**Exhibit13.1**

 

 

 

 

 

FIRST OTTAWABANCSHARES, INC.

 

 

 

FORM OF 2007ANNUAL REPORT TO STOCKHOLDERS

 

 

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FIRST OTTAWA BANCSHARES,INC. AND SUBSIDIARY

Ottawa, Illinois

 

CONSOLIDATED FINANCIALSTATEMENTS

December 31, 2007,2006 and 2005

 

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARY

Ottawa, Illinois

 

CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2007, 2006 and 2005

 

 

 

 

 

 

INDEX

 

 

 

 

 

 

 
| SELECTED CONSOLIDATED FINANCIAL INFORMATION                                                   |                                                 | 1      |
|-----------------------------------------------------------------------------------------------|------------------------------------------------------|--------|
|                                                                                          |                                                 |   |
| MANAGEMENT’ S DISCUSSION  AND ANALYSIS OFFINANCIAL  CONDITIONS AND RESULTS OF OPERATIONS |                                                 | 2      |
|                                                                                          |                                                 |   |
| REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING  FIRM                                      |                                                 | 17     |
|                                                                                          |                                                 |   |
| FINANCIAL STATEMENTS                                                                          |                                                 |   |
|                                                                                          |                                                 |   |
|                                                                                          | CONSOLIDATED BALANCE SHEETS                          |   | 18 |
|                                                                                          |                                                 |   |   |
|                                                                                          | CONSOLIDATED STATEMENTS OF INCOME                    |   | 19 |
|                                                                                          |                                                 |   |   |
|                                                                                          | CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY |   | 20 |
|                                                                                          |                                                 |   |   |
|                                                                                          | CONSOLIDATED STATEMENTS OF CASH FLOWS                |   | 21 |
|                                                                                          |                                                 |   |   |
|                                                                                          | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS           |   | 22 |

 

 

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**SELECTED CONSOLIDATED FINANCIAL INFORMATION**

 

Thefollowing table sets forth selected consolidated financial and other data ofFirst Ottawa Bancshares, Inc. and its wholly owned subsidiary, the FirstNational Bank of Ottawa (the Bank) and the Bank’s wholly owned subsidiary,First Ottawa Financial Corporation, together referred to as the Company.  This information should be read inconjunction with the Company’s consolidated financial statements and notesthereto included herein.  All dollaramounts are in thousands, except per share information.

 
| ** **                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **2007**                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Statement of Income Data:**                                               |       |                             |       |   |   |   |   |   |   |   |   |
| Total interest income                                                       |       | $                                | 15,231     |   | $ | 15,274 |   | $ | 14,164 |   | $ | 13,537 |   | $ | 12,651 |   |
| Total interest expense                                                      |       | 6,282                            |       | 6,361 |   | 4,613 |   | 4,200 |   | 4,384 |   |
| Net interest income                                                         |       | 8,949                            |       | 8,913 |   | 9,551 |   | 9,337 |   | 8,267 |   |
| Provision for loan  losses                                                  |       | 180                              |       | 180 |   | 300 |   | 300 |   | 120 |   |
| Noninterest income                                                          |       | 2,349                            |       | 2,430 |   | 2,586 |   | 3,195 |   | 2,592 |   |
| Noninterest expenses                                                        |       | 7,934                            |       | 8,075 |   | 8,501 |   | 8,807 |   | 7,413 |   |
| Income before income  taxes                                                 |       | 3,184                            |       | 3,088 |   | 3,336 |   | 3,425 |   | 3,326 |   |
| Provision for income  taxes                                                 |       | 769                              |       | 753 |   | 791 |   | 797 |   | 867 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| Net income                                                                  |       | $                                | 2,415      |   | 2,335 |   | $ | 2,545 |   | $ | 2,628 |   | $ | 2,459 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Per Share Data:**                                                         |       |                             |       |   |   |   |   |   |   |   |   |
| Net income — basic                                                     |       | $                                | 3.72       |   | 3.59 |   | $ | 3.92 |   | $ | 4.03 |   | $ | 3.75 |   |
| Net income — diluted                                                   |       | 3.71                             |       | 3.59 |   | 3.90 |   | 4.03 |   | 3.75 |   |
| Cash dividends declared                                                     |       | 3.00                             |       | 3.00 |   | 3.00 |   | 3.00 |   | 3.00 |   |
| Book value at end of year  (1)                                              |       | 38.72                            |       | 38.08 |   | 37.43 |   | 36.54 |   | 35.54 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Selected Financial Ratios:**                                              |       |                             |       |   |   |   |   |   |   |   |   |
| Return on average  assets (1)                                               |       | .87                              |       | .82 | % | .87 | % | .88 | % | 1.00 | % |
| Return on average  equity (1)                                               |       | 9.58                             |       | 9.43 |   | 10.50 |   | 11.05 |   | 10.50 |   |
| Dividend payout ratio                                                       |       | 80.65                            |       | 83.57 |   | 76.53 |   | 74.44 |   | 79.79 |   |
| Average equity to  average assets (1)                                       |       | 9.09                             |       | 8.71 |   | 8.30 |   | 7.96 |   | 9.56 |   |
| Net interest margin  (tax equivalent)                                       |       | 3.78                             |       | 3.63 |   | 3.80 |   | 3.60 |   | 3.89 |   |
| Allowance for loan  losses to total loans at the end of period              |       | .96                              |       | .91 |   | .88 |   | .88 |   | .80 |   |
| Nonperforming loans to  total loans at the end of period (2)                |       | .76                              |       | .42 |   | .87 |   | 1.55 |   | 2.04 |   |
| Net loans charged off  to average total loans                               |       | .03                              |       | .04 |   | .09 |   | .13 |   | .21 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                                     |       |                             |       |   |   |   |   |   |   |   |   |
| Total assets                                                                |       | $                                | 269,231    |   | 278,053 |   | $ | 278,739 |   | $ | 288,659 |   | $ | 294,490 |   |
| Total earning assets                                                        |       | 243,718                          |       | 253,259 |   | 253,641 |   | 262,618 |   | 276,767 |   |
| Average assets                                                              |       | 275,777                          |       | 282,729 |   | 290,765 |   | 299,665 |   | 247,961 |   |
| Gross loans, including  loans held for sale                                 |       | 165,805                          |       | 160,938 |   | 152,860 |   | 134,493 |   | 131,948 |   |
| Allowance for loan  losses                                                  |       | 1,588                            |       | 1,463 |   | 1,344 |   | 1,174 |   | 1,049 |   |
| Total deposits                                                              |       | 240,377                          |       | 250,341 |   | 239,881 |   | 253,964 |   | 264,921 |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | —                           |       | — |   | 12,700 |   | 6,350 |   | — |   |
| Shareholders’ equity                                                   |       | 24,606                           |       | 23,509 |   | 22,858 |   | 23,852 |   | 24,655 |   |
|                                                                             |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)     Excludes unrealized gain (loss) onsecurities available-for-sale.

(2)   Includes total nonaccrual loans, impairedloans, and all other loans 90 days past due and still accruing interest.

 

 

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** **

**MANAGEMENT’SDISCUSSION AND ANALYSIS**

**OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

** **

The followingdiscussion and analysis is intended as a review of significant factorsaffecting the financial condition and results of operations of the Company forthe periods indicated.  The discussionshould be read in conjunction with the Company’s consolidated financialstatements and notes thereto and the selected consolidated financial datapresented herein.  In addition tohistorical information, the following Management’s Discussion and Analysis ofFinancial Condition and Results of Operations contains forward-lookingstatements that involve risks and uncertainties.  The Company’s actual results could differsignificantly from those anticipated in these forward-looking statements as aresult of certain factors discussed elsewhere in this report.

 

# **Overview**

# ** **

The Company’sprincipal business is conducted by the Bank and consists of a full range ofcommunity-based financial services, including commercial and retail banking.  The profitability of the Company’s operationsdepends primarily on its net interest income, provision for loan losses, otherincome, and other expenses.  Net interestincome is the difference between the income the Company receives on its loanand securities portfolios and its cost of funds, which consists of interestpaid on deposits and borrowings.  Theprovision for loan losses reflects the cost of credit risk in the Company’sloan portfolio.  Other income consists ofservice charges on deposit accounts, trust and farm management fee income,securities gains (losses), gains (losses) on sales of loans, and otherincome.  Other expenses include salariesand employee benefits, as well as occupancy and equipment expenses and othernoninterest expenses.

 

Net interestincome is dependent on the amounts and yields of interest-earning assets ascompared to the amounts of and rates on interest-bearing liabilities.  Net interest income is sensitive to changesin market rates of interest and the Company’s asset/liability managementprocedures in coping with such changes. The provision for loan losses is dependent upon management’s assessmentof the collectibility of the loan portfolio under current economic conditions.

 

Net income was$2.4 million for the year ended December 31, 2007 compared to $2.3 millionfor the year ended December 31, 2006. The return on average assets was .87% in 2007 compared to .82% in2006.  The return on average equityincreased to 9.58% in 2007 from 9.43% in 2006. This resulted primarily from the increase in net income and an increasein other comprehensive income of $859,000 in 2007 partially offset by thechange in average equity due to stock repurchases in 2007 and 2006.

 

Net income was$2.3 million for the year ended December 31, 2006 compared to $2.5 millionfor the year ended December 31, 2005. The return on average assets was .82% in 2006 compared to .87% in2005.  The return on average equitydecreased to 9.43% in 2006 from 10.50% in 2005. This resulted primarily from the decrease in net income partially offsetby the change in average equity due to stock repurchases in 2006 and 2005.

 

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# **CriticalAccounting Policies**

# ** **

The accounting andreporting policies of the Company are in accordance with accounting principlesgenerally accepted in the United States of America and conform to generalpractices within the banking industry.  The Company’s significantaccounting policies are described in detail in the notes to the Company’s consolidatedfinancial statements. The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions.  The Company’s financial condition and resultsof operations can be affected by these estimates and assumptions and areintegral to the understanding of reported results. Critical accounting policiesare those policies that management believes are the most important to theportrayal of the Company’s financial condition and results of operations, andthey require management to make estimates that are difficult, subjective, orcomplex.

 

***Allowancefor Loan Losses*****.**Theallowance for loan losses provides coverage for probable losses inherent in theCompany’s loan portfolio.  Managementevaluates the adequacy of the allowance for loan losses each quarter based onchanges, if any, in underwriting activities, the loan portfolio composition(including product mix and geographic, industry or customer-specificconcentrations), trends in loan performance, regulatory guidance and economicfactors. This evaluation is inherently subjective, as it requires the use ofsignificant management estimates. Many factors can affect management’sestimates of specific and expected losses, including volatility of defaultprobabilities, rating migrations, loss severity and economic conditions.  The allowance is increased through provisionscharged to operating earnings and reduced by net charge-offs.

 

The Companydetermines the amount of the allowance based on relative risk characteristicsof the loan portfolio.  The allowancerecorded for commercial loans is based on reviews of individual creditrelationships and an analysis of the migration of commercial loans and actualloss experience.  The allowance recordedfor homogeneous consumer loans is based on an analysis of loan mix, riskcharacteristics of the portfolio, fraud loss and bankruptcy experiences, andhistorical losses, adjusted for current trends, for each homogeneous categoryor group of loans.  The allowance forloan losses relating to impaired loans is based on the loan’s observablemarket price, the collateral for certain collateral-dependent loans, or thediscounted cash flows using the loan’s effective interest rate.

 

Regardless of theextent of the Company’s analysis of customer performance, portfolio trends orrisk management processes, certain inherent but undetected losses are probablewithin the loan portfolio.  This is due toseveral factors including inherent delays in obtaining information regarding acustomer’s financial condition or changes in their unique business conditions,the judgmental nature of individual loan evaluations, collateral assessmentsand the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting theidentification and estimation of losses for larger non-homogeneous credits andthe sensitivity of assumptions utilized to establish allowances for homogenousgroups of loans are among other factors. The Company estimates a range of inherent losses related to theexistence of these exposures.  The estimates are based upon the Company’sevaluation of imprecise risk associated with the commercial and consumerallowance levels and the estimated impact of the current economic environment.

 

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***MortgageServicing Rights.*** Mortgage servicing rights (“MSRs”) associated with loans originatedand sold, where servicing is retained, are capitalized and included in otherintangible assets in the consolidated balance sheet.  The value of the capitalized servicing rightsrepresents the present value of the future servicing fees arising from theright to service loans in the portfolio. Critical accounting policies for MSRs relate to the initial valuationand subsequent impairment tests.  Themethodology used to determine the valuation of MSRs requires the developmentand use of a number of estimates, including anticipated principal amortizationand prepayments of that principal balance. Events that may significantly affect the estimates used are changes ininterest rates, mortgage loan prepayment speeds and the payment performance ofthe underlying loans.  The carrying valueof the MSRs is periodically reviewed for impairment based on a determination offair value.  For purposes of measuringimpairment, the servicing rights are compared to a valuation prepared based ona discounted cash flow methodology, utilizing current prepayment speeds anddiscount rates.  Impairment, if any, isrecognized through a valuation allowance and is recorded as amortization ofintangible assets.

 

***Derivatives.*******As a part of the Company’s funding strategy,derivative financial instruments, all of which are interest rate swaparrangements, are used to reduce exposure to changes in interest rates forcertain financial instruments.  These derivatives are accounted for byrecognizing the fair value of the contracts on the balance sheet.  Thevaluation of these derivatives is considered critical because carrying assetsand liabilities at fair value inherently results in more financial statementvolatility.  The fair values and the information used to record valuationadjustments for the interest rate swaps and related deposit products are providedby third parties.

 

Additionally, theCompany has purchased certificate of deposits which contain an equity relatedembedded derivative component.  The initial investment in the certificateof deposit is not at risk but the return on the investment is based onappreciation in the S&P 500 Index. Accordingly, the fair value of the embedded derivative is recorded atfair value as an adjustment to the certificate of deposit and interest income.

 

***StockCompensation***.Grants under the Company’s stock incentive plan are accounted for underthe provisions of Statement of Accounting Standards (SFAS) No. 123R,applying the fair value method and the use of an option pricing model toestimate the value of the options granted. The stock options are granted with an exercise price equal to the marketprice at the date of grant.  Resultingcompensation expense, under the stock options, is measured andrecorded based on the estimated value of the options.

 

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**ConsolidatedFinancial Condition**

 

Total assets at December 31,2007 were $269.2 million compared to $278.1 million at December 31, 2006,a decrease of $8.8 million, or 3.2%. Despite the decrease in our total assets, our total loans increased 2.7%in 2007 to $163.8 million.  Real estateloans increased by $18.1  million during2007, due to an effort by management to increase the size of the commercial andresidential real estate portfolios, and also due to a reclassification ofcommercial loans to better reflect the nature of the credits.  Commercial and agricultural loans decreased$11.2 million during 2007 due primarily to a reclassification betweencommercial and commercial real estate portfolios. These increases in commercialand residential real estate loans were partially offset by the decrease ininstallment loans of $2.0 million due to a general decline in indirect lendingvolume and more stringent underwriting guidelines on consumer loans. Investmentsecurities decreased by $15.2 million, and certificates of deposit held for investment purposes decreased by$2.3 million.  The increase in loans wasfunded by the decrease in securities and certificates of deposit held forinvestment purposes. Federal funds increased $3.2 million as total depositsdecreased $10.0 million.  This decreasewas primarily a result of management’s decision to reduce the number of specialrate deposit products which were designed to attract customers in new marketsin 2006 and the first half of 2007. Premises and equipment decreased by$236,000 due to normal depreciation and a reduction in capital expenditures onexisting buildings.

 

Total equity was$24.6 million at December 31, 2007 compared to $23.5 million at December 31,2006.  The increase was primarily theresult of a decrease in the unrealized gain on securities available-for-sale,net of tax, of $859,000, and $200,000 in additional paid in capital related tothe Company’s stock option plan. Dividends declared of $1.9 million and the repurchase of Company commonstock for $335,000 were offset by net income of $2.4 million.

 

# **ConsolidatedResults of Operations**

# ** **

# **2007Compared to 2006**

# ** **

*NetInterest Income.*  Net interest income was $8.9 million in 2007and 2006.  Interest income on earningassets decreased $43,000 in 2007 from 2006. This decrease was primarily attributable to decreased interest incomeearned on taxable and non taxable securities of $356,000, and certificates ofdeposit held for investment of $63,000. Increased interest income earned on the loan portfolio of $398,000helped to offset the decreased securities income.  The increase is attributable to increases inaverage balances and also average yields available in the marketplace in2007.  Interest expense on interest-bearingliabilities decreased $79,000 as a result of a decrease in the average balancesof liabilities in 2007 compared to 2006. The net interest margin on a tax equivalent basis increased to 3.78% in2007 from 3.63% in 2006.  The primaryreason for the increase in the net interest margin was the result of an increasein the market rates earned on assets during the continuing gradual reallocationof assets to loans which earn at higher rates than other types ofinterest-bearing assets.

 

*Provisionfor Loan Losses.*  The provision for loan losses was $180,000 in2007 and 2006.  As of December 31,2007, the allowance for loan losses totaled $1.6 million, or 0.96% of totalloans, compared to $1.5 million, or .91% of total loans, at December 31,2006.  The increase in the 

 

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allowance for loanlosses in 2007 was influenced by the continued growth in the loan portfolio andwas not a direct result of the current economy or the quality of our loanportfolio.

 

The amounts of theprovision and allowance for loan losses are influenced by current economicconditions, actual loss experience, industry trends and other factors,including real estate values in the Company’s market area and management’sassessment of current collection risks within the loan portfolio.  Along with other financial institutions,management shares a concern for the outlook of the economy for 2008.  Even though there are indications of emergingstrength, it is uncertain if this strength is sustainable. If it is not sustainable,borrowers may experience difficulty, and the level of non-performing loans,charge-offs, and delinquencies could rise and require increases in theprovision.  Regulatory agencies havewarned of possible higher charge-offs in the industry.  The allowance for loan losses representsmanagement’s estimate of probable incurred losses based on informationavailable as of the date of the financial statements.  The allowance for loan losses is based onmanagement’s evaluation of the collectibility of the loan portfolio, includingpast loan loss experience, known and inherent risks in the nature and volume ofthe portfolio, information about specific borrower situations and estimatedcollateral values, and economic conditions.

 

Management has concluded that the allowance for loanlosses was adequate at December  31, 2007.  However, there can be no assurance that theallowance for loan losses will be adequate to cover all losses.

 

*NoninterestIncome.*  The Company’s noninterest income decreased$81,000, or 3.3%, compared to 2006. Noninterest income decreased primarily due to a decrease in otherincome. Other income decreased by $144,000, or 15.9%, compared to 2006.  This decrease was primarily due to a $195,000decrease in the market value of derivatives related to index poweredcertificates of deposit held for investments and for customers of theBank.  Gains on loan sales to thesecondary market decreased $2,000 to $29,000 in 2007 compared to 2006 as aresult of fewer originations of residential real estate loans because of thegeneral increase in interest rates in 2007. Service charges on deposit accounts increased by $52,000, or 5.4%, to $1.0 million.  Trust and farm managementfee income remained constant at $540,000 in 2007 and 2006.

 

*Noninterest Expense.*  The Company’snoninterest expense was $7.9 million in 2007 and $8.1 million for 2006.  Salaries and benefits, whichis the largest component of non-interest expense, decreased $125,000, to $4.4million in 2007.  Decreases in supplies expense of $25,000,amortization of core deposit intangible expense of $51,000, and other expensesof $121,000 were partially offset by an increase in occupancy and equipmentexpense of $4,000, professional fees of $132,000, data processing expense of$45,000 in 2007.  Other expense wasreduced due to decreased collection expenses, decreased secondary mortgagemarket expenses, and decreased miscellaneous operating expenses.  Professional fees increased due to theresolution of two ongoing litigation matters during 2007. Income tax expenseincreased by $16,000 compared to 2006. The Company’s effective tax ratedecreased slightly in 2007.

 

*IncomeTaxes.*  The Company’s tax rate varied from statutoryrates principally due to interest income from tax-exempt securities andloans.  The Company’s effective tax ratewas 24.1% and 25.2% for 2007 and 2006.

 

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# **2006Compared to 2005**

# ** **

*NetInterest Income.*  Net interest income was $8.9 million and $9.6million in 2006 and 2005.  Interestincome on earning assets increased $1.1 million in 2006 from 2005.  This increase was primarily attributable toincreased interest income earned on the loan portfolio of $1.8 million, andfederal funds sold of $138,000. The increases were attributable to increases inaverage balances and also average yields available in the marketplace in 2006.Increases were offset by decreased interest income earned on taxable and nontaxable securities of $575,000, and certificates of deposit held for investmentof $316,000.  Interest expense oninterest-bearing liabilities increased $1.7 million as a result of an increasein the average rate paid on liabilities of 82 basis points, from 1.98% in 2005to 2.80% in 2006.  The net interestmargin on a tax equivalent basis decreased to 3.63% in 2006 from 3.80% in2005.  The primary reason for thedecrease in the net interest margin was the result of an increase in the marketrates offered on liabilities, and a more rapid upward repricing of liabilitiesduring a gradual reallocation of assets to loans which earn at higher ratesthan other types of interest-bearing assets.

 

*Provisionfor Loan Losses.*  The provision for loan losses was $180,000 in2006 compared to $300,000 in 2005.  As ofDecember 31, 2006, the allowance for loan losses totaled $1.5 million, or..91% of total loans, compared to $1.3 million, or .88% of total loans, at December 31,2005.  The increase in the allowance forloan losses in 2006 was influenced by the continued growth in the loanportfolio.

 

*NoninterestIncome.*  The Company’s noninterest income decreased$156,000, or 6.0%, compared to 2005. Noninterest income decreased primarily due to losses on securities soldof $13,000 in 2006, a decrease of $185,000 compared to the gains experienced in2005, as the Company sold securities for a gain in 2005.  Gains on loan sales to the secondary marketdecreased $60,000 to $31,000 in 2006 compared to 2005 as a result of feweroriginations of residential real estate loans because of the general increasein interest rates in 2006.  Servicecharges on deposit accounts decreased by $147,000, or 13.2%, to $1.0million.  Other income increased by$192,000, or 26.9%, compared to 2005. This increase was primarily due to a $371,000 increase in the marketvalue of derivatives related to index powered certificates of deposit held forinvestments and for customers of the Bank. Trust and farm management fee income increased by $44,000, to $540,000in 2006 compared to 2005.

 

*Noninterest Expense.*  The Company’snoninterest expense was $8.1 million in 2006 and $8.5 million for 2005.  Salaries and benefits, whichis the largest component of non-interest expense, decreased $104,000, to $4.5million in 2006.  Decreases in occupancy and equipmentexpense of $21,000, supplies expense of $63,000, professional fees of $96,000,amortization of core deposit intangible expense of $64,000, and other expensesof $100,000 were partially offset by an increase in data processing expense of$22,000 in 2006.  Other expense wasreduced due to decreased collection expenses, decreased secondary mortgage marketexpenses, and decreased miscellaneous operating expenses.  Income tax expense decreased by $38,000compared to the prior year. The Company’s effective tax rate increased slightlydue to an increase in state income tax expense.

 

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*IncomeTaxes.*  The Company’s tax rate varied from statutoryrates principally due to interest income from tax-exempt securities andloans.  The Company’s effective tax ratewas 25.2% and 23.7% for 2006 and 2005.

 

 

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The components ofthe changes in net interest income are shown below.  Changes in net interest income are allocatedbetween amounts attributed to changes in rate and changes in volume for thevarious categories of interest-earning assets and interest-bearing liabilities.

 

Analysis ofChanges in Interest Income and Expense

($000s)

 
| ** **                                             | ** ** | **2007 – 2006**    | ** ** | **2006 – 2005**    | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                             | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|                                                   |       | ** **              | ** ** | **Change**              | ** ** | **Change** | ** ** | ** ** | ** ** | **Change** | ** ** | **Change** | ** ** |
|                                                   |       | **Total**               | ** ** | **Due to**              | ** ** | **Due to** | ** ** | **Total** | ** ** | **Due to** | ** ** | **Due to** | ** ** |
|                                                   |       | **Change**              | ** ** | **Volume**              | ** ** | **Rate** | ** ** | **Change** | ** ** | **Volume** | ** ** | **Rate** | ** ** |
| INTEREST INCOME                                        |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
|                                                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| Loans                                                  |       | $                       | 386        |                    | $          | 106 |   | $ | 280 |   | $ | 1,883 |   | $ | 1,264 |   | $ | 619 |   |
| Investment CDs                                         |       | (63                     | )          | (62                     | )          | (1 | ) | (316 | ) | (281 | ) | (35 | ) |
| Securities                                             |       | (391                    | )          | (388                    | )          | (3 | ) | (626 | ) | (618 | ) | (8 | ) |
| Federal funds sold                                     |       | (22                     | )          | (12                     | )          | (10 | ) | 138 |   | 26 |   | 112 |   |
| Total interest income                                  |       | (90                     | )          | (356                    | )          | 266 |   | 1,079 |   | 391 |   | 688 |   |
|                                                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| INTEREST EXPENSE                                       |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
|                                                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| NOW and money market                                   |       | 182                     |       | 125                     |       | 57 |   | 671 |   | (127 | ) | 798 |   |
| Savings                                                |       | (6                      | )          | (9                      | )          | 3 |   | (10 | ) | (10 | ) | — |   |
| Time deposits                                          |       | (232                    | )          | (665                    | )          | 433 |   | 1,033 |   | 55 |   | 978 |   |
| Repurchase agreements                                  |       | —                  |       | —                  |       | — |   | (4 | ) | — |   | (4 | ) |
| Borrowings                                             |       | —                  |       | —                  |       | — |   | (8 | ) | — |   | (8 | ) |
| Federal funds purchased                                |       | (23                     | )          | (37                     | )          | 14 |   | 66 |   | 38 |   | 28 |   |
| Total interest expense                                 |       | (79                     | )          | (586                    | )          | 507 |   | 1,748 |   | (45 | ) | 1,793 |   |
|                                                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| Net interest earnings                                  |       | (11                     | )          | 230                     |       | (241 | ) | (669 | ) | 436 |   | (1,105 | ) |
| Tax equivalent  adjustment                             |       | 47                      |       | —                  |       | 47 |   | 31 |   | — |   | 31 |   |
|                                                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| Net interest earnings after tax equivalent  adjustment |       | $                       | 36         |                    | 230        |   | (194 | ) | (638 | ) | $ | 436 |   | $ | (1,074 | ) |
|                                                        |            |                         |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

### **Volume/rate variances are allocatedto the volume variance and the rate variance on an absolute basis.  Tax-exempt income is reflected on a fully tax-equivalentbasis utilizing a 34% rate for municipal securities and tax-exempt loans.**

### ** **

 

# **Interest-Earning Assets and Interest-BearingLiabilities**

# ** **

Thefollowing table sets forth the average balances, net interest income andexpense, and average yields and rates for the Company’s interest-earning assetsand interest-bearing liabilities for the indicated years on a tax-equivalentbasis assuming a 34% tax rate.

 

9

----

 

# ** **

# **Analysisof Average Balances, Tax Equivalent Yields and Rates**

Years Ended December 31,2007, 2006 and 2005

(in Thousands)

 
| ** **                                                                | ** ** | **2007**        | ** ** | **2006**     | ** ** | **2005**    | ** ** |
|---------------------------------------------------------------------------|------------|-----------------|------------|--------------|------------|-------------|------------|
| ** **                                                                | ** ** | **Average**     | ** ** | ** **   | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
|                                                                      | ** ** | **Balance (4)** | ** ** | **Interest** | ** ** | **Rate**    | ** ** | **Balance (4)** | ** ** | **Interest** | ** ** | **Rate** | ** ** | **Balance (4)** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| ASSETS                                                                    |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1) (3)                                                        |       | $               | 160,565    |         | $          | 11,992      |       | 7.47 | % | $ | 159,145 |   | $ | 11,606 |   | 7.29 | % | $ | 141,807 |   | $ | 9,723 |   | 6.86 | % |
| Investment CDs                                                            |       | 6,017           |       | 176          |       | 2.93        |       | 8,128 |   | 239 |   | 2.94 |   | 17,685 |   | 555 |   | 3.14 |   |
| Securities (2) (5)                                                   |       | 76,180          |       | 3,192        |       | 4.19        |       | 85,448 |   | 3,583 |   | 4.19 |   | 100,187 |   | 4,209 |   | 4.20 |   |
| Federal funds sold                                                        |       | 6,891           |       | 349          |       | 5.06        |       | 7,127 |   | 371 |   | 5.21 |   | 6,635 |   | 233 |   | 3.51 |   |
| Interest-earning assets                                                   |       | 249,653         |       | 15,709       |       | 6.29        |       | 259,848 |   | 15,799 |   | 6.08 |   | 266,314 |   | 14,720 |   | 5.53 |   |
| Noninterest-earning  assets (6)                                           |       | 23,297          |       |         |       |        |       | 22,881 |   |   |   |   |   | 29,365 |   |   |   |   |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Average assets                                                            |       | $               | 272,950    |         |       |        |       |   | $ | 282,729 |   |   |   |   |   | $ | 295,679 |   |   |   |   |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money market                                                      |       | $               | 98,592     |         | $          | 2,223       |       | 2.25 | % | $ | 93,042 |   | $ | 2,041 |   | 2.19 | % | $ | 98,826 |   | $ | 1,370 |   | 1.39 | % |
| Savings                                                                   |       | 23,418          |       | 124          |       | .53         |       | 25,067 |   | 130 |   | .52 |   | 27,083 |   | 140 |   | .52 |   |
| Time deposits                                                             |       | 90,970          |       | 3,835        |       | 4.22        |       | 106,750 |   | 4,067 |   | 3.81 |   | 105,301 |   | 3,034 |   | 2.88 |   |
| Repurchase agreements                                                     |       | —          |       | —       |       | —      |       | — |   | — |   | — |   | 232 |   | 4 |   | 1.72 |   |
| Federal funds purchased                                                   |       | 1,798           |       | 100          |       | 5.56        |       | 2,470 |   | 123 |   | 4.98 |   | 1,715 |   | 57 |   | 3.32 |   |
| Borrowings                                                                |       | —          |       | —       |       | —      |       | — |   | — |   | — |   | 126 |   | 8 |   | 6.35 |   |
| Interest-bearing liabilities                                              |       | 214,778         |       | 6,282        |       | 2.92        |       | 227,329 |   | 6,361 |   | 2.80 |   | 233,283 |   | 4,613 |   | 1.98 |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income (2)                                                   |       |            |       | 9,427        |       |        |       |   |   | 9,438 |   |   |   |   |   | 10,107 |   |   |   |
| Net yield on interest-earning assets                                      |       |            |       |         |       | 3.78        |       |   |   |   |   | 3.63 |   |   |   |   |   | 3.80 |   |
| Interest-bearing liabilities to earning assets ratio                      |       |            |       |         |       | 86.03       |       |   |   |   |   | 87.49 |   |   |   |   |   | 87.60 |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities                                          |       | 33,927          |       |         |       |        |       | 32,175 |   |   |   |   |   | 38,959 |   |   |   |   |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                                                 |       | 24,245          |       |         |       |        |       | 23,225 |   |   |   |   |   | 23,487 |   |   |   |   |   |
| Average liabilities and shareholders’ equity                         |       | $               | 272,950    |         |       |        |       |   | $ | 282,729 |   |   |   |   |   | $ | 295,679 |   |   |   |   |   |
| Tax equivalent  adjustment                                                |       |            |       | 478          |       |        |       |   |   | 525 |   |   |   |   |   | 556 |   |   |   |
| Net interest income as reported in the consolidated  statements of income |       |            |       | $            | 8,949      |        |       |   |   |   | $ | 8,913 |   |   |   |   |   | $ | 9,551 |   |   |   |

----

(1)          Interest income on loans includes loanorigination and other fees of $403 for 2007, $98 for 2006, and $136 for 2005.

(2)          Loan and securities income is reflectedon a fully tax-equivalent basis utilizing a 34% rate for municipal securitiesand tax-exempt loans.

(3)          Non-accrual loans are included in averageloans.

(4)          Average balances are derived from theaverage daily balances.

(5)          Rate information is calculated based uponaverage amortized cost.

(6)          Average balance information includes an averagevaluation allowance for securities of $(1,444) , $(2,327) and $(1,228),respectively.

 

10

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# **Impactof Accounting Changes**

 

**FutureAccounting Pronouncements**

 

**EmergingIssues Task Force Issue 06-4.** In September 2006, the Emerging IssuesTask Force (EITF) reached a consensus regarding the accounting for entitieswith split-dollar life insurance arrangements that provide an employee with aspecified benefit that is not limited to an employee’s active serviceperiod.  In reaching its consensus, theEITF determined that an employer should recognize as a liability the futurebenefits to be provided to employees beyond the employees active serviceperiod.  In the case of split-dollar planthat provides a death benefit to the employees designated beneficiary and thebenefit is provided to the employee beyond their active service period, anentity should accrue a liability during the employee’s active service periodfor the cost of maintaining the life insurance policy during the employee’sretirement period.   EITF Issue 06-4 iseffective for fiscal years beginning after December 15, 2007 with earlierapplication permitted.  Entities shouldrecognize the effects of applying EITF Issue 06-4 either as a change inaccounting principle through a cumulative-effect adjustment to retainedearnings or other components of equity as of the beginning of the year of adoptionor as a change in accounting principle through retrospective application to allprior periods.

 

On September 6,2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157,Fair Value Measurements.  SFAS 157clarifies the fair value measurement objective, its application in GAAP andestablishes a framework that builds on current practice and requirements.  The framework simplifies and, whereappropriate, codifies the similar guidance in existing pronouncements andapplies broadly to financial and non-financial assets and liabilities.  The Statement clarifies the definition offair value as the price that would be received from selling an asset or paid totransfer a liability in an orderly transaction between market participants at themeasurement date, known as an exit-price definition of fair value.  It also provides further guidance on thevaluation techniques to be used in estimating fair value.  Current disclosures about the use of fairvalue to measure assets and liabilities are expanded in this Statement.  The disclosures focus on the methods used forfair value measurements and apply whether the assets and liabilities aremeasured at fair value in all periods, such as trading securities, or in onlysome periods, such as impaired assets. The Statement is effective for all financial statements issued forfiscal years beginning after November 15, 2007 as well as for interimperiods within such fiscal years.  FASBStaff Position (FSP).  FSP FAS 157-2delays the effective date of SFAS 157 for nonfinancial assets and nonfinancialliabilities, except for those items that are recognized or disclosed at fairvalue in the financial statements on a recurring basis (at least annually)until fiscal years beginning after November 15, 2008.  The Company is currently evaluating theimpact of this Statement and the related FSP on its financial statements.

 

 

11

----

 

 

In February 2007,the FASB issued Statement of Financial Accounting Standards No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities*- Including an amendment of FASB Statement No. 115.  SFAS 159 allows companies to reportselected financial assets and liabilities at fair value. The changes in fairvalue are recognized in earnings and the assets and liabilities measured underthis methodology are required to be displayed separately in the balancesheet.  The main intent of the Statement is to mitigate the difficulty indetermining reported earnings caused by a “mixed-attribute model” (or reportingsome assets at fair value and others using a different valuation attribute suchas amortized cost). The project is separated into two phases.  This firstphase addresses the creation of a fair value option for financial assets andliabilities.  A second phase will address creating a fair value option forselected non-financial items. SFAS 159 is effective for all financialstatements issued for fiscal years beginning after November 15,2007.  The Company is currently evaluating the impact of this Statement onits financial statements.

 

 

12

----

 

 

**QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

TheCompany uses overall risk sensitivity to monitor and manage exposure to suddenchanges in interest rates.  The Company’soverall interest rate sensitivity is demonstrated by a net interest incomeanalysis.  Net interest income analysismeasures the change in net interest income in the event of hypothetical changesin interest rates.  This analysisassesses the risk of change in net interest income in the event of sudden andsustained 1.0% increases and decreases in market interest rates.  The tables below present the Company’sprojected changes in net income for the various rate shock levels for theperiods ended December 31, 2007 and 2006.

 
| ** ** | ** ** | **2007 Net Interest Income** | ** ** |
|------------|------------|------------------------------|------------|
| ** ** | ** ** | ** **                   | ** ** | ** ** | ** ** | **Percentage** | ** ** |
| ** ** | ** ** | **Amount**                   | ** ** | **Change** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** **                   | ** ** | **(Dollars  in Thousands)** | ** ** | ** ** | ** ** |
|       |       |                         |       |   |   |   |   |
| +100 bp    |       | $                            | 2,823      |   | $ | 59 |   | 2.1 | % |
| Base       |       | 2,764                        |       | — |   | — |   |
| -100 bp    |       | 2,743                        |       | (21 | ) | (0.7 | )% |
|            |            |                              |            |  |  |  |  |  |  |

 
| ** ** | ** ** | **2006 Net Interest Income** | ** ** |
|------------|------------|------------------------------|------------|
| ** ** | ** ** | ** **                   | ** ** | ** ** | ** ** | **Percentage** | ** ** |
| ** ** | ** ** | **Amount**                   | ** ** | **Change** | ** ** | **Change** | ** ** |
| ** ** | ** ** | ** **                   | ** ** | **(Dollars  in Thousands)** | ** ** | ** ** | ** ** |
|       |       |                         |       |   |   |   |   |
| +100 bp    |       | $                            | 2,564      |   | $ | (36 | ) | (1.4 | )% |
| Base       |       | 2,600                        |       | — |   | — |   |
| -100 bp    |       | 2,683                        |       | 83 |   | 3.2 | % |
|            |            |                              |            |  |  |  |  |  |  |

 

Asshown above, at December 31, 2007, the effect of an immediate 100 basispoint increase in interest rates would decrease the Company’s net income by2.1%, or approximately $59,000.  Theeffect of an immediate 100 basis point decrease in rates would increase theCompany’s net interest income by 0.7%, or approximately $21,000.  The Company’s Board of Directors has set arisk tolerance limit of 10% of estimated net interest income for the succeeding12 months based on an immediate 200 basis point change in market prices.

 

Interestrate sensitivity reflected modest exposure in an increasing rate environment atthe end of 2007 and 2006.  Overall netinterest income sensitivity decreased in 2007 compared to 2006.

 

 

13

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**Liquidityand Capital Resources**

 

TheCompany’s primary sources of funds are deposits, repurchase agreements, andproceeds from principal and interest payments on loans and securities.  While maturities and scheduled amortizationof loans and securities and calls of securities are predictable sources of funds,deposit flows and mortgage prepayments are greatly influenced by generalinterest rates, economic conditions, and competition.  The Company generally manages the pricing ofits deposits to be competitive and to increase core deposit relationships.

 

Liquiditymanagement is both a daily and long-term responsibility of management.  The Company adjusts its investments in liquidassets based upon management’s assessment of (i) expected loan demand, (ii) expecteddeposit flows, (iii) yields available on interest-earning deposits andsecurities, and (iv) the objectives of its asset/liability managementprogram.  Excess liquid assets areinvested generally in interest-earning overnight deposits and short- andintermediate-term U.S. Government and agency obligations.

 

TheCompany’s cash flows are comprised of three primary classifications:  cash flows from operating activities,investing activities, and financing activities. Cash flows provided by operating activities were $5.0 million, $2.6million, and $4.6 million for the years ended December 31, 2007, 2006 and2005.  Net cash from investing activitiesconsisted primarily of principal collections on loans and proceeds frommaturation and sales of securities offset by disbursements for loanoriginations and the purchase of securities. Net cash from financing activities consisted primarily of changes in netdeposits and short-term borrowings partially offset by dividends paid and thepurchase of Company stock.

 

TheCompany’s most liquid assets are cash and short-term investments.  The levels of these assets are dependent onthe Company’s operating, financing, lending, and investing activities duringany given year.  At December 31,2007, cash and short-term investments totaled $16.5 million.  The Company has other sources of liquidity ifa need for additional funds arises, including securities maturing within oneyear and the repayment of loans.  TheCompany may also utilize the sale of securities available-for-sale, federalfunds lines of credit from correspondent banks, and borrowings from the FederalHome Loan Bank of Chicago and Marshall and Ilsley Bank.

 

 

14

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Thefollowing table discloses contractual obligations and commercial commitments ofthe Company as of December 31, 2007:

 
| ** **                         | ** ** | ** ** | ** ** | **Less Than** | ** ** | ** **           | ** ** | ** **           | ** ** | **After**   | ** ** |
|------------------------------------|------------|------------|------------|---------------|------------|----------------------|------------|----------------------|------------|-------------|------------|
| ** **                         | ** ** | **Total**  | ** ** | **1 Year**    | ** ** | **1 – 3 Years** | ** ** | **4 – 5 Years** | ** ** | **5 Years** | ** ** |
|                               |       |       |       |          |       |                 |       |                 |       |        |       |
| Lines of credit(1)                 |       | $          | 15,102     |          | $          | 10,103               |       | $                    | 2,894      |        | $          | 264 |   | $ | 1,841 |   |
| Data processing   contract payable |       | 1,280      |       | 223           |       | 445                  |       | 445                  |       | 167         |       |
| Standby letters of  credit(1)      |       | 531        |       | 531           |       | —               |       | —               |       | —      |       |
|                               |       |       |       |          |       |                 |       |                 |       |        |       |
|                               |       | $          | 16,913     |          | $          | 10,857               |       | $                    | 3,339      |        | $          | 709 |   | $ | 2,008 |   |

----

(1) Represents amounts committed to customers.

 

During2007 and 2006, the Company repurchased 4,269 and 300 shares of common stock for$335,000 and $22,000.

 

Capitalprovides the foundation for future growth. Regulatory agencies have developed minimum guidelines by which theadequacy of a financial institution’s capital may be evaluated.  At December 31, 2007, all of theCompany’s ratios exceeded the levels required under regulatory guidelines asshown in Note 15 of the Consolidated Financial Statements.

 

**Facilities**

 

First OttawaBancshares, Inc. is the holding company for First National Bank ofOttawa.  The Company is headquartered inOttawa, Illinois and operates four offices in Ottawa, two branches in Streator,a branch in Morris, a branch in Yorkville and a recently opened loan productionoffice in Minooka.

 

**Impact ofInflation and Changing Prices**

 

Thefinancial statements and related data presented herein have been prepared inaccordance with accounting principles generally accepted in the United Statesof America, which require the measurement of financial position and operatingresults in terms of historical dollars without considering changes in the relativepurchasing power of money over time due to inflation.  The primary impact of inflation on theoperations of the Company is reflected in increased operating costs.  Unlike most industrial companies, virtuallyall of the assets and liabilities of a financial institution are monetary innature.  As a result, interest ratesgenerally have a more significant impact on a financial institution’sperformance than does inflation.  Interestrates do not necessarily move in the same direction or to the same extent asthe prices of goods and services.

 

 

15

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**SAFEHARBOR STATEMENT**

 

Thisdocument (including information incorporated by reference) contains, and futureoral and written statements of the Company and its management may contain,forward-looking statements, within the meaning of such term in the PrivateSecurities Litigation Reform Act of 1995, with respect to the financialcondition, results of operations, plans, objectives, future performance andbusiness of the Company.  Forward-lookingstatements, which may be based upon beliefs, expectations and assumptions ofthe Company’s management and on information currently available to management,are generally identifiable by the use of words such as “believe,” “expect,”“anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,”“should” or other similar expressions. Additionally, all statements in this document, including forward-lookingstatements, speak only as of the date they are made, and the Company undertakesno obligation to update any statement in light of new information or futureevents.

 

TheCompany’s ability to predict results or the actual effect of future plans orstrategies is inherently uncertain. The factors which could have a materialadverse effect on the operations and future prospects of the Company and itssubsidiaries include those discussed in “Management’s Discussion and Analysisof Financial Condition and Results of Operations”.  In addition to the risk factors described inthat section, there are other factors that may impact any public company,including ours, which could have a material adverse effect on the operationsand future prospects of the Company and its subsidiaries.  These risks and uncertainties should beconsidered in evaluating forward-looking statements and undue reliance shouldnot be placed on such statements.

 

 

16

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**Report ofIndependent Registered Public Accounting Firm**

 

Audit Committee,Board of Directors and Stockholders

First OttawaBancshares, Inc.

Ottawa, Illinois

 

We have auditedthe accompanying consolidated balance sheets of First Ottawa Bancshares, Inc.as of December 31, 2007 and 2006, and the related consolidated statementsof income, shareholders’ equity and cash flows for each of the three years inthe period ended December 31, 2007. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted ouraudits in accordance with the standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  The Company is notrequired to have, nor were we engaged to perform, an audit of its internalcontrol over financial reporting.  Ouraudits included consideration of internal control over financial reporting as abasis for designing auditing procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion,the consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of First Ottawa Bancshares, Inc.as of December 31, 2007 and 2006, and the results of its operations andits cash flows for each of the three years in the period ended December 31,2007, in conformity with accounting principles generally accepted in the UnitedStates of America.

 

 

 

BKD, LLP

 

Indianapolis,Indiana

March 14,2008

 

17

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FIRST OTTAWABANCSHARES, INC.

CONSOLIDATEDBALANCE SHEETS

December 31,2007 and 2006

(In thousands,except share and per share data)

 

 
| ** **                                                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                                                   |       |     |       |     |       |
|                                                                         |       |     |       |     |       |
| Cash and due from banks                                                      |       | $        | 10,209     |     | $          | 7,544 |   |
| Interest-bearing demand deposits                                             |       | 6,290    |       | 3,100    |       |
| Cash and cash equivalents                                                    |       | 16,499   |       | 10,644   |       |
| Certificates of deposit                                                      |       | 3,808    |       | 6,135    |       |
| Investment securities available for sale                                     |       | 67,815   |       | 83,085   |       |
| Loans, net of allowance for loan losses of $1,588  and $1,463                |       | 163,837  |       | 159,475  |       |
| Premises and equipment                                                       |       | 7,517    |       | 7,753    |       |
| Interest receivable and other assets                                         |       | 9,755    |       | 10,961   |       |
|                                                                         |       |     |       |     |       |
| Total assets                                                                 |       | $        | 269,231    |     | $          | 278,053 |   |
|                                                                         |       |     |       |     |       |
| **Liabilities and Shareholders’  Equity**                               |       |     |       |     |       |
|                                                                         |       |     |       |     |       |
| **Liabilities**                                                              |       |     |       |     |       |
| Deposits                                                                     |       | $        | 240,377    |     | $          | 250,341 |   |
| Other liabilities                                                            |       | 4,248    |       | 4,203    |       |
| Total liabilities                                                            |       | 244,625  |       | 254,544  |       |
|                                                                         |       |     |       |     |       |
| **Commitments and Contingencies**                                            |       |     |       |     |       |
|                                                                         |       |     |       |     |       |
| **Shareholders’ Equity**                                                |       |     |       |     |       |
|                                                                         |       |     |       |     |       |
| Preferred stock, $1 par value  Authorized and unissued – 20,000 shares  |       | —   |       | —   |       |
| Common stock, $1 par value, 1,000,000 shares   authorized and 750,000 issued |       | 753      |       | 750      |       |
| Additional paid-in capital                                                   |       | 4,300    |       | 4,103    |       |
| Retained earnings                                                            |       | 26,113   |       | 25,644   |       |
| Treasury stock, at cost – 105,220 and 100,951 shares                    |       | (6,102   | )          | (5,767   | )          |
| Accumulated other comprehensive loss                                         |       | (458     | )          | (1,221   | )          |
| Total shareholders’ equity                                              |       | 24,606   |       | 23,509   |       |
|                                                                         |       |     |       |     |       |
| Total liabilities and shareholders’ equity                              |       | $        | 269,231    |     | $          | 278,053 |   |

 

See notes to consolidated financial statements.

 

 

18

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FIRST OTTAWABANCSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31,2007, 2006 and 2005

(In thousands,except share and per share data)

 
| ** **                                                              | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                    |       |     |       |     |       |     |       |
| **Interest and Dividend Income**                                        |       |     |       |     |       |     |       |
| Loans receivable                                                        |       | $        | 11,945     |     | $          | 11,547   |       | $ | 9,684 |   |
| Investment securities                                                   |       |     |       |     |       |     |       |
| Taxable                                                                 |       | 1,924    |       | 2,211    |       | 2,688    |       |
| Exempt from federal tax                                                 |       | 837      |       | 906      |       | 1,004    |       |
| Federal funds sold                                                      |       | 349      |       | 371      |       | 233      |       |
| Interest-bearing deposits                                               |       | 176      |       | 239      |       | 555      |       |
| Total interest and dividend income                                      |       | 15,231   |       | 15,274   |       | 14,164   |       |
|                                                                    |       |     |       |     |       |     |       |
| **Interest Expense**                                                    |       |     |       |     |       |     |       |
| Deposits                                                                |       | 6,182    |       | 6,238    |       | 4,544    |       |
| Repurchase agreements                                                   |       | —   |       | —   |       | 4        |       |
| Federal funds purchased                                                 |       | 100      |       | 123      |       | 57       |       |
| Other interest expense                                                  |       | —   |       | —   |       | 8        |       |
| Total interest expense                                                  |       | 6,282    |       | 6,361    |       | 4,613    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Net Interest Income**                                                 |       | 8,949    |       | 8,913    |       | 9,551    |       |
| Provision for loan losses                                               |       | 180      |       | 180      |       | 300      |       |
| **Net Interest Income After  Provision for Loan Losses**                |       | 8,769    |       | 8,733    |       | 9,251    |       |
| ** **                                                              |       |     |       |     |       |     |       |
| **Noninterest Income**                                                  |       |     |       |     |       |     |       |
| Service fee income                                                      |       | 1,017    |       | 965      |       | 1,112    |       |
| Trust and farm management fee income                                    |       | 540      |       | 540      |       | 496      |       |
| Net realized gains (losses) on sales of available-  for-sale securities |       | —   |       | (13      | )          | 172      |       |
| Net gains on sales of loans                                             |       | 29       |       | 31       |       | 91       |       |
| Other income                                                            |       | 763      |       | 907      |       | 715      |       |
| Total noninterest income                                                |       | 2,349    |       | 2,430    |       | 2,586    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Noninterest Expenses**                                                |       |     |       |     |       |     |       |
| Salaries and employee benefits                                          |       | 4,422    |       | 4,547    |       | 4,651    |       |
| Occupancy and equipment expense                                         |       | 1,263    |       | 1,259    |       | 1,280    |       |
| Data processing fees                                                    |       | 438      |       | 393      |       | 371      |       |
| Supplies                                                                |       | 123      |       | 148      |       | 211      |       |
| Professional fees                                                       |       | 480      |       | 348      |       | 444      |       |
| Amortization of core deposit intangibles                                |       | 204      |       | 255      |       | 319      |       |
| Other expenses                                                          |       | 1,004    |       | 1,125    |       | 1,225    |       |
| Total noninterest expenses                                              |       | 7,934    |       | 8,075    |       | 8,501    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Income Before Income Tax**                                            |       | 3,184    |       | 3,088    |       | 3,336    |       |
| Income tax expense                                                      |       | 769      |       | 753      |       | 791      |       |
|                                                                    |       |     |       |     |       |     |       |
| **Net Income**                                                          |       | $        | 2,415      |     | $          | 2,335    |       | $ | 2,545 |   |
|                                                                    |       |     |       |     |       |     |       |
| **Earnings Per Share — Basic**                                     |       | $        | 3.72       |     | $          | 3.59     |       | $ | 3.92 |   |
| ** **                                                              |       |     |       |     |       |     |       |
| **Earnings Per Share — Diluted**                                   |       | $        | 3.71       |     | $          | 3.59     |       | $ | 3.90 |   |
| ** **                                                              |       |     |       |     |       |     |       |
| **Average Shares Outstanding**                                          |       | 649,009  |       | 649,605  |       | 649,830  |       |

 

See notes to consolidated financial statements.

 

 

19

----

 

FIRST OTTAWABANCSHARES, INC.

CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS’ EQUITY

Years Ended December 31,2007, 2006 and 2005

(In thousands, exceptshare and per share data)

 

 
| ** **                                                                     | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Treasury  Stock** | ** ** | **Accumulated  Other  Comprehensive  Income  (Loss)** | ** ** | **Total**  | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|------------|------------|
| ** **                                                                     | ** ** | ** **        | ** ** | ** **                       | ** ** | ** **             | ** ** | ** **          | ** ** | ** **                                            | ** ** | ** ** | ** ** |
| **Balances, January 1, 2005**                                             |       | 750               |       | 4,018                            |       | 24,662                 |       | (5,656              | )          | 78                                                    |       | 23,852     |       |
| Comprehensive income                                                           |       |              |       |                             |       |                   |       |                |       |                                                  |       |       |       |
| Net income                                                                     |       |              |       |                             |       | 2,545                  |       |                |       |                                                  |       | 2,545      |       |
| Other comprehensive income,   net of tax - unrealized   losses on securities   |       |              |       |                             |       |                   |       |                |       | (1,522                                                | )          | (1,522     | )          |
| Comprehensive income                                                           |       |              |       |                             |       |                   |       |                |       |                                                  |       | 1,023      |       |
| Cash dividends ($3.00 per share)                                               |       |              |       |                             |       | (1,949                 | )          |                |       |                                                  |       | (1,949     | )          |
| Stock options vested                                                           |       |              |       | 21                               |       |                   |       |                |       |                                                  |       | 21         |       |
| Purchase of 1,260 treasury shares                                              |       |              |       |                             |       |                   |       | (89                 | )          |                                                  |       | (89        | )          |
|                                                                           |       |              |       |                             |       |                   |       |                |       |                                                  |       |       |       |
| **Balances, December 31,  2005**                                          |       | 750               |       | 4,039                            |       | 25,258                 |       | (5,745              | )          | (1,444                                                | )          | 22,858     |       |
| Comprehensive income                                                           |       |              |       |                             |       |                   |       |                |       |                                                  |       |       |       |
| Net income                                                                     |       |              |       |                             |       | 2,335                  |       |                |       |                                                  |       | 2,335      |       |
| Other comprehensive income, net of tax — unrealized  losses on securities |       |              |       |                             |       |                   |       |                |       | 240                                                   |       | 240        |       |
| Comprehensive income                                                           |       |              |       |                             |       |                   |       |                |       |                                                  |       | 2,575      |       |
| Cash dividends ($3.00 per share)                                               |       |              |       |                             |       | (1,949                 | )          |                |       |                                                  |       | (1,949     | )          |
| Stock options vested                                                           |       |              |       | 38                               |       |                   |       |                |       |                                                  |       | 38         |       |
| Stock options exercised                                                        |       |              |       | 26                               |       |                   |       |                |       |                                                  |       | 26         |       |
| Purchase of 300 treasury shares                                                |       |              |       |                             |       |                   |       | (22                 | )          |                                                  |       | (22        | )          |
| Adjustment to initially apply FASB Statement  No. 158, net of tax         |       |              |       |                             |       |                   |       |                |       | (17                                                   | )          | (17        | )          |
|                                                                           |       |              |       |                             |       |                   |       |                |       |                                                  |       |       |       |
| **Balances, December 31,  2006**                                          |       | 750               |       | 4,103                            |       | 25,644                 |       | (5,767              | )          | (1,221                                                | )          | 23,509     |       |
| Comprehensive income                                                           |       |              |       |                             |       |                   |       |                |       |                                                  |       |       |       |
| Net income                                                                     |       |              |       |                             |       | 2,415                  |       |                |       |                                                  |       | 2,415      |       |
| Other comprehensive income,   net of tax                                       |       |              |       |                             |       |                   |       |                |       |                                                  |       |       |       |
| Unrealized gains on   securities                                               |       |              |       |                             |       |                   |       |                |       | 859                                                   |       | 859        |       |
| Net loss relating to   benefit liability                                       |       |              |       |                             |       |                   |       |                |       | (96                                                   | )          | (96        | )          |
| Comprehensive income                                                           |       |              |       |                             |       |                   |       |                |       |                                                  |       | 3,178      |       |
| Cash dividends ($3.00 per share)                                               |       |              |       |                             |       | (1,946                 | )          |                |       |                                                  |       | (1,946     | )          |
| Stock options vested                                                           |       |              |       | 77                               |       |                   |       |                |       |                                                  |       | 77         |       |
| Stock options exercised                                                        |       | 3                 |       | 120                              |       |                   |       |                |       |                                                  |       | 123        |       |
| Purchase of 4,269 treasury shares                                              |       |              |       |                             |       |                   |       | (335                | )          |                                                  |       | (335       | )          |
|                                                                           |       |              |       |                             |       |                   |       |                |       |                                                  |       |       |       |
| **Balances, December 31,  2007**                                          |       | $                 | 753        |                             | $          | 4,300                  |       | $                   | 26,113     |                                                  | $          | (6,102     | )          | $ | (458 | ) | $ | 24,606 |   |
|                                                                                |            |                   |            |                                  |            |                        |            |                     |            |                                                       |            |            |            |  |  |  |  |  |  |

 

See notes toconsolidated financial statements.

 

 

20

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FIRST OTTAWABANCSHARES, INC.

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

Years Ended December 31,2007, 2006 and 2005

(In thousands,except per share data)

 

 
| ** **                                                                | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                      |       |     |       |     |       |     |       |
| **Operating Activities**                                                  |       |     |       |     |       |     |       |
| Net income                                                                |       | $        | 2,415      |     | $          | 2,335    |       | $ | 2,545 |   |
| Items not requiring (providing) cash                                      |       |     |       |     |       |     |       |
| Provision for loan losses                                                 |       | 180      |       | 180      |       | 300      |       |
| Premium amortization on securities, net                                   |       | 360      |       | 380      |       | 421      |       |
| Derivative valuation adjustment                                           |       | 477      |       | (325     | )          | (373     | )          |
| Depreciation and amortization                                             |       | 699      |       | 696      |       | 822      |       |
| Loans originated for sale                                                 |       | (1,174   | )          | (1,453   | )          | (4,119   | )          |
| Proceeds from sale of loans                                               |       | 1,203    |       | 868      |       | 4,637    |       |
| Gains/losses on sales of securities, net                                  |       | —   |       | 13       |       | (172     | )          |
| Gains on sales of loans held for sale                                     |       | (29      | )          | (31      | )          | (91      | )          |
| Stock options vested                                                      |       | 77       |       | 38       |       | 21       |       |
| Change in                                                                 |       |     |       |     |       |     |       |
| Interest receivable and other assets                                      |       | 859      |       | (956     | )          | 419      |       |
| Interest payable and other liabilities                                    |       | (51      | )          | 903      |       | 151      |       |
| Net cash provided by operating activities                                 |       | 5,016    |       | 2,648    |       | 4,561    |       |
|                                                                      |       |     |       |     |       |     |       |
| **Investing Activities**                                                  |       |     |       |     |       |     |       |
| Purchases of securities available for sale                                |       | (221     | )          | (3,212   | )          | (4,729   | )          |
| Proceeds from maturities and paydowns of securities  available for   sale |       | 16,433   |       | 6,481    |       | 9,364    |       |
| Proceeds from sales of securities available for sale                      |       | —   |       | 4,247    |       | 6,830    |       |
| Purchases of certificates of deposit                                      |       | (3,082   | )          | —   |       | (3,460   | )          |
| Proceeds from maturities of certificates of deposit                       |       | 4,932    |       | 5,684    |       | 16,986   |       |
| Net change in loans                                                       |       | (4,859   | )          | (7,723   | )          | (19,392  | )          |
| Net purchases of premises and equipment                                   |       | (242     | )          | (153     | )          | (903     | )          |
| Net cash provided by investing activities                                 |       | 12,961   |       | 5,324    |       | 4,696    |       |
|                                                                      |       |     |       |     |       |     |       |
| **Financing Activities**                                                  |       |     |       |     |       |     |       |
| Net change in                                                             |       |     |       |     |       |     |       |
| Deposits                                                                  |       | (9,964   | )          | 10,460   |       | (14,083  | )          |
| Federal funds purchased                                                   |       | —   |       | (12,700  | )          | 7,100    |       |
| Securities sold under agreements to repurchase                            |       | —   |       | —   |       | (750     | )          |
| Proceeds from borrowings                                                  |       | —   |       | —   |       | 27       |       |
| Repayment of borrowings                                                   |       | —   |       | —   |       | (586     | )          |
| Purchase of treasury stock                                                |       | (335     | )          | (22      | )          | (89      | )          |
| Stock options exercised                                                   |       | 123      |       | 26       |       | —   |       |
| Dividends paid                                                            |       | (1,946   | )          | (1,949   | )          | (1,949   | )          |
| Net cash used in financing activities                                     |       | (12,122  | )          | (4,185   | )          | (10,330  | )          |
|                                                                      |       |     |       |     |       |     |       |
| **Net Change in Cash and Cash  Equivalents**                              |       | 5,855    |       | 3,787    |       | (1,073   | )          |
|                                                                      |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents,  Beginning of Year**                         |       | 10,644   |       | 6,857    |       | 7,930    |       |
|                                                                      |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, End  of Year**                               |       | $        | 16,499     |     | $          | 10,644   |       | $ | 6,857 |   |
|                                                                      |       |     |       |     |       |     |       |
| **Additional Cash Flows  Information**                                    |       |     |       |     |       |     |       |
| Interest paid                                                             |       | $        | 6,427      |     | $          | 6,030    |       | $ | 4,482 |   |
| Income tax paid, net of refunds                                           |       | 788      |       | 821      |       | 729      |       |
| Transfers from  loans to foreclosed real estate                           |       | 317      |       | 200      |       | 468      |       |

 

See notes to consolidated financial statements.

 

 

21

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FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 1 —SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

Natureof Operations and Principles of Consolidation:  First Ottawa Bancshares, Inc. is a bankholding company whose principal activity is the ownership and management of itswholly-owned subsidiary, First National Bank of Ottawa (the Bank).  The Bank is primarily engaged in providing afull range of banking and financial services to individual and corporatecustomers in LaSalle, Grundy and surrounding counties in Illinois.  The Bank is subject to competition from otherfinancial institutions.  The Bank issubject to the regulation of certain federal and state agencies and undergoesperiodic examinations by those regulatory authorities.  The consolidated financial statements includeFirst Ottawa Bancshares, Inc. and the Bank, and the Bank’s wholly ownedsubsidiary, First Ottawa Financial Corporation, together referred to as theCompany.  Intercompany transactions andbalances are eliminated in consolidation.

 

Useof Estimates:  Toprepare financial statements in conformity with accounting principles generallyaccepted in the United States of America, management makes estimates andassumptions based on available information. These estimates and assumptions affect the amounts reported in thefinancial statements and the disclosures provided, and future results coulddiffer.  The allowance for loan losses,fair values of financial instruments, derivatives, and status of contingenciesare particularly subject to change.

 

Securities:  Securities are classified as available-for-salewhen they might be sold before maturity. Securities available-for-sale are carried at fair value, with unrealizedholding gains and losses reported, net of tax, as other comprehensiveincome.  Equity securities includeFederal Home Loan Bank stock and Federal Reserve Bank stock, which arerestricted securities that are carried at cost, and a mutual fund investmentthat is carried at fair value. Securities are written down to fair value, with a charge to expense,when a decline in fair value is not temporary.

 

Realizedgains and losses on sales are determined using the amortized cost of thespecific security sold.  Interest incomeincludes amortization of purchase premiums and discounts.

 

Declinesin the fair value of securities below their cost that are other-than-temporaryare reflected as realized losses. In estimating other-than-temporary losses,management considers: (1) the length of time and extent that fair valuehas been less than cost; (2) the financial condition and near termprospects of the issuer; and (3) the Company’s ability and intent to holdthe security for a period sufficient to allow for any anticipated recovery infair value.

 

Derivatives:  All derivative instruments are recorded attheir fair values and the change in the fair value of a derivative is includedin interest income.  If derivativeinstruments are designated as hedges of fair values, both the change in thefair value of the hedge and the hedged item are included in currentearnings.  Fair value adjustments relatedto cash flow hedges are recorded in other comprehensive income and reclassifiedto earnings when the hedged transaction is reflected in earnings.  Ineffective portions of hedges are reflectedin earnings as they occur.

 

LoansHeld for Sale: Mortgage loans originated and intended for sale in the secondary marketare carried at the lower of cost or fair value in the aggregate.  Net unrealized losses, if any, are recognizedthrough a valuation allowance by charges to income.

 

Loans:  Loans are reported at the principal balanceoutstanding, net of deferred loan fees and costs and the allowance for loanlosses.  Interest income is reported onthe interest method and includes amortization of net deferred loan fees andcosts over the loan term.  Mortgage loansoriginated and intended for sale in the secondary market are carried at thelower of cost, net of deferred loan fees, or estimated fair value in theaggregate.  Interest income is notreported when full loan repayment is in doubt, typically when payments are pastdue over 90 days.  Payments received onsuch loans are reported as principal reductions.

 

 

22

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FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 1 —SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES** (Continued)

 

Allowancefor Loan Losses:  Theallowance for loan losses is established as losses are estimated to haveoccurred through a provision for loan losses charged to income.  Loan losses are charged against the allowancewhen management believes the uncollectibility of a loan balance isconfirmed.  Subsequent recoveries, ifany, are credited to the allowance. Management estimates the allowance balance required based on past loanloss experience, known and inherent risks in the portfolio, information aboutspecific borrower situations and estimated collateral values, economicconditions, and other factors. Allocations of the allowance may be made for specific loans, but theentire allowance is available for any loan that, in management’s judgment,should be charged off.

 

Loanimpairment is reported when full payment under the loan terms is notexpected.  Impairment is evaluated intotal for smaller-balance loans of similar nature, such as residential mortgageand consumer loans, and on an individual loan basis for other loans.  If a loan is impaired, a portion of theallowance is allocated so that the loan is reported, net, at the present valueof estimated future cash flows using the loan’s existing rate or at the loan’sobservable market price or the fair value of collateral if the loan iscollateral dependent.  Loans areevaluated for impairment when payments are delayed, typically 90 days or more,or when the internal grading system indicates a doubtful classification.

 

Premisesand Equipment:  Assetcost is reported net of accumulated depreciation.  Buildings and related components aredepreciated using the straight-line method with useful lives ranging from 7 to39 years.  Furniture, fixtures andequipment are depreciated using the straight-line method with useful livesranging from 5 to 15 years.  These assetsare reviewed for impairment when events indicate that the carrying amount maynot be recoverable.  Maintenance andrepairs are charged to expense and improvements are capitalized.

 

OtherReal Estate:  Realestate owned, other than that used in the normal course of business, is carriedat the lower of cost basis (fair value at date of foreclosure) or fair valueless estimated costs to sell.  Anyreduction to fair value from a related loan at the time of acquisition isaccounted for as a loan loss.  Anysubsequent reductions in fair value less estimated costs to sell are recordedby charges to expense and a corresponding valuation allowance on the relatedreal estate.

 

MortgageServicing Rights: Servicing rights are recognized as assets for the allocated value ofservicing rights retained on loans sold and are classified with interestreceivable and other assets in the consolidated balance sheets.  Servicing rights are expensed in proportionto and over the period of estimated net servicing revenues.  Impairment is evaluated based on the fairvalue of the rights using groupings of the underlying loans as to interest ratesand then, secondarily, as to geographic and prepayment characteristics.  Fair value is determined using prices forsimilar assets with similar characteristics, when available, or based upondiscounted cash flows using market—based assumptions.  Any impairment of a grouping is reported as avaluation allowance.  There was no suchvaluation allowance recorded at December 31, 2007 and 2006, and mortgageservicing rights were not material at either date.

 

Intangible Assets:  Core deposit intangibles are being amortizedon an accelerated basis over 11 years and are periodically evaluated as to therecoverability of their carrying value.

 

Goodwill:   Goodwill is reviewed for impairment annuallywith any loss recognized through the income statement.

 

StockOptions:  The Companyhas a stock-based compensation plan, which is more fully described in Note12.  The Company accounts for this planunder the recognition and measurement principles of Statement of FinancialAccounting Standards No. 123(R), *Share-Based Payment*,using the fair value method.  The valueof options granted under this plan is charged to expense over the vestingperiod of the grants.

 

 

23

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 1 —SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES** (Continued)

 

IncomeTaxes:  Income taxexpense is the sum of the current year income tax due or refundable and thechange in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future taxconsequences of temporary differences between the carrying amounts and taxbases of assets and liabilities, computed using enacted tax rates.  A valuation allowance, if needed, reducesdeferred tax assets to the amount expected to be realized.

 

TheCompany or one of its subsidiaries files income tax returns in the U.S. federaland Illinois jurisdictions.  With fewexceptions, the Company is no longer subject to U.S. federal, state and localexaminations by tax authorities for years before 2004.

 

TheCompany adopted the provisions of the Financial Accounting Standards Board(FASB) Interpretation No. 48 (FIN 48), *Accounting for Uncertaintyin Income Taxes — an interpretation of FASB Statement No. 109*,on January 1, 2007.  FIN 48prescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return.  FIN 48 also providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition. As a result of the implementation of FIN 48, the Company did notidentify any uncertain tax positions that it believes should be recognized inthe financial statements.

 

EarningsPer Share:  Basicearnings per share is calculated based on the weighted-average common sharesoutstanding during the year.

 

FairValues of Financial Instruments:  Fair values of financial instruments areestimated using relevant market information and other assumptions, as morefully disclosed separately.  Fair valueestimates involve uncertainties and matters of significant judgment regardinginterest rates, credit risk, prepayments, and other factors, especially in theabsence of broad markets for particular items. Changes in assumptions or in market conditions could significantlyaffect the estimates.  The fair valueestimates of existing on- and off-balance-sheet financial instruments do notinclude the value of anticipated future business or the values of assets andliabilities not considered financial instruments.

 

ComprehensiveIncome:  Comprehensiveincome includes both net income and other comprehensive income (loss).  Other comprehensive income (loss) includesthe changes in unrealized gains and losses on securities available-for-sale,and minimum pension liability, net of deferred income taxes.

 

Reclassifications:  Some items in the prior years’ financialstatements were reclassified to conform to the current presentation.

 

 

24

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 1 —SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES** (Continued)

 

##### Pending AccountingPronouncements

 

In September 2006, the Emerging Issues Task Force (EITF) reached aconsensus regarding the accounting for entities with split-dollar lifeinsurance arrangements that provide an employee with a specified benefit thatis not limited to an employee’s active service period.  In reaching its consensus, the EITFdetermined that an employer should recognize as a liability the future benefitsto be provided to employees beyond the employees active service period.  In the case of split-dollar plan thatprovides a death benefit to the employees designated beneficiary and thebenefit is provided to the employee beyond their active service period, anentity should accrue a liability during the employee’s active service periodfor the cost of maintaining the life insurance policy during the employee’sretirement period.  EITF Issue 06-4 iseffective for fiscal years beginning after December 15, 2007 with earlierapplication permitted.  Entities shouldrecognize the effects of applying EITF Issue 06-4 either as a change inaccounting principle through a cumulative-effect adjustment to retainedearnings or other components of equity as of the beginning of the year ofadoption or as a change in accounting principle through retrospectiveapplication to all prior periods.

 

On September 6,2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157,Fair Value Measurements.  SFAS 157clarifies the fair value measurement objective, its application in GAAP andestablishes a framework that builds on current practice and requirements.  The framework simplifies and, whereappropriate, codifies the similar guidance in existing pronouncements andapplies broadly to financial and non-financial assets and liabilities.  The Statement clarifies the definition offair value as the price that would be received from selling an asset or paid totransfer a liability in an orderly transaction between market participants atthe measurement date, known as an exit-price definition of fair value.  It also provides further guidance on thevaluation techniques to be used in estimating fair value.  Current disclosures about the use of fairvalue to measure assets and liabilities are expanded in this Statement.  The disclosures focus on the methods used forfair value measurements and apply whether the assets and liabilities aremeasured at fair value in all periods, such as trading securities, or in onlysome periods, such as impaired assets. The Statement is effective for all financial statements issued forfiscal years beginning after November 15, 2007 as well as for interimperiods within such fiscal years.  FASBStaff Position (FSP).  FSP FAS 157-2delays the effective date of SFAS 157 for nonfinancial assets and nonfinancialliabilities, except for those items that are recognized or disclosed at fairvalue in the financial statements on a recurring basis (at least annually)until fiscal years beginning after November 15, 2008.  The Company is currently evaluating theimpact of this Statement and the related FSP on its financial statements.

 

In February 2007,the FASB issued Statement of Financial Accounting Standards No. 159, TheFair Value Option for Financial Assets and Financial Liabilities - Including anamendment of FASB Statement No. 115. SFAS 159 allows companies to report selected financial assets andliabilities at fair value. The changes in fair value are recognized in earningsand the assets and liabilities measured under this methodology are required tobe displayed separately in the balance sheet.  The main intent of theStatement is to mitigate the difficulty in determining reported earnings causedby a “mixed-attribute model” (or reporting some assets at fair value and othersusing a different valuation attribute such as amortized cost). The project isseparated into two phases.  This first phase addresses the creation of afair value option for financial assets and liabilities.  A second phasewill address creating a fair value option for selected non-financial items.SFAS 159 is effective for all financial statements issued for fiscal yearsbeginning after November 15, 2007.  The Company is currentlyevaluating the impact of this Statement on its financial statements.

 

 

25

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 2 —SECURITIES AVAILABLE FOR SALE**

 
| ** **                                                          | ** ** | **Amortized  Cost** | ** ** | **Gross   Unrealized   Gains** | ** ** | **Gross   Unrealized   Losses** | ** ** | **Fair   Value** | ** ** |
|---------------------------------------------------------------------|------------|---------------------|------------|--------------------------------|------------|---------------------------------|------------|------------------|------------|
| **December 31, 2007**                                          |       |                |       |                           |       |                            |       |             |       |
| ** **                                                          |       |                |       |                           |       |                            |       |             |       |
| U. S. Treasury                                                      |       | $                   | 8,052      |                           | $          | 20                              |       | $                | (5         | ) | $ | 8,067 |   |
| Federal agencies                                                    |       | 25,968              |       | 55                             |       | (45                             | )          | 25,978           |       |
| State and municipal                                                 |       | 23,661              |       | 117                            |       | (173                            | )          | 23,605           |       |
| Mortgage-backed securities and collateralized  mortgage obligations |       | 6,333               |       | 30                             |       | (64                             | )          | 6,299            |       |
| Corporate obligations                                               |       | 850                 |       | —                         |       | —                          |       | 850              |       |
| Marketable equity securities                                        |       | 3,144               |       | —                         |       | (128                            | )          | 3,016            |       |
|                                                                |       |                |       |                           |       |                            |       |             |       |
| Total investment securities                                         |       | $                   | 68,008     |                           | $          | 222                             |       | $                | (415       | ) | $ | 67,815 |   |

 
| ** **                                                          | ** ** | **Amortized  Cost** | ** ** | **Gross   Unrealized   Gains** | ** ** | **Gross   Unrealized   Losses** | ** ** | **Fair   Value** | ** ** |
|---------------------------------------------------------------------|------------|---------------------|------------|--------------------------------|------------|---------------------------------|------------|------------------|------------|
| **December 31, 2006**                                          |       |                |       |                           |       |                            |       |             |       |
|                                                                |       |                |       |                           |       |                            |       |             |       |
| U. S. Treasury                                                      |       | $                   | 10,070     |                           | $          | —                          |       | $                | (237       | ) | $ | 9,833 |   |
| Federal agencies                                                    |       | 35,294              |       | —                         |       | (654                            | )          | 34,640           |       |
| State and municipal                                                 |       | 24,829              |       | 139                            |       | (457                            | )          | 24,511           |       |
| Mortgage-backed securities and collateralized  mortgage obligations |       | 7,948               |       | 24                             |       | (236                            | )          | 7,736            |       |
| Corporate obligations                                               |       | 3,250               |       | —                         |       | (43                             | )          | 3,207            |       |
| Marketable equity securities                                        |       | 3,190               |       | —                         |       | (32                             | )          | 3,158            |       |
|                                                                |       |                |       |                           |       |                            |       |             |       |
| Total investment securities                                         |       | $                   | 84,581     |                           | $          | 163                             |       | $                | (1,659     | ) | $ | 83,085 |   |

 

As of December 31,2007 and 2006, the Company had approximately $2,989,000 and $2,632,000 investedin bonds issued by municipalities located within LaSalle County, Illinois.

 

Securitieswith an approximate carrying value of $56,963,000 and $50,174,000 were pledgedat December 31, 2007 and 2006 to secure trust and public deposits, and forother purposes as required or permitted by law.

 

Thefair value of contractual maturities of securities available for sale at December 31,2007 were as follows.  Securities not dueat a single maturity date, primarily mortgage-backed and equity securities, areshown separately.

 
| ** **                                                          | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|---------------------------------------------------------------------|------------|---------------------|------------|-----------------|------------|
| ** **                                                          | ** ** | ** **          | ** ** | ** **      | ** ** |
| Within one year                                                     |       | $                   | 23,238     |            | $          | 23,285 |   |
| One to five years                                                   |       | 33,914              |       | 33,835          |       |
| Five to ten years                                                   |       | 1,379               |       | 1,380           |       |
| After ten years                                                     |       | —              |       | —          |       |
|                                                                |       | 58,531              |       | 58,500          |       |
| Mortgage-backed securities and collateralized  mortgage obligations |       | 6,333               |       | 6,299           |       |
| Marketable equity securities                                        |       | 3,144               |       | 3,016           |       |
|                                                                |       |                |       |            |       |
| Totals                                                              |       | $                   | 68,008     |            | $          | 67,815 |   |

 

 

26

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 2 –SECURITIES AVAILABLE FOR SALE**(Continued)

 

Informationregarding realized gains and losses on sales of securities available for salefollows:

 

| ** **   | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------|------------|----------|------------|----------|------------|----------|------------|
|         |       |     |       |     |       |     |       |
| Gross gains  |       | $        | —     |     | $          | 4        |       | $ | 178 |   |
| Gross losses |       | —   |       | 17       |       | 6        |       |
| Tax expense  |       | —   |       | (4       | )          | 58       |       |
|              |            |          |            |          |            |          |            |  |  |  |

 

Certaininvestments in debt and marketable equity securities are reported in thefinancial statements at an amount less than their historical cost.  Total fair value of these investments at December 31,2007 and 2006 was $34.8 million and $74.8 million, which was approximately51.3% and 90.0% of the Company’s available-for-sale investment portfolio atthose dates.  These declines primarilyresulted from increases in market interest rates.

 

Based onevaluation of available evidence, including recent changes in market interestrates, management  believes the declinesin fair value for these securities are temporary.   Should the impairment of any of thesesecurities become other-than-temporary, the cost basis of the investment willbe reduced and the resulting loss recognized in net income in the period theother-than-temporary impairment is identified.

 

The followingtable shows our investments’ gross unrealized losses and fair value, aggregatedby investment category and length of time that individual securities have beenin a continuous unrealized loss position.

 
| ** **                                                             | ** ** | **Less than 12 Months** | ** ** | **12 Months or More**  | ** ** | **Total**       | ** ** |
|------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|-----------------|------------|
| **Description  of  Securities**                                        | ** ** | **Fair  Value**         | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| ** **                                                             | ** ** | ** **              | ** ** | ** **             | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **December 31, 2007**                                             |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| ** **                                                             |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| U. S. Treasury                                                         |       | $                       | —     |                   | $          | —          |       | $ | 2,996 |   | $ | 5 |   | $ | 2,996 |   | $ | 5 |   |
| Federal agencies                                                       |       | 1,014                   |       | 3                      |       | 11,742          |       | 42 |   | 12,756 |   | 45 |   |
| State and municipal                                                    |       | 212                     |       | 1                      |       | 12,528          |       | 172 |   | 12,740 |   | 173 |   |
| Mortgage-backed securities   and collateralized   mortgage obligations |       | —                  |       | —                 |       | 4,944           |       | 64 |   | 4,944 |   | 64 |   |
| Corporate obligations                                                  |       | —                  |       | —                 |       | —          |       | — |   | — |   | — |   |
| Marketable equity securities                                           |       | 853                     |       | 76                     |       | 521             |       | 52 |   | 1,374 |   | 128 |   |
|                                                                   |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Total temporarily   impaired securities                                |       | $                       | 2,079      |                   | $          | 80              |       | $ | 32,731 |   | $ | 335 |   | $ | 34,810 |   | $ | 415 |   |
| ** **                                                             |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| ** **                                                             |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| **December 31, 2006**                                             |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| ** **                                                             |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| U. S. Treasury                                                         |       | $                       | —     |                   | $          | —          |       | $ | 9,833 |   | $ | 237 |   | $ | 9,833 |   | $ | 237 |   |
| Federal agencies                                                       |       | —                  |       | —                 |       | 34,640          |       | 654 |   | 34,640 |   | 654 |   |
| State and municipal                                                    |       | 1,555                   |       | 16                     |       | 15,258          |       | 441 |   | 16,813 |   | 457 |   |
| Mortgage-backed securities   and collateralized   mortgage obligations |       | 35                      |       | 1                      |       | 7,099           |       | 235 |   | 7,134 |   | 236 |   |
| Corporate obligations                                                  |       | —                  |       | —                 |       | 3,207           |       | 43 |   | 3,207 |   | 43 |   |
| Marketable equity securities                                           |       | —                  |       | —                 |       | 3,158           |       | 32 |   | 3,158 |   | 32 |   |
|                                                                   |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Total temporarily impaired securities                                  |       | $                       | 1,590      |                   | $          | 17              |       | $ | 73,195 |   | $ | 1,642 |   | $ | 74,785 |   | $ | 1,659 |   |

 

 

27

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 3 –LOANS**

 

Majorclassifications of loans as of December 31, 2007 and 2006 are summarizedas follows:

 

| ** **                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
|                        |       |     |       |     |       |
| Real estate                 |       | $        | 120,581    |     | $          | 102,516 |   |
| Commercial and agricultural |       | 28,354   |       | 39,610   |       |
| Installment                 |       | 5,439    |       | 7,401    |       |
| Home equity lines of credit |       | 11,051   |       | 11,411   |       |
| Total loans                 |       | 165,425  |       | 160,938  |       |
| Allowance for loan losses   |       | (1,588   | )          | (1,463   | )          |
|                        |       |     |       |     |       |
| Net loans                   |       | $        | 163,837    |     | $          | 159,475 |   |

 

Certainexecutive officers, directors, and their related interests are loan customersof the Company.  A summary of such loansmade by the Company in the ordinary course of business and made onsubstantially the same terms (including interest rates and collateral) as thoseprevailing at the time for comparable transactions with other persons is asfollows:

 

| Balance at January 1, 2007   |   |   |   | $      | 2,431  |   |
|-----------------------------------|--------|--------|--------|--------|--------|--------|
| New loans                         |   |   |   | 137    |   |
| Repayments                        |   |   |   | (46    | )      |
|                              |   |   |   |   |   |
| Balance at December 31, 2007 |   |   |   | $      | 2,522  |   |

 

Informationregarding impaired loans at December 31, 2007 and 2006 is as follows:

 

| ** **                                                                                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                             |       |     |       |     |       |
| Impaired loans with an allowance                                                                                 |       | $        | 1,192      |     | $          | 1,328 |   |
| Impaired loans for which the discounted cash flows  or collateral   value exceeds the carrying value of the loan |       | 988      |       | 225      |       |
|                                                                                                             |       |     |       |     |       |
| Total impaired loans                                                                                             |       | $        | 2,180      |     | $          | 1,553 |   |
|                                                                                                             |       |     |       |     |       |
| Allowance for impaired loans included in the  Company’s allowance  for loan losses                          |       | $        | 284        |     | $          | 386 |   |

 

| ** **                                                       | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                             |       |     |       |     |       |     |       |
| Average balance of impaired loans                                |       | $        | 2,183      |     | $          | 2,269    |       | $ | 2,039 |   |
| Interest income recognized on impaired loans                     |       | 224      |       | 149      |       | 169      |       |
| Interest income recognized on impaired loans –   cash basis |       | 148      |       | 102      |       | 126      |       |
|                                                                  |            |          |            |          |            |          |            |  |  |  |

 

Nonperformingloans were as follows at December 31:

 

| ** **                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
|                                         |       |     |       |     |       |
| Loans past due over 90 days still on accrual |       | $        | 649        |     | $          | 305 |   |
| Nonaccrual loans                             |       | 1,163    |       | 362      |       |
|                                              |            |          |            |          |            |  |  |

 

 

28

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 4 –ALLOWANCE FOR LOAN LOSSES**

** **

Activityin the allowance for loan losses is summarized as follows for the years ended December 31:

 

| ** **                 | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
|                       |       |     |       |     |       |     |       |
| Allowance for loan losses  |       |     |       |     |       |     |       |
| Balances, January 1   |       | $        | 1,463      |     | $          | 1,344    |       | $ | 1,174 |   |
| Provision for losses       |       | 180      |       | 180      |       | 300      |       |
| Recoveries on loans        |       | 83       |       | 56       |       | 86       |       |
| Loans charged off          |       | (138     | )          | (117     | )          | (216     | )          |
|                       |       |     |       |     |       |     |       |
| Balances, December 31 |       | $        | 1,588      |     | $          | 1,463    |       | $ | 1,344 |   |

 

**NOTE 5 – LOANSALES AND SERVICING**

 

The Company sellsmortgage loans with servicing retained to the Federal Home Loan MortgageCorporation (FHLMC).  The Companyrealized gross proceeds from the sales of mortgage loans totaling $1,203,000,$868,000 and $4,637,000 in 2007, 2006 and 2005. Mortgage loans serviced for others are not included in the accompanyingconsolidated balance sheets.  The unpaidprincipal balances of these loans are summarized as follows:

 

| ** **                     | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
|                           |       |     |       |     |       |
| Loans serviced for Freddie Mac |       | $        | 27,958     |     | $          | 30,255 |   |
|                                |            |          |            |          |            |  |  |

 

Following is ananalysis of the changes in originated mortgage servicing rights:

 

| ** **                       | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |     |       |
| Mortgage Servicing Rights        |       |     |       |     |       |     |       |
| Balances, January 1         |       | $        | 303        |     | $          | 328      |       | $ | 380 |   |
| Servicing rights capitalized     |       | 14       |       | 14       |       | 49       |       |
| Amortization of servicing rights |       | (37      | )          | (39      | )          | (101     | )          |
|                             |       |     |       |     |       |     |       |
| Balances, December 31       |       | $        | 280        |     | $          | 303      |       | $ | 328 |   |

 

 

29

----

 

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 6 –PREMISES AND EQUIPMENT**

 

Premises and equipmentconsisted of the following at December 31:

 

| ** **                                | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |
| Cost                                      |       |     |       |     |       |
| Land                                      |       | $        | 1,791      |     | $          | 1,791 |   |
| Buildings and land improvements           |       | 7,596    |       | 7,512    |       |
| Equipment                                 |       | 4,791    |       | 4,656    |       |
| Construction in progress                  |       | 43       |       | 19       |       |
| Total cost                                |       | 14,221   |       | 13,978   |       |
| Accumulated depreciation and amortization |       | (6,704   | )          | (6,225   | )          |
|                                      |       |     |       |     |       |
| Net                                       |       | $        | 7,517      |     | $          | 7,753 |   |

 

**NOTE 7 –DEPOSITS**

 

Deposits consisted of thefollowing at December 31:

 

| ** **                                                | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                      |       |     |       |     |       |
| Noninterest-bearing demand                                |       | $        | 33,710     |     | $          | 29,954 |   |
| Interest-bearing demand                                   |       | 54,963   |       | 53,864   |       |
| Savings                                                   |       | 21,954   |       | 24,062   |       |
| Money market savings                                      |       | 29,884   |       | 38,266   |       |
| Certificates and other time deposits of $100,000 or  more |       | 44,491   |       | 38,484   |       |
| Other certificates and time deposits                      |       | 55,375   |       | 65,711   |       |
|                                                      |       |     |       |     |       |
| Total deposits                                            |       | $        | 240,377    |     | $          | 250,341 |   |

 

At December 31,2007, the scheduled maturities of certificates of deposit were as follows:

 

| 2008   |   | $      | 71,699 |   |   |   |
|--------|--------|--------|--------|--------|--------|--------|
| 2009   |   | 16,543 |   |   |   |
| 2010   |   | 3,318  |   |   |   |
| 2011   |   | 5,743  |   |   |   |
| 2012   |   | 2,563  |   |   |   |
|   |   |   |   |   |   |
|   |   | $      | 99,866 |   |   |   |

 

Depositsheld by the Company from related parties at December 31, 2007 and 2006totaled $3.4 million and $3.8 million, respectively.

 

 

30

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 8 –BORROWINGS**

 

TheCompany has a note payable that consists of a $2,000,000 unsecured line ofcredit with Marshall & Ilsley Bank, maturing on August 25,2008.  The outstanding balance under theline of credit was $17,000 at December 31, 2007 and $0, at December 31,2006.  Interest is payable quarterly atLIBOR plus 165 basis points (6.25% and 7.04% at December 31, 2007 and2006).

 

**NOTE 9 –BENEFIT PLANS**

 

TheBank has a noncontributory defined-benefit pension plan covering all employeeswho meet the eligibility requirements. In 1999, all plan benefits were frozen. The Bank’s funding policy is to make the minimum annual contributionthat is required by applicable regulations, plus such amounts as the Bank maydetermine to be appropriate from time to time. The Bank expects to contribute approximately $80,000 to the plan in2008.  The Bank uses a December 31measurement date for the plan.

 

Thefollowing tables set forth the Bank’s pension plan’s funded status and amountsactuarially determined for the years indicated:

 

 

| ** **                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
|                         |       |     |       |     |       |
| Change in benefit obligation |       |     |       |     |       |
| Beginning benefit obligation |       | $        | 1,852      |     | $          | 1,887 |   |
| Interest cost                |       | 106      |       | 103      |       |
| Actuarial loss               |       | 44       |       | (21      | )          |
| Benefits paid                |       | (165     | )          | (117     | )          |
|                         |       |     |       |     |       |
| Ending benefit obligation    |       | $        | 1,837      |     | $          | 1,852 |   |
|                         |       |     |       |     |       |
|                         |       |     |       |     |       |
| Change in plan assets        |       |     |       |     |       |
| Beginning fair value         |       | $        | 1,800      |     | $          | 1,531 |   |
| Actual return                |       | 42       |       | 118      |       |
| Employer contribution        |       | 89       |       | 268      |       |
| Benefits paid                |       | 165      |       | (117     | )          |
|                         |       |     |       |     |       |
| Ending fair value            |       | $        | 1,766      |     | $          | 1,800 |   |
|                         |       |     |       |     |       |
| Funded status                |       | $        | (71        | )        | $          | (52 | ) |

 

 

31

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

**NOTE 9 –BENEFIT PLANS**(Continued)

 

Assets and liabilitiesrecognized in the balance sheets:

** **

| ** **                           | ** ** | **Pension Benefits** | ** ** |
|--------------------------------------|------------|----------------------|------------|
| ** **                           | ** ** | **2007**             | ** ** | **2006** | ** ** |
|                                 |       |                 |       |   |   |
| Interest receivable and other assets |       | $                    | (124       | ) | $ | (123 | ) |
| Other liabilities                    |       | 53                   |       | 71 |   |
|                                      |            |                      |            |  |  |  |  |

 

Amounts recognized inaccumulated other comprehensive income not yet recognized as components of netperiodic benefit cost consist of:

 

| ** ** | ** ** | **Pension Benefits** | ** ** |
|------------|------------|----------------------|------------|
| ** ** | ** ** | **2007**             | ** ** | **2006** | ** ** |
|       |       |                 |       |   |   |
| Net loss   |       | $                    | 500        |   | $ | 390 |   |
|            |            |                      |            |  |  |  |  |

 

| ** **                     | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
|                           |       |     |       |     |       |
| Accumulated benefit obligation |       | $        | 1,837      |     | $          | 1,852 |   |
| Fair value of plan assets      |       | 1,766    |       | 1,800    |       |
|                                |            |          |            |          |            |  |  |

 

| ** **                              | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                    |       |     |       |     |       |     |       |
| Components of net periodic benefit cost |       |     |       |     |       |     |       |
| Interest cost                           |       | $        | 106        |     | $          | 103      |       | $ | 112 |   |
| Return on plan assets                   |       | (126     | )          | (108     | )          | (106     | )          |
| Amortization                            |       | 18       |       | 15       |       | 8        |       |
|                                    |       |     |       |     |       |     |       |
| Net expense                             |       | $        | (2         | )        | $          | 10       |       | $ | 14 |   |

 

Other changes in planassets and benefit obligations recognized in other comprehensive income:

** **

| ** **                        | ** ** | **Pension Benefits** | ** ** |
|-----------------------------------|------------|----------------------|------------|
| ** **                        | ** ** | **2007**             | ** ** | **2006** | ** ** |
|                              |       |                 |       |   |   |
| Amounts arising during the period |       |                 |       |   |   |
| Net (gain) loss                   |       | $                    | 110        |   | $ | (46 | ) |
|                                   |            |                      |            |  |  |  |  |

 

 

32

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 9 –BENEFIT PLANS**(Continued)

 

Theestimated net loss for the defined-benefit pension plan that will be amortizedfrom accumulated other comprehensive income into net periodic benefit cost overthe next fiscal year is $20,770.

 

| ** **                                         | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Assumptions used to  determine benefit obligations |       |     |       |     |       |     |       |
| Discount rate                                      |       | 5.75     | %          | 5.75     | %          | 5.75     | %          |
| Expected return on plan assets                     |       | 7.0      |       | 7.0      |       | 7.0      |       |
| Assumptions used to  determine benefit costs       |       |     |       |     |       |     |       |
| Discount rate                                      |       | 5.75     | %          | 5.75     | %          | 6.00     | %          |
| Expected return on plan assets                     |       | 7.0      |       | 7.0      |       | 7.0      |       |

 

The Company hasestimated the long-term rate of return on plan assets based primarily onhistorical returns on plan assets, adjusted for changes in target portfolioallocations and recent changes in long-term interest rates based on publiclyavailable information.

 

Thefollowing benefit payments, which reflect expected future service, asappropriate, are expected to be paid as of December 31, 2007:

 

| ** ** | ** ** | **Pension  Benefits** | ** ** |
|------------|------------|-----------------------|------------|
| 2008       |       | $                     | 124        |   |
| 2009       |       | 123                   |       |
| 2010       |       | 116                   |       |
| 2011       |       | 125                   |       |
| 2012       |       | 118                   |       |
| Thereafter |       | 551                   |       |
|            |            |                       |            |  |

 

Plan assets areheld by a bank-administered trust fund, which invests the plan assets inaccordance with the provisions of the plan agreement.  The permitted investments as established bythe plan agreement include, but are not limited to, common and preferredstocks, open-end or closed-end mutual funds, bonds and other evidences ofindebtedness or ownership, and real estate or any interest therein.

 

Asset allocationis primarily based on a strategy to provide stable earnings while attempting torecognize potentially higher returns through limited investments in equitysecurities.  Plan assets are rebalancedperiodically.  At December 31, 2007and 2006, allocations by percentages were as follows:

 

| ** **                    | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Equity mutual funds           |       | 66.4     | %          | 58.3     | %          |
| Fixed income mutual  funds    |       | 16.8     |       | 15.5     |       |
| GNMA pool                     |       | .2       |       | .3       |       |
| Money market funds and  other |       | 4.2      |       | 20.4     |       |
| Time Certificates of  Deposit |       | 12.4     |       | 5.5      |       |

 

33

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 9 –BENEFIT PLANS**(Continued)

 

At December 31, 2007 and 2006, market values ofplan assets were as follows:

 

| ** **                    | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Equity mutual funds           |       | $        | 1,174      |     | $          | 1,050 |   |
| Fixed income mutual  funds    |       | 295      |       | 279      |       |
| GNMA pool                     |       | 4        |       | 5        |       |
| Money market funds and  other |       | 74       |       | 367      |       |
| Time Certificates of  Deposit |       | 221      |       | 99       |       |
|                               |            |          |            |          |            |  |  |

 

The Bank has adirectors’ retirement plan which provides retirement benefits primarily toformer members of the Board of Directors. The Bank also maintains a supplemental executive retirement plan thatprovides benefits to certain key executive officers and directors in accordancewith the plan document.  The Bank accruedexpenses related to these plans totaling $94,000, $90,000 and $105,000 in 2007,2006 and 2005.

 

TheCompany’s 401(k) profit-sharing plan covers eligible employees with morethan one year of service, as defined, and who are at least 21 years ofage.  The plan allows employeecontributions.  The Company may make amatching contribution equal to a percentage of salary deferral anddiscretionary profit-sharing contributions. The matching percentage is limited to 6% of compensation.  The Company’s contributions, which are madefollowing the end of the calendar year, totaled $145,000, $151,000 and $140,000for 2007, 2006 and 2005.

 

**NOTE  10 – STOCK OPTION PLAN**

 

The Company grantsselected executives and other key employees and directors incentive and non-qualifiedstock option awards which vest and become fully exercisable at the discretionof the Board of Directors as the options are granted.  The Company is authorized to grant optionsfor up to 150,000 shares of the Company’s common stock.  The exercise price of the options, which havea ten year life, may not be less than the market price of the Company’s stockon the date of grant.

 

The following is asummary of the status of the Company’s stock option plan and changes in thatplan for 2007, 2006 and  2005.  The Company had no grants outstanding priorto 2003.

 

| ** **                                                      | ** ** | **2007**   | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|
| **Options**                                                     | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
| Outstanding, beginning of year                                  |       | 30,690     |       | $ | 67.22 |   |   |   |   |   |
| Granted                                                         |       | 10,600     |       | 77.00 |   |   |   |   |   |
| Exercised                                                       |       | 2,098      |       | 58.32 |   |   |   |   |   |
| Forfeited or expired                                            |       | —     |       |   |   |   |   |   |   |
| Outstanding, end of year                                        |       | 39,192     |       | 70.34 |   | 7.88 |   | $ | 362 |   |
| Options exercisable at year end                                 |       | 15,584     |       | 64.03 |   | 6.72 |   | $ | 242 |   |
| Weighted-average fair value of options granted  during the year |       |       |       | $ | 14.74 |   |   |   |   |   |

 

34

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE  10 – STOCK OPTION PLAN** (Continued)

 

The weighted-averagegrant-date fair value of options granted during the years 2007, 2006 and 2005was $14.74, $11.78 and $3.26, respectively. The total intrinsic value of options exercised during the years ended December 31,2007, 2006 and 2005 was $46,000, $9,000 and $0. Total unrecognized compensation cost relating to stock options notvested as of December 31, 2007 was $205,000.

 

The fair value ofeach option grant was estimated on the grant date using an option-pricing modelwith the following assumptions:

 

| ** **                                                   | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free interest  rates                                    |       | 4.80     | %          | 4.29     | %          | 4.37     | %          |
| Dividend yields                                              |       | 3.96     | %          | 3.94     | %          | 4.29     | %          |
| Volatility factors of  expected market price of common stock |       | 20.35    | %          | 17.33    | %          | 5.37     | %          |
| Weighted-average  expected life of the options               |       | 10 years |       | 10 years |       | 10 years |       |

 

Cash received from optionexercise under share-based payment arrangements for the years ended December 31,2007,  2006 and 2005 was $122,000,$26,000 and $0, respectively.  The actualtax benefit realized for the tax deductions from option exercise of theshare-based payment arrangements totaled $8,000, $2,000 and $0, respectively,for the years ended December 31, 2007, 2006 and 2005.

 

**NOTE  11 – EARNINGS PER SHARE**

 

Earnings per share(EPS) were computed as follows:

 

| ** **                                                       | ** ** | **Year Ended December 31, 2007** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                       | ** ** | **Income**                            | ** ** | **Weighted-  Average  Shares** | ** ** | **Per Share  Amount** | ** ** |
| Net income                                                       |       | $                                     | 2,415      |   | 649,009 |   |   |   |
| Basic earnings per  share                                        |       |                                  |       |   |   |   |   |
| Income available to common stockholders                          |       |                                  |       |   |   | $ | 3.72 |   |
| Effect of dilutive  securities                                   |       |                                  |       |   |   |   |   |
| Stock options                                                    |       | —                                |       | 1,351 |   |   |   |
| Diluted earnings per  share                                      |       |                                  |       |   |   |   |   |
| Income available to common stockholders and assumed  conversions |       | $                                     | 2,415      |   | 650,360 |   | $ | 3.71 |   |

 

35

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE  11 – EARNINGS PER SHARE** (Continued)

** **

| ** **                                                       | ** ** | **Year Ended December 31, 2006** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                       | ** ** | **Income**                            | ** ** | **Weighted-  Average  Shares** | ** ** | **Per Share  Amount** | ** ** |
| ** **                                                       | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                       |       | $                                     | 2,335      |   | 649,605 |   |   |   |
| Basic earnings per  share                                        |       |                                  |       |   |   |   |   |
| Income available to common stockholders                          |       |                                  |       |   |   | $ | 3.59 |   |
| Effect of dilutive  securities                                   |       |                                  |       |   |   |   |   |
| Stock options                                                    |       | —                                |       | 1,577 |   |   |   |
| Diluted earnings per  share                                      |       |                                  |       |   |   |   |   |
| Income available to common stockholders and assumed  conversions |       | $                                     | 2,335      |   | 651,182 |   | $ | 3.59 |   |

** **

| ** **                                                       | ** ** | **Year Ended December 31, 2005** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                       | ** ** | **Income**                            | ** ** | **Weighted-  Average  Shares** | ** ** | **Per Share Amount** | ** ** |
| ** **                                                       | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                       |       | $                                     | 2,545      |   | $ | 649,830 |   |   |   |
| Basic earnings per  share                                        |       |                                  |       |   |   |   |   |
| Income available to common stockholders                          |       |                                  |       |   |   | $ | 3.92 |   |
| Effect of dilutive  securities                                   |       |                                  |       |   |   |   |   |
| Stock options                                                    |       | —                                |       | 2,629 |   |   |   |
| Diluted earnings per  share                                      |       |                                  |       |   |   |   |   |
| Income available to common stockholders and assumed  conversions |       | $                                     | 2,545      |   | 652,459 |   | $ | 3.90 |   |
|                                                                  |            |                                       |            |  |  |  |  |  |  |  |

 

**NOTE 12 –INCOME TAXES**

 

Thebalance sheets included the following amounts of deferred tax assets andliabilities at December 31:

 

| ** **                                                 | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income tax expense                                         |       |       |       |       |       |       |       |
| Currently payable                                          |       |       |       |       |       |       |       |
| Federal                                                    |       | $          | 704        |       | $          | 672        |       | $ | 721 |   |
| State                                                      |       | 153        |       | 119        |       | 88         |       |
| Deferred                                                   |       | (88        | )          | (38        | )          | (18        | )          |
|                                                       |       |       |       |       |       |       |       |
| Total income tax expense                                   |       | $          | 769        |       | $          | 753        |       | $ | 791 |   |
|                                                       |       |       |       |       |       |       |       |
| Reconciliation of  federal statutory to actual tax expense |       |       |       |       |       |       |       |
| Federal statutory income tax at 34%                        |       | $          | 1,083      |       | $          | 1,050      |       | $ | 1,134 |   |
| Tax-exempt income                                          |       | (407       | )          | (344       | )          | (415       | )          |
| Effect of state income taxes and other items, net          |       | 93         |       | 47         |       | 72         |       |
|                                                       |       |       |       |       |       |       |       |
| Actual tax expense                                         |       | $          | 769        |       | $          | 753        |       | $ | 791 |   |
|                                                       |       |       |       |       |       |       |       |
| Effective tax rate                                         |       | 24.1       | %          | 25.2       | %          | 23.7       | %          |

 

36

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 12 –INCOME TAXES**(Continued)

 

The components ofthe deferred asset (liability) included on the balance sheets are as follows:

 

| ** **                                         | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|----------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Assets**                                         |       |       |       |       |       |
| Unrealized losses on securities available for sale |       | $          | 220        |       | $          | 509 |   |
| Allowance for loan losses                          |       | 438        |       | 385        |       |
| Deferred compensation                              |       | 354        |       | 295        |       |
| Minimum pension liability                          |       | 29         |       | 49         |       |
| Other                                              |       | 7          |       | 36         |       |
| Total assets                                       |       | 1,048      |       | 1,274      |       |
| **Liabilities**                                    |       |       |       |       |       |
| FHLB stock                                         |       | (117       | )          | (116       | )          |
| Depreciation                                       |       | (515       | )          | (567       | )          |
| Mortgage servicing rights                          |       | (114       | )          | (120       | )          |
| Other                                              |       | (97        | )          | (84        | )          |
| Total liabilities                                  |       | (843       | )          | (887       | )          |
|                                               |       |       |       |       |       |
|                                               |       | $          | 205        |       | $          | 387 |   |

 

**NOTE 13 –DERIVATIVES**

 

TheCompany uses derivatives to fix future cash flows for interest payments on someof its floating rate certificates of deposit. In this regard, the Company has entered into an interest rate swap withthe Federal Home Loan Bank of Chicago, or the FHLB, to fix the interest rate ona specific certificate of deposit product. At December 31, 2007, the Company had $833,000 of certificates ofdeposit, which mature in 2008 through 2012, on which it pays the FHLB aweighted-average interest rate of 2.65% and will receive an interest rate fromthe FHLB based on the appreciation of the S&P 500 Index.  This interest received from the FHLB will bepaid to the customer.  The assets andliabilities in this transaction are being netted and the expense recorded ininterest expense on deposits.

 

Inaddition to the above, the Company also purchased $3.0 million of certificatesof deposit which are included in the certificates of deposit caption on theconsolidated balance sheet.  Theseinvestments have a five year term from date of purchase.  The investments that individually do notexceed $100,000 are insured by the FDIC. The initial investment is not at riskbut the return on the investment is based on a calculation of the appreciationin the S&P 500 Index. The fair value of this embedded derivative isrecorded in certificates of deposit and the fair value adjustment is includedin other income.  At December 31,2007, the Bank had allocated $902,000 to this asset and recorded a valuationallowance of $ 120,000.

 

**NOTE 14 –COMMITMENTS, OFF–BALANCE–SHEET RISK, AND CONTINGENCIES**

 

Thereare various contingent liabilities that are not reflected in the consolidatedfinancial statements, including claims and legal actions arising in theordinary course of business.  In theopinion of management, after consultation with legal counsel, the ultimatedisposition of these claims and legal actions is not expected to have amaterial effect on financial condition or results of operations.

 

37

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 14 –COMMITMENTS, OFF–BALANCE–SHEET RISK, AND CONTINGENCIES** (Continued)

 

TheBank is required to maintain reserve funds in cash and/or on deposit with theFederal Reserve Bank.  The reserverequired at December 31, 2007 was $350,000.

 

Somefinancial instruments are used in the normal course of business to meet thefinancing needs of customers.  Thesefinancial instruments include commitments to extend credit, standby letters ofcredit, and financial guarantees.  Theseinvolve, to varying degrees, credit and interest-rate risk in excess of theamounts reported in the financial statements.

 

Exposureto credit loss if the other party does not perform is represented by thecontractual amount for commitments to extend credit, standby letters of credit,and financial guarantees written.  Thesame credit policies are used for commitments and conditional obligations areused for loans.  Collateral or othersecurity is normally required to support financial instruments with creditrisk.

 

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the commitment.  Commitments generally have fixed expirationdates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected toexpire without being used, the total commitments do not necessarily representfuture cash requirements.  Standbyletters of credit and financial guarantees written are conditional commitmentsto guarantee a customer’s performance to a third party.

 

Asummary of the notional or contractual amounts of financial instruments withoff-balance-sheet risk at year end follows:

 

| ** **                | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|---------------------------|------------|------------|------------|------------|------------|
| ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unused lines of credit    |       | $          | 15,102     |       | $          | 17,850 |   |
| Standby letter of  credit |       | 531        |       | 513        |       |
|                           |            |            |            |            |            |  |  |

 

At December 31,2007, all of the commitments to extend credit were at variable rates of interest.

 

**NOTE 15 –FAIR VALUES OF FINANCIAL INSTRUMENTS**

 

Thefollowing methods and assumptions were used to estimate fair values forfinancial instruments.  The carryingamount is considered to estimate fair value for cash and due from banks,demand, NOW, money market and savings deposits, federal funds purchased,securities sold under repurchase agreements, accrued interest receivable andpayable, and variable rate loans or deposits. Securities fair values are based on quoted market prices or, if noquotes are available, on the rate and term of the security and on informationabout the issuer.  The fair value ofloans held for sale and derivatives are based on quoted market prices.  For fixed rate loans or deposits, the fairvalue is estimated by discounted cash flow analysis using current market ratesfor the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flowanalysis or underlying collateral values, where applicable.  The fair value of off-balance-sheet items isbased on the fees or cost that would currently be charged to enter into orterminate such agreements and is not material.

 

38

----

 

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 15 –FAIR VALUES OF FINANCIAL INSTRUMENTS** (Continued)

 

Thecarrying values and estimated fair values of the Company’s financialinstruments as of December 31, 2007 and 2006 were as follows:

 

| ** **                                     | ** ** | **2007**             | ** ** | **2006**        | ** ** |
|------------------------------------------------|------------|----------------------|------------|-----------------|------------|
| ** **                                     | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| ** **                                     | ** ** | ** **           | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Assets**                                     |       |                 |       |            |       |   |   |   |   |
| Cash and cash equivalents                      |       | $                    | 16,499     |            | $          | 16,499 |   | $ | 10,644 |   | $ | 10,644 |   |
| Certificates of deposit and related derivative |       | 3,808                |       | 3,808           |       | 6,135 |   | 6,135 |   |
| Securities available for sale                  |       | 67,815               |       | 67,815          |       | 83,085 |   | 83,085 |   |
| Loans                                          |       | 163,837              |       | 162,601         |       | 159,475 |   | 156,644 |   |
| Interest receivable                            |       | 1,934                |       | 1,934           |       | 2,120 |   | 2,120 |   |
| **Liabilities**                                |       |                 |       |            |       |   |   |   |   |
| Deposits with no stated maturities             |       | 140,511              |       | 140,511         |       | 146,146 |   | 146,146 |   |
| Time deposits                                  |       | 99,866               |       | 100,595         |       | 104,195 |   | 104,811 |   |
| Interest payable                               |       | 888                  |       | 888             |       | 1,033 |   | 1,033 |   |
|                                                |            |                      |            |                 |            |  |  |  |  |  |  |  |  |

 

 

**NOTE 16 –REGULATORY AND CAPITAL MATTERS**

 

TheCompany may pay dividends without restriction under the current Federal Reserveregulations so long as it remains “adequately capitalized” after suchpayment.  The Bank is subject tostatutory dividend restrictions which provide, in general, that the Bank maypay the current year’s earnings and the prior two years’ retained earningswithout the prior approval of the Office of the Comptroller of Currency.  At December 31, 2007, the Bank’sstockholder’s equity totaled $24,606,000, of which $23,350,000 was notavailable for payment of dividends, without prior regulatory approval.

 

TheCompany and the Bank are subject to various regulatory capital requirementsadministered by the federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involvequantitative measures of assets, liabilities, and certain off-balance-sheetitems calculated under regulatory accounting practices.  Capital amounts and classifications are alsosubject to qualitative judgments by regulators about components, risk weightings,and other factors, and the regulators can lower classifications in certaincases.  Failure to meet various capitalrequirements can initiate regulatory action that could have a direct materialeffect on the financial statements.

 

39

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 16 –REGULATORY AND CAPITAL MATTERS **(Continued)

 

Theprompt corrective action regulations provide five classifications, includingwell capitalized, adequately capitalized, undercapitalized, significantlyundercapitalized, and critically undercapitalized, although these terms are notused to represent overall financial condition. If adequately capitalized, regulatory approval is required to acceptbrokered deposits.  If  undercapitalized, capital distributions arelimited, as is asset growth and expansion, and plans for capital restorationare required.

 

TheCompany’s only activity is ownership of the Bank, and, therefore, its capital,capital ratios, and minimum required levels of capital are materially the sameas the Bank’s.   The actual capitallevels and minimum required levels for the Company were:

 

| ** **                                         | ** ** | **Actual** | ** ** | **Required for Adequate Capital** | ** ** | **To Be Well  Capitalized** | ** ** |
|----------------------------------------------------|------------|------------|------------|-----------------------------------|------------|-----------------------------|------------|
| ** **                                         | ** ** | **Amount** | ** ** | **Ratio**                         | ** ** | **Amount**                  | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                         | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **December 31, 2007**                         |       |       |       |                              |       |                        |       |   |   |   |   |   |   |
| Total risk-based capital (to risk-weighted assets) |       | $          | 23,320     |                              | 12.5       | %                           | $          | 14,810 |   | 8.0 | % | $ | 18,551 |   | 10.0 | % |
| Tier 1 capital (to risk-weighted  assets)          |       | 21,732     |       | 11.7                              |       | 7,420                       |       | 4.0 |   | 11,131 |   | 6.0 |   |
| Tier 1 capital (to  average assets)                |       | 21,732     |       | 8.1                               |       | 10,681                      |       | 4.0 |   | 13,352 |   | 5.0 |   |
| **December 31, 2006**                         |       |       |       |                              |       |                        |       |   |   |   |   |   |   |
| Total risk-based capital (to risk-weighted assets) |       | $          | 22,668     |                              | 12.0       | %                           | $          | 15,144 |   | 8.0 | % | $ | 18,930 |   | 10.0 | % |
| Tier 1 capital (to risk-weighted  assets)          |       | 21,205     |       | 11.2                              | %          | 7,572                       |       | 4.0 | % | 11,358 |   | 6.0 | % |
| Tier 1 capital (to  average assets)                |       | 21,205     |       | 7.5                               | %          | 11,321                      |       | 4.0 | % | 14,152 |   | 5.0 | % |

 

At December 31,2007, the Bank was categorized as well capitalized and management is not awareof any conditions or events since the most recent notification that wouldchange the Bank’s category.

 

**NOTE 17 –OTHER COMPREHENSIVE INCOME (LOSS)**

 

| ** **                                                                   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other comprehensive income  (loss)                                           |       |       |       |       |       |       |       |
| Unrealized holding gains (losses) arising during the  year                   |       | $          | 1,302      |       | $          | 351        |       | $ | (2,135 | ) |
| Less: reclassification adjustment for gains (losses)  realized in net income |       | —     |       | (13        | )          | 172        |       |
| Net loss relating to benefit liability                                       |       | (110       | )          | —     |       | —     |       |
| Tax effect                                                                   |       | (429       | )          | (124       | )          | 785        |       |
|                                                                         |       |       |       |       |       |       |       |
| Other comprehensive income (loss)                                            |       | $          | 763        |       | $          | 240        |       | $ | (1,522 | ) |

 

40

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 18 –PARENT COMPANY FINANCIAL STATEMENTS**

 

Thefollowing are the condensed balance sheets, statements of income and cash flowsfor First Ottawa Bancshares, Inc.

 

**Condensed Balance Sheets**

 

| ** **                                      | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Assets**                                      |       |       |       |       |       |
| Cash on deposit with Bank                       |       | $          | 1,297      |       | $          | 1,569 |   |
| Investment in common stock of Bank              |       | 24,415     |       | 23,083     |       |
| Other assets                                    |       | 208        |       | 157        |       |
|                                            |       |       |       |       |       |
| Total assets                                    |       | $          | 25,920     |       | $          | 24,809 |   |
| ** **                                      |       |       |       |       |       |
| **Liabilities**                                 |       |       |       |       |       |
| Note payable                                    |       | $          | 17         |       | $          | — |   |
| Dividends payable                               |       | 1,297      |       | 1,300      |       |
|                                            |       | 1,314      |       | 1,300      |       |
|                                            |       |       |       |       |       |
| **Shareholders’ Equity**                   |       | 24,606     |       | 23,509     |       |
| ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total liabilities and shareholders’ equity |       | $          | 25,920     |       | $          | 24,809 |   |

 

**Condensed Statements of Income**

 

| ** **                                                                       | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|----------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Income -**dividends from Bank                                                  |       | $          | 1,945      |       | $          | 1,949      |       | $ | 2,649 |   |
| ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Other income -**gain on the sale of investments                                |       | —     |       | —     |       | 124        |       |
| ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Expenses**                                                                     |       | 159        |       | 110        |       | 83         |       |
| ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Income before income tax and equity in  undistributed   income of subsidiary** |       | 1,786      |       | 1,839      |       | 2,690      |       |
| ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Income tax benefit**                                                           |       | 60         |       | —     |       | —     |       |
| ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Income before equity in  undistributed income of subsidiary**                  |       | 1,846      |       | 1,839      |       | 2,690      |       |
| ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Equity in undistributed income  of subsidiary**                                |       | 569        |       | 496        |       | (145       | )          |
| ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net Income**                                                                   |       | $          | 2,415      |       | $          | 2,335      |       | $ | 2,545 |   |

 

41

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FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 18 –PARENT COMPANY FINANCIAL STATEMENTS **(Continued)

 

**Condensed Statements of Cash Flows**

 

| ** **                                                                    | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                                          |       |       |       |       |       |       |       |
| **Operating Activities**                                                      |       |       |       |       |       |       |       |
| Net income                                                                    |       | $          | 2,415      |       | $          | 2,335      |       | $ | 2,545 |   |
| Items not requiring (providing) cash                                          |       |       |       |       |       |       |       |
| Equity in undistributed earnings of Bank                                      |       | (569       | )          | (496       | )          | 145        |       |
| Gains on sales of securities, net                                             |       | —     |       | —     |       | (124       | )          |
| Vested stock options                                                          |       | 77         |       | 38         |       | 21         |       |
| Other                                                                         |       | (54        | )          | (96        | )          | 14         |       |
| Net cash provided by operating activities                                     |       | 1,869      |       | 1,781      |       | 2,601      |       |
|                                                                          |       |       |       |       |       |       |       |
| **Investing Activity -**proceeds from sales of securities  available for sale |       | —     |       | —     |       | 469        |       |
| ** **                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Financing Activities**                                                      |       |       |       |       |       |       |       |
| Purchase of treasury shares                                                   |       | (335       | )          | (22        | )          | (89        | )          |
| Loan proceeds (payments), net                                                 |       | 17         |       | —     |       | (603       | )          |
| Cash dividends                                                                |       | (1,946     | )          | (1,949     | )          | (1,949     | )          |
| Options exercised                                                             |       | 123        |       | 26         |       | —     |       |
| Net cash used in financing activities                                         |       | (2,141     | )          | (1,945     | )          | (2,641     | )          |
|                                                                          |       |       |       |       |       |       |       |
| **Net Change in Cash and Cash  Equivalents**                                  |       | (272       | )          | (164       | )          | 429        |       |
| ** **                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Cash and Cash Equivalents,  Beginning of Year**                             |       | 1,569      |       | 1,733      |       | 1,304      |       |
| ** **                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Cash and Cash Equivalents, End  of Year**                                   |       | $          | 1,297      |       | $          | 1,569      |       | $ | 1,733 |   |

 

42

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FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2007, 2006 and 2005

(Table dollaramounts in thousands, except per share data)

 

 

**NOTE 19 –QUARTERLY FINANCIAL DATA (UNAUDITED)**

** **

** **

** **

| ** **     | ** ** | **Interest  Income** | ** ** | **Interest Expense** | ** ** | **Net Interest Income** | ** ** | **Provision** | ** ** | **Securities  Gains** | ** ** | **Net  Income** | ** ** | **Basic**  | ** ** | **Diluted** | ** ** |
|----------------|------------|----------------------|------------|----------------------|------------|-------------------------|------------|---------------|------------|-----------------------|------------|-----------------|------------|------------|------------|-------------|------------|
| ** **     | ** ** | ** **           | ** ** | ** **           | ** ** | ** **              | ** ** | ** **    | ** ** | ** **            | ** ** | ** **      | ** ** | ** ** | ** ** | ** **  | ** ** |
| **2007**       | ** ** | ** **           | ** ** | ** **           | ** ** | ** **              | ** ** | ** **    | ** ** | ** **            | ** ** | ** **      | ** ** | ** ** | ** ** | ** **  | ** ** |
| First quarter  |       | $                    | 3,647      |                 | $          | 1,608                   |       | $             | 2,039      |                  | $          | 45              |       | $          | —     |        | $          | 499 |   | $ | 0.77 |   | $ | 0.77 |   |
| Second quarter |       | 3,792                |       | 1,551                |       | 2,241                   |       | 45            |       | —                |       | 584             |       | 0.90       |       | 0.90        |       |
| Third quarter  |       | 4,003                |       | 1,610                |       | 2,393                   |       | 45            |       | —                |       | 673             |       | 1.04       |       | 1.04        |       |
| Fourth quarter |       | 3,789                |       | 1,513                |       | 2,276                   |       | 45            |       | —                |       | 659             |       | 1.01       |       | 1.00        |       |
| ** **     | ** ** | ** **           | ** ** | ** **           | ** ** | ** **              | ** ** | ** **    | ** ** | ** **            | ** ** | ** **      | ** ** | ** ** | ** ** | ** **  | ** ** |
| **2006**       | ** ** | ** **           | ** ** | ** **           | ** ** | ** **              | ** ** | ** **    | ** ** | ** **            | ** ** | ** **      | ** ** | ** ** | ** ** | ** **  | ** ** |
| First quarter  |       | $                    | 3,558      |                 | $          | 1,410                   |       | $             | 2,148      |                  | $          | 45              |       | $          | (13        | )           | $          | 520 |   | $ | 0.80 |   | $ | 0.80 |   |
| Second quarter |       | 3,629                |       | 1,470                |       | 2,159                   |       | 45            |       | —                |       | 436             |       | 0.67       |       | 0.67        |       |
| Third quarter  |       | 3,872                |       | 1,675                |       | 2,197                   |       | 45            |       | —                |       | 655             |       | 1.01       |       | 1.01        |       |
| Fourth quarter |       | 3,869                |       | 1,806                |       | 2,063                   |       | 45            |       | —                |       | 754             |       | 1.11       |       | 1.11        |       |

 

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FIRST OTTAWABANCSHARES, INC.

STOCKHOLDERSINFORMATION

 

 

ANNUALMEETING

 

TheAnnual Meeting of Stockholders will be held at 3:00 p.m., local time on May 21,2008 at the  Company’s corporateheadquarters located at 701 LaSalle Street, Ottawa, Illinois 61350.

 

PRICERANGE OF COMMON STOCK

 

As of February 8,2008, there were approximately 531 shareholders of record and 647,312outstanding shares of the Company’s common stock.

 

TheCompany’s common stock is not traded on any national or regional securitiesexchange and there is no established public trading market for it.  Transactions in the Company’s common stockhave been infrequent.  To the knowledgeof the Company’s management, during 2006, 2007 and the first month of 2008, anaggregate of approximately 90,816 shares of the Company’s common stock wastransferred in approximately 105 separate transactions, excluding 300 sharespurchased at $71.27 per share by the Company in 2006, and the 4,093 sharespurchased by the Company at prices between $75.78 and $79.59 per share in2007.  These transfers represented bothtransfers for consideration (i.e., sales) and transfers for no consideration(e.g., gifts, estate transfers, etc.). The Company’s management is unable to differentiate such transfers andhas limited knowledge of the sale prices for transfers involvingconsideration.  The last price known tothe Company’s management was a sale of 900 shares on February 8, 2008 at$79.50 per share.

 

Thefollowing dividends per share were paid on the Company’s common stock on the datesindicated:  January 1, 2006 – $2.00;July 1, 2006 – $1.00; January 1, 2007 – $2.00; and January 1,2008 - $2.00.

 

WEB SITE FOR UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION FILINGS

 

All reports filedelectronically by the Company with the United Stated Securities ExchangeCommission (the “SEC”), including the annual report on Form 10-K,quarterly reports on Form 10-Q, and current events reports on Form 8-K,as well as any amendments to those reports are accessible at no cost on ourinternet site at www.firstottawa.com and on the SEC’s web site atwww.sec.gov.  We will also provide youwith a copy free of charge by contacting Cheryl Gage, Corporate Secretary,First Ottawa Bancshares, Inc., 701 LaSalle Street, Ottawa, Illinois 61350.

 

CORPORATE GOVERNANCE

 

The Company’s corporategovernance practices are described in the following documents, which areavailable on the Company’s Web site at www.firstottawa.com or which may beobtained in print form through the investor relations department: Code ofBusiness Conduct and Ethics, Audit Committee Charter, Nominating and CorporateGovernance Committee Charter, and Compensation Committee Charter.

** **

**44**

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** **

**StockholderReturn Performance Graph**

** **

**               **The following graph shows acomparison of cumulative total returns for First Ottawa, the Nasdaq StockMarket and an index of Midwestern bank stocks which are quoted on theOTC-Bulletin Board and on Pink Sheets. The cumulative total stockholder return computations assume the investmentof $100 on December 31, 2002 and the reinvestment of all dividends.  Figures for First Ottawa’s common stockrepresent inter-dealer quotations, without retail markups, mark downs orcommissions and do not necessarily represent actual transactions.  The graph was prepared at our request by SNL FinancialL.L.C., Charlottesville, Virginia.

** **

** **

****

** **

 
| ** **                              | ** ** | **Period Ending** | ** ** |
|-----------------------------------------|------------|-------------------|------------|
| **Index**                               | ** ** | **12/31/02**      | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** |
| First Ottawa  Bancshares, Inc.          |       | 100.00            |       | 122.60 |   | 148.51 |   | 172.71 |   | 185.39 |   | 215.98 |   |
| NASDAQ Composite                        |       | 100.00            |       | 150.01 |   | 162.89 |   | 165.13 |   | 180.85 |   | 198.60 |   |
| SNL Midwest OTC-BB and  Pink Banks Inde |       | 100.00            |       | 126.23 |   | 150.40 |   | 156.59 |   | 164.90 |   | 160.97 |   |

 

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