 per diluted share in the third quarter of 2022 net income adjusted to exclude west suburban acquisition related costs net losses for branch sales.
And gains from the sale of our visa portfolio with land Trust portfolio was $19 6 million or <unk> 43 per share in the third quarter.
On the same adjusted basis return on assets was 130%.
Return on tangible equity was $21, 97% and the efficiency ratio was 50, 187%.
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 than we were at close.
As we've mentioned, we set out to double our loan origination capacity and through the first three quarters. This year were three X, 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 cannot be more pleased with where things 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 six 7% of net loan growth quarter over quarter or approximately $245 $3 million exclusive of PPP runoff.
Prepayments have slowed meaningfully it allows continuing stronger origination activity to impact the balance sheet.
Activity within loan committee remain robust and line utilization trends increased modestly during the quarter.
Recent hires are hitting their stride and the cultural fit has been fantastic.
The net interest margin expanded substantially this quarter with loan yields at less beginning to reflect recent increases in market interest rates.
Overall, the tax equivalent net interest margin was 396% for the third quarter.
<unk> to three 8% 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.
The 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 is shifted to balance sheet optimization from straight liquidity deployment.
Let Brad talk about that in a minute.
We recorded nominal charge offs of 67003rd quarter compared to 250000 of net charge offs in the second quarter total classified loans ticked up $10 6 million to.
To $113 7 million from $103 2 million last quarter other.
Other real estate owned decreased 63000 in the third quarter due to one property sale.
We remain confident in the strength of our portfolios.
<unk> for credit losses increased to $48 8 million.
As of September 30 from $45 $4 million in the previous quarter, which is $1 two 6% of 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 recorded.
As well as 973000 provision for unfunded commitments the increases were driven by loan growth and are based on our 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 person pessimistic scenarios given the high degree of uncertainty.
Recession probabilities increase relative to last quarter, and our estimation of 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 743000, and a gain on the sale of our land Trust book of business of 180000 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 650000 were recorded in the third quarter of 2022, which were increased by a net losses of branch sales of 411000 all pretax.
The branch sale losses are recorded as occupancy expense. The sum total of these nonrecurring noninterest income and expense items discussed totaled 101000 net after tax which is not a pet did not impact of <unk> 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 that 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.
Thanks, Jim.
Net interest income increased $10 3 million relative to last quarter and $33 million from the year ago quarter.
Margin trends increase due to the 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 linked quarter.
Offset by an overall four 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 non more dramatic than in the under three year portion of the year.
Auger portfolios and old second's would've seen relative outperformance stars given the sharpened version from the two year portion of the curve.
Mark on the Securities portfolio recognized through OCI went from $11 $1 million gain at December 31 to $94 3 million unrealized loss at September 30.
A 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 because we have navigated the interest rate portion of this quite well.
But a significant portion of our market losses in the portfolio are actually the result of spread widening in the face of a very strong credit.
Regardless the portfolio duration was 265 years the weighted average life was four five years.
Less than a 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 youre seeing is likely not directly comparable to others.
It's not fun to stare at this all day the market move we've seen is exactly what we were preparing for.
We would look 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 since.
As 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 and a loss of only a few million dollars.
And the other two year portion of the curve gaps like it has even extremely cautious portfolios can initially looked dislocated.
This impact should lessen quickly.
If the curve remained stable from here and spreads remain unchanged, we will recapture roughly half of the reported loss position inside of two and a half years in our estimation.
The end result of that is I don't think it gets a whole lot worse than no tangible book value declined by a little more than 4% this quarter.
Think we're turning the corner on book value growth at this point.
The rest of the balance sheet looks fantastic.
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.
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.
<unk> 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 has 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.
Im very pleased with the way the team has come together in 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.
Just a few properties remain that are targeted for closure.
Liquidation.
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.
It won't be anything.
Jaw dropping by any stretch the imagination.
Deposits declined a bit from second quarter levels, primarily from tax payment seasonality is 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.
<unk> <unk> an 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 .
Jim mentioned, we do feel good on the loan growth side of things, but I would not expect a repeat of 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 in 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 and.
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 711000 net gain on sale of mortgage loans and 466000 increase in the fair value of Msr's.
Additionally, the gain on the sale of our visa credit card portfolio provided 743000.
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, our economic outlook declined slightly quarter over quarter.
With an unemployment rate projection increasing to approximately four 5% to 575% through September 32023, 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, though that could change with significant worsening in the macro environment.
We recorded a provision for credit losses of approximately 973000 on 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 to 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 in 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, we'll be continuing to bring on additional talent, helping our customers and 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 Thanks, Brad and 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 they have the financial strength to wait for those to occur.
This concludes our prepared comments. This morning, so I will turn it over to the moderator to open it up for questions.
Thank you ladies and gentlemen, the floor is now opened for questions. If you have any questions or comments. Please press star one on your phone at this time.
We asked about posing your question you. Please pickup your handset after listening on speakerphone to provide optimum sand quality.
Once again, please press star one if you wish to ask a question at this time.
Please hold while we pull for questions.
And the first question is coming from David long from Raymond James David Your line is life.
Good morning, guys. Thanks for taking my question.
Jim Hope here.
Watching closely how well Brad has been managing the balance sheet, especially relative to some of your peers. So kudos to you guys for a for that.
But.
On the balance sheet with the cash amount of cash down and I think you said $75 million or.
Securities.
Cash flowing.
Per quarter does that impact your appetite to lend in and if the deposit growth does not keep up how will you fund excess loan growth.
So.
I think what we do probably as 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.
Thinking that they would be basically at par in a rate environment, such as this namely government guaranteed credit.
Majority of the principle.
And fully variable in structure with rapid repricing it should be where we bought it at right now, but because it is what you would consider typical bank buyer paper or insurance company buyer paper.
The bid on these is largely gone away as people have starting to see the liquidity strength. So the bid ask has gotten wide.
Is it 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 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 under water on on what I had anticipated being able to fund out of.
If that gets to one point or a half a point it probably becomes more compelling to fund out of the bond portfolio.
But we'll keep you posted on that will be granular what we 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.
Okay.
It sounds like then there's no hesitation if you have a good credit to make you're going to make that loan. There is no change to your appetite to lend at this point.
Yes, David It is correct that I would point out of 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 our pipelines are better today historically than they have been.
The fourth quarter of prior years, but I would not expect.
$200 million plus origination quarter like we've had in <unk>.
At <unk>, but yeah. We were we are still looking to actively redeploy.
Securities into loans.
Got it Okay and then on.
On the hiring front.
Still seems like Theres, 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 are there any particular.
Areas you'd be looking looking at closely any lenders this particular background that you'd prefer.
Yes, I think we're always open minded David about bringing on new talent.
As I mentioned on the call we did set out to increase the origination capacity by.
By a two fold and we've done that.
Yeah.
Given the disruption in the market Yeah, we will be budgeting for who are increased.
That's to staff if they become available.
Got it thanks, guys I appreciate you taking my questions.
Thank you Dave.
Thanks for the Shout out.
Thank you and the next question is coming from Chris Mcgratty from.
From BBW, Chris Your line is live.
Hey, good morning.
Great.
Brian maybe a couple of housekeeping items into the quarter.
Do you have the spot rates for <unk>.
Your interest bearing deposit costs your loan yields and really what your margin was in September .
Yeah.
So on on the loan side.
Loans were at five seven for the month of September .
And the margin itself was at $4 one two at.
At the end of September as you can see we hadn't moved 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 five 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 out.
Outside of the teaser rate phenomenon, which is reared its ugly head again in this world.
That would put us actually slightly above the median.
We do operate in a market, where Jamie diamond controls the world. So.
I guess, we all do for that matter, but.
So you will see a tick up data wont be zero going forward.
As I said I think we'll outperform what we did last cycle.
Okay.
So 412.
That's an all in margin rate, that's including the accretion stub.
That's correct okay.
I think I asked you last quarter.
And you said, 4% was reasonable based on the last cycle.
We're getting asked a lot about just the.
The rate of change from here if the fed continues to go but it would seem like youll 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.
There's really high margin to some degree we've seen some banks do swaps and hedges and just kind of given you had a little bit about how you're going to reposition the balance sheet.
So I could do a big thought piece on this but I won't.
We have started.
Done about 200 million in received fixed swaps at this point those are wildly underwater not beneficial to the margin.
<unk> seen some people that have tried to start to lock this in.
You can pick out the big banks.
Obviously saw a big decreases in book value and massive OCI margin you can see that that's what they were attempting to do.
To some extent.
We will never be able to to 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 of interest rates. So we're not going to try and muted it doesn't make any sense.
The goal is hopefully we're learning not to swing while 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 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 breasts to this very event.
We will be taking that back down.
But we're not going to lurch at it.
Okay and just just on the last one on this the bond strategy you guys. Obviously have managed it very well.
Did you say 75 of cash flows a month out of the bundle.
Out of the quarter.
Yes.
So the view would be.
Perhaps.
Shrink somewhat less than that but shrink it altogether.
Yeah, I mean, 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 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 and take out some of the variable rate structures 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.
And that's not for me okay.
I don't expect much from you Chris.
I I live for your respect.
We can talk about.
Oh good.
All kidding aside the.
I mean, this isn't a fourth quarter restructuring event as it is this more gradual oh, yeah no no. Okay. Forgive me if I've given anything approaching that expectation and I just want to make sure I'm clear.
Alright, Thanks, Brian .
Yep.
Okay.
Thank you and once again, ladies and gentlemen, if you wish to enter the queue to ask a question. Please press star one on your phone at any time. The next question is coming from Manuel <unk> from Davidson.
Your line is nice.
Hey, good morning.
And why.
How.
How high do you think the NIM can go what could it now.
Already at <unk> in September .
I don't know.
I don't I didn't think we were going to do this we protected against it.
In terms of rates I mean.
Obviously.
We have the advantage of a very good deposit base and.
You know I am.
I'm not going to tell you. This is in the 19 seventies, but I'm not going to tell you. It is either I mean, 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.
As long as.
The fed doesn't.
As long as the fed still cares about inflation and doesn't rapidly move short rates.
Then the margin will continue to go up.
That's just how it works.
Meanwhile, I would say our margin is still.
Very receptive to rate tailwind given that over half the loan portfolio is floating and 30% of the securities portfolio is floating.
We feel pretty good about our positioning.
Okay. That's helpful and is this kind of.
Bottom of where cash is going to sit.
Really not much more to play.
Well I mean, no cash is where we're going to hold cash where it is you need some to operate so yeah.
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.
Yes, the pipeline remains.
You know fairly healthy not certainly as strong as the last couple of quarters as we've.
A lot of new business, but it is it is fairly broad based.
In commercial real estate healthcare sponsored finance.
Investment in equipment leasing.
And our legacy community Bank all their pipelines are.
Our.
Pretty solid today.
Okay, so kind of like a similar mix, but maybe just.
A little bit lower.
Ultimate output.
Okay.
Yes.
And then can we just switch over I appreciate your comments on expenses.
Yes.
We're this is a good run rate to grow from you think this current.
Third quarter $35 million level.
This is where we're at I mean theres going to be.
The normal fits and starts from here right so far.
FICO is pretty much full.
For the year at this point and that'll come back in Q1.
And bonus accruals are running very high and those will step down next year as we don't accrue that the level that we are right now so.
There are some fits and starts but this is a pretty good core number.
Do expect occupancy occupancy expense to tick up a little bit it's not a ton.
Couple of hundred a quarter probably.
Sure.
Yeah.
Good baseline pretty pretty clean from us other than the.
Small gain and a small loss in.
That's what it looks like.
Okay, all right I appreciate it guys. Thank you.
Yep.
Thank you and the next question is coming from Nathan race from Piper Sandler Nathan Your line of sight.
Yes, hi, guys. Good morning, Thanks for taking the questions.
Randy.
Question, just on kind of the.
Posit growth expectations going forward.
We see 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 exist across the Chicago land area. So just curious are you guys expecting some additional deposit outflows leaked into the fourth quarter, how should we kind of just think about the overall deposit base.
Our goal is to be stable here.
We may have you know plus or minus 40 or $50 million in any given time, but that's what we're looking to achieve.
Yes.
And this type of environment requires a lot of rate.
So we're looking to hold the line.
<unk> deliver good service and.
We'll be at the median in terms of pricing.
Doesn't involve.
Caesars and games and whatnot.
Got it and then just.
On the increase in deposit service charges versus the second quarter is that kind of the <unk>.
Sustainable going forward, yes.
Yes, I think so.
Okay.
Great and then just one last one going back to the loan growth discussion.
Seen any moderation payoffs that occurred in the third quarter or is that continuing into the fourth quarter, whether it's what's the burberry related there against the legacy portfolio, which may help loan growth remains pretty solid at least in the fourth quarter.
I'd say since since rates started heading.
Heading north of last couple of quarters payoffs and prepayments have moderated.
Spec more of the same in the fourth quarter.
Okay, Great I appreciate guys, taking the questions. Thank you.
Thanks, Nick.
Thank you and there are no other questions in queue I would now like to hand, the call back to Jim Aker for some closing remarks.
Okay. Thanks to everyone for joining us this morning, and we'll look forward to speaking with you again next quarter Goodbye.
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.