UNITED STATES  SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549



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FORM 10-Q

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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008



Commission File Number 0-20050



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PRINCETON NATIONAL BANCORP, INC.

(Exact name of registrant as specified in its charter)



Delaware

        36-3210283(State or other jurisdiction of incorporation or organization)

        (I.R.S. Employer Identification No.)




606 S. Main Street, Princeton, IL 61356

(Address of principal executive offices and Zip Code)



(815) 875-4444

(Registrants telephone number, including area code)



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.



YesxNoo



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.



Large accelerated filer

        oAccelerated filer

        xNon-accelerated filer

        oSmaller reporting company

        o




Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).



YesoNox



As of October 20, 2008, the registrant had outstanding 3,296,669 shares of its $5 par value common stock.









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Part I:FINANCIAL INFORMATION



The unaudited consolidated financial statements of Princeton National Bancorp, Inc. and Subsidiary and managements discussion and analysis of financial condition and results of operation are presented in the schedules as follows:



Schedule 1:

        Consolidated Balance SheetsSchedule 2:

        Consolidated Statements of IncomeSchedule 3:

        Consolidated Statements of Stockholders EquitySchedule 4:

        Consolidated Statements of Cash FlowsSchedule 5:

        Notes to Consolidated Financial StatementsSchedule 6:

        Managements Discussion and Analysis of Financial Condition and Results of OperationsSchedule 7:

        Controls and Procedures






Part II:OTHER INFORMATION



Item 1A.Risk Factors



The current volatility in economic conditions and the financial markets may adversely affect our industry, business and financial performance. The second half of 2008 has witnessed unprecedented disruptions in financial markets, including volatility in asset values and constraints on the availability of credit.  In response to these developments, the U.S. government has taken, and may take further, steps designed to stabilize markets generally and strengthen financial institutions in particular.  The impact, if any, that these financial market events or these governmental actions might have on the Company and its business is uncertain and cannot be estimated at this time.  Item 1A (Risk Factors) of the Companys Annual Report on Form 10-K for the year ended December 31, 2007 discusses some of the principal risks inherent in the Companys business, including interest
rate risks, liquidity risks, credit risks, operational risks, risks from economic or market conditions and general business risks among others.  The current upheaval in financial markets has accentuated each of these risks and magnified their potential effect on the Company.



At the same time, there appears to be a general weakening of the U.S. economy.  To the extent these economic developments continue to worsen, and to the extent legislation or regulatory action adversely affects the U.S. economy, the Companys access to capital or the credit quality of the Companys loan portfolio, or imposes additional limitations or costs on the Companys business, there could be an adverse impact on the Companys costs, credit losses, access to capital or liquidity.



2

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Item 2.Unregistered Sales of Equity Securities and Use of Proceeds



(c)

        The following table provides information about purchases of the Corporations common stock by the Corporation during the quarter ended September 30, 2008:




Period

        

        (a) Total number ofshares purchased

        

        (b) Average price paidper share

        

        (c)  Total numberof shares purchasedas part ofpublicly announcedplans or programs

        

        (d) Maximum number(or approximate dollarvalue) of shares thatmay yet be purchasedunder the plans orprograms7/1/08 -7/31/08

        

        

        0

        

        $

        0.00

        

        

        0

        

        

        20,0008/1/08 -8/31/08

        

        

        0

        

        $

        0.00

        

        

        0

        

        

        20,0009/1/08  9/30/08

        

        

        0

        

        $

        0.00

        

        

        0

        

        

        20,000Total

        

        

        0

        

        $

        0.00

        

        

        0

        

        

        20,000




On April 24, 2007, the Board of Directors approved the repurchase of up to an aggregate of 50,000 shares of our common stock pursuant to a repurchase program announced the same day (the Program).  The original expiration date of this Program was April 24, 2008, but was extended to October 24, 2008 by the Board of Directors at their meeting held on April 28, 2008.  On October 27, 2008, the Board of Directors approved a new 50,000 share repurchase program that will expire on October 27, 2009.  Unless terminated earlier by resolution of our Board of Directors, the Program will expire on the earlier of such expiration date or when we have repurchased all shares authorized for repurchase under the Program.



Item 6.Exhibits



31.1

        Certification of Tony J. Sorcic required by Rule 13a-14(a).


31.2

        Certification of Todd D. Fanning required by Rule 13a-14(a).


32.1

        Certification of Tony J. Sorcic required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.


32.2

        Certification of Todd D. Fanning required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.




SIGNATURES



Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



PRINCETON NATIONAL BANCORP, INC.





By

        /s/ Tony J. Sorcic

        

        By

        /s/ Todd D. FanningTony J. SorcicPresident & Chief Executive OfficerNovember 6, 2008

        

        

        Todd D. FanningSr. VP & Chief Financial OfficerNovember 6, 2008






3

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Schedule 1

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share data)

September 30,2008(unaudited)

        

        December 31,2007ASSETSCash and due from banks

        

        $

        17,289

        

        $

        25,801Federal Funds sold

        

        $

        800

        

        $

        0Interest-bearing deposits with financial institutions

        

        

        100

        

        

        1,803Total cash and cash equivalents

        

        

        18,189

        

        

        27,604Loans held for sale, at lower of cost or market

        

        

        2,654

        

        

        928Investment securities:Available-for-sale, at fair value

        

        

        230,495

        

        

        218,095Held-to-maturity, at amortized cost (fair value of $15,398 and $14,799)

        

        

        15,296

        

        

        14,578Total investment securities

        

        

        245,791

        

        

        232,673Loans:Loans, net of unearned interest

        

        

        762,109

        

        

        722,647Allowance for loan losses

        

        

        (3,842

        )

        

        (3,248

        )Net loans

        

        

        758,267

        

        

        719,399Premises and equipment, net of accumulated depreciation

        

        

        30,290

        

        

        30,801Land held for sale, at lower of cost or market

        

        

        1,344

        

        

        1,344Bank-owned life insurance

        

        

        21,478

        

        

        22,461Accrued interest receivable

        

        

        10,253

        

        

        10,876Goodwill

        

        

        24,521

        

        

        24,521Intangible assets, net of accumulated amortization

        

        

        4,428

        

        

        5,090Other real estate owned

        

        

        1,330

        

        

        833Other assets

        

        

        5,027

        

        

        4,172TOTAL ASSETS

        

        $

        1,123,572

        

        $

        1,080,702LIABILITIESDeposits:Demand

        

        $

        97,430

        

        $

        102,452Interest-bearing demand

        

        

        260,056

        

        

        241,749Savings

        

        

        59,871

        

        

        58,401Time

        

        

        520,089

        

        

        488,805Total deposits

        

        

        937,446

        

        

        891,407Borrowings:Customer repurchase agreements

        

        

        34,420

        

        

        34,217Federal funds purchased

        

        

        0

        

        

        26,500Advances from the Federal Home Loan Bank

        

        

        30,490

        

        

        6,984Interest-bearing demand notes issued to the U.S. Treasury

        

        

        1,805

        

        

        1,838Trust preferred securities

        

        

        25,000

        

        

        25,000Note payable

        

        

        16,050

        

        

        14,550Total borrowings

        

        

        107,765

        

        

        109,089Other liabilities

        

        

        9,080

        

        

        11,599TOTAL LIABILITIES

        

        

        1,054,291

        

        

        1,012,095STOCKHOLDERS EQUITYCommon stock:  $5 par value, 7,000,000 shares authorized;  4,478,295 shares issued

        

        

        22,391

        

        

        22,391Surplus

        

        

        18,391

        

        

        18,275Retained earnings

        

        

        54,225

        

        

        51,279Accumulated other comprehensive income (loss), net of tax

        

        

        (1,631

        )

        

        344Less:  Cost of 1,181,626 and 1,169,848 treasury shares at September 30, 2008 and December 31, 2007, respectively

        

        

        (24,095

        )

        

        (23,682

        )TOTAL STOCKHOLDERS EQUITY

        

        

        69,281

        

        

        68,607TOTAL LIABILITIES AND STOCKHOLDERS EQUITY

        

        $

        1,123,572

        

        $

        1,080,702




See accompanying notes to unaudited consolidated financial statements



4



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Schedule 2



PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(dollars in thousands, except share data)



For the Three MonthsEnded September 30

        


        For the Nine MonthsEnded September 302008

        

        2007

        

        2008

        

        2007Interest income:Interest and fees on loans

        

        $

        11,977

        

        $

        12,980

        

        $

        36,129

        

        $

        36,880Interest on investment securities:Taxable

        

        

        1,766

        

        

        1,592

        

        

        5,063

        

        

        5,211Non-taxable

        

        

        1,006

        

        

        1,027

        

        

        3,047

        

        

        3,261Interest on federal funds sold

        

        

        37

        

        

        24

        

        

        66

        

        

        246Interest on interest-bearing time deposits in other banks

        

        

        26

        

        

        9

        

        

        46

        

        

        85Total interest income

        

        

        14,812

        

        

        15,632

        

        

        44,351

        

        

        45,683Interest expense:Interest on deposits

        

        

        5,771

        

        

        7,677

        

        

        18,250

        

        

        22,777Interest on borrowings

        

        

        869

        

        

        1,105

        

        

        2,658

        

        

        3,077Total interest expense

        

        

        6,640

        

        

        8,782

        

        

        20,908

        

        

        25,854Net interest income

        

        

        8,172

        

        

        6,850

        

        

        23,443

        

        

        19,829Provision for loan losses

        

        

        550

        

        

        250

        

        

        1,368

        

        

        550Net interest income after provision for loan losses

        

        

        7,622

        

        

        6,600

        

        

        22,075

        

        

        19,279Non-interest income:Trust & farm management fees

        

        

        309

        

        

        353

        

        

        1,120

        

        

        1,124Service charges on deposit accounts

        

        

        1,174

        

        

        1,174

        

        

        3,376

        

        

        3,259Other service charges

        

        

        563

        

        

        535

        

        

        1,587

        

        

        1,492Gain on sales of securities available-for-sale

        

        

        54

        

        

        149

        

        

        331

        

        

        358Brokerage fee income

        

        

        249

        

        

        224

        

        

        676

        

        

        641Mortgage banking income

        

        

        243

        

        

        257

        

        

        879

        

        

        666Bank-owned life insurance income

        

        

        227

        

        

        203

        

        

        648

        

        

        608Other operating income

        

        

        32

        

        

        40

        

        

        138

        

        

        154Total non-interest income

        

        

        2,851

        

        

        2,935

        

        

        8,755

        

        

        8,302Non-interest expense:Salaries and employee benefits

        

        

        4,459

        

        

        4,257

        

        

        13,082

        

        

        12,574Occupancy

        

        

        619

        

        

        569

        

        

        1,908

        

        

        1,770Equipment expense

        

        

        698

        

        

        756

        

        

        2,168

        

        

        2,371Federal insurance assessments

        

        

        99

        

        

        84

        

        

        267

        

        

        254Intangible assets amortization

        

        

        178

        

        

        177

        

        

        535

        

        

        528Data processing

        

        

        272

        

        

        268

        

        

        852

        

        

        797Advertising

        

        

        195

        

        

        188

        

        

        524

        

        

        539Other operating expense

        

        

        1,108

        

        

        1,088

        

        

        3,360

        

        

        3,219Total non-interest expense

        

        

        7,628

        

        

        7,387

        

        

        22,696

        

        

        22,052Income before income taxes

        

        

        2,845

        

        

        2,148

        

        

        8,134

        

        

        5,529Income tax expense

        

        

        658

        

        

        408

        

        

        1,836

        

        

        806Net income

        

        $

        2,187

        

        $

        1,740

        

        $

        6,298

        

        $

        4,723Earnings per share:Basic

        

        

        0.66

        

        

        0.53

        

        

        1.91

        

        

        1.42Diluted

        

        

        0.66

        

        

        0.52

        

        

        1.90

        

        

        1.41Basic weighted average shares outstanding

        

        

        3,295,200

        

        

        3,314,913

        

        

        3,298,408

        

        

        3,331,852Diluted weighted average shares outstanding

        

        

        3,305,195

        

        

        3,322,292

        

        

        3,309,560

        

        

        3,342,689




See accompanying notes to unaudited consolidated financial statements



5

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Schedule 3



PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

(Unaudited)

(dollars in thousands except per share data)



For the Nine Months EndedSeptember 30, 2008

        CommonStock

        


        Surplus

        

        RetainedEarnings

        

        AccumulatedOtherComprehensiveIncome (Loss),net of tax effect

        

        TreasuryStock

        

        TotalBalance, January 1, 2008

        $

        22,391

        
        $

        18,275

        

        $

        51,279

        

        $

        344

        

        $

        (23,682

        )

        $

        68,607Net income

        

        

        
        

        

        

        

        6,298

        

        

        

        

        

        

        

        

        6,298Purchase of 20,000 shares of treasury stock

        

        

        
        

        

        

        

        

        

        

        

        

        

        (554

        )

        

        (554

        )Sale of 3,722 shares of treasury stock

        

        

        
        

        33

        

        

        

        

        

        

        

        

        64

        

        

        97Exercise of stock options and re-issuance of treasury stock (4,500 shares)

        

        

        
        

        20

        

        

        

        

        

        

        

        

        77

        

        

        97Cash dividends ($.84 per share)

        

        

        
        

        

        

        

        (2,773

        )

        

        

        

        

        

        

        

        (2,773

        )Stock option compensation expense

        

        

        
        

        63

        

        

        

        

        

        

        

        

        

        

        

        63Adjustment to apply EITF 06-4

        

        

        
        

        

        

        

        (579

        )

        

        

        

        

        

        

        

        (579

        )Other comprehensive loss, net of $1,249 tax effect

        

        

        
        

        

        

        

        

        

        

        (1,975

        )

        

        

        

        

        (1,975

        )Balance, September 30, 2008

        $

        22,391

        
        $

        18,391

        

        $

        54,225

        

        $

        (1,631

        )

        $

        (24,095

        )

        $

        69,281For the Nine Months EndedSeptember 30, 2007Balance, January 1, 2007

        $

        22,391

        
        $

        18,158

        

        $

        48,109

        

        $

        (960

        )

        $

        (22,343

        )

        $

        65,355Net income

        

        

        
        

        

        

        

        4,723

        

        

        

        

        

        

        

        

        4,723Purchase of 40,000 shares of treasury stock

        

        

        
        

        

        

        

        

        

        

        

        

        

        (1,204

        )

        

        (1,204

        )Sale of 4,314 shares  of treasury stock

        

        

        
        

        46

        

        

        

        

        

        

        

        

        74

        

        

        120Exercise of stock options and re-issuance
 of treasury stock (500 shares)

        

        

        
        

        7

        

        

        (4

        )

        

        

        

        

        8

        

        

        11Cash dividends ($.81 per share)

        

        

        
        

        

        

        

        (2,702

        )

        

        

        

        

        

        

        

        (2,702

        )Stock option compensation expense

        

        

        
        

        35

        

        

        

        

        

        

        

        

        

        

        

        35Other comprehensive income, net of $133 tax effect

        

        

        
        

        

        

        

        

        

        

        210

        

        

        

        

        

        210Balance, September 30, 2007

        $

        22,391

        
        $

        18,246

        

        $

        50,126

        

        $

        (750

        )

        $

        (23,465

        )

        $

        66,548




See accompanying notes to unaudited consolidated financial statements



6

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Schedule 4



PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(dollars in thousands)



For the Nine Months EndedSeptember 302008

        

        2007Operating activities:Net income

        

        $

        6,298

        

        $

        4,723Adjustments to reconcile net income to net cash provided by operating activities:Depreciation

        

        

        1,664

        

        

        1,872Provision for loan losses

        

        

        1,368

        

        

        550Amortization of intangible assets and other purchase accounting adjustments, net

        

        

        535

        

        

        528Amortization (accretion) of premiums and discounts on investment securities, net

        

        

        5

        

        

        (212

        )Gain on sales of securities available-for-sale, net

        

        

        (331

        )

        

        (358

        )Compensation expense for vested stock options

        

        

        63

        

        

        35Loss on sales of other real estate owned, net

        

        

        2

        

        

        35Loans originated for sale

        

        

        (69,867

        )

        

        (41,155

        )Proceeds from sales of loans originated for sale

        

        

        68,141

        

        

        44,728(Decrease) increase in accrued interest payable

        

        

        (673

        )

        

        434Decrease in accrued interest receivable

        

        

        623

        

        

        564Decrease (increase) in other assets

        

        

        142

        

        

        (1,989

        )Decrease in other liabilities

        

        

        (1,168

        )

        

        (731

        )Net cash provided by operating activities

        

        

        6,802

        

        

        9,024Investing activities:Proceeds from sales of investment securities available-for-sale

        

        

        16,170

        

        

        12,872Proceeds from maturities of investment securities available-for-sale

        

        

        45,326

        

        

        48,925Purchase of investment securities available-for-sale

        

        

        (77,409

        )

        

        (15,187

        )Proceeds from maturities of investment securities held-to-maturity

        

        

        1,615

        

        

        995Purchase of investment securities held-to-maturity

        

        

        (1,769

        )

        

        (1,450

        )Proceeds from sales of other real estate owned

        

        

        798

        

        

        375Net increase in loans

        

        

        (41,367

        )

        

        (44,095

        )Purchases of premises and equipment

        

        

        (1,153

        )

        

        (1,340

        )Payments related to acquisition, net of cash and cash equivalents acquired

        

        

        0

        

        

        (10,110

        )Net cash used in investing activities

        

        

        (57,789

        )

        

        (9,015

        )Financing activities:Net increase (decrease) in deposits

        

        

        46,039

        

        

        6,854Net (decrease) increase in borrowings

        

        

        (1,334

        )

        

        7,248Dividends paid

        

        

        (2,773

        )

        

        (2,702

        )Purchases of treasury stock

        

        

        (554

        )

        

        (1,204

        )Exercise of stock options and issuance of treasury stock

        

        

        97

        

        

        11Sales of treasury stock

        

        

        97

        

        

        120Net cash provided by financing activities

        

        

        41,572

        

        

        10,327Increase (decrease) in cash and cash equivalents

        

        

        (9,415

        )

        

        10,336Cash and cash equivalents at beginning of period

        

        

        27,604

        

        

        39,185Cash and cash equivalents at September 30

        

        $

        18,189

        

        $

        49,521Supplemental disclosures of cash flow information:Cash paid during the period for:Interest

        

        $

        21,581

        

        $

        25,420Income taxes

        

        $

        2,368

        

        $

        1,335Supplemental disclosures of non-cash flow activities:Loans transferred to other real estate owned

        

        $

        1,297

        

        $

        1,076Land transferred to held for sale

        

        $

        0

        

        $

        1,344




See accompanying notes to unaudited consolidated financial statements



7

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Schedule 5



PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Unaudited)



The accompanying unaudited condensed consolidated financial statements reflect all adjustments, which, in the opinion of management, are necessary for a fair presentation of the results of the interim periods ended September 30, 2008 and 2007, and all such adjustments are of a normal recurring nature.  The 2007 year-end consolidated balance sheet data was derived from audited financial statements, but do not include all disclosures required by generally accepted accounting principles.



The unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information required by accounting principles generally accepted in the United States of America for complete financial statements and related footnote disclosures.  In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered for a fair presentation of the results for the interim period have been included.  For further information, refer to the consolidated financial statements and notes included in the Registrants 2007 Annual Report on Form 10-K.  Results of operations for interim periods are not necessarily indicative of the results that may be expected for the year.  Certain amounts in the 2007 consolidated financial statements have been reclassified to conform to the 2008 presentation.



(1)EARNINGS PER SHARE CALCULATION



The following table sets forth the computation of basic and diluted earnings per share for the periods indicated (in thousands, except share data):



Three Months EndedSeptember 30,

        

        Nine Months EndedSeptember 30,2008

        

        2007

        

        2008

        

        2007Numerator:Net income

        

        $

        2,187

        

        $

        1,740

        

        $

        6,298

        

        $

        4,723Denominator:Basic earnings per share-weighted average shares

        

        

        3,295,200

        

        

        3,314,913

        

        

        3,298,408

        

        

        3,331,852Effect of dilutive securities-stock options

        

        

        9,995

        

        

        7,379

        

        

        11,152

        

        

        10,837Diluted earnings per share-adjusted weighted average shares

        

        

        3,305,195

        

        

        3,322,292

        

        

        3,309,560

        

        

        3,342,689Net income per share:Basic

        

        $

        0.66

        

        $

        0.53

        

        $

        1.91

        

        $

        1.42Diluted

        

        $

        0.66

        

        $

        0.52

        

        $

        1.90

        

        $

        1.41




The earnings per share calculation for the three and nine-month periods ended September 30, 2008 and 2007 does not include 279,816 shares which were anti-dilutive.



8

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(2)ACQUISITION



On February 23, 2007, the Corporation completed the acquisition of the Plainfield office of HomeStar Bank in Manteno, Illinois, for $10.2 million in cash, including goodwill of $1.5 million, in order to expand its market presence in the area.  The Corporation purchased the existing facility for $4.5 million plus $17.0 million in loans (at book value) and assumed $12.9 million in deposit liabilities.  The Plainfield office operates as a branch of the subsidiary bank.



The transaction has been accounted for as a purchase, and the results of operations of the Plainfield office since the acquisition date have been included in the consolidated financial statements. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of this transaction (in thousands):



Cash and cash equivalents

        

        $

        93Loans

        

        

        17,043Premises and equipment

        

        

        4,500Goodwill

        

        

        1,492Other assets

        

        

        85Total assets acquired

        

        

        23,213Deposits

        

        

        12,865Other liabilities

        

        

        145Total liabilities assumed

        

        

        13,010Net assets acquired

        

        $

        10,203




Transaction costs related to the completion of the transaction were considered immaterial. The total fair value of the assets and liabilities acquired exceeded the book value, resulting in goodwill of $1,492,000 which is not subject to amortization.



9

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The following unaudited pro forma condensed combined financial information presents the results of operations of the Corporation, including the effects of the purchase accounting adjustments, had the acquisition taken place at the beginning of each period (in thousands):



Pro FormaFor the nine monthsendedSeptember 30, 2007Net interest income

        

        $

        19,869Provision for loan losses

        

        

        550Non-interest income

        

        

        8,337Non-interest expense

        

        

        22,067Income before income taxes

        

        

        5,589Income tax expense

        

        

        830Net income

        

        $

        4,759Earnings per shareBasic

        

        $

        1.43Diluted

        

        $

        1.42Basic weighted average shares outstanding

        

        

        3,331,852Diluted weighted average shares outstanding

        

        

        3,342,689




The unaudited pro forma condensed combined financial statements do not reflect any anticipated cost savings and revenue enhancements. Additionally, the income statement for the first nine months of 2007 includes merger-related expenses.  Accordingly, the pro forma results of operations of the Corporation as of and after the merger may not be indicative of the results that actually would have occurred if the merger had been in effect during the period presented or of the results that may be attained in the future.



(3)GOODWILL AND INTANGIBLE ASSETS



The balance of goodwill, net of accumulated amortization, totaled $24,521,000 at September 30, 2008 and December 31, 2007.  The balance of intangible assets, net of accumulated amortization, totaled $4,428,000 and $5,090,000 at September 30, 2008 and December 31, 2007, respectively.



10

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The following table summarizes the Corporations intangible assets, which are subject to amortization, as of September 30, 2008 and December 31, 2007:





(in thousands)September 30,
2008

        

        December 31, 2007Gross CarryingAmount

        

        

        AccumulatedAmortization

        

        Gross CarryingAmount

        

        

        

        AccumulatedAmortizationCore deposit intangible

        

        $

        9,004

        

        

        $

        (4,653

        )

        $

        9,004

        

        

        $

        (4,006

        )Other intangible assets

        

        

        234

        

        

        

        (157

        )

        

        234

        

        

        

        (142

        )Total

        

        $

        9,238

        

        

        $

        (4,810

        )

        $

        9,238

        

        

        $

        (4,148

        )




Amortization expense of all intangible assets totaled $535,000 for the nine months ended September 30, 2008 and $528,000 for the nine months ended September 30, 2007, respectively.  The amortization expense of these intangible assets will be approximately $179,000 for the remaining quarter in 2008.



The Corporation has originated
mortgage servicing rights which are included in other assets on the consolidated
balance sheets. Mortgage servicing rights are amortized in proportion to, and
over the period of, estimated net servicing income on a basis similar to the
interest method using an accelerated amortization method and are subject to
periodic impairment testing. No impairment had been
recorded during the year through September 30, 2008. Changes in the carrying value of capitalized mortgage
servicing rights are summarized as follows:



(in thousands)Balance, January 1, 2008

        

        $

        2,498Servicing rights capitalized

        

        

        724Amortization of servicing rights

        

        

        (324

        )Impairment of servicing rights

        

        

        0Balance, September 30, 2008

        

        $

        2,898




The Corporation services loans for others with unpaid principal balances at September 30, 2008 and December 31, 2007 of approximately $302,306,000, and $268,391,000, respectively.



The following table shows the future estimated amortization expense for mortgage servicing rights based on existing balances as of September 30, 2008.  The Corporations actual amortization expense in any given period may be significantly different from the estimated amounts displayed depending on the amount of additional mortgage servicing rights, changes in mortgage interest rates, estimated prepayment speeds, and market conditions.



Estimated Amortization Expense:



Amount (in thousands)For the three months ended December 31, 2008

        

        $

        81For the year ended December 31, 2009

        

        

        320For the year ended December 31, 2010

        

        

        300For the year ended December 31, 2011

        

        

        281For the year ended December 31, 2012

        

        

        264For the year ended December 31, 2013

        

        

        247Thereafter

        

        

        1,405






11

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(4)OTHER COMPREHENSIVE INCOME (LOSS)



Other comprehensive income (loss) components and related taxes for the nine months ended September 30, 2008 and 2007 were as follows:



(in thousands)



2008

        

        2007Net unrealized gains (losses) on securities available-for-sale

        

        $

        (2,905

        )

        $

        701Less:  Reclassification adjustment for realized gains included in income

        

        

        331

        

        

        358(3,236

        )

        

        343Amortization of transition obligation of post retirement health care

        

        

        12

        

        

        0Other comprehensive income (loss), before tax effect

        

        

        (3,224

        )

        

        343Tax (expense) benefit

        

        

        1,249

        

        

        (133

        )Other comprehensive income (loss)

        

        $

        (1,975

        )

        $

        210






The components of accumulated other comprehensive loss, included in stockholders equity at September 30, 2008 and 2007 are as follows:



2008

        

        2007Net unrealized loss on securities available-for-sale

        

        $

        (2,110

        )

        $

        (2,240

        )Net unrealized benefit obligations

        

        

        (552

        )

        

        (1,016

        )(2,662

        )

        

        (1,224

        )Tax effect

        

        

        1,031

        

        

        474Net-of-tax amount

        

        $

        (1,631

        )

        $

        (750

        )




(5)FEDERAL HOME LOAN BANK STOCK



Investment securities available-for-sale includes Federal Home Loan Bank stock totaling $2,373,000 at September 30, 2008 and December 31, 2007.  During the third quarter of 2007, the Federal Home Loan Bank of Chicago received a Cease and Desist Order from their regulator, the Federal Housing Finance Board.  The Federal Home Loan Bank will continue to provide liquidity and funding through advances, however, the order prohibits capital stock repurchases and redemptions until a time to be determined by the Federal Housing Finance Board and requires their approval for dividends.  With regard to dividends, the Federal Home Loan Bank will continue to assess its dividend capacity each quarter and make appropriate request for approval.  There were no dividends paid by the Federal Home Loan Bank of Chicago during the first nine months of 2008.  Management performed an analysis and deemed the
investment in Federal Home Loan Bank stock was not impaired as of September 30, 2008 or December 31, 2007.



12

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(6)FDIC ONE-TIME ASSESSMENT CREDIT



Effective November 17, 2006, the FDIC implemented a one-time credit of $4.7 billion to eligible institutions.  The purpose of the credit was to recognize contributions made by certain institutions to capitalize the Bank Insurance Fund and Savings Association Insurance Fund, which have now been merged into the Deposit Insurance Fund.  The Bank is an eligible institution and received notice from the FDIC that its share of the credit was $647,000.  This amount was not reflected in the accompanying financial statements as it represented contingent future credits against future insurance assessment payments.  For the nine months ended September 30, 2008 and 2007, FDIC premium credits received totaled $266,000 and $381,000, respectively, against the premium expense, leaving a remaining credit of $0, as of September 30, 2008, to offset future premium expense.



(7)CHANGE IN ACCOUNTING PRINCIPLE



The Financial Accounting Standards Board Emerging Issues Task Force (EITF) issued EITF No. 06-4 Accounting for Deferred Compensation and Post Retirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements, which requires the Company to recognize a liability and compensation expense for endorsement split-dollar life insurance arrangements that provide a benefit to an employee that extends to post retirement periods.  The benefit to the employees is the payment of the premiums by the Company.  The Company adopted EITF 06-4 as of January 1, 2008, through a cumulative effect adjustment as a liability and a decrease to retained earnings of $579,000.  Beginning January 1, 2008, an expense is being recorded as the remaining benefit is earned with a corresponding addition to the post retirement benefit obligation.  The amount of the expense for 2008 is
estimated to be approximately $59,000.  For the period from retirement to the estimated date of death for the participants, this liability is reversed into income.



(8)FAIR VALUE OF ASSETS AND LIABILITIES



Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards No. 157 (FAS 157), Fair Value Measurements.  FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  FAS 157 has been applied prospectively as of the beginning of the period.



FAS 157 defines the fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  FAS 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.



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In accordance with FAS 157, the Company groups its financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.  These levels are:



Level 1

        Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange.  Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.




Level 2

        Valuations for assets and liabilities traded in less active dealer or broker markets.  Valuations are obtained from third party pricing services for identical or comparable assets or liabilities which use observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data
for substantially the full term of the assets and liabilities.




Level 3

        Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.




Following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying balance sheet.



Available-for-Sale Securities



The fair value of available-for-sale securities are determined by various valuation methodologies.  Where quoted market prices are available in an active market, securities are classified within Level 1.  The Company has no securities classified within Level 1.  If quoted market prices are not available, then fair values are estimated by using pricing models or quoted prices of securities with similar characteristics.  Level 2 securities include U.S. Treasury securities, Obligations of U.S. government corporations and agencies, Obligations of states and political subdivisions, mortgage-backed securities, collateralized mortgage obligations and corporate bonds.  In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy.  The Company has no securities classified within Level 3.



The following table presents the Companys assets that are measured at fair value on a recurring basis and the level within the FAS 157 hierarchy in which the fair value measurements fall as of September 30, 2008 (in thousands):



Fair Value Measurements UsingFair Value

        

        Quoted Prices inActive Markets forIdentical Assets(Level 1)

        

        

        Significant OtherObservable Inputs(Level 2)

        

        SignificantUnobservableInputs(Level 3)Available-for-sale securities

        

        $

        230,495

        

        $

        0

        

        $

        230,495

        

        $

        0






14

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In February 2007, the FASB issued SFAS No. 159 (FAS 159), The Fair Value Option for Financial Assets and Financial Liabilities  Including an amendment of FASB Statement No. 115.  FAS 159 allows companies to report selected financial assets and liabilities at fair value. The changes in fair value are recognized in earnings and the assets and liabilities measured under this methodology are required to be displayed separately in the balance sheet.The main intent of the Statement is to mitigate the difficulty in determining reported earnings caused by a mixed-attribute model (or reporting some assets at fair value and others using a different valuation attribute such as amortized cost). The project is separated into two phases.  This first phase addresses the creation of a fair value
option for financial assets and liabilities.  A second phase will address creating a fair value option for selected non-financial items. FAS 159 is effective for all financial statements issued for fiscal years beginning after November 15, 2007.  The Corporation has not elected the fair value option for any financial assets or liabilities at September 30, 2008.



(9)IMPACT OF NEW ACCOUNTING STANDARDS



In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158 (FAS 158), Employers Accounting for Defined Benefit Pension and Other Postretirement Plans  an amendment of FASB Statements 87, 88, 106, and 132 (R), which requires recognition of a net liability or asset to report the funded status of defined benefit pension and other postretirement plans on the balance sheet and recognition (as a component of other comprehensive income) of changes in the funded status in the year in which the changes occur.  Additionally, FAS 158 requires measurement of a plans assets and obligations as of the balance sheet date and additional annual disclosures in the notes to the financial statements.  The recognition and disclosure provisions of FAS 158 were adopted during 2006, while the requirement to measure a plans assets and obligations as of
the balance sheet date is effective for fiscal years ending after December 15, 2008.  The Corporation does not expect the adoption of the measurement provisions to have a material impact on its financial reporting and disclosures.



In December 2007, the FASB issued SFAS No. 141R (FAS 141R), Business Combinations, which revises FAS 141 and changes multiple aspects of the accounting for business combinations.  Under the guidance in FAS 141R, the acquisition method must be used, which requires the acquirer to recognize most identifiable assets acquired, liabilities assumed, and non-controlling interests in the acquiree at their full fair value on the acquisition date.  Goodwill is to be recognized as the excess of the consideration transferred plus the fair value of the non-controlling interest over the fair values of the identifiable net assets acquired.  Subsequent changes in the fair value of contingent consideration classified as a liability are to be recognized in earnings, while contingent consideration classified as equity is not to be re-measured.  Costs such as transaction costs are to be
excluded from acquisition accounting, generally leading to recognizing expense and additionally, restructuring costs that do not meet certain criteria at acquisition date are to be subsequently recognized as post-acquisition costs.  FAS 141R is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.  The Company is currently evaluating the impact that this issuance will have on its financial position and results of operations; however, it anticipates that the standard will lead to more volatility in the results of operations during the periods subsequent to an acquisition.



15

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In March 2008, the FASB issued SFAS No. 161 (FAS 161), Disclosures About Derivative Instruments and Hedging Activities  an amendment of FAS 133.  FAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements.  FAS 161 is effective for fiscal years beginning after November 15, 2008.  The Company does not expect the implementation of FAS 161 to have a material impact on its consolidated financial statements.



In October 2008, the FASB issued FASB Staff Position No. 157-3 (FSP 157-3), Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active.  FSP 157-3 clarifies the application of Statement of Financial Accounting Standards No. 157 (FAS 157), Fair Value Measurements, in a market that is not active and provides an example to illustrate key considerations in determining fair value of financial assets when the market for that financial asset is not active.  FSP 157-3 applies to financial assets within the scope of accounting pronouncements that require or permit fair value measurements in accordance with FAS 157. FSP 157-3 was effective upon issuance and included prior periods for which financial statements had not been issued. The application of FSP 157-3 did not have a material impact on the Companys consolidated financial statements.





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Schedule 6



PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

For the three and nine months ended September 30, 2008 and 2007



The following discussion provides information about Princeton National Bancorp, Inc.s (PNBC or the Corporation) financial condition and results of operations for the three and nine month periods ended September 30, 2008 and 2007.  This discussion should be read in conjunction with the attached consolidated financial statements and notes thereto.  This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act), such as discussions of the Companys pricing and fee trends, credit quality and outlook, liquidity, new business results, expansion plans, anticipated expenses and planned schedules.  The Company intends such forward-looking statements to be covered by the safe harbor provisions for
forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions.  Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are identified by use of the words believe, expect, intend, anticipate, estimate, project, or similar expressions.  Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: the effect of the current severe disruption in financial markets and the United States government programs introduced to restore stability and liquidity, changes in interest rates, general economic conditions and the weakening state of the United States economy, legislative/regulatory changes, monetary and fiscal
policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products,
deposit flows, competition, demand for financial services in the Companys market area and accounting principles, policies and guidelines.  These risks and uncertainties should be considered in
 evaluating forward-looking statements and undue reliance should not be placed on such statements.  Further information concerning the Company and its business, including  a discussion of these and additional
 factors that could materially affect the Companys financial results, is included in the Companys 2007 Annual Report on Form 10-K under the headings Item 1. Business and Item 1A.
Risk Factors.



RESULTS OF OPERATIONS



The Company continues to generate strong earnings in 2008, once again realizing a significant improvement in earnings during the third quarter and the first nine months of the year.  Net income for the third quarter of 2008 was $2,187,000, or basic and diluted earnings per share of $0.66, as compared to net income of $1,740,000 in the third quarter of 2007, or basic earnings per share of $0.53 (diluted earnings per share of $0.52).  This represents an increase of $447,000 (or 25.7%), $0.13 basic earnings per share and $0.14 diluted earnings per share.  The earnings expansion is attributable to an increase in net interest income, discussed below, due to growth in the balance sheet and an improving net interest margin.  Net income for the first nine months of 2008 was $6,298,000 or basic earnings per share of $1.91 and diluted earnings per share of $1.90, compared to net income of $4,723,000,
or basic earnings per share of $1.42 and diluted earnings per share of $1.41 for the first nine months of 2007.  This represents an increase of $1,575,000,  (33.3%) or $0.49 per basic share and diluted share.  The higher net income figure is primarily attributed to an increase in the net yield on interest-earning assets from 3.17% for the first nine months of 2007 to 3.46% for the first nine months of 2008.    The annualized return on average assets and return on average equity were 0.78% and 12.54%, respectively, for the third quarter of 2008, compared with 0.67% and 10.65% for the third quarter of 2007.  For the nine-month periods, the annualized return on average assets and return on average equity were 0.77% and 12.17%, respectively for 2008, compared with 0.61% and 9.67%, respectively for 2007.



17

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Net interest income before provision for loan losses was $8,172,000 for the third quarter of 2008, compared to $6,850,000 for the third quarter of 2007 (an increase of $1,322,000 or 19.3%).  This improvement is a result of an increase in average interest-earning assets of $78.7 million over the past twelve months. For the three months ended September 30, 2008, average interest-earning assets were $988.9 million compared to $910.2 million for the three months ended September 30, 2007.  Additionally, the resulting net yield on interest-earning assets (on a fully taxable equivalent basis) increased to 3.50% in the third quarter of 2008 compared to 3.23% in the third quarter of 2007, contributing to the higher net income reported above.  Net interest income before any provision for loan losses for the first nine months of 2008 was $23,443,000, an increase of $3.6 million, or 18.2%, from the
$19,829,000 reported for the first nine months of 2007.  This is attributable to an increase in average interest-earning assets of $56.0 million over the past twelve months, along with the resulting net yield on interest-earning assets (on a fully taxable equivalent basis) increasing to 3.46% in the first three-quarters of 2008 from 3.17% for the same time frame of 2007, an improvement of 9.1%.



The Corporations provision for loan loss expense recorded each quarter is determined by managements evaluation of the risk characteristics of the loan portfolio.  For the third quarter of 2008, PNBC had net charge-offs of $103,000, (0.06% of total loans) comparable to net charge-offs of $139,000 for the third quarter of 2007.  For the nine-month comparable periods, PNBC had net charge-offs of $774,000 in 2008 and net charge-offs of $382,000 in 2007.  PNBC recorded a loan loss provision of $550,000 in the third quarter of 2008 and $1,368,000 in the first nine months of 2008 compared to a provision of $250,000 in the third quarter of 2007 and $550,000 in the first nine months of 2007.  The ratio of non-performing loans to total loans at September 30, 2008 has increased to 2.15% compared to 0.93% at September 30, 2007, but remains low by industry standards, particularly in light of
the current economic situation.  The Corporation has no sub-prime loans in the loan portfolio, nor is there any sub-prime exposure to securities in the investment portfolio.



Non-interest income totaled $2,851,000 for the third quarter of 2008, compared to $2,935,000 in the third quarter of 2007, a decrease of $84,000 (or 2.9%).  Annualized non-interest income as a percentage of average total assets decreased to 1.02% for the third quarter of 2008 from 1.13% for the same period in 2007.  This decrease was the result of $95,000 less in gains from the sale of investment securities quarter over quarter.  Year-to-date in 2008, non-interest income totaled $8,755,000 compared to $8,302,000 for the first nine months of 2007, an increase of $453,000 (or 5.5%).  The primary reason for the positive change is the increase in mortgage banking income which has improved by $213,000 (or 32.0%) in 2008 over 2007.  Additionally, the categories of service charges on deposits and other service charges saw increases of $117,000 and $95,000, respectively.  Annualized non-interest
income as a percentage of average total assets decreased from 1.08% for the first nine months of 2007, to 1.07% for the same period in 2008.



18

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Total non-interest expense for the third quarter of 2008 was $7,628,000, an increase of $241,000 (or 3.3%) from $7,387,000 in the third quarter of 2007.  The largest increase was in salaries and employee benefits which went up $202,000, or 4.7%.  Annualized non-interest expense as a percentage of total average assets decreased to 2.72% for the third quarter of 2008, compared to 2.85% for the same period in 2007, continuing a positive trend in the effort to control operating expenses as the Corporation grows and expands.  The annualized percentage of 2.72% is the lowest the Corporation has reported since 1988.  Year-to-date non-interest expense for the first three-quarters of 2008 was $22,696,000, an increase of $644,000 (or 2.9%) from the $22,052,000 for the same period in 2007.  Again, the majority of the increase is in salaries and employee benefits which rose $508,000 (or 4.0%), due to
an increase in the number of employees.  Annualized non-interest expense as a percentage of total average assets also decreased to 2.77% for the first nine months of 2008, compared to 2.87% for the same period in 2007.



INCOME TAXES



Income tax expense totaled $658,000 for the third quarter of 2008, as compared to $408,000 for the third quarter of 2007.  The effective tax rate was 23.1% for the three month period ended September 30, 2008 and 19.0% for the three month period ended September 30, 2007.  Income tax expense totaled $1,836,000 for the first nine months of 2008, as compared to $806,000 for the first nine months of 2007.  The effective tax rate was 22.6% for the nine month period ended September 30, 2008 and 14.6% for the nine month period ended September 30, 2007.   The higher effective tax rate in 2008 is due to a higher pre-tax income.



ANALYSIS OF FINANCIAL CONDITION



Total assets at September 30, 2008 increased to $1,123,572,000 from $1,080,702,000 at December 31, 2007 (an increase of $42.9 million or 4.0%).  Investment balances totaled $245,791,000 at September 30, 2008, compared to $232,673,000 at December 31, 2007 (an increase of $13.1 million or 5.6%).  Total deposits increased to $937,446,000 at September 30, 2008 from $891,407,000 at December 31, 2007 (an increase of $46.0 million or 5.2%).  Comparing categories of deposits at September 30, 2008 to December 31, 2007, interest-bearing demand deposits increased $18.3 million (or 7.6%), time deposits increased $31.3 million (or 6.4%), and savings deposits increased $1.5 million (or 2.5%), while demand deposits decreased $5.0 million (or 4.9%).  Borrowings, consisting of customer repurchase agreements, notes payable, treasury, tax, and loan (TT&L) deposits, and Federal Home Loan Bank
advances, decreased from $109,089,000 at December 31, 2007 to $107,765,000 at September 30, 2008 (a decrease of $1.3 million or 1.2%).



Loan balances, net of unearned interest, increased to $762,109,000 at September 30, 2008, compared to $722,647,000 at December 31, 2007 (an increase of $39.5 million or 5.5%).  Non-performing loans increased to $16,383,000 or 2.15% of net loans at September 30, 2008, as compared to $7,434,000 or 1.03% of net loans at December 31, 2007.  Although non-performing loans have increased in terms of total dollars since year-end, the majority of the increase occurred in the first quarter of 2008 and is comprised of two larger credits with substantial collateral.  All loans are individually evaluated and management continues to maintain adequate reserves in the allowance for loan losses.



19

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ASSET QUALITY



For the nine months ended September 30, 2008, the subsidiary bank charged off $915,000 of loans and had recoveries of $141,000, compared to charge-offs of $569,000 and recoveries of $187,000 during the nine months ended September 30, 2007.  The allowance for loan losses is based on factors that include the overall composition of the loan portfolio, types of loans, underlying collateral, past loss experience, loan delinquencies, substandard and doubtful credits, and such other factors that, in managements reasonable judgment, warrant consideration.  The adequacy of the allowance is monitored monthly.  At September 30, 2008, the allowance was $3,842,000 which is 23.5% of non-performing loans and 0.50% of total loans, compared with $3,248,000 which was 43.7% of non-performing loans and 0.45% of total loans at December 31, 2007.  Although the balance of non-performing loans has increased,
management has reviewed these loans and deemed they are adequately collateralized.



At September 30, 2008 non-accrual loans were $15,167,000 compared to $7,361,000 at December 31, 2007.  Impaired loans totaled $10,903,000 at September 30, 2008 compared to $4,523,000 at December 31, 2007.  The total amount of loans ninety days or more past due and still accruing interest at September 30, 2008 was $1,215,000 compared to $73,000 at December 31, 2007.  There was a specific loan loss reserve of $140,000 established for impaired loans as of September 30, 2008 compared to a specific loan loss reserve of $207,000 at December 31, 2007.  PNBCs management analyzes the allowance for loan losses monthly and believes the current level of allowance is adequate to meet probable losses as of September 30, 2008.



CAPITAL RESOURCES



Federal regulations require all financial institutions to evaluate capital adequacy by the risk-based capital method, which makes capital requirements more sensitive to the differences in the level of risk assets.  At September 30, 2008, total risk-based capital of PNBC was 8.44%, compared to 8.41% at December 31, 2007.  The Tier 1 capital ratio decreased slightly from 6.16% at December 31, 2007, to 6.14% at September 30, 2008.  Total stockholders' equity to total assets at September 30, 2008 decreased to 6.17% from 6.35% at December 31, 2007.



The Company is currently evaluating the possibility of raising capital and the opportunities under the recently announced Capital Purchase Program (CPP) of the U.S. Department of the Treasury (the Treasury).  Under the CPP, qualified U.S. banking organizations whose applications to participate are approved would sell preferred stock and grant warrants purchasing common stock to the Treasury. The Company is currently evaluating whether it will apply for participation in the CPP and any effects participation would have on the Companys capital structure. There are a variety of factors to be evaluated, including the cost of the capital to be provided and restrictions that would be imposed on the Company by participating in the CPP (such as restrictions on dividend increases and stock buy-backs), as well as the significant opportunities of the program. The Company
does not expect to make further announcements with respect to participation in the CPP unless and until it decides to participate.



20

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LIQUIDITY



Liquidity is measured by a financial institutions ability to raise funds through deposits, borrowed funds, capital, or the sale of assets.  Additional sources of liquidity include cash flow from the repayment of loans and the maturity of investment securities.  Major uses of cash include the origination of loans and purchase of investment securities.  Cash flows used in investing activities, offset by those provided by financing and operating activities, resulted in a net decrease in cash and cash equivalents of $9,415,000 from December 31, 2007 to September 30, 2008.  This decrease was primarily due to a net increase in loans and investments, offset by an increase in deposits.  For more detailed information, see PNBCs Consolidated Statements of Cash Flows.



In response to the overall economy, the Company has made a concerted effort during 2008 to increase its available liquidity sources to levels which management believes are appropriate given the current state of the economy and the banking industry.  As a result, the remaining borrowing sources available to the Company have increased to $95.6 million as of September 30, 2008 compared to $60.9 million as of December 31, 2007.



FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK



The Corporation generates agribusiness, commercial, mortgage and consumer loans to customers located primarily in North Central Illinois.  The Corporations loans are generally secured by specific items of collateral including real property, consumer assets and business assets.  Although the Corporation has a diversified loan portfolio, a substantial portion of its debtors ability to honor their contracts is dependent upon economic conditions in the agricultural industry.



In the normal course of business to meet the financing needs of its customers, the subsidiary bank is party to financial instruments with off-balance sheet risk.  These financial instruments include commitments to extend credit and standby letters of credit.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.  The contract amounts of those instruments reflect the extent of involvement the subsidiary bank has in particular classes of financial instruments.



The subsidiary banks exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments.  The subsidiary bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments.  At September 30, 2008, commitments to extend credit and standby letters of credit were approximately $162,998,000 and $6,597,000 respectively.



Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The subsidiary bank evaluates each customers creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary, by the subsidiary bank upon extension of credit is based on managements credit evaluation of the counterparty.  Collateral held varies, but may include real estate, accounts receivable, inventory, property, plant and equipment, and income-producing properties.



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Standby letters of credit are conditional commitments issued by the subsidiary bank to guarantee the performance of a customer to a third party.  The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers.  The subsidiary bank secures the standby letters of credit with the same collateral used to secure the loan.  The maximum amount of credit that would be extended under standby letters of credit is equal to the off-balance sheet contract amount.  The standby letters of credit have terms that expire in one year or less.



MERGERS AND ACQUISITIONS



On February 23, 2007, the Company completed the acquisition, for $10.2 million in cash, of the fixed assets and loans while assuming the deposit liabilities of the Plainfield, Illinois branch of HomeStar Bank in order to expand its market presence in this area. The Company financed the purchase price with existing cash and federal funds sold on the balance sheet at the time of purchase.   Since the completion of the merger, the Plainfield location operates as a branch of the Companys subsidiary bank.



The transaction has been accounted for as a purchase, and the results of operations of Plainfield since the acquisition date have been included in the consolidated financial statements.



LAND HELD FOR SALE



In 2004, the Corporation purchased approximately 14 acres of land in Aurora, Illinois in anticipation of the construction of a new branch facility.  Construction of the facility was completed in May, 2006 with the remaining acreage sub-divided in two lots and the necessary infrastructure completed.  These lots, with a cost basis of $1,344,000, were determined to be held for sale as of March 31, 2007.  A real estate appraisal has been completed indicating the market value of each lot to be approximately $2,000,000.  Accordingly, these lots were removed from the land balance and are now shown on the Corporations balance sheet as land held-for-sale, at the lower of cost or market.



LEGAL PROCEEDINGS



There are various claims pending against the Corporations subsidiary bank, arising in the normal course of business.  Management believes, based upon consultation with legal counsel, that liabilities arising from these proceedings, if any, will not be material to the Corporations financial position or results of operation.



QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



There has been no material change in market risk since December 31, 2007, as reported in PNBCs 2007 Annual Report on Form 10-K.



EFFECTS OF INFLATION



The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America and practices within the banking industry which require the measurement of financial condition and operating results in terms of historical dollars, without considering the changes in the relative purchasing power of money over time due to inflation.  Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature.  As a result, interest rates have a more significant impact on a financial institutions performance than the effects of general levels of inflation.



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PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY



The following table sets forth (in thousands) details of average balances, interest income and expense, and resulting annualized yields/costs for the Corporation for the periods indicated, reported on a fully taxable equivalent basis, using a tax rate of 34%.



Nine Months Ended, September 30, 2008

        

        Nine Months Ended, September 30, 2007AverageBalance

        

        Interest

        

        Yield/Cost

        

        AverageBalance

        

        Interest

        

        Yield/CostAverage Interest-Earning AssetsInterest-bearing deposits

        

        $

        2,872

        

        $

        46

        

        

        2.14%

        

        $

        2,208

        

        $

        85

        

        

        5.15%Taxable investment securities

        

        

        142,115

        

        

        5,063

        

        

        4.76%

        

        

        145,095

        

        

        5,211

        

        

        4.80%Tax-exempt investment securities

        

        

        93,179

        

        

        4,616

        

        

        6.62%

        

        

        100,568

        

        

        4,942

        

        

        6.57%Federal funds sold

        

        

        4,222

        

        

        66

        

        

        2.09%

        

        

        6,414

        

        

        246

        

        

        5.13%Net loans

        

        

        725,138

        

        

        36,182

        

        

        6.66%

        

        

        657,233

        

        

        36,949

        

        

        7.52%Total interest-earning assets

        

        

        967,526

        

        

        45,973

        

        

        6.35%

        

        

        911,518

        

        

        47,433

        

        

        6.96%Average non-interest earning assets

        

        

        125,445

        

        

        

        

        

        

        

        

        116,726Total average assets

        

        $

        1,092,971

        

        

        

        

        

        

        

        $

        1,028,244Average Interest-Bearing LiabilitiesInterest-bearing demand deposits

        

        $

        255,116

        

        $

        3,523

        

        

        1.84%

        

        $

        233,016

        

        $

        4,951

        

        

        2.84%Savings deposits

        

        

        62,229

        

        

        52

        

        

        0.11%

        

        

        64,890

        

        

        202

        

        

        0.42%Time deposits

        

        

        495,282

        

        

        14,675

        

        

        3.96%

        

        

        478,101

        

        

        17,624

        

        

        4.93%Interest-bearing demand notes issued to the U.S. Treasury

        

        

        937

        

        

        14

        

        

        1.99%

        

        

        1,072

        

        

        39

        

        

        4.86%Federal funds purchased

        

        

        6,075

        

        

        124

        

        

        2.72%

        

        

        759

        

        

        31

        

        

        5.46%Customer repurchase agreements

        

        

        36,196

        

        

        543

        

        

        2.00%

        

        

        31,663

        

        

        1,102

        

        

        4.65%Advances from Federal Home Loan Bank

        

        

        15,530

        

        

        406

        

        

        3.49%

        

        

        6,975

        

        

        271

        

        

        5.19%Trust preferred securities

        

        

        25,000

        

        

        1,065

        

        

        5.69%

        

        

        25,000

        

        

        1,065

        

        

        5.70%Note payable

        

        

        15,043

        

        

        506

        

        

        4.50%

        

        

        10,575

        

        

        569

        

        

        7.19%Total interest-bearing liabilities

        

        

        911,408

        

        

        20,908

        

        

        3.06%

        

        

        852,051

        

        

        25,854

        

        

        4.06%Net yield on average interest-earning assets

        

        

        

        

        $

        25,065

        

        

        3.46%

        

        

        

        

        $

        21,579

        

        

        3.17%Average non-interest-bearing liabilities

        

        

        112,431

        

        

        

        

        

        

        

        

        110,926Average stockholders' equity

        

        

        69,132

        

        

        

        

        

        

        

        

        65,267Total average liabilities and stockholders' equity

        

        $

        1,092,971

        

        

        

        

        

        

        

        $

        1,028,244




The following table reconciles tax-equivalent net interest income (as shown above) to net interest income as reported on the Consolidated Statements of Income.



For the Nine Months EndedSeptember 30,2008

        

        2007Net interest income as stated

        

        $

        23,443

        

        $

        19,829Tax equivalent adjustment-investments

        

        

        1,569

        

        

        1,680Tax equivalent adjustment-loans

        

        

        53

        

        

        70Tax equivalent net interest income

        

        $

        25,065

        

        $

        21,579




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Schedule 7.Controls and Procedures



(a)

        Disclosure controls and procedures.  We evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2008.  Our disclosure controls and procedures are the controls and other procedures that we designed to ensure that we record, process, summarize and report in a timely manner the information we must disclose in reports that we file with or submit to the SEC.  Tony J. Sorcic, President and Chief Executive Officer, and Todd D. Fanning, Senior Vice-President and Chief Financial Officer, reviewed and
participated in this evaluation.  Based on this evaluation, Messrs.  Sorcic and Fanning concluded that, as of the date of their evaluation, our disclosure controls were effective.




(b)

        Internal controls.  There have not been any significant changes in our internal accounting controls or in other factors during the quarter ended September 30, 2008 that could significantly affect those controls.




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INDEX TO EXHIBITS



ExhibitNumber

        Exhibit31.1

        Certification of Tony J. Sorcic required by Rule 13a-14(a).31.2

        Certification of Todd D. Fanning required by Rule 13a-14(a).32.1

        Certification of Tony J. Sorcic required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.32.2

        Certification of Todd D. Fanning required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.




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