Apr 30, 2017
Executives
James Eccher - CEO, President, Director Stan Fairie - Senior Vice President Treasurer Michael Kozak - Chief Credit Officer and EVP
Analysts
Christopher McGratty - KBW Andrew Liesch - Sandler O'Neill Brian Martin - FIG Partners
Operator
Welcome to the Old Second Bancorp First Quarter 2017 Earnings Conference Call. [Operator Instructions].
As a reminder, this conference is being recorded. I would now like to turn the conference over to your host Jim Eccher, President and CEO.
Thank you. You may begin.
James Eccher
Thank you and good morning, everyone and thank you for joining us today for our first quarter earnings call. I'm joined on the call by Gary Collins, Vice Chairman; Mike Kozak, Chief Credit Officer; and Stan Fairie, Senior Vice President Treasurer.
I will start with a reminder that our comments today may contain forward-looking statements 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.
I would ask you to refer to our SEC filing for a full discussion of the company's risk factors. Please refer to our website under the Investor Relations tab for access to our earnings release.
I have several prepared opening remarks and will give you my overview of the quarter and then turn it over to Stan for more detail on the securities portfolio for the quarter followed by Mike for more detailed report on asset quality and the loan portfolio. As we announced in an 8-K filing Tuesday, I am pleased to announce we have hired Brad Adams as our new CFO.
Prior to joining our executive team, Brad was an Executive Vice President and Director of Corporate Development and Strategy at TCF. And prior to that, an Executive Managing Director of Corporate Development and Strategy for Talmer Bankcorp.
Brad is in the process of transitioning to our company and not able to join us on the call today, but will be involved in all shareholder related calls in future quarters. Before I review first quarter highlights, just a couple of brief comments.
We believe that over the past few quarters, we have been successful in executing our strategy to improve and grow our earning asset mix which is led to a more diversified balance sheet and improved earnings momentum. The acquisition of the Talmer Chicago office and integration helped drive solid loan growth last year.
And the full impact of those earning assets were realized in the first quarter. In addition, we have remained focused on growing net interest income, enhancing our net interest margin by remaining disciplined in our pricing while continuing our efforts to improve credit quality.
This approach has helped us drive an improvement in our core earnings. And it has served us and our shareholders well as we expect to continue this trend in coming quarters.
First quarter operating highlights were highlighted by further expansion in net interest margin, solid deposit inflows and improved credit quality. Net interest income was bolstered by improved earnings assets mix and expansion in our net interest margin.
Loan growth did moderate in the first quarter, mostly due to seasonal trends along with accelerated loan closings in the prior quarter. With that backdrop, I'll start with some of the quarterly highlights.
First quarter net income of $4.6 million or $0.15 per share compared to $5 million or $0.17 per share in the fourth quarter of '16 and $3.3 million or $0.11 per share in the first quarter of 2016. Additionally, we experienced strong growth in our core deposit base and continued improvement in our funding mix.
Overall deposits were up 3.8% from year-end and up 7.8% from a year ago. However, actual core deposits which include time, were up 5.9% from year-end 2016 and 11.5% from a year-ago with the majority of the growth realized in demand deposits.
The year-over-year growth stem from about $49 million of purchased deposits from the Talmer branch acquisition. In addition, increases in both periods presented were due to organic commercial customer deposit growth and seasonal tax refunds.
We did have significant activity and repositioning in our securities portfolio in the quarter. And with that, I'm going to turn it over to Stan Fairie, so he can provide more detail on the portfolio.
Stan?
Stan Fairie
Thanks, Jim. There were significant shifts in the composition of the securities portfolio between year-end 2016 and March 31, 2017.
Securities issued by state and political subdivisions, generally referred to as munies, increased 220% from $69 million to $220 million while collateralized mortgage obligations declined 37% from $171 million to $108 million. These actions were prompted by several factors.
First, after the election of President Trump in November 2016, long term rates rose and muni spreads widened significantly. This was due to President Trump's pro-growth agenda that included potentially significant tax cuts which would negatively impact the tax equivalent yields of munies.
Second, the increasing profitability of the company and corresponding decline in the deferred tax assets. The company is in better position to take advantage of the munie's exemption from federal taxes.
Third, there was a favorable risk reward trade-off between munies and the Ginnie-Mae CMOs backed by multi-family properties that were sold during the quarter. Generally, the munies provided better nominal yields while having little negative impact on the company's interest rate risk profile.
On a tax equivalent basis, the increase in portfolio yield was significant. The vast majority of the muni growth was in general market munies referring to larger, nonlocal issues.
A careful selection process was employed when purchasing such securities, the goal being to build a portfolio with attractive spreads and yields, minimum credit risk and maximum liquidity. Purchase criteria included the following elements, first, stringent credit requirements were applied that hindered [indiscernible] Any issues below a AA rating by Moody's or Standard & Poor's and in some cases even excluded securities that carried a AA rating.
Such instances, for example, included securities that have been placed on negative watch, had concerning negative trends, lacked bondholder protections or had general economic concerns involving the region served. All general market munies purchased were either general obligations or revenue bonds; second, geographic diversification was required with the company's investment policy limiting the portfolio concentrations to 15% of Tier 1 capital for issuers in a given state.
In addition, effort was expended to diversify issuer geography within each state. As of March 31, 2017, issues were spread among 17 states and only 3 states had concentrations exceeding 8% of capital; third, the investment policy limits the total investment by issuer to 5% of Tier 1 capital.
In practice, no individual, general market issuer as of March 31, 2017, exceeded 4.1% of capital and the muni portfolio average was 2.4% of capital. 25 different issuers were purchased during the quarter.
All general market munies purchased during the quarter had the following characteristics, all had a 5% coupon; the nominal weighted average yield-to-call was 3.08%; and the nominal weighted-average yield-to-maturity was 3.73%; tax equivalent yields to call in maturity were 4.74% and 5.75%, respectively. The weighted average maturity date was November 2034 and the weighted-average call date was October 2026.
Maturity dates range from June 2030 to February 2038 while call dates range from February 2025 to October 2027. Most of the securities purchased during the quarter were eligible for pledging to public funds or to the federal home loan Bank of Chicago as collateral for borrowings.
This concludes my prepared comments. Now I'd like to turn it over to Mike Kozak to discuss asset quality.
Mike?
Michael Kozak
Okay. Thanks Stan.
Net loans increased by $10 million or 0.7% from the fourth quarter 2016 as our loan volume has historically been very slow in the first quarter of each year. Our pipelines however, do continue to build.
Our portfolio composition as of March 31, end of the first quarter, was as follows, C&I together with owner-occupied real estate at 41% of the portfolio; investor real estate 27%; construction and development loans 6%; multifamily 6%; agriculture 1%; consumer 7% and residential mortgages 12%. Our credit metrics continued to improve in the quarter with NPAs reducing to 1.73% compared to 1.87% at year end and 2.75% at 3/31/16.
In terms of the components of our problem areas. Nonaccrual loans were reduced by $3.6 million from the prior quarter to $11.7 million with approximately $3.4 million of the reduction due to the transfer of 7 loans from nonaccrual to OREO.
There were 10 loans totaling 1. -- that were repaid, remediated or charged-off during the quarter.
Five loans totaling $1 million were added in the quarter. As for problem loans, they were reduced by $1.2 million from the prior quarter to $9.3 million.
There were 4 loans totaling $1 million that were removed from problem status due to upgrade or payoff. There was one loan totaling $100,000 that moved to problem status.
And there was $300,000 decrease in the balance on various problem loans. OREO did increase by $1.6 million to $13.5 million from the prior quarter, largely due to the above-referenced transfer of the 7 loans from nonaccrual to OREO.
There were 7 properties totaling $1.5 million that were sold in the quarter, while again there were 8 properties, totaling $3.4 million that moved into OREO. Valuation write-downs for the quarter totaled $318,000, with one property accounting for the substantial portion of the write down.
Approximately 55% of the OREO is land carry. However, there are only 2 properties with a bases over $1 million, with one valued at $2 million and the other at $1.6 million.
This latter property consists actually of 2 separate buildings, the largest of which is now under contract. And I'll now turn it over to Jim for concluding comments.
James Eccher
Okay. Thanks, Mike.
I will provide some final comments on operating performance and then open it up to questions. Net interest income was $17.7 million in the quarter, $2.5 million increase or 16.3% year-over-year.
And $192,000 or 1.1% increase over the fourth quarter. In percentage terms, the NIM was 3.58% compared to 3.54% in the fourth quarter of '16 and 3.25% in the first quarter of '16.
And as we outlined in the earnings release, the repositioning in the investment portfolio and the acquisition of the Chicago branch helped fuel the increase with $221 million in loans recorded in the fourth quarter of 2016 driving increased loan interest income and purchase accounting accretion of $355,000 in the first quarter of 2017. Noninterest income was $7 million in the quarter compared to $8.4 million in the fourth quarter of '16 and $6.3 million in the first quarter of '16.
Each of the quarters presented was subject to variability of the mortgage servicing rate's valuation. In the first quarter of '17, MSR valuation losses were nominal, $133,000 as compared to MSR valuation gains of $1 million in the fourth quarter of '16 and losses of $1 million in the first quarter of '16.
In addition, other income for the first quarter of last year reflected an increase due to recovery from an SBA loan of $292,000 on an OREO properties disposed of in a prior year. Other components of noninterest income were relatively static for the first quarter as compared to prior quarters.
Noninterest expense was $18.1 million in the first quarter compared to $17.2 million in the fourth quarter of last year. And $16.3 million in the first quarter of '16.
As explained in the earnings release, the increase was primarily related to various one-time expenses related to salaries and employee benefits. There were no significant acquisition costs in 2017 related to the fourth quarter 2016 Talmer Branch acquisition.
The efficiency ratio was 67.5% in the quarter compared to 61.8% in the fourth quarter of '16 and 71.1% in the first quarter last year. The growth in the NIM has contributed to the improvement in the ratio, but was partially offset by the one-time cost incurred and related to salaries and employee benefits in the first quarter of this year.
We expect our efficiency ratio to trend lower in the coming quarters. Capital ratios declined in the quarter but are in good shape.
The declines resulted from an increase in total assets, an increase in tax exempt securities which are risk-weighted at slightly higher rate than lower risk-weight securities. And a shift in risk-weighted assets related to loans acquired, offset by the sale of lower risk-weight securities.
Lastly, I want to recap the Chicago Talmer Branch acquisition. Now that we have a full quarter, since the acquisition date last fall, with the loans purchased of $221 million, the purchase accounting discount recorded was approximately $2.8 million.
As of March 31, 2017, the PAA unearned discount totals $1.8 million. Last year purchase accounting accretion income was $605,000 year-to-date 2017, $355,000 has been accreted.
A full quarter of net interest margin impact of the acquisition is apparent in this quarter's numbers. And that concludes our prepared comments this morning.
So I will turn it over to the moderator to open it up for questions.
Operator
[Operator Instructions]. Our first question is from Andrew Liesch from Sandler O'Neill.
Andrew Liesch
Just a few questions here on the margin. Just curious what loan yields you're getting on new production relative to where the existing portfolio yield is?
Stan Fairie
Well on the floating rate side, we're generally looking to price anywhere between $250,000 to $350,000 over LIBOR as kind of a benchmark. On the fixed rate side we're probably in the upper-4s to low-5s.
Andrew Liesch
Okay. I would imagine then that it'd be slightly accretive to the margin.
Have you guys have seen some lift in the market and the yields that you're able to get with the rate hikes?
James Eccher
Yes. We have seen a little bit.
We're still working through some floors Andrew. But we're definitely seeing a little bit of benefit moving forward.
Andrew Liesch
And have you seen much on in the way of deposit pricing competition yet?
James Eccher
We have not. We did have a very good quarter with inflows.
However, we're seeing a little bit of pressure from some competitors, but a lot of our growth in the quarter was derived from commercial demand and then seasonal tax deposits that rolled in.
Operator
[Operator Instructions]. Our next question is from Chris McGratty from KBW.
Christopher McGratty
Jim, you guys have done a lot to the balance sheet over the past couple of quarters. And obviously that the top line growth's been pretty impressive year-over-year.
I guess where are we in terms of -- the repositioning of the investment portfolio? Are we done after this quarter?
Or is there any other tweaks to the investments that you may have been making in April?
James Eccher
Yes. There's still some more repositioning to be done, Chris.
We have a significant portion of the portfolio in CLOs that are being actively called away right now. I'm going to let Stan maybe give you a little more color on that.
Stan Fairie
Right, Chris. That's probably the biggest effect we're seeing.
We acquired most of our portfolio in 2014. And all of these issues are currently callable.
And you should probably aware the spreads have just collapsed in the CLO sector, down 90 basis points in discount margin. So we're obviously looking to redeploy that cash.
And it's a challenging environment. Spreads are tight across-the-board, but we're assessing alternatives that we will see some additional repositioning during second quarter.
James Eccher
I mean, Chris. Ideally, we've got about 25%, 26% of our assets in securities.
We'd like to obviously work that lower with loan growth. I think we've done a pretty good job getting it to where it is today.
We'd like to see that drift around 20%, if we can and do it through organic growth. But we will likely see some additional repositioning in the second quarter.
Christopher McGratty
Okay. So the message is lower proportional investments to improve the mix.
I guess for the next couple of quarters, Jim, does the -- do the balances shrink, given the repositioning? Or do you just grow loans at a faster rate to dilute the percentage?
James Eccher
We'd like to see loan growth accelerate in the second quarter and third quarter and historically that's been the case. We did foresee it.
Traditionally, slow first quarter in loan growth. And a lot of that was because we had accelerated fundings in the fourth quarter.
So we did deliberately take on a little bit of a leverage strategy in the first quarter using our FHLB advances to take advantage of some opportunities in the muni side. So yes, ideally we're going to change the mix.
And we'll work it down through loan growth.
Christopher McGratty
Okay. And Stan, I missed it.
What's the pro forma duration of the book at March 31?
Stan Fairie
March 31, nominal was 3.68%. And by nominal, you have to take into consideration that's just standard duration for the munies, but they don't respond one-for-one with market rate.
So effective duration would be lower than that.
Christopher McGratty
That's on the whole portfolio, right? 3.7%?
Stan Fairie
That is correct.
Christopher McGratty
Maybe a question, if I could, on expenses. How should we be thinking -- obviously you called out the $500,000, $600,000 of one-timers in the quarter.
Is this 17.5% a decent starting point, understanding first quarter was probably a little bit elevated for seasonal factors.
James Eccher
Yes. It was almost close to over $800,000 in one-timers in salaries and benefits, insurance costs.
So we don't foresee that going forward. So I think your number's probably a pretty good run rate.
Christopher McGratty
Okay. And based on the pipeline of the credit and your growth outlook, I guess what's the expectation to take either the reserve lower or the provision, perhaps, in depositor territory, as you kind of grow the balance sheet?
James Eccher
Yes. I think we're still looking at mid-to high single-digit loan growth for '17 -- so we still feel we're at an inflection point with provisioning.
So any material future growth is going to lead to more moderate provisioning I think in the next couple quarters.
Operator
Our next question is from Brian Martin with FIG Partners.
Brian Martin
Jim, just you kind of alluded to the comment on your outlook for loan growth. But like you said, a little slower start to the year, but some seasonality in there.
I guess the optimism you got on kind of getting to whatever mid-to high single-digit growth for the year. And I guess are you seeing good trends currently in the pipeline?
Or I guess just kind of what are you basing your outlook on right now? Is there anything that is pointing to upper single-digit is a good target or realistic at this point.
James Eccher
I'll let Mike comment on that.
Michael Kozak
Yes, Brian, I'd point to a couple things. One you alluded to the pipeline is continuing to build.
You're never happy that it's high enough, but it is building in a good manner. We also do a series of what we call screening loan screening meetings on a weekly basis.
And the activity at those screening meetings has really picked up in the last month. So we have seen some -- we're seeing some looks on a very preliminary basis at some strong transactions that should result over the next month to several months in the actual closings.
So on that basis, we feel pretty good about our estimates.
Brian Martin
Okay. And then maybe just jump into the margin for a second.
The commentary about the CLOs. And obviously we saw the yields on the portfolio go up sharply this quarter.
I guess if you have that runoff and not very attractive option, I guess should we think about the yields -- the overall yield on securities going lower in the second quarter given that repositioning is still to be done? Or is just a more big picture maybe for, Stan, on kind of how that plays out later in the quarter?
Stan Fairie
It's going to be a challenge because the CLOs are one of the best performing assets we had in the portfolio. But we're looking at reinvestment and a mix of possibilities that still include some of munies which is I still think are very attractive sector.
So we're --it's kind of my job to see if I can't maintain that portfolio yield as best as I can.
Brian Martin
Okay. And how big is the CLOs on the dollar basis relative to the size of the portfolio?
Stan Fairie
The CLOs represented at the end of the year -- actually let me give you the quarter. It's about 12%.
So it's not going to be a monstrous hit, but they were throwing off very attractive income levels, especially on a floating rate basis.
Brian Martin
Okay. And then maybe just secondly on the margin.
Jim, you talked about maybe burning through some -- still working through some floors. I guess what -- and not seeing a whole lot of pressure yet on the funding side.
The rate increase your saw in December. And I guess if you look at the rate, what -- the increase in margin?
How much of an impact, I guess, do we expect on -- or I guess how are you thinking about that impact on the margin at least in maybe the second quarter? And how to think about future rate increases given the asset sensitivity?
James Eccher
Yes. I guess couple of things.
We put on quite a bit of these munies midway through the quarter or later in the quarter. So we didn't really have the full effect of that in the first quarter.
So we think that will be a little bit of a tailwind. We've been pretty disciplined with our loan pricing.
So I don't see the margin really eroding. Our cost of deposits actually was down in the quarter.
The mix change was positive. Time deposits declined and demand went up.
So we think the margin at $350,000 to $355,000 range is a good number.
Brian Martin
Okay. All right.
And maybe just as it relates to the -- you talked about the expenses. But just anything on the -- I know you guys seemed a little bit more optimistic last quarter.
I guess with the remarks on fee income. I guess do you expect that?
I guess are you seeing anything different there, anything encouraging on the fee income side. How do we think about the run rate there absent the seasonality of this quarter?
James Eccher
A lot of it, Brian, is tied to what's going to happen with MSRs on the residential side. But we're definitely seeing a little bit of a tail off in the residential mortgage business.
That's down roughly 25%. Although, we're seeing pipelines build there.
So we're expecting better results in the second quarter. And then the other largest fee income driver's on the wealth side and that's performing above last year's levels and we expect with market performance that's going to continue to be a positive driver.
Service charges and fee income, we expect that to be relatively flat.
Brian Martin
Okay. And then just funding the loan growth.
Jim, I guess it sounds like that's -- maybe deposit growth is pretty minimal. And it's just being funded by the securities portfolio.
Would that kind of be the plan going forward?
James Eccher
Yes. We did -- as I mentioned, the deposits were up pretty strong in the quarter, up almost 4% from year-end.
A lot of it was driven by the commercial bank. So we think we've got pretty good momentum there.
But we certainly have ample liquidity in the securities portfolio to fund loan growth going forward as well. Ideally, we'd like to just change the mix.
Operator
[Operator Instructions]. Okay ladies and gentlemen, we have reached the end of the question-and-answer session.
I would now like to turn the call back over to our speakers for closing remarks.
James Eccher
Okay. Thank you, everyone for joining us this morning and for your interest in the company and we look forward to speaking with you again next quarter.
Goodbye.
Operator
This concludes today's conference. You may disconnect your lines at this time.
Thank you for your participation.