OLD SECOND BANCORP INC (OSBC) FY 2024 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

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The following discussion provides additional information regarding our operations for the twelve-month periods ending December 31, 2024, 2023 and 2022, and financial condition at December 31, 2024 and 2023 and should be read in conjunction with our consolidated financial statements and the related notes.  Historical results of operations and the percentage relationships among any amounts included, and any trends that may appear, may not indicate trends in operations or results of operations for any future periods.

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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” at the beginning of this annual report.

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Business overview

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We provide a wide range of financial services through our 53 banking locations 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 providing for the financial services needs of the communities in which we operate through our retail branch network.  We emphasize relationships with individual customers as well as small to medium-sized businesses throughout our market area.  Our market area includes a mix of commercial and industrial, real estate, and consumer related lending opportunities, and provides a stable, loyal core deposit base.  We also offer extensive wealth management services, which include a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts, including employee benefit plan administration services.

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Our primary deposit products are checking, NOW, money market, savings, and certificate of deposit accounts, and our primary lending products are commercial mortgages, leases, construction lending, commercial loans, residential mortgages, and consumer loans.  Many of our loans are secured by various forms of collateral including real estate, business assets, and consumer property although borrower cash flow is the primary source of repayment at the time of loan origination.

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On December 6, 2024, we closed on our branch purchase and assumption agreement with First Merchants Bank (“FRME”).  As a result of this transaction, we assumed approximately $268.0 million in deposits related to the branch locations and purchased approximately $7.1 million in branch-related loans along with the purchase of other branch-related assets.  The transaction resulted in increasing our presence in the south suburban Chicago area, as five branches were acquired with a retail and commercial client mix of loans and deposits. Historical periods before December 6, 2024, reflect results of our legacy operations. Subsequent to closing, results reflect all post-transaction activity.

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Summary Financial Data

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Old Second Bancorp, Inc. and Subsidiaries

Financial Highlights

(Dollars in thousands, except per share data)

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Old Second Bancorp, Inc. and Subsidiaries

Quarterly Financial Information

(Dollars in thousands, except per share data)

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2024 Financial Overview

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In 2024, we recorded net income of $85.3 million, or $1.87 per fully diluted share, compared to $91.7 million, or $2.02 per fully diluted share, in 2023, and $67.4 million, or $1.49 per fully diluted share, in 2022.  Our basic earnings per share for the periods presented were $1.90 in 2024, $2.05 in 2023 and $1.51 in 2022.

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Our 2024 net income, as compared to the prior year, decreased primarily as a result of deposit interest expense outpacing our increased interest income throughout much of 2024, as well as additional costs incurred with our FRME branch transaction. Adjusted net income, a non-GAAP financial measure that excludes transaction-related costs, litigation expense, and net gains on branch sales was $85.9 million in 2024. See the discussion entitled “Non-GAAP Financial Measures” on page 51 and the table below, which provides a reconciliation of this non-GAAP measure and related items, to the most comparable GAAP equivalents.

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Adjusted net income provides for a comparative analysis of our performance excluding those one-time matters, such as transaction-related costs for our purchase of five FRME branches, litigation expense related to a claim regarding prior years’ overdraft fee compliance, net gains or net losses stemming from branch sales completed to eliminate duplicative geographic locations due to past acquisitions, and the Visa credit card and land trust portfolio sales, which were executed to exit products that were not within our strategic plan.

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Net interest and dividend income decreased $10.3 million, or 4.1% for 2024 compared to 2023, due primarily to increased interest expense due to higher market rates on deposits throughout 2024, partially offset by the impact of market interest rates on loans, and lower average balances on FHLBC advances. Average loans, including loans held-for-sale, decreased $13.4 million, or 0.33%, in 2024 compared to 2023. Total interest and dividend income growth in 2024, compared to 2023, resulted in a 31 basis point increase in average rates earned on interest earning assets.  Average interest bearing deposits decreased $36.6 million, or 1.3%, for 2024 compared to 2023, while average deposit rates increased 81 basis points over the same period.  The increase in deposit rates was primarily due to growth in exception priced deposits and higher rates overall offered to customers, which impacted deposit expense in all interest bearing deposit categories.  Average noninterest bearing deposits decreased by $158.7 million, or 8.3%, from 2023 to 2024.

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We continued to reposition our balance sheet in 2024 to ensure adequate liquidity, reduce asset quality risk, and to offset the rising interest rate risk on our cost of funds.  In 2024, our available-for-sale securities portfolio decreased $31.1 million, compared to year-end 2023, due primarily to $304.2 million of paydowns, maturities, and calls and $5.3 million of strategic sales.  These decreases in 2024 were partially offset by security purchases of $265.5 million. The unrealized mark to market adjustment on securities was a $68.6 million unrealized loss as of December 31, 2024, compared to an $84.2 million unrealized loss at December 31, 2023, due primarily to changes in market interest rates and the portfolio holdings mix year over year.  Average interest bearing liabilities decreased $133.8 million, to $3.21 billion in 2024 from $3.34 billion in 2023.  Total average borrowings decreased $97.3 million to $394.7 million compared to $492.0 million in 2023. The decrease in average borrowings was primarily due to a $84.8 million decrease in other short-term borrowings due to a reduction in FHLBC advances throughout 2024. During 2023, we paid off our notes payable and our senior notes, resulting in a decrease in average borrowings of $1.3 million and $22.0 million, respectively.

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Management also continued to emphasize credit quality and maintained our capital ratios with continued strong liquidity.  In 2024, we experienced a decrease in loans of $61.6 million, or 1.5%, over 2023.  Nonperforming assets decreased slightly in 2024 and 2023 relative to total assets, with nonperforming assets of $51.9 million, or 0.92%, of total assets for 2024, compared to $73.9 million, or 1.29% of total assets for 2023, and $34.5 million, or 0.59% of total assets, for 2022.  The total dollar decrease in 2024, compared to 2023, was primarily due to a decrease in nonaccrual loans of $38.7 million, partially offset by a $16.5 million increase in OREO. We continue to take steps to control operating expenses and increase noninterest income.

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As we focused on reducing noninterest expenses, exclusive of acquisition-related activity, we were also able to maintain our profitable wealth management business, and continue profitability, though to a lesser extent, with the mortgage banking business as originations and sales are negatively impacted by elevated interest rates.

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For information comparing our financial condition and results of operations for the year ended December 31, 2023, to year ended December 31, 2022, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 7, 2024.

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Critical accounting estimates

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Our consolidated financial statements are prepared based on the application of accounting policies in accordance with GAAP and follow general practices within the banking industry.  These policies require the reliance on estimates, assumptions and judgements, which may prove inaccurate or are subject to variations.  Changes in underlying factors, estimates, assumptions or judgements could have a material impact on our future financial condition and results of operations.

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Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported.  We have identified the determination of the allowance for credit losses and fair value measurements to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates.  Therefore, we consider these policies, discussed below, to be critical accounting estimates and discuss them directly with the Audit Committee of our board of directors.

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Significant accounting policies are presented in Note 1 of the financial statements included in this annual report.  These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.  Recent accounting pronouncements and standards that have impacted or could potentially affect us are also discussed in Note 1 of the consolidated financial statements.

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Allowance for credit losses for loans

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The allowance for credit losses (“ACL”) for loans represents management’s estimate of all expected credit losses over the expected contractual life of our loan portfolio.  Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain.  Subsequent evaluations of the then-existing loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for credit losses in those future periods.

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The ACL involves critical accounting estimates because:

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Because our estimates of the ACL involve judgments and are influenced by factors outside of our control, there is uncertainty inherent in these estimates. Changes in such estimates could significantly impact our ACL 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 annual report for a discussion of our ACL.

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As a result of management’s modeling, we decreased our ACL on loans to $43.6 million as of December 31, 2024; in addition, we decreased our ACL on unfunded commitments to $1.9 million as of December 31, 2024, included within other liabilities.  We recorded provision for credit losses of $12.8 million in 2024, comprised of $13.6 million of provision for credit loss expense on loans, and a $834,000 release of provision on unfunded commitments.  In 2023, we recorded a provision for credit losses of $16.5 million, comprised of an $18.1 million provision for credit loss expense on loans, and a $1.6 million release of provision for credit losses on unfunded commitments. In 2022, we recorded a provision for credit losses of $6.6 million, comprised of a $6.8 million provision for credit loss expense on loans, and a $200,000 release of provision for credit losses on unfunded commitments.  In addition, a discussion of the factors driving changes in the amount of the ACL is included in the “Allowances for Credit Losses” section below.

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Fair Value Measurements

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The use of fair values is required in determining the carrying values of certain assets and liabilities, as well as for specific disclosures. Fair value is an estimate of the exchange price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction (i.e., not a forced transaction, such as a liquidation or distressed sale) between market participants at the measurement date and is based on the assumptions market participants would use when pricing an asset or liability.

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In determining the fair value of financial instruments, market prices of the same or similar instruments are used whenever such prices are available.  If observable market prices are unavailable or impracticable to obtain, we are required to make judgments about assumptions market participants would use in estimating the fair value of the financial instrument.  Fair value is estimated using modeling techniques and incorporates assumptions about interest rates, duration, prepayment speeds, risks inherent in a particular valuation technique and the risk of nonperformance. These assumptions are inherently subjective as they require material estimates, all of which may be susceptible to significant change.  See Note 17 “Fair Value Measurements” and Note 18 “Fair Values of Financial Instruments,” to the consolidated financial statements which include information about the extent to which fair value is used to measure assets and liabilities, and the valuation methodologies and key inputs used for further information regarding the valuation processes.

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Non-GAAP Financial Measures

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This annual report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of adjusted net income, net interest income and net interest income to interest earning assets on a tax equivalent (“TE”) basis and our tangible common equity to tangible assets ratio.  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

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Net interest income

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Net interest income, which is our primary source of earnings, is the difference between interest income and fees 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, 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.  Our asset and liability committee (“ALCO”) seeks to manage interest rate risk under a variety of rate environments by structuring our balance sheet and off-balance sheet positions.  This process is discussed in more detail in the section entitled “Interest Rate Risk” in “Quantitative and Qualitative Disclosures about Market Risk.”

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Our net interest income decreased $10.3 million, or 4.1%, to $241.6 million for 2024, from $251.9 million for 2023.  The decrease in 2024 was primarily driven by the higher interest rate environment through much of 2024, which resulted in our cost of funds increasing primarily due to CD specials, exception pricing on deposits and higher rates paid on short-term borrowings.  Our net interest margin, which is net interest income divided by total interest-earning assets, was 4.61% for the year ended 2024, compared to 4.64% for the year ended 2023, a decrease of three basis points.  Our net interest margin on a taxable equivalent (TE) basis was 4.63% for the year ended 2024, compared to 4.67% for the year ended 2023, a decrease of four basis points.  Average interest earning assets decreased $185.4 million during 2024 as volume slowed and rates reflected significant growth, impacting net interest income.  The increase in interest expense in 2024 compared to 2023 was due primarily to an expense increase in all interest bearing deposit categories due to higher rates, partially offset by lower average balances in our short-term funding (FHLBC advances) throughout 2024.

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Our average earning assets decreased $185.4 million, or 3.4%, to $5.24 billion in 2024, from $5.43 billion in 2023.  The decrease was primarily attributable to a decrease in our securities portfolio. Our average earning assets decreased $255.1 million, or 4.5%, to $5.43 billion in 2023, from $5.68 billion in 2022.  The decrease was primarily attributable to a decrease in our securities portfolio and our interest earning deposits, partially offset by organic leases, commercial real estate and multifamily loan growth.

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Our average interest bearing liabilities decreased $133.8 million, or 4.0%, to $3.21 billion for 2024, from $3.34 billion in 2023, due primarily to a decrease in all deposit categories other than time deposits, as well as a noteworthy decrease in other short-term borrowings.  Average interest bearing deposits decreased by $36.6 million, or 1.3%, to $2.81 billion in 2024, compared to $2.85 billion in 2023.  Our average borrowings decreased $97.3 million to $394.7 million in 2024 from $492.0 million in 2023. This was mainly due to a decrease of $84.8 million in average other short-term borrowings due to a reduction in FHLBC advances throughout 2024. Also contributing to the decrease in our average borrowings was a $22.0 million decrease in average senior notes as the remaining principal was paid off in its entirety in June 2023 and a $1.3 million decrease in average notes payable as the term loan was paid off in its entirety in February 2023. Partially offsetting the decrease in our average borrowings was an increase of $10.7 million in average securities sold under repurchase agreements.

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The following table sets forth certain information relating to our average Consolidated Balance Sheets and reflects the yield on average interest earning assets and cost of average interest bearing liabilities for the years indicated obtained by dividing the related interest by the average balance of assets or liabilities.  Average balances are derived from daily balances.

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1 Tax equivalent basis is calculated using a marginal tax rate of 21% in 2024, 2023 and 2022.  See the discussion entitled “Non-GAAP Financial Measures” on page 51 and the table on page 54 that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent.

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2  Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, discussed below, and includes net costs of $1.8 million for 2024, net costs of $2.7 million for 2023, and net fees of $3.0 million for 2022.  Nonaccrual loans are included in the above stated average balances.

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

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The following table allocates the changes in net interest income to changes in either average balances or average rates for interest earning assets and interest bearing liabilities.  Interest income is measured on a tax-equivalent basis using a 21% marginal rate for all periods presented.  Interest income not yet received on nonaccrual loans is reversed upon transfer to nonaccrual status; future receipt of interest income is a reduction to principal while in nonaccrual status.

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Analysis of Year-to-Year Changes in Net Interest Income1

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1  The changes in net interest income are created by changes in both interest rates and volumes.  In the table above, volume variances are computed using the change in volume multiplied by previous year’s rate. Rate variances are computed using the change in rate multiplied by the previous year’s volume.  The change in interest due to both rate and volume has been allocated between factors in proportion to the relationship of absolute dollar amounts of the change in each.

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Provision for credit losses

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The provision for credit losses is the expense necessary to maintain the ACL at levels appropriate to absorb our estimate of credit losses expected over the life of our loan portfolio and unfunded lending commitments.

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We recorded a $12.8 million provision for credit losses in 2024, a decrease of $3.8 million, from 2023. The decrease in provision expense over the prior year was primarily due to the decrease in loans of $61.6 million in 2024, and lower current-year net charge offs, as well as improved asset quality and economic factors.  The 2023 provision for credit losses of $16.5 million compared to $10.0 million in 2022 was primarily due to loan growth of $173.3 million in 2023 and prior-year net charge offs, partially offset by improved economic factors.

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For additional discussion of the credit provision and allowance for credit losses, see the section below “Allowance for Credit Losses” in this Item 7. Management’s Discussion and Analysis of Financial Condition.

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Noninterest income

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N/M - Not meaningful

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Our total noninterest income increased $9.6 million, or 28.2%, to $43.8 million for 2024, compared to $34.2 million for 2023.  The increase in 2024 from 2023 was primarily due to:

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Our total noninterest income decreased $8.9 million, or 20.7%, to $34.2 million for 2023, compared to $43.1 million for 2022.  The decrease was primarily due to lower mortgage banking earnings of $5.3 million, driven by mark to market losses on MSRs of $1.4 million in 2023, compared to mark to market gains on MSRs of $3.2 million recorded in 2022, primarily due to changes in market interest rates and prepayment speeds in 2023. Also contributing to the lower mortgage banking earnings in 2023 was a decrease of $545,000 related to net gains on sales of mortgage loans. In addition, total noninterest income decreased in 2023, compared to 2022, due to net securities losses of $4.1 million in 2023, compared to net securities losses of $944,000 in 2022, reflecting strategic sales in 2023 given the increasing rate environment resulting in downward pressure on the bond market during the year, a $938,000, or 8.5%, decrease in card-related income in 2023, compared to 2022, and a $1.0 million decrease in other income, primarily due to a $743,000 gain on a Visa credit card portfolio sale and a $180,000 gain on the sale of a land trust portfolio, both recorded in the third quarter of 2022. Partially offsetting these decreases was an increase in service charges on deposits of $255,000 and a $1.4 million increase in the cash surrender value of BOLI due to market interest rate changes. We had no BOLI death benefit proceeds in 2023 or 2022.

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Noninterest expense

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Our total noninterest expense increased by $14.5 million, or 10.0%, in 2024 compared to 2023.  The increase was primarily due to:

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Partially offsetting these increases to noninterest expense was a $2.1 million, or 12.4%, decrease in other expense primarily due to a $1.2 million litigation expense recorded in 2023 related to an overdraft case stemming from a prior year overdraft compliance claim, which has since been settled at the accrual total recorded in 2023.

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Our total noninterest expense decreased by $6.0 million, or 4.0%, in 2023 compared to 2022.  The decrease was comprised of a $555,000, or 3.7%, decrease in occupancy, furniture and equipment expense primarily due to higher equipment and maintenance costs incurred in 2022, and an $8.5 million, or 53.9%, decrease in computer and data processing expense, both primarily due to merger-related costs incurred related to our acquisition of West Suburban in 2021 as systems conversion was performed in April 2022.  In addition, 2023 reflected a $1.6 million, or 43.3%, decrease in net teller & bill paying services, primarily due to costs incurred in 2022 for new payment platforms related to our acquisition of West Suburban. Partially offsetting these decreases to noninterest expense was a $2.0 million, or 2.3%, increase in salaries and employee benefits. Our number of full-time equivalent employees was 834 as of December 31, 2023, compared to 819 as of December 31, 2022. Also partially offsetting the decrease in noninterest expense in 2023, as compared to 2022, was a $304,000, or 12.7%, increase in FDIC insurance, a $132,000, or 22.4%, increase in advertising expense for updated branding, a $775,000, or 17.8%, increase in card related expense, a $269,000 increase in other real estate owned expense due to six additions and nine disposals throughout 2023, and a $1.4 million increase in other expense primarily due to a $1.2 million litigation expense recorded in the fourth quarter of 2023 for an overdraft fee compliance claim.

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Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures

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1  See discussion entitled “Non-GAAP Financial Measures” on page 51.

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Income taxes

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Our provision for income taxes includes both federal and state income tax expense (benefit).  An analysis of the provision for income taxes for the three years ended December 31, 2024, is detailed in Note 11 of the consolidated financial statements and our income tax accounting policies are described in Note 1 to the consolidated financial statements.

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Our income tax expense totaled $27.7 million for December 31, 2024 compared to an income tax expense of $32.7 million in 2023 and $24.1 million for 2022.  The decrease in income tax expense in 2024, compared to 2023, is commensurate with the decrease in our pretax income as well as with the new state ruling regarding tax rate apportionment factors related to income generated from securities or loans originated in other states.  Income tax expense reflected all relevant statutory tax rates and GAAP accounting.  Our effective tax rate was 24.5% for 2024, 26.3% for 2023, and 26.4% for 2022.  Any changes in tax rates will be recorded in the period enacted.

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The determination of whether we will be able to realize our deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, available tax planning strategies, and assessments of both current and future economic and business conditions.  Management considered both positive and negative evidence regarding our ability to ultimately realize the deferred tax assets, which is largely dependent on our ability to derive benefits based on future taxable income.  For all periods presented, management determined that the realization of the deferred tax asset was “more likely than not” as required by GAAP.

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Financial condition

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General

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Our total assets were $5.65 billion at December 31, 2024, a decrease of $73.4 million, or 1.3%, from December 31, 2023.  Our total cash and cash equivalents decreased $816,000, driven by a decrease in cash and due from banks, primarily to pay down short-term borrowings.

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Our loans decreased by $61.6 million, or 1.5%, to $3.98 billion for the year ended December 31, 2024, compared to 2023.  This decrease is primarily due to declines in commercial, commercial real estate-owner occupied and multifamily portfolios.

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Our total securities decreased by $31.1 million, or 2.6%, for the year ended December 31, 2024, compared to 2023, primarily due to $304.2 million of paydowns, maturities, and calls and $5.3 million of strategic sales.  These decreases in 2024 were partially offset by security purchases of $265.5 million as well as the $15.5 million reduction of unrealized losses recorded in 2024. We recorded no pretax net security gains or losses in 2024 compared to pretax net losses of $4.1 million in 2023.

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Our total liabilities were $4.98 billion at December 31, 2024, a decrease of $167.2 million, or 3.2%, from December 31, 2023.  Total deposits increased by $198.0 million, or 4.3%, to $4.77 billion for the year ended December 31, 2024, compared to $4.57 billion for the year ended December 31, 2023, primarily due to the deposits received from the five branch purchase transaction with FRME.

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At December 31, 2024, total stockholders’ equity was $671.0 million, compared to $577.3 million at December 31, 2023. The increase in stockholders’ equity primarily stems from net income of $85.3 million recorded in 2024 as well as the decrease in unrealized losses in the available for sale securities portfolio.

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Investments

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As shown below, the overall composition of our securities portfolio was largely consistent in 2024 versus 2023, with moderate changes in the overall composition of our securities portfolio in 2023 versus 2022.

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Securities Available-for-Sale Portfolio

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Our investment portfolio serves as both an important source of liquidity and as a source of income.  Accordingly, the size and composition of the portfolio reflects our liquidity needs, loan demand and interest income objectives.  We will adjust the size and composition of the portfolio from time to time.  While a significant portion of the portfolio consists of readily marketable securities to address future liquidity needs, other parts of the portfolio may reflect funds invested pending future loan demand or to maximize interest income without undue interest rate risk.

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Some of our holdings of U.S. government agency mortgage-backed securities (“MBS”) and collateralized mortgage obligations (“CMOs”) are issuances of government-sponsored enterprises, such as Fannie Mae and Freddie Mac, which are not backed by the full faith and credit of the U.S. government.  Some holdings of MBS and CMOs are issued by Ginnie Mae, which do carry the full faith and credit of the U.S. government. We also hold some MBS and CMOs that were not issued by U.S. government agencies and are typically credit-enhanced via over-collateralization and/or subordination.  Holdings of ABS also includes securities backed by student loans issued under the U.S. Department of Education’s (“DOE”) FFEL program, which generally provides a minimum 97% U.S. DOE guarantee of principal.  These ABS securities also have added credit enhancement through over-collateralization and/or subordination.  The majority of holdings issued by states and political subdivisions are general obligation or revenue bonds that have S&P or Moody’s ratings of AA- or higher.  Other state and political subdivision issuances are unrated and generally consist of smaller investment amounts that involve issuers in our markets.  The credit quality of these issuers is monitored and none have been identified as posing a material risk of loss.  We also hold collateralized loan obligation (“CLOs”) securities that are generally backed by a pool of debt issued by multiple middle-sized and large businesses.  Our CLO S&P or Moody’s ratings distribution consists of 100% rated AAA or AA. CLO credit enhancement is achieved through over-collateralization and/or subordination.

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The following table presents the expected maturities or call dates and weighted average yield (nontax equivalent) of securities by major category as of December 31, 2024.  Weighted average yield is based on amortized costs and not calculated on a tax equivalent basis. Securities not due at a single maturity date are shown only in the total column.

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Securities Portfolio Maturity and Yields

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As of December 31, 2024, net unrealized losses on available-for-sale securities totaled $68.6 million, which, after the impact of the related deferred income taxes, resulted in an overall decrease to equity capital of $49.4 million.  As of December 31, 2023, net unrealized losses on available-for-sale securities totaled $84.2 million, which after the impact of the related deferred income taxes, resulted in an overall decrease to equity capital of $60.6 million.

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Loans

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The following table presents the composition of the loan portfolio at December 31 for the year indicated:

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Loan Portfolio

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1 The “Other” class includes consumer loans and overdrafts.

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Our total loans were $3.98 billion as of December 31, 2024, a decrease of $61.6 million from $4.04 billion as of December 31, 2023. This decrease was due to increased transfers into OREO and large payoffs. The largest decreases, net originations, were in commercial real estate – owner occupied for $113.3 million, in multifamily for $50.4 million, and in commercial for $41.2 million. Partially offsetting these declines, we experienced organic loan growth primarily in our leases and commercial real estate – investor loan portfolios.  We recorded total loan originations, excluding renewals, of $1.03 billion in 2024, but we also experienced accelerated paydowns in 2024 due to higher levels of customer liquidity.

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We strive to serve customers in and around our geographic locations and continue to seek opportunities in our primary lending markets; however, our markets remain very competitive for new loan business.

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Management continues to emphasize loan portfolio quality, and credit remediation continued in 2024. The decrease of nonaccrual and classified loans as of December 31, 2024, compared to the prior year end, is due to larger relationships with office buildings and assisted living centers that have been transferred into OREO, have been paid off, or have been upgraded in 2024, discussed in the “Asset Quality” section below.  We recorded net loan charge-offs of $14.2 million in 2024, $23.3 million in 2023, and $1.6 million in 2022.

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The quality of our loan portfolio is in large part a reflection of the economic health of the communities in which we operate.  Our local communities have been relatively stable in the past five years.  While 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 categories represented 67.2% and 68.8% of the portfolio at December 31, 2024 and 2023, respectively.  Our lending exposure is diversified across our each of our segments presented above. Though 2024 experienced a net decline in the overall portfolio, leases and commercial real estate – investor continued to grow. We had no concentration of loans exceeding 10% of total loans that were not otherwise disclosed as a category of loans at December 31, 2024.  We remain committed to overseeing and managing our loan portfolio to avoid unnecessarily high credit concentrations in accordance with the general interagency guidance on risk management.  Consistent with those commitments, management monitors our asset diversification and anticipates that the percentage of real estate lending in relation to the overall portfolio will decrease in the future.

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The following table sets forth the remaining contractual maturities for loan categories at December 31, 2024:

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Maturity and Rate Sensitivity of Loans to Changes in Interest Rate

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1 The “Other” class includes consumer loans and overdrafts; column one includes demand notes.

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Asset Quality

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Nonperforming loans consist of nonaccrual loans and loans 90 days or greater past due. Remediation work is ongoing in all relevant segments. Nonperforming loans decreased year over year by $38.5 million, or 56.0%, to $30.3 million at December 31, 2024, but increased by $35.9 million to $68.8 million at December 31, 2023, compared to December 31, 2022. Nonperforming assets, which includes nonperforming loans plus other real estate owned, totaled $51.9 million as of December 31, 2024, compared to $73.9 million as of December 31, 2023, and $34.5 million as of December 31, 2022.  Nonperforming credit metrics decreased in 2024, largely due to office buildings and senior/assisted living facilities which were paid off, upgraded or transferred into OREO, and management is carefully monitoring loans considered to be in a classified status. Nonperforming loans as a percent of total loans decreased to 0.8% as of December 31, 2024, from 1.7% as of December 31, 2023, and 0.9% December 31, 2022. Our nonperforming loans by performance metric is shown in the following table.

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Risk Elements

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The following table sets forth the amounts of nonperforming assets by performance metric at December 31 for the years indicated:

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Accrual of interest is discontinued on a loan when principal or interest is 90 days or more past due, unless the loan is well secured and in the process of collection.  When a loan is placed on nonaccrual status, interest previously accrued but not collected in the current period is reversed against current period interest income.  Interest income of approximately $815,000, $1.9 million and $284,000 was recorded and collected during 2024, 2023 and 2022, respectively, on loans that subsequently went to nonaccrual status by year-end.  Interest income, which would have been recognized during 2024, 2023 and 2022, had these loans been on an accrual basis throughout the year, was approximately $4.2 million, $7.3 million and $2.7 million, respectively.

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Total past due loans, including accruing and nonaccrual loans, totaled $27.3 million at year-end 2024, a $22.1 million decrease from year end 2023, resulting in the rate of past due loans to total loans decreasing to 0.7% at year-end 2024 compared to 1.2% at year-end 2023, and 0.6% at year-end 2022.  Refer to Note 5, “Loans and Allowance for Credit Losses on Loans”, in our Consolidated Financial Statements, below, for further detail of past due loans by classification for 2024 and 2023.

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Classified Assets

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N/M - Not meaningful

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1 The “Other” class includes consumer loans and overdrafts.

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Classified loans include nonaccrual 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.

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Total classified loans decreased in 2024 by $40.8 million compared to 2023, and increased in 2023 by $23.9 million compared to 2022. The decrease in 2024 is primarily due to a decrease of $29.3 million of Commercial real estate – investor loans and $27.0 million of commercial real estate – owner occupied, and partially offset by an increase of $16.3 million of commercial, compared to 2023. In 2024, the decrease to classified commercial real estate – owner occupied and commercial real estate – investor loans were driven by loan risk rating upgrades of $20.1 million for commercial real estate – owner occupied and $8.8 million for commercial real estate – investor, primarily in the healthcare industry. The rise in 2023 is primarily due to an increase of $16.4 million of Commercial real estate – investor loans, an increase of $13.7 million of commercial real estate – owner occupied, and an increase of $15.8 million of construction, compared to 2022. In 2023, the increases to classified commercial real estate – owner occupied and commercial real estate – investor loans were driven by downgrades to loans collateralized by office buildings and senior/assisted living facilities.

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Total classified assets, which includes OREO, decreased $24.3 million in 2024 compared to 2023 but increased compared to 2022. The decrease in classified loans year over year was negatively offset by a $16.5 million increase in OREO in 2024 compared to 2023, primarily due to the transfer of five properties with a net fair value of $19.4 million, net of participations and valuation adjustments.  Our OREO portfolio increased $3.6 million in 2023 from 2022.  Management monitors a metric of classified assets to the sum of Bank Tier 1 capital and the ACL, which is referred to as the “classified assets ratio.”  Our classified assets ratio decreased to 17.37% at December 31, 2024, compared to 21.66% at December 31, 2023, from 18.36% at December 31, 2022.

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Problem Loans

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We utilize an internal asset classification system as a means of reporting problem and potential problem assets.  At the scheduled directors loan committee meetings of the Bank, loan listings are presented, which show significant loan relationships listed as “Special Mention,” “Substandard,” and “Doubtful.”  Loans classified as Substandard include those that have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected.  Assets classified as Doubtful have all the weaknesses inherent as those classified 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.  Assets that do not currently expose us to sufficient risk to warrant classification in one of the aforementioned categories, but possess weaknesses that deserve management’s close attention, are deemed to be Special Mention.  Management defines problem loans as performing loans rated Substandard that do not meet the definition of a nonperforming loan, and those loans that have been placed on nonaccrual, which are classified as Doubtful.  These problem loans carry a higher probability of default and require additional attention by management.  A more detailed description of these loans can be found in Note 5 to the Consolidated Financial Statements, as listed in the credit quality indicators discussion.

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Allowance for Credit Losses

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At December 31, 2024, the ACL on loans totaled $43.6 million, and the ACL on unfunded commitments, included in other liabilities, totaled $1.9 million, compared to the ACL on loans of $44.3 million and ACL on unfunded commitments of $2.7 million at December 31, 2023. The decrease was due to large charge offs taken in the fourth quarter of 2024 and changes with our economic forecast during the year.

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One measure of the adequacy of the ACL is the ratio of the ACL on loans to total loans. The ACL as a percentage of total loans was 1.1% as of December 31, 2024 and as of December 31, 2023. In management’s judgment, an adequate allowance for estimated losses has been established; however, there can be no assurance that losses will not exceed the estimated amounts in the future.

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See Note 1 – Summary of Significant Accounting Policies in the accompanying notes to the consolidated financial statements in this annual report for discussion of our ACL methodology on loans.

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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 over the expected life of the loan portfolio as well as considering changes in macroeconomic conditions. During 2024, we recorded a $13.6 million of provision for credit losses expense on loans and a $834,000 release of provision for credit losses on unfunded commitments. During 2023, we recorded an $18.1 million provision for credit losses expense on loans, and a $1.6 release of provision for credit losses on unfunded commitments.

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Summary of Loan Loss Experience

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The following table summarizes, for the years indicated, activity in the ACL, including amounts charged-off, amounts of recoveries, additions to the allowance charged to operating expense, and the ratio of net charge-offs to loans outstanding:

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Analysis of Allowance for Credit Losses

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1 The “Other” class includes consumer loans and overdrafts.

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The following table summarizes, for the years indicated, net charge-offs per loan class and the percentage of total average loans per class:

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1 The “Other” class includes consumer loans and overdrafts.

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The provision for credit losses on loans is based upon management’s estimate of future expected credit losses in the loan and lease portfolio and its evaluation of the adequacy of the ACL.  Our provision for credit losses in 2024 totaled $12.8 million, compared to $16.5 million in 2023, and $6.6 million in 2022.  Net charge-offs recorded in 2024 totaled $14.2 million, compared to net charge-offs of $23.3 million recorded in 2023, and net charge-offs of $1.6 million in 2022. The significant charge offs in 2024 were comprised of one commercial credit, and four commercial real estate credits, offset by one significant commercial real estate recovery. Our ACL on loans to average loans was 1.1% as of December 31, 2024 and 2023, compared to 1.4% at December 31, 2022.

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The following table shows our allocation of the ACL by loan type at December 31 for the years indicated, and, for each category of loans, the percent of total loans represented by that category:

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Allocation of the Allowance for Credit Losses

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1 The “Other” class includes consumer loans and overdrafts for each year presented.

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Allocations of the allowance may be made for specific loans, but the entire allowance is available for losses in the loan portfolio.  In addition, the OCC, as part of their examination process, periodically reviews the ACL.  Regulators can require management to record adjustments to the allowance level based upon their assessment of the information available to them at the time of examination.  The OCC, in conjunction with the other federal banking agencies, has adopted an interagency policy statement on the ACL.  The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation guidelines.  Generally, the policy statement recommends that (1) institutions have effective systems and controls to identify, monitor and address asset quality problems; (2) management has analyzed all significant factors that affect the collectability of the portfolio in a reasonable manner; and (3) management has established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement.  Management believes it has established an adequate estimated allowance for expected credit losses over the estimated life of our loan portfolio.  Management reviews its process quarterly using an extensive and detailed loan review process, makes changes as needed, and reports those results at meetings of our Board of Directors and Audit Committee.

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Although management believes the ACL is sufficient to cover expected losses over the estimated life of our loan portfolio, there can be no assurance that the allowance will prove sufficient to cover actual loan and lease losses or that regulators, in reviewing the loan portfolio, would not request us to materially adjust our ACL at the time of their examination. Continued loan growth in future periods, a decline in our current level of recoveries, or an increase in charge-offs could result in an increase in provision expense. Additionally, provision expense may be more volatile due to changes in CECL model assumptions of credit quality, macroeconomic factors and conditions, and loan composition, which drive the allowance for credit losses balance.

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During 2024, the release of credit losses on unfunded commitments totaled $834,000, and the allowance for unfunded commitments totaled $1.9 million as of December 31, 2024.  During 2023, the release of credit losses on unfunded commitments totaled $1.6 million, and allowance for unfunded commitments totaled $2.7 million as of December 31, 2023. Management reviewed the securities portfolio for credit loss exposure and determined that no allowance for credit losses on securities was required for 2024 or 2023.  See Note 4 to the Consolidated Financial Statements for more detail on the ACL for securities analysis performed.

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Other Real Estate Owned

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Other real estate owned (“OREO”) increased to $21.6 million as of December 31, 2024, compared to $5.1 million as of December 31, 2023, reflecting a $16.5 million increase. During 2024, we transferred five OREO properties from loans with a total fair value of $19.4 million, net of participations and valuation adjustments, and we sold three properties which had a net book value of $2.8 million. Net gains on the sale of OREO properties during 2024 totaled $390,000, compared to net gains on sale of OREO properties of $256,000 in 2023 and $163,000 in 2022. The OREO valuation reserve increased to $1.9 million in 2024 compared to $118,000 in 2023.

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N/M - Not meaningful

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Other real estate assets transferred from loans are recorded at the fair value of the property when transferred, less estimated costs to sell, establishing a new cost basis. The OREO valuation reserve for the year ended 2024 was $1.9 million, which was 7.9% of gross OREO at year-end 2024. This compares to $118,000, or 2.3%, of gross OREO, net of participations and purchase accounting adjustments, at year-end 2023.

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Deposits

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Our total deposits increased by $198.0 million, or 4.3%, to a total of $4.77 billion at year-end 2024, compared to year-end 2023, due to increases in NOW accounts of $56.1 million, money market accounts of $90.3 million, and time deposits of $220.8 million, partially offset by decreases in non-interest bearing demand deposits of $130.0 million, and savings accounts of $39.1 million. Total deposits contracted by $540.0 million, or 10.6%, to a total of $4.57 billion at year-end 2023 compared to year-end 2022. We had no brokered certificates of deposit as of December 31, 2024 or December 31, 2023.

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Average Balances and Interest Rates

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