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, 2007

 

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)

 

 

(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.

 

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 9, 2007, the Registrant had outstanding 13,110,423 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

 

2

PART I - FINANCIAL INFORMATION

Item 1.  Financial Statements

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share data)

 

		(Unaudited)
		March 31,			December 31,
		2007			2006
Assets
Cash and due from banks		$	50,308		$	80,727
Interest bearing deposits with financial institutions		604			5,493
Federal funds sold		1,491			2,305
Cash and cash equivalents		52,403			88,525
Securities available for sale		487,176			472,897
Federal Home Loan Bank and Federal Reserve Bank stock		8,783			8,783
Loans held for sale		8,426			14,378
Loans		1,776,289			1,763,912
Less: allowance for loan losses		16,249			16,193
Net loans		1,760,040			1,747,719
Premises and equipment, net		49,542			48,404
Other real estate owned		—			48
Mortgage servicing rights, net		2,957			2,882
Goodwill, net		2,130			2,130
Bank owned life insurance (BOLI)		46,344			45,861
Accrued interest and other assets		26,230			27,513
Total assets		$	2,444,031		$	2,459,140
Liabilities
Deposits:
Noninterest bearing demand		$	259,349		$	280,630
Interest bearing:
Savings, NOW, and money market		828,102			807,949
Time		978,412			974,114
Total deposits		2,065,863			2,062,693
Securities sold under repurchase agreements		51,704			38,218
Other short-term borrowings		101,702			127,090
Junior subordinated debentures		31,625			31,625
Note payable		14,975			16,425
Accrued interest and other liabilities		15,941			24,534
Total liabilities		2,281,810			2,300,585
Stockholders’ Equity
Preferred stock, $1.00 par value; authorized 300,000 shares; none issued		—			—
Common stock, $1.00 par value; authorized 20,000,000 shares; issued 16,682,651 at March 31, 2007 and 16,634,520 at December 31, 2006; outstanding 13,110,423 at March 31, 2007 and 13,127,292 at December 31, 2006		16,683			16,635
Additional paid-in capital		15,341			14,814
Retained earnings		197,089			193,170
Accumulated other comprehensive loss		(1,498		)	(2,545		)
Treasury stock, at cost, 3,572,228 shares at March 31, 2007 and 3,507,228 at December 31, 2006		(65,394		)	(63,519		)
Total stockholders’ equity		162,221			158,555
Total liabilities and stockholders’ equity		$	2,444,031		$	2,459,140

See accompanying notes to consolidated financial statements.

3

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Income

(In thousands, except share data)

 

		(Unaudited)
		Three Months Ended
		March 31,
		2007			2006
Interest and dividend income
Loans, including fees		$	31,307		$	28,977
Loans held for sale		129			95
Securities:
Taxable		3,895			3,184
Tax-exempt		1,324			1,232
Federal funds sold		58			3
Interest bearing deposits		16			1
Total interest and dividend income		36,729			33,492
Interest expense
Savings, NOW, and money market deposits		5,734			3,678
Time deposits		11,840			9,129
Securities sold under repurchase agreements		553			487
Other short-term borrowings		1,243			1,402
Junior subordinated debentures		617			617
Note payable		263			44
Total interest expense		20,250			15,357
Net interest and dividend income		16,479			18,135
Provision for loan losses		—			444
Net interest and dividend income after provision for loan losses		16,479			17,691
Noninterest income
Trust income		2,176			1,734
Service charges on deposits		2,050			1,956
Secondary mortgage fees		122			153
Mortgage servicing income		148			98
Net gain on sales of mortgage loans		1,098			971
Securities gains, net		482			227
Increase in cash surrender value of bank owned life insurance		483			498
Debit card interchange income		463			419
Other income		952			1,019
Total noninterest income		7,974			7,075
Noninterest expense
Salaries and employee benefits		9,912			9,531
Occupancy expense, net		1,226			1,092
Furniture and equipment expense		1,494			1,282
Amortization of core deposit intangible assets		—			89
Advertising expense		425			464
Other expense		3,528			3,690
Total noninterest expense		16,585			16,148
Income before income taxes		7,868			8,618
Provision for income taxes		2,120			2,513
Net income		$	5,748		$	6,105
Share and per share information:
Ending number of shares		13,110,423			13,559,075
Average number of shares		13,134,897			13,529,648
Diluted average number of shares		13,267,077			13,708,648
Basic earnings per share		$	0.44		$	0.45
Diluted earnings per share		0.43			0.45
Dividends paid per share		0.14			0.13

 

See accompanying notes to consolidated financial statements.

 

4

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(In thousands)

 

		(Unaudited)
		Three Months Ended
		March 31,
		2007			2006
Cash flows from operating activities
Net income		$	5,748		$	6,105
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		1,186			880
Amortization of leasehold improvement		43			28
Amortization and recovery of mortgage servicing rights, net		80			98
Provision for loan losses		—			444
Origination of loans held for sale		(47,097		)	(65,270		)
Proceeds from sale of loans held for sale		53,992			66,536
Gain on sales of loans held for sale		(1,098		)	(971		)
Change in current income taxes payable		2,120			2,202
Increase in cash surrender value of bank owned life insurance		(483		)	(498		)
Change in accrued interest receivable and other assets		(1,520		)	2,547
Change in accrued interest payable and other liabilities		(8,587		)	1,778
Net premium amortization on securities		264			743
Securities gains, net		(482		)	(227		)
Amortization of core deposit intangible assets		—			89
Stock based compensation		156			51
Net cash provided by operating activities		4,322			14,535
Cash flows from investing activities
Proceeds from maturities and pre-refunds including pay down of securities available for sale		33,695			23,661
Proceeds from sales of securities available for sale		560			227
Purchases of securities available for sale		(46,586		)	(10,090		)
Purchases of Federal Home Loan Bank stock		—			(336		)
Net change in loans		(12,321		)	(34,546		)
Net sales of other real estate owned		48			—
Net purchases of premises and equipment		(2,367		)	(1,791		)
Net cash used in investing activities		(26,971		)	(22,875		)
Cash flows from financing activities
Net change in deposits		3,170			69,201
Net change in securities sold under repurchase agreements		13,486			(12,445		)
Net change in other short-term borrowings		(25,388		)	(66,392		)
Proceeds from note payable		2,050			—
Repayment of note payable		(3,500		)	—
Proceeds from exercise of stock options		277			590
Tax benefit from stock options exercised		142			257
Dividends paid		(1,835		)	(1,755		)
Purchase of treasury stock		(1,875		)	—
Net cash used in financing activities		(13,473		)	(10,544		)
Net change in cash and cash equivalents		(36,122		)	(18,884		)
Cash and cash equivalents at beginning of period		88,525			65,115
Cash and cash equivalents at end of period		$	52,403		$	46,231
Supplemental cash flow information
Income taxes paid		$	—		$	310
Interest paid for deposits		17,377			11,957
Interest paid for debt		2,689			2,357
Changes in dividends declared not paid		6			8

 

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 the interim financial statements are consistent with those used in the preparation of the 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, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007.  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”) annual report on Form 10-K for the year ended December 31, 2006.  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, 2006.  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.

Effective January 1, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Statement No. 156, Accounting for Servicing of Financial Assets-an amendment of FASB Statement No. 140.  This Statement provided the following: 1) revised guidance on when a servicing asset and servicing liability should be recognized; 2) requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable; 3) permits an entity to elect to measure servicing assets and servicing liabilities at fair value each reporting date and report changes in fair value in earnings in the period in which the changes occurred; 4) upon initial adoption, permits a onetime reclassification of available-for-sale securities to trading securities for securities which were identified as offsetting the entity’s exposure to changes in the fair value of servicing assets or liabilities that a servicer elected to subsequently measure at fair value; and 5) requires a separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional footnote disclosures.  Management continues to use the amortization method as illustrated in Note 5 and the adoption of this statement had no impact on the consolidated financial position or results of operations.

The Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), as of January 1, 2007.  A tax position is recognized  as  a  benefit only if it is “more likely than not” that the tax  position  would  be  sustained  in  a  tax  examination, with a tax  examination  being  presumed  to  occur.  The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination.  For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.  The adoption had no affect on the Company’s financial statements.

 

6

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The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of the state of Illinois.  The Company is no longer subject to examination by taxing authorities for years before 2003.  The Company does not expect the total amount of unrecognized tax benefits to significantly increase in the next twelve months.

The Company recognizes interest and/or penalties related to income tax matters in income tax expense.  The Company did not have any amounts accrued for interest and penalties at January 1, 2007.

In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-5, Accounting for Purchases of Life Insurance - Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4 (Accounting for Purchases of Life Insurance).  This issue requires that a policyholder consider contractual terms of a life insurance policy in determining the amount that could be realized under the insurance contract.  It also requires that if the contract provides for a greater surrender value if all individual policies in a group are surrendered at the same time, that the surrender value be determined based on the assumption that policies will be surrendered on an individual basis.  Lastly, the issue discusses whether the cash surrender value should be discounted when the policyholder is contractually limited in its ability to surrender a policy.  This issue is effective for fiscal years beginning after December 15, 2006.  The adoption of this issue had no material impact on the financial statements.

In September 2006, the FASB issued Statement No. 157, Fair Value Measurements.  This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  This Statement establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset.  The standard is effective for fiscal years beginning after November 15, 2007.  The Company has not completed its evaluation of the impact of adopting this standard.

In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-4 (“EITF 06-4”), Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.  This issue requires that a liability be recorded during the service period when a split-dollar life insurance agreement continues after participants’ employment or retirement.  The required accrued liability will be based on either the post-employment benefit cost for the continuing life insurance or the future death benefit depending on the contractual terms of the underlying agreement.  This issue is effective for fiscal years beginning after December 15, 2007.  The Company has not completed its evaluation of the impact of adopting EITF 06-4.

On February 15, 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities: Including an amendment of FASB Statement No. 115, to reduce earnings volatility caused by related assets and liabilities measured differently under GAAP.  Statement 159 allows all entities (including not-for-profit organizations, with certain modifications) to make an irrevocable instrument-by-instrument election to measure eligible items at fair value in their entirety.  In addition, unrealized gains and losses will be reported in earnings at each reporting date.  The Statement also establishes presentation and disclosure requirements that focus on providing information about the impact of electing the fair value option (“FVO”).  Note that the Company will be required to adopt Statement 157, Fair Value Measurements, no later than the adoption of Statement 159.  Statement 159 is effective as of January 1, 2008.  Earlier application is permitted for existing eligible items as of the beginning of a fiscal year that begins on or before November 15, 2007, but requires concurrent adoption of Statement 157.  Early adoption must be made no later than 120 days after the beginning of the entity’s fiscal year of adoption and prior to issuance of any financial statements for an interim period where the FVO will be adopted.  The Company has not completed its evaluation of the impact of adoption of this standard and chose not to early adopt Statement 159.

 

7

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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, 2007:
U.S. Treasury		$	10,015		$	—		$	(322	)	$	9,693
U.S. government agencies		258,814			99			(2,144		)	256,769
U.S. government agency mortgage-backed		26,874			84			(158		)	26,800
States and political subdivisions		161,578			949			(929		)	161,598
Collateralized mortgage obligations		32,321			72			(129		)	32,264
Other securities		52			—			—			52
		$	489,654		$	1,204		$	(3,682	)	$	487,176
December 31, 2006:
U.S. Treasury		$	10,014		$	—		$	(384	)	$	9,630
U.S. government agencies		270,439			53			(3,325		)	267,167
U.S. government agency mortgage-backed		19,775			31			(202		)	19,604
States and political subdivisions		149,843			925			(1,126		)	149,642
Collateralized mortgage obligations		26,904			2			(182		)	26,724
Other securities		130			—			—			130
		$	477,105		$	1,011		$	(5,219	)	$	472,897

 

Recognition of other than temporary impairment was not necessary in the first quarter of 2007.  The change in value was related to interest rate fluctuations and was not related to credit quality deterioration.  An increase in rates will generally cause a decrease in the value of individual securities while a decrease in rates typically results in an increase in value.  The Company has the ability and intent to hold all securities until recovery.

Note 3 — Loans

Major classifications of loans were as follows:

 

 

8

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Note 4 — Allowance for Loan Losses

Changes in the allowance for loan losses during the quarter ended March 31 were as follows:

		2007			2006
Balance at beginning of period		$	16,193		$	15,329
Provision for loan losses		—			444
Loans charged-off		(86		)	(46		)
Recoveries		142			164
Balance at end of period		$	16,249		$	15,891

 

Note 5 — Mortgage Servicing Rights

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

		2007			2006
Balance at beginning of period		$	3,032		$	2,271
Additions		155			285
Amortization		(190		)	(98		)
Balance at end of period		2,997			2,458
Changes in the valuation allowance for servicing assets were as follows:
Balance at beginning of period		(150		)	—
Recovery credited to expense		110			—
Balance at end of period		(40		)	—
Net balance		$	2,957		$	2,458

 

Note 6 — Deposits

Major classifications of deposits as of March 31, 2007, and December 31, 2006, were as follows:

		2007			2006
Noninterest bearing		$	259,349		$	280,630
Savings		108,361			104,229
NOW accounts		245,032			257,505
Money market accounts		474,709			446,215
Certificates of deposit of less than $100,000		589,178			591,941
Certificates of deposit of $100,000 or more		389,234			382,173
		$	2,065,863		$	2,062,693

 

Note 7 —Borrowings

The following table is a summary of borrowings as of March 31, 2007, and December 31, 2006:

		2007			2006
Securities sold under repurchase agreements		$	51,704		$	38,218
Federal funds purchased		31,000			54,000
FHLB advances		70,000			70,000
Treasury tax and loan		702			3,090
Junior subordinated debentures		31,625			31,625
Note payable		14,975			16,425
		$	200,006		$	213,358

 

9

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 and mortgage-backed securities at March 31, 2007 and December 31, 2006.

The Company borrowings at the Federal Home Loan Bank (“FHLB”) are limited to the lesser of 35% of total assets or 60% of the book value of certain mortgage loans.  In addition, these advances were collateralized by FHLB stock of $5.5 million and loans totaling $178.5 million at March 31, 2007.  FHLB stock of $5.5 million and loans totaling $170.4 million were pledged as of December 31, 2006.  As of March 31, 2007, a short-term FHLB advance of $40 million that has a floating rate of six basis points above the FHLB federal funds rate was scheduled to mature on April 30, 2007.  This floating rate advance can also be prepaid without fee with two-business days notice.  A new one-month FHLB advance with the same terms replaced the April 30, 2007 advance that matured.  As of March 31, 2007, a fixed-rate FHLB advance of $30 million was scheduled to mature on March 10, 2008.

At March 31, 2007 and December 31, 2006, respectively, the quarter to date average balance of short-term borrowings totaled $92.7 million at a weighted average rate of 5.4% and $100.5 million at a weighted average rate of 2.36%, which included a $961,000 reduction in the estimated accrual for other short-term borrowings.

The Company is a Treasury Tax & Loan (“TT&L”) depository for the Federal Reserve Bank and, as such, it accepts TT&L deposits.  The Company is allowed to hold these deposits for the Federal Reserve 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, 2007, and December 31, 2006, the TT&L deposits were $702,000 and $3.1 million, respectively.

The Company had a $20 million line of credit available with M&I Marshall & Ilsley Bank under which there were outstanding balances of $16.4 million as of December 31, 2006 and $15.0 million as of March 31, 2007.  A revolving business note dated April 30, 2006 secures the line of credit and that note is guaranteed by the Company.  The note provides that any outstanding principal will bear interest at the rate of 0.90 percentage points over the British Bankers Association one month LIBOR rate.  This line matured on April 29, 2007 and was renewed through April 29, 2008.  The line was increased to $30 million at maturity with all other terms substantially unchanged.  This borrowing facility is for general corporate purposes and has primarily been used to repurchase common stock.

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.  The trust-preferred securities can remain outstanding for a 30-year term but, subject to regulatory approval, can be called in whole or in part by the Company after a period of five 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.  The debentures that were issued by Old Second Bancorp, Inc. are recorded on the Consolidated Balance Sheets as junior subordinated debentures.

Note 9— Long-Term Incentive Plan

The Long-Term Incentive Plan (the “Incentive Plan”) authorizes the issuance of up to 1,333,332 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.  Total shares

 

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issuable under the plan were 210,073 at March 31, 2007 and 236,257 at December 31, 2006.  Stock based awards may be granted to selected directors and officers or employees at the discretion of the board of directors.  All stock options were granted for a term of ten years.  Restricted stock vests three years from the grant date.  Awards under the Incentive Plan become fully vested upon a merger or change in control of the Company.  Compensation expense is recognized over the vesting period of the options based on the fair value of the options at the grant date.

Total compensation cost that has been charged against income for those plans was $156,409 in the first quarter of 2007 and $50,629 in the first quarter of 2006.  The total income tax benefit was $54,743 in the first quarter of 2007 and $17,720 in the first quarter of 2006.

No options were issued during the first quarter of 2007.  Total unrecognized compensation cost related to nonvested stock options granted under the Incentive Plan is $492,305 as of March 31, 2007, and is expected to be recognized over a weighted-average period of 2.75 years.  There was no unrecognized compensation cost related to nonvested stock options granted as of March 31, 2006.

A summary of stock option activity in the Incentive Plan as of each quarter is as follows:

		Shares		Weighted Average Exercise Price			Weighted Average Remaining Contractual Term (years)		Aggregate Intrinsic Value
March 31, 2007:
Beginning outstanding		682,411		$	22.60
Granted		—		—
Exercised		(21,947	)	12.65
Expired		—		—
Ending outstanding		660,464		$	22.93		6.43		$	2,950,770
Exercisable at end of quarter		586,464		$	22.02		5.91		$	3,083,970
March 31, 2006:
Beginning outstanding		655,613		$	21.71
Granted		—		—
Exercised		(39,002	)	15.16
Expired		—		—
Ending outstanding		616,611		$	22.13		6.92		$	6,794,838
Exercisable at end of quarter		616,611		$	21.61		6.68		$	6,794,838

 

A summary of stock option activity as of the first quarter of each year is as follows:

		March 31, 2007			March 31, 2006
Intrinsic value of options exercised		$	634,728		$	1,238,490
Cash received from option exercises		277,739			591,188
Tax benefit realized from option exercises		141,886			256,797
Weighted average fair value of options granted		—			—

 

Restricted stock was granted beginning in 2005 under the Incentive Plan.  There were 26,184 shares issued during the first quarter of 2007 and none in the first quarter of 2006.  These shares are subject to forfeiture until certain restrictions have lapsed, including employment for a specific period. 

 

11

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These shares vest after a three-year period.  Compensation expense is recognized over the vesting period of the shares based on the market value of the shares at issue date.  Awards under the Incentive Plan become fully vested upon a merger or change in control of the Company.

A summary of changes in the Company’s nonvested shares of restricted stock is as follows:

		March 31, 2007					March 31, 2006
				Weighted					Weighted
				Average					Average
				Grant Date					Grant Date
		Shares		Fair Value			Shares		Fair Value
Nonvested at January 1		20,423		$	31.27		20,406		$	31.34
Granted		26,184		29.20			—		—
Vested		—		—			—		—
Forfeited		—		—			—		—
Nonvested at March 31		46,607		$	30.11		20,406		$	31.34

 

Total unrecognized compensation cost of restricted shares is $1,014,115 as of March 31, 2007, which is expected to be recognized over a weighted-average period of 2.33 years.  Total unrecognized compensation cost of restricted shares was $550,816 as of March 31, 2006, which was expected to be recognized over a weighted-average period of 2.67 years.  There were no restricted shares vested during the quarters ended March 31, 2007 or 2006.

Note 10 — Earnings Per Share

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

 

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Note 11 — Other Comprehensive Income

The following table summarizes the related income tax effect for the components of Other Comprehensive Income as of March 31:

 

Note 12 — Retirement Plans

The Company had a tax-qualified noncontributory defined benefit retirement plan covering substantially all full-time and regular part-time employees of the Company.  Generally, benefits were based on years of service and compensation.  As of December 31, 2005, the defined benefit plan was terminated.  All amounts due were paid to participants of the defined benefit plan between September and December of 2006.

The below table illustrates plan information as of March 31, 2006.  The key assumptions at that time included a 5.25% discount rate with a 5.0% return on assets:

 

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 $447,000 and $595,000 in the first quarters of 2007 and 2006, respectively, as the Company lowered its discretionary profit sharing contribution in 2007.

 

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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 currently provides financial services through its three subsidiary banks at its thirty—one banking locations.  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.

The Company completed a review of overlap in market areas serviced by its banking locations.  Due in large part to the findings of this analysis, management announced on April 17, 2007 that three leased branch locations would be closed after completion of the appropriate regulatory processes.  The Company also recently announced that it was seeking regulatory approval to combine its two existing state bank charters, Old Second Bank — Kane County and Old Second Bank — Yorkville, into its national bank charter, The Old Second National Bank of Aurora, and rename the combined entity “Old Second National Bank.”  The Company expects to complete this consolidation early in the third quarter of 2007.

The Company additionally announced a tender offer on April 17, 2007 to purchase up to 833,333 shares, or approximately 6.4%, of the outstanding common stock at the price of $30.00 per share.  The tender offer is set to expire on May 15, 2007, although it may be extended by the Company.  If the Company purchases all 833,333 shares that it has offered to purchase, the total purchase price will be approximately $25,000,000.  The Company will finance the tender offer from the aggregate net proceeds of a private placement of $25.0 million of aggregate face value trust preferred securities issued by a trust established by the Company.  The private placement of trust preferred securities closed on April 30, 2007.

Results of Operations

Net income for the first quarter of 2007 was $5.8 million, or $0.43 diluted earnings per share, compared with $6.1 million, or $0.45 diluted earnings per share, in the first quarter of 2006.  Noninterest income increased in the first quarter of 2007, but that increase was offset by a lower net interest margin and increased personnel and facility costs.  The Company made no provision for loan losses in the first quarter of 2007 whereas there was a $444,000 provision made in the first quarter of 2006.  The return on average equity decreased from 15.92% in the first three months of 2006, to 14.52% for the same period of 2007.

In comparing the first quarters of 2007 and 2006, there were securities sold in both years that affected earnings for both periods.  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.  In the first quarter of 2007, a securities gain of $482,000 added two cents per share after income taxes.

Net Interest Income

Net interest income decreased from $18.1 million in the first quarter of 2006 to $16.5 million in the first quarter of 2007. Average earning assets grew $67.8 million, or 3.1%, from March 31, 2006 to March 31, 2007.  Despite that growth, the net interest margin (tax equivalent basis), expressed as a percentage of average earning assets, declined from 3.49% in the first quarter of 2006 to 3.10% in the first quarter of 2007.  The average tax-equivalent yield on earning assets increased from 6.32% to 6.72%, or by 40 basis points.  At the same time, the cost of interest-bearing liabilities increased from 3.23% to 4.13%, or by 90 basis points.

 

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Changes in deposit funding composition continued to cause an increase in interest costs and a decline of the net interest margin in the first quarter of 2007.  The aggregate average balances of demand deposits and lower-cost sources of funds such as NOW accounts and savings accounts decreased nominally in the first quarter of 2007 as compared to the first quarter of 2006.  At the same time, deposit growth occurred primarily in higher-cost sources of funds, such as money market and time deposit accounts, which increased on average by $47.5 million, or 11.4%, and $27.3 million, or 2.87%, respectively.  Average non-deposit funding costs also increased $126,000, or 4.9%, in the first quarter of 2007 as compared to the first quarter of 2006 primarily due to a general increase in interest rates and an increase in the average note payable balance outstanding in the first quarter of 2007.  The proceeds from that note were primarily used to repurchase common stock.

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 tables and note below for supplemental data and the corresponding reconciliation to GAAP financial measures for the three months ended March 31, 2007 and 2006.

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.  Dividing the related interest by the average balance of assets or liabilities derives rates.  Average balances are derived from daily balances.

 

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ANALYSIS OF AVERAGE BALANCES,
TAX EQUIVALENT INTEREST AND RATES
Quarters ended March 31, 2007 and 2006
(Dollar amounts in thousands - unaudited)

		2007								2006
		Average								Average
		Balance			Interest			Rate		Balance			Interest			Rate
Assets
Interest bearing deposits		$	1,427		$	16		4.48	%	$	1,411		$	1		0.28	%
Federal funds sold		4,488			58			5.17		267			3			4.49
Securities:
Taxable		340,990			3,895			4.57		332,004			3,184			3.84
Non-taxable (tax equivalent)		144,454			2,037			5.64		140,375			1,895			5.40
Total securities		485,444			5,932			4.89		472,379			5,079			4.30
Loans and loans held for sale(1)		1,766,310			31,493			7.23		1,715,854			29,129			6.88
Total interest earning assets		2,257,669			37,499			6.72		2,189,911			34,212			6.32
Cash and due from banks		50,036			—			—		51,619			—			—
Allowance for loan losses		(16,220		)	—			—		(15,617		)	—			—
Other noninterest-bearing assets		124,827			—			—		119,026			—			—
Total assets		$	2,416,312							$	2,344,939
Liabilities and Stockholders’ Equity
NOW accounts		$	245,485		$	1,008		1.67	%	$	235,874		$	599		1.03	%
Money market accounts		466,201			4,511			3.92		418,682			2,942			2.85
Savings accounts		105,041			215			0.83		118,792			137			0.47
Time deposits		979,553			11,840			4.90		952,228			9,129			3.89
Interest bearing deposits		1,796,280			17,574			3.97		1,725,576			12,807			3.01
Securities sold under repurchase agreements		49,028			553			4.57		51,376			487			3.84
Federal funds purchased and other borrowed funds		92,684			1,243			5.36		113,373			1,402			4.95
Junior subordinated debentures		31,625			617			7.80		31,625			617			7.80
Note payable		16,896			263			6.23		3,200			44			5.50
Total interest bearing liabilities		1,986,513			20,250			4.13		1,925,150			15,357			3.23
Noninterest bearing deposits		253,838			—			—		250,135			—			—
Accrued interest and other liabilities		15,427			—			—		14,177			—			—
Stockholders’ equity		160,534			—			—		155,477			—			—
Total liabilities and stockholders’ equity		$	2,416,312							$	2,344,939
Net interest income (tax equivalent)					$	17,249							$	18,855
Net interest income (tax equivalent) to total earning assets								3.10	%							3.49	%
Interest bearing liabilities to earning assets		87.99		%						87.91		%

(1)             Interest income from loans is shown tax equivalent as discussed below and includes fees of $820,000 and $964,000 for the first quarter of 2007 and 2006, respectively.  Nonaccrual loans are included in the above stated average balances.

Note: For purposes of discussion, net interest income and net interest income to earning assets have been adjusted to a non-GAAP tax equivalent (“TE”) basis using a marginal rate of 35% to more appropriately compare returns on tax-exempt loans and securities to other earning assets.  The table below provides a reconciliation of each non-GAAP TE measure to the GAAP equivalent:

 

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		Effect of Tax Equivalent Adjustment
		Three Months Ended
		March 31,
		2007			2006
Interest income (GAAP)		$	36,729		$	33,492
Taxable equivalent adjustment - loans		57			57
Taxable equivalent adjustment - securities		713			663
Interest income (TE)		37,499			34,212
Less: interest expense (GAAP)		20,250			15,357
Net interest income (TE)		$	17,249		$	18,855
Net interest and income (GAAP)		$	16,479		$	18,135
Net interest income to total interest earning assets		2.96		%	3.36		%
Net interest income to total interest earning assets (TE)		3.10		%	3.49		%

 

Provision for Loan Losses

The Company recorded no provision for loan losses in the first quarter of 2007 as compared to a $444,000 provision for loan losses in the first quarter of 2006.  Loan portfolio quality remained strong as nonperforming loans decreased to $1.7 million at March 31, 2007 from $7.0 million at March 31, 2006.  The decrease in nonperforming loans was primarily due to three borrowing relationships that paid off in 2006.  The ratio of the allowance for loan losses to nonperforming loans was 932.8% as of March 31, 2007, compared with 227.1% as of March 31, 2006.  Net recoveries were $56,000 and $118,000 in each of the quarters ended 2007 and 2006, respectively.

Management determines the amount to provide for in the allowance for loan losses based upon a number of factors including loan growth, the quality and composition of the loan portfolio and loan loss experience.  While the amount of nonperforming loans decreased in the first quarter of 2007, management detected a general deceleration in real estate building and development activity in 2006 from the high levels of previous years.  While borrowers have generally continued to perform on their commercial real estate obligations, management believes that the slowdown in this sector combined with the Company’s concentration in commercial real estate and construction loans represents increased risk when assessing the adequacy of the allowance for loan losses.  Despite the general softening in the real estate market, management concluded that no additional provision adjustment was necessary in the first quarter of 2007.

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 on the consolidated balance sheet.

The allowance for loan losses as a percentage of total loans was 0.91% at both March 31, 2006 and 2007.  In management’s judgment, an adequate allowance for estimated losses has been established; however, there can be no assurance that actual losses will not exceed the estimated amounts in the future.

Nonperforming loans include loans in nonaccrual status, renegotiated loans, and loans past due ninety days or more and still accruing.  Nonaccrual loans remained at $1.6 million as of December 31, 2006 and March 31, 2007.

 

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Past due and nonaccrual loans for the periods ended March 31, 2007 and December 31, 2006 were as follows:

 

Noninterest Income

Noninterest income was $8.0 million during the first quarter of 2007 and $7.1 million during the first quarter of 2006, an increase of $899,000, or 12.7%.  Trust income increased $442,000, or 25.5%, to $2.2 million in the first quarter of 2007 primarily due to more income from increased volume in estate administration activity.  Mortgage banking income, including net gain on sales of mortgage loans, secondary market fees, and servicing income, was $1.4 million, an increase of $146,000, or 12.0%, from the first quarter of 2006.  The largest increase in income from mortgage operations was in net gain on sale, which resulted in part from better secondary market execution.

All of the remaining noninterest income categories increased in 2007 with the exception of the other income category and the increase in cash surrender value of bank owned life insurance.  Other income decreased in the first quarter of 2007 as compared to the first quarter of 2006 due to a nonrecurring gain on sale of property of $157,000 that was recognized in 2006.  Realized gains on sales of securities were $482,000 in the first quarter of 2007, compared with $227,000 in the first quarter of 2006.  Service charges on deposits increased $94,000, or 4.8%, to $2.1 million, which is in line with the Company’s modest deposit growth and current pricing strategies.  Interchange income from debit card usage also increased $44,000, or 10.5%, in the first quarter of 2007 as customers continue to show a preference for this payment method.

Noninterest Expense

Noninterest expense was $16.6 million during the first quarter of 2007, an increase of $437,000, or 2.7%, from $16.1 million in the first quarter of 2006.  Salaries and benefits expense was $9.9 million during the first quarter of 2007, an increase of $381,000, or 4.0%, from $9.5 million in the first quarter of 2006.  The increase in personnel expenses resulted primarily from the combination of normal annual increases in compensation rates and increased staffing levels.  The full time equivalent employee count rose from 556 at March 31, 2006 to 579 at March 31, 2007 due to the opening of five new retail branches over the course of 2006.  Management expects the employee count to decline somewhat during the remainder of 2007 as it announced on April 13, 2007 that the number of available positions within the Company is being reduced by approximately 8.5%.  While the staff reductions are expected to be mostly completed in the second quarter, management anticipates that the full effect of the savings will not be realized until the third quarter of 2007.

Net occupancy and furniture and equipment expenses increased $346,000, or 14.6%, from the first quarter of 2006 to the first quarter of 2007.  This increase was primarily attributable to the Company’s expansion and development into new markets with the five new 2006 retail locations and the related increase in facility expenses.  The Company announced on April 17, 2007 that three overlapping leased branch locations would be closed after completion of the appropriate regulatory processes.  The Company’s decision to seek regulatory approval to combine its two existing state bank charters into its national bank charter, and rename the combined entity “Old Second National Bank” early in the third quarter of 2007 is also expected to streamline administrative processes.  Other expense decreased $162,000, or 4.4%, from $3.7 million in the first quarter of 2006 to $3.5 million in the first quarter of 2007 as the Company emphasized overall cost control and review procedures.

 

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Income Taxes

The provision for income tax as a percentage of pretax income, or effective tax rate, decreased from 29.2% as of the first quarter of 2006 to 26.9% as of the first quarter of 2007.  Increased levels of tax-exempt income from securities, including tax credits from qualified zone academy bonds, helped reduce income tax expense in the first quarter of 2007.  The increased levels of tax-exempt income from securities was due to a 24 basis point increase in tax-equivalent yield combined with a 2.9% increase in average tax-exempt securities held by the Company as of March 31, 2007 compared to March 31, 2006.  The reduction in effective tax rate was primarily attributable, however, to the formation of a real estate investment trust (“REIT”) in the third quarter of 2006 for the purpose of holding certain commercial real estate loans, residential real estate loans and other loans, as well as mortgage-backed investment securities, that were previously held by our main bank subsidiary.  In addition to income tax benefits, which lowered the effective tax rate, the REIT ownership structure also provides the Company with an alternate vehicle for raising future capital as desired.

Financial Condition

Assets

Total assets were $2.44 billion as of March 31, 2007, compared with $2.46 billion as of December 31, 2006.  Loans and securities available for sale grew $12.4 million and $14.3 million, respectively, during the first quarter of 2007, while cash and noninterest bearing due from banks declined $30.4 million.

Loans

Total loans were $1.78 billion as of March 31, 2007, an increase of $12.4 million from $1.76 billion as of December 31, 2006.  The largest changes by loan type included increases in commercial real estate and real estate construction loans of $8.7 million and $21.1 million, respectively, and a decrease of $14.5 million in residential loans.

The loan portfolio generally reflects the profile of the communities in which the Company operates.  Because the Company is located in growing areas with significant open space, real estate lending (including commercial, residential, and construction) is a significant portion of the portfolio.  These categories comprised 89.1% of the portfolio as of March 31, 2007 and 88.8% of the portfolio as of December 31, 2006.

Securities

Securities available for sale totaled $487.2 million as of March 31, 2007, an increase of $14.3 million, or 3.0%, from $472.9 million as of December 31, 2006.  The largest category increase was in bank-qualified state and political subdivision securities, which increased $12.0 million, or 8.0%, in the first quarter of 2007.  The net unrealized losses, net of deferred tax benefit, in the portfolio decreased from a net unrealized loss of $2.5 million as of December 31, 2006 to a net unrealized loss of $1.5 million as of March 31, 2007.

Deposits and Borrowings

Total deposits increased $3.2 million during the first quarter of 2007, to $2.07 billion as of March 31, 2007.  Demand deposits decreased $21.3 million, to $259.3 million.  The largest growth category of deposits at first quarter end 2007 was money market deposit accounts, which increased by $28.5 million, from $446.2 million to $474.7 million.  Time deposits increased $4.3 million from $974.1 million to $978.4 million at March 31, 2007.

 

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Depositors generally shifted out of demand and NOW accounts into money market accounts and certificates of deposit.  The money market account offers the customer the advantage of liquidity while earning a higher rate of interest than a demand or NOW account and certificates of deposit allow the customer to lock in a fixed rate of interest for a period of time.  This deposit shift contributed to a higher cost of funds and had a negative impact on the net interest margin.  The net interest margin (tax equivalent basis), expressed as a percentage of average earning assets, declined from 3.49% in the first quarter of 2006 to 3.10% in the first quarter of 2007.  In comparing the first quarter of 2007 to the first quarter of 2006, the average cost of interest bearing funds increased 90 basis points.

Securities sold under repurchase agreements, which are typically of short-term duration, increased $13.5 million, or 35.3%, to $51.7 million as of March 31, 2007, from $38.2 million as of December 31, 2006.  Other short-term borrowings decreased $25.4 million during the first quarter of 2007 to $101.7 million, primarily due to a decrease in Federal Funds purchased of $23.0 million.  The note payable also decreased to $15.0 million at March 31, 2007 from $16.4 million at December 31, 2006.

 

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