Jan 24, 2019
Operator
Good morning everyone and thank you for joining us today for Old Second Bancorp’s Fourth Quarter 2018 Earnings Conference Call. On the call today is Jim Eccher, CEO and President 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 and 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 in their GAAP counterparts and our press earnings release, which is available on our Company’s 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. I have several prepared opening remarks and I will give you my overview of the quarter and then turn it over to Brad for more detail on fourth quarter performance.
I will then wrap up with some summary comments and thoughts about the future before we open it up for questions. Results and overall momentum continue to be very strong.
Net income was $8.6 million or $0.28 per diluted share in the quarter. Earnings this quarter were negatively impacted by approximately $700,000 of mortgage servicing rate, interest rate impairment and $100,000 of merger-related expenses pre-tax.
Absent these charges, earning trends were overall very strong with notable increases in the net interest margin and acceleration of loan growth from recent periods. Results continue to be very positive overall with an expanding core margin, solid expense control, sustained performance across our fee-based businesses and a stable credit outlook.
2018 was a very good year for our company with strong earnings momentum and the ability to invest significantly in the future growth of the Bank. In regards to the fourth quarter specifically, total loans increased by $62 million relative to last quarter with pipelines remaining above historical norms heading into the New Year.
Strong loan originations exceeded our expectations in what is normally a softer quarter. The competition for credit and our market remains more aggressive than we expected both in terms of pricing and structure.
With the tailwinds provided by an expanding margin, we are in a strong position and expect to remain very selective on the credit side, yield on the portfolio increased nicely during the quarter. Total deposits decreased modestly from last quarter albeit with solid overall repricing trends.
The loan-to-deposit ratio is now at 89% and I believe we can remain at these levels in the near-term with loan growth funded by a mix of deposit growth and run-off within the securities portfolio. Asset quality remains very well controlled.
The level of classifieds did tick modestly higher relative to last quarter and our overall positive traded outlook remains unchanged. Overall, we remain very encouraged about our results in a number of areas and I’ll turn it over to Brad to give you more color in his prepared comments.
Brad Adams
Thank you, Jim. Net interest income was up significantly due to increases in loan yields across the variable portfolios.
Some of you may have noticed fee income was a little softer due to mortgage – a difficult mortgage banking environment, specifically the large MSR impairment related to the back-up in interest rates during the quarter. The back-up in rates also had an impact just under 300 grand or so recognized revenue related to a BOLI position.
The reported taxable equivalent margin increased by seven basis points from last quarter, a similar level on the core margin. Core margin exclusive of purchase accounting trends remains very strong in trend.
Pricing movement on the liability side of the balance sheet remains well controlled albeit with the pickup in time deposit competition continuing. As discussed last quarter, this trend did result in some modest increases in funding cost.
We have moved rates modestly higher in checking money market and savings cash-ins in response to recent rate hikes with the goal of remaining within reasonable proximity to the median pricing in our markets. Overall deposit betas continued to significantly outperform our expectations as they had for much of the last year.
We are continuing to be very pleased with our outlook for loan and margin trends going forward. The loan-to-deposit ratio leaves us well positioned for higher rates albeit with an increase to 89% this quarter.
At this level though, we have ample flexibility both to continue pursue to quality loan growth and doing the right thing for our customers protect the core deposit base. As Jim mentioned, it is likely we will seek to optimize earning asset mix and fund future loan growth at the expense of securities portfolio going forward.
Probably expect to move out of variable rate positions within that portfolio as well. Looking forward, core margin trends continue to be biased modestly higher.
However the degree of that expansion will be more modest than recent periods. Old Second is not assuming any additional rate increases in the Fed fund rate during 2019.
That’s been the case for a while now actually. It remains true that the bulk of our deposit pricing pressure has isolated - the bulk of deposit pricing pressure in a market in general is isolated in larger balance deposit relationships to which our exposure is extremely limited relative to competitors.
On the fee income side, wealth management and trust income continues to perform above our budgeted expectations and had a very nice year in 2018. Mortgage banking experienced a very difficult quarter, also showing up in the decline again on sale margins.
Overall, the level of refinance activity was very poor during the quarter. A non-movers quarter as we have seen in the mortgage business for us in some time.
Expenses however remain extremely well controlled. There is not a lot to talk about here.
The efficiency ratio improved further and is now comfortably below 60%. The net contribution of purchase accounting to our income statement decreased by roughly a penny per share from last quarter due to the OREO benefit in Q3.
Investments for future growth are largely baked into the runrate trends as you have been seeing for us and continuing a trend since I got here. The effective tax rate was completely unpredictable based on my statements and I remain largely out of the forecasting business in regards to tax rate on a quarterly basis going forward.
With that, I will turn the call back over to Jim.
Jim Eccher
Okay, thanks Brad. In closing, there was a lot to like about the quarter.
We are very encouraged about how we closed the year and we are pleased with where the company is heading. On an organic basis, operating leverage remains strong with solid growth across business units and well-controlled expenses.
Returns on tangible equity are excellent in the mid-to-high teens on a core basis and the interest rate environment provides an opportunity for a company to demonstrate its strength for the first time in a long time. We remain well positioned.
Credit remains well controlled. We are continuing to invest in new talent and look for opportunities to further diversify our loan portfolio.
We are comfortable with current capital levels given the strength of our recent earnings, performance and the speed at which we are rebuilding capital. We continue be on the lookout for acquisition opportunities that meet our return thresholds and are optimistic about those opportunities and feel we can realize those in the coming quarters.
And that concludes our prepared comments this morning. So I’ll turn it over to the moderator and we can open it up to questions.
Operator
[Operator Instructions] Great. Thank you.
[Operator Instructions] Our first question is from Chris McGratty from Keefe, Bruyette & Woods. Please go ahead.
Chris McGratty
Hey, good morning.
Jim Eccher
Good morning, Chris.
Chris McGratty
Jim, maybe on – or Brad on growth, given the message that appears to have been remix. This quarter was strong.
You did buy a portfolio in the quarter. How should – and you commented about pipeline being higher.
How should we be thinking about kind of net loan growth for 2019? I mean, my guess is, earning assets will be a 200 basis like inside of that?
Thanks.
Jim Eccher
Yes, we were pleasantly surprised about the quarter. We had a pipeline that was building, Chris, and a lot of closings did happen in the quarter.
Fourth quarter and first quarter are traditionally softer for us. But we feel mid-single-digit growth again in 2019 is achievable and that’s our target.
Chris McGratty
Okay. In terms of the margin Brad, one of your larger competitors actually spoke yesterday about moderating competition of deposits.
I am wondering, number one, do you share that same view and could you also help us with kind of the margin outlook a little bit more. It seems like up, but not nearly to the same degree?
Brad Adams
So, I would say from the period of June until about mid-December, late December, there was a very interesting dynamic in our market whereby people were putting both teaser rates and time deposit rates that were anywhere between 12 and 25 basis points about the Fed funds’ curve, the Fed funds curve being based at the short end that is. So they were looking to capture some portion of expected movement in rates.
At the end of the quarter that was very far ahead of itself as expectations for Fed moves change pretty quickly and that has since backed off. So I think that’s probably the genesis of those comments and deposit pricings on time deposits within the 12 to 18 months timeframe have come down.
So I think, those that rely on that portion are probably relieved. For us, our strategy has largely been just a trade war within the time deposit portfolio.
So it’s not a big delta for us. I think we still got some benefits that roll through relative to the December rate hike and I think that’s what you’ll see from us in the first quarter maybe bleeding into the second.
From there, my bias is that a little bit of duration to the balance sheet and focus on operating leverage and growth going forward. Loan growth feels better than it did, say, six months ago and the fee income streams feel better as well absent what happens when you have a 40 basis point move in the ten year and a period of a couple weeks right at the end of the quarter, which have nothing whatsoever to do with our operating trends.
So, if I could guess, I’d say we probably got another eight basis points in us on the margin expansion absent no other changes in rates, which obviously isn’t going to happen. So nobody can ever say, you are wrong dummy
Chris McGratty
Got it. And maybe I can just sneak one in general on deals.
It sounded like some optimism on M&A. Given the volatility that’s occurred in the markets, has that at all begun to work more in the buyers’ favor such as yourself where your potential partners are talking to may accelerate wanting to get out before the economy becomes a little bit more of a question mark?
Brad Adams
Yes, I think that’s a good point, Chris. At our conversations, we are very constructive into the second and third quarter last year with the downturn in the markets.
In the fourth quarter things got a little more quiet. But I think you are right.
We expect conversations to pick up over the next couple of quarters and I think there is a general feeling that to look for potential partners before the next economic downturn. I think those are real concerns I think banks are having around the board table.
Chris McGratty
Got it. Thank you.
Operator
Our next question is from Kevin Reevey from D.A. Davidson.
Please go ahead.
Kevin Reevey
Good morning.
Jim Eccher
Good morning, Kevin.
Kevin Reevey
So, my question is around the mortgage business. First part of the question is, how should we think about that business going into first quarter of this year?
And then, if rates continue to rise, kind of how should we think about that on a full year basis relative to 2018? And then, assuming that that business continues to soften, what are your long-term plans?
Do you intend to right-size that business, you intend to scale it up?
Jim Eccher
So, let me first-off say that, all the places I have worked and some of you know I have worked in a lot. The mortgage business at Old Second is absolutely the perfect size and the most profitable mortgage banking business I have ever seen in a community bank.
It is extremely well managed. What you saw in the fourth quarter was purely a function of the movement of rates at the very end of the quarter and our profitability metrics within mortgage are basically twice as good as anywhere else I have ever worked.
Now, absent a further collapse in the five to ten year portion of the treasury curve, our mortgage business banking – mortgage banking business should perform extremely well in 2019. The back-up in rates is obviously good for volumes.
It just the speed of the rate move was far in excess of the ability to turn on a dime in terms of what the pipelines were doing. So, I would love to grow our mortgage banking business given if I could maintain the profitability metrics that we historically have done and that includes my relatively short time here.
However, that’s difficult given where we are on the expense margins relative to revenue. It’s hard to grow and maintain those margins, I would rather it stays the size it is, and we can expect probably 3% to 5% growth in that business even if the world remains such as it is now which is relatively uncertain.
So, those of you that know me know that I don’t often say this, but I am bullish on our mortgage banking trends in 2019, especially relative to what the fourth quarter performance was. Did I answer your question?
Kevin Reevey
That was exactly what I was looking for. And then, lastly, I know healthcare is one main – is an area that you talked about last quarter, is an area of focus.
Can you talk about what opportunities you are seeing on the C&I and CRE side there?
Brad Adams
Sure, Kevin. Last quarter it was very good.
We have about $62 million in growth. A third of that was a purchase a HELOC – a pretty diversified HELOC portfolio.
Two-thirds of that was organic growth split evenly between CRE, C&I and within that C&I bucket, a reasonable concentration was in healthcare and in leasing which we are beginning to ramp up that vertical and expect that to outperform in 2019. So, we are pretty happy with the diversification in the portfolio.
Kevin Reevey
Great. Thank you.
Operator
Our next question is from Andrew Liesch from Sandler O'Neill. Please go ahead.
Andrew Liesch
Good morning, guys.
Jim Eccher
Good morning, Andrew.
Andrew Liesch
You covered most of my questions, but just on the expense runrate here, I know accruals can bounce around quite a bit. But what’s a good number to use going into the first quarter for total expenses and then presumably that might tail-off a little bit as bonus accruals and other seasonal expenses decline as the year goes on?
Brad Adams
So, you’ll have some seasonal benefits and some seasonal headwinds specifically the return of FICO to some degree in the first quarter. I think, first quarter trends you are likely to see something that’s relatively flat overall.
I think for full year 2019, I think that we can probably be in the 3% range in terms of all-in expenses, may be leaking towards 4% if the growth environment is strong as we currently expect, will be some flexibility to call an audible if the growth environment is poor. I think our business – overall, I would classify that our business fundamentals trends are extremely bullish and our overall macro outlook is somewhat cautious.
And so, we are not barging head long into anything. But it sure is nice to be having the operating position that we are in right now that makes our job relatively easy and the decisions are fun to make.
Andrew Liesch
Got you. And then, just given some of the M&A activity that’s taken place in Chicago, do you have any additional hiring plans or any dislocation that might be coming or at least one large well-known deal?
Jim Eccher
We are always on the lookout for – to upgrade talent, we will say that.
Andrew Liesch
Okay. That covers my questions.
Thanks.
Jim Eccher
Thank you, Andrew.
Operator
Your next question is from Brian Martin from FIG Partners. Please go ahead.
Brian Martin
Hey guys.
Jim Eccher
Hi, Brian.
Brian Martin
Hey, just Jim, you talked about the pipelines maybe still being little bit stronger even after this quarter. Just kind of wonder what’s driving that pipeline.
Kind of where are you seeing that strength in that pipeline today? And just given especially since first quarter is typically kind of a softer quarter as well as you noted.
Jim Eccher
Interestingly, last year our originations were pretty similar to 2017. However our paydowns and pay-offs were two x with what they were in 2016, 2017.
So, if we get a normalization in paydowns and pay-offs in 2019 which I think we will. I think we can start to see more reasonable organic growth.
So, I still think mid-single-digits is a healthy growth rate. We are seeing a lot of activity in Chicago and some new talent that we brought in over the last year they are starting to gain some traction.
Brian Martin
Okay. So the pay-offs were still strong this quarter, it’s still on the higher side?
Jim Eccher
Well, they were strong through the first three quarters and they have aided a little bit.
Brian Martin
Yes.
Jim Eccher
They were 2 x what they were full year.
Brian Martin
Full year, okay. I got you.
Okay, and then Brad, you talked about just the remix on the – as you fund the loan growth, can you talk about the sizing of the bond portfolio, kind of where you – how you see that playing out as you fund the loan growth or just kind of what you are seeing there?
Brad Adams
I don’t expect any significant changes. I think it’s possible if deposit growth isn’t what we wanted to be that you can see a bleed down of $10 million to $20 million per quarter.
Brian Martin
Okay. On that side of it.
Okay. And then, do you expect on the – just on the loan side, I know you did a couple portfolio purchases last year in 2018, any more that you guess you are still thinking about doing more – I guess, given do you feel it sounds you feel a little bit better about organic loan growth?
Brad Adams
I am hopeful that the paydowns are less this year and the portfolio purchases are necessary. That being said, our consumer loan production capability is below what I’d like relative to the contribution on the balance sheet.
So, to maintain a diversified portfolio, that’s really the reason for consumer loan purchases in our relatively recent past. If we need to maintain a balance sheet mix that does has some consumer exposure, we may need to fill there.
But I would expect our appetite would be a bit less in 2019.
Jim Eccher
The other thing I would add, Brian, is that our leasing division and healthcare group are relatively new groups and we’ve made some meaningful investments in those verticals. So we are optimistic that we will see some growth in those areas without the headwinds of run-offs because the portfolios are so new.
Brian Martin
Okay. That’s helpful and just going back to the margin for one minute, I think you said it was six or eight basis points is kind of how you are thinking about things have progressed, Brad.
I mean, can you just talk about, I mean, do you get more a pickup early on the first quarter from the December rate hike and then it’s kind of more stable, I guess, as the year goes on and I guess just especially if you are not forecasting with the Fed is on pause I guess, how does the dynamics play out in the margin as you see it today?
Brad Adams
I think that, you are right. The bias is towards early in the quarter for additional margin expansion and January thus far certainly looks very positive.
I think that loan growth plays a factor and earning asset mix plays a factor in the periods to follow.
Brian Martin
I got you. Okay.
And then, just last one from me, just on operating leverage, as you guys look at 2019, I guess the expectation is you can still see some positive operating leverage as you look full year 2019 versus 2018?
Brad Adams
Absolutely.
Brian Martin
Yes, okay. I appreciate the color guys.
Thanks. Nice quarter.
Brad Adams
Thank you very much.
Operator
Our next question is from Eric Rupert, private investor. Please go ahead.
Unidentified Analyst
Hi, good morning, Jim. Just a couple of things.
You mentioned a comment about some classified ticking up. Is there anything notable in there?
And then on the loan growth side, excluding the home equity, you mentioned healthcare and I think leasing. Is there anything you are doing in terms of the originations, in terms of a larger credits, maybe is there any other risk appetite change with regard to that?
That was it for me.
Jim Eccher
Sure, Eric. First, I guess on classifieds, we got an uptick of just over $4 million that’s largely the result of two credits, one which was just shy of $4 million was a small type tenanted office building that lost a couple of tenants.
We’ve had that in our radar. We’ve had it classified in reserve four.
We took it to non-performing in the quarter. The guarantor continues to support it.
It’s current, but we thought it was prudent to take it to take that classification there. The other credit was about $700,000 or $800,000 that was in a process of foreclosure but we have – since the end of the quarter have received a pay-off on that loan already.
Still optimistic we will be able to move that up it looks. As far as loan growth, we continue to be pretty disciplined about the size and granularity of what we are looking to put on the books.
We have not really engaged in doing large club deals or syndications or significant participation. It’s fairly diversified, fairly granular, really focused more in our core markets.
Unidentified Analyst
Okay. Thanks very much.
Jim Eccher
Thank you.
Operator
Our next question is from Chris McGratty from Keefe, Bruyette & Woods. Please go ahead.
Chris McGratty
Yes, thanks. Brad, on the accretable outlook, can you help us what’s kind of the budget for accretion income for this year?
Brad Adams
It should be – I would say, the next three quarters would be roughly about $100,000 less than what you saw this quarter.
Chris McGratty
Okay. And then, I am going to make you guess on the tax rate please?
Jim Eccher
Don’t do that. Nobody wants to hear that from me.
Chris McGratty
No dice?
Jim Eccher
No dice.
Chris McGratty
All right. Thanks very much.
That’s fine.
Operator
And our next question is from Brian Martin from FIG Partners. Please go ahead.
Brian Martin
Hey. I wasn’t going to ask the tax question, Brad.
So, just on M&A, I guess, one follow-up was the – it sounds like, Jim, you said that it was pretty active in the second, third quarter and I guess, would you say, I guess, you did see – or have seen the slowdown and is that slowdown at least in discussions is that continuing or do you think you are seeing a pickup in discussions now. I guess, I was unclear on what you are saying assuming today?
Brad Adams
Yes, I think the market – obviously the market pullback has created a time to retrench for everybody and certainly there has been a valuation reset that we’ve seen and I think everyone has seen. So, that coupled with the holidays, I think things were pretty quite in the quarter, but we expect things to pick back up in the coming quarters.
Jim Eccher
I think when you see a movement in valuations in our industry that goes from what had been 15 times earnings to ten something change and I would say that, when valuations are going up, sellers adjust their expectations very quickly and the opposite is true in the other direction.
Brian Martin
Yes, okay. And can you just remind me, I mean, when you guys think about M&A, I guess, is there kind of, I guess, when you look at the size of a deal you guys would – kind of the optimal size deal or kind of what range, if you put a fence around what you guys are looking at.
I mean, is it more on the smaller side, larger, or I guess, any context on that and that was it?
Brad Adams
Something large from us is unlikely. Something $300 million to $800 million to $1 billion is certainly possible.
Our focus is on core deposit quality.
Brian Martin
Got you. Okay, thanks, Brad.
Brad Adams
Yes.
Operator
Great. Thank you.
This concludes the question and answer session. I would like to turn the floor back to management for any closing comments.
Jim Eccher
Okay. Thank you for your interest in the company and for joining us this morning.
And we look forward to speaking with you again next quarter. Goodbye.
Operator
This concludes today’s teleconference. You may disconnect your lines at this time.
Thank you for your participation.