UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

 

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		(I.R.S. Employer Identification Number)
of incorporation or organization)

 

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 July 25, 2006, the Registrant had outstanding 13,413,598 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)
		June 30,			December 31,
		2006			2005
Assets
Cash and due from banks		$	86,677		$	65,010
Interest bearing deposits with banks		108			105
Cash and cash equivalents		86,785			65,115
Securities available for sale		463,363			470,431
Federal Home Loan Bank and Federal Reserve Bank Stock		8,783			8,418
Loans held for sale		11,433			11,397
Loans		1,746,536			1,704,382
Allowance for loan losses		16,093			15,329
Net loans		1,730,443			1,689,053
Premises and equipment, net		43,534			42,485
Other real estate owned		333			251
Mortgage servicing rights		2,721			2,271
Goodwill		2,130			2,130
Core deposit intangible assets, net		178			355
Bank owned life insurance		42,588			41,627
Accrued interest and other assets		30,848			34,297
Total assets		$	2,423,139		$	2,367,830
Liabilities
Deposits:
Demand		$	255,937		$	264,124
Savings, NOW, and money market		802,196			795,028
Time		949,888			876,126
Total deposits		2,008,021			1,935,278
Securities sold under repurchase agreements		43,615			57,625
Other short-term borrowings		162,386			171,825
Junior subordinated debentures		31,625			31,625
Note payable		5,075			3,200
Accrued interest and other liabilities		17,089			16,015
Total liabilities		2,267,811			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 16,629,803 in 2006 and 16,592,301 in 2005; outstanding 13,412,575 in 2006 and 13,520,073 in 2005		16,630			16,592
Additional paid-in capital		14,658			13,746
Retained earnings		185,660			176,824
Accumulated other comprehensive loss		(6,848		)	(4,562		)
Treasury stock, at cost, 3,217,228 in 2006 and 3,072,228 in 2005		(54,772		)	(50,338		)
Total stockholders’ equity		155,328			152,262
Total liabilities and stockholders’ equity		$	2,423,139		$	2,367,830

 

See accompanying notes to unaudited 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						Six Months Ended
		June 30,						June 30,
		2006			2005			2006			2005
Interest and Dividend Income
Loans, including fees		$	30,700		$	24,946		$	59,677		$	47,960
Loans held for sale		131			189			226			362
Securities:
Taxable		3,167			2,842			6,351			5,592
Tax-exempt		1,259			1,207			2,491			2,331
Federal funds sold		—			3			3			3
Interest bearing deposits with banks		1			1			2			1
Total interest and dividend income		35,258			29,188			68,750			56,249
Interest Expense
Savings, NOW, and money market deposits		4,152			2,672			7,830			4,951
Time deposits		9,828			5,942			18,957			11,632
Repurchase agreements		507			296			994			507
Other short-term borrowings		2,011			1,176			3,413			1,785
Junior subordinated debentures		616			597			1,233			1,214
Note payable		54			27			98			50
Total interest expense		17,168			10,710			32,525			20,139
Net interest income		18,090			18,478			36,225			36,110
Provision for loan losses		400			400			844			363
Net interest income after provision for loan losses		17,690			18,078			35,381			35,747
Noninterest Income
Trust income		2,053			1,629			3,787			3,278
Service charges on deposits		2,047			2,109			4,003			3,909
Gain on sale of loans		935			1,450			1,906			2,828
Secondary mortgage fees		159			287			312			471
Mortgage servicing income		117			34			215			50
Securities gains (losses), net		191			(1		)	418			(5		)
Increase in cash surrender value of bank owned life insurance		489			215			961			434
Other income		1,374			1,382			2,838			2,612
Total noninterest income		7,365			7,105			14,440			13,577
Noninterest Expense
Salaries and employee benefits		8,926			8,980			18,457			18,100
Occupancy expense, net		1,098			983			2,190			1,594
Furniture and equipment expense		1,258			1,183			2,540			2,449
Amortization of core deposit intangible assets		88			89			177			178
Advertising expense		512			459			976			838
Other expense		3,765			3,716			7,455			7,250
Total noninterest expense		15,647			15,410			31,795			30,409
Income before income taxes		9,408			9,773			18,026			18,915
Provision for income taxes		3,042			3,203			5,555			6,156
Net income		$	6,366		$	6,570		$	12,471		$	12,759
Share and per share information:
Ending number of shares		13,412,575			13,497,889			13,412,575			13,497,889
Average number of shares		13,524,276			13,496,502			13,526,947			13,474,437
Diluted average number of shares		13,700,186			13,660,414			13,704,869			13,646,301
Basic earnings per share		$	0.47		$	0.49		$	0.92		$	0.95
Diluted earnings per share		$	0.46		$	0.48		$	0.91		$	0.94

 

See accompanying notes to unaudited consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Six Months Ended June 30, 2006 and 2005

(In thousands, unaudited)

 

		2006			2005
Cash flows from operating activities
Net income		$	12,471		$	12,759
Adjustments to reconcile net income to  net cash provided by operating activities:
Depreciation		1,855			1,744
Amortization of mortgage servicing rights		211			57
Provision for loan losses		844			363
Origination of loans held for sale		(139,736		)	(192,346		)
Proceeds from sale of loans held for sale		140,945			198,302
Gain on sale of loans held for sale		(1,906		)	(2,828		)
Increase in cash surrender value of bank owned life insurance		(961		)	(434		)
Change in current income taxes receivable		2,015			(651		)
Change in accrued interest receivable and other assets		2,951			(3,997		)
Change in accrued interest payable and other liabilities		954			8,272
Net premium amortization on securities		1,441			1,970
Securities losses (gains), net		(418		)	5
Amortization of core deposit intangible assets		177			178
Tax benefit from stock options exercised		—			408
Net cash provided by operating activities		20,843			23,802
Cash flows from investing activities
Proceeds from matured or called securities available for sale		39,340			62,525
Proceeds from sales of securities available for sale		339			349
Purchases of securities available for sale		(37,437		)	(66,188		)
Purchase of FHLB stock		(365		)	(1,261		)
Net change in loans		(42,234		)	(123,160		)
Net change in other real estate		(82		)	(76		)
Net purchases of premises and equipment		(2,904		)	(3,622		)
Net cash used in investing activities		(43,343		)	(131,433		)
Cash flows from financing activities
Net change in deposits		72,743			110,671
Net change in repurchase agreements		(14,010		)	6,889
Net change in other short-term borrowings		(9,439		)	(2,633		)
Proceeds from note payable		1,875			—
Proceeds from exercise of stock options		693			917
Tax benefit from stock options exercised		257			—
Dividends paid		(3,515		)	(3,230		)
Purchase of treasury stock		(4,434		)	—
Net cash provided by financing activities		44,170			112,614
Net change in cash and cash equivalents		21,670			4,983
Cash and cash equivalents at beginning of period		65,115			58,662
Cash and cash equivalents at end of period		$	86,785		$	63,645
Supplemental cash flow information
Income taxes paid		$	3,571		$	6,807
Interest paid		31,290			19,677

 

See accompanying notes to unaudited 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 periods presented.  Results for the periods ended June 30, 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 U.S. generally accepted accounting principles 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 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 will be effective for all financial instruments acquired, issued, or subject to a remeasurement event 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 will be 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.

In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48,

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Accounting for Uncertainty in Income Taxes, (“FIN 48”). FIN 48 will be effective for fiscal years beginning after December 15, 2006. FIN 48 applies to all income tax positions subject to Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes, (“SFAS 109”), including tax positions considered to be routine and those with a high degree of uncertainty. The Company is evaluating the potential impact in future periods.

Note 2 – Securities

Securities available for sale are summarized as follows:

					Gross			Gross
		Amortized			Unrealized			Unrealized			Fair
		Cost			Gains			Losses			Value
June 30, 2006:
U.S. Treasuries		$	10,013		$	—		$	(632	)	$	9,381
U.S. Government agencies		316,817			5			(7,117		)	309,705
States and political subdivisions		147,768			610			(4,231		)	144,147
Equity securities		130			—			—			130
		$	474,728		$	615		$	(11,980	)	$	463,363
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
Equity securities		52			—			—			52
		$	477,993		$	983		$	(8,545	)	$	470,431

 

Recognition of other than temporary impairment was not necessary in the first six months of 2006. The increase in unrealized losses resulted from an increase in interest rates.

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 June 30, are summarized as follows:

 

 

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Note 5 – Deposits

 

Major classifications of deposits as of June 30, 2006, and December 31, 2005 were as follows:

		2006			2005
Demand		$	255,937		$	264,124
Savings		116,619			117,849
NOW accounts		286,306			244,727
Money market accounts		399,271			432,452
Certificates of deposit of less than $100,000		580,998			554,618
Certificates of deposit of $100,000 or more		368,890			321,508
		$	2,008,021		$	1,935,278

 

Note 6 – Short-Term Borrowings and Note Payable

The following table is a summary of borrowings as of June 30, 2006 and December 31, 2005:

		2006			2005
Federal funds purchased and other short-term borrowings		$	100,588		$	169,575
FHLB advances		60,000			—
Treasury tax and loan notes		1,798			2,250
		$	162,386		$	171,825

 

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 June 30, 2006 and December 31, 2005, and are held in third party pledge accounts.

The Company’s 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 $7.8 million as of June 30, 2006. As of June 30, 2006, a $30 million FHLB advance was scheduled to mature on July 3, 2006, and another $30 million FHLB advance was scheduled to mature on July 26, 2006. New short-term FHLB advances replaced these advances upon maturity.

At June 30, 2006 and December 31, 2005, respectively, the period to date average balance of Federal funds purchased and other short-term borrowings totaled $180.4 million at a weighted average rate of 4.9% 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

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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 $5.1 million as of June 30, 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 7 – 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 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 six months of 2006.

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

		Six Months June 30, 2006
							Weighted
				Weighted			Average
				Average			Remaining		Aggregate
				Exercise			Contractual		Intrinsic
		Shares		Price			Life		Value
									(In thousands)
Beginning outstanding		655,613		$	21.71
Granted		—		—
Exercised		(39,002	)	15.16
Expired		—		—
Ending outstanding		616,611		$	22.13		81 Months		$	5,909

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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. There were no exercises in the second quarter of either 2005 or 2006.

 

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 2005.

		Three Months			Six Months
		Ended			Ended
		June 30, 2005			June 30, 2005
Net income as reported		$	6,570		$	12,759
Pro forma net income		6,437			12,492
Basic earnings per share as reported		0.49			0.95
Pro forma basic earnings per share		0.48			0.93
Diluted earnings per share as reported		0.48			0.94
Pro forma diluted earnings per share		0.47			0.92

 

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 six-month period ended June 30, 2006 is compensation expense for restricted shares of $101,000, with a related tax benefit of $40,000. As of June 30, 2006, the total compensation cost related to nonvested awards not yet recognized was $501,000. The Company expects to recognize this cost over a remaining period of thirty 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		(1,500	)	$	31.34
Nonvested shares at June 30, 2006		18,906		$	31.34

 

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Note 8 – Earnings Per Share

Earnings per share is included below as of June 30, (share data not in thousands):

		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2006			2005			2006			2005
Basic earnings per share:
Weighted-average common shares outstanding		13,524,276			13,496,502			13,526,947			13,474,437
Net income available to common stockholders		$	6,366		$	6,570		$	12,471		$	12,759
Basic earnings per share		$	0.47		$	0.49		$	0.92		$	0.95
Diluted earnings per share:
Weighted-average common shares outstanding		13,524,276			13,496,502			13,526,947			13,474,437
Dilutive effect of restricted shares		18,906			—			18,906			—
Dilutive effect of stock options		157,004			163,912			159,016			171,864
Diluted average common shares outstanding		13,700,186			13,660,414			13,704,869			13,646,301
Net income available to common stockholders		$	6,366		$	6,570		$	12,471		$	12,759
Diluted earnings per share		$	0.46		$	0.48		$	0.91		$	0.94
Number of antidilutive options excluded from the diluted earnings per share calculation		211,000			137,000			211,000			137,000
Number of antidilutive restricted shares excluded from the diluted earnings per share calculation		—			—			—			—

 

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Note 9 – Other Comprehensive Income (Loss)

 

Other comprehensive income (loss) is included below:

		Three Months Ended June 30,						Six Months Ended June 30,
		2006			2005			2006			2005
Change in net holding gains (losses) on available for sale securities arising during the period		$	(1,892	)	$	3,134		$	(3,385	)	$	(1,947	)
Related tax benefit		542			(1,249		)	1,351			773
Net unrealized gains / (losses)		(1,350		)	1,885			(2,034		)	(1,174		)
Less: Reclassification adjustment for the net gains (losses) realized during the period
Realized gains		191			5			418			5
Realized losses		—			(6		)	—			(10		)
Net realized gains (losses)		191			(1		)	418			(5		)
Income tax benefit (expense) on net realized gains (losses)		(76		)	—			(166		)	2
Net realized gains (losses) after tax		115			(1		)	252			(3		)
Total other comprehensive income (loss)		$	(1,465	)	$	1,886		$	(2,286	)	$	(1,171	)

Note 10 – 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 $1.1 million. 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.

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		Six Months Ended June,
		Pension Benefits						SERP
		2006			2005			2005
Service cost		$	—		$	851		$	38
Interest cost		181			466			48
Expected return on plan assets		(178		)	(435		)	—
Amortization of transition obligation		—			—			—
Amortization of prior service (benefit) cost		—			(2		)	9
Recognized net actuarial loss		—			142			24
Net periodic benefit cost		$	3		$	1,022		$	119
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 $1,130,000 and $721,000 in the first six months 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 second quarter of 2006 was $6.4 million, or $ 0.46 diluted earnings per share, compared with $6.6 million, or $0.48 diluted earnings per share, in the second quarter of 2005.  Earnings for the first half of 2006 were 91 cents per diluted share, on $12.5 million in net income, compared with 94 cents per diluted share in the first half of 2005, on earnings of $12.8 million. The return on equity decreased from 18.34% in the first half of 2005, to 16.05% in the first half of 2006.

In comparing the first half of 2006 and the first half of 2005, there were several items that had an impact on earnings. In the first half of 2005, there was a reduction of $250,000 in the estimated accrual for real estate taxes. In the first half of 2006, an income tax adjustment of $175,000 and securities gains of $418,000 were recorded. At the same time, the provision for loan losses was $844,000 in the first half of 2006, compared with $363,000 in the first half of 2005.

Net Interest Income

Net interest income increased slightly in the first half of 2006, to $36.2 million in 2006, from $36.1 million in 2005. Second quarter net interest income declined from $18.5 million in 2005, to $18.1 million in 2006. For both the quarter and year to date periods, growth in earning assets was offset by a lower net interest margin. Average earning assets grew $152.0 million, or 7.4% from the first half of 2005 to the first half of 2006. At the same time, the tax-equivalent net interest margin declined from 3.68% in the first half of 2005 to 3.44% in the first half of 2006.

The average tax-equivalent yield on earning assets increased from 5.65% to 6.42%, or 77 basis points, from the first half of 2005 to the first half of 2006. At the same time, the cost of interest-bearing and noninterest-bearing funds increased from 2.29% to 3.39%, or 110 basis points. Changes in funding composition also had a significant impact on the net interest margin. Among lower-cost sources of funds, the average balance of interest-bearing transaction accounts and savings accounts declined from the first half of 2005 to the first half of 2006, and noninterest-bearing deposits increased slightly. At the same time, average balances of higher-cost sources of funds, including time deposits, repurchase agreements, and other short-term borrowings increased $184.0 million, or 19.4%, in the aggregate.

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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 six months ended June 30, 2006 and 2005.

 

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.

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ANALYSIS OF AVERAGE BALANCES,

TAX EQUIVALENT INTEREST AND RATES

Six Months Ended June 30, 2006 and 2005

(Dollar amounts in thousands- unaudited)

 

		2006								2005
		Average								Average
		Balance			Interest			Rate		Balance			Interest			Rate
Assets
Interest bearing deposits with banks		$	750		$	2		0.54	%	$	567		$	1		0.36	%
Federal funds sold		133			3			4.51		215			3			2.79
Securities:
Taxable		326,540			6,351			3.89		329,107			5,592			3.40
Non-taxable (tax equivalent)(1)		140,605			3,832			5.45		134,643			3,586			5.33
Total securities		467,145			10,183			4.36		463,750			9,178			3.96
Loans and loans held for sale(2)(3)		1,738,183			60,016			6.96		1,589,716			48,420			6.14
Total interest earning assets		2,206,211			70,204			6.42		2,054,248			57,602			5.65
Cash and due from banks		50,906			—			—		53,933			—			—
Allowance for loan losses		(15,824		)	—			—		(15,517		)	—			—
Other noninterest-bearing assets		120,439			—			—		86,532			—			—
Total assets		$	2,361,732							$	2,179,196
Liabilities and Stockholders’ Equity
Interest bearing transaction accounts		$	650,302		7,548			2.34		$	668,395		4,698			1.42
Savings accounts		120,466			282			0.47		126,309			253			0.40
Time deposits		950,646			18,957			4.02		792,427			11,632			2.96
Interest bearing deposits		1,721,414			26,787			3.14		1,587,131			16,583			2.11
Repurchase agreements		49,291			994			4.07		42,571			507			2.40
Other short-term borrowings		131,148			3,413			5.25		112,104			1,785			3.21
Junior subordinated debentures		31,625			1,233			7.80		31,625			1,214			7.68
Note payable		3,442			98			5.74		2,700			50			3.73
Total interest bearing liabilities		1,936,920			32,525			3.39		1,776,131			20,139			2.29
Noninterest bearing deposits		253,372			—			—		248,092			—			—
Accrued interest and other liabilities		14,707			—			—		14,648			—			—
Stockholders’ equity		156,733			—			—		140,325			—			—
Total liabilities and stockholders’ equity		$	2,361,732							$	2,179,196
Net interest income (tax equivalent)					$	37,679							$	37,463
Net interest income (tax equivalent) to total earning assets								3.44	%							3.68	%
Interest bearing liabilities to earnings assets		87.79		%						86.46		%

 

Notes:

(1)    Tax equivalent basis is calculated using a marginal tax rate of 35%.

(2)    Nonaccrual loans are included in the above stated average balances.

(3)           Loan fees, included in interest on loans and loans held for sale, were $1.9 million and $1.5 million in the first six months of 2006 and 2005, respectively.

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.

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		Three Months Ended June 30,						Year to Date June 30,
		2006			2005			2006			2005
Net Interest Margin
Interest income (GAAP)		$	35,258		$	29,188		$	68,750		$	56,249
Taxable-equivalent adjustment:
Loans		56			52			113			98
Investments		678			648			1,341			1,255
Interest income - FTE		35,992			29,888			70,204			57,602
Interest expense (GAAP)		17,168			10,710			32,525			20,139
Net interest income - FTE		$	18,824		$	19,178		$	37,679		$	37,463
Net interest income - (GAAP)		$	18,090		$	18,478		$	36,225		$	36,110
Average interest earning assets		$	2,222,331		$	2,088,855		$	2,206,211		$	2,054,248
Net interest margin (GAAP)		3.26		%	3.55		%	3.31		%	3.54		%
Net interest margin - FTE		3.40		%	3.68		%	3.44		%	3.68		%

Provision for Loan Losses

The Company provided an additional $400,000 to the allowance for loan losses in the second quarter of 2006, unchanged from the second quarter of 2005. The Company provided $844,000 in the first half of 2006, compared with $363,000 in the first half of 2005, an increase of $481,000. The quality of the loan portfolio remained strong and charge-offs were low, and, after analyzing the allowance for loan losses, management has determined that the level reported as of June 30, 2006, was appropriate. In making this determination, both quantitative and qualitative factors are considered. Management’s growing concern with the commercial real estate market generally, and the large concentration of commercial real estate loans held by the Company contributed to the increase in the provision for the first half of 2006 compared to 2005, in spite of the decline in nonperforming loans. Management has observed slower real estate building and development activity in the Company’s market areas. Although the Company’s borrowers continue to meet their obligations, management believes that the general risk in this sector has increased. The ratio of the allowance for loan losses to nonperforming loans was 410% as of June 30, 2006, compared with 245% as of June 30, 2005. Nonperforming loans were $3.9 million as of June 30, 2006, and $6.6 million as of June 30, 2005. Net charge-offs were $198,000 in the second quarter of 2006 and $289,000 in the second quarter of 2005. For the year to date, net charge-offs were $80,000 in the first half of 2006 and $333,000 in the first half of 2005.

The allowance for loan losses represents management’s estimate of probable incurred 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 statements of condition.

The allowance for loan losses as a percentage of total loans was 0.92% as of June 30, 2006, compared to 0.90% as of December 31, 2005 and 0.95% as of June 30, 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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Past due and nonaccrual loans for the periods ended June 30, 2006 and December 31, 2005 were as follows:

 

		June 30,			December 31,
		2006			2005
Nonaccrual loans		$	2,857		$	3,845
Interest income recorded on nonaccrual loans		68			334
Interest income which would have been accrued on nonaccrual loans		147			636
Loans 90 days or more past due and still accruing interest		1,065			2,752

Noninterest Income

Noninterest income was $7.4 million during the second quarter of 2006 and $7.1 million during the second quarter of 2005, an increase of $260,000, or 3.7%. This increase occurred despite mortgage banking income, including gains on sales of mortgage loans, secondary market fees, and servicing income, declining $560,000, or 31.6%, from the second quarter of 2005 to the second quarter of 2006. For the year to date, mortgage banking income was down $916,000, or 27.4%, from the first half of 2005 to the first half of 2006. The higher cost of borrowing associated with an increase in interest rates has resulted in a decline in demand for mortgages and a decline in mortgage banking income.

Trust income was up $424,000, or 26.0%, from the second quarter of 2005 to the second quarter of 2006, to $2.1 million. Trust income was $3.8 million in the first six months of 2006, an increase of  $509,000, or 15.5%, from the first half of 2005. Increases in trust income for both the quarter and the year to date period were primarily associated with estate fees. Securities gains were $191,000 in the second quarter of 2006 and $418,000 in the first half of 2006, compared with a $1,000 loss in the second quarter of 2005 and a loss of $5,000 in the first half of 2005. Bank owned life insurance (“BOLI”) income increased from $215,000 to $489,000 in the second quarter, and from $434,000 to $961,000 for the first half, when comparing 2006 and 2005, as a result of BOLI purchases.

Noninterest Expense

Noninterest expense was $15.6 million during the second quarter of 2006, an increase of $237,000, or 1.5%, from $15.4 million in the second quarter of 2005. Noninterest expense was $31.8 million during the first half of 2006, an increase of $1.4 million, or 4.6%, from $30.4 million in the first half of 2005. Salaries and benefits expense was $8.9 million during the second quarter of 2006, a decrease of $54,000 from $9.0 million in the second quarter of 2005. In the first half of the year, salaries and benefits were $18.5 million in 2006 and $18.1 million in 2005, an increase of $357,000, or 2.0%.

Pension expense, included in salaries and benefits, was $981,000 in the first half of 2005 and $357,000 in the first half of 2006. The Company is in the process of distributing the assets of its defined benefit pension plan after terminating the plan in December of 2005. The liabilities are expected to exceed assets at the time of distribution of all benefits by approximately $1.1 million. A contribution of the shortfall amount is required to be made before the defined benefit plan is liquidated. Distribution to participants began in July, and management expects the distribution to be substantially completed during the third quarter of 2006.

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Net occupancy and furniture and equipment expenses increased $190,000 from the second quarter of 2005 to the second quarter of 2006, or 8.8%. Net occupancy and furniture and equipment expenses increased $687,000 from the first half of 2005 to the first half of 2006, or 17.0%. The increase in the year to date period is due, in part, to a reduction in the estimated accrual for occupancy related expenses in the first half 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. Other expense increased $49,000, or 1.3%, from the second quarter of 2005, to $3.8 million in the second quarter of 2006. Other expenses increased $205,000, or 2.8% from the first half of 2005 to $7.5 million in the first half of 2006.

Income Taxes

The Company’s provision for Federal and State of Illinois income taxes was $3.0 million and $3.2 million in the second quarters of 2006 and 2005 respectively. Income taxes totaled  $5.6 million and $6.2 million in the first six months of 2006 and 2005, respectively. The average effective income tax rate for the first half of 2006 and 2005 was 30.8% and 32.5%, respectively. A change in tax advisors during the first quarter of 2006 resulted in a management decision to reduce the income tax provision by $175,000.

Financial Condition

Assets

Total assets were $2.42 billion as of June 30, 2006, compared with $2.37 billion as of December 31, 2005. Loans grew $42.2 million during the first half of 2006, while cash and cash equivalents increased $21.7 million and securities available for sale declined $7.1 million.

Loans

The loan category that increased the most in the first half of 2006 was commercial real estate, which increased $31.4 million. Construction loans declined $5.8 million and residential loans increased by $22.7 million. The loan portfolio generally reflects the profile of the communities in which the Company operates. Because the Company is located in growing areas, real estate lending (including commercial, residential, and construction) is a significant portion of the portfolio. These categories comprised 88.7% of the portfolio as of June 30, 2006 and 88.1% of the portfolio as of December 31, 2005.

Securities and Bank Owned Life insurance

Securities available for sale totaled $463.4 million as of June 30, 2006, a decline of $7.0 million from $470.4 million as of December 31, 2005.  The Company also invests in bank-owned life insurance (“BOLI”). During December 2005, the Company purchased an additional $20 million in BOLI, bringing the total to $41.6 million as of December 31, 2005, and $42.6 million as of June 30, 2006. Net unrealized gains, net of deferred taxes, in the securities available for sale increased from a net unrealized loss of $4.6 million as of December 31, 2005 to a net unrealized loss of $6.8 million as of June 30, 2006.

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Deposits and Borrowings

Total deposits increased $72.7 million during the first half of 2006, to $2.01 billion as of June 30, 2006. Demand deposits decreased $8.2 million, to $255.9 million. Savings deposits decreased $1.2 million, to $116.6 million. Time deposits increased $73.8 million, or 8.4%, from $876.1 million to $949.9 million. Money market accounts declined from $432.5 million to $399.3 million in the first half of 2006.

Generally, depositors shifted somewhat from transaction accounts to certificates of deposits in the first half of 2006. While this had the effect of moving funds out of interest sensitive deposits into more stable pricing, this deposit shift resulted in a higher cost of funds and a negative impact on the net interest margin. The tax-equivalent net interest margin declined from 3.68% in the first half of 2005 to 3.44% in the first half of 2006. In comparing the first half of 2006 to the first half of 2005, the average cost of interest-bearing funds increased 110 basis points.

Securities sold under repurchase agreements, which are typically of short-term duration, decreased from $57.6 million as of December 31, 2005, to $43.6 million as of June 30, 2006. Other short-term borrowings decreased from $171.8 million to $162.4 million. Advances from the Federal Home Loan Bank of Chicago were $60.0 million as of June 30, 2006, while there were no advances as of December 31, 2005.  The Company is currently maintaining liquid assets and delivering consistent growth in core deposits to provide funding for loan growth.

Capital

The Company and its three subsidiary banks are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines provide for five classifications, the highest of which is well capitalized. The Company and its subsidiary banks were categorized as well capitalized as of June 30, 2006. The accompanying table shows the capital ratios of the Company and Old Second National Bank, the Company’s lead subsidiary bank, as of June 30, 2006 and December 31, 2005.

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Capital levels and minimum required levels:

							Minimum Required					Minimum Required
							for Capital					to be Well
		Actual					Adequacy Purposes					Capitalized
		Amount			Ratio		Amount			Ratio		Amount			Ratio
June 30, 2006:
Total capital to risk weighted assets
Consolidated		$	207,214		10.99	%	$	150,838		8.00	%	$	188,548		10.00	%
Old Second National Bank		142,235			10.99		103,538			8.00		129,422			10.00
Tier 1 capital to risk weighted assets
Consolidated		191,221			10.14		75,432			4.00		113,149			6.00
Old Second National Bank		131,372			10.15		51,772			4.00		77,658			6.00
Tier 1 capital to average assets
Consolidated		191,221			8.05		95,017			4.00		118,771			5.00
Old Second National Bank		131,372			8.00		65,686			4.00		82,108			5.00
December 31, 2005:
Total capital to risk weighted assets
Consolidated		$	200,981		10.91	%	$	147,374		8.00	%	$	184,217		10.00	%
Old Second National Bank		135,423			10.75		100,780			8.00		125,975			10.00
Tier 1 capital to risk weighted assets
Consolidated		185,737			10.08		73,705			4.00		110,558			6.00
Old Second National Bank		125,301			9.94		50,423			4.00		75,634			6.00
Tier 1 capital to average assets
Consolidated		185,737			8.02		92,637			4.00		115,796			5.00
Old Second National Bank		125,301			7.85		63,848			4.00		79,810			5.00

 

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