Jan 23, 2020
Operator
Good morning everyone, and thank you for joining us for today's Old Second Bancorp, Inc.’ s Fourth Quarter 2019 Earnings Call.
On the call today is Jim Eccher, CEO; Gary Collins, Vice Chairman; 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’ll turn the call over to Jim Eccher. Please go-ahead sir.
Jim Eccher
Thank you. Good morning and thank you 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 more additional details. I will then conclude with some summary thoughts and open it up for questions after that.
Net income for the quarter was $9.5 million or $0.31 per diluted share in the fourth quarter Our earnings this quarter were negatively impacted by compression and a net interest margin that totaled 28 basis points from third quarter levels. The core net interest margin contracted to somewhat more modest 15 basis points, excluding the impacts of purchase accounting income and acquired loans recorded in the third quarter.
This is a bit more than we're expecting although still within the range we provided of 3 basis points to 5 basis points for each Federal Reserve reduction in the overnight rate. Brad will provide some additional color of the margin in his prepared comments.
Earning trends were positively impacted by a BOLI death benefit of $872,000 during the quarter. Absent these items, earnings trends were relatively stable and consistent with last quarter, but we did see mortgage banking result soften from a seasonal slowdown in the quarter.
Returns on assets and equity continue to be very strong, driven by a still healthy net interest margin, solid expense control, sustained performance across our fee-based businesses and a stable credit outlook. High level of profitability has afforded us the ability to invest significantly in the future growth of the bank.
In regards to the quarter specifically, total loans increased by $31 million from last quarter with a strong level of originations mitigated by continuing payoff activity. Loan payoff activity accelerated every quarter in 2019 and we're hopeful the pace of payoffs will moderate in 2020.
We continue to be surprised by the level of payoff activity. However, loan pipelines remain healthy.
The competition for credit in our market still remains very aggressive both in terms of pricing and structure and with the tailwinds provided by an expanding margin having lessened, we expect to increase efforts to grow the loan book and capitalize upon recent additions to our staff. We’re optimistic we can achieve 5% to 7% loan growth in 2020, exclusive of any merger activity.
Lastly, as it pertains to the loan book, yields on the portfolio declined substantially from last quarter due to the benefit of accelerated accretion from the early payoff from an acquired loan in the prior quarter. Total deposits bounced back nicely on both a period end and average basis and growth here remains a key focus for us.
Our net total transaction account activity has largely been stable with declines primarily focused in higher cost relationships acquired in 2018. The loan to deposit ratio for the fourth quarter of 2019 remains unchanged at 91%.
We believe we can remain at these levels in the near term with long growth funded by a mix of deposit growth and modest balance sheet optimization. We remain very comfortable with asset quality trends overall.
Non-performing assets and classified loans increased modestly relative to last quarter, but remained well-controlled. Overall, we remain very encouraged about our results in a number of areas, and Brad will provide additional color in his prepared comments.
Brad Adams
Thank you, Jim. Net interest income declined by $1.6 million relative to the last quarter with about half of that decrease due to negative variances and accelerated accretion on acquired loans.
Fee income suffered a bit as mortgage banking income returned to a more normalized level. The reported taxable equivalent margin decreased by 28 basis points, as Jim said, from last quarter with about half of that contraction due to 15% pay downs in the acquired ABC portfolio during the prior quarter.
A few additional basis points were lost on the margin due to the sale of the securities during the third quarter though the trade in aggregate was a very good one with a subsequent movement in interest rates. Pricing movement on the liability side of balance sheet has been limited to this point, but we should begin to see reductions in funding costs in the first quarter of 2020.
Notably, margin trends in future periods will be impacted modestly by the adoption of CECL on January 1, 2020 with a further reduction in accretable discount offset by movement into the allowance for credit losses. Equity levels will also be modestly impacted by the change.
The overall increase in the level of credit loss reserve is currently estimated at a $4 million to $6 million increase in the loss reserve, will be largely derived by the reclassification of purchase accounting credit discount into the loss reserve. As these loans mature, we will begin to see these reserve levels migrate down to levels not inconsistent with historical trends for us given the relatively short duration nature of our loan portfolio.
Our efforts in the coming quarters will be focused on quality loan growth and core funding with the expectation of further modest contraction in margin trends going forward. The loan to deposit ratio leaves us well positioned and we have ample flexibility both to continue to pursue growth, while protecting our core deposit base.
As Jim mentioned, it is likely we will seek to optimize the earnings asset mix and fund future loan growth going forward through a mixture of deposit growth and earning asset optimization. Our margin trends in the future should be relatively stable with a modest negative bias absent any movement in the Fed funds rate.
Notably, we saw significant decreases in the LIBOR rate during the third quarter or during the fourth quarter that were in excess of our expectations. We are incredibly sensitive to movements in LIBOR rate.
Should it recover and start moving in the other direction, obviously, this guidance will prove conservative. Should it continue to trend downward, we would not do as well.
Overall loan growth will become a much more important factor for us with the outlook for short-term rates having changed, but I believe we have a significant opportunity in front of us. On the fee income side, mortgage banking reflected a decline, again, on sale margins during the quarter and more modest pipelines, although MSR valuations for the fourth quarter compared to third quarter were more favorable.
Trust and wealth management remained steady and retail banking trend slowed modestly in both fees and card activity during the quarter. Expenses remained very well-controlled, as you can see, with additional sales hires largely offset by seasonal factors during the fourth quarter and continuing investments for future growth are largely baked into a run rate trends you have been seeing from us.
With that, I’ll turn the call back over to Jim.
Jim Eccher
Thanks, Brad. In closing, we remain encouraged with these trends and optimistic about the future.
On an organic basis, operating leverage remained strong and we're excited about the quality of talent added to the organization in the last two quarters. Profitability remains excellent and we are pleased that the outlook for short-term rate movements has stabilized since we last spoke.
Capital has continued to build significantly for our company and though we remain very comfortable with the returns we are generating we will be evaluating opportunities to return capital to shareholders and reduce high cost debt versus our outlook for opportunities to invest capital. 2019 overall was a very good year for us.
2020 will be more difficult if interest rates hold here or decline further. We're taking the steps to position ourselves well for either continued strength in the local economy or the possibility of a potential slowdown.
We believe our credit underwriting has remained disciplined and our funding and capital position is strong. Overall, team here has never been better and I remain optimistic that opportunities are available to improve our footprint.
The focus for us is on timing and making sure that we have access to the capital we need in order to take advantage. Periods of significant changes in the volatility of bank valuations make M&A more difficult in the community bank space, but things can change quickly on that front, especially as move through what may well be a more difficult year for some banks.
That concludes our prepared comments this morning. So, I will turn it over to the moderator and open it up to questions.
Operator
Thank you. [Operator Instructions] We’ll go first to Chris McGratty with KBW.
Chris McGratty
Hi, Good morning, Jim. Hi, Brad.
Jim Eccher
Good morning, Chris.
Chris McGratty
Could you maybe start on expenses? You guys have done a pretty good job keeping the expenses flat.
In light of your comments on the revenue growth be more of a challenge for the group, how do we think about the trajectory of expenses given what you’re doing on the hiring front?
Brad Adams
You know, I think that given some momentum on the loan growth side, I don't think there's anything aggressive needs to be done there. We had talked in the past kind of a low-single digit number on the expense growth line.
We’re watching things carefully relative to loan growth. I’d say the prepayments are still very highly elevated.
We saw a number of significant prepayments during the fourth quarter. If that trend continues, we need to get more aggressive on expenses, but for now, we’re still comfortable with the thinking for the year.
Chris McGratty
Okay, great. And then, you talked about the balance sheet optimization.
You guys obviously have done a lot of work on the balance sheet in the last couple of years, how do we think about – if you’re loan growth, I think you said 5 to 7, to be assuming earning asset growth trails at in the security book like flat to down or how do we think about that mix, Brad?
Brad Adams
At this point given some positive moment on the deposit side, I think that we can hold relatively steady on the securities portfolio. That would be our lever if deposit growth isn’t there to shrink that portfolio modestly, but again, our real exposure is to down short rates and adding additional funding that does reprice with the short-end of the curve is not something that I would shy away from at this point given where we are in that cycle and what our overall positioning based on just the character of what we are, which is an extremely well core funded community bank.
Chris McGratty
Got it, great. And maybe just last one for you Jim, you touched upon in your closing remarks the capital, how do we think about the ranking of the priorities of return capital and redeeming the debt?
You talked about it last quarter, but obviously the rate outlook has gotten a little harder, thanks.
Jim Eccher
Yes, obviously we’re focused internally on organic loan growth first, but we certainly are taking a very hard look at TruPS redemption and reducing some of this high cost debt. That is probably right of the top of the list.
Chris McGratty
Thanks.
Operator
We’ll take our next question from David Long with Raymond James.
David Long
Good morning everyone.
Brad Adams
Hi, David. How are you?
David Long
Good. The pay downs that you've been having, what are you baking into the pay down levels for 2020 when you talk about a 5% to 7% loan growth outlook?
Jim Eccher
Yes, that’s been there. That’s been the challenge obviously in 2019.
We saw a pretty significant acceleration in pay downs each and every quarter, partially – the reason for that partially is the dynamics of our portfolio are changing. The duration is relatively short, but we had unusually very high pay downs in the third and fourth quarter, so we do expect that to moderate, you know, and you know, it's hard to peg that because we’re seeing a lot of clients sell properties that we – you know that we, you know, didn't even really know about.
So, given the pace of loan originations, we’re optimistic that’s going to slow to more, you know, normalized levels in 2020.
David Long
Got it, okay. And from an operating leverage perspective, can you guys put up positive operating leverage in 2020 even with the NIM challenges?
Or does the NIM – the headwinds from the NIM make that too difficult at this point?
Brad Adams
I think all we really need to see for the positive operating leverage is for LIBOR to quit contracting relative to the overnight rate. The LIBOR rate has shown great deal of compression during the fourth quarter and to a level that surprised me to be honest.
If that ceases, if it stabilizes, then I believe we can show operating leverage.
David Long
Got it. And then, as it relates to CECL, I think, Brad, you made some comments about the purchase accounting and did I hear right that you will move the credit marks out of the purchase loans into the reserve, I mean that you're considering the loans PCD at this point?
Brad Adams
Yes. So, overall the reserve level should go up like I said, $4 million to $6 million, a significant portion of that rather than being an adjustment to equity will be an adjustment from the credit loss reserve on acquired loans, and the adjustment overall, from an equity standpoint, should be relatively small for us.
Again, those loan books that have a short duration, i.e. more commercial bench, are not going to see the type of impact that residential and consumer balance sheets are going to see.
David Long
Got it. I appreciate the additional color there.
Thanks guys.
Operator
And we will go next to Evan Lisle with Janney.
Evan Lisle
Hi, good morning. I’m on the call for Brian Martin.
Jim Eccher
Okay.
Brad Adams
Okay.
Evan Lisle
First, appreciate the color on margin and I just – or just kind of curious how you're thinking about the margin in 2020 with a flat rate environment, and then possibly with forecasting one cut [indiscernible]?
Brad Adams
Well, I don’t think we’re going to see one cut. If we see any cuts, we’ll probably see a number of them.
Evan Lisle
Okay.
Brad Adams
One cut doesn’t make a whole lot of sense to me. You know, I think that a stable rate environment applying the methodology that nothing changes anywhere on the curve and you take the steepening that we saw, I would feel pretty good about that.
If you're talking about any rate cuts, that doesn't excite me on the slightest. You know, I think loan growth can overcome one rate cut if that’s been the scenario you want to talk about that, you know, in general, nothing changes.
I think that we would lose a couple of basis points with CECL and delayed impacts with the LIBOR moves that have that occurred, and I think we’d be relatively stable from that point.
Evan Lisle
Okay. [Indiscernible].
Brad Adams
The challenges in margin guidance is taking the rate moves that have happened, telling everybody their static and then accounting for the lagged effects of those rate moves that have occurred. You know, in general, over a full cycle, irrespective of when quarter cutoffs are, we lose 3 to 5 for a rate cut.
It's not – doesn't always fit well within to a quarter, but that is the overall impact.
Evan Lisle
Okay. No, I appreciate that.
and next just talking about the people you hired in 2019, can you just give a quick outlook about that, and then, you know, potential hires in 2020 and just your outlook for that in the future?
Jim Eccher
You know, we made a – we obviously made a number of adds in the latter half of 2019 all season Chicago-based lenders, about six of them. You know, we’ve also, you know, added to the retail bank and our treasury group, so we feel real good about the talent we’ve added.
A large portion of our loan growth in the fourth quarter came very late in quarter too, so while our footings are up, we’re really didn’t see much benefit of that in the margin. So, we continue to be opportunistic on the new talent front.
So, if those opportunities come along, we will selectively continue to add.
Evan Lisle
Awesome, and just touching on the loan pipeline and the Chicago hires, it looks like, you know, last quarter most of your originations are coming from the Chicago market, is that still fair to say in this quarter?
Jim Eccher
I would say yes.
Evan Lisle
Okay, awesome. And then, just housekeeping thing, just can you discuss, you know, how are you thinking about your provisioning in 2020 under CECL?
Jim Eccher
As we said previously, it – wouldn’t expect it to be materially different than historical trends. The provision level with the adjustment itself will be higher given the size of the acquired loan portfolio, but from our ongoing originations standpoint, I doubt it’s too much of a difference.
Evan Lisle
Alright, perfect. Yes, that’s all I have.
Thank you for that color.
Jim Eccher
Alright.
Operator
[Operator Instructions] We’ll go next to Nathan Race with Piper Sandler.
Nathan Race
Good morning [indiscernible] how are you doing. I wanted to touch on the $2.5 million in loans past 90 days on that period this quarter.
Could you provide some color on that maybe the industry focus and collateral back up and what you guys expect from that going forward? Thank you.
Jim Eccher
Yes, we had a couple of just administrative past dues at the quarter that weren't classified and we did see a – you know we did see a moderate uptick in classifieds where we expect to – we expect to have those remediated in the first quarter of this year.
Nathan Race
Okay. And then, turning to kind of loan pricing, do you guys by chance have the weighted average rate on new production this quarter?
Jim Eccher
Yes, this quarter we were – we obviously fell off a little bit with LIBOR dropping, but we were in the mid-to-high 4s on weighted average yield.
Nathan Race
And how did – okay and that dropped. Is there – how that compared to third quarter?
Jim Eccher
You know, we dropped about 30 basis points to 40 basis points.
Nathan Race
Okay, thanks. And then, maybe can you provide a little color on the loan pricing dynamics you're seeing in the market right now and maybe where the competition is coming from?
Is it the larger guys? Or is it the smaller community banks that are pushing the pricing?
Jim Eccher
Well, obviously, in Chicago, we're seeing competition from the larger banks. And then in our, you know, more rural areas, you know, the smaller community banks provide pretty competitive pressures there, but, you know, the primary growth engine for us has been in Chicago, so we’re competing with the larger banks there.
Nathan Race
Okay, thanks. I’ll step back.
Jim Eccher
Thank you.
Operator
Mr. Eccher, there appears to be no further questions at this time.
I’d like to turn the call back over to you for any closing comments.
Jim Eccher
Okay. Thank you everyone for joining us this morning and we look forward to speaking with you again next quarter.
Good bye.
Operator
Ladies and gentlemen, this does conclude today's teleconference. We appreciate your participation.
You may disconnect your line at this time and have a good day.