United
States
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C.   20549
 ________________________________________________________
 
 FORM
10-Q
 
 ý     QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d)
 OF
THE SECURITIES EXCHANGE ACT OF 1934
 
 For the
quarterly period ended September 30, 2009
 
 OR
  ̈      TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d)
 OF
THE SECURITIES EXCHANGE ACT OF 1934
 
 For the
transition period from _________  to __________
 _________________________________________________________
 Commission
File Number 000 - 19300
 NORTHERN
STATES FINANCIAL CORPORATION
 (Exact
name of Registrant as specified in its charter)
  Delaware
              
              36-3449727(State
      of Incorporation)
              
              (I.R.S.
      EmployerIdentification
      No.)
 
 1601
North Lewis Avenue
 Waukegan,
Illinois  60085
 (847)
244-6000
 (Address,
including zip code, and telephone number, including area code, of principal
executive office)
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for shorter period that the registrant was required to
file such reports) and (2) has been subject to such filing requirements for the
past 90 days.        YES: ý             NO:
 ̈
 
 Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such
files).        YES:  ̈             NO:
 ̈
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definitions of “large accelerated filer”, “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange
Act.
 Large
Accelerated Filer o    Accelerated
Filer  ̈      Non-accelerated
Filer  ̈ (Do not
check if a smaller reporting company)
 Smaller
reporting company ý
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange
Act).                     YES:   ̈              NO:  ý
 
 4,072,255
shares of common stock were outstanding
 at
November 13, 2009
 
 
 
  NORTHERN STATES FINANCIAL
CORPORATION AND SUBSIDIARY
 FORM
10-Q
 For the Quarter
Ended September 30, 2009
 INDEX
 
 Page
      NumberPART I.   FINANCIAL
      INFORMATIONItem 1.  Financial
      Statements
                                      2Report of Independent Registered Public
      Accounting Firm
                                      2Condensed Consolidated Financial Statements
      and Notes
                                      3Item 2.  Management’s Discussion and
      Analysis of Financial Condition and Results of
    Operations
                                      14Item 3. Quantitative and Qualitative Disclosures
      About Market Risk
                                      32Item 4. Controls and Procedures
                                      34PART II.   OTHER
    INFORMATIONItem 1.  Legal
Proceedings
                                      34Item 1A.  Risk Factors
                                      34Item 2.  Unregistered Sales of Equity
      Securities and Use of Proceeds
                                      34Item 3.  Defaults upon Senior
      Securities
                                      34Item 4.  Submission of Matters to a Vote
      of Security Holders
                                      34Item 5.  Other
Information
                                      34Item 6.  Exhibits
                                      35Signatures
                                      36EXHIBIT INDEX
                                      37
 1
 Table of
Contents
 
 PART I.
FINANCIAL INFORMATION
 
 ITEM
1. FINANCIAL STATEMENTS.
    
 REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM
 
 
 Board of
Directors and Stockholders
 Northern
States Financial Corporation
 Waukegan,
Illinois
 
 We have
reviewed the accompanying interim condensed consolidated balance sheet of
NORTHERN STATES FINANCIAL CORPORATION as of September 30, 2009, the
condensed consolidated statements of operations for the three and nine month
periods ended September 30, 2009 and 2008 and the condensed statements of
cash flows and stockholders equity for the nine month periods ended September
30, 2009 and 2008.  These interim financial statements are the
responsibility of the company's management.
 
 We
conducted our review in accordance with standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion.
 
 Based on
our review, we are not aware of any material modifications that should be made
to the accompanying interim condensed financial statements for them to be in
conformity with accounting principles generally accepted in the United States of
America.
 
 
 
 /s/  Plante
& Moran,
PLLC
 
 Chicago,
Illinois
 November
11, 2009
 
 
 2
 Table of Contents




NORTHERN STATES FINANCIAL
CORPORATION
 CONDENSED CONSOLIDATED BALANCE
SHEETS
 September 30,
2009 and December 31, 2008
 (In
thousands of dollars) (Unaudited)
  September
      30,
                                                    2009
                                                  
                                                  
                                                  December
      31,
                                                    2008AssetsCash
      and due from banks
                                                  
                                                  $
                                                  13,538
                                                  
                                                  
                                                  $
                                                  14,108Interest
      bearing deposits in financial institutions -
                                                    maturities less than 90 days
                                                  
                                                  
                                                  949
                                                  
                                                  
                                                  
                                                  242Federal
      funds sold
                                                  
                                                  
                                                  21,302
                                                  
                                                  
                                                  
                                                  7,518Total
      cash and cash equivalents
                                                  
                                                  
                                                  35,789
                                                  
                                                  
                                                  
                                                  21,868Securities
      available for sale
                                                  
                                                  
                                                  123,962
                                                  
                                                  
                                                  
                                                  103,194Loans
      and leases
                                                  
                                                  
                                                  449,669
                                                  
                                                  
                                                  
                                                  480,812Less:
      Allowance for loan and lease losses
                                                  
                                                  
                                                  (23,345
                                                  )
                                                  
                                                  
                                                  (10,402
                                                  )Loans
      and leases, net
                                                  
                                                  
                                                  426,324
                                                  
                                                  
                                                  
                                                  470,410Federal
      Home Loan Bank stock
                                                  
                                                  
                                                  1,801
                                                  
                                                  
                                                  
                                                  1,757Office
      buildings and equipment, net
                                                  
                                                  
                                                  9,824
                                                  
                                                  
                                                  
                                                  9,916Other
      real estate owned
                                                  
                                                  
                                                  21,461
                                                  
                                                  
                                                  
                                                  10,575Goodwill
                                                  
                                                  
                                                  0
                                                  
                                                  
                                                  
                                                  9,522Core
      deposit intangible asset
                                                  
                                                  
                                                  578
                                                  
                                                  
                                                  
                                                  926Accrued
      interest receivable and other assets
                                                  
                                                  
                                                  8,406
                                                  
                                                  
                                                  
                                                  12,551Total
      assets
                                                  
                                                  $
                                                  628,145
                                                  
                                                  
                                                  $
                                                  640,719Liabilities
      and Stockholders' EquityLiabilitiesDepositsDemand
      - noninterest bearing
                                                  
                                                  $
                                                  59,047
                                                  
                                                  
                                                  $
                                                  57,313Interest
      bearing
                                                  
                                                  
                                                  461,106
                                                  
                                                  
                                                  
                                                  443,508Total
      deposits
                                                  
                                                  
                                                  520,153
                                                  
                                                  
                                                  
                                                  500,821Securities
      sold under repurchase agreements
                                                  
                                                  
                                                  42,416
                                                  
                                                  
                                                  
                                                  42,574Federal
      Home Loan Bank advance
                                                  
                                                  
                                                  0
                                                  
                                                  
                                                  
                                                  20,000Subordinated
      debentures
                                                  
                                                  
                                                  10,000
                                                  
                                                  
                                                  
                                                  10,000Advances
      from borrowers for taxes and insurance
                                                  
                                                  
                                                  444
                                                  
                                                  
                                                  
                                                  1,011Accrued
      interest payable and other liabilities
                                                  
                                                  
                                                  6,366
                                                  
                                                  
                                                  
                                                  4,699Total
      liabilities
                                                  
                                                  
                                                  579,379
                                                  
                                                  
                                                  
                                                  579,105Stockholders'
      EquityCommon
      stock (Par value $0.40 per share, authorized 6,500,000
      shares,
                                                    issued
      4,472,255 shares at September 30, 2009 and December 31,
    2008)
                                                  
                                                  
                                                  1,789
                                                  
                                                  
                                                  
                                                  1,789Preferred
      stock (Par value $0.40 per share, authorized 1,000,000
                                                      shares,
      issued 17,211 shares with liquidation amounts of
                                                    $1,000.00
      per share at September 30, 2009)
                                                  
                                                  
                                                  16,611
                                                  
                                                  
                                                  
                                                  0Warrants
      (584,084 issued and outstanding at September 30, 2009)
                                                  
                                                  
                                                  681
                                                  
                                                  
                                                  
                                                  0Additional
      paid-in capital
                                                  
                                                  
                                                  11,584
                                                  
                                                  
                                                  
                                                  11,584Retained
      earnings
                                                  
                                                  
                                                  25,405
                                                  
                                                  
                                                  
                                                  56,082Treasury
      stock, at cost (400,000 shares at September 30, 2009
                                                    and
      December 31, 2008)
                                                  
                                                  
                                                  (9,280
                                                  )
                                                  
                                                  
                                                  (9,280
                                                  )Accumulated
      other comprehensive income
                                                  
                                                  
                                                  1,976
                                                  
                                                  
                                                  
                                                  1,439Total
      stockholders' equity
                                                  
                                                  
                                                  48,766
                                                  
                                                  
                                                  
                                                  61,614Total
      liabilities and stockholders' equity
                                                  
                                                  $
                                                  628,145
                                                  
                                                  
                                                  $
                                                  640,719
  The
accompanying notes are an integral part of these condensed consolidated
financial statements.
   3
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 CONDENSED CONSOLIDATED
STATEMENTS OF OPERATIONS
 Three and
nine months ended September 30, 2009 and 2008
 (In
thousands of dollars, except per share data)
 (Unaudited)
  Three
      months ended
                                      
                                      
                                      Nine
      months endedSeptember
      30,
                                      
                                      
                                      September
      30,
                                      
                                      
                                      September
      30,
                                      
                                      
                                      September
      30,2009
                                      
                                      
                                      2008
                                      
                                      
                                      2009
                                      
                                      
                                      2008Interest
      incomeLoans
      (including fee income)
                                      
                                      $
                                      6,187
                                      
                                      
                                      $
                                      7,287
                                      
                                      
                                      $
                                      18,620
                                      
                                      
                                      $
                                      21,585SecuritiesTaxable
                                      
                                      
                                      1,093
                                      
                                      
                                      
                                      1,544
                                      
                                      
                                      
                                      3,464
                                      
                                      
                                      
                                      5,137Exempt
      from federal income tax
                                      
                                      
                                      87
                                      
                                      
                                      
                                      121
                                      
                                      
                                      
                                      273
                                      
                                      
                                      
                                      347Federal
      funds sold and other
                                      
                                      
                                      8
                                      
                                      
                                      
                                      8
                                      
                                      
                                      
                                      20
                                      
                                      
                                      
                                      91Total
      interest income
                                      
                                      
                                      7,375
                                      
                                      
                                      
                                      8,960
                                      
                                      
                                      
                                      22,377
                                      
                                      
                                      
                                      27,160Interest
      expenseTime
      deposits
                                      
                                      
                                      1,831
                                      
                                      
                                      
                                      2,263
                                      
                                      
                                      
                                      6,115
                                      
                                      
                                      
                                      7,541Other
      deposits
                                      
                                      
                                      306
                                      
                                      
                                      
                                      396
                                      
                                      
                                      
                                      1,050
                                      
                                      
                                      
                                      1,288Repurchase
      agreements and federal funds purchased
                                      
                                      
                                      162
                                      
                                      
                                      
                                      279
                                      
                                      
                                      
                                      489
                                      
                                      
                                      
                                      922Federal
      Home Loan Bank advances
                                      
                                      
                                      4
                                      
                                      
                                      
                                      137
                                      
                                      
                                      
                                      52
                                      
                                      
                                      
                                      289Subordinated
      debentures
                                      
                                      
                                      109
                                      
                                      
                                      
                                      137
                                      
                                      
                                      
                                      349
                                      
                                      
                                      
                                      433Total
      interest expense
                                      
                                      
                                      2,412
                                      
                                      
                                      
                                      3,212
                                      
                                      
                                      
                                      8,055
                                      
                                      
                                      
                                      10,473Net
      interest income
                                      
                                      
                                      4,963
                                      
                                      
                                      
                                      5,748
                                      
                                      
                                      
                                      14,322
                                      
                                      
                                      
                                      16,687Provision
      for loan and lease losses
                                      
                                      
                                      12,825
                                      
                                      
                                      
                                      5,146
                                      
                                      
                                      
                                      18,244
                                      
                                      
                                      
                                      8,129Net
      interest income after provision for loan and lease losses
                                      
                                      
                                      (7,862
                                      )
                                      
                                      
                                      602
                                      
                                      
                                      
                                      (3,922
                                      )
                                      
                                      
                                      8,558Noninterest
      incomeService
      fees on deposits
                                      
                                      
                                      638
                                      
                                      
                                      
                                      672
                                      
                                      
                                      
                                      1,753
                                      
                                      
                                      
                                      1,953Trust
      income
                                      
                                      
                                      182
                                      
                                      
                                      
                                      188
                                      
                                      
                                      
                                      590
                                      
                                      
                                      
                                      619Gains
      on sales of securities
                                      
                                      
                                      0
                                      
                                      
                                      
                                      40
                                      
                                      
                                      
                                      0
                                      
                                      
                                      
                                      40Other
      than temporary impairment of securities
                                      
                                      
                                      (150
                                      )
                                      
                                      
                                      (2,180
                                      )
                                      
                                      
                                      (2,243
                                      )
                                      
                                      
                                      (2,180
                                      )Add (deduct) noncredit portion of other than
                                        temporary
      impairment of securities
                                      
                                      
                                      (2,274
                                      )
                                      
                                      
                                      0
                                      
                                      
                                      
                                      (809
                                      )
                                      
                                      
                                      0Net
      gains (loss) on sales of other real estate owned
                                      
                                      
                                      42
                                      
                                      
                                      
                                      0
                                      
                                      
                                      
                                      (1,594
                                      )
                                      
                                      
                                      0Other
      operating income
                                      
                                      
                                      320
                                      
                                      
                                      
                                      279
                                      
                                      
                                      
                                      881
                                      
                                      
                                      
                                      823Total
      noninterest income
                                      
                                      
                                      (1,242
                                      )
                                      
                                      
                                      (1,001
                                      )
                                      
                                      
                                      (1,422
                                      )
                                      
                                      
                                      1,255Noninterest
      expenseSalaries
      and employee benefits
                                      
                                      
                                      2,109
                                      
                                      
                                      
                                      2,127
                                      
                                      
                                      
                                      6,286
                                      
                                      
                                      
                                      6,432Occupancy
      and equipment, net
                                      
                                      
                                      556
                                      
                                      
                                      
                                      580
                                      
                                      
                                      
                                      1,872
                                      
                                      
                                      
                                      1,801Data
      processing
                                      
                                      
                                      472
                                      
                                      
                                      
                                      415
                                      
                                      
                                      
                                      1,345
                                      
                                      
                                      
                                      1,278FDIC
      insurance
                                      
                                      
                                      324
                                      
                                      
                                      
                                      24
                                      
                                      
                                      
                                      1,080
                                      
                                      
                                      
                                      98Legal
                                      
                                      
                                      308
                                      
                                      
                                      
                                      144
                                      
                                      
                                      
                                      942
                                      
                                      
                                      
                                      304Audit
      and other professional
                                      
                                      
                                      244
                                      
                                      
                                      
                                      260
                                      
                                      
                                      
                                      695
                                      
                                      
                                      
                                      997Amortization
      of core deposit intangible asset
                                      
                                      
                                      116
                                      
                                      
                                      
                                      116
                                      
                                      
                                      
                                      348
                                      
                                      
                                      
                                      348Write-down
      of goodwill
                                      
                                      
                                      0
                                      
                                      
                                      
                                      0
                                      
                                      
                                      
                                      9,522
                                      
                                      
                                      
                                      0Other
      real estate owned expense
                                      
                                      
                                      178
                                      
                                      
                                      
                                      27
                                      
                                      
                                      
                                      442
                                      
                                      
                                      
                                      75Other
      operating expenses
                                      
                                      
                                      663
                                      
                                      
                                      
                                      536
                                      
                                      
                                      
                                      2,024
                                      
                                      
                                      
                                      1,645Total
      noninterest expense
                                      
                                      
                                      4,970
                                      
                                      
                                      
                                      4,229
                                      
                                      
                                      
                                      24,556
                                      
                                      
                                      
                                      12,978Income
      before income taxes
                                      
                                      
                                      (14,074
                                      )
                                      
                                      
                                      (4,628
                                      )
                                      
                                      
                                      (29,900
                                      )
                                      
                                      
                                      (3,165
                                      )Income
      tax (benefit) expense
                                      
                                      
                                      3,668
                                      
                                      
                                      
                                      (1,847
                                      )
                                      
                                      
                                      1,130
                                      
                                      
                                      
                                      (1,435
                                      )Net
      income (loss)
                                      
                                      $
                                      (17,742
                                      )
                                      
                                      $
                                      (2,781
                                      )
                                      
                                      $
                                      (31,030
                                      )
                                      
                                      $
                                      (1,730
                                      )Dividends
      to preferred stockholders
                                      
                                      
                                      215
                                      
                                      
                                      
                                      0
                                      
                                      
                                      
                                      528
                                      
                                      
                                      
                                      0Accretion
      of discount on preferred stock
                                      
                                      
                                      30
                                      
                                      
                                      
                                      0
                                      
                                      
                                      
                                      81
                                      
                                      
                                      
                                      0Net
      income (loss) available to common stockholders
                                      
                                      $
                                      (17,987
                                      )
                                      
                                      $
                                      (2,781
                                      )
                                      
                                      $
                                      (31,639
                                      )
                                      
                                      $
                                      (1,730
                                      )Basic
      earnings (loss) per share
                                      
                                      $
                                      (4.42
                                      )
                                      
                                      $
                                      (0.68
                                      )
                                      
                                      $
                                      (7.77
                                      )
                                      
                                      $
                                      (0.42
                                      )Diluted
      earnings (loss) per share
                                      
                                      $
                                      (4.42
                                      )
                                      
                                      $
                                      (0.68
                                      )
                                      
                                      $
                                      (7.77
                                      )
                                      
                                      $
                                      (0.42
                                      )Comprehensive
      income (loss)
                                      
                                      $
                                      (15,686
                                      )
                                      
                                      $
                                      (683
                                      )
                                      
                                      $
                                      (29,531
                                      )
                                      
                                      $
                                      (1,725
                                      )
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
   4
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 CONDENSED CONSOLIDATED
STATEMENTS OF CASH FLOWS
 Nine months
ended September 30, 2009 and 2008
 (In
thousands of dollars) (Unaudited)
   Nine
      months endedSeptember
      30,
                                
                                
                                September
      30,2009
                                
                                
                                2008Cash
      flows from operating activitiesNet
      income
                                
                                $
                                (31,030
                                )
                                
                                $
                                (1,730
                                )Adjustments
      to reconcile net income to net cash from
                                  operating
      activities:Depreciation
                                
                                
                                466
                                
                                
                                
                                391Amortization
      of other intangible assets
                                
                                
                                348
                                
                                
                                
                                348Impairment
      loss on securities
                                
                                
                                3,052
                                
                                
                                
                                2,180Net
      gains on sales of securities
                                
                                
                                0
                                
                                
                                
                                (40
                                )Provision
      for loan and lease losses
                                
                                
                                18,244
                                
                                
                                
                                8,129Net
      (gain) loss on sale of other real estate owned
                                
                                
                                1,594
                                
                                
                                
                                0Write-down
      of goodwill
                                
                                
                                9,522
                                
                                
                                
                                0Deferred
      loan fees
                                
                                
                                (112
                                )
                                
                                
                                330Net
      change in accrued interest receivable and other assets
                                
                                
                                4,821
                                
                                
                                
                                (3,720
                                )Net
      change in accrued interest payable and other liabilities
                                
                                
                                1,557
                                
                                
                                
                                108Net
      cash from operating activities
                                
                                
                                8,462
                                
                                
                                
                                5,996Cash
      flows used in investing activitiesProceeds
      from maturities and calls of securities available for sale
                                
                                
                                25,887
                                
                                
                                
                                83,362Proceeds
      from sales of securities available for sale
                                
                                
                                0
                                
                                
                                
                                8,240Purchases
      of securities available for sale
                                
                                
                                (48,884
                                )
                                
                                
                                (62,223
                                )Change
      in loans made to customers
                                
                                
                                8,752
                                
                                
                                
                                (58,780
                                )Purchases
      of Federal Home Loan Bank stock
                                
                                
                                (44
                                )
                                
                                
                                (312
                                )Property
      and equipment expenditures
                                
                                
                                (374
                                )
                                
                                
                                (841
                                )Improvements
      to other real estate owned
                                
                                
                                (69
                                )
                                
                                
                                (213
                                )Proceeds
      from sales of other real estate owned
                                
                                
                                4,791
                                
                                
                                
                                0Net
      cash from investing activities
                                
                                
                                (9,941
                                )
                                
                                
                                (30,767
                                )Cash
      flows used in financing activitiesNet
      increase (decrease) in:Deposits
                                
                                
                                19,332
                                
                                
                                
                                12,162Issuance
      of preferred stock and warrants per TARP
                                
                                
                                17,211
                                
                                
                                
                                0Securities
      sold under repurchase agreements
                                  and
      federal funds purchased
                                
                                
                                (158
                                )
                                
                                
                                15,222Advances
      from borrowers for taxes and insurance
                                
                                
                                (567
                                )
                                
                                
                                (509
                                )Federal
      Home Loan Bank advances
                                
                                
                                10,000
                                
                                
                                
                                70,000Repayment
      of Federal Home Loan Bank advances
                                
                                
                                (30,000
                                )
                                
                                
                                (35,000
                                )Purchases
      of treasury stock
                                
                                
                                0
                                
                                
                                
                                (2,078
                                )Dividends
      paid on preferred stock
                                
                                
                                (418
                                )
                                
                                
                                0Dividends
      paid on common stock
                                
                                
                                0
                                
                                
                                
                                (1,628
                                )Net
      cash from financing activities
                                
                                
                                15,400
                                
                                
                                
                                58,169Net
      change in cash and cash equivalents
                                
                                
                                13,921
                                
                                
                                
                                33,398Cash
      and cash equivalents at beginning of period
                                
                                
                                21,868
                                
                                
                                
                                23,634Cash
      and cash equivalents at end of period
                                
                                $
                                35,789
                                
                                
                                $
                                57,032
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
  
 5
 Table of Contents
 
 NORTHERN STATES FINANCIAL
CORPORATION
 CONDENSED CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’EQUITY
 Nine
months ended September 30, 2009 and 2008
 (In
thousands of dollars, except for per share data) (Unaudited)


Common
                      Stock
                  
                  
                  Preferred
                      Stock
                  
                  
                  Warrants
                  
                  
                  Additional
                      Paid-In
                      Capital
                  
                  
                  Retained
                      Earnings
                  
                  
                  Treasury
                      Stock,
      at
                      Cost
                  
                  
                  Accumulated
                      Other
                      Comprehensive
                      Income
      (Loss)
                  
                  
                  Total
                      Stockholders’
                      EquityBalance,
      December 31, 2007
                  
                  $
                  1,789
                  
                  
                  $
                  0
                  
                  
                  $
                  0
                  
                  
                  $
                  11,584
                  
                  
                  $
                  66,983
                  
                  
                  $
                  (7,202
                  )
                  
                  $
                  300
                  
                  
                  $
                  73,454Net
      income (loss)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,730
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,730
                  )Cash
      dividends ($.40 per share)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,628
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,628
                  )Purchase
      of 105,850 shares of common stock as treasury stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (2,078
                  )
                  
                  
                  
                  
                  
                  
                  (2,078
                  )Unrealized
      gains on securitiesavailable
      for sale, net of deferred tax
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  5
                  
                  
                  
                  5Balance, September 30,
      2008
                  
                  $
                  1,789
                  
                  
                  $
                  0
                  
                  
                  $
                  0
                  
                  
                  $
                  11,584
                  
                  
                  $
                  63,625
                  
                  
                  $
                  (9,280
                  )
                  
                  $
                  305
                  
                  
                  $
                  68,023Balance,
      December 31, 2008
                  
                  $
                  1,789
                  
                  
                  $
                  0
                  
                  
                  $
                  0
                  
                  
                  $
                  11,584
                  
                  
                  $
                  56,082
                  
                  
                  $
                  (9,280
                  )
                  
                  $
                  1,439
                  
                  
                  $
                  61,614Net
      income (loss)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,457
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,457
                  )Issuance
      of preferred stock and warrants
                  
                  
                  
                  
                  
                  
                  16,530
                  
                  
                  
                  681
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  17,211Accrued
      dividend on preferred stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (98
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (98
                  )Accretion
      of preferred stock discount issued
                  
                  
                  
                  
                  
                  
                  20
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (20
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  0Unrealized
      loss on securities available for sale, net of deferred
      tax
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (735
                  )
                  
                  
                  (735
                  )Balance,
      March 31, 2009
                  
                  
                  1,789
                  
                  
                  
                  16,550
                  
                  
                  
                  681
                  
                  
                  
                  11,584
                  
                  
                  
                  54,507
                  
                  
                  
                  (9,280
                  )
                  
                  
                  704
                  
                  
                  
                  76,535Adjustment
      for change in accounting from adoption of FSP FAS 115-2 and FSP FAS 124-2,
      April 1, 2009 (see note 6)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  962
                  
                  
                  
                  
                  
                  
                  
                  (962
                  )
                  
                  
                  0Balance,
      April 1, 2009 restated
                  
                  
                  1,789
                  
                  
                  
                  16,550
                  
                  
                  
                  681
                  
                  
                  
                  11,584
                  
                  
                  
                  55,469
                  
                  
                  
                  (9,280
                  )
                  
                  
                  (258
                  )
                  
                  
                  76,535Net
      income (loss)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (29,573
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (29,573
                  )Accrued
      dividend on preferred stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (430
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (430
                  )Accretion
      of preferred stock discount issued
                  
                  
                  
                  
                  
                  
                  61
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (61
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  0Unrealized
      loss on securities available for sale, net of deferred tax
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2,234
                  
                  
                  
                  2,234Balance, September 30,
      2009
                  
                  $
                  1,789
                  
                  
                  $
                  16,611
                  
                  
                  $
                  681
                  
                  
                  $
                  11,584
                  
                  
                  $
                  25,405
                  
                  
                  $
                  (9,280
                  )
                  
                  $
                  1,976
                  
                  
                  $
                  48,766
   6
 Table of Contents




NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  September
30, 2009
  (Unaudited)
       Note 1 - Basis of
Presentation
 
 The
accompanying interim condensed consolidated financial statements are prepared
without audit and reflect all adjustments which are of a normal and recurring
nature and, in the opinion of management, are necessary to present interim
financial statements of Northern States Financial Corporation (the "Company") in
accordance with accounting principles generally accepted in the United States of
America. The interim financial statements do not purport to contain all the
necessary financial disclosures covered by accounting principles generally
accepted in the United States of America that might otherwise be necessary for
complete financial statements.
 
 To
prepare financial statements in conformity with accounting principles generally
accepted in the United States of America, management makes estimates and
assumptions based on available information.  These estimates and
assumptions affect the amounts reported in the financial statements and the
disclosures provided, and future results could differ.  The allowance
for loan and lease losses, valuation of other real estate owned, valuation of
other than temporarily impaired securities, valuation of deferred tax assets and
status of contingencies are particularly subject to change.
 
 The
interim condensed financial statements should be read in conjunction with the
audited financial statements and accompanying notes (or "notes thereto") of the
Company for the years ended December 31, 2008 and 2007 included in the Company’s
Annual Report on Form 10-K for the year ended December 31, 2008 as filed with
the Securities and Exchange Commission.  The results of operations for
the three and nine month periods ended September 30, 2009 included herein are
not necessarily indicative of the results to be expected for the full year
2009.
 
 Net
income (loss) was utilized to calculate earnings (loss) per share for all
periods presented.  During the first nine months of 2009, the Company
had preferred stock and common stock equivalents from warrants related to funds
received from the U.S Department of the Treasury (the “Treasury Department”)
through its Capital Purchase Program.  However, common stock
equivalents from warrants during the three and nine month periods ended
September 30, 2009 were antidilutive and, therefore, not considered in computing
diluted earnings per share.  The Company had no common stock
equivalents during the three and nine month periods ended September 30,
2008.   The average outstanding common shares used for earnings
(loss) per share were as follows:




7
 Table of Contents






NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  September
30, 2009
  (Unaudited)








(Dollars
      in thousands, except per share data)
                        
                        Three
      Months Ended
                          September
      30,
                        
                        
                        Nine
      Months Ended
                          September
      30,2009
                        
                        
                        2008
                        
                        
                        2009
                        
                        
                        2008Basic
      earnings per share:Net
      income (loss)
                        
                        $
                        (17,742
                        )
                        
                        $
                        (2,781
                        )
                        
                        $
                        (31,030
                        )
                        
                        $
                        (1,730
                        )Dividends
      to preferred stockholders
                        
                        
                        215
                        
                        
                        
                        -
                        
                        
                        
                        528
                        
                        
                        
                        -Accretion
      of discount on preferred stock
                        
                        
                        30
                        
                        
                        
                        -
                        
                        
                        
                        81
                        
                        
                        
                        -Net
      income available to common stockholders
                        
                        $
                        (17,987
                        )
                        
                        $
                        (2,781
                        )
                        
                        $
                        (31,639
                        )
                        
                        $
                        (1,730
                        )Weighted
      average common shares outstanding
                        
                        
                        4,072,255
                        
                        
                        
                        4,072,255
                        
                        
                        
                        4,072,255
                        
                        
                        
                        4,112,356Basic
      earnings per share
                        
                        $
                        (4.42
                        )
                        
                        $
                        (0.68
                        )
                        
                        $
                        (7.77
                        )
                        
                        $
                        (0.42
                        )Diluted
      earnings per share:Net
      income (loss)
                        
                        $
                        (17,742
                        )
                        
                        $
                        (2,781
                        )
                        
                        $
                        (31,030
                        )
                        
                        $
                        (
      1,730
                        )Dividends
      to preferred stockholders
                        
                        
                        215
                        
                        
                        
                        -
                        
                        
                        
                        528
                        
                        
                        
                        -Accretion
      of discount on preferred stock
                        
                        
                        30
                        
                        
                        
                        -
                        
                        
                        
                        81
                        
                        
                        
                        -Net
      income available to common stockholders
                        
                        $
                        (17,987
                        )
                        
                        $
                        (2,781
                        )
                        
                        $
                        (31,639
                        )
                        
                        $
                        (1,730
                        )Weighted
      average common shares outstanding
                        
                        
                        4,072,255
                        
                        
                        
                        4,072,255
                        
                        
                        
                        4,072,255
                        
                        
                        
                        4,112,356Add:
      Dilutive effect of assumed warrant exercises
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Weighted
      average common and dilutive common
                          shares
      outstanding
                        
                        
                        4,072,255
                        
                        
                        
                        4,072,255
                        
                        
                        
                        4,072,255
                        
                        
                        
                        4,112,356Diluted
      earnings per share
                        
                        $
                        (4.42
                        )
                        
                        $
                        (0.68
                        )
                        
                        $
                        (7.77
                        )
                        
                        $
                        (0.42
                        )






Note 2 – Preferred
Stock
  On February 20, 2009, pursuant to the Treasury Department’s TARP Capital
Purchase Program, the Company issued to the Treasury Department, in exchange for
total proceeds of $17,211,000, (i) 17,211 shares of the Company’s Fixed Rate
Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”),
par value $.40 per share and a liquidation amount per share equal to $1,000 per
share, and (ii) a ten-year warrant (the “Warrant”) to purchase up to 584,084
shares of the Company’s common stock, at an exercise price of $4.42 per
share.  The $17,211,000 proceeds were allocated to the Series A
Preferred Stock and the Warrant based on the relative fair value of the
instruments.  The difference between the initial carrying value of
$16,530,000 that was allocated to the Series A Preferred Stock and its
redemption value of $17,211,000 will be charged to retained earnings (with a
corresponding increase to the carrying value of the Series A Preferred Stock)
over the first five years as an adjustment to the dividend yield using the
effective yield method.  The Series A Preferred Stock is generally
non-voting and qualifies as Tier 1 capital.
 In the event of a liquidation or
dissolution of the Company, the Series A Preferred Stock then outstanding takes
precedence over the Company’s common stock for the payment of dividends and
distribution of assets.
  8
 Table of Contents




NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  September
30, 2009
  (Unaudited)
 Dividends are payable quarterly on the
Series A Preferred Stock at an annual dividend rate of 5% per year for the first
five years, and 9% per year thereafter.  The effective yield of the
Series A Preferred Stock approximates 5.94%.  Subsequent to September
30, 2009, the Company notified the Treasury Department of its intent to suspend
its dividend payments on its Series A Preferred Stock.  The suspension
of dividend payments is permissible under the terms of the TARP Capital Purchase
Program, but the dividend is a cumulative dividend and failure to pay dividends
for six dividend periods would trigger board of director appointment rights for
the holder of the Series A Preferred Stock.
 
 For as long as any shares of Series A
Preferred Stock are outstanding, no dividends may be declared or paid on the
Company’s common stock unless all accrued and unpaid dividends for all past
dividend periods on the Series A Preferred Stock are fully paid. Pursuant to the
Capital Purchase Program, the Treasury Department’s consent is required for any
increase in dividends on the Company’s common stock from the amount of $0.40 per
share, the last semi-annual stock dividend declared by the Company prior to
October 14, 2008, unless the Series A Preferred Stock is redeemed in whole or
the Treasury Department has transferred all of the Series A Preferred Stock it
owns to third parties.
 
 The Company may not repurchase any of
its common stock of the Company without the prior consent of the Treasury
Department for as long as the shares of Series A Preferred Stock are outstanding
to the Treasury Department or the Treasury Department transfers all of the
Series A Preferred Stock it owns to third parties.
 Note 3 – Common
Stock
 
 
 Information
related to common stock at the dates indicated was as follows:
 
 
 September
      30,
                        2009
                    
                    
                    December 31,
                        2008Par
      value per share
                    
                    $
                    0.40
                    
                    
                    $
                    0.40Authorized
      shares
                    
                    
                    6,500,000
                    
                    
                    
                    6,500,000Issued
      shares
                    
                    
                    4,472,255
                    
                    
                    
                    4,472,255Treasury
      shares
                    
                    
                    400,000
                    
                    
                    
                    400,000Outstanding
      shares
                    
                    
                    4,072,255
                    
                    
                    
                    4,072,255
 
 Pursuant to the Capital Purchase
Program, the Company issued to the Treasury Department a Warrant to purchase up
to 584,084 shares of the Company’s common stock at an exercise price of $4.42
per share.  Based upon its fair value relative to the Series A
Preferred Stock discussed in Note 2 above, the Warrant was recorded at a value
of $681,000 and is accounted for as equity.  The Warrant is
exercisable, in whole or in part, at any time and from time to time until the
tenth anniversary of the issue date.
   9
 Table of Contents




NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  September
30, 2009
  (Unaudited)
  Note 4 –
Securities
 
 At September 30, 2009 the Company had
the following securities in its investment securities
portfolio:




Gross
      UnrealizedSeptember
      30, 2009  ($000's)
                
                Fair
      Value
                
                
                Gain
                
                
                LossU.S.
      Treasury
                
                $
                1,011
                
                
                $
                12
                
                
                $
                —U.S.
      government-sponsored entities
                
                
                1,011
                
                
                
                11
                
                
                
                —States
      and political subdivisions
                
                
                11,085
                
                
                
                267
                
                
                
                (11
                )Mortgage-backed
      securities
                
                
                106,807
                
                
                
                3,685
                
                
                
                (53
                )Other
      bonds
                
                
                22
                
                
                
                —
                
                
                
                (757
                )Equity
      securities
                
                
                4,026
                
                
                
                47
                
                
                
                —Total
      securities available-for-sale
                
                $
                123,962
                
                
                $
                4,022
                
                
                $
                (821
                )Gross
      UnrealizedDecember
      31, 2008  ($000's)
                
                Fair
      Value
                
                
                Gains
                
                
                LossesU.S.
      Treasury
                
                $
                1,024
                
                
                $
                27
                
                
                $
                —U.S.
      government-sponsored entities
                
                
                1,038
                
                
                
                38
                
                
                
                —States
      and political subdivisions
                
                
                11,987
                
                
                
                83
                
                
                
                (211
                )Mortgage-backed
      securities
                
                
                83,055
                
                
                
                2,484
                
                
                
                (2
                )Other
      bonds
                
                
                2,265
                
                
                
                —
                
                
                
                —Equity
      securities
                
                
                3,825
                
                
                
                —
                
                
                
                (41
                )Total
      securities available-for-sale
                
                $
                103,194
                
                
                $
                2,632
                
                
                $
                (254
                )




There were no sales of securities
during the nine months ended September 30, 2009 compared with sales of
securities available for sale of $8.2 million during the nine months ended
September 30, 2008 from which gains of
$40,000 were recognized. Contractual maturities of securities available for sale
at September 30, 2009 were as
follows. Securities not due at a single maturity date, primarily mortgage-backed
securities, are shown separately.




September
      30, 2009  ($000's)
                            
                            FairValueDue
      in one year or less
                            
                            $
                            4,746Due
      after one year through five years
                            
                            
                            2,608Due
      after five years through ten years
                            
                            
                            1,583Due
      after ten years
                            
                            
                            4,19213,129Mortgage-backed
      securities
                            
                            
                            106,807Equity
      securities
                            
                            
                            4,026Total
      securities available-for-sale
                            
                            $
                            123,962






10
 Table of Contents




NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  September
30, 2009
  (Unaudited)
 At
September 30, 2009 and December 31, 2008, there were 7 and 20 securities,
respectively in an unrealized loss position.  Securities with
unrealized losses at September 30, 2009 aggregated by investment category and
length of time that individual securities have been in a continuous loss
position are as follows:
 
 
 Less than 12 Months
                                  
                                  
                                  12 Months or More
                                  
                                  
                                  TotalSeptember
      30, 2009  ($000's)
                                  
                                  FairValue
                                  
                                  
                                  UnrealizedLosses
                                  
                                  
                                  FairValue
                                  
                                  
                                  UnrealizedLosses
                                  
                                  
                                  FairValue
                                  
                                  
                                  UnrealizedLossesStates
      and political subdivisions
                                  
                                  $
                                  780
                                  
                                  
                                  $
                                  (11
                                  )
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  780
                                  
                                  
                                  $
                                  (11
                                  )Mortgage-backed
      securities
                                  
                                  
                                  14,876
                                  
                                  
                                  
                                  (53
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  14,876
                                  
                                  
                                  
                                  (53
                                  )Other
      bonds
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  22
                                  
                                  
                                  
                                  (757
                                  )
                                  
                                  
                                  22
                                  
                                  
                                  
                                  (757
                                  )Total
      temporarily impaired
                                  
                                  $
                                  15,656
                                  
                                  
                                  $
                                  (64
                                  )
                                  
                                  $
                                  22
                                  
                                  
                                  $
                                  (757
                                  )
                                  
                                  $
                                  15,678
                                  
                                  
                                  $
                                  (821
                                  )
    Less than 12 Months
                                
                                
                                12 Months or More
                                
                                
                                TotalDecember
      31, 2008  ($000's)
                                
                                FairValue
                                
                                
                                UnrealizedLosses
                                
                                
                                FairValue
                                
                                
                                UnrealizedLosses
                                
                                
                                FairValue
                                
                                
                                UnrealizedLossesStates
      and political subdivisions
                                
                                $
                                5,601
                                
                                
                                $
                                (211
                                )
                                
                                $
                                -
                                
                                
                                $
                                -
                                
                                
                                $
                                5,601
                                
                                
                                $
                                (211
                                )Mortgage-backed
      securities
                                
                                
                                157
                                
                                
                                
                                (2
                                )
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                157
                                
                                
                                
                                (2
                                )Equity
      securities
                                
                                
                                3,782
                                
                                
                                
                                (41
                                )
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                3,782
                                
                                
                                
                                (41
                                )Total
      temporarily impaired
                                
                                $
                                9,540
                                
                                
                                $
                                (254
                                )
                                
                                $
                                -
                                
                                
                                $
                                -
                                
                                
                                $
                                9,540
                                
                                
                                $
                                (254
                                )
 
 
 At
September 30, 2009, for securities in a loss position, the Company does not have
the intent to sell these securities and the Company believes it is unlikely that
the Company will be required to sell these securities while they are in a loss
position.
 
 The other
bonds consist of Collateralized Debt Obligations (“CDOs”).  During
2008, the Company had recognized impairment losses of $8.6 million on these CDOs
using cash flow analysis pursuant to the then current guidelines on recognition
of impairment losses.
 
 In April
2009, the accounting guidelines were changed and the Company adopted the new
guidance on recognition and presentation of other than temporary
impairment.  The new guidance requires that credit related other than
temporary impairment (“OTTI”)  be recognized on available for sale
debt securities while noncredit related OTTI be recognized as other
comprehensive income (“OCI”).
 
 The Company changed its accounting
treatment of the other than temporary impairment on its CDOs at April 1, 2009 to
comply with the new accounting pronouncements.  The Company determined
through cash flow analyses and analysis of the financial status of the debtors
underlying the CDOs at March 31, 2009 that $1.5 million of impairment losses
taken during 2008 were the result of noncredit related losses and, accordingly,
such credited retained earnings less the net tax effect.
   11
 Table of
Contents
 NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  September
30, 2009
  (Unaudited)
  At June
30, 2009 and again at September 30, 2009, the Company updated its cash flow
analyses on the CDOs to determine if there had been any changes to the credit
losses on these CDOs during quarters after March 31, 2009.   The
cash flow analyses used at June 30, 2009 and September 30, 2009, assumed that
18.00 percent of the debt that underlies the CDOs will default during the
following 7 quarters, and annually thereafter, there will be defaults of 1.25
percent and recoveries of .15 percent lagging two years after the
defaults.  The Company believes these estimates are supportable based
on its analyses of actual defaults and deferrals and the actual financial
condition of the debtors underlying the CDOs.  For the three months
ended June 30, 2009, it was determined that there were additional credit losses
on the CDOs and $628,000 of securities impairment losses for other than
temporary impairment were recognized during the three months ended June 30,
2009.   At September 30, 2009, the Company recognized $2,424,000
of additional other than temporary impairment losses due to additional credit
losses on the CDOs for the quarter ended September 30, 2009.  At
September 30, 2009 the CDO securities had been written down for other than
temporary impairment to $779,000 from a book value of $10.9
million.
 Below
shows the credit loss roll forward on debt securities from December 31, 2008
through September 30, 2009:
  
 ($000's)December
      31, 2008  Accumulated Credit Losses:
                                            
                                            $
                                            10,541April
      1, 2009  Adjustment to Credit Losses forfor
      Change in Accounting from Adoption ofAccounting Guideline on the Recognition of Other ThanTemporary
      Impairments:
                                            
                                            
                                            (1,572
                                            )June
      30, 2009  Recognition of Credit Losses:
                                            
                                            
                                            628September
      30, 2009 Recognition of Credit Losses:
                                            
                                            
                                            2,424September 30,
      2009  Accumulated Credit Losses:
                                            
                                            $
                                            12,021
   Note 5 – Subordinated
Debentures
 During
September 2005, the Company issued $10 million of trust preferred securities
through Northern States Statutory Trust I, a wholly-owned grantor
trust.  The Company issued $10 million of subordinated debentures to
Northern States Statutory Trust I, which in turn issued $10 million of trust
preferred securities.  The subordinated debentures mature in September
2035.  From December 2005 until September 15, 2010, the subordinated
debentures bear interest at a rate equal to the sum of the product of 50% times
the 3-month LIBOR plus 1.80%, plus the product of 50% times 6.186%, and
thereafter at a rate equal to the 3-month LIBOR plus 1.80%.  The rate
on the subordinated debentures was 4.14250% at September 30, 2009, which is the
effective rate from September 15, 2009 through December 14, 2009.  For
the three months ended September 30, 2009 and 2008, interest expense on the
subordinated debentures was $109,000 and $137,000, respectively.  For
the nine months ended September 30, 2009 and 2008, interest expense on the
subordinated debentures was $349,000 and $433,000, respectively.
 12
 Table of Contents
 NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  September
30, 2009
  (Unaudited)
 The
Company has guaranteed the payment of distributions and payments upon
liquidation or redemption of the trust preferred securities, in each case to the
extent of funds held by the Trust. The Company and the Trust believe that, taken
together, the obligations of the Company under the guarantee, the subordinated
debentures, and other related agreements provide, in the aggregate, a full,
irrevocable and unconditional guarantee, on a subordinated basis, of all of the
obligations of the Trust under the trust preferred securities. Subject to
certain limitations, the Company has the right to defer the payment of interest
on the junior subordinated debentures at any time, or from time to time, for a
period not to exceed 20 consecutive quarters.  Subsequent to September
30, 2009, the Company notified the trustee that holds the Company’s junior
subordinated debentures relating to its outstanding trust preferred securities
that the Company would be deferring its regularly scheduled quarterly interest
payments.  During the deferral period, the Company may not pay any
dividends on its common or preferred stock. The trust preferred securities are
subject to mandatory redemption, in whole or in part, upon repayment of the
subordinated debentures at maturity or their earlier redemption. The
subordinated debentures are callable at par beginning in 2010 and earlier at the
discretion of the Company if certain conditions are met, and, in any event, only
after the Company has obtained Federal Reserve approval, if then required under
applicable guidelines or regulations.  Subject to certain exceptions,
the Company may not without the consent of the Treasury Department engage in
repurchases of the Company’s common stock or trust preferred securities for
three years or, if earlier, the date on which all shares of Series A Preferred
Stock issued to the Treasury Department have been redeemed or transferred by the
Treasury Department.
 13
 Table of
Contents




NORTHERN STATES FINANCIAL
CORPORATION
  ITEM 2. MANAGEMENT’SDISCUSSION AND ANALYSIS OF
FINANCIAL CONDITIONAND RESULTS OF OPERATIONS.
  The following discussion focuses on the
consolidated financial condition of Northern States Financial Corporation (the
“Company”) at September 30, 2009 and the consolidated results of operations for
the three and nine month periods ended September 30, 2009, compared with the
three and nine month periods ended September 30, 2008.  The purpose of
this discussion is to provide a better understanding of the condensed
consolidated financial statements of the Company and the operations of its two
wholly-owned subsidiaries, NorStates Bank (the “Bank”) and NorProperties, Inc.
(“NorProp”), and the Bank’s wholly- owned subsidiary, Northern States Community
Development Corporation (“NSCDC”). This discussion should be read in conjunction
with the interim condensed consolidated unaudited financial statements and notes
thereto included herein.
 
 Statements
contained in this report that are not historical facts may constitute
forward-looking statements (within the meaning of Section 21E of the Securities
Exchange Act of 1934, as amended), which involve significant risks and
uncertainties.  The Company intends such forward-looking statements to
be covered by the safe harbor provisions for forward-looking statements
contained in the Private Securities Litigation Reform Act of 1995, and is
including this statement for purposes of invoking these safe harbor
provisions.  Forward-looking statements, which are based on certain
assumptions and describe future plans, strategies and expectations of the
Company, are generally identifiable by the use of the words "believe," "expect,"
"intend," "anticipate," "estimate," "project," "plan," or similar
expressions.  The Company's ability to predict results or the actual
effect of future plans or strategies is inherently uncertain and actual results
may differ from those predicted.  The Company undertakes no obligation
to update these forward-looking statements in the future.  The Company
cautions readers of this report that a number of important factors could cause
the Company’s actual results subsequent to September 30, 2009 to differ
materially from those expressed in forward-looking
statements.  Factors that could cause actual results to differ from
those predicted and could have a material adverse effect on the operations of
the Company and its subsidiaries include, but are not limited to, the potential
for further deterioration in the credit quality of the Company’s loan and lease
portfolios, uncertainty regarding the Company’s ability to ultimately recover on
loans currently on nonaccrual status, unanticipated changes in interest rates,
general economic conditions, increasing regulatory compliance burdens or
potential legislative/regulatory changes, monetary and fiscal policies of the
U.S. Government, including policies of the U.S. Treasury and the Federal Reserve
Board, the quality or composition of the Company’s loan or investment
portfolios, deposit flows, competition, demand for loan products and financial
services in the Company’s market area, and changes in accounting principles,
policies and guidelines.  These risks and uncertainties should be
considered in evaluating forward-looking statements.
 
 OVERVIEW
 
 Total
assets at September 30, 2009 were $628.1 million, a decrease of $12.6 million
from total assets of $640.7 million at December 31, 2008.  Loans
totaled $449.7 million at September 30, 2009, a decrease of $31.1 million, or
6.5 percent, from loans of $480.8 million at December 31, 2008. The loans
decreased as $23.0 million in loans that were revalued down by $6.2 million to
$16.8 million and were transferred to other real estate
owned.  Investment in overnight federal funds sold increased to $21.3
million at September 30, 2009, as compared with $7.5 million, at December 31,
2008, as the Company increased its liquidity levels due in part from the receipt
of $17.2 million in proceeds from the issuance of preferred stock under the
Treasury Department’s TARP Capital Purchase Program on February 20,
2009.  These funds increased the Company's capital levels, which
exceeded the regulatory minimums for capital adequacy at September 30,
2009.
 14
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  Deposits totaled $520.1 million at September 30, 2009, increasing $19.3 million
from December 31, 2008 deposit levels of $500.8 million due to growth to coreNOW accounts and CDARs time deposits (a reciprocal agreement where
NorStates Bank places certain customers’ larger time deposits with other
independent financial institutions allowing the Bank’s customers to maximize
FDIC insurance coverage).  At the same time, the Company reduced its
wholesale brokered time deposits by $36.6 million and also paid off its Federal
Home Loan Bank advances that had totaled $20.0 million at December 31,
2008.
  The
Company had a loss for the three months ended September 30, 2009 of $17.7
million, or $4.42 per share, compared with a loss of $2.8 million, or $0.68 per
share for the same three months of 2008.  The majority of the loss in
the third quarter of 2009 was caused by an increase to the provision to the
allowance for loan and lease losses of $12.8 million of which $8.3 million was
specifically allocated to a $10.3 million loan relationship consisting primarily
of 13
commercial loans and leases.  This loan relationship was placed on
nonaccrual status during the three months ended September 30, 2009 as the loans
and leases became past due amid allegations of possible fraud.  Other
factors affecting net income for the third quarter of 2009 were the creation of
a deferred tax asset valuation allowance,
additional write-downs to securities for other than temporaryimpairment and FDIC
insurance premiums.
 
 Per
accounting rules, the Company created a deferred tax asset valuation allowance
at September 30, 2009 that totaled $9.2 million.  The effect of this
deferred tax asset valuation allowance was that the Company’s tax expense
increased $9.2 million during the third quarter of 2009.  This was a
noncash event and the Company expects that it will be abletouse the
entire deferred tax asset valuation allowance in the future to lower tax
expense.
 
 Earnings
for the quarter ended September 30, 2009, were also negatively impacted by other
than temporary impairment charges of $2.4 million taken on collateralized debt
obligations.  The investment in collateralized debt obligations has
been written down to $779,000 from a book value of $10.9 million.
 
 The
Company’s net interest income, the difference between interest earned on loans
and investments and interest paid on deposits and borrowings, decreased 13.7
percent, or $785,000, to $4.9 million for the quarter ended September 30, 2009,
as compared with $5.7 million for the same quarter of 2008.  The
decline in net interest income was attributable to nonearning nonaccrual loans
that totaled $45.6 million at September 30, 2009 as compared with $19.7 million
at September 30, 2008. Also affecting net interest income was the increase to
lower interest earning federal funds sold that averaged $33.8 million during the
third quarter of 2009 as compared with only $2.4 million during the same quarter
of 2008 as the Company increased its liquidity levels. The net yield on interest
earning assets declined to 3.32 percent during the third quarter of 2009 as
compared with 3.80 percent during the same quarter of 2008.
  CRITICAL ACCOUNTING
POLICIES
  Certain
critical accounting policies involve estimates and assumptions by
management.  To prepare financial statements in conformity with
accounting principles generally accepted in the United States of America,
management makes estimates and assumptions based on available
information.  These estimates and assumptions affect the amounts
reported in the financial statements and the disclosures provided, and future
results could differ. The allowance for loan and lease losses is a critical
accounting policy for the Company because management must make estimates of
losses and these estimates are subject to change.
   15
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 The
allowance for loan and lease losses is a valuation allowance for probable
incurred credit losses, increased by the provision for loan and lease losses and
decreased by charge-offs less recoveries.  Management estimates the
allowance balance required using past loan and lease loss experience, the nature
and volume of the portfolio, information about specific borrower situations,
estimated collateral values, economic conditions and other
factors.  Allocations of the allowance may be made for specific loans
and leases, but the entire allowance is available for any loan or lease that,
based on management’s judgment, should be charged-off.
 
 Management analyzes the adequacy of the
allowance for loan and lease losses at least quarterly.   Factors
consid­ered in assessing the adequacy of the allowance include: changes in
the type and volume of the loan and lease portfolio; review of the larger
credits within the Bank; historical loss experi­ence; current economic
trends and conditions; review of the present value of expected cash flows or
fair value of collateral on impaired loans and leases; portfolio growth; and
other factors management deems appropriate.  Based on management’s
analysis, management believes the allowance for loan and lease losses at
September 30, 2009 is adequate to cover probable incurred credit
losses.
 
 One of
the components of the allowance for loan losses is historical loss
experience.  Due to the increased historical losses during the past
year as compared with previous years, the loss percentages based on the recent
trailing 12 months has been used as it is believed to be more indicative of
current loan loss estimates.  This differs from year-end 2008, when a
3-year historic loss average was used and from September 30, 2008, when a 5-year
historic loss average was used.
 
 Management
specifically analyzes its impaired loans for probable losses.  The
change in the volume of impaired loans may significantly impact the amount of
estimated losses specifically allocated to these loans depending on the adequacy
of the loan collateral and the borrowers’ ability to repay the
loans.  As specific allocations are done on a loan-by-loan basis, the
amount of the specific allocation is more likely subject to fluctuation than an
allocation for a pool of loans based on historical loss trends. The amount of
the allocations on nonperforming loans may fluctuate in future periods due to
changes in conditions of underlying collateral and changes in the borrowers’
ability to repay.
 
 Goodwill
resulted from business acquisitions and represents the excess of the purchase
price over the fair value of acquired tangible assets and liabilities and
identifiable intangible assets.  Goodwill was assessed for impairment
annually and more often if warranted by circumstances.  Any such
impairment was recognized in the period identified.  Goodwill was
analyzed at June 30, 2009 and was found to be impaired in its entirety and was
written off in the amount of $9.5 million during the quarter ended June 30,
2009.
 
 Other intangible assets consist of core
deposits and acquired customer relationship intangible assets arising from whole
bank and branch acquisitions, which is periodically evaluated for
impairment.  These assets were initially measured at fair value and
are being amortized on the straight-line method over their estimated useful life
of seven years.
 
 The Company analyzed its deferred tax
asset that totaled $15.1 million at September 30, 2009 due to its recent losses
prior to income taxes.  The analysis of the deferred tax asset
requires income projections into the future as well as any income tax refunds
that the Company may be able to receive.  Per accounting rules the
Company set up a deferred tax asset valuation allowance of $9.2 million at
September 30, 2009 based on its analysis.  The Company will need to
continue to analyze its deferred tax asset quarterly until such time as positive
net income streams become consistent and adequate enough to cause the deferred
tax asset valuation allowance to be reversed.
 16
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 FINANCIAL
CONDITION
 
 The
Company’s federal funds sold at September 30, 2009 increased to $21.3 million
compared with $7.5 million at December 31, 2008 as the Company managed its
liquidity.  The Company’s federal funds sold position increased
primarily as the result of the receipt of $17.2 million in proceeds from the
issuance of preferred stock under the Treasury Department’s TARP Capital
Purchase Program on February 20, 2009 and from increases to
deposits.  Federal funds sold are excess funds above what is necessary
to maintain at the Federal Reserve that the Company lends/sells to other
financial institutions on an overnight basis.  The Company may also
use these funds for its liquidity needs.
 
 The
Company’s securities available for sale increased $20.8 million, or 20.1
percent, to $124.0 million at September 30, 2009 compared with $103.2 million at
year-end 2008.  The Company increased its investment securities
portfolio to increase its yields on its earning assets while maintaining
liquidity.  The Company’s investments in mortgage-backed securities
increased $23.7 million and totaled $106.8 million at September 30, 2009
compared with $83.1 million at December 31, 2008.  The mortgage-backed
securities purchased by the Company are backed by seasoned mortgages and are
guaranteed by agencies of the U.S. government.   The Company’s
write-down of its collateralized debt obligations securities as being other than
temporarily impaired by $2.4 million caused a decrease to the Company’s other
bonds from year-end 2008.  At September 30, 2009, securities totaling
$86.8 million were pledged to secure public deposits, repurchase agreements and
for other purposes required or permitted by law.
 
 Loans and
leases totaled $449.7 million at September 30, 2009, decreasing $31.1 million
from $480.8 million at December 31, 2008.  The decrease was due in
part to $23.0 million in loans that were revalued down by $6.2 million by being
charged to the allowance for loan and lease losses, with the remaining $16.8
million transferred to other real estate owned.  The balance of the
decrease to loans and leases was due to lower borrower demands attributed to the
poor economy and to stricter loan underwriting.
 
 Approximately
90 percent of the Bank’s loan portfolio at September 30, 2009 was secured by
real estate.  The Company’s loans to the hotel industry totaled $73.0
million at September 30, 2009.    Loans totaling $110.1
million at September 30, 2009 were pledged to secure lines of credit from the
Federal Reserve Bank of Chicago and the Federal Home Loan Bank of
Chicago.  Loan commitments have decreased $17.4 million to $66.0
million at September 30, 2009, compared with $83.4 million at December 31, 2008,
corresponding with the decline in loan demand during the first nine months of
2009.  Letters of credit also decreased during the nine months ended
September 30, 2009, to $6.8 million from $7.8 million at year-end.  At
September 30, 2009, loans to related parties totaled $557,000 and loan
commitments and letters of credit issued to related parties were $1.9
million.  Loans, loan commitments and letters of credit to related
parties are made on the same terms and conditions that are available to the
public.
 
 Deposits
totaled $520.1 million at September 30, 2009, increasing $19.3 million from
$500.8 million at year-end 2008.   Deposit levels increased
primarily from increases to public deposits of $27.0 million that totaled $57.8
million at September 30, 2009 as compared with $30.8 million at year-end
2008.  The public deposits increased at September 30, 2009 as the
final installment of local real estate taxes were due in early September
2009.   Retail and commercial deposits declined $5.5 million and
$4.4 million, respectively during this same time period while brokered deposits
increased $3.0 million.  Although total retail deposits declined $5.5
million, retail NOW accounts increased $4.6 million from year-end 2008 due to
the Company’s “High Yield Checking Account” product that pays 4.50 percent
interest on the first $25,000 in the account if certain requirements are met
such as e-statements and debit card usage.   Although brokered
deposits increased $3.0 million, wholesale brokered deposits from depositors
outsidethe
Company’s marketing
area declined $36.6 million while the Company’s brokered deposits from its CDARs
product increased $39.6 million.  CDARs time deposits are
placed through a network of FDIC-insured financial institutions that work
cooperatively with one another to both purchase and place deposits of their
customers with one another so as to maximize the amount of FDIC insurance
available to the financial institutions’
customers.
  17
 Table of Contents
 NORTHERN STATES FINANCIAL
CORPORATION
 Securities
sold under repurchase agreements remained stable at $42.4 million at September
30, 2009 as compared with $42.6 million at December 31,
2008.  Borrowings from Federal Home Loan Bank term advances decreased
$20.0 million from year-end 2008 as the Company used excess liquidity to pay off
its Federal Home Loan Bank borrowings.
 
 During
January 2009, the Company’s stockholders approved an amendment to the
Certificate of Incorporation authorizing the Company to issue preferred
stock.  This was done in conjunction with the Company’s application in
late 2008 to the Treasury Department to participate in the TARP Capital Purchase
Program as the issuance of preferred stock by the Company was a requirement of
the program.  During January 2009, the Company received approval from
the Treasury Department for the TARP funds in the amount of $17,211,000. 
Both the Preferred Stock and the Warrants issued in conjunction with the
Preferred Stock qualify as Tier 1 capital.  During the three months
ended June 30, 2009, the Company used $16.0 million of the $17.2 million
received in TARP funds from the Treasury Department, along with other funds, to
make a capital contribution totaling $20.0 million to the Bank to further
enhance the Bank’s capital.
 
 
 FAIR VALUE
MEASUREMENTS
  The following tables present
information about the Company’s securities in its investment portfolio that were
measured at fair value on a recurring basis at September 30, 2009, and the
valuation techniques used by the Company to determine the fair
values.
  In
general, fair values determined by Level 1 inputs use quoted prices in active
markets for identical securities that the Company has the ability to
access.
  Fair
values determined by Level 2 inputs use other inputs that are observable, either
directly or indirectly.  These Level 2 inputs include quoted prices
for similar securities in active markets, and other inputs such as interest
rates and yield curves that are observable at commonly quoted
intervals.
  Level 3
inputs are unobservable inputs, including inputs that are available in
situations where there is little, if any, market activity for the related
securities.
  In
instances where inputs used to measure fair value fall into different levels in
the above fair value hierarchy, fair value measurements in their entirety are
categorized based on the lowest level input that is significant to the
valuation. The Company’s assessment of the significance of particular inputs to
these fair value measurements requires judgment and considers factors specific
to each security.
  On an
annual basis the Company validates the measurement of the fair values of its
securities by sending a listing of its securities to an independent securities
valuation firm.  This independent securities valuation firm determines
the fair values of the Company’s securities portfolio that is then compared to
the fair value using the methods outlined.  When this validation was
last done at September 30, 2008, the difference between the fair value reported
and the fair value determined by the independent securities valuation firm was
considered immaterial.  The Company is in the process of validating
the measurement of the fair value of its securities as of September 30,
2009.
 18
 Table of Contents
 NORTHERN STATES FINANCIAL
CORPORATION
    Disclosures
concerning securities measured at fair value are as follows:
  TABLE
1
  NORTHERN
STATES FINANCIAL CORPORATION
 ASSETS
MEASURED AT FAIR VALUE ON A RECURRING BASIS
 As
of September 30, 2009
 ($
000s)
  Fair
      Value Measurements at
                    Reporting
      Date UsingDescription
                
                09/30/09
                
                
                Quoted
                    Prices
                    in
      Active
                    Markets
      for
                    Identical
                    Assets
                    (Level
      1)
                
                
                Significant
                    Other
                    Observable
                    Inputs
                    (Level
      2)
                
                
                Significant
                    Unobservable
                    Inputs
                    (Level
      3)Securities
      available for sale
                
                $
                123,962
                
                
                $
                1,011
                
                
                $
                122,929
                
                
                $
                22
 
 Securities
classified within Level 3 consist primarily of collateralized debt obligations
(“CDOs”).  The CDOs were valued using discounted cash flow models that
integrate significant inputs, including prepayment speed, discount and loss
rates which are estimated based on projected performance of the specific
entities that secure the instruments.
  TABLE
2
  NORTHERN
STATES FINANCIAL CORPORATION
 CHANGES
IN LEVEL 3 MEASURED AT FAIR VALUE ON A RECURRING BASIS
 As
of September 30, 2009
 ($
000s)
  Securities
                    Available
                    for
      SaleBalance
      at December 31, 2008
                
                $
                2,265Total
      realized and unrealized gains (losses) included in income
                
                
                (3,052
                )Total
      unrealized gains (losses) included in other comprehensive
      income
                
                
                816Net
      purchase, sales, calls and maturities
                
                
                (7
                )Net
      transfer into Level 3
                
                
                0Balance
      at September 30, 2009
                
                $
                22
  19
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 The
Company also has assets that under certain conditions are subject to measurement
at fair value on a non-recurring basis. These assets are held to maturity loans
that are considered impaired per standards regarding impairment of
assets.  The Company has estimated the fair values of the impaired
loans using Level 3 inputs, specifically discounted cash flow projections, or,
if collateral dependent, the realizable value of the collateral.
  TABLE
3
  NORTHERN
STATES FINANCIAL CORPORATION
 ASSETS
MEASURED AT FAIR VALUE ON A NON-RECURRING BASIS
 As of
September 30, 2009
 ($
000s)
  Fair
      Value Measurements at Reporting Date UsingDescription
                            
                            09/30/09
                            
                            
                            Quoted
      Prices
                                in
      Active
                                Markets
      for
                                Identical
                                Assets
                                (Level
      1)
                            
                            
                            Significant
                                Other
                                Observable
                                Inputs
                                (Level
      2)
                            
                            
                            Significant
                                Unobservable
                                Inputs
                                (Level
      3)
                            
                            
                            Total
      Change
                                for
      the period
                                ended
      09/30/09Impaired
      loans per accounting guidelines
                            
                            $
                            44,871
                            
                            
                            $
                            —
                            
                            
                            $
                            —
                            
                            
                            $
                            44,871
                            
                            
                            $
                            (16,726
                            )
  
 The
following methods and assumptions were used to estimate fair values for
financial instruments.  Securities fair values are based on quoted
market prices, are based on observable inputs, including prices for similar
securities in active markets and interest rates and yield curves at commonly
quoted intervals, or are based on unobservable inputs, including inputs that are
available in situations where there is little, if any, market activity for the
related securities.  It is estimated that cash and cash equivalents,
accrued interest receivable and accrued interest payable are carried at fair
value.  For loans and leases, deposits, securities sold under
repurchase agreements and fixed rate Federal Home Loan Bank advances, the fair
value is estimated by discounted cash flow analysis using market rates for the
estimated life and credit.  Fair values for impaired loans are
estimated using discounted cash flow analyses or underlying collateral values,
where applicable.  The fair value of off-balance sheet items are based
on the fees or costs that would currently be charged to enter or terminate such
arrangements and the fair values are not material.
  20
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 TABLE
4
  NORTHERN
STATES FINANCIAL CORPORATION
 FAIR
VALUE OF FINANCIAL INSTRUMENTS
 As
of September 30, 2009
 ($
000s)
   September
      30, 2009
                    
                    Carrying
                      Value
                    
                    
                    Estimated
                      Fair
      ValueFinancial
      assets:Cash
      and cash equivalents
                    
                    $
                    35,789
                    
                    
                    $
                    35,789Securities
      available for sale
                    
                    
                    123,962
                    
                    
                    
                    123,962Loans and leases, net
                    
                    
                    426,324
                    
                    
                    
                    435,698Federal Home Loan Bank stock
                    
                    
                    1,801
                    
                    
                    
                    1,801Accrued interest receivable
                    
                    
                    2,259
                    
                    
                    
                    2,259Financial
      liabilities:Deposits
                    
                    $
                    (520,153
                    )
                    
                    $
                    (523,361
                    )Securities
      sold under repurchase agreement
                    
                    
                    (42,416
                    )
                    
                    
                    (42,388
                    )Subordinated
      debentures
                    
                    
                    (10,000
                    )
                    
                    
                    (10,186
                    )Advances
      from borrowers for taxes and insurance
                    
                    
                    (444
                    )
                    
                    
                    (444
                    )Accrued
      interest payable
                    
                    
                    (1,882
                    )
                    
                    
                    (1,882
                    )
  December
      31, 2008
                    
                    Carrying
                      Value
                    
                    
                    Estimated
                      Fair
      ValueFinancial
      assets:Cash
      and cash equivalents
                    
                    $
                    21,868
                    
                    
                    $
                    21,868Securities
      available for sale
                    
                    
                    103,194
                    
                    
                    
                    103,194Loans and leases, net
                    
                    
                    470,410
                    
                    
                    
                    485,206Federal Home Loan Bank stock
                    
                    
                    1,757
                    
                    
                    
                    1,757Accrued interest receivable
                    
                    
                    2,334
                    
                    
                    
                    2,334Financial
      liabilities:Deposits
                    
                    $
                    (500,821
                    )
                    
                    $
                    (505,905
                    )Securities sold under repurchase agreement
                    
                    
                    (42,574
                    )
                    
                    
                    (42,541
                    )Federal Home Loan Bank advances
                    
                    
                    (20,000
                    )
                    
                    
                    (20,004
                    )Subordinated debentures
                    
                    
                    (10,000
                    )
                    
                    
                    (10,151
                    )Advances
      from borrowers for taxes and insurance
                    
                    
                    (1,011
                    )
                    
                    
                    (1,011
                    )Accrued
      interest payable
                    
                    
                    (2,331
                    )
                    
                    
                    (2,331
                    )
  
 CAPITAL
RESOURCES
  Total
stockholders’ equity decreased $12.8 million to $48.8 million at September 30,
2009, as compared with $61.6 million at year-end 2008.  The decrease
was the result of losses for the first nine months of $31.0 million and the
accrual of dividends and accretion of the discount on the preferred stock that
totaled $528,000.   Partially offsetting these decreases was the
receipt of $17.2 million in TARP funds from the Treasury Department on February
20, 2009 for which the Company issued preferred stock and warrants to the
Treasury Department. Capital was increased by $1.0 million due to the adoption
of accounting pronouncements whereby the 2008 write-downs to collateral debt
obligations were adjusted to reflect only the credit loss on those
securities.  Also increasing capital was by $537,000 during the nine
months ended September 30, 2009 was increases to the accumulated other
comprehensive income relating to the unrealized gains on securities available
for sale, net of deferred tax.  The book value of the Company’s common
stock at September 30, 2009 was $7.75 per share, compared with $15.13 at
December 31, 2008.
 21
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  On a
consolidated basis, the Company’s Tier 1 to average assets ratio and total
capital to assets ratio, on a risk adjusted basis, were 8.37 percent and 11.83
percent, respectively, as of September 30, 2009, and both ratios exceed the
regulatory minimums for capital adequacy purposes.
 
 During the quarter ended June 30, 2009,
the Company used $16.0 million of the $17.2 million received in TARP funds from
the Treasury Department, along with other funds, to make a capital contribution
totaling $20.0 million to the Bank.  This capital contribution assists
in maintaining the Bank’s regulatory capital levels.
 
 At the
Company’s annual meeting of stockholders held on May 21, 2009, the stockholders
approved the 2009 Restricted Stock Plan (“Plan”).  The goal of the
Plan is to promote the Company’s long-term financial success, increase
stockholder value and enhance our ability to attract and retain employees and
directors.  The Plan authorizes the issuance of up to 400,000 shares
of the Company’s common stock, which is approximately 10 percent of the
Company’s total shares currently issued and outstanding, in connection with
incentive compensation awards.  Shares of the Company’s common stock
issued under the Plan as awards may consist of treasury shares or authorized and
unissued shares not reserved for any other purpose. Awards under the Plan may be
made to directors and employees of both the Company and its subsidiaries and may
consist of restricted stock with associated voting rights and the right to
receive dividends.   Awards may also be issued as restricted
stock units not having voting rights or the right to receive dividends until the
terms of the award are satisfied and shares of the Company’s common stock are
actually issued; however, dividends may be credited to a restricted stock unit
award.  The terms and conditions of each award will be set forth and
described in an award agreement between the Company and the
participant.  No awards have been issued under the Plan at September
30, 2009.
 
 
 LIQUIDITY
 
 The
Company’s liquidity is measured by the ability to raise funds through deposits,
borrowed funds, capital or cash flow from the repayment or maturities of loans
and securities and net profits.   Liquidity is primarily managed through
the growth of deposits and by liquid assets such as cash and due from banks less
any reserve requirements, securities available for sale less any pledged
securities and federal funds sold.  Asset and liability management is the
process of managing the balance sheet to achieve a mix of earning assets and
liabilities in such a way that achieves an interest rate risk profile acceptable
to management and assists in achieving a desired level of profitability.
 An important part of the overall asset and liability management process is
providing adequate liquidity.  Liquid assets at the Bank consist of
cash and cash equivalents less any Federal Reserve Bank deposit requirements
plus unpledged securities available for sale.  The Bank’s liquid
assets totaled $65.9 million at September 30, 2009, as compared with $46.8
million at December 31, 2008.
 
 Management
reviews the liquidity ratio as well as its sources and uses of funds
weekly.  The liquidity ratio is the net liquid assets divided by net
deposits and short-term liabilities.  At September 30, 2009, this
ratio at the Bank was 13.7 percent, compared with 9.5 percent at year-end
2008, and was within management’s internal policy guidelines.
 
 Liquidity
management involves the Company’s ability to meet the cash flow requirements of
customers and other operating needs.  The Company needs to have
sufficient cash flow to meet borrowers’ needs to fund loans or the requirements
of depositors wanting to withdraw funds.  The Statements of Cash Flows
shows that for the nine months ended September 30, 2009 cash and cash
equivalents increased by $13.9 million to $35.8 million, primarily as the result
of deposit increases of $19.3 million and the receipt of $17.2 million in TARP
funds.
 22
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  Federal
funds sold, interest bearing deposits in banks and available for sale
securities, particularly those of shorter maturities, are principal sources of
liquidity.  Federal funds sold at September 30, 2009 were $21.3
million as compared with $7.5 million at December 31, 2008.  The
Company classifies all of its securities as available for sale, which increases
the Company's flexibility in that the Company can use its unpledged securities
to meet liquidity requirements by increasing its repurchase agreement
balances.  Securities available for sale totaled $124.0 million at
September 30, 2009, of which $86.8 million were pledged to secure public
deposits and repurchase agreements, as compared with pledged securities of $72.0
million at December 31, 2008.
 
 An
important source of liquidity to the Company is deposits.  During the
first nine months of 2009, the Company had net incoming cash flows of $19.3
million in deposits.  Much of this increase is attributable to public
funds deposited in the Bank by local governmental units.  The Company
has the ability to increase deposits by increasing the interest rates it pays on
its deposits as compared to its competition.
 
 Another important source of liquidity
to the Company is borrowings.  During the nine months ended September
30, 2009, the Company paid off its advances at the Federal Home Loan Bank of
Chicago.  The Company’s line of credit available at the Federal Home
Loan Bank of Chicago was $36.0 million at September 30, 2009.  The
Company’s line of credit with the Federal Reserve Bank of Chicago was $18.8
million.  The Company has pledged loans totaling $110.1 million at
September 30, 2009 as security for potential borrowings the Company may incur by
drawing on the lines of credit at the Federal Home Loan Bank of Chicago and the
Federal Reserve Bank of Chicago.  Additional funds available from
available lines of credit at three independent banks at September 30, 2009
totaling $30.0 million also supplement the Company’s ability to meet any funding
needs, including any unexpected strain on liquidity.
 
 
 RESULTS OF
OPERATIONS
 
 NET
INCOME
 
 The
Company recognized a loss for the quarter ended September 30, 2009 of $17.7
million, as compared with a loss of $2.8 million for the same quarter of
2008.  The loss during the third quarter of 2009 was primarily
impacted by a provision for loan and lease losses of $12.8 millionandthe
creation of a deferred tax asset valuation allowance of $9.2 million that
increased the Company’s tax expense by that amount.
 
 Other
factors affecting the loss for the three months ended September 30, 2009,
include an impairment charge of $2.4 million taken on collateralized debt
obligations of trust preferred securities issued by financial institutions and
decreases to net interest income of $785,000 as compared with the same three
months of 2008.  Noninterest expenses also increased $741,000 during
the third quarter of 2009 as compared with the same quarter of
2008.
 
 For the nine months ended September 30,
2009, the Company posted a loss of $31.0 million as compared with a loss of $1.7
million for the same period of 2008.  The loss for the nine months
ended September 30, 2009 resulted from a provision for loan and lease losses of
$18.2 million, write-down of goodwill of $9.5 million, the increase of income
taxes of $9.2 million from the deferred tax asset valuation allowance, the
impairment write-down to securities of $3.1 million, net losses on the sale of
other real estate owned of $1.6 million, and FDIC insurance premiums of $1.1
million that included a special FDIC insurance assessment of
$304,000.
  23
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  NET
INTEREST INCOME
 
 Net
interest income, the difference between interest income on earning assets and
interest expense on interest bearing liabilities, decreased 13.7 percent, or
$785,000, to $4.9 million for the three months ended September 30, 2009, as
compared with $5.7 million for the same quarter of 2008.  The decline
in net interest income was attributable to increased levels of nonearning
nonaccrual loans and increases to lower earning federal funds sold during the
third quarter of 2009 as compared with the same quarter of 2008.
 
 Average interest earning assets during
the three months ended September 30, 2009 totaled $604.6 million, a decrease of
$4.9 million from average earning assets of $609.5 million during the three
months ended September 30, 2008.  The mix of average interest earning
assets show that lower earning average federal funds sold for the quarter ending
September 30, 2009 were $33.7 million as compared to only $2.4 million for the
same quarter of 2008.  Rates earned on federal funds for the quarter
ended September 30, 2009 were .09 percent as compared with 1.36 percent for the
same quarter last year, a decrease of 127 basis points.  As a result,
the change in earning asset mix reflecting an increase in lower yielding federal
funds sold had a negative impact on the total yield on interest earning
assets.  The Company increased its federal funds sold in 2009 as the
Company managed its liquidity.
 
 During
the quarter ended September 30, 2009, the net interest rate spread decreased 40
basis points to 3.00 percent as compared to 3.40 percent for the same quarter of
2008.  Rates on interest earning assets decreased 98 basis points
during the third quarter of 2009 as compared with the same quarter of
2008.  However, rates paid on interest bearing liabilities declined by
only 59 basis points during the third quarter of 2009 as compared with the same
quarter of 2008.  Rates earned on interest earning assets declined
more than rates paid on interest earning assets due in part to the increase to
nonearning nonaccrual loans, which totaled $45.6 million at September 30, 2009,
as compared with $19.7 million at September 30, 2008.
 
 For the
nine months ended September 30, 2009, the decline to net interest income was
attributable to the increases to nonaccrual loans as well as decreases to
general interest rate levels and increases to lower earning federal funds
sold.   The total yield on interest earning assets for the nine
months ended September 30, 2009 was 5.00 percent, a decline of 102 basis points
from 6.02 percent for the same nine months of 2008.  The loan yield
dropped 96 basis points during the first nine months of 2009 as compared to the
same period of 2008 due to the increases to nonaccrual loans in
2009.  Average federal funds rates declined 253 basis points as
average balances of federal funds sold increased $24.6 million. Rates paid on
average interest bearing deposits and borrowing for the nine months ended
September 30, 2009 declined 64 basis points compared to the same nine months
last year.  These factors caused the net interest spread to decrease
38 basis points and the net yield on interest earning assets to decrease 50
basis points during the nine months ended September 30, 2009, as compared with
the same nine months of 2008.
 24
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  TABLE
5
  NORTHERN
STATES FINANCIAL CORPORATION
 ANALYSIS
OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
 For the
Three Months Ended September 30, 2009 and 2008 - Rates are
Annualized
 ($
000s)
   2009
                                                                      
                                                                      
                                                                      2008AverageBalance
                                                                      
                                                                      
                                                                      Interest
                                                                      
                                                                      
                                                                      Rate
                                                                      
                                                                      
                                                                      AverageBalance
                                                                      
                                                                      
                                                                      Interest
                                                                      
                                                                      
                                                                      RateAssetsLoans
      (1)(2)(3)
                                                                      
                                                                      $
                                                                      470,543
                                                                      
                                                                      
                                                                      $
                                                                      6,208
                                                                      
                                                                      
                                                                      
                                                                      5.28
                                                                      %
                                                                      
                                                                      $
                                                                      485,366
                                                                      
                                                                      
                                                                      $
                                                                      7,308
                                                                      
                                                                      
                                                                      
                                                                      6.02
                                                                      %Taxable
      securities (4)
                                                                      
                                                                      
                                                                      91,728
                                                                      
                                                                      
                                                                      
                                                                      1,093
                                                                      
                                                                      
                                                                      
                                                                      4.69
                                                                      %
                                                                      
                                                                      
                                                                      110,136
                                                                      
                                                                      
                                                                      
                                                                      1,544
                                                                      
                                                                      
                                                                      
                                                                      5.40
                                                                      %Tax
      advantaged securities (2) (4)
                                                                      
                                                                      
                                                                      8,554
                                                                      
                                                                      
                                                                      
                                                                      132
                                                                      
                                                                      
                                                                      
                                                                      6.18
                                                                      %
                                                                      
                                                                      
                                                                      11,627
                                                                      
                                                                      
                                                                      
                                                                      183
                                                                      
                                                                      
                                                                      
                                                                      6.23
                                                                      %Federal
      funds sold
                                                                      
                                                                      
                                                                      33,761
                                                                      
                                                                      
                                                                      
                                                                      8
                                                                      
                                                                      
                                                                      
                                                                      0.09
                                                                      %
                                                                      
                                                                      
                                                                      2,351
                                                                      
                                                                      
                                                                      
                                                                      8
                                                                      
                                                                      
                                                                      
                                                                      1.36
                                                                      %Interest
      earning assets
                                                                      
                                                                      
                                                                      604,586
                                                                      
                                                                      
                                                                      
                                                                      7,441
                                                                      
                                                                      
                                                                      
                                                                      4.91
                                                                      %
                                                                      
                                                                      
                                                                      609,480
                                                                      
                                                                      
                                                                      
                                                                      9,043
                                                                      
                                                                      
                                                                      
                                                                      5.89
                                                                      %Noninterest
      earning assets
                                                                      
                                                                      
                                                                      29,711
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      38,961Average
      assets
                                                                      
                                                                      $
                                                                      634,297
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      $
                                                                      648,441Liabilities
      and stockholders' equityNOW
      deposits
                                                                      
                                                                      $
                                                                      50,001
                                                                      
                                                                      
                                                                      $
                                                                      77
                                                                      
                                                                      
                                                                      
                                                                      0.62
                                                                      %
                                                                      
                                                                      $
                                                                      44,636
                                                                      
                                                                      
                                                                      $
                                                                      38
                                                                      
                                                                      
                                                                      
                                                                      0.34
                                                                      %Money
      market deposits
                                                                      
                                                                      
                                                                      61,343
                                                                      
                                                                      
                                                                      
                                                                      191
                                                                      
                                                                      
                                                                      
                                                                      1.25
                                                                      %
                                                                      
                                                                      
                                                                      65,026
                                                                      
                                                                      
                                                                      
                                                                      280
                                                                      
                                                                      
                                                                      
                                                                      1.72
                                                                      %Savings
      deposits
                                                                      
                                                                      
                                                                      61,388
                                                                      
                                                                      
                                                                      
                                                                      38
                                                                      
                                                                      
                                                                      
                                                                      0.25
                                                                      %
                                                                      
                                                                      
                                                                      62,362
                                                                      
                                                                      
                                                                      
                                                                      78
                                                                      
                                                                      
                                                                      
                                                                      0.50
                                                                      %Time
      deposits
                                                                      
                                                                      
                                                                      275,531
                                                                      
                                                                      
                                                                      
                                                                      1,831
                                                                      
                                                                      
                                                                      
                                                                      2.66
                                                                      %
                                                                      
                                                                      
                                                                      250,197
                                                                      
                                                                      
                                                                      
                                                                      2,263
                                                                      
                                                                      
                                                                      
                                                                      3.62
                                                                      %Other
      borrowings
                                                                      
                                                                      
                                                                      56,847
                                                                      
                                                                      
                                                                      
                                                                      275
                                                                      
                                                                      
                                                                      
                                                                      1.94
                                                                      %
                                                                      
                                                                      
                                                                      92,453
                                                                      
                                                                      
                                                                      
                                                                      553
                                                                      
                                                                      
                                                                      
                                                                      2.39
                                                                      %Interest
      bearing liabilities
                                                                      
                                                                      
                                                                      505,110
                                                                      
                                                                      
                                                                      
                                                                      2,412
                                                                      
                                                                      
                                                                      
                                                                      1.91
                                                                      %
                                                                      
                                                                      
                                                                      514,674
                                                                      
                                                                      
                                                                      
                                                                      3,212
                                                                      
                                                                      
                                                                      
                                                                      2.50
                                                                      %Demand
      deposits
                                                                      
                                                                      
                                                                      57,439
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      58,343Other
      noninterest bearing liabilities
                                                                      
                                                                      
                                                                      6,503
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      6,676Stockholders'
      equity
                                                                      
                                                                      
                                                                      65,245
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      68,748Average
      liabilities and
                                                                        stockholders'
      equity
                                                                      
                                                                      $
                                                                      634,297
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      $
                                                                      648,441Net
      interest income
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      $
                                                                      5,029
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      $
                                                                      5,831Net
      interest spread
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3.00
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3.39
                                                                      %Net
      yield on interest earning assets (4)
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3.32
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3.80
                                                                      %Interest-bearing
      liabilities     to earning assets
      ratio
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      83.55
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      84.44
                                                                      %
  (1)
      -
                Interest
      income on loans includes loan origination and other fees of ($4,000) and
      $61,000 for the three
      months ended September 30, 2009 and 2008,
    respectively.
 (2)
      -
                Tax-exempt income is reflected on a fully tax equivalent basis
      utilizing a 34 percent tax rate. The tax
      equivalent adjustment reflected in the above table for municipal loans is
      approximately $21,000
      and $21,000 for the three months ended September 30, 2009 and 2008,
      respectively. The tax equivalent
      adjustment reflected in the above table for municipal securities is
      approximately $45,000 and
      $62,000 for the three months ended September 30, 2009 and 2008,
      respectively.
 (3)
      -
                Non-accrual
      loans are included in average
loans.
 (4)
      -
                  Rate
      information was calculated on the average amortized cost for
      securities.  The three months ended September 30, 2009 and 2008
      average balance information includes an average unrealized gain
      (loss) for taxable securities of ($1,578,000) and ($4,229,000) and for
      tax-advantaged securities of
      $12,000 and ($118,000),
  respectively.
  25
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 TABLE
6
  NORTHERN
STATES FINANCIAL CORPORATION
 ANALYSIS
OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
 For the
Nine Months Ended September 30, 2009 and 2008 - Rates are
Annualized
 ($
000s)
   2009
                                                                            
                                                                            
                                                                            2008Average
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            AverageBalance
                                                                            
                                                                            
                                                                            Interest
                                                                            
                                                                            
                                                                            Rate
                                                                            
                                                                            
                                                                            Balance
                                                                            
                                                                            
                                                                            Interest
                                                                            
                                                                            
                                                                            RateAssetsLoans
      (1)(2)(3)
                                                                            
                                                                            $
                                                                            474,673
                                                                            
                                                                            
                                                                            $
                                                                            18,685
                                                                            
                                                                            
                                                                            
                                                                            5.25
                                                                            %
                                                                            
                                                                            $
                                                                            464,994
                                                                            
                                                                            
                                                                            $
                                                                            21,651
                                                                            
                                                                            
                                                                            
                                                                            6.21
                                                                            %Taxable
      securities (4)
                                                                            
                                                                            
                                                                            91,026
                                                                            
                                                                            
                                                                            
                                                                            3,464
                                                                            
                                                                            
                                                                            
                                                                            5.15
                                                                            %
                                                                            
                                                                            
                                                                            124,842
                                                                            
                                                                            
                                                                            
                                                                            5,137
                                                                            
                                                                            
                                                                            
                                                                            5.44
                                                                            %Tax
      advantaged securities (2) (4)
                                                                            
                                                                            
                                                                            8,896
                                                                            
                                                                            
                                                                            
                                                                            414
                                                                            
                                                                            
                                                                            
                                                                            6.21
                                                                            %
                                                                            
                                                                            
                                                                            11,199
                                                                            
                                                                            
                                                                            
                                                                            526
                                                                            
                                                                            
                                                                            
                                                                            6.25
                                                                            %Federal
      funds sold
                                                                            
                                                                            
                                                                            29,267
                                                                            
                                                                            
                                                                            
                                                                            20
                                                                            
                                                                            
                                                                            
                                                                            0.09
                                                                            %
                                                                            
                                                                            
                                                                            4,627
                                                                            
                                                                            
                                                                            
                                                                            91
                                                                            
                                                                            
                                                                            
                                                                            2.62
                                                                            %Interest
      earning assets
                                                                            
                                                                            
                                                                            603,862
                                                                            
                                                                            
                                                                            
                                                                            22,583
                                                                            
                                                                            
                                                                            
                                                                            5.00
                                                                            %
                                                                            
                                                                            
                                                                            605,662
                                                                            
                                                                            
                                                                            
                                                                            27,405
                                                                            
                                                                            
                                                                            
                                                                            6.02
                                                                            %Noninterest
      earning assets
                                                                            
                                                                            
                                                                            37,335
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            37,693Average
      assets
                                                                            
                                                                            $
                                                                            641,197
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            $
                                                                            643,355Liabilities
      and stockholders' equityNOW
      deposits
                                                                            
                                                                            $
                                                                            47,029
                                                                            
                                                                            
                                                                            $
                                                                            163
                                                                            
                                                                            
                                                                            
                                                                            0.46
                                                                            %
                                                                            
                                                                            $
                                                                            45,402
                                                                            
                                                                            
                                                                            $
                                                                            117
                                                                            
                                                                            
                                                                            
                                                                            0.34
                                                                            %Money
      market deposits
                                                                            
                                                                            
                                                                            63,411
                                                                            
                                                                            
                                                                            
                                                                            741
                                                                            
                                                                            
                                                                            
                                                                            1.56
                                                                            %
                                                                            
                                                                            
                                                                            67,980
                                                                            
                                                                            
                                                                            
                                                                            925
                                                                            
                                                                            
                                                                            
                                                                            1.81
                                                                            %Savings
      deposits
                                                                            
                                                                            
                                                                            61,562
                                                                            
                                                                            
                                                                            
                                                                            146
                                                                            
                                                                            
                                                                            
                                                                            0.32
                                                                            %
                                                                            
                                                                            
                                                                            62,496
                                                                            
                                                                            
                                                                            
                                                                            246
                                                                            
                                                                            
                                                                            
                                                                            0.52
                                                                            %Time
      deposits
                                                                            
                                                                            
                                                                            271,857
                                                                            
                                                                            
                                                                            
                                                                            6,115
                                                                            
                                                                            
                                                                            
                                                                            3.00
                                                                            %
                                                                            
                                                                            
                                                                            249,073
                                                                            
                                                                            
                                                                            
                                                                            7,541
                                                                            
                                                                            
                                                                            
                                                                            4.04
                                                                            %Other
      borrowings
                                                                            
                                                                            
                                                                            65,017
                                                                            
                                                                            
                                                                            
                                                                            890
                                                                            
                                                                            
                                                                            
                                                                            1.83
                                                                            %
                                                                            
                                                                            
                                                                            82,361
                                                                            
                                                                            
                                                                            
                                                                            1,644
                                                                            
                                                                            
                                                                            
                                                                            2.66
                                                                            %Interest
      bearing liabilities
                                                                            
                                                                            
                                                                            508,876
                                                                            
                                                                            
                                                                            
                                                                            8,055
                                                                            
                                                                            
                                                                            
                                                                            2.11
                                                                            %
                                                                            
                                                                            
                                                                            507,312
                                                                            
                                                                            
                                                                            
                                                                            10,473
                                                                            
                                                                            
                                                                            
                                                                            2.75
                                                                            %Demand
      deposits
                                                                            
                                                                            
                                                                            54,993
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            57,411Other
      noninterest bearing liabilities
                                                                            
                                                                            
                                                                            5,229
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            7,030Stockholders'
      equity
                                                                            
                                                                            
                                                                            72,099
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            71,602Average
      liabilities and     stockholders'
      equity
                                                                            
                                                                            $
                                                                            641,197
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            $
                                                                            643,355Net
      interest income
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            $
                                                                            14,528
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            $
                                                                            16,932Net
      interest spread
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            2.89
                                                                            %
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            3.27
                                                                            %Net
      yield on interest earning assets (4)
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            3.22
                                                                            %
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            3.72
                                                                            %Interest-bearing
      liabilities    to earning assets
      ratio
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            84.27
                                                                            %
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            
                                                                            83.76
                                                                            %
  (1)
      -
                      Interest income on loans includes loan origination and other fees of
      $42,000 and $156,000 for the nine
      months ended September 30, 2009 and 2008,
  respectively.
 (2)
      -
                      Tax-exempt
      income is reflected on a fully tax equivalent basis utilizing a 34 percent
      tax rate. The tax
      equivalent adjustment reflected in the above table for municipal loans is
      approximately $65,000
      and $66,000 for the nine months ended September 30, 2009 and 2008,
      respectively. The tax equivalent
      adjustment reflected in the above table for municipal securities is
      approximately $141,000 and
      $179,000 for the nine months ended September 30, 2009 and 2008,
      respectively.
 (3)
      -
                      Non-accrual loans are included in average
loans.
 (4)
      -
                        Rate information was calculated on the average amortized cost for
      securities. The nine months ended
      September 30, 2009 and 2008 average balance information includes an
      average unrealized gain for taxable securities of $1,354,000 and
      ($1,051,000) and for tax-advantaged securities of
      $12,000 and ($20,000),
respectively.
  26
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  ASSET
QUALITY AND THE PROVISION FOR LOAN AND LEASE LOSSES
  At September 30, 2009, management, with
the concurrence of the Board of Directors, after carefully reviewing the
adequacy of the allowance for loan and lease losses and the levels of
nonperforming and impaired loans and leases, determined that an allowance of
$23.3 million was adequate to cover probable incurred loan and lease losses, as
compared with $10.4 million at year-end 2008. The Company’s allowance for loan
and lease losses to total loans ratio was 5.19 percent at September 30,
2009.
 
 During
the first nine months of 2009, $6.2 million in loans and leases were charged-off
against the allowance compared with charge-offs of $2.9 million during the same
period last year.  During the nine months ended September 30, 2009,
recoveries of loans previously charged-off totaled $930,000, as compared with
$73,000 in recoveries during the same period in 2008.
 
 During
the third quarter of 2009, the provision for loan and lease losses was $12.8
million as compared with $5.1 million during the same quarter of
2008.  During the nine months ended September 30, 2009, the provision
for loan and lease losses totaled $18.2 million as compared with $8.1 million
for the same nine months of 2008.
 
 Nonperforming
loans and leases, which include loans and leases on nonaccrual status in
addition to loans and leases 90 days or more past due and still accruing
interest, were $46.6 million at September 30, 2009, or 10.36 percent of total
loans and leases, as compared with $37.1 million at December 31, 2008, or 7.71
percent of loans and leases.   The increase to nonperforming
loans was attributable to the poor economic climate and to the continuing
decline in real estate prices.  Many borrowers have experienced cash
flow problems as unemployment rates have increased due to the economy, causing
the borrowers to become delinquent with their loan payments.  In
previous years, a borrower having financial difficulties, whose loan was secured
by real estate, could sell their real estate and pay off their
loan.  In the current economic environment, real estate values have
plummeted as much as 40 percent from two years ago and the time it takes to sell
real estate has lengthened considerably, making it difficult for borrowers to
cure their delinquency problems by selling their real estate.
 
 At
September 30, 2009, loans on nonaccrual status totaled $45.6 million, as
compared with $36.6 million at year-end 2008.  Three loan
relationships account for $31.3 million or 69 percent of total nonaccrual loans
at September 30, 2009.  One of these loan relationships, totaling
$11.6 million, is secured by commercial office and multi-family apartment
buildings on which the borrowers have experienced cash flow problems due to
vacancies.   The other two loan relationships were placed on
nonaccrual status during the third quarter 2009.
 
 During
the quarter ended September 30, 2009, nonaccrual loans decreased by $2.4
million.  Nonaccrual loans of $20.5 million were transferred out of
nonaccrual loans during the third quarter of 2009 as $5.3 million of these loans
were charged off with the remaining $15.2 million transferred to other real
estate owned as the Company received control of the properties securing these
loans.  A nonaccrual loan that totaled $2.1 million at June 30, 2009
was transferred back onto accrual status as the borrower brought the loan
payments up to date and demonstrated the ability to make future
payments.  Approximately $20.2 million in loans were placed on
nonaccrual status during the third quarter of 2009 primarily from two loan
relationships; one totaling $10.4 million and the other totaling $9.3
million.
 The loan
relationship totaling $10.4 million consists primarily of 13 commercial loans
and leases secured by equipment.  This loan relationship was placed on
nonaccrual status during the quarter ended September 30, 2009 as payments on the
loans and leases became past due amid allegations of possible
fraud.  The Company’s loan relationship is only a small portion of the
borrower’s total indebtedness.   The Company is attempting to
sort out these allegations to determine the direction the Company’s collection
efforts should take.  The Company has $8.3 million of its allowance
for loan and lease losses specifically allocated to this loan relationship at
September 30, 2009.
 27
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
   During
the quarter ended September 30, 2009, the Company placed a
loan relationship totaling $9.3 million that is secured by a motel on nonaccrual
status.  This motel has not generated the needed cash flows in order
to make the payments on the loans.  The borrower is attempting to
change the management of the motel or possibly sell the motel in order to cure
this situation. The Company has $2.4 million of its allowance for loan and lease
losses specifically allocated to this loan relationship at September 30,
2009.
 
 Loans and
leases 90 days or more past due and still accruing interest increased to $1.0
million at September 30, 2009 compared with $442,000 at December 31,
2008.  These loans are well secured and in the process of
collection.
 
 Impaired
loans and leases at September 30, 2009 totaled $50.0 million, as compared with
$43.8 million at December 31, 2008.  The Company considers a loan or
lease impaired if full principal and interest will not be collected under the
contractual terms of the note.  Nonaccrual loans and leases are
classified as impaired.  Impaired loans and leases are carried at the
present value of expected cash flows discounted at the loan's effective interest
rate or at the fair value of the collateral, if the loan or lease is collateral
dependent.  Impaired loans include a $4.4 million construction and
land development loan that is not on nonaccrual status.  The Company
considers the loan impaired as the Company has concerns as to the long-term cash
flows to be generated by the land to be developed that secures the
loan.  At September 30, 2009, $14.3 million of the Company’s $23.3
million allowance for loan and lease losses was allocated to impaired
loans.
 TABLE
7
  NORTHERN
STATES FINANCIAL CORPORATION
  NONPERFORMING
ASSETS
  ($
000’s)
  September
      30,
                    2009
                
                
                December 31,
                    2008Loans
      and leasesNonaccrual
      status
                
                $
                45,569
                
                
                $
                36,62490
      days or more past due, still accruing
                
                
                1,021
                
                
                
                442Total
      nonperforming loans and leases
                
                
                46,590
                
                
                
                37,066Other
      real estate owned
                
                
                21,461
                
                
                
                10,575Total
      nonperforming assets
                
                $
                68,051
                
                
                $
                47,641Nonperforming
      loans and leases as a
                  percentage
      of total loans, net of
                  unearned
      income and deferred loan fees
                
                
                10.36
                %
                
                
                7.71
                %Nonperforming
      assets as a percentage
                  of
      total assets
                
                
                10.68
                %
                
                
                7.44
                %Nonperforming
      loans and leases as a
                  percentage
      of the allowance for loan losses
                
                
                199.57
                %
                
                
                356.34
                %
 
 Management
continues to emphasize the early identification of loan related problems and
remains aggressive in pursuing resolution strategies.  The Company has
adopted a more stringent and disciplined loan underwriting policy in regards to
relationship size and out of market credits.  The Company continues to
be an active lender for its current customers as well as qualifying prospective
loan customers.
   28
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
   Another
component of nonperforming assets is other real estate owned, consisting of
assets acquired through loan foreclosure and repossession. At September 30,
2009, other real estate owned totaled $21.5 million, an increase of $10.9
million from $10.6 million at December 31, 2008.  During the three
months ended September 30, 2009 the Company sold two properties carried at
$154,000 and recognized net gains on the sales of these properties that totaled
$42,000.  During the nine months ended September 30, 2009 the Company
sold five properties carried as other real estate owned totaling $6.4 million
and recognized net losses of $1.6 million.
 
 The
Company had additions to other real estate of $17.2 million during the nine
months ended September 30, 2009.  The Company came into possession of
commercial office buildings valued at $10.3 million during the third quarter of
2009.  Also during the third quarter of 2009 a construction loan of
$1.7 million was transferred into other real estate owned.  This
construction loan was for a 4-unit luxury condominium building that has been
substantially completed with 2 of the units sold.  During the third
quarter of 2009, the Company took possession of 11 properties from one
borrower and placed them into other real estate owned at the value of $1.5
million.  Seven of these properties consisted of modest single family
homes.
 
 A
breakdown of the $21.5 million of other real estate owned at September 30, 2009,
shows $1.9 million in residential properties under construction, $1.8 million of
1-4 family homes and $17.8 million of commercial properties.  At
September 30, 2009, the Company had no 1-4 family homes in other real estate
owned with a carrying value of greater than $1.0 million. The Company is
actively marketing its other real estate properties for sale.
 
 Other
real estate owned includes a property acquired in 1987 through the receipt of
deed in lieu of foreclosure.  This property is a former
commercial/industrial site located in Waukegan, Illinois, overlooking Lake
Michigan, with a carrying value of $2,052,000 at September 30,
2009.  The Company is attempting to sell this property through the
Bank’s subsidiary, Northern States Community Development Corporation as part of
the City of Waukegan’s lakefront development plans.
 
 Environmental
remediation costs may be incurred in disposing of this property.  At
year-end 2008, the Company had an independent environmental consultant update
its opinion as to estimated environmental remediation costs with this
property.  This updated report estimated that there were remaining
costs of $259,000 to achieve acceptable levels of contaminants for
commercial/industrial or restricted residential land use and to prevent
migration of the contaminants to adjoining off-site properties and Lake
Michigan, as compared with estimated costs of $1.6 million at year-end
2007.   The Company was able to lower its estimated environmental
costs during 2008 as the Company entered into an agreement with a contractor
that provided for low cost delivery and grading of clean soil to the site for
surface capping purposes.  During 2008, the Company made environmental
improvements to the property in the amount of $281,000 that increased the
carrying value of the property.  During the nine months ended
September 30, 2009, additional environmental improvements totaling $69,000 were
made that increased the carrying value of the property.   No
determination has been made as to the ultimate end use of the property, which
would need to be approved by the City of Waukegan as part of its Lakefront
Downtown Master Plan. The appraised value of the property supports the Bank’s
carrying value, plus the estimated remediation costs and as such, at this time,
no liability has been recorded for these estimated environmental remediation
costs.
 
 The fair
value of other real estate owned is reviewed by management at least quarterly to
help ensure the reasonableness of its carrying value, which is lower of cost or
the fair value less estimated selling costs.
 29
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
   NONINTEREST
INCOME
 
 Noninterest
income for the three months ended September 30, 2009 was a loss of $1.2 million
as compared with a loss of $1.0 million for the three months ended September 30,
2008.  During the third quarter of 2009, Company had impairment losses
on its securities of $2.4 million as compared with $2.2 million during the same
quarter of 2008.  Excluding the impairment charges, noninterest income
would have been $1.2 million for both the third quarter of 2009 and the third
quarter of 2008.
 
 For the
nine months ended September 30, 2009, the Company showed a loss for noninterest
income of $1.4 million, as compared with noninterest income of $1.3 million for
the nine months ended September 30, 2008, a difference of $2.7 million less
during the nine months endedSeptember 30,
2009.   One  reason for the difference is that the
Company had net losses on the sale of other real estate owned during the nine
months ended September 30, 2009 of $1.6 million as the Company sold a luxury
home early in 2009 that had been valued at $5.9 million for $4.2 million
recognizing a $1.7 million loss on the sale.  The Company’s loss on
the sale was due to declining values of luxury homes, large inventory, and the
limited number of buyers for such homes. The Company also had impairment losses
on securities of $3.1 million for the first nine months of 2009 as compared with
$2.2 million during the same time period of 2008 causing noninterest income to
decline $872,000 during the first nine months of 2009.  Contributing
to the lower noninterest income during the first nine months of 2009 as compared
to the same time period of 2008 was decreased service fees on deposits of
$200,000, mainly from reduced overdraft fee income.
 
 NONINTEREST
EXPENSE
 
 Noninterest
expense for the quarter ended September 30, 2009 was $5.0 million, increasing
$741,000 from $4.2 million for the same quarter last year.  The
majority of the increase of noninterest expense for the third quarter of 2009
was due to increased FDIC insurance premiums of $300,000, legal expenses of
$164,000 and other real estate owned expenses of $151,000 as compared to the
same quarter of 2008.  It is expected that FDIC insurance expense will
continue to be at elevated levels in the foreseeable future.  Legal
expenses have increased due to the larger nonperforming assets of the Company in
2009 as compared with 2008, and increased $164,000 for the third quarter of 2009
as compared with the same quarter of 2008.  The increases to other
real estate owned in 2009 caused other real estate owned expenses to increase
$151,000 during the third quarter of 2009 as compared with the same quarter of
2008.
 
 Noninterest
expense for the nine months ended September 30, 2009 was $24.6 million,
increasing $11.6 million from $13.0 million for the nine months ended September
30, 2008.  The majority of the increase of noninterest expense for the
nine months ended September 30, 2009 was due to the write-down of goodwill in
the amount of $9.5 million as goodwill became impaired.  The
write-down eliminates the goodwill from the Company’s balance sheet and was a
one-time accounting, non-tax deductible, noncash transaction with no effect on
regulatory capital or liquidity.  The goodwill had been booked by the
Company primarily as the result of its 2004 acquisition of First State Bank of
Round Lake.
 
 Noninterest
expense for the nine months ended September 30, 2009 was affected by an increase
in FDIC insurance expense.  For the nine months ended September 30,
2009, FDIC insurance expense totaled $1.1 million as compared with $98,000 for
the same nine months last year, an increase of $1.0
million.   Regular FDIC insurance rates increased for the Company
in 2009 due to the economy as well as the expiration of the Company’s credits
with the FDIC in 2008.  In addition, the FDIC charged all financial
institutions a special assessment recognized during the second quarter of 2009
to recapitalize the FDIC. The Company’s special assessment came to
$304,000. On
November 12, 2009, the FDIC Board voted to approve an additional assessment
requiring prepayment of three years of FDIC insurance during the fourth quarter
of 2009.
 30
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
   Also
affecting noninterest expense during the first nine months of 2009 as compared
with the same period last year were increases to legal expenses of $638,000 and
other real estate owned expenses of operating expenses of
$367,000.  Legal expenses increased mainly due to collection efforts
as a result of increases to the Company’s nonperforming assets during
2009.  Expenses relating to other real estate owned
increased.
 
 FEDERAL
AND STATE INCOME TAXES
 
 For the
three months ended September 30, 2009, the Company had income taxes of $3.7
million as compared with a tax benefit of $1.8 million for the same three months
last year.   The Company showed income taxes for the third
quarter of 2009 although the Company recognized a pretax loss of $14.1
million.  At September 30, 2009 the Company had a deferred tax asset
of $15.1 million based primarily on its losses.  Per accounting rules,
the Company created a deferred tax asset valuation allowance at September 30,
2009 totaling $9.2 million.  The effect of this deferred tax asset
valuation allowance was that the Company’s tax expense increased $9.2 million
during the third quarter of 2009.  This was a noncash event and the
Company expects that it will be able use the entire valuation
allowance in the future to lower tax expense.
 
 The
Company had income taxes of $1.1 million the nine months ended September 30,
2009 as compared with a tax benefit of $1.4 million for the same nine months
last year.  The deferred tax asset valuation allowance of $9.2 million
booked during the third quarter 2009 caused income tax expense to be recognized
during the nine months ended September 30, 2009 even though the Company showed a
pretax loss of $29.9 million.
 
 REGULATORY ISSUES
 
 Following
a joint examination of the Bank by the Federal Deposit Insurance Corporation
(“FDIC”) and the Illinois Department of Financial and Professional Regulation
(“IDFPR”), the Board of Directors of the Bank approved and signed on September
21, 2009, a memorandum of understanding (“MOU”) concerning its commitment to
enhance certain areas of the Bank’s operation as identified during the
regulators’ examination of the Bank.
 
 The MOU
provides an understanding among the FDIC and the IDFPR and the Bank, that the
Bank will adopt written plans to: (i) budget and monitor earnings (ii) monitor,
improve and lessen risks from the Bank’s substandard assets (iii) correct loan
administration weaknesses (iv) restore Tier 1 capital to 8% of the Bank’s total
assets should Tier 1 capital fall below that 8% level.  As of
September 30, 2009, the Bank’s Tier 1 capital to total assets ratio was
7.61%.  Under the MOU, the Bank will report to the FDIC and the IDFPR
on a quarterly basis with respect to its progress on these
matters.  The Bank believes certain other matters addressed in the MOU
have already been satisfactorily resolved.
 
 Management
believes that the MOU will not have a material impact on the Company’s operating
results or financial condition and that, unless the Bank fails to adequately
address the concerns of the FDIC and the IDFPR, the MOU will not constrain the
Company’s business.  Management is committed to resolving the issues
addressed in the MOU as promptly as possible, and has already taken numerous
steps to address these matters prior to executing the MOU.
 
 SUBSEQUENT
EVENTS
 
 In early November 2009, the Company
notified the Treasury Department of its intent to suspend its dividend payments
on its Fixed Rate Cumulative Perpetual Preferred Stock, Series A.  The
suspension of the dividend payments is permissible under the terms of the TARP
Capital Purchase Program, but the dividend is a cumulative dividend and failure
to pay dividends for sixdividend periods would
trigger board of director appointment rights for the holder of the Series A
Preferred Stock.
  31
 Table of Contents
 NORTHERN STATES FINANCIAL
CORPORATION
   The
Company has also notified, in early November 2009, the trustee that holds the
Company’s junior subordinated debentures relating to its trust preferred
securities that the Company would be deferring its regularly scheduled quarterly
interest payments.  The Company has the right to defer the payment of
interest on the junior subordinated debentures at any time, for a period not to
exceed 20 consecutive quarters.  During the deferral period, the
Company may not pay any dividends on its common or preferred stock.
 
 CONTRACTUAL OBLIGATIONS AND
OFF-BALANCE SHEET ARRANGEMENTS
 
 The
Company has contractual obligations that may not appear on the balance
sheet.  Table 8 presents the Company’s significant fixed and
determinable contractual obligations as of September 30, 2009, by payment date.
The payment amounts in Table 8 represent those amounts contractually due to the
recipient and do not include any unamortized premiums or discounts or similar
carrying amount adjustments.
 TABLE
8
  NORTHERN
STATES FINANCIAL CORPORATION
 CONTRACTUAL
OBLIGATIONS
 As of
September 30, 2009
 ($
000s)
  
 Contractual
      obligations
                
                One
      year
                    or
      less
                
                
                Greater
      than
                    1
      yr. and less
                    than
      or equal
                    to
      3 yrs.
                
                
                Greater
      than
                    3
      yrs. and less
                    than
      or equal
                    to
      5 yrs.
                
                
                Greater
      than
                    5
      yrs.
                
                
                TotalLong-term
      debtSubordinated
      debentures
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                10,000
                
                
                $
                10,000Time
      deposits
                
                
                243,440
                
                
                
                43,316
                
                
                
                -
                
                
                
                -
                
                
                
                286,756Other
      contractual obligationsStandby
      letters of credit
                
                
                6,827
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                6,827
  
 ITEM 3. QUANTITATIVEAND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK.
  The
Company’s primary market risk exposure is interest rate risk and, to a lesser
extent, liquidity risk. Interest rate risk is the exposure of a banking
organization’s financial condition to adverse movements in interest
rates.  The Company seeks to achieve consistent growth in net interest
income and net income while managing volatility that arises from shifts in
interest rates.  The Company’s Asset and Liability Management
Committee (“ALCO”) oversees interest rate risk programs instituted by management
and measurements of interest rate risk verifying that they are within authorized
limits set by the Company’s Board of Directors.
 
 Evaluating
a financial institution’s exposure to changes in interest rates includes
assessing both the adequacy of the management process used to control interest
rate risk and the organization’s quantitative level of exposure.  When
assessing the interest rate risk management process, the Company seeks to ensure
that appropriate policies, procedures, management information systems and
internal controls are in place to maintain interest rate risk at prudent levels
with consistency and continuity.  Evaluating the quantitative level of
interest rate risk exposure requires the Company to assess the existing and
potential future effects of changes in interest rates on its consolidated
financial condition, including capital adequacy, earnings, liquidity, and, where
appropriate, asset quality.
  32
 Table of Contents
  The
primary approach used by management to analyze interest rate risk is to
periodically evaluate the “shock” to net interest income of an assumed
instantaneous decrease and increase in rates of 1% and 2% using computer
simulation to show the effect of rate changes on the base 12 month projected net
interest income.  This approach falls under the broad definition of
asset/liability management.
 
 Several
ways the Company can manage interest rate risk include: selling existing assets
or repaying certain liabilities and matching repricing periods for new assets
and liabilities, for example, by shortening terms of new loans or
securities.  Financial institutions are also subject to prepayment
risk in a falling rate environment.  For example, a debtor may prepay
financial assets so that the debtor may refinance obligations at new, lower
rates.  Prepayments of assets carrying higher rates reduce the
Company’s interest income and overall asset yields.  The Company
attempts to lessen prepayment risk by having prepayment penalties on commercial
purpose loans.  A large portion of an institution’s liabilities may be
short term or due on demand, while most of its assets may be invested in
longer-term loans or securities. Accordingly, the Company seeks to have in place
sources of cash to meet short-term demands.  These funds can be
obtained by increasing deposits, borrowing, or selling assets.
 
 Financial
institutions are also subject to interest rate risk in a rising rate
environment.  Call features on securities may not be exercised and
lower yielding securities may remain in the Company’s securities portfolio until
maturity.
 
 Table
9 shows how interest rate shocks of decreasing rates 1% and 2% and increasing
rates 1% and 2% affect 12 month projected net interest income at September 30,
2009 and December 31, 2008.  The computer simulation model used to do
the interest rate shocks and calculate the effect on projected net interest
income takes into consideration maturity and repricing schedules of the various
assets and liabilities as well as call provisions on the Company’s
securities.
 
 At
September 30, 2009 the projected annual net interest income decreases $39,000
when rates are shocked upward 2% while projected net interest income decreases
$368,000 for a 2% downward rate shock.  Interest rates at September
30, 2009, as evidenced by the prime lending rate at 3.25 percent, at its lowest
level since 1955, were very low.  Many deposit rates could not go down
200 basis points as the deposit rate would then become negative.  As
such, the rate shocks downward would lower interest income earned on loans and
investments to a greater extent than interest paid on deposits and borrowings,
thereby causing net interest income to decline.   Management
believes that it is highly unlikely that rates will decrease further in the near
future.
 
 At both
September 30, 2009 and December 31, 2008, the percentage changes from the base
forecasted 12-month net interest income are within policy guidelines and show
that interest rate risk was minimal at September 30, 2009.
  TABLE
9
  NORTHERN
STATES FINANCIAL CORPORATION
 EFFECT OF
INTEREST SHOCKS ON NET INTEREST INCOME
 as of
September 30, 2009 and December 31, 2008
 ($000s)
  Immediate
      Change in Rates-2.00
                      %
                      
                      
                      -1.00
                      %
                      
                      
                      +1.00
                      %
                      
                      
                      +2.00
                      %September 30,
      2009:Dollar
      Change from Base Forecast
                      
                      $
                      (368
                      )
                      
                      $
                      (56
                      )
                      
                      $
                      40
                      
                      
                      $
                      (39
                      )Percent
      Change from Base Forecast
                      
                      
                      -1.97
                      %
                      
                      
                      -0.30
                      %
                      
                      
                      0.21
                      %
                      
                      
                      -0.21
                      %December 31,
      2008:
 Dollar
      Change from Base Forecast
              
              $
              (656
              )
              
              $
              (325
              )
              
              $
              (88
              )
              
              $
              (250
              )Percent
      Change from Base Forecast
              
              
              -3.82
              %
              
              
              -1.89
              %
              
              
              -0.51
              %
              
              
              -1.45
              %
 33
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
   
 ITEM
4. CONTROLSAND PROCEDURES.
  The
Company’s management has evaluated, with the participation of the Chairman of
the Board and President, and Vice President and Treasurer, the Company’s
disclosure controls and procedures (as such term is defined in Rule 13a–15(e)
under the Securities Exchange Act of 1934) as of the end of the period covered
by this report.  Based on that evaluation, the Chairman of the Board
and President, and Vice President and Treasurer have concluded that these
controls and procedures were effective as of such date.  There were no
changes in internal control over financial reporting (as such term is defined in
Rule 13a–15(f) under the Securities Exchange Act of 1934) that occurred during
the third quarter of 2009 that materially affected, or are reasonably likely to
materially affect, the Company’s internal control over financial
reporting.
 
 
 PART II.
OTHER INFORMATION
 
 
 ITEM
1.  LEGAL PROCEEDINGS.
 
 From time
to time, due to the nature of its business, the Company and its subsidiaries are
often subject to various legal actions.  These legal actions, whether
pending or threatened, arise through the normal course of business and neither
the Company nor any of its subsidiaries are currently involved in any
proceedings that would, in management’s judgment, have a material adverse effect
on the Company’s business, results of operations, financial condition or cash
flows.
 
 
 ITEM
1A.  RISK FACTORS.
 
 There have been no material changes to
the risk factors relating to the Company from those risk factors previously
disclosed in the Company’s Annual Report on Form 10-K for its fiscal year ended
December 31, 2008 in response to Item 1A. to Part I of Form 10-K.
 
 
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE
OF PROCEEDS.
 
 None.
 
 
 ITEM
3.  DEFAULTS UPON SENIOR SECURITIES.
 
 None.
 
 
 ITEM
4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS.
 
 None.
 
 
 ITEM
5.  OTHER INFORMATION.
 
 None.
  34
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 ITEM
6.  EXHIBITS.
  (a)       
Exhibits.
  Exhibit
3.1 Certificate of Incorporation of the Company, as amended (incorporated herein
by reference to the Company’s Annual Report on Form 10-K for the year ended
December 31, 1994 (File No. 000-19300)).
 
 Exhibit
3.2 Certificate of Amendment of the Certificate of Incorporation of the Company,
as amended, dated April 27, 1998 (incorporated herein by reference to Exhibit
3.2 to the Company’s Annual Report on Form 10-K for the year ended December 31,
2008 (File No. 000-19300) filed on March 25, 2009).
 
 Exhibit
3.3 Certificate of Amendment of the Certificate of Incorporation of the Company,
as amended, dated January 20, 2009 (incorporated herein by reference to Exhibit
3.3 to the Company’s Annual Report on Form 10-K for the year ended December 31,
2008 (File No. 000-19300) filed on March 25, 2009).
 
 Exhibit
3.4 Certificate of Designations of Fixed Rate Cumulative Perpetual Preferred
Stock, Series A, dated February 18, 2009 (incorporated herein by reference to
Exhibit 3.1 to the Company’s Current Report on Form 8-K (File No. 000-19300)
filed on February 20, 2009).
 
 Exhibit
3.5 Amended and Restated By-laws of the Company dated April 20, 2004
(incorporated herein by reference to Exhibit 3.2 to the Company’s Quarterly
Report on Form 10-Q (File No. 000-19300) filed on May 10, 2004).
 
 Exhibit
4.1 Form of Certificate of the Preferred Stock (incorporated herein by reference
to Exhibit 4.1 to the Company’s Current Report on Form 8-K (File No. 000-19300)
filed on February 20, 2009).
 
 Exhibit
4.2 Warrant to purchase shares of Common Stock (incorporated herein by reference
to Exhibit 4.2 to the Company’s Current Report on Form 8-K (File No. 000-19300)
filed on February 20, 2009).
 
 Exhibit
11.1  Statement of Computation of per share earnings. (Contained in
Notes 1 and 3 to the condensed consolidated financial statements.)
 
 Exhibit
31.1 Section 302 Certification of Chairman of the Board and
President.
 
 Exhibit
31.2 Section 302 Certification of Vice President and Treasurer.
 
 Exhibit
32.1 Section 906 Certification.
   35
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 FORM
10-Q
 September 30,
2009
    SIGNATURES
   Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report on Form 10-Q to be signed on its behalf by the
undersigned hereunto duly authorized, on this 13th day of November
2009.
  NORTHERN
STATES FINANCIAL CORPORATION
 (Registrant)
     Date:  November 13,
      2009
              By: 
      /s/ Fred
      Abdula
                Fred
      Abdula
                Chairman
      of the Board of
                Directors
      and PresidentDate:  November 13,
      2009
              By: 
      /s/ Thomas M.
      Nemeth
                Thomas
      M. Nemeth
                Vice
      President and Treasurer
   
 36
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 FORM
10-Q
 September 30,
2009
   EXHIBIT INDEX
  Exhibits
  Exhibit
3.1 Certificate of Incorporation of the Company, as amended (incorporated herein
by reference to the Company’s Annual Report on Form 10-K for the year ended
December 31, 1994 (File No. 000-19300)).
 
 Exhibit
3.2 Certificate of Amendment of the Certificate of Incorporation of the Company,
as amended dated April 27, 1998 (incorporated herein by reference to Exhibit 3.2
to the Company’s Annual Report on Form 10-K for the year ended December 31, 2008
(File No. 000-19300) filed on March 25, 2009).
 
 Exhibit
3.3 Certificate of Amendment of the Certificate of Incorporation of the Company,
as amended dated January 20, 2009 (incorporated herein by reference to Exhibit
3.3 to the Company’s Annual Report on Form 10-K for the year ended December 31,
2008 (File No. 000-19300) filed on March 25, 2009).
 
 Exhibit
3.4 Certificate of Designations of Fixed Rate Cumulative Perpetual Preferred
Stock, Series A, dated February 18, 2009 (incorporated herein by reference to
Exhibit 3.1 to the Company’s Current Report on Form 8-K (File No. 000-19300)
filed on February 20, 2009).
 
 Exhibit
3.5 Amended and Restated By-laws of the Company dated April 20, 2004
(incorporated herein by reference to Exhibit 3.2 to the Company’s Quarterly
Report on Form 10-Q (File No. 000-19300) filed on May 10, 2004).
 
 Exhibit
4.1 Form of Certificate of the Preferred Stock (incorporated herein by reference
to Exhibit 4.1 to the Company’s Current Report on Form 8-K (File No. 000-19300)
filed on February 20, 2009).
 
 Exhibit
4.2 Warrant to purchase shares of Common Stock (incorporated herein by reference
to Exhibit 4.2 to the Company’s Current Report on Form 8-K (File No. 000-19300)
filed on February 20, 2009).
 
 Exhibit
11.1  Statement of Computation of per share earnings. (Contained in
Notes 1 and 3 to the condensed consolidated financial statements.)
 
 Exhibit
31.1 Section 302 Certification of Chairman of the Board and
President.
 
 Exhibit
31.2 Section 302 Certification of Vice President and Treasurer.
 
 Exhibit
32.1 Section 906 Certification.
   37