**Exhibit 13.1**

**SELECTED CONSOLIDATED FINANCIAL INFORMATION**

 

The following table sets forthselected consolidated financial and other data of First Ottawa Bancshares, Inc.and its wholly owned subsidiary, the First National 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 Consolidated Financial Statements and notes theretoincluded herein.  All dollar amounts arein thousands, except per share information.

 
|                                                                        |   | **Year ended  December 31,** |    |
|-----------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                        |   | **2003**                     |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| **Statement  of Income Data:**                                              |   |                         |    |   |   |   |   |   |   |   |   |
| Total interest income                                                       |   | $                            | 12,651  |   | $ | 13,092 |   | $ | 14,921 |   | $ | 15,995 |   | $ | 16,492 |   |
| Total interest expense                                                      |   | 4,384                        |    | 5,733 |   | 7,773 |   | 8,525 |   | 8,265 |   |
| Net interest income                                                         |   | 8,267                        |    | 7,359 |   | 7,148 |   | 7,470 |   | 8,227 |   |
| Provision for loan  losses                                                  |   | 120                          |    | 120 |   | 300 |   | 360 |   | 384 |   |
| Noninterest income                                                          |   | 2,592                        |    | 2,444 |   | 2,457 |   | 1,749 |   | 1,496 |   |
| Noninterest expenses                                                        |   | 7,413                        |    | 6,718 |   | 6,732 |   | 6,510 |   | 6,736 |   |
| Income before income  taxes                                                 |   | 3,326                        |    | 2,965 |   | 2,573 |   | 2,349 |   | 2,603 |   |
| Provision for income  taxes                                                 |   | 867                          |    | 678 |   | 460 |   | 257 |   | 449 |   |
|                                                                        |   |                         |    |   |   |   |   |   |   |   |   |
| Net income                                                                  |   | $                            | 2,459   |   | $ | 2,287 |   | $ | 2,113 |   | $ | 2,092 |   | $ | 2,154 |   |
|                                                                        |   |                         |    |   |   |   |   |   |   |   |   |
| **Per  Share Data:**                                                        |   |                         |    |   |   |   |   |   |   |   |   |
| Net income – basic and  diluted                                        |   | $                            | 3.75    |   | $ | 3.47 |   | $ | 3.19 |   | $ | 3.14 |   | $ | 2.87 |   |
| Cash dividends  declared                                                    |   | 3.00                         |    | 3.00 |   | 3.00 |   | 3.00 |   | 3.00 |   |
| Book value at end of  year (1)                                              |   | 35.54                        |    | 34.97 |   | 34.53 |   | 34.62 |   | 37.11 |   |
|                                                                        |   |                         |    |   |   |   |   |   |   |   |   |
| **Selected  Financial Ratios:**                                             |   |                         |    |   |   |   |   |   |   |   |   |
| Return on average  assets (1)                                               |   | 1.00                         | %       | .99 | % | .94 | % | .91 | % | .90 | % |
| Return on average  equity (1)                                               |   | 10.50                        |    | 9.73 |   | 9.18 |   | 8.89 |   | 7.58 |   |
| Dividend payout ratio                                                       |   | 79.79                        |    | 86.46 |   | 94.04 |   | 94.96 |   | 104.46 |   |
| Average equity to  average assets (1)                                       |   | 9.56                         |    | 10.20 |   | 10.29 |   | 10.25 |   | 11.87 |   |
| Net interest margin  (tax equivalent)                                       |   | 3.89                         |    | 3.77 |   | 3.74 |   | 3.87 |   | 4.11 |   |
| Allowance for loan  losses to total loans at the end of period              |   | .80                          |    | 1.06 |   | 1.01 |   | .94 |   | .82 |   |
| Nonperforming loans to  total loans at the end of period (2)                |   | 2.04                         |    | 1.83 |   | 1.15 |   | 2.26 |   | 1.52 |   |
| Net loans charged off  to average total loans                               |   | .21                          |    | .06 |   | .25 |   | .25 |   | .29 |   |
|                                                                        |   |                         |    |   |   |   |   |   |   |   |   |
| **Balance  Sheet Data:**                                                    |   |                         |    |   |   |   |   |   |   |   |   |
| Total assets                                                                |   | $                            | 294,490 |   | $ | 240,662 |   | $ | 232,565 |   | $ | 225,007 |   | $ | 240,490 |   |
| Total earning assets                                                        |   | 276,767                      |    | 223,324 |   | 216,927 |   | 210,058 |   | 219,427 |   |
| Average assets (3)                                                          |   | 247,961                      |    | 232,335 |   | 224,653 |   | 226,787 |   | 239,524 |   |
| Gross loans, including  loans held for sale                                 |   | 131,948                      |    | 111,454 |   | 109,508 |   | 117,612 |   | 129,444 |   |
| Allowance for loan  losses                                                  |   | 1,049                        |    | 1,167 |   | 1,109 |   | 1,108 |   | 1,059 |   |
| Total deposits                                                              |   | 264,921                      |    | 193,767 |   | 165,267 |   | 173,453 |   | 183,889 |   |
| Federal funds  purchased and securities sold under agreements to repurchase |   | —                       |    | 16,322 |   | 35,899 |   | 24,638 |   | 26,265 |   |
| Shareholders’ equity                                                   |   | 24,655                       |    | 25,183 |   | 22,907 |   | 22,583 |   | 25,983 |   |

 

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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.

(3)   Average for the year ended.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion andanalysis is intended as a review of significant factors affecting the financialcondition and results of operations of the Company for the periodsindicated.  The discussion should beread in conjunction with the Consolidated Financial Statements and Notes theretoand the Selected Consolidated Financial Data presented herein.  In addition to historical information, thefollowing Management’s Discussion and Analysis of Financial Condition andResults of Operations contains forward-looking statements that involve risksand uncertainties.  The Company’s actualresults could differ significantly from those anticipated in theseforward-looking statements as a result of certain factors discussed elsewherein this report.

 

**Overview**

 

The Company’s principalbusiness is conducted by the Bank and consists of a full range ofcommunity-based financial services, including commercial and retailbanking.  The profitability of theCompany’s operations depends primarily on its net interest income, provisionfor loan losses, other income, and other expenses.  Net interest income is the difference between the income theCompany receives on its loan and securities portfolios and its cost of funds,which consists of interest paid on deposits and borrowings.  The provision for loan losses reflects thecost of credit risk in the Company’s loan portfolio.  Other income consists of service charges on deposit accounts,trust and farm management fee income, securities gains (losses), gains (losses)on sales of loans, and other income. Other expenses include salaries and employee benefits, as well asoccupancy and equipment expenses and other noninterest expenses.

 

Net interest income isdependent on the amounts and yields of interest-earning assets as compared tothe 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 $2.5 million forthe year ended December 31, 2003 compared to $2.3 million for the year endedDecember 31, 2002.  The return onaverage assets was 1.00% in 2003 compared to .99% in 2002.  The return on average equity increased to10.50% in 2003 from 9.73% in 2002.  Thisresulted primarily from the increase in net income and the change in averageequity due to stock repurchases in 2003 and 2002.

 

Net income was $2.3 million forthe year ended December 31, 2002 compared to $2.1 million for the year endedDecember 31, 2001.  The return onaverage assets was .99% in 2002 compared to .94% in 2001.  The return on average equity increased to9.73% in 2002 from 9.18% in 2001.  Thisresulted primarily from the increase in net income and the change in averageequity due to stock repurchases in 2002 and 2001.

 

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**CriticalAccounting Policies**

 

The accounting and reportingpolicies of the Company are in accordance with accounting principles generallyaccepted in the United States and conform to general practices within thebanking industry.  The Company’s significant accounting policies aredescribed in detail in the notes to the Company’s consolidated financial statementsfor the year ended December 31, 2003. The preparation of financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions. The financial position andresults of operations can be affected by these estimates and assumptions andare integral to the understanding of reported results. Critical accountingpolicies are those policies that management believes are the most important tothe portrayal of the Company’s financial condition and results, and theyrequire management to make estimates that are difficult, subjective, orcomplex.

 

**Allowancefor Credit Losses-** The allowance for credit lossesprovides coverage for probable losses inherent in the Company’s loan portfolio.Management evaluates the adequacy of the allowance for credit losses eachquarter based on changes, if any, in underwriting activities, the loanportfolio composition (including product mix and geographic, industry orcustomer-specific concentrations), trends in loan performance, regulatoryguidance and economic factors. This evaluation is inherently subjective, as itrequires the use of significant management estimates. Many factors can affectmanagement’s estimates of specific and expected losses, including volatility ofdefault probabilities, rating migrations, loss severity and economic andpolitical conditions. The allowance is increased through provisions charged tooperating earnings and reduced by net charge-offs.

 

The Company determines theamount of the allowance based on relative risk characteristics of the loanportfolio. The allowance recorded for commercial loans is based on reviews ofindividual credit relationships and an analysis of the migration of commercialloans and actual loss experience. The allowance recorded for homogeneousconsumer loans is based on an analysis of loan mix, risk characteristics of theportfolio, fraud loss and bankruptcy experiences, and historical losses,adjusted for current trends, for each homogeneous category or group of loans. Theallowance for credit losses relating to impaired loans is based on the loan’sobservable market price, the collateral for certain collateral-dependent loans,or the discounted cash flows using the loan’s effective interest rate.

 

Regardless of the extent of theCompany’s analysis of customer performance, portfolio trends or risk managementprocesses, certain inherent but undetected losses are probable within the loanportfolio. This is due to several factors including inherent delays inobtaining information regarding a customer’s financial condition or changes intheir unique business conditions, the judgmental nature of individual loanevaluations, collateral assessments and 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 ofinherent losses related to the existence of these exposures.  Theestimates are based upon the Company’s evaluation of imprecision riskassociated with the commercial and consumer allowance levels and the estimatedimpact of the current economic environment.

 

3

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**MortgageServicing Rights-** Mortgage servicing rights (“MSRs”)associated with loans originated and sold, where servicing is retained, arecapitalized and included in other intangible assets in the consolidated balancesheet. The value of the capitalized servicing rights represents the presentvalue of the future servicing fees arising from the right to service loans inthe portfolio. Critical accounting policies for MSRs relate to the initial valuationand subsequent impairment tests. The methodology used to determine thevaluation of MSRs requires the development and use of a number of estimates,including anticipated principal amortization and prepayments of that principalbalance. 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 value of the MSRs is periodically reviewedfor impairment based on a determination of fair value. For purposes ofmeasuring impairment, the servicing rights are compared to a valuation preparedbased on a discounted cash flow methodology, utilizing current prepaymentspeeds and discount rates. Impairment, if any, is recognized through a valuationallowance and is recorded as amortization of intangible assets.

 

**Derivatives-**As a part of the Company’s funding strategy, derivative financial instruments,all of which are interest rate swap arrangements, are used to reduce exposureto changes in interest rates for certain financial instruments.  Thesederivatives are accounted for by recognizing the fair value of the contracts onthe balance sheet.  The valuation of these derivatives is consideredcritical because carrying assets and liabilities at fair value inherentlyresults in more financial statement volatility.  The fair values and theinformation used to record valuation adjustments for the interest rate swapsand related deposit products are provided by third parties.

 

Additionally, the Company haspurchased certificate of deposits which contain an equity related embeddedderivative component.  The initial investment in the certificate ofdeposit 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 stockincentive plan are accounted for under the provisions of Statement ofAccounting Standards (SFAS) No. 123, applying the fair value method and the useof an option pricing model to estimate the value of the options granted. Thestock options are granted with an exercise price equal to the market price at thedate of grant. Resulting compensation expense, under the stockoptions is measured and recorded based on the estimated value of the options.

 

**ConsolidatedFinancial Condition**

 

The Bank purchased and assumedsubstantially all of the deposit liabilities of two branch offices located inStreator, Illinois from First Midwest Bank on November 14, 2003.  Approximately $69.3 million of deposits andthe related cash balances were acquired, along with certain other assets of thebranches, including real estate, furniture and fixtures and approximately $11.8million of loans.  The Bank recordedgoodwill of $2.4 million and a core deposit intangible of $2.0 million inconnection with this transaction. Many of the employees remained with thebranches and became employees of the Bank.

 

4

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As a result of the branchacquisition, total assets at December 31, 2003 were $294.5 million compared to$240.7 million at December 31, 2002, an increase of $53.8 million, or22.4%.  Cash received in the transactionwas used to fund increases in cash and cash equivalents of $2.9 million,federal funds sold of $6.4 million, certificates of deposit held for investmentpurposes of $205,000, loans of  $20.6million, investments of $14.5 million, and other assets of $6.2 million.Premises and equipment increased by $3.0 million due to capital expenditures ona new branch facility in Morris, the purchase of land for a new branch inYorkville, and the acquisition of the Streator branches. Total borrowingsdecreased $14.9 million as a result of a $14.7 million decrease in federalfunds purchased and a $161,000 decrease in borrowed funds, due to the partialrepayment of a loan from Bank One. Repurchase agreements decreased by $1.6million due to a change in products offered by the Bank. Total depositsincreased $71.1 million, primarily due to the acquisition of the Streatorfacilities.

 

Total equity was $24.7 millionat December 31, 2003 compared to $25.2 million at December 31, 2002.  The decrease was primarily the result of adecrease in the unrealized gain on securities available-for-sale, net of tax,of $718,000, dividends declared of $2.0 million and by the repurchase ofCompany common stock for $315,000. The decrease was partially offset by net incomeof $2.5 million.

 

**Consolidated Results of Operations**

 

**2003 Compared to 2002**

 

*Net Interest Income*.  Net interest income was $8.3 million in 2003 compared to $7.4million in 2002, an increase of $900,000, or 12.3%.  Interest income on earning assets decreased $441,000 in 2003 from2002.  The decrease was primarily due todecreased interest income on investment securities of $638,000, attributable toa decrease in average balances and also average tax-equivalent yields availablein the marketplace in 2003. The decrease was partially offset by increases ininterest income earned on the loan portfolio of $81,000, and also interestbearing deposits held for investment purposes of $104,000. Increases in incomeare attributed to growth in average balances in these areas. Interest expenseon interest-bearing liabilities decreased $1.3 million as a result of adecrease in the average rate paid on liabilities of 85 basis points, from 3.11%in 2002 to 2.26% in 2003. The net interest margin on a tax equivalent basisincreased to 3.89% in 2003 from 3.77% in 2002. The primary reason for the increase in the net interest margin was theresult of rates on interest-bearing liabilities repricing downward and growthin NOW and Money Market products which pay lower interest rates.

 

*Provision for Loan Losses*.  The provision for loan losses remainedconstant at $120,000 in 2003 compared to 2002. As of December 31, 2003, theallowance for loan losses totaled $1.1 million, or .80% of total loans,compared to $1.2 million, or 1.06% of total loans, at December 31, 2002. Thereduction in the allowance for loan losses as a percentage of total loans wasinfluenced heavily by the acquisition of $11.4 million of Streator branch loans in the fourth quarter of 2003.

 

The amounts of the provisionand allowance for loan losses are influenced by current economic conditions,actual loss experience, industry trends and other factors, including realestate values in the Company’s market area and management’s assessment ofcurrent collection risks within the loan portfolio. Along with other financialinstitutions, management shares a concern for the

 

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outlook of the economy for2004. Even though there are indications of emerging strength, it is uncertainif this strength is sustainable. If it is not sustainable, borrowers mayexperience difficulty, and the level of non-performing loans, charge- offs, anddelinquencies could rise and require increases in the provision. The allowancefor loan losses represents management’s estimate of probable incurred lossesbased on information available 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 thatthe allowance for loan losses is adequate at December  31, 2003. However,there can be no assurance that the allowance for loan losses will be adequateto cover all losses.

 

*Noninterest Income*.  The Company’s noninterest income increased $148,000, or 6.1%compared to 2002. Noninterest income increased primarily due to increasedmortgage refinancing activity in the low rate environment. Gains on loan salesto the secondary market increased $288,000 to $733,000 in 2003 compared to2002. This increase was partially mitigated by decreases in gains on securitiessold of $102, and a decrease in other income from bank owned life insurance of$169,000. Service charges on deposit accounts increased by $98,000, or 12.8%,to $866,000. Trust and farm management fee income increased modestly by$13,000, to $472,000 in 2003 compared to 2002.

 

The increase in gains on salesof loans was the result of a continued increase in refinancings during thefirst nine months of 2003.  Due to therate structure in early 2004 and the large amount of loans that refinancedduring 2002 and 2003, current estimates indicate that the gain on sale of loansduring 2004 will be significantly less than 2003 or 2002.

 

*Noninterest Expense*.  The Company’s non-interest expense was $7.4 million in 2003 and$6.7 million for 2002.  Salaries andbenefits, which is the largest component of non-interest expense, increased$168,000, or 4.3%, to $4.1 million. Increases in occupancy and equipment expense of $76,000, data expense of$67,000, supplies expense of $73,000, advertising expense of $31,000,professional fees of $76,000 and other expenses of $204,000, contributed to the$695,000 increase in non-interest expense for the year. Increased salaries andbenefits were primarily a result of additional personnel hired to staff the newMorris facility, which opened in July 2003, and personnel retained in theacquisition of the two branches in Streator in November 2003. The increase inoccupancy and equipment expenses was due primarily to increased depreciation oncapital expenditures related to the renovation of the main banking facility inOttawa, the acquisition of the Streator facilities, and the construction of theMorris facility. In addition, the increases in supplies and advertising wereprimarily attributed to the new facilities in 2003. Increased professional feeswere a result of the consulting and legal costs associated with the branchacquisitions. Increased data expenses were a result of a platform conversionwhich was completed in November 2003. Increases in other expenses resulted primarily from increased mortgagebanking expenses of $85,000, amortization expense related to purchaseaccounting adjustments made as a result of the acquisition of the Streatorbranches of $27,000, and other expenses related to index-powered certificatesof deposit of $47,000.

 

6

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*Income Taxes*. The Company’s tax rate varied from statutory rates principally due tointerest income from tax-exempt securities and loans.  The Company’s effective tax rate was 26.1% and 22.9% for 2003 and2002.

 

**2002 Compared to 2001**

 

*Net Interest Income*.  Net interest income was $7.4 million in 2002 compared to $7.1million in 2001, an increase of $300,000, or 2.9%.  Interest income on earning assets decreased $1.8 million in 2002from 2001.  Decreased interest income onloans was attributable to a decrease in average tax-equivalent loan rates whichwere 7.65% during 2002, compared to 8.34% in 2001. Interest expense oninterest-bearing liabilities decreased $2.1 million as a result of a decreasein the average rate paid on liabilities of 125 basis points, from 4.36% in 2001to 3.11% in 2002 and a decrease in the average balance of time deposits of $5.7million.  The net interest margin on atax equivalent basis increased slightly to 3.77% in 2002 from 3.74% in 2001.

 

*Provision for Loan Losses*.  The provision for loan losses decreased$180,000 from $300,000 in 2001 to $120,000 in 2002.  The decrease in the provision was largely due to the decrease innet loans charged off,  $62,000 in 2002compared to $299,000 in 2001. Although loans considered impaired increased from$1.3 million at December 31, 2001, to $2.0 million one year later, totalportfolio delinquencies decreased to 2.5% of outstanding loans as of December31, 2002, from 4.2% at December 31, 2001. Additionally, allowance for loan lossspecific allocations relating to impaired loans increased to $396,000 in 2002,compared to $180,000 in the prior year. As of December 31, 2002, the allowancefor loan losses totaled $1.2 million, or 1.06% of total loans, compared to $1.1million, or 1.01% of total loans, at December 31, 2001.  The amounts of the provision and allowancefor loan losses are influenced by current economic conditions, actual lossexperience, industry trends, and other factors, including real estate values inthe Company’s market area and management’s assessment of current collectionrisks within its loan portfolio.

 

*Noninterest Income*.  The Company’s noninterest income totaled $2.4 million in 2002compared to $2.5 million in 2001.  Thedecrease was primarily a result of decreases in service charges on depositaccounts and net gains on sales of securities. Service charges decreased from $819,000 in 2001, to $768,000 in 2002, asa result of increases in charged off overdrafts and decreased service chargeson savings accounts.  Gains on the saleof investments also decreased to $102,000 in 2002 from $539,000 in 2001.  In 2001, management attempted to replacetax-exempt bonds with taxable positions, shorten maturities, improve interestrate risk, and enhance earnings, while in 2002 management had largelyimplemented this strategy and, as a result, security sales decreased. Thesedecreases were partially offset by changes to other income, which increasedfrom $441,000 in 2001, to $670,000 in 2002, due to a combined $245,000 increasein the cash surrender value of bank owned life insurance along with gains onproceeds from three policies settled in 2002. The $207,000 increase in gains onthe sale of mortgage loans in 2002 was primarily a result of the bank retainingservicing rights for loans sold to the secondary market in 2002, which resultedin an increase in servicing assets of $193,000.  This increase in servicing assets as well as the $14,000 increasein gains on loan sales comprised the increase in 2002 income from gains on loansales.

 

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*Noninterest Expense*.  The Company’s noninterest expense remained constant at $6.7million in 2002 and 2001. Slight decreases in data processing expense,supplies, advertising, professional fees, salaries, and employee benefits wereoffset by increases in occupancy and equipment expense due to increaseddepreciation of capital expenditures, and increases in other expenses due primarilyto expenses associated with a directors deferred compensation plan and adirectors retirement plan. Both plans are being funded primarily through theannual increase in cash surrender value of bank owned life insurance policies.

 

*Income Taxes*. The Company’s tax rate varies from statutory rates principally due tointerest income from securities, loans and income from cash surrender value oflife insurance.  The Company’s effectivetax rate was 22.9% and 17.9% for 2002 and 2001.

 

The components of the changesin net interest income are shown below. Changes in net interest income are allocated between amounts attributedto changes in rate and changes in volume for the various categories ofinterest-earning assets and interest-bearing liabilities.

 

Analysis of Changes in Interest Income and Expense

($000s)

 
|                    |   | **2003 -  2002  Increase (Decrease)** |   | **2002 -  2001  Increase (Decrease)** |   |
|-------------------------|--------|---------------------------------------|--------|---------------------------------------|--------|
|                    |   | **Total  Change**                     |   | **Change  Due to  Volume**            |   | **Change  Due to  Rate** |   | **Total  Change** |   | **Change  Due to  Volume** |   | **Change  Due to  Rate** |   |
| INTEREST  INCOME        |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| Loans                   |   | $                                     | (155   | )                                     | $      | 518 |   | $ | (673 | ) | $ | (1,194 | ) | $ | (408 | ) | $ | (786 | ) |
| Investment CDs          |   | 104                                   |   | 128                                   |   | (24 | ) | 181 |   | 193 |   | (12 | ) |
| Securities              |   | (729                                  | )      | (253                                  | )      | (476 | ) | (738 | ) | 272 |   | (1,010 | ) |
| Federal funds sold      |   | 12                                    |   | 21                                    |   | (9 | ) | (92 | ) | (27 | ) | (65 | ) |
| Total interest income   |   | (768                                  | )      | 415                                   |   | (1,183 | ) | (1,843 | ) | 30 |   | (1,873 | ) |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| INTEREST  EXPENSE       |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| NOW and money market    |   | 125                                   |   | 279                                   |   | (154 | ) | (41 | ) | 117 |   | (158 | ) |
| Savings                 |   | (105                                  | )      | 27                                    |   | (132 | ) | (14 | ) | 29 |   | (43 | ) |
| Time deposits           |   | (902                                  | )      | 43                                    |   | (945 | ) | (1,319 | ) | (263 | ) | (1,056 | ) |
| Repurchase agreements   |   | (465                                  | )      | (528                                  | )      | 63 |   | (650 | ) | (28 | ) | (622 | ) |
| Borrowings              |   | (101                                  | )      | (101                                  | )      | — |   | (26 | ) | 30 |   | (56 | ) |
| Federal funds purchased |   | 90                                    |   | 100                                   |   | (10 | ) | 10 |   | 40 |   | (30 | ) |
| Total interest expense  |   | (1,358                                | )      | (180                                  | )      | (1,178 | ) | (2,040 | ) | (75 | ) | (1,965 | ) |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| Net interest earnings   |   | $                                     | 590    |                                  | $      | 594 |   | $ | (4 | ) | $ | 197 |   | $ | 105 |   | $ | 92 |   |

 

Volume/rate variances areallocated to the volume variance and the rate variance on an absolutebasis.  Tax-exempt income is reflectedon a fully tax-equivalent basis utilizing a 34% rate for municipal securitiesand tax-exempt loans.

 

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

 

The following table sets forththe average balances, net interest income and expense, and average yields andrates for the Company’s interest-earning assets and interest-bearingliabilities for the indicated years on a tax-equivalent basis assuming a 34%tax rate.

 

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Analysis of Average Balances, Tax Equivalent Yields and Rates

Years ended December 31, 2003, 2002, and 2001

($000s)

 
|                                                                      |   | **2003**                 |    | **2002**     |   | **2001**          |   |
|---------------------------------------------------------------------------|--------|--------------------------|---------|--------------|--------|-------------------|--------|
|                                                                      |   | **Average  Balance (4)** |    | **Interest** |   | **Average  Rate** |   | **Average  Balance(4)** |   | **Interest** |   | **Average  Rate** |   | **Average  Balance (4)** |   | **Interest** |   | **Average  Rate** |   |
| ASSETS                                                                    |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1) (3)                                                             |   | $                        | 115,140 |         | $      | 8,089             |   | 7.03 | % | $ | 107,768 |   | $ | 8,244 |   | 7.65 | % | $ | 113,106 |   | $ | 9,438 |   | 8.34 | % |
| Investment CDs                                                            |   | 11,341                   |    | 357          |   | 3.15              |   | 7,259 |   | 253 |   | 3.49 |   | 1,728 |   | 72 |   | 4.17 |   |
| Securities (2) (5)                                                        |   | 93,944                   |    | 4,596        |   | 4.89              |   | 99,107 |   | 5,325 |   | 5.37 |   | 94,043 |   | 6,063 |   | 6.45 |   |
| Federal funds sold                                                        |   | 3,308                    |    | 32           |   | .97               |   | 1,154 |   | 20 |   | 1.73 |   | 2,697 |   | 112 |   | 4.15 |   |
|                                                                      |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets                                                   |   | 223,733                  |    | 13,074       |   | 5.84              |   | 215,288 |   | 13,842 |   | 6.43 |   | 211,574 |   | 15,685 |   | 7.41 |   |
|                                                                      |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest-earning assets (6)                                           |   | 24,228                   |    |         |   |              |   | 17,047 |   |   |   |   |   | 13,079 |   |   |   |   |   |
|                                                                      |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Average assets                                                            |   | $                        | 247,961 |         |   |              |   |   | $ | 232,335 |   |   |   |   |   | $ | 224,653 |   |   |   |   |   |
|                                                                      |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND SHAREHOLDERS’  EQUITY                                |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                      |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money market                                                      |   | $                        | 69,435  |         | $      | 708               |   | 1.02 |   | $ | 42,056 |   | $ | 583 |   | 1.39 |   | $ | 33,607 |   | $ | 624 |   | 1.86 |   |
| Savings                                                                   |   | 21,158                   |    | 207          |   | .98               |   | 18,388 |   | 312 |   | 1.70 |   | 16,654 |   | 326 |   | 1.96 |   |
| Time deposits                                                             |   | 92,110                   |    | 3,292        |   | 3.57              |   | 90,909 |   | 4,194 |   | 4.61 |   | 96,615 |   | 5,513 |   | 5.71 |   |
| Repurchase agreements                                                     |   | 475                      |    | 10           |   | 2.11              |   | 25,567 |   | 475 |   | 1.86 |   | 27,062 |   | 1,125 |   | 4.16 |   |
| Federal funds purchased                                                   |   | 10,713                   |    | 158          |   | 1.47              |   | 3,902 |   | 68 |   | 1.74 |   | 1,589 |   | 58 |   | 3.65 |   |
| Borrowings                                                                |   | —                   |    | —       |   | —            |   | 3,808 |   | 101 |   | 2.65 |   | 2,685 |   | 127 |   | 4.73 |   |
| Interest-bearing liabilities                                              |   | 193,891                  |    | 4,375        |   | 2.26              |   | 184,630 |   | 5,733 |   | 3.11 |   | 178,212 |   | 7,773 |   | 4.36 |   |
|                                                                      |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income(2)                                                    |   |                     |    | 8,699        |   |              |   |   |   | 8,109 |   |   |   |   |   | 7,912 |   |   |   |
| Net yield on interest- earning assets                                     |   |                     |    |         |   | 3.89              |   |   |   |   |   | 3.77 |   |   |   |   |   | 3.74 |   |
| Interest-bearing liabilities to earning assets ratio                      |   |                     |    |         |   | 86.66             |   |   |   |   |   | 85.76 |   |   |   |   |   | 84.23 |   |
|                                                                      |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing liabilities                                          |   | 28,644                   |    |         |   |              |   | 22,959 |   |   |   |   |   | 22,749 |   |   |   |   |   |
|                                                                      |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                                                 |   | 25,426                   |    |         |   |              |   | 24,746 |   |   |   |   |   | 23,692 |   |   |   |   |   |
| Average liabilities and shareholders’ equity                         |   | $                        | 247,961 |         |   |              |   |   | $ | 232,335 |   |   |   |   |   | $ | 224,653 |   |   |   |   |   |
|                                                                      |   |                     |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Tax equivalent adjustment                                                 |   |                     |    | 432          |   |              |   |   |   | 750 |   |   |   |   |   | 764 |   |   |   |
| Net interest income as reported in the consolidated statements of  income |   |                     |    | $            | 8,267  |              |   |   |   |   | $ | 7,359 |   |   |   |   |   | $ | 7,148 |   |   |   |

 

----

(1)          Interestincome on loans includes loan origination and other fees of $275 for 2003, $456for 2002, and $285 for 2001.

(2)          Loanand securities income is reflected on a fully tax-equivalent basis utilizing a34% rate for municipal securities and tax-exempt loans

(3)          Non-accrualloans are included in average loans.

(4)          Averagebalances are derived from the average daily balances.

(5)          Rateinformation is calculated based upon average amortized cost.

(6)          Averagebalance information includes an average valuation allowance for securities of$3,375, $1,867, and $1,023, respectively.

 

9

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**Impactof Accounting Changes**

 

In May 2003, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 150, *Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity*.  SFAS 150 establishesstandards for classification and measurement in the statement of financialposition of certain financial instruments with characteristics of bothliabilities and equity.  It requiresthat an issuer classify a financial instrument that is within its scope as aliability.  The FASB’s Staff Position150-3 deferred indefinitely the guidance in SFAS No. 150 on certain mandatorilyredeemable noncontrolling interests. The Company has determined that it has no such instruments covered bySFAS No. 150 and Staff Bulletin 150-3.

 

In April 2003, the FASB issuedSFAS No. 149, *Amendment of Statement 133 onDerivative Instruments and Hedging Activities*.  This statement clarifies reporting ofcontracts as either derivatives or hybrid instruments.  The Company has determined that allderivatives or hybrid instruments covered under this statement have beenproperly reported under SFAS No. 149.

 

In January 2003, the FASBissued FASB Interpretation No. 46 *Consolidationof Variable Interest Entities*. FIN 46 provides guidance with respect to variable interest entities andwhen the assets, liabilities, noncontrolling interest, and results ofoperations of a variable interest entity need to be included in a company’sconsolidated financial statements. A variable interest entity exists wheneither the total equity investment at risk is not sufficient to permit theentity to finance its activities by itself, or the equity investors lack one ofthree characteristics associated with owning a controlling financial interest.Those characteristics are the direct or indirect ability to make decisionsabout an entity’s activities through voting rights or similar rights, theobligation to absorb the expected losses of an entity if they occur, and theright to receive the expected residual returns of the entity if they occur.

 

In December 2003 the FASBdeferred certain effective dates for Interpretation No. 46.  For all variable interest entities otherthan special purpose entities, the revised Interpretation is effective forperiods ending after March 15, 2004. For variable interest entities meeting the definition of special purposeentities under earlier accounting rules, the Interpretation remains effectivefor periods ending after December 31, 2003.   The Company has determined that it has no such instruments covered byInterpretation No. 46.

 

In November 2002, FASBInterpretation No. 45 (“FIN 45”), Guarantor’s *Accountingand Disclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others* was issued. FIN 45 requires the disclosuresto be made by a guarantor in its financial statements about its obligationsunder certain guarantees that it has issued. It also clarifies that a guarantoris required to recognize, at the inception of a guarantee, a liability for thefair value of the obligation undertaken in issuing the guarantee. The mostsignificant FIN 45 instruments of the Company are standby letters ofcredit.  The Company has determined thatits standby letters of credit obligations under FIN 45 are not material fordisclosure.

 

10

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**QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

The Company uses overall risksensitivity to monitor and manage exposure to sudden changes in interestrates.  The Company’s overall interestrate sensitivity is demonstrated by a net interest income analysis.  Net interest income analysis measures the changein net interest income in the event of hypothetical changes in interestrates.  This analysis assesses the riskof change in net interest income in the event of sudden and sustained 1.0%increases and decreases in market interest rates.  The tables below present the Company’s projected changes in netinterest income for the various rate shock levels for the periods endedDecember 31, 2003 and 2002.

 
|         |   | **2003 Net  Interest Income** |   |
|--------------|--------|-------------------------------|--------|
|         |   | **Amount**                    |   | **Change** |   | **Change** |   |
|         |   | **(Dollars  in Thousands)**   |   |
|         |   |                          |   |   |   |   |   |
| +100 bp      |   | $                             | (3,210 | ) | $ | (64 | ) | (2.0 | )% |
| Base         |   | 3,146                         |   | — |   | — |   |
| –100 bp |   | 3,121                         |   | (25 | ) | (0.8 | )% |
|              |        |                               |        |  |  |  |  |  |  |

 
|         |   | **2002 Net  Interest Income** |   |
|--------------|--------|-------------------------------|--------|
|         |   | **Amount**                    |   | **Change** |   | **Change** |   |
|         |   | **(Dollars  in Thousands)**   |   |
|         |   |                          |   |   |   |   |   |
| +100 bp      |   | $                             | 2,560  |   | $ | (73 | ) | (2.8 | )% |
| Base         |   | 2,633                         |   | — |   | — |   |
| –100 bp |   | 2,561                         |   | (72 | ) | (2.7 | )% |
|              |        |                               |        |  |  |  |  |  |  |

 

As shown above, at December 31,2003, the effect of an immediate 100 basis point increase in interest rateswould decrease the Company’s net interest income by 2.0% or approximately$64,000.  The effect of an immediate 100basis point decrease in rates would decrease the Company’s net interest incomeby 0.8%, or approximately $25,000, as federal funds overnight rates were under2.0% as of December 31, 2003, market interest rates decreasing an additional200 basis points is not achievable.  TheCompany’s Board of Directors has set a risk tolerance limit of 10% of estimatednet interest income for the succeeding 12 months based on an immediate 200basis point change in market prices.

 

Interest rate sensitivityreflected modest exposure in an increasing rate environment at the end of2003.  Overall net interest incomesensitivity decreased in 2003 compared to 2002.

 

**Liquidityand Capital Resources**

 

The Company’s primary sourcesof funds are deposits, repurchase agreements, and proceeds from principal andinterest payments on loans and securities. While maturities and scheduled amortization of loans and securities andcalls of securities are predictable sources of funds, deposit flows andmortgage prepayments are greatly influenced by general interest rates, economicconditions, and competition.  TheCompany generally manages the pricing of its deposits to be competitive and toincrease core deposit relationships.

Liquidity management is both adaily and long-term responsibility of management.  The Company adjusts its investments in liquid assets based uponmanagement’s assessment of

 

11

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(i) expected loan demand,(ii) expected deposit flows, (iii) yields available oninterest-earning deposits and securities, and (iv) the objectives of itsasset/liability management program. Excess liquid assets are invested generally in interest-earningovernight deposits and short- and intermediate-term U.S. government and agencyobligations.

 

The Company’s cash flows arecomprised of three primary classifications: cash flows from operating activities, investing activities, andfinancing activities.  Cash flowsprovided by operating activities were $1.9 million, $2.0 million, and $2.4million for the years ended December 31, 2003, 2002, and 2001.  Net cash from investing activities consistedprimarily of principal collections on loans and proceeds from maturation andsales of securities offset by disbursements for loan originations and thepurchase of securities.  In 2003, cashflows from investing activities were also affected by the $51.2 million in cashreceived in connection with the branch acquisition.  Net cash from financing activities consisted primarily of changesin net deposits and short-term borrowings partially offset by dividends paidand the purchase of Company stock.

 

The Company’s most liquidassets are cash and short-term investments. The levels of these assets are dependent on the Company’s operating,financing, lending, and investing activities during any given year.  At December 31, 2003, cash and short-terminvestments totaled $17.9 million.  TheCompany has other sources of liquidity if a need for additional funds arises,including securities maturing within one year and the repayment of loans.  The Company may also utilize the sale ofsecurities available-for-sale, federal funds lines of credit from correspondentbanks, and borrowings from the Federal Home Loan Bank of Chicago and Bank One.

 

The following table disclosescontractual obligations and commercial commitments of the Company as ofDecember 31, 2003:

 
|                              |   | **Total** |   | **Less Than  1 Year** |   | **1 – 3  Years** |   | **4 – 5  Years** |   | **After  5 Years** |   |
|-----------------------------------|--------|-----------|--------|-----------------------|--------|-----------------------|--------|-----------------------|--------|--------------------|--------|
|                              |   |      |   |                  |   |                  |   |                  |   |               |   |
| Note payable                      |   | $         | 490    |                  | $      | 490                   |   | —                |   | —             |   | — |   |
| Data processing  contract payable |   | 1,091     |   | 193                   |   | $                     | 387    |                  | $      | 511                |   |   |   |
| Lines of credit(1)                |   | 15,801    |   | 10,527                |   | 2,860                 |   | 1,260                 |   | $                  | 1,154  |   |
| Standby letters of  credit(1)     |   | 136       |   | 136                   |   | —                |   | —                |   | —             |   |
|                              |   | $         | 16,427 |                  | $      | 11,153                |   | $                     | 2,860  |               | $      | 1,260 |   | $ | 1,154 |   |
|                                   |        |           |        |                       |        |                       |        |                       |        |                    |        |  |  |  |  |  |  |

 

----

(1)  Represents amounts committed to customers.

 

During 2003 and 2002, theCompany repurchased 5,329 and 1,400 shares of common stock for $315,000 and$74,000.

 

Capital provides the foundationfor future growth.  Regulatory agencieshave developed minimum guidelines by which the adequacy of a financialinstitution’s capital may be evaluated. At December 31, 2003, all of the Company’s ratios exceeded the levelsrequired under regulatory guidelines as shown in Note 15 of the ConsolidatedFinancial Statements.

 

12

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**Facilities**

 

The Company has purchased realestate in Yorkville, Illinois and is in the process of establishing a fullservice branch facility in that community. Construction of the facility is to begin in late 2004 and the branch isexpected to open in early 2005.  Thetotal estimated costs to complete the branch are $700,000 at December 31, 2003.

 

**Impactof Inflation and Changing Prices**

 

The financial statements andrelated data presented herein have been prepared in accordance with accountingprinciples generally accepted in the United States of America, which requirethe measurement of financial position and operating results in terms ofhistorical dollars without considering changes in the relative purchasing powerof money over time due to inflation. The primary impact of inflation on the operations of the Company isreflected in increased operating costs. Unlike most industrial companies, virtually all of the assets andliabilities of a financial institution are monetary in nature.  As a result, interest rates generally have amore significant impact on a financial institution’s performance than doesinflation.  Interest rates do notnecessarily move in the same direction or to the same extent as the prices ofgoods and services.

 

**SafeHarbor Statement**

 

This document (includinginformation incorporated by reference) contains, and future oral and writtenstatements of the Company and its management may contain, forward-lookingstatements, within the meaning of such terms in the Private SecuritiesLitigation Reform Act of 1995, with respect to the financial condition, resultsof operations, plans, objectives, future performance and business of theCompany.  Forward-looking statements,which may be based upon beliefs, expectations and assumptions of the Company’smanagement and on information currently available to management, are generallyidentifiable by the use of words such as “believe,” “expect,” “anticipate”“plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” or “should” orother similar expressions.  Additionally,all statements in this document, including forward-looking statements, speakonly as of the date they are made, and the Company undertakes no obligation toupdate any statements in light of new information or future events.

 

The Company’s ability topredict results of the actual effect of future plans or strategies isinherently uncertain.  Factors whichcould have a material adverse effect on the operations and future prospects ofthe Company and its subsidiaries include, but are not limited to, thefollowing:

 

•                  The strength ofthe United States economy in general and the strength of the local economies inwhich the Company conducts it operations which may be less favorable thanexpected and may result in, among other things, a deterioration in the creditquality and value of the Company’s assets

 

•                  The economicimpact of past and any future terrorist attacks, acts of war or threats thereofand the response of the United States to any such threats and attacks.

 

•                  The effects of,and changes in, federal, state, and local laws, regulations and policiesaffecting banking, securities, insurance and monetary and financial matters.

 

13

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•                  The effects ofchanges in interest rates (including the effects of changes in the rate ofprepayments of the Company’s assets) and the policies of the Board of Governorsof the Federal Reserve System.

 

•                  The ability ofthe Company to compete with other financial institutions as effectively as theCompany currently intends due to increases in competitive pressures in thefinancial services sector.

 

•                  The inability ofthe Company to obtain new customers and to retain existing customers.

 

•                  The timelydevelopment and acceptance of products and services, including products andservices offered through alternative delivery channels such as the Internet.

 

•                  Technologicalchanges implemented by the Company and by other parties, including third partyvendors, which may be more difficult or more expensive than anticipated orwhich may have unforeseen consequences to the Company and its customers.

 

•                  The ability ofthe Company to develop and maintain secure and reliable electronic systems.

 

•                  The ability ofthe Company to retain key executives and employees and the difficulty that theCompany may experience in replacing key executives and employees in aneffective manner.

 

•                  Consumerspending and savings habits which may change in a manner that affects theCompany’s business adversely.

 

•                  Businesscombinations and the integration of acquired businesses which may be moredifficult or expensive that expected.

 

•                  The costs,effects and outcomes of existing or future litigation.

 

•                  Changes inaccounting policies and practices, as may be adopted by state and federalregulatory agencies and the Financial Accounting Standards Board.

 

•                  The ability ofthe Company to manage the risks associated with the foregoing as well asanticipated.

 

These risks and uncertaintiesshould be considered in evaluating forward-looking statements and undue relianceshould not be placed on such statements. Additional information concerning theCompany and its business, including other factors that could materially affectthe Company’s financial results, is included in the Company’s filings with theSecurities and Exchange Commission.

 

14

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INDEPENDENTACCOUNTANTS’ REPORT

 

Board of Directors andShareholders

First Ottawa Bancshares, Inc.

Ottawa, Illinois

 

We have audited theaccompanying consolidated balance sheet of First Ottawa Bancshares, Inc. as ofDecember 31, 2003 and the related consolidated statements of income,shareholders’ equity, and cash flows for the year then ended.  These consolidated financial statements arethe responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audit. The consolidated financial statements of the Company as of December 31,2002 and for each of the two years in the period ended December 31, 2002 wereaudited by other accountants whose report dated January 17, 2003, expressed anunqualified opinion on those statements.

 

We conducted our audit inaccordance with auditing standards generally accepted in the United States ofAmerica.  Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, 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 statement presentation.  We believe that our audit provides areasonable basis for our opinion.

 

In our opinion, the 2003consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of First Ottawa Bancshares, Inc. asof December 31, 2003 and the results of its operations and its cash flows forthe year then ended in conformity with accounting principles generally acceptedin the United States of America.

 

BKD, LLP

Indianapolis, Indiana

January 23, 2004

 

15

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REPORT OFINDEPENDENT AUDITORS

 

Board of Directors andShareholders

First Ottawa Bancshares, Inc.

Ottawa, Illinois

 

We have audited theaccompanying balance sheet of First Ottawa Bancshares, Inc. as of December 31,2002, and the related consolidated statements of income, stockholders' equity,and cash flows for each of the two years in the period ended December 31,2002.  These financial statements arethe responsibility of the Company's management.  Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits inaccordance with auditing standards generally accepted in the United States ofAmerica.  Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, 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 ouraudits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of First Ottawa Bancshares, Inc. atDecember 31, 2002 and the results of its operations and its cash flows for eachof the two years in the period ended December 31, 2002, in conformity withaccounting principles generally accepted in the United States of America.

 

 

 

 
|   | Crowe Chizek  and Company LLC |
|--------|-------------------------------|

 

Oak Brook, Illinois

January 17, 2003

 

 

 

----

 

 

 

 

FIRST OTTAWA BANCSHARES, INC.

CONSOLIDATEDBALANCE SHEETS

December 31, 2003 and 2002

(In thousands, except share and per share data)

 
|                                                                         |   | **2003** |       | **2002** |       |
|------------------------------------------------------------------------------|--------|----------|------------|----------|------------|
| **ASSETS**                                                                   |   |     |       |     |       |
| Cash and due from  banks                                                     |   | $        | 11,477     |     | $          | 8,606 |   |
| Federal funds sold                                                           |   | 6,400    |       | —   |       |
| Cash and cash  equivalents                                                   |   | 17,877   |       | 8,606    |       |
| Certificates of deposit                                                      |   | 13,190   |       | 12,985   |       |
| Securities available for sale                                                |   | 113,433  |       | 98,885   |       |
| Loans held for sale                                                          |   | 1,644    |       | 1,811    |       |
| Loans, less allowance for loan losses of  $1,049 and $1,167                  |   | 129,255  |       | 108,476  |       |
| Premises and equipment, net                                                  |   | 7,537    |       | 4,555    |       |
| Interest receivable and other assets                                         |   | 11,554   |       | 5,344    |       |
|                                                                         |   |     |       |     |       |
| Total assets                                                                 |   | $        | 294,490    |     | $          | 240,662 |   |
|                                                                         |   |     | ** ** |     | ** ** |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                |   |     | ** ** |     | ** ** |
| Liabilities                                                                  |   |     |       |     |       |
| Deposits                                                                     |   | $        | 264,921    |     | $          | 193,767 |   |
| Federal funds  purchased                                                     |   | —   |       | 14,700   |       |
| Securities sold under agreements to  repurchase                              |   | —   |       | 1,622    |       |
| Other borrowings                                                             |   | 490      |       | 652      |       |
| Interest payable and other liabilities                                       |   | 4,424    |       | 4,738    |       |
| Total liabilities                                                            |   | 269,835  |       | 215,479  |       |
|                                                                         |   |     |       |     |       |
| Shareholders’ equity                                                    |   |     |       |     |       |
| Preferred stock -  $1 par value, 20,000 shares Authorized; none issued  |   | —   |       | —   |       |
| Common stock - $1 par value, 1,000,000  shares authorized and 750,000 issued |   | 750      |       | 750      |       |
| Additional paid-in  capital                                                  |   | 4,008    |       | 4,000    |       |
| Retained earnings                                                            |   | 23,988   |       | 23,491   |       |
| Treasury stock, at  cost - 98,373 and 93,044 shares                          |   | (5,585   | )          | (5,270   | )          |
| Accumulated other comprehensive income                                       |   | 1,494    |       | 2,212    |       |
| Total shareholders’ equity                                              |   | 24,655   |       | 25,183   |       |
|                                                                         |   |     |       |     |       |
| Total liabilities and shareholders’ equity                              |   | $        | 294,490    |     | $          | 240,662 |   |

 

See accompanying notes to consolidated financial statements.

 

16

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FIRST OTTAWA BANCSHARES, INC.

CONSOLIDATEDSTATEMENTS OF INCOME

Years ended December 31, 2003, 2002, and 2001

(In thousands, except share and per share data)

 
|                                                     |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Interest income                                          |   |     |   |     |   |     |   |
| Loans                                                    |   | $        | 8,057  |     | $      | 7,976    |   | $ | 9,416 |   |
| Securities                                               |   |     |   |     |   |     |   |
| Taxable                                                  |   | 3,457    |   | 3,933    |   | 3,880    |   |
| Exempt from federal income tax                           |   | 748      |   | 910      |   | 1,441    |   |
| Federal funds sold                                       |   | 32       |   | 20       |   | 112      |   |
| Interest-bearing deposits                                |   | 357      |   | 253      |   | 72       |   |
| Total interest income                                    |   | 12,651   |   | 13,092   |   | 14,921   |   |
|                                                     |   |     |   |     |   |     |   |
| Interest expense                                         |   |     |   |     |   |     |   |
| Deposits                                                 |   | 4,207    |   | 5,089    |   | 6,463    |   |
| Repurchase agreements                                    |   | 10       |   | 475      |   | 1,125    |   |
| Federal funds purchased                                  |   | 158      |   | 68       |   | 58       |   |
| Other borrowings                                         |   | 9        |   | 101      |   | 127      |   |
| Total interest expense                                   |   | 4,384    |   | 5,733    |   | 7,773    |   |
|                                                     |   |     |   |     |   |     |   |
| **Net interest income**                                  |   | 8,267    |   | 7,359    |   | 7,148    |   |
|                                                     |   |     |   |     |   |     |   |
| Provision for loan losses                                |   | 120      |   | 120      |   | 300      |   |
|                                                     |   |     |   |     |   |     |   |
| **Net interest income after provision for  loan losses** |   | 8,147    |   | 7,239    |   | 6,848    |   |
|                                                     |   |     |   |     |   |     |   |
| Noninterest income                                       |   |     |   |     |   |     |   |
| Service charges on deposit accounts                      |   | 866      |   | 768      |   | 819      |   |
| Trust and farm management fee income                     |   | 472      |   | 459      |   | 420      |   |
| Gain on sale of loans                                    |   | 733      |   | 445      |   | 238      |   |
| Securities gains net                                     |   | —   |   | 102      |   | 539      |   |
| Other income                                             |   | 521      |   | 670      |   | 441      |   |
| Total noninterest income                                 |   | 2,592    |   | 2,444    |   | 2,457    |   |
|                                                     |   |     |   |     |   |     |   |
| Noninterest expenses                                     |   |     |   |     |   |     |   |
| Salaries and employee benefits                           |   | 4,122    |   | 3,954    |   | 3,893    |   |
| Occupancy and equipment expense                          |   | 943      |   | 867      |   | 822      |   |
| Data processing expense                                  |   | 500      |   | 433      |   | 510      |   |
| Supplies                                                 |   | 190      |   | 117      |   | 119      |   |
| Professional fees                                        |   | 419      |   | 343      |   | 354      |   |
| Other expenses                                           |   | 1,239    |   | 1,004    |   | 1,034    |   |
| Total noninterest expenses                               |   | 7,413    |   | 6,718    |   | 6,732    |   |
|                                                     |   |     |   |     |   |     |   |
| **Income before income taxes**                           |   | 3,326    |   | 2,965    |   | 2,573    |   |
|                                                     |   |     |   |     |   |     |   |
| Provision for income taxes                               |   | 867      |   | 678      |   | 460      |   |
|                                                     |   |     |   |     |   |     |   |
| **Net income**                                           |   | $        | 2,459  |     | $      | 2,287    |   | $ | 2,113 |   |
|                                                     |   |     |   |     |   |     |   |
| Earnings per share                                       |   | $        | 3.75   |     | $      | 3.47     |   | $ | 3.19 |   |
|                                                     |   |     |   |     |   |     |   |
| Average shares outstanding                               |   | 655,243  |   | 658,267  |   | 662,249  |   |

 

See accompanying notes to consolidatedfinancial statements.

 

17

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FIRST OTTAWA BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

Years ended December 31, 2003, 2002, and 2001

(In thousands, except share and per share data)

 
|                                                                                             |   | **Common  Stock** |   | **Additional  Paid-In  Capital** |   | **Retained  Earnings** |   | **Treasury  Stock** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Total  Share-  holders’  Equity** |   |
|--------------------------------------------------------------------------------------------------|--------|-------------------|--------|----------------------------------|--------|------------------------|--------|---------------------|--------|------------------------------------------------------|--------|------------------------------------------|--------|
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Balance at January 1, 2001                                                                       |   | $                 | 750    |                             | $      | 4,000                  |   | $                   | 23,052 |                                                 | $      | (5,000                                   | )      | $ | (219 | ) | $ | 22,583 |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Net income                                                                                       |   | —            |   | —                           |   | 2,113                  |   | —              |   | —                                               |   | 2,113                                    |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Unrealized net gain on securities  available-for-sale, net of reclassi- fication and tax effects |   | —            |   | —                           |   | —                 |   | —              |   | 394                                                  |   | 394                                      |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Comprehensive income                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   | 2,507                                    |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Cash dividends ($3.00 per share)                                                                 |   | —            |   | —                           |   | (1,987                 | )      | —              |   | —                                               |   | (1,987                                   | )      |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Purchase of 3,925 treasury shares                                                                |   | —            |   | —                           |   | —                 |   | (196                | )      | —                                               |   | (196                                     | )      |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Balance at December 31, 2001                                                                     |   | 750               |   | 4,000                            |   | 23,178                 |   | (5,196              | )      | 175                                                  |   | 22,907                                   |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Net income                                                                                       |   | —            |   | —                           |   | 2,287                  |   | —              |   | —                                               |   | 2,287                                    |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Unrealized net gain on securities  available-for-sale, net of reclassi- fication and tax effects |   | —            |   | —                           |   | —                 |   | —              |   | 2,254                                                |   | 2,254                                    |   |
| Change in minimum pension liability, net of  tax                                                 |   | —            |   | —                           |   | —                 |   | —              |   | (217                                                 | )      | (217                                     | )      |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Comprehensive income                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   | 4,324                                    |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Cash dividends ($3.00 per share)                                                                 |   | —            |   | —                           |   | (1,974                 | )      | —              |   | —                                               |   | (1,974                                   | )      |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Purchase of 1,400 treasury shares                                                                |   | —            |   | —                           |   | —                 |   | (74                 | )      | —                                               |   | (74                                      | )      |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Balance at December 31, 2002                                                                     |   | 750               |   | 4,000                            |   | 23,491                 |   | (5,270              | )      | 2,212                                                |   | 25,183                                   |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Net income                                                                                       |   | —            |   | —                           |   | 2,459                  |   | —              |   | —                                               |   | 2,459                                    |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Unrealized net loss on securities  available-for-sale, net of reclassi- fication and tax effects |   | —            |   | —                           |   | —                 |   | —              |   | (718                                                 | )      | (718                                     | )      |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Comprehensive income                                                                             |   | —            |   | —                           |   | —                 |   | —              |   | —                                               |   | 1,741                                    |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Cash dividends ($3.00 per share)                                                                 |   | —            |   | —                           |   | (1,962                 | )      | —              |   | —                                               |   | (1,962                                   | )      |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Options vested                                                                                   |   | —            |   | 8                                |   | —                 |   | —              |   | —                                               |   | 8                                        |   |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Purchase of 5,329 treasury shares                                                                |   | —            |   | —                           |   | —                 |   | (315                | )      | —                                               |   | (315                                     | )      |
|                                                                                             |   |              |   |                             |   |                   |   |                |   |                                                 |   |                                     |   |
| Balance at December 31, 2003                                                                     |   | $                 | 750    |                             | $      | 4,008                  |   | $                   | 23,988 |                                                 | $      | (5,585                                   | )      | $ | 1,494 |   | $ | 24,655 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

18

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FIRST OTTAWA BANCSHARES, INC.

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

Years ended December 31, 2003, 2002, and 2001

(In thousands, except per share data)

 
|                                                                       |   | **2003** |       | **2002** |       | **2001** |       |
|----------------------------------------------------------------------------|--------|----------|------------|----------|------------|----------|------------|
| **Cash  flows from operating activities**                                  |   |     |       |     |       |     |       |
| Net income                                                                 |   | $        | 2,459      |     | $          | 2,287    |       | $ | 2,113 |   |
| Adjustments to reconcile net income to net  cash from operating activities |   |     |       |     |       |     |       |
| Provision for loan losses                                                  |   | 120      |       | 120      |       | 300      |       |
| Depreciation and amortization                                              |   | 335      |       | 331      |       | 283      |       |
| Premium amortization on securities, net                                    |   | 189      |       | 128      |       | 35       |       |
| Net real estate loans originated for sale                                  |   | 900      |       | 109      |       | (544     | )          |
| Net gains on loan sales                                                    |   | (733     | )          | (445     | )          | (238     | )          |
| Net gains on sales of securities                                           |   | —   |       | (102     | )          | (539     | )          |
| Change in interest receivable and other  assets                            |   | (1,465   | )          | 474      |       | 1,087    |       |
| Change in interest payable and other  liabilities                          |   | 70       |       | (929     | )          | (41      | )          |
| Net cash from operating activities                                         |   | 1,875    |       | 1,973    |       | 2,456    |       |
|                                                                       |   |     | ** ** |     | ** ** |     | ** ** |
| **Cash flows from investing activities**                                   |   |     | ** ** |     | ** ** |     | ** ** |
| Proceeds from sales of securities  available-for-sale                      |   | —   |       | 7,831    |       | 19,612   |       |
| Proceeds from maturities and calls of  securities                          |   | 27,879   |       | 18,280   |       | 46,297   |       |
| Purchases of securities and  available-for-sale                            |   | (43,703  | )          | (16,811  | )          | (77,159  | )          |
| Purchases of certificates of deposit                                       |   | (8,090   | )          | (9,885   | )          | (3,100   | )          |
| Proceeds from maturities of certificates of  deposit                       |   | 7,885    |       | —   |       | —   |       |
| Net change in loans receivable                                             |   | (9,295   | )          | (2,003   | )          | 8,372    |       |
| Premises and equipment expenditures, net                                   |   | (2,537   | )          | (2,030   | )          | (608     | )          |
| Cash received in branch acquisition                                        |   | 52,163   |       | —   |       | —   |       |
| Net cash from investing activities                                         |   | 24,302   |       | (4,618   | )          | (6,586   | )          |
|                                                                       |   |     | ** ** |     | ** ** |     | ** ** |
| **Cash flows from financing activities**                                   |   |     | ** ** |     | ** ** |     | ** ** |
| Change in deposits                                                         |   | 1,866    |       | 28,500   |       | (8,186   | )          |
| Change in federal funds purchased                                          |   | (14,700  | )          | 9,650    |       | 5,050    |       |
| Change in securities sold under agreements  to repurchase                  |   | (1,622   | )          | (29,227  | )          | 6,211    |       |
| Proceeds from borrowings                                                   |   | —   |       | 452      |       | 4,200    |       |
| Repayment of borrowings                                                    |   | (162     | )          | (4,000   | )          | —   |       |
| Purchase of treasury stock                                                 |   | (315     | )          | (74      | )          | (196     | )          |
| Dividends paid                                                             |   | (1,973   | )          | (1,983   | )          | (1,987   | )          |
| Net cash from financing activities                                         |   | (16,906  | )          | 3,318    |       | 5,092    |       |
|                                                                       |   |     |       |     |       |     |       |
| Change in cash and due from banks                                          |   | 9,271    |       | 673      |       | 962      |       |
|                                                                       |   |     |       |     |       |     |       |
| Cash and due from banks at beginning of  year                              |   | 8,606    |       | 7,933    |       | 6,971    |       |
|                                                                       |   |     |       |     |       |     |       |
| **Cash and due from banks at end of year**                                 |   | $        | 17,877     |     | $          | 8,606    |       | $ | 7,933 |   |
|                                                                       |   |     |       |     |       |     |       |
| Supplemental disclosures of cash flow  information                         |   |     |       |     |       |     |       |
| Cash paid during the year for                                              |   |     |       |     |       |     |       |
| Interest                                                                   |   | $        | 4,552      |     | $          | 6,217    |       | $ | 8,038 |   |
| Income taxes, net of refunds                                               |   | 821      |       | 563      |       | 350      |       |
|                                                                       |   |     |       |     |       |     |       |
| Noncash investing activities                                               |   |     |       |     |       |     |       |
| Transfers made from loans to other real  estate owned                      |   | 174      |       | 331      |       | 215      |       |
| Due from broker                                                            |   | —   |       | (477     | )          | 477      |       |
| Assets acquired and liabilities assumed in  branch acquisition:            |   |     |       |     |       |     |       |
| Loans                                                                      |   | 11,774   |       | —   |       | —   |       |
| Premises and equipment                                                     |   | 780      |       | —   |       | —   |       |
| Goodwill and core deposit intangibles                                      |   | 4,553    |       | —   |       | —   |       |
| Other assets, net                                                          |   | 18       |       | —   |       | —   |       |
| Deposits                                                                   |   | (69,288  | )          | —   |       | —   |       |

 

See accompanying notes to consolidated financial statements.

 

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FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2003, 2002, and 2001

(Table dollars in thousands, except per share data)

 

**NOTE1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

Nature ofOperations 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 (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 fromother financial institutions.  The Bankis subject to the regulation of certain federal and state agencies andundergoes periodic examinations by those regulatory authorities.  The consolidated financial statementsinclude 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.

 

Use ofEstimates:  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 asavailable-for-sale when they might be sold before maturity.  Securities available-for-sale are carried atfair value, with unrealized holding gains and losses reported, net of tax, asother comprehensive income.  Equitysecurities include Federal Home Loan Bank stock and Federal Reserve Bank stock,which are restricted securities that are carried at cost, and a mutual fundinvestment that 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.

 

Realized gains and losses onsales are determined using the amortized cost of the specific securitysold.  Interest income includesamortization of purchase premiums and discounts.

 

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 adjustmentsrelated to cash flow hedges are recorded in other comprehensive income andreclassified to earnings when the hedged transaction is reflected inearnings.  Ineffective portions ofhedges are reflected in earnings as they occur.

 

20

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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.

 

Allowance forLoan Losses: The allowance for loan losses is established as losses are estimated tohave occurred through a provision for loan losses charged to income.  Loan losses are charged against theallowance when management believes the uncollectibility of a loan balance isconfirmed.  Subsequent recoveries, ifany, are credited to the allowance. Management estimates the allowance balancerequired based on past loan loss experience, known and inherent risks in theportfolio, information about specific borrower situations and estimatedcollateral values, economic conditions, and other factors.  Allocations of the allowance may be made forspecific loans, but the entire allowance is available for any loan that, inmanagement’s judgment, should be charged off.

 

Loan impairment is reportedwhen full payment under the loan terms is not expected.  Impairment is evaluated in total forsmaller-balance loans of similar nature, such as residential mortgage andconsumer 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.

 

Premises andEquipment: Asset cost is reported net of accumulated depreciation. Buildings andrelated components are depreciated using the straight-line method with usefullives ranging from 7 to 39 years. Furniture, fixtures and equipment aredepreciated using the straight-line method with useful lives ranging from 5 to15 years. These assets are reviewed for impairment when events indicate thatthe carrying amount may not be recoverable. Maintenance and repairs are charged to expense and improvements arecapitalized.

 

Other RealEstate:  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 value lessestimated costs to sell.  Any reductionto fair value from a related loan at the time of acquisition is accounted foras a loan loss.  Any subsequentreductions in fair value less estimated costs to sell are recorded by chargesto expense and a corresponding valuation allowance on the related real estate.

 

21

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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 interestrates and then, secondarily, as to geographic and prepaymentcharacteristics.  Fair value isdetermined using prices for similar assets with similar characteristics, whenavailable, or based upon discounted cash flows using market-basedassumptions.  Any impairment of agrouping is reported as a valuation allowance. There was no such valuation allowance recorded at December 31, 2003 and2002, and mortgage servicing rights were not material at either date.

 

IntangibleAssets:  Coredeposit intangibles are being amortized on an accelerated basis over 11 yearsand are periodically evaluated as to the recoverability of their carryingvalue.

 

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

 

Stock Options:  The Company has a stock-based compensationplan, which is more fully described in Note 11.  The Company accounts for this plan under the recognition andmeasurement principles of Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation*.  The value of options granted under this planis charged to expense over the vesting period of the grants.

 

Income Taxes:  Income tax expense is the sum of the currentyear income tax due or refundable and the change in deferred tax assets andliabilities.  Deferred tax assets andliabilities are the expected future tax consequences of temporary differencesbetween the carrying amounts and tax bases of assets and liabilities, computedusing enacted tax rates.  A valuationallowance, if needed, reduces deferred tax assets to the amount expected to berealized.

 

Earnings PerShare:  Basicearnings per share is calculated based on the weighted average common sharesoutstanding during the year.  TheCompany had no dilutive securities during the three years in the period endedDecember 31, 2003.

 

Fair Values ofFinancial Instruments:  Fair values of financial instruments are estimated using relevantmarket information and other assumptions, as more fully disclosedseparately.  Fair value estimatesinvolve uncertainties and matters of significant judgment regarding interestrates, credit risk, prepayments, and other factors, especially in the absenceof broad markets for particular items. Changes in assumptions or in market conditions could significantlyaffect the

 

22

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estimates.  The fair value estimates of existing on- andoff-balance-sheet financial instruments do not include the value of anticipatedfuture business or the values of assets and liabilities not consideredfinancial instruments.

 

ComprehensiveIncome: Comprehensive income includes both net income and other comprehensiveincome (loss).  Other comprehensiveincome (loss) includes the changes in unrealized gains and losses on securitiesavailable-for-sale, and minimum pension liability, net of deferred incometaxes.

 

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

 

**NOTE2 - BUSINESS COMBINATION**

 

On November 14, 2003, theCompany assumed substantially all of the deposit liabilities and certain loansand other assets of two branch offices located in Streator, Illinois from FirstMidwest Bank.  As a result of theacquisition, the Company has an opportunity to increase its customer base andcontinue to increase its market share.

 

The acquisition was accountedfor under the purchase method of accounting. All assets and liabilities were recorded at their fair values as ofNovember 14, 2003, including goodwill of $2,446,000 which is deductible for taxpurposes.  Additionally, core depositintangibles totaling $2,027,000 were recognized and will be amortized over 11years using a declining balance method.  The purchase accounting adjustments are being amortized over thelife of the respective asset or liability.

 

The following table summarizesthe estimated fair values of the assets acquired and liabilities assumed at thedate of acquisition.

 
| Loans                                      |   | $       | 11,774  |   |
|--------------------------------------------|--------|---------|---------|--------|
| Premises and equipment                     |   | 780     |    |
| Goodwill and core  deposit intangibles     |   | 4,553   |    |
| Other assets, net                          |   | 18      |    |
| Deposits                                   |   | (69,288 | )       |
| Net liabilities  assumed and cash received |   | $       | (52,163 | )      |

 

The accumulated amortization ofthe core deposit intangibles at December 31, 2003 totaled $34,000.  Estimated amortization expense for each ofthe following five years is $399,000, $319,000, $255,000, $204,000 and$163,000.

 

23

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**NOTE3 - SECURITIES**

 

Securities available for saleas of December 31, 2003 were as follows:

 
|                                                                |   | **Fair  Value** |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   |
|---------------------------------------------------------------------|--------|-----------------|---------|------------------------------|--------|-------------------------------|--------|
|                                                                |   |            |    |                         |   |                          |   |
| U.S. treasuries                                                     |   | $               | 11,689  |                         | $      | 72                            |   | $ | (2 | ) |
| U.S. government  agencies                                           |   | 67,858          |    | 1,647                        |   | (56                           | )      |
| States and political  subdivisions                                  |   | 14,794          |    | 796                          |   | (43                           | )      |
| Mortgage-backed  securities and collateralized mortgage obligations |   | 13,393          |    | 189                          |   | (80                           | )      |
| Corporate bonds                                                     |   | 2,323           |    | 101                          |   | —                        |   |
| Equity securities                                                   |   | 3,376           |    | 20                           |   | (50                           | )      |
|                                                                |   |            |    |                         |   |                          |   |
|                                                                |   | $               | 113,433 |                         | $      | 2,825                         |   | $ | (231 | ) |

 

Securitiesavailable for sale as of December 31, 2002 were as follows:

 
|                                                                |   | **Fair  Value** |   | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   |
|---------------------------------------------------------------------|--------|-----------------|--------|------------------------------|--------|-------------------------------|--------|
|                                                                |   |            |   |                         |   |                          |   |
| U.S. treasuries                                                     |   | $               | 3,584  |                         | $      | 81                            |   | $ | — |   |
| U.S. government  agencies                                           |   | 65,014          |   | 2,641                        |   | —                        |   |
| States and political  subdivisions                                  |   | 16,962          |   | 777                          |   | —                        |   |
| Mortgage-backed  securities and collateralized mortgage obligations |   | 7,682           |   | 233                          |   | (21                           | )      |
| Corporate bonds                                                     |   | 2,415           |   | 80                           |   | (3                            | )      |
| Equity securities                                                   |   | 3,228           |   | 3                            |   | (111                          | )      |
|                                                                |   |            |   |                         |   |                          |   |
|                                                                |   | $               | 98,885 |                         | $      | 3,815                         |   | $ | (135 | ) |

 

As of December 31, 2003 and2002, the Company had approximately $6,950,000 and $7,730,000 invested in bondsissued by municipalities located within LaSalle County, Illinois.

 

Securities with an approximatecarrying value of $58,428,000 and $79,270,000 were pledged at December 31, 2003and 2002 to secure trust and public deposits, repurchase agreements, and forother purposes as required or permitted by law.

 

24

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The fair value of contractualmaturities of securities available for sale at December 31, 2003 were asfollows.  Securities not due at a singlematurity date, primarily mortgage-backed and equity securities, are shownseparately.

 
| Due in one year or less                                             |   | $      | 19,021  |   |
|---------------------------------------------------------------------|--------|--------|---------|--------|
| Due after one year  through five years                              |   | 59,622 |    |
| Due after five years  through ten years                             |   | 13,811 |    |
| Due after ten years                                                 |   | 4,210  |    |
| Mortgage-backed  securities and collateralized mortgage obligations |   | 13,393 |    |
| Equity securities                                                   |   | 3,376  |    |
|                                                                |   |   |    |
|                                                                |   | $      | 113,433 |   |

 

Information regarding realizedgains and losses of securities available for sale follows:

 
|         |   | **2003** |   | **2002** |   | **2001** |   |
|--------------|--------|----------|--------|----------|--------|----------|--------|
|         |   |     |   |     |   |     |   |
| Gross gains  |   | $        | — |     | $      | 104      |   | $ | 540 |   |
| Gross losses |   | —   |   | (2       | )      | (1       | )      |
|              |        |          |        |          |        |          |        |  |  |  |

 

At December 31, 2003, theCompany’s securities in a continuous unrealized-loss position for more than ayear totaled $600.

 

**NOTE4 - LOANS**

 

Major classifications of loansas of December 31, 2003 and 2002 are summarized as follows:

 
|                                 |   | **2003** |    | **2002** |   |
|--------------------------------------|--------|----------|---------|----------|--------|
|                                 |   |     |    |     |   |
| Real estate                          |   | $        | 70,859  |     | $      | 46,699 |   |
| Commercial and  agricultural         |   | 24,197   |    | 33,950   |   |
| Installment, net of  unearned income |   | 22,812   |    | 19,951   |   |
| Home equity lines of  credit         |   | 12,456   |    | 9,120    |   |
|                                 |   | 130,324  |    | 109,720  |   |
| Deferred loan fees                   |   | (20      | )       | (77      | )      |
| Allowance for loan  losses           |   | (1,049   | )       | (1,167   | )      |
|                                 |   |     |    |     |   |
|                                 |   | $        | 129,255 |     | $      | 108,476 |   |

 

25

----

 

Certain executive officers,directors, and their related interests are loan customers of the Company.  A summary of such loans made by the Companyin the ordinary course of business is as follows:

 
| Balance at January 1,  2003   |   | $      | 1,745  |   |
|-------------------------------|--------|--------|--------|--------|
| New loans                     |   | 3,259  |   |
| Repayments                    |   | (684   | )      |
|                          |   |   |   |
| Balance at December  31, 2003 |   | $      | 4,320  |   |

 

Information regarding impairedloans at December 31, 2003 and 2002 is as follows:

 
|                                                      |   | **2003** |   | **2002** |   |
|-----------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                      |   |     |   |     |   |
| Impaired loans with  related allowance for loan losses    |   | $        | 1,943  |     | $      | 1,447 |   |
| Impaired loans with no  related allowance for loan losses |   | 163      |   | 591      |   |
|                                                      |   |     |   |     |   |
| Total impaired loans                                      |   | $        | 2,106  |     | $      | 2,038 |   |
|                                                      |   |     |   |     |   |
| Allowance for loan  losses allocated to impaired loans    |   | $        | 342    |     | $      | 396 |   |

 
|                                          |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                          |   |     |   |     |   |     |   |
| Average of impaired loans during the year     |   | $        | 1,599  |     | $      | 1,636    |   | $ | 1,243 |   |
| Interest income recognized during  impairment |   | 157      |   | 155      |   | 95       |   |
| Cash-basis interest income recognized         |   | 153      |   | 112      |   | 81       |   |
|                                               |        |          |        |          |        |          |        |  |  |  |

 

Nonperforming loans were as follows atDecember 31:
|                                          |   | **2003** |   | **2002** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|
|                                          |   |     |   |     |   |
| Loans  past due over 90 days still on accrual |   | $        | 293    |     | $      | 757 |   |
| Nonaccrual  loans                             |   | 137      |   | 364      |   |
|                                               |        |          |        |          |        |  |  |

 

26

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**NOTE5 - ALLOWANCE FOR LOAN LOSSES**

 

Activity in the allowance forloan losses is summarized as follows for the years ended December 31:

 
|                                       |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                       |   |     |   |     |   |     |   |
| Balance at beginning  of year              |   | $        | 1,167  |     | $      | 1,109    |   | $ | 1,108 |   |
| Recoveries on loans previously charged off |   | 181      |   | 171      |   | 101      |   |
| Loans charged off                          |   | (419     | )      | (233     | )      | (400     | )      |
| Provision for loan losses                  |   | 120      |   | 120      |   | 300      |   |
|                                       |   |     |   |     |   |     |   |
| Balance at end of year                     |   | $        | 1,049  |     | $      | 1,167    |   | $ | 1,109 |   |

 

**NOTE6 - LOAN SALES AND SERVICING**

 

The Company sells mortgageloans with servicing retained to the Federal Home Loan Mortgage Corporation(FHLMC) and the Illinois Housing Development Authority (IHDA).  The Company realized gross proceeds from thesales of mortgage loans totaling $26,296,000, $15,841,000 and $17,643,000 in2003, 2002 and 2001.  Mortgage loansserviced for others are not included in the accompanying consolidated balancesheets.  The unpaid principal balancesof these loans are summarized as follows:

 
|   |   | **December  31,** |   |
|--------|--------|-------------------|--------|
|   |   | **2003**          |   | **2002** |   |
|   |   |              |   |   |   |
| FHLMC  |   | $                 | 32,823 |   | $ | 21,293 |   |
| IHDA   |   | 1,148             |   | 1,170 |   |
|   |   |              |   |   |   |
|   |   | $                 | 33,971 |   | $ | 22,463 |   |

 

Following is an analysis of the changes in originated mortgageservicing rights:

 
|                                 |   | **Year Ended  December 31,** |   |
|--------------------------------------|--------|------------------------------|--------|
|                                 |   | **2003**                     |   | **2002** |   | **2001** |   |
|                                 |   |                         |   |   |   |   |   |
| Balance at beginning of year         |   | $                            | 301    |   | $ | 135 |   | $ | 151 |   |
| Originated mortgage servicing rights |   | 256                          |   | 193 |   | — |   |
| Amortization                         |   | (112                         | )      | (27 | ) | (16 | ) |
|                                 |   |                         |   |   |   |   |   |
|                                 |   | $                            | 445    |   | $ | 301 |   | $ | 135 |   |

 

27

----

 

**NOTE7 - PREMISES AND EQUIPMENT**

 

Premises and equipmentconsisted of the following at December 31:

 
|                           |   | **2003** |   | **2002** |   |
|--------------------------------|--------|----------|--------|----------|--------|
|                           |   |     |   |     |   |
| Land                           |   | $        | 1,791  |     | $      | 1,340 |   |
| Bank premises                  |   | 6,521    |   | 4,408    |   |
| Furniture and  equipment       |   | 4,095    |   | 3,103    |   |
| Construction in  progress      |   | —   |   | 272      |   |
| Total cost                     |   | 12,407   |   | 9,123    |   |
| Less accumulated  depreciation |   | 4,870    |   | 4,568    |   |
|                           |   |     |   |     |   |
| Net book value                 |   | $        | 7,537  |     | $      | 4,555 |   |

 

**NOTE 8 – DEPOSITS**

 

Deposits consisted of thefollowing at December 31:

 
|                                |   | **2003** |    | **2002** |   |
|-------------------------------------|--------|----------|---------|----------|--------|
|                                |   |     |    |     |   |
| Demand –  non-interest-bearing |   | $        | 29,933  |     | $      | 19,475 |   |
| NOW accounts                        |   | 64,050   |    | 54,537   |   |
| Money market accounts               |   | 28,828   |    | 9,186    |   |
| Savings                             |   | 27,826   |    | 19,513   |   |
| Time, $100,000 and over             |   | 26,425   |    | 23,813   |   |
| Other time                          |   | 87,859   |    | 67,243   |   |
|                                |   |     |    |     |   |
| Total deposits                      |   | $        | 264,921 |     | $      | 193,767 |   |

 

At December 31, 2003, thescheduled maturities of certificates of deposit were as follows:

 

| 2004       |   | $      | 71,194  |   |
|------------|--------|--------|---------|--------|
| 2005       |   | 12,059 |    |
| 2006       |   | 8,391  |    |
| 2007       |   | 9,731  |    |
| 2008       |   | 12,430 |    |
| Thereafter |   | 479    |    |
|       |   |   |    |
|       |   | $      | 114,284 |   |

 

28

----

 

**NOTE9 - BORROWINGS**

 

The Company has a note payablethat consists of a $1,000,000 unsecured line of credit with Bank One, NA,maturing on May 15, 2004.  Theoutstanding balance under the line of credit was $490,000 and $652,000 atDecember 31, 2003 and 2002. Interest is payable quarterly at Bank One’s prime rate or LIBOR plus 175basis points (2.91% and 3.54% at December 31, 2003 and 2002).

 

**NOTE10 - SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE**

 

Securities sold underagreements to repurchase are financing arrangements.  Physical control is maintained for all securities sold underrepurchase agreements.  The average balanceand interest rate during 2003 and 2002 was $475,000 and $25,567,000 and 2.11%and 2.04%.  The average interest rate atDecember 31, 2002 was 1.86% and the maximum month-end balance during 2003 and2002 was $1,545,000 and $37,594,000.

 

**NOTE11 - BENEFIT PLANS**

 

The Bank has a noncontributorydefined benefit pension plan covering all employees who meet the eligibilityrequirements.  In 1999, all planbenefits were frozen.  The Bank’sfunding policy is to make the minimum annual contribution that is required byapplicable regulations, plus such amounts as the Bank may determine to beappropriate from time to time.  The Bankexpects to contribute approximately $100,000 to the plan in 2004.  The Bank uses a December 31 measurement datefor the plan.

 

The following tables set forththe Bank’s pension plan’s funded status and amounts actuarially determined forthe years indicated:

 
|                          |   | **2003** |   | **2002** |   |
|-------------------------------|--------|----------|--------|----------|--------|
| Change in benefit  obligation |   |     |   |     |   |
| Beginning benefit  obligation |   | $        | 1,929  |     | $      | 2,139 |   |
| Interest cost                 |   | 114      |   | 120      |   |
| Actuarial loss (gain)         |   | (43      | )      | 48       |   |
| Benefits paid                 |   | (158     | )      | (378     | )      |
|                          |   |     |   |     |   |
| Ending benefit  obligation    |   | $        | 1,842  |     | $      | 1,929 |   |

 

29

----

 
|                             |   | **2003** |   | **2002** |   |
|----------------------------------|--------|----------|--------|----------|--------|
|                             |   |     |   |     |   |
| Change in plan assets            |   |     |   |     |   |
| Beginning fair value             |   | $        | 1,233  |     | $      | 1,216 |   |
| Actual return                    |   | 256      |   | (105     | )      |
| Employer contribution            |   | 100      |   | 500      |   |
| Benefits paid                    |   | (158     | )      | (378     | )      |
|                             |   |     |   |     |   |
| Ending fair value                |   | $        | 1,431  |     | $      | 1,233 |   |
|                             |   |     |   |     |   |
| Funded status                    |   | $        | (411   | )        | $      | (696 | ) |
| Unrecognized net  actuarial loss |   | 155      |   | 381      |   |
|                             |   |     |   |     |   |
| Accrued benefit cost             |   | $        | (256   | )        | $      | (315 | ) |
|                             |   |     |   |     |   |
| Accumulated benefit obligation   |   | $        | 1,842  |     | $      | 1,929 |   |

 
|                                               |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Assumptions used to  determine benefit obligations |   |     |   |     |   |     |   |
| Discount rate                                      |   | 6.25     | %      | 6.25     | %      | 7.0      | %      |
| Expected return on  plan assets                    |   | 7.0      |   | 7.0      |   | 7.0      |   |
|                                               |   |     |   |     |   |     |   |
| Assumptions used to  determine benefit costs       |   |     |   |     |   |     |   |
| Discount rate                                      |   | 6.25     | %      | 7.0      | %      | 7.0      | %      |
| Expected return on  plan assets                    |   | 7.0      |   | 7.0      |   | 7.0      |   |

 

The Company has estimated thelong-term rate of return on plan assets based primarily on historical returnson plan assets, adjusted for changes in target portfolio allocations and recentchanges in long-term interest rates based on publicly available information.

 
| Components of net periodic benefit cost |   |   |   |   |   |   |   |
|-----------------------------------------|--------|--------|--------|--------|--------|--------|--------|
| Interest cost                           |   | $      | 114    |   | $      | 120    |   | $ | 151 |   |
| Return on plan assets                   |   | (82    | )      | (105   | )      | (61    | )      |
| Amortization                            |   | 9      |   | 20     |   | (152   | )      |
|                                    |   |   |   |   |   |   |   |
| Net expense (income)                    |   | $      | 41     |   | $      | 35     |   | $ | (62 | ) |

 

30

----

 

 

Plan assets are held by abank-administered trust fund, which invests the plan assets in accordance withthe provisions of the plan agreement. The permitted investments as established by the plan agreement include,but are not limited to, common and preferred stocks, open-end orclosed-end mutual funds, bonds and other evidences of indebtednessor ownership, and real estate or any interest therein.

 

Asset allocation is primarilybased on a strategy to provide stable earnings while attempting to recognizepotentially higher returns through limited investments in equitysecurities.  Plan assets are rebalancedperiodically.  At December 31, 2003, and2002 allocations by percentages were as follows:

 
|                          |   | **2003** |   | **2002** |   |
|-------------------------------|--------|----------|--------|----------|--------|
|                          |   |     |   |     |   |
| Equity mutual funds           |   | 64.3     | %      | 55.6     | %      |
| Fixed income mutual  funds    |   | 26.9     |   | 37.9     |   |
| GNMA pool                     |   | 1.2      |   | 2.1      |   |
| Money market funds and  other |   | 7.6      |   | 4.4      |   |

 

At December 31, 2003 and 2002market values of plan assets were as follows:

 
|                          |   | **2003** |   | **2002** |   |
|-------------------------------|--------|----------|--------|----------|--------|
|                          |   |     |   |     |   |
| Equity mutual funds           |   | $        | 920    |     | $      | 685 |   |
| Fixed income mutual  funds    |   | 385      |   | 467      |   |
| GNMA pool                     |   | 17       |   | 25       |   |
| Money market funds and  other |   | 109      |   | 55       |   |
|                               |        |          |        |          |        |  |  |

 

The Bank has a directors’ retirementplan which provides retirement benefits primarily to former members of theBoard of Directors.  The Bank alsomaintains a supplemental executive retirement plan that provides benefits tocertain key executive officers and directors in accordance with the plandocument.  The Bank accrued expensesrelated to these plans totaling $188,000, $191,000, and $86,000, in 2003, 2002 and 2001.

 

The Company’s 401(k) profitsharing plan covers eligible employees with more than one year of service, asdefined, and who are at least 21 years of age. The plan allows employee contributions. The Company may make a matching contribution equal to a percentage ofsalary deferral and discretionary profit sharing contributions.  The matching percentage is limited to 6% of compensation.  The Company made contributions of $122,000,$85,000 and $90,000 in 2003, 2002, and 2001.

 

31

----

 

**NOTE  12 - STOCK OPTION PLAN**

 

The Company has a fixed optionplan under which it may grant options that vest over four years to selectedemployees for up to 150,000 shares of common stock.  The exercise price of each option is intended to equal the fairvalue of the Company’s stock on the date of grant.  An option’s maximum term is 10 years.

 

In 2003, the Company firstgranted 6,750 shares under the plan at an exercise price of $56, none of whichwere exercisable at December 31, 2003. The remaining contractual life of these options at December 31, 2003 was9.5 years.

 

The fair value of the 2003option grant of $9.59 per share was estimated on the grant date using anoption-pricing model with the following assumptions – risk-free interest rateof 3.27%, dividend yield of 4.96%, volatility factor of expected market priceof 23.55% and a weighted-average expected life of the option of 9.5 years.  Expense recognized under the plan in 2003totaled $8,000.

 

**NOTE13 - INCOME TAXES**

 

The balance sheets included thefollowing amounts of deferred tax assets and liabilities at December 31:

 
|                                              |   | **2003** |   | **2002** |   |
|---------------------------------------------------|--------|----------|--------|----------|--------|
| Deferred tax assets                               |   |     |   |     |   |
| Bad debt deduction                                |   | $        | 219    |     | $      | 267 |   |
| Pension plan                                      |   | 118      |   | 166      |   |
| Deferred compensation                             |   | 219      |   | 163      |   |
| Deferred loan fees                                |   | —   |   | 8        |   |
| AMT carryforward                                  |   | 92       |   | 92       |   |
| Additional minimum  pension liability             |   | 137      |   | 137      |   |
| Other                                             |   | —   |   | 34       |   |
|                                              |   | 785      |   | 867      |   |
| Deferred tax  liabilities                         |   |     |   |     |   |
| Unrealized gain on  securities available-for-sale |   | (881     | )      | (1,251   | )      |
| Depreciation                                      |   | (168     | )      | (202     | )      |
| Mortgage servicing  rights                        |   | (184     | )      | —   |   |
| Federal Home Loan Bank  stock dividends           |   | (73      | )      | (51      | )      |
| Other                                             |   | (15      | )      | (13      | )      |
|                                              |   | (1,321   | )      | (1,517   | )      |
|                                              |   |     |   |     |   |
| Net deferred tax  liability                       |   | $        | (536   | )        | $      | (650 | ) |

 

32

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The components of the provisionfor income taxes for the years ended December 31 are as follows:

 
|                            |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Currently payable tax           |   |     |   |     |   |     |   |
| Federal                         |   | $        | 619    |     | $      | 332      |   | $ | 495 |   |
| State                           |   | (8       | )      | 104      |   | (12      | )      |
| Deferred tax expense  (benefit) |   | 256      |   | 242      |   | (23      | )      |
|                            |   |     |   |     |   |     |   |
|                            |   | $        | 867    |     | $      | 678      |   | $ | 460 |   |

 

The difference between thefinancial statement provision and the amounts computed by applying the federalincome tax rate of 34% to income before income taxes is reconciled as follows:

 
|                                          |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                          |   |     |   |     |   |     |   |
| Federal income tax  expense at statutory rate |   | $        | 1,131  |     | $      | 1,008    |   | $ | 875 |   |
| Increase (decrease) in  taxes resulting from  |   |     |   |     |   |     |   |
| Tax-exempt interest                           |   | (261     | )      | (320     | )      | (452     | )      |
| Nondeductible interest  expense               |   | 21       |   | 35       |   | 59       |   |
| State income taxes and  other items, net      |   | (24      | )      | (45      | )      | (22      | )      |
|                                          |   |     |   |     |   |     |   |
|                                          |   | $        | 867    |     | $      | 678      |   | $ | 460 |   |

 

**NOTE 14 - DERIVATIVES**

 

The Company uses derivatives tofix future cash flows for interest payments on some of its floating ratecertificates of deposit.  In thisregard, the Company has entered into an interest rate swap with the FederalHome Loan Bank of Chicago to fix the interest rate on a specific certificate ofdeposit product.  At December 31, 2003,the Company had $2,497,000 of certificates of deposit, which mature in 2007 and2008, in which it pays the Federal Home Loan Bank a weighted average interestrate of 2.93% and will receive an interest rate from the Federal Home Loan Bankbased on the appreciation of the S&P 500 Index.  This interest received from the Federal Home Loan Bank will bepaid to the customer.  The assets andliabilities in this transaction are being netted and the expense recorded ininterest expense on deposits.

 

In addition to the above, theCompany also purchased $5,900,000 of certificates of deposit which are includedin the certificates of deposit caption on the consolidated balance sheet.  These investments mature in 2006, 2007, and2008.  The investments that individuallydo not exceed $100,000 are insured by the FDIC.  Investments that individually exceed $100,000 are

 

33

----

 

guaranteed by a standby letterof credit issued by the Federal Home Loan Bank of Pittsburgh with nointerest.  The initial investment is notat risk but the return on the investment is based on a calculation of theappreciation in the S&P 500 Index. The fair value of this embeddedderivative is recorded in certificates of deposit and the fair value adjustmentis included in interest income.  AtDecember 31, 2003, the Bank had allocated $1,067,000 to this asset and recordeda valuation allowance of $350,000, which is classified with the certificates ofdeposit caption on the consolidated balance sheet.

 

**NOTE15 - COMMITMENTS, OFF-BALANCE-SHEET RISK, AND CONTINGENCIES**

 

There are various contingentliabilities that are not reflected in the consolidated financial statements,including claims and legal actions arising in the ordinary course ofbusiness.  In the opinion of management,after consultation with legal counsel, the ultimate disposition of these claimsand legal actions is not expected to have a material effect on financialcondition or results of operations.

 

The Bank is required tomaintain reserve funds in cash and/or on deposit with the Federal ReserveBank.  The reserve required at December31, 2003 was $5,900,000.

 

Some financial instruments areused in the normal course of business to meet the financing needs of customers.  These financial instruments includecommitments to extend credit, standby letters of credit, and financialguarantees.  These involve, to varyingdegrees, credit and interest-rate risk in excess of the amounts reported in thefinancial statements.

 

Exposure to credit loss if theother party does not perform is represented by the contractual amount forcommitments to extend credit, standby letters of credit, and financialguarantees written.  The same credit policiesare used for commitments and conditional obligations as are used forloans.  Collateral or other security isnormally required to support financial instruments with credit risk.

 

Commitments to extend creditare agreements to lend to a customer as long as there is no violation of anycondition established in the commitment. Commitments generally have fixed expiration dates or other terminationclauses and may require payment of a fee. Since many of the commitments are expected to expire without being used,the total commitments do not necessarily represent future cashrequirements.  Standby letters of creditand financial guarantees written are conditional commitments to guarantee acustomer’s performance to a third party.

 

34

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A summary of the notional orcontractual amounts of financial instruments with off-balance-sheet risk atyear end follows:

 
|                      |   | **2003** |   | **2002** |   |
|---------------------------|--------|----------|--------|----------|--------|
|                      |   |     |   |     |   |
| Unused lines of credit    |   | $        | 15,801 |     | $      | 12,590 |   |
| Standby letter of  credit |   | 136      |   | 361      |   |
|                           |        |          |        |          |        |  |  |

 

At December 31, 2003, all ofthe commitments to extend credit were at variable rates of interest.

 

**NOTE16 - FAIR VALUES OF FINANCIAL INSTRUMENTS**

 

The following methods andassumptions were used to estimate fair values for financial instruments.  The carrying amount is considered to estimatefair value for cash and due from banks, demand, NOW, money market and savingsdeposits, federal funds purchased, securities sold under repurchase agreements,accrued interest receivable and payable, and variable rate loans or deposits.  Securities fair values are based on quotedmarket prices or, if no quotes are available, on the rate and term of thesecurity and on information about the issuer. The fair value of loans held for sale and derivatives are based onquoted market prices.  For fixed rate loansor deposits, the fair value is estimated by discounted cash flow analysis usingcurrent market rates for the estimated life and credit risk.  Fair values for impaired loans are estimatedusing discounted cash flow analysis or underlying collateral values, whereapplicable.  The fair value ofoff-balance-sheet items is based on the fees or cost that would currently becharged to enter into or terminate such agreements and is not material.

 

The carrying values andestimated fair values of the Company’s financial instruments as of December 31,2003 and 2002 were as follows:

 
|                                            |   | **2003**            |   | **2002**                   |   |
|-------------------------------------------------|--------|---------------------|--------|----------------------------|--------|
|                                            |   | **Carrying  Value** |   | **Estimated  Fair  Value** |   | **Carrying  Value** |   | **Estimated  Fair  Value** |   |
| Financial assets                                |   |                |   |                       |   |   |   |   |   |
| Cash and cash  equivalents                      |   | $                   | 17,877 |                       | $      | 17,877 |   | $ | 8,606 |   | $ | 8,606 |   |
| Certificates of  deposit and related derivative |   | 13,190              |   | 13,190                     |   | 12,835 |   | 12,835 |   |
| Securities  available-for-sale                  |   | 113,433             |   | 113,433                    |   | 98,885 |   | 98,885 |   |
| Loans held for sale                             |   | 1,644               |   | 1,644                      |   | 1,811 |   | 1,811 |   |
| Loans, net                                      |   | 129,255             |   | 129,584                    |   | 108,476 |   | 110,296 |   |
| Interest receivable                             |   | 2,129               |   | 2,129                      |   | 2,135 |   | 2,135 |   |
|                                                 |        |                     |        |                            |        |  |  |  |  |  |  |  |  |

 

35

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|                                                              |   | **2003**            |   | **2002**                   |   |
|-------------------------------------------------------------------|--------|---------------------|--------|----------------------------|--------|
|                                                              |   | **Carrying  Value** |   | **Estimated  Fair  Value** |   | **Carrying  Value** |   | **Estimated  Fair  Value** |   |
|                                                              |   |                |   |                       |   |   |   |   |   |
| Financial liabilities                                             |   |                |   |                       |   |   |   |   |   |
| Deposits with no  stated maturities                               |   | 150,637             |   | 139,955                    |   | 102,711 |   | 102,711 |   |
| Time deposits and  securities sold under agreements to repurchase |   | 114,284             |   | 116,211                    |   | 92,678 |   | 94,896 |   |
| Federal funds  purchased                                          |   | —              |   | —                     |   | 14,700 |   | 14,700 |   |
| Borrowings                                                        |   | 490                 |   | 490                        |   | 652 |   | 655 |   |
| Interest payable                                                  |   | 832                 |   | 832                        |   | 999 |   | 999 |   |

 

**NOTE 17 - REGULATORY ANDCAPITAL MATTERS**

 

The Company may pay dividendswithout restriction under the current Federal Reserve regulations so long as itremains “adequately capitalized” after such payment.  The Bank is subject to statutory dividend restrictions whichprovide, in general, that the Bank may pay the current year’s earnings and theprior two years’ retained earnings without the prior approval of the Office ofthe Comptroller of Currency.  AtDecember 31, 2003, the Bank’s stockholder’s equity totaled $24,766,000, ofwhich $24,394,000 was not available for payment of dividends, without priorregulatory approval.

 

The Company and the Bank aresubject to various regulatory capital requirements administered by the federalbanking agencies.  Capital adequacyguidelines and prompt corrective action regulations involve quantitativemeasures of assets, liabilities, and certain off-balance-sheet items calculatedunder regulatory accounting practices. Capital amounts and classifications are also subject to qualitativejudgments by regulators about components, risk weightings, and other factors,and the regulators can lower classifications in certain cases.  Failure to meet various capital requirementscan initiate regulatory action that could have a direct material effect on thefinancial statements.

 

The prompt corrective actionregulations provide five classifications, including well capitalized,adequately capitalized, undercapitalized, significantly undercapitalized, andcritically undercapitalized, although these terms are not used to representoverall financial condition.  Ifadequately capitalized, regulatory approval is required to accept brokereddeposits.  If

 

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undercapitalized, capitaldistributions are limited, as is asset growth and expansion, and plans forcapital restoration are required.

 

The Company’s only activity isownership of the Bank, and, therefore, its capital, capital ratios, and minimumrequired levels of capital are materially the same as the Bank’s.   The actual capital levels and minimumrequired levels for the Bank were:

 
|                                     |   | **Actual** |   | **Minimum  Required  for Capital  Adequacy Purposes** |   | **Minimum  Required  to Be Well Capitalized  Under Prompt Corrective  Action Provisions** |   |
|------------------------------------------|--------|------------|--------|-------------------------------------------------------|--------|-------------------------------------------------------------------------------------------|--------|
|                                     |   | **Amount** |   | **Ratio**                                             |   | **Amount**                                                                                |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
| December  31, 2003                       |   |       |   |                                                  |   |                                                                                      |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $          | 19,661 |                                                  | 11.9   | %                                                                                         | $      | 13,201 |   | 8.0 | % | $ | 16,501 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 18,612     |   | 11.3                                                  |   | 6,600                                                                                     |   | 4.0 |   | 9,901 |   | 6.0 |   |
| Tier I capital (to average assets)       |   | 18,612     |   | 7.2                                                   |   | 10,303                                                                                    |   | 4.0 |   | 12,878 |   | 5.0 |   |
|                                     |   |       |   |                                                  |   |                                                                                      |   |   |   |   |   |   |   |
| December 31, 2002                        |   |       |   |                                                  |   |                                                                                      |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $          | 23,542 |                                                  | 17.5   | %                                                                                         | $      | 10,786 |   | 8.0 | % | $ | 13,482 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 22,375     |   | 16.6                                                  |   | 5,393                                                                                     |   | 4.0 |   | 8,089 |   | 6.0 |   |
| Tier I capital (to average assets)       |   | 22,375     |   | 9.5                                                   |   | 9,473                                                                                     |   | 4.0 |   | 11,841 |   | 5.0 |   |

 

At December 31, 2003, theCompany and the Bank were categorized as well capitalized and management is notaware of any conditions or events since the most recent notification that wouldchange the Company’s or Bank’s category.

 

**NOTE18 - OTHER COMPREHENSIVE INCOME**

 

Other comprehensive income componentsand related taxes for the years ended are as follows:

 
|                                                                |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Unrealized holding  gains (losses) on securities available for sale |   | $        | (1,086 | )        | $      | 3,517    |   | $ | 1,136 |   |
| Minimum pension  liability                                          |   | —   |   | (354     | )      | —   |   |
| Reclassification  adjustments for gains recognized in income        |   | —   |   | (102     | )      | (539     | )      |
| Net unrealized gains                                                |   | (1,086   | )      | 3,061    |   | 597      |   |
| Tax effect                                                          |   | 368      |   | (1,024   | )      | (203     | )      |
|                                                                |   |     |   |     |   |     |   |
| Other comprehensive  income (loss)                                  |   | $        | (718   | )        | $      | 2,037    |   | $ | 394 |   |

 

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**NOTE 19- PARENT COMPANY FINANCIAL STATEMENTS**

 

The following are the condensedbalance sheets and statements of income and cash flows for First OttawaBancshares, Inc.

 

Condensed balance sheets as ofDecember 31 are as follows:

 
|                                             |   | **2003** |   | **2002** |   |
|--------------------------------------------------|--------|----------|--------|----------|--------|
| **ASSETS**                                       |   |     |   |     |   |
| Cash and due from  banks                         |   | $        | 8      |     | $      | 1,325 |   |
| Investment in Bank                               |   | 24,766   |   | 25,450   |   |
| Dividends receivable                             |   | 1,305    |   | —   |   |
| Other assets                                     |   | 376      |   | 376      |   |
|                                             |   |     |   |     |   |
| Total assets                                     |   | $        | 26,455 |     | $      | 27,151 |   |
|                                             |   |     |   |     |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**    |   |     |   |     |   |
| Other liabilities                                |   | $        | 5      |     | $      | — |   |
| Loan payable                                     |   | 490      |   | 652      |   |
| Dividends payable                                |   | 1,305    |   | 1,316    |   |
| Shareholders’ equity                        |   | 24,655   |   | 25,183   |   |
|                                             |   |     |   |     |   |
| Total liabilities and  shareholders’ equity |   | $        | 26,455 |     | $      | 27,151 |   |

 

Condensed statements of income for the yearsended December 31 are as follows:

 
|                                 |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                 |   |     |   |     |   |     |   |
| Dividends from Bank                  |   | $        | 2,502  |     | $      | 2,034    |   | $ | 1,987 |   |
| Expenses                             |   | (76      | )      | (86      | )      | (11      | )      |
| Equity in  undistributed Bank income |   | 33       |   | 339      |   | 137      |   |
|                                 |   |     |   |     |   |     |   |
| Net income                           |   | $        | 2,459  |     | $      | 2,287    |   | $ | 2,113 |   |

 

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Condensed statements of cashflows for the years ended December 31 are as follows:

 
|                                                                       |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Cash flows from  operating activities                                      |   |     |   |     |   |     |   |
| Net income                                                                 |   | $        | 2,459  |     | $      | 2,287    |   | $ | 2,113 |   |
| Adjustments to  reconcile net income to net cash from operating activities |   |     |   |     |   |     |   |
| Change in other assets  and liabilities                                    |   | (1,302   | )      | 976      |   | 4        |   |
| Equity in  undistributed Bank income                                       |   | (33      | )      | (339     | )      | (137     | )      |
| Net cash from  operating activities                                        |   | 1,124    |   | 2,924    |   | 1,980    |   |
|                                                                       |   |     |   |     |   |     |   |
| Cash flows from  financing activities                                      |   |     |   |     |   |     |   |
| Loan proceeds                                                              |   | (161     | )      | 452      |   | 200      |   |
| Purchase of treasury  stock                                                |   | (315     | )      | (74      | )      | (196     | )      |
| Dividends paid                                                             |   | (1,973   | )      | (1,983   | )      | (1,987   | )      |
| Vested stock options                                                       |   | 8        |   | —   |   | —   |   |
| Net cash from  financing activities                                        |   | (2,441   | )      | (1,605   | )      | (1,983   | )      |
|                                                                       |   |     |   |     |   |     |   |
| Net change in cash and  cash equivalents                                   |   | (1,317   | )      | 1,319    |   | (3       | )      |
|                                                                       |   |     |   |     |   |     |   |
| Beginning cash and  cash equivalents                                       |   | 1,325    |   | 6        |   | 9        |   |
|                                                                       |   |     |   |     |   |     |   |
| Ending cash and cash  equivalents                                          |   | $        | 8      |     | $      | 1,325    |   | $ | 6 |   |

 

**NOTE 20 - QUARTERLY FINANCIALDATA (UNAUDITED)**

** **
|               |   | **Interest  Income** |   | **Net  Interest  Income** |   | **Net  Income** |   | **Earnings  Per Share** |   |
|--------------------|--------|----------------------|--------|---------------------------|--------|-----------------|--------|-------------------------|--------|
| 2003               |   |                 |   |                      |   |            |   |                    |   |
| First quarter      |   | $                    | 3,175  |                      | $      | 1,988           |   | $                       | 614    |   | $ | 0.94 |   |
| Second quarter     |   | 3,128                |   | 2,017                     |   | 652             |   | 0.99                    |   |
| Third quarter      |   | 3,094                |   | 2,082                     |   | 627             |   | 0.96                    |   |
| Fourth quarter (a) |   | 3,254                |   | 2,180                     |   | 566             |   | 0.87                    |   |
| 2002               |   |                 |   |                      |   |            |   |                    |   |
| First quarter      |   | $                    | 3,352  |                      | $      | 1,774           |   | $                       | 522    |   | $ | 0.79 |   |
| Second quarter     |   | 3,358                |   | 1,895                     |   | 483             |   | 0.73                    |   |
| Third quarter (b)  |   | 3,323                |   | 1,937                     |   | 661             |   | 1.00                    |   |
| Fourth quarter (c) |   | 3,059                |   | 1,753                     |   | 621             |   | 0.95                    |   |

 

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(a)              Net income andearnings per share in the fourth quarter of 2003 were affected by one timeexpenses related to the acquisition of Streator branch facilities.

 

(b)              Net income andearnings per share in the third quarter of 2002 were affected by the gains onsales of securities and gains on proceeds from bank owned life insurance policybenefits paid.

 

(c)              Net income and earnings per share in thefourth quarter of 2002 were affected by the gains on sales of securities.

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARY

SHAREHOLDER INFORMATION

 

ANNUAL MEETING

 

The Annual Meeting ofShareholders will be held at 3 p.m., local time on May 19, 2004 at thecorporate headquarters located at 701 LaSalle Street, Ottawa, Illinois 61350.

 

PRICE RANGE OF COMMON STOCK

 

As of February 27, 2004, therewere approximately 543 shareholders of record and 651,627 outstanding shares ofcommon stock.

 

The Company’s common stock isnot traded on any national or regional securities exchange and there is noestablished public trading market for it. Transactions in the Company’s common stock have been infrequent.  To the knowledge of the Company’s management,during 2002, 2003 and the first two months of 2004, an aggregate ofapproximately 212,821 shares of the Company’s common stock was transferred inapproximately 131 separate transactions, excluding the 1,400 shares purchasedby the Company in 2002 at $52 per share and 5,329 shares purchased by theCompany at $56 and $60.50 per share. These transfers represented both transfers for consideration (i.e.,sales) and transfers for no consideration (e.g., gifts, estate transfers,etc.).  The Company’s management isunable to differentiate such transfers and has limited knowledge of the saleprices for transfers involving consideration. The last price known to the Company’s management was a sale of 150shares on February 27, 2004 at $62.00 per share.

 

The following dividends pershare were paid on the Company’s common stock on the dates indicated:  January 1, 2002 - $2.00; July 1, 2002-$1.00; January 1, 2003 - $2.00; July 1, 2003 - $1.00; January 1, 2004 - $2.00

 

WEB SITE FOR UNITED STATESSECURITIES AND EXCHANGE COMMISSION FILINGS

 

All reports filedelectronically by the Company with the United States Securities ExchangeCommission (the “SEC”), including the annual report on Form 10-K, quarterlyreports on Form 10-Q, and current events reports on Form 8-K, as well as anyamendments to those reports are accessible at no cost on our internet site at www.firstottawa.com and on the SEC’sweb site at www.sec.gov.  We will also provide you with a copy free ofcharge 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.

 

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