Old Second Bancorp Inc: Form 10-Q for the period ended Mar 31, 2024

Overview

The following discussion provides additional information regarding our operations for the three months ended March 31, 2024, compared to the three months ended March 31, 2023, and our financial condition at March 31, 2024, compared to December 31, 2023. This discussion should be read in conjunction with our consolidated financial statements as well as the financial and statistical data appearing elsewhere in this report and our Form 10-K for the year ended December 31, 2023. The results of operations for the three months ended March 31, 2024, are not necessarily indicative of future results. Dollar amounts presented in the following tables are in thousands, except per share data, and March 31, 2024 and 2023 amounts are unaudited.

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

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

Business Overview

The Company is a bank holding company headquartered in Aurora, Illinois. Through our wholly-owned subsidiary bank, Old Second National Bank, a national banking organization also headquartered in Aurora, Illinois, we offer a wide range of financial services through our 48 banking centers located in Cook, DeKalb, DuPage, Kane, Kendall, LaSalle and Will counties in Illinois. These banking centers offer access to a full range of traditional retail and commercial banking services including treasury management operations as well as fiduciary and wealth management services. We focus our business on establishing and maintaining relationships with our clients while maintaining a commitment to provide for the financial services needs of the communities in which we operate. We emphasize relationships with individual customers as well as small to medium-sized businesses throughout our market area. We also have extensive wealth management services, which includes a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts and employee benefit plan administration services.

Our results of operations depend generally on net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. Net interest income is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. In addition, we are subject to interest rate risk to the degree that our interest-earning assets mature or reprice at different times, or at different speeds, than our interest-bearing liabilities. Our results of operations are also affected by noninterest income, such as service charges, wealth management fees, loan fees, gains from the sale of newly originated loans, gains or losses on investments and certain other noninterest related items. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, professional fees, data processing expenses and provision for credit losses.

We are significantly impacted by prevailing economic conditions, including federal monetary and fiscal policies, and federal regulations of financial institutions. Deposit balances are influenced by numerous factors such as competing investments, the level of income and the personal rate of savings within our market areas. Factors influencing lending activities include the demand for housing and the interest rate pricing competition from other lending institutions.

As of March 31, 2024, all of our capital ratios were in excess of all regulatory requirements. While we believe that we have sufficient capital to withstand an extended economic recession, our reported and regulatory capital ratios could be adversely impacted by credit losses.

Financial Overview

Net income for the first quarter of 2024 was $21.3 million, or $0.47 per diluted share, compared to $23.6 million, or $0.52 per diluted share, for the first quarter of 2023. The decrease was primarily due to a reduction in net interest and dividend income from contraction in our securities portfolio as well as higher market rates and increased short-term borrowing, which resulted in a $7.5 million increase to interest expense. Partially offsetting these changes was growth in loan related income due to higher market interest rates in the first quarter of 2024 compared to the like quarter in 2023. Noninterest income increased in the first quarter of 2024, compared to the like quarter of 2023, as a result of a reduction in net losses on security sales, growth in mortgage banking revenues, and an increase in the cash surrender value of BOLI. An increase was also noted in noninterest expense for the current quarter, primarily due to higher salaries and employee benefits. Adjusted net income, a non-GAAP financial measure that excludes certain nonrecurring items, as applicable, was $21.3 million for the first quarter of 2024, compared to $19.1 million for the fourth quarter of 2023, and $23.4 million for the first quarter of 2023. See the discussion entitled “Non-GAAP Financial Measures” on page 40, as well as the table below, which provides a reconciliation of this non-GAAP measure to the most comparable GAAP equivalents.

The following provides an overview of some of the factors impacting our financial performance for the three month period ended March 31, 2024, compared to the like period ended March 31, 2023:

• Net interest and dividend income was $59.8 million for the first quarter of 2024, compared to $64.1 million for the first quarter of 2023. The reduction in interest and dividend income in the first quarter of 2024 was primarily due to higher borrowing costs, partially offset by higher loan yields.
• We recorded a net provision for credit losses of $3.5 million in the first quarter of 2024, driven by a $3.5 million increase in the allowance for credit losses on loans based on increased historical loss rate updates given current quarter charge-offs, our assessment of nonperforming loan metrics and trends, downward risk rating migration, and estimated future credit losses, net of a reversal of $44,000 in our allowance for unfunded commitments based on an adjustment of historical benchmark assumptions, such as funding rates and the period used to forecast those rates, within the ACL calculation. We recorded a net provision for credit loss of $3.5 million in the first quarter of 2023.
• Noninterest income was $10.5 million for the first quarter of 2024, compared to $7.4 million for the first quarter of 2023. Contributing to the increase were security gains of $1,000 due to strategic sales in the first quarter of 2024, compared to losses on the sale of securities of $1.7 million in the first quarter of 2023. Also contributing to the growth in noninterest income was a $291,000 increase in wealth management income, a $590,000 increase in mortgage banking revenue and a $930,000 increase in the cash surrender value of BOLI. These increases were partially offset by a decrease of $459,000 in other income primarily due to a one-time vendor credit received in the first quarter of 2023; no like credit was received in 2024.
• Noninterest expense was $38.2 million for the first quarter of 2024, compared to $35.9 million for the first quarter of 2023, an increase of $2.3 million, or 6.5%. Contributing to the increase in noninterest expense in the first quarter of 2024 was higher salaries and employee benefits as well as increases in occupancy furniture and equipment and computer and data processing expenses. Partially offsetting the increase in noninterest expense was a reduction in consulting & management fees and as well as OREO valuation reserve expense, which is included in other real estate expense, net.
• We had a provision for income tax expense of $7.2 million for the first quarter of 2024, compared to a provision for income tax expense of $8.4 million for the first quarter of 2023. The effective tax rate for these two periods was 25.3% and 26.3%, respectively.
• Our community-focused banking franchise experienced a decrease of $73.5 million in total loans in the first quarter of 2024, compared to the year ended December 31, 2023, and a decrease of $33.9 million in total loans compared to the first quarter of 2023. We believe we are positioned for loan growth in 2024, though likely at a slower pace than in recent years, as we continue to serve our customers’ needs in a competitive economic environment. We continue to seek to provide value to our customers and the communities in which we operate, by executing on growth opportunities in our local markets and developing new banking relationships, while seeking to ensure the safety and soundness of our Bank, our customers, and our employees.
• Nonaccrual loans decreased $3.3 million as of March 31, 2024, compared to December 31, 2023, but increased $763,000 compared to March 31, 2023. The reduction in nonaccrual loans in the first quarter of 2024, compared to the prior quarter, was primarily due to a $3.9 million partial charge-off on a large healthcare loan. The increase in nonaccrual loans year over year is due to various downgrades in the last twelve months, primarily related to CRE-Owner Occupied and CRE-Investor portfolios, the majority of which are office and healthcare loans. Nonperforming loans as a percent of total loans was 1.6% as of March 31, 2024, compared to 1.7% as of December 31, 2023, and 1.6% as of March 31, 2023. Classified assets increased to $140.6 million as of March 31, 2024, which is $2.7 million, or 1.9% more than December 31, 2023, and $14.0 million, or 11.1%, more than March 31, 2023.

Critical Accounting Estimates

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

Of the significant accounting policies used in the preparation of our consolidated financial statements, we have identified certain items as critical accounting policies based on the associated estimates, assumptions, judgments and complexity. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Estimates” in our Annual Report on Form 10-K for the year ended December 31, 2023. There have been no material changes to our critical accounting policies or the estimates made pursuant to those policies during the most recent quarter from those disclosed in our 2023 Annual Report in Form 10-K.

Non-GAAP Financial Measures

This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of net interest income and net interest margin on a tax equivalent (“TE”) basis, adjusted net income, adjusted basic and diluted earnings per share, our adjusted efficiency ratio, 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 of our performance to investors. 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 measures 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.

Results of Operations

Overview

Three months ended March 31, 2024 and 2023

Our income before taxes was $28.5 million in the first quarter of 2024 compared to $32.0 million in the first quarter of 2023. This decrease in pretax income was primarily due to a $4.3 million decrease in net interest and dividend income. Income before taxes was positively impacted by a $3.2 million increase in noninterest income, primarily due to $1,000 of security gains, net, in the first quarter of 2024 compared to $1.7 million of security losses, net, in the first quarter of 2023 as well as a $590,000 increase in mortgage banking income. Income before taxes was negatively impacted by a $2.3 million increase in noninterest expense primarily due to a $2.1 million increase in salary and employee benefits expense in the first quarter of 2024. Our net income was $21.3 million, or $0.47 per diluted share, for the first quarter of 2024, compared to net income of $23.6 million, or $0.52 per diluted share, for the first quarter of 2023. The Bank remains well positioned to navigate uncertain macroeconomics; we have mitigated interest rate risk, controlled expenses in an inflationary environment, and actively managed daily liquidity. Furthermore, we continue to possess strong liquidity metrics and an outsized securities portfolio for funding needs.

Net interest and dividend income was $59.8 million in the first quarter of 2024, compared to $64.1 million in the first quarter of 2023. The $4.3 million decrease was driven by an increase in interest expense in the first quarter of 2024, compared to the first quarter of 2023, primarily due to a rise in deposit interest rates and borrowing costs. Decreases in our securities portfolio also contributed to the decrease in net interest and dividend income during the first quarter of 2024. Partially offsetting the decrease during the first quarter of 2024 compared to the like quarter a year ago was growth in our loan related income due to the effect of higher market interest rates on our loan portfolios.

Net Interest Income

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

Three months ended March 31, 2024 and 2023

The increased yield of six basis points on interest earning assets compared to the linked period was driven by repricing within the existing loan portfolios, and, to a lesser extent, the growth in the average balance of loans over the quarter. In addition, rates paid on FHLB dividends increased quarter over linked quarter. Changes in the market interest rate environment impact earning assets at varying intervals depending on the repricing timeline of loans, as well as the securities maturity, paydown and purchase activities.

The year over year increase of 42 basis points on interest earning assets was primarily driven by significant increases to benchmark interest rates over the past twelve months, primarily impacting variable rate loans. This increase was partially offset by the reduction in securities available for sale income during the quarter ended March 31, 2024, compared to the prior quarter and year over year quarter, as both security volumes and rates decreased.

Average balances of interest-bearing deposit accounts have increased steadily since the fourth quarter of 2023 through the first quarter of 2024, from $2.74 billion to $2.76 billion, as time deposits increased due to CD rate specials, partially offset by reductions in other deposit categories as customers sought higher yielding products. We have continued to control the cost of funds over the periods reflected, with the average rate of overall interest-bearing deposits increasing to 118 basis points for the quarter ended March 31, 2024, from 89 basis points for the quarter ended December 31, 2023, and from 25 basis points for the quarter ended March 31, 2023. A 24 basis point increase in the cost of money market funds for the quarter ended March 31, 2024 compared to prior linked quarter, and a 110 basis point increase compared to the prior year like quarter were both due to select deposit account exception pricing, and drove a significant portion of the overall increase. Average rates paid on time deposits for the quarter ended March 31, 2024 increased by 65 basis points and 229 basis points in the quarter over linked quarter and year over year quarters, respectively, primarily due to CD rate specials we offered.

Borrowing costs decreased in the first quarter of 2024, compared to the fourth quarter of 2023, primarily due to the $58.5 million decrease in average other short-term borrowings stemming from a decrease in average FHLB advances over the prior quarter. The increase of $131.4 million year over year of average FHLB advances was based on daily liquidity needs, and was the primary driver of the $2.2 million increase to interest expense due to other short-term borrowings. Subordinated and junior subordinated debt interest expense were essentially flat over each of the periods presented. Senior notes had the most significant interest expense decrease year over year, as we redeemed all of the $45.0 million senior notes, net of deferred issuance costs, in June 2023, resulting in senior notes having no balance after that time. In February 2023, we paid off the remaining balance of $9.0 million on the original $20.0 million term note issued in 2020, resulting in notes payable and other borrowings having no balance after that time.

Our net interest margin (GAAP) decreased four basis points to 4.55% for the first quarter of 2024, compared to 4.59% for the fourth quarter of 2023, and decreased 17 basis points compared to 4.72% for the first quarter of 2023. Our net interest margin (TE) decreased four basis points to 4.58% for the first quarter of 2024, compared to 4.62% for the fourth quarter of 2023, and decreased 16 basis points compared to 4.74% for the first quarter of 2023. The decrease in the first quarter of 2024, compared to the prior quarter, is driven by higher interest expense due to the current interest rate environment and its effect on interest bearing deposits. The decrease in the first quarter of 2024, compared to the prior year like quarter, is primarily due to an increase in market interest rates, and the related increase in costs of interest-bearing liabilities. See the discussion entitled “Non-GAAP Financial Measures” and the table on page 46 that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent.

Analysis of Average Balances,

Tax Equivalent Income / Expense and Rates

(Dollars in thousands - unaudited)

​

1 Represents a non-GAAP financial measure. See the discussion entitled “Reconciliation of Tax-Equivalent Non-GAAP Financial Measures” below that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent. Tax equivalent basis is calculated using a marginal tax rate of 21% in 2024 and 2023.

2 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 44, and includes loan fee expense of $867,000 for the first quarter of 2024, $922,000 for the fourth quarter of 2023, and $730,000 for the first quarter of 2023. Nonaccrual loans are included in the above-stated average balances.

Reconciliation of Tax-Equivalent (TE) Non-GAAP Financial Measures

Net interest and dividend income (TE) and net interest income (TE) to average interest earning assets are non-GAAP measures that have been adjusted on a TE basis using a marginal rate of 21% for 2024 and 2023 to compare returns more appropriately on tax-exempt loans and securities to other earning assets. The table below provides a reconciliation of each non-GAAP (TE) measure to the GAAP equivalent for the periods indicated:

Noninterest Income

Three months ended March 31, 2024 and 2023

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

(Dollars in thousands)

Noninterest income increased $1.8 million, or 20.3%, in the first quarter of 2024, compared to the fourth quarter of 2023, and increased $3.2 million, or 42.9%, compared to the first quarter of 2023. The increase from the fourth quarter of 2023 was primarily driven by a $1.3 million increase in residential mortgage banking revenue primarily due to MSRs mark to market gains, and a $631,000 increase in the cash surrender value of BOLI, both of which were due to market interest rate changes in the first quarter, as well as a $120,000 increase in other income, partially offset by a $39,000 decrease in wealth management income, a $112,000 decrease in service charges on deposits, and a $135,000 decrease in card related income.

The increase in noninterest income of $3.2 million in the first quarter of 2024, compared to the first quarter of 2023, is primarily due to a $291,000 increase in wealth management income primarily due to an increase in advisory fees, a $590,000 increase in mortgage banking revenue mainly due to a $619,000 increase in MSRs mark to market gain, $1,000 of realized gains on sales of securities in the first quarter of 2024 compared to realized losses on the sale of securities of $1.7 million in the first quarter of 2023, a $930,000 increase in the cash surrender value of BOLI, and a $132,000 increase in card related income. These increases were partially offset by a $459,000 decrease in other income, as the 2023 period included a one-time credit from a software vendor of $457,000.

Noninterest Expense

Three months ended March 31, 2024 and 2023

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

(Dollars in thousands)

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

2 The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits, OREO expenses, litigation expense, and net gains on branch sales, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains or losses on securities, mark to market gains or losses on MSRs, and includes a tax equivalent adjustment on the change in cash surrender value of BOLI. See the discussion entitled “Non-GAAP Financial Measures” above and the table on page 46 that provides a reconciliation of this non-GAAP financial measure to the most comparable GAAP equivalent.

Noninterest expense for the first quarter of 2024 increased $1.2 million, or 3.3%, compared to the fourth quarter of 2023, and increased $2.3 million, or 6.5%, compared to the first quarter of 2023. The increase in the first quarter of 2024 compared to the fourth quarter of 2023 was attributable to a $2.9 million increase in salaries and employee benefits, with increases reflected primarily in salaries due to annual merit increases, restricted stock expense and officers’ incentives due to annual payout true-ups, payroll taxes related to these annual payouts, and deferred executive compensation due to changes in market interest rates. Also contributing to the noninterest expense increase in the first quarter of 2024 was a $110,000 increase in occupancy, furniture and equipment and an $84,000 increase in FDIC insurance. Partially offsetting the increase in noninterest expense in the first quarter of 2024 compared to the fourth quarter of 2023 was a $191,000 decrease in advertising expense, a $61,000 decrease in card related expense, a $220,000 decrease in consulting & management fees, a $172,000 decrease in OREO related expense, and a $1.1 million decrease in other expense due to a $1.2 million litigation expense recorded in the fourth quarter of 2023 for a pending overdraft fee compliance claim.

The year over year increase in noninterest expense is primarily attributable to a $2.1 million increase in salaries and employee benefits, driven by increases in annual base salary rates, restricted stock expense, officers’ incentives, and deferred employee compensation due to market interest rate changes. Also contributing to the increase was a $452,000 increase in occupancy, furniture and equipment, primarily due to branch remodeling and offset by net gains on sales of branches in 2023, and a $481,000 increase in computer and data processing partially due to core processor credits received in 2023. Partially offsetting the increase in noninterest expense in the first quarter of 2024, compared to the first quarter of 2023, was a $93,000 decrease in legal fees, a $454,000 decrease in consulting & management fees, and a $260,000 decrease in OREO related expenses.

Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures

N/A - not applicable

Income Taxes

We recorded income tax expense of $7.2 million for the first quarter of 2024 on $28.5 million of pretax income, compared to income tax expense of $6.7 million on $24.9 million of pretax income in the fourth quarter of 2023, and income tax expense of $8.4 million on $32.0 million of pretax income in the first quarter of 2023. Our effective tax rate was 25.3% in the first quarter of 2024, 26.9% for the fourth quarter of 2023, and 26.3% for the first quarter of 2023. The slight reduction in the effective tax rate for the first quarter of 2024 reflects the impact of credits to tax expense related to vested stock awards in the first quarter 2024, which occurs annually each February; these stock awards were larger in the first quarter of 2024 than the like 2023 period.

Income tax expense reflected all relevant statutory tax rates and GAAP accounting. There were no significant changes in our ability to utilize our deferred tax assets during the quarter ended March 31, 2024. We had no valuation reserve on the deferred tax assets as of March 31, 2024.

Financial Condition

Total assets decreased $106.7 million to $5.62 billion at March 31, 2024, from $5.72 billion at December 31, 2023, due primarily to the decrease of $24.0 million in securities available-for-sale, the decrease of $73.5 million in total loans, and the $5.6 million decrease in other assets. The decrease in securities available-for-sale was primarily due to paydowns and strategic sales. These decreases were partially offset by increases in premises and equipment of $2.0 million and BOLI of $1.2 million. We continue to actively assess potential investment opportunities to utilize our excess liquidity. Total deposits were $4.61 billion at March 31, 2024, an increase of $37.5 million from December 31, 2023, primarily due to seasonal tax refunds, as well as deposit rate specials.

(Dollars in thousands)

N/M – Not meaningful.

Securities available-for-sale decreased $24.0 million as of March 31, 2024 compared to December 31, 2023, and decreased $286.3 million compared to March 31, 2023. The decrease in the portfolio during the first quarter of 2024 was driven by paydowns totaling $30.7 million, securities sales totaling $5.3 million, and maturities totaling $2.0 million, partially offset by $15.7 million in purchases. We continue to seek to position the portfolio in higher credit quality, shorter duration securities with an appropriate mix of fixed- and floating-rate exposures.

(Dollars in thousands)

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

Total loans were $3.97 billion as of March 31, 2024, a decrease of $73.5 million from December 31, 2023. The decrease in total loans in the first three months of 2024, compared to December 31, 2023, was due primarily to paydowns, net of originations, within commercial of $45.1 million, commercial real estate – investor of $16.0 million and multifamily of $14.2 million offset by net increases in leases of $27.4 million from December 31, 2023. Total loans decreased $33.9 million from March 31, 2023 to March 31, 2024, primarily due to paydowns, net of originations, within commercial of $55.2 million, commercial real estate - investor of $38.4 million, and commercial real estate – owner occupied of $87.5 million, offset by net increases in leases of $139.8 million and multifamily of $28.5 million. As required by CECL, the balance (or amortized cost basis) of purchased credit deteriorated loans, or PCD loans (discussed below) is carried on a gross basis (rather than net of the associated credit loss estimate), and the expected credit losses for PCD loans are estimated and separately recognized as part of the allowance for credit losses, or ACL.

The quality of our loan portfolio is impacted not only by our credit decisions but also by the economic health of the communities in which we operate. Since we are located in a corridor with significant open space and undeveloped real estate, real estate lending (including commercial real estate, construction, residential, multifamily, and HELOCs) has been and continues to be a sizeable portion of our portfolio. These categories comprised 68.7% of the portfolio as of March 31, 2024, compared to 68.8% of the portfolio as of December 31, 2023. At March 31, 2024, our outstanding commercial real estate loans and undrawn commercial real estate commitments, excluding owner occupied real estate were equal to 268.8% of our Tier 1 capital plus allowance for credit losses, a decrease from 286.9% at December 31, 2023. We continue to oversee and seek to manage our loan portfolio in accordance with interagency guidance on risk management.

Asset Quality

Nonperforming loans consist of nonaccrual loans and loans 90 days or greater past due. Nonperforming loans decreased by $3.7 million to $65.1 million at March 31, 2024 from $68.8 million at December 31, 2023 and increased $586,000 from $64.5 million at March 31, 2023. Purchased credit deteriorated loans, or PCD loans, are purchased loans that, as of the date of acquisition, we determined had experienced a more-than-insignificant deterioration in credit quality since origination. PCD loans and their related deferred loan costs are included in our nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan. Management continues to carefully monitor loans considered to be in a classified status. Nonperforming loans as a percent of total loans were 1.6% as of March 31, 2024, 1.7% as of December 31, 2023, and 1.6% as of March 31, 2023. The distribution of our nonperforming loans is shown in the following table.

(Dollars in thousands)

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

N/M – Not meaningful.

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

(Dollars in thousands)

Loan charge-offs, net of recoveries, for the first quarter of 2024, prior linked quarter and year over year quarter are shown in the following table.

(Dollars in thousands)

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

2 The “Other” segment includes consumer and overdrafts.

Net charge-offs of $3.7 million were recorded for the first quarter of 2024, compared to net charge-offs of $15.5 million for the fourth quarter of 2023, and net charge-offs of $740,000 for the first quarter of 2023, reflecting continuing management attention to credit quality and remediation efforts. The net charge-offs for the first quarter of 2024 were primarily due to a $3.9 million charge off of a commercial real estate – owner occupied loan. The commercial real estate – owner occupied credit had a reported reserve allocation of $3.9 million prior to the first quarter of 2024 charge-off. We have continued our conservative loan valuations and aggressive recovery efforts on prior charge-offs.

Classified loans include nonaccrual loans 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.

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

(Dollars in thousands)

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

N/M - Not meaningful

Total classified loans and classified assets increased $2.7 million as of March 31, 2024 from December 31, 2023. The increase since December 31, 2023 is due to the additions of $15.9 million, the majority of which consisted of three relationships totaling $14.7 million. Commercial loans were the majority of the additions, consisting of seven loans totaling $11.6 million and one relationship in commercial real estate – owner occupied totaling $3.3 million. The additions are offset by $13.2 million of outflows, most driven by $6.3 million of loan rating upgrades, and a $3.9 million partial charge off. The increase from March 31, 2023 is primarily due to additions to commercial real estate – owner occupied. Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the ACL on loans as another measure of overall change in loan related asset quality, which is referred to as the “classified assets ratio.” The classified assets ratio was 21.33% for the period ended March 31, 2024, compared to 21.66% as of December 31, 2023, and 20.04% as of March 31, 2023.

Allowance for Credit Losses on Loans

The provision for credit losses, which includes a provision for losses on unfunded commitments, is a charge to earnings to maintain the allowance for credit losses (“ACL”) at a level consistent with management’s assessment of expected losses in the loan portfolio at the balance sheet date.

At March 31, 2024, our ACL on loans totaled $44.1 million, and our ACL on unfunded commitments, included in other liabilities, totaled $2.7 million. In the first quarter of 2024, we recorded provision expense on loans of $3.5 million, based on historical loss rates, our assessment of nonperforming loan metrics and trends, downward risk rating migrations, and estimated future credit losses, and a $44,000 reversal of provision on unfunded commitments, primarily due to an adjustment of historical benchmark assumptions, such as funding rates and the period used to forecast those rates, within the ACL calculation. These adjustments resulted in a $3.5 million net impact to the provision for credit losses for the first quarter of 2024.

Management estimates the amount of provision required on a quarterly basis and records the appropriate provision expense, or release of expense, to maintain an adequate reserve for all potential and estimated credit losses on loans, leases and unfunded commitments. The ACL on loans totaled $44.1 million as of March 31, 2024, $44.3 million as of December 31, 2023, and $53.4 million as of March 31, 2023. Our ACL on loans to total loans was 1.1% as of March 31, 2024, compared to 1.1% as of December 31, 2023 and 1.3% as of March 31, 2023. See Item 7 – Critical Accounting Estimates in the Management Discussion and Analysis in our 2023 Annual Report in Form 10-K for discussion of our ACL methodology on loans. Allocations of the ACL may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off.

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

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

The coverage ratio of the ACL on loans to nonperforming loans was 67.8% as of March 31, 2024, which was an increase from the coverage ratio of 64.4% as of December 31, 2023 and a decrease from 82.7% as of March 31, 2023. When measured as a percentage of average loans, our total ACL on loans was 1.10% at March 31, 2024, 1.10% at December 31, 2023, and 1.36% at March 31, 2023.

In management’s judgment, an adequate ACL has been established to encompass the current lifetime expected credit losses at March 31, 2024, and general changes in lending policy, procedures and staffing, as well as other external factors. However, there can be no assurance that actual losses will not exceed the estimated amounts in the future, based on unforeseen economic events, changes in business climates and the condition of collateral at the time of default and repossession. Continued volatility in the economic environment stemming from the impacts of and response to inflation, potential recession, and the war in Ukraine and the conflict in the Middle East, and the associated effects on our customers, or other factors, such as changes in business climates and the condition of collateral at the time of default or repossession, may revise our current expectations of future credit losses in future reporting periods.

Other Real Estate Owned

As of March 31, 2024, OREO totaled $5.1 million, reflecting no change from December 31, 2023, and an increase of $3.9 million from $1.3 million at March 31, 2023. There were no property additions or disposals in the OREO portfolio in the first quarter of 2024. No valuation adjustments occurred in the first quarter of 2024 or in the fourth quarter of 2023. In the first quarter of 2023, we recorded two write-downs totaling $273,000 as well as a write-up for $4,000, totaling a net $269,000 increase in valuation reserve.

(Dollars in thousands)

N/M - Not meaningful

In management’s judgment, the property valuation allowance as established presents OREO at current estimates of fair value less estimated costs to sell; however, there can be no assurance that additional losses will not be incurred on disposals or upon updates to valuations in the future.

(Dollars in thousands)

Deposits and Borrowings

(Dollars in thousands)

Total deposits were $4.61 billion at March 31, 2024, which reflects a $37.5 million increase from total deposits of $4.57 billion at December 31, 2023, and a decrease of $288.9 million from total deposits of $4.90 billion at March 31, 2023. The increase in deposits at March 31, 2024, compared to December 31, 2023, was primarily due to increases in time deposits of $58.7 million and money market and NOW accounts of $29.6 million, partially offset by decreases in noninterest bearing deposits of $35.0 million and savings accounts of $15.8 million. The decrease in deposits at March 31, 2024, compared to March 31, 2023, was primarily due to decreases in noninterest bearing deposits of $150.2 million, savings accounts of $153.1 million, and money market accounts of $102.9 million, partially offset by an increase in time deposits of $155.7 million. Total quarterly average deposits decreased $417.9 million, or 8.4%, in the year over year period, driven by declines in our average demand deposits of $183.3 million, and savings, NOW and money markets combined of $358.4 million, partially offset by an increase in average time deposits of $123.8 million year over year. In general, the bulk of the decline in deposits year over year can be characterized as rate sensitive with significant flows and transfers into investing activities.

The following table presents estimated insured and uninsured deposits at March 31, 2024 and December 31, 2023 by deposit type, as well as the weighted average rates for each year to date ending period.

(Dollars in thousands)

Deposits increased 0.8% for the three months ended March 31, 2024, which reflects that our efforts on retaining and acquiring new deposits have been effective. Competitive rate pressures have eased, however, there is a continued remix into our time deposits and interest bearing accounts, drawn by higher rates. Overall, our deposit level remains stable as we continue to monitor customer relationships and liquidity closely.

In addition to deposits, we used other liquidity sources for our funding needs in all periods presented, such as repurchase agreements and other short-term borrowings with the FHLBC. Securities sold under repurchase agreements totaled $33.5 million at March 31, 2024, a $7.1 million, or 26.7%, increase from $26.5 million at December 31, 2023, and an increase of $5.6 million, or 20.2%, from March 31, 2023. The outstanding balance of our short-term FHLBC borrowings was $220.0 million as of March 31, 2024, $405.0 million as of December 31, 2023, and $315.0 million as of March 31, 2023.

We are also indebted on $25.8 million of junior subordinated debentures, net of deferred issuance costs, as of March 31, 2024, which are related to the trust preferred securities issued by its statutory trust subsidiary, Old Second Capital Trust II (“Trust II”). The Trust II issuance converted from fixed to floating rate at three month LIBOR, which is now three month Term SOFR, plus 150 basis points beginning June 15, 2017. Upon conversion to a floating rate, we initiated a cash flow hedge which resulted in the total interest rate paid on this debt of 4.37% as of March 31, 2024, as compared to 6.77%, which was the rate paid during the period prior to the June 15, 2017 rate reset.

In the second quarter of 2021, we entered into Subordinated Note Purchase Agreements with certain qualified institutional buyers pursuant to which we issued $60.0 million in aggregate principal amount of our 3.50% Fixed-to-Floating Rate Subordinated Notes due April 15, 2031 (the “Notes”). We sold the Notes to eligible purchasers in a private offering, and the proceeds of this issuance were used for general corporate purposes. The Notes bear interest at a fixed annual rate of 3.50% through April 14, 2026, payable semi-annually in arrears. As of April 15, 2026 forward, the interest rate on the Notes will generally reset quarterly to a rate equal to three-month Term SOFR (as defined by the Note) plus 273 basis points, payable quarterly in arrears. The Notes have a stated maturity of April 15, 2031, and are redeemable, in whole are in part, on April 15, 2026, or any interest payment date thereafter, and at any time upon the occurrence of certain events. As of March 31, 2024, we had $59.4 million of subordinated debentures outstanding, net of deferred issuance costs.

In December 2016, we completed a $45.0 million senior note issuance. The notes had a ten-year term, and included interest payable semiannually at 5.75% for five years. Beginning December 31, 2021, the interest became payable quarterly at three month LIBOR plus 385 basis points. On June 30, 2023, the senior notes were redeemed in full. The remaining balance of deferred debt issuance costs of $362,000 related to these senior notes was recognized as interest expense as of June 30, 2023.

On February 24, 2023, we paid off the remaining $9.0 million balance in notes payable and other borrowings, resulting in no balance in this line item as of March 31, 2024, December 31, 2023, and March 31, 2023. The balance in notes payable was related to a $20.0 million term note originated with a correspondent bank in the first quarter of 2020, to facilitate the redemption of our Old Second Capital Trust I trust preferred securities and related junior subordinated debentures, completed on March 2, 2020.

Capital

As of March 31, 2024, total stockholders’ equity was $596.2 million, which was an increase of $18.9 million from $577.3 million as of December 31, 2023. This increase was largely attributable to net income of $21.3 million in the first three months of 2024, partially offset by $2.2 million of dividends paid to our common stockholders. In addition, total stockholders’ equity as of March 31, 2024 increased over December 31, 2023, due to a reduction in unrealized net losses on available-for-sale securities, which contributed to the overall decrease in accumulated other comprehensive loss of $580,000 in the first three months of 2024, due to changes in market interest rates. Total stockholders’ equity as of March 31, 2024 increased $99.3 million compared to March 31, 2023 due to net income year over year and the decrease in accumulated other comprehensive loss of $15.7 million year over year.

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

1 Amounts are shown inclusive of a capital conservation buffer of 2.50%.

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

As part of its response to the impact of the COVID-19 pandemic, in the first quarter of 2020, U.S. federal regulatory authorities issued an interim final rule that provided banking organizations that adopted CECL during the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital relative to regulatory capital determined under the prior incurred loss methodology, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during the initial two-year delay (i.e., a five-year transition in total). In connection with our adoption of CECL on January 1, 2020, we elected to utilize the five-year CECL transition. As of March 31, 2024, our capital measures exclude $951,000, which is the modified CECL transition adjustment.

As of March 31, 2024, the Company, on a consolidated basis, exceeded the minimum capital ratios to be deemed “well capitalized” and met the capital conservation buffer requirements. In addition to the above regulatory ratios, our GAAP common equity to total assets ratio, which is used as a performance measurement for capital analysis and peer comparisons, increased from 10.09% at December 31, 2023, to 10.62% at March 31, 2024. Our GAAP tangible common equity to tangible assets ratio was 9.04% at March 31, 2024, compared to 8.53% as of December 31, 2023. Our non-GAAP tangible common equity to tangible assets ratio, which management also considers a valuable performance measurement for capital analysis, increased from 8.56% at December 31, 2023, to 9.08% at March 31, 2024, primarily due to an increase in tangible common equity in the first quarter of 2024. The increase in tangible common equity was primarily due to an increase in retained earnings of $19.1 million.

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

(Dollars in thousands)

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

Liquidity

Liquidity is our ability to fund operations, to meet depositor withdrawals, to provide for customers’ credit needs, and to meet maturing obligations and existing commitments. Our liquidity principally depends on our cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and our ability to borrow funds. In the first quarter of 2024, we experienced a decrease in loans, while deposits trended up as the rates offered on our deposit products remain competitive to peers. We managed the change in our funding through borrowing from the Federal Home Loan Bank of Chicago (“FHLBC”) and sales of securities, which resulted in minimal losses and mitigated our interest rate risk profile. The bank failures that occurred in 2023 exemplify the potentially serious results of the unexpected inability of insured depository institutions to obtain needed liquidity to satisfy deposit withdrawal requests, including how quickly such requests can accelerate once uninsured depositors lose confidence in an institution’s ability to satisfy its obligations to depositors. We seek to ensure our funding needs are met by maintaining a level of liquidity through asset and liability management. We monitor our borrowing capacity at the FHLBC as part of our liquidity management process as supervised by our Asset and Liability Committee (“ALCO”) and reviewed by our Board of Directors. In addition, our senior management team monitors cash balances daily to ensure we have adequate liquidity to meet our operational and financing needs. As of March 31, 2024, our cash on hand liquidity totaled $98.1 million, a decrease of $2.1 million over cash balances held as of December 31, 2023.

Net cash inflows from operating activities were $47.3 million during the first three months of 2024, compared with net cash inflows of $35.0 million in the same period of 2023. Proceeds from sales of loans held-for-sale, net of funds used to originate loans held-for-sale, were a source of inflows for the first three months of 2024 compared to a source of outflows for the like period of 2023. Interest paid, net of interest received, combined with changes in other assets and liabilities were a source of inflows for the three months ended March 31, 2024 and source of outflows for the like period of 2023. The management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows. Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, as part of the balance sheet management process.

Net cash inflows from investing activities were $93.9 million in the three months ended March 31, 2024, compared to net cash outflows of $42.9 million in the same period in 2023. In the first three months of 2024, securities transactions accounted for net inflows of $22.3 million, and the principal change on loans accounted for net inflows of $70.0 million. In the first three months of 2023, securities transactions accounted for net inflows of $99.7 million, and principal on loans funded, net of paydowns, accounted for net outflows of $132.4 million.

Net cash outflows from financing activities in the three months ended March 31, 2024, were $143.2 million, compared with net cash outflows of $4.2 million in the three months ended March 31, 2023. Net deposit inflows in the first three months of 2024 were $37.6 million compared to net deposit outflows of $213.1 million in the first three months of 2023. Other short-term borrowings had $185.0 million of net cash outflows in the first three months of 2024, compared to net cash inflows of $225.0 million for other short-term borrowings in the first three months of 2023. Changes in securities sold under repurchase agreements accounted for inflows of $7.1 million and outflows of $4.3 million for the three months ended March 31, 2024 and 2023, respectively. Dividends paid on our common stock totaled $2.2 million for both the three months ended March 31, 2024 and 2023. Vesting of restricted stock accounted for inflows of $99,000 in the three months ended March 31, 2024, compared to no cash flows from vestings of restricted stock in the same period of 2023. The purchase of treasury stock in the first three months of 2024 due to shares acquired with equity award vestings resulted in outflows of $776,000, compared to cash outflows of $605,000 in the first three months of 2023 related to shares acquired from equity award vestings.

Cash and cash equivalents for the three months ended March 31, 2024, totaled $98.1 million, as compared to $100.1 million as of December 31, 2023 and $103.0 million as of March 31, 2023. The decrease in cash and cash equivalents for the three months ended March 31, 2024 was mainly attributable to the decrease in FHLB advances during the period, partially offset by the decrease in our loan portfolio, sales of securities, and the increase in customer deposits during the first three months of 2024. The year over year decrease is driven by decreased FHLB advances and increased customer use of deposits, partially offset by a decline in loans and sales of securities. In addition to cash and cash equivalents on hand or held as deposits with other financial institutions, we rely on funding sources from customer deposits, cash flows from securities available-for-sale and loans, and a line of credit with the FHLBC to meet potential liquidity needs. These sources of liquidity are immediately available to satisfy any funding requirements due to depositor or borrower demands through the ordinary course of our business. Additional sources of funding include a $30.0 million undrawn line of credit held by the Company with a third party financial institution, as well as unpledged securities available-for-sale.

Interest Rate Risk

As part of our normal operations, we are subject to interest-rate risk on the assets we invest in (primarily loans and securities) and the liabilities we fund (primarily customer deposits and borrowed funds). Fluctuations in interest rates may result in changes in the fair market values of our financial instruments, cash flows, and net interest income. Like most financial institutions, we have an exposure to changes in both short-term and long-term interest rates. A financial institution’s ability to be relatively unaffected by changes in interest rates is a good indicator of its capability to perform in a volatile rate environment. We mitigate the impact of interest rate volatility to the Bank by managing our rate sensitivity under various scenarios.

The Federal Reserve Board (“FRB”) held rates unchanged in the first quarter of 2024, which was widely expected by market participants. The timing of rate cuts and implied Federal Funds Rate for 2024 have shifted, with a current outlook for higher rates for a longer time given an increase in the latest Consumer Price Index (“CPI”) data and continued economic activity. The FRB continued to shrink its balance sheet, ending 2023 at $7.7 trillion, down from a peak of $8.7 trillion in March 2023.

We manage interest rate risk within guidelines established by policy which are intended to limit the amount of rate exposure. In practice, we seek to manage our interest rate risk exposure within our guidelines so that such exposure does not pose a material risk to our future earnings. We manage various market risks in the normal course of our operations, including credit, liquidity risk, and interest-rate risk. Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of our business activities and operations. In addition, since we do not hold a trading portfolio, we are not exposed to significant market risk from trading activities. Our interest rate risk exposures at March 31, 2024 and December 31, 2023 are outlined in the table below.

Our net income can be significantly influenced by a variety of external factors, including: overall economic conditions, policies and actions of regulatory authorities, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities other than those that are assumed, early withdrawal of deposits, exercise of call options on borrowings or securities, competition, a general rise or decline in interest rates, changes in the slope of the yield-curve, changes in historical relationships between indices (such as SOFR and Prime), and balance sheet growth or contraction. Our asset-liability committee seeks to manage interest rate risk under a variety of rate environments by structuring our on-balance sheet and off-balance sheet positions, which includes interest rate swap derivatives as discussed in Note 19 of our consolidated financial statements found in in our Annual Report on Form 10-K for the year ended December 31, 2023. We seek to monitor and manage interest rate risk within approved policy guidelines and limits. Asset and liability modeling and tracking is performed and presented to the asset-liability committee and the Board of Directors no less than quarterly. The presentations discuss our current and historical interest rate risk posture, shifts in the balance sheet composition, and the impact of interest rate movements on earnings and equity. Our current balance sheet is a moderately asset sensitive profile, as our variable rate assets reprice faster than our longer duration, low beta deposit base. The market events of failed liquidity management at other banks have been discussed and reviewed by the asset-liability committee. The committee concluded that we continue to have a strong liquidity position and no new liquidity risks were identified. Prudently, we added new measures to assess liquidity risk and enhanced our reports to segment deposits by insured, uninsured, collateralized deposits; and monitor the bank’s funding sources and uses on a regular basis.

We also have a Risk Committee, chaired by our Chief Risk Officer, which reports no less than quarterly to senior management as well as our Board of Directors regarding compliance with risk tolerance limits, key risk factor changes, both internally and externally, due to portfolio changes as well as market conditions. Our enterprise risk management framework is governed by this committee, with input being provided by line of business managers, senior management and the Board.

We use simulation analysis to quantify the impact of various rate scenarios on our net interest income. Specific cash flows, repricing characteristics, and embedded options of the assets and liabilities held by us are incorporated into the simulation model. Earnings at risk are calculated by comparing the net interest income of a stable interest rate environment to the net interest income of a different interest rate environment in order to determine the percentage change. As of March 31, 2024, our net interest income profile remained sensitive to earnings gains (in both dollars and percentage) should interest rates rise. Our profile is slightly more asset sensitive compared to December 31, 2023, due to a decrease in operating borrowings from principal return on Assets, mild increase in funding, and cashflow from earnings.

The following table summarizes the effect on annual income before income taxes based upon an immediate increase or decrease in interest rates of 0.5%, 1.0%, and 2.0%, with no change in the slope of the yield curve.

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

Effects of Inflation

In management’s opinion, although changes in interest rates affect our financial condition to a far greater degree than changes in the inflation rate, we monitor both. The annual US inflation rate for March 2024 was 3.5%, up from 3.4% quarter-over-quarter, while Core CPI continued to decline to 3.8%. Management believes the inflation rate will continue to trend down, albeit at a much slower rate than 2023. The downside risks of high inflation put upwards pressure to our expenses, which could impact our profits. Furthermore, higher costs of living weaken the financial condition of our borrowers which could affect our credit profile. Inflation has declined to a comfortable level and has minimal direct impact to our results.

Evaluation of Disclosure Controls and Procedures

The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of March 31, 2024. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of March 31, 2024, the Company’s internal controls were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified.

There were no changes in the Company’s internal controls over financial reporting during the quarter ended March 31, 2024, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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