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OLD SECOND BANCORP INC - Quarter Report: 2020 September (Form 10-Q)

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I

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2020

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For transition period from          to          

Commission File Number 0-10537

Graphic

(Exact name of Registrant as specified in its charter)

Delaware

36-3143493

(State or other jurisdiction

(I.R.S. Employer Identification Number)

of incorporation or organization)

37 South River Street, AuroraIllinois     60507

(Address of principal executive offices) (Zip Code)

(630) 892-0202

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes         No 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  No 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of ‘‘large accelerated filer,’’ ‘‘accelerated filer,’’ ‘‘smaller reporting company,’’ and ‘‘emerging growth company’’ in Rule 12b–2 of the Exchange Act.

Large accelerated filerAccelerated filer

Non-accelerated filerSmaller reporting companyEmerging growth company

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).

Yes         No 

Title of each class

Trading Symbol(s)

Name of each exchange on which registered

Common Stock

OSBC

The Nasdaq Stock Market

As of November 4, 2020, the Registrant has 29,355,022 shares of common stock outstanding at $1.00 par value per share.

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OLD SECOND BANCORP, INC.

Form 10-Q Quarterly Report

Table of Contents

Cautionary Note Regarding Forward-Looking Statements

PART I

Page Number

Item 1.

Financial Statements

5

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

42

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

69

Item 4.

Controls and Procedures

70

PART II

Item 1.

Legal Proceedings

71

Item 1.A.

Risk Factors

71

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

71

Item 3.

Defaults Upon Senior Securities

72

Item 4.

Mine Safety Disclosure

72

Item 5.

Other Information

72

Item 6.

Exhibits

73

Signatures

74

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report and other publicly available documents of the Company contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act, including with respect to management’s expectations regarding future plans, strategies and financial performance, including regulatory developments, industry and economic trends, and other matters.  Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, can be identified by the inclusion of such qualifications as “expects,” “intends,” “believes,” “may,” “will,” “would,” “could,” “should,” “plan,” “anticipate,” “estimate,” “possible,” “likely” or other indications that the particular statements are not historical facts and refer to future periods. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and may be outside of the Company’s control. Actual events and results may differ materially from those described in such forward-looking statements due to numerous factors, including:

our ability to execute our growth strategy;
the impact of the outbreak of the novel coronavirus, or COVID-19, on our business, including the impact of the actions taken by governmental authorities to try and contain the virus or address the impact of the virus on the United States economy (including, without limitation, the Coronavirus Aid, Relief and Economic Security Act, or the CARES Act), and the resulting effect of these items on our operations, liquidity and capital position, and on the financial condition of our borrowers and other customers;
negative economic conditions that adversely affect the economy, real estate values, the job market and other factors nationally and in our market area, in each case that may affect our liquidity and the performance of our loan portfolio;
impairment of goodwill, other intangible assets or deferred tax assets;
our ability to achieve anticipated results from any bank acquisition depends on the state of the economic and financial markets going forward. Specifically, we may incur more credit losses than expected, cost savings may be less than expected, anticipated strategic gains may be significantly harder or take longer to achieve than expected or may not be achieved in their entirety, and customer attrition may be greater than expected;
the financial success and viability of the borrowers of our commercial loans;
changes in U.S. monetary policy, the level and volatility of interest rates, the capital markets and other market conditions that may affect, among other things, our liquidity and the value of our assets and liabilities;
competitive pressures from other financial service businesses and from nontraditional financial technology (“FinTech”) companies;
any negative perception of our reputation or financial strength;
ability to raise additional capital on acceptable terms when needed;
ability to raise cost-effective funding to support business plans when needed:
ability to use technology to provide products and services that will satisfy customer demands and create efficiencies in operations;
adverse effects on our information technology systems resulting from failures, human error or cyberattacks;
adverse effects of failures by our vendors to provide agreed upon services in the manner and at the cost agreed, particularly our information technology vendors and those vendors performing a service on the Company’s behalf;
the impact of any claims or legal actions, including any effect on our reputation;
losses incurred in connection with repurchases and indemnification payments related to mortgages;
the soundness of other financial institutions and other counter-party risk;
changes in accounting standards, rules and interpretations and the impact on our financial statements;
our ability to receive dividends from our subsidiaries;
a decrease in our regulatory capital ratios;
adverse federal or state tax assessments;
risks associated with actual or potential litigation or investigations by customers, regulatory agencies or others;
legislative or regulatory changes, particularly changes in regulation of financial services companies;
increased costs of compliance, heightened regulatory capital requirements and other risks associated with changes in regulation and the current regulatory environment, including the Dodd-Frank Act;
negative changes in our capital position;
the adverse effects of events such as outbreaks of contagious disease, war or terrorist activities, or essential utility outages, including deterioration in the global economy, instability in credit markets and disruptions in our customers’ supply chains and transportation;
changes in trade policy and any related tariffs; and

3

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each of the factors and risks under the heading “Risk Factors” in our 2019 Annual Report on Form 10-K, Part II, Item 1A, Risk Factors, in our Quarterly Reports on Form 10-Q, and in subsequent filings we make with the SEC.

Because the Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain, there can be no assurances that future actual results will correspond to any forward-looking statements and you should not rely on any forward-looking statements.  Additionally, all statements in this Form 10-Q, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events, except as required by applicable law.

4

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share data)

(unaudited)

September 30, 

December 31, 

    

2020

    

2019

Assets

Cash and due from banks

$

29,489

$

34,096

Interest earning deposits with financial institutions

283,651

16,536

Cash and cash equivalents

313,140

50,632

Securities available-for-sale, at fair value

448,421

484,648

Federal Home Loan Bank Chicago ("FHLBC") and Federal Reserve Bank Chicago ("FRBC") stock

9,917

9,917

Loans held-for-sale

10,229

3,061

Loans

2,030,327

1,930,812

Less: allowance for credit losses on loans

32,918

19,789

Net loans

1,997,409

1,911,023

Premises and equipment, net

44,914

44,354

Other real estate owned

2,686

5,004

Mortgage servicing rights, net

5,010

5,935

Goodwill and core deposit intangible

20,901

21,275

Bank-owned life insurance ("BOLI")

62,222

61,763

Deferred tax assets, net

9,626

11,459

Other assets

50,349

26,474

Total assets

$

2,974,824

$

2,635,545

Liabilities

Deposits:

Noninterest bearing demand

$

889,085

$

669,795

Interest bearing:

Savings, NOW, and money market

1,185,731

1,015,285

Time

404,427

441,669

Total deposits

2,479,243

2,126,749

Securities sold under repurchase agreements

59,268

48,693

Other short-term borrowings

6,125

48,500

Junior subordinated debentures

25,773

57,734

Senior notes

44,349

44,270

Notes payable and other borrowings

24,469

6,673

Other liabilities

39,329

25,062

Total liabilities

2,678,556

2,357,681

Stockholders’ Equity

Common stock

34,957

34,854

Additional paid-in capital

121,746

120,657

Retained earnings

228,825

213,723

Accumulated other comprehensive income

11,044

4,562

Treasury stock

(100,304)

(95,932)

Total stockholders’ equity

296,268

277,864

Total liabilities and stockholders’ equity

$

2,974,824

$

2,635,545

September 30, 2020

December 31, 2019

Common

Common

Stock

    

Stock

Par value

$

1.00

$

1.00

Shares authorized

60,000,000

60,000,000

Shares issued

34,957,384

34,853,757

Shares outstanding

29,451,585

29,931,809

Treasury shares

5,505,799

4,921,948

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Income

(In thousands, except per share data)

(unaudited)

(unaudited)

Three Months Ended September 30, 

Nine Months Ended September 30, 

    

2020

    

2019

    

2020

    

2019

    

Interest and dividend income

Loans, including fees

$

21,980

$

25,109

$

67,924

$

74,132

Loans held-for-sale

95

47

241

100

Securities:

Taxable

1,458

2,296

5,315

6,933

Tax exempt

1,327

1,719

4,178

5,958

Dividends from FHLBC and FRBC stock

118

154

366

459

Interest bearing deposits with financial institutions

68

119

185

344

Total interest and dividend income

25,046

29,444

78,209

87,926

Interest expense

Savings, NOW, and money market deposits

299

724

1,319

2,254

Time deposits

1,084

1,672

4,292

4,931

Securities sold under repurchase agreements

28

135

167

431

Other short-term borrowings

24

429

167

1,611

Junior subordinated debentures

285

933

1,932

2,791

Senior notes

673

682

2,019

2,026

Notes payable and other borrowings

144

89

439

312

Total interest expense

2,537

4,664

10,335

14,356

Net interest and dividend income

22,509

24,780

67,874

73,570

Provision for credit losses

300

550

10,413

1,450

Net interest and dividend income after provision for credit losses

22,209

24,230

57,461

72,120

Noninterest income

Trust income

1,506

1,730

4,702

4,955

Service charges on deposits

1,322

2,020

4,168

5,841

Secondary mortgage fees

492

282

1,267

621

Mortgage servicing rights mark to market loss

(160)

(946)

(2,739)

(2,902)

Mortgage servicing income

521

460

1,447

1,408

Net gain on sales of mortgage loans

5,246

2,074

12,123

3,999

Securities (losses) gains , net

(1)

3,463

(25)

4,476

Change in cash surrender value of BOLI

459

267

942

1,045

Death benefit realized on BOLI

(2)

-

57

-

Card related income

1,499

1,595

4,097

4,433

Other income

803

988

2,663

2,682

Total noninterest income

11,685

11,933

28,702

26,558

Noninterest expense

Salaries and employee benefits

12,586

12,062

36,846

35,261

Occupancy, furniture and equipment

2,003

2,235

6,239

6,149

Computer and data processing

1,226

1,490

3,808

4,346

FDIC insurance

191

(114)

403

176

General bank insurance

281

270

764

756

Amortization of core deposit intangible

122

157

374

410

Advertising expense

62

360

228

975

Card related expense

566

531

1,612

1,360

Legal fees

169

111

476

480

Other real estate expense, net

125

26

505

324

Other expense

2,935

2,826

8,909

9,037

Total noninterest expense

20,266

19,954

60,164

59,274

Income before income taxes

13,628

16,209

25,999

39,404

Provision for income taxes

3,363

4,036

6,221

9,485

Net income

$

10,265

$

12,173

$

19,778

$

29,919

Basic earnings per share

$

0.35

$

0.41

$

0.67

$

1.00

Diluted earnings per share

0.34

0.40

0.65

0.98

Dividends declared per share

0.01

0.01

0.03

0.03

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(In thousands)

(unaudited)

(unaudited)

Three Months Ended September 30, 

Nine Months Ended September 30, 

    

2020

    

2019

    

2020

    

2019

Net Income

$

10,265

$

12,173

$

19,778

$

29,919

Unrealized holding gains on available-for-sale securities arising during the period

5,812

5,824

10,455

23,661

Related tax expense

(1,633)

(1,638)

(2,932)

(6,657)

Holding gains after tax on available-for-sale securities

4,179

4,186

7,523

17,004

Less: Reclassification adjustment for the net (losses) gains realized during the period

Net realized (losses) gains

(1)

3,463

(25)

4,476

Related tax (expense) benefit

-

(973)

7

(1,257)

Net realized gains (losses) after tax

(1)

2,490

(18)

3,219

Other comprehensive income on available-for-sale securities

4,180

1,696

7,541

13,785

Changes in fair value of derivatives used for cash flow hedges

615

(1,996)

(1,472)

(4,638)

Related tax (expense) benefit

(173)

559

413

1,303

Other comprehensive income (loss) on cash flow hedges

442

(1,437)

(1,059)

(3,335)

Total other comprehensive income

4,622

259

6,482

10,450

Total comprehensive income

$

14,887

$

12,432

$

26,260

$

40,369

Accumulated

Accumulated

Total

Unrealized Gain

Unrealized Gain

Accumulated Other

(Loss) on Securities

(Loss) on Derivative

Comprehensive

Available-for -Sale

Instruments

Income/(Loss)

For the Three Months Ended

Balance, June 30, 2019

$

8,051

$

(1,939)

$

6,112

Other comprehensive income (loss), net of tax

1,696

(1,437)

259

Balance, September 30, 2019

$

9,747

$

(3,376)

$

6,371

Balance, June 30, 2020

$

10,188

$

(3,766)

$

6,422

Other comprehensive income, net of tax

4,180

442

4,622

Balance, September 30, 2020

$

14,368

$

(3,324)

$

11,044

For the Nine Months Ended

Balance, December 31, 2018

$

(4,038)

$

(41)

$

(4,079)

Other comprehensive income (loss), net of tax

13,785

(3,335)

10,450

Balance, September 30, 2019

$

9,747

$

(3,376)

$

6,371

Balance, December 31, 2019

$

6,827

$

(2,265)

$

4,562

Other comprehensive income (loss), net of tax

7,541

(1,059)

6,482

Balance, September 30, 2020

$

14,368

$

(3,324)

$

11,044

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

Nine Months Ended September 30, 

2020

    

2019

    

Cash flows from operating activities

Net income

$

19,778

$

29,919

Adjustments to reconcile net income to net cash provided by operating activities:

Net premium / discount from amortization on securities

1,712

2,128

Securities losses (gains), net

25

(4,476)

Provision for credit losses

10,413

1,450

Originations of loans held-for-sale

(296,388)

(126,929)

Proceeds from sales of loans held-for-sale

300,045

127,455

Net gains on sales of mortgage loans

(12,123)

(3,999)

Mortgage servicing rights mark to market loss

2,739

2,902

Net discount from accretion on loans

(841)

(1,052)

Net change in cash surrender value of BOLI

(942)

(1,045)

Net gains on sale of other real estate owned

(188)

(254)

Provision for other real estate owned valuation losses

264

399

Depreciation of fixed assets and amortization of leasehold improvements

2,075

1,869

Net gains on disposal and transfer of fixed assets

-

(32)

Amortization of core deposit intangibles

374

410

Change in current income taxes receivable

(781)

3,319

(Benefit from) / Provision for deferred tax expense

(693)

4,493

Change in accrued interest receivable and other assets

(19,144)

(7,441)

Accretion of purchase accounting adjustment on time deposits

-

(38)

Amortization of purchase accounting adjustment on notes payable and other borrowings

25

75

Amortization of junior subordinated debentures issuance costs

643

36

Amortization of senior notes issuance costs

79

86

Change in accrued interest payable and other liabilities

8,060

6,366

Stock based compensation

1,623

1,905

Net cash provided by operating activities

16,755

37,546

Cash flows from investing activities

Proceeds from maturities and calls, including pay down of securities available-for-sale

41,645

32,631

Proceeds from sales of securities available-for-sale

18,006

177,824

Purchases of securities available-for-sale

(14,681)

(136,096)

Net proceeds from sales of FHLBC stock

-

2,722

Net change in loans

(100,370)

(2,833)

Proceeds from claims on BOLI, net of claims receivable

483

-

Proceeds from sales of other real estate owned, net of participation purchase

3,140

2,644

Proceeds from disposition of fixed assets

-

32

Net purchases of premises and equipment

(2,635)

(2,330)

Net cash (used in) provided by investing activities

(54,412)

74,594

Cash flows from financing activities

Net change in deposits

352,494

(42,144)

Net change in securities sold under repurchase agreements

10,575

2,238

Net change in other short-term borrowings

(42,375)

(65,500)

Redemption of junior subordinated debentures

(32,604)

-

Issuance of term note

20,000

-

Repayment of term note

(2,000)

-

Net change in notes payable and other borrowings, excluding term note

(229)

(6,598)

Proceeds from exercise of stock options

-

32

Dividends paid on common stock

(893)

(896)

Purchase of treasury stock

(4,803)

(470)

Net cash provided by (used in) financing activities

300,165

(113,338)

Net change in cash and cash equivalents

262,508

(1,198)

Cash and cash equivalents at beginning of period

50,632

55,235

Cash and cash equivalents at end of period

$

313,140

$

54,037

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Changes in

Stockholders’ Equity

(In thousands)

Accumulated

Additional

Other

Total

(unaudited)

Common

Paid-In

Retained

Comprehensive

Treasury

Stockholders’

    

Stock

    

Capital

    

Earnings

    

Income (Loss)

    

Stock

    

Equity

For the Three Months Ended

Balance, June 30, 2019

$

34,825

$

119,762

$

192,612

$

6,112

$

(96,047)

$

257,264

Net income

12,173

12,173

Other comprehensive income, net of tax

259

259

Dividends declared and paid, ($0.01 per share)

(299)

(299)

Vesting of restricted stock

(135)

135

-

Stock based compensation

664

664

Purchase of treasury stock

(40)

(40)

Balance, September 30, 2019

$

34,825

$

120,291

$

204,486

$

6,371

$

(95,952)

$

270,021

Balance, June 30, 2020

$

34,957

$

121,437

$

218,856

$

6,422

$

(99,156)

$

282,516

Net income

10,265

10,265

Other comprehensive income, net of tax

4,622

4,622

Dividends declared and paid, ($0.01 per share)

(296)

(296)

Stock based compensation

309

309

Purchase of treasury stock from stock repurchase program

(1,148)

(1,148)

Balance, September 30, 2020

$

34,957

$

121,746

$

228,825

$

11,044

$

(100,304)

$

296,268

Accumulated

Additional

Other

Total

Common

Paid-In

Retained

Comprehensive

Treasury

Stockholders’

Stock

    

Capital

    

Earnings

    

Income (Loss)

    

Stock

    

Equity

For the Nine Months Ended

Balance, December 31, 2018

$

34,720

$

119,081

$

175,463

$

(4,079)

$

(96,104)

$

229,081

Net income

29,919

29,919

Other comprehensive income, net of tax

10,450

10,450

Dividends declared and paid, ($0.03 per share)

(896)

(896)

Vesting of restricted stock

103

(389)

286

-

Stock option exercised

2

7

23

32

Stock warrants exercised

(313)

313

-

Stock based compensation

1,905

1,905

Purchase of treasury stock

(470)

(470)

Balance, September 30, 2019

$

34,825

$

120,291

$

204,486

$

6,371

$

(95,952)

$

270,021

Balance, December 31, 2019

$

34,854

$

120,657

$

213,723

$

4,562

$

(95,932)

$

277,864

Net income

19,778

19,778

Other comprehensive income, net of tax

6,482

6,482

Adoption of ASU 2016-13

(3,783)

(3,783)

Dividends declared and paid, ($0.03 per share)

(893)

(893)

Vesting of restricted stock

103

(534)

431

-

Stock based compensation

1,623

1,623

Purchase of treasury stock from taxes withheld on stock awards

(423)

(423)

Purchase of treasury stock from stock repurchase program

(4,380)

(4,380)

Balance, September 30, 2020

$

34,957

$

121,746

$

228,825

$

11,044

$

(100,304)

$

296,268

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Note 1 – Basis of Presentation and Changes in Significant Accounting Policies

Except as set forth below in this Note 1, the accounting policies followed in the preparation of the interim consolidated financial statements are consistent with those used in the preparation of the annual financial information.  The interim consolidated financial statements reflect all normal and recurring adjustments that are necessary, in the opinion of management, for a fair statement of results for the interim period presented.  Results for the period ended September 30, 2020, are not necessarily indicative of the results that may be expected for the year ending December 31, 2020.  These interim consolidated financial statements are unaudited and should be read in conjunction with the audited financial statements and notes included in Old Second Bancorp, Inc.’s (the “Company”) annual report on Form 10-K for the year ended December 31, 2019.  Unless otherwise indicated, dollar amounts in the tables contained in the notes to the consolidated financial statements are in thousands.  Certain items in prior periods have been reclassified to conform to the current presentation.

The Company’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry.  Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes.  These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements.  Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.

Recent Accounting Pronouncements

In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Measurement of Credit Losses on Financial Instruments (Topic 326),” also known as Current Expected Credit Losses, or CECL.  ASU 2016-13 was issued to provide financial statement users with more useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date to enhance the decision making process.  The new methodology reflects expected credit losses based on relevant vintage historical information, supported by reasonable forecasts of projected loss given defaults, which will affect the collectability of the reported amounts.  This new methodology also requires available-for-sale debt securities to have a credit loss recorded through an allowance rather than write-downs through an other than temporary impairment analysis.  In addition, an allowance must be established for the credit risk related to unfunded commitments.  ASU 2016-13 is effective for financial statements issued for fiscal years beginning after December 15, 2019, and was adopted as of January 1, 2020, by the Company.

Upon issuance of ASU 2016-13, the Company set up a CECL committee, with the goal of establishing a timeline for CECL data collection, implementation, parallel runs, testing, and model validation.  The Company has implemented a software solution provided by a third party vendor to assist in the determination of the allowance for credit losses (“ACL”), and the third party validation process was completed in the fourth quarter of 2019.  The Company accumulated historical data by loan pools and collateral classifications.  All historical data, model assumptions and calculation parameters were analyzed by the third party validation team, and management made enhancements to the software model used based on their recommendations.

Our approach for estimating expected life-time credit losses for loans includes the following components:

An initial forecast period of one year for all portfolio segments and off-balance-sheet credit exposures. This period reflects management’s expectation of losses based on forward-looking economic scenarios over that time.
A historical reversion loss forecast period covering the remaining contractual life, adjusted for prepayments, by portfolio segment based on the historical loss rate of loans within those segments.
The initial loss forecast period and historical reversion loss rate is based on economic conditions at the measurement date.
We primarily utilized the static pool and migration analysis methods to estimate credit losses. Such methods would obtain estimated life-time credit losses using the conceptual components described above.

Based on our portfolio composition at December 31, 2019, and the economic environment at that time, we recorded an overall increase in our ACL for loans and leases of $5.9 million and an ACL for unfunded commitments of $1.7 million.  Approximately $2.5 million of the increase to the ACL on loans resulted from the transfer of the non-accretable purchase accounting adjustments on purchased credit impaired loans.  There was no impact from adoption of CECL on securities available-for sale. As a result of the adoption of this new standard on January 1, 2020, we recorded a reduction to retained earnings of approximately $3.7 million, which was net of the $1.4

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

million deferred tax asset impact stemming from adoption.  The Company finalized internal control processes and disclosure documentation related to adoption of this standard during the first quarter of 2020.

As of March 31, 2020, a provision for credit losses of $8.0 million was recorded, comprised of $5.2 million of ACL related to loans and leases and $2.5 million of ACL related to unfunded commitments, based on the uncertainty experienced in the macroeconomic environment, primarily due to falling interest rates and the impact of COVID-19.  This additional ACL was not considered part of the ASU 2016-13 adoption, as these changes in the assessment of the ACL occurred after the January 1, 2020, adoption. We recorded a provision for credit losses of $2.1 million during the second quarter of 2020, comprised of $1.4 million of ACL related to loans and leases, and $734,000 of ACL related to unfunded commitments.  We recorded a provision for credit losses of $300,000 during the third quarter of 2020, comprised of $1.3 million of ACL related to loans and leases, and a $980,000 reversal of ACL related to unfunded commitments due to a reduction in the funding rate assumptions based on analysis of the twelve month utilization rate on commercial commitments. We will continue to assess and evaluate the estimated future credit loss impact of current market conditions in subsequent reporting periods, which will be highly dependent on credit quality, macroeconomic forecasts and conditions, the local and national response to the COVID-19 pandemic, as well as the composition of our loans and available-for-sale securities portfolio.

Change in Significant Accounting Policies

Significant accounting policies are presented in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.  These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined.

In addition to the significant accounting policies presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, on January 1, 2020, as discussed above, the Company adopted CECL, an expected loss methodology which replaces the incurred loss methodology for determining the Company’s provision for loan losses and allowance for loan and lease losses. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables and held-to-maturity debt securities. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) and net investments in leases recognized by a lessor in accordance with ASU 2016-02 “Leases (Topic 842)” (“ASU 2016-02”). In addition, CECL made changes to the accounting for available-for-sale debt securities. The allowance for credit losses under CECL is discussed below.

Allowance for Credit Losses

The ACL is an estimate of the expected credit losses on the loans held for investment, unfunded loan commitments, and available-for-sale debt securities portfolios.

Allowance for Credit Losses on Loans

The ACL is calculated according to GAAP standards and is maintained by management at a level believed adequate to absorb estimated credit losses that are expected to occur within the existing loan portfolio through their contractual terms.  The ACL is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on loans.  Determination of the ACL is inherently subjective in nature since it requires significant estimates and management judgment, and includes a level of imprecision given the difficulty of identifying and assessing the factors impacting loan repayment and estimating the timing and amount of losses.  While management utilizes its best judgment and information available, the ultimate adequacy of the ACL is dependent upon a variety of factors beyond the Company’s direct control, including, but not limited to, the performance of the loan portfolio, consideration of current economic trends, changes in interest rates and property values, estimated losses on pools of homogeneous loans based on an analysis that uses historical loss experience for prior periods that are determined to have like characteristics with the current period such as pre-recessionary, recessionary, or recovery periods, portfolio growth and concentration risk, management and staffing changes, the interpretation of loan risk classifications by regulatory authorities and other credit market factors.  While each component of the ACL is determined separately, the entire balance is available for the entire loan portfolio.

The ACL methodology consists of measuring loans on a collective (pool) basis when similar risk characteristics exist.  The Company has identified the following loan portfolios and measures the ACL using the following methods:

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Commercial loans – the Company uses a migration analysis, and within this segment classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative factor adjustment in addition to the loss rates applied, as discussed below.
Leases – the Company uses a remaining life methodology, also known as WARM (weighted average remaining maturity), as this segment is relatively new to the Company and more than four years of the Company’s own historical loss data is not available.  In accordance with accounting standards, we used an identified peer group to estimate losses for this portfolio.
Real estate – commercial (“CRE”) – this loan portfolio is segregated into two segments:
oCRE owner occupied – the Company uses a migration analysis, and within this segment classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative adjustment in addition to the loss rates applied, as discussed below.
oCRE investor – the Company uses a migration analysis, and within this segment classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative adjustment in addition to the loss rates applied, as discussed below.
Real estate-construction – the Company uses a static segment analysis, which relies on the Company’s historical loss rates, as well as a qualitative adjustment in addition to the loss rates applied.  
Real estate-residential  – this loan portfolio is segregated into two segments:
oResidential owner occupied and Residential investor – the Company uses a static segment analysis, applying historical loss rates from periods with like characteristics as the current period, and also a qualitative adjustment in addition to the loss rates applied.
Multifamily – the Company uses a migration analysis, and within this segment, the Company classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative adjustment in addition to the loss rates applied.
HELOCs – this portfolio is segregated into two segments, a HELOC legacy segment which uses a static pool analysis, and a HELOC purchased segment, which uses the WARM method, and applies loss rates from the institutions from which the Company purchased the HELOCs, if available.

Purchased credit deteriorated loans (“PCD loans”), are purchased loans that, as of the date of acquisition, the Company determined had experienced a more-than-insignificant deterioration in credit quality since origination. The Company records acquired PCD loans by adding the expected credit losses (i.e., the ACL) to the purchase price of the financial assets rather than recording it through the provision for credit losses in the income statement; thus, the sum of the loans’ purchase price and initial ALLL estimate represents the initial amortized cost basis.    The difference between the initial amortized cost basis and the unpaid principal balance is the non-credit discount or premium.  Subsequent changes in the ACL on PCD loans is recognized through the provision for credit losses.  

The non-credit discount or premium is accreted or amortized into interest income over the remaining life of the PCD loan on a level-yield basis.  In accordance with the transition requirements within the CECL standard, the Company’s purchased credit impaired loans (“PCI loans”) are now treated as PCD loans.  Before January 1, 2020, PCI loans that met the definition of nonperforming loans were excluded from the Company’s nonperforming disclosures, as long as their cash flows and the timing of such cash flows continued to be estimable and probable of collection. As a result of CECL implementation on January 1, 2020, PCD loans that meet the definition of nonperforming loans are now included in the Company’s nonperforming disclosures.

The qualitative factors applied to each loan portfolio consist of the impact of other internal and external qualitative and credit market factors as assessed by management through a detailed loan review, ACL analysis and credit discussions.  These internal and external qualitative and credit market factors include:

changes in lending policies and procedures, including changes in underwriting standards and collections, charge-offs and recovery practices;
changes in international, national, regionally and local conditions (specific factors which impact portfolios or discrepancies with national economic factors which are utilized within the economic forecast);
changes in the experience, depth and ability of lending management;
changes in the volume and severity of past due loans and other similar loan conditions;
changes in the nature and volume of the loan portfolio and terms of loans;
the existence and effect of any concentrations of credit and changes in the levels of such concentrations (this characteristic requires any portfolio exceeding 25% of capital to have a factor considered unless the pool is otherwise well diversified or holds a relatively low inherent risk);

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

effects of other external factors, such as competition, legal or regulatory factors, on the level of estimated credit losses;
changes in the quality of our loan review functions; and
changes in the value of underlying collateral for collateral dependent loans.

The impact of the above listed internal and external qualitative and credit market risk factors is assessed within predetermined ranges to adjust the ACL totals calculated.

In addition to the pooled analysis performed for the majority of our loan and commitment balances, we also individually review those loans that have collateral dependency or are nonperforming.  Finally, we maintain a component of the ACL for those factors that cannot be quantified in the above analysis or are as yet unknown to us, due to changing economic conditions and other aspects of credit risk; which is known as the Company’s “Other Reserves.”

Loans are charged off against the ACL when management believes the uncollectibility of a loan balance is confirmed, while recoveries of amounts previously charged-off are credited to the ACL.  Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged off.  Approved releases from previously established ACL reserves authorized under our ACL methodology also reduce the ACL.  Additions to the ACL are established through the provision for credit losses on loans, which is charged to expense.

 

The Company’s ACL methodology is intended to reflect all loan portfolio risk, but management recognizes the inability to accurately depict all future credit losses in a current ACL estimate, as the impact of various factors cannot be fully known.  Accrued interest receivable on loans is excluded from the amortized cost basis of financing receivables for the purpose of determining the allowance for credit losses.  All calculations conform to GAAP.

Allowance for Credit Losses on Unfunded Loan Commitments

The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk by a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company.  The ACL related to off-balance sheet credit exposures, which is within other liabilities on the Company’s balance sheet, is estimated at each balance sheet date under the CECL model, and is adjusted as determined necessary through the provision for credit losses on the income statement.  The estimate for ACL on unfunded loan commitments includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life.  

Allowance for Credit Losses on Securities Available-for-Sale

For available-for-sale debt securities in an unrealized loss position, the Company first assesses whether it intends to sell, or it is more likely than not that it will sell, the security before recovery of its amortized cost basis.  If either of the aforementioned criteria exists, the Company will record an ACL related to securities available-for-sale with an offsetting entry to the provision for credit losses on securities on the income statement.  If either of these criteria does not exist, the Company will evaluate the securities individually to determine whether the decline in the fair value below the amortized cost basis (impairment) is due to credit-related factors or noncredit-related factors, such as market interest rate fluctuations.  

In evaluating securities available-for sale for potential impairment, the Company considers many factors, including the financial condition and near-term prospects of the issuer, which for debt securities considers external credit ratings and recent downgrades; and its ability and intent to hold the security for a period of time sufficient for a recovery in value.  The Company also considers the extent to which the securities are issued by the federal government or its agencies, and any guarantee of issued amounts by those agencies. The amount of the impairment related to other factors is recognized in other comprehensive income (loss).

Accrued interest receivable on securities available-for-sale is excluded from the amortized cost basis of those securities for the purpose of determining the allowance for credit losses.  All calculations conform to GAAP.  

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Risks and Uncertainties

The coronavirus (COVID-19) pandemic, which was declared a national emergency in the United States in March 2020, continues to create extensive disruptions to the global economy and financial markets and to businesses and the lives of individuals throughout the world. In particular, the COVID-19 pandemic has severely restricted the level of economic activity in the Company’s markets.  Federal and state governments have taken, and may continue to take, unprecedented actions to contain the spread of the disease, including quarantines, travel bans, shelter-in-place orders, closures of businesses and schools, fiscal stimulus, and legislation designed to deliver monetary aid and other relief to businesses and individuals impacted by the pandemic. Although in various locations certain activity restrictions have been relaxed and businesses and schools have reopened with some level of success, in many states and localities the number of individuals diagnosed with COVID-19 has increased significantly, which may cause a freezing or, in certain cases, a reversal of previously announced relaxation of activity restrictions and may prompt the need for additional aid and other forms of relief.

The impact of the COVID-19 pandemic is fluid and continues to evolve. The unprecedented and rapid spread of COVID-19 and its associated impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending, and other economic activities has resulted in less economic activity, lower bank equity market valuations and significant volatility and disruption in financial markets.  In addition, due to the COVID-19 pandemic, market interest rates have declined significantly, with the 10-year Treasury bond falling below 1.00% on March 3, 2020, for the first time, and declining further to 0.65% as of June 30, 2020. On March 3, 2020, the Federal Open Market Committee reduced the targeted federal funds interest rate range by 50 basis points to 1.00% to 1.25%. This range was further reduced to 0% to 0.25% percent on March 16, 2020. These reductions in interest rates and the other effects of the COVID-19 pandemic have had, and are expected to continue to have, possibly materially, an adverse effect on the Company’s business, financial condition and results of operations.  The ultimate extent of the impact of the COVID-19 pandemic on the Company’s business, financial condition and results of operations is currently uncertain and will depend on various developments and other factors, including, among others, the duration and scope of the pandemic, as well as governmental, regulatory and private sector responses to the pandemic, and the associated impacts on the economy, financial markets and the Company’s customers, employees and vendors.

As of September 30, 2020, our consolidated balance sheet included goodwill of $18.6 million.  For each quarter end of 2020, we considered whether a quantitative assessment of goodwill was required as a result of the significant economic disruption caused by the COVID-19 pandemic.  Impacts of the economic disruptions were noted from the latter half of March through the third quarter, specifically, the decline in the trading price of our common stock and an increase in the U.S. unemployment rate.  After considering qualitative factors regarding the expected impacts of the pandemic on our business, operations and financial condition, we determined that these conditions did not indicate that it is more likely than not that the Company’s carrying value exceeded our fair value as of September 30, 2020. However, further delayed recovery or further deterioration in market conditions related to the general economy, financial markets, and the associated impacts on our customers, employees and vendors, among other factors, could significantly impact the impairment analysis and may result in future goodwill impairment charges that, if incurred, could have a material adverse effect on our results of operations and financial condition.

Subsequent Events

On October 19, 2020, the Company’s Board of Directors declared a cash dividend of $0.01 per share payable on November 9, 2020, to stockholders of record as of October 30, 2020; dividends of $295,000 are scheduled to be paid to stockholders on November 9, 2020.

Note 2 – Acquisitions

On April 20, 2018, the Company acquired Greater Chicago Financial Corp. (“GCFC”) and its wholly-owned subsidiary, ABC Bank, which operated four branches in the Chicago metro area.  In addition to the acquisition price of $41.1 million, the Company retired the convertible and nonconvertible debentures held by GCFC upon acquisition, which totaled $6.6 million, including interest due.  The purchase and the retirement of the debentures were funded with the Company’s cash on hand, and all GCFC common stock was retired and cancelled simultaneous with the close of the transaction.  The Company acquired $227.6 million of loans, net of purchase accounting adjustments, and $248.5 million of deposits, net of purchase accounting adjustments for time deposits.  Purchase accounting adjustments recorded include a loan valuation mark of $11.2 million, a core deposit intangible of $3.1 million, a fixed asset valuation adjustment of $1.5 million, and goodwill of $10.2 million.  In addition, a deferred tax asset of $3.5 million was recorded as of the date of acquisition

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

based on analysis of the fair value of assets acquired, less liabilities assumed.  None of the $10.2 million recorded as goodwill is expected to be deductible for tax purposes. These fair value estimates were considered final as of March 31, 2019, and no further refinements to the values recorded are anticipated.  

Note 3 – Securities

Investment Portfolio Management

Our investment portfolio serves the liquidity needs and income objectives of the Company.  While the portfolio serves as an important component of the overall liquidity management at the Bank, portions of the portfolio also serve as income producing assets.  The size and composition of the portfolio reflects liquidity needs, loan demand and interest income objectives.  Portfolio size and composition will be adjusted from time to time.  While a significant portion of the portfolio consists of readily marketable securities to address liquidity, other parts of the portfolio may reflect funds invested pending future loan demand or to maximize interest income without undue interest rate risk.

Investments are comprised of debt securities and non-marketable equity investments.  Securities available-for-sale are carried at fair value.  Unrealized gains and losses, net of tax, on securities available-for-sale are reported as a separate component of equity.  This balance sheet component changes as interest rates and market conditions change.  Unrealized gains and losses are not included in the calculation of regulatory capital.  

Federal Home Loan Bank of Chicago (“FHLBC”) and Federal Reserve Bank of Chicago (“FRBC”) stock are considered nonmarketable equity investments.  FHLBC stock was recorded at $3.7 million at September 30, 2020, and December 31, 2019.  FRBC stock was recorded at $6.2 million at September 30, 2020, and December 31, 2019.  

The following tables summarize the amortized cost and fair value of the securities portfolio at September 30, 2020, and December 31, 2019, and the corresponding amounts of gross unrealized gains and losses:

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Gross

Gross

Amortized

Unrealized

Unrealized

Fair

September 30, 2020

    

Cost1

    

Gains

    

Losses

Value

Securities available-for-sale

U.S. Treasury

$

4,013

$

121

$

-

$

4,134

U.S. government agencies

7,169

-

(164)

7,005

U.S. government agencies mortgage-backed

17,056

1,165

(2)

18,219

States and political subdivisions

232,416

18,316

(955)

249,777

Collateralized mortgage obligations

54,597

2,839

(423)

57,013

Asset-backed securities

81,986

905

(1,306)

81,585

Collateralized loan obligations

31,202

19

(533)

30,688

Total securities available-for-sale

$

428,439

$

23,365

$

(3,383)

$

448,421

Gross

Gross

Amortized

Unrealized

Unrealized

Fair

December 31, 2019

    

Cost1

    

Gains

    

Losses

Value

Securities available-for-sale

U.S. Treasury

$

4,010

$

26

$

-

$

4,036

U.S. government agencies

8,502

-

(165)

8,337

U.S. government agencies mortgage-backed

16,164

443

(19)

16,588

States and political subdivisions

240,399

11,207

(2,431)

249,175

Collateralized mortgage obligations

57,059

963

(38)

57,984

Asset-backed securities

82,114

617

(887)

81,844

Collateralized loan obligations

66,898

29

(243)

66,684

Total securities available-for-sale

$

475,146

$

13,285

$

(3,783)

$

484,648

1 Excludes accrued interest receivable of $2.6 million and $3.2 million at September 30, 2020 and December 31, 2019, respectively, that is recorded in other assets on the consolidated balance sheet.

The fair value, amortized cost and weighted average yield of debt securities at September 30, 2020, by contractual maturity, were as follows in the table below.  Securities not due at a single maturity date are shown separately.

Weighted

Amortized

Average

Fair

Securities available-for-sale

    

Cost

    

Yield

    

Value

  

Due in one year or less

$

413

2.01

%

$

415

Due after one year through five years

6,056

2.11

6,309

Due after five years through ten years

28,014

2.31

28,993

Due after ten years

209,115

3.03

225,199

243,598

2.92

260,916

Mortgage-backed and collateralized mortgage obligations

71,653

3.08

75,232

Asset-backed securities

81,986

1.51

81,585

Collateralized loan obligations

31,202

2.12

30,688

Total securities available-for-sale

$

428,439

2.62

%

$

448,421

At September 30, 2020, the Company’s investments included $55.9 million of asset-backed securities that are backed by student loans originated under the Federal Family Education Loan program (“FFEL”).  Under the FFEL, private lenders made federally guaranteed student loans to parents and students. While the program was modified several times before elimination in 2010, FFEL securities are generally guaranteed by the U.S Department of Education (“DOE”) at not less than 97% of the outstanding principal amount of the loans.  The guarantee will reduce to 85% if the DOE receives reimbursement requests in excess of 5% of insured loans; reimbursement will drop

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

to 75% if reimbursement requests exceed 9% of insured loans.  In addition to the DOE guarantee, total added credit enhancement in the form of overcollateralization and/or subordination amounted to $5.1 million, or 9.00% of outstanding principal.

At September 30, 2020, the Company had invested in securities issued from one originator that individually amounted to over 10% of the Company’s stockholders’ equity.  Information regarding this issuer and the value of the securities issued follows:

September 30, 2020

    

Amortized

    

Fair

Issuer

Cost

Value

Towd Point Mortgage Trust

$

33,242

$

35,477

Securities with unrealized losses with no corresponding allowance for credit losses at September 30, 2020 and December 31, 2019, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands except for number of securities):

Less than 12 months

12 months or more

September 30, 2020

in an unrealized loss position

in an unrealized loss position

Total

Number of

Unrealized

Fair

Number of

Unrealized

Fair

Number of

Unrealized

Fair

Securities available-for-sale

    

Securities

   

Losses

   

Value

   

Securities

   

Losses

   

Value

   

Securities

   

Losses

   

Value

U.S. government agencies

-

$

-

$

-

4

$

164

$

7,005

4

$

164

$

7,005

U.S. government agencies mortgage-backed

1

2

260

-

-

-

1

2

260

States and political subdivisions

-

-

-

1

955

3,872

1

955

3,872

Collateralized mortgage obligations

4

421

8,027

1

2

279

5

423

8,306

Asset-backed securities

5

425

22,603

3

881

33,069

8

1,306

55,672

Collateralized loan obligations

1

123

7,376

4

410

21,245

5

533

28,621

Total securities available-for-sale

11

$

971

$

38,266

13

$

2,412

$

65,470

24

$

3,383

$

103,736

Less than 12 months

12 months or more

December 31, 2019

in an unrealized loss position

in an unrealized loss position

Total

Number of

Unrealized

Fair

Number of

Unrealized

Fair

Number of

Unrealized

Fair

Securities available-for-sale

    

Securities

   

Losses

   

Value

   

Securities

   

Losses

   

Value

   

Securities

   

Losses

   

Value

U.S. government agencies

-

$

-

$

-

4

$

165

$

8,337

4

$

165

$

8,337

U.S. government agencies mortgage-backed

3

10

3,018

2

9

843

5

19

3,861

States and political subdivisions

6

1,665

41,043

2

766

6,593

8

2,431

47,636

Collateralized mortgage obligations

2

26

9,054

2

12

1,209

4

38

10,263

Asset-backed securities

4

839

54,540

1

48

3,238

5

887

57,778

Collateralized loan obligations

4

62

21,927

4

181

25,020

8

243

46,947

Total securities available-for-sale

19

$

2,602

$

129,582

15

$

1,181

$

45,240

34

$

3,783

$

174,822

As required upon the adoption of ASU 2016-13, we performed an analysis to determine if any of the unrealized losses on securities available-for-sale were comprised of credit losses as compared to unrealized losses due to market interest rate adjustments.  Our assessment included a review of the unrealized loss for each security issuance held; the financial condition and near-term prospects of the issuer, including external credit ratings and recent downgrades; and our ability and intent to hold the security for a period of time sufficient for a recovery in value.  The Company also considered the extent to which the securities are issued by the federal government or its agencies, and any guarantee of issued amounts by those agencies.  No credit losses were determined to be present as of the date of CECL adoption or as of the quarter ended September 30, 2020, as there was no credit quality deterioration noted.  Therefore, no provision for credit losses on securities was recognized for the third quarter end.

The following table presents net realized gains (losses) on securities available-for-sale for the three and nine months ended September 30, 2020 and 2019.  

17

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

Securities available-for-sale

    

2020

    

2019

    

2020

    

2019

    

Proceeds from sales of securities

$

-

$

57,228

$

18,006

$

177,824

Gross realized gains on securities

$

-

$

3,841

$

17

$

5,432

Gross realized losses on securities

 

(1)

 

(378)

 

(42)

 

(956)

Net realized (losses) gains

$

(1)

$

3,463

$

(25)

$

4,476

Income tax (expense) benefit on net realized gains (losses)

$

-

$

(973)

$

7

$

(1,257)

Effective tax rate applied

0.0

%

28.1

%

28.0

%

28.1

%

Securities valued at $353.2 million as of September 30, 2020, an increase from $320.8 million at year-end 2019, were pledged to secure deposits and borrowings, and for other purposes.  

Note 4 – Loans and Allowance for Credit Losses on Loans

Major segments of loans were as follows:

    

September 30, 2020

    

December 31, 2019

Commercial

$

436,277

$

332,842

Leases

133,676

119,751

Commercial real estate - Investor

548,970

520,095

Commercial real estate - Owner occupied

335,978

345,504

Construction

91,856

69,617

Residential real estate - Investor

61,923

71,105

Residential real estate - Owner occupied

114,283

136,023

Multifamily

188,398

189,773

HELOC

85,882

91,605

HELOC - Purchased

22,312

31,852

Other 1

10,772

12,258

Total loans, excluding deferred loan costs and PCI loans 2

2,030,327

1,920,425

Net deferred loan costs

-

1,786

Total loans, excluding PCI loans 2

2,030,327

1,922,211

PCI loans

-

8,601

Total loans, including deferred loan costs and PCI loans 2

$

2,030,327

$

1,930,812

Allowance for credit losses on loans

(32,918)

(19,789)

Net loans 3

$

1,997,409

$

1,911,023

1 The “Other” segment for 2020 includes consumer and overdrafts in this table and in subsequent tables within Note 4 - Loans and Allowance for Credit Losses on Loans.

2As noted in the paragraph below, for periods before the Company’s adoption of CECL on January 1, 2020, PCI loans and their related deferred loan costs (now PCD loans) were excluded from nonperforming loan disclosures and were therefore separately reported.  After the adoption of CECL, all PCD loans are now included within each relevant loan type and are not separately reported as PCI loans, because such loans are now included within the Company’s nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan.

3 Excludes accrued interest receivable of $7.1 million and $6.5 million at September 30, 2020 and December 31, 2019, respectively, that is recorded in other assets on the consolidated balance sheet.

Purchased credit deteriorated loans, or PCD loans, are purchased loans that, as of the date of acquisition, the Company determined had experienced a more-than-insignificant deterioration in credit quality since origination.  Before the Company adopted CECL on January 1, 2020, PCD loans were referred to as purchased credit impaired loans, or PCI loans, and such PCI loans and their related

18

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

deferred loan costs were excluded from the Company’s nonperforming loan disclosures, as long as the cash flows on such loans and the timing of such cash flows continued to be estimable and probable of collection. However, after the Company adopted CECL on January 1, 2020, PCD loans and their related deferred loan costs are now included in the Company’s nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan.

It is the policy of the Company to review each prospective credit prior to making a loan in order to determine if an adequate level of security or collateral has been obtained.  The type of collateral, when required, will vary from liquid assets to real estate.  The Company’s access to collateral, in the event of borrower default, is assured through adherence to lending laws, the Company’s lending standards and credit monitoring procedures.  Although the Bank makes loans primarily within its market area, there are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector.  The real estate related categories listed above represent 71.4% and 75.4% of the portfolio at September 30, 2020, and December 31, 2019, respectively, and include a mix of owner and non-owner occupied, residential, construction and multifamily loans.  

The following table presents the collateral dependent loans and the related ACL allocated by segment of loans as of September 30, 2020:

Accounts

ACL

September 30, 2020

Real Estate

Receivable

Equipment

Other

Total

Allocation

Commercial

$

-

$

1,543

$

64

$

-

$

1,607

$

65

Leases

-

-

3,744

-

3,744

911

Commercial real estate - Investor

4,580

-

-

-

4,580

92

Commercial real estate - Owner occupied

10,846

-

-

-

10,846

198

Construction

1,883

-

-

-

1,883

944

Residential real estate - Investor

935

-

-

-

935

-

Residential real estate - Owner occupied

3,559

-

-

-

3,559

11

Multifamily

2,305

-

-

-

2,305

384

HELOC

1,047

-

-

-

1,047

96

HELOC - Purchased

-

-

-

-

-

-

Other

-

-

-

10

10

6

Total

$

25,155

$

1,543

$

3,808

$

10

$

30,516

$

2,707

The following table presents the activity in the allowance for credit losses (“ACL”) for the three and nine months ended September 30, 2020. The Company’s estimate of the ACL reflects losses over the expected remaining contractual life of the loans.  

Impact of

Provision

Beginning

Adopting

for Credit

Ending

Allowance for credit losses

   

Balance

   

ASC 326

   

Losses

   

Charge-offs

   

Recoveries

   

Balance

Three months ended September 30, 2020

Commercial

$

2,292

$

-

$

98

$

5

$

12

$

2,397

Leases

2,012

-

1,965

119

-

3,858

Commercial real estate - Investor

7,725

-

783

-

102

8,610

Commercial real estate - Owner occupied

2,521

-

(535)

145

565

2,406

Construction

4,431

-

406

60

1

4,778

Real estate - Investor

2,217

-

(290)

3

18

1,942

Real estate - Owner occupied

3,204

-

(508)

-

25

2,721

Multifamily

3,518

-

(301)

-

-

3,217

HELOC

2,255

-

(359)

-

52

1,948

HELOC - Purchased

398

-

(43)

66

-

289

Other1

700

-

64

53

41

752

$

31,273

$

-

$

1,280

$

451

$

816

$

32,918

19

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Nine months ended September 30, 2020

Commercial

$

3,015

$

(292)

$

(250)

$

124

$

48

$

2,397

Leases

1,262

501

2,214

119

-

3,858

Commercial real estate - Investor

6,218

(741)

3,009

15

139

8,610

Commercial real estate - Owner occupied

3,678

(848)

556

1,546

566

2,406

Construction

513

1,334

2,990

60

1

4,778

Residential real estate - Investor

601

740

564

8

45

1,942

Residential real estate - Owner occupied

1,257

1,320

30

43

157

2,721

Multifamily

1,444

1,732

41

-

-

3,217

HELOC

1,161

1,526

(902)

85

248

1,948

HELOC - Purchased

-

-

355

66

-

289

Other

640

607

(433)

192

130

752

$

19,789

$

5,879

$

8,174

$

2,258

$

1,334

$

32,918

The ACL on loans excludes $4.0 million of allowance for unfunded commitments, recorded within Other Liabilities, as of September 30, 2020.

The following table presents activity in the allowance for loan and lease losses for the three and nine months ended at September 30, 2019, as determined in accordance with ASC 310 prior to the adoption of ASU 2016-13:

Provision

Beginning

for Loan

Ending

Allowance for loan and lease losses:

   

Balance

   

Losses

   

Charge-offs

   

Recoveries

   

Balance

Three months ended September 30, 2019

Commercial

$

3,377

$

(49)

$

20

$

10

$

3,318

Leases

961

66

47

-

980

Commercial real estate - Investor

6,307

(431)

159

12

5,729

Commercial real estate - Owner occupied

2,973

428

-

-

3,401

Construction

820

(7)

7

-

806

Real estate - Investor

586

(6)

1

7

586

Real estate - Owner occupied

1,204

62

2

15

1,279

Multifamily

1,230

(78)

-

-

1,152

HELOC

1,304

(79)

19

21

1,227

HELOC - Purchased

38

(2)

-

-

36

Other1

572

646

142

61

1,137

$

19,372

$

550

$

397

$

126

$

19,651

Nine months ended September 30, 2019

Commercial

$

2,832

$

539

$

99

$

46

$

3,318

Leases

734

293

47

-

980

Commercial real estate - Investor

5,492

496

303

44

5,729

Commercial real estate - Owner occupied

3,835

(308)

129

3

3,401

Construction

969

(156)

8

1

806

Residential real estate - Investor

629

(62)

7

26

586

Residential real estate - Owner occupied

1,302

(61)

14

52

1,279

Multifamily

1,143

1

-

8

1,152

HELOC

1,449

(232)

69

79

1,227

HELOC - Purchased

-

265

229

-

36

Other1

621

675

311

152

1,137

$

19,006

$

1,450

$

1,216

$

411

$

19,651

1 The “Other” segment includes consumer, overdrafts and net deferred costs.

20

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Aged analysis of past due loans by segments of loans was as follows:

90 days or

90 Days or

Greater Past

30-59 Days

60-89 Days

Greater Past

Total Past

Due and

September 30, 20201

    

Past Due

    

Past Due

    

Due

    

Due

    

Current

    

Total Loans

    

Accruing

Commercial

$

56

$

-

$

1,368

$

1,424

$

434,853

$

436,277

$

-

Leases

64

105

339

508

133,168

133,676

169

Commercial real estate - Investor

6

128

1,655

1,789

547,181

548,970

-

Commercial real estate - Owner occupied

1,965

-

7,618

9,583

326,395

335,978

207

Construction

-

-

-

-

91,856

91,856

-

Residential real estate - Investor

63

-

324

387

61,536

61,923

-

Residential real estate - Owner occupied

220

500

391

1,111

113,172

114,283

44

Multifamily

2,664

-

707

3,371

185,027

188,398

-

HELOC

313

19

175

507

85,375

85,882

2

HELOC - Purchased

-

-

-

-

22,312

22,312

-

Other2

14

-

-

14

10,758

10,772

-

Total

$

5,365

$

752

$

12,577

$

18,694

$

2,011,633

$

2,030,327

$

422

1 Loans modified under the CARES Act are considered current if they are in compliance with the modified terms.  There were 468 loans which totaled $226.2 million modified under the CARES Act.  As of September 30, 2020, 96 loans of the original 468 loans deferred, or $54.1 million, had an active deferral request and were in compliance with modified terms; 372 loans which totaled $172.1 million had resumed payments.

2 The “Other” segment includes consumer and overdrafts.

Recorded

Investment

90 days or

90 Days or

Greater Past

30-59 Days

60-89 Days

Greater Past

Total Past

Due and

December 31, 2019

    

Past Due

    

Past Due

    

Due

    

Due

    

Current

    

Nonaccrual

    

Total Loans

    

Accruing

Commercial

$

1,271

$

925

$

2,103

$

4,299

$

328,399

$

144

$

332,842

$

2,132

Leases

362

-

81

443

118,979

329

119,751

128

Commercial real estate - Investor

626

95

343

1,064

517,336

1,695

520,095

348

Commercial real estate - Owner occupied

2,469

1,026

-

3,495

336,829

5,180

345,504

-

Construction

26

-

-

26

69,498

93

69,617

-

Residential real estate - Investor

141

125

-

266

70,051

788

71,105

-

Residential real estate - Owner occupied

3,450

1,351

-

4,801

128,650

2,572

136,023

-

Multifamily

10

1,700

-

1,710

187,995

68

189,773

-

HELOC

735

50

18

803

89,438

1,364

91,605

20

HELOC - Purchased

-

-

-

-

31,672

180

31,852

-

Other 1

28

-

-

28

13,997

19

14,044

-

Total, excluding PCI

9,118

5,272

2,545

16,935

1,892,844

12,432

1,922,211

2,628

PCI loans, net of purchase accounting adjustments

261

-

-

261

5,377

2,963

8,601

-

Total

$

9,379

$

5,272

$

2,545

$

17,196

$

1,898,221

$

15,395

$

1,930,812

$

2,628

1 The “Other” segment includes consumer, overdrafts and net deferred costs.

21

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

The table presents all nonaccrual loans and loans on nonaccrual for which there was no related allowance for credit losses as of September 30, 2020, and December 31, 2019:

September 30, 2020

December 31, 2019

Nonaccrual

Nonaccrual

    

    

Nonaccrual

    

With no ACL

    

Nonaccrual

    

With no ACL

Commercial

$

1,605

$

50

$

144

$

-

Leases

1,910

1,910

329

70

Commercial real estate - Investor

2,021

2,021

1,695

1,590

Commercial real estate - Owner occupied

8,428

5,944

5,180

2,366

Construction

-

-

93

93

Residential real estate - Investor

935

935

788

788

Residential real estate - Owner occupied

3,229

3,229

2,572

2,475

Multifamily

895

895

68

68

HELOC

1,047

835

1,364

1,154

HELOC - Purchased

-

-

180

180

Other

6

-

19

2

Total, excluding PCI loans

20,076

15,819

12,432

8,786

PCI loans, net of purchase accounting adjustments

-

-

2,963

2,963

Total

$

20,076

$

15,819

$

15,395

$

11,749

The Company recognized $93,000 of interest on nonaccrual loans during the three months ended September 30, 2020.

Credit Quality Indicators

The Company categorizes loans into credit risk categories based on current financial information, overall debt service coverage, comparison to industry averages, historical payment experience, and current economic trends.  This analysis includes loans with outstanding balances or commitments greater than $50,000 and excludes homogeneous loans such as home equity lines of credit and residential mortgages.  Loans with a classified risk rating are reviewed quarterly regardless of size or loan type.  The Company uses the following definitions for classified risk ratings:

Special Mention.  Loans classified as special mention have a potential weakness that deserves management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan at some future date.

Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.

Doubtful.  Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Credits that are not covered by the definitions above are pass credits, which are not considered to be adversely rated. The Company follows the guidance of ASC 310-20 when determining whether a modification, extension, or renewal of a loan constitutes a current period origination. Generally, current period renewals of credit are re-underwritten at the point of renewal and considered current period financing receivables. The following table summarizes loans held for investment by year of origination and the related credit quality indicators at September 30, 2020:

22

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Revolving

Loans

Converted

Revolving

To Term

    

2020

    

2019

    

2018

    

2017

    

2016

    

Prior

    

Loans

    

Loans

    

Total

Commercial

Pass

$

161,595

$

42,502

$

16,568

$

7,215

$

3,096

$

2,755

$

188,270

$

-

$

422,001

Special Mention

443

1,564

68

13

4

16

6,176

-

8,284

Substandard1

2,252

52

2,036

-

-

13

1,639

-

5,992

Total commercial

164,290

44,118

18,672

7,228

3,100

2,784

196,085

-

436,277

Leases

Pass

39,333

55,923

18,937

7,755

6,463

1,196

-

-

129,607

Special Mention

-

799

-

-

-

-

-

-

799

Substandard1

-

1,255

1,004

64

467

480

-

-

3,270

Total leases

39,333

57,977

19,941

7,819

6,930

1,676

-

-

133,676

Commercial real estate - Investor

Pass

128,123

168,503

92,140

70,566

56,666

24,362

868

-

541,228

Special Mention

1,816

-

231

-

99

-

-

-

2,146

Substandard1

474

3,783

-

-

345

994

-

-

5,596

Total commercial real estate - investor

130,413

172,286

92,371

70,566

57,110

25,356

868

-

548,970

Commercial real estate - Owner occupied

Pass

55,107

54,702

78,655

45,928

51,895

30,174

1,083

-

317,544

Special Mention

925

-

464

2,141

5,246

-

-

-

8,776

Substandard1

185

2,454

1,088

1,695

708

3,528

-

-

9,658

Total commercial real estate - owner occupied

56,217

57,156

80,207

49,764

57,849

33,702

1,083

-

335,978

Construction

Pass

28,182

40,302

6,972

589

245

1,283

9,136

-

86,709

Special Mention

39

-

-

-

-

-

-

-

39

Substandard1

-

3,058

2,050

-

-

-

-

-

5,108

Total construction

28,221

43,360

9,022

589

245

1,283

9,136

-

91,856

Residential real estate - Investor

Pass

10,497

14,632

11,721

8,488

2,558

11,985

516

-

60,397

Special Mention

-

-

-

-

-

-

-

-

-

Substandard1

340

-

614

-

99

473

-

-

1,526

Total residential real estate - investor

10,837

14,632

12,335

8,488

2,657

12,458

516

-

61,923

Residential real estate - Owner occupied

Pass

8,747

23,545

12,094

18,796

10,716

33,867

2,682

-

110,447

Special Mention

-

-

-

-

-

-

-

-

-

Substandard1

48

-

412

221

535

2,620

-

-

3,836

Total residential real estate - owner occupied

8,795

23,545

12,506

19,017

11,251

36,487

2,682

-

114,283

Multifamily

Pass

27,856

37,940

45,291

45,516

13,143

10,514

202

-

180,462

Special Mention

-

-

1,544

552

7

-

-

-

2,103

23

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Substandard1

69

-

2,687

901

119

2,057

-

-

5,833

Total multifamily

27,925

37,940

49,522

46,969

13,269

12,571

202

-

188,398

HELOC

Pass

2,185

2,287

1,697

2,471

694

1,197

73,772

-

84,303

Special Mention

-

-

-

-

-

-

13

-

13

Substandard1

-

-

88

37

265

93

1,083

-

1,566

Total HELOC

2,185

2,287

1,785

2,508

959

1,290

74,868

-

85,882

HELOC - Purchased

Pass

-

-

-

-

-

22,312

-

-

22,312

Special Mention

-

-

-

-

-

-

-

-

-

Substandard1

-

-

-

-

-

-

-

-

-

Total HELOC - purchased

-

-

-

-

-

22,312

-

-

22,312

Other

Pass

995

1,415

451

320

468

324

6,527

-

10,500

Special Mention

-

-

-

-

-

-

-

-

-

Substandard1

-

-

266

6

-

-

-

-

272

Total other

995

1,415

717

326

468

324

6,527

-

10,772

Total loans

Pass

462,620

441,751

284,526

207,644

145,944

139,969

283,056

-

1,965,510

Special Mention

3,223

2,363

2,307

2,706

5,356

16

6,189

-

22,160

Substandard1

3,368

10,602

10,245

2,924

2,538

10,258

2,722

-

42,657

Total loans

$

469,211

$

454,716

$

297,078

$

213,274

$

153,838

$

150,243

$

291,967

$

-

$

2,030,327

1 The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.

Credit quality indicators by loan segment at December 31, 2019 were as follows:

December 31, 2019

Special

    

Pass

    

Mention

    

Substandard2

    

Doubtful

    

Total

Commercial

$

307,948

$

13,206

$

11,688

$

-

$

332,842

Leases

119,045

377

329

-

119,751

Commercial real estate - Investor

510,640

4,529

4,926

520,095

Commercial real estate - Owner occupied

330,891

6,657

7,956

-

345,504

Construction

69,355

-

262

-

69,617

Residential real estate - Investor

69,715

-

1,390

-

71,105

Residential real estate - Owner occupied

132,258

134

3,631

-

136,023

Multifamily

187,560

1,710

503

-

189,773

HELOC

89,804

12

1,789

-

91,605

HELOC - Purchased

31,672

-

180

-

31,852

Other 1

13,685

-

359

-

14,044

Total, excluding PCI loans

$

1,862,573

$

26,625

$

33,013

$

-

$

1,922,211

PCI loans, net of purchase accounting adjustments

573

261

7,767

-

8,601

Total

$

1,863,146

$

26,886

$

40,780

$

-

$

1,930,812

1 The “Other” segment includes consumer, overdrafts and net deferred costs.

2 The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.

The Company had $541,000 and $831,000 in residential real estate loans in the process of foreclosure as of September 30, 2020, and December 31, 2019, respectively.  

24

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Troubled debt restructurings (“TDRs”) are loans for which the contractual terms have been modified and both of these conditions exist: (1) there is a concession to the borrower and (2) the borrower is experiencing financial difficulties.  Loans are restructured on a case-by-case basis during the loan collection process with modifications generally initiated at the request of the borrower.  These modifications may include reduction in interest rates, extension of term, deferrals of principal, and other modifications.  The Bank participates in the U.S. Department of the Treasury’s (the “Treasury”) Home Affordable Modification Program (“HAMP”) which gives qualifying homeowners an opportunity to refinance into more affordable monthly payments.  Additionally, in accordance with interagency guidance, short-term deferrals granted due to the COVID-19 pandemic are not considered TDRs unless the borrower was experiencing financial difficulty prior to the pandemic.

The specific allocation of the allowance for credit losses for TDRs is determined by calculating the present value of the TDR cash flows by discounting the original payment less an assumption for probability of default at the original note’s issue rate, and adding this amount to the present value of collateral less selling costs.  If the resulting amount is less than the recorded book value, the Bank either establishes a valuation allowance (i.e., specific reserve) as a component of the allowance for credit losses or charges off the impaired balance if it determines that such amount is a confirmed loss.  This method is used consistently for all segments of the portfolio.  The allowance for credit losses also includes an allowance based on a loss migration analysis for each loan category on loans and leases that are not individually evaluated for specific impairment.  All loans charged-off, including TDRs charged-off, are factored into this calculation by portfolio segment.

TDRs that were modified during the period are as follows:

TDR Modifications

TDR Modifications

Three Months Ended September 30, 2020

Nine Months Ended September 30, 2020

# of 

Pre-modification 

Post-modification 

# of 

Pre-modification 

Post-modification 

    

contracts

    

recorded investment

    

recorded investment

    

contracts

    

recorded investment

    

recorded investment

  

Troubled debt restructurings

Residential real estate - Owner occupied

HAMP1

1

$

154

$

153

3

$

410

$

404

Total

1

$

154

$

153

3

$

410

$

404

TDR Modifications

TDR Modifications

Three Months Ended September 30, 2019

Nine Months Ended September 30, 2019

# of 

Pre-modification 

Post-modification 

# of 

Pre-modification 

Post-modification 

    

contracts

    

recorded investment

    

recorded investment

    

contracts

    

recorded investment

    

recorded investment

  

Troubled debt restructurings

Commercial real estate - Investor

Other2

1

$

1,159

$

1,122

2

$

1,217

$

1,177

Residential real estate - Owner occupied

HAMP1

-

-

-

3

399

297

HELOC

HAMP1

-

-

-

1

39

34

Other2

-

-

-

1

39

38

Total

1

$

1,159

$

1,122

7

$

1,694

$

1,546

1 HAMP: Home Affordable Modification Program.

25

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

2 Other: Change of terms from bankruptcy court.

TDRs are classified as being in default on a case-by-case basis when they fail to be in compliance with the modified terms.  There was no TDR default activity for the periods ended September 30, 2020, and September 30, 2019, for loans that were restructured within the prior 12 month period.

Note 5 – Other Real Estate Owned

Details related to the activity in the other real estate owned (“OREO”) portfolio, net of valuation allowance, for the periods presented are itemized in the following table:

Three Months Ended

Nine Months Ended

    

September 30, 

    

September 30, 

  

Other real estate owned

    

2020

    

2019

    

2020

    

2019

Balance at beginning of period

$

5,082

$

5,668

$

5,004

$

7,175

Property additions, net of acquisition adjustments

314

305

898

305

Less:

Proceeds from property disposals, net of participation purchase and of gains/losses

2,664

1,088

2,952

2,390

Period valuation adjustments

46

203

264

399

Other adjustments

-

-

-

9

Balance at end of period

$

2,686

$

4,682

$

2,686

$

4,682

Activity in the valuation allowance was as follows:

    

Three Months Ended

Nine Months Ended

  

    

September 30, 

    

September 30, 

  

    

2020

    

2019

    

2020

    

2019

  

Balance at beginning of period

$

6,464

$

8,061

$

6,712

$

8,027

Provision for unrealized losses

46

203

264

399

Reductions taken on sales

(4,897)

(798)

(5,363)

(960)

Balance at end of period

$

1,613

$

7,466

$

1,613

$

7,466

Expenses related to OREO, net of lease revenue includes:

Three Months Ended

Nine Months Ended

September 30, 

    

September 30, 

    

2020

    

2019

    

2020

    

2019

Gain on sales, net

$

(165)

$

(104)

$

(188)

$

(254)

Provision for unrealized losses

46

203

264

399

Operating expenses

253

(73)

460

184

Less:

Lease revenue

9

-

31

5

Net OREO expense

$

125

$

26

$

505

$

324

26

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Note 6 – Deposits

Major classifications of deposits were as follows:

    

September 30, 2020

    

December 31, 2019

  

Noninterest bearing demand

$

889,085

$

669,795

Savings

382,711

307,015

NOW accounts

492,407

425,792

Money market accounts

310,613

282,478

Certificates of deposit of less than $100,000

208,570

227,578

Certificates of deposit of $100,000 through $250,000

129,522

151,279

Certificates of deposit of more than $250,000

66,335

62,812

Total deposits

$

2,479,243

$

2,126,749

Note 7 – Borrowings

The following table is a summary of borrowings as of September 30, 2020, and December 31, 2019.  Junior subordinated debentures are discussed in more detail in Note 8:

    

September 30, 2020

    

December 31, 2019

  

Securities sold under repurchase agreements

$

59,268

$

48,693

Other short-term borrowings 1

6,125

48,500

Junior subordinated debentures

25,773

57,734

Senior notes

44,349

44,270

Notes payable and other borrowings

24,469

6,673

Total borrowings

$

159,984

$

205,870

1 Includes short-term FHLBC advances for both periods presented.

The Company enters into deposit sweep transactions where the transaction amounts are secured by pledged securities.  These transactions consistently mature overnight from the transaction date and are governed by sweep repurchase agreements.  All sweep repurchase agreements are treated as financings secured by U.S. government agencies and collateralized mortgage-backed securities and had a carrying amount of $59.3 million at September 30, 2020, and $48.7 million at December 31, 2019.  The fair value of the pledged collateral was $79.3 million at September 30, 2020, and $70.7 million at December 31, 2019.  At September 30, 2020, there were no customers with secured balances exceeding 10% of stockholders’ equity.

The Company’s borrowings at the FHLBC require the Bank to be a member and invest in the stock of the FHLBC.  Total borrowings are generally limited to the lower of 35% of total assets or 60% of the book value of certain mortgage loans.  As of September 30, 2020, the Bank had $6.1 million in short-term advances outstanding under the FHLBC compared to $48.5 million outstanding as of December 31, 2019; the remaining $6.1 million was issued at a rate of 2.19%.   The Bank also assumed $23.4 million of long-term FHLBC advances with the ABC Bank acquisition in 2018.  At September 30, 2020, one advance remains in long-term status, with a total outstanding balance of $6.5 million, at a 2.83% interest rate, and is scheduled to mature on February 2, 2026. FHLBC stock as of September 30, 2020 was valued at $3.7 million, and any potential FHLBC advances were collateralized by securities with a fair value of $53.1 million and loans with a principal balance of $569.7 million, which carried a FHLBC-calculated combined collateral value of $428.4 million.  The Company had excess collateral of $289.6 million available to secure borrowings at September 30, 2020.

The Company also has $44.3 million of senior notes outstanding, net of deferred issuance costs, as of September 30, 2020 and December 31, 2019.  The senior notes were issued in December 2016 with a ten year maturity, and terms include interest payable semiannually at 5.75% for five years.  Beginning December 2021, the senior debt will pay interest at a floating rate, with interest payable quarterly at three month LIBOR plus 385 basis points.  The notes are redeemable, in whole or in part, at the option of the Company, beginning with the interest payment date on December 31, 2021, and on any floating rate interest payment date thereafter, at a redemption price equal to 100% of the principal amount of the notes plus accrued and unpaid interest.  As of September 30, 2020, and December 31,

27

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

2019, unamortized debt issuance costs related to the senior notes were $651,000 and $730,000, respectively, and are included as a reduction of the balance of the senior notes on the Consolidated Balance Sheet.  These deferred issuance costs will be amortized to interest expense over the ten year term of the notes and are included in the Consolidated Statements of Income.

On February 24, 2020, the Company originated a $20.0 million term note, of which $18.0 million is outstanding as of September 30, 2020,  with a correspondent bank related to the Company’s redemption of the 7.80% cumulative trust preferred securities issued by Old Second Capital Trust I and related junior subordinated debentures.  See the discussion in Note 8 – Junior Subordinated Debentures.  The term note was issued for a three year term at one-month Libor plus 175 basis points, requires principal and interest payments quarterly, and the balance of this note is included within Notes Payable and Other Borrowings on the Consolidated Balance Sheet.   The Company also has an undrawn line of credit of $20.0 million with a correspondent bank to be used for short-term funding needs; advances under this line can be outstanding up to 360 days from the date of issuance.  This line of credit has not been utilized since early 2019.

Note 8 – Junior Subordinated Debentures

On March 2, 2020, the Company redeemed the 7.80% cumulative trust preferred securities issued by Old Second Capital Trust I (“OSBCP”) and related debentures, which totaled $32.6 million.  These debentures were originally issued in 2003 for a term of 30 years at 7.80%, and subject to regulatory approval, were able to be called in whole or in part by the Company after June 30, 2008.  The Company received regulatory approval to redeem the debentures in early 2020, and notified OSBCP stockholders of the redemption in late January 2020.  Cash disbursed for the redemption, including accrued interest on the debentures, totaled $33.0 million, or $10.13 per OSBCP share.  The OSBCP redemption was funded by cash on hand and the $20 million term note discussed in Note 7 – Borrowings.  Upon redemption of the junior subordinated debentures related to OSBCP in March 2020, the Company recognized the remaining unamortized debt issuance costs of $635,000.

The Company issued $25.0 million of cumulative trust preferred securities through a private placement completed by another unconsolidated subsidiary, Old Second Capital Trust II, in April 2007.  These trust preferred securities also mature in 30 years, but subject to the aforementioned regulatory approval, can be called in whole or in part on a quarterly basis commencing June 15, 2017.  The quarterly cash distributions on the securities were fixed at 6.77% through June 15, 2017, and float at 150 basis points over three-month LIBOR thereafter.  Upon conversion to a floating rate, a cash flow hedge was initiated which resulted in the total interest rate paid on the debt of 4.40% for the quarter ended September 30, 2020, compared to the rate paid for the quarter ended September 30, 2019, of 4.40%.  The Company issued a new $25.8 million subordinated debenture to Old Second Capital Trust II in return for the aggregate net proceeds of this trust preferred offering.  The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.  

The junior subordinated debentures issued by the Company are disclosed on the Consolidated Balance Sheet, and the related interest expense for each issuance is included in the Consolidated Statements of Income.  As of September 30, 2020, and December 31, 2019, the remaining unamortized debt issuance costs related to the junior subordinated debentures were $1,000 and $644,000 respectively, and are included as a reduction to the balance of the junior subordinated debentures on the Consolidated Balance Sheet.  The remaining deferred issuance costs on the junior subordinated debentures related to the issuance of Old Second Capital Trust II will be amortized to interest expense over the remainder of the 30-year term of the notes and are included in the Consolidated Statements of Income.

Note 9 – Equity Compensation Plans

Stock-based awards are outstanding under the Company’s 2014 Equity Incentive Plan, as amended (the “2014 Plan”), and the Company’s 2019 Equity Incentive Plan (the “2019 Plan” and together with the 2014 Plan, the “Plans”). The 2019 Plan was approved at the May 2019 annual stockholders’ meeting and the number of authorized shares under the 2019 Plan is fixed at 600,000.  Following approval of the 2019 Plan, no further awards were to be granted under the 2014 Plan or any other prior Company equity compensation plan.  The 2019 Plan authorizes the granting of qualified stock options, non-qualified stock options, restricted stock, restricted stock units, and stock appreciation rights (“SARs”).  Awards may be granted to selected directors, officers, employees or eligible service providers under the 2019 Plan at the discretion of the Compensation Committee of the Company’s Board of Directors.  As of September 30, 2020, 343,602 shares remained available for issuance under the 2019 Plan.

28

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Under the 2019 Plan, unless otherwise provided in an award agreement, upon the occurrence of a change in control, all stock options and SARs then held by the participant will become fully exercisable immediately if, and all stock awards and cash incentive awards will become fully earned and vested immediately if, (i) the 2019 Plan is not an obligation of the successor entity following a change in control or (ii) the 2019 Plan is an obligation of the successor entity following a change in control and the participant incurs a termination of service without cause  or for good reason  following the change in control.  Notwithstanding the immediately preceding sentence, if the vesting of an award is conditioned upon the achievement of performance measures, then such vesting will generally be subject to the following: if, at the time of the change in control, the performance measures are less than 50% attained (pro rata based upon the time of the period through the change in control), the award will become vested and exercisable on a fractional basis with the numerator being equal to the percentage of attainment and the denominator being 50%; and if, at the time of the change in control, the performance measures are at least 50% attained (pro rata based upon the time of the period through the change in control), the award will become fully earned and vested immediately upon the change in control.  

Generally, restricted stock and restricted stock units granted under the Plans vest three years from the grant date, but the Compensation Committee of the Company’s Board of Directors has discretionary authority to change some terms including the amount of time until the vest date.  There were no stock options granted or exercised during the nine months ended September 30, 2020, and as of September 30, 2020, there were no stock options outstanding.

The Company granted restricted stock under its equity compensation plans beginning in 2005 and it began granting restricted stock units in February 2009.  Awards of restricted stock under the Plans generally entitle holders to voting and dividend rights upon grant and are subject to forfeiture until certain restrictions have lapsed including employment for a specific period.  Awards of restricted stock units under the Plans are also subject to forfeiture until certain restrictions have lapsed including employment for a specific period, but do not entitle holders to voting rights until the restricted period ends and shares are transferred in connection with the units.

There were 137,944 and 166,106 restricted stock units issued under the 2019 Plan during the nine months ended September 30, 2020 and September 30, 2019, respectively. Compensation expense is recognized over the vesting period of the restricted stock units based on the market value of the award on the issue date.  Total compensation cost that has been recorded for the Plan was $1.6 million in the first nine months of 2020 and $1.9 million for the first nine months of 2019.

A summary of changes in the Company’s unvested restricted awards for the nine months ended September 30, 2020, is as follows:

September 30, 2020

Weighted

Restricted

Average

Stock Shares

Grant Date

    

and Units

    

Fair Value

Unvested at January 1

555,283

$

12.85

Granted

137,944

12.26

Vested

(149,952)

11.16

Forfeited

-

-

Unvested at September 30

543,275

$

13.17

Total unrecognized compensation cost of restricted awards was $2.8 million as of September 30, 2020, which is expected to be recognized over a weighted-average period of 1.75 years.  

29

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Note 10 – Earnings Per Share

The earnings per share, both basic and diluted, are included below as of September 30:

Three Months Ended September 30, 

Nine Months Ended September 30, 

    

2020

    

2019

    

2020

    

2019

    

Basic earnings per share:

Weighted-average common shares outstanding

29,559,026

29,899,063

29,708,239

29,880,511

Net income

$

10,265

$

12,173

$

19,778

$

29,919

Basic earnings per share

$

0.35

$

0.41

$

0.67

$

1.00

Diluted earnings per share:

Weighted-average common shares outstanding

29,559,026

29,899,063

29,708,239

29,880,511

Dilutive effect of unvested restricted awards 1

543,275

539,270

553,482

510,454

Diluted average common shares outstanding

30,102,301

30,438,333

30,261,721

30,390,965

Net Income

$

10,265

$

12,173

$

19,778

$

29,919

Diluted earnings per share

$

0.34

$

0.40

$

0.65

$

0.98

1 Includes the common stock equivalents for restricted share rights that are dilutive.

Note 11 Regulatory & Capital Matters

The Bank is subject to the risk-based capital regulatory guidelines, which include the methodology for calculating the risk-weighted Bank assets, developed by the Office of the Comptroller of the Currency (the “OCC”) and the other bank regulatory agencies.  In connection with the current risk-based capital regulatory guidelines, the Bank’s Board of Directors has established an internal guideline requiring the Bank to maintain a Tier 1 leverage capital ratio at or above eight percent (8%) and a total risk-based capital ratio at or above twelve percent (12%).  At September 30, 2020, the Bank exceeded those thresholds.

At September 30, 2020, the Bank’s Tier 1 capital leverage ratio was 10.90%, a decrease of 160 basis points from December 31, 2019, but is well above the 8.00% objective.  The reduction in the Tier 1 capital leverage ratio is primarily due to a $30.0 million dividend the Bank paid the Company in March 2020.The Bank’s total capital ratio was 15.49%, an increase of 26 basis points from December 31, 2019, and also well above the objective of 12.00%.

Bank holding companies are generally required to maintain minimum levels of capital in accordance with capital guidelines implemented by the Board of Governors of the Federal Reserve System.  The general bank and holding company capital adequacy guidelines are shown in the accompanying table, as are the capital ratios of the Company and the Bank, as of September 30, 2020, and December 31, 2019.

In July 2013, the U.S. federal banking authorities issued final rules (the “Basel III Rules”) establishing more stringent regulatory capital requirements for U.S. banking institutions, which went into effect on January 1, 2015. The Basel III Rules are applicable to all banking organizations that are subject to minimum capital requirements, including federal and state banks and savings and loan associations, as well as to bank and savings and loan holding companies, other than “small bank holding companies” generally holding companies with consolidated assets of less than $3 billion. The Company is currently considered a “small bank holding company.” A detailed discussion of the Basel III Rules is included in Part I, Item 1 of the Company’s Form 10-K for the year ended December 31, 2019, under the heading “Supervision and Regulation.”

At September 30, 2020, and December 31, 2019, the Company, on a consolidated basis, exceeded the minimum thresholds to be considered “well capitalized” under current regulatory defined capital ratios.

30

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Capital levels and industry defined regulatory minimum required levels are as follows:

Minimum Capital

Well Capitalized

Adequacy with Capital

Under Prompt Corrective

Actual

Conservation Buffer, if applicable1

Action Provisions2

    

Amount

    

Ratio

    

Amount

    

Ratio

    

Amount

    

Ratio

September 30, 2020

Common equity tier 1 capital to risk weighted assets

Consolidated

$

269,874

11.97

%

$

157,821

7.000

%

N/A

N/A

Old Second Bank

319,662

14.24

157,137

7.000

$

145,913

6.50

%

Total capital to risk weighted assets

Consolidated

323,041

14.33

236,701

10.500

N/A

N/A

Old Second Bank

347,723

15.49

235,706

10.500

224,482

10.00

Tier 1 capital to risk weighted assets

Consolidated

294,874

13.08

191,623

8.500

N/A

N/A

Old Second Bank

319,662

14.24

190,809

8.500

179,585

8.00

Tier 1 capital to average assets

Consolidated

294,874

10.07

117,130

4.00

N/A

N/A

Old Second Bank

319,662

10.90

117,307

4.00

146,634

5.00

December 31, 2019

Common equity tier 1 capital to risk weighted assets

Consolidated

$

251,477

11.14

%

$

158,020

7.000

%

N/A

N/A

Old Second Bank

322,496

14.35

157,315

7.000

$

146,078

6.50

%

Total capital to risk weighted assets

Consolidated

327,886

14.53

236,944

10.500

N/A

N/A

Old Second Bank

342,280

15.23

235,978

10.500

224,741

10.00

Tier 1 capital to risk weighted assets

Consolidated

308,102

13.65

191,858

8.500

N/A

N/A

Old Second Bank

322,496

14.35

191,026

8.500

179,789

8.00

Tier 1 capital to average assets

Consolidated

308,102

11.93

103,303

4.00

N/A

N/A

Old Second Bank

322,496

12.50

103,199

4.00

128,998

5.00

1 Amounts are shown inclusive of a capital conservation buffer of 2.50%. Under the Federal Reserve’s Small Bank Holding Company Policy Statement, the Company is not subject to the minimum capital adequacy and capital conservation buffer capital requirements at the holding company level, unless otherwise advised by the Federal Reserve (such capital requirements are applicable only at the Bank level). Although the minimum regulatory capital requirements are not applicable to the Company, we calculate these ratios for our own planning and monitoring purposes.

2 The prompt corrective action provisions are only applicable at the Bank level. The Bank exceeded the general minimum regulatory requirements to be considered “well capitalized.”

As part of its response to the impact of the COVID-19 pandemic, in the first quarter of 2020, U.S. federal regulatory authorities issued an interim final rule that provided banking organizations that adopted CECL during the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital relative to regulatory capital determined under the prior incurred loss methodology, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during the initial two-year delay (i.e., a five-year transition in total). In connection with our adoption of CECL on January 1, 2020, we have elected to utilize the five-year CECL transition.  The cumulative amount that is not recognized in regulatory capital, in addition to the $3.8 million Day 1 impact of CECL adoption, will be phased in at 25% per year beginning January 1, 2022. As of September 30, 2020, the capital

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Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

measures of the Company exclude $5.7 million, which is the Day 1 impact to retained earnings and 25% of the $10.4 million increase in the allowance for credit losses in the first nine months of 2020, excluding PCD loans.

Dividend Restrictions

In addition to the above requirements, banking regulations and capital guidelines generally limit the amount of dividends that may be paid by a bank without prior regulatory approval.  Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s profits, combined with the retained profit of the previous two years, subject to the capital requirements described above.  Pursuant to the Basel III rules that came into effect January 1, 2015, and were fully phased in as of January 1, 2019, the Bank must keep a capital conservation buffer of 2.50% above the new regulatory minimum capital requirements, which must consist entirely of Common Equity Tier 1 capital in order to avoid additional limitations on capital distributions and certain other payments.

Stock Repurchase Program

In September 2019, our board of directors authorized the repurchase of up to 1,494,826 shares of our common stock (the “Repurchase Program”).  Repurchases by us under the Repurchase Program may be made from time to time through open market purchases, trading plans established in accordance with SEC rules, privately negotiated transactions, or by other means.  During the first, second and third quarters of 2020, we repurchased 312,723 shares, 145,932 shares, and 137,756 shares of our common stock at weighted average prices of $7.06 per share, $6.97 per share, and $8.34 per share, respectively, pursuant to the Repurchase Program.

Note 12 Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  The fair value hierarchy established by the Company also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  Three levels of inputs that may be used to measure fair value are:

Level 1:  Quoted prices (unadjusted) for identical assets or liabilities in active markets that the Company has the ability to access as of the measurement date.

Level 2:  Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3:  Significant unobservable inputs that reflect a company’s own view about the assumptions that market participants would use in pricing an asset or liability.

The majority of securities available-for-sale are valued by external pricing services or dealer market participants and are classified in Level 2 of the fair value hierarchy.  Both market and income valuation approaches are utilized.  Quarterly, the Company evaluates the methodologies used by the external pricing services or dealer market participants to develop the fair values to determine whether the results of the valuations are representative of an exit price in the Company’s principal markets and an appropriate representation of fair value.  The Company uses the following methods and significant assumptions to estimate fair value:

Government-sponsored agency debt securities are primarily priced using available market information through processes such as benchmark spreads, market valuations of like securities, like securities groupings and matrix pricing.
Other government-sponsored agency securities, MBS and some of the actively traded real estate mortgage investment conduits and collateralized mortgage obligations are priced using available market information including benchmark yields, prepayment speeds, spreads, volatility of similar securities and trade date.
State and political subdivisions are largely grouped by characteristics (e.g., geographical data and source of revenue in trade dissemination systems).  Because some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities.
Auction rate securities are priced using market spreads, cash flows, prepayment speeds, and loss analytics.  Therefore, the valuations of auction rate asset-backed securities are considered Level 2 valuations.

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Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Asset-backed collateralized loan obligations were priced using data from a pricing matrix supported by our bond accounting service provider and are therefore considered Level 2 valuations.
Annually every security holding is priced by a pricing service independent of the regular and recurring pricing services used.  The independent service provides a measurement to indicate if the price assigned by the regular service is within or outside of a reasonable range.  Management reviews this report and applies judgment in adjusting calculations at year end related to securities pricing.
Residential mortgage loans available for sale in the secondary market are carried at fair market value.  The fair value of loans held-for-sale is determined using quoted secondary market prices.
Lending related commitments to fund certain residential mortgage loans, e.g., residential mortgage loans with locked interest rates to be sold in the secondary market and forward commitments for the future delivery of mortgage loans to third party investors, as well as forward commitments for future delivery of MBS are considered derivatives.  Fair values are estimated based on observable changes in mortgage interest rates including prices for MBS from the date of the commitment and do not typically involve significant judgments by management.
The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income.  The valuation model incorporates assumptions that market participants would use in estimating future net servicing income to derive the resultant value.  The Company is able to compare the valuation model inputs, such as the discount rate, prepayment speeds, weighted average delinquency and foreclosure/bankruptcy rates to widely available published industry data for reasonableness.
Interest rate swap positions, both assets and liabilities, are based on valuation pricing models using an income approach reflecting readily observable market parameters such as interest rate yield curves.
The fair value of impaired loans with specific allocations of the allowance for credit losses is essentially based on recent real estate appraisals or the fair value of the collateralized asset.  These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.  Adjustments are made in the appraisal process by the appraisers to reflect differences between the available comparable sales and income data.  Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
Nonrecurring adjustments to certain commercial and residential real estate properties classified as OREO are measured at fair value, less costs to sell.  Fair values are based on third party appraisals of the property, resulting in a Level 3 classification, or an executed pending sales contract.  In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

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Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Assets and Liabilities Measured at Fair Value on a Recurring Basis:

The tables below present the balance of assets and liabilities at September 30, 2020, and December 31, 2019, respectively, measured by the Company at fair value on a recurring basis:

September 30, 2020

    

Level 1

    

Level 2

    

Level 3

    

Total

Assets:

Securities available-for-sale

U.S. Treasury

$

4,134

$

-

$

-

$

4,134

U.S. government agencies

-

7,005

-

7,005

U.S. government agencies mortgage-backed

-

18,219

-

18,219

States and political subdivisions

-

244,987

4,790

249,777

Collateralized mortgage obligations

-

57,013

-

57,013

Asset-backed securities

-

81,585

-

81,585

Collateralized loan obligations

-

30,688

-

30,688

Loans held-for-sale

-

10,229

-

10,229

Mortgage servicing rights

-

-

5,010

5,010

Interest rate swap agreements

-

10,506

-

10,506

Mortgage banking derivatives

-

1,434

-

1,434

Total

$

4,134

$

461,666

$

9,800

$

475,600

Liabilities:

Interest rate swap agreements, including risk participation agreements

$

-

$

15,231

$

-

$

15,231

Total

$

-

$

15,231

$

-

$

15,231

December 31, 2019

    

Level 1

    

Level 2

    

Level 3

    

Total

Assets:

Securities available-for-sale

U.S. Treasury

$

4,036

$

-

$

-

$

4,036

U.S. government agencies

-

8,337

-

8,337

U.S. government agencies mortgage-backed

-

16,588

-

16,588

States and political subdivisions

-

243,756

5,419

249,175

Collateralized mortgage obligations

-

57,984

-

57,984

Asset-backed securities

-

81,844

-

81,844

Collateralized loan obligations

-

66,684

-

66,684

Loans held-for-sale

-

3,061

-

3,061

Mortgage servicing rights

-

-

5,935

5,935

Interest rate swap agreements

-

2,771

-

2,771

Mortgage banking derivatives

-

250

-

250

Total

$

4,036

$

481,275

$

11,354

$

496,665

Liabilities:

Interest rate swap agreements, including risk participation agreements

$

-

$

5,974

$

-

$

5,974

Total

$

-

$

5,974

$

-

$

5,974

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Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are as follows:

Nine Months Ended September 30, 2020

Securities available-for-sale

States and

Mortgage

Political

Servicing

   

Subdivisions

   

Rights

Beginning balance January 1, 2020

$

5,419

$

5,935

Total gains or losses

Included in earnings

(16)

(2,463)

Included in other comprehensive income

(216)

-

Purchases, issuances, sales, and settlements

Purchases

12,900

-

Issuances

-

1,813

Settlements

(13,297)

(275)

Ending balance September 30, 2020

$

4,790

$

5,010

Nine Months Ended September 30, 2019

Securities available-for-sale

States and

Mortgage

Political

Servicing

    

Subdivisions

    

Rights

Beginning balance January 1, 2019

$

8,165

$

7,357

Total gains or losses

Included in earnings

(25)

(2,384)

Included in other comprehensive income

898

-

Purchases, issuances, sales, and settlements

Purchases

17,643

-

Issuances

-

906

Settlements

(20,808)

(518)

Ending balance September 30, 2019

$

5,873

$

5,361

The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of September 30, 2020:

Weighted

Measured at fair value

Unobservable

Average

on a recurring basis:

   

Fair Value

   

Valuation Methodology

   

Inputs

   

Range of Input

   

of Inputs

Mortgage servicing rights

$

5,010

Discounted Cash Flow

Discount Rate

11.0 - 15.0%

11.0

%

Prepayment Speed

0.0 - 42.8%

15.4

%

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Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of December 31, 2019:

Weighted

Measured at fair value

Unobservable

Average

on a recurring basis:

   

Fair Value

   

Valuation Methodology

   

Inputs

   

Range of Input

   

of Inputs

Mortgage servicing rights

$

5,935

Discounted Cash Flow

Discount Rate

10.0 - 58.8%

10.1

%

Prepayment Speed

0.0 - 69.0%

14.1

%

In addition to the above, Level 3 fair value measurement included $4.8 million for state and political subdivisions representing various local municipality securities at September 30, 2020.  This was classified as securities available-for-sale, and was valued using a discount based on market spreads of similar assets, but the liquidity premium was an unobservable input.  The state and political subdivisions securities balance in Level 3 fair value at September 30, 2019, was $5.9 million.  These securities were classified as securities available-for-sale, and were valued using a discount based on market spreads of similar assets, but the liquidity premium was an unobservable input.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis:

The Company may be required, from time to time, to measure certain other assets at fair value on a nonrecurring basis in accordance with GAAP.  These assets consist of individually evaluated (formerly, impaired) loans and OREO.  For assets measured at fair value on a nonrecurring basis at September 30, 2020, and December 31, 2019, respectively, the following tables provide the level of valuation assumptions used to determine each valuation and the carrying value of the related assets:

September 30, 2020

    

Level 1

    

Level 2

    

Level 3

    

Total

Individually evaluated loans1

$

-

$

-

$

12,200

$

12,200

Other real estate owned, net2

-

-

2,686

2,686

Total

$

-

$

-

$

14,886

$

14,886

1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans; had a carrying amount of $14.9 million and a valuation allowance of $2.7 million resulting in an increase of specific allocations within the allowance for credit losses on loans of $1.6 million for the nine months ended September 30, 2020.

2 OREO is measured at fair value, less costs to sell, and had a net carrying amount of $2.7 million at September 30, 2020, which is made up of the outstanding balance of $4.3 million, net of a valuation allowance of $1.6 million and no participations.

December 31, 2019

    

Level 1

    

Level 2

    

Level 3

    

Total

Impaired loans1

$

-

$

-

$

7,435

$

7,435

Other real estate owned, net2

-

-

5,004

5,004

Total

$

-

$

-

$

12,439

$

12,439

1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans; had a carrying amount of $8.6 million and a valuation allowance of $1.2 million resulting in an increase of specific allocations within the allowance for credit losses on loans of $783,000 for the year December 31, 2019.

2 OREO is measured at fair value, less costs to sell, and had a net carrying amount of $5.0 million at December 31, 2019, which is made up of the outstanding balance of $12.7 million, net of a valuation allowance of $6.7 million and a participation of $937,000.

The Company has estimated the fair values of these assets based primarily on Level 3 inputs.  OREO and impaired loans are generally valued using the fair value of collateral provided by third party appraisals.  These valuations include assumptions related to cash flow

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Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

projections, discount rates, and recent comparable sales.  The numerical ranges of unobservable inputs for these valuation assumptions are not meaningful.

Note 13 – Fair Values of Financial Instruments

The estimated fair values approximate carrying amount for all items except those described in the following table.  Securities available-for-sale fair values are based upon market prices or dealer quotes, and if no such information is available, on the rate and term of the security.  The carrying value of FHLBC stock approximates fair value as the stock is nonmarketable and can only be sold to the FHLBC or another member institution at par.  FHLBC stock is carried at cost and considered a Level 2 fair value.  For September 30, 2020 and December 31, 2019, the fair values of loans and leases are estimated on an exit price basis incorporating discounts for credit, liquidity and marketability factors.  The fair value of time deposits is estimated using discounted future cash flows at current rates offered for deposits of similar remaining maturities.  The fair values of borrowings were estimated based on interest rates available to the Company for debt with similar terms and remaining maturities.  The fair value of off balance sheet volume is not considered material.

The carrying amount and estimated fair values of financial instruments were as follows:

September 30, 2020

Carrying

Fair

    

Amount

    

Value

    

Level 1

    

Level 2

    

Level 3

Financial assets:

Cash and due from banks

$

29,489

$

29,489

$

29,489

$

-

$

-

Interest earning deposits with financial institutions

283,651

283,651

283,651

-

-

Securities available-for-sale

448,421

448,421

4,134

439,497

4,790

FHLBC and FRBC stock

9,917

9,917

-

9,917

-

Loans held-for-sale

10,229

10,229

-

10,229

-

Net loans

1,997,409

2,013,415

-

-

2,013,415

Interest rate swap agreements

10,506

10,506

-

10,506

-

Interest receivable on securities and loans

9,706

9,706

-

9,706

-

Financial liabilities:

Noninterest bearing deposits

$

889,085

$

889,085

$

889,085

$

-

$

-

Interest bearing deposits

1,590,158

1,593,058

-

1,593,058

-

Securities sold under repurchase agreements

59,268

59,268

-

59,268

-

Other short-term borrowings

6,125

6,125

-

6,125

-

Junior subordinated debentures

25,773

14,167

-

14,167

-

Senior notes

44,349

44,799

44,799

-

-

Note payable and other borrowings

24,469

25,160

-

25,160

-

Interest rate swap agreements

15,128

15,128

-

15,128

-

Interest payable on deposits and borrowings

1,257

1,257

-

1,257

-

37

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

December 31, 2019

Carrying

Fair

    

Amount

    

Value

    

Level 1

    

Level 2

    

Level 3

Financial assets:

Cash and due from banks

$

34,096

$

34,096

$

34,096

$

-

$

-

Interest earning deposits with financial institutions

16,536

16,536

16,536

-

-

Securities available-for-sale

484,648

484,648

4,036

475,193

5,419

FHLBC and FRBC stock

9,917

9,917

-

9,917

-

Loans held-for-sale

3,061

3,061

-

3,061

-

Net loans

1,911,023

1,915,531

-

-

1,915,531

Interest rate swap agreements

2,771

2,771

-

2,771

-

Interest receivable on securities and loans

9,697

9,697

-

9,697

-

Financial liabilities:

Noninterest bearing deposits

$

669,795

$

669,795

$

669,795

$

-

$

-

Interest bearing deposits

1,456,954

1,457,832

-

1,457,832

-

Securities sold under repurchase agreements

48,693

48,693

-

48,693

-

Other short-term borrowings

48,500

48,500

-

48,500

-

Junior subordinated debentures

57,734

51,188

33,614

17,574

-

Senior notes

44,270

46,269

46,269

-

-

Note payable and other borrowings

6,673

7,003

-

7,003

-

Interest rate swap agreements

5,921

5,921

-

5,921

-

Interest payable on deposits and borrowings

1,079

1,079

-

1,079

-

Note 14 – Derivatives, Hedging Activities and Financial Instruments with Off-Balance Sheet Risk

Risk Management Objective of Using Derivatives

The Company is exposed to certain risk arising from both its business operations and economic conditions.  The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments.  Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates.  The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s loan portfolio.  

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish these objectives, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy.  Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.  In December of 2019, the Company also executed a loan pool hedge of $50 million to convert variable rate loans to a fixed rate index for a five year term.

For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in Accumulated Other Comprehensive Income and subsequently reclassified into interest income/expense in the same period(s) during which the hedged transaction affects earnings. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are received on the Company’s variable-rate borrowings.  During the next twelve months, the Company estimates that an additional $180,000 will be reclassified as an increase to interest income and an additional $163,000 will be reclassified as an increase to interest expense.  

38

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Non-designated Hedges

Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers.  The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies.  Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions.  As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives with financial counterparties are recognized directly in earnings.  

The Company also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards.  The interest rate risk associated with these loan interest rate lock commitments is managed with contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts.  Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward MBS contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking revenue.  Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.

Disclosure of Fair Values of Derivative Instruments on the Balance Sheet

The Company entered into a forward starting interest rate swap on August 18, 2015, with an effective date of June 15, 2017.  This transaction had a notional amount totaling $25.8 million as of September 30, 2020, was designated as a cash flow hedge of certain junior subordinated debentures and was determined to be fully effective during the period presented.  As such, no amount of ineffectiveness has been included in net income.  Therefore, the aggregate fair value of the swap is recorded in other liabilities with changes in fair value recorded in other comprehensive income, net of tax.  The amount included in other comprehensive income would be reclassified to current earnings should all or a portion of the hedge no longer be considered effective.  The Company expects the hedge to remain fully effective during the remaining term of the swap.  The Bank will pay the counterparty a fixed rate and receive a floating rate based on three month LIBOR.  The trust preferred securities changed from fixed rate to floating rate on June 15, 2017.  The cash flow hedge has a maturity date of June 15, 2037.

In December 2019, the Company also executed a loan pool hedge of $50.0 million to convert variable rate loans to a fixed rate index for a five year term.  This transaction falls under hedge accounting standards and is paired against a pool of the Bank’s Libor-based loans. Overall, the new swap only bolsters income in down rate scenarios by a modest degree.  We consider the current level of interest rate risk to be moderate but intend to continue looking for market opportunities to hedge further.  The Bank held $1.7 million of cash collateral related to one correspondent financial institution to cover the loan pool hedge mark to market valuation at September 30, 2020.

The Bank also has interest rate derivative positions to assist with risk management that are not designated as hedging instruments.  These derivative positions relate to transactions in which the Bank enters an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution.  The Bank had $17.2 million of cash collateral held by one correspondent financial institution to support interest rate swap activity at September 30, 2020 and no investment securities were required to be pledged to any correspondent financial institution.  The Bank had $114,000 of cash collateral pledged with one correspondent financial institution to support interest rate swap activity at December 31, 2019 and $11.0 million of investment securities were required to be pledged to two correspondent financial institutions.  At September 30, 2020, the notional amount of non-hedging interest rate swaps was $191.3 million with a weighted average maturity of 5.0 years.  At December 31, 2019, the notional amount of non-hedging interest rate swaps was $177.9 million with a weighted average maturity of 5.9 years.  The Bank offsets derivative assets and liabilities that are subject to a master netting arrangement.

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet as of September 30, 2020 and December 31, 2019.

39

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Fair Value of Derivative Instruments

September 30, 2020

No. of Trans.

Notional Amount $

Balance Sheet Location

Fair Value $

Balance Sheet Location

Fair Value $

Derivatives designated as hedging instruments

Interest rate swaps

2

75,774

Other Assets

2,988

Other Liabilities

7,610

Total derivatives designated as hedging instruments

2,988

7,610

Derivatives not designated as hedging instruments

Interest rate swaps with commercial loan customers

28

191,341

Other Assets

7,518

Other Liabilities

7,518

Interest rate lock commitments and forward contracts

250

92,154

Other Assets

1,434

Other Liabilities

-

Other contracts

4

26,683

Other Assets

-

Other Liabilities

103

Total derivatives not designated as hedging instruments

8,952

7,621

December 31, 2019

No. of Trans.

Notional Amount $

Balance Sheet Location

Fair Value $

Balance Sheet Location

Fair Value $

Derivatives designated as hedging instruments

Interest rate swaps

2

75,774

Other Assets

-

Other Liabilities

3,150

Total derivatives designated as hedging instruments

-

3,150

Derivatives not designated as hedging instruments

Interest rate swaps with commercial loan customers

25

177,872

Other Assets

2,771

Other Liabilities

2,771

Interest rate lock commitments and forward contracts

87

23,667

Other Assets

250

Other Liabilities

-

Other contracts

4

28,176

Other Assets

-

Other Liabilities

53

Total derivatives not designated as hedging instruments

3,021

2,824

Disclosure of the Effect of Fair Value and Cash Flow Hedge Accounting

The fair value and cash flow hedge accounting related to derivatives covered under ASC Subtopic 815-20 impacted Accumulated Other Comprehensive Income (“AOCI”) and the Income Statement.  The loss recognized in AOCI on derivatives totaled $3.3 million as of September 30, 2020, and a loss of $3.4 million as of September 30, 2019.  The amount of the loss reclassified from AOCI to interest income on the income statement totaled $72,000 and $27,000 for the nine months ended September 30, 2020, and September 30, 2019, respectively.  

Credit-risk-related Contingent Features

For derivative transactions involving counterparties who are lending customers of the Company, the derivative credit exposure is managed through the normal credit review and monitoring process, which may include collateralization, financial covenants and/or financial guarantees of affiliated parties.  Agreements with such customers require that losses associated with derivative transactions receive payment priority from any funds recovered should a customer default and ultimate disposition of collateral or guarantees occur.

Credit exposure to broker/dealer counterparties is managed through agreements with each derivative counterparty that require collateralization of fair value gains owed by such counterparties.  Some small degree of credit exposure exists due to timing differences between when a gain may occur and the subsequent point in time that collateral is delivered to secure that gain.  This is monitored by the Company and procedures are in place to minimize this exposure.  Such agreements also require the Company to collateralize counterparties in circumstances wherein the fair value of the derivatives result in loss to the Company.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Other provisions of such agreements include the definition of certain events that may lead to the declaration of default and/or the early termination of the derivative transaction(s):

If the Company either defaults or is capable of being declared in default on any of its indebtedness (exclusive of deposit obligations), then the Company could also be declared in default on its derivative obligations.
If a merger occurs that materially changes the Company's creditworthiness in an adverse manner.
If certain specified adverse regulatory actions occur, such as the issuance of a Cease and Desist Order, or citations for actions considered Unsafe and Unsound or that may lead to the termination of deposit insurance coverage by the FDIC.

The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party.  The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as that involved in extending loan commitments to our customers.  In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO.  The following table represents the Company’s contractual commitments due to letters of credit as of September 30, 2020, and December 31, 2019.

The following table is a summary of letter of credit commitments:

September 30, 2020

December 31, 2019

    

Fixed

    

Variable

    

Total

    

Fixed

    

Variable

    

Total

  

Letters of credit:

Borrower:

Financial standby

$

329

$

8,881

$

9,210

$

339

$

9,612

$

9,951

Commercial standby

-

-

-

-

-

-

Performance standby

356

5,825

6,181

571

6,212

6,783

685

14,706

15,391

910

15,824

16,734

Non-borrower:

Performance standby

-

67

67

-

67

67

Total letters of credit

$

685

$

14,773

$

15,458

$

910

$

15,891

$

16,801

Unused loan commitments:

$

93,875

$

325,162

$

419,037

$

111,348

$

320,120

$

431,468

As of January 1, 2020, we adopted ASU 2016-13, and per CECL guidance, the Company recorded an allowance for credit losses on unfunded commitments of $1.7 million.  As of September 30, 2020, the Company evaluated current market conditions, including the impacts related to COVID-19 and market interest rates during the third quarter of 2020, and based on that analysis under CECL methodology, the Company recorded a reversal of the provision for credit losses related to unfunded commitments of $980,000.  The reduction in the ACL for unfunded commitments in the third quarter of 2020, compared to the prior quarter end, is primarily related to a decrease in the commercial unfunded commitments funding rate assumptions based on our analysis of the last 12 months of utilization.  The Company will continue to assess the credit risk at least quarterly, and adjust the allowance for unfunded commitments, which is carried within other liabilities on our Consolidated Balance Sheet, as needed, with the appropriate offsetting entry to the provision for credit losses on our Consolidated Statements of Income.

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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

The following discussion provides additional information regarding our operations for the three and nine months ended September 30, 2020, compared to the three and nine months ended September 30, 2019, and our financial condition at September 30, 2020, and December 31, 2019.  This discussion should be read in conjunction with our consolidated financial statements as well as the financial and statistical data appearing elsewhere in this report and our Form 10-K for the year ended December 31, 2019.  The results of operations for the three and nine months ended September 30, 2020, are not necessarily indicative of future results.  Dollar amounts presented in the following tables are in thousands, except per share data, and September 2020 and 2019 amounts are unaudited.

In this report, unless the context suggests otherwise, references to the “Company,” “we,” “us,” and “our” mean the combined business of Old Second Bancorp, Inc. and its subsidiary bank, Old Second National Bank (the “Bank”).

We have made, and will continue to make, various forward-looking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” on page 3 of this report.

Business Overview

The Company is a bank holding company headquartered in Aurora, Illinois. Through our wholly-owned subsidiary bank, Old Second National Bank, a national banking organization also headquartered in Aurora, Illinois, we offer a wide range of financial services through our 29 banking centers located in Cook, DeKalb, DuPage, Kane, Kendall, LaSalle and Will counties in Illinois.  These banking centers offer access to a full range of traditional retail and commercial banking services including treasury management operations as well as fiduciary and wealth management services.  We focus our business on establishing and maintaining relationships with our clients while maintaining a commitment to provide for the financial services needs of the communities in which we operate.  We emphasize relationships with individual customers as well as small to medium-sized businesses throughout our market area.  We also have extensive wealth management services, which includes a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts and employee benefit plan administration services.

Recent Events—COVID-19

The coronavirus (COVID-19) pandemic, which was declared a national emergency in the United States in March 2020, continues to create extensive disruptions to the global economy and financial markets and to businesses and the lives of individuals throughout the world. In particular, the COVID-19 pandemic has severely restricted the level of economic activity in our markets.  Federal and state governments have taken, and may continue to take, unprecedented actions to contain the spread of the disease, including quarantines, travel bans, shelter-in-place orders, closures of businesses and schools, fiscal stimulus, and legislation designed to deliver monetary aid and other relief to businesses and individuals impacted by the pandemic. Although in various locations certain activity restrictions have been relaxed and businesses and schools have reopened with some level of success, in many states and localities the number of individuals diagnosed with COVID-19 has increased significantly, which may cause a freezing or, in certain cases, a reversal of previously announced relaxation of activity restrictions and may prompt the need for additional aid and other forms of relief.

The impact of the COVID-19 pandemic is fluid and continues to evolve.  The unprecedented and rapid spread of COVID-19 and its associated impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending, and other economic activities has resulted in less economic activity, lower bank equity market valuations and significant volatility and disruption in financial markets.  In addition, due to the COVID-19 pandemic, market interest rates have declined significantly, with the 10-year Treasury bond falling below 1.00% on March 3, 2020, for the first time, and declining further to 0.65% as of June 30, 2020. On March 3, 2020, the Federal Open Market Committee reduced the targeted federal funds interest rate range by 50 basis points to 1.00% to 1.25%. This range was further reduced to 0% to 0.25% percent on March 16, 2020. These reductions in interest rates and the other effects of the COVID-19 pandemic have had, and are expected to continue to have, possibly materially, an adverse effect on our business, financial condition, and results of operations.  The ultimate extent of the impact of the COVID-19 pandemic on our business, financial condition and results of operations is currently uncertain and will depend on various developments and other factors, including, among others, the duration and scope of the pandemic, as well as governmental, regulatory and private sector responses to the pandemic, and the associated impacts on the economy, financial markets and our customers, employees and vendors.

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Our business, financial condition and results of operations generally rely upon the ability of our borrowers to repay their loans, the value of collateral underlying our secured loans, and demand for loans and other products and services we offer, which are highly dependent on the business environment in our primary markets where we operate and in the United States as a whole.

Temporary Operational Changes

We have taken a number of steps to protect our employees, customers and communities.  In March 2020, as part of our efforts to exercise social distancing, we closed all of our banking lobbies (other than by appointment) conducted most of our business through drive-thru tellers and through electronic and online means.  At this time, our lobbies have been reopened, but we encourage customers to use other means to conduct their banking, and are following social distancing and personal protective protocols as directed by the Center for Disease Control and Prevention.  In addition, a majority of our workforce has been working from home since mid-March 2020, and we expect this to continue through the end of 2020.

Results of Operation and Financial Condition

We are monitoring the impact of the COVID-19 pandemic on our results of operation and financial condition.  While the pandemic has not yet had a significant impact to our financial condition as of September 30, 2020, in the form of incurred losses or communications from our borrowers that significant losses were imminent, we nevertheless determined it prudent to increase our provision for credit losses in anticipation of continued market risk and uncertainty at this time.  Our provision for credit losses was $8.0 million for the first quarter of 2020, which was impacted by both our adoption of the new CECL methodology and the expected impact, as of March 31, 2020, of the COVID-19 pandemic and market interest rate reductions.  Our provision for credit losses was $300,000 for the third quarter of 2020, as we continued to forecast an increase in future expected credit losses due to the ongoing impact of the pandemic.  Periods ending after September 30, 2020 may also be materially impacted by the COVID-19 pandemic.  

We also adjust our investment securities portfolio to market each period end and review for any impairment that would require a provision for credit losses.  At this time, we have determined there is no need for a provision for credit losses related to our investment securities portfolio.  Because of changing economic and market conditions affecting issuers, we may be required to recognize impairments in the future on the securities we hold as well as experience reductions in other comprehensive income.  We cannot currently determine the ultimate impact of the pandemic on the long-term value of our portfolio.

As of September 30, 2020, we had $18.6 million of goodwill.  At each quarter end in 2020, we have considered whether a quantitative assessment of our goodwill was required because of the significant economic disruption caused by the COVID-19 pandemic.  At September 30, 2020, we determined no goodwill impairment was required.  However, further delayed recovery or further deterioration in market conditions related to the general economy, financial markets, and the associated impacts on our customers, employees and vendors, among other factors, could significantly impact the impairment analysis and may result in future goodwill impairment charges that, if incurred, could have a material adverse effect on our results of operations and financial condition.

Lending Operations and Accommodations to Borrowers

To more fully support our customers during the pandemic, we established client assistance programs, including offering commercial, consumer, and mortgage loan payment deferrals for certain clients.  During the 2020 year to date period, we executed 468 of these deferrals on loan balances of $226.2 million.  In accordance with interagency guidance issued in March 2020, these short term deferrals were not considered troubled debt restructurings.  As of September 30, 2020, 372 loans previously in deferral status, representing loan balances of $172.1 million, had resumed payments.  We also suspended late fees for consumer loans through June 30, 2020, and, although consumer late fees have been reinstated, we will continue to evaluate any late fee suspension based on the borrower’s financial situation and prior payment history.  We also paused new foreclosure and repossession actions through September 30, 2020, and will continue to re-evaluate these activities based on the ongoing COVID-19 pandemic. These programs may negatively impact our revenue and other results of operations in the near term and, if not effective in mitigating the effect of COVID-19 on our customers, may adversely affect our business and results of operations more substantially over a longer period of time. Future governmental actions may require these and other types of customer-related responses.  

We are also participating in the Coronavirus Aid, Relief and Economic Security Act (“CARES” Act). As of August 10, 2020, the date of the conclusion of the SBA program offering, we had processed 746 loan applications for the SBA Paycheck Protection Program (“PPP”), representing a total of $136.7 million.  In early October, we started the application process for PPP loan forgiveness, and expect this process to continue through the remainder of 2020, with funds to be received from the SBA for the forgiven loans well into 2021.  In addition, as of September 30, 2020, we had originated one loan for $125,000 under the Main Street Lending Program.  We remain ready to continue to fund eligible client requests if Congress appropriates additional funds.

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Capital and Liquidity

As of September 30, 2020, all of our capital ratios were in excess of all regulatory requirements. While we believe that we have sufficient capital to withstand an extended economic recession brought about by the COVID-19 pandemic, our reported and regulatory capital ratios could be adversely impacted by credit losses.

We believe there could be potential stresses on liquidity management as a result of the COVID-19 pandemic and our participation in the PPP.  As customers manage their own liquidity stress, we could experience an increase in the utilization of existing lines of credit.  

The Federal Reserve Bank has provided a lending facility that will allow us to obtain funding specifically for loans that we make under the PPP (the “PPPLF”), which will allow us to retain existing sources of liquidity for our traditional operations. PPP loans will be pledged as collateral on any of our borrowings under the Federal Reserve Bank’s lending facility.  These factors, together or in combination with other events or occurrences that may not yet be known or anticipated, may materially and adversely affect our business, financial condition and results of operations.  We have not yet participated in the PPPLF program, but have the ability to do so should the need arise.

We have also developed new processes to monitor our liquidity on a daily basis, and have run stress testing based on various economic assumptions under stress and severe stress scenarios.  In addition, management continues to communicate each week in structured meetings with key staff to ensure all current events related to the COVID-19 pandemic, such as federal government stimulus check receipt, and PPP loan fundings and the forgiveness application process, are managed appropriately.

Financial Overview

Our community-focused banking franchise experienced growth in total loans in the third quarter of 2020, compared to both the year ended December 31, 2019, and the third quarter of 2019, and we believe we are positioned for further moderate loan growth as we continue to serve our customers’ needs in a competitive economic environment.  Given the ongoing, dynamic and unprecedented nature of the COVID-19 pandemic, it is difficult to predict the full impact the pandemic will have on our business; however, we expect the pandemic will make it challenging for us to attain the levels of profitability and growth we have experienced in the past five years.  We are continuing to seek to provide value to our customers and the communities in which we operate, by executing on growth opportunities in our local markets and developing new banking relationships, while ensuring the safety and soundness of our Bank, our customers and our employees during the COVID-19 pandemic.  

The following provides an overview of some of the factors impacting our financial performance for the three month period ended September 30, 2020, compared to the like period ended September 30, 2019:

Net income for the third quarter of 2020 was $10.3 million, or $0.34 per diluted share, compared to $12.2 million, or $0.40 per diluted share, for the third quarter of 2019.  

Net interest and dividend income was $22.5 million for the third quarter of 2020, compared to $24.8 million for the third quarter of 2019.  The decrease in 2020 was primarily due to the year over year decline in market interest rates, which negatively impacted loan and security income, despite growth in our loan portfolio of $130.5 million in the same period.  

A provision for credit losses of $300,000 was recorded for the third quarter of 2020, consisting of $1.3 million related to loans and leases and a $980,000 reversal related to unfunded commitments, compared to a provision for loan and lease losses of $550,000 in the third quarter of 2019.  We adopted the new current expected credit losses accounting standard, or CECL, effective January 1, 2020, which measures the allowance based on management’s best estimate of lifetime expected credit losses inherent in our lending activities, which resulted in a $5.9 million allowance for credit losses related to loans and a $1.7 million allowance for credit losses related to unfunded commitments as of January 1, 2020.  The provision expense recorded in 2020 was impacted by both the new CECL methodology applied and the expected impact, as of September 30, 2020, of the COVID-19 pandemic on future losses.

Noninterest income was $11.7 million for the third quarter of 2020, compared to $11.9 million for the third quarter of 2019.  The decrease was primarily due to a $3.5 million reduction in securities gains, net, due to sales in the third quarter of 2019 and no like sales in the current period, as well as reductions stemming from COVID-19 related impacts in the third quarter of 2020, compared to the third quarter of 2019, including a $698,000 decrease in service charges on deposits due to a reduction in overdraft fees.  Partially offsetting these decreases were interest rate driven growth in net gain on sales of mortgage loans, as

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proceeds from mortgages sold in the third quarter of 2020 totaled $116.5 million, compared to $63.3 million in the third quarter of 2019, resulting in an increase in noninterest income of $3.2 million.  A reduction in mark to market losses on mortgage servicing rights (“MSRs”) of $786,000 in the third quarter of 2020, compared to the third quarter of 2019, and a net increase in the cash surrender value of bank owned life insurance (“BOLI”) of $192,000 for the third quarter of 2020, compared the third quarter of 2019, also mitigated the overall decrease in noninterest income for the quarter year over year.

Noninterest expense was $20.3 million for the third quarter of 2020, compared to $20.0 million for the third quarter of 2019, an increase of $312,000, or 1.6%.  The increase in 2020 was primarily due to an increase in salaries and employee benefits expense driven by an increase in full-time equivalent employees in 2020, annual merit increases in early 2020, and higher employee insurance costs, and an increase in FDIC insurance expense related to an accrual reversal in the third quarter of 2019.  Partially offsetting these increases were reductions in occupancy, furniture and equipment expense, computer and data processing expense and advertising expense, as we reduced our marketing efforts during the COVID-19 pandemic.  

The provision for income taxes was $3.4 million for the third quarter of 2020, compared to $4.0 million for the third quarter of 2019.   Pretax income was $13.6 million in the third quarter of 2020, compared to $16.2 million for the third quarter of 2019.  

Asset quality remained consistent with nonperforming loans as a percent of total loans remaining relatively steady at 1.0% as of September 30, 2020, 0.8% as of December 31, 2019, and 0.7% as of September 30, 2019.  

During the third quarter of 2020, we repurchased 137,756 shares of our common stock at a weighted average price of $8.34 per share pursuant to our stock repurchase program.

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Critical Accounting Policies

Our consolidated financial statements are prepared based on the application of accounting policies in accordance with generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry.  These policies require the reliance on estimates and assumptions, which may prove inaccurate or are subject to variations.  These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements.  Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.  Changes in underlying factors, assumptions, or estimates could have a material impact on our future financial condition and results of operations.  

Of the significant accounting policies used in the preparation of our consolidated financial statements, we have identified certain items as critical accounting policies based on the associated estimates, assumptions, judgments and complexity. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in our Annual Report on Form 10-K for the year ended December 31, 2019.  

Determining the allowance for loan and lease losses has historically been identified as a critical accounting policy. On January 1, 2020, we adopted the new CECL accounting methodology which requires entities to estimate and recognize an allowance for lifetime expected credit losses for loans and other financial assets measured at amortized cost.  Previously, an allowance for loan and lease losses was recognized based on probable incurred losses. The accounting estimates relating to the allowance for credit losses is also a “critical accounting policy” as:

changes in the provision for credit losses can materially affect our financial results;
estimates relating to the allowance for credit losses require us to project future borrower performance, including cash flows, delinquencies and charge-offs, along with, when applicable, collateral values, based on a reasonable and supportable forecast period utilizing forward-looking economic scenarios in order to estimate probability of default and loss given default; and
the allowance for credit losses is influenced by factors outside of our control such as industry and business trends, geopolitical events and the effects of laws and regulations as well as economic conditions such as trends in housing prices, interest rates, GDP, inflation, energy prices and unemployment; and
considerable judgment is required to determine whether the models used to generate the allowance for credit losses produce an estimate that is sufficient to encompass the current view of lifetime expected credit losses.

Because our estimates of the allowance for credit losses involve judgment and are influenced by factors outside our control, there is uncertainty inherent in these estimates. Our estimate of lifetime expected credit losses is inherently uncertain because it is highly sensitive to changes in economic conditions and other factors outside of our control. Changes in such estimates could significantly impact our allowance and provision for credit losses. See Note 1 – Basis of Presentation and Changes in Significant Accounting Policies in the accompanying notes to the consolidated financial statements included elsewhere in this report for a discussion of our Allowance for Credit Losses.

Non-GAAP Financial Measures

This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of net interest income and net interest margin on a tax equivalent (“TE”) basis, our adjusted efficiency ratio, our tangible common equity to tangible assets ratio, and our core net interest margin on a TE basis.  Management believes that the presentation of these non-GAAP financial measures (a) provides important supplemental information that contributes to a proper understanding of our operating performance, (b) enables a more complete understanding of factors and trends affecting our business, and (c) allows investors to evaluate our performance in a manner similar to management, the financial services industry, bank stock analysts, and bank regulators. Management uses non-GAAP measures as follows: in the preparation of our operating budgets, monthly financial performance reporting, and in our presentation to investors of our performance.  However, we acknowledge that these non-GAAP financial measures have a number of limitations. Limitations associated with non-GAAP financial measures include the risk that persons might disagree as to the appropriateness of items comprising these measures and that different companies might calculate these measures differently.  These disclosures should not be considered an alternative to our GAAP results.  A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is presented below or alongside the first instance where each non-GAAP financial measure is used.

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Results of Operations

Overview

Three months ended September 30, 2020 and 2019

Our income before taxes was $13.6 million in the third quarter of 2020 compared to $16.2 million in the third quarter of 2019.  This $2.6 million decrease in pretax income was primarily due to the $2.3 million decrease in net interest and dividend income in the third quarter of 2020, compared to the third quarter of 2019.  Also contributing to the decline in pretax income in the third quarter of 2020, compared to the third quarter of 2019, was a $248,000 reduction in noninterest income and a $312,000 increase in noninterest expense.  These negative variances were partially offset by a $250,000 reduction in the provision for credit losses for the year over year quarter.  We adopted the new CECL methodology effective January 1, 2020, which requires us to estimate and recognize an allowance for lifetime expected credit losses, and we recorded provision expense of $10.1 million during the first two quarters of 2020, due to the expected impact of the COVID-19 pandemic and related market interest rate reductions.  Our provision build in the first and second quarters of 2020 allowed us to record a lower provision of $300,000 in the third quarter of 2020, compared to a $550,000 provision for loan and lease losses in the third quarter of 2019, under the incurred loss model.  Our net income was $10.3 million, or $0.34 per diluted share, for the third quarter of 2020, compared to net income of $12.2 million, or $0.40 per diluted share, for the third quarter of 2019.

Net interest and dividend income was $22.5 million in the third quarter of 2020, compared to $24.8 million in the third quarter of 2019.  The $2.3 million decrease was primarily driven by a $4.4 million decrease in interest and dividend income in the third quarter of 2020, compared to the third quarter of 2019, driven by the reduction in market interest rates on loans and securities.  Loan growth of $130.5 million was recorded in the year over year period, but interest income on loans declined $3.1 million from the quarter ended September 30, 2019 to September 30, 2020.  Securities available-for-sale decreased $40.0 million as of September 30, 2020, compared to September 30, 2019, which exacerbated the reduction in securities related income of $1.2 million in the same year over year period. Partially offsetting the decrease in interest and dividend income was a $2.1 million reduction in total interest expense in the third quarter of 2020, compared to the third quarter of 2019, due to a reduction in interest expense of $1.0 million on deposits, $405,000 on other short-term borrowings, and $648,000 on junior subordinated debentures, due to the redemption of the Old Second Capital Trust I trust preferred securities and related subordinated debentures in the first quarter of 2020.  

Management has remained diligent in reviewing our loan portfolio to analyze and determine if charge-offs are required.  Average loan growth, including loans held for sale, in the third quarter of 2020, compared to the third quarter of 2019, totaled $153.5 million, stemming from 746 PPP loans originated in the second and third quarters of 2020 totaling $136.7 million, as well as organic growth primarily in our commercial, leases, and commercial real estate-investor portfolios.

Nine months ended September 30, 2020 and 2019

Our income before taxes was $26.0 million for the nine months ended September 30, 2020, compared to $39.4 million for the nine months ended September 30, 2019.  This $13.4 million decrease in pretax income was primarily due to a $9.0 million increase in provision for credit losses for the nine months ended September 30, 2020, compared to the same period in 2019, due both to our adoption of the new CECL methodology effective January 1, 2020 and the expected impact, as of September 30, 2020, of the COVID-19 pandemic and related market interest rate reductions.  Our net income was $19.8 million, or $0.65 per diluted share, for the nine months ended September 30, 2020, compared to net income of $29.9 million, or $0.98 per diluted share, for the nine months ended September 30, 2019.  

Net interest and dividend income was $67.9 million for the nine months ended September 30, 2020, compared to $73.6 million for the same period of 2019.  The decrease in net interest and dividend income was primarily due to the impact of the reduction in market interest rates on loans and securities.  Also impacting net income was a $2.1 million increase in noninterest income for the nine months ended September 30, 2020, compared to the like 2019 period, driven primarily by a $8.1 million increase in net gain on sales of mortgage loans, which more than offset the reduction year over year due to securities gains, net, of $4.5 million for the nine months ended September 30, 2019, compared to securities losses, net, of $25,000 for the nine months ended September 30, 2020, and a $1.7 million reduction in service charges on deposits in the year over year period due to a decline in customer spending due to the COVID-19 pandemic and resultant decrease in overdraft and bounce fees.  Noninterest expense increased $890,000 for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019, due primarily to growth in salaries and employee benefits expense driven by an increase in full-time equivalent employees, annual merit increases and higher employee insurance costs, partially offset by reductions in computer and data processing and advertising expense.

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Net Interest Income

Net interest income, which is our primary source of earnings, is the difference between interest income earned on interest-earning assets, such as loans and investment securities, as well as accretion income on purchased loans, and interest incurred on interest-bearing liabilities, such as deposits and borrowings.  Net interest income depends upon the relative mix of interest-earning assets and interest-bearing liabilities, the ratio of interest-earning assets to total assets and of interest-bearing liabilities to total funding sources, and movements in market interest rates.  Our net interest income can be significantly influenced by a variety of factors, including overall loan demand, economic conditions, credit risk, the amount of nonearning assets including nonperforming loans and OREO, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities, early withdrawal of deposits, exercise of call options on borrowings or securities, a general rise or decline in interest rates, changes in the slope of the yield-curve, and balance sheet growth or contraction.

Three months ended September 30, 2020 and 2019

Our net interest and dividend income decreased by $2.3 million, to $22.5 million, for the third quarter of 2020, from $24.8 million for the third quarter of 2019.  This decline was attributable to the $4.4 million, or 14.9%, decrease in interest and dividend income for the third quarter of 2020 compared to the third quarter of 2019, partially offset by a $2.1 million decrease in interest expense.  Net interest and dividend income for the third quarter of 2020 reflected a decrease of $198,000, or 0.9%, compared to the second quarter of 2020.

Average earning assets for the third quarter of 2020 were $2.77 billion, reflecting an increase of $102.3 million, or 3.8%, compared to the second quarter of 2020, and an increase of $349.2 million, or 14.4%, compared to the third quarter of 2019.  Total average loans, including loans held-for-sale, totaled $2.05 billion in the third quarter of 2020, which reflected a decrease of $3.1 million compared to the second quarter of 2020, and an increase of $153.5 million compared to the third quarter of 2019.  The growth in average loan balances year over year was primarily due to an increase in commercial loans related to PPP loan disbursements and lease and commercial real estate-investor loans stemming from organic growth.  This growth in loan volumes was offset by the reduction in market interest rates over the past year, which resulted in a decrease in interest income of $3.1 million related to loans in the year over year period.  For the third quarter of 2020, the yield on average loans decreased to 4.29%, compared to the yield on average loans of 4.40% for the second quarter of 2020, and 5.27% for the third quarter of 2019.  Securities also reflected a reduction in interest income, due to both decreases in market interest rates over the past year and volumes used to fund loan growth.  Total average securities for the third quarter of 2020 decreased $4.3 million from the second quarter of 2020, and decreased $45.6 million from the third quarter of 2019.  The yield on average securities declined to 2.78% for the third quarter of 2020, compared to 3.07% for the second quarter of 2020 and 3.59% for third quarter of 2019.

Average interest bearing liabilities increased $44.6 million, or 2.6%, in the third quarter of 2020, compared to the second quarter of 2020, and increased $71.5 million, or 4.3%, compared to the third quarter of 2019.  The growth in average interest bearing deposits of $37.4 million from the prior quarter was due to seasonal deposit fluctuations from income tax refunds, commercial deposit build for projects to be deployed later in the year, and growth in depositor liquidity due to market uncertainty related to the COVID-19 pandemic. The growth in average interest bearing deposits of $142.0 million from the third quarter of 2019 was primarily due to the impacts of the COVID-19 pandemic, which also impacted the $240.9 million of growth in noninterest bearing deposits for the same period, as reductions in market interest rates over the past year have provided less incentive to maintain funds in interest bearing deposits.  

Average other short-term borrowings, which consist of FHLBC advances, decreased $192,000 in the third quarter of 2020, compared to the second quarter of 2020, and decreased $67.1 million compared to the third quarter of 2019.  We drew on a $4.0 million, zero interest, 360 day advance offered by the FHLB to its members under a COVID-19 liquidity program in the third quarter of 2020.  The average rate paid on short-term FHLBC advances was impacted by the reduction in interest rates in 2020, resulting in an average rate of 1.16% for the third quarter of 2020, compared to 1.63% for the second quarter of 2020, and 2.26% for the third quarter of 2019.  As of September 30, 2020, notes payable and other borrowings consisted of one long-term FHLBC advance of $6.5 million that we acquired in our acquisition of ABC Bank, and $18.0 million outstanding on a term note with a correspondent bank originated in the first quarter of 2020 to fund our redemption of the Old Second Capital Trust I trust preferred securities and related junior subordinated debentures of $32.6 million.  This redemption occurred in March 2020 and was the primary cause of the decrease of 201 basis points in the cost of the average junior subordinated debentures for the third quarter of 2020 compared to the third quarter of 2019.  The rate paid on the redeemed junior subordinated debentures was 7.8%, in comparison to the rate to be paid going forward on the newly executed $20.0 million term note of one month Libor plus 175 basis points.

Our net interest margin, expressed as a percentage of average earning assets, was 3.23% for the third quarter of 2020, reflecting a 19 basis point decrease from the second quarter of 2020, and an 83 basis point decrease from the third quarter of 2019.  Our net interest margin,

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on a tax-equivalent (TE) basis, expressed as a percentage of average earning assets, was 3.28% for the third quarter of 2020, reflecting a 20 basis point decrease from the second quarter of 2020, and an 86 basis point decrease from the third quarter of 2019.  The average tax-equivalent yield on earning assets decreased to 3.65% for the third quarter of 2020, compared to 3.93% for the second quarter of 2020, and 4.90% for the third quarter of 2019.  The decreases in net interest margin and the yield on average earning assets for the third quarter of 2020, compared to the third quarter of 2019, was primarily attributable to a decline in security volumes and interest rate reductions which impacted loans and securities in the third quarter of 2020.  Average PPP loans for the third quarter of 2020 totaled $136.3 million, which resulted in a reduction to our net interest margin (TE) of six basis points for the quarter as these loans were issued at a 1.00% interest rate, plus origination fees, net of costs. The cost of funds on interest bearing liabilities was 0.58% for the third quarter of 2020, 0.72% for the second quarter of 2020, and 1.11% for the third quarter of 2019.  The decrease in our cost of funds in the third quarter of 2020 compared to the second quarter of 2020 was primarily driven by a full quarter of impact of interest rate reductions on our deposits.   The decrease in our cost of funds in the third quarter of 2020 compared to the third quarter of 2019 was primarily driven by a decline in the rates paid on deposits, a decline in volume and rates paid on short-term borrowings, and the redemption of our junior subordinated debentures in the first quarter of 2020 which resulted in the average yield on our junior subordinated debentures of 4.40% for the third quarter of 2020, compared to 6.41% in the prior year like quarter.

Nine months ended September 30, 2020 and 2019

Our net interest and dividend income decreased by $5.7 million to $67.9 million for the nine months ended September 30, 2020, compared to $73.6 million for the nine months ended September 30, 2019.  This decline was attributable to a $9.7 million, or 11.1%, decrease in interest and dividend income for the nine months ended September 30, 2020, compared to the nine months ended September 30, 2019, partially offset by a $4.0 million decrease in interest expense.  

Average earning assets for the nine months ended September 30, 2020 were $2.63 billion, reflecting an increase of $197.0 million, or 8.1%, compared to the nine months ended September 30, 2019.  The yield on average earning assets for the nine months ended September 30, 2020 was 4.02%, compared to 4.91% for the nine months ended September 30, 2019.  Total average loans, including loans held-for-sale, totaled $2.02 billion for the nine months ended September 30, 2020, which reflected an increase of $119.5 million compared to the nine months ended September 30, 2019.  The growth in average loan balances was more than offset by market interest rate reductions, which resulted in a $6.1 million decrease in loan interest income for the nine months ended September 30, 2020, compared to the like 2019 period.  For the nine months ended September 30, 2020, yields on average securities decreased by 71 basis points and yields on average loans decreased by 72 basis points, each as compared to the nine months ended September 30, 2019, due primarily to the falling interest rate environment. Average interest earning deposits with financial institutions increased $128.9 million in the nine months ended September 30, 2020, compared to the prior year like period as consumer spending declined year over year as a result of the COVID-19 pandemic, which increased our liquidity.

Average interest bearing liabilities decreased $23.2 million, or 1.4%, in the nine months ended September 30, 2020, compared to the nine months ended September 30, 2019.  The decrease was due to reductions in average other short-term borrowings of $75.7 million, which primarily consist of FHLBC advances, and a reduction in average junior subordinated debentures of $24.8 million due to the redemption of the trust preferred securities and the related $32.6 million of subordinated debentures issued by Old Second Capital Trust I in March 2020.   The rate on our junior subordinated debentures was 7.85% for the nine months ended September 30, 2020, and 6.47% for the nine months ended September 30, 2019, as $635,000 of deferred issuance costs was expensed upon the redemption in 2020.  Average interest bearing deposits increased by $61.9 million in the nine months ended September 30, 2020, compared to the nine months ended September 30, 2019, but the reduction in market interest rates resulted in a 16 basis point reduction in the cost of interest bearing deposits for the nine months ended September 30, 2020, compared to the like 2019 period.  Average noninterest bearing deposits increased $167.2 million in the nine months ended September 30, 2020, compared to the nine months ended September 30, 2019, as customers spent less as a result of the COVID-19 pandemic.

Our net interest margin for the nine months ended September 30, 2020 was 3.44% compared to 4.04% for the nine months ended September 30, 2019, reflecting a 60 basis point decrease.  Our net interest margin (TE) for the nine months ended September 30, 2020 was 3.50% compared to 4.13% for the nine months ended September 30, 2019, reflecting a 63 basis point decrease. The decrease in net interest margin for the nine months ended September 30, 2020, compared to the nine months ended September 30, 2019, was due primarily to reductions in the market interest rates as well as the issuance of $136.7 million of PPP loans at 1.00%, and the growth of our liquidity with an increase in cash and due from banks, which have not yet been reinvested into higher yielding assets.  We are currently assessing potential investment opportunities for this excess liquidity.  Core net interest margin (TE), a non-GAAP financial measure that excludes PPP loans, was 3.54% for the nine months ended September 30, 2020, reflecting a four basis point reduction from net interest margin (TE) for the same period.  These reductions to the net interest margin were partially offset by reductions in rates paid on deposits, as well as reductions in volumes and rates paid on borrowings, and growth in noninterest bearing deposits, which drove down our overall cost of funds.

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We continue to observe competitive pressure to maintain reduced interest rates on loans retained at renewal.  While our loan prices are targeted to achieve certain returns on equity, significant competition for commercial and industrial loans as well as commercial real estate loans has put pressure on loan yields, and our stringent underwriting standards limit our ability to make higher-yielding loans.

The following tables set forth certain information relating to our average consolidated balance sheet and reflect the yield on average earning assets and cost of average interest bearing liabilities for the periods indicated.  These yields reflect the related interest, on an annualized basis, divided by the average balance of assets or liabilities over the applicable period.  Average balances are derived from daily balances.  For purposes of discussion, net interest income and net interest income to total earning assets in the following tables have been adjusted to a non-GAAP TE basis using a marginal rate of 21% in 2020 and 2019 to more appropriately compare returns on tax-exempt loans and securities to other earning assets.

Analysis of Average Balances,

Tax Equivalent Income / Expense and Rates

(Dollars in thousands - unaudited)

Quarters Ended

September 30, 2020

June 30, 2020

September 30, 2019

Average

Income /

Rate

Average

Income /

Rate

Average

Income /

Rate

Balance

Expense

%

Balance

Expense

%

Balance

Expense

%

Assets

Interest earning deposits with financial institutions

$

263,199

$

68

0.10

$

153,532

$

42

0.11

$

21,425

$

119

2.20

Securities:

Taxable

251,760

1,458

2.30

247,868

1,694

2.75

260,842

2,296

3.49

Non-taxable (TE)1

196,648

1,680

3.40

204,840

1,767

3.47

233,208

2,176

3.70

Total securities (TE)1

448,408

3,138

2.78

452,708

3,461

3.07

494,050

4,472

3.59

Dividends from FHLBC and FRBC

9,917

118

4.73

9,917

123

4.99

10,398

154

5.88

Loans and loans held-for-sale1, 2

2,048,968

22,078

4.29

2,052,060

22,460

4.40

1,895,454

25,159

5.27

Total interest earning assets

2,770,492

25,402

3.65

2,668,217

26,086

3.93

2,421,327

29,904

4.90

Cash and due from banks

31,354

-

-

30,594

-

-

34,315

-

-

Allowance for credit losses on loans

(31,518)

-

-

(30,747)

-

-

(19,452)

-

-

Other noninterest bearing assets

185,228

-

-

187,305

-

-

172,250

-

-

Total assets

$

2,955,556

$

2,855,369

$

2,608,440

Liabilities and Stockholders' Equity

NOW accounts

$

470,474

$

106

0.09

$

457,772

$

129

0.11

$

420,437

$

334

0.32

Money market accounts

306,763

91

0.12

279,873

85

0.12

282,797

269

0.38

Savings accounts

378,957

102

0.11

359,358

171

0.19

308,483

121

0.16

Time deposits

417,952

1,084

1.03

439,735

1,442

1.32

420,429

1,672

1.58

Interest bearing deposits

1,574,146

1,383

0.35

1,536,738

1,827

0.48

1,432,146

2,396

0.66

Securities sold under repurchase agreements

54,313

28

0.21

45,882

23

0.20

40,342

135

1.33

Other short-term borrowings

8,204

24

1.16

8,396

34

1.63

75,310

429

2.26

Junior subordinated debentures

25,773

285

4.40

25,773

283

4.42

57,716

933

6.41

Senior notes

44,337

673

6.04

44,310

673

6.11

44,222

682

6.12

Notes payable and other borrowings

25,482

144

2.25

26,551

165

2.50

10,973

89

3.22

Total interest bearing liabilities

1,732,255

2,537

0.58

1,687,650

3,005

0.72

1,660,709

4,664

1.11

Noninterest bearing deposits

892,811

-

-

854,324

-

-

651,863

-

-

Other liabilities

39,589

-

-

39,613

-

-

30,329

-

-

Stockholders' equity

290,901

-

-

273,782

-

-

265,539

-

-

Total liabilities and stockholders' equity

$

2,955,556

$

2,855,369

$

2,608,440

Net interest income (GAAP)

$

22,509

$

22,707

$

24,780

Net interest margin (GAAP)

3.23

3.42

4.06

Net interest income (TE)1

$

22,865

$

23,081

$

25,240

Net interest margin (TE)1

3.28

3.48

4.14

Core net interest margin (TE - excluding PPP loans)1

3.34

3.51

4.14

Interest bearing liabilities to earning assets

62.53

%

63.25

%

68.59

%

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Table of Contents

1Represents a non-GAAP financial measure. See the discussion entitled “Non-GAAP Presentations” below and the table on page 52 that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent. Tax equivalent basis is calculated using a marginal tax rate of 21% in 2020 and 2019.

2 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 50, and includes fees of $975,000, $718,000 and $295,000 for the third quarter of 2020, the second quarter of 2020, and the third quarter of 2019, respectively.  Nonaccrual loans are included in the above-stated average balances.

Analysis of Average Balances,

Tax Equivalent Income / Expense and Rates

(Dollars in thousands - unaudited)

Nine Months Ended September 30, 

2020

2019

Average

Income /

Rate

Average

Income /

Rate

Balance

Expense

%

Balance

Expense

%

Assets

Interest earning deposits with financial institutions

$

148,660

$

185

0.17

$

19,783

$

344

2.32

Securities:

Taxable

257,664

5,315

2.76

242,417

6,933

3.82

Non-taxable (TE)1

201,242

5,289

3.51

266,694

7,542

3.78

Total securities (TE)1

458,906

10,604

3.09

509,111

14,475

3.80

Dividends from FHLBC and FRBC

9,917

366

4.93

11,056

459

5.55

Loans and loans held-for-sale 1 , 2

2,015,592

68,174

4.52

1,896,096

74,243

5.24

Total interest earning assets

2,633,075

79,329

4.02

2,436,046

89,521

4.91

Cash and due from banks

31,498

-

-

33,896

-

-

Allowance for credit losses on loans

(28,601)

-

-

(19,375)

-

-

Other noninterest bearing assets

181,762

-

-

175,998

-

-

Total assets

$

2,817,734

$

2,626,565

Liabilities and Stockholders' Equity

NOW accounts

$

450,178

$

468

0.14

$

437,025

$

1,086

0.33

Money market accounts

289,219

412

0.19

290,206

801

0.37

Savings accounts

353,737

439

0.17

310,018

367

0.16

Time deposits

435,419

4,292

1.32

429,403

4,931

1.54

Interest bearing deposits

1,528,553

5,611

0.49

1,466,652

7,185

0.65

Securities sold under repurchase agreements

49,358

167

0.45

43,210

431

1.33

Other short-term borrowings

13,205

167

1.69

88,918

1,611

2.42

Junior subordinated debentures

32,889

1,932

7.85

57,704

2,791

6.47

Senior notes

44,310

2,019

6.09

44,196

2,026

6.13

Notes payable and other borrowings

22,277

439

2.63

13,100

312

3.18

Total interest bearing liabilities

1,690,592

10,335

0.82

1,713,780

14,356

1.12

Noninterest bearing deposits

808,273

-

-

641,053

-

-

Other liabilities

35,911

-

-

21,285

-

-

Stockholders' equity

282,958

-

-

250,447

-

-

Total liabilities and stockholders' equity

$

2,817,734

$

2,626,565

Net interest income (GAAP)

$

67,874

$

73,570

Net interest margin (GAAP)

3.44

4.04

Net interest income (TE)1

$

68,994

$

75,165

Net interest margin (TE)1

3.50

4.13

Core net interest margin (TE - excluding PPP loans)1

3.54

4.13

Interest bearing liabilities to earning assets

64.21

%

70.35

%

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Table of Contents

1 Represents a non-GAAP financial measure. See the discussion entitled “Non-GAAP Presentations” below and the table on page 52 that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent. Tax equivalent basis is calculated using a marginal tax rate of 21% in 2020 and 2019.

2 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 52, and includes fees of $2.0 million and $708,000 for the first nine months of 2020 and 2019, respectively.  Nonaccrual loans are included in the above-stated average balances.

Reconciliation of Tax-Equivalent Non-GAAP Financial Measures

Net interest and dividend income (TE) and net interest income (TE) to average interest earning assets are non-GAAP measures that have been adjusted on a TE basis using a marginal rate of 21% for 2020 and 2019 to more appropriately compare returns on tax-exempt loans and securities to other earning assets.  The table below provides a reconciliation of each non-GAAP (TE) measure to the GAAP equivalent for the periods indicated:

Three Months Ended

Nine Months Ended

September 30, 

June 30, 

September 30, 

September 30, 

Net Interest Margin

    

2020

    

2020

2019

    

2020

2019

(Dollars in thousands)

Interest income (GAAP)

$

25,046

$

25,712

$

29,444

$

78,209

$

87,926

Taxable-equivalent adjustment:

Loans

3

3

3

9

11

Securities

353

371

457

1,111

1,584

Interest and dividend income (TE)

25,402

26,086

29,904

79,329

89,521

Interest expense (GAAP)

2,537

3,005

4,664

10,335

14,356

Net interest income (TE)

$

22,865

$

23,081

$

25,240

$

68,994

$

75,165

Paycheck Protection Program ("PPP") loan - interest and net fee income

736

603

NA

1,339

NA

Net interest income (TE) - excluding PPP loans

$

22,129

22,478

NA

$

67,655

NA

Net interest income (GAAP)

$

22,509

$

22,707

$

24,780

$

67,874

$

73,570

Average interest earning assets

$

2,770,492

$

2,668,217

$

2,421,327

$

2,633,075

$

2,436,046

Average PPP loans

$

136,281

$

90,447

N/A

$

77,302

N/A

Average interest earning assets, excluding PPP loans

$

2,634,211

2,577,770

2,421,327

$

2,555,773

2,436,046

Net interest margin (GAAP)

3.23

%

3.42

%

4.06

%

3.44

%

4.04

%

Net interest margin (TE)

3.28

%

3.48

%

4.14

%

3.50

%

4.13

%

Core net interest margin (TE - excluding PPP loans)

3.34

%

3.51

%

4.14

%

3.54

%

4.13

%

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Noninterest Income

Three months ended September 30, 2020 and 2019

The following table details the major components of noninterest income for the periods presented:

3rd Quarter 2020

Noninterest Income

Three Months Ended

Percent Change From

(Dollars in thousands)

September 30, 

June 30, 

September 30, 

June 30, 

September 30, 

    

2020

    

2020

    

2019

    

2020

    

2019

 

Trust income

$

1,506

$

1,664

$

1,730

(9.5)

(12.9)

Service charges on deposits

1,322

1,120

2,020

18.0

(34.6)

Residential mortgage banking revenue

Secondary mortgage fees

492

505

282

(2.6)

74.5

Mortgage servicing rights mark to market loss

(160)

(445)

(946)

64.0

83.1

Mortgage servicing income

521

458

460

13.8

13.3

Net gain on sales of mortgage loans

5,246

4,631

2,074

13.3

152.9

Total residential mortgage banking revenue

6,099

5,149

1,870

18.5

226.1

Securities (losses) gains, net

(1)

-

3,463

N/M

(100.0)

Change in cash surrender value of BOLI

459

532

267

(13.7)

71.9

Death benefit realized on BOLI

(2)

59

-

(103.4)

N/M

Card related income

1,499

1,311

1,595

14.3

(6.0)

Other income

803

860

988

(6.6)

(18.7)

Total noninterest income

$

11,685

$

10,695

$

11,933

9.3

(2.1)

N/M - Not meaningful

Noninterest income increased $990,000, or 9.26%, in the third quarter of 2020, compared to the second quarter of 2020, and decreased $248,000, or 2.08%, compared to the third quarter of 2019.  The increase in the linked quarters was primarily driven by an increase of $615,000 in net gain on sales of mortgage loans and a reduction of $285,000 in the mark to market losses on MSRs in the third quarter of 2020, compared to the prior quarter.  Service charges on deposits also increased in the third quarter of 2020 compared to the prior quarter, as customer spending increased and overdraft and bounces fees increased commensurately.  

The $248,000 decrease in noninterest income in the third quarter of 2020 compared to the third quarter of 2019 was primarily driven by $3.5 million of pretax securities gain, net, recorded in the third quarter of 2019, and no like transactions in the third quarter of 2020.  In addition, service charges on deposits decreased $698,000 in the third quarter of 2020, compared to the year over year period due to the reduction in customer spending and resultant fee income due to the COVID-19 pandemic.   Materially offsetting these decreases in noninterest income was a $4.2 million increase in total residential mortgage banking revenue in the third quarter of 2020, compared to the third quarter of 2019, due to the large volume of mortgage originations and refinances in the lower interest rate environment.  The cash surrender value of BOLI also increased $192,000 in the third quarter of 2020, compared to the third quarter of 2019, due to market interest rate fluctuations.

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Table of Contents

Nine months ended September 30, 2020 and 2019

The following table details the major components of noninterest income for the periods presented:

Noninterest Income

Nine Months Ended

YTD

(Dollars in thousands)

September 30, 

September 30, 

Percent

    

2020

    

2019

    

Change

Trust income

$

4,702

$

4,955

(5.1)

Service charges on deposits

4,168

5,841

(28.6)

Residential mortgage banking revenue

Secondary mortgage fees

1,267

621

104.0

Mortgage servicing rights mark to market loss

(2,739)

(2,902)

5.6

Mortgage servicing income

1,447

1,408

2.8

Net gain on sales of mortgage loans

12,123

3,999

203.2

Total residential mortgage banking revenue

12,098

3,126

287.0

Securities (losses) gains, net

(25)

4,476

(100.6)

Change in cash surrender value of BOLI

942

1,045

(9.9)

Death benefit realized on BOLI

57

-

Card related income

4,097

4,433

(7.6)

Other income

2,663

2,682

(0.7)

Total noninterest income

$

28,702

$

26,558

8.1

Noninterest income for the nine months ended September 30, 2020 increased $2.1 million, or 8.1%, compared to the nine months ended September 30, 2019. This increase was primarily driven by a $9.0 million increase in total residential mortgage banking revenue stemming from the falling interest rate environment and the resultant net gain on sales of mortgage loans and secondary mortgage fees.  Partially offsetting these increases were a reduction in service charges on deposits and card related income due to reductions in customer activity as a result of the COVID-19 pandemic, a $4.5 million decrease in security (losses) gains, net, and a $253,000 reduction in trust income primarily due to a decline in estate fees year over year.  

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Noninterest Expense

Three months ended September 30, 2020 and 2019

The following table details the major components of noninterest expense for the periods presented:

3rd Quarter 2020

Noninterest Expense

Three Months Ended

Percent  Change From

(Dollars in thousands)

September 30, 

June 30, 

September 30, 

June 30, 

September 30, 

    

2020

    

2020

    

2019

    

2020

    

2019

 

Salaries

$

9,731

$

8,588

$

9,460

13.3

2.9

Officers incentive

968

968

923

-

4.9

Benefits and other

1,887

1,786

1,679

5.7

12.4

Total salaries and employee benefits

12,586

11,342

12,062

11.0

4.3

Occupancy, furniture and equipment expense

2,003

1,935

2,235

3.5

(10.4)

Computer and data processing

1,226

1,247

1,490

(1.7)

(17.7)

FDIC insurance

191

155

(114)

23.2

(267.5)

General bank insurance

281

237

270

18.6

4.1

Amortization of core deposit intangible asset

122

124

157

(1.6)

(22.3)

Advertising expense

62

57

360

8.8

(82.8)

Card related expense

566

514

531

10.1

6.6

Legal fees

169

176

111

(4.0)

52.3

Other real estate owned expense, net

125

143

26

(12.6)

380.8

Other expense

2,935

2,966

2,826

(1.0)

3.9

Total noninterest expense

$

20,266

$

18,896

$

19,954

7.3

1.6

Efficiency ratio (GAAP)1

58.27

%

55.13

%

57.82

%

Adjusted efficiency ratio (non-GAAP)2

57.47

%

54.28

%

56.93

%

N/M - Not meaningful

1 The efficiency ratio shown in the table above is a GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income and total noninterest income less any BOLI death benefit recorded, net gains or losses on securities and mark to market gains or losses on MSRs.

2 The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains or losses on securities and mark to market gains or losses on MSRs, and includes a tax equivalent adjustment on the change in cash surrender value of BOLI.  

See the section entitled “Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures” on page 57 for a reconciliation of this non-GAAP measure to the most comparable GAAP equivalent.

Noninterest expense for the third quarter of 2020 increased $1.4 million, or 7.3%, compared to the second quarter of 2020, and increased $312,000, or 1.6%, compared to the third quarter of 2019.  The linked quarter increase is primarily attributable to a $1.2 million increase in salaries and employee benefits stemming from deferrals of new loan origination costs related to PPP loans in the second quarter of 2020, which reduced expense in the second quarter.

The year over year increase in noninterest expense is primarily attributable to a $524,000 increase in salaries and employee benefits due to an increase in full-time equivalent employees, annual merit increases in early 2020, and higher employee insurance costs.  In addition, a $305,000 increase in FDIC insurance due to an accrual reversal in the third quarter of 2019, and a $99,000 increase in other real estate owned expense, net, due to property valuation write-downs.  Partially offsetting the year over year increases were a $232,000 decrease in occupancy, furniture and equipment expense, a $264,000 decrease in computer and data processing expense, and a $298,000 decrease in advertising expense due to a reduction in our marketing efforts as a result of the pandemic.

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Table of Contents

Nine months ended September 30, 2020 and 2019

Noninterest Expense

Nine Months Ended

YTD

(Dollars in thousands)

September 30, 

September 30, 

Percent

    

2020

    

2019

    

Change

Salaries

$

28,080

$

27,098

3.6

Officers incentive

2,894

2,698

7.3

Benefits and other

5,872

5,465

7.4

Total salaries and employee benefits

36,846

35,261

4.5

Occupancy, furniture and equipment expense

6,239

6,149

1.5

Computer and data processing

3,808

4,346

(12.4)

FDIC insurance

403

176

129.0

General bank insurance

764

756

1.1

Amortization of core deposit intangible asset

374

410

(8.8)

Advertising expense

228

975

(76.6)

Card related expense

1,612

1,360

18.5

Legal fees

476

480

(0.8)

Other real estate owned expense, net

505

324

55.9

Other expense

8,909

9,037

(1.4)

Total noninterest expense

$

60,164

$

59,274

1.5

Efficiency ratio (GAAP)1

59.71

%

59.40

%

Adjusted efficiency ratio (non-GAAP)2

58.89

%

58.29

%

1 The efficiency ratio shown in the table above is a GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income and total noninterest income less any BOLI death benefit recorded, net gains or losses on securities and mark to market gains or losses on MSRs.

2 The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains or losses on securities and mark to market gains or losses on MSRs, and includes a tax equivalent adjustment on the change in cash surrender value of BOLI.  

See the section entitled “Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures” on page 57 for a reconciliation of this non-GAAP measure to the most comparable GAAP equivalent.

Noninterest expense for the nine months ended September 30, 2020, increased $890,000, or 1.5%, compared to the nine months ended September 30, 2019, primarily due to a $1.6 million increase in salaries and employee benefits related to an increase in full-time equivalent employees, annual merit increases in early 2020, and higher employee insurance costs; a $227,000 increase in FDIC insurance related to assessment credits that were applied in 2019; a $252,000 increase in card related expenses; and a $181,000 increase in other real estate owned expense, net, due to a higher amount of gains recorded in 2019.

Partially offsetting these increases were decreases in computer and data processing expense of $538,000, advertising expense of $747,000, and other expense of $128,000.   Computer and data processing expense declined year over year due to a new core system contract that we executed in the last half of 2019, which included cost savings, as well as voice and data services price reductions negotiated over the past year.  Advertising expenses decreased year over year due to a reduction in our marketing efforts as a result of the pandemic.  Other expense decreased year over year due to a reduction in employee travel costs primarily due to the pandemic, and a reduction in consulting and management fees.

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Table of Contents

Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures

GAAP

Non-GAAP

Three Months Ended

Three Months Ended

September 30, 

June 30, 

September 30, 

September 30, 

June 30, 

September 30, 

2020

2020

2019

2020

2020

2019

Efficiency Ratio / Adjusted Efficiency Ratio

(Dollars in thousands)

Noninterest expense

$

20,266

$

18,896

$

19,954

$

20,266

$

18,896

$

19,954

Less amortization of core deposit

122

124

157

122

124

157

Less other real estate expense, net

125

143

26

125

143

26

Noninterest expense less adjustments

$

20,019

$

18,629

$

19,771

$

20,019

$

18,629

$

19,771

Net interest income

$

22,509

$

22,707

$

24,780

$

22,509

$

22,707

$

24,780

Taxable-equivalent adjustment:

Loans

N/A

N/A

N/A

3

3

3

Securities

N/A

N/A

N/A

353

371

457

Net interest income including adjustments

22,509

22,707

24,780

22,865

23,081

25,240

Noninterest income

11,685

10,695

11,933

11,685

10,695

11,933

Less death benefit related to BOLI

(2)

59

-

(2)

59

-

Less securities (losses) gains, net

(1)

-

3,463

(1)

-

3,463

Less MSRs mark to market loss

(160)

(445)

(946)

(160)

(445)

(946)

Taxable-equivalent adjustment:

Change in cash surrender value of BOLI

N/A

N/A

N/A

122

157

71

Noninterest income (less) / including adjustments

11,848

11,081

9,416

11,970

11,238

9,487

Net interest income including adjustments plus noninterest income (less) / including adjustments

$

34,357

$

33,788

$

34,196

$

34,835

$

34,319

$

34,727

Efficiency ratio / Adjusted efficiency ratio

58.27

%

55.13

%

57.82

%

57.47

%

54.28

%

56.93

%

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GAAP

Non-GAAP

Nine Months Ended

Nine Months Ended

September 30, 

September 30, 

September 30, 

September 30, 

2020

2019

2020

2019

Efficiency Ratio / Adjusted Efficiency Ratio

(Dollars in thousands)

Noninterest expense

$

60,164

$

59,274

$

60,164

$

59,274

Less amortization of core deposit

374

410

374

410

Less other real estate expense, net

505

324

505

324

Noninterest expense less adjustments

$

59,285

$

58,540

$

59,285

$

58,540

Net interest income

$

67,874

$

73,570

$

67,874

$

73,570

Taxable-equivalent adjustment:

Loans

N/A

N/A

9

11

Securities

N/A

N/A

1,111

1,584

Net interest income including adjustments

67,874

73,570

68,994

75,165

Noninterest income

28,702

26,558

28,702

26,558

Less death benefit related to BOLI

57

-

57

-

Less securities (losses) gains, net

(25)

4,476

(25)

4,476

Less MSRs mark to market loss

(2,739)

(2,902)

(2,739)

(2,902)

Taxable-equivalent adjustment:

Change in cash surrender value of BOLI

N/A

N/A

266

285

Noninterest income (less) / including adjustments

31,409

24,984

31,675

25,269

Net interest income including adjustments plus noninterest income (less) / including adjustments

$

99,283

$

98,554

$

100,669

$

100,434

Efficiency ratio / Adjusted efficiency ratio

59.71

%

59.40

%

58.89

%

58.29

%

Income Taxes

We recorded income tax expense of $3.4 million for the third quarter of 2020 on $13.6 million of pretax income, compared to income tax expense of $3.1 million on $12.4 million of pretax income in the second quarter of 2020, and $4.0 million of income tax expense on $16.2 million of pretax income in the third quarter of 2019.  The effective tax rate was 24.7% for the third quarter of 2020, 25.4% for the second quarter of 2020, and 24.9% for the third quarter of 2019.  We recorded income tax expense of $6.2 million on $26.0 million of pretax income for the nine months ended September 30, 2020, compared to income tax expense of $9.5 million on $39.4 million of pretax income for the nine months ended September 30, 2019, which reflected effective tax rates of 23.9% and 24.1%, respectively.

Income tax expense reflected all relevant statutory tax rates and GAAP accounting.  There were no significant changes in our ability to utilize the deferred tax assets during the quarter ended September 30, 2020.  We had no valuation reserve on the deferred tax assets as of September 30, 2020.

Financial Condition

Total assets increased $339.3 million to $2.97 billion at September 30, 2020, from $2.64 billion at December 31, 2019, due primarily to an increase in cash and cash equivalents of $262.5 million and loan growth of $99.5 million, partially offset by a reduction of $36.2 million in securities available-for-sale.  We are currently assessing potential investment opportunities for this excess liquidity. Total deposits were $2.48 billion at September 30, 2020, an increase of $352.5 million from December 31, 2019, primarily due to increases in noninterest bearing demand accounts, savings accounts, and NOW accounts due to a decrease in consumer spending during the COVID-19 pandemic, and federal stimulus funds received by many depositors.

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Table of Contents

September 30, 2020

Securities

As of

Percent Change From

(Dollars in thousands)

September 30, 

December 31, 

September 30, 

December 31, 

September 30, 

    

2020

    

2019

    

2019

    

2019

    

2019

Securities available-for-sale, at fair value

U.S. Treasuries

$

4,134

$

4,036

$

4,038

2.4

2.4

U.S. government agencies

7,005

8,337

9,143

(16.0)

(23.4)

U.S. government agencies mortgage-backed

18,219

16,588

16,940

9.8

7.6

States and political subdivisions

249,777

249,175

238,727

0.2

4.6

Collateralized mortgage obligations

57,013

57,984

64,121

(1.7)

(11.1)

Asset-backed securities

81,585

81,844

83,182

(0.3)

(1.9)

Collateralized loan obligations

30,688

66,684

72,271

(54.0)

(57.5)

Total securities

$

448,421

$

484,648

$

488,422

(7.5)

(8.2)

Securities available-for-sale decreased $36.2 million as of September 30, 2020, compared to December 31, 2019, and decreased $40.0 million compared to September 30, 2019.  Available-for-sale security calls, maturities and paydowns during the three months ended September 30, 2020, totaled $6.1 million and consisted primarily of tax exempt state and political subdivisions securities and collateralized debt obligations, whereas purchases during the quarter ended September 30, 2020 totaled $1.9 million and were primarily U.S. agency mortgage backed securities.  During the third quarter of 2020 $1,000 of security losses, net, were recorded, compared to $3.5 million of securities gains, net, in the third quarter of 2019.  

September 30, 2020

Loans

As of

Percent Change From

(Dollars in thousands)

September 30, 

December 31, 

September 30, 

December 31, 

September 30, 

2020

2019

2019

2019

    

2019

Commercial

$

436,277

$

332,842

$

333,664

31.1

30.8

Leases

133,676

119,751

108,152

11.6

23.6

Commercial real estate - Investor

548,970

520,095

491,794

5.6

11.6

Commercial real estate - Owner occupied

335,978

345,504

334,986

(2.8)

0.3

Construction

91,856

69,617

91,066

31.9

0.9

Residential real estate - Investor

61,923

71,105

68,989

(12.9)

(10.2)

Residential real estate - Owner occupied

114,283

136,023

136,046

(16.0)

(16.0)

Multifamily

188,398

189,773

183,476

(0.7)

2.7

HELOC

85,882

91,605

90,791

(6.2)

(5.4)

HELOC - Purchased

22,312

31,852

35,518

(30.0)

(37.2)

Other 1

10,772

12,258

14,140

(12.1)

(23.8)

Total loans, excluding deferred loan costs and PCI Loans 2

2,030,327

1,920,425

1,888,622

5.7

7.5

Net deferred loan costs

-

1,786

2,054

(100.0)

(100.0)

Total loans, excluding PCI loans 2

2,030,327

1,922,211

1,890,676

5.6

7.4

PCI loans, net of purchase accounting adjustments 2

-

8,601

9,135

(100.0)

(100.0)

Total loans

$

2,030,327

$

1,930,812

$

1,899,811

5.2

6.9

1 The “Other” segment includes consumer and overdrafts.

2 As discussed below, for periods before our adoption of CECL on January 1, 2020, PCI loans and their related deferred loan costs (now PCD loans) were excluded from nonperforming loan disclosures and were therefore separately reported.  After the adoption of CECL, all PCD loans are now included within each relevant loan type and are not separately reported as PCI loans, because such loans are now included within our nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan.

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Table of Contents

Total loans were $2.03 billion as of September 30, 2020, an increase of $99.5 million from December 31, 2019.  The increase in total loans in the first nine months of 2020 was due primarily to our origination of 746 PPP loans that totaled $136.7 million within commercial loans, as well as organic growth in our leases, commercial real estate-investor, and construction portfolios, partially offset by reductions in our commercial real estate-owner occupied, residential real estate-investor, residential real estate-owner occupied, HELOC and HELOC–purchased portfolios.  Total loans increased $130.5 million from September 30, 2019 to September 30, 2020, due primarily to loan growth in our commercial loans due to PPP loan originations, leases, commercial real estate-investor, and multifamily portfolios, partially offset by reductions in our residential real estate-investor, residential real estate-owner occupied, HELOC, and HELOC-purchased portfolios. As required by CECL, the balance (or amortized cost basis) of PCD loans are carried on a gross basis (rather than net of the associated credit loss estimate), and the expected credit losses for PCD loans are estimated and separately recognized as part of the ACL.  Accordingly, at January 1, 2020, $2.5 million of purchase accounting adjustments related to PCD loans were reclassified to the ACL from loans, resulting in an increase to total PCD loans.

The quality of our loan portfolio is impacted not only by our credit decisions but also by the economic health of the communities in which we operate.  Since we are located in a corridor with significant open space and undeveloped real estate, real estate lending (including commercial real estate, construction, residential, multifamily, and HELOCs) has been and continues to be a sizeable portion of our portfolio.  These categories comprised 71.4% of the portfolio as of September 30, 2020, compared to 75.4% of the portfolio as of December 31, 2019.  We continue to oversee and seek to manage our loan portfolio in accordance with interagency guidance on risk management.

Asset Quality

The provision for credit losses, which includes a provision for losses on unfunded commitments, is a charge to earnings to maintain the ACL at a level consistent with management’s assessment of expected losses in the loan portfolio at the balance sheet date. During the first quarter of 2020, we adopted ASU 2016-13, or CECL.

We recorded a $1.3 million provision for credit losses on loans and a $980,000 reversal of provision for credit losses on unfunded commitments for the third quarter of 2020, compared to a $550,000 provision for loan and lease losses for the third quarter of 2019.  In the third quarter of 2020, we determined provision expense was necessary, after considering our net recoveries of $365,000 for the quarter, due to the guidance under the newly adopted CECL methodology, which requires a provision based on future expected credit losses, as compared to the previously used incurred loss model.  Runoffs on our acquired loan portfolios are trending with expectations.  Management estimates the amount of provision required on a quarterly basis and records the appropriate provision expense, or release of expense, to maintain an adequate reserve for all potential and estimated credit losses on loans and leases.  In addition, we established a separate ACL on unfunded commitments of $1.7 million under CECL guidelines as of January 1, 2020, and we recorded a $734,000 provision for credit losses on unfunded commitments in the second quarter of 2020.  During our third quarter projected credit losses assessment, we determined the utilization rate on lines during the past 12 months had declined, resulting in a reversal of $980,000 of ACL related to unfunded commitments for the quarter.  The increase in the total provision for credit losses stems from our CECL model calculations due to the ongoing COVID-19 pandemic.

Nonperforming loans consist of nonaccrual loans, performing restructured accruing loans and loans 90 days or greater past due.  Remediation work continues in all segments.  Nonperforming loans increased by $5.0 million to $20.8 million at September 30, 2020, from $15.8 million at December 31, 2019.  Purchased credit deteriorated loans, or PCD loans, are purchased loans that, as of the date of acquisition, the Company determined had experienced a more-than-insignificant deterioration in credit quality since origination.  Before we adopted CECL on January 1, 2020, PCD loans were referred to as purchased credit impaired loans, or PCI loans, and such PCI loans and their related deferred loan costs were excluded from our nonperforming loan disclosures, as long as the cash flows on such loans and the timing of such cash flows continued to be estimable and probable of collection. However, after we adopted CECL on January 1, 2020, PCD loans and their related deferred loan costs are now included in our nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan.  As of the date of CECL adoption, $2.5 million of the credit related component of the purchase accounting adjustment on PCI loans was reclassified to the ACL, which comprises half of the $5.0 million increase in nonperforming loans since December 31, 2019.  Credit metrics, excluding the impact of this reclassification, continue to be relatively stable regarding nonperforming loan levels, and management is carefully monitoring loans considered to be in a classified status.  Nonperforming loans as a percent of total loans increased to 1.0% as of September 30, 2020, from 0.8% as of December 31, 2019, and 0.7% September 30, 2019.  The distribution of our nonperforming loans is shown in the following table.

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Table of Contents

September 30, 2020

Nonperforming Loans

As of

Percent Change From

(Dollars in thousands)

September 30, 

December

September 30, 

December

September 30, 

2020

2019

2019

2019

2019

Commercial

$

1,605

$

2,247

$

148

(28.6)

984.5

Leases

2,079

410

74

407.1

N/M

Commercial real estate - Investor

2,021

2,092

4,701

(3.4)

(57.0)

Commercial real estate - Owner occupied

8,635

5,180

2,899

66.7

197.9

Construction

-

93

94

(100.0)

(100.0)

Residential real estate - Investor

935

788

379

18.7

146.7

Residential real estate - Owner occupied

3,516

3,169

3,300

10.9

6.5

Multifamily

895

68

-

N/M

N/M

HELOC

1,140

1,603

1,604

(28.9)

(28.9)

HELOC - Purchased

-

180

181

(100.0)

(100.0)

Other 1

6

19

22

(68.4)

(72.7)

Total nonperforming loans

$

20,832

$

15,849

$

13,402

31.4

55.4

N/M - Not meaningful

1 The “Other” segment includes consumer and overdrafts.

The components of our nonperforming assets is shown in the following table.

Nonperforming Assets

As of

Percent Change From

(Dollars in Thousands)

September 30, 

December 31, 

September 30, 

December 31, 

September 30, 

  

2020

  

2019

  

2019

  

2019

2019

Nonaccrual loans

$

20,076

$

12,432

$

11,852

61.5

69.4

Performing troubled debt restructured loans accruing interest

 

334

 

872

 

1,532

(61.7)

(78.2)

Loans past due 90 days or more and still accruing interest

 

422

 

2,545

 

18

(83.4)

N/M

Total nonperforming loans

 

20,832

 

15,849

 

13,402

31.4

55.4

Other real estate owned

 

2,686

 

5,004

 

4,682

(46.3)

(42.6)

Total nonperforming assets

$

23,518

$

20,853

$

18,084

12.8

30.0

PCD loans, net of purchase accounting adjustments1

$

10,638

$

8,601

$

9,135

23.7

16.5

30-89 days past due loans and still accruing interest

$

5,511

$

14,390

$

7,937

Nonaccrual loans to total loans

1.0

%

0.6

%

0.6

%

Nonperforming loans to total loans

1.0

%

0.8

%

0.7

%

Nonperforming assets to total loans plus OREO

1.2

%

1.1

%

0.9

%

Purchased credit-deteriorated loans to total loans

0.5

%

0.4

%

0.5

%

Allowance for credit losses

$

32,918

$

19,789

$

19,651

Allowance for credit losses to total loans

1.6

%

1.0

%

1.0

%

Allowance for credit losses to nonaccrual loans

164.0

%

159.2

%

165.8

%

1 In 2020, due to the adoption of CECL, PCD loans are included in total nonperforming assets, if their risk rating at period end so indicates. For 2019 periods presented, PCI loans are not included within total nonperforming assets as these loans had an accretable yield.

Loan charge-offs, net of recoveries, for the current quarter, prior linked quarter and year over year quarter are shown in the following table.

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Loan Charge-offs, Net of Recoveries

Three Months Ended

(Dollars in thousands)

September 30, 

% of

June 30, 

% of

September 30, 

% of

2020

Total1

2020

Total1

2019

Total1

Commercial

$

(7)

1.9

$

(2)

(1.2)

$

10

3.7

Leases

119

(32.6)

-

-

47

17.3

Commercial real estate - Investor

(102)

27.9

(14)

(8.4)

147

54.2

Commercial real estate - Owner occupied

(420)

115.1

292

174.9

-

-

Construction

59

(16.2)

-

-

7

2.6

Residential real estate - Investor

(15)

4.1

(2)

(1.2)

(6)

(2.2)

Residential real estate - Owner occupied

(25)

6.8

(66)

(39.5)

(13)

(4.8)

Multifamily

-

-

-

-

-

-

HELOC

(52)

14.2

(53)

(31.7)

(2)

(0.7)

HELOC - Purchased

66

(18.1)

-

-

-

-

Other 2

12

(3.10)

12

7.10

81

29.9

Net (recoveries) charge-offs

$

(365)

100.0

$

167

100.0

$

271

100.0

1 Represents the percentage of net charge-offs attributable to each category of loans.

2 The “Other” segment includes consumer and overdrafts.

Net recoveries of $365,000 were recorded for the third quarter of 2020, compared to net charge-offs of $167,000 for the second quarter of 2020 and $271,000 for the third quarter of 2019, reflecting continuing management attention to credit quality and remediation efforts.  The net recoveries for the third quarter of 2020 were primarily due to a recovery on one large charge-off recorded earlier in 2020.  We have continued our conservative loan valuations and aggressive recovery efforts on prior charge-offs.

The following table shows classified assets by segment for the following periods.

September 30, 2020

Classified Assets

As of

Percent Change From

(Dollars in thousands)

September 30, 

December 31, 

September 30, 

December 31, 

September 30, 

2020

2019

2019

2019

2019

Commercial

$

5,992

$

11,688

$

7,704

(48.7)

(22.2)

Leases

3,270

329

125

893.9

N/M

Commercial real estate - Investor

5,596

4,926

8,791

13.6

(36.3)

Commercial real estate - Owner occupied

9,658

7,956

11,605

21.4

(16.8)

Construction

5,108

262

273

N/M

N/M

Residential real estate - Investor

1,526

1,390

1,029

9.8

48.3

Residential real estate - Owner occupied

3,836

3,631

3,773

5.6

1.7

Multifamily

5,833

503

493

N/M

N/M

HELOC

1,566

1,789

1,894

(12.5)

(17.3)

HELOC - Purchased

-

180

184

(100.0)

(100.0)

Other 1

272

359

24

(24.2)

N/M

Total classified loans, excluding PCI loans2

42,657

33,013

35,895

29.2

18.8

Other real estate owned

2,686

5,004

5,668

(46.3)

(52.6)

Total classified assets, excluding PCI loans2

45,343

38,017

41,563

19.3

9.1

PCI, net of purchase accounting adjustments2

-

8,601

10,834

(100.0)

(100.0)

Total classified assets

$

45,343

$

46,618

$

52,397

(2.7)

(13.5)

N/M - Not meaningful

1 The “Other” segment includes consumer and overdrafts.

2 Due to the adoption of CECL, as of January 1, 2020, we no longer have PCI loans.

Classified loans include nonaccrual, performing troubled debt restructurings and all other loans considered substandard.  Classified assets include both classified loans and OREO.  Loans classified as substandard are inadequately protected by either the current net worth and ability to meet payment obligations of the obligor, or by the collateral pledged to secure the loan, if any.  These loans have a well-defined

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weakness or weaknesses that jeopardize the liquidation of the debt and carry the distinct possibility that we will sustain some loss if deficiencies remain uncorrected.

Total classified loans increased as of September 30, 2020, from the levels at December 31, 2019, and June 30, 2019, primarily due to inclusion of PCD loans in their respective segments in 2020 due to the adoption of CECL.  Total classified assets, including PCD loans, reflected a decrease as of September 30, 2020, compared to the level at December 31, 2019, and the level one year ago.  Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the ACL on loans as another measure of overall change in loan related asset quality, which is referred to as the “classified assets ratio.”  The classified assets ratio was 12.95% for the period ended September 30, 2020, compared to 11.11% as of December 31, 2019, and 9.84% as of September 30, 2019.  The increase in the classified assets ratio for the period ended September 30, 2020, compared to September 30, 2019, is also due to the inclusion of PCD loans in their respective segments within the calculation, as these loans were previously excluded.  The increase in total PCD loans as of September 30, 2020, compared to December 31, 2019, is due to our reclassification of the credit-related component of the purchase accounting adjustments carried on former PCI loans to the ACL on January 1, 2020, the date we adopted the CECL methodology.  The PCD balance of $10.6 million is now included within total classified assets, as applicable, under CECL guidance.

Allowance for Credit Losses on Loans

Upon adoption of CECL on January 1, 2020, (Day One), we recognized an increase in our ACL on outstanding loans of $5.9 million and an increase in our ACL on unfunded commitments of $1.7 million as a cumulative effect adjustment from change in accounting policies.  Approximately $2.5 million of the increase to the ACL resulted from the transfer of the non-accretable purchase accounting adjustments on PCD loans.  The Day One adjusting entries resulted in a $3.8 million reduction to retained earnings, and a deferred tax asset adjustment of $1.4 million.  At September 30, 2020, the ACL on loans totaled $32.9 million, and the ACL on unfunded commitments, included in other liabilities, totaled $4.0 million.  This reserve build was driven by $300,000 of provision expense and $365,000 of net recoveries in the third quarter of 2020, as well as $2.1 million of provision expense in the second quarter of 2020, and $8.0 million of provision expense in the first quarter of 2020, augmented by the previously mentioned impact of adopting CECL on January 1, 2020.  The total increase in the ACL reflects forecasted credit deterioration due to the COVID-19 pandemic and the resultant recession.  Our ACL on loans to total loans was 1.6% as of September 30, 2020, compared to 1.0% at both December 31, 2019, and September 30, 2019.   See Note 1 – Basis of Presentation and Changes in Significant Accounting Policies in the accompanying notes to the consolidated financial statements included elsewhere in this report for discussion of our ACL methodology on loans. Allocations of the ACL may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off.

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Below is a reconciliation of the activity in the allowance for credit losses on loans for the periods indicated (dollars in thousands):

Three Months Ended

Nine Months Ended

September 30, 

June 30, 

September 30, 

September 30, 

September 30, 

2020

2020

2019

2020

2019

Allowance at beginning of period

$

31,273

$

30,045

$

19,372

$

19,789

$

19,006

Charge-offs:

Commercial

5

22

20

124

99

Leases

119

-

47

119

47

Commercial real estate - Investor

-

2

159

15

303

Commercial real estate - Owner occupied

145

292

-

1,546

129

Construction

60

-

7

60

8

Residential real estate - Investor

3

4

1

8

7

Residential real estate - Owner occupied

-

43

2

43

14

Multifamily

-

-

-

-

-

HELOC

-

2

19

85

69

HELOC - Purchased

66

-

-

66

229

Other 1

53

41

142

192

311

Total charge-offs

451

406

397

2,258

1,216

Recoveries:

Commercial

12

24

10

48

46

Leases

-

-

-

-

-

Commercial real estate - Investor

102

16

12

139

44

Commercial real estate - Owner occupied

565

-

-

566

3

Construction

1

-

-

1

1

Residential real estate - Investor

18

6

7

45

26

Residential real estate - Owner occupied

25

109

15

157

52

Multifamily

-

-

-

-

8

HELOC

52

55

21

248

79

HELOC - Purchased

-

-

-

-

-

Other 1

41

29

61

130

152

Total recoveries

816

239

126

1,334

411

Net (recoveries) charge-offs

(365)

167

271

924

805

Adoption of ASU 326

-

-

-

5,879

-

Provision for credit losses on loans

1,280

1,395

550

8,174

1,450

Allowance at end of period

$

32,918

$

31,273

$

19,651

$

32,918

$

19,651

Average total loans (exclusive of loans held-for-sale)

$

2,035,584

$

2,038,082

$

1,890,992

$

1,989,921

$

1,893,025

Net charge-offs / (recoveries) to average loans

(0.02)

%

0.01

%

0.01

%

0.05

%

0.04

%

Allowance at period end to average loans

1.62

%

1.53

%

1.04

%

1.65

%

1.04

%

1 The “Other” segment includes consumer and overdrafts.

The coverage ratio of the ACL on loans to nonperforming loans was 158.0% as of September 30, 2020, which was an increase from the coverage ratio of 124.9% as of December 31, 2019, and an increase from 146.6% as of September 30, 2019.  When measured as a percentage of average loans, our total ACL on loans was 1.62% for the nine months ended September 30, 2020, and 1.04% for the like period of September 30, 2019.  This increase was driven by the adoption of CECL as of January 1, 2020.  

We recorded PCD loans (formerly PCI loans), which refers to loans that showed evidence of deteriorated credit quality upon purchase, in our acquisition of ABC Bank.  PCD loans totaled $10.6 million, net of purchase accounting adjustments, as of September 30, 2020, and the credit-related component of the purchase accounting adjustments on these loans, which totaled $2.5 million, was reclassified to ACL, per CECL guidance, on January 1, 2020.  We perform re-estimations of cash flows on our PCD loan portfolio on a quarterly basis.  Any decline in expected cash flows as a result of these re-estimations, due in any part to a change in credit, is deemed credit impairment, and recorded as provision for credit losses during the period.  

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In management’s judgment, an adequate ACL has been established to encompass the current lifetime expected credit losses at September 30, 2020, and general changes in lending policy, procedures and staffing, as well as other external factors, such as the impacts of the COVID-19 pandemic.  However, there can be no assurance that actual losses will not exceed the estimated amounts in the future, based on unforeseen economic events, changes in business climates and the condition of collateral at the time of default and repossession.  Further delayed recovery or further deterioration in market conditions related to COVID-19 and the associated impacts on our customers, changes in business climates and the condition of collateral at the time of default or repossession may revise our current expectations of future credit losses in future reporting periods.

Other Real Estate Owned

As of September 30, 2020, OREO totaled $2.7 million, reflecting a $2.3 million reduction from the $5.0 million at December 31, 2019, and a $2.0 million reduction from the $4.7 million at September 30, 2019.  There was one property addition of $314,000 to the OREO portfolio in the third quarter of 2020.  There were seven property disposals totaling $2.7 million in the third quarter of 2020.  Valuation write-downs occurred in the third quarter of 2020 which totaled $46,000, compared to $120,000 of OREO valuation write-downs in the fourth quarter of 2019, and $203,000 of valuation write-downs recorded in the third quarter of 2019.

September 30, 2020

OREO

Three Months Ended

Percent Change From

(Dollars in thousands)

September 30, 

December 31, 

September 30, 

December 31, 

September 30, 

2020

2019

2019

2019

2019

Balance at beginning of period

$

5,082

$

4,682

$

5,668

8.5

(10.3)

Property additions, net of acquisition adjustments

314

567

305

(44.6)

3.0

Less:

Proceeds from property disposals, net of participation purchase and of gains/losses

2,664

125

1,088

2,031.2

144.9

Period valuation adjustments

46

120

203

(61.7)

(77.3)

Balance at end of period

$

2,686

$

5,004

$

4,682

(46.3)

(42.6)

N/M - Not meaningful

In management’s judgment, the property valuation allowance as established presents OREO at current estimates of fair value less estimated costs to sell; however, there can be no assurance that additional losses will not be incurred on disposals or upon updates to valuations in the future.  Of note, properties valued in total at $1.5 million, or approximately 55.8% of total OREO at September 30, 2020, have been in OREO for five years or more.  The appropriate regulatory approval has been obtained for any OREO properties held in excess of five years.

OREO Properties by Type

(Dollars in thousands)

September 30, 2020

December 31, 2019

September 30, 2019

Amount

% of Total

Amount

% of Total

Amount

% of Total

Single family residence

$

450

17

%

$

174

3

%

$

-

-

%

Lots (single family and commercial)

1,461

54

%

3,945

79

%

4,044

86

%

Vacant land

351

13

%

41

1

%

42

1

%

Commercial property

424

16

%

844

17

%

596

13

%

Total other real estate owned

$

2,686

100

%

$

5,004

100

%

$

4,682

100

%

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Deposits and Borrowings

September 30, 2020

Deposits

As of

Percent Change From

(Dollars in thousands)

September 30, 

December 31, 

September 30, 

December 31, 

September 30, 

2020

2019

2019

2019

    

2019

Noninterest bearing demand

$

889,085

$

669,795

$

643,355

32.7

38.2

Savings

382,711

307,015

304,726

24.7

25.6

NOW accounts

492,407

425,792

413,291

15.6

19.1

Money market accounts

310,613

282,478

286,484

10.0

8.4

Certificates of deposit of less than $100,000

208,570

227,578

222,378

(8.4)

(6.2)

Certificates of deposit of $100,000 through $250,000

129,522

151,279

142,669

(14.4)

(9.2)

Certificates of deposit of more than $250,000

66,335

62,812

61,588

5.6

7.7

Total deposits

$

2,479,243

$

2,126,749

$

2,074,491

16.6

19.5

Total deposits were $2.48 billion at September 30, 2020, which reflects a $352.5 million increase from total deposits of $2.13 billion at December 31, 2019, and an increase of $404.8 million from total deposits of $2.07 billion at September 30, 2019.  The increase in deposits at September 30, 2020, compared to both December 31, 2019, and September 30, 2019, was due to increases in noninterest bearing demand, savings and NOW accounts, with smaller increases noted in money market accounts and certificates of deposit more than $250,000.  These increases in the linked quarter as well as year over year periods were primarily due to federal stimulus funds received by depositors and a decrease in consumer spending due to the COVID-19 pandemic.  

In addition to deposits, we obtained funding from other sources in all periods presented.  Securities sold under repurchase agreements totaled $59.3 million at September 30, 2020, a $10.6 million, or 21.7%, increase from $48.7 million at December 31, 2019.  We also had short-term borrowings of $6.1 million from the FHLBC at September 30, 2020, as compared to $48.5 million in short-term borrowings at December 31, 2019.  Our notes payable and other borrowings is comprised of one remaining $6.5 million long-term FHLBC advance acquired in our ABC Bank acquisition, which matures on February 2, 2026, and $18.0 million outstanding on a $20.0 million term note originated with a correspondent bank in the first quarter of 2020, to facilitate the redemption of our Old Second Capital Trust I trust preferred securities and related junior subordinated debentures, completed on March 2, 2020.  Notes payable and other borrowings of $24.5 million as of September 30, 2020, increased $17.8 million from December 31, 2019, and increased $15.6 million from September 30, 2019.  

The Company is indebted on senior notes originated in December 2016, totaling $44.3 million, net of deferred issuance costs, as of September 30, 2020.  These notes mature in December 2026, and include interest payable semi-annually at 5.75% for five years.  Beginning December 2021, the interest becomes payable quarterly at three month LIBOR plus 385 basis points.  The Company is also indebted on $25.8 million, net of deferred issuance costs, of junior subordinated debentures, which are related to the trust preferred securities issued by its statutory trust subsidiary, Old Second Capital Trust II (“Trust II”).  The Trust II issuance converted from fixed to floating rate at three month LIBOR plus 150 basis points on June 15, 2017.  Upon conversion to a floating rate, we initiated a cash flow hedge which resulted in the total interest rate paid on this debt of 4.40% as of September 30, 2020, as compared to 6.77%, which was the rate paid during the period prior to the June 15, 2017, rate reset.  The Company also redeemed $32.6 million of trust preferred securities issued by its statutory trust subsidiary, Old Second Capital Trust I, on March 2, 2020, as noted above.  The cash paid at redemption of $33.0 million included accrued interest of $438,000 on the debentures, and resulted in a payment of $10.13 per preferred share.  

Capital

As of September 30, 2020, total stockholders’ equity was $296.3 million, which was an increase of $18.4 million from $277.9 million as of December 31, 2019.  This increase is attributable to an increase in retained earnings of $15.1 million, comprised of net income year to date of $19.8 million, less a reduction to retained earnings of $3.8 million upon the adoption of ASU 2016-13 (CECL) as of January 1, 2020, and payment of $900,000 of dividends to our common stockholders in the nine months ended September 30, 2020. In addition, an increase to accumulated other comprehensive income of $6.5 million was recorded due to a net increase in unrealized gains on available-for-sale securities, net of unrealized losses on swaps. Total stockholders’ equity was reduced by an increase of $4.4 million to our treasury stock year to date 2020, primarily due to repurchases of our common shares pursuant to our stock repurchase program.

In the third quarter of 2019, our Board of Directors authorized a stock repurchase program, under which we were authorized to  repurchase up to approximately 1.5 million shares (or approximately 5%) of our outstanding common stock through open market purchases, trading plans established in accordance with U.S. Securities and Exchange Commission rules, privately negotiated transactions, or by other means.  The stock repurchase program expired on September 19, 2020; however, we received a notice of non-objection from the Federal Reserve Bank of Chicago to extend the previously authorized stock repurchase program through October 20, 2021.  The actual means

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and timing of any repurchases, quantity of purchased shares and prices will be, subject to certain limitations, at the discretion of management and will depend on a number of factors, including, without limitation, market prices of our common stock, general market and economic condition, and applicable legal and regulatory requirements.  These share purchases are anticipated to be funded by our cash on hand.  During the third quarter of 2020, we repurchased 137,756 shares of our common stock at a weighted average price of $8.34 per share pursuant to our stock repurchase program.  To date, we have repurchased 596,411 shares or our common stock at a weighted average price of $7.35 per share, under our stock repurchase program.

The following table shows the regulatory capital ratios and the current well capitalized regulatory requirements for the Company and the Bank as of the dates indicated:

Minimum Capital

Well Capitalized

Adequacy with

Under Prompt

Capital Conservation

Corrective Action

September 30, 

December 31, 

September 30, 

Buffer, if applicable1

Provisions2

2020

2019

2019

The Company

Common equity tier 1 capital ratio

7.00

%

N/A

11.97

%

11.14

%

10.89

%

Total risk-based capital ratio

10.50

%

N/A

14.33

%

14.53

%

14.34

%

Tier 1 risk-based capital ratio

8.50

%

N/A

13.08

%

13.65

%

13.45

%

Tier 1 leverage ratio

4.00

%

N/A

10.07

%

11.93

%

11.54

%

The Bank

Common equity tier 1 capital ratio

7.00

%

6.50

%

14.24

%

14.35

%

14.83

%

Total risk-based capital ratio

10.50

%

10.00

%

15.49

%

15.23

%

15.72

%

Tier 1 risk-based capital ratio

8.50

%

8.00

%

14.24

%

14.35

%

14.83

%

Tier 1 leverage ratio

4.00

%

5.00

%

10.90

%

12.50

%

12.68

%

1 Amounts are shown inclusive of a capital conservation buffer of 2.50%. Under the Federal Reserve’s Small Bank Holding Company Policy Statement, the Company is not subject to the minimum capital adequacy and capital conservation buffer capital requirements at the holding company level, unless otherwise advised by the Federal Reserve (such capital requirements are applicable only at the Bank level). Although the minimum regulatory capital requirements are not applicable to the Company, we calculate these ratios for our own planning and monitoring purposes.

2 The prompt corrective action provisions are only applicable at the Bank level.

As part of its response to the impact of the COVID-19 pandemic, in the first quarter of 2020, U.S. federal regulatory authorities issued an interim final rule that provides banking organizations that adopt CECL during the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital relative to regulatory capital determined under the prior incurred loss methodology, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during the initial two-year delay (i.e., a five-year transition in total). In connection with our adoption of CECL on January 1, 2020, we elected to utilize the five-year CECL transition.  The cumulative amount that is not recognized in regulatory capital, in addition to the $3.8 million Day One impact of CECL adoption, will be phased in at 25% per year beginning January 1, 2022. As of September 30, 2020, the capital measures of the Company exclude $5.7 million, which is the Day One impact to retained earnings, and 25% of the $10.4 million increase, net of taxes, in the ACL in the nine months ended September 30, 2020, excluding PCD loans.

As of September 30, 2020, the Company, on a consolidated basis, exceeded the minimum capital ratios to be deemed “well capitalized” and met the now fully phased-in capital conservation buffer requirements.  In addition to the above regulatory ratios, our GAAP common equity to total assets ratio, which is used as a performance measurement for capital analysis and peer comparisons, decreased from 10.54% at December 31, 2019, to 9.96% at September 30, 2020. Our GAAP tangible common equity to tangible assets ratio was 9.32% at September 30, 2020, compared to 9.81% as of December 31, 2019.  Our non-GAAP tangible common equity to tangible assets ratio, which management also considers a valuable performance measurement for capital analysis, decreased from 9.83% at December 31, 2019, to 9.34% at September 30, 2020.  

In November 2019, the federal banking agencies published final rules to provide an optional simplified measure of capital adequacy for qualifying community banking organizations, which we refer to as the community bank leverage ratio (“CBLR”) framework. Generally, under the CBLR framework, qualifying community banking organizations with total assets of less than $10 billion, and limited amounts of off-balance-sheet exposures and trading assets and liabilities, may elect whether to be subject to the CBLR framework if they have a

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CBLR of greater than 9%. Qualifying community banking organizations that elect to be subject to the CBLR framework and continue to meet all requirements under the framework would not be subject to risk-based or other leverage capital requirements and, in the case of an insured depository institution, would be considered to have met the well capitalized ratio requirements for purposes of the FDIC’s Prompt Corrective Action framework.  The final rule became effective on January 1, 2020.  We do not have any immediate plans to elect to use the community bank leverage ratio framework, but may make such an election in the future.

Reconciliation of Tangible Common Equity to Tangible Assets Ratio Non-GAAP Measure

September 30, 2020

December 31, 2019

Tangible common equity

GAAP

Non-GAAP

GAAP

Non-GAAP

(Dollars in thousands)

Total Equity

$

296,268

$

296,268

$

277,864

$

277,864

Less: Goodwill and intangible assets

20,901

20,901

21,275

21,275

Add: Limitation of exclusion of core deposit intangible (80%)

N/A

459

N/A

534

Adjusted goodwill and intangible assets

20,901

20,442

21,275

20,741

Tangible common equity

$

275,367

$

275,826

$

256,589

$

257,123

Tangible assets

Total assets

$

2,974,824

$

2,974,824

$

2,635,545

$

2,635,545

Less: Adjusted goodwill and intangible assets

20,901

20,442

21,275

20,741

Tangible assets

$

2,953,923

$

2,954,382

$

2,614,270

$

2,614,804

Common equity to total assets

9.96

%

9.96

%

10.54

%

10.54

%

Tangible common equity to tangible assets

9.32

%

9.34

%

9.81

%

9.83

%

The non-GAAP intangible asset exclusion reflects the 80% core deposit limitation per Basel III guidelines within risk based capital calculations, and is useful for us when reviewing risk based capital ratios and equity performance metrics.

Liquidity

Liquidity is our ability to fund operations, to meet depositor withdrawals, to provide for customers’ credit needs, and to meet maturing obligations and existing commitments.  Our liquidity principally depends on our cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and our ability to borrow funds.  We monitor our borrowing capacity at the FHLBC as part of our liquidity management process as supervised by our Asset and Liability Committee (“ALCO”) and reviewed by our Board of Directors.  In addition, due to the potential impacts on our liquidity stemming from the COVID-19 pandemic, our senior management team monitors cash balances daily to ensure we have adequate liquidity to meet our operational and financing needs.  As of September 30, 2020, our cash on hand liquidity totaled $313.1 million, an increase of $262.5 million over cash balances held as of December 31, 2019.  

Net cash inflows from operating activities were $16.8 million during the first nine months of 2020, compared with net cash inflows of $37.5 million in the same period of 2019.  Funds used to originate loans held-for-sale, net of proceeds from sales of loans held-for-sale, were a source of inflows for the first nine months of 2020 and the like period of 2019.  Interest paid, net of interest received, combined with changes in other assets and liabilities were a source of outflows for the nine months ended September 30, 2020 and the like period of 2019.  The management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows.  Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, as part of the balance sheet management process.

Net cash outflows from investing activities were $54.4 million in the nine months ended September 30, 2020, compared to net cash inflows of $74.6 million in the same period in 2019.  In the first nine months of 2020, securities transactions accounted for net inflows of $45.0 million, and the principal change on loans accounted for net outflows of $100.4 million.  In the first nine months of 2019, securities transactions accounted for net inflows of $77.1 million, and net principal on loans funded accounted for net outflows of $2.8 million.  Proceeds from sales of OREO accounted for $3.1 million and $2.6 million in investing cash inflows for the nine months ended September 30, 2020 and 2019, respectively.  

Net cash inflows from financing activities in the nine months ended September 30, 2020 were $300.2 million, compared with net cash outflows of $113.3 million in the nine months ended September 30, 2019.   Net deposit inflows in the first nine months of 2020 were

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$352.5 million compared to net deposit outflows of $42.1 million in the first nine months of 2019.  Other short-term borrowings had net cash outflows of $42.4 million in the first nine months of 2020, and $65.5 million in the first nine months of 2019.  Changes in securities sold under repurchase agreements accounted for $10.6 million and $2.2 million in net inflows for the nine months ended September 30, 2020 and 2019, respectively.  The redemption of our Old Second Capital Trust I trust preferred securities and related junior subordinated debentures resulted in cash outflows of $32.6 million in the first quarter of 2020, which was partially offset by a $20.0 million term note cash inflow which was originated to partially fund this trust preferred redemption; $18.0 million of this term note remains outstanding as of September 30, 2020.

Cash and cash equivalents for the nine months ended September 30, 2020, totaled $313.1 million, as compared to $54.0 million as of September 30, 2019.  In addition to cash and cash equivalents on hand or held as deposits with other financial institutions, we rely on funding sources from customer deposits, cash flows from securities available-for-sale and loans, and a line of credit with the FHLBC to meet potential liquidity needs.  These sources of liquidity are immediately available to satisfy any funding requirements due to depositor or borrower demands through the ordinary course of our business.  Additional sources of funding include a $20 million undrawn line of credit held by the Company with a third party financial institution, as well as unpledged securities available-for-sale.    

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

As part of our normal operations, we are subject to interest-rate risk on the assets we invest in (primarily loans and securities) and the liabilities we fund (primarily customer deposits and borrowed funds).  Fluctuations in interest rates may result in changes in the fair market values of our financial instruments, cash flows, and net interest income.  Like most financial institutions, we have an exposure to changes in both short-term and long-term interest rates.

In the first quarter of 2020 the Federal Reserve cut the Fed Funds rate three times down to a target range of 0% to 0.25%. Additionally, the Federal Reserve has been aggressively purchasing various assets since March 2020 in an effort to stabilize the economy from the continuing effects of COVID-19. Overall, the Federal Reserve’s balance sheet has increased from about $4.2 trillion in early March 2020 to about $7.1 trillion as of September 30, 2020. The Federal Reserve has indicated that it expects the Fed Funds rate to remain in the 0% to 0.25% range through 2023 and possibly even longer. We manage interest rate risk within guidelines established by policy which are intended to limit the amount of rate exposure.  In practice, we seek to manage our interest rate risk exposure well within our guidelines so that such exposure does not pose a material risk to our future earnings.

We manage various market risks in the normal course of our operations, including credit, liquidity risk, and interest-rate risk.  Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of our business activities and operations.  In addition, since we do not hold a trading portfolio, we are not exposed to significant market risk from trading activities.  Our interest rate risk exposures at September 30, 2020, and December 31, 2019, are outlined in the table below.

Our net income can be significantly influenced by a variety of external factors, including: overall economic conditions, policies and actions of regulatory authorities, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities other than those that are assumed, early withdrawal of deposits, exercise of call options on borrowings or securities, competition, a general rise or decline in interest rates, changes in the slope of the yield-curve, changes in historical relationships between indices (such as LIBOR and prime), and balance sheet growth or contraction.  Our asset-liability committee seeks to manage interest rate risk under a variety of rate environments by structuring our balance sheet and off-balance sheet positions, which includes interest rate swap derivatives as discussed in Note 14 of our consolidated financial statements included in this quarterly report.  We seek to monitor and manage interest rate risk within approved policy guidelines and limits.

We use simulation analysis to quantify the impact of various rate scenarios on our net interest income.  Specific cash flows, repricing characteristics, and embedded options of the assets and liabilities held by us are incorporated into the simulation model.  Earnings at risk are calculated by comparing the net interest income of a stable interest rate environment to the net interest income of a different interest rate environment in order to determine the percentage change.  As of December 31, 2019, we had modest amounts of earnings gains (in both dollars and percentage) should interest rates rise, and limited earnings reductions should interest rates fall.  The projected increases in income across all up rate interest rate shock scenarios as of September 30, 2020 were considerably higher than those in December 31, 2019. This was primarily the result of updated assumptions in our asset liability management model associated with an updated deposit decay study, deposit beta study, and loan prepayment study. Additionally, large growth in non-maturity deposits since the beginning of the year also contributed to the increases. However, the September 30, 2020 net interest income sensitivity profile did not materially change from the June 30, 2020 result. The June 30, 2020 and September 30, 2020 percent change in net interest income projected varied by less than 0.5% for all interest rate shock scenarios. The general balance sheet composition of both assets and liabilities changed only

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modestly during the quarter, which resulted in minimal change to our interest rate risk profile.  Management still considers the current level of interest rate risk to be moderate but intends to continue looking for market opportunities to flatten its interest rate risk profile.

The following table summarizes the effect on annual income before income taxes based upon an immediate increase or decrease in interest rates of 0.5%, 1%, and 2% and no change in the slope of the yield curve.  Due to the low interest rate environment, it was not possible to calculate certain down rate scenarios because rates would fall below zero in all down rate scenarios.

Analysis of Net Interest Income Sensitivity

(Dollars in thousands)

Immediate Changes in Rates

    

(2.0)

%

    

(1.0)

%

    

  

(0.5)

%

    

  

0.5

%

    

  

1.0

%

    

  

2.0

%

September 30, 2020

Dollar change

N/M

N/M

N/M

$

3,093

$

6,099

$

11,278

Percent change

N/M

N/M

N/M

3.7

%

7.2

%

13.4

%

December 31, 2019

Dollar change

N/M

$

(6,229)

$

(2,670)

$

993

$

2,016

$

3,856

Percent change

N/M

(6.6)

%

(2.8)

%

1.1

%

2.1

%

4.1

%

N/M - Not meaningful

The amounts and assumptions used in the simulation model should not be viewed as indicative of expected actual results.  Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies.  The above results do not take into account any management action to mitigate potential risk.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of September 30, 2020.  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2020, the Company’s internal controls were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified.

We adopted the new guidance under Accounting Standards Update 2016-13, (ASC Topic 326) “Measurement of Credit Losses on Financial Instruments,” also known as Current Expected Credit Losses, or CECL, on January 1, 2020.  The Company implemented new accounting processes and procedures, which required us to update our internal controls over accounting for the allowance for credit losses, and the related disclosures under the new guidance.  As a result of the adoption of CECL, we implemented new internal controls designed to mitigate the risks associated with these new processes and to provide assurance at a reasonable level of the fair presentation of our consolidated financial statements and related disclosures. There were no other changes in the Company’s internal controls over financial reporting during the nine months ended September 30, 2020, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.  

The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

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PART II - OTHER INFORMATION

Item 1.  Legal Proceedings

The Company and its subsidiaries, from time to time, are involved in collection suits in the ordinary course of business against its debtors and are defendants in legal actions arising from normal business activities.  Management, after consultation with legal counsel, believes that the ultimate liabilities, if any, resulting from these actions will not have a material adverse effect on the financial position of the Bank or on the consolidated financial position of the Company.

Item 1.A.  Risk Factors

Investing in shares of our common stock involves certain risks, including those identified and described in Item 1A. of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, as well as cautionary statements contained in this Quarterly Report on Form 10-Q, including those under the caption “Cautionary Note Regarding Forward-Looking Statements,” and set forth in Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2020.

Except as set forth in Part II, Item 1A of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2020 and filed with the SEC on May 11, 2020, which is incorporated herein by this reference, there have been no material changes to the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019 filed with the SEC on March 6, 2020.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

Stock Repurchases

In September 2019, our board of directors authorized the repurchase of up to 1,494,826 shares of our common stock (the “Repurchase Program”).  The Repurchase Program expired on September 19, 2020.  However, on October 20, 2020, the Company received notice of non-objection from the Federal Reserve Bank of Chicago to extend the Repurchase Program through October 20, 2021.  As of October 20, 2020, 898,415 shares remained available to be repurchased under the Repurchase Program.  Repurchases by the Company under the Repurchase Program may be made from time to time through open market purchases, trading plans established in accordance with SEC rules, privately negotiated transactions, or by other means.

The actual means and timing of any repurchases, quantity of purchased shares and prices will be, subject to certain limitations, at the discretion of management and will depend on a number of factors, including, without limitation, market prices of our common stock, general market and economic conditions, and applicable legal and regulatory requirements.   Repurchases under the Repurchase Program may be initiated, discontinued, suspended or restarted at any time provided that repurchases under the Repurchase Program after October 20, 2021, would require Federal Reserve non-objection or approval.  We are not obligated to repurchase any shares under the Repurchase Program.    

The following table presents our stock repurchases for the quarter ended September 30, 2020.

Total Number of

Maximum Number

Total

Shares Purchased

of Shares that May

Number of

Average

as Part of Publicly

Yet Be

(Dollars in thousands, except for per share

Shares

Price Paid

Announced Plans

Purchased Under

amounts)

Purchased

per Share

or Programs

the Plans or Programs

July 1, 2020 - July 31, 2020

-

$

-

-

1,036,171

August 1, 2020 - August 31, 2020

-

-

-

1,036,171

September 1, 2020 - September 30, 2020

137,756

8.34

596,411

898,415

Total

137,756

$

8.34

596,411

898,415

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Item 3.  Defaults Upon Senior Securities

None.

Item 4.  Mine Safety Disclosures

Not applicable

Item 5.  Other Information

Amendment to Bylaws

Given the timing of the following amendment, the following information is included in this Quarterly Report on Form 10-Q pursuant to Item 5.03 of Form 8-K, “Amendments to Articles of Incorporation or Bylaws; Change in Fiscal Year” in lieu of filing a Form 8-K.

On November 4, 2020, our board of directors amended and restated our Company’s bylaws (the “Amended Bylaws”), effective immediately.  The Amended Bylaws replace and supersede in their entirety the then existing bylaws of the Company (the “Prior Bylaws”).  Substantive amendments to the Prior Bylaws include:

Stockholder Proposals

Article II, Section 2.4 of the Prior Bylaws generally provided that a stockholder wishing to submit new business at an annual meeting of stockholders must provide a notice of such proposal at least 60 days in advance of the first anniversary date of the previous year’s annual meeting to be considered at the annual meeting.  Article II, Section 2.4 of the Prior Bylaws required certain information to be provided by the stockholder making any such proposal.

Article II, Section 2.4 of the Amended Bylaws require additional information in the stockholder’s notice to the Company with respect to a stockholder proposal (other than a director nomination) for an annual meeting of stockholders, including, among other things, (a) the stockholder’s name and address; (b) information about the stockholder’s stock ownership in the Company and certain interests and relationships; and (c) a description of the business the stockholder desires to bring before the meeting.  In connection with an annual meeting of stockholders, a stockholder generally must submit notice of such stockholder’s intentions to submit a proposal not earlier than 120 days and not later than 90 days prior to the first anniversary of the preceding year’s annual meeting; provide that, if the date of the annual meeting is moved to more than 30 days before or more than 60 days after the anniversary date of the previous year’s meeting, for notice by the stockholder to be timely it must be delivered to us not earlier than 120 days prior to the date of such annual meeting and not later than 90 days prior to the date of such annual meeting or, if the first public announcement of the date of such annual meeting is less than 100 days prior to the date of such annual meeting, then the tenth day following the day on which public announcement of the date of such meeting is first made by the Company.  Article II, Section 2.4 of the Amended Bylaws also eliminated a provision in the Prior Bylaws that allowed a stockholder to make a proposal at any time (including the date of the annual meeting) that would be discussed and considered at the annual meeting but not voted on until the subsequent annual meeting.

Director Nominations

Article II, Section 2.5 of the Prior Bylaws generally provided that a stockholder could nominate candidates for election to the Company’s board of directors if such nominations were made in writing to the Company not less than 60 days nor more than 90 days before the first anniversary of the preceding year’s annual meeting.  Article II, Section 2.5 of the Prior Bylaws also required such stockholder’s notice to include certain information related to each proposed nominee, including (a) such nominee’s name, age, business address and residential address; (b) such nominee’s principal occupation; (c) certain information about the nominee’s stock ownership in the Company; and (d) any other information relating to such nominee that would be required to be disclosed on Schedule 13D pursuant to Regulation 13D-G under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and pursuant to Regulation 14A under the Exchange Act.  In addition, the stockholder giving the notice was required to provide their name and address, the name and principal business or residential address of any other beneficial stockholders known by such stockholder to support such nominees, and certain information about the their stock ownership in the Company and any other record or beneficial stockholders known by such stockholder to be supporting such nominee. Article II, Section 2.5 of the Prior Bylaws also included requirements for the Board to provide notice of any failure of a stockholder to satisfy these information requirements and a time period to cure such deficiencies.

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Article II, Section 2.5 of the Amended Bylaws has been revised to generally replicate the language in Article X.F of the Company’s Certificate of Incorporation.  Article II, Section 2.5 of the Amended Bylaws generally provides that a stockholder can nominate candidates for election to the Company’s board of directors if such nominations are made in writing to the Company not more than 60 days nor fewer than 14 days before any meeting of the stockholders called for the election of directors.  Each such written nomination must include (a) the name, age, business address and, if known, residence address of each nominee proposed; (b) the principal occupation or employment of each such nominee for the past five years; and (c) the number of shares of stock of the Company beneficially owned by each such nominee and by the nominating stockholder. The Chairman of the meeting may, if the facts warrant, determine and declare to the meeting that a nomination was not made in accordance with these requirements, and if so determined, the Chairman will declare to the meeting that the defective nomination will be disregarded.

The foregoing description of the Amended Bylaws is qualified in its entirety by reference to the full text of the Amended  Bylaws, a copy of which is filed as Exhibit 3.1 to this Form 10-Q and is incorporated herein by reference.

Date of Annual Meeting of Stockholders

We currently anticipate that we will hold our 2021 annual meeting of stockholders (the “2021 Annual Meeting”) on May 18, 2021, which will be more than 30 calendar days before the anniversary date of our 2020 annual meeting of stockholders.  In accordance with Rule 14a-5(f) under the Exchange Act, we are hereby notifying our stockholders that, to be considered for inclusion in our 2021 Annual Meeting proxy material under Rule 14a-8 of the Exchange Act, your proposal must be submitted in writing by December 17, 2020.  If you wish to bring a proposal (other than a director nomination)  before the 2021 Annual Meeting outside of Rule 14a-8 (that will not be included in our proxy materials), you must submit your proposal in writing not later than the close of business on February 17, 2021, but no earlier than the close of business on January 18, 2021. If you wish to nominate a candidate for election to our board of directors at the 2021 Annual Meeting, you must provide written notice of such nomination no later than May 4, 2021, but no earlier than March 19, 2021. You are also advised to review our certificate of incorporation or bylaws, as applicable, which contain additional requirements about advance notice of director nominations and stockholder proposals.  All such notices should be directed, in writing, to our Secretary at 37 South River Street, Aurora, Illinois 60507.

Item 6.  Exhibits

Exhibits:

3.1

10.1

Old Second Bancorp, Inc. Voluntary Deferred Compensation Plan, effective November 1, 2020 (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on September 29, 2020).

31.1

Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).

31.2

Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).

32.1

Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2

Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101

Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets at September 30, 2020, and December 31, 2019; (ii) Consolidated Statements of Income for the nine months ended September 30, 2020 and 2019; (iii) Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2020 and 2019; (iv) Consolidated Statements of Cash Flows for the nine months ended September 30,  2020 and 2019; and (v) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail.*

* As provided in Rule 406T of Regulation S-T, these interactive data files shall not be deemed “filed” for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934 as amended, or otherwise subject to liability under those sections.

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SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

OLD SECOND BANCORP, INC.

BY:

/s/ James L. Eccher

James L. Eccher

President and Chief Executive Officer

(principal executive officer)

BY:

/s/ Bradley S. Adams

Bradley S. Adams

Executive Vice President and Chief Financial Officer

(principal financial and accounting officer)

DATE: November 6, 2020

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