===============================================================================
United States
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
---------------------------------------------------------
FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2005
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to __________
---------------------------------------------------------
NORTHERN STATES FINANCIAL CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 0-19300 36-3449727
(State of Incorporation) (Commission (I.R.S. Employer
File Number) Identification 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: XXX NO:
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). YES: XXX NO:
--- ---
4,295,105 shares of common stock were outstanding
as of August 9, 2005
NORTHERN STATES FINANCIAL CORPORATION AND SUBSIDIARY
----------------------------------------------------
FORM 10-Q
---------
FOR THE QUARTER ENDED JUNE 30, 2005
-----------------------------------
INDEX
-----
PART I. FINANCIAL INFORMATION
Page Number
Item 1. Financial Statements
Report of Independent Registered Public Accounting Firm........ 2
Condensed Consolidated Financial Statements and Notes.......... 3
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations......................... 7
Item 3. Quantitative and Qualitative Disclosures
About Market Risk...........................................19
Item 4. Controls and Procedures........................................21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings..............................................21
Item 2. Unregistered Sales of Equity Securities
and Use of Proceeds.........................................22
Item 3. Defaults upon Senior Securities................................22
Item 4. Submission of Matters to a Vote of Security Holders............22
Item 5. Other Information..............................................22
Item 6. Exhibits.......................................................23
Signatures.............................................................24
EXHIBIT INDEX.............................................................25
1
PART I. FINANCIAL INFORMATION
-----------------------------
ITEM 1. FINANCIAL STATEMENTS
----------------------------
REPORT OF 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, 2005, the
condensed consolidated statements of income for the three and six month periods
ended June 30, 2005 and 2004 and the condensed statements of cash flows for the
six month periods ended June 30, 2005 and 2004. 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 U.S. generally accepted accounting principles.
/s/ Crowe Chizek and Company LLC
----------------------------------
Oak Brook, Illinois
August 4, 2005
2
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
CONDENSED CONSOLIDATED BALANCE SHEETS
-------------------------------------
June 30, 2005 and December 31, 2004
(In thousands of dollars) (Unaudited)
June 30, December 31,
Assets 2005 2004
------ --------- -----------
Cash and due from banks....................................... $ 30,379 $ 20,292
Interest bearing deposits in financial institutions -
maturities less than 90 days............................... 97 75
Federal funds sold............................................ 34,873 8,932
-------- --------
Total cash and cash equivalents............................ 65,349 29,299
Securities available for sale................................. 249,257 250,929
Loans and leases.............................................. 407,897 442,562
Less: Allowance for loan and lease losses.................... (8,008) (7,812)
-------- --------
Loans and leases, net...................................... 399,889 434,750
Federal Home Loan Bank and Federal Reserve Bank stock......... 2,192 2,138
Office buildings and equipment, net........................... 9,388 9,313
Other real estate owned....................................... 4,911 4,802
Goodwill...................................................... 9,522 9,522
Core deposit intangible asset................................. 2,550 2,782
Accrued interest receivable and other assets.................. 7,290 6,049
-------- --------
Total assets............................................... $750,348 $749,584
======== ========
Liabilities and Stockholders' Equity
Liabilities
Deposits
Demand - noninterest bearing............................... $ 61,187 $ 61,907
Interest bearing........................................... 546,785 527,437
-------- --------
Total deposits.......................................... 607,972 589,344
Securities sold under repurchase agreements................... 58,075 59,764
Federal funds purchased....................................... 0 15,000
Federal Home Loan Bank advances............................... 6,500 6,500
Advances from borrowers for taxes and insurance............... 963 906
Accrued interest payable and other liabilities................ 5,202 4,888
-------- --------
Total liabilities....................................... 678,712 676,402
Stockholders' Equity
Common stock.................................................. 1,789 1,789
Additional paid-in capital.................................... 11,584 11,584
Retained earnings............................................. 65,352 66,102
Accumulated other comprehensive loss, net..................... (2,429) (1,633)
Treasury stock, at cost....................................... (4,660) (4,660)
-------- --------
Total stockholders' equity................................. 71,636 73,182
-------- --------
Total liabilities and stockholders' equity.............. $750,348 $749,584
======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
-------------------------------------------
Three and six months ended June 30, 2005 and 2004
(In thousands of dollars, except per share data) (Unaudited)
Three Months Ended Six Months Ended
June 30, June 30, June 30, June 30,
2005 2004 2005 2004
---------- ---------- ---------- ----------
Interest income
Loans (including fee income)...................... $6,369 $5,728 $12,872 $11,379
Securities
Taxable........................................ 1,908 1,912 3,811 3,830
Exempt from federal income tax................. 77 96 160 193
Federal funds sold and other...................... 301 73 394 168
------ ------ ------- -------
Total interest income.......................... 8,655 7,809 17,237 15,570
------ ------ ------- -------
Interest expense
Time deposits..................................... 2,482 1,747 4,499 3,378
Other deposits.................................... 630 387 1,169 764
Repurchase agreements, federal funds purchased
and Federal Home Loan Bank advances............ 430 256 840 561
------ ------ ------- -------
Total interest expense......................... 3,542 2,390 6,508 4,703
------ ------ ------- -------
Net interest income.................................. 5,113 5,419 10,729 10,867
Provision for loan and lease losses.................. 75 2,300 728 2,550
------ ------ ------- -------
Net interest income after provision for loan and
lease losses...................................... 5,038 3,119 10,001 8,317
Noninterest income
Service fees on deposits.......................... 602 631 1,156 1,250
Trust income...................................... 190 175 384 390
Loss on sale of securities available for sale..... 0 0 (169) 0
Other operating income............................ 319 307 609 539
------ ------ ------- -------
Total noninterest income....................... 1,111 1,113 1,980 2,179
------ ------ ------- -------
Noninterest expense
Salaries and employee benefits.................... 2,222 2,141 4,472 4,257
Occupancy and equipment, net...................... 525 490 1,033 955
Data processing................................... 346 379 722 696
Legal............................................. 102 181 174 349
Audit and other professional...................... 303 137 616 278
Amortization of core deposit intangible asset..... 116 116 232 232
Write-down of other real estate owned............. 1,067 0 1,067 0
Other operating expenses.......................... 676 631 1,395 1,085
------ ------ ------- -------
Total noninterest expense...................... 5,357 4,075 9,711 7,852
------ ------ ------- -------
Income before income taxes........................... 792 157 2,270 2,644
Provision for income taxes........................... 205 (85) 658 741
------ ------ ------- -------
Net income........................................... $ 587 $ 242 $ 1,612 $ 1,903
====== ====== ======= =======
Earnings per share................................... $ 0.14 $ 0.06 $ 0.38 $ 0.44
Comprehensive income (loss).......................... $1,440 ($3,866) $ 816 ($ 807)
The accompanying notes are an integral part of these condensed
consolidated financial statements.
4
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
-----------------------------------------------
Six months ended June 30, 2005 and 2004
(In thousands of dollars) (Unaudited)
Six Months Ended
June 30, June 30,
2005 2004
-------- ---------
Cash flows from operating activities
Net income..................................................... $ 1,612 $ 1,903
Adjustments to reconcile net income to net cash from
operating activities:
Depreciation................................................ 269 273
Federal Home Loan Bank stock dividends...................... (54) (59)
Loss on sale of securities available for sale............... 169 0
Provision for loan and lease losses......................... 728 2,550
Write-down of other real estate owned....................... 1,067 0
Deferred loan fees.......................................... (84) 46
Proceeds from sale of loans................................. 276 1,164
Loans originated for sale................................... (276) (837)
Amortization of other intangible assets..................... 232 232
Net change in accrued interest receivable and other
assets.................................................... (738) 552
Net change in accrued interest payable and other
liabilities............................................... 314 575
------- -------
Net cash from operating activities........................ 3,515 6,399
------- -------
Cash flows from investing activities
Acquisition of subsidiary, net of cash equivalents received.... 0 (366)
Proceeds from sales of securities available for sale........... 6,127 0
Proceeds from maturities and calls of securities available
for sale.................................................... 22,555 375,261
Purchases of securities available for sale..................... (28,478) (366,992)
Change in loans made to customers.............................. 33,041 (14,064)
Property and equipment expenditures............................ (344) (240)
------- -------
Net cash from investing activities.......................... 32,901 (6,401)
------- -------
Cash flows from financing activities
Net increase (decrease) in:
Deposits.................................................... 18,628 50,599
Securities sold under repurchase agreements and federal
funds purchased........................................... (16,689) (45,380)
Advances from borrowers for taxes and insurance............. 57 99
Federal Home Loan Bank advances................................ 15,000 0
Repayment of Federal Home Loan Bank advances................... (15,000) 0
Dividends paid................................................. (2,362) (2,368)
------- -------
Net cash from financing activities.......................... (366) 2,950
------- -------
Net change in cash and cash equivalents........................... 36,050 2,948
Cash and cash equivalents at beginning of period.................. 29,299 38,584
------- -------
Cash and cash equivalents at end of period........................ $65,349 $41,532
======= =======
The accompanying notes are an integral part of these condensed
consolidated financial statements.
5
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
----------------------------------------------------
June 30, 2005
(Dollar amounts in thousands, except share and per share data)
(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 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, 2004 and 2003.
The results of operations for the three and six month periods ended June 30,
2005, are not necessarily indicative of the results to be expected for the full
year.
Net income was utilized to calculate both basic and diluted earnings
per share for all periods presented. The average outstanding common shares
utilized in computing basic and diluted earnings per share were 4,295,105 and
4,305,105 for the three and six month periods ended June 30, 2005 and 2004,
respectively. The Company had no common stock equivalents during the two
periods.
On April 17, 2002, the Company announced that its Board of Directors
had approved a stock repurchase program that allows the Company to purchase up
to 200,000 shares of Northern States Financial Corporation stock either in open
market or private transactions. On February 19, 2003, the Company announced that
its Board of Directors had approved an additional repurchase program to purchase
200,000 additional shares of its stock. During the three and six months ended
June 30, 2005 no shares of stock were repurchased. At June 30, 2005, the Company
had a total of 177,150 shares of treasury stock that it purchased under these
programs. Treasury stock is carried at cost.
Information related to common stock was as follows:
June 30, December 31,
2005 2004
------- -----------
Par value per share........ $ 0.40 $ 0.40
Authorized shares.......... 6,500,000 6,500,000
Issued shares.............. 4,472,255 4,472,255
Treasury shares............ 177,150 177,150
Outstanding shares......... 4,295,105 4,295,105
6
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-------------------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
The following discussion focuses on the consolidated financial
condition of Northern States Financial Corporation (the "Company") at June 30,
2005 and the consolidated results of operations for the three and six month
periods ended June 30, 2005, compared with the same period of 2004. The purpose
of this discussion is to provide a better understanding of the condensed
consolidated financial statements of Northern States Financial Corporation and
the operations of its wholly owned subsidiaries, Bank of Waukegan (the "Bank")
and First State Bank of Round Lake ("First State Bank") 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, 2005 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 the surety bonds relating to
equipment lease pools and other loans currently on nonaccrual status, the
Company's ability to timely and sufficiently address the concerns and implement
the changes required by its regulators under the memorandum of understanding,
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.
7
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
OVERVIEW
--------
At June 30, 2005, total assets were $750.3 million compared with $749.6
million at December 31, 2004. Loans and leases totaled $407.9 million at June
30, 2005, decreasing $34.7 million from year-end 2004, as borrowers paid down
their loan balances and loan demand declined. Deposits at June 30, 2005, totaled
$608.0 million, increasing $18.6 million from December 31, 2004. Book value per
share decreased to $16.68 per share from $17.04 per share at December 31, 2004.
Earnings increased $345,000 during the second quarter of 2005 to $.14
per share, or $587,000 as compared with $.06 per share, or $242,000 for the
second quarter of 2004. Earnings during the second quarter of 2005 were
positively affected by a reduced provision to the allowance for loan and lease
losses. The provision for loan and lease losses during the second quarter of
2005 was $75,000 as compared with $2.3 million during the second quarter of 2004
when most of that period's provision had been allocated to nonperforming lease
pools originated by Commercial Money Center that then totaled $11.3 million. A
write-down of $1.1 million was taken during the second quarter of 2005 on other
real estate owned to reflect the current market value of those properties. The
decline in loans during 2005 has contributed to a decline in net interest income
during the second quarter of 2005, which was $306,000 less than the same quarter
of 2004.
Net income for the six months ended June 30, 2005 was $.38 per share or
$1,612,000 as compared with $.44 per share or $1,903,000 for the six months
ended June 30, 2004. Net interest income declined $138,000 during the first six
months of 2005 compared to the same period of 2004, primarily due to the decline
in interest earning assets. The provision for loan and lease losses during the
first half of 2005 was $728,000 compared with $2.6 million for the same period
of 2004, a decline of $1.8 million. Noninterest income decreased $199,000 during
the first six months of 2005 as compared with the same period of 2004, primarily
due to a $169,000 loss recognized during the first half of 2005 on the sale of
securities available for sale. Noninterest expense was $1.9 million greater
during the six months ended June 30, 2005 compared with the same six months of
2004 with the majority of the increase resulting from the $1.1 million
write-down of other real estate owned.
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.
8
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
Management analyzes the adequacy of the allowance for loan and lease
losses at least quarterly. Loans and leases judged to be impaired, with probable
incurred loss exposure, that are no longer accruing interest, and historical net
loss percentages are reviewed in the analysis of the allowance for loan and
lease losses. 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 subsidiary banks; 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, the allowance for loan and lease losses at June 30, 2005 is adequate
to cover probable incurred credit losses.
One of the components of the allowance for loan losses is historical
loss experience. Different loan classifications within the portfolio have
different loss experience ratios. For example, loans secured by real estate
generally have a better loss experience than loans secured by other assets.
Changes in the classification between periods can impact the allocation for
historical losses.
Management specifically analyzes its nonperforming loans for probable
losses. The change in the volume of nonperforming 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 results 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 is assessed for
impairment quarterly and any such impairment will be recognized in the period
identified.
Other intangible assets consist of core deposit and acquired customer
relationship intangible assets arising from whole bank and branch acquisitions.
They are initially measured at fair value and then are 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, 2005 increased $25.9
million to $34.8 million compared with $8.9 million at December 31, 2004. The
Company's federal funds sold position increased as loans and leases declined
$34.7 million while deposits grew $18.6 million from year-end. At June 30, 2005,
the Company's securities available for sale totaled $249.3 million, which
included $159.0 million in U.S. government-sponsored entity securities with call
options.
Loans and leases at June 30, 2005, decreased $34.7 million and totaled
$407.9 million as compared with $442.6 million at December 31, 2004. The
decrease in loans resulted from loan repayments outpacing loan growth during the
first half of 2005. One borrower paid off $16.3 million in loans while
consolidating their borrowings at another financial institution. Loans to the
lodging industry at June 30, 2005 totaled $24.7 million. Loan commitments have
decreased $30.3 million to $84.0 million at June 30, 2005 compared with $114.2
million at December 31, 2004 as some borrowers have allowed the loan commitments
issued to them to lapse. The Company is planning on increasing its lending staff
to reverse this trend and increase its loan portfolio. At June 30, 2005, loans
to related parties totaled $3.0 million, decreasing $672,000 from December 31,
2004. Loan commitments to related parties were $2.6 million at June 30, 2005.
9
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
During the first six months of 2005, deposits increased to $608.0
million at June 30, 2005, from $589.3 million at December 31, 2004. Much of the
growth is attributable to increases in brokered time deposits, which totaled
$96.8 million at June 30, 2005 compared with $71.3 million at December 31, 2004.
Brokered time deposits are deposits placed in the Bank by a broker from
depositors outside the Bank's geographic area. The brokered time deposits have
rates that are generally 10 to 15 basis points greater than the rates offered to
local depositors. It is expected that during the third quarter of 2005, as these
brokered deposits mature, the Company will choose not to renew these deposits as
the decreases in loans have lessened the need for these funds. At June 30, 2005,
deposits from related parties totaled $11.7 million compared with $11.4 million
at December 31, 2004.
Securities sold under repurchase agreements decreased by $1.7 million
to $58.1 million at June 30, 2005 from $59.8 million at December 31, 2004.
Securities sold under repurchase agreements from related parties totaled $11.7
million at June 30, 2005. There were no federal funds purchased at June 30, 2005
compared to $15.0 million at December 31, 2004, indicating an increase in the
Company's liquidity during the first half of 2005. Borrowings from the Federal
Home Loan Bank through term advances remained at $6.5 million at June 30, 2005.
Included in other liabilities at June 30, 2005 is $400,000 related to
estimated environmental clean-up expenses from conditions of a parcel of other
real estate sold in previous years. The Company intends to seek reimbursement of
these expenses from the State of Illinois that has a fund for this type of
cleanup. However, there can be no assurance that the Company will be successful
in obtaining any such reimbursement.
CAPITAL
-------
Total stockholders' equity decreased $1.6 million to $71.6 million
during the six months ended June 30, 2005. The decrease is the result of net
income of $1.6 million, less the adjustment for unrealized losses on securities
available for sale, net of deferred tax, of $796,000, less the cash dividend
paid to stockholders of $.55 per share that amounted to $2.4 million. Book value
per share of Company stock was $16.68 at June 30, 2005 as compared with $17.04
at December 31, 2004.
On a consolidated basis, the Company's tier 1 to total assets ratio and
total capital to assets ratio, on a risk adjusted basis, both calculated in
accordance with the regulations of the Board of Governors of the Federal Reserve
System, were 8.35% and 13.65%, respectively, as of June 30, 2005.
LIQUIDITY
---------
Liquidity management involves the ability to meet the cash flow
requirements of customers. The Company needs to have proper cash flow to meet
the requirements of depositors wanting to withdraw funds. The Company's
liquidity position has improved since December 31, 2004 as measured by increases
in the amount of federal funds sold, decreases in the amount of pledged
securities and decreases in the amount of federal funds purchased.
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, 2005 were $34.9 million.
The Company sells excess funds overnight to money center banks. The Company
classifies all of its securities as available for sale, which increases the
Company's flexibility in that the Company can sell any of its unpledged
securities to meet liquidity requirements. Securities available for sale had a
carrying value of $249.3 million at June 30, 2005, of which $151.0 million was
pledged to secure public deposits and repurchase agreements. At December 31,
2004, the Company's securities totaled $250.9 million of which $223.0 million
was pledged.
10
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
Other sources of liquidity available to the Company for funds are
deposits and borrowings. The Company also uses brokered deposits as another
source of liquidity. To help ensure the ability to meet its funding needs,
including any unexpected strain on liquidity, the Company has arrangements that
allow it to purchase $25.0 million in federal funds from an independent bank.
REGULATORY ISSUES
-----------------
As previously disclosed, following a joint examination by the Federal
Deposit Insurance Corporation ("FDIC") and the Illinois Department of Financial
and Professional Regulation ("IDFPR") the Board of Directors of the Bank of
Waukegan approved and signed on May 17, 2005, a memorandum of understanding
("MOU") in connection with certain deficiencies identified during the
regulators' examination of the Bank.
The MOU provides an understanding among the FDIC and the IDFPR and the
Bank, that the Bank will correct certain violations of law, including certain
violations regarding the Bank Secrecy Act, such as the timeliness of currency
transaction reports and the quality of customer identification documentation in
connection with the purchases of money orders, and improve its procedures so as
to prevent similar violations. In addition, the MOU confirms the understanding
among the FDIC and the IDFPR and the Bank, that the Bank will adopt written
plans to: (i) lessen the Bank's risk position with respect to certain troubled
assets; (ii) improve the Bank's liquidity and lessen its dependence upon
volatile liabilities; (iii) improve earnings; and (iv) restore tier 1 capital to
8% of the Bank's total assets should tier 1 capital fall below that 8% level. As
of June 30, 2005, the Bank's tier 1 capital to total assets ratio was 8.26%.
Under the MOU, the FDIC, the IDFPR and the Bank have also reached an
understanding that the Board of Directors will cause a review of the Bank's
staffing needs with particular emphasis in the area of loan collections and loan
administration. The Bank will report to the FDIC and the IDFPR on a quarterly
basis with respect to its progress on these matters. The Bank believes certain
other matters addressed in the MOU have already been satisfactorily resolved.
Management believes that the MOU will not have a material impact on the
Company's operating results or financial condition and that, unless the Bank
fails to adequately address the concerns of the FDIC and the IDFPR, the MOU will
not constrain the Company's business. Management is committed to resolving the
issues addressed in the MOU as promptly as possible, and had already taken
numerous steps to address the identified deficiencies prior to executing the
MOU.
RESULTS OF OPERATIONS
---------------------
NET INCOME
Consolidated net income for the quarter ended June 30, 2005 was
$587,000, increasing $345,000 compared with net income of $242,000 for the same
quarter of 2004. The annualized return on average assets was .31% for the
quarter, an increase from .12% for the same quarter the previous year. The
increase in net income for the quarter is primarily the result of decreases to
the provision for loan and lease losses that were partially offset by the
write-down of other real estate owned and decreases to net interest income. For
the six months ended June 30, 2005, consolidated net income was $1,612,000
compared to $1,903,000 for the same period last year. The annualized return on
average assets for the first six months of 2005 was .43%, decreasing from the
return on average assets for the same period of 2004 of .48%.
11
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
NET INTEREST INCOME
Net interest income, the difference between interest income on earning
assets and interest expense on interest bearing liabilities, decreased $306,000
to $5,113,000 during the three months ended June 30, 2005 compared with
$5,419,000 for the same period of 2004.
A factor affecting net interest income was the decline in average loans
during the second quarter of 2005 compared with the same quarter of 2004. Loans,
generally, earn higher interest rates than other interest earning assets of the
Company. Average loans declined $20.8 million during the second quarter of 2005
due to loan payoffs and a decline in loan demand as compared with the same
quarter last year while average federal funds sold, earning lower interest
rates, increased $9.7 million. As loan balances decreased federal funds sold
balances increased and interest income from federal funds sold was $301,000 for
the second quarter of 2005, compared with $73,000 during the second quarter of
2004.
Also adversely affecting net interest income during the second quarter
of 2005 was that rates paid on interest bearing liabilities increased to a
greater extent than the rates on interest earning assets. During the second
quarter of 2005, short-term interest rates increased, as evidenced by the prime
lending rate, which was 5.75% on March 31, 2005 and increased to 6.25% by June
30, 2005. During the second quarter of 2004, the prime lending rate remained at
4.00% during the entire quarter. Table 1 shows that the yield on interest
earning assets increased 73 basis points to 4.95% during the second quarter of
2005 from 4.22% during the same quarter last year. The rates on interest bearing
liabilities increased 86 basis points during the second quarter of 2005 to 2.33%
as compared with 1.47% during the same quarter of 2004. Interest rates on time
deposits increased 101 basis points from the same quarter last year due to
competitive pressures and the increase in brokered time deposits during 2005. It
is expected that rates paid on time deposits will continue to rise in 2005 due
to competition and expected increases to the prime lending rate.
Table 2 shows that during the six months ended June 30, 2005 net
interest income declined $138,000 compared with the same period of 2004. The
decrease in net interest income is primarily the result of a $40.5 million
decline in interest earning assets during the six months ended June 30, 2005
compared with the same period last year.
12
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
TABLE 1
NORTHERN STATES FINANCIAL CORPORATION
ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
For the Three Months Ended June 30, 2005 and 2004 - Rates are Annualized
($000s)
2005 2004
------------------------------- ----------------------------
Average Average
Balance Interest Rate Balance Interest Rate
-------- ----------- ------ --------- ---------- ------
Assets
Loans (1)(2)(3) $414,487 $6,386 6.16% $435,331 $5,754 5.29%
Taxable securities (4) 235,330 1,908 3.18% 267,360 1,912 2.83%
Tax advantaged securities (2) (4) 9,396 116 4.93% 11,485 145 5.09%
Federal funds sold 40,341 301 2.98% 30,625 73 0.95%
-------- ------ ----- -------- ------ -----
Interest earning assets 699,554 8,711 4.95% 744,801 7,884 4.22%
Noninterest earning assets 50,233 49,940
-------- ------ ----- -------- ------ -----
Average assets $749,787 $794,741
======== ========
Liabilities and stockholders' equity
NOW deposits $ 57,058 $ 126 0.88% $ 65,831 $ 92 0.56%
Money market deposits 60,609 280 1.85% 65,553 140 0.85%
Savings deposits 84,976 224 1.05% 84,879 155 0.73%
Time deposits 341,749 2,482 2.91% 367,105 1,747 1.90%
Other borrowings 63,761 430 2.70% 67,228 256 1.52%
-------- ------ ----- -------- ------ -----
Interest bearing liabilities 608,153 3,542 2.33% 650,596 2,390 1.47%
Demand deposits 62,041 61,771
Other noninterest bearing liabilities 7,612 7,459
Stockholders' equity 71,981 74,915
-------- ------ ----- -------- ------ -----
Average liabilities and
stockholders' equity $749,787 $794,741
======== ========
Net interest income $5,169 $5,494
====== ======
Net yield on interest earning assets (4) 2.94% 2.94%
===== =====
Interest-bearing liabilities
to earning assets ratio 86.93% 87.35%
===== =====
(1) - Interest income on loans includes loan origination fees of
$151 and $160 for the three months ended June 30, 2005 and
2004.
(2) - Tax-exempt income is reflected on a fully tax equivalent
basis utilizing a 34% tax rate.
(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, 2005 and 2004
average balance information includes an average unrealized
gain (loss) for taxable securities of ($4,622) and ($3,073)
and for tax-advantaged securities of ($13) and $82.
13
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
TABLE 2
NORTHERN STATES FINANCIAL CORPORATION
ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
For the Six Months Ended June 30, 2005 and 2004 - Rates are Annualized
($000s)
2005 2004
------------------------------- ----------------------------
Average Average
Balance Interest Rate Balance Interest Rate
-------- ----------- ------ --------- ---------- ------
Assets
Loans (1)(2)(3) $425,338 $12,907 6.07% $431,686 $11,429 5.30%
Taxable securities (4) 236,758 3,811 3.17% 261,875 3,830 2.91%
Tax advantaged securities (2)(4) 9,722 242 4.98% 11,243 292 5.28%
Federal funds sold 27,673 394 2.85% 35,155 168 0.96%
-------- ------- ----- -------- ------- -----
Interest earning assets 699,491 17,354 4.93% 739,959 15,719 4.24%
Noninterest earning assets 48,707 47,368
-------- ------- ----- -------- ------- -----
Average assets $748,198 $787,327
======== ========
Liabilities and stockholders' equity
NOW deposits $ 60,307 $ 242 0.80% $ 63,495 $ 174 0.55%
Money market deposits 62,110 518 1.67% 66,984 285 0.85%
Savings deposits 83,983 409 0.97% 83,331 305 0.73%
Time deposits 333,783 4,499 2.70% 355,613 3,378 1.90%
Other borrowings 66,428 840 2.53% 72,849 561 1.54%
-------- ------- ----- -------- ------- -----
Interest bearing liabilities 606,611 6,508 2.15% 642,272 4,703 1.46%
Demand deposits 62,080 62,137
Other noninterest bearing liabilities 6,736 6,813
Stockholders' equity 72,771 76,105
-------- ------- ----- -------- ------- -----
Average liabilities and
stockholders' equity $748,198 $787,327
======== ========
Net interest income $10,846 $11,016
======= =======
Net yield on interest earning assets (4) 3.08% 2.97%
===== =====
Interest-bearing liabilities
to earning assets ratio 86.72% 86.80%
===== =====
(1) - Interest income on loans includes loan origination and other
fees of $250 and $266 for the six months ended June 30, 2005
and 2004.
(2) - Tax-exempt income is reflected on a fully tax equivalent
basis utilizing a 34% tax rate.
(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, 2005 and 2004
average balance information includes an average unrealized
gain (loss) for taxable securities of ($3,918) and ($1,571)
and for tax-advantaged securities of $11 and $172.
14
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
ASSET QUALITY AND THE PROVISION FOR LOAN AND LEASE LOSSES
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, found that a $75,000
provision for loan and lease losses was necessary for the quarter ended June 30,
2005 compared with $2.3 million for the same period of 2004. Much of the $2.3
million provision during the second quarter of 2004 was allocated to the
nonperforming lease pools originated by Commercial Money Center ("CMC") that
then totaled $11.3 million. For the six months ended June 30, 2005, the
provision for loan and lease losses was $728,000 compared with $2,550,000 for
the first half of 2004.
The Company previously disclosed its involvement in certain lease pools
purchased in 2000 and 2001 from CMC. These lease pools were secured by both the
leased equipment and surety bonds issued by Illinois Union Insurance Company, a
wholly owned subsidiary of Ace Limited Insurance Company, and RLI Insurance
Company. When CMC filed for protection under the bankruptcy laws in 2002, and at
the direction of the bankruptcy court, the lease servicer held all payments made
by the obligors under the leases, pending the resolution of the claims of the
creditors. During the second quarter of 2004, the bankruptcy trustee brought
suit alleging that the financial institutions that had participated in the
various lease pools, including the Company, had failed to perfect their interest
in the lease pools and that they should be treated no better than unsecured
creditors. The Company, along with the other financial institutions that had
purchased the lease pools, have now entered into a settlement agreement with the
bankruptcy trustee. As part of the settlement, the Company has received
approximately $1.7 million. This sum represents the Company's portion of lease
payments that had been held by the servicer at the direction of the bankruptcy
court. This payment, along with subsequent payments received from the servicer
of the lease pools, has reduced the amount of these non-performing leases at
June 30, 2005 to $9.6 million, from the $11.3 million reported at March 31,
2005. As part of the settlement, the Company and CMC executed mutual releases of
one another. The Company may now continue to pursue the litigation it previously
brought against the two sureties. The sureties have asserted certain defenses
against having to pay under the surety bonds. No assurance can be given as to
the exact amounts that will be ultimately collected, if any, through this
litigation. At June 30, 2005, the Company had $2.4 million of its allowance for
loan and lease losses allocated to the remaining $9.6 million in leases
purchased from CMC.
At June 30, 2005, the allowance for loan and lease losses was $8.0
million or 1.96% of loans and leases as compared with $7.8 million or 1.77% of
total loans and leases at December 31, 2004. During the first half of 2005,
$598,000 in loans were charged off against the allowance compared with $1.9
million during the same period last year. There were $66,000 in recoveries of
loans previously charged off during the first six months of 2005 compared with
$13,000 in recoveries during the same period in 2004.
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 $14.8 million at June 30, 2005 or 3.63% of total
loans and leases as compared with $19.5 million at December 31, 2004 or 4.40% of
loans and leases. The decrease in nonperforming loans and leases is primarily
the result of the $1.7 million payment received on the nonperforming lease
pools, the charge off of $598,000 of loans and the transfer of $1.2 million in
nonperforming loans to other real estate owned through foreclosure. Also
decreasing nonperforming loans from year-end was the collection and payoff of
$835,000 in nonaccrual loans brought about by collection efforts.
15
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
Included as part of the $14.8 million of nonperforming loans at June
30, 2005 were the $9.6 million in nonaccrual lease pools previously discussed
and a $4.3 million nonaccrual loan that is for a 90-unit condominium
construction project. The Company participated in this 90-unit condominium
construction project with other financial institutions and only has a portion of
the total loan. The construction project experienced substantial cost overruns
and the principal borrowers declared bankruptcy. The construction project has
been completed and all of the units have been sold, with the bankruptcy trustee
holding the sale proceeds in escrow. There are $8.0 million in disputed mechanic
liens of which the majority of the mechanic liens are insured by a title
company. The bankruptcy trustee will not release the sales proceeds from escrow
until the disputed mechanic liens are resolved. The mechanic lien issue is not
expected to be concluded prior to year-end 2005.
Impaired loans and leases at June 30, 2005 totaled $29.4 million. 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 included 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. Included as impaired loans at June 30, 2005 are $14.7 million of
restructured loans. The amount of the allowance for loan and lease losses
specifically allocated for impaired loans and leases was $4.6 million at June
30, 2005 compared with $5.2 million at December 31, 2004.
Another component of nonperforming assets is other real estate owned,
consisting of assets acquired through loan foreclosure and repossession. 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. During the quarter
ended June 30, 2005, the Company took a write-down of other real estate owned of
$1.1 million to reflect the fair value of those properties. Two other properties
were transferred into other real estate owned totaling $1.2 million during the
first quarter of 2005. One property was a foreclosed motel that has a fair value
of $1.1 million and another property with a fair value of $126,000. At June 30,
2005, other real estate owned totaled $4.9 million.
NONINTEREST INCOME
Noninterest income for the three months ended June 30, 2005 was $1.1
million, unchanged from the three months ended June 30, 2004. Noninterest income
for the six months ended June 30, 2005 was $2.0 million decreasing $199,000 as
compared with $2.2 million for the same period last year. The decrease was
primarily attributable to loss of $169,000 on the sale of securities available
for sale that had been carried at $6.3 million prior to the sale. The securities
were sold for liquidity purposes during the first quarter of 2005.
NONINTEREST EXPENSE
Noninterest expense for the quarter ended June 30, 2005 was $5.4
million, increasing $1.3 million from the same quarter last year. The Company
recorded a $1.1 million write-down of its other real estate owned during the
second quarter of 2005 that accounted for much of the increase to noninterest
expense. The Company's efficiency ratio, noninterest expense divided by the sum
of net interest income and noninterest income, was also affected by the other
real estate write-down and was 86.07% for the second quarter of 2005 as compared
with 62.39% for the same quarter of 2004. Increased salaries and employee
benefits and audit and other professional fees also contributed to the increase
to noninterest expense.
16
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
Salary and employee benefits were $81,000 greater during the second
quarter of 2005 compared to the same period last year as annual salary increases
went into effect in January 2005. Continued increases to group insurance
premiums also contributed to the increase.
Audit and other nonlegal professional fees increased during the second
quarter of 2005 by $166,000 totaling $303,000 as compared with $137,000 for the
same quarter last year. These fees are the result of the Company's continued
efforts to comply with Section 404 of the Sarbanes-Oxley Act in 2005. It is
expected that audit and other professional fees will continue to be at higher
levels during the remaining quarters of 2005 than they were in 2004 as the
Sarbanes-Oxley Act, Section 404 assessment must be performed annually and the
Company has chosen to outsource a majority of its internal audit work.
During the three months ended June 30, 2005, legal fees declined
$79,000 and data processing expenses declined $33,000 from the same period of
2004. Legal fees decreased in 2005 as much of the litigation expense incurred as
part of the nonperforming Commercial Money Center lease pools legal proceedings
took place in 2004. Data processing expense declined in the second quarter of
2005 compared to the same quarter of 2004 resulting from expenses during 2004
incurred as part of the integration of First State Bank of Round Lake into the
Company after its purchase in 2004.
For the six months ended June 30, 2005, noninterest expense was $9.7
million, increasing $1.9 million from the same period last year. Noninterest
expense increased during the first half of 2005 primarily due to the $1.1
million write-down of other real estate owned in the first half of 2005.
Salaries and employee benefits expense was greater for the first half of 2005 by
$215,000 as yearly salary increases went into effect and group insurance
premiums rose. Audit and other professional expenses were $338,000 higher,
primarily due to expenses associated with the Sarbanes-Oxley Act, Section 404
internal control assessment process. Other operating expenses increased $310,000
during the first half of 2005 as compared with the first half of 2004, primarily
as FDIC assessments increased $75,000 and expenses relating to nonperforming
assets increased $69,000. Legal expense during the six months ended June 30,
2005 was $175,000 less than for the same period of 2004 due to higher legal fees
relating to the Commercial Money Center lease pools paid during the first half
of 2004.
FEDERAL AND STATE INCOME TAXES
For the three months ended June 30, 2005, the Company's income tax
expense was $205,000 compared with an income tax benefit of $85,000 for the same
three months last year. The income tax benefit during the second quarter of 2004
resulted from the increased provision for loan and lease losses that amounted to
$2.3 million during the second quarter of 2004. The income tax expense for the
first six months of 2005 was $658,000 as compared with $741,000 for the first
half of 2004. As a percentage of pre-tax income, tax expense was 29.0% for the
six months ended June 30, 2005 and 28.0% for the same period of 2004.
17
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
----------------------------------------------------------
The Company has contractual obligations that may not appear on the
balance sheet. The largest of these obligations are commitments to make loans or
extend credit through stand-by letters of credit. Many of the commitments expire
without being used. Table 3 presents the Company's significant fixed and
determinable contractual obligations as of June 30, 2005, by payment date. The
payment amounts in Table 3 represent those amounts contractually due to the
recipient and do not include any unamortized premiums or discounts or similar
carrying amount adjustments.
TABLE 3
NORTHERN STATE FINANCIAL CORPORATION
CONTRACTUAL OBLIGATIONS, COMMITMENTS, CONTINGENT
LIABILITIES AND OFF-BALANCE SHEET ARRANGEMENTS
As of June 30, 2005
($000s)
Greater than Greater than
1 yr. And less 3 yrs. and less
One year than or equal than or equal Greater than
Contractual obligations or less To 3 yrs. to 5 yrs. 5 yrs. Total
------- -------------- --------------- ------------ -----
Long-term debt
Federal Home Loan Bank advance $ 0 $ 6,500 $ 0 $0 $ 6,500
Time deposits 272,006 48,617 23,998 0 344,621
Other commitments
Standby letters of credit 4,873 0 0 0 4,873
Community Reinvestment Act
Investment commitment 42 395 272 0 709
Subsequent to June 30, 2005, the Company committed to the issuance of
$10.0 million in trust preferred securities in a private placement. The Company
plans on using the funds generated by the trust preferred securities to increase
its tier 1 capital at the Bank of Waukegan, subsidiary level. It is expected
that the issuance of the trust preferred securities will be completed during the
third quarter of 2005.
18
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
ITEM 3. QUANTITATIVE AND 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 ("IRR") is the exposure
of a banking organization's financial condition to adverse movements in interest
rates. Accepting this risk can be an important source of profitability and
stockholder value, however excessive levels of IRR can pose a significant threat
to the Company's earnings and capital base.
Evaluating a financial institution's exposure to changes in interest
rates includes assessing both the adequacy of the management process used to
control IRR and the organization's quantitative level of exposure. When
assessing the IRR management process, the Company seeks to ensure that
appropriate policies, procedures, management information systems and internal
controls are in place to maintain IRR at prudent levels with consistency and
continuity. Evaluating the quantitative level of IRR 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.
One approach used by management to analyze IRR is to periodically
evaluate the "shock" to the balance sheet of an assumed instantaneous decrease
and increase in rates of 2% using computer simulation to show the effect of rate
changes on the fair value of the Company's financial instruments. This approach
falls under the broad definition of asset/liability management. The Company's
primary asset/liability management technique is the interest rate shock.
Several ways the Company can manage IRR include: selling existing
assets or repaying certain liabilities and matching repricing periods for new
assets and liabilities, for example, by shortening terms of new loans or
securities. Financial institutions are also subject to prepayment risk in a
falling rate environment. For example, a debtor may prepay financial assets so
that the debtor may refinance obligations at new, lower rates. Prepayments of
assets carrying higher rates reduce the Company's interest income and overall
asset yields. 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. For example, call features on securities may not be
exercised and the lower yielding securities may remain in the Company's
securities portfolio until maturity.
Table 4 shows how interest rate shocks of decreasing rates 2% and
increasing rates 2% affect the fair value of the Company's financial instruments
at June 30, 2005 and December 31, 2004. The computer simulation model used to do
the interest rate shocks and calculate the effect on the fair value of the
Company's financial instruments 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, 2005 the fair value of securities
available for sale increases $5.6 million when rates are shocked downward 2%
while the fair value decreases $8.3 million for a 2% upward rate shock. The
change in fair value of securities is smaller when rates are shocked down
because there were call provisions on $159.0 million of the U.S. government
-sponsored entity securities at June 30, 2005. At June 30, 2005 the fair value
of the Company's financial asset instruments was $714.3 million compared to the
fair value on the Company's financial asset instruments at December 31, 2004 of
$717.1 million.
19
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
----------------------------------------------------------
TABLE 4
NORTHERN STATES FINANCIAL CORPORATION
EFFECT OF INTEREST SHOCKS ON FINANCIAL INSTRUMENTS
as of June 30, 2005
($000s)
Fair Value at June 30, 2005
-------------------------------------------
Down 2% Current Up 2%
------------- ------------- -------------
Assets
Cash and cash equivalents $ 65,352 $ 65,349 $ 65,346
Securities available for sale 254,879 249,257 240,970
Loans and leases 404,843 393,940 383,695
Federal Home Loan Bank and Federal
Reserve Bank stock 2,192 2,192 2,192
Accrued interest receivable 3,542 3,542 3,542
Financial liabilities:
Deposits $610,738 $605,693 $601,160
Securities sold under repurchase agreements
and other short-term borrowings 58,081 57,923 57,768
Federal Home Loan Bank term advance 6,618 6,355 6,101
Advances from borrowers for taxes and insurance 963 963 963
Accrued interest payable 2,552 2,552 2,552
Fair Value at December 31, 2004
-------------------------------------------
Down 2% Current Up 2%
------------- ------------ -----------
Assets
Cash and cash equivalents $ 29,300 $ 29,299 $ 29,298
Securities available for sale 257,458 250,929 239,934
Loans and leases 444,563 431,293 418,867
Federal Home Loan Bank and Federal
Reserve Bank stock 2,138 2,138 2,138
Accrued interest receivable 3,447 3,447 3,447
Financial liabilities:
Deposits $591,376 $587,529 $583,996
Securities sold under repurchase agreements
and other short-term borrowings 59,747 59,636 59,526
Federal funds purchased 15,000 15,000 15,000
Federal Home Loan Bank term advance 6,680 6,356 6,048
Advances from borrowers for taxes and insurance 906 906 906
Accrued interest payable 2,140 2,140 2,140
20
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
ITEM 4. CONTROLS AND PROCEDURES
-------------------------------
As of the end of the period covered by this report, an evaluation was
carried out under the supervision and with the participation of Northern States
Financial Corporation's management, including our Chairman of the Board and
President and Vice President and Treasurer, of the effectiveness of our
disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934). Based on and as of the date of their
evaluation, our Chairman of the Board and President and Vice President and
Treasurer have concluded that the Company's disclosure controls and procedures
are effective to ensure that information required to be disclosed by Northern
States Financial Corporation in reports that it files or submits under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in Securities and Exchange Commission rules and forms and are
effective to ensure that information required to be disclosed in the reports
that the Company files or submits under the Exchange Act is accumulated and
communicated to the Company's management, including our Chairman of the Board
and President and Vice President and Treasurer, to allow timely decisions
regarding required disclosure.
There was no change in the Company's internal control over financial
reporting that occurred during the six months ended June 30, 2005, that has
materially affected, or is reasonably likely to materially affect, the Company's
internal control over financial reporting.
PART II. OTHER INFORMATION
--------------------------
ITEM 1. LEGAL PROCEEDINGS
--------------------------
Due to the nature of their business, the Company and its subsidiaries
are often subject to various legal actions. Other than as described below, these
legal actions, whether pending or threatened, arise through the normal course of
business and are not considered unusual or material.
As previously disclosed, on May 5, 2004, the bankruptcy trustee for
Commercial Money Center and its affiliate brought suit in the United States
Bankruptcy Court Southern District of California (San Diego) against financial
institutions owning the various lease pools, including the Company, in an
attempt to make the financial institutions unsecured creditors (Adversary
Proceeding 04-90139-JH), alleging, among other things, that the Bank of Waukegan
failed to timely file Form UCC-1 Financing Statements relating to the
acquisition of certain rights associated with individual lease pools and
property.
In September 2004, the bankruptcy judge directed all parties to engage
in mediation, which occurred later that month. Subsequent to the mediation, the
Company, along with the other financial institutions that had purchased the
lease pools, entered into a settlement agreement with the bankruptcy trustee. As
part of the settlement, the Bank has received approximately $1.7 million. This
sum represents the Company's portion of lease payments that had been held by the
servicer at the direction of the bankruptcy court. As part of the settlement,
the Company and CMC executed mutual releases of one another. The Company may now
continue to pursue the litigation it previously brought against the two
sureties. The sureties have asserted certain defenses against having to pay
under the surety bonds. No assurance can be given as to the exact amounts that
will be ultimately collected, if any, through this litigation.
21
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND
---------------------------------------------------
USE OF PROCEEDS
---------------
ISSUER PURCHASES OF EQUITY SECURITIES
There were no purchases made by, or on behalf of, the Company of shares
of the Company's common stock during the quarterly period ended June 30, 2005.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
----------------------------------------
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
------------------------------------------------------------
The annual meeting of stockholders of Northern States Financial
Corporation was held on May 19, 2005 with the stockholders of record at April 7,
2005 voting in person or by proxy, with one vote for each share owned, to elect
directors for a one year term each and to ratify Crowe Chizek and Company LLC as
independent auditors of the Company for the year ending December 31, 2005. There
were 4,295,105 shares of stock as of April 7, 2005 that could be voted. Crowe
Chizek and Company LLC was ratified as the Company's independent auditors for
the year ending December 31, 2005 by a vote of 3,797,707 for ratification, 3,515
against, and 26,016 abstaining. The following directors were duly elected:
Authority Authority
Granted Withheld
---------------- --------------
Fred Abdula......................... 3,818,886 8,352
Kenneth W. Balza.................... 3,816,832 10,406
Theodore A. Bertrand................ 3,819,098 8,140
Jack H. Blumberg.................... 3,803,198 24,040
Frank Furlan........................ 3,813,713 13,525
Harry S. Gaples..................... 3,813,013 14,225
James A. Hollesteiner............... 3,811,718 15,520
Allan J. Jacobs..................... 3,818,598 8,640
Raymond M. Mota..................... 3,773,098 54,140
Helen Rumsa......................... 3,785,667 41,571
Frank Ryskiewicz.................... 3,818,360 8,878
ITEM 5. OTHER INFORMATION
--------------------------
None
22
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
ITEM 6. EXHIBITS
-----------------
(a) Exhibits.
Exhibit 3.1 Articles of Incorporation of the Company, as amended to
date. (Filed with Company's annual report on Form 10-K for the year
ended December 31, 1994 (Commission File 0-19300) and incorporated
herein by reference.)
Exhibit 3.2 By-Laws of the Company, as amended and restated to date.
(Filed with Company's quarterly report on Form 10-Q for the quarter
ended March 31, 2004 (Commission File 0-19300) and incorporated herein
by reference.)
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.
23
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
FORM 10-Q
---------
JUNE 30, 2005
-------------
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 9th day of August 2005.
NORTHERN STATES FINANCIAL CORPORATION
(Registrant)
Date: August 9, 2005 By: /s/ Fred Abdula
---------------------------- --------------------------------
Fred Abdula
Chairman of the Board of
Directors and President
Date: August 9, 2005 By: /s/ Thomas M. Nemeth
---------------------------- --------------------------------
Thomas M. Nemeth
Vice President and Treasurer
24
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
FORM 10-Q
---------
JUNE 30, 2005
-------------
EXHIBIT INDEX
-------------
Exhibits
--------
Exhibit 3.1 Articles of Incorporation of the Company, as amended to
date. (Filed with Company's annual report on Form 10-K for the year
ended December 31, 1994 (Commission File 0-19300) and incorporated
herein by reference.)
Exhibit 3.2 By-Laws of the Company, as amended and restated to date.
(Filed with Company's quarterly report on Form 10-Q for the quarter
ended March 31, 2004 (Commission File 0-19300) and incorporated herein
by reference.)
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.
25