Old Second Bancorp Inc Q4 FY2020 Earnings Call

Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc. Fourth Quarter 2020 Earnings Call. On the call today is Jim Eccher, the company's CEO; Gary Collins, the Vice Chairman of our Board; and the company's CFO, Brad Adams. I will start with a reminder that Old Second's comments today may 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 for the company’s risk factors. On the call today, we will be discussing certain non-GAAP financial measures. These non-GAAP financial measures are described and reconciled with their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com, under the Investor Relations tab. I would now turn the conference over to Mr. Jim Eccher. Please go ahead.

Good morning and thank you for joining us today. 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 some summary comments and thoughts about the future before we open it up for questions. Net income was $8 million or $0.27 per diluted share in the fourth quarter. Earnings in the quarter were negatively impacted by $1.3 million and MSR valuation mark-to-market losses despite continuing strength in mortgage banking overall. Fee income declined from last quarter based on some moderation in mortgage banking revenues relative to recent record results and seasonal reductions in mortgages originated as well as the aforementioned mark-to-market losses at MSRs due to movements in interest rates. Approximately $63 million of the PPP loans were forgiven by the SBA during the quarter which resulted in an increase in our net interest margin over the prior quarter through full recognition of net deferred fees on those loans upon payoff. Our loan-to-deposit ratio is a fraction over 80% at year-end, relatively stable with last quarter and a significant increase from 90.8% a year ago. Expense discipline continues to be strong with a slight increase noted in non-interest expense for the current quarter compared to the prior year-like quarter, due to the higher salaries and employee benefit costs and FDIC insurance expense in assessment credits received in the fourth quarter of 2019. Asset quality trends at this point remain remarkably stable and the bulk of our lending team continues to focus on the second round of PPP loan origination while staying in close contact with our customers. Non-performing and classified assets experienced slight increases only, and we remain confident in the strength of our portfolios. Details are available in the earnings release tables on these changes. Loans under modification stand at approximately 1.4% of the loan book today and we are working closely with our borrowers to understand each and every situation. Of the original $231.3 million of loans, which were COVID-19 related deferrals, $198.6 million or 86% have either returned to payment status or paid off as of year-end 2020. As of year-end, 51 loans totaling $32.7 million are currently in deferral status. Concurrent with our earnings release, Old Second also filed loan portfolio disclosures that will provide investors with additional details on the composition of the portfolio, current modification breakdowns, and reserve levels. Exclusive of PPP loans, the reserve currently stands at 1.73% of total loans. During the fourth quarter, $1 million of reserves for unfunded commitments was reclassified in the allowance for credit losses on our loans. Our outlook remains cautious given the uncertainties but optimistic that the underlying economy will continue to improve. We believe that we are more than adequately reserved under base case scenarios and have continued to adopt a more pessimistic stance given the high degree of uncertainty. Overall fundamentals and earnings trends were relatively stable and consistent with prior quarters, with mortgage banking results continuing to reflect the positive impact of the low-rate environment. Loan growth trends exclusive of the payoff and forgiveness of PPP loans during the quarter were very strong, and we are cautiously deploying liquidity into short-dated assets. Profitability remains strong and we are extremely pleased with this level of performance. Old Second continues to focus on the steps and protocols necessary to protect our employees, customers, and communities during this pandemic. For our customers, our locations remain open and available, albeit with safety precautions. We are continuing to work with those who have been directly impacted and we’re offering the ability to defer payments as appropriate. The vast majority of our staff excluding retail continues to work remotely without issues. Old Second is proud to serve our communities, and we couldn't be more grateful for the efforts of our employees in 2020. We are fortunate that our core lending strengths have steered us clear of many of the most impacted industries. We recognize that the potential still exists for many industries to be significantly impacted in the short and intermediate term from the implications of high unemployment and the potential for fading consumer and commercial demand. We are closely monitoring trends in both retail and commercial office real estate both for our customers and in our operating footprint. Our overall outlook remains cautious at this point, though we are seeking new lending relationships. We do believe we will have losses at some point, but we believe our portfolios are well diversified and will hold up much better than most. Importantly, we believe our capital and liquidity position are as strong as they have been. In regards to the fourth quarter specifically, total loans increased by $4.5 million from last quarter in spite of the $62.6 million of PPP loans forgiven. We did not see a significant line of credit drawdowns at Old Second in the fourth quarter. Thus far in 2020, line drawdowns have continued to remain muted. Loan growth trends in 2021 should improve from the year-ago levels, though the path to the overall economy and pandemic progression could impact that estimation. Overall, we remain cautious but surprisingly encouraged by our results in a number of areas and I will turn it over to Brad to provide more color.

Thank you, Jim. Good morning, everybody. Net interest income increased by $1.4 million relative to last quarter and $700,000 relative to the fourth quarter of 2019. The margin was favorably impacted by the net loan fee income recorded due to the $62.6 million of forgiven PPP loans in the fourth quarter. This net fee income offset the further expansion of excess liquidity on the balance sheet and the impact of lower yielding loans still outstanding. We continue to have strong deposit inflows and substantial excess liquidity for the entirety of the quarter. We have begun to cautiously deploy some of that excess liquidity, including the purchase of approximately $50 million of securities during the quarter. We also made other short-duration investments. The strategy to deploy a portion of the excess liquidity will continue in the short term while we remain cautious on both duration and credit. Our margin performance exclusive of the liquidity and PPP factors remained relatively stable this quarter. I still am not assuming at this point anyway that the deposit inflows will reverse quickly. If the outflow or bounce back is relatively quick, our margin outlook would improve substantially. If the economic conditions improve, then loan growth returns, our margin outlook would improve substantially. I do not currently expect either of those conditions to occur in the short term. Fee income trends declined in the fourth quarter of 2020 compared to the last quarter due to the seasonal slowdown in mortgage originations as well as a higher mark-to-market loss on MSRs. Net gains on the sale of mortgage loans were still approximately 200% over net gains from the fourth quarter of 2019. Overall, the quarter was still very strong in this respect. Service charges on deposits were slightly higher in the fourth quarter of 2020 compared to the last quarter, but 28% less than the fourth quarter of 2019. In addition, a large debt benefit of approximately $900,000 was received in the fourth quarter of 2019, which was not repeated in this quarter. No provision for loan losses was recorded in this quarter following the approximate $10.4 million provision expense recorded earlier in the year. The economic outlook for us assumes a slight improvement to the prolonged recessionary environment with an unemployment rate remaining at approximately 7% through September 30 of this year and elevated over the remaining life of the loans. As Jim mentioned, Old Second has minimal exposure to the hardest hit industries and a very strong credit culture overall. We spend a lot of time looking at things and it’s extremely interesting to us that, exclusive of a couple of credits that are obviously due to COVID shutdowns, our credit overall, including trends in classifications and non-accruals, has improved markedly this year, certainly not something we expected. Still, our consumer lending exposure remains relatively modest. We're not seeing any weakening there at all. Reserves across the commercial book are up substantially, obviously over 50% this year. At this point we are extremely pleased with both how credit has performed in 2020 and also what the trends for 2021 look like; we couldn't be more surprised. Our efforts in the coming quarters will be focused on continuing to help our customers, funding quality loan growth where we can, remaining short in duration, and being extremely cautious on credit, but we are open for business. I currently expect a stable margin, maybe modest contraction, and that assumes liquidity remains robust and credit risk spreads remain unreasonably tight. Our capital and liquidity levels are obviously extremely high at this point. We continue to be interested in and repurchasing stock. We're on the lookout for M&A opportunities as they present themselves. Expenses for us were modestly higher in the fourth quarter due to some one-off items. We expect to remain relatively well controlled for the remainder of 2021, and if we see things continuing to remain relatively difficult from an economic environment, the likelihood of some expense initiatives in the second half of the year increases.

Okay, thanks Brad. In closing, we remain encouraged by these trends, confident in our balance sheet, and ready for the challenges ahead. We have taken the steps to position ourselves well for a slowdown in recession. As Brad mentioned, we believe our credit underwriting has remained disciplined and our funding and capital position is strong. We remain optimistic that opportunities will be available to improve our franchise. The focus continues to be on timing and making sure that we have the balance sheet, liquidity, and access to capital that we need in order to take advantage. That concludes our prepared comments this morning. So I will turn it over to the moderator to open it up for questions.

Thank you. Ladies and gentlemen, the floor is now open for questions. Our first question is coming from Chris McGratty of Keefe, Bruyette and Woods. Please go ahead.

Hey, good morning.

Hey Chris.

Good morning Chris.

Hey Brad, just want to start on capital. I appreciate you're looking for inorganic growth but with your stock at tangible, isn't the play to get really aggressive with the buyback given where your capital levels are?

A powerful argument can certainly be made for that. It's not something we'd be shy about.

And in terms of that direction, I mean would you entertain kind of an accelerated buyback given where the levels are?

Yes, I mean that certainly comes with certain expenses associated with it. It's more complicated execution. It's something that we've looked at over the last six months or so. I think that there's still a lot of uncertainty out there Chris and you can open up a web browser at any given point over the last week and see a number of things that will bother you if you let it. So I would say that it's unlikely that we'll lurch at anything, but given how much capital we've built, the strength of our earnings stream, and the underlying trends that we're seeing on credit, the few problems that we have right now are so obvious in terms of their COVID nature and so quantifiable in terms of the potential risk that we don't see a ton of concern about. That being said, there are some obvious structural things in the economy that are changing that will have longer lasting implications, which include the appetite for office space downtown, as well as what brick-and-mortar retail looks like. We're not a huge player in the former, and obviously have some exposure in the latter, but stressing those things will impact us just as it will everyone. So in times like this, I don't feel an overarching desire to lurch at anything but buyback remains, at this point anyway, I do say with confidence the most attractive thing that I see out there to do with capital.

Great. Thanks for the color. Just in terms of the revenue outlook because margin is obviously pretty tough to predict with liquidity. How should we think about net interest income –

I guess we lost Chris there. Chris are you still there?

Yes. I am here. Am I still there?

Yes sir, I can hear you. Management team can you hear us at this time? I'm sorry they seem to be having some technical issues.

Well, it appears that we might have some technical difficulties. We are not able to hear anything that's coming through the line right now.

Ladies and gentlemen, please stand by while we get our management team back on the line. Mr. McGratty, just one moment please, we will bring you back in the queue. Ladies and gentlemen, we apologize for that inconvenience. Chris, you are back on with the presenters for today.

Thank you for the insights on the buyback, Brad. I would like to shift the conversation to the outlook for net interest income. Considering the margin challenges due to liquidity, how should we view the potential growth or stability of net interest income, excluding the PPP? I also noticed there are some borrowings on the balance sheet; could you provide any insights on that? Thanks.

So I feel pretty good that we can offset the runoff of the PPP loans with obviously significantly better yields than what the PPP is giving us, and that should be basically a one-to-one watch as the remainder of our PPP loans are forgiven. We will continue to deploy some of the excess liquidity in very short duration, low credit risk ways. In addition, the debt that you speak of on the balance sheet is callable at the very end of the year, so it won't provide any benefit this year but will provide a substantial benefit next year assuming that the issuance market remains the same and the same level of spreads. Overall, I do believe that we'll grow net interest income quite nicely this year. What the margin is almost a separate discussion at this point given the impact of the liquidity and the sizeable cash position that we're holding that basically pays us 10 basis points. So really the reported margin is just a function of that. Net interest income should grow at a rate that's in line with what we typically have produced. I expect 2021 will be a pretty good year on the revenue growth front.

Brad, what's left on the PPP like the fees?

I think we've got about $400,000 - $500,000 in remaining.

Okay. Great thanks for the color.

Thank you. Our next question is coming from Bob Shone of Piper Sandler. Please go ahead.

Good morning. How are you all doing?

Good.

Bob, how are you?

Good. I just wanted to start on expenses and maybe we know that we get the 1Q compensation increase that we usually see but maybe how should we think about the quarterly run rate and overall expense growth for 2021 and then in addition maybe an update on any willingness to hire additional relationship managers given kind of the dislocation we've seen in the Chicago market?

So a big part of the underlying expense trend that we've seen, aside from some of the one-timers that we discussed in the fourth quarter, we actually had some people start going to the doctor again in the last part of the year. So claims within basically employee benefits were up rather sizably. I think that a significant portion of the expense growth that we expect in 2021 will be people just actually going to the doctor again as fear level subsides. Employee benefits were down this year by a substantial amount just based on people not leaving the house. I would say that's probably going to account for half of the expense growth overall. I think somewhere in the 3% to 4% range and that's going to push you somewhere around $20 million to $21 million per quarter, maybe closer to $21 million in total OpEx exclusive of mortgage banking activity. That is assuming that mortgage banking activity remains the same as it is right now, which I don't actually believe will occur, but just to give you an idea of the underlying dynamics.

That's great color, and then maybe turning to loan growth, can you talk about some of the drivers of the loan growth excluding PPP that we saw this quarter and then maybe how pipelines have trended since last quarter?

Sure Bob, we were obviously very pleased with the fourth quarter. There was a handful of large relationships that we were successfully able to close. Some of them thought we were going to close in the third quarter kind of spilled over into the fourth quarter. We had further expansion in multifamily, professional services, healthcare had an extremely successful year, and we had continued expansion on leasing. So unusual for the fourth quarter, but we're very pleased with it. Looking in the next year, you asked about adding to our talent base. We're certainly open-minded about that and I think we have the capacity to take on another team if one becomes available without really adding to the overall headcount, as we do expect a few retirements at some point this year.

Okay, thanks, and then maybe if I could sneak one more in. In your prepared remarks, you talked about the reserve and having more weight on pessimistic scenarios. Say that there is a little less weight on these pessimistic scenarios, what's a more normalized reserve level for the company under kind of that situation?

That's a question with many variables. If we were to equally consider the base case scenarios presented by Moody’s and the Fed right now, our reserve would likely be about 15% lower than it is today.

Awesome. Great. I'll step back.

Thank you.

Thank you. Our next question is coming from Evan Lisle of Janney Montgomery Scott. Please go ahead.

Hey guys, yes it's Evan. I'm on for Brian Martin this morning. Good morning.

Good morning.

Yes. So first I think I'm going to start with just, I know you guys get some color on the curve size and classified levels. Would you anticipate that those levels in 4Q maybe they're at a peak with a slightly better macroeconomic outlooks and just, I don't know, just some color on your anticipation with that going forward?

Sure. I guess if you step back and look at your year-over-year classified assets were down about 8.5%. So we're pleased with the overall progression. If macroeconomic factors improve, obviously we expect to see continued improvement in the loan portfolio. We do anticipate meaningful improvement in some of our deferrals in the next quarters; we're already hearing from borrowers that things are stabilizing and they expect to come off deferral within the next quarter. Credit is holding in nicely.

Okay perfect, yes and just kind of on that point, I know last quarter you guys don't have direct exposure to COVID industries as you said on the call, but I was just curious if you give some color on stressed areas and just if you would give an update on those areas that would be helpful.

Yes. I mean, the most stressed areas now are investor CRE, some multifamily, and some retail CRE. Surprisingly, we only have really one investor retail CRE in deferral, one office in deferral, which is remarkable, but all signs show that our deferral activity will continue to improve in the next quarter.

Okay. Perfect, and then next, I think you guys have given color on kind of a loan pipeline, and I was just curious your thoughts on that loan production versus payoff and just how are you looking at that moving forward?

Well, the first quarter is always a challenging quarter for loan growth. Obviously, we were very pleased with what we did in the fourth quarter. A lot of that was booked later in the quarter, so I realized some nice benefits as we head into the first quarter. We're seeing some opportunities. Our pipelines are building. We couldn't be more pleased with our healthcare team, and we've got good momentum along various verticals. So I think loan growth in 2021 will be better than in 2020.

Okay. Perfect. And then last one for me, just housekeeping. Looking at your core fees, looking at that level in 4Q, is that a good stepping off point headed into '21? Are you comfortable with that or just how are you looking at core fees going into '21?

I think that core fees are entirely dependent upon what kind of assumptions you place on mortgage and what happens there. The other things are pretty much at run rate. We should do reasonably well growing that within the other caption, if commercial loan growth activity comes in, we start to use some loan origination fees, we can get a nice balance there, but your guess on mortgage is as good as mine.

Okay. Well, perfect appreciate the color and that's all for me. So great quarter guys.

Thanks Evan.

Our next question is coming from David Long of Raymond James. Please go ahead.

Good morning everyone.

Hey David.

Good morning David.

I know you mentioned M&A opportunities are always kind of looking there. But we expected M&A activity to be rather light, but it seems like volume is really picking up here and we even had a deal announced in Chicago here last week. Just curious if you're one actively having conversations today and two what is the tone from potential partners on pricing and how has their expectations changed?

We are having conversations, but that has been the case for the bulk of this year. Just we’re trying to stay close to people so you know what everybody's going through. I think that when we see six or seven months of valuations being depressed, and albeit universally so, everybody's expectations become closer together. There's very little dispersion right now, at least in the community bank space, in terms of where valuations are. So I think that deals can get done in this environment. I'm optimistic if that's the case, and I think sellers are more rational today than they have been in probably two years.

Got it. Okay and then as you're having these discussions, what is the key item that you're looking for in a bank that you'd like to partner with? Is it, I feel it used to be getting good core deposits, but everyone has liquidity today. So just curious what you're looking to accomplish with doing a transaction at this point.

I think enhanced Chicago distribution is a factor still to make the M&A math work. A base level of profitability is required. It doesn't have to be off-the-charts good, but supplementing a Chicago presence, if it comes with a couple of good lenders, that would be a bonus but that's not always the case. A base level of profitability to make M&A work, but I think there wouldn't be a shy about leveraging at this point to something that gives returns to our investors. I think it's prudent given the level of capital that we're having. So maybe more so today than we would have even a year ago. I think a simple leverage can be attractive.

Got it. Thanks Brad. Appreciate the color.

Thank you. Our next question is coming from David Konrad of D.A. Davidson. Please go ahead.

Hey, good morning. Can you hear me?

Good morning.

Couple of questions. One is housekeeping on the PPP. Just wondered on the forgiveness this quarter. What would have been the dollar amount of the fees that came through NII?

Yes, I think we'll get that right. I think it's about $1.6 million.

Yes. Okay. So, and then that will drop to $450 or so in the first half of next year with the remaining outstanding.

That's correct.

Okay, and then more of a broader picture. A lot of your peers are putting liquidity in the mortgage-backed securities despite compressed spreads and obviously convexity risks, but it looks like you guys are doing something a little bit unique and going in the asset-backed market. So just wondering what you are doing there and then what type of securities and kind of the yield versus maybe the MBS yield, kind of the trade-off there versus the shorter duration.

So the only thing that we've done at this point was we put about $50 million into variable rate products, and largely that was done or in its entirety, that was done before the chatter around student loan forgiveness. So basically it was a dislocation there based on both the variable and the opportunity for some spread tightening based on the political chatter. And where does that fit broadly in what we are doing? So we talked about relatively short duration based on that factor and then also there's an implicit 97% government guarantee on those assets as well. So we're staying relatively at least effectively short and then also looking for very strong supportive credit. The only other thing we've done is some issues that are likely to be callable and also variable based on call trends within similar assets. So basically effective short duration with a better guarantee is basically where we've been playing.

Great. Thank you.

Thank you. Our next question is from Eric, a private investor. Please proceed.

Yes. Hi. Good morning. Jim, I may have missed this at the beginning, but did you mention your potential activity in the second round of the PPP loans and what you might be doing there compared to the first round?

Yes, we have started Eric. I would say loans in the pipeline now after the first couple of weeks in the program relative to the first round is significantly lower. Right now for us, we are probably at 20% to 25% of the volume today where we were in the first loan round.

So impact on margin that is not going to be as meaningful as it was in the past.

I’d, if I had to guess that would be somewhere between 25% and 50%. It's both. We had the conversation for upwards of 20 years about how brick-and-mortar distribution is going away, and it tends to coincide with the movement of interest rates, specifically 5 to 10-year interest rates. Every time it falls, everybody assumes that nobody cares about branches anymore, and every time it rises they announce they're going to build more branches. The reality is if things don't change that quickly. The bulk of depositors still grew up in a world and no world where physical presence matters. To think that people come out of this situation once the pandemic subsides and don't want to return to some level of normalcy, and running errands and walking into the branch and saying hi to Susie at the teller is naive. So similar to I answered the stock buyback question; we tend not to lurch in any one direction which way the wind is blowing. The reality is for at least probably the next 10 years physical distribution still is going to matter at some level. To the degree it was 10 years ago, absolutely not, but it's also not obsolete at this point either given the fact that the bulk of depositors are baby boomers or later. So we still place a value on that. There is still value on that, and we will evaluate it based on that fundamental assumption.

Okay, great. Thanks very much.

Thanks Eric.

Thank you. At this time, I'd like to turn the floor back over to management for closing comments.

Okay. That concludes our presentation for today. Thank you for joining us, and we look forward to talking to you again next quarter.