Earnings Call Transcript - OSBC Q1 2020

Operator, Operator

Good morning, everyone, and thank you for joining us for today's Old Second Bancorp, Inc First Quarter 2020 Earnings Conference 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 of the company's risk factors. 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 under the Investor Relations tab. I will now turn the call over to Mr. Jim Eccher. Sir, the floor is yours.

Jim Eccher, CEO

Thank you. Good morning and thank you all for joining us today. 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 some summary comments and thoughts about the future before we open it up for some Q&A. Net income was $275,000 or $0.01 per diluted share in the first quarter. Earnings this quarter were negatively impacted by a sizable provision for credit losses of $8 million associated with changes in economic assumptions, primarily driven by COVID-19. We also recognized $635,000 in accelerated interest expenses due to the redemption of TruPS and $2.1 million in mark-to-market losses on the value of mortgage servicing rights associated with the movement of interest rates during the quarter. The core net interest margin showed strength during the quarter due to reductions in deposit rates and the muted contraction of LIBOR relative to other rates. Brad will provide additional color on the margin in a moment. Absent these items, overall fundamentals and earnings trends were relatively stable and consistent with last quarter, though we did see mortgage banking results rebound from a seasonal slowdown in the prior quarter. Old Second has taken a number of steps to protect our employees, customers, and communities. For our customers, our locations remain open and available, albeit with necessary safety precautions. We are continuing to work with those that have been directly impacted and we are offering the ability to defer payments as appropriate. The vast majority of our staff has been working remotely for well over a month without issue. Old Second is proud to serve our communities and I couldn't be more proud of the efforts of our employees in supporting our customers and each other in what has proved to be a very difficult time. We are fortunate that our core lending strengths have steered us clear of many of the most impacted industries. We currently have zero direct energy or aircraft exposures in our loan portfolio. Hotel lending is limited to three matured credits at low loan to values totaling approximately $14 million. Direct restaurant exposure is less than $20 million across both commercial real estate and C&I portfolios, and a significant percentage of those is focused on major fast food franchises. We realize the potential exists for these industries to be significantly impacted in the short term, but we also believe few sectors will be spared difficulty in the immediate near term from the implications of rising unemployment and falling consumer and commercial demand. Our base economic forecast at March 31st contemplated a significant decrease in GDP and an unemployment rate in the high single to low double-digit percentages, both in 2020 and over the life of the loan portfolios. In only a two-week time period, we went to a zero Fed funds rate and an inevitable near-term recession in a low to flat yield curve that gives all commercial bankers nightmares. Industrywide stress tests are one of the real positives that came out of the last financial crisis, and I think we've done a real good job with our stress testing. However, I doubt any bank could imagine, let alone model these circumstances. I don't recall ever seeing any consultant propose modeling a 50% drop-off in revenues in certain industries in less than a month. This is new territory. We will have some losses at some point, but we do believe our portfolio is well diversified and will hold up much better than most. Importantly, we believe our capital and liquidity position are as strong as they have ever been. In regards to the first quarter specifically, total loans increased $26.4 million from last quarter with a strong level of originations mitigated by continuing payoff activity. We did not see a significant line of credit drawdown at Old Second in the first quarter. Thus far in April, line drawdowns have continued to remain muted. In a very short period of time, we saw a fairly robust loan pipeline mostly disappear. Concurrent with this, we quickly froze any lending activity that featured cash out refinancing. The above phase and economic outlook mean that the loan growth expectations that we shared with you a few months ago are no longer relevant. I do not expect to see significant loan growth for the remainder of 2020. Total deposits bounced back nicely on both the period and average basis, and growth has remained strong thus far in April as well, despite the reduction in rates. The loan to deposit ratio for the first quarter of 2020 has modestly improved at 89%. I believe we can remain at this level for the near term, with modest loan growth funded by a mix of deposit growth and modest balance sheet optimization. Thus far through April 21st, we have deferrals on our loan portfolio for 130 loans totaling approximately $40 million in principal or 1.8% of commitments outstanding. The largest contributors to these requests are churches, child care services, and residential mortgages, which together make up approximately half of the requests. In terms of the paycheck protection plan, Old Second has approved and funded approximately $80 million in April. We have another $43 million waiting processing and believe some additional requests will continue to come in. We are committed to doing what we can to help our customers on this front. We will attempt to isolate and report on the impact participating in this program has on our financial statements for investors. Overall, we remain cautious but surprisingly encouraged about our results in a number of areas. And I'll turn it over to Brad who can give you more color in his prepared comments.

Brad Adams, CFO

Thank you, Jim. Net interest income declined by $531,000 relative to last quarter, due to an acceleration of $635,000 of interest costs associated with the termination of $32 million of trust-preferred securities. Absent this item, spread income has held up very well and should continue to benefit from interest savings on this retirement going forward. Approximately $20 million of the pay-off was financed into a three-year term note at LIBOR plus 1.75%, a substantial savings relative to the 7.8% cost of the TruPS. The income trends were soft relative to last quarter, with the exception of mortgage banking sale gains; servicing rights experienced a sizable write-down based on declines in interest rates during the quarter as well. The reported taxable equivalent margin decreased by 9 basis points from last quarter, with the majority of the contraction due to the one-time accelerated amortization of TruP issuance costs. We reduced deposit pricing across the Board in late March based on Federal Reserve rate movements. The full quarter impact of these actions should be evident in the second quarter results, with reductions beyond that more modest in effect as time deposits mature and reprice. The adoption of CECL resulted in an $8 million increase in the allowance for credit losses for both funded loans and unfunded commitments. This is at the high end digit and $6 million exclusive of unfunded commitments. This is at the high end of the range previously provided and resulted in an adjustment to equity net of purchase accounting implications and deferred tax adjustments of $3.7 million on January 1. The change in economic outlook resulted in an additional $8 million for credit losses in the first quarter. This economic outlook for us is characterized by a near double-digit unemployment rate and a 15% to 20% underemployment rate. Notably, it reflects a high single-digit unemployment rate over the remaining life of the loans, a substantial change. As Jim mentioned, Old Second has minimal exposure to the hardest-hit industries and a very strong credit culture overall. This quarter's provisions result in reserves in excess of 2.5% on the consumer-lending book, which features no subprime exposure at origination. Reserves across the commercial book have been increased by 25% relative to January 1st and by 46% relative to December 31. Our efforts in the coming quarters will be on helping customers, funding quality loan growth as we find it, and maximizing core funding with the expectation of further modest contraction in margin trends beginning after the second quarter of 2020. The degree of contraction in the margin will be completely dependent upon LIBOR trends. I do not currently expect that the current level of spread between overnight swap rates and short-term LIBOR rates is sustainable. The longer the spread remains elevated, the better our margin trends will remain and vice versa. Capital and liquidity levels leave us extremely well positioned, and we have ample flexibility to continue the pursuit of quality relationships while protecting the franchise and our customers. On the fee income side, mortgage banking reflected a significant increase in gain on sale margins and volumes during the quarter, although the MSR valuations for the first quarter compared to the fourth quarter were ugly. Trust and wealth management softened a bit, and retail banking trends slowed modestly in both fees and card activity. Notably, card activity continues to be even softer in April. Expenses remain well controlled, with additional sales hires in 2019 anticipated to be largely offset by seasonal factors in the remainder of the year, and some likely modest expense initiatives in the remainder of the year as the depth of the economic strain becomes clear. With that, I'll turn the call back over to Jim.

Jim Eccher, CEO

Thanks, Brad. In closing, we remain encouraged with these trends, confident in our balance sheet, and ready for the challenges ahead. On a core basis, Old Second is operating at a very high level and we are excited about the quality of talent added to the organization. We have taken steps to position ourselves well for a potential slowdown and recession. We believe our credit and underwriting has remained disciplined, and our funding and capital position is strong. Overall, the team has never been better. And at some point, I remain optimistic that opportunities will be available to improve our footprint. The focus for us is on timing and making sure that we have the balance sheet liquidity and access to the capital we need in order to take advantage. That concludes our prepared comments this morning. So I will turn it over to Jess to open it up for questions.

Operator, Operator

Thank you. We'll go first to Chris McGratty at KBW.

Chris McGratty, Analyst

Let me start with a question on the margin. I just want to make sure I understand kind of the numbers. If you add back the charge that runs through the margins from the preferred or the TruPS redemption, it looks like margins were kind of in the high mid-to-high 3.80s. If I take your prior comments that each cut was roughly 3 to 5 and effectively we got 6 last quarter. That would suggest somewhere in the realm of 25 basis points to 30 basis points of pressure, assuming the LIBOR dynamic flushed itself out. Is that the right way to think about margins kind of trending toward the 3.60% range, more or less over the next several quarters, if that relationship holds?

Brad Adams, CFO

I agree with that completely, Chris.

Chris McGratty, Analyst

Okay, so 3.60%. Could you speak to, I guess, couple of items on the margin, was there a notable accretion in the quarter that we should draw out?

Brad Adams, CFO

The accretion volatility we observed was primarily due to credit outcomes, which have now been eliminated under CECL. It is now much more predictable, leading to a discussion about distinguishing between excess accretion and normal accretion. I characterize excess accretion as the portion that can be accrued over the actual coupon of the asset. For this quarter, the excess accretion was less than $200,000. Moving forward, I anticipate it will remain remarkably stable and do not expect to discuss it frequently.

Chris McGratty, Analyst

Okay. I mean, kind of a question for you, Jim. Given the revenue backdrop that we're all facing, could you speak to investments that you may or may not be making and kind of the pace of expense growth from here? I think, first quarter is a little bit higher, understandably, it was a little seasonal. Thanks.

Jim Eccher, CEO

Well, as far as our biggest investments last year were obviously in new talent. We've brought on half a dozen new lenders in the fourth quarter, which we're very pleased about. Absent that, we're not projecting anything in the near term. We've got potentially a couple of the capital projects that we'll probably suspend the remainder. But we do not see any sizable investments outside of some software upgrades.

Chris McGratty, Analyst

Okay. And so if I take the roughly $21 million that you had this quarter, my guess, Brad, is that, that number comes down from seasonal and just kind of holds from there. Is that a fair assumption?

Brad Adams, CFO

I expect it will trend toward a $20 million quarterly level before we move to any expense cut initiatives.

Jim Eccher, CEO

Thanks, Chris.

Operator, Operator

We'll go next to Nathan Race of Piper Sandler.

Nathan Race, Analyst

Hi, guys, good morning. Thanks for taking the questions. Maybe just first, curious to kind of hear what you guys are seeing from clients in terms of loan deferral requests and just what are your outreach efforts with your customer base on the commercial side of things, that has resulted in terms of how you guys are perhaps stressing the loan book, just with everything going on today?

Jim Eccher, CEO

Yes. Maybe surprisingly we've thus far had about 1.8% of the loan book that have made requests for abatements or interest only. We certainly expect that to accelerate as long as the shutdown lasts, but we continue to stress test the portfolio on a quarterly basis. So, a lot of it, and we feel pretty good about the loan book overall. One of the sectors we were very worried about was our church exposure, which is about 2.5% of the loan book; surprisingly that sector has been very resilient. We're hearing they're doing a lot of services on social media and tithing continues. So that's kind of surprised us. Absent that, we have no direct exposure to some of these hard-hit areas. Obviously, the indirect exposure is what we're focused on today, particularly retail, and we're diving deep into that portfolio now. But so far, we feel pretty good about it.

Nathan Race, Analyst

It's great to hear. I appreciate that commentary, Jim. And then just going back to the margin, Brad, I think you allude to the fact that you guys cut deposit rates at some point in the first quarter. I'm just curious if that occurred more so late in the quarter, and then we should expect kind of a more perhaps relatively pronounced drop in deposit costs into 2Q; obviously you guys had a pretty low beta over the course of the Fed hikes and several cycle measures a ton there but just curious in terms of what do you expect from the magnitude of deposit cost cuts in the second quarter.

Jim Eccher, CEO

I think the cost of our non-time deposits will trend toward 10 basis points relatively quickly. And as promos wear off over the remainder of the year, namely the 1.51% promo money market that we offered for a period of time, as that matures they should trend toward 6 basis points. Time deposits over the next two years, probably more like 12 months will trend toward 50 basis points. Our all-in cost of deposit funding will be very, very low. I think everyone understands that we are in a zero-rate environment. I think safety and soundness matter. I think that the quality of a deposit franchise, despite low rates will still matter, especially in times of stress. Wouldn't trade our position on the liability side for anyone, and the same is true on the asset side.

Nathan Race, Analyst

Understood. That's helpful, and then just lastly on wealth management and trust fees. I appreciate that there were obviously some headwinds there, but I guess I'm just curious, if the 1Q run rate is largely reflective of the equity market valuation pressures that we have seen recently or if you guys are expecting another step down in that line item entering 2Q?

Jim Eccher, CEO

No, I think given the fact how far markets have bounced back, the percentage of the market-sensitive revenues, I don't expect a lot of pressure from that level.

Nathan Race, Analyst

Okay, great. I appreciate you guys for taking the questions.

Operator, Operator

We will go next to David Long at Raymond James.

David Long, Analyst

Can you provide an update on the fees associated with your payroll protection program loans? Most discussions have indicated they are around 3%, so where do you currently stand on the loans you have received approval for?

Jim Eccher, CEO

Yes. We have been taking risks as they arise, and they are quite varied, but I believe 2.5% to 3% is the appropriate perspective on that.

David Long, Analyst

Okay, got it. And then you guys were pretty opportunistic to hold off on buying back stock, and then this quarter, you did move forward with the stock repurchase and guided a pretty good discount here. What are your plans for share purchases here in the near term, and then again looking out over the longer term as well?

Jim Eccher, CEO

I actually don't know. I think that, so we executed at a weighted average price of a little over $7 in the first quarter specifically, the last part of March. It's difficult. Right. I am extremely comfortable with our capital position. I am extremely comfortable with what our credit quality looks like. I'm extremely comfortable with our reserve levels based on the economic scenario that we see right now. That being said. There are 26 million jobless claims which implies an unemployment rate somewhere just south of 20%. That has profound implications. I also know that the safety and soundness of the bank is in my opinion very strong, and a component of that and the perception of that, which I believe has been out of line, has been the valuation of the stock relative to others even. So it's difficult for me to rule out that we wouldn't be there to repurchase the stock, given what we see, relative to what the perception is. That being said, our first priority is the safety and soundness of the bank and the safety and soundness of our customers and serving them. So I can't tell you that our thoughts are fully formed on that front.

David Long, Analyst

I understand. I appreciate your perspective, and it makes a lot of sense. Regarding the reserve building, can you provide any guidance on your thoughts about that as we approach June? What scenarios by June 30th might lead to another reserve build similar to what we experienced in the March quarter?

Jim Eccher, CEO

I think the most significant part of our reserve build is the under-employment factor. Everybody is coming in at an assumption of a double-digit or near double-digit anyway unemployment rate. And I think that they are assuming based on some surprisingly low reserve levels that I've seen elsewhere that it is a short-duration phenomenon. I don't believe that to be the case. I think that when you talk about the level of revenue stoppages for large loss in the economy, you talk about something that has persistence, and so we have assumed persistently low under-employment for a long period of time, specifically, the entire life of the loan portfolio. I can tell you that doesn't mean more reserves in the second quarter, as I sit here today, it doesn't. But if we continue to see $5 million and $6 million and if we continue to see white-collar jobless claims following what has been largely a service sector phenomenon at this point, which I believe will happen, then there could be modest further additions to the reserve. I think that anybody that tells you that things are going to be better in September has been looking at the same data that I am in terms of the overall economy. And we have seen very little change in delinquency; we have seen very little change in terms of line of credit drawdowns. We have seen relatively extremely light modification requests up to this point relative to others. But I am under no delusion that that will continue if people continue to lose their jobs.

David Long, Analyst

Got it. Thanks. Appreciate it.

Operator, Operator

We'll go next to Brian Martin at Janney Montgomery.

Brian Martin, Analyst

Hey Brad, if the unemployment rate increases from 8% to 10%, what kind of reserve build would you need if it reached 15% in the short term? And if it then decreased, especially with data suggesting a possible 20%, how much would that require based on your model for reserves?

Brad Adams, CFO

Quite frankly, not much, because we have assumed that the unemployment rate is persistent. I'm not sure that others are making the same assumption. A short-term spike into the high teens or low 20s that isn't lasting wouldn't significantly affect reserve levels. However, I don't believe that a 20% unemployment rate is feasible over an extended period, which I define as three years. The American economy is simply more robust than that. Nonetheless, I do consider a 15% to 20% underemployment rate over the duration of the loan portfolio to be an extremely pessimistic assumption, and we have already accounted for it.

Brian Martin, Analyst

That's helpful. You mentioned the limited risk to sectors most affected by COVID, but looking at the portfolio today, where do you see the greatest risk?

Jim Eccher, CEO

Well, Brian, as you know, our portfolio is significantly different from what it was during the last recession. We have spent nearly a decade diversifying our loan book, and we feel confident about it. However, there is always risk in construction lending; last recession, over 20% of our book was tied to that, and today it's about 5%. Much of that is commercial construction, which is still ongoing, and we have solid sponsors backing it. On the other hand, anything related to retail currently poses risks, especially the longer this shutdown lasts. That’s where our primary focus lies.

Brian Martin, Analyst

Okay. Regarding retail exposure, Jim, could you elaborate on its size and share any loan-to-values or debt service coverage levels that you have disclosed?

Jim Eccher, CEO

Yes, I mean, I can tell you, Brian, before COVID hit, we did a complete review of the retail portfolio. And there were no real issues there. Tenancy was strong, good sponsorship, LTVs were in line; obviously now all bets are off, that sector bears watching and we're starting to see some loan deferment requests come in, but the reality is over the next 90 to 180 days, we're prepared to do abatements and deferrals during this tough time. So we still feel pretty good about the sponsorship behind it and the quality of the tenants, but the retail sector will not be immune to this as long as this goes on.

Brad Adams, CFO

If you examine the graphs in the release, you'll see the balances that make up those pie charts are present. The first chart shows a balance of $850 million, and the second, which pertains to investor commercial real estate, indicates a balance of $514 million. This concentration in real estate and owner-occupied properties is quite unique within the Chicago MSA, and no other bank in our market resembles us in this aspect. The first graph shows a 10% retail trade position in relation to the $850 million figure, with a significant portion in essential industries, particularly gas stations. The accommodation and food service category, which stands at 2%, also includes a considerable share from grocery stores. Therefore, I wouldn't overly focus on the retail label in these pie charts, as it does not represent a high-risk area. Based on the information available today, I believe the overall portfolio will remain resilient for at least the next 180 days. My main concern lies with broader economic effects, which is what CECL was designed to address, hence our updated economic forecast. I want to emphasize that our reserving decisions are not influenced by current trends in delinquencies or customer communications; they are solely a reflection of the economic data available in financial releases up to now.

Brian Martin, Analyst

Yes, I understand. That's helpful, Brad. Just one more question from me regarding the PPP program and how it impacts the income statement. Is this reflected as a margin event? If I recall correctly, you mentioned an estimated benefit of around $75 million. Using a 2.5% to 3% metric, that would equate to approximately $2 million. Could you provide some insight into the timeline for how you foresee this affecting the income statement?

Brad Adams, CFO

We have $80 million that has been funded to date, and with the program's expansion, we have an additional $40 million available. The weighted average fee is expected to be between 2.5% and 3%. The remaining assets in process will likely be in the 5% range, which presents some potential upside. The fees will adjust as necessary, and the spread on these assets is currently very low. We hold a significant position in Fed funds and will utilize that excess funding, which will lead to the full poultry spread. If we secure funding beyond the currently approved $80 million, we may consider accessing the Fed's facility. These assets have a short duration, and my current plan is to clearly outline both the interest income and expense tied to this, providing a margin that is separate from our participation in the program.

Brian Martin, Analyst

Okay. Regarding the timing, Brad, it seems that most of the benefit is likely to occur in the third quarter, especially if these credits have a 90-day term. Would that be a fair assessment? It’s a small amount that’s given.

Brad Adams, CFO

I would say that the bulk of the benefit will be in 2Q.

Operator, Operator

With no other questions holding at this time, I'll turn the conference back to Mr. Eccher for any additional or closing comments.

Jim Eccher, CEO

Okay, thank you everyone for joining us this morning and we look forward to speaking with you again next quarter. Have a good day.

Operator, Operator

Ladies and gentlemen, now we’ll conclude today’s call. Thank you for your participation. You may disconnect your phone lines at this time. And have a great day.