Old Second Bancorp, Inc. — Q2 2012 Form 10-Q
Business context and period: Unaudited consolidated results for the quarter and six months ended June 30, 2012. The company is an Illinois-focused 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
- Q2 earnings: Net income was $1.25 million, versus $1.01 million in Q2 2011. After $1.24 million of preferred dividends and accretion, income available to common shareholders was just $14,000; reported diluted EPS was $0.00.
- First-half earnings: Net loss was $1.72 million, improved from a $2.11 million loss in H1 2011. Loss available to common shareholders was $4.18 million, or $0.29 per diluted share, versus $4.44 million, or $0.31, a year earlier. No income tax benefit was recorded.
- Revenue and margin: Q2 net interest income was $15.69 million, down from $16.47 million; noninterest income rose to $10.40 million from $9.40 million. H1 net interest income was $30.79 million, down from $33.01 million, while noninterest income increased to $20.86 million from $18.34 million. Tax-equivalent net interest margin improved to 3.65% for Q2 and 3.57% for H1, from 3.59% and 3.54%, respectively.
- Expenses and credit costs: Q2 noninterest expense was $24.63 million, slightly above the prior-year $24.36 million; H1 expense fell to $47.09 million from $48.96 million. H1 loan-loss provision increased to $6.28 million from $4.50 million. Net loan charge-offs were $18.0 million in H1 2012, compared with $14.8 million in H1 2011.
- Balance sheet and liquidity: Assets were $1.986 billion at June 30, up 2.3% from year-end. Cash and cash equivalents were $130.0 million, versus $50.9 million at year-end; available-for-sale securities rose to $398.9 million from $307.6 million. H1 operating, investing, and financing cash flows were positive $17.9 million, $19.1 million, and $42.1 million, respectively. The company reported $62.5 million of available FHLB funding and $70.8 million of FRB borrowing capacity, with no outstanding FHLB advances.
- Loans and asset quality: Loans declined 9.6% from year-end to $1.238 billion. Nonperforming loans fell to $112.6 million from $138.9 million at December 31, 2011, and $179.4 million at June 30, 2011. The allowance was $40.3 million, 3.3% of loans, compared with 4.3% a year earlier; coverage of nonperforming loans was 35.8%. Other real estate owned (OREO) was $89.7 million, down $3.6 million from year-end, but H1 OREO valuation adjustments were $7.8 million.
- Deposits, debt, and capital: Deposits increased 1.7% from year-end to $1.770 billion, including a large late-June noninterest-bearing deposit that left after quarter-end. Borrowings totaled $117.7 million, including $58.4 million of junior subordinated debentures and $45.0 million of subordinated debt. Stockholders’ equity was $70.1 million, down 5.2% from year-end. The Bank’s total risk-based capital ratio was 13.25% and leverage ratio 9.35%; consolidated total risk-based and Tier 1 leverage ratios were 12.33% and 4.81%.
Material changes and management commentary
- Management attributed lower interest income to shrinking average earning assets, reduced qualified-loan demand, charge-offs and transfers to OREO, and investment in lower-yielding securities. Lower funding costs partly offset the decline.
- H1 noninterest income benefited from stronger mortgage banking activity and higher debit-card interchange income, while trust income declined, in part following three client departures. Mortgage banking income increased 84.8% year over year for H1.
- Management said asset quality was improving, with lower nonperforming and classified loans and a smaller construction-and-development problem-loan balance. It also cautioned that actual loan and property losses could exceed estimates. Real estate-related lending remained 91.2% of the loan portfolio.
- No specific earnings or financial guidance was provided. Management noted proposed Basel III rules could change capital requirements; their final form and effect were uncertain.
Risks, contingencies, and unusual items
- The Bank remained subject to an OCC Consent Order and the holding company to an FRB Written Agreement. The Bank exceeded the Consent Order’s stated capital objectives but remained formally classified as “adequately capitalized” while under the order. Regulatory restrictions include dividend and other payment limitations.
- The company remained out of compliance with two Bank of America credit-facility financial covenants. The lender’s potential remedies include accelerating the $0.5 million senior term debt and exercising collateral rights; the $45.0 million subordinated debt is not subject to those remedies for this covenant default. The lender had invoked the default rate on the term debt.
- The company had deferred interest on $58.4 million of junior subordinated debentures since 2010; unpaid interest was $9.2 million at June 30. It had also deferred Series B preferred dividends; unpaid dividends were $7.1 million. Common dividends cannot resume until required arrears are paid and regulatory approvals are obtained.
- Common equity was negative on a tangible basis: tangible common equity was negative $5.4 million, and the reported non-GAAP tangible-common-equity-to-tangible-assets ratio was negative 0.27%.
- The available-for-sale portfolio included $9.2 million of Level 3 collateralized debt obligations with $8.7 million of unrealized losses. Management said it did not intend to sell them and expected to hold until cost recovery; valuation depended on estimates amid limited market activity.
- A purported ERISA class action remained pending; mediation had not made meaningful progress, and a motion-to-dismiss ruling was scheduled for August 22, 2012. The company said it could not quantify the requested monetary relief.
Investor verification priorities
- Track loan-loss provisions, charge-offs, nonperforming and classified loans, OREO valuation adjustments, and allowance coverage as asset-quality improvement continues.
- Confirm the persistence of deposits and liquidity after the large late-June deposit left, and monitor borrowing availability and pledged collateral.
- Review compliance with the OCC and FRB agreements, the two credit covenants, and the implications of deferred debt interest and preferred dividends.
- Assess capital quality, especially negative tangible common equity, alongside regulatory capital ratios and potential Basel III effects.
- Check the valuation and credit performance of Level 3 collateralized debt obligations and other less-liquid securities, as well as the outcome of the ERISA litigation.