Old Second Bancorp, Inc. — Q2 2013 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2013; comparisons are to the periods ended June 30, 2012, unless otherwise noted. The company is an Illinois-based bank holding company providing commercial and retail banking, trust, and wealth management services. Dollar figures below are in millions unless stated otherwise.
Financial performance and condition
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Interest and dividend income | $16.9 | $19.7 | $34.4 | $39.2 |
| Net interest and dividend income | $13.4 | $15.7 | $27.3 | $30.8 |
| Net interest margin, tax-equivalent | 3.07% | 3.65% | 3.13% | 3.57% |
| Noninterest income | $10.5 | $10.4 | $21.1 | $20.9 |
| Noninterest expense | $22.2 | $24.6 | $43.7 | $47.1 |
| Net income (loss), before preferred dividends and accretion | $3.5 | $1.3 | $8.9 | $(1.7) |
| Net income (loss) available to common shareholders | $2.2 | $0.014 | $6.4 | $(4.2) |
| Diluted EPS | $0.15 | $0.00 | $0.45 | $(0.29) |
| Loan loss provision (release) | $(1.8) | $0.2 | $(4.3) | $6.3 |
- Balance sheet at June 30: Total assets were $1.93 billion, down 5.5% from December 31, 2012. Loans were $1.103 billion, down $47.3 million; deposits were $1.691 billion, down $26.6 million. Stockholders’ equity was $71.1 million, down $1.5 million.
- Credit quality: Nonperforming loans were $62.7 million, down from $69.8 million at March 31 and $112.6 million a year earlier. The allowance for loan losses was $35.0 million, 3.2% of loans; coverage of nonperforming loans was 55.9%. Net charge-offs were $1.8 million in Q2, while first-half net recoveries were $0.7 million.
- Other real estate owned: Net OREO was $59.5 million, down $13.0 million from year-end. The valuation reserve was $30.5 million. First-half OREO valuation expense was $4.6 million.
- Cash flow: First-half operating cash flow was $15.5 million and investing cash flow was $38.0 million; financing used $114.1 million. Cash and equivalents declined $60.6 million to $67.9 million. Financing outflows included repayment of $100 million in FHLB advances and net deposit outflows.
- Debt and liquidity: Borrowings totaled $134.4 million, including $58.4 million of junior subordinated debentures and $45.0 million of subordinated debt. Securities available-for-sale were $584.9 million fair value; management described the portfolio and borrowing capacity as substantial liquidity sources. The Bank reported $18.2 million of unused Federal Reserve borrowing capacity.
- Capital: The Bank’s total risk-based capital ratio was 16.30%, Tier 1 risk-based ratio 15.03%, and Tier 1 leverage ratio 10.40%, exceeding Consent Order targets. Consolidated ratios were 14.70%, 7.89%, and 5.46%, respectively. Tangible common equity remained negative at $(3.5) million; tangible common equity to tangible assets was (0.18%).
Material changes versus comparable periods
- First-half net income improved to $8.9 million from a $1.7 million loss, aided by the $4.3 million loan-loss reserve release versus a $6.3 million provision in 2012, lower noninterest expense, and improved credit metrics.
- Net interest income and margin declined: lower average loan balances and yields, competitive loan repricing, and a shift toward lower-yielding securities outweighed reduced funding costs. First-half tax-equivalent margin fell to 3.13% from 3.57%.
- Loans continued to contract, but management reported a smaller second-quarter decline and a larger loan pipeline. Securities available-for-sale rose to 30.3% of total assets at June 30, compared with 28.3% at year-end.
- Gross unrealized securities losses increased; accumulated other comprehensive loss was $10.5 million at June 30 versus $1.3 million at year-end. The filing attributes the fair-value changes mainly to interest-rate movements and states no other-than-temporary impairment was identified.
- Total deposits fell 1.5% in the first half, with management citing the expiration of the FDIC TAG program, tax payments, and customers moving funds to other investments.
Outlook, commentary, risks, and unusual items
- Management expected continued runoff of troubled assets during the remainder of 2013 and said modest organic loan growth might occur in the second half. It cited improving asset quality and a stronger loan pipeline, but noted that results are not assured.
- Management reported gradual local economic recovery and real estate market stabilization, while acknowledging that weak business expansion and real estate conditions continued to weigh on borrowers and loan demand. Real estate-related loans represented 89.3% of the portfolio.
- The Bank remains subject to an OCC Consent Order; the holding company remains subject to a Federal Reserve Written Agreement. These impose capital, risk-management, reporting, and dividend or debt restrictions. The Bank’s formal regulatory status remains “adequately capitalized” while under the Consent Order, despite exceeding its agreed capital targets.
- The company was out of compliance with one financial covenant under its Bank of America credit agreement at June 30. The lender may have remedies concerning the $0.5 million term debt, including acceleration or foreclosure; the filing does not report that such remedies were exercised.
- The company had deferred interest on $58.4 million of junior subordinated debentures since 2010; accrued unpaid interest was $14.3 million. Deferred Series B preferred dividends were $11.2 million. Common dividends are restricted, including until deferred obligations are paid and required regulatory approvals are obtained. The Board did not declare or accrue a Series B dividend for Q2; the preferred dividend rate is scheduled to rise from 5% to 9% in 2014.
- Management recorded no income tax expense despite first-half pretax income of $8.9 million because the deferred tax asset valuation allowance remained in place. A $0.375 million BOLI death benefit and a $0.612 million restricted-stock recapture benefit were included in first-half results.
- Some securities, including collateralized debt obligations, use Level 3 fair-value estimates with significant unobservable inputs. The CDO portfolio had $10.3 million fair value and $6.8 million gross unrealized losses at June 30. Rate changes and liquidity assumptions could affect reported fair values and equity.
- Management said the new Basel III capital rules, generally effective in 2015, were under review. Interest-rate sensitivity modeling estimated annual pretax income increases of 1.8%, 3.8%, and 8.4% for immediate rate increases of 0.5%, 1%, and 2%, respectively; management cautioned that modeled outcomes may differ from actual results.
- A 401(k) plan class action settlement was approved in June and became effective July 15, 2013; insurers paid the settlement, which the company said was not material. Management reported no material change in the risk factors from the 2012 Form 10-K and stated disclosure controls were effective.
Most important facts for investors to verify
- Whether credit quality and OREO continue to improve, and whether reserve releases remain appropriate given nonperforming loans, collateral valuations, and real estate concentration.
- Whether loan growth, deposit stability, and net interest margin trends support earnings without reliance on reserve releases or unusual income items.
- How the covenant noncompliance, OCC Consent Order, and Federal Reserve Written Agreement evolve, including any lender or regulatory action and the company’s capacity to meet restrictions.
- The status and terms of deferred junior-debt interest and preferred dividends, and the implications for common dividends, capital, and potential preferred-stock repurchases.
- The sensitivity of securities fair values and regulatory capital to interest rates, Level 3 valuation assumptions, and future Basel III implementation.