**Exhibit 13.1**

 

**SELECTED CONSOLIDATED FINANCIALINFORMATION**

 

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

 
| ** **                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Statement  of Income Data:**                                              |       |                             |       |   |   |   |   |   |   |   |   |
| Total  interest income                                                      |       | $                                | 13,537     |   | $ | 12,651 |   | $ | 13,092 |   | $ | 14,921 |   | $ | 15,995 |   |
| Total  interest expense                                                     |       | 4,200                            |       | 4,384 |   | 5,733 |   | 7,773 |   | 8,525 |   |
| Net interest  income                                                        |       | 9,337                            |       | 8,267 |   | 7,359 |   | 7,148 |   | 7,470 |   |
| Provision  for loan losses                                                  |       | 300                              |       | 120 |   | 120 |   | 300 |   | 360 |   |
| Noninterest  income                                                         |       | 3,195                            |       | 2,592 |   | 2,444 |   | 2,457 |   | 1,749 |   |
| Noninterest  expenses                                                       |       | 8,807                            |       | 7413 |   | 6,718 |   | 6,732 |   | 6,510 |   |
| Income  before income taxes                                                 |       | 3,425                            |       | 3,326 |   | 2,965 |   | 2,573 |   | 2,349 |   |
| Provision  for income taxes                                                 |       | 797                              |       | 867 |   | 678 |   | 460 |   | 257 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| Net income                                                                  |       | $                                | 2,628      |   | $ | 2,459 |   | $ | 2,287 |   | $ | 2,113 |   | $ | 2,092 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Per Share  Data:**                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| Net income –  basic and diluted                                        |       | $                                | 4.03       |   | $ | 3.75 |   | $ | 3.47 |   | $ | 3.19 |   | $ | 3.14 |   |
| Cash  dividends declared                                                    |       | 3.00                             |       | 3.00 |   | 3.00 |   | 3.00 |   | 3.00 |   |
| Book value  at end of year (1)                                              |       | 36.54                            |       | 35.54 |   | 34.97 |   | 34.53 |   | 34.62 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Selected  Financial Ratios:**                                             |       |                             |       |   |   |   |   |   |   |   |   |
| Return on  average assets (1)                                               |       | .88                              | %          | 1.00 | % | .99 | % | .94 | % | .91 | % |
| Return on  average equity (1)                                               |       | 11.05                            |       | 10.50 |   | 9.73 |   | 9.18 |   | 8.89 |   |
| Dividend  payout ratio                                                      |       | 74.44                            |       | 79.79 |   | 86.46 |   | 94.04 |   | 94.96 |   |
| Average  equity to average assets (1)                                       |       | 7.96                             |       | 9.56 |   | 10.20 |   | 10.29 |   | 10.25 |   |
| Net interest  margin (tax equivalent)                                       |       | 3.60                             |       | 3.89 |   | 3.77 |   | 3.74 |   | 3.87 |   |
| Allowance  for loan losses to total loans at the end of period              |       | .88                              |       | .80 |   | 1.06 |   | 1.01 |   | .94 |   |
| Nonperforming  loans to total loans at the end of period (2)                |       | 1.55                             |       | 2.04 |   | 1.83 |   | 1.15 |   | 2.26 |   |
| Net loans  charged off to average total loans                               |       | .13                              |       | .21 |   | .06 |   | .25 |   | .25 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Balance  Sheet Data:**                                                    |       |                             |       |   |   |   |   |   |   |   |   |
| Total assets                                                                |       | $                                | 288,659    |   | $ | 294,490 |   | $ | 240,662 |   | $ | 232,565 |   | $ | 225,007 |   |
| Total  earning assets                                                       |       | 262,618                          |       | 276,767 |   | 223,324 |   | 216,927 |   | 210,058 |   |
| Average  assets                                                             |       | 299,665                          |       | 247,961 |   | 232,335 |   | 224,653 |   | 226,787 |   |
| Gross loans,  including loans held for sale                                 |       | 134,493                          |       | 131,948 |   | 111,454 |   | 109,508 |   | 117,612 |   |
| Allowance  for loan losses                                                  |       | 1,174                            |       | 1,049 |   | 1,167 |   | 1,109 |   | 1,108 |   |
| Total  deposits                                                             |       | 253,964                          |       | 264,921 |   | 193,767 |   | 165,267 |   | 173,453 |   |
| Federal  funds purchased and securities sold under agreements to repurchase |       | 6,350                            |       | — |   | 16,322 |   | 35,899 |   | 24,638 |   |
| Shareholders’  equity                                                  |       | 23,852                           |       | 24,655 |   | 25,183 |   | 22,907 |   | 22,583 |   |

 

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(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.

 

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**MANAGEMENT’S DISCUSSIONAND ANALYSIS**

**OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS**

 

Thefollowing discussion and analysis is intended as a review of significantfactors affecting the financial condition and results of operations of theCompany for the periods indicated.  Thediscussion should be read in conjunction with the Consolidated FinancialStatements and Notes thereto and the Selected Consolidated Financial Datapresented herein.  In addition to historicalinformation, the following Management’s Discussion and Analysis of FinancialCondition and Results of Operations contains forward–looking statements thatinvolve risks and uncertainties.  TheCompany’s actual results could differ significantly from those anticipated inthese forward–looking statements as a result of certain factors discussedelsewhere in this report.

 

# **Overview**

 

TheCompany’s principal business is conducted by the Bank and consists of a fullrange of community–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.

 

Netinterest income is dependent on the amounts and yields of interest–earningassets as compared to the amounts of and rates on interest–bearingliabilities.  Net interest income issensitive to changes in market rates of interest and the Company’sasset/liability management procedures in coping with such changes.  The provision for loan losses is dependentupon management’s assessment of the collectibility of the loan portfolio undercurrent economic conditions.

 

Netincome was $2.6 million for the year ended December 31, 2004 compared to$2.5 million for the year ended December 31, 2003.  The return on average assets was .88% in 2004compared to 1.00% in 2003.  The return onaverage equity increased to 11.05% in 2004 from 10.50% in 2003.  This resulted primarily from the increase innet income and the change in average equity due to stock repurchases in 2004and 2003.

 

Netincome was $2.5 million for the year ended December 31, 2003 compared to$2.3 million for the year ended December 31, 2002.  The return on average assets was 1.00% in2003 compared to .99% in 2002.  Thereturn on average equity increased to 10.50% in 2003 from 9.73% in 2002.  This resulted primarily from the increase innet income and the change in average equity due to stock repurchases in 2003and 2002.

 

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# **CriticalAccounting Policies**

 

Theaccounting and reporting policies of the Company are in accordance withaccounting principles generally accepted in the United States of America andconform to general practices within the banking industry.  The Company’ssignificant accounting policies are described in detail in the notes to theCompany’s consolidated financial statements for the year ended December 31,2003. The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions. The financial position and results of operations can be affected bythese estimates and assumptions and are integral to the understanding ofreported results. Critical accounting policies are those policies thatmanagement believes are the most important to the portrayal of the Company’sfinancial condition and results, and they require management to make estimatesthat are difficult, subjective, or complex.

 

**Allowance for Credit Losses–**The allowance for credit losses provides coverage for probable lossesinherent in the Company’s loan portfolio. Management evaluates the adequacy ofthe allowance for credit 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 loan performance,regulatory guidance and economic factors. This evaluation is inherentlysubjective, as it requires the use of significant management estimates. Manyfactors can affect management’s estimates of specific and expected losses,including volatility of default probabilities, rating migrations, loss severityand economic and political conditions. The allowance is increased throughprovisions charged to operating earnings and reduced by net charge–offs.

 

TheCompany determines the amount of the allowance based on relative riskcharacteristics of the loan portfolio. The allowance recorded for commercialloans is based on reviews of individual credit relationships and an analysis ofthe migration of commercial loans and actual loss experience. The allowancerecorded for homogeneous consumer loans is based on an analysis of loan mix,risk characteristics of the portfolio, fraud loss and bankruptcy experiences,and historical losses, adjusted for current trends, for each homogeneouscategory or group of loans. The allowance for credit losses relating toimpaired 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.

 

Regardlessof the extent of the Company’s analysis of customer performance, portfoliotrends or risk management processes, certain inherent but undetected losses areprobable within the loan portfolio. This is due to several factors includinginherent delays in obtaining information regarding a customer’s financialcondition or changes in their unique business conditions, the judgmental natureof individual loan evaluations, collateral assessments and the interpretationof economic trends. Volatility of economic or customer–specific conditionsaffecting 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 rangeof inherent losses related to the existence of these exposures.  Theestimates are based upon the Company’s evaluation of imprecision riskassociated with the commercial and consumer allowance levels and the estimatedimpact of the current economic environment.

 

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**Mortgage Servicing 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, is recognized through a valuation allowanceand is recorded as amortization of intangible assets.

 

**Derivatives–**Asa part of the Company’s funding strategy, derivative financial instruments, allof which are interest rate swap arrangements, are used to reduce exposure to changesin interest rates for certain financial instruments.  These derivativesare accounted for by recognizing the fair value of the contracts on the balancesheet.  The valuation of these derivatives is considered critical becausecarrying assets and liabilities at fair value inherently results in morefinancial statement volatility.  The fair values and the information usedto record valuation adjustments for the interest rate swaps and related depositproducts are provided by third parties.

 

Additionally,the Company has purchased certificate of deposits which contain an equityrelated embedded derivative component.  The initial investment in thecertificate of deposit is not at risk but the return on the investment is basedon appreciation 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.

 

**Stock Compensation**– Grants under the Company’s stock incentive plan are accountedfor under the provisions of Statement of Accounting Standards (SFAS) No. 123,applying the fair value method and the use of an option pricing model toestimate the value of the options granted. The stock options are granted with an exercise price equal to the marketprice at the date of grant.  Resultingcompensation expense, under the stock options, is measured andrecorded based on the estimated value of the options.

 

# **ConsolidatedFinancial Condition**

 

Totalassets at December 31, 2004 were $288.7 million compared to $294.5 millionat December 31, 2003, a decrease of $5.8 million, or 2.0%.  The decrease in total assets was a result ofa $9.9 million decrease in cash and cash equivalents due to a reduction in thereserve amount required by the Federal Reserve Bank, and also  a reduction in federal funds sold of $6.4million. Investment securities decreased by $8.8 million, however, this wasoffset by an $11.5 million increase in certificates of deposit held forinvestment purposes.  Commercial andagricultural loans increased $4.1 million during 2004 due to an effort bymanagement to increase the size of the commercial loan portfolio.  Real estate loans also increased by $3.4million during 2004, again due to an effort by management to increase the sizeof the portfolio.  These increases were 

 

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partiallyoffset by the decrease in installment loans of $5.2 million due to a generaldecline in indirect lending volume and more stringent underwriting guidelineson consumer loans.  Loans held for saleincreased modestly by $57,000 as customers refinanced loans in reaction to thecurrent rate environment.  Premises andequipment increased by $87,000 due to capital expenditures on existingbuildings and the start of construction on a new Yorkville, Illinois branchfacility. The Bank anticipates additional 2005 capital expenditures ofapproximately $700,000, to complete this branch facility.  The increase in loans and certificates ofdeposits was funded by a decrease in securities and increases in federal fundspurchased and repurchase agreements. Total borrowings increased $6.4 million asa result of a $5.6 million increase in federal funds purchased and a $750,000increase in securities sold under repurchase agreements.  Total deposits decreased $11.0 million.  This decrease was a result of managementsplan to attract customers to lower cost products by diminishing reliance onwholesale funding sources while increasing core deposits.  As a result, transaction accounts includingnon interest bearing demand, savings, NOW, and money market accounts increased$9.1 million while time deposits decreased by $20.0 million.

 

Totalequity was $23.9 million at December 31, 2004 compared to $24.7 million atDecember 31, 2003.  The decrease wasprimarily the result of a decrease in the unrealized gain on securitiesavailable–for–sale, net of tax, of $1.4 million, dividends declared of $2.0million and by the repurchase of Company common stock for $71,000. The decreasewas partially offset by net income of $2.6 million.

# ** **

# **ConsolidatedResults of Operations**

 

# **2004Compared to 2003**

 

*Net Interest Income.*  Net interest income was $9.3million in 2004 compared to $8.3 million in 2003, an increase of $1.0 million,or 12.9%.  Interest income on earningassets increased $886,000 in 2004 from 2003. All classifications of interest earning assets experienced growth in2004 when compared to 2003.  Theincreases were attributable to increases in average balances and also averagetax–equivalent yields available in the marketplace in 2004.  Interest expense on interest–bearingliabilities decreased $184,000 as a result of a decrease in the average ratepaid on liabilities of 54 basis points, from 2.26% in 2003 to 1.72% in 2004.The net interest margin on a tax equivalent basis decreased to 3.60% in 2004from 3.89% in 2003.  The primary reasonfor the decrease in the net interest margin was the result of lower ratesearned on interest-bearing assets during the low rate environment experiencedthroughout 2004.

 

*Provision for Loan Losses.*  The provision for loan lossesincreased to $300,000 in 2004  comparedto $120,000 in 2003.  As of December 31,2004, the allowance for loan losses totaled $1.2 million, or .88% of totalloans, compared to $1.1 million, or .80% of total loans, at December 31,2003.  The increase in the provision forloan losses in 2004 was influenced heavily by the acquisition of  $11.4 million of Streator branch loans in thefourth quarter of 2003.

 

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 

 

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outlook of the economyfor 2005.  Even though there areindications of emerging strength, it is uncertain if this strength is sustainable.If it is not sustainable, borrowers may experience difficulty, and the level ofnon–performing loans, charge-offs, and delinquencies could rise and requireincreases in the provision.  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 concludedthat the allowance for loan losses is adequate at December  31,2004.  However, there can be no assurancethat the allowance for loan losses will be adequate to cover all losses.

 

*Noninterest Income.*  The Company’s noninterest income increased$603,000, or 23.3% compared to 2003. Noninterest income increased primarily due to gains on securities soldof $465,000 in 2004, an increase of $448,000 over 2003.  Service charges on deposit accounts increasedby $223,000, or 25.8%, to $1.1 million. Increases in service charge income are attributable to higher averagebalances and an increase in the average number of accounts during 2004.  Other income increased by $399,000, or 79.2%compared to 2003.  This increase isprimarily due to a $301,000 increase in the market value of derivatives relatedto index powered certificates of deposit held for investments and for customersof the bank.  Trust and farm managementfee income increased modestly by $12,000, to $484,000 in 2004 compared to2003.  Gains on loan sales to thesecondary market decreased $479,000 to $254,000 in 2004 compared to 2003.  Due to the rate structure in early 2004 andthe large amount of loans that refinanced during 2002 and 2003, gains on saleof loans during 2004 were significantly less than 2003.

 

*Noninterest Expense.*  The Company’s noninterest expense was $8.8million in 2004 and $7.4 million for 2003. Salaries and benefits, which is the largest component of noninterestexpense, increased $529,000, or 12.8%, to $4.7 million.  Increases in occupancy and equipment expenseof $327,000, professional fees of $65,000 and other expenses of $299,000,contributed to the $1.4 million increase in noninterest expense for theyear.  Increased salaries and benefitswere primarily a result of additional personnel retained in the acquisition ofthe two branches in Streator in November 2003.  The increase in occupancy and equipmentexpenses was due primarily to increased depreciation on capital expendituresrelated to the renovation of the main banking facility in Ottawa, theacquisition of the Streator facilities, and the construction of the Morrisfacility. Increased professional fees were a result of the increase in auditcosts and consulting costs associated with establishing new bankingbranches.  Increases in other expensesresulted primarily from increased mortgage banking expenses of $53,000, andadditional insurance expenses related to added facilities of $98,000.  Data expenses decreased $166,000, or 33.2%from 2003, and were a result of a platform conversion which was completed in November 2003.  The Company also experienced decreases insupplies expense of $25,000, and advertising expense of $72,000, during 2004.

 

*Income Taxes.*  The Company’s tax rate varied from statutoryrates principally due to interest income from tax–exempt securities andloans.  The Company’s effective tax ratewas 23.3% and 26.1% for 2004 and 2003.

 

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# **2003Compared to 2002**

 

*Net Interest Income.*  Net interest income was $8.3million in 2003 compared to $7.4 million in 2002, an increase of $900,000, or12.3%.  Interest income on earning assetsdecreased $441,000 in 2003 from 2002. The decrease was primarily due to decreased interest income oninvestment securities of $638,000, attributable to a decrease in averagebalances and also average tax–equivalent yields available in the marketplace in2003.  The decrease was partially offsetby increases in interest income earned on the loan portfolio of $81,000, andalso interest-bearing deposits held for investment purposes of $104,000.Increases in income are attributed to growth in average balances in theseareas. Interest expense on interest–bearing liabilities decreased $1.3 millionas a result of a decrease in the average rate paid on liabilities of 85 basispoints, from 3.11% in 2002 to 2.26% in 2003. The net interest margin on a tax equivalent basis increased to 3.89% in2003 from 3.77% in 2002.  The primaryreason for the increase in the net interest margin was the result of rates oninterest–bearing liabilities repricing downward and growth in NOW and moneymarket products which pay lower interest rates.

 

*Provision for Loan Losses.*  The provision for loan lossesremained constant at $120,000 in 2003 compared to 2002.  As of December 31, 2003, the allowancefor loan losses totaled $1.1 million, or .80% of total loans, compared to $1.2million, or 1.06% of total loans, at December 31, 2002.  The reduction in the allowance for loanlosses as a percentage of total loans was influenced heavily by the acquisitionof  $11.4 million of Streator branch loansin the fourth quarter of 2003.

 

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 2004.  Even though there are indications of emergingstrength, it is uncertain if this strength is sustainable.  If it is not sustainable, borrowers mayexperience difficulty, and the level of non–performing loans, charge–offs, anddelinquencies could rise and require increases in the provision.  The 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 concludedthat the allowance for loan losses is adequate at December  31,2003.  However, there can be no assurancethat the allowance for loan losses will be adequate to cover all losses.

 

*Noninterest Income.*  The Company’s noninterest income increased$148,000, or 6.1% compared to 2002. Noninterest income increased primarily due to increased mortgagerefinancing activity in the low rate environment.  Gains on loan sales to the secondary marketincreased $288,000 to $733,000 in 2003 compared to 2002.  This increase was partially mitigated bydecreases in gains on securities sold of $102, and a decrease in other incomefrom bank owned life insurance of $169,000.  Service charges on deposit accounts increased by $98,000, or 12.8%, to$866,000.  

 

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Trust and farmmanagement fee income increased modestly by $13,000, to $472,000 in 2003compared to 2002.

 

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

 

*Noninterest Expense.*  The Company’s noninterest expense was $7.4million in 2003 and $6.7 million for 2002. Salaries and benefits, which is the largest component of noninterestexpense, increased $168,000, or 4.3%, to $4.1 million.  Increases in occupancy and equipment expenseof $76,000, data expense of $67,000, supplies expense of $73,000, advertisingexpense of $31,000, professional fees of $76,000 and other expenses of$201,000, contributed to the $695,000 increase in noninterest expense for theyear.  Increased salaries and benefitswere primarily a result of additional personnel hired to staff the new Morrisfacility, which opened in July 2003, and personnel retained in theacquisition of the two branches in Streator in November 2003.  The increase in occupancy and equipmentexpenses was due primarily to increased depreciation on capital expendituresrelated to the renovation of the main banking facility in Ottawa, theacquisition of the Streator facilities, and the construction of the Morrisfacility.  In addition, the increases insupplies and advertising were primarily attributed to the new facilities in2003. Increased professional fees were a result of the consulting and legalcosts associated with the branch acquisitions. Increased data expenses were aresult of a platform conversion which was completed in November 2003.  Increases in other expenses resultedprimarily from increased mortgage banking expenses of $85,000, and otherexpenses related to index–powered certificates of deposit of $47,000.

 

*Income Taxes.*  The Company’s tax rate varied from statutoryrates principally due to interest income from tax–exempt securities andloans.  The Company’s effective tax ratewas 26.1% and 22.9% for 2003 and 2002.

 

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Thecomponents of the 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 of Changes inInterest Income and Expense

($000s)

 
| ** **                                             | ** ** | **2004 – 2003  Increase (Decrease)** | ** ** | **2003 – 2002  Increase (Decrease)** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **Total  Change**                         | ** ** | **Change  Due to  Volume**                | ** ** | **Change  Due to  Rate** | ** ** | **Total  Change** | ** ** | **Change  Due to  Volume** | ** ** | **Change  Due to  Rate** | ** ** |
| INTEREST INCOME                                        |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
|                                                   |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Loans                                                  |       | $                                         | 242        |                                      | $          | 1,019 |   | $ | (777 | ) | $ | (155 | ) | $ | 518 |   | $ | (673 | ) |
| Investment  CDs                                        |       | 276                                       |       | 290                                       |       | (14 | ) | 104 |   | 128 |   | (24 | ) |
| Securities                                             |       | 441                                       |       | 989                                       |       | (548 | ) | (729 | ) | (253 | ) | (476 | ) |
| Federal  funds sold                                    |       | 8                                         |       | 3                                         |       | 5 |   | 12 |   | 22 |   | (10 | ) |
| Total interest  income                                 |       | 967                                       |       | 2,301                                     |       | (1,334 | ) | (768 | ) | 415 |   | (1,183 | ) |
|                                                   |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| INTEREST  EXPENSE                                      |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
|                                                   |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| NOW and  money market                                  |       | 546                                       |       | 441                                       |       | 105 |   | 125 |   | 279 |   | (154 | ) |
| Savings                                                |       | (36                                       | )          | 47                                        |       | (83 | ) | (105 | ) | 27 |   | (132 | ) |
| Time  deposits                                         |       | (555                                      | )          | 336                                       |       | (891 | ) | (902 | ) | 43 |   | (945 | ) |
| Repurchase  agreements                                 |       | (8                                        | )          | (2                                        | )          | (6 | ) | (465 | ) | (528 | ) | 63 |   |
| Borrowings                                             |       | (134                                      | )          | (195                                      | )          | 61 |   | (91 | ) | (111 | ) | 20 |   |
| Federal  funds purchased                               |       | 2                                         |       | 3                                         |       | (1 | ) | 90 |   | 100 |   | (10 | ) |
| Total  interest expense                                |       | (185                                      | )          | 630                                       |       | (815 | ) | (1,348 | ) | (190 | ) | (1,158 | ) |
|                                                   |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Net interest  earnings                                 |       | 1,152                                     |       | 1,671                                     |       | (519 | ) | 580 |   | 604 |   | (24 | ) |
| Tax  equivalent adjustment                             |       | (82                                       | )          | —                                    |       | (82 | ) | 328 |   | — |   | 328 |   |
|                                                   |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Net interest  earnings after tax equivalent adjustment |       | $                                         | 1,070      |                                      | $          | 1,671 |   | $ | (601 | ) | $ | 908 |   | $ | 604 |   | $ | 304 |   |

 

### **Volume/rate variances areallocated to the volume variance and the rate variance on an absolutebasis.  Tax–exempt income is reflected ona fully tax–equivalent basis utilizing a 34% rate for municipal securities andtax–exempt loans.**

# ** **

# **Interest–EarningAssets and Interest–Bearing Liabilities**

 

The following table setsforth the average balances, net interest income and expense, and average yieldsand rates for the Company’s interest–earning assets and interest–bearing liabilitiesfor the indicated years on a tax–equivalent basis assuming a 34% tax rate.

 

9

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

Years Ended December 31, 2004, 2003, and2002

($000s)

 
| ** **                                                                | ** ** | **2004**                 | ** ** | **2003**     | ** ** | **2002**          | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------|------------|--------------|------------|-------------------|------------|
|                                                                      | ** ** | **Average  Balance (4)** | ** ** | **Interest** | ** ** | **Average  Rate** | ** ** | **Average  Balance (4)** | ** ** | **Interest** | ** ** | **Average  Rate** | ** ** | **Average  Balance (4)** | ** ** | **Interest** | ** ** | **Average  Rate** | ** ** |
| ASSETS                                                                    |       |                     |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                      |       |                     |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1)  (3)                                                       |       | $                        | 131,191    |         | $          | 8,331             |       | 6.35 | % | $ | 115,140 |   | $ | 8,089 |   | 7.03 | % | $ | 107,768 |   | $ | 8,244 |   | 7.65 | % |
| Investment CDs                                                            |       | 20,910                   |       | 633          |       | 3.03              |       | 11,341 |   | 357 |   | 3.15 |   | 7,259 |   | 253 |   | 3.49 |   |
| Securities (2)  (5)                                                  |       | 116,892                  |       | 5,037        |       | 4.31              |       | 93,944 |   | 4,596 |   | 4.89 |   | 99,107 |   | 5,325 |   | 5.37 |   |
| Federal funds sold                                                        |       | 3,589                    |       | 40           |       | 1.11              |       | 3,308 |   | 32 |   | .97 |   | 1,154 |   | 20 |   | 1.73 |   |
| Interest-earning assets                                                   |       | 272,582                  |       | 14,041       |       | 5.15              |       | 223,733 |   | 13,074 |   | 5.84 |   | 215,288 |   | 13,842 |   | 6.43 |   |
| Non-interest-earning assets (6)                                           |       | 27,083                   |       |         |       |              |       | 24,228 |   |   |   |   |   | 17,047 |   |   |   |   |   |
|                                                                      |       |                     |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Average assets                                                            |       | $                        | 299,665    |         |       |              |       |   | $ | 247,961 |   |   |   |   |   | $ | 232,335 |   |   |   |   |   |
|                                                                      |       |                     |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                 |       |                     |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                      |       |                     |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money market                                                      |       | $                        | 107,136    |         | 1,254      |              | 1.17       |   | $ | 69,435 |   | 708 |   | 1.02 |   | $ | 42,056 |   | 583 |   | 1.39 |   |
| Savings                                                                   |       | 29,121                   |       | 171          |       | .59               |       | 21,158 |   | 207 |   | .98 |   | 18,388 |   | 312 |   | 1.70 |   |
| Time deposits                                                             |       | 105,002                  |       | 2,737        |       | 2.61              |       | 92,110 |   | 3,292 |   | 3.57 |   | 90,909 |   | 4,194 |   | 4.61 |   |
| Repurchase agreements                                                     |       | 215                      |       | 2            |       | .93               |       | 475 |   | 10 |   | 2.11 |   | 25,567 |   | 475 |   | 1.86 |   |
| Federal funds purchased                                                   |       | 1,175                    |       | 24           |       | 2.04              |       | 10,713 |   | 158 |   | 1.47 |   | 3,902 |   | 68 |   | 1.74 |   |
| Borrowings                                                                |       | 438                      |       | 12           |       | 2.74              |       | 313 |   | 10 |   | 3.19 |   | 3,808 |   | 101 |   | 2.65 |   |
| Interest-bearing liabilities                                              |       | 243,087                  |       | 4,200        |       | 1.73              |       | 194,204 |   | 4,385 |   | 2.26 |   | 184,630 |   | 5,733 |   | 3.11 |   |
|                                                                      |       |                     |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income  (2)                                             |       |                     |       | 9,841        |       |              |       |   |   | 8,689 |   |   |   |   |   | 8,109 |   |   |   |
| Net yield on interest-earning assets                                      |       |                     |       |         |       | 3.61              |       |   |   |   |   | 3.88 |   |   |   |   |   | 3.77 |   |
| Interest-bearing liabilities to earning assets ratio                      |       |                     |       |         |       | 89.18             |       |   |   |   |   | 86.80 |   |   |   |   |   | 85.76 |   |
|                                                                      |       |                     |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing liabilities                                          |       | 32,185                   |       |         |       |              |       | 28,331 |   |   |   |   |   | 22,959 |   |   |   |   |   |
|                                                                      |       |                     |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                                                 |       | 24,393                   |       |         |       |              |       | 25,426 |   |   |   |   |   | 24,746 |   |   |   |   |   |
| Average liabilities and shareholders’ equity                         |       | $                        | 299,665    |         |       |              |       |   | $ | 247,961 |   |   |   |   |   | $ | 232,335 |   |   |   |   |   |
| Tax equivalent adjustment                                                 |       |                     |       | 504          |       |              |       |   |   | 422 |   |   |   |   |   | 750 |   |   |   |
| Net interest income as reported in the consolidated  statements of income |       |                     |       | $            | 9,337      |              |       |   |   |   | $ | 8,267 |   |   |   |   |   | $ | 7,359 |   |   |   |

 

----

(1)          Interest income on loans includes loan origination and other fees of$168 for 2004, $275 for 2003, and $456 for 2002.

(2)          Loan and securities income is reflected on a fully tax–equivalent basisutilizing a 34% rate for municipal securities and tax–exempt loans.

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

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

(5)          Rate information is calculated based upon average amortized cost.

(6)          Average balance information includes an average valuation allowance forsecurities of $909, $3,375, and $1,867, respectively.

 

10

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# **Impactof Accounting Changes**

 

In March 2004, the Emerging Issues Task Force(EITF) finalized and issued EITF 03-1, *The Meaning ofOther-Than-Temporary Impairment and its Application to Certain Investments*(EITF 03-1).  EITF 03-1 providesrecognition and measurement guidance regarding when impairments of equity anddebt securities are considered other-than-temporary requiring a charge toearnings, and also requires additional annual disclosures for investments inunrealized loss positions.  Theadditional annual disclosure requirements were previously issued by the EITF inNovember 2003 and were effective for the Company for the year ended December 31,2003.  In September 2004, theFinancial Accounting Standards Board (FASB) issued FASB Staff Position (FSP)EITF 03-1-1, which delays the recognition and measurement provisions of EITF03-1 pending the issuance of further implementation guidance.  We are currently evaluating the effect of therecognition and measurement provisions of EITF 03-1.  While our analysis is pending the FASB’srevisions to EITF 03-1, we currently believe the adoption of EITF 03-1 will notresult in a material impact on the Company’s results of operations or financialcondition.

 

On December 12, 2003, the American Institute ofCertified Public Accountants issued Statement of Position No. 03-3, *Accounting for Certain Loans or Debt Securities Acquired in a Transfer*(SOP 03-3).  SOP 03-3 requires acquiredloans with poor credit quality to be recorded at fair value and prohibitscarrying over or creation of valuation allowances in the initial accounting forthe loans.  SOP 03-3 also limits theyield that may be accreted to income. SOP 03-3 applies to the purchase of an individual loan, a pool of loans,a group of loans, and loans acquired in a business combination.  SOP 03-3 is effective for loans acquired infiscal years beginning after December 31, 2004.  SOP 03-3 is not expected to have a materialimpact on the Company’s results of operations or financial condition.

 

In December 2004, the FASB issued an amendmentto SFAS 123  (SFAS 123R) which eliminatesthe ability to account for share-based compensation transactions usingAccounting Principles Board Opinion No. 25, *Accounting for StockIssued to Employees*, and generally requires that such transactionsbe accounted for using a fair value-based method.  SFAS 123R will be effective for the Companybeginning July 1, 2005.

 

The Company adopted the fair value-based method ofaccounting for stock-based employee compensation prospectively as of January 1,2003, and as a result, adoption of SFAS 123R is not expected to have a materialimpact on the Company’s results of operations or financial condition.

 

11

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FIRST OTTAWA BANCSHARES, INC.AND SUBSIDIARY

MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

 

**QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET 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 interest income for the various rate shock levels forthe periods ended December 31, 2004 and 2003.

 
| ** **   | ** ** | **2004 Net Interest Income** | ** ** |
|--------------|------------|------------------------------|------------|
| ** **   | ** ** | **Amount**                   | ** ** | **Change** | ** ** | **Percentage  Change** | ** ** |
| ** **   | ** ** | **(Dollars in Thousands)**   | ** ** |
|         |       |                         |       |   |   |   |   |
| +100 bp      |       |                         | $          | 2,045 |   | $ | (100 | ) | (4.7 | )% |
| Base         |       |                         | 2,145      |   | — |   | — |   |
| –100 bp |       |                         | 2,287      |   | 142 |   | 6.6 | % |
|              |            |                              |            |  |  |  |  |  |  |  |

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

 

As shown above, at December 31,2004, the effect of an immediate 100 basis point increase in interest rateswould decrease the Company’s net interest income by 4.7%, or approximately$100,000.  The effect of an immediate 100basis point decrease in rates would increase the Company’s net interest incomeby 6.6%, or approximately $142,000.  Asfederal funds overnight rates were under 2.0% as of December 31, 2003,market interest rates decreasing an additional 200 basis points was notachievable.  The Company’s Board ofDirectors has set a risk tolerance limit of 10% of estimated net interestincome for the succeeding 12 months based on an immediate 200 basis pointchange in market prices.

 

Interest ratesensitivity reflected modest exposure in an increasing rate environment at theend of 2004 and 2003.  Overall netinterest income sensitivity increased in 2004 compared to 2003.

 

**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, 

 

12

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deposit flows andmortgage prepayments are greatly influenced by general interest rates, economicconditions, and competition.  The Companygenerally manages the pricing of its deposits to be competitive and to increasecore 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) expected deposit flows, (iii) yields available on interest–earningdeposits and securities, and (iv) the objectives of its asset/liabilitymanagement program.  Excess liquid assetsare invested generally in interest–earning overnight deposits and short– andintermediate–term U.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 $4.4 million, $1.9 million, and $2.0million for the years ended December 31, 2004, 2003, and 2002.  Net cash from investing activities consistedprimarily of principal collections on loans and proceeds from maturation andsales of securities offset by disbursements for loan originations and thepurchase of securities.  In 2003, cashflows from investing activities were also affected by the $51.2 million in cashreceived in connection with the branch acquisition.  Net cash from financing activities consistedprimarily of changes in net deposits and short–term borrowings partially offsetby dividends paid and the purchase of Company stock.

 

The Company’s mostliquid assets are cash and short–term investments.  The levels of these assets are dependent onthe Company’s operating, financing, lending, and investing activities duringany given year.  At December 31,2004, cash and short–term investments totaled $7.9 million.  The Company has other sources of liquidity ifa need for additional funds arises, including securities maturing within oneyear and the repayment of loans.  TheCompany may also utilize the sale of securities available–for–sale, federalfunds lines of credit from correspondent banks, and borrowings from the FederalHome Loan Bank of Chicago and  Bank One.

 

The following tablediscloses contractual obligations and commercial commitments of the Company asof December 31, 2004:

 
| ** **                        | ** ** | **Total** | ** ** | **Less Than  1 Year** | ** ** | **1 – 3 Years** | ** ** | **4 – 5 Years** | ** ** | **After  5 Years** | ** ** |
|-----------------------------------|------------|-----------|------------|-----------------------|------------|----------------------|------------|----------------------|------------|--------------------|------------|
|                              |       |      |       |                  |       |                 |       |                 |       |               |       |
| Note payable                      |       | $         | 559        |                  | $          | 559                  |       | $                    | —     |               | $          | — |   | $ | — |   |
| Data  processing contract payable |       | 881       |       | 193                   |       | 454                  |       | 234                  |       | —             |       |
| Lines of  credit(1)               |       | 12,163    |       | 6,925                 |       | 3,483                |       | 940                  |       | 815                |       |
| Standby  letters of credit(1)     |       | 171       |       | 171                   |       | —               |       | —               |       | —             |       |
|                              |       |      |       |                  |       |                 |       |                 |       |               |       |
|                              |       | $         | 13,774     |                  | $          | 7,848                |       | $                    | 3,937      |               | $          | 1,174 |   | $ | 815 |   |

 

----

(1)  Represents amounts committed to customers.

 

13

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During 2004 and 2003,the Company repurchased 1,018 and 5,329 shares of common stock for $71,000 and$315,000.

 

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, 2004, all of the Company’s ratios exceeded the levelsrequired under regulatory guidelines as shown in Note 15 of the ConsolidatedFinancial Statements.

 

**Facilities**

 

The Company haspurchased real estate in Yorkville, Illinois and is in the process ofestablishing a full service branch facility in that community.  Construction of the facility began in late2004 and the branch is expected to open in early 2005.  The total estimated costs to complete thebranch are $700,000 at December 31, 2004.

 

**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.

 

**SAFE HARBOR STATEMENT**

 

This document contains,and future oral and written statements of the Company and its management maycontain, forward–looking statements, within the meaning of such term in thePrivate Securities Litigation Reform Act of 1995, with respect to the financialcondition, results of operations, plans, objectives, future performance andbusiness of the Company.  Forward–lookingstatements, which may be based upon beliefs, expectations and assumptions ofthe Company’s management and on information currently available to management,are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,”“plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” orother similar expressions.  Additionally,all statements in this document, including forward–looking statements, speakonly as of the date they are made, and the Company undertakes no obligation toupdate any statement in light of new information or future events.

 

14

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TheCompany’s ability to predict results or the actual effect of future plans orstrategies is inherently uncertain. Factors which could have a material adverse effect on the operations andfuture prospects of the Company and its subsidiaries include, but are notlimited to, the following:

 

•                                         Thestrength of the United States economy in general and the strength of the localeconomies in which the Company conducts its operations which may be lessfavorable than expected and may result in, among other things, a deteriorationin the credit quality and value of the Company’s assets.

 

•                                         Theeconomic impact of past and any future terrorist attacks, acts of war orthreats thereof and the response of the United States to any such threats andattacks.

 

•                                         Theeffects of, and changes in, federal, state and local laws, regulations andpolicies affecting banking, securities, insurance and monetary and financialmatters.

 

•                                         Theeffects of changes in interest rates (including the effects of changes in therate of prepayments of the Company’s assets) and the policies of the Board ofGovernors of the Federal Reserve System.

 

•                                         Theability of the Company to compete with other financial institutions aseffectively as the Company currently intends due to increases in competitivepressures in the financial services sector.

 

•                                         Theinability of the Company to obtain new customers and to retain existingcustomers.

 

•                                         Thetimely development and acceptance of products and services, including productsand services offered through alternative delivery channels such as theInternet.

 

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

 

•                                         Theability of the Company to develop and maintain secure and reliable electronicsystems.

 

•                                         Theability of the Company to retain key executives and employees and thedifficulty that the Company may experience in replacing key executives andemployees in an effective manner.

 

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

 

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

 

15

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•                                         Thecosts, effects and outcomes of existing or future litigation.

 

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

 

•                                         Theability of the Company to manage the risks associated with the foregoing aswell as anticipated.

 

Theserisks and uncertainties should be considered in evaluating forward–lookingstatements and undue reliance should not be placed on such statements.  Additional information concerning the Companyand its business, including other factors that could materially affect theCompany’s financial results, is included in the Company’s filings with theSecurities and Exchange Commission.

 

16

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM

 

Boardof Directors and Shareholders

FirstOttawa Bancshares, Inc.

Ottawa,Illinois

 

Wehave audited the accompanying consolidated balance sheets of First OttawaBancshares, Inc. as of December 31, 2004 and 2003, and the relatedconsolidated statements of income, shareholders’ equity, and cash flows for theyears then ended.  These consolidatedfinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.  The consolidated financial statements of theCompany for the year ended December 31, 2002, were audited by otheraccountants whose report dated January 17, 2003, expressed an unqualifiedopinion on those statements.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

Inour opinion, the 2004 and 2003 consolidated financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of First Ottawa Bancshares, Inc. as of December 31, 2004 and 2003and the results of its operations and its cash flows for the years then ended,in conformity with accounting principles generally accepted in the UnitedStates of America.

 
| /s/ BKD, LLP          |   |
|-----------------------|--------|
| Indianapolis, Indiana |
| January 23, 2005 |

 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

 

Board of Directors andShareholders

First Ottawa Bancshares, Inc.

Ottawa, Illinois

 

We have audited theaccompanying consolidated statements of income, changes in shareholders'equity, and cash flows of First Ottawa Bancshares, Inc. for the year endedDecember 31, 2002.  These financialstatements are the responsibility of the Company's management.  Our responsibility is to express an opinionon these financial statements based on our audit.

 

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audit provides a reasonable basisfor our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, First Ottawa Bancshares, Inc.'s results of operations andcash flows for the year ended December 31, 2002, in conformity with U.S.generally accepted accounting principles.

 
|   | /s/ Crowe  Chizek and Company LLC |   |
|--------|-----------------------------------|--------|
|   |                              |
|   |                              |
|   | Crowe Chizek  and Company LLC     |

 

Oak Brook, Illinois

January 17, 2003

 

17

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FIRST OTTAWA BANCSHARES, INC. 

CONSOLIDATED BALANCE SHEETS

December 31, 2004 and 2003

(In thousands, except share and per sharedata)

 
| ** **                                                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                                                  |       |     |       |     |       |
| Cash and due  from banks                                                    |       | $        | 7,930      |     | $          | 11,477 |   |
| Interest-bearing  demand deposits                                           |       | —   |       | 6,400    |       |
| Cash and  cash equivalents                                                  |       | 7,930    |       | 17,877   |       |
| Certificates  of deposit                                                    |       | 24,647   |       | 13,190   |       |
| Investment  securities available for sale                                   |       | 104,652  |       | 113,433  |       |
| Loans held  for sale                                                        |       | 1,701    |       | 1,644    |       |
| Loans, net  of allowance for loan losses of $1,174 and $1,049               |       | 131,618  |       | 129,255  |       |
| Premises and  equipment                                                     |       | 7,624    |       | 7,537    |       |
| Interest  receivable and other assets                                       |       | 10,487   |       | 11,554   |       |
| Total assets                                                                |       | $        | 288,659    |     | $          | 294,490 |   |
| **Liabilities  and Shareholders’ Equity**                              |       |     |       |     |       |
| **Liabilities**                                                             |       |     |       |     |       |
| Deposits                                                                    |       | $        | 253,964    |     | $          | 264,921 |   |
| Federal  funds purchased                                                    |       | 5,600    |       | —   |       |
| Securities  sold under agreement to repurchase                              |       | 750      |       | —   |       |
| Other  borrowings                                                           |       | 559      |       | 490      |       |
| Other  liabilities                                                          |       | 3,934    |       | 4,424    |       |
| Total  liabilities                                                          |       | 264,807  |       | 269,835  |       |
| **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 750,000 issued |       | 750      |       | 750      |       |
| Additional  paid-in capital                                                 |       | 4,018    |       | 4,008    |       |
| Retained  earnings                                                          |       | 24,662   |       | 23,988   |       |
| Treasury  stock, at cost – 99,391 and 98,373 shares                    |       | (5,656   | )          | (5,585   | )          |
| Accumulated  other comprehensive income                                     |       | 78       |       | 1,494    |       |
| Total  shareholders’ equity                                            |       | 23,852   |       | 24,655   |       |
| Total  liabilities and shareholders’ equity                            |       | $        | 288,659    |     | $          | 294,490 |   |

 

Seenotes to consolidated financial statements.

 

18

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FIRST OTTAWA BANCSHARES, INC. 

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2004, 2003 and2002

(In thousands, except share and per sharedata)

 
| ** **                                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Interest  and Dividend Income**                                       |       |     |       |     |       |     |       |
| Loans  receivable                                                       |       | $        | 8,318      |     | $          | 8,057    |       | $ | 7,976 |   |
| Investment  securities                                                  |       |     |       |     |       |     |       |
| Taxable                                                                 |       | 3,592    |       | 3,457    |       | 3,933    |       |
| Exempt from  federal tax                                                |       | 954      |       | 748      |       | 910      |       |
| Federal  funds sold                                                     |       | 40       |       | 32       |       | 20       |       |
| Interest–bearing  deposits                                         |       | 633      |       | 357      |       | 253      |       |
| Total  interest and dividend income                                     |       | 13,537   |       | 12,651   |       | 13,092   |       |
| **Interest  Expense**                                                   |       |     |       |     |       |     |       |
| Deposits                                                                |       | 4,162    |       | 4,207    |       | 5,089    |       |
| Repurchase  agreements                                                  |       | 2        |       | 10       |       | 475      |       |
| Federal  funds purchased                                                |       | 24       |       | 158      |       | 68       |       |
| Other  interest expense                                                 |       | 12       |       | 9        |       | 101      |       |
| Total  interest expense                                                 |       | 4,200    |       | 4,384    |       | 5,733    |       |
| **Net  Interest Income**                                                |       | 9,337    |       | 8,267    |       | 7,359    |       |
| Provision  for loan losses                                              |       | 300      |       | 120      |       | 120      |       |
| **Net  Interest Income After Provision for Loan Losses**                |       | 9,037    |       | 8,147    |       | 7,239    |       |
| **Noninterest  Income**                                                 |       |     |       |     |       |     |       |
| Service fee  income                                                     |       | 1,089    |       | 866      |       | 768      |       |
| Trust and  farm management fee income                                   |       | 484      |       | 472      |       | 459      |       |
| Net realized  gains on sales of available–for–sale securities |       | 465      |       | —   |       | 102      |       |
| Net gains on  sales of loans                                            |       | 254      |       | 733      |       | 445      |       |
| Other income                                                            |       | 903      |       | 521      |       | 670      |       |
| Total  noninterest income                                               |       | 3,195    |       | 2,592    |       | 2,444    |       |
| **Noninterest  Expenses**                                               |       |     |       |     |       |     |       |
| Salaries and  employee benefits                                         |       | 4,651    |       | 4,122    |       | 3,954    |       |
| Occupancy  and equipment expense                                        |       | 1,270    |       | 943      |       | 867      |       |
| Data  processing fees                                                   |       | 334      |       | 500      |       | 433      |       |
| Supplies                                                                |       | 165      |       | 190      |       | 117      |       |
| Professional  fees                                                      |       | 484      |       | 419      |       | 343      |       |
| Amortization  of core deposit intangibles                               |       | 399      |       | 34       |       | —   |       |
| Other  expenses                                                         |       | 1,504    |       | 1,205    |       | 1,004    |       |
| Total  noninterest expenses                                             |       | 8,807    |       | 7,413    |       | 6,718    |       |
| **Income  Before Income Tax**                                           |       | 3,425    |       | 3,326    |       | 2,965    |       |
| Income tax  expense                                                     |       | 797      |       | 867      |       | 678      |       |
| **Net  Income**                                                         |       | $        | 2,628      |     | $          | 2,459    |       | $ | 2,287 |   |
| **Earnings  Per Share – Basic and Diluted**                        |       | $        | 4.03       |     | $          | 3.75     |       | $ | 3.47 |   |
| **Average  Shares Outstanding**                                         |       | 651,561  |       | 655,243  |       | 658,267  |       |

 

Seenotes to consolidated financial statements.

 

19

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FIRST OTTAWA BANCSHARES, INC. 

CONSOLIDATED STATEMENTS OFSHAREHOLDERS’ EQUITY

Years Ended December 31, 2004, 2003 and2002

(In thousands, except share and per sharedata)

 
| ** **                                                                     | ** ** | **Common   Stock** | ** ** | **Additional   Paid–in   Capital** | ** ** | **Retained   Earnings** | ** ** | **Treasury   Stock** | ** ** | **Accumulated   Other   Comprehensive  Income** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------------------------|------------|-------------------------|------------|----------------------|------------|-------------------------------------------------|------------|-----------|------------|
| ** **                                                                     |       |               |       |                                    |       |                    |       |                 |       |                                            |       |      |       |
| **Balances,  January 1, 2002**                                            |       | $                  | 750        |                                    | $          | 4,000                   |       | $                    | 23,178     |                                            | $          | (5,196    | )          | $ | 175 |   | $ | 22,907 |   |
| Comprehensive  income                                                          |       |               |       |                                    |       |                    |       |                 |       |                                            |       |      |       |
| Net income                                                                     |       |               |       |                                    |       | 2,287                   |       |                 |       |                                            |       | 2,287     |       |
| Other  comprehensive income, net of tax:                                       |       |               |       |                                    |       |                    |       |                 |       |                                            |       |      |       |
| Unrealized  gains on securities                                                |       |               |       |                                    |       |                    |       |                 |       | 2,254                                           |       | 2,254     |       |
| Minimum  pension liability                                                     |       |               |       |                                    |       |                    |       |                 |       | (217                                            | )          | (217      | )          |
| Comprehensive  income                                                          |       |               |       |                                    |       |                    |       |                 |       |                                            |       | 4,324     |       |
| Cash  dividends ($3.00 per share)                                              |       |               |       |                                    |       | (1,974                  | )          |                 |       |                                            |       | (1,974    | )          |
| Purchase of  1,400 treasury shares                                             |       |               |       |                                    |       |                    |       | (74                  | )          |                                            |       | (74       | )          |
| **Balances,  December 31, 2002**                                          |       | 750                |       | 4,000                                   |       | 23,491                  |       | (5,270               | )          | 2,212                                           |       | 25,183    |       |
| Comprehensive  income                                                          |       |               |       |                                    |       |                    |       |                 |       |                                            |       |      |       |
| Net income                                                                     |       |               |       |                                    |       | 2,459                   |       |                 |       |                                            |       | 2,459     |       |
| Other  comprehensive income, net of tax – unrealized losses on securities |       |               |       |                                    |       |                    |       |                 |       | (718                                            | )          | (718      | )          |
| Comprehensive  income                                                          |       |               |       |                                    |       |                    |       |                 |       |                                            |       | 1,741     |       |
| Cash  dividends ($3.00 per share)                                              |       |               |       |                                    |       | (1,962                  | )          |                 |       |                                            |       | (1,962    | )          |
| Stock  options vested                                                          |       |               |       | 8                                       |       |                    |       |                 |       |                                            |       | 8         |       |
| Purchase of  5,329 treasury shares                                             |       |               |       |                                    |       |                    |       | (315                 | )          |                                            |       | (315      | )          |
| **Balances,  December 31, 2003**                                          |       | 750                |       | 4,008                                   |       | 23,988                  |       | (5,585               | )          | 1,494                                           |       | 24,655    |       |
| Comprehensive  income                                                          |       |               |       |                                    |       |                    |       |                 |       |                                            |       |      |       |
| Net income                                                                     |       |               |       |                                    |       | 2,628                   |       |                 |       |                                            |       | 2,628     |       |
| Other  comprehensive income, net of tax – unrealized losses on securities |       |               |       |                                    |       |                    |       |                 |       | (1,416                                          | )          | (1,416    | )          |
| Comprehensive  income                                                          |       |               |       |                                    |       |                    |       |                 |       |                                            |       | 1,212     |       |
| Cash  dividends ($3.00 per share)                                              |       |               |       |                                    |       | (1,954                  | )          |                 |       |                                            |       | (1,954    | )          |
| Stock  options vested                                                          |       |               |       | 10                                      |       |                    |       |                 |       |                                            |       | 10        |       |
| Purchase of  1,018 treasury shares                                             |       |               |       |                                    |       |                    |       | (71                  | )          |                                            |       | (71       | )          |
| **Balances,  December 31, 2004**                                          |       | $                  | 750        |                                    | $          | 4,018                   |       | $                    | 24,662     |                                            | $          | (5,656    | )          | $ | 78 |   | $ | 23,852 |   |

 

Seenotes to consolidated financial statements.

 

20

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FIRST OTTAWA BANCSHARES, INC. 

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2004, 2003 and 2002

(In thousands, except per share data)

 
| ** **                                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Operating Activities**                                                |       |     |       |     |       |     |       |
| Net income                                                              |       | $        | 2,628      |     | $          | 2,459    |       | $ | 2,287 |   |
| Items not requiring (providing) cash                                    |       |     |       |     |       |     |       |
| Provision for loan losses                                               |       | 300      |       | 120      |       | 120      |       |
| Premium amortization on securities, net                                 |       | 502      |       | 189      |       | 128      |       |
| Derivative valuation adjustment                                         |       | (411     | )          | —   |       | —   |       |
| Depreciation and amortization                                           |       | 871      |       | 335      |       | 331      |       |
| Loans originated for sale, net                                          |       | 197      |       | 900      |       | 109      |       |
| Gains on sales of securities, net                                       |       | (465     | )          | —   |       | (102     | )          |
| Gains on sales of loans held for sale                                   |       | (254     | )          | (733     | )          | (445     | )          |
| Stock options vested                                                    |       | 10       |       | —   |       | —   |       |
| Change in                                                               |       |     |       |     |       |     |       |
| Interest receivable and other assets                                    |       | 791      |       | (1,465   | )          | 474      |       |
| Interest payable and other liabilities                                  |       | 241      |       | 70       |       | (929     | )          |
| Net cash provided by operating activities                               |       | 4,410    |       | 1,875    |       | 1,973    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Investing Activities**                                                |       |     |       |     |       |     |       |
| Purchases of securities available for sale                              |       | (32,247  | )          | (43,703  | )          | (16,811  | )          |
| Proceeds from maturities and paydowns of  securities available for sale |       | 21,616   |       | 27,879   |       | 18,280   |       |
| Proceeds from sales of securities available  for sale                   |       | 17,230   |       |     |       | 7,831    |       |
| Purchases of certificates of deposit                                    |       | (18,086  | )          | (8,090   | )          | (9,885   | )          |
| Proceeds from maturities of certificates of  deposit                    |       | 7,040    |       | 7,885    |       | —   |       |
| Net change in loans                                                     |       | (2,804   | )          | (9,295   | )          | (2,003   | )          |
| Purchases of premises and equipment                                     |       | (543     | )          | (2,537   | )          | (2,030   | )          |
| Cash received in branch acquisition                                     |       | —   |       | 52,163   |       | —   |       |
| Net cash provided by (used in) investing  activities                    |       | (7,794   | )          | 24,302   |       | (4,618   | )          |
|                                                                    |       |     |       |     |       |     |       |
| **Financing Activities**                                                |       |     |       |     |       |     |       |
| Net change in                                                           |       |     |       |     |       |     |       |
| Deposits                                                                |       | (10,957  | )          | 1,866    |       | 28,500   |       |
| Federal funds purchased                                                 |       | 5,600    |       | (14,700  | )          | 9,650    |       |
| Securities sold under agreements to repurchase                          |       | 750      |       | (1,622   | )          | (29,227  | )          |
| Proceeds from borrowings                                                |       | 70       |       | —   |       | 452      |       |
| Repayment of borrowings                                                 |       | (1       | )          | (162     | )          | (4,000   | )          |
| Purchase of treasury stock                                              |       | (71      | )          | (315     | )          | (74      | )          |
| Cash dividends                                                          |       | (1,954   | )          | (1,973   | )          | (1,983   | )          |
| Net cash provided by (used in) financing  activities                    |       | (6,563   | )          | (16,906  | )          | 3,318    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Net Change in Cash and Cash Equivalents**                             |       | (9,947   | )          | 9,271    |       | 673      |       |
| ** **                                                              |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, Beginning of  Year**                       |       | 17,877   |       | 8,606    |       | 7,933    |       |
| ** **                                                              |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, End of Year**                              |       | $        | 7,930      |     | $          | 17,877   |       | $ | 8,606 |   |
| ** **                                                              |       |     |       |     |       |     |       |
| **Additional Cash Flows Information**                                   |       |     |       |     |       |     |       |
| Interest paid                                                           |       | $        | 4,460      |     | $          | 4,552    |       | $ | 6,217 |   |
| Income tax paid, net of refunds                                         |       | 158      |       | 821      |       | 563      |       |
| Transfers from loans to foreclosed real  estate                         |       | 141      |       | 174      |       | 331      |       |
| Due from broker                                                         |       | —   |       | —   |       | (477     | )          |
| Assets acquired and liabilities assumed in  branch acquisition:         |       |     |       |     |       |     |       |
| Loans                                                                   |       | —   |       | 11,774   |       | —   |       |
| Premises and equipment                                                  |       | —   |       | 780      |       | —   |       |
| Goodwill and core deposit intangibles                                   |       | —   |       | 4,553    |       | —   |       |
| Other assets, net                                                       |       | —   |       | 18       |       | —   |       |
| Deposits                                                                |       | —   |       | (69,288  | )          | —   |       |

 

See notes to consolidatedfinancial statements.

 

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FIRST OTTAWA BANCSHARES, INC. 

NOTESTO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2004, 2003 and 2002

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

 

**NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

Nature of Operations and Principles ofConsolidation:  First Ottawa Bancshares, Inc. is a bankholding company whose principal activity is the ownership and management of itswholly–owned subsidiary, First National Bank of Ottawa (Bank).  The Bank is primarily engaged in providing afull range of banking and financial services to individual and corporatecustomers in LaSalle, Grundy and surrounding counties in Illinois.  The Bank is subject to competition 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. Securities are written down to fair value, with a charge to expense,when a decline in fair value is not temporary.

 

Realized gains and losses on sales aredetermined using the amortized cost of the specific security sold.  Interest income includes amortization ofpurchase premiums and discounts.

 

Derivatives:  All derivative instruments are recorded attheir fair values and the change in the fair value of a derivative is includedin interest income.  If derivativeinstruments are designated as hedges of fair values, both the change in thefair value of the hedge and the hedged item are included in currentearnings.  Fair value 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:  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 not reportedwhen full loan repayment is in doubt, typically when payments are past due over90 days.  Payments received on such loansare reported as principal reductions.

 

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 is reported when full paymentunder the loan terms is not expected. Impairment is evaluated in total for smaller–balance loans of similarnature, such as residential mortgage and consumer loans, and on an individualloan basis for other loans.  If a loan isimpaired, a portion of the allowance is allocated so that the loan is reported,net, at the present value of estimated future cash flows using the loan’sexisting rate or at the loan’s observable market price or the fair value ofcollateral if the loan is collateral dependent. Loans are evaluated for impairment when payments are delayed, typically90 days or more, or when the internal grading system indicates a doubtfulclassification.

 

22

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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 depreciatedusing the straight–line method with useful lives ranging from 5 to 15 years.  These assets are reviewed for impairment whenevents indicate that the carrying amount may not be recoverable.  Maintenance and repairs are charged toexpense and improvements are capitalized.

 

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

 

Mortgage Servicing Rights:  Servicing rights are recognized as assets forthe allocated value of servicing rights retained on loans sold and areclassified with interest receivable and other assets in the consolidatedbalance sheets.  Servicing rights areexpensed in proportion to and over the period of estimated net 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 prepayment characteristics.  Fair value is determined using prices forsimilar assets with similar characteristics, when available, or based upondiscounted cash flows using market–based assumptions.  Any impairment of a grouping is reported as avaluation allowance.  There was no suchvaluation allowance recorded at December 31, 2004 and 2003, and mortgageservicing 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 12. The Company accounts for this plan under the recognition and measurementprinciples of Statement of Financial Accounting Standards No. 123, *Accounting for Stock–Based Compensation*.  The value of options granted under this planis charged to expense over the vesting period of the grants.

 

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

 

Earnings Per Share:  Basic earnings per share is calculated basedon the weighted-average common shares outstanding during the year.  The Company had no dilutive securities duringthe three years in the period ended December 31, 2004.

 

Fair Values of Financial Instruments:  Fair values of financial instruments areestimated using relevant market information and other assumptions, as morefully disclosed separately.  Fair valueestimates involve uncertainties and matters of significant judgment regardinginterest rates, credit risk, prepayments, and other factors, especially in theabsence of broad markets for particular items. Changes in assumptions or in market conditions could significantlyaffect the estimates.  The fair valueestimates of existing on– and off–balance–sheet financial instruments do notinclude the value of anticipated future business or the values of assets andliabilities not considered financial 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.

 

23

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**NOTE 2 – BUSINESS COMBINATION**

 

On November 14, 2003, the Company assumedsubstantially all of the deposit liabilities and certain loans and other assetsof two branch offices located in Streator, Illinois from First MidwestBank.  As a result of the acquisition,the Company has an opportunity to increase its customer base and continue toincrease its market share.

 

The acquisition was accounted for under thepurchase method of accounting.  Allassets and liabilities were recorded at their fair values as of November 14,2003, including goodwill of $2,446,000 which is deductible for taxpurposes.  Additionally, core depositintangibles totaling $2,027,000 were recognized and will be amortized over 11years using a declining balance method. The purchase accounting adjustments are being amortized over the life ofthe respective asset or liability.  Thefollowing table summarizes the estimated fair values of the assets acquired andliabilities assumed at the date of acquisition.

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

 

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

 

**NOTE 3 – SECURITIES AVAILABLE FOR SALE**

 
| ** **                                                               | ** ** | **Amortized   Cost** | ** ** | **Gross   Unrealized   Gains** | ** ** | **Gross   Unrealized   Losses** | ** ** | **Fair   Value** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------|------------|--------------------------------|------------|---------------------------------|------------|------------------|------------|
| **December 31, 2004**                                                    |       |                 |       |                           |       |                            |       |             |       |
| ** **                                                               |       |                 |       |                           |       |                            |       |             |       |
| U. S. Treasury                                                           |       | $                    | 10,103     |                           | $          | 1                               |       | $                | (45        | ) | $ | 10,059 |   |
| Federal agencies                                                         |       | 47,482               |       | 345                            |       | (226                            | )          | 47,601           |       |
| State and municipal                                                      |       | 26,250               |       | 576                            |       | (244                            | )          | 26,582           |       |
| Mortgage–backed securities and  collateralized mortgage obligations |       | 12,252               |       | 120                            |       | (32                             | )          | 12,340           |       |
| Corporate obligations                                                    |       | 4,686                |       | 20                             |       | (53                             | )          | 4,653            |       |
| Marketable equity securities                                             |       | 3,431                |       | 14                             |       | (28                             | )          | 3,417            |       |
| Total investment securities                                              |       | $                    | 104,204    |                           | $          | 1,076                           |       | $                | (628       | ) | $ | 104,652 |   |
|                                                                     |       |                 |       |                           |       |                            |       |             |       |
| **December 31, 2003**                                                    |       |                 |       |                           |       |                            |       |             |       |
| ** **                                                               |       |                 |       |                           |       |                            |       |             |       |
| U. S. Treasury                                                           |       | $                    | 11,619     |                           | $          | 72                              |       | $                | (2         | ) | $ | 11,689 |   |
| Federal agencies                                                         |       | 66,267               |       | 1,647                          |       | (56                             | )          | 67,858           |       |
| State and municipal                                                      |       | 14,041               |       | 796                            |       | (43                             | )          | 14,794           |       |
| Mortgage–backed securities and  collateralized mortgage obligations |       | 13,284               |       | 189                            |       | (80                             | )          | 13,393           |       |
| Corporate obligations                                                    |       | 2,222                |       | 101                            |       | —                          |       | 2,323            |       |
| Marketable equity securities                                             |       | 3,406                |       | 20                             |       | (50                             | )          | 3,376            |       |
| Total investment securities                                              |       | $                    | 110,839    |                           | $          | 2,825                           |       | $                | (231       | ) | $ | 113,433 |   |

 

24

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As of December 31, 2004 and 2003, the Companyhad approximately $4,505,000 and $6,950,000 invested in bonds issued bymunicipalities located within LaSalle County, Illinois.

 

Securities with an approximate carrying value of$59,097,000 and $58,428,000 were pledged at December 31, 2004 and 2003 tosecure trust and public deposits, repurchase agreements, and for other purposesas required or permitted by law.

 

The fair value of contractual maturities ofsecurities available for sale at December 31, 2004 were as follows.  Securities not due at a single maturity date,primarily mortgage–backed and equity securities, are shown separately.

 
| Within one year                                                          |   | $      | 2,541   |   |
|--------------------------------------------------------------------------|--------|--------|---------|--------|
| One to five years                                                        |   | 66,593 |    |
| Five to ten years                                                        |   | 16,782 |    |
| After ten years                                                          |   | 2,979  |    |
|                                                                     |   | 88,895 |    |
| Mortgage–backed securities and  collateralized mortgage obligations |   | 12,340 |    |
| Marketable equity securities                                             |   | 3,417  |    |
| Totals                                                                   |   | $      | 104,652 |   |

 

Information regarding realized gains and losseson sales of securities available for sale follows:

 
| ** **   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------|------------|----------|------------|----------|------------|----------|------------|
| Gross gains  |       | $        | 465        |     | $          | —   |       | $ | 104 |   |
| Gross losses |       | —   |       | —   |       | (2       | )          |
|              |            |          |            |          |            |          |            |  |  |  |

 

Certaininvestments in debt and marketable equity securities are reported in the financialstatements at an amount less than their historical cost.  Total fair value of these investments atDecember 31, 2004 and 2003, was $48.9 million and $14.7 million, which wasapproximately 47.1% and 13.0% of the Company’s available–for–sale investmentportfolio at those dates.  These declinesprimarily resulted from recent increases in market interest rates.

 

Basedon evaluation of available evidence, including recent changes in marketinterest rates, management  believes thedeclines in fair value for these securities are temporary.   Should the impairment of any of thesesecurities become other than temporary, the cost basis of the investment willbe reduced and the resulting loss recognized in net income in the period theother–than–temporary impairment is identified.

 

25

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Thefollowing table shows our investments’ gross unrealized losses and fair value,aggregated by investment category and length of time that individual securitieshave been in a continuous unrealized loss position.

 
| ** **                                                               | ** ** | **Less than 12 Months** | ** ** | **12 Months or More**   | ** ** | **Total**        | ** ** |
|--------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|------------------|------------|
| **Description of   Securities**                                          | ** ** | **Fair   Value**        | ** ** | **Unrealized   Losses** | ** ** | **Fair   Value** | ** ** | **Unrealized   Losses** | ** ** | **Fair   Value** | ** ** | **Unrealized   Losses** | ** ** |
| ** **                                                               | ** ** | ** **              | ** ** | ** **              | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **December 31, 2004**                                                    |       |                    |       |                    |       |             |       |   |   |   |   |   |   |
| ** **                                                               |       |                    |       |                    |       |             |       |   |   |   |   |   |   |
| U. S. Treasury                                                           |       | $                       | 8,062      |                    | $          | 45               |       | $ | — |   | $ | — |   | $ | 8,062 |   | $ | 45 |   |
| Federal agencies                                                         |       | 20,130                  |       | 226                     |       | —           |       | — |   | 20,130 |   | 226 |   |
| State and municipal                                                      |       | 11,353                  |       | 244                     |       | —           |       | — |   | 11,353 |   | 244 |   |
| Mortgage–backed securities and  collateralized mortgage obligations |       | 5,458                   |       | 31                      |       | 6                |       | 1 |   | 5,464 |   | 32 |   |
| Corporate obligations                                                    |       | 3,328                   |       | 53                      |       | —           |       | — |   | 3,328 |   | 53 |   |
| Marketable equity securities                                             |       | —                  |       | —                  |       | 546              |       | 28 |   | 546 |   | 28 |   |
| Total temporarily impaired securities                                    |       | $                       | 48,331     |                    | $          | 599              |       | $ | 552 |   | $ | 29 |   | $ | 48,883 |   | $ | 628 |   |
|                                                                     |       |                    |       |                    |       |             |       |   |   |   |   |   |   |
| **December 31, 2003**                                                    |       |                    |       |                    |       |             |       |   |   |   |   |   |   |
| ** **                                                               |       |                    |       |                    |       |             |       |   |   |   |   |   |   |
| U. S. Treasury                                                           |       | $                       | 1,001      |                    | $          | 2                |       | $ | — |   | $ | — |   | $ | 1,001 |   | $ | 2 |   |
| Federal agencies                                                         |       | 9,285                   |       | 56                      |       | —           |       | — |   | 9,285 |   | 56 |   |
| State and municipal                                                      |       | 153                     |       | 43                      |       | —           |       | — |   | 153 |   | 43 |   |
| Mortgage–backed securities and  collateralized mortgage obligations |       | 2,928                   |       | 80                      |       | —           |       | — |   | 2,928 |   | 80 |   |
| Corporate obligations                                                    |       | —                  |       | —                  |       | —           |       | — |   | — |   | — |   |
| Marketable equity securities                                             |       | —                  |       | —                  |       | 1,360            |       | 50 |   | 1,360 |   | 50 |   |
| Total temporarily impaired securities                                    |       | $                       | 13,367     |                    | $          | 181              |       | $ | 1,360 |   | $ | 50 |   | $ | 14,727 |   | $ | 231 |   |

 

26

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**NOTE 4 – LOANS**

 

Major classifications of loans as of December31, 2004 and 2003 are summarized as follows:

 
| ** **                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
|                        |       |     |       |     |       |
| Real estate                 |       | $        | 74,225     |     | $          | 70,839 |   |
| Commercial and agricultural |       | 28,341   |       | 24,197   |       |
| Installment                 |       | 17,575   |       | 22,812   |       |
| Home equity lines of credit |       | 12,651   |       | 12,456   |       |
| Total loans                 |       | 132,792  |       | 130,304  |       |
| Allowance for loan losses   |       | (1,174   | )          | (1,049   | )          |
|                        |       |     |       |     |       |
| Net loans                   |       | $        | 131,618    |     | $          | 129,255 |   |

 

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

 
| Balance at January 1, 2004   |   | $      |  4,320 |   |
|------------------------------|--------|--------|-------------|--------|
| New loans                    |   | 51     |        |
| Repayments                   |   | (2,716 | )      |
|                         |   |   |        |
| Balance at December 31, 2004 |   | $      |  1,655 |   |

 

Information regarding impaired loans at December31, 2004 and 2003 is as follows:

 
| ** **                                                                                                     | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Impaired loans with an allowance                                                                               |       | $          | 2,017      |       | $          | 1,943 |   |
| Impaired loans for which the discounted  cash flows or collateral value exceeds the carrying value of the loan |       | 44         |       | 163        |       |
|                                                                                                           |       |       |       |       |       |
| Total impaired loans                                                                                           |       | $          | 2,061      |       | $          | 2,106 |   |
|                                                                                                           |       |       |       |       |       |
| Allowance for impaired loans included in  the Company’s allowance for loan losses                         |       | $          | 493        |       | $          | 342 |   |

 
| ** **                                                      | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Average balance of impaired loans                               |       | $          | 2,074      |       | $          | 1,599      |       | $ | 1,636 |   |
| Interest income recognized on impaired  loans                   |       | 127        |       | 157        |       | 155        |       |
| Interest income recognized on impaired  loans – cash basis |       | 107        |       | 153        |       | 112        |       |
|                                                                 |            |            |            |            |            |            |            |  |  |  |

 

Nonperformingloans were as follows at December 31:

** **
| ** **                                    | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-----------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans past due over 90 days still on  accrual |       | $          | 727        |       | $          | 293 |   |
| Nonaccrual loans                              |       | 161        |       | 137        |       |
|                                               |            |            |            |            |            |  |  |

 

27

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**NOTE 5 – ALLOWANCE FORLOAN LOSSES**

 

Activity in the allowance for loan losses issummarized as follows for the years ended December 31:

 
| ** **                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
| Allowance for loan losses |       |     |       |     |       |     |       |
| Balances, January 1       |       | $        | 1,049      |     | $          | 1,167    |       | $ | 1,109 |   |
| Provision for losses      |       | 300      |       | 120      |       | 120      |       |
| Recoveries on loans       |       | 98       |       | 181      |       | 171      |       |
| Loans charged off         |       | (273     | )          | (419     | )          | (233     | )          |
|                      |       |     |       |     |       |     |       |
| Balances, December 31     |       | $        | 1,174      |     | $          | 1,049    |       | $ | 1,167 |   |
|                           |            |          |            |          |            |          |            |  |  |  |  |

** **

**NOTE 6 – LOAN SALES ANDSERVICING**

 

The Company sells mortgage loans with servicingretained to the Federal Home Loan Mortgage Corporation (FHLMC) and the IllinoisHousing Development Authority (IHDA). The Company realized gross proceeds from the sales of mortgage loanstotaling $9,133,000, $26,296,000 and $15,841,000 in 2004, 2003 and 2002.  Mortgage loans serviced for others are not includedin the accompanying consolidated balance sheets.  The unpaid principal balances of these loansare summarized as follows:

 
| ** **         | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------|------------|----------|------------|----------|------------|
| Loans serviced for |       |     |       |     |       |
| Freddie Mac        |       | $        | 35,698     |     | $          | 32,823 |   |
| IHDA               |       | 732      |       | 1,148    |       |
|               |       |     |       |     |       |
|               |       | $        | 36,430     |     | $          | 33,971 |   |
|                    |            |          |            |          |            |  |  |  |  |

 

Followingis an analysis of the changes in originated mortgage servicing rights:

 
| ** **                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Mortgage Servicing Rights        |       |     |       |     |       |     |       |
| Balances, January 1              |       | $        | 445        |     | $          | 301      |       | $ | 135 |   |
| Servicing rights capitalized     |       | 89       |       | 256      |       | 193      |       |
| Amortization of servicing rights |       | (154     | )          | (112     | )          | (27      | )          |
|                             |       |     |       |     |       |     |       |
| Balances, December 31            |       | $        | 380        |     | $          | 445      |       | $ | 301 |   |
|                                  |            |          |            |          |            |          |            |  |  |  |  |

 

28

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**NOTE 7 – PREMISES AND EQUIPMENT**

 

Premises and equipment consisted of thefollowing at December 31:

 
| ** **                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Cost                                      |       |     |       |     |       |
| Land                                      |       | $        | 1,816      |     | $          | 1,791 |   |
| Buildings and land improvements           |       | 6,809    |       | 6,521    |       |
| Equipment                                 |       | 4,307    |       | 4,095    |       |
| Construction in progress                  |       | 46       |       | —   |       |
| Total cost                                |       | 12,978   |       | 12,407   |       |
| Accumulated depreciation and amortization |       | (5,354   | )          | (4,870   | )          |
|                                      |       |     |       |     |       |
| Net                                       |       | $        | 7,624      |     | $          | 7,537 |   |

 

The Company anticipates additional capitalexpenditures of approximately $488,000 to complete a full service branchcurrently under construction in Yorkville, Illinois.

 

**NOTE 8 – DEPOSITS**

 

Deposits consisted of the following at December31:

 
| ** **                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
| Noninterest–bearing demand                           |       | $        | 31,582     |     | $          | 29,933 |   |
| Interest–bearing demand                              |       | 61,613   |       | 64,050   |       |
| Savings                                                   |       | 28,235   |       | 27,826   |       |
| Money market savings                                      |       | 38,252   |       | 28,828   |       |
| Certificates and other time deposits of  $100,000 or more |       | 22,462   |       | 26,425   |       |
| Other certificates and time deposits                      |       | 71,820   |       | 87,859   |       |
|                                                      |       |     |       |     |       |
| Total deposits                                            |       | $        | 253,964    |     | $          | 264,921 |   |

 

At December 31, 2004, the scheduled maturitiesof certificates of deposit were as follows:

 
| 2005   |   | $      | 44,678 |   |
|--------|--------|--------|--------|--------|
| 2006   |   | 17,379 |   |
| 2007   |   | 11,669 |   |
| 2008   |   | 15,264 |   |
| 2009   |   | 5,292  |   |
|   |   |   |   |
|   |   | $      | 94,282 |   |

 

Deposits held by the Company from relatedparties at December 31, 2004 totaled $2,163,000.

 

29

----

 

**NOTE 9 – BORROWINGS**

 

The Company has a note payable that consists ofa $2,000,000 unsecured line of credit with Marshall & Ilsley Bank, maturingon August 25, 2005.  The outstandingbalance under the line of credit was $559,000 and $490,000 at December 31,2004 and 2003.  Interest is payablequarterly at LIBOR plus 165 basis points (4.07% and 2.91% at December 31,2004 and 2003).

 

**NOTE 10 – SECURITIES SOLD UNDER AGREEMENTS TOREPURCHASE**

 

Securities sold under agreements to repurchaseare financing arrangements.  Physicalcontrol is maintained for all securities sold under repurchase agreements.  The average balance and interest rate during2004 and 2003 was $215,000 and $475,000 and 1.63% and 2.11%.  The maximum month–end balance during 2004 and2003 was $750,000 and $1,545,000.

 

**NOTE 11 – BENEFIT PLANS**

 

The Bank has a noncontributory defined-benefitpension plan covering all employees who meet the eligibility requirements.  In 1999, all plan benefits were frozen.  The Bank’s funding policy is to make theminimum annual contribution that is required by applicable regulations, plussuch amounts as the Bank may determine to be appropriate from time totime.  The Bank expects to contributeapproximately $200,000 to the plan in 2005. The Bank uses a December 31 measurement date for the plan.

 

The following tables set forth the Bank’spension plan’s funded status and amounts actuarially determined for the yearsindicated:

 
| ** **                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Change in benefit obligation    |       |     |       |     |       |
| Beginning benefit obligation    |       | $        | 1,842      |     | $          | 1,929 |   |
| Interest cost                   |       | 117      |       | 114      |       |
| Actuarial loss (gain)           |       | 146      |       | (43      | )          |
| Settlements                     |       | (107     | )          | —   |       |
| Benefits paid                   |       | (130     | )          | (158     | )          |
|                            |       |     |       |     |       |
| Ending benefit obligation       |       | $        | 1,868      |     | $          | 1,842 |   |
|                            |       |     |       |     |       |
| Change in plan assets           |       |     |       |     |       |
| Beginning fair value            |       | $        | 1,431      |     | $          | 1,233 |   |
| Actual return                   |       | 113      |       | 256      |       |
| Employer contribution           |       | 200      |       | 100      |       |
| Settlements                     |       | (107     | )          | —   |       |
| Benefits paid                   |       | (130     | )          | (158     | )          |
|                            |       |     |       |     |       |
| Ending fair value               |       | $        | 1,507      |     | $          | 1,431 |   |
|                            |       |     |       |     |       |
| Funded status                   |       | $        | (361       | )        | $          | (411 | ) |
| Unrecognized net actuarial loss |       | (269     | )          | (155     | )          |
|                            |       |     |       |     |       |
| Accrued benefit cost            |       | $        | (92        | )        | $          | (256 | ) |
|                            |       |     |       |     |       |
| Accumulated benefit obligation  |       | $        | 1,868      |     | $          | 1,842 |   |

 

30

----

 
| ** **                                         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Assumptions used to determine benefit  obligations |       |     |       |     |       |     |       |
| Discount rate                                      |       | 6.00     | %          | 6.25     | %          | 6.25     | %          |
| Expected return on plan assets                     |       | 7.0      |       | 7.0      |       | 7.0      |       |
|                                               |       |     |       |     |       |     |       |
| Assumptions used to determine benefit costs        |       |     |       |     |       |     |       |
| Discount rate                                      |       | 6.25     | %          | 6.25     | %          | 7.0      | %          |
| Expected return on plan assets                     |       | 7.0      |       | 7.0      |       | 7.0      |       |

 

The Company has estimated the long–term rate ofreturn on plan assets based primarily on historical returns on plan assets,adjusted for changes in target portfolio allocations and recent changes in long–terminterest rates based on publicly available information.

 
| ** **                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Components of net periodic benefit cost |       |     |       |     |       |     |       |
| Interest cost                           |       | $        | 117        |     | $          | 114      |       | $ | 120 |   |
| Return on plan assets                   |       | (97      | )          | (82      | )          | (105     | )          |
| Amortization                            |       | 3        |       | 9        |       | 20       |       |
|                                    |       |     |       |     |       |     |       |
| Net expense                             |       | $        | 23         |     | $          | 41       |       | $ | 35 |   |

 

Plan assets are held by a bank–administeredtrust fund, which invests the plan assets in accordance with the provisions ofthe plan agreement.  The permittedinvestments as established by the plan agreement include, but are not limitedto, common and preferred stocks, open–end or closed–end mutual funds, bonds andother evidences of indebtedness or ownership, and real estate or any interesttherein.

 

Asset allocation is primarily based on astrategy to provide stable earnings while attempting to recognize potentiallyhigher returns through limited investments in equity securities.  Plan assets are rebalanced periodically.  At December 31, 2004, and 2003, allocationsby percentages were as follows:

 
| ** **                   | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
|                         |       |     |       |     |       |
| Equity mutual funds          |       | 63.8     | %          | 64.3     | %          |
| Fixed income mutual funds    |       | 22.3     |       | 26.9     |       |
| GNMA pool                    |       | .6       |       | 1.2      |       |
| Money market funds and other |       | 13.3     |       | 7.6      |       |

 

At December 31, 2004 and 2003 market values ofplan assets were as follows:

 
| ** **                   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|
| ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equity mutual funds          |       | $          | 961        |       | $          | 920 |   |
| Fixed income mutual funds    |       | 336        |       | 385        |       |
| GNMA pool                    |       | 9          |       | 17         |       |
| Money market funds and other |       | 201        |       | 109        |       |
|                              |            |            |            |            |            |  |  |

 

The Bank has a directors’ retirement planwhich provides retirement benefits primarily to former members of the Board ofDirectors.  The Bank also maintains asupplemental executive retirement plan that provides benefits to certain keyexecutive officers and directors in accordance with the plan document.  The Bank accrued expenses related to theseplans totaling  $126,000, $188,000 and$191,000 in 2004, 2003 and 2002.

 

31

----

 

The Company’s 401(k) profit sharing plan coverseligible employees with more than one year of service, as defined, and who areat least 21 years of age.  The planallows employee contributions.  TheCompany may make a matching contribution equal to a percentage of salary deferraland discretionary 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 $140,000, $122,000 and $85,000for 2004, 2003, and 2002.

 

**NOTE  12 – 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 2004 and 2003.  The Company had no grantsoutstanding prior to 2003.

 
| ** **                                                           | ** ** | **2004**   | ** ** | **2003**                                        | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|-------------------------------------------------|------------|
| **Options**                                                          | ** ** | **Shares** | ** ** | **Weighted–   Average   Exercise   Price** | ** ** | **Shares** | ** ** | **Weighted–   Average   Exercise   Price** | ** ** |
| ** **                                                           | ** ** | ** ** | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding, beginning of year                                       |       | 6,750      |       | $                                               | 56.00      |   | — |   | $ |   |   |
| Granted                                                              |       | 6,750      |       | 62.00                                           |       | 6,750 |   | 56.00 |   |
| Outstanding, end of year                                             |       | 13,500     |       | 59.00                                           |       | 6,750 |   | 56.00 |   |
| Options exercisable at year end                                      |       | 1,684      |       |                                            |       | — |   |   |   |
| Weighted–average fair value of options  granted during the year |       |       |       | $                                               | 1.30       |   |   |   | $ | 9.59 |   |

 

AtDecember 31, 2004, certain information by exercise price for optionsoutstanding and exercisable is as follows:

 
| **Exercise   Price** | ** ** | **Number   of Shares** | ** ** | **Weighted–   Average   Remaining   Contractual   Life** | ** ** | **Number of   Shares   Exercisable** | ** ** |
|----------------------|------------|------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **           | ** ** | ** **             | ** ** | ** **                                                    | ** ** | ** **                           | ** ** |
| $                    | 56.00      |                   |       | 6,750                                                         |       | 9.5 years                            |       | 1,684 |   |
| 62.00                |       |                   | 6,750      |                                                          | 8.5 years  |                                 | —     |   |

 

32

----

 

Thefair value of each option grant was estimated on the grant date using an option–pricingmodel with the following assumptions:

 
| ** **                                                   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Risk–free interest rates                                |       | 4.21       | %          | 3.27       | %          |
| Dividend yields                                              |       | 4.35       | %          | 4.96       | %          |
| Volatility factors of expected market price  of common stock |       | 3.06       | %          | 23.55      | %          |
| Weighted–average expected life of the  options          |       | 9.5years   |       | 9.5years   |       |

 

**NOTE 13 – INCOME TAXES**

 

The balance sheets included the followingamounts of deferred tax assets and liabilities at December 31:

 
| ** **                                                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income tax expense                                         |       |     |       |     |       |     |       |
| Currently payable                                          |       |     |       |     |       |     |       |
| Federal                                                    |       | $        | 337        |     | $          | 619      |       | $ | 332 |   |
| State                                                      |       | (58      | )          | (8       | )          | 104      |       |
| Deferred                                                   |       | 518      |       | 256      |       | 242      |       |
| Total income tax expense                                   |       | $        | 797        |     | $          | 867      |       | $ | 678 |   |
| Reconciliation of federal statutory to  actual tax expense |       |     |       |     |       |     |       |
| Federal statutory income tax at 34%                        |       | $        | 1,165      |     | $          | 1,131    |       | $ | 1,008 |   |
| Tax–exempt income                                     |       | (330     | )          | (261     | )          | (320     | )          |
| Nondeductible interest expense                             |       | 24       |       | 21       |       | 35       |       |
| Effect of state income taxes and other  items, net         |       | (62      | )          | (24      | )          | (45      | )          |
|                                                       |       |     |       |     |       |     |       |
| Actual tax expense                                         |       | $        | 797        |     | $          | 867      |       | $ | 678 |   |
|                                                       |       |     |       |     |       |     |       |
| Effective tax rate                                         |       | 23.3     | %          | 26.1     | %          | 22.9     | %          |
|                                                            |            |          |            |          |            |          |            |  |  |  |  |

 

33

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Thecomponents of the deferred liability included on the balance sheets are asfollows:

 
| ** **                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                        |       |     |       |     |       |
| Allowance for loan losses                         |       | $        | 270        |     | $          | 219 |   |
| Deferred compensation                             |       | 259      |       | 219      |       |
| Pension costs                                     |       | 201      |       | 118      |       |
| Minimum pension liability                         |       | 137      |       | 137      |       |
| AMT credit carryovers                             |       | —   |       | 92       |       |
| Other                                             |       | 49       |       | —   |       |
| Total assets                                      |       | 916      |       | 785      |       |
| **Liabilities**                                   |       |     |       |     |       |
| FHLB stock                                        |       | (98      | )          | (73      | )          |
| Depreciation                                      |       | (584     | )          | (168     | )          |
| Mortgage servicing rights                         |       | (157     | )          | (184     | )          |
| Unrealized gain on securities available for  sale |       | (152     | )          | (881     | )          |
| Other                                             |       | (112     | )          | (15      | )          |
| Total liabilities                                 |       | (1,103   | )          | (1,321   | )          |
|                                              |       | $        | (187       | )        | $          | (536 | ) |

 

**NOTE 14 – DERIVATIVES**

 

The Company uses derivatives to fix future cashflows for interest payments on some of its floating rate certificates ofdeposit.  In this regard, the Company hasentered into an interest rate swap with the Federal Home Loan Bank of Chicagoto fix the interest rate on a specific certificate of deposit product.  At December 31, 2004, the Company had$2,719,000 of certificates of deposit, which mature in 2007, 2008, and 2009, inwhich it pays the Federal Home Loan Bank a weighted-average interest rate of3.33% and will receive an interest rate from the Federal Home Loan Bank basedon the appreciation of the S&P 500 Index. This interest received from the Federal Home Loan Bank will be paid tothe customer.  The assets and liabilitiesin this transaction are being netted and the expense recorded in interestexpense on deposits.

 

In addition to the above, the Company alsopurchased $7,150,000 of certificates of deposit which are included in thecertificates of deposit caption on the consolidated balance sheet.  These investments have a five year term fromdate of purchase.  The investments thatindividually do not exceed $100,000 are insured by the FDIC.  Investments that individually exceed $100,000are guaranteed by a standby letter of credit issued by the Federal Home LoanBank of Pittsburgh with no interest.  Theinitial investment is not at risk but the return on the investment is based ona calculation of the appreciation in the S&P 500 Index. The fair value ofthis embedded derivative is recorded in certificates of deposit and the fairvalue adjustment is included in other income. At December 31, 2004, the Bank had allocated $982,000 to this asset andrecorded a valuation allowance of $242,000, which is classified with thecertificates of deposit caption on the consolidated balance sheet.

 

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

 

There are various contingent liabilities thatare not reflected in the consolidated financial statements, including claimsand legal actions arising in the ordinary course of business.  In the opinion of management, afterconsultation with legal counsel, the ultimate disposition of these claims andlegal actions is not expected to have a material effect on financial conditionor results of operations.

 

The Bank is required to maintain reserve fundsin cash and/or on deposit with the Federal Reserve Bank.  The reserve required at December 31, 2004 was$350,000.

 

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

 

Exposure to credit loss if the other party doesnot perform is represented by the contractual amount for commitments to extendcredit, standby letters of credit, and financial guarantees written.  The same credit policies are used forcommitments and conditional obligations as are used for loans.  Collateral or other security is normallyrequired to support financial instruments with credit risk.

 

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

 

A summary of the notional or contractual amountsof financial instruments with off–balance–sheet risk at year end follows:

 
| ** **               | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------|------------|------------|------------|------------|------------|
| ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unused lines of credit   |       | $          | 12,163     |       | $          | 15,801 |   |
| Standby letter of credit |       | 171        |       | 136        |       |
|                          |            |            |            |            |            |  |  |

 

At December 31, 2004, all of the commitments toextend credit were at variable rates of interest.

 

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

 

The following methods and assumptions were usedto estimate fair values for financial instruments.  The carrying amount is considered to estimatefair value for cash and due from banks, demand, NOW, money market and savingsdeposits, federal funds purchased, securities sold under repurchase agreements,accrued interest receivable and payable, and variable rate loans ordeposits.  Securities fair values arebased on quoted market prices or, if no quotes are available, on the rate andterm of the security and on information about the issuer.  The fair value of loans held for sale andderivatives are based on quoted market prices. For fixed rate loans or deposits, the fair value is estimated bydiscounted cash flow analysis using current market rates for the estimated lifeand credit risk.  Fair values forimpaired loans are estimated using discounted cash flow analysis or underlyingcollateral values, where applicable.  Thefair value of off–balance–sheet items is based on the fees or cost that wouldcurrently be charged to enter into or terminate such agreements and is notmaterial.

 

35

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The carrying values and estimated fair values ofthe Company’s financial instruments as of December 31, 2004 and 2003 were asfollows:

 
| ** **                                      | ** ** | **2004**              | ** ** | **2003**         | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|------------------|------------|
| ** **                                      | ** ** | **Carrying   Amount** | ** ** | **Fair   Value** | ** ** | **Carrying   Amount** | ** ** | **Fair   Value** | ** ** |
| **Assets**                                      |       |                  |       |             |       |   |   |   |   |
| Cash and cash equivalents                       |       | $                     | 7,930      |             | $          | 7,930 |   | $ | 17,877 |   | $ | 17,877 |   |
| Certificates of deposit and related  derivative |       | 24,647                |       | 24,647           |       | 13,190 |   | 13,190 |   |
| Securities available for sale                   |       | 104,652               |       | 104,652          |       | 113,433 |   | 113,433 |   |
| Loans held for sale                             |       | 1,701                 |       | 1,701            |       | 1,644 |   | 1,644 |   |
| Loans                                           |       | 131,618               |       | 132,474          |       | 129,255 |   | 129,584 |   |
| Cash value of life insurance                    |       | 2,884                 |       | 2,884            |       | 1,806 |   | 1,806 |   |
| Interest receivable                             |       | 1,932                 |       | 1,932            |       | 2,129 |   | 2,129 |   |
| **Liabilities**                                 |       |                  |       |             |       |   |   |   |   |
| Deposits with no stated maturities              |       | 159,682               |       | 146,178          |       | 150,637 |   | 139,955 |   |
| Time deposits                                   |       | 94,282                |       | 96,519           |       | 114,284 |   | 116,211 |   |
| Federal funds purchased                         |       | 5,600                 |       | 5,600            |       | — |   | — |   |
| Securities sold under agreement to  repurchase  |       | 750                   |       | 752              |       | — |   | — |   |
| Other borrowings                                |       | 559                   |       | 559              |       | 490 |   | 490 |   |
| Interest payable                                |       | 571                   |       | 571              |       | 832 |   | 832 |   |
|                                                 |            |                       |            |                  |            |  |  |  |  |  |  |  |  |

 

**NOTE 17 – REGULATORY AND CAPITAL MATTERS**

 

The Company may pay dividends withoutrestriction under the current Federal Reserve regulations so long as it remains“adequately capitalized” after such payment. The Bank is subject to statutory dividend restrictions which provide, ingeneral, that the Bank may pay the current year’s earnings and the prior twoyears’ retained earnings without the prior approval of the Office of theComptroller of Currency.  At December 31,2004, the Bank’s stockholder’s equity totaled $24,031,000, of which $23,317,000was not available for payment of dividends, without prior regulatory approval.

 

The Company and the Bank are subject to variousregulatory capital requirements administered by the federal bankingagencies.  Capital adequacy guidelinesand prompt corrective action regulations involve quantitative measures ofassets, liabilities, and certain off–balance–sheet items calculated underregulatory accounting practices.  Capitalamounts and classifications are also subject to qualitative judgments byregulators about components, risk weightings, and other factors, and theregulators can lower classifications in certain cases.  Failure to meet various capital requirementscan initiate regulatory action that could have a direct material effect on thefinancial statements.

 

The prompt corrective action regulations providefive classifications, including well capitalized, adequately capitalized,undercapitalized, significantly undercapitalized, and criticallyundercapitalized, although these terms are not used to represent overallfinancial condition.  If adequatelycapitalized, regulatory approval is required to accept brokered deposits.  If undercapitalized, capital distributions are limited, as is asset growthand expansion, and plans for capital restoration are required.

 

36

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The Company’s only activity is ownership of theBank, and, therefore, its capital, capital ratios, and minimum required levelsof capital are materially the same as the Bank’s.   The actual capital levels and minimumrequired levels for the Company were:

 
| ** **                                                    | ** ** | **Actual** | ** ** | **Required for Adequate   Capital** | ** ** | **To Be Well   Capitalized** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|-------------------------------------|------------|------------------------------|------------|
| ** **                                                    | ** ** | **Amount** | ** ** | **Ratio**                           | ** ** | **Amount**                   | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                                    | ** ** | ** ** | ** ** | ** **                          | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **December 31, 2004**                                         |       |       |       |                                |       |                         |       |   |   |   |   |   |   |
| Total risk–based capital (to risk–weighted  assets) |       | $          | 20,769     |                                | 12.2       | %                            | $          | 13,600 |   | 8.0 | % | $ | 16,991 |   | 10.0 | % |
| Tier 1 capital (to risk–weighted assets)                 |       | 19,595     |       | 11.5                                | %          | 6,800                        |       | 4.0 | % | 10,200 |   | 6.0 | % |
| Tier 1 capital (to average assets)                            |       | 19,595     |       | 6.7                                 | %          | 11,670                       |       | 4.0 | % | 14,588 |   | 5.0 | % |
|                                                          |       |       |       |                                |       |                         |       |   |   |   |   |   |   |
| **December 31, 2003**                                         |       |       |       |                                |       |                         |       |   |   |   |   |   |   |
| Total risk–based capital (to risk–weighted  assets) |       | $          | 19,661     |                                | 11.9       | %                            | $          | 13,201 |   | 8.0 | % | $ | 16,501 |   | 10.0 | % |
| Tier 1 capital (to risk–weighted assets)                 |       | 18,612     |       | 11.3                                | %          | 6,600                        |       | 4.0 | % | 9,901 |   | 6.0 | % |
| Tier 1 capital (to average assets)                            |       | 18,612     |       | 7.2                                 | %          | 10,303                       |       | 4.0 | % | 12,878 |   | 5.0 | % |

 

At December 31, 2004, the Company and the Bankwere categorized as well capitalized and management is not aware of anyconditions or events since the most recent notification that would change theCompany’s or Bank’s category.

 

**NOTE 18 – OTHER COMPREHENSIVE INCOME**

 
| ** **                                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Unrealized gains (losses) on securities                             |       |     |       |     |       |     |       |
| Unrealized holding gains (losses) arising  during the year          |       | $        | (2,145     | )        | $          | (1,086   | )          | $ | 3,517 |   |
| Less: reclassification adjustment for gains  realized in net income |       | —   |       | —   |       | (102     | )          |
| Minimum pension liability                                           |       | —   |       | —   |       | (354     | )          |
|                                                                |       | (2,145   | )          | (1,086   | )          | 3,061    |       |
| Tax effect                                                          |       | 729      |       | 368      |       | (1,024   | )          |
|                                                                |       |     |       |     |       |     |       |
| Other comprehensive income (loss)                                   |       | $        | (1,416     | )        | $          | (718     | )          | $ | 2,037 |   |

 

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**NOTE 19 – PARENT COMPANY FINANCIAL STATEMENTS**

 

The following are the condensed balance sheets,statements of income and cash flows for First Ottawa Bancshares, Inc.

 

**Condensed Balance Sheets**

 
| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                      |       |     |       |     |       |
| Cash on deposit with Bank                       |       | $        | 1,304      |     | $          | 8 |   |
| Investment in common stock of Bank              |       | 24,031   |       | 24,766   |       |
| Dividends receivable                            |       | —   |       | 1,305    |       |
| Other assets                                    |       | 404      |       | 376      |       |
| Total assets                                    |       | $        | 25,739     |     | $          | 26,455 |   |
|                                            |       |     |       |     |       |
| **Liabilities**                                 |       |     |       |     |       |
| Note payable                                    |       | $        | 559        |     | $          | 490 |   |
| Dividends payable                               |       | 1,303    |       | 1,305    |       |
| Other liabilities                               |       | 25       |       | 5        |       |
|                                            |       | 1,887    |       | 1,800    |       |
| **Shareholders’ Equity**                   |       | 23,852   |       | 24,655   |       |
| ** **                                      |       |     |       |     |       |
| Total liabilities and shareholders’ equity |       | $        | 25,739     |     | $          | 26,455 |   |

 

**Condensed Statements of Income**

 
| ** **                                                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                           |       |     |       |     |       |     |       |
| **Income –**dividends  from Bank                                          |       | $        | 2,003      |     | $          | 2,502    |       | $ | 2,034 |   |
| **Expenses**                                                                   |       | 85       |       | 109      |       | 86       |       |
| **Income before income tax and equity in  undistributed income of subsidiary** |       | 1,918    |       | 2,393    |       | 1,948    |       |
| **Income tax benefit**                                                         |       | 29       |       | 33       |       | —   |       |
| **Income before equity in undistributed  income of subsidiary**                |       | 1,947    |       | 2,426    |       | 1,948    |       |
| **Equity in undistributed income of  subsidiary**                              |       | 681      |       | 33       |       | 339      |       |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Net Income**                                                                 |       | $        | 2,628      |     | $          | 2,459    |       | $ | 2,287 |   |
|                                                                                |            |          |            |          |            |          |            |  |  |  |  |

 

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**Condensed Statements of Cash Flows**

 
| ** **                                        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Operating Activities**                          |       |     |       |     |       |     |       |
| Net income                                        |       | $        | 2,628      |     | $          | 2,459    |       | $ | 2,287 |   |
| Item not requiring (providing) cash               |       |     |       |     |       |     |       |
| Equity in undistributed earnings of Bank          |       | (681     | )          | (33      | )          | (339     | )          |
| Other                                             |       | 1,295    |       | (1,302   | )          | 976      |       |
| Net cash provided by operating activities         |       | 3,242    |       | 1,124    |       | 2,924    |       |
|                                              |       |     |       |     |       |     |       |
| **Financing Activities**                          |       |     |       |     |       |     |       |
| Purchase of treasury shares                       |       | (71      | )          | (315     | )          | (74      | )          |
| Loan proceeds (payments), net                     |       | 69       |       | (161     | )          | 452      |       |
| Cash dividends                                    |       | (1,954   | )          | (1,973   | )          | (1,983   | )          |
| Vested stock options                              |       | 10       |       | 8        |       | —   |       |
| Net cash used in financing activities             |       | (1,946   | )          | (2,441   | )          | (1,605   | )          |
|                                              |       |     |       |     |       |     |       |
| **Net Change in Cash and Cash Equivalents**       |       | 1,296    |       | (1,317   | )          | 1,319    |       |
| ** **                                        |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, Beginning of  Year** |       | 8        |       | 1,325    |       | 6        |       |
| ** **                                        |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, End of Year**        |       | $        | 1,304      |     | $          | 8        |       | $ | 1,325 |   |
|                                                   |            |          |            |          |            |          |            |  |  |  |  |

 

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

** **
| ** **         | ** ** | **Interest   Income** | ** ** | **Net Interest   Income** | ** ** | **Net Income** | ** ** | **Basic and   Diluted   Earnings Per   Share** | ** ** |
|--------------------|------------|-----------------------|------------|---------------------------|------------|----------------|------------|------------------------------------------------|------------|
| **2004**           |       |                  |       |                      |       |           |       |                                           |       |
| First quarter      |       | $                     | 3,369      |                      | $          | 2,272          |       | $                                              | 479        |   | $ | 0.74 |   |
| Second quarter     |       | 3,373                 |       | 2,332                     |       | 578            |       | 0.88                                           |       |
| Third quarter      |       | 3,398                 |       | 2,363                     |       | 677            |       | 1.04                                           |       |
| Fourth quarter     |       | 3,397                 |       | 2,370                     |       | 894            |       | 1.37                                           |       |
| **2003**           |       |                  |       |                      |       |           |       |                                           |       |
| First Quarter      |       | 3,175                 |       | 1,988                     |       | 614            |       | 0.94                                           |       |
| Second quarter     |       | 3,128                 |       | 2,017                     |       | 652            |       | 0.99                                           |       |
| Third quarter      |       | 3,094                 |       | 2,082                     |       | 627            |       | 0.96                                           |       |
| Fourth quarter (a) |       | 3,254                 |       | 2,180                     |       | 566            |       | 0.87                                           |       |
|                    |            |                       |            |                           |            |                |            |                                                |            |  |  |  |  |

 

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(a)  Net income and earnings per share in thefourth quarter of 2003 were affected by one time expenses related to theacquisition of Streator branch facilities.

 

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FIRST OTTAWA BANCSHARES, INC. 

SHAREHOLDER INFORMATION

ANNUAL MEETING

 

The Annual Meeting of Shareholders will be heldat 3 p.m., local time on May 18, 2005 at the corporate headquarterslocated at 701 LaSalle Street, Ottawa, Illinois 61350.

 

PRICE RANGE OF COMMON STOCK

 

As of February 8, 2005, there were approximately541 shareholders of record and 650,609 outstanding shares of common stock.

 

The Company’s common stock is not traded on anynational or regional securities exchange and there is no established publictrading market for it.  Transactions inthe Company’s common stock have been infrequent.  To the knowledge of the Company’s management,during 2003, 2004 and the first month of 2005, an aggregate of approximately169,738 shares of the Company’s common stock was transferred in approximately95 separate transactions, excluding the 5,329 shares purchased by the Companyin 2003 at $56 per share and 1,018 shares purchased by the Company in 2004 at$70 per share.  These transfersrepresented both transfers for consideration (i.e., sales) and transfers for noconsideration (e.g., gifts, estate transfers, etc.).  The Company’s management is unable todifferentiate such transfers and has limited knowledge of the sale prices fortransfers involving consideration.  Thelast price known to the Company’s management was a sale of 346 shares onJanuary 24, 2005 at $70.00 per share.

 

The following dividends per share were paid onthe Company’s common stock on the dates indicated: January 1, 2003 – $2.00;July 1, 2003 – $1.00; January 1, 2004 – $2.00; July 1, 2004 – $1.00; January 1,2005 – $2.00

 

WEB SITE FOR UNITED STATES SECURITIES ANDEXCHANGE COMMISSION FILINGS

 

All reports filed electronically by the Companywith the United Stated Securities Exchange Commission (the “SEC”), includingthe annual report on Form 10–K, quarterly reports on Form 10–Q, and currentevents reports on Form 8–K, as well as any amendments to those reports areaccessible at no cost on our internet site at www.firstottawa.com and on theSEC’s web site at www.sec.gov.  We willalso provide you with a copy free of charge by contacting Cheryl Gage,Corporate Secretary, First Ottawa Bancshares, Inc., 701 LaSalle Street, Ottawa,Illinois 61350.

 

CORPORATEGOVERNANCE

 

The Company’s corporate governance practices aredescribed in the following documents, which are available on the Company’s Website at www.firstottawa.com or which may be obtained in print form through theinvestor relations department: Code of Business Conduct and Ethics, AuditCommittee Charter, Nominating and Corporate Governance Committee Charter, andCompensation Committee Charter.

 

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