**EXHIBIT13.1**

 

**SELECTED CONSOLIDATED FINANCIALINFORMATION**

 

The followingtable sets forth selected consolidated financial and other data of First OttawaBancshares, Inc. and its wholly owned subsidiary, the First National Bank ofOttawa (“the Bank”) and the Bank’s wholly owned subsidiary, First OttawaFinancial Corporation, together referred to as “the Company.” This informationshould be read in conjunction with the Consolidated Financial Statements andnotes thereto included herein.  Alldollar amounts are in thousands, except per share information.

 
|                                                                        |   | **Year ended  December 31,** |       |
|-----------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                        |   | **2002**                     | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** | **1998** | ** ** |
| **Statement  of Income Data:**                                              |   |                         |       |   |   |   |   |   |   |   |   |
| Total interest income                                                       |   | $                            | 13,092     |   | $ | 14,921 |   | $ | 15,995 |   | $ | 16,492 |   | $ | 17,055 |   |
| Total interest expense                                                      |   | 5,733                        |       | 7,773 |   | 8,525 |   | 8,265 |   | 8,651 |   |
| Net interest income                                                         |   | 7,359                        |       | 7,148 |   | 7,470 |   | 8,227 |   | 8,404 |   |
| Provision for loan losses                                                   |   | 120                          |       | 300 |   | 360 |   | 384 |   | 460 |   |
| Noninterest income                                                          |   | 2,444                        |       | 2,457 |   | 1,749 |   | 1,496 |   | 1,905 |   |
| Noninterest expenses                                                        |   | 6,718                        |       | 6,732 |   | 6,510 |   | 6,736 |   | 6,347 |   |
| Income before income taxes                                                  |   | 2,965                        |       | 2,573 |   | 2,349 |   | 2,603 |   | 3,502 |   |
| Provision for income taxes                                                  |   | 678                          |       | 460 |   | 257 |   | 449 |   | 543 |   |
|                                                                        |   |                         |       |   |   |   |   |   |   |   |   |
| Net income                                                                  |   | $                            | 2,287      |   | $ | 2,113 |   | $ | 2,092 |   | $ | 2,154 |   | $ | 2,959 |   |
|                                                                        |   |                         |       |   |   |   |   |   |   |   |   |
| **Per  Share Data:**                                                        |   |                         |       |   |   |   |   |   |   |   |   |
| Net income                                                                  |   | $                            | 3.47       |   | $ | 3.19 |   | $ | 3.14 |   | $ | 2.87 |   | $ | 3.95 |   |
| Cash dividends declared                                                     |   | 3.00                         |       | 3.00 |   | 3.00 |   | 3.00 |   | 3.00 |   |
| Book value at end of year(1)                                                |   | 34.97                        |       | 34.53 |   | 34.62 |   | 37.11 |   | 37.24 |   |
|                                                                        |   |                         |       |   |   |   |   |   |   |   |   |
| **Selected  Financial Ratios:**                                             |   |                         |       |   |   |   |   |   |   |   |   |
| Return on average assets(1)                                                 |   | .99                          | %          | .94 | % | .91 | % | .90 | % | 1.24 | % |
| Return on average equity(1)                                                 |   | 9.73                         |       | 9.18 |   | 8.89 |   | 7.58 |   | 10.64 |   |
| Dividend payout ratio                                                       |   | 86.46                        |       | 94.04 |   | 94.96 |   | 104.46 |   | 76.04 |   |
| Average equity to average assets(1)                                         |   | 10.20                        |       | 10.29 |   | 10.25 |   | 11.87 |   | 11.66 |   |
| Net interest margin (tax equivalent)                                        |   | 3.77                         |       | 3.74 |   | 3.87 |   | 4.11 |   | 4.09 |   |
| Allowance for loan losses to total loans at the end  of period              |   | 1.06                         |       | 1.01 |   | .94 |   | .82 |   | .87 |   |
| Nonperforming loans to total loans at the end of  period(2)                 |   | 1.83                         |       | 1.15 |   | 2.26 |   | 1.52 |   | 1.21 |   |
| Net loans charged off to average total loans                                |   | .06                          |       | .25 |   | .25 |   | .29 |   | .19 |   |
|                                                                        |   |                         |       |   |   |   |   |   |   |   |   |
| **Balance  Sheet Data:**                                                    |   |                         |       |   |   |   |   |   |   |   |   |
| Total assets                                                                |   | $                            | 240,662    |   | $ | 232,565 |   | $ | 225,007 |   | $ | 240,490 |   | $ | 249,674 |   |
| Total earning assets                                                        |   | 223,324                      |       | 216,927 |   | 210,058 |   | 219,427 |   | 236,187 |   |
| Average assets(3)                                                           |   | 232,335                      |       | 224,653 |   | 226,787 |   | 239,524 |   | 240,612 |   |
| Gross loans, including loans held for sale                                  |   | 111,454                      |       | 109,508 |   | 117,612 |   | 129,444 |   | 119,364 |   |
| Allowance for loan losses                                                   |   | 1,167                        |       | 1,109 |   | 1,108 |   | 1,059 |   | 1,029 |   |
| Total deposits                                                              |   | 193,767                      |       | 165,267 |   | 173,453 |   | 183,889 |   | 194,629 |   |
| Federal funds purchased and securities sold under  agreements to repurchase |   | 16,322                       |       | 35,899 |   | 24,638 |   | 26,265 |   | 21,496 |   |
| Shareholders’ equity                                                   |   | 25,183                       |       | 22,907 |   | 22,583 |   | 25,983 |   | 29,259 |   |

 

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

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

(3)   Average for the year ended.

 

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**MANAGEMENT’SDISCUSSION AND ANALYSIS**

**OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The followingdiscussion and analysis is intended as a review of significant factorsaffecting the financial condition and results of operations of the Company forthe periods indicated.  The discussionshould be read in conjunction with the Consolidated Financial Statements andNotes thereto and the Selected Consolidated Financial Data presented herein.  In addition to historical information, thefollowing Management’s Discussion and Analysis of Financial Condition andResults of Operations contains forward-looking statements that involve risksand uncertainties.  The Company’s actualresults could differ significantly from those anticipated in theseforward-looking statements as a result of certain factors discussed elsewherein this report.

 

# **Overview**

 

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

 

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

 

# **Consolidated Financial Condition**

 

Total assets atDecember 31, 2002 were $240.7 million compared to $232.6 million atDecember 31, 2001, an increase of $8.1 million, or 3.48%.  The increase in total assets was a result ofa $9.9 million increase in certificates of deposit held for investment purposesand a $1.6 million increase in loans receivable. Commercial and agriculturalloans increased $4.6 million during 2002 due to an effort by management toincrease the size of the commercial loan portfolio. Home equity lines of credit,a variable rate product, also increased $2.3 million due to favorable rateenvironment. These increases were partially offset by the decrease ininstallment loans of $4.6 million due to a general decline in indirect lendingvolume and more stringent underwriting guidelines on consumer loans.  Real estate loans also decreased$0.6 million due to the current rate environment and the increase inrefinancing and conventional loan sales during 2002. Loans held for saleincreased $336,000 as customers refinanced loans in reaction to the currentrate environment. Premises and equipment increased by $1.8 million due tocapital expenditures on existing buildings and the purchase of land in Morrisand the start of

 

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construction on a newbranch facility. The Bank anticipates additional 2003 capital expenditures ofapproximately $1.0 million to complete this branch facility. The increase inloans and certificates of deposits was funded by a decrease in securities andincreases in federal funds purchased and other borrowed funds. Total borrowingsincreased $6.1 million as a result of a $9.6 million increase in federal fundspurchased and a $3.5 million decrease in borrowed funds, due to the repaymentof Federal Home Loan Bank advances. Repurchase agreements decreased by $29.2million while NOW accounts increased by $30.7 million due to a change inproducts offered by the Bank. Total deposits increased $28.5 million due tothis reclassification between repurchase agreements and NOW accounts. Thisincrease was partially offset by fluctuations in other deposit types resultingin a net decrease of $2.2 million in all other deposit types.

 

Total equity was$25.2 million at December 31, 2002 compared to $22.9 million at December 31,2001.  The increase was primarily theresult of an increase in the unrealized gain (loss) on securitiesavailable-for-sale, net of tax, of $2.0 million and net income of $2.3 million.  The increase was partially offset by therepurchase of Company common stock for $74,000, the change in minimum pensionliability, net of tax, of $217,000, and dividends declared of $2.0 million.

 

# **Consolidated Results of Operations**

 

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

 

Net income was$2.1 million for the year ended December 31, 2001 compared to $2.1 million forthe year ended December 31, 2000.  Thereturn on average assets was .94% in 2001 compared to .91% in 2000.  The return on average equity increased from8.89% in 2000 to 9.18% in 2001.  Thisresulted primarily from the change in average equity due to stock repurchasesin 2000 and 2001.

 

# **2002 Compared to 2001**

 

*Net Interest Income.*  Net interest income was $7.4 million in 2002compared to $7.1 million in 2001, an increase of $300,000, or 2.9%.  Interest income on earning assets decreased$1.8 million in 2002 from 2001.  Decreasedinterest income on loans was attributable to a decrease in average tax-equivalentloan rates which were 7.65% during 2002, compared to 8.34% in 2001. Interestexpense on interest-bearing liabilities decreased $2.1 million as a result of adecrease in the average rate paid on liabilities of 125 basis points, from4.36% in 2001 to 3.11% in 2002 and a decrease in the average balance of timedeposits of $5.7 million.  The netinterest margin on a tax equivalent basis increased to 3.77% in 2002 from 3.74%in 2001.

 

*Provision for Loan Losses.*  The provision for loan losses decreased$180,000 from $300,000 in 2001 to $120,000 in 2002.  The decrease in the provision was largely due to the decrease innet loans charged off,  $62,000 in 2002compared to $299,000 in 2001. Although loans considered impaired have increasedfrom $1.3 million at December 31, 2001, to $2.0 million one year later, totalportfolio delinquencies have decreased to 2.5% of outstanding loans as ofDecember 31, 2002,

 

3

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from 4.2% atDecember 31, 2001. Additionally, allowance for loan loss specific allocationsrelating to impaired loans have increased to $396,000 in the current year,compared to $180,000 in the prior year. As of December 31, 2002, the allowancefor loan losses totaled $1.2 million, or 1.06% of total loans, compared to $1.1million, or 1.01% of total loans, at December 31, 2001.  The amounts of the provision and allowancefor loan losses are influenced by current economic conditions, actual lossexperience, industry trends, and other factors, including real estate values inthe Company’s market area and management’s assessment of current collectionrisks within its loan portfolio.  Alongwith other financial institutions, management shares a concern for the possiblecontinued weak economy in 2003.  Should theeconomic climate continue to deteriorate, borrowers may experience difficulty,and the level of non-performing loans, charge-offs, and delinquencies couldrise and require increases in the provision.

 

*Noninterest Income.*  The Company’s noninterest income totaled$2.4 million in 2002 compared to $2.5 million in 2001.  The decrease was primarily a result ofdecreases in service charges on deposit accounts and net gains on sales ofsecurities.  Service charges decreasedfrom $819,000 in 2001, to $768,000 in 2002, as a result of increases in chargedoff overdrafts and decreased service charges on savings accounts.  Gains on the sale of investments alsodecreased to $102,000 in 2002 from $539,000 in 2001.  In 2001, management was attempting to replace tax-exempt bondswith taxable positions, shorten maturities, improve interest rate risk, andenhance earnings, while in 2002 management had largely implemented thisstrategy and, as a result, security sales decreased. These decreases werepartially offset by changes to other income, which increased from $441,000 in2001, to $670,000 in 2002, due to a combined $245,000 increase in the cashsurrender value of bank owned life insurance along with gains on proceeds fromthree policies settled in 2002. The $207,000 increase in gains on the sale ofmortgage loans in 2002 was primarily a result of the bank retaining servicingrights for loans sold to the secondary market in 2002, which resulted in anincrease in servicing assets of $193,000. This increase in servicing assets as well as the $14,000 increase ingains on loan sales comprised the increase in 2002 income from gains on loansales.

 

*Noninterest Expense.*  The Company’s noninterest expense remainedconstant at $6.7 million in 2002 and 2001. Slight decreases in data processingexpense, supplies, advertising, professional fees, salaries, and employeebenefits were offset by increases in occupancy and equipment expense due toincreased depreciation of capital expenditures, and increases in other expensesdue primarily to expenses associated with a directors deferred compensationplan and a directors retirement plan. Both plans are being funded primarilythrough the annual increase in cash surrender value of bank owned lifeinsurance policies.

 

*Income Taxes.*  The Company’s tax rate varies from statutoryrates principally due to interest income from securities, loans and income fromcash surrender value of life insurance. The Company’s effective tax rate was 22.9% and 17.9% for 2002 and 2001.

 

# **2001 Compared to 2000**

 

*Net Interest Income.*  Net interest income was $7.2 million in 2001compared to $7.5 million in 2000, a decrease of $300,000, or 4.0%.  Interest income on earning assets decreased$1.1 million in 2001 from 2000.  Thedecrease was primarily due to decreased interest income on loans attributableto a decrease in the average balance of loans of $10 million, while averagetax-equivalent

 

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loan rates werefalling.  During 2001, the FederalReserve made eleven interest rate cuts that ultimately reduced the Bank’s primelending rate from 9.50% to 4.75% at the conclusion of the year.  This unprecedented decline in rates putpressure on the Company’s primary driver of earnings, the net interestmargin.  Interest expense oninterest-bearing liabilities decreased $752,000 as a result of a decrease inthe average rate paid on liabilities of 29 basis points, from 4.65% in 2000 to4.36% in 2001 and a decrease in the average balance of certificates of depositsof $6.6 million. The net interest margin on a tax equivalent basis decreased to3.74% in 2001 from 3.87% in 2000.  Theprimary reason for the decrease in the net interest margin was the result ofrates on earning assets repricing downward more quickly than the rates on interest-bearingliabilities in addition to an overall decrease in volume of assets andliabilities.

 

*Provision for Loan Losses.*  The provision for loan losses decreased$60,000 from $360,000 in 2000 to $300,000 in 2001.  The decrease in the provision was largely due to the decrease inthe size of the loan portfolio in 2001 compared to 2000.  As of December 31, 2001, the allowance forloan losses totaled $1.1 million, or 1.01% of total loans, compared to $1.1million, or .94% of total loans, at December 31, 2000.  The amounts of the provision and allowancefor loan losses are influenced by current economic conditions, actual lossexperience, industry trends, and other factors, including real estate values inthe Company’s market area and management’s assessment of current collectionrisks within its loan portfolio. Management had a concern that the possiblecontinued softening of the economy in 2001 could lead to borrowers experiencingdifficulty, and that the level of non-performing loans, charge-offs, and delinquenciescould rise and require increases in the provision.

 

*Noninterest Income.*  The Company’s noninterest income totaled$2.5 million in 2001 compared to $1.7 million in 2000.  The increase was primarily a result ofincreases in service charges on deposit accounts and net gains on sales ofsecurities and loans.  Service chargesincreased as a result of changes in the fee structure related tooverdrafts.  The $164,000 increase ingains on the sale of mortgage loans in 2001 was primarily due to customers refinancingloans as rates decreased during the year. Gains on the sale of investments also increased to $539,000 in 2001 from$11,000 in 2000 due to the sales of bonds to replace tax-exempt bonds withtaxable positions, shorten maturities, improve interest rate risk, and enhancecurrent earnings.

 

*Noninterest Expense.*  The Company’s noninterest expense increasedto $6.7 million in 2001 from $6.5 million in 2000.  The increase was primarily due to increases in salaries andemployee benefits and professional fees. Salaries and employee benefits increased $157,000 due to general payincreases, the hiring of new loan personnel, and increases in employeeinsurance costs in 2001.  Professionalfees increased due to negotiations and professional fees associated with thepurchase of the property in Morris, Illinois for the purpose of branchexpansion.  These increases werepartially offset by decreases in supplies and advertising and promotionexpenses.  Supplies and advertising andmarketing expenses decreased as a result of cost control efforts initiated bymanagement in late 2000.

 

*Income Taxes.*  The Company’s tax rate varies from statutoryrates principally due to interest income from tax-exempt securities andloans.  The Company’s effective tax ratewas 17.9% and 10.9% for 2001 and 2000.

 

5

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

 

The followingtable sets forth the average balances, net interest income and expense, andaverage yields and rates for the Company’s interest-earning assets andinterest-bearing liabilities for the indicated years on a tax-equivalent basisassuming a 34% tax rate.

 

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

Years endedDecember 31, 2002, 2001, and 2000

($000s)

 

 
|                                                  |   | **2002**                |    | **2001**     |   | **2000**          |   |
|-------------------------------------------------------|--------|-------------------------|---------|--------------|--------|-------------------|--------|
|                                                  |   | **Average  Balance(4)** |    | **Interest** |   | **Average  Rate** |   | **Average  Balance(4)** |   | **Interest** |   | **Average  Rate** |   | **Average  Balance(4)** |   | **Interest** |   | **Average  Rate** |   |
| ASSETS                                                |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                  |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans(1) (3)                                          |   | $                       | 107,768 |         | $      | 8,244             |   | 7.65 | % | $ | 113,106 |   | $ | 9,438 |   | 8.34 | % | $ | 123,110 |   | $ | 10,482 |   | 8.49 | % |
| Investment CDs                                        |   | 7,259                   |    | 253          |   | 3.49              |   | 1,728 |   | 72 |   | 4.17 |   | — |   | — |   |   |   |
| Securities(2) (5)                                     |   | 99,107                  |    | 5,325        |   | 5.37              |   | 94,043 |   | 6,063 |   | 6.45 |   | 91,325 |   | 6,328 |   | 6.91 |   |
| Federal funds sold                                    |   | 1,154                   |    | 20           |   | 1.73              |   | 2,697 |   | 112 |   | 4.15 |   | 1,391 |   | 88 |   | 6.31 |   |
|                                                  |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets                               |   | 215,288                 |    | 13,842       |   | 6.43              |   | 211,574 |   | 15,685 |   | 7.41 |   | 215,826 |   | 16,898 |   | 7.81 |   |
|                                                  |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest-earning  assets(6)                       |   | 17,047                  |    |         |   |              |   | 13,079 |   |   |   |   |   | 10,961 |   |   |   |   |   |
|                                                  |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Average assets                                        |   | $                       | 232,335 |         |   |              |   |   | $ | 224,653 |   |   |   |   |   | $ | 226,787 |   |   |   |   |   |
|                                                  |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES  AND SHAREHOLDERS’ EQUITY            |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                  |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money market                                  |   | $                       | 42,056  |         | $      | 583               |   | 1.39 |   | $ | 33,607 |   | $ | 624 |   | 1.86 |   | $ | 38,056 |   | $ | 936 |   | 2.45 |   |
| Savings                                               |   | 18,388                  |    | 312          |   | 1.70              |   | 16,654 |   | 326 |   | 1.96 |   | 17,928 |   | 368 |   | 2.04 |   |
| Time deposits                                         |   | 90,909                  |    | 4,194        |   | 4.61              |   | 96,615 |   | 5,513 |   | 5.71 |   | 103,171 |   | 5,784 |   | 5.59 |   |
| Repurchase agreements                                 |   | 25,567                  |    | 475          |   | 1.86              |   | 27,062 |   | 1,125 |   | 4.16 |   | 19,111 |   | 1,158 |   | 6.06 |   |
| Federal funds purchased                               |   | 3,902                   |    | 68           |   | 1.74              |   | 1,589 |   | 58 |   | 3.65 |   | 4,495 |   | 279 |   | 6.18 |   |
| Borrowings                                            |   | 3,808                   |    | 101          |   | 2.65              |   | 2,685 |   | 127 |   | 4.73 |   | — |   | — |   |   |   |
| Interest-bearing  liabilities                         |   | 184,630                 |    | 5,733        |   | 3.11              |   | 178,212 |   | 7,773 |   | 4.36 |   | 182,761 |   | 8,525 |   | 4.65 |   |
|                                                  |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                   |   |                    |    | $            | 8,109  |              |   |   |   |   | $ | 7,912 |   |   |   |   |   | $ | 8,373 |   |   |   |
|                                                  |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net yield on  interest-earning assets                 |   |                    |    |         |   | 3.77              |   |   |   |   |   | 3.74 |   |   |   |   |   | 3.87 |   |
| Interest-bearing  liabilities to earning assets ratio |   |                    |    |         |   | 85.76             |   |   |   |   |   | 84.23 |   |   |   |   |   | 84.68 |   |
|                                                  |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing  liabilities                     |   | 22,959                  |    |         |   |              |   |   |   | 22,749 |   |   |   |   |   | 22,278 |   |   |   |
|                                                  |   |                    |    |         |   |              |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                             |   | 24,746                  |    |         |   |              |   |   |   | 23,692 |   |   |   |   |   | 21,748 |   |   |   |
| Average liabilities and  shareholders’ equity    |   | $                       | 232,335 |         |   |              |   |   |   |   | $ | 224,653 |   |   |   |   |   | $ | 226,787 |   |   |   |

 

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(1)          Interestincome on loans includes loan origination and other fees of $456 for 2002, $285for 2001, and $176 for 2000.

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

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

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

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

(6)          Averagebalance information includes an average valuation allowance for  securities of  $1,867,  $1,023, and$(2,706), respectively.

 

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The components ofthe changes in net interest income are shown below.  Changes in net interest income are allocated between amountsattributed to changes in rate and changes in volume for the various categoriesof interest-earning assets and interest-bearing liabilities.

 

Analysis ofChanges in Interest Income and Expense

($000s)

 
|                    |   | **2002 -  2001  Increase (Decrease)** |   | **2001 -  2000  Increase (Decrease)** |   |
|-------------------------|--------|---------------------------------------|--------|---------------------------------------|--------|
|                    |   | **Total  Change**                     |   | **Change  Due to  Volume**            |   | **Change  Due to  Rate** |   | **Total  Change** |   | **Change  Due to  Volume** |   | **Change  Due to  Rate** |   |
| INTEREST INCOME         |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| Loans                   |   | $                                     | (1,194 | )                                     | $      | (408 | ) | $ | (786 | ) | $ | (1,044 | ) | $ | (835 | ) | $ | (209 | ) |
| Investment CDs          |   | 181                                   |   | 193                                   |   | (12 | ) | 72 |   | 72 |   | — |   |
| Securities              |   | (738                                  | )      | 272                                   |   | (1,010 | ) | (265 | ) | 175 |   | (440 | ) |
| Federal funds sold      |   | (92                                   | )      | (27                                   | )      | (65 | ) | 24 |   | 54 |   | (30 | ) |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| Total interest income   |   | (1,843                                | )      | 30                                    |   | (1,873 | ) | (1,213 | ) | (534 | ) | (679 | ) |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| INTEREST EXPENSE        |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| NOW and money market    |   | (41                                   | )      | 117                                   |   | (158 | ) | (312 | ) | (83 | ) | (229 | ) |
| Savings                 |   | (14                                   | )      | 29                                    |   | (43 | ) | (42 | ) | (25 | ) | (17 | ) |
| Time deposits           |   | (1,319                                | )      | (263                                  | )      | (1,056 | ) | (271 | ) | (374 | ) | 103 |   |
| Repurchase agreements   |   | (650                                  | )      | (28                                   | )      | (622 | ) | (33 | ) | 330 |   | (363 | ) |
| Borrowings              |   | (26                                   | )      | 30                                    |   | (56 | ) | 127 |   | 127 |   | — |   |
| Federal funds purchased |   | 10                                    |   | 40                                    |   | (30 | ) | (221 | ) | (106 | ) | (115 | ) |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| Total interest expense  |   | (2,040                                | )      | (75                                   | )      | (1,965 | ) | (752 | ) | (131 | ) | (621 | ) |
|                    |   |                                  |   |                                  |   |   |   |   |   |   |   |   |   |
| Net interest earnings   |   | $                                     | 197    |                                  | $      | 105 |   | $ | 92 |   | $ | (461 | ) | $ | (403 | ) | $ | (58 | ) |

 

### **Volume/ratevariances are allocated to the volume variance and the rate variance on anabsolute basis.**

 

Tax-exempt incomeis reflected on a fully tax-equivalent basis utilizing a 34% rate for municipalsecurities and tax-exempt loans.

 

8

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**QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

The Company’soverall interest rate sensitivity is demonstrated by net interest incomeanalysis and “Gap” analysis.  Netinterest income analysis measures the change in net interest income in theevent of hypothetical changes in interest rates.  This analysis assesses the risk of change in net interest incomein the event of sudden and sustained 1.0% increases and decreases in marketinterest rates.  The tables belowpresent the Company’s projected changes in net interest income for the variousrate shock levels for the three months ended December 31, 2002 and 2001.

 
|         |   | **2002 Net  Interest Income** |       |
|--------------|--------|-------------------------------|------------|
|         |   | **Amount**                    | ** ** | **Change** | ** ** | **Change** | ** ** |
|         |   | **(Dollars  in Thousands)**   | ** ** |
|         |   |                          | ** ** |   | ** ** |   | ** ** |
| +100 bp      |   | $                             | 2,560      |   | $ | (73 | ) | (2.8 | %) |
| Base         |   | 2,633                         |       | — |   | — |   |
| –100 bp |   | 2,561                         |       | (72 | ) | (2.7 | %) |
|         |   |                          |       |   |   |   |   |
|         |   | **2001 Net Interest Income**  |       |
|         |   | **Amount**                    |       | **Change** |   | **Change** |   |
|         |   | **(Dollars in Thousands)**    |       |
|         |   |                          |       |   |   |   |   |
| +100 bp      |   | $                             | 1,676      |   | $ | (254 | ) | (13.2 | %) |
| Base         |   | 1,930                         |       | — |   | — |   |
| –100 bp |   | 2,153                         |       | 223 |   | 11.6 | % |

 

As shown above, atDecember 31, 2002, the effect of an immediate 100 basis point increase ininterest rates would decrease the Company’s net interest income by 2.8% orapproximately $73,000.  The effect of animmediate 100 basis point decrease in rates would decrease the Company’s netinterest income by 2.7%, or approximately $72,000, as federal funds overnightrates were under 2.0% as of December 31, 2002, market interest rates decreasingan additional 200 basis points is not achievable.

 

Interest ratesensitivity reflects modest exposure in an increasing rate environment at theend of 2001.  Overall net interestincome sensitivity has decreased in 2002 compared to 2001.

 

**Liquidity and Capital Resources**

 

The Company’sprimary sources of funds are deposits, repurchase agreements, and proceeds fromprincipal and interest payments on loans and securities.  While maturities and scheduled amortizationof loans and securities and calls of securities are predictable sources offunds, deposit flows and mortgage prepayments are greatly influenced by generalinterest rates, economic conditions, and competition.  The Company generally manages the pricing of its deposits to becompetitive and to increase core deposit relationships.

 

Liquiditymanagement is both a daily and long-term responsibility of management.  The Company adjusts its investments inliquid assets based upon management’s assessment of (i) expected loandemand, (ii) expected deposit flows, (iii) yields available oninterest-earning

 

9

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deposits andsecurities, and (iv) the objectives of its asset/liability managementprogram.  Excess liquid assets areinvested generally in interest-earning overnight deposits and short- andintermediate-term U.S. government and agency obligations.

 

The Company’s cashflows are comprised of three primary classifications:  cash flows from operating activities, investing activities, andfinancing activities.  Cash flowsprovided by operating activities were $1.9 million, $2.4 million, and $3.1million for the years ended December 31, 2002, 2001, and 2000.  Net cash from investing activities consistedprimarily of principal collections on loans and proceeds from maturation andsales of securities offset by disbursements for loan originations and thepurchase of securities.  Net cash fromfinancing activities consisted primarily of changes in net deposits, short-termborrowings, and Federal Home Loan Bank advances partially offset by dividendspaid and the purchase of Company stock.

 

The Company’s mostliquid assets are cash and short-term investments.  The levels of these assets are dependent on the Company’soperating, financing, lending, and investing activities during any givenyear.  At December 31, 2002, cash andshort-term investments totaled $16.6 million. The Company has other sources of liquidity if a need for additionalfunds arises, including securities maturing within one year and the repaymentof loans.  The Company may also utilizethe sale of securities available-for-sale, federal funds lines of credit fromcorrespondent banks, and borrowings from the Federal Home Loan Bank of Chicagoand  Bank One.

 

The followingtable discloses contractual obligations and commercial commitments of theCompany as of December 31, 2002:

 
|                                           |   | **Total** | ** ** | **Less Than  1 Year** | ** ** | **1 – 3  Years** | ** ** | **4 – 5  Years** | ** ** | **After  5 Years** | ** ** |
|------------------------------------------------|--------|-----------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|--------------------|------------|
|                                           |   |      | ** ** |                  | ** ** |                  | ** ** |                  | ** ** |               | ** ** |
| Federal funds purchased                        |   | $         | 14,700     |                  | $          | 14,700                |       | $                     | —     |               | $          | — |   | $ | — |   |
| Securities sold under agreements to repurchase |   | 1,622     |       | 1,622                 |       | —                |       | —                |       | —             |       |
| Note payable                                   |   | 652       |       | 652                   |       | —                |       | —                |       | —             |       |
|                                           |   |      |       |                  |       |                  |       |                  |       |               |       |
|                                           |   | $         | 16,974     |                  | $          | 16,974                |       | $                     | —     |               | $          | — |   | $ | — |   |

 

10

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|                         |   | **Total  Amounts  Committed** |   | **Less Than  1 Year** |   | **1 – 3 Years** |   | **4 – 5 Years** |   | **Over  5 Years** |   |
|------------------------------|--------|-------------------------------|--------|-----------------------|--------|----------------------|--------|----------------------|--------|-------------------|--------|
|                         |   |                          |   |                  |   |                 |   |                 |   |              |   |
| Lines of credit(1)           |   | $                             | 12,590 |                  | $      | 5,005                |   | $                    | 296    |              | $      | 1,242 |   | $ | 6,047 |   |
| Standby letters of credit(1) |   | 361                           |   | 361                   |   | —               |   | —               |   | —            |   |
|                         |   |                          |   |                  |   |                 |   |                 |   |              |   |
|                         |   | $                             | 12,951 |                  | $      | 5,366                |   | $                    | 296    |              | $      | 1,242 |   | $ | 6,047 |   |

 

----

(1)  Represents amounts committed to customers.

 

During 2002 and2001, the Company repurchased 1,400 and 3,925 shares of common stock for$74,000 and $196,000.

 

Capital providesthe foundation for future growth. Regulatory agencies have developed minimum guidelines by which theadequacy of a financial institution’s capital may be evaluated.  All of the Company’s ratios exceed thelevels required under regulatory guidelines as shown in Note 15 of theConsolidated Financial Statements.

 

**Facilities**

 

The Company has purchased real estate in Morris, Illinois and is in theprocess of establishing a full service branch facility in that community.  Construction of the facility began in late 2002and total estimated costs to complete the branch are $1,007,000 at December 31,2002.  In addition, a remodeling projectof the main banking facility was completed in the third quarter of 2002.

 

**Impact of Inflation and ChangingPrices**

 

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

 

11

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**Recent Regulatory Developments**

 

On July 30, 2002, President Bush signed the Sarbanes-Oxley Actof 2002 (the *“Sarbanes-Oxley Act”*).This legislation impacts corporate governance of public companies, affectingtheir officers and directors, their audit committees, their relationships withtheir accountants and the audit function itself. Certain provisions of the Actbecame effective on July 30, 2002. Others will become effective as the SECadopts appropriate rules.

 

The Sarbanes-Oxley Act implements a broad range of corporategovernance and accounting measures for public companies designed to promotehonesty and transparency in corporate America and better protect investors fromcorporate wrongdoing. The Sarbanes-Oxley Act’s principal legislation includes:

 

•                  the creation of an independentaccounting oversight board to oversee the audit of public companies andauditors who perform such audits;

 

•                  auditor independence provisionswhich restrict non-audit services that independent accountants may provide totheir audit clients;

 

•                  additional corporate governance andresponsibility measures, including

(i)                             requiring the chief executiveofficer and chief financial officer to certify financial statements;

(ii)                          prohibiting trading of securities byofficers and directors during periods in which certain employee benefit plansare prohibited from trading;

(iii)                       requiring a company’s chief executiveofficer and chief financial officer to forfeit salary and bonuses, includingprofits on the sale of company securities, in certain situations; and

(iv)                      protecting whistleblowers andinformants;

 

•                  expansion of the power of the auditcommittee, including the requirements that the audit committee

(i)          have direct control of the engagementof the outside auditor,

(ii)         be able to hire and fire the auditor,and

(iii)        approve all non-audit services;

 

•                  expanded disclosure requirements,including accelerated reporting of stock transactions by insiders and theprohibition of most loans to directors and executive officers of non-financialinstitutions;

 

•                  mandatory disclosure by analysts ofpotential conflicts of interest;

and

•                  a range of enhanced penalties forfraud and other violations.

 

Senior management, the audit committee, and the board ofdirectors have taken steps necessary to implement policies and procedures tocomply with applicable requirements of the Sarbanes-Oxley Act.

 

12

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**Safe Harbor Statement**

 

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

 

The Company’sability to predict results of the actual effect of future plans or strategiesis inherently uncertain.  Factors whichcould have a material adverse effect on the operations and future prospects ofthe Company and its subsidiaries include, but are not limited to, thefollowing:

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

•                  Technologicalchanges implemented by the Company and by other parties, including third partyvendors, which may be more difficult or more expensive than

 

13

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anticipated or which may have unforeseen consequencesto the Company and its customers.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

These risks anduncertainties should be considered in evaluating forward-looking statements andundue reliance should not be placed on such statements. Additional informationconcerning the Company and its business, including other factors that couldmaterially affect the Company’s financial results, is included in the Company’sfilings with the Securities and Exchange Commission.

 

14

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REPORT OFINDEPENDENT AUDITORS

 

Board of Directorsand Shareholders

First OttawaBancshares, Inc.

Ottawa, Illinois

 

We have auditedthe accompanying consolidated balance sheets of First Ottawa Bancshares, Inc.and Subsidiary as of December 31, 2002 and 2001 and the related consolidatedstatements of income, shareholders’ equity, and cash flows for each of thethree years in the period ended December 31, 2002.  These consolidated financial statements are the responsibility ofthe Company’s management.  Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

 

We conducted ouraudits in accordance with auditing standards generally accepted in the UnitedStates of America.  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion,the consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of First Ottawa Bancshares, Inc. andSubsidiary as of December 31, 2002 and 2001 and the results of their operationsand their cash flows for each of the three years in the period ended December31, 2002 in conformity with accounting principles generally accepted in theUnited States of America.

 
|                 | Crowe, Chizek and  Company LLP |
|----------------------|--------------------------------|
|                 |                           |
| Oak Brook,  Illinois |                           |
| January 17, 2003     |                           |

 

15

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FIRST OTTAWABANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATEDBALANCE SHEETS

December 31, 2002and 2001

(In thousands,except share and per share data)

 
|                                                                         |   | **2002** |       | **2001** |       |
|------------------------------------------------------------------------------|--------|----------|------------|----------|------------|
| **ASSETS**                                                                   |   |     |       |     |       |
| Cash and due from banks                                                      |   | $        | 8,606      |     | $          | 7,933 |   |
| Certificates of deposit                                                      |   | 12,985   |       | 3,100    |       |
| Securities available-for-sale                                                |   | 98,885   |       | 104,319  |       |
| Loans held for sale                                                          |   | 1,811    |       | 1,475    |       |
| Loans, less allowance for loan losses of $1,167 and  $1,109                  |   | 108,476  |       | 106,924  |       |
| Premises and equipment, net                                                  |   | 4,555    |       | 2,839    |       |
| Due from broker                                                              |   | —   |       | 477      |       |
| Interest receivable and other assets                                         |   | 5,344    |       | 5,498    |       |
|                                                                         |   |     |       |     |       |
| Total assets                                                                 |   | $        | 240,662    |     | $          | 232,565 |   |
|                                                                         |   |     |       |     |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                |   |     | ** ** |     | ** ** |
| Liabilities                                                                  |   |     |       |     |       |
| Deposits                                                                     |   |     |       |     |       |
| Demand – non-interest-bearing                                           |   | $        | 19,475     |     | $          | 21,437 |   |
| NOW accounts                                                                 |   | 54,537   |       | 23,835   |       |
| Money market accounts                                                        |   | 9,186    |       | 8,554    |       |
| Savings                                                                      |   | 19,513   |       | 16,860   |       |
| Time, $100,000 and over                                                      |   | 23,813   |       | 20,479   |       |
| Other time                                                                   |   | 67,243   |       | 74,102   |       |
| Total deposits                                                               |   | 193,767  |       | 165,267  |       |
|                                                                         |   |     |       |     |       |
| Federal funds purchased                                                      |   | 14,700   |       | 5,050    |       |
| Securities sold under agreements to repurchase                               |   | 1,622    |       | 30,849   |       |
| Borrowings                                                                   |   | 652      |       | 4,200    |       |
| Interest payable and other liabilities                                       |   | 4,738    |       | 4,292    |       |
| Total liabilities                                                            |   | 215,479  |       | 209,658  |       |
|                                                                         |   |     |       |     |       |
| Shareholders’ equity                                                    |   |     |       |     |       |
| Preferred stock -   $1 par value, 20,000 shares Authorized; none issued |   | —   |       | —   |       |
| Common stock - $1 par value, 1,000,000 shares  authorized and 750,000 issued |   | 750      |       | 750      |       |
| Additional paid-in capital                                                   |   | 4,000    |       | 4,000    |       |
| Retained earnings                                                            |   | 23,491   |       | 23,178   |       |
| Treasury stock, at cost; 93,044 shares in 2002;  91,644 shares in 2001       |   | (5,270   | )          | (5,196   | )          |
| Accumulated other comprehensive income                                       |   | 2,212    |       | 175      |       |
| Total shareholders’ equity                                              |   | 25,183   |       | 22,907   |       |
|                                                                         |   |     |       |     |       |
| Total liabilities and shareholders’ equity                              |   | $        | 240,662    |     | $          | 232,565 |   |

 

See accompanyingnotes to consolidated financial statements.

 

16

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FIRST OTTAWABANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATEDSTATEMENTS OF INCOME

Years endedDecember 31, 2002, 2001, and 2000

(In thousands,except share and per share data)

 
|                                                     |   | **2002** |       | **2001** |       | **2000** |       |
|----------------------------------------------------------|--------|----------|------------|----------|------------|----------|------------|
| Interest income                                          |   |     |       |     |       |     |       |
| Loans (including fee income)                             |   | $        | 7,976      |     | $          | 9,416    |       | $ | 10,461 |   |
| Securities                                               |   |     |       |     |       |     |       |
| Taxable                                                  |   | 3,933    |       | 3,880    |       | 3,793    |       |
| Exempt from federal income tax                           |   | 910      |       | 1,441    |       | 1,653    |       |
| Federal funds sold                                       |   | 20       |       | 112      |       | 88       |       |
| Certificates of deposit                                  |   | 253      |       | 72       |       | —   |       |
| Total interest income                                    |   | 13,092   |       | 14,921   |       | 15,995   |       |
|                                                     |   |     |       |     |       |     |       |
| Interest expense                                         |   |     |       |     |       |     |       |
| NOW account deposits                                     |   | 435      |       | 387      |       | 562      |       |
| Money market deposit accounts                            |   | 148      |       | 237      |       | 374      |       |
| Savings deposits                                         |   | 312      |       | 326      |       | 368      |       |
| Time deposits                                            |   | 4,194    |       | 5,513    |       | 5,784    |       |
| Repurchase agreements                                    |   | 475      |       | 1,125    |       | 1,158    |       |
| Federal funds purchased                                  |   | 68       |       | 58       |       | 279      |       |
| Borrowings                                               |   | 101      |       | 127      |       | —   |       |
| Total interest expense                                   |   | 5,733    |       | 7,773    |       | 8,525    |       |
|                                                     |   |     | ** ** |     | ** ** |     | ** ** |
| **Net  interest income**                                 |   | 7,359    |       | 7,148    |       | 7,470    |       |
|                                                     |   |     |       |     |       |     |       |
| Provision for loan losses                                |   | 120      |       | 300      |       | 360      |       |
|                                                     |   |     | ** ** |     | ** ** |     | ** ** |
| **Net  interest income after provision for loan losses** |   | 7,239    |       | 6,848    |       | 7,110    |       |
|                                                     |   |     |       |     |       |     |       |
| Noninterest income                                       |   |     |       |     |       |     |       |
| Service charges on deposit accounts                      |   | 768      |       | 819      |       | 746      |       |
| Trust and farm management fee income                     |   | 459      |       | 420      |       | 417      |       |
| Other income                                             |   | 670      |       | 441      |       | 501      |       |
| Gain on sale of loans                                    |   | 445      |       | 238      |       | 74       |       |
| Securities gains net                                     |   | 102      |       | 539      |       | 11       |       |
| Total noninterest income                                 |   | 2,444    |       | 2,457    |       | 1,749    |       |
|                                                     |   |     |       |     |       |     |       |
| Noninterest expenses                                     |   |     |       |     |       |     |       |
| Salaries and employee benefits                           |   | 3,954    |       | 3,893    |       | 3,736    |       |
| Occupancy and equipment expense                          |   | 867      |       | 822      |       | 813      |       |
| Data processing expense                                  |   | 433      |       | 510      |       | 513      |       |
| Supplies                                                 |   | 117      |       | 119      |       | 142      |       |
| Advertising and promotions                               |   | 67       |       | 112      |       | 141      |       |
| Professional fees                                        |   | 343      |       | 354      |       | 308      |       |
| Other expenses                                           |   | 937      |       | 922      |       | 857      |       |
| Total noninterest expenses                               |   | 6,718    |       | 6,732    |       | 6,510    |       |
|                                                     |   |     | ** ** |     | ** ** |     | ** ** |
| **Income  before income taxes**                          |   | 2,965    |       | 2,573    |       | 2,349    |       |
|                                                     |   |     |       |     |       |     |       |
| Provision for income taxes                               |   | 678      |       | 460      |       | 257      |       |
|                                                     |   |     | ** ** |     | ** ** |     | ** ** |
| **Net  income**                                          |   | $        | 2,287      |     | $          | 2,113    |       | $ | 2,092 |   |
|                                                     |   |     |       |     |       |     |       |
| Earnings per share                                       |   | $        | 3.47       |     | $          | 3.19     |       | $ | 3.14 |   |
|                                                     |   |     |       |     |       |     |       |
| Average shares outstanding                               |   | 658,267  |       | 662,249  |       | 667,092  |       |

 

See accompanyingnotes to consolidated financial statements.

 

17

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FIRST OTTAWABANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

Years ended December 31, 2002, 2001, and 2000

(In thousands, except share and per share data)

 
|                                                                                            |   | **Common  Stock** |       | **Additional  Paid-In  Capital** |       | **Retained  Earnings** |       | **Treasury  Stock** |       | **Accumulated  Other  Comprehensive  Income (Loss)** |       | **Total  Share-  holders’  Equity** |       |
|-------------------------------------------------------------------------------------------------|--------|-------------------|------------|----------------------------------|------------|------------------------|------------|---------------------|------------|------------------------------------------------------|------------|------------------------------------------|------------|
|                                                                                            |   |              | ** ** |                             | ** ** |                   | ** ** |                | ** ** |                                                 | ** ** |                                     | ** ** |
| Balance at January 1, 2000                                                                      |   | $                 | 750        |                             | $          | 4,000                  |       | $                   | 22,947     |                                                 | $          | —                                   |       | $ | (1,714 | ) | $ | 25,983 |   |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Net income                                                                                      |   | —            |       | —                           |       | 2,092                  |       | —              |       | —                                               |       | 2,092                                    |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Unrealized net gain on  securities available-for-sale, net of reclassification and tax effects  |   | —            |       | —                           |       | —                 |       | —              |       | 1,495                                                |       | 1,495                                    |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Comprehensive income                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       | 3,587                                    |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Cash dividends declared  ($3.00 per share)                                                      |   | —            |       | —                           |       | (1,987                 | )          | —              |       | —                                               |       | (1,987                                   | )          |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Purchase of 87,719 treasury  shares                                                             |   | —            |       | —                           |       | —                 |       | (5,000              | )          | —                                               |       | (5,000                                   | )          |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Balance at December 31,  2000                                                                   |   | 750               |       | 4,000                            |       | 23,052                 |       | (5,000              | )          | (219                                                 | )          | 22,583                                   |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Net income                                                                                      |   | —            |       | —                           |       | 2,113                  |       | —              |       | —                                               |       | 2,113                                    |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Unrealized net gain on  securities available-for-sale, net of reclassi-fication and tax effects |   | —            |       | —                           |       | —                 |       | —              |       | 394                                                  |       | 394                                      |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Comprehensive income                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       | 2,507                                    |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Cash dividends declared  ($3.00 per share)                                                      |   | —            |       | —                           |       | (1,987                 | )          | —              |       | —                                               |       | (1,987                                   | )          |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Purchase of 3,925 treasury  shares                                                              |   | —            |       | —                           |       | —                 |       | (196                | )          | —                                               |       | (196                                     | )          |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Balance at December 31,  2001                                                                   |   | 750               |       | 4,000                            |       | 23,178                 |       | (5,196              | )          | 175                                                  |       | 22,907                                   |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Net income                                                                                      |   | —            |       | —                           |       | 2,287                  |       | —              |       | —                                               |       | 2,287                                    |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Unrealized net gain on  securities available-for-sale, net of reclassi-fication and tax effects |   | —            |       | —                           |       | —                 |       | —              |       | 2,254                                                |       | 2,254                                    |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Change in minimum pension  liability, net of tax                                                |   | —            |       | —                           |       | —                 |       | —              |       | (217                                                 | )          | (217                                     | )          |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Comprehensive income                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       | 4,324                                    |       |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Cash dividends declared  ($3.00 per share)                                                      |   | —            |       | —                           |       | (1,974                 | )          | —              |       | —                                               |       | (1,974                                   | )          |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Purchase of 1,400 treasury  shares                                                              |   | —            |       | —                           |       | —                 |       | (74                 | )          | —                                               |       | (74                                      | )          |
|                                                                                            |   |              |       |                             |       |                   |       |                |       |                                                 |       |                                     |       |
| Balance at December 31,  2002                                                                   |   | $                 | 750        |                             | $          | 4,000                  |       | $                   | 23,491     |                                                 | $          | (5,270                                   | )          | $ | 2,212 |   | $ | 25,183 |   |

 

See accompanyingnotes to consolidated financial statements.

 

18

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years ended December 31, 2002, 2001, and 2000

(In thousands, except per share data)

 
|                                                                       |   | **2002** |       | **2001** |       | **2000** |       |
|----------------------------------------------------------------------------|--------|----------|------------|----------|------------|----------|------------|
| **Cash  flows from operating activities**                                  |   |     |       |     |       |     |       |
| Net income                                                                 |   | $        | 2,287      |     | $          | 2,113    |       | $ | 2,092 |   |
| Adjustments to reconcile net income to net cash from  operating activities |   |     |       |     |       |     |       |
| Change in deferred loan fees                                               |   | 37       |       | —   |       | (6       | )          |
| Provision for loan losses                                                  |   | 120      |       | 300      |       | 360      |       |
| Depreciation and amortization                                              |   | 331      |       | 283      |       | 290      |       |
| Premium amortization on securities, net                                    |   | 128      |       | 35       |       | 35       |       |
| Net real estate loans originated for sale                                  |   | 109      |       | (544     | )          | 1,119    |       |
| Net (gains) on loan sales                                                  |   | (445     | )          | (238     | )          | (74      | )          |
| Federal Home Loan Bank stock dividends                                     |   | (42      | )          | (40      | )          | —   |       |
| Net (gains) on sales of securities  available-for-sale                     |   | (102     | )          | (539     | )          | (11      | )          |
| Change in interest receivable and other assets                             |   | 474      |       | 1,087    |       | (807     | )          |
| Change in interest payable and other liabilities                           |   | (929     | )          | (41      | )          | 156      |       |
| Net cash from operating activities                                         |   | 1,968    |       | 2,416    |       | 3,154    |       |
|                                                                       |   |     |       |     |       |     |       |
| **Cash flows from investing activities**                                   |   |     | ** ** |     | ** ** |     | ** ** |
| Proceeds from sales of securities available-for-sale                       |   | 7,831    |       | 19,612   |       | 2,452    |       |
| Proceeds from maturities of securities                                     |   | 18,280   |       | 46,297   |       | 4,662    |       |
| Purchases of securities available-for-sale                                 |   | (16,769  | )          | (77,119  | )          | (7,335   | )          |
| Purchases of investment certificates of deposit                            |   | (9,885   | )          | (3,100   | )          | —   |       |
| Net change in loans receivable                                             |   | (2,040   | )          | 8,372    |       | 10,296   |       |
| Premises and equipment expenditures, net                                   |   | (2,030   | )          | (608     | )          | (276     | )          |
| Net cash from investing activities                                         |   | (4,613   | )          | (6,546   | )          | 9,799    |       |
|                                                                       |   |     |       |     |       |     |       |
| **Cash flows from financing activities**                                   |   |     | ** ** |     | ** ** |     | ** ** |
| Change in deposits                                                         |   | 28,500   |       | (8,186   | )          | (10,436  | )          |
| Change in federal funds purchased                                          |   | 9,650    |       | 5,050    |       | (7,600   | )          |
| Change in securities sold under agreements to  repurchase                  |   | (29,227  | )          | 6,211    |       | 5,973    |       |
| Proceeds from borrowings                                                   |   | 452      |       | 4,200    |       | —   |       |
| Repayment of borrowings                                                    |   | (4,000   | )          | —   |       | —   |       |
| Purchase of treasury stock                                                 |   | (74      | )          | (196     | )          | (5,000   | )          |
| Dividends paid                                                             |   | (1,983   | )          | (1,987   | )          | (2,162   | )          |
| Net cash from financing activities                                         |   | 3,318    |       | 5,092    |       | (19,225  | )          |
|                                                                       |   |     |       |     |       |     |       |
| Change in cash and due from banks                                          |   | 673      |       | 962      |       | (6,272   | )          |
|                                                                       |   |     |       |     |       |     |       |
| Cash and due from banks at beginning of year                               |   | 7,933    |       | 6,971    |       | 13,243   |       |
|                                                                       |   |     |       |     |       |     |       |
| **Cash  and due from banks at end of year**                                |   | $        | 8,606      |     | $          | 7,933    |       | $ | 6,971 |   |
|                                                                       |   |     |       |     |       |     |       |
| Supplemental disclosures of cash flow information                          |   |     |       |     |       |     |       |
| Cash paid during the year for                                              |   |     |       |     |       |     |       |
| Interest                                                                   |   | $        | 6,217      |     | $          | 8,038    |       | $ | 8,371 |   |
| Income taxes, net of refunds                                               |   | 563      |       | 350      |       | 393      |       |
|                                                                       |   |     |       |     |       |     |       |
| Noncash investing activities                                               |   |     |       |     |       |     |       |
| Transfers made from loans to other real estate owned                       |   | 331      |       | 215      |       | 186      |       |
| Due from broker                                                            |   | (477     | )          | 477      |       | —   |       |

 

 

See accompanyingnotes to consolidated financial statements.

 

19

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FIRST OTTAWA BANCSHARES,INC. AND SUBSIDIARY

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

December 31, 2002, 2001,and 2000

(Table dollars inthousands, except per share data)

 

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

 

Nature of Operations andPrinciples of Consolidation: The consolidated financial statements include First Ottawa Bancshares,Inc. and its wholly owned subsidiary, First National Bank of Ottawa (the Bank)and the Bank’s wholly owned subsidiary, First Ottawa Financial Corporation,together referred to as the Company. Intercompany transactions and balances areeliminated in consolidation.

 

Use of Estimates:  To prepare financial statements inconformity with accounting principles generally accepted in the United Statesof America, management makes estimates and assumptions based on availableinformation.  These estimates andassumptions affect the amounts reported in the financial statements and thedisclosures provided, and future results could differ.  The allowance for loan losses, fair valuesof financial instruments, derivatives, and status of contingencies areparticularly subject to change.

 

Cash Flow Reporting:  Net cash flows are reported for customerloan and deposit transactions, federal funds purchased, and securities soldunder repurchase agreements.

 

Securities:  Securities are classified asavailable-for-sale when they might be sold before maturity.  Securities available-for-sale are carried atfair value, with unrealized holding gains and losses reported, net of tax, asother comprehensive income.  Equitysecurities include Federal Home Loan Bank stock and Federal Reserve Bank stock,which are restricted securities that are carried at cost, and a mutual fundinvestment that is carried at fair value. Securities are written down to fair value, with a charge to expense,when a decline in fair value is not temporary.

 

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

 

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

 

21

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Loans:  Loans are reported at the principal balanceoutstanding, net of deferred loan fees and costs and the allowance for loanlosses.  Interest income is reported onthe interest method and includes amortization of net deferred loan fees andcosts over the loan term.  Mortgageloans originated and intended for sale in the secondary market are carried atthe lower of cost, net of deferred loan fees, or estimated fair value in theaggregate.

 

Interest income is notreported when full loan repayment is in doubt, typically when payments are pastdue over 90 days.  Payments received onsuch loans are reported as principal reductions.

 

Allowance for Loan Losses:  The allowance for loan losses is a valuationallowance for probable incurred credit losses, increased by the provision forloan losses and decreased by charge-offs less recoveries.  Management estimates the allowance balancerequired based on past loan loss experience, known and inherent risks in theportfolio, information about specific borrower situations and estimatedcollateral values, economic conditions, and other factors.  Allocations of the allowance may be made forspecific loans, but the entire allowance is available for any loan that, inmanagement’s judgment, should be charged off.

 

Loan impairment isreported when full payment under the loan terms is not expected.  Impairment is evaluated in total forsmaller-balance loans of similar nature, such as residential mortgage andconsumer loans, and on an individual loan basis for other loans.  If a loan is impaired, a portion of theallowance is allocated so that the loan is reported, net, at the present valueof estimated future cash flows using the loan’s existing rate or at the loan’sobservable market price or the fair value of collateral if the loan iscollateral dependent.  Loans areevaluated for impairment when payments are delayed, typically 90 days or more,or when the internal grading system indicates a doubtful classification.

 

Premises and Equipment:  Asset cost is reported net of accumulateddepreciation. Buildings and related components are depreciated using thestraight-line method with useful lives ranging from 7 to 39 years. Furniture,fixtures and equipment are depreciated using the straight-line method withuseful lives ranging from 5 to 15 years. These assets are reviewed forimpairment when events indicate that the carrying amount may not berecoverable.  Maintenance and repairsare charged to expense and improvements are capitalized.

 

22

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Mortgage Servicing Rights:  Servicing rights are recognized as assetsfor the allocated value of servicing rights retained on loans sold and areclassified with interest receivable and other assets in the consolidatedbalance sheets.  Servicing rights areexpensed in proportion to and over the period of estimated net servicingrevenues.  Impairment is evaluated basedon the fair value of the rights usinggroupings of the underlying loans as to interest rates and then, secondarily,as to geographic and prepayment characteristics.  Fair value is determined using prices for similar assets withsimilar characteristics, when available, or based upon discounted cash flowsusing market-based assumptions.  Anyimpairment of a grouping is reported as a valuation allowance.  There was no such valuation allowancerecorded at year-end 2002 and 2001, and mortgage servicing rights were notmaterial at either date.

 

Other Real Estate:  Real estate owned, other than that used inthe normal course of business, is carried at the lower of cost basis (fairvalue at date of foreclosure) or fair value less estimated costs to sell.  Any reduction to fair value from a relatedloan at the time of acquisition is accounted for as a loan loss.  Any subsequent reductions in fair value lessestimated costs to sell are recorded by charges to expense and a correspondingvaluation allowance on the related real estate.

 

Employee Benefits:  A defined benefit pension plan coverssubstantially all employees, with benefits based on years of service andcompensation prior to retirement. On November 10, 1999, all pension planbenefits were frozen with the intent of considering alternative methods ofproviding retirement benefits to employees. Pension expense is the net of interest cost, return on plan assets, andamortization of gains and losses not immediately recognized.  Contributions to the plan are based on themaximum amount deductible for income tax purposes.

 

A 401(k) profit sharingplan covers eligible employees with more than one year of service (one thousandworking hours) and who are at least 21 years of age.  The plan allows employee contributions.  The Company may make a discretionary matching contribution equalto a percentage of salary deferral.  Thematching percentage is limited to 6% of compensation.  The Company made contributions of $85,000 in 2002, $90,000 in2001, and $87,000 in 2000.

 

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

 

23

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Fair Values of FinancialInstruments:  Fairvalues of financial instruments are estimated using relevant market informationand other assumptions, as more fully disclosed separately.  Fair value estimates involve uncertaintiesand matters of significant judgment regarding interest rates, credit risk,prepayments, and other factors, especially in the absence of broad markets forparticular items.  Changes inassumptions or in market conditions could significantly affect theestimates.  The fair value estimates ofexisting on- and off-balance-sheet financial instruments do not include thevalue of anticipated future business or the values of assets and liabilitiesnot considered financial instruments.

 

Earnings Per Share:  Basic earnings per share is calculated basedon the weighted average common shares outstanding during the year.  The Company had no dilutive securitiesduring 2002, 2001, or 2000.

 

Comprehensive Income:  Comprehensive income includes both netincome and other comprehensive income (loss). Other comprehensive income (loss) includes the change in unrealizedgains and losses on securities available-for-sale, net of deferred incometaxes.

 

New AccountingPronouncements:  TheFinancial Accounting Standards Board issued SFAS No. 142, Go*odwill and Other Intangible Assets,*inJuly 2001.  The statement, which wasadopted by the Company effective January 1, 2002, no longer allows for theamortization of goodwill and requires that the carrying value of goodwill bewritten down when it is deemed to be impaired. The adoption of this standard did not have any effect on the Company’sfinancial statements, as the Company does not have any goodwill.

 

Newly Issued ButNot Yet Effective Accounting Standards: New accounting standards on asset retirement obligations, restructuringactivities and exit costs, operating leases, and early extinguishment of debtwere issued in 2002.  Managementdetermined that when the new accounting standards are adopted in 2003 they willnot have a material impact on the Company’s financial condition or results ofoperations.

 

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

 

24

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**NOTE 2 - SECURITIES**

 

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

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

 

Securities available-for-saleas of December 31, 2001 were as follows:

 
|                                                                |   | **Fair  Value** |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   |
|---------------------------------------------------------------------|--------|-----------------|---------|------------------------------|--------|-------------------------------|--------|
|                                                                |   |            |    |                         |   |                          |   |
| U.S. treasuries                                                     |   | $               | 1,580   |                         | $      | 70                            |   | $ | — |   |
| U.S. government agencies                                            |   | 74,568          |    | 545                          |   | (891                          | )      |
| States and political subdivisions                                   |   | 18,614          |    | 505                          |   | (153                          | )      |
| Mortgage-backed securities and collateralized  mortgage obligations |   | 5,030           |    | 203                          |   | —                        |   |
| Corporate bonds                                                     |   | 2,614           |    | 18                           |   | (13                           | )      |
| Equity securities                                                   |   | 1,913           |    | 26                           |   | (45                           | )      |
|                                                                |   |            |    |                         |   |                          |   |
|                                                                |   | $               | 104,319 |                         | $      | 1,367                         |   | $ | (1,102 | ) |

 

As of December 31,2002 and 2001, the Company had approximately $7,730,000 and $7,042,000 investedin bonds issued by municipalities located within LaSalle County, Illinois.

 

Securities with anapproximate carrying value of $79,270,000 and $58,826,000 were pledged atDecember 31, 2002 and 2001 to secure trust and public deposits, repurchaseagreements, and for other purposes as required or permitted by law.

 

25

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Securities  with an amortized cost of $26,898,000 and acarrying value of $27,494,000 at year-end 2002 were callable at the issuers’option.

 

Contractual maturities ofsecurities available-for-sale at year-end 2002 were as follows.  Securities not due at a single maturitydate, primarily mortgage-backed and equity securities, are shown separately.

 
|                                                                |   | **Fair  Value** |   |
|---------------------------------------------------------------------|--------|-----------------|--------|
|                                                                |   |            |   |
| Due in one year or less                                             |   | $               | 3,968  |   |
| Due after one year through five years                               |   | 76,488          |   |
| Due after five years through ten years                              |   | 3,505           |   |
| Due after ten years                                                 |   | 4,014           |   |
| Mortgage-backed securities and collateralized  mortgage obligations |   | 7,682           |   |
| Equity securities                                                   |   | 3,228           |   |
|                                                                |   |            |   |
|                                                                |   | $               | 98,885 |   |

 

Information fo theyears indicated regarding sales of securities available-for-sale follows:

 
|         |   | **2002** |   | **2001** |   | **2000** |   |
|--------------|--------|----------|--------|----------|--------|----------|--------|
|         |   |     |   |     |   |     |   |
| Proceeds     |   | $        | 7,831  |     | $      | 19,612   |   | $ | 2,452 |   |
| Gross gains  |   | 104      |   | 540      |   | 14       |   |
| Gross losses |   | (2       | )      | (1       | )      | (3       | )      |
|              |        |          |        |          |        |          |        |  |  |  |

 

26

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**NOTE 3 - LOANS**

 

Major classifications ofloans as of December 31, 2002 and 2001 are summarized as follows:

 
|                                |   | **2002** |    | **2001** |   |
|-------------------------------------|--------|----------|---------|----------|--------|
|                                |   |     |    |     |   |
| Real estate                         |   | $        | 46,699  |     | $      | 47,322 |   |
| Commercial and agricultural         |   | 33,950   |    | 29,361   |   |
| Installment, net of unearned income |   | 19,951   |    | 24,595   |   |
| Home equity lines of credit         |   | 9,120    |    | 6,795    |   |
|                                |   | 109,720  |    | 108,073  |   |
| Deferred loan fees                  |   | (77      | )       | (40      | )      |
| Allowance for loan losses           |   | (1,167   | )       | (1,109   | )      |
|                                |   |     |    |     |   |
|                                |   | $        | 108,476 |     | $      | 106,924 |   |

 

Certain executiveofficers, directors, and their related interests are loan customers of theCompany.  A summary of such loans madeby the Company in the ordinary course of business is as follows:

 
| Balance at December 31, 2001 |   | $      | 2,021  |   |
|------------------------------|--------|--------|--------|--------|
| New loans                    |   | 982    |   |
| Repayments                   |   | (1,258 | )      |
|                         |   |   |   |
| Balance at December 31, 2002 |   | $      | 1,745  |   |

 

Tax-exemptcommercial and agricultural loans totaled approximately $528,000 and $712,000at December 31, 2002 and 2001.  Theinterest on these loans, which is included in loan income and is exempt fromfederal income tax, totaled approximately $32,000, $43,000, and $40,000 for theyears ended December 31, 2002, 2001, and 2000.

 

Informationregarding impaired loans at December 31, 2002 and 2001 is as follows:

 
|                                                      |   | **2002** |   | **2001** |   |
|-----------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                      |   |     |   |     |   |
| Impaired loans with related allowance for loan  losses    |   | $        | 1,447  |     | $      | 635 |   |
| Impaired loans with no related allowance for loan  losses |   | 591      |   | 689      |   |
|                                                      |   |     |   |     |   |
| Total impaired loans                                      |   | $        | 2,038  |     | $      | 1,324 |   |
|                                                      |   |     |   |     |   |
| Allowance for loan losses allocated to impaired  loans    |   | $        | 396    |     | $      | 180 |   |

 

27

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|                                         |   | **2002** |   | **2001** |   | **2000** |   |
|----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                         |   |     |   |     |   |     |   |
| Average of impaired loans during the year    |   | $        | 1,636  |     | $      | 1,243    |   | $ | 1,295 |   |
| Interest income recognized during impairment |   | 155      |   | 95       |   | 221      |   |
| Cash-basis interest income recognized        |   | 112      |   | 81       |   | 125      |   |
|                                              |        |          |        |          |        |          |        |  |  |  |

 

Nonperformingloans were as follows at December 31:

 
|                                         |   | **2002** |   | **2001** |   |
|----------------------------------------------|--------|----------|--------|----------|--------|
|                                         |   |     |   |     |   |
| Loans past due over 90 days still on accrual |   | $        | 757    |     | $      | 860 |   |
| Nonaccrual loans                             |   | 364      |   | 387      |   |
|                                              |        |          |        |          |        |  |  |

 

Nonperformingloans and impaired loans are defined differently.  Some loans may be included in both categories, whereas otherloans may only be included in one category.

 

**NOTE 4 - ALLOWANCE FOR LOAN LOSSES**

 

Activity in theallowance for loan losses is summarized as follows for the years ended December31:

 
|                                       |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                       |   |     |   |     |   |     |   |
| Balance at beginning of year               |   | $        | 1,109  |     | $      | 1,108    |   | $ | 1,059 |   |
| Recoveries on loans previously charged off |   | 171      |   | 101      |   | 204      |   |
| Loans charged off                          |   | (233     | )      | (400     | )      | (515     | )      |
| Provision for loan losses                  |   | 120      |   | 300      |   | 360      |   |
|                                       |   |     |   |     |   |     |   |
| Balance at end of year                     |   | $        | 1,167  |     | $      | 1,109    |   | $ | 1,108 |   |

 

28

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**NOTE5 - LOAN SALES AND SERVICING**

 

The following summarizes the secondary mortgage market activities:

 
|                                  |   | **Year Ended December 31,** |   |
|---------------------------------------|--------|-----------------------------|--------|
|                                  |   | **2002**                    |   | **2001** |   | **2000** |   |
|                                  |   |                        |   |   |   |   |   |
| Proceeds from sale of  mortgage loans |   | $                           | 15,841 |   | $ | 17,643 |   | $ | 1,741 |   |
|                                  |   |                        |   |   |   |   |   |
| Gain on sale of mortgage  loans       |   | $                           | 445    |   | $ | 238 |   | $ | 74 |   |

 

The Company sells mortgage loans with servicing retained to the FederalHome Loan Mortgage Corporation (FHLMC) and the Illinois Housing DevelopmentAuthority (IHDA).  Mortgage loansserviced for others are not included in the accompanying consolidated balancesheets.  The unpaid principal balancesof these loans are summarized as follows:

 
|   |   | **December 31,** |   |
|--------|--------|------------------|--------|
|   |   | **2002**         |   | **2001** |   |
|   |   |             |   |   |   |
| FHLMC  |   | $                | 21,293 |   | $ | 13,068 |   |
| IHDA   |   | 1,170            |   | 1,272 |   |
|   |   |             |   |   |   |
|   |   | $                | 22,463 |   | $ | 14,340 |   |

 

Custodial escrow balances maintained in connection with the foregoing loanservicing were approximately $7,000, and $7,000,  at December 31, 2002, and 2001, respectively.

 

Following is an analysis of the changes in originated mortgage servicingrights:

 
|                                  |   | **Year Ended December 31,** |   |
|---------------------------------------|--------|-----------------------------|--------|
|                                  |   | **2002**                    |   | **2001** |   | **2000** |   |
|                                  |   |                        |   |   |   |   |   |
| Balance at beginning of  year         |   | $                           | 135    |   | $ | 151 |   | $ | 147 |   |
| Originated mortgage  servicing rights |   | 193                         |   | — |   | 4 |   |
| Amortization                          |   | (27                         | )      | (16 | ) | — |   |
|                                  |   |                        |   |   |   |   |   |
|                                  |   | $                           | 301    |   | $ | 135 |   | $ | 151 |   |

 

29

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**NOTE 6 - PREMISES AND EQUIPMENT**

 

Bank premises andequipment consisted of the following at December 31:

 
|                          |   | **2002** |   | **2001** |   |
|-------------------------------|--------|----------|--------|----------|--------|
|                          |   |     |   |     |   |
| Land                          |   | $        | 1,340  |     | $      | 549 |   |
| Bank premises                 |   | 4,408    |   | 3,245    |   |
| Furniture and equipment       |   | 3,103    |   | 2,923    |   |
| Total cost                    |   | 8,851    |   | 6,717    |   |
| Less accumulated depreciation |   | 4,568    |   | 4,255    |   |
|                          |   | 4,283    |   | 2,462    |   |
| Construction in progress      |   | 272      |   | 377      |   |
|                          |   |     |   |     |   |
| Net book value                |   | $        | 4,555  |     | $      | 2,839 |   |

 

The Bank is in theprocess of building a branch office in Morris, Illinois.  Additional estimated costs to complete thebranch are $1,007,000 at December 31, 2002.

 

**NOTE 7 - DEPOSITS**

 

At December 31,2002, the scheduled maturities of certificates of deposit were as follows:

 
| 2003   |   | $      | 58,085 |   |
|--------|--------|--------|--------|--------|
| 2004   |   | 18,212 |   |
| 2005   |   | 3,165  |   |
| 2006   |   | 2,600  |   |
| 2007   |   | 8,994  |   |
|   |   |   |   |
|   |   | $      | 91,056 |   |

 

**NOTE 8 -BORROWINGS**

 

The Company has a notepayable that consists of a $1,000,000 unsecured line of credit with Bank One,NA, maturing on May 15, 2003.  Theoutstanding balance under the line of credit was $652,000 and $500,000 atDecember 31, 2002 and 2001. Interest is payable quarterly at Bank One’s prime rate or LIBOR plus 175basis points (3.54% and 3.63% at December 31, 2002 and 2001).

 

30

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**NOTE 9 - SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE**

 

Securities sold underagreements to repurchase are financing arrangements.  Physical control is maintained for all securities sold underrepurchase agreements.  Informationconcerning securities sold under agreements to repurchase is summarized asfollows:

 
|                                      |   | **2002** |   | **2001** |   |
|-------------------------------------------|--------|----------|--------|----------|--------|
|                                      |   |     |   |     |   |
| Average balance during the year           |   | $        | 25,567 |     | $      | 27,062 |   |
| Average interest rate at year end         |   | 2.04     | %      | 2.31     | %      |
| Average interest rate during the year     |   | 1.86     | %      | 4.16     | %      |
| Maximum month-end balance during the year |   | $        | 37,594 |     | $      | 33,203 |   |

 

**NOTE 10 - PENSION PLAN**

 

The followingtables set forth the pension plan’s funded status and amounts actuariallydetermined for the years indicated:

 
|                            |   | **2002** |   | **2001** |   |
|---------------------------------|--------|----------|--------|----------|--------|
| Change in benefit obligation    |   |     |   |     |   |
| Beginning benefit obligation    |   | $        | 2,139  |     | $      | 2,230 |   |
| Interest cost                   |   | 120      |   | 151      |   |
| Actuarial loss (gain)           |   | 48       |   | (37      | )      |
| Benefits paid                   |   | (378     | )      | (205     | )      |
|                            |   |     |   |     |   |
| Ending benefit obligation       |   | $        | 1,929  |     | $      | 2,139 |   |
|                            |   |     |   |     |   |
| Change in plan assets           |   |     |   |     |   |
| Beginning fair value            |   | $        | 1,216  |     | $      | 1,367 |   |
| Actual return                   |   | (105     | )      | (61      | )      |
| Employer contribution           |   | 500      |   | 115      |   |
| Benefits paid                   |   | (378     | )      | (205     | )      |
|                            |   |     |   |     |   |
| Ending fair value               |   | $        | 1,233  |     | $      | 1,216 |   |
|                            |   |     |   |     |   |
| Funded status                   |   | $        | (696   | )        | $      | (923 | ) |
| Unrecognized net actuarial loss |   | 381      |   | —   |   |
|                            |   |     |   |     |   |
| Accrued benefit cost            |   | $        | (315   | )        | $      | (923 | ) |

 

31

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|                                    |   | **2002** |   | **2001** |   | **2000** |   |
|-----------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Assumptions used                        |   |     |   |     |   |     |   |
| Discount rate                           |   | 6.25     | %      | 7.0      | %      | 7.0      | %      |
| Expected return on plan assets          |   | 7.0      |   | 7.0      |   | 7.0      |   |
|                                    |   |     |   |     |   |     |   |
| Components of net periodic benefit cost |   |     |   |     |   |     |   |
| Interest cost                           |   | $        | 120    |     | $      | 151      |   | $ | 180 |   |
| Return on plan assets                   |   | (105     | )      | (61      | )      | (12      | )      |
| Amortization                            |   | 20       |   | (152     | )      | (79      | )      |
|                                    |   |     |   |     |   |     |   |
| Net expense (income)                    |   | $        | 35     |     | $      | (62      | )      | $ | 89 |   |

 

The Bank has adirectors’ retirement plan which provides retirement benefits primarily toformer members of the Board of Directors vested under the plan in accordancewith the plan document.  During theyears ended December 31, 2002, 2001, and 2000 the Bank accrued expenses relatedto the plan totaling $42,000, $42,000 and $39,000, respectively.

 

During 2000, theBank implemented a supplemental executive retirement plan that providesbenefits to certain key executive officers in accordance with the plandocument.  The Bank has funded this planthrough the purchase of $1 million in bank-owned life insurance.  During the years ended December 31, 2002,2001, and 2000, the Bank accrued expenses related to the plan totaling$149,000, $44,000 and $0, respectively.

 

**NOTE  11 - STOCK OPTION PLAN**

 

On May 15, 2002,the Company approved the 2002 Stock Incentive Plan.  Under this  plan,  150,000 shares of common stock are available to be granted at fair  market value.   At December 31, 2002,none of these shares had been granted.

 

32

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**NOTE 12 - INCOME TAXES**

 

The components ofthe provision for income taxes for the years ended December 31 are as follows:

 
|                           |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Currently payable tax          |   |     |   |     |   |     |   |
| Federal                        |   | $        | 332    |     | $      | 495      |   | $ | 411 |   |
| State                          |   | 104      |   | (12      | )      | —   |   |
| Deferred tax (benefit) expense |   | 242      |   | (23      | )      | (154     | )      |
|                           |   |     |   |     |   |     |   |
|                           |   | $        | 678    |     | $      | 460      |   | $ | 257 |   |

 

The balance sheetsincluded the following amounts of deferred tax assets and liabilities atDecember 31:

 
|                                              |   | **2002** |   | **2001** |   |
|---------------------------------------------------|--------|----------|--------|----------|--------|
| Deferred tax assets                               |   |     |   |     |   |
| Bad debt deduction                                |   | $        | 267    |     | $      | 228 |   |
| Pension plan                                      |   | 166      |   | 347      |   |
| Deferred compensation                             |   | 163      |   | 104      |   |
| Deferred loan fees                                |   | 8        |   | 10       |   |
| AMT carryforward                                  |   | 92       |   | 90       |   |
| Additional minimum pension  liability             |   | 137      |   | —   |   |
| Other                                             |   | 34       |   | 105      |   |
|                                              |   | 867      |   | 884      |   |
| Deferred tax liabilities                          |   |     |   |     |   |
| Unrealized gain on  securities available-for-sale |   | (1,251   | )      | (90      | )      |
| Depreciation                                      |   | (202     | )      | (90      | )      |
| Mortgage servicing rights                         |   | —   |   | (52      | )      |
| Federal Home Loan Bank  stock dividends           |   | (51      | )      | (32      | )      |
| Other                                             |   | (13      | )      | (4       | )      |
|                                              |   | (1,517   | )      | (268     | )      |
|                                              |   |     |   |     |   |
| Net deferred tax  asset(liability)                |   | $        | (650   | )        | $      | 616 |   |

 

No valuationallowance was required on deferred tax assets.

 

The differencebetween the financial statement provision and the amounts computed by applyingthe federal income tax rate of 34% to income before income taxes is reconciledas follows:

 

33

----

 
|                                         |   | **2002** |   | **2001** |   | **2000** |   |
|----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                         |   |     |   |     |   |     |   |
| Federal income tax expense at statutory rate |   | $        | 1,008  |     | $      | 875      |   | $ | 799 |   |
| Increase (decrease) in taxes resulting from  |   |     |   |     |   |     |   |
| Tax-exempt interest                          |   | (320     | )      | (452     | )      | (576     | )      |
| Nondeductible interest expense               |   | 35       |   | 59       |   | 84       |   |
| State income taxes and other items, net      |   | (45      | )      | (22      | )      | (50      | )      |
|                                         |   |     |   |     |   |     |   |
|                                         |   | $        | 678    |     | $      | 460      |   | $ | 257 |   |

 

**NOTE13 - DERIVATIVES**

 

The Company usesderivatives to fix future cash flows for interest payments on some of itsfloating rate certificates of deposit. In this regard, the Company has entered into an interest rate swap withthe Federal Home Loan Bank of Chicago to fix the interest rate on a specificcertificate of deposit product.  AtDecember 31, 2002, the Company had $2,029,000 of certificates of deposit, whichmature in 2006 and 2007, in which it pays the Federal Home Loan Bank a weightedaverage interest rate of 2.93% and will receive an interest rate from theFederal Home Loan Bank based on the appreciation of the S&P 500 Index.  This interest received from the Federal HomeLoan Bank will be paid to the customer. The assets and liabilities in this transaction are being netted and theexpense recorded in interest expense on deposits.

 

In addition to theabove, the Company also purchased $4,900,000 of certificates of deposit whichare included in the certificates of deposit caption on the consolidated balancesheet.  These investments maturethroughout 2006 and 2007.  Theinvestments that individually do not exceed $100,000 are secured by theFDIC.  Investments that do individuallyexceed $100,000 are guaranteed by a standby letter of credit issued by theFederal Home Loan Bank of Pittsburgh with an interest rate of 0%.  The initial investment is not at risk butthe return on the investment is based on a calculation of the appreciation inthe S&P 500 Index. The fair value of this embedded derivative is recordedin investment certificates of deposit and the fair value adjustment is includedin interest income.  At December 31,2002, the Bank had allocated $920,000 to this asset and recorded a valuationallowance of $151,000, which is classified with the certificates of depositcaption on the consolidated balance sheet.

 

34

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

 

There are variouscontingent liabilities that are not reflected in the consolidated financialstatements, including claims and legal actions arising in the ordinary courseof business.  In the opinion ofmanagement, after consultation with legal counsel, the ultimate disposition ofthese matters is not expected to have a material effect on financial conditionor results of operations.

 

At year-end 2002and 2001, reserves of $2,921,000 and $1,256,000 were required as deposits withthe Federal Reserve or as cash on hand. These reserves do not earn interest.

 

Some financialinstruments are used in the normal course of business to meet the financingneeds of customers.  These financialinstruments include commitments to extend credit, standby letters of credit,and financial guarantees.  Theseinvolve, to varying degrees, credit and interest-rate risk in excess of theamounts reported in the financial statements.

 

Exposure to creditloss if the other party does not perform is represented by the contractualamount for commitments to extend credit, standby letters of credit, andfinancial guarantees written.  The samecredit policies are used for commitments and conditional obligations as areused for loans.  Collateral or othersecurity is normally required to support financial instruments with creditrisk.

 

Commitments toextend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the commitment.  Commitments generally have fixed expirationdates or other termination clauses and may require payment of a fee.  Since many of the commitments are expectedto expire without being used, the total commitments do not necessarilyrepresent future cash requirements. Standby letters of credit and financial guarantees written areconditional commitments to guarantee a customer’s performance to a third party.

 

A summary of thenotional or contractual amounts of financial instruments with off-balance-sheetrisk at year end follows:

 
|                         |   | **2002** |   | **2001** |   |
|------------------------------|--------|----------|--------|----------|--------|
|                         |   |     |   |     |   |
| Commitments to extend credit |   | $        | — |     | $      | 99 |   |
| Unused lines of credit       |   | 12,590   |   | 11,971   |   |
| Standby letter of credit     |   | 361      |   | 342      |   |
|                              |        |          |        |          |        |  |  |

 

At December 31,2001, all of the commitments to extend credit were at variable rates ofinterest.

 

35

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**NOTE 15 - FAIR VALUES OF FINANCIALINSTRUMENTS**

 

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

 

The carryingvalues and estimated fair values of the Company’s financial instruments as ofDecember 31, 2002 and 2001 were as follows:

 
|                                                              |   | **2002**            |   | **2001**                   |   |
|-------------------------------------------------------------------|--------|---------------------|--------|----------------------------|--------|
|                                                              |   | **Carrying  Value** |   | **Estimated  Fair  Value** |   | **Carrying  Value** |   | **Estimated  Fair  Value** |   |
| Financial assets                                                  |   |                |   |                       |   |   |   |   |   |
| Cash and due from banks                                           |   | $                   | 8,606  |                       | $      | 8,606 |   | $ | 7,933 |   | $ | 7,933 |   |
| Certificates of deposit  and related derivative                   |   | 12,835              |   | 12,835                     |   | 3,172 |   | 3,172 |   |
| Securities  available-for-sale                                    |   | 98,885              |   | 98,885                     |   | 104,319 |   | 104,319 |   |
| Loans held for sale                                               |   | 1,811               |   | 1,811                      |   | 1,475 |   | 1,475 |   |
| Loans, net                                                        |   | 108,476             |   | 110,296                    |   | 106,924 |   | 107,974 |   |
| Due from broker                                                   |   | —              |   | —                     |   | 477 |   | 477 |   |
| Accrued interest  receivable                                      |   | 2,135               |   | 2,135                      |   | 2,325 |   | 2,325 |   |
|                                                              |   |                |   |                       |   |   |   |   |   |
| Financial liabilities                                             |   |                |   |                       |   |   |   |   |   |
| Deposits with no stated  maturities                               |   | (102,711            | )      | (102,711                   | )      | (70,686 | ) | (70,686 | ) |
| Time deposits and  securities sold under agreements to repurchase |   | (92,678             | )      | (94,896                    | )      | (125,430 | ) | (127,227 | ) |
| Federal funds purchased                                           |   | (14,700             | )      | (14,700                    | )      | (5,050 | ) | (5,050 | ) |
| Borrowings                                                        |   | (652                | )      | (655                       | )      | (4,200 | ) | (4,236 | ) |
| Accrued interest payable                                          |   | (999                | )      | (999                       | )      | (1,483 | ) | (1,483 | ) |
|                                                                   |        |                     |        |                            |        |  |  |  |  |  |  |  |  |

 

36

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**NOTE 16 - REGULATORY AND CAPITALMATTERS**

 

The Company maypay dividends without restriction under the current Federal Reserve regulationsso long as it remains “adequately capitalized” after such payment.  The Bank is subject to statutory dividendrestrictions which provide, in general, that the Bank may pay the currentyear’s earnings and the prior two years’ retained earnings without the priorapproval of the Office of the Comptroller of Currency (OCC).  The Bank requested and obtained approval ofthe OCC to pay a special dividend of $5,000,000 to the Company in 2000.  The Bank also requested and received priorapproval to pay up to $2,250,000 in other dividends during 2000.  Because of the extraordinary $5,000,000dividend paid in 2000, the Bank was required and received prior approval fromthe OCC to pay dividends in 2001 and 2002.

 

The Company andthe Bank are subject to various regulatory capital requirements administered bythe federal banking agencies.  Capitaladequacy guidelines and prompt corrective action regulations involvequantitative measures of assets, liabilities, and certain off-balance-sheetitems calculated under regulatory accounting practices.  Capital amounts and classifications are alsosubject to qualitative judgments by regulators about components, riskweightings, and other factors, and the regulators can lower classifications incertain cases.  Failure to meet variouscapital requirements can initiate regulatory action that could have a directmaterial effect on the financial statements.

 

The promptcorrective action regulations provide five classifications, including wellcapitalized, adequately capitalized, undercapitalized, significantlyundercapitalized, and critically undercapitalized, although these terms are notused to represent overall financial condition. If adequately capitalized, regulatory approval is required to acceptbrokered deposits.  If undercapitalized,capital distributions are limited, as is asset growth and expansion, and plansfor capital restoration are required.

 

The Company’s onlyactivity is ownership of the Bank, and, therefore, its capital, capital ratios,and minimum required levels of capital are materially the same as theBank’s.  At year end, actual capitallevels and minimum required levels for the Bank were:

 

37

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|                                     |   | **Actual** |   | **Minimum  Required  for Capital  Adequacy Purposes** |   | **Minimum  Required  to Be Well Capitalized  Under Prompt Corrective  Action Provisions** |   |
|------------------------------------------|--------|------------|--------|-------------------------------------------------------|--------|-------------------------------------------------------------------------------------------|--------|
|                                     |   | **Amount** |   | **Ratio**                                             |   | **Amount**                                                                                |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
| December 31, 2002                        |   |       |   |                                                  |   |                                                                                      |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $          | 23,542 |                                                  | 17.5   | %                                                                                         | $      | 10,786 |   | 8.0 | % | $ | 13,482 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 22,375     |   | 16.6                                                  |   | 5,393                                                                                     |   | 4.0 |   | 8,089 |   | 6.0 |   |
| Tier I capital (to average assets)       |   | 22,375     |   | 9.5                                                   |   | 9,473                                                                                     |   | 4.0 |   | 11,841 |   | 5.0 |   |
|                                     |   |       |   |                                                  |   |                                                                                      |   |   |   |   |   |   |   |
| December 31, 2001                        |   |       |   |                                                  |   |                                                                                      |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $          | 23,848 |                                                  | 18.6   | %                                                                                         | $      | 10,245 |   | 8.0 | % | $ | 12,807 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 22,739     |   | 17.6                                                  |   | 5,155                                                                                     |   | 4.0 |   | 7,733 |   | 6.0 |   |
| Tier I capital (to average assets)       |   | 22,739     |   | 10.1                                                  |   | 9,010                                                                                     |   | 4.0 |   | 11,263 |   | 5.0 |   |

 

At December 31,2002, the Company and the Bank were categorized as well capitalized andmanagement is not aware of any conditions or events since the most recentnotification that would change the Company’s or Bank’s category.

 

**NOTE 17 - OTHER COMPREHENSIVE INCOME**

 

Othercomprehensive income components and related taxes for the years ended are asfollows:

 
|                                                         |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Unrealized holding gains on securities  available-for-sale   |   | $        | 3,517  |     | $      | 1,136    |   | $ | 2,276 |   |
| Change in minimum pension liability                          |   | (354     | )      | —   |   | —   |   |
| Reclassification adjustments for gains recognized in  income |   | (102     | )      | (539     | )      | (11      | )      |
| Net unrealized gains                                         |   | 3,061    |   | 597      |   | 2,265    |   |
| Tax effect                                                   |   | (1,024   | )      | (203     | )      | (770     | )      |
|                                                         |   |     |   |     |   |     |   |
| Other comprehensive income                                   |   | $        | 2,037  |     | $      | 394      |   | $ | 1,495 |   |

 

38

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**NOTE 18 - PARENT COMPANY FINANCIALSTATEMENTS**

 

The following arethe condensed balance sheets and statements of income and cash flows for FirstOttawa Bancshares, Inc. without subsidiary.

 

Condensed balancesheets as of December 31 are as follows:

 
|                                            |   | **2002** |   | **2001** |   |
|-------------------------------------------------|--------|----------|--------|----------|--------|
| **ASSETS**                                      |   |     |   |     |   |
| Cash and due from banks                         |   | $        | 1,325  |     | $      | 6 |   |
| Investment in subsidiary                        |   | 25,450   |   | 23,074   |   |
| Dividends receivable                            |   | —   |   | 1,325    |   |
| Other assets                                    |   | 376      |   | 32       |   |
|                                            |   |     |   |     |   |
| Total assets                                    |   | $        | 27,151 |     | $      | 24,437 |   |
|                                            |   |     |   |     |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**  |   |     |   |     |   |
| Other liabilities                               |   | $        | — |     | $      | 5 |   |
| Loan payable                                    |   | 652      |   | 200      |   |
| Dividends payable                               |   | 1,316    |   | 1,325    |   |
| Shareholders’ equity                       |   | 25,183   |   | 22,907   |   |
|                                            |   |     |   |     |   |
| Total liabilities and shareholders’ equity |   | $        | 27,151 |     | $      | 24,437 |   |

 

Condensedstatements of income for the years ended December 31 are as follows:

 
|                                                   |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                   |   |     |   |     |   |     |   |
| Dividends from Bank                                    |   | $        | 2,034  |     | $      | 1,987    |   | $ | 7,075 |   |
| Other expenses                                         |   | 86       |   | 11       |   | 79       |   |
| Income tax benefit                                     |   | —   |   | —   |   | (30      | )      |
| Equity in (overdistributed) undistributed Bank  income |   | 339      |   | 137      |   | (4,934   | )      |
|                                                   |   |     |   |     |   |     |   |
| Net income                                             |   | $        | 2,287  |     | $      | 2,113    |   | $ | 2,092 |   |

 

39

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Condensedstatements of cash flows for the years ended December 31 are as follows:

 
|                                                                       |   | **2002** |   | **2001** |   | **2000** |   |
|----------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Cash flows from operating activities                                       |   |     |   |     |   |     |   |
| Net income                                                                 |   | $        | 2,287  |     | $      | 2,113    |   | $ | 2,092 |   |
| Adjustments to reconcile net income to net cash from  operating activities |   |     |   |     |   |     |   |
| Change in other assets and liabilities                                     |   | 976      |   | 4        |   | 145      |   |
| Equity in overdistributed (undistributed) Bank  income                     |   | (339     | )      | (137     | )      | 4,934    |   |
| Net cash from operating activities                                         |   | 2,924    |   | 1,980    |   | 7,171    |   |
|                                                                       |   |     |   |     |   |     |   |
| Cash flows from financing activities                                       |   |     |   |     |   |     |   |
| Loan proceeds                                                              |   | 452      |   | 200      |   | —   |   |
| Purchase of treasury stock                                                 |   | (74      | )      | (196     | )      | (5,000   | )      |
| Dividends paid                                                             |   | (1,983   | )      | (1,987   | )      | (2,162   | )      |
| Net cash from financing activities                                         |   | (1,605   | )      | (1,983   | )      | (7,162   | )      |
|                                                                       |   |     |   |     |   |     |   |
| Net change in cash and cash equivalents                                    |   | 1,319    |   | (3       | )      | 9        |   |
|                                                                       |   |     |   |     |   |     |   |
| Beginning cash and cash equivalents                                        |   | 6        |   | 9        |   | —   |   |
|                                                                       |   |     |   |     |   |     |   |
| Ending cash and cash equivalents                                           |   | $        | 1,325  |     | $      | 6        |   | $ | 9 |   |

 

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**NOTE19 - QUARTERLY FINANCIAL DATA (UNAUDITED)**

 
|              |   | **Interest  Income** |   | **Net  Interest  Income** |   | **Net  Income** |   | **Earnings  Per Share** |   |
|-------------------|--------|----------------------|--------|---------------------------|--------|-----------------|--------|-------------------------|--------|
|              |   |                 |   |                      |   |            |   |                    |   |
| 2002              |   |                 |   |                      |   |            |   |                    |   |
| First quarter     |   | $                    | 3,352  |                      | $      | 1,774           |   | $                       | 522    |   | $ | .79 |   |
| Second quarter    |   | 3,358                |   | 1,895                     |   | 483             |   | .73                     |   |
| Third quarter(a)  |   | 3,323                |   | 1,937                     |   | 661             |   | 1.00                    |   |
| Fourth quarter(b) |   | 3,059                |   | 1,753                     |   | 621             |   | .95                     |   |
|              |   |                 |   |                      |   |            |   |                    |   |
| 2001              |   |                 |   |                      |   |            |   |                    |   |
| First quarter     |   | $                    | 3,845  |                      | $      | 1,776           |   | $                       | 478    |   | $ | 0.72 |   |
| Second quarter    |   | 3,785                |   | 1,807                     |   | 445             |   | 0.67                    |   |
| Third quarter     |   | 3,713                |   | 1,783                     |   | 522             |   | 0.79                    |   |
| Fourth quarter(b) |   | 3,578                |   | 1,782                     |   | 668             |   | 1.01                    |   |

 

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(a)         Net income and earningsper share in the third quarter of 2002 were affected by the gains on sales ofsecurities and gains on proceeds from bank owned life insurance policy benefitspaid.

 

(b)        Net income and earningsper share in the fourth quarter of 2002 and 2001 were affected by the gains onsales of securities.

 

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ANNUAL MEETING

 

The Annual Meetingof Shareholders will be held at 3 p.m., local time on May 21, 2003 at thecorporate headquarters located at 701 LaSalle Street, Ottawa, Illinois 61350.

 

PRICE RANGE OFCOMMON STOCK

 

As of January 21,2003, there were approximately 550 shareholders of record and 656,956outstanding shares of common stock.

 

The Companyrepurchased 1,400 shares of its common stock at a price of $52 per share duringthe fourth quarter of 2002.

 

The Company’scommon stock is not traded on any national or regional securities exchange andthere is no established public trading market for it.  Transactions in the Company’s common stock have beeninfrequent.  To the knowledge of theCompany’s management, during 2001, 2002 and the first two months of 2003, anaggregate of approximately 177,643 shares of the Company’s common stock wastransferred in approximately 109 separate transactions, excluding the 3,925shares purchased by the Company in 2001 at $50 per share, and 1,400 sharespurchased by the Company in 2002 at $52 per share.  These transfers represented both transfers for consideration(i.e., sales) and transfers for no consideration (e.g., gifts, estatetransfers, etc.).  The Company’smanagement is unable to differentiate such transfers and has limited knowledgeof the sale prices for transfers involving consideration.  The last price known to the Company’smanagement was a sale of 1,000 shares on December 31, 2002 at $52 per share.

 

The followingtable sets forth dividends paid per share on the Company’s common stock on thedates indicated:

 
| **Date**        |   | **Dividends** |   |
|-----------------|--------|---------------|--------|
| January 1, 2001 |   | $             | 2.00   |   |
| July 1, 2001    |   | 1.00          |   |
| January 1, 2002 |   | 2.00          |   |
| July 1, 2002    |   | 1.00          |   |
| January 1, 2003 |   | 2.00          |   |
|                 |        |               |        |  |

 

ANNUAL REPORT

 

A copy of First OttawaBancshares, Inc.’s Annual Report on Form 10-K for the year ended December 31,2002 as filed with the Securities and Exchange Commission may be obtainedwithout charge by contacting Cheryl Gage, Corporate Secretary, First OttawaBancshares, Inc., 701-705 LaSalle Street, Ottawa, Illinois 61350.

 

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