Old Second Bancorp, Inc. — Q3 2011 Form 10-Q
Reporting period: Three and nine months ended September 30, 2011; balance sheet comparisons are to December 31, 2010. Amounts are in U.S. dollars; financial figures below are in millions unless stated otherwise.
Business context and financial performance
Old Second Bancorp is an Illinois-based bank holding company providing commercial and retail banking, trust, and wealth-management services. Results remained affected by weak local economic conditions, real-estate credit stress, and subdued demand from qualified borrowers.
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Net interest income | $15.9 | $19.5 | $48.9 | $60.5 |
| Provision for loan losses | $3.0 | $11.8 | $7.5 | $75.7 |
| Noninterest income | $8.5 | $14.7 | $26.8 | $33.8 |
| Noninterest expense | $22.8 | $23.6 | $71.8 | $73.8 |
| Net loss | $(1.4) | $(0.1) | $(3.5) | $(32.0) |
| Loss per diluted share | $(0.18) | $(0.09) | $(0.49) | $(2.52) |
Net loss available to common shareholders was $2.6 million for Q3 and $7.0 million year to date, after preferred dividends and accretion. No income tax benefit was recorded in 2011 because deferred tax assets had been fully reserved. Management’s non-GAAP “core earnings” were $5.6 million for Q3 and $17.2 million year to date; this measure excludes loan-loss provision, OREO net expense, taxes, and specified unusual items.
Balance sheet, cash flow, liquidity, and credit
- Total assets were $1.94 billion, down 8.6% since year-end 2010. Loans declined 15.7% to $1.42 billion; available-for-sale securities rose 26.6% to $188.2 million.
- Deposits declined 9.5% to $1.73 billion, principally from lower time deposits. Cash and cash equivalents were $108.7 million, versus $98.8 million at year-end.
- Nine-month operating cash flow was $20.7 million; investing cash inflow was $169.0 million and financing cash outflow was $179.8 million. Net cash increased $9.9 million.
- Total borrowings were $110.8 million, including $58.4 million of junior subordinated debentures and $45.0 million of subordinated debt. The company had deferred interest on the junior subordinated debt; accrued unpaid interest was $5.6 million. Bank of America covenant noncompliance continued, though the lender’s acceleration remedies for the $45 million subordinated debt are restricted as described in the filing.
- Tax-equivalent net interest margin was 3.63% in Q3 versus 3.60% a year earlier; year-to-date margin was 3.57% versus 3.67%. Lower average earning assets drove the decline in net interest income; lower funding costs partly offset it. Loan interest collections from credits returning to performance also supported reported yields.
- Nonperforming loans fell to $139.3 million from $228.9 million at year-end 2010. Net charge-offs were $24.0 million year to date. The allowance was $59.9 million, 4.2% of loans, and equaled 43.0% of nonperforming loans.
- Other real estate owned (OREO) increased to $100.6 million from $75.6 million. New foreclosures and transfers exceeded dispositions; year-to-date OREO valuation adjustments were $9.2 million.
- Real-estate-related loans were 91.2% of the portfolio. The portfolio remained exposed to commercial real estate, construction and development, and residential property weakness.
Material changes, outlook, and risks
- The year-to-date loss improved substantially from 2010, primarily because loan-loss provision fell to $7.5 million from $75.7 million. However, Q3 net loss increased versus the prior-year quarter, while net interest income and noninterest income declined.
- Noninterest income comparisons were affected by 2010’s $2.6 million litigation-related income and $0.9 million BOLI death benefit; mortgage banking income also fell amid lower demand. Lower staffing and OREO valuation expense helped contain expenses.
- The Bank was subject to an OCC Consent Order requiring a strategic plan, credit-risk and liquidity measures, and minimum capital ratios. At September 30, Bank total risk-based capital was 12.98% and Tier 1 leverage was 9.52%; both exceeded the specified 11.25% and 8.75% objectives. The Company also remained subject to a Federal Reserve Written Agreement limiting dividends, debt, stock repurchases, and certain distributions without approval.
- Common and preferred dividends were suspended, and trust-preferred interest payments were deferred. Deferred TARP preferred dividends totaled $4.2 million. The filing provides no specific earnings or revenue guidance; management anticipated a future decline in the real-estate share of loans and expected construction-related losses to continue trending downward, while cautioning that actual losses could exceed estimates.
- Liquidity sources included cash, marketable securities, and unused Federal Reserve borrowing capacity of $84.9 million. Risks include deposit outflows, limited qualified loan demand, real-estate concentration, uncertain collateral values, and unobservable valuation inputs for collateralized debt obligations. Those CDOs had $10.3 million fair value and $7.6 million of unrealized losses; the filing reported no other-than-temporary impairment.
- A former employee’s putative ERISA class action concerning the company 401(k) plan seeks unquantified relief. The company disputes the claims and intends to defend them; the motion to dismiss had not been ruled on. Management reported disclosure controls were effective and no material change in internal control during the quarter.
Most important facts for investors to verify
- Whether nonperforming loans and charge-offs continue to decline, and whether the $59.9 million allowance adequately covers losses, especially in real-estate and construction portfolios.
- OREO additions, sale pace, and valuation write-downs, given the $100.6 million balance and ongoing appraisal uncertainty.
- Compliance with OCC and Federal Reserve requirements, capital levels, and any restrictions or approvals affecting distributions, debt, or funding.
- Deposit trends, available liquidity, and the company’s ability to meet obligations while junior-debt interest and preferred dividends remain deferred.
- Whether operating performance can improve despite shrinking loans and deposits, lower noninterest income, and the absence of a recognized tax benefit.
- Developments in the ERISA litigation and the valuation or credit performance of the Level 3 CDO holdings.