Old Second Bancorp Q4 2023 Earnings Call Transcript

Quartr
Provided by Quartr
January 25, 2024

There are 8 speakers on the call.

Operator

Good morning, everyone, and thank you for joining us today for Old Second Bancorp's Inc. 4th quarter 2023 earnings call. On the call today are Jim Ecker, the company's Chairman, President and CEO Brad Adams, the company's COO and CFO and Gary Collins, the Vice Chairman of our Board. I will start with a reminder that Old Second's comments today will contain forward looking statements about the company's business strategies and prospects, which are based on management's existing expectations in the current economic environment. These statements are not a guarantee of future performance and results may differ materially from those projected.

Operator

Management would ask you refer to the company's SEC filings of our full discussion of the company's risk factors. The company does not undertake any duty to update such forward looking statements. On today's call, we will also be discussing certain non GAAP financial measures. These non GAAP measures are described and reconciled to their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com on the homepage and under the Investor Relations tab. Now I will turn the floor over to Jim Ecker.

Operator

The floor is yours.

Speaker 1

Good morning and thank you for joining us. I have several prepared opening remarks and will give my overview of the quarter and then turn it over to Brad for additional details. I will then conclude with certain summary comments and thoughts about the future before we open it up for questions. Net income was $18,200,000 or $0.40 per diluted share in the Q4 of 2023. Adjusted net income was 19,100,000 or $0.42 per diluted share in the 4th quarter.

Speaker 1

On the same adjusted basis, return on assets was 1.33%. There's also an additional $0.02 impact from the fair value of mortgage servicing rights in the 4th quarter. Quarter 2023 adjusted return on average tangible common equity was 17.21 percent and the tax equivalent efficiency ratio was 48.76 percent. 4th quarter 2023 earnings were negatively impacted by $8,000,000 of provision for credit losses and a $1,200,000 estimated litigation accrual. The combined after tax impact quarter.

Speaker 1

These two items reduced diluted earnings per share by $0.15 in the 4th quarter. Despite these setbacks, profitability Old Second remains exceptionally strong and balance sheet strengthening continues with our tangible common equity ratio increasing by 86 basis points linked quarter to 8.53%. Our financials continue to be positively impacted by higher market interest rates. Pre provision net revenues quarter remains stable and exceptionally strong. For the Q4 of 2023 compared to the prior year like period, income on earning assets increased $6,000,000 or 8.7 percent, while interest expense increased 8,800,000 The increase in both cases is rate driven.

Speaker 1

However, average balance on other short term borrowings increased significantly compared to prior year like period, Causing an overall equal increase between rate and volume factors on the liability side. The Q4 of 2020 quarter. Reflected loan growth of $13,400,000 from the prior linked period and expanded $173,300,000 or 4.5% over the same period last year, which was in line with our revised expectations for the year following the volatility in banks Earlier in the year. Loan prepayments continue to be modest and origination activity remained steady over the last quarter. Activity within our loan committees remained modest relative to prior periods due to both higher interest rates and seasonal impacts.

Speaker 1

The net interest margin compressed slightly this quarter driven by higher funding costs. Loan yields were flat during the quarter with no change in the linked quarter and 55 basis point increase year over year. Funding costs increased due to the increases in both rates and balances. Quarter. The tax equivalent net interest margin was 4.62% for the 4th quarter compared to 4.66% in the 3rd quarter.

Speaker 1

The net interest margin decreased slightly in the year over year quarter due to the impact of rising rates on the cost of funds, which was partially mitigated by growth in interest income driven by the variable portion of the loan and securities portfolio and continuing loan growth in 23. The loan to deposit ratio is 88% at the end of the year compared to 87% after the 3rd quarter and 76% as twelvethirty onetwenty 2. As we said last quarter, our focus continues to be on balance sheet optimization. And I'll let Brad talk about that more in a moment. Turning to credit, 4th quarter represents our hope that to provide an inflection point in our credit trends.

Speaker 1

Old Second began substantially downgrading large amounts of commercial real estate loans, including office and healthcare at the end of 2021 and accelerating through 2022. Substandard and criticized loans went from approximately 60,000,000 or a little more than 1% of loans at the end of the Q3 in 2021 to a peak of nearly $300,000,000 or over 7% of loans in the Q1 of 2023. In the Q4 of 2023, substandard and criticized loans are down to $200,000,000 and the expectation remains for further improvement in the 2024. Encouragingly, our special mention loans are now at their lowest levels in 2 years. We expect to realize a relatively less costly resolution on a number of non performers in the near future and remain hopeful we can recover some of the losses realized in the second half of twenty twenty three.

Speaker 1

The reality is that commercial real estate valuations are heavily dependent upon market level of interest rates as a primary determinant of cash flow for a given property. A movement in rates such as we've had seen is substantial enough to significantly impair the equity positions in a large percentage of commercial real estate credits. Additionally, the residual stress brought upon by the pandemic in CRE office and healthcare is not abated. The idea that bank portfolios are somehow immune and should not be risk rated for such is improbable. We believe we are being proactive and realistic in addressing commercial real estate loans facing deterioration from higher interest rates, declining appraisal values and cash flow pressures.

Speaker 1

We recorded net charge offs of $15,500,000 in the Q4 of 2023 compared to $6,600,000 of net charge offs in the Q3 of 2023. The majority of the current period charge offs were specific to 3 borrowers within commercial real estate. The charge offs realized in the 4th quarter relate to the positioning of the Chicago office credit for potential sale and further write downs on 2 assisted living facilities in California. All have been rated substandard and classified for some time. The latter credits had subpar occupancy and higher labor cost for some time.

Speaker 1

However, projected cash flows experienced further stress with the passage of new draconian healthcare minimum wage laws in California quarter that necessitated more aggressive action. 1 of the 2 properties saw an updated appraisal decrease by more than 70% from an appraisal performed not that long ago due to the impact of cash flows. The good news Is that criticized that classified loans are declining and the remainder of the portfolio remains well behaved. Non accrual assets ticked up modestly based largely on expected migration, timing issue and the transfer of 2 properties into OREO that had been significantly marked based on very recent appraisals. Stress testing at renewal rates has not raised any new red flags for us and the bulk of our loan portfolio has transitioned and is seasoning into a higher rate environment.

Speaker 1

Being short duration on the asset side has obviously helped us immensely in terms of interest rate risk management, But it's probably put us at the vanguard in terms of commercial real estate stress. This belief is reinforced by The experience that a significant percentage of our substandard loans are acquired secondary participations. My hope and belief based on the weight of the metrics is that Old Second has turned the corner that others are just beginning to approach. Please refer to our additional loan disclosures in our earnings release. The allowance for credit losses on loans decreased to $44,300,000 as of Twelvethirty Onetwenty 3 from $51,700,000 at September 30, Which is 1.1 percent of total loans as of December 31, 2023, down from 1.3% total ACL to gross loans as of September 30, 2023.

Speaker 1

Unemployment and GDP forecast used in future rate loss rate assumptions remain fairly static from last quarter. The change in provision levels largely relates to the 26% reduction and criticized assets since the middle of 2023. I think investors should know that we will be aggressive in addressing weak credits And that we remain confident in the strength of our portfolios. Non interest income continued to perform well, excluding changes in fair value of mortgage servicing rights and losses on security sales. The decline from the previous quarter was approximately $500,000 driven by the change in cash surrender value of bank owned life insurance.

Speaker 1

Pre tax losses of $924,000 on security sales in the Q3 of 2023 compared to minimal losses during the Q4 quarter from a few calls were offset by a decrease of $1,600,000 in the fair value of our mortgage servicing rates. Expense discipline continues to be strong and our efficiency ratio continues to be excellent. As we look forward, We are focused on doing more of the same, which is managing liquidity, building capital and also building commercial loan origination capability for the long term. The goal is to obviously continue to build towards a more stable long term balance sheet mix featuring more loans and less securities in order to maintain the returns on equity commensurate with our recent performance. With that, I will now turn it over to Brad for more color.

Speaker 2

Thank you, Jim. Net interest income decreased by $1,800,000 to $61,200,000 for the quarter Relative to the prior quarter $63,000,000 and decreased $2,900,000 or 4.5 percent from the year ago like quarter. Loan yields were flat in the 4th quarter compared to the 3rd quarter and securities yields increased only slightly. Total yield on interest earning assets increased 6 basis points over the linked quarter to 5 55 basis points. This was partially offset by a 24 basis point increase in the cost of interest bearing deposits and 18 basis point increase to interest bearing liabilities in aggregate.

Speaker 2

The end result was a 4 basis point I would note that the entirety of our margin give up up to this point is largely attributed to the sale of variable rate securities. We have gone from some 35% variable rate securities positioning to 19% as we sit here today. Deposit flows this quarter showed signs of stabilization. Deposit pricing in our markets remains exceptionally aggressive relative to the treasury curve It's largely pricing off overnight borrowing levels. Some signs of abatement are beginning to appear, however, with the most aggressive Showing shortening of time deposit specials as hopes of a Fed rate cut end.

Speaker 2

Regardless, marginal spreads remain unattractive quarter. At this point, Old Second does not feel the pressure to swell in order to overcome margin pressures. Marginal returns on allocated equity remain poor for outsized growth. We have made some fairly significant progress in reducing asset sensitivity over the last year, including reducing variable rate securities concentrations as mentioned. We are beginning to extend duration in the loan portfolio as well.

Speaker 2

I do believe this most recent move in interest rate futures has gotten ahead of itself Just as it did at this time last year. I don't really understand the mechanisms and reasoning behind the Fed's dovish pivot this quarter. A A more cynical person might conclude that either the Fed is prioritizing fiscal over monetary policy or the inflation target rate has changed. I'll let you read about that in somebody else's newsletter though. As a result, we are somewhat on pause here in terms of further reduction in variable rate asset concentrations.

Speaker 2

The loan to deposit ratio remains low at 88% and our ability to source liquidity from the portfolio continues to improve As market rates have allowed us to recoup fair value over the past quarter. The unrealized loss mark on the securities portfolio declined by $36,000,000 in the 4th quarter $121,000,000 to $84,200,000 which remains high, but will be recaptured relatively quickly. The net result is that Old Second should continue to build capital quickly as evidenced by the 86 basis point improvement in the TCE ratio over the linked quarter, Which means we have added an astonishing 2.29 basis points of TCE and $2.63 of tangible book value for the year. As we sit here today, we have approximately $700,000,000 in undrawn borrowing capacity and additional $380,000,000 in unpledged securities. In short, liquidity at the bank is excellent and the holding company is in a strong position as well.

Speaker 2

We received non objection from the Fed in December to resume stock purchases in 2024. We have been in a capital build mode for the last 2 years and I expect that to continue. I believe having capital can result in tremendous merger based earnings per share accretion if further stress is realized in our industry. Capital availability will be the gating factor to this accretion. The capital build strategy will be somewhat aborted And we would aggressively buy back shares if our valuation crosses a 12 month forward tangible book value per share of 1x.

Speaker 2

At that time and absent a significant macro environment change of buyback would commence. I'm not opposed to doing so much sooner if our M and A outlook remains soft. For example, buying back today would currently be less than a 2 year earn back absent any improvement in AOCI. I continue to believe we have been proactive and realistic on credit evaluation. You can see from our disclosures that we began rerating CRE exposures as interest The risk for maturing credit given the equity cushion deterioration is simply much higher today.

Speaker 2

To not see that reflected in credit trends broadly is confusing to me. Any cash flow stress As we have seen from market office demand and wage pressures in healthcare results in a problem that must be addressed. We are doing so. Good news is that our loan portfolio is seasoning nicely into the current rate environment and risk as we perceive it is declining rapidly. I believe you can see this in our disclosures.

Speaker 2

Margin trends from here are projected to be relatively stable this year with benefits from fixed rate loan repricing largely swallowed up by the recent declines in variable rate market indices. For example, I currently expect 1st quarter margin to decline mid single digit basis points with the largest driver of that being the decline in sulfur. I also expect loan growth to be roughly consistent with provision growth over the near term, though that could change with significant worsening in the macro environment. Non interest expense decreased $397,000 from the previous quarter mitigated by $1,200,000 one time estimated litigation expense. I continue to expect quarterly wages and benefits to be between $22,000,000 $23,000,000 going forward.

Speaker 2

Given the revenue employee investment costs have been running high, but we maintain the ability to dial back as conditions warrant. I would be remiss if I didn't add that we are not really in the market to much growth here. It doesn't really make sense given the marginal yields available relative to the marginal cost of funding and the cost associated with origination. As such, we remain focused on optimization and efficiency. I believe our results indicate that we are doing a pretty good job of this.

Speaker 2

It can continue and I believe we can potentially even grow earnings absent balance sheet growth. At the very least, I believe earnings can be much more resilient, quarter. Perhaps much better than many people expect from us. With that, I'd like to turn the call back over to Jim.

Speaker 1

Okay. Thanks, Brad. In closing, We are confident in our balance sheet and the opportunities that are ahead for Old Second. Our focus remains on assessing and monitoring risks within the loan portfolio and optimizing the earning asset mix in order to reduce our overall sensitivity to interest rates. Net interest margin trends are stable and income statement efficiency remains at record levels.

Speaker 1

The expectations for continuing record efficiency gives me confidence that we are well quarter. I look forward to the opportunity to demonstrate the strength of the franchise we have built. That concludes our prepared comments this morning. So I will turn it over to our moderator to open it up for questions.

Operator

Certainly. The floor is now open for questions. Your first question is coming from Jeff Rulis with D. A. Davidson.

Operator

Please post your question. Your line is live.

Speaker 3

Thanks. Good morning. Good morning, Jim. Jim, you mentioned I wanted to just talk about the workout potential on the non accruals and OREO. I think you mentioned there's hopeful of Some progress there.

Speaker 3

Anything kind of lumpier in there? If you could look at a basket of those to In the first half of this year, we feel like there's some chunkier credits that could be resolved. Just Any color there is helpful.

Speaker 1

Yes. There is some lumpiness in the non accrual bucket. We did move a couple of office buildings in the OREO, so that's obviously last stage in migration, which will position those assets for sale. The larger credits are healthcare related. And we've had these on our radar for quite some time.

Speaker 1

We did have a couple of large ones that moved into non accrual this quarter. Unfortunately, It's going to be a long slug to work these out as we look towards litigation. Absent that, we did execute a loan sale Late in the quarter, we have a potential another loan sale coming up this quarter. So I am confident We're going to have some positive movement. There's also a large SMIC credit that we're Very optimistic we'll get upgraded this quarter as it was performing well last quarter.

Speaker 1

So we're just waiting On the OCC to give us the green light to upgrade that one.

Speaker 3

Got it. I don't want to put you in a tough spot, but I guess if you're Thinking about NPAs next year at this time, can we think about something half that balance or what just big picture progress from your end, where does that balance head?

Speaker 1

Yes, I think that's obviously the goal is to start Aggressively working through these. The litigation process does take some time. But I do feel We've got about $130,000,000 in classifieds. I think we can make meaningful improvement In the coming quarters.

Speaker 3

Okay. And Brad, Got your comments about reducing asset sensitivity and as well as your Q1 expectation for margin. Could you just kind of give us an update on if and when you don't sound too convinced we've got a wall of rate cuts? I'm with you, but if we do see a few in the back half of the year, kind of give us an update on rate sensitivity, what that does to the margin, My guess is a little bit of headwinds, but maybe just an update there.

Speaker 2

Yes. I mean the way I said it, based on our current trends right now, my expectation would be and Again, I don't really see a pathway for this world scenario, but I'm obligated to follow it to some degree. If we got 3 rate cuts in 2024, we would probably have a very similar year in terms of bottom line, kind of that $2 per share type level and margin down some 15 basis points. We've got a lot of things that are helping us on the margin and largely that stems from how we built the securities portfolio with all the liquidity inflows in 2020 2021. Specifically, we've got almost $100,000,000 of very low yielding Securities that fully mature this year staggered throughout the year in addition to just cash flow pay downs.

Speaker 2

As I indicated, the only margin give up we've seen at this point is just simply been a structure of reducing asset activity. And to give you an idea of what we've been doing there, we've gone from some all in earning asset mix of some 65% variable to something more approaching 50% today. And it's not about lurching at it. There seems to be a popular perception that a bank can and should be a hedge fund and can go from fixed to variable at the flip of a coin. Really all we're trying to do here just as we did in 2021 is just eliminate tails.

Speaker 2

And it is true that as Rates go down, we earn less because of what we are, which is a great retail deposit base. But we still We are exceptionally profitable in any reasonable interest rate scenario, and I expect well above peers. So Nothing bearish on that front. I think we've done a great job with the balance sheet and earnings outlook remains very strong.

Speaker 3

Okay. I appreciate it. And maybe just one last one is, you brushed up upon the buyback. I guess if You do feel strongly you've turned the corner on credit with a bit of weakness in the stock. You feel and you're building capital rather quickly.

Speaker 3

Do you lean into that buyback a little heavier? Just interested in kind of comments there.

Speaker 2

Well, let me first say, I get people's concern. Credit is not something that we take lightly and neither does the market. It makes sense. Buyback is part of capital management strategy, and I think we've been pretty transparent on what we're trying to do with capital. Just to refresh those that may be new, we typically run between a 7% and 9% TCE ratio 7 when we've just deployed a large amount of capital and 9 when I get scared of my own shadow.

Speaker 2

We're approaching the top end of that range right now, but I think it's less about fear today than it is about the fact that so many balance sheets in our industry are impaired. And the gating factor to M and A is going to be capital availability. Large earnings per share is accretion For those that can stomach the dilution from marks, and it is a bond math exercise. So There is an idea of carrying capital for the potential of an opportunity like that. However, It is not unlimited and those deals don't grow on trees.

Speaker 2

They aren't easy to source. So we remain realistic in terms of its availability and to the extent that that deal doesn't come to fruition, the capital needs to go back because we'll be above capital targets very quickly here. Again, the overarching is a return on tangible common equity mindset here at Old Second, And we expect to be in the mid teens or better. We have been obviously far above that. We expect to continue to be.

Speaker 3

Got it. Thank you.

Operator

Your next question is coming from Nathan Race with Piper Sandler. Please proceed your question. Your line is live.

Speaker 4

Yes. Hi, guys. Good morning.

Speaker 1

Hi, Dave.

Speaker 4

Just going back to credit and Just kind of thinking about the healthcare portfolio specifically, that's a decent remaining balance of the classified loans. So So just curious to what extent you have any other out of footprint healthcare loans that are maybe more susceptible to the inflationary environment and other factors impacting that space?

Speaker 1

Yes. First of all, Nate, I think the healthcare portfolio is diversified Throughout the country, we're seeing the stress. It's about $42,000,000 classified in that book, $28,000,000 is in the assisted living space where we have a 2% allowance against that. Another $14,000,000 in skilled nursing. We've got a 10% allowance reserved against that.

Speaker 1

Where we're seeing the most pain geographically is in California where the State of California had the most restrictive gating rules around entrance and occupancy during COVID. Let's also further The portfolio is that they're all a lot of our floating rate structures. So, the interest rate carry and debt burden has That's substantial. So we think we've addressed everything. We've stress tested all the remaining commercial real estate that's helped me in office and healthcare that are maturing in 2024 and we think we've got everything Well reserved for.

Speaker 4

Okay, great. And I know it's difficult to predict, but I appreciate that you guys have gotten I'm in front of a lot of the credit issues that popped up earlier in last year and kind of clean things up a little bit here in 4Q. But as you kind of look out over the next year or so, what's kind of a decent range to expect charge offs going forward within that context, Just given your guys' conservatism generally and just any guidepost around charge offs as you guys See the world today would be helpful.

Speaker 2

I think in the first half of the year depending on timing of resolution that You're likely to see between $3,000,000 $5,000,000 in charge offs, which is currently already reserved for and I don't see a lot after that. So which is why our comments earlier reflected around provision consistent with loan growth. Now I will say that all of our discussion is kind of on a ceteris paribus type basis, which is absent any changes in econ. I think Most bank stock investors are a jittery breed anyway, and I think that we're always lurching its shadows. I think that we are in A type of macro environment where it could fall either way.

Speaker 2

It's been interesting watching the belief That soft landing is a real animal in nature. I don't really subscribe to that. But absent any changes in macro, that is our current outlook.

Speaker 4

Okay, great. And then so I I suppose that implies maybe the reserve relative to loans trends down a little bit, just given that those charge offs expected in the first half of the year Largely allocated 4th. So just any thoughts on kind of where the reserve settles out in the back half

Speaker 2

of this year, some of those qualitative adjustments that you

Speaker 4

spoke to on the macro

Speaker 2

front? Stable to modestly down, but I think that we're comfortable where we are in that regard. And again, as it relates to a stable economic environment broadly.

Speaker 4

Okay, got it. I appreciate your guidance on the salary line for expenses this year. Just Any overall thoughts on the run rate and just how you guys are kind of thinking about year over year expense growth? I mean, expenses were really well Controlled last year, up 1%, but it may be a low to mid single digit trajectory more appropriate to use for 2024?

Speaker 2

I'm hoping to be in that kind of that 3% range to be honest. We've done a really good job of Migrating cost saves from an acquisition 2 years ago and continuing to realize synergies there. That has belied some Significant investment that both in people and facilities that allows us to step into our next decade here at Old Second and continue to grow into being a Chicago based bank. Feel very good about what our expense trends look like. Feel very good About what kind of our balance sheet flexibility is and our ability to maintain earnings as well.

Speaker 4

Got you. And just lastly, going back to the discussion around margin, but maybe translating that into kind of NII thoughts for this year. I appreciate that you guys are obviously asset sensitive and have less inherent deposit cost leverage as rate cuts occur. But just given kind of maybe a low to mid single digit growth outlook in terms of loans, how you guys kind of think about just The NII cadence and just overall year over year NII growth prospects for 2024?

Speaker 2

Pretty stable, to be honest, within that piece. That's and that's just a function of when you're looking at what Potential marginal yields are marginal spreads, to be more specific. They're very tight. A lot of people are lending kind of in that 7% range and they're funding, whether they realize it or not, in that 5% to 5.5% range. That doesn't make a ton of sense.

Speaker 2

We have started to dabble in the 7s On the loan side, but that's more a function of overall decreasing asset sensitivity because it allows us With cash flows that are coming in to lock in at that rate and just overall migrate down. Just to give you some context, we've been Basically outside of absolute policy limits in terms of asset sensitivity all the way from the end of 2020 through the middle part of 'twenty two. We have now reduced that such that we are within policy limits from overall asset sensitivity. We've made substantial progress, But it is a function of basically remaking the balance sheet and continuing to eliminate tail risk with movements in interest rates. As we spoke last quarter and the quarter for that, We were selling variable instruments hand over fist and everybody was buying.

Speaker 2

Obviously, that trade has not worked out well for somebody As variable rates have taken a nosedive, so that opportunity has kind of slowed down a bit. But it can go back the other way quickly as we saw last year. So we'll continue to be flexible.

Speaker 1

Okay.

Speaker 4

And just to clarify that kind of flat NII outlook for this year, does that include 2 or 3 rate cuts in the back half of this year?

Speaker 2

It includes 3 rate cuts spread over the year.

Operator

Your next question is coming from Terry McEvoy with Stephens. Please proceed with your question. Your line is live.

Speaker 5

Hi, thanks. Good morning, everyone. You've been using loan modifications a bit more than your peers, specifically the term extensions. Can you just talk about 4Q activity and modifications in the portfolio?

Speaker 2

So That's in the context of the discussion I just had, Terry, where we've taken variable rate structures and move them into fixed rate structures as part of our basically almost 12 to 15 month strategy of reducing asset rate asset sensitivity. So it's Basically taking variable loan portfolios and moving them into fixed. It's not a function of credit give up or restructuring in terms of doing that sort of thing at all. That's not what you're saying.

Speaker 5

Thanks for clearing that up. And I guess just looking at the 100 and $37,000,000 of CRE fixed rate loans that mature in the first half of this year. I guess when's the last time you stress test the portfolio For today's rate environment and are there specific reserves against that bucket of loans?

Speaker 1

Yes, Terry, we did quarter. Analysis on all fixed rate CRE loans that are maturing in 2024 and stress tested all of them And feel that we have no additional reserve needed. I think what's important to know is we started building reserves pretty significantly Really in the second and third quarter of 'twenty two and into 'twenty three when we really started seeing stress in certain portfolios. We hadn't really used those reserves Until really the last two quarters. So despite a little bit of a decline in the reserve levels, we still have a pretty healthy pool reserve level out there and the team has done a good job of stress testing what we have coming forward.

Speaker 5

And just last one, Brad, I was trying to track when you'd look to repurchase stock. Is it the forward 12 month expectations on where Tangible book value is expected to be?

Speaker 2

Yes. So take basically 4 quarters of earnings and if we cross below 1, we We'll be active and aggressive in terms of repurchasing shares. Although as we sit here today, It is less than a 2 year earn back on that same basis. And a bank like us with a 2 year earn back is not a bad acquisition. So it's not something that I'd rule out.

Speaker 2

And that's not trying to be flirty. I'm just trying to tell people how we think And it's in relation to an M and A outlook type thing, Kerry.

Speaker 5

Understood. Thanks a lot.

Operator

On your phone. Your next question is coming from Brian Martin with Janney. Please proceed your question. Your line is live.

Speaker 6

Hey, good morning, guys. Hey, Jim, just to clarify one, the special mention level today, just the total Criticized and Classified. Can you just run through what those are today? I think you said they're the lowest level, but just want to make sure I think you give the classified in the release. I don't know about The special mention.

Speaker 1

Yes. So obviously, criticized or special mention, those are the early warning buckets, right, that all banks focus on. But that Those levels have declined 4 consecutive quarters and are down 26% just this last quarter and lowest level in 2 years. So That gives us a little bit of optimism that future migration from there to substandard is going to be a lot lower than it has been the last couple of years. Total classifieds and sub standards are down about $100,000,000 over the last year.

Speaker 1

So we're making progress, Obviously, a tough quarter, but we think we've done a pretty good job around putting a fence around a lot of these problems

Speaker 2

Moving forward.

Speaker 6

Yes. Okay, got it. And then I think just on the M and A outlook, I guess, I mean, They mentioned that in the context of capital and kind of how you're looking at things. I mean, is that market soft today? I guess, are you not given the working through these credit issues, is it less of a focus or just how should we think about the M and A opportunities that may be out there in the context of how you're running the bank today?

Speaker 2

I mean, as always, banks are sold and not bought. So it's a question of are there willing sellers. I think over the last 2 months, we've seen Pretty large influx of hopium that short rates are going to fall and that all the sins in terms of duration are going to be forgiven and absolved. I don't, as you know, necessarily agree with that interest rate outlook. So I think that there's At least possible that that will swing back to the other direction to some degree.

Speaker 2

Duration is a tricky thing. As great as it's been to not have any in terms of interest rate risk management, it does offer Kind of an opposite impact when it comes to credit and credit migration. There was an awful lot of people in our industry doing 7 10 year balloons on commercial real estate from 2020 all the way through 2022. And that may give some comfort that those loans are fine. And obviously, the cash flow is benefited by that having that locked in low debt service coverage.

Speaker 2

But given the fact that we didn't really depart from 3 5 year balloons, we don't have That duration of cushion that others may be experiencing.

Speaker 6

Got you. Okay. And then Brad, you talked about the fixed rate, the fixed loans repricing. Can you just remind us how much of that, how much is occurring over the next maybe 12 months and just What pickup you're getting on that fixed rate repricing?

Speaker 2

You're basically talking between somewhere between $150,000,000 $200,000,000 depending on level of prepayments that is repricing from a 3.5% to 4% range into a 7% to 8% range.

Speaker 6

Okay. And then

Speaker 2

Based on where Sofar is today.

Speaker 6

Got you. In your commentary, just high level on margin, and I appreciate all that you've given me. Kind of last quarter, you kind of talked about where the margin could bottom with X number of rate cuts, any change in your outlook as far as how much impact it could have

Speaker 2

on No, that's broadly structural. It would take mountain movement to see us fall below 4%. And I'm very comfortable with basically running this balance sheet at a 4 margin, but we are so far from that, that it gives you a great deal of comfort. You would take a lot more recuts than even the most optimistic person who believes the Fed will buttress equity markets to infinity to achieve to get us below 4.

Speaker 6

Okay. That's all I had guys. I appreciate it. Thank you.

Speaker 1

Thank you. Thanks, Brian.

Operator

Your next question is coming from Chris McGratty with KBW. Please proceed with your question. Your line is live.

Speaker 7

Hey, this is Andrew Leishner on for Chris McGratty. I know you mentioned in your opening remarks that deposit pricing has remained aggressive in your markets. Now how should we Think about non interest bearing outflows going forward and when should we expect to see a little more stabilization there?

Speaker 2

I think that the speed of the movement down has slowed considerably. I would expect that to continue. I think that There's an awful lot of people who thought that the massive amount of deposit inflows into our industry in 'twenty one and 'twenty two were somehow because they became great bankers. They elected to plow that money out the curve and Now that rates have reversed, they are forced to compete with fixed income markets for those flows, which is where they should have always been absent volatility in rate markets and COVID. We don't feel compelled to compete with that front.

Speaker 2

But largely what you've seen in terms of non bearing flows from us is simply a function of earnings credits and needing less balances to offset given fee levels. There's no real change on an economic basis underlying our non interest bearing trends at all. As you may or may not know, we are a very granular kind

Speaker 1

of Andrew, I mean, we are non interest bearing balances relative to the entire deposit focus It's remained around 40%, which is an exceptionally strong position. It's very sticky. We have not seen a lot of outflows in that area.

Speaker 7

Okay, great. Thank you. I guess on your low to mid single digit loan growth guidance, where should we expect the source of that To come from and what areas are you intentionally pulling back from?

Speaker 1

Activity within our loan committee remains, As we mentioned on the call, pretty modest. Where we're seeing growth is really in C and I, sponsored finance, Lease Banking, primarily. We think in today's environment With 3% GDP, probably mid single digit outlook is realistic for us.

Speaker 7

Okay. And then last one, sorry if I missed this on the M and A question, but can you just remind us what your ideal target would look like?

Speaker 2

Trades are significantly less than us, so we're buying a dollar of earnings for $0.85 or less.

Operator

Your next question is coming from Kevin Roth with Black Maple Capital. Please proceed your question. Your line is live.

Speaker 2

Hey, guys. Happy New Year to you. With regard to the 2 assisted living facilities in California, you mentioned litigation. Are those is that litigation as a foreclosure actions or some other type of litigation? Thanks.

Speaker 1

We're in very early stages. I mean, that's obviously an option. But we don't expect quick resolution on either one of them. But we can't at this point, we can't really speak to the course of action we're going to take, but they are marked. We took aggressive allocations and charges against We're positioning them for remediation.

Speaker 2

Got it. Okay. I just want a clarification on what It wasn't some other type of litigation related to smaller California laws. The litigation estimate that Impacted earnings this quarter relates to consumer overdraft and specifically relates to disclosures that were in our account disclosure booklets Between 37 years ago.

Operator

There are no additional questions in queue at this time. I would now like to turn the floor back over to Jim Ecker for any closing remarks.

Speaker 1

Okay. Thanks everyone for joining us this morning and we look forward to speaking with you again next quarter. Have a great day. Thanks. Bye now.

Operator

Thank you. This does conclude today's conference call. You may disconnect your phone lines at this time and have a wonderful day. Thank you for your participation.

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Key Takeaways

  • Old Second reported Q4 net income of $18.2 M ($0.40/share) and adjusted ROTCE of 17.21%, while boosting tangible common equity to 8.53% and improving its efficiency ratio to 48.76%.
  • Loan balances rose 4.5% year-over-year to $4.0 B, with a loan-to-deposit ratio of 88%, but the net interest margin dipped slightly to 4.62% due to higher funding costs.
  • Credit quality showed inflection, with classified and criticized CRE loans falling from a $300 M peak to $200 M, special mention loans at a two-year low, and Q4 net charge-offs of $15.5 M, as management expects further improvement.
  • Liquidity remains robust with $700 M of undrawn borrowing capacity and $380 M in unpledged securities; the bank secured Fed approval to resume buybacks once forward tangible book crosses 1.0x.
  • Looking ahead, the focus is on balance sheet optimization—shifting toward more loan growth, maintaining stable margins and record efficiency, and targeting low-mid single-digit expense growth even under potential rate cuts.
AI Generated. May Contain Errors.
Earnings Conference Call
Old Second Bancorp Q4 2023
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