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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 ending September 30, 2003
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: ____
4,305,105 shares of common stock were outstanding
as of September 30, 2003
NORTHERN STATES FINANCIAL CORPORATION AND SUBSIDIARY
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2003
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements Page Number
Report of Independent Accountants..............................2
Condensed Consolidated Financial Statements and Notes.......... 3
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations...........................9
Item 3. Quantitative and Qualitative Disclosures
About Market Risk........................................... 20
Item 4. Disclosure Controls and Procedures.......................... 22
PART II. OTHER INFORMATION
Item 1. Legal Proceedings........................................... 22
Item 2. Changes in Securities and Use of Proceeds....................23
Item 3. Defaults upon Senior Securities..............................23
Item 4. Submission of Matters to a Vote of Security Holders..........23
Item 5. Other Information............................................23
Item 6. Exhibits and Reports on Form 8-K.............................23
Signatures............................................................25
EXHIBIT 31.1 Section 302 Certifications..................................26
EXHIBIT 31.2 Section 302 Certifications..................................27
EXHIBIT 32.1 Section 906 Certification...................................28
1
PART 1. FINANCIAL INFORMATION
- -----------------------------
ITEM 1. FINANCIAL STATEMENTS
- -----------------------------
REPORT OF INDEPENDENT ACCOUNTANTS
Board of Directors and Stockholders
Northern States Financial Corporation
Waukegan, Illinois
We have reviewed the condensed consolidated balance sheet of NORTHERN
STATES FINANCIAL CORPORATION as of September 30, 2003 and the related condensed
consolidated statements of income for the three and nine month periods ended
September 30, 2003 and 2002 and the condensed consolidated statements of cash
flows for the nine month periods ended September 30, 2003 and 2002. These
financial statements are the responsibility of the Company's management.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. 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
generally accepted auditing standards, 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 reviews, we are not aware of any material modifications that
should be made to the condensed financial statements referred to above for them
to be in conformity with accounting principles generally accepted in the United
States of America.
We have previously audited, in accordance with auditing standards generally
accepted in the United States of America, the consolidated balance sheet of
Northern States Financial Corporation as of December 31, 2002, and the related
consolidated statements of income, stockholders' equity and cash flows for the
year then ended (not presented herein); and in our report dated February 7,
2003, we expressed an unqualified opinion on those financial statements. In our
opinion, the information set forth in the accompanying condensed consolidated
balance sheet as of December 31, 2002, is fairly stated, in all material
respects, in relation to the consolidated balance sheet from which it has been
derived.
/s/ Crowe Chizek and Company LLC
- -----------------------------------
Oak Brook, Illinois
October 27, 2003
2
NORTHERN STATES FINANCIAL CORPORATION
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CONDENSED CONSOLIDATED BALANCE SHEETS
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September 30, 2003 and December 31, 2002
(In thousands of dollars) (Unaudited)
September 30, December 31,
2003 2002
----------------- ----------------
Assets
Cash and due from banks......................................... $18,037 $16,475
Interest bearing deposits in financial institutions -
maturities less than 90 days................................ 96 163
Federal funds sold.............................................. 1,111 20,940
----------------- ----------------
Total cash and cash equivalents.............................. 19,244 37,578
Securities available for sale................................... 248,702 236,898
Loans and leases................................................ 351,599 352,124
Less: Allowance for loan and lease losses....................... (3,782) (3,698)
----------------- ----------------
Loans and leases, net........................................ 347,817 348,426
Federal Home Loan Bank stock.................................... 1,839 1,734
Office buildings and equipment, net............................. 5,453 5,478
Other real estate owned......................................... 3,966 2,022
Accrued interest receivable and other assets.................... 4,840 3,540
----------------- ----------------
Total assets................................................. $631,861 $635,676
================= ================
Liabilities and Stockholders' Equity
Liabilities
Deposits
Demand - noninterest bearing................................. $48,678 $47,658
Interest bearing............................................. 417,036 401,936
----------------- ----------------
Total deposits............................................ 465,714 449,594
Securities sold under repurchase agreements..................... 78,037 97,181
Federal Home Loan Bank advances................................. 6,500 6,500
Advances from borrowers for taxes and insurance................. 274 466
Accrued interest payable and other liabilities.................. 4,176 5,343
----------------- ----------------
Total liabilities......................................... 554,701 559,084
Stockholders' Equity
Common stock.................................................... 1,789 1,789
Additional paid-in capital...................................... 11,584 11,584
Retained earnings............................................... 67,876 65,957
Accumulated other comprehensive income, net..................... 299 1,365
Treasury stock, at cost......................................... (4,388) (4,103)
----------------- ----------------
Total stockholders' equity................................... 77,160 76,592
----------------- ----------------
Total liabilities and stockholders' equity................ $631,861 $635,676
================= ================
The accompanying notes are an integral part of these condensed
consolidated financial statements.
3
NORTHERN STATES FINANCIAL CORPORATION
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CONDENSED CONSOLIDATED STATEMENTS OF INCOME
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Three and nine months ended September 30, 2003 and 2002
(In thousands of dollars, except per share data) (Unaudited)
Three months ended Nine months ended
September 30, September 30, September 30, September 30,
2003 2002 2003 2002
---------------- ---------------- ---------------- ---------------
Interest income
Loans (including fee income)................ $4,830 $5,418 $15,176 $16,438
Securities
Taxable................................... 1,568 1,986 4,969 6,599
Exempt from federal income tax............ 73 100 240 332
Federal funds sold and other................ 16 116 52 226
---------------- ---------------- ---------------- ---------------
Total interest income.................... 6,487 7,620 20,437 23,595
---------------- ---------------- ---------------- ---------------
Interest expense
Time deposits............................... 1,388 1,993 4,797 5,648
Other deposits.............................. 290 513 1,020 1,512
Other borrowings............................ 463 574 1,551 1,824
---------------- ---------------- ---------------- ---------------
Total interest expense................... 2,141 3,080 7,368 8,984
---------------- ---------------- ---------------- ---------------
Net interest income............................ 4,346 4,540 13,069 14,611
Provision for loan and lease losses............ 150 75 430 225
---------------- ---------------- ---------------- ---------------
Net interest income after provision for
loan and lease losses....................... 4,196 4,465 12,639 14,386
---------------- ---------------- ---------------- ---------------
Noninterest income
Service fees on deposits.................... 566 536 1,650 1,532
Trust income................................ 199 141 530 504
Mortgage banking income..................... 50 71 287 200
Other operating income...................... 218 166 578 517
---------------- ---------------- ---------------- ---------------
Total noninterest income................. 1,033 914 3,045 2,753
---------------- ---------------- ---------------- ---------------
Noninterest expense
Salaries and employee benefits.............. 1,669 1,670 5,074 4,988
Occupancy and equipment, net................ 354 327 1,063 1,005
Data processing............................. 166 124 473 429
Legal....................................... 285 143 868 283
Other operating expenses.................... 686 565 1,684 1,675
---------------- ---------------- ---------------- ---------------
Total noninterest expense................ 3,160 2,829 9,162 8,380
---------------- ---------------- ---------------- ---------------
Income before income taxes..................... 2,069 2,550 6,522 8,759
Provision for income taxes..................... 709 865 2,278 2,980
---------------- ---------------- ---------------- ---------------
Net income..................................... $1,360 $1,685 $4,244 $5,779
================ ================ ================ ===============
Basic and diluted earnings per share........... $0.32 $0.39 $0.99 $1.31
Comprehensive income............................ $261 $1,867 $3,178 $7,066
The accompanying notes are an integral part of these condensed
consolidated financial statements.
4
NORTHERN STATES FINANCIAL CORPORATION
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
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Nine months ended September 30, 2003 and 2002
(In thousands of dollars) (Unaudited)
Nine months ended
September 30, September 30,
2003 2002
------------------ -------------------
Cash flows from operating activities
Net income......................................................... $4,244 $5,779
Adjustments to reconcile net income to net cash from
operating activities:
Depreciation.................................................... 285 274
Net gains on sales of securities................................ 0 (8)
Net gains on sales of other real estate owned................... (29) 0
Federal Home Loan Bank stock dividends.......................... (105) (65)
Provision for loan and lease losses............................. 430 225
Net change in accrued interest receivable and other assets...... (512) 1,329
Net change in accrued interest payable and other liabilities.... (1,167) (2,121)
------------------ -------------------
Net cash from operating activities........................... 3,146 5,413
------------------ -------------------
Cash flows from investing activities
Proceeds from maturities and calls of securities
available for sale........................................... 967,284 410,234
Proceeds from sales of securities available for sale............ 0 4,436
Proceeds from sales of other real estate owned.................. 535 0
Purchases of securities available for sale...................... (980,828) (415,090)
Change in loans made to customers............................... (2,385) (34,337)
Property and equipment expenditures............................. (260) (186)
------------------ -------------------
Net cash from investing activities........................... (15,654) (34,943)
------------------ -------------------
Cash flows from financing activities
Net increase (decrease) in:
Deposits..................................................... 16,120 51,141
Securities sold under repurchase agreements
and other short-term borrowings............................ (19,144) (10,277)
Advances from borrowers for taxes and insurance.............. (192) (559)
Federal Home Loan Bank advances................................. 0 6,500
Repayment of Federal Home Loan Bank advances.................... 0 (10,000)
Net proceeds from exercise of stock options..................... 0 21
Purchases of treasury stock..................................... (285) (3,753)
Dividends paid.................................................. (2,325) (2,370)
------------------ -------------------
Net cash from financing activities........................... (5,826) 30,703
------------------ -------------------
Net change in cash and cash equivalents................................... (18,334) 1,173
Cash and cash equivalents at beginning of period.......................... 37,578 34,315
------------------ -------------------
Cash and cash equivalents at end of period................................ $19,244 $35,488
================== ===================
The accompanying notes are an integral part of these condensed
consolidated financial statements.
5
NORTHERN STATES FINANCIAL CORPORATION
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
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September 30, 2003
(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, 2002, 2001 and 2000.
The results of operations for the three and nine month periods ended September
30, 2003, 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. Information regarding weighted average shares
utilized in computing basic and diluted earnings per share follows. It should be
noted that all stock options were exercised in early 2002 and there have since
been none outstanding.
Three months ended Nine months ended
September 30, September 30, September 30, September 30,
2003 2002 2003 2002
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Average outstanding common shares..... 4,305,105 4,343,148 4,306,131 4,414,895
Effect of stock options............... 0 0 0 6
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Average outstanding shares for
diluted earnings per share......... 4,305,105 4,343,148 4,306,131 4,414,901
=============================================================
6
NORTHERN STATES FINANCIAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2003
(Dollar amounts in thousands, except share and per share data)
(Unaudited)
On April 17, 2002 it was announced that the Northern States Financial
Corporation's 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 it had approved an additional repurchase
program to purchase an additional 200,000 shares of its stock. The Company has
repurchased 10,000 shares at an average cost of $28.50 per share during the
first nine months of 2003. At September 30, 2003, the Company had a total of
167,150 shares of treasury stock that it purchased under these programs.
Treasury stock is carried at cost.
Information related to stockholders' equity was as follows:
September 30, December 31,
2003 2002
----------------------------------
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............... 167,150 157,150
Outstanding shares............ 4,305,105 4,315,105
Note 2 - Commitments, Off-Balance Sheet Risk and Contingencies
- --------------------------------------------------------------
At September 30, 2003 and December 31, 2002, the contract amount of the
Company's off-balance sheet commitments were as follows:
September 30, December 31,
2003 2002
-----------------------------------
Unused lines of credit and
commitments to make loans:
Fixed rate........................... $17,975 $11,533
Variable rate........................ 77,429 99,896
------------------------------------
Total...................................... $95,404 $111,429
====================================
Standby letters of credit.................. $5,651 $5,435
7
NORTHERN STATES FINANCIAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2003
(Dollar amounts in thousands, except share and per share data)
(Unaudited)
Since many commitments to make loans expire without being used, the amounts
above do not necessarily represent future cash commitments. Collateral obtained
upon exercise of the commitments is determined using management's credit
evaluation of the borrower, and may include commercial and residential real
estate and other business and consumer assets.
Commitments to make loans to related parties totaled $569 and $1,006 at
September 30, 2003 and December 31, 2002. These commitments were made at the
same terms and conditions available to nonrelated parties.
The Company also has Community Reinvestment Act (CRA) investment
commitments outstanding of $871 as of September 30, 2003. The commitment is to
be funded over the next six years.
Note 3 - Announcement of Merger Agreement
- -----------------------------------------
On September 11, 2003, Northern States Financial Corporation announced that
it had agreed to acquire privately held Round Lake Bankcorp, Inc. based in Round
Lake, Illinois and that their respective boards of directors had approved a
definitive Agreement and Plan of Merger. The transaction is valued at $19.8
million and will be paid in cash. The transaction is subject to regulatory and
Round Lake Bankcorp stockholder approval. Subject to receipt of regulatory and
Round Lake Bankcorp stockholder approval, the transaction is expected to close
in early January 2004.
8
NORTHERN STATES FINANCIAL CORPORATION
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
- -------------------------------------------------------------------
AND RESULTS OF OPERATIONS
- -------------------------
The following discussion focuses on the consolidated financial condition of
the Northern States Financial Corporation (the "Company") at September 30, 2003
and the consolidated results of operations for the three and nine month periods
ended September 30, 2003, compared to the same period of 2002. 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 subsidiary, the Bank of Waukegan (the "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.
The Company cautions readers of this report that a number of important
factors could cause the Company's actual results subsequent to September 30,
2003 to differ materially from those expressed in forward-looking statements.
Statements contained in this management's discussion and analysis 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. Factors that could cause actual results to differ from
those predicted and could affect the future prospects of the Company and its
subsidiaries include, but are not limited to, difficulties or delays in
completing the planned acquisition of Round Lake Bankcorp, Inc., changes in the
estimated purchase accounting adjustments relating to the acquisition,
difficulties in achieving anticipated cost savings related to the operation of
the acquired banking offices or higher than expected costs related to the
transaction, 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 the equipment
lease pools currently on nonaccrual status, unanticipated changes in interest
rates, general economic conditions, 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
investment portfolios, demand for loan products, deposit flows, competition,
demand for 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.
9
NORTHERN STATES FINANCIAL CORPORATION
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
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AND RESULTS OF OPERATIONS
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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
disclosure provided, and future results could differ. Accounting for 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 situation,
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, in the management's
judgement, should be charged-off. Loan and lease losses are charged against the
allowance when management believes the uncollectibility of a loan or lease
balance is confirmed.
A loan or lease is impaired when full payment under the loan or lease terms
is not expected. Impairment is evaluated on an aggregate basis for
smaller-balance loans of similar nature such as residential mortgage, consumer
and credit card loans, and on an individual loan or lease basis for other loans
and leases. If a specific loan or lease is determined by management to be
impaired, a portion for the allowance is allocated so that the loan or lease,
net of the allocated reserve, is reflected in total assets at the present value
of estimated cash flows using the loan's or lease's existing rate or at the fair
value of collateral if repayment is expected solely from the collateral.
FINANCIAL CONDITION
- -------------------
The Company's consolidated total assets were $631.9 million at September
30, 2003, decreasing $3.8 million from $635.7 million at December 31, 2002. The
decrease was primarily attributable to declines to the Company's cash and cash
equivalents that were partially offset by increases in the value of the
Company's securities portfolio.
The Company's federal funds sold at September 30, 2003 declined $19.8
million to $1.1 million from $20.9 million at December 31, 2002. The Company's
federal funds sold position decreased in order to fund increases to securities
available for sale that were $11.8 million greater than at December 31, 2002.
The fair value of securities at September 30, 2003 was $248.7 million of which
$231.5 million were pledged to secure repurchase agreements and public deposits.
During the first nine months of 2003, $967.3 million in securities were called
or matured compared to only $410.2 million for the same period last year. As
interest rates fell, the issuers of securities had incentive to call the
securities. At September 30, 2003, the Company has $123.9 million in U.S.
Government agency securities with call options and an additional $71.0 million
that will mature within 90 days.
10
NORTHERN STATES FINANCIAL CORPORATION
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
Loans and leases declined slightly at September 30, 2003 from December
31, 2002 by $525,000. Loan demand for the first nine months of 2003 has receded
compared to the previous year as the economy has slowed. The Company's
commercial loans and real estate construction loans decreased $7.4 million and
$6.7 million from year-end as commercial loans were secured by real estate and
construction projects were completed. These loans were reclassified to the real
estate mortgage portfolio to more consistently reflect the underlying collateral
of these loans, causing real estate mortgage loans to increase $12.6 million.
The Company's home equity loans increased by $941,000 to $28.3 million compared
to $27.4 million at December 31, 2002, indicating the continued popularity of
this type of loan because of its tax advantages to the borrower. Installment
consumer loans also increased from year-end by $521,000. At September 30, 2003,
loans to related parties totaled $4.4 million increasing $1.9 million from
December 31, 2002.
During the first nine months of 2003, deposits increased by $16.1 million
to $465.7 million from $449.6 million at December 31, 2002. The growth was
attributable to an increase of $15.7 million in deposits from local government
agencies. This increase resulted from the normal cyclical nature of public
entities receiving funds as real estate tax payments are received during the
third quarter of the year that are then drawn down for operational purposes
during the rest of the year.
Securities sold under repurchase agreements decreased by $19.2 million to
$78.0 million at September 30, 2003 from $97.2 million at December 31, 2002.
Securities sold under repurchase agreements are offered through either an
overnight repurchase agreement product or a term product with maturities from 7
days to one year. The decrease in repurchase agreements was mainly from the term
product maturities as the purchasers of the term product used the funds for
business purposes. At September 30, 2003, securities sold under repurchase
agreements to related parties totaled $44.3 million. Borrowings from the Federal
Home Loan Bank through term advances remained at $6.5 million at September 30,
2003.
Total stockholders' equity increased $568,000 to $77.2 million during the
nine months ended September 30, 2003. The increase is the result of net income
of $4,244,000, less the adjustment to the market value of securities available
for sale, net of tax, of $1,066,000, less $285,000 due to the Company's
repurchase of 10,000 shares of its common stock, and less $2,325,000 paid out as
a cash dividend of $.54 per share on June 1, 2003.
The Company's tier 1 capital to average asset ratio at September 30, 2003
was 12.18% and the total tier 2 capital to asset ratio, on a risk adjusted
basis, amounted to 18.44%, exceeding the minimum required to be well capitalized
under prompt corrective action regulations, which minimums are 5.00% and 10.00%.
Book value per share was $17.92 at September 30, 2003 as compared to $17.75 at
December 31, 2002. On September 30, 2003, the Company and the Bank were in
compliance with all applicable regulatory capital requirements. After the
acquisition of Round Lake Bankcorp, Inc. that is expected to close in early
January 2004, the Company's capital position is expected to continue to exceed
regulatory capital adequacy requirements.
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 must meet
the needs of borrowers for credit as well. The acquisition of Round Lake
Bankcorp, Inc. for $19.8 million will also require liquidity management to fund
the transaction.
11
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
Federal funds sold, interest bearing deposits in banks and marketable
securities, particularly those of shorter maturities, are principal sources of
asset liquidity. Federal funds sold at September 30, 2003 were $1.1 million. The
Company sells excess funds overnight to the money center banks and these funds
provide the Company with liquidity to fund loans or meet depositor requirements.
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 $248.7 million at September 30, 2003 of which
$231.5 million were pledged to secure public deposits and repurchase agreements.
Other sources of liquidity available to the Company for funds are deposits
and borrowings. The Company has used brokered deposits for liquidity and at
September 30, 2003 had $15.9 million in brokered time deposits. To insure the
ability to meet its funding needs, including any unexpected strain on liquidity,
the Company has $30 million in federal funds lines of credit from two
independent banks. At September 30, 2003, the Company had borrowings from the
Federal Home Loan Bank of $6.5 million with the ability to borrow $1.9 million
in additional funds based on the Company's available collateral of one to four
family dwellings.
RESULTS OF OPERATIONS
- ---------------------
NET INCOME
Consolidated net income for the quarter ended September 30, 2003 was
$1,360,000, or $.32 per diluted share, decreasing $325,000 or 19.29% compared to
net income of $1,685,000, or $.39 per diluted share, for the same period the
previous year. The annualized return on average assets was .86% for the quarter,
a decrease from a return on average assets for the same quarter the previous
year of 1.10%. The consolidated net income for the nine months ended September
30, 2003 was $4,244,000, or $.99 per diluted share, a decrease of $1,535,000
from $5,779,000, or $1.31 per diluted share for the first nine months of 2002.
The annualized return on average assets for the first nine months of 2003 was
..90%, decreasing from the return on average assets for the same period the
previous year of 1.32%. Earnings were adversely affected by higher legal fees to
collect on nonperforming loans and by increases to the provision for loan and
lease losses. Decreased interest earned on the nonperforming loans and on the
securities portfolio contributed to the decline in income.
NET INTEREST INCOME
Net interest income, the difference between interest income earned on
average interest earning assets and interest expense on average interest bearing
liabilities, decreased $194,000 to $4,346,000 during the three months ended
September 30, 2003, compared to the same three months in 2002.
The major factor affecting net interest income during the third quarter of
2003 was the decline in interest rates. The Company reduced its prime lending
rate to 4.00% on June 30, 2003 from 4.25%. The prime rate was 4.75% during the
third quarter of 2002. The decline in interest rates lowered the yields earned
on
12
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
interest earning assets. Table 1, "Analysis of Average Balance and Tax
Equivalent Rates for the Three Months ended September 30, 2003 and 2002" shows
that the net yield on interest earning assets decreased 94 basis points to 4.31%
during the third quarter of 2003 from 5.25% last year causing interest income to
decline $1,148,000 on a fully tax equivalent basis during the third quarter of
2003 compared to the prior year period.
The lower interest income was only partially offset by lower interest
expense as the Company lowered deposit rates during the quarter. Yields on
interest bearing liabilities decreased by only 85 basis points during the third
quarter of 2003 to 1.71% compared to 2.56% during the third quarter of 2002. The
lower rates paid on interest bearing liabilities had the effect of lowering
interest expense during the third quarter of 2003 by $939,000 compared to the
same quarter of 2002.
Net interest income for the nine months ended September 30, 2003 decreased
$1,542,000 compared to the same period of 2002. Interest rates during the first
nine months of 2003 declined as the prime rate dropped from 4.25% to 4.00% at
June 30, 2003 while, during the same period of 2002, rates remained stable, with
the prime rate at 4.75% throughout the period. Table 2, "Analysis of Average
Balance and Tax Equivalent Rates for the Nine Months ended September 30, 2003
and 2002" shows that yields on interest earning assets declined 116 basis points
during the first nine months of 2003 compared to last year. Table 2 shows that
rates paid on interest bearing liabilities decreased to a lesser extent,
declining only 67 basis points during the first nine months of 2003 compared to
the same nine months of 2002. These developments caused net interest income to
decrease.
Interest earned on loans during the nine months ended September 30, 2003,
on a fully tax equivalent basis, was $15,207,000 or $1,268,000 lower than for
the same period last year. Besides the lower rates, another major factor
affecting interest income earned on loans during the nine months ended September
30, 2003 was the amount of nonaccrual loans and leases. Lease pools totaling
$11.3 million were placed on non-accrual status at June 30, 2002. The Company
had been recognizing income of $290,000 per quarter on these lease pools prior
to placing the lease pools on nonaccrual status causing interest income earned
on loans during the nine months ended September 30, 2003 to be $580,000 less
than what it had been for the same period of 2002.
Lower general interest rates during the nine months ended September 30,
2003 compared to the same period of 2002 contributed to lower net interest
income as securities yields dropped to a greater extent than yields on deposits
and borrowings. Yields earned on taxable securities decreased 167 basis points
to 2.78% during the first nine months of 2003 compared to the same period last
year. Interest income on taxable securities consequently declined by $1,630,000
to $4,969,000 during the first nine months of 2003 compared to $6,599,000 last
year. During the nine months ended September 30, 2003, $967 million in
securities were called or matured as compared to $410 million for the same time
period last year. The effect of the calls and maturities during the nine months
ended September 30, 2003 is that the yields on taxable securities fell to a much
greater extent than other interest bearing assets, as new securities yielding
lower interest rates were purchased to replace the called and matured
securities.
13
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
TABLE 1
NORTHERN STATES FINANCIAL CORPORATION
ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
For the Three Months Ended September 30, 2003 and 2002 -
Rates are Annualized
($ 000s)
2003 2002
------------------------------------ -------------------------------------
Average Average
Balance Interest Rate Balance Interest Rate
------------------------------------ -------------------------------------
Assets
Loans (1)(2)(3) $352,062 $4,840 5.50% $344,025 $5,429 6.31%
Taxable securities (4) 241,143 1,568 2.60% 207,179 1,986 3.86%
Tax-advantaged securities (2) (4) 7,857 110 5.79% 9,080 151 6.87%
Federal funds sold and other 6,356 16 1.01% 26,692 116 1.74%
------------------------------------ -------------------------------------
Interest earning assets (4) 607,418 6,534 4.31% 586,976 7,682 5.25%
Noninterest earning assets 23,899 23,323
------------ -------------
Average assets $631,317 $610,299
============ =============
Liabilities and stockholders' equity
NOW deposits $47,719 $70 .59% $48,700 $121 .99%
Money market deposits 51,997 116 .89% 47,621 211 1.77%
Savings deposits 52,659 104 .79% 48,236 181 1.50%
Time deposits 246,687 1,388 2.25% 250,207 1,993 3.19%
Other borrowings 101,035 463 1.83% 86,464 574 2.66%
------------------------------------ -------------------------------------
Total interest bearing liabilities 500,097 2,141 1.71% 481,228 3,080 2.56%
------------------------ ------------------------
Demand deposits 49,954 46,825
Other noninterest earning
liabilities 4,874 5,528
Stockholders' equity 76,392 76,718
------------ -------------
Average liabilities and
Stockholders' equity $631,317 $610,299
============ =============
Net interest income $4,393 $4,602
============= =============
Net yield on interest earning
assets (4) 2.89% 3.15%
=========== ===========
Interest bearing liabilities
To earning assets ratio 82.39% 82.25%
=========== ===========
(1) - Interest income on loans includes loan origination and other fees of $91
and $104 for the three months ended September 30, 2003 and 2002.
(2) - Tax-exempt income is reflected on a fully tax equivalent basis utilizing a
34% 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 September 30, 2003 and 2002 average
balance information includes an average unrealized gain for taxable
securities of $181 and $1,619 and for tax-advantaged securities of $258
and $283.
14
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
TABLE 2
NORTHERN STATES FINANCIAL CORPORATION
ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
For the Nine Months Ended September 30, 2003 and 2002 -
Rates are Annualized
($ 000s)
2003 2002
------------------------------------ -------------------------------------
Average Average
Balance Interest Rate Balance Interest Rate
------------------------------------ -------------------------------------
Assets
Loans (1)(2)(3) $354,864 $15,207 5.71% $333,501 $16,475 6.59%
Taxable securities (4) 239,753 4,969 2.78% 198,281 6,599 4.45%
Tax-advantaged securities (2) (4) 8,103 363 6.18% 9,782 503 7.03%
Federal funds sold and other 6,178 52 1.12% 17,976 226 1.68%
------------------------------------ -------------------------------------
Interest earning assets (4) 608,898 20,591 4.52% 559,540 23,803 5.68%
Noninterest earning assets 22,709 25,347
------------ -------------
Average assets $631,607 $584,887
============ =============
Liabilities and stockholders' equity
NOW deposits $49,361 $235 .63% $46,708 $336 .96%
Money market deposits 50,291 434 1.15% 48,721 649 1.78%
Savings deposits 51,073 351 .92% 47,314 527 1.49%
Time deposits 248,487 4,797 2.57% 224,145 5,648 3.36%
Other borrowings 102,095 1,551 2.03% 87,846 1,824 2.77%
------------------------------------ -------------------------------------
Total interest bearing liabilities 501,307 7,368 1.96% 454,734 8,984 2.63%
------------------------ ------------------------
Demand deposits 47,986 46,513
Other noninterest earning
liabilities 5,616 6,694
Stockholders' equity 76,698 76,946
------------ -------------
Average liabilities and
Stockholders' equity $631,607 $584,887
============ =============
Net interest income $13,223 $14,819
============= =============
Net yield on interest earning
assets (4) 2.90% 3.54%
=========== ===========
Interest bearing liabilities
To earning assets ratio 82.54% 81.37%
=========== ===========
(1) - Interest income on loans includes loan origination and other fees of $306
and $314 for the nine months ended September 30, 2003 and 2002.
(2) - Tax-exempt income is reflected on a fully tax equivalent basis utilizing a
34% rate.
(3) - Non-accrual loans are included in average loans.
(4) - Rate information was calculated on the average amortized cost for
securities. The nine months ended September 30, 2003 and 2002 average
balance information includes an average unrealized gain for taxable
securities of $1,279 and $473 and for tax-advantaged securities of $276
and $239.
15
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 $150,000 provision
for loan and lease losses was necessary for the three months ended September 30,
2003 compared to $75,000 for the same period of 2002. The provision for loan and
lease losses for the first nine months of 2003 was $430,000 compared to $225,000
last year and increased due to allocations for problem loans, as discussed
below.
At September 30, 2003, the allowance for loan and lease losses was
$3,782,000 or 1.08% of loans and leases as compared $3,698,000 or 1.05% of loans
and leases at December 31, 2002. During the third quarter of 2003, $157,000 in
loans were charged off through the allowance compared to $79,000 during the same
period last year. There was $1,000 in recoveries of loans previously charged off
recognized during the third quarter of 2003 compared to $3,000 in recoveries
during the same period in 2002. For the nine months ended September 30, 2003,
$509,000 in loans were charged off compared to $392,000 for the same period last
year. Recoveries of loans previously charged off totaled $163,000 during the
first nine months of 2003 compared to $8,000 during the first nine months of
2002.
Nonperforming loans and leases, which includes loans and leases on
nonaccrual status in addition to loans and leases 90 days or more past due and
in the process of collection, were $14.8 million at September 30, 2003 or 4.22%
of loans and leases. Nonperforming loan and lease totals increased $762,000 from
December 31, 2002 when nonperforming loan levels were $14.1 million or 4.00% of
loans and leases. The largest group of nonperforming loans and leases consists
of lease pools totaling $11.3 million that were placed on nonaccrual status at
June 30, 2002. The lease pools had been purchased from an investment-banking
house and are secured by equipment and carry surety bonds. The Company is in the
process of collecting, through legal proceedings, on these leases from the
insurance companies that issued the surety bonds. The Company also has
nonperforming loans totaling $1.5 million that are secured by motels. The
lodging industry has been especially hurt by the aftermath of 9/11 due to the
decline in travel. At September 30, 2003, the Company had loans for motels
totaling $42.5 million in its loan portfolio that, other than the $1.5 million
discussed above, are performing in accordance to their terms. Nonaccrual loans
and leases at September 30, 2003 were $13.7 million increasing from $13.2
million at December 31, 2002.
Impaired loans and leases at September 30, 2003 were $13.7 million
increasing from $13.2 million at December 31, 2002. The Company considers a loan
or lease impaired if it is expected that full principal and interest will not be
collected under the contractual terms of the note. 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 and
lease is collateral dependent. The amount of the allowance for loan losses
allocated for impaired loans and leases was $961,000 at September 30, 2003,
decreasing from $1,307,000 at year-end because of impaired loans that were
charged-off or transferred to other real estate owned during the first nine
months of 2003. The portion of the allowance allocated to the $11.3 million in
impaired lease pools was $604,000 at September 30, 2003.
Management and the Board of Directors analyze 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
16
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
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 Bank; historical loss
experience; current economic trends and conditions; review of the present value
of expected cash flows and fair value of collateral on impaired loans and
leases; growth; and other factors management deems appropriate. Based on
management and the Board of Directors' analysis, the allowance for loan and
lease losses at September 30, 2003 is adequate to cover probable incurred credit
losses.
Another component of non-performing assets is other real estate owned that
consists of assets acquired through loan foreclosure and repossession. The fair
value of other real estate owned is reviewed by management at least quarterly to
assure the reasonableness of its carrying value, which is lower of cost or the
fair value less estimated selling costs. At September 30, 2003, other real
estate owned was $4.0 million increasing from $2.0 million at December 31, 2002.
During the quarter ended September 30, 2003, two properties secured by motels
were transferred from loans, through foreclosure proceedings, to other real
estate owned that totaled $1,544,000. During the first nine months of 2003, a
total of five properties, that had been used to secure loans, were transferred
to other real estate in the amount of $2,449,000. Two properties held as other
real estate owned were sold for $535,000 during the second quarter of 2003 and
$29,000 in gains was recognized from the sales.
One major piece of property reported as other real estate owned is carried
at the amount of $1,783,000 and was acquired by the Bank of Waukegan through the
receipt of a deed in lieu of foreclosure in 1987. The parcel consists of
approximately 525,000 square feet of land situated on Lake Michigan in Waukegan,
Illinois. During the fourth quarter of 2002, the Bank formed Northern States
Community Development Corporation ("NSCDC"), as a subsidiary of the Bank. NSCDC
assets consist of cash and this parcel of other real estate owned. For financial
accounting purposes the other real estate is consolidated into the Bank and is
reported as other real estate owned at the Company level. This subsidiary was
formed for the purpose of developing and selling this parcel as part of the City
of Waukegan's lakefront development plans. Proposals under discussion for use of
this property include the building of a minor league baseball park and
condominiums.
NONINTEREST INCOME
Noninterest income for the three months ended September 30, 2003 was
$1,033,000 as compared to $914,000 for the three months ended September 30,
2002, an increase of $119,000. Trust fees, service fees on deposits and ATM and
debit card transactions (a component of other operating income) contributed to
the increase in noninterest income. Trust income increased $58,000 during the
third quarter of 2003 compared to the same quarter last year. Much of the trust
fees are tied to the performance of securities held in trust accounts. The
rebounding of the equity markets during the third quarter of 2003 contributed to
the increase in trust fee income during the quarter. Service fees on deposits
increased by $30,000 as compared to the same quarter last year because of
increased service charges on commercial checking accounts related to lower
interest rates as well as increased overdraft fee income. Mortgage banking
income declined in the third quarter of 2003 by $21,000 compared to the same
quarter last year as the level of mortgage banking activity slowed due to an
increase in mortgage rates during the quarter. The Company originates mortgage
loans that are closed on behalf of other institutions that fund and own the
loans, with the Company receiving a fee. Other operating income increased during
the quarter by $52,000 due to ATM and debit card fee income increasing $45,000
compared to the same quarter last year as the Bank continued to promote the
debit card that was first introduced during the summer of 2002.
17
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
For the nine months ended September 30, 2003, noninterest income was
$3,045,000, an increase of $292,000 compared to the first nine months of 2002.
Service fees on deposits and mortgage banking income were $118,000 and $87,000
greater during the first nine months of 2003 compared to the same period last
year. Service fees on deposits increased due to greater overdraft fee income
generated by the Company's overdraft program that honors overdraft items on
qualified customers. Increased volumes of mortgage banking activity brought
about by lower mortgage rates contributed to the increased mortgage banking
income during the first nine months of 2003. Other operating income increased
during the nine months ended September 30, 2003 by $61,000 due to ATM and debit
card fee income. Trust fee income during the first nine months of 2003 increased
$26,000 compared to the first nine months of 2002 due to the rebounding of the
equity markets during the first nine months of 2003.
NONINTEREST EXPENSES
Noninterest expenses for the quarter ended September 30, 2003 were
$3,160,000, increasing $331,000 from the same quarter last year. The Company's
efficiency ratio, noninterest expenses divided by the sum of net interest income
and noninterest income, was 58.75% for the third quarter of 2003 as compared to
51.87% for the same quarter of 2002. Increases to legal fees, as discussed
below, primarily impacted noninterest expense and this ratio.
Salary and employee benefit expenses were $1,000 less during the third
quarter of 2003 compared to the same period last year. One senior Bank officer
left his position at the end of June 2003 and has not been replaced keeping
salary expenses down during the quarter.
Occupancy expenses for the third quarter of 2003 were $27,000 greater than
the same quarter of 2002. Real estate taxes on the Company's properties have
increased $5,000 during the third quarter 2003 as tax bond referendums were
approved. Maintenance expenses increased $15,000 as the Company's equipment has
aged and requires more repairs.
Data processing expense increased $42,000 during the three months ended
September 30, 2003 to $166,000 compared to $124,000 last year. ATM processing
costs were up for the quarter as the Company continued to promote its debit
card.
Legal expenses increased $142,000 during the third quarter of 2003 compared
to the same time period last year. The levels of nonperforming loans and leases
caused legal expenses to increase especially pertaining to the nonperforming
lease pools that totaled $11.3 million at September 30, 2003. It is expected
that litigation against the insurance companies that issued the surety bonds on
the lease pools will continue into 2004 and the Company expects to continue to
incur legal expenses in connection with this litigation.
The Company's other operating expenses during the three months ended
September 30, 2003 were $121,000 greater than during the same period of 2002.
Increases to other real estate owned expenses during the third quarter of 2003
account for a majority of the increase in other operating expenses. During the
third quarter of 2003 two motels securing loans were transferred into other real
estate owned and there were expenses for real estate taxes, unpaid water bills
and repairs in order to prepare the properties for sale. It is expected that the
other real estate expenses will continue to be at higher levels as compared to
the previous year until these properties are sold.
18
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
For the nine months ended September 30, 2003 noninterest expenses were
$9,162,000, increasing $782,000 or 9.33% from the same period last year. The
Company's efficiency ratio, noninterest expenses divided by the sum of net
interest income and noninterest income, was 56.86% for the first nine months of
2003 as compared to 48.26% for the first nine months of 2002. Legal fees, as
discussed below, primarily affected this ratio.
Increases in salary and employee benefit expenses of $86,000 occurred
during the first nine months of 2003 compared to the same period last year.
Annual merit increases caused regular salary expense to increase $58,000 during
the first nine months of 2003 as compared to the same time period of 2002 and
would have been greater as a senior officer of the Bank left at the end of June
2003. Group insurance expense was $56,000 greater during the nine months ended
September 30, 2003 compared to last year due to insurance premium increases.
Partially offsetting these increases, compensation expense relating to stock
appreciation rights were $55,000 less during the nine months ended September 30,
2003 than for the same nine months last year as all outstanding stock
appreciation rights were exercised in 2002 and are not presently being awarded.
Occupancy expenses for the first nine months of 2003 were $58,000 greater
than during the first nine months of 2002. Real estate taxes on the Company's
properties have increased $20,000 during the first nine months of 2003 as tax
bond referendums were approved. Maintenance expenses increased $35,000 as more
repairs are required to the Company's equipment as it has aged.
Legal expenses increased $585,000 during the nine months ended September
30, 2003 compared to the same time period last year. Much of the increase in
legal expenses pertains to the nonperforming lease pools totaling $11.3 million
at September 30, 2003. The Company is in litigation against the insurance
companies that issued the surety bonds on the lease pools.
The Company's other operating expenses during the nine months ended
September 30, 2003 were $9,000 greater than during the same period of 2002. At
the end of 2002 the Company had made a charitable contribution totaling
$183,000. The Company subsequently received information late in the first
quarter of 2003 that disallowed the charitable contribution. The Company
consequently reversed the contribution expense in the first quarter of 2003 and
the tax benefit related to the contribution. Other real estate owned expenses
increased $75,000 during the nine months ended September 30, 2003 as compared to
the same time period last year due to the increases to the Company's other real
estate owned portfolio. Product development expense for the first nine months of
2003 increased $49,000 from the same period of 2002 as the Company's promotional
checking account product and overdraft program grew. During the first nine
months of 2003 loan and collection expenses grew $24,000 due to the levels of
nonperforming loans and leases. Correspondent bank expenses for the Company's
accounts with money center banks increased $24,000 due to lower interest rates.
FEDERAL AND STATE INCOME TAXES
For the three months ended September 30, 2003 and 2002, the Company's
provisions for federal and state income taxes were $709,000 and $865,000, which
as a percentage of pretax earnings was 34.3% and 33.9%. For the first nine
months of 2003 and 2002, the Company's provisions for federal and state income
taxes were $2,278,000 and $2,980,000, which as a percentage of pretax earnings
was 34.9% and 34.0%.
19
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
The tax rate as a percentage of pretax earnings increased during the first
nine months of 2003 as the result of the reversal during the first quarter of
2003 of a tax benefit of $72,000. The $72,000 tax benefit had been booked late
in 2002 based on a charitable contribution made at that time but was disallowed
during the first quarter of 2003. Income taxes as a percentage of pretax
earnings would have been 33.8% if the tax benefit reversal had not taken place.
RECENT ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board (FASB) recently issued two new
accounting standards, Statement 149, "Amendment of Statement 133 on Derivative
Instruments and Hedging Activities", and Statement 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equities",
both of which became effective in the quarter beginning July 1, 2003. Because
the Company did not have these instruments or is only nominally involved in
these instruments, the new accounting standards did not materially affect the
Company's operating results or financial condition.
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. Accordingly, effective risk
management that maintains IRR at prudent levels is essential to the Company's
safety and soundness.
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.
It is important that the board of directors and management oversee a
comprehensive risk-management process that effectively identifies, measures, and
controls IRR. One approach used by management to analyze IRR is to periodically
measure 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.
20
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
----------------------------------------------------------
TABLE 2
NORTHERN STATES FINANCIAL CORPORATION
EFFECT OF INTEREST SHOCKS ON FINANCIAL INSTRUMENTS
as of June 30, 2003 and December 31, 2002
($000s)
Fair Value at June 30, 2003
-------------------------------------------------
Down 2% Current Up 2%
-------------------------------------------------
Assets
Cash and cash equivalents $19,980 $19,979 $19,978
Securities available for sale 254,396 252,974 246,397
Loans and leases 377,407 359,651 343,260
Federal Home Loan Bank stock 1,810 1,810 1,810
Accrued interest receivable 2,587 2,587 2,587
Financial
liabilities:
Deposits $456,645 $453,659 $450,815
Securities sold under repurchase agreements
and other short-term borrowings 93,915 93,585 93,258
Federal Home Loan Bank term advances 7,290 6,753 6,256
Advances from borrowers for taxes
and insurance 506 506 506
Accrued interest payable 2,754 2,754 2,754
Fair Value at December 31, 2002
-------------------------------------------------
Down 2% Current Up 2%
-------------------------------------------------
Assets
Cash and cash equivalents $37,580 $37,578 $37,576
Securities available for sale 238,968 236,898 230,683
Loans and leases 379,290 361,709 345,796
Federal Home Loan Bank stock 1,734 1,734 1,734
Accrued interest receivable 2,951 2,951 2,951
Financial
liabilities:
Deposits $454,566 $451,460 $448,508
Securities sold under repurchase agreements
and other short-term borrowings 97,437 97,192 96,948
Federal Home Loan Bank term advances 7,102 6,523 5,995
Advances from borrowers for taxes
and insurance 466 466 466
Accrued interest payable 3,407 3,407 3,407
Several ways an institution can manage IRR include: selling existing assets
or repaying certain liabilities; matching repricing periods for new assets and
liabilities for example, by shortening terms of new loans or investments.
Financial institutions are also subject to prepayment risk in falling rate
environments. For example, a debtor may prepay other financial assets so that
the debtor may refinance their 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 long-term loans or
investments. Accordingly, the Company seeks to have in place sources of cash to
meet short-term demands. Increasing deposits, borrowing, or selling assets can
obtain these funds.
21
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
----------------------------------------------------------
Table 2, "Effect of Interest Shocks on Financial Instruments as of June 30,
2003 and December 31, 2002", shows how interest rate shocks of decreasing rates
2% and increasing rates 2% effect the fair value of the Company's financial
instruments. The data shown in Table 2 is as of June 30, 2003 as it is the most
current period available from the computer simulation model. 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. At June
30, 2003 the fair value of securities available for sale increases $1.4 million
when rates are shocked downward 2% while the fair value decreases $6.6 million
for a 2% upwards rate shock. The change in fair value of securities is smaller
when rates are shocked down because there were call provisions on $127.9 million
of the U.S. Government agency securities at June 30, 2003. At June 30, 2003 the
fair value of the Company's financial asset instruments was $637.0 million
compared to the book or carrying value on the Company's financial asset
instruments at June 30, 2003 of $625.2 million.
ITEM 4. DISCLOSURE CONTROLS AND PROCEDURES REPORT
- -------------------------------------------------
As of the end 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, to the best of their knowledge, effective in all material respects, 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.
PART II. OTHER INFORMATION
- --------------------------
ITEM 1. LEGAL PROCEEDINGS
- --------------------------
Due to the nature of their business, the Company and its subsidiary are
often subject to various legal actions. These legal actions, whether pending or
threatened, arise through the normal course of business and are not considered
unusual or material, other than as discussed below.
Between November 2000 and August 2001, the Company purchased commercial
lease pools from Commercial Money Center, a now bankrupt equipment leasing
company. These lease pools, with outstanding balances of $11.3 million at
September 30, 2003, are secured by assignments of payment streams, underlying
equipment and surety bonds. These lease pools are included as impaired loans and
leases at September 30, 2003 and are on nonaccrual status. Upon default of these
lease pools, the Company made demand for payment from Illinois Union Insurance
Company ("IU") a wholly owned subsidiary of Ace Limited Insurance Company
("ACE") and RLI Insurance Company ("RLI") under the relevant surety bonds. IU,
ACE and RLI (the "Sureties") have failed to make the payments required under the
surety bonds. As a result, in April 2002, the Company filed suit against each of
the Sureties. The Company's complaints allege that the Sureties are liable for
payment due to the Company under the terms of the bonds.
22
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
ACE, IU and RLI are seeking to rescind on the surety bonds alleging that the
originator of the leases fraudulently induced the insurers to issue the surety
bonds, and that the bonds are therefore void. The Company has reviewed these
matters with its legal counsel and believes that it has valid claims as the
Sureties undertook the responsibility for all credit and fraud underwriting, and
waived all defenses associated with the bonds, including defenses of fraud. The
Company will continue to assert all the rights and remedies available to it in
an effort to obtain payment under the bonds.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
- --------------------------------------------------
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
- ----------------------------------------
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ------------------------------------------------------------
None
ITEM 5. OTHER INFORMATION
- --------------------------
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
- -----------------------------------------
(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 here by
reference.)
Exhibit 3.2 Bylaws 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 here by reference.)
Exhibit 31.1 Section 302 Certifications of Chairman of the Board and
President.
Exhibit 31.2 Section 302 Certifications of Vice President and Treasurer.
Exhibit 32.1 Section 906 Certification.
(b) The following current reports on Form 8-K were filed by the Company with
the Securities and Exchange Commission during the third quarter of 2003:
(1) Form 8-K (Item 9) furnished to the SEC on July 16, 2003.
(2) Form 8-K (Item 9) furnished to the SEC on September 12, 2003.
23
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
FORM 10-Q
---------
September 30, 2003
------------------
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 here by
reference.)
Exhibit 3.2 Bylaws 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 here by reference.)
Exhibit 31.1 Section 302 Certifications of Chairman of the Board and
President.
Exhibit 31.2 Section 302 Certifications of Vice President and Treasurer.
Exhibit 32.1 Section 906 Certification.
24
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report on Form 10-Q to sign on its behalf by the
undersigned hereunto duly authorized, on this 11th day of November 2003.
NORTHERN STATES FINANCIAL CORPORATION
(Registrant)
Date: November 11, 2003 By: /s/ Fred Abdula
----------------- ----------------------------------
Fred Abdula
Chairman of the Board of
Directors and President
Date: November 11, 2003 By: /s/ Thomas M. Nemeth
----------------- ----------------------------------
Thomas M. Nemeth
Vice President and Treasurer
25