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Old Second Bancorp Inc (NASDAQ:OSBC)
Q3 2019 Earnings Call
Oct 24, 2019, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, everyone, and thank you for joining us today for Old Second Bancorp Inc.'s Third Quarter Earnings Call. On the call today is Jim Eccher, CEO; Gary Collins, Vice Chairman; 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 performances and results may differ materially from those projected management would ask that you refer to the company's SEC filings for a full discussion of the company's at risk factors. On today's call, we will also be discussing certain non GAAP financial measures. These non-GAAP measures are described and reconciled in their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com under the Investor Relations tab.

I will now turn it over to Jim Eccher.

James L. Eccher -- President and Chief Executive Officer

Good morning, and thank you for joining us today. I have several prepared opening remarks and will give you my overview of the quarter and then turn it over to Brad for some additional color. I will then conclude with some summary comments and thoughts about the future before we open it up for questions.

Results and overall momentum continue to be very good. Net income was $12.2 million or $0.40 per diluted share in the third quarter. Earnings this quarter were negatively impacted by approximately $620,000 of MSR interest rate impairment pre-tax. Securities gains taken during the quarter more than offset the impact of MSR interest rate impairment pre tax securities gains taken during the quarter more than offset the impact of MSRP pyramid in total 3.5 million pre tax for the quarter. Absent these items, earnings trends were relatively stable and consistent with last quarter. Although we did see significant improvement in mortgage banking recently. as close production was up over 50% from the second quarter. Returns on assets and equity continue to be very strong, driven by strong net interest margin, solid expense control, sustained performance across our fee-based businesses and a stable credit outlook.

The high level of profitability has afforded us to continue to invest significantly in the future growth of the bank. In regards to the third quarter specifically, total loans were unchanged from last quarter, with a reasonably strong level of originations, mitigated by continuing payoff activity. We have continued to be surprised by the level of loan payoffs. However, our lower pipelines remain robust. The competition for credit in our market remains very aggressive, both in terms of pricing and structure. Commercial real estate loan competition specifically has been fierce and we're seeing rational pricing and structure very similar to pre-recessionary times.

We recently lost out on proposals for several meaningful opportunities as our terms and pricing weren't even close to the winning bidders. With the tail was provided by an expanding margin having less than we expected increase our efforts to grow the loan book and capitalize upon recent additions to our sales staff. We are still optimistic we can achieve low single digit long growth for the year despite being relatively flat most of this year. Lastly, as it pertains to the loan book yields on the portfolio are essentially unchanged due to the benefit of accelerated accretion from the early payoff from an acquired loan. Total deposits were down modestly on seasonal factors with stable repricing trends.

Our net total transaction account activity has largely been stable with declines primarily focused in higher cost relationships acquired in 2018. The loan-to-deposit ratio was unchanged and remains at 91%. We believe we can remain at these levels in the near term with loan growth funded by a mix of deposit growth and modest balance sheet optimization. We remain very comfortable at asset quality trends overall. Nonperformers and classifieds both declined relative to last quarter. Past dues remain very well controlled.

Overall, we remain very encouraged about our results in a number of areas, and Brad will provide additional colors in his prepared comments.

Brad Adams -- Chief Financial Officer

Thank you, Jim. Net interest income was unchanged from last quarter with loan -- yields on loans stabilized by an increased benefit from purchase accounting, which mitigated a core margin decline from falling interest rates. Fee income bounced back very nicely with a significant rebound and mortgage banking activity and spreads there are very good.

The reported taxable equivalent margin decreased by 1 basis point from last quarter with the aforementioned larger contribution from PA due to a 15% pay down in the acquired ABC portfolio during the quarter, which was simply massive. However, of note, the remaining accretable difference in the portfolio as a percent of the portfolio actually increased by 5 basis points at the end of the quarter. Pricing movement on the liability side of the balance sheet remains well controlled and recently, market pricing and time deposits have shown further signs of abating. A few months ago, we would have been 75 basis points out of the market on the 12 to 18-month time frame on time deposits. Old Second now leads the market where we are, which is a pretty significant movement in a relatively short period of time. We have yet to move those deposit rates and reflection of the loan growth that still feels very good with the pipelines that we have out there.

So we have yet to move despite the recent reductions in the Fed funds rate. Our efforts in the coming quarters will be focused on the quality long growth and corresponding with the expected of further modest contraction and margin trends going forward. The loan-to-deposit ratio leaves us well positioned at a little over 90%, and we have ample flexibility both to continue to pursue the growth while protecting our core deposit base.

As Jim mentioned, it is likely we will seek to optimize the earning asset mix and fund future loan growth to a mixture of deposit growth and earning asset optimization. Looking forward, core margin trends should remain relatively stable absent any movement in Fed funds rate. As we both know that's unlikely to be no movement in the Fed funds rate, we should continue to see kind of a 3 to 5 basis point type range with each 25 basis point reduction.

Reported margin trends, however, potentially show more stability than that with the impact of prepayments on both acquired and nonaccrual loans. Overall, loan growth will become much more important for us with the outlook for short-term rates having changed, but I believe we have a significant opportunity in front of us. And as Jim mentioned, the pipelines are strong.

On the fee income side, mortgage banking reflected a significant improvement in gain on sale margins during the quarter and pipelines have built quickly with a pickup in the level of refinance activity.

The quarter was significantly impacted by the previously mentioned rate-driven impairment in the MSR portfolio. Trust and wealth management had another strong quarter and retail banking trends were solid in both fees and card activity. We should continue to see swap fee income return, which should provide an additional tailwind. Securities gains were obviously a big part of the quarter. And they were taken toward the end of August, and the size of the portfolio was reduced modestly in recognition of near-unprecedented spread tightness within municipal securities. As you know, we have a very large concentration in munis and I don't believe that spreads relative to treasuries have ever been tighter.

We elected about 70% reinvestment of what was sold, realized a $3.5 million gain. We gave up at the reinvestment, again assuming that none goes into loans, which is obviously unlikely. We give up about $130,000 to $140,000 a quarter in gross income on the reduction in exchange for that $3.5 million gain. The gain would have been significantly less if those same securities were sold today. Expenses remain well controlled, though we did see some increases in personnel-related expenses due to recent hiring in the commercial sales department. Additional sale titers will largely be offset by seasonal factors in the remainder of the year and continuing investments for future growth are largely baked in at this point.

With that, I'll turn the call back over to Jim.

James L. Eccher -- President and Chief Executive Officer

Thanks Brad. In closing, we are encouraged about the trends this quarter. We're excited about the future. On an organic basis, operating leverage remains strong and we are excited about the possibilities to continue to add quality talent to the organization.

We have added several relationship managers over the last quarter. There is still significant dislocation in Chicago and further opportunities to add to our talent staff will be -- should be realized in the coming quarters. Returns on tangible equity are excellent and the challenging interest rate environment provides an opportunity for a bank like Old Second to demonstrate its strengths. Capital has continued to build significantly for our company, and we remain very comfortable with the returns we are generating. We will be evaluating opportunities to return capital to shareholders and potentially reduce high cost debt versus our outlook for opportunities to invest capital. We remain optimistic that there are opportunities to improve our footprint, but we will remain disciplined in their evaluation.

The focus for us is going to be on timing, making sure we have access to capital that we need in order to take advantage. Periods of significant changes in the volatility of bank valuations make M&A more difficult at this time, but things can change quickly on that front, especially as we approach a period that very well may be a difficult year for some banks.

That concludes our prepared comments this morning, so I will turn it over to the moderator to open it up for questions.

Questions and Answers:

Operator

[Operator Instructions] And our first question comes from Chris McGratty with KBW. Please go ahead.

Chris McGratty -- KBW -- Analyst

Hey, good morning. Brad, maybe I'll start with you, the optimization comments. I have asked in the past about the trust prefers. I assume that's what you're talking about, maybe you can elaborate. I know some of your senior debt isn't callable for a couple of years, but there is some high cost, $30-plus million, almost 8%. Is that what you're referring to? And if so, what will be the timing and the strategy to redeem it?

Brad Adams -- Chief Financial Officer

Yeah. My referring is specifically to 2 things. One, you did see during the quarter that we sold down some of the securities portfolio, didn't reinvest it fully. Expectation is there's some portion of that will continue to bleed into loans, although it's a relatively small contribution. And you're right. There is an opportunity to significantly reduce interest expense related to that trust preferred specifically.

No comments in terms of near-term intentions, but that is certainly something that we're evaluating. I think larger it's a question of capital. We are having still excellent returns on tangible common and that's primarily what we focus on in terms of what investment opportunities to take advantage of. I think that we need to make some careful decisions in terms of what we do with that capital position going forward. Taking out some debt is certainly an option, stock buybacks are certainly an option and M&A is still a preferred option. All will be evaluated.

Chris McGratty -- KBW -- Analyst

And is there -- if you were to rank those 3, just to follow up, would it seem -- I guess, how would you rank the 3 in terms of willingness or preference?

Brad Adams -- Chief Financial Officer

M&A is the first preference. Debt taken care of is the second preference. Third preference is stock buybacks.

Chris McGratty -- KBW -- Analyst

Okay. Great. And may be just one on the margin. The prepay in the ABC book you preference-ed in the quarter, how does that affect the go-forward run rate of accretion? i think prior it was around $400,000. This quarterly it spiked a bit. How do we think about that over the next several quarters in terms of just margin composition?

Brad Adams -- Chief Financial Officer

So I think normal is still around $400,000. The decrease in rates rather dramatically this quarter. Obviously, there's an impact on prepayments. And I would say that I would never have expected a 15% pay down in the portfolio in a 3-month time frame, so that was a bit shocking.

Specifically, the bulk of the excess contribution this quarter came from 1 particular credit that was resolved. That can happen at any time. I don't know when it's going to happen, but the portfolio has significantly outperformed our marks overall and I do not see anything that's going to change that in the near term, unless something happens different in the world. So it could be fourth quarter, it could be first, but there will be quarters that top up where the margin is supported by pay downs.

Chris McGratty -- KBW -- Analyst

Great. And then may be last one, tax rate for Q3 going forward?

Brad Adams -- Chief Financial Officer

Modestly lower than this quarter.

Chris McGratty -- KBW -- Analyst

Okay.

Operator

[Operator Instructions] Our next question comes from David Long with Raymond James. Please go ahead.

David Joseph Long -- Raymond James and Associates -- Analyst

Hi, everyone, May be you disclosed it, but the -- just to follow up on that question with the impact of purchase accounting accretion, what was it in the quarter?

Brad Adams -- Chief Financial Officer

So last quarter, it was around $400,000. This quarter, we did -- one moment, a little over $1 million.

David Joseph Long -- Raymond James and Associates -- Analyst

Okay. Got it. Okay. And with the securities gains in the quarter, do you expect to continue to look for opportunities? Is it something of your broader management of the balance sheet at this point?

Brad Adams -- Chief Financial Officer

I think that -- so the securities portfolio for us given the lack of duration elsewhere on the sheet is effectively a warehouse for duration. I never would have expected that munis broadly would get to within 25 basis points of treasuries. And I'm not old, old, but I'm kind of old. I've never seen that before. And I don't think 25 basis points versus risk-free is a realistic interpretation of the world. So it's certainly interesting, right? And if you present me with a lot of opportunities where you say, I can have $3.5 million today or I can have $100,000 -- $130,000 a quarter for like a decade, I'm going to take the $3.5 million today.

So it is -- given the potential for that to widen. I think if we see moves like that again where we go from 200 basis points to 150 basis points on the tenure, I think there's a possibility we will be opportunistic, recognizing that nobody is paying Old Second to be a better on interest rates, but I think relative spreads is something we watch. And the relative spreads on munis, quite frankly, got a little stupid. So if we see something that looks dumb, we'll probably move. If we don't, we won't.

David Joseph Long -- Raymond James and Associates -- Analyst

Got it. Makes sense. And then switching gears over to M&A. I understand that you guys are still very disciplined there, but what have you seen from some of the smaller banks on their price expectations? Has that come down at this point or do you expect that to still come down?

James L. Eccher -- President and Chief Executive Officer

David, right now, we're still seeing probably unrealistic high expectations from smaller community banks. We have not seen -- over the last 90 days, we have not seen transaction close at what I would call realistic pricing at this point. So until we see something credit, I think the expectation is going to remain high and this is probably a normal cycle. We need to slowly see expectations come down.

David Joseph Long -- Raymond James and Associates -- Analyst

Good, thanks for taking my questions, guys.

James L. Eccher -- President and Chief Executive Officer

Thank you, David.

Operator

And our next question comes from Brian Martin with Janney Montgomery. Please go ahead.

Brian Martin -- Janney Montgomery -- Analyst

Hey, morning, guys, Brad, may be can you -- I appreciate the color on the margin. Just kind of your thoughts on -- if we go 3 to 5 basis points down, when you talk about kind of the repricing of loans versus deposits and kind of how that plays out under multiple cuts here, may be 2 to 3 more cuts, can you just -- is that 3 to 5 basis points narrow as you get more cuts or it sounds like it increases may be with more cuts? Just kind of any context on that, if you got multiple cuts coming?

Brad Adams -- Chief Financial Officer

Yes. I mean there is a lag effect to everyone, right? So -- and then our job is to give some sort of directional guidance that exists within 90-day windows. So there's a little bit of mistranslation that's possible. And it works the other way too because we've seen a couple of cuts now, but the reality is that the third quarter has some portion of the cut that's going to come already in it as LIBOR pricing reflects that. So it's difficult to qualify. But I would say that if you look at what was essentially kind of an 11 or 12 basis point contraction in the core margin in the third quarter, that's reflective of 2 rate cuts in a relative close proximity to the third quarter.

This showed up in the LIBOR curve. So not terribly inconsistent with 3 to 5, but some of that was also movements within the securities portfolio and some of it was also the LIBOR curve getting ahead of an October rate meeting. So it is -- if you ask me what we got from each rate cut, I would say it was probably in the range of about 4 for each one. If you ask me what the next one is going to do, I would say it's also going to be about 4, but prepayment could show up to make me a liar and we could show more stability.

And I would say that if we get another one, there is probably 1 to 2 basis points of headwinds from that in the following quarter. All in all, I'd say if you saw 5 to 6 in aggregate, I think that it would be -- at the end of the cycle and every all the lags to kick in, I think we'll probably give up about 30 basis points. And I think we can overcome a significant portion of that with balance sheet optimization and a significant portion with actually growing loans. So I think even in that scenario, Old Second remains an incredibly profitable institution with excellent returns on equity.

Brian Martin -- Janney Montgomery -- Analyst

Yes. Okay. No, I appreciate that. That's helpful, Brad. And the -- just remind me, do you guys have much in the way of floors on the loan portfolio or is that kind of not significant?

James L. Eccher -- President and Chief Executive Officer

Yes. Brian, we are implementing floors on, let's say, 3 quarters of our loan proposals. And historically, we have obviously always tried to get floors in there. They're not always easy to negotiate, but they are at every new transaction we're doing today.

Brian Martin -- Janney Montgomery -- Analyst

Okay. All right. And the -- and Jim, maybe just to your point about the originations versus kind of pay downs, I mean do you kind of have some color on -- will there be this quarter or just kind of year-to-date, just kind of how those moves have transpired?

James L. Eccher -- President and Chief Executive Officer

Yes. Brian, obviously, loan growth has been challenging and a bit frustrating for us. I will say this, our loan pipelines today are better than they have been in 24 months. Originations, we are projecting by the end of the year to be north of 15% higher than 2018. It's -- the payoff activity has been unprecedented, and we're seeing it come from all areas. So we are optimistic next quarter we will finally return some decent growth based on what we're seeing today.

Brian Martin -- Janney Montgomery -- Analyst

Okay. And most of the originations today, Jim, when you kind of characterize geographically, it sounds like more of it continues to come from the Chicago market. Is that fair?

James L. Eccher -- President and Chief Executive Officer

That's fair. Yes. The new talent we have hired, Brian, is starting to really build their pipeline, so we're optimistic going into the next few quarters.

Brian Martin -- Janney Montgomery -- Analyst

Okay. Fine. And then maybe just one last thing on the debt, on that -- on the $30 million, Brad. I guess is it possible as you kind of rank the priorities? Could you do a piece of that? Would it maybe the all of it, I guess, in your mind? Or I guess how would you think about that?

Brad Adams -- Chief Financial Officer

It can be done in pieces. And again, no decision has been made on that, but it is something that we're evaluating.

Brian Martin -- Janney Montgomery -- Analyst

Gotcha. Okay. I appreciate the call you guys. Thanks.

Brad Adams -- Chief Financial Officer

Thank you.

Operator

[Operator Instructions] And we have a question from Chris McGratty with KBW. Please go ahead.

Chris McGratty -- KBW -- Analyst

Good, thanks. you know the bump up in expenses in the second quarter, I think you talked about last quarter was related to the hires. Pretty stable this quarter. How do we think about the rate of investment, expense growth from here, given the $20 million level, optimistic about new hires? Or is this the kind of low single-digit self growth?

Brad Adams -- Chief Financial Officer

Yes. So fourth quarter should be seasonally better just because of some relief factors that you get in the fourth quarter. Next year kind of feels like a 3% to 4% year for me, Chris.

Chris McGratty -- KBW -- Analyst

Thanks.

Operator

And there appear to be no further questions at this time, so I'll turn the call back over to management for any closing remarks.

James L. Eccher -- President and Chief Executive Officer

Okay. Thank you for your interest in the company for joining us this morning, and we look forward to speaking with you again next quarter. Goodbye.

Operator

[Operator Closing Remarks]

Duration: 25 minutes

Call participants:

James L. Eccher -- President and Chief Executive Officer

Brad Adams -- Chief Financial Officer

Chris McGratty -- KBW -- Analyst

David Joseph Long -- Raymond James and Associates -- Analyst

Brian Martin -- Janney Montgomery -- Analyst

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