Old Second Bancorp 10Q 2020 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
	THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2020


☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
	SECURITIES EXCHANGE ACT OF 1934

For transition period from to

Commission File Number 0-10537

Old Second Bancorp, Inc.

(Exact name of Registrant as specified in its charter)


Delaware		36-3143493
(State or other jurisdiction		(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 ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of ‘‘large accelerated filer,’’ ‘‘accelerated filer,’’ ‘‘smaller reporting company,’’ and ‘‘emerging growth company’’ in Rule 12b–2 of the Exchange Act.

Large accelerated filer☐Accelerated filer☒

Non-accelerated filer☐Smaller reporting company☐Emerging growth company☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).

Yes ☐ No ☒


Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common Stock	OSBC	The Nasdaq Stock Market

As of August 5, 2020, the Registrant has 29,589,341 shares of common stock outstanding at $1.00 par value per share.

OLD SECOND BANCORP, INC.

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report and other publicly available documents of the Company contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act, including with respect to management’s expectations regarding future plans, strategies and financial performance, including regulatory developments, industry and economic trends, and other matters. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, can be identified by the inclusion of such qualifications as “expects,” “intends,” “believes,” “may,” “will,” “would,” “could,” “should,” “plan,” “anticipate,” “estimate,” “possible,” “likely” or other indications that the particular statements are not historical facts and refer to future periods. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and may be outside of the Company’s control. Actual events and results may differ materially from those described in such forward-looking statements due to numerous factors, including:

●

our ability to execute our growth strategy, including realizing the benefits from our recent strategic hires;

●

the impact of the recent outbreak of the novel coronavirus, or COVID-19, on our business, including the impact of the actions taken by governmental authorities to try and contain the virus or address the impact of the virus on the United States economy (including, without limitation, the Coronavirus Aid, Relief and Economic Security Act, or the CARES Act), and the resulting effect of these items on our operations, liquidity and capital position, and on the financial condition of our borrowers and other customers;

●

negative economic conditions that adversely affect the economy, real estate values, the job market and other factors nationally and in our market area, in each case that may affect our liquidity and the performance of our loan portfolio;

●

impairment of goodwill, other intangible assets or deferred tax assets;

●

our ability to achieve anticipated results from any bank acquisition depends on the state of the economic and financial markets going forward. Specifically, we may incur more credit losses than expected, cost savings may be less than expected, anticipated strategic gains may be significantly harder or take longer to achieve than expected or may not be achieved in their entirety, and customer attrition may be greater than expected;

●

the financial success and viability of the borrowers of our commercial loans;

●

changes in U.S. monetary policy, the level and volatility of interest rates, the capital markets and other market conditions that may affect, among other things, our liquidity and the value of our assets and liabilities;

●

competitive pressures from other financial service businesses and from nontraditional financial technology (“FinTech”) companies;

●

any negative perception of our reputation or financial strength;

●

ability to raise additional capital on acceptable terms when needed;

●

ability to raise cost-effective funding to support business plans when needed:

●

ability to use technology to provide products and services that will satisfy customer demands and create efficiencies in operations;

●

adverse effects on our information technology systems resulting from failures, human error or cyberattacks;

●

adverse effects of failures by our vendors to provide agreed upon services in the manner and at the cost agreed, particularly our information technology vendors and those vendors performing a service on the Company’s behalf;

●

the impact of any claims or legal actions, including any effect on our reputation;

●

losses incurred in connection with repurchases and indemnification payments related to mortgages;

●

the soundness of other financial institutions and other counter-party risk;

●

changes in accounting standards, rules and interpretations and the impact on our financial statements;

●

our ability to receive dividends from our subsidiaries;

●

a decrease in our regulatory capital ratios;

●

adverse federal or state tax assessments;

●

risks associated with actual or potential litigation or investigations by customers, regulatory agencies or others;

●

legislative or regulatory changes, particularly changes in regulation of financial services companies;

●

increased costs of compliance, heightened regulatory capital requirements and other risks associated with changes in regulation and the current regulatory environment, including the Dodd-Frank Act;

●

negative changes in our capital position;

●

the adverse effects of events such as outbreaks of contagious disease, war or terrorist activities, or essential utility outages, including deterioration in the global economy, instability in credit markets and disruptions in our customers’ supply chains and transportation;

●

changes in trade policy and any related tariffs; and

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●

each of the factors and risks under the heading “Risk Factors” in our 2019 Annual Report on Form 10-K, Part II, Item 1A, Risk Factors, in our Quarterly Reports on Form 10-Q, and in subsequent filings we make with the SEC.

Because the Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain, there can be no assurances that future actual results will correspond to any forward-looking statements and you should not rely on any forward-looking statements. Additionally, all statements in this Form 10-Q, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events, except as required by applicable law.

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share data)


	(unaudited)
	June 30,		December 31,
	2020		2019
Assets
Cash and due from banks	$	32,424	$	34,096
Interest earning deposits with financial institutions		225,065		16,536
Cash and cash equivalents		257,489		50,632
Securities available-for-sale, at fair value		447,436		484,648
Federal Home Loan Bank Chicago ("FHLBC") and Federal Reserve Bank Chicago ("FRBC") stock		9,917		9,917
Loans held-for-sale		9,416		3,061
Loans		2,052,336		1,930,812
Less: allowance for credit losses on loans		31,273		19,789
Net loans		2,021,063		1,911,023
Premises and equipment, net		44,536		44,354
Other real estate owned		5,082		5,004
Mortgage servicing rights, net		4,479		5,935
Goodwill and core deposit intangible		21,023		21,275
Bank-owned life insurance ("BOLI")		61,763		61,763
Deferred tax assets, net		13,242		11,459
Other assets		36,990		26,474
Total assets	$	2,932,436	$	2,635,545

Liabilities
Deposits:
Noninterest bearing demand	$	890,636	$	669,795
Interest bearing:
Savings, NOW, and money market		1,133,283		1,015,285
Time		427,398		441,669
Total deposits		2,451,317		2,126,749
Securities sold under repurchase agreements		52,088		48,693
Other short-term borrowings		8,250		48,500
Junior subordinated debentures		25,773		57,734
Senior notes		44,323		44,270
Notes payable and other borrowings		25,541		6,673
Other liabilities		42,628		25,062
Total liabilities		2,649,920		2,357,681

Stockholders’ Equity
Common stock		34,957		34,854
Additional paid-in capital		121,437		120,657
Retained earnings		218,856		213,723
Accumulated other comprehensive income		6,422		4,562
Treasury stock		(99,156)		(95,932)
Total stockholders’ equity		282,516		277,864
Total liabilities and stockholders’ equity	$	2,932,436	$	2,635,545


	June 30, 2020		December 31, 2019
	Common		Common
	Stock		Stock
Par value	$	1.00	$	1.00
Shares authorized		60,000,000		60,000,000
Shares issued		34,957,384		34,853,757
Shares outstanding		29,589,341		29,931,809
Treasury shares		5,368,043		4,921,948

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Income

(In thousands, except per share data)


		(unaudited)			(unaudited)
	Three Months Ended June 30,				Six Months Ended June 30,
	2020		2019		2020		2019
Interest and dividend income
Loans, including fees	$	22,347	$	24,924	$	45,944	$	49,023
Loans held-for-sale		110		31		146		53
Securities:
Taxable		1,694		2,223		3,857		4,637
Tax exempt		1,396		2,141		2,851		4,239
Dividends from FHLBC and FRBC stock		123		156		248		305
Interest bearing deposits with financial institutions		42		111		117		225
Total interest and dividend income		25,712		29,586		53,163		58,482
Interest expense
Savings, NOW, and money market deposits		385		759		1,020		1,530
Time deposits		1,442		1,641		3,208		3,259
Securities sold under repurchase agreements		23		147		139		296
Other short-term borrowings		34		575		143		1,182
Junior subordinated debentures		283		931		1,647		1,858
Senior notes		673		672		1,346		1,344
Notes payable and other borrowings		165		107		295		223
Total interest expense		3,005		4,832		7,798		9,692
Net interest and dividend income		22,707		24,754		45,365		48,790
Provision for credit losses		2,129		450		10,113		900
Net interest and dividend income after provision for credit losses		20,578		24,304		35,252		47,890
Noninterest income
Trust income		1,664		1,739		3,196		3,225
Service charges on deposits		1,120		1,959		2,846		3,821
Secondary mortgage fees		505		203		775		339
Mortgage servicing rights mark to market loss		(445)		(1,137)		(2,579)		(1,956)
Mortgage servicing income		458		491		926		948
Net gain on sales of mortgage loans		4,631		1,163		6,877		1,925
Securities gains (losses) , net		-		986		(24)		1,013
Change in cash surrender value of BOLI		532		320		483		778
Death benefit realized on BOLI		59		-		59		-
Card related income		1,311		1,552		2,598		2,837
Other income		860		867		1,860		1,695
Total noninterest income		10,695		8,143		17,017		14,625
Noninterest expense
Salaries and employee benefits		11,342		11,587		24,260		23,199
Occupancy, furniture and equipment		1,935		1,925		4,236		3,914
Computer and data processing		1,247		1,524		2,582		2,856
FDIC insurance		155		116		212		290
General bank insurance		237		236		483		486
Amortization of core deposit intangible		124		121		252		253
Advertising expense		57		381		166		615
Card related expense		514		474		1,046		829
Legal fees		176		243		307		369
Other real estate expense, net		143		248		380		298
Other expense		2,966		3,271		5,974		6,211
Total noninterest expense		18,896		20,126		39,898		39,320
Income before income taxes		12,377		12,321		12,371		23,195
Provision for income taxes		3,139		3,043		2,858		5,449
Net income	$	9,238	$	9,278	$	9,513	$	17,746

Basic earnings per share	$	0.31	$	0.31	$	0.32	$	0.59
Diluted earnings per share		0.31		0.31		0.31		0.58
Dividends declared per share		0.01		0.01		0.02		0.02

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(In thousands)


	(unaudited)				(unaudited)
	Three Months Ended June 30,				Six Months Ended June 30,
	2020		2019		2020		2019
Net Income	$	9,238	$	9,278	$	9,513	$	17,746

Unrealized holding gains on available-for-sale securities arising during the period		11,019		8,645		4,643		17,837
Related tax expense		(3,096)		(2,432)		(1,299)		(5,019)
Holding gains after tax on available-for-sale securities		7,923		6,213		3,344		12,818

Less: Reclassification adjustment for the net (losses) gains realized during the period
Net realized gains (losses)		-		986		(24)		1,013
Related tax (expense) benefit		-		(276)		7		(284)
Net realized gains (losses) after tax		-		710		(17)		729
Other comprehensive income on available-for-sale securities		7,923		5,503		3,361		12,089

Changes in fair value of derivatives used for cash flow hedges		443		(1,569)		(2,087)		(2,642)
Related tax (expense) benefit		(125)		442		586		744
Other comprehensive income (loss) on cash flow hedges		318		(1,127)		(1,501)		(1,898)

Total other comprehensive income		8,241		4,376		1,860		10,191
Total comprehensive income	$	17,479	$	13,654	$	11,373	$	27,937


	Accumulated		Accumulated		Total
	Unrealized Gain		Unrealized Gain		Accumulated Other
	(Loss) on Securities		(Loss) on Derivative		Comprehensive
	Available-for -Sale		Instruments		Income/(Loss)
For the Three Months Ended
Balance, March 31, 2019	$	2,548	$	(812)	$	1,736
Other comprehensive income (loss), net of tax		5,503		(1,127)		4,376
Balance, June 30, 2019	$	8,051	$	(1,939)	$	6,112

Balance, March 31, 2020	$	2,265	$	(4,084)	$	(1,819)
Other comprehensive income, net of tax		7,923		318		8,241
Balance, June 30, 2020	$	10,188	$	(3,766)	$	6,422



For the Six Months Ended
Balance, December 31, 2018	$	(4,038)	$	(41)	$	(4,079)
Other comprehensive income (loss) , net of tax		12,089		(1,898)		10,191
Balance, June 30, 2019	$	8,051	$	(1,939)	$	6,112

Balance, December 31, 2019	$	6,827	$	(2,265)	$	4,562
Other comprehensive income (loss), net of tax		3,361		(1,501)		1,860
Balance, June 30, 2020	$	10,188	$	(3,766)	$	6,422

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(In thousands)


	(Unaudited)
	Six Months Ended June 30,
	2020		2019
Cash flows from operating activities
Net income	$	9,513	$	17,746
Adjustments to reconcile net income to net cash provided by operating activities:
Net premium / discount from amortization on securities		1,126		1,476
Securities losses (gains), net		24		(1,013)
Provision for credit losses		10,113		900
Originations of loans held-for-sale		(183,854)		(64,762)
Proceeds from sales of loans held-for-sale		183,570		64,181
Net gains on sales of mortgage loans		(6,877)		(1,925)
Mortgage servicing rights mark to market loss		2,579		1,956
Net discount from accretion on loans		(606)		(246)
Net change in cash surrender value of BOLI		(483)		(778)
Net gains on sale of other real estate owned		(23)		(150)
Provision for other real estate owned valuation losses		218		196
Depreciation of fixed assets and amortization of leasehold improvements		1,357		1,278
Net gains on disposal and transfer of fixed assets		-		(3)
Amortization of core deposit intangibles		252		253
Change in current income taxes receivable		1,137		2,395
(Benefit from) / Provision for deferred tax expense		(2,503)		3,013
Change in accrued interest receivable and other assets		(7,338)		(2,570)
Accretion of purchase accounting adjustment on time deposits		-		(38)
Amortization of purchase accounting adjustment on notes payable and other borrowings		20		54
Amortization of junior subordinated debentures issuance costs		643		24
Amortization of senior notes issuance costs		53		50
Change in accrued interest payable and other liabilities		10,578		16,575
Stock based compensation		1,314		1,241
Net cash provided by operating activities		20,813		39,853
Cash flows from investing activities
Proceeds from maturities and calls, including pay down of securities available-for-sale		35,523		27,863
Proceeds from sales of securities available-for-sale		18,006		120,596
Purchases of securities available-for-sale		(12,800)		(82,930)
Net proceeds from sales of FHLBC stock		-		2,825
Net change in loans		(123,645)		(6,195)
Proceeds from claims on BOLI, net of claims receivable		483		-
Proceeds from sales of other real estate owned, net of participation purchase		311		1,452
Proceeds from disposition of fixed assets		-		3
Net purchases of premises and equipment		(1,539)		(1,390)
Net cash (used in) provided by investing activities		(83,661)		62,224
Cash flows from financing activities
Net change in deposits		324,568		(38,861)
Net change in securities sold under repurchase agreements		3,395		7,534
Net change in other short-term borrowings		(40,250)		(62,375)
Redemption of junior subordinated debentures		(32,604)		-
Issuance of term note		20,000		-
Repayment of term note		(1,000)		-
Net change in notes payable and other borrowings, excluding term note		(152)		(4,398)
Proceeds from exercise of stock options		-		32
Dividends paid on common stock		(597)		(597)
Purchase of treasury stock		(3,655)		(430)
Net cash provided by (used in) financing activities		269,705		(99,095)
Net change in cash and cash equivalents		206,857		2,982
Cash and cash equivalents at beginning of period		50,632		55,235
Cash and cash equivalents at end of period	$	257,489	$	58,217

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Changes in

Stockholders’ Equity

(In thousands)


							Accumulated
			Additional				Other				Total
(unaudited)	Common		Paid-In		Retained		Comprehensive		Treasury		Stockholders’
	Stock		Capital		Earnings		Income (Loss)		Stock		Equity
For the Three Months Ended

Balance, March 31, 2019	$	34,825	$	119,126	$	183,634	$	1,736	$	(96,066)	$	243,255
Net income						9,278						9,278
Other comprehensive income, net of tax								4,376				4,376
Dividends declared and paid, ($0.01 per share)						(300)						(300)
Vesting of restricted stock				(32)						32		-
Stock option exercised				668								668
Purchase of treasury stock										(13)		(13)
Balance, June 30, 2019	$	34,825	$	119,762	$	192,612	$	6,112	$	(96,047)	$	257,264

Balance, March 31, 2020	$	34,957	$	121,081	$	209,915	$	(1,819)	$	(98,357)	$	265,777
Net income						9,238						9,238
Other comprehensive income, net of tax								8,241				8,241
Dividends declared and paid, ($0.01 per share)						(297)						(297)
Vesting of restricted stock				(229)						229		-
Stock based compensation				585								585
Purchase of treasury stock from taxes withheld on stock awards										(12)		(12)
Purchase of treasury stock from stock repurchase program										(1,016)		(1,016)
Balance, June 30, 2020	$	34,957	$	121,437	$	218,856	$	6,422	$	(99,156)	$	282,516


							Accumulated
			Additional				Other				Total
	Common		Paid-In		Retained		Comprehensive		Treasury		Stockholders’
	Stock		Capital		Earnings		Income (Loss)		Stock		Equity
For the Six Months Ended

Balance, December 31, 2018	$	34,720	$	119,081	$	175,463	$	(4,079)	$	(96,104)	$	229,081
Net income						17,746						17,746
Other comprehensive income, net of tax								10,191				10,191
Dividends declared and paid, ($0.02 per share)						(597)						(597)
Vesting of restricted stock		103		(254)						151		-
Stock option exercised		2		7						23		32
Stock warrants exercised				(313)						313		-
Stock based compensation				1,241								1,241
Purchase of treasury stock										(430)		(430)
Balance, June 30, 2019	$	34,825	$	119,762	$	192,612	$	6,112	$	(96,047)	$	257,264


Balance, December 31, 2019	$	34,854	$	120,657	$	213,723	$	4,562	$	(95,932)	$	277,864
Net income						9,513						9,513
Other comprehensive income, net of tax								1,860				1,860
Adoption of ASU 2016-13						(3,783)						(3,783)
Dividends declared and paid, ($0.02 per share)						(597)						(597)
Vesting of restricted stock		103		(534)						431		-
Stock based compensation				1,314								1,314
Purchase of treasury stock from taxes withheld on stock awards										(423)		(423)
Purchase of treasury stock from stock repurchase program										(3,232)		(3,232)
Balance, June 30, 2020	$	34,957	$	121,437	$	218,856	$	6,422	$	(99,156)	$	282,516

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Note 1 – Basis of Presentation and Changes in Significant Accounting Policies

Except as set forth below in this Note 1, the accounting policies followed in the preparation of the interim consolidated financial statements are consistent with those used in the preparation of the annual financial information. The interim consolidated financial statements reflect all normal and recurring adjustments that are necessary, in the opinion of management, for a fair statement of results for the interim period presented. Results for the period ended June 30, 2020, are not necessarily indicative of the results that may be expected for the year ending December 31, 2020. These interim consolidated financial statements are unaudited and 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, 2019. Unless otherwise indicated, dollar amounts in the tables contained in the notes to the consolidated financial statements 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 United States generally accepted accounting principles (“GAAP”) 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 consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.

Recent Accounting Pronouncements

In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Measurement of Credit Losses on Financial Instruments (Topic 326),” also known as Current Expected Credit Losses, or CECL. ASU 2016-13 was issued to provide financial statement users with more useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date to enhance the decision making process. The new methodology reflects expected credit losses based on relevant vintage historical information, supported by reasonable forecasts of projected loss given defaults, which will affect the collectability of the reported amounts. This new methodology also requires available-for-sale debt securities to have a credit loss recorded through an allowance rather than write-downs through an other than temporary impairment analysis. In addition, an allowance must be established for the credit risk related to unfunded commitments. ASU 2016-13 is effective for financial statements issued for fiscal years beginning after December 15, 2019, and was adopted as of January 1, 2020, by the Company.

Upon issuance of ASU 2016-13, the Company set up a CECL committee, with the goal of establishing a timeline for CECL data collection, implementation, parallel runs, testing, and model validation. The Company has implemented a software solution provided by a third party vendor to assist in the determination of the allowance for credit losses (“ACL”), and the third party validation process was completed in the fourth quarter of 2019. The Company accumulated historical data by loan pools and collateral classifications. All historical data, model assumptions and calculation parameters were analyzed by the third party validation team, and management made enhancements to the software model used based on their recommendations.

Our approach for estimating expected life-time credit losses for loans includes the following components:

●

An initial forecast period of one year for all portfolio segments and off-balance-sheet credit exposures. This period reflects management’s expectation of losses based on forward-looking economic scenarios over that time.

●

A historical reversion loss forecast period covering the remaining contractual life, adjusted for prepayments, by portfolio segment based on the historical loss rate of loans within those segments.

●

The initial loss forecast period and historical reversion loss rate is based on economic conditions at the measurement date.

●

We primarily utilized the static pool and migration analysis methods to estimate credit losses. Such methods would obtain estimated life-time credit losses using the conceptual components described above.

Based on our portfolio composition at December 31, 2019, and the economic environment at that time, we recorded an overall increase in our ACL for loans and leases of $5.9 million and an ACL for unfunded commitments of $1.7 million. Approximately $2.5 million of the increase to the ACL on loans resulted from the transfer of the non-accretable purchase accounting adjustments on purchased credit impaired loans. There was no impact from adoption of CECL on securities available-for sale. As a result of the adoption of this new standard on January 1, 2020, we recorded a reduction to retained earnings of approximately $3.7 million, which was net of the $1.4

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

million deferred tax asset impact stemming from adoption. The Company finalized internal control processes and disclosure documentation related to adoption of this standard during the first quarter of 2020.

As of March 31, 2020, a provision for credit losses was recorded based on the current uncertainty experienced in the macroeconomic environment, primarily due to falling interest rates and the impact of COVID-19. This additional ACL was not considered part of the ASU 2016-13 adoption, as these changes in the assessment of the ACL occurred after the January 1, 2020, adoption. We recorded a provision for credit losses of $2.1 million during the second quarter of 2020, comprised of $1.4 million of ACL related to loans and leases, and $734,000 of ACL related to unfunded commitments. We will continue to assess and evaluate the estimated future credit loss impact of current market conditions in subsequent reporting periods, which will be highly dependent on credit quality, macroeconomic forecasts and conditions, the local and national response to the COVID-19 pandemic, as well as the composition of our loans and available-for-sale securities portfolio.

Change in Significant Accounting Policies

Significant accounting policies are presented in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019. 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 consolidated financial statements and how those values are determined.

In addition to the significant accounting policies presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, on January 1, 2020, as discussed above, the Company adopted CECL, an expected loss methodology which replaces the incurred loss methodology for determining the Company’s provision for loan losses and allowance for loan and lease losses. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables and held-to-maturity debt securities. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) and net investments in leases recognized by a lessor in accordance with ASU 2016-02 “Leases (Topic 842)” (“ASU 2016-02”). In addition, CECL made changes to the accounting for available-for-sale debt securities. The allowance for credit losses under CECL is discussed below.

Allowance for Credit Losses

The ACL is an estimate of the expected credit losses on the loans held for investment, unfunded loan commitments, and available-for-sale debt securities portfolios.

Allowance for Credit Losses on Loans

The ACL is calculated according to GAAP standards and is maintained by management at a level believed adequate to absorb estimated credit losses that are expected to occur within the existing loan portfolio through their contractual terms. The ACL is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on loans. Determination of the ACL is inherently subjective in nature since it requires significant estimates and management judgment, and includes a level of imprecision given the difficulty of identifying and assessing the factors impacting loan repayment and estimating the timing and amount of losses. While management utilizes its best judgment and information available, the ultimate adequacy of the ACL is dependent upon a variety of factors beyond the Company’s direct control, including, but not limited to, the performance of the loan portfolio, consideration of current economic trends, changes in interest rates and property values, estimated losses on pools of homogeneous loans based on an analysis that uses historical loss experience for prior periods that are determined to have like characteristics with the current period such as pre-recessionary, recessionary, or recovery periods, portfolio growth and concentration risk, management and staffing changes, the interpretation of loan risk classifications by regulatory authorities and other credit market factors. While each component of the ACL is determined separately, the entire balance is available for the entire loan portfolio.

The ACL methodology consists of measuring loans on a collective (pool) basis when similar risk characteristics exist. The Company has identified the following loan portfolios and measures the ACL using the following methods:

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

●

Commercial loans – the Company uses a migration analysis, and within this segment classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative factor adjustment in addition to the loss rates applied, as discussed below.

●

Leases – the Company uses a remaining life methodology, also known as WARM (weighted average remaining life), as this segment is relatively new to the Company and more than four years of the Company’s own historical loss data is not available. In accordance with accounting standards, we used an identified peer group to estimate losses for this portfolio.

●

Real estate – commercial (“CRE”) – this loan portfolio is segregated into two segments:

CRE owner occupied – the Company uses a migration analysis, and within this segment classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative adjustment in addition to the loss rates applied, as discussed below.

CRE investor – the Company uses a migration analysis, and within this segment classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative adjustment in addition to the loss rates applied, as discussed below.

●

Real estate – construction – the Company uses a static segment analysis, which relies on the Company’s historical loss rates, as well as a qualitative adjustment in addition to the loss rates applied.

●

Real estate-residential - this loan portfolio is segregated into two segments:

Residential owner occupied and Residential investor – the Company uses a static segment analysis, applying historical loss rates from periods with like characteristics as the current period, and also a qualitative adjustment in addition to the loss rates applied.

●

Multifamily – the Company uses a migration analysis, and within this segment, the Company classifies six different risk levels to assign a loss rate based on historical losses, as well as applying a qualitative adjustment in addition to the loss rates applied.

●

HELOCs – this portfolio is segregated into two segments, a HELOC legacy segment which uses a static pool analysis, and a HELOC purchased segment, which uses the WARM method, and applies loss rates from the institutions from which the Company purchased the HELOCs, if available.

Purchased credit deteriorated loans (“PCD loans”), are purchased loans that, as of the date of acquisition, the Company determined had experienced a more-than-insignificant deterioration in credit quality since origination. The Company records acquired PCD loans by adding the expected credit losses (i.e., the ACL) to the purchase price of the financial assets rather than recording it through the provision for credit losses in the income statement; thus, the sum of the loans’ purchase price and initial ALLL estimate represents the initial amortized cost basis. The difference between the initial amortized cost basis and the unpaid principal balance is the non-credit discount or premium. Subsequent changes in the ACL on PCD loans is recognized through the provision for credit losses.

The non-credit discount or premium is accreted or amortized into interest income over the remaining life of the PCD loan on a level-yield basis. In accordance with the transition requirements within the CECL standard, the Company’s purchased credit impaired loans (“PCI loans”) are now treated as PCD loans. Before January 1, 2020, PCI loans that met the definition of nonperforming loans were excluded from the Company’s nonperforming disclosures, as long as their cash flows and the timing of such cash flows continued to be estimable and probable of collection. As a result of CECL implementation on January 1, 2020, PCD loans that meet the definition of nonperforming loans are now included in the Company’s nonperforming disclosures.

The qualitative factors applied to each loan portfolio consist of the impact of other internal and external qualitative and credit market factors as assessed by management through a detailed loan review, ACL analysis and credit discussions. These internal and external qualitative and credit market factors include:

●

changes in lending policies and procedures, including changes in underwriting standards and collections, charge-offs and recovery practices;

●

changes in international, national, regionally and local conditions (specific factors which impact portfolios or discrepancies with national economic factors which are utilized within the economic forecast);

●

changes in the experience, depth and ability of lending management;

●

changes in the volume and severity of past due loans and other similar loan conditions;

●

changes in the nature and volume of the loan portfolio and terms of loans;

●

the existence and effect of any concentrations of credit and changes in the levels of such concentrations (this characteristic requires any portfolio exceeding 25% of capital to have a factor considered unless the pool is otherwise well diversified or holds a relatively low inherent risk);

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

●

effects of other external factors, such as competition, legal or regulatory factors, on the level of estimated credit losses;

●

changes in the quality of our loan review functions; and

●

changes in the value of underlying collateral for collateral dependent loans.

The impact of the above listed internal and external qualitative and credit market risk factors is assessed within predetermined ranges to adjust the ACL totals calculated.

In addition to the pooled analysis performed for the majority of our loan and commitment balances, we also individually review those loans that have collateral dependency or are nonperforming. Finally, we maintain a component of the ACL for those factors that cannot be quantified in the above analysis or are as yet unknown to us, due to changing economic conditions and other aspects of credit risk; which is known as the Company’s “Other Reserves.”

Loans are charged off against the ACL when management believes the uncollectibility of a loan balance is confirmed, while recoveries of amounts previously charged-off are credited to the ACL. Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged off. Approved releases from previously established ACL reserves authorized under our ACL methodology also reduce the ACL. Additions to the ACL are established through the provision for credit losses on loans, which is charged to expense.

The Company’s ACL methodology is intended to reflect all loan portfolio risk, but management recognizes the inability to accurately depict all future credit losses in a current ACL estimate, as the impact of various factors cannot be fully known. Accrued interest receivable on loans is excluded from the amortized cost basis of financing receivables for the purpose of determining the allowance for credit losses. All calculations conform to GAAP.

Allowance for Credit Losses on Unfunded Loan Commitments

The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk by a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company. The ACL related to off-balance sheet credit exposures, which is within other liabilities on the Company’s balance sheet, is estimated at each balance sheet date under the CECL model, and is adjusted as determined necessary through the provision for credit losses on the income statement. The estimate for ACL on unfunded loan commitments includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life.

Allowance for Credit Losses on Securities Available-for-Sale

For available-for-sale debt securities in an unrealized loss position, the Company first assesses whether it intends to sell, or it is more likely than not that it will sell, the security before recovery of its amortized cost basis. If either of the aforementioned criteria exists, the Company will record an ACL related to securities available-for-sale with an offsetting entry to the provision for credit losses on securities on the income statement. If either of these criteria does not exist, the Company will evaluate the securities individually to determine whether the decline in the fair value below the amortized cost basis (impairment) is due to credit-related factors or noncredit-related factors, such as market interest rate fluctuations.

In evaluating securities available-for sale for potential impairment, the Company considers many factors, including the financial condition and near-term prospects of the issuer, which for debt securities considers external credit ratings and recent downgrades; and its ability and intent to hold the security for a period of time sufficient for a recovery in value. The Company also considers the extent to which the securities are issued by the federal government or its agencies, and any guarantee of issued amounts by those agencies. The amount of the impairment related to other factors is recognized in other comprehensive income (loss).

Accrued interest receivable on securities available-for-sale is excluded from the amortized cost basis of those securities for the purpose of determining the allowance for credit losses. All calculations conform to GAAP.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Risks and Uncertainties

In December 2019, a novel strain of coronavirus (COVID-19) was reported to have surfaced in China, and has since spread to many other countries, including the United States. In March 2020, the World Health Organization declared COVID-19 a global pandemic and the United States declared a National Public Health Emergency. The COVID-19 pandemic has severely restricted the level of economic activity in the Company’s markets. In response to the COVID-19 pandemic, the State of Illinois and most other states took preventative or protective actions, such as imposing restrictions on travel and business operations, advising or requiring individuals to limit or forego their time outside of their homes, and ordering temporary closures of businesses that were deemed to be non-essential. Although many businesses have begun to re-open, some markets, including those in Illinois, have since experienced a resurgence of COVID-19 cases, which may further slow overall economic activity and recovery. Uncertainty also remains if, how and when schools will re-open and the impact of such re-opening decision on the economy.

The impact of the COVID-19 pandemic is fluid and continues to evolve. The unprecedented and rapid spread of COVID-19 and its associated impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending, and other economic activities has resulted in less economic activity, lower bank equity market valuations and significant volatility and disruption in financial markets. In addition, due to the COVID-19 pandemic, market interest rates have declined significantly, with the 10-year Treasury bond falling below 1.00% on March 3, 2020, for the first time, and declining further to 0.65% as of June 30, 2020. On March 3, 2020, the Federal Open Market Committee reduced the targeted federal funds interest rate range by 50 basis points to 1.00% to 1.25%. This range was further reduced to 0% to 0.25% percent on March 16, 2020. These reductions in interest rates and the other effects of the COVID-19 pandemic have had, and are expected to continue to have, possibly materially, an adverse effect on the Company’s business, financial condition and results of operations. The ultimate extent of the impact of the COVID-19 pandemic on the Company’s business, financial condition and results of operations is currently uncertain and will depend on various developments and other factors, including, among others, the duration and scope of the pandemic, as well as governmental, regulatory and private sector responses to the pandemic, and the associated impacts on the economy, financial markets and the Company’s customers, employees and vendors.

As of June 30, 2020, our consolidated balance sheet included goodwill of $18.6 million. During the first and second quarter of 2020, we considered whether a quantitative assessment of goodwill was required as a result of the significant economic disruption caused by the COVID-19 pandemic. Impacts of the economic disruptions were noted from the latter half of March through the second quarter, specifically, the decline in the trading price of our common stock and an increase in the U.S. unemployment rate. After considering qualitative factors regarding the expected impacts of the pandemic on our business, operations and financial condition, we determined that these conditions did not indicate that it is more likely than not that the Company’s carrying value exceeded our fair value as of June 30, 2020, based on information available at this time, as these negative market indicators were not observed over a sustained period of time. However, further delayed recovery or further deterioration in market conditions related to the general economy, financial markets, and the associated impacts on our customers, employees and vendors, among other factors, could significantly impact the impairment analysis and may result in future goodwill impairment charges that, if incurred, could have a material adverse effect on our results of operations and financial condition.

Subsequent Events

On July 21, 2020, the Company’s Board of Directors declared a cash dividend of $0.01 per share payable on August 10, 2020, to stockholders of record as of July 31, 2020; dividends of $296,000 are scheduled to be paid to stockholders on August 10, 2020.

Note 2 – Acquisitions

On April 20, 2018, the Company acquired Greater Chicago Financial Corp. (“GCFC”) and its wholly-owned subsidiary, ABC Bank, which operated 4 branches in the Chicago metro area. In addition to the acquisition price of $41.1 million, the Company retired the convertible and nonconvertible debentures held by GCFC upon acquisition, which totaled $6.6 million, including interest due. The purchase and the retirement of the debentures were funded with the Company’s cash on hand, and all GCFC common stock was retired and cancelled simultaneous with the close of the transaction. The Company acquired $227.6 million of loans, net of purchase accounting adjustments, and $248.5 million of deposits, net of purchase accounting adjustments for time deposits. Purchase accounting adjustments

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

recorded include a loan valuation mark of $11.2 million, a core deposit intangible of $3.1 million, a fixed asset valuation adjustment of $1.5 million, and goodwill of $10.2 million. In addition, a deferred tax asset of $3.5 million was recorded as of the date of acquisition based on analysis of the fair value of assets acquired, less liabilities assumed. None of the $10.2 million recorded as goodwill is expected to be deductible for tax purposes. These fair value estimates were considered final as of March 31, 2019, and no further refinements to the values recorded are anticipated.

Note 3 – Securities

Investment Portfolio Management

Our investment portfolio serves the liquidity needs and income objectives of the Company. While the portfolio serves as an important component of the overall liquidity management at the Bank, portions of the portfolio also serve as income producing assets. The size and composition of the portfolio reflects liquidity needs, loan demand and interest income objectives. Portfolio size and composition will be adjusted from time to time. While a significant portion of the portfolio consists of readily marketable securities to address liquidity, other parts of the portfolio may reflect funds invested pending future loan demand or to maximize interest income without undue interest rate risk.

Investments are comprised of debt securities and non-marketable equity investments. Securities available-for-sale are carried at fair value. Unrealized gains and losses, net of tax, on securities available-for-sale are reported as a separate component of equity. This balance sheet component changes as interest rates and market conditions change. Unrealized gains and losses are not included in the calculation of regulatory capital.

Federal Home Loan Bank of Chicago (“FHLBC”) and Federal Reserve Bank of Chicago (“FRBC”) stock are considered nonmarketable equity investments. FHLBC stock was recorded at $3.7 million at June 30, 2020, and December 31, 2019. FRBC stock was recorded at $6.2 million at June 30, 2020, and December 31, 2019.

The following tables summarize the amortized cost and fair value of the securities portfolio at June 30, 2020, and December 31, 2019, and the corresponding amounts of gross unrealized gains and losses:

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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


			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
June 30, 2020	Cost		Gains		Losses		Value
Securities available-for-sale
U.S. Treasury	$	4,012	$	135	$	-	$	4,147
U.S. government agencies		7,450		-		(174)		7,276
U.S. government agencies mortgage-backed		15,505		1,274		-		16,779
States and political subdivisions		235,111		16,388		(1,135)		250,364
Collateralized mortgage obligations		55,391		1,672		(950)		56,113
Asset-backed securities		82,004		430		(2,408)		80,026
Collateralized loan obligations		33,794		46		(1,109)		32,731
Total securities available-for-sale	$	433,267	$	19,945	$	(5,776)	$	447,436


			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
December 31, 2019	Cost¹		Gains		Losses		Value
Securities available-for-sale
U.S. Treasury	$	4,010	$	26	$	-	$	4,036
U.S. government agencies		8,502		-		(165)		8,337
U.S. government agencies mortgage-backed		16,164		443		(19)		16,588
States and political subdivisions		240,399		11,207		(2,431)		249,175
Collateralized mortgage obligations		57,059		963		(38)		57,984
Asset-backed securities		82,114		617		(887)		81,844
Collateralized loan obligations		66,898		29		(243)		66,684
Total securities available-for-sale	$	475,146	$	13,285	$	(3,783)	$	484,648

¹ Excludes accrued interest receivable of $2.9 million and $3.2 million at June 30, 2020 and December 31, 2019, respectively, that is recorded in other assets on the consolidated balance sheet.

The fair value, amortized cost and weighted average yield of debt securities at June 30, 2020, by contractual maturity, were as follows in the table below. Securities not due at a single maturity date are shown separately.


			Weighted
	Amortized		Average		Fair
Securities available-for-sale	Cost		Yield		Value
Due in one year or less	$	416	2.01	%	$	420
Due after one year through five years		6,066	2.11			6,326
Due after five years through ten years		15,770	2.43			16,211
Due after ten years		224,321	2.98			238,830
		246,573	2.93			261,787
Mortgage-backed and collateralized mortgage obligations		70,896	3.10			72,892
Asset-backed securities		82,004	1.60			80,026
Collateralized loan obligations		33,794	2.44			32,731
Total securities available-for-sale	$	433,267	2.66	%	$	447,436

At June 30, 2020, the Company’s investments included $55.9 million of asset-backed securities that are backed by student loans originated under the Federal Family Education Loan program (“FFEL”). Under the FFEL, private lenders made federally guaranteed student loans to parents and students. While the program was modified several times before elimination in 2010, FFEL securities are generally guaranteed by the U.S Department of Education (“DOE”) at not less than 97% of the outstanding principal amount of the loans. The guarantee will reduce to 85% if the DOE receives reimbursement requests in excess of 5% of insured loans; reimbursement will drop

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

to 75% if reimbursement requests exceed 9% of insured loans. In addition to the DOE guarantee, total added credit enhancement in the form of overcollateralization and/or subordination amounted to $4.9 million, or 8.71% of outstanding principal.

The Company has invested in securities issued from 1 originator that individually amount to over 10% of the Company’s stockholders equity. Information regarding this issuer and the value of the securities issued follows:


	June 30, 2020
(in thousands)	Amortized		Fair
Issuer	Cost		Value
Towd Point Mortgage Trust	$	33,298	$	34,394

Securities with unrealized losses with no corresponding allowance for credit losses at June 30, 2020 and December 31, 2019, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands except for number of securities):


	Less than 12 months					12 months or more
June 30, 2020	in an unrealized loss position					in an unrealized loss position					Total
	Number of	Unrealized		Fair		Number of	Unrealized		Fair		Number of	Unrealized		Fair
Securities available-for-sale	Securities	Losses		Value		Securities	Losses		Value		Securities	Losses		Value
U.S. government agencies	-	$	-	$	-	4	$	174	$	7,276	4	$	174	$	7,276
States and political subdivisions	1		7		890	2		1,128		5,466	3		1,135		6,356
Collateralized mortgage obligations	8		944		11,867	1		6		522	9		950		12,389
Asset-backed securities	9		1,223		36,955	2		1,185		30,055	11		2,408		67,010
Collateralized loan obligations	3		646		16,343	2		463		11,703	5		1,109		28,046
Total securities available-for-sale	21	$	2,820	$	66,055	11	$	2,956	$	55,022	32	$	5,776	$	121,077


	Less than 12 months					12 months or more
December 31, 2019	in an unrealized loss position					in an unrealized loss position					Total
	Number of	Unrealized			Fair	Number of	Unrealized			Fair	Number of	Unrealized			Fair
Securities available-for-sale	Securities	Losses			Value	Securities	Losses			Value	Securities	Losses			Value
U.S. government agencies	-	$	-	$	-	4	$	165	$	8,337	4	$	165	$	8,337
U.S. government agencies mortgage-backed	3		10		3,018	2		9		843	5		19		3,861
States and political subdivisions	6		1,665		41,043	2		766		6,593	8		2,431		47,636
Collateralized mortgage obligations	2		26		9,054	2		12		1,209	4		38		10,263
Asset-backed securities	4		839		54,540	1		48		3,238	5		887		57,778
Collateralized loan obligations	4		62		21,927	4		181		25,020	8		243		46,947
Total securities available-for-sale	19	$	2,602	$	129,582	15	$	1,181	$	45,240	34	$	3,783	$	174,822

As required upon the adoption of ASU 2016-13, we performed an analysis to determine if any of the unrealized losses on securities available-for-sale were comprised of credit losses as compared to unrealized losses due to market interest rate adjustments. Our assessment included a review of the unrealized loss for each security issuance held; the financial condition and near-term prospects of the issuer, including external credit ratings and recent downgrades; and our ability and intent to hold the security for a period of time sufficient for a recovery in value. The Company also considered the extent to which the securities are issued by the federal government or its agencies, and any guarantee of issued amounts by those agencies. No credit losses were determined to be present as of the date of CECL adoption or as of the quarter ended June 30, 2020, as there was no credit quality deterioration noted. Therefore, no provision for credit losses on securities was recognized for the second quarter end.

The following table presents net realized gains (losses) on securities available-for-sale for the three and six months ended June 30, 2020 and 2019.

Three Months Ended

Six Months Ended

June 30,

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Securities available-for-sale	2020			2019			2020			2019
Proceeds from sales of securities	$	-		$	39,072		$	18,006		$	120,596
Gross realized gains on securities		-			986			17			1,591
Gross realized losses on securities		-			-			(41)			(578)
Net realized gains (losses)	$	-		$	986		$	(24)		$	1,013
Income tax (expense) benefit on net realized gains (losses)	$	-		$	(276)		$	7		$	(284)
Effective tax rate applied		0.0	%		28.0	%		29.2	%		28.0	%

Securities valued at $329.5 million as of June 30, 2020, an increase from $320.8 million at year-end 2019, were pledged to secure deposits and borrowings, and for other purposes.

Note 4 – Loans and Allowance for Credit Losses on Loans

Major segments of loans were as follows:


	June 30, 2020		December 31, 2019
Commercial	$	441,642	$	332,842
Leases		133,293		119,751
Commercial real estate - Investor		525,714		520,095
Commercial real estate - Owner occupied		343,982		345,504
Construction		83,939		69,617
Residential real estate - Investor		69,421		71,105
Residential real estate - Owner occupied		126,303		136,023
Multifamily		197,521		189,773
HELOC		89,170		91,605
HELOC - Purchased		26,467		31,852
Other ¹		14,884		12,258
Total loans, excluding deferred loan costs and PCI loans ²		2,052,336		1,920,425
Net deferred loan costs		-		1,786
Total loans, excluding PCI loans ²		2,052,336		1,922,211
PCI loans		-		8,601
Total loans, including deferred loan costs and PCI loans ²	$	2,052,336	$	1,930,812
Allowance for credit losses on loans		(31,273)		(19,789)
Net loans³	$	2,021,063	$	1,911,023

¹ The “Other” segment for 2020 includes consumer and overdrafts in this table and in subsequent tables within Note 4 - Loans and Allowance for Credit Losses on Loans.

²As noted in the paragraph below, for periods before the Company’s adoption of CECL on January 1, 2020, PCI loans and their related deferred loan costs (now PCD loans) were excluded from nonperforming loan disclosures and were therefore separately reported. After the adoption of CECL, all PCD loans are now included within each relevant loan type and are not separately reported as PCI loans, because such loans are now included within the Company’s nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan.

³ Excludes accrued interest receivable of $7.3 million and $6.5 million at June 30, 2020 and December 31, 2019, respectively, that is recorded in other assets on the consolidated balance sheet.

Purchased credit deteriorated loans, or PCD loans, are purchased loans that, as of the date of acquisition, the Company determined had experienced a more-than-insignificant deterioration in credit quality since origination. Before the Company adopted CECL on January 1, 2020, PCD loans were referred to as purchased credit impaired loans, or PCI loans, and such PCI loans and their related deferred loan costs were excluded from the Company’s nonperforming loan disclosures, as long as the cash flows on such loans and the timing of such cash flows continued to be estimable and probable of collection. However, after the Company adopted CECL on January 1, 2020, PCD loans and their related deferred loan costs are now included in the Company’s nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

It is the policy of the Company to review each prospective credit prior to making a loan in order to determine if an adequate level of security or collateral has been obtained. The type of collateral, when required, will vary from liquid assets to real estate. The Company’s access to collateral, in the event of borrower default, is assured through adherence to lending laws, the Company’s lending standards and credit monitoring procedures. Although the Bank makes loans primarily within its market area, there are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector. The real estate related categories listed above represent 71.3% and 75.4% of the portfolio at June 30, 2020, and December 31, 2019, respectively, and include a mix of owner and non-owner occupied, residential, construction and multifamily loans.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

The following table presents the collateral dependent loans and the related ACL allocated by segment of loans as of June 30, 2020:


			Accounts						ACL
June 30, 2020	Real Estate		Receivable		Other		Total		Allocation
Commercial	$	6	$	2,165	$	16	$	2,187	$	12
Leases		-		-		254		254		74
Commercial real estate - Investor		4,363		-		-		4,363		126
Commercial real estate - Owner occupied		9,089		-		-		9,089		199
Construction		2,318		-		-		2,318		933
Residential real estate - Investor		845		-		-		845		-
Residential real estate - Owner occupied		3,591		-		-		3,591		214
Multifamily		2,299		-		-		2,299		482
HELOC		1,148		-		-		1,148		212
HELOC - Purchased		113		-		-		113		-
Other		-		-		13		13		8
Total	$	23,772	$	2,165	$	283	$	26,220	$	2,260

The following table presents the activity in the allowance for credit losses (“ACL”) for the three and six months ended June 30, 2020. The Company’s estimate of the ACL reflects losses over the expected remaining contractual life of the loans.


			Impact of		Provision
	Beginning		Adopting		for Credit						Ending
Allowance for credit losses	Balance		ASC 326		Losses		Charge-offs		Recoveries		Balance
Three months ended June 30, 2020
Commercial	$	3,177	$	-	$	(887)	$	22	$	24	$	2,292
Leases		1,890		-		122		-		-		2,012
Commercial real estate - Investor		6,021		-		1,690		2		16		7,725
Commercial real estate - Owner occupied		2,051		-		762		292		-		2,521
Construction		4,031		-		400		-		-		4,431
Real estate - Investor		1,896		-		319		4		6		2,217
Real estate - Owner occupied		3,368		-		(230)		43		109		3,204
Multifamily		3,850		-		(332)		-		-		3,518
HELOC		2,260		-		(58)		2		55		2,255
HELOC - Purchased		850		-		(452)		-		-		398
Other¹		651		-		61		41		29		700
	$	30,045	$	-	$	1,395	$	406	$	239	$	31,273


Six months ended June 30, 2020
Commercial	$	3,015	$	(292)	$	(348)	$	119	$	36	$	2,292
Leases		1,262		501		249		-		-		2,012
Commercial real estate - Investor		6,218		(741)		2,226		15		37		7,725
Commercial real estate - Owner occupied		3,678		(848)		1,091		1,401		1		2,521
Construction		513		1,334		2,584		-		-		4,431
Residential real estate - Investor		601		740		854		5		27		2,217
Residential real estate - Owner occupied		1,257		1,320		538		43		132		3,204
Multifamily		1,444		1,732		342		-		-		3,518
HELOC		1,161		1,526		(543)		85		196		2,255
HELOC - Purchased		-		-		398		-		-		398
Other		640		607		(497)		139		89		700
	$	19,789	$	5,879	$	6,894	$	1,807	$	518	$	31,273

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

The following table presents activity in the allowance for loan and lease losses for the three and six months ended at June 30, 2019, as determined in accordance with ASC 310 prior to the adoption of ASU 2016-13:


			Provision
	Beginning		for Loan						Ending
Allowance for loan and lease losses:	Balance		Losses		Charge-offs		Recoveries		Balance
Three months ended June 30, 2019
Commercial	$	3,052	$	386	$	67	$	6	$	3,377
Leases		805		156		-		-		961
Commercial real estate - Investor		5,719		576		-		12		6,307
Commercial real estate - Owner occupied		3,148		(133)		42		-		2,973
Construction		800		19		1		2		820
Real estate - Investor		636		(53)		-		3		586
Real estate - Owner occupied		1,320		(127)		-		11		1,204
Multifamily		1,153		77				-		1,230
HELOC		1,325		17		50		12		1,304
HELOC - Purchased		-		267		229		-		38
Other¹		1,358		(735)		85		34		572
	$	19,316	$	450	$	474	$	80	$	19,372


Six months ended June 30, 2019
Commercial	$	2,832	$	588	$	79	$	36	$	3,377
Leases		734		227		-		-		961
Commercial real estate - Investor		5,492		927		144		32		6,307
Commercial real estate - Owner occupied		3,835		(736)		129		3		2,973
Construction		969		(149)		1		1		820
Residential real estate - Investor		629		(56)		6		19		586
Residential real estate - Owner occupied		1,302		(123)		12		37		1,204
Multifamily		1,143		79		-		8		1,230
HELOC		1,449		(153)		50		58		1,304
HELOC - Purchased		-		267		229		-		38
Other¹		621		29		169		91		572
	$	19,006	$	900	$	819	$	285	$	19,372

¹ The “Other” class includes consumer, overdrafts and net deferred costs.

Aged analysis of past due loans by class of loans was as follows:


													90 days or
					90 Days or								Greater Past
	30-59 Days		60-89 Days		Greater Past		Total Past						Due and
June 30, 2020	Past Due		Past Due		Due		Due		Current		Total Loans		Accruing
Commercial	$	-	$	13	$	2,151	$	2,164	$	439,478	$	441,642	$	-
Leases		93		415		181		689		132,604		133,293		-
Commercial real estate - Investor		242		430		1,515		2,187		523,527		525,714		-
Commercial real estate - Owner occupied		473		1,650		6,083		8,206		335,776		343,982		579
Construction		3,285		-		375		3,660		80,279		83,939		52
Residential real estate - Investor		80		160		689		929		68,492		69,421		-
Residential real estate - Owner occupied		6		314		1,307		1,627		124,676		126,303		209
Multifamily		4,133		821		69		5,023		192,498		197,521		-
HELOC		110		52		277		439		88,731		89,170		-
HELOC - Purchased		49		-		64		113		26,354		26,467		-
Other		31		1		8		40		14,844		14,884		-
Total	$	8,502	$	3,856	$	12,719	$	25,077	$	2,027,259	$	2,052,336	$	840

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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


															Recorded
															Investment
															90 days or
					90 Days or										Greater Past
	30-59 Days		60-89 Days		Greater Past		Total Past								Due and
December 31, 2019	Past Due		Past Due		Due		Due		Current		Nonaccrual		Total Loans		Accruing
Commercial	$	1,271	$	925	$	2,103	$	4,299	$	328,399	$	144	$	332,842	$	2,132
Leases		362		-		81		443		118,979		329		119,751		128
Commercial real estate - Investor		626		95		343		1,064		517,336		1,695		520,095		348
Commercial real estate - Owner occupied		2,469		1,026		-		3,495		336,829		5,180		345,504		-
Construction		26		-		-		26		69,498		93		69,617		-
Residential real estate - Investor		141		125		-		266		70,051		788		71,105		-
Residential real estate - Owner occupied		3,450		1,351		-		4,801		128,650		2,572		136,023		-
Multifamily		10		1,700		-		1,710		187,995		68		189,773		-
HELOC		735		50		18		803		89,438		1,364		91,605		20
HELOC - Purchased		-		-		-		-		31,672		180		31,852		-
Other ¹		28		-		-		28		13,997		19		14,044		-
Total, excluding PCI		9,118		5,272		2,545		16,935		1,892,844		12,432		1,922,211		2,628
PCI loans, net of purchase accounting adjustments		261		-		-		261		5,377		2,963		8,601		-
Total	$	9,379	$	5,272	$	2,545	$	17,196	$	1,898,221	$	15,395	$	1,930,812	$	2,628

¹ The “Other” class includes consumer, overdrafts and net deferred costs.

The table presents loans on nonaccrual for which there was no related allowance for credit losses as of June 30, 2020, and December 31, 2019:


	June 30, 2020				December 31, 2019
			Nonaccrual				Nonaccrual
	Nonaccrual		With no ACL		Nonaccrual		With no ACL
Commercial	$	2,168	$	2,166	$	144	$	-
Leases		181		103		329		70
Commercial real estate - Investor		1,968		1,968		1,695		1,590
Commercial real estate - Owner occupied		6,644		6,194		5,180		2,366
Construction		2,151		50		93		93
Residential real estate - Investor		845		845		788		788
Residential real estate - Owner occupied		3,259		2,626		2,572		2,475
Multifamily		69		69		68		68
HELOC		937		937		1,364		1,154
HELOC - Purchased		113		113		180		180
Other		8		1		19		2
Total, excluding PCI loans		18,343		15,072		12,432		8,786
PCI loans, net of purchase accounting adjustments		-		-		2,963		2,963
Total	$	18,343	$	15,072	$	15,395	$	11,749

The Company recognized $284,000 of interest on nonaccrual loans during the three months ended June 30, 2020.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Credit Quality Indicators

The Company categorizes loans into credit risk categories based on current financial information, overall debt service coverage, comparison to industry averages, historical payment experience, and current economic trends. This analysis includes loans with outstanding balances or commitments greater than $50,000 and excludes homogeneous loans such as home equity lines of credit and residential mortgages. Loans with a classified risk rating are reviewed quarterly regardless of size or loan type. The Company uses the following definitions for classified risk ratings:

Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan at some future date.

Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.

Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Credits that are not covered by the definitions above are pass credits, which are not considered to be adversely rated. The Company follows guidance of ASC 310-20 when determining whether a modification, extension, or renewal of a loan constitutes a current period origination. Generally, current period renewals of credit are re-underwritten at the point of renewal and considered current period financing receivables. The following table summarizes loans held for investment by year of origination and the related credit quality indicators at June 30, 2020:

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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


															Revolving
															Loans
															Converted
													Revolving		To Term
	2020		2019		2018		2017		2016		Prior		Loans		Loans		Total
Commercial
Pass	$	153,129	$	44,105	$	18,257	$	9,747	$	3,352	$	3,368	$	191,684	$	-	$	423,642
Special Mention		120		1,609		68		15		359		32		7,170		-		9,373
Substandard¹		507		23		2,623		-		1,972		-		3,502		-		8,627
Total commercial		153,756		45,737		20,948		9,762		5,683		3,400		202,356		-		441,642

Leases
Pass		29,370		61,681		21,732		8,897		8,470		2,371		-		-		132,521
Special Mention		-		518		-		-		-		-		-		-		518
Substandard¹		-		-		-		73		181		-		-		-		254
Total leases		29,370		62,199		21,732		8,970		8,651		2,371		-		-		133,293

Commercial real estate - Investor
Pass		88,855		174,146		97,629		70,088		59,039		29,000		969		-		519,726
Special Mention		56		151		233		-		103		-		-		-		543
Substandard¹		484		3,572		-		-		268		1,121		-		-		5,445
Total commercial real estate - investor		89,395		177,869		97,862		70,088		59,410		30,121		969		-		525,714

Commercial real estate - Owner occupied
Pass		46,088		54,932		81,718		48,807		53,601		40,323		1,163		-		326,632
Special Mention		-		-		464		2,168		5,286		-		-		-		7,918
Substandard¹		1,130		2,787		1,147		1,762		1,472		1,134		-		-		9,432
Total commercial real estate - owner occupied		47,218		57,719		83,329		52,737		60,359		41,457		1,163		-		343,982

Construction
Pass		11,657		41,167		17,823		597		470		1,326		8,540		-		81,580
Special Mention		41		-		-		-		-		-		-		-		41
Substandard¹		-		323		1,945		-		-		50		-		-		2,318
Total construction		11,698		41,490		19,768		597		470		1,376		8,540		-		83,939

Residential real estate - Investor
Pass		7,585		19,341		13,598		10,211		3,513		12,604		1,115		-		67,967
Special Mention		-		-		-		-		-		-		-		-		-
Substandard¹		343		-		633		2		-		372		104		-		1,454
Total residential real estate - investor		7,928		19,341		14,231		10,213		3,513		12,976		1,219		-		69,421

Residential real estate - Owner occupied
Pass		6,345		26,051		15,223		23,746		11,256		37,674		1,738		-		122,033
Special Mention		-		-		-		-		-		-		-		-		-
Substandard¹		48		-		267		619		547		2,789		-		-		4,270
Total residential real estate - owner occupied		6,393		26,051		15,490		24,365		11,803		40,463		1,738		-		126,303

Multifamily
Pass		10,067		54,973		45,603		45,780		13,777		19,460		207		-		189,867
Special Mention		-		-		1,527		557		8		-		-		-		2,092
Substandard¹		-		-		2,103		961		124		2,374		-		-		5,562
Total multifamily		10,067		54,973		49,233		47,298		13,909		21,834		207		-		197,521

HELOC
Pass		2,550		2,470		1,763		2,605		785		1,123		76,171		-		87,467
Special Mention		-		-		-		-		-		-		13		-		13
Substandard¹		-		1		73		37		259		58		1,262		-		1,690
Total HELOC		2,550		2,471		1,836		2,642		1,044		1,181		77,446		-		89,170

HELOC - Purchased

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Pass		-		-		-		-		-		26,354		-		-		26,354
Special Mention		-		-		-		-		-		-		-		-		-
Substandard¹		-		65		48		-		-		-		-		-		113
Total HELOC - purchased		-		65		48		-		-		26,354		-		-		26,467

Other
Pass		872		3,038		986		481		687		413		8,054		-		14,531
Special Mention		-		-		-		-		-		-		-		-		-
Substandard¹		-		-		345		8		-		-		-		-		353
Total other		872		3,038		1,331		489		687		413		8,054		-		14,884

Total loans
Pass		356,518		481,904		314,332		220,959		154,950		174,016		289,641		-		1,992,320
Special Mention		217		2,278		2,292		2,740		5,756		32		7,183		-		20,498
Substandard¹		2,512		6,771		9,184		3,462		4,823		7,898		4,868		-		39,518
Total loans	$	359,247	$	490,953	$	325,808	$	227,161	$	165,529	$	181,946	$	301,692	$	-	$	2,052,336

¹The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.

Credit quality indicators by loan segment at December 31, 2019 were as follows:


December 31, 2019			Special
	Pass		Mention		Substandard²		Doubtful		Total
Commercial	$	307,948	$	13,206	$	11,688	$	-	$	332,842
Leases		119,045		377		329		-		119,751
Commercial real estate - Investor		510,640		4,529		4,926				520,095
Commercial real estate - Owner occupied		330,891		6,657		7,956		-		345,504
Construction		69,355		-		262		-		69,617
Residential real estate - Investor		69,715		-		1,390		-		71,105
Residential real estate - Owner occupied		132,258		134		3,631		-		136,023
Multifamily		187,560		1,710		503		-		189,773
HELOC		89,804		12		1,789		-		91,605
HELOC - Purchased		31,672		-		180				31,852
Other ¹		13,685		-		359		-		14,044
Total, excluding PCI loans	$	1,862,573	$	26,625	$	33,013	$	-	$	1,922,211
PCI loans, net of purchase accounting adjustments		573		261		7,767		-		8,601
Total	$	1,863,146	$	26,886	$	40,780	$	-	$	1,930,812

¹ The “Other” class includes consumer, overdrafts and net deferred costs.

²The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.

The Company had $598,000 and $831,000 in residential real estate loans in the process of foreclosure as of June 30, 2020, and December 31, 2019, respectively.

Troubled debt restructurings (“TDRs”) are loans for which the contractual terms have been modified and both of these conditions exist: (1) there is a concession to the borrower and (2) the borrower is experiencing financial difficulties. Loans are restructured on a case-by-case basis during the loan collection process with modifications generally initiated at the request of the borrower. These modifications may include reduction in interest rates, extension of term, deferrals of principal, and other modifications. The Bank participates in the U.S. Department of the Treasury’s (the “Treasury”) Home Affordable Modification Program (“HAMP”) which gives qualifying homeowners an opportunity to refinance into more affordable monthly payments. Additionally, in accordance with interagency guidance, short-term deferrals granted due to the COVID-19 pandemic are not considered TDRs unless the borrower was experiencing financial difficulty prior to the pandemic.

The specific allocation of the allowance for loan and lease losses for TDRs is determined by calculating the present value of the TDR cash flows by discounting the original payment less an assumption for probability of default at the original note’s issue rate, and adding

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

this amount to the present value of collateral less selling costs. If the resulting amount is less than the recorded book value, the Bank either establishes a valuation allowance (i.e., specific reserve) as a component of the allowance for loan and lease losses or charges off the impaired balance if it determines that such amount is a confirmed loss. This method is used consistently for all segments of the portfolio. The allowance for loan and lease losses also includes an allowance based on a loss migration analysis for each loan category on loans and leases that are not individually evaluated for specific impairment. All loans charged-off, including TDRs charged-off, are factored into this calculation by portfolio segment.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

TDRs that were modified during the period are as follows:


	TDR Modifications					TDR Modifications
	Three Months Ended June 30, 2020					Six Months Ended June 30, 2020
	# of	Pre-modification		Post-modification		# of	Pre-modification		Post-modification
	contracts	recorded investment		recorded investment		contracts	recorded investment		recorded investment
Troubled debt restructurings
Residential real estate - Owner occupied
HAMP¹	2	$	256	$	253	2	$	256	$	253
Total	2	$	256	$	253	2	$	256	$	253


	TDR Modifications					TDR Modifications
	Three Months Ended June 30, 2019					Six Months Ended June 30, 2019
	# of	Pre-modification		Post-modification		# of	Pre-modification		Post-modification
	contracts	recorded investment		recorded investment		contracts	recorded investment		recorded investment
Troubled debt restructurings
Commercial real estate - owner occupied
Other²	-	$	-	$	-	1	$	58	$	57
Residential real estate - owner occupied
HAMP¹	2		294		292	3		399		299
HELOC
HAMP¹	-		-		-	1		39		34
Other²	-		-		-	1		39		39
Total	2	$	294	$	292	6	$	535	$	429

¹ HAMP: Home Affordable Modification Program.

² Other: Change of terms from bankruptcy court.

TDRs are classified as being in default on a case-by-case basis when they fail to be in compliance with the modified terms. There was 0 TDR default activity for the periods ended June 30, 2020, and June 30, 2019, for loans that were restructured within the prior 12 month period.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Note 5 – Other Real Estate Owned

Details related to the activity in the other real estate owned (“OREO”) portfolio, net of valuation reserve, for the periods presented are itemized in the following table:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
Other real estate owned	2020		2019		2020		2019
Balance at beginning of period	$	5,049	$	6,365	$	5,004	$	7,175
Property additions, net of acquisition adjustments		93		-		584		-
Property improvements		-		-		-		-
Less:
Proceeds from property disposals, net of participation purchase and of gains/losses		-		501		288		1,302
Period valuation adjustments		60		196		218		196
Other adjustments		-		-		-		9
Balance at end of period	$	5,082	$	5,668	$	5,082	$	5,668

Activity in the valuation allowance was as follows:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2020		2019		2020		2019
Balance at beginning of period	$	6,404	$	7,875	$	6,712	$	8,027
Provision for unrealized losses		60		196		218		196
Reductions taken on sales		-		(10)		(466)		(162)
Balance at end of period	$	6,464	$	8,061	$	6,464	$	8,061

Expenses related to OREO, net of lease revenue includes:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2020		2019		2020		2019
Gain on sales, net	$	-	$	(77)	$	(23)	$	(150)
Provision for unrealized losses		60		196		218		196
Operating expenses		105		129		207		257
Less:
Lease revenue		22		-		22		5
Net OREO expense	$	143	$	248	$	380	$	298

Note 6 – Deposits

Major classifications of deposits were as follows:


	June 30, 2020		December 31, 2019
Noninterest bearing demand	$	890,636	$	669,795
Savings		373,448		307,015
NOW accounts		466,762		425,792
Money market accounts		293,073		282,478
Certificates of deposit of less than $100,000		215,777		227,578
Certificates of deposit of $100,000 through $250,000		146,374		151,279
Certificates of deposit of more than $250,000		65,247		62,812
Total deposits	$	2,451,317	$	2,126,749

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Note 7 – Borrowings

The following table is a summary of borrowings as of June 30, 2020, and December 31, 2019. Junior subordinated debentures are discussed in more detail in Note 8:


	June 30, 2020		December 31, 2019
Securities sold under repurchase agreements	$	52,088	$	48,693
Other short-term borrowings ¹		8,250		48,500
Junior subordinated debentures		25,773		57,734
Senior notes		44,323		44,270
Notes payable and other borrowings		25,541		6,673
Total borrowings	$	155,975	$	205,870

¹ Includes short-term FHLBC advances for both periods presented.

The Company enters into deposit sweep transactions where the transaction amounts are secured by pledged securities. These transactions consistently mature overnight from the transaction date and are governed by sweep repurchase agreements. All sweep repurchase agreements are treated as financings secured by U.S. government agencies and collateralized mortgage-backed securities and had a carrying amount of $52.1 million at June 30, 2020, and $48.7 million at December 31, 2019. The fair value of the pledged collateral was $69.6 million at June 30, 2020, and $70.7 million at December 31, 2019. At June 30, 2020, there were 0 customers with secured balances exceeding 10% of stockholders’ equity.

The Company’s borrowings at the FHLBC require the Bank to be a member and invest in the stock of the FHLBC. Total borrowings are generally limited to the lower of 35% of total assets or 60% of the book value of certain mortgage loans. As of June 30, 2020, the Bank had $8.3 million in short-term advances outstanding under the FHLBC compared to $48.5 million outstanding as of December 31, 2019; the remaining $8.3 million was issued at rates ranging from 2.19% to 2.23%. The Bank also assumed $23.4 million of long-term FHLBC advances with the ABC Bank acquisition in 2018. At June 30, 2020, one advance remains in long-term status, with a total outstanding balance of $6.5 million, at a 2.83% interest rate, and is scheduled to mature on February 2, 2026. FHLBC stock held at June 30, 2020 was valued at $3.7 million, and any potential FHLBC advances were collateralized by securities with a fair value of $52.2 million and loans with a principal balance of $620.9 million, which carried a FHLBC-calculated combined collateral value of $461.2 million. The Company had excess collateral of $335.2 million available to secure borrowings at June 30, 2020.

The Company also has $44.3 million of senior notes outstanding, net of deferred issuance costs, as of June 30, 2020 and December 31, 2019. The senior notes were issued in December 2016 with a ten year maturity, and terms include interest payable semiannually at 5.75% for five years. Beginning December 2021, the senior debt will pay interest at a floating rate, with interest payable quarterly at three month LIBOR plus 385 basis points. The notes are redeemable, in whole or in part, at the option of the Company, beginning with the interest payment date on December 31, 2021, and on any floating rate interest payment date thereafter, at a redemption price equal to 100% of the principal amount of the notes plus accrued and unpaid interest. As of June 30, 2020, and December 31, 2019, unamortized debt issuance costs related to the senior notes were $677,000 and $730,000, respectively, and are included as a reduction of the balance of the senior notes on the Consolidated Balance Sheet. These deferred issuance costs will be amortized to interest expense over the ten year term of the notes and are included in the Consolidated Statements of Income.

On February 24, 2020, the Company originated a $20.0 million term note, of which $19.0 million is outstanding as of June 30, 2020, with a correspondent bank in anticipation of the redemption of the Company’s 7.80% cumulative trust preferred securities issued by Old Second Capital Trust I and related junior subordinated debentures. See the discussion in Note 8 – Junior Subordinated Debentures. The term note was issued for a three year term at one-month Libor plus 175 basis points, requires principal and interest payments quarterly, and the balance of this note is included within Notes Payable and Other Borrowings on the Consolidated Balance Sheet. The Company also has an undrawn line of credit of $20.0 million with a correspondent bank to be used for short-term funding needs; advances under this line can be outstanding up to 360 days from the date of issuance. This line of credit has not been utilized since early 2019.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Note 8 – Junior Subordinated Debentures

On March 2, 2020, the Company redeemed 7.80% cumulative trust preferred securities issued by Old Second Capital Trust I (“OSBCP”) and related debentures, which totaled $32.6 million. These debentures were originally issued in 2003 for a term of 30 years at 7.80%, and subject to regulatory approval, were able to be called in whole or in part by the Company after June 30, 2008. The Company received regulatory approval to redeem the debentures in early 2020, and notified OSBCP stockholders of the redemption in late January 2020. Cash disbursed for the redemption, including accrued interest on the debentures, totaled $33.0 million, or $10.13 per OSBCP share. The OSBCP redemption was funded by cash on hand and the $20 million term note discussed in Note 7 – Borrowings. Upon redemption of the junior subordinated debentures related to OSBCP in March 2020, the Company recognized the remaining unamortized debt issuance costs of $635,000.

The Company issued $25.0 million of cumulative trust preferred securities through a private placement completed by another unconsolidated subsidiary, Old Second Capital Trust II, in April 2007. These trust preferred securities also mature in 30 years, but subject to the aforementioned regulatory approval, can be called in whole or in part on a quarterly basis commencing June 15, 2017. The quarterly cash distributions on the securities were fixed at 6.77% through June 15, 2017, and float at 150 basis points over three-month LIBOR thereafter. Upon conversion to a floating rate, a cash flow hedge was initiated which resulted in the total interest rate paid on the debt of 4.42% for the quarter ended June 30, 2020, compared to the rate paid for the quarter ended June 30, 2019, of 4.40%. The Company issued a new $25.8 million subordinated debenture to Old Second Capital Trust II in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.

The junior subordinated debentures issued by the Company are disclosed on the Consolidated Balance Sheet, and the related interest expense for each issuance is included in the Consolidated Statements of Income. As of June 30, 2020, and December 31, 2019, the remaining unamortized debt issuance costs related to the junior subordinated debentures were $1,000 and $644,000 respectively, and are included as a reduction to the balance of the junior subordinated debentures on the Consolidated Balance Sheet. The remaining deferred issuance costs on the junior subordinated debentures related to the issuance of Old Second Capital Trust II will be amortized to interest expense over the remainder of the 30-year term of the notes and are included in the Consolidated Statements of Income.

Note 9 – Equity Compensation Plans

Stock-based awards are outstanding under the Company’s 2014 Equity Incentive Plan, as amended (the “2014 Plan”), and the Company’s 2019 Equity Incentive Plan (the “2019 Plan” and together with the 2014 Plan, the “Plans”). The 2019 Plan was approved at the May 2019 annual stockholders’ meeting and the number of authorized shares under the 2019 Plan is fixed at 600,000. Following approval of the 2019 Plan, no further awards were to be granted under the 2014 Plan or any other prior Company equity compensation plan. The 2019 Plan authorizes the granting of qualified stock options, non-qualified stock options, restricted stock, restricted stock units, and stock appreciation rights (“SARs”). Awards may be granted to selected directors, officers, employees or eligible service providers under the 2019 Plan at the discretion of the Compensation Committee of the Company’s Board of Directors. As of June 30, 2020, 343,602 shares remained available for issuance under the 2019 Plan.

Under the 2019 Plan, unless otherwise provided in an award agreement, upon the occurrence of a change in control, all stock options and SARs then held by the participant will become fully exercisable immediately if, and all stock awards and cash incentive awards will become fully earned and vested immediately if, (i) the 2019 Plan is not an obligation of the successor entity following a change in control or (ii) the 2019 Plan is an obligation of the successor entity following a change in control and the participant incurs a termination of service without cause or for good reason following the change in control. Notwithstanding the immediately preceding sentence, if the vesting of an award is conditioned upon the achievement of performance measures, then such vesting will generally be subject to the following: if, at the time of the change in control, the performance measures are less than 50% attained (pro rata based upon the time of the period through the change in control), the award will become vested and exercisable on a fractional basis with the numerator being equal to the percentage of attainment and the denominator being 50%; and if, at the time of the change in control, the performance measures are at least 50% attained (pro rata based upon the time of the period through the change in control), the award will become fully earned and vested immediately upon the change in control.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Generally, restricted stock and restricted stock units granted under the Plans vest three years from the grant date, but the Compensation Committee of the Company’s Board of Directors has discretionary authority to change some terms including the amount of time until the vest date. There were 0 stock options granted or exercised during the six months ended June 30, 2020, and as of June 30, 2020, there were 0 stock options outstanding.

The Company granted restricted stock under its equity compensation plans beginning in 2005 and it began granting restricted stock units in February 2009. Awards of restricted stock under the Plans generally entitle holders to voting and dividend rights upon grant and are subject to forfeiture until certain restrictions have lapsed including employment for a specific period. Awards of restricted stock units under the Plans are also subject to forfeiture until certain restrictions have lapsed including employment for a specific period, but do not entitle holders to voting rights until the restricted period ends and shares are transferred in connection with the units.

There were 137,944 restricted stock units issued under the 2019 Plan during the six months ended June 30, 2020 and 139,606 restricted stock units were issued under the 2014 Plan during the six months ended June 30, 2019. Compensation expense is recognized over the vesting period of the restricted stock unit based on the market value of the award on the issue date. Total compensation cost that has been recorded for the Plans was $1.3 million in the first six months of 2020 and 2019.

A summary of changes in the Company’s unvested restricted awards for the six months ended June 30, 2020, is as follows:


	June 30, 2020
		Weighted
	Restricted	Average
	Stock Shares	Grant Date
	and Units	Fair Value
Unvested at January 1	555,283	$	12.85
Granted	137,944		12.26
Vested	(149,952)		11.16
Forfeited	-		-
Unvested at June 30	543,275	$	13.17

Total unrecognized compensation cost of restricted awards was $3.4 million as of June 30, 2020, which is expected to be recognized over a weighted-average period of 1.92 years.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Note 10 – Earnings Per Share

The earnings per share, both basic and diluted, are included below as of June 30:


	Three Months Ended June 30,				Six Months Ended June 30,
	2020		2019		2020		2019
Basic earnings per share:
Weighted-average common shares outstanding		29,637,567		29,896,231		29,783,665		29,871,081
Net income	$	9,238	$	9,278	$	9,513	$	17,746
Basic earnings per share	$	0.31	$	0.31	$	0.32	$	0.59

Diluted earnings per share:
Weighted-average common shares outstanding		29,637,567		29,896,231		29,783,665		29,871,081
Dilutive effect of unvested restricted awards ¹		556,440		493,661		558,641		495,808
Diluted average common shares outstanding		30,194,007		30,389,892		30,342,306		30,366,889

Net Income	$	9,238	$	9,278	$	9,513	$	17,746
Diluted earnings per share	$	0.31	$	0.31	$	0.31	$	0.58


¹ Includes the common stock equivalents for restricted share rights that are dilutive.

Note 11 – Regulatory & Capital Matters

The Bank is subject to the risk-based capital regulatory guidelines, which include the methodology for calculating the risk-weighted Bank assets, developed by the Office of the Comptroller of the Currency (the “OCC”) and the other bank regulatory agencies. In connection with the current risk-based capital regulatory guidelines, the Bank’s Board of Directors has established an internal guideline requiring the Bank to maintain a Tier 1 leverage capital ratio at or above 8 percent (8%) and a total risk-based capital ratio at or above 12 percent (12%). At June 30, 2020, the Bank exceeded those thresholds.

At June 30, 2020, the Bank’s Tier 1 capital leverage ratio was 10.86%, a decrease of 164 basis points from December 31, 2019, but is well above the 8.00% objective. The Bank’s total capital ratio was 14.71%, a decrease of 52 basis points from December 31, 2019, but also well above the objective of 12.00%. The reduction in the ratios is primarily due to a $30.0 million dividend the Bank paid the Company in March 2020.

Bank holding companies are generally required to maintain minimum levels of capital in accordance with capital guidelines implemented by the Board of Governors of the Federal Reserve System. The general bank and holding company capital adequacy guidelines are shown in the accompanying table, as are the capital ratios of the Company and the Bank, as of June 30, 2020, and December 31, 2019.

In July 2013, the U.S. federal banking authorities issued final rules (the “Basel III Rules”) establishing more stringent regulatory capital requirements for U.S. banking institutions, which went into effect on January 1, 2015. The Basel III Rules are applicable to all banking organizations that are subject to minimum capital requirements, including federal and state banks and savings and loan associations, as well as to bank and savings and loan holding companies, other than “small bank holding companies” generally holding companies with consolidated assets of less than $3 billion. The Company is currently considered a “small bank holding company.” A detailed discussion of the Basel III Rules is included in Part I, Item 1 of the Company’s Form 10-K for the year ended December 31, 2019, under the heading “Supervision and Regulation.”

At June 30, 2020, and December 31, 2019, the Company, on a consolidated basis, exceeded the minimum thresholds to be considered “well capitalized” under current regulatory defined capital ratios.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Capital levels and industry defined regulatory minimum required levels are as follows:



					Minimum Capital				Well Capitalized
					Adequacy with Capital				Under Prompt Corrective
	Actual				Conservation Buffer, if applicable¹				Action Provisions²
	Amount		Ratio		Amount		Ratio		Amount		Ratio
June 30, 2020
Common equity tier 1 capital to risk weighted assets
Consolidated	$	260,384	11.31	%	$	161,157	7.000	%		N/A	N/A
Old Second Bank		308,038	13.46			160,198	7.000		$	148,755	6.50	%
Total capital to risk weighted assets
Consolidated		313,380	13.63			241,415	10.500			N/A	N/A
Old Second Bank		336,483	14.71			240,182	10.500			228,744	10.00
Tier 1 capital to risk weighted assets
Consolidated		285,384	12.39			195,784	8.500			N/A	N/A
Old Second Bank		308,038	13.46			194,526	8.500			183,084	8.00
Tier 1 capital to average assets
Consolidated		285,384	10.06			113,473	4.00			N/A	N/A
Old Second Bank		308,038	10.86			113,458	4.00			141,822	5.00

December 31, 2019
Common equity tier 1 capital to risk weighted assets
Consolidated	$	251,477	11.14	%	$	158,020	7.000	%		N/A	N/A
Old Second Bank		322,496	14.35			157,315	7.000		$	146,078	6.50	%
Total capital to risk weighted assets
Consolidated		327,886	14.53			236,944	10.500			N/A	N/A
Old Second Bank		342,280	15.23			235,978	10.500			224,741	10.00
Tier 1 capital to risk weighted assets
Consolidated		308,102	13.65			191,858	8.500			N/A	N/A
Old Second Bank		322,496	14.35			191,026	8.500			179,789	8.00
Tier 1 capital to average assets
Consolidated		308,102	11.93			103,303	4.00			N/A	N/A
Old Second Bank		322,496	12.50			103,199	4.00			128,998	5.00

¹Amounts are shown inclusive of a capital conservation buffer of 2.50%. Under the Federal Reserve’s Small Bank Holding Company Policy Statement, the Company is not subject to the minimum capital adequacy and capital conservation buffer capital requirements at the holding company level, unless otherwise advised by the Federal Reserve (such capital requirements are applicable only at the Bank level). Although the minimum regulatory capital requirements are not applicable to the Company, we calculate these ratios for our own planning and monitoring purposes.

² The prompt corrective action provisions are only applicable at the Bank level. The Bank exceeded the general minimum regulatory requirements to be considered “well capitalized.”

As part of its response to the impact of the COVID-19 pandemic, in the first quarter of 2020, U.S. federal regulatory authorities issued an interim final rule that provided banking organizations that adopted CECL during the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital relative to regulatory capital determined under the prior incurred loss methodology, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during the initial two-year delay (i.e., a five-year transition in total). In connection with our adoption of CECL on January 1, 2020, we have elected to utilize the five-year CECL transition. The cumulative amount that is not recognized in regulatory capital, in addition to the $3.8 million Day 1 impact of CECL adoption, will be phased in at 25% per year beginning January 1, 2022. As of June 30, 2020, the capital measures

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

of the Company exclude $5.6 million, which is the Day 1 impact to retained earnings and 25% of the 10.1 million increase in the allowance for credit losses in the first six months of 2020, excluding PCD loans.

Dividend Restrictions

In addition to the above requirements, banking regulations and capital guidelines generally limit the amount of dividends that may be paid by a bank without prior regulatory approval. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s profits, combined with the retained profit of the previous two years, subject to the capital requirements described above. Pursuant to the Basel III rules that came into effect January 1, 2015, and were fully phased in as of January 1, 2019, the Bank must keep a capital conservation buffer of 2.50% above the new regulatory minimum capital requirements, which must consist entirely of Common Equity Tier 1 capital in order to avoid additional limitations on capital distributions and certain other payments.

Stock Repurchase Program

In September 2019, our board of directors authorized the repurchase of up to 1,494,826 shares of our common stock (the “Repurchase Program”). Repurchases by us under the Repurchase Program may be made from time to time through open market purchases, trading plans established in accordance with SEC rules, privately negotiated transactions, or by other means. During the first and second quarters of 2020, we repurchased 312,723 shares and 145,932 shares of our common stock at weighted average prices of $7.06 per share and $6.97 per share, respectively, pursuant to the Repurchase Program.

Note 12 – Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The fair value hierarchy established by the Company also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Three levels of inputs that may be used to measure fair value are:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the Company has the ability to access as of the measurement date.

Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a company’s own view about the assumptions that market participants would use in pricing an asset or liability.

The majority of securities available-for-sale are valued by external pricing services or dealer market participants and are classified in Level 2 of the fair value hierarchy. Both market and income valuation approaches are utilized. Quarterly, the Company evaluates the methodologies used by the external pricing services or dealer market participants to develop the fair values to determine whether the results of the valuations are representative of an exit price in the Company’s principal markets and an appropriate representation of fair value. The Company uses the following methods and significant assumptions to estimate fair value:

●

Government-sponsored agency debt securities are primarily priced using available market information through processes such as benchmark spreads, market valuations of like securities, like securities groupings and matrix pricing.

●

Other government-sponsored agency securities, MBS and some of the actively traded real estate mortgage investment conduits and collateralized mortgage obligations are priced using available market information including benchmark yields, prepayment speeds, spreads, volatility of similar securities and trade date.

●

State and political subdivisions are largely grouped by characteristics (e.g., geographical data and source of revenue in trade dissemination systems). Because some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities.

●

Auction rate securities are priced using market spreads, cash flows, prepayment speeds, and loss analytics. Therefore, the valuations of auction rate asset-backed securities are considered Level 2 valuations.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

●

Asset-backed collateralized loan obligations were priced using data from a pricing matrix supported by our bond accounting service provider and are therefore considered Level 2 valuations.

●

Annually every security holding is priced by a pricing service independent of the regular and recurring pricing services used. The independent service provides a measurement to indicate if the price assigned by the regular service is within or outside of a reasonable range. Management reviews this report and applies judgment in adjusting calculations at year end related to securities pricing.

●

Residential mortgage loans available for sale in the secondary market are carried at fair market value. The fair value of loans held-for-sale is determined using quoted secondary market prices.

●

Lending related commitments to fund certain residential mortgage loans, e.g., residential mortgage loans with locked interest rates to be sold in the secondary market and forward commitments for the future delivery of mortgage loans to third party investors, as well as forward commitments for future delivery of MBS are considered derivatives. Fair values are estimated based on observable changes in mortgage interest rates including prices for MBS from the date of the commitment and do not typically involve significant judgments by management.

●

The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income to derive the resultant value. The Company is able to compare the valuation model inputs, such as the discount rate, prepayment speeds, weighted average delinquency and foreclosure/bankruptcy rates to widely available published industry data for reasonableness.

●

Interest rate swap positions, both assets and liabilities, are based on valuation pricing models using an income approach reflecting readily observable market parameters such as interest rate yield curves.

●

The fair value of impaired loans with specific allocations of the allowance for credit losses is essentially based on recent real estate appraisals or the fair value of the collateralized asset. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are made in the appraisal process by the appraisers to reflect differences between the available comparable sales and income data. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

●

Nonrecurring adjustments to certain commercial and residential real estate properties classified as OREO are measured at fair value, less costs to sell. Fair values are based on third party appraisals of the property, resulting in a Level 3 classification, or an executed pending sales contract. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Assets and Liabilities Measured at Fair Value on a Recurring Basis:

The tables below present the balance of assets and liabilities at June 30, 2020, and December 31, 2019, respectively, measured by the Company at fair value on a recurring basis:


	June 30, 2020
	Level 1		Level 2		Level 3		Total
Assets:
Securities available-for-sale
U.S. Treasury	$	4,147	$	-	$	-	$	4,147
U.S. government agencies		-		7,276		-		7,276
U.S. government agencies mortgage-backed		-		16,779		-		16,779
States and political subdivisions		-		245,686		4,678		250,364
Collateralized mortgage obligations		-		56,113		-		56,113
Asset-backed securities		-		80,026		-		80,026
Collateralized loan obligations		-		32,731		-		32,731
Loans held-for-sale		-		9,416		-		9,416
Mortgage servicing rights		-		-		4,479		4,479
Interest rate swap agreements		-		11,165		-		11,165
Mortgage banking derivatives		-		1,238		-		1,238
Total	$	4,147	$	460,430	$	9,157	$	473,734

Liabilities:
Interest rate swap agreements, including risk participation agreements	$	-	$	16,518	$	-	$	16,518
Total	$	-	$	16,518	$	-	$	16,518


	December 31, 2019
	Level 1		Level 2		Level 3		Total
Assets:
Securities available-for-sale
U.S. Treasury	$	4,036	$	-	$	-	$	4,036
U.S. government agencies		-		8,337		-		8,337
U.S. government agencies mortgage-backed		-		16,588		-		16,588
States and political subdivisions		-		243,756		5,419		249,175
Collateralized mortgage obligations		-		57,984		-		57,984
Asset-backed securities		-		81,844		-		81,844
Collateralized loan obligations		-		66,684		-		66,684
Loans held-for-sale		-		3,061		-		3,061
Mortgage servicing rights		-		-		5,935		5,935
Interest rate swap agreements		-		2,771		-		2,771
Mortgage banking derivatives		-		250		-		250
Total	$	4,036	$	481,275	$	11,354	$	496,665

Liabilities:
Interest rate swap agreements, including risk participation agreements	$	-	$	5,974	$	-	$	5,974
Total	$	-	$	5,974	$	-	$	5,974

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are as follows:


	Six Months Ended June 30, 2020
	Securities available-for-sale
	States and		Mortgage
	Political		Servicing
	Subdivisions		Rights
Beginning balance January 1, 2020	$	5,419	$	5,935
Total gains or losses
Included in earnings		(12)		(2,304)
Included in other comprehensive income		(363)		-
Purchases, issuances, sales, and settlements
Purchases		12,800		-
Issuances		-		1,123
Settlements		(13,166)		(275)
Ending balance June 30, 2020	$	4,678	$	4,479


	Six Months Ended June 30, 2019
	Securities available-for-sale
	States and		Mortgage
	Political		Servicing
	Subdivisions		Rights
Beginning balance January 1, 2019	$	8,165	$	7,357
Total gains or losses
Included in earnings		(17)		(1,701)
Included in other comprehensive income		500		-
Purchases, issuances, sales, and settlements
Purchases		17,554		-
Issuances		-		417
Settlements		(19,027)		(254)
Ending balance June 30, 2019	$	7,175	$	5,819

The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of June 30, 2020:

Weighted

Measured at fair value

Unobservable

Average

on a recurring basis:

Fair Value

Valuation Methodology

Inputs

Range of Input

of Inputs

Mortgage servicing rights

4,479

Discounted Cash Flow

Discount Rate

11.0 - 15.0%

11.0

Prepayment Speed

0.0 - 45.4%

16.7

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of December 31, 2019:

Weighted

Measured at fair value

Unobservable

Average

on a recurring basis:

Fair Value

Valuation Methodology

Inputs

Range of Input

of Inputs

Mortgage servicing rights

5,935

Discounted Cash Flow

Discount Rate

10.0 - 58.8%

10.1

Prepayment Speed

0.0 - 69.0%

14.1

In addition to the above, Level 3 fair value measurement included $4.7 million for state and political subdivisions representing various local municipality securities at June 30, 2020. This was classified as securities available-for-sale, and was valued using a discount based on market spreads of similar assets, but the liquidity premium was an unobservable input. The state and political subdivisions securities balance in Level 3 fair value at June 30, 2019, was $7.2 million. These securities were classified as securities available-for-sale, and were valued using a discount based on market spreads of similar assets, but the liquidity premium was an unobservable input.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis:

The Company may be required, from time to time, to measure certain other assets at fair value on a nonrecurring basis in accordance with GAAP. These assets consist of individually evaluated (formerly, impaired) loans and OREO. For assets measured at fair value on a nonrecurring basis at June 30, 2020, and December 31, 2019, respectively, the following tables provide the level of valuation assumptions used to determine each valuation and the carrying value of the related assets:


	June 30, 2020
	Level 1		Level 2		Level 3		Total
Individually evaluated loans¹	$	-	$	-	$	8,313	$	8,313
Other real estate owned, net²		-		-		5,082		5,082
Total	$	-	$	-	$	13,395	$	13,395

¹ Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans; had a carrying amount of $10.6 million and a valuation allowance of $2.3 million resulting in an increase of specific allocations within the allowance for credit losses on loans of $1.1 million for the six months ended June 30, 2020.

² OREO is measured at fair value, less costs to sell, and had a net carrying amount of $5.1 million, which is made up of the outstanding balance of $12.4 million, net of a valuation allowance of $6.5 million and a participation of $937,000 at June 30, 2020.


	December 31, 2019
	Level 1		Level 2		Level 3		Total
Impaired loans¹	$	-	$	-	$	7,435	$	7,435
Other real estate owned, net²		-		-		5,004		5,004
Total	$	-	$	-	$	12,439	$	12,439

¹ Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans; had a carrying amount of $8.6 million and a valuation allowance of $1.2 million resulting in an increase of specific allocations within the allowance for credit losses on loans of $783,000 for the year December 31, 2019.

² OREO is measured at fair value, less costs to sell, and had a net carrying amount of $5.0 million, which is made up of the outstanding balance of $12.6 million, net of a valuation allowance of $6.7 million and a participation of $937,000, at December 31, 2019.

The Company has estimated the fair values of these assets based primarily on Level 3 inputs. OREO and impaired loans are generally valued using the fair value of collateral provided by third party appraisals. These valuations include assumptions related to cash flow projections, discount rates, and recent comparable sales. The numerical ranges of unobservable inputs for these valuation assumptions are not meaningful.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Note 13 – Fair Values of Financial Instruments

The estimated fair values approximate carrying amount for all items except those described in the following table. Securities available-for-sale fair values are based upon market prices or dealer quotes, and if no such information is available, on the rate and term of the security. The carrying value of FHLBC stock approximates fair value as the stock is nonmarketable and can only be sold to the FHLBC or another member institution at par. FHLBC stock is carried at cost and considered a Level 2 fair value. For June 30, 2020 and December 31, 2019, the fair values of loans and leases are estimated on an exit price basis incorporating discounts for credit, liquidity and marketability factors. The fair value of time deposits is estimated using discounted future cash flows at current rates offered for deposits of similar remaining maturities. The fair values of borrowings were estimated based on interest rates available to the Company for debt with similar terms and remaining maturities. The fair value of off balance sheet volume is not considered material.

The carrying amount and estimated fair values of financial instruments were as follows:


	June 30, 2020
	Carrying		Fair
	Amount		Value		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	32,424	$	32,424	$	32,424	$	-	$	-
Interest earning deposits with financial institutions		225,065		225,065		225,065		-		-
Securities available-for-sale		447,436		447,436		4,147		438,611		4,678
FHLBC and FRBC stock		9,917		9,917		-		9,917		-
Loans held-for-sale		9,416		9,416		-		9,416		-
Net loans		2,021,063		2,038,963		-		-		2,038,963
Interest rate swap agreements		11,165		11,165		-		11,165
Interest receivable on securities and loans		10,169		10,169		-		10,169		-

Financial liabilities:
Noninterest bearing deposits	$	890,636	$	890,636	$	890,636	$	-	$	-
Interest bearing deposits		1,560,681		1,563,979		-		1,563,979		-
Securities sold under repurchase agreements		52,088		52,088		-		52,088		-
Other short-term borrowings		8,250		8,250		-		8,250		-
Junior subordinated debentures		25,773		11,957		-		11,957		-
Senior notes		44,323		42,553		42,553		-		-
Note payable and other borrowings		25,541		26,239		-		26,239		-
Interest rate swap agreements		16,402		16,402		-		16,402		-
Interest payable on deposits and borrowings		794		794		-		794		-

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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


	December 31, 2019
	Carrying		Fair
	Amount		Value		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	34,096	$	34,096	$	34,096	$	-	$	-
Interest earning deposits with financial institutions		16,536		16,536		16,536		-		-
Securities available-for-sale		484,648		484,648		4,036		475,193		5,419
FHLBC and FRBC stock		9,917		9,917		-		9,917		-
Loans held-for-sale		3,061		3,061		-		3,061		-
Net loans		1,911,023		1,915,531		-		-		1,915,531
Interest rate swap agreements		2,771		2,771		-		2,771		-
Interest receivable on securities and loans		9,697		9,697		-		9,697		-

Financial liabilities:
Noninterest bearing deposits	$	669,795	$	669,795	$	669,795	$	-	$	-
Interest bearing deposits		1,456,954		1,457,832		-		1,457,832		-
Securities sold under repurchase agreements		48,693		48,693		-		48,693		-
Other short-term borrowings		48,500		48,500		-		48,500		-
Junior subordinated debentures		57,734		51,188		33,614		17,574		-
Senior notes		44,270		46,269		46,269		-		-
Note payable and other borrowings		6,673		7,003		-		7,003		-
Interest rate swap agreements		5,921		5,921		-		5,921		-
Interest payable on deposits and borrowings		1,079		1,079		-		1,079		-

Note 14 – Derivatives, Hedging Activities and Financial Instruments with Off-Balance Sheet Risk

Risk Management Objective of Using Derivatives

The Company is exposed to certain risk arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s loan portfolio.

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish these objectives, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. In December of 2019, the Company also executed a loan pool hedge of $50 million to convert variable rate loans to a fixed rate index for a five year term.

For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in Accumulated Other Comprehensive Income and subsequently reclassified into interest income/expense in the same period(s) during which the hedged transaction affects earnings. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are received on the Company’s variable-rate borrowings. During the next twelve months, the Company estimates that an additional $722,000 will be reclassified as an increase to interest income and an additional $662,000 will be reclassified as an increase to interest expense.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Non-designated Hedges

Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives with financial counterparties are recognized directly in earnings.

The Company also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan interest rate lock commitments is managed with contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts. Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward MBS contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking revenue. Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.

Disclosure of Fair Values of Derivative Instruments on the Balance Sheet

The Company entered into a forward starting interest rate swap on August 18, 2015, with an effective date of June 15, 2017. This transaction had a notional amount totaling $25.8 million as of December 31, 2018, was designated as a cash flow hedge of certain junior subordinated debentures and was determined to be fully effective during the period presented. As such, no amount of ineffectiveness has been included in net income. Therefore, the aggregate fair value of the swap is recorded in other liabilities with changes in fair value recorded in other comprehensive income, net of tax. The amount included in other comprehensive income would be reclassified to current earnings should all or a portion of the hedge no longer be considered effective. The Company expects the hedge to remain fully effective during the remaining term of the swap. The Bank will pay the counterparty a fixed rate and receive a floating rate based on three month LIBOR. The trust preferred securities changed from fixed rate to floating rate on June 15, 2017. The cash flow hedge has a maturity date of June 15, 2037.

In December of 2019, the Company also executed a loan pool hedge of $50.0 million to convert variable rate loans to a fixed rate index for a five year term. This transaction falls under hedge accounting standards and is paired against a pool of the Bank’s Libor-based loans. Overall, the new swap only bolsters income in down rate scenarios by a modest degree. We consider the current level of interest rate risk to be moderate but intend to continue looking for market opportunities to hedge further.

The Bank also has interest rate derivative positions to assist with risk management that are not designated as hedging instruments. These derivative positions relate to transactions in which the Bank enters an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution. The Bank had a net $3.1 million of cash collateral held by 1 correspondent financial institution to support interest rate swap activity at June 30, 2020 and $14.1 million of investment securities were required to be pledged to 1 correspondent financial institution. The Bank had $114,000 of cash collateral pledged with 1 correspondent financial institution to support interest rate swap activity at December 31, 2019 and $11.0 million of investment securities were required to be pledged to 2 correspondent financial institutions. At June 30, 2020, the notional amount of non-hedging interest rate swaps was $193.5 million with a weighted average maturity of 5.2 years. At December 31, 2019, the notional amount of non-hedging interest rate swaps was $177.9 million with a weighted average maturity of 5.9 years. The Bank offsets derivative assets and liabilities that are subject to a master netting arrangement.

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet as of June 30, 2020 and December 31, 2019.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Fair Value of Derivative Instruments


			June 30, 2020
	No. of Trans.	Notional Amount $	Balance Sheet Location	Fair Value $	Balance Sheet Location	Fair Value $
Derivatives designated as hedging instruments
Interest rate swaps	2	75,774	Other Assets	3,155	Other Liabilities	8,392
Total derivatives designated as hedging instruments				3,155		8,392

Derivatives not designated as hedging instruments
Interest rate swaps with commercial loan customers	273	193,532	Other Assets	8,010	Other Liabilities	8,010
Interest rate lock commitments and forward contracts	15	67,000	Other Assets	1,238	Other Liabilities	-
Other contracts	4	27,894	Other Assets	-	Other Liabilities	116
Total derivatives not designated as hedging instruments				9,248		8,126


			December 31, 2019
	No. of Trans.	Notional Amount $	Balance Sheet Location	Fair Value $	Balance Sheet Location	Fair Value $
Derivatives designated as hedging instruments
Interest rate swaps	2	75,774	Other Assets	-	Other Liabilities	3,150
Total derivatives designated as hedging instruments				-		3,150

Derivatives not designated as hedging instruments
Interest rate swaps with commercial loan customers	25	177,872	Other Assets	2,771	Other Liabilities	2,771
Interest rate lock commitments and forward contracts	87	23,667	Other Assets	250	Other Liabilities	-
Other contracts	4	28,176	Other Assets	-	Other Liabilities	53
Total derivatives not designated as hedging instruments				3,021		2,824

Disclosure of the Effect of Fair Value and Cash Flow Hedge Accounting

The fair value and cash flow hedge accounting related to derivatives covered under ASC Subtopic 815-20 impacted Accumulated Other Comprehensive Income (“AOCI”) and the Income Statement. The loss recognized in AOCI on derivatives totaled $3.8 million as of June 30, 2020, and a gain of $1.6 million as of June 30, 2019. The amount of the loss reclassified from AOCI to interest income on the income statement totaled $90,000 and $15,000 for the six months ended June 30, 2020, and June 30, 2019, respectively.

Credit-risk-related Contingent Features

For derivative transactions involving counterparties who are lending customers of the Company, the derivative credit exposure is managed through the normal credit review and monitoring process, which may include collateralization, financial covenants and/or financial guarantees of affiliated parties. Agreements with such customers require that losses associated with derivative transactions receive payment priority from any funds recovered should a customer default and ultimate disposition of collateral or guarantees occur.

Credit exposure to broker/dealer counterparties is managed through agreements with each derivative counterparty that require collateralization of fair value gains owed by such counterparties. Some small degree of credit exposure exists due to timing differences between when a gain may occur and the subsequent point in time that collateral is delivered to secure that gain. This is monitored by the Company and procedures are in place to minimize this exposure. Such agreements also require the Company to collateralize counterparties in circumstances wherein the fair value of the derivatives result in loss to the Company.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Other provisions of such agreements include the definition of certain events that may lead to the declaration of default and/or the early termination of the derivative transaction(s):

●

If the Company either defaults or is capable of being declared in default on any of its indebtedness (exclusive of deposit obligations), then the Company could also be declared in default on its derivative obligations.

●

If a merger occurs that materially changes the Company's creditworthiness in an adverse manner.

●

If certain specified adverse regulatory actions occur, such as the issuance of a Cease and Desist Order, or citations for actions considered Unsafe and Unsound or that may lead to the termination of deposit insurance coverage by the FDIC.

The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as that involved in extending loan commitments to our customers. In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO. The following table represents the Company’s contractual commitments due to letters of credit as of June 30, 2020, and December 31, 2019.

The following table is a summary of letter of credit commitments:


	June 30, 2020						December 31, 2019
	Fixed		Variable		Total		Fixed		Variable		Total
Letters of credit:
Borrower:
Financial standby	$	329	$	8,921	$	9,250	$	339	$	9,612	$	9,951
Commercial standby		-		-		-		-		-		-
Performance standby		356		6,007		6,363		571		6,212		6,783
		685		14,928		15,613		910		15,824		16,734
Non-borrower:
Performance standby		-		67		67		-		67		67
Total letters of credit	$	685	$	14,995	$	15,680	$	910	$	15,891	$	16,801

Unused loan commitments:	$	127,763	$	347,384	$	475,147	$	111,348	$	320,120	$	431,468

As of January 1, 2020, we adopted ASU 2016-13, and per CECL guidance, the Company recorded an allowance for credit losses on unfunded commitments of $1.7 million. As of June 30, 2020, the Company evaluated current market conditions, including the impacts related to COVID-19 and market interest rate reductions during the second quarter of 2020, and based on that analysis under CECL methodology, the Company recorded a provision for credit losses related to unfunded commitments of $734,000. The growth in the ACL for unfunded commitments in the second quarter of 2020, compared to the prior quarter end, is primarily related to an increase in the commercial unfunded commitments funding rate assumptions based on our analysis of the last 12 months of utilization. The Company will continue to assess the credit risk at least quarterly, and adjust the allowance for unfunded commitments, which is carried within other liabilities on our Consolidated Balance Sheet, as needed, with the appropriate offsetting entry to the provision for credit losses on our Consolidated Statements of Income.

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

Overview

The following discussion provides additional information regarding our operations for the three and six months ended June 30, 2020, as compared to the three and six months ended June 30, 2019, and our financial condition at June 30, 2020, compared to December 31, 2019. This discussion should be read in conjunction with our consolidated financial statements as well as the financial and statistical data appearing elsewhere in this report and our Form 10-K for the year ended December 31, 2019. The results of operations for the three and six months ended June 30, 2020, are not necessarily indicative of future results. Dollar amounts presented in the following tables are in thousands, except per share data, and June 2020 and 2019 amounts are unaudited.

In this report, unless the context suggests otherwise, references to the “Company,” “we,” “us,” and “our” mean the combined business of Old Second Bancorp, Inc. and its subsidiary bank, Old Second National Bank (the “Bank”).

We have made, and will continue to make, various forward-looking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” on page 3 of this report.

Business Overview

The Company is a bank holding company headquartered in Aurora, Illinois. Through our wholly-owned subsidiary bank, Old Second National Bank, a national banking organization also headquartered in Aurora, Illinois, we offer a wide range of financial services through our 29 banking centers located in Cook, DeKalb, DuPage, Kane, Kendall, LaSalle and Will counties in Illinois. These banking centers offer access to a full range of traditional retail and commercial banking services including treasury management operations as well as fiduciary and wealth management services. We focus our business on establishing and maintaining relationships with our clients while maintaining a commitment to provide for the financial services needs of the communities in which we operate. We emphasize relationships with individual customers as well as small to medium-sized businesses throughout our market area. We also have extensive wealth management services, which includes a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts and employee benefit plan administration services.

Recent Events—COVID-19

In December 2019, a novel strain of coronavirus (COVID-19) surfaced in China, and has since spread to many other countries, including the United States. In March 2020, the World Health Organization declared COVID-19 a global pandemic and the United States declared a National Public Health Emergency. The COVID-19 pandemic has severely restricted the level of economic activity in our markets. In response to the COVID-19 pandemic, the State of Illinois and most other states took preventative or protective actions, such as imposing restrictions on travel and business operations, advising or requiring individuals to limit or forego their time outside of their homes, and ordering temporary closures of businesses that were deemed to be non-essential. Although many businesses have begun to reopen, some markets, including those in Illinois, have since experienced a resurgence of COVID-19 cases, which may further slow overall economic activity and recovery. Uncertainty also remains regarding if, how and when schools will reopen and the impact of such reopening decisions on the economy.

The impact of the COVID-19 pandemic is fluid and continues to evolve. The unprecedented and rapid spread of COVID-19 and its associated impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending, and other economic activities has resulted in less economic activity, lower equity market valuations and significant volatility and disruption in financial markets. In addition, due to the COVID-19 pandemic, market interest rates have declined significantly, with the 10-year Treasury bond falling below 1.00% on March 3, 2020, for the first time, and declining further to 0.65% as of June 30, 2020. On March 3, 2020, the Federal Open Market Committee reduced the targeted federal funds interest rate range by 50 basis points to 1.00% to 1.25%. This range was further reduced to 0% to 0.25% percent on March 16, 2020. These reductions in interest rates and the other effects of the COVID-19 pandemic have had, and are expected to continue to have, possibly materially, an adverse effect on our business, financial condition, and results of operations. The ultimate extent of the impact of the COVID-19 pandemic on our business, financial condition and results of operations is currently uncertain and will depend on various developments and other factors, including, among others, the duration and scope of the pandemic, as well as governmental, regulatory and private sector responses to the pandemic, and the associated impacts on the economy, financial markets and our customers, employees and vendors.

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Our business, financial condition and results of operations generally rely upon the ability of our borrowers to repay their loans, the value of collateral underlying our secured loans, and demand for loans and other products and services we offer, which are highly dependent on the business environment in our primary markets where we operate and in the United States as a whole.

Temporary Operational Changes

We have taken a number of steps to protect our employees, customers and communities. In March 2020, as part of our efforts to exercise social distancing, we closed all of our banking lobbies (other than by appointment) conducted most of our business through drive-thru tellers and through electronic and online means. At this time, our lobbies have been reopened, but we encourage customers to use other means to conduct their banking, and are following social distancing and personal protective protocols as directed by the Center for Disease Control and Prevention. In addition, a majority of our workforce has been working from home since mid-March 2020, and will continue to do so through the near future.

Results of Operation and Financial Condition

We are monitoring the impact of the COVID-19 pandemic on our results of operation and financial condition. While we did not yet have a significant impact to our financial condition as of June 30, 2020, in the form of incurred losses or communications from our borrowers that significant losses were imminent, we nevertheless determined it prudent to increase our provision for credit losses in anticipation of continued market risk and uncertainty at this time. Our provision for credit losses was $8.0 million for the first quarter of 2020, which was impacted by both our adoption of the new CECL methodology and the expected impact, as of March 31, 2020, of the COVID-19 pandemic and market interest rate reductions. Our provision for credit losses was $2.1 million for the second quarter of 2020, as we continued to forecast an increase in future expected credit losses due to the ongoing impact of the pandemic. Periods ending after June 30, 2020 may also be materially impacted by the COVID-19 pandemic.

We also adjusted our investment securities portfolio to market each period end and review for any impairment that would require a provision for credit losses. At this time, we have determined there is no need for a provision for credit losses related to our investment securities portfolio. Because of changing economic and market conditions affecting issuers, we may be required to recognize impairments in the future on the securities we hold as well as reductions in other comprehensive income. We cannot currently determine the ultimate impact of the pandemic on the long-term value of our portfolio.

As of June 30, 2020, we had $18.6 million of goodwill. During the first and second quarters of 2020, we considered whether a quantitative assessment of our goodwill was required because of the significant economic disruption caused by the COVID-19 pandemic. At June 30, 2020, we determined no goodwill impairment was required, since the negative market indicators were not observed over a sustained period of time. However, further delayed recovery or further deterioration in market conditions related to the general economy, financial markets, and the associated impacts on our customers, employees and vendors, among other factors, could significantly impact the impairment analysis and may result in future goodwill impairment charges that, if incurred, could have a material adverse effect on our results of operations and financial condition.

Lending Operations and Accommodations to Borrowers

During this unprecedented situation, we have established client assistance programs, including offering commercial, consumer, and mortgage loan payment deferrals for certain clients. As of August 5, 2020, we had executed 469 of these deferrals on outstanding loan balances of $231.1 million. In accordance with interagency guidance issued in March 2020, these short term deferrals are not considered troubled debt restructurings. We also suspended late fees for consumer loans through June 30, 2020, and continue to evaluate any late fee suspension based on the borrower’s financial situation and prior payment history. We also paused new foreclosure and repossession actions through June 30, 2020, and will continue to re-evaluate these activities based on the ongoing COVID-19 pandemic. These programs may negatively impact our revenue and other results of operations in the near term and, if not effective in mitigating the effect of COVID-19 on our customers, may adversely affect our business and results of operations more substantially over a longer period of time. Future governmental actions may require these and other types of customer-related responses.

We are also participating in the Coronavirus Aid, Relief and Economic Security Act (“CARES” Act). As of August 5, 2020, we had processed 727 loan applications for the SBA Paycheck Protection Program (“PPP”), representing a total of $136.9 million. We remain ready to continue to fund eligible client requests if Congress appropriates additional funds.

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Capital and Liquidity

As of June 30, 2020, all of our capital ratios were in excess of all regulatory requirements. While we believe that we have sufficient capital to withstand an extended economic recession brought about by the COVID-19 pandemic, our reported and regulatory capital ratios could be adversely impacted by credit losses.

We believe there could be potential stresses on liquidity management as a result of the COVID-19 pandemic and our participation in the PPP. As customers manage their own liquidity stress, we could experience an increase in the utilization of existing lines of credit.

The Federal Reserve Bank has provided a lending facility that will allow us to obtain funding specifically for loans that we make under the PPP (the “PPPLF”), which will allow us to retain existing sources of liquidity for our traditional operations. PPP loans will be pledged as collateral on any of our borrowings under the Federal Reserve Bank’s lending facility. These factors, together or in combination with other events or occurrences that may not yet be known or anticipated, may materially and adversely affect our business, financial condition and results of operations. We have not yet participated in the PPPLF program, but have the ability to do so should the need arise.

We have also developed new processes to monitor our liquidity on a daily basis, and have run stress testing based on various economic assumptions under stress and severe stress scenarios. In addition, management is communicating each week in structured meetings with key staff to seek to ensure all current events related to the COVID-19 pandemic, such as federal government stimulus check receipt and PPP loan fundings, are managed appropriately.

Financial Overview

Our community-focused banking franchise experienced growth in total loans in the second quarter of 2020, compared to both the year ended December 31, 2019, and the second quarter of 2019, and we believe we are positioned for further moderate loan growth as we continue to serve our customers’ needs in a competitive economic environment. While the impact of the COVID-19 pandemic continues to evolve and is not yet known, and regulatory and governmental developments stemming from the economic and social disruption caused by the pandemic have not yet been fully implemented, we realize this pandemic will make it challenging to attain the levels of profitability and growth reflected in the past five years. We are continuing to seek to provide value to our customers and the communities in which we operate, by executing on growth opportunities in our local markets and developing new banking relationships, while ensuring the safety and soundness of our Bank, our customers and our employees during the COVID-19 pandemic.

The following provides an overview of some of the factors impacting our financial performance for the three month period ended June 30, 2020, compared to the like period ended June 30, 2019:

●

Net income for the second quarter of 2020 was $9.2 million, or $0.31 per diluted share, compared to $9.3 million, or $0.31 per diluted share, for the second quarter of 2019.

●

Net interest and dividend income was $22.7 million for the second quarter of 2020, compared to $24.8 million for the second quarter of 2019. The decrease in 2020 was primarily due to the year over year decline in market interest rates, which negatively impacted loan and security income, despite growth in our loan portfolio of $149.4 million in the same period.

●

A provision for credit losses of $2.1 million was recorded for the second quarter of 2020, consisting of $1.4 million related to loans and $734,000 related to unfunded commitments, compared to a provision for loan and lease losses of $450,000 in the second quarter of 2019. We adopted the new current expected credit losses accounting standard, or CECL, effective January 1, 2020, which measures the allowance based on management’s best estimate of lifetime expected credit losses inherent in our lending activities, which resulted in a $5.9 million allowance for credit losses related to loans and a $1.7 million allowance for credit losses related to unfunded commitments as of January 1, 2020. The provision expense recorded in 2020 was impacted by both the new CECL methodology applied and the expected impact, as of June 30, 2020, of the COVID-19 pandemic on future losses.

●

Noninterest income was $10.7 million for the second quarter of 2020, compared to $8.1 million for the second quarter of 2019. The increase was primarily due to interest rate driven growth in net gain on sales of mortgage loans, as proceeds from mortgages sold in the second quarter of 2020 totaled $137.9 million, compared to $36.0 million in the second quarter of 2019, resulting in an increase in noninterest income of $3.5 million. The increase was also driven by a reduction in mark to market losses on mortgage servicing rights (“MSRs”) of $692,000 in the second quarter of 2020, compared to the second quarter of 2019, and a net increase in the cash surrender value of bank owned life insurance (“BOLI”) of $212,000 for the second quarter of 2020,

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compared the second quarter of 2019. Partially offsetting these increases were reductions in other noninterest income categories stemming from COVID-19 related impacts in the second quarter of 2020, compared to the second quarter of 2019, including a $839,000 decrease in service charges on deposits due to a reduction in overdraft fees, and a $241,000 decrease in card related income, due to a reduction in consumer transactional volumes.

●

Noninterest expense was $18.9 million for the second quarter of 2020, compared to $20.1 million for the second quarter of 2019, a decrease of $1.2 million, or 6.1%. The decrease in 2020 was primarily due to a decrease in salaries and employee benefit expense related to the deferral of loan origination costs on PPP loans, a decrease in computer and data processing, and a decrease in advertising expense due to reduced marketing efforts during the COVID-19 pandemic.

●

The provision for income taxes was $3.1 million for the second quarter of 2020, compared to $3.0 million for the second quarter of 2019. Pretax income was $12.4 million in the second quarter of 2020, compared to $12.3 million for the second quarter of 2019.

●

Asset quality remained consistent with nonperforming loans as a percent of total loans remaining relatively steady at 1.0% as of June 30, 2020, 0.8% as of December 31, 2019, and 0.7% as of June 30, 2019.

●

During the second quarter of 2020, we repurchased 145,932 shares of our common stock at a weighted average price of $6.97 per share pursuant to our stock repurchase program.

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Critical Accounting Policies

Our consolidated financial statements are prepared based on the application of accounting policies in accordance with generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. These policies require the reliance on estimates and assumptions, which may prove inaccurate or are subject to variations. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements. Changes in underlying factors, assumptions, or estimates could have a material impact on our future financial condition and results of operations.

Of the significant accounting policies used in the preparation of our consolidated financial statements, we have identified certain items as critical accounting policies based on the associated estimates, assumptions, judgments and complexity. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in our Annual Report on Form 10-K for the year ended December 31, 2019.

Determining the allowance for loan and lease losses has historically been identified as a critical accounting policy. On January 1, 2020, we adopted the new CECL accounting methodology which requires entities to estimate and recognize an allowance for lifetime expected credit losses for loans and other financial assets measured at amortized cost. Previously, an allowance for loan and lease losses was recognized based on probable incurred losses. The accounting estimates relating to the allowance for credit losses is also a “critical accounting policy” as:

●

changes in the provision for credit losses can materially affect our financial results;

●

estimates relating to the allowance for credit losses require us to project future borrower performance, including cash flows, delinquencies and charge-offs, along with, when applicable, collateral values, based on a reasonable and supportable forecast period utilizing forward-looking economic scenarios in order to estimate probability of default and loss given default; and

●

the allowance for credit losses is influenced by factors outside of our control such as industry and business trends, geopolitical events and the effects of laws and regulations as well as economic conditions such as trends in housing prices, interest rates, GDP, inflation, energy prices and unemployment; and

●

considerable judgment is required to determine whether the models used to generate the allowance for credit losses produce an estimate that is sufficient to encompass the current view of lifetime expected credit losses.

Because our estimates of the allowance for credit losses involve judgment and are influenced by factors outside our control, there is uncertainty inherent in these estimates. Our estimate of lifetime expected credit losses is inherently uncertain because it is highly sensitive to changes in economic conditions and other factors outside of our control. Changes in such estimates could significantly impact our allowance and provision for credit losses. See Note 1 – Basis of Presentation and Changes in Significant Accounting Policies in the accompanying notes to the consolidated financial statements included elsewhere in this report for a discussion of our Allowance for Credit Losses.

Non-GAAP Financial Measures

This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of net interest income and net interest margin on a tax equivalent (“TE”) basis, our adjusted efficiency ratio, our tangible common equity to tangible assets ratio, and our core net interest margin on a TE basis. Management believes that the presentation of these non-GAAP financial measures (a) provides important supplemental information that contributes to a proper understanding of our operating performance, (b) enables a more complete understanding of factors and trends affecting our business, and (c) allows investors to evaluate our performance in a manner similar to management, the financial services industry, bank stock analysts, and bank regulators. Management uses non-GAAP measures as follows: in the preparation of our operating budgets, monthly financial performance reporting, and in our presentation to investors of our performance. However, we acknowledge that these non-GAAP financial measures have a number of limitations. Limitations associated with non-GAAP financial measures include the risk that persons might disagree as to the appropriateness of items comprising these measures and that different companies might calculate these measures differently. These disclosures should not be considered an alternative to our GAAP results. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is presented below or alongside the first instance where each non-GAAP financial measure is used.

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Results of Operations

Overview

Three months ended June 30, 2020 and 2019

Our income before taxes was $12.4 million in the second quarter of 2020, compared to $12.3 million in the second quarter of 2019. This $100,000 increase in pretax income was primarily due to the $2.6 million increase in noninterest income in the second quarter of 2020, compared to the second quarter of 2019, and a $1.2 million reduction in noninterest expense in the second quarter of 2020, compared to the second quarter of 2019. These favorable variances were materially offset by a $2.0 million reduction in net interest income in the second quarter of 2020, compared to the second quarter of 2019, as well as a $1.7 million increase in the provision for credit losses, due both to our adoption of the new CECL methodology effective January 1, 2020 and the expected impact, as of June 30, 2020, of the COVID-19 pandemic and related market interest rate reductions, compared to a $450,000 provision for loan and lease losses in the second quarter of 2019. Our net income was $9.2 million, or $0.31 per diluted share, for the second quarter of 2020, compared to net income of $9.3 million, or $0.31 per diluted share, for the second quarter of 2019.

Net interest and dividend income was $22.7 million in the second quarter of 2020, compared to $24.8 million in the second quarter of 2019. The $2.0 million decrease was primarily driven by a $3.9 million decrease in interest and dividend income in the second quarter of 2020, compared to the second quarter of 2019, driven by the reduction in market interest rates on loans and securities. Loan growth of $149.4 million was recorded in the year over year period, but interest income on loans declined $2.5 million from the quarter ended June 30, 2019 to June 30, 2020. Securities available-for-sale decreased $44.6 million as of June 30, 2020, compared to June 30, 2019, which exacerbated the reduction in securities related income of $1.3 million in the same year over year period. Partially offsetting the decrease in interest and dividend income was a $1.8 million reduction in total interest expense in the second quarter of 2020, compared to the second quarter of 2019, due to a reduction in interest expense on deposits of $573,000, on other short-term borrowings of $541,000, and on junior subordinated debentures of $648,000, due to the redemption of the Old Second Capital Trust I trust preferred securities and related subordinated debentures in the first quarter of 2020.

Management has remained diligent in reviewing our loan portfolio to analyze and determine if charge-offs are required. Average loan growth, including loans held for sale, in the second quarter of 2020, compared to the second quarter of 2019, totaled $154.7 million, stemming from 669 PPP loans originated in the second quarter of 2020 totaling $133.9 million, as well as organic growth primarily in our commercial, leases, and commercial real estate-investor portfolios.

Six months ended June 30, 2020 and 2019

Our income before taxes was $12.4 million for the six months ended June 30, 2020, compared to $23.2 million for the six months ended June 30, 2019. This $10.8 million decrease in pretax income was primarily due to a $9.2 million increase in provision for credit losses for the six months ended June 30, 2020, compared to the same period in 2019, due both to our adoption of the new CECL methodology effective January 1, 2020 and the expected impact, as of June 30, 2020, of the COVID-19 pandemic and related market interest rate reductions. Our net income was $9.5 million, or $0.31 per diluted share, for the six months ended June 30, 2020, compared to net income of $17.7 million, or $0.58 per diluted share, for the six months ended June 30, 2019.

Net income was $9.5 million for the six months ended June 30, 2020, compared to $17.7 million for the same period of 2019. The decrease in net income was primarily due to a $9.2 million increase in provision for credit losses for the six months ended June 30, 2020, compared to the like period of 2019, as well as a $5.3 million decrease in interest and dividend income for the six months ended June 30, 2020, compared to the like period of 2019, driven by the impact of the reduction in market interest rates on loans and securities. Also impacting net income was a $2.4 million increase in noninterest income for the six months ended June 30, 2020, compared to the like 2019 period, driven primarily by a $5.0 million increase in net gain on sales of mortgage loans, which more than offset the mark to market losses of $2.6 million on MSRs for the six months ended June 30, 2020, compared to a $2.0 million mark to market loss on MSRs for the six months ended June 30, 2019.

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Net Interest Income

Net interest income, which is our primary source of earnings, is the difference between interest income earned on interest-earning assets, such as loans and investment securities, as well as accretion income on purchased loans, and interest incurred on interest-bearing liabilities, such as deposits and borrowings. Net interest income depends upon the relative mix of interest-earning assets and interest-bearing liabilities, the ratio of interest-earning assets to total assets and of interest-bearing liabilities to total funding sources, and movements in market interest rates. Our net interest income can be significantly influenced by a variety of factors, including overall loan demand, economic conditions, credit risk, the amount of nonearning assets including nonperforming loans and OREO, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities, early withdrawal of deposits, exercise of call options on borrowings or securities, a general rise or decline in interest rates, changes in the slope of the yield-curve, and balance sheet growth or contraction.

Three months ended June 30, 2020 and 2019

Our net interest and dividend income decreased by $2.0 million, to $22.7 million, for the second quarter of 2020, from $24.8 million for the second quarter of 2019. This decline was attributable to the $3.9 million, or 13.1%, decrease in interest and dividend income for the second quarter of 2020, compared to the second quarter of 2019, partially offset by a $1.8 million decrease in interest expense. Interest and dividend income for the second quarter of 2020 reflected a decrease of $1.7 million, or 6.3%, compared to the first quarter of 2020.

Average earning assets for the second quarter of 2020 were $2.67 billion, reflecting an increase of $209.2 million, or 8.5%, compared to the first quarter of 2020, and an increase of $220.5 million, or 9.0%, compared to the second quarter of 2019. Total average loans, including loans held-for-sale, totaled $2.05 billion in the second quarter of 2020, which reflected an increase of $106.7 million compared to the first quarter of 2020, and an increase of $154.7 million compared to the second quarter of 2019. The growth in average loan balances, which was primarily due to an increase in commercial loans related to PPP loan disbursements and lease and commercial real estate-investor loans stemming from organic growth, was offset by the reduction in market interest rates over the past year, which resulted in a decrease in interest income of $2.6 million related to loans in the year over year period. For the second quarter of 2020, the yield on average loans decreased to 4.40%, compared to the yield on average loans of 4.89% for the first quarter of 2020 and 5.28% for the second quarter of 2019. Securities also reflected a reduction in yields, due to both decreases in market interest rates over the past year and volumes used to fund loan growth. Total average securities for the second quarter of 2020 decreased $23.0 million from the first quarter of 2020, and decreased $67.3 million from the second quarter of 2019. The yield on average securities declined to 3.07% for the second quarter of 2020, compared to 3.39% for the first quarter of 2020 and 3.80% for second quarter of 2019.

Average interest bearing liabilities increased $36.2 million, or 2.2%, in the second quarter of 2020, compared to the first quarter of 2020, but decreased $32.8 million, or 1.9%, compared to the second quarter of 2019. The growth in average interest bearing deposits of $62.5 million from the prior quarter was due to seasonal deposit fluctuations from income tax refunds, commercial deposit build for projects to be deployed later in the year, and growth in depositor liquidity due to market uncertainty related to the COVID-19 pandemic. The growth in average interest bearing deposits of $68.8 million from the second quarter of 2019 was primarily due to the impacts of the COVID-19 pandemic, which also impacted the $208.7 million of growth in noninterest bearing deposits for the same period, as reductions in market interest rates over the past year have provided less incentive to maintain funds in interest bearing deposits.

Average other short-term borrowings, which consist of FHLBC advances, decreased $14.7 million in the second quarter of 2020, compared to the first quarter of 2020, and decreased $85.0 million compared to the second quarter of 2019. The average rate paid on short-term FHLBC advances was impacted by the reduction in interest rates in the first quarter of 2020, resulting in an average rate of 1.63% for the second quarter of 2020, compared to 1.90% for the first quarter of 2020, and 2.47% for the second quarter of 2019. As of June 30, 2020, notes payable and other borrowings consisted of one long-term FHLBC advance of $6.5 million we acquired in our acquisition of ABC Bank, and $19.0 million outstanding on a term note with a correspondent bank originated in the first quarter of 2020 to fund our redemption of the Old Second Capital Trust I trust preferred securities and related junior subordinated debentures of $32.6 million. This redemption occurred in March 2020 and resulted in a decrease of 720 basis points in the cost of the average junior subordinated debentures for the second quarter of 2020 due to the recognition of the remaining unamortized deferred issuance costs of $635,000 in the first quarter of 2020. The rate paid on the redeemed junior subordinated debentures was 7.8%, in comparison to the rate to be paid going forward on the newly executed $20.0 million term note of one month Libor plus 175 basis points.

Our net interest margin, expressed as a percentage of average earning assets, was 3.42% for the second quarter of 2020, reflecting a 29 basis point decrease from the first quarter of 2020, and a 64 basis point decrease from the second quarter of 2019. Our net interest margin, on a tax-equivalent (TE) basis, expressed as a percentage of average earning assets, was 3.48% for the second quarter of 2020, reflecting a 29 basis point decrease from the first quarter of 2020, and a 67 basis point decrease from the second quarter of 2019. The average tax-

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equivalent yield on earning assets decreased to 3.93% for the second quarter of 2020, compared to 4.55% for the first quarter of 2020, and 4.94% for the second quarter of 2019. The decreases in net interest margin and the yield on average earning assets for the second quarter of 2020, compared to the second quarter of 2019, was primarily attributable to a decline in security volumes and interest rate reductions which impacted loans and securities in the second quarter of 2020. The cost of funds on interest bearing liabilities was 0.72% for the second quarter of 2020, 1.17% for the first quarter of 2019, and 1.13% for the second quarter of 2019. The decrease in our cost of funds in the second quarter of 2020 compared to the first quarter of 2020 was primarily driven by the redemption of our junior subordinated debentures and the resulting recognition of $635,000 of deferred issuance costs in March 2020, partially offset by a decline in the volume and rates paid on short-term borrowings. The decrease in our cost of funds in the second quarter of 2020 compared to the second quarter of 2019 was primarily driven by a decline in the rates paid on deposits, a decline in volume and rates paid on short-term borrowings, and the redemption of our junior subordinated debentures in the first quarter of 2020 which resulted in the average yield on our junior subordinated debentures of 4.42% for the second quarter of 2020, compared to 6.47% in the prior year like quarter.

Six months ended June 30, 2020 and 2019

Our net interest and dividend income decreased by $3.4 million to $45.4 million for the six months ended June 30, 2020, compared to $48.8 million for the six months ended June 30, 2019. This decline was attributable to a $5.3 million, or 9.1%, decrease in interest and dividend income for the six months ended June 30, 2020, compared to the six months ended June 30, 2019, partially offset by a $1.9 million decrease in interest expense.

Average earning assets for the six months ended June 30, 2020 were $2.56 billion, reflecting an increase of $120.1 million, or 4.9%, compared to the six months ended June 30, 2019. The yield on average earning assets for the six months ended June 30, 2020 was 4.23%, compared to 4.92% for the six months ended June 30, 2019. Total average loans, including loans held-for-sale, totaled $2.0 billion for the six months ended June 30, 2020, which reflected an increase of $102.3 million, compared to the six months ended June 30, 2019. The growth in average loan balances was more than offset by market interest rate reductions, which resulted in a $3.0 million decrease in interest income for the six months ended June 30, 2020, compared to the like 2019 period. For the six months ended June 30, 2020, yields on average securities decreased by 67 basis points and yields on average loans decreased by 58 basis points, each as compared to the six months ended June 30, 2019, due primarily to the falling interest rate environment. Average interest earning deposits with financial institutions increased $71.8 million in the six months ended June 30, 2020 compared to the prior year like period as consumer spending declined as a result of the COVID-19 pandemic, which increased our liquidity.

Average interest bearing liabilities decreased $71.2 million, or 4.1%, in the six months ended June 30, 2020, compared to the six months ended June 30, 2019. The decrease was due to reductions in average other short-term borrowings of $80.1 million, which primarily consist of FHLBC advances, and a reduction in average junior subordinated debentures of $21.2 million due to the redemption of the trust preferred securities issued by Old Second Capital Trust I and the related $32.6 million of subordinated debentures in March 2020. The rate on our junior subordinated debentures was 9.08% for the six months ended June 30, 2020, and 6.49% for the six months ended June 30, 2019, as $635,000 of deferred issuance costs was expensed upon the redemption in 2020. Average interest bearing deposits increased by $21.3 million in the six months ended June 30, 2020, compared to the six months ended June 30, 2019, but the reduction in market interest rates resulted in a nine basis point reduction in the cost of interest bearing deposits for the six months ended June 30, 2020, compared to the like 2019 period. Average noninterest bearing deposits increased $130.0 million in the six months ended June 30, 2020, compared to the six months ended June 30, 2019, as customers spent less as a result of the COVID-19 pandemic.

Our net interest margin for the six months ended June 30, 2020 was 3.56% compared to 4.03% for the six months ended June 30, 2019, reflecting a 47 basis point decrease. Our net interest margin (TE) for the six months ended June 30, 2020 was 3.62% compared to 4.12% for the six months ended June 30, 2019, reflecting a 50 basis point decrease. The decrease in net interest margin for the six months ended June 30, 2020, compared to the six months ended June 30, 2019, was due primarily to reductions in the market interest rates as well as the issuance of $133.9 million of PPP loans at 1.00%, and the growth of our liquidity with an increase in cash and due from banks, which were not yet reinvested into higher yielding assets. These reductions to the net interest margin were partially offset by reductions in rates paid on deposits, as well as reductions in volumes and rates paid on borrowings, and growth in noninterest bearing deposits, which drove down our overall cost of funds.

We continue to observe competitive pressure to maintain reduced interest rates on loans retained at renewal. While our loan prices are targeted to achieve certain returns on equity, significant competition for commercial and industrial loans as well as commercial real estate loans has put pressure on loan yields, and our stringent underwriting standards limit our ability to make higher-yielding loans.

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The following tables set forth certain information relating to our average consolidated balance sheet and reflect the yield on average earning assets and cost of average interest bearing liabilities for the periods indicated. These yields reflect the related interest, on an annualized basis, divided by the average balance of assets or liabilities over the applicable period. Average balances are derived from daily balances. For purposes of discussion, net interest income and net interest income to total earning assets in the following tables have been adjusted to a non-GAAP TE basis using a marginal rate of 21% in 2020 and 2019 to more appropriately compare returns on tax-exempt loans and securities to other earning assets.

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Analysis of Average Balances,
Tax Equivalent Income / Expense and Rates
(Dollars in thousands - unaudited)

	Quarters Ended
	June 30, 2020						March 31, 2020						June 30, 2019
	Average			Income /		Rate	Average			Income /		Rate	Average			Income /		Rate
	Balance			Expense		%	Balance			Expense		%	Balance			Expense		%
Assets
Interest earning deposits with financial institutions	$	153,532		$	42	0.11	$	27,989		$	75	1.08	$	19,053		$	111	2.34
Securities:
Taxable		247,868			1,694	2.75		273,429			2,163	3.18		229,263			2,223	3.89
Non-taxable (TE)¹		204,840			1,767	3.47		202,289			1,842	3.66		290,743			2,710	3.74
Total securities (TE)¹		452,708			3,461	3.07		475,718			4,005	3.39		520,006			4,933	3.80
Dividends from FHLBC and FRBC		9,917			123	4.99		9,917			125	5.07		11,317			156	5.53
Loans and loans held-for-sale^{1, 2}		2,052,060			22,460	4.40		1,945,383			23,636	4.89		1,897,324			24,958	5.28
Total interest earning assets		2,668,217			26,086	3.93		2,459,007			27,841	4.55		2,447,700			30,158	4.94
Cash and due from banks		30,594			-	-		32,549			-	-		33,618			-	-
Allowance for credit losses on loans		(30,747)			-	-		(23,507)			-	-		(19,435)			-	-
Other noninterest bearing assets		187,305			-	-		172,712			-	-		174,075			-	-
Total assets	$	2,855,369					$	2,640,761					$	2,635,958

Liabilities and Stockholders' Equity
NOW accounts	$	457,772		$	129	0.11	$	422,065		$	233	0.22	$	442,430		$	373	0.34
Money market accounts		279,873			85	0.12		280,828			236	0.34		288,698			262	0.36
Savings accounts		359,358			171	0.19		322,618			166	0.21		313,822			124	0.16
Time deposits		439,735			1,442	1.32		448,763			1,766	1.58		422,975			1,641	1.56
Interest bearing deposits		1,536,738			1,827	0.48		1,474,274			2,401	0.66		1,467,925			2,400	0.66
Securities sold under repurchase agreements		45,882			23	0.20		47,825			116	0.98		44,184			147	1.33
Other short-term borrowings		8,396			34	1.63		23,069			109	1.90		93,369			575	2.47
Junior subordinated debentures		25,773			283	4.42		47,200			1,364	11.62		57,704			931	6.47
Senior notes		44,310			673	6.11		44,284			673	6.11		44,196			672	6.10
Notes payable and other borrowings		26,551			165	2.50		14,762			130	3.54		13,101			107	3.28
Total interest bearing liabilities		1,687,650			3,005	0.72		1,651,414			4,793	1.17		1,720,479			4,832	1.13
Noninterest bearing deposits		854,324			-	-		676,755			-	-		645,580			-	-
Other liabilities		39,613			-	-		28,490			-	-		19,586			-	-
Stockholders' equity		273,782			-	-		284,102			-	-		250,313			-	-
Total liabilities and stockholders' equity	$	2,855,369					$	2,640,761					$	2,635,958
Net interest income (GAAP)				$	22,707					$	22,658					$	24,754
Net interest margin (GAAP)						3.42						3.71						4.06

Net interest income (TE)¹				$	23,081					$	23,048					$	25,326
Net interest margin (TE)¹						3.48						3.77						4.15
Core net interest margin (TE - excluding PPP loans)¹						3.51						N/A						N/A
Interest bearing liabilities to earning assets		63.25	%					67.16	%					70.29	%

¹Represents a non-GAAP financial measure. See the discussion entitled “Non-GAAP Presentations” below and the table on page 50 that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent. Tax equivalent basis is calculated using a marginal tax rate of 21% in 2020 and 2019.

² Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 50, and includes fees of $718,000, $294,000 and $184,000 for the second quarter of 2020, the first quarter of 2020, and the second quarter of 2019, respectively. Nonaccrual loans are included in the above-stated average balances.

Table of Contents


Analysis of Average Balances,
Tax Equivalent Income / Expense and Rates
(Dollars in thousands - unaudited)

	Six Months Ended June 30,
	2020						2019
	Average			Income /		Rate	Average			Income /		Rate
	Balance			Expense		%	Balance			Expense		%
Assets
Interest earning deposits with financial institutions	$	90,760		$	117	0.26	$	18,948		$	225	2.39
Securities:
Taxable		260,649			3,857	2.98		233,051			4,637	4.01
Non-taxable (TE)¹		203,564			3,609	3.57		283,715			5,366	3.81
Total securities (TE)¹		464,213			7,466	3.23		516,766			10,003	3.90
Dividends from FHLBC and FRBC		9,917			248	5.03		11,390			305	5.40
Loans and loans held-for-sale ^{1 , 2}		1,998,721			46,096	4.64		1,896,422			49,084	5.22
Total interest earning assets		2,563,611			53,927	4.23		2,443,526			59,617	4.92
Cash and due from banks		31,571			-	-		33,683			-	-
Allowance for credit losses on loans		(27,127)			-	-		(19,335)			-	-
Other noninterest bearing assets		180,010			-	-		177,904			-	-
Total assets	$	2,748,065					$	2,635,778

Liabilities and Stockholders' Equity
NOW accounts	$	439,918		$	362	0.17	$	445,457		$	752	0.34
Money market accounts		280,351			321	0.23		293,972			532	0.36
Savings accounts		340,988			337	0.20		310,798			246	0.16
Time deposits		444,249			3,208	1.45		433,964			3,259	1.51
Interest bearing deposits		1,505,506			4,228	0.56		1,484,191			4,789	0.65
Securities sold under repurchase agreements		46,854			139	0.60		44,668			296	1.34
Other short-term borrowings		15,732			143	1.83		95,835			1,182	2.49
Junior subordinated debentures		36,487			1,647	9.08		57,698			1,858	6.49
Senior notes		44,297			1,346	6.11		44,184			1,344	6.13
Notes payable and other borrowings		20,656			295	2.87		14,181			223	3.17
Total interest bearing liabilities		1,669,532			7,798	0.94		1,740,757			9,692	1.12
Noninterest bearing deposits		765,539			-	-		635,557			-	-
Other liabilities		34,051			-	-		16,688			-	-
Stockholders' equity		278,943			-	-		242,776			-	-
Total liabilities and stockholders' equity	$	2,748,065					$	2,635,778
Net interest income (GAAP)				$	45,365					$	48,790
Net interest margin (GAAP)						3.56						4.03

Net interest income (TE)¹				$	46,129					$	49,925
Net interest margin (TE)¹						3.62						4.12
Core net interest margin (TE - excluding PPP loans)¹						3.64						N/A
Interest bearing liabilities to earning assets		65.12	%					71.24	%

² Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 50, and includes fees of $1.0 million and $413,000 for the first six months of 2020 and 2019, respectively. Nonaccrual loans are included in the above-stated average balances.

Reconciliation of Tax-Equivalent Non-GAAP Financial Measures

Table of Contents

Net interest and dividend income (TE) and net interest income (TE) to average interest earning assets are non-GAAP measures that have been adjusted on a TE basis using a marginal rate of 21% for 2020 and 2019 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 for the periods indicated:


	Three Months Ended									Six Months Ended
	June 30,			March 31,			June 30,			June 30,
Net Interest Margin	2020			2020			2019			2020			2019
(Dollars in thousands)

Interest income (GAAP)	$	25,712		$	27,451		$	29,586		$	53,163		$	58,482
Taxable-equivalent adjustment:
Loans		3			3			3			6			8
Securities		371			387			569			758			1,127
Interest and dividend income (TE)		26,086			27,841			30,158			53,927			59,617
Interest expense (GAAP)		3,005			4,793			4,832			7,798			9,692
Net interest income (TE)	$	23,081		$	23,048		$	25,326		$	46,129		$	49,925
Paycheck Protection Program ("PPP") loan - interest and fee income		603			NA			NA			603			NA
Net interest income (TE) - excluding PPP loans	$	22,478			NA			NA		$	45,526			NA
Net interest income (GAAP)	$	22,707		$	22,658		$	24,754		$	45,365		$	48,790
Average interest earning assets	$	2,668,217		$	2,459,007		$	2,447,700		$	2,563,611		$	2,443,526
Average PPP loans	$	90,447			N/A			N/A		$	51,684			N/A
Average interest earning assets, excluding PPP loans	$	2,577,770			N/A			N/A		$	2,511,927			N/A
Net interest margin (GAAP)		3.42	%		3.71	%		4.06	%		3.56	%		4.03	%
Net interest margin (TE)		3.48	%		3.77	%		4.15	%		3.62	%		4.12	%
Core net interest margin (TE - excluding PPP loans)		3.51	%		N/A			N/A			3.64	%		N/A

Noninterest Income

Three months ended June 30, 2020 and 2019

The following table details the major components of noninterest income for the periods presented:


							2nd Quarter 2020
Noninterest Income	Three Months Ended						Percent Change From
(Dollars in thousands)	June 30,		March 31,		June 30,		March 31,	June 30,
	2020		2020		2019		2020	2019
Trust income	$	1,664	$	1,532	$	1,739	8.6	(4.3)
Service charges on deposits		1,120		1,726		1,959	(35.1)	(42.8)
Residential mortgage banking revenue
Secondary mortgage fees		505		270		203	87.0	148.8
Mortgage servicing rights mark to market loss		(445)		(2,134)		(1,137)	79.1	60.9
Mortgage servicing income		458		468		491	(2.1)	(6.7)
Net gain on sales of mortgage loans		4,631		2,246		1,163	106.2	298.2
Total residential mortgage banking revenue		5,149		850		720	505.8	615.1
Securities (losses) gains, net		-		(24)		986	100.0	(100.0)
Change in cash surrender value of BOLI		532		(49)		320	N/M	66.3
Death benefit realized on BOLI		59		-		-	N/M	N/M
Card related income		1,311		1,287		1,552	1.9	(15.5)
Other income		860		1,000		867	(14.0)	(0.8)
Total noninterest income	$	10,695	$	6,322	$	8,143	69.2	31.3

N/M - Not meaningful

Table of Contents

Noninterest income increased $4.4 million, or 69.2%, in the second quarter of 2020, compared to the first quarter of 2020, and increased $2.6 million, or 31.3%, compared to the second quarter of 2019. These increases were primarily driven by $4.6 million in net gain on sales of mortgage loans and a reduction in the mark to market losses on MSRs in the second quarter of 2020, compared to both the prior quarter and year over year quarter. The cash surrender value of BOLI increased in the second quarter of 2020 by $581,000, compared to the first quarter of 2020, and increased $212,000, compared to the second quarter of 2019, due to market interest rate fluctuations.

The noted increases were partially offset by a reduction in service charges on deposits, as overdraft and bounce fees declined due to a decrease in customer transactional activity as a result of the COVID-19 pandemic, resulting in a decrease of $606,000 in the second quarter of 2020, compared to the linked quarter, and a decrease of $839,000 year over year. The year over year increase in noninterest income was also offset by a $986,000 decrease in securities gains, net, and a $241,000 decrease in card related income.

Six months ended June 30, 2020 and 2019

The following table details the major components of noninterest income for the periods presented:


Noninterest Income	Six Months Ended				YTD
(Dollars in thousands)	June 30,		June 30,		Percent
	2020		2019		Change
Trust income	$	3,196	$	3,225	(0.9)
Service charges on deposits		2,846		3,821	(25.5)
Residential mortgage banking revenue
Secondary mortgage fees		775		339	128.6
Mortgage servicing rights mark to market loss		(2,579)		(1,956)	(31.9)
Mortgage servicing income		926		948	(2.3)
Net gain on sales of mortgage loans		6,877		1,925	257.2
Total residential mortgage banking revenue		5,999		1,256	377.6
Securities (losses) gains, net		(24)		1,013	(102.4)
Change in cash surrender value of BOLI		483		778	(37.9)
Death benefit realized on BOLI		59		-
Card related income		2,598		2,837	(8.4)
Other income		1,860		1,695	9.7
Total noninterest income	$	17,017	$	14,625	16.4

Noninterest income for the six months ended June 30, 2020 increased $2.4 million, or 16.4%, compared to the six months ended June 30, 2019. This increase was primarily driven by a $4.7 million increase in total residential mortgage banking revenue stemming from the falling interest rate environment and the resultant net gain on sales of mortgage loans and secondary mortgage fees, and an increase in other income due to a $243,000 increase in commercial swap fees. These increases were partially offset by decreases in service charges on deposits and card related income due to reductions in customer activity as a result of the COVID-19 pandemic, and decreases in security (losses) gains, net, and the cash surrender value of BOLI.

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Noninterest Expense

Three months ended June 30, 2020 and 2019

The following table details the major components of noninterest expense for the periods presented:


										2nd Quarter 2020
Noninterest Expense	Three Months Ended									Percent Change From
(Dollars in thousands)	June 30,			March 31,			June 30,			March 31,	June 30,
	2020			2020			2019			2020	2019
Salaries	$	8,588		$	9,761		$	9,004		(12.0)	(4.6)
Officers incentive		968			958			893		1.0	8.4
Benefits and other		1,786			2,199			1,690		(18.8)	5.7
Total salaries and employee benefits		11,342			12,918			11,587		(12.2)	(2.1)
Occupancy, furniture and equipment expense		1,935			2,301			1,925		(15.9)	0.5
Computer and data processing		1,247			1,335			1,524		(6.6)	(18.2)
FDIC insurance		155			57			116		171.9	33.6
General bank insurance		237			246			236		(3.7)	0.4
Amortization of core deposit intangible asset		124			128			121		(3.1)	2.5
Advertising expense		57			109			381		(47.7)	(85.0)
Card related expense		514			532			474		(3.4)	8.4
Legal fees		176			131			243		34.4	(27.6)
Other real estate owned expense, net		143			237			248		(39.7)	(42.3)
Other expense		2,966			3,008			3,271		(1.4)	(9.3)
Total noninterest expense	$	18,896		$	21,002		$	20,126		(10.0)	(6.1)
Efficiency ratio (GAAP)¹		55.13	%		66.28	%		59.78	%
Adjusted efficiency ratio (non-GAAP)²		54.28	%		65.48	%		58.62	%

N/M - Not meaningful

¹The efficiency ratio shown in the table above is a GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income and total noninterest income less any BOLI death benefit recorded, net gains or losses on securities and mark to market gains or losses on MSRs.

² The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains or losses on securities and mark to market gains or losses on MSRs, and includes a tax equivalent adjustment on the change in cash surrender value of BOLI.

See the section entitled “Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures” on page 54 for a reconciliation of this non-GAAP measure to the most comparable GAAP equivalent.

Noninterest expense for the second quarter of 2020 decreased $2.1 million, or 10.0%, compared to the first quarter of 2020, and decreased $1.2 million, or 6.1%, compared to the second quarter of 2019. The linked quarter decrease is primarily attributable to a $1.6 million decrease in salaries and employee benefits stemming from an increase in deferrals of new loan origination costs related to PPP loans, a $366,000 decrease in occupancy, furniture and equipment expense, a $94,000 decrease in other real estate owned expense, primarily due to valuation write-downs on properties in the first quarter of 2020, and a $52,000 reduction in advertising expense. These reductions were partially offset by an increase of $98,000 in FDIC insurance, as FDIC assessment credits were fully utilized in the first quarter of 2020, and $45,000 in legal fees.

The year over year decrease in noninterest expense is primarily attributable to a $245,000 decrease in salaries and employee benefits, a $277,000 decrease in computer and data processing expense, a $324,000 decrease in advertising expense due to a reduction in marketing efforts during the COVID-19 pandemic, a $105,000 decrease in other real estate owned expense, net, due to property valuation write-downs, and a $305,000 decrease in other expense. The decrease in other expense was mainly attributable to reductions in consulting and management fees and other marketing expenses. Partially offsetting the year over year decreases were a $39,000 increase in FDIC insurance and a $40,000 increase in card related expense.

Table of Contents

Six months ended June 30, 2020 and 2019


Noninterest Expense	Six Months Ended						YTD
(Dollars in thousands)	June 30,			June 30,			Percent
	2020			2019			Change
Salaries	$	18,349		$	17,638		4.0
Officers incentive		1,926			1,775		8.5
Benefits and other		3,985			3,786		5.3
Total salaries and employee benefits		24,260			23,199		4.6
Occupancy, furniture and equipment expense		4,236			3,914		8.2
Computer and data processing		2,582			2,856		(9.6)
FDIC insurance		212			290		(26.9)
General bank insurance		483			486		(0.6)
Amortization of core deposit intangible asset		252			253		(0.4)
Advertising expense		166			615		(73.0)
Card related expense		1,046			829		26.2
Legal fees		307			369		(16.8)
Other real estate owned expense, net		380			298		27.5
Other expense		5,974			6,211		(3.8)
Total noninterest expense	$	39,898		$	39,320		1.5
Efficiency ratio (GAAP)¹		60.48	%		60.24	%
Adjusted efficiency ratio (non-GAAP)²		59.64	%		59.01	%

² The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains or losses on securities and mark to market gains or losses on MSRs, and includes a tax equivalent adjustment on the change in cash surrender value of BOLI.

Noninterest expense for the six months ended June 30, 2020, increased $578,000, or 1.5%, compared to the six months ended June 30, 2019, primarily due to occupancy, furniture and equipment expense of $322,000 stemming from planned building repairs and maintenance, card related expense of $217,000 primarily due to an accrual reversal in 2019 for an expired rewards program, and other real estate owned expense, net, of $82,000. Partially offsetting these increases were decreases in computer and data processing expense of $274,000, FDIC insurance of $78,000, advertising expense of $449,000 as marketing efforts were reduced during the COVID-19 pandemic, legal fees of $62,000, and other expense of $237,000. Computer and data processing expense declined year over year due to a new core system contract that we executed in the last half of 2019, which included cost savings, as well as voice and data services price reductions negotiated over the past year. Other expense decreased year over year due to a reduction in audit fees, employee travel costs primarily due to the shelter in place during the COVID-19 pandemic, and consulting and management fees.

Table of Contents

Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures


	GAAP									Non-GAAP
		Three Months Ended									Three Months Ended
	June 30,			March 31,			June 30,			June 30,			March 31,			June 30,
	2020			2020			2019			2020			2020			2019
Efficiency Ratio / Adjusted Efficiency Ratio
(Dollars in thousands)

Noninterest expense	$	18,896		$	21,002		$	20,126		$	18,896		$	21,002		$	20,126
Less amortization of core deposit		124			128			121			124			128			121
Less other real estate expense, net		143			237			248			143			237			248
Noninterest expense less adjustments	$	18,629		$	20,637		$	19,757		$	18,629		$	20,637		$	19,757

Net interest income	$	22,707		$	22,658		$	24,754		$	22,707		$	22,658		$	24,754
Taxable-equivalent adjustment:
Loans		N/A			N/A			N/A			3			3			3
Securities		N/A			N/A			N/A			371			387			569
Net interest income including adjustments		22,707			22,658			24,754			23,081			23,048			25,326
Noninterest income		10,695			6,322			8,143			10,695			6,322			8,143
Less death benefit related to BOLI		59			-			-			59			-			-
Less securities (losses) gains, net		-			(24)			986			-			(24)			986
Less MSRs mark to market loss		(445)			(2,134)			(1,137)			(445)			(2,134)			(1,137)
Taxable-equivalent adjustment:
Change in cash surrender value of BOLI		N/A			N/A			N/A			157			(13)			85
Noninterest income (less) / including adjustments		11,081			8,480			8,294			11,238			8,467			8,379

Net interest income including adjustments plus noninterest income (less) / including adjustments	$	33,788		$	31,138		$	33,048		$	34,319		$	31,515		$	33,705
Efficiency ratio / Adjusted efficiency ratio		55.13	%		66.28	%		59.78	%		54.28	%		65.48	%		58.62	%


	GAAP				Non-GAAP
		Six Months Ended				Six Months Ended
	June 30,		June 30,		June 30,		June 30,
	2020		2019		2020		2019
Efficiency Ratio / Adjusted Efficiency Ratio
(Dollars in thousands)

Noninterest expense	$	39,898	$	39,320	$	39,898	$	39,320
Less amortization of core deposit		252		253		252		253
Less other real estate expense, net		380		298		380		298
Noninterest expense less adjustments	$	39,266	$	38,769	$	39,266	$	38,769

Net interest income	$	45,365	$	48,790	$	45,365	$	48,790
Taxable-equivalent adjustment:
Loans		N/A		N/A		6		8
Securities		N/A		N/A		758		1,127
Net interest income including adjustments		45,365		48,790		46,129		49,925
Noninterest income		17,017		14,625		17,017		14,625
Less death benefit related to BOLI		59		-		59		-
Less securities (losses) gains, net		(24)		1,013		(24)		1,013
Less MSRs mark to market loss		(2,579)		(1,956)		(2,579)		(1,956)
Taxable-equivalent adjustment:
Change in cash surrender value of BOLI		N/A		N/A		144		207
Noninterest income (less) / including adjustments		19,561		15,568		19,705		15,775

Table of Contents

Net interest income including adjustments plus noninterest income (less) / including adjustments		$	64,926		$	64,358		$	65,834		$	65,700
Efficiency ratio / Adjusted efficiency ratio			60.48	%		60.24	%		59.64	%		59.01	%

Income Taxes

We recorded income tax expense of $3.1 million on $12.4 million of pretax income for the second quarter of 2020, compared to an income tax benefit of $281,000 on $6,000 of pretax loss in the first quarter of 2020, and $3.0 million of income tax expense on $12.3 million of pretax income in the second quarter of 2019. Comparison of the effective tax rate of 25.4% for the second quarter of 2020 to the first quarter of 2020 was not meaningful, due to the low level of pretax net loss in the first quarter. The effective tax rate was 24.7% for the second quarter of 2019.

Income tax expense reflected all relevant statutory tax rates and GAAP accounting. There were no significant changes in our ability to utilize the deferred tax assets during the quarter ended June 30, 2020. We had no valuation reserve on the deferred tax assets as of June 30, 2020.

Financial Condition

Total assets increased $296.9 million to $2.93 billion at June 30, 2020, from $2.64 billion at December 31, 2019, due primarily to an increase in cash and cash equivalents of $206.9 million and loan growth of $121.5 million, partially offset by a reduction of $37.2 million in securities available-for-sale. Total deposits were $2.45 billion at June 30, 2020, an increase of $324.6 million from December 31, 2019, primarily due to increases in noninterest bearing demand accounts, savings accounts, and NOW accounts due to ta decrease in consumer spending during the COVID-19 pandemic, and federal stimulus funds received by many depositors.


							June 30, 2020
Securities	As of						Percent Change From
(Dollars in thousands)	June 30,		December 31,		June 30,		December 31,	June 30,
	2020		2019		2019		2019	2019
Securities available-for-sale, at fair value
U.S. Treasuries	$	4,147	$	4,036	$	4,025	2.8	3.0
U.S. government agencies		7,276		8,337		9,812	(12.7)	(25.8)
U.S. government agencies mortgage-backed		16,779		16,588		16,999	1.2	(1.3)
States and political subdivisions		250,364		249,175		251,295	0.5	(0.4)
Collateralized mortgage obligations		56,113		57,984		64,867	(3.2)	(13.5)
Asset-backed securities		80,026		81,844		82,725	(2.2)	(3.3)
Collateralized loan obligations		32,731		66,684		62,357	(50.9)	(47.5)
Total securities	$	447,436	$	484,648	$	492,080	(7.7)	(9.1)

Securities available-for-sale decreased $37.2 million as of June 30, 2020, compared to December 31, 2019, and $44.6 million compared to June 30, 2019. Available-for-sale security calls and maturities during the three months ended June 30, 2020, totaled $13.1 million and consisted of tax exempt state and political subdivisions securities, whereas purchases during the quarter ended June 30, 2020 totaled $6.7 million and were tax exempt state and political subdivisions securities. During the second quarter of 2020, no security sales or associated gains or losses were recorded, compared to $986,000 of securities gains, net, in the second quarter of 2019.

Table of Contents


							June 30, 2020
Loans	As of						Percent Change From
(Dollars in thousands)	June 30,		December 31,		June 30,		December 31,	June 30,
	2020		2019		2019		2019	2019
Commercial	$	441,642	$	332,842	$	337,848	32.7	30.7
Leases		133,293		119,751		98,379	11.3	35.5
Commercial real estate - Investor		525,714		520,095		476,906	1.1	10.2
Commercial real estate - Owner occupied		343,982		345,504		348,185	(0.4)	(1.2)
Construction		83,939		69,617		93,079	20.6	(9.8)
Residential real estate - Investor		69,421		71,105		68,990	(2.4)	0.6
Residential real estate - Owner occupied		126,303		136,023		132,793	(7.1)	(4.9)
Multifamily		197,521		189,773		191,764	4.1	3.0
HELOC		89,170		91,605		96,821	(2.7)	(7.9)
HELOC - Purchased		26,467		31,852		31,852	(16.9)	(16.9)
Other ¹		14,884		12,258		13,533	21.4	10.0
Total loans, excluding deferred loan costs and PCI Loans ²		2,052,336		1,920,425		1,890,150	6.9	8.6
Net deferred loan costs		-		1,786		1,959	(100.0)	(100.0)
Total loans, excluding PCI loans²		2,052,336		1,922,211		1,892,109	6.8	8.5
PCI loans, net of purchase accounting adjustments²		-		8,601		10,834	(100.0)	(100.0)
Total loans	$	2,052,336	$	1,930,812	$	1,902,943	6.3	7.9

¹The “Other” class includes consumer and overdrafts.

² As discussed below, for periods before our adoption of CECL on January 1, 2020, PCI loans and their related deferred loan costs (now PCD loans) were excluded from nonperforming loan disclosures and were therefore separately reported. After the adoption of CECL, all PCD loans are now included within each relevant loan type and are not separately reported as PCI loans, because such loans are now included within our nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan.

Total loans were $2.05 billion as of June 30, 2020, an increase of $121.5 million from December 31, 2019. The increase in total loans in the first six months of 2020 was due primarily to our origination of 669 PPP loans that totaled $133.9 million within commercial loans, as well as organic growth in our leases, construction, and multifamily loan portfolios, partially offset by reductions in our residential real estate-investor, residential real estate-owner occupied, HELOC and HELOC–purchased portfolios. Total loans increased $149.4 million from June 30, 2019 to June 30, 2020, due primarily to loan growth in our commercial loans due to PPP loan originations, leases, commercial real estate-investor, and multifamily portfolios, partially offset by reductions in our commercial real estate-owner occupied, construction, residential real estate-owner occupied, HELOC, and HELOC-purchased portfolios. As required by CECL, the balance (or amortized cost basis) of PCD loans are carried on a gross basis (rather than net of the associated credit loss estimate), and the expected credit losses for PCD loans are estimated and separately recognized as part of the ACL. Accordingly, at January 1, 2020, $2.5 million of purchase accounting adjustments related to PCD loans were reclassified to the ACL from loans, resulting in an increase to total PCD loans.

The quality of our loan portfolio is impacted not only by our credit decisions but also by the economic health of the communities in which we operate. Since we are located in a corridor with significant open space and undeveloped real estate, real estate lending (including commercial real estate, construction, residential, multifamily, and HELOCs) has been and continues to be a sizeable portion of our portfolio. These categories comprised 71.3% of the portfolio as of June 30, 2020, compared to 75.4% of the portfolio as of December 31, 2019. We continue to oversee and seek to manage our loan portfolio in accordance with interagency guidance on risk management.

Asset Quality

The provision for credit losses, which includes a provision for losses on unfunded commitments, is a charge to earnings to maintain the ACL at a level consistent with management’s assessment of expected losses in the loan portfolio at the balance sheet date. During the first quarter of 2020, we adopted ASU 2016-13, or CECL.

We recorded a $2.1 million provision for credit losses on loans for the second quarter of 2020, compared to a $450,000 provision for loan and lease losses for the second quarter of 2019. In the second quarter of 2020, we determined provision expense was necessary at a level higher than our net charge-offs for the quarter, which were $167,000, due to the guidance under the newly adopted CECL methodology,

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which requires a provision based on future expected credit losses, as compared to the previously used incurred loss model. Runoffs on our acquired loan portfolios are trending with expectations. Management estimates the amount of provision required on a quarterly basis and records the appropriate provision expense, or release of expense, to maintain an adequate reserve for all potential and estimated credit losses on loans. In addition, we established a separate ACL on unfunded commitments of $1.7 million under CECL guidelines as of January 1, 2020, and we recorded a $734,000 provision for credit losses on unfunded commitments in the second quarter of 2020. The significant increase in the total provision for credit losses stems from our CECL model calculations due to the COVID-19 pandemic and market interest rate reductions.

Nonperforming loans consist of nonaccrual loans, performing restructured accruing loans and loans 90 days or greater past due. Remediation work continues in all segments. Nonperforming loans increased by $4.3 million at June 30, 2020, to $20.2 million from $15.8 million at December 31, 2019. Purchased credit deteriorated loans, or PCD loans, are purchased loans that, as of the date of acquisition, the Company determined had experienced a more-than-insignificant deterioration in credit quality since origination. Before we adopted CECL on January 1, 2020, PCD loans were referred to as purchased credit impaired loans, or PCI loans, and such PCI loans and their related deferred loan costs were excluded from our nonperforming loan disclosures, as long as the cash flows on such loans and the timing of such cash flows continued to be estimable and probable of collection. However, after we adopted CECL on January 1, 2020, PCD loans and their related deferred loan costs are now included in our nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan. As of the date of CECL adoption, $2.5 million of the credit related component of the purchase accounting adjustment on PCI loans was reclassified to the ACL, which comprises more than half of the $4.3 million increase in nonperforming loans since December 31, 2019. Credit metrics, excluding the impact of this reclassification, continue to be relatively stable regarding nonperforming loan levels, and management is carefully monitoring loans considered to be in a classified status. Nonperforming loans as a percent of total loans increased to 1.0% as of June 30, 2020, from 0.8% as of December 31, 2019, and 0.7% as of June 30, 2019. The distribution of our nonperforming loans is shown in the following table.


							June 30, 2020
Nonperforming Loans	As of						Percent Change From
(Dollars in thousands)	June 30,		December		June 30,		December	June 30,
	2020		2019		2019		2019	2019
Commercial	$	2,168	$	2,247	$	151	(3.5)	N/M
Leases		181		410		125	(55.9)	44.8
Commercial real estate - Investor		1,968		2,092		2,050	(5.9)	(4.0)
Commercial real estate - Owner occupied		7,223		5,180		4,723	39.4	52.9
Construction		2,203		93		102	N/M	N/M
Residential real estate - Investor		845		788		383	7.2	120.6
Residential real estate - Owner occupied		4,107		3,169		3,228	29.6	27.2
Multifamily		69		68		-	1.5	N/M
HELOC		1,276		1,603		1,689	(20.4)	(24.5)
HELOC - Purchased		113		180		184	(37.2)	(38.6)
Other ¹		8		19		24	(57.9)	(66.7)
Total nonperforming loans	$	20,161	$	15,849	$	12,659	27.2	59.3

N/M - Not meaningful

¹ The “Other” class includes consumer and overdrafts.

The components of our nonperforming assets is shown in the following table.


Nonperforming Assets	As of						Percent Change From
(Dollars in thousands)	June 30,		December 31,		June 30,		December 31,	June 30,
	2020		2019		2019		2019	2019
Nonaccrual loans	$	18,343	$	12,432	$	11,089	47.5	65.4
Performing troubled debt restructured loans accruing interest		978		872		1,570	12.2	(37.7)
Loans past due 90 days or more and still accruing interest		840		2,545		-	(67.0)	N/M
Total nonperforming loans		20,161		15,849		12,659	27.2	59.3
Other real estate owned		5,082		5,004		5,668	1.6	(10.3)
Total nonperforming assets	$	25,243	$	20,853	$	18,327	21.1	37.7

PCD loans, net of purchase accounting adjustments¹	$	11,096	$	8,601	$	10,834	29.0	2.4


30-89 days past due loans and still accruing interest	$	11,330	$	14,390	$	8,888

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Nonaccrual loans to total loans		0.9	%		0.6	%		0.6	%
Nonperforming loans to total loans		1.0	%		0.8	%		0.7	%
Nonperforming assets to total loans plus OREO		1.2	%		1.1	%		1.0	%
Purchased credit-deteriorated loans to total loans		0.5	%		0.4	%		0.6	%

Allowance for credit losses	$	31,273		$	19,789		$	19,372
Allowance for credit losses to total loans		1.5	%		1.0	%		1.0	%
Allowance for credit losses to nonaccrual loans		170.5	%		159.2	%		174.7	%

Loan charge-offs, net of recoveries, for the current quarter, prior linked quarter and year over year quarter are shown in the following table.


Loan Charge-offs, Net of Recoveries	Three Months Ended
(Dollars in thousands)	June 30,		% of	March 31,		% of	June 30,		% of
	2020		Total¹	2020		Total¹	2019		Total¹
Commercial	$	(2)	(1.2)	$	85	7.6	$	61	15.5
Leases		-	-		-	-		-	-
Commercial real estate - Investor		(14)	(8.4)		(8)	(0.7)		(12)	(3.0)
Commercial real estate - Owner occupied		292	174.9		1,108	98.8		42	10.7
Construction		-	-		-	-		(1)	(0.3)
Residential real estate - Investor		(2)	(1.2)		(20)	(1.8)		(3)	(0.8)
Residential real estate - Owner occupied		(66)	(39.5)		(23)	(2.0)		(11)	(2.8)
Multifamily		-	-		-	-		-	-
HELOC		(53)	(31.7)		(58)	(5.2)		38	9.6
HELOC - Purchased		-	-		-	-		229	58.2
Other ²		12	7.1		38	3.4		51	12.9
Net charge-offs	$	167	100.0	$	1,122	100.0	$	394	100.0

¹Represents the percentage of net charge-offs attributable to each category of loans.

² The “Other” class includes consumer and overdrafts.

Net charge-offs of $167,000 were recorded for the second quarter of 2020, compared to net charge-offs of $1.1 million for the first quarter of 2020 and $394,000 for the second quarter of 2019, reflecting continuing management attention to credit quality and remediation efforts. The decline in net charge-offs for the second quarter of 2020 was primarily due to one large charge-off related to a nonperforming note sale in the first quarter of 2020. We have continued our conservative loan valuations and aggressive recovery efforts on prior charge-offs.

The following table shows classified assets by segment for the following periods.

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							June 30, 2020
Classified Assets	As of						Percent Change From
(Dollars in thousands)	June 30,		December 31,		June 30,		December 31,	June 30,
	2020		2019		2019		2019	2019
Commercial	$	8,627	$	11,688	$	7,704	(26.2)	12.0
Leases		254		329		125	(22.8)	103.2
Commercial real estate - Investor		5,445		4,926		8,791	10.5	(38.1)
Commercial real estate - Owner occupied		9,432		7,956		11,605	18.6	(18.7)
Construction		2,318		262		273	784.7	749.1
Residential real estate - Investor		1,454		1,390		1,029	4.6	41.3
Residential real estate - Owner occupied		4,270		3,631		3,773	17.6	13.2
Multifamily		5,562		503		493	N/M	N/M
HELOC		1,690		1,789		1,894	(5.5)	(10.8)
HELOC - Purchased		113		180		184	(37.2)	(38.6)
Other ¹		353		359		24	(1.7)	N/M
Total classified loans, excluding PCI loans		39,518		33,013		35,895	19.7	10.1
Other real estate owned		5,082		5,004		5,668	1.6	(10.3)
Total classified assets, excluding PCI loans		44,600		38,017		41,563	17.3	7.3
PCI, net of purchase accounting adjustments		-		8,601		10,834	(100.0)	(100.0)
Total classified assets	$	44,600	$	46,618	$	52,397	(4.3)	(14.9)

N/M - Not meaningful

¹ The “Other” class includes consumer and overdrafts.

Classified loans include nonaccrual, performing troubled debt restructurings and all other loans considered substandard. Classified assets include both classified loans and OREO. Loans classified as substandard are inadequately protected by either the current net worth and ability to meet payment obligations of the obligor, or by the collateral pledged to secure the loan, if any. These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and carry the distinct possibility that we will sustain some loss if deficiencies remain uncorrected.

Total classified loans increased as of June 30, 2020, from the levels at December 31, 2019, and June 30, 2019, primarily due to inclusion of PCD loans in their respective segments in 2020 due to the adoption of CECL. Total classified assets, including PCD loans, reflected a decrease as of June 30, 2020, compared to the level at December 31, 2019, and the level one year ago. Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the ACL on loans as another measure of overall change in loan related asset quality, which is referred to as the “classified assets ratio.” The classified assets ratio was 13.43% for the period ended June 30, 2020, compared to 11.11% as of December 31, 2019, and 12.56% as of June 30, 2019. The increase in the classified assets ratio for period ended June 30, 2020, compared to June 30, 2019, is also due to the inclusion of PCD loans in their respective segments within the calculation, as these loans were previously excluded. The increase in total PCD loans as of June 30, 2020, compared to December 31, 2019, is due to our reclassification of the credit-related component of the purchase accounting adjustments carried on former PCI loans to the ACL on January 1, 2020, the date we adopted the CECL methodology. The PCD balance of $11.1 million is now included within total classified assets, as applicable, under CECL guidance.

Allowance for Credit Losses on Loans

Upon adoption of CECL on January 1, 2020, (Day One), we recognized an increase in our ACL on outstanding loans of $5.9 million and an increase in our ACL on unfunded commitments of $1.7 million as a cumulative effect adjustment from change in accounting policies. Approximately $2.5 million of the increase to the ACL resulted from the transfer of the non-accretable purchase accounting adjustments on PCD loans. The Day One adjusting entries resulted in a $3.8 million reduction to retained earnings, and a deferred tax asset adjustment of $1.4 million. At June 30, 2020, the ACL on loans totaled $31.3 million, and the ACL on unfunded commitments, included in other liabilities, totaled $5.0 million. This reserve build was driven by the $2.1 million provision expense in the second quarter of 2020, and the $8.0 million provision expense in the first quarter of 2020, augmented by the previously mentioned impact of adopting CECL on January 1, 2020. The total increase in the ACL reflects forecasted credit deterioration due to the COVID-19 pandemic and the resultant recession. Our ACL on loans to total loans was 1.5% as of June 30, 2020, compared to 1.0% at both December 31, 2019, and June 30, 2019.

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See Note 1 – Basis of Presentation and Changes in Significant Accounting Policies in the accompanying notes to the consolidated financial statements included elsewhere in this report for discussion of our ACL methodology on loans. Allocations of the ACL may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off.

Below is a reconciliation of the activity in the allowance for credit losses on loans for the periods indicated (dollars in thousands):


		Three Months Ended								Six Months Ended
	June 30,			March 31,			June 30,			June 30,			June 30,
	2020			2020			2019			2020			2019
Allowance at beginning of period	$	30,045		$	19,789		$	19,316		$	19,789		$	19,006
Charge-offs:
Commercial		22			97			67			119			79
Leases		-			-			-			-			-
Commercial real estate - Investor		2			13			-			15			144
Commercial real estate - Owner occupied		292			1,109			42			1,401			129
Construction		-			-			1			-			1
Residential real estate - Investor		4			1			-			5			6
Residential real estate - Owner occupied		43			-			-			43			12
Multifamily		-			-			-			-			-
HELOC		2			83			50			85			50
HELOC - Purchased		-			-			229			-			229
Other ¹		41			98			85			139			169
Total charge-offs		406			1,401			474			1,807			819
Recoveries:
Commercial		24			12			6			36			36
Leases		-			-			-			-			-
Commercial real estate - Investor		16			21			12			37			32
Commercial real estate - Owner occupied		-			1			-			1			3
Construction		-			-			2			-			1
Residential real estate - Investor		6			21			3			27			19
Residential real estate - Owner occupied		109			23			11			132			37
Multifamily		-			-			-			-			8
HELOC		55			141			12			196			58
HELOC - Purchased		-			-			-			-			-
Other ¹		29			60			34			89			91
Total recoveries		239			279			80			518			285
Net charge-offs		167			1,122			394			1,289			534
Adoption of ASU 326		-			5,879			-			5,879			-
Provision for credit losses on loans		1,395			5,499			450			6,894			900
Allowance at end of period	$	31,273		$	30,045		$	19,372		$	31,273		$	19,372

Average total loans (exclusive of loans held-for-sale)	$	2,038,082		$	1,941,760		$	1,894,454		$	1,989,921		$	1,894,058
Net charge-offs / (recoveries) to average loans		0.01	%		0.06	%		0.02	%		0.06	%		0.03	%
Allowance at period end to average loans		1.53	%		1.55	%		1.02	%		1.57	%		1.02	%

¹ The “Other” class includes consumer and overdrafts.

The coverage ratio of the ACL on loans to nonperforming loans was 155.1% as of June 30, 2020, which was an increase from the coverage ratio of 137.6% as of March 31, 2020, and an increase from 153.0% as of June 30, 2019. When measured as a percentage of average loans, our total ACL on loans was 1.57% for the six months ended June 30, 2020, and 1.02% for the like period of 2019. This increase was driven by the adoption of CECL as of January 1, 2020.

We recorded PCD loans (formerly PCI loans), which refers to loans that showed evidence of deteriorated credit quality upon purchase, in our acquisition of ABC Bank. PCD loans totaled $11.1 million, net of purchase accounting adjustments, as of June 30, 2020, and the credit-related component of the purchase accounting adjustments on these loans, which totaled $2.5 million, was reclassified to ACL, per CECL guidance, on January 1, 2020. We perform re-estimations of cash flows on our PCD loan portfolio on a quarterly basis. Any decline in expected cash flows as a result of these re-estimations, due in any part to a change in credit, is deemed credit impairment, and recorded as provision for credit losses during the period.

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In management’s judgment, an adequate ACL has been established to encompass the current lifetime expected credit losses at June 30, 2020, and general changes in lending policy, procedures and staffing, as well as other external factors, such as the impacts of the COVID-19 pandemic. However, there can be no assurance that actual losses will not exceed the estimated amounts in the future, based on unforeseen economic events, changes in business climates and the condition of collateral at the time of default and repossession. Further delayed recovery or further deterioration in market conditions related to COVID-19 and the associated impacts on our customers, changes in business climates and the condition of collateral at the time of default or repossession may revise our current expectations of future credit losses in future reporting periods.

Other Real Estate Owned

As of June 30, 2020, OREO totaled $5.1 million, reflecting no material change from the $5.0 million at December 31, 2019, and $5.7 million at June 30, 2019. There was one property addition which totaled $93,000 to the OREO portfolio in the second quarter of 2020. There were no property disposals in the second quarter of 2020. One valuation write-down occurred in the second quarter of 2020 with an expense total of $60,000, compared to $120,000 of OREO valuation write-downs in the fourth quarter of 2019, and $196,000 of valuation write-downs recorded in the second quarter of 2019.


							June 30, 2020
OREO	Three Months Ended						Percent Change From
(Dollars in thousands)	June 30,		December 31,		June 30,		December 31,	June 30,
	2020		2019		2019		2019	2019
Balance at beginning of period	$	5,049	$	4,682	$	6,365	7.8	(20.7)
Property additions, net of acquisition adjustments		93		567		-	(83.7)	100.0
Less:
Proceeds from property disposals, net of participation purchase and of gains/losses		-		125		501	(100.0)	(100.0)
Period valuation adjustments		60		120		196	(50.0)	(69.4)
Balance at end of period	$	5,082	$	5,004	$	5,668	1.5	(10.3)

N/M - Not meaningful

In management’s judgment, the property valuation allowance as established presents OREO at current estimates of fair value less estimated costs to sell; however, there can be no assurance that additional losses will not be incurred on disposals or upon updates to valuations in the future. Of note, properties valued in total at $3.6 million, or approximately 71.5% of total OREO at June 30, 2020, have been in OREO for five years or more. The appropriate regulatory approval has been obtained for any OREO properties held in excess of five years, with one exception. One parcel of raw land remains challenging to dispose of, and, while not material in value, was held as OREO in excess of the time allowed per regulatory guidance as of June 30, 2020. This property was sold on July 10, 2020, resulting in a minimal gain.



OREO Properties by Type
(Dollars in thousands)	June 30, 2020				December 31, 2019				June 30, 2019
		Amount	% of Total			Amount	% of Total			Amount	% of Total
Single family residence	$	450	9	%	$	174	3	%	$	370	7	%
Lots (single family and commercial)		3,691	72	%		3,945	79	%		4,162	73	%
Vacant land		37	1	%		41	1	%		440	8	%
Commercial property		904	18	%		844	17	%		696	12	%
Total other real estate owned	$	5,082	100	%	$	5,004	100	%	$	5,668	100	%

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Deposits and Borrowings


							June 30, 2020
Deposits	As of						Percent Change From
(Dollars in thousands)	June 30,		December 31,		June 30,		December 31,	June 30,
	2020		2019		2019		2019	2019
Noninterest bearing demand	$	890,636	$	669,795	$	632,900	33.0	40.7
Savings		373,448		307,015		311,887	21.6	19.7
NOW accounts		466,762		425,792		426,511	9.6	9.4
Money market accounts		293,073		282,478		285,223	3.8	2.8
Certificates of deposit of less than $100,000		215,777		227,578		220,973	(5.2)	(2.4)
Certificates of deposit of $100,000 through $250,000		146,374		151,279		144,148	(3.2)	1.5
Certificates of deposit of more than $250,000		65,247		62,812		56,132	3.9	16.2
Total deposits	$	2,451,317	$	2,126,749	$	2,077,774	15.3	18.0

Total deposits were $2.45 billion at June 30, 2020, which reflects a $324.6 million increase from total deposits of $2.13 billion at December 31, 2019, and an increase of $373.5 million from the $2.08 billion at June 30, 2019. The increase in deposits at June 30, 2020, compared to December 31, 2019, was due primarily to increases in noninterest bearing demand, savings and NOW accounts, with smaller increases noted in money market accounts and certificates of deposit more than $250,000. The increase in deposits in the year over year period was primarily due to growth in noninterest bearing demand deposits, savings, NOW accounts, money markets, and time deposits of $100,000 or more. These increases in the linked quarter as well as year over year periods were primarily due to federal stimulus funds received by depositors and a decrease in consumer spending during the COVID-19 pandemic.

In addition to deposits, we obtained funding from other sources in all periods presented. Securities sold under repurchase agreements totaled $52.1 million at June 30, 2020, a $3.4 million, or 7.0%, increase from $48.7 million at December 31, 2019. We also had short-term borrowings of $8.3 million from the FHLBC at June 30, 2020, as compared to $48.5 million in short-term borrowings at December 31, 2019. Our notes payable and other borrowings is comprised of one remaining $6.5 million long-term FHLBC advance acquired in our ABC Bank acquisition, which matures on February 20, 2026, and $19.0 million outstanding on a $20.0 million term note originated with a correspondent bank in the first quarter of 2020, to facilitate in the redemption of our Old Second Capital Trust I trust preferred securities and related junior subordinated debentures, completed on March 2, 2020. Notes payable and other borrowings of $25.5 million as of June 30, 2020, increased $18.9 million from December 31, 2019, and increased $14.5 million from June 30, 2019.

The Company is indebted on senior notes originated in December 2016, totaling $44.3 million, net of deferred issuance costs, as of June 30, 2020. These notes mature in December 2026, and include interest payable semi-annually at 5.75% for five years. Beginning December 2021, the interest becomes payable quarterly at three month LIBOR plus 385 basis points. The Company is also indebted on $25.8 million, net of deferred issuance costs, of junior subordinated debentures, which are related to the trust preferred securities issued by its statutory trust subsidiary, Old Second Capital Trust II (“Trust II”). The Trust II issuance converted from fixed to floating rate at three month LIBOR plus 150 basis points on June 15, 2017. Upon conversion to a floating rate, we initiated a cash flow hedge which resulted in the total interest rate paid on this debt of 4.42% as of June 30, 2020, as compared to 6.77%, which was the rate paid during the period prior to the June 15, 2017, rate reset. The Company also redeemed $32.6 million of trust preferred securities issued by its statutory trust subsidiary, Old Second Capital Trust I, on March 2, 2020, as noted above. The cash paid at redemption of $33.0 million included accrued interest of $438,000 on the debentures, and resulted in a payment of $10.13 per preferred share.

Capital

As of June 30, 2020, total stockholders’ equity was $282.5 million, which was an increase of $4.7 million from $277.9 million as of December 31, 2019. This increase is attributable to an increase in retained earnings of $5.1 million, comprised of net income year to date of $9.5 million, less a reduction to retained earnings of $3.8 million upon the adoption of ASU 2016-13 (CECL) as of January 1, 2020, and payment of $600,000 of dividends to our common stockholders in the six months ended June 30, 2020. In addition, an increase to accumulated other comprehensive income of $1.9 million was recorded due to a net increase in unrealized gains on available-for-sale securities, net of unrealized losses on swaps. Total stockholders’ equity decreased as our treasury stock increased $3.2 million in the second quarter of 2020, primarily due to repurchases of our common shares pursuant to our stock repurchase program.

In the third quarter of 2019, our Board of Directors authorized a stock repurchase program, in which we may repurchase up to approximately 1.5 million shares (or approximately 5%) of our outstanding common stock by September 2020, through open market purchases, trading plans established in accordance with U.S. Securities and Exchange Commission rules, privately negotiated transactions, or by other means. The actual means and timing of any repurchases, quantity of purchased shares and prices will be, subject to certain limitations, at the discretion of management and will depend on a number of factors, including, without limitation, market

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prices of our common stock, general market and economic condition, and applicable legal and regulatory requirements. These share purchases are anticipated to be funded by our cash on hand. During the second quarter of 2020, we repurchased 145,932 shares of our common stock at a weighted average price of $6.97 per share pursuant to our stock repurchase program. To date, we have repurchased 458,655 shares or our common stock at a weighted average price of $7.05 per share, under our stock repurchase program.

The following table shows the regulatory capital ratios and the current well capitalized regulatory requirements for the Company and the Bank as of the dates indicated:


	Minimum Capital		Well Capitalized
	Adequacy with		Under Prompt
	Capital Conservation		Corrective Action		June 30,		December 31,		June 30,
	Buffer, if applicable¹		Provisions²		2020		2019		2019
The Company
Common equity tier 1 capital ratio	7.00	%	N/A		11.31	%	11.14	%	10.26	%
Total risk-based capital ratio	10.50	%	N/A		13.63	%	14.53	%	13.70	%
Tier 1 risk-based capital ratio	8.50	%	N/A		12.39	%	13.65	%	12.83	%
Tier 1 leverage ratio	4.00	%	N/A		10.06	%	11.93	%	10.85	%

The Bank
Common equity tier 1 capital ratio	7.00	%	6.50	%	13.46	%	14.35	%	13.96	%
Total risk-based capital ratio	10.50	%	10.00	%	14.71	%	15.23	%	14.83	%
Tier 1 risk-based capital ratio	8.50	%	8.00	%	13.46	%	14.35	%	13.96	%
Tier 1 leverage ratio	4.00	%	5.00	%	10.86	%	12.50	%	11.96	%

¹ Amounts are shown inclusive of a capital conservation buffer of 2.50%. Under the Federal Reserve’s Small Bank Holding Company Policy Statement, the Company is not subject to the minimum capital adequacy and capital conservation buffer capital requirements at the holding company level, unless otherwise advised by the Federal Reserve (such capital requirements are applicable only at the Bank level). Although the minimum regulatory capital requirements are not applicable to the Company, we calculate these ratios for our own planning and monitoring purposes.

² The prompt corrective action provisions are only applicable at the Bank level.

As part of its response to the impact of the COVID-19 pandemic, in the first quarter of 2020, U.S. federal regulatory authorities issued an interim final rule that provides banking organizations that adopt CECL during the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital relative to regulatory capital determined under the prior incurred loss methodology, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during the initial two-year delay (i.e., a five-year transition in total). In connection with our adoption of CECL on January 1, 2020, we elected to utilize the five-year CECL transition. The cumulative amount that is not recognized in regulatory capital, in addition to the $3.8 million Day One impact of CECL adoption, will be phased in at 25% per year beginning January 1, 2022. As of June 30, 2020, the capital measures of the Company exclude $5.6 million, which is the Day One impact to retained earnings, and 25% of the $10.1 million increase, net of taxes, in the ACL in the six months ended June 30, 2020, excluding PCD loans.

As of June 30, 2020, the Company, on a consolidated basis, exceeded the minimum capital ratios to be deemed “well capitalized” and met the now fully phased-in capital conservation buffer requirements. In addition to the above regulatory ratios, our GAAP common equity to total assets ratio, which is used as a performance measurement for capital analysis and peer comparisons, decreased from 10.54% at December 31, 2019, to 9.63% at June 30, 2020. Our GAAP tangible common equity to tangible assets ratio was 8.98% at June 30, 2020, compared to 9.81% as of December 31, 2019. Our non-GAAP tangible common equity to tangible assets ratio, which management also considers a valuable performance measurement for capital analysis, decreased from 9.83% at December 31, 2019, to 9.00% at June 30, 2020.

In November 2019, the federal banking agencies published final rules to provide an optional simplified measure of capital adequacy for qualifying community banking organizations, which we refer to as the community bank leverage ratio (“CBLR”) framework. Generally, under the CBLR framework, qualifying community banking organizations with total assets of less than $10 billion, and limited amounts of off-balance-sheet exposures and trading assets and liabilities, may elect whether to be subject to the CBLR framework if they have a CBLR of greater than 9%. Qualifying community banking organizations that elect to be subject to the CBLR framework and continue to meet all requirements under the framework would not be subject to risk-based or other leverage capital requirements and, in the case of

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an insured depository institution, would be considered to have met the well capitalized ratio requirements for purposes of the FDIC’s Prompt Corrective Action framework. The final rule became effective on January 1, 2020. We do not have any immediate plans to elect to use the community bank leverage ratio framework, but may make such an election in the future.

Reconciliation of Tangible Common Equity to Tangible Assets Ratio Non-GAAP Measure


	June 30, 2020						December 31, 2019
Tangible common equity	GAAP			Non-GAAP			GAAP			Non-GAAP
(Dollars in thousands)

Total Equity	$	282,516		$	282,516		$	277,864		$	277,864
Less: Goodwill and intangible assets		21,023			21,023			21,275			21,275
Add: Limitation of exclusion of core deposit intangible (80%)		N/A			484			N/A			534
Adjusted goodwill and intangible assets		21,023			20,539			21,275			20,741
Tangible common equity	$	261,493		$	261,977		$	256,589		$	257,123
Tangible assets
Total assets	$	2,932,436		$	2,932,436		$	2,635,545		$	2,635,545
Less: Adjusted goodwill and intangible assets		21,023			20,539			21,275			20,741
Tangible assets	$	2,911,413		$	2,911,897		$	2,614,270		$	2,614,804

Common equity to total assets		9.63	%		9.63	%		10.54	%		10.54	%
Tangible common equity to tangible assets		8.98	%		9.00	%		9.81	%		9.83	%

The non-GAAP intangible asset exclusion reflects the 80% core deposit limitation per Basel III guidelines within risk based capital calculations, and is useful for us when reviewing risk based capital ratios and equity performance metrics.

Liquidity

Liquidity is our ability to fund operations, to meet depositor withdrawals, to provide for customers’ credit needs, and to meet maturing obligations and existing commitments. Our liquidity principally depends on our cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and our ability to borrow funds. We monitor our borrowing capacity at the FHLBC as part of our liquidity management process as supervised by our Asset and Liability Committee (“ALCO”) and reviewed by our Board of Directors. In addition, due to the potential impacts on our liquidity stemming from the COVID-19 pandemic, our senior management team monitors cash balances daily to ensure we have adequate liquidity to meet our operational and financing needs. As of June 30, 2020, our cash on hand liquidity totaled $257.5 million, an increase of $206.9 million over cash balances held as of December 31, 2019, which is over a 400% increase.

Net cash inflows from operating activities were $20.8 million during the first six months of 2020, compared with net cash inflows of $39.9 million in the same period of 2019. Funds used to originate loans held-for-sale, net of proceeds from sales of loans held-for-sale, were a source of outflows for the first six months of 2020 and the like period of 2019. Interest paid, net of interest received, combined with changes in other assets and liabilities were a source of outflows for the six months ended June 30, 2020 and the like period of 2019. The management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows. Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, as part of the balance sheet management process.

Net cash outflows from investing activities were $83.7 million in the six months ended June 30, 2020, compared to net cash inflows of $62.2 million in the same period in 2019. In the first six months of 2020, securities transactions accounted for net inflows of $40.7 million, and the principal change on loans accounted for net outflows of $123.6 million. In the first six months of 2019, securities transactions accounted for net inflows of $68.4 million, and net principal on loans funded accounted for net outflows of $6.2 million. Proceeds from sales of OREO accounted for $311,000 and $1.5 million in investing cash inflows for the six months ended June 30, 2020 and 2019, respectively.

Net cash inflows from financing activities in the six months ended June 30, 2020 were $269.7 million, compared with net cash outflows of $99.1 million in the six months ended June 30, 2019. Net deposit inflows in the first six months of 2020 were $324.6 million compared to net deposit outflows of $38.9 million in the first six months of 2019. Other short-term borrowings had net cash outflows of $40.2 million in the first six months of 2020, and $62.4 million in the first six months of 2019. Changes in securities sold under repurchase

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agreements accounted for $3.4 million and $7.5 million in net inflows for the six months ended June 30, 2020 and 2019, respectively. The redemption of our Old Second Capital Trust I trust preferred securities and related junior subordinated debentures resulted in cash outflows of $32.6 million in the first quarter of 2020, which was partially offset by a $19.0 million term note cash inflow which was originated to partially fund this trust preferred redemption.

Cash and cash equivalents for the six months ended June 30, 2020, totaled $257.5 million, as compared to $58.2 million as of June 30, 2019. In addition to cash and cash equivalents on hand or held as deposits with other financial institutions, we rely on funding sources from customer deposits, cash flows from securities available-for-sale and loans, and a line of credit with the FHLBC to meet potential liquidity needs. These sources of liquidity are immediately available to satisfy any funding requirements due to depositor or borrower demands through the ordinary course of our business. Additional sources of funding include a $20 million undrawn line of credit held by the Company with a third party financial institution, as well as unpledged securities available-for-sale.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

As part of our normal operations, we are subject to interest-rate risk on the assets we invest in (primarily loans and securities) and the liabilities we fund (primarily customer deposits and borrowed funds). Fluctuations in interest rates may result in changes in the fair market values of our financial instruments, cash flows, and net interest income. Like most financial institutions, we have an exposure to changes in both short-term and long-term interest rates.

In the first quarter of 2020, the Federal Reserve cut short-term interest rates on three separate occasions. One cut occurred on the scheduled meeting date in January, and the other two were announced prior to the scheduled meeting date in March. In response to the COVID-19 pandemic, the Federal Reserve aggressively cut rates as low as they could without taking rates negative. Overall the Fed Funds upper bound target rate dropped from 1.75% to 0.25% during the quarter, a decline of 1.50%. As a result, the Bank's prime rate also dropped by 1.50% from 4.75% to 3.25%. The general market consensus is that the Federal Reserve will keep the Fed Funds rates unchanged for the foreseeable future in an effort to combat the harsh economic effects of COVID-19. We manage interest rate risk within guidelines established by policy which are intended to limit the amount of rate exposure. In practice, we seek to manage our interest rate risk exposure well within our guidelines so that such exposure does not pose a material risk to our future earnings.

We manage various market risks in the normal course of our operations, including credit, liquidity risk, and interest-rate risk. Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of our business activities and operations. In addition, since we do not hold a trading portfolio, we are not exposed to significant market risk from trading activities. Our interest rate risk exposures at June 30, 2020, and December 31, 2019, are outlined in the table below.

Our net income can be significantly influenced by a variety of external factors, including: overall economic conditions, policies and actions of regulatory authorities, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities other than those that are assumed, early withdrawal of deposits, exercise of call options on borrowings or securities, competition, a general rise or decline in interest rates, changes in the slope of the yield-curve, changes in historical relationships between indices (such as LIBOR and prime), and balance sheet growth or contraction. Our asset-liability committee seeks to manage interest rate risk under a variety of rate environments by structuring our balance sheet and off-balance sheet positions, which includes interest rate swap derivatives as discussed in Note 14 of our consolidated financial statements included in this quarterly report. We seek to monitor and manage interest rate risk within approved policy guidelines and limits.

We use simulation analysis to quantify the impact of various rate scenarios on our net interest income. Specific cash flows, repricing characteristics, and embedded options of the assets and liabilities held by us are incorporated into the simulation model. Earnings at risk are calculated by comparing the net interest income of a stable interest rate environment to the net interest income of a different interest rate environment in order to determine the percentage change. As of December 31, 2019, we had modest amounts of earnings gains (in both dollars and percentage) should interest rates rise, and limited earnings reductions should interest rates fall. The projected increases in income across all up rate interest rate shock scenarios as of June 2020 were considerably higher than those in December 2019. These increases were primarily driven by two factors. Earlier in the year, we performed an internal historical deposit study on both decay rates and betas. The results of this study were used to update assumptions within our asset liability model. In general, the updated deposit study resulted in lower betas being applied in the ALM model. In the rising rate scenarios, this caused a lower interest expense than was previously modeled. The other factor driving the uptick in earnings gains in the up rate scenarios was a large increase in non-maturity deposits. Overall, non-maturity deposits have increased approximately $339 million since year end. Management still believes the current level of interest rate risk to be moderate but intends to continue looking for market opportunities to flatten its interest rate risk profile.

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The following table summarizes the effect on annual income before income taxes based upon an immediate increase or decrease in interest rates of 0.5%, 1%, and 2% and no change in the slope of the yield curve. Due to recent dramatic market interest rate declines, it was not possible to calculate certain down rate scenarios because rates would fall below zero in all down rate scenarios.

Analysis of Net Interest Income Sensitivity

(Dollars in thousands)



	Immediate Changes in Rates
		(2.0)	%		(1.0)	%		(0.5)	%		0.5	%		1.0	%		2.0	%
June 30, 2020
Dollar change		N/M			N/M			N/M		$	3,184		$	6,407		$	11,814
Percent change		N/M			N/M			N/M			3.7	%		7.5	%		13.8	%

December 31, 2019
Dollar change		N/M		$	(6,229)		$	(2,670)		$	993		$	2,016		$	3,856
Percent change		N/M			(6.6)	%		(2.8)	%		1.1	%		2.1	%		4.1	%

N/M - Not meaningful

The amounts and assumptions used in the simulation model should not be viewed as indicative of expected actual results. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies. The above results do not take into account any management action to mitigate potential risk.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of June 30, 2020. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of June 30, 2020, the Company’s internal controls were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified.

We adopted the new guidance under Accounting Standards Update 2016-13, (ASC Topic 326) “Measurement of Credit Losses on Financial Instruments,” also known as Current Expected Credit Losses, or CECL, on January 1, 2020. The Company implemented new accounting processes and procedures, which required us to update our internal controls over accounting for the allowance for credit losses, and the related disclosures under the new guidance. As a result of the adoption of CECL, we implemented new internal controls designed to mitigate the risks associated with these new processes and to provide assurance at a reasonable level of the fair presentation of our consolidated financial statements and related disclosures. There were no other changes in the Company’s internal controls over financial reporting during the six months ended June 30, 2020, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

The Company and its subsidiaries, from time to time, are involved in collection suits in the ordinary course of business against its debtors and are defendants in legal actions arising from normal business activities. Management, after consultation with legal counsel, believes

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that the ultimate liabilities, if any, resulting from these actions will not have a material adverse effect on the financial position of the Bank or on the consolidated financial position of the Company.

Item 1.A. Risk Factors

Investing in shares of our common stock involves certain risks, including those identified and described in Item 1A. of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, as well as cautionary statements contained in this Quarterly Report on Form 10-Q, including those under the caption “Cautionary Note Regarding Forward-Looking Statements,” and set forth in Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2020.

Except as set forth in Part II, Item 1A of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2020 and filed with the SEC on May 11, 2020, which is incorporated herein by this reference, there have been no material changes to the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019 filed with the SEC on March 6, 2020.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Stock Repurchases

The actual means and timing of any repurchases, quantity of purchased shares and prices will be, subject to certain limitations, at the discretion of management and will depend on a number of factors, including, without limitation, market prices of our common stock, general market and economic conditions, and applicable legal and regulatory requirements. Repurchases under the Repurchase Program may be initiated, discontinued, suspended or restarted at any time; provided that repurchases under the Repurchase Program after September 19, 2020 would require Federal Reserve non-objection or approval. We are not obligated to repurchase any shares under the Repurchase Program.

The following table presents our stock repurchases for the quarter ended June 30, 2020.

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				Total Number of	Maximum Number
	Total			Shares Purchased	of Shares that May
	Number of		Average	as Part of Publicly	Yet Be
(Dollars in thousands, except for per share	Shares		Price Paid	Announced Plans	Purchased Under
amounts)	Purchased		per Share	or Programs	the Plans or Programs
April 1, 2020 - April 30, 2020	7,341	$	8.12	320,064	1,174,762
May 1, 2020 - May 31, 2020	138,591		6.91	458,655	1,036,171
June 1, 2020 - June 30, 2020	-		-	-	1,036,171
Total	145,932	$	6.97	458,655	1,036,171

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None.

Item 6. Exhibits

Exhibits:



31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).

31.2	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).

32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101	Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets at June 30, 2020, and December 31, 2019; (ii) Consolidated Statements of Income for the six months ended June 30, 2020 and 2019; (iii) Consolidated Statements of Stockholders’ Equity for the six months ended June 30, 2020 and 2019; (iv) Consolidated Statements of Cash Flows for the six months ended June 30, 2020 and 2019; and (v) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail.*

	* As provided in Rule 406T of Regulation S-T, these interactive data files shall not be deemed “filed” for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934 as amended, or otherwise subject to liability under those sections.

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SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	OLD SECOND BANCORP, INC.


		BY:	/s/ James L. Eccher
			James L. Eccher
			President and Chief Executive Officer
			(principal executive officer)


		BY:	/s/ Bradley S. Adams
			Bradley S. Adams
			Executive Vice President and Chief Financial Officer
			(principal financial and accounting officer)


DATE: August 7, 2020

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