Old Second Bancorp Inc (OSBC) 2020 Q1 法說會逐字稿

Good morning, everyone, and thank you for joining us for today's Old Second Bancorp, Inc.'s First Quarter 2020 Earnings Conference Call. On the call today is Jim Eccher, 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.

I will now turn the call over to Mr. Jim Eccher. Sir, the floor is yours.

Thank you. Good morning, and thank you all for joining us today. I have several prepared opening remarks and will give you 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 some Q&A.

Net income was $275,000 or $0.01 per diluted share in the first quarter. Earnings this quarter were negatively impacted by a sizable provision for credit losses of $8 million associated with changes in economic assumptions primarily driven by COVID-19.

We also recognized $635,000 in accelerated interest expenses due to the redemption of TruPS and $2.1 million in mark-to-market losses on the value of mortgage servicing rights associated with the movement of interest rates during the quarter. The core net interest margin showed strength during the quarter due to reductions in deposit rates and the muted contraction of LIBOR relative to other rates. Brad will provide additional color on the margin in a moment.

Absent these items, overall fundamentals and earnings trends were relatively stable and consistent with last quarter, though we did see mortgage banking results rebound from a seasonal slowdown in the prior quarter. Old Second has taken a number of steps to protect our employees, customers and communities. For our customers, our locations remain open and available, albeit with necessary safety precautions. We are continuing to work with those that have been directly impacted, and we are offering the ability to defer payments as appropriate. The vast majority of our staff has been working remotely for well over a month without issue. Old Second is proud to serve our communities, and I couldn't be more proud of the efforts of our employees in supporting our customers and each other in what is proving to be a very difficult time.

We are fortunate that our core lending strengths have steered us clear of many of the most impacted industries. We currently have 0 direct energy or aircraft exposures in our loan portfolio. Hotel lending is limited to 3 mature credits at low loan to values totaling approximately $14 million. Direct restaurant exposure is less than $20 million across both commercial real estate and C&I portfolios, and a significant percentage of those is focused in major fast food franchises. We realize the potential exists for these industries to be significantly impacted in the short term. We also believe few sectors will be spared difficulty in the immediate near term from the implications of rising unemployment and falling consumer and commercial demand.

Our base economic forecast at March 31 contemplated a significant decrease in GDP and an unemployment rate in the high single to low double digit percent, both in 2020 and over the life of loan portfolios. In only a 2-week time period, we went to a 0 fed funds rate in an inevitable near-term recession in a low to flat yield curve that gives all commercial bankers nightmares. Industry-wide stress tests are one of the real positives that came out of the last financial crisis, and I think we've done a real good job with our stress testing. However, I doubt any bank has imagined, let alone modeled, these circumstances. I don't recall ever seeing any consultant propose modeling 50% drop-offs in revenues in certain industries in less than a month. This is new territory. We will have some losses at some point, but we do believe our portfolio is well diversified and will hold up much better than most. Importantly, we believe our capital and liquidity position are as strong as they've ever been.

In regards to the first quarter specifically, total loans increased $26.4 million from last quarter with a strong level of originations mitigated by continuing payoff activity. We did not see a significant line of credit drawdown at Old Second in the first quarter. Thus far in April, line drawdowns have continued to remain muted. In a very short period of time, we saw a fairly robust loan pipeline mostly disappear. Concurrent with this, we quickly froze any lending activity that featured cash out refinancing. The about-face in economic outlook means that the loan growth expectations that we shared with you a few months ago are no longer relevant. I do not expect to see significant loan growth for the remainder of 2020.

Total deposits bounced back nicely on both a period end and average basis, and growth has remained strong thus far in April as well despite the reduction in rates. The loan-to-deposit ratio for the first quarter of 2020 has modestly improved at 89%. I believe we can remain at this level for the near term with modest loan growth funded by a mix of deposit growth and modest balance sheet optimization. Thus far, through April 21, we have processed deferrals in our loan portfolio for 130 loans totaling approximately $40 million in principal or 1.8% of commitments outstanding. The largest contributors to these requests have been churches, child care services and residential mortgages, which together make up approximately half of the requests.

In terms of the Paycheck Protection Plan, Old Second has approved and funded approximately $80 million in April. We have another $43 million waiting processing and believe some additional requests will continue to come in. We are committed to doing what we can to help our customers on this front. We will attempt to isolate and report on the impact participating in this program has on our financial statements for investors. Overall, we remain cautious but surprisingly encouraged about our results in a number of areas.

And I'll turn it over to Brad who can give you more color in his prepared comments.

Thank you, Jim.

Net interest income declined by $531,000 relative to last quarter due to an acceleration of $635,000 of interest costs associated with the termination of $32 million of trust preferred securities. Absent this item, spread income has held up very well and should continue to benefit from interest savings on this retirement going forward. Approximately $20 million of the payoff was financed into a 3-year term note at LIBOR plus 175, a substantial savings relative to the 7.8% cost of the TruPS.

Fee income trends were soft relative to last quarter with the exception of mortgage banking sale gains. Servicing rights experienced a sizable write-down based on declines in interest rates during the quarter as well. The reported taxable equivalent margin decreased by 9 basis points from last quarter, with the majority of the contraction due to the onetime accelerated amortization of TruPS issuance costs.

We reduced deposit pricing across the board in late March based on Federal Reserve rate movements. A full quarter impact of these actions should be evident in the second quarter results with reductions beyond that more modest in effect as time deposits mature and reprice.

The adoption of CECL resulted in an $8 million increase in the allowance for credit losses for both funded loans and unfunded commitments. This is at the high end -- and $6 million exclusive of unfunded commitments. This is at the high end of the range previously provided and resulted in an adjustment to equity net of purchase accounting implications and deferred tax adjustments of $3.7 million on January 1. The change in economic outlook resulted in an additional $8 million for credit losses in the first quarter. This economic outlook for us is characterized by a near double-digit unemployment rate and a 15% to 20% underemployment rate. Notably, it reflects a high single-digit unemployment rate over the remaining life of the loans, a substantial change.

As Jim mentioned, Old Second has minimal exposure to the hardest-hit industries and a very strong credit culture overall. This quarter's provisions result in reserves in excess of 2.5% on the consumer lending book, which features no subprime exposure at origination. Reserves across the commercial book have been increased by 25% relative to January 1 and by 46% relative to December 31.

Our efforts in the coming quarters will be on helping customers, funding quality loan growth as we find it and maximizing core funding with the expectation of further modest contraction in margin trends beginning after the second quarter of 2020. The degree of contraction in the margin will be completely dependent on LIBOR trends. I do not currently expect that the current level of spread between overnight swap rates and short-term LIBOR rates is sustainable. The longer this spread remains elevated, the better our margin trends will remain and vice versa.

Our capital and liquidity levels leave us extremely well positioned, and we have ample flexibility to continue the pursuit of quality relationships while protecting the franchise and our customers.

On the fee income side, mortgage banking reflected a significant increase in gain-on-sale margins and volumes during the quarter, although the MSR valuations for the first quarter compared to the fourth quarter was ugly. Trust and wealth management softened a bit and retail banking trends slowed modestly in both fees and card activity. Notably, card activity continues to be even softer in April.

Expenses remain well controlled with additional sales hires in 2019 are anticipated to be largely offset by seasonal factors in the remainder of the year and some likely modest expense initiatives in the remainder of the year as the depth of the economic strain becomes clearer.

With that, I'll turn the call back over to Jim.

Thanks, Brad.

In closing, we remain encouraged with these trends, confident in our balance sheet and ready for the challenges ahead. On a core basis, Old Second is operating at a very high level, and we are excited about the quality of talent added to the organization. We have taken steps to position ourselves well for a potential slowdown and recession. We believe our credit and underwriting has remained disciplined and our funding and capital position is strong. Overall, the team has never been better, and at some point, I remain optimistic that opportunities will be available to improve our footprint. The focus for us is on timing and making sure that we have the balance sheet, liquidity and access to the capital we need in order to take advantage.

That concludes our prepared comments this morning. So I will turn it over to Jess to open it up for questions.

(Operator Instructions) We'll go first to Chris McGratty at KBW.

Brad, let me start with a question on the margin. Just want to make sure I understand kind of the numbers. If you add back the charge that ran through the margin from the preferred or the TruPS redemption, it looks like margins were kind of in the mid to high 3.80s. If I take your prior comments that each cut roughly were 3 to 5 and effectively, we got 6 last quarter, that would suggest somewhere in the realm of 25 to 30 basis points of pressure, assuming the LIBOR dynamic flushed itself out. Is that the right way to think about margins kind of trending towards that 3.60% range more or less over the next several quarters if that relationship holds?

I agree with that completely, Chris.

Okay. Okay. So 3.60%. Could you speak to, I guess, a couple of items on the margin. Was there notable accretion in the quarter that we should draw out?

The accretion volatility that we saw was largely due to credit outcomes, which has now been removed under CECL. It is much more predictable and you get into a discussion of what is excess accretion versus what is normal accretion. I define excess accretion as the amount that's accretable over and above the contractual coupon of the asset. The excess accretion for this quarter was less than $200,000. So largely going forward, I expect it to be remarkably stable and don't expect to be talking about it much.

Okay. Okay. Maybe kind of a question for you, Jim. Given the revenue backdrop that we're all facing, could you speak to investments that you may or may not be making and kind of the pace of expense growth from here? I think first quarter is a little bit higher. Understandably, it was a little seasonal.

Well, as far as our biggest investments last year was obviously in new talent. We brought on half a dozen new lenders in the fourth quarter which we're very pleased about. Absent that, we're not projecting anything in the near term. We've got potentially a couple of capital projects we will probably suspend the remainder of the year, but we do not see any sizable investments outside of some software upgrades.

Okay. And so if I take the roughly $21 million that you had this quarter, my guess, Brad, is that, that number comes down from seasonal and just kind of holds from there. Is that a fair assumption?

I expect we'll trend towards a $20 million level before we move -- $20 million quarterly level before we move to any expense cut initiatives.

We'll go next to Nathan Race at Piper Sandler.

Maybe just first, curious to kind of hear what you guys are seeing from clients in terms of loan deferral requests. And just what are your outreach efforts with your customer base on the commercial side of things that have resulted in terms of how you guys are perhaps stressing the loan book just with everything going on today?

Yes. Maybe surprisingly, thus far, we have about 1.8% of the loan book that have made requests for abatements or interest only. We certainly expect that to accelerate as long as the shutdown lasts, but we continue to stress test the portfolio on a quarterly basis a lot. We feel pretty good about the loan book overall. One of the sectors we were very worried about was our church exposure, which was about 2.5% of the loan book. Surprisingly, that sector has been very resilient. We're hearing they're doing a lot of services on social media and tithing continues. So that's kind of surprised us. Absent that, we have no direct exposure to some of these hard-hit areas. Obviously, the indirect exposure is what we're focused on today, particularly retail, and we're diving deep into that portfolio now. But so far, we feel pretty darn good about it.

That's great to hear, appreciate that commentary, Jim. And then just going back to the margin. Brad, I think you alluded to the fact that you guys cut deposit rates at some point in the first quarter. I'm just curious if that occurred more so late in the quarter and then we should expect kind of a more perhaps relatively pronounced drop in deposit costs into 2Q. Obviously, you guys had a pretty low beta over the course of deferred tax incentives that you kind of mentioned there's a trend in there, but just curious in terms of what you expect on the magnitude of deposit cost cuts in the second quarter.

I think the cost of our non-time deposits will trend towards 10 basis points relatively quickly. And as promos wear off over the remainder of the year, namely 150% promo money market that we were offering for a period of time, as that matures, they should trend towards 6 basis points. Time deposits over the next 2 years, probably more like 12 months, will trend towards 50 basis points. Our all-in cost of deposit funding will be very, very low. I think everyone understands that we are in a 0 rate environment. I think safety and soundness matters. I think that the quality of a deposit franchise despite low rates will still matter, especially in times of stress. Wouldn't trade our position on the liability side for anyone. And the same is true on the asset side.

Understood. That's helpful. And then just lastly on wealth management and trust fees, and I appreciate there's obviously some headwinds there. But I guess I'm just curious if the 1Q run rate is largely reflective of the equity market valuation pressures that we have seen recently or if you guys are expecting another step-down in that line item entering 2Q.

No. I think given the fact how far markets have bounced back, the percentage of market-sensitive revenues, I don't expect a lot of pressure from that level.

(Operator Instructions) We will go next to David Long at Raymond James.

Jumping around here a little bit, but the fees on your payroll protection program loans, most banks have been talking about running in the vicinity of 3%. Where do you guys stand on that on the loans that you guys have gotten approval for?

Yes. We're taking requests as they come in, and they're far ranging, right? But I think 2.5%, 3% is probably the right way to think about that.

Okay. Got it. And then you guys were pretty opportunistic to hold off on buying back stock, and then this quarter you did move forward with the stock repurchase and got at a pretty good discount here. What are your plans for share repurchases here in the near term and then again looking out over the longer term as well?

I actually don't know. I think that we executed at a weighted average price of a little over $7 in the first quarter, specifically the last part of March. It's difficult, right? I am extremely comfortable with our capital position. I am extremely comfortable with what our credit quality looks like. I'm extremely comfortable with our reserve levels based on the economic scenario that we see right now. That being said, there are 26 million jobless claims, which implies an unemployment rate somewhere just south of 20%. That has profound implications. I also know that the safety and the soundness of the bank is, in my opinion, very strong. And a component of that and the perception of that, which I believe has been out of line, has been the valuation of the stock relative to others even. So it's difficult for me to rule out that we wouldn't be there to repurchase the stock given what we see relative to what the perception is. That being said, our first priority is the safety and soundness of the bank and the safety and soundness of our customers and serving them. So I can't tell you that our thoughts are fully formed on that front.

Got it. No. I appreciate your thought process on that and it makes sense, makes sense. On the reserve building side, any guidance on how you're thinking about that as we get to June? In what scenario come June 30 would it cause another reserve build similar to what we saw here in the March quarter?

I think the most significant part of our reserve build is the underemployment factor. Everybody is coming in at an assumption of a double-digit or a near double-digit anyway unemployment rate. And I think that they are assuming based on some surprisingly low reserve levels that I've seen elsewhere that it is a short duration phenomenon. I don't believe that to be the case. I think that when you talk about the level of revenue stoppages for large swaths of the economy, you talk about something that has persistence. And so we have assumed a persistently low underemployment for a long period of time, specifically the entire life of the loan portfolio. I can't tell you that doesn't mean more reserves in the second quarter. As I sit here today, it doesn't. But if we continue to see $5 million and $6 million and if we continue to see white collar jobless claims following what has been largely a service sector phenomenon at this point, which I believe will happen, then there could be modest further additions to the reserve. I think that anybody that tells you that things are going to be better in September isn't looking at the same data that I am in terms of the overall economy. And we have seen very little change in delinquency. We have seen very little change in terms of line of credit drawdowns. We have seen relatively extremely light modification requests up to this point relative to others. But I am under no delusion that, that will continue if people continue to lose their jobs.

We'll go next to Brian Martin at Janney Montgomery.

Brad, if you went to a greater unemployment percentage from that 8% to 10% maybe that you've got now, how much of a reserve build would that necessitate if you went to a 15% level in the short term and then maybe moving back down, at least if you're saying kind of the data suggesting 20%, I guess, if you go higher earlier and then have a tail off how much could that necessitate based on the models you guys looked at to the reserve?

Quite frankly, not that much because what we've assumed is that the unemployment rate is persistent. I'm not sure that others are doing that. A short-term spike into the high teens or low 20s that isn't persistent wouldn't have a great deal of impact on reserve levels. That being said, I don't believe that a 20% unemployment rate is remotely possible over a sustained period of time, a sustained period of time being 3 years. The American economy is simply stronger than that, but I do believe that a 15% to 20% underemployment rate over the life of a loan portfolio is an extremely bearish assumption for which we have already taken.

Right. Okay. That's helpful. I appreciate it. And just you guys outlined the limited risk to these sectors that are kind of more highly to be impacted by COVID. But the -- if you look at the portfolio today, where do you guys view the greatest risk in the portfolio?

Well, Brian, as you know, our portfolio looks vastly different than it did during the last recession. We've spent the better part of the last decade diversifying the loan book, and we feel pretty darn good about it. That being said, there's always risk in construction lending. Going back to the last recession, it was over 20% of our book. Today, it's 5% roughly. A lot of that's commercial construction. It's still ongoing, and we've got pretty good sponsors behind it. Absent that, anything with a retail focus right now poses risk the longer this shutdown happens, right? So that's where our main focus is.

Okay. And the retail, I guess, exposure, Jim, maybe just how big is that? And just do you guys have kind of -- have you disclosed kind of any loan to values or debt service coverage levels that you can share or is that?

Yes. I mean I can tell you, Brian, before COVID hit, we did a complete review of the retail portfolio, and there were no real issues there. Tenancy was strong, good sponsorship. LTVs were in line. Obviously, now all bets are off. That sector bears watching, and we're starting to see some loan deferment requests come in. But the reality is over the next 90 to 180 days, we're prepared to do abatements and deferrals during this tough time. So we still feel pretty good about the sponsorship behind it and the quality of the tenants, but the retail sector will not be immune to this as long as this goes on.

If you look at the graphs in the release that were provided, one thing we omitted is the actual balances there that make up those pie charts. The first one represents a balance of $850 million, and the second, which is the investor commercial real estate makes up a balance of $514 million. Now I would tell you that this looks very different from a number of banks in our market. That level of concentration in real estate and owner-occupied properties is something that's very unique in the Chicago MSA. I don't know of another bank that looks like us from that standpoint. When you talk about -- if you look at the first graph, it indicates a 10% retail trade position relative to an $850 million number, a substantial portion of that has been in essential industries, namely gas stations. There are when you look at the accommodation and food service number of 2%, a substantial portion of that is grocery stores. So we have -- I wouldn't get caught up in terms of something labeled retail in these pie charts and be assuming that, that's a high-risk area because it's simply not. The overall portfolio will be very resilient in my estimation based on the information I have today for at least the next 180 days. My concern is largely off a broader pull-through in the wider swaths of the economy, which is what CECL is meant to do, which is why our economic forecast change. I want to be quite clear on the fact that our reserving is not based on anything that we've seen in terms of trends in delinquencies or communications with customers. It is strictly a byproduct of the economic numbers that are evident in financial releases up to this point.

Yes. Got you. No, that's helpful, Brad. And maybe just the last one for me, just to understand that the PPP program, Brad, just as far as the benefit, as it works through the income statement, is that a margin event? And just, I guess, if you kind of quantify, I mean, I guess if it plays out the way you're anticipating and you -- I think you said $75 million or so was the number and if you use a 2.5%, 3% level, it's about $2 million, that benefit that you realize, can you kind of give a time line of how you're thinking about that manifesting itself into the income statement?

Well, it's $80 million in terms of what's been funded so far. Based on the expansion of the program, we've got another $40 million in the pipe. That weighted average fee is going to be, as Jim mentioned, somewhere between 2.5% and 3%. I don't know. The stuff that's still working its way through is going to be in the 5% bucket. So I think there's some upside to that number in terms of how that does. Now the fee will work itself through. The spread on these assets is obviously very low and it would be -- we are in a Fed fund sold position and a substantial one. We will use that excess funding. So we'll see the full policy spread. To the extent that we get significantly more than the $80 million that's approved now, we may access the Fed provided facility in order to fund that, but these are short duration assets. My intention, as I sit here today, is to break out specifically both the interest income and expense that results from this and give you a margin that is independent of participation in the program.

Okay. And as far as just, I guess, the timing, as you sit today, Brad, just that benefit in most of it, you would think is a 3Q event, if these credits are kind of a 90-day type of term? Is that -- is that fair to say? I mean, it's a minimal amount...

I would say that the bulk of the benefit will be in 2Q.

In 2Q, okay.

Yes.

And with no other questions holding at this time, I'll turn the conference back to Mr. Eccher for any additional or closing comments.

Okay. Thank you, everyone, for joining us this morning, and we look forward to speaking to you again next quarter. Have a good day.

Ladies and gentlemen, that will conclude today's call. We thank you for your participation. You may disconnect your phone line at this time and have a great day.