OSBC

Business Context and Reporting Period

Company: Old Second Bancorp, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2007
Overview: Old Second Bancorp is a financial services company headquartered in Aurora, Illinois, operating 29 banking locations in the Chicago suburban area. The third quarter of 2007 marked the first quarter of operations exclusively under the Old Second National Bank trade name following a July 1, 2007, merger of two state bank charters into a single national charter.

Key Financial Metrics

Material Changes vs. Prior Period

• Earnings Growth: Net income increased 22.8% in Q3 2007 compared to Q3 2006. This improvement was driven by reduced nonrecurring expenses in 2006 (pension settlement losses and core deposit intangible amortization) and a reduction in shares outstanding due to a stock repurchase in May 2007.
• Net Interest Margin Compression: The net interest margin (tax-equivalent basis) declined from 3.37% to 3.06% for the nine-month period. This was caused by a shift in deposit composition toward higher-cost money market and time deposits, while lower-cost NOW and savings accounts decreased.
• Asset Growth: Total assets grew 7.1% to $2.63 billion. Loans increased by $125.6 million, primarily in commercial real estate and construction categories. Securities available for sale increased by $45.2 million.
• Expense Management: Noninterest expense decreased 6.2% in Q3 2007 compared to Q3 2006, largely due to the absence of pension settlement costs. However, occupancy and equipment expenses increased due to branch closures and accelerated leasehold depreciation.
• Asset Quality: Nonperforming loans increased to $5.6 million from $2.2 million at year-end 2006, primarily due to two new commercial real estate relationships and one residential home equity loan placed on nonaccrual status.

Guidance, Outlook, and Risks

• Merger Activity: On November 5, 2007, the Company entered into a merger agreement to acquire Heritage Banc, Inc. for an aggregate purchase price of $86.0 million (50% cash, 50% stock). Closing is expected in Q1 or Q2 2008 pending regulatory and shareholder approval.
• Capital Position: The Company and its subsidiary bank remain "well capitalized" under regulatory guidelines. The Company recently issued $25.0 million in trust preferred securities to fund a common stock repurchase.
• Interest Rate Risk: The Company maintains a negative interest rate sensitivity gap in the short term (1 year), meaning rising rates could negatively impact net interest income in the near term. Management aims to minimize margin fluctuations regardless of rate levels.
• Legal Proceedings: A $2.0 million verdict was entered in the Company's favor in January 2007 against an insurance company. The defendant has appealed, and the Company will not record the judgment as income until the appeal is resolved.
• Operational Changes: The Company closed three leased branches in Q3 2007 due to market overlap, resulting in accelerated depreciation expenses. Five new retail locations were opened in 2006 and one in May 2007.

Investor Verification Checklist

• Merger Closing: Verify the status of the Heritage Banc merger and potential dilution or cash outflow impacts.
• Asset Quality Trends: Monitor the $5.6 million in nonperforming loans to ensure the allowance for loan losses (currently 0.92% of loans) remains adequate given the increase in nonaccruals.
• Deposit Cost Structure: Assess the sustainability of the shift toward higher-cost money market and time deposits and its long-term impact on net interest margins.
• Branch Rationalization: Track the realization of cost savings from the closure of three overlapping branches as leases expire between late 2007 and 2009.
• Legal Outcome: Confirm the resolution of the $2.0 million insurance appeal to determine if the amount will be recognized as income.