**EXHIBIT 13.1**

 

FIRST OTTAWA BANCSHARES,INC. AND SUBSIDIARY

Ottawa, Illinois

 

CONSOLIDATED FINANCIALSTATEMENTS

December 31, 2008,2007 and 2006

 

----

 

FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARY

Ottawa, Illinois

 

CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

 

INDEX

 
| SELECTED  CONSOLIDATED FINANCIAL INFORMATION                                                  | 1      |
|-----------------------------------------------------------------------------------------------|--------|
|                                                                                          |   |
| MANAGEMENT’ S DISCUSSION  AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS | 2      |
|                                                                                          |   |
| REPORT  OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM                                      | 18     |
|                                                                                          |   |
| FINANCIAL  STATEMENTS                                                                         |   |
|                                                                                          |   |
| CONSOLIDATED BALANCE  SHEETS                                                                  | 19     |
|                                                                                          |   |
| CONSOLIDATED STATEMENTS OF  INCOME                                                            | 20     |
|                                                                                          |   |
| CONSOLIDATED STATEMENTS OF  SHAREHOLDERS’ EQUITY                                         | 21     |
|                                                                                          |   |
| CONSOLIDATED STATEMENTS OF  CASH FLOWS                                                        | 22     |
|                                                                                          |   |
| NOTES TO CONSOLIDATED  FINANCIAL STATEMENTS                                                   | 23     |

 

----

 

**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, FirstOttawa 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,** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                  | ** ** | **2008**                              | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Statement of Income Data:**                                               |       |                                  |       |   |   |   |   |   |   |   |   |
| Total interest income                                                       |       | $                                     | 13,961     |   | $ | 15,231 |   | $ | 15,274 |   | $ | 14,164 |   | $ | 13,537 |   |
| Total interest expense                                                      |       | 4,807                                 |       | 6,282 |   | 6,361 |   | 4,613 |   | 4,200 |   |
| Net interest income                                                         |       | 9,154                                 |       | 8,949 |   | 8,913 |   | 9,551 |   | 9,337 |   |
| Provision for loan losses                                                   |       | 170                                   |       | 180 |   | 180 |   | 300 |   | 300 |   |
| Noninterest income                                                          |       | 1,044                                 |       | 2,349 |   | 2,430 |   | 2,586 |   | 3,195 |   |
| Noninterest expense                                                         |       | 7,740                                 |       | 7,934 |   | 8,075 |   | 8,501 |   | 8,807 |   |
| Income before income taxes                                                  |       | 2,288                                 |       | 3,184 |   | 3,088 |   | 3,336 |   | 3,425 |   |
| Provision for income taxes                                                  |       | 435                                   |       | 769 |   | 753 |   | 791 |   | 797 |   |
|                                                                        |       |                                  |       |   |   |   |   |   |   |   |   |
| Net income                                                                  |       | $                                     | 1,853      |   | $ | 2,415 |   | $ | 2,335 |   | $ | 2,545 |   | $ | 2,628 |   |
|                                                                        |       |                                  |       |   |   |   |   |   |   |   |   |
| **Per Share Data:**                                                         |       |                                  |       |   |   |   |   |   |   |   |   |
| Net income – basic                                                     |       | $                                     | 2.87       |   | 3.72 |   | $ | 3.59 |   | $ | 3.92 |   | $ | 4.03 |   |
| Net income – diluted                                                   |       | 2.86                                  |       | 3.71 |   | 3.59 |   | 3.90 |   | 4.03 |   |
| Cash dividends declared                                                     |       | 3.00                                  |       | 3.00 |   | 3.00 |   | 3.00 |   | 3.00 |   |
| Book value at end of year (1)                                               |       | 38.60                                 |       | 38.72 |   | 38.08 |   | 37.43 |   | 36.54 |   |
|                                                                        |       |                                  |       |   |   |   |   |   |   |   |   |
| **Selected Financial Ratios:**                                              |       |                                  |       |   |   |   |   |   |   |   |   |
| Return on average assets (1)                                                |       | .67                                   | %          | .87 | % | .82 | % | .87 | % | .88 | % |
| Return on average equity (1)                                                |       | 7.32                                  |       | 9.58 |   | 9.43 |   | 10.50 |   | 11.05 |   |
| Dividend payout ratio                                                       |       | 104.40                                |       | 80.65 |   | 83.57 |   | 76.53 |   | 74.44 |   |
| Average equity to average assets (1)                                        |       | 9.11                                  |       | 9.09 |   | 8.71 |   | 8.30 |   | 7.96 |   |
| Net interest margin (tax equivalent)                                        |       | 3.91                                  |       | 3.78 |   | 3.63 |   | 3.80 |   | 3.60 |   |
| Allowance for loan losses to total loans at the end  of period              |       | 1.01                                  |       | .96 |   | .91 |   | .88 |   | .88 |   |
| Nonperforming loans to total loans at the end of  period (2)                |       | 1.92                                  |       | .76 |   | .42 |   | .87 |   | 1.55 |   |
| Net loans charged off to average total loans                                |       | .09                                   |       | .03 |   | .04 |   | .09 |   | .13 |   |
|                                                                        |       |                                  |       |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                                     |       |                                  |       |   |   |   |   |   |   |   |   |
| Total assets                                                                |       | $                                     | 275,181    |   | $ | 269,231 |   | $ | 278,053 |   | $ | 278,739 |   | $ | 288,659 |   |
| Total earning assets                                                        |       | 236,287                               |       | 243,718 |   | 253,259 |   | 253,641 |   | 262,618 |   |
| Average assets                                                              |       | 275,772                               |       | 275,777 |   | 282,729 |   | 290,765 |   | 299,665 |   |
| Gross loans, including loans held for sale                                  |       | 159,592                               |       | 165,805 |   | 160,938 |   | 152,860 |   | 134,493 |   |
| Allowance for loan losses                                                   |       | 1,612                                 |       | 1,588 |   | 1,463 |   | 1,344 |   | 1,174 |   |
| Total deposits                                                              |       | 240,730                               |       | 240,377 |   | 250,341 |   | 239,881 |   | 253,964 |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | —                                |       | — |   | — |   | 12,700 |   | 6,350 |   |
| Shareholders’   equity                                            |       | 24,669                                |       | 24,606 |   | 23,509 |   | 22,858 |   | 23,852 |   |

 

----

(1)               Excludesunrealized gain (loss) on securities available–for–sale.

(2)               Includestotal nonaccrual loans, impaired loans, and all other loans 90 days past dueand still accruing interest.

 

1

----

 

**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$1.9 million for the year ended December 31, 2008, compared to $2.4million for the year ended December 31, 2007.  The return on average assets was .67% in 2008compared to .87% in 2007.  The return onaverage equity decreased to 7.32% in 2008 from 9.58% in 2007.  This decrease resulted primarily from thedecrease in net income of $563,000 and an increase in accumulated othercomprehensive income of $234,000 in 2008, partially offset by the change inaverage equity due to stock repurchases in 2008 and 2007.

 

Net income was$2.4 million for the year ended December 31, 2007, compared to $2.3million for the year ended December 31, 2006.  The return on average assets was .87% in 2007compared to .82% in 2006.  The return onaverage equity increased to 9.58% in 2007 from 9.43% in 2006.  This increase resulted primarily from theincrease in net income of $80,000 and an increase in accumulated othercomprehensive income of $859,000 in 2007, partially offset by the change inaverage equity due to stock repurchases in 2007 and 2006.

 

2

----

 

# **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. The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions.  The Company’s financial condition and resultsof operations can be affected by these estimates and assumptions and areintegral to the understanding of reported results. Critical accounting policiesare those policies that management believes are the most important to theportrayal of the Company’s financial condition and results of operations, andthey require management to make estimates that are difficult, subjective, orcomplex.

 

***Allowancefor Loan Losses*.**The allowance for loan losses providescoverage for probable losses inherent in the Company’s loan portfolio.  Management evaluates the adequacy of theallowance for loan losses each quarter based on changes, if any, inunderwriting activities, the loan portfolio composition (including product mixand geographic, industry or customer–specific concentrations), trends in loanperformance, regulatory guidance and economic factors. This evaluation isinherently subjective, as it requires the use of significant managementestimates. Many factors can affect management’s estimates of specific andexpected losses, including volatility of default probabilities, ratingmigrations, 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 their unique businessconditions, the judgmental nature of individual loan evaluations, collateralassessments 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.

 

3

----

 

***MortgageServicing Rights.*** Mortgage servicing rights (“MSRs”)associated with loans originated and sold, where servicing is retained, arecapitalized and included in other intangible assets in the consolidated balancesheet.  The value of the capitalizedservicing rights represents the present value of the future servicing feesarising from the right to service loans in the portfolio.  Critical accounting policies for MSRs relateto the initial valuation and subsequent impairment tests.  The methodology used to determine thevaluation of MSRs requires the development and use of a number of estimates,including anticipated principal amortization and prepayments of that principalbalance.  Events that may significantlyaffect the estimates used are changes in interest rates, mortgage loanprepayment speeds and the payment performance of the underlying loans.  The carrying value of the MSRs isperiodically reviewed for impairment based on a determination of fairvalue.  For purposes of measuringimpairment, the servicing rights are compared to a valuation prepared based ona discounted cash flow methodology, utilizing current prepayment speeds anddiscount rates.  Impairment, if any, isrecognized through a valuation allowance and is recorded as amortization ofintangible assets.

 

***Derivatives.***As a part of the Company’s funding strategy, derivative financialinstruments, all of which are interest rate swap arrangements, are used toreduce exposure to changes in interest rates for certain financialinstruments.  These derivatives are accounted for by recognizing the fairvalue of the contracts on the balance sheet.  The valuation of thesederivatives is considered critical because carrying assets and liabilities atfair value inherently results in more financial statement volatility.  Thefair values and the information used to record valuation adjustments for theinterest rate swaps and related deposit products are provided by third parties.

 

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

 

***StockCompensation***. Grants under the Company’s stockincentive plan are accounted for under the provisions of Statement of AccountingStandards (SFAS) No. 123R, applying the fair value method and the use ofan option pricing model to estimate the value of the options granted.  The stock options are granted with anexercise price equal to the market price at the date of grant.  Resulting compensationexpense, under the stock options, is measured and recorded based onthe estimated value of the options.

 

***Valuation Measurements.***  Valuation methodologies ofteninvolve a significant degree of judgment, particularly when there are no observableactive markets for the items being valued. Investment securities andderivatives are carried at fair value, as defined in SFAS No. 157 “FairValue Measurement” (“SFAS 157”), which requires key judgments affectinghow fair value for such assets and liabilities is determined. In addition, theoutcomes of valuations have a direct bearing on the carrying amounts ofgoodwill, mortgage servicing rights, and pension and other postretirementbenefit obligations. To determine the values of these assets and liabilities,as well as the extent to which related assets may be impaired, Management makesassumptions and estimates related to discount rates, asset returns, prepaymentrates and other factors. The use of different discount rates or other valuationassumptions could produce significantly different results, which could affectthe Company’s results of operations.

 

4

----

 

***Goodwill******.***   Under SFAS No. 142, “Goodwilland Other Intangible Assets” (“SFAS 142”), the Company is required toevaluate goodwill for impairment on an annual basis or whenever events orchanges in circumstances indicate that the carrying value may not berecoverable. The Corporation has elected to test for goodwill impairment as of December 31stof each year. The Company cannot predict the occurrence of certain futureevents that 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.

 

5

----

 

**ConsolidatedFinancial Condition**

 

Total assets at December 31,2008 were $275.2 million compared to $269.2 million at December 31, 2007,an increase of $6.0 million, or 2.2%. Despite the increase in our total assets, our total loans, net of theallowance for loan losses, decreased 3.7% in 2008 to $158.0 million.  Real estate loans decreased by $8.1  million during 2008, due to an effort bymanagement to maintain credit quality during a period of decreasing demand. Inaddition to the decreases in commercial and residential real estate loans,installment loans decreased by $1.7 million due to a general decline inindirect lending volume and more stringent underwriting guidelines on consumerloans.   Commercial and agriculturalloans increased $5.3 million during 2008, partially offsetting the decreasedvolume in real estate loans. Investment securities decreased by $8.3 million,and certificates of deposit held for investment purposes increased by $11.0million.  The increase in certificates ofdeposit held for investment purposes was funded by the decrease in investmentsecurities. Cash and cash equivalents increased $10.0 million as managementattempted to remain liquid through the end of 2008.  Premises and equipment decreased by $319,000due to normal depreciation and a reduction in capital expenditures on existingbuildings. Deposits increased by $350,000, to $240.7 million at December 31,2008, compared to $240.4 million in the prior year. Other borrowings increasedby $6 million due to an increase in Federal Home Loan Bank advances in 2008compared to none in 2007

 

Total shareholders’equity was $24.7 million at December 31, 2008, and $24.6 million at December 31,2007.  This slight increase was primarilythe result of a decrease in the unrealized loss on securities available–for–sale,net of tax, of $234,000, and $108,000 in additional paid in capital related tothe Company’s stock option plan. Dividends declared of $1.9 million and the repurchase of Company commonstock for $197,000 were offset by net income of $1.9 million.

 

# **ConsolidatedResults of Operations**

 

# **2008Compared to 2007**

 

*NetInterest Income.*  Netinterest income was $9.2 million in 2008 and $8.9 million in 2007.  Interest income on earning assets decreased$1.3 million in 2008 from 2007.  Thisdecrease was primarily attributable to a decrease in interest income earned onthe loan portfolio of $1.0 million, taxable securities of $638,000, and federalfunds sold of $146,000.  Increasedinterest income earned on certificates of deposit held for investment of$322,000 and tax exempt securities of $205,000 helped to offset the decreasedloan and taxable securities income.  Thedecrease in interest income on earning assets is attributable to decreases inaverage balances and also average yields available in the marketplace in2008.  Interest expense on interest–bearingliabilities decreased $1.5 million as a result of a decrease in the averagecost of funds in 2008 compared to 2007. The net interest margin on a tax equivalent basis increased to 3.91% in2008 from 3.78% in 2007.  The primaryreason for the increase in the net interest margin was the result of anincrease in the market rates earned on assets during the continuing gradualreallocation of assets to instruments which earn at higher rates than othertypes of interest-bearing assets.

 

*Provisionfor Loan Losses.*  Theprovision for loan losses was $170,000 in 2008 compared to $180,000 in2007.  As of December 31, 2008, theallowance for loan losses totaled $1.6 million, or 

 

6

----

 

1.01% of totalloans, compared to $1.6 million, or .96% of total loans, at December 31,2007.  The increase in the allowance forloan losses in 2008 was influenced by the current economy and the assessment ofrisk factors affecting the Company’s 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 2009.  If the economy continues to slump, borrowersmay experience difficulty, and the level of non–performing loans, charge-offs,and delinquencies could rise and require increases in the provision.  Regulatory agencies have warned of possiblehigher charge-offs in the industry.  Theallowance for loan losses represents management’s estimate of probable incurredlosses based on information available as of the date of the financialstatements.  The allowance for loanlosses is based on management’s evaluation of the collectibility of the loanportfolio, including past loan loss experience, known and inherent risks in thenature and volume of the portfolio, information about specific borrowersituations and estimated collateral values, and economic conditions.

 

Management has concluded that the allowance for loanlosses was adequate at December 31, 2008 to absorb probable losse onexisting loans.  However, there can be noassurance that the allowance for loan losses will be adequate to cover suchlosses.

 

*NoninterestIncome.*  The Company’stotal noninterest income in 2008 decreased $1.3 million, or 55.6%, compared to2007.  Noninterest income decreasedprimarily due to impairment losses realized on equity security investments of$647,000 and decreases in the market value of derivatives related to indexpowered certificates of deposit held for investments and for customers of theBank. The impairment losses were realized on Fannie Mae common stock and alsoon equity mutual funds with underlying collateral consisting of variouscorporate loans. The market adjustment for the index powered certificates ofdeposit in the current year decreased $521,000, resulting in a loss of$401,000, compared to a gain of $120,000 in the prior year.  Service charges on deposit accounts decreasedby $165,000, or 16.2%, to $852,000 due to decreased overdraft volume in 2008compared to 2007. Net gains on sales of loans to the secondary market increased$29,000 to $58,000 in 2008 compared to 2007 as a result of increasedoriginations of residential real estate loans because of the general decreasein interest rates in 2008. Trust and farm management fee income remainedconstant at $540,000 in 2008 and 2007.

 

*Noninterest Expense.*  The Company’s total noninterest expense was$7.7 million in 2008 and $7.9 million in 2007. Salaries and employee benefits,which is the largest component of noninterest expense, decreased $166,000 to$4.3 million in 2008.  Decreases in supplies of $11,000,amortization of core deposit intangibles of $41,000, and professional fees of$75,000 were partially offset by an increase in occupancy and equipment expenseof $56,000 and data processing fees of $42,000 in 2008.  Income tax expense in 2008 decreased by$334,000 compared to 2007. The Company’s effective tax rate decreased in 2008due to impairment losses recognized.

 

7

----

 

*IncomeTaxes.*  The Company’sincome tax rate varied from statutory rates principally due to interest incomefrom tax—exempt securities and loans. The Company’s effective tax rate was 15.2% and 24.1% for 2008 and 2007,respectively.

 

# **2007Compared to 2006**

 

*NetInterest Income.*  Netinterest income was $8.9 million in 2007 and 2006.  Interest income on earning assets decreased$43,000 in 2007 from 2006.  This decreasewas primarily attributable to decreased interest income earned on taxable andnon taxable securities of $356,000, and certificates of deposit held forinvestment of $63,000.  Increasedinterest income earned on the loan portfolio of $398,000 helped to offset thedecreased securities income.  Theincrease is attributable to increases in average balances and also averageyields available in the marketplace in 2007. Interest expense on interest–bearing liabilities decreased $79,000 as aresult of a decrease in the average balances of liabilities in 2007 compared to2006.  The net interest margin on a taxequivalent basis increased to 3.78% in 2007 from 3.63% in 2006.  The primary reason for the increase in thenet interest margin was the result of an increase in the market rates earned onassets during the continuing gradual reallocation of assets to loans which earnat higher rates than other types of interest-bearing assets.

 

*Provisionfor Loan Losses.*  Theprovision for loan losses was $180,000 in 2007 and 2006.  As of December 31, 2007, the allowancefor loan losses totaled $1.6 million, or 0.96% of total loans, compared to $1.5million, or .91% of total loans, at December 31, 2006.  The increase in the allowance for loan lossesin 2007 was influenced by the continued growth in the loan portfolio and wasnot a direct result of the current economy or the quality of our loanportfolio.

 

The amounts of theprovision and allowance for loan losses are influenced by current economicconditions, actual loss experience, industry trends and other factors,including real estate values in the Company’s market area and management’sassessment of current collection risks within the loan portfolio.  Along with other financial institutions,management shares a concern for the outlook of the economy for 2008.  Even though there are indications of emergingstrength, it is uncertain if this strength is sustainable. If it is 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, 2007. However, there can be no assurance that the allowance for loan losseswill be adequate to cover all losses.

 

*NoninterestIncome.*  The Company’snoninterest income decreased $81,000, or 3.3%, compared to 2006.  Noninterest income decreased primarily due toa decrease in other income. Other income decreased by $144,000, or 15.9%,compared to 2006.  This decrease wasprimarily due to a 

 

8

----

 

$195,000 decrease in themarket value of derivatives related to index powered certificates of depositheld for investments and for customers of the Bank.  Gains on loan sales to the secondary marketdecreased $2,000 to $29,000 in 2007 compared to 2006 as a result of feweroriginations of residential real estate loans because of the general increasein interest rates in 2007.  Servicecharges on deposit accounts increased by $52,000, or 5.4%, to $ 1.0million.  Trust and farm management feeincome remained constant at $540,000 in 2007 and 2006.

 

*Noninterest Expense.*  The Company’s noninterest expense was $7.9million in 2007 and $8.1 million for 2006. Salaries and benefits, which isthe largest component of non-interest expense, decreased $125,000, to $4.4million in 2007.  Decreases in supplies expense of$25,000, amortization of core deposit intangible expense of $51,000, and otherexpenses of $121,000 were partially offset by an increase in occupancy andequipment expense of $4,000, professional fees of $132,000, data processingexpense of $45,000 in 2007.  Otherexpense was reduced due to decreased collection expenses, decreased secondarymortgage market expenses, and decreased miscellaneous operating expenses.  Professional fees increased due to theresolution of two ongoing litigation matters during 2007. Income tax expenseincreased by $16,000 compared to 2006. The Company’s effective tax ratedecreased slightly in 2007.

 

*IncomeTaxes.*  The Company’stax rate varied from statutory rates principally due to interest income fromtax–exempt securities and loans.  TheCompany’s effective tax rate was 24.1% and 25.2% for 2007 and 2006.

 

9

----

 

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)

 
| ** **                                             | ** ** | **2008 - 2007**    | ** ** | **2007 – 2006** | ** ** |
|--------------------------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **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                                                  |       | $                            | (1,012     | )                              | $          | 60 |   | $ | (1,072 | ) | $ | 386 |   | $ | 106 |   | $ | 280 |   |
| Investment CDs                                         |       | 321                          |       | 282                            |       | 39 |   | (63 | ) | (62 | ) | (1 | ) |
| Securities                                             |       | (327                         | )          | (470                           | )          | 143 |   | (391 | ) | (388 | ) | (3 | ) |
| Federal funds sold                                     |       | (146                         | )          | 39                             |       | (185 | ) | (22 | ) | (12 | ) | (10 | ) |
| Total interest income                                  |       | (1,164                       | )          | (89                            | )          | (1,075 | ) | (90 | ) | (356 | ) | 266 |   |
|                                                   |       |                         |       |                           |       |   |   |   |   |   |   |   |   |
| INTEREST EXPENSE                                       |       |                         |       |                           |       |   |   |   |   |   |   |   |   |
|                                                   |       |                         |       |                           |       |   |   |   |   |   |   |   |   |
| NOW and money market                                   |       | (1,206                       | )          | (37                            | )          | (1,169 | ) | 182 |   | 125 |   | 57 |   |
| Savings                                                |       | (9                           | )          | (3                             | )          | (6 | ) | (6 | ) | (9 | ) | 3 |   |
| Time deposits                                          |       | (335                         | )          | (10                            | )          | (325 | ) | (232 | ) | (665 | ) | 433 |   |
| Repurchase agreements                                  |       | 1                            |       | 1                              |       | — |   | — |   | — |   | — |   |
| Borrowings                                             |       | 173                          |       | 173                            |       | — |   | — |   | — |   | — |   |
| Federal funds purchased                                |       | (99                          | )          | (61                            | )          | (38 | ) | (23 | ) | (37 | ) | 14 |   |
| Total interest expense                                 |       | (1,475                       | )          | 63                             |       | (1,538 | ) | (79 | ) | (586 | ) | 507 |   |
|                                                   |       |                         |       |                           |       |   |   |   |   |   |   |   |   |
| Net interest earnings                                  |       | 311                          |       | (152                           | )          | 463 |   | (11 | ) | 230 |   | (241 | ) |
| Tax equivalent adjustment                              |       | (106                         | )          |                           |       | (106 | ) | 47 |   | — |   | 47 |   |
|                                                   |       |                         |       |                           |       |   |   |   |   |   |   |   |   |
| Net interest earnings after tax equivalent  adjustment |       | $                            | 205        |                           | (152       | ) | 357 |   | 36 |   | $ | 230 |   | $ | (194 | ) |
|                                                        |            |                              |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

### **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.

 

10

----

 

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

Years Ended December 31, 2008, 2007 and2006

(in Thousands)

 
| ** **                                                                | ** ** | **2008**             | ** ** | **2007**     | ** ** | **2006**    | ** ** |
|---------------------------------------------------------------------------|------------|----------------------|------------|--------------|------------|-------------|------------|
| ** **                                                                | ** ** | **Average**          | ** ** | ** **   | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                                | ** ** | **Balance (4)** | ** ** | **Interest** | ** ** | **Rate**    | ** ** | **Balance (4)** | ** ** | **Interest** | ** ** | **Rate** | ** ** | **Balance (4)** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| ASSETS                                                                    |       |                 |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                      |       |                 |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1) (3)                                                        |       | $                    | 161,440    |         | $          | 10,980      |       | 6.80 | % | $ | 160,565 |   | $ | 11,992 |   | 7.47 | %   | $ | 159,145 |   | $ | 11,606 |   | 7.29 | % |
| Investment CDs                                                            |       | 13,883               |       | 497          |       | 3.58        |       | 6,017 |   | 176 |   | 2.93 |   | 8,128 |   | 239 |   | 2.94 |   |
| Securities (2) (5)                                                   |       | 65,447               |       | 2,865        |       | 4.38        |       | 76,180 |   | 3,192 |   | 4.19 |   | 85,448 |   | 3,583 |   | 4.19 |   |
| Federal funds sold                                                        |       | 8,545                |       | 203          |       | 2.38        |       | 6,891 |   | 349 |   | 5.06 |   | 7,127 |   | 371 |   | 5.21 |   |
| Interest–earning assets                                              |       | 249,315              |       | 14,545       |       | 5.83        |       | 249,653 |   | 15,709 |   | 6.29 |   | 259,848 |   | 15,799 |   | 6.08 |   |
| Noninterest–earning assets (6)                                       |       | 26,457               |       |         |       |        |       | 23,297 |   |   |   |   |   | 22,881 |   |   |   |   |   |
|                                                                      |       |                 |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Average assets                                                            |       | $                    | 275,772    |         |       |        |       |   | $ | 272,950 |   |   |   |   |   | $ | 282,729 |   |   |   |   |   |
|                                                                      |       |                 |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                 |       |                 |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                      |       |                 |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money market                                                      |       | $                    | 95,138     |         | $          | 1,017       |       | 1.07 | % | $ | 98,592 |   | $ | 2,223 |   | 2.25 | % | $ | 93,042 |   | $ | 2,041 |   | 2.19 | % |
| Savings                                                                   |       | 22,739               |       | 115          |       | .51         |       | 23,418 |   | 124 |   | .53 |   | 25,067 |   | 130 |   | .52 |   |
| Time deposits                                                             |       | 90,715               |       | 3,500        |       | 3.86        |       | 90,970 |   | 3,835 |   | 4.22 |   | 106,750 |   | 4,067 |   | 3.81 |   |
| Repurchase agreements                                                     |       | 76                   |       | 1            |       | 1.32        |       | — |   | — |   | — |   | — |   | — |   | — |   |
| Federal funds purchased                                                   |       | 29                   |       | 1            |       | 3.45        |       | 1,798 |   | 100 |   | 5.56 |   | 1,715 |   | 123 |   | 4.98 |   |
| Borrowings                                                                |       | 5,557                |       | 173          |       | 3.11        |       | — |   | — |   | — |   | 126 |   | — |   | — |   |
| Interest–bearing liabilities                                         |       | 214,254              |       | 4,807        |       | 2.24        |       | 214,778 |   | 6,282 |   | 2.92 |   | 227,329 |   | 6,361 |   | 2.80 |   |
|                                                                      |       |                 |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income (2)                                                   |       |                 |       | 9,738        |       |        |       |   |   | 9,427 |   |   |   |   |   | 9,438 |   |   |   |
| Net yield on interest– earning assets                                |       |                 |       |         |       | 3.91        |       |   |   |   |   | 3.78 |   |   |   |   |   | 3.63 |   |
| Interest–bearing liabilities to earning  assets ratio                |       |                 |       |         |       | 85.94       |       |   |   |   |   | 86.03 |   |   |   |   |   | 87.49 |   |
|                                                                      |       |                 |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest–bearing liabilities                                      |       | 36,544               |       |         |       |        |       | 33,927 |   |   |   |   |   | 32,175 |   |   |   |   |   |
|                                                                      |       |                 |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                                                 |       | 24,974               |       |         |       |        |       | 24,245 |   |   |   |   |   | 23,225 |   |   |   |   |   |
| Average liabilities and shareholders’  equity                        |       | $                    | 275,722    |         |       |        |       |   | $ | 272,950 |   |   |   |   |   | $ | 282,729 |   |   |   |   |   |
| Tax equivalent adjustment                                                 |       |                 |       | 584          |       |        |       |   |   | 478 |   |   |   |   |   | 525 |   |   |   |
| Net interest income as reported in the consolidated  statements of income |       |                 |       | $            | 9,154      |        |       |   |   |   | $ | 8,949 |   |   |   |   |   | $ | 8,913 |   |   |   |

 

----

(1)         Interestincome on loans includes loan origination and other fees of $301 for 2008, $403for 2007, and $98 for 2006.

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

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

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

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

(6)         Averagebalance information includes an average valuation allowance for securities of$(523) , $(1,444) and $(2,327), respectively.

 

11

----

 

# **Impact ofAccounting Changes**

 

**Future Accounting Pronouncements**

 

DuringDecember 2007, the FASB issued Statementof Financial Accounting Standards No. 141 (Revised 2007), Business Combinations(“SFAS 141(R)”).  This Statementreplaces SFAS 141 “Business Combinations” (“Statement 141”). SFAS 141(R) retainsthe fundamental requirements in Statement 141 that the acquisition method ofaccounting (called the ‘purchase method’) be used for all business combinationsand for an acquirer to be identified for each business combination. ThisStatement defines the acquirer as the entity that obtains control of one ormore businesses, including those sometimes referred to as “true mergers” or “mergersof equals” and combinations achieved without the transfer of consideration, forexample, by contract alone or through the lapse of minority veto rights. Thisis broader than in Statement 141 which applied only to business combinations inwhich control was obtained by transferring consideration. This Statementrequires an acquirer to recognize the assets acquired, liabilities assumed andany noncontrolling interest in the acquiree at the acquisition date, measuredat their fair values as of that date. SFAS 141(R) recognizes and measures thegoodwill acquired in the business combination and defines a bargain purchase asa business combination in which the total acquisition-date fair value of theidentifiable net assets acquired exceeds the fair value of the considerationtransferred plus any noncontrolling interest in the acquiree, and it requiresthe acquirer to recognize that excess as a gain attributable to the acquirer.In contrast, Statement 141 required the “negative goodwill” amount to beallocated as a pro rata reduction of the amounts assigned to assets acquired.SFAS 141(R) applies prospectively to business combinations for which theacquisition date is on or after December 15, 2008. An entity may not apply itbefore that date.

 

DuringDecember 2007, the FASB issued Statementof Financial Accounting Standards No. 160, Noncontrolling Interests inConsolidated Financial Statements — an amendment of ARB No. 51 (“SFAS 160”).  SFAS 160 to establish accounting andreporting standards for the noncontrolling interest in a subsidiary and for thedeconsolidation of a subsidiary. It clarifies that a noncontrolling interest ina subsidiary is an ownership interest in the consolidated entity that should bereported as equity in the consolidated financial statement, but separate fromthe parent’s equity. Before the Statement was issued these so-called minorityinterests were reported in the consolidated statement of financial position asliabilities or in the mezzanine section between liabilities and equity. Theamount of consolidated net income attributable to the parent and to the noncontrollinginterest must be clearly identified and presented in the consolidated statementof income. This Statement requires that a parent recognize a gain or loss innet income when a subsidiary is deconsolidated. SFAS 160 is effective forfiscal years, and interim periods within those fiscal years, beginning on orafter December 15, 2008. Earlier adoption is prohibited. Management does notanticipate that this Statement will have a material impact on the Company’sconsolidated financial condition or results of operations.

 

DuringMarch 2008, the FASB issued Statementof Financial Accounting Standards No. 161, Disclosures about DerivativeInstruments and Hedging Activities — an amendment of FASB Statement No. 133(“SFAS 161”).  SFAS 161 amends and expands the disclosurerequirement of SFAS 133 No. 133 “Accounting for DerivativeInstruments and Hedging Activities” (“SFAS 133”) with the intent toprovide users of financial statements with an enhanced 

 

12

----

 

understandingof: (a) how and why an entity uses derivative instruments; (b) howderivative instrument and related hedged items are accounted for underSFAS 133 and its related interpretations; and (c) how derivativeinstruments and related hedged items affect an entity’s financial position,financial performance, and cash flows. To meet those objectives, SFAS 161requires qualitative disclosures about objectives and strategies for usingderivative, quantitative disclosures about fair value amounts of and gains andlosses on derivative instruments, and disclosures about credit-risk-relatedcontingent features in derivative agreements. SFAS 161 is effective forfinancial statements issued for fiscal years and interim periods beginningafter November 15, 2008. Early application is encouraged.  Management does not anticipate that thisStatement will have a material impact on the Company’s consolidated financialcondition or results of operations.

 

DuringMay 2008, the FASB issued Statementof Financial Accounting Standards, The Hierarchy of Generally AcceptedAccounting Principles (“SFAS 162”).   This Statementidentifies the sources of account principles and the framework for selectingthe principles to be used in the preparation of financial statements of nongovernmentalentities that are presented in conformity with generally accepted accountingprinciples (GAAP) in the United States. This Statement is effective60 days following the SEC approval of the Public Company AccountingOversight Board amendments to AU Section 411, “The Meaning of PresentFairly in Conformity With Generally Accepted Accounting Principles.” Adoptionof SFAS 162 will not be a change in the Company’s current accountingpractices; therefore, it will not have a material impact on the Company’sconsolidated financial condition or results of operations.

 

DuringJune 2008, the FASB issued FASB Staff Position EITF 03-6-1,Determining Whether Instruments Granted in Share-Based Payment Transactions areParticipating Securities (“FSP EITF 03-6-1”).   FSPEITF 03-6-1 clarifies whether instruments, such as restricted stock,granted in share-based payments are participating securities prior to vesting.Such participating securities must be included in the computation of earningsper share under the two-class method as described in SFAS No. 128, “Earningsper Share.” FSP EITF 03-6-1 requires companies to treat unvestedshare-based payment awards that have non-forfeitable rights to dividend ordividend equivalents as a separate class of securities in calculating earningsper share. FSP EITF 03-6-1 is effective for financial statements issuedfor fiscal years and interim periods beginning after December 15, 2008,and requires a company to retrospectively adjust its earning per share data.Early adoption is not permitted. It is not expected that the adoption of FSPEITF 03-6-1 will have a material effect on consolidated results ofoperations or earnings per share.

 

13

----

 

**QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

The Company uses overallrisk sensitivity to monitor and manage exposure to sudden changes in interestrates.  The Company’s overall interestrate sensitivity is demonstrated by a net interest income analysis.  Net interest income analysis measures thechange in net interest income in the event of hypothetical changes in interestrates.  This analysis assesses the riskof change in net interest income in the event of sudden and sustained 1.0%increases and decreases in market interest rates.  The tables below present the Company’sprojected changes in net income for the various rate shock levels for theperiods ended December 31, 2008 and 2007.

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

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

 

As shown above, at December 31,2008, the effect of an immediate 100 basis point increase in interest rateswould increase the Company’s net income by 1.2%, or approximately $32,000.  The effect of an immediate 100 basis pointdecrease in rates would decrease the Company’s net interest income by 2.3%, orapproximately $62,000.  The Company’sBoard of Directors has set a risk tolerance limit of 10% of estimated netinterest income for the succeeding 12 months based on an immediate 200 basispoint change in market prices. Federal funds overnight rates were under 1.0% asof December 31, 2008, therefore market interest rates decreasing anadditional 100 basis points may not be achievable in today’s rate environment.

 

Interest rate sensitivityreflected modest exposure in an decreasing rate environment at the end of 2008and 2007.  Overall net interest incomesensitivity increased slightly in 2008 compared to 2007.

 

14

----

 

**Liquidity and Capital Resources**

 

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

 

Liquidity management isboth 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– and intermediate–termU.S. Government and agency obligations.

 

The Company’s cash flowsare comprised of three primary classifications: cash flows from operating activities, investing activities, andfinancing activities.  Cash flowsprovided by operating activities were $3.9 million, $5.0 million, and $2.6million for the years ended December 31, 2008, 2007 and 2006,respectively.  Net cash from investingactivities consisted primarily of principal collections on loans and proceedsfrom maturation and sales of securities offset by disbursements for loanoriginations and the purchase of securities. Net cash from financing activities consisted primarily of changes in netdeposits and short–term borrowings partially offset by dividends paid and thepurchase of Company stock.

 

The Company’s most liquidassets are cash and short–term investments. The levels of these assets are dependent on the Company’s operating,financing, lending, and investing activities during any given year.  At December 31, 2008, cash and short–terminvestments totaled $26.5 million.  TheCompany has other sources of liquidity if a need for additional funds arises,including securities maturing within one year and the repayment of loans.  The Company may also utilize the sale ofsecurities available–for–sale, federal funds lines of credit from correspondentbanks, and borrowings from the Federal Home Loan Bank of Chicago and Marshalland Ilsley Bank.

 

15

----

 

The following tablediscloses contractual obligations and commercial commitments of the Company asof December 31, 2008:

 
| ** **                        | ** ** | ** ** | ** ** | **Less Than** | ** ** | ** **                          | ** ** | ** **                          | ** ** | **After**        | ** ** |
|-----------------------------------|------------|------------|------------|--------------------|------------|-------------------------------------|------------|-------------------------------------|------------|------------------|------------|
| ** **                        | ** ** | **Total**  | ** ** | **1 Year**    | ** ** | **1 – 3 Years** | ** ** | **4 – 5 Years** | ** ** | **5 Years** | ** ** |
|                              |       |       |       |               |       |                                |       |                                |       |             |       |
| Lines of  credit(1)               |       | $          | 15,972     |               | $          | 10,339                              |       | $                                   | 2,797      |             | $          | 693 |   | $ | 2,143 |   |
| Data processing  contract payable |       | 1,057      |       | 223                |       | 445                                 |       | 389                                 |       | —           |       |
| FHLB Advances                     |       | 6,000      |       | 2,000              |       | 4,000                               |       | —                              |       | —           |       |
| Standby letters  of credit(1)     |       | 185        |       | 173                |       | 12                                  |       | —                              |       | —           |       |
|                              |       |       |       |               |       |                                |       |                                |       |             |       |
|                              |       | $          | 23,034     |               | $          | 12,735                              |       | $                                   | 7,254      |             | $          | 1,082 |   | $ | 2,143 |   |

 

----

(1)  Represents amounts committed to customers.

 

During 2008 and 2007, theCompany repurchased 2,526 and 4,269 shares of common stock for $197,000 and$335,000, respectively.

 

Capital provides thefoundation for future growth.  Regulatoryagencies have developed minimum guidelines by which the adequacy of a financialinstitution’s capital may be evaluated. At December 31, 2008, all of the Company’s ratios exceeded thelevels required under regulatory guidelines as shown in Note 15 of theConsolidated Financial Statements.

 

**Facilities**

 

The Company is theholding company for the Bank.  The Bankis headquartered in Ottawa, Illinois and operates four offices in Ottawa, twobranches in Streator, a branch in Morris, a branch in Yorkville and a recently openedloan production office in Minooka. The Company has submitted an applicationwith the Office of the Comptroller of Currency and received approval torelocate the branch located at 401 East Main Street in Streator, Illinois, to409 East Bridge Street in Streator Illinois. This relocation would beconsidered a short distance relocation as defined in 12 CFR 5.3(i).

 

**Impact of Inflation and ChangingPrices**

 

The financial statementsand related data presented herein have been prepared in accordance withaccounting principles generally accepted in the United States of America, whichrequire the measurement of financial position and operating results in terms ofhistorical dollars without considering changes in the relative purchasing powerof money over time due to inflation.  Theprimary impact of inflation on the operations of the Company is reflected inincreased operating costs.  Unlike mostindustrial companies, virtually all of the assets and liabilities of afinancial institution are monetary in nature. As a result, interest rates generally have a more significant impact ona financial institution’s performance than does inflation.  Interest rates do not necessarily move in thesame direction or to the same extent as the prices of goods and services.

 

16

----

 

**SAFEHARBOR STATEMENT**

 

This document (includinginformation incorporated by reference) contains, and future oral and writtenstatements of the Company and its management may contain, forward-lookingstatements, within the meaning of such term in the Private SecuritiesLitigation Reform Act of 1995, with respect to the financial condition, resultsof operations, plans, objectives, future performance and business of theCompany.  Forward-looking statements,which may be based upon beliefs, expectations and assumptions of the Company’smanagement and on information currently available to management, are generallyidentifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,”“intend,” “estimate,” “may,” “will,” “would,” “could,” “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.

 

The Company’s ability topredict results or the actual effect of future plans or strategies isinherently uncertain. There are many factors that may impact any publiccompany, including ours, which could have a material adverse effect on theoperations and future prospects of the Company and its subsidiaries.  These risks and uncertainties should beconsidered in evaluating forward-looking statements and undue reliance shouldnot be placed on such statements.

 

17

----

 

**Report ofIndependent Registered Public Accounting Firm**

 

Audit Committee, Board ofDirectors and Stockholders

First Ottawa Bancshares, Inc.

Ottawa, Illinois

 

We have audited theaccompanying consolidated balance sheets of First Ottawa Bancshares, Inc.as of December 31, 2008 and 2007, and the related consolidated statementsof income, shareholders’ equity and cash flows for each of the three years inthe period ended December 31, 2008. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  The Company is not required to have, nor werewe engaged to perform, an audit of its internal control over financialreporting.  Our audits includedconsideration of internal control over financial reporting as a basis fordesigning auditing procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting.  Accordingly, we express no such opinion.  Our audits also included examining, on a testbasis, evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of First Ottawa Bancshares, Inc.as of December 31, 2008 and 2007, and the results of its operations andits cash flows for each of the three years in the period ended December 31,2008, in conformity with accounting principles generally accepted in the UnitedStates of America.

 

As discussed in Note 16,the Company changed it’s method of accounting for fair value measurements inaccordance with Statement of Financial Accounting Standards No. 157 in2008.

 

 

BKD, LLP

 

 

Indianapolis, Indiana

March 14, 2009

 

18

----

 

FIRST OTTAWABANCSHARES, INC.

CONSOLIDATEDBALANCE SHEETS

December 31,2008 and 2007

(In thousands,except share and per share data)

 
| ** **                                                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                                  |       |     |       |     |       |
| **Assets**                                                                  |       |     |       |     |       |
| ** **                                                                  |       |     |       |     |       |
| Cash and due  from banks                                                    |       | $        | 26,474     |     | $          | 10,209 |   |
| Interest–bearing  demand deposits                                      |       | —   |       | 6,290    |       |
| Cash and cash  equivalents                                                  |       | 26,474   |       | 16,499   |       |
| Certificates of  deposit                                                    |       | 14,854   |       | 3,808    |       |
| Investment  securities available for sale                                   |       | 57,825   |       | 66,174   |       |
| Loans held for  sale                                                        |       | 229      |       | —   |       |
| Loans, net of  allowance for loan losses of $1,612 and $1,588               |       | 157,751  |       | 163,837  |       |
| Premises and  equipment                                                     |       | 7,198    |       | 7,517    |       |
| Goodwill                                                                    |       | 2,446    |       | 2,446    |       |
| Core deposit  intangible                                                    |       | 653      |       | 816      |       |
| Interest  receivable and other assets                                       |       | 7,751    |       | 8,134    |       |
|                                                                        |       |     |       |     |       |
| Total assets                                                                |       | $        | 275,181    |     | $          | 269,231 |   |
|                                                                        |       |     |       |     |       |
| **Liabilities  and Shareholders’ Equity**                              |       |     |       |     |       |
|                                                                        |       |     |       |     |       |
| **Liabilities**                                                             |       |     |       |     |       |
| Deposits                                                                    |       | $        | 240,730    |     | $          | 240,377 |   |
| Other borrowings                                                            |       | $        | 6,000      |     | $          | — |   |
| Other  liabilities                                                          |       | 3,782    |       | 4,248    |       |
| Total  liabilities                                                          |       | 250,512  |       | 244,625  |       |
|                                                                        |       |     |       |     |       |
| **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 752,595 issued |       | 753      |       | 753      |       |
| Additional paid–in  capital                                            |       | 4,408    |       | 4,300    |       |
| Retained  earnings                                                          |       | 26,031   |       | 26,113   |       |
| Treasury stock,  at cost – 107,746 and 105,220 shares                  |       | (6,299   | )          | (6,102   | )          |
| Accumulated  other comprehensive loss                                       |       | (224     | )          | (458     | )          |
| Total  shareholders’ equity                                            |       | 24,669   |       | 24,606   |       |
|                                                                        |       |     |       |     |       |
| Total  liabilities and shareholders’ equity                            |       | $        | 275,181    |     | $          | 269,231 |   |

 

See notes toconsolidated financial statements.

 

19

----

 

FIRST OTTAWABANCSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31,2008, 2007 and 2006

(In thousands,except share and per share data)

 
| ** **                                                                       | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Interest  and Dividend Income**                                                |       |     |       |     |       |     |       |
| Loans receivable                                                                 |       | $        | 10,933     |     | $          | 11,945   |       | $ | 11,547 |   |
| Investment  securities                                                           |       |     |       |     |       |     |       |
| Taxable                                                                          |       | 1,286    |       | 1,924    |       | 2,211    |       |
| Exempt from  federal tax                                                         |       | 1,042    |       | 837      |       | 906      |       |
| Federal funds  sold                                                              |       | 203      |       | 349      |       | 371      |       |
| Interest–bearing  deposits                                                  |       | 497      |       | 176      |       | 239      |       |
| Total interest  and dividend income                                              |       | 13,961   |       | 15,231   |       | 15,274   |       |
|                                                                             |       |     |       |     |       |     |       |
| **Interest  Expense**                                                            |       |     |       |     |       |     |       |
| Deposits                                                                         |       | 4,632    |       | 6,182    |       | 6,238    |       |
| Repurchase  agreements                                                           |       | 1        |       | —   |       | —   |       |
| Federal funds  purchased                                                         |       | 1        |       | 100      |       | 123      |       |
| Other interest  expense                                                          |       | 173      |       | —   |       | —   |       |
| Total interest  expense                                                          |       | 4,807    |       | 6,282    |       | 6,361    |       |
|                                                                             |       |     |       |     |       |     |       |
| **Net  Interest Income**                                                         |       | 9,154    |       | 8,949    |       | 8,913    |       |
| Provision for  loan losses                                                       |       | 170      |       | 180      |       | 180      |       |
| **Net  Interest Income After Provision for Loan Losses**                         |       | 8,984    |       | 8,769    |       | 8,733    |       |
|                                                                             |       |     |       |     |       |     |       |
| **Noninterest  Income**                                                          |       |     |       |     |       |     |       |
| Service fee  income                                                              |       | 852      |       | 1,017    |       | 965      |       |
| Trust and farm  management fee income                                            |       | 540      |       | 540      |       | 540      |       |
| Net realized  gains (losses) on sales of available–for–sale securities |       | (647     | )          | —   |       | (13      | )          |
| Net gains on  sales of loans                                                     |       | 58       |       | 29       |       | 31       |       |
| Other income                                                                     |       | 241      |       | 763      |       | 907      |       |
| Total  noninterest income                                                        |       | 1,044    |       | 2,349    |       | 2,430    |       |
|                                                                             |       |     |       |     |       |     |       |
| **Noninterest  Expense**                                                         |       |     |       |     |       |     |       |
| Salaries and  employee benefits                                                  |       | 4,256    |       | 4,422    |       | 4,547    |       |
| Occupancy and  equipment expense                                                 |       | 1,319    |       | 1,263    |       | 1,259    |       |
| Data processing  fees                                                            |       | 480      |       | 438      |       | 393      |       |
| Insurance  expense                                                               |       | 198      |       | 147      |       | 148      |       |
| Professional  fees                                                               |       | 405      |       | 480      |       | 348      |       |
| Amortization of  core deposit intangibles                                        |       | 163      |       | 204      |       | 255      |       |
| Other expenses                                                                   |       | 919      |       | 980      |       | 1,125    |       |
| Total  noninterest expenses                                                      |       | 7,740    |       | 7,934    |       | 8,075    |       |
|                                                                             |       |     |       |     |       |     |       |
| **Income  Before Income Tax**                                                    |       | 2,864    |       | 3,184    |       | 3,088    |       |
| Income tax  expense                                                              |       | 435      |       | 769      |       | 753      |       |
|                                                                             |       |     |       |     |       |     |       |
| **Net  Income**                                                                  |       | $        | 1,853      |     | $          | 2,415    |       | $ | 2,335 |   |
| ** **                                                                       |       |     |       |     |       |     |       |
| **Earnings  Per Share – Basic**                                             |       | $        | 2.87       |     | $          | 3.72     |       | $ | 3.59 |   |
| ** **                                                                       |       |     |       |     |       |     |       |
| **Earnings  Per Share – Diluted**                                           |       | $        | 2.86       |     | $          | 3.71     |       | $ | 3.59 |   |
|                                                                             |       |     |       |     |       |     |       |
| **Average  Shares Outstanding**                                                  |       | 645,275  |       | 649,009  |       | 649,605  |       |

 

See notes to consolidatedfinancial statements.

 

20

----

 

FIRST OTTAWABANCSHARES, INC.

CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS’ EQUITY

Years Ended December 31,2008, 2007 and 2006

(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, 2006**                                            |       | 750               |       | 4,039                                 |       | 25,258                 |       | (5,745              | )          | (1,444                                                | )          | 22,858    |       |
| Comprehensive income                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| Net income                                                                    |       |              |       |                                  |       | 2,335                  |       |                |       |                                                  |       | 2,335     |       |
| Other comprehensive income, net of tax - unrealized  losses on securities     |       |              |       |                                  |       |                   |       |                |       | 240                                                   |       | 240       |       |
| Comprehensive income                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       | 2,575     |       |
| Cash dividends ($3.00 per share)                                              |       |              |       |                                  |       | (1,949                 | )          |                |       |                                                  |       | (1,949    | )          |
| Stock options vested                                                          |       |              |       | 38                                    |       |                   |       |                |       |                                                  |       | 38        |       |
| Stock options exercised                                                       |       |              |       | 26                                    |       |                   |       |                |       |                                                  |       | 26        |       |
| Purchase of 300 treasury shares                                               |       |              |       |                                  |       |                   |       | (22                 | )          |                                                  |       | (22       | )          |
|                                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| Adjustment to initially apply FASB Statement  No. 158, net of tax        |       |              |       |                                  |       |                   |       |                |       | (17                                                   | )          | (17       | )          |
|                                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| **Balances, December 31, 2006**                                          |       | 750               |       | 4,103                                 |       | 25,644                 |       | (5,767              | )          | (1,221                                                | )          | 23,509    |       |
| Comprehensive income                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| Net income                                                                    |       |              |       |                                  |       | 2,415                  |       |                |       |                                                  |       | 2,415     |       |
| Other comprehensive income, net of tax – unrealized  gains on securities |       |              |       |                                  |       |                   |       |                |       | 859                                                   |       | 859       |       |
| Net loss relating to benefit liability                                        |       |              |       |                                  |       |                   |       |                |       | (96                                                   | )          | (96       | )          |
| Comprehensive income                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       | 3,178     |       |
| Cash dividends ($3.00 per share)                                              |       |              |       |                                  |       | (1,946                 | )          |                |       |                                                  |       | (1,946    | )          |
| Stock options vested                                                          |       |              |       | 77                                    |       |                   |       |                |       |                                                  |       | 77        |       |
| Stock options exercised                                                       |       | 3                 |       | 120                                   |       |                   |       |                |       |                                                  |       | 123       |       |
| Purchase of 4,269 treasury shares                                             |       |              |       |                                  |       |                   |       | (335                | )          |                                                  |       | (335      | )          |
|                                                                          |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| **Balances, December 31, 2007**                                          |       | 753               |       | 4,300                                 |       | 26,113                 |       | (6,102              | )          | (458                                                  | )          | 24,606    |       |
| 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 |   |
|                                                                               |            |                   |            |                                       |            |                        |            |                     |            |                                                       |            |           |            |  |  |  |  |  |  |

 

See notes toconsolidated financial statements.

 

21

----

 

FIRST OTTAWABANCSHARES, INC.

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

Years Ended December 31,2008, 2007 and 2006

(In thousands,except per share data)

 
| ** **                                                              | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Operating  Activities**                                               |       |     |       |     |       |     |       |
| Net income                                                              |       | $        | 1,853      |     | $          | 2,415    |       | $ | 2,335 |   |
| Items not  requiring (providing) cash                                   |       |     |       |     |       |     |       |
| Provision for  loan losses                                              |       | 170      |       | 180      |       | 180      |       |
| Premium  amortization on securities, net                                |       | 250      |       | 360      |       | 380      |       |
| Derivative  valuation adjustment                                        |       | 898      |       | 477      |       | (325     | )          |
| Depreciation and  amortization                                          |       | 653      |       | 699      |       | 696      |       |
| Loans originated  for sale                                              |       | (2,928   | )          | (1,174   | )          | (1,453   | )          |
| Proceeds from  sale of loans                                            |       | 2,757    |       | 1,203    |       | 868      |       |
| Gains/losses on  sales of securities, net                               |       | 647      |       | —   |       | 13       |       |
| Gains on sales  of loans held for sale                                  |       | (58      | )          | (29      | )          | (31      | )          |
| Stock options  vested                                                   |       | 105      |       | 77       |       | 38       |       |
| Change in                                                               |       |     |       |     |       |     |       |
| Interest  receivable and other assets                                   |       | 462      |       | 859      |       | (956     | )          |
| Interest payable  and other liabilities                                 |       | (867     | )          | (51      | )          | 903      |       |
| Net cash  provided by operating activities                              |       | 3,942    |       | 5,016    |       | 2,648    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Investing  Activities**                                               |       |     |       |     |       |     |       |
| Purchases of  securities available for sale                             |       | (21,627  | )          | (221     | )          | (3,212   | )          |
| Proceeds from  maturities and paydowns of securities available for sale |       | 25,472   |       | 16,433   |       | 6,481    |       |
| Proceeds from  sales of securities available for sale                   |       | 4,333    |       | —   |       | 4,247    |       |
| Purchases of  certificates of deposit                                   |       | (19,253  | )          | (3,082   | )          | —   |       |
| Proceeds from  maturities of certificates of deposit                    |       | 7,309    |       | 4,932    |       | 5,684    |       |
| Net change in  loans                                                    |       | 5,729    |       | (4,859   | )          | (7,723   | )          |
| Net purchases of  premises and equipment                                |       | (154     | )          | (242     | )          | (153     | )          |
| Net cash  provided by investing activities                              |       | 1,809    |       | 12,961   |       | 5,324    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Financing  Activities**                                               |       |     |       |     |       |     |       |
| Net change in                                                           |       |     |       |     |       |     |       |
| Deposits                                                                |       | 353      |       | (9,964   | )          | 10,460   |       |
| Federal funds  purchased                                                |       | —   |       | —   |       | (12,700  | )          |
| Proceeds from  borrowings                                               |       | 6,214    |       | —   |       | —   |       |
| Repayment of  borrowings                                                |       | (214     | )          | —   |       | —   |       |
| Purchase of  treasury stock                                             |       | (197     | )          | (335     | )          | (22      | )          |
| Stock options  exercised                                                |       | 3        |       | 123      |       | 26       |       |
| Dividends paid                                                          |       | (1,935   | )          | (1,946   | )          | (1,949   | )          |
| Net cash  provided by (used in) financing activities                    |       | 4,224    |       | (12,122  | )          | (4,185   | )          |
|                                                                    |       |     |       |     |       |     |       |
| **Net  Change in Cash and Cash Equivalents**                            |       | 9,975    |       | 5,855    |       | 3,787    |       |
| ** **                                                              |       |     |       |     |       |     |       |
| **Cash  and Cash Equivalents, Beginning of Year**                       |       | 16,499   |       | 10,644   |       | 6,857    |       |
| ** **                                                              |       |     |       |     |       |     |       |
| **Cash  and Cash Equivalents, End of Year**                             |       | $        | 26,474     |     | $          | 16,499   |       | $ | 10,644 |   |
|                                                                    |       |     |       |     |       |     |       |
| **Additional  Cash Flows Information**                                  |       |     |       |     |       |     |       |
| Interest paid                                                           |       | $        | 5,009      |     | $          | 6,427    |       | $ | 6,030 |   |
| Income tax paid,  net of refunds                                        |       | 833      |       | 788      |       | 821      |       |
| Transfers from  loans to foreclosed real estate                         |       | 187      |       | 317      |       | 200      |       |

 

See notes to consolidatedfinancial statements.

 

22

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(Table dollaramounts in thousands, except per share data)

 

**NOTE 1 – SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

 

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

 

Use of 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.

 

Securities:  Securities are classified as available–for–salewhen they might be sold before maturity. Securities available–for–sale are carried at fair value, with unrealizedholding gains and losses reported, net of tax, as other comprehensiveincome.  Equity securities includeFederal Home Loan Bank stock and Federal Reserve Bank stock, which arerestricted securities that are carried at cost, and a mutual fund investmentthat is carried at fair value.

 

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

 

Declines in the fairvalue of securities below their cost that are other-than-temporary arereflected 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. Securities are written down to fair value, with a charge toexpense, when a decline in fair value is not temporary.

 

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

 

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

 

23

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(Table dollaramounts in thousands, except per share data)

 

**NOTE 1 – SUMMARY OF SIGNIFICANTACCOUNTING POLICIES** (Continued)

 

Allowance for 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.

 

Loan impairment isreported when full payment under the loan terms is not expected.  Impairment is evaluated in total for smaller–balanceloans of similar nature, such as residential mortgage and consumer loans, andon an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so thatthe loan is reported, net, at the present value of estimated future cash flowsusing the loan’s existing rate or at the loan’s observable market price or thefair value of collateral if the loan is collateral dependent.  Loans are evaluated for impairment whenpayments are delayed, typically 90 days or more, or when the internal gradingsystem indicates a doubtful classification.

 

Premises and 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.

 

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

 

Mortgage Servicing Rights:  Servicing rights are recognized as assets atthe fair value of servicing rights retained on loans sold and are classifiedwith interest receivable and other assets in the consolidated balance sheets.  Servicing rights are expensed in proportionto and over the period of estimated net servicing revenues.  Impairment is evaluated based on the fairvalue of the rights using groupings of the underlying loans as to interestrates and then, secondarily, as to geographic and prepaymentcharacteristics.  Fair value isdetermined using prices for similar assets with similar characteristics, whenavailable, or based upon discounted cash flows using market–basedassumptions.  Any impairment of agrouping is reported as a valuation allowance. There was no such valuation allowance recorded at December 31, 2008and 2007, and mortgage servicing rights were not material at either date.

 

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

 

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

 

Stock Options:  The Company has a stock–based compensationplan, which is more fully described in Note 11. The Company accounts for this plan under the recognition and measurementprinciples of Statement of Financial Accounting Standards No. 123(R), *Share–Based Payment*, using the fair value method.  The value of options granted under this planis charged to expense over the vesting period of the grants.

 

24

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(Table dollaramounts in thousands, except per share data)

 

**NOTE 1 – SUMMARY OF SIGNIFICANTACCOUNTING POLICIES** (Continued)

 

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

 

The Company or one of itssubsidiaries files income tax returns in the U.S. federal and Illinoisjurisdictions.  With few exceptions, theCompany is no longer subject to U.S. federal, state and local examinations bytax authorities for years before 2004.

 

The Company adopted theprovisions of the Financial Accounting Standards Board (FASB) Interpretation No. 48(FIN 48), *Accounting for Uncertainty in Income Taxes – aninterpretation of FASB Statement No. 109*, on January 1,2007.  FIN 48 prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.  FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition.  As aresult of the implementation of FIN 48, the Company did not identify anyuncertain tax positions that it believes should be recognized in the financialstatements.

 

Earnings Per Share:  Earnings per share is calculated based on theweighted-average common shares outstanding during the year.

 

Fair Values of FinancialInstruments:  Fairvalues of financial instruments are estimated using relevant market informationand other assumptions, as more fully disclosed separately.  Fair value estimates involve uncertaintiesand matters of significant judgment regarding interest rates, credit risk,prepayments, and other factors, especially in the absence of broad markets forparticular items.  Changes 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.

 

Comprehensive Income:  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 pensionliability, net of deferred income taxes.

 

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

 

Current Economic Conditions: The currenteconomic environment presents financial institutions with unprecedentedcircumstances and challenges which in some cases have resulted in largedeclines in the fair values of investments and other assets, constraints onliquidity and significant credit quality problems, including severe volatilityin the valuation of real estate and other collateral supporting loans.  The financial statements have been preparedusing values and information currently available to the Company.

 

Given the volatility of current economic conditions, the values ofassets and liabilities recorded in the financial statements could changerapidly, resulting in material future adjustments in asset values, theallowance for loan losses, capital that could negatively impact the Company’sability to meet regulatory capital requirements and maintain sufficientliquidity.

 

25

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(Table dollaramounts in thousands, except per share data)

 

**NOTE 1 – SUMMARY OF SIGNIFICANTACCOUNTING POLICIES** (Continued)

 

Adoptionof New Accounting Standards

 

EffectiveJanuary 1, 2008, the Company adopted Statement of Financial AccountingStandards No. 157, Fair Value Measurements (“SFAS 157”) for existingfair value measurement requirements related to financial and nonfinancialassets and liabilities. SFAS 157 establishes a hierarchy to be used inperforming measurements of fair value. Additionally, SFAS 157 emphasizesthat fair value should be determined from the perspective of a marketparticipant while also indicating that valuation methodologies should firstreference available market data before using internally developed assumptions.SFAS 157 also provides expanded disclosure requirements regarding theeffects of fair value measurements on the financial statements. The adoption ofSFAS 157 did not have a material impact on the consolidated financialcondition or results of operations, or liquidity.

 

OnOctober 10, 2008,  the FinancialAccounting Standards Board (“FASB”) issued FSP FAS 157-3, “Determining theFair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSPFAS 157-3”). FSP FAS 157-3 clarifies the application of SFAS 157in a market that is not active and provides an example to illustrate keyconsideration in determining the fair value of a financial asset when themarket for that financial asset is not active. FSP FAS 157-3 is effectiveupon issuance, including prior periods for which financial statements have notbeen issued. The Company adopted FSP FAS 157-3 for the period ended September 30,2008 and the adoption did not have any significant impact on consolidatedstatements of financial position, consolidated statement of operations, ordisclosures.

 

Effect  of Newly  Issued  But Not Yet Effective Accounting Standards

 

DuringDecember 2007, the FASB issued Statementof Financial Accounting Standards No. 141 (Revised 2007), Business Combinations(“SFAS 141(R)”).  This Statement replacesSFAS 141 “Business Combinations” (“Statement 141”). SFAS 141(R) retains the fundamentalrequirements in Statement 141 that the acquisition method of accounting (calledthe ‘purchase method’) be used for all business combinations and for an acquirerto be identified for each business combination. This Statement defines the acquireras the entity that obtains control of one or more businesses, including those sometimesreferred to as “true mergers” or “mergers of equals” and combinations achieved withoutthe transfer of consideration, for example, by contract alone or through the lapseof minority veto rights. This is broader than in Statement 141 which applied onlyto business combinations in which control was obtained by transferring consideration.This Statement requires an acquirer to recognize the assets acquired, liabilitiesassumed and any noncontrolling interest in the acquiree at the acquisition date,measured at their fair values as of that date. SFAS 141(R) recognizes and measuresthe goodwill acquired in the business combination and defines a bargain purchaseas a business combination in which the total acquisition-date fair value of theidentifiable net assets acquired exceeds the fair value of the consideration transferredplus any noncontrolling interest in the acquiree, and it requires the acquirer torecognize that excess as a gain attributable to the acquirer. In contrast, Statement141 required the “negative goodwill” amount to be allocated as a pro rata reductionof the amounts assigned to assets acquired. SFAS 141(R) applies prospectively tobusiness combinations for which the acquisition date is on or after December 15,2008. An entity may not apply it before that date.

 

DuringDecember 2007, the FASB issued Statementof Financial Accounting Standards No. 160, Noncontrolling Interests inConsolidated Financial Statements — an amendment of ARB No. 51 (“SFAS 160”).  SFAS 160 to establish accountingand reporting standards for the noncontrolling interest in a subsidiary and forthe deconsolidation of a subsidiary. It clarifies that a noncontrollinginterest in a subsidiary is an ownership interest in the consolidated entitythat should be reported as equity in the consolidated financial statement, butseparate from the parent’s equity. Before the Statement was issued theseso-called minority interests were reported in the consolidated statement offinancial position as liabilities or in the mezzanine section betweenliabilities and equity. The amount of consolidated net income attributable tothe parent and to the noncontrolling interest must be clearly identified andpresented in the consolidated statement of income. This Statement requires thata parent recognize a gain or loss in net income when a subsidiary isdeconsolidated. SFAS 160 is effective for fiscal years, and interimperiods within those fiscal years, beginning on or after December 15, 2008.Earlier adoption is prohibited. Management does not anticipate that thisStatement will have a material impact on the Company’s consolidated financialcondition or results of operations.

 

26

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(Table dollaramounts in thousands, except per share data)

 

**NOTE 1 – SUMMARY OF SIGNIFICANTACCOUNTING POLICIES** (Continued)

 

DuringMarch 2008, the FASB issued Statement ofFinancial Accounting Standards No. 161, Disclosures about Derivative Instrumentsand Hedging Activities — an amendment of FASB Statement No. 133 (“SFAS 161”).  SFAS 161 amends and expands the disclosure requirementof SFAS 133 No. 133 “Accounting for Derivative Instruments and Hedging Activities”(“SFAS 133”) with the intent to provide users of financial statements with an enhancedunderstanding of: (a) how and why an entity uses derivative instruments; (b) howderivative instrument and related hedged items are accounted for under SFAS 133and its related interpretations; and (c) how derivative instruments and relatedhedged items affect an entity’s financial position, financial performance, and cashflows. To meet those objectives, SFAS 161 requires qualitative disclosures aboutobjectives and strategies for using derivative, quantitative disclosures about fairvalue amounts of and gains and losses on derivative instruments, and disclosuresabout credit-risk-related contingent features in derivative agreements. SFAS 161is effective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2008. Early application is encouraged.  Management does not anticipate that this Statementwill have a material impact on the Company’s consolidated financial condition orresults of operations.

 

DuringMay 2008, the FASB issued Statementof Financial Accounting Standards, The Hierarchy of Generally AcceptedAccounting Principles (“SFAS 162”).   This Statementidentifies the sources of account principles and the framework for selectingthe principles to be used in the preparation of financial statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles (GAAP) in the United States. This Statement iseffective 60 days following the SEC approval of the Public CompanyAccounting Oversight Board amendments to AU Section 411, “The Meaning ofPresent Fairly in Conformity With Generally Accepted Accounting Principles.”Adoption of SFAS 162 will not be a change in the Company’s currentaccounting practices; therefore, it will not have a material impact on theCompany’s consolidated financial condition or results of operations.

 

DuringJune 2008, the FASB issued FASB Staff PositionEITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactionsare Participating Securities (“FSP EITF 03-6-1”).   FSP EITF 03-6-1 clarifies whether instruments,such as restricted stock, granted in share-based payments are participating securitiesprior to vesting. Such participating securities must be included in the computationof earnings per share under the two-class method as described in SFAS No. 128, “Earningsper Share.” FSP EITF 03-6-1 requires companies to treat unvested share-based paymentawards that have non-forfeitable rights to dividend or dividend equivalents as aseparate class of securities in calculating earnings per share. FSP EITF 03-6-1is effective for financial statements issued for fiscal years and interim periodsbeginning after December 15, 2008, and requires a company to retrospectively adjustits earning per share data. Early adoption is not permitted. It is not expectedthat the adoption of FSP EITF 03-6-1 will have a material effect on consolidatedresults of operations or earnings per share.

 

27

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(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, 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           |       |
| Marketable equity securities                                             |       | 893                 |       | —                       |       | —                        |       | 893             |       |
|                                                                     |       |                |       |                         |       |                          |       |            |       |
| Total investment securities                                              |       | $                   | 57,293     |                         | $          | 644                           |       | $               | (112       | ) | $ | 57,825 |   |

** **
| ** **                                                               | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| **December 31, 2007**                                               |       |                |       |                         |       |                          |       |            |       |
|                                                                     |       |                |       |                         |       |                          |       |            |       |   |   |   |   |
| U. S. Treasury                                                           |       | $                   | 8,052      |                         | $          | 20                            |       | $               | (5         | ) | $ | 8,067 |   |
| Federal agencies                                                         |       | 25,968              |       | 55                           |       | (45                           | )          | 25,978          |       |
| State and municipal                                                      |       | 23,661              |       | 117                          |       | (173                          | )          | 23,605          |       |
| Mortgage—backed securities and collateralized  mortgage obligations |       | 6,333               |       | 30                           |       | (64                           | )          | 6,299           |       |
| Corporate obligations                                                    |       | 850                 |       | —                       |       | —                        |       | 850             |       |
| Marketable equity securities                                             |       | 1,503               |       | —                       |       | (128                          | )          | 1,375           |       |
|                                                                     |       |                |       |                         |       |                          |       |            |       |
| Total investment securities                                              |       | $                   | 66,367     |                         | $          | 222                           |       | $               | (415       | ) | $ | 66,174 |   |

 

As of December 31,2008 and 2007, the Company had approximately $14,498,000 and $2,081,000invested in bonds issued by municipalities located within LaSalle County,Illinois.

 

Securities with anapproximate carrying value of $35,927,000 and $56,963,000 were pledged at December 31,2008 and 2007 to secure trust and public deposits, and for other purposes asrequired or permitted by law.

 

The amortized cost andfair value of contractual maturities of securities available for sale at December 31,2008 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                                                          |       | $                   | 20,168     |            | $          | 20,385 |   |
| One to five years                                                        |       | 27,256              |       | 27,417          |       |
| Five to ten years                                                        |       | 4,091               |       | 4,160           |       |
| After ten years                                                          |       | —              |       | —          |       |
|                                                                     |       |                |       |            |       |
| Mortgage—backed securities and collateralized  mortgage obligations |       | 4,885               |       | 4,970           |       |
| Marketable equity securities                                             |       | 893                 |       | 893             |       |
|                                                                     |       |                |       |            |       |   |   |
| Totals                                                                   |       | $                   | 57,293     |            | $          | 57,825 |   |

 

28

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(Table dollaramounts in thousands, except per share data)

 

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

 

Information regardingrealized gains and losses on sales of securities available for sale follows:

 
| ** **   | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------|------------|----------|------------|----------|------------|----------|------------|
|         |       |     |       |     |       |     |       |   |   |   |
| Gross gains  |       | $        | 30         |     | $          | —   |       | $ | 4 |   |
| Gross losses |       | 677      |       | —   |       | 17       |       |
| Tax expense  |       | (220     | )          | —   |       | (4       | )          |

 

Certain investments indebt and marketable equity securities are reported in the financial statementsat an amount less than their historical cost. Total fair value of these investments at December 31, 2008 and 2007was $9.7 million and $34.8 million, which was approximately 16.7% and 51.3% ofthe Company’s available—for—sale investment portfolio at those dates.  These declines primarily resulted from marketinterest rates being greater than the coupon rates on the individual bonds.

 

Based on evaluation ofavailable evidence, including recent changes in market interest rates,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 following table showsour investments’ gross unrealized losses and fair value, aggregated byinvestment category and length of time that individual securities have been ina 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, 2008**                                               |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
|                                                                     |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 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 | ) |
|                                                                     |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Total temporarily impaired securities                                    |       | $                                      | 8,896      |                                 | $          | (108            | )          | $ | 781 |   | $ | (4 | ) | $ | 9,677 |   | $ | (112 | ) |
| ** **                                                               |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| **December 31, 2007**                                               |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
|                                                                     |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U. S. Treasury                                                           |       | $                                      | —     |                                 | $          | —          |       | $ | 2,996 |   | $ | (5 | ) | $ | 2,996 |   | $ | (5 | ) |
| Federal agencies                                                         |       | 1,014                                  |       | (3                                   | )          | 11,742          |       | (42 | ) | 12,756 |   | (45 | ) |
| State and municipal                                                      |       | 212                                    |       | (1                                   | )          | 12,258          |       | (172 | ) | 12,740 |   | (173 | ) |
| Mortgage—backed securities and collateralized  mortgage obligations |       | —                                 |       | —                               |       | 4,944           |       | (64 | ) | 4,944 |   | (64 | ) |
| Marketable equity securities                                             |       | 853                                    |       | (76                                  | )          | 521             |       | (52 | ) | 1,374 |   | (128 | ) |
|                                                                     |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total temporarily impaired securities                                    |       | $                                      | 2,079      |                                 | $          | (80             | )          | $ | 32,731 |   | $ | (335 | ) | $ | 34,810 |   | $ | (415 | ) |
|                                                                          |            |                                        |            |                                      |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

29

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(Table dollaramounts in thousands, except per share data)

 

**NOTE 3 —LOANS**

 

Major classifications ofloans as of December 31, 2008 and 2007 are summarized as follows:

 
| ** **                  | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
|                        |       |     |       |     |       |   |   |
| Real estate                 |       | $        | 112,466    |     | $          | 120,581 |   |
| Commercial and agricultural |       | 33,632   |       | 28,354   |       |
| Installment                 |       | 3,772    |       | 5,439    |       |
| Home equity lines of credit |       | 9,721    |       | 11,051   |       |
| Total loans                 |       | 159,592  |       | 165,425  |       |
| Allowance for loan losses   |       | (1,612   | )          | (1,588   | )          |
|                        |       |     |       |     |       |   |   |
| Net loans                   |       | $        | 157,980    |     | $          | 163,837 |   |

 

Certain executiveofficers, directors, and their related interests are loan customers of theCompany.  A summary of such loans made bythe Company in the ordinary course of business and made on substantially thesame terms (including interest rates and collateral) as those prevailing at thetime for comparable transactions with other persons is as follows:

 
| Balance at January 1, 2008   |   | $      | 2,522  |   |
|-----------------------------------|--------|--------|--------|--------|
| New loans                         |   | 1,675  |   |
| Repayments                        |   | (113   | )      |
|                              |   |   |   |
| Balance at December 31, 2008 |   | $      | 4,084  |   |

 

Information regardingimpaired loans at December 31, 2008 and 2007 is as follows:

 
| ** **                                                                                                     | ** ** | **2008** | ** ** | **2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                           |       |     |       |     |       |
| Impaired loans with an allowance                                                                               |       | $        | 1,145      |     | $          | 1,192 |   |
| Impaired loans for which the discounted cash flows  or collateral value exceeds the carrying value of the loan |       | 2,511    |       | 988      |       |
|                                                                                                           |       |     |       |     |       |
| Total impaired loans                                                                                           |       | $        | 3,656      |     | $          | 2,180 |   |
|                                                                                                           |       |     |       |     |       |
| Allowance for impaired loans included in the  Company’s allowance for loan losses                         |       | $        | 390        |     | $          | 284 |   |

 
| ** **                                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                            |       |     |       |     |       |     |       |
| Average balance of impaired loans                               |       | $        | 2,800      |     | $          | 2,183    |       | $ | 2,269 |   |
| Interest income recognized on impaired loans                    |       | 234      |       | 224      |       | 149      |       |
| Interest income recognized on impaired loans — cash  basis |       | 245      |       | 148      |       | 102      |       |
|                                                                 |            |          |            |          |            |          |            |  |  |  |

 

Nonperforming loans wereas follows at December 31:

 
| ** **                                    | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
|                                          |       |     |       |     |       |   |   |
| Loans past due over 90  days still on accrual |       | $        | 2,098      |     | $          | 649 |   |
| Nonaccrual loans                              |       | 965      |       | 1,163    |       |

 

30

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(Table dollaramounts in thousands, except per share data)

 

**NOTE 4 —ALLOWANCE FOR LOAN LOSSES**

** **

Activity in the allowancefor loan losses is summarized as follows for the years ended December 31:

 
| ** **                 | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Allowance for loan losses  |       |     |       |     |       |     |       |
| Balances, January 1   |       | $        | 1,588      |     | $          | 1,463    |       | $ | 1,344 |   |
| Provision for losses       |       | 170      |       | 180      |       | 180      |       |
| Recoveries on loans        |       | 61       |       | 83       |       | 56       |       |
| Loans charged off          |       | (207     | )          | (138     | )          | (117     | )          |
|                       |       |     |       |     |       |     |       |
| Balances, December 31 |       | $        | 1,612      |     | $          | 1,588    |       | $ | 1,463 |   |

** **

**NOTE 5 — LOANSALES AND SERVICING**

** **

The Company sellsmortgage loans with servicing retained to the Federal Home Loan MortgageCorporation (FHLMC).  The Companyrealized gross proceeds from the sales of mortgage loans totaling $2,757,000,$1,203,000 and $868,000 in 2008, 2007 and 2006. Mortgage loans serviced for others are not included in the accompanyingconsolidated balance sheets.  The unpaidprincipal balances of these loans are summarized as follows:

 
| ** **                      | ** ** | **2008** | ** ** | **2007** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
|                            |       |     |       |     |       |
| Loans serviced for Freddie  Mac |       | $        | 26,505     |     | $          | 27,958 |   |
|                                 |            |          |            |          |            |  |  |

 

Following is an analysisof the changes in originated mortgage servicing rights:

 
| ** **                       | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Mortgage Servicing Rights        |       |     |       |     |       |     |       |
| Balances, January 1         |       | $        | 280        |     | $          | 303      |       | $ | 328 |   |
| Servicing rights capitalized     |       | 29       |       | 14       |       | 14       |       |
| Amortization of servicing rights |       | (42      | )          | (37      | )          | (39      | )          |
|                             |       |     |       |     |       |     |       |
| Balances, December 31       |       | $        | 267        |     | $          | 280      |       | $ | 303 |   |

 

31

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(Table dollaramounts in thousands, except per share data)

 

**NOTE 6 —PREMISES AND EQUIPMENT**

 

Premises and equipmentconsisted of the following at December 31:

 
| ** **                                | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Cost                                      |       |     |       |     |       |
| Land                                      |       | $        | 1,791      |     | $          | 1,791 |   |
| Buildings and land improvements           |       | 7,655    |       | 7,596    |       |
| Equipment                                 |       | 4,877    |       | 4,791    |       |
| Construction in progress                  |       | 52       |       | 43       |       |
| Total cost                                |       | 14,375   |       | 14,221   |       |
| Accumulated depreciation and amortization |       | (7,177   | )          | (6,704   | )          |
| Net                                       |       | $        | 7,198      |     | $          | 7,517 |   |

 

**Note7 — OTHER INTANGIBLE ASSETS**

** **

Thecarrying basis and accumulated amortization of recognized intangible assets at December 31,2008 and 2007, were:

 
| ** **    | ** ** | **2008**                        | ** ** | **2007**                      | ** ** |
|---------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **    | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **    | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Core deposits |       | $                               | 2,027      |                          | $          | 1,374 |   | $ | 2,027 |   | $ | 1,210 |   |
|               |            |                                 |            |                               |            |  |  |  |  |  |  |  |  |

 

Amortizationexpense for the years ended December 31, 2008 and 2007, was $163,000 and$204,000, respectively.  Estimatedamortization expense for each of the following five years is:

 
| 2009 |   | $       | 146,000 |   |
|------|--------|---------|---------|--------|
| 2010 |   | 146,000 |    |
| 2011 |   | 146,000 |    |
| 2012 |   | 146,000 |    |
| 2013 |   | 69,000  |    |

 

32

----

 

FIRST OTTAWABANCSHARES, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

December 31,2008, 2007 and 2006

(Table dollaramounts in thousands, except per share data)

 

**NOTE 8 —DEPOSITS**

 

Deposits consisted of thefollowing at December 31:

 
| ** **                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
| Noninterest—bearing demand                           |       | $        | 31,374     |     | $          | 33,710 |   |
| Interest—bearing demand                              |       | 72,624   |       | 54,963   |       |
| Savings                                                   |       | 22,235   |       | 21,954   |       |
| Money market savings                                      |       | 28,959   |       | 29,884   |       |
| Certificates and other time deposits of $100,000 or  more |       | 30,868   |       | 44,491   |       |
| Other certificates and time deposits                      |       | 54,670   |       | 55,375   |       |
|                                                      |       |     |       |     |       |
| Total deposits                                            |       | $        | 240,730    |     | $          | 240,377 |   |

 

At December 31,2008, the scheduled maturities of certificates of deposit were as follows:

 
| 2009   |   | $      | 56,196 |   |
|--------|--------|--------|--------|--------|
| 2010   |   | 8,770  |   |
| 2011   |   | 7,960  |   |
| 2012   |   | 4,419  |   |
| 2013   |   | 8,193  |   |
|   |   |   |   |
|   |   | $      | 85,538 |   |

 

Deposits held by theCompany from related parties at December 31, 2008 and 2007 totaled $4.2million and $3.4 million, respectively.

 

33

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE 9 — BORROWINGS**

 

Borrowingsat December 31, 2008 consisted of a Federal Home Loan Bank advance and anote payable.  The Federal Home Loan Bankadvance at December 31, 2008 consists of three $2,000,000 advances withthe Federal Home Loan Bank of Chicago, maturing on January 28, 2009, 2010and 2011.  The advances are secured by ablanket lien on the Company’s portfolio of one-to-four family mortgages in theamount of $33,047,000.  The interestrates for each advance is fixed at 2.87% for the 2009 maturity, 2.97% for the2010 maturity, and 3.21% for the 2011 maturity.

 

TheCompany has a note payable that consists of a $2,000,000 unsecured line ofcredit with Marshall & Ilsley Bank, maturing on August 25,2009.  The outstanding balance under theline of credit was $0 at December 31, 2008, and  $17,000 at December 31, 2007.  Interest is payable quarterly at LIBOR plus205 basis points (4.44% and 6.25% at December 31, 2008 and 2007).

 

**NOTE 10 — 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 $84,000 to the plan in2009.  The Bank uses a December 31measurement date for the plan.

 

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

 
| ** **                   | ** ** | **2008** | ** ** | **2007** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
|                         |       |     |       |     |       |
| Change in benefit obligation |       |     |       |     |       |
| Beginning benefit obligation |       | $        | 1,837      |     | $          | 1,852 |   |
| Interest cost                |       | 102      |       | 106      |       |
| Actuarial loss               |       | (36      | )          | 44       |       |
| Benefits paid                |       | (100     | )          | (165     | )          |
|                         |       |     |       |     |       |
| Ending benefit obligation    |       | $        | 1,803      |     | $          | 1,837 |   |
|                         |       |     |       |     |       |
| Change in plan assets        |       |     |       |     |       |
| Beginning fair value         |       | $        | 1,766      |     | $          | 1,800 |   |
| Actual return                |       | (308     | )          | 42       |       |
| Employer contribution        |       | 20       |       | 89       |       |
| Benefits paid                |       | (100     | )          | 165      |       |
|                         |       |     |       |     |       |
| Ending fair value            |       | $        | 1,378      |     | $          | 1,766 |   |
|                         |       |     |       |     |       |
| Funded status                |       | $        | (425       | )        | $          | (71 | ) |

 

34

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE 10 — BENEFIT PLANS**(Continued)

 

Assetsand liabilities recognized in the balance sheets:

** **
| ** **                           | ** ** | **Pension Benefits** | ** ** |
|--------------------------------------|------------|---------------------------|------------|
| ** **                           | ** ** | **2008**                  | ** ** | **2007** | ** ** |
| ** **                           | ** ** | ** **                | ** ** | ** ** | ** ** |
| Interest receivable and other assets |       | $                         | —     |   | $ | (124 | ) |
| Other liabilities                    |       | (425                      | )          | 53 |   |
|                                      |            |                           |            |  |  |  |  |

 

Amountsrecognized in accumulated other comprehensive income not yet recognized ascomponents of net periodic benefit cost consist of:

 
| ** ** | ** ** | **Pension Benefits** | ** ** |
|------------|------------|---------------------------|------------|
| ** ** | ** ** | **2008**                  | ** ** | **2007** | ** ** |
| ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| Net loss   |       | $                         | 872        |   | $ | 500 |   |
|            |            |                           |            |  |  |  |  |

 

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

 
| ** **                     | ** ** | **2008** | ** ** | **2007** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Accumulated benefit obligation |       | $        | 1,803      |     | $          | 1,837 |   |
| Fair value of plan assets      |       | 1,378    |       | 1,766    |       |
|                                |            |          |            |          |            |  |  |

 

Othersignificant balances and costs are:

 
| ** **                              | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Components of net periodic benefit cost |       |       |       |       |       |       |       |
| Interest cost                           |       | $          | 102        |       | $          | 106        |       | $ | 103 |   |
| Return on plan assets                   |       | (125       | )          | (126       | )          | (108       | )          |
| Amortization                            |       | 21         |       | 18         |       | 15         |       |
|                                    |       |       |       |       |       |       |       |
| Net expense                             |       | $          | (2         | )          | $          | (2         | )          | $ | 10 |   |

 

Otherchanges in plan assets and benefit obligations recognized in othercomprehensive income:

** **
| ** **                        | ** ** | **Pension Benefits** | ** ** |
|-----------------------------------|------------|---------------------------|------------|
| ** **                        | ** ** | **2008**                  | ** ** | **2007** | ** ** |
| Amounts arising during the period |       |                      |       |   |   |
| Net (gain) loss                   |       | $                         | 375        |   | $ | 110 |   |
|                                   |            |                           |            |  |  |  |  |

 

35

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE 10 — 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 $65,000.

 
| ** **                                        | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|---------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Assumptions used to determine benefit obligations |       |       |       |       |       |       |       |
| Discount rate                                     |       | 5.75       | %          | 5.75       | %          | 5.75       | %          |
| Expected return on plan assets                    |       | 7.0        |       | 7.0        |       | 7.0        |       |
|                                              |       |       |       |       |       |       |       |
| Assumptions used to determine benefit costs       |       |       |       |       |       |       |       |
| Discount rate                                     |       | 5.75       | %          | 5.75       | %          | 5.75       | %          |
| Expected return on plan assets                    |       | 7.0        |       | 7.0        |       | 7.0        |       |

 

TheCompany has estimated the long—term rate of return on plan assets basedprimarily on historical returns on plan assets, adjusted for changes in targetportfolio allocations and recent changes in long—term interest rates based onpublicly available information.

 

Thefollowing benefit payments, which reflect expected future service, asappropriate, are expected to be paid as of December 31, 2008:

 
| ** ** | ** ** | **Pension**  | ** ** |
|------------|------------|--------------|------------|
| ** ** | ** ** | **Benefits** | ** ** |
| ** ** | ** ** | ** **   | ** ** |
| 2009       |       | $            | 122        |   |
| 2010       |       | 116          |       |
| 2011       |       | 125          |       |
| 2012       |       | 118          |       |
| 2013       |       | 113          |       |
| Thereafter |       | 578          |       |
|            |            |              |            |  |

 

Planassets are held by a bank—administered trust fund, which invests the planassets in accordance 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.

 

Assetallocation is primarily based on a strategy to provide stable earnings whileattempting to recognize potentially higher returns through limited investmentsin equity securities.  Plan assets arerebalanced periodically.  At December 31,2008 and 2007, allocations by percentages were as follows:

 
| ** **                   | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|
| ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equity mutual funds          |       | 57.0       | %          | 66.4       | %          |
| Fixed income mutual funds    |       | 23.9       |       | 16.8       |       |
| GNMA pool                    |       | .2         |       | .2         |       |
| Money market funds and other |       | 12.9       |       | 4.2        |       |
| Time Certificates of Deposit |       | 6.0        |       | 12.4       |       |

 

36

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE 10 — BENEFIT PLANS**(Continued)

 

At December 31, 2008 and2007, market values of plan assets were as follows:

 
| ** **                   | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|
| ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equity mutual funds          |       | $          | 785        |       | $          | 1,174 |   |
| Fixed income mutual funds    |       | 329        |       | 295        |       |
| GNMA pool                    |       | 3          |       | 4          |       |
| Money market funds and other |       | 178        |       | 74         |       |
| Time Certificates of Deposit |       | 83         |       | 221        |       |
|                              |            |            |            |            |            |  |  |

 

TheBank has a directors’ retirement plan which provides retirement benefitsprimarily to former members of the Board of Directors.  The Bank also maintains a supplementalexecutive retirement plan that provides benefits to certain key executiveofficers and directors in accordance with the plan document.  The Bank accrued expenses related to theseplans totaling $11,000, $94,000 and $90,000 in 2008, 2007 and 2006.

 

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 $144,000, $145,000 and $151,000for 2008, 2007 and 2006.

 

**NOTE  11 —  STOCK OPTION PLAN**

 

TheCompany grants selected executives and other key employees and directorsincentive and non—qualified stock option awards which vest and become fullyexercisable at the discretion of the Board of Directors as the options aregranted.  The Company is authorized togrant options for 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.

 

Thefollowing is a summary of the status of the Company’s stock option plan andchanges in that plan for 2008, 2007 and 2006.  The Company had no grantsoutstanding prior to 2003.

 
| ** **                                                           | ** ** | **2008**   | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|
| **Options**                                                          | ** ** | **Shares** | ** ** | **Weighted–  Average  Exercise Price** | ** ** | **Weighted–  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|                                                                 |       |       |       |   |   |   |   |   |   |
| Outstanding, beginning of year                                       |       | 39,192     |       | $ | 70.34 |   |   |   |   |   |
| Granted                                                              |       | 12,200     |       | 78.13 |   |   |   |   |   |
| Exercised                                                            |       | 63         |       | 56.00 |   |   |   |   |   |
| Forfeited or expired                                                 |       | 500        |       | 76.20 |   |   |   |   |   |
|                                                                 |       |       |       |   |   |   |   |   |   |
| Outstanding, end of year                                             |       | 50,829     |       | 72.17 |   | 7.25 |   | $ | 398 |   |
|                                                                 |       |       |       |   |   |   |   |   |   |
| Options exercisable at year end                                      |       | 24,076     |       | 66.92 |   | 6.03 |   | $ | 315 |   |
|                                                                 |       |       |       |   |   |   |   |   |   |
| Weighted—average fair value of options granted  during the year |       |       |       | $ | 9.20 |   |   |   |   |   |

 

37

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE  11 —  STOCK OPTION PLAN** (Continued)

 

Theweighted-average grant-date fair value of options granted during the years2008, 2007 and 2006 was $9.20, $14.74 and $11.78, respectively.  The total intrinsic value of optionsexercised during the years ended December 31, 2008, 2007 and 2006 was $0,$46,000 and $9,000, respectively.  Totalunrecognized compensation cost relating to stock options not vested as of December 31,2008 was $211,000.

 

Thefair value of each option grant was estimated on the grant date using anoption—pricing model with the following assumptions:

 
| ** **                                                   | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Risk—free interest rates                                |       | 3.04       | %          | 4.80       | %          | 4.29       | %          |
| Dividend yields                                              |       | 3.83       | %          | 3.96       | %          | 3.94       | %          |
| Volatility factors of expected market price of  common stock |       | 16.51      | %          | 20.35      | %          | 17.33      | %          |
| Weighted—average expected life of the options           |       | 8 years    |       | 10 years   |       | 10 years   |       |

 

Cashreceived from option exercise under share-based payment arrangements for theyears ended December 31, 2008,  2007and 2006 was $4,000, $122,000 and $26,000, respectively.  The actual tax benefit realized for the taxdeductions from option exercise of the share-based payment arrangements totaled$0, $8,000 and $2,000, respectively, for the years ended December 31,2008, 2007 and 2006.

 

**NOTE  12 —  EARNINGS PER SHARE**

 

Earningsper share (EPS) were computed as follows:

 
| ** **                                                       | ** ** | **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 |   |

 

The number of stock options that were anti dilutive and therefore were not included inthe calculation of  earnings pershare  at December 31, 2008, 2007and 2006 were 39,300, 0, and 10,500, respectively.

 

38

----

 

FIRSTOTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE  12 —  EARNINGS PER SHARE** (Continued)

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

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

 

**NOTE 13 — INCOME TAXES**

 

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

 
| ** **                                                 | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income tax expense                                         |       |       |       |       |       |       |       |
| Currently payable                                          |       |       |       |       |       |       |       |
| Federal                                                    |       | $          | 350        |       | $          | 704        |       | $ | 672 |   |
| State                                                      |       | 124        |       | 153        |       | 119        |       |
| Deferred                                                   |       | (39        | )          | (88        | )          | (38        | )          |
|                                                       |       |       |       |       |       |       |       |
| Total income tax expense                                   |       | $          | 435        |       | $          | 769        |       | $ | 753 |   |
|                                                       |       |       |       |       |       |       |       |
| Reconciliation of federal statutory to actual tax  expense |       |       |       |       |       |       |       |
| Federal statutory income tax at 34%                        |       | $          | 778        |       | $          | 1,083      |       | $ | 1,050 |   |
| Tax—exempt income                                     |       | (346       | )          | (407       | )          | (344       | )          |
| Effect of state income taxes and other items, net          |       | 3          |       | 93         |       | 47         |       |
|                                                       |       |       |       |       |       |       |       |
| Actual tax expense                                         |       | $          | 435        |       | $          | 769        |       | $ | 753 |   |
|                                                       |       |       |       |       |       |       |       |
| Effective tax rate                                         |       | 15.2       | %          | 24.1       | %          | 25.2       | %          |

 

39

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE 13 — INCOME TAXES** (Continued)

 

Thecomponents of the deferred asset (liability) included on the balance sheets areas follows:

 
| ** **                                                  | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Assets**                                                  |       |       |       |       |       |
| Unrealized (gains) losses on securities available  for sale |       | $          | (181       | )          | $          | 220 |   |
| Allowance for loan losses                                   |       | 447        |       | 438        |       |
| Deferred compensation                                       |       | 348        |       | 354        |       |
| Minimum pension liability                                   |       | 174        |       | 29         |       |
| Other                                                       |       | 297        |       | 7          |       |
| Total assets                                                |       | 1,085      |       | 1,048      |       |
|                                                        |       |       |       |       |       |
| **Liabilities**                                             |       |       |       |       |       |
| FHLB stock                                                  |       | (117       | )          | (117       | )          |
| Depreciation                                                |       | (479       | )          | (515       | )          |
| Mortgage servicing rights                                   |       | (110       | )          | (114       | )          |
| Other                                                       |       | (176       | )          | (97        | )          |
| Total liabilities                                           |       | (882       | )          | (843       | )          |
|                                                        |       |       |       |       |       |
|                                                        |       | $          | 203        |       | $          | 205 |   |

 

**NOTE 14 — DERIVATIVES**

 

TheCompany uses derivatives to fix future cash flows for interest payments on someof its floating rate certificates of deposit. In this regard, the Company has entered into an interest rate swap withthe Broker Dealer Financial Services Corporation (BDFS), to fix the interestrate on a specific certificate of deposit product.  At December 31, 2008, the Company had$3.2 million of certificates of deposit, which mature in 2009 through 2013, onwhich it has prepaid the Broker Dealer Financial Services Corporation for aninterest rate swap and will receive an interest rate from the Broker DealerFinancial Services Corporation based on the appreciation of the S&P 500Index.  This interest received from theBroker Dealer Financial Services Corporation will be paid to the customer.  The assets and liabilities in thistransaction are being netted and the expense recorded in interest expense ondeposits.

 

Inaddition to the above, the Company also purchased $2.0 million of certificatesof deposit which are included in the certificates of deposit caption on theconsolidated balance sheet.  Theseinvestments have a five year term from date of purchase.  The investments do not individually exceed$100,000 and are insured by the FDIC. The initial investment is not at risk butthe return on the investment is based on a calculation of the appreciation inthe S&P 500 Index. The fair value of this embedded derivative is recordedin certificates of deposit and the fair value adjustment is included in otherincome.  At December 31, 2008, theBank had allocated $135,000 to this asset and recorded a valuation loss of $401,000.

 

**NOTE 15 — COMMITMENTS, OFF—BALANCE—SHEET RISK, ANDCONTINGENCIES**

 

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.

 

40

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE 15 — COMMITMENTS, OFF—BALANCE—SHEET RISK, ANDCONTINGENCIES**(Continued)

 

TheBank is required to maintain reserve funds in cash and/or on deposit with theFederal Reserve Bank.  The reserverequired at December 31, 2008 was $1,268,000.

 

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:

 
| ** **               | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|--------------------------|------------|------------|------------|------------|------------|
| ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unused lines of credit   |       | $          | 26,479     |       | $          | 25,823 |   |
| Standby letter of credit |       | 185        |       | 531        |       |
|                          |            |            |            |            |            |  |  |

 

**NOTE 16 — FAIR VALUES OF FINANCIAL INSTRUMENTS**

 

EffectiveJanuary 1, 2008, the Company adopted Statement of Financial AccountingStandards No. 157, *Fair ValueMeasurements* (FAS 157).  FAS157 defines fair value, establishes a framework for measuring fair value andexpands disclosures about fair value measurements.  FAS 157 has been applied prospectively asof the beginning of the year.

 

FAS157 defines fair value as the price that would be received to sell an asset orpaid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. FAS 157 also establishes a fair value hierarchy which requires an entityto maximize the use of observable inputs and minimize the use of unobservableinputs when measuring fair value.  Thestandard describes three levels of inputs that may be used to measure fairvalue:

 
| **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                                                                                                                                                                 |

 

41

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE 16 — FAIR VALUES OF FINANCIAL INSTRUMENTS** (Continued)

 

Followingis a description of the valuation methodologies used for instruments measuredat fair value, as well as the general classification of such instrumentspursuant to the valuation hierarchy.

 

**Available-for-sale Securities**

 

Wherequoted market prices are available in an active market, securities areclassified within Level 1 of the valuation hierarchy.  Level 1 securities include highly liquidgovernment bonds**and 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 agency bondsand certain municipal securities.  Incertain cases where Level 1 or Level 2 inputs are not available, securities areclassified within Level 3 of the hierarchy. The Company currently holds noLevel 3 securities.

 

**Interest Rate Swap Agreements and Call Options**

 

Thefair value is estimated by a third party using inputs that are observable orthat can be corroborated by observable market data and, therefore, areclassified within Level 2 of the valuation hierarchy.

 

Thefollowing table presents the fair value measurements of assets and liabilitiesrecognized in the accompanying balance sheet measured at fair value on arecurring basis and the level within the FAS 157 fair value hierarchy in whichthe 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)** | ** ** |
| Available-for-sale securities                     |       | $                   | 57,825     |                                                                                                | $          | 893 |   | $ | 56,932 |   | $ | — |   |
| Purchased call options — investment cds      |       | 135                 |       | —                                                                                              |       | 135 |   | — |   |
| Written call options — customer cds          |       | (597                | )          | —                                                                                              |       | (597 | ) | — |   |
| Interest rate swap agreements — customer cds |       | 594                 |       | —                                                                                              |       | 594 |   | — |   |
|                                                   |            |                     |            |                                                                                                     |            |  |  |  |  |  |  |  |  |

 

42

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE 16 — FAIR VALUES OF FINANCIAL INSTRUMENTS** (Continued)

 

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 interestreceivable and payable, and variable rate loans or deposits.  The fair value of loans held for sale arebased on quoted market prices.  For fixedrate loans, deposits, or other borrowings, the fair value is estimated bydiscounted cash flow analysis using current market rates for the estimated lifeand credit risk. The fair value of off—balance—sheet items is based on the feesor cost that would currently be charged to enter into or terminate suchagreements and is not material.

 

Thecarrying values and estimated fair values of the Company’s financial instrumentsas of December 31, 2008 and 2007 were as follows:

 
| ** **                                     | ** ** | **2008**             | ** ** | **2007**              | ** ** |
|------------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **Carrying  Amount** | ** ** | **Fair   Value** | ** ** | **Carrying  Amount** | ** ** | **Fair   Value** | ** ** |
| ** **                                     |       |                 |       |                  |       |   |   |   |   |
| **Assets**                                     |       |                 |       |                  |       |   |   |   |   |
| Cash and cash equivalents                      |       | $                    | 26,474     |                  | $          | 26,474 |   | $ | 16,499 |   | $ | 16,499 |   |
| Certificates of deposit and related derivative |       | 14,854               |       | 15,071                |       | 3,808 |   | 3,808 |   |
| Securities available for sale                  |       | 57,825               |       | 57,825                |       | 66,174 |   | 66,174 |   |
| Loans held for sale                            |       | 229                  |       | 229                   |       | — |   | — |   |
| Loans                                          |       | 157,751              |       | 156,826               |       | 163,837 |   | 162,601 |   |
| Interest receivable                            |       | 1,603                |       | 1,603                 |       | 1,934 |   | 1,934 |   |
|                                           |       |                 |       |                  |       |   |   |   |   |
| **Liabilities**                                |       |                 |       |                  |       |   |   |   |   |
| Deposits with no stated maturities             |       | 155,192              |       | 155,192               |       | 140,511 |   | 140,511 |   |
| Time deposits                                  |       | 85,538               |       | 86,498                |       | 99,866 |   | 100,595 |   |
| Other Borrowings                               |       | 6,000                |       | 6,081                 |       | — |   | — |   |
| Interest Receivable                            |       | 684                  |       | 684                   |       | 888 |   | 888 |   |
|                                                |            |                      |            |                       |            |  |  |  |  |  |  |  |  |

 

**NOTE 17 — 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, 2008, the Bank’sstockholder’s equity totaled $24,422,000 of which $24,080,000 was not availablefor 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 certainoff—balance—sheet items 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.

 

43

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

** **

**NOTE 17 — 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 plans for capital restoration arerequired.

 

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

 
| ** **                                                   | ** ** | **Actual** | ** ** | **Required for Adequate  Capital** | ** ** | **To Be Well  Capitalized** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                   | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                            | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                                   |       |       |       |                                         |       |                                  |       |   |   |   |   |   |   |
| **December 31, 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 | % |
| ** **                                                   |       |       |       |                                         |       |                                  |       |   |   |   |   |   |   |
| **December 31, 2007**                                   |       |       |       |                                         |       |                                  |       |   |   |   |   |   |   |
| Total risk—based capital (to risk—weighted assets) |       | $          | 23,320     |                                         | 12.5       | %                                     | $          | 14,810 |   | 8.0 | % | $ | 18,551 |   | 10.0 | % |
| Tier 1 capital (to risk—weighted assets)                |       | 21,732     |       | 11.7                                         | %          | 7,420                                 |       | 4.0 | % | 11,131 |   | 6.0 | % |
| Tier 1 capital (to average assets)                           |       | 21,732     |       | 8.1                                          | %          | 10,681                                |       | 4.0 | % | 13,352 |   | 5.0 | % |

 

AtDecember 31, 2008, the Bank was categorized as well capitalized andmanagement is not aware of any conditions or events since the most recentnotification that would change the Bank’s category.

 

**NOTE 18 — OTHER COMPREHENSIVE INCOME (LOSS)**

 
| ** **                                                           | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other comprehensive income                                           |       |       |       |       |       |       |       |
| Unrealized holding gains arising during the year                     |       | $          | 79         |       | $          | 1,302      |       | $ | 351 |   |
| Less: reclassification adjustment for losses  realized in net income |       | (647       | )          | —     |       | (13        | )          |
| Net loss relating to benefit liability                               |       | (401       | )          | (110       | )          | —     |       |
| Tax effect                                                           |       | 91         |       | (429       | )          | (124       | )          |
|                                                                 |       |       |       |       |       |       |       |
| Other comprehensive income                                           |       | $          | 234        |       | $          | 763        |       | $ | 240 |   |

 

Thecomponents of accumulated other comprehensive income (loss), included instockholders equity are as follows:

 
| ** **                                                   | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net unrealized gain (loss) on securities available  for sale |       | 532      |       | (193     | )          | (1,496   | )          |
| Net loss relating to benefit liability                       |       | (872     | )          | (500     | )          | (390     | )          |
| Tax effect                                                   |       | 116      |       | 235      |       | 665      |       |
|                                                         |       |     |       |     |       |     |       |
| Accumulated other comprehensive loss                         |       | $        | (224       | )        | $          | (458     | )          | $ | (1,221 | ) |
|                                                              |            |          |            |          |            |          |            |  |  |  |

 

44

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE 19 — PARENT COMPANY FINANCIAL STATEMENTS**

 

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

 

**Condensed Balance Sheets**

 
| ** **                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                      |       |     |       |     |       |
| Cash on deposit with Bank                       |       | $        | 1,333      |     | $          | 1,297 |   |
| Investment in common stock of Bank              |       | 24,423   |       | 24,415   |       |
| Other assets                                    |       | 203      |       | 208      |       |
|                                            |       |     |       |     |       |
| Total assets                                    |       | $        | 25,959     |     | $          | 25,920 |   |
| ** **                                      |       |     |       |     |       |
| **Liabilities**                                 |       |     |       |     |       |
| Note payable                                    |       | $        | —     |     | $          | 17 |   |
| Dividends payable                               |       | 1,290    |       | 1,297    |       |
|                                            |       | 1,290    |       | 1,314    |       |
| ** **                                      |       |     |       |     |       |
| **Shareholders’ Equity**                   |       | 24,669   |       | 24,606   |       |
|                                            |       |     |       |     |       |
| Total liabilities and shareholders’ equity |       | $        | 25,959     |     | $          | 25,920 |   |

 

**Condensed Statements of Income**

 
| ** **                                                                     | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Income****-**dividends from Bank                                             |       | $          | 2,250      |       | $          | 1,945      |       | $ | 1,949 |   |
| ** **                                                                     |       |       |       |       |       |       |       |
| **Expenses**                                                                   |       | 198        |       | 159        |       | 110        |       |
| ** **                                                                     |       |       |       |       |       |       |       |
| **Income before income tax and equity in  undistributed income of subsidiary** |       | 2,052      |       | 1,786      |       | 1,839      |       |
| ** **                                                                     |       |       |       |       |       |       |       |
| **Income tax benefit**                                                         |       | 28         |       | 60         |       | —     |       |
| ** **                                                                     |       |       |       |       |       |       |       |
| **Income before equity in undistributed income of  subsidiary**                |       | 2,080      |       | 1,846      |       | 1,839      |       |
| ** **                                                                     |       |       |       |       |       |       |       |
| **Equity in undistributed income (loss) of  subsidiary**                       |       | (227       | )          | 569        |       | 496        |       |
| ** **                                                                     |       |       |       |       |       |       |       |
| **Net Income**                                                                 |       | $          | 1,853      |       | $          | 2,415      |       | $ | 2,335 |   |

 

45

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per share data)

 

**NOTE 19 –PARENT COMPANY FINANCIAL STATEMENTS**(Continued)

 

**Condensed Statements of Cash Flows**

 
| ** **                                       | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Operating Activities**                         |       |     |       |     |       |     |       |
| Net income                                       |       | $        | 1,853      |     | $          | 2,415    |       | $ | 2,335 |   |
| Items not requiring (providing) cash             |       |     |       |     |       |     |       |
| Equity in undistributed earnings of Bank         |       | 227      |       | (569     | )          | (496     | )          |
| Vested stock options                             |       | 105      |       | 77       |       | 38       |       |
| Other                                            |       | (3       | )          | (54      | )          | (96      | )          |
| Net cash provided by operating activities        |       | 2,182    |       | 1,869    |       | 1,781    |       |
| ** **                                       |       |     |       |     |       |     |       |
| **Financing Activities**                         |       |     |       |     |       |     |       |
| Purchase of treasury shares                      |       | (197     | )          | (335     | )          | (22      | )          |
| Loan proceeds (payments), net                    |       | (17      | )          | 17       |       | —   |       |
| Cash dividends                                   |       | (1,935   | )          | (1,946   | )          | (1,949   | )          |
| Options exercised                                |       | 3        |       | 123      |       | 26       |       |
| Net cash used in financing activities            |       | (2,146   | )          | (2,141   | )          | (1,9445  | )          |
| ** **                                       |       |     |       |     |       |     |       |
| **Net Change in Cash and Cash Equivalents**      |       | 36       |       | (272     | )          | (164     | )          |
| ** **                                       |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, Beginning of Year** |       | 1,297    |       | 1,569    |       | 1,733    |       |
| ** **                                       |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, End of Year**       |       | $        | 1,333      |     | $          | 1,297    |       | $ | 1,569 |   |

 

46

----

 

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008, 2007 and 2006

(Table dollar amounts in thousands, except per share data)

 

**NOTE 20 –QUARTERLY FINANCIAL DATA (UNAUDITED)**

** **
| ** **     | ** ** | **Interest   Income** | ** ** | **Interest  Expense** | ** ** | **Net Interest   Income** | ** ** | **Provision** | ** ** | **Securities  Gains(losses)** | ** ** | **Net   Income** | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|----------------|------------|----------------------------|------------|-----------------------|------------|-------------------------------------|------------|---------------|------------|-------------------------------|------------|-----------------------|------------|-----------|------------|-------------|------------|
| ** **     |       |                       |       |                  |       |                                |       |          |       |                          |       |                  |       |      |       |        |       |
| **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        |       |
| ** **     |       |                       |       |                  |       |                                |       |          |       |                          |       |                  |       |      |       |        |       |
| **2007**       |       |                       |       |                  |       |                                |       |          |       |                          |       |                  |       |      |       |        |       |
| ** **     |       |                       |       |                  |       |                                |       |          |       |                          |       |                  |       |      |       |        |       |
| First quarter  |       | $                          | 3,647      |                  | $          | 1,608                               |       | 2,039         |       | $                             | 45         |                  | $          |      | $          | 499         |       | $ | 0.77 |   | $ | 0.77 |   |
| Second quarter |       | 3,792                      |       | 1,551                 |       | 2,241                               |       | 45            |       | —                        |       | 584                   |       | 0.90      |       | 0.90        |       |
| Third quarter  |       | 4,003                      |       | 1,610                 |       | 2,393                               |       | 45            |       | —                        |       | 673                   |       | 1.04      |       | 1.04        |       |
| Fourth quarter |       | 3,789                      |       | 1,513                 |       | 2,276                               |       | 45            |       | —                        |       | 659                   |       | 1.01      |       | 1.00        |       |
|                |            |                            |            |                       |            |                                     |            |               |            |                               |            |                       |            |           |            |             |            |  |  |  |  |  |  |  |  |

 

Fourth quarter 2008securities losses consisted of impairment charges related to Fannie Mae commonstock and equity mutual funds with underlying collateral consisting ofcommercial real estate loans.

 

**NOTE 21 – Subsequent Events**

 

Federal Deposit Insurance Corporation (FDIC) Special Assessment: Subsequent to December 31, 2008, the Board of Directors of the FDICvoted to adopt an interim rule that would impose a special assessment onoutstanding deposits of insured institutions as of June 30, 2009.  This assessment is to be collected on September 30,2009.  The interim rule would alsopermit the Board to impose an emergency special assessment after June 30,2009, of up to 10 basis points on outstanding deposits, if deemed necessary bythe Board.

 

47

----

 

FIRST OTTAWA BANCSHARES, INC.

STOCKHOLDERS INFORMATION

 

ANNUALMEETING

 

TheAnnual Meeting of Stockholders will be held at 3:00 p.m., local time on May 20,2009 at the Company’s corporate headquarters located at 701 LaSalle Street,Ottawa, Illinois 61350.

 

PRICERANGE OF COMMON STOCK

 

As of February 9,2009, there were approximately 513 shareholders of record and 644,849outstanding 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 2007, 2008 and the first month of 2009, anaggregate of approximately 112,337 shares of the Company’s common stock wastransferred in approximately 99 separate transactions, excluding 4,093 sharespurchased by the Company at prices between $75.78 and $79.59 per share in 2007and 2,526 shares purchased by the company at $78.13 in 2008.  These transfers represented both transfersfor consideration (i.e., sales) and transfers for no consideration (e.g.,gifts, estate transfers, etc.).  TheCompany’s management is unable to differentiate such transfers and has limitedknowledge of the sale prices for transfers involving consideration.  The last price known to the Company’smanagement was a sale of 300 shares on February 24, 2009 at $60.00 pershare.

 

Thefollowing dividends per share were paid on the Company’s common stock on thedates indicated:  January 1, 2007 –$2.00; July 1, 2007 - $1.00; January 1, 2008 - $2.00; July 1,2008 - $1.00; and January 1, 2009 - $2.00.

 

WEBSITE FOR UNITED STATES SECURITIES AND EXCHANGE COMMISSION FILINGS

 

Allreports filed electronically by the Company with the United Stated SecuritiesExchange Commission (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

 

TheCompany’s corporate governance practices are described in the followingdocuments, which are available on the Company’s Web site at www.firstottawa.comor which may be obtained in print form through the investor relationsdepartment: Code of Business Conduct and Ethics, Audit Committee Charter,Nominating and Corporate Governance Committee Charter, and CompensationCommittee Charter.

 

48

----

 

**Stockholder Return Performance Graph**

** **

**Thefollowing graph shows a comparison of cumulative total returns for First OttawaBancshares, the Nasdaq Stock Market and an index of Midwestern bank stockswhich are quoted on the OTC-Bulletin Board and on Pink Sheets.  The cumulative total stockholder returncomputations assume the investment of $100 on December 31, 2003 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 represent actualtransactions.  The graph was prepared atour request by SNL Financial L.C., Charlottesville, Virginia.**

** **

****

 
| ** **                         | ** ** | ** **   | ** ** | **Period Ending** | ** ** |
|------------------------------------|------------|--------------|------------|------------------------|------------|
| **Index**                          | ** ** | **12/31/03** | ** ** | **12/31/04**           | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** | **12/31/08** | ** ** |
| First Ottawa Bancshares, Inc. |       | $            | 100.00     |                   | $          | 121.13 |   | $ | 140.87 |   | $ | 151.22 |   | $ | 176.17 |   | $ | 142.76 |   |
| NASDAQ Composite                   |       | 100.00       |       | 108.59                 |       | 110.08 |   | 120.56 |   | 132.39 |   | 78.72 |   |
| SNL Midwest OTC-BB and Pink Banks  |       | 100.00       |       | 119.15                 |       | 124.05 |   | 130.64 |   | 127.52 |   | 95.04 |   |
|                                    |            |              |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

49

----