Oct 21, 2021
Operator
Good morning, everyone, and thank you for joining us today for Old Second Bancorp Inc's Third Quarter 2021 Earnings 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. Now I will turn it over to Jim Eccher.
Jim Eccher
Good morning and thank you for joining us today. I have several prepared opening remarks and I will give my review of the quarter and then turn it over to Brad for additional details.
I will then conclude with some summary comments and thoughts about the future before we open it up for questions. Net income was $8.4 million or $0.29 per diluted share in the third quarter.
Our earnings this quarter were favorably impacted by $1.5 million reversal, a provision for credit losses due to more favorable unemployment projections over the next year. However, earnings were negatively impacted by the MSR valuation mark-to-market loss of $282,000 due to decreases in market interest rates and merger related costs incurred in the third quarter totaling $425,000.
In regards to the balance sheet, loans were essentially unchanged on a core basis this quarter, excluding approximately $35.5 million of PPP loans forgiven by the SBA during the third quarter. Only 34.7 million PPP loans from both the first and second round remain outstanding as of September 30.
Approximately 83% of all PPP loans originated have now been forgiven. Loan growth has certainly been a bit of a disappointment for us this year, but I am encouraged that our pipeline at quarter end is by far the strongest we have seen since the pandemic began.
We are seeing significant pipeline builds and equipment leasing health care and CRE although CNI activity and line utilization remains somewhat soft. We have a new CRE team that started with us in the third quarter and a senior leasing officer was added in October.
Given these factors and the strong pipeline, I'm optimistic we can see a solid long growth net of PPP in the last quarter of this year. Expense discipline continues to be strong with a slight increase noted and non-interest expense for the current quarter compared to the prior quarter due to growth in occupancy, furniture and equipment cost as well as computer and data processing costs.
Exclusive of merger related costs of 425,000 occurred in the quarter, non-interest expenses increased 1.4% over the prior quarter. Non-performing loans increased by 5.9 million compared to the prior quarter with two loans added to non-accrual status.
However, past dues declined and although there was an uptick in non-performers total classified assets declined 7.3% compared to the linked quarter. We remain confident in the strength of our loan portfolios.
Details are available in the earnings release tables on these changes. Loans under modification stands at approximately 0.5% of the loan book today and we are working closely with our borrowers to understand each and every situation.
Of the original 237.8 million of loans which were on COVID-19 related deferral at some point in the past year, 229 million or more than 96% of either returned to payment status or paid off as of September 30. As the most recent quarter end, 12 loans totaling 8.8 million and balances are currently on deferral status.
Concurrent with our earnings release, Old Second also filed loan portfolio disclosures that will give investors additional detail on the composition of the loan portfolio current modification breakdowns and reserve levels. Exclusive of PPP loans, the reserve currently stands at 1.47% of total loans.
During the third quarter of 2021, 1.5 million of provision for credit losses on loans was reversed, 47,000 of reserves for unfunded commitments was reversed based on a review of the line utilization trends at 237,000 of net charge offs were record in the third quarter, resulting in a net decrease to the allowance for credit losses, including unfunded commitments of 1.7 million. Our outlook is cautiously optimistic as the underlying economy continues to improve, albeit with a significant uncertainties.
We believe that we are more than adequately reserved under base case scenarios but continue to modestly overweight more pessimistic scenarios, given the high degree of uncertainty. I'll turn it over to Brad now for more color in his prepared comments.
Brad Adams
Thank you, Jim. Net interest income increased 664,000 relative to last quarter and 109,000 from the year ago quarter.
Margin trends stabilized with securities portfolio growth mitigating continuing increases in liquidity. The reinvestment rate on the portfolio purchases was slightly less than 100 basis points as we continue to avoid duration at this point in the rate cycle.
Continued to have strong deposit inflows and substantial excess liquidity persisted for the entirety of the quarter. The cautious strategy to deploy a portion of that liquidity will continue in the short-term.
If loan growth improves, which we currently expect, our margin trends should improve significantly. If the excess liquidity flow reverses, our margin outlook would improve dramatically.
If excess liquidity persist, net interest income trends will benefit but margin will remain artificially depressed as we continue to invest in short duration lower yielding assets. I think it's important to note that our excess liquidity has resulted primarily from retail flows, which I expect will be absorbed quickly once the pace of stimulus lessons, so I don't believe it prudent to add significant duration at this point.
If economic conditions continue to improve and loan growth returns to a level commensurate with that growth, our margin outlook would improve. I continue to remain surprised that loan demand is not followed reported economic conditions, that Jim mentioned that appears to be changing.
The sum total of that discussion is that we currently expect loan growth trends to meaningfully improve which will continue to result in net interest income growth. We do not currently expect liquidity flows to lessen and which should leave the margin artificially depressed.
In short, we remain cautious and patient. Non-interest income increased from last quarter with an increase of 291,000 quarter-over-quarter and net gain on sale on mortgage loans and a reduction of 750,000 in the MSR valuation last recorded.
Wealth management income remained strong with 2.4 million in both the current quarter and prior quarter. Securities gains net of 244,000 were also recorded in the third quarter, those were minimal in second quarter.
Provision for credit losses reversal of the net 1.5 million was recorded in the third quarter compared to 3.5 million last quarter. The economic outlook for us assumes continued improvement with an unemployment rate projection remaining at approximately 5.25 to 6.75 through September 30, 2022 and over the remaining life of the loans.
This is a decline from the previous estimate of 5.5 to 6.75 from the last quarter. I recognize that our assumptions are probably still more pessimistic than most at this point and expect the severity of these assumptions to be lessened in the coming quarters.
I'm extremely pleased with our credit as performed, I’m continue to be pleased with the direction in classified assets. Credit metrics have remained stable to improving for a number of quarters now.
And the number of credits that I would have been concerned about it then resolved favorably. Our efforts in the coming quarters we focused on helping our customers and funding quality loan growth with the expectation of a stable to improving margin assuming liquidity remains robust and risk spreads remain unreasonably tight.
Expenses are well controlled at this point. We will continue to review for efficiencies as the year progresses.
With that I'd like to turn the call back over to Jim.
Jim Eccher
Thanks, Brad. In closing, we are increasingly optimistic about the remainder of the year confident in our balance sheet and ready for the challenges ahead.
Prolonged low rates is certainly not the best environment for deposit base like old second, but we are extremely profitable given our focus on expense discipline. We expect to remain so.
We believe our credit and underwriting has remained disciplined in our funding and capital position is strong. Today we have the balance sheet and liquidity to take advantage as things improve.
We are extremely active in the effort to bring additional sales people to our team and are making substantial progress on the planning to ensure a smooth transition for west suburban customers and employees. We are excited about the opportunities that exist at Old Second in 2022 and beyond.
That concludes our prepared comments this morning. So I will turn it over back over to Kate to open it up for questions.
Operator
Thank you. Ladies and gentlemen, the floor is now open for questions.
[Operator Instructions] Our first question today is coming from David Long at Raymond James. Your line is live.
David Long
I know what's suburban transaction. I think you've got the proper approvals.
Is that still expected to close? Maybe early December and then that's the case.
And then also, as a follow up to that one to just hear about any progress you've made in preparing for the integration. And when this branch integration system conversion may happen?
Jim Eccher
So David, we have all regulatory approvals in hand. We basically just need to have a shareholder meetings on both sides, which we're targeting for the end of November.
Anticipating in early December close. So yes, we are knee deep and working through integration plans and targeting mid to late April for system conversions.
David Long
Got it. Okay.
And Brad, you've got 17% of your earning assets in cash you're talking about, you've been putting yielding or using some of that in some short duration yields or what securities are you willing to add at this point on the yield and the duration side?
Brad Adams
That we've been targeting a little under a two year duration, the purchases in the last six months have been primarily concentrated in variable government guaranteed student loan paper, some AAA rated CMOS and CLOs basically.
David Long
Got it. Okay.
And what would it take to get you to extend that duration?
Brad Adams
Higher rates.
David Long
Easy enough. And then, finally, on the liability side of the balance sheet, any non-core funding that you think you can shore up, I think you've got some senior debt that becomes callable here soon.
Just curious if there's any opportunities to make the liability side even more efficient than it is now.
Brad Adams
There are some opportunities. The senior debt issue is, is in the $40 million range and it goes variable at the end of the year.
The rate will be -- the variable term will be a substantial improvement in the cost of that. It's likely that we'll evaluate the potential for replacing that in the first quarter of next year but nothing is definitive at this point.
I think there's a lot of things you can do from the capital management perspective, especially, with the fundamental balance sheet change we've got coming at us. We'll continue to look for opportunities there and believe that the projections as we've laid them out in the proxy statement still appear reasonable.
Operator
Thank you. Our next question today is coming from Nathan Race at Piper Sandler.
Your line is live.
Nathan Race
Appreciate the constructive outlook for loan growth, ex-PPP in the fourth quarter, and congrats to some of the hires that you guys have had recently along those lines. Just curious as you kind of look out to 2022 obviously, the law of large numbers is working against you in terms of percent of loan growth.
But when you kind of look at the team you have in place now with just the opportunity to continue to hire across the Chicagoland area, what are a good kind of range of expectations in terms of organic growth in 2022.
Brad Adams
I think that the trend that we have right now on the hiring front and what we expect in terms of pre payments, we're getting increasingly optimistic that by the end of next year, we may very well double our loan origination capability, which is a very exciting thing for us. Obviously, that doesn't come cheaply, and we're investing a lot in salespeople.
But we have a lot of reasons to be excited in terms of the level of talent and conversations that we've been able to have over the last several months. So we're getting increasingly optimistic on what we're capable of doing from an asset generation standpoint while still staying in our credit box.
Jim Eccher
I would just add, the third quarter while it was flat was relatively active in new fundings and production, what's been a little frustrating is really paydowns basically are running at 2X level from where they were last year. And our line utilization is down about 8%.
So the effect of both of those factors and if we have returned to a more normalized run rate and then see any kind of increase in line utilization, coupled with the talent and the pipelines that are building should meet a very strong year next year.
Nathan Race
Okay, great. And then just in terms of kind of providing for that growth, expectation to next year, obviously, you have the CECL dates you double count in the fourth quarter as the acquisition closes.
So how should we kind of think about, excess reserves that exists today, in terms of thinking about just the trajectory of credit costs and provisioning in 2022, as well.
Brad Adams
I think independent of any merger considerations which those calculations aren't fully done yet, though, our estimates as detailed in the proxy statement appear reasonable. I think that, as I said, we're probably more conservative than maybe others in terms of what our estimates are for economic activity.
And I would expect just on a standalone core basis that all segments reserve would continue to trend down. So while if we do achieve loan growth next year on a scale that which we are hopeful for, there will be some level of provisioning, I would expect it to be pretty muted by continuing economic improvement.
Operator
Thank you. [Operator Instructions] Our next question today is coming from Chris McGratty at KBW.
Your line is live.
Chris McGratty
I want to start just on NII, a couple of housekeeping items before the main question. Can you quantify the level of PPP income in the quarter and also the size of that prepay that you cite in release?
Brad Adams
So the prepay was a $200,000. And calling it large probably wasn't the best word choice that kind of stuff happens quite frequently, especially here lately over the last nine months or so.
In terms of PPP income, we've only got about 30 million in the portfolio left, it looks like –
Jim Eccher
It was 20,000 or 300,000, Brad, it wasn't that much.
Brad Adams
It wasn't significant.
Chris McGratty
Okay. And so you kind of put the loan growth and the securities caution together.
How do we think about just the trajectory of NII from here on an organic basis?
Brad Adams
As we said last quarter, and we saw this quarter we would expect to grow in NII from these levels and all linked quarter periods.
Chris McGratty
Okay. And then, if I could the -- two more questions, a little bit of color on those nonaccrual that you talked about that would be great and then once the deal closes and given the valuation like how are you thinking about resuming the buyback?
Jim Eccher
Sure. As far as the uptick and non-accrual it was really two credits.
One is a large, big box retailer on our watch list for a long time and classified last year actually last a major tenant single tenant property. We've had put an allocation on it a couple of quarters ago, so not a surprise by us they are actively negotiating a new lease with another tenant.
So we don't see any further charges there. The other one is a couple of million dollar crane operator that was hit extremely hard by the pandemic.
We are very well secured on that and don't see any further losses. Absent that overall classifieds we're down about 7% for the quarter.
Chris McGratty
Okay. And then on the buyback any thoughts there?
Brad Adams
No imminent plans, I would say that just from kind of theoretical standpoint, I would view a buyback at these valuations to be an extremely good use of capital.
Operator
Thank you. Our next question today is coming from Brian Martin at Janney Montgomery Scott.
Your line is live.
Brian Martin
Can you give a little bit of color just on the hiring, you've done, Jim? And just I mean to Brad's comment about, potentially I guess doubling your capability just kind of, does that assume that you're going to pick up more talent here?
Is that kind of baked in with what you have? And just so those couple of questions and just kind of the hiring outlook, given some of the disruption in the market, you just kind of updates on that, or what how that's progressing?
Jim Eccher
Sure, Brian. Yes.
So we added a new commercial real estate team earlier in the quarter, very optimistic that that team is going to hit the ground running and even produce, yet the fourth quarter. And then a senior leasing executive that's been in the business north of 25 years joined us a couple of weeks ago, we continue to have very constructive dialogue with a number of additional lenders in the Chicago market, optimistic that we will be successful in landing a number of them over the next couple of quarters.
So we feel real good about that.
Brian Martin
Okay. And how about I mean, just as far as maybe, you are Brad, Jim, just kind of the expense outlook?
I mean, I guess the hires you got are currently in the run rate, just the -- how do we think about that with in conjunction with some optimistic thoughts on hiring additional folks here?
Jim Eccher
Yes. Good question.
I mean, these folks are certainly, going to cost us -- it's going to be an investment. But we have also recently seen a few retirements along with the departure too.
So as of now, we're probably net-net equal. We certainly look to see further investments over the coming quarters that will probably pick up our run rate on an overhead.
Brian Martin
Got you.
Brad Adams
I think that we're all under some fairly significant wage pressure across the franchise, there's no secret in terms of what's going on out there in the quest to maintain workforce, wage inflation is significant in the Chicago marketplace. So I don't know that we'll be as successful as holding the cost down as we were in 2021.
But it is our effort to find efficiencies where we can, we would expect to see increases and benefit costs and overall salary levels commensurate with the level of inflation that we're seeing in the Chicago marketplace. But we'll do our best to lock down efficiencies where we can.
We've done some of that on the IT side, there are a number of investments that we've made in the last two years that that won't be there in 2022. So we got a good handle on it.
But certainly it's not going to be as easy in 2022 as it was in '21.
Brian Martin
Got you. That makes sense.
And just your comment Brad about kind of doubling the origination capability, I guess that's kind of just driven off of the people you already got hired. So you're expecting --
Brad Adams
No. That is not the case.
We have not made that kind of expansion yet. But what I would tell you is, is that every hire that we're looking at and the various stages of getting there is evaluated based on what the earn back is just as we'd look at an M&A transaction and we don't expect anybody not to pay for themselves in relatively short order in terms of the sales people we are looking at.
So I think that it's quite possible that over the next six to nine months that we will have achieved the ability to double our loan origination capability.
Brian Martin
Got you. Okay, that's helpful.
And then, just last one for me just on your -- with West Suburban coming on just kind of your mix of what you're doing on the liquidity front, kind of what are the securities to asset levels? I guess, how are you thinking about that, the combined balance sheet as you as you look with the combination on that front?
Brad Adams
I'd point you to the proxy statement on that the information that's in there is pretty detailed, and we do have some discussions on what the pro forma balance sheet looks like. I would just say this is that we are going to run with substantial excess liquidity.
I also don't believe that the risks versus return in terms of plowing, that that excess liquidity at a point in time into a securities portfolio is a good idea at all. I've spoken quite plainly about that in the past.
I see no reason to do it. We will be patient.
We've got growth out there in the overall economy and we also have a great deal of inflation. Neither one of those things is consistent with rates staying where they are.
And if it takes one to two years to get there, I got to tell you, that doesn't bother me. I would rather wait and then announce some sort of portfolio restructuring because you plowed into 30 year mortgages or did something stupid like that.
Operator
Thank you. We have no further questions in the queue at this time.
Mr. Eccher, do you have any closing comments you'd like to finish with?
Jim Eccher
Okay. Thanks, Kate.
Okay, thanks, everyone, for joining us this morning, and we will look forward to speaking with you again next quarter. Have a good day.
Operator
Thank you, ladies and gentlemen, this does conclude today's event. You may disconnect at this time and have a wonderful day.
Thank you for your participation.