Old Second Bancorp (OSBC) in Aurora, Ill., is trying to escape one of banking's deepest holes — and it could lead the way out for the dozen U.S. banks stuck there.

Protracted losses from soured real estate loans completely eroded Old Second's tangible common equity, the first line of defense against trouble and regulators' favored form of capital since the meltdown. It has had negative tangible common equity for more than a year, with its only cushion being its federal bailout funds and some other nonequity forms of capital.

Old Second's break came last week when the Treasury Department auctioned nearly all of its 73,000 preferred shares in Old Second for $24.7 million, experts say.

"I see the Tarp sale as positive since it takes the shares from the Treasury, which wasn't going to do anything with them, and puts them in the hands of folks that could make use of them," says Justin Barr, president of BankDATAWORKS.com. "Perhaps they can be used to bolster its existing equity position."

The $2 billion-asset Old Second is a step ahead of several other struggling institutions. Eleven other bank holding companies still owe money under the Troubled Asset Relief Program as of March 4 and had negative tangible common equity at yearend, according to data from SNL Financial.

But its problems are far from solved, and there are many questions about what happens next.

Whoever purchased the preferred shares "controls the destiny of the company," says Michael Iannaccone, president and managing partner of MDI Investments.

The Federal Reserve Board guards against undue influence by limiting an investor to no more than 33% of the total equity of an institution, says Robert Klingler, a partner at Bryan Cave. Since Old Second's tangible common equity is negative, then there were probably at least three buyers of the preferred stock, he adds. Treasury declined to disclose who purchased the shares.

Old Second did not return calls seeking comment for this story.

At Dec. 31 its tangible common equity to tangible assets was negative 0.13%, according to its fourth-quarter filing with the Securities and Exchange Commission. Experts say that ratio should be a positive 7% and that could increase under proposed Basel III requirements. Old Second would need $143.2 million in common equity on its balance sheet to have a 7% ratio, Iannaccone says.

Having negative tangible common equity does not immediately put the company in danger of failing. Its primary banking unit, Old Second National Bank, had a leverage ratio of 9.67% and a total risk-based capital ratio of 14.86% at Dec. 31, according to Federal Deposit Insurance Corp. data.

The parent company's capital included the preferred stock, $58 million in trust-preferred securities and $45 million in subordinated debt.

But the banking unit has been under a consent order with the Office of the Comptroller of the Currency since May 2011 that required it to boost its Tier 1 leverage ratio. And Old Second also entered into a written agreement with the Federal Reserve Bank of Chicago in July 2011. That agreement called for the parent company to serve as a source of strength for the banking unit.

The market embraced the auction because it gave Old Second a chance to survive.

Its shares closed Wednesday at $3.23, up 11% higher since the Tarp auction was announced Feb. 22.

The "successful offering gives common equity shareholder some hope that these investors are making a bet on the bank's survival," Barr says. "It has rallied others." 

Old Second basically has three options to return to healthy status.

It could try to convince the preferred shareholders to exchange their stake for common shares, Klingler says.

But this can be tricky. The Federal Reserve has to approve any transaction that would result in a preferred shareholder owning 10% of common stock. If the preferred shares were converted to common equity, Old Second would still need to raise an additional $70 million to reach a 7% tangible common equity to tangible assets ratio, Iannaccone says.

A conversion "would significantly dilute" the existing common shares, but common shareholders "wouldn't be wiped out," Barr says.

Secondly, Old Second could seek to raise more capital from its existing and new investors to help shore up its common equity, experts say.

The preferred shareholders could have purchased the stake with the intention of investing additional money into the company, Iannaccone says. "The entity that bought the preferred shares could have the intention of putting more money into the company," Iannaccone says. "Why else would you buy the preferred shares?"

But having negative tangible common equity might make it difficult to appeal to enough new investors to make a broader offering successful.

Finally, Old Second could separate the bank from its underwater holding company through bankruptcy, which is a more likely path for the company, Klingler and Barr say. More bank holding companies have explored this option in recent months and that trend that is likely to accelerate. In bankruptcy, the bank is sold in an auction under section 363 of the bankruptcy code.

However, a bankruptcy would wipe out common shareholders and poses other risks. Last year Treasury tried to delay the auction of First Place Bank — whose parent company had received $73 million from Tarp — to allow more time for other bidders. The judge denied the request but the purchaser, Talmer Bancorp, increased its stalking-horse bid to $60 million from $45 million.

Still, "the only road to recapitalization that I see is a holding company bankruptcy," Barr says.

Another lingering question is whether Old Second's business operations will improve. Its loan portfolio is heavily concentrated in real estate loans, making up more than 90% of its loans at Dec. 31, according to FDIC data. Old Second lost almost $200 million from 2009 through 2012 after recording elevated levels of nonperforming loans.

However, it reported earnings of $253,000 in the fourth quarter and did not record a provision for loan losses in the second half. Its nonperforming loans also fell almost 41%, to $82.6 million, their lowest level since 2008.

"My concern at the end of the day is that this is a terrific franchise, but I see an equity hole and I don't know how you fill," Barr says.

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