Earnings Call Transcript - OSBC Q2 2021

Operator, Operator

Good morning, everyone, and thank you for joining us today for Old Second Bancorp's Second Quarter 2021 Earnings Call. On the call today is Jim Eccher, the company's CEO; Gary Collins, the Vice Chairman of our Board; 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. Now I will turn it over to Jim Eccher.

Jim Eccher, CEO

Good morning, and thank you for joining us. I have several prepared opening remarks, and I'll 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 $8.8 million or $0.30 per diluted share in the second quarter. Earnings this quarter were favorably impacted by a $3.5 million reversal of provision for credit losses due to more favorable unemployment projections over the next year. However, earnings were negatively impacted by an MSR valuation mark-to-market loss of $1 million due to decreases in market interest rates over the past quarter. In addition, mortgage origination and refinancing markets have slowed, resulting in a reduction of net gain on sale of mortgage loans of $1.8 million in the second quarter compared to the first quarter of 2021. Our wealth management team continues to perform at a high level with solid fee income growth of $238,000 over the prior quarter. In regards to the balance sheet, approximately $34 million in PPP loans were forgiven by the SBA during the second quarter of 2021 and $70.2 million PPP loans from both the first and second round remain outstanding as of June 30, 2021. To date, over 65% of our PPP loans have now been forgiven. Our loan-to-deposit ratio is 71% at June 30, a decline from last quarter due to a decrease of $56.3 million, $22 million net exclusive of PPP and total loans, and deposit growth of $25.5 million over the prior quarter end. This is a significant decrease from the 83.7% loan-to-deposit ratio a year ago. The loan growth is certainly a bit of a disappointment for us. Origination activity has remained relatively steady this year but was overwhelmed by $73 million in early payoffs this quarter. Payoffs through June 30 are nearly identical to what we experienced in all of last year. Additionally, we have seen an $80 million decline in purchase participations year-to-date. This is an area that's simply not a big part of our loan book, so I would expect this headwind to be significantly less in coming quarters. To provide a little additional color around this, we only have about $100 million in purchase participations on our books. So almost 45% of our entire purchase participation has either paid down or paid off year-to-date. We simply don't see that trend continuing. On a more positive note, pipelines are building nicely in equipment leasing, healthcare, and commercial real estate. We have a new commercial real estate team starting with us in the third quarter that's seasoned and proven. We've also hired an additional commercial and industrial lender in the second quarter. Additionally, our pipeline for new lenders looks very promising. Given these factors, I'm optimistic we can see loan growth net of PPP activity in the second half of this year. Expense discipline continues to be strong with a slight decrease noted in noninterest expense for the current quarter compared to the prior quarter due to a reduction of salaries and employee benefit costs and occupancy, furniture, and equipment costs. Asset quality trends at this point remain stable, and we remain confident in the strength of our portfolios. Details are available in the earnings release tables on these changes. Loans under modifications stand at approximately 0.4% of the loan book today, and we are working closely with our borrowers to understand each and every situation. Of the original $237.8 million of loans which were on COVID-19-related deferral at some point in the past year, $228.7 million or over 96% have either returned to payment status or paid off as of June 30. As of the most recent quarter end, only 18 loans are remaining totaling $9.1 million in balances currently on deferral. We're very pleased with how our deferrals continue to unwind. Concurrent with our earnings release, Old Second also filed loan portfolio disclosures that will give investors additional detail on the composition of the loan portfolio, current modification breakdowns, and reserve levels. Exclusive of PPP, the reserve currently stands at 1.56% of total loans. During the second quarter, $2.3 million of provision for credit losses on loans was reversed, $1.2 million of reserves for unfunded commitments was reversed based on a review of line utilization trends, and $65,000 net charge-offs were recorded in the second quarter resulting in a net decrease to the allowance, including unfunded commitments, of $3.6 million. Our outlook is cautiously optimistic as the underlying economy continues to improve, albeit with significant uncertainties. We believe that we are more than adequately reserved under base case scenarios but continue to modestly overweight more pessimistic scenarios, given a high degree of uncertainty. Brad will provide additional color in his prepared remarks.

Brad Adams, CFO

Thank you, Jim, and good morning, everybody. Net interest income decreased $1.6 million relative to last quarter and $750,000 from the year-ago quarter. Obviously, the big questions for us relate to the large decline in the reported margin and the lack of loan growth. Jim addressed the latter, so I'll add some additional color on the margin. The core reported margin declined a little over 40 basis points in the second quarter, with interest income declining by a less dramatic amount. The contribution to the reported margin decline was as follows: about 13 basis points resulted from a $140 million increase in average cash balances at the Fed, earning 10 or 11 basis points; 10 basis points of contraction resulted from the decline in average loans, neither of these were expected in our previous guidance; a further 6 basis points of contraction resulted from a 97 basis point reinvestment rate within the bond portfolio. The period-end balance on that portfolio was down more than the average as we had some sales toward the end of the quarter. 7 basis points of contraction resulted from the issuance of the sub-debt early in the quarter. The latter 2 factors were expected but were forecast to be offset by loan growth. We continue to have strong deposit inflows and substantial excess liquidity persistent for the entirety of the quarter. The latest round of fiscal stimulus had a dramatic impact on our liquidity position with substantial inflows during the quarter, given the predominance of retail and the granularity of our deposit base. The strategy to deploy a portion of the excess liquidity will continue in the short term while being extremely cautious on both duration and credit. I'm not assuming at this point that the deposit inflows will reverse quickly. If loan growth improves, which we currently expect, our margin trends should improve significantly. If the excess liquidity flow reverses, our margin outlook would improve significantly. If excess liquidity persists, which we currently expect, net interest income trends will benefit, but margin will remain artificially depressed as we continue to invest in short-duration, lower-yielding assets. I think it's important to note that our excess liquidity has resulted primarily from retail flows, which I expect will be absorbed quickly once the pace of stimulus lessens. So I don't believe it's prudent to add significant duration. If economic conditions improve and loan growth returns to a level commensurate with that growth, our margin outlook would again improve. I remain surprised that loan demand has not followed the reported economic conditions, but I expect that trend to narrow a little bit here in the very near future. The sum total of this discussion is that we currently expect loan growth trends to meaningfully improve, which will result in NII growth. We do not currently expect liquidity flows to lessen. The recent backup in rates is not consistent with adding duration from that liquidity. We will remain cautious and patient on that front. On the fee income side, it declined modestly from last quarter with a decrease in margins and reduced refinance activity in mortgages attributable to a $2.1 million decrease in mark-to-market gains on MSRs, stemming from rate movements, and a $1.8 million decrease in sales of mortgage loans in the second quarter. Mortgage activity remains above historical levels in our markets, and I expect the backup in rates will boost refinance activity in the third quarter. Mortgage impact on noninterest income was partially offset by a $238,000 increase in wealth management and a $218,000 increase in card-related income as we show some signs of spending picking up. Provision for credit losses reversal of the net $3.5 million was recorded in the second quarter compared to a $3 million reversal last quarter. The economic outlook for us assumes continued improvement to the recessionary environment or former recessionary environment with an unemployment rate projection remaining at approximately 5.5% to 6.75% through the end of the year and over the remaining life of the loans, which is a decline from the approximate 6.25% to 7.5% estimate that we gave you last quarter. I recognize that our assumptions are probably more pessimistic than most at this point and expect the severity of these assumptions to be lessened in the coming quarters. I'm extremely pleased with how credit has performed through the pandemic. Credit metrics have remained stable to actually improved, and a number of the credits that I would have been concerned about have been resolved favorably. Our efforts in the coming quarters will be focused on helping our customers fund quality loan growth with the expectation of a more stable margin. Assuming liquidity remains robust and the risk spreads remain unreasonably tight, our capital and liquidity levels leave us well positioned with ample flexibility to continue to pursue quality relationships, return excess capital to shareholders, and pursue M&A opportunities as warranted. We repurchased 311,000 shares during the second quarter at an average price of $13.55 and have substantially completed the existing authorization. Since March of last year, we have repurchased approximately 5% of outstanding shares at an average price of $10.31. Tangible book value per share is currently $10.29 per share after this quarter's results. Obviously, if rates remain extremely low, share buyback would continue to be attractive to us, and we will evaluate that in the near future. Additionally, if rates remain low for a prolonged period of time, we will exercise extreme expense discipline and we'll look at cuts as necessary. Overall, expenses remain well controlled, though, and we will continue to review for efficiencies as the year progresses. With that, I'd like to turn the call back over to Jim.

Jim Eccher, CEO

Okay. Thanks, Brad. In closing, we are increasingly optimistic about the rest of the year, confident in our balance sheet and ready for the challenges ahead. Prolonged low rates are certainly not the best environment for a deposit base like Old Second, but we remain extremely profitable given our focus on expense discipline. We will remain so. We believe our credit and underwriting has remained disciplined, and our funding and capital position is strong. Today, we have the balance sheet and liquidity to take advantage as things improve. That concludes our prepared comments this morning. So I will turn it over to the moderator and open it up to questions.

Operator, Operator

Thank you. Our first question comes from Chris McGratty with KBW. Please go ahead with your question.

Chris McGratty, Analyst

Brad, maybe start with you on the growth and NII comments. I want to make sure I heard the guidance on loan growth. I think Jim said it exceeds the runoff of PPP. So is that suggesting reported loans grow? Or are you guiding to core loan growth in the back half of the year?

Brad Adams, CFO

So I believe that the PPP runoff next quarter should be relatively light. So I would expect that we actually show bottom line loan growth next quarter.

Chris McGratty, Analyst

Okay. And then if I try to solve for net interest income, is the message you're trying to leave with us off this quarter's NII, this is a trough and we grow? Or is it a little bit more pressure before you trough and grow?

Brad Adams, CFO

I believe we grow from here.

Chris McGratty, Analyst

Okay. And then just on the capital comments. You bought a little over 300,000 shares in the quarter, and your stock is about 10% lower. Given liquidity, I mean, your stock, can you step up the pace? Or is this about what you can do in a quarter?

Brad Adams, CFO

So assuming that volume trends remain consistent with what we have observed over the past 6 to 9 months, we could potentially reach up to 500,000 shares a day if we were active in the market for a quarter. That was a big misspeak there.

Chris McGratty, Analyst

Okay. I've heard some of your peers mention the need to become more competitive on rates due to a lack of growth opportunities. Is that how you plan to achieve loan growth, by being a bit less selective on rates while maintaining the structure?

Jim Eccher, CEO

Yes. That's certainly one way, Chris. I mean, we certainly have tried to hold the line on pricing. Opportunities are aggressively bid, and it is competitive out there. So we will certainly sharpen our pencil on pricing as needed for the right relationship.

Operator, Operator

Thank you. Our next question comes from the line of Nathan Race with Piper Sandler. Please proceed with your question.

Nathan Race, Analyst

On the core margin outlook in the back half of this year, I appreciate your comments, Brad, that the excess liquidity levels are likely to remain elevated. Hopefully, they don't increase much from the level here in Q2 and just kind of framing up the comments around some continued pressure on loan pricing just now. How should we kind of think about additional pressure on the margin in terms of basis points from the 291 level we saw ex PPP here in Q2?

Brad Adams, CFO

The challenge is just how much cash we have at the Fed. I had no idea we’d be up another $150 million on the balance sheet. So the reported margin is tough to predict, especially given how far off my expectations were. It's hard to say what the reported margin will do. However, I can assure you that we are much more confident in loan growth than we have been in the last six months. It's been a bit frustrating to witness the slow reopening in Chicago and the pace of loan demand compared to other parts of the country. Still, there are signs of momentum building in this market as it reopens. That said, it is definitely competitive. But I feel good about our current position. Jim and I discussed this yesterday, and I feel more positive about the team than ever before. We have a level of talent that we simply didn’t have two years ago.

Jim Eccher, CEO

Yes. Nate, also when we look at new loan originations through the first half of the year, they're not too far off of where we were a year ago, maybe slightly lower. But when you couple massive payoffs and paydowns that we experienced in the first half, along with a line utilization rate that is more than a 5-year low, we're just seeing our commercial clients with extremely healthy balance sheets and using that liquidity to pay down debt. So we're certainly not expecting a level of paydowns. And given the pipeline activity that we're seeing in loan committee, we're optimistic that we are at or near an inflection in loan growth right now.

Brad Adams, CFO

I also think that maybe 6 to 9 months ago and up until recently, we probably would have contended to see relationships that were kind of below the median in terms of our favorite relationships leave the bank, given the uncertainty in the economic environment, I think we're in a very different place in terms of the mindset on that as well now.

Nathan Race, Analyst

Got it. That's great color. And just thinking about some of the teams that you've added recently. Is that mostly coming from larger banks? So is the expectation, coupled with the folks that you guys have added over the last couple of years as well and in the wake of the M&A-related disruption in Chicago that a lot of the growth that you guys are going to see going forward is more going to be driven by share gains versus existing client credit demand increasing?

Jim Eccher, CEO

Yes. I mean, I think what we're really excited about, Nate, with the new CRE team that's joining us here in the third quarter is that they are known to us from a prior life, proven performers, seasoned lenders that have a track record that we're going to be able to count on. So that, coupled with the new C&I lender we hired along with a potential additional team that we're having substantive conversations with now, we are optimistic about getting some share gain here.

Brad Adams, CFO

If we weren't confident or at least optimistic in terms of our ability to hire over the next 6 months, we probably would have been guiding expenses down at this point.

Nathan Race, Analyst

Understood. And maybe just lastly, just going back to the capital discussion. Obviously, with total risk-based capital shored up pretty noticeably on the sub-debt raised in the quarter. How are you guys feeling about acquisition prospects over the back half of this year? Obviously, it's a competitive environment out there, and you guys are a little bit of a currency disadvantaged relative to some. So just any kind of updated thoughts on optimism level along M&A?

Brad Adams, CFO

I mean, obviously, M&A's difficult with our valuation, but it's possible something gets done. We do have a senior debt issuance that's callable at the end of the year. So that would probably be a wash if nothing materializes.

Operator, Operator

Our next question comes from the line of David Long with Raymond James. Please proceed with your question.

David Long, Analyst

You talked a little bit about the mortgage pipeline and this pullback in rates. Can you provide a little bit more color? Are you seeing an increase in the pipeline? Are your expectations for volume to pick up here in the third quarter?

Gary Collins, Vice Chairman

Yes, we did encounter a slowdown last month, but things have been improving significantly over the past few weeks. One of the issues in the purchase market is the limited availability of properties for sale. Overall, the outlook is positive.

David Long, Analyst

Okay. And then on the credit side, I recall your day 1 CECL prepandemic was you talked about about 1.28% level. You're not there yet. Is that the right level we should think of you eventually getting to? Or has the risk profile of your loan portfolio changed enough to adjust that day 1 level, assuming we get back to a similar economic backdrop that we had prepandemic?

Brad Adams, CFO

I think that is the right level, but I also think our risk profile of our loan portfolio is down. We have lost a number of credits that we would have been concerned about in terms of being higher risk. But that being said, I don't know that I feel comfortable being below that level. There's still an awful lot of concerns. But I do think the trend is down in terms of provision levels. We are still overweight in bearish scenarios, and I don't think that's going to continue to be the case if things continue on the same trajectory that they have been.

Operator, Operator

Thank you. Our next question comes from Brian Martin with Janney Montgomery. Please proceed with your question.

Brian Martin, Analyst

Hey, Jim, I have a question about the pipeline for new hires. It sounds like you recently brought on a C&I lender and mentioned the CRE team in the third quarter. Can you comment on the pipeline beyond that? It seems strong. Also, considering the currency situation and M&A opportunities, do you think hiring will be the primary focus for growth over the next 6 to 12 months instead of pursuing M&A?

Jim Eccher, CEO

Yes, I can address that, Brian. Our healthcare equipment leasing and legacy CRE teams are currently experiencing significantly higher pipelines compared to 90 days ago. We're pleasantly surprised with the increase in loan activity. Regarding the new team we hired, along with the lender we brought on, they have been known to us for quite a while and have a track record of success. We are also in discussions with another potential team that we are familiar with. We anticipate seeing some low single-digit organic loan growth in the latter half of the year. On the M&A front, as Brad mentioned, we are certainly open to opportunities if we can find the right partner.

Brian Martin, Analyst

Okay. And then just as far as the utilization goes, obviously, still at low levels. And I guess in kind of your guide, are you expecting any rebound in that utilization at this point? It was like the earlier question just all market share movement at this point from the teams you've brought on.

Brad Adams, CFO

We saw almost no movement in utilization rates. Our commercial line utilization was down about $10 million during the quarter. Our guidance assumes that, that doesn't move and continues to flatline along a very low level.

Brian Martin, Analyst

Yes, there is potential for improvement if the economy strengthens and that component shows some growth. Also, Brad, regarding the buyback, it seems like the authorization has been completed. What are the current plans for the buyback?

Brad Adams, CFO

We'll go through the steps we need to evaluate that as a possibility.

Brian Martin, Analyst

Okay, that's still an option. Regarding the PPP, is it correct to assume that there's a bit over $2 million remaining, mostly expected to be collected in the second half of the year? Is that your perspective, or are there too many uncertainties to establish a clear expectation for the next couple of quarters?

Brad Adams, CFO

Yes. I think certainly, over the next 9 months, the bulk of that will be gone.

Brian Martin, Analyst

Okay. All right. And then just your comments, Brad, I guess, I'll go back and I can listen to the call, but just the high level on the margin guide over the next quarter or two. I guess just the high level, I guess, can you just run back through what that was? It was just what the liquidity stays towards that, you get some loan growth? And is there something else I missed in there?

Brad Adams, CFO

If liquidity remains stable and we experience loan growth, the margin will improve. Conversely, if liquidity increases, the margin will decline regardless of loan growth. The primary factor influencing this situation is the amount of cash we have at the Federal Reserve. It's important for our investors to understand that current growth in our securities portfolio may lead to restructuring charges in the future. I don’t anticipate a significant return from extending duration. Right now, we are maintaining an effective duration of about 1.5 to 2.5 with our recent purchases, yielding only 97 basis points. Currently, our margins depend heavily on the influx of retail deposits. As time deposits are paid off, we expect the cost of funds to decrease, and we will also lower rates for any lingering accounts. However, predicting margin fluctuations is challenging, especially considering the unpredictable nature of retail cash inflows into our bank.

Brian Martin, Analyst

Right. Okay. And then the retail flows, have you started to see them stabilize? I mean, I know if the stimulus is obviously…

Brad Adams, CFO

No, they accelerated through the quarter with the child tax credit flows.

Brian Martin, Analyst

Okay. And even in the early part of the third quarter, we are still making progress.

Operator, Operator

Our next question is a follow-up from Chris McGratty with KBW. Please proceed with your question.

Chris McGratty, Analyst

Just want to make sure I got the debt comment right, Brad. The instrument you're talking about is the $45 million at 5.75%. Is that what you're talking about?

Brad Adams, CFO

That's correct.

Chris McGratty, Analyst

And I guess what would prevent that from happening just kind of automatically? Or is that just kind of…

Brad Adams, CFO

Well, we have to actually call it. So it doesn't happen automatically, but that is our expectation at this point. We can't.

Chris McGratty, Analyst

Right. But there's no need for it in the capital right now because you're so flushed?

Brad Adams, CFO

Not at this moment, for sure.

Operator, Operator

Ladies and gentlemen, at this time, there are no further questions. I would like to turn the floor back to management for closing comments.

Jim Eccher, CEO

Okay. Thank you for joining us this morning, and we look forward to speaking with you again next quarter. Goodbye.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.