OSBC

Business Context and Reporting Period

Company: Old Second Bancorp, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2010
Business Overview: A financial services holding company headquartered in Aurora, Illinois, operating Old Second National Bank. The company provides commercial and retail banking services and trust/wealth management services primarily in the Chicago metropolitan area.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability Improvement: The net loss for the second quarter of 2010 ($23.4 million) was significantly lower than the second quarter of 2009 ($58.4 million). The 2009 loss included a one-time goodwill impairment charge of $57.6 million.
• Loan Loss Provisions: The provision for loan losses increased to $63.8 million for the six months ended June 30, 2010, compared to $56.9 million in the same period of 2009. Net charge-offs totaled $47.4 million for the first half of 2010, up from $23.6 million in 2009.
• Asset Contraction: Total assets decreased by $133.9 million (5.2%) from December 31, 2009, to $2.46 billion. Total loans decreased by $163.8 million (7.9%) due to charge-offs and reduced demand.
• Nonperforming Assets: Nonperforming loans increased to $242.9 million at June 30, 2010, from $189.7 million at December 31, 2009. Other Real Estate Owned (OREO) increased to $47.1 million.
• Capital Ratios: The Bank's Tier 1 capital ratio declined to 7.76% and total risk-based capital ratio to 10.73% as of June 30, 2010. These figures fell below the heightened ratios (8.75% and 11.25%, respectively) agreed upon with the Office of the Comptroller of the Currency (OCC).

Guidance, Outlook, Risks, and Unusual Items

• Capital Strategy: Management is pursuing a multi-faceted capital strategy, including an exchange offer to swap $31.6 million of trust preferred securities for common stock. They are also seeking to exchange $73.0 million of TARP Series B Preferred Stock for trust preferred securities, contingent on Treasury approval under the Dodd-Frank Act.
• Regulatory Compliance: The Bank is currently out of compliance with the heightened capital ratios agreed to with the OCC. While management does not anticipate immediate material impact, failure to restore compliance could lead to enforcement actions.
• Credit Quality Risks: Continued weakness in the real estate market, particularly in the construction and commercial real estate sectors, is driving charge-offs. Management noted "strategic defaults" where borrowers with ability to pay are choosing not to.
• Unusual Items:
  • Goodwill Impairment (2009): A $57.6 million charge in Q2 2009 distorted year-over-year comparisons.
  • Accounting Change: Adoption of fair value measurement for mortgage servicing rights (ASC 860-35) on January 1, 2010, impacting noninterest income reporting.
  • IRS Audit: The Company received notice of an IRS audit for tax years 2007, 2008, and 2009.
• Legal Proceedings: A pending appeal in the Illinois Supreme Court regarding a $2.0 million insurance coverage dispute with West American Insurance Company.

Investor Verification Checklist

• Capital Adequacy: Verify the status of the proposed exchange offers (Trust Preferred for Common Stock and TARP Preferred for Trust Preferred) and their impact on Tier 1 capital ratios.
• Nonperforming Loan Trends: Monitor the migration of loans into nonperforming status, specifically in the Real Estate Construction ($99.9 million) and Commercial Real Estate ($92.9 million) sectors.
• Allowance Adequacy: Assess the sufficiency of the $81.0 million allowance for loan losses given the $47.4 million in net charge-offs for the first half of the year.
• Regulatory Actions: Watch for any enforcement actions or Memoranda of Understanding from the OCC regarding the Bank's failure to meet heightened capital ratios.
• Deferred Tax Assets: Evaluate the risk of a valuation allowance being required against the $65.1 million net deferred tax asset if losses persist.