Old Second Bancorp Q3 2024 Earnings Call Transcript

Quartr
Provided by Quartr
October 17, 2024

There are 10 speakers on the call.

Operator

Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Incorporated Third Quarter 2024 Earnings Call. On the call today are Jim Eckert, 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. Management would ask you to refer to the company's SEC filings for a full discussion of the company's risk factors.

Operator

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 it over to Jim Eckert.

Speaker 1

Good morning, everyone, and thank you for joining us. I have several prepared opening remarks and will give you 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 to Q and A. Net income was $23,000,000 or $0.50 per diluted share in the Q3 of 2024 and return on assets was 1.63%. 3rd quarter 2024 return on average tangible common equity was 17.14 percent and the tax equivalent efficiency ratio was 53.38%.

Speaker 1

3rd quarter 2024 earnings were negatively impacted by $2,000,000 of provision for credit losses in the absence of significant loan growth, which reduced after tax earnings by $0.03 per diluted share. However, despite this, profitability of Old Second remains exceptionally strong and balance sheet strengthening continues with our tangible equity ratio increasing by 75 basis points linked quarter to 10.14%. Common Equity Tier 1 increased to 12.86% in the 3rd quarter and we feel very good both about profitability and our balance sheet positioning at this point. We are pleased to announce a 20% increase in the common dividend this quarter reflective of continuing strong profitability and a well capitalized balance sheet. We like to position ourselves to regularly deliver growth in the common dividend as we continue to build Old Second into one of the best banks in Chicago.

Speaker 1

Our financials continue to reflect a strong net interest margin even as market interest rates begin to decline. Pre provision net revenues remained stable and exceptionally strong. For the Q3 of 2024 compared to the prior year like period, income on average earning assets increased $1,800,000 or 2.5 percent, while interest expense on average interest bearing liabilities increased $4,300,000 or 38.4 percent. The increase in interest expense is rate driven and primarily due to remixing and market pricing on certain commercial deposits. The Q3 of 2024 reflected an increase in total loans of $14,500,000 from the prior linked quarter end, primarily due to growth in commercial lease and construction portfolios, net of payoffs on a few large credits during the quarter.

Speaker 1

Comparatively, loan growth in the Q3 of last year was $14,000,000 which is in line with the 2024 late quarter's total loan growth. The historical trend in our bank is loan growth in the 2nd and third quarters of the year due to seasonal construction and business activities. Currently, activity within loan committee is improving but remains relatively modest to prior periods, primarily due to many customers waiting to see how market volatility, including election results and any further interest rate reductions play out in the next 3 to 6 months. The tax equivalent net interest margin increased by 1 basis point in this quarter driven by continuing higher rates on variable securities and loans partially offset by higher funding costs. Loan yields reflected a 16 basis point increase during the Q3 compared to the linked quarter and 28 basis point increase year over year.

Speaker 1

Funding costs increased due to increases in both rates and growth and time deposits. The tax equivalent net interest margin was 4.64 percent for the Q3 of 2024 compared to 4.63% for the Q2 and 4.66% in the Q3 of last year. The net interest margin has remained relatively stable in the year over year period due to the impact of rising rates on both the variable portions of the loan and securities portfolios as well as the deposit base and our short term borrowing costs. Loan to deposit ratio is at 89% as of September 30 compared to 88% last quarter and 87% as of September 30, 2023. As we have said in the past, our focus continues to be on balance sheet optimization.

Speaker 1

I'll let Brad talk more about that in a minute. The Q3 of 2024 saw improving asset quality metrics and moderate actions taken on substandard credits. Continuing remediation trends noted primarily since late last year. Our belief remains that the Q4 of 2023 represented an inflection point in our credit trends. Old segment began substantially downgrading large amounts of commercial real estate loans, including office and healthcare at the end of 2021 and accelerating through 2022.

Speaker 1

Substandard and criticized loans went from approximately $60,000,000 or a little more than 1% of loans at Q3 of 2021 to a peak of nearly 300,000,000 dollars or over 7% of loans in the Q1 of 2023. As of the end of Q3 of 2024, substandard and criticized loans are down $187,600,000 which is essentially flat to last quarter and approximately $15,700,000 less than year end 2023 and more than 40% below peak levels. The expectation remains for further improvement through the rest of the year. Encouragingly, our special mention loans decreased $45,600,000 or more than 37% from a year ago. We continue to expect realization of a relatively less costly resolution on a number of non performers in the near future and remain hopeful we can recover some of those losses realized in the second half of twenty twenty three.

Speaker 1

In the Q3 of 2024, we recorded net recoveries with the allowance for credit losses on loans of $155,000 compared to net charge offs of $5,800,000 in the Q2 of this year and net charge offs of $6,600,000 in the Q3 of 2023. Prior quarter elevated net charge off levels and continued asset remediation efforts have resulted in a more stable credit outlook on current problem loans. And the good news is that classified loans continue to decline, falling by almost $10,000,000 in the 3rd quarter, with the remainder of the portfolio remaining well behaved. Continued stress testing has not raised any new red flags for us, and the bulk of our loan portfolios transition into the higher rate environment and will be impacted with downward rate movements going forward. The allowance for credit losses on loans increased to $44,400,000 as of September 30, 2024, or 1.11 percent of total loans from $42,300,000 at the end of the 2nd quarter, which was at 1.06 percent of loans.

Speaker 1

Unemployment and GDP forecast used in future loss rate assumptions remain fairly static from last year with a 25 basis point uptick in the unemployment assumptions on the upper end of the range based on recent Fed projections. The change in provision level quarter over linked quarter reflects the reduction in our allowance allocations on substandard loans, which largely relates to the 29% reduction in criticized assets since September 30, 2023. I think investors should know that with our continuing level of strong profitability, we will be aggressive in addressing weak credits, and we remain confident in the strength of our portfolios. Non interest income continued to perform well with growth relatively flat in the Q3 of 2024 compared to the linked quarter in wealth management fees, service charges on deposits, card related income and mortgage income, excluding the impact of mortgage servicing rights mark to market. A death benefit of $893,000 was realized on 1 BOLI contract in the Q2 of 2024 with final true up of these proceeds in the Q3 of 2024.

Speaker 1

No life benefit was recorded in 2023. Other income increased in the Q3 of 2024 compared to the prior linked quarter and prior year like quarter due to recoveries on a vendor contract and refunds of prior servicing advances on a sold credit card portfolio. Expense discipline continues to be strong with total non interest expense for the Q3 of 2024 at $1,400,000 more than the prior linked quarter, primarily due to an increase in incentive accruals and the First Merchants acquisition cost incurred of $471,000 in the 3rd quarter. OREO expenses also increased in the Q3 of 2024 compared to the prior quarter as the 2nd quarter included a net gain on the sale of OREO of $259,000 Our efficiency ratio continues to be excellent as the tax equivalent and efficiency ratio adjusted to exclude acquisition costs and BOLI debt benefits was 52.31 percent for the 3rd quarter compared to 52.68 percent for the prior linked quarter. 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.

Speaker 1

The goal is obviously to continue to create 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'll turn it over to Brad for additional color.

Speaker 2

Thanks, Jim.

Speaker 3

I don't know

Speaker 2

there's a ton more for me to talk about. I think Jim covered a lot of things. Net interest income increased by a little less than $1,000,000 or 1.5 percent to $60,600,000 for this quarter ended September 30, relative to $59,700,000 last quarter. Securities yield increased 17 basis points and loan yields increased by 16 basis points. Total yield on interest earning assets up by a similar 16 basis points to 5.83 basis points in aggregate.

Speaker 2

This is partially offset by a 15 basis point increase in the cost of interest bearing deposits and 19 basis point increase to interest bearing liabilities in aggregate. The end result of that was a 1 basis point increase in the NIM, basically making my guidance from last quarter wrong yet again, but not by much. Obviously, we have rate cuts now, 50 basis points and more expected in the forward curve, which tends to show up in market indices and before the cuts actually happen and does impact our margin. I don't have anything different to say in terms of the guidance there. I still think it's around 7 basis points per 25 basis point cut impact to the margin.

Speaker 2

That will be mitigated somewhat in the near term by the announced acquisition of 5 branches and a couple of 100,000,000 in deposits that are coming with that that we expect to close in early December. Deposit flows this quarter were pretty much stable, nothing like the volatility we saw last year and earlier this year. Average deposits decreased by $91,000,000 or 2 percent quarter over linked quarter and period end total deposits somewhat better at $56,300,000 or 1.2%. Deposit pricing in our markets has come down a bit, but it remains exceptionally aggressive relative to the treasury curve and is still largely pricing off overnight borrowing levels. Public funds has provided a bit of a headwind as fixed income markets offer an attractive alternative to some customers.

Speaker 2

My overall position remains and excuse me while I talk our book here for a minute. My overall position remains that markets continue to believe that inflationary trends are far easier to kill than they actually are. The level of rate cuts reflected in the forward curve is not a realistic expectation without significant declines in real demand and consumption otherwise known as a recession. My current expectation does not include a near term recession with the amount of fiscal and monetary large asset is currently on the table. As a result, I see very little value in duration at this point and cash flows are being reinvested in variable rate opportunities.

Speaker 2

With credit spreads unbelievably tight, there is simply no value out the curve at this point relative to the risk. So poor marginal spreads persist and Old Second is continuing to focus on compounding book value and maximizing returns. For us that means being careful with expenses and pricing risk appropriately. As a result of the recent rate cuts and their impact on these market indices that I referenced, margin trends for the remainder of the year are expected to trend down modestly. The magnitude will be mitigated by the expected closure of the branch acquisition as I mentioned.

Speaker 2

Success in funding loan growth with these newly acquired deposits offers the opportunity for upside to these expectations. The loan to deposit ratio is still very low at below 90% and our ability to source liquidity from the securities portfolio remains excellent. AOCI on the portfolio came down by some 30% this quarter, which resulted in some of the capital build that you saw. I think that illustrates what we have been talking about in terms of where that portfolio was positioned on the curve and seeing improvement that maybe somewhat better than others are seeing at this point, given the short overall duration of the portfolio. I think capital build will slow from here and I do believe that the overall M and A environment remains very favorable to a bank like Old Second.

Speaker 2

If that does not come to fruition, we will return capital. A buyback is still in place and is on the table. Non interest expense increased $1,400,000 from the previous quarter, primarily due to acquisition related costs, an increase in office and cinema accruals and an increase in net OREO related expenses due to ongoing credit remediation, the small gain recorded in OREO last quarter. Given the bottom line performance, employee investment costs have been running high, but we will maintain the ability to dial that back as conditions warrant. That's all I really have.

Speaker 2

With that, I'd turn the call back over to Jim.

Speaker 1

All right. Thanks, Brad. In closing, we remain confident in our balance sheet and the opportunities that are ahead. Our focus remains on assessing and monitoring risks within the loan portfolio and optimizing the earning asset mix in order to maintain excellent profitability. Net interest margin trends are perhaps more resilient than some expect and income statement efficiency remains at record levels.

Speaker 1

I am proud of the year that is shaping up for us given the risk we have faced. That concludes our prepared comments this morning. So I'll turn it over to the moderator, and we can open it up to questions.

Operator

Thank you. Ladies and gentlemen, the floor is now open for questions. And your first question this morning is coming from Terry McEvoy from Stephens. Terry, your line is live. Please go ahead.

Speaker 4

Hi. Good morning, guys. Maybe if you could talk about loan pipelines today and thoughts on organic loan growth over the next several quarters for the bank?

Speaker 1

Yes, sure, Terry. Good morning. Yes, this is the time of the year heading into the last quarter. Pipelines generally are a little softer than they were in the 2nd and third quarters. I will say pipelines are better than they were a year ago, but traditionally the Q4 is a softer quarter for us.

Speaker 1

I think looking into 2025, we still think and confident that we can be a mid single digit grower organically in loans.

Speaker 4

Thanks, Jim. And then maybe a question on expenses, kind of looking out into 2025, anything to call out in terms of technology spending, digital spending, preparing for being a larger bank and how do you think about just that core expense growth next year?

Speaker 2

I think the biggest driver for expense growth for us next year is going to be on the salary and benefits line. I think you're likely to see something kind of mid single digits maybe in the 3% to 5% range and some of that is the benefits that's not fully baked yet in terms of what we're going to see there. Most of the technology spend and infrastructure spend, to be quite honest, we were spending like a drunken sailor for the better part of the last 2 years trying to get all the infrastructure in place. I don't anticipate a lot of CapEx moving forward into next year. So I think expense growth will be pretty modest outside of what happens with employee benefits.

Speaker 2

I think that obviously some parts of the wage scale are suffering more than others in terms of the inflation that we've seen. I think we all see that at the grocery store. There's no doubt it's cumbersome, if not devastating to many. And we are committed to taking care of our employees and making sure that we offer a very good value proposition and believe we're an excellent place to work and we intend to honor that.

Speaker 4

Great. Thanks for taking my questions, guys.

Speaker 1

Thanks, Terry.

Operator

Thank you. Your next question is coming from Chris McGratty from KBW. Chris, your line is live. Please go ahead.

Speaker 5

Hey, good morning. Jim or Brad, the 7 basis point to cut per cut is roughly mapping to kind of like a 4% terminal margin, if you believe the futures market, which I think we can debate. Is that about the right way to think about it, given the position in the balance sheet and then the transaction that's pending?

Speaker 2

I think we can do better than that, Chris, to be honest. I don't think I think we've learned enough that how damaging 0% rates are and we can talk about where the terminal is and get into all that. There's a lot of things going on right now and it is very difficult to know what actually is the right level of interest rates for this economy. I think an election plays a part in it. I think the fiscal mess we've gotten into plays a part in it.

Speaker 2

And we've all seen how very wrong the forward curve can be just in recent history. So it's difficult to know what's going on there. I think that if say for example that the terminal Fed funds is 3%, we are significantly far north of a 4% margin just given where we are and how we're constructed. I think that a higher curve at the short end, which is anything above 2.5%, there is no reason why Old Second wouldn't be north of a 4% margin.

Speaker 5

Helpful. Thank you. And then, Jim, on capital, markets are up. I mean, any change in kind of timing or priorities on either pulling that buyback or doing something inorganic? Are there maybe how would you describe the inorganic opportunities today?

Speaker 1

Yes. I mean, obviously, we're building capital rapidly every quarter. Chris, we understand to maintain a high level of return on tangible common, we're going to need to deploy some of that capital. All that you mentioned is on the table at this point. We are open to inorganic growth.

Speaker 1

The buyback is still on the table. You saw that we raised the dividend this quarter. We're fully aware of where we're at with capital. It's going to be one of our key initiatives heading into 2025.

Speaker 6

Thank you.

Operator

Thank you. Your next question is coming from Nathan Race from Piper Sandler. Nathan, your line is live. Please go ahead.

Speaker 7

Hi, guys. Good morning. Thanks for taking the questions.

Speaker 1

Hi, Nate. Hi, Nate.

Speaker 7

I was wondering if you could just spend some time describing the 14 $1,000,000 loan that moved to non performing in the quarter and also any additional color on the $36,000,000 roughly in classified loans that inflate as well?

Speaker 1

Sure, Nate. I mean, the increase in non accruals is stemming from 1 commercial credit C and I loan that deteriorated late in the quarter. We thought it was prudent to take that to non accrual. Cash flow is strained with this company. We're still in the early stages of assessing next steps here, but our strategy has always been to be an early identifier and we're moving towards hopefully a remediation process that's going to allow us to mitigate any significant losses there.

Speaker 1

And what was the second part of your question, Nate?

Speaker 7

Yes, I think we had about $35,500,000 in classified loans that flowed in the quarter. Obviously, classifieds came down in aggregate just based on some improvement across some other loans, but we're just curious in terms of the inflow drivers.

Speaker 1

Yes. I mean, there was some inflow and obviously a lot more outflow, but movement was significant in the quarter. We had really a couple of credits that we took to the substandard, although they're still accruing. 1 was a healthcare loan, 1 was a C and I loan, both are we feel pretty well collateralized. And then we had $36,000,000 in reductions to sub standards and the reasons behind that ranged anywhere from loans that were paid off either upgraded, curtailed or paid off by a sponsor.

Speaker 1

I will say this, we feel we've got our arms around the office portfolio pretty well. We actually have no office loans in Chicago that are classified. So that's the first time that's happened in a couple of years. We're down only $9,000,000 in classified loans in the office book. So we feel really good about that.

Speaker 1

It's really still working through healthcare and a couple of these C and I loans. But by and large, we still feel very confident in the portfolios.

Speaker 7

Okay, great. That's very helpful. And then just thinking about future levels of provisioning going forward, it seems like you're not seeing much in the way of loss content going forward and loan growth maybe still somewhat slow here in the Q4, but just any thoughts on just how you guys are thinking about the provision and reserve trajectory going forward absent any deterioration

Speaker 8

broadly?

Speaker 1

Yes, I think this quarter you saw a $2,000,000 provision. Some macro factors were tweaked, but we had run that allowance down a little bit the last couple of quarters. So we feel a lot more comfortable north of 1%. So yes, I think future provisioning in that $2,000,000 range per quarter is probably a good way to think about it going forward.

Speaker 7

Okay, great. And then just another one on the margin outlook. I believe Brad mentioned you should have some offsets with the branch deal coming online here late in the Q4 in terms of that 7 basis point impact following each 25 cut. So just curious how you're thinking about what the magnitude of that offset could be with that branch yield depending on how you're thinking about redeploying those proceeds. I imagine loan growth is the number one priority there, but just curious how you're thinking about also redeploying the bond book as well?

Speaker 2

You kind of answered it in the way you asked it, is that it's highly dependent upon what we do with it. We frame that deal announcement on a bit of an unusual basis in that trying to keep it as simple as possible. We just said, if we elected to take the liquidity and pay down overnight borrowings that it would be 5% accretive to earnings and roughly 10 basis points accretive to margin. If we do something different than that, it could be more or less. So there's pretty much its impact is anywhere between a flat margin next quarter to maybe if we're more conservative and put it in a bond portfolio and maybe instead of a 15 basis point decline in the margin, it's more like a 7 basis point decline in the margin.

Speaker 2

It's highly dependent. And I would say that feels like a wishy washy answer, but it's really not. Given the volatility that we have in a given 3 month window as it's occurred over the last 6 months, we go from 200 basis points of cuts before the end of the year to the long end of the curve absolutely rejecting every message point that we've seen over the last 2 weeks. Things move around quite a bit. I can tell you that I kind of alluded to it a little bit.

Speaker 2

I see a hell of a lot more value and basically high credit tranche variable rate commercial backed securities than I do anything else at this point. If somebody is reaching for duration at this point, it's a fool's errand. I'm not entirely confident that the Fed stands on inflation could be a lot more aggressive fight on the other side of an election. I certainly see things that indicate that inflation is by no means the courts that people thought it was. So we're being cautious and don't get me wrong, when I speak about this, you could get the impression that we're taking some sort of rate, but we're not.

Speaker 2

We're doing the very opposite of that and just staying short and flexible and I think that's the best path forward for Old Second.

Speaker 1

Got it.

Speaker 7

That's helpful. One last one for me, just going back to the M and A discussions earlier. Could you guys just remind us in terms of the size of potential partners that you would look to

Speaker 1

acquire down the road? Yes, Meta, obviously Chicago's obviously still overbanked in a lot of areas. We think there's a lot of opportunity just in our core market. But for us, I think anything from $500,000,000 to $3,000,000,000 would be something we would be interested in and conversations are ongoing and active right now.

Speaker 8

Okay, perfect.

Speaker 7

Thanks guys.

Speaker 1

Thanks, Nick.

Operator

Thank you. Your next question is coming from David Long from Raymond James. David, your line is live. Please go ahead.

Speaker 9

Thank you. Hey, guys. On the lending side, it seems like you guys have the infrastructure in place, people in place to take advantage of the backdrop if it was appropriate to grow more aggressively, see more than mid single digit loan growth, what would it take for Old Second to increase your appetite to lend at this point?

Speaker 1

Well, I think, 1, demand has got to improve. We're not seeing demand like we did 18 months ago, but also risk adjusted returns just haven't been there for us. And when you have the benefit of a 4.60% margin chasing loan growth at yields around 7% don't make a whole lot of sense. We do have the team in place to be a high single digit grower. I think as the economy continues to evolve, we get a few more rate cuts, we get some clarity around the election.

Speaker 1

I do think we'll get back to a mid single digit grower. We'll continue to look at teams as they become available, but that's kind of where I see 2025.

Speaker 2

And David, we saw as soon as those rate cuts occurred and maybe even on before on market pricing for loans that we were bidding on immediately get into the low 6s. So competitors aren't wasting any time. And if you just take a step back and think about that for a second, you're looking at effectively a 3 year loan that you're earning 6% on that your marginal funding cost is 5 percent and then you're at 50 basis point provision, you're talking about a marginal return on equity that is poultry. And that's where markets have been. And some of that's just a function of an inverted curve and you can pretend all you want that a deeply inverted yield curve doesn't impact our industry, but it sure as heck should in terms of how you think about investing capital.

Speaker 2

And that's what we've tried to explain perhaps ineloquently at times, but that's why you haven't seen a lot of growth from us. I think that we could be quite aggressive in terms of growing earning assets in an environment where the curve is simply flat. That offers a lot. I think that certainly the volatility that we've seen in interest rates for the last 6 months specifically and certainly for the last 2 years more generally makes things very difficult in terms of growing earning assets consistently.

Speaker 9

Got it. Thanks for the color there. And then a follow-up question. Jim mentioned the potential for more credit resolutions to come. I know you're going to have those from time to time, but it seems a bit elevated here given some of the moves you made, which seems to be ahead of most of your peers.

Speaker 9

But can Old Second record another can you have another quarter or 2 with recoveries exceeding gross charge offs?

Speaker 2

As we said, we remain hopeful that we can recover a significant portion of the losses that were charged off last year. Whether that occurs or not is uncertain, but we have said that we expect mitigation efforts to be less costly than what you've seen from us over the last 12 months. Now, a $1,000,000 or $2,000,000 may show up here or there as we elect or don't elect to pull the trigger and exit something that we're worried about. So that's hard to predict. But we don't see anything big and lumpy, I guess, is the real takeaway.

Speaker 2

Got it. Thanks, guys. Appreciate it. Thanks, Dave.

Operator

Thank you. Your next question is coming from Martin Friedman from FJ Capital. Martin, your line is live. Please go ahead.

Speaker 3

Good morning. Congratulations on a good quarter. Just wanted to expand upon the M and A discussion, General Brad. To me, it looks like you didn't buy any stock this quarter. Is that suggesting that something is imminent on the M and A front?

Speaker 3

And given the capital build, why can't you do both at the same time?

Speaker 2

In short, we can. There is no reason why we can't. Now, capital levels come down a little bit with the branch purchase that will burn 30 basis points to 40 basis points of capital. The movement this quarter obviously is extreme and that's reflective of an AOCI just basically collapse for us. Now we do add organically what is about 30 basis points to 40 basis points of tangible equity per quarter.

Speaker 2

I would say this too, as our earnings have been more resilient than I think anybody expected from us, at least on some level, be that in the future or currently. And if you look at a valuation on an earnings basis, old second looks downright pated in some respects. But there's been a significant risk of a recession at least or the potential for a recession at some time. And I think that as we work through some credit problems and there was some skepticism about what was going to happen with credit trends at Old Second, building tangible book value is something that has provided a level of stability. And make no mistake, carrying more capital at a point where the curve is higher at the short end carries very relatively little cost.

Speaker 2

And the barriers to entry to M and A this time is capital and a lot of people don't have it, which is kind of the reason we were alluded to it being a favorable environment for banks like Old Second. We have what it takes at this point, which is a well positioned balance sheet and a lot of capital flexibility. You're right in that one does not preclude the other. What you have is our commitment that we are focused on a return on tangible common as Jim mentioned. And if earnings come down, the likelihood of capital being returned goes up exponentially.

Speaker 2

We will be smart with capital levels and the return that we earn and are provided to our shareholders and that's the primary focus. I hope and I know certainly that you understand that, Marty, and I hope others understand that as well.

Speaker 3

Great. Thank you. And I have another question about the margin, but I'll ask you offline.

Speaker 1

Okay. Thanks, Mark.

Speaker 2

Thank you.

Operator

And your next question is coming from Jeff Rulis from D. A. Davidson. Jeff, your line is live. Please go ahead.

Speaker 6

Thanks. Good morning. Just wanted to follow on the non accrual. Just in terms of the inflows of the increase there, you mentioned the C and I credit. What industry was that and if that was related to the inflows on the classifieds as well?

Speaker 1

Yes. It was the main inflow was that one C and I credit. It's and the scrapping industry just has been not performing, and we thought we'd be aggressive with the downgrade. I don't have a whole lot more to share at this point, but that was really the main credit that migrated. The remaining credits in the substandard bucket, I think I mentioned the 2 main ones are another one other health care facility and solutions product company that had negative debt service coverage, but still accruing.

Speaker 1

But many more downgrade or many more upgrades than downgrades in the quarter. So overall, we still feel good about the portfolio. Obviously, we're going to have, from time to time, some credits go south. And we feel like we'll get our arms around this one and hopefully take next steps to remediate.

Speaker 6

Okay. So it sounds pretty idiosyncratic. The scrapping industry credit was bit of a one off in terms of you're not seeing other like factors, okay. Wanted to just one other thing on the deposit side, you mentioned some larger non interest bearing depositors in the quarter departures. Any sense of that seasonality?

Operator

I don't recall mentioning that. So I think when you look

Speaker 2

at what happens with Old Second's deposit base, I don't think anybody would be confused in terms of what we look like at this point. We are our deposits, our funding is dominated by very low balance denomination checking accounts. If you look at where stress is, given the level of inflation, given some softening in employment is at the low end of the wage scale, which is where we live on the funding side. We are not seeing negative impacts in terms of either account closures or anything other than just average balance migration down reflecting of these difficulties at the low end that I believe is driven by inflation. That's been true for 2 years now.

Speaker 2

I think that when the liquidity spigots are open, you do see deposit funds flowing into the industry that many confuse with organic growth. I assure you it is not. And we saw some of that too just as people fled fixed income markets, namely public funds and larger commercial customers. But no, we are not seeing significant migrations or loss of accounts or anything like that. As a matter of fact, we have a positive open to close ratio here recently this year, our first time since the closure of West Suburban in terms of that acquisition and we are now opening more accounts than we are closing, which the reason why you don't hear about that statistic very often is because it is overwhelmingly negative for our industry as a whole.

Speaker 6

Brad, I guess I'm referencing the $60,000,000 non interest bearing deposits by a few larger customers that linked quarter, just interested in that flow. That's

Speaker 2

just liquidity flows and seasonality and tax payment flows, nothing significant.

Speaker 6

Got it. And is there seasonality with those customers that you believe comes back? Yes. Trying to I'm sorry, was it yes? Yes.

Speaker 6

Okay, great. Thank you. All right. Thanks, guys. Thank

Speaker 2

you. Thank

Operator

you. Your next question is coming from Brian Martin from Janney.

Speaker 8

Jim, you went through the criticized level. Can you just talk about where that was at this quarter relative to last quarter? I think you kind of said, I think, maybe whether it went up or down. I missed what you said specifically. But I thought the criticized were about $187,000,000 last quarter.

Speaker 8

We know classifieds went down a bit. Were criticized equal this quarter, meaning the special mention maybe went up a bit? Or just linked quarter change and criticized Yes,

Speaker 1

pretty flat. I think up a tick, Brian, from last quarter's special mention was sub standards were down about $9,000,000 and then the one credit that went to non accrual. A lot of migration in and out, but that's hopefully, that answers your question.

Speaker 8

Yes. So if classifieds were down 8% or 9%, then special mention we're up

Speaker 1

8% or 9%, kind of

Speaker 8

net neutral to the total criticized. Is that fair?

Speaker 1

That's correct.

Speaker 8

Yes. Okay, perfect. That's what I thought. And then in terms of the buyback, I guess, Brad, I think it sounds like the inorganic is maybe the priority if it's available. But on the buyback, can you talk about just give some thoughts on pricing as far as where you're interested in buying the stock?

Speaker 8

I think a while ago, you talked about maybe wanting to do it at pretty attractive levels. Some thought on if you do go that route based on what's available? I

Speaker 2

mean, everybody loves a bargain, right? But there's nothing about our current valuation that will preclude a buyback.

Speaker 8

Okay. Got you. Okay. And then I think just given your outlook, Brad, that maybe inflation isn't quite gone yet. I mean, if we don't see the forward curve come to fruition and see these rate cuts or significant rate cuts materialize, I mean, fair to say that the margin is relatively flattish or down modestly as you kind of go into next year, especially with potential?

Speaker 2

Yes, my gut would say down modestly. I think this is a very difficult time to be an economist, not that economists have a very good track record of ever being correct. But I think where we are on the eve of an election that is very polarizing, just being overly blunt because that's what I do. I'm not sure that we'll have a willingness to declare victory on inflation on the other side of an election if Trump is the winner of the election. So I'm cautious and think that things can snap in either direction pretty aggressively.

Speaker 2

And that's why we've maintained our positioning is relatively neutral. And I think that we'll know more in a few months.

Speaker 8

Yes. Okay. And then in terms of I think Jim mentioned that you thought you might mention a little bit more on the optimization of the balance sheet, Brad. I guess can you just expand a little bit on that or just how you're thinking here the next couple of quarters?

Speaker 2

I would like to earn in excess of a 4% spread on marginal growth on the balance sheet. And if we can't, then we can sit tight for a bit.

Speaker 8

Okay. And last one, since economists are usually not right, Brad, I know the tax is a favorite item of yours. So the tax rate was down a little bit this quarter. Is that probably a decent rate to use as we look forward given kind of the changes?

Speaker 2

No. Yes, I love I've thought about this a lot. I was going to answer your question, Brian. And I've decided I'm going to go with an oddly specific guidance for tax rate and we're just going to see how it turns out and then you guys can really give me a hard time when I'm wildly wrong. I'm going to go with 24.763 for the effective tax rate going next quarter.

Speaker 2

We'll see how I do.

Speaker 8

Okay. And big picture for next year, can you give a thought as far as how you're thinking about that or stick with your

Speaker 2

I really like that 24.763. I'll add another digit on there. We'll call that 7.6 35. That's what I feel good about.

Speaker 8

All right. We'll stay tuned. I appreciate the color and thanks. Great quarter, guys.

Speaker 2

All right. Thanks, Brian. Thanks, Brian.

Operator

Thank you. And there are no further questions in queue at this time. I would now like to hand the floor back to Jim Ecker for closing remarks.

Speaker 1

Okay. Thanks everyone for joining us. We appreciate your interest in the company. Look forward to speaking with you again next quarter. Goodbye.

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 Q3 net income of $23 million ($0.50/share), a 1.63% return on assets and 17.14% return on average tangible common equity on a 53.38% efficiency ratio despite a $2 million provision for credit losses.
  • Capital remained robust with a Common Equity Tier 1 ratio of 12.86% and a tangible equity ratio up 75 bps to 10.14%, enabling a 20% increase in the quarterly dividend.
  • The tax-equivalent net interest margin held at 4.64%, with net interest income up 1.5% quarter-over-quarter, benefiting from higher rates on variable loans and securities partly offset by elevated funding costs.
  • Asset quality continued to improve as substandard and criticized loans fell over 40% from peak levels, special mention loans dropped 37% year-over-year, and Q3 saw net recoveries of $155,000 versus prior-quarter charge-offs.
  • Management reiterated a focus on balance sheet optimization—targeting mid-single-digit organic loan growth, maintaining expense discipline, and evaluating both inorganic M&A opportunities and capital return options.
AI Generated. May Contain Errors.
Earnings Conference Call
Old Second Bancorp Q3 2024
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