UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2006
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For transition period from                  to                

 

Commission File Number 0 -10537

 

OLD SECOND BANCORP, INC.

(Exact name of Registrant as specified in its charter)

 

Delaware	36-3143493
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

 

37 South River Street, Aurora, Illinois        60507

(Address of principal executive offices)  (Zip Code)

(630) 892-0202

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x    No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o                 Accelerated filer x                 Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).     Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: As of May 1, 2006, the Registrant had outstanding 13,559,075 shares of common stock, $1.00 par value per share.

OLD SECOND BANCORP, INC.

Form 10-Q Quarterly Report

Table of Contents

PART I
Item 1.		Financial Statements
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.		Quantitative and Qualitative Disclosures about Market Risk
Item 4.		Controls and Procedures
PART II
Item 1.		Legal Proceedings
Item 1.A.		Risk factors
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.		Defaults Upon Senior Securities
Item 4.		Submission of Matters to a Vote of Security Holders
Item 5.		Other Information
Item 6.		Exhibits
		Signatures

 

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

 

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share data)

 

		March 31,			December 31,
		2006			2005
Assets
Cash and due from banks		$	46,116		$	65,010
Interest bearing deposits with banks		115			105
Cash and cash equivalents		46,231			65,115
Securities available for sale		454,345			470,379
Federal Home Loan Bank and Federal Reserve Bank Stock		8,806			8,470
Loans held for sale		10,817			11,397
Loans		1,739,046			1,704,382
Allowance for loan losses		15,891			15,329
Net loans		1,723,155			1,689,053
Premises and equipment, net		43,368			42,485
Other real estate owned		251			251
Mortgage servicing rights, net		2,458			2,271
Goodwill, net		2,130			2,130
Core deposit intangible assets, net		266			355
Bank owned life insurance		42,099			41,627
Accrued interest and other assets		30,473			34,297
Total assets		$	2,364,399		$	2,367,830
Liabilities
Deposits:
Demand		$	249,324		$	264,124
Savings, NOW, and money market		769,821			795,028
Time		985,334			876,126
Total deposits		2,004,479			1,935,278
Securities sold under repurchase agreements		45,180			57,625
Other short-term borrowings		105,433			171,825
Junior subordinated debentures		31,625			31,625
Note payable		3,200			3,200
Accrued interest and other liabilities		17,800			16,015
Total liabilities		2,207,717			2,215,568
Stockholders’ Equity
Preferred stock, no par value; authorized 300,000 shares; none issued		—			—
Common stock, $1.00 par value; authorized 20,000,000 shares; issued 16,631,303 in 2006 and 16,592,301 in 2005; outstanding 13,559,075 in 2006 and 13,520,073 in 2005		16,631			16,592
Additional paid-in capital		14,605			13,746
Retained earnings		181,167			176,824
Accumulated other comprehensive loss		(5,383		)	(4,562		)
Treasury stock, at cost, 3,072,228 shares in 2006 and 2005		(50,338		)	(50,338		)
Total stockholders’ equity		156,682			152,262
Total liabilities and stockholders’ equity		$	2,364,399		$	2,367,830

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Income

(In thousands, except share data)

 

		(unaudited)
		Three Months Ended
		March 31,
		2006			2005
Interest and Dividend Income
Loans, including fees		$	28,977		$	23,014
Loans held for sale		95			173
Securities:
Taxable		3,184			2,750
Tax-exempt		1,232			1,124
Federal funds sold		3			—
Interest bearing deposits with banks		1			—
Total interest and dividend income		33,492			27,061
Interest Expense
Savings, NOW, and money market deposits		3,678			2,279
Time deposits		9,129			5,690
Repurchase agreements		487			211
Other short-term borrowings		1,402			609
Junior subordinated debentures		617			617
Note payable		44			23
Total interest expense		15,357			9,429
Net interest income		18,135			17,632
Provision for loan losses		444			(37		)
Net interest income after provision for loan losses		17,691			17,669
Noninterest Income
Trust income		1,734			1,649
Service charges on deposits		1,956			1,800
Gain on sale of loans		971			1,378
Secondary mortgage fees		153			184
Mortgage servicing income		98			16
Securities gains (losses), net		227			(4		)
Bank owned life insurance		472			219
Other income		1,464			1,230
Total noninterest income		7,075			6,472
Noninterest Expense
Salaries and employee benefits		9,531			9,120
Occupancy expense, net		1,092			611
Furniture and equipment expense		1,282			1,266
Amortization of core deposit intangible assets		89			89
Advertising expense		464			380
Other expense		3,690			3,533
Total noninterest expense		16,148			14,999
Income before income taxes		8,618			9,142
Provision for income taxes		2,513			2,953
Net income		$	6,105		$	6,189
Share and per share information:
Ending number of shares		13,559,075			13,496,111
Average number of shares		13,529,648			13,452,126
Diluted average number of shares		13,708,648			13,594,802
Basic earnings per share		$	0.45		$	0.46
Diluted earnings per share		$	0.45		$	0.46
Dividends paid per share		$	0.13		$	0.12

 

See accompanying notes to consolidated financial statements.

4

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Three Months Ended March 31, 2006 and 2005

(In thousands)

 

		(Unaudited)			(Unaudited)
		2006			2005
Cash flows from operating activities
Net income		$	6,105		$	6,189
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		908			818
Amortization of mortgage servicing rights		98			8
Provision for loan losses		444			(37		)
Origination of loans held for sale		(64,985		)	(85,731		)
Proceeds from sale of loans held for sale		65,961			90,629
Gain on sale of loans held for sale		(681		)	(755		)
Increase in cash surrender value of bank owned life insurance		(472		)	(219		)
Change in current income taxes receivable		2,202			2,704
Change in accrued interest receivable and other assets		2,521			(5,238		)
Change in accrued interest payable and other liabilities		1,778			3,956
Net premium amortization on securities		743			1,046
Securities losses (gains), net		(227		)	4
Amortization of core deposit intangible assets		89			89
Tax benefit from stock options exercised		—			398
Net cash provided (used) by operating activities		14,484			13,861
Cash flows from investing activities
Proceeds from matured or called securities available for sale		23,661			24,750
Proceeds from sales of securities held for sale		227			—
Purchases of securities available for sale		(10,090		)	(57,149		)
Purchase of FHLB stock		(336		)	(80		)
Net change in loans		(34,546		)	(81,006		)
Net purchases of premises and equipment		(1,791		)	(2,261		)
Net cash used in investing activities		(22,875		)	(115,746		)
Cash flows from financing activities
Net change in deposits		69,201			37,730
Net change in repurchase agreements		(12,445		)	(7,385		)
Net change in other borrowings		(66,392		)	60,825
Proceeds from exercise of stock options		641			891
Tax benefit from stock options exercised		257			—
Dividends paid		(1,755		)	(1,611		)
Net cash (used in) provided by financing activities		(10,493		)	90,450
Net change in cash and cash equivalents		(18,884		)	(11,435		)
Cash and cash equivalents at beginning of period		65,115			58,662
Cash and cash equivalents at end of period		$	46,231		$	47,227
Supplemental cash flow information
Income taxes paid		$	310		$	—
Interest paid		14,315			9,136

 

See accompanying notes to consolidated financial statements.

5

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

 

Note 1 — Summary of Significant Accounting Policies

The accounting policies followed in the preparation of interim financial statements are consistent with those used in the preparation of annual financial information. The interim financial statements reflect all normal and recurring adjustments, which are necessary, in the opinion of management, for a fair statement of results for the interim period presented. Results for the period ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. These interim financial statements should be read in conjunction with the audited financial statements and notes included in Old Second Bancorp, Inc.’s (the Company) 2005 Form 10-K. Unless otherwise indicated, amounts in the tables contained in the notes are in thousands. Certain items in prior periods have been reclassified to conform to the current presentation.

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

All significant accounting policies are presented in Note A to the consolidated financial statements included in the Company’s annual report on Form 10-K for the year ended December 31, 2005. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.

In November 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP FAS 115-1”). FSP FAS 115-1 was issued to address the steps in determining when an investment is considered impaired, whether the impairment is other-than-temporary, and the measurement of an impairment loss. FSP FAS 115-1 discusses accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain quantitative and qualitative disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP FAS 115-1 clarifies that an investor should recognize an impairment loss when the impairment loss is deemed other-than-temporary, even if the decision to sell has not been made. FSP FAS 115-1 replaces the impairment evaluation guidance set forth in paragraphs 10-18 of Emerging Issues Task Force Issue No. 03-1 (“EITF 03-1”) and amends existing other-than-temporary impairment guidance, including that provided in FASB Statement No. 115, “Accounting for Debt and Equity Securities,” and APB 18, “The Equity Method of Accounting for Investments in Common Stock.” FSP FAS 115-1 is effective for reporting periods beginning after December 15, 2005. In addition to the guidance under FSP FAS 115-1, the disclosure requirements under EITF 03-1 remain in effect. The

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adoption of FSP FAS 115-1 has not had a material impact on the Company’s financial position, results of operations, or liquidity.

In December 2004, the FASB issued Statement 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R is a revision of SFAS No. 123, “Accounting for Stock Based Compensation,” supersedes APB 25 and amends FASB Statement No. 95, “Statement of Cash Flows.” SFAS No. 123R established standards for the accounting for transactions in which an entity (i) exchanges its equity instruments for goods or services or (ii) incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of the equity instruments. SFAS No. 123R eliminates the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the date of the grant. The statement also requires that the benefits of tax deductions in excess of recognized compensation expense be reported as a financing cash flow, rather than as an operating cash flow as required under existing accounting rules. In April 2005, the Securities and Exchange Commission (“SEC”) delayed the required effective date of SFAS No. 123R to the beginning of the first annual period beginning after June 15, 2005. The Company adopted SFAS No. 123R on January 1, 2006 using the modified prospective method. The Company has not restated the financial results for any prior periods. Under the modified prospective method, compensation costs were recognized in the financial statements beginning January 1, 2006 based on the requirements of SFAS No. 123R for all share-based payments granted after that date, and based on the requirements of SFAS No. 123 for all unvested awards granted prior to 2006.

In May 2005, the FASB issued Statement 154 (“SFAS 154”), “Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3.” This Statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date this Statement is issued. The Company had no accounting changes or corrections of errors in the periods being reported.

In February 2006, the FASB issued Statement 155 (“SFAS 155”), “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140.” This Statement is effective for all financial instruments acquired, issued, or subject to a remeasurement event occurring after the beginning of fiscal years beginning after September 15, 2006. Earlier adoption was permitted as of the beginning of 2006, provided an entity has not yet issued financial statements, including financial statements for any interim period, for that fiscal year. The Company did not elect early adoption, and is evaluating the potential impact in future periods.

In March 2006, the FASB issued Statement (“SFAS 156”), “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140.” This Statement is effective as of the beginning of fiscal years beginning after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including interim financial statements, for any period of that fiscal year. The Company did not elect early adoption, and is evaluating the potential impact in future periods.

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Note 2 — Securities

Securities available for sale are summarized as follows:

					Gross			Gross
		Amortized			Unrealized			Unrealized			Fair
		Cost			Gains			Losses			Value
March 31, 2006:
U.S. Treasuries		$	11,012		$	—		$	516		$	10,496
U.S. Government agencies		306,914			10			6,260			300,664
States and political subdivisions		145,701			857			3,373			143,185
		$	463,627		$	867		$	10,149		$	454,345
December 31, 2005:
U.S. Treasuries		$	11,010		$	—		$	273		$	10,737
U.S. Government agencies		318,560			51			4,940			313,671
States and political subdivisions		148,371			932			3,332			145,971
		$	477,941		$	983		$	8,545		$	470,379

 

Note 3 — Loans

Major classifications of loans were as follows:

 

Note 4 — Allowance for Loan Losses

Changes in the allowance for loan losses as of March 31, are summarized as follows:

 

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Note 5 — Mortgage Servicing Rights

Changes in capitalized mortgage servicing rights during the quarter ended March 31, were as follows:

 

Note 6 — Deposits

Major classifications of deposits as of March 31, 2006, and December 31, 2005 were as follows:

 

Note 7 — Other Short Term Borrowings and Note Payable

The following table is a summary of other short term borrowings as of March 31, 2006 and December 31, 2005:

 

The Company enters into sales of securities under agreements to repurchase (repurchase agreements). These repurchase agreements are treated as financings. The dollar amounts of securities underlying the agreements remain in the asset accounts. Securities sold under agreements to repurchase consisted of U.S. government agencies at March 31, 2006 and December 31, 2005, and are held in third party pledge accounts.

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The Company borrowings at the FHLB are limited to the lesser of 35% of total assets or 60% of the book value of certain mortgage loans. In addition, these notes were collateralized by FHLB stock of $7.3 million at December 31, 2005, and $7.7 million as of March 31, 2006. The maturity date of the outstanding FHLB advances as of March 31, 2006, was April 28, 2006.

At March 31, 2006 and December 31, 2005, respectively, the period to date average balance of short-term borrowings totaled $164.7 million at a weighted average rate of 4.7% and $160.6 million at a weighted average rate of 3.5%.

The Company is a Treasury Tax & Loan (TT&L) depository for the Federal Reserve Bank (FRB), and as such, it accepts TT&L deposits. The Company is allowed to hold these deposits for the FRB until they are called. The interest rate is the federal funds rate less 25 basis points. Securities with a face value greater than or equal to the amount borrowed are pledged as a condition of borrowing TT&L deposits. As of March 31, 2006 and December 31, 2005, the TT&L deposits were $814,000 and $2.3 million, respectively.

The Company had a $20 million line of credit available with Marshall & Ilsley under which there was a $3.2 million outstanding balance as of December 31, 2005 and March 31, 2006. A revolving business note dated April 30, 2005 secures the line of credit and is guaranteed by the Company. The note provides that any outstanding principal will bear interest at the Company’s option, at the rate of either 1.00% over the previous month average (Federal Reserve targeted rate) federal funds rate or 0.90% over the adjusted interbank rate with a minimum interest rate of 2.20%. This borrowing is for general corporate purposes, including funding loans held for sale at the Old Second Mortgage Company subsidiary.

Note 8 — Junior Subordinated Debentures

The Company completed the sale of $27.5 million of cumulative trust preferred securities by its unconsolidated subsidiary, Old Second Capital Trust I in June 2003. An additional $4.1 million of cumulative trust preferred securities was sold in the first week of July 2003. The costs associated with the tender offer of the cumulative trust preferred securities are being amortized over 30 years. Cash distributions on the securities are payable quarterly at an annual rate of 7.80% and are included in interest expense in the consolidated financial statements.

Note 9 — Long-Term Incentive Plan

The Long-Term Incentive Plan (the “Incentive Plan”) authorizes the issuance of up to 1,333,000 shares of the Company’s common stock, including the granting of qualified stock options (“Incentive Stock Options”), nonqualified stock options, restricted stock and stock appreciation rights. Stock based awards may be granted to selected directors and officers or employees at the discretion of the board of directors. The Incentive Plan requires the exercise price of any incentive stock option issued to an employee to be at least equal to the fair market value of Company common stock on the date the option is granted. All stock options were granted for a term of ten years. Vesting of stock options granted in 2004 and prior years was accelerated to immediately vest all options as of December 20, 2005. The accelerated vesting eliminated the future compensation expense that the Company would otherwise recognize with respect to these options, in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004) “Share — Based Payment”, (“SFAS No. 123”) issued by the Financial

10

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Accounting Standards Board, effective for reporting periods beginning after January 1, 2006. Options granted in 2005 were immediately vested and restricted stock vests three years from the grant date.

Nonqualified stock options may be granted to directors based upon a formula. These and other awards under the Incentive Plan may be granted subject to a vesting requirement and would become fully vested upon a merger or change in control of the Company. There were no stock options granted in the first quarter of 2006.

A summary of activity in the Incentive Plan and options outstanding is included below:

		Quarter-ended March 31, 2006
							Weighted
				Weighted			Average		Aggregate
				Average			Remaining		Intrinsic
				Exercise			Contractual		Value
		Shares		Price			Life		(In thousands)
Beginning outstanding		655,613		$	21.71
Granted		—		—
Exercised		(39,002	)	15.16
Expired		—		—
Ending outstanding		616,611		$	22.13		83 Months		$	6,795

 

All options were exercisable at the end of the period. The total intrinsic value of options exercised during the first quarter of 2006 and 2005 was $647,000 and $1,476,000, respectively.

The following pro forma information presents net income and earnings per share had the fair value method of SFAS No. 123 been used to measure compensation cost for stock option plans in the first quarter of 2005.

Net income as reported		$	6,189
Pro forma net income		6,056
Basic earnings per share as reported		0.46
Pro forma basic earnings per share		0.45
Diluted earnings per share as reported		0.46
Pro forma diluted earnings per share		0.45

 

Restricted stock was granted beginning December 20, 2005 under the Incentive Plan. These shares are subject to forfeiture until certain restrictions have lapsed including employment for a specific period. The fair value of the restricted stock grant was $640,000 on the date of grant. Compensation expense for restricted shares is recognized on a straight-line basis over the vesting period. Included in the determination of net income as reported for the three-month period ending March 31, 2006 is compensation expense for restricted shares of $51,000, with a related tax benefit is $18,000. As of March 31, 2006, the total compensation cost related to nonvested awards not yet recognized was $551,000. The Company expects to recognize this cost over a remaining period of thirty-three months.

The following table is a summary of restricted stock activity.

				Weighted
				Average
				Grant-Date
		Shares		Fair Value
Nonvested shares at December 31, 2004		—		—
Granted		20,406		$	31.34
Vested		—		—
Forfeited		—		—
Nonvested shares at December 31, 2005		20,406		$	31.34
Granted		—		—
Vested		—		—
Forfeited		—		—
Nonvested shares at March 31, 2006		20,406		$	31.34

 

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Note 10 — Earnings Per Share

Earnings per share is included below as of March 31, (share data not in thousands):

		2006			2005
Basic earnings per share:
Weighted-average common shares outstanding		13,529,648			13,452,126
Net income available to common stockholders		$	6,105		$	6,189
Basic earnings per share		$	0.45		$	0.46
Diluted earnings per share:
Weighted-average common shares outstanding		13,529,648			13,452,126
Dilutive effect of restricted shares		20,406			—
Dilutive effect of stock options		158,594			142,676
Diluted average common shares outstanding		13,708,648			13,594,802
Net income available to common stockholders		$	6,105		$	6,189
Diluted earnings per share		$	0.45		$	0.46
Number of antidilutive options excluded from the diluted earnings per share calculation		137,000			137,000
Number of antidilutive restricted shares exclude from the diluted earnings per share calculation		—			—

 

Note 11 — Other Comprehensive Loss

Other comprehensive loss is included below:

		Three Months Ended
		March 31,
		2006			2005
Change in net holding losses on available
for sale securities arising during the period		$	(1,493	)	$	(5,081	)
Related tax benefit		809			2,022
Net unrealized losses		(684		)	(3,059		)
Less: Reclassification adjustment for the net
gains (losses) realized during the period
Realized gains		227			—
Realized losses		—			(4		)
Net realized gains (losses)		227			(4		)
Income tax benefit (expense) on net realized gains		(90		)	2
Net realized gains (losses) after tax		137			(2		)
Total other comprehensive loss		$	(821	)	$	(3,057	)

 

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Note 12 — Retirement Plans

The Company has a tax-qualified noncontributory defined benefit retirement plan covering substantially all full-time and regular part-time employees of the Company. Generally, benefits are based on years of service and compensation. Certain participants in the defined benefit plan are also covered by an unfunded supplemental retirement plan. The purpose of the supplemental retirement plan is to extend full retirement benefits to individuals without regard to statutory limitations under tax-qualified plans.

As of December 31, 2005, the defined benefit and supplemental retirement plans were terminated. Prior to December 31, 2005 all amounts due were paid to participants of the supplemental executive retirement plan (“SERP”). Following receipt of all regulatory approvals, all accrued benefits will be distributed to the participants of the defined benefit plan either in one lump sum payment or by the purchase of an annuity contract. The liabilities are expected to exceed assets at the time of distribution of all benefits by approximately $1,000,000. A contribution of the shortfall amount is required to be made before the defined benefit plan is liquidated, which is anticipated to be in the third quarter of 2006.

		Three Months Ended March 31,
		Pension Benefits						SERP
		2006			2005			2005
Service cost		$	—		$	425		$	19
Interest cost		181			233			23
Expected return on plan assets		(178		)	(217		)	—
Amortization of transition obligation / (asset)		—			—			—
Amortization of prior service cost		—			(1		)	4
Recognized net actuarial (gain) / loss		—			71			15
Net periodic benefit cost		$	3		$	511		$	61
Key Assumptions:
Discount rate		5.25		%	5.50		%	5.50		%
Long-term rate of return on assets		5.00		%	7.50		%	7.50		%
Salary increases		0.00		%	5.00		%	5.00		%

 

The Company maintains tax-qualified contributory and non-contributory profit sharing plans covering substantially all full-time and regular part-time employees. The expense of these plans was $595,000 and $400,000 in the first quarters of 2006 and 2005, respectively.

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

Overview

Old Second Bancorp, Inc. (the “Company”) is a financial services company with its main headquarters located in Aurora, Illinois. The Company has offices located in Kane, Kendall, DeKalb, DuPage, LaSalle, and Will counties in Illinois. The Company provides financial services through its three subsidiary banks at its twenty-eight banking locations. Old Second Mortgage, which also conducts business as “Maple Park Mortgage”, provides mortgage-banking services at its three offices. Old Second Financial, Inc. provides insurance products. The Old Second National Bank of Aurora, the Company’s lead subsidiary bank, also engages in trust operations.

Results of Operations

Net income for the first quarter of 2006 was $6.11 million, or $0.45 diluted earnings per share, compared with $6.19 million, or $0.46 diluted earnings per share in the first quarter of 2005. A $444,000 provision for loan losses and a decline in the net interest margin were the primary factors in the decline. The return on equity decreased from 18.20% in the first three months of 2005, to 15.92% for the same period of 2006.

In comparing the first quarters of 2006 and 2005, there were several nonrecurring items that had an impact on earnings. In the first quarter of 2005, there was a reduction of $250,000 in the estimated accrual for real estate taxes, or one cent per share after income taxes. In the first quarter of 2006, an income tax adjustment of $175,000 and a securities gain of $227,000, added a combined two cents per share after income taxes.

Net Interest Income

Net interest income increased $503,000, or 2.9%, to $18.14 million in the first quarter of 2006, compared with $17.63 million in the first quarter of 2005. The increase resulted from higher average earning assets, partially offset by a lower net interest margin. Average earning assets grew 8.45%, while the net interest margin declined from 3.67% in the first quarter of 2005 to 3.49% in the first quarter of 2006. During the quarter ended March 31, 2006, there was an increased pressure on the Company’s net interest margin because of market-driven pressure to increase the rates paid on deposits and decrease the yield received on loans. Additionally, the change in funding mix from lower-cost deposits to certificates of deposit also negatively impacted the Company’s net interest margin. The average tax-equivalent yield on earning assets increased from 5.57% to 6.34%, or 77 basis points. At the same time, the cost of interest-bearing and noninterest-bearing funds increased from 1.92% to 2.86%, or 94 basis points. A significant increase in certificates of deposit contributed to the increased cost of funds.

Management, in order to evaluate and measure performance, uses certain non-GAAP performance measures and ratios. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures and ratios provide users of the financial information with a more accurate view of the performance of the interest-earning assets and interest-bearing liabilities and of the Company’s operating efficiency for comparison purposes. Other financial holding companies may define or calculate these measures and ratios differently. See the table below for supplemental data and the corresponding reconciliation to GAAP financial measures for the three months ended March 31, 2006 and 2005.

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The following table sets forth certain information relating to the Company’s average consolidated balance sheets and reflects the yield on average earning assets and cost of average liabilities for the periods indicated. The rates are determined by dividing the related interest by the average balance of assets or liabilities. Average balances are derived from daily balances.

ANALYSIS OF AVERAGE BALANCES,

TAX EQUIVALENT INTEREST AND RATES

Quarters ended March 31, 2006 and 2005

(Dollar amounts in thousands — unaudited)

		2006								2005
		Average								Average
		Balance			Interest			Rate		Balance			Interest			Rate
Assets
Interest bearing deposits with banks		$	1,411		$	1		0.29	%	$	890		$	—		—	%
Federal funds sold		267			3			4.56		—			—			—
Securities:
Taxable		332,004			3,184			3.89		329,272			2,750			3.39
Non-taxable (tax equivalent)		140,375			1,895			5.47		129,053			1,729			5.43
Total securities		472,379			5,079			4.36		458,325			4,479			3.96
Loans and loans held for sale		1,715,854			29,129			6.88		1,560,042			23,234			6.04
Total interest earning assets		2,189,911			34,212			6.34		2,019,257			27,713			5.57
Cash and due from banks		51,619			—			—		54,077			—			—
Allowance for loan losses		(15,617		)	—			—		(15,471		)	—			—
Other noninterest-bearing assets		119,026			—			—		84,591			—			—
Total assets		$	2,344,939							$	2,142,454
Liabilities and Stockholders’ Equity
Interest bearing transaction accounts		$	654,556		3,541			2.19		$	662,322		2,167			1.33
Savings accounts		118,792			137			0.47		124,718			112			0.36
Time deposits		952,228			9,129			3.89		799,521			5,690			2.89
Interest bearing deposits		1,725,576			12,807			3.01		1,586,561			7,969			2.04
Repurchase agreements		51,376			487			3.84		39,639			211			2.16
Other short-term borrowings		113,373			1,402			5.02		85,250			609			2.90
Junior subordinated debentures		31,625			617			7.80		31,625			617			7.80
Note payable		3,200			44			5.58		2,700			23			3.45
Total interest bearing liabilities		1,925,150			15,357			3.24		1,745,775			9,429			2.19
Noninterest bearing deposits		250,135			—			—		244,364			—			—
Accrued interest and other liabilities		14,177			—			—		14,417			—			—
Stockholders’ equity		155,477			—			—		137,898			—			—
Total liabilities and stockholders’ equity		$	2,344,939							$	2,142,454
Net interest income (tax equivalent)					$	18,855							$	18,284
Net interest income (tax equivalent)
to total earning assets								3.49	%							3.67	%
Interest bearing liabilities to earning assets		87.91		%						86.46		%

 

Notes: Nonaccrual loans are included in the above stated average balances. Tax equivalent basis is calculated using a marginal tax rate of 35%. Loan fees, included in interest on loans and loans held for sale, were $705,000 and $964,000 in the first quarter of 2005 and 2006, respectively.

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Yields on certain asset categories and the net interest margin of the Company and its banking subsidiaries are reviewed on a fully taxable-equivalent basis (“FTE”). In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measure ensures comparability of net interest income arising from both taxable and tax-exempt sources.

 

Provision for Loan Losses

After releasing $37,000 from the allowance for loan losses in the first quarter of 2005, the Company provided an additional $444,000 to the allowance for loan losses in 2006. Provisions for loan losses are made to provide for probable and estimable losses inherent in the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the amount of past due accruing loans (90 days or more), the amount of non-accrual loans and management’s overall view on current credit quality. The increased size of the portfolio, reflecting growth of $34.7 million during the quarter, was a principal factor in evaluating the provision for loan losses. Net charge-offs were $44,000 in the first quarter of 2005 and net recoveries were $118,000 in the first quarter of 2006.

The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated statement of condition.

One measure of the adequacy of the allowance for loan losses is the ratio of the allowance to total loans. The allowance for loan losses as a percentage of total loans was 0.91% as of March 31, 2006, compared to 0.90% as of December 31, 2005 and 0.97% as of March 31, 2005. In management’s judgment, an adequate allowance for estimated losses has been established; however, there can be no assurance that such losses will not exceed the estimated amounts in the future.

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Nonperforming loans were $7.0 million as of March 31, 2006, and $6.5 million as of March 31, 2005. The ratio of the allowance for loan losses to nonperforming loans was 227% as of March 31, 2006, compared with 237% as of March 31, 2005. Nonperforming loans include loans in nonaccrual status, renegotiated loans, and loans past due ninety days or more and still accruing. Nonaccrual loans remained steady, at $3.8 million as of December 31, 2005 and March 31, 2006.

Past due and nonaccrual loans for the periods ended March 31, 2006 and December 31, 2005 were as follows:

 

Noninterest Income

Noninterest income was $7.1 million during the first quarter of 2006 and $6.5 million during the first quarter of 2005, an increase of $603,000, or 9.3%. Mortgage banking income, including gains on sales of mortgage loans, secondary market fees, and servicing income, was $1.2 million, down $356,000 from the first quarter of 2005. This decline was primarily associated with an increase in interest rates, which reduced volume of mortgage loans originated for sale. All other noninterest income categories increased. Securities gains were $227,000 in the first quarter of 2006, compared with a loss of $4,000 in 2005. Service charges on deposits increased $156,000, or 8.7%, to $1,956,000, which is in line with deposit growth. Service charges on deposits generally reach a seasonal low in the first quarter of the year. Bank owned life insurance (“BOLI”) increased from $219,000 to $472,000 as a result of a $20 million BOLI purchase in the fourth quarter of 2005. Other income increased from $1,230,000 to $1,464,000, or 19.0%, including an increase of $134,000 in ATM and debit card fees.

Noninterest Expense

Noninterest expense was $16.1 million during the first quarter of 2006, an increase of $1.1 million, or 7.7%, from $15.0 million in the first quarter of 2005. Salaries and benefits, the largest component of noninterest expense, was $9.5 million during the first quarter of 2006, an increase of $411,000, or 4.5%, from $9.1 million in the first quarter of 2005. The increase in salaries and benefits was primarily related to increased staffing due to branch expansion, and annual merit increases. As of quarter-end, there were 556 full-time equivalent employees in 2006, as compared with 546 one year earlier.

Net occupancy and furniture and equipment expenses increased $497,000 from the first quarter of 2005 to the first quarter of 2006, or 26.5%. This was due, in part, to a reduction of $250,000 in the estimated accrual for real estate taxes in the first quarter of 2005. As the Company has expanded into and developed new markets, related facility expenses have increased. Three new branches have opened since the beginning of 2005, including the most recent addition in Batavia, Illinois.

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