**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**Washington D.C. 20549**

 

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**FORM 10-KSB**

 

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE FISCAL YEAR ENDED JUNE 30, 2004**

 

**Commission File No.: 000-25231**

 

**NORTHERN STAR FINANCIAL, INC.**

(Name of Small Business Issuer as specifiedin its charter)

 
| **Minnesota**                                                   |   | **41-1912467**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (IRS Employer  Identification Number) |

 

**1650 Madison Avenue, Mankato, Minnesota 56001**

Address of principal executive offices) (ZipCode)

 

Issuer’s telephone number, including areacode:                                 **(507) 387-2265**

 

Securities registered pursuant toSection 12(b) of the Exchange Act: **None**

 

Securities registered pursuant toSection 12(g) of the Exchange Act: Common Stock, $.01 par value per share

 

Check whether the Issuer(1) has filed all reports required to be filed by Section 13 or 15 (d) ofthe Exchange Act during the past 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý   No o

 

Check if there is no disclosure of delinquent filers in response toItem 405 of Regulation S-B contained herein, and will not be contained, to thebest of Registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or any amendment tothis Form 10-KSB.  ý

 

Issuer’s revenues for its most recent fiscal year:  $2,773,272.

 

The aggregate market value of the Common Stock held by nonaffiliates ofthe Registrant as of September 2, 2004 was approximately $885,856 basedupon the average high and low bid prices of the Registrant’s Common stock onsuch date.

 

There were 594,506 sharesof Common Stock, $.01 par value, outstanding as of August 24, 2004.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Documents incorporated byreference pursuant to Rule 12b-23: Portions of the Registrant’s Proxy Statement for its 2004 Annual Meetingare incorporated by reference into Items 9, 10, 11, 12 and 14 of Part III.

 

Transitional Small Business Disclosure Format (check one).  Yes o                            No ý

 

 

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INDEX

 
| **Description** |                                                                    |
|-----------------|-------------------------------------------------------------------------|
|            |                                                                    |
| PART I          |                                                                    |   |
|            |
|            | ITEM 1. DESCRIPTION OF BUSINESS                                         |   |
|            |                                                                    |   |
|            | ITEM 2. DESCRIPTION OF PROPERTY                                         |   |
|            |                                                                    |   |
|            | ITEM 3. LEGAL PROCEEDINGS                                               |   |
|            |                                                                    |   |
|            | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF  SECURITY HOLDERS            |   |
|            |
| PART II         |                                                                    |   |
|            |
|            | ITEM 5. MARKET FOR COMMON EQUITY AND  RELATED STOCKHOLDER MATTERS       |   |
|            |                                                                    |   |
|            | ITEM 6. MANAGEMENT’S DISCUSSION AND  ANALYSIS OR PLAN OF OPERATION |   |
|            |                                                                    |   |
|            | ITEM 7. FINANCIAL STATEMENTS                                            |   |
|            |                                                                    |   |
|            | ITEM 8.                                                                 | CHANGES IN AND DISAGREEMENTS WITH  ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE |   |
|            |                                                                    |   |
|            | **ITEM 8A. CONTROLS AND  PROCEDURES**                                   |   |
|            |                                                                    |   |
|            | **ITEM  8B. OTHER INFORMATION**                                         |   |
|            |                                                                    |   |
| PART III        |                                                                    |   |
|            |
|            | ITEM 9.                                                                 | DIRECTORS, EXECUTIVE OFFICERS, PROMOTORS  AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16 (a) OF THE EXCHANGE ACT |   |
|            |                                                                    |   |
|            | ITEM 10. EXECUTIVE COMPENSATION                                         |   |
|            |                                                                    |   |
|            | ITEM 11.                                                                | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL  OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS |   |
|            |                                                                    |   |
|            | ITEM 12. CERTAIN RELATIONSHIPS AND RELATED  TRANSACTIONS                |   |
|            |                                                                    |   |
|            | ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K                               |   |
|            |                                                                    |   |
|            | ITEM 14. PRINCIPAL ACCOUNTANT FEES AND  SERVICES                        |   |
|                 |                                                                         |  |  |  |

 

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**PART I**

 
| **ITEM 1.** |   | **DESCRIPTION OF BUSINESS** |
|-------------|--------|-----------------------------|

 

Certain statements in this Annual Report on Form 10-KSB includeforward-looking information within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended, and are subject to the “safe harbor” createdby those sections. These forward-looking statements involve certain risks anduncertainties that could cause actual results to differ materially from thosein the forward-looking statements. Forward-looking statements, which are basedon certain assumptions and describe future plans, strategies, and expectations,are generally identifiable by the use of words such as “believe”, “expect”,“intend”, “anticipate”, “estimate”, “project”, “assume,” “plan,” “predict,”“forecast” or similar expressions. These forward-looking statements relate to,among other things, expectations of the business environment in which theCompany operates, projections of future performance, potential futureperformance, potential future credit experience, perceived opportunities in themarket, and statements regarding the Company’s mission and vision.

 

The Company’s actual results, performance, and achievements may differmaterially from the results, performance, and achievements expressed or impliedin such forward-looking statements due to a wide range of risks anduncertainties. Such risks and uncertainties include, but are not limited to,the following factors: competitive pressure in the banking industry; changes inthe interest rate environment; general economic conditions, either nationallyor regionally, becoming less favorable than expected and resulting in, amongother things, a deterioration in credit quality and an increase in theprovision for possible loan losses; changes in the regulatory environment;monetary and fiscal policies of the United States Government; changes in realestate valuations; changes in business conditions; volatility of rate sensitivedeposits; operational risks, including data processing system failures orfraud; asset/liability matching risks and liquidity risks; civil disturbancesor terrorist threats or acts; or apprehension about the possible futureoccurrences of acts of this type; the outbreak or escalation of hostilitiesinvolving the United States; and changes in the securities markets. Also,virtually all of the Company’s operations and customers are located inMinnesota. In addition, the potential for the occurrence of events similar tothose of September 11, 2001, have increased the uncertainty related to thenational and Minnesota economic outlook and could have an effect on the futureoperations of the Company or its customers, including borrowers.

 

The Company does not undertake, and specifically disclaims anyobligation, to update any forward-looking statements to reflect occurrences orunanticipated events or circumstances after the date of such statements.

 

**GENERAL**

 

Northern Star Financial, Inc. (the “Company”) was incorporated underthe laws of the State of Minnesota in January 1998 and operatesprincipally as a bank holding company for its wholly owned subsidiary, NorthernStar Bank, (the “Bank”). The Company is registered under the Bank HoldingCompany Act of 1956, as amended. The Bank is the principal source of income forthe Company. The Company holds all of the capital stock of its subsidiary. All

 

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references herein to the “Company” include the Bank unless the contextotherwise requires.

 

Our strategy is to establish de novo banks, branches, or representativeoffices in major retail centers located throughout Minnesota. By virtue ofrepresentative local ownership, management, and decision-making, we hope tobenefit from the continuing trend in the banking industry towards merger andconsolidation with the resulting loss of local control and personalizedservices. The Bank’s, business strategy and promotional activities emphasizeservice and responsiveness to local needs. In order to compete with other financial institutions in its primaryservice area, the Bank relies principally on local promotional activities,personal contacts by its officers, directors, employees and stockholders,extended hours and specialized services. The Bank’s promotional activitiesemphasize the advantages of dealing with a locally owned and headquarteredinstitution sensitive to the particular needs of the community. The Bank alsoassists customers in obtaining loans in excess of the Bank’s lending limit orservices not offered by the Bank by arranging such loans or services inparticipation with or through its correspondent banks.

 

**TheBank is a community bank providing a broad range of commercial and retailbanking services designed to meet the borrowing and depository needs of smalland medium sized businesses and consumers in the communities we serve. TheBank’s customer base consists primarily of small to medium-sized businesses andtheir owners, managers, and employees residing in Blue Earth, Nicollet,LeSueur, Benton, Sherburne and Stearns counties. Businesses served includemanufacturers, distributors, contractors, professional corporations andpartnerships, and service businesses. We offer a range of loans including commercial, real estate,construction, inventory and accounts receivable, and equipment loans.  We also accept checking, savings, and timedeposits; offer NOW and money market deposit accounts; and provide travelers’checks, safe deposit boxes, and other customary non-deposit banking services.We issue VISA and MasterCard credit cards as an agent of a correspondent bank.**

** **

The Bank’s principal sources of income are interest on loanreceivables, interest and dividends collected on investments, gains on the saleof loans, and service fees on deposit accounts. The Bank’s principal expensesare interest paid on savings, time, NOW and money market deposits, loan lossprovision, employee compensation, office expenses, and other overhead expenses.

 

**MARKET AREA**

 

Our principal market area is the Minnesota counties of Blue Earth,Nicollet, LeSueur, Benton, Stearns, and Sherburne, which includes thecommunities of Mankato and St. Cloud, Minnesota, from which we are expected todraw a significant portion of our business. Approximately 85,000 people reside in Mankato and the surrounding areaand 191,000 people reside in St. Cloud and the surrounding area.  For calendar year 2003, median householdincome of residents living in our principal market areas was approximately$62,000.

 

**COMPETITION**

 

The banking business is highly competitive. The Bank competes withother commercial banks, savings and loan associations, and non-financialinstitutions in its primary service area. Recent legislation, regulatorychanges by the regulators of the various financial institutions, and

 

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competition from unregulated entities, has eliminated many traditionaldistinctions among commercial banks, thrift institutions and other providers offinancial services. Consequently, competition among all financial institutionsis virtually unlimited with respect to their legal ability and authority toprovide most financial services.

 

Banks compete with other financial institutions through the bankingproducts and services they offer, the pricing of their services, the level ofservice provided, the convenience and availability of services, and the degreeof expertise and personal manner in which services are offered. Managementanticipates that the Bank will continue to face strong competition from thefinancial institutions in the Bank’s primary service area. In certain areas of itsbanking business, the Bank also competes with credit unions, consumer financecompanies, insurance companies, money market mutual funds, non-bank lenders andother financial institutions, some of which are not subject to the same degreeof regulation and restrictions imposed upon the Bank. Many of these competitorshave substantially greater resources and lending limits than the Bank and offercertain products, such as international banking services, that the Bank doesnot provide.  We believe that competitivepricing, a hometown atmosphere and personalized service allow the Bank tocompete effectively in its primary service area.

 

**DEPOSITS**

 

We offer a full range of deposit services that are typically availablein most banks and savings associations, including checking accounts, commercialaccounts, savings accounts, and other time deposits of various types, rangingfrom daily money market accounts to longer-term certificates of deposit. Thetransaction accounts and time certificates are tailored to our principal marketareas at rates competitive to those offered in the Mankato and St. Cloud,Minnesota areas. In addition, we offer certain retirement account services,such as Individual Retirement Accounts (IRAs), and sweep accounts.  The FDIC insures all of the funds ourcustomers place on deposit up to the maximum amount permitted by law.

 

**LENDING ACTIVITIES**

 

The Bank’s philosophy is to originate loans, taking into considerationthe interests of its stockholders, safety of the depositors’ funds,preservation of Bank liquidity, welfare of the community and adherence tofederal and state regulations. Loans will always be the major source of theBank’s income. Various elements of risk are associated with each category ofloan offered by the Bank. The economy plays an important part in lending risks,and these risks may be greater at times of economic downturns.

 

REAL ESTATE LOANS. The Bank originates multi-family and single-familyresidential construction loans. The Bank requires a first lien position on theconstruction site and offers these loans only to qualified residential buildingcontractors. Currently, the Bank requires that the builder obtain permanenttake-out financing for all multi-family construction loans prior to the startof construction.  Loan disbursementsrequire on-site inspections to assure the project is on budget and that theloan proceeds are being used in accordance with the plans, specifications andsurvey for the construction project. The loan-to-value ratio for such loans ispredominately 80% of the lower of the appraised value or project cost.  Loans for construction can present a highdegree of risk to the lender, depending on, among other things, whether thebuilder can sell

 

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the home to a buyer, whether the buyer can obtain permanent financing,whether the transaction produces income in the interim, and the nature ofchanging economic conditions. Almost all first mortgage, single-familyresidential loans originated by the Bank are sold, servicing released, into thesecondary market.

 

Additionally, the Bank offers first mortgage loans on commercial realestate and for owner-occupied or investment real estate having a loan-to-valueratio that does not exceed 80% with a maximum term of 30 years and call orre-pricing provisions every three to five years.  The increase in the Bank’s real estate loan portfolio is a resultof this lending activity related to the origination of multi-family residentialand commercial real estate. Commercial mortgage lending risks include: titledefects, fraud, general real estate market deterioration, inaccurateappraisals, violation of consumer protection laws, interest rate fluctuationsand financial deterioration of a borrower. Such loans typically carry adjustableinterest rates.  The Bank is generallyable to collect fees to the extent of the costs of underwriting the loan inconnection with the origination of commercial and multi-family residential realestate loans.

 

COMMERCIAL NON-MORTGAGE LOANS. The Bank markets its commercialnon-mortgage loans to parties whose demand for funds falls within the Bank’slegal lending limits and who are existing or potential deposit customers of theBank. This category includes loans made to individual, partnership or corporateborrowers and obtained for a variety of purposes. Risks associated with theseloans can be significant. Risks include fraud, bankruptcy, economic downturn,deteriorated or non-existing collateral and changes in interest rates.

 

CONSUMER LOANS. The Bank originates consumer loans, consistingprimarily of installment loans to individuals for personal, family andhousehold purposes including loans for automobiles and investments. Risksassociated with these loans include fraud, deteriorated or non-existingcollateral, general economic downturn and customer financial problems.

 

LOAN APPROVAL AND REVIEW.  Ourloan approval policies provide for various levels of officer lending authority.When the amount of aggregate loans to a single borrower exceeds that individualofficer’s lending authority, the loan request will be considered and approvedby an officer with a higher lending limit. We have established a directors’loan committee that has lending limits, and any loan in excess of a lendingofficer’s lending limit will be approved by the directors’ loan committee. Ourlending policy does not permit us to make loans to any director, officer, oremployee of the Bank unless the loan is approved by the disinterested membersof the board of directors of the Bank and is made on terms not more favorableto such person than would be available to a person not affiliated with theBank.

 

LENDING LIMITS.** **Ourlending activities are subject to a variety of lending limits imposed by stateand federal law. While differing lending limits apply in certain circumstancesbased on the type of loan or the nature of the borrower (including theborrower’s relationship to the Bank), in general, we are subject to aloan-to-one-borrower limit. We generally may not make loans to one borrower andrelated entities in an amount which exceeds 15% of the Bank’s unimpairedcapital and surplus, although loans in an amount equal to an additional 10% ofunimpaired capital and surplus may be made to a borrower if the loans are fullysecured by readily marketable securities. Unless we are able to sellparticipation interests in our Bank’s

 

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loans to other financial institutions, we will not be able to meet allof the lending needs of loan customers requiring aggregate extensions of creditabove these limits.

 

CREDIT RISK AND LOAN REVIEW. Credit risk represents the possibility that a customer may not performin accordance with contractual terms. The Bank incurs credit risk whenever itextends credit to or enters into other transactions with its customers.  The risks associated with extensions ofcredit include general risk, which is inherent in the lending business, andrisk specific to individual borrowers. Loan review and other loan monitoringpractices provide a means for our management to ascertain whether propercredit, underwriting and loan documentation policies, procedures and practicesare being followed by our loan officers and are being applied uniformlythroughout the Bank. Implementation and daily administration of loan reviewrests with the Chief Lending Officer and the President who approve loan officerrequests for changes in risk ratings. Loan officers are responsible forcontinually grading their loans so that individual credits properly reflect therisk inherent therein. The Board of Directors has made provisions for a thirdparty outside loan review of all loans that meet certain criteria that wereoriginated since the previous review. While we continue to review these andother related functional areas, there can be no assurance that the steps wehave taken to date will be sufficient to enable it to identify, measure,monitor and control all credit risk.

 

**OTHER BANKINGSERVICES**

 

Other services we provide include telephone banking, cash managementservices, safe deposit boxes, traveler’s checks, and direct deposit of payrolland social security checks. We are associated with a shared network ofautomated teller machines that may be used by our customers throughoutMinnesota and other regions and permit customers to access their funds 24 hoursa day from locations outside our primary market area.  As previously noted, we also offer MasterCard and VISA creditcard services through a correspondent bank as an agent.

 

**INVESTMENT ACTIVITIES**

 

After establishing necessary cash reserves and funding loans, the Bankinvests its remaining liquid assets in investments allowed under banking lawsand regulations. The Bank invests primarily in obligations of the United Statesor obligations guaranteed as to principal and interest by the United States,and other taxable securities and in certain obligations of states andmunicipalities. The Bank also has federal funds transactions with its principalcorrespondent banks and primarily acts as a net seller of such funds. The saleof federal funds amounts to a short-term loan from the Bank to another bank.Risks associated with these investments include loss of value relative tointerest rate and maturities as compared to other investments.

 

**ASSET/LIABILITY MANAGEMENT**

 

The Bank’s objective is to manage its assets and liabilities to providea satisfactory, consistent level of profitability within the framework ofestablished cash, loan, investment, borrowing and capital policies. Variousofficers of the Bank are responsible for developing and monitoring policies andprocedures to insure an acceptable asset/liability mix. Management’s philosophyis to support asset growth primarily through growth of core deposits, whichinclude deposits of all categories made by individuals, partnerships andcorporations. Management of the

 

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Bank seeks to invest the largest portion of the Bank’s assets incommercial and commercial real estate related loans. The Bank’s asset/liabilitymix is periodically monitored. Management prepares a report reflectinginterest-sensitive assets and interest-sensitive liabilities for the Bank’sBoard of Directors on a quarterly basis. Our objective is to manageinterest-sensitive assets and liabilities so as to minimize the impact ofsubstantial movements in interest rates on the Bank’s earnings.

 

**EMPLOYEES**

 

**AtJune 30, 2004, the Bank employed 19 full-time employees and 2 part-timeemployees. Various executive officers of the Bank also serve as the officers ofthe Company. Other than our chief executive officer, the Company does notcompensate any other officer or employees. Neither the Company nor the Bank isa party to a collective bargaining agreement, and, in the opinion ofmanagement, the Bank enjoys satisfactory relations with its employees.**

** **

**SUPERVISION ANDREGULATION**

 

General

 

Commercial banking is highly regulated at both the federal and statelevel.  In addition to a variety ofgenerally applicable state and federal laws governing businesses and employers,the Company is extensively regulated by special laws applicable only tofinancial institutions.  Virtually allaspects of the Company’s operations are subject to specific requirements orrestrictions and general regulatory oversight. Deposits, reserves, capital, investments, loans, issuance of securities,payment of dividends, mergers and consolidations, electronic funds transfers,management practices, the scope of activities and other aspects of ouroperations are subject to regulation. With few exceptions, state and federal banking laws have as theirprincipal objective either the maintenance of the safety and soundness of thefinancial institution and the federal deposit insurance fund or the protectionof consumers or classes of consumers, rather than the specific protection ofour stockholders.

 

Set forth below is a summary of certain laws which relate to theregulation of the Company and the Bank. The description does not purport to becomplete and is qualified in its entirety by reference to the applicable lawsand regulations.

 

As a registered bank holding company, the Company is subject to thesupervision of, and to regular examination by, the Board of Governors of theFederal Reserve System (FRS). Historically the activities of bank holdingcompanies, such as the Company, have been limited by the Bank Holding CompanyAct (BHCA) to banking, managing or controlling banks, furnishing services to orperforming services for their subsidiaries, and other activities which the FRSdeems to be so closely related to banking or managing or controlling banks asto be a proper incident thereto. In making such determinations, the FRS isrequired to consider whether the performance of such activities by a bankholding company or its subsidiaries can reasonably be expected to producebenefits to the public such as greater convenience, increased competition, orgains in efficiency that outweigh the possible adverse effects, such as undueconcentration of resources, decreased or unfair competition, conflicts ofinterest, or unsound banking practices. Generally, bank holding companies arerequired to give notice to or obtain prior approval from

 

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FRS to engage in any new activity or to acquire more than 5% of anyclass of voting stock of any bank.

 

The Company’s common stock is registered with the Securities andExchange Commission (“SEC”) under the Securities Exchange Act of 1934, asamended (the “Exchange Act”). As such, the Company is subject to the information,proxy solicitation, insider trading, and other requirements and restrictions ofthe Exchange Act.

 

The Bank is a state bank chartered by and subject to supervision of theState of Minnesota and the Federal Deposit Insurance Corporation (FDIC).  Deposit accounts at the Banks are insured bythe FDIC, which currently insures deposits to a maximum of $100,000 perdepositor. For this protection, the Bank pays a semi-annual assessment and issubject to the rules and regulations of the FDIC pertaining to depositinsurance and other matters.

 

**PAYMENT OF DIVIDENDS**

 

Whetheror not the Board of Directors will elect to pay stock dividends or any cashdividends will be paid in the future depends upon their consideration ofvarious factors.  The Company’s and the Bank’s profitability andregulatory capital ratios in addition to other financial conditions will be keyfactors considered by the Board of Directors in making such determinationsregarding the payment of dividends. There are state and federal statutory andregulatory requirements limiting the amount of dividends that may be paid tothe Company by our Bank.  Generally, theBank may pay cash dividends out of current operating earnings to the extentthat the current rate of earnings retention is consistent with the Bank’scapital needs, asset quality, and overall financial condition.  The governing regulatory agency has theauthority to prohibit the Bank from engaging in business practices that thegoverning authority considers unsafe or unsound.  It is possible, depending upon the financial condition of theBank, that the governing regulatory agency may determine that the payment ofdividends to the Company by the Bank might, under some circumstances, be suchan unsafe and unsound practice.

 

Since there are no current operatingearnings, no amounts are available for the payment of dividends.  Neither the Company nor the Bank has plansto pay any cash dividends to its stockholders in the foreseeable future.

 

**REGULATORY CAPITALREQUIREMENTS**

 

The Federal Reserve Board’s capital guidelines establish the followingminimum regulatory capital requirements for bank holding companies: (i) acapital leverage requirement expressed as a percentage of total assets, (ii) arisk-based requirement expressed as a percentage of total risk-weighted assets,and (iii) a Tier 1 leverage requirement expressed as a percentage of totalassets.  Tier 1 capital consists ofcommon stockholders’ equity, qualifying preferred stock, and minority interestsin the equity accounts of consolidated subsidiaries. The failure of a bankholding company to meet its risk-weighted capital ratios may result insupervisory action, as well as an inability to obtain approval of anyregulatory applications and, potentially, increased frequency of examination.  The federal bank regulators have proposedchanges to capital

 

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requirements for banking organizations. The effect of any future changein the required capital ratios cannot be determined at this time.

 

**Qualifyingcapital consists of two types of capital components: “core capital elements”(“Tier 1” capital) and “supplementary capital elements” (“Tier 2”capital).  Tier 1 capital is generallydefined as the sum of core capital elements less goodwill and otherintangibles.  Core capital elementsconsist of (i) common stockholders’ equity, (ii) qualifying perpetual preferredstock, subject to certain limitations, and (iii) minority interests in theequity accounts of consolidated subsidiaries. Supplementary capital (“Tier 2” capital) consists of such additionalcapital elements as (i) allowance for loan and lease losses (subject tolimitations); (ii) perpetual preferred stock which does not qualify as Tier 1capital (subject to certain conditions); (iii) hybrid capital instruments,perpetual debt and mandatory convertible debt securities; and (iv) termsubordinated debt and intermediate-term preferred stock (subject tolimitations).  The maximum amount ofTier 2 capital that may be included in qualifying total capital is limited to100% of Tier 1 capital (net of goodwill). Under current capital adequacy standards, financial institutions mustmeet a minimum ratio of qualifying capital to risk-weighted assets of 8%.  Of that ratio, at least half, or 4%, must bein the form of Tier 1 capital.  The Bankalso must maintain an allowable leverage ratio.  The leverage ratio is defined as the ratio of Tier 1 capital toaverage total assets.**

** **

**As aresult of the FDIC Improvement Act of 1991, the federal bank regulatory agencieswere directed to adopt regulations defining banks as “well capitalized,”“adequately capitalized,” “undercapitalized,” “significantly undercapitalized”and “critically undercapitalized.” Under the law, depending upon the bank’s classification, a bank may bedirected to prepare and implement a capital restoration plan, to be guaranteedby its parent bank holding company. Further, banks are subject to increased restrictions upon activities andheightened regulatory supervision as capital classifications decline.**

** **

**Generally,under regulations adopted by all of the bank federal regulatory agencies, “wellcapitalized” has been defined as an institution with a total capital torisk-based asset ratio of 10%, a Tier 1 capital to risk-based asset ratio of 6%and a Tier 1 leverage ratio of 5%.  Theregulations further provide that an “adequately capitalized” institution musthave a total capital to risk-based asset ratio of at least 8%, a Tier 1 capitalto risk-based asset ratio of 4% and a Tier 1 leverage ratio of 4%.  Institutions not satisfying the requirementsfor “adequately capitalized” will be deemed “undercapitalized.”  Institutions with a total capital torisk-based asset ratio of 6% or less, a Tier 1 capital to risk-based assetratio of 3% or less, or a Tier 1 leverage ratio of 3% or less will be deemed“significantly undercapitalized.” Finally, the regulations provide that an institution with a Tier 1leverage ratio of less than 2% will be deemed “critically undercapitalized.”  Federal bank regulatory agencies, includingthe FDIC, are authorized to downgrade a financial institution from one capital**category to the next if theydetermine the asset quality, management, earnings or liquidity of thatinstitution warrant such downgrade. Under the regulations, as of June 30, 2004 and 2003, the Bank isclassified as “well capitalized.”

 

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**AFFILIATE TRANSACTIONLIMITATIONS**

 

Financial institutions are subject to certain restrictions imposed byfederal law on any extensions of credit to, or the issuance of a guarantee orletter of credit on behalf of, the Company or other affiliates, the purchase ofor investment in stock or other securities thereof, the taking of suchsecurities as collateral for loans and the purchase of assets from the Companyor other affiliates.  Such restrictionsprevent the Company and such other affiliates from borrowing from the Bank andany other subsequently acquired bank unless the loans are secured by marketableobligations of specified amounts. Further, such secured loans, investments and other transactions betweenthe Bank and the Company or any other affiliate are limited to 10% of theBank’s capital and surplus (as defined by federal regulations) and such securedloans, investments and other transactions are limited, in the aggregate, to 20%of the Bank’s capital and surplus (as defined by federal regulations).  Such transactions must also comply withregulations prohibiting terms that would be preferential to the Company orother affiliates of the Bank.  In fiscalyear 2002, the Federal Reserve issued a new Regulation W to implement federallaws governing transactions between affiliates.  Regulation W restricts loans by a depositor institution to itsaffiliates, asset purchases by a depository institution from its affiliates andother transactions between a depository institution and its affiliates.

 

**COMMUNITYREINVESTMENT ACT**

 

Pursuant to the Community Reinvestment Act of 1977 (CRA), the federalregulatory agencies that oversee the banking industry are required to use theirauthority to encourage financial institutions to help meet the credit needs ofthe local communities in which such institutions are located, consistent withsafe and sound banking practices.

 

When conducting an examination of financial institutions, such as theBank, the agencies assess the institution’s record of meeting the credit needsof its entire community, including low- and moderate-income neighborhoods. Thisrecord is taken into account in an agency’s evaluation of an application forcreation or relocation of domestic branches or for merger with anotherinstitution. Failure to address the credit needs of a bank’s community may alsoresult in the imposition of certain other regulatory sanctions, including arequirement that corrective action be taken.

 

The federal banking agencies determine a bank’s CRA rating byevaluating its performance on lending, service, and investment tests, with thelending test as the most important. The tests are to be applied in an“assessment context” that is developed by the agency for a particularinstitution. The assessment context takes into account demographic data aboutthe community, the community’s characteristics and needs, the institution’scapacities and constraints, the institution’s product offerings and businessstrategy, the institution’s prior performance, and data on similarly situatedlenders. Since the assessment context is developed by the regulatory agencies,a particular bank will not know until it is examined whether its CRA programsand efforts have been sufficient.

 

Larger institutions are required to compile and report certain data ontheir lending activities in order to measure performance. Some of this data isalso required under other laws,

 

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such as the Equal Credit Opportunity Act. Small institutions are nowbeing examined on a “streamlined assessment method.” The streamlined methodfocuses on the institution’s loan to deposit ratio, degree of local lending,record of lending to borrowers and neighborhoods of differing income levels,and record of responding to complaints. Large and small institutions have theoption of being evaluated for CRA purposes in relation to their ownpre-approved strategic plan. Such a strategic plan must be submitted to theinstitution’s regulator three months before its effective date and be publishedfor public comment.

 

**CONSUMER PROTECTION**

 

Banks are subject to a variety of federal and state laws andregulations promulgated to provide consumer protection.  These laws can be grouped into three generalcategories: disclosure laws, civil rights laws, and laws designed to providesafeguards against specific abuses in the extension, collection, and reportingof consumer credit.  Examples ofdisclosure laws are the Truth in Lending Act and the Federal Reserve’sRegulation Z, the Consumer Leasing Act of 1976 and the Federal Reserve’sRegulation M, the Real Estate Settlement Procedures Act of 1974 and RegulationX of the Department of Housing and Urban Development, the Electronic FundTransfer Act and Federal Reserve Regulation E, the Expedited Funds AvailabilityAct of 1987 and Federal Reserve Regulation CC, and the Truth in Savings Act andthe Federal Reserve’s Regulation DD.

 

The second category of laws, the civil rights laws, are aimed ateliminating invidious discrimination. Under the laws, lenders are not allowed to make lending decisions on anyfactors that are unrelated to a person’s creditworthiness.  These laws include the Equal CreditOpportunity Act and the Federal Reserve’s Regulation B, the Fair Housing Act of1968, the Home Mortgage Disclosure Act of 1975 and the Federal Reserve’sRegulation C, and the Community Reinvestment Act of 1977 discussed above.

 

The third category of laws addresses problems that arise in particularaspects of credit transactions.  Theselaws include the Fair Credit Reporting Act of 1970, the Fair Debt CollectionPractices Act of 1977, the Right to Financial Privacy Act of 1978, and theNational Flood Insurance Act.

 

In addition to federal consumer protection laws, Company and Bank aresubject to state consumer laws that govern interest rates, advertising, andtrade practices.

 

**FINANCIAL PRIVACY**

 

Significant consumer legislation was passed by Congress in 1999 as partof the Gramm-Leach-Bliley Act (“GLBA”). Title V of GLBA contains new privacy requirements.  Under GLBA and regulations implemented bythe federal banking regulators, a financial institution must (i) provideconsumers and customers with a notice of the financial institution’s privacypolicies and practices; (ii) provide customers, during the continuation of acustomer relationship, with an annual privacy notice; and (iii) provideconsumers and customers with an opportunity to opt-out of having theirnonpublic personal financial information shared with nonaffiliated thirdparties if disclosure does not fit within one of the exceptions contained inthe law.

 

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**USA PATRIOT ACT**

 

The terrorist attacks in September, 2001 impacted the financialservices industry and led to the Uniting and Strengthening America by ProvidingAppropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the“USA PATRIOT Act”).

 

The USA PATRIOT Act authorizes the Secretary of the Treasury, inconsultation with the heads of other government agencies, to adopt specialmeasures applicable to banks, bank holding companies, and/or other financialinstitutions. These measures may include enhanced record keeping and reportingrequirements for certain financial transactions that are of primary moneylaundering concern, due diligence requirements concerning the beneficialownership of certain types of accounts, and restrictions or prohibitions oncertain types of accounts with foreign financial institutions.

 

Among its other provisions, USA PATRIOT Act requires each financialinstitution to: (i) establish an anti-money laundering program; (ii) establishdue diligence policies, procedures and controls with respect to its privatebanking accounts and correspondent banking accounts involving foreignindividuals and certain foreign banks; and (iii) avoid establishing,maintaining, administering, or managing correspondent accounts in the UnitedStates for, or on behalf of, a foreign bank that does not have a physicalpresence in any country. In addition, USA PATRIOT Act contains a provisionencouraging cooperation among financial institutions, regulatory authoritiesand law enforcement authorities with respect to individuals, entities andorganizations engaged in, or reasonably suspected of engaging in, terroristacts or money laundering activities. USA Patriot Act expands the circumstancesunder which funds in a bank account may be forfeited and requires coveredfinancial institutions to respond under certain circumstances to requests forinformation from federal banking agencies within 120 hours. USA PATRIOT Actalso amends the Bank Holding Company Act and the Bank Merger Act to require thefederal banking agencies to consider the effectiveness of a financialinstitution’s anti-money laundering activities when reviewing an applicationunder these acts.

 

A number of the USA PATRIOT Act provisions became effectiveOctober 26, 2001. Additional regulations were adopted during 2002 and 2003to implement minimum standards to verify customer identity, to encouragecooperation among financial institutions, federal banking agencies, and lawenforcement authorities regarding possible money laundering or terroristactivities, to prohibit the anonymous use of “concentration accounts,” and torequire all covered financial institutions to have in place a Bank Secrecy Actcompliance program.

 

The Company has established policies and procedures to ensurecompliance with the USA PATRIOT Act. As of the date of this filing, the Companydoes not believe that USA PATRIOT Act will have a significant adverse impact onthe Company’s operations.

 

**SARBANES-OXLEY**

 

The Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley”) implementedlegislative reforms intended to address corporate and accounting fraud. Inaddition to the establishment of a new

 

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accounting oversight board that will enforce auditing, quality controland independence standards and will be funded by fees from all publicly tradedcompanies, Sarbanes-Oxley places certain restrictions on the scope of servicesthat may be provided by accounting firms to their public company audit clients.Any non-audit services being provided to a public company audit client willrequire pre-approval by the company’s audit committee. In addition,Sarbanes-Oxley makes certain changes to the requirements for accounting firmpartner rotation after a period of time. Sarbanes-Oxley requires chiefexecutive officers and chief financial officers, or their equivalent, tocertify to the accuracy of periodic reports filed with the SEC, subject tocivil and criminal penalties if they knowingly or willingly violate thecertification requirement. In addition, under Sarbanes-Oxley, counsel arerequired to report evidence of a material violation of the securities laws or abreach of fiduciary duty by a company to its chief executive officer or itschief legal officer, and, if such officer does not appropriately respond, toreport such evidence to the audit committee or other similar committee of theboard of directors or to the board itself.

 

Under Sarbanes-Oxley, longer prison terms will apply to corporateexecutives who violate federal securities laws; the period during which certaintypes of suits can be brought against a company or its officers is extended;and bonuses issued to top executives prior to restatement of a company’sfinancial statements are subject to disgorgement if the restatement was due tocorporate misconduct. Executives are also prohibited from insider tradingduring retirement plan “blackout” periods, and loans to company executives(other than loans by financial institutions permitted by federal rules andregulations) are restricted. In addition, a provision directs that civilpenalties levied by the SEC as a result of any judicial or administrativeaction under Sarbanes-Oxley be deposited to a fund for the benefit of harmedinvestors. The legislation accelerates the time frame for disclosures by publiccompanies, as they must immediately disclose any material changes in theirfinancial condition or operations. Directors and executive officers must alsoprovide information for most changes in ownership in a company’s securitiesgenerally within two business days of the change.

 

Sarbanes-Oxley also increases responsibilities and codifies certainrequirements relating to audit committees of public companies and how theyinteract with the company’s “registered public accounting firm.” AuditCommittee members must be independent and are absolutely barred from acceptingconsulting, advisory or other compensatory fees from the issuer. In addition,companies must disclose whether at least one member of the committee is a“financial expert” (as defined by the SEC) and if not, why not. A company’spublic accounting firm is prohibited from performing audit services for thecompany if the company’s chief executive officer, chief financial officer,comptroller, chief accounting officer or any person serving in equivalent positionshad been employed by the auditor and participated in the company’s audit duringthe year preceding the audit initiation date. Sarbanes-Oxley also prohibits anyofficer or director of a company or any other person acting under theirdirection from taking any action to fraudulently influence, coerce, manipulateor mislead any independent accountant engaged in the audit of the company’sfinancial statements for the purpose of rendering the financial statementsmaterially misleading. Sarbanes-Oxley requires the SEC to prescribe rulesrequiring inclusion of any internal control report and assessment by managementin the annual report to stockholders. Sarbanes-Oxley also requires the publicaccounting firm that issues a company’s audit report to attest to and report onmanagement’s assessment of the company’s internal controls.

 

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Although the Company anticipates that it will incur additional expensein complying with the provisions of Sarbanes-Oxley, management does not expectthat compliance will have a material impact on the Company’s financialcondition or results of operations.

 

**ITEM2.  DESCRIPTIONOF PROPERTY**

 

The Company and Bank’s office is located at 1650 Madison Avenue,Mankato, Minnesota.  The Bank hasentered into a 10-year lease agreement with Colonial Square Partners, Inc. tolease approximately 5,107 square feet. Dean Doyscher, a director and principal shareholder of the Company was,but no longer is, a partner of Colonial Square Partners, Inc.  Pursuant to the lease agreement, the Bankpays monthly rent of approximately $6,384 during the first three years of thelease, $6,491 a month for the next three years and $6,704 per month for thelast four years of the lease term.  TheBank currently pays monthly rent of $6,491 a month.  The Bank has the option to extend the lease term for twoconsecutive five-year periods with a right of first refusal on any additionalspace that becomes available.  TheBank’s office includes a teller line with three tellers, two platformpositions, two drive-through lanes, an ATM drive-through lane and executive andadministrative offices.

 

The Bank also maintains a banking facility that is located at 300 EastSt. Germain Street in St. Cloud, Minnesota. On March 7, 2001 the Bank has entered into a 10-year leaseagreement with Five Star Properties of St. Cloud, LLC to rent approximately3,100 square feet.  James H. Illies, adirector of the Company and Bank, is an owner of Five Star Properties of St.Cloud, LLC.  Pursuant to the leaseagreement, the Bank pays monthly rent of approximately $5,540 month. Rents arescheduled to escalate at the rate of $1.00 per square foot annually during thenext three years.  Under the terms ofthe lease the Bank will pay $20.00 per square foot during years six throughten.  The Bank has the option to extendthe lease term for one consecutive five-year period with a right of firstrefusal on any additional space that becomes available.  The Bank’s office includes a teller linewith three tellers, two platform positions, two drive-through lanes, an ATMdrive-through lane and executive and administrative offices.

 

Under the terms of both of the above referenced leases, the landlordpays building insurance, taxes, assessments and all utilities excepttelephone.  Real estate tax increasesover the base year of the lease are to be pro-rated based upon squarefootage.  These facilities are in goodcondition and meet our current needs.

 

**ITEM3.  LEGALPROCEEDINGS**

 

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

 

During 1999 and 2000, the Bank made a series of loans to Frank Gazzola,then a Director of the Company, in various amounts at market rates of interestand for terms of various lengths

 

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of time. Mr. Gazzola defaulted on the loans and the Bank foreclosed onthe collateral for the loans. The Trustee for the U.S. Bankruptcy Court,District of Minnesota, claimed that since certain collateral was conveyed tothe Bank within one year of Gazzola’s bankruptcy filing and since he was aninsider, they were preferential transfers and must be reversed.  On June 12, 2003, in an out of courtsettlement, the court approved a settlement agreement where-in the Bank agreedto pay the bankruptcy court a settlement fee for which the Bank retained a claimagainst the unsecured assets of Mr. Gazzola’s bankruptcy estate and a releaseby the court of all claims to the collateral held by the Bank.

 

In the normal course of business, the Company and its subsidiary areinvolved in litigation.  Management doesnot believe that any litigation in which it is currently involved will have amaterial impact on the Company’s financial condition or results of operations.

 

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

**Therewere no matters submitted to a vote of stockholders of the Company during thefourth quarter of fiscal year 2004.**

** **

**PART II**

 

**ITEM 5. MARKET FOR COMMON EQUITY ANDRELATED STOCKHOLDER****MATTERS**

 

Our common stock has been quoted on the OTC Bulletin Board under thesymbol “NSBK” since February 2, 1999, and is currently under the symbol “NSBK.OB”.  Quotations in the following table representinter-dealer prices, without retail markup, markdown or commission, and do notnecessarily represent actual transactions.

 
|                     |   | **Common  Stock** |   |
|--------------------------|--------|-------------------|--------|
| **Fiscal Quarter Ended** |   | **High Bid**      |   | **Low Bid** |   |
|                     |   |              |   |   |   |
| September 30, 2002  |   | 7.25              |   | 5.50 |   |
| December 31, 2002   |   | 6.50              |   | 5.50 |   |
| March 31, 2003      |   | 7.00              |   | 4.75 |   |
| June 30, 2003       |   | 6.50              |   | 4.50 |   |
| September 30, 2003  |   | 5.70              |   | 4.25 |   |
| December 31, 2003   |   | 6.00              |   | 4.50 |   |
| March 31, 2004      |   | 7.00              |   | 5.50 |   |
| June 30, 2004       |   | 5.50              |   | 3.25 |   |

 

At July 30, 2004, the last sale price for the Company’s commonstock was $3.25 per share.  AtJune 30, 2004, there were issued and outstanding 588,506 shares of commonstock of the Company held by 59 stockholders of record.  Record ownership includes ownership bynominees who may hold for multiple owners.

 

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In the fourth quarter of fiscal year 2004, the Board of Directors ofthe Company sold in a private placement of 20,000 shares of its common stock ata price of $5.00 per share.  Theproceeds will be used to support our on-going operations.

 

The Company has paid no dividends on its common stock and does notanticipate paying any such dividends in the foreseeable future.  In the second quarter of fiscal year 2004,on December 31, 2003, the Company sold $100,000 of convertiblesubordinated unsecured note to an accredited investor.  The notes bear interest at the rate of 6.50%per annum and are convertible into common stock of the Company any time priorto maturity at the rate of $9.00 per share. The term of the note is one year.

 

On April 7, 2004 and June 23, 2004, the Company sold anaggregate of $200,000 of convertible subordinated unsecured notes to accreditedinvestors.  The notes bear interest atthe rate of 6.00% per annum and are convertible into common stock of theCompany any time prior to maturity at the rate of $6.00 per share.  The term of the April 7, 2004 note istwo years and the term of June 23, 2004 notes are six months.

 

  In connection with the sale ofthe notes the Company relied on the exemption from registration provided bySection 4(2) of the Securities Act of 1933.  The investors have taken the notes for investment purposes, andthe notes contain a restrictive securities legend.

 

Generally,the Bank may pay cash dividends out of current operating earnings or retainedearnings to the extent that the current rate of earnings retention isconsistent with the Bank’s capital needs, asset quality, and overall financialcondition.  The governing regulatoryagency has the authority to prohibit the Bank from engaging in businesspractices that the governing authority considers unsafe or unsound.  It is possible, depending upon the financialcondition of the Bank, that the governing regulatory agency may determine thatthe payment of dividends to the Company by the Bank might, under somecircumstances, be such an unsafe and unsound practice.

 

**ITEM 6. MANAGEMENT’S DISCUSSION ANDANALYSIS OR PLAN OF OPERATION**

 

This section presents management’s review of the operating resultsand financial condition of the Company and its subsidiary, the Bank. Thissection provides information which management believes may not beotherwise apparent from the Consolidated Statements of Financial Condition,Operations, Stockholders’ Equity and Cash Flows and is intended to assistreaders in understanding the Company’s performance and financial condition.

 

**THIS ANNUAL REPORT ON FORM 10-KSBCONTAINS FORWARD-LOOKING INFORMATION AND ACTUAL RESULTS MAY DIFFER**

 

Statements that the Company may publish, including those in this AnnualReport on Form 10-KSB that are not strictly historical are “forward looking”statements made under the safe harbor provisions of the Private SecuritiesLitigation Reform Act of 1995.  Theseinclude statements about the Company’s plans, objectives, expectations andintentions that are not historical facts. When used in this Annual Report, thewords “expects”, “anticipates”, “plans”,

 

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“believes”, “seeks”, “estimates”, and similar expressions are generallyintended to identify forward-looking statements.  Statements made in this Annual Report regarding the Company’sbeliefs and expectations that (i) it expects to be able to maintain or slightlyimprove its net interest margin in a declining rate environment; (ii) loandemand is expected to remain satisfactory in the near future with any growth afunction of local and national economic conditions; (iii) the present loanallowance is adequate; (iv) the Company maintains overall liquidity sufficientto satisfy its depositors’ requirements and meet its customers’ credit needs;and (v) it expects a decrease in the overall cost of money during fiscal 2004are “forward looking” statements which involve known and unknown risks anduncertainties that may cause the actual results to differ materially from thoseexpected and stated in this announcement. Actual results could differ as a result of: (i) a further slowdown ofeconomic growth in the United States, particularly in the Company’s marketareas; (ii) an increase in loan defaults; (iii) changes in consumer behaviorresulting from attacks similar to the September 11, 2001 attack on theUnited States and changes in federal and state laws; (iv) increased competitionsfrom other financial and non-financial institutions; (v) the failure of theCompany to successfully implement its growth strategy; and (vi) costs andexpenses incurred in defending the Company and Bank in connection withlitigation and payment of damages and settlement costs associated with suchlitigation.  Shareholders and otherreaders are cautioned not to place undue reliance on forward-lookingstatements, which speak only as of the date on which they are made.  We undertake no obligation to update publiclyor revise any forward-looking statements.

 

**BUSINESS**

 

We are a bank holding company. Our subsidiary, Northern Star Bank, is a state-chartered commercial bankproviding a broad range of commercial and retail banking services designed tomeet the borrowing and depository needs of small and mid-sized businesses andconsumers in the Cities of Mankato and St. Cloud as well as the counties ofBlue Earth, Nicollet, LeSueur, Benton, Stearns and Sherburne.  We offer a full range of lending servicesincluding commercial, real estate and consumer loans. Unless indicatedotherwise the results of operation of the Company include the results ofoperation of the Bank.

 

Our principal business consists of attracting deposits from the generalpublic and using these deposits, together with borrowings and other funds, tooriginate commercial, commercial real estate, residential, agricultural,automobile and other consumer loans.  Wealso originate construction loans and invest in securities.  Our results of operations are primarilydependent on our interest rate spread, which is the difference (“spread”)between the average yield on interest-earning assets, such as loans, andinvestment securities and short-term interest bearing deposits and the averagerate paid on interest-bearing liabilities, such as deposits and borrowings. Thespread is affected by regulatory, economic and competitive factors thatinfluence interest rates, loan demand and deposit flows. In addition to creditrisk, we are subject to interest rate risk to the degree that ourinterest-earning assets mature or re-price at different times, or on adifferent basis, than our interest-bearing liabilities.

 

Our results of operations also depend upon, among other things, thelevel of fee income, gains or losses on the sale of loans and other assets,provisions for possible loan losses, income derived from subsidiary andinvestment activities, operating expenses and income taxes.  Our

 

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operating expenses principally consist of employee compensation andbenefits, occupancy expenses, federal deposit insurance premiums and othergeneral and administrative expenses.

 

We are affected by prevailing economic conditions, including federalmonetary and fiscal policies, as well as by federal regulation of financialinstitutions. Deposit balances are influenced by a number of factors, includinginterest rates paid on competing personal investments and the level of personalincome and savings within the institution’s market area. In addition, depositbalances are influenced by the perceptions of customers regarding the stabilityof the financial markets and financial services industry.  We expect to retain a significant portion ofexisting deposit balances by offering competitive rates on such deposits.  We have adopted a strategy of employingFederal Home Loan Bank (FHLB) advances to supplement deposits. FHLB advancesare expected to augment the liquidity necessary to fund lending operations andinvestment opportunities. Lending activities are influenced by demand forhousing, consumer and commercial loans as well as competition from otherlending institutions. The primary sources of funds for lending activitiesinclude deposits, loan payments, borrowings, the sale of loans and other assetsand funds provided from operations.

 

**OVERVIEWOF EARNINGS PERFORMANCE**

 

During thefiscal year ending June 30, 2004, the Company reported a net loss of$367,607 or a basic loss of $0.66 per share. This represents a $134,791increase in net losses or $0.19 per share over the fiscal year endedJune 30, 2003. The significant factors impacting net loss for fiscal year2004 compared to 2003 were:

 

•                  Non-interestincome in the form of gain on the sale of loans decreased $439,976 from$865,581 earned during fiscal year 2003 to $425,605 earned during fiscal year2004 as a result of rising interest rates and the depletion of refinancingactivity in our marketplace.

•                  Compensation andemployee benefits increased $96,428 during fiscal year 2004 to $1,119,419 comparedto $1,022,991 during fiscal year 2003, due to staff additions, higher employeebenefit costs, and executive search fees.

•                  The Bank’s netinterest income increased $190,712 as a result of improvements in the Bank’snet interest margin despite lower levels of interest earning assets andinterest bearing liabilities.

•                  The Bank’sprovision for anticipated loan and lease losses decreased $205,665 whencompared to fiscal year ended June 30, 2003 as a result of improvements inthe Bank’s loan portfolio resulting from the favorable resolution of the BridgeLenders related litigation.

 

The impact tothe Company from these items, and others of both a positive and negativenature, is discussed in more detail below.

 

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**RESULTS OF OPERATIONS**

 

**Net Income (Loss)**

 

The Company’s net operating loss totaled $367,607 for the fiscal yearended June 30, 2004, compared to a $232,816 net operating loss of theprior fiscal year ended June 30, 2003.  The basic loss per share in fiscal year 2004 was $0.66, compared to abasic loss of $0.47 and $2.27 in 2003 and 2002, respectively.

 

During fiscal year 2004, the Company experienced decreases in bothinterest earning assets and in interest bearing liabilities resulting in a$107,045 decease in interest income and a $297,757 decrease in interestexpense. As a result, the Company realized an increase in net interest incomeof $190,712 during fiscal year 2004.  The yield earned on interest earning assetsdecreased 27 basis points to 6.15% at fiscal year end June 30, 2004compared to a yield of 6.42% earned on interest earning assets during thefiscal year ended June 30, 2003.  During fiscal year 2004 the average cost of funding interest earningassets decreased 74 basis points from 3.34% during fiscal year 2003 to 2.60%during fiscal year 2004.

 

We maintain an allowance for loan and lease losses that is intended toabsorb inherent losses in the loan portfolio. Loans are charged against the allowance when management believescollection of the principal is unlikely. Management is continually analyzing its loan portfolio in an effort torecognize and resolve its problem assets as quickly and efficiently aspossible.  As a result of an evaluationof the existing loans in our loan portfolio the Company made provisions forloan losses of $168,272 during fiscal year 2004.

 

The Bank was successful in collecting interest totaling $191,573 onloans that had previously been written off. Interest forgone on non-accrual loans amounted to $42,015 during fiscalyear 2004 compared to $74,936 during fiscal year 2003.

 

During the fiscal year ended June 30, 2004, the Bank’s loanportfolio including loans held for sale decreased $7.4 million or 17.58% whencompared to fiscal year end June 30, 2003.  The lower interest rate environment during fiscal year 2004, whencompared to fiscal year 2003 resulted in a reduction in the Bank’s interestincome and loan volume, as shown in the rate column of the Rate/Volume Analysistable.

 

The lower interest rate environment within the Bank’s loan portfolioduring fiscal year 2004, as compared to fiscal year 2003, also resulted in adecrease in the Company’s total interest expense. The reduction in interestexpense occurred primarily as a result of a decrease in the overall interestrate paid for deposits and a reduction in time deposits of $2.9 million, whichwas partially offset by an increase in lower cost savings account deposits.

 

Non-interest income totaled $684,398 for the year ending June 30,2004 representing a decrease of $402,779, or 37.05% over the prior year. Thedecrease resulted primarily from reduced gains on the sale of loans, partiallyoffset by an increase in other fees and service charges, and gains on sale ofinvestment securities. Total non-interest expense increased $128,289 or 5.35%from $2,398,059 in 2003 to $2,526,448 during 2004 primarily as a result of thelitigation settlement expenses, pay increases for existing staff as well asadditions to our staff

 

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and to overall increases in the cost of operations associated with anincrease in the number of deposit and loan accounts.

 

**Net Interest Income**

 

Net interest income increased $190,712, or 13.13% to $1,642,715 in 2004after increasing 55.16% in 2003. While the yield on average earning assetsdeclined to 6.15% in 2004 as compared to 6.42% in 2003, the cost of funds foraverage interest bearing liabilities assets also decreased to 2.60% in 2004from 3.34% in 2003. The amount of the increase in net interest income in 2004is attributable to a decrease of 0.74% in the cost of average interest bearingliabilities, which was offset, by a 0.27% decrease in the yield on averageearning assets.  The Bank’s interest ratespread improved to 3.55% from 3.08% at June 30, 2004 and 2003,respectively.  The Bank’s net interestmargin increased from 3.24% during fiscal year 2003 to 3.65% during fiscal year2004.

 

The Bank’s net interest margin increased 41 basis points during fiscalyear 2004 after increasing 98 basis points in fiscal year 2003. The increase in2004 was the result of several key items:

 

•                  Interest forgoneon non-accrual loans during fiscal year 2004 totaled $42,015 as compared to$74,936 during fiscal year 2003.  Thiswas a $32,921 improvement year to year. For fiscal year 2004, this reduced theyield on loans by 12 basis points and the net interest margin by 10 basispoints.

 

•                  Interestcollected on loans that had previously been charged off or on nonaccrual statustotaled $191,573.

 

•                  Changes in the mixof the investment portfolio during fiscal year 2004 resulted in a decrease of98 basis points in the average yield earned on investments securities.

 

•                  The generaldecrease in the interest rate environment during 2004 resulted in a decrease of52 basis points in the average yield earned on federal funds sold.

 

•                  The decrease ininterest rates during 2004 also resulted in a decrease of 98 basis points inthe cost of average certificates of deposit.

 

•                  During fiscalyear 2002, the Company adopted provisions to its lending policies establishinga floor rate of interest for new and renewing loans.

 

During fiscal year 2004, average loans decreased $156,931 or 0.43%,while investment securities decreased $715,379, or 11.13%, compared to fiscalyear end 2003. Average interest bearing deposits increased $551,879, or 1.54%during 2004 and other borrowings increased an average of $157,418, primarily asa result of an increase of $200,000 in convertible subordinated notes issuedduring the fourth quarter of fiscal year 2004 which was offset by a $246,851decrease in the average amount of Federal Home Loan Bank advances outstandingduring fiscal year 2004.

 

Net interest income increased $190,712 or 13.13% during fiscal year2004 after increasing

 

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55.16% during fiscal year 2003. The increase in net interest incomeduring fiscal year 2003 is attributable to an increase of 8.30% in averageinterest earning assets combined with an 11.32% increase in average interestbearing liabilities.

 

The mix of interest earning assets at June 30, 2004 changed ascompared to June 30, 2003 as a result of a year-over-year decline in loangrowth of 15.05% during fiscal year 2004 as compared to an increase of 15.90%in fiscal year 2003.

 

Average interest bearing deposits during fiscal year 2004 increased$551,879 or 1.54% to  $36.4 million ascompared to average interest bearing deposits of  $35.9 million during fiscal year 2003.

 

The volume variances for total interest income in 2004 compared to 2003was comprised of a decrease in average loans of 0.43% together with increasesin average investment securities and federal funds sold of 3.99%, combined fora net decrease in interest income of $107,000. The continued decline of theinterest rate environment within the Bank’s loan portfolio during fiscal year2004 decreased interest income $107,000, as compared to the prior year, with$79,000 of the decrease resulting from a basis point decline in the yieldearned on loans; a $90,000 decrease resulting from a 98 basis points decline inthe yield earned on investment securities and a $3,000 decrease resulting froma 52 basis points decline in the yield earned on federal funds sold.  While average interest bearing liabilitiesincreased 1.66% during 2004, the average rate paid on interest bearingliabilities declined 74 basis points resulting in a net decrease in totalinterest expense of $297,000.

 

**Provision for LoanLosses**

 

The provisionfor loan losses decreased $205,665 or 55.00% to $168,272 during the fiscal yearended June 30, 2004 as compared to $373,937 for the fiscal year endedJune 30, 2003.  The decrease in theprovision for loan losses is primarily in response to the decrease in loangrowth during fiscal year 2004 as compared to fiscal year 2003 and to theresolution of the litigation associated with the Bridge Lenders loans.

 

The Bank madea $114,667 and a $287,114 provision for loan and lease losses for the yearsended June 30, 2004 and 2003, respectively, for loan losses associatedwith the risk of loss inherent in one commercial loan with an outstandingbalance of approximately $600,000. The Bank does not have any other creditsassociated with the related industry and type of loan and, as a result,management does not believe the deterioration in this credit represents anadverse trend in the quality of our loan portfolio.

 

The provisionfor loan losses represents the current period expense associated withmaintaining an appropriate allowance for credit losses. The provision for loanlosses and level of allowance for each period is dependent upon many factors,including loan growth, net charge-offs, changes in the composition of the loanportfolio, delinquencies, management’s assessment of the quality of the loanportfolio, the valuation of problem loans and the general economic conditionsin the Bank’s market area. Periodic fluctuations in the provision for loanlosses result from management’s assessment of the adequacy of the allowance forloan and lease losses; however, actual loan losses may vary from currentestimates.

 

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Netcharge-offs during 2004 totaled $750,386 and represents an increase of $744,860over 2003.  During 2004, the Bankcharged off $518,837 of principal as result of losses incurred in connectionwith the commercial loan identified above and with one of the loans subject tolitigation.  The Bank has not modifiedor significantly changed its underwriting standards or estimation methods andassumptions affecting the allowance for loan and lease losses.

 

**Non-Interest Income**

 

Non-interest income decreased 37.05% and increased 142.96% in 2004 and2003, respectively. The primary components of non-interest income consist of:service charges, gain on sale of loans, and other non-interest income.

 

Other fees and service charge revenue increased 7.52% in 2004 whencompared to 2003 and 61.36 in 2003 when compared to 2002. While average totaldeposits decreased 0.67% in 2004 and increased 13.95% in 2003, averagenon-interest-bearing demand deposits decreased 19.64% during fiscal year 2004and increased 73.98% during fiscal year 2003. NOW and money market accountsincreased 2.42% during 2004 as compared to 2003.

 

The Company experienced decreased mortgage lending activity for bothnew loans and refinancing of existing loans due to the continued increase inmortgage lending rates during 2004. The decreased lending activity resulted ina decrease in the Company’s gain on sale of loans totaling $439,976, or 50.83%from 2003 to 2004 compared to an increased of $616,102, or 246.96% in 2003 ascompared to 2002.

 

The Company realized gains on the sale of investment securitiestotaling $24,296 and $3,504 in 2004 and 2003, respectively.

 

**Non-Interest Expenses**

 

Non-interest expenses increased 5.35% in 2004 compared to 2003 and42.19% in 2003 compared to 2002. The increase in non-interest expense during2004 was primarily a result of litigation expenses, increases in the number offull-time equivalent employees, and the cost of employee benefits, incentivecompensation, marketing and occupancy expenditures. In addition, during 2004,the Company incurred $168,892 of expenses associated with the recentlyconcluded litigation (see Item 3. Legal Proceedings).

 

Non-interest expense is broken down into four primary categories eachof which is discussed in this section.

 

***Salaries and Employee Benefits***

 

The number of full-time equivalent employees increased to 19 in 2004compared to 17 in 2003 and 15 in 2002. Total salaries and benefits expenseincreased 9.43% in 2004 compared to 2003 and 28.84% in 2003 compared 2002. Theaverage total payroll and benefits per full-time equivalent employee decreased2.09% in 2004 compared to 2003 and increased 13.68% in 2003 when compared to2002.

 

Incentive compensation includes compensation in the form of bonusawards to employees

 

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under the Incentive Compensation Plan and matching contributions to theSimple Individual Retirement Account Plan. The Incentive Compensation Plan paysincentive compensation to officers and employees based upon the achievement ofspecific performance goals within their area of responsibility combined withthe achievement of company-wide performance goals. Matching contributions tothe employee Simple Individual Retirement Account Plan are made at the rate of2% of the employee’s base compensation.

 

***Occupancy Expense***

 

Occupancy expenses increased 9.60% in 2004 compared to 2003 and 15.90%in 2003 compared to 2002. The primary reason for the increases in 2004 is dueto general increases in the cost of insurance, utilities and maintenanceexpenses for the Mankato and St. Cloud offices.

 

***Other Non-interest Expense***

 

Other non-interest expense decreased 4.08% in 2004 as compared to 2003and increased 28.21% in 2003 compared to 2002.

 

Third party data processing expenses increased 4.72% during 2004 as aresult of an increase in fees paid to a third party data processing serviceproviders which resulted from increased transactional activity and increases inthe third party service provider’s fee schedule.  During the fiscal year ended June 30, 2004, third party dataprocessing expenses increased $7,231, compared to 2003. Professional feesincreased 0.88% during 2004 as a result of professional fees incurred inconnection with the recently concluded litigation.

 

During 2004, the Company expensed $102,000 for director fees, which wassubstantially unchanged from the prior fiscal year.

 

During 2004, the Company expensed $183,253 in costs associated with theresolution of non-performing loans. Included in these costs are amounts paidfor legal representation, security and other asset preservation expenses. Thesecurity and other property maintenance expenses were incurred by the Companyin order to protect and preserve the quality of assets pledged as collateralfor the non-performing loans.

 

***Income Taxes***

 

The effective income tax rate for the Company was 0 % for the fiscalyear ended June 30, 2004 and 2003 because the tax benefit of the netoperating loss is reduced by a deferred tax asset valuation allowance inaccordance with generally accepted accounting principles.  The Company’s deferred tax assets have beenreduced by a valuation account due to the uncertainty of the Company’s abilityto make use of the underlying net operating loss carry forwards.

 

**FINANCIAL CONDITIONAS OF JUNE 30, 2004**

 

Average total assets decreased 0.19% in 2004 compared to 2003 and12.72% in 2003 as compared to 2002. Year-end asset at June 30, 2004 were$45.0 million and represented a decrease of 12.23% over June 30, 2003. Thedecrease in average total assets during fiscal year

 

24

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2004 when compared to 2003 is the results of management’s efforts toimprove the Bank’s net interest margin and the results of management’s decisionto repay  $1.3 million in FHLBborrowings that created an immediate and corresponding decrease in totalassets.

 

During fiscal year 2004 average interest earning assets increased$188,421 or 0.42%. This increase in average interest earning assets is largelyattributable to a $1.06 million or 47.66% increase in Federal Funds sold offset by decrease of $715,379 or 11.13% decrease in investment securities.  The increase in average interest earningassets was accompanied by a $709,297 or 1.66% increase in average interestbearing liabilities.

 

**Investment Securities**

 

The available for sale investment portfolio decreased $303,110 or4.96%, at June 30, 2004 as compared to June 30, 2003 and decreased$3.49 million, or 36.31%, at June 30, 2003 as compared to June 30,2002. The decrease in the investment portfolio during 2004 and 2003 occurred asa result of management’s decision to draw down on excess liquidity in order tofund new and renewing loans rather than by growing deposits or increasingborrowings. During 2004 and 2003, proceeds received from the sale andprepayments of investment securities totaled $6.68 million and $7.73 million,respectively. Proceeds from the sale of investment securities resulted in gainstotaling $24,296 and $3,504 for the years ended June 30, 2004 and 2003,respectively.

 

**Loans**

 

Gross loans outstanding as of fiscal year end June 30, 2004 wereless than the comparable prior year-end totals by $5.98 million or 15.05%. Thecollection of $1,591,919 million of loans subject to litigation as well asmanagement’s decision to focus it’s efforts toward making improvement in netinterest margin contributed to the decrease in gross loans outstanding atfiscal year end June 30, 2004.

 

The most significant segment of the loan portfolio is multi-family andcommercial real estate loans, which represented 52.89% and 46.52% of the totalportfolio at June 30, 2004 and 2003, respectively. Commercial andagricultural loans represent 18.28% and 17.55% of our loan receivables as ofJune 30, 2004 and 2003 respectively. Loans made to individual consumers represented 17.33% and 24.69% of ourloan portfolio as of June 30, 2004 and 2003, respectively.

 

Loans maturing after one year are approximately 81.39% of the loanportfolio and have a fixed rate of interest as of June 30, 2004, whileapproximately 72.23% of the portfolio matures within five years.

 

**Deposits**

 

Average deposits decreased $266,623 or 0.67% during fiscal year 2004when compared to fiscal year 2003. Due to a decreasing interest rateenvironment during 2004 and 2003, the average rate of interest paid on depositsdecreased 71 basis points and 146 basis points when comparing 2004 to 2003 and2003 to 2002, respectively. The growth in both the number of accounts and theaverage account balance remained relatively unchanged during fiscal year 2004as compared to fiscal year 2003 and was the result of management’s efforts toimprove the Bank’s net interest margin. Total deposits as of June 30, 2004were $36.4 million as compared

 

25

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with $41.4 as of June 30, 2003, a decrease of $5.03 million or12.13%. Certificates of deposit remain the largest category of deposits atJune 30, 2004 representing 55.51% of total deposits.

 

Certificates of deposit contain regular and individual retirement timeaccount balances. Certificates of $100,000 or more represent approximately22.96% and 21.93% of the certificate of deposit portfolio at June 30, 2004and 2003, respectively.

 

**Short Term Borrowings**

 

The Bank has a line of credit with a correspondent bank totaling$600,000 of which $550,000 was advanced at June 30, 2004 and $600,000 atJune 30, 2003. The note matures on March 31, 2005 and bears interestat the Wall Street Journal Prime Rate of interest plus 1% and is payablequarterly.

 

**Asset Quality**

 

The Company’s non-performing assets totaled $720,774 or 2.13% of totalloans as of June 30, 2004, compared to $1,872,700 or 4.71 % of total loansas of June 30, 2003. Non-performing loans decreased $1,151,926 or 61.51%in 2004 when compared to fiscal year end 2003. Delinquent loans as a percentageof the Bank’s total loan portfolio decreased to 4.95% at fiscal year end 2004from 7.29% at fiscal year end 2003, from 10.90% and 5.70% in 2002 and 2001,respectively.

 

Since fiscal year endJune 30, 2003, the Company’s non-accrual loans decreased $1,651,696million.  The Company’s allowance forloan and lease losses as of June 30, 2004 was $447,467, which was 1.32% oftotal loans as of that date. This compares with an allowance for loan and leaselosses of $1,029,581 as of June 30, 2003, which was 2.59% of total loans.The allowance for loan and lease losses decreased $582,114 during fiscal year2004 as a result of net charge-offs taken during the period exceeding theprovision for loan loss taken. As of June 30, 2004, the allowance for loanand lease losses was 62.08% of nonperforming loans compared with 54.90% as ofJune 30, 2003. Based on the inherent risk in the loan portfolio,management believes that as of June 30, 2004, the allowance for loan andlease losses is adequate. For the twelve months ended June 30, 2004, theCompany’s net loan charge-offs were $750,386 compared with net charge-offs of$5,526 during the twelve months ended June 30, 2003.  Much of the additional charge-offs thatoccurred during fiscal year 2004 were attributable to bankruptcy filings of twocommercial credits.  Prospects forrecovery of these charge-offs are deemed minimal. Management does not believethat these charge-offs are reflective of an overall deterioration in theCompany’s credit quality.

 

The Company’s non-accrual policy is discussed in Note 1 to theconsolidated financial statements. Interest income recorded on these nonaccrualloans was approximately $15,786 and  $153,578in 2004 and 2003, respectively. Interest income foregone or reversed on theseloans was approximately $42,015 and $74,936 in 2004 and 2003, respectively.

 

When a loan becomes impaired as a result of adeterioration in credit quality to the extent that the bank no longer hasreasonable assurance of timely collection of the full amount of principal andinterest, the carrying value of the loan is reduced. The reduction in thecarrying amount is recognized as a charge to earnings in the period in which impairmentis identified.

 

26

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When a loan has been identified as impairedits carrying value is reduced to its estimated realizable value.  When estimating the realizable value thebank considers: 1) the fair value of the collateral after holding and sellingcosts, 2) the value the bank would receive if the loan were sold, and 3) thepresent value of the discounted expected cash flow the bank will receive forthe remaining life of the loan.

 

The Bank has established a methodology forthe determination of provisions for loan losses.  The methodology is setforth in a formal policy and takes into consideration the need for an overallallowance for loan and lease losses as well as specific allowances that are tiedto individual loans.  The Bank’s methodology for assessing theappropriateness of the allowance consists of several key elements, whichinclude the formula allowance and a specific allowance for identified problemloans.

 

In originating loans, the Bank recognizesthat losses will be experienced and that the risk of loss will vary with, amongother things, the type of loan being made, the creditworthiness of the borrowerover the term of the loan, general economic conditions and, in the case of asecured loan, the quality of the collateral securing the loan.  Theallowance is increased by provisions charged against earnings and reduced bynet loan charge-offs.  Loans are charged off when they are deemed to beuncollectible, or partially charged off when portions of a loan are deemed tobe uncollectible.   Recoveries are generally recorded only when cashpayments are received.

 

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

 

The directors’ loan committee meets quarterlyto review and monitor conditions in the portfolio and to determine theappropriate allowance for loan and lease losses.  To the extent that anyof these conditions are evidenced by identifiable problem credit or portfoliosegment as of the evaluation date, the committee’s estimate of such conditionmay be reflected as a specific allowance applicable to such credit or portfoliosegment.  By assessing the probable estimated losses inherent in the loanportfolio on a quarterly basis, the Bank is able to adjust specific andinherent loss estimates based upon the most recent information that has becomeavailable.

 

**Market Risk**

 

Market risk is the risk to a company’s financial position resultingfrom adverse changes in market rates or prices, such as interest rates, foreignexchange rates or equity prices. The

 

27

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Company has no exposure to foreign currency exchange risk or anyspecific exposure to commodity price risk. The Company’s major area of marketrisk exposure is interest rate risk (“IRR”). The Company’s exposure to IRR canbe explained as the potential for change in its reported earnings and/or themarket value of the Company’s net worth. Variations in interest rates affectearnings by changing net interest income and the level of otherinterest-sensitive income and operating expenses. Interest rate changes alsoaffect the underlying economic value of the Company’s assets, liabilities andoff-balance sheet items. These changes arise because the present value offuture cash flows, and often the cash flows themselves, change with theinterest rates. The effects of the changes in these present values reflect thechange in the Company’s underlying economic value and provide a basis for theexpected change in future earnings related to the interest rate. IRR isinherent in the role of banks as financial intermediaries, however a bank witha high IRR level may experience lower earnings, impaired liquidity and capitalpositions, and most likely, a greater risk of insolvency. Therefore, theCompany and Bank must carefully evaluate IRR to promote safety and soundness intheir activities.

 

The responsibility for the Company’s market risk sensitivity managementhas been delegated to the Asset/Liability Committee (“ALCO”). Specifically,ALCO utilizes computerized modeling techniques to monitor and attempt tocontrol the influence that market changes have on rate sensitive assets (“RSA”)and rate sensitive liabilities (“RSL”).

 

Market risk continues to be a major focal point of regulatory emphasis.In accordance with regulation, each bank is required to develop its own IRRmanagement program depending on its structure, including certain fundamentalcomponents, which are mandatory to ensure sound IRR management. These elementsinclude appropriate regulatory and management oversight as well as acomprehensive risk management process that effectively identifies, measures,monitors and controls risk. Should a bank have material weaknesses in its riskmanagement process or high exposure relative to its capital, the regulatoryagencies will take action to remedy these shortcomings. Moreover, the level ofa bank’s IRR exposure and the quality of its risk management process is adetermining factor when evaluating a bank’s capital adequacy.

 

At June 30, 2004, the Bank held federal funds sold of $1.58million with a yield of 0.89% and available for sale investment securitiestotaling $5.81 million with a weighted-average, tax-equivalent yield of 3.72%,which was a decrease of $303,110 over June 30 2003 balance of $6.11million with a weighted-average, tax equivalent yield of 4.70%. AtJune 30, 2004, gross loans totaled $33.8 million with a weighted-averageyield of 7.02% as compared to $39.8 million with a weighted-average yield of7.03% at June 30, 2003. Overall, average interest-earning assets of $45.1million have a weighted-average yield of 6.15%, which $5.4 million arescheduled to mature within one year.

 

As of June 30, 2004, interest-bearing liabilities including NOWaccounts, money market and savings deposits of $13.2 million with aweighted-average cost of 1.18% were scheduled to mature within one year.  Certificates of deposit totaling $20.2million have a weighted-average cost of 3.00%, which $12.7 million arescheduled to mature within one year.  Inaddition, short-term borrowings totaling $6.5 million, with a weighted-averagecost of 4.17%, of which $3.9 million are schedule to mature within oneyear. In aggregate, total interest-bearing liabilities of $42.9 million have aweighted-average cost of 2.60%, which $29.8 million are schedule to

 

28

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mature within one year.

 

Historical withdrawal patterns with respect to interest-bearing andnoninterest-bearing transaction accounts are not necessarily indicative offuture performance as the volume of cash flows may increase or decrease. Loaninformation is presented based on payment due dates, which may materiallydiffer from actual results due to prepayments caused by changes in interestrates, sociological conditions, demographics, and the economic climate.

 

Models that consider re-pricing frequencies of Rate Sensitive Assets(RSA) and Rate Sensitive Liabilities (RSL) in addition to maturitydistributions are also used to monitor Interest Rate Risk (IRR). One suchtechnique utilizes a static gap report, which attempts to measure the Company’sinterest rate exposure by calculating the net amount of RSA and RSL thatre-price within specific time intervals.

 

The Company’s interest rate sensitivity gap position, illustrating RSAand RSL at their related carrying values, is summarized in the Interest RateSensitivity Analysis Table. The distributions in the table are based on acombination of maturities; call provisions, re-pricing frequencies andprepayment patterns. Adjustable-rate assets are distributed based on there-pricing frequency of the instrument.

 

The interest rate gaps reported in the table arise when assets arefunded with liabilities having different re-pricing intervals. Since these gapsare actively managed and change daily as adjustments are made in interest rateforecasts and market outlook, positions at the end of any period may not bereflective of the Company’s interest rate sensitivity in subsequent periods.Active management dictates that longer-term economic views are balanced againstprospects for short-term interest rate changes in all re-pricing intervals. Forpurposes of the above analysis, re-pricing of fixed-rate instruments is basedupon the contractual maturity of the applicable instruments. In addition,re-pricing of assets and liabilities is assumed in the first availablere-pricing period. Actual payment patterns may differ from contractual paymentpatterns, and it has been management’s experience that re-pricing does notalways correlate directly with market changes in the yield curve.

 

Fluctuations in interest rates can also impact the market value ofassets and liabilities either favorably or adversely depending upon the natureof the rate fluctuations as well as the maturity and re-pricing structure ofthe underlying financial instruments. To the extent that financial instrumentsare held to contractual maturity, market value fluctuations related to interestrate changes are realized only to the extent that future net interest margin iseither higher or lower than comparable market rates for the period. To theextent that liquidity management dictates the need to liquidate certain assetsprior to contractual maturity, changes in market value from fluctuatinginterest rates will be realized in income to the extent of any gain or lossincurred upon the liquidation of the related assets.

 

**Liquidity**

 

The Company’s primary sources of liquidity are the sale of commonstock, borrowings, and dividends from the Bank.

 

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Liquidity management involves meeting the cash flow requirements ofdepositors and borrowers. The Company conducts liquidity management on both adaily and long-term basis; and it adjusts its investments in liquid assetsbased on expected loan demand, projected loan maturities and payments,estimated cash flows from the loan pool participations, expected deposit flows,yields available on interest-bearing deposits, and the objectives of itsasset/liability management program. The Company had liquid assets (cash andcash equivalents) of $2.03 million as of June 30, 2004, compared with$2.38 million as of June 30, 2003. Investment securities classified asavailable for sale could be sold to meet liquidity needs if necessary.Additionally, the bank maintains a line of credit with a correspondent bank.The Bank also has the ability to obtain advances from the Federal Home LoanBank that would allow them to borrow funds on a short-term basis if necessary.

 

 It is the Company’s generalpolicy to maintain liquidity levels at the parent which management believes tobe consistent with the safety and soundness of the Company as a whole. Federalregulatory agencies have the authority to prohibit the payment of dividends bythe Bank to the Company if a finding is made that such payment would constitutean unsafe or unsound practice or if the Bank would be undercapitalized as aresult. Currently the Company’s primary use of liquidity is associated withpayment of operating expenses.

 

The Bank’s liquidity is managed on a daily basis by maintaining cash,federal funds sold, and short-term investments at levels commensurate with theestimated requirements for loan demand and fluctuations in deposits. Loandemand and deposit fluctuations are affected by a number of factors, includingeconomic conditions, seasonality of the borrowing and deposit bases, and thegeneral level of interest rates.

 

At June 30, 2004, liquidity was considered adequate, and fundsavailable in the local deposit market combined with scheduled maturities andprepayments of available for sale investment securities and borrowingfacilities are considered sufficient to meet both the short and long-termliquidity needs and commitments.

 

**Capital Resources**

 

Total shareholders’ average equity was 3.88% of total average assets asof June 30, 2004 and 3.84% as of June 30, 2003. The Company’s Tier 1Capital Ratio was 8.74% of risk-weighted assets as of June 30, 2004 andwas 8.04% as of June 30, 2003, compared to a 4.0% regulatory requirement.Risk-based capital guidelines require the classification of assets and someoff-balance-sheet items in terms of credit-risk exposure and the measuring ofcapital as a percentage of the risk-adjusted asset totals. Tier 1 Capital isthe Company’s total common shareholders’ equity.  Management believes that, as of June 30, 2004, the Companyand its subsidiary banks meet all capital adequacy requirements to which theyare subject. As of that date, the Bank subsidiaries were “well capitalized”under regulatory prompt corrective action provisions.  Consolidated capital decreased $96,223, or 5.03%, during 2004.

 

**Off-Balance Sheet Arrangements andContractual Obligations**

 

The Company’s off-balance sheet arrangements and contractualobligations consist of Notes Payable and Other Borrowings, as described in Note7 to the consolidated financial statements, Convertible Subordinated NotesPayable, as described in Note 8 to the consolidated

 

30

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financial statements, and operating leases as described in Note 12 tothe consolidated financial statements.

 

## **Effects of Inflation and Changing Prices**

## ** **

The accompanying consolidated financial statements have been preparedin accordance with generally accepted accounting principles in the UnitedStates of America, which require the measurement of financial position andoperating results in terms of historical dollars without considering the changein the relative purchasing power of money over time due to inflation.  Unlike most industrial companies, interestrates generally have a more significant impact on the performance of afinancial institution than the effects of general levels of inflation.  Although interest rates do not necessarilymove in the same direction or to the same extent as the prices of goods andservices, increases in inflation generally have resulted in increased interestrates.  In addition, inflation affectsfinancial institutions’ increased cost of goods and services purchased, thecost of salaries and benefits, occupancy expense, and similar items.  Inflation and related increases in interestrates generally decrease the market value of investments and loans held and mayadversely affect liquidity, earnings, and stockholders’ equity.  Commercial and other loan originations andre-financings tend to slow as interest rates increase, and can reduce the Company’searnings from such activities.

 

**SECONDARY STOCKOFFERING AND ISSUANCE OF CONVERTIBLE SUBORDINATED DEBENTURES**

 

During the second and fourth quarters of fiscal year 2003, the Board ofDirectors of the Company authorized a private placement of 40,000 and 20,000shares respectively, of its common stock at a price of $5.50 per share.  In July 2003, the Board of Directors ofthe Company amended its original motion of 20,000 shares be increased to 50,000shares.  The Company did not incur anyunderwriting or placement expenses in connection with these offerings.  As of July 31, 2003, subscriptions toall of the authorized shares had been received.  As of June 30, 2003, payment for 40,000 shares had beenreceived.  The proceeds will be used tosupport our on-going operations.

 

In the first quarter of fiscal 2004, the Board of Directors of theCompany amended its original motion of 20,000 shares to be increased to 50,000shares at $5.50 per share.  In thefourth quarter of fiscal year 2004, the Board of Directors of the Companyamended its motion of 50,000 shares to be increased to 125,000 shares of itscommon stock at a price of $5.00 per share. The Company did not incur any underwriting or placement expenses inconnection with these offerings.  As ofJune 30, 2004, payments for 69,000 shares, totaling $369,500, had beenreceived.  The proceeds will be used tosupport our on-going operations.

 

In July and August 2001, the Company raised $1.0 millionthrough the sale of convertible subordinated unsecured notes, and fromJune to August, 2002 the Company raised an additional $500,000 through thesale of similar notes.  The notes wereissued for a three-year term and bear interest at the rate of eight percent perannum (as to the 2001 notes) and seven percent per annum (as to the 2002notes), payable quarterly.  Investors inthe notes were granted the right to convert their investment into shares of theCompany’s common stock any time prior to maturity at the rate of $10.50 pershare (as to the 2001 notes) and $9.00 per share (as to the 2002 notes).

 

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In the second quarter of fiscal year 2003, on December 31, 2003,the Company sold $100,000 of convertible subordinated unsecured note to anaccredited investor.  The notes bearinterest at the rate of 6.50% per annum and are convertible into common stockof the Company any time prior to maturity at the rate of $9.00 per share. Theterm of the note is one year.

 

On April 7, 2004 and June 23, 2004, the Company sold anaggregate of $200,000 of convertible subordinated unsecured notes to accreditedinvestors.  The notes bear interest atthe rate of 6.00% per annum and are convertible into common stock of theCompany any time prior to maturity at the rate of $6.00 per share.  The term of the April 7, 2004 note istwo years and the term of June 23, 2004 notes are six months.

 

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**Average Balances,Yields and Rates**

 

The following table summarizes our weightedaverage yields earned, weighted average rates paid, interest rate spread andnet yield on earning assets and interest-bearing liabilities.

 
|                                                                              |   | **For the  Year Ended** |       |
|-----------------------------------------------------------------------------------|--------|-------------------------|------------|
|                                                                              |   | **June 30,  2004** |       | **June 30,  2003** |   |
|                                                                              |   |                    |       |   |   | **Average** |   |   |   |   |   | **Average** |   |
|                                                                              |   | **Average**             |       |   |   | **Yield or** |   | **Average** |   |   |   | **Yield or** |   |
|                                                                              |   | **Balance**             |       | **Interest** |   | **Rates** |   | **Balance** |   | **Interest** |   | **Rates** |   |
| **Assets**                                                                        |   |                    |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable                                                                  |   | $                       | 36,069,793 |   | $ | 2,531,426 |   | 7.02 | % | $ | 36,226,724 |   | $ | 2,547,014 |   | 7.03 | % |
| Investment securities                                                             |   | 5,710,994               |       | 212,585 |   | 3.72 | % | 6,426,373 |   | 302,030 |   | 4.70 | % |
| Federal funds sold                                                                |   | 3,286,558               |       | 29,261 |   | 0.89 | % | 2,225,827 |   | 31,273 |   | 1.41 | % |
| Total interest-earning assets                                                     |   | 45,067,345              |       | 2,773,272 |   | 6.15 | % | 44,878,924 |   | 2,880,317 |   | 6.42 | % |
| Non-interest-earning assets                                                       |   | 4,095,072               |       |   |   |   |   | 4,378,059 |   |   |   |   |   |
| Total assets                                                                      |   | $                       | 49,162,417 |   |   |   |   |   | $ | 49,256,983 |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**                                    |   |                    |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits                                                         |   | $                       | 36,443,390 |   | 839,790 |   | 2.30 | % | $ | 35,891,511 |   | 1,130,416 |   | 3.15 | % |
| Other liabilities                                                                 |   | 6,977,684               |       | 290,767 |   | 4.17 | % | 6,820,266 |   | 297,898 |   | 4.37 | % |
| Total interest-bearing liabilities                                                |   | 43,421,074              |       | 1,130,557 |   | 2.60 | % | 42,711,777 |   | 1,428,314 |   | 3.34 | % |
| Non-interest-bearing liabilities                                                  |   | 3,641,913               |       |   |   |   |   | 4,514,078 |   |   |   |   |   |
| Total liabilities                                                                 |   | 47,062,987              |       |   |   |   |   | 47,225,855 |   |   |   |   |   |
| Stockholders’ Equity                                                         |   | 2,099,430               |       |   |   |   |   | 2,031,128 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                                   |   | $                       | 49,162,417 |   |   |   |   |   | $ | 49,256,983 |   |   |   |   |   |
| Net interest spread                                                               |   |                    |       |   |   | 3.55 | % |   |   |   |   | 3.08 | % |
| Net interest income/margin                                                        |   |                    |       | $ | 1,642,715 |   | 3.65 | % |   |   | $ | 1,452,003 |   | 3.24 | % |
| Ratio of average interest-earning assets to  average interest-bearing liabilities |   | 1.04                    | x          |   |   |   |   | 1.05 | x |   |   |   |   |

 

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**Rate/VolumeAnalysis**

 

The table below setsforth certain information regarding changes in interest income and interestexpense of the Bank for the periods indicated. For each category of interest-earning and interest-bearing liabilities,information is provided on changes attributable to (i) changes in volume(change in average volume multiplied by old rate); (ii) changes in rates(changes in rate multiplied by old average volume);  (iii) changes in rate-volume (changes in rate multiplied by thechange in average volume)

 
|                               |   | **Year Ended  June 30, 2004** |   |
|------------------------------------|--------|------------------------------------|--------|
|                               |   | **2004 vs  2003**                  |   |
|                               |   | **Increase  (decrease) due to**    |   |
|                               |   | **(dollars  in thousands)**        |   |
|                               |   | **Volume**                         |   | **Rate** |   | **Rate/Volume** |   | **Net** |   |
| Interest income:                   |   |                               |   |   |   |   |   |   |   |
| Loans receivable                   |   | $                                  | (11    | ) | $ | (4 | ) | $ | — |   | $ | (15 | ) |
| Investment securities              |   | (34                                | )      | (63 | ) | 7 |   | (90 | ) |
| Federal funds sold                 |   | 16                                 |   | (12 | ) | (6 | ) | (2 | ) |
| Other interest-earning assets      |   | —                             |   | — |   | — |   | — |   |
| Total interest-earning assets      |   | (29                                | )      | (79 | ) | 1 |   | (107 | ) |
| Interest expense:                  |   |                               |   |   |   |   |   |   |   |
| Deposit accounts                   |   | 17                                 |   | (304 | ) | (5 | ) | (292 | ) |
| Other liabilities                  |   | 8                                  |   | (14 | ) | — |   | (6 | ) |
| Total interest-bearing liabilities |   | 25                                 |   | (318 | ) | (5 | ) | (298 | ) |
| Net change in net interest income  |   | $                                  | (54    | ) | $ | 239 |   | $ | 6 |   | $ | 191 |   |

 
|                               |   | **Year Ended  June 30, 2003** |   |
|------------------------------------|--------|------------------------------------|--------|
|                               |   | **2003 vs  2002**                  |   |
|                               |   | **Increase  (decrease) due to**    |   |
|                               |   | **(dollars  in thousands)**        |   |
|                               |   | **Volume**                         |   | **Rate** |   | **Rate/Volume** |   | **Net** |   |
| Interest income:                   |   |                               |   |   |   |   |   |   |   |
| Loans receivable                   |   | $                                  | 482    |   | $ | (53 | ) | $ | (12 | ) | $ | 417 |   |
| Investment securities              |   | (193                               | )      | (91 | ) | 32 |   | (252 | ) |
| Federal funds sold                 |   | 5                                  |   | (29 | ) | (3 | ) | (27 | ) |
| Other interest-earning assets      |   | —                             |   | — |   | — |   | — |   |
| Total interest-earning assets      |   | 294                                |   | (173 | ) | 17 |   | 138 |   |
| Interest expense:                  |   |                               |   |   |   |   |   |   |   |
| Deposit accounts                   |   | 144                                |   | (473 | ) | (45 | ) | (374 | ) |
| Other liabilities                  |   | 66                                 |   | (58 | ) | (12 | ) | (4 | ) |
| Total interest-bearing liabilities |   | 210                                |   | (531 | ) | (57 | ) | (378 | ) |
| Net change in net interest income  |   | $                                  | 84     |   | $ | 358 |   | $ | 74 |   | $ | 516 |   |

 

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## **Investment Portfolio**

## ** **

At June 30, 2004, our available for sale investments securitiesportfolio represented approximately 14.11% of our interest earning assets of$41.2 million.  We also held investmentsin stock of the Federal Home Loan Bank and United Bankers Bank in the amount of$385,100, which are not included in the table below.

 

At June 30, 2003, our securities portfolio representedapproximately 13.2% of our interest earning assets of $46.4 million.

 
|                     |   | **June 30,  2004** |   |
|--------------------------|--------|-------------------------|--------|
|                     |   |                    |   |   |   | **After one** |   |   |   | **After five** |   |   |   |   |   |   |   |   |   |   |   |
|                     |   | **One Year**            |   |   |   | **year thru** |   |   |   | **years thru** |   |   |   | **After ten** |   |   |   |   |   |   |   |
|                     |   | **or Less**             |   | **Yield** |   | **five years** |   | **Yield** |   | **ten years** |   | **Yield** |   | **years** |   | **Yield** |   | **Total** |   | **Yield** |   |
|                     |   |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. agencies            |   | $                       | — |   | 0.00 | % | $ | 974,477 |   | 2.73 | % | $ | 970,000 |   | 4.07 | % | $ | — |   | 0.00 | % | $ | 1,944,477 |   | 3.40 | % |
| Mortgage-back securities |   | —                  |   | 0.00 | % | 288,875 |   | 3.63 | % | 900,838 |   | 4.28 | % | 2,675,789 |   | 4.00 | % | 3,865,502 |   | 4.03 | % |
| Corporate bonds          |   | —                  |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % |
| Mutual fund              |   | —                  |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % |
|                     |   | $                       | — |   | 0.00 | % | $ | 1,263,352 |   | 2.93 | % | $ | 1,870,838 |   | 4.17 | % | $ | 2,675,789 |   | 4.00 | % | $ | 5,809,979 |   | 3.82 | % |

 
|                       |   | **June 30,  2003** |   |
|----------------------------|--------|-------------------------|--------|
|                       |   |                    |   |   |   | **After one** |   |   |   | **After five** |   |   |   |   |   |   |   |   |   |   |   |
|                       |   | **One Year**            |   |   |   | **year thru** |   |   |   | **years thru** |   |   |   | **After ten** |   |   |   |   |   |   |   |
|                       |   | **or Less**             |   | **Yield** |   | **five years** |   | **Yield** |   | **ten years** |   | **Yield** |   | **years** |   | **Yield** |   | **Total** |   | **Yield** |   |
|                       |   |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. agencies              |   | $                       | — |   | 0.00 | % | $ | 507,656 |   | 3.31 | % | $ | 1,259,828 |   | 4.11 | % | $ | 499,255 |   | 4.02 | % | $ | 2,266,739 |   | 3.91 | % |
| Mortgage-backed securities |   | —                  |   | 0.00 | % | 164,558 |   | 5.75 | % | 985,332 |   | 5.27 | % | 2,168,540 |   | 5.74 | % | 3,318,430 |   | 5.60 | % |
| Corporate bonds            |   | —                  |   | 0.00 | % | 527,919 |   | 6.06 | % | — |   | 0.00 | % | — |   | 0.00 | % | 527,919 |   | 6.06 | % |
| Mutual fund                |   | —                  |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % |
|                       |   | $                       | — |   | 0.00 | % | $ | 1,200,133 |   | 4.85 | % | $ | 2,245,160 |   | 4.62 | % | $ | 2,667,795 |   | 5.42 | % | $ | 6,113,088 |   | 5.01 | % |

 

Contractual maturities and yields on the Bank’s available for saleinvestments are summarized in the above table. Expected maturities may differ from contractual maturities becauseissuers may have the right to call or prepay obligations with or without callor prepayment penalties.  Short-terminvestments in the amount of $1.6 million and $482,000 at June 30, 2004and 2003, respectively, were funds invested in Federal Funds sold on an overnightbasis, which are considered cash equivalents.

 

**Interest Rate Sensitivity Analysis**

 

The Company continually evaluates the asset mix of our balance sheet interms of several variables:  yields,credit quality, appropriate funding sources and liquidity.  To effectively manage the liability mix ofthe balance sheet, the Company focuses on expanding various fundingsources.  The interest rate sensitivityposition at June 30, 2004 and 2003 is summarized in the following tables.  The difference between rate sensitive assetsand rate sensitive liabilities, or the interest rate sensitivity gap, for eachperiod is show at the bottom of each table. Since all interest rates and yields do not adjust at the same velocity,the gap is only a general indicator of

 

35

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rate sensitivity.  The tablesmay not be indicative of our rate sensitivity position at other points in time.

 
|                                                                  |   | **As of  June 30, 2004** |   |
|-----------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                  |   | **Within  Three  Months**     |   | **After  Three  but within  Twelve Months** |   | **After  Twelve  but within  Five Years** |   | **After  Five Years** |   | **Total** |   |
|                                                                  |   |                          |   | **(Dollars  in Thousands)** |   |   |   |   |   |
| Interest earning assets                                               |   |                          |   |   |   |   |   |   |   |   |   |
| Federal funds sold                                                    |   | $                             | 1,582  |   | $ | — |   | $ | — |   | $ | — |   | $ | 1,582 |   |
| Investment securities                                                 |   | —                        |   | — |   | 1,263 |   | 4,547 |   | 5,810 |   |
| Loans receivable                                                      |   | 1,437                         |   | 2,397 |   | 20,573 |   | 9,382 |   | 33,789 |   |
| Total earning assets                                                  |   | $                             | 3,019  |   | $ | 2,397 |   | $ | 21,836 |   | $ | 13,929 |   | $ | 41,181 |   |
|                                                                  |   |                          |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities                                          |   |                          |   |   |   |   |   |   |   |   |   |
| NOW and money market                                                  |   | $                             | 8,371  |   | $ | — |   | $ | — |   | $ | — |   | $ | 8,371 |   |
| Savings                                                               |   | 4,878                         |   | — |   | — |   | — |   | 4,878 |   |
| Time deposits                                                         |   | 2,892                         |   | 9,788 |   | 7,526 |   | — |   | 20,206 |   |
| Borrowed funds                                                        |   | 1,850                         |   | 2,000 |   | 2,050 |   | 600 |   | 6,500 |   |
| Total interest bearing liabilities                                    |   | $                             | 17,991 |   | $ | 11,788 |   | $ | 9,576 |   | $ | 600 |   | $ | 39,955 |   |
|                                                                  |   |                          |   |   |   |   |   |   |   |   |   |
| Interest sensitivity gap                                              |   | (14,972                       | )      | (9,391 | ) | 12,260 |   | 13,329 |   | 1,226 |   |
| Cumulative interest sensitivity gap                                   |   | 0                             |   | (9,391 | ) | 2,869 |   | 16,198 |   | 1,226 |   |
| Ratio of interest sensitivity gap to total  earning assets            |   | -36.36                        | %      | -22.80 | % | 29.77 | % | 32.37 | % | 2.98 | % |
| Ratio of cumulative interest Sensitivity  gap to total earning assets |   | 0.00                          | %      | -22.80 | % | 6.97 | % | 39.33 | % | 2.98 | % |

 

36

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|                                                                  |   | **As of  June 30, 2003** |   |
|-----------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                  |   | **Within  Three  Months**     |   | **After  Three  but within  Twelve Months** |   | **After  Twelve  but within  Five Years** |   | **After  Five Years** |   | **Total** |   |
|                                                                  |   |                          |   | **(Dollars  in Thousands)** |   |   |   |   |   |
| Interest earning assets                                               |   |                          |   |   |   |   |   |   |   |   |   |
| Federal funds sold                                                    |   | $                             | 482    |   | $ | — |   | $ | — |   | $ | — |   | $ | 482 |   |
| Investment securities                                                 |   | —                        |   | — |   | 1,200 |   | 4,913 |   | 6,113 |   |
| Loans receivable                                                      |   | 5,368                         |   | 5,061 |   | 22,323 |   | 7,021 |   | 39,773 |   |
| Total earning assets                                                  |   | $                             | 5,850  |   | $ | 5,061 |   | $ | 23,523 |   | $ | 11,934 |   | $ | 46,368 |   |
|                                                                  |   |                          |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities                                          |   |                          |   |   |   |   |   |   |   |   |   |
| NOW and money market                                                  |   | $                             | 8,624  |   | $ | — |   | $ | — |   | $ | — |   | $ | 8,624 |   |
| Savings                                                               |   | 4,631                         |   | — |   | — |   | — |   | 4,631 |   |
| Time deposits                                                         |   | 3,449                         |   | 12,902 |   | 6,732 |   | — |   | 23,083 |   |
| Borrowed funds                                                        |   | —                        |   | 2,675 |   | 4,200 |   | 700 |   | 7,575 |   |
| Total interest bearing liabilities                                    |   | $                             | 16,704 |   | $ | 15,577 |   | $ | 10,932 |   | $ | 700 |   | $ | 43,913 |   |
|                                                                  |   |                          |   |   |   |   |   |   |   |   |   |
| Interest sensitivity gap                                              |   | (10,854                       | )      | (10,516 | ) | 12,591 |   | 11,234 |   | 2,455 |   |
| Cumulative interest sensitivity gap                                   |   | (10,854                       | )      | (21,370 | ) | (8,779 | ) | 2,455 |   | 2,455 |   |
| Ratio of interest sensitivity gap to total  earning assets            |   | -23.41                        | %      | -22.68 | % | 27.15 | % | 24.23 | % | 5.29 | % |
| Ratio of cumulative interest Sensitivity  gap to total earning assets |   | -23.41                        | %      | -46.09 | % | -18.93 | % | 5.29 | % | 5.29 | % |

 

## **Loan Portfolio**

## ** **

Since loans typically provide higher interest yields than do othertypes of earning assets, our intent is to channel a substantial percentage ofour earning assets into the loan category. The gross loans outstanding, at June 30, 2004 and 2003 were$33,788,683 and $39,773,287, respectively. This table excludes loans held for sale as of June 30, 2004 and2003 of $697,433 and $2,035,176, respectively. Loans held for sale are comprised of real estate mortgages. Thefollowing table summarizes the composition of our loan portfolio.

 
|                           |   | **June 30,  2004** |       | **June 30,  2003** |   |
|--------------------------------|--------|-------------------------|------------|-------------------------|--------|
|                           |   | **Amount**              |       | **% of Total**          |   | **Amount** |   | **% of Total** |   |
| Commercial & agricultural  |   | $                       | 6,176,151  |                    | 18.28  | % | $ | 6,979,307 |   | 17.55 | % |
| Real estate - construction     |   | 3,852,695               |       | 11.40                   | %      | 4,433,072 |   | 11.15 | % |
| Real estate - mortgages        |   | 17,872,513              |       | 52.89                   | %      | 18,504,208 |   | 46.52 | % |
| Consumer loans                 |   | 5,854,728               |       | 17.33                   | %      | 9,821,027 |   | 24.69 | % |
| Lease financing                |   | 32,596                  |       | 0.10                    | %      | 35,673 |   | 0.09 | % |
| Total loans                    |   | $                       | 33,788,683 |                    | 100.00 | % | $ | 39,773,287 |   | 100.00 | % |
| Net deferred loan fees/(costs) |   | 59,956                  |       |                    |   | 108,422 |   |   |   |
| Less: allowance for loan loss  |   | (447,467                | )          |                    |   | (1,029,581 | ) |   |   |
| Total net loans                |   | $                       | 33,401,172 |                    |   |   | $ | 38,852,128 |   |   |   |

 

37

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Loans in nonaccrual, past due and restructured loans arelisted below:

 
|                           |   | **June 30** |    |
|--------------------------------|--------|------------------|---------|
|                           |   | **2004**         |    | **2003** |   |
| Non-accrual loans              |   | $                | 193,215 |   | $ | 1,844,911 |   |
|                           |   |             |    |   |   |
| Accruing > 90 days past due |   | $                | —  |   | $ | — |   |
|                           |   |             |    |   |   |
| Troubled debt restructured     |   | $                | 235,522 |   | $ | — |   |

 

## **Maturities and Sensitivity of Loans to Changes inInterest Rates**

## ** **

The information in the following tables is based on the contractualmaturities of individual loans, including loans, which may have been subject torenewal at their contractual maturity. Renewal of these loans is subject to review and credit approval, as wellas modifications in terms upon their maturity. Actual repayments of loans may differ from maturities reflected belowbecause borrowers have the right to prepay obligations with or withoutprepayment penalties.  The followingtables summarize loan maturities, by type, and related interest ratecharacteristics:

 
|                               |   | **As of  June 30, 2004** |       |
|------------------------------------|--------|-------------------------------|------------|
|                               |   | **One Year  or Less**         |       | **After One  but  within Five Years** |   | **After  Five Years** |   | **Total** |   |
| Commercial & agricultural      |   | $                             | 1,443,592  |   | $ | 3,006,584 |   | $ | 1,725,975 |   | $ | 6,176,151 |   |
| Real estate - construction         |   | 890,557                       |       | 2,958,397 |   | 3,741 |   | 3,852,695 |   |
| Real estate - mortgages            |   | 850,534                       |       | 10,137,694 |   | 6,884,285 |   | 17,872,513 |   |
| Consumer loans                     |   | 623,230                       |       | 4,463,154 |   | 768,344 |   | 5,854,728 |   |
| Lease financing                    |   | 26,197                        |       | 6,399 |   | — |   | 32,596 |   |
| Total                              |   | $                             | 3,834,110  |   | $ | 20,572,228 |   | $ | 9,382,345 |   | $ | 33,788,683 |   |
| Loans maturing after one year with |   |                          |       |   |   |   |   |   |   |
| Fixed interest rate                |   | $                             | 27,500,905 |   |   |   |   |   |   |   |
| Floating interest rates            |   | $                             | 2,453,668  |   |   |   |   |   |   |   |

 
|                               |   | **As of  June 30, 2003** |       |
|------------------------------------|--------|-------------------------------|------------|
|                               |   | **One Year  or Less**         |       | **After One  but  within Five Years** |   | **After  Five Years** |   | **Total** |   |
| Commercial & agricultural      |   | $                             | 2,613,798  |   | $ | 2,597,750 |   | $ | 1,767,759 |   | $ | 6,979,307 |   |
| Real estate - construction         |   | 3,496,939                     |       | 936,133 |   | — |   | 4,433,072 |   |
| Real estate - mortgages            |   | 2,034,243                     |       | 12,075,344 |   | 4,394,621 |   | 18,504,208 |   |
| Consumer loans                     |   | 2,283,747                     |       | 6,678,656 |   | 858,624 |   | 9,821,027 |   |
| Lease financing                    |   | —                        |       | 35,673 |   | — |   | 35,673 |   |
| Total                              |   | $                             | 10,428,727 |   | $ | 22,323,556 |   | $ | 7,021,004 |   | $ | 39,773,287 |   |
| Loans maturing after one year with |   |                          |       |   |   |   |   |   |   |
| Fixed interest rate                |   | $                             | 27,452,321 |   |   |   |   |   |   |   |
| Floating interest rates            |   | $                             | 1,892,239  |   |   |   |   |   |   |   |

 

## **Provision and Allowance for Loan and Lease Losses**

## ** **

We have developed policies and procedures for evaluating the overallquality of our credit portfolio and the timely identification of potentialcredit problems.  Additions to the

 

38

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allowance for loan and lease losses will be made periodically tomaintain the allowance in an appropriate level based on our analysis of thepotential risk in the loan portfolio.

 

The following table summarizes our Bank’s loan loss experience and theallowance for possible loan losses.

 
|                                                                                       |   | **Year Ended**          |      |
|--------------------------------------------------------------------------------------------|--------|-------------------------|-----------|
|                                                                                       |   | **June 30,  2004** |      | **June 30,  2003** |   |
| Balance at beginning of period                                                             |   | $                       | 1,029,581 |   | $ | 661,170 |   |
|                                                                                       |   |                    |      |   |   |
| Charge-offs:                                                                               |   |                    |      |   |   |
| Commercial   & agricultural                                                       |   | (521,669                | )         | — |   |
| Consumer loans                                                                             |   | (266,194                | )         | (14,680 | ) |
|                                                                                       |   | (787,863                | )         | (14,680 | ) |
|                                                                                       |   |                    |      |   |   |
| Recoveries:                                                                                |   |                    |      |   |   |
| Commercial & agricultural                                                              |   | 5,000                   |      | 7,930 |   |
| Consumer loans                                                                             |   | 32,477                  |      | 1,224 |   |
|                                                                                       |   | 37,477                  |      | 9,154 |   |
|                                                                                       |   |                    |      |   |   |
| Net charge offs                                                                            |   | (750,386                | )         | (5,526 | ) |
| Provision charged to operations                                                            |   | 168,272                 |      | 373,937 |   |
|                                                                                       |   |                    |      |   |   |
| Balance at end of period                                                                   |   | $                       | 447,467   |   | $ | 1,029,581 |   |
|                                                                                       |   |                    |      |   |   |
| Ratio of net charge-offs during the period  to average loans outstanding during the period |   | 2.08                    | %         | 0.02 | % |

 

The allowance for loan and lease losses was allocated as follows:

 
|                          |   | **June 30,  2004** |    | **June 30,  2003** |   |
|-------------------------------|--------|-------------------------|---------|-------------------------|--------|
|                          |   |                    |    | **Percent of  Loans**   |   |   |   | **Percent of  Loans** |   |
|                          |   |                    |    | **in Each  Category**   |   |   |   | **in Each  Category** |   |
|                          |   | **Amount**              |    | **of Total  Loans**     |   | **Amount** |   | **of Total  Loans** |   |
| Commercial & agricultural |   | $                       | 181,754 |                    | 18.28  | % | $ | 341,993 |   | 17.55 | % |
| Real estate - construction    |   | 24,584                  |    | 11.40                   | %      | 26,896 |   | 11.15 | % |
| Real estate - mortgages       |   | 148,790                 |    | 52.89                   | %      | 151,417 |   | 46.52 | % |
| Consumer loans                |   | 92,095                  |    | 17.33                   | %      | 509,007 |   | 24.69 | % |
| Lease financing               |   | 244                     |    | 0.10                    | %      | 268 |   | 0.09 | % |
| Total                         |   | $                       | 447,467 |                    | 100.00 | % | $ | 1,029,581 |   | 100.00 | % |

 

## **Deposits and Other Interest-Bearing Liabilities**

## ** **

As of June 30, 2004, interest bearing deposits were 83.93% ofinterest-bearing liabilities compared to 84.03% for the same period endingJune 30, 2003.  The followingtables summarize deposits by category.

 

39

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|                              |   | **As of  June 30, 2004** |       |
|-----------------------------------|--------|-------------------------------|------------|
|                              |   |                          |       |   |   |   |   | **Percentage** |   |   |   |
|                              |   |                          |       | **Percentage** |   |   |   | **of Total** |   | **Average** |   |
|                              |   | **Ending**                    |       | **of Total** |   | **Average** |   | **Average** |   | **Rate** |   |
|                              |   | **Balance**                   |       | **Deposits** |   | **Balance** |   | **Deposits** |   | **Paid** |   |
| Demand deposit                    |   | $                             | 2,946,891  |   | 8.10 | % | $ | 3,348,407 |   | 8.41 | % | 0.00 | % |
| Now and money market              |   | 8,370,929                     |       | 23.00 | % | 8,886,851 |   | 22.33 | % | 1.08 | % |
| Savings                           |   | 4,878,038                     |       | 13.40 | % | 5,109,988 |   | 12.84 | % | 1.36 | % |
| Time accounts less than $100,000  |   | 15,567,016                    |       | 42.76 | % | 17,106,995 |   | 42.99 | % | 3.00 | % |
| Time accounts of $100,000 or more |   | 4,638,667                     |       | 12.74 | % | 5,339,556 |   | 13.43 | % | 3.02 | % |
| Total deposits                    |   | $                             | 36,401,541 |   | 100.00 | % | $ | 39,791,797 |   | 100.00 | % |   |   |

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

 

As of June 30, 2004, the Bank haddeposits classified as brokered deposit totaling $1.4 million.  The Bank does not rely on brokered deposits.  Core deposits, excluding time deposits of$100,000 or more, provide a relatively stable funding source for our loanportfolio and other earning assets.  Ourloan to deposit ratio was 92.82% at June 30, 2004 and 96.00% atJune 30, 2003.  The maturitydistribution of our time deposits is as follows.

 
|                             |   | **June 30,  2004** |      |
|----------------------------------|--------|-------------------------|-----------|
|                             |   | **3 months  or less**   |      | **Over 3  months  thru 6 months** |   | **Over 6  months  thru 12 months** |   | **Over  12 months** |   | **Total** |   |
| Time accounts less than $100,000 |   | $                       | 2,167,501 |   | $ | 3,072,967 |   | $ | 4,582,225 |   | $ | 5,744,323 |   | $ | 15,567,016 |   |
| Time accounts of $100,00 or more |   | 724,244                 |      | 1,146,957 |   | 986,238 |   | 1,781,228 |   | 4,638,667 |   |
| Total                            |   | $                       | 2,891,745 |   | $ | 4,219,924 |   | $ | 5,568,463 |   | $ | 7,525,551 |   | $ | 20,205,683 |   |

 
|                             |   | **June 30,  2003** |      |
|----------------------------------|--------|-------------------------|-----------|
|                             |   | **3 months  or less**   |      | **Over 3  months  thru 6 months** |   | **Over 6  months  thru 12 months** |   | **Over  12 months** |   | **Total** |   |
| Time accounts less than $100,000 |   | $                       | 2,939,671 |   | $ | 5,615,341 |   | $ | 4,475,488 |   | $ | 4,990,979 |   | $ | 18,021,479 |   |
| Time accounts of $100,00 or more |   | 509,409                 |      | 1,986,830 |   | 824,491 |   | 1,741,442 |   | 5,062,172 |   |
| Total                            |   | $                       | 3,449,080 |   | $ | 7,602,171 |   | $ | 5,299,979 |   | $ | 6,732,421 |   | $ | 23,083,651 |   |

 

40

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**RETURN ON EQUITY ANDASSETS**

** **

The following table shows the return (loss) on average assets (net lossdivided by average total assets), return on average equity (net loss divided byaverage equity), and equity to assets ratio (average equity divided by averagetotal assets) for fiscal year 2004 and 2003. Since its inception, we have not paid any cash dividends.  The payment of dividends by the Bank issubject to limitations imposed by law and governmental regulations.

 
|                            |   | **For the  Year Ended  June 30, 2004** |   | **For the  Year Ended  June 30, 2003** |   |
|---------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|--------|
| Return (loss) on average assets |   | (0.76                                       | )%     | (0.47                                       | )%     |
|                            |   |                                        |   |                                        |   |
| Return (loss) on average equity |   | (19.70                                      | )%     | (12.13                                      | )%     |
|                            |   |                                        |   |                                        |   |
| Equity to assets ratio          |   | 3.88                                        | %      | 3.84                                        | %      |

 

## **BORROWINGS**

## ** **

Deposits are the primary source of funds for the Bank’s lending andinvestment activities and for its general business purposes.  If the need arises, the Bank may rely uponadvances from the Federal Home Loan Bank of Des Moines to supplement its supplyof lendable funds and to meet ending and deposit withdrawal requirements.  Advances from the FHLB are typically securedby a portion of the Bank’s security portfolio. In addition to borrowings from FHLB, we have had a line of credit in theamount of $600,000 with a correspondent bank in Minneapolis, Minnesota.

 
|                     |   | **As of and  for the fiscal year Ended June 30** |      |
|--------------------------|--------|-------------------------------------------------------|-----------|
|                     |   | **2004**                                              |      | **2003** |   |
| Maximum balance          |   | $                                                     | 7,575,000 |   | $ | 7,575,000 |   |
|                     |   |                                                  |      |   |   |
| Average balance          |   | 6,977,684                                             |      | 6,820,266 |   |
|                     |   |                                                  |      |   |   |
| Balance at end of period |   | 6,500,000                                             |      | 7,575,000 |   |
|                     |   |                                                  |      |   |   |
| Weighted average rate:   |   |                                                  |      |   |   |
| at end of period         |   | 4.39                                                  | %         | 4.03 | % |
| during the period        |   | 4.17                                                  | %         | 4.37 | % |
|                          |        |                                                       |           |  |  |  |  |

 

41

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**ITEM7.  FINANCIAL STATEMENTS**

 

**Northern Star Financial, Inc.**

**And Subsidiary**

 

 

**Consolidated Financial Report**

 

 

**June 30, 2004**

 
| Reports of Independent Auditors                       |   |
|-------------------------------------------------------|--------|
|                                                  |   |
| Consolidated Statements of Financial  Condition       |   |
| as of June 30, 2004 and 2003                          |   |
|                                                  |   |
| Consolidated Statements of Operations                 |   |
| for the Years Ended June 30, 2004 and 2003            |   |
|                                                  |   |
| Consolidated Statements of Stockholders’  Equity |   |
| for the Years Ended June 30, 2004 and 2003            |   |
|                                                  |   |
| Consolidated Statements of Cash Flows                 |   |
| for the Years Ended June 30, 2004 and 2003            |   |
|                                                  |   |
| Notes to Consolidated Financial Statements            |   |

 

42

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Audit Committee andStockholders of Northern Star Financial, Inc.Mankato, Minnesota

 

We have audited theaccompanying consolidated statements of financial condition of Northern StarFinancial, Inc. and Subsidiary as of June 30, 2004 and 2003, and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows forthe years then ended.  These consolidatedfinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the consolidated financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe consolidated financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Northern Star Financial, Inc. andSubsidiary as of June 30, 2004 and 2003, and the results of their operationsand their cash flows for the years then ended in conformity with U.S. generallyaccepted accounting principles.

 
|   | /s/ Boulay,  Heutmaker, Zibell & Co. P.L.L.P |                         |
|--------|--------------------------------------------------|------------------------------|
|   |                                             | Certified Public Accountants |
|        |                                                  |                              |  |

 

Minneapolis, Minnesota

August 17, 2004

 

43

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**NORTHERN STARFINANCIAL, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENTS OF FINANCIALCONDITION**

 
|                                                                                                                      |   | **June 30** |       |
|---------------------------------------------------------------------------------------------------------------------------|--------|-------------|------------|
|                                                                                                                      |   | **2004**    |       | **2003** |   |
| **ASSETS**                                                                                                                |   |        | ** ** |   | ** ** |
|                                                                                                                      |   |        | ** ** |   | ** ** |
| Cash and due from banks                                                                                                   |   | $           | 1,953,163  |   | $ | 2,377,132 |   |
| Federal funds sold                                                                                                        |   | 1,582,000   |       | 482,000 |   |
| Securities available for sale, at fair  value                                                                             |   | 5,809,978   |       | 6,113,088 |   |
| Securities held for trading, at fair value                                                                                |   | —      |       | 115,862 |   |
| Federal Home Loan Bank and United Bankers  Bank stock, at cost                                                            |   | 385,100     |       | 367,100 |   |
| Loans held for sale                                                                                                       |   | 697,433     |       | 2,035,176 |   |
| Loans receivable, net of allowance for loan  and lease losses of $447,467 and $1,029,581                                  |   | 33,401,172  |       | 38,852,128 |   |
| Accrued interest receivable                                                                                               |   | 214,476     |       | 282,416 |   |
| Property and equipment, net of depreciation                                                                               |   | 524,787     |       | 503,397 |   |
| Other assets                                                                                                              |   | 416,210     |       | 124,363 |   |
| **Total Assets**                                                                                                          |   | $           | 44,984,319 |   | $ | 51,252,662 |   |
|                                                                                                                      |   |        |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                             |   |        |       |   |   |
| **Liabilities:**                                                                                                          |   |        |       |   |   |
| Demand deposits                                                                                                           |   | $           | 2,946,891  |   | $ | 5,090,364 |   |
| NOW and money market                                                                                                      |   | 8,370,929   |       | 8,623,932 |   |
| Savings                                                                                                                   |   | 4,878,038   |       | 4,630,763 |   |
| Time deposits                                                                                                             |   | 20,205,683  |       | 23,083,651 |   |
| Total deposits                                                                                                            |   | 36,401,541  |       | 41,428,710 |   |
| Notes payable and other borrowings                                                                                        |   | 4,700,000   |       | 5,975,000 |   |
| Convertible subordinated notes payable                                                                                    |   | 1,800,000   |       | 1,600,000 |   |
| Accrued interest payable and other                                                                                        |   | 264,867     |       | 334,818 |   |
| Total Liabilities                                                                                                         |   | 43,166,408  |       | 49,338,528 |   |
|                                                                                                                      |   |        |       |   |   |
| **Stockholders’ Equity:**                                                                                            |   |        |       |   |   |
| Common stock, $.01 par value, 15,000,000  shares authorized; 588,506 and 519,506 shares issued outstanding,  respectively |   | 5,885       |       | 5,195 |   |
| Undesignated stock, par value $.01 per  share; 5,000,000 shares authorized, no shares issued                              |   | —      |       | — |   |
| Additional paid in capital                                                                                                |   | 4,746,914   |       | 4,378,104 |   |
| Accumulated deficit                                                                                                       |   | (2,880,782  | )          | (2,513,175 | ) |
| Unearned stock compensation                                                                                               |   | (4,005      | )          | (8,005 | ) |
| Accumulated other comprehensive income                                                                                    |   | (50,101     | )          | 52,015 |   |
| **Total Stockholders’ Equity**                                                                                       |   | 1,817,911   |       | 1,914,134 |   |
| **Total Liabilities and Stockholders Equity**                                                                             |   | $           | 44,984,319 |   | $ | 51,252,662 |   |

 

See Notes to Consolidated Financial Statements

 

44

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

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
|                                                           |   | **For the  Year Ended June 30** |      |
|----------------------------------------------------------------|--------|---------------------------------|-----------|
|                                                           |   | **2004**                        |      | **2003** |   |
| **Interest income:**                                           |   |                            |      |   |   |
| Loans receivable                                               |   | $                               | 2,531,426 |   | $ | 2,547,014 |   |
| Securities available for sale                                  |   | 212,585                         |      | 302,030 |   |
| Federal funds sold                                             |   | 29,261                          |      | 31,273 |   |
| Total interest income                                          |   | 2,773,272                       |      | 2,880,317 |   |
|                                                           |   |                            |      |   |   |
| **Interest expense:**                                          |   |                            |      |   |   |
| Deposits                                                       |   | 839,790                         |      | 1,130,416 |   |
| Borrowed funds                                                 |   | 290,767                         |      | 297,898 |   |
| Total interest expense                                         |   | 1,130,557                       |      | 1,428,314 |   |
|                                                           |   |                            |      |   |   |
| Net interest income                                            |   | 1,642,715                       |      | 1,452,003 |   |
| Provision for loan and lease losses                            |   | 168,272                         |      | 373,937 |   |
|                                                           |   |                            |      |   |   |
| Net interest income after provision for  loan and lease losses |   | 1,474,443                       |      | 1,078,066 |   |
|                                                           |   |                            |      |   |   |
| **Non-interest income:**                                       |   |                            |      |   |   |
| Other fees and service charges                                 |   | 234,497                         |      | 218,092 |   |
| Gain on sale of securities                                     |   | 24,296                          |      | 3,504 |   |
| Gain on sale of loans held for sale                            |   | 425,605                         |      | 865,581 |   |
| Total non-interest income                                      |   | 684,398                         |      | 1,087,177 |   |
|                                                           |   |                            |      |   |   |
| **Non-interest expense:**                                      |   |                            |      |   |   |
| Compensation and employee benefits                             |   | 1,119,419                       |      | 1,022,991 |   |
| Board fees                                                     |   | 102,000                         |      | 101,500 |   |
| Occupancy                                                      |   | 196,062                         |      | 178,890 |   |
| Printing & supplies                                        |   | 91,030                          |      | 78,576 |   |
| Property and equipment depreciation                            |   | 81,759                          |      | 75,282 |   |
| Data processing                                                |   | 160,270                         |      | 153,039 |   |
| Professional fees                                              |   | 412,156                         |      | 408,554 |   |
| Other                                                          |   | 363,752                         |      | 379,227 |   |
| Total non-interest expense                                     |   | 2,526,448                       |      | 2,398,059 |   |
|                                                           |   |                            |      |   |   |
| **Loss before income tax benefit**                             |   | (367,607                        | )         | (232,816 | ) |
| Income tax benefit                                             |   | —                          |      | — |   |
|                                                           |   |                            |      |   |   |
| **Net loss**                                                   |   | $                               | (367,607  | ) | $ | (232,816 | ) |
|                                                           |   |                            |      |   |   |
| **Net loss per common share**                                  |   |                            |      |   |   |
| Basic and diluted loss per share of comon  stock               |   | $                               | (0.66     | ) | $ | (0.47 | ) |

 

See Notes to Consolidated Financial Statements

 

45

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

### **CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**Years Ended June 30, 2004 and 2003**

 
|                          |   | **Comprehensive  Income  (Loss)** |      | **Common  Stock  Par Value** |   | **Additional  Paid-In  Capital** |   | **Accumulated  Deficit** |     | **Unearned  Stock  Compensation** |       | **Accumulated  Other  Comprehensive  Income (loss)** |   | **Total** |     |
|-------------------------------|--------|-----------------------------------|-----------|------------------------------|--------|----------------------------------|--------|--------------------------|----------|-----------------------------------|------------|------------------------------------------------------|--------|-----------|----------|
| Balance, June 30, 2002        |   |                              |      | 4,795                        |   | 4,158,504                        |   | (2,280,359               | )        | (12,004                           | )          | 52,728                                               |   | 1,923,664 |     |
|                          |   |                              |      |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |
| Comprehensive income:         |   |                              |      |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |
| Net income                    |   | $                                 | (232,816  | )                            | — |                             | — |                     | (232,816 | )                                 | —     |                                                 | — |      | (232,816 | ) |
|                          |   |                              |      |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |
| Unrealized loss on securities |   | (713                              | )         | —                       |   | —                           |   | —                   |     | —                            |       | (713                                                 | )      | (713      | )        |
|                          |   | $                                 | (233,529) |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |   |
| Restricted stock earned       |   |                              |      |                         |   |                             |   |                     |     | 3,999                             |       |                                                 |   | 3,999     |     |
|                          |   |                              |      |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |
| Issuance of common stock      |   |                              |      | 400                          |   | 219,600                          |   | —                   |     | —                            |       | —                                               |   | 220,000   |     |
|                          |   |                              |      |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |
| Balance, June 30, 2003        |   |                              |      | 5,195                        |   | 4,378,104                        |   | (2,513,175               | )        | (8,005                            | )          | 52,015                                               |   | 1,914,134 |     |
|                          |   |                              |      |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |
| Comprehensive income:         |   |                              |      |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |
| Net income                    |   | $                                 | (367,607  | )                            | — |                             | — |                     | (367,607 | )                                 | —     |                                                 | — |      | (367,607 | ) |
|                          |   |                              |      |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |
| Unrealized loss on securities |   | (102,116                          | )         | —                       |   | —                           |   | —                   |     | —                            |       | (102,116                                             | )      | (102,116  | )        |
|                          |   | $                                 | (469,723) |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |   |
| Restricted stock earned       |   |                              |      |                         |   |                             |   |                     |     | 4,000                             |       |                                                 |   | 4,000     |     |
|                          |   |                              |      |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |
| Issuance of common stock      |   |                              |      | 690                          |   | 368,810                          |   | —                   |     | —                            |       | —                                               |   | 369,500   |     |
|                          |   |                              |      |                         |   |                             |   |                     |     |                              |       |                                                 |   |      |     |
| Balance, June 30, 2004        |   |                              |      | $                            | 5,885  |                             | $      | 4,746,914                |     | $                                 | (2,880,782 | )                                                    | $      | (4,005    | )        | $ | (50,101 | ) | $ | 1,817,911 |   |
|                               |        |                                   |           |                              |        |                                  |        |                          |          |                                   |            |                                                      |        |           |          |  |  |  |  |  |  |  |

 

### **See Notes to Consolidated Financial Statements**

 

46

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**NORTHERN STARFINANCIAL, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
|                                                                                 |   | **June 30** |      |
|--------------------------------------------------------------------------------------|--------|-------------|-----------|
|                                                                                 |   | **2004**    |      | **2003** |   |
| Cash flows from operating activities:                                                |   |        |      |   |   |
| RECONCILIATION OF NET LOSS TO NET CASH  PROVIDED BY (USED IN) OPERATING ACTIVITIES   |   |        |      |   |   |
| Net income (loss)                                                                    |   | (367,607    | )         | (232,816 | ) |
| Adjustments:                                                                         |   |        |      |   |   |
| Depreciation                                                                         |   | 96,756      |      | 89,676 |   |
| Provision for loan losses                                                            |   | 168,272     |      | 373,937 |   |
| Increase in value of trading securities                                              |   | (17,999     | )         | — |   |
| Accretion and (amortization) of premiums  and discounts, net                         |   | 29,234      |      | 14,356 |   |
| Stock compensation earned                                                            |   | 4,000       |      | 3,999 |   |
| Gain on sale of investments                                                          |   | (6,296      | )         | (3,504 | ) |
| Deferred loan fees                                                                   |   | 54,361      |      | (71,708 | ) |
| Originations of loans held for sale                                                  |   | (30,361,996 | )         | (59,812,028 | ) |
| Proceeds from sales of loans held for sale                                           |   | 31,699,739  |      | 58,402,589 |   |
| Other                                                                                |   | (53,659     | )         | 39,557 |   |
| Net cash provided by (used in) operating  activities                                 |   | 1,244,805   |      | (1,195,942 | ) |
|                                                                                 |   |        |      |   |   |
| Cash flows from investing activities:                                                |   |        |      |   |   |
| Purchases of available-for-sale securities                                           |   | (6,570,748  | )         | (4,256,624 | ) |
| Proceeds from maturities of  available-for-sale securities                           |   | 3,182,314   |      | 1,760,797 |   |
| Proceeds from sales of available-for-sale  securities                                |   | 3,498,412   |      | 5,969,220 |   |
| Proceeds from sales/maturities of trading  securities                                |   | 133,862     |      | — |   |
| Purchase of restricted stock                                                         |   | (18,000     | )         | (128,300 | ) |
| Net (increase) decrease in federal funds  sold                                       |   | (1,100,000  | )         | 555,000 |   |
| Loan originations and principal payments on  loans, net                              |   | 4,993,121   |      | (5,576,945 | ) |
| Purchase of property and equipment                                                   |   | (118,146    | )         | (57,136 | ) |
| Proceeds from sale of repossessed assets                                             |   | 63,080      |      | — |   |
| Net cash provided by (used in) investing  activities                                 |   | 4,063,895   |      | (1,733,988 | ) |
|                                                                                 |   |        |      |   |   |
| Cash flows from financing activities:                                                |   |        |      |   |   |
| Net (decrease) increase in non-interest  bearing demand and savings deposit accounts |   | (2,149,201  | )         | 1,524,165 |   |
| Net (decrease) increase in time deposits                                             |   | (2,877,968  | )         | 314,816 |   |
| Proceeds from other borrowings                                                       |   | 1,300,000   |      | 3,850,000 |   |
| Repayments of other borrowings                                                       |   | (2,575,000  | )         | (3,150,000 | ) |
| Proceeds from issuance of convertible  subordinated notes                            |   | 300,000     |      | 400,000 |   |
| Repayment of convertible subordinated notes                                          |   | (100,000    | )         | (200,000 | ) |
| Proceeds from sale of common stock                                                   |   | 369,500     |      | 220,000 |   |
| Net cash (used in) provided by financing  activities                                 |   | (5,732,669  | )         | 2,958,981 |   |
| Net (decrease) increase in cash                                                      |   | (423,969    | )         | 29,051 |   |
| Cash and cash equivalents at beginning of  year                                      |   | 2,377,132   |      | 2,348,081 |   |
| Cash and cash equivalents at end of year                                             |   | $           | 1,953,163 |   | $ | 2,377,132 |   |
|                                                                                 |   |        |      |   |   |
| Supplemental disclosure of cash flow  information:                                   |   |        |      |   |   |
| Cash paid for interest                                                               |   | $           | 1,189,173 |   | $ | 1,513,535 |   |
|                                                                                 |   |        |      |   |   |
| Non-cash investing and financing  activities:                                        |   |        |      |   |   |
| Investments acquired in settlement of loan                                           |   | $           | 154,548   |   | $ | 115,862 |   |
|                                                                                 |   |        |      |   |   |
| Loans transferred to repossessed assets                                              |   | $           | 95,336    |   | $ | — |   |

 

See Notes to Consolidated Financial Statements

 

47

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## **NORTHERNSTAR FINANCIAL, INC. AND SUBSIDIARY**

#### **NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

#### ** **

## **Note 1.**                                                          Summary of Significant AccountingPolicies

## ** **

The followingsummarizes the significant accounting policies Northern Star Financial, Inc.(the Company) follows in presenting its financial statements.

 

*Principles of Consolidation*– The consolidated financial statements include the accounts of the Company andits wholly owned subsidiary, Northern Star Bank (the Bank).  All significant intercompany transactionsand balances are eliminated in consolidation.

 

*Nature of business –*****The Company is a bank holding companywhose subsidiary provides financial services. The Bank’s business is that of a financial intermediary and consistsprimarily of attracting deposits from the general public and using suchdeposits, together with borrowings and other funds, to make secured andunsecured loans to business and professional concerns and mortgage loanssecured by residential real estate and other consumer loans.  At June 30, 2004 and 2003, the Bank operatedone retail banking office in Mankato, Minnesota and a full service branchoffice in St. Cloud, Minnesota. The Bank is subject to significant competitionfrom other financial institutions, and is also subject to regulation by certainfederal and state agencies and undergoes periodic examinations by thoseregulatory authorities.

 

*Use of estimates -*In preparing the consolidated financial statements, management is required tomake estimates and assumptions that affect the reported amounts of assets andliabilities as of the date of the statement of financial condition, and incomeand expenses for the period.  Actualresults could differ from those estimates. Material estimates that are particularly susceptible to significantchange are those related to the determination of the allowance for losses onloans, the valuation of real estate acquired in connection with foreclosures orin satisfaction of loans, and the valuation allowance for deferred taxes.  In connection with the determination of theallowance for losses on loans and foreclosed real estate, management obtainsindependent appraisals for significant properties.

 

Whilemanagement uses available information to recognize losses on loans andforeclosed assets, future additions to the allowance may be necessary based onchanges in local economic conditions. In addition, regulatory agencies, as an integral part of theirexamination process, periodically review the Bank’s allowance for losses onloans and foreclosed real estate.  Suchagencies may require the Bank to recognize additions to the allowance based ontheir judgment about information available to them at the time of theirexamination.

 

*Cash equivalents -*****For purposes of reporting cash flows, cashincludes cash on hand and non-interest bearing balances due from banks.

 

*Securities –*Securitiesclassified as available-for-sale are those debt securities that the Companyintends to hold for an indefinite period of time, but not necessarily tomaturity.

 

48

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Any decisionto sell a security classified as available-for-sale would be based on variousfactors, including significant movements in interest rates, changes in thematurity mix of the Company’s assets and liabilities, liquidity needs,regulatory capital considerations, and other similar factors.  Securities available for sale are carried atfair value.  Unrealized gains or losses,net of the related deferred tax effect, are reported as a separate component ofother comprehensive income.  Realizedgains or losses, determined on the basis of the cost of specific securities sold,are included in earnings.

 

Marketablesecurities that are acquired and held principally for the purpose of sellingthem in the near term are classified as trading securities and are reported atfair value, with unrealized gains and losses recognized in earnings.

 

Premium anddiscounts on all investment securities are accreted (deducted) and amortized(added), respectively, to interest income on the straight-line and interestmethods over the period of the maturity of the related security.

 

*RestrictedStock -*The Bank, as a member of the Federal Home Loan BankSystem, maintains an investment in capital stock of the Federal Home Loan Bankof Des Moines.      In addition the Bankmaintains an investment of capital stock of the United Bankers Bank.  Because no ready market exists for thesestocks, and there is no quoted market value, the Bank’s investment in thesestocks are carried at cost.

 

*Loans Held for Sale*– Mortgage loans originated and intended for sale in the secondary market arecarried at the lower of cost or estimated market value in the aggregate.  Net unrealized losses are recognized througha valuation allowance by charges to income. Gains or losses on the sale of loans are recorded in non-interestincome, based on the net proceeds received and the recorded investment in theloan.

 

*Loans Receivable* –Loans receivable that management has the intent and ability to hold for theforeseeable future or until maturity or pay-off are reported at theiroutstanding principal balance adjusted for any charge-off, the allowance ofloan and lease losses, and any deferred fees or costs on originated loans andunamortized premiums or discounts on purchased loans.  Discounts and premiums on purchased residential real estate loansare amortized to income using the interest method over the remaining period tocontractual maturity, adjusted for anticipated prepayments.  Discounts and premiums on purchased consumerloans are recognized over the expected lives of the loans using the level yieldmethod.

 

A loan is impairedwhen it is probable the Bank will be unable to collect all principal andinterest payments due in accordance with the terms of the loan agreement.  Impaired loans are measured based on thepresent value of expected future cash flows or, alternatively, the observablemarket price or the fair value of the collateral if the loan is collateraldependent.  The amount of impairment, ifany, and any subsequent changes are included in the allowance for loan andlease losses.

 

49

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The allowancefor loan and lease losses was established by a charge to income based onmanagement’s evaluation of the known and inherent risks in the loan portfolio,adverse situations that may affect the borrower’s ability to repay, theestimated value of any underlying collateral, and current economic conditions.While management uses the best information available to makes its evaluation,future adjustments to the allowance may be necessary if there are significantchanges in economic conditions.

 

Uncollectibleinterest on loans contractually past due for three months is charged off or anallowance is established based on management’s periodic evaluation.  The allowance is established by a charge tointerest income equal to all interest previously accrued and income issubsequently recognized only to the extent cash payments are received or until,in management’s judgment, the borrower’s ability to make periodic interest andprincipal payments returns to normal, in which case the loan is returned toaccrual status.

 

Loanorigination fees and certain direct origination costs are capitalized with thenet fee or cost recognized as an adjustment to interest income using theinterest method.

 

*Premises and Equipment*–Leasehold improvements, furniture and equipment are carried at the lower ofcost less accumulated depreciation or fair market value.  Depreciation is computed by thestraight-line method over the estimated useful lives of the assets, which rangefrom three to seven years on furniture and equipment and five to twenty yearson leasehold improvements.

 

*Advertising* – TheCompany expenses all advertising costs as incurred. Advertising costs of$59,111 and $52,562 are included in other non-interest expense for the yearsended June 30, 2004 and 2003, respectively.

 

*Income Taxes –*Deferred income taxes are recognized for the tax consequences of temporarydifferences by applying enacted statutory tax rates applicable to future yearsto differences between the financial statement carrying amounts and the taxbasis of existing assets and liabilities. The effect on deferred taxes of a change in tax rates is recognized inincome in the period that includes the enactment date.  Deferred tax assets are reduced by avaluation allowance if, based on the weight of available evidence, it is morelikely than not that some portion or all of the benefits will not berealized.  The effect of a change in thebeginning-of-the-year balance of a valuation allowance that results from achange in judgment about the realizability of deferred tax assets is includedin income.

 

The Company filesconsolidated income tax returns with the Bank and they have entered into a taxsharing agreement which provides that the Bank will pay to the Company, orreceive a refund from the Company, as if the Bank portion of income taxliability or benefit was separately determined based on the Bank’s taxableincome or loss.

 

*Salary Reduction – SIMPLE IRA plan –*TheBank provides a salary reduction plan, which covers substantially all of theBank’s employees who are eligible as to age and length of service.  A participant may elect to makecontributions of up to the maximum

 

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amounteligible by law.  The Bank makescontributions of 2 percent of each participant’s compensation and complies withthe requirements of the plan agreement.

 

*Earnings (Loss) Per Share –*Basic income (loss) per share amounts are computed by dividing net income(loss) by weighted average number of common shares outstanding.  Diluted income (loss) per share amounts arecomputed by dividing net income (loss), adjusted for the effect of assumedconversions, by the weighted average number of common shares outstanding plusdilutive potential common shares calculated for stock options outstanding usingthe treasury method.

 

Nonvestedrestricted stock compensation is to be considered outstanding as of itsissuance date for computing diluted EPS even though it is contingent uponfuture time-related vesting and is not included in basic EPS until thetime-based vesting restriction has lapsed.

 

*Stock Based Compensation*- At June 30, 2004, the Company has a stock-based employee compensation plan,which is described more fully in Note 10. The Company accounts for the plan under the recognition and measurementprinciples of APB Opinion No. 25, Accounting for Stock Issued**to Employees and relatedInterpretations.  No stock basedemployee compensation cost is reflected in net income (loss), as all optionsgranted under those plans had an exercise price equal to the market value ofthe underlying common stock on the date of grant.  The following table illustrates the effect on net income (loss)and earnings (loss) per share if the Company had applied the fair valuerecognition provisions of FASB Statement No. 148, Accounting for Stock-BasedCompensation-Transition and Disclosure, to stock-based employee compensation.

 
|                                                                                                                                          |   | **Year Ended  June 30** |     |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|----------|
|                                                                                                                                          |   | **2004**                |     | **2003** |   |
| Net income (loss), as reported                                                                                                                |   | $                       | (367,607 | ) | $ | (232,816 | ) |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (6,904                  | )        | (23,694 | ) |
|                                                                                                                                          |   |                    |     |   |   |
| Pro forma net income (loss)                                                                                                                   |   | $                       | (374,511 | ) | $ | (256,510 | ) |
|                                                                                                                                          |   |                    |     |   |   |
| Earnings (loss) per share:                                                                                                                    |   |                    |     |   |   |
| Basic—as reported                                                                                                                        |   | $                       | (0.66    | ) | $ | (0.47 | ) |
| Basic—pro forma                                                                                                                          |   | $                       | (0.67    | ) | $ | (0.52 | ) |
|                                                                                                                                          |   |                    |     |   |   |
| Stock based compensation included in net  loss as reported (see Note 11)                                                                      |   | $                       | 4,000    |   | $ | 3,999 |   |

 

*Fair Values of Financial Instruments -*SFAS No. 107, Disclosure about Fair Value of Financial Instruments, requiresdisclosure of fair value information about financial instruments, whether ornot recognized in the statement of financial condition.  In cases where quoted market prices are notavailable, fair values are based on estimates using

 

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present valueor other valuation techniques.  Thosetechniques are significantly affected by the assumptions used, including thediscount rate and estimates of future cash flows.  In that regard, the derived fair value estimated cannot besubstantiated by comparison to independent markets and, in many cases, couldnot be realized in immediate settlement of the instruments.  SFAS No. 107 excludes certain financialinstruments and all nonfinancial assets and liabilities from its disclosurerequirements.  Accordingly, theaggregate fair value amounts presented to do not represent the underlying valueof the Company.

 

The followingmethods and assumptions were used by the Company in estimating its fair valuedisclosures, presented in Note 15, for financial instruments:

 

*Cash and cash equivalents:*The carrying amounts reported in the statements of financial condition for cashand cash equivalents equal their fair values.

 

*Debt and equity securities:*  Fair values for debt and equity securitiesare based on quoted market prices, where available.  If quoted market prices are not available, fair values are basedon quoted market prices of comparable instruments.

 

*FHLB and UBB stock:*The carrying amount of FHLB and UBB stock approximates fair value.

 

*Loans held for sale*:  Fair values are based on quoted marketprices of similar loans sold on the secondary market.  Net unrealized losses are recognized through a valuationallowance by charges to income.  Gainsor losses on the sale of loans are recorded in non-interest income, based onthe net proceeds received and the recorded investment in the loan.

 

*Loans:* Forvariable-rate loans that reprice frequently with no significant change incredit risk, fair values are based on carrying amounts.  The fair values for other loans (forexample, fixed rate commercial real estate, rental property mortgage loans, andcommercial and industrial loans) are estimated using discounted cash flowanalyses, based on interest rates currently being offered for loans withsimilar terms to borrowers of similar credit quality giving consideration toestimated prepayment and credit loss factors. Loan fair value estimates include judgments regarding future expectedloss experience and risk characteristics. Fair values for impaired loans are estimated using discounted cash flowanalysis or underlying collateral values, where applicable.

 

*Accrued interest receivable*:  The carrying amount of accrued interestreceivable approximates fair value.

 

*Deposits*: The fairvalues disclosed for demand deposits are, by definition, equal to the amountpayable on demand at the reporting date (that is, their carrying amounts).  Fair values for time deposits are estimatedusing a discounted cash flow calculation that applies interest rates currentlyoffered on certificates to a

 

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schedule ofaggregated expected monthly maturities on time deposits.  The carrying amount of accrued interestpayable approximates fair value.

 

*Notes payable, other borrowings, andconvertible subordinated notes payable: *The fair values of the Company’s long-termborrowings (other than deposits) are estimated using discounted cash flowanalyses, based on the Company’s current incremental borrowing rates forsimilar types of borrowing arrangements.

 

*Accrued interest payable*:The carrying amount of accrued interest payable approximates fair value.

 

*Loan commitments*:Commitments to extend credit were evaluated and fair value was estimated usingthe fees currently charged to enter into similar agreements, taking intoaccount the remaining terms of the agreements and the present creditworthinessof the counterparties.  For fixed-rateloan commitments, fair value also considers the difference between currentlevels of interest rates and the committed rates. The carrying value and fairvalue of commitments to extend credit are not considered material fordisclosure.

 

*Recent Accounting Developments -*InJanuary 2003, the Financial Accounting Standards Board (“FASB”) issued FIN No.46, Consolidation of Variable Interest Entities, an interpretation ofAccounting Research Bulletin No. 51. FIN No. 46, which was revised in December2003, requires that variable interest entities be consolidated by a company ifthat company is subject to a majority of expected loss from the variableinterest entity’s activities or is entitled to receive a majority of theentity’s expected residual returns or both. FIN No. 46 also requiresdisclosures about variable interest entities that companies are not required toconsolidate but in which a company has a significant variable interest. Theconsolidation requirements of FIN No. 46 applied immediately to variableinterest entities created after January 31, 2003. The consolidationrequirements applied to entities established prior to January 31, 2003 in thefirst fiscal year or interim period beginning after December 15, 2003. TheCompany adopted the consolidation requirements of FIN No. 46 effective December31, 2003. The adoption did not have a material impact on its results ofoperations, financial position or cash flows.

 

In April 2003, the FASB issuedSFAS No. 149, Amendment of Statement 133 on Derivative Instruments and HedgingActivities, which amends and clarifies accounting for derivative instruments,including certain derivative instruments embedded in other contracts, and forhedging activities under SFAS No. 133, Accounting for Derivative Instrumentsand Hedging Activities. SFAS No. 149 is effective for contracts entered into ormodified after June 30, 2003 and for hedging relationships designated afterJune 30, 2003. The provisions of SFAS No. 149 that relate to SFAS No. 133Implementation Issues that have been effective for fiscal quarters that beganprior to June 15, 2003 should continue to be applied in accordance with theirrespective effective dates. Specifically, this Statement (1) clarifies underwhat circumstances a contract with an initial net investment meets thecharacteristic of a derivative, (2) clarifies when a derivative contains afinancing component, (3) amends the definition of an underlying instrument toconform it to language used in FIN No. 45, and (4) amends certain otherexisting pronouncements. Such changes will result in more consistent reportingof contracts as either

 

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derivatives or hybridinstruments. The adoption of this standard did not have material impact on theCompany’s financial position, results of operations, or cash flows.

 

In May 2003, the FASB issuedSFAS No. 150, Accounting for Certain Financial Instruments with Characteristicsof both Liabilities and Equity. This Statement establishes standards for how anissuer classifies and measures certain financial instruments with characteristicsof both liabilities and equity. It requires that an issuer classify a financialinstrument that is within its scope as a liability (or an asset in somecircumstances). Many of these instruments were previously classified as equity.This Statement is effective for financial instruments entered into or modifiedafter May 31, 2003, and otherwise is effective for public companies at thebeginning of the first interim period beginning after June 15, 2003. Theadoption of this standard did not have a material impact on the Company’sfinancial position, results of operations, or cash flows.

 

In December 2003, theAccounting Standards Executive Committee of the AICPA issued Statement ofPosition No. 03-3 (“SOP 03-3”), Accounting for Certain Loans or Debt SecuritiesAcquired in a Transfer. SOP 03-3 addresses the accounting for differencesbetween contractual cash flows and the cash flows expected to be collected frompurchased loans or debt securities if those differences are attributable, inpart, to credit quality. SOP 03-3 requires purchased loans and debt securitiesto be recorded initially at fair value based on the present value of the cashflows expected to be collected with no carryover of any valuation allowancepreviously recognized by the seller. Interest income should be recognized basedon the effective yield from the cash flows expected to be collected. To theextent that the purchased loans or debt securities experience subsequentdeterioration in credit quality, a valuation allowance would be established forany additional cash flows that are not expected to be received. However, ifmore cash flows subsequently are expected to be received than originallyestimated, the effective yield would be adjusted on a prospective basis. SOP03-3 will be effective for loans and debt securities acquired after December31, 2004. Management does not expect the adoption of this statement to have amaterial impact on the Company’s financial position, results of operations, orcash flows.

 

In March 2004, the Securitiesand Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 105,“Application of Accounting Principles to Loan Commitments”. This SAB summarizesthe views of the staff regarding the application of accounting principlesgenerally accepted in the United States of America to loan commitmentsaccounted for as derivative instruments. The provisions of this SAB wereeffective after March 31, 2004. The adoption of this SAB did not have amaterial impact on the consolidated financial statements of the Company.

 

## **Note2. Securities – Available for sale and held for trading**

 

The amortizedcosts and approximate fair values of debt and equity securities are summarizedas follows:

 
| **June 30, 2004:**                  |   | **Amortized  Cost** |      | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |    |
|-------------------------------------|--------|---------------------|-----------|------------------------------|--------|-------------------------------|--------|-----------------|---------|
| Debt securities available for sale: |   |                |      |                         |   |                          |   |            |    |
| US agency obligations               |   | $                   | 1,986,562 |                         | $      | —                        |   | $               | (42,086 | ) | $ | 1,944,476 |   |
| Mortgage-backed securities          |   | 3,906,915           |      | 6,437                        |   | (47,850                       | )      | 3,865,502       |    |
| Corporate bonds                     |   | —              |      | —                       |   | —                        |   | —          |    |
|                                |   | 5,893,477           |      | 6,437                        |   | (89,936                       | )      | 5,809,978       |    |
| Securities held for trading         |   |                |      |                         |   |                          |   |            |    |
| Securities held for trading         |   | —              |      | —                       |   | —                        |   | —          |    |
| Total                               |   | $                   | 5,893,477 |                         | $      | 6,437                         |   | $               | (89,936 | ) | $ | 5,809,978 |   |

 

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| **June 30, 2003:**                  |   | **Amortized  Cost** |      | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   |
|-------------------------------------|--------|---------------------|-----------|------------------------------|--------|-------------------------------|--------|-----------------|--------|
|                                |   |                |      |                         |   |                          |   |            |   |
| Debt securities available for sale: |   |                |      |                         |   |                          |   |            |   |
| US agency obligations               |   | $                   | 2,249,496 |                         | $      | 17,243                        |   | $               | — |   | $ | 2,266,739 |   |
| Mortgage-backed securities          |   | 3,275,935           |      | 48,489                       |   | (5,994                        | )      | 3,318,430       |   |
| Corporate bonds                     |   | 500,962             |      | 26,957                       |   | —                        |   | 527,919         |   |
|                                |   | 6,026,393           |      | 92,689                       |   | (5,994                        | )      | 6,113,088       |   |
| Securities held for trading         |   |                |      |                         |   |                          |   |            |   |
| Securities held for trading         |   | 115,862             |      | —                       |   | —                        |   | 115,862         |   |
| Total                               |   | $                   | 6,142,255 |                         | $      | 92,689                        |   | $               | (5,994 | ) | $ | 6,228,050 |   |

 

Proceeds from the sale of securities for the year ended June 30, 2004and 2003 were $3,498,412 and $5,969,220 respectively.  Net gains for the year ended June 30, 2004 and 2003 of $24,296and $3,504, respectively, were realized on these sales.

 

The amortized cost and estimated market value of debt securities atJune 30, 2004, by contractual maturity, are shown below.

 
|                       |   | **June 30,  2004**  |      |
|----------------------------|--------|---------------------|-----------|
|                       |   | **Amortized  Cost** |      | **Estimated  Fair Value** |   |
| Due in one year or less    |   | $                   | —    |   | $ | — |   |
| Due from one to five years |   | 996,320             |      | 974,476 |   |
| Due from five to ten years |   | 990,242             |      | 970,000 |   |
| Due after ten years        |   | —              |      | — |   |
|                       |   | 1,986,562           |      | 1,944,476 |   |
|                       |   |                |      |   |   |
| Mortgage-backed securities |   | 3,906,915           |      | 3,865,502 |   |
|                       |   | $                   | 5,893,477 |   | $ | 5,809,978 |   |

 

 

## **Anticipated maturities on mortgage-backedsecurities are not readily determinable since they may be prepaid withoutpenalty.**

## ** **

## **Pledged securities:  Available for sale securities with anapproximate carrying value of $768,000 and $2,800,000 at June 30, 2004 and2003, respectively, were pledged to secure borrowings and for other purposes asrequired or permitted by law.**

## ** **

Changes in theunrealized gain (loss) on available for sale securities:

 
|                                                                       |   | **Years  Ended June 30** |    |
|----------------------------------------------------------------------------|--------|--------------------------|---------|
|                                                                       |   | **2004**                 |    | **2003** |   |
| Balance, beginning                                                         |   | $                        | 52,015  |   | $ | 52,728 |   |
| Unrealized gain during the year                                            |   | 7,907                    |    | 3,033 |   |
| Less reclassification adjustments for gains  realized in net income (loss) |   | (41,946                  | )       | (4,220 | ) |
| Deferred tax effect related to unrealized  gain                            |   | (68,077                  | )       | 474 |   |
| Balance, ending                                                            |   | $                        | (50,101 | ) | $ | 52,015 |   |

 

55

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## **Note3.**          Loans Receivable

## ** **

Loans receivable consist of the following:

 
|                           |   | **June 30,  2004** |       | **June 30,  2003** |   |
|--------------------------------|--------|--------------------|------------|--------------------|--------|
|                           |   | **Amount**         |       | **% of Total**     |   | **Amount** |   | **% of Total** |   |
| Commercial & agricultural  |   | $                  | 6,176,151  |               | 18.28  | % | $ | 6,979,307 |   | 17.55 | % |
| Real estate - construction     |   | 3,852,695          |       | 11.40              | %      | 4,433,072 |   | 11.15 | % |
| Real estate - mortgages        |   | 17,872,513         |       | 52.89              | %      | 18,504,208 |   | 46.52 | % |
| Consumer loans                 |   | 5,854,728          |       | 17.33              | %      | 9,821,027 |   | 24.69 | % |
| Lease financing                |   | 32,596             |       | 0.10               | %      | 35,673 |   | 0.09 | % |
| Total loans                    |   | $                  | 33,788,683 |               | 100.00 | % | $ | 39,773,287 |   | 100.00 | % |
| Net deferred loan fees/(costs) |   | 59,956             |       |               |   | 108,422 |   |   |   |
| Less: allowance for loan loss  |   | (447,467           | )          |               |   | (1,029,581 | ) |   |   |
| Total net loans                |   | $                  | 33,401,172 |               |   |   | $ | 38,852,128 |   |   |   |

 

A summary ofthe activity in the allowance for loan and lease losses is as follows:

 
|                                |   | **Years  Ended June 30** |      |
|-------------------------------------|--------|--------------------------|-----------|
|                                |   | **2004**                 |      | **2003** |   |
| Balance,   beginning of period |   | $                        | 1,029,581 |   | $ | 661,170 |   |
| Charge-offs                         |   | (787,863                 | )         | (14,680 | ) |
| Recoveries                          |   | 37,477                   |      | 9,154 |   |
| Provision charged to operations     |   | 168,272                  |      | 373,937 |   |
| Balance, end of period              |   | $                        | 447,467   |   | $ | 1,029,581 |   |

 

In the ordinary course of business, the Bank has granted loans tocertain executive officers, directors and their related interest.  Loan activity in these accounts for the yearended June 30, is as follows:

 
|                |   | **2004**  |      | **2003**  |   |
|---------------------|--------|-----------|-----------|-----------|--------|
| Beginning balance   |   | $         | 3,288,617 |      | $      | 3,957,000 |   |
| New loans           |   | 1,146,929 |      | 5,769,954 |   |
| Participations sold |   | 844,087   |      | 4,691,500 |   |
| Less: Repayments    |   | 550,388   |      | 1,746,837 |   |
|                |   |      |      |      |   |
| Ending balance      |   | $         | 3,041,071 |      | $      | 3,288,617 |   |

 

Interest income from related parties was approximately $175,000 and$250,000 as of June 30, 2004 and 2003, respectively.

 

*Impaired loans:*** **Informationabout impaired loans as of and for the year ended June 30, 2004 is as follows:

 
| Loans receivable at year end, all of which  have related allowance for credit loss |   | $ | 720,774   |   |
|------------------------------------------------------------------------------------|--------|---|-----------|--------|
| Average impaired loans (based on quarter  end balances)                            |   | $ | 1,709,995 |   |
| Related allowance for credit losses at year  end                                   |   | $ | 224,942   |   |
| Interest income recognized on impaired  loans                                      |   | $ | 89,147    |   |

 

 

56

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Information about impaired loans as of andfor the year ended June 30, 2003 is as follows:

 
| Loans receivable at year end, all of which  have related allowance for credit loss |   | $ | 3,111,421 |   |
|------------------------------------------------------------------------------------|--------|---|-----------|--------|
| Average impaired loans (based on quarter  end balances)                            |   | $ | 2,333,336 |   |
| Related allowance for credit losses at year  end                                   |   | $ | 806,954   |   |
| Interest income recognized on impaired  loans                                      |   | $ | 29,584    |   |

 

Loans receivable on non-accrual status for which interest income hasnot been recognized were $193,215 and $1,844,911 at June 30, 2004 and 2003,respectively.  The interest income notrecognized on these loans was $42,015 and $145,830, respectively.

 

## **Note4.**          Accrued Interest Receivable

## ** **

Accrued interest receivable is summarized as follows:

 
|                  |   | **June 30** |    |
|-----------------------|--------|-------------|---------|
|                  |   | **2004**    |    | **2003** |   |
| Investment securities |   | $           | 37,314  |   | $ | 50,096 |   |
| Loans receivable      |   | 177,162     |    | 232,320 |   |
|                  |   |        |    |   |   |
| Total                 |   | $           | 214,476 |   | $ | 282,416 |   |

 

## **Note5.**          Premises and Equipment

## ** **

Premises and equipment consists of thefollowing:

 
|                          |   | **June 30** |    |
|-------------------------------|--------|-------------|---------|
|                          |   | **2004**    |    | **2003** |   |
| Leashold improvements         |   | $           | 282,868 |   | $ | 270,189 |   |
| Furniture and equipment       |   | 661,729     |    | 567,926 |   |
| Total                         |   | 944,597     |    | 838,115 |   |
|                          |   |        |    |   |   |
| Less accumulated depreciation |   | 419,810     |    | 334,718 |   |
|                          |   |        |    |   |   |
| Premises and equipment, net   |   | $           | 524,787 |   | $ | 503,397 |   |

 

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**Note6.****          Deposits**

 
|                              |   | **June 30** |       |
|-----------------------------------|--------|-------------|------------|
|                              |   | **2004**    |       | **2003** |   |
| Demand deposit                    |   | $           | 2,946,891  |   | $ | 5,090,364 |   |
| Now and money market              |   | 8,370,929   |       | 8,623,932 |   |
| Savings                           |   | 4,878,038   |       | 4,630,763 |   |
| Time accounts less than $100,000  |   | 15,567,016  |       | 18,021,479 |   |
| Time accounts of $100,000 or more |   | 4,638,667   |       | 5,062,172 |   |
| Total deposits                    |   | $           | 36,401,541 |   | $ | 41,428,710 |   |

 

The scheduled maturities of time deposits areas follows:

 
| Years ending June 30: |   |      |       |
|-----------------------|--------|-----------|------------|
| 2005                  |   | $         | 12,680,132 |   |
| 2006                  |   | 4,600,693 |       |
| 2007                  |   | 2,175,102 |       |
| 2008                  |   | 254,359   |       |
| 2009                  |   | 495,397   |       |
| Total                 |   | $         | 20,205,683 |   |

## ** **

## ** **

The amount of deposit accounts reclassified to the loan category was$2,009 and $27,348 as of June 30, 2004 and 2003, respectively.

 

Interest expense by category follows:

 
|                              |   | **June 30** |    |
|-----------------------------------|--------|-------------|---------|
|                              |   | **2004**    |    | **2003** |   |
| Demand deposit                    |   | $           | —  |   | $ | — |   |
| Now and money market              |   | 96,399      |    | 148,974 |   |
| Savings                           |   | 69,334      |    | 77,077 |   |
| Time accounts less than $100,000  |   | 512,937     |    | 719,918 |   |
| Time accounts of $100,000 or more |   | 161,120     |    | 184,447 |   |
| Total                             |   | $           | 839,790 |   | $ | 1,130,416 |   |

 

Deposits by related parties were approximately $4,665,000 and$6,617,000 as of June 30, 2004 and 2003, respectively.  Interest expense paid to related parties wasapproximately $98,000 and $208,000 as of June 30, 2004 and 2003, respectively.  Of the related party deposits, approximately$3,507,000 and $5,496,000 as of June 30, 2004 and 2003, respectively, were fromtwo individuals and their corresponding businesses.

 

## **Note7.**          Notes Payable and Other Borrowings

## ** **

Fixed-rate advances from the Federal Home Loan Bank of Des Moines(FHLB), interest payable monthly (1.44% to 5.36%), due at varying dates through2011, secured by securities with a carrying value of approximately $768,000 and$2,800,000, and residential real estate loans with a carrying value of$3,382,000 and $6,600,000 as of June 30, 2004 and 2003, respectively.  A $500,000 advance from the Federal HomeLoan Bank with a maturity date of October 2010 is callable quarterly.

 

A note payable to a bank, in the amount of $600,000 with an unpaidbalance of $550,000 and $600,000 at June 30, 2004 and 2003, respectively, hasinterest payable

 

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quarterly at avariable interest rate of Prime + 1.00% at June 30, 2004 and 2003, secured bycommon stock of Northern Star Bank, matures March 31, 2005.

 

In connection with the note payable to the bank, the Company hasagreed, among other things, to maintain certain financial ratios.  The agreement also has restrictions on thepayment of dividends and limits future borrowing by the Company.

 
|            |   | **June 30** |      |
|-----------------|--------|-------------|-----------|
|            |   | **2004**    |      | **2003** |   |
| FHLB borrowing  |   | $           | 4,150,000 |   | $ | 5,375,000 |   |
| Note payable    |   | 550,000     |      | 600,000 |   |
| Total borrowing |   | $           | 4,700,000 |   | $ | 5,975,000 |   |
|            |   |        |      |   |   |

 

At June 30, 2004, scheduled maturities, based on contractual maturitydates of the Company’s borrowings, including convertible subordinated notespayable were as follows:

 
| Years ending  June 30: |   |      |      |   |
|------------------------|--------|-----------|-----------|--------|
| 2005                   |   | $         | 3,850,000 |   |
| 2006                   |   | 350,000   |      |
| 2007                   |   | 1,100,000 |      |
| 2008                   |   | 500,000   |      |
| 2009                   |   | 100,000   |      |
| Thereafter             |   | 600,000   |      |
|                   |   | $         | 6,500,000 |   |

 

**Note8.****          ConvertibleSubordinated Notes Payable**

 

During fiscal 2004, the Company has completedtwo re-issuances of $100,000, unsecured convertible subordinated notes payableand one issuance of $100,000, unsecured convertible subordinated notepayable.  The holders of the notes havethe right to convert at any time prior to maturity all or any part of the notesinto shares of common stock of the Company at the conversion rate.  The conversion rate is adjustable if thenumber of outstanding shares changes.  Asummary of the convertible subordinated notes payable at June 30, 2004 follows:

 
|         |   | **Total  Authorized** |         | **Principal  Outstanding** |   | **Interest  Rate** |   | **Maturity  Date** |   | **Conversion  Rate  (per share)** |   | **Conversion  Shares** |   |
|--------------|--------|-----------------------|--------------|----------------------------|--------|--------------------|--------|--------------------|--------|-----------------------------------|--------|------------------------|--------|
| First Issue  |   | $                     | 1,000,000.00 |                       | $      | 1,000,000.00       |   | 8.00               | %      | July thru August 2004             |   | $                      | 10.50  |   | 95,238 |   |
| Second Issue |   | 500,000.00            |         | 500,000.00                 |   | 7.00               | %      | June 2005          |   | $                                 | 9.00   |                   | 55,555 |   |
| Third Issue  |   | 100,000.00            |         | —                     |   | 7.00               | %      | December 2003      |   | $                                 | 8.00   |                   | — |   |
| Fourth Issue |   | 100,000.00            |         | 100,000.00                 |   | 6.50               | %      | December 2004      |   | $                                 | 9.00   |                   | 11,111 |   |
| Fifth Issue  |   | 100,000.00            |         | 100,000.00                 |   | 6.00               | %      | April 2006         |   | $                                 | 6.00   |                   | 16,667 |   |
| Sixth Issue  |   | 100,000.00            |         | 100,000.00                 |   | 6.00               | %      | December 2004      |   | $                                 | 6.00   |                   | 16,666 |   |
| Total        |   | $                     | 1,900,000.00 |                       | $      | 1,800,000.00       |   |               |   |                              |   |                   |   | 195,237 |   |

 

Convertiblesubordinated notes payable totaling $1,050,000 and $850,000 were issued torelated parties as of June 30, 2004 and 2003, respectively. Interest expensepaid to related parties was approximately $65,400 and $61,000 as of June 30,2004 and 2003, respectively.

 

59

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## **Note9.**          Income Taxes

 

The Company and the Bank incurred no current tax expense becausetaxable income was offset by net operating loss carry forwards.  A reconciliation of income taxes computed atthe federal statutory income tax rate to total income taxes is as follows:

 
|                                                |   | **Years  Ended June 30** |     |
|-----------------------------------------------------|--------|--------------------------|----------|
|                                                |   | **2004**                 |     | **2003** |   |
|                                                |   |                     |     |   |   |
| Computed “expected” tax expense (benefit) |   | $                        | (125,000 | ) | $ | (81,000 | ) |
|                                                |   |                     |     |   |   |
| Increase (decrease) in income tax resulting  from:  |   |                     |     |   |   |
| State income taxes, net of federal tax  benefit     |   | (26,000                  | )        | (15,000 | ) |
| Other                                               |   | (68,000                  | )        | 36,000 |   |
| Change in valuation allowance                       |   | 219,000                  |     | 60,000 |   |
|                                                |   |                     |     |   |   |
| Net income tax expense (benefit)                    |   | $                        | —   |   | $ | — |   |

 

Temporary differences between financial statement carrying amounts andthe tax basis of assets and liabilities that create deferred tax assets andliabilities are as follows:

 
|                                              |   | **June 30** |    |
|---------------------------------------------------|--------|-------------|---------|
|                                              |   | **2004**    |    | **2003** |   |
| Deferred tax assets:                              |   |        |    |   |   |
| Loan loss allowance                               |   | $           | 181,000 |   | $ | 417,000 |   |
| Net operating loss carryover                      |   | 1,005,000   |    | 616,000 |   |
| Other                                             |   | 14,000      |    | 21,000 |   |
| Securities unrealized losses (net)                |   | 33,000      |    | — |   |
|                                              |   | 1,233,000   |    | 1,054,000 |   |
|                                              |   |        |    |   |   |
| Less: valuation allowance                         |   | (1,151,000  | )       | (932,000 | ) |
| Total deferred tax asset                          |   | 82,000      |    | 122,000 |   |
|                                              |   |        |    |   |   |
| Deferred tax liability:                           |   |        |    |   |   |
| Property and equipment                            |   | 44,000      |    | 32,000 |   |
| Unrealized gain on available for sale  securities |   | —      |    | 35,000 |   |
| Deferred loan fees and costs                      |   | 38,000      |    | 55,000 |   |
| Total deferred tax liabilities                    |   | 82,000      |    | 122,000 |   |
|                                              |   |        |    |   |   |
| Net deferred tax asset (liability)                |   | $           | —  |   | $ | — |   |

 

During the years ended June 30, 2004 and 2003, the Company increasedthe valuation allowance by $219,000 and $60,000, respectively.  Management reviews the estimate of thisvaluation account on a regular basis, and it is reasonably possible that itsestimate will change in the next year.

 

60

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At June 30, 2004, the Company has a cumulative net operating losscarryover for tax purposes of approximately $2,480,000 subject to a carryoverlimitation period ranging from 16 to 20 years.

 

## **Note10.**   Stock Options

## ** **

In August 1998, the Company adopted the 1998 Equity Incentive Plan (the“Plan”) and reserved 41,700 shares of common stock for issuance pursuant to thePlan to certain employees and directors of the Company and its subsidiary.  In addition, the Company granted to itsorganizing directors options to purchase an aggregate of 30,800 shares outsidethe Plan.  These plans provide for thegranting of incentive stock options as defined in Section 422 of the InternalRevenue Code as well as nonqualified stock options (collectively stockoptions).

 

In October 1999, the Company amended the Plan and reserved anadditional 75,000 shares of its common stock for issuance.  The options vest over a period ranging fromimmediate to 3 years and must be exercised within 10 years of grant date.

 

The following summarizes the stock optionactivity:

 
|             |   | **Shares  Available  for Grant** |   | **Options  Shares  Outstanding** |   | **Weighted  Average  Exercise Price** |   |
|------------------|--------|----------------------------------|--------|----------------------------------|--------|---------------------------------------|--------|
| At June 30, 2002 |   | 20,900                           |   | 126,600                          |   | $                                     | 9.19   |   |
|             |   |                             |   |                             |   |                                  |   |
| Granted          |   | (25,600                          | )      | 25,600                           |   | 5.57                                  |   |
|             |   |                             |   |                             |   |                                  |   |
| Shares cancelled |   | 9,000                            |   | (9,000                           | )      | (9.66                                 | )      |
|             |   |                             |   |                             |   |                                  |   |
| At June 30, 2003 |   | 4,300                            |   | 143,200                          |   | 8.51                                  |   |
|             |   |                             |   |                             |   |                                  |   |
| Granted          |   | (4,300                           | )      | 4,300                            |   | 5.50                                  |   |
|             |   |                             |   |                             |   |                                  |   |
| Shares cancelled |   | 3,700                            |   | (3,700                           | )      | 8.81                                  |   |
|             |   |                             |   |                             |   |                                  |   |
| At June 30, 2004 |   | 3,700                            |   | 143,800                          |   | $                                     | 8.52   |   |

 

A summary ofthe status of the stock options as of and for the year ended June 30, 2004 ispresented below:

 
|        |   | **Shares** |   | **Weighted  Avg.  Exercise Price** |   |
|-------------|--------|------------|--------|------------------------------------|--------|
| Granted     |   | 143,800    |   | $                                  | 8.52   |   |
| Outstanding |   | 143,800    |   | $                                  | 8.52   |   |
| Exercisable |   | 134,096    |   | $                                  | 8.74   |   |

 

61

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| **Stock options  Issued** |   | **Weighted  average  fair value** |   | **Weighed  average contractual  life of options outstanding** |   |
|---------------------------|--------|-----------------------------------|--------|---------------------------------------------------------------|--------|
| 1999                      |   | $                                 | 4.33   |                                                          | 4.3    |   |
| 2000                      |   | $                                 | 3.06   |                                                          | 5.4    |   |
| 2001                      |   | $                                 | 2.15   |                                                          | 6.4    |   |
| 2002                      |   | $                                 | 0.47   |                                                          | 7.4    |   |
| 2003                      |   | $                                 | 0.57   |                                                          | 8.4    |   |
| 2004                      |   | $                                 | 0.73   |                                                          | 9.8    |   |
| overall                   |   |                              |   | 6.2                                                           |   |

 

Statement of Financial Accounting Standards No. 123, Accounting forStock-Based Compensation (SFAS 123), provides for companies to recognizecompensation expense associated with stock-based compensation plans over theanticipated service period based on the fair value of the award on the date ofgrant.  However, SFAS 123 allowscompanies to continue to measure compensation costs prescribed by AccountingPrinciples Board Opinion No. 25, Accounting for Stock Issued to Employees (APB25).

 

The Company elected to follow APB 25 and related Interpretations inaccounting for its employee stock options. Under APB 25, the exercise price of the Company’s employee stock optionsequal the market price of the underlying stock on the date of grant, and,therefore, no compensation expense is recognized.

 

Proforma information regarding net income (loss) and earnings (loss)per share is required by SFAS No. 148 Accounting for Stock-BasedCompensation-Transition and Disclosure, and has been determined as if theCompany had accounted for its employee stock option under the fair value methodof that statement. Proforma net income (loss) and earnings (loss) per share forthe fiscal year end 2004 and 2003 follows:

 
|              |   | **Fiscal  2004** |     | **Fiscal  2003** |   |
|-------------------|--------|------------------|----------|------------------|--------|
| Net income (loss) |   |             |     |             |   |
| As reported       |   | $                | (367,607 | )                | $      | (232,816 | ) |
| Pro forma         |   | $                | (374,511 | )                | $      | (256,510 | ) |

 

Earnings (loss) per common share and common share equivalent

 
| As reported |   | (0.66 | ) | (0.47 | ) |
|-------------|--------|-------|---|-------|---|
| Pro forma   |   | (0.67 | ) | (0.52 | ) |

 

The above-disclosed pro forma effects of applying SFAS No. 123 tocompensation costs may not be representative of the effects on reported proforma net income (loss) for future years.

 

Thefair value for each option grant is estimated on the date of the grant usingthe Black Scholes Model.  The modelincorporates the following assumptions:

 
|                    |   | **Options  Issued** |   |
|-------------------------|--------|---------------------|--------|
|                    |   | **Fiscal  2004**    |   | **Fiscal  2003** |   |
| Risk-free interest rate |   | 4.62                | %      | 4.35 | % |
| Expected life           |   | 10 Yrs.             |   | 10 Yrs. |   |
| Expected volatility     |   | 65.00               | %      | 77.00 | % |
| Expected dividends      |   | None                |   | None |   |

 

62

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# **Note 11.**   EmployeeBenefits

# ** **

In December 1999, the Bank adopted a salary reduction plan (Simple IRA)which covers substantially all full time employees.  The cost to the Bank for this plan was approximately $15,600 and$14,000 for the years ended June 30, 2004, and 2003, respectively.

 

On December 22, 1999, the Company granted its Chief Executive Officer arestricted stock award of 2,000 shares of the Company’s common stock. Theshares are subject to a vesting period ranging from three to five years.  The unearned compensation, measured by thequoted price of the stock on the award date ($10 per share), is shown as aseparate reduction of the stockholders’ equity.  The unearned compensation will be accounted for as expense overthe vesting period. Unearned compensation and compensation expense was $4,005and $4,000 and $8,005 and $3,999 at June 30, 2004 and 2003, respectively.

 

# **Note 12.**   Commitments

# ** **

At June 30, 2004, the Bank was obliged under operating leases foroffice space and equipment.  The Bank’sSt. Cloud office space is leased from a lessor entity in which a Companystockholder has a significant interest. Minimum lease payments under the operating leases are as follows:

 
| **For the Year  Ended June 30,** |   | **Mankato  Office  lease** |    | **St Cloud  Office  lease** |   | **Equipment  lease** |   |
|----------------------------------|--------|----------------------------|---------|-----------------------------|--------|----------------------|--------|
| 2005                             |   | $                          | 78,953  |                        | $      | 66,111               |   | $ | 9,821 |   |
| 2006                             |   | 80,442                     |    | 70,543                      |   | 3,542                |   |
| 2007                             |   | 80,442                     |    | 87,163                      |   | —               |   |
| 2008                             |   | 80,442                     |    | 88,640                      |   |                 |   |
| 2009                             |   | 46,925                     |    | 88,640                      |   |                 |   |
| Thereafter                       |   | —                     |    | 177,280                     |   |                 |   |
| Total                            |   | $                          | 367,204 |                        | $      | 578,377              |   | $ | 13,363 |   |

 

The Bank has an option to renew the Mankato office lease for twoadditional five-year terms and the St. Cloud office lease for an additionalfive-year term.  Rent expense for thefiscal year 2004 and 2003 was approximately $159,000 and $132,000,respectively.  Rent expense to relatedparties for fiscal year 2004 and 2003 was approximately $72,000 and $119,000,respectively.

 

# **Note 13.**   StockWarrants

# ** **

On April 11, 2001, the Company entered into an agency agreement to sellthe Company’s common stock.  Inaccordance with the agreement, warrants were issued to the underwriters toacquire 5,190 shares of the Company’s stock at $12.60 per share any time duringthe period of April 11, 2002 and April 10, 2007.

 

63

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# **Note 14. Financial Instruments With Off-Balance Sheet Risk**

 

The Bank is a party to financial instruments with off-balance sheetrisk in the normal course of business to meet the financing needs of itscustomers.  These financial instrumentsare commitments to extend credit and involve, to varying degrees, elements ofcredit risk in excess of the amount recognized in the balance sheet. The Bank’sexposure to credit loss in the event of nonperformance by the other party tothe financial instrument for commitments to extend credit is represented by thecontractual amount of those instruments. The Bank uses the same credit policies in making commitments as it doesfor on-balance sheet instruments. The Bank had outstanding commitments for

 
|                                                         |   | **At June 30** |      |
|--------------------------------------------------------------|--------|----------------|-----------|
|                                                         |   | **2004**       |      | **2003** |   |
| Revolving, open-end secured by 1-4 family  residential       |   | $              | 1,856,403 |   | $ | 1,438,965 |   |
| Commercial real estate, construction and  land development   |   | 4,348,989      |      | 1,453,467 |   |
| Other, agricultural real estate, unsecured  and check credit |   | 707,766        |      | 1,888,010 |   |
| Total outstanding commitments and  additional borrowings     |   | $              | 6,913,158 |   | $ | 4,780,442 |   |

 

additionalborrowings as follows:

 

Commitments to extend credit are agreements to lend to a customer aslong as there is no violation of any condition established in thecontract.  Commitments generally havefixed expiration dates or other termination clauses and may require payment ofa fee.  Since many of the commitmentsare expected to expire without being drawn upon, the total commitments amountsdo not necessarily represent future cash requirements. The Bank examines eachcustomer’s creditworthiness on a case-by-case basis. The amount and type ofcollateral obtained, if deemed necessary by the Bank upon extension of credit,varies and is based on management’s credit evaluation of the counterparty.

 

Commitments to sell loans amounted to $697,433 at June 30, 2004 and$2,035,176 at June 30, 2003.

 

# **Note 15.**     FairValue of Financial Instruments

 

The estimatedfair values of the Company’s and the Bank’s financial instruments are asfollows:

 
|                                   |   | **June 30,  2004**   |   | **June 30,  2003** |   |
|----------------------------------------|--------|----------------------|--------|--------------------|--------|
|                                   |   | **Carrying  Amount** |   | **Fair  Value**    |   | **Carrying  Amount** |   | **Fair  Value** |   |
| Financial assets:                      |   |                 |   |               |   |   |   |   |   |
| Cash and cash equivalents              |   | 1,953,163            |   | 1,953,163          |   | 2,377,132 |   | 2,377,132 |   |
| Federal funds sold                     |   | 1,582,000            |   | 1,582,000          |   | 482,000 |   | 482,000 |   |
| Securities available for sale          |   | 5,809,978            |   | 5,809,978          |   | 6,113,088 |   | 6,113,088 |   |
| Securities held for sale               |   | —               |   | —             |   | 115,862 |   | 115,862 |   |
| Investment in FHLB and UBB stock       |   | 385,100              |   | 385,100            |   | 367,100 |   | 367,100 |   |
| Loans held for sale                    |   | 697,433              |   | 697,433            |   | 2,035,176 |   | 2,035,176 |   |
| Loans                                  |   | 33,401,172           |   | 33,641,237         |   | 38,852,128 |   | 39,900,355 |   |
| Accrued interest receivable            |   | 214,476              |   | 214,476            |   | 282,416 |   | 282,416 |   |
| Financial liabilities;                 |   |                 |   |               |   |   |   |   |   |
| Deposits                               |   | 36,401,541           |   | 36,490,269         |   | 41,428,710 |   | 41,787,398 |   |
| Notes payable and other borrowing      |   | 4,700,000            |   | 4,659,648          |   | 5,975,000 |   | 6,049,138 |   |
| Convertible subordinated notes payable |   | 1,800,000            |   | 1,808,478          |   | 1,600,000 |   | 1,607,774 |   |
| Accrued interest payable               |   | 264,867              |   | 264,867            |   | 266,708 |   | 266,708 |   |

 

64

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*Interest Rate Risk:* The Company and the Bank assume interest raterisk (the risk that general interest rate levels will change) as a result oftheir normal operations.   As a result,the fair values of the Company’s and Bank’s financial instruments will changewhen rate levels change, and that change may be either favorable or unfavorableto the Company and the Bank.  Managementattempts to match maturities of assets and liabilities to the extent believednecessary to minimize interest rate risk. However, borrowers with fixed-rate obligations are less likely to prepayin a rising-rate environment and more likely****toprepay in a falling-rate environment. Conversely, depositors who are receivingfixed rates are more likely to withdraw funds before maturity in a rising-rateenvironment and less likely to do so in a falling-rate environment.  Management monitors rates and maturities ofassets and liabilities and attempts to minimize interest rate risk by adjustingterms of new loans and deposits and by investing in securities with terms thatmitigate the Company’s and the Bank’s overall interest rate risk.

 

# **Note 16.  Concentration of Credit Risk**

# ** **

*Concentration over insured limits: *The nature of theBank’s business requires that it maintain amounts due from banks, which, attimes, may exceed federally insured limits. The Bank has not experienced any losses in such accounts.

 

*Concentration by geographic location: *The Bank makescommercial, real estate, and consumer loans to its customers primarily in theBank’s primary trade areas of Mankato and St. Cloud, Minnesota.  Although the Bank’s loan portfolio isdiversified, a substantial portion of the Bank’s customers’ ability to honortheir contracts is dependent upon the local business economy, which is takeninto consideration by management in determining the allowance for loan andlease losses.

 

# **Note 17.  Stockholders’ Equity and Regulatory Matters**

# ** **

The Bank is subject to various regulatorycapital requirements administered by the Federal Deposit Insurance Corporation(FDIC). Failure to meet minimum capital requirements can initiate certainmandatory and possible additional discretionary actions by regulators that, ifundertaken, could have a direct material effect on the Bank’s financialstatements.  Under capital adequacyguidelines and the regulatory framework for prompt corrective action, the Bankmust meet specific capital guidelines that involve quantitative measures of theBank’s assets, liabilities and certain off-balance sheet items as calculatedunder regulatory accounting practices. The Bank’s capital amounts and classification are also subject toqualitative judgments by the regulators about components, risk weightings, andother factors.

 

Quantitative measures established byregulation to ensure capital adequacy require the Bank to maintain minimumratios (set forth in the table below) of total and Tier I capital torisk-weighted assets, and of Tier I capital to average assets (all as definedin the regulations).  Managementbelieves, as of June 30, 2004, that the Bank meets all capital adequacyrequirements to which it is subject.

 

65

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As of June 30, 2004, the most recentnotification for the Bank’s primary regulator (FDIC) categorized the Bank aswell capitalized under the regulatory framework for prompt correctiveaction.  To be categorized as wellcapitalized, the Bank must maintain minimum total risk-based, Tier Irisk-based, and Tier I leverage ratios as set forth in the table below.

 

Banking regulations restrict the amount ofdividends that may be paid by the Bank without prior approval of banksupervisory authorities.

 
|                      |   |       |      |                   |   |                  |   |                         |   | **To Be Well  Capitalized** |   |
|---------------------------|--------|------------|-----------|------------------------|--------|-----------------------|--------|------------------------------|--------|-----------------------------|--------|
|                      |   |       |      |                   |   | **For  Capital**      |   | **Under  Prompt Corrective** |   |
|                      |   | **Actual** |      | **Adequacy  Purposes** |   | **Action  Provision** |   |
|                      |   | **Amount** |      | **Percent**            |   | **Amount**            |   | **Percent**                  |   | **Amount**                  |   | **Percent** |   |
| As of June 30, 2004  |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| Total Capital             |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| (to Risk Weighted Assets) |   | $          | 4,504,196 |                   | 11.83  | %                     | $      | 3,044,640                    |   | >8.00                    | %      | $ | 3,805,800 |   | >10.0 | % |
|                      |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| Tier I Capital            |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| (to Risk Weighted Assets) |   | $          | 4,056,729 |                   | 10.66  | %                     | $      | 1,522,320                    |   | >4.00                    | %      | $ | 2,283,480 |   | >6.00 | % |
|                      |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| Leverage Ratio            |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| Tier I Captial            |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| (to Average Assets)       |   | $          | 4,056,729 |                   | 8.74   | %                     | $      | 1,856,360                    |   | >4.00                    | %      | $ | 2,320,450 |   | >5.00 | % |
|                      |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| As of June 30, 2003  |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| Total Capital             |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| (to Risk Weighted Assets) |   | $          | 4,518,323 |                   | 11.60  | %                     | $      | 3,117,680                    |   | >8.00                    | %      | $ | 3,897,110 |   | >10.0 | % |
|                      |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| Tier I Capital            |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| (to Risk Weighted Assets) |   | $          | 4,024,323 |                   | 10.33  | %                     | $      | 1,558,840                    |   | >4.00                    | %      | $ | 2,338,260 |   | >6.00 | % |
|                      |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| Leverage Ratio            |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| Tier I Captial            |   |       |      |                   |   |                  |   |                         |   |                        |   |   |   |
| (to Average Assets)       |   | $          | 4,024,323 |                   | 8.04   | %                     | $      | 2,002,560                    |   | >4.00                    | %      | $ | 2,503,200 |   | >5.00 | % |

 

**TheBank may not declare or pay cash dividends to the Company if the effect wouldbe to reduce capital below applicable regulatory requirements or if suchdeclaration and payment would otherwise violate regulatory requirements.  Since there are no current operatingearnings or retained earnings, no amounts are available for the payment ofdividends.**

** **

**Inthe second quarter of fiscal year 2003, the Board of Directors of the Companysold in a private placement of 15,000 shares of its common stock at a price of$5.50 per share.  In the third quarterof fiscal 2003, the Board of Directors of the Company sold in a privateplacement of 16,000 shares of its common stock at a price of $5.50 per share.  In the fourth quarter of fiscal year 2003,the Board of Directors of the Company sold in a private placement of 9,000shares of its common stock at a price of $5.50 per share.  The proceeds were used to support on-goingoperations.**

** **

During the first quarter of fiscal year 2004,the Board of Directors of the Company sold in a private placement of 23,000shares of its common stock at a price of

 

66

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$5.50 per share.  In the secondquarter of fiscal year 2004, the Board of Directors of the Company sold in aprivate placement of 26,000 shares of its common stock at a price of $5.50 pershare.  In the fourth quarter of fiscalyear 2004, the Board of Directors of the Company sold in a private placement of20,000 shares of its common stock at a price of $5.00 per share.    The proceeds will be used to support ouron-going operations.

 

**Note 18.  Earnings (Loss) Per Share**

** **

**Thebasic earnings (loss) per share amounts were computed using theweighted-average number of shares outstanding during the years presented.  For the years ended June 30, 2004 and2003, the weighted-average number of shares outstanding for basic and dilutedearnings (loss) per share were 556,113 and 495,084, respectively.  Common stock shares issuable upon theconversion of subordinated debt (Note 8) and from the exercise of stock options(Note 10) and warrants issued (Note 13) totaling 334,523 and 307,189 shares atJune 30, 2004 and 2003 respectively, were not used in the calculation ofdiluted earnings (loss) per share because they were anti-dilutive**

** **

**Note 19.  Parent Only Condensed Financial Information**

** **

CONDENSED STATEMENTS OF FINANCIAL CONDITION

 
|                                      |   | **June 30** |      |
|-------------------------------------------|--------|------------------|-----------|
|                                      |   | **2004**         |      | **2003** |   |
| Assets                                    |   |             |      |   |   |
|                                      |   |             |      |   |   |
| Cash on deposit with subsidiary bank      |   | $                | 128,463   |   | $ | 68,178 |   |
| Other assets                              |   | 75,000           |      | — |   |
| Investment in subsidiary                  |   | 4,006,629        |      | 4,076,339 |   |
|                                      |   | $                | 4,210,092 |   | $ | 4,144,517 |   |
|                                      |   |             |      |   |   |
| Liabilities and Stockholders’ Equity |   |             |      |   |   |
|                                      |   |             |      |   |   |
| Note payable to bank                      |   | $                | 550,000   |   | $ | 600,000 |   |
| Convertible subordinated notes payable    |   | 1,800,000        |      | 1,600,000 |   |
| Other liabilities                         |   | 42,181           |      | 30,383 |   |
|                                      |   | 2,392,181        |      | 2,230,383 |   |
|                                      |   |             |      |   |   |
| Stockholders’ equity                 |   | 1,817,911        |      | 1,914,134 |   |
|                                      |   | $                | 4,210,092 |   | $ | 4,144,517 |   |

 

67

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CONDENSED STATEMENTS OF INCOME

 
|                                          |   | **Years  Ended June 30** |     |
|-----------------------------------------------|--------|-------------------------------|----------|
|                                          |   | **2004**                      |     | **2003** |   |
| Interest Income                               |   | $                             | —   |   | $ | 411 |   |
| Equity in undistributed income of  subsidiary |   | 32,407                        |     | 197,227 |   |
|                                          |   | 32,407                        |     | 197,638 |   |
|                                          |   |                          |     |   |   |
| Interest expense                              |   | 154,830                       |     | 145,201 |   |
| Non-interest expense                          |   | 245,184                       |     | 285,253 |   |
|                                          |   | 400,014                       |     | 430,454 |   |
|                                          |   |                          |     |   |   |
| Loss before income taxes                      |   | (367,607                      | )        | (232,816 | ) |
|                                          |   |                          |     |   |   |
| Income tax expense (benefit)                  |   | —                        |     | — |   |
| Net loss                                      |   | $                             | (367,607 | ) | $ | (232,816 | ) |

 

CONDENSED STATEMENTS OF CASH FLOWS

 
|                                                              |   | **Years  Ended June 30** |     |
|-------------------------------------------------------------------|--------|-------------------------------|----------|
|                                                              |   | **2004**                      |     | **2003** |   |
| Cash flows from operating activities:                             |   |                          |     |   |   |
| Net loss                                                          |   | $                             | (367,607 | ) | $ | (232,816 | ) |
| Adjustments:                                                      |   |                          |     |   |   |
| Equity in undistributed income of  subsidiary                     |   | (32,406                       | )        | (197,227 | ) |
| Earned stock compensation                                         |   | 4,000                         |     | 3,999 |   |
| Other                                                             |   | 11,798                        |     | 2,229 |   |
|                                                              |   | (384,215                      | )        | (423,815 | ) |
|                                                              |   |                          |     |   |   |
| Cash flows from financing activities:                             |   |                          |     |   |   |
| Proceeds from issuance of common stock, net                       |   | 369,500                       |     | 220,000 |   |
| Proceeds from issuance of convertible  subordinated notes payable |   | 300,000                       |     | 400,000 |   |
| Repayment of convertible subordinated notes  payable              |   | (100,000                      | )        | (200,000 | ) |
| Repayment of notes payable and other  borrowing                   |   | (50,000                       | )        | — |   |
|                                                              |   | 519,500                       |     | 420,000 |   |
|                                                              |   |                          |     |   |   |
| Net increase (decrease) in cash                                   |   | 135,285                       |     | (3,815 | ) |
|                                                              |   |                          |     |   |   |
| Cash, beginning                                                   |   | 68,178                        |     | 71,993 |   |
| Cash, ending                                                      |   | $                             | 203,463  |   | $ | 68,178 |   |

 

**Note 20.  Litigation Matters**

** **

The Bank was a defendant in a complaint filed on February 23, 2002in United States District Court, District of South Dakota Southern Division byBridge Lenders, LLC; Jim Perry; Larry Ticknor; Doug English; Rollyn H. Samp;Courtney Anderson; Henry Carlson, Jr.; Michael M. Samp; Ernest Olson; DonDavis; Jerry Landerville; Allen Lewis; Gary Viger; Glen Jamtgaard and SteveHerman (“Plaintiffs”).  The complaintarose out of a series of loans that the Bank made to Plaintiffs in 2000.  Plaintiffs used the proceeds of the loans tomake an investment in

 

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Bridge Lenders, LLC, and Bridge Lenders, LLC in turn used the funds tomake an investment in Phenix Biocomposites, which has defaulted in itsobligations to Plaintiffs.  The Bank wasa defendant in this action due to the fact that its former director, FrankGazzola, was also a director of Phenix Biocomposites.  On February 24, 2004, the court dismissed all claims againstNorthern Star Bank and Frank Gazzola.

 

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

 

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

 

**In thenormal course of business, the Company and its subsidiary are involved inlitigation.   Management does notbelieve that any litigation in which it is currently involved will have amaterial impact on the Company’s financial condition or results of operations.**

** **

**ITEM 8.  CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE**

** **

On September 24, 2002, the Board of Directors of the Companydismissed McGladrey & Pullen, LLP, the independent accountant, which hadbeen engaged by the Company for the fiscal year ended June 30, 2002. Therewere not any disagreements with McGladrey & Pullen, LLP, the independentaccountant engaged by the Company for 2002 on any matter of accountingprinciples or practices, financial statement disclosure, or auditing scope orprocedure which, if not resolved to McGladrey & Pullen, LLP’s satisfaction,would have cause it to make reference to the subject matter of the disagreementin connection with its report, nor did McGladrey & Pullen, LLP’s report onthe financial statements of the Company for the past two years contain anadverse opinion or disclaimer of opinion or was modified as to uncertainty,audit scope or accounting principles, nor are there any events requiringdisclosure under Item 304(a)(1)(iv)(B) of Regulation S-B.  McGladrey & Pullen, LLP’s opinion didinclude an explanatory paragraph regarding significant litigation matters.

 

On October 28, 2002, the Company’s Audit Committee and Board ofDirectors approved Boulay, Heutmaker, Zibell, & Co. P.L.L.P. to serve asthe Company’s independent auditors for the 2003 fiscal year.  During the two most recent fiscal yearsprior to October 28, 2002, the 

 

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Company had not consulted with Boulay, Heutmaker, Zibell, & Co.P.L.L.P. on items which:  (i) involvethe application of accounting principles to specified transaction eithercompleted or proposed, or involved the type of audit opinion which might be renderedupon the Company’s financial statements, or (ii) concern the subject matter ofa disagreement or reportable event with the former auditor.

 

## **ITEM 8A.  CONTROLS AND PROCEDURES**

## ** **

Evaluation of Disclosure Controls Procedures

 

As of the end of the period covered by this report, the Company conductedan evaluation under the supervision and with the participation of the company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, regarding the effectiveness of the design and operation of theCompany’s disclosure controls and procedures pursuant to Rules 13a-15(b) of theSecurities Exchange Act of 1934 (the “Exchange Act”).  Based upon that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that the Company’s disclosure controls and proceduresare effective to ensure that information that is required to be disclosed bythe Company in reports that it files under the Exchange Act is recorded,processed, summarized and reported within the time period specified in therules of the Securities Exchange Commission.

 

Changes in Internal Controls

 

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

 

## **ITEM 8B.  OTHER INFORMATION**

## ** **

All information required to be reported on a Form 8-K has been reportedon a Form 8-K.

 

**PARTIII**

 
| **ITEM 9.** |   | **DIRECTO**RS,   EXECUTIVE OFFICERS, PROMOTORS AND CONTROL PERSONS; COMPLIANCE WITH  SECTION 16 (a) OF THE EXCHANGE ACT |
|-------------|--------|-----------------------------------------------------------------------------------------------------------------------------------|

 

The names and ages of theexecutive officers of the Registrant and their positions and offices held areas follows:

 
| **Name**             |   | **Age** |   | **Position  with Company**                                                                                                                                                                                                                                                                                             |   |
|----------------------|--------|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                 |   |    |   |                                                                                                                                                                                                                                                                                                                   |   |
| Thomas P. Stienessen |   | 57      |   | Chief Executive Officer, President and a Director of  the Registrant since its formation.   From January 1991 to January 1998, Chief Executive Officer  and President of SGL, Inc., a holding company for Family Bank, and Chairman,  Chief Executive Officer, President and a Director of Family Bank. |   |

 

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| Gerald W. Eick |   | 50 |   | Chief Financial Officer and Treasurer of the Registrant since  August 2002, and a Director of the Registrant since May 2002.  Was a certified public accountant with  Abdo, Eick and Meyers, LLP from 1974 to 2002.  Since June 2002, CFO for Weerts Companies. |   |
|----------------|--------|----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|

 

The information required by Item 9 relating to directors, familyrelationships and compliance with Section 16(a) of the Exchange Act andRule 401 of Regulation S-K is incorporated herein by reference to the sectionslabeled “Election of Directors”, Corporate Governance, and “Section 16(a)Beneficial Ownership Reporting Compliance”, respectively, which appear in theCompany’s definitive Proxy Statement for its 2004 Annual Meeting ofStockholders.

 

CODE OF ETHICS

 

The Company has adopted a Code of Ethics and Business Conduct, attachedas Exhibit 14 to this Form 10-KSB, that applies to all its principal executiveofficers, principal financial officer, principal accounting officer orcontroller, or persons performing similar functions.

 
| **ITEM 10.** |   | **EXECUTIVE COMPENSATION** |
|--------------|--------|----------------------------|

## ** **

The information required by Item 10 is incorporated herein by referenceto the section labeled “Executive Compensation” which appears in the Registrantsdefinitive Proxy Statement for its 2004 Annual Meeting of Stockholders.

 
| **ITEM 11.** |   | **SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS**AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS |
|--------------|--------|----------------------------------------------------------------------------------------------------|

 

The information required by Item 11 relating to security ownership ofcertain beneficial owners and management is incorporated herein by reference tothe section labeled “Shareholdings of Principal Stockholders andManagement,” which appears in the Registrant’s definitive Proxy Statement forits 2004 Annual Meeting of Stockholders.

 

71

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The following table provides information as of June 30, 2004 aboutthe Company’s equity compensation plans.

 
| **June 30, 2004**                                      |   | **Number of  securities  to be issued upon  exercise of outstanding  options, warrants and  rights** |   | **Weighted  average  exercise price of  outstanding  options, warrants  and rights** |   | **Number of  securities remaining  available for future issuance  under equity compensation plans  (excluding securities reflected  in column (a))** |   |
|-------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                        |   | **(a)**                                                                                              |   | **(b)**                                                                              |   | **(c)**                                                                                                                                              |   |
| Equity compensation plans approved by  security holders     |   | 113,000                                                                                              |   | $                                                                                    | 8.11   |                                                                                                                                                 | 3,700  |   |
| Equity compensation plans not approved by  security holders |   | 30,800                                                                                               | *      | $                                                                                    | 10.00  |                                                                                                                                                 | 0      |   |
| Total                                                       |   | 143,800                                                                                              |   |                                                                                 |   | 3,700                                                                                                                                                |   |

 

## **ITEM 12.**                                           CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

## ** **

The information required by Item 12 is incorporated by reference to thesection labeled “Certain Transactions” which appears in the Registrant’sdefinitive Proxy Statement for its 2004 Annual Meeting of Stockholders.

 

## **ITEM 13.**                                           EXHIBITSAND REPORTS ON FORM 8-K

## ** **

(a)                                  Exhibits.

 

Exhibits are numbered in accordance with Item 601 of RegulationS-B.  See “Exhibit Index” immediatelyfollowing the signature page of this Form 10-KSB.

 

Reports on Form 8-K

 

(b)                                 On May 13, 2004, theRegistrant filed a Form 8-K dated May 13, 2004 announcing results for theCompany and its wholly owned subsidiary Northern Star Bank for the thirdquarter of the fiscal year ending June 30, 2004.

 

(c)                                  On September 13,2004, the Registrant filed a Form 8-K dated September 10, 2004 announcingresults for the Company and its wholly owned subsidiary Northern Star Bank forthe fourth quarter of the fiscal year ending June 30, 2004.

 

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**ITEM 14.****                                              PRINCIPAL AUDITOR FEES AND SERVICES**

 

Information relating tothe fees and services of the Company’s principal accountant is incorporatedherein by reference to the section labeled “Independent PublicAccountant,” and “ Audit Fees”, that appears in the Registrant’s definitiveProxy statement for its 2004 Annual Meeting of Shareholders.

 

**SIGNATURES**

 

In accordance with Section 13 or 15(d) of the Exchange Act, theregistrant caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|   |                    |   | NORTHERN STAR FINANCIAL, INC. |
|--------|-------------------------|--------|-------------------------------|
|   |                    |   |                          |
| Dated: | September 16, 2004 |   | by:                           | /s/ Thomas P. Stienessen |
|   |                    |   |                          | Thomas P. Stienessen, Chief Executive Officer |

 

In accordance with the Exchange Act, the following persons on behalf ofthe registrant and in the capacities and on the dates indicated have signedthis Report.

 

(POWER OF ATTORNEY)

 

Each person whose signature appears below constitutes and appointsTHOMAS P. STIENESSEN and GERALD W. EICK as true and lawful attorneys-in-factand agents, each acting alone, with full power of substitution and resubstitution,for him and in his name, place and stead, in any and all capacities, to signany or all amendments to this Annual Report on Form 10-KSB and to file thesame, with all exhibits thereto, and other documents in connection thereto, andother documents in connection therewith, with the Securities and ExchangeCommission, granting unto said attorneys-in-fact- and agents, each actingalone, full power and authority to do and perform each and every act and thingrequisite and necessary to be done in and about the premises, as fully to allintents and purposes as he might or could do in person, hereby ratifying andconfirming all said attorneys-in-fact and agents, each acting alone, or hissubstitute or substitutes, may lawfully do or cause to be done by virtuethereof.

 
| **Signature and Title**                        |   | **Date** |
|------------------------------------------------|--------|----------|
|                                           |   |     |
| /s/ Thomas P. Stienessen                       |   |     | September 16, 2004 |
| Thomas P. Stienessen, Chief Executive Officer, |   |     |
| President, and Director                        |   |     |
|                                           |   |     |
| /s/ Dean M. Doyscher                           |   |     | September 16, 2004 |
| Dean M. Doyscher, Director                     |   |     |
|                                           |   |     |
| /s/ Robert H. Dittrich                         |   |     | September 16, 2004 |
| Robert H. Dittrich, Director                   |   |     |

 

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| /s/ Gerald W. Eick                       |   |   | September 16, 2004 |
|------------------------------------------|--------|--------|-------------------------|
| Gerald W. Eick, Treasurer and Director   |   |   |
| (Chief Financial and Accounting Officer) |   |   |
|                                     |   |   |
| /s/ James H. Illies                      |   |   | September 16, 2004 |
| James H Illies, Director                 |   |   |
|                                     |   |   |
| /s/ Steven A Loehr                       |   |   | September 16, 2004 |
| Steven A Loehr, Director                 |   |   |
|                                     |   |   |
| /s/ Michael P. Reynolds                  |   |   | September 16, 2004 |
| Michael P. Reynolds, Director            |   |   |
|                                     |   |   |
| /s/ Thomas J. Reynolds                   |   |   | September 16, 2004 |
| Thomas J. Reynolds, Director             |   |   |

 

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NORTHERN STAR FINANCIAL, INC.

 

EXHIBIT INDEX TO FORM 10-KSB

 
| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                                                                                                 |
|---------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                                                                                                                                                                                                            |
| 3.1                 |   | Amended and Restated Articles of Incorporation, as amended to  date.  (Incorporated by reference to  Exhibit 2.1 to the Company’s Registration Statement on Form SB-1, Reg. No.  333-61655)                                                                                                                           |
|                |   |                                                                                                                                                                                                                                                                                                                            |
| 3.2                 |   | By-Laws, as amended to date. (Incorporated by reference to Exhibit  2.2 to the Company’s Registration Statement on Form SB-2, Reg. No. 333-61655)                                                                                                                                                                          |
|                |   |                                                                                                                                                                                                                                                                                                                            |
| 10.1                |   | Lease Agreement between Northern Star Bank (the “Bank”) and Colonial  Square Partners relating to the space located at 1650 Madison Avenue,  Mankato, Minnesota.  (Incorporated by  reference to Exhibit 6.1 to the Company’s Registration Statement on Form  SB-1, Reg. No. 333-61655)                     |
|                |   |                                                                                                                                                                                                                                                                                                                            |
| **10.2****          |   | **Employment  Agreement between the Bank and Thomas P. Stienessen.  (Incorporated by reference to Exhibit 6.2  to the Company’s Registration Statement on Form SB-1, Reg. No. 333-61655)****                                                                                                                          |
|                |   |                                                                                                                                                                                                                                                                                                                            |
| **10.3****          |   | **1998  Equity Incentive Plan, including specimen of Incentive Stock Option Agreement  and Nonqualified Stock Option Agreement.   (Incorporated by reference to Exhibit 6.5 to the Company’s  Registration Statement on Form SB-1, Reg. No. 333-61655)****                                                            |
|                |   |                                                                                                                                                                                                                                                                                                                            |
| **10.4****          |   | **Form  of Nonqualified Stock Option Agreement governing options granted to  Organizers.  (Incorporated by  reference to Exhibit 6.6 to the Company’s Registration Statement on Form  SB-1, Reg. No. 333-61655)****                                                                                                   |
|                |   |                                                                                                                                                                                                                                                                                                                            |
| **10.5**            |   | **Lease  Agreement between Northern Star Bank (the “Bank”) and Five Star Properties of  St. Cloud, LLC relating to the space located at 300 East St. Germain Street,  St. Cloud, Minnesota. (Incorporated by reference to Exhibit 10.5 to the  Company’s Form 10-KSB for the period ended June 30, 2002.)** |
|                |   |                                                                                                                                                                                                                                                                                                                            |
| **10.6**            |   | **Form  and amounts of Convertible Subordinated Unsecured Notes issued by the  Registrant to certain of its directors in July and August, 2001.  (Incorporated by reference to Exhibit 10.6 to the Company’s Form 10-KSB for  the period ended June 30, 2002.)**                                                 |

 

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| **10.7** |   | **Form  and amounts of Convertible Subordinated Unsecured Notes issued by the  Registrant to certain of its directors in 2002, 2003 and 2004. (Incorporated  by reference to Exhibit 10.6 to the Company’s Form 10-KSB for the period  ended June 30, 2002.)** |
|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |   |                                                                                                                                                                                                                                                                     |
| **11**   |   | **Statement  re: Computation of Earning (Loss) Per Share (included in Notes to Financial  Statements)**                                                                                                                                                                  |
|     |   |                                                                                                                                                                                                                                                                     |
| **14**   |   | **Code  of Ethics*****                                                                                                                                                                                                                                                   |
|     |   |                                                                                                                                                                                                                                                                     |
| **21**   |   | **Subsidiaries  of the Registrant:**                                                                                                                                                                                                                                     |
|     |   |                                                                                                                                                                                                                                                                     |
|     |   | **Name**                                                                                                                                                                                                                                                                 |   | **State  of Organization** |
|     |   | **Northern  Star Bank, Inc.**                                                                                                                                                                                                                                            |   | **Minnesota** |
|     |   |                                                                                                                                                                                                                                                                     |
| **24**   |   | **Power  of Attorney from Certain Directors (See Signature Page)**                                                                                                                                                                                                       |
|     |   |                                                                                                                                                                                                                                                                     |
| **31.1** |   | **Certification  of CEO Pursuant to Sec. 302 of the Sarbanes-Oxley Act of 2002*****                                                                                                                                                                                      |
|     |   |                                                                                                                                                                                                                                                                     |
| **31.2** |   | **Certification  of CFO Pursuant to Sec. 302 of the Sarbanes-Oxley Act of 2002*****                                                                                                                                                                                      |
|     |   |                                                                                                                                                                                                                                                                     |
| **32**   |   | **Certification  of the CEO and CFO Pursuant to Sec. 906 of The Sarbanes-Oxley Act. of  2002*****                                                                                                                                                                   |

 

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****Indicatesa management contract or compensatory plan or arrangement required to be filedas an exhibit to this form 10-KSB.**

*****Filedherewith.**

 

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