**UnitedStates Securities and Exchange Commission**

 

**Washington,D.C. 20549**

 

# **FORM 10-QSB**

# ** **

**ý**** QUARTERLY REPORTUNDER SECTION 13 OR 15 (D) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For the quarterly period ended March 31,2004**

 

**OR**

 

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

 

**For the transition periodfrom                  to                  .**

 

**CommissionFile No. 000-25231**

 

**NorthernStar Financial, Inc.**

(Exact name of registrant as specified in itscharter)

 
| **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 the issuer (1) filed allreports required to be filed by Sections 13 or 15(d) of the Exchange Act duringthe past 12 months (or such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirements forthe past 90 days.

Yes   ý   No   o.

 

State the number of shares outstanding ofeach of the issuer’s classes of common equity as of the latest practicabledate.

 

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

 

TransitionalSmall Business Disclosure Format (Check one):   Yes   o   No   ý.

 

 

----

 

**NorthernStar Financial, Inc. and Subsidiary**

 

**Indexto Form 10-QSB**

**March 31,2004**

 
| PART I.    | FINANCIAL INFORMATION |                                                                                                                |
|------------|-----------------------|---------------------------------------------------------------------------------------------------------------------|
|       |                  |                                                                                                                |
|       | Item 1.               | Summary  of Financial Data                                                                                          |   |
|       |                  |                                                                                                                |   |
|       |                  | Consolidated Statements of Financial  Condition at March 31, 2004 (unaudited) and June 30, 2003 (audited) |   |
|       |                  |                                                                                                                |   |
|       |                  | Unaudited Consolidated Statements of  Operations for the three and nine months ended March 31, 2004 and 2003   |   |
|       |                  |                                                                                                                |   |
|       |                  | Unaudited  Consolidated Statement of Cash Flows for the three and nine months ended  March 31, 2004 and 2003   |   |
|       |                  |                                                                                                                |   |
|       |                  | 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**

 

Northern Star Financial, Inc. and Subsidiary Summary of Financial Data

 

The following table summarizes certain historical financial data ofNorthern Star Financial, Inc. and its subsidiary on a consolidated basis as ofand for the three and nine months ended March 31, 2004 and 2003.  You should read this table in conjunctionwith our financial statements and related notes appearing elsewhere in thisdocument.

 
|                                                                  |   | **For the  Three Months  Ended March 31,** |    | **As of and  for the Nine Months  Ended March 31,** |   |
|-----------------------------------------------------------------------|--------|-------------------------------------------------|---------|----------------------------------------------------------|--------|
|                                                                  |   | **2004**                                        |    | **2003**                                                 |   | **2004** |   | **2003** |   |
| Statement of Income:                                                  |   |                                            |    |                                                     |   |   |   |   |   |
| Interest income                                                       |   | $                                               | 739,959 |                                                     | $      | 694,204 |   | $ | 2,144,667 |   | $ | 2,142,750 |   |
| Interest expense                                                      |   | 273,433                                         |    | 341,303                                                  |   | 876,678 |   | 1,117,122 |   |
| Net interest income                                                   |   | 466,526                                         |    | 352,901                                                  |   | 1,267,989 |   | 1,025,628 |   |
| Provision for loan losses                                             |   | —                                          |    | 34,900                                                   |   | 16,605 |   | 63,600 |   |
| Other non-interest income                                             |   | 148,492                                         |    | 265,269                                                  |   | 551,752 |   | 738,110 |   |
| Non-interest expense                                                  |   | 633,059                                         |    | 539,841                                                  |   | 1,851,274 |   | 1,700,580 |   |
| Income (loss) before income tax expense                               |   | (18,041                                         | )       | 43,429                                                   |   | (48,138 | ) | (442 | ) |
| Income tax expense (benefit)                                          |   | —                                          |    | —                                                   |   | — |   | — |   |
| Net income (loss)                                                     |   | $                                               | (18,041 | )                                                        | $      | 43,429 |   | $ | (48,138 | ) | $ | (442 | ) |
| Balance Sheet:                                                        |   |                                            |    |                                                     |   |   |   |   |   |
| Assets                                                                |   |                                            |    |                                                     |   | $ | 51,543,666 |   | $ | 49,995,985 |   |
| Allowance for loan losses                                             |   |                                            |    |                                                     |   | $ | 644,780 |   | $ | 718,045 |   |
| Deposits                                                              |   |                                            |    |                                                     |   | $ | 42,797,906 |   | $ | 40,937,680 |   |
| Stockholders’ equity                                             |   |                                            |    |                                                     |   | $ | 2,114,582 |   | $ | 2,099,289 |   |
|                                                                  |   |                                            |    |                                                     |   |   |   |   |   |
| Per Share Data:                                                       |   |                                            |    |                                                     |   |   |   |   |   |
| Net income (loss) - basic                                             |   | $                                               | (0.03   | )                                                        | $      | 0.09 |   | $ | (0.09 | ) | $ | (0.00 | ) |
| Net income (loss) - diluted                                           |   | $                                               | (0.03   | )                                                        | $      | 0.09 |   | $ | (0.09 | ) | $ | (0.00 | ) |
| Book value                                                            |   |                                            |    |                                                     |   | 3.72 |   | 4.11 |   |
|                                                                  |   |                                            |    |                                                     |   |   |   |   |   |
| Other Data                                                            |   |                                            |    |                                                     |   |   |   |   |   |
| Weighted average shares outstanding - basic                           |   | 568,506                                         |    | 498,439                                                  |   | 551,902 |   | 488,681 |   |
| Weighted average shares outstanding -  diluted                        |   | 568,506                                         |    | 498,439                                                  |   | 551,902 |   | 488,681 |   |
|                                                                  |   |                                            |    |                                                     |   |   |   |   |   |
| Financial Ratios:                                                     |   |                                            |    |                                                     |   |   |   |   |   |
| Equity to assets                                                      |   |                                            |    |                                                     |   | 3.92 | % | 4.08 | % |
| Return on average assets                                              |   |                                            |    |                                                     |   | -0.09 | % | 0.00 | % |
| Return on average stockholders’ equity                           |   |                                            |    |                                                     |   | -2.39 | % | -0.02 | % |
| Net interest margin                                                   |   |                                            |    |                                                     |   | 3.68 | % | 3.10 | % |
| Tier 1 leverage ratio                                                 |   |                                            |    |                                                     |   | 8.58 | % | 8.46 | % |
| Tier 1 capital to risk-weighted assets                                |   |                                            |    |                                                     |   | 10.82 | % | 11.16 | % |
| Total capital to risk-weighted assets                                 |   |                                            |    |                                                     |   | 12.07 | % | 12.42 | % |
|                                                                  |   |                                            |    |                                                     |   |   |   |   |   |
| Asset Quality Ratios:                                                 |   |                                            |    |                                                     |   |   |   |   |   |
| Nonperforming assets to total assets                                  |   |                                            |    |                                                     |   | 1.03 | % | 4.26 | % |
| Nonperforming assets to total loans and and  other real estated owned |   |                                            |    |                                                     |   | 1.50 | % | 5.60 | % |
| Allowance for loan losses to total loans                              |   |                                            |    |                                                     |   | 1.81 | % | 1.89 | % |

 

3

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**NorthernStar Financial, Inc. and Subsidiary**

Consolidated Statements of FinancialCondition

 
|                                                                                                                          |   | **March 31,  2004** |       | **June 30,  2003** |       |
|-------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|------------|-------------------------|------------|
|                                                                                                                          |   | **(Unaudited)**          |       | **(Audited)**           |       |
| **ASSETS**                                                                                                                    |   |                     | ** ** |                    | ** ** |
|                                                                                                                          |   |                     | ** ** |                    | ** ** |
| Cash and due from banks                                                                                                       |   | $                        | 4,380,402  |                    | $          | 2,377,132 |   |
| Federal funds sold                                                                                                            |   | 3,562,000                |       | 482,000                 |       |
| Securities available for sale, at fair  value                                                                                 |   | 6,279,734                |       | 6,113,088               |       |
| Securities held for trading, at fair value                                                                                    |   | —                   |       | 115,862                 |       |
| Federal Home Loan Bank and United Bankers  Bank stock, at cost                                                                |   | 385,100                  |       | 367,100                 |       |
| Loans held for sale                                                                                                           |   | 970,000                  |       | 2,035,176               |       |
| Loans receivable, net of allowance for loan  and lease losses of $644,780 and $1,029,581                                      |   | 34,896,244               |       | 38,852,128              |       |
| Accrued interest receivable                                                                                                   |   | 236,429                  |       | 282,416                 |       |
| Property and equipment, net of depreciation                                                                                   |   | 520,152                  |       | 503,397                 |       |
| Other assets                                                                                                                  |   | 313,605                  |       | 124,363                 |       |
| **Total Assets**                                                                                                              |   | $                        | 51,543,666 |                    | $          | 51,252,662 |   |
|                                                                                                                          |   |                     |       |                    |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                |   |                     |       |                    |       |
| **Liabilities:**                                                                                                              |   |                     |       |                    |       |
| Demand deposits                                                                                                               |   | $                        | 6,622,557  |                    | $          | 5,090,364 |   |
| NOW and money market                                                                                                          |   | 8,632,115                |       | 8,623,932               |       |
| Savings                                                                                                                       |   | 5,731,545                |       | 4,630,763               |       |
| Time deposits                                                                                                                 |   | 21,811,689               |       | 23,083,651              |       |
| Total deposits                                                                                                                |   | 42,797,906               |       | 41,428,710              |       |
| Notes payable and other borrowings                                                                                            |   | 4,750,000                |       | 5,975,000               |       |
| Convertible subordinated notes payable                                                                                        |   | 1,600,000                |       | 1,600,000               |       |
| Accrued interest payable and other                                                                                            |   | 281,178                  |       | 334,818                 |       |
| Total Liabilities                                                                                                             |   | 49,429,084               |       | 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                                                                                                           |   | (2,561,313               | )          | (2,513,175              | )          |
| Unearned stock compensation                                                                                                   |   | (5,005                   | )          | (8,005                  | )          |
| Accumulated other comprehensive income                                                                                        |   | 28,101                   |       | 52,015                  |       |
| **Total Stockholders’  Equity**                                                                                          |   | 2,114,582                |       | 1,914,134               |       |
| **Total Liabilities  and Stockholders’ Equity**                                                                          |   | $                        | 51,543,666 |                    | $          | 51,252,662 |   |

 

See Notes to Consolidated FinancialStatements

 

4

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**NorthernStar Financial, Inc. and Subsidiary**

Unaudited Consolidated Statements ofOperations

 
|                                                      |   | **For the  Three Months  Ended March 31,** |    | **For the  Nine Months  Ended March 31,** |   |
|-----------------------------------------------------------|--------|-------------------------------------------------|---------|------------------------------------------------|--------|
|                                                      |   | **2004**                                        |    | **2003**                                       |   | **2004** |   | **2003** |   |
| **Interest income:**                                      |   |                                            |    |                                           |   |   |   |   |   |
| Loans receivable                                          |   | $                                               | 669,895 |                                           | $      | 620,225 |   | $ | 1,956,343 |   | $ | 1,881,633 |   |
| Securities available for sale                             |   | 61,137                                          |    | 64,260                                         |   | 164,012 |   | 232,419 |   |
| Federal funds sold                                        |   | 8,927                                           |    | 9,719                                          |   | 24,312 |   | 28,698 |   |
| Total interest income                                     |   | 739,959                                         |    | 694,204                                        |   | 2,144,667 |   | 2,142,750 |   |
|                                                      |   |                                            |    |                                           |   |   |   |   |   |
| **Interest expense:**                                     |   |                                            |    |                                           |   |   |   |   |   |
| Deposits                                                  |   | 203,822                                         |    | 268,118                                        |   | 655,871 |   | 888,780 |   |
| Borrowed funds                                            |   | 69,611                                          |    | 73,185                                         |   | 220,807 |   | 228,342 |   |
| Total interest expense                                    |   | 273,433                                         |    | 341,303                                        |   | 876,678 |   | 1,117,122 |   |
|                                                      |   |                                            |    |                                           |   |   |   |   |   |
| Net interest income                                       |   | 466,526                                         |    | 352,901                                        |   | 1,267,989 |   | 1,025,628 |   |
| Provision for loan losses                                 |   | —                                          |    | 34,900                                         |   | 16,605 |   | 63,600 |   |
|                                                      |   |                                            |    |                                           |   |   |   |   |   |
| Net interest income after provision for  loan loss        |   | 466,526                                         |    | 318,001                                        |   | 1,251,384 |   | 962,028 |   |
|                                                      |   |                                            |    |                                           |   |   |   |   |   |
| **Non-interest  income:**                                 |   |                                            |    |                                           |   |   |   |   |   |
| Other fees and service charges                            |   | 97,151                                          |    | 84,270                                         |   | 187,309 |   | 172,204 |   |
| Gain on sale of securities                                |   | 659                                             |    | —                                         |   | 18,658 |   | 3,504 |   |
| Gain on sale of loans                                     |   | 50,682                                          |    | 180,999                                        |   | 345,785 |   | 562,402 |   |
| Total non-interest income                                 |   | 148,492                                         |    | 265,269                                        |   | 551,752 |   | 738,110 |   |
|                                                      |   |                                            |    |                                           |   |   |   |   |   |
| **Non-interest  expense:**                                |   |                                            |    |                                           |   |   |   |   |   |
| Compensation and employee benefits                        |   | 275,934                                         |    | 247,509                                        |   | 801,648 |   | 762,508 |   |
| Board fees                                                |   | 23,500                                          |    | 24,000                                         |   | 79,000 |   | 78,500 |   |
| Occupancy                                                 |   | 46,712                                          |    | 45,104                                         |   | 141,345 |   | 129,960 |   |
| Printing & supplies                                   |   | 19,612                                          |    | 17,742                                         |   | 63,216 |   | 62,386 |   |
| Property and equipment depreciation                       |   | 21,216                                          |    | 19,162                                         |   | 60,603 |   | 56,016 |   |
| Data processing                                           |   | 42,659                                          |    | 37,398                                         |   | 122,276 |   | 112,914 |   |
| Professional fees                                         |   | 114,672                                         |    | 58,648                                         |   | 304,160 |   | 194,704 |   |
| Other                                                     |   | 88,754                                          |    | 90,278                                         |   | 279,026 |   | 303,592 |   |
| Total non-interest expense                                |   | 633,059                                         |    | 539,841                                        |   | 1,851,274 |   | 1,700,580 |   |
|                                                      |   |                                            |    |                                           |   |   |   |   |   |
| **Income (loss)  before income tax benefit**              |   | (18,041                                         | )       | 43,429                                         |   | (48,138 | ) | (442 | ) |
| Income tax benefit                                        |   | —                                          |    | —                                         |   | — |   | — |   |
|                                                      |   |                                            |    |                                           |   |   |   |   |   |
| **Net income (loss)**                                     |   | $                                               | (18,041 | )                                              | $      | 43,429 |   | $ | (48,138 | ) | $ | (442 | ) |
|                                                      |   |                                            |    |                                           |   |   |   |   |   |
| **Net income (loss)  per common share**                   |   |                                            |    |                                           |   |   |   |   |   |
| Basic and diluted income (loss) per share  of comon stock |   | $                                               | (0.03   | )                                              | $      | 0.09 |   | $ | (0.09 | ) | $ | (0.00 | ) |

 

See Notes to Consolidated FinancialStatements

 

5

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## **Northern Star Financial, Inc. and Subsidiary**

UnauditedConsolidated Statements of Cash Flows

 
|                                                                                 |   | **For the  Three Months  Ended March 31,** |      | **For the  Nine Months  Ended March 31,** |   |
|--------------------------------------------------------------------------------------|--------|-------------------------------------------------|-----------|------------------------------------------------|--------|
|                                                                                 |   | **2004**                                        |      | **2003**                                       |   | **2004** |   | **2003** |   |
| Cash flows from operating activities:                                                |   |                                            |      |                                           |   |   |   |   |   |
| RECONCILIATION OF NET (LOSS) TO NET CASH  PROVIDED BY OPERATING ACTIVITIES           |   |                                            |      |                                           |   |   |   |   |   |
| Net income (loss)                                                                    |   | $                                               | (18,041   | )                                              | $      | 43,429 |   | $ | (48,138 | ) | $ | (442 | ) |
| Adjustments:                                                                         |   |                                            |      |                                           |   |   |   |   |   |
| Depreciation                                                                         |   | 23,932                                          |      | 22,389                                         |   | 70,753 |   | 65,509 |   |
| Provision for loan losses                                                            |   | —                                          |      | 34,900                                         |   | 16,605 |   | 63,600 |   |
| Increase in value of trading securities                                              |   | —                                          |      | —                                         |   | (17,999 | ) | — |   |
| Accretion and (amortization) of premiums  and discounts, net                         |   | 1,133                                           |      | 2,063                                          |   | (104 | ) | 3,218 |   |
| Stock compensation earned                                                            |   | 1,000                                           |      | 1,001                                          |   | 3,000 |   | 2,999 |   |
| Gain on sale of investments                                                          |   | (659                                            | )         | —                                         |   | (659 | ) | (3,504 | ) |
| Defered loan fees                                                                    |   | (14,480                                         | )         | (70,940                                        | )      | (31,323 | ) | (30,128 | ) |
| Originations of loans held for sale                                                  |   | (3,614,709                                      | )         | (12,151,925                                    | )      | (28,672,904 | ) | (38,472,911 | ) |
| Proceeds from sales of loans held for sale                                           |   | 3,136,318                                       |      | 12,071,172                                     |   | 29,738,080 |   | 37,356,803 |   |
| Other                                                                                |   | 21,189                                          |      | (79,911                                        | )      | (103,836 | ) | 61,531 |   |
| Net cash provided by (used in) operating  activities                                 |   | (464,317                                        | )         | (127,822                                       | )      | 953,475 |   | (953,325 | ) |
|                                                                                 |   |                                            |      |                                           |   |   |   |   |   |
| Cash flows from investing activities:                                                |   |                                            |      |                                           |   |   |   |   |   |
| Purchases of available-for-sale securities                                           |   | (3,646,109                                      | )         | (2,247,999                                     | )      | (5,670,842 | ) | (3,757,374 | ) |
| Proceeds from maturities of  available-for-sale securities                           |   | 1,519,943                                       |      | —                                         |   | 2,859,019 |   | 500,000 |   |
| Proceeds from sales of available-for-sale  securities                                |   | 1,403,676                                       |      | 417,371                                        |   | 2,606,082 |   | 6,386,591 |   |
| Proceeds from sale/maturities of trading  securities                                 |   | 68,344                                          |      | —                                         |   | 133,862 |   | — |   |
| Purchase of restricted stock                                                         |   | (18,000                                         | )         | (22,500                                        | )      | (18,000 | ) | (67,500 | ) |
| Net increase (decrease) in federal funds  sold                                       |   | 943,000                                         |      | 4,112,000                                      |   | (3,080,000 | ) | 1,037,000 |   |
| Loan originations and principal payments on  loans, net                              |   | 1,624,345                                       |      | (1,632,297                                     | )      | 3,893,486 |   | (3,658,906 | ) |
| Purchase of property and equipment                                                   |   | (46,504                                         | )         | (22,714                                        | )      | (87,508 | ) | (55,592 | ) |
| Net cash provided by investing activities                                            |   | 1,848,695                                       |      | 603,861                                        |   | 636,099 |   | 384,219 |   |
|                                                                                 |   |                                            |      |                                           |   |   |   |   |   |
| Cash flows from financing activities:                                                |   |                                            |      |                                           |   |   |   |   |   |
| Net increase (decrease) in non-interest  bearing demand and savings deposit accounts |   | 2,503,206                                       |      | (168,059                                       | )      | 2,641,158 |   | 1,471,631 |   |
| Net decrease in time deposits                                                        |   | (774,761                                        | )         | (111,128                                       | )      | (1,271,962 | ) | (123,680 | ) |
| Proceeds from other borrowings                                                       |   | —                                          |      | 112,000                                        |   | — |   | 212,000 |   |
| Repayments of other borrowings                                                       |   | (475,000                                        | )         | —                                         |   | (1,225,000 | ) | (300,000 | ) |
| Proceeds from sale of common stock                                                   |   | —                                          |      | 88,000                                         |   | 269,500 |   | 170,500 |   |
| Net cash provided by (used in) financing  activities                                 |   | 1,253,445                                       |      | (79,187                                        | )      | 413,696 |   | 1,430,451 |   |
| Net increase in cash                                                                 |   | 2,637,823                                       |      | 396,852                                        |   | 2,003,270 |   | 861,345 |   |
| Cash and cash equivalents at beginning of  period                                    |   | 1,742,579                                       |      | 2,812,574                                      |   | 2,377,132 |   | 2,348,081 |   |
| Cash and cash equivalents at end of period                                           |   | $                                               | 4,380,402 |                                           | $      | 3,209,426 |   | $ | 4,380,402 |   | $ | 3,209,426 |   |
|                                                                                 |   |                                            |      |                                           |   |   |   |   |   |
| Supplemental disclosure of cash flow  information:                                   |   |                                            |      |                                           |   |   |   |   |   |
| Cash paid for interest                                                               |   | $                                               | 285,698   |                                           | $      | 324,817 |   | $ | 922,425 |   | $ | 1,127,785 |   |
|                                                                                 |   |                                            |      |                                           |   |   |   |   |   |
| Supplemental disclosure of non-cash  investing and financing activities:             |   |                                            |      |                                           |   |   |   |   |   |
| Renewal of convertible subordinated notes                                            |   | $                                               | —    |                                           | $      | — |   | $ | 100,000 |   | $ | — |   |

 

See Notes to Consolidated FinancialStatements

 

6

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

## **NOTES TO CONDENSED** CONDOLIDATED FINANCIAL STATEMENTS

**March 31,2004 (Unaudited)**

 

Note 1:  PRINCIPLES OFCONSOLIDATION

 

The unaudited consolidated financial statements as of and for the threeand nine month period ended March 31, 2004 and 2003 include the accountsof 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.

 

Note 2:  BASIS OF PRESENTATION

 

The accompanying unaudited interim consolidated financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America for interim financial information.  Accordingly, they do not include allinformation and disclosures required by generally accepted accountingprinciples for complete financial statements. The accompanying consolidated financial statements do not purport tocontain all the necessary financial disclosures required by generally acceptedaccounting principles that might otherwise be necessary in the circumstancesand should be read with the fiscal 2003 consolidated financial statements andnotes of Northern Star Financial, Inc. and Subsidiary included in their annualreport as of and for the year ended June 30, 2003.

 

In the opinion of management, all adjustments (consisting of normalrecurring accruals) considered necessary for fair presentations have beenincluded.  The results of operations forthree and nine month periods ended March 31, 2004 and 2003, are notnecessarily indicative of the results that may be expected for the entirefiscal year or any other interim period.

 

The presentation of the unaudited consolidated statement of cash flowsfor the three and nine months ended March 31, 2003 has been changed toconform with the classifications used in 2004. These reclassifications had no effect on net cash provided by (used in)operating activities or cash equivalents as previously reported.

 

Note 3:  EARNINGS PER SHARE

 

The earnings per share amounts were computed using the weighted averagenumber of shares outstanding during the periods presented.  For the nine-month periods endingMarch 31, 2004 and 2003, the weighted average number of shares outstandingfor basic and diluted earnings per share computation were 551,902 and 488,681, respectively.As of March 31, 2004 and 2003, of the potential common shares of 310,094and 309,548, respectively, related to stock options, warrants, and convertiblesubordinated notes payable, 304,089 and 301,611, respectively, were exercisableand anti-dilutive.

 

During the quarter ended March 31, 2004, there were no optionsgranted.

 

7

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Note 4:  COMPREHENSIVE INCOME(LOSS)

 
|                                                                    |   | **For the  Nine Months  Ended March 31,** |    |
|-------------------------------------------------------------------------|--------|------------------------------------------------|---------|
|                                                                    |   | **2004**                                       |    | **2003** |   |
| 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                                        |   | (23,914                                        | )       | 2,568 |   |
| Ending balance                                                          |   | $                                              | 28,101  |   | $ | 55,296 |   |
|                                                                    |   |                                           |    |   |   |
| Comprehensive income (loss) consists of the  following:                 |   |                                           |    |   |   |
| Net income (loss)                                                       |   | $                                              | (48,138 | ) | $ | (442 | ) |
| Other comprehensive income (loss)                                       |   | (23,914                                        | )       | 2,568 |   |
| Comprehensive income (loss)                                             |   | $                                              | (72,052 | ) | $ | 2,126 |   |

 

Note 5:  STOCK OPTION ACCOUNTING

 

The Company accounts for stock options under the intrinsic value methodof recognition and measurement principles of APB Opinion No. 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 ofFinancial Accounting 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)and earnings (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.

 

8

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|                                                                                                                                      |   | **For the  Three Months  Ended March 31,** |    | **For the  Nine Months  Ended March 31,** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------|---------|------------------------------------------------|--------|
|                                                                                                                                      |   | **2004**                                        |    | **2003**                                       |   | **2004** |   | **2003** |   |
| Net income (loss), as reported                                                                                                            |   | $                                               | (18,041 | )                                              | $      | 43,429 |   | $ | (48,138 | ) | $ | (442 | ) |
| Deduct:                                                                                                                                   |   |                                            |    |                                           |   |   |   |   |   |
| Total stock-based employee compensation  expense determined under the fair value based method for all awards, net of  related tax effects |   | 1,726                                           |    | —                                         |   | 5,178 |   | 32,889 |   |
|                                                                                                                                      |   |                                            |    |                                           |   |   |   |   |   |
| Pro-forma net income (loss)                                                                                                               |   | $                                               | (19,767 | )                                              | $      | 43,429 |   | $ | (53,316 | ) | $ | (33,331 | ) |
|                                                                                                                                      |   |                                            |    |                                           |   |   |   |   |   |
| Earnings (loss) per share:                                                                                                                |   |                                            |    |                                           |   |   |   |   |   |
| Basic, as reported                                                                                                                        |   | $                                               | (0.03   | )                                              | $      | 0.09 |   | $ | (0.09 | ) | $ | (0.00 | ) |
| Basic, pro-forma                                                                                                                          |   | $                                               | (0.03   | )                                              | $      | 0.09 |   | $ | (0.10 | ) | $ | (0.07 | ) |
| Diluted, as reported                                                                                                                      |   | $                                               | (0.03   | )                                              | $      | 0.09 |   | $ | (0.09 | ) | $ | (0.00 | ) |
| Diluted, as pro-forma                                                                                                                     |   | $                                               | (0.03   | )                                              | $      | 0.09 |   | $ | (0.10 | ) | $ | (0.07 | ) |
|                                                                                                                                      |   |                                            |    |                                           |   |   |   |   |   |
| Basic shares                                                                                                                              |   | 586,506                                         |    | 498,439                                        |   | 551,902 |   | 488,681 |   |
| Diluted shares                                                                                                                            |   | 586,506                                         |    | 498,439                                        |   | 551,902 |   | 488,681 |   |

 

Note 6:  CONTINGENCIES

 

The Federal Deposit Insurance Corporation (FDIC) conducted its annualSafety and Soundness Examination of the Bank during the first quarter of fiscalyear 2004 and has issued its report thereon. This report specifies a variety of financial and operational actions tobe taken by the Bank, some of which the Bank did not concur with and, as aresult, the Bank explored with the FDIC alternative means of addressing theirconcerns.  The Bank and the FDIC wereable to resolve their differences regarding the action to be taken.

 

**ITEM 2****:  MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OFOPERATION**

 

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

 

The following is management’s discussion andanalysis of the major factors that influenced the financial performance of theBank for the three and nine months ended March 31, 2004.  Thisanalysis should be read in conjunction with the Company’s 2003 Annual Report asfiled on form 10-KSB and with the unaudited financial statements and notes asset forth in this report.

 

Certain statements contained in this Report, including, withoutlimitation, statements containing the words “believes”, “anticipates”,“intends”, “expects”, and words of similar import, constitute “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934.  Suchforward looking statements involve known and unknown risks, uncertainties andother factors that may cause the actual results, performance or achievements ofthe Company to be materially different 

 

9

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from any future results, performance or achievements expressed orimplied by such forward-looking statements.  Such factors include, amongothers, the following: general economic and business conditions in those areasin which the Company operates, demographic changes, competition, fluctuationsin interest rates, changes in business strategy or development plans, changesin governmental 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 globalchanges.  The Company disclaims anyobligation to update any such factors or to publicly announce the results ofany revisions to any of the forward-looking statements contained herein toreflect future events or developments.

 

This discussion should be read in conjunction with the financialstatements of the Company, including the notes thereto, appearing elsewhere inthis report.

 

**CRITICAL ACCOUNTING POLICIES**

### ** **

We haveadopted accounting principles generally accepted in the United States ofAmerica (GAAP) in the preparation of our financial statements.  The financial information contained withinour financial statements is, to a significant extent, based on approximatemeasures of the financial effects of transactions and events that have alreadyoccurred.  Our significant accountingpolicies are described in the notes to the consolidated financial statements atJune 30, 2003 as filed in our annual report on Form 10-KSB. Certainaccounting policies involve significant judgments and assumptions by us andhave a material impact on the carrying value of certain assets and liabilities.We consider these accounting policies to be critical accounting policies. Thejudgments and assumptions we use are based on the historical experience andother 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 whichwould result in either a beneficial or adverse impact to the Company’sfinancial results.  Other estimates thatthe Company 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 Companyaccounts for its stock based awards using the intrinsic value method inaccordance with Accounting Principles Board (APB) Opinion No. 25 and relatedinterpretations. Since the Company’s stock option plans provide for theissuance of options at a price of no less than the fair market value at thedate of the grant, no compensation expense has been recognized in the financialstatements at the date of grant.

 

We believe the allowance for loan and lease losses is a criticalaccounting policy that 

 

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requires the most significant judgments and estimates used inpreparation of our consolidated financial statements.  The allowance for probable loan and lease losses is an estimateof the losses that may be sustained in the Company’s loan portfolio. Theallowance is based on two basic principles of accounting. (1) Statement ofFinancial Accounting Standards (SFAS) No. 5 *Accountingfor Contingencies*, which requires that losses be accrued when theyare probable of occurring and estimable and (2) SFAS No. 114, *Accounting by Creditors for Impairment of a Loan*,which requires that losses be accrued based on the differences between thevalue of collateral, present value of future cash flows or values that areobservable in the secondary market and the loan balance.

 

**RESULTSOF OPERATIONS**

 

**NetIncome**

The Company’s net operating loss was $18,041 and $48,138 for the threeand nine months ended March 31, 2004 compared to a profit of $43,429 and aloss of  $442 for the three and ninemonths ended March 31, 2003, respectively.  Basic and diluted earnings per share were $(0.03) and $0.09 forthe three months ended March 31, 2004 and 2003, respectively.  Thedecline in earnings was the result of the decline in mortgage refinanceactivity that produced a 38.5% decrease in gains on the sale of loans whencompared with the same nine-month period a year ago. The decline in earningswas lessened by the recovery of $187,789 in past due interest and late feescollected during the third quarter realized in connection with the favorableresolution of the Bridge Lenders related litigation. The decrease in earningswas also eased by a $242,361 increase in net interest income, which in turn wascounteracted by a $150,694 increase in operating expenses. The lower levelof gains on loans sold during the nine months ended March 31, 2004 ascompared to the same period of the prior fiscal year are the result of customerreaction to a less favorable interest rate environment.  Management does not expect gains realized onthe sale of residential mortgage loans to continue to the same extent in thecurrent rate environment as in the prior fiscal year.  Net interest income increased due to an increase in net interestmargin.  Non-interest income decreaseddue to a decrease in the amount of residential mortgage loans originated andsold into the secondary market. Non-interest expenses increased during the three months endedMarch 31, 2004 when compared to the same period of the prior fiscal yeardue to a increase in compensation and employee benefits associated withadditions to staff and was also due to an increase in the amount ofprofessional fees incurred by the Bank in connection with the resolution theBridge Lenders related litigation that arose out of the tenure of a formerdirector (see Part II Item 1- Legal Proceedings).

 

The return on average equity was (2.39)% for the nine months endedMarch 31, 2004 compared to (0.02)% for the nine months endedMarch 31, 2003.  Return on average assets for the nine months endedMarch 31, 2004 was (0.09)% compared to (0.00)% for the nine months endedMarch 31, 2003.  The return on average assets was (0.47)% for fiscalyear ended June 30, 2003.  The decrease in the return on averageassets from March 31, 2003 to March 31, 2004 was due to an increasein net losses noted above, which was the result of a 25.2% decrease innon-interest income and an 8.86% increase in non-interest expenses.  The resulting decrease in the return onaverage assets was mitigated by a 23.6% growth in net interest income.

 

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**InterestIncome**

Net interest income is a significantcomponent of the Bank’s income from operations.  Net interest income isthe difference between the gross interest earned on the loan and investmentportfolios and the interest paid on deposits and other borrowings.  Netinterest income depends on the volume of and interest rate earned on interestearning assets and the volume of and interest rate paid on interest bearingliabilities.

 

Interest income for the three months endedMarch 31, 2004 increased $45,755 to $739,959, compared to $694,204 for thethree months ended March 31, 2003. Interest income for the ninemonths ended March 31, 2004 was $2.1 million compared to $2.1 million, forthe nine months ended March 31, 2003. Interest income for the nine-monthperiod ended March 31, 2004 was relatively unchanged when compared to thenine-month period ending March 31, 2003 as the level of interest earningassets was materially unchanged from the prior period end.  Interest earning assets include loanreceivables, securities available for sale and federal funds sold.  Net interest income increased by $113,625 or32.2% for the three-month period ended March 31, 2004 when compared to theprior period and by $242,361 or 23.6% for the nine-month period as compared tothe nine-month period ended March 31, 2003.  The improvement in net interest income was the result ofdecreases in interest expense on deposits and borrowed funds. Our net interestmargin improved 93 basis points to 4.03% for the three months endedMarch 31, 2004 from a margin of 3.10% for the three months ended March 31,2003. The yield on interest earning assets increased to 6.39% for the threemonths ended March 31, 2004 compared to 6.10% for the three months endedMarch 31, 2003.

 

#### **Interest Expense**

Interest expense for the three months endedMarch 31, 2004 decreased to $273,433 compared to $341,303 for the threemonths ended March 31, 2003.  Interest expense for the nine monthsended March 31, 2004 decreased to $876,678 compared to $1,117,122 for thenine months ended March 31, 2003.  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 Bank 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 2.94% to 2.17%, for the three months endedMarch 31, 2003 and 2004, respectively, and 3.29% to 2.36% for the ninemonths ended March 31, 2003 and 2004, respectively. The cost of notespayable and other borrowings declined from 4.49% to 4.21%, for the three monthsended March 31, 2003 and 2004, respectively and 4.63% to 4.12% for thenine months ended March 31, 2003 and 2004, respectively.  Averageinterest-bearing deposits increased to $37.6 million compared to $36.5 millionfor the three months ended March 31, 2004 and 2003, respectively, whilethey increased to $37.1 million compared to $36.0 million for the nine monthsended March 31, 2004 and 2003, respectively.

 

**NetInterest Income Before Provision for Estimated Loan Losses**

Net interest income before provision forestimated loan losses for the three months ended March 31, 2004 was$466,526, compared to $352,901 for the three months ended March 31, 2003. For the nine months ended March 31, 2004 and 2003, net interest incomebefore provision for estimated loan losses was $1,267,989 and $1,025,628,respectively.  Average interest earningassets were $46.3 million for the three months ended March 31, 2004 with ayield of 6.39% compared to $45.5 million with a yield of 6.10% for the threemonths ended March 31, 2003. 

 

12

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Average interest earning assets were $46.0million for the nine months ended March 31, 2004 with a yield of 6.22%compared to $44.9 million with a yield of 6.37% for the nine months endedMarch 31, 2003.

 

**Provisionfor Estimated Loan Losses**

The provision for estimated loan losses was zero for the three monthsended March 31, 2004 compared to $34,900 for the three months endedMarch 31, 2003 and was $16,605 for the nine months ended March 31,2004 compared to $63,600 for the nine months ended March 31, 2003.  The provision for estimated loan losses totaled $373,937 for the fiscal yearended June 30, 2003.  The provisionfor loan losses decreased $46,995 or 73.9% for the nine-month period endedMarch 31, 2004 as compared to the same nine-month period endedMarch 31, 2003.  The decrease inthe provision for loan losses is primarily in response to the resolution of thelitigation associated with the Gazzola Bankruptcy and Bridge Lenders as well asto the stabilization of the over all quality of the loan portfolio.

 

During fiscal year 2003, the Bank made a $287,114 provision for loanlosses associated with the risk of loss inherent in one commercial loan with anoutstanding balance of approximately $600,000. The Bank does not have any othercredits associated with the related industry and type of loan and, as a result,management does not believe the deterioration in this credit represents anadverse trend in the quality of our loan portfolio.

 

The provision for loan losses represents the current period expenseassociated with maintaining an appropriate allowance for loan and lease losses.The provision for loan losses and level of allowance for each period isdependent upon many factors, including loan growth, net charge-offs, changes inthe composition of the loan portfolio, delinquencies, management’s assessmentof the quality of the loan portfolio, the valuation of problem loans and thegeneral economic conditions in the Bank’s market area. Periodic fluctuations inthe provision for loan losses result from management’s assessment of theadequacy of the allowance for loan and lease losses; however, actual loanlosses may vary from current estimates.

 

**Non-InterestIncome**

Non-interest income represents non-interesttypes of revenue and is comprised of net gain on sale of loans, loan servicingfees, customer service charges and other fee income.  Non-interest income was $148,492 and $265,269 for the threemonths ended March 31, 2004 and 2003, respectively.  Non-interest income was $551,752 and$738,110 for the nine months ended March 31, 2004 and 2003, respectively.

 

The Bank’s current policy is to sell in thesecondary market all residential mortgage loans with a fixed interest rate andwith a re-pricing term of more than five years.  Mortgage loans originated and intended for sale are carried atthe lower of cost or estimated market value in the aggregate.  Gains on the sale of loans are based on thenet proceeds received and the recorded investment in the loan.  Net gain on sale of loans decreased from$180,999 to $50,682 for the three months ended March 31, 2003 and 2004,respectively. For the nine-month periods ended March 31, 2003 and 2004, therewas a decrease from $562,402 to $345,785, respectively.  Net gain on saleof loans for the fiscal year ended June 30, 2003 was $865,581.

 

13

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During the three months ended March 31,2004, the Bank originated for sale $3.6 million in residential mortgage loansas compared to $11.9 million during the three months ended March 31,2003.  The Bank sold 100%, of the residential real estate loans originatedduring the three-month periods ended March 31, 2004 and March 31,2003.  Based upon current forecasts of increasing interest rates, management anticipates that the Bank’s volumeof residential mortgage lending is likely to fall appreciably during the fourthquarter of the current fiscal year.

 

Other fee income and service chargesincreased from $84,270 for the three months ended March 31, 2003 to$97,151 for the three months ended March 31, 2004. For the nine-monthperiods ending March 31, 2003 and 2004, other fee income and servicecharges increased from $172,204 to $187,309, 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-InterestExpenses**

Other operating expenses are non-interest types of expenses and areincurred by the Company and the Bank in its normal course of business.  Salaries and employee benefits, board fees,occupancy, premises and equipment, data processing, professional services, andother expenses are the major categories of other operating expenses.  For the three-month period ending March 31,2004, total non-interest expense increased $93,218 or 17.3% over the sameperiod ended March 31, 2003, while total non-interest expense increased$150,694, or 8.9%, when comparing the nine-month periods ended March 31, 2004and 2003, respectively. For the nine-month period ending March 31, 2004, salaryand benefit expense increased $39,140, or 5.1%, over the comparable nine-monthperiod ending March 31, 2003. The increase was the result of an increase inemployee benefit expenses, combined with an increase in volume of mortgagelending and the related incentive expense.

 

For the three-month period ending March 31, 2004, occupancyexpenses increased $1,608 or 3.6%, while during the nine-month period endingMarch 31, 2004, occupancy expenses increased $11,385, or 8.8% compared tothe same periods in 2003. Other non-interest expenses decreased $24,566 or8.1%, when comparing the nine-month period ended March 31, 2004 to thenine-month period ended March 31, 2003. For the nine-month period endingMarch 31, 2004, professional fees increased $109,456 or 56.2% over thecomparable period ending March 31, 2003.  The increase in these expensesis associated with an increase in activity relating to the litigationpreviously noted.

 

**Provisionfor Income Taxes**

The effective income tax rate for the Companywas 0% for the three and nine months ended March 31, 2004 and 2003 becausethe expected future tax benefit of the net operating loss is reduced by adeferred tax asset valuation allowance in accordance with generally acceptedaccounting principles.

 

14

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**FINANCIALCONDITION**

**Summaryof Changes in Consolidated Balance Sheets**

**March 31,2004 compared to March 31, 2003 and June 30, 2003**

 

Total assets of the Bank increased to $51.5million as of March 31, 2004 compared to $50.0 million as ofMarch 31, 2003. Total assets of the Bank increased $291,004 or 0.57% whencompared to the $51.3 million as of June 30, 2003.  Managementbelieves that the increase in total assets occurring during the nine monthperiod ended March 31, 2004 was not significant. However, the lower levelof loans held for sale resulting from a reduction in the volume of residentialmortgage lending activity associated with refinancing activity in its marketsignificantly changed the mix of interest earning assets.  The lower levels of  residential mortgage lending activityresulted in a 58.2% increase in the Bank’s cash, Federal funds sold andinvestment portfolio of $8.97 million as June 30, 2003 to $14.22 millionas of March 31, 2004 as the proceeds realized from the sale of the loanswere held in short term investments.

 

The level of total deposits held at the Bank,increased $1.9 million to $42.8 million as of March 31, 2004 compared to$40.9 million of March 31, 2003. Total deposits increased $1.4 million when comparing the quarter endingMarch 31, 2004 with the previous fiscal year end June 30, 2003. Cash and cash equivalents increased to $4.4 million as of March 31, 2004compared to $3.2 million as of March 31, 2003 and increased $2.0 millionwhen compared to the $2.4 million held as of June 30, 2003.

 

Stockholders’ equity was $2.1 million as ofMarch 31, 2004 compared to $2.1 million as of March 31, 2003 and $1.9million as of June 30, 2003.

 

**Investments**

The Bank’s investment portfolio consists primarily of securities issuedby agencies of the United States and overnight investments in the Federal Fundsmarket. US Government agency securities, mortgaged back securities, and corporatebonds totaled $6.3 million as of March 31, 2004 compared to $6.5 millionas of March 31, 2003 and were $6.1 million as of June 30,2003. Federal Funds sold totaled $3.6 million as of March 31, 2004compared to zero balance as of March 31, 2003 and were $482,000 as ofJune 30, 2003.  Managementattributes the fluctuations in the investment portfolio during the periods totiming differences associated with securities maturing and reinvestingactivities as well as to the level of loans held for sale.

 

**Loans**

Approximately55% of the loan portfolio of the Bank is secured by various forms of realestate, including residential and commercial real estate. A decline in currenteconomic conditions or rising interest rates could have an adverse effect onthe demand for new loans, the ability of borrowers to repay outstanding loansand the value of real estate and other collateral securing loans. The realestate securing the Company’s loan portfolio is concentrated in Minnesota. Ifreal estate values decline significantly higher vacancies and other factorscould harm the financial condition of the Bank’s borrowers, the collateral forits loans will provide less security, and the Bank would be more likely tosuffer losses on defaulted loans.

 

15

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Loan balances, net of the allowance for loanand lease losses, decreased to $34.9 million as of March 31, 2004 comparedto $37.3 million as of March 31, 2003. However, loan balances, net of the allowance for loan and lease losses,decreased $4.0 million as of March 31, 2004 from $38.9 million as ofJune 30 2003. The decrease in loan balances is attributed to themanagement’s effort to improve net interest margin and due to the repayment ofthe Bridge Lender loans in the amount of $1.1 million in principal and $187,789in interest and late fees.

 

**Non-performingAssets.**

Nonperforming assets consist of nonperforming loans and other realestate owned (“OREO”) and other repossessed assets.  Nonperforming loansare those loans which have (i) been placed on nonaccrual status, (ii) beensubject to troubled debt restructurings, or (iii) become contractually past due90 days or more with respect to principal or interest and have not beenrestructured or placed on nonaccrual status. At March 31, 2004, the Bank had $531,765 in non-performing assetscompared to $2.13 million at March 31, 2003, and $1.96 million atJune 30, 2003.

 

**NonaccrualLoans.**

Nonaccrual loans are impaired loans where theoriginal contractual amount may not be fully collectible.  The Bankmeasures its impaired loans by using the fair value of the collateral if theloan is collateral-dependent and the present value of the expected future cashflows discounted at the loan’s effective interest rate if the loan is not collateral-dependent. The Bank places loans on nonaccrual status that are delinquent 90 days or moreor when a reasonable doubt exists as to the collectibility of all payments dueunder the terms of the loan.  As ofMarch 31, 2004 the Bank had 2 loans on nonaccrual status totaling $531,765million, at June 30, 2003, 9 loans on nonaccrual status totaling $1.84million and as of March 31, 2003, the Bank had 10 loans on nonaccrualstatus totaling $2.14 million.

 

**ClassifiedAssets.**

From time to time, management has reason tobelieve that certain borrowers will not repay their loans within the parametersof the present repayment terms, even though, in some cases, the loans arecurrent at the time. These loans are graded in the classified loan grades of“substandard,” “doubtful,” or “loss” and include non-performing loans. Each classified loan is monitored monthly.  Classified assets (consistingof nonaccrual loans, loans graded as substandard or lower and other repossessedassets) at March 31, 2004 were $1.15 million compared to $2.16 million asof March 31, 2003 and were $3.11 million at June 30, 2003.

 

**Allowancefor Loan and Lease Losses.**

The Bank has established a methodology for the determination ofprovisions for loan losses.  The methodology is set forth in a formalpolicy and takes into consideration the need for an overall allowance for loanand lease losses as well as specific allowances that are tied to individualloans.  The Bank’s methodology for assessing the appropriateness of theallowance consists of several key elements, which include the formula allowanceand a specific allowance for identified problem loans.  The balance in theallowance is affected by the amounts provided from operations, amounts chargedoff and recoveries of loans previously charged off.

 

 

16

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In originating loans, the Bank recognizesthat losses will be experienced and that the risk of loss will vary with, amongother things, the type of loan being made, the creditworthiness of the borrowerover the term of the loan, general economic conditions and, in the case of asecured loan, the quality of the collateral securing the loan.  Theallowance is increased by provisions charged against earnings and reduced bynet 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.

 

The allowance for loan and lease losses is maintained to cover lossesinherent in the loan portfolio.  The responsibility for the review of theBank’s assets and the determination of the adequacy of the general valuationallowance lies with the Director’s Loan Committee.  This committee assignsthe loss reserve ratio for each type of asset and reviews the adequacy of theallowance at least quarterly based on an evaluation of the portfolio, pastexperience, prevailing market conditions, amount of government guarantees,concentration in loan types and other relevant factors.  Specificvaluation allowances are established to absorb losses on loans for which fullcollectability may not be reasonably assured.  The amount of the specificallowance is based on the estimated value of the collateral securing theimpaired loans and other analyses pertinent to each situation.  Estimatesof identifiable losses are reviewed continually and, generally, a provision forlosses is charged against operations on a monthly basis as necessary tomaintain the allowance at an appropriate level.  Management presents ananalysis of the allowance for loan and lease losses to the Bank’s Board ofDirectors on a quarterly basis.  Noassurance can be given that nonperforming loans will not increase or that theallowance for loan and lease losses will be adequate to cover losses inherentin the loan portfolio.

 

The Director’s Loan Committee meets quarterly to review and monitorconditions in the portfolio and to determine the appropriate allowance for loanand lease losses.  To the extent that any of these conditions areevidenced by identifiable problem credit or portfolio segment as of theevaluation date, the committee’s estimate of such condition may be reflected asa specific allowance applicable to such credit or portfolio segment.  Byassessing the probable estimated losses inherent in the loan portfolio on aquarterly basis, the Bank is able to adjust specific and inherent lossestimates based upon the most recent information that has become available.

 

As of March 31, 2004, the balance in theallowance for loan and lease losses was $644,780 compared to $718,045 as ofMarch 31, 2003 and $1,029,581 as of June 30, 2003. The allowancefor loan and lease losses as a percentage of total loans was 1.81% as of March 31,2004 compared to 1.89% as of March 31, 2003 and 2.58% as of June 30,2003.  Management believes the allowance at March 31, 2004 isadequate based upon its ongoing analysis of the loan portfolio, historical losstrends, general economic conditions and other factors.

 

**Depositsand Borrowings**

Total deposits increased to $42.8 million asof March 31, 2004 compared to $40.9 million as of March 31, 2003 and$41.4 million as of June 30, 2003.  The decrease in deposits is theresult of management’s efforts to decrease the Bank’s cost of funds and wasaccompanied by a decrease in the level of residential mortgage loans originatedand held for sale.

 

Notes payable and other borrowings totaled$4.8 million as of March 31, 2004 and $6.0 million as of June 30,2003, compared to $5.0 million as of March 31, 2003.  Included inother 

 

17

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borrowings are advances from the FHLB andother banks.  The Bank established a line of credit with the FHLBcollateralized by loans and securities.  Funds from the credit line wereused to purchase government securities and increase liquidity at the Bank.

 

In addition, the Company has issued $1.6million of unsecured subordinated notes payable, the proceeds of which was usedto provide equity capital to the Bank and to pay the operating expenses of theCompany.  The holders of the unsecurednotes have the right to convert at any time prior to maturity all or any partof the notes into shares of common stock of the Company at the conversionrate.  The conversion rate is adjustedif the number of shares changes.

 

**Capital**

The Company’s capital increased to $4.6million as of March 31, 2004 compared to $4.3 million as of March 31,2003 and was $4.4 million as of June 30, 2003.  For the nine-monthperiod ending March 31, 2004 the Company sold 49,000 shares of commonstock and received proceeds of $269,500.

 

Management considers capital requirements aspart of its strategic planning process.  Based on current projections,management believes that the Bank will continue to remain well capitalizedduring 2004.  Future asset growth is dependent upon many factors,including the Bank’s access to capital markets, earnings growth, and overalleconomic conditions.  The ability to obtain capital is dependent upon thecapital markets as well as performance of the Bank.  Management regularlyevaluates sources of capital and the timing required to accomplish itsstrategic objectives.

 

At March 31, 2004 and March 31, 2003, all capital ratios wereabove all current Federal capital guidelines for a “well capitalized”bank.   As of March 31, 2004, the Bank’s regulatory totalcapital to risk-weighted assets ratio was 12.07% compared to 12.42% as ofMarch 31, 2003 and 11.60% as of June 30, 2003.  The Bank’sregulatory Tier 1 capital to risk-weighted assets ratio was 10.82% as ofMarch 31, 2004 compared to 11.16% as of March 31, 2003 and 10.33% asof June 30, 2003.  The Bank’s regulatory Tier 1 Capital to averageassets ratio was 8.58% as of March 31, 2004 compared to 8.46% atMarch 31, 2003 and 8.04% at June 30, 2003.

 

**Dividends**

Whether or not the Board of Directors willdetermine stock dividends or any cash dividends will be paid in the futuredepends upon their consideration of various factors.  The Company’s andthe Bank’s profitability and regulatory capital ratios in addition to otherfinancial conditions will be key factors considered by the Board of Directorsin making such determinations regarding the payment of dividends. There arestate and federal statutory and regulatory requirements limiting the amount ofdividends that may be paid to the Company by our Bank.  Generally, a bank may pay cash dividends outof current operating earnings to the extent that the current rate of earningsretention is consistent with the Bank’s capital needs, asset quality, andoverall financial condition.  Thegoverning regulatory agency has the authority to prohibit our Bank fromengaging in business practices that the governing authority considers to be unsafeor unsound.  It is possible, dependingupon the financial condition of our Bank, that the governing regulatory agencymay determine that the payment of dividends to the Company by 

 

18

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our Bank might, under somecircumstances, be such an unsafe and unsound practice.  Neither the Company nor the Bank has plansto pay any cash dividends to its stockholders in the foreseeable future.

 

**Liquidityand Interest Rate Risk**

The Bank utilizes electronic data processingmodeling software for liquidity, asset/liability management, and budgetmodeling calculation and analysis.  Ouruse of these data processing applications enable us to effectively identify,measure, monitor and control our exposure to risk and help grow earnings.

 

The Bankclosely monitors its liquidity so that the cash requirements for loans anddeposit withdrawals are met in an economical manner.  Management monitorsliquidity in relation to trends of loans and deposits for short term andlong-term requirements.  Liquidity sources are cash, deposits with otherbanks, overnight Federal Funds investments, un-pledged  investment securities, and the ability tosell loans. As of March 31, 2004, liquid assets as a percentage ofdeposits were 25.23% compared to 11.34% as of March 31, 2003. Liquidityrisk represents the potential for loss as a result of limitations on theCompany’s ability to adjust for future cash flows, to meet the needs ofdepositors and borrowers, and to fund operations on a timely and cost-effectivebasis. The Bank’s liquidity policy requires monthly review of the Bank’sliquidity by the board of directors.

 

The Bank had anegative cumulative one year gap of $(10.2) million, or (19.7)% of totalassets, at March 31, 2004. In theory, this would indicate that moreliabilities than assets would reprice if there were a change in interest ratesover the next year. If interest rates were to increase, the negative gap wouldtend to result in a lower net interest margin, conversely if interest rateswere to decline, the negative gap would tend to result in a higher net interestmargin. However, changes in the mix of earning assets or supporting liabilitiescan either increase or decrease the net interest margin without affectinginterest rate sensitivity. This characteristic is referred to as a basis riskand, generally, relates to the re-pricing characteristics of certain short-termfunding sources.

 

Interest ratechanges do not affect all categories of assets and liabilities equally or atthe same time. Varying interest rate environments can create unexpected changesin prepayment levels of assets and liabilities, which may have a significanteffect on the net interest margin and are not reflected in the interestsensitivity analysis table. Because of these factors, an interest sensitivity gapreport may not provide a complete assessment of the exposure to changes ininterest rates. To supplement traditional gap analysis, the Bank performssimulation modeling to estimate the potential effects of changing interest rateenvironments. The process allows the Bank to explore the complex relationshipswithin the gap over time and various interest rate environments.

 

The Bank’sinternal asset/liability committee and the finance and investment committee ofthe Board of Directors each meet monthly to monitor the Bank’s investments,liquidity needs and to oversee its asset/liability management. The Bankevaluates the rates offered on its deposit products on a weekly basis.

 

19

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**AVERAGE BALANCES, YIELDS AND RATES**

The following table sets forth, for the threeand nine month periods ended March 31, 2004 and 2003, the weighted averageyields or earned, the weighted average rates paid, the interest rate spread andthe net yield on earning assets and interest-bearing liabilities, on anannualized basis.****

 
|                                                                              |   | **For the  Three Months Ended** |       |
|-----------------------------------------------------------------------------------|--------|---------------------------------|------------|
|                                                                              |   | **March 31,  2004**        |       | **March 31,  2003** |   |
|                                                                              |   | **Average  Balance**            |       | **Interest** |   | **Average  Yield or  Rates Paid** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield or  Rates Paid** |   |
| **Assets**                                                                        |   |                            |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable                                                                  |   | $                               | 36,123,445 |   | $ | 669,895 |   | 7.42 | % | $ | 36,164,518 |   | $ | 620,225 |   | 6.86 | % |
| Investment securities                                                             |   | 6,056,333                       |       | 61,137 |   | 4.04 | % | 5,925,454 |   | 64,260 |   | 4.34 | % |
| Federal funds sold                                                                |   | 4,113,052                       |       | 8,927 |   | 0.87 | % | 3,416,667 |   | 9,719 |   | 1.14 | % |
| Total interest-earning assets                                                     |   | 46,292,830                      |       | 739,959 |   | 6.39 | % | 45,506,639 |   | 694,204 |   | 6.10 | % |
| Non-interest-earning assets                                                       |   | 3,659,671                       |       |   |   |   |   | 3,923,669 |   |   |   |   |   |
| Total assets                                                                      |   | $                               | 49,952,501 |   |   |   |   |   | $ | 49,430,308 |   |   |   |   |   |
| **Liabilities and  Stockholders’ Equity**                                    |   |                            |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits                                                         |   | $                               | 37,616,352 |   | 203,822 |   | 2.17 | % | $ | 36,491,693 |   | 268,118 |   | 2.94 | % |
| Other liabilities                                                                 |   | 6,612,069                       |       | 69,611 |   | 4.21 | % | 6,525,667 |   | 73,185 |   | 4.49 | % |
| Total interest-bearing liabilities                                                |   | 44,228,421                      |       | 273,433 |   | 2.47 | % | 43,017,360 |   | 341,303 |   | 3.17 | % |
| Non-interest-bearing liabilities                                                  |   | 3,621,295                       |       |   |   |   |   | 4,382,831 |   |   |   |   |   |
| Total liabilities                                                                 |   | 47,849,716                      |       |   |   |   |   | 47,400,191 |   |   |   |   |   |
| Stockholders’ Equity                                                         |   | 2,102,785                       |       |   |   |   |   | 2,030,117 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                                   |   | $                               | 49,952,501 |   |   |   |   |   | $ | 49,430,308 |   |   |   |   |   |
| Net interest spread                                                               |   |                            |       |   |   | 3.92 | % |   |   |   |   | 2.93 | % |
| Net interest income/margin                                                        |   |                            |       | $ | 466,526 |   | 4.03 | % |   |   | $ | 352,901 |   | 3.10 | % |
| Ratio of average interest-earning assets to  average interest-bearing liabilities |   | 1.05                            | x     |   |   |   |   | 1.06 | x  |   |   |   |   |
|                                                                              |   |                            |       |   |   |   |   |   |   |   |   |   |   |
|                                                                              |   | **For the  Nine Months Ended**  | ** ** |
|                                                                              |   | **March 31,  2004**        | ** ** | **March 31,  2003** | ** ** |
|                                                                              |   | **Average  Balance**            | ** ** | **Interest** | ** ** | **Average  Yield or  Rates Paid** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield or  Rates Paid** | ** ** |
| **Assets**                                                                        |   |                            |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable                                                                  |   | $                               | 36,679,973 |   | $ | 1,956,343 |   | 7.11 | % | $ | 35,534,696 |   | $ | 1,881,633 |   | 7.06 | % |
| Investment securities                                                             |   | 5,608,045                       |       | 164,012 |   | 3.90 | % | 6,478,429 |   | 232,419 |   | 4.78 | % |
| Federal funds sold                                                                |   | 3,667,562                       |       | 24,312 |   | 0.88 | % | 2,866,186 |   | 28,698 |   | 1.34 | % |
| Total interest-earning assets                                                     |   | 45,955,580                      |       | 2,144,667 |   | 6.22 | % | 44,879,311 |   | 2,142,750 |   | 6.37 | % |
| Non-interest-earning assets                                                       |   | 4,115,935                       |       |   |   |   |   | 4,108,765 |   |   |   |   |   |
| Total assets                                                                      |   | $                               | 50,071,515 |   |   |   |   |   | $ | 48,988,076 |   |   |   |   |   |
| **Liabilities and  Stockholders’ Equity**                                    |   |                            |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits                                                         |   | $                               | 37,056,228 |   | 655,871 |   | 2.36 | % | $ | 35,978,484 |   | 888,780 |   | 3.29 | % |
| Other liabilities                                                                 |   | 7,154,023                       |       | 220,807 |   | 4.12 | % | 6,575,568 |   | 228,342 |   | 4.63 | % |
| Total interest-bearing liabilities                                                |   | 44,210,251                      |       | 876,678 |   | 2.64 | % | 42,554,052 |   | 1,117,122 |   | 3.50 | % |
| Non-interest-bearing liabilities                                                  |   | 3,734,253                       |       |   |   |   |   | 4,461,470 |   |   |   |   |   |
| Total liabilities                                                                 |   | 47,944,504                      |       |   |   |   |   | 47,015,522 |   |   |   |   |   |
| Stockholders’ Equity                                                         |   | 2,127,011                       |       |   |   |   |   | 1,972,554 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                                   |   | $                               | 50,071,515 |   |   |   |   |   | $ | 48,988,076 |   |   |   |   |   |
| Net interest spread                                                               |   |                            |       |   |   | 3.58 | % |   |   |   |   | 2.87 | % |
| Net interest income/margin                                                        |   |                            |       | $ | 1,267,989 |   | 3.68 | % |   |   | $ | 1,025,628 |   | 3.05 | % |
| Ratio of average interest-earning assets to  average interest-bearing liabilities |   | 1.04                            | x          |   |   |   |   | 1.05 | x  |   |   |   |   |

 

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**INVESTMENT PORTFOLIO**

At March 31, 2004, our available forsale investments securities portfolio represented approximately 13.3% of ourinterest earning assets of $47.1 million. We also held investments in stock of the Federal Home Loan Bank andUnited Bankers Bank in the amount of $385,100, which is not included in thetables below.  The securities are listedat fair value.

 
|                                |   | **March 31,  2004** |      | **June 30,  2003** |   |
|-------------------------------------|--------|--------------------------|-----------|-------------------------|--------|
|                                |   |                     |      |                    |   |
| U.S. Agencies                       |   | $                        | 2,506,864 |                    | $      | 2,266,739 |   |
| Mortgage-back securities            |   | 3,772,870                |      | 3,318,430               |   |
| Corporate bonds                     |   | —                   |      | 527,919                 |   |
| Total securities available for sale |   | $                        | 6,279,734 |                    | $      | 6,113,088 |   |

 

Contractual maturities and yields on theCompany’s available for sale investments are summarized in the followingtable.  Expected maturities may differfrom contractual maturities because issuers may have the right to call orprepay obligations with our without call or prepayment penalties.

 
|                     |   | **March 31,  2004** |   |
|--------------------------|--------|--------------------------|--------|
|                     |   | **One Year  or Less**    |   | **Yield** |   | **After one  year thru  five years** |   | **Yield** |   | **ten years** |   | **After five  years thru  Yield** |   | **After 10  years** |   | **Yield** |   | **Total** |   | **Yield** |   |
|                     |   |                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Agencies            |   | $                        | — |   | 0.00 | % | $ | 1,503,114 |   | 2.91 | % | $ | 1,003,750 |   | 5.63 | % | $ | — |   | 0.00 | % | $ | 2,506,864 |   | 4.00 | % |
| Mortgage-back securities |   | —                   |   | 0.00 | % | 304,616 |   | 3.66 | % | 1,489,438 |   | 4.80 | % | 1,978,816 |   | 4.28 | % | 3,772,870 |   | 4.44 | % |
|                     |   | $                        | — |   | 0.00 | % | $ | 1,807,730 |   | 3.04 | % | $ | 2,493,188 |   | 5.13 | % | $ | 1,978,816 |   | 4.28 | % | $ | 6,279,734 |   | 4.26 | % |
|                          |        |                          |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**LOAN PORTFOLIO**

The following table summarizes thecomposition of the loan portfolio. Total gross loans including net of deferred loan fees and costsoutstanding at March 31, 2004 and June 30, 2003 were $35,541,024 and$39,881,709, respectively.  This tableexcludes loans held for sale as of March 31, 2004 and June 30, 2003 of$970,000 and $2,035,176, respectively. Loans held for sale are comprised of real estate mortgages. 

 
|                           |   | **March 31,  2004** |       | **June 30,  2003** |   |
|--------------------------------|--------|--------------------------|------------|-------------------------|--------|
|                           |   | **Amount**               |       | **% of Total**          |   | **Amount** |   | **% of Total** |   |
| Commercial & agricultural  |   | $                        | 7,092,970  |                    | 19.99  | % | $ | 6,979,307 |   | 17.55 | % |
| Real estate - construction     |   | 3,104,142                |       | 8.75                    | %      | 4,433,072 |   | 11.15 | % |
| Real estate - mortgages        |   | 18,920,724               |       | 53.33                   | %      | 18,504,208 |   | 46.52 | % |
| Consumer loans                 |   | 6,327,023                |       | 17.83                   | %      | 9,821,027 |   | 24.69 | % |
| Lease financing                |   | 33,536                   |       | 0.10                    | %      | 35,673 |   | 0.09 | % |
| Total loans                    |   | $                        | 35,478,395 |                    | 100.00 | % | $ | 39,773,287 |   | 100.00 | % |
| Net deferred loan fees/(costs) |   | 62,629                   |       |                    |   | 108,422 |   |   |   |
| Less: allowance for loan loss  |   | (644,780                 | )          |                    |   | (1,029,581 | ) |   |   |
| Total net loans                |   | $                        | 34,896,244 |                    |   |   | $ | 38,852,128 |   |   |   |

 

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### **MATURITIES AND SENSITIVITY OFLOANS TO CHANGES IN INTEREST RATES**

The information in the following table isbased on the contractual maturities of individual loans, which may be subjectto renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval as wellas modification of terms upon maturity. Actual repayments of loans may differ from maturities reflected belowbecause borrowers have the right to repay obligations with or withoutprepayment penalties.  The followingtable summarizes loan maturities, by type at March 31, 2004 andJune 30, 2003. 

 
|                               |   | **As of  March 31, 2004** |       |
|------------------------------------|--------|--------------------------------|------------|
|                               |   | **One Year  or Less**          |       | **After One  but  within Five Years** |   | **After  Five Years** |   | **Total** |   |
| Commercial & agricultural      |   | $                              | 2,080,879  |   | $ | 2,962,876 |   | $ | 2,049,215 |   | $ | 7,092,970 |   |
| Real estate - construction         |   | 1,323,191                      |       | 1,780,951 |   | — |   | 3,104,142 |   |
| Real estate - mortgages            |   | 1,042,413                      |       | 11,624,848 |   | 6,253,463 |   | 18,920,724 |   |
| Consumer loans                     |   | 604,936                        |       | 4,725,509 |   | 996,578 |   | 6,327,023 |   |
| Lease financing                    |   | —                         |       | 33,536 |   | — |   | 33,536 |   |
| Total                              |   | $                              | 5,051,419  |   | $ | 21,127,720 |   | $ | 9,299,256 |   | $ | 35,478,395 |   |
| Loans maturing after one year with |   |                           |       |   |   |   |   |   |   |
| Fixed interest rate                |   | $                              | 27,421,023 |   |   |   |   |   |   |   |
| Floating interest rates            |   | $                              | 3,005,953  |   |   |   |   |   |   |   |
|                               |   |                           |       |   |   |   |   |   |   |
|                               |   | **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  |   |   |   |   |   |   |   |

 

**PROVISION AND ALLOWANCE FOR LOAN AND LEASELOSSES**

We havedeveloped policies and procedures for evaluating the overall quality of itscredit portfolio and the timely identification of potential creditproblems.  Additions to the allowancefor loan and lease losses will be made periodically to maintain the allowanceat an appropriate level based on management’s analysis of the potential risk inthe loan portfolio.

 

The Bank madeno additions to the allowance for loan and lease losses during the three monthsended March 31, 2004.  AtMarch 31, 2004, the allowance for loan and lease losses was $644,780, or1.81% of $35.5 million in loan receivables (net of loans held for sale).  At June 30, 2003, the allowance forloan and lease 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 thenine months ending March 31, 2004, management charged off $401,406 (net ofrecoveries) and provided $16,605 to the provision for loan losses.  For the nine-month period 

 

22

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endedMarch 31, 2004, net charge offs as a percentage of average loansoutstanding was 1.09%, compared to 0.00% for the nine-month period endedMarch 31, 2003. The increase in net charge-offs for the first nine monthsof fiscal year 2004 was primarily due to increased charge-offs that occurredwithin the Bank’s commercial loan portfolio.

 

Managementbelieves the allowance at March 31, 2004 is adequate based upon its ongoinganalysis of the loan portfolio, historical loss trends and other factors.Although management believes that they use the best information available tomake such determinations, future adjustments to the allowance for loan andlease losses may be necessary and results of operations could be significantlyand adversely affected if circumstances differ substantially from theassumptions used in making the determinations. 

 
|                                                                                       |   | **Nine  Months Ended  March 31, 2004** |      | **Year Ended  June 30, 2003** |   |
|--------------------------------------------------------------------------------------------|--------|---------------------------------------------|-----------|------------------------------------|--------|
| Balance at beginning of period                                                             |   | $                                           | 1,029,581 |                               | $      | 661,170 |   |
| Charge-offs:                                                                               |   |                                        |      |                               |   |
| Commercial   & agricultural                                                       |   | (185,611                                    | )         | —                             |   |
| Consumer loans                                                                             |   | (251,304                                    | )         | (14,680                            | )      |
|                                                                                       |   | (436,915                                    | )         | (14,680                            | )      |
| Recoveries:                                                                                |   |                                        |      |                               |   |
| Commercial & agricultural                                                              |   | 4,000                                       |      | 7,930                              |   |
| Consumer loans                                                                             |   | 31,509                                      |      | 1,224                              |   |
|                                                                                       |   | 35,509                                      |      | 9,154                              |   |
| Net charge offs                                                                            |   | (401,406                                    | )         | (5,526                             | )      |
| Provision charged to operations                                                            |   | 16,605                                      |      | 373,937                            |   |
| Balance at end of period                                                                   |   | $                                           | 644,780   |                               | $      | 1,029,581 |   |
|                                                                                       |   |                                        |      |                               |   |
| Ratio of net charge-offs during the period  to average loans outstanding during the period |   | 1.09                                        | %         | 0.02                               | %      |

 

At March 31, 2004 and June 30, 2003 the allowance wasallocated as follows:

 
|                          |   | **March 31,  2004** |    | **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 |   | $                        | 361,487 |                                                    | 19.99  | % | $ | 341,993 |   | 17.55 | % |
| Real estate - construction    |   | 19,952                   |    | 8.75                                                    | %      | 26,896 |   | 11.15 | % |
| Real estate - mortgages       |   | 155,202                  |    | 53.33                                                   | %      | 151,417 |   | 46.52 | % |
| Consumer loans                |   | 107,887                  |    | 17.83                                                   | %      | 509,007 |   | 24.69 | % |
| Lease financing               |   | 252                      |    | 0.10                                                    | %      | 268 |   | 0.09 | % |
| Total                         |   | $                        | 644,780 |                                                    | 100.00 | % | $ | 1,029,581 |   | 100.00 | % |

 

23

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**DEPOSITS**

The followingis a table of deposits by category at March 31, 2004 and June 30,2003.

 
|                              |   | **As of  March 31, 2004** |       |
|-----------------------------------|--------|--------------------------------|------------|
|                              |   | **Ending  Balance**            |       | **Percentage  of Total  Deposits** |   | **Average  Balance** |   | **Percentage  of Total  Average  Deposits** |   | **Effective  Cost** |   |
| Demand deposit                    |   | $                              | 6,622,557  |   | 15.47 | % | $ | 3,426,516 |   | 8.46 | % | 0.00 | % |
| Now and money market              |   | 8,632,115                      |       | 20.17 | % | 8,732,425 |   | 21.57 | % | 1.12 | % |
| Savings                           |   | 5,731,545                      |       | 13.39 | % | 5,294,227 |   | 13.08 | % | 1.26 | % |
| Time accounts less than $100,000  |   | 15,944,344                     |       | 37.25 | % | 17,570,894 |   | 43.40 | % | 3.10 | % |
| Time accounts of $100,000 or more |   | 5,867,345                      |       | 13.72 | % | 5,458,682 |   | 13.49 | % | 3.03 | % |
| Total deposits                    |   | $                              | 42,797,906 |   | 100.00 | % | $ | 40,482,744 |   | 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 of time deposits of $100,000.00 and over and timedeposits of less than $100,000 is as follows:

 
|                              |   | **March 31,  2004** |      |
|-----------------------------------|--------|--------------------------|-----------|
|                              |   | **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  |   | $                        | 2,504,942 |   | $ | 2,208,483 |   | $ | 3,828,364 |   | $ | 7,402,555 |   | $ | 15,944,344 |   |
| Time accounts of $100,00 and over |   | 1,750,791                |      | 824,699 |   | 1,230,677 |   | 2,061,178 |   | 5,867,345 |   |
| Total                             |   | $                        | 4,255,733 |   | $ | 3,033,182 |   | $ | 5,059,041 |   | $ | 9,463,733 |   | $ | 21,811,689 |   |

 

**ITEM3****. CONTROLS ANDPROCEDUERS**

Evaluation of Disclosure Controls Procedures

As of the end of the period covered by this report, the Companyconducted an evaluation under the supervision and with the participation of theCompany’s management, including the Company’s Chief Executive Officer andPrincipal Financial Officer, regarding the effectiveness of the design andoperation of the Company’s disclosure controls and procedures pursuant to Rules13a-15(b) of the Securities Exchange Act of 1934 (the “Exchange Act”).  Based upon that evaluation, the ChiefExecutive Officer and Principal Financial Officer concluded that the Company’sdisclosure controls and procedures are effective to ensure that informationthat is 

 

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required to be disclosed by the Company in reports that it files underthe Exchange Act is recorded, processed, summarized and reported within thetime period specified in the rules of the Securities Exchange Commission.

 

Changes in Internal Controls

There were no changes in the Company’sinternal control over financial reporting that occurred during the periodcovered by this report that have materially affected, or are reasonably likelyto materially affect, the Company’s internal control over financial reporting.

 

## **Part II**

**OTHER INFORMATION**

 

### **Item 1.  Legal Proceedings**

The Bank was a defendant in a complaint filed on February 23, 2002in United States District Court, District of South Dakota Southern Division byBridge Lenders, LLC; Jim Perry; Larry Ticknor; Doug English; Rollyn H. Samp;Courtney Anderson; Henry Carlson, Jr.; Michael M. Samp; Ernest Olson; DonDavis; Jerry Landerville; Allen Lewis; Gary Viger; Glen Jamtgaard and SteveHerman (“Plaintiffs”).  The complaintarose out of a series of loans that the Bank made to Plaintiffs in 2000.  Plaintiffs used the proceeds of the loans tomake an investment in Bridge Lenders, LLC, and Bridge Lenders, LLC in turn usedthe funds to make an investment in Phenix Biocomposites, which has defaulted inits obligations to Plaintiffs.  The Bankwas a defendant in this action due to the fact that its former director, FrankGazzola, was also a director of Phenix Biocomposites.  On February 24, 2004, the court dismissed all claims againstNorthern Star Bank and Frank Gazzola.

 

The Company was a defendant and third party plaintiff in a complaintoriginally filed on March 22, 2002 in the United States District Court forthe Western District of Wisconsin by Catalytic Combustion Corporation 401(k)Profit Sharing Plan and Catalytic Combustion Corporation (“Plaintiffs”).   On March 31, 2003, the Company, thethird party defendant, and the plaintiffs entered into a confidential final andbinding mutual release of all claims and settlement agreement.

 

During 1999 and 2000, the Bank made a series of loans to Frank Gazzola,then a Director of the Company, in various amounts at market rates of interestand for terms of various lengths of time. Mr. Gazzola defaulted on the loansand the Bank foreclosed on the collateral for the loans. The bankruptcy courtclaimed that since certain of the collateral was conveyed to the Bank withinone year of Gazzola’s bankruptcy filing and since he was an insider, they werepreferential transfers and must be reversed. On June 12, 2003, in an out of court settlement, the court approveda settlement agreement where-in the Bank agreed to pay the bankruptcy court asettlement fee for which the Bank retained a claim against the unsecured assetsof Mr. Gazzola’s bankruptcy estate and a release by the court of all claims tothe collateral held by the Bank.

 

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

During the first quarter of the currentfiscal year, the Company issued 23,000 shares of stock in the amount of$126,500 under a private placement offering for 50,000 shares.  During 

 

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the second quarter of the current fiscalyear, the Company issued 26,000 shares of stock in the amount of $143,000 underthis private placement offering. The Company did not incur any underwriting orplacement expenses in connection with these issuances.  The proceeds will be utilized to support ouron-going operations.

 

**Item 3.  DefaultsUpon Senior Securities**

 

None to report.

 

**Item 4.  Submissionof Matters to a Vote of Security Holders**

 

No matters were submitted to the securityholders.

 

**Item 5.  Other Information**

 

None to report

 

**Item 6.  Exhibitsand Reports Form 8-K**

 

a) Exhibits

 

Exhibits arenumbers in accordance with Item 601 of Regulation S-B. See “Exhibit Index”immediately following the signature page of this Form 10-QSB.

 

b) Reportson Form 8-K

 

1) A Form8-K dated February 10, 2003 was filed to announce and furnish results ofthe Company and its wholly owned subsidiary Northern Star Bank for the secondquarter of the fiscal year ended June 30, 2004

 

2) A Form8-K dated February 26, 2003 was filed to announce the dismissal, withprejudice, of all claims asserted by plaintiffs against Northern Star Bank inUnited States District Court.

 

 

**SIGNATURES**

 

In accordance with the requirements of the Exchange Act, the registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                     | NORTHERN STAR FINANCIAL, INC. |
|--------------------------|-------------------------------|
|                     |                          |   |
| Date:  May 13, 2004 | By                            | /s/ Thomas P. Stienessen |   |
|                     |                          | Thomas P. Stienessen, President and  Chief Executive Officer |
|                     |                          |   |
| Date:  May 13, 2004 | By                            | /s/ Gerald W. Eick |   |
|                     |                          | Gerald W. Eick, Treasurer |

 

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**EXHIBITINDEX**

**NORTHERNSTAR FINANCIAL, INC.**

**FORM10-QSB FOR QUARTER ENDED MARCH 31, 2004**

 
| **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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