**Exhibit 13.1**

 

FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARY 

 

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**SELECTED CONSOLIDATED FINANCIAL INFORMATION**

 

The following table sets forth selected consolidatedfinancial and other data of First Ottawa Bancshares, Inc. and its whollyowned subsidiary, the First National Bank of Ottawa (the Bank) and the Bank’swholly owned subsidiary, First Ottawa Financial Corporation, together referredto as the Company. This information should be read in conjunction with theConsolidated Financial Statements and Notes thereto included herein. All dollaramounts are in thousands, except per share information.

 
| ** **                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Statement of Income Data:**                                               | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total interest income                                                       |       | $                                | 13,908     |   | $ | 13,537 |   | $ | 12,651 |   | $ | 13,092 |   | $ | 14,921 |   |
| Total interest expense                                                      |       | 4,613                            |       | 4,200 |   | 4,384 |   | 5,733 |   | 7,773 |   |
| Net interest income                                                         |       | 9,295                            |       | 9,337 |   | 8,267 |   | 7,359 |   | 7,148 |   |
| Provision for loan losses                                                   |       | 300                              |       | 300 |   | 120 |   | 120 |   | 300 |   |
| Noninterest income                                                          |       | 2,842                            |       | 3,195 |   | 2,592 |   | 2,444 |   | 2,457 |   |
| Noninterest expenses                                                        |       | 8,501                            |       | 8,807 |   | 7,413 |   | 6,718 |   | 6,732 |   |
| Income before income taxes                                                  |       | 3,336                            |       | 3,425 |   | 3,326 |   | 2,965 |   | 2,573 |   |
| Provision for income taxes                                                  |       | 791                              |       | 797 |   | 867 |   | 678 |   | 460 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| Net income                                                                  |       | $                                | 2,545      |   | $ | 2,628 |   | $ | 2,459 |   | $ | 2,287 |   | $ | 2,113 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Per Share Data:**                                                         | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income – basic                                                     |       | $                                | 3.92       |   | $ | 4.03 |   | $ | 3.75 |   | $ | 3.47 |   | $ | 3.19 |   |
| Net income – diluted                                                   |       | 3.90                             |       | 4.03 |   | 3.75 |   | 3.47 |   | 3.19 |   |
| Cash dividends declared                                                     |       | 3.00                             |       | 3.00 |   | 3.00 |   | 3.00 |   | 3.00 |   |
| Book value at end of year (1)                                               |       | 37.43                            |       | 36.54 |   | 35.54 |   | 34.97 |   | 34.53 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Selected Financial Ratios:**                                              | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Return on average assets (1)                                                |       | .87                              | %          | .88 | % | 1.00 | % | .99 | % | .94 | % |
| Return on average equity (1)                                                |       | 10.50                            |       | 11.05 |   | 10.50 |   | 9.73 |   | 9.18 |   |
| Dividend payout ratio                                                       |       | 76.53                            |       | 74.44 |   | 79.79 |   | 86.46 |   | 94.04 |   |
| Average equity to average assets (1)                                        |       | 8.30                             |       | 7.96 |   | 9.56 |   | 10.20 |   | 10.29 |   |
| Net interest margin (tax equivalent)                                        |       | 3.70                             |       | 3.60 |   | 3.89 |   | 3.77 |   | 3.74 |   |
| Allowance for loan  losses to total loans at the end of period              |       | .88                              |       | .88 |   | .80 |   | 1.06 |   | 1.01 |   |
| Nonperforming loans to  total loans at the end of period (2)                |       | .87                              |       | 1.55 |   | 2.04 |   | 1.83 |   | 1.15 |   |
| Net loans charged off  to average total loans                               |       | .09                              |       | .13 |   | .21 |   | .06 |   | .25 |   |
|                                                                        |       |                             |       |   |   |   |   |   |   |   |   |
| **Balance  Sheet Data:**                                                    | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total assets                                                                |       | $                                | 278,739    |   | $ | 288,659 |   | $ | 294,490 |   | $ | 240,662 |   | $ | 232,565 |   |
| Total earning assets                                                        |       | 253,641                          |       | 262,618 |   | 276,767 |   | 223,324 |   | 216,927 |   |
| Average assets                                                              |       | 290,765                          |       | 299,665 |   | 247,961 |   | 232,335 |   | 224,653 |   |
| Gross loans, including  loans held for sale                                 |       | 152,860                          |       | 134,493 |   | 131,948 |   | 111,454 |   | 109,508 |   |
| Allowance for loan  losses                                                  |       | 1,344                            |       | 1,174 |   | 1,049 |   | 1,167 |   | 1,109 |   |
| Total deposits                                                              |       | 239,881                          |       | 253,964 |   | 264,921 |   | 193,767 |   | 165,267 |   |
| Federal funds purchased  and securities sold under agreements to repurchase |       | 12,700                           |       | 6,350 |   | — |   | 16,322 |   | 25,899 |   |
| Shareholders’ equity                                                   |       | 22,858                           |       | 23,852 |   | 24,655 |   | 25,183 |   | 22,907 |   |

 

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

(2)               Includes totalnonaccrual loans, impaired loans, and all other loans 90 days past due andstill accruing interest.

 

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**MANAGEMENT’S DISCUSSION AND ANALYSIS**

**OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

** **

The following discussion and analysis is intended as a review ofsignificant factors affecting the financial condition and results of operationsof the Company for the periods indicated. The discussion should be read inconjunction with the Consolidated Financial Statements and Notes thereto andthe Selected Consolidated Financial Data presented herein. In addition tohistorical information, the following Management’s Discussion and Analysis ofFinancial Condition and Results of Operations contains forward–lookingstatements that involve risks and uncertainties. The Company’s actual resultscould differ significantly from those anticipated in these forward–lookingstatements as a result of certain factors discussed elsewhere in this report,including under “Risk Factors” in Item I.A. of our Form 10-K.

 

# **Overview**

# ** **

The Company’s principal business is conducted by the Bank and consistsof a full range of community–based financial services, including commercial andretail banking. The profitability of the Company’s operations depends primarilyon its net interest income, provision for loan losses, other income, and otherexpenses. Net interest income is the difference between the income the Companyreceives on its loan and securities portfolios and its cost of funds, whichconsists of interest paid on deposits and borrowings. The provision for loanlosses reflects the cost of credit risk in the Company’s loan portfolio. Otherincome consists of service charges on deposit accounts, trust and farmmanagement fee income, securities gains (losses), gains (losses) on sales ofloans, and other income. Other expenses include salaries and employee benefits,as well as occupancy and equipment expenses and other noninterest expenses.

 

Net interest income is dependent on the amounts and yields ofinterest–earning assets as compared to the amounts of and rates oninterest–bearing liabilities. Net interest income is sensitive to changes inmarket rates of interest and the Company’s asset/liability managementprocedures in coping with such changes. The provision for loan losses isdependent upon management’s assessment of the collectibility of the loanportfolio under current economic conditions.

 

Net income was $2.5 million for the year ended December 31, 2005compared to $2.6 million for the year ended December 31, 2004. The returnon average assets was .87% in 2005 compared to .88% in 2004. The return onaverage equity decreased to 10.50% in 2005 from 11.05% in 2004. This resultedprimarily from the decrease in net income partially offset by the change inaverage equity due to stock repurchases in 2005 and 2004. 

 

Net income was $2.6 million for the year ended December 31, 2004compared to $2.5 million for the year ended December 31, 2003. The returnon average assets was .88% in 2004 compared to 1.00% in 2003. The return onaverage equity increased to 11.05% in 2004 from 10.50% in 2003. This resultedprimarily from the increase in net income and the change in average equity dueto stock repurchases in 2004 and 2003. 

 

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# **CriticalAccounting Policies**

 

The accounting and reporting policies of the Company are in accordancewith accounting principles generally accepted in the United States of Americaand conform 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 31,2005. 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 andresults of operations can be affected by these estimates and assumptions andare integral to the understanding of reported results. Critical accountingpolicies are those policies that management believes are the most important tothe portrayal of the Company’s financial condition and results, and theyrequire management to make estimates that are difficult, subjective, orcomplex.

 

**Allowance for Credit Losses–**Theallowance for credit losses provides coverage for probable losses inherent inthe Company’s loan portfolio. Management evaluates the adequacy of theallowance 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 loanperformance, regulatory guidance and economic factors. This evaluation isinherently subjective, as it requires the use of significant managementestimates. Many factors can affect management’s estimates of specific andexpected losses, including volatility of default probabilities, ratingmigrations, loss severity and economic conditions. The allowance is increasedthrough provisions charged to operating earnings and reduced by netcharge–offs.

 

The Company determines the amount of the allowance based on relativerisk characteristics of the loan portfolio. The allowance recorded forcommercial loans is based on reviews of individual credit relationships and ananalysis of the migration of commercial loans and actual loss experience. Theallowance recorded for homogeneous consumer loans is based on an analysis ofloan mix, risk characteristics of the portfolio, fraud loss and bankruptcyexperiences, and historical losses, adjusted for current trends, for eachhomogeneous category or group of loans. The allowance for credit lossesrelating to impaired loans is based on the loan’s observable market price,the collateral for certain collateral–dependent loans, or the discounted cashflows using the loan’s effective interest rate.

 

Regardless of the extent of the Company’s analysis of customerperformance, portfolio trends or risk management processes, certain inherentbut undetected losses are probable within the loan portfolio. This is due toseveral factors including inherent delays in obtaining information regarding acustomer’s financial condition or changes in their unique business conditions,the judgmental nature of individual loan evaluations, collateral assessmentsand the interpretation of economic trends. Volatility of economic orcustomer–specific conditions affecting the identification and estimation oflosses for larger non–homogeneous credits and the sensitivity of assumptionsutilized to establish allowances for homogenous groups of loans are among otherfactors. The Company estimates a range of inherent losses related to theexistence of these exposures. The estimates are based upon the Company’sevaluation of imprecise risk associated with the commercial and consumerallowance levels and the estimated impact of the current economic environment.

 

3

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**Mortgage Servicing Rights*–***Mortgage servicing rights (“MSRs”) associated with loans originated and sold,where servicing is retained, are capitalized and included in other intangibleassets in the consolidated balance sheet. 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 accountingpolicies for MSRs relate to the initial valuation and subsequent impairmenttests. The methodology used to determine the valuation of MSRs requires thedevelopment and use of a number of estimates, including anticipated principalamortization and prepayments of that principal balance. Events that may significantlyaffect the estimates used are changes in interest rates, mortgage loanprepayment speeds and the payment performance of the underlying loans. Thecarrying value of the MSRs is periodically reviewed for impairment based on adetermination of fair value. For purposes of measuring impairment, theservicing rights are compared to a valuation prepared based on a discountedcash flow methodology, utilizing current prepayment speeds and discount rates. Impairment,if any, is recognized through a valuation allowance and is recorded asamortization of intangible assets.

 

**Derivatives–**As a part ofthe Company’s funding strategy, derivative financial instruments, all of whichare interest rate swap arrangements, are used to reduce exposure to changes ininterest rates for certain financial instruments. These derivatives areaccounted 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 used torecord valuation adjustments for the interest rate swaps and related depositproducts are provided by third parties.

 

Additionally, the Company has purchased certificate of deposits whichcontain an equity related embedded derivative component. The initial investmentin the certificate of deposit is not at risk but the return on the investmentis based on appreciation in the S&P 500 Index. Accordingly, the fair valueof the embedded derivative is recorded at fair value as an adjustment to thecertificate of deposit and interest income.

 

**Stock Compensation**– Grants underthe Company’s stock incentive plan are accounted for under the provisionsof Statement of Accounting Standards (SFAS) No. 123, applying the fairvalue method and the use of an option pricing model to estimate the value ofthe options granted. The stock options are granted with an exercise price equalto the market price at the date of grant. Resulting compensationexpense, under the stock options, is measured and recorded based onthe estimated value of the options. 

 

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**Consolidated Financial Condition**

 

Total assets at December 31, 2005 were $278.7 million compared to$288.7 million at December 31, 2004, a decrease of $10.0 million, or 3.5%.Despite the decrease in our total assets, our total loans increased 15.11% in2005. Commercial and agricultural loans increased $5.3 million during 2005due to an effort by management to increase the size of the commercial loanportfolio. Real estate loans also increased by $21.2 million during 2005, againdue to an effort by management to increase the size of the portfolio. Theseincreases were partially offset by the decrease in installment loans of $6.0million due to a general decline in indirect lending volume and more stringentunderwriting guidelines on consumer loans. Loans held for sale decreased by$1.7 million as refinancing activity cooled during 2005 as a result of theincrease in interest rates throughout 2005 from the historical low levels of2003. Contributing to the decrease in total assets was a $1.1 million decreasein cash and cash equivalents due to a reduction in the reserve amount requiredby the Federal Reserve Bank. Investment securities decreased by $14.0 million,and certificates of deposit held for investment purposes decreased by $13.1million. Premises and equipment increased by $400,000 due to capitalexpenditures on existing buildings and the construction of a new Yorkville,Illinois branch facility. The increase in loans was funded by a decrease insecurities and increases in federal funds purchased. Total borrowings increased$5.8 million as a result of a $7.1 million increase in federal funds purchased,a $559,000 decrease in other borrowings, and a $750,000 decrease in securitiessold under repurchase agreements. Total deposits decreased $14.1 million. Thisdecrease was primarily a result of management’s decision to reduce the numberof special rate deposit products which were offered to attract customers in newmarkets in 2004. 

 

Total equity was $22.9 million at December 31, 2005 compared to$23.9 million at December 31, 2004. The decrease was primarily the resultof a decrease in the unrealized gain on securities available–for–sale, net oftax, of $1.5 million, dividends declared of $1.9 million and by the repurchaseof Company common stock for $89,000. The decrease was partially offset by netincome of $2.5 million. 

 

# **ConsolidatedResults of Operations**

 

# **2005 Compared to2004**

 

*Net Interest Income.*Net interestincome was $9.3 million in 2005 and 2004. Interest income on earning assetsincreased $371,000 in 2005 from 2004. This increase was primarily attributableto increased interest income earned on the loan portfolio of $1.1 million, taxexempt securities of $50,000, and federal funds sold of $193,000. The increaseswere attributable to increases in average balances and also averagetax–equivalent yields available in the marketplace in 2005. Increases wereoffset by decreased interest income earned on taxable securities of $904,000,and certificates of deposit held for investment of $78,000. Interest expense oninterest–bearing liabilities increased $413,000 as a result of an increase inthe average rate paid on liabilities of 25 basis points, from 1.73% in 2004 to1.98% in 2005. The net interest margin on a tax equivalent basis increased to3.70% in 2005 from 3.60% in 2004. The primary reason for the increase in thenet interest margin was the result of a gradual reallocation to loans whichearn at higher rates than other types of interest-bearing assets.

 

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*Provision for Loan Losses.*Theprovision for loan losses remained constant at $300,000 in 2005 and 2004. As ofDecember 31, 2005, the allowance for loan losses totaled $1.3 million, or..88% of total loans, compared to $1.2 million, or .88% of total loans, at December 31,2004. The increase in the allowance for loan losses in 2005 was influenced bythe continued growth in the loan portfolio.

 

The amounts of the provision and allowance for loanlosses are influenced by current economic conditions, actual loss experience,industry trends and other factors, including real estate values in the Company’smarket area and management’s assessment of current collection risks within theloan portfolio. Along with other financial institutions, management shares aconcern for the outlook of the economy for 2006. Even though there areindications of emerging strength, it is uncertain if this strength issustainable. If it is not sustainable, borrowers may experiencedifficulty, and the level of non–performing loans, charge-offs, anddelinquencies could rise and require increases in the provision. The allowancefor loan losses represents management’s estimate of probable incurred lossesbased on information available as of the date of the financial statements. Theallowance for loan losses is based on management’s evaluation of thecollectibility of the loan portfolio, including past loan loss experience,known and inherent risks in the nature and volume of the portfolio, informationabout specific borrower situations and estimated collateral values, andeconomic conditions. 

 

Management has concluded that the allowance for loanlosses is adequate at December 31, 2005. However, there can be noassurance that the allowance for loan losses will be adequate to cover alllosses.

 

*Noninterest Income.*The Company’snoninterest income decreased $353,000, or 11.0%, compared to 2004. Noninterestincome decreased primarily due to gains on securities sold of $172,000 in 2005,a decrease of $293,000 compared to 2004, as the Company sold a large amount ofsecurities for a gain in 2004. Gains on loan sales to the secondary marketdecreased $163,000 to $91,000 in 2005 compared to 2004 as a result of feweroriginations of residential real estate loans in 2004 because of the generalincrease in interest rates in 2005. Service charges on deposit accountsincreased modestly by $23,000, or 2.1%, to $1.1 million. Other income increasedby $68,000, or 7.5%, compared to 2004. This increase is primarily due to a$188,000 increase in the market value of derivatives related to index poweredcertificates of deposit held for investments and for customers of the Bank. Trustand farm management fee income increased modestly by $12,000, to $496,000 in2005 compared to 2004.

 

*Noninterest Expense.*The Company’snoninterest expense was $8.5 million in 2005 and $8.8 million for 2004. Salariesand benefits, which is the largest component of noninterest expense, remainedconstant at $4.7 million. Increases in occupancy and equipment expense of$10,000, data expense of $37,000, and supplies expense of $46,000 were offsetby decreases in professional fees of $40,000, amortization of core depositintangible expense of $80,000, and other expenses of $279,000. Other expensewas reduced due to decreased collection expenses, decreased secondary mortgagemarket expenses, decreased directors’ life insurance expense and decreasedmiscellaneous loan expenses. Income tax expense decreased by $6,000 compared tothe prior year. The Company’s effective tax rate increased slightly due to anincrease in state income tax expense.

 

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*Income Taxes.*The Company’s taxrate varied from statutory rates principally due to interest income fromtax–exempt securities and loans. The Company’s effective tax rate was 23.7% and23.3% for 2005 and 2004.

 

# **2004 Compared to2003**

# ** **

*Net Interest Income.*Net interestincome was $9.3 million in 2004 compared to $8.3 million in 2003, an increaseof $1.0 million, or 12.9%. Interest income on earning assets increased $886,000in 2004 from 2003. All classifications of interest earning assets experiencedgrowth in 2004 when compared to 2003. The increases were attributable toincreases in average balances and also average tax–equivalent yields availablein the marketplace in 2004. Interest expense on interest–bearing liabilitiesdecreased $184,000 as a result of a decrease in the average rate paid onliabilities of 54 basis points, from 2.26% in 2003 to 1.72% in 2004. The netinterest margin on a tax equivalent basis decreased to 3.60% in 2004 from 3.89%in 2003. The primary reason for the decrease in the net interest margin was theresult of lower rates earned on interest-bearing assets during the low rateenvironment experienced throughout 2004.

 

*Provision for Loan Losses.*Theprovision for loan losses increased to $300,000 in 2004  compared to $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 for loan losses in 2004 was influencedheavily by the acquisition of $11.4 million of Streator branch loans in thefourth quarter of 2003.

 

The amounts of the provision and allowance for loanlosses are influenced by current economic conditions, actual loss experience,industry trends and other factors, including real estate values in the Company’smarket area and management’s assessment of current collection risks within theloan portfolio. Along with other financial institutions, management shares aconcern for the outlook of the economy for 2005. Even though there areindications of emerging strength, it is uncertain if this strength issustainable. If it is not sustainable, borrowers may experiencedifficulty, and the level of non–performing loans, charge-offs, anddelinquencies could rise and require increases in the provision. The allowancefor loan losses represents management’s estimate of probable incurred lossesbased on information available as of the date of the financial statements. Theallowance for loan losses is based on management’s evaluation of thecollectibility of the loan portfolio, including past loan loss experience,known and inherent risks in the nature and volume of the portfolio, informationabout specific borrower situations and estimated collateral values, andeconomic conditions. 

 

Management has concluded that the allowance for loanlosses is adequate at December  31, 2004. However, there can be noassurance that the allowance for loan losses will be adequate to cover alllosses.

 

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*Noninterest Income.*The Company’snoninterest income increased $603,000, or 23.3% compared to 2003. Noninterestincome increased primarily due to gains on securities sold of $465,000 in 2004,an increase of $448,000 over 2003. Service charges on deposit accountsincreased by $223,000, or 25.8%, to $1.1 million. Increases in service chargeincome are attributable to higher average balances and an increase in theaverage number of accounts during 2004. Other income increased by $399,000, or79.2% compared to 2003. This increase is primarily due to a $301,000 increasein the market value of derivatives related to index powered certificates ofdeposit held for investments and for customers of the bank. Trust and farmmanagement fee income increased modestly by $12,000, to $484,000 in 2004compared to 2003. Gains on loan sales to the secondary market decreased$479,000 to $254,000 in 2004 compared to 2003. Due to the rate structure inearly 2004 and the large amount of loans that refinanced during 2002 and 2003,gains on sale of loans during 2004 were significantly less than 2003.

 

*Noninterest Expense.*The Company’snoninterest expense was $8.8 million in 2004 and $7.4 million for 2003. Salariesand benefits, which is the largest component of noninterest expense, increased$529,000, or 12.8%, to $4.7 million. Increases in occupancy and equipmentexpense of $327,000, professional fees of $65,000 and other expenses of$299,000, contributed to the $1.4 million increase in noninterest expense forthe year. Increased salaries and benefits were primarily a result of additionalpersonnel retained in the acquisition of the two branches in Streator in November 2003.The increase in occupancy and equipment expenses was due primarily to increaseddepreciation on capital expenditures related to the renovation of the mainbanking facility in Ottawa, the acquisition of the Streator facilities, and theconstruction of the Morris facility. Increased professional fees were a resultof the increase in audit costs and consulting costs associated withestablishing new banking branches. Increases in other expenses resulted primarilyfrom increased mortgage banking expenses of $53,000, and additional insuranceexpenses related to added facilities of $98,000. Data expenses decreased$166,000, or 33.2% from 2003, and were a result of a platform conversionwhich was completed in November 2003. The Company also experienceddecreases in supplies expense of $25,000, and advertising expense of $72,000,during 2004.

 

*Income Taxes.*The Company’s taxrate varied from statutory rates principally due to interest income fromtax–exempt securities and loans. The Company’s effective tax rate was 23.3% and26.1% for 2004 and 2003.

 

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The components of the changes in net interest income are shown below. Changesin net interest income are allocated between amounts attributed to changes inrate and changes in volume for the various categories of interest–earningassets and interest–bearing liabilities.

 

Analysis of Changes in Interest Income and Expense

($000s)

 
| ** **                                             | ** ** | **2005 – 2004**    | ** ** | **2004 – 2003**       | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                             | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)**    | ** ** |
| ** **                                             | ** ** | **Total  Change**       | ** ** | **Change  Due to  Volume** | ** ** | **Change  Due to  Rate** | ** ** | **Total  Change** | ** ** | **Change  Due to  Volume** | ** ** | **Change  Due to  Rate** | ** ** |
| INTEREST INCOME                                        |       |                    |       |                       |       |   |   |   |   |   |   |   |   |
|                                                   |       |                    |       |                       |       |   |   |   |   |   |   |   |   |
| Loans                                                  |       | $                       | 1,136      |                       | $          | 708 |   | $ | 428 |   | $ | 242 |   | $ | 1,019 |   | $ | (777 | ) |
| Investment CDs                                         |       | (78                     | )          | (101                       | )          | 23 |   | 276 |   | 290 |   | (14 | ) |
| Securities                                             |       | (828                    | )          | (701                       | )          | (127 | ) | 441 |   | 989 |   | (548 | ) |
| Federal funds sold                                     |       | 193                     |       | 107                        |       | 86 |   | 8 |   | 3 |   | 5 |   |
| Total interest income                                  |       | 423                     |       | 13                         |       | 410 |   | 967 |   | 2,301 |   | (1,334 | ) |
|                                                   |       |                    |       |                       |       |   |   |   |   |   |   |   |   |
| INTEREST EXPENSE                                       |       |                    |       |                       |       |   |   |   |   |   |   |   |   |
|                                                   |       |                    |       |                       |       |   |   |   |   |   |   |   |   |
| NOW and money market                                   |       | 116                     |       | (114                       | )          | 230 |   | 546 |   | 441 |   | 105 |   |
| Savings                                                |       | (31                     | )          | (11                        | )          | (20 | ) | (36 | ) | 47 |   | (83 | ) |
| Time deposits                                          |       | 297                     |       | 9                          |       | 288 |   | (555 | ) | 336 |   | (891 | ) |
| Repurchase agreements                                  |       | 2                       |       | —                     |       | 2 |   | (8 | ) | (2 | ) | (6 | ) |
| Borrowings                                             |       | (4                      | )          | (20                        | )          | 16 |   | (134 | ) | (195 | ) | 61 |   |
| Federal funds purchased                                |       | 33                      |       | 18                         |       | 15 |   | 2 |   | 3 |   | (1 | ) |
| Total interest expense                                 |       | 413                     |       | (118                       | )          | 531 |   | (185 | ) | 630 |   | (815 | ) |
|                                                   |       |                    |       |                       |       |   |   |   |   |   |   |   |   |
| Net interest earnings                                  |       | 10                      |       | 131                        |       | (121 | ) | 1,152 |   | 1,671 |   | (519 | ) |
| Tax equivalent adjustment                              |       | (52                     | )          | —                     |       | (52 | ) | (82 | ) | — |   | (82 | ) |
|                                                   |       |                    |       |                       |       |   |   |   |   |   |   |   |   |
| Net interest earnings  after tax equivalent adjustment |       | $                       | (42        | )                          | $          | 131 |   | $ | (173 | ) | $ | 1,070 |   | $ | 1,671 |   | $ | (601 | ) |

 

### **Volume/rate variances are allocated to the volume varianceand the rate variance on an absolute basis. Tax–exempt income is reflected on afully tax–equivalent basis utilizing a 34% rate for municipal securities andtax–exempt loans.**

### ** **

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

 

The following table sets forth the average balances,net interest income and expense, and average yields and rates for the Company’sinterest–earning assets and interest–bearing liabilities for the indicatedyears on a tax–equivalent basis assuming a 34% tax rate.

 

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# **Analysis of Average Balances, TaxEquivalent Yields and Rates**

Years Ended December 31, 2005, 2004, and 2003

(in Thousands)

 
| ** **                                                                | ** ** | **2005**                      | ** ** | **2004**     | ** ** | **2003**          | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------|------------|--------------|------------|-------------------|------------|
| ** **                                                                | ** ** | **Average  Balance (4)** | ** ** | **Interest** | ** ** | **Average  Rate** | ** ** | **Average  Balance (4)** | ** ** | **Interest** | ** ** | **Average  Rate** | ** ** | **Average  Balance (4)** | ** ** | **Interest** | ** ** | **Average  Rate** | ** ** |
| ASSETS                                                                    | ** ** | ** **                    | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                      |       |                          |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1) (3)                                                        |       | $                             | 141,807    |         | $          | 9,467             |       | 6.68 | % | $ | 131,191 |   | $ | 8,331 |   | 6.35 | % | $ | 115,140 |   | $ | 8,089 |   | 7.03 | % |
| Investment CDs                                                            |       | 17,685                        |       | 555          |       | 3.14              |       | 20,910 |   | 633 |   | 3.03 |   | 11,341 |   | 357 |   | 3.15 |   |
| Securities (2) (5)                                                   |       | 100,187                       |       | 4,209        |       | 4.20              |       | 116,892 |   | 5,037 |   | 4.31 |   | 93,944 |   | 4,596 |   | 4.89 |   |
| Federal funds sold                                                        |       | 6,635                         |       | 233          |       | 3.51              |       | 3,589 |   | 40 |   | 1.11 |   | 3,308 |   | 32 |   | .97 |   |
| Interest–earning assets                                              |       | 266,314                       |       | 14,464       |       | 5.43              |       | 272,582 |   | 14,041 |   | 5.15 |   | 223,733 |   | 13,074 |   | 5.84 |   |
| Noninterest–earning  assets (6)                                      |       | 29,365                        |       |         |       |              |       | 27,083 |   |   |   |   |   | 24,228 |   |   |   |   |   |
|                                                                      |       |                          |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Average assets                                                            |       | $                             | 295,679    |         |       |              |       |   | $ | 299,665 |   |   |   |   |   | $ | 247,961 |   |   |   |   |   |
|                                                                      |       |                          |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND SHAREHOLDERS’  EQUITY                                |       |                          |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                      |       |                          |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money market                                                      |       | $                             | 98,826     |         | 1,370      |              | 1.39       |   | $ | 107,136 |   | 1,254 |   | 1.17 |   | $ | 69,435 |   | 708 |   | 1.02 |   |
| Savings                                                                   |       | 27,083                        |       | 140          |       | .52               |       | 29,121 |   | 171 |   | .59 |   | 21,158 |   | 207 |   | .98 |   |
| Time deposits                                                             |       | 105,301                       |       | 3,034        |       | 2.88              |       | 105,002 |   | 2,737 |   | 2.61 |   | 92,110 |   | 3,292 |   | 3.57 |   |
| Repurchase agreements                                                     |       | 232                           |       | 4            |       | 1.72              |       | 215 |   | 2 |   | .93 |   | 475 |   | 10 |   | 2.11 |   |
| Federal funds purchased                                                   |       | 1,715                         |       | 57           |       | 3.32              |       | 1,175 |   | 24 |   | 2.04 |   | 10,713 |   | 158 |   | 1.47 |   |
| Borrowings                                                                |       | 126                           |       | 8            |       | 6.35              |       | 438 |   | 12 |   | 2.74 |   | 313 |   | 10 |   | 3.19 |   |
| Interest–bearing  liabilities                                        |       | 233,283                       |       | 4,613        |       | 1.98              |       | 243,087 |   | 4,200 |   | 1.73 |   | 194,204 |   | 4,385 |   | 2.26 |   |
|                                                                      |       |                          |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income** **(2)                                          |       |                          |       | 9,851        |       |              |       |   |   | 9,841 |   |   |   |   |   | 8,689 |   |   |   |
| Net yield on interest–  earning assets                               |       |                          |       |         |       | 3.70              |       |   |   |   |   | 3.61 |   |   |   |   |   | 3.88 |   |
| Interest–bearing  liabilities to earning assets ratio                |       |                          |       |         |       | 87.60             |       |   |   |   |   | 89.18 |   |   |   |   |   | 86.80 |   |
| Noninterest–bearing liabilities                                      |       | 38,959                        |       |         |       |              |       | 32,185 |   |   |   |   |   | 28,331 |   |   |   |   |   |
|                                                                      |       |                          |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                                                 |       | 23,487                        |       |         |       |              |       | 24,393 |   |   |   |   |   | 24,426 |   |   |   |   |   |
| Average liabilities and  shareholders’ equity                        |       | $                             | 295,679    |         |       |              |       |   | $ | 299,665 |   |   |   |   |   | $ | 246,961 |   |   |   |   |   |
| Tax equivalent adjustment                                                 |       |                          |       | 556          |       |              |       |   |   | 504 |   |   |   |   |   | 422 |   |   |   |
| Net interest income as  reported in the consolidated statements of income |       |                          |       | $            | 9,295      |              |       |   |   |   | $ | 9,337 |   |   |   |   |   | $ | 8,267 |   |   |   |

 

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(1)          Interest income on loansincludes loan origination and other fees of $136 for 2005, $168 for 2004, and$275 for 2003.

(2)          Loan and securitiesincome is reflected on a fully tax–equivalent basis utilizing a 34% rate formunicipal securities and tax–exempt loans.

(3)          Non–accrual loans areincluded in average loans.

(4)          Average balances arederived from the average daily balances.

(5)          Rate information iscalculated based upon average amortized cost.

(6)          Average balanceinformation includes an average valuation allowance for securities of $(1,228),$909, and $3,375, respectively.

 

10

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# **Impact of AccountingChanges**

 

***Shared-BasedPayment***

 

In December 2004,the FASB issued SFAS No. 123, Revised, *Share-Based Payment (SFAS123(R)),*which requires all public companies to record compensationcost for stock options and other awards provided to employees in return foremployee service. The cost of the options is measured at the fair value of theoptions when granted and is expensed over the employee service period, which isnormally the vesting period of the options granted. The Company adopted SFAS123(R) on January 1, 2006. Future compensation cost and the impact on theCompany’s results of operation as a result of any future option grants willdepend on the level of any future option grants, the related vesting period,and the calculation of the fair value of the options granted as of the grantdate. As such, the Company cannot currently estimate compensation expenserelating to future awards.

 

Since the Company previously accounted for its stock options inaccordance with SFAS No. 123, the adoption of SFAS No. 123(R) is notexpected to have a significant impact on the Company’s financial condition orresults of operations.

 

*** The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments***

 

In January 2003, the Emerging Issues Task Force (*EITF*) began a project to provide additional guidance on whena market value decline on debt and marketable equity securities should beconsidered other-than-temporary. Currently, declines in market value that areconsidered to be other-than-temporary require that a loss be recognized throughthe income statement. In March 2004, the FASB ratified the consensusreached by the EITF in Issue 03-1, *The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments*(*EITF 03-1*). EITF 03-1 provides guidancefor determining when an investment is considered impaired, whether impairmentis other-than-temporary, and measurement of an impairment loss. In September 2004,the FASB issued a staff position (*FSP 03-1-1*)which delayed the effective date for the measurement and recognitionguidance of EITF 03-1 due to additional proposed guidance. 

 

In June 2005, the FASB decided not to provide additional guidanceon the meaning of other-than-temporary impairment, but directed the FASB staffto issue a FASB Staff Position (*FSP*) titled FSP115-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*. The final FSP supersedesEITF 03-1 and EITF Topic No. D-44, *Recognition ofOther-Than-Temporary Impairment Upon the Planned Sale of a Security Whose CostExceeds Fair Value*. FSP FAS 115-1 replaces guidance in EITF 03-1 onloss recognition with references to existing other-than-temporary impairmentguidance, such as FASB Statement No. 115, *Accountingfor Certain Investments in Debt and Equity Securities* (*SFAS No. 115*). FSP FAS 115-1 also clarifies that aninvestor should recognize an impairment loss no later than when the impairmentis deemed other-than-temporary, even if a decision to sell has not been made.

 

FSP FAS 115-1 was effective for other-than-temporaryimpairment analysis conducted in periods beginning after September 15,2005. The Company has consistently followed the loss recognition guidance inSFAS No. 115, so the adoption of FSP FAS 115-1 did not have a significantimpact on the Company’s financial condition or results of operations.

 

*** Earnings Per Share***

 

On September 30, 2005, the FASB issued a proposed amendment toSFAS No. 128, *Earnings per Share*,to clarify guidance for mandatorily convertible instruments, the treasury stockmethod, contingently issuable shares, and contracts that may be settled incash or shares. The primary impact on the Company of the proposed Statementwould be a change to the treasury stock method for year-to-date dilutedearnings per share.

 

11

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARY

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION

AND RESULTS OF OPERATIONS

 

**QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

The Company uses overall risk sensitivity to monitorand manage exposure to sudden changes in interest rates. The Company’s overallinterest rate sensitivity is demonstrated by a net interest income analysis. Netinterest income analysis measures the change in net interest income in theevent of hypothetical changes in interest rates. This analysis assesses therisk of 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 theCompany’s projected changes in net income for the various rate shock levels forthe periods ended December 31, 2005 and 2004.

 
| ** **   | ** ** | **2005 Net Interest Income**         | ** ** |
|--------------|------------|--------------------------------------|------------|
| ** **   | ** ** | **Amount**                           | ** ** | **Change** | ** ** | **Percentage  Change** | ** ** |
| ** **   | ** ** | **(Dollars in Thousands)** | ** ** |
| +100 bp      |       | $                                    | 2,812      |   | $ | (68 | ) | (2.4 | )% |
| Base         |       | 2,880                                |       | — |   | — |   |
| –100 bp |       | 2,943                                |       | 63 |   | 2.2 | % |
|              |            |                                      |            |  |  |  |  |  |  |

 
| ** **   | ** ** | **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 | % |
|              |            |                              |            |  |  |  |  |  |  |

 

As shown above, at December 31, 2005, the effectof an immediate 100 basis point increase in interest rates would decrease theCompany’s net income by 2.4%, or approximately $68,000. The effect of animmediate 100 basis point decrease in rates would increase the Company’s netinterest income by 2.2%, or approximately $63,000. 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 rate sensitivity reflected modest exposure inan increasing rate environment at the end of 2005 and 2004. Overall netinterest income sensitivity decreased in 2005 compared to 2004.

 

12

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**Liquidity and Capital Resources**

 

The Company’s primary sources of funds are deposits,repurchase agreements, and proceeds from principal and interest payments onloans and securities. While maturities and scheduled amortization of loans andsecurities and calls of securities are predictable sources of funds, depositflows and mortgage prepayments are greatly influenced by general interestrates, economic conditions, and competition. The Company generally manages thepricing of its deposits to be competitive and to increase core depositrelationships.

 

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

 

The Company’s cash flows are comprised of threeprimary classifications:  cash flows fromoperating activities, investing activities, and financing activities. Cashflows provided by operating activities were $4.6 million, $4.4 million, and$1.9 million for the years ended December 31, 2005, 2004, and 2003. Netcash from investing activities consisted primarily of principal collections onloans and proceeds from maturation and sales of securities offset bydisbursements for loan originations and the purchase of securities. In 2003,cash flows from investing activities were also affected by the $51.2 million incash received in connection with the branch acquisition. Net cash fromfinancing activities consisted primarily of changes in net deposits andshort–term borrowings partially offset by dividends paid and the purchase ofCompany stock.

 

The Company’s most liquid assets are cash andshort–term investments. The levels of these assets are dependent on the Company’soperating, financing, lending, and investing activities during any given year. AtDecember 31, 2005, cash and short–term investments totaled $6.9 million. TheCompany has other sources of liquidity if a need for additional funds arises,including securities maturing within one year and the repayment of loans. TheCompany may also utilize the sale of securities available–for–sale,federal funds lines of credit from correspondent banks, and borrowings from theFederal Home Loan Bank of Chicago and Marshall and Ilsley Bank.

 

13

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The following table discloses contractual obligationsand commercial commitments of the Company as of December 31, 2005:

 
| ** **                       | ** ** | ** ** | ** ** | **Less Than** | ** ** | ** **           | ** ** | ** **           | ** ** | **After**   | ** ** |
|----------------------------------|------------|------------|------------|---------------|------------|----------------------|------------|----------------------|------------|-------------|------------|
| ** **                       | ** ** | **Total**  | ** ** | **1 Year**    | ** ** | **1 – 3 Years** | ** ** | **4 – 5 Years** | ** ** | **5 Years** | ** ** |
| Lines of credit(1)               |       | $          | 13,143     |          | $          | 7,900                |       | $                    | 3,143      |        | $          | 751 |   | $ | 1,349 |   |
| Data processing contract payable |       | 688        |       | 198           |       | 490                  |       | —               |       | —      |       |
| Standby letters of credit(1)     |       | 721        |       | 721           |       | —               |       | —               |       | —      |       |
|                             |       |       |       |          |       |                 |       |                 |       |        |       |
|                             |       | $          | 14,552     |          | $          | 8,819                |       | $                    | 3,633      |        | $          | 751 |   | $ | 1,349 |   |
|                                  |            |            |            |               |            |                      |            |                      |            |             |            |  |  |  |  |  |  |

 

----

(1)  Represents amounts committed to customers.

 

During 2005 and 2004, the Company repurchased 1,260and 1,018 shares of common stock for $89,000 and $71,000.

 

Capital provides the foundation for future growth. Regulatoryagencies have developed minimum guidelines by which the adequacy of a financialinstitution’s capital may be evaluated. At December 31, 2005, all ofthe Company’s ratios exceeded the levels required under regulatory guidelinesas shown in Note 15 of the Consolidated Financial Statements.

 

**Facilities**

 

First Ottawa Bancshares, Inc. is the holding company for FirstNational Bank of Ottawa. The Company is headquartered in Ottawa, Illinois andoperates four offices in Ottawa, two branches in Streator, a branch in Morrisand a recently opened branch in Yorkville. 

 

**Impact of Inflation and Changing Prices**

 

The financial statements and related data presentedherein have been prepared in accordance with accounting principles generallyaccepted in the United States of America, which require the measurement offinancial position and operating results in terms of historical dollars withoutconsidering changes in the relative purchasing power of money over time due toinflation. The primary impact of inflation on the operations of the Company isreflected in increased operating costs. Unlike most industrial companies,virtually all of the assets and liabilities of a financial institution aremonetary in nature. As a result, interest rates generally have a moresignificant impact on a financial institution’s performance than does inflation.Interest rates do not necessarily move in the same direction or to the sameextent as the prices of goods and services.

 

14

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**SAFE HARBOR STATEMENT**

 

This document contains,and future oral and written statements of the Company and its management may contain,forward–looking statements, within the meaning of such term in the PrivateSecurities Litigation Reform Act of 1995, with respect to the financialcondition, results of operations, plans, objectives, future performance andbusiness of the Company. Forward–looking statements, which may be basedupon beliefs, expectations and assumptions of the Company’s management and oninformation currently available to management, are generally identifiable bythe use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,”“may,” “will,” “would,” “could,” “should” or other 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.

 

The Company’s ability to predict results or the actual effect of futureplans or strategies is inherently uncertain. Factors which could have amaterial adverse effect on the operations and future prospects of the Companyand its subsidiaries include, but are not limited 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, adeterioration in 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.****

 

15

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•                                         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.

 

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

 

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

 

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

 

These risks and uncertainties should be considered in evaluatingforward–looking statements and undue reliance should not be placed on suchstatements. Additional information concerning the Company and its business,including other factors that could materially affect the Company’s financialresults, is included in the Company’s Form 10-K under Item I.A. entitled “RiskFactors” and in other filings with the Securities and Exchange Commission.

 

16

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Shareholders

First Ottawa Bancshares, Inc.

Ottawa, Illinois

 

We have audited the accompanying consolidated balance sheets of FirstOttawa Bancshares, Inc. as of December 31, 2005 and 2004, and therelated consolidated statements of income, shareholders’ equity and cash flowsfor each of the three years in the period ended December 31, 2005. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believe thatour audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of FirstOttawa Bancshares, Inc. as of December 31, 2005 and 2004, and theresults of its operations and its cash flows for each of the three years in theperiod ended December 31, 2005, in conformity with accounting principlesgenerally accepted in the United States of America.

 
|                       |   |
|-----------------------|--------|
|                  |
| BKD, LLP              |
|                  |
| Indianapolis, Indiana |
| January 20, 2006 |

 

17

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FIRST OTTAWA BANCSHARES, INC. 

CONSOLIDATED BALANCE SHEETS

December 31, 2005 and 2004

(In thousands, except share and per share data)

 
| ** **                                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                                                  |       |     |       |     |       |
| Cash and due from banks                                                     |       | $        | 6,857      |     | $          | 7,930 |   |
| Interest–bearing demand  deposits                                      |       | —   |       | —   |       |
| Cash and cash  equivalents                                                  |       | 6,857    |       | 7,930    |       |
| Certificates of deposit                                                     |       | 11,494   |       | 24,647   |       |
| Investment securities  available for sale                                   |       | 90,631   |       | 104,652  |       |
| Loans held for sale                                                         |       | —   |       | 1,701    |       |
| Loans, net of allowance  for loan losses of $1,344 and $1,174               |       | 151,516  |       | 131,618  |       |
| Premises and equipment                                                      |       | 8,024    |       | 7,624    |       |
| Interest receivable and  other assets                                       |       | 10,217   |       | 10,487   |       |
|                                                                        |       |     |       |     |       |
| Total assets                                                                |       | $        | 278,739    |     | $          | 288,659 |   |
|                                                                        |       |     |       |     |       |
| **Liabilities and Shareholders’ Equity**                               |       |     |       |     |       |
| ** **                                                                  |       |     |       |     |       |
| **Liabilities**                                                             |       |     |       |     |       |
| Deposits                                                                    |       | $        | 239,881    |     | $          | 253,964 |   |
| Federal funds purchased                                                     |       | 12,700   |       | 5,600    |       |
| Securities sold under  agreement to repurchase                              |       | —   |       | 750      |       |
| Other borrowings                                                            |       | —   |       | 559      |       |
| Other liabilities                                                           |       | 3,300    |       | 3,934    |       |
| Total liabilities                                                           |       | 255,881  |       | 264,807  |       |
|                                                                        |       |     |       |     |       |
| **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                                            |       | 4,039    |       | 4,018    |       |
| Retained earnings                                                           |       | 25,258   |       | 24,662   |       |
| Treasury stock, at cost  – 100,651 and 99,391 shares                   |       | (5,745   | )          | (5,656   | )          |
| Accumulated other  comprehensive income (loss)                              |       | (1,444   | )          | 78       |       |
| Total shareholders’  equity                                            |       | 22,858   |       | 23,852   |       |
|                                                                        |       |     |       |     |       |
| Total liabilities and  shareholders’ equity                            |       | $        | 278,739    |     | $          | 288,659 |   |

 

See notes to consolidated financial statements.

 

18

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FIRST OTTAWA BANCSHARES, INC. 

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2005, 2004 and 2003

(In thousands, except share and per share data)

 
| ** **                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Interest and Dividend Income**                                        |       |     |       |     |       |     |       |
| Loans receivable                                                        |       | $        | 9,428      |     | $          | 8,318    |       | $ | 8,057 |   |
| Investment securities                                                   |       |     |       |     |       |     |       |
| Taxable                                                                 |       | 2,688    |       | 3,592    |       | 3,457    |       |
| Exempt from federal tax                                                 |       | 1,004    |       | 954      |       | 748      |       |
| Federal funds sold                                                      |       | 233      |       | 40       |       | 32       |       |
| Interest–bearing  deposits                                         |       | 555      |       | 633      |       | 357      |       |
| Total interest and  dividend income                                     |       | 13,908   |       | 13,537   |       | 12,651   |       |
|                                                                    |       |     |       |     |       |     |       |
| **Interest Expense**                                                    |       |     |       |     |       |     |       |
| Deposits                                                                |       | 4,544    |       | 4,162    |       | 4,207    |       |
| Repurchase agreements                                                   |       | 4        |       | 2        |       | 10       |       |
| Federal funds purchased                                                 |       | 57       |       | 24       |       | 158      |       |
| Other interest expense                                                  |       | 8        |       | 12       |       | 9        |       |
| Total interest expense                                                  |       | 4,613    |       | 4,200    |       | 4,384    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Net Interest Income**                                                 |       | 9,295    |       | 9,337    |       | 8,267    |       |
| Provision for loan  losses                                              |       | 300      |       | 300      |       | 120      |       |
| **Net Interest Income After Provision for Loan  Losses**                |       | 8,995    |       | 9,037    |       | 8,147    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Noninterest Income**                                                  |       |     |       |     |       |     |       |
| Service fee income                                                      |       | 1,112    |       | 1,089    |       | 866      |       |
| Trust and farm  management fee income                                   |       | 496      |       | 484      |       | 472      |       |
| Net realized gains on  sales of available–for–sale securities |       | 172      |       | 465      |       | —   |       |
| Net gains on sales of  loans                                            |       | 91       |       | 254      |       | 733      |       |
| Other income                                                            |       | 971      |       | 903      |       | 521      |       |
| Total noninterest  income                                               |       | 2,842    |       | 3,195    |       | 2,592    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Noninterest Expenses**                                                |       |     |       |     |       |     |       |
| Salaries and employee  benefits                                         |       | 4,651    |       | 4,651    |       | 4,122    |       |
| Occupancy and equipment  expense                                        |       | 1,280    |       | 1,270    |       | 943      |       |
| Data processing fees                                                    |       | 371      |       | 334      |       | 500      |       |
| Supplies                                                                |       | 211      |       | 165      |       | 190      |       |
| Professional fees                                                       |       | 444      |       | 484      |       | 419      |       |
| Amortization of core  deposit intangibles                               |       | 319      |       | 399      |       | 34       |       |
| Other expenses                                                          |       | 1,225    |       | 1,504    |       | 1,205    |       |
| Total noninterest  expenses                                             |       | 8,501    |       | 8,807    |       | 7,413    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Income Before Income Tax**                                            |       | 3,336    |       | 3,425    |       | 3,326    |       |
| Income tax expense                                                      |       | 791      |       | 797      |       | 867      |       |
|                                                                    |       |     |       |     |       |     |       |
| **Net Income**                                                          |       | $        | 2,545      |     | $          | 2,628    |       | $ | 2,459 |   |
| ** **                                                              |       |     |       |     |       |     |       |
| **Earnings Per Share – Basic**                                     |       | $        | 3.92       |     | $          | 4.03     |       | $ | 3.75 |   |
| ** **                                                              |       |     |       |     |       |     |       |
| **Earnings Per Share – Diluted**                                   |       | $        | 3.90       |     | $          | 4.03     |       | $ | 3.75 |   |
|                                                                    |       |     |       |     |       |     |       |
| **Average Shares Outstanding**                                          |       | 649,830  |       | 651,561  |       | 655,243  |       |

 

See notes to consolidated financial statements.

 

19

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FIRST OTTAWA BANCSHARES, INC. 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

Years Ended December 31, 2005, 2004 and 2003

(In thousands, except share and per share data)

 
| ** **                                                                     | ** ** | **Common  Stock** | ** ** | **Additional  Paid–in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Treasury  Stock** | ** ** | **Accumulated  Other  Comprehensive  Income  (Loss)** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------|------------|---------------------------------------|------------|------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|-----------|------------|
| **Balances, January 1, 2003**                                             |       | $                 | 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    |       |
| Comprehensive income                                                           |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| Net income                                                                     |       |              |       |                                  |       | 2,545                  |       |                |       |                                                  |       | 2,545     |       |
| Other comprehensive  income, net of tax – unrealized losses on securities |       |              |       |                                  |       |                   |       |                |       | (1,522                                                | )          | (1,522    | )          |
| Comprehensive income                                                           |       |              |       |                                  |       |                   |       |                |       |                                                  |       | 1,023     |       |
| Cash dividends ($3.00  per share)                                              |       |              |       |                                  |       | (1,949                 | )          |                |       |                                                  |       | (1,949    | )          |
| Stock options vested                                                           |       |              |       | 21                                    |       |                   |       |                |       |                                                  |       | 21        |       |
| Purchase of 1,260  treasury shares                                             |       |              |       |                                  |       |                   |       | (89                 | )          |                                                  |       | (89       | )          |
|                                                                           |       |              |       |                                  |       |                   |       |                |       |                                                  |       |      |       |
| **Balances, December 31, 2005**                                           |       | $                 | 750        |                                  | $          | 4,039                  |       | $                   | 25,258     |                                                  | $          | (5,745    | )          | $ | (1,444 | ) | $ | 22,858 |   |

 

See notes to consolidated financial statements.

 

20

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FIRST OTTAWA BANCSHARES, INC. 

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2005, 2004 and 2003

(In thousands, except per share data)

 
| ** **                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Operating Activities**                                                |       |     |       |     |       |     |       |
| Net income                                                              |       | $        | 2,545      |     | $          | 2,628    |       | $ | 2,459 |   |
| Items not requiring  (providing) cash                                   |       |     |       |     |       |     |       |
| Provision for loan  losses                                              |       | 300      |       | 300      |       | 120      |       |
| Premium amortization on  securities, net                                |       | 421      |       | 502      |       | 189      |       |
| Derivative valuation  adjustment                                        |       | (373     | )          | (411     | )          | —   |       |
| Depreciation and  amortization                                          |       | 822      |       | 871      |       | 335      |       |
| Loans originated for  sale, net                                         |       | 518      |       | 197      |       | 900      |       |
| Gains on sales of  securities, net                                      |       | (172     | )          | (465     | )          | —   |       |
| Gains on sales of loans  held for sale                                  |       | (91      | )          | (254     | )          | (733     | )          |
| Change in                                                               |       |     |       |     |       |     |       |
| Interest receivable and  other assets                                   |       | 419      |       | 791      |       | (1,465   | )          |
| Interest payable and  other liabilities                                 |       | 151      |       | 241      |       | 70       |       |
| Net cash provided by  operating activities                              |       | 4,540    |       | 4,400    |       | 1,875    |       |
|                                                                    |       |     |       |     |       |     |       |
| **Investing Activities**                                                |       |     |       |     |       |     |       |
| Purchases of securities  available for sale                             |       | (4,729   | )          | (32,247  | )          | (43,703  | )          |
| Proceeds from  maturities and paydowns of securities available for sale |       | 9,364    |       | 21,616   |       | 27,879   |       |
| Proceeds from sales of  securities available for sale                   |       | 6,830    |       | 17,230   |       | —   |       |
| Purchases of  certificates of deposit                                   |       | (3,460   | )          | (18,086  | )          | (8,090   | )          |
| Proceeds from  maturities of certificates of deposit                    |       | 16,986   |       | 7,040    |       | 7,885    |       |
| Net change in loans                                                     |       | (19,392  | )          | (2,804   | )          | (9,295   | )          |
| Purchases of premises  and equipment                                    |       | (903     | )          | (543     | )          | (2,537   | )          |
| Cash received in branch  acquisition                                    |       | —   |       | —   |       | 52,163   |       |
| Net cash provided by  (used in) investing activities                    |       | 4,696    |       | (7,794   | )          | 24,302   |       |
|                                                                    |       |     |       |     |       |     |       |
| **Financing Activities**                                                |       |     |       |     |       |     |       |
| Net change in                                                           |       |     |       |     |       |     |       |
| Deposits                                                                |       | (14,083  | )          | (10,957  | )          | 1,866    |       |
| Federal funds purchased                                                 |       | 7,100    |       | 5,600    |       | (14,700  | )          |
| Securities sold under  agreements to repurchase                         |       | (750     | )          | 750      |       | (1,622   | )          |
| Proceeds from  borrowings                                               |       | 27       |       | 70       |       | —   |       |
| Repayment of borrowings                                                 |       | (586     | )          | (1       | )          | (162     | )          |
| Purchase of treasury  stock                                             |       | (89      | )          | (71      | )          | (315     | )          |
| Stock options vested                                                    |       | 21       |       | 10       |       | —   |       |
| Cash dividends                                                          |       | (1,949   | )          | (1,954   | )          | (1,973   | )          |
| Net cash used in  financing activities                                  |       | (10,309  | )          | (6,553   | )          | (16,906  | )          |
|                                                                    |       |     |       |     |       |     |       |
| **Net Change in Cash and Cash Equivalents**                             |       | (1,073   | )          | (9,947   | )          | 9,271    |       |
| ** **                                                              |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, Beginning of Year**                        |       | 7,930    |       | 17,877   |       | 8,606    |       |
| ** **                                                              |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, End of Year**                              |       | $        | 6,857      |     | $          | 7,930    |       | $ | 17,877 |   |
|                                                                    |       |     |       |     |       |     |       |
| **Additional Cash Flows Information**                                   |       |     |       |     |       |     |       |
| Interest paid                                                           |       | $        | 4,482      |     | $          | 4,460    |       | $ | 4,552 |   |
| Income tax paid, net of  refunds                                        |       | 729      |       | 158      |       | 821      |       |
| Transfers from loans to  foreclosed real estate                         |       | 468      |       | 141      |       | 174      |       |
|                                                                    |       |     |       |     |       |     |       |
| 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 consolidated financial statements.

 

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FIRST OTTAWA BANCSHARES, INC. 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

(Table dollar amounts in thousands, except per sharedata)

 

**NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

Nature of Operations and Principles of Consolidation:  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 isprimarily engaged in providing a full range of banking and financial servicesto individual and corporate customers in LaSalle, Grundy and surroundingcounties in Illinois. The Bank is subject to competition from other financialinstitutions. The Bank is subject to the regulation of certain federal andstate agencies and undergoes periodic examinations by those regulatoryauthorities. The consolidated financial statements include First OttawaBancshares, Inc. and the Bank, and the Bank’s wholly owned subsidiary,First Ottawa Financial Corporation, together referred to as the Company. Intercompanytransactions and balances 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. Theseestimates and assumptions affect the amounts reported in the financialstatements and the disclosures provided, and future 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 asavailable–for–sale when they might be sold before maturity. Securitiesavailable–for–sale are carried at fair value, with unrealized holding gains andlosses reported, net of tax, as other comprehensive income. Equity securitiesinclude Federal 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, witha charge to expense, when a decline in fair value is not temporary.

 

Realized gains and losses on sales are determinedusing the amortized cost of the specific security sold. Interest incomeincludes amortization of purchase premiums and discounts.

 

Declines in the fair value of securities below theircost that are other-than-temporary are reflected as realized losses. Inestimating other-than-temporary losses, management considers: (1) thelength of time and extent that fair value has been less than cost, (2) thefinancial condition and near term prospects of the issuer, and (3) theCompany’s ability and intent to hold the security for a period sufficient toallow for any anticipated recovery in fair value.

 

Derivatives:  All derivative instruments are recorded attheir fair values and the change in the fair value of a derivative is includedin interest income. If derivative instruments are designated as hedges of fairvalues, both the change in the fair value of the hedge and the hedged item areincluded in current earnings. Fair value adjustments related to cash flowhedges are recorded in other comprehensive income and reclassified to earningswhen the hedged transaction is reflected in earnings. Ineffective portions ofhedges are reflected in earnings as they occur.

 

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

 

Loans:  Loans are reported at the principal balanceoutstanding, net of deferred loan fees and costs and the allowance for loan losses.Interest income is reported on the interest method and includes amortization ofnet deferred loan fees and costs over the loan term. Mortgage loans originatedand intended for sale in the secondary market are carried at the lower of cost,net of deferred loan fees, or estimated fair value in the aggregate. Interestincome is not reported when full loan repayment is in doubt, typically whenpayments are past due over 90 days. Payments received on such loans arereported 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 are charged against the allowance whenmanagement believes the uncollectibility of a loan balance is confirmed. Subsequentrecoveries, if any, are credited to the allowance. Management estimates theallowance balance required based on past loan loss experience, known andinherent risks in the portfolio, information about specific borrower situationsand estimated collateral values, economic conditions, and other factors. Allocationsof the allowance may be made for specific loans, but the entire allowanceis available for any loan that, in management’s judgment, should be chargedoff.

 

22

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Loan impairment is reported when full payment underthe loan terms is not expected. Impairment is evaluated in total forsmaller–balance loans of similar nature, such as residential mortgage andconsumer loans, and on an individual loan basis for other loans. If a loan 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 forimpairment when payments are delayed, typically 90 days or more, or when theinternal grading system indicates a doubtful classification.

 

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

 

Other Real Estate:  Real estate owned, other than that used inthe normal course of business, is carried at the lower of cost basis (fairvalue at date of foreclosure) or fair value less estimated costs to sell. Anyreduction to fair value from a related loan at the time of acquisition isaccounted 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 are expensed in proportion to and over theperiod of estimated net servicing revenues. Impairment is evaluated based onthe fair value of the rights using groupings of the underlying loans as tointerest rates and then, secondarily, as to geographic and prepaymentcharacteristics. Fair value is determined using prices for similar assets withsimilar characteristics, when available, or based upon discounted cash flowsusing market–based assumptions. Any impairment of a grouping is reported as avaluation allowance. There was no such valuation allowance recorded at December 31,2005 and 2004, and mortgage servicing rights were not material at either date.

 

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

 

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

 

Stock Options:  The Company has a stock–based compensationplan, which is more fully described in Note 12. The Company accounts for thisplan under the recognition and measurement principles of Statement of FinancialAccounting Standards No. 123, *Accounting for Stock–BasedCompensation*, using the fair value method. The value of optionsgranted under this plan is charged to expense over the vesting period of thegrants.

 

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 and liabilities are the expected future taxconsequences of temporary differences between the carrying amounts and taxbases of assets and liabilities, computed using 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. 

 

23

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Fair Values of Financial Instruments:  Fair values of financial instruments areestimated using relevant market information and other assumptions, as morefully disclosed separately. Fair value estimates involve uncertainties andmatters of significant judgment regarding interest rates, credit risk,prepayments, and other factors, especially in the absence of broad markets forparticular items. Changes in assumptions or in market conditions couldsignificantly affect the estimates. The fair value estimates of existing on–and off–balance–sheet financial instruments do not include the value ofanticipated future business or the values of assets and liabilities notconsidered financial instruments.

 

Comprehensive Income:  Comprehensive income includes both net incomeand other comprehensive income (loss). Other comprehensive income (loss)includes the changes in unrealized gains and losses on securitiesavailable–for–sale, and minimum pension liability, net of deferred incometaxes.

 

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

 

##### PendingAccounting Pronouncements

 

***Shared-BasedPayment***

*** ***

In December 2004,the FASB issued SFAS No. 123, Revised, *Share-Based Payment (SFAS123(R)),*which requires all public companies to record compensationcost for stock options and other awards provided to employees in return foremployee service. The cost of the options is measured at the fair value of theoptions when granted and is expensed over the employee service period, which isnormally the vesting period of the options granted. The Company adopted SFAS123(R) on January 1, 2006. Future compensation cost and the impact on theCompany’s results of operation as a result of any future option grants willdepend on the level of any future option grants, the related vesting period,and the calculation of the fair value of the options granted as of the grantdate. As such, the Company cannot currently estimate compensation expenserelating to future awards.

 

Since the Company previously accounted for its stock options inaccordance with SFAS No. 123, the adoption of SFAS No. 123(R) is notexpected to have a significant impact on the Company’s financial condition orresults of operations.

 

*** The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments***

 

In January 2003, the Emerging Issues Task Force (*EITF*) began a project to provide additional guidance on whena market value decline on debt and marketable equity securities should beconsidered other-than-temporary. Currently, declines in market value that areconsidered to be other-than-temporary require that a loss be recognized throughthe income statement. In March 2004, the FASB ratified the consensusreached by the EITF in Issue 03-1, *The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments* (*EITF 03-1*). EITF 03-1 provides guidance for determining whenan investment is considered impaired, whether impairment isother-than-temporary, and measurement of an impairment loss. In September 2004,the FASB issued a staff position (*FSP 03-1-1*)which delayed the effective date for the measurement and recognitionguidance of EITF 03-1 due to additional proposed guidance. 

 

In June 2005, the FASB decided not to provide additional guidanceon the meaning of other-than-temporary impairment, but directed the FASB staffto issue a FASB Staff Position (*FSP*) titled FSP115-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*. The final FSP supersedesEITF 03-1 and EITF Topic No. D-44, *Recognition ofOther-Than-Temporary Impairment Upon the Planned Sale of a Security Whose CostExceeds Fair Value*. FSP FAS 115-1 replaces guidance in EITF 03-1 onloss recognition with references to existing other-than-temporary impairmentguidance, such as FASB Statement No. 115, *Accountingfor Certain Investments in Debt and Equity Securities* (*SFAS No. 115*). FSP FAS 115-1 also clarifies that aninvestor should recognize an impairment loss no later than when the impairmentis deemed other-than-temporary, even if a decision to sell has not been made.

 

24

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FSP FAS 115-1 was effective for other-than-temporaryimpairment analysis conducted in periods beginning after September 15,2005. The Company has consistently followed the loss recognition guidance inSFAS No. 115, so the adoption of FSP FAS 115-1 did not have a significantimpact on the Company’s financial condition or results of operations.

 

***Earnings Per Share***

 

On September 30, 2005, the FASB issued a proposed amendment toSFAS No. 128, *Earnings per Share*,to clarify guidance for mandatorily convertible instruments, the treasury stockmethod, contingently issuable shares, and contracts that may be settled incash or shares. The primary impact on the Company of the proposed Statementwould be a change to the treasury stock method for year-to-date dilutedearnings per share.

 

**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 Midwest Bank. Asa result of the acquisition, the Company has an opportunity to increase itscustomer base and continue to increase its market share. 

 

The acquisition was accounted for under the purchasemethod of accounting. All assets and liabilities were recorded at their fairvalues as of November 14, 2003, including goodwill of $2,446,000 which isdeductible for tax purposes. Additionally, core deposit intangibles totaling$2,027,000 were recognized and will be amortized over 11 years using adeclining balance method. The purchase accounting adjustments are beingamortized over the life of the respective asset or liability. The followingtable 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, 2005 totaled $751,000. Estimated amortizationexpense for each of the following three years is $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, 2005**                                               |       |                |       |                         |       |                          |       |             |       |
| U. S. Treasury                                                           |       | $                   | 10,086     |                         | $          | —                        |       | $                | (284       | ) | $ | 9,802 |   |
| Federal agencies                                                         |       | 40,364              |       | 2                            |       | (961                          | )          | 39,405           |       |
| State and municipal                                                      |       | 25,455              |       | 225                          |       | (484                          | )          | 25,196           |       |
| Mortgage–backed  securities and collateralized mortgage obligations |       | 10,082              |       | 43                           |       | (256                          | )          | 9,869            |       |
| Corporate obligations                                                    |       | 3,416               |       | —                       |       | (97                           | )          | 3,319            |       |
| Marketable equity  securities                                            |       | 3,086               |       | —                       |       | (46                           | )          | 3,040            |       |
|                                                                     |       |                |       |                         |       |                          |       |             |       |
| Total investment  securities                                             |       | $                   | 92,489     |                         | $          | 270                           |       | $                | (2,128     | ) | $ | 90,631 |   |

 

25

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

 

As of December 31, 2005 and 2004, the Company hadapproximately $4,269,000 and $4,505,000 invested in bonds issued bymunicipalities located within LaSalle County, Illinois.

 

Securities with an approximate carrying value of$58,012,000 and $59,097,000 were pledged at December 31, 2005 and 2004 tosecure trust and public deposits, repurchase agreements, and for other purposesas required or permitted by law.

 

The fair value of contractual maturities of securitiesavailable for sale at December 31, 2005 were as follows. Securities notdue at a single maturity date, primarily mortgage–backed and equity securities,are shown separately.

 
| ** **                                                               | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------|------------|-----------------|------------|
| Within one year                                                          |       | $                   | 6,366      |            | $          | 5,975 |   |
| One to five years                                                        |       | 69,309              |       | 67,133          |       |
| Five to ten years                                                        |       | 815                 |       | 1,689           |       |
| After ten years                                                          |       | 2,831               |       | 2,925           |       |
|                                                                     |       | 79,321              |       | 77,722          |       |
| Mortgage–backed securities and collateralized  mortgage obligations |       | 10,082              |       | 9,869           |       |
| Marketable equity securities                                             |       | 3,086               |       | 3,040           |       |
| Totals                                                                   |       | $                   | 92,489     |            | $          | 90,631 |   |

 

Information regarding realized gains and losses onsales of securities available for sale follows:

 
| ** **   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------|------------|----------|------------|----------|------------|----------|------------|
| Gross gains  |       | $        | 178        |     | $          | 465      |       | $ | — |   |
| Gross losses |       | 6        |       | —   |       | —   |       |
| Tax expense  |       | 58       |       | 158      |       | —   |       |
|              |            |          |            |          |            |          |            |  |  |  |

 

Certain investments in debt and marketable equitysecurities are reported in the financial statements at an amount less thantheir historical cost. Total fair value of these investments at December 31,2005 and 2004 was $79.3 million and $48.9 million, which was approximately87.4% and 47.1% of the Company’s available–for–sale investment portfolio atthose dates. These declines primarily resulted from increases in marketinterest rates.

 

26

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Based on evaluation of available evidence, includingrecent changes in market interest rates, management  believes the declines in fair value for thesesecurities are temporary. Should the impairment of any of these securitiesbecome other than temporary, the cost basis of the investment will be reducedand the resulting loss recognized in net income in the period theother–than–temporary impairment is identified.

 

The following table shows our investments’ grossunrealized losses and fair value, aggregated by investment category and lengthof time that individual securities have been in a continuous unrealized lossposition.

 
| ** **                                                               | ** ** | **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, 2005**                                               |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| ** **                                                               |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| U. S. Treasury                                                           |       | $                       | —     |                   | $          | —          |       | $ | 9,802 |   | $ | 284 |   | $ | 9,802 |   | $ | 284 |   |
| Federal agencies                                                         |       | 14,711                  |       | 238                    |       | 23,691          |       | 723 |   | 38,402 |   | 961 |   |
| State and municipal                                                      |       | 4,774                   |       | 34                     |       | 11,646          |       | 450 |   | 16,420 |   | 484 |   |
| Mortgage–backed  securities and collateralized mortgage obligations |       | 4,970                   |       | 151                    |       | 3,388           |       | 105 |   | 8,358 |   | 256 |   |
| Corporate obligations                                                    |       | —                  |       | —                 |       | 3,319           |       | 97 |   | 3,319 |   | 97 |   |
| Marketable equity  securities                                            |       | —                  |       | —                 |       | 3,040           |       | 46 |   | 3,040 |   | 46 |   |
| Total temporarily  impaired securities                                   |       | $                       | 24,455     |                   | $          | 423             |       | $ | 54,886 |   | $ | 1,705 |   | $ | 79,341 |   | $ | 2,128 |   |
|                                                                     |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| **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 |   |

 

27

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**NOTE 4 – LOANS**

 

Major classifications of loans as of December 31,2005 and 2004 are summarized as follows:

 
| ** **                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
| Real estate                 |       | $        | 95,469     |     | $          | 74,225 |   |
| Commercial and agricultural |       | 33,686   |       | 28,341   |       |
| Installment                 |       | 11,585   |       | 17,575   |       |
| Home equity lines of credit |       | 12,120   |       | 12,651   |       |
| Total loans                 |       | 152,860  |       | 132,792  |       |
| Allowance for loan losses   |       | (1,344   | )          | (1,174   | )          |
|                        |       |     |       |     |       |
| Net loans                   |       | $        | 151,516    |     | $          | 131,618 |   |

 

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

 
| Balance at January 1,  2005  |   | $      | 1,655  |   |
|-----------------------------------|--------|--------|--------|--------|
| New loans                         |   | 1,511  |   |
| Repayments                        |   | (715   | )      |
|                              |   |   |   |
| Balance at December 31, 2005 |   | $      | 2,451  |   |

 

Information regarding impaired loans at December 31,2005 and 2004 is as follows:

 
| ** **                                                                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Impaired loans with an allowance                                                                                |       | $        | 2,342      |     | $          | 2,017 |   |
| Impaired loans for  which the discounted cash flows or collateral value exceeds the carrying  value of the loan |       | 87       |       | 44       |       |
|                                                                                                            |       |     |       |     |       |
| Total impaired loans                                                                                            |       | $        | 2,429      |     | $          | 2,061 |   |
|                                                                                                            |       |     |       |     |       |
| Allowance for impaired loans included in the Company’s  allowance for loan losses                          |       | $        | 497        |     | $          | 493 |   |

 
| ** **                                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Average balance of impaired loans                               |       | $        | 2,039      |     | $          | 2,074    |       | $ | 1,599 |   |
| Interest income recognized on impaired loans                    |       | 169      |       | 127      |       | 157      |       |
| Interest income recognized on impaired loans – cash  basis |       | 126      |       | 107      |       | 153      |       |
|                                                                 |            |          |            |          |            |          |            |  |  |  |

 

Nonperforming loans were as follows at December 31:

 
| ** **                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
| Loans past due over 90 days still on accrual |       | $        | 1,337      |     | $          | 727 |   |
| Nonaccrual loans                             |       | —   |       | 161      |       |
|                                              |            |          |            |          |            |  |  |

 

28

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**NOTE 5 – ALLOWANCE FOR LOAN LOSSES**

 

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

 
| ** **                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Allowance for loan losses  |       |     |       |     |       |     |       |
| Balances, January 1   |       | $        | 1,174      |     | $          | 1,049    |       | $ | 1,167 |   |
| Provision for losses       |       | 300      |       | 300      |       | 120      |       |
| Recoveries on loans        |       | 86       |       | 98       |       | 181      |       |
| Loans charged off          |       | (216     | )          | (273     | )          | (419     | )          |
|                       |       |     |       |     |       |     |       |
| Balances, December 31 |       | $        | 1,344      |     | $          | 1,174    |       | $ | 1,049 |   |
|                            |            |          |            |          |            |          |            |  |  |  |  |

 

**NOTE 6 – LOAN SALES AND SERVICING**

 

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 fromthe sales of mortgage loans totaling $4,637,000, $9,133,000 and $26,296,000 in2005, 2004 and 2003. Mortgage loans serviced for others are not included in theaccompanying consolidated balance sheets. The unpaid principal balances ofthese loans are summarized as follows:

 
|               |   | **2005** | ** ** | **2004** |   |
|--------------------|--------|----------|------------|----------|--------|
|               |   |     |       |     |   |
| Loans serviced for |   |     |       |     |   |
| Freddie Mac        |   | $        | 32,757     |     | $      | 35,698 |   |
| IHDA               |   | —   |       | 732      |   |
|               |   |     |       |     |   |
|               |   | $        | 32,757     |     | $      | 36,430 |   |
|                    |        |          |            |          |        |  |  |  |

 

Following is an analysis of the changes in originated mortgageservicing rights:

 
| ** **                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Mortgage Servicing Rights         |       |     |       |     |       |     |       |
| Balances, January 1          |       | $        | 380        |     | $          | 445      |       | $ | 301 |   |
| Servicing rights  capitalized     |       | 49       |       | 89       |       | 256      |       |
| Amortization of  servicing rights |       | (101     | )          | (154     | )          | (112     | )          |
|                              |       |     |       |     |       |     |       |
| Balances, December 31        |       | $        | 328        |     | $          | 380      |       | $ | 445 |   |
|                                   |            |          |            |          |            |          |            |  |  |  |  |

 

29

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**NOTE 7 – PREMISES AND EQUIPMENT**

 

Premises and equipment consisted of the following at December 31:

 
| ** **                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Cost                                      |       |     |       |     |       |
| Land                                      |       | $        | 1,791      |     | $          | 1,816 |   |
| Buildings and land  improvements          |       | 7,428    |       | 6,809    |       |
| Equipment                                 |       | 4,606    |       | 4,307    |       |
| Construction in  progress                 |       | —   |       | 46       |       |
| Total cost                                |       | 13,825   |       | 12,978   |       |
| Accumulated depreciation and amortization |       | (5,801   | )          | (5,354   | )          |
|                                      |       |     |       |     |       |
| Net                                       |       | $        | 8,024      |     | $          | 7,624 |   |

 

**NOTE 8 – DEPOSITS**

 

Deposits consisted of the following at December 31:

 
| ** **                                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
| Noninterest–bearing demand                           |       | $        | 30,436     |     | $          | 31,582 |   |
| Interest–bearing demand                              |       | 57,624   |       | 61,613   |       |
| Savings                                                   |       | 24,847   |       | 28,235   |       |
| Money market savings                                      |       | 26,184   |       | 38,252   |       |
| Certificates and other time deposits of $100,000 or  more |       | 31,420   |       | 22,462   |       |
| Other certificates and time deposits                      |       | 69,370   |       | 71,820   |       |
|                                                      |       |     |       |     |       |
| Total deposits                                            |       | $        | 239,881    |     | $          | 253,964 |   |
|                                                           |            |          |            |          |            |  |  |  |

 

At December 31, 2005, the scheduled maturities ofcertificates of deposit were as follows:

 
| 2006   |   | $      | 57,698  |   |
|--------|--------|--------|---------|--------|
| 2007   |   | 19,630 |    |
| 2008   |   | 15,803 |    |
| 2009   |   | 5,626  |    |
| 2010   |   | 2,033  |    |
|   |   |   |    |
|   |   | $      | 100,790 |   |

 

Deposits held by the Company from related parties at December 31,2005 and 2004 totaled $2.3 million and $2.2 million, respectively.

 

30

----

 

**NOTE 9 – BORROWINGS**

 

The Company has a note payable that consists of a$2,000,000 unsecured line of credit with Marshall & Ilsley Bank,maturing on August 25, 2006. The outstanding balance under the line ofcredit was $0 and $559,000 at December 31, 2005 and 2004. Interest ispayable quarterly at LIBOR plus 165 basis points (5.96% and 4.07% at December 31,2005 and 2004).

 

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

 

Securities sold under agreements to repurchase arefinancing arrangements. Physical control is maintained for all securities soldunder repurchase agreements. The average balance during 2005 and 2004 was$232,000 and $215,000 with an interest rate of 1.63% for both years. Themaximum month–end balance during 2005 and 2004 was $750,000 for both years.

 

**NOTE 11 – BENEFIT PLANS**

 

The Bank has a noncontributory defined-benefit pensionplan covering all employees who meet the eligibility requirements. In 1999, allplan benefits were frozen. The Bank’s funding policy is to make the minimumannual contribution that is required by applicable regulations, plus suchamounts as the Bank may determine to be appropriate from time to time. TheBank expects to contribute approximately $200,000 to the plan in 2005. The Bankuses a December 31 measurement date for the plan.

 

The following tables set forth the Bank’s pension plan’sfunded status and amounts actuarially determined for the years indicated:

 
| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Change in benefit obligation    |       |     |       |     |       |
| Beginning benefit  obligation   |       | $        | 1,868      |     | $          | 1,842 |   |
| Interest cost                   |       | 112      |       | 117      |       |
| Actuarial loss                  |       | 141      |       | 146      |       |
| Settlements                     |       | (108     | )          | (107     | )          |
| Benefits paid                   |       | (126     | )          | (130     | )          |
|                            |       |     |       |     |       |
| Ending benefit  obligation      |       | $        | 1,887      |     | $          | 1,868 |   |
|                            |       |     |       |     |       |
| Change in plan assets           |       |     |       |     |       |
| Beginning fair value            |       | $        | 1,507      |     | $          | 1,431 |   |
| Actual return                   |       | 49       |       | 113      |       |
| Employer contribution           |       | 209      |       | 200      |       |
| Settlements                     |       | (108     | )          | (107     | )          |
| Benefits paid                   |       | (126     | )          | (130     | )          |
|                            |       |     |       |     |       |
| Ending fair value               |       | $        | 1,531      |     | $          | 1,507 |   |
|                            |       |     |       |     |       |
| Funded status                   |       | $        | (356       | )        | $          | (361 | ) |
| Unrecognized net actuarial loss |       | (436     | )          | (269     | )          |
|                            |       |     |       |     |       |
| Prepaid (accrued) benefit cost  |       | $        | 80         |     | $          | (92 | ) |
|                            |       |     |       |     |       |
| Accumulated benefit obligation  |       | $        | 1,887      |     | $          | 1,868 |   |

 

31

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Other amounts recognized in the balance sheets:

 
| ** **                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
| Accumulated other comprehensive loss |       | $        | (217       | )        | $          | (217 | ) |
|                                      |            |          |            |          |            |  |  |

 
| ** **                                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Assumptions used to determine benefit obligations |       |     |       |     |       |     |       |
| Discount rate                                     |       | 5.75     | %          | 6.00     | %          | 6.25     | %          |
| Expected return on plan  assets                   |       | 7.0      |       | 7.0      |       | 7.0      |       |
|                                              |       |     |       |     |       |     |       |
| Assumptions used to determine benefit costs       |       |     |       |     |       |     |       |
| Discount rate                                     |       | 6.00     | %          | 6.25     | %          | 6.25     | %          |
| Expected return on plan  assets                   |       | 7.0      |       | 7.0      |       | 7.0      |       |

 

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

 
| ** **                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Components of net periodic benefit cost |       |     |       |     |       |     |       |
| Interest cost                           |       | $        | 112        |     | $          | 117      |       | $ | 114 |   |
| Return on plan assets                   |       | (106     | )          | (97      | )          | (82      | )          |
| Amortization                            |       | 8        |       | 3        |       | 9        |       |
|                                    |       |     |       |     |       |     |       |
| Net expense                             |       | $        | 14         |     | $          | 23       |       | $ | 41 |   |

 

The following benefit payments, which reflect expectedfuture service, as appropriate, are expected to be paid as of December 31,2005:

 
| ** ** | ** ** | **Pension  Benefits** | ** ** |
|------------|------------|-----------------------|------------|
| 2005       |       | $                     | 132        |   |
| 2006       |       | 126                   |       |
| 2007       |       | 119                   |       |
| 2008       |       | 118                   |       |
| 2009       |       | 112                   |       |
| Thereafter |       | 553                   |       |
|            |            |                       |            |  |

 

Plan assets are held by a bank–administered trustfund, which invests the plan assets in accordance with the provisions of theplan agreement. The permitted investments as established by the plan agreementinclude, but are not limited to, common and preferred stocks, open–end orclosed–end mutual funds, bonds and other evidences of indebtedness orownership, and real estate or any interest therein.

 

32

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Asset allocation is primarily based on a strategy toprovide stable earnings while attempting to recognize potentially higherreturns through limited investments in equity securities. Plan assets arerebalanced periodically. At December 31, 2005 and 2004, allocations bypercentages were as follows:

 
| ** **                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
| Equity mutual funds          |       | 64.2     | %          | 63.8     | %          |
| Fixed income mutual funds    |       | 17.7     |       | 22.3     |       |
| GNMA pool                    |       | .4       |       | .6       |       |
| Money market funds and other |       | 4.8      |       | 13.3     |       |
| Time Certificates of Deposit |       | 13.0     |       | —   |       |

 

At December 31, 2005 and 2004, market values ofplan assets were as follows:

 
| ** **                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
| Equity mutual funds          |       | $        | 983        |     | $          | 961 |   |
| Fixed income mutual funds    |       | 271      |       | 336      |       |
| GNMA pool                    |       | 5        |       | 9        |       |
| Money market funds and other |       | 73       |       | 201      |       |
| Time Certificates of Deposit |       | 199      |       | —   |       |
|                              |            |          |            |          |            |  |  |

 

The Bank has a directors’ retirement plan whichprovides retirement benefits primarily to former members of the Board ofDirectors. The Bank also maintains a supplemental executive retirement planthat provides benefits to certain key executive officers and directors inaccordance with the plan document. The Bank accrued expenses related to theseplans totaling  $105,000, $126,000 and$188,000 in 2005, 2004 and 2003.

 

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 plan allows employee contributions. The Company may makea matching contribution equal to a percentage of salary deferral anddiscretionary profit-sharing contributions. The matching percentage is limitedto 6% of compensation. The Company’s contributions, which are made followingthe end of the calendar year, totaled $140,000, $140,000 and $122,000 for 2005,2004 and 2003.

 

**NOTE  12 – STOCK OPTION PLAN**

 

The Company grants selected executives and other keyemployees and directors incentive and non–qualified stock option awards whichvest and become fully exercisable at the discretion of the Board of Directorsas the options are granted. The Company is authorized to grant options for upto 150,000 shares of the Company’s common stock. The exercise price of theoptions, which have a ten year life, may not be less than the market priceof the Company’s stock on the date of grant.

 

33

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The following is a summary of the status of the Company’sstock option plan and changes in that plan for 2005, 2004 and  2003. The Company had no grants outstandingprior to 2003.

 
| ** **                                                           | ** ** | **2005**   | ** ** | **2004**                                    | ** ** | **2003**   | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|---------------------------------------------|------------|------------|------------|
| **Options**                                                          | ** ** | **Shares** | ** ** | **Weighted–  Average  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted–  Average  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted–  Average  Exercise Price** | ** ** |
| Outstanding, beginning  of year                                      |       | 14,500     |       | $                                           | 59.21      |       | 6,750      |   | $ | 56.00 |   | — |   | $ |   |   |
| Granted                                                              |       | 6,500      |       | 70.00                                       |       | 7,750      |       | 62.00 |   | 6,750 |   | 56.00 |   |
|                                                                 |       |       |       |                                        |       |       |       |   |   |   |   |   |   |
| Outstanding, end of  year                                            |       | 21,000     |       | 62.55                                       |       | 14,500     |       | 59.21 |   | 6,750 |   | 56.00 |   |
|                                                                 |       |       |       |                                        |       |       |       |   |   |   |   |   |   |
| Options exercisable at  year end                                     |       | 5,313      |       |                                        |       | 1,684      |       |   |   | — |   |   |   |
|                                                                 |       |       |       |                                        |       |       |       |   |   |   |   |   |   |
| Weighted–average fair  value of options granted during the year |       |       |       | $                                           | 3.26       |       |       |   | $ | 1.30 |   |   |   | $ | 7.36 |   |

 

At December 31, 2004, certain information byexercise price for options outstanding and exercisable is as follows:

 
| **Exercise  Price** | ** ** | ** ** | **Number   of Shares** | ** ** | **Weighted–  Average  Remaining  Contractual  Life** | ** ** | **Number of  Shares  Exercisable** | ** ** |
|---------------------|------------|------------|------------------------|------------|-----------------------------------------------------------|------------|------------------------------------|------------|
| $                   | 56.00      |       |                   | 6,750      |                                                      | 7.5 years  |                               | 3,375      |   |
| 62.00               |       |       | 7,750                  |       | 8.5 years                                                 |       | 1,938                              |       |
| 70.00               |       |       | 6,500                  |       | 9.5 years                                                 |       | —                             |       |
|                     |            |            |                        |            |                                                           |            |                                    |            |  |

 

The fair value of each option grant was estimated onthe grant date using an option–pricing model with the following assumptions:

 
| ** **                                                   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Risk–free interest rates                                |       | 4.37       | %          | 4.21       | %          | 3.27       | %          |
| Dividend yields                                              |       | 4.29       | %          | 4.35       | %          | 4.96       | %          |
| Volatility factors of expected market price of  common stock |       | 5.37       | %          | 3.06       | %          | 23.55      | %          |
| Weighted–average expected life of the options           |       | 10 years   |       | 9.5 years  |       | 9.5 years  |       |

 

34

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**NOTE  13 – EARNINGS PER SHARE**

 

Earnings per share (EPS) were computed as follows:

 
| ** **                                                       | ** ** | **Year Ended December 31,  2005** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                       | ** ** | **Income**                             | ** ** | **Weighted-  Average  Shares** | ** ** | **Per Share  Amount** | ** ** |
| Net income                                                       |       | $                                      | 2,545      |   | $ | 649,830 |   |   |   |
| Basic earnings per  share                                        |       |                                   |       |   |   |   |   |
| Income available to  common stockholders                         |       |                                   |       |   |   | $ | 3.92 |   |
|                                                             |       |                                   |       |   |   |   |   |
| Effect of dilutive  securities                                   |       |                                   |       |   |   |   |   |
| Stock options                                                    |       | —                                 |       | 2,629 |   |   |   |
| Diluted earnings per  share                                      |       |                                   |       |   |   |   |   |   |   |
| Income available to  common stockholders and assumed conversions |       | $                                      | 2,545      |   | 652,459 |   | $ | 3.90 |   |
|                                                                  |            |                                        |            |  |  |  |  |  |  |  |  |

 
| ** **                                                       | ** ** | **Year Ended December 31,  2004** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                       | ** ** | **Income**                             | ** ** | **Weighted-  Average  Shares** | ** ** | **Per Share  Amount** | ** ** |
| Net income                                                       |       | $                                      | 2,628      |   | $ | 651,561 |   |   |   |
| Basic earnings per  share                                        |       |                                   |       |   |   |   |   |
| Income available to  common stockholders                         |       |                                   |       |   |   | $ | 4.03 |   |
|                                                             |       |                                   |       |   |   |   |   |
| Effect of dilutive  securities                                   |       |                                   |       |   |   |   |   |
| Stock options                                                    |       | —                                 |       | 1,172 |   |   |   |
| Diluted earnings per  share                                      |       |                                   |       |   |   |   |   |   |   |
| Income available to  common stockholders and assumed conversions |       | $                                      | 2,628      |   | 652,733 |   | $ | 4.03 |   |
|                                                                  |            |                                        |            |  |  |  |  |  |  |  |  |

 
| ** **                                                       | ** ** | **Year Ended December 31,  2003** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                       | ** ** | **Income**                             | ** ** | **Weighted-  Average  Shares** | ** ** | **Per Share  Amount** | ** ** |
| Net income                                                       |       | $                                      | 2,459      |   | $ | 655,243 |   |   |   |
| Basic earnings per  share                                        |       |                                   |       |   |   |   |   |
| Income available to  common stockholders                         |       |                                   |       |   |   | $ | 3.75 |   |
|                                                             |       |                                   |       |   |   |   |   |
| Effect of dilutive  securities                                   |       |                                   |       |   |   |   |   |
| Stock options                                                    |       | —                                 |       | — |   |   |   |
| Diluted earnings per  share                                      |       |                                   |       |   |   |   |   |   |   |
| Income available to common  stockholders and assumed conversions |       | $                                      | 2,459      |   | 655,243 |   | $ | 3.75 |   |
|                                                                  |            |                                        |            |  |  |  |  |  |  |  |  |

 

35

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**NOTE 14 – INCOME TAXES**

 

The balance sheets included the following amounts ofdeferred tax assets and liabilities at December 31:

 
| ** **                                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income tax expense                                         |       |     |       |     |       |     |       |
| Currently payable                                          |       |     |       |     |       |     |       |
| Federal                                                    |       | $        | 721        |     | $          | 337      |       | $ | 619 |   |
| State                                                      |       | 88       |       | (58      | )          | (8       | )          |
| Deferred                                                   |       | (18      | )          | 518      |       | 256      |       |
|                                                       |       |     |       |     |       |     |       |
| Total income tax  expense                                  |       | $        | 791        |     | $          | 797      |       | $ | 867 |   |
|                                                       |       |     |       |     |       |     |       |
| Reconciliation of federal statutory to actual tax  expense |       |     |       |     |       |     |       |
| Federal statutory  income tax at 34%                       |       | $        | 1,134      |     | $          | 1,165    |       | $ | 1,131 |   |
| Tax–exempt income                                     |       | (415     | )          | (330     | )          | (261     | )          |
| Nondeductible interest  expense                            |       | —   |       | 24       |       | 21       |       |
| Effect of state income  taxes and other items, net         |       | 72       |       | (62      | )          | (24      | )          |
|                                                       |       |     |       |     |       |     |       |
| Actual tax expense                                         |       | $        | 791        |     | $          | 797      |       | $ | 867 |   |
|                                                       |       |     |       |     |       |     |       |
| Effective tax rate                                         |       | 23.7     | %          | 23.3     | %          | 26.1     | %          |

 

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

 
| ** **                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                          |       |     |       |     |       |
| Unrealized losses on  securities available for sale |       | $        | 632        |     | $          | — |   |
| Allowance for loan  losses                          |       | 341      |       | 270      |       |
| Deferred compensation                               |       | 278      |       | 259      |       |
| Pension costs                                       |       | —   |       | 201      |       |
| Minimum pension  liability                          |       | 133      |       | 137      |       |
| Other                                               |       | 52       |       | 49       |       |
| Total assets                                        |       | 1,436    |       | 916      |       |
|                                                |       |     |       |     |       |
| **Liabilities**                                     |       |     |       |     |       |
| FHLB stock                                          |       | (118     | )          | (98      | )          |
| Depreciation                                        |       | (622     | )          | (584     | )          |
| Mortgage servicing  rights                          |       | (135     | )          | (157     | )          |
| Unrealized gain on  securities available for sale   |       | —   |       | (152     | )          |
| Other                                               |       | (84      | )          | (112     | )          |
| Total liabilities                                   |       | (959     | )          | (1,103   | )          |
|                                                |       |     |       |     |       |   |   |
|                                                |       | $        | (477       | )        | $          | (187 | ) |

 

36

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**NOTE 15 – DERIVATIVES**

 

The Company uses derivatives to fix future cash flowsfor interest payments on some of its floating rate certificates of deposit. Inthis regard, the Company has entered into an interest rate swap with the FHLBof Chicago to fix the interest rate on a specific certificate of depositproduct. At December 31, 2005, the Company had $2.8 million ofcertificates of deposit, which mature in 2006 through 2010, in which it pays theFHLB a weighted-average interest rate of 3.77% and will receive an interestrate from the FHLB based on the appreciation of the S&P 500 Index. Thisinterest received from the FHLB will be paid to the customer. The assets andliabilities in this transaction are being netted and the expense recorded ininterest expense on deposits.

 

In addition to the above, the Company also purchased$7.9 million of certificates of deposit which are included in the certificatesof deposit caption on the consolidated balance sheet. These investments have afive year term from date of purchase. The investments that individually do notexceed $100,000 are insured by the FDIC. Investments that individually exceed$100,000 are guaranteed by a standby letter of credit issued by the FHLB ofPittsburgh with no interest. The initial investment is not at risk but thereturn on the investment is based on a calculation of the appreciation in theS&P 500 Index. The fair value of this embedded derivative is recorded incertificates of deposit and the fair value adjustment is included in otherincome. At December 31, 2005, the Bank had allocated $1.2 million to thisasset and recorded a valuation allowance of $116,000.

 

**NOTE 16 – COMMITMENTS, OFF–BALANCE–SHEET RISK, ANDCONTINGENCIES**

 

There are various contingent liabilities that are notreflected in the consolidated financial statements, including claims and legalactions arising in the ordinary course of business. In the opinion ofmanagement, after consultation with legal counsel, the ultimate disposition ofthese claims and legal actions is not expected to have a material effect onfinancial condition or results of operations.

 

The Bank is required to maintain reserve funds in cashand/or on deposit with the Federal Reserve Bank. The reserve required at December 31,2005 was $370,000.

 

Some financial instruments are used in the normalcourse of business to meet the financing needs of customers. These financialinstruments include commitments to extend credit, standby letters of credit, andfinancial guarantees. These involve, to varying degrees, credit andinterest–rate risk in excess of the amounts reported in the financialstatements.

 

Exposure to credit loss if the other party does notperform is represented by the contractual amount for commitments to extendcredit, standby letters of credit, and financial guarantees written. The samecredit policies are used for commitments and conditional obligations are usedfor loans. Collateral or other security is normally required to support financialinstruments with credit risk.

 

Commitments to extend credit are agreements to lend toa customer as long as there is no violation of any condition established in thecommitment. Commitments generally have fixed expiration dates or othertermination clauses and may require payment of a fee. Since many of thecommitments are expected to expire without being used, the total commitments donot necessarily represent future cash requirements. Standby letters of creditand financial guarantees written are conditional commitments to guarantee acustomer’s performance to a third party.

 

37

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

 
| ** **               | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------|------------|------------|------------|------------|------------|
| ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unused lines of credit   |       | $          | 13,143     |       | $          | 12,163 |   |
| Standby letter of credit |       | 721        |       | 171        |       |
|                          |            |            |            |            |            |  |  |

 

At December 31, 2005, all of the commitments toextend credit were at variable rates of interest.

 

**NOTE 17 – FAIR VALUES OF FINANCIAL INSTRUMENTS**

 

The following methods and assumptions were used toestimate fair values for financial instruments. The carrying amount isconsidered to estimate fair value for cash and due from banks, demand, NOW,money market and savings deposits, federal funds purchased, securities soldunder repurchase agreements, accrued interest receivable and payable, andvariable rate loans or deposits. Securities fair values are based on quotedmarket prices or, if no quotes are available, on the rate and term of thesecurity and on information about the issuer. The fair value of loans held forsale and derivatives are based on quoted market prices. For fixed rate loans ordeposits, the fair value is estimated by discounted cash flow analysis usingcurrent market rates for the estimated life and credit risk. Fair values forimpaired loans are estimated using discounted cash flow analysis or underlyingcollateral values, where applicable. The fair value of off–balance–sheet itemsis based on the fees or cost that would currently be charged to enter into orterminate such agreements and is not material.

 

The carrying values and estimated fair values of theCompany’s financial instruments as of December 31, 2005 and 2004 were asfollows:

 
| ** **                                      | ** ** | **2005**             | ** ** | **2004**        | ** ** |
|-------------------------------------------------|------------|----------------------|------------|-----------------|------------|
| ** **                                      | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| **Assets**                                      |       |                 |       |            |       |   |   |   |   |
| Cash and cash  equivalents                      |       | $                    | 6,857      |            | $          | 6,857 |   | $ | 7,930 |   | $ | 7,930 |   |
| Certificates of deposit  and related derivative |       | 11,494               |       | 11,209          |       | 24,647 |   | 24,647 |   |
| Securities available  for sale                  |       | 90,631               |       | 90,631          |       | 104,652 |   | 104,652 |   |
| Loans held for sale                             |       | —               |       | —          |       | 1,701 |   | 1,701 |   |
| Loans                                           |       | 151,516              |       | 151,460         |       | 131,618 |   | 132,474 |   |
| Interest receivable                             |       | 2,031                |       | 2,031           |       | 1,932 |   | 1,932 |   |
|                                            |       |                 |       |            |       |   |   |   |   |
| **Liabilities**                                 |       |                 |       |            |       |   |   |   |   |
| Deposits with no stated  maturities             |       | 139,091              |       | 124,917         |       | 159,682 |   | 146,178 |   |
| Time deposits                                   |       | 100,790              |       | 102,508         |       | 94,282 |   | 96,519 |   |
| Federal funds purchased                         |       | 12,700               |       | 12,700          |       | 5,600 |   | 5,600 |   |
| Securities sold under  agreement to repurchase  |       | —               |       | —          |       | 750 |   | 752 |   |
| Other borrowings                                |       | —               |       | —          |       | 559 |   | 559 |   |
| Interest payable                                |       | 702                  |       | 702             |       | 571 |   | 571 |   |
|                                                 |            |                      |            |                 |            |  |  |  |  |  |  |  |  |

 

38

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**NOTE 18 – REGULATORY AND CAPITAL MATTERS**

 

The Company may pay dividends without restrictionunder the current Federal Reserve regulations so long as it remains “adequatelycapitalized” after such payment. The Bank is subject to statutory dividendrestrictions which provide, in general, that the Bank may pay the currentyear’s earnings and the prior two years’ retained earnings without the priorapproval of the Office of the Comptroller of Currency. At December 31,2005, the Bank’s stockholder’s equity totaled $22,363,000, of which $21,827,000was 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 banking agencies. Capitaladequacy guidelines and prompt corrective action regulations involvequantitative measures of assets, liabilities, and certain off–balance–sheetitems calculated under regulatory accounting practices. Capital amounts andclassifications are also subject to qualitative judgments by regulators aboutcomponents, risk weightings, and other factors, and the regulators can lowerclassifications 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 provide fiveclassifications, including well capitalized, adequately capitalized,undercapitalized, significantly undercapitalized, and criticallyundercapitalized, although these terms are not used to represent overallfinancial condition. If adequately capitalized, regulatory approval is requiredto accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growthand expansion, and plans for capital restoration are required.

 

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

 
| ** **                                                    | ** ** | **Actual** | ** ** | **Required for Adequate  Capital** | ** ** | **To Be Well  Capitalized** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                    | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                            | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **December 31, 2005**                                    |       |       |       |                                         |       |                                  |       |   |   |   |   |   |   |
| Total risk–based  capital (to risk–weighted assets) |       | $          | 21,786     |                                         | 11.9       | %                                     | $          | 14,672 |   | 8.0 | % | $ | 18,340 |   | 10.0 | % |
| Tier 1 capital (to  risk–weighted assets)                |       | 20,442     |       | 11.2                                         | %          | 7,336                                 |       | 4.0 | % | 11,004 |   | 6.0 | % |
| Tier 1 capital (to  average assets)                           |       | 20,442     |       | 7.2                                          | %          | 11,331                                |       | 4.0 | % | 14,163 |   | 5.0 | % |
|                                                          |       |       |       |                                         |       |                                  |       |   |   |   |   |   |   |
| **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 | % |

 

At December 31, 2005, 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.

 

39

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**NOTE 19 – OTHER COMPREHENSIVE LOSS**

 
| ** **                                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Unrealized losses on securities                                     |       |     |       |     |       |     |       |
| Unrealized holding losses  arising during the year                  |       | $        | (2,135     | )        | $          | (1,680   | )          | $ | (1,086 | ) |
| Less: reclassification  adjustment for gains realized in net income |       | 172      |       | 465      |       | —   |       |
| Tax effect                                                          |       | 785      |       | 729      |       | 368      |       |
|                                                                |       |     |       |     |       |     |       |
| Other comprehensive  loss                                           |       | $        | (1,522     | )        | $          | (1,416   | )          | $ | (718 | ) |

 

**NOTE 20 – 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**

 
| ** **                                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                       |       |     |       |     |       |
| Cash on deposit with  Bank                       |       | $        | 1,733      |     | $          | 1,304 |   |
| Investment in common  stock of Bank              |       | 22,364   |       | 24,031   |       |
| Other assets                                     |       | 59       |       | 404      |       |
|                                             |       |     |       |     |       |   |   |
| Total assets                                     |       | $        | 24,156     |     | $          | 25,739 |   |
| ** **                                       |       |     |       |     |       |
| **Liabilities**                                  |       |     |       |     |       |
| Note payable                                     |       | $        | —     |     | $          | 559 |   |
| Dividends payable                                |       | 1,298    |       | 1,303    |       |
| Other liabilities                                |       | —   |       | 25       |       |
|                                             |       | 1,298    |       | 1,887    |       |
| ** **                                       |       |     |       |     |       |
| **Shareholders’ Equity**                    |       | 22,858   |       | 23,852   |       |
| ** **                                       |       |     |       |     |       |
| Total liabilities and  shareholders’ equity |       | $        | 24,156     |     | $          | 25,739 |   |

 

40

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**Condensed Statements of Income**

 
| ** **                                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Income -**dividends from Bank                                                |       | $        | 2,649      |     | $          | 2,003    |       | $ | 2,502 |   |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Other income -**gain on the  sale of investments                             |       | 124      |       | —   |       | —   |       |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Expenses**                                                                   |       | 83       |       | 85       |       | 109      |       |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Income  before income tax and equity in undistributed income of subsidiary** |       | 2,690    |       | 1,918    |       | 2,393    |       |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Income tax benefit**                                                         |       | —   |       | 29       |       | 33       |       |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Income before equity in undistributed income of  subsidiary**                |       | 2,690    |       | 1,947    |       | 2,426    |       |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Equity in undistributed income of subsidiary**                               |       | (145     | )          | 681      |       | 33       |       |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Net Income**                                                                 |       | $        | 2,545      |     | $          | 2,628    |       | $ | 2,459 |   |

 

**Condensed Statements of Cash Flows**

 
| ** **                                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Operating Activities**                                                       |       |     |       |     |       |     |       |
| Net income                                                                     |       | $        | 2,545      |     | $          | 2,628    |       | $ | 2,459 |   |
| Item not requiring  (providing) cash                                           |       |     |       |     |       |     |       |
| Equity in undistributed  earnings of Bank                                      |       | 145      |       | (681     | )          | (33      | )          |
| Gains on sales of  securities, net                                             |       | (124     | )          | —   |       | —   |       |
| Other                                                                          |       | 14       |       | 1,295    |       | (1,302   | )          |
| Net cash provided by  operating activities                                     |       | 2,580    |       | 3,242    |       | 1,124    |       |
|                                                                           |       |     |       |     |       |     |       |
| **Investing  Activity -**proceeds from sales of securities available for  sale |       | 469      |       | —   |       | —   |       |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Financing Activities**                                                       |       |     |       |     |       |     |       |
| Purchase of treasury  shares                                                   |       | (89      | )          | (71      | )          | (315     | )          |
| Loan proceeds  (payments), net                                                 |       | (603     | )          | 69       |       | (161     | )          |
| Cash dividends                                                                 |       | (1,949   | )          | (1,954   | )          | (1,973   | )          |
| Vested stock options                                                           |       | 21       |       | 10       |       | 8        |       |
| Net cash used in  financing activities                                         |       | (2,620   | )          | (1,946   | )          | (2,441   | )          |
|                                                                           |       |     |       |     |       |     |       |
| **Net Change in Cash and Cash Equivalents**                                    |       | 429      |       | 1,296    |       | (1,317   | )          |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, Beginning of Year**                               |       | 1,304    |       | 8        |       | 1,325    |       |
| ** **                                                                     |       |     |       |     |       |     |       |
| **Cash and Cash Equivalents, End of Year**                                     |       | $        | 1,733      |     | $          | 1,304    |       | $ | 8 |   |

 

41

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**NOTE 21 – QUARTERLY FINANCIAL DATA (UNAUDITED)**

 
| ** **     | ** ** | **Interest  Income** | ** ** | **Interest  Expense** | ** ** | **Net Interest  Income** | ** ** | **Provision** | ** ** | **Securities  Gains** | ** ** | **Net  Income** | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|----------------|------------|----------------------|------------|-----------------------|------------|--------------------------|------------|---------------|------------|-----------------------|------------|-----------------|------------|-----------|------------|-------------|------------|
| **2005**       |       |                 |       |                  |       |                     |       |          |       |                  |       |            |       |      |       |        |       |
| First quarter  |       | $                    | 3,278      |                  | $          | 1,013                    |       | 2,265         |       | $                     | 75         |            | $          | 30        |       | $           | 495        |   | $ | 0.76 |   | $ | 0.76 |   |
| Second quarter |       | 3,375                |       | 1,101                 |       | 2,274                    |       | 75            |       | 24                    |       | 571             |       | 0.88      |       | 0.88        |       |
| Third quarter  |       | 3,635                |       | 1,224                 |       | 2,411                    |       | 75            |       | —                |       | 660             |       | 1.02      |       | 1.01        |       |
| Fourth quarter |       | 3,620                |       | 1,275                 |       | 2,345                    |       | 75            |       | 118                   |       | 819             |       | 1.26      |       | 1.25        |       |
| **2004**       |       |                 |       |                  |       |                     |       |          |       |                  |       |            |       |      |       |        |       |
| First quarter  |       | $                    | 3,369      |                  | 1,097      |                     | 2,272      |          | $          | 75                    |       | $               | 111        |      | $          | 479         |       | $ | 0.74 |   | $ | 0.74 |   |
| Second quarter |       | 3,373                |       | 1,041                 |       | 2,332                    |       | 75            |       | 72                    |       | 578             |       | 0.88      |       | 0.88        |       |
| Third quarter  |       | 3,398                |       | 1,035                 |       | 2,363                    |       | 75            |       | 159                   |       | 677             |       | 1.04      |       | 1.04        |       |
| Fourth quarter |       | 3,397                |       | 1,027                 |       | 2,370                    |       | 75            |       | 123                   |       | 894             |       | 1.37      |       | 1.37        |       |
|                |            |                      |            |                       |            |                          |            |               |            |                       |            |                 |            |           |            |             |            |  |  |  |  |  |  |  |

 

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FIRST OTTAWA BANCSHARES, INC.

SHAREHOLDERS INFORMATION

 

ANNUAL MEETING

 

The Annual Meeting of Shareholders will be held at 3 p.m.,local time on May 17, 2006 at the corporate headquarters located at 701LaSalle Street, Ottawa, Illinois 61350.

 

PRICE RANGE OF COMMON STOCK

 

As of February 7, 2006, there were approximately539 shareholders of record and 649,349 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 in the Company’s common stock have beeninfrequent. To the knowledge of the Company’s management, during 2004, 2005 andthe first month of 2006, an aggregate of approximately 129,603 shares of theCompany’s common stock was transferred in approximately 117 separatetransactions, excluding the 1,018 shares purchased by the Company in 2004 at$70 per share, and the 620 shares purchased at $70 per share and the 640 sharespurchased at $72 per share by the Company in 2005. These transfers representedboth transfers for consideration (i.e., sales) and transfers for noconsideration (e.g., gifts, estate transfers, etc.). The Company’s managementis unable to differentiate such transfers and has limited knowledge of the saleprices for transfers involving consideration. The last price known to theCompany’s management was a sale of 30 shares on February 6, 2006 at $78per share.

 

The following dividends per share were paid on theCompany’s common stock on the dates indicated: January 1, 2004 – $2.00; July 1,2004 – $1.00; January 1, 2005 – $2.00; July 1, 2005 – $1.00; January 1,2006 – $2.00.

 

WEB SITE FOR UNITED STATES SECURITIES AND EXCHANGECOMMISSION FILINGS

 

All reports filed electronically by the Company withthe United Stated Securities Exchange Commission (the “SEC”), including theannual report on Form 10–K, quarterly reports on Form 10–Q, andcurrent events reports on Form 8–K, as well as any amendments to thosereports are accessible at no cost on our internet site at www.firstottawa.comand on the SEC’s web site at www.sec.gov. We will also provide you with a copyfree of charge by contacting Cheryl Gage, Corporate Secretary, First OttawaBancshares, Inc., 701 LaSalle Street, Ottawa, Illinois 61350.

 

CORPORATE GOVERNANCE

 

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 throughthe investor relations department: Code of Business Conduct and Ethics, AuditCommittee Charter, Nominating and Corporate Governance Committee Charter, andCompensation Committee Charter.

 

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