UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 001-13735

MIDWEST BANC HOLDINGS, INC.

(708) 865-1053
(Registrant’s telephone number, including area code)

     Indicate by checkmark 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 such 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 x No o

     Indicate by checkmark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No o

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

MIDWEST BANC HOLDINGS, INC.

Form 10-Q

Table of Contents

i

MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS (Unaudited)
(In thousands)

See accompanying notes to unaudited consolidated financial statements.

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MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
Three months ended March 31, 2004 and 2003
(In thousands, except per share data)

See accompanying notes to unaudited consolidated financial statements.

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MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited)
Three months ended March 31, 2004 and 2003
(In thousands, except share and per share data)

See accompanying notes to unaudited consolidated financial statements.

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MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Three Months Ended March 31, 2004 and 2003
(In thousands)

See accompanying notes to unaudited consolidated financial statements.

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MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Continued)

See accompanying notes to unaudited consolidated financial statements.

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NOTE 1 — BASIS OF PRESENTATION

     The consolidated financial information of Midwest Banc Holdings, Inc. (the “Company”) included herein is unaudited; however, such information reflects all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation for the interim periods. The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.

     The annualized results of operations for the three months ended March 31, 2004 are not necessarily indicative of the results expected for the full year ending December 31, 2004.

NOTE 2 — BUSINESS COMBINATIONS

     On January 3, 2003, the Company acquired Big Foot Financial Corp. (“BFFC”) through the issuance of approximately 1,599,088 shares of common stock valued at $18.81 per share and cash paid of $1.4 million, and incurred acquisition costs of $557,000, resulting in total consideration of $32.0 million. BFFC was merged into the Company, and its banking subsidiary was merged into and its offices became branches of Midwest Bank and Trust Company. At closing the Company transferred $3.4 million of securities categorized as held-to-maturity to available-for-sale under permissible provisions of FASB Statement No. 115. During the first quarter of 2003, the Company sold the mortgage loans and mortgage servicing rights of $141.9 million of the acquired loans on a non-recourse basis.

     The business combination is accounted for under the purchase method of accounting. Accordingly, the results of operations of BFFC have been included in the Company’s results of operations since January 3, 2003, the date of acquisition. Under this method of accounting, the purchase price is allocated to the respective assets acquired and liabilities assumed based on their estimated fair values. The excess of purchase price over the net assets acquired is recorded as goodwill.

NOTE 3 — GOODWILL AND INTANGIBLES

     On January 1, 2002, the Company implemented Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. Under the provisions of SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life, but instead is subject to at least annual assessments for impairment by applying a fair-value based test. SFAS No. 142 also requires that an acquired intangible asset be separately recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the asset can be sold, transferred, licensed, rented or exchanged, regardless of the acquirer’s intent to do so.

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     Intangible asset disclosures are as follows (in thousands):

     The following tables present the changes in the carrying amount of goodwill and other intangibles during the three months ended March 31, 2004 and the year ended December 31, 2003 (in thousands):

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NOTE 4 — EARNINGS PER SHARE

     For purposes of per share calculations, the Company had 17,869,366 shares of common stock outstanding at March 31, 2004, and 17,798,118 shares of common stock outstanding at March 31, 2003. Basic earnings per share for the three months ended March 31, 2004 and 2003 were computed by dividing net income by the weighted average number of shares outstanding during the period. Diluted earnings per share for the three months ended March 31, 2004 and 2003 were computed by dividing net income by the weighted average number of shares outstanding during the period, adjusted for the dilutive effect of the outstanding stock options. Computations for basic and diluted earnings per share are provided below.

     All outstanding options were included in the computation of diluted earnings per share for the three months ended March 31, 2004 and 2003.

NOTE 5 — STOCK OPTIONS AND COMPENSATION

     During the first quarter of 2004, 8,160 options were exercised. The total stock options outstanding were 1,066,885 at March 31, 2004 with exercise prices ranging between $5.42 and $18.34 and expiration dates between 2006 and 2013. No stock options were granted in the three months ended March 31, 2004.

     Employee compensation expense under stock options is reported using the intrinsic value method. No stock-based compensation cost is reflected in net income, as all options granted had an exercise price equal to or greater than the market price of the underlying common stock at date of grant. The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of FASB Statement No. 123, “Accounting for Stock-Based Compensation.”

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NOTE 6 — TRUST PREFERRED SECURITIES

     In May 2000, the Company formed the MBHI Capital Trust I (“Trust”). The Trust is a statutory business trust formed under the laws of the State of Delaware and is wholly owned by the Company. In June 2000, the Trust issued 10.0% Company obligated mandatory redeemable trust preferred securities with an aggregate liquidation amount of $20.0 million ($25 per preferred security) to third-party investors in an underwritten public offering. The Company issued 10.0% junior subordinated debentures aggregating $20.0 million to the Trust. The junior subordinated debentures are the sole assets of the Trust. The Company obligated mandatory redeemable trust preferred securities and the junior subordinated debentures pay distributions and dividends, respectively, on a quarterly basis, which are included in interest expense. The Company obligated mandatory redeemable trust preferred securities will mature on June 7, 2030, at which time the preferred securities must be redeemed. The Company obligated mandatory redeemable trust preferred securities and junior subordinated debentures can be redeemed contemporaneously, in whole or in part, beginning June 7, 2005 at a redemption price of $25 per preferred security. The Company has provided a full, irrevocable, and unconditional guarantee on a subordinated basis of the obligations of the Trust under the preferred securities in the event of the occurrence of an event of default, as defined in such guarantee. The following table details the four trusts formed by the Company:

     FIN No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (Revised December 2003). FIN 46 establishes accounting guidance for consolidation of variable interest entities (“VIE”) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE entity is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with the VIE. Prior to the implementation of FIN 46, VIE’s were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The provisions of FIN 46 were effective immediately for all arrangements entered into after January 31, 2003. If a VIE existed prior to February 1, 2003, FIN 46 was effective at the beginning of the first interim period beginning after June 15, 2003. However, subsequent revisions to the interpretation deferred the implementation date of FIN 46 until the first period ending after December 15, 2003. The Company adopted FIN 46, as revised, in connection with its consolidated financial statements for the quarter ended March 31, 2004. The implementation of FIN 46 required the Company to de-consolidated its investment in MBHI Capital Trust I, II, III, and IV because the Company is not the primary beneficiary. The Company owns $1.7 million of common securities that have been issued by the four statutory trusts previously formed. There was no impact on stockholders’ equity or net income.

     The trust preferred securities issued by MBHI Capital Trust I, II, III, and IV are currently included in the Tier 1 capital of the Company for regulatory capital purposes. The Federal Reserve Board may in the future disallow inclusion of the trust preferred securities in Tier 1 capital for regulatory capital purposes. In July 2003, the Federal Reserve Board issued a supervisory letter instructing bank holding companies to continue to include the trust preferred securities in their Tier 1 capital for regulatory capital purposes until notice is given to the contrary. The Federal Reserve Board intends to review the regulatory implications of the change in accounting treatment of subsidiary trusts that issue trust preferred securities and, if necessary or warranted, provide further appropriate guidance. There can be no assurance that the Federal Reserve Board will continue to permit institutions to include trust preferred securities in Tier I capital for regulatory capital purposes.

     As of March 31, 2004, assuming the Company was not permitted to include the $54.0 million in trust preferred securities issued by MBHI Capital Trust I, II, III, and IV in its Tier 1 capital, the Company would still exceed the regulatory required minimums for capital adequacy purposes. If the trust preferred securities were no longer permitted to be included in Tier 1 capital, the Company would also be permitted to redeem the capital securities without penalty.

     The interpretations of FIN 46 and its application to various transaction types and structures are continually evolving. Management continuously monitors emerging issues related to FIN 46, some of which could potentially impact the Company’s financial statements.

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NOTE 7 — DERIVATIVE INSTRUMENTS

     As of March 31, 2004, the Company has entered into various interest rate swap transactions, which result in the Company converting $137.5 million of its Federal Home Loan Bank Advance fixed rate debt to floating rate debt. The swap transactions require payment of interest by the Company at a rate equal to the three-month LIBOR plus a spread and, in turn, the Company receives a fixed rate. The Company has documented these to be fair value hedges that are carried at their estimated fair value with the changes recorded as an other asset or other liability as appropriate.

     Summary information about interest rate swaps at March 31 are as follows:

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     The Company has also bought and sold various put and call options with terms less than 90 days on U.S. Treasury and government agency obligations, mortgage-backed securities, and future contracts. These are stand-alone derivatives that are carried at their estimated fair value with the corresponding gain or loss recorded in net trading profits or losses. The outstanding amounts at March 31 are as follows:

     In 2004, the Company entered into 3,000 U.S. Treasury 10-year note futures contracts with a notional value of $300.0 million and a delivery date of June 2004. The Company sold these contracts in order to hedge certain U.S. Agency notes held in its available-for-sale portfolio. The Company’s objective was to offset changes in the fair market value of the U.S. Agency notes with changes in the fair market value of the futures contracts, thereby reducing interest rate risk. The Company has documented these futures contracts as fair value hedges with the changes in market value of the futures contracts as well as the changes in the market value of the hedged items charged or credited to earnings on a quarterly basis in net gains on securities transactions. For the three months ending March 31, 2004, the change in the market values resulted in a net loss of $1.7 million.

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NOTE 8 — UNREALIZED LOSSES ON SECURITIES

     The following is a summary of the fair value of securities held-to-maturity and available-for-sale with unrealized losses and an aging of those unrealized losses:

     Management does not believe any individual unrealized loss as of March 31, 2004 represents other-than-temporary impairment. The unrealized loss for U.S. government agencies and mortgage-backed securities relate primarily to securities issued by FNMA and FHLMC. The unrealized losses for equity securities relate primarily to callable preferred stock issued by FNMA and FHLMC with a variable dividend. The unrealized losses reported for Corporate and other debt securities relate to securities which were rated single A minus or more by a nationally recognized rating agency. These unrealized losses are primarily attributable to changes in interest rates. The Company has both the intent and ability to hold the securities contained in the previous table for a time necessary to recover its amortized cost, and due to the high quality of the securities, the Company may also realize its amortized cost through the use of options or interest rate derivatives in conjunction with these securities. The majority of the above temporary loss is reflected net of tax in other comprehensive loss which does not impact regulatory capital.

NOTE 9 — OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK

     The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet financing needs of customers. Since many commitments to extend credit expire without being used, the amounts below do not necessarily represent future cash commitments. These financial instruments include lines of credit, letters of credit, and commitments to extend credit. These are summarized as follows:

     At March 31, 2004, commitments to extend credit included $21,720,000 of fixed rate loan commitments. These commitments are due to expire within 30 to 90 days of issuance and have rates ranging primarily from 4.00% to 6.85%. Substantially all of the unused lines of credit are at adjustable rates of interest.

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     The credit risk amounts represent the maximum accounting loss that would be recognized at the reporting date if counterparties failed completely to perform as contracted and any collateral or security proved to be of no value. The Company has experienced little difficulty in accessing collateral when necessary. The amounts of credit risk shown therefore greatly exceed expected losses.

NOTE 10 — CAPITAL CONTRIBUTION AND REGULATORY MATTERS

     On March 5, 2003 one of the Company’s subsidiary banks, Midwest Bank and Trust Company (“Bank”), received a joint letter from the Federal Reserve Bank of Chicago (“Federal Reserve”) and the Illinois Office of Banks and Real Estate (“OBRE”) regarding additional provisions for loan losses that the Federal Reserve and OBRE determined were appropriate based on their review of a series of loans to an individual borrower and certain Affiliated Companies. The total relationship approximated $19.6 million. In response to the letter, the Company obtained an independent valuation of the primary collateral for the largest portion of the relationship which is two companies in bankruptcy (“Affiliated Companies”). As a result of further communication with the Federal Reserve and OBRE, additional analysis completed by the Company, and the receipt of a supplemental letter from the Federal Reserve and OBRE as of April 10, 2003, the Company determined it would provide an additional $14.7 million to the allowance for loan losses, charge off approximately $5.6 million in loans, and reverse out $1 million of interest.

     As previously reported by the Company, on March 26, 2003, the Bank received proceeds from an entity indirectly owned by certain directors and family members of directors of the Bank of approximately $13.3 million in connection with the sale of previously classified loans, which consisted of $12.5 million of the loan principal balance, $750,000 for the letter of credit and $67,000 of accrued interest and late charges. As a result, the Bank recognized a $4.0 million after-tax capital contribution as a result of the sale of these loans to the related parties. As of December 31, 2002, $6.3 million of the $12.5 million outstanding principal amount of these loans was considered impaired.

     On April 24, 2003, the Federal Reserve and the OBRE completed the on-site portion of their regularly scheduled examination of the Company’s banking subsidiaries. The examination included, among other items, a review of the Company’s over-all risk management, lending and credit review practices. The Company received the examination report during the third quarter of 2003.

     On December 29, 2003, the Company and Midwest Bank and Trust Company received a proposed written agreement from the Federal Reserve and the OBRE which detailed recommended corrective actions in the Company’s over all risk management, lending and credit review practices, including the engagement of third party consultants. This agreement relates to the joint examination which began on March 3, 2003 and ended on May 23, 2003. Following discussions with the regulators in late January 2004, the Company and the Bank received a revised written agreement from the Federal Reserve and the OBRE on March 11, 2004. The regulators have requested the Company and the Bank take action on the proposed written agreement by March 15, 2004. The written agreement was filed upon execution by the Company and the Bank on March 15, 2004.

     The written agreement outlines a series of steps to address and strengthen the Company’s risk management practices. These steps include third-party reviews and the submission of written plans in a number of areas. These areas include the Company’s and the Bank’s boards of directors and management, corporate governance, internal controls, risk management, lending and credit, including allowance for loan and lease losses and loan review, and loan policies and procedures. The agreement does not relate to the financial condition, capital, earnings or liquidity of the Company or the Bank.

     Management believes that compliance with the terms will not have a direct material effect

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upon the Company’s consolidated financial position or results of operations. No restrictions have been proposed relating to the payment of dividends.

     The agreement requires submission of written plans, programs and policies and procedures to the regulators for review and approval within specified time frames.

     Failure to satisfy the terms of the agreement could result in further regulatory actions against the Company, the Bank and their boards of directors and management.

     Since the joint examination of March 2003, the Company and the Bank have taken steps, and continue to take steps, to address the recommendations proposed by the regulators in their report dated August 1, 2003, which are now incorporated into the written agreement. On March 29, 2004, the regulators began their regularly scheduled joint examination of the Company and the Bank.

     The Securities and Exchange Commission has opened an inquiry in connection with the Company’s September 30, 2002 restatement. The Company is cooperating fully with the SEC on this matter.

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ITEM 2 —	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     The following discussion and analysis is intended as a review of significant factors affecting the financial condition and results of operations of the Company for the periods indicated. The discussion should be read in conjunction with the unaudited Consolidated Financial Statements and the Notes thereto presented herein. In addition to historical information, the following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors discussed in this report. Also, see “Note 10 — Capital Contribution and Regulatory Matters” to our unaudited consolidated financial statements for a discussion of certain regulatory matters.

Critical Accounting Policies and Estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. By their nature, changes in these assumptions and estimates could significantly affect the Company’s financial position or results of operations. Actual results could differ from those estimates. Discussed below are those critical accounting policies that are of particular significance to the Company.

     Allowance for Loan Losses: The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.

     The allowance for loan losses consists of an allocated component and an unallocated component. The components of the allowance represent an estimation pursuant to either Statement of Financial Accounting Standards No. (“SFAS”) 5, Accounting for Contingencies, or SFAS 114, Accounting by Creditors for Impairment of a Loan. The allocated component of the allowance for loan losses reflects expected losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on regular analyses of all loans over a fixed-dollar amount where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The Company’s historical loss experience is updated quarterly. The allocated component of the allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume, and other qualitative factors.

     There are many factors affecting the allowance for loan losses; some are quantitative while

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others require qualitative judgment. The process for determining the allowance (which management believes adequately considers all of the potential factors which potentially result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for credit losses could be required that could adversely affect earnings or financial position in future periods.

     Evaluation of Securities for Impairment: Securities are classified as held-to-maturity when the Company has the ability and management has the positive intent to hold those securities to maturity. Accordingly, they are stated at cost adjusted for amortization of premiums and accretion of discounts. Securities are classified as available-for-sale when the Company may decide to sell those securities for changes in market interest rates, liquidity needs, changes in yields or alternative investments, and for other reasons. They are carried at fair value with unrealized gains and losses, net of taxes, reported in other comprehensive income (loss). Interest income is reported net of amortization of premium and accretion of discount. Realized gains and losses on disposition of securities available-for-sale are based on the net proceeds and the adjusted carrying amounts of the securities sold, using the specific identification method. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other than temporary losses, management considers (1) the length of time and extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. The evaluation also considers the impact that impairment may have on future capital, earnings, and liquidity.

     Fair Value of Financial Instruments and Derivatives: Fair values of financial instruments, including derivatives, are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for the particular items. There is no ready market for a significant portion of the Company’s financial instruments. Accordingly, fair values are based on various factors relative to expected loss experience, current economic conditions, risk characteristics, and other factors. The assumptions and estimates used in the fair value determination process are subjective in nature and involve uncertainties and significant judgment. As a consequence, fair values cannot be determined with precision. Changes in assumptions or in market conditions could significantly affect these estimates.

Results of Operations — Three Months Ended
March 31, 2004 and 2003

     Set forth below are some highlights of the first quarter 2004 results compared to the first quarter of 2003.

•		Consolidated net income for the first quarter of 2004 was $4.8 million, a 24.5% decrease when compared to $6.4 million for the first quarter of 2003.
•		Basic earnings per share for the three months ended March 31, 2004 were $0.27 or 25.0%, lower than for the comparable period in 2003.
•		Diluted earning per share for the three months ended March 31, 2004 were $0.26 or 25.7% lower than for the comparable period in 2003.
•		The return on average assets for the three months ended March 31, 2004 was 0.85% compared to 1.19% for the similar period in 2003.

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•		The return on average equity for the three months ended March 31, 2004 was 13.45% compared to 17.70% for the similar period in 2003.
•		Net interest income decreased 16.5% to $14.2 million in the first quarter of 2004 compared to $17.0 million in the first quarter of 2003.
•		Excluding gains on securities, other income decreased 72.8% to $1.1 million in the first quarter of 2004 compared to $4.0 million in the first quarter of 2003.
•		Other expenses increased 2.4% to $11.0 million in the first quarter of 2004 compared to $10.8 million in the first quarter of 2003.

Net Interest Income

     Net interest income is the difference between interest income and fees on earning assets and interest expense on deposits and borrowings. Net interest margin represents net interest income on a tax equivalent basis as a percentage of average earning assets during the period. Net interest margin reflects the spread between average yields earned on interest earning assets and the average rates paid on interest bearing deposits and borrowings.

     Net interest income was $14.2 million and $17.0 million during the three months ended March 31, 2004 and 2003, respectively, a decrease of 16.5%. Net interest income decreased because the decrease in the yields on earning assets was greater than the decrease in average rates paid on deposits and borrowings. Evidence of this is the reduction in the Company’s net interest margin (tax equivalent net interest income as a percentage of earning assets) to 2.84% for the three months ended March 31, 2004 compared to 3.45% for the comparable period in 2003. Yields on earning assets decreased 14.8% to 5.08% during the first quarter of 2004 compared to 5.96% for the first quarter of 2003. Average earning assets, however, increased $46.0 million for the three months ended March 31, 2004 compared to the first quarter of 2003.

     The average loan yield was 6.16% during the first quarter of 2004, a decrease of 8.3% from 6.72% during the comparable period in 2003. Average loan balances decreased $141.7 million, or 11.6%, to $1.1 billion during the first quarter of 2004 from $1.2 billion during the first quarter of 2003. In February 2003, $141.9 million of mortgage loans were sold following the closing of the BFFC acquisition. The sale of these loans completed a step to reduce the Company’s interest rate risk. The Company established a new loan program which has attracted considerable attention. The more competitive pricing structure of this program has resulted in a significant increase in the Company’s loan pipeline. Since March 31, 2004, the Company’s loan pipeline has grown with $44.1 million of additional loan commitments. This increase in loan commitments along with expanded loan origination activity may result in higher average loan yields during the remainder of 2004. The program’s capacity will be expanded, and the Company expects to realize loan growth ranging from 7% to 11% for the balance of 2004.

     Yields on securities were 4.68% during the first quarter of 2004, a decrease of 5.6% from 4.96% during the comparable period in 2003. Average securities balances increased $8.5 million while interest income on securities decreased by $490,000.

     During the first quarter of 2004, the Company held $197.0 million in cash equivalents, which earned, on average, 94 basis points. Consistent with the investment strategy adopted during 2003, the Company further reduced its holdings in mortgage-backed securities by $45.6 million

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during the first quarter of 2004. As yields remained at historic lows during the quarter, the Company liquidated another $195.9 million of securities to record gains at current market levels and planned on reinvesting in shorter duration securities and higher yielding loans. The anticipated increase in interest rates did not occur by quarter-end, and the Company decided to invest cautiously under current market conditions to protect its longer-term profitability and reduce any adverse impact of any mark-to-market adjustments on its capital base in the future.

     The decrease in yields on earning assets was offset by a decrease of 11.6% in average rates paid on deposits and borrowings. Average rates on deposits decreased 13.8% to 2.00% for the three months ended March 31, 2004 from 2.32% for the comparable period in 2003. Average rates on borrowings were 3.72% for the first quarter of 2004 compared to 3.96% in the comparable period in 2003.

     The net interest margin calculation for the three months ended March 31, 2004 and 2003 is shown below (net interest income and average rate on non-taxable securities and loans are reflected on a tax equivalent basis, assuming a 35% tax rate for 2004 and 2003 and adjusted for the dividends received deduction where applicable):

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(1)

Adjusted for 35% tax rate in 2004 and 2003 and adjusted for the dividends-received deduction where applicable.

(2)

Not adjusted for 35% tax rate in 2004 and 2003 or for the dividends-received deduction.

(3)

Nonaccrual loans are included in the average balance; however, these loans are not earning any interest.

(4)

Includes loan fees; these fees are immaterial.

(5)

The following table reconciles reported net interest income on a tax equivalent basis for the periods presented:

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Other Income

     Other income, excluding net gains on securities transactions, was $1.1 million for the three months ended March 31, 2004, a decrease of $2.9 million, or 72.8%, over the comparable period in 2003. The other income, excluding net gains on securities transactions, to average assets ratio was 0.19% for the three months ended March 31, 2004 compared to 0.73% for the same period in 2003. The increase in other income was due to the increases in insurance and investment brokerage commissions and the increase in cash surrender value of life insurance.

     Service charges and fees decreased 2.1%, or $31,000, to $1.4 million in the first quarter of 2004 from $1.5 million in the first quarter of 2003. Service charges and fees include service charges on deposit accounts, which are expected to increase with future deposit growth within our existing markets.

     Insurance and investment brokerage commissions increased 5.9%, or $27,000, from $458,000 for the first quarter of 2003 to $485,000 for the first quarter of 2004. This increase is due to the increased investment brokerage activities through Midwest Financial and Investment Services, Inc., the Company’s subsidiary, which provides securities brokerage services to both bank and non-bank customers. The Company anticipates that investment brokerage commissions will increase in the future through this subsidiary.

     Gains on sales of loans decreased 49.0% to $147,000 during the first quarter of 2004 from $288,000 for the comparable period in 2003 due to a lower level of mortgage refinancing volume. The Company places most mortgages originated into the secondary market.

     Trust income increased 10.4%, or $14,000, to $149,000 for the first quarter of 2004 compared to $135,000 for the comparable period in 2003.

     Sales of securities available-for-sale resulted in net gains of $2.9 million in the first quarter of 2004 compared to $102,000 for the comparable period in 2003. Included in the net gains on available-for-sale securities transactions was a net loss of $1.7 million as a result of the difference in market values for the futures contracts and hedged items. See Note 7 to the notes to the unaudited consolidated financial statements.

     Periodically, the Company has bought or sold various covered put and call options, with terms less than 90 days, on mortgage-backed securities, U.S. Treasury and government agency obligations, and futures contracts. These covered options have either expired or have been exercised, and the associated income or expense has been recognized in the corresponding period. Option fee income, included in net trading profits or losses, increased $728,000 to $1.7 million during the first quarter of 2004 compared to $997,000 in the first quarter of 2003. Option fees are part of management’s ongoing strategy to manage risk in the securities portfolio and take advantage of favorable market conditions. Management has effectively used the proceeds from selling covered call and put options to offset net interest margin compression and has administered such sales in a coordinated process with the Company’s overall asset/liability management. Management is poised to adjust its option strategy when interest rates increase or decrease. There is no assurance that the option fee income realized through March 31, 2004 is sustainable in future periods. The Company had no covered put or call options outstanding at March 31, 2004. See Note 7 to the notes to the unaudited consolidated financial statements.

     Also included in net trading profits or losses was a $3.6 million loss during the first quarter of 2004. This

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loss resulted from a futures position used as a strategy designed to benefit the Company for relatively constant or rising interest rates. The objectives of this strategy were not realized. The sharp decline in long-term U.S. Treasury yields during March 2004 unfavorably impacted the position resulting in the above-mentioned loss.

Other Expenses

     Total other expenses increased 2.4%, or $258,000, to $11.0 million during the first quarter of 2004 compared to $10.8 million for the comparable period in 2003. The other expenses to average assets ratio was 1.95% for the three months ended March 31, 2004 compared to 2.00% for the same period in 2003. The efficiency ratio was 66.97% for the three months ended March 31, 2004 compared to 48.38% for the same period in 2003. The efficiency ratio is equal to other expense less amortization and other real estate expense divided by the sum of net interest income on a fully tax-equivalent basis plus other income excluding security gains. The increase in the efficiency ratio was due primarily to the decrease in net interest income on a fully tax-equivalent basis and in other income during the quarter.

     Salary and benefit expenses increased 7.1%, or $429,000, to $6.5 million for the first quarter of 2004 compared to $6.1 million for the comparable period in 2003. The number of full-time equivalent employees was 442 at March 31, 2004 compared to 429 as of March 31, 2003. Increased full-time staff positions, enhanced benefit programs, and increased health insurance costs have resulted in the increase in salaries and employee benefits.

     Occupancy expenses decreased $69,000, or 3.9%, to $1.7 million during the first quarter of 2004 compared to $1.8 million for the comparable period in 2003.

     Professional services expense decreased $307,000, or 25.8%, to $881,000 for the first quarter of 2004 compared to $1.2 million for the first quarter of 2003. Consulting and data processing fees decreased by $326,000 and $98,000, respectively, for the first three months of 2004 compared to 2003. The expenses reflected in the first quarter of 2003 were due to the BFFC acquisition and problem loans (see Note 10 to the notes to the unaudited consolidated financial statements).

     Expenses, other than salary and employee benefits, occupancy, and professional services, increased $205,000, or 11.5%, to $2.0 million in the first quarter of 2004 from $1.8 million for the comparable period in 2003.

Income Taxes

     The Company recorded income tax expense of $1.5 million, or 23.6% of income, and $2.9 million, or 30.9% of income, for the quarters ended March 31, 2004 and 2003, respectively. The decrease in the tax rate was due in part to the large increase in U.S. Government Agencies securities the Company held during the first quarter of 2004 compared to similar period in 2003.

Financial Condition

Loans

     The following table sets forth the composition of the Company’s loan portfolio as of the indicated dates.

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(1)

Includes loans held for sale.

     Total loans decreased $5.8 million, or 0.5%, to $1.1 billion at March 31, 2004 from December 31, 2003.

     The decrease in loans was due to loan repayments resulting from the successful completion of several large construction projects by existing borrowers. In addition, the decrease in loans was due to a corporate commitment to tighter credit standards and pricing disciplines applied to commercial and commercial real estate loans to protect long-term profitability. During the first quarter of 2004, management has implemented a more aggressive loan pricing structure in efforts to increase loan volume. Set forth below are other highlights of the loan portfolio.

•		Commercial loans decreased $12.8 million to $191.1 million as of March 31, 2004 from $203.9 million as of December 31, 2003, a decrease of 6.3% for the reasons indicated above.
•		Commercial real estate loans decreased 0.2% from December 31, 2003 compared to March 31, 2004. The Company has added lending personnel to assist in the growth in this category on which the Company maintains a primary focus.
•		Agricultural loans increased $7.0 million, or 12.0% as of March 31, 2004 compared to December 31, 2003.
•		Consumer real estate loans increased $1.9 million as of March 31, 2004 compared to December 31, 2003.
•		Most consumer residential mortgage loans the Company originates are sold in the secondary market. At any point in time, loans will be at various stages of the mortgage banking process. Included as part of consumer real estate loans are loans held for sale. The carrying value of these loans approximated their market value at that time.

     The Company attempts to balance the types of loans in its portfolio with the objective of reducing risk. Some of the risks the Company attempts to reduce include:

•

The primary risks associated with commercial loans are the quality of the borrower’s management, financial strength and cash flow resources, and the impact of local economic

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		factors.
•		Risks associated with real estate loans include concentrations of loans in a certain loan type, such as commercial or residential, and fluctuating land and property values.
•		Consumer loans also have risks associated with concentrations of loans in a single type of loan, as well as the risk a borrower may become unemployed as a result of deteriorating economic conditions.

Allowance for Loan Losses

     Allowance for loan losses has been established to provide for those loans that may not be repaid in their entirety for a variety of reasons. The allowance is maintained at a level considered by management to be adequate to provide for probable incurred losses. The allowance is increased by provisions charged to earnings and is reduced by chargeoffs, net of recoveries. The provision for loan losses is based upon past loan loss experience and management’s evaluation of the loan portfolio under current economic conditions. Loans are charged to the allowance for loan losses when, and to the extent, they are deemed by management to be uncollectible. The allowance for loan losses is composed of allocations for specific loans and a historical portion for all other loans.

     Following is a summary of changes in the allowance for loan losses for the three months ended March 31:

(1)Adjustment made following the March 26, 2003 receipt of $13.3 million of proceeds relating to the sale of certain loans, of which $12.5 million was applied to outstanding principal, $750,000 to the letter of credit, and $67,000 applied to interest income and late charges. See Note 10.

     The Company recognizes that credit losses will be experienced and the risk of loss will vary with, among other things, general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan; and in the case of a collateralized loan, the quality of the collateral for such loan. The allowance for loan losses represents the Company’s estimate of the amount needed necessary to provide for probable incurred losses in the portfolio. In making this determination, the Company analyzes the ultimate collectibility of the loans in its portfolio by incorporating feedback provided by internal loan staff, an independent loan review personnel, and information provided by examinations performed by regulatory agencies. The Company makes an ongoing evaluation as to the adequacy of the allowance for loan losses.

     On a quarterly basis, management of the Banks meets to review the adequacy of the allowance for loan losses. Each loan officer grades these individual commercial credits. The

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Company’s independent loan review personnel reviews the officers’ grades. In the event that the loan downgraded during this review, the loan is included in the allowance analysis at the lower grade. The grading system is in compliance with the regulatory classifications, and the allowance is allocated to the loans based on the regulatory grading, except in instances where there are known differences (e.g. collateral value is nominal).

     The allowance for loan losses represents management’s estimate of probable credit losses in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.

     The allowance for loan losses consists of an allocated component and an unallocated component. The components of the allowance represent an estimation pursuant to either Statement of Financial Accounting Standards No. (“SFAS”) 5, Accounting for Contingencies, or SFAS 114, Accounting by Creditors for Impairment of a Loan. The allocated component of the allowance for loan losses reflects expected losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on regular analyses of all loans over a fixed-dollar amount where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The Company’s historical loss experience is updated quarterly. The allocated component of the allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume, and other qualitative factors.

     There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. The process for determining the allowance (which management believes adequately considers all of the potential factors which potentially result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for credit losses could be required that could adversely affect earnings or financial position in future periods.

     The Company’s provision for loan losses was $756,000 for the first quarter of 2004 compared to $990,000 for the similar period in 2003.

     The allowance for loan losses as a percentage of total loans was 1.48% as of March 31, 2004 and 1.45% at December 31, 2003.

Nonaccrual and Nonperforming Loans

     Nonaccrual loans decreased $935,000 to $14.7 million at March 31, 2004 from $15.7 million at December 31, 2003.

     Nonperforming loans include nonaccrual loans and accruing loans which are 90 days or more delinquent. Typically, these loans have adequate collateral protection or personal guaranties to

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provide a source of repayment to the bank. Nonperforming loans were $14.7 million at March 31, 2004 compared to $15.7 million at December 31, 2003.

     The following table sets forth information on the Company’s nonperforming loans and other nonperforming assets as of the indicated dates.

     The Company utilizes an internal asset classification system as a means of reporting problem and potential problem assets. At each scheduled Bank Board of Directors meeting, a watch list is presented, showing significant loan relationships listed as Special Mention, Substandard, and Doubtful. An asset is classified Substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or the collateral pledged, if any. Assets classified as Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Assets classified as Loss are those considered uncollectible and viewed as non-bankable assets and have been charged off. Assets that do not currently expose the Company to sufficient risk to warrant classification in one of the aforementioned categories, but possess weaknesses that may or may not be within the control of the customer, are deemed to be Special Mention.

     The Company’s determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Banks’ primary regulators in the course of its regulatory examinations, which can order the establishment of additional general or specific loss allowances. There can be no assurance that regulators, in reviewing the Company’s loan portfolio, will not request the Company to materially increase its allowance for loan losses. Although management believes that adequate specific and general loan loss allowances have been established, actual losses are dependent upon future events and, as such, further additions to the level of specific and general loan loss allowances may become necessary.

     Other real estate owned was $7.0 million at March 31, 2004, an increase of $34,000 compared to $6.9 million at December 31, 2003. Included in other real estate owned is one property totaling $6.5 million. The fair market value of this property was determined by a recent appraisal of the real property. This property is a townhouse development for which the borrower ceased construction activities on the project and a construction manager has been appointed. The Company will continue

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the development and has engaged a well established construction contractor to complete the development in the next two years. The contractor has been approved by the local village and has commenced marketing and construction. There are 101 townhouse units to be built, and the Company expects full retirement of its outstanding other real estate owned amount.

     Potential problem loans are loans included on the watch list presented to the Board of Directors that do not meet the definition of a nonperforming loan, but where known information about possible credit problems of borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present loan repayment terms. At March 31, 2004, special mention, substandard, and doubtful classifications were $17.4 million, $41.9 million, and $1.1 million, respectively, compared to $12.7 million, $48.6 million, and $2.7 million, respectively, at December 31, 2003. Total classifications include those loans that have been adversely classified by bank examiners and the Company’s internal loan review department. The Company’s allowance for loan losses is considered by management to be adequate at March 31, 2004.

Securities

     The Company manages, via a centralized portfolio management department, its securities portfolio to provide a source of both liquidity and earnings. Each Bank has its own asset/liability committee, which develops current investment policies based upon its operating needs and market circumstances. The investment policy of each Bank is reviewed by senior financial management of the Company in terms of its objectives, investment guidelines and consistency with overall Company performance and risk management goals. Each Bank’s investment policy is formally reviewed and approved annually by its board of directors. The asset/liability committee of each Bank is responsible for reporting and monitoring compliance with the investment policy. Reports are provided to each Bank’s board of directors and the Board of Directors of the Company on a regular basis.

     Securities available-for-sale are carried at fair value, with related unrealized net gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital. At March 31, 2004, unrealized losses, net of taxes on securities available-for-sale, were $18.7 million compared to $15.8 million at December 31, 2003. The increase in net unrealized losses on securities available-for-sale resulted in a $2.8 million decrease in book equity. The Company has entered into futures contracts as a means to reduce market risk and partially offset further declines in book equity attributable to increases in interest rates. In 2004, the Company entered into 3,000 U.S. Treasury 10 year note futures contracts with a notional value of $300.0 million and a delivery date of June 2004. The Company sold these contracts in order to hedge a group of U.S. Agency notes held in its available-for-sale portfolio. The Company’s objective was to offset changes in the market value of the U.S. Agency notes with changes in the fair market value of the futures contracts, thereby reducing interest rate risk. See Note 7 to the notes to the unaudited consolidated financial statements.

     During the first quarter of 2004, the Company held $197.0 million in cash equivalents, which earned, on average, 94 basis points. Consistent with the investment strategy adopted during 2003, the Company further reduced its holdings in mortgage-backed securities by $45.6 million during the first quarter of 2004. As yields remained at historic lows during the quarter, the Company liquidated another $195.9 million of securities to record gains at current market levels and planned on reinvesting in shorter duration securities and higher yielding loans. The anticipated increase in interest rates did not occur by quarter-end, and the Company decided to invest cautiously under current market conditions to protect its longer-term profitability and reduce any adverse impact of any mark-to-market adjustments on its capital base in the future.

     Securities available-for-sale decreased to $589.2 million at March 31, 2004 from

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$796.1 million at December 31, 2003:

•		U.S. government agency mortgage-backed securities decreased 52.2%, or $90.0 million, from $172.4 million at December 31, 2003 to $82.4 million at March 31, 2004.
•		Equity securities decreased $50.7 million from $159.4 million at December 31, 2003 to $108.7 million at March 31, 2004. Equity securities included capital securities of United States Agencies and the Federal Home Loan Bank as well as Federal Reserve Bank stock at March 31, 2004.
•		Obligations of state and political subdivisions decreased $32.0 million to $3.1 million at March 31, 2004 from $35.1 million at December 31, 2003.
•		Other bonds decreased $75.0 million to $20.6 million at March 31, 2004 compared to $95.6 million at December 31, 2003. Other bonds include high grade corporate bonds primarily issued by financial institutions.

     Securities held-to-maturity increased $44.6 million, or 79.5%, from $56.1 million at December 31, 2003 to $100.6 million at March 31, 2004.

     There were no trading account securities held at March 31, 2004 or December 31, 2003. The Company holds trading account securities and derivatives on a short-term basis based on market and liquidity conditions.

Other Assets

     The Company’s investment in bank-owned life insurance (“BOLI”) increased by $463,000 due to the increase in the cash surrender value of the insurance. The BOLI is intended to provide funding for future employee benefit expense.

Deposits and Borrowed Funds

     Total deposits of $1.6 billion at March 31, 2004 represented a decrease of $12.5 million, or 0.8%, from December 31, 2003. Non-interest-bearing deposits were $155.1 million at March 31, 2004, approximately $5.6 million lower than the $160.7 million level at December 31, 2003. Over the same period, interest-bearing deposits decreased 0.5%, or $6.9 million.

     Core deposits, excluding certificates of deposits under $100,000, increased $2.7 million to $710.8 million at March 31, 2004 from $708.1 million at December 31, 2003. Certificates of deposit under $100,000 increased $26.1 million from December 31, 2003 to $765.5 million at March 31, 2004. Certificates of deposit over $100,000 and public funds decreased $41.3 million from December 31, 2003 to $97.6 million at March 31, 2004. The majority of the decrease was a result of maturities of brokered certificates of deposit and public fund which were not core deposits and were allowed to run-off. The Company’s marketing efforts focused on core and time deposit account growth in its retail markets, reducing the need to rely on public funds and brokered certificates of deposit.

     The Company’s membership in the Federal Home Loan Bank System gives it the ability to borrow funds from the Federal Home Loan Bank of Chicago for short- or long-term purposes under a variety of programs. The advances were used to fund growth and permit the Company’s bank subsidiaries to extend term maturities, reduce funding costs and manage interest rate risk exposures more effectively.

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     Federal Home Loan Bank advances were $256.1 million at March 31, 2004 and $253.5 million at December 31, 2003. The Company has converted $137.5 million of its FHLB advances from fixed rate debt to floating rate through interest rate swap transactions in during 2003. These swap transactions resulted in a $762,000 decrease in interest expense for the three months ended March 31, 2004. The weighted average rate for FHLB advances was 3.94% at March 31, 2004, with a range of maturities on such advances between one and ten years.

     Borrowed funds at March 31, 2004 and December 31, 2003 are listed below:

     The Company entered into a new credit agreement on April 8, 2004 with a correspondent bank, which provides the Company with a revolving line of credit with a maximum availability of $25.0 million. The Company has not yet drawn on this line of credit. This revolving line of credit matures on April 7, 2005.

     The Company also utilizes securities sold under repurchase agreements as a source of funds. Most local municipalities and some other organizations must have funds insured or collateralized as a matter of their own policies. Repurchase agreements provide a source of funds and do not increase the Company’s reserve requirement. Although the balance of repurchase agreements is subject to variation, particularly seasonal variation, the account relationships represented by these balances are principally local and have been maintained for relatively long periods of time. The Company had $203.1 million in securities sold under repurchase agreements at March 31, 2004 compared to $202.7 at December 31, 2003. The Company had no federal funds purchased at March 31, 2004 and December 31, 2003.

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Capital Resources

          Stockholders’ equity decreased $38,000 from December 31, 2003 to $143.0 million at March 31, 2004. Total capital to average risk-weighted assets decreased to 14.4% on March 31, 2004 from 14.7% on December 31, 2003. The Company issued 1,599,088 shares of common stock due to the acquisition of BFFC in 2003. The purchase price for that acquisition totaled $32.0 million.

          The Company and its two subsidiary banks are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings and other factors, and the regulators can lower classifications in certain areas. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.

          The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and plans for capital restoration are required.

          Each of the Banks were categorized as well capitalized as of March 31, 2004. Management is not aware of any conditions or events since the most recent regulatory notification that would change the Company’s or the Banks’ categories.

          Capital levels and minimum required levels (dollars in thousands):

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