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Old Second Bancorp Inc (NASDAQ:OSBC)
Q2 2020 Earnings Call
Jul 23, 2020, 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 Incorporated's second quarter 2020 earnings call. On the call today is Jim Eccher, the Company's CEO; Gary Collins, the 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 like 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 also 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 under the Investor Relations tab.

Now, I will turn it over to Jim Eccher. Sir, the floor is yours.

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 additional detail. I will then conclude with some summary comments and thoughts about the future before we open it up for questions.

Net income was $9.2 million or $0.31 per diluted share in the second quarter. Earnings this quarter were positively impacted by growth in mortgage banking income, specifically net gains on sale of mortgage loans, which was partially offset by a sizable provision for credit losses of $2.1 million, associated with changes in economic assumptions, primarily driven by COVID-19.

Net interest income was essentially unchanged from last quarter, despite shrinkage in the core loan book on the strength of a full quarter's reduction in funding costs. The impact of $134 million in PPP loans and a massive increase in core deposits without corresponding earning asset growth resulted in a sizable reduction in our reported taxable equivalent margin of 29 basis points. This was higher than our expectations because we had not anticipated the magnitude of the increased liquidity, taking our loan to deposit ratio from 89% to 84%.

Expense discipline was strong with deferral of expenses related to the origination of PPP loans, reduced hours of operations and lower overall volumes. Asset quality trends at this point remain remarkably stable. And the bulk of our lending team is focused on monitoring and staying in close contact with our customers. Nonperforming and classified assets increased somewhat modestly, and we remain confident in the strength of our loan portfolios. Details are available in the earnings release tables on these changes. Loans under modifications stand at approximately 9% of the loan book today. And we are working closely with our borrowers to understand each and every situation. Early indications are that approximately 60% of these loans will not require an extension of the original modification.

Concurrent with our earnings release, Old Second has also filed additional detail on our loan portfolio to give investors additional detail on the composition of the loan portfolio, current modification breakdowns and reserve levels. Exclusive of PPP loans, the reserve currently stands at 1.63% of total loans, and 1.89% if the reserve for unfunded commitments is also considered.

Overall fundamentals and earnings trends were relatively stable and consistent with prior quarters, with mortgage banking results reflecting a positive impact of a low rate environment. We're extremely proud of this performance. Old Second has taken a number of steps to protect our employees, customers and communities. For our customers, our locations remain open and available, albeit with necessary safety precautions. We are continuing to work with those that have been directly impacted, and we are offering the ability to defer payments as appropriate. Fees have also been waived in many cases. The vast majority of our staff has been working remotely for well over three months without issue. Old Second is proud to serve our communities, and I couldn't be more proud of the efforts of our employees over the last few months.

We are fortunate that our core lending strengths has steered us clear of many of the most impacted industries. As a reminder, we have zero direct energy or aircraft exposures in our loan portfolio. Hotel lending is extremely limited and restaurant lending is similarly scarce in our portfolio. We realize the potential exists for many other industries to be significantly impacted in the short to intermediate term from the implications of rising unemployment and falling consumer and commercial demand.

Our base economic forecast at June 30 contemplated a significant decrease in GDP and an unemployment rate in the low-double digit percent, both [Phonetic] for the remainder of 2020 and remain highly elevated over the life of the loan portfolio. Our assumptions were notably more bearish than most last quarter and were again adjusted downward in the second quarter. We will have losses at some point, but we believe our portfolio is well-diversified and will hold up much better than most. Importantly, we believe our capital and liquidity position are as strong as they ever have been.

In regards to the second quarter specifically, total loans increased $95.1 million from last quarter due to $133.9 million of PPP loan originations, in addition to a strong level of lease and commercial real estate originations, mitigated by continuing payoff activity. We did not see significant line of credit drawdowns at Old Second in the second quarter. And thus far in 2020, line drawdowns had continued to be relatively muted.

In a very short period of time, we saw a robust pipeline of loan demand mostly disappear. Concurrent with this, we quickly froze any lending activity that featured cash-out refinancing. The about-face [Phonetic] in economic outlook means that the loan growth expectations that we shared in January are no longer relevant. We do not expect to see significant loan growth for the balance of 2020.

Thus far through July 20, we have processed deferrals on our loan portfolio for 462 loans, totaling approximately $220 million in principal. The largest contributors to these requests have been churches, child care services and residential mortgages, which together make up approximately half of the requests. In terms of the Paycheck Protection Plan, Old Second has funded approximately $134 million in loans in the second quarter of 2020.

Overall, we remain cautious, but surprisingly encouraged about our results in a number of areas. And, I'll turn it over to Brad to provide additional color.

Bradley S. Adams -- Chief Financial Officer

Thank you, Jim. Net interest income increased $49,000 relative to last quarter, as the prior quarter included an acceleration of $635,000 of interest costs associated with the termination of $32 million of trust preferred securities. Absent this item, spread income was down but has held up very well, considering the core loan portfolio contraction during the quarter, and should continue to benefit from interest savings on this retirement of trust going forward. Fee income trends were soft relative to last quarter with the exception of very strong mortgage banking activity. Mortgage banking increased by $2.4 million, or more than 100% in the second quarter of 2020 over the first quarter. Servicing rights experienced a more modest writedown based on declines in interest rates during the quarter as well.

We reported taxable equivalent margin decreased by 29 basis points from last quarter, with the majority of the contraction due to a lower yield on PPP loans and the impact of unprecedented growth in liquidity on the balance sheet. Deposit growth has been nothing short of eye-popping. As expected, the elevated spread between LIBOR and overnight swap rates evaporated quickly during the second quarter. I think, it was about an hour of our earnings call. Recall that we had reduced deposit pricing across the board in late March based on Fed movements and experienced a full quarter of the impacts of these actions in the second quarter. We expect much more modest overall margin contraction going forward. I'm not assuming at this point anyway that the deposit inflows will reverse quickly. If the outflow or bounce back is relatively quick, our margin outlook would improve dramatically. If the economic conditions improve and loan growth returns, our margin outlook would improve dramatically. I do not expect either of these conditions to occur this year.

The provision for loan losses totaled $2.1 million in the second quarter, following an approximate $8 million increase in the allowance in the first quarter of 2020. The economic outlook for us assumes a prolonged recessionary environment, with an unemployment rate remaining above 10% through the remainder of the year and above 8% through June 30 next year. It reflects a high-single digit unemployment rate over the remaining life of the loans.

As Jim mentioned, Old Second has minimal exposure to the hardest hit industries and very strong credit culture overall. Our consumer lending exposure is relatively modest compared to peers, very modest actually, and extremely well-seasoned. Reserves across the commercial book have increased dramatically this year in excess of 50% relative to last year. Our efforts in the coming quarters will be focused on helping our customers, funding quality loan growth and maximizing core funding with the expectation of further [Phonetic] modest contraction in margin trends, assuming liquidity remains robust, as I said, and risk spreads remain unreasonably tight.

Our capital and liquidity levels leave us well-positioned, and we have ample flexibility to continue to pursue quality relationships and protecting the franchise. On the fee income side, mortgage banking reflected a significant increase in gain on sale margins and volumes during the quarter. I expect mortgage banking trends to continue to remain strong in the near term. Trust and wealth management bounced back quite a bit and retail banking trends slowed dramatically with fee rationalization undertaken during the quarter. I'm not sure when we will return to standard policy here yet.

Expenses remain extremely well-controlled, and we will likely pursue some modest expense initiatives in the remainder of the year as the depth of the economic strain becomes clearer. I think broadly, what investors should take away is that we are by no means assuming anything resembling a V-shape recovery and expect the strain to continue in both the near and intermediate term. We will continue to pursue quality relationships, and we are on the lookout for opportunities to expand the franchise when appropriate.

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

James L. Eccher -- President and Chief Executive Officer

Okay. Thanks Brad. In closing, we remain encouraged with these trends, confident in our balance sheet and ready for the challenges ahead. We have taken the steps to position ourselves well for a slowdown and recession. We believe our credit and underwriting has remained disciplined, and our funding and capital position is strong.

Overall, the team has never been better. And at some point, to Brad's point, I do remain optimistic that opportunities will be available to improve our footprint. The focus for us is on timing and making sure that we have the balance sheet, liquidity and access to capital that we need in order to take advantage.

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] We'll take our first question from Nathan Race with Piper Sandler. Please go ahead, sir.

Nathan Race -- Piper Sandler -- Analyst

Yes. Hi, guys. Good morning.

James L. Eccher -- President and Chief Executive Officer

Good morning, Nathan.

Nathan Race -- Piper Sandler -- Analyst

Brad, I was maybe just hoping to start on your expense comments. It sounds like you guys are looking at some opportunities to kind of refine the cost structure in the back-half of this year. I was just wondering, perhaps you could elaborate on the magnitude of potential cost that you guys are contemplating at this point.

Bradley S. Adams -- Chief Financial Officer

I think it's too early to tell. I think that some of the -- kind of large infrastructure spends that we had contemplated and that were consistent with the guidance that we have provided will largely be on hold. We are doing our absolutely very best to make sure that nobody is sent home during the pandemic. And we run a pretty lean shop as it is, as evidenced by the profitability ratios that we usually report and are again reporting this quarter. I think that the way to think about us is being extremely cautious on any investment opportunity. We're in one of those rare scenarios where there's going to be opportunities to acquire things for less than you can grow them organically at some point. The key is evaluating where asset values are going to be. We certainly don't have clarity on that yet. But I think that for the near term, an operating expense run rate around $20 million is going to be appropriate.

Nathan Race -- Piper Sandler -- Analyst

Yeah. That's helpful. And just changing gears a little bit and thinking about to reserve build trajectory from here, I appreciate that the classified loans came down in the quarter. I imagine the provision you guys incurred this quarter was largely just a function of qualitative inputs. So, just kind of as we sit here today and as you guys look out, should we continue to expect the reserve to increase by the level that we saw here in the third quarter -- I'm sorry, in the second quarter into the third quarter? Or is kind of what you're seeing from an internal perspective not really supporting that type of build at this point?

Bradley S. Adams -- Chief Financial Officer

I think that if I had the answer to that I would tell you. We saw a strong rebound in a number of economic indicators that my strong suspicion is largely a factor of unprecedented levels of stimulus. Broadly speaking, we're still running somewhere in the neighborhood of down 15% on consumer spending. That is going to have profound implications. And I don't know what the government response is going to be and I don't know what the availability of credit is going to be broadly in the economy. All of these things are fundamental in determining what the path of things is going to be. The visibility is quite simply very low. I think it's possible that we'll continue to see reserve builds consistent with this quarter in the next two and I think it's possible that we will begin to taper off. I don't know what's going to happen on that front. So, I wouldn't want to lead anybody astray.

Nathan Race -- Piper Sandler -- Analyst

Fair enough. Understandable. And then just last one for me on the core margin from here. I appreciate the disclosures in the deck around the impact from PPP loans and so forth. But I guess stripping that out going forward, and it doesn't sound like you guys expect the excess liquidity levels to come down near term. Just any thoughts on kind of trajectory of the core NIM into the third quarter at this point?

Bradley S. Adams -- Chief Financial Officer

Well, my opinion on what core deposits are going to do is worth about nothing because I did not expect to have $200 million in cash earning 11 basis points. That is simply a major whiff on the forecast. Exclusive of that impact and exclusive of PPP, the margin was only down a few basis points, which would have been consistent with my expectations. I don't know what's going to happen. My strong suspicion is that -- based on what we see is that a fair amount of this deposit growth is not in any way related to PPP and reflects a change in the savings rate for -- within our customer base or desire to have a cushion. I don't know how long that lasts. I do know that the last time we went from low-80s loan-to-deposit ratio back to 90%, it added 30 basis points to our margins. So, at some point, it is a significant driver of profitability and earnings growth, if it is more than transient.

We have a very good deposit franchise. And I think that at some point that becomes worse something again. And Jim and I talk every day in terms of when is the right time to look forward and get back to doing something other than playing defense. I don't think we're there yet. But based on the amount of effort that our lenders have put in and getting close -- remaining close to our customers and having conversations and understanding their financial situation, it would be remarkably difficult to be more bearish than I was last quarter.

Nathan Race -- Piper Sandler -- Analyst

Got it. That's very helpful. I appreciate that and all the other color and congrats on a nice quarter. Thanks, guys.

Bradley S. Adams -- Chief Financial Officer

Thanks, Nate.

Operator

Our next question comes from Chris McGratty with KBW. Please go ahead, sir.

Chris McGratty -- KBW -- Analyst

Hey, good morning guys.

James L. Eccher -- President and Chief Executive Officer

Good morning, Chris.

Chris McGratty -- KBW -- Analyst

Hi Jim. Brad, I want to come back to the margin question. I'll ask a little different. Understanding the ballooning of the balance sheet is, in some ways, just a percentage, right? We care about NII. How do we think about core NII, excluding the PPP? It sounds like, core loans will not going to be ton of loan growth near-term and margins is still biased downward. So, it would feel like we're still downward bias in NII? Just any color on that would be great?

Bradley S. Adams -- Chief Financial Officer

Yeah. I don't think we'll see a ton of growth, but I'm not prepared to throw in the towel on loan growth in 2020 either. I think that there are opportunities out there, because I believe that others will struggle. I think that we're largely contrary in the nature, at least we have been for the last 18 months. We spent the bulk of last year pruning and not chasing relationships that were borderline in nature. And to continue that now doesn't make sense. We did most of the hard work last year, in addition to growing capital into this, which is why raising capital now makes little sense for us, given how much we've built.

Earnings visibility is tough here. You run the chance of being very wrong, like I certainly wouldn't have expected that we would report near 14% return on tangible common this quarter, and this level of strength, especially with the balance sheet ballooning and low earning or non-earning assets, namely cash. But I think it's certainly possible that we can maintain this level of profitability absent a turn down, an overall economic conditions of dramatic scale.

Chris McGratty -- KBW -- Analyst

Okay, thanks. In terms of the PPP, do you have a couple of details just for modeling purposes? The amount of fees that are going to come through, then your thoughts on timing, and then what might the average balance of PPP loans be?

Bradley S. Adams -- Chief Financial Officer

So, I think we'll begin to see forgiveness in the fourth quarter. Our gain is around $4.5 million. That will be somewhat muted by expense deferrals that have been realized. But you should see, if I had to guess, I would say half of it in the fourth quarter and the remainder in the first quarter of next year, and somewhere around 95%, forgiven, maybe higher.

Our PPP loan originations, I would remind people were entirely to existing customers and with only a couple loans of any size whatsoever. You can see in the credit disclosures that we provided last night, that this is a very granular loan portfolio with average exposures across every loan category, below $0.5 million, very granular, very small, very solid lending portfolio. And I can tell you that the work that we've done over the last five months, I put myself in that group, but that's not remotely accurate. It's entirely the work of our lending team has made us very confident in where we sit relative to current economic conditions.

James L. Eccher -- President and Chief Executive Officer

Yes. Chris, if you look at the second to last page of the deck, the average tickets about $200,000. So, we've done 454 of these loans, but to Brad's point there, very small ticket.

Chris McGratty -- KBW -- Analyst

Okay. Maybe last question and I'll step back. You guys have obviously been pretty cautious on the environment for some time. But you bought stock in the quarter, which is, I would say in a very small minority of banks this quarter. How do we think about using buybacks continuing going forward?

Bradley S. Adams -- Chief Financial Officer

I think it will be opportunistic.

Chris McGratty -- KBW -- Analyst

Thanks.

Operator

[Operator instructions] We'll take our next question from Stan Faries, Private Investor. Please go ahead, sir.

Stan Faries -- Private Investor

Good morning, gentlemen.

James L. Eccher -- President and Chief Executive Officer

Good morning, Stan.

Stan Faries -- Private Investor

I really don't have a question. I did want to throw out a comment. I wanted to say hi to you and all my past colleagues and friends at Old Second. I think that there's a reason that the bank is almost 150 years old. I think that it's been demonstrated in the past that when adversity hits the Directors and Officers rise to the occasion. And I think it's clear that that's what you guys are doing now. And I just wanted to say kudos on a great quarter and great management job. It seems like the bank might be doing a little better since I retired. I hope that's just a coincidence.

James L. Eccher -- President and Chief Executive Officer

Thanks, Stan. Obviously, you were a big part of building this foundation. So, we have to give you some credit for this too. So, thank you for the kind words.

Stan Faries -- Private Investor

Yes. I appreciate it. I wish you all the best. And keep making me money in my stock portfolio.

James L. Eccher -- President and Chief Executive Officer

We'll do.

Operator

We'll take our next question Brian Martin with Janney Montgomery. Please go ahead, sir.

Brian Martin -- Janney Montgomery -- Analyst

Hey, guys, good morning.

James L. Eccher -- President and Chief Executive Officer

Good morning, Brian.

Brian Martin -- Janney Montgomery -- Analyst

Hey, just one question. Jim, I think you said in the deferrals, so far, I guess, was it 60% of the total is what you expect to be kind of go back to normal, so kind of you get down to a low-single digit level of deferrals when we look quarter two out when they kind of roll through?

James L. Eccher -- President and Chief Executive Officer

That's based on early conversations we've been having with a lot of our clients. And we think that those numbers could potentially be better.

Brian Martin -- Janney Montgomery -- Analyst

Okay. And I guess if you're seeing any second deferrals today. I guess, are you seeing -- it sounds like you're not seeing much at all on the request for second deferrals, correct?

James L. Eccher -- President and Chief Executive Officer

No. But we certainly expect them, with some of these harder hit industries. Certainly in retail -- part of the retail book will certainly have a second wave, Brian. But, again, we don't have a lot of exposure to those other hard hit sectors. So we won't be immune from doing second deferrals. But we're very pleased with the conversations we're having with clients. We've actually had a number of clients, Brian that have taken modifications, but yet continue to make normal payments. So, we do expect these numbers to improve next quarter.

Brian Martin -- Janney Montgomery -- Analyst

Yes. Okay. All right. That's helpful. And just I think you guys talked about loan growth being obviously pretty muted here. But you also kind of talked about the other opportunities to buy deeper as opposed to growing organically. I guess, can you just give any sense, I mean, I realized it's early and where we're having the uncertainty of the pandemic. But just it sounds as though there's more thinking surrounding M&A? Or is it M&A or would it just be more lift-outs that you're thinking would create these opportunities as you go forward?

James L. Eccher -- President and Chief Executive Officer

Well, I mean, obviously organic growth is obviously something that we're very focused on internally. And, loan committees are -- I wouldn't say are robust at this point. But we are starting to see more activity on a weekly basis. We are confident we're going to be able to redeploy some of this liquidity in the coming quarters. After that, certainly lift-outs are fair game for us. And we'll continue to look at talent whenever we can. And then probably a little bit early. I'll let Brad speak to M&A, but probably a little bit early in the cycle. But, we certainly want to look for those opportunities to improve our footprint.

Bradley S. Adams -- Chief Financial Officer

I think M&A would require a great deal of due diligence right now.

Brian Martin -- Janney Montgomery -- Analyst

Right. Okay. It sounds as though it was more on the plate than that. So, OK. And then maybe just last one for me guys. It's just on the fee income this quarter. Some of that you talked about eliminating some of the service charge income and deposit service charges. How do you think those fees that are kind of customer related trend here in the next quarter or two? Or just any near-term visibility on that?

Bradley S. Adams -- Chief Financial Officer

I think they'll slowly return to normal over the next six months on the retail side.

Brian Martin -- Janney Montgomery -- Analyst

Okay. On the service charge income. Okay. So next year, it kind of looks a little bit more normal than the next couple quarters.

Bradley S. Adams -- Chief Financial Officer

I think so. Yes.

Brian Martin -- Janney Montgomery -- Analyst

Okay. I think that's all I had. So thanks, guys.

Bradley S. Adams -- Chief Financial Officer

Alright. Thank you, Brian.

James L. Eccher -- President and Chief Executive Officer

Thanks, Brian.

Operator

[Operator Instructions]. Our next question comes from Eric Grubelich with -- a Private Investor. Please go ahead, sir.

Eric Grubelich -- Private Investor

Hi, good morning. I just had a question on your loans with payment modification. When you look at that, I guess you have a balance you show on the chart of about $216 million outstanding. How much of those are actually just on interest-only payment versus some other kind of modification?

James L. Eccher -- President and Chief Executive Officer

Good morning, Eric. It's Jim.

Eric Grubelich -- Private Investor

Hi Jim.

James L. Eccher -- President and Chief Executive Officer

About a third of those, Eric, are on interest-only, and two-thirds are in full payment deferral. The vast majority of them over 85% are for 90 days or less, the remainders over 120 or 180.

Eric Grubelich -- Private Investor

Yeah, I saw that in the detail of those -- of what you had. So, OK. No, I am sorry, I just saw you had that in there, a third on IO. Okay. I missed it. But anyway, good to hear it anyway from you. Okay, thanks a lot.

James L. Eccher -- President and Chief Executive Officer

Thanks, Eric.

Operator

[Operator Instructions]. And it appears we have no further questions at this time. I'd like to turn the floor back to you Mr. Eccher.

James L. Eccher -- President and Chief Executive Officer

Okay. Thank you, everyone for joining us this morning. And we look forward to speaking with you again next quarter. Good bye.

Operator

[Operator Closing Remarks]

Duration: 30 minutes

Call participants:

James L. Eccher -- President and Chief Executive Officer

Bradley S. Adams -- Chief Financial Officer

Nathan Race -- Piper Sandler -- Analyst

Chris McGratty -- KBW -- Analyst

Stan Faries -- Private Investor

Brian Martin -- Janney Montgomery -- Analyst

Eric Grubelich -- Private Investor

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