Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc.'s fourth quarter 2021 earnings call. On the call today is James Eccher, the company's CEO, Gary Collins, the Vice Chairman of the 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 to reconcile to their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com on the homepage under the Investor Relations tab. Now, I will turn it over to James Eccher.
Good morning, and thank you for joining us. I have several prepared opening remarks. I 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. Okay, net loss was $9.1 million or $0.26 per diluted share in the fourth quarter.
Net income, excluding acquisition-related adjustments to our provision for credit losses and merger-related costs, was $12.5 million or $0.36 per share in the fourth quarter. On the same basis, return on assets was 1.15%, return on tangible common equity was 14.1%, and the efficiency ratio was 66.1%.
Earnings this quarter were favorably impacted by the inclusion of one month of the legacy West Suburban net interest income, as well as a $2.3 million reversal provision for credit losses due to more favorable unemployment projections over the next year. In addition, a MSR valuation mark-to-market gain of $1.5 million was recorded in the fourth quarter.
We closed the West Suburban acquisition on December first, which resulted in some transformational changes to our financial statements. For the full year, earnings were $41.9 million or $1.36 per diluted share, excluding the merger-related charges and CECL adjustments. ROA was 1.20%, ROTC was 13.66%, and the efficiency ratio was 65.8% on the same basis.
Overall, we are very pleased with the financial performance we delivered in 2021, but the acquisition of West Suburban and what it can mean for us in the future is clearly the story for us. We now have $6.2 billion in assets, including $3.4 billion in loans and an incredibly granular low beta of $5.5 billion in deposits.
We are focused on deploying liquidity in order to more fully leverage the quality of the deposit base by building commercial loan origination capability for the long term and making prudent investments in the securities portfolio in the short term that do not carry excess spread or credit risk. The goal is obviously to build back towards an 80%+ loan-to-deposit ratio in order to drive the returns on equity commensurate with our recent historical performance.
We have a plan and are making progress. In regards to the quarter and the balance sheet specifically, securities and loan growth quarter over quarter included the growth from the inclusion of the West Suburban portfolio at year-end.
The West Suburban securities portfolio was fair valued at $1.07 billion, and it was recorded in its entirety within our available-for-sale portfolio. We executed $570.8 million of security sales or 54% of the portfolio immediately upon acquisition close in order to align the portfolio with our investment strategy.
This included subsequent purchases of $533.9 million of securities throughout the fourth quarter of 2021. We significantly improved the liquidity and reduced the duration of the portfolio, thereby reducing extension risk.
There was certainly a cost to doing this in both income and fair value associated with these actions. Their outlook that we shared with you when we announced the transaction is unchanged. Period-end loans for the fourth quarter included the addition of $1.5 billion from West Suburban merger as well as organic growth of $81.6 million, exclusive of PPP loan paydowns of $29.7 million for the quarter.
Only $38.4 million of PPP loans for both the first and second round remain outstanding as of the end of the year, which includes both legacy Old Second and West Suburban portfolios. We are encouraged both by returning to growth mode and that our pipeline at quarter end is by far the strongest we have seen since the pandemic began.
We are seeing significant pipeline builds in commercial real estate and in healthcare, although C&I activity and line utilization remain soft. After a strong fourth quarter last year, equipment leasing will ramp up as the new year unfolds.
With the new CRE team that started with us in the third quarter, along with a senior leasing officer and an experienced team leading a new sponsor finance vertical added in the fourth quarter of 2021, I'm optimistic we can see solid loan growth in 2022.
Nonperforming loans increased by $15.7 million compared to the prior quarter with the addition of the West Suburban portfolio. The increase is attributable to three newly acquired West Suburban credits. Importantly, legacy Old Second nonperforming loans decreased $2 million in the quarter.
Additionally, we did charge off two large credits in the fourth quarter, one in commercial from legacy Old Second and one commercial real estate from legacy West Suburban, resulting in net charge-offs of $4.7 million for the quarter. Both of these large credits were fully allocated in prior quarters. Total classified loans increased $39.6 million to $74.5 million due to the inclusion of the West Suburban portfolio. We remain confident in the strength of our portfolios.
Other real estate owned did not increase materially as the West Suburban portfolio had minimal OREO at acquisition, and two of the three properties we did acquire were sold in December. Details are available in the earnings release tables on these changes. The allowance for credit losses totaled $44.3 million as of December 31, which is 1.3% of total loans.
During the fourth quarter of 2021, the credit mark on acquired PCD loans of $12.1 million increased the ACL, as well as the day two provision for credit losses adjustment based on the estimated future credit losses on non-PCD loans acquired of $12.2 million for loans. In addition, $2.4 million was recorded to the provision for credit losses for the day two unfunded commitments future losses estimate.
At quarter end, $2.3 million of provision for credit losses on loans was reversed, and $49,000 of reserves for unfunded commitments was reversed based on a review of line utilization trends. 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 the high degree of uncertainty. Expense discipline continues to be strong, and we are making good progress on cost-saving targets announced with the acquisition.
Write-downs on four legacy Old Second branches of $3.8 million were recorded in the fourth quarter of 2021, with the potential of marketing these properties in the near future. These branches are in addition to the nine West Suburban branches that have been identified as overlapping with newly acquired branches.
Total merger-related costs of $12.8 million were recorded in the fourth quarter, which includes this $3.8 million fixed asset write-down, as well as other merger costs, including severance and retention, data deconversion, legal, investment banker, and other consulting fees. With that, I'll turn it over to Brad for additional color in his prepared comments.
Thank you, Jim. I think probably the best use of the time we have remaining is to talk a bit about how things have changed and what we got right and wrong in the estimates we put out in July at the announcement. C ertainly, the macro environment is a bit different with the world seemingly waking up to the reality of inflation here very recently.
Credit and facility marks for the WSB acquisition were consistent with expectations, though the day two adjustments were slightly larger than our initial expectations once the model runs were completed. The rally in rates in late November and early December appeared inexplicable on our end and provided us an opportunity for a much larger than we expected portfolio repositioning that substantially reduces the risk posed by the prospect of higher rates.
The WSB portfolio was around $1 billion, as Jim said, and the duration on that portfolio was reduced from an excess of six to well under three without a meaningful change in yield. I am extremely pleased that we were able to get this done here, given the illiquidity of some of the issues that were in that portfolio.
Obviously, I don't have a crystal ball, but whether that will turn out to be worth it or not, but the bias and results so far indicate that it favors significantly higher rates than where we are today, and certainly higher than where we were in early December. As we moved towards announcement of this deal, we discussed internally the things that we needed to do to be successful with the investment we were making and in the years ahead more generally.
In the short term, we decided we needed to double our loan origination capability within a year of the close. I'm pleased with where we are in this effort, and we are much further along than I expected to be at this point. On the cost savings front, I would love to tell you that we expect to outperform the $21 million number we gave you in July, and we are.
But we have already spent the difference in new talent acquisition, and I'm optimistic additional opportunities are out there, and we will keep you posted on these efforts. From a cultural standpoint, there are always challenges to overcome, but I would say that the communication is very good, and we are getting to the right answers, and things feel even better than we expected. With that said, I'll move more into the results.
Net interest income increased $6 million relative to last quarter and $4.8 million from the year ago quarter. Margin trends were stable on a core basis due to the securities portfolio growth, which mitigated the continuing increase in liquidity. The reinvestment rate on the portfolio was slightly less than 100 basis points as we continued to avoid duration throughout the fourth quarter.
Given the more recent moves that we've seen, we have been going quite a bit longer, but we do remain somewhat cautious on that front. We continue to have strong deposit inflows and substantial excess liquidity persisted for the entirety of the quarter. Our margin trends will be a function of loan growth primarily, and we will continue to deploy liquidity within the securities portfolio as well.
I would have even more confidence if we were able to see positive developments in C&I and utilization rates, both of which remain depressed. We do feel quite a bit better on loan growth side of things, though, as you mentioned, actually substantially better. If the forward curve is accurate, the first two rate hikes will benefit us, but not to the degree of any subsequent moves would.
We do have significant floors in the loan portfolio, though West Suburban did not. I would add that we expect our deposit beta to be excellent in a rising rate environment. The sum total of that discussion is that we currently expect loan growth trends to drive net interest income growth with modest margin improvement. If things move further along in the rate hike development, obviously that would be biased upward further.
I kind of feel like we're on a chicken or the egg discussion here. I don't want to count on that yet. Noninterest income increased from last quarter with an increase of $1.7 million quarter over quarter in MSR mark-to-market gains and service charges on deposits growth of $256,000.
Wealth management income remains strong with $2.4 million in both the current quarter and the prior quarter. Excluding the $14.6 million of day two acquisition-related provision for credit loss adjustments, a provision for credit loss reversal of $2.3 million was recorded in the fourth quarter compared to a $1.5 million reversal last quarter.
The economic outlook for us assumes continued improvement with an unemployment rate projection remaining at approximately 5%-6% through December 31, 2022, and over the remaining life of the loans, which is going to sound high to you, but it's just at a substantial decline from the approximate 5.25%-6.75% from last quarter.
I certainly recognize that our assumptions are probably more pessimistic than most at this point, and expect the severity of these assumptions to be less in incoming quarters. As those assumptions are relaxed, I would expect loan growth to outpace provision growth in the near term. I am extremely pleased with how credit has performed through the pandemic. Credit metrics have remained stable to improving, and a number of credits that I would have been concerned about have been resolved favorably.
Expenses are difficult to manage in 2022, absent the acquisition, with mid-single-digit increases in salaries and double-digit increases in benefits reflecting wage inflation and a difficult environment to hire. We are managing through this and are thankful for the flexibility and opportunities for synergies that exist for us right now. We had expected to realize more synergies from scale on the benefit side, but inflation is very real on this front.
Fortunately, we are able to look to other opportunities on the expense side to get to where we need to be. Our efforts in the coming quarters will be on delivering on the synergies that we promise, continuing to bring additional loan growth talent on board, helping our customers in funding quality loan growth with the expectation of a stable and improving margin. This all assumes that liquidity remains robust and risk spreads remain unreasonably tight. With that, I'd like to turn the call back over to Jim.
Okay, thanks, Brad. In closing, we are optimistic about the new year, confident in our balance sheet and loan growth opportunities that are ahead. Prolonged low rates is certainly not the best environment for a deposit base like Old Second, but it certainly appears we are near an inflection point in rates. Regardless, we remain extremely profitable given our focus on expense discipline. We expect to remain so.
We believe our credit and underwriting has remained disciplined and our funding position is strong. Today, we have the balance sheet and liquidity to take advantage of a rising rate environment and have the financial strength to wait for this to occur.
We continue to be active in the effort to bring additional salespeople to our team and are making substantial progress on the systems integration to ensure a smooth transition for West Suburban customers and employees. We are excited about the opportunities that exist for Old Second in 2022 and beyond. That concludes our prepared comments this morning, so I will turn it back over to you, Holly, to open it up for questions.
Certainly. Ladies and gentlemen, the floor is now open for questions. If you have any questions or comments, please press star one on your phone at this time. We ask that while posing your question, you please pick up your handset if listening on speakerphone to provide optimum sound quality. Please hold while we poll for questions. Your first question for today is coming from Christopher McGratty. Please announce your affiliation, then pose your question.
Hey, good morning. Christopher McGratty from KBW. Jim and Brad, the outlook for loan growth seems like a little bit of a divide, right? Commercial real estate doing better, C&I kind of stuck. Can you elaborate on the outlook for organic loan growth in light of the team hires and those comments in your prepared remarks?
Sure, Chris. You know, we've added substantial talent, you know, over the last couple of quarters. Not to mention, we are seeing some increased demand across all fronts. You know, we feel, you know, we have an opportunity with our new teams to generate, you know, mid upper single digit loan growth, really fueled by, you know, a pretty good pipeline of CRE.
Healthcare continues to build their pipeline, you know, then our triple net leases CRE team and our newly formed sponsor finance team, which will probably deliver results later in the year. We're certainly more optimistic today than we have been. You know, the West Suburban legacy portfolio, we had originally expected more significant runoff in the near term, we're not seeing that. We're optimistic we can generate some growth with that team as well.
Okay. With that and your 80% target on your loan-to-deposit you talked about, how do we think about just is this a remix year of the balance sheet? I know you took actions with the West Suburban bond portfolio, but should the security book be used as a source of funds to fund the growth, or will you grow that as well?
That will be grown as well in the near term. It's largely going to be driven by what happens to liquidity. If rates do in fact go up, I would expect that some of the liquidity to drain. It's been far more persistent than I expected. I would expect to see another $200 million in portfolio growth for us over the next two quarters. We'll also focus on the loan growth. Getting back to a loan-to-deposit ratio that looks more like us is going to take some time, but obviously represents a long-term opportunity.
Maybe if I could squeeze one more in. The 21 million you said you're doing better on the cost save, but you're putting it back into the business. How far along are we on the cost saves? I guess how should we be thinking about just the expense cadence over the rest of the year?
I would expect that at some point this year, we'll get to the fully phased in run rate.
Okay. Outside of that, you know, we're seeing inflationary pressures, core bank growing, what, 3%-4%?
If we were standalone today, we would probably be staring at expenses that got north of 4%. A couple of things embedded in that. One, the increase that we saw on the benefit side was far in excess of my expectations. A little bit of that is fueled by people actually going to the doctor again, thank goodness, and filing claims, but some of it is also basically provider driven in terms of what's being passed through.
You know, obviously there are people with much bigger workforces that can speak to the dynamics that is going on within hiring markets. There is substantial wage inflation in the competition to hire people. Though we have not seen excess turnover at this point, filling roles is difficult. People have a lot of choices on who they can work for, and it is showing up in wage markets.
Okay. Thanks, Brad.
Your next question is coming from Nathan Race. Please announce your affiliation, then pose your question.
Hi, Nathan Race with Piper Sandler. Morning, guys. Question on the outlook for the reserve going forward, you know, with the within the mid- to high-single-digit loan growth expectations that you guys have, just curious in terms of kind of remaining unallocated reserves that you guys can grow into and just expectations from a provision perspective in terms of having to provide for that growth over the course of 2022.
Yeah, a lot's going to be determined by what assumptions go into the model, obviously. Given the fact that we stated that our assumptions probably will be relaxed at some point if nothing else changes in the world, I think it's safe to assume that provision growth will lag loan growth.
The magnitude of that, I'm not fully confident in laying that out for you. For example, I'm not going to say there is no provision growth in 2022, but it will be substantially level, less than what you would expect if everything stayed the same.
Understood. Perhaps within that context, you know, it seems like, you know, with the elevated charge-offs that we saw here in the fourth quarter, that may have been somewhat of a cleanup heading into this year. Just sounds like, Brad, that you guys are feeling pretty optimistic on the outlook for credit quality going forward. Just be interested to hear some comments in terms of kind of what you guys are expecting from a charge-off perspective over the course of 2022 as well.
The one credit that was legacy Old Second that we charged off was. I think we first talked about that credit on these earnings calls about five quarters ago. We've talked about it in two other earnings calls as well. It's not something that's new. It's not a new development. I think we provided for it 12 or 15 months ago.
It's been a while. If that's the only thing you worry about, that it's something that's 12 to 15 months stale, you're obviously feeling pretty good. The other credit, as Jim mentioned, was a West Suburban credit that they've been aware of for quite some time. In terms of new issues popping up, nobody's come to meetings with any really bad news or any scary stuff here recently. I think we feel pretty good. Jim, do you have anything?
Yeah, I mean, we've tracked obviously early stage delinquencies are very benign. You know, we're seeing very little migration from watchlist credits to problem credits and non-accrual. Remarkably stable at this point. Our outlook in the near term anyway is very positive.
Okay. I don't mean to oversimplify the margin outlook, you know, with all the various moving pieces there, but perhaps, Brad, just any comments on kind of the starting point for the core margin ex PPP and accretion, and would be interested to hear from a reported margin basis your expectations for purchase accounting accretion starting off in 2022, and then I imagine kind of running off thereafter incrementally.
That's a huge question, dude. I think the reported margin will be relatively stable. I think that there'll be a slight goose relative to the purchase accounting. It's not a massive number. You know, I think on a full year basis, we're probably looking at $2 million that we'll benefit on that front. It'll last for basically two years. In terms of.
You know, we had originally expected in July that you know, the combination with Old Second would be roughly 25 basis points diluted to our reported margin. That's because they were obviously carrying as much excess liquidity as we were, but with even less loan-to-deposit ratio. We've essentially swallowed that up with the deployment of liquidity at this point.
Just so nobody gets nervous on that front, we have largely looked at being between 1.5 and 3 years on the duration curve and are taking somewhere less than or in spitting distance of 100 basis points, with a lot of variable as well. I don't feel like we're giving up much, and we are offering some level of protection in case it's one,two or three rate increases and then something breaks.
We're trying to be prudent here. Obviously, Old Second is what it is. It's a nearly perfect creature for higher short term rates. That's just who we are because of the deposit base, and West Suburban came with the very same traits. We're a good bank. We're managing it prudently. Margin is biased higher. Purchase accounting will help a little bit. We're just kind of looking forward and waiting for it gets here before we count on it.
Got it. It's a helpful color. I appreciate you unpacking that, and thanks again for taking the questions.
Sure. Thank you, Nathan.
Once again, if there are any questions or comments, please press star one on your phone at this time. Your next question is coming from David Long. Please announce your affiliation, then pose your question.
Good morning, everyone. It's David Long from Raymond James. I wanted to stick with the discussion on the net interest margin, Brad. Not to put you on the spot again, but, you know, as you're thinking about rate hikes and the sensitivity, it sounded like from your prepared comments that the first couple of rate hikes may not have as much of a positive impact as the second couple rate hikes. My question, you know, the first rate hike, what does that impact the NIM all else equal versus maybe the third or fourth rate hike?
The first rate hike and the second rate hike, they do impact us very positively. So do the third and the fourth, if that happens to fruition. You know, in terms of basis points, I think that you can see, depending on when in a quarter it comes, a rate hike can impact our margin if it's mid-quarter or later by a few basis points to upper single digit basis points.
On a full year basis, a rate hike equals, you know, it's. You don't even want to say this stuff because you don't want to count on it, but it's wildly positive to us, right? One rate hike equals, you know, somewhere between $2 million and $3 million, even inclusive of burning through floors, in net income.
It piles on as you get further because I would expect that our beta on the first two would be pretty darn close to zero. It wouldn't be much on three and four. We are short duration on the asset side. That's who we are. We are funded by $1,000 checking accounts. It's a perfect balance sheet for higher rates on the short end of the curve.
Got it. Okay. That's helpful. Switching gears here, you know, obviously you just closed West Suburban and are still working through that. Do you have an appetite to do additional deals? If so, is there a time frame on that when you'd really start to consider them again? How are you thinking about the M&A environment for Old Second in 2022?
Yeah, Dave, obviously, this is a significant transaction for Old Second. You know, we've got systems conversions, you know, late April. We've got to digest that. We've got plenty to do here internally to work through branch rationalization and integration changes.
We certainly aren't in a position to do anything in the near term. Clearly, the regulators would want us to definitely integrate this in a satisfactory manner before green lighting us. You know, we probably entertain something later in the year but we can't do anything now.
Got it. Thanks, Jim. I appreciate it.
Your next question is coming from Brian Martin. Please announce your affiliation, then pose your question.
Hey, good morning, Brian Martin with Janney Montgomery Scott. Hey, good morning, guys.
Good morning, Brian.
Maybe just one last from Brad on the margin or asset sensitivity. What is the percentage of loans that are variable and then just did you just maybe I missed what you just said, but if you had the 125 basis point increase, you know, at the beginning of a quarter, how much of a benefit to margin would that have on the hikes?
Roughly half the loan book is variable. You know, I don't have completely reliable data in terms of what has floors within the West Suburban portfolio. They're not fully integrated into our ALCO model yet. Obviously, we still have systems conversions ahead.
There's substantial uncertainty here. So the uncertainty is only in one direction, and that's the magnitude of the positivity. If we were to get a rate hike in March, I would say that second quarter margin, everything else would be up probably 10 basis points.
Gotcha. Okay. Helpful. Then maybe just on the integration of with the cost savings, when do you guys expect to set the systems integration, when is that scheduled for? Kind of give us a path to when full cost savings will be in there.
It'll be done by mid-second quarter.
Okay.
You'll start to see some benefit of cost savings leaking in the second quarter, and you'll see a very healthy run rate reduction in the third.
Okay. Perfect. That's helpful. How about just from a you guys had talked about the senior debt that was out there, kind of would reevaluate that. Can you give us an update on how you're thinking about that or just the capital?
We are still in the reevaluation stage.
Okay. Just stay tuned. Just you, Jim, you talked about the significant hires you've had here the last couple of quarters. Just kind of wondering what your and Brad's comments about, you know, getting near the, you know, the capabilities you were hoping to get to as far as doubling the, you know, the origination activity. What does the pipeline look like for recruiting today? You know, just it sounds like you still expect to be pretty active here in the next couple of quarters. Is that a fair assessment?
Yeah, Chris or Brian, we certainly are still actively looking to add talent to the team. We're very happy with the new talent that joined us in the last couple of quarters. We certainly have high expectations as we move into 2022. Keeping one eye on cost savings is important and expense control, but we've also, you know, had a handful of retirements, and we clearly have room to continue to pursue additional talent.
Gotcha. Okay. All right. Maybe just last one for you, Brad. Just going back to the sensitivity. I guess your comment about the floors and just the impact of future hikes. It sounds like the 10 basis points or whatnot could be, you know, all else equal, a little bit better in the future. Albeit with, you know, deposit betas going higher. Is that fair based on your comments?
Yeah. I mean, last rate hike cycle, Old Second experienced over the duration of the cycle deposit beta of around 10%. I don't think there's anything within the West Suburban deposit portfolio that looks substantially different from us. So I think we perform similarly. You know, it is at this point before they've come, and I had probably more hope than most that they would actually do something yesterday in the face of mid- to high single-digit inflation.
B ut the reality is that, you know, it substantially benefits margin. I would point you to when we were 150 basis points higher on the short end of the curve a couple years ago, Old Second was running at a 4.25% margin. Today, we're 3% or below. If we get back to that level, and I'm trying to steer you towards a longer-term look here, I don't know how many basis points hit in which quarter.
Yeah.
If you think back two years ago when people asked me that question, I got it really wrong, because I was telling people we'd get five or six basis points, and we'd wind up getting 20. It's hard to know with the speed and you know, what loans pay down and what pays up and how many basis points are gonna fall in which quarter.
I can tell you there's nothing structurally different about Old Second from a contribution analysis standpoint that says we can't be north of a 4% margin if we get back to that 1.50 type rate level on the short end of the curve.
Gotcha. Okay. That's all very helpful. Thanks for taking the questions, guys.
Thanks.
There is a follow-up question coming from Chris. Chris, your line is live.
Chris, you want to talk about.
Yeah, hey, thanks for the follow-up. The $2 million-$3 million, Brad, for each quarter hike, was that, did you say net income, or did you say net interest income? I missed that.
I said net income and on a full year basis for each hike.
Got it. Okay. Thank you.
The one that comes in September is not going to be that much of a contributor.
Yep.
For 2022.
Yep. Got it. Perfect. Thank you.
Yep.
There are no further questions in queue at this time.
Okay. Thanks everyone for joining us this morning, and we look forward to speaking with you again next quarter. Goodbye.
Thank you, ladies and gentlemen. 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.