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Edited Transcript of OSBC earnings conference call or presentation 23-Jan-20 4:00pm GMT

Q4 2019 Old Second Bancorp Inc Earnings Call

Aurora Jan 27, 2020 (Thomson StreetEvents) -- Edited Transcript of Old Second Bancorp Inc earnings conference call or presentation Thursday, January 23, 2020 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bradley S. Adams

Old Second Bancorp, Inc. - Executive VP & CFO

* James L. Eccher

Old Second Bancorp, Inc. - CEO, President, COO & Director

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Conference Call Participants

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* Christopher Edward McGratty

Keefe, Bruyette, & Woods, Inc., Research Division - MD

* David Joseph Long

Raymond James & Associates, Inc., Research Division - Senior Analyst

* Evan Lisle

Janney Montgomery Scott LLC, Research Division - Research Analyst

* Nathan James Race

Piper Sandler & Co., Research Division - VP & Senior Research Analyst

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Presentation

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Operator [1]

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Good morning, everyone, and thank you for joining us for today's Old Second Bancorp, Inc.'s Fourth Quarter 2019 Earnings Call. On the call today is Jim Eccher, CEO; Gary Collins, Vice Chairman; and the company's CFO, Brad Adams.

I will start with a reminder that Old Second's comments today may contain forward-looking statements about the company's business, strategies and prospects, which are based on management's existing expectations and the current economic environment. These statements are not a guarantee of future performance, and results may differ materially from those projected. Management would ask you prefer -- I'm sorry, refer to the company's SEC filings for a full discussion of the company's risk factors.

On today's call, we will also be discussing certain non-GAAP financial measures. These non-GAAP measures are described and reconciled to their GAAP counterparts in our earnings release which is available on our website at oldsecond.com under the Investor Relations tab.

Now I'll turn the call over to Jim Eccher. Please go ahead, sir.

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [2]

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Thank you. Good morning and thank you for joining us today. I have several prepared opening remarks and will give you my overview of the quarter and then turn it over to Brad for more additional details. I will then conclude with some summary thoughts and open it up to -- open it up for questions after that.

Net income for the quarter was $9.5 million or $0.31 per diluted share in the fourth quarter. Earnings this quarter were negatively impacted by a compression in the net interest margin that totaled 28 basis points from third quarter levels. The core net interest margin contracted a somewhat more modest 15 basis points, excluding the impacts of purchase accounting income on acquired loans recorded in the third quarter. This is a bit more than we were expecting although still within the range we've provided of 3 to 5 basis points for each Federal Reserve reduction in the overnight rate. Brad will provide some additional color on the margin in his prepared comments.

Earning trends were positively impacted by a BOLI death benefit of $872,000 during the quarter. Absent these items, earnings trends were relatively stable and consistent with last quarter, but we did see mortgage banking results soften from a seasonal slowdown in the quarter. Returns on assets and equity continue to be very strong driven by a still healthy net interest margin, solid expense control, sustained performance across our fee-based businesses and a stable credit outlook. A high level of profitability has afforded us the ability to invest significantly in the future growth of the bank.

In regards to the quarter specifically, total loans increased by $31 million from last quarter with a strong level of originations mitigated by continuing payoff activity. Loan payoff activity accelerated every quarter in 2019, and we're hopeful the pace of payoffs will moderate in 2020. We continue to be surprised by the level of payoff activity. However, loan pipelines remain healthy.

The competition for credit in our market still remains very aggressive, both in terms of pricing and structure. And with the tailwinds provided by an expanding margin having lessened, we expect to increase efforts to grow the loan book and capitalize upon recent additions to our staff. We're optimistic we can achieve 5% to 7% loan growth in 2020, exclusive of any merger activity.

Lastly, as it pertains to the loan book, yields on the portfolio declined substantially from last quarter due to the benefit of accelerated accretion from the early payoff from an acquired loan in the prior quarter. Total deposits bounced back nicely on both of period-end and average basis, and growth here remains a key focus for us.

Our net total transaction account activity has largely been stable, with declines primarily focused in higher-cost relationships acquired in 2018. The loan-to-deposit ratio for the fourth quarter of 2019 remains unchanged at 91%. We believe we can remain at these levels in the near term with loan growth funded by a mix of deposit growth and modest balance sheet optimization. We remain very comfortable with asset quality trends overall. Nonperforming assets and classified loans increased modestly relative to last quarter but remain well controlled.

Overall, we remain very encouraged about our results in a number of areas, and Brad will provide additional color in his prepared comments.

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Bradley S. Adams, Old Second Bancorp, Inc. - Executive VP & CFO [3]

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Thank you, Jim. Net interest income declined by $1.6 million relative to last quarter, with about half of that decrease due to negative variances, accelerated accretion on acquired loans. Fee income suffered a bit as mortgage banking income returned to a more normalized level. The reported taxable equivalent margin decreased by 28 basis points, as Jim said, from last quarter, with about half of that contraction due to 15% paydowns in the acquired ABC portfolio during the prior quarter.

A few additional basis points were lost on the margin due to the sale of the securities during the third quarter, though the trade, in aggregate, was a very good one with the subsequent movement in interest rates. Pricing movement on the liability side of the balance sheet has been limited to this point, but we should begin to see reductions in funding costs in the fourth quarter -- in the first quarter of 2020.

Notably, margin trends in future periods will be impacted modestly by the adoption of CECL on January 1, 2020, with a further reduction in accretable discount, offset by movement into the allowance for credit losses. Equity levels will also be modestly impacted by the change.

The overall level -- the overall increase in the level of credit loss reserves currently estimated at a $4 million to $6 million increase in the loss reserve will be largely derived by the reclassification of purchase accounting credit discount into the loss reserve. As these loans mature, we will begin to see these reserve levels migrate down to levels not inconsistent with historical trends for us given the relatively short-duration nature of our loan portfolio.

Our efforts in the coming quarters will be focused on quality loan growth and core funding and with the expectation of further modest contraction in margin trends going forward. The loan-to-deposit ratio leaves us well positioned, and we have ample flexibility, both to continue to pursue the growth while protecting our core deposit base. As Jim mentioned, it is likely we will seek to optimize the earning asset mix and fund future loan growth going forward through a mixture of deposit growth and earning asset optimization.

Our margin trends in the future should be relatively stable with a modest negative bias, absent any movement in the fed funds rate. Notably, we saw significant decreases in the LIBOR rate during the third quarter -- or during the fourth quarter that were in excess of our expectations. We are incredibly sensitive to movements in LIBOR rate. Should it recover and start moving the other direction, obviously this guidance will prove conservative. Should it continue to trend downward, we would not do as well.

Overall loan growth will become a much more important factor for us with the outlook for short-term rates having changed, but I believe we have a significant opportunity in front of us.

On the fee income side, mortgage banking reflected a decline in gain-on-sale margins during the quarter and more modest pipelines, although MSR valuations for the fourth quarter compared to the third quarter were more favorable. Trust and wealth management remains steady, and retail banking trends slowed modestly in both fees and card activity during the quarter.

Expenses remained very well controlled, as you can see, with additional sales hires largely offset by seasonal factors during the fourth quarter. And continuing investments for future growth are largely baked into run rate trends you have been seeing from us.

With that, I'll turn the call back over to Jim.

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [4]

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Thanks, Brad. In closing, we remain encouraged with these trends and optimistic about the future. On an organic basis, operating leverage remained strong, and we are excited about the quality of talent added to the organization in the last 2 quarters. Profitability remains excellent, and we are pleased that the outlook for short-term rate movements has stabilized since we last spoke. Capitals continue to build significantly for our company. And though we remain very comfortable with the returns we are generating, we will be evaluating opportunities to return capital to the shareholders and reduce high-cost debt versus our outlook for opportunities to invest capital.

2019 overall was a very good year for us. 2020 will be more difficult if interest rates hold here or decline further. We are taking the steps to position ourselves well for either continued strength in a local economy or the possibility of a potential slowdown. We believe our credit underwriting has remained disciplined, and our funding and capital position is strong. Overall, the team here has never been better, and I remain optimistic that opportunities are available to improve our footprint.

The focus for us is on timing and making sure that we have access to the capital we need in order to take advantage. Periods of significant changes and the volatility of bank valuations make M&A more difficult in the community bank space, but things can change quickly on that front, especially as we move through what may well be a more difficult year for some banks.

That concludes our prepared comments this morning. So I will turn it over to the moderator and open it up to questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll go first to Chris McGratty with KBW.

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Christopher Edward McGratty, Keefe, Bruyette, & Woods, Inc., Research Division - MD [2]

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Can you maybe start on expenses? You guys have done a pretty good job keeping the expenses flat in light of your comments on revenue growth being more of a challenge for the group. How do we think about the trajectory of expenses given what you're doing on the hiring front?

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Bradley S. Adams, Old Second Bancorp, Inc. - Executive VP & CFO [3]

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I think that given some momentum on the loan growth side, I don't think there's anything aggressive that needs to be done there. We talked in the past as kind of a low single-digit number on the expense growth line. We're watching things carefully relative to loan growth. I'd say the prepayments are still very highly elevated. We saw a number of significant prepayments during the fourth quarter. If that trend continues, we'll continue to get more aggressive on expenses. But for now, we're still comfortable with what we're thinking for the year.

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Christopher Edward McGratty, Keefe, Bruyette, & Woods, Inc., Research Division - MD [4]

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Okay, great. And then you talked about the balance sheet optimization. You guys obviously have done a lot of work on the balance sheet in the last couple of years. How do we think about, if your loan growth, I think you said 5% to 7%, to be assuming earning asset growth trails at in the security book, like is flat to down? Or how do we think about that mix, Brad?

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Bradley S. Adams, Old Second Bancorp, Inc. - Executive VP & CFO [5]

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I -- at this point, given some positive momentum on the deposit side, I think that we can hold relatively steady on the securities portfolio. That would be our lever if deposit growth isn't there to shrink that portfolio modestly. But again, our real exposure is to down short rates, and adding additional funding that does reprice with the short end of the curve is not something that I would shy away from at this point given where we are in that cycle and what our overall positioning based on just the character of what we are, which is an extremely well core-funded community bank.

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Christopher Edward McGratty, Keefe, Bruyette, & Woods, Inc., Research Division - MD [6]

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Got it. Great. And maybe just last one for you, Jim. You touched about in your closing remarks the capital. How do we think about the ranking of the priorities of returning capital and redeeming the debt? You talked about it last quarter, but obviously, the rate outlook has gotten a little harder.

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [7]

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Yes. Obviously, we're focused internally on organic loan growth first, but we certainly are taking a very hard look at TruPS redemption and reducing some of this high-cost debt. That is probably right at the top of the list.

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Operator [8]

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We'll take our next question from David Long with Raymond James.

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David Joseph Long, Raymond James & Associates, Inc., Research Division - Senior Analyst [9]

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The paydowns that you've been having, what are you baking into the paydown levels for 2020 when you talk about a 5% to 7% loan growth outlook?

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [10]

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Yes. That's been -- David, that's been the challenge. Obviously, in 2019, we saw pretty significant acceleration in paydowns each and every quarter. Partially -- the reason for that, partially, is our -- the dynamics of our portfolio are changing. The duration is relatively short. But we had unusually very high paydowns in the third and fourth quarter, so we do expect that to moderate. And it's hard to peg that because we're seeing a lot of clients sell properties that we didn't even really know about. So given the pace of loan originations, we're optimistic that's going to slow to more normalized levels in 2020.

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David Joseph Long, Raymond James & Associates, Inc., Research Division - Senior Analyst [11]

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Got it. Okay. And from an operating leverage perspective, can you guys put up positive operating leverage in 2020, even with the NIM challenges? Or does the NIM -- the headwinds from the NIM make that too difficult at this point?

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Bradley S. Adams, Old Second Bancorp, Inc. - Executive VP & CFO [12]

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I think all we really need to see for positive operating leverage is for LIBOR to quit contracting relative to overnight rate. The LIBOR rate has some great deal of compression during the fourth quarter and to a level that surprised me, to be honest. If that ceases, if it stabilizes, then I believe we can show operating leverage.

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David Joseph Long, Raymond James & Associates, Inc., Research Division - Senior Analyst [13]

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Got it. And then as it relates to CECL, I think, Brad, you made some comments about the purchase accounting. And did I hear right that you will move the credit marks out of the purchase loans into the reserve, meaning that you're considering the loan's PCD at this point?

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Bradley S. Adams, Old Second Bancorp, Inc. - Executive VP & CFO [14]

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Yes. So overall, the reserve level should go up, like I said, $4 million to $6 million. A significant portion of that, rather than being an adjustment to equity, will be an adjustment from the credit loss reserve on acquired loans. And the adjustment overall, from an equity standpoint, should be relatively small for us. Again, those loan books that have a short duration, i.e., more commercial bench, are not going to see the type of impact that residential and consumer balance sheets are going to see.

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Operator [15]

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And we'll go next to Evan Lisle with Janney.

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Evan Lisle, Janney Montgomery Scott LLC, Research Division - Research Analyst [16]

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I'm on the call for Brian Martin. First, appreciate the color on margin. And I just -- we're just kind of curious how you're thinking about the margin in '20 with a flat rate environment and then possibly with forecasting one cut later in the year.

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Bradley S. Adams, Old Second Bancorp, Inc. - Executive VP & CFO [17]

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Well, I don't think we're going to see one cut. If we see any cuts, we'll probably see a number of them. One cut doesn't make a whole lot of sense to me. I think that a stable rate environment, applying the methodology that nothing changes anywhere along the curve and you take the steepening that we saw, I would feel pretty good about that. If you're talking about any rate cuts, that doesn't excite me in the slightest. I think loan growth can overcome one rate cut, if that's the scenario you want to talk about. But in general, nothing changes. I think that we would lose a couple of basis points with CECL and delayed impacts of the LIBOR moves that have occurred, and I think we'd be relatively stable from that point.

The challenges in margin guidance is taking the rate moves that have happened, telling everybody they're static and then accounting for the lag effects of those rate moves that have occurred. In general, over a full cycle, irrespective of when quarter cutoffs are, we lose 3% to 5% for a rate cut. It's not -- doesn't always fit well within to a quarter, but that is the overall impact.

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Evan Lisle, Janney Montgomery Scott LLC, Research Division - Research Analyst [18]

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Okay. Yes. No, appreciate that. And next, just talking about the people you hired in '19. Can you just give a quick outlook about that and then potential hires in '20? And just your outlook for that in the future.

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [19]

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Yes. We made -- we obviously made a number of adds in the latter half of 2019, all-seasoned Chicago-based lenders, about 6 of them. But we've also added to the retail bank and our treasury group, so we feel real good about the talent we've added.

A large portion of our loan growth in the fourth quarter came very late in the quarter, too. So while our footings were up, we really didn't see much benefit of that in the margin. So we continue to be opportunistic on the new talent front. So if those opportunities come along, we will selectively continue to add.

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Evan Lisle, Janney Montgomery Scott LLC, Research Division - Research Analyst [20]

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Awesome. And just touching on the loan pipeline and the Chicago hires. It looks like last quarter, most of your originations are coming from the Chicago market. Is that still fair to say in this quarter?

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [21]

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I would say yes.

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Evan Lisle, Janney Montgomery Scott LLC, Research Division - Research Analyst [22]

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Okay. Awesome. And then just a housekeeping thing. Just can you discuss how you're thinking about your provisioning in '20 under CECL?

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Bradley S. Adams, Old Second Bancorp, Inc. - Executive VP & CFO [23]

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As we said previously, it -- wouldn't expect it to be materially different than historical trends. The provision level with the adjustment itself will be higher given the size of the acquired loan portfolio. But from our ongoing origination standpoint, I doubt we'll see much of a difference.

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Operator [24]

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(Operator Instructions) At this time, we'll go next to Nathan Race with Piper Sandler.

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Nathan James Race, Piper Sandler & Co., Research Division - VP & Senior Research Analyst [25]

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I wanted to touch on the $2.5 million in loans past 90 days that appeared this quarter. Could you provide some color on that, maybe the industry's focus and collateral backup and what you guys expect from that going forward?

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [26]

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Yes. We had a couple of just administrative past dues at the quarter that weren't classified. We did see a moderate uptick in classifieds, but we expect to have those remediated in the first quarter this year.

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Nathan James Race, Piper Sandler & Co., Research Division - VP & Senior Research Analyst [27]

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Okay. And then turning to kind of loan pricing. Do you guys, by chance, have the weighted average rate on new production this quarter?

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [28]

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Yes. This quarter, we were -- it obviously fell off a little bit with LIBOR dropping, but we were the mid- to high 4s on a weighted average yield.

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Nathan James Race, Piper Sandler & Co., Research Division - VP & Senior Research Analyst [29]

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And how do -- okay. And that drop, is there -- how that compared to third quarter?

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [30]

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It dropped about 30 to 40 basis points.

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Nathan James Race, Piper Sandler & Co., Research Division - VP & Senior Research Analyst [31]

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Okay. And then maybe could you provide a little color on the loan pricing dynamics you're seeing in the market right now and maybe where the competition is coming from? Is it the larger guys? Or is it the smaller community banks that are pushing the pricing?

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [32]

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Well, obviously, in Chicago, we're seeing competition from the larger banks. And then in our more rural areas, the smaller community banks provide pretty competitive pressures there. But the primary growth engine for us has been in Chicago, so we're competing with the larger banks there.

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Operator [33]

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Mr. Eccher, there appears to be no further questions at this time. I'd like to turn the call back over to you for any closing comments.

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James L. Eccher, Old Second Bancorp, Inc. - CEO, President, COO & Director [34]

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Okay. Thank you, everyone, for joining us this morning, and we look forward to speaking with you again next quarter. Goodbye.

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Operator [35]

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Ladies and gentlemen, this does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time, and have a good day.