Old Second Bancorp Inc (OSBC) 2011 Q4 法說會逐字稿

Greetings and welcome to the Old Second Bancorp third-quarter 2011 earnings conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Doug Cheatham, Executive Vice President and CFO. Thank you, Mr. Cheatham, you may now begin.

Thank you. Good morning, everyone, and thank you for joining us. I will start with a reminder that our comments today may contain forward-looking statements, which are based on management's existing expectations and the current economic environment. These statements are not a guarantee of future performance, and results may differ materially from those projected. I ask you to refer to our SEC filings for a full discussion of the Company's risk factors.

With me this morning are Bill Skoglund, President, Chairman and CEO of Old Second Bancorp; Jim Eccher, President and CEO of Old Second Bank and COO of Old Second Bancorp; and Joe Marchese, Executive Vice President and Chief Credit Officer. Joe will not be in the presentation portion this time around, but he will be here for questions at the end.

And now to kick things off, I'll turn it over to Bill.

Thanks, Doug. Good morning. I'd like to start with some opening remarks and then turn it over to the rest of the group for the more detailed information and follow that up with some questions at the end.

We do appreciate everyone's interest today and look at this as a relatively positive quarter and very similar to the second quarter, in fact, our third consecutive quarter of mainly improving results.

Three areas to look at, or four areas to look at -- one, net income. On the bank side, the Bank continues to be profitable. The Bank showed a profit of $275,000 and year-to-date is making $1.7 million. We did have losses at the Bancorp before TARP; we lost $1.4 million. And at the Bancorp after TARP, we lost $2.6 million.

And I did want to point out a few selected year-to-date expenses that are somewhat unique to our current problems which I think we're working through.

Through nine months, our OREO expense was $16.6 million. We've put $7.5 million in the provision for loan losses. We have extraordinary insurance expenses that were over 2010 of $2.1 million. And our legal expenses year-to-date are $2.9 million. So it's a total of $29 million for the nine months. And although we are not where we ultimately want to be with a small profit at the Bank and small losses at the Bancorp, if we can reduce or eliminate some of these current expenses relating to problem assets, I think we could still show some good profitability.

The second point I wanted to cover was capital ratios at the Bank, which is what we closely follow. As we've reported before, we do have some regulatory ratio minimums. The leverage ratio for the regulatories group is 8.75%, and for the total capital, 11.25%.

As of September 30, we were at 9.52% on the leverage; that's up from 9.1% in June. And on the total capital we're at 12.98% versus 12.61% in June. So comfortably above the regulatory requirements. And we've got enough capital now that I think we can begin to look at maybe growing in certain areas.

In fact, our Texas ratio calculated for the regulatory calculations is down from 117% at year end to 96.52%, so we are under the 100% Texas ratio.

The third area is loans. And I like to look at problem loans that are on nonaccrual, which are the most problematic, and problem loans accruing instead of just nonperforming loans, which include both.

Problem loans nonaccrual -- we ended the quarter at $122 million; and that is down from $212 million at the end of the year or down $90 million from year end. It's our third consecutive quarter of reduction. The first quarter we were down $34 million; second quarter $18 million; and now the third quarter, down $38 million. And we are down $108 million from our peak of June 30 of 2010, or down 47% from that peak period.

As far as loans accruing, those also dropped to $133 million from $178 million, and so a total of difference of down $135 million from year end.

The OREO properties were up to over $101 million from $76 million at the end of the year. So it's a good reduction in problem loans with a migration to OREO and some being paid off; some of them being -- their ratings improving.

We're starting to see the markets improve for sale of OREO. And we're starting to see appraisals if not stabilizing -- some areas are stabilizing. Some are not going down as much and improving in areas like multifamily properties. We continue to look at all our options for reducing OREO. And this is a high priority for us to continue to see these problem loans and problem assets reduced.

As far as the allowance, I did want to mention that. Our allowance is down from the year end. It was $76 million at the year end. It's down to $60 million now. And although reserves are down $16 million from the year end, which is a 21% reduction, problem loans are down $135 million or 35%. And we like to look at the ratios as compared to problems -- our reserve as a percentage of nonaccrual loans are up to 49% from 36% at the year end. And our reserves from all problems are also up about 4%. Our reserves to total loans are about 4.2%.

So despite the fact that we still have a lot of work to do and we are fighting a number of headwinds with the economy and other political issues, I continue to be cautiously optimistic that we have turned the corner on getting control of our problem loans. And with our improved capital position, especially at the bank, we can now begin to change our strategy from capital preservation to one of capital stability, which puts us in a position to begin stabilizing and growing again.

So that would end my comments. I'll turn it over to Doug for some more detail on the financial part.

Okay, Thanks, Bill. Net income, as Bill mentioned, net income available to common shareholders was a loss of $2,580,000 for the quarter and $7 million for the year to date. This compares to a $1.2 million loss available to common in the third quarter of 2010 and a $35.4 million loss for the first three quarters of 2010.

The third quarter of 2011 is the third consecutive quarter of relatively modest loss available to common and improving asset quality.

The subsidiary bank is profitable for both the quarter and the year to date with net income in the third quarter of $275,000 and $1.7 million for the year to date. The decline in the provision for loan losses was the biggest factor in comparing 2011 and 2010 quarterly and year-to-date earnings. In 2010 the provision was $11.8 million in the third quarter and $75.7 million for the year to date. In contrast, this year the provision was $3 million in the third quarter and $7.5 million for the year to date.

The net interest margin has been fairly steady at 3.63% in the third quarter of 2011 from 3.60% in the third quarter of 2010. For the year to date the margin was 3.57% and improving modestly each quarter. For the nine months ended September 30, 2010, the margin was 3.67%.

Total assets were $1.9 billion as of September 30, 2011 from $2.3 billion a year earlier. Of the $357 million decline, $40.7 million of it occurred in the third quarter of 2011, reflecting a slowing of the decline on assets.

Now that we've exceeded the Bank's capital ratios that we targeted, we have begun to invest liquid funds and securities available for sale rather than seeking to shrink the bank further. This is demonstrated by the fact that securities available for sale increased $42.6 million during the third quarter after remaining relatively flat in the first and second quarters.

Deposits totaled $1.7 billion as of quarter end compared to $1.9 billion at year end 2010. Most of the decline came from CDs and the roll off of CDs is helping support the margin. We have consistently pursued pricing that benefits customers who have multiple services, so for the most part the reduction in deposits is explained by the exit of single service customers.

In comparing year-over-year and non-interest income, we need to separate two nonrecurring items in the third quarter of 2010. These were a BOLI death benefit of $938,000 and a $2.6 million gain on a lawsuit. Excluding these items, non-interest income declined from $11.1 million in the third quarter of 2010 to $8.5 million in the third quarter of 2011. Most of the declines in both the quarter and the year to date are explained by a decline in mortgage business, and to a lesser extent, by the difference in securities gains and losses.

Again, this quarter, noninterest expenses were down for both the quarter and the year to date. For the third quarter, the largest decline was in salaries and benefits, which were down 13.5% compared to the third quarter of 2010. For the year to date, salaries and benefits are down 6.2%.

One item that increased was insurance, which increased by about $2 million for the year to date and $680,000 in the third quarter.

Other real estate expenses were flat in the third quarter of 2011 compared to the third quarter of 2010, but down for the year to date. Other real estate expenses were $18.6 million in the first three quarters of 2010 and $16.6 million in the first three quarters of 2011. The decline in year-to-date other real estate expenses is primarily due to a reduction in loss allocations on property values. The year-to-date loss allocation on other real estate was $14.5 million for the first nine months of 2010 and $9.2 million in the first nine months of 2011.

And finally, regarding capital, while the tangible common equity ratio is 0.15% at the consolidated level, the Old Second National Bank capital ratios have increased significantly. The total capital ratio was 12.98% and the leverage ratio was 9.52%. So since one year ago, the total capital ratio increased by 157 basis points, and the leverage ratio increased by 114 basis points. This puts the Bank in a strong capital position.

That's my part of the presentation. At this point I will turn it over to Jim Eccher.

Thanks, Doug. The central theme in the third quarter, as both Bill and Doug pointed out, is that our Company continues to reduce the level of its non-accrual of problem loans. Total classified assets and accruing loans 30 to 89 days past due both declined again this quarter. And although we have quite a bit of work ahead of us, we continue to make good progress on reducing our balance sheet risk.

Non-accrual loans declined 24% in the third quarter after an 11% reduction in the second quarter. And nonaccruals are now down 47% from the peak, which was in June of last year. Total classified loans declined 15% on a linked-quarter basis and are now at their lowest levels in over 2.5 years.

Internally, our focus continues to be on credit remediation and capital stabilization. We continue to reduce our exposure to both commercial real estate loans and construction-related credit. Those efforts are proving successful and are ongoing.

Loan growth has not been a priority the past few quarters, but as we stabilize our capital position, business development will become more of a priority over the next few quarters. We expect the loan portfolio to continue to contract the next few months as loan demand in our core markets remains pretty weak.

Our credit remediation initiatives were affected as more properties migrated into OREO in the quarter. Our OREO portfolio of $101 million increased $18 million in the third quarter. OREO inflows exceeded outflows by a pretty wide margin in the quarter. However, based on current sales activity and contracts for sale, we expect OREO outflow to accelerate next quarter.

We controlled adverse loan migration in the quarter through strong portfolio management and extensive loan review. Continuing the trend from the first two quarters of the year, we were effective in reducing nonperforming assets through a variety of remediation efforts. Our special assets group continues to make good progress on several fronts.

We continue to investigate bulk loan and OREO sale opportunities with third parties and based on current market conditions, we feel opportunities to sell OREO are more probable than a bulk loan sale at this time. Internal efforts to sell OREO are netting anywhere from $0.87 to $1.12 at par.

As Doug mentioned, our provision for loan losses of $3 million in the quarter was up $2.5 million from the second quarter, although year-to-date through three quarters, our provision is down $68 million from the like period of a year ago.

Credit metrics improved really in all loan types for the quarter. Commercial real estate remains our largest challenge today, consistent with prior quarters. Most of the stress in the commercial real estate portfolio remains in the retail category, mainly strip malls and special purpose real estate, where net operating income is diminished due to economic conditions in our market. And while the retail category represents less than 5% of our entire loan portfolio, it does represent about 30% of our nonperforming loans in this commercial real estate segment.

The good news is that retail nonperforming loans did decline 24% in the quarter due mostly to OREO migration and further charge-offs.

Most of our nonperforming loans in the retail strip category are in properties that are partially leased, which should produce opportunities for restructuring significant portions of the portfolio around documented cash flow.

Our second highest nonperforming segment is in construction and development. This portfolio continues to slowly wind through the cycle. And as we've communicated in prior quarters, the portfolio continues to shrink as properties are sold and charge down. The construction and development portfolio is now down to $78 million, which is lower by 18% from a quarter ago and now down over 83% from the peak in the third quarter of 2008.

Of the $78 million in balances, over half of it is nonperforming and two-thirds of it is already adversely rated. We have continued to see a pretty steady flow into OREO and the construction category, and we're seeing continued modest increases and opportunities to sell these assets.

On the valuation side, we're still seeing a few construction and development appraisals with valuation declines. Most of that in the retail lot segment. Many construction properties are declining at a much slower rate as heavy discounts were applied in prior periods. And we haven't really seen any new material migration in this segment in the last three quarters.

Beyond commercial real estate and construction, we continue to have one- to four-family residential loans make up the next largest share of our nonperformers. The local housing market remains challenging. We currently have about 16% of the portfolio in one to four residential loans. But we're seeing increased sales efforts in OREO properties in this segment, and we are moving about $1 million per month over the last several months at or near par, on average, in the residential area.

Nonperformers in this category declined for the fourth straight quarter. Losses remain a pretty low percentage of the portfolio and a modest percentage of total charge-offs. And we think this trend will continue.

Our C&I exposure remains relatively low, represents about 10% of the portfolio. And our losses in nonperforming totals within that portfolio have been minimal. We only have about $2 million in this category of nonperforming, and no losses were recognized in this segment in the quarter. The C&I portfolio continues to perform well, and we do not anticipate large losses in C&I.

I'll now turn it over to the moderator and we can certainly address any questions you may have.

(Operator Instructions). Brian Martin, FIG Partners.

Maybe just a couple of questions here. Doug, you talked a little bit about the expenses and what's still in the income statement as far as related to resolving some of these credit issues. Can you just give a little thought or just a little -- expand a little bit on your outlook as far as how long it's going to take to bring some of those costs down and maybe just your thoughts on doing so, and maybe just getting back to profitability at the holding company -- kind of how you see things unfolding here.

Well, that's a pretty broad question. I guess the credit-related costs, legal fees, expenses, and other real estate -- obviously, we're going to have -- it's going to take some amount of time to get rid of $100 million in other real estate unless we're able to do a significant bulk sale. The good news on that is that a year ago about 75% of the expense in that line item was really loss allocations as the property values were continuing to decline. That portion of it is less currently, so really the real cost to carry, separating the valuation issue, is much less than it appears at first glance. So we've seen a slowing of the decline in values, stabilization in some property types, so that a portion of the expense should continue to decline. But obviously, we're going to have some expenses until we can reduce the volume of property in there.

As far as other things go, we're continuing to take a hard look at expenses. You can see that we reduced salaries and employee benefits during the quarter. Everything is on the table as far as keeping control of expenses.

But I think now that we've reached the capital ratios that we need to at the Bank level, one hope for earnings in the long run is to turn back to a growth mode and be able to put on some profitable assets.

Okay.

We're kind of optimistic too, Brian, on the mortgage division, which didn't do real well the first couple quarters. It's starting to pick up again rather dramatically. So I think we're more optimistic from our mortgage group that we'll see some picked up income there.

And Jim mentioned -- he talked about the improvement you guys saw in the classifieds in the quarter. How are the special mention credits I guess tracking at this point? They were down from the first to the second quarter -- I think they were somewhere in the [$6 million to $7 million] range. Did those go down as well this quarter? It seemed like the nonperformings going down with the classifieds going down, the trend would be similar with the special mention credits. Is that probably accurate?

No, Brian. We did see an uptick in special mention, but most of that -- the bulk of that -- was due to internal upgrades, borrowers improving their core operations, which allowed us to upstream those and upgrade them to special mentions. We did not have a whole lot of adverse migration from past to special mention.

Okay. Our practice, Brian, is if something is sub-standard we tend to not just make it pass; we tend to move it to watch for a quarter and make sure everything is holding and then tend to move it up. So some of the movement from the substandard categories went to watch. And we're hopeful -- or optimistic that next quarter we can end up passing them. We likely do a little more conservatively than just pass them right away.

Okay. And then just one last thing, was the -- the inflows to nonaccruals in the quarter, do you have an idea of what those were? I think last quarter they might have been in the $20 million, $23 million range, which was down from the earlier quarters of, you know I think previous couple quarters of the $40 million and $30 million range. Were they pretty stable or did they go down? What was the movement there?

Not total -- looking at just inflow versus outflow, right, it was less than $20 million. I can get you that exact number, but there was definitely a slowing of adverse migration in really -- in the nonaccrual and in the problem accrual.

All the categories. Okay, all right. That's good enough, Jim. I just wanted to get a sense of what the trend was there on that. So, all right. Thank you, guys, very much.

John Barber, KBW.

Good morning. It sounds like there's a big initiative at the Bank just to move OREO properties. Wondering, can you give us a sense of how current-year appraisals are? Thanks.

John, this is Joe Marchese; I am the CCO. Actually, our appraisals on OREO properties have to be updated once annually. And -- or as the loans migrate into OREO, we have to request fresh appraisals. So all of the appraisals are less than 12 months old and the new OREOs would be very, very current.

We also take a case though, of -- if please see the trend is moving down on certain properties, we'll adjust those downward in between that appraisal. So we are constantly looking at certain categories like lots. And if we see lots or moving down or land is, we'll adjust those before we get the appraisal. So our goal is that when we get the appraisal, there's not too much of an adjustment.

Okay. And Doug, you mentioned that you're growing the securities portfolio. Just wondering what you're investing in, what kind of duration is.

We're keeping it pretty short. A lot of these are floaters. We have invested in corporates, which we didn't do previously. We're just trying to -- we've had some excess liquidity. And instead of earning 0.25 point at the Fed, we're trying to pick up some spread.

Great, thank you.

(Operator Instructions). Stephen Geyen, Stifel Nicolaus.

Maybe just one additional question on OREO. Just curious if you have some idea of what the holding value is versus the original value of the loans.

Steve, we'd have to get you that off-line. We don't have that number handy right now.

Okay.

And you know, as I mentioned in my comments, though, we have been very proactive in our marks and typically won't wait a year to make valuation adjustments. I think that is evidenced by the fact that the OREO sales that we've been able to execute on a one-off basis internally, we're netting very close to par, in some cases, over par. So we feel pretty good about our marks.

Okay. And Bill, you had mentioned a shift from capital stability versus capital preservation. And maybe some additional thoughts on your outlook for loan balances -- period-end loan balances and whether you're considering a bulk sale of performing loans as well as OREO.

Steve, we've been running off loans either through pay downs of customers or when loans get paid off or we sell them or move them to OREO, so our challenge today I think is we still have $122 million of loans nonaccrual that we're hopeful to move out of here. We'd like to replace those loans. And we would like to start to grow a little bit. We're selective on our growth. We're looking at good credits, relationship kind of lending, C&I lending. And it's difficult to find those.

We're starting to gear up with that again. We've hired a few new commercial lenders. And we're still -- but we're -- it's not a turn on the switch kind of a thing. It takes a little while to do that and to get our marketing. We're starting to move any problem loans away from the lenders to the special asset group. And we've -- Joe could to speak to this, but we've beefed up that group to move these out.

We have in the past looked at selling loans, nonperforming loans, but the groups we've talked to, Stephen, for example say, well, put some good loans in there and only discount them 15%. And we're trying to hold onto the good loans now, so we're not really interested in sprinkling good loans into that.

And that market is still pretty difficult. I think that there's probably some potential for the OREO markets as we see -- as we have $100 million in there, and we're starting to see values stabilize -- we're going through the process again now to look at the market -- the wholesale market on what if you sold some properties. We seem to be getting a lot of interest from that from a lot of different groups. We haven't got some of the results back yet or bids back yet, but we're going to look at that and see if there's a way we can move the OREO faster.

And I think we're making some good progress moving the problem loans nonaccrual, but we've still got to move the OREOs. So that's $100 million today. So that's our challenge, is still to move those.

And Joe Marchese, who is our Chief Credit guy, might speak a little bit to what they're doing in the workout group and how you're trying to sell some of these OREOs. So Joe, you want to speak to that?

Yes, Stephen, actually, as Jim referred to earlier, we have had pretty good success at selling the OREO properties at fairly close to par. Over the last six months or so, the range of the sales have been between 87% and 112% of book value. And keeping in mind that our book values are marked-to-market based on appraisal and actually 90% of appraisal value because we allow some cushion in there for expected liquidation costs, so we feel pretty good about those values.

And we are making monthly reviews and adjustments to the OREs as the market indicates. We're only marketing to serious investors, although we do have some of those smaller properties listed with local realtors.

And the timing, actually, is much healthier now. We feel the market in most sectors has bottomed. Appraisal values have stabilized and have actually gone up slightly in certain areas. And then based on that, we've seen a lot of money that has been sitting by the sidelines come back into the market. And what it is resulting in is more realistic offers on the OREO properties that we have.

We have doubled the size of our staff in special assets in order to gain more velocity in the liquidation of these ORE properties. That's a relatively recent event. It hasn't quite taken hold yet, but we expect over the next quarter or two that we're going to see some acceleration in the pace of the liquidations in the OREOs.

And part of that, Stephen, is we've taken away these problem loan management away from -- or trying to take it away from all the lenders so they can get out and start working on new business. So that's a significant step that we needed to take in order to get that growth. And so it's going to take a little while to move from it, but we're starting to do a full-court press on that.

Okay. That's helpful. Thank you.

(Operator Instructions). [Brian Hipp, Hipp Law Office].

A quick question -- I was just reading the 8-K and I had a question about the July 2011 written agreement and what was the impetus for entering that agreement? And if you could give me more detail on what's in the agreement.

Well, Brian, that's an agreement with the old CC. It's a public record, I think, the one you're talking about. Or is it -- there's also one with the Fed that joined that --

With the Fed.

The Fed is pretty much just similar to the OCCs, protect the -- there's no real different conditions on that. It's really comply with the OCC.

There's no change from the OCC?

No, it's really comply with the OCC; restricts us from dividends and some things at the Bancorp, but other than that it's pretty much the same.

Okay. Thank you.

(Operator Instructions). We appear to have no further questions. I'd like to turn the call back to our speakers for any closing comments.

We appreciate your interest in the Bank. Again, we're looking at this as a relatively positive quarter and that we've put together three in a row. And hopefully we can continue to do that. And our ultimate goal is -- number one goal is to reduce these problem loans, keep the capital up, and return to profitability as soon as possible. So again, we appreciate your interest and thanks for calling in.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.