---

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549   FORM 10-Q   RQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934  For the Quarterly Period Ended June 30, 2010  Commission File Number: 0-20050   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 Number)606 S. Main St.
Princeton, Illinois
     61356(Address of principal executive offices)
     (Zip code)
  (815) 875-4444 (Registrants telephone number, including area code)    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 for 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.  YesRNo£  Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes£No£  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 the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):  Large accelerated filer£
     Accelerated filer£
     Non-accelerated filer£
     Smaller reporting companyR
  Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes£NoR  Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.  Class
     Outstanding at July 29, 2010Common, par value $5.00
     3,313,003


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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  Smaller reporting companies are not required to provide the information required by this item.  Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds  (a)  None.  Item 4.  Reserved.  Item 6.  Exhibits  31.1
     Certification of Chief Executive Officer required by Rule 13a-14(a).31.2
     Certification of Chief Financial Officer required by Rule 13a-14(a).32.1
     Certification of Chief Executive Officer and Chief Financial Officer 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/Thomas D. Ogaard
     
     By
     /s/Todd D. FanningThomas D. OgaardPresident & Chief Executive OfficerJuly29, 2010
     
     
     Todd D. FanningExecutive Vice President &
Chief Financial OfficerJuly 29, 2010
    2 of 32


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Schedule 1  Princeton National Bancorp, Inc.
Consolidated Balance Sheets (dollars in thousands except per share data)  June 30,2010(unaudited)
     
     December 31,2009ASSETSCash and due from banks
     
     $
     13,165
     
     $
     15,546Interest-bearing deposits with financial institutions
     
     
     47,280
     
     
     55,527Total cash and cash equivalents
     
     
     60,445
     
     
     71,073Loans held-for-sale, at lower of cost or market
     
     
     1,408
     
     
     3,296Investment securities:Available-for-sale, at fair value
     
     
     231,295
     
     
     288,474Held-to-maturity, at amortized cost (fair value of $15,451 and $13,331)
     
     
     14,936
     
     
     12,793Total investment securities
     
     
     246,231
     
     
     301,267Loans:Loans, net of unearned interest
     
     
     741,924
     
     
     798,074Allowance for loan losses
     
     
     (15,975
     )
     
     (12,075
     )Net loans
     
     
     725,949
     
     
     785,999Premises and equipment, net of accumulated depreciation
     
     
     27,496
     
     
     28,269Land held for sale, at lower of cost or market
     
     
     2,354
     
     
     2,354Federal Reserve and Federal Home Loan Bank stock
     
     
     4,498
     
     
     4,230Bank-owned life insurance
     
     
     22,962
     
     
     22,540Accrued interest receivable
     
     
     6,953
     
     
     9,267Intangible assets, net of accumulated amortization
     
     
     2,938
     
     
     3,347Other real estate owned
     
     
     19,701
     
     
     17,658Other assets
     
     
     9,892
     
     
     11,430TOTAL ASSETS
     
     $
     1,130,827
     
     $
     1,260,730LIABILITIESDeposits:Demand
     
     $
     122,810
     
     $
     136,026Interest-bearing demand
     
     
     371,188
     
     
     374,624Savings
     
     
     74,658
     
     
     68,292Time
     
     
     399,198
     
     
     496,597Total deposits
     
     
     967,854
     
     
     1,075,539Borrowings:Customer repurchase agreements
     
     
     33,135
     
     
     47,327Advances from the Federal Home Loan Bank
     
     
     22,500
     
     
     31,500Interest-bearing demand notes issued to the U.S. Treasury
     
     
     298
     
     
     1,021Trust preferred securities
     
     
     25,000
     
     
     25,000Total borrowings
     
     
     80,933
     
     
     104,848Other liabilities
     
     
     4,435
     
     
     5,683TOTAL LIABILITIES
     
     
     1,053,222
     
     
     1,186,070STOCKHOLDERS EQUITYPreferred stock: no par value, 100,000 shares authorized:25,083 shares issued and outstanding at June 30, 2010 and December 31, 2009
     
     
     24,972
     
     
     24,958Common stock:   $5 par value, 7,000,000 shares authorized:4,478,295 shares issued at June 30, 2010 and December 31, 2009
     
     
     22,391
     
     
     22,391Common stock warrants
     
     
     150
     
     
     150Additional paid-in capital
     
     
     18,405
     
     
     18,423Retained earnings
     
     
     29,888
     
     
     29,851Accumulated other comprehensive income, net of taxes
     
     
     5,614
     
     
     2,816Less: cost of 1,165,292 and 1,171,926 treasury shares at June 30, 2010 and December 31, 2009
     
     
     (23,815
     )
     
     (23,929
     )TOTAL STOCKHOLDERS EQUITY
     
     
     77,605
     
     
     74,660TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
     
     $
     1,130,827
     
     $
     1,260,730
  See accompanying notes to unaudited consolidated financial statements.
   3 of 32


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Schedule 2  Princeton National Bancorp, Inc.
Consolidated Statements of Income (unaudited) (dollars in thousands, except share data)  THREE MONTHSENDEDJune 30, 2010
     
     THREE MONTHSENDEDJune 30, 2009
     
     SIX MONTHSENDEDJune 30, 2010
     
     SIX MONTHSENDEDJune 30, 2009INTEREST INCOMEInterest and fees on loans
     
     $
     9,841
     
     $
     11,167
     
     $
     20,427
     
     $
     22,543Interest and dividends on investment securities
     
     
     2,492
     
     
     3,216
     
     
     5,335
     
     
     6,147Interest on interest-bearing time deposits in other banks
     
     
     40
     
     
     35
     
     
     72
     
     
     51Total interest income
     
     
     12,373
     
     
     14,418
     
     
     25,834
     
     
     28,741INTEREST EXPENSEInterest on deposits
     
     
     2,657
     
     
     5,103
     
     
     6,030
     
     
     10,250Interest on borrowings
     
     
     531
     
     
     686
     
     
     1,136
     
     
     1,467Total interest expense
     
     
     3,188
     
     
     5,789
     
     
     7,166
     
     
     11,717Net interest income
     
     
     9,185
     
     
     8,629
     
     
     18,668
     
     
     17,024Provision for loan losses
     
     
     2,650
     
     
     1,465
     
     
     6,575
     
     
     2,635Net interest income after provision  for loan losses
     
     
     6,535
     
     
     7,164
     
     
     12,093
     
     
     14,389NON-INTEREST INCOMETrust & farm management fees
     
     
     317
     
     
     394
     
     
     581
     
     
     708Service charges on deposit accounts
     
     
     958
     
     
     977
     
     
     1,849
     
     
     1,953Other service charges
     
     
     507
     
     
     486
     
     
     967
     
     
     900Gain on sales of securities available-for-sale
     
     
     80
     
     
     574
     
     
     722
     
     
     761Brokerage fee income
     
     
     224
     
     
     249
     
     
     413
     
     
     447Mortgage servicing rights impairment
     
     
     (589
     )
     
     0
     
     
     (589
     )
     
     (556
     )Mortgage banking income
     
     
     268
     
     
     787
     
     
     763
     
     
     1,485Bank-owned life insurance
     
     
     228
     
     
     230
     
     
     457
     
     
     473Other operating income
     
     
     36
     
     
     34
     
     
     58
     
     
     148Total non-interest income
     
     
     2,029
     
     
     3,731
     
     
     5,221
     
     
     6,319NON-INTEREST EXPENSESalaries and employee benefits
     
     
     4,452
     
     
     4,113
     
     
     8,864
     
     
     8,693Occupancy
     
     
     633
     
     
     602
     
     
     1,333
     
     
     1,311Equipment expense
     
     
     747
     
     
     763
     
     
     1,514
     
     
     1,536Federal insurance assessments
     
     
     534
     
     
     826
     
     
     1,232
     
     
     1,523Intangible assets amortization
     
     
     201
     
     
     208
     
     
     402
     
     
     416Data processing
     
     
     320
     
     
     339
     
     
     632
     
     
     655Advertising
     
     
     206
     
     
     211
     
     
     382
     
     
     408Other real estate expenes, net
     
     
     387
     
     
     419
     
     
     1,122
     
     
     509Loan collection expenses
     
     
     184
     
     
     97
     
     
     388
     
     
     202Other operating expense
     
     
     1,152
     
     
     1,137
     
     
     2,233
     
     
     2,222Total non-interest expense
     
     
     8,816
     
     
     8,715
     
     
     18,102
     
     
     17,475Income (Loss) before income taxes
     
     
     (252
     )
     
     2,180
     
     
     (788
     )
     
     3,233Income tax expense (benefit)
     
     
     (672
     )
     
     282
     
     
     (1,467
     )
     
     178Net income
     
     
     420
     
     
     1,898
     
     
     679
     
     
     3,055Preferred stock dividends
     
     
     314
     
     
     317
     
     
     627
     
     
     554Accretion of preferred stock discount
     
     
     7
     
     
     6
     
     
     14
     
     
     11Net income available to common stockholders
     
     $
     99
     
     $
     1,575
     
     $
     38
     
     $
     2,490Net income per share available to common stockholders:BASIC
     
     $
     0.03
     
     $
     0.48
     
     $
     0.01
     
     $
     0.75DILUTED
     
     $
     0.03
     
     $
     0.48
     
     $
     0.01
     
     $
     0.75Basic weighted average shares outstanding
     
     
     3,309,746
     
     
     3,300,161
     
     
     3,308,262
     
     
     3,299,119Diluted weighted average shares outstanding
     
     
     3,309,746
     
     
     3,300,586
     
     
     3,308,262
     
     
     3,299,634
  See accompanying notes to unaudited consolidated financial statements.
  4 of 32


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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 Six Months Ended
June 30, 2010
     
     Preferred
Stock
     
     Common
Stock
     
     Common
Stock
Warrants
     
     Additional
Paid-in
Capital
     
     Retained
Earnings
     
     Accumulated
Other 
Comprehensive
Income,
net of tax effect
     
     Treasury
Stock
     
     TotalBalance, January 1, 2010
     
     $
     24,958
     
     $
     22,391
     
     $
     150
     
     $
     18,423
     
     $
     29,851
     
     $
     2,816
     
     $
     (23,929
     )
     $
     74,660Net income
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     679
     
     
     
     
     
     
     
     
     679Dividends on preferred stock
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     (628
     )
     
     
     
     
     
     
     
     (628
     )Accretion on preferred stock discount
     
     
     14
     
     
     
     
     
     
     
     
     
     
     
     (14
     )
     
     
     
     
     
     
     
     Sale of 4,634 common shares and of treasurycommon stock
     
     
     
     
     
     
     
     
     
     
     
     (49
     )
     
     
     
     
     
     
     
     80
     
     
     31Award of 2,000 shares of restricted commonstock of treasury common stock
     
     
     
     
     
     
     
     
     
     
     
     (14
     )
     
     
     
     
     
     
     
     34
     
     
     20Stock option compensation expense
     
     
     
     
     
     
     
     
     
     
     
     45
     
     
     
     
     
     
     
     
     
     
     
     45Other comprehensive income, net of $1,769tax effect
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     2,798
     
     
     
     
     
     2,798Balance, June 30, 2010
     
     $
     24,972
     
     $
     22,391
     
     $
     150
     
     $
     18,405
     
     $
     29,888
     
     $
     5,614
     
     $
     (23,815
     )
     $
     77,605For the Six Months Ended June 30, 2009Balance, January 1, 2009
     
     $
     
     
     $
     22,391
     
     $
     
     
     $
     18,420
     
     $
     54,329
     
     $
     1,402
     
     $
     (24,071
     )
     $
     72,471Net income
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     3,055
     
     
     
     
     
     
     
     
     3,055Issuance of 25,083 shares of preferred stockand 155,025 common stock warrants, netof expenses
     
     
     24,933
     
     
     
     
     
     150
     
     
     (63
     )
     
     
     
     
     
     
     
     
     
     
     25,020Dividends on preferred stock
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     (390
     )
     
     
     
     
     
     
     
     (390
     )Accretion on preferred stock discount
     
     
     11
     
     
     
     
     
     
     
     
     
     
     
     (11
     )
     
     
     
     
     
     
     
     Sale of 4,116 shares of treasury commonstock
     
     
     
     
     
     
     
     
     
     
     
     (9
     )
     
     
     
     
     
     
     
     70
     
     
     61Dividends on common stock ($.42 per share)
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     (1,386
     )
     
     
     
     
     
     
     
     (1,386
     )Stock option compensation expense
     
     
     
     
     
     
     
     
     
     
     
     47
     
     
     
     
     
     
     
     
     
     
     
     47Other comprehensive loss, net of $492 taxeffect
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     (778
     )
     
     
     
     
     (778
     )Balance, June 30, 2009
     
     $
     24,944
     
     $
     22,391
     
     $
     150
     
     $
     18,395
     
     $
     55,597
     
     $
     624
     
     $
     (24,001
     )
     $
     98,100
  See accompanying notes to unaudited consolidated financial statements
    5 of 32


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Schedule 4  Princeton National Bancorp, Inc. and Subsidiary
Consolidated Statements of Cash Flows (Unaudited)
(dollars in thousands)  For the Six Months EndedJune 302010
     
     2009Operating activities:Net income
     
     $
     679
     
     $
     3,055Adjustments to reconcile net income to net cash provided by operating activities:Depreciation
     
     
     1,057
     
     
     1,114Provision for loan losses
     
     
     6,575
     
     
     2,635Amortization of intangible assets and other purchase accounting adjustments, net
     
     
     402
     
     
     417Amortization of premiums and discounts on investment securities, net
     
     
     799
     
     
     516Gain on sales of securities available-for-sale, net
     
     
     (722
     )
     
     (761
     )Impairment of mortgage servicing rights
     
     
     589
     
     
     556Compensation expense for vested stock options
     
     
     45
     
     
     47Losses on sales and write downs of other real estate owned, net
     
     
     388
     
     
     49Loans originated for sale
     
     
     (38,962
     )
     
     (81,492
     )Proceeds from sales of loans originated for sale
     
     
     40,850
     
     
     80,881(Decrease) increase in accrued interest payable
     
     
     (959
     )
     
     53Decrease in accrued interest receivable
     
     
     2,314
     
     
     1,853Decrease (increase) in other assets
     
     
     259
     
     
     (1,022
     )Decrease in other liabilities
     
     
     (2,058
     )
     
     (344
     )Net cash provided by operating activities
     
     
     11,256
     
     
     7,557Investing activities:Proceeds from sales of investment securities available-for-sale
     
     
     42,929
     
     
     41,310Proceeds from maturities of investment securities available-for-sale
     
     
     23,373
     
     
     38,630Purchase of investment securities available-for-sale
     
     
     (5,436
     )
     
     (161,550
     )Proceeds from maturities of investment securities held-to-maturity
     
     
     0
     
     
     1,105Purchase of investment securities held-to-maturity
     
     
     (1,340
     )
     
     (2,105
     )Proceeds from sales of other real estate owned
     
     
     2,309
     
     
     226Net decrease in loans
     
     
     48,742
     
     
     10,545Purchases of premises and equipment
     
     
     (284
     )
     
     (752
     )Net cash provided (used) in investing activities
     
     
     110,293
     
     
     (72,591
     )Financing activities:Net (decrease) increase in deposits
     
     
     (107,685
     )
     
     93,525Net decrease in borrowings
     
     
     (23,915
     )
     
     (23,387
     )Dividends on common stock
     
     
     0
     
     
     (1,386
     )Dividends on preferred stock
     
     
     (628
     )
     
     (390
     )Sales of treasury common stock
     
     
     31
     
     
     61Award of restricted stock
     
     
     20
     
     
     0Proceeds from issuance of preferred stock and common stock warrants, net of expenses
     
     
     0
     
     
     25,020Net cash (used) provided by financing activities
     
     
     (132,177
     )
     
     93,443(Decrease) Increase in cash and cash equivalents
     
     
     (10,628
     )
     
     28,409Cash and cash equivalents at beginning of period
     
     
     71,073
     
     
     20,261Cash and cash equivalents at June 30
     
     $
     60,445
     
     $
     48,670Supplemental disclosures of cash flow information:Cash paid during the period for:Interest
     
     $
     8,125
     
     $
     11,664Income taxes
     
     
     $1,019
     
     
     $820Supplemental disclosures of non-cash flow activities:Loans transferred to other real estate owned
     
     $
     4,740
     
     $
     13,038
  See accompanying notes to unaudited consolidated financial statements
    6 of 32


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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 three and six month periods ended June 30, 2010 and 2009, and all such adjustments are of a normal recurring nature.  The 2009 year-end consolidated balance sheet data was derived from audited financial statements, but does 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 2009 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 2009 consolidated financial statements have been reclassified to conform to the 2010 presentation.  NOTE 1  CAPITAL PURCHASE PROGRAM  On January 23, 2009, the Corporation received $25,083,000 of equity capital by issuing to the United States Department of Treasury 25,083 shares of the Corporations 5.00% Series B Fixed Rate Cumulative Perpetual Preferred Stock, no par value, with a liquidation preference of $1,000 per share and a ten-year warrant to purchase up to 155,025 shares of the Corporations common stock, par value $5.00 per share, at an exercise price of $24.27 per share.  The proceeds received were allocated to the preferred stock and common stock warrants based on their relative fair values.  The resulting discount on the preferred stock is amortized against retained earnings and is reflected in the Corporations consolidated statement of income as Preferred stock dividends, resulting in additional dilution to the Corporations earnings per common share.  The warrants are immediately exercisable, in whole or in part, over a term of 10 years.  The warrants were included in the Corporations diluted average common shares outstanding (subject to anti-dilution).  Both the preferred securities and warrants were accounted for as additions to the Corporations regulatory Tier 1 and total capital.  The Series B Preferred stock is not mandatorily redeemable and will pay cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter.  Any redemption requires Federal Reserve approval.  The Series B Perpetual Preferred stock ranks senior to the Corporations existing authorized Series A Junior Participating Preferred stock.  A company that participates must adopt certain standards for executive compensation, including (a) prohibiting golden parachute payments as defined in the Emergency Economic Stabilization Act of 2008 (EESA) to senior Executive Officers; (b) requiring recovery of any compensation paid to senior Executive Officers based on criteria that is later proven to be materially inaccurate; (c) prohibiting incentive compensation that encourages unnecessary and excessive risks that threaten the value of the financial institution; and (d) accepting restrictions on the payment of dividends and the repurchase of common stock.  7 of 32


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NOTE 2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 Ended
June 30,
     
     Six Months Ended
June 30,2010
     
     2009
     
     2010
     
     2009Numerator:Net income available to common stockholders
     
     $
     99
     
     $
     1,575
     
     $
     38
     
     $
     2,490Denominator:Basic earnings per share  weighted average common shares
     
     
     3,309,746
     
     
     3,300,161
     
     
     3,308,262
     
     
     3,299,119Effect of dilutive securities  stock options
     
     
     
     
     
     425
     
     
     
     
     
     515Diluted earnings per share adjusted weighted average common shares
     
     
     3,309,746
     
     
     3,300,586
     
     
     3,308,262
     
     
     3,299,634Net income per share available for common stockholders:Basic
     
     $
     0.03
     
     $
     0.48
     
     $
     0.01
     
     $
     0.75Diluted
     
     $
     0.03
     
     $
     0.48
     
     $
     0.01
     
     $
     0.75
   The following shares were not considered in computing diluted earnings per share for the three and six month periods ended June 30, 2010 and 2009 because they were anti-dilutive:  Three Months Ended
June 30,
     
     Six Months Ended
June 30,2010
     
     2009
     
     2010
     
     2009Stock options to purchase shares of common stock
     
     
     522,511
     
     
     456,627
     
     
     522,511
     
     
     456,627Average diluted potential common shares associated with common stock warrants
     
     
     155,025
     
     
     155,025
     
     
     155,025
     
     
     155,025
   NOTE 3GOODWILL AND INTANGIBLE ASSETS  The balance of intangible assets, net of accumulated amortization, totaled $2,938,000 and $3,347,000  at June 30, 2010 and December 31, 2009, respectively.  The Corporation had a goodwill impairment study performed as of December 31, 2009.  If the implied fair value of goodwill is lower than its carrying amount, goodwill impairment is indicated and goodwill is written down to its implied fair value.  Subsequent increases in goodwill value are not recognized in the financial statements.  The goodwill was deemed impaired as of December 31, 2009 and written off in its entirety.    8 of 32


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The following table summarizes the Corporations intangible assets, which are subject to amortization, as of June 30, 2010 and December 31, 2009:

(in thousands)
     
     June 30, 2010
     
     December 31, 2009Gross
Carrying 
Amount
     
     Accumulated
Amortization
     
     Gross
Carrying
Amount
     
     Accumulated
AmortizationCore deposit intangibles
     
     $
     9,004
     
     $
     (6,118
     )
     $
     9,004
     
     $
     (5,715
     )Other intangible assets
     
     
     234
     
     
     (182
     )
     
     234
     
     
     (176
     )Total
     
     $
     9,238
     
     $
     (6,300
     )
     $
     9,238
     
     $
     (5,891
     )
  Amortization expense of all intangible assets totaled $402,000 and $417,000 for of the six months ended June 30, 2010 and 2009, respectively.  The amortization expense of these intangible assets will be approximately $402,000 for the remaining two quarters of 2010.  NOTE 4ORIGINATED MORTGAGE SERVICING RIGHTS  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.  A non-cash impairment expense of $589,000 was recognized at June 30, 2010 based upon the results of an independent third party valuation study.  Changes in the carrying value of capitalized mortgage servicing rights are summarized as follows:  (in thousands)  Balance, January 1, 2010
     
     $
     3,285Servicing rights capitalized
     
     
     326Amortization of servicing rights
     
     
     (219
     )Impairment of servicing rights
     
     
     (589
     )Balance, June 30, 2010
     
     $
     2,803
   Activity in the valuation allowance for mortgage servicing rights was as follows:  (in thousands)  Balance, January 1, 2010
     
     $
     185Additions
     
     
     589Reductions
     
     
     Direct write-downs
     
     
     Balance, June 30, 2010
     
     $
     774
   9 of 32


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The Corporation services loans for others with unpaid principal balances at June 30, 2010 and December 31, 2009 of approximately $377.0 million, and $363.9 million, respectively.  The following table shows the future estimated amortization expense for mortgage servicing rights based on existing balances as of June 30, 2010.  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 six months ended December 31, 2010
     $
     169For the year ended December 31, 2011
     
     328For the year ended December 31, 2012
     
     307For the year ended December 31, 2013
     
     288For the year ended December 31, 2014
     
     271For the year ended December 31, 2015
     
     254Thereafter
     
     1,186
   NOTE 5OTHER COMPREHENSIVE INCOME (LOSS)  Other comprehensive income (loss) components and related taxes for the six months ended June 30, 2010 and 2009 were as follows:  (in thousands)
     
     2010
     
     2009Net unrealized gains (losses) on securities available-for-sale
     
     $
     5,289
     
     $
     (509
     )Reclassification adjustment for realized gains included in income
     
     
     (722
     )
     
     (761
     )Other comprehensive income (loss), before tax effect
     
     
     4,567
     
     
     (1,270
     )Less:  tax expense (benefit)
     
     
     1,769
     
     
     (492
     )Other comprehensive income (loss)
     
     $
     2,798
     
     $
     (778
     )
    The components of accumulated other comprehensive income, included in stockholders equity at June 30, 2010 and 2009 are as follows:  (in thousands)
     
     2010
     
     2009Net unrealized gain on securities available-for-sale
     
     $
     9,694
     
     $
     1,549Net unrealized benefit obligations
     
     
     (530
     )
     
     (530
     )9,164
     
     
     1,019Less: tax effect
     
     
     (3,550
     )
     
     (395
     )Net-of-tax amount
     
     $
     5,614
     
     $
     624
   10 of 32


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NOTE 6FEDERAL HOME LOAN BANK STOCK  The subsidiary bank held Federal Home Loan Bank stock totaling $2,373,000 at June 30, 2010 and December 31, 2009. The Federal Home Loan Bank of Chicago is operating under 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 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 six months of 2010 or during 2009.  Management performed an analysis and deemed the cost method investment in Federal Home Loan Bank stock was ultimately recoverable as of June 30, 2010 and December 31, 2009.  NOTE 7INVESTMENT SECURITIES  The amortized cost and fair value of securities available-for-sale and held-to-maturity are as follows at June 30, 2010:  (in thousands)
     
     Amortized
Cost
     
     Gross
Unrealized
Gains
     
     Gross
Unrealized
Losses
     
     Fair
ValueSecurities available-for-saleObligations of U.S. government agencies and sponsored entities (1)(2)
     
     $
     17,122
     
     $
     920
     
     $
     
     
     $
     18,042Obligations of states and political subdivisions
     
     
     110,696
     
     
     5,190
     
     
     139
     
     
     115,747Other mortgage-backed securities, includes CMOs (3)
     
     
     93,783
     
     
     3,723
     
     
     0
     
     
     97,506Total securities available-for-sale
     
     $
     221,600
     
     $
     9,833
     
     $
     139
     
     $
     231,295Securities held-to-maturityObligations of states and political subdivisions
     
     $
     14,936
     
     $
     519
     
     $
     4
     
     $
     15,451Total securities
     
     $
     236,537
     
     $
     10,351
     
     $
     143
     
     $
     246,746
  ________ (1)  Includes obligations of the Government National Mortgage Association (GNMA).  (2)  Includes obligations of the Federal Home Loan Mortgage Corporation (FHLMC) and Fannie Mae Mortgage Association (FNMA).  (3)  Includes obligations issued or guaranteed by FNMA, FHLMC or GNMA.  The amortized cost and fair value of securities available-for-sale and held-to-maturity are as follows at December 31, 2009:  (in thousands)
     
     Amortized
Cost
     
     Gross
Unrealized
Gains
     
     Gross
Unrealized
Losses
     
     Fair
ValueSecurities available-for-saleObligations of U.S. government agencies and sponsored entities (1)(2)
     
     $
     95,498
     
     $
     1,560
     
     $
     (745
     )
     $
     96,313Obligations of states and political subdivisions
     
     
     116,864
     
     
     3,580
     
     
     (366
     )
     
     120,078Other mortgage-backed securities, includes CMOs (3)
     
     
     70,985
     
     
     1,156
     
     
     (58
     )
     
     72,083Total securities available-for-sale
     
     $
     283,347
     
     $
     6,296
     
     $
     (1,169
     )
     $
     288,474Securities held-to-maturityObligations of states and political subdivisions
     
     $
     12,793
     
     $
     547
     
     $
     9
     
     $
     13,331Total securities
     
     $
     296,140
     
     $
     6,843
     
     $
     (1,160
     )
     $
     301,805
  ____________ (1)  Includes obligations of the FHLMC and FNMA.  (2)  Includes obligations of the Federal Home Loan Mortgage Corporation (FHLMC) and Fannie Mae Mortgage Association (FNMA).  (3)  Includes obligations issued or guaranteed by FNMA, FHLMC or GNMA.   11 of 32


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The following is a summary of the fair value of securities held-to-maturity and available-for-sale with unrealized losses and an aging of those unrealized losses:  June 30, 2010(in thousands)
     
     Less Than 12 Months
     
     12 Months or More
     
     TotalFair
Value
     
     Unrealized
Losses
     
     Fair
Value
     
     Unrealized
Losses
     
     Fair
Value
     
     Unrealized
LossesSecurities available-for-saleObligations of states and political subdivisions
     
     $
     7,017
     
     $
     (124
     )
     $
     2,507
     
     $
     (15
     )
     $
     9,523
     
     $
     (139
     )Securities held-to-maturityObligations of states and political subdivisions
     
     $
     156
     
     $
     
     
     $
     400
     
     $
     (4
     )
     $
     556
     
     $
     (4
     )
   December 31, 2009(in thousands)
     
     Less Than 12 Months
     
     12 Months or More
     
     TotalFair
Value
     
     Unrealized
Losses
     
     Fair
Value
     
     Unrealized
Losses
     
     Fair
Value
     
     Unrealized
LossesObligations of U.S. government agencies and government-sponsored entities (GSEs) (1)(2)
     
     $
     39,012
     
     $
     (745
     )
     $
     7
     
     $
     
     
     $
     39,019
     
     $
     (745
     )Obligations of states and political subdivisions
     
     
     17,114
     
     
     (255
     )
     
     5,344
     
     
     (120
     )
     
     22,458
     
     
     (375
     )Collateralized mortgage obligations
     
     
     8,006
     
     
     (58
     )
     
     
     
     
     
     
     
     8,006
     
     
     (58
     )Total temporarily impaired securities
     
     $
     64,132
     
     $
     (1,058
     )
     $
     5,351
     
     $
     (120
     )
     $
     69,483
     
     $
     (1,178
     )
 ____________  (1)  Includes obligations of GNMA. (2)  Includes issues from FNMA and FHLMC.  The unrealized loss on available-for-sale securities is included in other accumulated comprehensive income on the consolidated balance sheets. Management has concluded that no individual unrealized loss as of June 30, 2010, identified in the preceding table, represents other-than-temporary impairment. The Corporation does not intend to sell nor would it be required to sell the securities shown in the table with unrealized losses before recovering their amortized cost.  Maturities of investment securities classified as available-for-sale and held to maturity were as follows at June 30, 2010:  (in thousands)
     
     Adjusted
Carrying Value
     
     Fair
ValueAvailable-for-sale:Due in one year or less
     
     $
     1,320
     
     $
     1,350Due after one year through five years
     
     
     14,896
     
     
     15,654Due after five years through ten years
     
     
     55,949
     
     
     58,774Due after ten years
     
     
     48,518
     
     
     58,011127,819
     
     
     133,789Mortgage-backed securities
     
     
     47,380
     
     
     49,104Collateral mortgage obligations
     
     
     46,403
     
     
     48,402$
     221,601
     
     $
     231,295Held-to-maturity:Due in one year or less
     
     $
     3,402
     
     $
     3,435Due after one year through five years
     
     
     7,609
     
     
     7,953Due after five years through ten years
     
     
     3,617
     
     
     3,758Due after ten years
     
     
     308
     
     
     305$
     14,936
     
     $
     15,451
   12 of 32


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Proceeds from sales of investment securities available-for sale was $42.9 million for the first six months of 2010 compared to $41.3 million for the first six months of 2009. Net gains were realized of $722,000 and $761,000 for the first six months of 2010 and 2009, respectively.  The carrying value of securities pledged as collateral, to secure public deposits and for other purposes was $216.9 million at June 30, 2010 and $283.0 million at December 31, 2009.  NOTE 8  LOANS  The composition of the loan portfolio, excluding loans held for sale was as follows:  (in thousands)
     
     June 30, 2010
     
     December 31, 2009Amount
     
     % of Total
     
     Amount
     
     % of TotalAgricultural
     
     $
     70,555
     
     
     9.5
     %
     $
     76,918
     
     
     9.6
     %Commercial (1)
     
     
     140,955
     
     
     19.0
     
     
     244,049
     
     
     30.6Real Estate:1-4 family residences
     
     
     100,642
     
     
     13.6
     
     
     123,374
     
     
     15.4Agricultural
     
     
     44,940
     
     
     6.1
     
     
     61,022
     
     
     7.6Construction (1)
     
     
     111,688
     
     
     15.1
     
     
     24,118
     
     
     3.0Commercial
     
     
     208,565
     
     
     28.1
     
     
     198,914
     
     
     24.9Total Real Estate
     
     
     465,835
     
     
     62.8
     
     
     407,428
     
     
     51.1Installment
     
     
     64,579
     
     
     8.7
     
     
     69,679
     
     
     8.7Total loans
     
     $
     741,924
     
     
     100.0
     %
     $
     798,074
     
     
     100.0
     %
 _______________________ (1) Loans previously classified as commercial have been reclassified as construction.  The allowance for loan losses for the six months ended June 30, 2010 and 2009 were as follows:  (in thousands)
     
     2010
     
     2009Balance beginning of the year
     
     $
     6,159
     
     $
     5,064Provision for loan losses
     
     
     6,575
     
     
     2,635Loans charged-off
     
     
     2,789
     
     
     1,640Recoveries of loans previously charged off
     
     
     (114
     )
     
     (100
     )Balance end of the period
     
     $
     10,059
     
     $
     6,159
  NOTE 9FAIR VALUE OF ASSETS AND LIABILITIES  ASC 820 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.  ASC 820 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.  In accordance with ASC 820, the Corporation 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.  Financial Accounting Standards Board Accounting Standards Codification 820 (ASC 820), Fair Value Measurements. ASC 820 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  ASC 820 has been applied prospectively as of the beginning of the period.
  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.   13 of 32


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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 Corporation 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.  For these investments, the inputs used by the pricing service to determine fair value may include one, or a combination or, observable inputs such as benchmark yields, reported trades, broker/dealer quotes, issurer spreads, two-sided markets, benchmark securities, bids, offers and reference data market research publications and are classified within Level 2 of the valuation hierarchy.  Level 2 securities include Obligations of U.S. Treasury securities, Obligations of U.S. government corporations and agencies, obligations of states and political subdivisions, mortgage-backed securities, and collateralized mortgage obligations.  In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy.  The Corporation has no securities classified within Level 3.
 The following table presents the Corporations assets that are measured at fair value on a recurring basis and the level within the ASC 820 hierarchy in which the fair value measurements fall as of June 30, 2010 and December 31, 2009 (in thousands):  June 30, 2010
     
     
     
     Fair Value Measurements Using(in thousands)
     
     Fair Value
     
     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
     
     Significant Other
Observable Inputs
(Level 2)
     
     Significant
Unobservable
Inputs
(Level 3)Available-for-sale securitiesUnited States Government and Federal agency and U.S. Government sponsored Enterprises (GSEs)
     
     $
     67,146
     
     $
     
     
     $
     67,146
     
     $
     State and Municipal
     
     
     115,747
     
     
     
     
     
     115,747
     
     
     Collateral mortgage obligations:GSE Residential
     
     
     48,402
     
     
     
     
     
     48,402
     
     
     Total
     
     $
     231,295
     
     $
     
     
     $
     231,295
     
     $
     
   December 31, 2009
     
     
     
     
     Fair Value Measurements Using(in thousands)
     
     Fair Value
     
     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
     
     Significant Other
Observable Inputs
(Level 2)
     
     Significant
Unobservable
Inputs
(Level 3)Available-for-sale securitiesUnited States Government and Federal agency and U.S. Government sponsored Enterprises (GSEs)
     
     $
     96,313
     
     $
     
     
     $
     96,313
     
     $
     State and Municipal
     
     
     120,078
     
     
     
     
     
     120,078
     
     
     Collateral mortgage obligations:GSE Residential
     
     
     72,083
     
     
     
     
     
     72,083
     
     
     Total
     
     $
     288,474
     
     $
     
     
     $
     288,474
     
     $
     
  Following is a description of the valuation methodologies used for assets and liabilities measured at fair value on a non-recurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets and liabilities pursuant to the valuation hierarchy.  Impaired Loans  Loans for which it is probable that the Corporation will not collect all principal and interest due according to contractual terms are measured for impairment in accordance with the provisions of ASC 310-10-35, authoritative guidance for impairments. Allowable methods for estimating fair value include using the fair value of the collateral for collateral dependent loans or, where a loan is determined not to be collateral dependent, using the discounted cash flow method.  If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value.  If the impaired loan is determined not to be collateral dependent, then the discounted cash flow method is used. This method requires the impaired loan to be recorded at the present value of expected future cash flows discounted at the loans effective interest rate. The effective interest rate of a loan is the contractual interest rate adjusted for any net deferred loan fees or costs, premiums or discount existing at origination or acquisition of the loan.  Impaired loans are classified within Level 3 of the fair value hierarchy.   14 of 32


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Mortgage Servicing Rights  The fair value used to determine the valuation allowance is estimated using discounted cash flow models. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the hierarchy.  Other Real Estate Owned  Other real estate owned acquired through loan foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis.  The adjustment at the time of foreclosure is recorded through the allowance for loan losses.  Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate.  If it is determined the fair value declines subsequent to foreclosure, a valuation allowance is recorded through non-interest expense.  Operating costs associated with the assets after acquisition are also recorded as non-interest expense.  Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to other non-interest expense.  The following table presents the fair value measurement of assets and liabilities measured at fair value on a nonrecurring basis and the level within the ASC 820 fair value hierarchy in which the fair value measurements fall at June 30, 2010 and December 31, 2009 (in thousands):  June 30, 2010
     
     
     
     
     Fair Value Measurements Using(in thousands)
     
     Fair Value
     
     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
     
     Significant Other
Observable Inputs
(Level 2)
     
     Significant
Unobservable
Inputs
(Level 3)Impaired loans (collateral dependent)
     
     $
     26,248
     
     
     
     
     
     
     
     $
     26,248Mortgage servicing rights
     
     
     2,803
     
     
     
     
     
     
     
     
     2,803Other real estate owned
     
     
     5,418
     
     
     
     
     
     
     
     
     5,418
   December 31, 2009
     
     
     
     
     Fair Value Measurements Using(in thousands)
     
     Fair Value
     
     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
     
     Significant Other
Observable Inputs
(Level 2)
     
     Significant
Unobservable
Inputs
(Level 3)Impaired loans (collateral dependent)
     
     $
     7,970
     
     
     
     
     
     
     
     $
     7,970Mortgage servicing rights
     
     
     3,285
     
     
     
     
     
     
     
     
     3,285Other real estate owned
     
     
     17,658
     
     
     
     
     
     
     
     
     17,658
  ASC 825, "Disclosures about Fair Value of Financial Instruments," requires all entities to disclose the estimated fair value of their financial instrument assets and liabilities.  For the Corporation, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in ASC 825.  Many of the Corporations financial instruments, however, lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction.  It is also the Corporations general practice and intent to hold its financial instruments to maturity and to not engage in trading or sales activities except for loans held-for-sale and available-for-sale securities.  Therefore, significant estimations and assumptions, as well as present value calculations, were used by the Corporation for the purposes of this disclosure.    15 of 32


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Estimated fair values have been determined by the Corporation using the best available data and an estimation methodology suitable for each category of financial instruments.  For those loans and deposits with floating interest rates, it is presumed that estimated fair values generally approximate the recorded book balances.  The estimation methodologies used, the estimated fair values, and the recorded book balances at June 30, 2010 and December 31, 2009, were as follows:

June 30, 2010
     
     December 31, 2009(in thousands)
     
     Carrying
Value
     
     Fair
Value
     
     Carrying
Value
     
     Fair
ValueFinancial Assets:Cash and due from banks
     
     $
     13,165
     
     $
     13,165
     
     $
     15,546
     
     $
     15,546Interest-bearing deposits in financial institutions
     
     
     47,280
     
     
     47,280
     
     
     55,527
     
     
     55,527Investment securities
     
     
     246,231
     
     
     246,746
     
     
     301,267
     
     
     301,805Loans, net, including loans held for sale
     
     
     727,357
     
     
     747,590
     
     
     789,295
     
     
     793,674Accrued interest receivable
     
     
     6,935
     
     
     6,953
     
     
     9,267
     
     
     9,267Total financial assets
     
     $
     1,040,986
     
     $
     1,061,733
     
     $
     1,170,902
     
     $
     1,175,819Financial Liabilities:Non-interest bearing demand deposits
     
     $
     122,810
     
     $
     122,810
     
     $
     136,026
     
     $
     136,026Interest-bearing deposits
     
     
     845,044
     
     
     845,399
     
     
     939,513
     
     
     945,637Borrowings
     
     
     80,933
     
     
     92,940
     
     
     104,848
     
     
     119,301Accrued interest payable
     
     
     2,040
     
     
     2,040
     
     
     2,999
     
     
     2,999Total financial liabilities
     
     $
     1,050,827
     
     $
     1,063,189
     
     $
     1,183,386
     
     $
     1,203,963Unrecognized financial instruments (net of contract amount)Commitments to originate loans
     
     $
     
     
     $
     
     
     $
     
     
     $
     Lines of credit
     
     
     
     
     
     
     
     
     
     
     
     Letters of credit
     
     
     
     
     
     
     
     
     
     
     
     
  Financial instruments actively traded in a secondary market have been valued using quoted available market prices. Cash and due from banks, interest-bearing time deposits in other banks, federal funds sold, loans held-for-sale and interest receivable are valued at book value, which approximates fair value.  Financial liability instruments with stated maturities have been valued using a present value discounted cash flow analysis with a discount rate approximating current market for similar liabilities. Interest payable is valued at book value, which approximates fair value.  Financial instrument liabilities with no stated maturities have an estimated fair value equal to both the amount payable on demand and the recorded book balance.  The net loan portfolio has been valued using a present value discounted cash flow.  The discount rate used in these calculations is the current rate at which similar loans would be made to borrowers with similar credit ratings, same remaining maturities, and assumed prepayment risk.  The fair value of commitments to originate loans is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties.  For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.  The fair values of letters of credit and lines of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties at the reporting date.  Changes in assumptions or estimation methodologies may have a material effect on these estimated fair values.   16 of 32


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The Corporations remaining assets and liabilities, which are not considered financial instruments, have not been valued differently than has been customary with historical cost accounting.  No disclosure of the relationship value of the Corporations core deposit base is required by ASC 825.  Fair value estimates are based on existing balance sheet financial instruments, without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.  For example, the subsidiary bank has a large fiduciary services department that contributes net fee income annually.  The fiduciary services department is not considered a financial instrument, and its value has not been incorporated into the fair value estimates.  Other significant assets and liabilities that are not considered financial assets or liabilities include the mortgage banking operation, brokerage network, deferred taxes, premises and equipment, and goodwill.  In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.  Management believes that reasonable comparability between financial institutions may not be likely, due to the wide range of permitted valuation techniques and numerous estimates which must be made, given the absence of active secondary markets for many of the financial instruments.  This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values.  NOTE 10  INCOME TAXES  A reconciliation of income tax expense at 34 percent of pre-tax income to the Corporations actual tax expense (benefit) for the three-month periods ended March 31 is shown below:  (in thousands) Three Months Ended
June 30,
     
     Six Months Ended
June 30,2010
     
     2009
     
     2010
     
     2009Computed expected tax (benefit) expense
     
     $
     (86
     )
     $
     741
     
     $
     (267
     )
     $
     1,099Increase (decrease) in income taxes resulting from:Tax-exempt income
     
     
     (461
     )
     
     (435
     )
     
     (924
     )
     
     (814
     )State income tax, net of federal tax benefit
     
     
     (42
     )
     
     116
     
     
     (104
     )
     
     157Bank-owned life insurance income
     
     
     (77
     )
     
     (79
     )
     
     (159
     )
     
     (165
     )Other, net
     
     
     (6
     )
     
     (61
     )
     
     (12
     )
     
     (99
     )$
     (672
     )
     $
     282
     
     $
     (1,467
     )
     $
     178
   NOTE 11  IMPACT OF NEW ACCOUNTING STANDARDS  In July 2010, the FASB issued ASU No. 2010-20,Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses,which will require the Corporation to provide a greater level of disaggregated information about the credit quality of the Corporations loans and leases and the Allowance for Loan Losses (the Allowance).  This ASU will also require the Corporation to disclose additional information related to credit quality indicators, past due information, and information related to loans modified in a troubled debt restructuring.  The provisions of this ASU are effective for the Corporations reporting period ending December 31, 2010.  As this ASU amends only the disclosure requirements for loans and leases and the Allowance, the adoption will have no impact on the Corporations statements of income and condition.  NOTE 12  REGULATORY MATTERS  On March 15, 2010, Citizens First National Bank, Princeton, Illinois (the Bank), a subsidiary of Princeton National Bancorp, Inc. (the Corporation) entered into a formal written agreement (the Agreement) with the Comptroller of the Currency (the Comptroller) that contains provisions to lower nonperforming loan levels and foster improvement in the Banks policies and procedures with respect to the Banks allowance for loan and lease losses, and loan risk rating system. The Bank has begun addressing all of these requirements.   17 of 32


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Pursuant to the Agreement, the Banks board is required to review the adequacy of the Banks allowance for loan and lease losses and to establish a program for the maintenance of an adequate allowance. A copy of the boards program is required to be submitted to the Comptroller for review. The Bank is also required to take immediate action to protect its interest in criticized assets identified in the Banks most recent Report of Examination with the Comptroller and to adopt individual written workout plans with respect to such assets. A copy of the workout plans is required to be submitted to the Comptroller with respect to any criticized asset equal to or exceeding $100,000. The Bank is prohibited from extending any additional credit to any borrower whose loan is criticized, unless a majority of the Banks board (or appropriate committee) has determined that the extension is necessary to promote the best interests of the Bank and such determination is properly recorded. Under the Agreement, the board must ensure that the Banks internal ratings of credit relationships are timely, accurate, and consistent with the regulatory credit classification criteria set forth in the Comptrollers Handbook and related authority. The board must also ensure that any loan relationship with a high probability of payment default or other well-defined weakness is rated no better than substandard, regardless of the existence of certain mitigants that reduce credit risk.  The Banks board and management has taken relevant actions to comply with the terms of this agreement, including the implementation of remediation steps to protect its interest in criticized assets, enhanced workout plans among other steps.   18 of 32


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PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the three and six month periods ended June 30, 2010 and 2009  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 six month periods ended June 30, 2010 and 2009.  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 Corporations pricing and fee trends, credit quality and outlook, liquidity, new business results, expansion plans, anticipated expenses and planned schedules.  The Corporation 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 Corporation, 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 Corporation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 Corporation and its business, including  a discussion of these and additional factors that could materially affect the Corporations financial results, is included in the Corporations 2009 Annual Report on Form 10-K under the headings Item 1. Business and Item 1A. Risk Factors.  CRITICAL ACCOUNTING POLICIES AND USE OF SIGNIFICANT ESTIMATES  The Corporation has established various accounting policies that govern the application of U.S. generally accepted accounting principles in the preparation of the Corporations financial statements. The significant accounting policies of the Corporation are described in the footnotes to the consolidated financial statements. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and assumptions, which could have a material impact on the carrying values of assets and liabilities and the results of operations of the Corporation. Allowance for Loan Losses The Corporation believes the allowance for loan losses is the critical accounting policy that requires the most significant judgments and assumptions used in the preparation of its consolidated financial statements. We determine probable incurred losses inherent in our loan portfolio and establish an allowance for those losses by considering factors including historical loss rates, expected cash flows and estimated collateral values. In assessing these factors, we use organizational history and experience with credit decisions and related outcomes. The allowance for loan losses represents our best estimate of losses inherent in the existing loan portfolio. The allowance for loan losses is increased by the provision for loan losses charged to expense and reduced by loans charged off, net of recoveries. We evaluate our allowance for loan losses quarterly. If our underlying assumptions later prove to be inaccurate based on subsequent loss evaluations, the allowance for loan losses is adjusted. We estimate the appropriate level of allowance for loan losses by separately evaluating impaired and non-impaired loans. A specific allowance is assigned to an impaired loan when expected cash flows or collateral do not justify the carrying amount of the loan. The methodology used to assign an allowance to a non-impaired loan is more subjective. Generally, the allowance assigned to non-impaired loans is determined by applying historical loss rates to existing loans with similar risk characteristics, adjusted for qualitative factors including the volume and severity of identified classified loans, changes in economic conditions, changes in credit policies or underwriting standards, and changes in the level of credit risk associated with specific industries and markets. Because the economic and business climate in any given industry or market, and its impact on any given borrower, can change rapidly, the risk profile of the loan portfolio is continually assessed and adjusted when appropriate. Notwithstanding these procedures, there still exists the possibility that our assessment could prove to be significantly incorrect and that an immediate adjustment to the allowance for loan losses would be required.   19 of 32


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Other Real Estate Owned  Other real estate owned acquired through loan foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined that fair value declines subsequent to foreclosure, a valuation allowance is recorded through non-interest expense. Operating costs associated with the assets after acquisition are also recorded as non-interest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to other non-interest expense.  Deferred Income Tax Assets/Liabilities  Our net deferred income tax asset arises from differences in the dates that items of income and expense enter into our reported income and taxable income. Deferred tax assets and liabilities are established for these items as they arise. From an accounting standpoint, deferred tax assets are reviewed to determine if they are realizable based on the historical level of our taxable income, estimates of our future taxable income and the reversals of deferred tax liabilities. In most cases, the realization of the deferred tax asset is based on our future profitability. If we were to experience net operating losses for tax purposes in a future period, the realization of our deferred tax assets would be evaluated for a potential valuation reserve.  Additionally, the Corporation reviews its uncertain tax positions annually under ASC 740-10. An uncertain tax position is recognized as a benefit only if it is more likely than not that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount actually recognized is the largest amount of tax benefit that is greater than 50% likely to be recognized on examination. For tax positions not meeting the more likely than not test, no tax benefit is recorded. A significant amount of judgment is applied to determine both whether the tax position meets the more likely than not test as well as to determine the largest amount of tax benefit that is greater than 50% likely to be recognized. Differences between the position taken by management and that of taxing authorities could result in a reduction of a tax benefit or increase to tax liability, which could adversely affect future income tax expense.  Impairment of Intangible Assets  Core deposit and customer relationships, which are intangible assets with a finite life, are recorded on our balance sheets. These intangible assets were capitalized as a result of past acquisitions and are being amortized over their estimated useful lives of up to 15 years. Core deposit intangible assets, with finite lives will be tested for impairment when changes in events or circumstances indicate that its carrying amount may not be recoverable. Core deposit intangible assets were tested for impairment during 2010 and no impairment was recognized.  Mortgaging Service Rights (MSRs)  MSR fair values are very sensitive to movements in interest rates as expected future net servicing income depends on the projected outstanding principal balances of the underlying loans, which can be greatly reduced by prepayments. Prepayments usually increase when mortgage interest rates decline and decrease when mortgage interest rates rise.  For discussion regarding the impairment of MSRs, see Note 4  Originated Mortgage Servicing Rights in the Notes to Consolidated Financial Statements.  Fair Value Measurements  ASC 820 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.  ASC 820 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.  In accordance with ASC 820, the Corporation 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.
   20 of 32


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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.  Financial Accounting Standards Board Accounting Standards Codification 820 (ASC 820), Fair Value Measurements. ASC 820 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  ASC 820 has been applied prospectively as of the beginning of the period.
  At the end of each quarter, the Corporation assesses the valuation hierarchy for each asset or liability measured. From time to time, assets or liabilities may be transferred within hierarchy levels due to changes in availability of observable market inputs to measure fair value at the measurement date. Transfers into or out of hierarchy levels are based upon the fair value at the beginning of the reporting period. A more detailed description of the fair values measured at each level of the fair value hierarchy can be found in Note 8  Fair Value of Assets and Liabilities in the Notes to Consolidated Financial Statements.  RECENT DEVELOPMENTS  Effective as of March 15, 2010, Citizens First National Bank, entered into a formal written agreement (the Agreement) with the Comptroller of the Currency (the Comptroller) that contains provisions to lower nonperforming loan levels and foster improvement in the Banks policies and procedures with respect to the Banks allowance for loan and lease losses and loan risk rating system. The Bank has begun addressing all of these requirements.  Pursuant to the Agreement, the Banks board is required to review the adequacy of the Banks allowance for loan and lease losses and to establish a program for the maintenance of an adequate allowance. A copy of the boards program is required to be submitted to the Comptroller for review. The Bank is also required to take immediate action to protect its interest in criticized assets identified in the Banks most recent Report of Examination with the Comptroller and to adopt individual written workout plans with respect to such assets. A copy of the workout plans is required to be submitted to the Comptroller with respect to any criticized asset equal to or exceeding $100,000. The Bank is prohibited from extending any additional credit to any borrower whose loan is criticized, unless a majority of the Banks board (or appropriate committee) has determined that the extension is necessary to promote the best interests of the Bank and such determination is properly recorded. Under the Agreement, the board must ensure that the Banks internal ratings of credit relationships are timely, accurate, and consistent with the regulatory credit classification criteria set forth in the Comptrollers Handbook and related authority. The board must also ensure that any loan relationship with a high probability of payment default or other well-defined weakness is rated no better than substandard, regardless of the existence of certain mitigants that reduce credit risk.  RESULTS OF OPERATIONS  Net income for the second quarter of 2010 was $420,000, as compared to $1.9 million for the second quarter of 2009.  Net income available to common stockholders for the second quarter of 2010 was $99,000, as compared to $1.6 million for the second quarter of 2009.  For the second quarter of 2010, basic and diluted earnings per common share available to common stockholders was $0.03, as compared to $0.48 for the second quarter of 2009.  The decrease in income for the second quarter of 2010 as compared to the second quarter of 2009 is attributed to a $1.2 million increase in loan loss provisions, a $589,000 non-cash impairment expense of mortgage servicing rights, a $519,000 reduction in mortgage banking income and a $494,000 reduction in gains on sales of securities available-for-sale partially offset by a $556,000 increase in net interest income.  The net income available to common stockholders to average assets was 0.03% and 0.51% for the second quarters of 2010 and 2009, respectively. The net income available to common stockholders to average stockholder equity was 0.52% and 6.45% for the second quarters of 2010 and 2009, respectively.   21 of 32


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Net income for the first six months of 2010 was $679,000, as compared to $3.1 million for the first six months of 2009.  Net income available to common stockholders was $38,000, as compared to $2.5 million for the first six months of 2009.  For the first six months of 2010 basic and diluted earnings per common share available to common stockholders was $0.01, as compared to $0.75 for the first six months of 2009.  The decrease in income for the first six months of 2010 as compared to the first six months of 2009 is attributed to a $3.9 million increase in loan loss provisions and a $722,000 decrease in mortgage banking income, a $613,000 increase in other real estate expenses partially offset by an increase of $1.6 million in net interest income.  The  net income available to common stockholders to average assets was 0.01% and 0.41% for the first six months of 2010 and 2009, respectively.  The net income available to common stockholders to average stockholder equity was 0.10% and 5.31% for the first six months of 2010 and 2009, respectively.  Net interest income before the provision for loan losses was $9.2 million for the second quarter of 2010, as compared to $8.6 million for the second quarter of 2009, respectively.  This $556,000 (or 6.4%) increase was driven by lower funding costs.  The net yield on average earning assets increased by 53 basis points to 3.96% in the second quarter of 2010 from 3.43% in the second quarter of 2009.  Net interest income before the provision for losses was $18.7 million for the first six months of 2010, as compared to $17.0 million for the first six months of 2009, respectively.  This $1.6 million (or 9.7%) increase was driven by reductions in interest expenses on deposits and borrowings.   The net yield on earning assets increased by 45 basis points to 3.93% in the first six months of 2010 from 3.48% in the second quarter of 2009.  Average costs for interest-bearing deposits, time deposits, customer repurchase agreements and FHLB advances have contributed to this increasing net interest margin despite the current level of non-performing assets.  For the first six months of 2010 the cost of interest-bearing liabilities declined 90 basis points to 1.46%.  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 second quarter of 2010 the provision for loan losses increased to $2.7 million or 80.9% from $1.5 million for the second quarter of 2009.  Net charge-offs increased by $1.0 million or 266.8% to $1.4 million compared to $370,000 for the second quarter of 2009.    Annualized net loans charged-off to average loans for the second quarter of 2010 was 0.70% compared to 0.69% in the first quarter of 2010.  Net charge-offs increased in the first six months of 2010 by $1.2 million or 73.7% to $2.7 million compared to $1.5 million for the first six months of 2009.  The allowance for loan losses is discussed more fully below.  Non-interest income totaled $2.0 million for the second quarter of 2010, as compared to $3.7 for the second quarter of 2009.  This decline of $1.7 million (or 45.6%) is attributed to a $589,000 non-cash impairment expense on mortgage servicing rights, a $528,000 decrease in mortgage banking income, a $494,000 reduction in gains on sales of securities available-for-sale and a $77,000 drop in trust and farm management fees.  Non-interest income to average assets for the second quarters of 2010 and 2009 was 0.70% and 1.20%, respectively.  Non-interest income totaled $5.2 million for the first six months of 2010, as compared to $6.3 million for the first six months of 2009.  This decline of $1.1 million or 17.4% is attributed to the following:  a $736,000 decrease in mortgage banking income, a $127,000 drop in trust and farm management fees, a $104,000 decline in service charges on deposit accounts and a $90,000 decrease in other operating income.  Non-interest income to average assets for the first six months of 2010 and 2009 was 0.88% and 1.05%, respectively.  Total non-interest expense for the second quarter of 2010 was $8.8 million, as compared to $8.7 million for the first six months of 2009, representing a marginal increase of $101,000.  Non-interest expenses to average assets for the second quarter of 2010 and 2009 was 3.04% and 2.81%. respectively.  Total non-interest expense for the first six months of 2010 was $18.1 million, as compared to $17.5 million for the first six months of 2009.  This increase of $627,000 or 3.6% is attributed to a $613,000 rise in other real estate expenses.  Non-interest expense to average assets for the first six months of 2010 and 2009 was 2.96% and 2.90%, respectively.   22 of 32


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INCOME TAXES

The Corporation recorded an income tax benefit of $672,000 for the second quarter of 2010, as compared to an income tax expense of $282,000 for the second quarter of 2009.  The effective tax rate was (266.7%) for the second quarter of 2010, as compared to 12.9% for the second quarter of 2009. For the first six months of 2010, the Corporation recorded an income tax benefit of $1.5 million, as compared to income tax expense of $178,000 for the first six months of 2009.  The income tax benefit is due to a pre-tax loss coupled with the effect of tax-exempt investment interest income.  For more information on the Corporations income taxes see Note 9  Income Taxes in the Notes to Consolidated Financial Statements.  FDIC  On September 29, 2009 the Board of Directors of the FDIC adopted a Notice of Proposed Rulemaking (NPR) that would require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC estimated that the total prepaid assessments collected would be approximately $45 billion. The FDIC Board also voted to adopt a uniform three-basis point increase in assessment rates effective on January 1, 2011, and extend the restoration period from seven to eight years.  Under GAAP accounting rules, unlike special assessments, prepaid assessments would not immediately affect bank earnings. Each institution would record the entire amount of its assessment related to future periods as a prepaid expense (an asset) as of December 31, 2009, the date the payment would be made.  The Corporation paid an assessment of $6,763,000 for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.  Beginning January 1, 2010, and each quarter thereafter, each institution would record an expense (charge to earnings) for its regular quarterly assessment and an offsetting credit to the prepaid assessment until the asset is exhausted.  At June 30, 2010, the Corporation had a remaining prepaid assessment of $5,292,000.  This amount is reflected in the category of Other Assets in the Consolidated Balance Sheets. The Corporation recorded $534,000 of FDIC assessment expense for the second quarter of 2010 and $1.2 million for the first six months of 2009.  LOANS  The Corporations loan portfolio largely reflects the profile of the communities in which it operates.  The Corporation essentially offers four types of loans:  agricultural, commercial, real estate and consumer installment.  The Corporation has no foreign loans.  The following table summarizes the Corporations loan portfolio excluding loans held-for-sale:  (in thousands)
     
     June 30, 2010
     
     December 31, 2009
     
     ChangeAmount
     
     % of Total
     
     Amount
     
     % of Total
     
     Amount
     
     PercentageAgricultural
     
     $
     70,555
     
     
     9.5
     %
     $
     76,918
     
     
     9.6
     %
     $
     (6,363
     )
     
     (8.3
     )%Commercial (1)
     
     
     140,955
     
     
     19.0
     
     
     244,049
     
     
     30.6
     
     $
     (103,094
     )
     
     (42.2
     )Real Estate:1-4 family residences
     
     
     100,642
     
     
     13.6
     
     
     123,374
     
     
     15.4
     
     
     (22,732
     )
     
     (18.4
     )Agricultural
     
     
     44,940
     
     
     6.1
     
     
     61,022
     
     
     7.6
     
     
     (16,082
     )
     
     (26.4
     )Construction (1)
     
     
     111,688
     
     
     15.1
     
     
     24,118
     
     
     3.0
     
     
     87,570
     
     
     363.1Commercial
     
     
     208,565
     
     
     28.1
     
     
     198,914
     
     
     24.9
     
     
     9,651
     
     
     4.9Total Real Estate
     
     
     465,835
     
     
     62.8
     
     
     407,428
     
     
     51.1
     
     
     58,407
     
     
     14.3Installment
     
     
     64,579
     
     
     8.7
     
     
     69,679
     
     
     8.7
     
     
     (5,100
     )
     
     (7.3
     )Total loans
     
     $
     741,924
     
     
     100.0
     %
     $
     798,074
     
     
     100.0
     %
     $
     (56,150
     )
     
     (7.0
     )%Total assets
     
     $
     1,130,827
     
     
     
     
     $
     1,260,730Loans to total assets
     
     
     
     
     
     65.6
     %
     
     
     
     
     63.3
     %
 _______________________ (1)  Loans previously classified as commercial have been reclassified as construction.  Total loans decreased to $741.9 million from $798.1 million (a decrease of $56.2 million or 7.0%), as part of managements overall asset/liability management plan to increase liquidity and reduce assets.  The Corporation continued to work with borrowers to resolve problem loan situations.  Commercial and total real estate loans were effected by a call report reclassification review of the loan portfolio.  Commercial loans declined at June 30, 2010 to $141.0 million (a decrease of $103.1 million or 42.2%) largely due to the reclassification review.  Construction loans increased at June 30, 2010 to $111.7 million (an increase of $87.6 million or 363.1%) largely due to the reclassification review.  1-4 family loans declined to $100.6 million (a decrease of 22.7 million or 18.4%) due to loan repayments including prepayments and sales.  Loans to total assets at June 30, 2010 compared to December 31, 2009 increased to 65.6% from 63.3% while the loan portfolio decline by $56.2 million.  ANALYSIS OF FINANCIAL CONDITION  Total assets decreased to $1.131 billion at June 30, 2010 from $1.261 billion at December 31, 2009.  This is part of the Companys plan to right size the balance sheet in proportion to capital.  Total loans decreased to $741.9 million from $798.1 million (a decrease of $56.2 million or 7.0%).  Investment securities decreased to $246.2 million from $301.3 million (a decrease of $55.0 million or 18.3%), as part of managements overall asset/liability management plan to increase liquidity and reduce assets.  Other real estate owned increased to $19.7 million from $17.7 million (increase of $2.0 million or 11.6%).  Total deposits decreased to $967.9 million at June 30, 2010 from $1.076 billion at December 31, 2009.  Time deposits have decreased to $399.2 million from $496.6 million (a decrease of $97.4 million or 19.6%).  Demand deposits have decreased to $122.8 million from $136.0 million (a decrease of $13.2 million or 9.7%).  Interest-bearing deposits decreased to $371.2 million from $374.6 million (a decrease of $3.4 million or 0.9%).  Savings deposits have increased to $74.7 million from $68.3 million (an increase of $6.4 million or 9.3%).  Deposit pricing reductions have resulted in decreases in Preferred Time Deposits (public funds) and other Time Deposits with some funds flowing into other interest-bearing deposit products.  The Corporation has no wholesale Brokered CDs, but does offer its depositors access to the CDARS program.  The CDARS deposits are considered for regulatory reporting purposes to be Brokered CDs.  CDARS is a network of financial institutions that provides for increased FDIC coverage.  (For example, when you place a large deposit with a CDARS Network member, that institution uses the CDARS service to place your funds into CDs issued by other members of the CDARS Network. This occurs in increments below the standard FDIC insurance maximum so that both principal and interest are eligible for FDIC insurance.)  The Corporation had $22.7 million of CDARS deposits at June 30, 2010.   23 of 32






Total borrowings decreased to $80.9 million at June 30, 2010 from $104.8 million at December 31, 2009.  Customer repurchase agreements have decreased to $33.1 million from $47.3 million (a decrease of $14.2 million or 30.0%).  Advances from the Federal Home Loan Bank have decreased to $22.5 million from $31.5 million (a decrease of $9.0 million or 28.6%).  Interest-bearing demand notes issued by the U.S. Treasury decreased to $298,000 from $1.0 million (a decrease of $702,000 or 70.2%).

CAPITAL PURCHASE PROGRAM

On January 23, 2009, the Corporation received $25,083,000 of equity capital by issuing to the United States Department of Treasury 25,083 shares of the Corporations 5.00% Series B Fixed Rate Cumulative Perpetual Preferred Stock, no par value, with a liquidation preference of $1,000 per share and a ten-year warrant to purchase up to 155,025 shares of the Corporations common stock, par value $5.00 per share, at an exercise price of $24.27 per share.  The proceeds received were allocated to the preferred stock and common stock warrants based on their relative fair values.  The resulting discount on the preferred stock is amortized against retained earnings and is reflected in the Corporations consolidated statement of income as Preferred stock dividends, resulting in additional dilution to the Corporations earnings per common share.  The warrants are immediately exercisable, in whole or in part, over a term of 10 years.  The warrants were included in the Corporations diluted average common shares outstanding (subject to anti-dilution).  Both the preferred securities and warrants were accounted for as additions to the Corporations regulatory Tier 1 and total capital.  The Series B Preferred stock is not mandatorily redeemable and will pay cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter.  Any redemption requires Federal Reserve approval.  The Series B Perpetual Preferred stock ranks senior to the Corporations existing authorized Series A Junior Participating Preferred stock.  A company that participates must adopt certain standards for executive compensation, including (a) prohibiting golden parachute payments as defined in the Emergency Economic Stabilization Act of 2008 (EESA) to senior Executive Officers; (b) requiring recovery of any compensation paid to senior Executive Officers based on criteria that is later proven to be materially inaccurate; (c) prohibiting incentive compensation that encourages unnecessary and excessive risks that threaten the value of the financial institution; and (d) accepting restrictions on the payment of dividends and the repurchase of common stock.  ASSET QUALITY  For the first six months of 2010, the subsidiary bank charged off $2.8 million of loans and had recoveries of $114,000, compared to charge-offs of $1.6 million and recoveries of $100,000 during the first six months of 2009.  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 June 30, 2010, the allowance was $16.0 million which is 24.16% of non-performing loans and 2.15% of total loans, compared with $12.1 million which was 20.60% of non-performing loans and 1.51% of total loans at December 31, 2009.  Non-performing loans increased to $66.1 million or 8.91% of net loans at June 30, 2010, as compared to $58.6 million or 7.38% of net loans at December 31, 2009.  All loans are individually evaluated and management continues to maintain adequate reserves in the allowance for loan losses.  At June 30, 2010 non-accrual loans were $60.4 million compared to $42.6 million at December 31, 2009.  Impaired loans totaled $38.1 million, at June 30, 2010 compared to $12.2 million at December 31, 2009.  The total amount of loans ninety days or more past due and still accruing interest at June 30, 2010 was $509,000 compared to $2.1 million at December 31, 2009.  There was a specific loan loss reserve on impaired loans of $7.3 million established for impaired loans as of June 30, 2010 compared to a specific loan loss reserve of $2.9 million at December 31, 2009.  The Corporations management analyzes the allowance for loan losses monthly and believes the current level of allowance is adequate to meet probable losses as of June 30, 2010.  The allowance for loan losses increased to 2.15% of total loans at June 30, 2010 compared to 1.51% at December 31, 2009.  This increase was determined by management to be appropriate due to the increases in classified assets, specific reserves for impaired loans, nonperforming loans and the on-going recession. The following table provides information (in thousands) about the Corporations non-performing assets:   24 of 32


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The following table provides information (in thousands) about the Corporations non-performing assets:  June 30,
2010
     
     December 31,
2009
     
     June 30,
2009Non-accrual
     
     $
     60,427
     
     $
     42,593
     
     $
     21,52790 days past due still accruing
     
     
     509
     
     
     2,098
     
     
     494Restructured
     
     
     5,179
     
     
     13,941
     
     
     Total non-performing loans
     
     $
     66,115
     
     $
     58,621
     
     $
     22,021Other real estate owned
     
     
     19,701
     
     
     17,658
     
     
     15,250Total non-performing assets
     
     $
     85,816
     
     $
     76,279
     
     $
     37,271Non-performing loans to total loans
     
     
     8.91
     %
     
     7.35
     %
     
     2.88
     %Non-performing assets to total assets
     
     
     7.59
     %
     
     6.05
     %
     
     2.96
     %
   The allowance for possible loan losses shown in this table below represents the allowance available to absorb losses within the portfolio (in thousands):  (in thousands)
     
     June 30,
2010
     
     December 31,
2009
     
     June 30,2009Amount of loans outstanding at end of period (net of unearned interest)
     
     $
     741,924
     
     $
     798,074
     
     $
     765,754Average amount of loans outstanding for the period (net of unearned interest)
     
     $
     765,342
     
     $
     743,877
     
     $
     741,320Allowance for possible loan losses at beginning of the period
     
     $
     12,075
     
     $
     5,064
     
     $
     5,064Charge-offs:Agricultural
     
     
     
     
     
     21
     
     
     Commercial
     
     
     2,141
     
     
     2,516
     
     
     751Real estate mortgage
     
     
     508
     
     
     511
     
     
     189Installment
     
     
     140
     
     
     1,208
     
     
     700Total charge-offs
     
     
     2,789
     
     
     4,256
     
     
     1,640Recoveries:Agricultural
     
     
     
     
     
     
     
     
     Commercial
     
     
     30
     
     
     42
     
     
     21Real estate mortgage
     
     
     
     
     
     
     
     
     Installment
     
     
     84
     
     
     163
     
     
     79Total recoveries
     
     
     114
     
     
     205
     
     
     100Net loan charged-off
     
     
     2,675
     
     
     4,051
     
     
     1,540Provision for loan losses
     
     
     6,575
     
     
     11,062
     
     
     2,635Allowance for possible loan losses at end of period
     
     $
     15,975
     
     $
     12,075
     
     $
     6,159Net loans charged-off to average loans (annualized)
     
     
     0.70
     %
     
     0.54
     %
     
     0.42
     %Allowance for possible loan losses to total to non-performing loans
     
     
     24.16
     %
     
     20.60
     %
     
     27.96
     %Allowance for possible loan losses to total loans at end of period (net of unearned interest)
     
     
     2.15
     %
     
     1.51
     %
     
     0.80
     %
    25 of 32


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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 June 30, 2010, total risk-based capital of PNBC was 12.34%, compared to 11.50% at December 31, 2009.  The Tier 1 capital ratio increased from 7.48% at December 31, 2009, to 7.76% at June 30, 2010.  Total stockholders equity to total assets at June 30, 2010 increased to 6.86% from 5.92% at December 31, 2009.  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 provided by investing and operating activities, offset by those used in financing activities, resulted in a net decrease in cash and cash equivalents of $10.6 million from December 31, 2009 to June 30, 2010.  This decrease was primarily the result of the proceeds received from the sale of investment securities and a decrease in loans, offset by net decreases in deposits and borrowings.  For more detailed information, see PNBCs Consolidated Statements of Cash Flows.  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 June 30, 2010, commitments to extend credit and standby letters of credit were approximately $95.4 million and $3.9 million 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.  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.  LAND HELD FOR SALE  The Corporation owns separate lots in Elburn, Aurora and Somonauk, Illinois that have been 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.  The land in Elburn, approximately 2 acres, was purchased in 2003 for $930,000 in anticipation of the construction of a branch facility.  The land in Aurora, consisting of two lots remaining from the original purchase of fourteen acres in 2004 which was used to construct a branch facility has a cost basis of $1,344,000.  The land in Somonauk, acquired in 2005 during the acquisition of FSB Bancorp, Inc., consists of approximately two acres with a cost basis of $80,000.    26 of 32


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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.  QUANTIATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK  Smaller reporting companies are not required to provide the information required by this item.  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.      27 of 32


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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%.
 Six Months Ended, June 30, 2010
     
     Six Months Ended, June 30, 2009Average
Balance
     
     Interest
     
     Yield/
Cost
     
     Average
Balance
     
     Interest
     
     Yield/
CostAverage Interest-Earning AssetsInterest-bearing deposits
     
     $
     61,577
     
     $
     72
     
     
     0.24
     %
     $
     47,171
     
     $
     51
     
     
     0.22
     %Taxable investment securities
     
     
     134,655
     
     
     2,647
     
     
     3.96
     %
     
     161,551
     
     
     3,723
     
     
     4.65
     %Tax-exempt investment securities
     
     
     125,765
     
     
     4,073
     
     
     6.53
     %
     
     114,108
     
     
     3,673
     
     
     6.49
     %Federal funds sold
     
     
     139
     
     
     0
     
     
     0.00
     %
     
     192
     
     
     0
     
     
     0.00
     %Net loans (1)
     
     
     711,002
     
     
     20,500
     
     
     5.81
     %
     
     741,320
     
     
     22,615
     
     
     6.15
     %Total interest-earning assets
     
     
     1,033,138
     
     
     27,292
     
     
     5.33
     %
     
     1,064,342
     
     
     30,062
     
     
     5.70
     %Average non-interest earning assets (2)
     
     
     158,790
     
     
     
     
     
     
     
     
     151,214Total average assets
     
     $
     1,191,927
     
     
     
     
     
     
     
     $
     1,215,556Average Interest-Bearing LiabilitiesInterest-bearing demand deposits
     
     $
     383,475
     
     
     1,683
     
     
     0.89
     %
     $
     261,839
     
     
     1,569
     
     
     1.21
     %Savings deposits
     
     
     72,716
     
     
     31
     
     
     0.09
     %
     
     65,198
     
     
     25
     
     
     0.08
     %Time deposits
     
     
     446,103
     
     
     4,316
     
     
     1.95
     %
     
     579,251
     
     
     8,656
     
     
     3.01
     %Interest-bearing demand notes issued to the U.S. Treasury
     
     
     892
     
     
     0
     
     
     0.02
     %
     
     1,034
     
     
     0
     
     
     0.00
     %Federal funds purchased
     
     
     0
     
     
     0
     
     
     0.00
     %
     
     512
     
     
     1
     
     
     0.39
     %Customer repurchase agreements
     
     
     39,130
     
     
     160
     
     
     0.82
     %
     
     32,563
     
     
     176
     
     
     1.09
     %Advances from Federal Home Loan Bank
     
     
     25,058
     
     
     266
     
     
     2.14
     %
     
     32,494
     
     
     484
     
     
     3.00
     %Trust preferred securities
     
     
     25,000
     
     
     710
     
     
     5.73
     %
     
     25,000
     
     
     710
     
     
     5.73
     %Note payable
     
     
     0
     
     
     0
     
     
     0.00
     %
     
     4,789
     
     
     96
     
     
     4.04
     %Total interest-bearing liabilities
     
     
     992,373
     
     
     7,166
     
     
     1.46
     %
     
     1,002,680
     
     
     11,717
     
     
     2.36
     %Net yield on average interest-earning assets
     
     
     
     
     $
     20,126
     
     
     3.93
     %
     
     
     
     $
     18,345
     
     
     3.48
     %Average non-interest-bearing liabilities
     
     
     125,013
     
     
     
     
     
     
     
     
     118,285Average stockholders equity
     
     
     76,563
     
     
     
     
     
     
     
     
     94,591Total average liabilities and stockholders equity
     
     $
     1,191,927
     
     
     
     
     
     
     
     $
     1,215,556
 ____________ (1)  Excludes nonaccrual loans and overdrafts. (2)  Includes nonaccrual loans and overdrafts.  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 Six Months Ended
June 30,2010
     
     2009Net interest income as stated
     
     $
     18,668
     
     $
     17,024Tax equivalent adjustment-investments
     
     
     1,385
     
     
     1,249Tax equivalent adjustment-loans
     
     
     73
     
     
     72Tax equivalent net interest income
     
     $
     20,126
     
     $
     18,345
   28 of 32


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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 June 30, 2010.  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.  The President and Chief Executive Officer, and Executive Vice-President and Chief Financial Officer, reviewed and participated in this evaluation.  Based on this evaluation, they 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 June 30, 2010 that could significantly affect those controls.
            29 of 32


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