Jim Eccher - Chief Executive Officer Brad Adams - Chief Financial Officer Gary Collins - Vice Chairman of the Board

Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc.'s Fourth Quarter 2022 Earnings Call. On the call today is Jim Eccher, the company's CEO; Brad Adams, the Company’s CFO; and Gary Collins the Vice Chairman of our Board. I will start with a reminder that Old Second's comments today may contain forward-looking statements about the company's business, strategies and prospects, which are based on management's existing expectations in the current economic environment. These statements are not a guarantee of future performance and results may differ materially from those projected. Management would ask you to refer to the company's SEC filings for a full discussion of the company's risk factors. On today's call, we will be discussing certain non-GAAP financial measures. These non-GAAP measures are described and reconciled to their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com on the homepage and under the Investor Relations tab. Now I will turn it over to Mr. Jim Eccher.

Good morning and thank you for joining us today. Same format as prior quarters. I have several prepared opening remarks. Give my overview of the quarter and then I’ll turn it over to Brad for more additional details. We’ll then conclude with some summary comments and thoughts about the future and then open up for some questions. Net income was $23.6 million or $0.52 per diluted share in the fourth quarter. Net income adjusted to exclude West Suburban acquisition related costs, less net gains for brand sales was $24.1 million or $0.53 per diluted share in the fourth quarter. On the same adjusted basis, return on assets was 1.61%. Return on tangible equity was 28.33% and the tax equivalent efficiency ratio was 51.29%. Fourth quarter earnings were also negatively impacted by a combined $1.3 million in pre-tax security losses and fair value adjustments for mortgage servicing rights. In aggregate, obviously an exceptionally strong quarter with more than 20% earnings growth linked quarter on annualized. Our financials continue to be favorably impacted by the increase in market interest rates with a 15% increase in the net interest income or $8.5 million over the third quarter of 2022 due to relatively stable funding costs and increasing asset yields across the balance sheet. The fourth quarter marks a full year since our acquisition of West Suburban Bank and I believe both, our execution and the positive impacts of the acquisition are apparent in our financials. We have outperformed our own internal expectations on cost saves, loan growth in revenue that we had set out for ourselves. These internal targets became more aggressive as we move from deal announcement to the months following the closing of the transaction. We have been more successful than we had hoped in bringing on new sales teams along…

Thank you Jim. Net interest income increased $8.5 million relative to last quarter and $35.5 million from the year-ago quarter. Margin trends increased due to a loan portfolio growth, as well as due to the increases in security and loan yields from market interest rate increases. Total yield on interest earning assets increased 76 basis points to 489 basis points over the linked quarter, partially offset by an 8 basis point increase in the cost of interest bearing deposits and a15 basis point increase in interest-bearing liabilities aggregate. Obviously, exceptional margin performance. The fourth quarter continued to see a significant movement in rate, albeit this time in the opposite direction, with inversion across the entirety of the curve that leads many to read this or that from the tea leaves. Obviously the short end of the curve remains high and this is where Old Second largely lives. I won't bore you with my take on macro things, other than to briefly mention that I don't believe that a Fed focused on inflation is going to whipsaw short rates absent a significant shock of some sort. The once popular belief that zero interest rate policy had no risk has proven shockingly misguided and any expectation and a reversion to that mean is foolish in my opinion. Obviously I'm biased as a decade-long sufferer of the belief that core deposits matter. So take that opinion for what it's worth and feel free to unsubscribe from my newsletter going forward. The implications for investors in Old Second is that we aren't in a hurry to place a large bets on the path of interest rates. Duration is being added to reduce asset sensitivity in numerous ways, including remixing out of the variable securities that has served us so well, and the addition of…

Okay. Thanks, Brad. In closing, we remain confident in our balance sheet and the opportunities that are ahead for Old Second. We're paying close attention to both expenses and credit. We believe our underwriting has remained disciplined and our funding position is strong. Today, we have the balance sheet and liquidity flexibility to take advantage of a rising rate environment and will be aggressive in looking at new talent and new relationships. That concludes our prepared comments this morning. So I will turn it over to the moderator and open it up to any questions.

Thank you. The floor is now open for questions. [Operator Instructions]. Thank you. Our first question is coming from Jeff Rulis with D.A. Davidson. Please go ahead.

Thanks. Good morning.

Morning Jeff.

Good morning Jeff.

Just wanted to try to get some detail on the success of the NPA reductions in non-accruals. If you could just kind of give us a little color on the – you know with these loans acquired through West Suburban with a legacy, you know what type. I’m just trying to get a sense of what declined in the quarter.

Yeah, the big mover Jeff was a large commercial real-estate property, a retail property that we have been – it has been in our workout team for the better part of the year. We finally were able to find a buyer that took a corresponding charge off. Finally moved that one off the books. Absent that, it was a combination of some prepayments, some pay downs, some upgrades, but the large real estate property where we took about a $900,000 charge was long-standing workout credit.

Got you. Okay, and that’s without – was that a legacy Old Second not acquired.

Yes, that was a legacy Old Second credit.

Okay. Was there any interest recoveries included in that? What – you know the margin is pretty big. I was just wondering if that added to any you know? No, okay.

No, no, we took a further charge on it.

Got you, okay. Brad you rattled through the expense expectations a little bit. Sorry if I missed it. Obviously ‘22 digesting some hires and comp increase. I think you alluded to sort of digesting some of that and I guess expectations for ‘23 growth as we kind of muddled through the year.

You know, I think like I said or tried to hand to maybe gracefully maybe not, I'll do a little, maybe a Mea culpa here. We kind of blew through stretch incentive goal and it had a big impact on compensation. We beat our budget quite handsomely in 2022. Met at implications for incentive comp. Perhaps it would have been better if that could have been approved more gracefully, but we had well in excess of 100 basis points of margin expansion in two quarters, less that two quarters. So it was a bit lumpy on that front. We should see a step down in compensation expense in the first quarter, that will be somewhat mitigated by FICO coming back on board, full boat. But I still think overall operating expenses are kind of like a 4% to 5% type number on a full year, absent that step down.

4% to 5% off a base of the full year ’22, the 151 or so?

Yeah, I think so.

Okay, okay. And maybe the last one. Just on the fee income side obviously impacted by the securities losses and MSR, just your expectation on expect mortgage to stay low. Can we look at a quarterly run rate in the $9.5 million $10 million range? Any feel for fee income growth in the coming year?

Well, what I'd like to see is, I'd like to see commercial loan fees and slot fees start to contribute more meaningfully. We've seen some momentum here recently in the second half of the year. I think we’ll get a big kick from that. I don't expect mortgage banking to perform very well in 2023. I don't think I'm alone in that opinion. So I think we'll see kind of mid-single digit growth on the fee side this year. I think we’d be pretty happy.

I think that's been our trend, especially with wealth and card related income, low to mid-single digits.

Got you. Well, thank you. I think the self-congratulations are warranted. So, I'll step back. Thanks.

Thanks Jeff. Operator Thank you. Our next question is coming from Chris McGratty with KBW. Please go ahead.

Hey! Good morning.

Hey Chris.

Hey Chris.

Hey Brad, Hey Jeff. The comments about earnings assets trailing loan growth, if I heard you right Brad, $50 million is coming off of the bond book, is it one? I mean it feels like that could fund mid-single digit loan growth by itself. So it sounds like no growth in Q1 kind of seasonally or low growth and then what mid-single over the course of year. Is that kind of flat earning assets or you think any assets will grow?

Yeah Chris, I mean historically we've been a shop that's had pretty good loan growth in the second and third quarters. Yeah, obviously fourth quarter was pretty flat. I will say in recent weeks’ activity loan committee is picking it up. If you remember, we set out to double our origination capacity last year and we actually tripled it, going from about $500 million to about $1.5 million. I certainly don't see that kind of production in 2023, but certainly could see somewhere in the $1 billion range in production. But, I'm optimistic. I think mid-single digit growth is very achievable.

Okay. And then on the margin, there was a comment in the release about upward pressure on deposit cost, but I think here the word was moderate. So I guess maybe a little bit of color there. I think the banks that have held out so far on deposit betas have more or less signaled an acceleration. Are you signaling, perhaps not the same degree of pressure Brad and margin lift from that 4.6.

So, as you can see, we've seen a little bit of deposit attrition. It's largely been concentrated in public funds, fewer districts, that sort of thing. And that is money that flowed in while the spigots were on full, right? I mean everybody saw that. Absent that we don't have a lot of very high balance accounts here. We are – I've said this before, it's a little bit folksy, but we are funded largely by $1000 checking accounts and that serves us well in times like these. We do have, you know from an outpost stand point we do have some time deposit contribution and the cost of that is early going up. There are 4%’s being thrown around in our market at this point. And you see the usual games, where people are basically gaming the Fed Funds Futures curve and trying to capture 10 basis points here and 25 basis points there, it's the same old game. We’ll keep some level of time deposit just to keep things balanced from an outgo standpoint. There is obviously some pressure, but not a ton. We are doing really well.

So, just to push on the margin again. You talked about perhaps taking some of the asset sensitivity off, but not making a huge bet. If the market is right, that we get another hike or two in the first quarter or two. I mean where do you kind of see peak margins?

If we get two more, our margins go on above five.

Okay. And then one of your peers in Chicago I think has managed to balance sheet just very well like you. Wouldn't that be the time to make a little bit more of a bet to lock in that really, really high margin?

I mean, we're – don't misconstrue me. We are certainly taking off assets sensitivity and adding duration and doing so in a measured manner. A big part of that is stepping out of these variable securities that we bought and that comes without a fee and it also comes without accounting risk. I don't want to give the impression that we're not locking in, to some extent we certainly are. But right now what you see is, you see a sharp drop-off, but that the three-year portion of the curve, and after you take the fee into account and start looking at the economics of that and you balance that against what has shown up here recently which is 50 basis points cuts at the end of the year and you’re not locking in you know 4.5% margins, your locking in basically 3.5% margins, the net-net of it. So I think what I’m trying to say is that we’re not lurching at anything, but we’re certainly reducing asset sensitivity as quickly and as prudently as we can. But bear in mind that it was never my intention to have 30% of the securities portfolio and variable, simply we had no choice, what fixed rate yields were and what the risks were and if I could get out of them tomorrow with no loss, I probably would.

Do you happen – and also to backup, do you have the December margins?

Yes, I do. Its high than what we reported for the full quarter.

Thank you. [Operator Instructions] Our next question is coming from David Long with Raymond James. Please go ahead.

Good morning everyone.

Good morning.

Good morning David.

Brad, I like your core deposits manner of newsletter. Do you have a balance sheet management newsletter? I believe some of your peers may want to subscribe to that. But no, serious on this, the non-interest bearing deposits to total open deposits still running around 40%, you know your very core funded and a lot of like you said $1000 deposit accounts. But do you expect that number to veer any lower to net. You know do you see that close to 30%, 35% at some point or is 40% a good run rate?

Yeah, it feels pretty stable right now. You know things happen when rates go up and certainly one of – and it gets slashed away in a headline as that liquidity – the liquidity evaporates and that always becomes more profound than people expect. You know it’s been a long time since we saw what happens in these scenarios, but I can tell you that it’s better to be a retail funded, granular deposit base when liquidity gets tight. And I think when you talk about volatility of those deposit basis, its lesser in that kind of makeup than what you’d see in a commercial funded bank or something like that. So it’s good to be what we are right now. I certainly recognize that environments can change and we’ll do what we can, but we are fundamentally what we are, I’ve said that many times, and we shouldn’t start making giant bets to be something different than that because there’s not a darn thing we can do about it.

Got it! Cool! Thanks for that one. And then, one of your competitors did a deal in your neck of the woods. Any appetite from any at this point? Is there – are you having any conversations? Have you seen an increase in dialogue there?

Yeah David, you know we’ve obviously been working real hard to integrate less suburban. You know it’s been a year. We’ll certainly be open minded about a strategic opportunity. I would say this dialogue in our markets is ongoing, but certainly not at the level it was you know a couple of years ago. But yes, we would be open to a transaction if we found one that – there are criteria.

Got it, thanks guys. I appreciate it.

Thank you David.

Thanks David.

Thank you. There appear to be no further questions in queue at this time. So I hand it back to Mr. Eccher for any closing comments.

Okay, all right thank you. Thanks everyone for joining us this morning and we look forward to speaking with you again next quarter. Good bye!

Thank you and this does conclude today’s conference call. You may disconnect your lines at this time and have a wonderful day and we thank you for your participation.