Old Second Bancorp, Inc. (NASDAQ:OSBC) Q4 2023 Earnings Call Transcript

Old Second Bancorp, Inc. (NASDAQ:OSBC) Q4 2023 Earnings Call Transcript January 28, 2024

Old Second Bancorp, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc. Fourth Quarter 2023 Earnings Call. On the call today are Jim Eccher, the company’s Chairman, President and CEO; Brad Adams, the company’s COO and CFO; 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 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 also be discussing certain non-GAAP financial measures. These non-GAAP measures are described and reconciled to their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com on homepage and under the Investor Relations tab. Now, I will turn the floor over to Jim Eccher. The floor is yours.

Jim Eccher: Good morning, and thank you for joining us. I have several prepared opening remarks and give my overview of the quarter and then 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 for questions. Net income was $18.2 million or $0.40 per diluted share in the fourth quarter of 2023. Adjusted net income was $19.1 million or $0.42 per diluted share in the fourth quarter. On the same adjusted basis, return on assets was 1.33%. There was also an additional $0.02 impact from the fair value of mortgage servicing rights in the fourth quarter. Fourth quarter 2023 adjusted return on average tangible common equity was 17.21% and the tax equivalent efficiency ratio was 48.76%.

Fourth quarter 2023 earnings were negatively impacted by $8 million of provision for credit losses and a $1.2 million estimated litigation accrual. The combined after-tax impact of these two items reduced diluted earnings per share by $0.15 in the fourth quarter. Despite these setbacks, profitability at Old Second remains exceptionally strong and balance sheet strengthening continues with our tangible common equity ratio increasing by 86 basis points linked quarter to 8.53%. Our financials continue to be positively impacted by higher market interest rates. Pre-provision net revenues remained stable and exceptionally strong. For the fourth quarter of 2023 compared to the prior year like period, income on earning assets increased $6 million or 8.7%, while interest expense increased $8.8 million.

The increase in both cases is rate driven. However, average balance on other short-term borrowings increased significantly compared to the prior year like period, causing an overall equal increase between rate and volume factors on the liability side. The fourth quarter of 2023 reflected loan growth of $13.4 million from the prior linked period and expanded $173.3 million or 4.5% over the same period last year. Which was in line with our revised expectations for the year following the volatility in banks earlier in the year. Loan prepayments continued to be modest and origination activity remained steady over the last quarter. Activity within our loan committees remain modest relative to prior periods due to both higher interest rates and seasonal impacts.

The net interest margin compressed slightly this quarter, driven by higher funding costs. Loan yields were flat during the quarter with no change from the linked quarter and 55 basis point increase year-over-year. Funding costs increased due to the increases in both rates and balances. The tax equivalent net interest margin was 4.62% for the fourth quarter compared to 4.66% in the third quarter. The net interest margin decreased slightly in the year-over-year quarter due to the impact of rising rates on the cost of funds, which was partially mitigated by growth in interest income driven by the variable portion of the loan and securities portfolio and continuing loan growth in 2023. The loan-to-deposit ratio was 88% at the end of the year compared to 87% after the third quarter and 76% as of 12/31/22.

As we said last quarter, our focus continues to be on balance sheet optimization, and I’ll let Brad talk about that more in a moment. Turning to credit. Fourth quarter represents our hope that to provide an inflection point in our credit trends, Old Second began substantially downgrading large amounts of commercial real estate loans, including office and healthcare at the end of 2021 and accelerating through 2022. Substandard and criticized loans went from approximately $60 million or a little more than 1% of loans at the end of the third quarter in ’21 to a peak of nearly $300 million or over 7% of loans in the first quarter of 2023. In the fourth quarter of 2023, substandard and criticized loans were down to $200 million and the expectation remains for further improvement into 2024.

Encouragingly, our special mention loans are now at their lowest levels in two years. We expect to realize a relatively less costly resolution on a number of nonperformers in the near future and remain hopeful we can recover some of the losses realized in the second half of 2023. The reality is that commercial real estate valuations are heavily dependent upon market level of interest rates as a primary determinative cash flow for a given property. A movement in rates such as we’ve had seeing it substantial enough to significantly impair the equity positions and a large percentage of commercial real estate credits. Additionally, the residual stress brought upon by the pandemic and CRE office and healthcare is not abated. The idea that bank portfolios are somehow immune and should not be risk rated for such is improbable.

We believe we are being proactive and realistic in addressing commercial real estate loans facing deterioration from higher interest rates, declining appraisal values and cash flow pressures. We recorded net charge-offs of $15.5 million in the fourth quarter of 2023 compared to $6.6 million of net charge-offs in the third quarter of 2023. The majority of the current period charge-offs were specific to three borrowers within commercial real estate. The charge-offs realized in the fourth quarter relate to the positioning of a Chicago office credit for potential sale and further write-downs on two assisted living facilities in California. All [integrated] (ph) substandard and classified for some time. The latter credits had subpar occupancy and higher labor costs for some time.

However, projected cash flows experienced further stress with the passage of new draconian healthcare minimum wage laws in California that necessitated more aggressive action. One of the two properties saw an updated appraisal decrease by more than 70% from an appraisal performed not that long ago due through the impact of cash flows. The good news is that criticized and classified loans are declining and the remainder of the portfolio remains well behaved. Nonaccrual assets ticked up modestly based largely on expected migration, timing issue in the transfer of two properties into OREO that have been significantly marked based on very recent appraisals. Stress testing at renewal rates has not raised any new red flags for us and the bulk of our loan portfolio has transitioned and is seasoning into a higher rate environment.

Being short duration on the asset side has obviously helped us immensely in terms of interest rate risk management, but has probably put us at the vanguard in terms of commercial real estate stress. This belief is reinforced by the experience that a significant percentage of our substandard loans are acquired secondary participations. My hope and belief based on the weight of the metrics is that Old Second has turned the corner that others are just beginning to approach. Please refer to our additional loan disclosures in our earnings release. The allowance for credit losses on loans decreased to $44.3 million as of 12/31/23 from $51.7 million at September 30, which is 1.1% of total loans as of December 31, 2023, down from 1.3% total ACL to gross loans as of September 30, 2023.

Unemployment and GDP forecast used in future rate loss rate assumptions remained fairly static from last quarter. The change in provision levels largely relates to the 26% reduction in criticized assets since the middle of 2023. I think investors should know that we will be aggressive in addressing weak credits and that we remain confident in the strength of our portfolios. Noninterest income continued to perform well, excluding changes in fair value of mortgage servicing rights and losses on security sales. The decline from the previous quarter was approximately $500,000, driven by the change in cash surrender value of bank-owned life insurance. Pretax losses of $924,000 on security sales in the third quarter of 2023 compared to minimal losses during the fourth quarter from a few calls were offset by a decrease of $1.6 million in the fair value of our mortgage servicing rights.

Expense discipline continues to be strong, and our efficiency ratio continues to be excellent. As we look forward, we are focused on doing more of the same, which is managing liquidity, building capital and also building commercial loan origination capability for the long term. The goal is to obviously 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. With that, I will now turn it over to Brad for more color.

Brad Adams: Thank you, Jim. Net interest income decreased by $1.8 million to $61.2 million for the quarter, relative to the prior quarter’s $53 million and decreased $2.9 million or 4.5% from the year ago, like quarter. Loan yields were flat in the fourth quarter compared to the third quarter and securities yields increased only slightly. Total yield on interest-earning assets increased 6 basis points over the linked quarter to 555 basis points. This was partially offset by a 24 basis point increase in the cost of interest-bearing deposits and 18 basis point increase to interest-bearing liabilities in aggregate. The end result was a 4 basis point decrease in the tax-equivalent NIM from last quarter to 4.62% which we believe continues to be exceptional margin performance.

I would note that the entirety of our margin give-up up to this point is largely attributed to the sale of variable rate securities. We have gone from some 35% variable rate securities positioning to 19% as we sit here today. Deposit flows this quarter showed signs of stabilization. Deposit pricing in our markets remains exceptionally aggressive relative to the treasury curve and is largely pricing off overnight borrowing levels. Some signs of abatement are beginning to appear, however, with the most aggressive showing shortening of time deposit specials as hopes of a Fed rate cut end. Regardless, marginal spreads remain unattractive at this point and Old Second does not feel the pressure to swell in order to overcome margin pressures. Marginal returns on allocated equity remain poor for outsized growth.

We have made some fairly significant progress in reducing asset sensitivity over the last year, including releasing variable rate securities concentrations, as mentioned. We are beginning to extend duration in the loan portfolio as well. I do believe this most recent move in interest rate futures has gotten ahead of itself, just as it did at this time last year. I don’t really understand the mechanisms and reasoning behind the Fed’s dovish pivot this quarter. A more cynical person might conclude that either the Fed is prioritizing fiscal over monetary policy or the inflation target rate has changed. I’ll let you read about that in somebody else’s newsletter though. As a result, we are somewhat on pause here in terms of further reduction in variable rate asset concentrations.

The loan-to-deposit ratio remains low at 88%, and our ability to source liquidity from the portfolio continues to improve as market rates have allowed us to recoup fair value over the past quarter. The unrealized loss mark on the securities portfolio declined by $36 million in the fourth quarter from $121 million to $84.2 million, which remains high but will be recaptured relatively quickly. The net result is that Old Second should continue to build capital quickly as evidenced by the 86 basis point improvement in the TCE ratio over the linked quarter, which means we have added an astonishing 229 basis points of TCE and $2.63 of tangible book value for the year. As we sit here today, we have approximately $700 million in undrawn borrowing capacity and additional $380 million in unpledged securities.

And short liquidity at the bank is excellent, and the holding company is in a strong position as well. We received non-objection from the Fed in December to resume stock repurchases in 2024. We have been in a capital build mode for the last two years, and I expect that to continue. I believe having capital can result in tremendous merger based earnings per share accretion if further stress is realized in our industry. Capital availability will be the gating factor to this accretion. The capital build strategy will be somewhat aborted, and we would aggressively buy back shares if our valuation processes 12-month forward tangible book value per share of one time. At that time, and absent a significant macro environment change, a buyback would commence.

I’m not opposed to doing so much sooner if our M&A outlook remains soft. For example, buying back today will currently be less than a two-year earn-back absent any improvement in AOCI. I continue to believe we have been proactive and realistic on credit evaluation. You can see from our disclosures that we began rerating CRE exposures as interest rates rose. The risk for maturing credit given the equity cushion deterioration is simply much higher today. To not see that reflected in credit trends broadly is confusing to me. Any cash flow stress, as we have seen from market office demand and wage pressures in health care results in a problem that must be addressed. We are doing so. The good news is that our loan portfolio is seasoning nicely into the current rate environment and risk as we perceive it, is declining rapidly.

I believe this you can see — I believe you can see this in our disclosures. Margin trends from here are projected to be relatively stable this year with benefits from fixed rate loan repricing largely swallowed up by the recent declines in variable rate market indices. For example, I currently expect first quarter margin to decline mid-single-digit basis points with the largest driver of that being the decline in SOFR. I also 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 decreased $397,000 from the previous quarter, mitigated by a $1.2 million onetime estimated litigation expense. I continue to expect quarterly wages and benefits to be between $22 million and $23 million going forward.

Given the revenue performance, employee investment costs have been running high, but we maintain the ability to dial back as conditions warrant. I’d be remiss if I didn’t add that we are not really in the market to chase much growth here. It doesn’t really make sense given the marginal yields available relative to the marginal cost of funding and the costs associated with origination. As such, we remain focused on optimization and efficiency. I believe our results indicate that we are doing a pretty good job of this. We can continue when I believe we can potentially even grow our earnings absent balance sheet growth. At the very least, I believe earnings can be much more resilient and perhaps much better than many people expect from us. With that, I’d like to turn the call back over to Jim.

Jim Eccher: Okay. Thanks, Brad. In closing, we are confident in our balance sheet and the opportunities that are ahead for Old Second. Our focus remains on assessing and monitoring risks within the loan portfolio and optimizing the earning asset mix in order to reduce our overall sensitivity to interest rates. Net interest margin trends are stable and income statement efficiency remains at record levels. The expectations for continuing record efficiency gives me confidence that we are well positioned to deliver another strong year in 2024. I look forward to the opportunity to demonstrate the strength of the franchise we have built. That concludes our prepared comments this morning. So I will turn it over to our moderator to open it up for questions.

Operator: [Operator Instructions] Your first question is coming from Jeff Rulis with DA Davidson. Please post your question. Your line is live.

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Q&A Session

Jeff Rulis: Thanks, good morning. Jim, you mentioned — I wanted to just talk about the workout potential on the non-accruals and OREO. I think you mentioned there’s hopeful of some progress there. Anything kind of lumpier in there if you could look at a basket of those to say, hey, in the first half of this year, we feel like there’s some chunkier credits that could be resolved? Just any color there would be helpful.

Jim Eccher: Yeah, there is some lumpiness in the non-accrual bucket. We did move a couple of office buildings into OREO. So that’s obviously the last stage in migration, which will position those assets for sale. The larger credits are healthcare related. And we’ve had these on our radar for quite some time. We did have a couple of large ones that moved into non-accrual this quarter. Unfortunately, it’s going to be a long slog to work these out as we look towards litigation. Absent that, we did execute a loan sale late in the quarter. We have a potential another loan sale coming up this quarter. So I am confident we’re going to have some positive movement. There’s also a large SNC credit that we’re very optimistic will get upgraded this quarter as it was performing well last quarter. So we’re just waiting on the OCC to give us the green light to upgrade that one.

Jeff Rulis: Got it. I don’t want to put you in a tough spot, but I guess if you’re thinking about NPAs next year at this time, can we think about something half that balance or what — just big picture progress from your end? Where does that balance head?

Jim Eccher: Yeah. I think that’s — obviously the goal is to start aggressively working through these. The litigation process does take some time. But I do feel we’ve got about $130 million in classifieds. I think we can make meaningful improvement in the coming quarters.

Jeff Rulis: Okay. And Brad, I got your comments about reducing asset sensitivity and as well as your Q1 expectation for margin. Could you just kind of give us an update on if and when you don’t sound too convinced to get a wall of rate cuts? I mean, I’m with you. But if we do see a few in the back half of the year, kind of give us an update on rate sensitivity, what that does to the margin? I guess, is a little bit of headwind, but maybe just an update there.

Brad Adams: Yeah. I mean the way I said it, based on our current trends right now, my expectation would be — and again, I don’t really see a pathway for this world scenario, but I’m obligated to follow it to some degree. If we got three rate cuts in 2024, we would probably have a very similar year in terms of bottom line. Kind of that $2 per share type level and margin down some 15 basis points. We’ve got a lot of things that are helping us on the margin. And largely, that stems from how we built the securities portfolio with all the liquidity inflows in 2020 and 2021. Specifically, we’ve got almost $100 million of very low-yielding securities that fully mature this year staggered throughout the year in addition to just cash flow paydowns.

As I indicated, margin give-up we’ve seen at this point has just simply been a structure of reducing asset sensitivity and to give you an idea of what we’ve been doing there. We’ve gone from some all-in earning asset mix of some 65% variable to something more approaching 50% today. And it’s not about lurching at it. There seems to be a popular perception that a bank can and should be a hedge fund and can go from fixed to variable at the flip of a coin. But really, all we’re trying to do here, just as we did in 2021 is just eliminate tails. And it is true that as rates go down, we earn less because of what we are, which is a great retail deposit base, but we still are exceptionally profitable in any reasonable interest rate scenario and I expect well above peers.

So nothing bearish on that front. I think we’ve done a great job with the balance sheet, and our earnings outlook remains very strong.

Jeff Rulis: Okay. Appreciate it. And maybe just one last one is, you brushed up upon the buyback. I guess if you do feel strongly, you’ve turned the corner on credit with a bit of weakness in the stock. You feel and you’re building capital rather quickly. Do you lean into that buyback a little heavier? Just interested in kind of comments there.

Brad Adams: Well, let me first say, I get people’s concern. Credit is not something that we take lightly and neither does the market. It makes sense. Buyback is part of capital management strategy. And I think we’ve been pretty transparent on what we’re trying to do with capital. Just to refresh those that may be new, we typically run between a 7% and 9% TCE ratio, 7% when we just deployed a large amount of capital and 9% when I get scared of my own shadow. We’re approaching the top end of that range right now. But I think it’s less about fear today than it is about the fact that so many balance sheets in our industry are impaired. And the gating factor to M&A is going to be capital availability. Large earnings per share is accretion for those that can stomach the dilution from marks.

And it is a bond math exercise. So there is an idea of carrying capital for the potential of an opportunity like that. However, it is not unlimited and those deals don’t grow on trees. They aren’t easy to source. So we remain realistic in terms of its availability. And to the extent that, that deal doesn’t come to fruition, the capital needs to go back because we’ll be above capital targets very quickly here. Again, the overarching is a return on tangible common equity mindset here at Old Second, and we expect to be in the mid-teens and better. We have been obviously far above that. We expect to continue to be.

Jeff Rulis: Got it. Thank you.

Operator: Your next question is coming from Nathan Race with Piper Sandler. Please post your question, your line is live.

Nathan Race: Yeah. Hi, guys, good morning.

Jim Eccher: Hey, Nathan.

Nathan Race: Just going back to credit and just kind of thinking about the healthcare portfolio specifically. That’s a decent remaining balance of the classified loans. So just curious to what extent you have any other out of footprint, healthcare loans that are maybe more susceptible to the inflationary environment and other factors impacting that space?

Jim Eccher: Yeah. First of all, Nate, I think the healthcare portfolio is diversified throughout the country where we’re seeing the stress, there’s about $42 million classified in that book, $28 million is in the assisted living space where we have a 2% allowance against that, another $14 million in skilled nursing. We’ve got a 10% allowance reserved against that. Where we’re seeing the most paying geographically is in California, where the state of California had the most restrictive gating rules around entrance and occupancy during COVID. What’s also further stressed the portfolio is that they’re all — a lot of our floating rate structures. So the interest rate carry and debt burden has been substantial. So we think we’ve addressed everything. We’ve stress tested all the remaining commercial real estate that’s in health — in office and healthcare that are maturing in 2024, and we think we’ve got everything well reserved for.

Nathan Race: Okay. Great. And I know it’s difficult to predict, but I appreciate that you guys have gotten out in front of a lot of the credit issues that popped up earlier in last year and kind of cleaned things up a little bit here in 4Q. But as you kind of look out over the next year or so, what’s kind of a decent range to expect charge-offs going forward within that context? Just given your guys’ conservatism generally? And just any guideposts around charge-offs as you guys see the world today would be helpful.

Brad Adams: I think in the first half of the year, depending on timing of resolution that you’re likely to see between $3 million and $5 million in charge-offs, which is currently already reserved for. And I don’t see a lot after that. So which is why the — our comments earlier reflected around provision consistent with loan growth. Now, I will say that all of our discussion is kind of ceteris paribus type basis, which is absent changes in econ. I think most bank stock investors are a jittery breed anyway. And I think that we’re always lurching at shadows. I think that we are in a type of macro environment where it could fall either way. It’s been interesting watching the belief that soft landing is a real animal in nature. I don’t really subscribe to that. But absent any changes in macro, that is our current outlook.

Nathan Race: Okay. Great. And then — so I suppose that implies maybe the reserve relative to loans trends down a little bit. Just given those charge-offs expected in the first half of the year largely allocated for. So just any thoughts on kind of where the reserve settles out in the back half of this year, after some of those qualitative adjustments as we spoke to on the macro front.

Brad Adams: Stable to modestly down. But I think that we’re comfortable where we are in that regard. And again, as it relates to a stable economic environment broadly.

Nathan Race: Okay. Got it. And I appreciate your guidance on the salary line for expenses this year. Just any overall thoughts on the run rate and just how you guys are kind of thinking about year-over-year expense growth? And the expenses were really well controlled last year, up 1%, but maybe a low to mid-single-digit trajectory more appropriate to use for 2024.

Brad Adams: I’m hoping to be in that kind of that 3% range, to be honest. We’ve done a really good job of migrating cost saves from the acquisition two years ago and continue to realize synergies there. That has belied some significant investment that both in people and facilities that allows us to step into our next decade here at Old Second and continue to grow into being a Chicago-based bank. Feel very good about what our expense trends look like. We feel very good about what kind of our balance sheet flexibility is and our ability to maintain earnings as well.

Nathan Race: Got you. And just lastly, going back to the discussion around margin, but maybe translating that into kind of NII thoughts for this year. I appreciate that you guys are obviously asset sensitive have less inherent deposit cost leverage as rate cuts occur. But just given kind of maybe a low to mid-single-digit growth outlook in terms of loans, how are you guys kind of thinking about just the NII cadence and just overall year-over-year NOI growth prospects for 2024?

Brad Adams: Pretty stable, to be honest, within that piece. That’s — and that’s just a function of when you’re looking at what potential marginal yields are, marginal spreads to be more specific, they’re very tight. A lot of people are lending kind of in that 7% range, and they’re funding whether they realize it or not in that 5% to 5.5% range. That doesn’t make a ton of sense. We have started to dabble in the 7s on the loan side, but that’s more a function of overall decreasing asset sensitivity because it allows us with cash flows that are coming in to lock in at that rate and just overall migrate down. Just to give you some context, we’ve been basically outside of absolute policy limits in terms of asset sensitivity all the way from the end of ’22 — the middle part ’22.

We have now reduced that such that we are within policy limits from overall asset sensitivity. We’ve made substantial progress, but it is a function of basically remaking the balance sheet and continuing to eliminate tail risk with movements in interest rates. As we spoke last quarter and the quarter before that, we were selling variable instruments hand over fist, and everybody was buying. And obviously, that trade has not worked out well for somebody as variable rates have taken a nose dive. So that opportunity has kind of slowed down a bit. But it can go back the other way quickly as we saw last year. So we’ll continue to be flexible.

Nathan Race: Okay. And just to clarify that kind of flat NII outlook for this year. Does that include two to three rate cuts in the back half of this year?

Brad Adams: It includes three rate cuts spread over the year.

Nathan Race: Okay, great. I’ll step back. Thanks guys.

Operator: Your next question is coming from Terry McEvoy with Stephens. Please post your question. Your line is live.

Terry McEvoy: Hi, thanks. Good morning everyone. You’ve been using loan modifications a bit more than your peers, specifically the term extensions. Can you just talk about 4Q activity and modifications in the portfolio?

Brad Adams: So that’s in the context of the discussion I just had, Terry, where we’ve taken variable rate structures and moved them into fixed rate structures as part of our basically almost 12 to 15 months of strategy of reducing asset sensitivity. So it’s basically taking variable loan portfolios and moving them into fixed. It’s not a function of credit give-up or restructuring in terms of doing that sort of thing at all. That’s not what you’re seeing.

Terry McEvoy: Thanks for clearing that up. I guess just looking at the $137 million of CRE fixed rate loans that mature in the first half of this year, I guess, when is the last time you stress test the portfolio for today’s rate environment? And are there specific reserves against that bucket of loans?

Jim Eccher: Yeah. Terry, we did an analysis on all fixed rate CRE loans that are maturing in 2024 and stress tested all of them and feel that we have no additional reserve needed. I think what’s important to know is we started building reserves pretty significantly, really in the second and third quarter of ’22 and into ’23, when we really started seeing stress in certain portfolios. We hadn’t really used those reserves until really the last two quarters. So despite a little bit of a decline in the reserve levels, we still have a pretty healthy pooled reserve level out there, and the team has done a good job of stress testing what we have coming forward.

Terry McEvoy: And just last one, Brad, I was trying to track when you’d look to repurchase stock. Is it the forward 12-month expectations on where tangible book value is expected to be?

Brad Adams: Yes. So take basically four quarters of earnings. And if we cross below one, we absolutely will be active and aggressive in terms of repurchasing shares. Although as we sit here today, it is less than a two-year earn back on that same basis. And a bank like us with a two-year earn-back is not a bad acquisition. So it’s not something that I’d rule out. And that’s not trying to be flirty I’m just trying to tell people how we think about it. And it’s in relation to an M&A outlook type thing, Terry.

Terry McEvoy: Understood. Thanks a lot.

Operator: [Operator Instructions] Your next question is coming from Brian Martin with Janney. Please post your question. Your line is live.

Brian Martin: Hey, good morning, guys.

Jim Eccher: Hey, Brian. Good morning.

Brian Martin: Hey, Jim, just to clarify, one, the special mention level today, just the total criticized and classified. Can you just run through what those are today? I think you said they were the lowest level, but just want to make sure if you give the classified in the release, I don’t know about the special mention.

Jim Eccher: Yeah. So obviously, criticized or special mention, those are the early warning buckets, right, that all banks focus on with that. Those levels have declined four consecutive quarters and are down 26% just this last quarter and lowest level in two years. So that gives us a little bit of optimism that future migration from there to substandard is going to be a lot lower than it has been the last couple of years. Total classified and substandards are down about $100 million over the last year. So we’re making progress. Obviously, a tough quarter, but we think we’ve done a pretty good job around putting a fence around a lot of these problems moving forward.

Brian Martin: Yeah. Okay. Got it. And then I think just on the M&A outlook, I guess, I know you mentioned that in the context of capital and kind of how you’re looking at the things. I mean is that market soft today? I guess, are you not given the — working through these credit issues, is it less of a focus? Or just how should we think about the M&A opportunities that may be out there in the context of how you’re running the bank today?

Brad Adams: I mean, as always, banks are sold and not bought. So it’s a question of are there willing sellers? I think over the last two months, we’ve seen a pretty large influx of hopium, that short rates are going to fall and that all the sins in terms of duration are going to be forgiven and absolved. I don’t, as you know, necessarily agree with that interest rate outlook. So I think that at least possible that, that will swing back the other direction to some degree. Duration is a tricky thing. As great as it’s been to not have any in terms of interest rate risk management, it does offer kind of an opposite impact when it comes to credit and credit migration. There was an awful lot of people in our industry doing seven and 10-year balloons on commercial real estate from 2020 all the way through 2022.

And that may give some comfort that those loans are fine. And obviously, the cash flow was benefited by that having that locked in low debt service coverage. But given the fact that we didn’t really depart from three and five year balloons, we don’t have that duration cushion that others may have been experiencing.

Brian Martin: Got you. Okay. And then Brad, you talked about the fixed rate — the fixed loans repricing. Can you just remind us how much of that — how much is occurring over the next maybe 12 months? And just what pickup you’re getting on that that fixed rate repricing?

Brad Adams: You’re basically talking between somewhere between $150 million and $200 million depending on some level of prepayments. That is repricing from a 3.5% to 4% range into a 7% to 8% range.

Brian Martin: Okay. And then…

Brad Adams: Based on where SOFR is today.

Brian Martin: Got you. In your commentary, just high level on margin, and I appreciate all that you’ve given me. Kind of last quarter, you kind of talked about where the margin could bottom with x number of rate cuts. Any change in your outlook as far as how much impact it could have on…

Brad Adams: No, that’s broadly structural. It would take a mountain movement to see us fall below 4%. And I’m very comfortable with basically running this balance sheet at a 4% margin, but we are so far from that, that it’s — it gives you a great deal of comfort. It would take a lot more rate cuts than even the most optimistic person who believes the Fed will buttress equity markets to infinity to achieve to get us below 4%.

Brian Martin: Okay. That’s all I had, guys. I appreciate it. Thank you.

Brad Adams: Thank you.

Jim Eccher: Thanks, Brad.

Operator: Your next question is coming from Chris McGratty with KBW. Please post your question, your line is live.

Andrew Leischner: This is Andrew Leischner on for Chris McGratty. I know you mentioned in your opening remarks that deposit pricing has remained aggressive in your markets. Now, how should we think about noninterest-bearing outflows going forward? And when should we expect to see a little more stabilization there?

Brad Adams: I think that the speed of the movement down has slowed considerably. I would expect that to continue. I think that there’s an awful lot of people who thought that the massive amount of deposit inflows into our industry in ’21 and ’22 were somehow because they became great bankers. They elected to plow that money out the curve. And now that rates have reversed, they are forced to compete with fixed income markets for those flows, which is where they should have always been, absent volatility in rate markets in COVID. We don’t feel compelled to compete with that front. But largely, what you’ve seen in terms of noninterest-bearing flows from us is simply a function of earnings credits and needing less balances to offset given fee levels. There’s no real change on economic basis underlying our noninterest-bearing trends at all. As you may or may not know, we are a very granular kind of…

Jim Eccher: Yeah, Andrew, we — our noninterest-bearing balances relative to the entire deposit book has remained around 40%, which is an exceptionally strong position, very sticky. We have not seen a lot of outflows in that area.

Andrew Leischner: Okay. Great. Thank you. I guess on your low to mid-single-digit loan growth guidance, where should we expect the source of that to come from? And what areas are you intentionally pulling back from?

Jim Eccher: The activity within our loan committee remains, as we mentioned on the call, pretty modest, where we’re seeing growth is really in C&I, sponsored finance lease banking primarily. We think in today’s environment, with 3% GDP, probably mid-single-digit outlook is realistic for us.

Andrew Leischner: Okay. And then last one. Sorry, if I missed this on the M&A question. But can you just remind us what your ideal target would look like?

Brad Adams: Trades is significantly less than us. So we’re buying a $1 of earnings for $0.85 or less.

Andrew Leischner: Okay. Thank you. That’s all I got.

Operator: Your next question is coming from Kevin Roth with Black Maple Capital. Please post your question, your line is live.

Kevin Roth: Hey guys. Happy New Year to you. With regard to the two assisted living facilities in California, you mentioned litigation. Are those — is that litigation is a foreclosure actions or some other type of litigation? Thanks.

Jim Eccher: We’re in very early stages. And that’s obviously an option. But we don’t expect a quick resolution on either one of them. We can’t — at this point, we can’t really speak to the course of action we’re going to take. But they are marked. We took aggressive allocations and charges against them that we’re positioning them for remediation.

Kevin Roth: Got it. Okay. I just wanted a clarification on what — it wasn’t some other type of litigation related to some California laws.

Brad Adams: The litigation estimate that have impacted earnings this quarter relates to consumer overdraft and specifically relates to disclosures that were in our account disclosure booklets between three and seven years ago.

Kevin Roth: Okay. Got it. All right. Thank you very much.

Operator: There are no additional questions in queue at this time. I would now like to turn the floor back over to Jim Eccher for any closing remarks.

Jim Eccher: Okay. Thanks, everyone, for joining us this morning. We look forward to speaking with you again next quarter. Have a great day. Thanks. Bye now.

Operator: Thank you. This does conclude today’s conference call. You may disconnect your phone lines at this time, and have a wonderful day. Thank you for your participation.