================================================================================
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 September 30, 2004
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: ____
4,299,105 shares of common stock were outstanding
as of November 5, 2004
NORTHERN STATES FINANCIAL CORPORATION AND SUBSIDIARY
----------------------------------------------------
FORM 10-Q
---------
FOR THE QUARTER ENDED SEPTEMBER 30, 2004
----------------------------------------
INDEX
-----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements Page Number
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...........................9
Item 3. Quantitative and Qualitative Disclosures
About Market Risk............................................22
Item 4. Controls and Procedures......................................24
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................24
Item 2. Unregistered Sales of Equity Securities
and Use of Proceeds..........................................25
Item 3. Defaults upon Senior Securities..............................25
Item 4. Submission of Matters to a Vote of Security Holders..........26
Item 5. Other Information............................................26
Item 6. Exhibits.....................................................26
Signatures............................................................27
EXHIBIT INDEX............................................................28
1
PART 1. 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 September 30, 2004
and the condensed consolidated statements of income for the three month and nine
month periods ended September 30, 2004 and 2003 and the condensed consolidated
statements of cash flows for the nine months ended September 30, 2004 and 2003.
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
November 1, 2004
2
NORTHERN STATES FINANCIAL CORPORATION
- -------------------------------------
CONDENSED CONSOLIDATED BALANCE SHEETS
- -------------------------------------
September 30, 2004 and December 31, 2003
(In thousands of dollars) (Unaudited)
September 30, December 31,
Assets 2004 2003
------------- ------------
Cash and due from banks........................................ $25,880 $18,403
Interest bearing deposits in financial institutions -
maturities less than 90 days............................... 139 181
Federal funds sold............................................. 22,669 20,000
-------- --------
Total cash and cash equivalents............................. 48,688 38,584
Securities available for sale.................................. 250,518 280,445
Loans and leases............................................... 440,401 358,226
Less: Allowance for loan and lease losses...................... (6,265) (4,383)
-------- --------
Loans and leases, net....................................... 434,136 353,843
Federal Home Loan Bank and Federal Reserve Bank stock.......... 2,108 1,871
Office buildings and equipment, net............................ 9,172 5,370
Other real estate owned........................................ 4,916 3,766
Goodwill....................................................... 9,717 85
Other intangible assets........................................ 2,898 0
Accrued interest receivable and other assets................... 5,351 5,655
-------- --------
Total assets................................................ $767,504 $689,619
======== ========
Liabilities and Stockholders' Equity
Liabilities
Deposits
Demand - noninterest bearing................................ $62,844 $52,398
Interest bearing............................................ 575,892 440,734
-------- --------
Total deposits........................................... 638,736 493,132
Securities sold under repurchase agreements.................... 40,958 83,367
Federal funds purchased........................................ 0 26,500
Federal Home Loan Bank advance................................. 6,500 6,500
Advances from borrowers for taxes and insurance................ 531 535
Accrued interest payable and other liabilities................. 5,259 4,256
-------- --------
Total liabilities........................................ 691,984 614,290
Stockholders' Equity
Common stock................................................... 1,789 1,789
Additional paid-in capital..................................... 11,584 11,584
Retained earnings.............................................. 67,757 66,833
Accumulated other comprehensive (loss)......................... (1,060) (489)
Treasury stock, at cost........................................ (4,550) (4,388)
-------- --------
Total stockholders' equity.................................. 75,520 75,329
-------- --------
Total liabilities and stockholders' equity............... $767,504 $689,619
======== ========
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 nine months ended September 30, 2004 and 2003
(In thousands of dollars, except per share data) (Unaudited)
Three months ended Nine months ended
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
------------- ------------- ------------- -------------
Interest income
Loans (including fee income)................................ $6,014 $4,830 $17,393 $15,176
Securities
Taxable................................................... 2,074 1,568 5,904 4,969
Exempt from federal income tax............................ 95 73 288 240
Federal funds sold and other................................ 76 16 244 52
------ ------ ------- -------
Total interest income................................... 8,259 6,487 23,829 20,437
------ ------ ------- -------
Interest expense
Time deposits............................................... 1,876 1,388 5,254 4,797
Other deposits.............................................. 405 290 1,169 1,020
Repurchase agreements, federal funds purchased
and Federal Home Loan Bank advances....................... 218 463 779 1,551
------ ------ ------- -------
Total interest expense.................................. 2,499 2,141 7,202 7,368
------ ------ ------- -------
Net interest income............................................ 5,760 4,346 16,627 13,069
Provision for loan and lease losses............................ 500 150 3,050 430
------ ------ ------- -------
Net interest income after provision for
loan and lease losses....................................... 5,260 4,196 13,577 12,639
------ ------ ------- -------
Noninterest income
Service fees on deposits.................................... 660 566 1,910 1,650
Trust income................................................ 158 199 548 530
Mortgage banking income..................................... 67 50 131 287
Other operating income...................................... 275 218 750 578
------ ------ ------- -------
Total noninterest income................................ 1,160 1,033 3,339 3,045
------ ------ ------- -------
Noninterest expense
Salaries and employee benefits.............................. 2,158 1,669 6,415 5,074
Occupancy and equipment, net................................ 507 354 1,462 1,063
Data processing............................................. 387 166 1,083 473
Legal....................................................... 364 285 713 868
Amortization of intangible assets........................... 116 0 348 0
Other operating expenses.................................... 862 686 2,225 1,684
------ ------ ------- -------
Total noninterest expense............................... 4,394 3,160 12,246 9,162
------ ------ ------- -------
Income before income taxes..................................... 2,026 2,069 4,670 6,522
Income tax expense............................................. 637 709 1,378 2,278
------ ------ ------- -------
Net income..................................................... $1,389 $1,360 $3,292 $4,244
====== ====== ====== ======
Basic and diluted earnings per share........................... $0.32 $0.32 $0.76 $0.99
Comprehensive income .......................................... $3,528 $261 $2,721 $3,178
The accompanying notes are an integral part of these condensed consolidated financial statements.
4
NORTHERN STATES FINANCIAL CORPORATION
- -------------------------------------
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
- -----------------------------------------------
Nine months ended September 30, 2004 and 2003
(In thousands of dollars)
(Unaudited)
Nine months ended
September 30, September 30,
2004 2003
------------- -------------
Cash flows from operating activities
Net income............................................................ $3,292 $4,244
Adjustments to reconcile net income to net cash from
operating activities:
Depreciation....................................................... 432 285
Amortization of other intangible assets............................ 348 0
Net gains on sales of other real estate owned...................... 0 (29)
Federal Home Loan Bank stock dividends............................. (87) (105)
Provision for loan and lease losses................................ 3,050 430
Deferred loan fees................................................. 14 114
Proceeds from sale of loans........................................ 1,751 0
Loans originated for sale.......................................... (1,424) 0
Net change in accrued interest receivable and other assets......... 1,160 (626)
Net change in accrued interest payable and other liabilities....... (428) (1,167)
------- -------
Net cash from operating activities.............................. 8,108 3,146
------- -------
Cash flows from investing activities
Acquisition of subsidiary, net of cash equivalents received........... (366) 0
Proceeds from maturities and calls of securities available for sale... 431,796 967,284
Purchases of securities available for sale............................ (388,980) (980,828)
Proceeds from sales of other real estate owned........................ 175 535
Change in loans made to customers..................................... (14,420) (2,385)
Property and equipment expenditures................................... (324) (260)
------- -------
Net cash from investing activities.............................. 27,881 (15,654)
------- -------
Cash flows from financing activities
Net increase (decrease) in:
Deposits........................................................... 45,798 16,120
Securities sold under repurchase agreements
and federal funds purchased..................................... (68,909) (19,144)
Advances from borrowers for taxes and insurance.................... (244) (192)
Purchases of treasury stock........................................... (162) (285)
Dividends paid........................................................ (2,368) (2,325)
------- -------
Net cash from financing activities.............................. (25,885) (5,826)
------- -------
Net change in cash and cash equivalents.................................. 10,104 (18,334)
Cash and cash equivalents at beginning of period......................... 38,584 37,578
------- -------
Cash and cash equivalents at end of period............................... $48,688 $19,244
======= =======
The accompanying notes are an integral part of these condensed consolidated financial statements.
5
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
----------------------------------------------------
September 30, 2004
(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, 2003 and 2002.
The results of operations for the three and nine month periods ended September
30, 2004, 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
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2004 2003 2004 2003
--------- --------- --------- ---------
Average outstanding common shares..... 4,301,322 4,305,105 4,303,835 4,306,131
Effect of stock options............... 0 0 0 0
--------- --------- --------- ---------
Average outstanding shares for
diluted earnings per share......... 4,301,322 4,305,105 4,303,835 4,306,131
========= ========= ========= =========
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 months ended September
30, 2004 the Company repurchased 6,000 shares of stock for $162. At September
30, 2004, the Company had a total of 173,150 shares of treasury stock that it
purchased under these programs. Treasury stock is carried at cost.
6
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
----------------------------------------------------
September 30, 2004
(Dollar amounts in thousands, except share and per share data)
(Unaudited)
Information related to common stock was as follows:
September 30, December 31,
2004 2003
------------- ------------
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................ 173,150 167,150
Outstanding shares............. 4,299,105 4,305,105
Note 2 - Acquisition
On January 5, 2004, the Company acquired the outstanding stock of Round
Lake Bankcorp, Inc., the holding Company for First State Bank of Round Lake
("First State Bank"), for cash in the amount of $21,408 including transaction
costs. Round Lake Bankcorp, Inc. was dissolved through the transaction with
First State Bank remaining as a separate subsidiary of the Company. The results
of First State Bank have been included in the consolidated financial statements
since that date. As a result of the acquisition, the Company has expanded into
the Round Lake area of Lake County, Illinois. The Company expects to merge the
First State Bank into its Bank of Waukegan subsidiary at some point in the
future.
The following table summarizes estimated fair values of the assets acquired
and liabilities assumed at January 5, 2004. The allocation of the purchase price
is subject to refinement.
January 5, 2004
---------------
Cash and cash equivalents $21,042
Securities available for sale 13,810
Loans 70,589
Federal Reserve Bank stock 150
Office buildings and equipment 3,910
Other assets 1,165
Intangible assets 3,246
Goodwill 9,632
-------
Total assets acquired 123,544
Deposits 99,806
Other liabilities 2,330
-------
Total liabilities acquired 102,136
-------
Net assets acquired $21,408
=======
The acquired intangible asset was assigned to core deposits and will be
amortized over 10 years.
7
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
----------------------------------------------------
September 30, 2004
(Dollar amounts in thousands, except share and per share data)
(Unaudited)
Unaudited proforma, consolidated results of operation for the three and
nine months ended September 30, 2003 as though First State Bank had been
acquired as of January 1, 2003 are presented below.
Three months Nine months
ended ended
September 30, September 30,
2003 2003
------------- -------------
Net interest income $5,228 $16,101
Net income 1,469 4,831
Basic and diluted earnings per share 0.34 1.12
8
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 September
30, 2004 and the consolidated results of operations for the three and nine month
periods ended September 30, 2004, compared with the same period of 2003. 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 September 30,
2004 to differ materially from those expressed in forward-looking statements.
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 in integrating the acquired operations of First
State Bank, changes from the estimated purchase accounting adjustments relating
to the acquisition of Round Lake Bankcorp, Inc., difficulties in achieving
anticipated cost savings related to the operation of the acquired banking
offices, the potential for further deterioration in the credit quality of the
Company's loan and lease portfolio, uncertainty regarding the Company's ability
to ultimately recover on the surety bonds and cash held by the bankruptcy
trustee 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 loan or securities
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.
9
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
------------------------
OVERVIEW
- --------
At September 30, 2004, assets reached $767.5 million compared with
$689.6 million at December 31, 2003. Loans and leases totaled a record $440.4
million at September 30, 2004, a record level. Deposits, at September 30, 2004,
totaled $638.7 million. The growth is primarily attributable to the acquisition
of First State Bank that added $134.1 million in assets, $70.4 million in loans
and $109.7 million in deposits to the Company at September 30, 2004. Book value
per share increased to $17.57 per share from $17.50 per share at December 31,
2003. The Company recorded $12.9 million of goodwill and other intangible assets
resulting from the acquisition of First State Bank in the first quarter of 2004.
Earnings increased $29,000 during the third quarter of 2004 and were
$.32 per share (diluted), or $1,389,000 as compared with $.32 per share
(diluted), or $1,360,000 for the third quarter of 2003, increasing 2.1%. Net
interest income increased $1,414,000 during the quarter ended September 30, 2004
compared with the same quarter last year in part from the acquisition of First
State Bank and due to increases to a 75 basis point increase to the prime
lending rate since June 30, 2004 as over half of the Company's loan portfolio is
variable with rates tied to the prime lending rate.
Net income for the nine months ended September 30, 2004 was $3,292,000,
or $.76 per share (diluted), compared with $4,244,000, or $.99 per share
(diluted), for the same period last year. The decrease in earnings during the
nine months ended September 30, 2004 is primarily attributable to increases in
the provision for loan and lease losses. The provision for loan and lease losses
for the nine months ended September 30, 2004 was $3,050,000 compared to $430,000
for the same period last year. Much of this additional provision was allocated
to $11.3 million in nonaccrual lease pools. (See "Asset Quality and the
Provision for Loan Losses" and "Legal Proceedings".)
It is expected that the provision for loan losses will continue to be
greater in 2004 if nonperforming loans and leases remain at current levels or
increase. At September 30, 2004, nonperforming loans and leases totaled
$19,794,000 as compared to $19,650,000 at December 31, 2003.
Noninterest income increased $127,000 during the third quarter of 2004
as compared with the same quarter of 2003. The majority of the increase resulted
from growth in the number of accounts due to the acquisition of First State Bank
with service fee income on deposits increasing $94,000 as a result.
Noninterest expense increased $1,234,000 during the three months ended
September 30, 2004 as compared with the same quarter of 2003, mostly
attributable to the acquisition of First State Bank. The acquisition added 36
additional employees and two branch offices. Data processing expense also
increased during the quarter as First State Bank used a separate data processing
service bureau than the Bank. During the fourth quarter of 2004, First State
Bank is converting to the same data processing service bureau as the Bank and it
is expected that data processing expenses will be reduced approximately $40,000
a quarter in future periods.
10
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
------------------------
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
judgement, should be charged-off.
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 September 30, 2004 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. Although loans increased due to the acquisition of First
State Bank during the first quarter of 2004, there was no significant change in
the composition of the loan portfolio.
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 specific allocation on
the $11.3 million of nonaccrual lease pools was increased during the second
quarter of 2004. At September 30, 2004, $3.0 million is specifically allocated
to these lease pools. 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.
11
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
------------------------
FINANCIAL CONDITION
- -------------------
The Company's consolidated total assets were $767.5 million at
September 30, 2004, increasing $77.9 million from $689.6 million at December 31,
2003. Loans and leases, at September 30, 2004, increased $82.2 million and
totaled $440.4 million as compared with $358.2 million at December 31, 2003.
Deposits increased $145.6 million to $638.7 million at September 30, 2004 as
compared to $493.1 million at December 31, 2003. These increases were primarily
the result of the First State Bank acquisition on January 5, 2004. First State
Bank added $134.1 million in assets, $70.4 million in loans and $109.7 million
in deposits at September 30, 2004. The Company carried $12.6 million of goodwill
and other intangible assets at September 30, 2004 as a result of the
acquisition.
The Company's federal funds sold at September 30, 2004 increased $2.7
million to $22.7 million compared with $20.0 million at December 31, 2003. The
Company's federal funds sold position increased as securities available for sale
declined $29.9 million from year-end to $250.5 million at September 30, 2004.
The fair value of securities at September 30, 2004 was $250.5 million, of which
$203.6 million were pledged to secure repurchase agreements and public deposits.
At September 30, 2004, the Company held $162.9 million in U.S. Government agency
securities with call options.
Loans and leases increased to $440.4 million at September 30, 2004
compared with $358.2 million at December 31, 2003. The acquisition of First
State Bank accounted for much of the $82.2 million growth in the loan portfolio
from year-end. The cash flow statement shows that the net cash outflows for
loans and leases made to customers came to $14.4 million during the nine months
ended September 30, 2004. Loan commitments have increased $14.9 million to
$101.8 million at September 30, 2004 compared with $86.9 million at December 31,
2003, with $8.4 million of the increase attributable to the First State Bank
acquisition. Borrowers have not been drawing on their credit lines due to
uncertainties as to future interest rates and fuel prices.
At September 30, 2004, loans to related parties totaled $3.7 million,
decreasing $895,000 from December 31, 2003. Loan commitments to related parties
were $1,299,000 at September 30, 2004.
During the first nine months of 2004, deposits increased by $145.6
million to $638.7 million at September 30, 2004 from $493.1 million at December
31, 2003. A majority of the growth in deposits is attributable to the acquired
First State Bank that had $109.7 million in deposits at September 30, 2004, of
which $69.6 million were in core deposits consisting of checking, NOW, money
market and savings accounts. Additional growth in deposits came from brokered
time deposits that increased $46.7 million to $95.6 million at September 30,
2004 compared with $48.9 million at December 31, 2003. Brokered time deposits of
$19.1 million at September 30, 2004 have remaining maturities of greater than
one year. Brokered time deposits in denominations of $100,000 or more totaled
$72.0 million at September 30, 2004. At September 30, 2004, deposits from
related parties totaled $13.0 million.
Securities sold under repurchase agreements decreased by $42.4 million
to $41.0 million at September 30, 2004 from $83.4 million at December 31, 2003.
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 as purchasers of the term product retained their funds for other
business purposes or found higher yielding financial instruments. At September
30, 2004, securities sold under repurchase agreements to related parties totaled
$8.5 million. Borrowings from the Federal Home Loan Bank through term advances
remained at $6.5 million during the first nine months of 2004.
12
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
------------------------
Included in other liabilities at September 30, 2004 is $400,000 related
to estimated environmental clean-up expenses, an obligation that was assumed by
the Company in the First State Bank acquisition. 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 increased $191,000 to $75.5 million during
the nine months ended September 30, 2004. The increase is the result of net
income of $3.3 million, less the adjustment to the market value of securities
available for sale, net of deferred tax, of $571,0000, less the cash dividends
paid to stockholders of $.55 per share on June 1, 2004 that amounted to $2.4
million. During the quarter ended September 30, 2004, the Company repurchased
6,000 shares for $162,000 that is carried at cost as treasury stock. The Company
has stock repurchase programs that allow the Company to purchase additional
226,850 shares as treasury stock. Book value per share was $17.57 at September
30, 2004 as compared to $17.50 at December 31, 2003.
The Company's tier 1 capital to average assets ratio at September 30,
2004 was 8.32% and the total capital to assets ratio, on a risk adjusted basis,
amounted to 12.92%. These ratios exceed the minimum required to be considered
"well capitalized" under Federal Reserve regulations, which minimums are 5.00%
and 10.00%, respectively. The impact of $12.6 million in goodwill and other
intangible assets at September 30, 2004, associated from the First State Bank
transaction caused the tier 1 capital to average assets and total capital to
risk adjusted assets ratios to decline from December 31, 2003, when they had
been 11.92% and 17.67%, respectively. Goodwill and other intangible assets must
be deducted from capital when determining capital for regulatory purposes.
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. Federal funds sold,
interest bearing deposits in banks and available for sale securities,
particularly those of shorter maturities, are principal sources of liquidity.
Federal funds sold at September 30, 2004 were $22.7 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 $250.5
million at September 30, 2004, of which $203.6 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, 2004 had $95.6 million in brokered time deposits. 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. At September 30, 2004 the Company had
no purchases of federal funds compared with $26.5 million at December 31, 2004.
13
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
------------------------
RESULTS OF OPERATIONS
- ---------------------
NET INCOME
Consolidated net income for the quarter ended September 30, 2004 was
$1,389,000 increasing $29,000 compared with net income of $1,360,000 for the
same quarter the previous year. The annualized return on average assets was .71%
for the quarter, a decrease from .86% for the same quarter the previous year.
For the nine months ended September 30, 2004 consolidated net income was
$3,292,000 compared to $4,244,000 for the same period last year. The annualized
return on average assets for the first nine months of 2004 was .56%, decreasing
from .90% for the same period of 2003. The decline in net income for the nine
months ended September 30, 2004 is primarily the result of increases to the
provision for loan and lease losses and increased noninterest expense due to the
acquisition of First State Bank.
NET INTEREST INCOME
Net interest income, the difference between interest income on earning
assets and interest expense on interest bearing liabilities, increased
$1,414,000 or 32.5% to $5,760,000 during the three months ended September 30,
2004 compared with $4,346,000 for the same period of 2003.
A positive factor that helped to increase net interest income for the
three months ended September 30, 2004 was the acquisition of First State Bank on
January 5, 2004. During the quarter ended September 30, 2004, First State Bank
added $1,018,000 to net interest income on a fully tax equivalent basis. First
State Bank's net interest income is attributable to its low cost interest
bearing core deposits that averaged $57.2 million during the quarter.
Net interest income for the three months ended September 30, 2004
increased as yields on earning assets improved while rates on deposits and
borrowings declined. Table 1 shows that the yield on interest earning assets
increased 22 basis points to 4.53% during the third quarter of 2004 from 4.31%
during the same quarter last year. General interest rates during the quarter
ended September 30, 2004 increased as evidenced by the prime lending rate that
increased 75 basis points since June 30, 2004, positively affecting yields on
earning assets. The rates on interest bearing liabilities decreased 14 basis
points during the third quarter of 2004 to 1.57% as compared with 1.71% during
the third quarter of 2003. During the third quarter of 2004, the Company did not
increase the rates paid on interest bearing liabilities until the end of the
quarter when it increased interest rates paid on many of its time deposit
products by 40 basis points. This increase in time deposit rates at the end of
the third quarter of 2004 is expected to slow the growth of net interest income
in future quarters.
Net interest income for the nine months ended September 30, 2004
increased $3,558,000 compared to the same period of 2003 as rates paid on
deposits and borrowings declined to a greater extent than the yields earned on
interest earning assets. Table 2 shows that the yield on interest earning assets
declined 18 basis points during the first nine months of 2004 compared with the
same period of 2003, while rates on interest bearing liabilities decreased to a
greater extent, declining 46 basis points in 2004. First State Bank added
$3,004,000 on a fully tax equivalent basis to net interest income during the
three quarters ended September 30, 2004, due to the influx of lower cost core
deposits that contributed to the Company's lower average rates on interest
bearing liabilities.
14
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
------------------------
TABLE 1
NORTHERN STATES FINANCIAL CORPORATION
ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
For the Three Months Ended September 30, 2004 and 2003 - Rates are Annualized
($ 000s)
2004 2003
------------------------- -------------------------
Average Average
Balance Interest Rate Balance Interest Rate
------- -------- ---- ------- -------- ----
Assets
Loans (1)(2)(3) $440,527 $6,037 5.48% $352,062 $4,840 5.50%
Taxable securities (4) 258,614 2,074 3.16% 241,143 1,568 2.60%
Tax advantaged securities (2)(4) 11,303 144 5.11% 7,857 110 5.79%
Federal funds sold 21,514 76 1.41% 6,356 16 1.01%
-------- ------ ---- -------- ------ ----
Interest earning assets (4) 731,958 8,331 4.53% 607,418 6,534 4.31%
Noninterest earning assets 49,501 23,899
-------- --------
Average assets $781,459 $631,317
======== ========
Liabilities and stockholders' equity
NOW deposits $65,433 $92 0.56% $47,719 $70 0.59%
Money market deposits 65,607 157 0.96% 51,997 116 0.89%
Savings deposits 83,544 156 0.75% 52,659 104 0.79%
Time deposits 371,084 1,876 2.02% 246,687 1,388 2.25%
Other borrowings 52,929 218 1.65% 101,035 463 1.83%
-------- ------ ---- -------- ------ ----
Total interest bearing liabilities 638,597 2,499 1.57% 500,097 2,141 1.71%
------ ---- ------ ----
Demand deposits 63,199 49,954
Other noninterest bearing liabilities 5,634 4,874
Stockholders' equity 74,029 76,392
-------- --------
Average liabilities and
Stockholders' equity $781,459 $631,317
======== ========
Net interest income $5,832 $4,393
====== ======
Net yield on interest
Earning assets (4) 3.17% 2.89%
==== ====
Interest-bearing liabilities
to earning assets ratio 87.25% 82.33%
===== =====
(1) - Interest income on loans includes loan origination fees of
$170 and $91 for the three months ended September 30, 2004 and 2003.
(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, 2004 and 2003 average balance
Information includes an average unrealized gain (loss) for taxable securities of
($3,539) and $181 and for tax-advantaged securities of $28 and $258.
15
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
------------------------
TABLE 2
NORTHERN STATES FINANCIAL CORPORATION
ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
For the Nine Months Ended September 30, 2004 and 2003 - Rates are Annualized
($ 000s)
2004 2003
------------------------- -------------------------
Average Average
Balance Interest Rate Balance Interest Rate
------- -------- ---- ------- -------- ----
Assets
Loans (1)(2)(3) $434,633 $17,466 5.36% $354,864 $15,207 5.71%
Taxable securities (4) 260,788 5,904 3.00% 239,753 4,969 2.78%
Tax advantaged securities (2)(4) 11,263 436 5.22% 8,103 363 6.18%
Federal funds sold 30,608 244 1.06% 6,178 52 1.12%
-------- ------- ---- -------- ------- ----
Interest earning assets (4) 737,292 24,050 4.34% 608,898 20,591 4.52%
Noninterest earning assets 48,079 22,709
-------- --------
Average assets $785,371 $631,607
======== ========
Liabilities and stockholders' equity
NOW deposits $64,141 $266 0.55% $49,361 $235 0.63%
Money market deposits 66,525 442 0.89% 50,291 434 1.15%
Savings deposits 83,402 461 0.74% 51,073 351 0.92%
Time deposits 360,770 5,254 1.94% 248,487 4,797 2.57%
Other borrowings 66,209 779 1.57% 102,095 1,551 2.03%
-------- ------- ---- -------- ------- ----
Total interest bearing liabilities 641,047 7,202 1.50% 501,307 7,368 1.96%
------- ---- ------- ----
Demand deposits 62,491 47,986
Other noninterest bearing liabilities 6,420 5,616
Stockholders' equity 75,413 76,698
-------- --------
Average liabilities and
stockholders' equity $785,371 $631,607
======== ========
Net interest income $16,848 $13,223
======= =======
Net yield on interest
earning assets (4) 3.04% 2.90%
==== ====
Interest-bearing liabilities
to earning assets ratio 86.95% 82.33%
===== =====
(1) - Interest income on loans includes loan origination and other fees of $436 and $306
for the nine months ended September 30, 2004 and 2003.
(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, 2004 and 2003 average balance
Information includes an average unrealized gain (loss) for taxable securities of
($1,961) and $1,279 and for tax-advantaged securities of $124 and $276.
16
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 $500,000
provision for loan and lease losses was necessary for the three months ended
September 30, 2004 compared with $150,000 for the same period of 2003.
Deterioration in the credit quality of loans at the Bank was the reason for the
increased provision during the third quarter of 2004. For the nine months ended
September 30, 2004, the provision for loan and lease losses was $3,050,000
compared with $430,000 for the nine months ended September 30, 2003. A majority
of the increased provision for loan and lease losses during 2004 resulted from
the need to allocate a greater amount of the allowance to nonperforming lease
pools totaling $11.3 million that were placed on nonaccrual status at June 30,
2002. At September 30, 2004, the Company had $3.0 million of its allowance for
loan and lease losses allocated to these lease pools.
The $11.3 million in lease pools were purchased in late 2000 and 2001
from Commercial Money Center, a now bankrupt equipment leasing company, and are
secured by equipment and carry surety bonds that were designed to provide
protection against losses from defaults on these lease pools. The sureties are
Illinois Union Insurance Company, a wholly owned subsidiary of Ace Limited
Insurance Company, and RLI Insurance Company.
The Company is continuing its efforts to collect on these leases from
the sureties through litigation. 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 from the bankruptcy trustee
and the sureties.
Since the beginning of the bankruptcy, payments by the underlying
obligors on the lease pools have been held by the lease servicer at the
direction of the bankruptcy trustee. The Company's portion of these held
payments at September 30, 2004 is $1.4 million. In the second quarter of 2004,
the bankruptcy trustee brought suit against financial institutions that had
participated in the various lease pools, including the Company, alleging that
the position of the Company and the other participants in the lease pools should
be no better than that of unsecured creditors. In September 2004, the bankruptcy
judge directed all parties to engage in mediation, which occurred later that
month. The parties are now attempting to negotiate a settlement based on the
mediation. A final resolution of these matters is expected either in the fourth
quarter of 2004 or in the first quarter of 2005.
At September 30, 2004, the allowance for loan and lease losses was
$6,265,000 or 1.42% of loans and leases as compared with $4,383,000 or 1.22% of
total loans and leases at December 31, 2003. The acquisition of First State Bank
on January 5, 2004 included an allowance for loan and lease losses of $805,000.
During the first nine months of 2004, $1,996,000 in loans were charged off
against the allowance compared with $509,000 during the same period last year.
Of the $1,996,000 charged off during the first nine months of 2004, the Company
had specific loss allocations of $1,765,000 at December 31, 2003. There were
$23,000 in recoveries of loans previously charged off during the first nine
months of 2004 compared with $163,000 in recoveries during the same period in
2003.
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
in the process of collection, were $19.8 million at September 30, 2004 or 4.50%
of total loans and leases. Included as part of the $19.8 million of
nonperforming loans at September 30, 2004 were $19.3 million in loans and leases
classified as nonaccrual and $477,000 in loans and leases 90 days past due and
in the process of collection. Nonperforming loan and leases at December 31, 2003
totaled $19.7 million and were 5.49% of total loans and leases.
17
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
------------------------
In addition to the $11.3 million in lease pools that are nonperforming,
the Company is carrying a $4.3 million loan on nonaccrual status that is for a
90-unit condominium construction project. This loan was classified as nonaccrual
at December 31, 2003. The Company has participated on this construction project
with other financial institutions and only has a portion of the total loan. The
construction project has experienced substantial cost overruns and the principal
borrowers have declared bankruptcy. The participating financial institutions as
a group have begun foreclosure procedures in an attempt to remedy the situation.
At September 30, 2004, the Company has $289,000 of the allowance for loan and
lease losses allocated to this loan.
The Company also has a nonperforming loan totaling $1.5 million that is
secured by a motel. This loan has been classified as nonaccrual since June 30,
2003. The lodging industry has been especially hurt by the aftermath of 9/11 due
to the decline in travel. The Company has $500,000 of the allowance for loan and
lease losses allocated at September 30, 2004 to this loan. At September 30,
2004, the Company had loans secured by motels totaling $40.7 million.
Impaired loans and leases at September 30, 2004 were $19.3 million,
increasing from $18.2 million at December 31, 2003. 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 considered
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. The amount of
the allowance for loan and lease losses specifically allocated for impaired
loans and leases was $4.0 million at September 30, 2004, increasing from $1.2
million at December 31, 2003.
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 September 30, 2004, a property was transferred into other real estate for
$175,000 and was sold for the same amount by the end of the quarter. At
September 30, 2004, other real estate owned was $4.9 million, increasing $1.2
million from December 31, 2003 as the Company took title to a local office
building used to secure loans to a business that went bankrupt. 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 purposes of
financial reporting, NSCDC is consolidated into the Bank's financial statements
and the Company carries this property as other real estate owned. 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. The Company also has title to two motels, valued
together at $1.5 million, that the Company is actively attempting to sell.
18
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
------------------------
NONINTEREST INCOME
Noninterest income for the three months ended September 30, 2004 was
$1,160,000 as compared with $1,033,000 for the three months ended September 30,
2003, an increase of $127,000. Service fees on deposits increased $94,000 during
the third quarter of 2004 as a result of a higher number of accounts resulting
from the acquisition of First State Bank. Mortgage banking income increased in
the third quarter of 2004 by $17,000 compared with the same quarter last year.
Although mortgage refinancing has slowed as mortgage rates have increased, the
local real estate market remains strong and much of the mortgage banking
activity during the third quarter of 2004 was for home purchases. It is expected
that interest rates will continue to rise and mortgage banking income will
decrease in future quarters. Trust income declined $41,000 during the
three-month period ended September 30, 2004 compared to the same period last
year as the result of one-time trust fees that were collected in the third
quarter of 2003. Other operating income increased during the quarter by $57,000
with much of the increase resulting from the First State Bank acquisition. It is
expected that fourth quarter 2004 noninterest income will be greater than fourth
quarter 2003's due to the First State Bank acquisition.
For the nine months ended September 30, 2004, noninterest income was
$3,339,000 as compared with $3,045,000 for the same period of 2003, an increase
of $294,000. The acquisition of First State Bank increased the number of
accounts, and service fees on deposits consequently increased $260,000 during
the first nine months of 2004 compared with the same period last year. Trust
income increased $18,000 during the nine months ended September 30, 2004
compared with the same period of 2003. Increased home mortgage rates caused
refinancing activities of the mortgage banking activity to decrease and mortgage
banking income consequently declined $156,000 in the first nine months of 2004.
The First State Bank acquisition helped to increase other operating income that
was $172,000 greater during the nine months ended September 30, 2004 compared
with the same period last year.
NONINTEREST EXPENSE
Noninterest expense for the quarter ended September 30, 2004 was
$4,394,000, increasing $1,234,000 from the same quarter last year. The Company's
efficiency ratio, noninterest expense divided by the sum of net interest income
and noninterest income, was 63.50% for the third quarter of 2004 as compared
with 58.75% for the same quarter of 2003. Increased noninterest expense due to
the purchase of First State Bank primarily affected this ratio. The Company
expects that its efficiency ratio will continue to be impacted until the two
bank subsidiaries are merged at some point in the future.
Salary and employee benefits were $489,000 greater during the third
quarter of 2004 compared to the same period last year. The acquisition of First
State Bank added 36 employees to the staff of the Company. In January 2004,
yearly merit increases occurred, also increasing salary expense compared to
2003.
Occupancy and equipment expense for the third quarter of 2004 was
$153,000 greater than the same quarter of 2003. Two offices were added to the
Company from the First State Bank acquisition and the depreciation and utility
expenses of these branches account for this increase.
Data processing expense increased $221,000 during the three months
ended September 30, 2004 to $387,000 compared with $166,000 last year. First
State Bank uses a separate data processing service bureau than the one used by
the Bank of Waukegan. The Company converted First State Bank to the same data
processing service bureau as the Bank of Waukegan in October 2004. This
conversion is expected to reduce future increases to data processing expenses.
In April 2004, the Bank of Waukegan outsourced its item processing function to
accommodate new check clearing technologies required to meet new
19
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
------------------------
regulations. Data processing expense increased $100,000 in the third quarter as
a result of the outsourcing of its item processing function. The outsourcing of
the item processing function is expected to contribute to future data processing
expense at approximately $80,000 per quarter.
Legal expenses increased $79,000 to $364,000 during the third quarter
of 2004 compared to the same time period last year. A majority of the legal fees
pertained to litigation involving the nonperforming lease pools. It is expected
that similar levels of legal fees will continue in future periods until
litigation in this matter is resolved.
Purchase accounting for financial institutions requires that an
intangible asset be recorded for the acquisition of core deposits such as
checking, savings and money market accounts. The core deposit valuation for the
acquisition of First State Bank was $3.2 million and is being amortized over its
estimated life. During the third quarter of 2004, the related amortization of
intangibles was $116,000.
The Company's other operating expenses during the three months ended
September 30, 2004 were $176,000 greater than the same period of 2003. Once
again, the acquisition of First State Bank increased these expenses as compared
to the prior year.
For the nine months ended September 30, 2004, noninterest expense was
$12,246,000, increasing $3,084,000 from the same period last year. Noninterest
expense increased during the first nine months of 2004 primarily due to the
acquisition of First State Bank on January 5, 2004. The addition of 36 employees
and two offices from the acquisition caused salary and employee benefits to be
$1,341,000 more and occupancy expenses to be $399,000 greater than during the
same nine month period of 2003. Data processing expense increased $610,000,
other operating expenses increased $541,000 and amortization of intangibles
increased $348,000 as compared with the same nine months last year due to the
First State Bank acquisition.
Legal expenses decreased $155,000 to $713,000 for the nine month period
ended September 30, 2004 compared with $868,000 for the same time period last
year. Most of the legal fees pertain to litigation involving the nonperforming
lease pools as discussed earlier. Legal fees during the first nine months of
2003 were greater than in 2004 as there were higher initial legal fees in early
2003 related to this litigation.
FEDERAL AND STATE INCOME TAXES
For the three months ended September 30, 2004, the Company's income tax
expense was $637,000 compared with income tax expense of $709,000 for the same
three months last year. As a percentage of pre-tax income the income tax expense
was 31.4% for the third quarter of 2004 and 34.3% for the third quarter of 2003.
The tax rate declined during the third quarter of 2004, as a larger percentage
of pre-tax income was not taxable for state purposes due to interest earned on
the Company's U.S. agency securities portfolio. Another factor reducing the tax
rate was an increase of income exempt from federal taxes from municipal
securities that increased $22,000 during the third quarter of 2004 due to the
acquisition of First State Bank.
For the nine months ended September 30, 2004 and 2003, the Company's
federal and state income tax expense was $1,378,000 and $2,278,000, which as a
percentage of pre-tax income was 29.5% and 34.9%. The tax rate for the first
nine months of 2004 was lower as pre-tax income declined, interest income exempt
from federal income taxes from municipal securities increased $48,000 from the
same period last year and a larger percentage of pre-tax income was not taxable
for state purposes due to the amount of U.S. agency securities that are carried
by the Company.
20
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 September 30, 2004, 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. The Company does not have any material off-balance
sheet arrangements that have, or are reasonably likely to have, a current or
future effect on its financial condition.
During the third quarter of 2004 the Company paid the termination
obligation on First State Bank's data processing contract in the amount of
$609,000 that had been set aside in the purchase accounting entries. Table 3 at
September 30, 2004 consequently shows lower data processing contractual
obligations than at June 30, 2004. In October 2004, First State Bank's data
processing systems were converted to the same data processor as Bank of
Waukegan.
TABLE 3
NORTHERN STATES FINANCIAL CORPORATION
CONTRACTUAL OBLIGATIONS, COMMITMENTS, CONTINGENT
LIABILITIES AND OFF-BALANCE SHEET ARRANGEMENTS
As of September 30, 2004
($000s)
Greater than
1 year and less
One year than or equal Greater than
or less to 3 years 3 years Total
--------- --------------- ------------ -----
Contractual Obligations
Long-term debt
Federal Home Loan Bank advance........... $0 $6,500 $0 $6,500
Off-balance Sheet Obligations
Unused commitments to make loans............ 44,033 29,285 28,485 101,803
Standby letters of credit................... 4,587 483 36 5,106
Community Reinvestment Act
investment commitment.................... 0 0 774 774
Contractual obligations to third parties reflect the payments due by
period as of September 30, 2004. Off-balance sheet obligations represent the
expected maturities of significant commitments. The above listed commitments do
not necessarily represent future cash requirements, in that these commitments
often expire without being drawn upon.
21
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. Increasing deposits, borrowing, or selling assets
can obtain these funds.
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 September 30, 2004 and December 31, 2003. 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 September 30, 2004 the fair value of securities
available for sale increases $6.1 million when rates are shocked downward 2%
while the fair value decreases $11.5 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 $162.9 million of the U.S. Government
agency securities at September 30, 2004. At September 30, 2004 the fair value of
the Company's financial asset instruments was $738.5 million compared to the
fair value on the
22
Company's financial asset instruments at December 31, 2003 of $680.1 million.
This increase reflects the financial instruments added to the Company through
the acquisition of First State Bank on January 5, 2004.
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 September 30, 2004
($000s)
Fair Value at September 30, 2004
--------------------------------
Down 2% Current Up 2%
------- ------- -----
Assets
Cash and cash equivalents $48,690 $48,688 $48,686
Securities available for sale 256,647 250,518 239,033
Loans and leases, net 449,332 433,451 418,616
Federal Home Loan Bank and Federal
Reserve Bank stock 2,108 2,108 2,108
Accrued interest receivable 3,707 3,707 3,707
Financial liabilities:
Deposits $641,900 $637,825 $634,075
Securities sold under repurchase agreements
and other short-term borrowings 40,992 40,741 40,493
Federal Home Loan Bank term advance 6,847 6,471 6,120
Advances from borrowers for taxes and insurance 531 531 531
Accrued interest payable 2,270 2,270 2,270
Fair Value at December 31, 2003
-------------------------------
Down 2% Current Up 2%
------- ------- -----
Assets
Cash and cash equivalents $38,586 $38,584 $38,582
Securities available for sale 284,264 280,445 267,427
Loans and leases, net 370,694 355,769 342,007
Federal Home Loan Bank stock 1,871 1,871 1,871
Accrued interest receivable 3,429 3,429 3,429
Financial liabilities:
Deposits $497,245 $493,555 $490,134
Securities sold under repurchase agreements
and other short-term borrowings 83,573 83,352 83,132
Federal funds purchased 26,500 26,500 26,500
Federal Home Loan Bank term advance 7,001 6,542 6,115
Advances from borrowers for taxes and insurance 535 535 535
Accrued interest payable 2,180 2,180 2,180
23
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 third quarter of 2004, 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
- ------- -----------------
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.
At September 30, 2004, the bankruptcy trustee is holding $1.4 million
of payments on the Company's lease pools that the Company had previously
expected would be paid to the Company by the bankruptcy trustee. In September
2004, the bankruptcy judge directed all parties to engage in mediation, which
occurred later that month. The parties are now attempting to negotiate a
settlement based on the mediation. A final resolution of these matters is
expected either in the fourth quarter of 2004 or in the first quarter of 2005.
The Company is continuing its efforts to collect on these leases from
the sureties through litigation. The sureties have asserted certain defenses
against having to pay under the surety bonds, including fraud. No evidence has
been discovered that implicates any of the investor banks, including the
Company, in any fraud, notwithstanding over 200 depositions in the subject
multi-district litigation relating
24
to the sureties. No assurance can be given as to the exact amounts that will be
ultimately collected from the bankruptcy trustee and the sureties.
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
ITEM 2. UNREGISTERED SALES OF SECURITIES AND USE OF PROCEEDS
- ----------------------------------------------------------
ISSUER PURCHASES OF EQUITY SECURITIES
The following table sets forth information in connection with purchases
made by, or on behalf of, the Company of shares of the Company's common stock
during the quarterly period ended September 30, 2004.
TOTAL NUMBER MAXIMUM NUMBER
TOTAL NUMBER AVERAGE OF SHARES PURCHASED OF SHARES THAT MAY
OF SHARES PRICE PAID AS PART OF PUBLICLY YET BE PURCHASED
PERIOD PURCHASED (1) PER SHARE ANNOUNCED PLANS UNDER THE PLANS
------------- ---------- -------------------- -----------------
July 1, 2004
Through
July 31, 2004 0 $0.00 0 232,850
August 1, 2004
Through
August 31, 2004 6,000 26.90 6,000 226,850
September 1, 2004
Through
September 30, 2004 0 0.00 0 226,850
----- ------
TOTAL 6,000 $26.90
(1) On April 17, 2002, the Company's Board of Directors authorized the
repurchase of up to 200,000 shares of the Company's either in open market or
private transactions. On February 19, 2003, the Company's Board of Directors
authorized the repurchase of an additional 200,000 shares. (No time limit has
been set for the completion of the plans.)
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
- ------- -------------------------------
None
25
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
ITEM 5. OTHER INFORMATION
- ------- -----------------
None
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.
26
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
FORM 10-Q
---------
SEPTEMBER 30, 2004
------------------
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 8th day of November 2004.
NORTHERN STATES FINANCIAL CORPORATION
(Registrant)
Date: November 8, 2004 By: /s/ Fred Abdula
---------------- ----------------------------
Fred Abdula
Chairman of the Board of
Directors and President
Date: November 8, 2004 By: /s/ Thomas M. Nemeth
---------------- ----------------------------
Thomas M. Nemeth
Vice President and Treasurer
27
NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
FORM 10-Q
---------
SEPTEMBER 30, 2004
------------------
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 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.
28