Old Second Bancorp, Inc. (NASDAQ:OSBC) Q3 2023 Earnings Call Transcript

Old Second Bancorp, Inc. (NASDAQ:OSBC) Q3 2023 Earnings Call Transcript October 20, 2023

Operator: Good morning, everyone, and thank you for joining us today for Old Second Bancorp Incorporated Third Quarter 2023 Earnings Call. On the call today are Jim Eccher, the company’s Chairman, President and Chief Executive Officer; Brad Adams, the company’s Chief Operating Officer and Chief Financial Officer; and Gary Collins, the Vice Chairman of our Board. I will start with a reminder that Old Second’s comments today will 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. The company does not undertake any duty to update such forward-looking statements. 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.

A customer meeting with a loan officer in a bank office, discussing their financial goals. Editorial photo for a financial news article. 8k. –ar 16:9

James Eccher: Good morning, and thank you for joining us today. As customary, I have several prepared opening remarks, we’ll give my overview of the quarter, then I’ll turn it over to Brad for additional details. I will then conclude with certain summary comments and thoughts about the future before we open it up to Q&A. Net income was $24.3 million or $0.54 per diluted share in the third quarter. Adjusted net income was $24.8 million or $0.55 per diluted share in the third quarter. On the same adjusted basis, return on assets was 1.70% and third quarter 2023 return on average tangible common equity was 22.80% and the tax equivalent efficiency ratio was 50.08%. Third quarter earnings were negatively impacted by $924,000 in pretax securities losses on strategic security sales as well as $629,000 in net deconversion and liquidation costs related to the Visa credit card portfolio sale last year.

The combined impact of these 2 items reduced diluted earnings per share by $0.03 in the third quarter. Our financials continue to be favorably impacted by elevated market interest rates with a $7.5 million or 13.4% increase in net interest income in the third quarter compared to the prior year late quarter due to manageable funding cost increases along with significant expansion in asset yields across the balance sheet. The third quarter of 2023 reflected loan growth of $14 million for the linked period and expanded $160.2 million or 4.1% over the same period last year. Loan prepayments continue to be modest. However, origination activity has slowed significantly over the last 6 months. Activity within loan committee remains modest relative to prior periods due both to higher interest rates and seasonal impacts.

The net interest margin expanded slightly this quarter, driven by increased loan yields, partially offset by the higher cost of deposits. Loan yields continued to expand modestly during the quarter increasing by 9 basis points over the linked quarter and 127 basis points year-over-year. The tax equivalent net interest margin was 4.66% for the third quarter compared to 3.96% in the third quarter of last year. The margin has benefited year-over-year from balance sheet mix improvement, the impact of rising rates on the variable portion of the loan portfolio and continuing loan growth in 2023. The loan-to-deposit ratio is now 87% as of September 30 compared to 85% last quarter and 73% as of September 30, 2022. As we said last quarter, our focus continues to be balance sheet optimization, and I’ll let Brad talk about that in a minute.

We had previously expected to report a linked quarter improvement in credit metrics with workout plans in place for a few credits we had downgraded in prior quarters. Unfortunately, these plans designed to improve cash flow metrics fail to materialize this quarter. Our outlook has not changed, though, although the speed of resolution will be slower than hoped. The good news is the portfolio trends remain well behaved on an overall basis and the stress testing at renewal rates has not raised any new red flags for us. On an overall basis, nonaccruals were largely unchanged with some pluses and minuses under the covers. Classified loans did tick up a bit this quarter, due largely to 3 credits. First is a $17 million multifamily mixed-use project that is characterized at this point is half complete and leased and half unimproved, sponsors are looking to liquidate the property.

We don’t expect significant losses here, if any. The other credits are health care related, and while nicely occupied at below par debt service coverage ratios due to the combination of higher renewal rates and significantly higher labor cost inputs. Beyond these impacts are ongoing evaluations of commercial real estate and office have not revealed significant deterioration at this point. And the trends within criticize assets are stable. Clearly our focus remains on monitoring potential weakness in commercial real estate and office and health care specifically. We have stressed on maturing credits under renewal rates and believe we don’t see broad-based risk. We’ve been very proactive on refreshing valuations. And as a result, our outlook for credit has not changed.

I think it’s important to remember that nearly half of our commercial real estate exposure is owner-occupied, which we believe is unusual for a bank of our size. And our office exposure is only about 5% of the loan book. We simply don’t have much exposure here, and we are watching it very closely. Please refer to the additional disclosures in our earnings release for more color on the portfolio. We recorded net charge-offs of $6.6 million in the third quarter of 2023 compared to $505,000 of net charge-offs in the second quarter. The majority of the current period charge-offs were specific to 2 borrowers within commercial real estate on which we had existing specific allocations within the ACL of $4.7 million at June 30. Other real estate owned reflected a $354,000 decrease in the third quarter to end at $407,000 in total based on 4 property sales during the quarter, net of one transfer into OREO.

The allowance for credit losses on loans decreased to $51.7 million as of September 30 from $55.3 million at the end of the previous quarter, which is 1.3% of total loans as of September 30, 2023, down from 1.4% total ACL to gross loans as of June 30. Unemployment and GDP forecast used in future loss rate assumptions remained fairly static from last quarter. I think investors should know that we remain confident in the strength of our portfolios and the credits driving the reduction in the allowance of the same credits we’ve talked about previously and which we continue to monitor and work towards remediation or sale. Noninterest income continued to perform well, and excluding losses on security sales discussed earlier, noninterest income increased $1 million compared to the second quarter of 2023 driven by gains on BOLI income due to restructuring, MSR gains and other income.

Pretax losses of $924,000 on security sales in the third quarter were incurred related to strategic repositioning within certain types in the portfolio. Expense discipline continues to be strong and our efficiency ratio continues to be excellent. As we look forward, we’re focused on doing more of the same, which is managing liquidity and building commercial loan origination capability for the long term. The goal is obviously to continue to build towards a more stable long-term balance sheet mix featuring more loans and less securities in order to maintain the returns on equity commensurate with our recent performance. I’ll turn it over to Brad now for more color in his comments.

Bradley Adams: Thank you, Jim. Net interest income decreased slightly to $63 million for the quarter relative to the prior quarter of $63.6 million, but increased $7.5 million or 13.4% from the year ago quarter. Loan yields continued to grow in the third quarter, though at a slower pace than recent periods, and securities yields declined slightly since last quarter due to the significant sales of variable rate issues this quarter and last. Total yield on interest-earning assets increased 10 basis points to 549 basis points and was partially mitigated by a 25 basis point increase in the cost of interest-bearing deposits and a 14 basis point increase to interest-bearing liabilities in aggregate. The end result was a 2 basis point increase in the taxable equivalent NIM from last quarter to 466, which we believe continues to be exceptional margin performance.

As discussed in last quarter’s call, we redeemed the outstanding senior debt issuance on June 30. This redemption provided a net interest margin cost savings of approximately 3 basis points net of alternative funding costs. Deposit flow this quarter showed modest leakage on the high end, along with typical seasonal decline in the third quarter, we always see based on tax payments for personal and business customers and commercial customers rolling out new activities throughout the summer. The nature and character of the decline largely looks like an inverse move of the flows into the bank, we saw beginning in the latter half of 2020 through 2021. Fortunately, we have the liquidity and the balance sheet flexibility to adapt and will continue to remix and optimize rather than chase high beta deposits.

We still aren’t lurching at anything, but have made some fairly significant progress in reducing asset sensitivity over the last year, including reducing variable rate securities concentrations. Variable rate issues within the bond portfolio are now approximately 18%, a level that is roughly half where it was before rates started moving higher. There has been some significant income and margin give-up associated with doing this, but it’s the right time to return to a normal duration profile within the portfolio. As the belief in higher for longer has taken hold, spreads have tightened considerably on some of the variable rate issues we hold. Duration is slowly being added to reduce asset sensitivity and numerous other ways as well. I still don’t see much opportunity to hedge away asset sensitivity, but balance sheet positioning and flexibility at this point is excellent, in my opinion.

Effective duration on the bond portfolio is now 2.7 years. Rates during the quarter moved much more significantly further out the curve. So Old Second saw significantly less fair value deterioration than perhaps some peers experienced. The loan-to-deposit ratio remains low, and our ability to source liquidity from the portfolio has increased relative to the color we gave you last quarter. The bid has come back a bit on variable rate issues, as I said, and that has allowed us to move out of our excess positioning here quite effectively. The mark on the securities portfolio remains high but will be recaptured relatively quickly. The net result is that Old Second should continue to build capital very quickly as evidenced by the 50 basis point improvement in the TCE ratio over the linked quarter, even without a tailwind from AOCI, which combined with the 93 basis points in the first 6 months means we’ve added 143 basis points of TCE this year.

As we sit here today, we have approximately $700 million in undrawn borrowing capacity and an additional $420 million in unpledged securities and short liquidity at the bank is excellent, and the holding company is in a strong position as well. We are likely to seek non-objection to resume stock repurchases soon. Margin trends from here are expected to be relatively stable over the remainder of the year with benefits from the last rate hike still to come and continued asset repricing not expected to outpace the increased reliance on our overnight borrowings by very much. Provision for credit losses of $3 million was recorded during the quarter and was primarily attributable to credit losses on loans. Net of an immaterial reversal of provision on unfunded commitments during the quarter.

I would expect loan growth to be roughly consistent with provision growth over the near term, though that could change with significant worsening in the macro environment. Noninterest expense increased $2.6 million from the previous quarter, driven by higher salaries and employee benefits as well as expenses related to liquidation and deconversion fees from the Visa credit card portfolio. I continue to expect quarterly wages and benefits to be between $22 million and $23 million going forward in the near term. Given the revenue performance, employee investment costs have been running high, but we will maintain the ability to dial back as conditions warrant. I would be remiss if I didn’t add that we are not really in the market to chase much growth here.

Doesn’t really make sense given the marginal yields available relative to the marginal cost of funding and the cost associated with origination. As such, we remain focused on optimization and efficiency. I believe our results indicate that we are doing a pretty darn good job at this so far. It can continue, and I believe we can potentially grow earnings absent balance sheet growth. At the very least, I believe earnings can be much more resilient than perhaps many people expect from us. With that, I’d like to turn the call back to Jim.

James Eccher: Okay. Thanks, Brad. In closing, we remain confident in our balance sheet and the opportunities that are ahead for us. We’re paying close attention to both credit and expenses. We believe our underwriting has remained disciplined, and our funding position is strong. We have the balance sheet and flexibility to excel at a higher rate environment. Capital levels should continue to grow and maintain levels above targets, and we will look to be aggressive in adding talent and relationships. That concludes our prepared comments this morning. So I’ll turn it over to the moderator to open it up for questions.

See also 20 States With Most Expensive Electricity In The US and 20 Countries With The Highest Chicken Consumption.

Q&A Session

Operator: Thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions] Thank you. Our first question is coming from Jeff Rulis with D.A. Davidson. Your line is live.

Jeff Rulis: Thanks. Good morning.

James Eccher: Good morning, Jeff.

Jeff Rulis: Jim, I appreciate the comments on the credit side. I kind of want to just check in on the balance of nonaccruals. Are there some – maybe I think you mentioned the time line to resolution maybe extended a bit, but trying to get a sense for that balance of nonaccruals. Are there some chunkier credits in there that may have kind of a shorter time line to resolution? I’m trying to dig into a little bit of pace of resolution from your perspective.

James Eccher: Yes, there are chunkier ones, Jeff. And I will tell you, it’s primarily concentrated in CRE office and health care. What’s made some of this challenging is that there are shared credits so that their participation is purchased. And we’re working closely with the lead bank to write a resolution. We do feel we will have resolution on a couple of these. It’s just taking a little bit longer. There’s a couple of properties under contract. We’re looking at no sale options. But it seems as though the time to resolve credits has just taken longer than what it used to.

Jeff Rulis: Got it. And within the charge-offs looks like mostly in the CRE bucket, were those from credits that were kind of new to classifieds or just something that’s existing…

James Eccher: Those are two office buildings that we had already allocated for prior quarters and we took the charges to position them for either sale or no sale.

Bradley Adams: These are the same credits we’ve been talking about in the last 2 calls, Jeff.

Jeff Rulis: Yes. Just making sure that I didn’t know where to – I appreciate that detail. And I guess those increase in classifieds sounded like a multifamily mixed-use and then to health care related. I guess the first of which, I think you said not a lot of losses expected there and perhaps liquidation occurring soon. On the health care front, are these – what any more detail on those 2 credits?

James Eccher: Sure. Sure. I’ll give you some color. The largest net addition to classified were from health care construction and owner-occupied commercial real estate. I would say the construction in the owner-occupied commercial real estate credits are isolated issues pretty well collateralized. The owner-occupied one is SBA backed 55% loan to value or we don’t see a loss there, obviously. And then the construction-related project is backed by some sponsors that have just decided to abort the project. It’s a mixed-use multifamily retail. We – there’s substantial equity behind us on this. Again, we think these properties are in the process of being sold. It’s just taking a little bit longer. The two health care credits, both are just struggling from a cash flow perspective as they’re dealing with the aftermaths of COVID, higher labor cost and just weaker occupancy.

Surprisingly, we’ve got refreshed appraisals for loan to values in both of those properties, and we’re talking about appraisals within the last few months, are still hanging in there, one at sub-50% and one about 65%. So there’s going to be longer-term workouts and really probably going to be a situation where we’re going to have to go back to the sponsors and ask for more equity to rightsize the transactions. That answer your questions, Jeff?

Jeff Rulis: Yes. No, that’s – Jim, appreciate the color. I mean I – trying to true that up with kind of your thoughts on overall credit. It sounds like while kind of frustrated by the pace in some of these. But the positioning and loss content, you feel pretty good about. So I appreciate the color. Maybe just one other question on the – just on security sales. Do you think you’ve got similar positioning to do there? Or you’re happy with what happened this quarter and that could be pretty quiet going forward?

Bradley Adams: Yes, we’re going to keep selling. We peaked out at around 35% of the portfolio when rates were 0 being variable just to make sure we were protected in a higher rate world. As we’ve kind of started to slow down on the movement in rates, we have been moving out of that, as we’ve told you about. We’re down to 18% now, a good long-term rate stability type level is probably like 10%. As you know, we don’t have a lot of duration on the asset side of the balance sheet. So typically, a securities portfolio does serve as both a warehouse for liquidity and duration for us, but we couldn’t do that given the kind of asymmetric risk that existed when rates were zero. So we did this. And now we are moving out of it, and we – you should expect us to continue to move out of it.

A couple of things. I mean, one, we would probably have a margin above five right now if we just stood pat and hadn’t done this, and our earnings susbtantially higher. But – we will always be asset sensitive just given what we are, which is the strength of the deposit base, but we can be less so. And that’s what we’re progressing towards, and we’re doing it in such a manner that doesn’t involve paying transaction fees and broker fees and having to fair value various hedge accounting issues. This is the most cost-effective way to step out of it. And I’m grateful that everybody has decided they want to be in variable rate issues over the last 4 months because it has tightened up our execution a great deal.

Jeff Rulis: Okay. Well, appreciate it, Brad. It sounds as if a lot of the legwork has been done and it looks like you got, I guess, if you go 18% to 10%, you get a little bit more. But the securities losses have been narrowing as well. Would that be the expectation as you wind it down, that would become less of a drag on the income statement?

Bradley Adams: I mean what we got to sell is all the rage these days. So we’re doing pretty well.

Jeff Rulis: Okay. Thanks, guys. I’ll step back.

Operator: Thank you. Our next question is coming from Terry McEvoy with Stephens. Your line is live.

Terence McEvoy: Hi, good morning guys.

James Eccher: Good morning, Terry.

Terence McEvoy: Maybe first question. What are you going to do with all the capital you’re building? Brad, you mentioned stock repurchase program, but what are your thoughts on building it to take advantage of any future kind of in-market M&A opportunities?

Bradley Adams: It’s hard to say when something is going to present itself. But what I do know is in this environment, it takes a lot of capital to stomach the marks in order to earn a lot of accretion. I don’t know whether that’s going to show up or not, which is why we need to be ready with the buyback as well. It’s not lost on me that when you raise rates this fast and this far, 99 times out of 100, you enter some sort of form of recession. And I also know that the tangible book value per share effectively serves as some level of a floor in valuation. So I think our investors are well protected by us raising that floor. There’s very little cost to carry excess capital right now, given the alternative funding yields are [$5.5 million].

So on a relative basis, the cost of carrying excess capital is much lower today than it typically is. So all of that just in terms of prudence and protecting against tail risks. Minimizing potential shocks to the stock price, all of that argues to carry more capital than not right now, and that’s what we’re doing. I do recognize that some level is too much. And so we are prepared to step in and return some of it should that condition present itself. I can’t tell you we will be there in the near term, but I can tell you we will be ready to be there in the near term, at least that’s my hope that there is no objection, I can’t imagine there would be. So that’s kind of what my thinking is, Terry, if that makes sense.

Terence McEvoy: And what are your thoughts on the near-term margin outlook? Can new loan yields and some of the balance sheet flexibility you talked about earlier offset just deposit pricing pressure. I did – you called out CD specials and I looked, you’ve got a 4.5% 8-month CD. Tough to keep the margin if that’s your incremental funding cost.

Bradley Adams: Well, we’re doing okay. I mean we’re growing some. It’s just, I’m a bit mystified, right, is that you can’t fight the flows in this business. Money has only a few places to go to. And everybody decided they were a genius of growing deposits when money into the banking system was flowing in at 35% a year. The reality is that nothing to do with execution for almost everybody. And you can fight those flows if you want to, but it will cost you 5.5%. What we’ve tried to do is maintain the balance sheet flexibility to stomach the outflows just like we stomach the inflows, not do anything stupid. And we can make a lot of money just optimizing. So that’s kind of what we’re up to. As far as margin goes, I think last quarter, I said plus or minus 5 basis points.

Maybe I said it, but it was certain – maybe I didn’t. But it was my intention that the plus side of that was more likely. We do still have some benefit to come on the loan repricing side from the last rate hike. If there’s another one, our bias is for a higher margin. If there’s not another one, I would say that we’re probably more like minus 3 basis points. Given what we’re selling on the variable portion and given our current positioning. So stable, plus or minus a few basis points with minus more likely if there’s no further rate hikes, but everything should be pretty much like this.

Terence McEvoy: And maybe one last question, if I could. CRE loan maturities in the fourth quarter and early part of next year, have you gotten ahead of that in terms of what higher rates could do to those borrowers and was that incorporated?

Bradley Adams: We’ve been pulling our hair out, shocking stuff. And you know me, Terry, I don’t have much hair anyway, so…

Terence McEvoy: Understood. Thanks for taking my questions, guys.

James Eccher: Thanks, Terence.

Operator: Thank you. Our next question is coming from Chris McGratty with KBW. Your line is live.

Christopher McGratty: Hey, good morning, Jim and Brad. Some of your peers are restructuring balance sheets for mistakes they made with rates. You guys seemingly don’t have to do that, but you could if you had to prove them. I guess the question more open ended on that and also just max loan to deposit you’re willing to run with given the optimization you talked about.

Bradley Adams: So you’re talking about selling securities that are perfectly mark-to-market in order to buy different securities that are perfectly mark-to-market?

Christopher McGratty: Just – yes, within the bond, but then I know what you say. But – is there any piece of it that you would think about?

Bradley Adams: No. I see absolutely no scenario whereby we would do that. We – 2.7-year duration means we’re in darn good shape. I’m very happy with where we are. And what was the second part…

James Eccher: Yes, I think from a loan-to-deposit standpoint, Chris, I mean I think we could comfortably take this up to 90, 95. I would not expect a whole lot of growth, a whole lot of loan growth for the balance of this year based on kind of where our pipelines are, they’re about 1/3 of what they were a year ago. So we’re really focused on optimization, expense control and credit.

Christopher McGratty: Okay. You talked about margin. I mean, NII, I guess, putting the pieces together around these levels, Brad.

Bradley Adams: Yes. I think so. I think we’ve got a chance of growing it. I mean we’re making a lot of money right now, and that’s kind of what our focus is. I’m a little surprised that expectations for us as pessimistic as they are. But we’re just going to continue to make sure we’re positioned for any tails that are out there and doing the prudent thing on the balance sheet, which is reducing asset sensitivity, while still making a healthy amount of money.

Christopher McGratty: Maybe just the last 2. The BOLI looked a little high. So just comment on that. And then just going back to capital, you get the nonobjection, but what’s the binding – what’s the ratio that keeps you, I guess, prevent you or let you do the buyback? What’s the binding metric?

Bradley Adams: I guess the CET1, which we’re pretty healthy on. It’s – I can’t imagine there would be much of an objection here. I mean we’re in real good shape in almost any way you can evaluate a bank. So things feel pretty good on that front.

Christopher McGratty: Okay, thanks.

Operator: Thank you. Our next question is coming from Nathan Race with Piper Sandler. Your line is live.

Nathan Race: Thank you, all. Hey, guys, good morning.

James Eccher: Good morning.

Nathan Race: Going back to Chris’ question just on terms of growing NII at least near term. What does that contemplate in terms of kind of deposit balances from here in the overall size of the sheet. It sounds like, Brad, maybe there’s an opportunity to continue to reduce wholesale funding, which would support that outlook. But kind of curious to kind of hear some of the underlying balance sheet drivers to get there.

Bradley Adams: Optimization, right? So a smaller bond portfolio that can add their manifest through smaller overnight borrowings. But what we tried to do during 2021, when everybody was convinced inflation was transitory as we try to stagger maturities such that we get back a healthy amount of money relatively quickly. Should the situation we find ourselves in today, present itself, which it obviously has. Over the next 12 months, we have several hundred million dollars – well, we got a couple of hundred million dollars anyway of treasury securities that are yielding sub-70 basis points to us that it will be coming back to us. And again, that can either manifest through smaller overnight borrowings, earning a 400 basis point spread improvement or it can manifest through loans, earning 700 basis point spread improvement.

We just have money coming in at the appropriate time in order to reposition and optimize the earning asset mix, which is what we’ve been talking about for the last year. It’s tough, right? You try and tell people that you’re in a good position in terms of what maturities you’ve got rolling off win, but we’ve done a nice job. And we’ve got ample opportunities to continue to optimize the earning asset mix coming at us over the next 12 months.

Nathan Race: Okay. Got it. And just going back to credit and the charge-offs in the quarter. It sounds like these were the office CRE loans that you guys flagged, I think, back in April coming out of 1Q earnings tied to West Suburban. And it also seems like there’s still some chunky nonperformers that are tied to that acquisition. Can you just remind us kind of what fair value marks of purchase accounting, you’re holding against those loans and just kind of how you’re thinking about loss content potentially going forward as those credits are resolved going forward?

James Eccher: So both of the properties that we took the charges on were, in fact, office loans. One, both downtown Chicago that had just been struggling as a result of COVID. And again, we’re positioning those for sale or no sale. With regards to the nonaccruals, yes, they’re chunky. And like I mentioned before, a fair amount of them are our participations that were not leading. So we’re working with the lead bank to find an equitable resolution there. As far as the purchase of accounting marks, I’ll let Brad talk about that.

Bradley Adams: So the purchase accounting is a little different than it used to be, right? And what we tried to do is rebuild the provision as the credit marks accrete and we – I think you can see that, that’s occurred. We do have substantial allocations to anything that we are concerned about. So that’s why earnings streams really shouldn’t be interrupted in terms of what falls to the bottom line as we work out of these credits. I think that what I’d like investors to know is that the acquisition that we’ve done has been an absolute home run for our investors. It was both well timed and well executed. But no acquisition is perfect. And certainly, the weakness within the last one was on the asset generation side and they basically purchased syndicated loans within that deal.

And we’ve – we told you from the very beginning that we were going to work out of those, and we’ve cut the syndications from that deal in half at this point, and we’ll continue to move it down. What we’ve seen so far in terms of weakness in downgrades, and we are downgrading realistically even without loss content is that the bulk of our problems, the overwhelming majority of our problems are poorly rated credits do come from acquisitions. Old Second originated portfolio remains very strong. So we’ll continue to get through this. And what’s helpful is for people to have perspective that not everything is a 100, but even that 90% in terms of acquisition – the execution on an acquisition is still pretty darn good.

Nathan Race: Understood. And it sounds like kind of the near-term loan growth outlook is pretty modest at least near term. So just curious how you guys are thinking about the reserve trajectory from here? You guys still sit at a pretty healthy level compared to a lot of your peers. And it does sound like there’s additional material charge-offs moving on the horizon from what we can see today. So just any thoughts on just how the reserve trends going forward?

Bradley Adams: I think we’ll probably take one more charge-off, but it’s largely allocated for. And then we’ll probably do what we’ve been doing, which is protect against the tail risk of a potential recession and just kind of hold it where it is, maybe bleed it up just a tiny bit. But I don’t see a lot to be worried about at this point.

Nathan Race: Okay, great. And if I could just ask one more on expenses. I think you mentioned 22% to 23% in terms of comp near term. Does that kind of translate to kind of flattish expenses in the fourth quarter? And just get any overall thoughts on how you figure that out?

Bradley Adams: And that reminds me too, that is the case, flattish kind of in the fourth quarter, maybe a little bit of improvement. Chris, I forgot to answer your question about the BOLI. I’m sorry, I’m below par today. We restructured the BOLI from an absolute ridiculously awful asset to a slightly better asset in terms of what we did with that, and that is both the portfolio that we acquired from previous acquisitions and our existing. So what you’re seeing this quarter is at run rate it’s still awful and we’ll never buy any ever again. But it is at run rate.

Nathan Race: I’m sorry. So BOLI should stay around the 3Q level. Is that what you’re suggesting, Brad?

Bradley Adams: Yes. That’s correct. I apologize for failing to answer that earlier.

Nathan Race: No problem. And then just any thoughts on kind of overall expenses. I know it’s early in the process and thinking about 2024 expenses, but any high-level thoughts on your…

Bradley Adams: Right now, I’m open for 3% to 4%, right? We still have to make sure that our employees are treated well, given how much more expensive a gallon of milk and a pound of bacon is. And we want people to be happy to work here. So we do have some inflationary headwinds that we do have to be mindful of. But what we did do as our margin was rocketing higher as any deferred maintenance and buying a whole bunch of new computers and repaving parking lots and all that stuff. We’ve got that in our rearview mirror. So we don’t have a lot of CapEx ahead of us.

Nathan Race: And is that 3% to 4% outlook, did that contemplate any opportunities to hire on the RM side of things to make sure there’s been opportunities – materialize on that front these days.

Bradley Adams: Yes, we’re always looking to get better.

Nathan Race: Okay, great. I appreciate all the color.

Operator: Thank you. Our next question is coming from David Long with Raymond James. Your line is live.

David Long: Good morning, guys.

James Eccher: Good morning, Dave.

David Long: On the loan growth expectations, obviously, benign here, but just want to see if you can break it down between how much is based on Old Second’s appetite versus demand in the marketplace?

James Eccher: Well, first, David, I would say overall loan demand is pretty muted right now. We’re seeing a lot of borrowers just pull back on CapEx and kind of expansion. We’re still seeing a decent amount of deal flow in our sponsored finance group and some of our leasing verticals. Beyond that, C&I and commercial real estate is largely dormant. We’re still looking at opportunities, but the risk-adjusted returns on what we’re seeing today just don’t make a lot of sense when you look at really where we have to fund it at the margin. So we’ll be very selective. I think with what we have in our pipeline will probably keep up with the runoff and paydowns, but low single-digit growth is probably what we’re looking at over the near and long term.

David Long: Got it. Okay. And then a follow-up question. When you look at the securities portfolio, obviously, running off, and you guys have – I’ve said it before, you have done one of the best jobs in managing that portfolio through the pandemic. But when you look at using that as a liquidity base, how low is a percentage of earning assets do you see that getting at this point?

Bradley Adams: It can go from – I think it’s what it’s like 20 right now, can go to 15, yes.

David Long: Yes, got it. Okay, that’s all I had. Thanks, guys. Appreciate it.

James Eccher: Thank you, Dave.

Operator: Thank you. [Operator Instructions] Our next question is coming from Brian Martin with Janney. Your line is live.

Brian Martin: Hey guys, good morning.

James Eccher: Hey, Brian.

Bradley Adams: Good morning, Brian.

Brian Martin: Hey, Brad, just you talked last quarter, I think, maybe before that, if we did see – going to their comment about the pessimism on people’s outlook, I mean, I guess, as far as the margin goes, I think you talked about if rates went lower, the margin could kind of bottom in that 4 to 4.25 range. I mean I guess, if we don’t see – if we are higher for longer, we don’t see these cuts. I mean is that margin bottom kind of occurring here in the next quarter, and it’s in the – you kind of hold the 450 type of level. Is that kind of more realistic than if we don’t see the rate cuts?

Bradley Adams: Yes. We don’t see any rate cuts. We’ll – we are a 450-plus margin bank. If there are no rate cuts from here. If there are 100 basis points in rate cuts, you’d probably see us at that 4 to 4.25. If there’s 200 basis points in rate cuts, you probably see is the 3.75 to 4. There’s – I’ve tried to give – the candor is that when you look like Old Second, which is a retail quality deposit base, you’re inherently volatile to interest rates. And I’m not smart enough to try and hedge that. I don’t think you can anyway. So I’m perfectly willing to accept that we make a lot of money when rates aren’t 0, and we make less money when rates are 0. But I don’t think we’re going back to 0 anytime soon.

I think it’s been an absolute disaster of a strategy with all kinds of ills. But even if they are 0, we’re still a 1% ROA bank. So do the right thing, protect against tails, except when you – be willing to accept when you make a lot of money and be willing to make – accept when you make just a normal amount of money, and that’s what we do.

Brian Martin: Yes. Okay. I appreciate that. And then just going back to those credits, the new ones that came on board this quarter, the 3 that were classified, it sounded like the loss content just in general, is pretty low for all 3 of those. Is that kind of what the message is with…

James Eccher: That’s how we see now, Brian, we’ve refreshed appraisals. We’ve got workout strategies in place. Right now, we just don’t see any major losses given the fault here. And then I didn’t say it on the prior list of questions, but all of these new classified are still paying, and they still have sponsors behind it that are supporting the credits, but we just felt the overall cash flow was weak enough and necessitated downgrade.

Brian Martin: Okay. And the charge-off that Brad talked about potentially still coming debt from a previous credit that was already identical.

Bradley Adams: Yes, that’s the same stuff we’ve been talking about since April.

Brian Martin: Okay. Just making clear on that. And then the portfolio, you mentioned the participation portfolio where some of these credits have come from. Can you size up where that’s at today?

Bradley Adams: $250 million to $300 million.

Brian Martin: So the $250 million to $300 million. And how much of that is currently classified today?

Bradley Adams: What 4%, 5%.

James Eccher: Yes, I’d say less than that.

Brian Martin: Okay, 4% to 5%. And then just on the – you talked about always wanted to get better, Brad, and I guess are you seeing opportunities, given the weak demand out there currently? I mean it sounds like the ability to hire is what’s going to contribute to improvements in the economy, getting loan engine kind of moving back. I mean, are there opportunities to add talent today? Or is it a struggle to find talent today?

James Eccher: We’ve continued to add some one-off relationship managers even this year, we budget for it every year. And we still – we’ve had some success even this quarter. So we’ll continue to look for those opportunities in the ‘24.

Bradley Adams: The best time to grow is when everybody else gets scared. So that’s kind of what our viewpoint is.

Brian Martin: Yep. Okay. All right. Well, thank you for taking the questions, guys.

James Eccher: All right. Thanks, Brian.

Operator: We have reached the end of our question-and-answer session. So I will now turn the call back over to Mr. Eccher for his closing remarks.

James Eccher: Okay. Thank you for joining us today. We appreciate your interest in the company, and we look forward to speaking with you next quarter. Goodbye.

Operator: Thank you. This concludes today’s conference, and you may disconnect your lines at this time, and we thank you for your participation.