** **

**UnitedStates Securities and Exchange Commission**

** **

**Washington, D.C. 20549**

 

**FORM 10-QSB**

# ** **

**ý****QUARTERLY REPORT UNDERSECTION 13 OF 15 (D) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For the quarterly period endedDecember 31, 2003**

 

**OR**

 

**o****TRANSITION REPORT UNDER SECTION 13OF 15 (D) OF THE SECURITIESEXCHANGE ACT**

 

**For the transition period from                  to                  .**

 

**Commission File No. 000-25231**

 

**NorthernStar Financial, Inc.**

(Exact name ofregistrant as specified in its charter)

 

| **Minnesota**                                          |   | **41-1912467**       |
|--------------------------------------------------------|--------|----------------------|
| (State of  Incorporation)                              |   | (IRS Employer ID  #) |
|                                                   |   |                 |
| **1650 Madison Avenue  Mankato, MN  56001**       |
| (Address  of Principal Executive Offices)              |
|                                                   |   |                 |
| **507-387-2265**                                       |
| (Issuer’s  Telephone Number, Including Area Code) |

 

Check whether theissuer (1) filed all reports required to be filed by Sections 13 or 15(d) ofthe Exchange Act during the past 12 months (or such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes ý  No o.

 

State the numberof shares outstanding of each of the issuer’s classes of common equity as ofthe latest practicable date.

 

**Class:  Common Stock, par value $.01 per shareOutstanding shares at February 5,2004:  568,506**

## ** **

Transitional Small Business DisclosureFormat (Check one):  Yes o  No ý.

 

 

----

 

**Northern Star Financial, Inc. andSubsidiary**

 

**Index to Form 10-QSBDecember 31, 2003**

 
| PART I.                             FINANCIAL  INFORMATION |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   | Item 1. | Summary of Financial  Data |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   |   | Consolidated  Statements of Financial Condition at December 31, 2003 (unaudited) and  June 30, 2003 (audited) |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   |   | Unaudited  Consolidated Statements of Operations for the three and six months ended  December 31, 2003 and 2002 |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   |   | Unaudited Consolidated Statement of Cash  Flows for the three and six months ended December 31, 2003 and 2002 |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   |   | Notes  to Condensed Consolidated Financial Statements (unaudited) |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   | Item  2. | Management’s  Discussion and Analysis or Plan of Operation |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   | Item 3. | Controls and Procedures |
|                                                                                                                                                                                                   |   |   |
| PART II.                         OTHER  INFORMATION                            |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   | Item 1. | Legal Proceedings |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   | Item  2. | Changes  in Securities and Use of Proceeds |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   | Item  3. | Default  Upon Senior Securities |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   | Item  4. | Submission  of Matters to a Vote of Security Holders |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   | Item 5. | Other Information |
|                                                                                                                                                                                                   |   |   |
|                                                                                                                                                                                                   | Item 6. | Exhibits  and Reports on Form 8-K |
|                                                                                                                                                                                                   |   |   |
| SIGNATURES                                                                                                                                                                                             |

 

2

----

 

### **ITEM 1. SUMMARY OF FINANCIAL DATA**

 

NorthernStar Financial, Inc. Summary of Financial Data

 

The following tablesummarizes certain historical financial data of Northern Star Financial, Inc.and its subsidiary on a consolidated basis as of and for the three and sixmonths ended December 31, 2003 and 2002. You should read this table in conjunction with our financial statementsand related notes appearing elsewhere in this document.

 

 
|                                                                  |   | **For the Three Months  Ended December 31,** |    | **As of and for the Six Months  Ended December 31,** |   |
|-----------------------------------------------------------------------|--------|---------------------------------------------------|---------|-----------------------------------------------------------|--------|
|                                                                  |   | **2003**                                          |    | **2002**                                                  |   | **2003** |   | **2002** |   |
| Statement  of Income:                                                 |   |                                              |    |                                                      |   |   |   |   |   |
| Interest  income                                                      |   | $                                                 | 706,114 |                                                      | $      | 705,009 |   | $ | 1,404,708 |   | $ | 1,448,546 |   |
| Interest  expense                                                     |   | 291,052                                           |    | 371,333                                                   |   | 603,245 |   | 775,819 |   |
| Net  interest income                                                  |   | 415,062                                           |    | 333,676                                                   |   | 801,463 |   | 672,727 |   |
| Provision  for loan losses                                            |   | 1,405                                             |    | 7,700                                                     |   | 16,605 |   | 28,700 |   |
| Other  non-interest income                                            |   | 113,936                                           |    | 319,605                                                   |   | 403,260 |   | 472,841 |   |
| Non-interest  expense                                                 |   | 623,835                                           |    | 650,226                                                   |   | 1,218,215 |   | 1,160,739 |   |
| (Loss)  before income tax expense                                     |   | (96,242                                           | )       | (4,645                                                    | )      | (30,097 | ) | (43,871 | ) |
| Income  tax expense (benefit)                                         |   | —                                            |    | —                                                    |   | — |   | — |   |
| Net  (loss)                                                           |   | $                                                 | (96,242 | )                                                         | $      | (4,645 | ) | $ | (30,097 | ) | $ | (43,871 | ) |
| Balance  Sheet:                                                       |   |                                              |    |                                                      |   |   |   |   |   |
| Assets                                                                |   |                                              |    |                                                      |   | $ | 50,318,956 |   | $ | 50,142,410 |   |
| Allowance  for loan losses                                            |   |                                              |    |                                                      |   | $ | 796,564 |   | $ | 688,519 |   |
| Deposits                                                              |   |                                              |    |                                                      |   | $ | 41,069,461 |   | $ | 41,216,867 |   |
| Stockholders’  equity                                            |   |                                              |    |                                                      |   | $ | 2,136,831 |   | $ | 1,947,028 |   |
|                                                                  |   |                                              |    |                                                      |   |   |   |   |   |
| Per  Share Data:                                                      |   |                                              |    |                                                      |   |   |   |   |   |
| Net  (loss) - basic                                                   |   | $                                                 | (0.17   | )                                                         | $      | (0.01 | ) | $ | (0.06 | ) | $ | (0.09 | ) |
| Net  (loss) - diluted                                                 |   | $                                                 | (0.17   | )                                                         | $      | (0.01 | ) | $ | (0.06 | ) | $ | (0.09 | ) |
| Book  value                                                           |   |                                              |    |                                                      |   | 3.76 |   | 3.94 |   |
|                                                                  |   |                                              |    |                                                      |   |   |   |   |   |
| Other  Data                                                           |   |                                              |    |                                                      |   |   |   |   |   |
| Weighted  average shares outstanding - basic                          |   | 566,713                                           |    | 488,310                                                   |   | 543,691 |   | 483,908 |   |
| Weighted  average shares outstanding - diluted                        |   | 566,713                                           |    | 488,310                                                   |   | 543,691 |   | 483,908 |   |
|                                                                  |   |                                              |    |                                                      |   |   |   |   |   |
| Financial  Ratios:                                                    |   |                                              |    |                                                      |   |   |   |   |   |
| Equity  to assets                                                     |   |                                              |    |                                                      |   | 3.99 | % | 3.92 | % |
| Return  on average assets                                             |   |                                              |    |                                                      |   | -0.06 | % | -0.09 | % |
| Return  on average stockholders’ equity                          |   |                                              |    |                                                      |   | -1.49 | % | -2.27 | % |
| Net  interest margin                                                  |   |                                              |    |                                                      |   | 3.50 | % | 3.02 | % |
| Tier  1 leverage ratio                                                |   |                                              |    |                                                      |   | 8.53 | % | 8.35 | % |
| Tier  1 capital to risk-weighted assets                               |   |                                              |    |                                                      |   | 11.15 | % | 10.81 | % |
| Total  capital to risk-weighted assets                                |   |                                              |    |                                                      |   | 12.41 | % | 12.07 | % |
|                                                                  |   |                                              |    |                                                      |   |   |   |   |   |
| Asset  Quality Ratios:                                                |   |                                              |    |                                                      |   |   |   |   |   |
| Nonperforming  assets to total assets                                 |   |                                              |    |                                                      |   | 3.84 | % | 3.99 | % |
| Nonperforming  assets to total loans and and other real estated owned |   |                                              |    |                                                      |   | 5.17 | % | 5.49 | % |
| Allowance  for loan losses to total loans                             |   |                                              |    |                                                      |   | 2.13 | % | 1.89 | % |

 

3

----

 

**Northern Star Financial, Inc. andSubsidiary**

ConsolidatedStatements of Financial Condition

 
|                                                                                                                          |   | **December 31, 2003** |       | **June 30, 2003** |   |
|-------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|------------|------------------------|--------|
|                                                                                                                          |   | **(Unaudited)**            |       | **(Audited)**          |   |
| **ASSETS**                                                                                                                    |   |                       |       |                   |   |
|                                                                                                                          |   |                       |       |                   |   |
| Cash  and due from banks                                                                                                      |   | $                          | 1,742,579  |                   | $      | 2,377,132 |   |
| Federal  funds sold                                                                                                           |   | 4,505,000                  |       | 482,000                |   |
| Securities  available for sale, at fair value                                                                                 |   | 5,566,398                  |       | 6,113,088              |   |
| Securities  held for trading, at fair value                                                                                   |   | 68,343                     |       | 115,862                |   |
| Federal  Home Loan Bank and United Bankers Bank stock, at cost                                                                |   | 367,100                    |       | 367,100                |   |
| Loans  held for sale                                                                                                          |   | 491,610                    |       | 2,035,176              |   |
| Loans  receivable, net of allowance for loan and lease losses of $796,564 and  $1,029,581                                     |   | 36,547,679                 |       | 38,852,128             |   |
| Accrued  interest receivable                                                                                                  |   | 240,681                    |       | 282,416                |   |
| Property  and equipment, net of depreciation                                                                                  |   | 497,580                    |       | 503,397                |   |
| Other  assets                                                                                                                 |   | 291,986                    |       | 124,363                |   |
| **Total Assets**                                                                                                              |   | $                          | 50,318,956 |                   | $      | 51,252,662 |   |
|                                                                                                                          |   |                       |       |                   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                 |   |                       |       |                   |   |
| **Liabilities:**                                                                                                              |   |                       |       |                   |   |
| Demand  deposits                                                                                                              |   | $                          | 3,662,162  |                   | $      | 5,090,364 |   |
| NOW  and money market                                                                                                         |   | 8,567,907                  |       | 8,623,932              |   |
| Savings                                                                                                                       |   | 6,252,942                  |       | 4,630,763              |   |
| Time  deposits                                                                                                                |   | 22,586,450                 |       | 23,083,651             |   |
| Total  deposits                                                                                                               |   | 41,069,461                 |       | 41,428,710             |   |
| Notes  payable and other borrowings                                                                                           |   | 5,225,000                  |       | 5,975,000              |   |
| Convertible  subordinated notes payable                                                                                       |   | 1,600,000                  |       | 1,600,000              |   |
| Accrued  interest payable and other                                                                                           |   | 287,664                    |       | 334,818                |   |
| Total  Liabilities                                                                                                            |   | 48,182,125                 |       | 49,338,528             |   |
|                                                                                                                          |   |                       |       |                   |   |
| **Stockholders’ Equity:**                                                                                                |   |                       |       |                   |   |
| Common  stock, $.01 par value, 15,000,000 shares authorized; 568,506 and 519,506  shares issued and outstanding, respectively |   | 5,685                      |       | 5,195                  |   |
| Undesignated  stock, par value $.01 per share; 5,000,000 shares authorized, no shares  issued                                 |   | —                     |       | —                 |   |
| Additional  paid in capital                                                                                                   |   | 4,647,114                  |       | 4,378,104              |   |
| Accumulated  deficit                                                                                                          |   | (2,543,272                 | )          | (2,513,175             | )      |
| Unearned  stock compensation                                                                                                  |   | (6,005                     | )          | (8,005                 | )      |
| Accumulated  other comprehensive income                                                                                       |   | 33,309                     |       | 52,015                 |   |
| **Total Stockholders’ Equity**                                                                                           |   | 2,136,831                  |       | 1,914,134              |   |
| **Total Liabilities and Stockholders’ Equity**                                                                           |   | $                          | 50,318,956 |                   | $      | 51,252,662 |   |

 

See Notes toConsolidated Financial Statements

 

4

----

 

**NorthernStar Financial, Inc. and Subsidiary**UnauditedConsolidated Statements of Operations

 
|                                               |   | **For the Three Months  Ended December 31,** |    | **For the Six Months  Ended December 31,** |   |
|----------------------------------------------------|--------|---------------------------------------------------|---------|-------------------------------------------------|--------|
|                                               |   | **2003**                                          |    | **2002**                                        |   | **2003** |   | **2002** |   |
| **Interest income:**                               |   |                                              |    |                                            |   |   |   |   |   |
| Loans  receivable                                  |   | $                                                 | 646,148 |                                            | $      | 626,252 |   | $ | 1,286,448 |   | $ | 1,261,408 |   |
| Securities  available for sale                     |   | 51,760                                            |    | 70,883                                          |   | 102,875 |   | 168,159 |   |
| Federal  funds sold                                |   | 8,206                                             |    | 7,874                                           |   | 15,385 |   | 18,979 |   |
| Total  interest income                             |   | 706,114                                           |    | 705,009                                         |   | 1,404,708 |   | 1,448,546 |   |
|                                               |   |                                              |    |                                            |   |   |   |   |   |
| **Interest expense:**                              |   |                                              |    |                                            |   |   |   |   |   |
| Deposits                                           |   | 217,203                                           |    | 297,359                                         |   | 452,049 |   | 620,662 |   |
| Borrowed  funds                                    |   | 73,849                                            |    | 73,974                                          |   | 151,196 |   | 155,157 |   |
| Total  interest expense                            |   | 291,052                                           |    | 371,333                                         |   | 603,245 |   | 775,819 |   |
|                                               |   |                                              |    |                                            |   |   |   |   |   |
| Net  interest income                               |   | 415,062                                           |    | 333,676                                         |   | 801,463 |   | 672,727 |   |
| Provision  for loan losses                         |   | 1,405                                             |    | 7,700                                           |   | 16,605 |   | 28,700 |   |
|                                               |   |                                              |    |                                            |   |   |   |   |   |
| Net  interest income after provision for loan loss |   | 413,657                                           |    | 325,976                                         |   | 784,858 |   | 644,027 |   |
|                                               |   |                                              |    |                                            |   |   |   |   |   |
| **Non-interest income:**                           |   |                                              |    |                                            |   |   |   |   |   |
| Other  fees and service charges                    |   | 38,110                                            |    | 43,509                                          |   | 90,158 |   | 87,934 |   |
| Gain  on sale of securities                        |   | 4,239                                             |    | 379                                             |   | 17,999 |   | 3,504 |   |
| Gain  on sale of loans                             |   | 71,587                                            |    | 275,717                                         |   | 295,103 |   | 381,403 |   |
| Total  non-interest income                         |   | 113,936                                           |    | 319,605                                         |   | 403,260 |   | 472,841 |   |
|                                               |   |                                              |    |                                            |   |   |   |   |   |
| **Non-interest expense:**                          |   |                                              |    |                                            |   |   |   |   |   |
| Compensation  and employee benefits                |   | 249,010                                           |    | 293,294                                         |   | 525,714 |   | 514,999 |   |
| Board  fees                                        |   | 32,000                                            |    | 31,500                                          |   | 55,500 |   | 54,500 |   |
| Occupancy                                          |   | 48,514                                            |    | 44,983                                          |   | 94,633 |   | 84,856 |   |
| Printing  & supplies                           |   | 24,194                                            |    | 23,142                                          |   | 43,604 |   | 44,644 |   |
| Property  and equipment depreciation               |   | 19,616                                            |    | 18,981                                          |   | 39,387 |   | 36,854 |   |
| Data  processing                                   |   | 39,467                                            |    | 43,577                                          |   | 79,617 |   | 75,516 |   |
| Professional  fees                                 |   | 114,027                                           |    | 60,498                                          |   | 189,488 |   | 136,056 |   |
| Other                                              |   | 97,007                                            |    | 134,251                                         |   | 190,272 |   | 213,314 |   |
| Total  non-interest expense                        |   | 623,835                                           |    | 650,226                                         |   | 1,218,215 |   | 1,160,739 |   |
|                                               |   |                                              |    |                                            |   |   |   |   |   |
| **(Loss) before income tax benefit**               |   | (96,242                                           | )       | (4,645                                          | )      | (30,097 | ) | (43,871 | ) |
| Income  tax benefit                                |   | —                                            |    | —                                          |   | — |   | — |   |
|                                               |   |                                              |    |                                            |   |   |   |   |   |
| **Net (loss)**                                     |   | $                                                 | (96,242 | )                                               | $      | (4,645 | ) | $ | (30,097 | ) | $ | (43,871 | ) |
|                                               |   |                                              |    |                                            |   |   |   |   |   |
| **Net (loss) per common share**                    |   |                                              |    |                                            |   |   |   |   |   |
| Basic  and diluted (loss) per share of comon stock |   | $                                                 | (0.17   | )                                               | $      | (0.01 | ) | $ | (0.06 | ) | $ | (0.09 | ) |

 

See Notes toConsolidated Financial Statements

 

5

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**NorthernStar Financial, Inc. and Subsidiary**

 
|                                                                       |   | **For  the Three Months  Ended December 31,** |      | **For  the Six Months  Ended December 31,** |   |
|----------------------------------------------------------------------------|--------|-----------------------------------------------|-----------|---------------------------------------------|--------|
|                                                                       |   | **2003**                                      |      | **2002**                                    |   | **2003** |   | **2002** |   |
| Cash flows  from operating activities:                                     |   |                                          |      |                                        |   |   |   |   |   |
| RECONCILIATION OF NET  (LOSS) TO NET CASH PROVIDED BY OPERATING ACTIVITIES |   |                                          |      |                                        |   |   |   |   |   |
| Net (loss)                                                                 |   | $                                             | (96,242   | )                                           | $      | (4,645 | ) | $ | (30,097 | ) | $ | (43,871 | ) |
| Adjustments:                                                               |   |                                          |      |                                        |   |   |   |   |   |
| Depreciation                                                               |   | 23,333                                        |      | 22,122                                      |   | 46,821 |   | 43,120 |   |
| Provision for loan losses                                                  |   | 1,405                                         |      | 7,700                                       |   | 16,605 |   | 28,700 |   |
| Increase in value of  trading securities                                   |   | (2,073                                        | )         | —                                      |   | (2,073 | ) |   |   |
| Accretion and  (amortization) of premiums and discounts, net               |   | (1,340                                        | )         | 650                                         |   | (1,237 | ) | 1,155 |   |
| Stock compensation earned                                                  |   | 1,000                                         |      | 998                                         |   | 2,000 |   | 1,998 |   |
| Gain on sale of investments                                                |   | (2,166                                        | )         | (379                                        | )      | (15,926 | ) | (3,504 | ) |
| Defered loan fees                                                          |   | (30,978                                       | )         | 19,502                                      |   | (16,843 | ) | 40,812 |   |
| Originations of loans held  for sale                                       |   | (10,386,531                                   | )         | (13,755,294                                 | )      | (25,058,195 | ) | (21,159,387 | ) |
| Proceeds from sales of  loans held for sale                                |   | 10,840,598                                    |      | 13,916,474                                  |   | 26,601,762 |   | 20,124,032 |   |
| Other                                                                      |   | (43,987                                       | )         | 77,547                                      |   | (125,025 | ) | 141,442 |   |
| Net cash provided by (used  in) operating activities                       |   | $                                             | 303,019   |                                        | $      | 284,675 |   | $ | 1,417,792 |   | $ | (825,503 | ) |
|                                                                       |   |                                          |      |                                        |   |   |   |   |   |
| Cash flows from investing  activities:                                     |   |                                          |      |                                        |   |   |   |   |   |
| Purchases of  available-for-sale securities                                |   | (1,339,375                                    | )         | (1,509,375                                  | )      | (2,024,733 | ) | (1,509,375 | ) |
| Proceeds from maturities of  available-for-sale securities                 |   | 879,285                                       |      | —                                      |   | 1,388,669 |   | 500,000 |   |
| Proceeds from sales of  available-for-sale securities                      |   | —                                        |      | 2,146,839                                   |   | 1,202,406 |   | 5,969,220 |   |
| Proceeds from  sale/maturities of trading securities                       |   | 9,384                                         |      | —                                      |   | 15,926 |   | — |   |
| Purchase of restricted  stock                                              |   | —                                        |      | —                                      |   | — |   | (45,000 | ) |
| Net increase in federal  funds sold                                        |   | (655,000                                      | )         | (782,000                                    | )      | (4,023,000 | ) | (3,075,000 | ) |
| Loan originations and  principal payments on loans, net                    |   | (225,855                                      | )         | (1,313,982                                  | )      | (2,269,141 | ) | (2,026,609 | ) |
| Purchase of property and  equipment                                        |   | (27,242                                       | )         | (9,922                                      | )      | (41,004 | ) | (32,878 | ) |
| Net cash provided used in  investing activities                            |   | (1,358,803                                    | )         | (468,440                                    | )      | (1,212,595 | ) | (219,642 | ) |
|                                                                       |   |                                          |      |                                        |   |   |   |   |   |
| Cash flows from financing  activities:                                     |   |                                          |      |                                        |   |   |   |   |   |
| Net increase in  non-interest bearing demand and savings deposit accounts  |   | 2,353,376                                     |      | 1,125,449                                   |   | 137,951 |   | 1,639,690 |   |
| Net increase (decrease) in  time deposits                                  |   | (900,445                                      | )         | 88,568                                      |   | (497,201 | ) | (12,552 | ) |
| Proceeds from other  borrowings                                            |   | —                                        |      | —                                      |   | — |   | 100,000 |   |
| Repayments of other  borrowings                                            |   | (750,000                                      | )         | —                                      |   | (750,000 | ) | (300,000 | ) |
| Proceeds from sale of  common stock                                        |   | 143,000                                       |      | 82,500                                      |   | 269,500 |   | 82,500 |   |
| Net cash provided by (used  in) financing activities                       |   | 845,931                                       |      | 1,296,517                                   |   | (839,750 | ) | 1,509,638 |   |
| Net increase (decrease) in  cash                                           |   | (209,853                                      | )         | 1,112,752                                   |   | (634,553 | ) | 464,493 |   |
| Cash and cash equivalents  at beginning of period                          |   | 1,952,432                                     |      | 1,699,822                                   |   | 2,377,132 |   | 2,348,081 |   |
| Cash and cash equivalents  at end of period                                |   | $                                             | 1,742,579 |                                        | $      | 2,812,574 |   | $ | 1,742,579 |   | $ | 2,812,574 |   |
|                                                                       |   |                                          |      |                                        |   |   |   |   |   |
| Supplemental disclosure of  cash flow information:                         |   |                                          |      |                                        |   |   |   |   |   |
| Cash paid for interest                                                     |   | $                                             | 381,602   |                                        | $      | 437,842 |   | $ | 636,727 |   | $ | 802,968 |   |
|                                                                       |   |                                          |      |                                        |   |   |   |   |   |
| Supplemental disclosure of  non-cash investing and financing activities:   |   |                                          |      |                                        |   |   |   |   |   |
| Renewal of convertible  subordinated notes                                 |   | $                                             | 100,000   |                                        | $      | — |   | $ | 100,000 |   | $ | — |   |

 

Unaudited ConsolidatedStatements of Cash Flows

See Notes to ConsolidatedFinancial Statements

 

## **NORTHERN STAR FINANCIAL,INC AND SUBSIDIARY**

## **NOTESTO CONDENSED CONDOLIDATED FINANCIAL STATEMENTS**

**December 31, 2003 (Unaudited)**

 

Note 1:  PRINCIPLES OFCONSOLIDATION

 

The unaudited consolidated financial statements as ofand for the three and six month period ended December 31, 2003 include theaccounts of Northern Star Financial, Inc. (the “Company”) and its wholly ownedsubsidiary Northern Star Bank (the “Bank”). All significant inter-company accounts and transactions have beeneliminated in consolidation.

 

6

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Note 2:  BASIS OF PRESENTATION

 

The accompanying unaudited interim consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial information.  Accordingly,they do not include all information and disclosures required by generallyaccepted accounting principles for complete financial statements.  The accompanying consolidated financialstatements do not purport to contain all the necessary financial disclosuresrequired by generally accepted accounting principles that might otherwise benecessary in the circumstances and should be read with the fiscal 2003consolidated financial statements and notes of Northern Star Financial, Inc.and Subsidiary included in their annual report as of and for the year endedJune 30, 2003.

 

In the opinion of management, all adjustments (consistingof normal recurring accruals) considered necessary for fair presentations havebeen included.  The results ofoperations for three and six month periods ended December 31, 2003 and 2002,are not necessarily indicative of the results that may be expected for theentire fiscal year or any other interim period.

 

The presentationof the unaudited consolidated statement of cash flows for the three and sixmonths ended December 31, 2002 has been changed to conform with theclassifications used in 2003.  Thesereclassifications had no effect on net cash provided by (used in) operatingactivities or cash equivalents as previously reported.

 

Note 3:  EARNINGS PER SHARE

 

The earnings per share amounts were computed using theweighted average number of shares outstanding during the periodspresented.  For the six month periodsending December 31, 2003 and 2002 the weighted average number of sharesoutstanding for basic and diluted earnings per share computation were 543,691and 483,908, respectively. As of December 31, 2003 and 2002, of the potentialcommon shares of 310,094 and 303,083, respectively, related to stock options,warrants, and convertible subordinated notes payable, 302,010 and 297,078,respectively, were exercisable and anti-dilutive.

 

During the quarter ended December 31, 2003 there wereno options granted. During the quarter ended December 31, 2002 there were19,500 options granted.

 

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Note 4:    COMPREHENSIVE INCOME(LOSS)

 
|                                                    |   | **For the Six Months  Ended December 31,** |    |
|---------------------------------------------------------|--------|--------------------------------------------|---------|
|                                                    |   | **2003**                                   |    | **2002** |   |
| Accumulated comprehensive income (loss)                 |   |                                       |    |   |   |
| in composted of the following:                          |   |                                       |    |   |   |
|                                                    |   |                                       |    |   |   |
| Unrealized gains (losses) on securities                 |   |                                       |    |   |   |
| Beginning balance                                       |   | $                                          | 52,015  |   | $ | 52,728 |   |
| Current-period change net of tax                        |   | (18,706                                    | )       | (17,263 | ) |
| Ending balance                                          |   | $                                          | 33,309  |   | $ | 35,465 |   |
|                                                    |   |                                       |    |   |   |
| Comprehensive income (loss) consists of the  following: |   |                                       |    |   |   |
| Net income (loss)                                       |   | $                                          | (30,097 | ) | $ | (43,871 | ) |
| Other comprehensive income (loss)                       |   | (18,706                                    | )       | (17,263 | ) |
| Comprehensive income (loss)                             |   | $                                          | (48,803 | ) | $ | (61,134 | ) |

 

Note 5:  STOCK OPTION ACCOUNTING

 

The Company accounts for stock options under theintrinsic value method of recognition and measurement principles of APB OpinionNo. 25, *Accountingfor Stock Issued to Employees*, and related interpretations.  No stock-based employee compensation cost isreflected in net income (loss), as all options granted under those plans had anexercise price equal to the market value of the underlying common stock on thedate of the grant.  Statement of FinancialAccounting Standards No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure*, is effective for the interim period beginning afterDecember 15, 2002 and requires pro-forma net income (loss) and earnings (loss)per share disclosures on a quarterly basis. The following table illustrates the effect on net income (loss) andearnings (loss) per share as if the Company had applied the fair valuerecognition provision of FASB Statement No. 123, *Accounting for Stock Based Compensation*,to stock-based employee compensation.

 
|                                                                                                                                     |   | **Three  Months  Ended December 31** |    | **Six Months  Ended December 31** |   |
|------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|---------|-----------------------------------|--------|
|                                                                                                                                     |   | **2003**                             |    | **2002**                          |   | **2003** |   | **2002** |   |
|                                                                                                                                     |   |                                 |    |                              |   |   |   |   |   |
| Net income (loss), as reported                                                                                                           |   | $                                    | (96,242 | )                                 | $      | (4,645 | ) | $ | (30,097 | ) | $ | (43,871 | ) |
| Deduct:                                                                                                                                  |   |                                 |    |                              |   |   |   |   |   |
| Total stock-based employee compensation expense determined under the  fair value based method for all awards, net of related tax effects |   | 1,726                                |    | —                            |   | 3,452 |   | — |   |
|                                                                                                                                     |   |                                 |    |                              |   |   |   |   |   |
| Pro-forma net income (loss)                                                                                                              |   | $                                    | (97,968 | )                                 | $      | (4,645 | ) | $ | (33,549 | ) | $ | (43,871 | ) |
|                                                                                                                                     |   |                                 |    |                              |   |   |   |   |   |
| Earnings (loss) per share:                                                                                                               |   | $                                    | (0.17   | )                                 | $      | (0.01 | ) | $ | (0.06 | ) | $ | (0.09 | ) |
| Basic, as reported                                                                                                                       |   | $                                    | (0.17   | )                                 | $      | (0.01 | ) | $ | (0.06 | ) | $ | (0.09 | ) |
| Basic, pro-forma                                                                                                                         |   | $                                    | (0.17   | )                                 | $      | (0.01 | ) | $ | (0.06 | ) | $ | (0.09 | ) |
| Diluted, as reported                                                                                                                     |   | $                                    | (0.17   | )                                 | $      | (0.01 | ) | $ | (0.06 | ) | $ | (0.09 | ) |
| Diluted, pro-forma                                                                                                                       |   |                                 |    |                              |   |   |   |   |   |
|                                                                                                                                     |   |                                 |    |                              |   |   |   |   |   |
| Basic Shares                                                                                                                             |   | 566,713                              |    | 488,310                           |   | 543,691 |   | 483,908 |   |
|                                                                                                                                     |   |                                 |    |                              |   |   |   |   |   |
| Diluted Shares                                                                                                                           |   | 566,713                              |    | 488,310                           |   | 543,691 |   | 483,908 |   |

 

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Note 6:  CONTINGENCIES

 

The Federal Deposit Insurance Corporation (FDIC)conducted its annual Safety and Soundness Examination of the Bank during thefirst quarter of 2004 and has issued its report thereon.  This report specifies a variety of financialand operational actions to be taken by the Bank, some of which the Bank did notconcur with and, as a result, is exploring with the FDIC alternative means ofaddressing their concerns.  The ultimateresolution of these matters and their effects on the financial statements, ifany, cannot be determined at this time. While the occurrence of a material loss in connection with therequirements of the FDIC in this regard is a reasonable possibility, managementanticipates that it is unlikely that such a loss will occur.

 

**ITEM 2:  MANAGEMENT’S DISCUSSION AND ANALYSISOR PLAN OF OPERATION**

 

Northern Star Financial, Inc.(the “Company”) is the bank holding company of Northern Star Bank (the“Bank”).  Since the principal businessof the Company is the Bank, the following discussion pertains mainly to the Bank.

 

The following is management’sdiscussion and analysis of the major factors that influenced the financialperformance of the Bank for the three and six months ended December 31,2003.  This analysis should be read in conjunction with the Company’s 2003Annual Report as filed on form 10-KSB and with the unaudited financialstatements and notes as set forth in this report.

 

Certain statementscontained in this Report, including, without limitation, statements containingthe words “believes”, “anticipates”, “intends”, “expects”, and words of similarimport, constitute “forward-looking statements” within the meaning of Section27A of the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934.  Such forward looking statements involve known and unknownrisks, uncertainties and other factors that may cause the actual results,performance or achievements of the Company to be materially different from anyfuture results, performance or achievements expressed or implied by suchforward-looking statements.  Such factors include, among others, thefollowing: general economic and business conditions in those areas in which theCompany operates, demographic changes, competition, fluctuations in interestrates, changes in business strategy or development plans, changes ingovernmental regulation, the outcomes of pending and future litigation andcontingencies, credit quality, the availability of capital to fund theexpansion of the Company’s business, economic, political and global changes.  The Company disclaims any obligation toupdate any such factors or to publicly announce the results of any revisions toany of the forward-looking statements contained herein to reflect future eventsor developments.

 

This discussion should beread in conjunction with the financial statements of the Company, including thenotes thereto, appearing elsewhere in this report.

 

### **CRITICALACCOUNTING POLICIES**

### ** **

We have adopted accounting principles generallyaccepted in the United States of

 

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America (GAAP) in the preparation of our financialstatements.  The financial informationcontained within our financial statements is, to a significant extent, based onapproximate measures of the financial effects of transactions and events thathave already occurred.  Our significantaccounting policies are described in the notes to the consolidated financialstatements at June 30, 2003 as filed in our annual report on Form 10-KSB.Certain accounting policies involve significant judgments and assumptions by usand have a material impact on the carrying value of certain assets andliabilities. We consider these accounting policies to be critical accountingpolicies. The judgments and assumptions we use are based on the historical experienceand other factors, which we believe to be reasonable under the circumstances.Because of the nature of the judgments and assumptions we make, actual resultscould differ from these judgments and estimates which could have a major impacton our carrying values of assets and liabilities and on our results ofoperations. A variety of factors could affect the ultimate value that isobtained either when earning income, recognizing an expense, recovering anasset or relieving a liability. In certain instances, the Company uses thediscount factor and prepayment assumptions to determine the present value ofassets and liabilities. A change in the discount factor or prepayment spreadscould increase or decrease the values of those assets and liabilities which wouldresult in either a beneficial or adverse impact to the Company’s financialresults.  Other estimates that theCompany uses are related to the expected useful lives of the Company’sdepreciable assets. In addition, GAAP itself may change from one previouslyacceptable method to another method. Although the economics of the Company’stransactions would be the same, the timing of events that would impact theCompany’s transactions could change.

 

The Company accounts for its stock based awards usingthe intrinsic value method in accordance with Accounting Principles Board (APB)Opinion No. 25 and related interpretations. Since the Company’s stock optionplans provide for the issuance of options at a price of no less than the fairmarket value at the date of the grant, no compensation expense has beenrecognized in the financial statements at the date of grant.

 

We believe the allowancefor loan losses is a critical accounting policy that requires the mostsignificant judgments and estimates used in preparation of our consolidatedfinancial statements.  The allowance forprobable loan losses is an estimate of the losses that may be sustained in theCompany’s loan portfolio. The allowance is based on two basic principles ofaccounting. (1) Statement of Financial Accounting Standards (SFAS) No. 5 *Accounting for Contingencies*, whichrequires that losses be accrued when they are probable of occurring andestimable and (2) SFAS No. 114, *Accountingby Creditors for Impairment of a Loan*, which requires that losses beaccrued based on the differences between the value of collateral, present valueof future cash flows or values that are observable in the secondary market andthe loan balance.

 

**RESULTS OF OPERATIONS**

 

**Net Income**

 

The Company’s net operating loss was $96,242 and$30,097 for the three and six months ended December 31, 2003 compared to a lossof $4,645 and $43,871 for the three and six months ended December 31, 2002,respectively.  Basic and dilutedearnings per share were $(0.17) and

 

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$(0.01) for the three months ended December 31, 2003and 2002, respectively.  The decrease in earnings was led by a decline in mortgage refinanceactivity that produced a 22.63% decrease in gains on the sale of mortgage loanswhen compared with the same six-month period a year ago.  The decrease in gain on sale of loans wasoffset by a $128,736 increase in net interest income, which in turn wascounteracted by a $23,042 decrease in other operating expenses. The lower level of gains on mortgage loanssold during the six months ended December 31, 2003 as compared to the sameperiod of the prior fiscal year are the result of customer reaction to a lessfavorable interest rate environment, and management does not expect these gainsto continue to the same extent in the current rate environment. Netinterest income increased due to an increase in net interest margin.  Non-interest income decreased due to adecrease in the amount of residential mortgage loans originated and sold intothe secondary market.  Non-interestexpenses decreased during the three months ended December 31, 2003 due  to a decrease in the indirect cost incurredin connection with the decrease in the amount of residential mortgage loansoriginated and sold.  The decrease innon-interest expenses was lessened by a $53,529 increase in professional fessassociated with the on-going litigation that the Bank is involved in (see Item1 Legal Proceedings).

 

The return on average equity was(1.49)% for the six months ended December 31, 2003 compared to (2.27)% for thesix months ended December 31, 2002.  Return on average assets for the sixmonths ended December 31, 2003 was (0.06)% compared to (0.09)% for the sixmonths ended December 31, 2002.  The return on average equity was (12.13)%for fiscal year ended June 30, 2003.  The increase in the return onaverage assets from December 31, 2002 to December 31, 2003 was due to thedecrease in net losses noted above, which was the result of the 19.14% growthin net interest income, reduced by a 4.95% increase in non-interest expense anda 14.72% decrease in non-interest income.

 

**Interest Income**

 

Net interest income is asignificant component of the Bank’s income from operations.  Net interestincome is the difference between the gross interest earned on the loan andinvestment portfolios and the interest paid on deposits and otherborrowings.  Net interest income depends on the volume of and interestrate earned on interest earning assets and the volume of and interest rate paidon interest bearing liabilities.

 

Interest income for the threemonths ended December 31, 2003 remained relatively unchanged at $706,114,compared to $705,009 for the three months ended December 31,2002. Interest income for the six months ended December 31, 2003 was$1,404,708 compared to $1,448,546, for the six months ended December 31, 2002.Interest income was relatively unchanged when compared to the prior periods asthe level of interest earning assets was unchanged from the prior period end.  Interest earning assets include loanreceivables, securities available for sale and federal funds sold.  Net interest income increased by $81,386 or24.39% for the three-month period ended December 31, 2003 when compared to theprior period and by $128,736 or 19.14% for the six month period as compared tothe six month period ended December 31, 2002. The improvement in net interest income was the result of decreases ininterest expense on deposits and borrowed funds. Our net interest marginimproved 58 basis points to 3.65% for the three months ended December 31, 2003from a margin of 3.07% for the three months ended December 31, 2002 despite adecline of 29 basis points in the yield on

 

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interestearning assets.  The yield on interestearning assets decreased to 6.20% for the three months ended December 31, 2003compared to  6.49% for the three monthsended December 31, 2002.

 

#### **Interest Expense**

#### ** **

Interest expense for the threemonths ended December 31, 2003 decreased to $291,052 compared to $371,333 forthe three months ended December 31, 2002.  Interest expense for the sixmonths ended December 31, 2003 decreased to $603,245 compared to $775,819 forthe six months ended December 31, 2002.  This decrease was due to a lowerlevel of interest rates on interest bearing liabilities that resulted from andwas aided by an initiative undertaken by the Company to reduce its average costof funds.  Due to the decline in the rates of interest paid by the Bank,the cost of deposits declined from 3.35% to 2.38%, for the three months endedDecember 31, 2002 and 2003, respectively, and 3.48% to 2.46% for the six monthsended December 31, 2002 and 2003, respectively. The cost of notes payableand other borrowings declined from 4.57% to 4.06%, for the three months endedDecember 31, 2002 and 2003, respectively and 4.70% to 4.07% for the six monthsended December 31, 2002 and 2003, respectively.  Average interest-bearingdeposits increased to $36.51 million compared to $35.51 million for the threemonths ended December 31, 2003 and 2002, respectively, while they increased to$36.78 million compared to $35.69 million for the six months ended December 31,2003 and 2002, respectively.

 

**Net Interest Income Before Provision for Estimated Loan Losses**

 

Net interest income beforeprovision for estimated loan losses for the three months ended December 31,2003 was $415,062, compared to $333,676 for the three months ended December 31,2002.  For the six months ended December 31, 2003 and 2002, net interestincome before provision for estimated loan losses was $801,463 and $672,727,respectively.  Average interest earningassets were $45.54 million for the three months ended December 31, 2003 with ayield of 6.20% compared to $43.47 million with a yield of 6.49% for the threemonths ended December 31, 2002. Average interest earning assets were $45.79million for the six months ended December 31, 2003 with a yield of 6.14%compared to $44.57 million with a yield of 6.50% for the six months endedDecember 31, 2002.

 

**Provision for Estimated Loan Losses**

 

The provision for estimated loanlosses totaled $1,405 for the three months ended December 31, 2003 compared to$7,700 for the three months ended December 31, 2002 and was $16,605 for the sixmonths ended December 31, 2003 compared to $28,700 for the six months endedDecember 31, 2002.   The provision for estimated loan losses totaled$373,937 for the fiscal year ended June 30, 2003.

 

**Other Operating Income**

 

Other operating incomerepresents non-interest types of revenue and is comprised of net gain on saleof loans, loan servicing fees, customer service charges and other feeincome.  Other operating income was$113,936 and $319,605 for the three months ended December 31, 2003 and 2002,respectively.  Other operating incomewas $403,260 and $472,841 for the six months ended December 31, 2003 and 2002,respectively.

 

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The Bank’s current policy is tosell in the secondary market all residential mortgage loans with a fixedinterest rate and with a re-pricing term of more than five years.  Mortgage loans originated and intended forsale are carried at the lower of cost or estimated market value in theaggregate.  Gains on the sale of loansare based on the net proceeds received and the recorded investment in theloan.  Net gain on sale of loansdecreased from $275,717 to $71,587 for the three months ended December 31, 2002and 2003, respectively. For the six-month periods ended December 31, 2002 and2003, respectively, there was a decrease from $381,403 to $295,103.  Netgain on sale of loans for the fiscal year ended June 30, 2003 was $865,581.

 

During the three months endedDecember 31, 2003, the Bank originated for sale $10.39 million in residentialmortgage loans as compared to $13.76 million during the three months endedDecember 31, 2002.  The Bank sold 100%, of the residential real estateloans originated during the three-month periods ended December 31, 2003 andDecember 31, 2002.  Based upon current forecasts of interest rates,management anticipates that the Bank’s volume of residential mortgage lendingis likely to fall appreciably during the third quarter of the current fiscalyear.

 

Other fee income and servicecharges decreased from $43,509 for the three months ended December 31, 2002 to$38,110 for the three months ended December 31, 2003. For the six monthperiods ending December 31, 2002 and 2003, other fee income and service chargesincreased from $87,934 to $90,158, respectively.   The changes are the result of fluctuationsin the volume of fees earned that are associated with current period loan fees,check cashing and other service charges.

 

**Non-Interest Expenses**

 

Other operating expenses arenon-interest types of expenses and are incurred by the Company and the Bank inits normal course of business.  Salaries and employee benefits, boardfees, occupancy, premises and equipment, data processing, professionalservices, and other expenses are the major categories of other operatingexpenses.  For thethree-month period ending December 31, 2003 total non-interest expensedecreased $26,391 or 4.06% over the same period ended December 31, 2002, whiletotal non-interest expense increased $57,476, or 4.95%, when comparing thesix-month periods ended December 31, 2003 and 2002. For the six-month periodending December 31, 2003 salary and benefit expense increased $10,715, or2.08%, over the comparable six-month period ending December 31, 2002, this wasthe result of an increase in employee benefit expenses, combined with anincrease in volume of mortgage lending and the related incentive expense.

 

For the three-month periodending December 31, 2003, occupancy expenses increased $3,531 or 7.85%, whileduring the six-month period ending December 31, 2003, occupancy expensesincreased $9,777, or 11.52% compared to the same periods in 2002. This increaseis due in part to the expansion in the St. Cloud office. Other non-interestexpenses decreased $23,042 or 10.80%, when comparing the six-month period endedDecember 31, 2003 to the six-month period ended December 31, 2002. For thesix-month period ending December 31, 2003 legal and other professional feesincreased $53,432 or 39.27% over the comparable period ending December 31,2002. The increase in these expenses is associated with an increase inactivity relating to the litigation previously noted.

 

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**Provision for Income Taxes**

 

The effective income tax rate for the Company was 0%for the three and six months ended December 31, 2003 and 2002 because theexpected future tax benefit of the net operating loss is reduced by a deferredtax asset valuation allowance in accordance with generally accepted accountingprinciples.

 

**FINANCIAL CONDITION**

 

**Summary of Changes in Consolidated Balance Sheets**

**December 31, 2003 compared to December 31, 2002 and June 30,2003**

 

Total assets of the Bankincreased to $50.32 million as of December 31, 2003 compared to $50.14 millionas of December 31, 2002. Total assets of the Bank decreased $0.93 million or1.82% when compared to the $51.25 million as of June 30, 2003.  Managementattributes the decrease in total assets occurring during the six month periodended December 31, 2003 to the lower level of loans held for sale resultingfrom a reduction in the volume of residential mortgage lending activityassociated with refinancing activity in its market.

 

The level of total deposits heldat the Bank, were for the most part unchanged at $41.07 million as of December31, 2003 compared to $41.22 million of December 31, 2002.  Total deposits decreased $360 thousand whencomparing the quarter ending December 31, 2003 with the previous fiscal yearend June 30, 2003.  Cash and cash equivalents decreased to $1.74 millionas of December 31, 2003 compared to $2.81 million as of December 31, 2002 anddeclined $630 thousand when compared to the $2.38 million held as of June 30,2003.

 

Stockholders’ equity was $2.14million as of December 31, 2003 compared to $1.95 million as of December 31,2002 and $1.91 million as of June 30, 2003.

 

**Investments**

 

The Bank’s investmentportfolio consists primarily of securities issued by agencies of the UnitedStates and overnight investments in the Federal Funds market. US Governmentagency securities, mortgaged back securities, and corporate bonds totaled $5.57million as of December 31, 2003 compared to $4.61 million as of December 31,2002 and were $6.11 million as of June 30, 2003. Federal Funds soldtotaled $4.51 million as of December 31, 2003 compared to $4.11 million as ofDecember 31, 2002 and were $480 thousand as of June 30, 2003.  Management attributes the fluctuations inthe investment portfolio during the periods to timing differences associatedwith securities maturing and reinvesting activities as well as to the level ofloans held for sale.

 

**Loans**

 

Loan balances, net of theallowance for loan losses, increased to $36.55 million as of December 31, 2003compared to $35.76 million as of December 31, 2002.  However, loan balances, net of the allowance for loan losses,decreased $2.30 million as of December 31, 2003 from $38.85 million as of June30 2003. The decrease in loan balances is attributed to the

 

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management’seffort to improve net interest margin.

 

**Non-performing Assets.**

 

Nonperforming assets consist ofnonperforming loans and other real estate owned (“OREO”) and other repossessedassets.  Nonperforming loans are those loans which have (i) been placed onnonaccrual status, (ii) been subject to troubled debt restructurings, or (iii)become contractually past due 90 days or more with respect to principal orinterest and have not been restructured or placed on nonaccrual status.  At December 31, 2003, the Bank had $2.16 millionin non-performing assets compared to $2.02 million at December 31, 2002, and$1.96 million at June 30, 2003.

 

**Nonaccrual Loans.**

 

Nonaccrual loans are impairedloans where the original contractual amount may not be fully collectible. The Bank measures its impaired loans by using the fair value of the collateralif the loan is collateral-dependent and the present value of the expectedfuture cash flows discounted at the loan’s effective interest rate if the loanis not collateral-dependent.  The Bank places loans on nonaccrual statusthat are delinquent 90 days or more or when a reasonable doubt exists as to thecollectibility of all payments due under the terms of the loan.  As of December 31, 2003 the Bank had 9 loanson nonaccrual status totaling $1.93 million, at June 30, 2003,  9 loans on nonaccrual status totaling $1.84million and as of December 31, 2002, the Bank had 9 loans on nonaccrual statustotaling $2.0 million.

 

**Classified Assets.**

 

From time to time, managementhas reason to believe that certain borrowers will not repay their loans withinthe parameters of the present repayment terms, even though, in some cases, theloans are current at the time. These loans are graded in the classified loangrades of “substandard,” “doubtful,” or “loss” and include non-performingloans.  Each classified loan is monitored monthly.  Classified assets(consisting of nonaccrual loans, loans graded as substandard or lower and otherrepossessed assets) at December 31, 2003 were $2.27 million compared to $1.84million as of December 31, 2002 and were $3.11 million at June 30, 2003.

 

**Allowance for Loan Losses.**

 

The Bank has established amethodology for the determination of provisions for loan losses.  Themethodology is set forth in a formal policy and takes into consideration theneed for an overall allowance for loan losses as well as specific allowancesthat are tied to individual loans.  The Bank’s methodology for assessingthe appropriateness of the allowance consists of several key elements, whichinclude the formula allowance and a specific allowance for identified problemloans.

 

In originating loans, the Bankrecognizes that losses will be experienced and that the risk of loss will varywith, among other things, the type of loan being made, the creditworthiness ofthe borrower over the term of the loan, general economic conditions and, in thecase of a secured loan, the quality of the collateral securing the loan. The allowance is increased by provisions charged against earnings and reducedby net loan charge-offs.  Loans are charged off when they are deemed to beuncollectable, or partially charged off when portions of a loan are deemed tobe uncollectable.   Recoveries are generally recorded only when cashpayments are received.

 

15

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The allowance for loan losses ismaintained to cover losses inherent in the loan portfolio.  Theresponsibility for the review of the Bank’s assets and the determination of theadequacy of the general valuation allowance lies with the Director’s LoanCommittee.  This committee assigns the loss reserve ratio for each type ofasset and reviews the adequacy of the allowance at least quarterly based on anevaluation of the portfolio, past experience, prevailing market conditions,amount of government guarantees, concentration in loan types and other relevantfactors.  Specific valuation allowances are established to absorb losseson loans for which full collectability may not be reasonably assured.  Theamount of the specific allowance is based on the estimated value of the collateralsecuring the impaired loans and other analyses pertinent to eachsituation.  Estimates of identifiable losses are reviewed continually and,generally, a provision for losses is charged against operations on a monthlybasis as necessary to maintain the allowance at an appropriate level. Management presents an analysis of the allowance for loan losses to the Bank’sBoard of Directors on a quarterly basis.

 

The Director’s LoanCommittee meets quarterly to review and monitor conditions in the portfolio andto determine the appropriate allowance for loan losses.  To the extentthat any of these conditions are evidenced by identifiable problem credit orportfolio segment as of the evaluation date, the committee’s estimate of suchcondition may be reflected as a specific allowance applicable to such credit orportfolio segment.  By assessing the probable estimated losses inherent inthe loan portfolio on a quarterly basis, the Bank is able to adjust specificand inherent loss estimates based upon the most recent information that hasbecome available.

 

As of December 31, 2003, thebalance in the allowance for loans losses was $796,564 compared to $688,519 asof December 31, 2002 and $1,029,581 as of June 30, 2003. The allowance forloan losses as a percentage of total loans was 2.13% as of December 31, 2003compared to 1.89% as of December 31, 2002 and 2.58% as of June 30,2003.  Management believes the allowance at December 31, 2003 isadequate based upon its ongoing analysis of the loan portfolio, historical losstrends, general economic conditions and other factors.

 

**Deposits and Borrowings**

 

Total deposits decreased to$41.07 million as of December 31, 2003 compared to $41.22 million as ofDecember 31, 2002 and $41.43 million as of June 30, 2003.  The decrease indeposits is the result of management’s efforts to decrease the Bank’s cost offunds and was accompanied by a decrease in the level of residential mortgageloans originated and held for sale.

 

Other borrowings totaled $5.23million as of December 31, 2003 and $5.98 million as of June 30, 2003, comparedto $4.98 million as of December 31, 2002.  Included in other borrowingsare advances from the FHLB and other banks.  The Bank established a lineof credit with the FHLB collateralized by loans and securities.  Fundsfrom the credit line were used to purchase government securities and increaseliquidity at the Bank.

 

In addition, the Company has issued $1.60 million of unsecuredsubordinated notes payable, the proceeds of which was used to provide equitycapital to the Bank and to pay the operating expenses of the Company.  The holders of the unsecured notes have theright to

 

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convertat any time prior to maturity all or any part of the notes into shares ofcommon stock of the Company at the conversion rate.  The conversion rate is adjusted if the number of shares changes.

 

**Capital**

 

The Company’s capital increasedto $4.65 million as of December 31, 2003 compared to $4.24 million as ofDecember 31, 2002 and was $4.38 million as of June 30, 2003.  For the sixmonth period ending December 31, 2003 the Company sold 49,000 shares of commonstock and received proceeds of $269,500.

 

Management considers capitalrequirements as part of its strategic planning process.  Based on currentprojections, management believes that the Bank will continue to remain wellcapitalized during 2003.  Future asset growth is dependent upon manyfactors, including the Bank’s access to capital markets, earnings growth, andoverall economic conditions.  The ability to obtain capital is dependentupon the capital markets as well as performance of the Bank.  Managementregularly evaluates sources of capital and the timing required to accomplishits strategic objectives.

 

At December 31, 2003 andDecember 31, 2002, all capital ratios were above all current Federal capitalguidelines for a “well capitalized” bank.   As of December 31, 2003,the Bank’s regulatory total capital to risk-weighted assets ratio was 12.41%compared to 12.07% as of December 31, 2002 and 11.60% as of June 30,2003.  The Bank’s regulatory Tier 1 capital to risk-weighted assets ratiowas 11.15% as of December 31, 2003 compared to 10.81% as of December 31, 2002and 10.33% as of June 30, 2003.  The Bank’s regulatory Tier 1 Capital toaverage assets ratio was 8.53% as of December 31, 2003 compared to 8.35% atDecember 31, 2003 and 8.04% at June 30, 2003.

 

**Dividends**

 

Whether or not the Board ofDirectors will determine stock dividends or any cash dividends will be paid inthe future depends upon their consideration of various factors.  TheCompany’s and the Bank’s profitability and regulatory capital ratios inaddition to other financial conditions will be key factors considered by theBoard of Directors in making such determinations regarding the payment ofdividends. There are state and federal statutory and regulatory requirementslimiting the amount of dividends that may be paid to the Company by ourBank.  Generally, a bank may pay cashdividends out of current operating earnings to the extent that the current rateof earnings retention is consistent with the Bank’s capital needs, assetquality, and overall financial condition. The governing regulatory agency has the authority to prohibit our Bankfrom engaging in business practices that the governing authority considers tobe unsafe or unsound.  It is possible,depending upon the financial condition of our Bank, that the governingregulatory agency may determine that the payment of dividends to the Company byour Bank might, under some circumstances, be such an unsafe and unsoundpractice.  Neither the Companynor the Bank has plans to pay any cash dividends to its stockholders in theforeseeable future.

 

**Liquidity and Interest Rate Risk**

 

The Bank utilizes electronic dataprocessing modeling software for liquidity,

 

17

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asset/liabilitymanagement, and budget modeling calculation and analysis.  Our use of these data processingapplications enable us to effectively identify, measure, monitor and controlour exposure to risk and help grow earnings.

 

The Bank closely monitors itsliquidity so that the cash requirements for loans and deposit withdrawals aremet in an economical manner.  Management monitors liquidity in relation totrends of loans and deposits for short term and long-term requirements. Liquidity sources are cash, deposits with other banks, overnight Federal Fundsinvestments, un-pledged  investmentsecurities, and the ability to sell loans. As of December 31, 2003, liquidassets as a percentage of deposits were 16.30% compared to 15.25% as ofDecember 31, 2002. Liquidity risk represents the potential for loss as aresult of limitations on the Company’s ability to adjust for future cash flows,to meet the needs of depositors and borrowers, and to fund operations on atimely and cost-effective basis. The Bank’s liquidity policy requires monthlyreview of the Bank’s liquidity by the board of directors.

 

The Bank had a negative cumulative one year gap of$9.70 million, or 19.28% of total assets, at December 31, 2003. In theory, thiswould indicate that more liabilities than assets would reprice if there were achange in interest rates over the next year. If interest rates were toincrease, the negative gap would tend to result in a lower net interest margin,conversely if interest rates were to decline, the negative gap would tend toresult in a higher net interest margin. However, changes in the mix of earningassets or supporting liabilities can either increase or decrease the netinterest margin without affecting interest rate sensitivity. Thischaracteristic is referred to as a basis risk and, generally, relates to there-pricing characteristics of certain short-term funding sources.

 

Interest rate changes do not affect all categories ofassets and liabilities equally or at the same time. Varying interest rateenvironments can create unexpected changes in prepayment levels of assets andliabilities, which may have a significant effect on the net interest margin andare not reflected in the interest sensitivity analysis table. Because of thesefactors, an interest sensitivity gap report may not provide a completeassessment of the exposure to changes in interest rates. To supplementtraditional gap analysis, the Company performs simulation modeling to estimatethe potential effects of changing interest rate environments. The processallows the Company to explore the complex relationships within the gap overtime and various interest rate environments.

 

The Company’s internal asset/liability committee andthe finance and investment committee of the Board of Directors each meetmonthly to monitor the Company’s investments, liquidity needs and to overseeits asset/liability management. The Company evaluates the rates offered on itsdeposit products on a weekly basis.

 

**AVERAGEBALANCES, YIELDS AND RATES**

 

The following table sets forth, for the three and six month periods endedDecember 31, 2003 and 2002, the weighted average yields or earned, the weightedaverage rates paid, the interest rate spread and the net yield on earningassets and interest-bearing liabilities, on an annualized basis.

 

18

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|                                                                              |   | **For the Three Months Ended** |       |
|-----------------------------------------------------------------------------------|--------|--------------------------------|------------|
|                                                                              |   | **December 31, 2003**          |       | **December 31, 2002** |   |
|                                                                              |   | **Average****Balance**         |       | **Interest** |   | **Average  Yield or****Rates Paid** |   | **Average****Balance** |   | **Interest** |   | **Average  Yield or****Rates Paid** |   |
| **Assets**                                                                        |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Loans  receivable                                                                 |   | $                              | 36,740,819 |   | $ | 646,148 |   | 7.03 | % | $ | 35,348,062 |   | $ | 626,252 |   | 7.09 | % |
| Investment  securities                                                            |   | 5,088,814                      |       | 51,760 |   | 4.07 | % | 5,516,189 |   | 70,883 |   | 5.14 | % |
| Federal  funds sold                                                               |   | 3,709,156                      |       | 8,206 |   | 0.88 | % | 2,603,647 |   | 7,874 |   | 1.21 | % |
| Total  interest-earning assets                                                    |   | 45,538,789                     |       | 706,114 |   | 6.20 | % | 43,467,898 |   | 705,009 |   | 6.49 | % |
| Non-interest-earning  assets                                                      |   | 3,947,321                      |       |   |   |   |   | 5,027,482 |   |   |   |   |   |
| Total  assets                                                                     |   | $                              | 49,486,110 |   |   |   |   |   | $ | 48,495,380 |   |   |   |   |   |
| **Liabilities and Stockholders’ Equity**                                     |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest  bearing deposits                                                        |   | $                              | 36,513,238 |   | 217,203 |   | 2.38 | % | $ | 35,510,650 |   | 297,359 |   | 3.35 | % |
| Other  liabilities                                                                |   | 7,275,000                      |       | 73,849 |   | 4.06 | % | 6,468,178 |   | 73,974 |   | 4.57 | % |
| Total  interest-bearing liabilities                                               |   | 43,788,238                     |       | 291,052 |   | 2.66 | % | 41,978,828 |   | 371,333 |   | 3.54 | % |
| Non-interest-bearing  liabilities                                                 |   | 3,554,707                      |       |   |   |   |   | 4,528,182 |   |   |   |   |   |
| Total  liabilities                                                                |   | 47,342,945                     |       |   |   |   |   | 46,507,010 |   |   |   |   |   |
| Stockholders’  Equity                                                        |   | 2,143,165                      |       |   |   |   |   | 1,988,370 |   |   |   |   |   |
| Total  liabilities and stockholders’ equity                                  |   | $                              | 49,486,110 |   |   |   |   |   | $ | 48,495,380 |   |   |   |   |   |
| Net  interest spread                                                              |   |                           |       |   |   | 3.54 | % |   |   |   |   | 2.95 | % |
| Net  interest income/margin                                                       |   |                           |       | $ | 415,062 |   | 3.65 | % |   |   | $ | 333,676 |   | 3.07 | % |
| Ratio  of average interest-earning assets to average interest-bearing liabilities |   | 1.04                           | x     |   |   |   |   | 1.04 | x  |   |   |   |   |

 
|                                                                              |   | **For the Six Months Ended** |       |
|-----------------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                              |   | **December 31, 2003**        |       | **December 31, 2002** |   |
|                                                                              |   | **Average  Balance**         |       | **Interest** |   | **Average  Yield or  Rates Paid** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield or  Rates Paid** |   |
| **Assets**                                                                        |   |                         |       |   |   |   |   |   |   |   |   |   |   |
| Loans  receivable                                                                 |   | $                            | 36,958,237 |   | $ | 1,286,448 |   | 6.96 | % | $ | 35,219,784 |   | $ | 1,261,408 |   | 7.16 | % |
| Investment  securities                                                            |   | 5,386,059                    |       | 102,875 |   | 3.82 | % | 6,754,917 |   | 168,159 |   | 4.98 | % |
| Federal  funds sold                                                               |   | 3,444,817                    |       | 15,385 |   | 0.89 | % | 2,590,946 |   | 18,979 |   | 1.47 | % |
| Total  interest-earning assets                                                    |   | 45,789,113                   |       | 1,404,708 |   | 6.14 | % | 44,565,647 |   | 1,448,546 |   | 6.50 | % |
| Non-interest-earning  assets                                                      |   | 4,341,910                    |       |   |   |   |   | 4,201,312 |   |   |   |   |   |
| Total  assets                                                                     |   | $                            | 50,131,023 |   |   |   |   |   | $ | 48,766,959 |   |   |   |   |   |
| **Liabilities and Stockholders’ Equity**                                     |   |                         |       |   |   |   |   |   |   |   |   |   |   |
| Interest  bearing deposits                                                        |   | $                            | 36,776,167 |   | 452,049 |   | 2.46 | % | $ | 35,688,392 |   | 620,662 |   | 3.48 | % |
| Other  liabilities                                                                |   | 7,425,000                    |       | 151,196 |   | 4.07 | % | 6,600,519 |   | 155,157 |   | 4.70 | % |
| Total  interest-bearing liabilities                                               |   | 44,201,167                   |       | 603,245 |   | 2.73 | % | 42,288,911 |   | 775,819 |   | 3.67 | % |
| Non-interest-bearing  liabilities                                                 |   | 3,790,732                    |       |   |   |   |   | 4,534,278 |   |   |   |   |   |
| Total  liabilities                                                                |   | 47,991,899                   |       |   |   |   |   | 46,823,189 |   |   |   |   |   |
| Stockholders’  Equity                                                        |   | 2,139,124                    |       |   |   |   |   | 1,943,770 |   |   |   |   |   |
| Total  liabilities and stockholders’ equity                                  |   | $                            | 50,131,023 |   |   |   |   |   | $ | 48,766,959 |   |   |   |   |   |
| Net  interest spread                                                              |   |                         |       |   |   | 2.87 | % |   |   |   |   | 2.83 | % |
| Net  interest income/margin                                                       |   |                         |       | $ | 801,463 |   | 3.50 | % |   |   | $ | 672,727 |   | 3.02 | % |
| Ratio  of average interest-earning assets to average interest-bearing liabilities |   | 1.04                         | x     |   |   |   |   | 1.05 | x  |   |   |   |   |

 

**INVESTMENT PORTFOLIO**

 

At December 31, 2003, our available for sale investments securitiesportfolio represented approximately 11.94% of our interest earning assets of$46.62 million.  We also heldinvestments in stock of the Federal Home Loan Bank and United Bankers Bank inthe amount of

 

19

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$367,100, and securities held for trading in the amount of $68,343, whichis not included in the tables below.The securities are listed at fair value.

 
|                                 |   | **December 31, 2003** |      | **June 30, 2003** |   |
|--------------------------------------|--------|-----------------------|-----------|-------------------|--------|
|                                 |   |                  |      |              |   |
| U.S. Agencies                        |   | $                     | 3,080,609 |              | $      | 2,266,739 |   |
| Mortgage-back  securities            |   | 1,950,739             |      | 3,318,430         |   |
| Corporate bonds                      |   | 535,050               |      | 527,919           |   |
| Total securities  available for sale |   | $                     | 5,566,398 |              | $      | 6,113,088 |   |

 

Contractual maturities and yields on the Company’s available for saleinvestments are summarized in the following table.  Expected maturities may differ from contractual maturities becauseissuers may have the right to call or prepay obligations with our without callor prepayment penalties.

 
|                      |   | **December 31, 2003** |   |
|---------------------------|--------|-----------------------|--------|
|                      |   | **One Year  or Less** |   | **Yield** |   | **After one  year thru  five years** |   | **Yield** |   | **After five  years thru  ten years** |   | **Yield** |   | **After 10  years** |   | **Yield** |   | **Total** |   | **Yield** |   |
|                      |   |                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S.  Agencies            |   | $                     | — |   | 0.00 | % | $ | 989,687 |   | 3.34 | % | $ | 1,600,297 |   | 4.17 | % | $ | 490,625 |   | 4.02 | % | $ | 3,080,609 |   | 3.88 | % |
| Mortgage-back  securities |   | —                |   | 0.00 | % | 266,223 |   | 3.46 | % | 841,234 |   | 5.36 | % | 843,282 |   | 6.17 | % | 1,950,739 |   | 5.45 | % |
| Corporate  bonds          |   | —                |   | 0.00 | % | 535,050 |   | 6.06 | % | — |   | 0.00 | % | — |   | 0.00 | % | 535,050 |   | 6.06 | % |
|                      |   | $                     | — |   | 0.00 | % | $ | 1,790,960 |   | 4.17 | % | $ | 2,441,531 |   | 4.58 | % | $ | 1,333,907 |   | 5.38 | % | $ | 5,566,398 |   | 4.64 | % |

 

**LOAN PORTFOLIO**

 

The following table summarizesthe composition of the loan portfolio. Total gross loans including net of deferred loan fees and costsoutstanding at December 31, 2003 and June 30, 2002 were $37,344,243 and$39,881,709, respectively.  This tableexcludes loans held for sale as of December 31, 2003 and June 30, 2003 of$491,610 and $2,035,176, respectively. Loans held for sale are comprised of real estate mortgages.

 
|                            |   | **December 31, 2003** |       | **June 30, 2003** |   |
|---------------------------------|--------|-----------------------|------------|-------------------|--------|
|                            |   | **Amount**            |       | **% of Total**    |   | **Amount** |   | **% of Total** |   |
| Commercial  & agricultural  |   | $                     | 7,070,392  |              | 18.98  | % | $ | 6,979,307 |   | 17.55 | % |
| Real  estate - construction     |   | 3,808,627             |       | 10.22             | %      | 4,433,072 |   | 11.15 | % |
| Real  estate - mortgages        |   | 18,278,594            |       | 49.06             | %      | 18,504,208 |   | 46.52 | % |
| Consumer  loans                 |   | 8,063,374             |       | 21.64             | %      | 9,821,027 |   | 24.69 | % |
| Lease  financing                |   | 33,537                |       | 0.10              | %      | 35,673 |   | 0.09 | % |
| Total  loans                    |   | $                     | 37,254,524 |              | 100.00 | % | $ | 39,773,287 |   | 100.00 | % |
| Net  deferred loan fees/(costs) |   | 89,719                |       |              |   | 108,422 |   |   |   |
| Less:  allowance for loan loss  |   | (796,564              | )          |              |   | (1,029,581 | ) |   |   |
| Total  net loans                |   | $                     | 36,547,679 |              |   |   | $ | 38,852,128 |   |   |   |

 

### **MATURITIES AND SENSITIVITY OF LOANS TO CHANGES ININTEREST RATES**

 

The information in the following table is based on the contractualmaturities of individual loans, which may be subject to renewal at theircontractual maturity.  Renewal of suchloans is subject to review and credit approval as well as modification of termsupon maturity.  Actual repayments ofloans may differ from maturities reflected below because borrowers have theright to repay obligations with or without prepayment penalties.  The

 

20

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followingtable summarizes loan maturities, by type at December 31, 2003 andJune 30, 2003.

 
|                                |   | **As of December 31, 2003** |       |
|-------------------------------------|--------|----------------------------------|------------|
|                                |   | **One Year  or Less**            |       | **After One but  within Five Years** |   | **After  Five Years** |   | **Total** |   |
| Commercial  & agricultural      |   | $                                | 2,376,421  |   | $ | 2,514,643 |   | $ | 2,179,328 |   | $ | 7,070,392 |   |
| Real  estate - construction         |   | 1,438,717                        |       | 2,369,910 |   | — |   | 3,808,627 |   |
| Real  estate - mortgages            |   | 722,530                          |       | 10,792,173 |   | 6,763,891 |   | 18,278,594 |   |
| Consumer  loans                     |   | 1,980,034                        |       | 5,003,149 |   | 1,080,191 |   | 8,063,374 |   |
| Lease  financing                    |   | —                           |       | 33,537 |   | — |   | 33,537 |   |
| Total                               |   | $                                | 6,517,702  |   | $ | 20,713,412 |   | $ | 10,023,410 |   | $ | 37,254,524 |   |
| Loans  maturing after one year with |   |                             |       |   |   |   |   |   |   |
| Fixed  interest rate                |   | $                                | 27,926,243 |   |   |   |   |   |   |   |
| Floating  interest rates            |   | $                                | 2,810,579  |   |   |   |   |   |   |   |
|                                |   |                             |       |   |   |   |   |   |   |
|                                |   | **As of  June 30, 2003**    | ** ** |
|                                |   | **One Year  or Less**            |       | **After One  but  within Five Years** | ** ** | **After  Five Years** | ** ** | **Total** | ** ** |
| Commercial  & agricultural      |   | $                                | 2,613,798  |   | $ | 2,597,750 |   | $ | 1,767,759 |   | $ | 6,979,307 |   |
| Real  estate - construction         |   | 3,496,939                        |       | 936,133 |   | — |   | 4,433,072 |   |
| Real  estate - mortgages            |   | 2,034,243                        |       | 12,075,344 |   | 4,394,621 |   | 18,504,208 |   |
| Consumer  loans                     |   | 2,283,747                        |       | 6,678,656 |   | 858,624 |   | 9,821,027 |   |
| Lease  financing                    |   | —                           |       | 35,673 |   | — |   | 35,673 |   |
| Total                               |   | $                                | 10,428,727 |   | $ | 22,323,556 |   | $ | 7,021,004 |   | $ | 39,773,287 |   |
| Loans  maturing after one year with |   |                             |       |   |   |   |   |   |   |
| Fixed  interest rate                |   | $                                | 27,452,321 |   |   |   |   |   |   |   |
| Floating  interest rates            |   | $                                | 1,892,239  |   |   |   |   |   |   |   |

 

**PROVISIONAND ALLOWANCE FOR LOAN LOSSES**

 

We have developed policies and procedures forevaluating the overall quality of its credit portfolio and the timelyidentification of potential credit problems. Additions to the allowance for loan losses will be made periodically tomaintain the allowance at an appropriate level based on management’s analysisof the potential risk in the loan portfolio.

 

At December 31, 2003, the allowance for loanlosses was $796,564, or 2.13% of $37,344,243 in loan receivables (net of loansheld for sale).  At June 30, 2003,the allowance for loan losses was $1,029,581, or 2.58% of $39,881,709 in loanreceivables (net of loans held for sale). The provision for loan losses wasmade primarily as a result of management’s assessment of impaired loans andgeneral loan loss risk as our loan portfolio increases.

 

During the six month endingDecember 31, 2003 management charged off $249,622 (net of recoveries) andprovided $16,605 to the provision for loan losses. During the six month periodended December 31, 2002 management charged off $1,351 (net of recoveries)to the allowance while we provided $28,700 to the provision for loan losses.  Forthe six-month period ended December 31, 2003, net charge offs as apercentage of average loans outstanding was .68%, compared to .004% for thesix-month period ended December 31, 2002. Management believes theallowance at December 31, 2003 is adequate based upon its ongoing analysisof the loan portfolio, historical loss trends and other factors. Althoughmanagement believes that they use the best information available to make suchdeterminations, future adjustments to the allowance

 

21

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for loan losses may benecessary and results of operations could be significantly and adverselyaffected if circumstances differ substantially from the assumptions used inmaking the determinations.

 
|                                                                                        |   | **Six Months Ended  December 31, 2003** |      | **Year Ended  June 30, 2003** |   |
|---------------------------------------------------------------------------------------------|--------|----------------------------------------------|-----------|------------------------------------|--------|
| Balance  at beginning of period                                                             |   | $                                            | 1,029,581 |                               | $      | 661,170 |   |
| Charge-offs:                                                                                |   |                                         |      |                               |   |
| Commercial  & agricultural                                                              |   | (2,333                                       | )         | —                             |   |
| Consumer  loans                                                                             |   | (251,229                                     | )         | (14,680                            | )      |
|                                                                                        |   | (253,562                                     | )         | (14,680                            | )      |
| Recoveries:                                                                                 |   |                                         |      |                               |   |
| Commercial  & agricultural                                                              |   | 2,000                                        |      | 7,930                              |   |
| Consumer  loans                                                                             |   | 1,940                                        |      | 1,224                              |   |
|                                                                                        |   | 3,940                                        |      | 9,154                              |   |
| Net  charge offs                                                                            |   | (249,622                                     | )         | (5,526                             | )      |
| Provision  charged to operations                                                            |   | 16,605                                       |      | 373,937                            |   |
| Balance  at end of period                                                                   |   | $                                            | 796,564   |                               | $      | 1,029,581 |   |
|                                                                                        |   |                                         |      |                               |   |
| Ratio  of net charge-offs during the period to average loans outstanding during the  period |   | 0.68                                         | %         | 0.02                               | %      |

 

At December 31, 2003and June 30, 2003 the allowance was allocated as follows:

 
|                           |   | **December 31, 2003** |    | **June 30, 2003**                                 |   |
|--------------------------------|--------|----------------------------|---------|--------------------------------------------------------|--------|
|                           |   | **Amount**                 |    | **Percent of Loans  in Each Category  of Total Loans** |   | **Amount** |   | **Percent of Loans  in Each Category  of Total Loans** |   |
| Commercial  & agricultural |   | $                          | 350,013 |                                                   | 18.98  | % | $ | 341,993 |   | 17.55 | % |
| Real  estate - construction    |   | 23,356                     |    | 10.22                                                  | %      | 26,896 |   | 11.15 | % |
| Real  estate - mortgages       |   | 153,653                    |    | 49.06                                                  | %      | 151,417 |   | 46.52 | % |
| Consumer  loans                |   | 269,290                    |    | 21.64                                                  | %      | 509,007 |   | 24.69 | % |
| Lease  financing               |   | 252                        |    | 0.10                                                   | %      | 268 |   | 0.09 | % |
| Total                          |   | $                          | 796,564 |                                                   | 100.00 | % | $ | 1,029,581 |   | 100.00 | % |

 

**DEPOSITS**

 

The following is a table of deposits by category atDecember 31, 2003 and June 30, 2003.

 

22

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|                              |   | **As of December 31, 2003** |       |
|-----------------------------------|--------|----------------------------------|------------|
|                              |   | **Ending  Balance**              |       | **Percentage  of Total  Deposits** |   | **Average  Balance** |   | **Percentage  of Total  Average  Deposits** |   | **Effective  Cost** |   |
| Demand deposit                    |   | $                                | 3,662,162  |   | 8.92 | % | $ | 3,462,282 |   | 8.60 | % | 0.00 | % |
| Now and money market              |   | 8,567,907                        |       | 20.86 | % | 8,570,372 |   | 21.30 | % | 1.13 | % |
| Savings                           |   | 6,252,942                        |       | 15.23 | % | 4,847,498 |   | 12.05 | % | 1.21 | % |
| Time accounts less than $100,000  |   | 17,090,628                       |       | 41.61 | % | 18,012,528 |   | 44.76 | % | 3.22 | % |
| Time accounts of $100,000 or more |   | 5,495,822                        |       | 13.38 | % | 5,345,769 |   | 13.29 | % | 3.15 | % |
| Total deposits                    |   | $                                | 41,069,461 |   | 100.00 | % | $ | 40,238,449 |   | 100.00 | % |   |   |

 
|                              |   | **As of June 30, 2003** | ** ** |
|-----------------------------------|--------|------------------------------|------------|
|                              |   | **Ending  Balance**          |       | **Percentage  of Total  Deposits** | ** ** | **Average  Balance** | ** ** | **Percentage****of Total  Average  Deposits** | ** ** | **Effective  Cost** | ** ** |
| Demand deposit                    |   | $                            | 5,090,364  |   | 12.29 | % | $ | 4,166,918 |   | 10.40 | % | 0.00 | % |
| Now and money market              |   | 8,623,932                    |       | 20.82 | % | 8,676,758 |   | 21.66 | % | 1.72 | % |
| Savings                           |   | 4,630,763                    |       | 11.18 | % | 4,530,948 |   | 11.31 | % | 1.70 | % |
| Time accounts less than $100,000  |   | 18,021,479                   |       | 43.50 | % | 18,096,268 |   | 45.17 | % | 3.98 | % |
| Time accounts of $100,000 or more |   | 5,062,172                    |       | 12.21 | % | 4,587,528 |   | 11.46 | % | 4.02 | % |
| Total deposits                    |   | $                            | 41,428,710 |   | 100.00 | % | $ | 40,058,420 |   | 100.00 | % |   |   |

 

Maturity distribution oftime deposits of less than $100,000 and time deposits of $100,000.00 or more isas follows:

 
|                               |   | **December 31, 2003** |      |
|------------------------------------|--------|----------------------------|-----------|
|                               |   | **3 months  or less**      |      | **Over 3 months  thru 6 months** |   | **Over 6 months  thru 12 months** |   | **Over  12 months** |   | **Total** |   |
| Time  accounts less than $100,000  |   | $                          | 2,802,110 |   | $ | 2,504,819 |   | $ | 4,661,872 |   | $ | 7,121,827 |   | $ | 17,090,628 |   |
| Time  accounts of $100,000 or more |   | 124,476                    |      | 1,750,792 |   | 1,563,470 |   | 2,057,084 |   | 5,495,822 |   |
| Total                              |   | $                          | 2,926,586 |   | $ | 4,255,611 |   | $ | 6,225,342 |   | $ | 9,178,911 |   | $ | 22,586,450 |   |

 

**ITEM3. CONTROLS AND PROCEDUERS**

 

Evaluation of DisclosureControls Procedures

 

As of the end of theperiod covered by this report, the Company conducted an evaluation under thesupervision and with the participation of the Company’s management, includingthe Company’s Chief Executive Officer and Principal Financial Officer,regarding the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to Rules 13a-15(b) of theSecurities Exchange Act of 1934 (the “Exchange Act”).  Based upon that evaluation, the Chief Executive Officer andPrincipal Financial Officer concluded that the Company’s disclosure controlsand procedures are effective to ensure that information that is required to bedisclosed by the Company in reports that it files under the Exchange Act isrecorded, processed, summarized and reported within the time period specifiedin the rules of the Securities Exchange Commission.

 

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Changes in InternalControls

 

Therewere no changes in the Company’s internal control over financial reporting thatoccurred during the period covered by this report that have materiallyaffected, or are reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

**Part II**

**OTHER INFORMATION**

 

**Item1.  Legal Proceedings**

 

The Bank was a defendantin a complaint filed on February 23, 2002 in United States District Court,District of South Dakota Southern Division by Bridge Lenders, LLC; Jim Perry;Larry Ticknor; Doug English; Rollyn H. Samp; Courtney Anderson; Henry Carlson,Jr.; Michael M. Samp; Ernest Olson; Don Davis; Jerry Landerville; Allen Lewis;Gary Viger; Glen Jamtgaard and Steve Herman (“Plaintiffs”).  The complaint arose out of a series of loansthat the Bank made to Plaintiffs in 2000. Plaintiffs used the proceeds of the loans to make an investment inBridge Lenders, LLC, and Bridge Lenders, LLC in turn used the funds to make aninvestment in Phenix Biocomposites, which has defaulted in its obligations toPlaintiffs.  The Bank was a defendant inthis action due to the fact that its former director, Frank Gazzola, was also adirector of Phenix Biocomposites.  ThePlaintiffs alleged that Mr. Gazzola failed to inform the Plaintiffs that theirinvestment in Phenix Biocomposites was not secured.  The Plaintiffs have alleged claims stating that the Bank had afiduciary duty to the Plaintiffs because of Mr. Gazzola’s dual role as adirector of both the Bank and Phenix Biocomposites.  Plaintiffs’ claims include: (1) breach of fiduciary duty, (ii)violation of implied covenant of good faith and fair dealing; (iii) negligentmisrepresentation; (iv) fraudulent misrepresentation; and (v) punitivedamages.  Plaintiffs’ claims (ii) and(v) have been dismissed.  Plaintiffsallege that Mr. Gazzola provided false information to Plaintiffs, and that thefalse information allegedly provided by Mr. Gazzola constituted intentional orunintentional fraud by Northern Star Bank. Plaintiffs seek compensatory andgeneral damages. The Bank denied the Plaintiffs’ allegations and brought amotion to dismiss all claims for lack of personal jurisdiction. OnJuly 22, 2003, the court dismissed the complaint based upon the failure ofthe plaintiffs to enjoin Mr. Gazzola. On July 28, 2003, the Bank initiated legal action in the Blue Earthcounty court of the State of Minnesota to compel payment on the notes.  On July 29, 2003, the Plaintiffs fileda revised complaint in United States District Court, District of Minnesota,re-asserting their earlier allegations. The Company is aggressively asserting its claims and defending itselfagainst Plaintiffs’ claims and expects resolution of this matter will occur inthe Company’s third fiscal quarter 2004.

 

The Company was a defendantand third party plaintiff in a complaint originally filed on March 22,2002 in the United States District Court for the Western District of Wisconsinby Catalytic Combustion Corporation 401(k) Profit Sharing Plan and CatalyticCombustion Corporation (“Plaintiffs”).  On March 31, 2003, the Company, the third party defendant, and theplaintiffs entered into a confidential final and binding mutual release of allclaims and settlement agreement.

 

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During 1999 and 2000, theBank made a series of loans to Frank Gazzola, then a Director of the Company,in various amounts at market rates of interest and for terms of various lengthsof time. Mr. Gazzola defaulted on the loans and the Bank foreclosed on the collateralfor the loans. The bankruptcy court claimed that since certain of thecollateral was conveyed to the Bank within one year of Gazzola’s bankruptcyfiling and since he was an insider, they were preferential transfers and mustbe reversed.  On June 12, 2003, inan out of court settlement, the court approved a settlement agreement where-inthe Bank agreed to pay the bankruptcy court a settlement fee for which the Bankretained a claim against the unsecured assets of Mr. Gazzola’s bankruptcy estateand a release by the court of all claims to the collateral held by the Bank.

 

**Item 2.  Changes in Securities and Use ofProceeds**

 

Duringthe first quarter of the current fiscal year, the Company issued 23,000 sharesof stock in the amount of $126,500 under a private placement offering for50,000 shares.  During the secondquarter of the current fiscal year, the Company issued 26,000 shares of stockin the amount of $143,000 under this private placement offering. The Companydid not incur any underwriting or placement expenses in connection with theseissuances.  The proceeds will beutilized to support our on-going operations.

 

**Item 3.  Defaults Upon Senior Securities**

 

Noneto report.

 

**Item 4.  Submission of Matters to a Vote ofSecurity Holders**

 

(a)            TheAnnual Meeting of the Company’s stockholders was held on November 19,2003.

 

(b)           At theAnnual Meeting a proposal to set the number of directors at eight was adoptedby a vote of  332,910 shares in favor,with 500 shares against and 9,000 shares abstaining.

 

(c)            Proxiesfor the Annual Meeting were solicited pursuant to Regulation A under theSecurities Exchange Act of 1934, there were no solicitation in opposition tomanagement’s nominees, and the following persons were elected Class IIdirectors of the Company to serve for a period of three years and until theirsuccessors shall have been duly elected and qualified:

 
| **Nominee**           |   | **Number of Votes For** |   | **Number of  Votes Withheld** |
|-----------------------|--------|-------------------------|--------|-------------------------------|
|                  |   |                    |   |                          |
| Robert  H. Dittrich   |   | 341,410                 |   | 1,000                         |
| Gerald  W. Eick       |   | 341,410                 |   | 1,000                         |
| Thomas  P. Stienessen |   | 340,410                 |   | 2,000                         |

 

Theterms of office of the following directors continued after the Annual Meeting:

 

DeanM. Doyscher

 

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JamesH. Illies

ThomasJ. Reynolds

StevenA. Loehr

MichaelP. Reynolds

 

**Item 5.  Other Information**

 

Noneto report

 

**Item 6.  Exhibits and Reports Form 8-K**

 

a)Exhibits

 

Exhibits are numbered in accordance with Item 601 ofRegulation S-B. See “Exhibit Index” immediately following the signature page ofthis Form 10-QSB.

 

b) Reports on Form 8-K

 

A Form 8-K dated November 12, 2003 was filed toannounce and furnish results of the Company and its wholly owned subsidiaryNorthern Star Bank for the first quarter of the fiscal year ended June 30,2004.

 

**SIGNATURES**

 

In accordance with therequirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|                              | NORTHERN STAR  FINANCIAL, INC. |
|-----------------------------------|--------------------------------|
|                              |                           |   |
| Date:  February 6, 2004 | By                             | /s/  Thomas P. Stienessen |
|                              |                           | Thomas P.  Stienessen, President and  Chief Executive Officer |
|                              |                           |   |
| Date:  February 6, 2004 | By                             | /s/  Gerald W. Eick |
|                              |                           | Gerald W. Eick,  Treasurer |

 

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**EXHIBIT INDEXNORTHERN STAR FINANCIAL, INC.FORM 10-QSB FOR QUARTER ENDED DECEMBER 31, 2003**

 
| **EXHIBIT** |   | **DESCRIPTION**                                                                                  |
|-------------|--------|--------------------------------------------------------------------------------------------------|
|        |   |                                                                                             |
| 31.1        |   | Certification of CEO Pursuant to Section 302 of The Sarbanes-Oxley  Act of 2002             |
|        |   |                                                                                             |
| 31.2        |   | Certification of CFO Pursuant to Section 302 of The Sarbanes-Oxley  Act of 2002             |
|        |   |                                                                                             |
| 32          |   | Certification of the CEO and CFO Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

 

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