UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2006

OR

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

For transition period from                      to                      

Commission File Number 0 -10537

OLD SECOND BANCORP, INC.

(Exact name of Registrant as specified in its charter)

 

37 South River Street, Aurora, Illinois        60507

(Address of principal executive offices)  (Zip Code)

(630) 892-0202

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes    x    No   o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).    Yes  o  No   x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: As of November 3, 2006, the Registrant had outstanding 13,126,798 shares of common stock, $1.00 par value per share.

OLD SECOND BANCORP, INC.

Form 10-Q Quarterly Report

Table of Contents

		PART I
Item 1.		Financial Statements
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.		Quantitative and Qualitative Disclosures about Market Risk
Item 4.		Controls and Procedures
		PART II
Item 1.		Legal Proceedings
Item 1.A.		Risk factors
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.		Defaults Upon Senior Securities
Item 4.		Submission of Matters to a Vote of Security Holders
Item 5.		Other Information
Item 6.		Exhibits
		Signatures

 

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PART I - FINANCIAL INFORMATION

Item 1.                          Financial Statements

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share data)

 

		(Unaudited)
		September 30,			December 31,
		2006			2005
Assets
Cash and due from banks		$	58,758		$	65,010
Interest bearing deposits with banks		117			105
Cash and cash equivalents		58,875			65,115
Securities available for sale		445,437			470,431
Federal Home Loan Bank and Federal Reserve Bank Stock		8,783			8,418
Loans held for sale		5,509			11,397
Loans		1,785,406			1,704,382
Allowance for loan losses		16,344			15,329
Net loans		1,769,062			1,689,053
Premises and equipment, net		45,736			42,485
Other real estate owned		83			251
Mortgage servicing rights		2,900			2,271
Goodwill		2,130			2,130
Core deposit intangible assets, net		89			355
Bank owned life insurance		43,071			41,627
Accrued interest and other assets		30,989			34,297
Total assets		$	2,412,664		$	2,367,830
Liabilities
Deposits:
Demand		$	258,403		$	264,124
Savings, NOW, and money market		813,641			795,028
Time		945,787			876,126
Total deposits		2,017,831			1,935,278
Securities sold under repurchase agreements		42,506			57,625
Other short-term borrowings		133,724			171,825
Junior subordinated debentures		31,625			31,625
Note payable		13,375			3,200
Accrued interest and other liabilities		19,049			16,015
Total liabilities		2,258,110			2,215,568
Stockholders’ Equity
Preferred stock, no par value; authorized 300,000 shares; none issued		—			—
Common stock, $1.00 par value; authorized 20,000,000 shares; issued 16,634,026 in 2006 and 16,592,301 in 2005; outstanding 13,166,798 in 2006 and 13,520,073 in 2005		16,634			16,592
Additional paid-in capital		14,758			13,746
Retained earnings		188,768			176,824
Accumulated other comprehensive loss		(3,310		)	(4,562		)
Treasury stock, at cost, 3,467,228 in 2006 and 3,072,228 in 2005		(62,296		)	(50,338		)
Total stockholders’ equity		154,554			152,262
Total liabilities and stockholders’ equity		$	2,412,664		$	2,367,830

 

See accompanying notes to unaudited consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Income

(In thousands, except share data.  Unaudited)

 

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2006			2005			2006			2005
Interest and Dividend Income
Loans, including fees		$	31,867		$	26,413		$	91,544		$	74,373
Loans held for sale		127			185			353			547
Securities:
Taxable		3,167			3,193			9,518			8,785
Tax-exempt		1,258			1,266			3,749			3,597
Federal funds sold		2			4			5			7
Interest bearing deposits with banks		1			1			3			2
Total interest and dividend income		36,422			31,062			105,172			87,311
Interest Expense
Savings, NOW, and money market deposits		5,031			3,276			12,861			8,227
Time deposits		10,523			6,760			29,480			18,392
Repurchase agreements		517			390			1,511			897
Other short-term borrowings		2,289			1,135			5,702			2,920
Junior subordinated debentures		617			617			1,850			1,831
Note payable		146			35			244			85
Total interest expense		19,123			12,213			51,648			32,352
Net interest income		17,299			18,849			53,524			54,959
Provision for loan losses		400			450			1,244			813
Net interest income after provision for loan losses		16,899			18,399			52,280			54,146
Noninterest Income
Trust income		1,707			1,580			5,494			4,858
Service charges on deposits		2,146			2,194			6,149			6,103
Gain on sale of loans		849			1,531			2,755			4,359
Secondary mortgage fees		201			288			513			759
Mortgage servicing income		133			62			348			112
Securities gains (losses), net		—			—			418			(5		)
Increase in cash surrender value of bank owned life insurance		483			218			1,444			652
Other income		1,355			1,501			4,193			4,113
Total noninterest income		6,874			7,374			21,314			20,951
Noninterest Expense
Salaries and employee benefits		9,193			8,780			27,293			26,880
Loss on settlement of benefit obligation		1,001			—			1,358			—
Occupancy expense, net		1,179			1,015			3,369			2,609
Furniture and equipment expense		1,418			1,378			3,958			3,827
Amortization of core deposit intangible assets		89			88			266			266
Advertising expense		485			473			1,461			1,311
Other expense		3,812			3,316			11,267			10,566
Total noninterest expense		17,177			15,050			48,972			45,459
Income before income taxes		6,596			10,723			24,622			29,638
Provision for income taxes		1,648			3,541			7,203			9,697
Net income		$	4,948		$	7,182		$	17,419		$	19,941
Share and per share information:
Ending number of shares		13,166,798			13,497,889			13,166,798			13,497,889
Average number of shares		13,279,824			13,497,889			13,443,668			13,482,340
Diluted average number of shares		13,451,345			13,690,895			13,619,125			13,675,603
Basic earnings per share		$	0.37		$	0.53		$	1.30		$	1.48
Diluted earnings per share		$	0.37		$	0.52		$	1.28		$	1.46
Dividends declared per share		$	0.14		$	0.13		$	0.41		$	0.38

 

See accompanying notes to unaudited consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Nine Months Ended September 30, 2006 and 2005

(In thousands, unaudited)

 

		2006			2005
Cash flows from operating activities
Net income		$	17,419		$	19,941
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		2,881			2,624
Amortization of mortgage servicing rights		357			69
Provision for loan losses		1,244			813
Origination of loans held for sale		(215,989		)	(303,917		)
Proceeds from sale of loans held for sale		223,646			314,588
Gain on sale of loans		(2,755		)	(4,359		)
Increase in cash surrender value of bank owned life insurance		(1,444		)	(652		)
Change in current income taxes payable		211			(654		)
Change in accrued interest receivable and other assets		2,279			(6,233		)
Change in accrued interest payable and other liabilities		2,949			4,512
Net premium amortization on securities		2,002			2,771
Securities losses (gains), net		(418		)	5
Amortization of core deposit intangible assets		266			266
Tax benefit from stock options exercised		—			408
Net cash provided by operating activities		32,648			30,182
Cash flows from investing activities
Proceeds from matured or called securities available for sale		97,554			96,765
Proceeds from sales of securities available for sale		339			349
Purchases of securities available for sale		(72,413		)	(176,235		)
Purchase of FHLB stock		(365		)	(1,397		)
Net change in loans		(81,253		)	(162,043		)
Net change in other real estate		168			(576		)
Net purchases of premises and equipment		(6,132		)	(6,147		)
Net cash used in investing activities		(62,102		)	(249,284		)
Cash flows from financing activities
Net change in deposits		82,553			148,005
Net change in securities sold under repurchase agreements		(15,119		)	10,876
Net change in other short-term borrowings		(38,101		)	65,912
Proceeds from note payable		10,175			500
Proceeds from exercise of stock options		768			917
Tax benefit from stock options exercised		286			—
Dividends paid		(5,390		)	(4,985		)
Purchase of treasury stock		(11,958		)	—
Net cash provided by financing activities		23,214			221,225
Net change in cash and cash equivalents		(6,240		)	2,123
Cash and cash equivalents at beginning of period		65,115			58,662
Cash and cash equivalents at end of period		$	58,875		$	60,785
Supplemental cash flow information
Income taxes paid		$	7,022		$	10,351
Interest paid		49,567			31,610

 

See accompanying notes to unaudited consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Table amounts in thousands, except per share data, unaudited)

Note 1 — Summary of Significant Accounting Policies

The accounting policies followed in the preparation of interim financial statements are consistent with those used in the preparation of annual financial information. The interim financial statements reflect all normal and recurring adjustments, which are necessary, in the opinion of management, for a fair statement of results for the interim periods presented. Results for the periods ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. These interim financial statements should be read in conjunction with the audited financial statements and notes included in Old Second Bancorp, Inc.’s (the “Company”) 2005 Form 10-K.  Unless otherwise indicated, amounts in the tables contained in the notes are in thousands. Certain items in prior periods have been reclassified to conform to the current presentation.

The Company’s consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the financial statements.

All significant accounting policies are presented in Note A to the consolidated financial statements included in the Company’s annual report on Form 10-K for the year ended December 31, 2005. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.

In February 2006, the FASB issued Statement 155 (“SFAS 155”), “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140.” This Statement is effective for all financial instruments acquired, issued, or subject to a remeasurement event occurring after the beginning of fiscal years beginning after September 15, 2006. Earlier adoption was permitted as of the beginning of 2006, provided an entity had not yet issued financial statements, including financial statements for any interim period, for that fiscal year. The Company did not elect early adoption, and is evaluating the potential impact in future periods.

In March 2006, the FASB issued Statement (“SFAS 156”), “Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140.” This Statement is effective as of the beginning of fiscal years beginning after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including interim financial statements, for any period of that fiscal year. The Company did not elect early adoption, and is evaluating the potential impact in future periods.

In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, (“FIN 48”). FIN 48 is effective for fiscal years

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

In September 2006, the Securities Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) 108, which was issued to address diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build up of improper amounts on the balance sheet. The Company is evaluating the potential impact of the standard on future periods.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.”  SFAS No. 157 clarifies the definition of fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, although earlier application is encouraged. Prospective application of the provisions of SFAS No. 157 is required as of the beginning of the fiscal year in which it is initially applied, except for certain circumstances specified in the Statement that require retrospective application. The Company is in the process of assessing the impact of the adoption of this statement on the Company’s financial statements.

Note 2 — Securities

Securities available for sale were as follows:

					Gross			Gross
		Amortized			Unrealized			Unrealized			Fair
		Cost			Gains			Losses			Value
September 30, 2006:
U.S. Treasuries		$	10,013		$	—		$	(405	)	$	9,608
U.S. Government agencies		292,956			13			(4,325		)	288,644
States and political subdivisions		147,830			873			(1,648		)	147,055
Equity securities		130			—			—			130
		$	450,929		$	886		$	(6,378	)	$	445,437
December 31, 2005:
U.S. Treasuries		$	11,010		$	—		$	(273	)	$	10,737
U.S. Government agencies		318,560			51			(4,940		)	313,671
States and political subdivisions		148,371			932			(3,332		)	145,971
Equity securities		52			—			—			52
		$	477,993		$	983		$	(8,545	)	$	470,431

 

Recognition of other than temporary impairment was not necessary in the first nine months of 2006. The unrealized loss in the portfolio was attributed to an increase in rates, which has caused the amortized cost to be more than the current fair value. When interest rates decrease, the individual securities typically will increase in value. The change in value is not related to credit quality deterioration and the Company has the ability and intent to hold all securities until recovery.

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Note 3 — Loans

Major loan classifications as of September 30, 2006 and December 31, 2005 were as follows:

 

 

Note 4 — Allowance for Loan Losses

Changes in the allowance for loan losses as of September 30 were as follows:

 

Note 5 — Deposits

Major deposit classifications as of Septmber 30, 2006 and December 31, 2005 were as follows:

 

Note 6 — Securities Sold Under Repurchase Agreements, Short-Term Borrowings and Note Payable

 Major borrowing classifications as of September 30, 2006 and December 31, 2005 were as follows:

 

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The Company enters into sales of securities under agreements to repurchase (repurchase agreements). These repurchase agreements are treated as financings. The dollar amounts of securities underlying the agreements remain in the asset accounts. Securities sold under agreements to repurchase consisted of U.S. government agencies at September 30, 2006 and December 31, 2005, and are held in third party pledge accounts.

The Company’s borrowings at the FHLB are limited to the lesser of 35% of total assets or 60% of the book value of certain mortgage loans. In addition, these notes were collateralized by FHLB stock of $7.3 million and loans totaling $61.5 million at December 31, 2005. FHLB stock of $7.7 million and loans totaling $81.5 million were required to be pledged as of September 30, 2006. As of September 30, 2006, FHLB advances of $30 million and $50 million were scheduled to mature on November 6, 2006 and November 28, 2006 respectively.  A new short-term FHLB advance replaced the November 6, 2006 advance that matured.

At September 30, 2006 and December 31, 2005, respectively, the period to date average balance of Federal funds purchased, other short-term borrowings, and securities sold under agreements to repurchase totaled $185.9 million at a weighted average rate of 5.2% and $160.6 million at a weighted average rate of 3.5%.

The Company is a Treasury Tax & Loan (“TT&L”) depository for the Federal Reserve Bank (“FRB”), and as such, it accepts TT&L deposits. The Company is allowed to hold these deposits for the FRB until they are called. The interest rate is the federal funds rate less 25 basis points.  Securities with a face value greater than or equal to the amount borrowed are pledged as a condition of borrowing TT&L deposits.

The Company has a $20 million line of credit available with a correspondent bank under which there was a $3.2 million outstanding balance as of December 31, 2005 and $13.4 million as of September 30, 2006. A revolving business note dated April 30, 2006 secures the line of credit and is guaranteed by the Company. The note provides that any outstanding principal will bear interest at the rate of 0.90% over the British Bankers Association (“BBA”) 1-month LIBOR rate and can change monthly. This borrowing is for general corporate purposes, including common stock repurchases.

Note 7 — Long-Term Incentive Plan

The Long-Term Incentive Plan (the “Incentive Plan”) authorizes the issuance of up to 1,333,000 shares of the Company’s common stock, including the granting of qualified stock options (“Incentive Stock Options”), nonqualified stock options, restricted stock and stock appreciation rights. Stock based awards may be granted to selected directors and officers or employees at the discretion of the board of directors. The Incentive Plan requires the exercise price of any incentive stock option issued to an employee to be at least equal to the fair market value of Company common stock on the date the option is granted. All stock options were granted for a term of ten years. Vesting of stock options granted in 2004 and prior years was accelerated to immediately vest all options as of December 20, 2005. The accelerated vesting eliminated the future compensation expense that the Company would otherwise recognize with respect to these options, in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004) “Share - Based Payment”, (“SFAS No. 123”) issued by the Financial Accounting Standards Board, effective for reporting periods beginning after January 1, 2006. Options granted in 2005 were immediately vested and restricted stock vests three years from the grant date.

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Nonqualified stock options may be granted to directors based upon a formula. These and other awards under the Incentive Plan may be granted subject to a vesting requirement and would become fully vested upon a merger or change in control of the Company. There were no stock options granted in the first nine months of 2006.

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

 

All options were exercisable at the end of the period. The total intrinsic value of options exercised during the first quarter of 2006 and 2005 was $647,000 and $1,476,000, respectively. There were no exercises in the second quarter of either 2005 or 2006. The total intrinsic value of options exercised during the third quarter of 2006 was $73,000 and there were no options exercised during the third quarter of 2005.

The following pro forma information presents net income and earnings per share had the fair value method of SFAS No. 123 been used to measure compensation cost for stock option plans in 2005.

 

Restricted stock was granted beginning December 20, 2005 under the Incentive Plan. These shares are subject to forfeiture until certain restrictions have lapsed, including employment for a specific period. Restricted stock awards are granted at fair market value. Compensation expense for restricted shares is recognized on a straight-line basis over the three-year vesting period. Included in the determination of net income as reported for the nine-month period ended September 30, 2006, is compensation expense for restricted shares of $152,000, with a related tax benefit of $60,000. As of September 30, 2006, the total compensation cost related to

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nonvested awards not yet recognized was $451,000. The Company expects to recognize this cost over a remaining period of twenty-seven months.

The following table is a summary of restricted stock activity.

 

 

Note 8 — Earnings Per Share

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

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2006			2005			2006			2005
Basic earnings per share:
Weighted-average common shares outstanding		13,279,824			13,497,889			13,443,668			13,482,340
Net income available to common stockholders		$	4,948		$	7,182		$	17,419		$	19,941
Basic earnings per share		$	0.37		$	0.53		$	1.30		$	1.48
Diluted earnings per share:
Weighted-average common shares outstanding		13,279,824			13,497,889			13,443,668			13,482,340
Dilutive effect of restricted shares		19,929			—			19,929			—
Dilutive effect of stock options		151,592			193,006			155,528			193,263
Diluted average common shares outstanding		13,451,345			13,690,895			13,619,125			13,675,603
Net income available to common stockholders		$	4,948		$	7,182		$	17,419		$	19,941
Diluted earnings per share		$	0.37		$	0.52		$	1.28		$	1.46
Number of antidilutive options excluded from the diluted earnings per share calculation		208,000			137,000			208,000			137,000
Number of antidilutive restricted shares excluded from the diluted earnings per share calculation		—			—			—			—

 

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Note 9 — Other Comprehensive Income (Loss)

Other comprehensive income (loss) is included below:

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2006			2005			2006			2005
Change in net holding gains (losses) on available for sale securities arising during the period		$	5,873		$	(3,030	)	$	2,488		$	(4,982	)
Related tax benefit / (expense)		(2,335		)	1,202			(984		)	1,977
Net unrealized gains / (losses)		3,538			(1,828		)	1,504			(3,005		)
Less: Reclassification adjustment for the net gains (losses) realized during the period
Realized gains		—			—			418			5
Realized losses		—			—			—			(10		)
Net realized gains (losses)		—			—			418			(5		)
Income tax benefit (expense) on net realized gains (losses)		—			—			(166		)	2
Net realized gains (losses) after tax		—			—			252			(3		)
Total other comprehensive income (loss)		$	3,538		$	(1,828	)	$	1,252		$	(3,002	)

 

Note 10 — Retirement Plans

The Company had historically maintained a tax-qualified noncontributory defined benefit retirement plan covering substantially all full-time and regular part-time employees. Benefits were generally based on years of service and compensation. Certain participants in the defined benefit plan were also covered by an unfunded supplemental retirement plan. The purpose of the supplemental retirement plan was to extend full retirement benefits to individuals without regard to statutory limitations under tax-qualified plans.

As of December 31, 2005, the defined benefit and supplemental retirement plans were terminated. Prior to December 31, 2005, all amounts due were paid to participants of the supplemental executive retirement plan (“SERP”). The Company received regulatory approval to distribute accrued benefits to the participants of the defined benefit plan. These distributions began in the third quarter of 2006, and approximately 80% of the distribution payments had been made as of September 30, 2006. As of October 31, 2006, the distribution of the remaining benefit obligation was substantially completed and the remaining liabilities exceeded assets by approximately $163,000. A contribution of that shortfall amount was made as part of the defined benefit plan liquidation process.

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The Company maintains tax-qualified contributory and non-contributory profit sharing plans covering substantially all full-time and regular part-time employees. The expense of these plans was $1,706,000 and $1,059,000 in the first nine months of 2006 and 2005, respectively.

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

Overview

Old Second Bancorp, Inc. (the “Company”) is a financial services company with its main headquarters located in Aurora, Illinois. The Company has offices located in Kane, Kendall, DeKalb, DuPage, LaSalle, and Will counties in Illinois. The Company provides financial services through its three subsidiary banks at its thirty banking locations. Old Second Mortgage, which also conducts business as “Maple Park Mortgage”, provides mortgage-banking services at its three offices.  Old Second Financial, Inc. provides insurance products. The Old Second National Bank of Aurora, the Company’s lead subsidiary bank, also engages in trust operations.

Results of Operations

Net income for the third quarter of 2006 was $4.9 million, or $0.37 diluted earnings per share, compared with $7.2 million, or $0.52 diluted earnings per share in the third quarter of 2005. Earnings for the first nine months of 2006 were $1.28 per diluted share, on $17.4 million in net income, compared with $1.46 per diluted share in the first nine months of 2005, on earnings of $19.9 million. The return on equity decreased from 18.67% in the first nine months of 2005, to 15.11% in the first nine months of 2006.

The Company is in the process of distributing the assets of its defined benefit pension plan after terminating the plan in December of 2005. A loss on settlement of the benefit obligations of $1.0 million was recorded in the third quarter of 2006. The loss related to termination of the defined benefit pension plan was $1.4 million for the first nine months of 2006. The liabilities exceeded assets at the time of final distribution of benefits by approximately $163,000. A contribution of that shortfall amount was made in the fourth quarter of 2006 and is discussed in more detail in Note 10.

In comparing the first nine months of 2006 and the first nine months of 2005, several items had an impact on earnings in addition to the termination of the pension plan discussed previously. In the first nine months of 2005, there was a reduction of $340,000 in the estimated accrual for real estate taxes. In the first nine months of 2006, net interest income decreased $1,435,000, and there was a reduction of $1,604,000 in gains on the sale of loans, both of which resulted primarily because of the increase in interest rates. These were offset by an income tax adjustment of $250,000 and securities gains of $418,000 in the first nine months of 2006. At the same time, the provision for loan losses was $1,244,000 in the first nine months of 2006, compared with $813,000 in the first nine months of 2005.

Net Interest Income

Net interest income decreased in the first nine months of 2006, to $53.5 million in 2006, from $55.0 million in 2005. Third quarter net interest income declined from $18.8 million in 2005, to $17.3 million in 2006. For both the quarter and year to date periods, growth in earning assets was offset by a lower net interest margin. Average earning assets grew $128.0 million, or 6.14% from the first nine months of 2005 to the first nine months of 2006. In the same period, however, the net interest margin declined from 3.66% in 2005 to 3.37% in 2006.

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On a year to date comparative basis, the average tax-equivalent yield on earning assets increased from 5.73% in 2005 to 6.49% in 2006, which was a 76 basis point increase. During the same nine-month period, however, the cost of funds increased from 2.40% to 3.55%, or 115 basis points. Changes in funding composition had a significant affect on increasing interest costs and lowering the net interest margin. The average balances of lower cost sources of funds such as interest-bearing transaction accounts and savings accounts declined $26.1 million, or 3.2%, from the first nine months of 2005 to the first nine months of 2006. Noninterest-bearing deposits increased by a nominal amount while the aggregate categories of higher-cost sources of funds such as time deposits, repurchase agreements and short-term borrowing increased $170.4 million, or 17.7%.

Management, in order to evaluate and measure performance, uses certain non-GAAP performance measures and ratios. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures and ratios provide users of the financial information with a more accurate view of the performance of the interest-earning assets and interest-bearing liabilities and of the Company’s operating efficiency for comparison purposes. Other financial holding companies may define or calculate these measures and ratios differently. See the table below for supplemental data and the corresponding reconciliation to GAAP financial measures for the nine months ended September 30, 2006 and 2005.

The following table sets forth certain information relating to the Company’s average consolidated balance sheets and reflects the yield on average earning assets and cost of average liabilities for the periods indicated. The rates are determined by dividing the related interest by the average balance of assets or liabilities. Average balances are derived from daily balances.

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ANALYSIS OF AVERAGE BALANCES,

TAX EQUIVALENT INTEREST AND RATES

Nine Months Ended September 30, 2006 and 2005

(Dollar amounts in thousands- unaudited)

 

		2006								2005
		Average								Average
		Balance			Interest			Rate		Balance			Interest			Rate
Assets
Interest bearing deposits with banks		$	531		$	3		0.76	%	$	443		$	2		0.60	%
Federal funds sold		143			5			4.67		289			7			3.23
Securities:
Taxable		322,589			9,518			3.93		335,522			8,785			3.49
Non-taxable (tax equivalent)(1)		140,600			5,768			5.47		138,355			5,534			5.33
Total securities		463,189			15,286			4.40		473,877			14,319			4.03
Loans and loans held for sale(2)(3)		1,749,005			92,067			7.04		1,610,212			75,074			6.23
Total interest earning assets		2,212,868			107,361			6.49		2,084,821			89,402			5.73
Cash and due from banks		52,231			—			—		55,330			—			—
Allowance for loan losses		(15,984		)	—			—		(15,582		)	—			—
Other noninterest-bearing assets		120,950			—			—		88,306			—			—
Total assets		$	2,370,065							$	2,212,875
Liabilities and Stockholders’ Equity
Interest bearing transaction accounts		$	662,286		12,424			2.51		$	680,925		7,835			1.54
Savings accounts		117,697			437			0.50		125,188			392			0.42
Time deposits		944,317			29,480			4.17		804,390			18,392			3.06
Interest bearing deposits		1,724,300			42,341			3.28		1,610,503			26,619			2.21
Repurchase agreements		47,500			1,511			4.25		45,919			897			2.61
Other short-term borrowings		138,433			5,702			5.51		112,116			2,920			3.48
Junior subordinated debentures		31,625			1,850			7.80		31,625			1,831			7.72
Note payable		5,427			244			6.01		2,812			85			4.04
Total interest bearing liabilities		1,947,285			51,648			3.55		1,802,975			32,352			2.40
Noninterest bearing deposits		253,570			—			—		251,682			—			—
Accrued interest and other liabilities		15,064			—			—		15,433			—			—
Stockholders’ equity		154,146			—			—		142,785			—			—
Total liabilities and stockholders’ equity		$	2,370,065							$	2,212,875
Net interest income (tax equivalent)					$	55,713							$	57,050
Net interest income (tax equivalent) to total earning assets								3.37	%							3.66	%
Interest bearing liabilities to earnings assets		88.00		%						86.48		%

 

Notes:

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

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

(3)             Loan fees, included in interest on loans and loans held for sale, were $2.8 million and $2.3 million in the first nine months of 2006 and 2005, respectively.

Yields on certain asset categories and the net interest margin of the Company and its banking subsidiaries are reviewed on a fully taxable-equivalent basis (“FTE”). In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measure ensures comparability of net interest income arising from both taxable and tax-exempt sources.

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