**Exhibit 13.1**

 

*“I bought my first stock in 1942,and this roller coaster surpassed anything that I’ve seen. We didn’t do all thesmartest things. We didn’t do anything really dumb.” — Warren Buffet, WallStreet Journal, December 12, 2009.*

 

DearShareholders and Friends:

 

Youmay have read in the news that the “recession is over.”  That is technically true, since the economy,as measured by gross domestic product, is no longer receding.  But the point to which it has receded is atrough of very deep declines in our collateral values, and an upswing inborrowers who are no longer able to pay their bills, compounded by astronomicalincreases in the premiums we pay for deposit insurance.

 

“Weare all in the same boat” is one of my regular messages to our employees inperiodic meetings when we are updating everybody on what’s going on in thebank. I am usually using this to highlight specific performance in one sector,or a weakness in another. The historical separation of duties in a bank cancause a split in motivation among different groups. I also intend it to encompassall five constituencies we serve, the shareholders, communities, borrowers,depositors and employees.

 

Thatboat belongs to you, the shareholders. The analogy also fits the state of thecommunity banking industry.  When I lookat our financial reports, I see mediocrity, and this is not what we havepledged to you. When I look at our performance relative to our industry, I seethat our return on equity, at around 7.18% for the year, is nearly four timesour peer group average (1.82% ROE) of similarly sized Illinois banks. (Source: *UBPR custom peer group report, $100-500 million, Illinois, commercialsubchapter C banks, www.ffiec.gov*) We must conclude that whatstarted out as a “subprime” crisis has devolved into the worst communitybanking climate in living memory. Industry-wide, community banks rely heavilyon real estate collateral, as our bank does, and those values have declinednationally by 20-50% with erosion of values continuing.  Our regulators have expressed concern about possiblefurther declines in values of income-producing commercial real estate.  So our boat is navigating the same precariouswaters as all of these other community banks, 30% of which, in Illinois, hadactual operating losses in 2009.

 

So,in comparison, our performance looks really good, in the 80th percentile of banks like us in Illinois.However, our performance was not quite as pretty as it looks. As you will seefrom the accompanying statements, we had significant gains in investments in2009. These gains represent real earnings, and are great to have, especially ina year in which we were required to pay more for deposit insurance, and had toreserve more for future loan losses.   Butthis is not recurring income, and we cannot expect to duplicate these gainsregularly.

 

*“And so we missed the first waveof this banking crisis, but we have been touched by the second wave, as haveall banks of all sizes.  And a third waveis still likely to come.  This thirdwave, which will undoubtedly affect community banks, including our own, iscontinued lower interest rates which lowers our gross revenue, lessdebt-financed lending by fewer borrowers, unemployment and recession whichendangers the ability of our borrowers to repay, and the deprecation in valueof the safety net of our collateral, whether that is real estate, grain,equipment, consumer goods, or securities.” — First Ottawa Bancshares AnnualReport 2008.*

 

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Atyear end 2009, our past due loans increased to record levels, and higher thanour peer group. These loans (virtually all real estate related) involveborrowers who are unable to pay their interest when due. Many of these willprocess through foreclosure and migrate along our balance sheet from “otherreal estate” to eventual disposal, with losses and costs along the way. This isthe reason why we dramatically increased our reserve for loan losses this year,from $1,612,000 at year end of 2008 to $2,334,000 at year end of 2009, net oflosses posted during the year. Unfortunately, even as the growth of past dueloans subsides and recedes, the duration of the economic climate and realestate value depression will likely mean more and higher loan losses andreserves going forward. My informal survey of others in community bankingindicates that nobody expects 2010 to be any better that 2009, and it may beworse.

 

Ihave previously informed you of our FDIC premium expense for 2009, and thatthis insurance works the same as any other: when a disaster occurs, premiumsincrease. Because of the nature and depth of this disaster, we are facing muchhigher premiums on our deposit insurance for a much longer period of time, eventhough we remain in one of the lowest rate tiers, because of the strength ofthe bank.

 

Webelieve that the other aspects of risk management, including interest raterisk, transaction risk, compliance etc. are all in great shape.  Our overhead controls and funding costs arefunctioning well. In these areas, many efforts banks have been forced into(health insurance and pension cost cutting) we already tackled in goodyears.  And, at our core, our netinterest margin on earning assets acts as a wonderful shock absorber.

 

“Yeah,Ok, well, blah blah blah, what about my dividend?” Believe me, your board is asconcerned about the dividend and its perception as any of us.  And please remember that each of ourdirectors has a significant investment in the company as well.  Our commitment is to long term value for you,one element of which is current value distribution in the form of adividend.  That “long term” value maymean retaining earnings instead of distributing them as we did in 2009, and maydo in coming years.  Our “tier oneleverage” capital ratio is 8%.  Theregulatory minimum is 5%. In the industry, we all knew that 5% always meant 8%,and that with 8%, we could pay out or use capital however we saw fit.  In the wake of the banking crisis, the newcomfort level will be higher than 8%, and we need, for the long term health ofthe bank, to be prepared.  For the timebeing, our capital levels will be our primary focus.

 

*“Even though we avoided anyinvolvement in the “meltdown” by scrupulously adhering to these ethical bankingprinciples, we will not escape the aftermath, any more than we, in our bank andin community banking, escaped paying for the S&L crisis of the 1980s.  This is not a “subprime” or even a “mortgage”problem, but rather a complete breakdown in the assumptions and financialmodels that underpin the valuation and mobility of debt financing in the globaleconomy. So far, we have successfully navigated this minefield.” — First OttawaBancshares Annual Report 2008*

 

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Besidesthe distribution of current earnings in the form of a dividend, another measureof shareholder value is the retention of earnings.  Any earnings not distributed are retained,with a consequent increase in book value and reinvestment in the bank. Theseearnings not distributed, representing $1.30 per share in 2009, satisfy a partof our requirement to enhance shareholder value, while balancing the needs foradditional capital going forward.

 

Ithrew out my crystal ball several years ago, as the Federal Reserve manipulatedinterest rates. So I don’t have one, now that we need it for 2010 andthereafter.  The experts can’t decide ifthis recession has a double dip, is v-shaped, u-shaped, or w-shaped; they alsocan’t decide if rates are going up, when, and how far.  With respect to interest rates, we try toremain as neutral as possible.  I canpredict that as far as our non-performing assets are concerned, we will continueto take steps intended to reduce them and their effect on our earnings in aprompt, judicious, and prudent manner.

 
| Very Truly Yours,                            |   |   |
|----------------------------------------------|--------|--------|
|                                         |   |   |
| /s/ Joachim J. Brown                         |   |   |
|                                         |   |   |
| Joachim J. Brown                             |   |   |
| President & Chief Executive Officer |   |   |

 

*“We don’t know where the nextcrisis is going to come from.  We won’tbe able to foresee it.  We’re not goingto pre-empt all future bubbles.  So wewant to build a much bigger cushion into the system against those basic humanlimitations. I don’t want a system that depends on clairvoyance orbravery.  The top three things to getdone are capital, capital, and capital.” — Treasury Secretary Timothy Geitner,New York Times, March 28, 2010.*

 

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FIRST OTTAWA BANCSHARES,INC. AND SUBSIDIARY

Ottawa,Illinois

 

CONSOLIDATED FINANCIALSTATEMENTS

December 31, 2009and 2008

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARY

Ottawa, Illinois

 

CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2009 and 2008

 

INDEX

 
| SELECTED CONSOLIDATED FINANCIAL INFORMATION                                                  | 1      |
|----------------------------------------------------------------------------------------------|--------|
|                                                                                         |   |
| MANAGEMENT’ S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND  RESULTS OF OPERATIONS | 2      |
|                                                                                         |   |
| REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM                                      | 14     |
|                                                                                         |   |
| FINANCIAL STATEMENTS                                                                         |   |
|                                                                                         |   |
| CONSOLIDATED BALANCE  SHEETS                                                                 | 15     |
|                                                                                         |   |
| CONSOLIDATED STATEMENTS OF  INCOME                                                           | 16     |
|                                                                                         |   |
| CONSOLIDATED STATEMENTS OF  SHAREHOLDERS’ EQUITY                                        | 17     |
|                                                                                         |   |
| CONSOLIDATED STATEMENTS OF  CASH FLOWS                                                       | 18     |
|                                                                                         |   |
| NOTES TO CONSOLIDATED  FINANCIAL STATEMENTS                                                  | 19     |

 

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**SELECTED CONSOLIDATED FINANCIAL INFORMATION**

 

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

 
| ** **                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **2009**                         | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Statement of Income Data:**                                               |       |                             |       |   |   |   |   |   |   |   |   |
| Total interest income                                                       |       | $                                | 12,372     |   | $ | 13,961 |   | $ | 15,231 |   | $ | 15,274 |   | $ | 14,164 |   |
| Total interest expense                                                      |       | 3,237                            |       | 4,807 |   | 6,282 |   | 6,361 |   | 4,613 |   |
| Net interest income                                                         |       | 9,135                            |       | 9,154 |   | 8,949 |   | 8,913 |   | 9,551 |   |
| Provision for loan losses                                                   |       | 1,330                            |       | 170 |   | 180 |   | 180 |   | 300 |   |
| Noninterest income                                                          |       | 3,416                            |       | 1,044 |   | 2,349 |   | 2,430 |   | 2,586 |   |
| Noninterest expenses                                                        |       | 8,908                            |       | 7,740 |   | 7,934 |   | 8,075 |   | 8,501 |   |
| Income before income taxes                                                  |       | 2,313                            |       | 2,288 |   | 3,184 |   | 3,088 |   | 3,336 |   |
| Provision for income taxes                                                  |       | 479                              |       | 435 |   | 769 |   | 753 |   | 791 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| Net income                                                                  |       | $                                | 1,834      |   | 1,853 |   | $ | 2,415 |   | $ | 2,335 |   | $ | 2,545 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Per Share Data:**                                                         |       |                             |       |   |   |   |   |   |   |   |   |
| Net income – basic                                                     |       | $                                | 2.84       |   | 2.87 |   | $ | 3.72 |   | $ | 3.59 |   | $ | 3.92 |   |
| Net income – diluted                                                   |       | 2.83                             |       | 2.86 |   | 3.71 |   | 3.59 |   | 3.90 |   |
| Cash dividends declared                                                     |       | 1.54                             |       | 3.00 |   | 3.00 |   | 3.00 |   | 3.00 |   |
| Book value at end of year (1)                                               |       | 40.14                            |       | 38.60 |   | 38.72 |   | 38.08 |   | 37.43 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Selected Financial Ratios:**                                              |       |                             |       |   |   |   |   |   |   |   |   |
| Return on average assets (1)                                                |       | .64                              | %          | .67 | % | .87 | % | .82 | % | .87 | % |
| Return on average equity (1)                                                |       | 7.18                             |       | 7.32 |   | 9.58 |   | 9.43 |   | 10.50 |   |
| Dividend payout ratio                                                       |       | 54.24                            |       | 104.40 |   | 80.65 |   | 83.57 |   | 76.53 |   |
| Average equity to average assets (1)                                        |       | 8.96                             |       | 9.11 |   | 9.09 |   | 8.71 |   | 8.30 |   |
| Net interest margin (tax equivalent)                                        |       | 3.88                             |       | 3.91 |   | 3.78 |   | 3.63 |   | 3.80 |   |
| Allowance for loan losses to total loans at the end  of period              |       | 1.56                             |       | 1.01 |   | .96 |   | .91 |   | .88 |   |
| Nonperforming loans to total loans at the end of  period (2)                |       | 6.29                             |       | 1.92 |   | .76 |   | .42 |   | .87 |   |
| Net loans charged off to average total loans                                |       | .41                              |       | .09 |   | .03 |   | .04 |   | .09 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                                     |       |                             |       |   |   |   |   |   |   |   |   |
| Total assets                                                                |       | $                                | 283,701    |   | $ | 275,181 |   | $ | 269,231 |   | $ | 278,053 |   | $ | 278,739 |   |
| Total earning assets                                                        |       | 243,366                          |       | 236,287 |   | 243,718 |   | 253,259 |   | 253,641 |   |
| Average assets                                                              |       | 285,055                          |       | 275,772 |   | 275,777 |   | 282,729 |   | 290,765 |   |
| Gross loans, including loans held for sale                                  |       | 149,485                          |       | 159,592 |   | 165,805 |   | 160,938 |   | 152,860 |   |
| Allowance for loan losses                                                   |       | 2,334                            |       | 1,612 |   | 1,588 |   | 1,463 |   | 1,344 |   |
| Total deposits                                                              |       | 251,229                          |       | 240,730 |   | 240,377 |   | 250,341 |   | 239,881 |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | —                           |       | — |   | — |   | — |   | 12,700 |   |
| Shareholders’ equity                                                   |       | 25,978                           |       | 24,669 |   | 24,606 |   | 23,509 |   | 22,858 |   |

 

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

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

 

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**MANAGEMENT’SDISCUSSION AND ANALYSIS**

**OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

** **

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

 

# **Overview**

 

The Company’sprincipal business is conducted by the Bank and consists of a full range ofcommunity–based financial services, including commercial and 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 betweenthe income the Company receives on its loan and securities portfolios and itscost 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 ondeposit accounts, trust and farm management fee income, securities gains(losses), gains (losses) on sales of loans, and other income.  Other expenses include salaries and employeebenefits, as well as occupancy and equipment expenses and other noninterestexpenses.

 

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

 

Net income was$1.8 million for the year ended December 31, 2009 compared to $1.9 millionfor the year ended December 31, 2008. The return on average assets was .64% in 2009 compared to .67% in 2008.  The return on average equity decreased to7.18% in 2009 from 7.32% in 2008.  Thisresulted primarily from an increase in other comprehensive income of $273,000in 2009, causing an increase in average equity. In addition, net incomedecreased by $19,000 in 2009 compared to 2008.

 

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# **CriticalAccounting Policies**

 

The accounting andreporting policies of the Company are in accordance with accounting principlesgenerally accepted in the United States of America and conform to generalpractices within the banking industry.  The Company’s significantaccounting policies are described in detail in the notes to the Company’sconsolidated financial statements.  Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions.  The Company’sfinancial condition and results of operations can be affected by theseestimates and assumptions and are integral to the understanding of reportedresults. Critical accounting policies are those policies that managementbelieves are the most important to the portrayal of the Company’s financialcondition and results of operations, and they require management to makeestimates that are difficult, subjective, or complex.

 

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

 

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

 

Regardless of theextent of the Company’s analysis of customer performance, portfolio trends orrisk management processes, certain inherent but undetected losses are probablewithin the loan portfolio.  This is dueto several factors, including inherent delays in obtaining informationregarding a customer’s financial condition or changes in the customer’s uniquebusiness conditions, the judgmental nature of individual loan evaluations,collateral assessments and the interpretation of economic trends.  Volatility of economic or customer–specificconditions affecting the identification and estimation of losses for larger non—homogeneouscredits and the sensitivity of assumptions utilized to establish allowances forhomogenous groups of loans are among other factors.  The Company estimates a range of inherentlosses related to the existence of these exposures.  The estimates arebased upon the Company’s evaluation of imprecise risk associated with thecommercial and consumer allowance levels and the estimated impact of thecurrent economic environment.

 

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***MortgageServicing Rights.*** Mortgage servicing rights (“MSRs”) associated with loans originatedand sold, where servicing is retained, are capitalized and included in otherintangible assets in the consolidated balance sheet.  The value of the capitalized MSRs representsthe present value of the future servicing fees arising from the right toservice loans in the portfolio.  Criticalaccounting policies for MSRs relate to the initial valuation and subsequentimpairment tests.  The methodology usedto determine the valuation of MSRs requires the development and use of a numberof estimates, including anticipated principal amortization and prepayments ofthat principal balance.  Events that maysignificantly affect the estimates used are changes in interest rates, mortgageloan prepayment speeds and the payment performance of the underlyingloans.  The carrying value of the MSRs isperiodically reviewed for impairment based on a determination of fair value.  For purposes of measuring impairment, theservicing rights are compared to a valuation prepared based on a discountedcash flow methodology, utilizing current prepayment speeds and discountrates.  Impairment, if any, is recognizedthrough a valuation allowance and is recorded as amortization of intangible assets.

 

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

 

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

 

***Stock Compensation***. Grants under the Company’s stockincentive plan are accounted for by applying the fair value method and the useof an option pricing model to estimate the value of the options granted. Thestock options are granted with an exercise price equal to the market price atthe date of grant. Resulting compensation expense relating to the stock optionsis measured and recorded based on the estimated value of the options.

 

***Valuation Measurements.***  Valuation methodologies ofteninvolve a significant degree of judgment, particularly when there are noobservable active markets for the items being valued. Investment securities andderivatives are carried at fair value, as defined in FASB ASC Topic 820, whichrequires key judgments affecting how fair value for such assets and liabilitiesis determined. In addition, the outcomes of valuations have a direct bearing onthe carrying amounts of goodwill, mortgage servicing rights, and pension andother postretirement benefit obligations. To determine the values of theseassets and liabilities, as well as the extent to which related assets may beimpaired, management makes assumptions and estimates related to discount rates,asset returns, prepayment rates and other factors. The use of differentdiscount rates or other valuation assumptions could produce significantlydifferent results, which could affect the Company’s results of operations.

 

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***Goodwill******.***  Under FASB ASC Topic 350, the Company isrequired to evaluate goodwill for impairment on an annual basis or wheneverevents or changes in circumstances indicate that the carrying value may not berecoverable. The Company has elected to test for goodwill impairment as ofDecember 31 ofeach year. The Company cannot predict the occurrence of certain future eventsthat might adversely affect the reported value of goodwill. Such eventsinclude, but are not limited to, strategic decisions made in response toeconomic and competitive conditions, the effect of the economic environment onthe Company’s customer base, or a material negative change in its relationshipwith significant customers.

 

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**ConsolidatedFinancial Condition**

 

Total assets at December 31,2009 were $283.7 million compared to $275.2 million at December 31, 2008,an increase of $8.5 million, or 3.1%. Despite the increase in our total assets, our net loans decreased 6.7%in 2009 to $147.2 million.  Commercialand residential real estate loans decreased by $8.8  million during 2009, due to an effort bymanagement to maintain credit quality during a period of decreasingdemand.  In addition to the decreases incommercial and residential real estate loans, installment loans decreased by$1.1 million due to a general decline in indirect lending volume and morestringent underwriting guidelines on consumer loans.  Commercial and agricultural loans increased$1.2 million during 2009, partially offsetting the decreased volume in realestate loans. Investment securities decreased by $1.5 million, and certificatesof deposit held for investment purposes increased by $26.2 million.  The increase in certificates of deposit heldfor investment purposes was funded by the decrease in loans and investmentsecurities. Cash and cash equivalents decreased $8.6 million to $17.9 million,as management attempted to deploy excess balances at the Federal Reserve Bankwhile remaining liquid through the end of 2009. Deposits increased by $10.5 million, to $251.2 million at December 31,2009, compared to $240.7 million in the prior year. Premises and equipmentincreased by $286,000 due to the purchase of a building with the intent torelocate an existing branch in Streator, Illinois. The Company has submitted anapplication with the Office of the Comptroller of Currency and receivedapproval to relocate the branch located at 401 East Main Street in Streator,Illinois, to 409 East Bridge Street in Streator Illinois. This relocation wouldbe considered a short distance relocation as defined in 12 CFR 5.3(i).

 

Total shareholders’equity was $26.0 million at December 31, 2009 and $24.7 million at December 31,2008.  This was primarily the result of adecrease in the unrealized loss on securities available–for–sale, net of tax,of $162,000, and $186,000 in additional paid in capital related to the Company’sstock option plan.  Dividends declared of$994,000 were offset by net income of $1.8 million.

 

# **ConsolidatedResults of Operations**

 

# **2009Compared to 2008**

 

*NetInterest Income.*  Net interest income was $9.1 million in 2009and $9.2 million in 2008.  Interestincome on earning assets decreased $1.6 million in 2009 from 2008.  This decrease was primarily attributable todecreased interest income earned on the loan portfolio of $1.7 million, taxablesecurities of $246,000, and federal funds sold of $168,000.  Increased interest income earned oncertificates of deposit held for investment of $477,000, and tax exemptsecurities of $56,000, helped to offset the decreased loan and securitiesincome.  The decrease is attributable todecreases in average balances and also average yields available in themarketplace in 2009.  Interest expense oninterest–bearing liabilities decreased $1.6 million as a result of a decreasein the average cost of funds in 2009 compared to 2008.  The net interest margin on a tax equivalentbasis decreased to 3.88% in 2009 from 3.91% in 2008.  The primary reason for the decrease in thenet interest margin was the result of a decrease in the market rates earned onassets during the current year.

 

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*Provisionfor Loan Losses.*  The provision for loan losses was $1.3million in 2009 compared to $170,000 in 2008. As of December 31, 2009, the allowance for loan losses totaled $2.3million, or 1.56% of total loans, compared to $1.6 million, or 1.01% of totalloans, at December 31, 2008.  Theincrease in the allowance for loan losses in 2009 was influenced by the currenteconomy, increased delinquencies, increased non-performing loans, and theassessment of risk factors affecting our loan portfolio.

 

The amounts of theprovision and allowance for loan losses are influenced by current economicconditions, actual loss experience, industry trends and other factors,including real estate values in the Company’s market area and management’sassessment of current collection risks within the loan portfolio.  Along with other financial institutions,management shares a concern for the outlook of the economy for 2010.  Even though there are indications of emergingstrength, it is uncertain if this strength is sustainable. If it is notsustainable, borrowers may experience difficulty, and the level of non–performingloans, charge-offs, and delinquencies could rise and require increases in theprovision.  Regulatory agencies havewarned of possible higher charge-offs in the industry.  The allowance for loan losses representsmanagement’s estimate of probable incurred losses based on informationavailable as of the date of the financial statements.  The allowance for loan losses is based onmanagement’s evaluation of the collectibility of the loan portfolio, includingpast loan loss experience, known and inherent risks in the nature and volume ofthe portfolio, information about specific borrower situations and estimatedcollateral values, and economic conditions.

 

Management has concluded that the allowance for loanlosses was adequate at December 31, 2009. However, there can be no assurance that the allowance for loan losseswill be adequate to cover all losses.

 

*NoninterestIncome.*  The Company’s noninterest income increased$2.4 million, or 227.2%, compared to 2008. Noninterest income increased primarily due to $979,000 of gains realizedon the sale of investment securities in 2009, compared to 2008 impairmentlosses realized on equity security investments of $647,000. The marketadjustment for the index powered certificates of deposit in the current yeardecreased $5,000, compared to a loss of $401,000, in the prior year.  Service charges on deposit accounts decreasedby $9,000, or 1.1%, to $843,000 due to decreased overdraft volume in 2009compared to 2008.  Gains on loan sales tothe secondary market increased $374,000 to $432,000 in 2009 compared to 2008 asa result of increased originations of residential real estate loans because ofthe general decrease in interest rates in 2009. Trust and farm management feeincome decreased slightly to $503,000 in 2009 from $540,000 in 2008.

 

*Noninterest Expense.*  The Company’snoninterest expense was $8.9 million in 2009 and $7.7 million for 2008.  Salaries and employeebenefits, which is the largest component of noninterest expense, increased$345,000, to $4.6 million in 2009.  Increases in data processing expense of $5,000,insurance expense of $510,000, other expense of $345,000, and professional feesof $65,000 were partially offset by a decrease in occupancy and equipmentexpense of $85,000, and decreased amortization of core deposit intangibleexpense of $17,000 in 2009.  Insuranceexpense increased dramatically in 2009 due to a $526,000 increase in FDICinsurance premiums compared to 2008.  Thisincrease was primarily the result of industry-wide increases as the FDIC increasedits deposit insurance fund that has been depleted from the high level of bankfailures in 2009. Other expense increased due to expenses incurred as a resultof the increase in 

 

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other real estate owned of $139,000, increased losseson the sale of other real estate owned of $19,000, increased directors lifeinsurance expense of $117,000, and increased amortization of mortgage servicingasset of $84,000 during 2009.

 

*IncomeTaxes.*  Income tax expense increased by $44,000compared to 2008.  The Company’seffective tax rate increased slightly in 2009. The Company’s tax rate variedfrom statutory rates principally due to interest income from tax–exemptsecurities and loans.  The Company’seffective tax rate was 20.71% and 19.01% for 2009 and 2008, respectively.

 

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

 

Analysis ofChanges in Interest Income and Expense

($000s)

 
| ** **                                             | ** ** | **2009 - 2008**         | ** ** | **2008 — 2007**    | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                             | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                             | ** ** | ** **              | ** ** | **Change**              | ** ** | **Change** | ** ** | ** ** | ** ** | **Change** | ** ** | **Change** | ** ** |
| ** **                                             | ** ** | **Total**               | ** ** | **Due to**              | ** ** | **Due to** | ** ** | **Total** | ** ** | **Due to** | ** ** | **Due to** | ** ** |
| ** **                                             | ** ** | **Change**              | ** ** | **Volume**              | ** ** | **Rate** | ** ** | **Change** | ** ** | **Volume** | ** ** | **Rate** | ** ** |
| INTEREST INCOME                                        |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
|                                                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| Loans                                                  |       | $                       | (1,700     | )                       | $          | (777 | ) | $ | (923 | ) | $ | (1,012 | ) | $ | 60 |   | $ | (1,072 | ) |
| Investment CDs                                         |       | 477                     |       | 590                     |       | (113 | ) | 321 |   | 282 |   | 39 |   |
| Securities                                             |       | (162                    | )          | (6                      | )          | (156 | ) | (327 | ) | (470 | ) | 143 |   |
| Federal funds sold                                     |       | (201                    | )          | (18                     | )          | (183 | ) | (146 | ) | 39 |   | (185 | ) |
| Total interest income                                  |       | (1,586                  | )          | (211                    | )          | (1,375 | ) | (1,164 | ) | (89 | ) | (1,075 | ) |
|                                                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| INTEREST EXPENSE                                       |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
|                                                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| NOW and money market                                   |       | (617                    | )          | 74                      |       | (691 | ) | (1,206 | ) | (37 | ) | (1,169 | ) |
| Savings                                                |       | (34                     | )          | 5                       |       | (39 | ) | (9 | ) | (3 | ) | (6 | ) |
| Time deposits                                          |       | (874                    | )          | (336                    | )          | (538 | ) | (335 | ) | (10 | ) | (325 | ) |
| Repurchase agreements                                  |       | (1                      | )          | —                  |       | (1 | ) | 1 |   | 1 |   | — |   |
| Borrowings                                             |       | (43                     | )          | (44                     | )          | 1 |   | 173 |   | 173 |   | — |   |
| Federal funds purchased                                |       | —                  |       | 1                       |       | (1 | ) | (99 | ) | (61 | ) | (38 | ) |
| Total interest expense                                 |       | (1,569                  | )          | (301                    | )          | (1,268 | ) | (1,475 | ) | 63 |   | (1,538 | ) |
|                                                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| Net interest earnings                                  |       | (17                     | )          | 90                      |       | (107 | ) | 311 |   | (152 | ) | 463 |   |
| Tax equivalent adjustment                              |       | (2                      | )          |                    |       | (2 | ) | (106 | ) | — |   | (106 | ) |
|                                                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| Net interest earnings after tax equivalent  adjustment |       | $                       | (19        | )                       | 90         |   | (109 | ) | 205 |   | $ | (152 | ) | $ | 357 |   |
|                                                        |            |                         |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

# **Interest–Earning Assets and Interest–BearingLiabilities**

 

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

 

8

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

Years Ended December 31,2009, 2008 and 2007

(in Thousands)

 
| ** **                                                                | ** ** | **2009**        | ** ** | **2008**     | ** ** | **2007**    | ** ** |
|---------------------------------------------------------------------------|------------|-----------------|------------|--------------|------------|-------------|------------|
| ** **                                                                | ** ** | **Average**     | ** ** | ** **   | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                                | ** ** | **Balance (4)** | ** ** | **Interest** | ** ** | **Rate**    | ** ** | **Balance (4)** | ** ** | **Interest** | ** ** | **Rate** | ** ** | **Balance (4)** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| ASSETS                                                                    |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1) (3)                                                        |       | $               | 148,967    |         | $          | 9,280       |       | 6.23 | % | $ | 161,440 |   | $ | 10,980 |   | 6.80 | % | $ | 160,565 |   | $ | 11,992 |   | 7.47 | % |
| Investment CDs                                                            |       | 35,250          |       | 974          |       | 2.76        |       | 13,883 |   | 497 |   | 3.58 |   | 6,017 |   | 176 |   | 2.93 |   |
| Securities (2) (5)                                                   |       | 65,300          |       | 2,703        |       | 4.14        |       | 65,447 |   | 2,865 |   | 4.38 |   | 76,180 |   | 3,192 |   | 4.19 |   |
| Federal funds sold                                                        |       | 849             |       | 2            |       | .24         |       | 8,545 |   | 203 |   | 2.38 |   | 6,891 |   | 349 |   | 5.06 |   |
| Interest—earning assets                                              |       | 250,366         |       | 12,959       |       | 5.18        |       | 249,315 |   | 14,545 |   | 5.83 |   | 249,653 |   | 15,709 |   | 6.29 |   |
| Noninterest—earning assets (6)                                       |       | 34,689          |       |         |       |        |       | 26,457 |   |   |   |   |   | 23,297 |   |   |   |   |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Average assets                                                            |       | $               | 285,055    |         |       |        |       |   | $ | 275,772 |   |   |   |   |   | $ | 272,950 |   |   |   |   |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                 |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money market                                                      |       | $               | 116,570    |         | $          | 400         |       | .34 | % | $ | 95,138 |   | $ | 1,017 |   | 1.07 | % | $ | 98,592 |   | $ | 2,223 |   | 2.25 | % |
| Savings                                                                   |       | 24,118          |       | 81           |       | .34         |       | 22,739 |   | 115 |   | .51 |   | 23,418 |   | 124 |   | .53 |   |
| Time deposits                                                             |       | 80,426          |       | 2,626        |       | 3.27        |       | 90,715 |   | 3,500 |   | 3.86 |   | 90,970 |   | 3,835 |   | 4.22 |   |
| Repurchase agreements                                                     |       | —          |       | —       |       |        |       | 76 |   | 1 |   | 1.32 |   | — |   | — |   | — |   |
| Federal funds purchased                                                   |       | 208             |       | 1            |       | .48         |       | 29 |   | 1 |   | 3.45 |   | 1,798 |   | 100 |   | 5.56 |   |
| Borrowings                                                                |       | 4,148           |       | 130          |       | 3.13        |       | 5,557 |   | 173 |   | 3.11 |   | — |   | — |   | — |   |
| Interest–bearing liabilities                                         |       | 225,470         |       | 3,238        |       | 1.44        |       | 214,254 |   | 4,807 |   | 2.24 |   | 214,778 |   | 6,282 |   | 2.92 |   |
| Net interest income (2)                                                   |       |            |       | 9,721        |       |        |       |   |   | 9,738 |   |   |   |   |   | 9,427 |   |   |   |
| Net yield on interest–earning assets                                 |       |            |       |         |       | 3.88        |       |   |   |   |   | 3.91 |   |   |   |   |   | 3.78 |   |
| Interest–bearing liabilities to earning assets ratio                 |       |            |       |         |       | 90.06       |       |   |   |   |   | 85.94 |   |   |   |   |   | 86.03 |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest–bearing liabilities                                      |       | 34,035          |       |         |       |        |       | 36,544 |   |   |   |   |   | 33,927 |   |   |   |   |   |
|                                                                      |       |            |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                                                 |       | 25,550          |       |         |       |        |       | 24,974 |   |   |   |   |   | 24,245 |   |   |   |   |   |
| Average liabilities and shareholders’ equity                         |       | $               | 285,055    |         |       |        |       |   | $ | 275,722 |   |   |   |   |   | $ | 272,950 |   |   |   |   |   |
| Tax equivalent adjustment                                                 |       |            |       | 586          |       |        |       |   |   | 584 |   |   |   |   |   | 478 |   |   |   |
| Net interest income as reported in the consolidated  statements of income |       |            |       | $            | 9,135      |        |       |   |   |   | $ | 9,154 |   |   |   |   |   | $ | 8,949 |   |   |   |

 

----

(1)          Interest income on loans includes loanorigination and other fees of $292 for 2009, $301 for 2008, and $403 for 2007.

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

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

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

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

(6)          Average balance information includes an averagevaluation allowance for securities of $(208) , $(523) and $(1,444),respectively.

 

9

----

 

**QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

TheCompany uses overall risk sensitivity to monitor and manage exposure to suddenchanges in interest rates.  The Company’soverall interest rate sensitivity is demonstrated by a net interest incomeanalysis.  Net interest income analysismeasures the change in net interest income in the event of hypothetical changesin interest rates.  This analysisassesses the risk of change in net income in the event of sudden and sustained1.0% increases and decreases in market interest rates.  The tables below present the Company’sprojected changes in net income for the various rate shock levels for theperiods ended December 31, 2009 and 2008.

 
| ** **   | ** ** | **2009 Net Income**         | ** ** |
|--------------|------------|-----------------------------|------------|
| ** **   | ** ** | **Amount**                  | ** ** | **Change** | ** ** | **Percentage  Change** | ** ** |
| ** **   | ** ** | **(Dollars  in Thousands)** | ** ** |
| ** **   | ** ** | ** **                  | ** ** |
| +100 bp      |       | $                           | 1,746      |   | $ | 26 |   | 1.6 | % |
| Base         |       | 1,720                       |       |   |   |   |   |
| –100 bp |       | 1,338                       |       | (382 | ) | (22.2 | )% |
|              |            |                             |            |  |  |  |  |  |  |

 
| ** **   | ** ** | **2008 Net Income**         | ** ** |
|--------------|------------|-----------------------------|------------|
| ** **   | ** ** | **Amount**                  | ** ** | **Change** | ** ** | **Percentage  Change** | ** ** |
| ** **   | ** ** | **(Dollars  in Thousands)** | ** ** |
| ** **   | ** ** | ** **                  | ** ** |
| +100 bp      |       | $                           | 2,664      |   | $ | 32 |   | 1.2 | % |
| Base         |       | 2,632                       |       | — |   | — |   |
| –100 bp |       | 2,570                       |       | (62 | ) | (2.3 | )% |
|              |            |                             |            |  |  |  |  |  |  |

 

Asshown above, at December 31, 2009, the effect of an immediate 100 basispoint increase in interest rates would increase the Company’s net income by1.6%, or approximately $26,000.  Theeffect of an immediate 100 basis point decrease in rates would decrease theCompany’s net interest income by 22.2%, or approximately $382,000.  The Company’s Board of Directors has set arisk tolerance limit of 10% of estimated net interest income for the succeeding12 months based on an immediate 200 basis point change in market prices.  Federal funds overnight rates were under 1.0%as of December 31, 2009, therefore market interest rates decreasing anadditional 100 basis points may not be achievable in today’s rate environment.

 

Interestrate sensitivity reflected exposure in a decreasing rate environment at the endof 2009 and 2008.  Overall net interestincome sensitivity increased slightly in 2009 compared to 2008.

 

10

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**Liquidityand Capital Resources**

 

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

 

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

 

TheCompany’s cash flows are comprised of three primary classifications:  cash flows from operating activities,investing activities, and financing activities. Cash flows provided by operating activities were $1.7 million, and $3.9million, for the years ended December 31, 2009, and 2008.  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 and short–termborrowings partially offset by dividends paid and the purchase of Companystock.

 

TheCompany’s most liquid assets are cash and due from banks.  The levels of these assets are dependent onthe Company’s operating, financing, lending, and investing activities duringany given year.  At December 31,2009, cash and short–term investments totaled $17.9 million.  The Company has other sources of liquidity ifa need for additional funds arises, including securities maturing within oneyear and the repayment of loans.  TheCompany may also utilize the sale of securities available–for–sale, federalfunds lines of credit from correspondent banks, and borrowings from the FederalHome Loan Bank of Chicago.

 

11

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Thefollowing table discloses contractual obligations and commercial commitments ofthe Company as of December 31, 2009:

 
|                             |   | **Total** |   | **Less  Than  1 Year** |   | **1 – 3  Years** |   | **3 – 5  Years** |   | **After  5 Years** |   |
|----------------------------------|--------|-----------|--------|------------------------|--------|-----------------------|--------|-----------------------|--------|--------------------|--------|
|                             |   |      |   |                   |   |                  |   |                  |   |               |   |
| Lines of credit(1)               |   | $         | 12,165 |                   | $      | 6,821                 |   | $                     | 2,400  |               | $      | 553 |   | $ | 2,391 |   |
| Data processing contract payable |   | 835       |   | 223                    |   | 445                   |   | 167                   |   | —             |   |
| FHLB Advances                    |   | 4,000     |   | 2,000                  |   | 2,000                 |   | —                |   | —             |   |
| Standby letters of credit(1)     |   | 472       |   | 248                    |   | 224                   |   | —                |   | —             |   |
|                             |   |      |   |                   |   |                  |   |                  |   |               |   |
|                             |   | $         | 17,472 |                   | $      | 9,292                 |   | $                     | 5,069  |               | $      | 720 |   | $ | 2,391 |   |

 

----

(1) Represents amounts committed to customers.

 

During2009, the Company did not repurchase any stock. During 2008, the Companyrepurchased 2,526 shares of common stock for $197,000.

 

Capitalprovides the foundation for future growth. Regulatory agencies have developed minimum guidelines by which theadequacy of a financial institution’s capital may be evaluated.  At December 31, 2009, all of the Company’sratios exceeded the levels required under regulatory guidelines as shown inNote 16 of the Consolidated Financial Statements.

 

**Facilities**

 

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

 

The Company hassubmitted an application with the Office of the Comptroller of Currency andreceived approval to relocate the branch located at 401 East Main Street inStreator, Illinois, to 409 East Bridge Street in Streator Illinois. Thisrelocation would be considered a short distance relocation as defined in 12 CFR5.3(i).

 

**Impact ofInflation and Changing Prices**

 

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

 

12

----

 

**SAFEHARBOR STATEMENT**

 

Thisdocument (including information incorporated by reference) contains, and futureoral and written statements of the Company and its management may contain,forward-looking statements, within the meaning of such term in the PrivateSecurities Litigation Reform Act of 1995, with respect to the financial condition,results of operations, plans, objectives, future performance and business ofthe Company.  Forward-looking statements,which may be based upon beliefs, expectations and assumptions of the Company’smanagement and on information currently available to management, are generallyidentifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,”“intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or othersimilar expressions.  Additionally, allstatements in this document, including forward-looking statements, speak onlyas of the date they are made, and the Company undertakes no obligation toupdate any statement in light of new information or future events.

 

TheCompany’s ability to predict results or the actual effect of future plans orstrategies is inherently uncertain. There are many factors that may impact any public company, includingours, which could have a material adverse effect on the operations and futureprospects of the Company and its subsidiaries. These risks and uncertainties should be considered in evaluatingforward-looking statements and undue reliance should not be placed on suchstatements.

 

13

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|  | 201 N. Illinois  Street, Suite 700

P.O. Box 44998

Indianapolis, IN  46244-0998

317.383.4000  Fax 317.383.4200  www.bkd.com |
|--|-----------------------------------------------------------------------------------------------------------------------------------------|

 

**Report of Independent Registered Public AccountingFirm**

 

Audit Committee, Board of Directors and Stockholders

First Ottawa Bancshares, Inc.

Ottawa, Illinois

 

We have audited the accompanying consolidated balance sheets of FirstOttawa Bancshares, Inc. as of December 31, 2009 and 2008, and the relatedconsolidated statements of income, shareholders’ equity and cash flows for theyears then ended. The Company’s management is responsible for these financialstatements. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audits to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  The Company is notrequired to have, nor were we engaged to perform, an audit of its internalcontrol over financial reporting. Our audits included consideration of internalcontrol over financial reporting as a basis for designing auditing proceduresthat are appropriate in the circumstances, but not for the purpose ofexpressing an opinion on the effectiveness of the Company’s internalcontrol over financial reporting. Accordingly, we express no such opinion. Ouraudits also included examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management and evaluating theoverall financial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of FirstOttawa Bancshares, Inc. as of December 31, 2009 and 2008, and the resultsof its operations and its cash flows for the years then ended, in conformitywith accounting principles generally accepted in the United States of America.

 

 

BKD, LLP

 

Indianapolis, Indiana

March 25, 2010

 
|  |  |
|--|--|

 

14

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FIRST OTTAWABANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS

December 31,2009 and 2008

(In thousands,except share and per share data)

 
| ** **                                                                              | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                                                              |       |     |       |     |       |
| ** **                                                                              |       |     |       |     |       |
| Cash and due from banks                                                                 |       | $        | 17,921     |     | $          | 26,474 |   |
| Certificates of deposit                                                                 |       | 41,011   |       | 14,854   |       |
| Investment securities available for sale                                                |       | 56,373   |       | 57,825   |       |
| Loans held for sale                                                                     |       | 46       |       | 229      |       |
| Loans, net of allowance for loan losses of $2,334  and $1,612                           |       | 147,105  |       | 157,751  |       |
| Premises and equipment                                                                  |       | 7,484    |       | 7,198    |       |
| Goodwill                                                                                |       | 2,446    |       | 2,446    |       |
| Core deposit intangible                                                                 |       | 507      |       | 653      |       |
| Interest receivable and other assets                                                    |       | 10,808   |       | 7,751    |       |
|                                                                                    |       |     |       |     |       |
| Total assets                                                                            |       | $        | 283,701    |     | $          | 275,181 |   |
| ** **                                                                              |       |     |       |     |       |
| **Liabilities and Shareholders’ Equity**                                           |       |     |       |     |       |
| ** **                                                                              |       |     |       |     |       |
| **Liabilities**                                                                         |       |     |       |     |       |
| Deposits                                                                                |       | $        | 251,229    |     | $          | 240,730 |   |
| Other borrowings                                                                        |       | $        | 4,000      |     | $          | 6,000 |   |
| Other liabilities                                                                       |       | 2,494    |       | 3,782    |       |
| Total liabilities                                                                       |       | 257,723  |       | 250,512  |       |
|                                                                                    |       |     |       |     |       |
| **Commitments and Contingencies**                                                       |       |     |       |     |       |
| ** **                                                                              |       |     |       |     |       |
| **Shareholders’ Equity**                                                           |       |     |       |     |       |
| Preferred stock, $1 par value Authorized and  unissued - 20,000 shares                  |       | —   |       | —   |       |
| Common stock, $1 par value, 1,000,000 shares authorized  and 753,734 and 752,595 issued |       | 754      |       | 753      |       |
| Additional paid–in capital                                                         |       | 4,603    |       | 4,408    |       |
| Retained earnings                                                                       |       | 26,871   |       | 26,031   |       |
| Treasury stock, at cost – 107,746 and 107,746 shares                               |       | (6,299   | )          | (6,299   | )          |
| Accumulated other comprehensive loss                                                    |       | 49       |       | (224     | )          |
| Total shareholders’ equity                                                         |       | 25,978   |       | 24,669   |       |
|                                                                                    |       |     |       |     |       |
| Total liabilities and shareholders’ equity                                         |       | $        | 283,701    |     | $          | 275,181 |   |

 

See notes to consolidated financial statements.

 

15

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FIRST OTTAWABANCSHARES, INC.

CONSOLIDATED STATEMENTSOF INCOME

Years Ended December 31,2009 and 2008

(In thousands,except share and per share data)

 
| ** **                                                                       | ** ** | **2009** | ** ** | **2008** | ** ** |
|----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Interest and Dividend Income**                                                 |       |     |       |     |       |
| Loans receivable                                                                 |       | $        | 9,225      |     | $          | 10,933 |   |
| Investment securities                                                            |       |     |       |     |       |
| Taxable                                                                          |       | 1,040    |       | 1,286    |       |
| Exempt from federal tax                                                          |       | 1,098    |       | 1,042    |       |
| Federal funds sold                                                               |       | 35       |       | 203      |       |
| Interest–bearing deposits                                                   |       | 974      |       | 497      |       |
| Total interest and dividend income                                               |       | 12,372   |       | 13,961   |       |
|                                                                             |       |     |       |     |       |
| **Interest Expense**                                                             |       |     |       |     |       |
| Deposits                                                                         |       | 3,106    |       | 4,632    |       |
| Repurchase agreements                                                            |       | —   |       | 1        |       |
| Federal funds purchased                                                          |       | 1        |       | 1        |       |
| Other interest expense                                                           |       | 130      |       | 173      |       |
| Total interest expense                                                           |       | 3,237    |       | 4,807    |       |
|                                                                             |       |     |       |     |       |
| **Net Interest Income**                                                          |       | 9,135    |       | 9,154    |       |
| Provision for loan losses                                                        |       | 1,330    |       | 170      |       |
| **Net Interest Income After Provision for Loan  Losses**                         |       | 7,805    |       | 8,984    |       |
| ** **                                                                       |       |     |       |     |       |
| **Noninterest Income**                                                           |       |     |       |     |       |
| Service fee income                                                               |       | 843      |       | 852      |       |
| Trust and farm management fee income                                             |       | 503      |       | 540      |       |
| Net realized gains (losses) on sales of available–for–sale  securities |       | 979      |       | (647     | )          |
| Net gains on sales of loans                                                      |       | 432      |       | 58       |       |
| Other income                                                                     |       | 659      |       | 241      |       |
| Total noninterest income                                                         |       | 3,416    |       | 1,044    |       |
| ** **                                                                       |       |     |       |     |       |
| **Noninterest Expenses**                                                         |       |     |       |     |       |
| Salaries and employee benefits                                                   |       | 4,601    |       | 4,256    |       |
| Occupancy and equipment expense                                                  |       | 1,234    |       | 1,319    |       |
| Data processing fees                                                             |       | 485      |       | 480      |       |
| Insurance expense                                                                |       | 708      |       | 198      |       |
| Professional fees                                                                |       | 470      |       | 405      |       |
| Amortization of core deposit intangibles                                         |       | 146      |       | 163      |       |
| Other expense                                                                    |       | 1,264    |       | 919      |       |
| Total noninterest expense                                                        |       | 8,908    |       | 7,740    |       |
|                                                                             |       |     |       |     |       |
| **Income Before Income Tax**                                                     |       | 2,313    |       | 2,288    |       |
| Income tax expense                                                               |       | 479      |       | 435      |       |
| ** **                                                                       |       |     |       |     |       |
| **Net Income**                                                                   |       | $        | 1,834      |     | $          | 1,853 |   |
| ** **                                                                       |       |     |       |     |       |
| **Earnings Per Share – Basic**                                              |       | $        | 2.84       |     | $          | 2.87 |   |
| ** **                                                                       |       |     |       |     |       |
| **Earnings Per Share – Diluted**                                            |       | $        | 2.83       |     | $          | 2.86 |   |
| ** **                                                                       |       |     |       |     |       |
| **Average Shares Outstanding**                                                   |       | 645,623  |       | 645,275  |       |

 

See notes toconsolidated financial statements.

 

16

----

 

FIRST OTTAWABANCSHARES, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

Years Ended December 31,2009 and 2008

(In thousands,except share and per share data)

 
| ** **                                                                    | ** ** | **Common  Stock** | ** ** | **Additional  Paid–in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Treasury  Stock** | ** ** | **Accumulated  Other  Comprehensive  Income  (Loss)** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------|------------|---------------------------------------|------------|------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|-----------|------------|
| ** **                                                                    |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| **Balances, January 1,  2008**                                           |       | 753               |       | 4,300                                 |       | 26,113                 |       | (6,102              | )          | (458                                                  | )          | 24,606    |       |
| Comprehensive income                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| Net income                                                                    |       |              |       |                                  |       | 1,853                  |       |                |       |                                                  |       | 1,853     |       |
| Other comprehensive income,  net of tax – unrealized gains on securities |       |              |       |                                  |       |                   |       |                |       | 479                                                   |       | 479       |       |
| Net loss relating to  benefit liability                                       |       |              |       |                                  |       |                   |       |                |       | (245                                                  | )          | (245      | )          |
| Comprehensive income                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       | 2,087     |       |
| Cash dividends ($3.00 per  share)                                             |       |              |       |                                  |       | (1,935                 | )          |                |       |                                                  |       | (1,935    | )          |
| Stock options vested                                                          |       |              |       | 105                                   |       |                   |       |                |       |                                                  |       | 105       |       |
| Stock options exercised                                                       |       | —            |       | 3                                     |       |                   |       |                |       |                                                  |       | 3         |       |
| Purchase of 2,526 treasury  shares                                            |       |              |       |                                  |       |                   |       | (197                | )          |                                                  |       | (197      | )          |
|                                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| **Balances,  December 31, 2008**                                         |       | $                 | 753        |                                  | $          | 4,408                  |       | $                   | 26,031     |                                                  | $          | (6,299    | )          | $ | (224 | ) | $ | 24,669 |   |
| Comprehensive income                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| Net income                                                                    |       |              |       |                                  |       | 1,834                  |       |                |       |                                                  |       | 1,834     |       |
| Other comprehensive income,  net of tax                                       |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| Unrealized gains on  securities                                               |       |              |       |                                  |       |                   |       |                |       | 162                                                   |       | 162       |       |
| Net gain relating to  benefit liability                                       |       |              |       |                                  |       |                   |       |                |       | 111                                                   |       | 111       |       |
| Comprehensive income                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       | 2,107     |       |
| Cash dividends ($1.54 per  share)                                             |       |              |       |                                  |       | (994                   | )          |                |       |                                                  |       | (994      | )          |
| Stock options vested                                                          |       |              |       | 117                                   |       |                   |       |                |       |                                                  |       | 117       |       |
| Shares granted                                                                |       | —            |       | 9                                     |       |                   |       |                |       |                                                  |       | 9         |       |
| Stock options exercised                                                       |       | 1                 |       | 69                                    |       |                   |       |                |       |                                                  |       | 70        |       |
|                                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| **Balances,  December 31, 2009**                                         |       | $                 | 754        |                                  | $          | 4,603                  |       | $                   | 26,871     |                                                  | $          | (6,299    | )          | $ | 49 |   | $ | 25,978 |   |

 

See notes toconsolidated financial statements.

 

17

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FIRST OTTAWABANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31,2009 and 2008

(In thousands,except per share data)

 
| ** **                                                              | ** ** | **2009** | ** ** | **2008** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Operating Activities**                                                |       |     |       |     |       |
| Net income                                                              |       | $        | 1,834      |     | $          | 1,853 |   |
| Items not requiring (providing) cash                                    |       |     |       |     |       |
| Provision for loan losses                                               |       | 1,330    |       | 170      |       |
| Premium amortization on securities, net                                 |       | 399      |       | 250      |       |
| Derivative valuation adjustment                                         |       | 95       |       | 898      |       |
| Depreciation and amortization                                           |       | 537      |       | 653      |       |
| Loans originated for sale                                               |       | (20,254  | )          | (2,928   | )          |
| Proceeds from sale of loans                                             |       | 20,868   |       | 2,757    |       |
| Gains/losses on sales of securities, net                                |       | (979     | )          | 647      |       |
| Gains on sales of loans held for sale                                   |       | (431     | )          | (58      | )          |
| Loss on sale of other real  estate owned                                |       | 34       |       | 17       |       |
| Stock options vested                                                    |       | 117      |       | 105      |       |
| Grant of Incentive shares                                               |       | 9        |       | —   |       |
| Change in                                                               |       |     |       |     |       |
| Interest receivable and other assets                                    |       | (1,626   | )          | 221      |       |
| Interest payable and other liabilities                                  |       | (231     | )          | (867     | )          |
| Net cash provided by operating activities                               |       | 1,702    |       | 3,718    |       |
| ** **                                                              |       |     |       |     |       |
| **Investing Activities**                                                |       |     |       |     |       |
| Purchases of securities available for sale                              |       | (46,587  | )          | (21,627  | )          |
| Proceeds from maturities and paydowns of securities  available for sale |       | 21,595   |       | 25,472   |       |
| Proceeds from sales of securities available for sale                    |       | 27,269   |       | 4,333    |       |
| Purchases of certificates of deposit                                    |       | (49,121  | )          | (19,253  | )          |
| Proceeds from maturities of certificates of deposit                     |       | 22,869   |       | 7,309    |       |
| Net change in loans                                                     |       | 6,556    |       | 5,729    |       |
| Proceeds from sale of other  real estate owned                          |       | 1,138    |       | 224      |       |
| Net purchases of premises and equipment                                 |       | (660     | )          | (154     | )          |
| Net cash provided by (used in) investing activities                     |       | (16,941  | )          | 2,033    |       |
|                                                                    |       |     |       |     |       |
| **Financing Activities**                                                |       |     |       |     |       |
| Net change in deposits                                                  |       | 10,499   |       | 353      |       |
| Proceeds from borrowings                                                |       | —   |       | 6,214    |       |
| Repayment of borrowings                                                 |       | (2,000   | )          | (214     | )          |
| Purchase of treasury stock                                              |       | —   |       | (197     | )          |
| Stock options exercised                                                 |       | 70       |       | 3        |       |
| Dividends paid                                                          |       | (1,883   | )          | (1,935   | )          |
| Net cash provided by financing activities                               |       | 6,686    |       | 4,224    |       |
|                                                                    |       |     |       |     |       |
| **Net Change in Cash and due from banks**                               |       | (8,553   | )          | 9,975    |       |
| ** **                                                              |       |     |       |     |       |
| **Cash and due from banks, Beginning of Year**                          |       | 26,474   |       | 16,499   |       |
| ** **                                                              |       |     |       |     |       |
| **Cash and due from banks, End of Year**                                |       | $        | 17,921     |     | $          | 26,474 |   |
| ** **                                                              |       |     |       |     |       |
| **Additional Cash Flows Information**                                   |       |     |       |     |       |
| Interest paid                                                           |       | $        | 3,494      |     | $          | 5,009 |   |
| Income tax paid, net of refunds                                         |       | 715      |       | 833      |       |
| Transfers from loans to foreclosed real estate                          |       | 2,760    |       | 187      |       |

 

See notes toconsolidated financial statements.

 

18

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FIRST OTTAWABANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

Natureof Operations and Principles of Consolidation:  First OttawaBancshares, Inc. is a bank holding company whose principal activity is theownership and management of its wholly—owned subsidiary, First National Bank ofOttawa (the Bank).  The Bank is primarilyengaged in providing a full range of banking and financial services toindividual and corporate customers in LaSalle, Grundy and surrounding countiesin Illinois.  The Bank is subject tocompetition from other financial institutions. The Bank is subject to the regulation of certain federal and stateagencies and undergoes periodic examinations by those regulatoryauthorities.  The consolidated financialstatements include First Ottawa Bancshares, Inc. and the Bank, and theBank’s wholly owned subsidiary, First Ottawa Financial Corporation, togetherreferred to as the Company.  Intercompanytransactions and balances are eliminated in consolidation.

 

Useof Estimates:  To prepare financial statements in conformitywith accounting principles generally accepted in the United States of America,management makes estimates and assumptions based on available information.  These estimates and assumptions affect theamounts reported in the financial statements and the disclosures provided, andfuture results could differ.  Theallowance for loan losses, fair values of financial instruments, derivatives,and status of contingencies are particularly subject to change.

 

Cashand due from banks:The financial institutions holding the Company’s cash accounts areparticipating in the FDIC’s Transaction Account Guarantee Program. Under thatprogram, through June 30, 2010, all noninterest-bearing transactionaccounts are fully guaranteed by the FDIC for the entire amount of the account.The Company has deposits of $129,000 and $12.1 million at the Federal Home LoanBank and the Federal Reserve Bank, respectively, that are not fully insured bythe FDIC.

 

Securities: Securities are classified as available—for—sale when they might be soldbefore maturity.  Securities available—for—saleare carried at fair value, with unrealized holding gains and losses reported,net of tax, as other comprehensive income. Equity securities include Federal Home Loan Bank stock and FederalReserve Bank stock, which are restricted securities that are carried at cost,and a mutual fund investment 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.

 

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

 

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

 

Derivatives: All derivative instruments are recorded at their fair values and thechange in the fair value of a derivative is included in interest income.  If derivative instruments are designated ashedges of fair values, both the change in the fair value of the hedge and thehedged item are included in current earnings. Fair value adjustments related to cash flow hedges are recorded in othercomprehensive income and reclassified to earnings when the hedged transactionis reflected in earnings.  Ineffectiveportions of hedges are reflected in earnings as they occur.

 

LoansHeld for Sale:  Mortgage loans originated and intended forsale in the secondary market are carried at the lower of cost or fair value inthe aggregate.  Net unrealized losses, ifany, are recognized through a valuation allowance by charges to income.

 

Loans: Loans are reported at the principal balance outstanding, net of deferredloan fees and costs and the allowance for loan losses.  Interest income is reported on the interestmethod and includes amortization of net deferred loan fees and costs over theloan term.  Mortgage loans originated andintended for sale in the secondary market are carried at the lower of cost, netof deferred loan fees, or estimated fair value in the aggregate.  Interest income is not reported when fullloan repayment is in doubt, typically when payments are past due over 90days.  Payments received on such loansare reported as principal reductions.

 

19

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

Allowancefor Loan Losses:  The allowance for loan losses is establishedas losses are estimated to have occurred through a provision for loan lossescharged to income.  Loan losses arecharged against the allowance when management believes the uncollectibility ofa loan balance is confirmed.  Subsequentrecoveries, if any, are credited to the allowance.  Management estimates the allowance balancerequired based on past loan loss experience, known and inherent risks in theportfolio, information about specific borrower situations and estimatedcollateral values, economic conditions, and other factors.  Allocations of the allowance may be made forspecific loans, but the entire allowance is available for any loan that, inmanagement’s judgment, should be charged off.

 

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

 

Premisesand Equipment:  Asset cost is reported net of accumulateddepreciation.  Buildings and relatedcomponents are depreciated using the straight—line method with useful livesranging 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 for impairment when events indicate that thecarrying amount may not be recoverable. Maintenance and repairs are charged to expense and improvements arecapitalized.

 

OtherReal 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.

 

MortgageServicing Rights:  Servicing rights are recognized as assets forthe 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 using groupings of the underlying loans as tointerest rates and then, secondarily, as to geographic and prepaymentcharacteristics.  Fair value isdetermined using prices for similar assets with similar characteristics, whenavailable, or based upon discounted cash flows using market—basedassumptions.  Any impairment of agrouping is reported as a valuation allowance. There was no such valuation allowance recorded at December 31, 2009and 2008.

 

Intangible Assets: Core deposit intangibles are being amortized on an accelerated basisover 11 years and are periodically evaluated as to the recoverability of theircarrying value.

 

Goodwill: Goodwill is reviewed for impairment annually with any loss recognizedthrough the income statement.

 

Stock Options:  The Companyhas a stock—based compensation plan, which is more fully described in Note10.  Grants under the Company’sstock incentive plan are accounted for by applying the fair value method andthe use of an option pricing model to estimate the value of the optionsgranted. The stock options are granted with an exercise price equal to themarket price at the date of grant. Resulting compensation expense relating tothe stock options is measured and recorded based on the estimated value of theoptions. The value ofoptions granted under this plan is charged to expense over the vesting periodof the grants.

 

20

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

IncomeTaxes:  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.

 

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

 

EarningsPer Share:  Basic earnings per share is calculated basedon the weighted-average common shares outstanding during the year.

 

FairValues of Financial Instruments:  Fair valuesof financial instruments are estimated using relevant market information andother 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 in assumptionsor in market conditions could significantly affect the estimates.  The fair value estimates of existing on— andoff—balance—sheet financial instruments do not include the value of anticipatedfuture business or the values of assets and liabilities not consideredfinancial instruments.

 

ComprehensiveIncome:  Comprehensive income includes both net incomeand other comprehensive income (loss). Other comprehensive income (loss) includes the changes in unrealizedgains and losses on securities available—for—sale, and minimum pension liability,net of deferred income taxes.

 

Reclassifications: Some items in the prior years’ financial statements were reclassified toconform to the current presentation.

 

***CurrentEconomic Conditions:*** Thecurrent protracted economic decline continues to present financial institutionswith circumstances and challenges, which in some cases have resulted in largeand unanticipated declines in the fair values of investments and other assets,constraints on liquidity and capital and significant credit quality problems,including severe volatility in the valuation of real estate and othercollateral supporting loans.

 

At December 31, 2009, the Company held $324,000in commercial real estate and $57.9 million in loans collateralized bycommercial and development real estate, in the northern Illinois geographicarea.  Due to national, state and localeconomic conditions, values for commercial and development real estate havedeclined, and the market for these properties is depressed.

 

The accompanying financial statements have beenprepared using values and information currently available to the Company.

 

Given the volatility of current economic conditions,the values of assets and liabilities recorded in the financial statements couldchange rapidly, resulting in future adjustments in asset values, the allowancefor loan losses and capital that could negatively impact the Company’searnings, liquidity, and capital levels.

 

21

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

**Recently Issued AccountingStandards**

 

FASB ASC Topic 860, Transfers and Servicing, wasupdated by ASU 2009-16 which was Accounting for Transfers of Financial Assets (“SFAS166”), and ASU 2009-17 which was SFAS No.167, Amendments to FASB ASC 810-10 (“SFAS 167”) . SFAS 166 and SFAS 167changed the way entities account for securitizations and special-purposeentities, and will have a material effect on how banking organizations accountfor off-balance sheet vehicles. The new standards amend Statement of FASB ASC860-10, Accounting for Transfers and Servicing of Financial Assets and Extinguishmentsof Liabilities, and FASB ASC 810-10, Consolidation of Variable InterestEntities.  Both SFAS 166 and SFAS 167were effective January 1, 2010 for companies reporting earnings on acalendar-year basis.

 

OnJanuary 21, 2010, the Board of Governors of the Federal Reserve Systemissued final risk based capital rules related to the adoption of theseaccounting standards by financial institutions. SFAS 166 and SFAS 167 make substantive changes to how bankingorganizations account for many items, including securitized assets, that hadbeen previously excluded from their balance sheets. Banking organizationsaffected by SFAS 166 and SFAS 167 generally will be subject to higherrisk-based regulatory capital requirements intended to better align risk-basedcapital requirements with the actual risks of certain exposures.

 

FirstOttawa is evaluating the impact that adoption of these standards will have onthe Company’s consolidated financial statements. We will take into account inour internal capital planning processes the impact of these standards and willassess whether additional capital may be necessary to support the risksassociated with off-balance-sheet vehicles affected by the new accountingstandards.

 

22

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FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

**NOTE 2 —SECURITIES AVAILABLE FOR SALE**

 
| ** **                                                               | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| **December 31, 2009**                                               |       |                |       |                         |       |                          |       |            |       |
| U. S. Treasury                                                           |       | $                   | 5,182      |                         | $          | 16                            |       | $               | —     |   | $ | 5,198 |   |
| Federal agencies                                                         |       | 23,732              |       | 183                          |       | (38                           | )          | 23,877          |       |
| State and municipal                                                      |       | 23,332              |       | 526                          |       | (27                           | )          | 23,831          |       |
| Mortgage—backed securities and collateralized  mortgage obligations |       | 3,325               |       | 115                          |       | —                        |       | 3,440           |       |
| Corporate obligations                                                    |       | —              |       | —                       |       | —                        |       | —          |       |
| Marketable equity securities                                             |       | 25                  |       | 4                            |       | (2                            | )          | 27              |       |
|                                                                     |       |                |       |                         |       |                          |       |            |       |   |   |   |   |
| Total investment securities                                              |       | $                   | 55,596     |                         | $          | 844                           |       | $               | (67        | ) | $ | 56,373 |   |

** **
| ** **                                                               | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| **December 31, 2008**                                               |       |                |       |                         |       |                          |       |            |       |
| U. S. Treasury                                                           |       | $                   | 1,033      |                         | $          | 51                            |       | $               | —     |   | $ | 1,084 |   |
| Federal agencies                                                         |       | 11,556              |       | 234                          |       | —                        |       | 11,790          |       |
| State and municipal                                                      |       | 38,926              |       | 268                          |       | (106                          | )          | 39,088          |       |
| Mortgage—backed securities and collateralized  mortgage obligations |       | 4,885               |       | 91                           |       | (6                            | )          | 4,970           |       |
| Corporate obligations                                                    |       | —              |       | —                       |       | —                        |       | —          |       |
| Marketable equity securities                                             |       | 893                 |       | —                       |       | —                        |       | 893             |       |
|                                                                     |       |                |       |                         |       |                          |       |            |       |   |   |   |   |
| Total investment securities                                              |       | $                   | 57,293     |                         | $          | 644                           |       | $               | (112       | ) | $ | 57,825 |   |

 

As of December 31,2009 and 2008, the Company had approximately $10,884,000 and $14,498,000invested in bonds issued by municipalities located within LaSalle County,Illinois.

 

Securitieswith an approximate carrying value of $47,793,000 and $35,927,000 were pledgedat December 31, 2009 and 2008 to secure trust and public deposits, and forother purposes as required or permitted by law.

 

Thefair value of contractual maturities of securities available for sale at December 31,2009 were as follows.  Securities not dueat a single maturity date, primarily mortgage—backed and equity securities, areshown separately.

 
| ** **                                                               | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------|------------|-----------------|------------|
|                                                                     |       |                |       |            |       |
| Within one year                                                          |       | $                   | 20,182     |            | $          | 20,226 |   |
| One to five years                                                        |       | 28,012              |       | 28,454          |       |
| Five to ten years                                                        |       | 4,052               |       | 4,226           |       |
| After ten years                                                          |       | —              |       | —          |       |
|                                                                     |       | 52,246              |       | 52,906          |       |
| Mortgage—backed securities and collateralized  mortgage obligations |       | 3,325               |       | 3,440           |       |
| Marketable equity securities                                             |       | 25                  |       | 27              |       |
|                                                                     |       |                |       |            |       |   |   |
| Totals                                                                   |       | $                   | 55,596     |            | $          | 56,373 |   |

 

23

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

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

 
| ** **   | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------|------------|----------|------------|----------|------------|
|         |       |     |       |     |       |
| Gross gains  |       | $        | 980        |     | $          | 30 |   |
| Gross losses |       | 1        |       | 677      |       |
| Tax expense  |       | 333      |       | (220     | )          |
|              |            |          |            |          |            |  |  |

 

Certaininvestments in debt and marketable equity securities are reported in thefinancial statements at an amount less than their historical cost.  Total fair value of these investments at December 31,2009 and 2008 was $14.7 million and $9.7 million, which was approximately 26.1%and 16.7% of the Company’s available—for—sale investment portfolio at thosedates.  These declines primarily resultedfrom increases in market interest rates.

 

Based onevaluation of available evidence, including recent changes in market interestrates, management believes the declines in fair value for these securities aretemporary.  Should the impairment of anyof these securities become other-than-temporary, the cost basis of theinvestment will be reduced and the resulting loss recognized in net income inthe period the other—than—temporary impairment is identified.

 

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

 
| ** **                                                               | ** ** | **Less than 12 Months** | ** ** | **12 Months or More**  | ** ** | **Total**       | ** ** |
|--------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|-----------------|------------|
| **Description of  Securities**                                           | ** ** | **Fair  Value**         | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| ** **                                                               |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| **December 31, 2009**                                               |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Federal agencies                                                         |       | $                       | 9,814      |                   | $          | (38             | )          | $ | — |   | $ | — |   | $ | 9,814 |   | $ | (38 | ) |
| State and municipal                                                      |       | 4,867                   |       | (26                    | )          | 52              |       | (1 | ) | 4,919 |   | (27 | ) |
| Mortgage—backed securities  and collateralized mortgage obligations |       | —                  |       | —                 |       | —          |       | — |   | — |   | — |   |
| Marketable equity  securities                                            |       | 8                       |       | (2                     | )          | —          |       | — |   | 8 |   | (2 | ) |
|                                                                     |       |                    |       |                   |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total temporarily impaired  securities                                   |       | $                       | 14,689     |                   | $          | (66             | )          | $ | 52 |   | $ | (1 | ) | $ | 14,741 |   | $ | (67 | ) |
| ** **                                                               |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| **December 31, 2008**                                               |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Federal agencies                                                         |       | $                       | —     |                   | $          | —          |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| State and municipal                                                      |       | 8,241                   |       | (104                   | )          | 400             |       | (2 | ) | 8,641 |   | (106 | ) |
| Mortgage—backed securities and collateralized  mortgage obligations |       | 655                     |       | (4                     | )          | 381             |       | (2 | ) | 1,036 |   | (6 | ) |
| Marketable equity securities                                             |       | —                  |       | —                 |       | —          |       | — |   | — |   | — |   |
|                                                                     |       |                    |       |                   |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total temporarily impaired securities                                    |       | $                       | 8,896      |                   | $          | (108            | )          | $ | 781 |   | $ | (4 | ) | $ | 9,677 |   | $ | (112 | ) |

 

24

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

**NOTE 3 —LOANS**

 

Majorclassifications of loans as of December 31, 2009 and 2008 are summarizedas follows:

 
| ** **                  | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
|                        |       |     |       |     |       |   |   |
| Real estate                 |       | $        | 103,579    |     | $          | 112,238 |   |
| Commercial and agricultural |       | 34,855   |       | 33,632   |       |
| Installment                 |       | 2,654    |       | 3,772    |       |
| Home equity lines of credit |       | 8,351    |       | 9,721    |       |
| Total loans                 |       | 149,439  |       | 159,363  |       |
| Allowance for loan losses   |       | (2,334   | )          | (1,612   | )          |
|                        |       |     |       |     |       |   |   |
| Net loans                   |       | $        | 147,105    |     | $          | 157,751 |   |

 

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

 
| Balance at January 1, 2009   |   | $      | 4,084  |   |
|-----------------------------------|--------|--------|--------|--------|
| New loans                         |   | 1,893  |   |
| Repayments                        |   | (1,158 | )      |
|                              |   |   |   |
| Balance at December 31, 2009 |   | $      | 4,819  |   |

 

Informationregarding impaired loans at December 31, 2009 and 2008 is as follows:

 
| ** **                                                                                                     | ** ** | **2009** | ** ** | **2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                           |       |     |       |     |       |   |   |
| Impaired loans with an allowance                                                                               |       | $        | 93         |     | $          | 1,145 |   |
| Impaired loans for which the discounted cash flows  or collateral value exceeds the carrying value of the loan |       | 8,821    |       | 2,511    |       |
|                                                                                                           |       |     |       |     |       |
| Total impaired loans                                                                                           |       | $        | 8,914      |     | $          | 3,656 |   |
|                                                                                                           |       |     |       |     |       |
| Allowance for impaired loans included in the  Company’s allowance for loan losses                         |       | $        | 39         |     | $          | 390 |   |

 
| ** **                                                      | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                            |       |     |       |     |       |
| Average balance of impaired loans                               |       | $        | 5,552      |     | $          | 2,800 |   |
| Interest income recognized on impaired loans                    |       | 295      |       | 234      |       |
| Interest income recognized on impaired loans — cash  basis |       | 322      |       | 245      |       |
|                                                                 |            |          |            |          |            |  |  |

 

Nonperformingloans were as follows at December 31:

 
| ** **                                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
|                                         |       |     |       |     |       |   |   |
| Loans past due over 90 days still on accrual |       | $        | 2,583      |     | $          | 2,098 |   |
| Nonaccrual loans                             |       | 6,809    |       | 965      |       |

** **

**25**

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

**NOTE 4 — ALLOWANCE FOR LOANLOSSES**

** **

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

 
| ** **                 | ** ** | **2009** | ** ** | **2008** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|
| Allowance for loan losses  |       |     |       |     |       |
| Balances, January 1   |       | $        | 1,612      |     | $          | 1,588 |   |
| Provision for losses       |       | 1,330    |       | 170      |       |
| Recoveries on loans        |       | 76       |       | 61       |       |
| Loans charged off          |       | (684     | )          | (207     | )          |
|                       |       |     |       |     |       |
| Balances, December 31 |       | $        | 2,334      |     | $          | 1,612 |   |

** **

**NOTE 5 — LOAN SALES ANDSERVICING**

** **

The Company sellsmortgage loans with servicing retained to the Federal Home Loan MortgageCorporation (FHLMC).  The Companyrealized gross proceeds from the sales of mortgage loans totaling $20,868,000,and $2,757,000 in 2009, and 2008. Mortgage loans serviced for others are not included in the accompanyingconsolidated balance sheets.  The unpaidprincipal balances of these loans are summarized as follows:

 
| ** **         | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------|------------|----------|------------|----------|------------|
| Loans serviced for |       |     |       |     |       |
| Freddie Mac        |       | $        | 31,745     |     | $          | 26,505 |   |
|                    |            |          |            |          |            |  |  |

 

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

 
| ** **                       | ** ** | **2009** | ** ** | **2008** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Mortgage Servicing Rights        |       |     |       |     |       |
| Balances, January 1         |       | $        | 267        |     | $          | 280 |   |
| Servicing rights capitalized     |       | 145      |       | 29       |       |
| Amortization of servicing rights |       | (126     | )          | (42      | )          |
|                             |       |     |       |     |       |   |   |
| Balances, December 31       |       | $        | 286        |     | $          | 267 |   |

 

26

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

**NOTE 6 —PREMISES AND EQUIPMENT**

 

Premises and equipmentconsisted of the following at December 31:

 
| ** **                                | ** ** | **2009** | ** ** | **2008** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Cost                                      |       |     |       |     |       |
| Land                                      |       | $        | 1,884      |     | $          | 1,791 |   |
| Buildings and land improvements           |       | 8,118    |       | 7,655    |       |
| Equipment                                 |       | 4,948    |       | 4,877    |       |
| Construction in progress                  |       | 83       |       | 52       |       |
| Total cost                                |       | 15,033   |       | 14,375   |       |
| Accumulated depreciation and amortization |       | (7,549   | )          | (7,177   | )          |
|                                      |       |     |       |     |       |   |   |
| Net                                       |       | $        | 7,484      |     | $          | 7,198 |   |

 

**NOTE 7 —DEPOSITS**

 

Deposits consisted of thefollowing at December 31:

 
| ** **                                                | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                      |       |     |       |     |       |   |   |
| Noninterest—bearing demand                           |       | $        | 34,851     |     | $          | 31,374 |   |
| Interest—bearing demand                              |       | 93,322   |       | 72,624   |       |
| Savings                                                   |       | 25,787   |       | 22,235   |       |
| Money market savings                                      |       | 20,912   |       | 28,959   |       |
| Certificates and other time deposits of $100,000 or  more |       | 28,553   |       | 30,868   |       |
| Other certificates and time deposits                      |       | 47,804   |       | 54,670   |       |
|                                                      |       |     |       |     |       |   |   |
| Total deposits                                            |       | $        | 251,229    |     | $          | 240,730 |   |

 

At December 31,2009, the scheduled maturities of certificates of deposit were as follows:

 
| 2010       |   | $      | 41,598 |   |
|------------|--------|--------|--------|--------|
| 2011       |   | 14,054 |   |
| 2012       |   | 6,514  |   |
| 2013       |   | 8,521  |   |
| 2014       |   | 5,623  |   |
| Thereafter |   | 47     |   |
|       |   |   |   |   |
|       |   | $      | 76,357 |   |

 

Depositsheld by the Company from related parties at December 31, 2009 and 2008totaled $3.7 million and $4.2 million, respectively.

 

27

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

**NOTE 8 —BORROWINGS**

 

Borrowings at December 31, 2009 consisted of aFederal Home Loan Bank advance.  TheFederal Home Loan Bank advance at December 31, 2009 consists of two$2,000,000 advances from the Federal Home Loan Bank of Chicago, maturing on January 28,2010 and 2011.  The advances are securedby a blanket lien on the Company’s portfolio of one-to-four family mortgageswhich was approximately $23.6 million at December 31, 2009.  The interest rates for each advance is fixedat 2.97% for the 2010 maturity, and 3.21% for the 2011 maturity.

 

**NOTE 9 —BENEFIT PLANS**

 

TheBank has a noncontributory defined-benefit pension plan covering all employeeswho meet the eligibility requirements. In 1999, all plan benefits were frozen. The Bank’s funding policy is to make the minimum annual contributionthat is required by applicable regulations, plus such amounts as the Bank maydetermine to be appropriate from time to time. The Bank expects to contribute approximately $100,000 to the plan in2010.  The Bank uses a December 31measurement date for the plan.

 

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

 
| ** **                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
|                         |       |     |       |     |       |
| Change in benefit obligation |       |     |       |     |       |
| Beginning benefit obligation |       | $        | 1,803      |     | $          | 1,837 |   |
| Interest cost                |       | 101      |       | 102      |       |
| Actuarial loss               |       | 45       |       | (36      | )          |
| Settlements                  |       | (177     | )          | —   |       |
| Benefits paid                |       | (92      | )          | (100     | )          |
|                         |       |     |       |     |       |   |   |
| Ending benefit obligation    |       | $        | 1,680      |     | $          | 1,803 |   |
|                         |       |     |       |     |       |
| Change in plan assets        |       |     |       |     |       |
| Beginning fair value         |       | $        | 1,378      |     | $          | 1,766 |   |
| Actual return                |       | 163      |       | (308     | )          |
| Employer contribution        |       | 84       |       | 20       |       |
| Settlements                  |       | (177     | )          | —   |       |
| Benefits paid                |       | (92      | )          | (100     | )          |
|                         |       |     |       |     |       |   |   |
| Ending fair value            |       | $        | 1,356      |     | $          | 1,378 |   |
|                         |       |     |       |     |       |   |   |
| Funded status                |       | $        | (324       | )        | $          | (425 | ) |

 

28

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

**NOTE 9 —BENEFIT PLANS**(Continued)

 

Assets and liabilitiesrecognized in the balance sheets:

** **
| ** **        | ** ** | **Pension Benefits** | ** ** |
|-------------------|------------|----------------------|------------|
| ** **        | ** ** | **2009**             | ** ** | **2008** | ** ** |
|              |       |                 |       |   |   |
| Other liabilities |       | $                    | (324       | ) | $ | (425 | ) |
|                   |            |                      |            |  |  |  |  |

 

Gross amounts recognizedin accumulated other comprehensive income not yet recognized as components ofnet periodic benefit cost consist of:

 
| ** ** | ** ** | **Pension Benefits** | ** ** |
|------------|------------|----------------------|------------|
| ** ** | ** ** | **2009**             | ** ** | **2008** | ** ** |
| Net loss   |       | $                    | 703        |   | $ | 872 |   |
|            |            |                      |            |  |  |  |  |

 

Informationfor pension plans with an accumulated benefit obligation in excess of planassets:

** **
| ** **                     | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Accumulated benefit obligation |       | $        | 1,680      |     | $          | 1,803 |   |
| Fair value of plan assets      |       | 1,356    |       | 1,378    |       |
|                                |            |          |            |          |            |  |  |

 

Other significantbalances and costs are:

 
| ** **                              | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
|                                    |       |     |       |     |       |
| Components of net periodic benefit cost |       |     |       |     |       |
| Interest cost                           |       | $        | 101        |     | $          | 102 |   |
| Return on plan assets                   |       | (84      | )          | (125     | )          |
| Amortization                            |       | 65       |       | 21       |       |
|                                    |       |     |       |     |       |   |   |
| Net expense                             |       | $        | 82         |     | $          | (2 | ) |

 

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

** **
| ** **                        | ** ** | **Pension Benefits** | ** ** |
|-----------------------------------|------------|----------------------|------------|
| ** **                        | ** ** | **2009**             | ** ** | **2008** | ** ** |
|                              |       |                 |       |   |   |
| Amounts arising during the period |       |                 |       |   |   |
| Net (gain) loss                   |       | $                    | (169       | ) | $ | 375 |   |
| Net amortization                  |       | (50                  | )          | — |   |
|                                   |            |                      |            |  |  |  |  |

 

29

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

**NOTE 9 —BENEFIT PLANS**(Continued)

 

Theestimated net loss for the defined-benefit pension plan that will be amortizedfrom accumulated other comprehensive income into net periodic benefit cost overthe next fiscal year is $41,000.

 
| ** **                                        | ** ** | **2009** | ** ** | **2008** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
|                                              |       |     |       |     |       |
| Assumptions used to determine benefit obligations |       |     |       |     |       |
| Discount rate                                     |       | 5.75     | %          | 5.75     | %          |
| Expected return on plan assets                    |       | 7.0      |       | 7.0      |       |
|                                              |       |     |       |     |       |
| Assumptions used to determine benefit costs       |       |     |       |     |       |
| Discount rate                                     |       | 5.75     | %          | 5.75     | %          |
| Expected return on plan assets                    |       | 7.0      |       | 7.0      |       |

 

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

 

Thefollowing benefit payments, which reflect expected future service, asappropriate, are expected to be paid as of December 31, 2009:

 
| ** ** | ** ** | **Pension  Benefits** | ** ** |
|------------|------------|-----------------------|------------|
|       |       |                  |       |   |
| 2010       |       | $                     | 105        |   |
| 2011       |       | 115                   |       |
| 2012       |       | 110                   |       |
| 2013       |       | 106                   |       |
| 2014       |       | 107                   |       |
| Thereafter |       | 571                   |       |

 

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

 

Asset allocationis primarily based on a strategy to provide stable earnings while attempting torecognize potentially higher returns through limited investments in equitysecurities.  Plan assets are rebalancedperiodically.  At December 31, 2009and 2008, allocations by percentages were as follows:

 
| ** **                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
|                         |       |     |       |     |       |
| Equity mutual funds          |       | 69.2     | %          | 57.0     | %          |
| Fixed income mutual funds    |       | 12.8     |       | 23.9     |       |
| GNMA pool                    |       | .2       |       | .2       |       |
| Money market funds and other |       | 8.9      |       | 12.9     |       |
| Time Certificates of Deposit |       | 8.9      |       | 6.0      |       |

 

30

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

**NOTE 9 —BENEFIT PLANS**(Continued)

 

At December 31, 2009 and 2008, market values ofplan assets were as follows:

 
| ** **                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
|                         |       |     |       |     |       |
| Equity mutual funds          |       | $        | 938        |     | $          | 712 |   |
| Fixed income mutual funds    |       | 174      |       | 298      |       |
| GNMA pool                    |       | 3        |       | 3        |       |
| Money market funds and other |       | 121      |       | 160      |       |
| Time Certificates of Deposit |       | 120      |       | 75       |       |
|                              |            |          |            |          |            |  |  |

 

The Bank has adirectors’ retirement plan which provides retirement benefits primarily toformer members of the Board of Directors. The Bank also maintains a supplemental executive retirement plan thatprovides benefits to certain key executive officers and directors in accordancewith the plan document.  The Bank accruedexpenses related to these plans totaling $94,000, and $11,000 in 2009, and2008.

 

TheCompany’s 401(k) profit-sharing plan covers eligible employees with morethan one year of service, as defined, and who are at least 21 years ofage.  The plan allows employeecontributions.  The Company may make amatching contribution equal to a percentage of salary deferral anddiscretionary profit-sharing contributions. The matching percentage is limited to 6% of compensation.  The Company’s contributions, which are madefollowing the end of the calendar year, totaled $145,000, and $144,000 for2009, and 2008.

 

**NOTE  10 — STOCK OPTION PLAN**

 

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

 

The following is asummary of the status of the Company’s stock option plan and changes in thatplan for 2009.  The Company had no grantsoutstanding prior to 2003.

 
| ** **                                                           | ** ** | **2009**   | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|
| **Options**                                                          | ** ** | **Shares** | ** ** | **Weighted–  Average  Exercise Price** | ** ** | **Weighted–  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|                                                                 |       |       |       |   |   |   |   |   |   |
| Outstanding, beginning of year                                       |       | 50,829     |       | $ | 72.21 |   |   |   |   |   |
| Granted                                                              |       | 12,400     |       | 62.87 |   |   |   |   |   |
| Exercised                                                            |       | 989        |       | 70.51 |   |   |   |   |   |
| Forfeited or expired                                                 |       | 1,200      |       | 72.67 |   |   |   |   |   |
|                                                                 |       |       |       |   |   |   |   |   |   |
| Outstanding, end of year                                             |       | 61,040     |       | 70.30 |   | 6.82 |   | $ | 136 |   |
|                                                                 |       |       |       |   |   |   |   |   |   |   |
| Options exercisable at year end                                      |       | 31,965     |       | 69.27 |   | 5.55 |   | $ | 62 |   |
|                                                                 |       |       |       |   |   |   |   |   |   |   |
| Weighted—average fair value of options granted  during the year |       |       |       | $ | 8.96 |   |   |   |   |   |

 

31

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

The weighted-averagegrant-date fair value of options granted during the years 2009 and 2008 was$8.96, and $9.20, respectively.  Thetotal intrinsic value of options exercised during the years ended December 31,2009 and 2008 was $0 and $0.  Totalunrecognized compensation cost relating to stock options not vested as of December 31,2009 was $196,000.

 

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

 
| ** **                                                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                         |       |     |       |     |       |
| Risk—free interest rates                                |       | 2.53     | %          | 3.04     | %          |
| Dividend yields                                              |       | 4.77     | %          | 3.83     | %          |
| Volatility factors of expected market price of  common stock |       | 24.48    | %          | 16.51    | %          |
| Weighted—average expected life of the options           |       | 8 years  |       | 8 years  |       |

 

Cash received from optionexercise under share-based payment arrangements for the years ended December 31,2009 and 2008 was $70,000, and $4,000, respectively.  The actual tax benefit realized for the taxdeductions from option exercise of the share-based payment arrangements totaled$0, and $0, respectively, for the years ended December 31, 2009, and 2008.

 

**NOTE  11 — EARNINGS PER SHARE**

 

Earnings per share(EPS) were computed as follows:

 
| ** **                                                       | ** ** | **Year Ended December 31, 2009** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                       | ** ** | **Income**                            | ** ** | **Weighted-  Average  Shares** | ** ** | **Per Share  Amount** | ** ** |
|                                                             |       |                                  |       |   |   |   |   |
| Net income                                                       |       | $                                     | 1,834      |   | 645,623 |   |   |   |
| Basic earnings per share                                         |       |                                  |       |   |   |   |   |
| Income available to common stockholders                          |       |                                  |       |   |   | $ | 2.84 |   |
|                                                             |       |                                  |       |   |   |   |   |
| Effect of dilutive securities                                    |       |                                  |       |   |   |   |   |
| Stock options                                                    |       | —                                |       | 1,845 |   |   |   |
| Diluted earnings per share                                       |       |                                  |       |   |   |   |   |
| Income available to common stockholders and assumed  conversions |       | $                                     | 1,834      |   | 647,468 |   | $ | 2.83 |   |

 

32

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 
| ** **                                                       | ** ** | **Year Ended December 31, 2008** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                       | ** ** | **Income**                            | ** ** | **Weighted-  Average  Shares** | ** ** | **Per Share  Amount** | ** ** |
| Net income                                                       |       | $                                     | 1,853      |   | 645,275 |   |   |   |
| Basic earnings per share                                         |       |                                  |       |   |   |   |   |
| Income available to common stockholders                          |       |                                  |       |   |   | $ | 2.87 |   |
|                                                             |       |                                  |       |   |   |   |   |
| Effect of dilutive securities                                    |       |                                  |       |   |   |   |   |
| Stock options                                                    |       | —                                |       | 1,617 |   |   |   |
| Diluted earnings per share                                       |       |                                  |       |   |   |   |   |
| Income available to common stockholders and assumed  conversions |       | $                                     | 1,853      |   | 646,892 |   | $ | 2.86 |   |

 

Atotal of 59,215 and 39,300 options for the year ended December 31, 2009and 2008 are not included in the above calculations as they are non-dilutive.

 

**NOTE 12 —INCOME TAXES**

 

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

 
| ** **                                                 | ** ** | **2009** | ** ** | **2008** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|
| Income tax expense                                         |       |     |       |     |       |
| Currently payable                                          |       |     |       |     |       |
| Federal                                                    |       | $        | 496        |     | $          | 350 |   |
| State                                                      |       | 190      |       | 124      |       |
| Deferred                                                   |       | (207     | )          | (39      | )          |
|                                                       |       |     |       |     |       |
| Total income tax expense                                   |       | $        | 479        |     | $          | 435 |   |
|                                                       |       |     |       |     |       |
| Reconciliation of federal statutory to actual tax  expense |       |     |       |     |       |
| Federal statutory income tax at 34%                        |       | $        | 787        |     | $          | 778 |   |
| Tax—exempt income                                     |       | (384     | )          | (346     | )          |
| Effect of state income taxes and other items, net          |       | 76       |       | 3        |       |
|                                                       |       |     |       |     |       |
| Actual tax expense                                         |       | $        | 479        |     | $          | 435 |   |
|                                                       |       |     |       |     |       |
| Effective tax rate                                         |       | 20.7     | %          | 19.0     | %          |

 

33

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

**NOTE 12 —INCOME TAXES**(Continued)

 

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

 
| ** **                                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                                  |       |     |       |     |       |
| Allowance for loan losses                                   |       | $        | 748        |     | $          | 447 |   |
| Deferred compensation                                       |       | 363      |       | 348      |       |
| Change in defined benefit pension plan losses               |       | 133      |       | 174      |       |
| Other                                                       |       | 176      |       | 297      |       |
| Total assets                                                |       | 1,420    |       | 1,266    |       |
|                                                        |       |     |       |     |       |
| **Liabilities**                                             |       |     |       |     |       |
| Unrealized (gains) losses on securities available  for sale |       | $        | (265       | )        | $          | (181 | ) |
| FHLB stock                                                  |       | (117     | )          | (117     | )          |
| Depreciation                                                |       | (464     | )          | (479     | )          |
| Mortgage servicing rights                                   |       | (118     | )          | (110     | )          |
| Other                                                       |       | (230     | )          | (176     | )          |
| Total liabilities                                           |       | (1,194   | )          | (1,063   | )          |
|                                                        |       |     |       |     |       |
|                                                        |       | $        | 226        |     | $          | 203 |   |

 

**NOTE 13 —DERIVATIVES**

 

Fair value hedges are intended to reduce the interestrate risk associated with the underlying hedged item. Fair value hedges areconsidered to be highly effective and any hedge ineffectiveness was deemed notmaterial. The Company uses this fair value hedge to fix future cash flows forinterest payments on some of its floating rate certificates of deposit.  In this regard, the Company has entered intoan interest rate swap with the Broker Dealer Financial Services Corporation(BDFS) to fix the interest rate on a specific certificate of depositproduct.  At December 31, 2009, theCompany had $3.6 million of certificates of deposit, which mature in 2009through 2014, on which it has prepaid BDFS for an interest rate swap and willreceive an interest rate from BDFS based on the appreciation of the S&P 500Index.  This interest received from BDFSwill be paid to the customer.  Thecertificates of deposit have an embedded derivative which is a written calloption. The assets and liabilities in this transaction are being netted in timedeposits and the fair value adjustment recorded in other income.

 

In addition to the above, the Company also purchased$775,000 of certificates of deposit which are included in the certificates ofdeposit caption on the consolidated balance sheet.  These certificates of deposit were purchasedas investments to generate a return and have a five year term from date ofpurchase.  The investments do notindividually exceed $100,000 and are insured by the FDIC. The initialinvestment is not at risk but the return on the investment is based on a calculationof the appreciation in the S&P 500 Index. The fair value of this embeddedderivative, which is a purchased call option, is recorded in certificates ofdeposit and the fair value adjustment is included in other income.  At December 31, 2009, the Company hadallocated $400 to this asset and recorded a valuation loss of $5,000.

 

34

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

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

 

TheBank is required to maintain reserve funds in cash and/or on deposit with theFederal Reserve Bank.  The reserverequired at December 31, 2009 was $494,000.

 

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

 

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

 

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

 

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

 
| ** **               | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Unused lines of credit   |       | $        | 21,161     |     | $          | 26,479 |   |
| Standby letter of credit |       | 472      |       | 185      |       |
|                          |            |          |            |          |            |  |  |

 

35

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

FASB Accounting Standards Codification (ASC) Topic 820 defines fairvalue as the price that would be received to sell an asset or paid to transfera liability in an orderly transaction between market participants at themeasurement date.  Topic 820 alsoestablishes a fair value hierarchy which requires an entity to maximize the useof observable inputs and minimize the use of unobservable inputs when measuringfair value.  The standard describes threelevels of inputs that may be used to measure fair value:

 
| **Level 1** | Quoted prices in active markets for identical assets or liabilities                                                                                                                                                                                                                                              |
|-------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |                                                                                                                                                                                                                                                                                                             |
| **Level 2** | Observable inputs other than Level 1 prices, such as quoted prices for  similar assets or liabilities; quoted prices in active markets that are not  active; or other inputs that are observable or can be corroborated by  observable market data for substantially the full term of the assets or  liabilities |
|        |                                                                                                                                                                                                                                                                                                             |
| **Level 3** | Unobservable inputs that are supported by little or  no market activity and that are significant to the fair value of the assets  or liabilities                                                                                                                                                                 |

 

Following is a description of the valuation methodologies used forinstruments measured at fair value, as well as the general classification ofsuch instruments pursuant to the valuation hierarchy.

 

***Available-for-saleSecurities***

 

Where quoted market prices are available in an active market, securitiesare classified within Level 1 of the valuation hierarchy.  Level 1 securities include exchangetraded equities.  If quoted market pricesare not available, then fair values are estimated by using pricing models,quoted prices of securities with similar characteristics or discounted cashflows.  Level 2 securities includecertain collateralized mortgage and debt obligations, government agencybondsand certain municipal securities, and corporate obligations. Third party vendorscompile prices from various sources and may apply such techniques as matrixpricing to determine the value of identical or similar investment securities(level 2). Matrix pricing is a mathematical technique widely used in thebanking industry to value investment securities without relying exclusively onquoted prices for specific investment securities but rather relying on theinvestment securities’ relationship to other benchmark quoted investmentsecurities. In certain cases where Level 1 or Level 2 inputs are not available,securities are classified within Level 3 of the hierarchy. The Companycurrently holds no Level 3 securities.

 

36

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

***Interest Rate SwapAgreements***

 

The fair value is estimated by a third party using inputs that areobservable or that can be corroborated by observable market data (such as theS&P 500 index) and, therefore, are classified within Level 2 of thevaluation hierarchy.

 

The following table presents the fair value measurements of assets andliabilities recognized in the accompanying balance sheet measured at fair valueon a recurring and non-recurring basis and the level within the fair valuehierarchy in which the fair value measurements fall at December 31, 2009:

 
| ** **                                                               | ** ** | ** **     | ** ** | **Fair Value Measurements Using**                                           | ** ** |
|--------------------------------------------------------------------------|------------|----------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                               | ** ** | **Fair Value** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets********(Level 1)** | ** ** | **Significant Other  Observable Inputs********(Level 2)** | ** ** | **Significant  Unobservable  Inputs********(Level 3)** | ** ** |
| Recurring basis:                                                         |       |           |       |                                                                        |       |   |   |   |   |
| Assets:                                                                  |       |           |       |                                                                        |       |   |   |   |   |
| Available-for-sale  securities:                                          |       |           |       |                                                                        |       |   |   |   |   |
| U.S. Treasuries                                                          |       | $              | 5,198      |                                                                        | $          | — |   | $ | 5,198 |   | $ | — |   |
| Federal Agencies                                                         |       | 23,877         |       | —                                                                      |       | 23,877 |   | — |   |
| State and Municipals                                                     |       | 23,831         |       | —                                                                      |       | 23,831 |   | — |   |
| Mortgage—backed securities  and collateralized mortgage obligations |       | 3,440          |       | —                                                                      |       | 3,440 |   | — |   |
| Equities                                                                 |       | 27             |       | 27                                                                          |       | — |   | — |   |
| Interest rate swap  agreements — customer cds                       |       | 835            |       | —                                                                      |       | 835 |   | — |   |
| Total assets                                                             |       | 57,208         |       | 27                                                                          |       | 57,181 |   | — |   |
|                                                                     |       |           |       |                                                                        |       |   |   |   |   |
| Liabilities:                                                             |       |           |       |                                                                        |       |   |   |   |   |
| Written call  options-customer cds                                       |       | (835           | )          | —                                                                      |       | (835 | ) | — |   |
|                                                                          |            |                |            |                                                                             |            |  |  |  |  |  |  |  |  |

 

37

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

The following table presents the fair value measurements of assets andliabilities recognized in the accompanying balance sheet measured at fair valueon a recurring basis and the level within the FASB ASC fair value hierarchy inwhich the fair value measurements fall at December 31, 2008:

 
| ** **                                                               | ** ** | ** **     | ** **  | **Fair Value Measurements Using**                                           | ** ** |
|--------------------------------------------------------------------------|------------|----------------|-------------|-----------------------------------------------------------------------------|------------|
| ** **                                                               | ** ** | **Fair Value** | ** **  | **Quoted Prices in  Active Markets for  Identical Assets********(Level 1)** | ** ** | **Significant Other   Observable Inputs  (Level 2)** | ** ** | **Significant   Unobservable   Inputs********(Level 3)** | ** ** |
| Assets:                                                                  |       |           |        |                                                                        |       |   |   |   |   |
| Available-for-sale  securities:                                          |       |           |        |                                                                        |       |   |   |   |   |
| U.S. Treasuries                                                          |       | $              |  1,084 |                                                                        | $          | — |   | $ | 1,084 |   | $ | — |   |
| Federal Agencies                                                         |       | 11,790         |        | —                                                                      |       | 11,790 |   | — |   |
| State and Municipals                                                     |       | 39,088         |        | —                                                                      |       | 39,088 |   | — |   |
| Mortgage–backed securities  and collateralized mortgage obligations |       | 4,970          |        | —                                                                      |       | 4,970 |   | — |   |
| Equities                                                                 |       | 893            |        | 893                                                                         |       | — |   | — |   |
| Purchased call options –  investment cds                            |       | 135            |        | —                                                                      |       | 135 |   | — |   |
| Interest rate swap  agreements – customer cds                       |       | 594            |        | —                                                                      |       | 594 |   | — |   |
| Total assets                                                             |       | 58,554         |        | 893                                                                         |       | 57,661 |   | — |   |
|                                                                     |       |           |        |                                                                        |       |   |   |   |   |
| Liabilities:                                                             |       |           |        |                                                                        |       |   |   |   |   |
| Written call options –  customer cds                                |       | (597           | )           | —                                                                      |       | (597 | ) | — |   |
|                                                                          |            |                |             |                                                                             |            |  |  |  |  |  |  |  |  |

 

Thefollowing methods and assumptions were used to estimate fair values forfinancial instruments carried on the balance sheet at other than fairvalue.  The carrying amount is consideredto estimate fair value for cash and due from banks, demand, NOW, money marketand savings deposits, accrued interest receivable and payable, and variablerate loans or deposits.  The fair valueof loans held for sale are based on quoted market prices.  For fixed rate loans, deposits, or otherborrowings, the fair value is estimated by discounted cash flow analysis usingcurrent market rates for the estimated life and credit risk. The fair value ofoff—balance—sheet items is based on the fees or cost that would currently becharged to enter into or terminate such agreements and is not material.

 

38

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

Thecarrying values and estimated fair values of the Company’s financialinstruments as of December 31, 2009 and 2008 were as follows:

 
| ** **                                     | ** ** | **2009**             | ** **   | **2008**        | ** ** |
|------------------------------------------------|------------|----------------------|--------------|-----------------|------------|
| ** **                                     | ** ** | **Carrying  Amount** | ** **   | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| **Assets**                                     |       |                 |         |            |       |   |   |   |   |
| Cash and cash equivalents                      |       | $                    |  17,921 |            | $          | 17,921 |   | $ | 26,474 |   | $ | 26,474 |   |
| Certificates of deposit and related derivative |       | 41,011               |         | 41,781          |       | 14,854 |   | 15,071 |   |
| Securities available for sale                  |       | 56,373               |         | 56,373          |       | 57,825 |   | 57,825 |   |
| Loans held for sale                            |       | 46                   |         | 46              |       | 229 |   | 229 |   |
| Loans                                          |       | 147,105              |         | 145,690         |       | 157,751 |   | 156,826 |   |
| Interest receivable                            |       | 1,361                |         | 1,361           |       | 1,603 |   | 1,603 |   |
| ** **                                     |       |                 |         |            |       |   |   |   |   |
| **Liabilities**                                |       |                 |         |            |       |   |   |   |   |
| Deposits with no stated maturities             |       | 174,872              |         | 174,872         |       | 155,192 |   | 155,192 |   |
| Time deposits                                  |       | 76,357               |         | 77,705          |       | 85,538 |   | 86,498 |   |
| Other Borrowings                               |       | 4,000                |         | 4,061           |       | 6,000 |   | 6,081 |   |
| Interest payable                               |       | 427                  |         | 427             |       | 684 |   | 684 |   |
|                                                |            |                      |              |                 |            |  |  |  |  |  |  |  |  |

 

**NOTE 16 —REGULATORY AND CAPITAL MATTERS**

 

TheCompany may pay dividends without restriction under the current Federal Reserveregulations so long as it remains “adequately capitalized” after suchpayment.  The Bank is subject tostatutory dividend restrictions which provide, in general, that the Bank maypay the current year’s earnings and the prior two years’ retained earningswithout the prior approval of the Office of the Comptroller of Currency.  At December 31, 2009, the Bank’sstockholder’s equity totaled $25,653,000, of which $24,924,000 was notavailable for payment of dividends, without prior regulatory approval.

 

TheCompany and the Bank are subject to various regulatory capital requirementsadministered by the federal banking agencies. Capital adequacy guidelines and prompt corrective action regulationsinvolve quantitative 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.

 

39

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

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

 

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

 
| ** **                                                   | ** ** | **Actual** | ** ** | **Required for Adequate  Capital** | ** ** | **To Be Well  Capitalized** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------------------------------|------------|-----------------------------|------------|
| ** **                                                   | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                  | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **December 31, 2009**                                   |       |       |       |                               |       |                        |       |   |   |   |   |   |   |
| Total risk–based capital (to risk–weighted assets) |       | $          | 25,133     |                               | 14.3       | %                           | $          | 14,041 |   | 8.0 | % | $ | 17,552 |   | 10.0 | % |
| Tier 1 capital (to risk–weighted assets)                |       | 22,939     |       | 13.1                               | %          | 7,021                       |       | 4.0 | % | 10,531 |   | 6.0 | % |
| Tier 1 capital (to average assets)                           |       | 22,939     |       | 8.1                                | %          | 11,387                      |       | 4.0 | % | 14,234 |   | 5.0 | % |
| ** **                                                   |       |       |       |                               |       |                        |       |   |   |   |   |   |   |
| **December 31, 2008**                                   |       |       |       |                               |       |                        |       |   |   |   |   |   |   |
| Total risk–based capital (to risk–weighted assets) |       | $          | 23,354     |                               | 13.2       | %                           | $          | 14,203 |   | 8.0 | % | $ | 17,754 |   | 10.0 | % |
| Tier 1 capital (to risk–weighted assets)                |       | 21,742     |       | 12.3                               | %          | 7,102                       |       | 4.0 | % | 10,652 |   | 6.0 | % |
| Tier 1 capital (to average assets)                           |       | 21,742     |       | 8.1                                | %          | 10,793                      |       | 4.0 | % | 13,491 |   | 5.0 | % |

 

At December 31,2009, the Bank was categorized as well capitalized and management is not awareof any conditions or events since the most recent notification that wouldchange the Bank’s category.

 

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

 
| ** **                                                                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Other comprehensive income                                                   |       |     |       |     |       |
| Unrealized holding gains (losses) arising during the  year                   |       | $        | 1,224      |     | $          | 79 |   |
| Less: reclassification adjustment for (gains) losses  realized in net income |       | (979     | )          | 647      |       |
| Net gains ( losses)   relating to benefit liability                     |       | 169      |       | (401     | )          |
| Tax effect                                                                   |       | (141     | )          | (91      | )          |
|                                                                         |       |     |       |     |       |
| Other comprehensive income                                                   |       | $        | 273        |     | $          | 234 |   |

 

The components ofaccumulated other comprehensive income (loss), included in stockholders equityare as follows:

 
| ** **                                                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net unrealized gain (loss) on securities available  for sale |       | 777      |       | 532      |       |
| Net loss relating to benefit liability                       |       | (703     | )          | (872     | )          |
| Tax effect                                                   |       | (25      | )          | 116      |       |
|                                                         |       |     |       |     |       |
| Accumulated other comprehensive income (loss)                |       | $        | 49         |     | $          | (224 | ) |
|                                                              |            |          |            |          |            |  |  |

 

40

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

**NOTE 18 —PARENT COMPANY FINANCIAL STATEMENTS**

 

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

 

**Condensed Balance Sheets**

 
| ** **                                      | ** ** | **2009** | ** ** | **2008** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                      |       |     |       |     |       |
| Cash on deposit with Bank                       |       | $        | 502        |     | $          | 1,333 |   |
| Investment in common stock of Bank              |       | 25,654   |       | 24,423   |       |
| Other assets                                    |       | 223      |       | 203      |       |
|                                            |       |     |       |     |       |
| Total assets                                    |       | $        | 26,379     |     | $          | 25,959 |   |
| ** **                                      |       |     |       |     |       |
| **Liabilities**                                 |       |     |       |     |       |
| Dividends payable                               |       | $        | 401        |     | $          | 1,290 |   |
|                                            |       | 401      |       | 1,290    |       |
| ** **                                      |       |     |       |     |       |
| **Shareholders’ Equity**                   |       | 25,978   |       | 24,669   |       |
|                                            |       |     |       |     |       |
| Total liabilities and shareholders’ equity |       | $        | 26,379     |     | $          | 25,959 |   |

 

**Condensed Statements of Income**

 
| ** **                                                                     | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Income** - dividends from Bank                                               |       | $        | 1,067      |     | $          | 2,250 |   |
| ** **                                                                     |       |     |       |     |       |
| **Expenses**                                                                   |       | 219      |       | 198      |       |
| ** **                                                                     |       |     |       |     |       |
| **Income before income tax and equity in  undistributed income of subsidiary** |       | 848      |       | 2,052    |       |
| ** **                                                                     |       |     |       |     |       |
| **Income tax benefit**                                                         |       | 29       |       | 28       |       |
| ** **                                                                     |       |     |       |     |       |
| **Income before equity in undistributed income of  subsidiary**                |       | 877      |       | 2,080    |       |
| ** **                                                                     |       |     |       |     |       |
| **Equity in undistributed income (loss) of  subsidiary**                       |       | 957      |       | (227     | )          |
| ** **                                                                     |       |     |       |     |       |
| **Net Income**                                                                 |       | $        | 1,834      |     | $          | 1,853 |   |

 

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FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

 

**Condensed Statements of Cash Flows**

 
| ** **                                                         | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Operating Activities**                                           |       |     |       |     |       |
| Net income                                                         |       | $        | 1,834      |     | $          | 1,853 |   |
| Items not requiring (providing) cash                               |       |     |       |     |       |
| Equity in undistributed earnings of Bank                           |       | (957     | )          | 227      |       |
| Grant of incentive shares                                          |       | 9        |       |     |       |
| Vested stock options                                               |       | 117      |       | 105      |       |
| Other                                                              |       | (1       | )          | (3       | )          |
| Net cash provided by operating activities                          |       | 1,002    |       | 2,182    |       |
| ** **                                                         |       |     |       |     |       |
| **Investing Activity -**purchase of securities available for  sale |       | (20      | )          | —   |       |
| ** **                                                         |       |     |       |     |       |
| **Financing Activities**                                           |       |     |       |     |       |
| Purchase of treasury shares                                        |       | —   |       | (197     | )          |
| Loan proceeds (payments), net                                      |       | —   |       | (17      | )          |
| Cash dividends                                                     |       | (1,883   | )          | (1,935   | )          |
| Options exercised                                                  |       | 70       |       | 3        |       |
| Net cash used in financing activities                              |       | (1,813   | )          | (2,146   | )          |
| ** **                                                         |       |     |       |     |       |
| **Net Change in Cash and Cash Equivalents**                        |       | (831     | )          | 36       |       |
| ** **                                                         |       |     |       |     |       |
| **Cash and Cash Equivalents, Beginning of Year**                   |       | 1,333    |       | 1,297    |       |
| ** **                                                         |       |     |       |     |       |
| **Cash and Cash Equivalents, End of Year**                         |       | $        | 502        |     | $          | 1,333 |   |

 

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FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2009 and 2008

(Table dollaramounts in thousands, except per share data)

 

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

** **
| ** **     | ** ** | **Interest  Income** | ** ** | **Interest  Expense** | ** ** | **Net Interest  Income** | ** ** | **Provision** | ** ** | **Securities  Gains  (Losses)** | ** ** | **Net  Income** | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|----------------|------------|----------------------|------------|-----------------------|------------|-------------------------------|------------|---------------|------------|---------------------------------|------------|-----------------|------------|-----------|------------|-------------|------------|
|           |       |                 |       |                  |       |                          |       |          |       |                            |       |            |       |      |       |        |       |
| **2009**       |       |                 |       |                  |       |                          |       |          |       |                            |       |            |       |      |       |        |       |
| First quarter  |       | $                    | 3,230      |                  | $          | 944                           |       | $             | 2,286      |                            | $          | 270             |       | $         | 231        |        | $          | 553 |   | $ | 0.86 |   | $ | 0.86 |   |
| Second quarter |       | 3,039                |       | 855                   |       | 2,184                         |       | 120           |       | 4                               |       | 475             |       | 0.73      |       | 0.73        |       |
| Third quarter  |       | 3,153                |       | 763                   |       | 2,390                         |       | 120           |       | 3                               |       | 491             |       | 0.76      |       | 0.76        |       |
| Fourth quarter |       | 2,950                |       | 675                   |       | 2,275                         |       | 820           |       | 741                             |       | 315             |       | 0.49      |       | 0.49        |       |
| ** **     |       |                 |       |                  |       |                          |       |          |       |                            |       |            |       |      |       |        |       |
| **2008**       |       |                 |       |                  |       |                          |       |          |       |                            |       |            |       |      |       |        |       |
| First quarter  |       | $                    | 3,655      |                  | $          | 1,410                         |       | $             | 2,245      |                            | $          | 30              |       | $         | 22         |        | $          | 468 |   | $ | 0.72 |   | $ | 0.72 |   |
| Second quarter |       | 3,570                |       | 1,228                 |       | 2,342                         |       | 30            |       | —                          |       | 616             |       | 0.96      |       | 0.95        |       |
| Third quarter  |       | 3,445                |       | 1,128                 |       | 2,317                         |       | 30            |       | —                          |       | 573             |       | 0.89      |       | 0.89        |       |
| Fourth quarter |       | 3,291                |       | 1,041                 |       | 2,250                         |       | 80            |       | (668                            | )          | 196             |       | 0.30      |       | 0.30        |       |
|                |            |                      |            |                       |            |                               |            |               |            |                                 |            |                 |            |           |            |             |            |  |  |  |  |  |  |  |  |  |  |  |

 

Fourth quarter 2009 net income declined due to a$700,000 increase in the provision for loan losses due to increased nonperforming assets, compared to the prior quarter.

 

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FIRST OTTAWABANCSHARES, INC.

STOCKHOLDERSINFORMATION

 

ANNUALMEETING

 

TheAnnual Meeting of Stockholders will be held at 3:00 p.m., local time on May 19,2010 at the  Company’s corporateheadquarters located at 701 LaSalle Street, Ottawa, Illinois 61350.

 

PRICERANGE OF COMMON STOCK

 

As of February 22,2010, there were approximately 508 shareholders of record and 645,988outstanding shares of the Company’s common stock.

 

TheCompany’s common stock is not traded on any national or regional securitiesexchange and there is no established public trading market for it.  Transactions in the Company’s common stockhave been infrequent.  To the knowledgeof the Company’s management, during 2008, 2009 and the first two months of2010, an aggregate of approximately 68,549 shares of the Company’s common stockwas transferred in approximately 72 separate transactions. These transfersrepresented both transfers for consideration (i.e., sales) and transfers for noconsideration (e.g., gifts, estate transfers, etc.).  The Company’s management is unable todifferentiate such transfers and has limited knowledge of the sale prices fortransfers involving consideration.  Thelast price known to the Company’s management was a sale of 200 shares on February 16,2010 at $60.00 per share.

 

Thefollowing dividends per share were paid on the Company’s common stock on thedates indicated:  July 1, 2008 —$1.00; January 1, 2009 — $2.00; and July 1, 2009 - $0.92; January 1,2010 - $0.62.

 

WEB SITE FOR UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION FILINGS

 

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

 

CORPORATEGOVERNANCE

 

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

 

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** **

**StockholderReturn Performance Graph**

** **

**Thefollowing graph shows a comparison of cumulative total returns for FirstOttawa, the Nasdaq Stock Market and an index of Midwestern bank stocks whichare quoted on the OTC-Bulletin Board and on Pink Sheets.  The cumulative total stockholder returncomputations assume the investment of $100 on December 31, 2004 and thereinvestment of all dividends.  Figuresfor First Ottawa’s common stock represent inter-dealer quotations, withoutretail markups, mark downs or commissions and do not necessarily representactual transactions.  The graph wasprepared at our request by SNL Financial L.C., Charlottesville, Virginia.**

*** ***

***First Ottawa Bancshares, Inc.***

 

 
| ** **                         | ** ** | **Period Ending** | ** ** |
|------------------------------------|------------|------------------------|------------|
| **Index**                          | ** ** | **12/31/04**           | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** | **12/31/08** | ** ** | **12/31/09** | ** ** |
| First Ottawa Bancshares, Inc. |       | 100.00                 |       | 116.30 |   | 124.84 |   | 145.44 |   | 117.86 |   | 131.23 |   |
| NASDAQ Composite                   |       | 100.00                 |       | 101.37 |   | 111.03 |   | 121.92 |   | 72.49 |   | 104.31 |   |
| SNL Midwest OTC-BB and Pink Banks  |       | 100.00                 |       | 104.11 |   | 109.64 |   | 107.03 |   | 79.77 |   | 68.06 |   |

 

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