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 June 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 August
5, 2009
 
 
 
  NORTHERN STATES FINANCIAL
CORPORATION AND SUBSIDIARY
 FORM
10-Q
 For the Quarter Ended June
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
                                      13Item 3. Quantitative and Qualitative Disclosures
      About Market Risk
                                      29Item 4. Controls and Procedures
                                      31PART II.   OTHER
      INFORMATIONItem 1.  Legal
Proceedings
                                      31Item 1A.  Risk Factors
                                      31Item 2.  Unregistered Sales of Equity
      Securities and Use of Proceeds
                                      31Item 3.  Defaults upon Senior
      Securities
                                      31Item 4.  Submission of Matters to a Vote
      of Security Holders
                                      32Item 5.  Other
Information
                                      32Item 6.  Exhibits
                                      32Signatures
                                      34EXHIBIT INDEX
                                      35
 1
 
 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 June 30, 2009, the condensed
consolidated statements of income for the three and six month periods ended June
30, 2009 and 2008 and the condensed statements of cash flows and stockholders
equity for the six month periods ended June 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
 August
10, 2009
 
 
 2
 Table of Contents




NORTHERN STATES FINANCIAL
CORPORATION
 CONDENSED CONSOLIDATED BALANCE
SHEETS
 June 30,
2009 and December 31, 2008
 (In
thousands of dollars) (Unaudited)
  June
      30,
                    2009
                
                
                December
      31,
                    2008AssetsCash
      and due from banks
                
                $
                13,148
                
                
                $
                14,108Interest
      bearing deposits in financial institutions –
                  maturities less than 90 days
                
                
                1,176
                
                
                
                242Federal
      funds sold
                
                
                30,901
                
                
                
                7,518Total
      cash and cash equivalents
                
                
                45,225
                
                
                
                21,868Securities
      available for sale
                
                
                94,948
                
                
                
                103,194Loans
      and leases
                
                
                474,044
                
                
                
                480,812Less:
      Allowance for loan and lease losses
                
                
                (14,861
                )
                
                
                (10,402
                )Loans
      and leases, net
                
                
                459,183
                
                
                
                470,410Federal
      Home Loan Bank stock
                
                
                1,801
                
                
                
                1,757Office
      buildings and equipment, net
                
                
                9,753
                
                
                
                9,916Other
      real estate owned
                
                
                6,015
                
                
                
                10,575Goodwill
                
                
                0
                
                
                
                9,522Core
      deposit intangible asset
                
                
                694
                
                
                
                926Accrued
      interest receivable and other assets
                
                
                15,646
                
                
                
                12,551Total
      assets
                
                $
                633,265
                
                
                $
                640,719Liabilities
      and Stockholders’ EquityLiabilitiesDepositsDemand
      - noninterest bearing
                
                $
                54,359
                
                
                $
                57,313Interest
      bearing
                
                
                446,350
                
                
                
                443,508Total
      deposits
                
                
                500,709
                
                
                
                500,821Securities
      sold under repurchase agreements
                
                
                41,397
                
                
                
                42,574Federal
      Home Loan Bank advance
                
                
                10,000
                
                
                
                20,000Subordinated
      debentures
                
                
                10,000
                
                
                
                10,000Advances
      from borrowers for taxes and insurance
                
                
                847
                
                
                
                1,011Accrued
      interest payable and other liabilities
                
                
                5,645
                
                
                
                4,699Total
      liabilities
                
                
                568,598
                
                
                
                579,105Stockholders’
      EquityCommon
      stock (Par value $0.40 per share, authorized 6,500,000 shares, issued
      4,472,255 shares at June 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
      June 30, 2009)
                
                
                16,581
                
                
                
                0Warrants
      (584,084 issued and outstanding at June 30, 2009)
                
                
                681
                
                
                
                0Additional
      paid-in capital
                
                
                11,584
                
                
                
                11,584Retained
      earnings
                
                
                43,392
                
                
                
                56,082Treasury
      stock, at cost (400,000 shares at June 30, 2009 and December 31,
      2008)
                
                
                (9,280
                )
                
                
                (9,280
                )Accumulated
      other comprehensive income
                
                
                (80
                )
                
                
                1,439Total
      stockholders’ equity
                
                
                64,667
                
                
                
                61,614Total
      liabilities and stockholders’ equity
                
                $
                633,265
                
                
                $
                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
six months ended June 30, 2009 and 2008
 (In
thousands of dollars, except per share data)
 (Unaudited)
 
 Three
      months ended
                
                Six months
  endedJune
      30,
                    2009
                
                
                June
      30,
                    2008
                
                
                June
      30,2009
                
                
                June
      30,2008Interest
      incomeLoans
      (including fee income)
                
                $
                5,999
                
                
                $
                7,052
                
                
                $
                12,433
                
                
                $
                14,298SecuritiesTaxable
                
                
                1,117
                
                
                
                1,705
                
                
                
                2,371
                
                
                
                3,593Exempt
      from federal income tax
                
                
                88
                
                
                
                111
                
                
                
                186
                
                
                
                226Federal
      funds sold and other
                
                
                9
                
                
                
                13
                
                
                
                12
                
                
                
                83Total
      interest income
                
                
                7,213
                
                
                
                8,881
                
                
                
                15,002
                
                
                
                18,200Interest
      expenseTime
      deposits
                
                
                2,029
                
                
                
                2,452
                
                
                
                4,284
                
                
                
                5,278Other
      deposits
                
                
                324
                
                
                
                413
                
                
                
                744
                
                
                
                892Repurchase
      agreements and federal funds purchased
                
                
                156
                
                
                
                233
                
                
                
                327
                
                
                
                643Federal
      Home Loan Bank advances
                
                
                21
                
                
                
                90
                
                
                
                48
                
                
                
                152Subordinated
      debentures
                
                
                117
                
                
                
                137
                
                
                
                240
                
                
                
                296Total
      interest expense
                
                
                2,647
                
                
                
                3,325
                
                
                
                5,643
                
                
                
                7,261Net
      interest income
                
                
                4,566
                
                
                
                5,556
                
                
                
                9,359
                
                
                
                10,939Provision
      for loan and lease losses
                
                
                3,715
                
                
                
                2,720
                
                
                
                5,419
                
                
                
                2,983Net
      interest income after provision for loan and lease losses
                
                
                851
                
                
                
                2,836
                
                
                
                3,940
                
                
                
                7,956Noninterest
      incomeService
      fees on deposits
                
                
                577
                
                
                
                647
                
                
                
                1,115
                
                
                
                1,281Trust
      income
                
                
                236
                
                
                
                218
                
                
                
                408
                
                
                
                431Other
      than temporary impairment of securities
                
                
                (72
                )
                
                
                0
                
                
                
                (2,086
                )
                
                
                0Add
      (deduct) noncredit portion of other than temporary impairment of
      securities
                
                
                (556
                )
                
                
                0
                
                
                
                1,458
                
                
                
                0Net
      gains (loss) on sales of other real estate owned
                
                
                37
                
                
                
                0
                
                
                
                (1,636
                )
                
                
                0Other
      operating income
                
                
                323
                
                
                
                251
                
                
                
                561
                
                
                
                544Total
      noninterest income
                
                
                545
                
                
                
                1,116
                
                
                
                (180
                )
                
                
                2,256Noninterest
      expenseSalaries
      and employee benefits
                
                
                2,076
                
                
                
                2,089
                
                
                
                4,177
                
                
                
                4,305Occupancy
      and equipment, net
                
                
                584
                
                
                
                587
                
                
                
                1,316
                
                
                
                1,221Data
      processing
                
                
                482
                
                
                
                424
                
                
                
                873
                
                
                
                863FDIC
      insurance
                
                
                604
                
                
                
                32
                
                
                
                756
                
                
                
                74Legal
                
                
                395
                
                
                
                76
                
                
                
                634
                
                
                
                160Audit
      and other professional
                
                
                180
                
                
                
                385
                
                
                
                451
                
                
                
                737Amortization
      of core deposit intangible asset
                
                
                116
                
                
                
                116
                
                
                
                232
                
                
                
                232Write-down
      of goodwill
                
                
                9,522
                
                
                
                0
                
                
                
                9,522
                
                
                
                0Printing
      and supplies
                
                
                100
                
                
                
                61
                
                
                
                185
                
                
                
                151Other
      operating expenses
                
                
                704
                
                
                
                549
                
                
                
                1,440
                
                
                
                1,006Total
      noninterest expense
                
                
                14,763
                
                
                
                4,319
                
                
                
                19,586
                
                
                
                8,749Income
      before income taxes
                
                
                (13,367
                )
                
                
                (367
                )
                
                
                (15,826
                )
                
                
                1,463Income
      tax (benefit) expense
                
                
                (1,536
                )
                
                
                (217
                )
                
                
                (2,538
                )
                
                
                412Net
      income (loss)
                
                $
                (11,831
                )
                
                $
                ( 150
                )
                
                $
                (13,288
                )
                
                $
                1,051Dividends
      to preferred stockholders
                
                
                215
                
                
                
                0
                
                
                
                313
                
                
                
                0Accretion
      of discount on preferred stock
                
                
                31
                
                
                
                0
                
                
                
                51
                
                
                
                0Net
      income (loss) available to common stockholders
                
                $
                (12,077
                )
                
                $
                ( 150
                )
                
                $
                (13,652
                )
                
                $
                1,051Basic
      earnings (loss) per share
                
                $
                ( 2.97
                )
                
                $
                ( 0.04
                )
                
                $
                ( 3.35
                )
                
                $
                0.25Diluted
      earnings (loss) per share
                
                $
                ( 2.97
                )
                
                $
                ( 0.04
                )
                
                $
                ( 3.35
                )
                
                $
                0.25Comprehensive
      income (loss)
                
                $
                (11,653
                )
                
                $
                (2,400
                )
                
                $
                (13,845
                )
                
                $
                (1,042
                )
 
 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
 Six
months ended June 30, 2009 and 2008
 (In
thousands of dollars) (Unaudited)
  Six
      months endedJune 30,
                    2009
                
                
                June 30,2008Cash
      flows from operating activitiesNet
      income
                
                $
                (13,288
                )
                
                $
                1,051Adjustments
      to reconcile net income to net cash from operating
    activities:Depreciation
                
                
                308
                
                
                
                253Amortization
      of other intangible assets
                
                
                232
                
                
                
                232Impairment
      loss on securities
                
                
                628
                
                
                
                0Provision
      for loan and lease losses
                
                
                5,419
                
                
                
                2,983Net
      loss on sale of other real estate owned
                
                
                1,636
                
                
                
                0Write-down
      of goodwill
                
                
                9,522
                
                
                
                0Net
      change in accrued interest receivable and other assets
                
                
                (1,268
                )
                
                
                (511
                )Net
      change in accrued interest payable and other liabilities
                
                
                836
                
                
                
                (1,296
                )Net
      cash from operating activities
                
                
                4,025
                
                
                
                2,712Cash
      flows from investing activitiesProceeds
      from maturities and calls of securities available for sale
                
                
                12,192
                
                
                
                76,697Purchases
      of securities available for sale
                
                
                (7,076
                )
                
                
                (50,084
                )Change
      in loans made to customers
                
                
                4,316
                
                
                
                (40,894
                )Purchases
      of Federal Home Loan Bank stock
                
                
                (44
                )
                
                
                (312
                )Property
      and equipment expenditures
                
                
                (145
                )
                
                
                (634
                )Improvements
      to other real estate owned
                
                
                (62
                )
                
                
                0Proceeds
      from sales of other real estate owned
                
                
                4,596
                
                
                
                0Net
      cash from investing activities
                
                
                13,777
                
                
                
                (15,227
                )Cash
      flows from financing activitiesNet
      increase (decrease) in:Deposits
                
                
                (112
                )
                
                
                (12,841
                )Issuance of preferred stock and warrants per TARP
                
                
                17,211
                
                
                
                0Securities sold under repurchase agreements and federal funds
      purchased
                
                
                (1,177
                )
                
                
                (4,602
                )Advances from borrowers for taxes and insurance
                
                
                (164
                )
                
                
                (35
                )Federal
      Home Loan Bank advances
                
                
                10,000
                
                
                
                60,000Repayment
      of Federal Home Loan Bank advances
                
                
                (20,000
                )
                
                
                (35,000
                )Purchases
      of treasury stock
                
                
                0
                
                
                
                (2,078
                )Dividends
      paid on preferred stock
                
                
                (203
                )
                
                
                0Dividends
      paid on common stock
                
                
                0
                
                
                
                (1,628
                )Net
      cash from financing activities
                
                
                5,555
                
                
                
                3,816Net
      change in cash and cash equivalents
                
                
                23,357
                
                
                
                (8,699
                )Cash
      and cash equivalents at beginning of period
                
                
                21,868
                
                
                
                23,634Cash
      and cash equivalents at end of period
                
                $
                45,225
                
                
                $
                14,935
 
 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
 Six
months ended June 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
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,051
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,051Cash
      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
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (2,093
                  )
                  
                  
                  (2,093
                  )Balance,
      June 30, 2008
                  
                  $
                  1,789
                  
                  
                  $
                  0
                  
                  
                  $
                  0
                  
                  
                  $
                  11,584
                  
                  
                  $
                  66,406
                  
                  
                  $
                  (9,280
                  )
                  
                  $
                  (1,793
                  )
                  
                  $
                  68,706Balance,
      December 31, 2008
                  
                  $
                  1,789
                  
                  
                  $
                  0
                  
                  
                  $
                  0
                  
                  
                  $
                  11,584
                  
                  
                  $
                  56,082
                  
                  
                  $
                  (9,280
                  )
                  
                  $
                  1,439
                  
                  
                  $
                  61,614Net
      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (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
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (11,831
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (11,831
                  )Accrued
      dividend on preferred stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (215
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (215
                  )Accretion
      of preferred stock discount issued
                  
                  
                  
                  
                  
                  
                  31
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (31
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  0Unrealized
      loss on securities available for sale, net of deferred tax
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  178
                  
                  
                  
                  178Balance,
      June 30, 2009
                  
                  $
                  1,789
                  
                  
                  $
                  16,581
                  
                  
                  $
                  681
                  
                  
                  $
                  11,584
                  
                  
                  $
                  43,392
                  
                  
                  $
                  (9,280
                  )
                  
                  $
                  (80
                  )
                  
                  $
                  64,667
   6
 Table of Contents




NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  June 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 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 Commisision.  The results of operations
for the three and six month periods ended June 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 six 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 six month periods ended June 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 six month periods ended June 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
  June 30,
2009
  (Unaudited)




(Dollars
      in thousands, except per share data)
                      
                      Three
      Months Ended
                          June
      30,
                      
                      
                      Six
      Months Ended
                          June
      30,2009
                      
                      
                      2008
                      
                      
                      2009
                      
                      
                      2008Basic
      earnings per share:Net
      income (loss)
                      
                      $
                      (11,831
                      )
                      
                      $
                      (150
                      )
                      
                      $
                      (13,288
                      )
                      
                      $
                      1,051Dividends
      to preferred stockholders
                      
                      
                      215
                      
                      
                      
                      -
                      
                      
                      
                      313
                      
                      
                      
                      -Accretion
      of discount on preferred stock
                      
                      
                      31
                      
                      
                      
                      -
                      
                      
                      
                      51
                      
                      
                      
                      -Net
      income available to common stockholders
                      
                      $
                      (12,077
                      )
                      
                      $
                      (150
                      )
                      
                      $
                      (13,652
                      )
                      
                      $
                      1,051Weighted
      average common shares outstanding
                      
                      
                      4,072,255
                      
                      
                      
                      4,175,907
                      
                      
                      
                      4,072,255
                      
                      
                      
                      4,175,907Basic
      earnings per share
                      
                      $
                      (2.97
                      )
                      
                      $
                      (0.04
                      )
                      
                      $
                      (3.35
                      )
                      
                      $
                      0.25Diluted
      earnings per share:Net
      income (loss)
                      
                      $
                      (11,831
                      )
                      
                      $
                      (150
                      )
                      
                      $
                      (13,288
                      )
                      
                      $
                      1,051Dividends
      to preferred stockholders
                      
                      
                      215
                      
                      
                      
                      -
                      
                      
                      
                      313
                      
                      
                      
                      -Accretion
      of discount on preferred stock
                      
                      
                      31
                      
                      
                      
                      -
                      
                      
                      
                      51
                      
                      
                      
                      -Net
      income available to common stockholders
                      
                      $
                      (12,077
                      )
                      
                      $
                      (150
                      )
                      
                      $
                      (13,652
                      )
                      
                      $
                      1,051Weighted
      average common shares outstanding
                      
                      
                      4,072,255
                      
                      
                      
                      4,175,907
                      
                      
                      
                      4,072,255
                      
                      
                      
                      4,175,907Add:
      Dilutive effect of assumed warrant exercises
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Weighted
      average common and dilutive common shares outstanding
                      
                      
                      4,072,255
                      
                      
                      
                      4,175,907
                      
                      
                      
                      4,072,255
                      
                      
                      
                      4,175,907Diluted
      earnings per share
                      
                      $
                      (2.97
                      )
                      
                      $
                      (0.04
                      )
                      
                      $
                      (3.35
                      )
                      
                      $
                      0.25




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 “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 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
  June 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%.
 
 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:
 
 
 June
      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
  June 30,
2009
  (Unaudited)
  Note 4 –
Securities
 
 At June 30, 2009 the Company had the
following securities:




Gross
      UnrealizedJune
      30, 2009  ($000's)
                
                Fair
      Value
                
                
                Gain
                
                
                LossU.S.
      Treasury
                
                $
                1,014
                
                
                $
                16
                
                
                $
                -U.S.
      government-sponsored entities
                
                
                8,020
                
                
                
                21
                
                
                
                -States
      and political subdivisions
                
                
                11,065
                
                
                
                108
                
                
                
                (187
                )Mortgage-backed
      securities
                
                
                70,746
                
                
                
                2,960
                
                
                
                —Other
      bonds
                
                
                172
                
                
                
                —
                
                
                
                (3,030
                )Equity
      securities
                
                
                3,931
                
                
                
                —
                
                
                
                (12
                )Total
      securities available-for-sale
                
                $
                94,948
                
                
                $
                3,105
                
                
                $
                (3,229
                )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
                )




Contractual maturities of securities
available for sale at June 30, 2009 were as follows.  Securities not
due at a single maturity date, primarily mortgage-backed securities, are shown
separately.
 
 FairValueDue
      in one year or less
                      
                      $
                      12,082Due
      after one year through five years
                      
                      
                      2,608Due
      after five years through ten years
                      
                      
                      1,134Due
      after ten years
                      
                      
                      4,44720,271Mortgage-backed
      securities
                      
                      
                      70,746Equity
      securities
                      
                      
                      3,931Total
      securities available-for-sale
                      
                      $
                      94,948






10
 Table of Contents




NORTHERN STATES FINANCIAL
CORPORATION
  NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
  June 30,
2009
  (Unaudited)
 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 using Financial Accounting Standards Board Staff
Position No. 157-3 (“FSP FAS 157-3”).
 
 In April
2009, FSP FAS 115-2 and FSP 124-2 were issued.  The new guidance
required 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 loss and as such credited retained earnings less the net tax
effect.
 
 At June
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 the three
months ended June 30, 2009.   The cash flow analyses used at June
30, 2009, assume 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.  It was determined that
there wereadditional credit losses on the CDOs and the Company recognized $628,000
of securities impairment losses for other than temporary impairment during the
three months ended June 30, 2009.
 
 Below
shows the credit loss roll forward on debt securities from December 31, 2008
through June 30, 2009:
 
 
 ($000's)December
      31, 2008  Accumulated Credit Losses:
                          
                          $
                          10,541April
      1, 2009  Adjustment to Credit Lossesfor
      Change in Accounting from Adoption ofFSP
      FAS 115-2 and FSP FAS 124-2:
                          
                          
                          (
      1,572
                          )June
      30, 2009  Recognition of Credit Losses:
                          
                          
                          628June
      30, 2009  Accumulated Credit Losses:
                          
                          $
                          9,597
 
 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 4.30769% at June 30, 2009, which is the
effective rate from June 15, 2009 through September 14, 2009.  For the
three months
  11
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 ended
June 30, 2009 and 2008, interest expense on the subordinated debentures was
$117,000 and $137,000, respectively.   For the six months ended
June 30, 2009 and 2008, interest expense on the subordinated debentures was
$240,000 and $296,000, respectively.
  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 subordinated debentures at any time, or from time to time, for a period
not to exceed 20 consecutive quarters. 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.
  Note 6 – Adoption of FSP FAS
115-2 and FAS 124-2
  In April
2009, the Company adopted the Financial Accounting Standards Board (“FASB”)
Staff Positions (“FSP”) FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of
Other-Than-Temporary Impairments,” that amended other-than-temporary
impairment GAAP guidance for debt securities to make the guidance more
operational and to improve the presentation and disclosure of other than
temporary impairments (“OTTI”)  in the financial statements.  The
new guidance required that credit related OTTI be recognized on available for
sale debt securities while noncredit related OTTI be recognized as other
comprehensive income (“OCI”).  Under the new guidance the Company
reclassified the noncredit related portion of the OTTI losses previously
recognized in earnings during 2008.  The $962,000 after tax amount was
reflected as a cumulative effect adjustment that increased retained earnings and
decreased OCI.
  12
 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 June 30, 2009 and the
consolidated results of operations for the three and six month periods ended
June 30, 2009, compared with the three and six month periods ended
June 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 June 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 June 30, 2009 were $633.3 million, a decrease of $7.4 million, or
1.2 percent, from total assets of $640.7 million at December 31,
2008.  Loans totaled $474.0 million at June 30, 2009, a decrease
of $6.8 million, or 1.4 percent, from loans of $480.8 million at
December 31, 2008.  Investment in overnight federal funds sold
increased to $30.9 million at June 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
June 30, 2009.
  13
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  Deposit
totals at June 30, 2009 of $500.7 million remained relatively unchanged
from December 31, 2008 deposit levels of $500.8 million.  Higher
cost time deposits declined $3.1 million from year-end as the Company lowered
its levels of wholesale brokered deposits by $14.9 million from year-end
levels.
  The
Company had a loss for the three months ended June 30, 2009 of $11.8
million, or $2.97 per share, compared with a loss of $150,000, or $0.04 per
share for the same three months of 2008.  The majority of the loss in
the second quarter of 2009 was caused by the one-time write-down of $9.5 million
of goodwill as weakening financial markets and the faltering economy negatively
affected bank stock prices and the Company’s earnings.  The goodwill
write-down was a one-time accounting noncash transaction with no effect on
regulatory capital or liquidity and was not tax deductible.  Earnings
for the quarter ended June 30, 2009, were also negatively impacted by a
provision for loan and lease losses of $3.7 million, an impairment charge of
$628,000 taken on collateralized debt obligations and a FDIC insurance special
assessment of $304,000.
  The
Company’s net interest income, the difference between interest earned on loans
and investments and interest paid on deposits and borrowings, decreased 17.8
percent, or $1.0 million, to $4.6 million for the quarter ended June 30,
2009, as compared with $5.6 million for the same quarter of 2008.  The
decline in net interest income was attributable to nonearning nonaccrual loans
that totaled $48.0 million at June 30, 2009 as compared with $18.9 million
at June 30, 2008, and increases to lower earning federal funds
sold.  The net yield on interest earning assets declined to 3.09
percent during the second quarter of 2009 as compared with 3.75 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.
  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 June 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 June 30, 2008, when a 5-year
historic loss average was used.
  14
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 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.
  FINANCIAL
CONDITION
  The
Company’s federal funds sold at June 30, 2009 increased to $30.9 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.  Loans declined $6.8
million and securities investments declined $8.3 million from year-end
2008.  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 the
funds for its liquidity needs.
  The
Company’s securities available for sale declined $8.3 million to $94.9 million
at June 30, 2009 compared with $103.2 million at year-end
2008.  The Company, in reviewing its collateralized debt obligations
securities, determined and recognized impairment of $628,000 based on its
analysis of the creditworthiness of the financial institutions and insurance
companies that had issued the debt backing the securities.  The amount
of securities in the Company’s investment portfolio declined as the Company has
found it difficult to replace maturing securities with new securities having
maturities of less than five years and a sufficient yield.  At
June 30, 2009, securities totaling $78.4 million were pledged to secure
public deposits, repurchase agreements and for other purposes required or
permitted by law.
  Loans and
leases totaled $474.0 million at June 30, 2009, decreasing $6.8 million
from $480.8 million at December 31, 2008.  The decrease primarily
occurred in commercial loans that were not secured by real estate, which
declined $10.4 million from year-end 2008.  The decrease to total
loans was also attributable to the receipt of normal scheduled principal
payments as well as lower demand during the quarter due to borrowers’ concerns
about the continued weakness in the economy.  Management is
considering various alternatives in order to increase its loan portfolio in the
coming quarters.
  Approximately
90 percent of the Bank’s loan portfolio at June 30, 2009 was secured by
real estate.  The Company’s loans to the hotel industry were $72.1
million at June 30, 2009.  Loans totaling $119.3 million at
June 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 $13.6 million to $69.8
million at June 30, 2009, compared with $83.4 million at December 31,
2008, corresponding with the decline in loan demand during the first half of
2009.  Letters of credit also decreased during the six months ended
June 30, 2009, to $6.6 million from $7.8 million at year-end.  At
June 30, 2009, loans to related parties totaled $669,000 and loan
commitments and letters of credit issued to related parties were $2.0
 15
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  Deposits
remained stable at June 30, 2009, totaling $500.7 million as compared with
$500.8 million at year-end 2008.  The deposit mix changed in that
retail and commercial deposits declined $1.9 million and $7.2 million,
respectively, while public deposits increased $7.7 million from year-end
2008.  The increase in deposits from public entities reflects the
cyclical nature of the collection of real estate taxes in June and
September of each year.  The decline in commercial deposits was
attributable to the weakened economy and the need for businesses to draw on
their reserves.  The decline in retail deposits of $1.9 million was
attributable to decreases to higher cost retail time deposits of $8.3 million
from year-end 2008.  Offsetting much of this decrease to retail time
deposits was solid growth to retail core deposits consisting of lower cost
checking, NOW, savings and money market accounts that totaled $165.6 million at
June 30, 2009, increasing $6.4 million, as compared with $159.2 million at
December 31, 2008.
  Brokered
deposits showed increases of $1.5 million to $100.7 million from $99.2 million
at year-end 2008.  Brokered time deposits consists of nonlocal time
deposits from wholesale brokers that the Company pays a premium of 5 to 10 basis
points above its regular time deposit rates and time deposits issued through its
CDARs program to local depositors in order to increase customers’ FDIC insurance
coverage.  The higher cost wholesale brokered time deposits decreased
$14.9 million while brokered time deposits offered through the CDARs program
increased by $16.4 million.  The CDARs program provides customers with
time deposit balances of $250,000 or greater the ability to increase their FDIC
insurance coverage over the FDIC limits because the Bank trades portions of the
customers’ time deposits with other independent financial institutions across
the country.
  Securities
sold under repurchase agreements decreased by $1.2 million to $41.4 million at
June 30, 2009 from $42.6 million at December 31, 2008.  The
decline in repurchase agreement balances increases the Company’s liquidity as it
lowers the amount of securities needed to be pledged.  Borrowings from
Federal Home Loan Bank term advances also decreased $10.0 million from year-end
2008 as the Company used excess liquidity to pay down its
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 contributed $16.0 million of these funds 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
June 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.
  16
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  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.
  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
June 30, 2009
 ($
000s)
  Fair
      Value Measurements at
                    Reporting
      Date UsingDescription
                
                06/30/09
                
                
                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
                
                $
                94,948
                
                
                $
                1,014
                
                
                $
                93,762
                
                
                $
                172
 
 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
June 30, 2009
 ($
000s)
  Securities
                    Available
                    for
      SaleBalance
      at December 31, 2008
                
                $
                2,265Total
      realized and unrealized gains (losses) included in income
                
                
                (628
                )Total
      unrealized gains (losses) included in other comprehensive
      income
                
                
                (1,458
                )Net
      purchase, sales, calls and maturities
                
                
                (7
                )Net
      transfer into Level 3
                
                
                0Balance
      at June 30, 2009
                
                $
                172
  17
 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 Financial Accounting Standard
114.  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
June 30, 2009
 ($
000s)
  Fair
      Value Measurements at Reporting Date UsingDescription
                            
                            06/30/09
                            
                            
                            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
      06/30/09Impaired
      loans accounted for under FAS 114
                            
                            $
                            29,064
                            
                            
                            $
                            —
                            
                            
                            $
                            —
                            
                            
                            $
                            29,064
                            
                            
                            $
                            (6,775
                            )
 
 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.
  18
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 TABLE
4
  NORTHERN
STATES FINANCIAL CORPORATION
 FAIR
VALUE OF FINANCIAL INSTRUMENTS
 As of
June 30, 2009
 ($
000s)
  June 30, 2009
                  
                  Carrying
                      Value
                  
                  
                  Estimated
                      Fair
      ValueFinancial
      assets:Cash
      and cash equivalents
                  
                  $
                  45,225
                  
                  
                  $
                  45,225Securities
      available for sale
                  
                  
                  94,948
                  
                  
                  
                  94,948Loans
      and leases, net
                  
                  
                  459,183
                  
                  
                  
                  467,942Federal
      Home Loan Bank stock
                  
                  
                  1,801
                  
                  
                  
                  1,801Accrued
      interest receivable
                  
                  
                  2,181
                  
                  
                  
                  2,181Financial
      liabilities:Deposits
                  
                  $
                  (500,709
                  )
                  
                  $
                  (504,194
                  )Securities
      sold under repurchase agreement
                  
                  
                  (41,397
                  )
                  
                  
                  (41,361
                  )Federal
      Home Loan Bank advances
                  
                  
                  (10,000
                  )
                  
                  
                  (9,999
                  )Subordinated
      debentures
                  
                  
                  (10,000
                  )
                  
                  
                  (10,192
                  )Advances
      from borrowers for taxes and insurance
                  
                  
                  (847
                  )
                  
                  
                  (847
                  )Accrued
      interest payable
                  
                  
                  (2,101
                  )
                  
                  
                  (2,101
                  )
  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 increased $3.1 million to $64.7 million at June 30,
2009, as compared with $61.6 million at year-end 2008.  The increase
was the result of the receipt of $17.2 million in TARP funds from the Treasury
Department on February 20, 2009.  In exchange for these funds the
Company issued preferred stock and warrants to the Treasury
Department.  Also increasing capital during the six months ended 2009
was a $1.0 million adjustment due to the adoption of accounting staff positions
FSP FAS 115-2 and FSP FAS 124-2 whereby the 2008 impairment write-downs to
collateral debt obligations were adjusted to reflect only the credit loss on
those securities. During the six months ended June 30, 2009, capital was
reduced as the Company recognized losses of $13.3 million.  Capital
was also reduced by $313,000 during the six months ended June 30, 2009, to
account for accrued dividends on the preferred stock for the period
February 20, 2009 through June 30, 2009.  Capital was
further reduced by $557,000 during the six months ended June 30, 2009 due
to the decline in the accumulated other comprehensive income relating to the
unrealized loss on securities available for sale, net of deferred
tax.  The book value of the Company’s common stock at June 30,
2009 was $11.65 per share, compared with $15.13 at December 31,
2008.
  19
 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 9.93 percent and 13.47
percent, respectively, as of June 30, 2009, and 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
Plan authorizes the issuance of 400,000 shares of the Company’s common stock,
which is approximately 10 percent of the Company’s total shares currently
outstanding.  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
June 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 $55.7 million at June 30,
2009, as compared with $46.8 million at December 31, 2008.
  Management
reviews the liquidity ratio and 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 June 30, 2009, this
ratio at the Bank was 11.7 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 six months ended June 30, 2009 cash and cash equivalents
increased by $23.3 million to $45.2 million, primarily as the result of the
receipt of $17.2 million in TARP funds.
  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 June 30, 2009 were $30.9
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 $94.9 million at
June 30, 2009, of which $78.4 million were pledged to
  20
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 secure
public deposits and repurchase agreements, as compared with pledged securities
of $72.0 million at December 31, 2008.
  During
the first half of 2009, the Company had incoming cash flows from maturities and
calls of securities available for sale of $12.2 million and cash outflows for
purchases of securities of $7.1 million.  These securities activities
during the first six months of 2009 provided liquidity of $5.1
million.
  An
important source of liquidity to the Company is deposits.  During the
first half of 2009, the Company had net outgoing cash flows of $112,000 due to a
slight decline in deposits.  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 six months ended June 30, 2009, the Company lowered its borrowings
through repurchase agreements by $1.2 million.  The Company also paid
down its line of credit at the Federal Home Loan Bank of Chicago during the
first half of 2009 in the amount of $10.0 million leaving $26.0 million
available at June 30, 2009.  At June 30, 2009, the Company
had a line of credit with the Federal Reserve Bank of Chicago of $26.1 million
which was available to the Company for liquidity.  The Company has
pledged loans totaling $119.3 million at June 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 June 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 June 30, 2009 of $11.8
million, as compared with a loss of $150,000 for the same quarter of
2008.  The loss during the second quarter of 2009 was impacted by the
write-down of goodwill of $9.5 million, a provision for loan and lease losses of
$3.7 million, a special FDIC insurance assessment of $304,000 and an impairment
charge of $628,000 taken on collateralized debt obligations of trust preferred
securities issued by financial institutions.  The write-down of the
goodwill occurred because the goodwill was deemed to be impaired due to general
market conditions negatively affected bank stock prices and the Company’s
earnings.  The goodwill write-down was a one-time accounting, noncash
transaction and had no effect on the Company’s regulatory capital or liquidity
and was not tax deductible.
  For the
six months ended June 30, 2009, the Company posted a loss of $13.3 million
as compared with net income of $1.1 million for the same period of
2008.  The loss resulted from the write-down of goodwill of $9.5
million, a provision for loan and lease losses of $5.4 million, net losses on
the sale of other real estate owned of $1.6 million, FDIC insurance premiums of
$756,000 that included a special FDIC insurance assessment of $304,000 and the
impairment write-down to securities of $628,000.
  NET
INTEREST INCOME
  Net
interest income, the difference between interest income on earning assets and
interest expense on interest bearing liabilities, decreased 17.8 percent, or
$1.0 million, to $4.6 million for the three months ended June 30, 2009, as
compared with $5.6 million for the same quarter of 2008.  The decline
in net interest income was attributable to increased levels of nonearning
nonaccrual loans and increases to lower earning federal funds sold during the
second quarter of 2009 as compared with the same quarter of 2008.
 21
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  TABLE
5
  NORTHERN
STATES FINANCIAL CORPORATION
 ANALYSIS
OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
 For the
Three Months Ended June 30, 2009 and 2008 - Rates are
Annualized
 ($
000s)
  2009
                
                
                2008Average
                    Balance
                
                
                Interest
                
                
                Rate
                
                
                Average
                    Balance
                
                
                Interest
                
                
                RateAssetsLoans
      (1)(2)(3)
                
                $
                473,482
                
                
                $
                6,021
                
                
                
                5.09
                %
                
                $
                463,369
                
                
                $
                7,075
                
                
                
                6.11
                %Taxable
      securities (4)
                
                
                85,303
                
                
                
                1,117
                
                
                
                5.43
                %
                
                
                125,124
                
                
                
                1,705
                
                
                
                5.45
                %Tax
      advantaged securities (2) (4)
                
                
                8,716
                
                
                
                133
                
                
                
                6.12
                %
                
                
                10,731
                
                
                
                169
                
                
                
                6.33
                %Federal
      funds sold
                
                
                35,279
                
                
                
                9
                
                
                
                0.10
                %
                
                
                2,303
                
                
                
                13
                
                
                
                2.26
                %Interest
      earning assets
                
                
                602,780
                
                
                
                7,280
                
                
                
                4.85
                %
                
                
                601,527
                
                
                
                8,962
                
                
                
                5.96
                %Noninterest
      earning assets
                
                
                42,975
                
                
                
                
                
                
                
                
                
                
                
                37,470Average
      assets
                
                $
                645,755
                
                
                
                
                
                
                
                
                
                
                $
                638,997Liabilities
      and stockholders’ equityNOW
      deposits
                
                $
                47,469
                
                
                $
                51
                
                
                
                0.43
                %
                
                $
                48,006
                
                
                $
                40
                
                
                
                0.33
                %Money
      market deposits
                
                
                63,717
                
                
                
                234
                
                
                
                1.47
                %
                
                
                68,742
                
                
                
                295
                
                
                
                1.72
                %Savings
      deposits
                
                
                62,565
                
                
                
                39
                
                
                
                0.25
                %
                
                
                63,595
                
                
                
                78
                
                
                
                0.49
                %Time
      deposits
                
                
                266,574
                
                
                
                2,029
                
                
                
                3.04
                %
                
                
                245,477
                
                
                
                2,452
                
                
                
                4.00
                %Other
      borrowings
                
                
                64,621
                
                
                
                294
                
                
                
                1.82
                %
                
                
                75,400
                
                
                
                460
                
                
                
                2.44
                %Interest
      bearing liabilities
                
                
                504,946
                
                
                
                2,647
                
                
                
                2.10
                %
                
                
                501,220
                
                
                
                3,325
                
                
                
                2.65
                %Demand
      deposits
                
                
                56,848
                
                
                
                
                
                
                
                
                
                
                
                58,383Other
      noninterest bearing liabilities
                
                
                681
                
                
                
                
                
                
                
                
                
                
                
                7,451Stockholders’
      equity
                
                
                83,280
                
                
                
                
                
                
                
                
                
                
                
                71,943Average liabilities and stockholders’ equity
                
                $
                645,755
                
                
                
                
                
                
                
                
                
                
                $
                638,997Net
      interest income
                
                
                
                
                
                $
                4,633
                
                
                
                
                
                
                
                
                
                
                $
                5,637Net
      interest spread
                
                
                
                
                
                
                
                
                
                
                2.75
                %
                
                
                
                
                
                
                
                
                
                
                3.31
                %Net
      yield on interest earning assets (4)
                
                
                
                
                
                
                
                
                
                
                3.09
                %
                
                
                
                
                
                
                
                
                
                
                3.75
                %Interest-bearing liabilities to
                  earning assets ratio
                
                
                
                
                
                
                
                
                
                
                83.77
                %
                
                
                
                
                
                
                
                
                
                
                83.32
                %
 
 (1)
      -
                Interest
      income on loans includes loan origination and other fees of $14,000 and
      $63,000 for the three months ended June 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 $22,000 and $23,000 for the three months
      ended June 30, 2009 and 2008, respectively.  The
      tax equivalent adjustment reflected in the above table for municipal
      securities is approximately $45,000 and $58,000 for the three months
      ended June 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 June 30, 2009 and 2008
      average balance information includes an average unrealized gain (loss) for
      taxable securities of $2,897,000 and ($72,000) and for tax-advantaged
      securities

                      of
      $27,000 and $49,000,
respectively.
  22
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 TABLE
6
  NORTHERN
STATES FINANCIAL CORPORATION
 ANALYSIS
OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
 For the
Six Months Ended June 30, 2009 and 2008 - Rates are
Annualized
 ($
000s)
  2009
                
                
                2008Average
                    Balance
                
                
                Interest
                
                
                Rate
                
                
                Average
                    Balance
                
                
                Interest
                
                
                RateAssetsLoans
      (1)(2)(3)
                
                $
                476,738
                
                
                $
                12,477
                
                
                
                5.23
                %
                
                $
                454,808
                
                
                $
                14,343
                
                
                
                6.31
                %Taxable
      securities (4)
                
                
                90,675
                
                
                
                2,371
                
                
                
                5.40
                %
                
                
                132,195
                
                
                
                3,593
                
                
                
                5.46
                %Tax
      advantaged securities (2) (4)
                
                
                9,067
                
                
                
                282
                
                
                
                6.23
                %
                
                
                10,985
                
                
                
                343
                
                
                
                6.26
                %Federal
      funds sold
                
                
                27,020
                
                
                
                12
                
                
                
                0.09
                %
                
                
                5,765
                
                
                
                83
                
                
                
                2.88
                %Interest
      earning assets
                
                
                603,500
                
                
                
                15,142
                
                
                
                5.04
                %
                
                
                603,753
                
                
                
                18,362
                
                
                
                6.09
                %Noninterest
      earning assets
                
                
                41,147
                
                
                
                
                
                
                
                
                
                
                
                37,059Average
      assets
                
                $
                644,647
                
                
                
                
                
                
                
                
                
                
                $
                640,812Liabilities
      and stockholders’ equityNOW
      deposits
                
                $
                45,543
                
                
                $
                86
                
                
                
                0.38
                %
                
                $
                45,785
                
                
                $
                79
                
                
                
                0.35
                %Money
      market deposits
                
                
                64,445
                
                
                
                550
                
                
                
                1.71
                %
                
                
                69,457
                
                
                
                645
                
                
                
                1.86
                %Savings
      deposits
                
                
                61,649
                
                
                
                108
                
                
                
                0.35
                %
                
                
                62,563
                
                
                
                168
                
                
                
                0.54
                %Time
      deposits
                
                
                270,020
                
                
                
                4,284
                
                
                
                3.17
                %
                
                
                248,511
                
                
                
                5,278
                
                
                
                4.25
                %Other
      borrowings
                
                
                69,102
                
                
                
                615
                
                
                
                1.78
                %
                
                
                77,315
                
                
                
                1,091
                
                
                
                2.82
                %Interest
      bearing liabilities
                
                
                510,759
                
                
                
                5,643
                
                
                
                2.21
                %
                
                
                503,631
                
                
                
                7,261
                
                
                
                2.88
                %Demand
      deposits
                
                
                53,770
                
                
                
                
                
                
                
                
                
                
                
                56,945Other
      noninterest bearing liabilities
                
                
                4,592
                
                
                
                
                
                
                
                
                
                
                
                7,207Stockholders’
      equity
                
                
                75,526
                
                
                
                
                
                
                
                
                
                
                
                73,029Average
      liabilities and stockholders’ equity
                
                $
                644,647
                
                
                
                
                
                
                
                
                
                
                $
                640,812Net
      interest income
                
                
                
                
                
                $
                9,499
                
                
                
                
                
                
                
                
                
                
                $
                11,101Net
      interest spread
                
                
                
                
                
                
                
                
                
                
                2.83
                %
                
                
                
                
                
                
                
                
                
                
                3.21
                %Net
      yield on interest earning assets (4)
                
                
                
                
                
                
                
                
                
                
                3.16
                %
                
                
                
                
                
                
                
                
                
                
                3.68
                %Interest-bearing liabilities to earning
                  assets ratio
                
                
                
                
                
                
                
                
                
                
                84.63
                %
                
                
                
                
                
                
                
                
                
                
                83.42
                %
 
 (1)
      - Interest income on loans includes loan origination and other fees of
      $46,000 and $95,000 for the six months ended June 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 $44,000 and $45,000 for
      the six months ended June 30, 2009 and 2008,
      respectively.  The tax equivalent adjustment reflected in the
      above table for municipal securities is approximately $96,000 and $117,000
      for the six months ended June 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 six months ended
      June 30, 2009 and 2008 average balance information includes an
      average unrealized gain for taxable securities of $2,820,000 and $538,000
      and for tax-advantaged securities of $12,000 and $29,000,
      respectively.
  23
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 Average
interest earning assets during the three months ended June 30, 2009 totaled
$602.8 million, a slight increase of $1.3 million from average earning assets of
$601.5 million during the three months ended June 30,
2008.  However the mix of average interest earning assets show that
average federal funds sold for the quarter ending June 30, 2009 were $35.3
million as compared to only $2.3 million for the same quarter of
2008.  Rates earned on federal funds for the quarter ended
June 30, 2009 were .10 percent as compared with 2.26 percent for the same
quarter last year, a decrease of 216 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.
  Interest
rates were generally lower during the second quarter of 2009 than during the
second quarter of 2008.  The lower interest rates were evidenced by a
prime lending rate of 3.25 percent during the entire second quarter of 2009,
compared to the prime rate at the beginning of the second quarter of 2008 of
5.25 percent, which decreased 25 basis points, to end at 5.00 percent at
June 30, 2008.  This decrease to general interest rates affected
net interest income by causing rates on interest earning assets and rates paid
on interest bearing liabilities to decrease during the second quarter of 2009 as
compared with the same quarter last year.
  During
the quarter ended June 30, 2009 the net interest rate spread decreased 56
basis points to 2.75 percent as compared to 3.31 percent for the same quarter of
2008.  Rates on interest earning assets decreased 111 basis points
during the second quarter of 2009 as compared with the same quarter of
2008.  However, rates paid on interest bearing liabilities declined by
only 55 basis points during the second 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 to an increase in nonearning
nonaccrual loans, which totaled $48.0 million at June 30, 2009, as compared
with $18.9 million at June 30, 2008 and due to the change in the asset
earning mix, which included an increase to lower yielding federal funds
sold.
  For the
six months ended June 30, 2009, net interest income declined $1.6 million
from the same six months last year.  The decline to net interest
income was attributable to the increases to nonaccrual loans as well as
decreases to general interest rate levels and increased lower earning federal
funds sold.  The loan yield dropped 108 basis points during the first
half of 2009 as compared to the same period of 2008.  Average federal
funds rates declined 279 basis points and as average balances of federal funds
sold increased $21.2 million during the six months ended June 30, 2009 as
compared with the same six months of 2008.  These factors caused the
net interest spread to decrease 38 basis points and the net yield on interest
earning assets to decrease 52 basis points during the six months ended
June 30, 2009, as compared with the same six months of 2008.
  ASSET
QUALITY AND THE PROVISION FOR LOAN AND LEASE LOSSES
  At
June 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 $14.9 million was adequate to cover probable incurred loan
and lease losses, as compared with $10.4 million at year-end
2008.  During the first half of 2009, $972,000 in loans and leases
were charged-off against the allowance compared with charge-offs of $82,000
during the same period last year.  During the first half of 2009,
recoveries of loans previously charged-off totaled $12,000, as compared with
$54,000 in recoveries during the same period in 2008.  During the
second quarter of 2009, the provision for loan and lease losses was $3.7 million
as compared with $2.7 million during the same quarter of 2008.  During
the six months ended June 30, 2009, the provision for loan and lease losses
totaled $5.4 million as compared with $3.0 million for the same six months of
2008.
  24
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  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 $50.0 million at June
30, 2009, or 10.55 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 June
30, 2009, loans on nonaccrual status totaled $48.0 million, as compared with
$36.6 million at year-end 2008.  Two loan relationships account for
$26.1 million or 54 percent of total nonaccrual loans at June 30,
2009.  These loans are secured by commercial office and multi-family
apartment buildings on which the borrowers have experienced cash flow problems
due to vacancies.   The Company is taking steps to collect on the
loans, including foreclosure.
 
 During
the quarter ended June 30, 2009, nonaccrual loans increased by $11.0 million
from March 31, 2009.  Most of these additions to nonaccrual loans
pertain to five borrowers.
 
 One
borrower’s loans totaling $3.5 million, which include a $2.3 million home equity
loan, were placed on nonaccrual status during the quarter as the borrower
experienced severe cash flow difficulties. The Company anticipates initiating
foreclosure proceedings.
 
 The
Company participated with other financial institutions on a construction project
for 890 unit condominiums in Florida that has experienced construction delays
and problems due to purchasers of the condominiums having problems finding
financing.  The Company’s portion of this loan was $2.5 million and
was placed on nonaccrual status during the quarter, with the Company allocating
$656,000 of its allowance for loan and lease losses to this loan at June 30,
2009.
 
 Loans
totaling $2.3 million to a borrower secured by several single family homes as
well as two commercial buildings were placed on nonaccrual status during the
quarter as rent receipts used by the borrower to service the loan payments have
declined.  The borrower is attempting to sell the properties, with one
property expected to close during the third quarter of 2009.  The
Company was filing for foreclosure on the properties.
 
 A loan
for $1.1 million on a newly built commercial property was placed on nonaccrual
status during the quarter as the borrower has not made payments while attempting
to sell the property.   The Company is attempting to work with
the borrower pending the sale of the property.
 
 During
the quarter ended June 30, 2009, a loan for $904,000 on a hotel was placed on
nonaccrual status as the borrower has experienced cash flow problems due to
higher vacancy rates.  A foreclosure suit has been filed.
 
 Loans and
leases 90 days or more past due and still accruing interest increased to $2.0
million at June 30, 2009 compared with $442,000 at December 31,
2008.  These loans are well secured and in the process of
collection.
 25
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  Impaired
loans and leases at June 30, 2009 totaled $61.6 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 $9.2 million loan relationship
that is not on nonaccrual status but has been classified as restructured as the
Company has made reductions to the loans’ interest rates in an attempt to assist
the borrower in servicing their loan payments.  At June 30, 2009,
$8.7 million of the Company’s $14.9 million allowance for loan and lease losses
was allocated to impaired loans.
  TABLE
7
  NORTHERN
STATES FINANCIAL CORPORATION
  NONPERFORMING
ASSETS
  ($
000’s)
  June 30,
                    2009
                
                
                December 31,
                    2008Loans
      and leasesNonaccrual
      status
                
                $
                48,010
                
                
                $
                36,62490
      days or more past due, still accruing
                
                
                2,022
                
                
                
                442Total
      nonperforming loans and leases
                
                
                50,032
                
                
                
                37,066Other
      real estate owned
                
                
                6,015
                
                
                
                10,575Total
      nonperforming assets
                
                $
                56,047
                
                
                $
                47,641Nonperforming
      loans and leases as a
                  percentage
      of total loans, net of
                  unearned
      income and deferred loan fees
                
                
                10.55
                %
                
                
                7.71
                %Nonperforming
      assets as a percentage
                  of
      total assets
                
                
                8.85
                %
                
                
                7.44
                %Nonperforming
      loans and leases as a
                  percentage
      of the allowance for loan losses
                
                
                336.67
                %
                
                
                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.
  Another
component of nonperforming assets is other real estate owned, consisting of
assets acquired through loan foreclosure and repossession. At June 30,
2009, other real estate owned totaled $6.0 million, a decrease of $4.6 million
from $10.6 million at December 31, 2008.  During the three months
ended June 30, 2009 the Company sold two properties carried at $317,000 and
recognized gains on the sales of these properties that totaled
$37,000.  During the first quarter of 2009, the Company sold a luxury
home that had been carried at $5.9 million at year-end, for $4.2 million
recognizing a $1.7 million loss on the sale.  The Company’s loss on
this sale was due to declining values of luxury homes, large inventory, and the
limited number of buyers for such homes.  At June 30, 2009, the
Company had no homes in other real estate owned with a carrying value of greater
than $1.0 million.  During the first half of 2009, $1.6 million in
properties acquired through foreclosure were transferred into other real estate
owned from loans.
   26
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 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 June 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 first half of 2009,
additional environmental improvements that increased the carrying value of the
property were made totaling $61,000.  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.
  NONINTEREST
INCOME
  Noninterest
income for the three months ended June 30, 2009 was $545,000 as compared
with $1.1 million for the three months ended June 30, 2008.  The
decline was due to an impairment charge of $628,000 on collateral debt
obligation securities resulting from credit issues with financial institutions
issuing the debt backing the securities.  Excluding the impairment
charge, noninterest income would have been $1.2 million for the second quarter
of 2009, increasing $57,000 as compared with $1.1 million for the same quarter
of 2008.
  For the
six months ended June 30, 2009, the Company showed a negative noninterest
income of $180,000, as compared with $2.3 million for the six months ended
June 30, 2008.  The reasons for the loss during the first six
months of 2009 were the securities impairment charge of $628,000 described above
and the net losses from sales of other real estate owned of $1.6
million.  Excluding the securities impairment charge and net losses on
the sale of other real estate owned, noninterest income would have been $2.1
million for the six months ended June 30, 2009, a decline of $172,000 from
the same period of 2008.  This decline is attributable to decreased
service fees on deposits, mainly from reduced overdraft fee income, during the
first half of 2009 of $166,000 compared to the same period of 2008.
  NONINTEREST
EXPENSE
  Noninterest
expense for the quarter ended June 30, 2009 was $14.8 million, increasing
$10.4 million from $4.3 million for the same quarter last year.  The
majority of the increase of noninterest expense for the second quarter of 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.
  27
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  Also
affecting noninterest expense for the quarter ended June 30, 2009 was an
increase in FDIC insurance expense.  For the three months ended
June 30, 2009, FDIC insurance expense totaled $604,000 as compared with
$32,000 for the same three months last year, an increase of
$572,000.  Regular FDIC insurance rates increased for the Company in
2009 as the Company’s credits with the FDIC expired in 2008.  In
addition, the FDIC charged all financial institutions a special assessment
during the second quarter of 2009 to recapitalize the FDIC.  The
amount of the special assessment was equal to 5 basis points of the Bank’s
assets less its Tier I regulatory capital. The Company accrued an additional
$304,000 during the second quarter of 2009 for this special
assessment.  The FDIC may levy additional assessments during the third
and fourth quarters of 2009 if needed.
  Noninterest
expense for the six months ended June 30, 2009 was $19.6 million,
increasing $10.9 million from $8.7 million for the six months ended
June 30, 2008.  The goodwill impairment and increased FDIC
insurance expense account for $10.2 million of the increase.
  Also
affecting noninterest expense during the first half of 2009 as compared with the
same period last year were increases to legal expenses of $474,000 and other
operating expenses of $434,000.  Legal expenses increased mainly due
to collection efforts as a result of increases to the Company’s nonperforming
assets during 2009.  Most of the increase to other operating expenses
pertained to increases to the advertising and other real estate owned expense
components of other operating expenses. The Company increased its advertising
outlay during the first half of 2009 by $169,000 compared with the same period
last year as the Bank updated its branding and introduced a new checking account
product.  Expenses relating to other real estate owned during the six
months ended June 30, 2009 also increased $216,000 as compared with the
same six months last year as $1.6 million in properties were transferred into
other real estate owned.
  Offsetting
some of the increases to noninterest expense during the six months ended
June 30, 2009 as compared to the same period of 2008 was decreases to
salaries and employee benefits of $128,000 and to audit and other professional
fees of $286,000.  Salaries expense declined as the Company has
continued to reduce staff whenever possible.  The number of full time
equivalent employees declined to 142 at June 30, 2009 as compared to 155 at
June 30, 2008.  Audit and other professional fee expense declined
as the Company was no longer an accelerated filer.
  FEDERAL
AND STATE INCOME TAXES
  For the
three months ended June 30, 2009, the Company had a tax benefit of $1.5
million as compared with a tax benefit of $217,000 for the same three months
last year.  The tax benefit during the quarter ended June 30,
2009 as a percentage of losses before income taxes was 11.49 percent as compared
with 59.13 percent for the same quarter of 2008.  The much lower tax
benefit as a percentage of losses before income taxes of 11.49 percent was
attributable to the write-down of goodwill of $9.5 million being not deductible
for tax purposes.  Excluding the goodwill write-down, the tax benefit
as a percentage of losses before income taxes becomes 39.95
percent.
  The
Company had a tax benefit of $2.5 million for the six months ended June 30,
2009 as compared to income tax expense of $412,000 for the same period of
2008.  The tax benefit rate for the first half of 2009 comes to 16.04%
but when factoring out the non tax deductible $9.5 million write-down of
goodwill the tax benefit rate comes to 40.26%.
  During
2008, the Company had an accumulated net operating loss for state income tax
purposes of approximately $615,000, which will be carried forward to reduce
future taxable income.  The net operating loss carried forward will
expire in 2021, if it is not utilized.
  CONTRACTUAL OBLIGATIONS AND
OFF-BALANCE SHEET ARRANGEMENTS
  28
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 The
Company has contractual obligations that may not appear on the balance
sheet.  Table 7 presents the Company’s significant fixed and
determinable contractual obligations as of June 30, 2009, by payment date.
The payment amounts in Table 7 represent those amounts contractually due to the
recipient and do not include any unamortized premiums or discounts or similar
carrying amount adjustments.
  TABLE
8
  NORTHERN
STATES FINANCIAL CORPORATION
 CONTRACTUAL
OBLIGATIONS
 As of
June 30, 2009
 ($
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
      debtFederal
      Home Loan Bank term      
      advances
                
                $
                10,000
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                10,000Subordinated
      debentures
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                10,000
                
                
                
                10,000Time
      deposits
                
                
                235,031
                
                
                
                30,674
                
                
                
                9,905
                
                
                
                -
                
                
                
                275,610Other
      contractual obligationsStandby
      letters of credit
                
                
                6,575
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                6,575
 
 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.
  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
  29
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  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 June 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
June 30, 2009 the projected annual net interest income increases $136,000
when rates are shocked upward 2% while projected net interest income decreases
$601,000 for a 2% downward rate shock.  Interest rates at
June 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
June 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 June 30, 2009.
  TABLE
9
  NORTHERN
STATES FINANCIAL CORPORATION
 EFFECT OF
INTEREST SHOCKS ON NET INTEREST INCOME
 as of
June 30, 2009 and December 31, 2008
 ($000s)
  Immediate
      Change in Rates-2.00
                      %
                      
                      
                      -1.00
                      %
                      
                      
                      +1.00
                      %
                      
                      
                      +2.00
                      %June 30,
      2009:Dollar
      Change from Base Forecast
                      
                      $
                      (601
                      )
                      
                      $
                      (156
                      )
                      
                      $
                      147
                      
                      
                      $
                      136Percent
      Change from Base Forecast
                      
                      
                      -3.24
                      %
                      
                      
                      -0.84
                      %
                      
                      
                      0.79
                      %
                      
                      
                      0.73
                      %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
                      %
 
 30
 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 second quarter of 2009 that materially affected, or are reasonably likely to
materially affect, the Company’s internal control over financial
reporting.
  PART II. OTHERINFORMATION
  ITEM
1.  LEGALPROCEEDINGS.
  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 judgement, have a material adverse
effect on the Company’s business, results of operations, financial
condition or cash flows.
  ITEM
1A.  RISKFACTORS.
  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. UNREGISTEREDSALES OF EQUITY SECURITIES AND
USE OF PROCEEDS.
  None.
  ITEM
3.  DEFAULTSUPON SENIOR SECURITIES.
  None.
  31
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
  ITEM
4.  SUBMISSIONOF MATTERS TO A VOTE OF SECURITY
HOLDERS.
  The
annual meeting of stockholders of Northern States Financial Corporation was held
on May 21, 2009, with the stockholders of record at April 16, 2009
eligible to vote in person or by proxy, with one vote for each share owned, to
elect directors for a one year term each, to approve the 2009 Restricted Stock
Plan, togive
an advisory (non-binding) vote on 2008 executive compensation and to ratify the
appointment of Plante & Moran, PLLC as independent auditors of the
Company for the year ending December 31, 2009.  There were
4,072,255 shares of stock outstanding and eligible to vote as of April 16,
2009.  The following directors were duly elected at the meeting to
serve a one year term:
  Votes
                    FOR
                Votes
                    WITHHELDFred
      Abdula
                3,137,765
                89,640Kenneth
      W. Balza
                3,149,488
                77,917Theodore
      A. Bertrand
                3,149,988
                77,417Jack
      H. Blumberg
                3,059,815
                167,590Frank J.
      Furlan
                3,086,791
                140,614Harry
      S. Gaples
                3,073,535
                153,870James
      A. Hollensteiner
                3,084,832
                142,573Allan J.
      Jacobs
                3,149,003
                78,402Raymond
      M. Mota
                3,091,591
                135,814Helen
      Rumsa
                3,090,582
                136,823Scott
      Yelvington
                3,137,848
                89,557
 
 The 2009
Restricted Stock Plan was approved by a vote of 2,561,574 shares FOR approval,
169,222 shares voting AGAINST, and 19,969 shares voting to ABSTAIN.
  The
advisory (non-binding) vote on executive compensation showed a vote of 3,014,186
shares FOR, 103,657 shares voting AGAINST, and 109,652 shares voting to
ABSTAIN.
  The
appointment of Plante & Moran, PLLC as the Company’s independent
auditors for the year ending December 31, 2009 was ratified by a vote of
3,172,348 shares FOR ratification, with 18,151 shares voting AGAINST, and 36,906
shares voting to ABSTAIN.
  ITEM
5.  OTHERINFORMATION.
  None.
  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)).
  32
 Table of Contents
   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.
   33
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 FORM
10-Q
 June 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 10th day of
August 2009.
  NORTHERN
STATES FINANCIAL CORPORATION
 (Registrant)
     Date: 
      August 10,
      2009
              By: 
      /s/ Fred
      Abdula
                Fred Abdula
                Chairman of the Board
      of
                Directors and
      PresidentDate:  August 10,
      2009
              By: 
      /s/ Thomas M.
      Nemeth
                Thomas M. Nemeth
                Vice President and
      Treasurer
   
 34
 Table of Contents
  NORTHERN STATES FINANCIAL
CORPORATION
 FORM
10-Q
 June 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.
   35
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