**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

 

**ANNUALREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the fiscal year ended December 31, 2005**

 

**Commission file number:  005-57237**

 

**FIRSTOTTAWA BANCSHARES, INC.**

(Exact name of Registrant as specified in itscharter)

 

| **Delaware**                                                    | ** ** | **36-4331185**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or Other Jurisdiction  of Incorporation or Organization) |       | (I.R.S. Employer Identification No.) |
|                                                            |       |                                 |
| **701-705 LaSalle Street  Ottawa, Illinois**                    | ** ** | **61350**                            |
| (Address of Principal Executive Offices)                        |       | (ZIP Code)                           |

** **

**(815) 434-0044**

(Registrant Telephone Number,including Area Code)

 

Securities registered underSection 12(b) of the Exchange Act:

**None**

 

Securities registered under Section 12(g) ofthe Exchange Act:

 

**Common Stock, par value $1.00 per share**

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act.

Yes  o    No  ý

 

Indicate by check mark if the registrant is not required to filereports pursuant to Section 13 or Section 15(d) of the Exchange Act.

Yes  o    No  ý

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe past 12 months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subject to such filingrequirements for the past 90 days.                                          Yes  ý    No  o

 

Indicateby check mark if disclosure of delinquent filers in response to Item 405of Regulation S-K is not contained herein, and will not be contained, tothe best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. ý

 

Indicate bycheck mark whether the registrant is a large accelerated filer, an acceleratedfiler, or a non-accelerated filer. See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.
| Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer ý |
|---------------------------|--------|---------------------|--------|------------------------------|

 

Indicate bycheck mark whether the registrant is a shell company (as defined in ExchangeAct Rule 12b-2).

Yes  o    No  ý

 

The aggregatemarket value of the voting and non-voting common equity held by non-affiliatesof the registrant, based on the last known sales price on or prior to June 30,2005, the last business day of the registrant’s most recently completed secondfiscal quarter, was $39,458,020.

 

649,349 shares of common stock were outstanding as of March 14, 2006.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

** **

The Registrant’s 2005 Annual Report to Stockholders is incorporated byreference in Parts II and IV and the Registrant’s Proxy Statement for theAnnual Meeting of Stockholders to be held May 17, 2006 is incorporated byreference in Part III.

 

Except for those portions of the 2005 Annual Report incorporated byreference, the Annual Report is not deemed filed as part of this Report.

 

 

----

 

INDEX

 
| PART I    |                                                                                                                   |   |
|-----------|------------------------------------------------------------------------------------------------------------------------|--------|
|      |                                                                                                                   |   |
| Item  1   | Business                                                                                                               |   |
| Item 1A   | Risk Factors                                                                                                           |   |
| Item 1B   | Unresolved Staff Comments                                                                                              |   |
| Item 2    | Properties                                                                                                             |   |
| Item 3    | Legal Proceedings                                                                                                      |   |
| Item 4    | Submission of Matters to a Vote of Security  Holders                                                                   |   |
|      |                                                                                                                   |   |
| PART  II  |                                                                                                                   |   |
|      |                                                                                                                   |   |
| Item 5    | Market for the Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities |   |
| Item 6    | Selected Financial Data                                                                                                |   |
| Item 7    | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                            |   |
| Item 7A   | Quantitative and Qualitative Disclosures  about Market Risk                                                            |   |
| Item 8    | Financial Statements and Supplementary Data                                                                            |   |
| Item 9    | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure                                  |   |
| Item 9A   | Controls and Procedures                                                                                                |   |
| Item 9B   | Other Information                                                                                                      |   |
|      |                                                                                                                   |   |
| PART  III |                                                                                                                   |   |
|      |                                                                                                                   |   |
| Item 10   | Directors and Executive Officers of the  Registrant                                                                    |   |
| Item 11   | Executive Compensation                                                                                                 |   |
| Item 12   | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                        |   |
| Item 13   | Certain Relationships and Related  Transactions                                                                        |   |
| Item 14   | Principal Accountant Fees and Services                                                                                 |   |
|      |                                                                                                                   |   |
| PART  IV  |                                                                                                                   |   |
|      |                                                                                                                   |   |
| Item 15   | Exhibits and Financial Statement Schedules                                                                             |   |

 

----

 

**PARTI**

** **

**Item 1.    Business**.

 

FirstOttawa Bancshares, Inc. (the “Company”) is a bank holding company for itswholly-owned subsidiary, First National Bank of Ottawa (the “Bank”), and theBank’s wholly owned subsidiary, First Ottawa Financial Corporation. The Companywas organized during 1999 and on October 1, 1999 exchanged 100% of itscommon stock for 100% of the Bank’s common stock. This exchange was accountedfor as an internal reorganization. All references to the combined Company,unless otherwise indicated, at or before October 1, 1999, refer to the Bank. Asof December 31, 2005, the Company had total assets of $278.7 million, totaldeposits of $239.9 million, loans, including loans held for sale, of $152.9million and total stockholders’ equity of $22.9 million. For the year endedDecember 31, 2005, the Company had interest income of $13.9 million and netincome of $2.5 million, which amounted to basic net income per share of $3.92,and diluted net income per share of $3.90.

 

TheCompany conducts a general banking business embracing most of the services,both commercial and consumer, which banks may lawfully provide, including thefollowing principal services:  theacceptance of deposits for demand, savings, and time accounts and the servicingof such accounts; commercial, agricultural, consumer, and real estate lending,including installment loans, personal lines of credit, and overdraftprotection; trust operations; farm management; safe deposit operations; and anextensive variety of additional services tailored to the needs of individualcustomers, including the sale of traveler’s checks, cashier’s checks, andforeign currency and other special services. Loans, both commercial andconsumer, are provided on either a secured or unsecured basis to corporations,partnerships, and individuals. Commercial lending covers such areas asbusiness, industry, capital, agriculture, inventory, and real estate, with thelatter including residential properties. Consumer loans are made for a varietyof purposes including automobile purchases, recreational vehicle purchases,consumer goods, installment loans, and other types of loans.

 

The Company is located in the city of Ottawa, Illinois (population17,500) in LaSalle County in Illinois. A substantial portion of the Company’sbusiness is dependent upon the economic conditions in this market area. LaSalleCounty is the second largest county by area in the state of Illinois. Ottawa islocated in northeastern Illinois approximately 80 miles southwest of Chicagoand approximately 65 miles north of Bloomington. Ottawa may be accessed byInterstate 80; U.S. Route 6; State Routes 23 and 71; and recently completedInterstate 39, which is located 11 miles west of Ottawa. The city is alsoserviced by two railroads and the Ottawa Airport.

 

Ottawais the county seat of LaSalle County. Accordingly, many county, state, andother governmental offices are located in Ottawa.

 

1

----

 

LaSalle County has a diverse economy with a balance inagriculture, transportation and industry. Grain terminals on the Illinois DeepWaterway at Ottawa provide a direct distribution point for agriculturalproducts to overseas markets via the Gulf of Mexico and the St. Lawrence Seaway.LaSalle County annually ranks in the top 10 counties in Illinois for corn andsoybean production. LaSalle County, the site of the largest producer of silicasand in the United States, has a diverse manufacturing sector which includes,in addition to the production of silica sand, the manufacture of residentialglass, automotive and industrial belts and equipment, electronic typewritersand computer printers, plastics, office supplies, and rubber products. Many ofthese companies conduct business in national and, in some instances,international markets.

 

The LaSalle County economy is continuing to expand. Manydevelopments have had a significant impact on the area economy, including a newCounty Office Building on the north edge of Ottawa and several new and expandedshopping center projects.

 

The Bankpurchased and assumed substantially all of the deposit liabilities of twobranch offices located in Streator, Illinois from First Midwest Bank(collectively, the “Branches”) on November 14, 2003. Approximately $69.3million of deposits and the related cash balances were transferred to the Bankvia cash transfers from First Midwest Bank. In connection with the acquisitionof such deposit liabilities and related cash balances, the Bank also acquiredcertain other assets of the Branches, including real estate, furniture andfixtures and approximately $11.8 million of the loans carried on the books ofthe Branches. Many of the employees remained with the Branches and becameemployees of the Bank.

 

The Company opened full service banking facilities in 2003in the city of Morris, Illinois, and in 2005 in the city of Yorkville,Illinois. The Company continues to explore expansion opportunities within itsexisting market area and in surrounding areas.

 

***Lending Activities***.The Company relies on interest income from lending activities as a major sourceof revenue. The Company has a community bank focus — serving the credit needsof the local community. Because of this local focus, the Company has a flexibleprocess for handling loan requests rather than being tied to rigid standards. Thediscussions below regarding lending policies reflect general guidelines and mayvary on a case-by-case basis depending on the borrower’s credit history and thetype and size of loan. During the approval process for loans it originates, theCompany assesses both the applicant’s ability to repay the loan and the valueof any collateral securing the loan. The Company verifies the applicant’sability to repay the loan by using credit reports, financial statements,confirmations, and other items, including appraisals.

 

Twelveloan officers have the authority to handle all lending activities of theCompany. Each lending officer has authority to approve extensions of credit upto their individual lending limit. The Company has an Officers Loan Committee(consisting of Loan Officers, the Chief Lending Officer, and the President ofthe Bank) which approves loans of up to $1,000,000. All loans between$1,000,000 and $2,000,000 are sent to the Director’s Loan Committee forapproval. The Director’s Loan Committee is also responsible for monitoringconcentration of credits, problem and past due loans, and charge-offs ofuncollectible loans; formulating recommendations for the Board of Directorsregarding loan policy modifications, loan classifications, and charge-offs. Allloans in excess of $2,000,000 are reviewed and approved by the Board ofDirectors. The Board of Directors also is responsible for directing andsupervising the Director’s Loan Committee, policy

 

2

----

 

review, and oversight of the loan and investment functionsof the Company. The Board of Directors also monitors the adequacy of theCompany’s loan loss reserves.

 

***Loan Portfolio Composition***.The Company’s gross loan portfolio, totaled $152.9 million at December 31,2005, representing 63.7% of the Company’s total deposits at that date. TheCompany’s loan portfolio at December 31, 2005 included $95.5 million for realestate purposes, $23.7 million for consumer purposes, and $33.7 million forcommercial and agricultural purposes.

 

Certain risks, including the risk of non-payment, are associated witheach type of loan. The primary risks associated with consumer loans relate tothe borrower, such as the risk of a borrower’s unemployment as a result ofdeteriorating economic conditions or the amount and nature of a borrower’sother existing indebtedness, and the value of the collateral securing the loanif the Company must take possession of the collateral. Consumer loans also haverisks associated with concentrations of loans in a single type of loan. Theprimary risks associated with commercial loans are the experience and qualityof the borrower’s management, the business climate, and the impact of economicfactors. With respect to agricultural loans, the primary risks are weather,market conditions, and, like commercial loans, the quality of the borrower’smanagement. Risks associated with real estate loans include concentrations ofloans in a loan type such as commercial or agricultural and fluctuating landvalues.

 

The Company’s strategy in addressing and managing these types of risksis to follow its loan policies and underwriting practices, which include(i) granting loans on a sound and collectible basis; (ii) investingfunds profitably for the benefit of the stockholders and the protection ofdepositors; (iii) serving the legitimate needs of the community and theCompany’s general market area while maintaining a balance between maximum yieldand minimum risk; (iv) ensuring that primary and secondary sources ofrepayment are adequate in relation to amount of the loan; (v) developingand maintaining adequate diversification of the loan portfolio as a whole andof the loans within each loan category; (vi) ensuring that each loan isproperly documented and, if appropriate, secured or guaranteed by governmentagencies; and (vii) developing and applying adequate collectionsprocedures.

 

3

----

 

**All table amounts throughout the Form 10-K are in thousandsexcept share and per share data.**

** **

Thefollowing table presents the components of the Company’s loan portfolio as ofDecember 31 for each year shown.

 
| ** **                                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |     |       |     |       |     |       |
| Real estate loans                         |       | $        | 95,469     |     | $          | 74,225   |       | $        | 70,839     |     | $          | 46,622 |   | $ | 47,282 |   |
|                                      |       |     |       |     |       |     |       |     |       |     |       |
| Commercial and agricultural loans         |       | 33,686   |       | 28,341   |       | 24,197   |       | 33,950   |       | 29,361   |       |
|                                      |       |     |       |     |       |     |       |     |       |     |       |
| Installment loans, net of unearned income |       | 11,585   |       | 17,575   |       | 22,812   |       | 19,951   |       | 24,595   |       |
|                                      |       |     |       |     |       |     |       |     |       |     |       |
| Home equity lines of credit               |       | 12,120   |       | 12,651   |       | 12,456   |       | 9,120    |       | 6,795    |       |
|                                      |       |     |       |     |       |     |       |     |       |     |       |
| Total Loans                               |       | 152,860  |       | 132,792  |       | 130,304  |       | 109,643  |       | 108,033  |       |
|                                      |       |     |       |     |       |     |       |     |       |     |       |
| Allowance for loan losses                 |       | (1,344   | )          | (1,174   | )          | (1,049   | )          | (1,167   | )          | (1,109   | )          |
|                                      |       |     |       |     |       |     |       |     |       |     |       |
| Loans, net                                |       | $        | 151,516    |     | $          | 131,618  |       | $        | 129,255    |     | $          | 108,476 |   | $ | 106,924 |   |
|                                      |       |     |       |     |       |     |       |     |       |     |       |
| Loans held for sale                       |       | $        | —     |     | $          | 1,701    |       | $        | 1,644      |     | $          | 1,811 |   | $ | 1,475 |   |

 

Maturities(based on contractual terms) of the Company’s commercial and construction loanportfolio at December 31, 2005 are summarized below:

 
| ** **                  | ** ** | **One Year  or Less** | ** ** | **One to  Five Years** | ** ** | **Over  Five Years** | ** ** | **Total** | ** ** |
|-----------------------------|------------|-----------------------|------------|------------------------|------------|----------------------|------------|-----------|------------|
|                        |       |                  |       |                   |       |                 |       |      |       |
| Commercial and agricultural |       | $                     | 15,634     |                   | $          | 8,856                |       | $         | 9,196      |   | $ | 33,686 |   |
|                        |       |                  |       |                   |       |                 |       |      |       |
| Construction                |       | 7,950                 |       | 4,133                  |       | 2,332                |       | 14,415    |       |
|                        |       |                  |       |                   |       |                 |       |      |       |
| Total                       |       | $                     | 23,584     |                   | $          | 12,989               |       | $         | 11,528     |   | $ | 48,101 |   |

 

At December 31, 2005, of the total loans that maturein more than one year, $65.8 million, or 65.7%, bear interest at fixed ratesand $34.3 million, or 34.3%, bear interest at variable rates.

 

***ConsumerLoans***. The Company makesconsumer loans for various purposes, including personal, family, andnonbusiness reasons such as automobile loans and recreational vehicle loans, onboth a direct and indirect basis. Consumer loans totaled approximately $23.7million at December 31, 2005, or approximately 15.5% of the Company’stotal loan portfolio. Approximately 40.0% of the Company’s consumer loans wereautomobile loans, and of these loans, approximately 67.8% were made indirectlyby the Company through automobile dealers. At December 31, 2005, the Companyhad 11 consumer loans totaling $101,000 that were past due in excess of 90days. Management feels the Company is well collateralized and expects no lossin excess of specific allocations on the loans.

 

4

----

 

Inapproving consumer loans, lending officers consider the borrower’s past credithistory, the borrower’s ability to repay the debt, the collateral offered, andlocal economic conditions that could affect the borrower’s income. Loans beingoriginated for new borrowers must be accompanied by a completed applicationdated and signed by the borrower, giving the details of the loan request. Totaldebts, along with the gross monthly income of the borrower, are required to beshown on the application. A brief cash flow analysis is performed by the loanofficer showing the amount of the borrower’s income available for debt servicebased on current debts plus the new loan request. Generally, debt service togross income should not exceed 40%. New credit reports are obtained on allborrowers with each loan request. The value of collateral on loans secured byused automobiles is generally determined by using industry-accepted used carguides. In connection with used automobile loans, the Company generallyrequires a 90% loan-to-value ratio; however, depending upon various factors,including the credit experience of the Company with the borrower, the Companymay extend credit in excess of the value of the used automobile. A loan-to-valueratio of 90% of sticker price is generally required for new automobile loans. Boats,mobile homes, recreational vehicles, and similar items generally require a loan-to-valueratio of 70% to 80% of the current market value of the collateral. Unsecuredconsumer loans are granted to borrowers based upon satisfactory income,indebtedness levels, and credit records and experience.

 

***Commercial, Agricultural, and Real EstateLending***.

 

Commercialand Agricultural.At December 31, 2005, the Company’s commercial and agricultural loans totaled$33.7 million, or approximately 22.0% of the total loan portfolio of theCompany. The majority of agricultural and commercial non-real estate loans arewritten for one to five years, may bear interest at a fixed or variable rateand are amortized over a 15-year to 20-year period. Fixed rates are establishedby the Company’s management after considering the cost of funds to the Companyas well as the rates of competing institutions. The variable rate is generallybased upon the national prime rate as disclosed in *The WallStreet Journal*. Principal and interest payments on commercial loansgenerally are required monthly; whereas, payments on agricultural loans varyfrom monthly, quarterly, semi-annually, and annually. At December 31, 2005, theCompany had 3 commercial non-real estate loanstotaling $29,000 that werepast due in excess of 90 days. There were 4 agricultural non-real estate loanstotaling $513,000 at December 31, 2005 that were past due in excess of 90 days.Management feels the Company is well collateralized and expects no loss inexcess of specific allocations on the loans.

 

All commercial and agricultural borrowers, both existing and new, arerequired by policy to have a current financial statement no older than one year.Borrowers also are required to provide the Company with recent tax returns andpro forma projections. Using certain computer programs and the data supplied byborrowers, the loan officers produce additional financial information utilizedin analyzing the loans and the borrowers. The general nature of the collateralsecuring the Company’s commercial and agricultural loans consists of equipment,farm products, crops, inventory, chattel paper, accounts receivable, andgeneral intangibles. The Company’s loan-to-value ratio with respect toagricultural and commercial non-real estate loans averages 66 2/3% to 75% ofthe value of the collateral securing the loan.

 

Real Estate Lending.The Company’s primary real estate lending consists of commercial loans with asmall portion in residential and agricultural real estate loans. Real estateloans at

 

5

----

 

December 31, 2005 totaled approximately $95.5 million orapproximately 62.5% of the Company’s total loan portfolio. All borrowersrequesting a real estate loan are required to submit an application which isreviewed by the lending officer. A credit investigation is performed and ananalysis of the borrower’s ability to repay is conducted. Subsequently, aninspection and appraisal of the real property is conducted to determine whetheror not the property is of sufficient value to meet the Company’s suggestedmaximum loan-to-value ratio of 80% to 85% of the lesser of the appraised valueor the purchase price of the property securing the loan. Under certain federalguaranteed loan programs utilized by the Company, the maximum loan-to-valueratio is higher. With respect to loans secured by commercial or industrial realestate, the Company analyzes the potential for environmental liability concernsand, depending upon the circumstances, the Company may require additionalinformation or testing. Commercial and agricultural real estate loans aregenerally originated under the same policies and procedures as discussed abovefor commercial and agricultural non-real estate loans.

 

The Company’s residential real estate loans consist of 15-year, 20-yearand 30-year fixed-rate and variable-rate loans with amortization periods equalto the maturity of the loan. The Company’s fixed-rate loans with biweeklypayments account for approximately 59.7% of all the residential real estateloans of the Company. The biweekly loan program amortizes 25 year loans inapproximately 18.9 years. The Company also originates a variety of loans thatare sold into the secondary market through Federal Home Loan MortgageCorporation (“Freddie Mac”) and private investors. These loans are underwrittento meet all Freddie Mac requirements. The Company retains servicing rights onloans sold into the secondary market. At December 31, 2005, mortgage loansserviced for the secondary market totaled approximately $32.8 million.

 

AtDecember 31, 2005, the Company had 8 personal real estate mortgage loanstotaling $627,000, and 3 commercial real estate loans totaling $67,000, pastdue in excess of 90 days. Management feels the Company is well collateralizedand expects no loss in excess of specific allocations on the loans.

 

***Interest Rates and Fees***.Interest rates and fees charged on the Company’s loans are affected primarilyby the market demand for loans and the supply of money available for lendingpurposes. These factors are affected by, among other things, general economicconditions and the policies of the federal government, including the FederalReserve Board, legislative tax policies, and governmental budgetary matters.

 

***Non-Performing Loans***.When a borrower fails to make a required payment on a loan and does not curethe delinquency within 30 days, the loan is classified as delinquent. In thisevent, the normal procedure followed by the Company is to make contact with theborrower at prescribed intervals in an effort to bring the loan to a currentstatus. In most cases, delinquencies are cured promptly, but, if not, theCompany normally records a notice of default, subject to any required priornotice to the borrower, and commences foreclosure proceedings when loanpayments are 120 days past due.

 

At December 31, 2005, the Company had 59 loans delinquent for 30 to 90days in an aggregate principal amount of $2.0 million and representing 1.3% ofthe total loan portfolio. At

 

6

----

 

December 31, 2005, the Company had 29 loans totaling $1.3 milliondelinquent for more than 90 days.

 

It is the Company’s policy to discontinue the accrual of interestincome on any loan when, in accordance with banking regulations or in theopinion of management, there is reasonable doubt as to the collectibility ofinterest or principal. Interest on these loans is credited to income only whenthe collection of principal is reasonably assured and only to the extentinterest payments are received. If management feels collection of both interestand principal is probable, the loan is not transferred to nonaccrual status. AtDecember 31, 2005, there were no loans on nonaccrual status.

 

As a result of economic conditions and other factors beyond the Company’scontrol, the Company’s future loss and delinquency experience cannot bepredicted with certainty.

 

Thenonperforming assets of the Company as of December 31 are indicated below:

 
| ** **                                                            | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
|                                                                  |       |     |       |     |       |     |       |     |       |     |       |
| Non-accrual loans                                                     |       | $        | —     |     | $          | 161      |       | $        | 137        |     | $          | 364 |   | $ | 387 |   |
| Loans ninety days past due and still  accruing interest               |       | 1,337    |       | 727      |       | 293      |       | 757      |       | 860      |       |
| Other real estate owned                                               |       | 88       |       | —   |       | —   |       | 204      |       | —   |       |
|                                                                  |       |     |       |     |       |     |       |     |       |     |       |
| Total nonperforming assets                                            |       | $        | 1,425      |     | $          | 888      |       | $        | 430        |     | $          | 1,325 |   | $ | 1,247 |   |
|                                                                  |       |     |       |     |       |     |       |     |       |     |       |
| Nonperforming loans as a percentage of  total loans                   |       | .88      | %          | .66      | %          | .33      | %          | 1.02     | %          | 1.17     | %          |
|                                                                  |       |     |       |     |       |     |       |     |       |     |       |
| Nonperforming assets as a percentage of  total assets                 |       | .51      |       | .31      |       | .15      |       | .55      |       | .54      |       |
|                                                                  |       |     |       |     |       |     |       |     |       |     |       |
| Nonperforming loans as a percentage of the  allowance for loan losses |       | 99.48    |       | 75.64    |       | 40.99    |       | 96.06    |       | 112.44   |       |

 

Theeffect of nonaccrual loans upon interest income is not deemed to be material bymanagement. Loans are placed in nonaccrual status when 90 days past due, unlessthey are fully secured and in the process of collection. At December 31, 2005,there were other impaired loans with specific reserve allocations classified asproblem loans that were not included above. Management also maintains a reporton loans requiring attention that includes loans greater than 60 daysdelinquent or other loans as deemed necessary by the Company’s internal loanreview or the loan committee. The total of loans requiring attention as ofDecember 31, 2005 was $4.3 million.

 

***Allowance for Losses on Loans***.In originating loans, the Company recognizes that losses will be experienced onloans and that the risk of loss will vary with, among other things, the type ofloan being made, the creditworthiness of the borrower over the term of theloan, general economic conditions and, in the case of a secured loan, thequality of the security for the loan.

 

7

----

 

The Company maintains an allowance for loan losses to absorb probableincurred credit losses inherent in the loan portfolio. The allowance for loanlosses represents management’s estimate of probable incurred losses based oninformation available as of the date of the financial statements. The allowancefor loan losses is based on management’s evaluation of the collectibility ofthe loan portfolio, including past loan loss experience, known and inherentrisks in the nature and volume of the portfolio, information about specificborrower situations, estimated collateral values, and economic conditions.

 

The loan portfolio and other credit exposures are regularly reviewed bymanagement to evaluate the adequacy of the allowance for loan losses. Themethodology for assessing the appropriateness of the allowance includescomparisons to actual losses, industry data and economic conditions. Inaddition, the regulatory agencies, as an integral part of their examinationprocess, periodically review the Company’s allowance for loan losses. Suchagencies may require the Company to make additional provisions for estimatedlosses based upon judgments different from those of management.

 

In connection with assessing the allowance, loss factors are applied tovarious pools of outstanding loans. The Company segregates the loan portfolioaccording to risk characteristics (i.e., mortgage loans, commercial realestate, agricultural, business, consumer, etc.) and risk gradings. Loss factorsare derived using the Company’s historical loss experience and may be adjustedfor significant factors that, in management’s judgment, affect thecollectibility of the portfolio as of the evaluation date. Commercial realestate and commercial business loans are individually evaluated for impairmentand specific reserves are allocated as needed in accordance with Statement ofFinancial Accounting Standards No. 114 and No. 118.

 

In addition, management assesses the allowance using factors thatcannot be associated with specific credit or loan categories. These factorsinclude management’s subjective evaluation of local and economic and businessconditions, portfolio concentration and changes in the character and size ofthe loan portfolio. The allowance methodology reflects management’s objectivethat the overall allowance appropriately reflects a margin for the imprecisionnecessarily inherent in the estimates of expected credit losses.

 

The allowance for loan losses is established through a charge tooperations at the time loan value becomes impaired or, in the judgment ofmanagement, other subjective factors warrant additional reserves. As noted inthe previous table, nonperforming loans increased by $449,000 in 2005 afterincreasing by $458,000 during 2004. Management considered this informationalong with other portfolio trends when considering the adequacy of theallowance for loan losses at December 31, 2005. At December 31, 2005,the balance in the allowance was $1.3 million, or .88% of gross loansoutstanding. Management has concluded that the allowance for loan losses isadequate at December 31, 2005. However, there can be no assurance that theallowance for loan losses is adequate to cover all losses.

 

The Company had 1 property valued at $88,000, resulting fromforeclosure, classified as other real estate owned at December 31, 2005. Otherreal estate is generally carried at the lower of cost or estimated marketvalue.

 

8

----

 

***Summary of Loan Loss Experience.***Theallowance for loan losses is maintained by management at a level consideredadequate to cover losses that are currently anticipated based upon past lossexperience, general economic conditions, information about specific borrowersituations, including their financial position and collateral values, and otherfactors and estimates which are subject to change over time.

 

Loanloss experience for the five years ended December 31, 2005 is summarized asfollows:

 
| ** **                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
|                                                           |       |     |       |     |       |     |       |     |       |     |       |
| Balance of the allowance for loan losses at  beginning of year |       | $        | 1,174      |     | $          | 1,049    |       | $        | 1,167      |     | $          | 1,109 |   | $ | 1,108 |   |
| Charge-offs                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Real Estate                                                    |       | —   |       | 63       |       | 66       |       | 46       |       | 111      |       |
| Commercial                                                     |       | 71       |       | —   |       | 50       |       | 6        |       | 35       |       |
| Installment                                                    |       | 145      |       | 210      |       | 303      |       | 181      |       | 254      |       |
| Total charge-offs                                              |       | 216      |       | 273      |       | 419      |       | 233      |       | 400      |       |
|                                                           |       |     |       |     |       |     |       |     |       |     |       |
| Recoveries                                                     |       |     |       |     |       |     |       |     |       |     |       |
| Real Estate                                                    |       | 8        |       | —   |       | 16       |       | 39       |       | 4        |       |
| Commercial                                                     |       | 16       |       | 4        |       | 57       |       | 63       |       | 6        |       |
| Installment                                                    |       | 62       |       | 94       |       | 108      |       | 69       |       | 91       |       |
| Total recoveries                                               |       | 86       |       | 98       |       | 181      |       | 171      |       | 101      |       |
| Net charge-offs                                                |       | 130      |       | 175      |       | 238      |       | 62       |       | 299      |       |
| Provision                                                      |       | 300      |       | 300      |       | 120      |       | 120      |       | 300      |       |
|                                                           |       |     |       |     |       |     |       |     |       |     |       |
| Balance at end of year                                         |       | $        | 1,344      |     | $          | 1,174    |       | $        | 1,049      |     | $          | 1,167 |   | $ | 1,109 |   |
|                                                           |       |     |       |     |       |     |       |     |       |     |       |
| Net charge-offs to average total loans                         |       | .09      | %          | .13      | %          | .21      | %          | .06      | %          | .26      | %          |
| Allowance for loan losses to total loans at  year-end          |       | .88      |       | .87      |       | .80      |       | 1.06     |       | 1.03     |       |

 

9

----

 

TheCompany’s allocation of the allowance for loan losses as of December 31 ispresented below:

 
| ** **                         | ** ** | **2005**   | ** ** | **2004**                     | ** ** | **2003**   | ** ** | **2002**                     | ** ** | **2001**   | ** ** |
|------------------------------------|------------|------------|------------|------------------------------|------------|------------|------------|------------------------------|------------|------------|------------|
| ** **                         | ** ** | **Amount** | ** ** | **Percent  of Total  Loans** | ** ** | **Amount** | ** ** | **Percent  of Total  Loans** | ** ** | **Amount** | ** ** | **Percent  of Total  Loans** | ** ** | **Amount** | ** ** | **Percent  of Total  Loans** | ** ** | **Amount** | ** ** | **Percent  of Total  Loans** | ** ** |
|                               |       |       |       |                         |       |       |       |                         |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Real estate loans                  |       | $          | 131        |                         | 62.45      | %          | $          | 234                          |       | 19.88      | %          | $ | 444 |   | 54.37 | % | $ | 281 |   | 42.56 | % | $ | 308 |   | 43.78 | % |
|                               |       |       |       |                         |       |       |       |                         |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Commercial and  agricultural loans |       | 613        |       | 22.04                        |       | 519        |       | 44.24                        |       | 209        |       | 18.57 |   | 307 |   | 30.94 |   | 380 |   | 27.62 |   |
|                               |       |       |       |                         |       |       |       |                         |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Installment loans                  |       | 141        |       | 15.51                        |       | 185        |       | 15.79                        |       | 242        |       | 27.06 |   | 236 |   | 26.50 |   | 287 |   | 28.60 |   |
|                               |       |       |       |                         |       |       |       |                         |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Unallocated                        |       | 459        |       | N/A                          |       | 236        |       | N/A                          |       | 154        |       | N/A |   | 343 |   | N/A |   | 134 |   | N/A |   |
|                               |       |       |       |                         |       |       |       |                         |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Balance at end of  year            |       | $          | 1,344      |                         | 100.00     | %          | $          | 1,174                        |       | 100.00     | %          | $ | 1,049 |   | 100.00 | % | $ | 1,167 |   | 100.00 | % | $ | 1,109 |   | 100.00 | % |

 

***InvestmentActivities****.*The investment policies of the Company asestablished by the Board of Directors attempt to provide and maintainliquidity, generate a favorable return on investments without incurring undueinterest rate and credit risk, and complement the Company’s lending activities.The policies provide the authority to invest in United States Treasury andfederal agency securities, mortgage-backed securities, municipal securities,equity securities, and Certificates of Deposits.

** **

Approximately $1.0 million of the United States government agency notesheld at December 31, 2005 are callable at the option of the issuer, whichpresent limited prepayment risk to the Company.

 

As of December 31, 2005, the Company had approximately $4.3 millioninvested in municipalities located within LaSalle County, Illinois.

 

The Company purchased $7.9 million of Index Powered Certificates ofDeposit between 2002 and 2005. These deposits were placed with multiple issuersso that $7.0 million of the principal deposited is insured through the FDIC andthe remaining $900,000 is collateralized with a letter of credit from thesingle issuing institution. Income returns are not guaranteed for theseinstruments, however principal is guaranteed if held to maturity.

 

10

----

 

***Securities Portfolio.***Thefollowing table shows the maturity distribution of the available-for-salesecurities portfolio and the weighted average yield of the portfolio atDecember 31, 2005.

 
| ** **                                                     | ** ** | **One Year  or Less** | ** ** | **Weighted  Average  Yield** | ** ** | **One to  Five  Years** | ** ** | **Weighted  Average  Yield** | ** ** | **Five  to Ten  Years** | ** ** | **Weighted  Average  Yield** | ** ** | **Over  Ten  Years** | ** ** | **Weighted  Average  Yield** | ** ** | **Total** | ** ** | **Weighted  Average  Yield** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|------------------------------|------------|-------------------------|------------|------------------------------|------------|-------------------------|------------|------------------------------|------------|----------------------|------------|------------------------------|------------|-----------|------------|------------------------------|------------|
|                                                           |       |                  |       |                         |       |                    |       |                         |       |                    |       |                         |       |                 |       |                         |       |      |       |                         |       |
| U.S. Treasury  securities                                      |       | $                     | —     |                         | —     | %                       | $          | 9,802                        |       | 3.26                    | %          | $                            | —     |                 | —     | %                            | $          | —    |       | —                       | %          | $ | 9,802 |   | 3.26 | % |
| U.S. Government  agencies                                      |       | 4,253                 |       | 4.37                         |       | 35,152                  |       | 3.51                         |       | —                  |       | —                       |       | —               |       | —                       |       | 39,405    |       | 3.60                         |       |
| States and  political subdivisions                             |       | 2,022                 |       | 7.59                         |       | 19,411                  |       | 4.49                         |       | 838                     |       | 6.38                         |       | 2,925                |       | 6.75                         |       | 25,196    |       | 3.54                         |       |
| Mortgage-backed  securities and collateralized obligations (1) |       | 137                   |       | 4.29                         |       | 9,732                   |       | 4.46                         |       | —                  |       | —                       |       | —               |       | —                       |       | 9,869     |       | 4.46                         |       |
|                                                           |       |                  |       |                         |       |                    |       |                         |       |                    |       |                         |       |                 |       |                         |       |      |       |                         |       |
| Corporate bonds                                                |       | 100                   |       | 5.98                         |       | 3,219                   |       | 2.87                         |       | —                  |       | —                       |       | —               |       | —                       |       | 3,319     |       | 2.96                         |       |
| Equity securities                                              |       | 3,040                 |       | N/A                          |       | —                  |       | —                       |       | —                  |       | —                       |       | —               |       | —                       |       | 3,040     |       | N/A                          |       |
|                                                           |       |                  |       |                         |       |                    |       |                         |       |                    |       |                         |       |                 |       |                         |       |      |       |                         |       |
| Total securities                                               |       | $                     | 9,552      |                         | 5.41       | %                       | $          | 77,316                       |       | 3.82                    | %          | $                            | 838        |                 | 6.38       | %                            | $          | 2,925     |       | 6.75                         | %          | $ | 90,631 |   | 3.61 | % |

 

----

(1) Mortgage-backed securities reflect the contractual maturity of therelated instrument.

 

11

----

 

***Deposits****.*The Company offers deposit services including demand,savings, and time deposit accounts and programs, which include interest-bearingand non-interest-bearing demand deposits and individual retirement accounts. TheCompany has had a stable deposit base. Management believes that this stabilityis due to the Company’s emphasis on being a locally owned and operated bank andby providing quality, personalized service to its customers.

 

The following shows the Company’s average balances and rates paidduring the years shown.

 
| ** **                                         | ** ** | **For the  Years Ended December 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                         | ** ** | **2005**                              | ** ** | **2004** |   | **2003** | ** ** |
| ** **                                         | ** ** | **Average  Balance**                  | ** ** | **Percent  of  Deposits** | ** ** | **Rate** | ** ** | **Average  Balance** | ** ** | **Percent  of  Deposits** | ** ** | **Rate** |   | **Average  Balance** | ** ** | **Percent  of  Deposits** | ** ** | **Rate** | ** ** |
|                                               |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest- bearing demand deposits               |       | $                                     | 31,153     |   | 11.9 | % | — | % | $ | 29,815 |   | 11.0 | % | — | % | $ | 20,775 |   | 10.2 | % | — | % |
| Interest-bearing demand and money market  accounts |       | 98,826                                |       | 37.7 |   | 1.39 |   | 107,136 |   | 39.5 |   | 1.17 |   | 69,435 |   | 34.1 |   | 1.02 |   |
| Savings accounts                                   |       | 27,083                                |       | 10.3 |   | .52 |   | 29,121 |   | 10.8 |   | .59 |   | 21,158 |   | 10.4 |   | .98 |   |
| Time deposits accounts                             |       | 105,301                               |       | 40.1 |   | 2.88 |   | 105,002 |   | 38.7 |   | 2.60 |   | 92,110 |   | 45.3 |   | 3.57 |   |
|                                               |       | $                                     | 262,363    |   | 100.0 | % | 1.73 | % | $ | 271,074 |   | 100.0 | % | 1.53 | % | $ | 203,478 |   | 100.0 | % | 2.07 | % |

 

Thedistribution of the major components of deposits as of December 31, 2005 and2004 is summarized in the balance sheets included in the 2005 consolidatedfinancial statements, which consolidated financial statements are incorporatedherein by reference. The following is a maturity distribution of timecertificates of deposit of $100,000 or more at December 31, 2005:

 
| ** **                      | ** ** | **Balance** | ** ** | **Percentage** | ** ** |
|---------------------------------|------------|-------------|------------|----------------|------------|
|                            |       |        |       |           |       |
| Maturity                        |       |        |       |           |       |
| Three months or less            |       | $           | 10,357     |           | 33.0       | % |
| Over three months to six months |       | 3,630       |       | 11.6           |       |
| Over six months to one year     |       | 5,041       |       | 16.0           |       |
| Over one year                   |       | 12,392      |       | 39.4           |       |
|                            |       |        |       |           |       |
| Total                           |       | $           | 31,420     |           | 100.0      | % |

 

12

----

*** ***

***Borrowings.***The Company’s otheravailable sources of funds include financing arrangements for securities soldunder agreements to repurchase, federal funds purchased lines, and Federal HomeLoan Bank borrowings. Total borrowings increased $5.8 million in 2005. Thisincrease was a result of a $7.1 million increase in federal funds purchased,partially offset by a $559,000 decrease in other borrowings and a $750,000decrease in repurchase agreements. The Bank maintains physical control of allsecurities sold under repurchase agreements. Information concerning securitiessold under agreements to repurchase is summarized as follows:

 
| ** **                                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                   |       |     |       |     |       |     |       |
| Balance at December 31                                 |       | $        | —     |     | $          | 750      |       | $ | — |   |
| Weighted average interest rate during the  year        |       | 1.63     | %          | 1.63     | %          | 2.11     | %          |
| Weighted average interest rate at the end  of the year |       | —   | %          | 1.63     | %          | —   | %          |
| Maximum month-end balance                              |       | $        | 750        |     | $          | 750      |       | $ | 1,545 |   |
| Average balance for the year                           |       | 232      |       | 215      |       | 475      |       |

 

***Trust.***The Company’s trustdepartment primarily services LaSalle County and surrounding counties. At December31, 2005, the trust department had 250 accounts under management, 158 of whichwere discretionary accounts. The trust department provides a full complement ofasset management services for personal trusts, estates, and agencies. The trustdepartment had assets under management of approximately $60.3 million atDecember 31, 2005, of which $51.1 million was in discretionary accounts.

 

The Company, in conjunction with its trust department, also providesfarm management services. At December 31, 2005, the department managed 44 farms.The department manages or directs approximately 6,582 acres of farmland inLaSalle County, Illinois and surrounding counties.

 

***Competition***. TheCompany has active competition in all product and service areas in which it presentlyengages. The Company not only competes for commercial and individual deposits,loans, and trust business with other LaSalle County, Illinois banks, but alsowith savings and loan associations, credit unions, and other financial servicecompanies located in and around LaSalle County. Many of these competitors maynot be subject to the same regulatory restrictions as the Company. There areapproximately 16 commercial banks and 6 savings institutions with offices inLaSalle County, Illinois. The principal methods of competition in the bankingand financial services industry are quality of services to the customer; easeof access to services; and pricing of services, including interest rates paidon deposits, interest rates charged on borrowings, and fees charged forfiduciary services. The financial services industry is also likely to becomemore competitive as further technological advances enable more companies toprovide financial services.

 

***Employees.***As ofDecember 31, 2005, the Company had 99 employees, consisting of 86 full-timeemployees and 13 part-time employees. None of the employees are subject to acollective bargaining agreement, and management believes it has excellentrelations with its staff.

 

13

----

 

***StockRepurchases.***During 2005 and 2004,the Company repurchased 1,260 and 1,018 shares of its common stock for anaggregate purchase price of $89,000 and $71,000.

 

## **Website.**The Company maintains a website atwww.firstottawa.com. The Company makes available free of charge on or throughits website, the annual report on Form 10K, quarterly reports on Form 10-Q,current reports on Form 8-K and amendments to those reports filed or furnishedpursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonablypracticable after the Company electronically files such material with, orfurnish it to, the Securities and Exchange Commission. The Company will alsoprovide copies of its filings free of charge upon written request to: Ms.Cheryl Gage, Corporate Secretary, First Ottawa Bancshares, Inc. 701-705 LaSalleStreet, P.O. Box 657, Ottawa, Illinois 61350. Additionally, all of the Company’sfilings with the Securities and Exchange Commission are also available, free ofcharge, through the SEC’s website at www.sec.gov.

##  

**Code of Business Conduct and Ethics.**TheCompany has a code of business conduct and ethics in place that applies to allof its directors and employees. The code sets forth the standard of ethics thatthe Company expects all of its directors and employees to follow, including theChief Executive Officer and Chief Financial Officer. The code of businessconduct and ethics is posted on the Company’s website at www.firstottawa.com. TheCompany intends to satisfy the disclosure requirements under Item 5.05 of Form8-K regarding any amendment to or waiver of the code with respect to the ChiefExecutive Officer and Chief Financial Officer, and persons performing similarfunctions, by posting such information on its website.

 

**Supervision and Regulation**

 

# General

#  

Financial institutions, their holding companies and theiraffiliates are extensively regulated under federal and state law. As a result,the growth and earnings performance of the Company may be affected not only bymanagement decisions and general economic conditions, but also by therequirements of federal and state statutes and by the regulations and policiesof various bank regulatory authorities, including the Office of the Comptrollerof the Currency (the ”OCC”), the Board of Governors of the Federal ReserveSystem (the ”Federal Reserve”) and the Federal Deposit InsuranceCorporation (the “FDIC”). Furthermore, taxation laws administered by theInternal Revenue Service and state taxing authorities and securities lawsadministered by the Securities and Exchange Commission (the ”SEC”) andstate securities authorities have an impact on the business of the Company. Theeffect of these statutes, regulations and regulatory policies may besignificant, and cannot be predicted with a high degree of certainty.

 

Federal and state laws and regulations generally applicable tofinancial institutions regulate, among other things, the scope of business, thekinds and amounts of investments, reserve requirements, capital levels relativeto operations, the nature and amount of collateral for loans, the establishmentof branches, mergers and consolidations and the payment of dividends. Thissystem of supervision and regulation establishes a comprehensive framework forthe respective operations of the Company and its subsidiaries and is intendedprimarily for the protection of the FDIC-insured deposits and depositors of theBank, rather than shareholders.

 

14

----

 

The followingis a summary of the material elements of the regulatory framework that appliesto the Company and its subsidiaries.  Itdoes not describe all of the statutes, regulations and regulatory policies thatapply, nor does it restate all of the requirements of those statutes,regulations and regulatory policies that are described. As such, the followingis qualified in its entirety by reference to applicable law.  Any change in applicable statutes,regulations or regulatory policies may have a material effect on the businessof the Company and its subsidiaries.

 

**TheCompany**

 

***General.**** *The Company, as thesole shareholder of the Bank, is a bank holding company.  As a bank holding company, the Company isregistered with, and is subject to regulation by, the Federal Reserve under theBank Holding Company Act of 1956, as amended (the “BHCA”).  In accordance with Federal Reservepolicy, the Company is expected to act as a source of financial strength to theBank and to commit resources to support the Bank in circumstances where theCompany might not otherwise do so.  Underthe BHCA, the Company is subject to periodic examination by the FederalReserve.  The Company is also required tofile with the Federal Reserve periodic reports of the Company’s operations andsuch additional information regarding the Company and its subsidiaries as theFederal Reserve may require.

 

***Acquisitions,Activities and Change in Control.* **The primary purpose of a bank holding company isto control and manage banks.****The BHCAgenerally requires the prior approval of the Federal Reserve for any mergerinvolving a bank holding company or any acquisition by a bank holding companyof another bank or bank holding company. Subject to certain conditions (including deposit concentration limitsestablished by the BHCA), the Federal Reserve may allow a bank holding companyto acquire banks located in any state of the United States. In approvinginterstate acquisitions, the Federal Reserve is required to give effect toapplicable state law limitations on the aggregate amount of deposits that maybe held by the acquiring bank holding company and its insured depositoryinstitution affiliates in the state in which the target bank is located(provided that those limits do not discriminate against out-of-state depositoryinstitutions or their holding companies) and state laws that require that thetarget bank have been in existence for a minimum period of time (not to exceedfive years) before being acquired by an out-of-state bank holding company.

 

The BHCA generally prohibits the Company fromacquiring direct or indirect ownership or control of more than 5% of the votingshares of any company that is not a bank and from engaging in any businessother than that of banking, managing and controlling banks or furnishingservices to banks and their subsidiaries. This general prohibition is subject to a number of exceptions.The principal exception allows bank holding companies to engage in, and toown shares of companies engaged in, certain businesses found by the FederalReserve to be “so closely related to banking ... as to be a proper incidentthereto.”  This authority would permitthe Company to engage in a variety of banking-related businesses, including theoperation of a thrift, consumer finance, equipment leasing, the operation of acomputer service bureau (including software development), and mortgage bankingand brokerage. The BHCA generally does not place territorial restrictions onthe domestic activities of non-bank subsidiaries of bank holding companies.

 

Additionally, bank holding companies thatmeet certain eligibility requirements prescribed

 

15

----

 

by the BHCA and elect to operate as financial holding companies mayengage in, or own shares in companies engaged in, a wider range of nonbankingactivities, including securities and insurance underwriting and sales, merchantbanking and any other activity that the Federal Reserve, in consultation withthe Secretary of the Treasury, determines by regulation or order is financialin nature, incidental to any such financial activity or complementary to anysuch financial activity and does not pose a substantial risk to the safety orsoundness of depository institutions or the financial system generally.  As of the date of this filing, the Companyhas not applied for approval to operate as a financial holdingcompany.

 

Federal lawalso prohibits any person or company from acquiring “control” of anFDIC-insured depository institution or its holding company without prior noticeto the appropriate federal bank regulator. “Control” is conclusively presumed to exist upon the acquisition of 25%or more of the outstanding voting securities of a bank or bank holding company,but may arise under certain circumstances at 10% ownership.

 

***Capital Requirements.***  Bank holding companies are required tomaintain minimum levels of capital in accordance with Federal Reserve capitaladequacy guidelines.  If capital levelsfall below the minimum required levels, a bank holding company, among otherthings, may be denied approval to acquire or establish additional banks ornon-bank businesses.

 

The Federal Reserve’s capital guidelinesestablish the following minimum regulatory capital requirements for bankholding companies: (i) a risk-based requirement expressed as a percentage oftotal assets weighted according to risk; and (ii) a leverage requirementexpressed as a percentage of total assets. The risk-based requirement consists of a minimum ratio of total capitalto total risk-weighted assets of 8% and a minimum ratio of Tier 1 capital tototal risk-weighted assets of 4%.  Theleverage requirement consists of a minimum ratio of Tier 1 capital to totalassets of 3% for the most highly rated companies, with a minimum requirement of4% for all others.  For purposes of thesecapital standards, Tier 1 capital consists primarily of permanent stockholders’equity less intangible assets (other than certain loan servicing rights andpurchased credit card relationships). Total capital consists primarily of Tier1 capital plus certain other debt and equity instruments that do not qualify asTier 1 capital and a portion of the company’s allowance for loan and leaselosses.

 

The risk-basedand leverage standards described above are minimum requirements. Higher capitallevels will be required if warranted by the particular circumstances or riskprofiles of individual banking organizations. For example, the Federal Reserve’scapital guidelines contemplate that additional capital may be required to takeadequate account of, among other things, interest rate risk, or the risks posedby concentrations of credit, nontraditional activities or securities tradingactivities.  Further, any bankingorganization experiencing or anticipating significant growth would be expectedto maintain capital ratios, including tangible capital positions (*i.e.*, Tier 1 capital less all intangible assets), well abovethe minimum levels.  As of December 31,2005, the Company had regulatory capital in excess of the Federal Reserve’sminimum requirements.

 

***Dividend Payments.**** *The Company’s ability to paydividends to its shareholders may be affected by both general corporate lawconsiderations and policies of the Federal Reserve applicable to bank holdingcompanies*.* As a Delaware corporation, the Companyis subject to the

 

16

----

 

limitations of the DelawareGeneral Corporation Law (the ”DGCL”). The DGCL allows the Company to paydividends only out of its surplus (as defined and computed in accordance withthe provisions of the DGCL) or if the Company has no such surplus, out of itsnet profits for the fiscal year in which the dividend is declared and/or thepreceding fiscal year. Additionally, policies of the Federal Reserve cautionthat a bank holding company should not pay cash dividends that exceed its netincome or that can only be funded in ways that weaken the bank holding company’sfinancial health, such as by borrowing. The Federal Reserve also possesses enforcement powers over bank holdingcompanies and their non-bank subsidiaries to prevent or remedy actions thatrepresent unsafe or unsound practices or violations of applicable statutes andregulations.  Among these powers is theability to proscribe the payment of dividends by banks and bank holdingcompanies.

 

***Federal Securities Regulation.***  The Company’s common stock is registered withthe SEC under the Securities Act of 1933, as amended, and the SecuritiesExchange Act of 1934, as amended (the ”Exchange Act”).  Consequently, the Company is subject to theinformation, proxy solicitation, insider trading and other restrictions andrequirements of the SEC under the Exchange Act.

 

**The Bank**

 

***General.***  The Bankis a national bank, chartered by the OCC under the National Bank Act.  The deposit accounts of the Bank areinsured by the FDIC’s Bank Insurance Fund (“BIF”), and the Bank is a member ofthe Federal Reserve System.  As anational bank, the Bank is subject to the examination, supervision, reportingand enforcement requirements of the OCC, the chartering authority for nationalbanks. The FDIC, as administrator of the BIF, also has regulatory authorityover the Bank.

 

***DepositInsurance.* **Asan FDIC-insured institution, the Bank is required to pay deposit insurancepremium assessments to the FDIC.  TheFDIC has adopted a risk-based assessment system under which all insureddepository institutions are placed into one of nine categories and assessedinsurance premiums based upon their respective levels of capital and results ofsupervisory evaluations.  Institutionsclassified as well-capitalized (as defined by the FDIC) and considered healthypay the lowest premium while institutions that are less than adequatelycapitalized (as defined by the FDIC) and considered of substantial supervisoryconcern pay the highest premium.  Riskclassification of all insured institutions is made by the FDIC for eachsemi-annual assessment period.

 

During the year ended December 31, 2005, BIFassessments ranged from 0% of deposits to 0.27% of deposits.  For the semi-annual assessment periodbeginning January 1, 2006, BIF assessment rates will continue to range from 0%of deposits to 0.27% of deposits.

 

***FICO Assessments.***  Since1987, a portion of the deposit insurance assessments paid by members of theFDIC’s Savings Association Insurance Fund (“SAIF”) has been used to coverinterest payments due on the outstanding obligations of the FinancingCorporation (“FICO”). FICO was created in 1987 to finance the recapitalizationof the Federal Savings and Loan Insurance Corporation, the SAIF’s predecessorinsurance fund. As a result of federal legislation enacted in 1996, beginningas of January 1, 1997, both SAIF members and BIF members became

 

17

----

 

subject to assessmentsto cover the interest payments on outstanding FICO obligations until the finalmaturity of such obligations in 2019. These FICO assessments are in addition to amounts assessed by the FDICfor deposit insurance. During the year ended December 31, 2005, the FICOassessment rate for BIF and SAIF members was approximately 0.01% of deposits.

 

***SupervisoryAssessments.***  National banks are required to paysupervisory assessments to the OCC to fund the operations of the OCC.  The amount of the assessment is calculatedusing a formula that takes into account the bank’s size and its supervisorycondition (as determined by the composite rating assigned to the bank as aresult of its most recent OCC examination).** **During the year ended December 31,2005, the Bank paid supervisory assessments to the OCC totaling $87,000.

 

***CapitalRequirements.* **Banksare generally required to maintain capital levels in excess of otherbusinesses. The OCC has established the following minimum capital standards fornational banks, such as the Bank: (i) a leverage requirement consisting of aminimum ratio of Tier 1 capital to total assets of 3% for the most highly-ratedbanks with a minimum requirement of at least 4% for all others; and (ii) arisk-based capital requirement consisting of a minimum ratio of total capitalto total risk-weighted assets of 8% and a minimum ratio of Tier 1 capital tototal risk-weighted assets of 4%.  Ingeneral, the components of Tier 1 capital and total capital are the same asthose for bank holding companies discussed above.

 

The capital requirements described above areminimum requirements.  Higher capitallevels will be required if warranted by the particular circumstances or riskprofiles of individual institutions.  Forexample, regulations of the OCC provide that additional capital may be requiredto take adequate account of, among other things, interest rate risk or therisks posed by concentrations of credit, nontraditional activities orsecurities trading activities.

 

Further, federal law and regulations provide various incentives forfinancial institutions to maintain regulatory capital at levels in excess ofminimum regulatory requirements. For example, a financial institution thatis “well-capitalized” may qualify for exemptions from prior notice orapplication requirements otherwise applicable to certain types of activitiesand may qualify for expedited processing of other required notices orapplications. Additionally, one of the criteria that determines a bank holdingcompany’s eligibility to operate as a financial holding company is arequirement that all of its financial institution subsidiaries be “well-capitalized.”  Under the regulations of the OCC, in order tobe “well-capitalized” a financial institution must maintain a ratio oftotal capital to total risk-weighted assets of 10% or greater, a ratio of Tier1 capital to total risk-weighted assets of 6% or greater and a ratio of Tier 1capital to total assets of 5% or greater.

 

Federal law also provides the federalbanking regulators with broad power to take prompt corrective action to resolvethe problems of undercapitalized institutions. The extent of the regulators’ powers depends on whether the institutionin question is “adequately capitalized,” “undercapitalized,” “significantlyundercapitalized” or “critically undercapitalized,” in each case as defined byregulation.  Depending upon the capitalcategory to which an institution is assigned, the regulators’ corrective powersinclude: (i) requiring the institution to submit a capital restoration plan;(ii) limiting the institution’s asset growth and restricting its activities;(iii) requiring the institution to issue additional capital stock (includingadditional voting stock) or to be acquired;

 

18

----

 

(iv) restricting transactions between theinstitution and its affiliates; (v) restricting the interest rate theinstitution may pay on deposits; (vi) ordering a new election of directors ofthe institution; (vii) requiring that senior executive officers ordirectors be dismissed; (viii) prohibiting the institution from acceptingdeposits from correspondent banks; (ix) requiring the institution to divestcertain subsidiaries; (x) prohibiting the payment of principal or interest onsubordinated debt; and (xi) ultimately, appointing a receiver for theinstitution.

 

As of December 31, 2005: (i) the Bank was not subject to a directivefrom the OCC to increase its capital to anamount in excess of the minimum regulatory capital requirements; (ii) theBank exceeded its minimum regulatory capital requirements under OCC capitaladequacy guidelines; and (iii) the Bank was “well-capitalized,” as defined byOCC regulations.

 

***Dividends.***  Theprimary source of funds for the Company is dividends from the Bank. Under theNational Bank Act, a national bank may pay dividends out of its undividedprofits in such amounts and at such times as the bank’s board of directorsdeems prudent.  Without prior OCCapproval, however, a national bank may not pay dividends in any calendar yearthat, in the aggregate, exceed the bank’s year-to-date net income plus the bank’sretained net income for the two preceding years.

 

The payment of dividends by any financialinstitution is affected by the requirement to maintain adequate capitalpursuant to applicable capital adequacy guidelines and regulations, and afinancial institution generally is prohibited from paying any dividends if,following payment thereof, the institution would be undercapitalized.  As described above, the Bank exceeded itsminimum capital requirements under applicable guidelines as of December 31,2005.  As of December 31, 2005,approximately $536,000 was available to be paid as dividends by the Bank.  Notwithstanding the availability of funds fordividends, however, the OCC may prohibit the payment of any dividends by theBank if the OCC determines such payment would constitute an unsafe or unsoundpractice.

 

***InsiderTransactions.* **TheBank is subject to certain restrictions imposed by federal law on extensions ofcredit to the Company, on investments in the stock or other securities of theCompany and the acceptance of the stock or other securities of the Company ascollateral for loans made by the Bank. Certain limitations and reportingrequirements are also placed on extensions of credit by the Bank to itsdirectors and officers, to the directors and officers of the Company, toprincipal stockholders of the Company, and to “related interests” of suchdirectors, officers and principal stockholders. In addition, federal law and regulations may affect the terms upon whichany person who is a director or officer of the Company or the Bank or aprincipal stockholder of the Company may obtain credit from banks with whichthe Bank maintains correspondent relationships.

 

***Safety andSoundness Standards.***  The federal banking agencieshave adopted guidelines that establish operational and managerial standards topromote the safety and soundness of federally insured depository institutions.  The guidelines set forth standards forinternal controls, information systems, internal audit systems, loandocumentation, credit underwriting, interest rate exposure, asset growth,compensation, fees and benefits, asset quality and earnings.

 

In general, the safety and soundnessguidelines prescribe the goals to be achieved in each area, and eachinstitution is responsible for establishing its own procedures to achieve thosegoals.

 

19

----

 

If an institution fails to comply with any of the standards set forthin the guidelines, the institution’s primary federal regulator may require theinstitution to submit a plan for achieving and maintaining compliance. If aninstitution fails to submit an acceptable compliance plan, or fails in anymaterial respect to implement a compliance plan that has been accepted by itsprimary federal regulator, the regulator is required to issue an orderdirecting the institution to cure the deficiency. Until the deficiency cited inthe regulator’s order is cured, the regulator may restrict the institution’srate of growth, require the institution to increase its capital, restrict therates the institution pays on deposits or require the institution to take anyaction the regulator deems appropriate under the circumstances. Noncompliancewith the standards established by the safety and soundness guidelines may alsoconstitute grounds for other enforcement action by the federal bankingregulators, including cease and desist orders and civil money penaltyassessments.

 

***BranchingAuthority.***  National banks headquartered in Illinois,such as the Bank, have the same branching rights in Illinois as banks charteredunder Illinois law, subject to OCC approval. Illinois law grants Illinois-chartered banks the authority to establish branchesanywhere in the State of Illinois, subject to receipt of all requiredregulatory approvals.

 

Federal law permits state and national banks to merge with banks inother states subject to: (i) regulatory approval; (ii) federal and statedeposit concentration limits; and (iii) state law limitations requiring themerging bank to have been in existence for a minimum period of time (not toexceed five years) prior to the merger. The establishment of new interstate branches or the acquisition ofindividual branches of a bank in another state (rather than the acquisition ofan out-of-state bank in its entirety) is permitted only in those states thelaws of which expressly authorize such expansion.

 

***FinancialSubsidiaries. ***UnderFederal law and OCC regulations, national banks are authorized to engage,through “financial subsidiaries,” in any activity that is permissible for afinancial holding company and any activity that the Secretary of the Treasury,in consultation with the Federal Reserve, determines is financial in nature orincidental to any such financial activity, except (i) insurance underwriting,(ii) real estate development or real estate investment activities (unlessotherwise permitted by law), (iii) insurance company portfolio investments and(iv) merchant banking.  Theauthority of a national bank to invest in a financial subsidiary is subject toa number of conditions, including, among other things, requirements that thebank must be well-managed and well-capitalized (after deducting from capitalthe bank’s outstanding investments in financial subsidiaries).  The Bank has not applied for approval toestablish any financial subsidiaries.

 

***FederalReserve System.***  Federal Reserve regulations, aspresently in effect, require depository institutions to maintain non-interestearning reserves against their transaction accounts (primarily NOW and regularchecking accounts), as follows: for transaction accounts aggregating $48.3million or less, the reserve requirement is 3% of total transaction accounts;and for transaction accounts aggregating in excess of $48.3 million, thereserve requirement is $1.215 million plus 10% of the aggregate amount of totaltransaction accounts in excess of $48.3 million.  The first $7.8 million of otherwisereservable balances are exempted from the reserve requirements.  These reserve requirements are subject toannual adjustment by the Federal Reserve. The Bank is in compliance with theforegoing requirements.

 

20

----

 

***Recent RegulatoryDevelopments***On February8, 2006, President Bush signed the FederalDeposit Insurance Reform Act of 2005 (“FDIRA”) into law as part of the DeficitReduction Act of 2005. On February 15, 2006, President Bush signed into law thetechnical and conforming amendments designed to implement FDIRA.  FDIRA provides for legislative reforms tomodernize the federal deposit insurance system.

 

Among other things, FDIRA: (i) merges the Bank Insurance Fund (the “BIF”)and the Savings Association Insurance Fund (the “SAIF”) of the Federal DepositInsurance Corporation (the “FDIC”) into a new Deposit Insurance Fund (the ”DIF”);(ii) allows the FDIC, after March 31, 2010, to increase depositinsurance coverage by an adjustment for inflation and requires the FDIC’s Boardof Directors, not later than April 1, 2010 and every five years thereafter, toconsider whether such an increase is warranted; (iii) increases the depositinsurance limit for certain employee benefit plan deposits from $100,000 to$250,000, subject to adjustments for inflation after March 31, 2010, andprovides for pass-through insurance coverage for such deposits; (iv) increasesthe deposit insurance limit for certain retirement account deposits from$100,000 to $250,000, subject to adjustments for inflation after March 31,2010; (v) allows the FDIC’s Board of Directors to set deposit insurance premiumassessments in any amount the Board of Directors deems necessary orappropriate, after taking into account various factors specified in FDIRA; (vi)replaces the fixed designated reserve ratio of 1.25% with a reserve ratio rangeof 1.15%-1.50%, with the specific reserve ratio to be determined annually bythe FDIC by regulation; (vii) permits the FDIC to revise the risk-basedassessment system by regulation; (viii) requires the FDIC, at the end of anyyear in which the reserve ratio of the DIF exceeds 1.50% of estimated insureddeposits, to declare a dividend payable to insured depository institutions inan amount equal to 100% of the amount held by the DIF in excess of the amountnecessary to maintain the DIF’s reserve ratio at 1.50% of estimated insureddeposits or to declare a dividend equal to 50% of the amount in excess of theamount necessary to maintain the reserve ratio at 1.35% if the reserve ratio isbetween 1.35%-1.50% of estimated insured deposits; and (ix) provides aone-time credit based upon the assessment base of the institution onDecember 31, 1996 to each insured depository institution that was inexistence as of December 31, 1996 and paid a deposit insurance assessmentprior to that date (or a successor to any such institution).

 

The merger of the BIF and the SAIF will take effect no later than July1, 2006, while the remaining provisions are not effective until the FDIC issuesfinal regulations.  FDIRA requires theFDIC to issue final regulations no later than 270 days after enactment: (i)designating a reserve ratio; (ii) implementing increases in depositinsurance coverage; (iii) implementing the dividend requirement; (iv)implementing the one-time assessment credit; and (v) providing for assessmentsin accordance with FDIRA.

 

**Item1A.   Risk Factors**

 

In addition to the otherinformation in this Annual Report on Form 10-K, shareholders or prospectiveinvestors should carefully consider the following risk factors:

 

**Ourbusiness is concentrated in and dependent upon the continued growth and welfareof the LaSalle County market area.**

 

21

----

 

While we continue to expand ourmarket area and presence into the surrounding counties of Grundy and Kendall,we operate primarily in LaSalle County, and as a result, our financialcondition, results of operations and cash flows are subject to changes in theeconomic conditions in this market area. We have developed a particularly strong presence in Ottawa and itssurrounding communities.  Our successdepends upon the business activity, population, income levels, deposits andreal estate activity in this area. Although our customers’ business andfinancial interests may extend well beyond its market area, adverse economicconditions that affect the market area could reduce our growth rate, affect theability of our customers to repay their loans to us and generally affect ourfinancial condition and results of operations. Because of our geographicconcentration, we are less able than other regional or national financialinstitutions to diversify our credit risks across multiple markets.

 

**We mayexperience difficulties in managing our growth and our growth strategy involvesrisks that may negatively impact our net income.**

 

As part of our general growthstrategy, we may expand into additional communities or attempt to strengthenour position in our current market and in surrounding areas by opening newbranches and acquiring existing branches of other financial institutions.  To the extent that we undertake additionalbranch openings and acquisitions, we are likely to continue to experience theeffects of higher operating expenses relative to operating income from the newoperations, which may have an adverse effect on our levels of reported netincome, return on average equity and return on average assets.  Other effects of engaging in such growthstrategies may include potential diversion of our management’s time and attentionand general disruption to our business.

 

Although we do not have anycurrent plans to do so, we may also acquire banks and related businesses thatwe believe provide a strategic fit with our business or engage in de novo bankformations.  To the extent that we growthrough acquisitions and de novo bank formations, we cannot assure you that wewill be able to adequately and profitably manage this growth. Acquiring otherbanks and businesses will involve similar risks to those commonly associated withbranching, but may also involve additional risks, including:

 

•                                          potentialexposure to unknown or contingent liabilities of banks and businesses weacquire;

 

•                                          exposureto potential asset quality issues of the acquired bank or related business;

 

•                                          difficultyand expense of integrating the operations and personnel of banks and businesseswe acquire; and

 

•                                          thepossible loss of key employees and customers of the banks and businesses weacquire.

 

**We faceintense competition in all phases of our business from other banks andfinancial institutions.**

 

The banking and financialservices business in our market is highly competitive.  Our competitors include large regional banks,local community banks, savings and loan associations, securities and brokeragecompanies, mortgage companies, insurance companies, finance companies, moneymarket mutual funds, credit unions and other non-bank financial serviceproviders. Many of these competitors are not subject to the same regulatoryrestrictions as we are

 

22

----

 

and are able to providecustomers with a feasible alternative to traditional banking services.  Additionally, technological advances mayenable more companies to provide financial services, increasing competition amongfinancial service providers.

 

Increased competition in ourmarket may also result in a decrease in the amounts of our loans and deposits,reduced spreads between loan rates and deposit rates or loan terms that aremore favorable to the borrower.  Any ofthese results could have a material adverse effect on our ability to grow andremain profitable.  If increasedcompetition causes us to significantly discount the interest rates we offer onloans or increase the amount we pay on deposits, our net interest income couldbe adversely impacted.  If increasedcompetition causes us to relax****ourunderwriting standards, we could be exposed to higher losses from lendingactivities.  Additionally, many of ourcompetitors are much larger in total assets and capitalization, have greateraccess to capital markets and larger lending limits and offer a broader rangeof financial services than we can offer.

 

**Interestrates and other conditions impact our results of operations.**

 

Our profitability is in part afunction of the spread between the interest rates earned on investments andloans and the interest rates paid on deposits and other interest-bearingliabilities.  Like most bankinginstitutions, our net interest spread and margin will be affected by generaleconomic conditions and other factors, including fiscal and monetary policiesof the federal government, that influence market interest rates and our abilityto respond to changes in such rates.  Atany given time, our assets and liabilities will be such that they are affecteddifferently by a given change in interest rates.  As a result, an increase or decrease inrates, the length of loan terms or the mix of adjustable and fixed rate loansin our portfolio could have a positive or negative effect on our net income,capital and liquidity.  We measureinterest rate risk under various rate scenarios and using specific criteria andassumptions.  A summary of this process,along with the results of our net interest income simulations is presented at “Quantitativeand Qualitative Disclosures About Market Risk” included under Item 7A of PartII of this Form 10-K.  Although webelieve our current level of interest rate sensitivity is reasonable andeffectively managed, significant fluctuations in interest rates may have an adverseeffect on our business, financial condition and results of operations.

 

**We must effectively manage our credit risk.**

 

Thereare risks inherent in making any loan, including risks inherent in dealing withindividual borrowers, risks of nonpayment, risks resulting from uncertaintiesas to the future value of collateral and risks resulting from changes ineconomic and industry conditions.  Weattempt to minimize our credit risk through prudent loan application approval procedures,careful monitoring of the concentration of our loans within specific industriesand periodic independent reviews of outstanding loans by our credit reviewdepartment.  However, we cannot assureyou that such approval and monitoring procedures will reduce these creditrisks.

 

The majorityof the bank’s loan portfolio is invested in commercial real estate, residentialreal estate, general commercial, agricultural and consumer lending.  We may assume greater lending risks thanfinancial institutions that have a lesser concentration of such loans.  Our lending

 

23

----

 

activityand the risks commonly associated with such lending, including the risk ofnon-payment, are further described in the “Business” section included underItem 1 of Part I of this Form 10-K.

 

**Ourallowance for credit losses may prove to be insufficient to absorb potentiallosses in our loan portfolio.**

 

We established our allowancefor credit losses in consultation with management and maintain it at a levelconsidered adequate by management to absorb credit losses that are inherent inthe portfolio.  The amount of futurecredit losses is susceptible to changes in economic, operating and otherconditions, including changes in interest rates, which may be beyond ourcontrol, and such losses may exceed current estimates.  At December 31, 2005, our allowance forcredit losses as a percentage of total loans was .88% and as a percentage oftotal non-performing loans was approximately 99.5%.  Although management believes that the allowancefor credit losses is adequate to absorb losses on any existing loans that maybecome uncollectible, we cannot predict credit losses with certainty, and wecannot assure you that our allowance for credit losses will prove sufficient tocover actual credit losses in the future. Credit losses in excess of our reserves may adversely affect ourbusiness, financial condition and results of operations.  Additional information regarding ourallowance for credit losses and the methodology we use to determine an appropriatelevel of reserves is located in the “Management’s Discussion and Analysis”section included under Item 7 of Part II of this Form 10-K.

 

**Ourcontinued pace of growth may require us to raise additional capital in thefuture, but that capital may not be available when it is needed.**

 

We are required by federal andstate regulatory authorities to maintain adequate levels of capital to supportour operations.  We anticipate that ourexisting capital resources will satisfy our capital requirements for theforeseeable future.  However, we may atsome point need to raise additional capital to support our continued growth.Our ability to raise additional capital, if needed, will depend on conditionsin the capital markets at that time, which are outside our control, and on ourfinancial performance.  Accordingly, wecannot assure you of our ability to raise additional capital, if needed, onterms acceptable to us.  If we cannot raiseadditional capital when needed, our ability to further expand our operationsthrough internal growth, branching, de novo bank formations and/or acquisitionscould be materially impaired.

 

**Ourcommunity banking strategy relies heavily on our management team, and theunexpected loss of key managers may adversely affect our operations.**

 

Much of our success to date hasbeen influenced strongly by our ability to attract and to retain seniormanagement experienced in banking and financial services and familiar with thecommunities in our market area.  Ourability to retain executive officers, the current management teams, branchmanagers and loan officers will continue to be important to the successfulimplementation of our strategy.  It isalso critical, as we grow, to be able to attract and retain qualifiedadditional management and loan officers with the appropriate level ofexperience and knowledge about our market area to implement our community-basedoperating strategy.  The unexpected lossof services of any key management personnel, or the inability to recruit andretain qualified personnel in the future, could have an adverse effect on ourbusiness, financial

 

24

----

 

condition and results ofoperations.

 

**Governmentregulation can result in limitations on our operations.**

 

We operate in a highlyregulated environment and are subject to supervision and regulation by a numberof governmental regulatory agencies, including the Board of Governors of theFederal Reserve System, the Office of the Comptroller of the Currency and theFederal Deposit Insurance Corporation. Regulations adopted by these agencies, which are generally intended toprovide protection for depositors and customers rather than for the benefit ofshareholders, govern a comprehensive range of matters relating to ownership andcontrol of our shares, our acquisition of other companies and businesses,permissible activities for us to engage in, maintenance of adequate capitallevels and other aspects of our operations. These bank regulators possess broadauthority to prevent or remedy unsafe or unsound practices or violations oflaw. The laws and regulations applicable to the banking industry could changeat any time and we cannot predict the effects of these changes on our businessand profitability. Increased regulation could increase our cost of complianceand adversely affect profitability.  Forexample, new legislation or regulation may limit the manner in which we mayconduct our business, including our ability to offer new products, obtainfinancing, attract deposits, make loans and achieve satisfactory interestspreads.

 

**There is alimited trading market for our common shares, and you may not be able to resellyour shares at or above the price shareholders paid for them.**

 

The trading in our commonshares has less liquidity than many other companies quoted on the nationalsecurities exchanges or markets.  Apublic trading market having the desired characteristics of depth, liquidityand orderliness depends on the presence in the market of willing buyers andsellers of our common shares at any given time. This presence depends on the individual decisions of investors andgeneral economic and market conditions over which we have no control.  We cannot assure you that volume of tradingin our common shares will increase in the future.

 

**System failure or breaches of our networksecurity could subject us to increased operating costs as well as litigationand other liabilities.**

 

The computer systems and networkinfrastructure we use could be vulnerable to unforeseen problems.  Our operations are dependent upon our abilityto protect our computer equipment against damage from physical theft, fire,power loss, telecommunications failure or a similar catastrophic event, as wellas from security breaches, denial of service attacks, viruses, worms and otherdisruptive problems caused by hackers. Any damage or failure that causes an interruption in our operationscould have a material adverse effect on our financial condition and results ofoperations.  Computer break-ins, phishingand other disruptions could also jeopardize the security of information storedin and transmitted through our computer systems and network infrastructure,which may result in significant liability to us and may cause existing andpotential customers to refrain from doing business with us.  Although we, with the help of third-partyservice providers, intend to continue to implement security technology andestablish operational procedures to prevent such damage, there can be noassurance that these security measures will be successful. In addition,advances in computer capabilities, new discoveries in the field of

 

25

----

 

cryptography or other developments couldresult in a compromise or breach of the algorithms we and our third-partyservice providers use to encrypt and protect customer transaction data.  A failure of such security measures couldhave a material adverse effect on our financial condition and results ofoperations.

 

**We are subject to certain operational risks, including, but not limitedto, customer or employee fraud and data processing system failures and errors.**

 

Employee errors and misconduct could subject us to financial losses orregulatory sanctions and seriously harm our reputation. Misconduct by our employeescould include hiding unauthorized activities from us, improper or unauthorizedactivities on behalf of our customers or improper use of confidentialinformation. It is not always possible to prevent employee errors andmisconduct, and the precautions we take to prevent and detect this activity maynot be effective in all cases. Employee errors could also subject us tofinancial claims for negligence.

 

We maintain a system of internal controls andinsurance coverage to mitigate against operational risks, including dataprocessing system failures and errors and customer or employee fraud. Shouldour internal controls fail to prevent or detect an occurrence, or if anyresulting loss is not insured or exceeds applicable insurance limits, it couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

**Item 1B.**

 

None

 

26

----

 

**Item 2.   Properties.**

 

The Company’s main office is located at 701-705LaSalle Street, Ottawa, Illinois.  Thebuilding is comprised of approximately 15,000 square feet.  The main office building is a two-storystructure constructed principally of masonry which was opened in 1865.  The Company also operates six branch officefacilities. A limited service branch, which contains eight drive-in lanes, islocated at 300 West Madison Street, Ottawa, Illinois, and six full-servicebranches are located at 601 State Street, Ottawa, Illinois; 2771 North ColumbusStreet, Ottawa, Illinois; 1771 North Division Street, Morris, Illinois; 2324North Bloomington Street, Streator, Illinois; 401 East Main Street, Streator,Illinois; and 1459 Cannonball Trail, Yorkville, Illinois. The main bankingoffice and branch offices are owned by the Company in fee and are unencumbered.

 

**Item 3.   Legal Proceedings.**

 

The Company is from time to time a partyto legal proceedings in the ordinary course of business that are incident tothe business of banking. The Company is not engaged in any legal proceedings ofa material nature at the present time.

 

**Item 4.   Submission of Matters to a Vote of Security Holders.**

 

No matters were submitted to a vote ofsecurity holders during the quarter ended December 31, 2005.

 

27

----

 

**PART II**

 

**Item 5.****           Market For Registrant’s Common Equity, RelatedStockholder Matters and Issuer Purchases of Equity Securities**

 

See page — of the 2005 Annual Report toStockholders (filed as Exhibit 13.1 of this report) which is incorporatedherein by reference.

 

**Item 6.   SelectedFinancial Data**

 

The information set forth under thecaption “Selected Consolidated Financial Information” on page 1 of the 2005Annual Report to Stockholders (filed as Exhibit 13.1 of this report) isincorporated herein by reference.

 

**Item7.****         ****Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

The information set forth under thecaption “Management’s Discussion and Analysis of Financial Condition andResults of Operations” on pages 2 through 11 of the 2005 Annual Report to Stockholders(filed as Exhibit 13.1 of this report) is incorporated herein by reference.

 

**Item7A.Quantitative and Qualitative Disclosures about Market Risk**

 

The information set forth under thecaption “Quantitative and Qualitative Disclosures about Market Risk” on page 12of the 2005 Annual Report to Stockholders (filed as Exhibit 13.1 of thisreport) is incorporated herein by reference.

 

28

----

 

**Item8.   Financial Statements andSupplementary Data**

 

The consolidated financial statements ofthe Registrant and the Report of Independent Registered Public Accounting Firmas set forth on pages 17 through 42 of the 2005 Annual Report to Stockholders(filed as Exhibit 13.1 of this report) are incorporated herein by reference:

 
| ** **                                                                                                  | ** ** | **Annual Report to  Stockholders Page** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| Report of Independent Registered Public  Accounting Firm                                                    |       | 17                                      |       |
|                                                                                                        |       |                                    |       |
| Consolidated Balance Sheets as of December  31, 2005 and 2004                                               |       | 18                                      |       |
|                                                                                                        |       |                                    |       |
| Consolidated Statements of Income for the  years ended December 31, 2005, 2004, and 2003                    |       | 19                                      |       |
|                                                                                                        |       |                                    |       |
| Consolidated Statements of Stockholders’  Equity for the years ended December 31, 2005, 2004, and 2003 |       | 20                                      |       |
|                                                                                                        |       |                                    |       |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2005, 2004, and 2003                |       | 21                                      |       |
|                                                                                                        |       |                                    |       |
| Notes to the Consolidated Financial  Statements                                                             |       | 22                                      |       |

 

The portions of the 2005 Annual Report toStockholders which are not specifically incorporated by reference as a part ofthis Form 10-K are not deemed to be a part of this report.

 

**Item9.   Changes in and Disagreements withAccountants on Accounting and Financial Disclosure**

 

None.

 

**Item9A.Controls and Procedures**

 

An evaluationwas performed under the supervision and with the participation of the Company’smanagement, including the Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of the Company’s disclosurecontrols and procedures (as defined in Rule 13a-15(e) promulgated underthe Exchange Act) as of December 31, 2005. Based on that evaluation, theCompany’s management, including the Chief Executive Officer and Chief FinancialOfficer, concluded that the Company’s disclosure controls and procedures wereeffective. There have been no significant changes in the Company’s internalcontrols or in other factors that could significantly affect internal controls.

 

**Item 9B.Other Information**

 

None

 

29

----

 

**PART III**

 

**Item 10. Directors and Executive Officers at the Registrant**

 

The information set forth under the captions “InformationRegarding Nominees and Executive Officers”, “Corporate Governance and the Boardof Directors” and “Section 16 Beneficial Ownership Reporting Compliance” of theRegistrant’s Proxy Statement, relating to the 2006 Annual Meeting ofStockholders is incorporated herein by reference.

 

**Item 11. Executive Compensation**

 

The information set forth under the caption “ExecutiveCompensation” of the Registrant’s Proxy Statement, relating to the 2006 AnnualMeeting of Stockholders is incorporated herein by reference, except for the “Stockholder’sPerformance Table” and the “Board Compensation Committee’s Report onCompensation”, which are not hereby incorporated.

 

**Item 12.**    SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

 

The information set forth under the caption “Security Ownership ofCertain Beneficial Owners and Management” of the Registrant’s Proxy Statement,relating to the 2006 Annual Meeting of Stockholders is incorporated herein byreference.

 

**Equity Compensation PlanInformation**

 

Thetable below sets forth the following information as of December 31, 2005 for(i) all compensation plans previously approved by the Company’s stockholdersand (ii) all compensation plans not previously approved by the Company’s stockholders:

 

(a)   thenumber of securities to be issued upon the exercise of outstanding options,warrants and rights; 

 

(b)   the weighted-averageexercise price of such outstanding options, warrants and rights; 

 

(c)   otherthan securities to be issued upon the exercise of such outstanding options,warrants and rights, the number of securities remaining available for futureissuance under the plans. 

 

30

----

 

EQUITY COMPENSATION PLAN INFORMATION

 
| **Plan category**                                           | ** ** | **Number  of securities to  be issued upon exercise  of outstanding options** | ** ** | **Weighted-average  exercise  price of outstanding  options** | ** ** | **Number  of securities  remaining available for  future issuance** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
|                                                        |       |                                                                          |       |                                                          |       |                                                                |       |
| Equity  compensation plans approved by security holders     |       | 21,000                                                                        |       | $                                                             | 62.55      |                                                                | 129,000    |   |
| Equity  compensation plans not approved by security holders |       | 0                                                                             |       | 0                                                             |       | 0                                                                   |       |
| **Total**                                                   |       | 21,000                                                                        |       | $                                                             | 62.55      |                                                                | 129,000    |   |

 

**Item 13.     Certain Relationshipsand Related Transactions**

 

The information set forth under the caption “Certain Relationships andRelated Transactions” of the Registrant’s Proxy Statement, relating to the 2006Annual Meeting of Stockholders is incorporated herein by reference.

 

**Item 14.     Principal AccountingFees and Services**

 

The information set forth under the caption “Independent PublicAccountants” of the Registrant’s Proxy Statement relating to the 2006 AnnualMeeting of Shareholders is incorporated herein by reference.

 

31

----

 

**PART IV**

 

**Item 15. Exhibits and Financial Statement Schedules**

 

(a)          1.     FinancialStatements

 

Allfinancial statements of the Registrant are incorporated herein by reference asset forth under Item 8, Part II of this report on Form 10-K.

 

2.     FinancialStatement Schedules

 

Not applicable.

 

3.     Exhibits(Numbered in accordance with Item 601 of Regulation S-K)

 

The following exhibits are filed as part of this report:

 
| 3(i)   |   | Certificate of Incorporation of First Ottawa  Bancshares, Inc.                                                                                      |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                |
| 3(ii)  |   | By-Laws  of First Ottawa Bancshares, Inc.                                                                                                           |
|   |   |                                                                                                                                                |
| 10.1   |   | Employment  Agreement for J. Brown*                                                                                                                 |
|   |   |                                                                                                                                                |
| 10.2   |   | Executive  Officer Bonus Plan*                                                                                                                      |
|   |   |                                                                                                                                                |
| 10.3   |   | Employment  Agreement for Donald Harris*                                                                                                            |
|   |   |                                                                                                                                                |
| 10.4   |   | Stock  Incentive Plan                                                                                                                               |
|   |   |                                                                                                                                                |
| 10.5   |   | Summary  of Director Fees                                                                                                                           |
|   |   |                                                                                                                                                |
| 10.6   |   | Form  of Supplemental Nonqualified Retirement Agreement                                                                                             |
|   |   |                                                                                                                                                |
| 10.7   |   | Employment  Agreement for Patrick Fayhee*                                                                                                           |
|   |   |                                                                                                                                                |
| 10.8   |   | Employment  Agreement for Steven Gonzalo*                                                                                                           |
|   |   |                                                                                                                                                |
| 10.9   |   | Employment  Agreement for Vincent Easi*                                                                                                             |
|   |   |                                                                                                                                                |
| 13.1   |   | Annual  Report to Stockholders                                                                                                                      |
|   |   |                                                                                                                                                |
| 21.1   |   | Subsidiaries                                                                                                                                        |
|   |   |                                                                                                                                                |
| 31.1   |   | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                      |
|   |   |                                                                                                                                                |
| 31.2   |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                      |
|   |   |                                                                                                                                                |
| 32.1   |   | Certification  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
|   |   |                                                                                                                                                |
| 32.2   |   | Certification  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

----

* Indicates management contract or compensation plan or arrangement.

 

32

----

 

**SIGNATURE**

 

In accordance with Section 13 or 15(d) of the Exchange Act, theregistrant caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|   | **FIRST  OTTAWA BANCSHARES, INC.** |
|--------|------------------------------------|
|   |                               |
|   | By:                                | /s/ Joachim  Brown |   |
|   |                               | Joachim Brown,  President and Chief  Executive Officer (Principal Executive  Officer) |
|   |                               |   |
|   | By:                                | /s/ Vincent  G. Easi |   |
|   |                               | Vincent G.  Easi, Principal Financial Officer |
|   |
| Date:  | March 28,  2006                    |
|        |                                    |  |  |  |

 

 

In accordancewith the Exchange Act, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and onthe dates indicated.

 

 
| **Signature**             | ** ** | **Title**                        | ** **               | **Date** |
|---------------------------|------------|----------------------------------|--------------------------|----------|
|                      |       |                             |                     |     |
| /s/ Joachim  Brown        |       |                             | Director and  President/ |     | March 28,  2006 |
| Joachim  Brown            |       | Chief  Executive Officer         |                     |     |
|                      |       |                             |                     |     |
| /s/ Bradley  J. Armstrong |       |                             | Director                 |     | March 28,  2006 |
| Bradley J. Armstrong      |       |                             |                     |     |
|                      |       |                             |                     |     |
| /s/ John L.  Cantlin      |       |                             | Director                 |     | March 28,  2006 |
| John L. Cantlin           |       |                             |                     |     |
|                      |       |                             |                     |     |
| /s/ Patty P.  Godfrey     |       |                             | Director                 |     | March 28,  2006 |
| Patty P. Godfrey          |       |                             |                     |     |
|                      |       |                             |                     |     |
| /s/ Thomas  E. Haeberle   |       |                             | Director                 |     | March 28,  2006 |
| Thomas E.  Haeberle       |       |                             |                     |     |
|                      |       |                             |                     |     |
| /s/ Donald  J. Harris     |       |                             | Director and  Executive  |     | March 28,  2006 |
| Donald J.  Harris         |       | Vice  President, Chief Operating |                     |     |
|                      |       | Officer                          |                     |     |
|                           |            |                                  |                          |          |  |  |  |

 

33

----

 
| /s/ Thomas  P. Rooney |   |   | Director |   | March 28,  2006 |
|-----------------------|--------|--------|----------|--------|-----------------|
| Thomas P.  Rooney     |   |   |     |   |
|                  |   |   |     |   |
| /s/ William  J. Walsh |   |   | Director |   | March 28,  2006 |
| William J.  Walsh     |   |   |     |   |
|                       |        |        |          |        |                 |  |

 

34

----

 

**EXHIBIT INDEX**

 
| **Exhibit  Number** |   | **Description**                                                             | ** ** | **Incorporated  by Reference to**      | ** ** | **Attached****Hereto** |
|---------------------|--------|-----------------------------------------------------------------------------|------------|----------------------------------------|------------|------------------------|
| 3(i)                |   | Certificate of Incorporation of First Ottawa Bancshares, Inc. (as  amended) |       | Form 10K for the year ended 12/31/2002 |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 3(ii)               |   | By-Laws of First Ottawa Bancshares, Inc.                                    |       | Form 10K for the year ended 12/31/2003 |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 10.1                |   | Employment Agreement for J. Brown                                           |       | Form 10K for the year ended 12/31/2002 |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 10.2                |   | Executive Officer Bonus Plan                                                |       | Form 10K for the year ended 12/31/2002 |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 10.3                |   | Employment Agreement for Donald Harris                                      |       | Form 8-K filed on June 10, 2005        |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 10.4                |   | Stock Incentive Plan                                                        |       | Form S-8 dated 8/1/03                  |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 10.5                |   | Summary of Director Fees                                                    |       | Form 10K for the year ended 12/31/2004 |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 10.6                |   | Form of Supplemental Nonqualified Retirement Agreement                      |       | Form 10K for the year ended 12/31/2004 |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 10.7                |   | Employment Agreement for Patrick Fayhee                                     |       | Form 8-K filed on June 10, 2005        |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 10.8                |   | Employment Agreement for Steven Gonzalo                                     |       | Form 8-K filed on June 10, 2005        |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 10.9                |   | Employment Agreement for Vincent Easi                                       |       | Form 8-K filed on June 10, 2005        |       |                   |
|                |   |                                                                        |       |                                   |       |                   |
| 13.1                |   | 2005 Annual Report to Stockholders                                          |       |                                   |       | X                      |
|                |   |                                                                        |       |                                   |       |                   |
| 21.1                |   | Subsidiaries                                                                |       |                                   |       | X                      |
|                |   |                                                                        |       |                                   |       |                   |
| 31.1                |   | Certification of Chief Exectutive Officer                                   |       |                                   |       | X                      |
|                |   |                                                                        |       |                                   |       |                   |
| 31.2                |   | Certification of Chief Financial Officer                                    |       |                                   |       | X                      |
|                |   |                                                                        |       |                                   |       |                   |
| 32.1                |   | Certification of Chief Exectutive Officer                                   |       |                                   |       | X                      |
|                |   |                                                                        |       |                                   |       |                   |
| 32.2                |   | Certification of Chief Financial Officer                                    |       |                                   |       | X                      |

 

35

----