OLD SECOND BANCORP INC annual report, FY2013

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Old Second Bancorp, Inc. — 2013 Form 10-K

Reporting period: Fiscal year ended December 31, 2013. The filing also reports fourth-quarter results. Dollars are in U.S. dollars; financial amounts below are rounded.

Business context

Old Second is a community bank holding company operating through Old Second National Bank, with 27 banking locations in the Chicago metropolitan area, primarily in Aurora and surrounding Illinois counties. Its business includes commercial and consumer lending, residential mortgage banking, deposits, trust and wealth management services. Lending is heavily concentrated in real estate.

Financial results and condition

  • Annual earnings: Net income was $82.1 million, compared with a $72,000 loss in 2012. Net income available to common shareholders was $76.8 million, or $5.45 per diluted share, versus a $5.1 million loss available to common shareholders in 2012.
  • Tax item: 2013 results included a $70.2 million income tax benefit, principally from reversing $74.1 million of the deferred-tax-asset valuation allowance. Pretax income was $11.8 million. The reported profit therefore substantially reflects a nonrecurring tax accounting benefit, not operating income alone.
  • Fourth quarter: Net income was $213,000. Net interest income was $13.7 million, down from $13.9 million in fourth-quarter 2012; the quarter included a $2.5 million loan-loss reserve release and a $4.1 million pretax loss on CDO sales.
  • Revenue and margins: Annual net interest income was $55.3 million, down 6.9% from $59.3 million. Net interest margin was 3.16% on a tax-equivalent basis, versus 3.43% in 2012; fourth-quarter margin was 3.13%, versus 3.17% a year earlier. Noninterest income fell to $31.2 million from $37.2 million, while noninterest expense declined to $83.1 million from $90.4 million.
  • Credit costs and asset quality: The company released $8.6 million of loan-loss reserves in 2013, compared with a $6.3 million provision in 2012. Net charge-offs fell to $2.8 million from $19.7 million. Nonperforming loans declined to $39.8 million from $82.6 million, and nonperforming assets to $81.3 million from $155.0 million. The allowance was $27.3 million, or 2.48% of loans, versus $38.6 million, or 3.36%, in 2012.
  • Balance sheet: Total assets were $2.00 billion, down 2.0%; gross loans were $1.10 billion, down 4.2%; and deposits were $1.68 billion, down 2.0%. Securities increased by $48.9 million to $628.8 million. Real-estate-related loans represented 89% of the portfolio.
  • Cash flow and liquidity: Operating cash flow was $35.3 million; investing activities provided $9.6 million; financing activities used $125.7 million. Cash and cash equivalents declined $80.8 million to $47.7 million, partly reflecting repayment of $95.0 million in short-term borrowings. The filing describes continued liquidity monitoring and contingency stress testing; it does not provide a single summary liquidity ratio.
  • Capital and equity: Stockholders’ equity rose to $147.7 million from $72.6 million, largely due to the deferred-tax valuation allowance reversal. The Bank’s Tier 1 leverage ratio was 10.97% and total risk-based capital ratio 18.04%; both exceeded its board targets of 8% and 12%, respectively.
  • Debt: Borrowings totaled $131.4 million, including $58.4 million of junior subordinated debentures and $45.0 million of subordinated debt. The company was out of compliance with a financial covenant on its credit facility at year-end; the $500,000 term debt was in default and secured by the Bank’s stock. The lender had potential acceleration and collateral remedies.

Material changes versus the prior year

  • Credit quality improved substantially: nonperforming loans and assets, net charge-offs, and OREO all declined. OREO fell to $41.5 million from $72.4 million.
  • The loan portfolio continued to contract year over year, although fourth-quarter originations increased loans from the third quarter. Management cited muted qualified-borrower demand and intense competition.
  • The company shifted more assets into securities amid limited loan demand and transferred $237.2 million of securities from available-for-sale to held-to-maturity in September 2013. Unrealized securities losses reduced equity by $7.0 million at year-end, compared with $1.3 million in 2012.
  • The company sold its CDO holdings in December 2013, recording a $4.1 million pretax loss, in response to uncertainty around the Volcker Rule.
  • Both regulatory enforcement actions ended: the OCC terminated the Bank’s Consent Order on October 17, 2013, and the Federal Reserve terminated the Company’s Written Agreement on January 17, 2014. Management nevertheless expected to continue seeking Federal Reserve approval before dividends or additional debt.

Outlook, risks and unusual items

  • Management’s stated priorities included further reducing problem assets, growing relationship-based lending, controlling expenses, and maintaining capital and liquidity. It reported stronger late-year commercial loan pipelines, but gave no quantified financial guidance.
  • Key risks include the concentration in Illinois real estate lending, uncertain property values and local economic conditions, potential further credit losses, pressure on margins from low rates and competition, and the possibility that loan growth remains weak.
  • The allowance for loan losses and collateral valuations require substantial management judgment. Management cautioned that actual losses may exceed estimates and regulators may require additional reserves.
  • The $70.2 million tax benefit depended on management’s conclusion that most deferred tax assets were more likely than not realizable. A future valuation allowance could materially reduce earnings and equity; an ownership change could also limit use of tax-loss carryforwards.
  • The Company had deferred interest on its trust-preferred-related debentures since 2010. Accumulated unpaid interest was $17.0 million at year-end. It also reported $13.3 million in unpaid Series B preferred dividends. Common dividends are restricted until these obligations are addressed, and no common dividends were paid in 2013.
  • Other notable exposures include $154.1 million of Level 3 asset-backed securities, largely student-loan-backed, and $28.9 million of Credit Suisse mortgage securities with a $26.3 million fair value. The filing also notes ordinary-course litigation and a reserve for possible fourth-quarter expenses related to a debit-card security compromise and an ongoing dispute; no material adverse litigation outcome was expected based on information then available.

Most important facts for investors to verify

  • How much future earnings and capital depend on the deferred-tax-asset reversal, and whether the remaining deferred tax assets are realizable.
  • Current status and any waiver or cure of the credit-facility covenant default, including the lender’s rights regarding the Bank-stock collateral.
  • Whether credit-quality gains continue, and whether the reduced allowance and reserve releases adequately reflect remaining real-estate and OREO risks.
  • Performance, valuation assumptions and concentration risks in the securities portfolio, particularly Level 3 asset-backed and mortgage securities.
  • Conditions for resuming trust-preferred interest and preferred dividends, and the resulting timing and feasibility of common dividends.
  • Whether loan growth, net interest margin and operating revenue improve without renewed deterioration in credit quality.