I  

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 March 31, 2018

OR

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

For transition period fromto

Commission File Number 0 -10537

(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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T 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☐

(Do not check if a smaller reporting 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 ☒

As of May 4, 2018, the Registrant had 29,747,078 shares of common stock outstanding at $1.00 par value per share.

OLD SECOND BANCORP, INC.

Form 10-Q Quarterly Report

Table of Contents

	PART I
		Page Number
Item 1.	Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	37
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	51
Item 4.	Controls and Procedures	52
	PART II
Item 1.	Legal Proceedings	52
Item 1.A.	Risk Factors	52
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	52
Item 3.	Defaults Upon Senior Securities	52
Item 4.	Mine Safety Disclosure	52
Item 5.	Other Information	52
Item 6.	Exhibits	53
	Signatures	54

2

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report and other publicly available documents of the Company, including the documents incorporated herein by reference, contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act, including, but not limited to, statements regarding management’s belief that we are positioned for future growth, expectations regarding future plans, strategies and financial performance, 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,” “seeks,” “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 significantly from those described in such forward-looking statements, due to numerous factors, including:

· 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;

· defaults and losses on our loan portfolio;

· the anticipated benefits of the Company’s recent merger with Greater Chicago Financial Corp., including estimated cost savings and anticipated strategic gains, may be significantly harder or take longer to achieve than expected or may not be achieved in their entirety as a result of unexpected factors or events;

· the integration of Greater Chicago Financial Corp.’s business and operations into the Company, which will include conversion of Greater Chicago Financial Corp.’s operating systems and procedures, may take longer than anticipated or be more costly than anticipated or have unanticipated adverse results relating to Greater Chicago Financial Corp.’s or the Company’s existing businesses;

· the Company’s ability to achieve anticipated results from the Greater Chicago Financial Corp. transaction is dependent on the state of the economic and financial markets going forward. Specifically, the Company may incur more credit losses than expected, cost savings may be less than expected and customer attrition may be greater than expected;

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

· market conditions in the commercial and residential real estate markets in our market area;

· 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 in the financial services business;

· any negative perception of our reputation or financial strength;

· ability to raise additional capital on acceptable terms 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;

· 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;

· 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;

· 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;

· the impact of heightened capital requirements; and

· each of the factors and risks under the heading  “Risk Factors” in our 2017 Form 10-K and Form 10-Qs filed 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.

3

PART I - FINANCIAL INFORMATION

Item 1.  Financial Statements

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share data)

	(unaudited)
	March 31,		December 31,
	2018		2017
Assets
Cash and due from banks	$	29,478	$	37,444
Interest bearing deposits with financial institutions		18,394		18,389
Cash and cash equivalents		47,872		55,833
Securities available-for-sale, at fair value		550,942		541,439
Federal Home Loan Bank Chicago ("FHLBC") and Federal Reserve Bank Chicago ("FRBC") stock		7,468		10,168
Loans held-for-sale		2,426		4,067
Loans		1,601,812		1,617,622
Less: allowance for loan and lease losses		18,188		17,461
Net loans		1,583,624		1,600,161
Premises and equipment, net		37,209		37,628
Other real estate owned		7,063		8,371
Mortgage servicing rights, net		7,541		6,944
Goodwill and core deposit intangible		8,901		8,922
Bank-owned life insurance ("BOLI")		60,808		61,764
Deferred tax assets, net		26,581		25,356
Other assets		26,050		22,776
Total assets	$	2,366,485	$	2,383,429
Liabilities
Deposits:
Noninterest bearing demand	$	582,766	$	572,404
Interest bearing:
Savings, NOW, and money market		998,008		967,750
Time		381,274		382,771
Total deposits		1,962,048		1,922,925
Securities sold under repurchase agreements		41,366		29,918
Other short-term borrowings		45,000		115,000
Junior subordinated debentures		57,650		57,639
Senior notes		44,083		44,058
Other liabilities		12,337		13,539
Total liabilities		2,162,484		2,183,079
Stockholders’ Equity
Common stock		34,717		34,626
Additional paid-in capital		117,379		117,742
Retained earnings		151,833		142,959
Accumulated other comprehensive (loss) income		(3,634)		1,479
Treasury stock		(96,294)		(96,456)
Total stockholders’ equity		204,001		200,350
Total liabilities and stockholders’ equity	$	2,366,485	$	2,383,429

	March 31, 2018		December 31, 2017
	Common		Common
	Stock		Stock
Par value	$	1.00	$	1.00
Shares authorized		60,000,000		60,000,000
Shares issued		34,716,589		34,625,734
Shares outstanding		29,747,078		29,627,086
Treasury shares		4,969,511		4,998,648

See accompanying notes to consolidated financial statements.

4

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Income

(In thousands, except per share data)

	(unaudited)
	Quarters Ended March 31,
	2018		2017
Interest and dividend income
Loans, including fees	$	18,732	$	16,609
Loans held-for-sale		24		24
Securities:
Taxable		2,170		2,963
Tax exempt		2,061		912
Dividends from FHLBC and FRBC stock		106		85
Interest bearing deposits with financial institutions		49		23
Total interest and dividend income		23,142		20,616
Interest expense
Savings, NOW, and money market deposits		344		223
Time deposits		1,175		979
Other short-term borrowings		408		108
Junior subordinated debentures		927		1,084
Senior notes		672		673
Total interest expense		3,526		3,067
Net interest and dividend income		19,616		17,549
Release of loan and lease losses		(722)		-
Net interest and dividend income after (release) provision for loan and lease losses		20,338		17,549
Noninterest income
Trust income		1,495		1,458
Service charges on deposits		1,592		1,618
Secondary mortgage fees		162		176
Mortgage servicing rights mark to market loss		305		(133)
Mortgage servicing income		452		435
Net gain on sales of mortgage loans		917		1,147
Securities gains (losses), net		35		(136)
Increase in cash surrender value of BOLI		248		359
Death benefit realized on bank-owned life insurance		1,026		-
Debit card interchange income		1,012		975
Losses on disposal and transfer of fixed assets, net		-		(2)
Other income		1,261		1,131
Total noninterest income		8,505		7,028
Noninterest expense
Salaries and employee benefits		10,207		10,573
Occupancy, furniture and equipment		1,558		1,566
Computer and data processing		1,344		1,090
FDIC insurance		156		148
General bank insurance		251		270
Amortization of core deposit intangible		21		25
Advertising expense		341		386
Debit card interchange expense		281		349
Legal fees		159		104
Other real estate expense, net		173		709
Other expense		2,863		2,834
Total noninterest expense		17,354		18,054
Income before income taxes		11,489		6,523
Provision for income taxes		2,000		2,096
Net income available to common stockholders	$	9,489	$	4,427
Basic earnings per share	$	0.32	$	0.15
Diluted earnings per share		0.31		0.15

See accompanying notes to consolidated financial statements.

5

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(In thousands)

	(unaudited)
	Quarters Ended March 31,
	2018		2017
Net Income	$	9,489	$	4,427
Unrealized holding (losses) gains on available-for-sale securities arising during the period		(8,808)		4,231
Related tax benefit (expense)		2,484		(1,675)
Holding (losses) gains after tax on available-for-sale securities		(6,324)		2,556
Less: Reclassification adjustment for the net gains (losses) realized during the period
Net realized gains (losses)		35		(136)
Income tax (expense) benefit on net realized gains (losses)		(10)		54
Net realized gains (losses) after tax		25		(82)
Other comprehensive (loss) income on available-for-sale securities		(6,349)		2,638
Changes in fair value of derivatives used for cash flow hedges		1,279		149
Related tax expense		(362)		(61)
Other comprehensive income on cash flow hedges		917		88
Total other comprehensive (loss) income		(5,432)		2,726
Total comprehensive income	$	4,057	$	7,153

See accompanying notes to consolidated financial statements.

6

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(In thousands)

	(Unaudited)
	Three Months Ended  March 31,
	2018		2017
Cash flows from operating activities
Net income	$	9,489	$	4,427
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation of fixed assets and amortization of leasehold improvements		537		593
Change in fair value of mortgage servicing rights		(305)		133
Release for loan and lease losses		(722)		-
Provision for deferred tax expense		907		2,036
Originations of loans held-for-sale		(31,096)		(30,401)
Proceeds from sales of loans held-for-sale		33,305		32,313
Net gains on sales of mortgage loans		(917)		(1,147)
Net premium amortization/discount (accretion) of purchase accounting adjustment on loans		51		(345)
Change in current income taxes receivable		1,093		60
Increase in cash surrender value of BOLI		(248)		(359)
Change in accrued interest receivable and other assets		(4,081)		(2,407)
Change in accrued interest payable and other liabilities		(152)		718
Net premium amortization/discount (accretion) on securities		706		275
Securities (gains) losses, net		(35)		136
Amortization of core deposit		21		25
Amortization of junior subordinated debentures issuance costs		11		12
Amortization of senior notes issuance costs		25		26
Stock based compensation		395		321
Net gains on sale of other real estate owned		(80)		(74)
Provision for other real estate owned valuation losses		112		318
Net losses on disposal  and transfer of fixed assets		-		2
Net cash provided by operating activities		9,016		6,662
Cash flows from investing activities
Proceeds from maturities and calls including pay down of securities available-for-sale		2,391		15,005
Proceeds from sales of securities available-for-sale		2,522		64,388
Purchases of securities available-for-sale		(23,930)		(154,653)
Net disbursements/proceeds from sales (purchases) of FHLBC stock		2,700		(675)
Net change in loans		17,208		(12,700)
Proceeds from claims on BOLI, net of premiums paid		1,204		-
Improvements in other real estate owned		(59)		-
Proceeds from sales of other real estate owned, net of participation purchase		1,335		1,607
Net purchases of premises and equipment		(118)		(212)
Net cash provided by (used in) investing activities		3,253		(87,240)
Cash flows from financing activities
Net change in deposits		39,123		70,369
Net change in securities sold under repurchase agreements		11,448		9,016
Net change in other short-term borrowings		(70,000)		15,000
Payment of senior note issuance costs		-		(42)
Dividends paid on common stock		(296)		(296)
Purchase of treasury stock		(505)		(124)
Net cash (used in) provided by financing activities		(20,230)		93,923
Net change in cash and cash equivalents		(7,961)		13,345
Cash and cash equivalents at beginning of period		55,833		47,334
Cash and cash equivalents at end of period	$	47,872	$	60,679

7

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows - Continued

(In thousands)

	Three Months Ended  March 31,
Supplemental cash flow information	2018		2017
Interest paid for deposits	$	1,518	$	1,247
Interest paid for borrowings		1,321		1,164
Non-cash transfer of loans to other real estate owned		-		3,416

See accompanying notes to consolidated financial statements.

8

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Changes in

Stockholders’ Equity

(In thousands)

							Accumulated
			Additional				Other				Total
	Common		Paid-In		Retained		Comprehensive		Treasury		Stockholders’
	Stock		Capital		Earnings		Income (Loss)		Stock		Equity
Balance, December 31, 2016	$	34,534	$	116,653	$	129,005	$	(8,762)	$	(96,220)	$	175,210
Net income						4,427						4,427
Other comprehensive income, net of tax								2,726				2,726
Dividends declared and paid						(296)						(296)
Vesting of restricted stock		36		(36)								-
Stock based compensation				321								321
Purchase of treasury stock										(124)		(124)
Balance, March 31, 2017	$	34,570	$	116,938	$	133,136	$	(6,036)	$	(96,344)	$	182,264
Balance, December 31, 2017	$	34,626	$	117,742	$	142,959	$	1,479	$	(96,456)	$	200,350
Net income						9,489						9,489
Other comprehensive loss, net of tax								(5,432)				(5,432)
Dividends declared and paid						(296)						(296)
Vesting of restricted stock		91		(758)						667		-
Reclassification of stranded tax effects						(319)		319				-
Stock based compensation				395								395
Purchase of treasury stock										(505)		(505)
Balance, March 31, 2018	$	34,717	$	117,379	$	151,833	$	(3,634)	$	(96,294)	$	204,001

Seeaccompanyingnotestoconsolidatedfinancialstatements.

9

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

Note 1 – Summary of Significant Accounting Policies

The accounting policies followed in the preparation of the interim 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 March 31, 2018, are not necessarily indicative of the results that may be expected for the year ending December 31, 2018.  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, 2017.  Unless otherwise indicated, 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.

All 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, 2017.  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.

Recent Accounting Pronouncements

In May 2014, the FASB issued ASU No. 2014-09 "Revenue from Contracts with Customers (Topic 606)."  The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services.  In August 2015, the FASB issued ASU 2015-14 “Revenue from Contracts with Customers (Topic 606) Deferral of the Effective Date.”  This accounting standard update deferred the effective date of ASU 2014-09 for an additional year.  ASU 2015-14 was effective for annual reporting periods beginning after December 15, 2017.  The amendments could be applied retrospectively to each prior reporting period or retrospectively with the cumulative effect of initially applying this update recognized at the date of initial application.  Early application was not permitted.  In March 2016, the FASB issued ASU 2016-08 “Revenue from Contracts with Customers (TOPIC 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)” and in April 2016, the FASB issued ASU 2016-10 “Revenue from Contracts with Customers (TOPIC 606): Identifying Performance Obligations and Licensing.”  ASU 2016-08 requires the entity to determine if it is acting as a principal with control over the goods or services it is contractually obligated to provide, or an agent with no control over specified goods or services provided by another party to a customer.  ASU 2016-10 was issued to further clarify ASU 2014-09 implementation regarding identifying performance obligation materiality, identification of key contract components, and scope. 

The Company performed an analysis of the impact of adoption of this ASU, reviewing revenue recorded from service charges on deposit accounts, asset management fees, gains (losses) on other real estate owned, and debit card interchange fees.  Certain revenue received, such as service charges on deposit accounts and interchange fees, is recorded immediately or as the service is performed.  Asset management fees recorded by the Company take the form of wealth management income and brokerage income, and both types of fees are recorded after services are rendered, with no contractual requirement of refund to a customer based on non-achievement of fund performance objectives.  Finally, the methodology used to record revenue from gains (losses) due to the sale of other real estate owned is not anticipated to change, as the Company currently records income or expense only upon consummation of the sale, and any revenue recorded stemming from seller financed transactions is reviewed for deferral, as appropriate.  The Company adopted ASU 2014-09 and related issuances on January 1, 2018, with no cumulative effect adjustment to opening retained earnings required upon implementation of this standard.

In January 2016, the FASB issued ASU No. 2016-01 “Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.”  The objective of the issuance is to provide users of financial statements with more decision–useful information, by making targeted improvements to GAAP.  These targeted improvements included revisions to the methodology of accounting for equity investments, eliminating certain disclosures on fair value assumptions for financial instruments measured at amortized cost, and requiring public business entities to use the exit price notion, as defined in ASC 820, for

10

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

the measurement of the fair value of financial instruments.  This standard was effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years.  The Company adopted this standard as of January 1, 2018.  Adoption of this standard resulted in the Company’s use of an exit price rather than an entrance price to determine the fair value of loans and deposits not already measured at fair value on a non-recurring basis in the consolidated balance sheet disclosures; see Note 14–Fair Value of Financial Instruments  for further information regarding the valuation processes.

In February 2016, the FASB issued ASU No. 2016-02 “Leases (Topic 842).”  This ASU was issued to increase transparency and comparability among organizations by recognizing lease assets and liabilities on the balance sheet and disclosing key information about leasing arrangements.  One key revision from prior guidance was to include operating leases within assets and liabilities recorded; another revision was included which created a new model to follow for sale-leaseback transactions.  The impact of this pronouncement will affect lessees primarily, as virtually all of their assets will be recognized on the balance sheet, by recording a right of use asset and lease liability.  This pronouncement is effective for fiscal years beginning after December 15, 2018.  The Company is assessing the impact of ASU 2016-02 on its accounting and disclosures. 

In June 2016, the FASB issued ASU No. 2016-13 “Measurement of Credit Losses on Financial Instruments (Topic 326).”  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 to be used should reflect 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 will also require available-for-sale debt securities to have a credit loss recorded through an allowance rather than write-downs.  ASU 2016-13 is effective for financial statements issued for fiscal years beginning after December 15, 2019.  The Company is assessing the impact of ASU 2016-13 on its accounting and disclosures, and is in the process of accumulating data and evaluating model options to support future risk assessments. 

In March 2017, the FASB issued ASU No. 2017-08 “Receivables-Nonrefundable Fees and Other Costs – Premium Amortization on Purchased Callable Debt Securities (Subtopic 310-20).”  This ASU was issued to shorten the amortization period for the premium to the earliest call date on debt securities.  This premium is required to be recorded as a reduction to net interest margin during the shorter yield to call period, as compared to prior practice of amortizing the premium as a reduction to net interest margin over the contractual life of the instrument.  This ASU does not change the current method of amortizing any discount over the contractual life of the debt security, and this pronouncement is effective for fiscal years beginning after December 15, 2018, with earlier adoption permitted.  The Company adopted ASU 2017-08 as a change in accounting principle in the third quarter of 2017 on a modified retrospective basis, which required the Company to reflect its adoption effective January 1, 2017.  The effect of amortizing the premium over a shorter period will continue to decrease future quarterly net interest income over the call period until the premium is fully amortized.  As a result of management’s analysis, the impact of the change in accounting principle as a result of ASU 2017-08 to adjust beginning of year retained earnings was considered insignificant and, accordingly, the impact was adjusted through 2017 earnings.

In August 2017, the FASB issued ASU No. 2017-12, “Derivatives and Hedging:Targeted Improvements to Accounting for Hedging Activities”. The purpose of this updated guidance is to better align a company’s financial reporting for hedging activities with the economic objectives of those activities. ASU 2017-12 is effective for public business entities for fiscal years beginning after December 15, 2018, with early adoption, including adoption in an interim period, permitted.  The Company adopted ASU 2017-12 on January 1, 2018, on a modified retrospective basis.  FASB ASC 815, Derivatives and Hedging (“ASC 815”), provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Further, qualitative disclosures are required that explain the Company’s objectives and strategies for using derivatives, as well as quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

As required by ASC 815, the Company records all derivatives on the balance sheet at fair value.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives may also be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.  The Company may enter into

11

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.

In accordance with the FASB’s fair value measurement guidance in ASU 2011-04, the Company made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio.  As the Company does not currently have any derivative financial instruments subject to master netting agreements, there was no impact to the balance sheet. 

In February 2018, the FASB issued ASU No. 2018-02, “Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income.”  This ASU was issued in response to the enactment of tax bill H.R.1 “Tax Cuts and Jobs Act”, which resulted in “stranding” the tax effects of items within accumulated other comprehensive income related to the adjustment of deferred taxes due to the reduction of the federal corporate income tax rate.  The amendments proposed allow the reclassification of these stranded tax effects to retained earnings, and were effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years.  Early adoption is permitted, and should be applied either in the period of adoption or retrospectively to each period in which the effect of the change in the U.S. federal corporate tax rate is recognized.  The Company adopted ASU 2018-02 as of January 1, 2018, and a reclassification of $319,000, net, was recorded, which increased accumulated other comprehensive income and reduced retained earnings with the change in accounting principle.

Subsequent Events

On April 17, 2018, the Company’s Board of Directors declared a cash dividend of $0.01 per share payable on May 7, 2018, to stockholders of record as of April 27, 2018; dividends of $297,000 were paid to stockholders on May 7, 2018.

On April 20, 2018, the Company acquired Greater Chicago Financial Corp. (“GCFC”), and its wholly owned subsidiary, ABC Bank.  See the information disclosed in Note 2, “Acquisitions”, for further details.

Note 2 – Acquisitions

On April 20, 2018, the Company acquired GCFC, and its wholly owned subsidiary, ABC Bank, which operates four branches in the Chicago metro area.  GCFC reported total assets of $333.7 million as of March 31, 2018, which includes $233.1 million of net loans, and total liabilities of $300.0 million, comprised primarily of deposits totaling $250.5 million.  In addition to the acquisition price of $41.1 million, the Company also retired the convertible and nonconvertible debentures held by GCFC upon acquisition, which totaled $6.6 million.  The purchase and the debentures’ retirement 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. Acquisition related costs incurred by the Company during the first quarter of 2018 totaled $246,000.  In the second quarter of 2018, the Company will perform the appropriate purchase accounting valuation analysis, and record the commensurate fair market value adjustments as needed.    

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. 

FHLBC and FRBC stock are considered nonmarketable equity investments.  FHLBC stock was recorded at $2.7 million at March 31, 2018, and $5.4 million at December 31, 2017 FRBC stock was recorded at $4.8 million at March 31, 2018, and December 31, 2017. 

12

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

The following table summarizes the amortized cost and fair value of the securities portfolio at March 31, 2018, and December 31, 2017, and the corresponding amounts of gross unrealized gains and losses:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
March 31, 2018	Cost		Gains		Losses		Value
Securities available-for-sale
U.S. Treasuries	$	4,003	$	-	$	(108)	$	3,895
U.S. government agencies		12,788		-		(58)		12,730
U.S. government agencies mortgage-backed		14,331		-		(487)		13,844
States and political subdivisions		287,825		2,046		(4,331)		285,540
Corporate bonds		685		23		(5)		703
Collateralized mortgage obligations		65,561		71		(1,888)		63,744
Asset-backed securities		111,493		1,264		(1,887)		110,870
Collateralized loan obligations		59,305		334		(23)		59,616
Total securities available-for-sale	$	555,991	$	3,738	$	(8,787)	$	550,942

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
December 31, 2017	Cost		Gains		Losses		Value
Securities available-for-sale
U.S. Treasury	$	4,002	$	-	$	(55)	$	3,947
U.S. government agencies		13,062		8		(9)		13,061
U.S. government agencies mortgage-backed		12,372		7		(165)		12,214
States and political subdivisions		272,240		7,116		(1,264)		278,092
Corporate bonds		823		21		(11)		833
Collateralized mortgage obligations		66,892		202		(1,155)		65,939
Asset-backed securities		113,983		862		(1,913)		112,932
Collateralized loan obligations		54,271		251		(101)		54,421
Total securities available-for-sale	$	537,645	$	8,467	$	(4,673)	$	541,439

The fair value, amortized cost and weighted average yield of debt securities at March 31, 2018, 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	$	18,800	1.90	%	$	18,645
Due after one year through five years		4,207	1.96			4,095
Due after five years through ten years		5,919	3.34			6,017
Due after ten years		276,375	2.96			274,111
		305,301	2.89			302,868
Mortgage-backed and collateralized mortgage obligations		79,892	2.98			77,588
Asset-backed securities		111,493	2.93			110,870
Collateralized loan obligations		59,305	4.64			59,616
Total securities available-for-sale	$	555,991	3.10	%	$	550,942

At March 31, 2018, the Company’s investments include $93.9 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 to 75% if reimbursement requests exceed 9% of insured loans.  In addition to the U.S. Department of Education guarantee, total added credit enhancement in the form of overcollateralization and/or subordination amounted to $11.5 million, or 11.80%, of outstanding principal.

13

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

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

The Company has invested in securities issued from three originators that individually amount to over 10% of the Company’s stockholders equity.  Information regarding these three issuers and the value of the securities issued follows: