Good morning, Everyone, thank you for joining us today for Old Second Bancorp, Inc.'s Fourth Quarter 2022 Earnings Call. On the call today is Jim Eccher, the company's CEO, Brad Adams, the company's CFO, and Gary Collins, the Vice Chairman of our board. 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 on the homepage and under the Investor Relations tab. Now, I will turn it over to Mr. Jim Eccher.
Good morning, thank you for joining us today. The same format as prior quarters. I have several prepared opening remarks, give my overview of the quarter, then I'll turn it over to Brad for more additional details. We'll then conclude with some summary comments and thoughts about the future, and then open up for some questions. Net income was $23.6 million or $0.52 per diluted share in the fourth quarter. Net income adjusted to exclude West Suburban acquisition-related costs, less net gains for branch sales was $24.1 million or $0.53 per diluted share. On the same adjusted basis, return on assets was 1.61%. Return on tangible equity was 28.33%, and the tax equivalent efficiency ratio was 51.29%.
Fourth quarter earnings were also negatively impacted by a combined $1.3 million in pre-tax security losses and fair value adjustments for mortgage servicing rights. In aggregate, obviously an exceptionally strong quarter with a 20% earnings growth linked quarter on annualized. Our financials continue to be favorably impacted by the increase in market interest rates with a 15% increase in net interest income or $8.5 million over the third quarter of 2022 due to relatively stable funding costs and increasing asset yields across the balance sheet. The fourth quarter marks a full year since our acquisition of West Suburban Bank. I believe both our execution and the positive impacts of the acquisition are apparent in our financials. We have outperformed our own internal expectations on cost saves, loan growth, and revenue that we had set out for ourselves.
These internal targets became more aggressive as we moved from deal announcement to the months following the closing of the transaction. We've been more successful than we had hoped in bringing on new sales teams along with experienced back office managerial talent. We are a better company today than we were at the close of the acquisition. Plenty of work remains. This will be the full extent of our self-congratulations, but it seems appropriate to close the loop on this with a full year behind us. Overall, we cannot be more pleased with where things stand today from both a balance sheet positioning and operational standpoint. The fourth quarter of 2022 reflected minimal loan growth due to both the usual seasonal slowdowns and reduced demand with an increased cost of borrowing.
Exclusive of PPP loan runoff, we had $1.1 million of loan growth quarter-over-quarter. Prepayments continue at a lesser rate than prior years, origination activity slowed considerably in the fourth quarter. Activity within loan committee remains better than expected for this time of year, and our confidence in loan growth in 2023 has not changed. January pipelines are building nicely, we believe originations will be strong in 2023. The net interest margin continued to expand this quarter, with loan yields reflecting recent increases in market interest rates. Overall, the tax equivalent net interest margin was 4.63% for the fourth quarter compared to 3.96% in the third quarter.
The margin benefit resulted from balance sheet mix improvement, the impact of rising rates on the variable portion of the loan portfolio, and strong loan growth for both the second and third quarter, which are now represented in the growth in net interest income. The loan-to-deposit ratio is now 76% compared to 73% last quarter. As we said last quarter, the focus for us now has shifted to balance sheet optimization. Brad will talk about that more in a minute. Turning to credit, we recorded a net charge-offs of $940,000 in the fourth quarter of 2022 compared to $68,000 of net charge-offs in the third quarter. Total classified loans decreased $4.8 million to $108.9 million from $113.7 million last quarter.
Other real estate owned reflected no change in the fourth quarter and remains de minimis at $1.6 million. We remain confident in the strengths of our loan portfolios. The allowance for credit losses on loans increased to $49.5 million at the end of the year from $48.8 million at the previous quarter, which is 1.28% of total loans and just a few basis points more than the total ACL to gross loans at September 30, 2022.
At quarter end, $1.6 million of provision for credit losses on loans was recorded, partially offset by a reduction of $74,000 of provision for unfunded commitments. The increase in the ACL on loans was primarily driven by a slightly higher loss rate in the fourth quarter compared to the prior few quarters, primarily due to the sale and related charge-offs resulting from one larger non-performing credit, which we have spoken about on this call for over a year now. Our outlook is cautiously optimistic as the underlying economy appears strong, albeit with significant uncertainties. We believe that we are more than adequately reserved under base case scenarios, but continue to overweight more pessimistic scenarios given the high degree of uncertainty. Recession probabilities increased relative to last quarter in our estimation.
Credit remains very well behaved. We remain mindful and diligent in monitoring trends both within the portfolio and more broadly. Non-interest income continued to perform well, with growth noted in the fourth quarter of 2022 compared to the third quarter of 2022 in wealth management fees, BOLI income, and card-related income. Pre-tax losses of $910,000 on security sales were incurred related to strategic repositioning within certain security types in our portfolio. Expense discipline continues to be strong, and we are far ahead of schedule on cost save targets announced with the acquisition. Total merger-related costs of $645,000 were recorded in the fourth quarter. We recorded net gains on branch sales of $28,000, all pre-tax. The branch sale gains are recorded within occupancy and good expense.
The sum total of these non-recurring, non-interest expense items discussed total a net $457,000 expense after tax, which resulted in adjusted earnings per fully diluted share of $0.53 for the fourth quarter. As we look forward, we are focused on doing more of the same, managing liquidity, building commercial loan origination capability for the long term, and making prudent investments in the securities portfolio in the short term that did not carry excess credit risk. The goal remains to continue to build back towards an 80%+ loan-to-deposit ratio in order to drive the returns on equity commensurate with our recent historical performance. With that, I will turn it over to Brad for more color.
Thank you, Jim. Net interest income increased $8.5 million relative to last quarter and $35.5 million from a year ago quarter. Margin trends increased due to the loan portfolio growth as well as due to the increases in security and loan yields from market interest rate increases. Total yield on interest earning assets increased 76 basis points to 489 basis points over the linked quarter, partially offset by an eight basis point increase in the cost of interest-bearing deposits and a 15 basis point increase in interest-bearing liabilities aggregate. Obviously, exceptional margin performance. The fourth quarter continued to see a significant movement in rates, albeit this time in the opposite direction, with inversion across the entirety of the curve that leads many to read this or that from the tea leaves.
Obviously, the short end of the curve remains high, and this is where Old Second largely lives. I won't bore you with my take on macro things other than to briefly mention that I don't believe that a Fed focused on inflation is going to whipsaw short rates absent a significant shock of some sort. The once popular belief that zero interest rate policy had no risk has proven shockingly misguided, and any expectation or reversion to that mean is foolish in my opinion. Obviously, I'm biased as a decade-long sufferer of the belief that core deposits matter. Take that opinion for what it's worth and feel free to unsubscribe from my newsletter going forward. The implications for investors in Old Second is that we aren't in a hurry to place large bets on the path of interest rates.
Duration is being added to reduce asset sensitivity in numerous ways, including remixing out of the variable securities that has served us so well and the addition of receive fixed swaps. Few saw this coming and fewer still will nail attempted inflection point trades. Old Second is a very good bank in my opinion and should not attempt to be a hedge fund. Our positioning over the last 18 months was undertaken to provide us with flexibility to fund in an environment where deposits become expensive. The success of that strategy is somewhat on display this quarter, with $76 million in liquidity provided from the securities portfolio with only a small loss realized. The loan-to-deposit ratio remains very low and our ability to source liquidity from the portfolio has increased relative to the color we gave you last quarter.
I would like to remind you that portfolios with longer duration than Old Second's would have seen relative outperformance to ours, given the sharp inversion from the short end. The mark on the securities portfolio remains high, will be recaptured relatively quickly. Net result is that Old Second should build capital quickly, as evidenced by the 57 basis point improvement in the TCE ratio linked quarter. At 12/31, the portfolio duration was approximately three years. The weighted average life was approximately four and a half years, a little less than a third of the entire portfolio was still variable. I would also remind that Old Second has not moved anything to held-to-maturity, what you're seeing is not maybe directly comparable to others.
The tax equivalent yield on the securities portfolio increased by approximately 55 basis points during the quarter. We are continuing to project a little less than $50 million per quarter in cash flow from the portfolio quarterly. If necessary, we can quickly sell several hundred million dollars at a loss approximating 3%-4% of net book value. That may not sound great at first blush. I think it compares exceptionally well to others on a relative basis. The end result of that is that I don't think it gets a whole lot worse with tangible book value increasing by more than 8% this quarter. I'm optimistic we have turned the corner. The trend should be very positive from here. The rest of the balance sheet looks fantastic. The deposit base, as many of you know, is extremely granular and insensitive to rates.
On the loan side, Old Second is transitioning quickly to a higher rate world with rapidly improving profitability. The coming quarters will likely see us pay down the notes payable with $9 million coming off in the first quarter, and our attention turning from here to the senior debt, perhaps later in the year. On the expenses front, a little bit elevated in the fourth quarter, in large part due to incentive compensation and Old Second's performance this year on loan growth and bottom line performance relative to budget. There should be some relief in the first quarter of 2023. Wage pressure continues to be real in our markets, but has lessened considerably in recent months. The fourth quarter did represent the first full quarter impact of wholesale wage increases across the retail network.
That being said, I would expect quarterly wages and benefits to more closely approximate $22 million going forward. Given the revenue performance, investment has been running high, we will maintain the ability to dial back as conditions warrant. I'm very pleased with the way the team's come together in identifying the improvements we need to make to transition into a larger and more dynamic company. Deposits declined 3.2% from third quarter levels, primarily from tax payment seasonality as some parked funds exited. We also had a modest impact from the rate-sensitive acquired accounts. In aggregate, though, trends were stable throughout the quarter. The resulting remix and improvement in the loan-to-deposit ratio clearly benefited the margin. 67 basis points of margin improvement is, by any measure, a lot. Margin trends from here will be more subdued.
The trend remains positive and soon the fixed rate portion of the loan portfolio will begin to contribute as well. As Jim mentioned, we do feel good on the loan growth side, but I would expect slower growth until the second quarter of 2023. Deposits are a tougher game now, with a couple of local banks recently going very big on the time deposit and teaser rate front. I still believe Old Second will perform as well or better than it did during the last tightening cycle. The end result is that margin trends are expected to continue to trend in the right direction.
Non-interest income decreased from last quarter by $2.6 million, driven by a $1.1 million net decrease in mortgage banking revenues, primarily stemming from a reduction in MSR income, as well as $910,000 net losses in security sales. There's a reduction in other income due to pre-tax gains recorded in the third quarter of $743,000 from the sale of our Visa credit card portfolio and $180,000 due to the sale of a land trust business, both acquired with the West Suburban acquisition. Wealth management, BOLI, and card-related income each reflected growth in the current quarter.
Provision for Credit Losses of $1.6 million and our economic outlook remains largely unchanged from the third quarter, with an unemployment rate projection of approximately 4.5%-5.75% through December 31st of this year and over the remaining life of the loans. I would expect loan growth to be roughly consistent with provision growth over the near term, though that could change with significant worsening in the macro environment. We recorded a reversal of Provision of Credit Loss of approximately $74,000 on unfunded commitments. non-accrual loans declined a bit this quarter. 90 days past due declined considerably from the $20.8 million balance from the third quarter to $1.3 million at year-end.
Classified loans decreased modestly, as Jim noted, and I would add that a larger credit we downgraded in a prior quarter was sold early in the first quarter of 2023, resulting in an $800,000 charge-off taken at year-end. Overall, we are pleased with how credit has performed and continue to consider credit metrics as both stable and excellent. Expenses were difficult to manage this year and into 2023, with mid-single-digit increases in salary and double-digit increases in benefits reflecting wage inflation and a difficult environment to hire. We are managing through this and thankful for the flexibility and revenue strength that exists for us right now. Our efforts in the coming quarters will be to continue additional talent on board, helping our customers in funding quality loan growth with the continuing trend of excellent overall core profitability.
Expect loan growth to outpace earning asset growth for the bulk of 2023. We are continuing to look to build capital back a bit following our investment in West Suburban and think it will happen quickly. With that, I'd like to turn the call back over to Jim.
Okay, thanks, Brad. In closing, we remain confident in our balance sheet and the opportunities that are ahead for Old Second. We are paying close attention to both expenses and credit. We believe our underwriting has remained disciplined and our funding position is strong. Today, we have the balance sheet and liquidity flexibility to take advantage of a rising rate environment, and we'll be aggressive in looking to add new talent and new relationships. That concludes our prepared comments this morning, I will turn it over to the moderator and open it up to any questions.
Thank you. 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 while we poll for questions. Thank you. Our first question is coming from Jeff Rulis with D.A. Davidson. Please go ahead.
Thanks. Good morning.
Morning, Jeff.
Morning, Jeff.
Just wanted to try to get some detail on the success of the NPA reduction, the non-accruals. If you could just kind of give us a little color on the, you know, were these loans acquired through West Suburban? Were they legacy? You know, what type? I'm just trying to get a sense of what declined in the quarter.
The big mover, Jeff, was a large commercial real estate property. It's a retail property that we have been, it's been in our workout team for the better part of the year. We finally were able to find a buyer, took a corresponding charge off, finally moved that one off the books. Absent that, it was a combination of, you know, some prepayments, some pay downs, some upgrades. The large real estate property where we took about a $900,000 charge was a long-standing one.
Gotcha. okay. that was that a legacy Old Second, not acquired?
That was a legacy. Yeah, that was a legacy Old Second credit.
The interest recoveries, with included in that. You know, the margin's pretty big. I was just wondering if that added to any. No? Okay.
No. No.
Uh-
We took a further charge on it.
Gotcha. Okay. I, Brad, you rattled through the expense expectations a little bit. Sorry if I missed it. I obviously 2022 digesting some hires and comp increase. I think you alluded to, you know, sort of digesting some of that and I guess expectations for 2023 growth as we kind of muddle through the year.
You know, I think, like I said or tried to hint to maybe gracefully, maybe not, I'll do a little maybe a mea culpa here. We kind of blew through stretch incentive goals and it had a big impact on compensation. We beat our budget quite handsomely in 2022, and that had implications for incentive comp. Perhaps it would have been better, if that could have been accrued more gracefully. We had well in excess of 100 basis points of margin expansion in two quarters, less than two quarters. It was a bit lumpy on that front. We should see a step down, in compensation expense in the first quarter that'll be somewhat mitigated by FICA coming back on board full boat.
I still think overall operating expenses are kind of like a 4%-5% type number on a full year absent that step down.
four to five off of, a base of the full year 2022, 151 or so?
Yeah, I think so.
Okay. Okay. Maybe last one, just on the fee income side, obviously impacted by the securities losses in MSR. Just to your expectation on, you know, expect mortgage to stay low. You know, can we look at a quarterly run rate in the $9.5 million-$10 million range? Any feel for fee income growth in the coming year?
Well, what I'd like to see is I'd like to see commercial loan fees and swap fees start to contribute more meaningfully. We've seen some momentum here recently in the second half of the year. I think we'll get a big kick from that. I don't expect mortgage banking to perform very well in 2023. I don't think I'm alone in that opinion. I think we'll see kind of mid-single digit growth on the fee side this year. I think we'd be pretty happy with that.
Yeah. I think that's been our trend with, especially with wealth and card related income, low to mid-single digits.
Gotcha. Well, thank you. I think the self-congratulations are warranted, so I'll step back. Thanks.
Hopefully that wasn't too over the top.
Thanks, Jeff.
Thank you. Our next question is coming from Chris McGratty with KBW. Please go ahead.
Hey, good morning.
Hey, Chris.
Hey, Chris.
Hey, Brad. Hey, Jim. The comments about earning asset trailing loan growth, if I heard you right, Brad, $50 million's coming off the bond book. I mean, it feels like that could fund mid-single digit loan growth by itself. It sounds like no growth in Q1 kind of seasonally or low growth and then, what? Mid-single over the course of the year. Is that kind of flat earning assets or you think earning assets will grow?
Yeah. Chris, I mean, historically, we've been a shop that's had pretty good loan growth in the second and third quarters. You know, obviously fourth quarter was pretty flat. I will say in recent weeks, activity and loan committee is picking up. If you remember, we set out to double our origination capacity last year, and we actually tripled it, going from about $500 million to about $1.5 million. I certainly don't see that kind of production in 2023, but I certainly could see somewhere in the, you know, in the zillion dollar range in production.
I'm optimistic. I think mid-single digit growth is very achievable.
Okay. On the margin, there was a comment in the release about upward pressure on deposit costs, but I think the word was moderate. I guess maybe a little bit of color there. I think the banks that have held out so far on deposit betas have more or less signaled an acceleration. Are you signaling, perhaps not the same degree of pressure, Brad, and margin lift from that four-six?
As you can see, we've seen a little bit of deposit attrition. It's largely been concentrated in public funds, sewer districts, that sort of thing. And that is money that flowed in while the spigots were on full, right? I mean, everybody saw that. Absent that, we don't have a lot of very high balance accounts here. I've said this before, it's a little bit folksy, but we're funded largely by 1,000 dollar checking accounts. And that serves us well in times like these. We do have, you know, from an ALCO standpoint, we do have some time deposit contribution, and the cost of that is certainly going up. There are 4% being thrown around in our market at this point.
You see the usual games where people are basically gaming the Fed Funds Futures curve and trying to capture 10 basis points here and 25 basis points there. It's the same old game. We'll keep some level of time deposit just to keep things balanced from an ALCO standpoint. There is obviously some pressure, but not a ton. We're doing really well.
If I just push on the margin again. You talked about perhaps taking some of the asset sensitivity off, but, you know, not making a huge bet. If the market's right that we get another hike or two in the first quarter or two, I mean, where do you kind of see peak margins?
If we get two more, our margin's going above five.
Okay. then, you know, one of your peers in Chicago, I think has managed the balance sheet just very well like you. Wouldn't this be the time to make a little bit more of a bet to lock in that really high margin?
I mean, don't misconstrue me. We are certainly taking off asset sensitivity and adding duration, and doing so in a measured manner. A big part of that is stepping out of these variable securities that we bought. That comes without a fee, and it also comes without accounting risk. I don't wanna give the impression that we're not locking in to some extent. We certainly are. Right now, what you see is you see a sharp drop off at the three-year portion of the curve.
After you take the fee into account and start looking at the economics of that, and you balance that against what has shown up here recently, which is 50 basis point cuts at the end of the year, and you're not locking in, you know, 4.5% margins. You're locking in basically 3.5% margins, the net of it. I think what I'm trying to say is that we're not lurching at anything, but we are certainly reducing asset sensitivity as quickly and as prudently as we can. Bear in mind that it was never my intention to have 30% of a securities portfolio in variables. Simply, we had no choice.
Mm-hmm
What fixed rate yields were and what the risks were. If I could get out of them tomorrow with no loss, I probably would.
Okay. I'll step back after this. Do you have the December margin by chance?
Yes, I do. It's higher than what we reported for the full quarter.
Well then.
Thank you. Once again, if there are any remaining questions or comments, please press star one on your phone at this time. Our next question is coming from David Long with Raymond James. Please go ahead.
Good morning, Everyone.
Morning.
Morning.
Brad, I like your core deposits matter newsletter. Do you have a balance sheet management newsletter? I believe some of your peers may wanna subscribe to that. No, in seriousness, non-interest bearing deposits to total deposits still running around 40%. You know, very core funded and a lot of, like you said, $1,000 deposit accounts. Do you expect that number to veer any lower? Can that, you know, do you see that in closer to 30%-35% at some point, or is 40% a good run rate?
Yeah. It feels pretty stable right now. Yeah, things happen when rates go up and certainly one of them, and it gets washed away in a headline, is that liquidity, as the liquidity evaporates. That always becomes more profound than people expect. You know, it's been a long time since we, we saw what happens in these scenarios. I can tell you that it's better to be a retail funded granular deposit base, when liquidity gets tight. I think when you talk about volatility of those deposit bases, it's lesser in that kind of makeup than what you'd see in a, in a commercial funded bank or something like that. It's good to be what we are right now.
I certainly recognize that environments can change, we'll do what we can, but we are fundamentally what we are. I've said that many times. We shouldn't start making giant bets to be something different than that because there's not a darn thing we can do about it.
Got it. Cool. Thanks for that one. Then, one of your competitors did deal in your neck of the woods, any appetite for M&A at this point? Are you having any conversations? Have you seen an increase in dialogue there?
Yeah, David, you know, we've obviously been working real hard to integrate West Suburban. You know, it's been a year. We'd certainly be open-minded about a strategic opportunity. I would say this dialogue in our markets is ongoing, but certainly not at the level it was, you know, a couple of years ago. Yes, we would be open to a transaction if we found one that fit our criteria.
Got it. Thanks, guys. Appreciate it.
Thank you, David.
Thanks, David.
Thank you. There appear to be no further questions in queue at this time. I'll hand it back to Mr. Eccher for any closing comments.
Okay. Thank you. Thanks everyone for joining us this morning. We look forward to speaking with you again next quarter. Goodbye.
Thank you. This does conclude today's conference call. You may disconnect your lines at this time and have a wonderful day. We thank you for your participation.