Earnings Call: Q2 2021

Jul 22, 2021

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 Ecker, 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. Now, I will turn it over to Jim Eckers. 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. Net income was $8,800,000 or $0.30 per diluted share in the Q2. Earnings this quarter were favorably impacted by $3,500,000 reversal of provision for credit losses due to more favorable unemployment projections over the next year. However, earnings were negatively impacted by MSR valuation mark to market loss of $1,000,000 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 $1,800,000 in the 2nd quarter compared to the Q1 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 $34,000,000 in PPP loans were forgiven by the SBA during the Q2 of 2021 $70,200,000 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 $56,300,000 $22,000,000 net exclusive of PPP in total loans and deposit growth of $25,500,000 over the prior quarter end. This is a significant decrease from the 83.7 percent 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 $73,000,000 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 nearly an $80,000,000 decline in purchase participations year to date. This is an area that is simply not a big part of our loan book, so I would expect this headwind to be significantly lessened in coming quarters. To provide a little additional color around this, we only have about $100,000,000 in purchase participations on our books. So almost 45% of our entire purchase participation book 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 CRE. We have a new CRE team starting with us in the Q3 that's especially season and proven. We've also hired an additional C and I lender in the Q2. 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 non interest expense for the current quarter compared to the prior quarter due to a reduction in 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 modification 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 $237,800,000 of loans, which were on a COVID-nineteen related deferral at some point in the past year, dollars 228,700,000 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 $9,100,000 in balances currently on deferral. We're very pleased with how our deferrals continue to wind down. Concurrent with our earnings release, Old Second also filed loan portfolio disclosures that will give investors additional detail on the composition of loan portfolio, current modification breakdowns and reserve levels. Exclusive of PPP, the reserve currently stands at 1.5% to 6% of total loans. During the Q2, dollars 2,300,000 of provision for credit losses on loans was reversed, $1,200,000 of reserves for unplanned commitments was reversed based on a review of line utilization trends and 65,000 net charge offs were recorded in the 2nd quarter, resulting in a net decrease to the allowance, including unfunded commitments of $3,600,000 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. Brad will provide additional color in his prepared remarks. Thank you, Jim, and good morning, everybody. Net interest income decreased $1,600,000 relative to last quarter and $750,000 from the year ago quarter. Obviously, the big questions for us relate around 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 by a little more than 40 basis points in the 2nd 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 $140,000,000 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 towards the end of the quarter. 7 basis points of contraction resulted from the issuance of the sub debt early in the quarter. The latter two factors were expected but were forecast to be offset by loan growth. We continue to have strong deposit inflows and substantial excess liquidity persisted 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 preponderance 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 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 reported economic conditions, but I expect that trend to narrow a little bit here in the very near future. The sum total of the discussion is that we currently expect loan growth trends to meaningfully improve, which will result in NII growth. We do not currently expect liquidity close to less than 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 mortgage attributable to a $2,100,000 decrease in mark to market gains on MSRs stemming from rate movements and a $1,800,000 decrease on sales of mortgage loans in the 2nd quarter. Mortgage activity remains above historical levels in our markets, and I expect the backup in rates will boost refinance activity in the Q3. Mortgage impact to noninterest income were partially offset by $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 a net $3,500,000 was recorded in the 2nd quarter compared to $3,000,000 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, they 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 funding 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 the quality relationships, return excess capital to shareholders and pursue M and A opportunities as warranted. We repurchased 311,000 shares during the Q2 at an average price of $13.55 and 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. 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 is certainly not the best environment for a deposit base like Old Second, but we remained 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. Thank you. You. Our first question comes from the line of Chris McGratty with KBW. Please proceed with your question. Hey, good morning guys. Hey Chris. Good morning Chris. 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 Jimmy said exceeds the runoff PPP. So is that suggesting reported loans grow? Or are you guiding to core loan growth in the back half of the year? So I believe that PPP runoff next quarter should be relatively light. So I would expect that we actually show bottom line loan growth next quarter. Okay. And then if I kind of try to solve for net interest income, is the message you're trying to leave with us that off this quarter's NII, this is a trough we grow? Or is it a little bit more pressure before you trough and grow? I believe we grow from here. Okay. And then just on the capital comments. You borrowed 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? So given assuming that volume trends remain the same that we have seen over the last kind of 6 to 9 months or so, we could potentially get upwards of 500,000 shares a day if we were to be active in the market a quarter, sorry. Big misspeak there. There you go. Okay. I knew what you meant. Okay. So you could do a little bit more. Okay. Just a last comment on loan pricing. I've heard a couple of your peers this morning talk about perhaps the need to get more competitive on rate because there's just a lack of growth opportunities. Is that something is that how you're going to get some of the loan growth, just a little bit less picky on rate, but holding the structure? 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. Got it. Thanks. Thanks a lot. Thanks, Chris. Thank you. Our next question comes from the line of Nathan Race with Piper Sandler. Please proceed with your question. Yes. Hi, guys. Good morning. Hey, Nate. Good morning, Nate. Just 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 2Q. 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 2.91% level we saw ex PPP here in Q2? The challenge is just how much in cash do we have at the Fed, right? I had no idea that we'd be up another $150,000,000 on the balance sheet. So the reported margin is just it's a tough thing to call, obviously, because the scale of how badly I missed is off the charts relative to that. So I think it's difficult to tell you what the reported margin is going to do. I can tell you that we are far more confident in loan growth than we've been at any time in the last 6 months. It's been a little frustrating to see how slow Chicago has reopened and what the pace of loan demand has looked like, I think, relative to other areas of the country. But it does show some signs that there is some momentum building around reopening in this market as well at long last. That said, it certainly is competitive. But I feel good about where we are. I feel better about the team. Jim and I were talking about this yesterday, better about the team that we've ever felt. We have a level of talent that we simply didn't have 2 years ago. 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 pay downs. And given the pipeline activity that we're seeing in loan committee, we're optimistic that we are at or near inflection in loan growth right now. I also think that maybe 6 to 9 months ago and up until recently, we probably would have content 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. 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 in the wake of the M and 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? Yes. I mean, I think what we're really excited about Nate with the new CRE team that's joining us here in the Q3 is that they're 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 a new C and 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. 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. Understood. And maybe just lastly, just going back to the capital discussion, obviously, with total risk based capital short of pretty noticeably on the sub debt raise 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 in a little bit of a currency disadvantage relative to some. So just any kind of updated thoughts on optimism level along M and A? I mean, obviously, M and A is difficult with our valuation, but it's possible something to get stuck. 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. Okay, great. I appreciate all the color. Thanks guys. All right. Thanks, Nick. Thank you. Our next question comes from the line of David Long with Raymond James. Please proceed with your question. Good morning, everyone. Hey, David. Good morning, David. 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 volumes to pick up here in the Q3? David, it's Gary Collins. Yes, we've actually we kind of trough hit a low point there in the last month, but it's actually been picking up quite nicely in the last couple of weeks again. One of the challenges in the purchase market is obviously a limited supply of homes available for sale. Sure. I think that definitely is picking up. Okay. And then on the credit side, I recall your day 1 CECL pre pandemic was you talked 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 pre pandemic? 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 hair on things. But I think the trend do think the trend is down in terms of provision levels. We are still over weight 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. Got it. Thank you, guys. Thank you. Thank you. Our next question comes from the line of Brian Martin with Cantor Montgomery. Thanks for taking your question. Hey guys, good morning. Hey Brian. Hey Brian. Hey just a question Jim on the pipeline for new hires. I mean I guess can you it sounds like you brought on a C and I lender, you kind of ran through it there, but the C and I lender you also have the CRE team you talked about just a minute ago in Q3. But just the pipeline beyond that sounds like it's still strong. I mean, I guess, can you just comment a little bit on that? And then just does that seem with the currency and where it's at today and M and A opportunities, the hiring and kind of that aspect is the way to think about where you guys grow going the next 6 to 12 months rather than doing M and A, is that seem more likely? Yes. I guess a couple of ways to answer that, Brian. Certainly, our healthcare equipment leasing and legacy CRE teams are showing significantly higher pipelines today than we did 90 days ago. We're pleasantly surprised with how loan activity is building. As far as the new teams, the new team that we hired along with the lender we hired, they are they've been known to us for quite some time. So they're proven performers along with another potential team that we're talking to that we know very well. So we think back half of the year, we'll definitely see some low to mid interest low single digit organic loan growth. And then on the M and A side, I think Brad kind of alluded to that, we're certainly open for business here if we can find the right partner. Okay. And then just as far as the utilization goes, obviously still at low levels. And then I guess in kind of your guide, are you expecting any rebound in that utilization at this point? Or is it like the earlier question, just all market share movement at this from the teams you brought on? We saw almost no movement utilization rates. Our commercial line utilization was down about $10,000,000 during the quarter. Our guidance assumes that that doesn't move and continues to flat line along a very low level. Yes. Okay. So there's upside if we start to see some strengthening of the economy and you get some pickup in that component. So okay. And then maybe Brad just on the buyback, it sounds like the authorization is completed at this point. I guess, what are the plans on the buyback at this point? We'll go through the steps we need to evaluate that as a possibility. Okay. That's still on the table. And then okay. And then just as far as the PPP goes, fair to assume Brad that I guess or at least big picture that the remaining piece of that PPP I think is a little bit over $2,000,000 that the bulk of that gets collected in the second half of the year? Is that how you're thinking about it? Or is it too unknown too many unknowns on that to give some kind of put sense around what you're thinking in the next couple of quarters? Yes. I think certainly over the next 9 months that the bulk of that will be gone. 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 2, I guess, just the high level, I guess, can you just run back through what that was? It was just liquidity stays where it's at, you get some loan growth and is there something else I missed in there? If liquidity stays where it's at and we get loan growth, the margin will be better. If liquidity goes up, the margin will be down, regardless of what happens with loan growth. The big driver here is how much cash we've got at the Fed. I think that what our investors should know is that at this point, it feels to me like securities portfolio today's securities portfolio growth is tomorrow's restructuring charge. I just don't see a return in terms of plowing out duration. We are hanging around kind of a 1.5% to 2.5% effective duration with the flow purchases that we've made earning a whopping 97 basis points. So that's where the appetite is right now. Margin is purely a function of how much retail deposits flows into our shop. The cost of the funds will continue to eke down as we see time deposit payoff come off, and we'll move any stragglers and rate down as well. But margin is a tough game to protect right now given just how badly you can miss on retail flows in terms of cash into your bank. Right. Okay. And then the retail flows, have you started to see them stabilize? And I know the stimulus is obviously No. They accelerate through the quarter with the child tax credit flows. Okay. And even into the 1st part of Q3, you're still building or We got a lot of cash. We got a lot of cash. Yes. Okay. All right. Thanks for taking the questions, guys. Thank you. Feel free to call Brad back. Thank you. Our next question is a follow-up from Chris McGratty with KBW. Please proceed with your question. Hey, thanks for the follow-up. Just want to make sure I got the debt comment right Brad. The instrument you're talking about is the $45,000,000 at 5.75%. Is that what you're talking about? That's correct. And I guess what would prevent that from happening just kind of automatically or is that just kind of Well, we have to actually call it. So it doesn't happen automatically, but that is our expectation at this point. Right. But there's no I guess there's no need for it in the capital right now because you're so flushed? Not at this moment, for sure. Got it. All right. Thank you. Thank you. Thank you. Ladies and gentlemen, at this time, there are no further questions. I would like to turn the floor back to management for closing comments. Thank you. Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.