Business Context and Reporting Period
Company: Old Second Bancorp, Inc.
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2007
Headquarters: Aurora, Illinois
Old Second Bancorp operates as a financial holding company providing full-service community banking and trust services through its primary subsidiary, Old Second National Bank. As of December 31, 2007, the Company operated 29 banking locations and one commercial loan production office across six counties in Illinois (Kane, Kendall, DeKalb, DuPage, LaSalle, and Will). The Company completed the acquisition of Heritage Banc, Inc. on February 8, 2008, expanding its footprint into Cook County and the south Chicago suburbs with six additional locations.
Key Financial Metrics
Note: All dollar amounts in the tables below are in thousands, unless otherwise noted.
Balance Sheet and Asset Composition
| Metric | 2007 | 2006 | 2005 |
|---|---|---|---|
| Total Assets | $2,515,740 | $2,377,771 | $2,239,334 |
| Total Loans (Gross) | $1,891,110 | $1,763,912 | $1,704,382 |
| Allowance for Loan Losses | $(16,835) | $(16,193) | $(15,329) |
| Total Deposits | $2,096,241 | $1,992,249 | $1,883,351 |
| Stockholders' Equity | $148,652 | $154,690 | $144,843 |
Income and Profitability
| Metric | 2007 | 2006 | 2005 |
|---|---|---|---|
| Interest Income (Tax Equivalent) | $159,030 | $144,953 | $123,025 |
| Interest Expense | $87,143 | $70,830 | $46,224 |
| Net Interest Income (Tax Equivalent) | $71,887 | $74,123 | $76,801 |
| Net Interest Margin (TE) | 3.05% | 3.34% | 3.64% |
| Return on Average Assets | 0.95% | 0.99% | 1.24% |
| Return on Average Equity | 16.13% | 15.29% | 19.11% |
Liquidity and Capital
- Capital Status: As of December 31, 2007, the Bank was classified as "well-capitalized" under OCC regulations, exceeding minimum requirements for Tier 1 and total capital.
- Dividend Capacity: Approximately $46.9 million was available to be paid as dividends by the Bank as of year-end 2007.
- Debt: The Company held $57.4 million in junior subordinated debentures held by Old Second Capital Trust I and II. Interest payments on these debentures total $4.2 million annually beginning in 2008.
Material Changes vs. Prior Period
- Net Interest Income Decline: Net interest income (tax equivalent) decreased by $2.2 million (3.0%) from 2006 to 2007. This was primarily driven by a $3.5 million decrease due to higher interest rates paid on liabilities, partially offset by a $1.3 million increase due to higher average balances.
- Loan Portfolio Growth: Gross loans increased by $127.2 million (7.2%) to $1.89 billion. Real estate construction loans grew significantly, comprising 21.1% of the portfolio.
- Nonperforming Assets Increase: Total nonperforming assets rose to $5.97 million in 2007 from $2.26 million in 2006. Nonaccrual loans increased to $5.35 million from $1.63 million.
- Provision for Loan Losses: The provision for loan losses was $1.19 million in 2007, compared to $1.24 million in 2006. Net charge-offs were $0.55 million in 2007 versus $0.38 million in 2006.
- Securities Portfolio: The securities portfolio grew to $560.9 million, with a notable increase in U.S. government agency mortgage-backed securities and collateralized mortgage obligations.
Outlook, Risks, and Contingencies
Management Commentary and Outlook
Management anticipates continued growth but notes that the real estate market has experienced significant weakness. The Company expects the slower rate of real estate building and development activity observed in 2006 to continue into 2008. The acquisition of Heritage Banc is expected to expand the Company's market presence in the Chicago metropolitan area, though integration risks remain.
Key Risks
- Real Estate Concentration: Approximately 88.1% of the loan portfolio ($1.7 billion) consists of residential, commercial, and construction real estate loans. Adverse developments in real estate values pose a significant credit risk.
- Interest Rate Sensitivity: The Company's profitability is sensitive to changes in interest rates. Rising rates increased the cost of funds, compressing the net interest margin.
- Tax Strategy Challenges: The Company utilizes a Nevada-domiciled subsidiary and a REIT to minimize Illinois state taxes. New Illinois legislation effective January 1, 2009, may eliminate these benefits. Additionally, the Illinois Department of Revenue may attempt to apply the new law retroactively to 2007, potentially resulting in additional tax liabilities, interest, and penalties.
- Acquisition Integration: The February 2008 merger with Heritage Banc carries risks regarding the integration of operations, retention of customers, and potential exposure to unknown liabilities.
Contingencies
- Legal Proceedings: A $2.0 million verdict was entered in favor of Old Second Bank - Yorkville against an insurance company in January 2007. The insurance company appealed, and the Company will not record this as income until the appeal is resolved.
Investor Verification Checklist
- Allowance Adequacy: Verify if the allowance for loan losses (0.89% of total loans) is sufficient given the 188% increase in nonperforming assets and the high concentration in real estate construction loans.
- Tax Liability Exposure: Assess the potential financial impact of the Illinois Department of Revenue challenging the Company's 2007 state tax return retroactively under new legislation.
- Net Interest Margin Trend: Monitor the continued compression of the net interest margin (down to 3.05% from 3.64% in 2005) in a rising rate environment.
- Heritage Integration: Review post-acquisition performance of the Heritage Banc locations to ensure projected synergies and customer retention are being realized.
- Securities Valuation: Confirm the valuation of the securities portfolio, particularly mortgage-backed securities, given the turmoil in the sub-prime mortgage market and potential downgrades of monoline insurers.