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 [   ]

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

     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

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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 JUNE 30, 2004 AND 2003

See accompanying notes to unaudited consolidated financial statements.

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MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
SIX MONTHS ENDED JUNE 30, 2004 AND 2003

See accompanying notes to unaudited consolidated financial statements.

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MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited)
SIX MONTHS ENDED JUNE 30, 2004 AND 2003

See accompanying notes to unaudited consolidated financial statements.

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MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
SIX MONTHS ENDED JUNE 30, 2004 AND 2003

See accompanying notes to unaudited consolidated financial statements.

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MIDWEST BANC HOLDINGS, INC.

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 six months ended June 30, 2004 are not necessarily indicative of the results expected for the full year ending December 31, 2004.

NOTE 2 – BUSINESS COMBINATION AND MERGER TERMINATION

     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 six months ended June 30, 2004 and the year ended December 31, 2003 (in thousands):

NOTE 4 – EARNINGS PER SHARE

     For purposes of per share calculations, the Company had 17,896,832 and 17,799,968 shares of common stock outstanding at June 30, 2004 and 2003, respectively. Basic earnings per share for the three months and six months ended June 30, 2004 and 2003 were computed by dividing net income by the weighted average number of shares outstanding. Diluted earnings per share for the three and six months ended June 30, 2004 and 2003 were computed by dividing net income by the weighted average number of shares outstanding, adjusted for the dilutive effect of stock options. Computations for basic and diluted earnings per share are provided below.

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     All outstanding options were included in the computation of diluted earnings per share for the quarters and six months ended June 30, 2004 and 2003.

NOTE 5 – STOCK OPTIONS

     During the first six months of 2004, 35,626 stock options exercised. The total stock options outstanding were 1,040,918 at June 30, 2004 with exercise prices ranging between $5.42 and $18.34 and expiration dates between 2006 and 2013.

     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” for three and six months ended June 30, 2004 and 2003.

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NOTE 6 – ISSUANCE OF TRUST PREFERRED SECURITIES

     The following table details the four trusts formed by the Company:

     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.

     FIN No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (Revised December 2003) (“FIN 46”). 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 deconsolidate 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 trust previously formed. The deconsolidation did not have an impact on stockholders’ equity or net income.

     The Federal Reserve Board issued a proposed rule on May 6, 2004 that would retain trust preferred securities in the Tier 1 capital of bank holding companies. After a three-year transition, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25 percent of Tier 1 capital elements – net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions. Comments on the proposed rule were due to the Federal Reserve by July 11, 2004.

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NOTE 7 — DERIVATIVE INSTRUMENTS

     As of June 30, 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 June 30 are as follows:

     The Company has also bought and sold various put and call options with terms approximating 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 June 30 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 September 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 and six months ending June 30, 2004, the change in the market values resulted in a net loss of $1.1 million and $2.8 million, respectively, which was recorded in net gains on securities transactions. Gains or losses for fair value hedges occur when changes in the market value of the hedged items are not identical to changes in the market value of hedge instruments during the reporting period. The hedging relationship is assessed to be highly effective, that is, there is a high correlation between the hedge instruments and hedged items.

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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 June 30, 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. 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 June 30, 2004 commitments to extend credit included $25,979,000 of fixed rate loan commitments. These commitments are due to expire within 30 to 90 days of issuance and have rates ranging primarily from 3.99% to 6.79%. Substantially all of the unused lines of credit are at adjustable rates of interest.

     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.

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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 (the “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. These changes caused the Company to restate its September 30, 2002 financial statements.

     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, which was dated August 1, 2003, 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 on March 11, 2004 a revised written agreement from the Federal Reserve and the OBRE. 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 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.

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     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, which was completed in April 2004. A written report was received during the quarter, and the Board and management noted that progress was noted in many of the areas addressed in the previous examination.

     The Securities and Exchange Commission has opened an inquiry in connection with the Company’s restatement of its September 30, 2002 financial statements. 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.

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     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.

     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 and Six Months
Ended June 30, 2004 and 2003

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

•

Consolidated net income for the second quarter of 2004 was $3.2 million, a 59.1% decrease when compared to $7.8 million for the second quarter of 2003.

•

Basic earnings per share for the three months ended June 30, 2004 were $0.18 or 59.1% lower than for the comparable period in 2003.

•

Diluted earnings per share for the three months ended June 30, 2004 were $0.17 or 60.5% lower than for the comparable period in 2003.

•

The return on average assets for the three months ended June 30, 2004 was 0.56%

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compared to 1.40% for the similar period in 2003.

•

The return on average equity for the three months ended June 30, 2004 was 9.10% compared to 19.63% for the similar period in 2003.

•

Net interest income decreased 11.7% to $13.1 million in the second quarter of 2004 compared to $14.8 million in the second quarter of 2003.

•

Excluding gains on securities, other income decreased 25.9% to $3.9 million in the second quarter of 2004 compared to $5.2 million in the second quarter of 2003.

•

Other expenses increased 7.1% to $11.4 million in the second quarter of 2004 compared to $10.7 million in the second quarter of 2003.

     Set forth below are some highlights of the six months ended June 30, 2004 results compared to the six months ended June 30, 2003.

•

Consolidated net income for the six months ended June 30, 2004 was $8.0 million, a 43.5% decrease when compared to $14.2 million for the second quarter of 2003.

•

Basic earnings per share for the six months ended June 30, 2004 were $0.45 or 43.8% lower than for the comparable period in 2003.

•

Diluted earnings per share for the six months ended June 30, 2004 were $0.44 or 43.6% lower than for the comparable period in 2003.

•

The return on average assets for the six months ended June 30, 2004 was 0.71% compared to 1.29% for the similar period in 2003.

•

The return on average equity for the six months ended June 30, 2004 was 11.30% compared to 18.71% for the similar period in 2003.

•

Net interest income decreased 14.3% to $27.3 million in the first half of 2004 compared to $31.8 million in the first half of 2003.

•

Excluding gains on securities, other income decreased 46.1% to $5.0 million in the first half of 2004 compared to $9.2 million in the first half of 2003.

•

Other expenses increased 4.8% to $22.5 million in the first six months of 2004 compared to $21.5 million in the first six months 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 $13.1 million and $14.8 million during the three months ended June 30, 2004 and 2003, respectively, a decrease of $1.7 million, or 11.7%. During the six months ended June 30,

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2004, net interest income decreased $4.5 million or 14.3% to $27.3 million compared to $31.8 million for the similar period in 2003. The Company’s net interest margin (tax equivalent net interest income as a percentage of earning assets) was 2.61% for the three months ended June 30, 2004 compared to 3.03% for the comparable period in 2003. Due to the timing of repositioning its earning assets, the margin declined from 2.84% at March 31, 2004. During the period of April 1, 2004 through May 17, 2004, market yields on maturing terms preferred by the Company at this juncture increased approximately 100 basis points. Repositioning occurred after that increase. During the six months ended June 30, 2004, the net interest margin was 2.73% compared to 3.24% for the similar period in 2003.

     Yields on earning assets decreased 10.3% to 4.88% during the second quarter of 2004 compared to 5.44% for the second quarter of 2003. During the first six months of 2004, yields on earning assets decreased to 4.98%, or 12.6%, from 5.70% for the similar period in 2003. Average earning assets decrease by $7.7 million for the three months ended June 30, 2004; however, they increased $17.8 million for the six months ended June 30, 2004 from the six months ended June 30, 2003. During the first half of 2004, the Company held $157.0 million in cash equivalents, which earned, on average, 99 basis points. During the second quarter of 2004, management elected to invest cash equivalent holdings after the fixed income markets and the Federal Reserve adjusted interest rates to levels more consistent with the generally rising nominal interest rate environment that management expected. Had the market and central bank adjustments occurred at the beginning of the quarter with cash equivalents invested at levels consistent with the prior year, earning asset yields would have been 5.07% and the net interest margin would have been 2.88% for the quarter ended June 30, 2004. The Company did increase its loans and securities by reducing its cash equivalents. However, a significant portion of this activity was completed near quarter-end and the increase in net interest income is expected to be realized in future quarters.

     The average loan yield was 6.00% during the second quarter of 2004, a decrease of 8.0% from 6.52% during the comparable period in 2003. For the six months ended June 30, 2004, the average loan yield was 6.08%, a decrease of 8.2% from 6.62% during the comparable period in 2003. Average loan balances decreased $5.8 million, or 0.5%, to $1.1 billion during the second quarter of 2004 compared to the similar period in 2003. During the first six months of 2004, average loan balances decreased $74.3 million, or 6.4%, to $1.1 billion compared to the similar period of 2003. The Company purchased $30.2 million in fixed rate mortgages at an average yield of 4.61% in June 2004 to offset loans paid off during the year. Previously, the Company discussed its more aggressive loan pricing strategies which have aided the realized growth in loans and unfunded commitments. These pricing strategies remain in place and additional high-quality lending opportunities will be pursued.

     Yields on securities were 4.24% during the second quarter of 2004, a slight decrease from 4.28% during the comparable period in 2003. During the six months ended June 30, 2004, securities yields decreased 3.0% to 4.46% from 4.60% in the comparable period in 2003. Consistent with the investment strategy adopted during 2003, the Company further reduced its holdings in mortgage-backed securities by $49.7 million during the first and second quarters of 2004.

     The decrease in yields on earning assets was partially offset by a decrease in rates paid on deposits and borrowings. Average rates paid on deposits decreased 10.7% to 2.00% for the three months ended June 30, 2004 from 2.24% for the comparable period in 2003. For the first six months of 2004, average rates paid on deposits decreased 12.3% to 2.00% from 2.28% for the similar period of 2003. Average rates paid on borrowings were 3.60% for the second quarter of 2004 compared to 3.92% for the second quarter of 2003. During the six months ended June 30, 2004, average rates paid on borrowings were 3.66% compared to 3.92% for the similar period in 2003.

     The Company anticipates a moderate improvement in net interest margin as the second half of the year progresses. Primary factors include the redeployment of its short-term securities position, higher loan volumes, and continued benefit of interest rate swaps related to high interest rate FHLB advances. Rising interest rates would have a nominal but beneficial impact on the net interest margin.

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     The quarter-to-date net interest margin calculation for June 30, 2004 and 2003 is shown below (interest income and average rate on non-taxable securities and loans are reflected on a tax equivalent basis, assuming a 35% federal tax rate for 2004 and 2003 and adjusted for the dividend received deduction where applicable):

(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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     The year-to-date net interest margin calculation for June 30, 2004 and 2003 is shown below (interest income and average rate on non-taxable securities and loans are reflected on a tax equivalent basis, assuming a 35% federal tax rate for 2004 and 2003 and adjusted for the dividend received deduction where applicable):