BAYLAKE CORP - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

{X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004
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OR

{ } TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from to
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Commission file number 0-8679
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BAYLAKE CORP.
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(Exact name of registrant as specified in its charter)

Wisconsin 39-1268055
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(State or other jurisdiction of incorporation (Identification No.)
or organization)

217 North Fourth Avenue, Sturgeon Bay, WI 54235
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(Address of principal executive offices) (Zip Code)

(920)-743-5551
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(Registrant's telephone number, including area code)

None
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(Former name, former address and former fiscal year, if changed since last
report)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for 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 check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).

Yes X No
--- ---

Applicable Only to Corporate Issuers:

Number of outstanding shares of each of common stock, par value $5.00 per share,
as of August 12, 2004: 7,653,277 shares

BAYLAKE CORP. AND SUBSIDIARIES

INDEX

2

PART 1 - FINANCIAL INFORMATION

BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEET (UNAUDITED)
(dollars in thousands)

3

Junior subordinated debentures issued to
unconsolidated subsidiary trust 16,598 16,598
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Total liabilities 936,931 905,610
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STOCKHOLDERS' EQUITY

Common stock, $5 par value: authorized
50,000,000 shares; issued 7,676,436 shares as of
June 30, 2004 and 7,628,135 as of December 31, 2003;
outstanding 7,653,277 as of June 30, 2004 and
7,604,976 as of December 31, 2003 38,382 38,141
Additional paid-in capital 8,511 8,163
Retained earnings 24,217 21,864
Treasury Stock (625) (625)
Net unrealized gain (loss) on securities available
for sale, net of tax of ($190) as of June 30,
2004 and $1,094 as of December 31, 2003 (230) 2,085
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Total stockholders' equity 70,255 69,628
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Total liabilities and stockholders' equity $ 1,007,186 $ 975,238
============= =============

4

BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(dollars in thousands, except per share amounts)

5

Net Income $ 2,593 $ 1,867 $ 4,489 $ 3,693
============= ============= ============= =============

Basic earnings per common share (1) $ 0.34 $ 0.25 $ 0.59 $ 0.49
Diluted earnings per common share (1) $ 0.33 $ 0.24 $ 0.58 $ 0.48
Cash dividends per share $ 0.14 $ 0.13 $ 0.28 $ 0.26

(1) Based on 7,625,818 average shares outstanding in 2004 and 7,506,591 in 2003.

6

BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (UNAUDITED)
(dollars in thousands)

7

BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASHFLOWS (UNAUDITED)
(dollars in thousands)

9

BAYLAKE CORP. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2004

1. The accompanying consolidated financial statements should be read in
conjunction with Baylake Corp.'s 2003 annual report on Form 10-K. The
accompanying consolidated financial statements are unaudited. In the
opinion of management, the unaudited financial information included in
this report reflects all adjustments, consisting only of normal
recurring accruals, which are necessary for a fair statement of the
financial position as of June 30, 2004 and December 31, 2003. The
results of operations for the three and six months ended June 30, 2004
and 2003 are not necessarily indicative of results to be expected for
the entire year.

2. The book value of investment securities, by type, held by Baylake Corp.
are as follows:

3. At June 30, 2004 and December 31, 2003, loans were as follows:

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4. Baylake Corp. declared a cash dividend of $0.14 per share payable on
June 15, 2004 to shareholders of record as of June 1, 2004.

5. Diluted earnings per share, which reflects the potential dilution that
could occur if outstanding stock options were exercised and stock
awards were fully vested and resulted in the issuance of common stock
that then shared in the earnings of the Company, is computed by
dividing net income by weighted average number of common shares and
common stock equivalents. The following table shows the computation of
the basic and diluted earnings per share for the six months ended June
30 (dollars in thousands, except per share amounts):

6. The Company has a non-qualified stock option plan, which is described
more fully in the Company's December 31, 2003 Annual Report on Form
10-K. The Company accounts for this plan under the recognition and
measurement principles of APB Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations. No stock-based
employee compensation cost is reflected in net income, as all options
granted under these plans had an exercise price at least equal to the
fair market value of the underlying common stock on the grant date. The
following table illustrates the effect on net income and earnings per
share if the Company had applied the fair value provisions of SFAS 123
"Accounting for Stock-Based Compensation," to stock-based employee
compensation.

11

PART 1 - FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

General

The following sets forth management's discussion and analysis of the
consolidated financial condition and results of operations of Baylake Corp.
("Baylake" or the "Company") for the three and six months ended June 30, 2004
and 2003 which may not be otherwise apparent from the consolidated financial
statements included in this report. Unless otherwise stated, the "Company" or
"Baylake" refers to this entity and to its subsidiaries on a consolidated basis
when the context indicates. For a more complete understanding, this discussion
and analysis should be read in conjunction with the financial statements,
related notes, the selected financial data and the statistical information
presented elsewhere in this report.

In 1998, the Company acquired Evergreen Bank, N.A. ("Evergreen"), which was
later merged into Baylake Bank. In the acquisition as a result of Evergreen's
capital regulatory condition, the Company was required to contribute capital to
Evergreen, but no payment to the seller of Evergreen was made by the Company and
no payments are presently due. However, the Company is obligated for certain
contingent payments that may become payable in the future, not to exceed $2
million. Such contingent payments are not accrued at June 30, 2004, since that
amount, if any, is not estimable.

Forward-Looking Information

This discussion and analysis of financial condition and results of operations,
and other sections of this report, may contain forward-looking statements that
are based on the current expectations of management. Such expressions of
expectations are not historical in nature and are forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995.
Words such as "anticipates," "believes," "estimates," "expects," "forecasts,"
"intends," "is likely," "plans," "projects," and other such words are intended
to identify in such forward-looking statements. The statements contained herein
and in such forward-looking statements involve or may involve certain
assumptions, risks and uncertainties, many of which are beyond the control of
the Company, that may cause actual future results to differ materially from what
may be expressed or forecasted in such forward-looking statements. Readers
should not place undue expectations on any forward-looking statements. In
addition to the assumptions and other factors referenced specifically in
connection with such statements, the following factors could impact the business
and financial prospects of the relationships; demand for financial products and
financial services; the degree of competition by traditional and non-traditional
financial services competitors; changes in banking legislation or regulations;
changes in tax laws and the results of recent Wisconsin state tax developments;
changes in interest rates; changes in prices; the impact of technological
advances; governmental and regulatory policy changes; trends in customer
behavior as well as their ability to repay loans; and changes in the general
economic conditions, nationally or in the State of Wisconsin.

Critical Accounting Policies

In the course of the Company's normal business activity, management must select
and apply many accounting policies and methodologies that lead to the financial
results presented in the consolidated financial statements of the Company. Some
of these policies are more critical than others.

Allowance for Loan Losses: Management considers the accounting policy relating
to the allowance for loan losses to be a critical accounting policy because of
the uncertainty and subjectivity inherent in estimating the levels of allowance
needed to cover probable credit losses within the loan portfolio and the

12

material effect that these estimates can have on the Company's results of
operations. While management's evaluation of the allowance for loan losses as of
June 30, 2004 considers the allowance to be adequate, under adversely different
conditions or assumptions, the Company would need to increase the allowance. In
addition, the assumptions and estimates used in the internal reviews of the
Company's non-performing loans and potential problem loans, as well as the
associated evaluation of the related collateral coverage for these loans, has a
significant impact on the overall analysis of the adequacy of the allowance for
loan losses. Though management has concluded that the current evaluation of
collateral values is reasonable under the circumstances, if collateral
evaluation were significantly lowered, the Company's allowance for loan losses
policy would also require making additional provisions for loan losses.

Management reviews the adequacy of the Allowance for Loan Losses ("allowance" or
"ALL") on a quarterly basis to determine whether, in management's estimate, the
allowance is adequate to provide for possible losses inherent in the loan
portfolio as of the balance sheet date. Management's evaluation of the adequacy
of the ALL is based primarily on management's periodic assessment and grading of
the loan portfolio as described below. Additional factors considered by
management include the consideration of past loan loss experience, trends in
past due and non-performing loans, risk characteristics of the various
classifications of loans, current economic conditions, the fair value of
underlying collateral, and other regulatory or legal issues that could affect
credit losses.

Loans are initially graded when originated. They are re-graded as they are
renewed, when there is a loan to the same borrower, when identified facts
demonstrate heightened risk of nonpayment, or if they become delinquent. The
loan review, or, grading process attempts to identify and measure problem and
watch list loans. Problem loans are those loans that management determines have
a higher than average risk for default, with workout and/or legal action
probable within one year. These loans are reported at least quarterly to the
directors' loan committee and reviewed at the officers' loan committee for
action to be taken. Watch list loans are those loans considered as having
weakness detected in either character, capacity to repay or balance sheet
concerns and prompt management to take corrective action at the earliest
opportunity. Problem and watch list loans generally exhibit one or more of the
following characteristics:

1. Adverse financial trends and condition

2. Decline in the entire industry

3. Managerial problems

4. Customer's failure to provide financial information or other collateral
documentation

5. Repeated delinquency, overdrafts or renewals

Every significant problem credit is reviewed by the loan review process and
assessments are performed quarterly to confirm the risk rating, proper
accounting and the adequacy of loan loss reserve assigned. In addition to this
quarterly management review, all problem loans are monitored and evaluated on a
monthly basis by a designated review committee. Depending on the change in
condition, loans may be reassessed concerning allocation of risk, probable
disposition, and potential loss, including changes to the ALL.

After reviewing the gradings in the loan portfolio, management will allocate or
assign a portion of the ALL to categories of loans and individual loans to cover
management's estimate of probable loss. Allocation is related to the grade of
the loan and includes a component resulting from the application of the
measurement criteria of Statements of Financial Accounting Standards No. 114,
"Accounting by Creditors for Impairment of a Loan" ("SFAS 114") and No. 118,
"Accounting by Creditors for Impairment of a Loan-Income Recognition and
Disclosures" ("SFAS 118"). Allocations also are made for unrated loans, such as
credit card loans, based on historical loss experience adjusted for portfolio
activity. The indirect risk in the form of off-balance sheet unfunded
commitments are also taken into consideration. These allocated reserves are
further supplemented by unallocated reserves based on management's estimate
regarding risk of error, local economic conditions and any other relevant
factors. Management then compares the amounts allocated for probable losses to
the current allowance. To the extent that the current allowance is insufficient
to cover management's best estimate of probable losses, management records
additional

13

provision for credit loss. If the allowance is greater than required at that
point in time, provision expense is adjusted accordingly.

Mortgage servicing rights: Another valuation that requires management's judgment
relates to mortgage servicing rights. Essentially, mortgage servicing rights are
established on residential mortgage loans and guaranteed commercial loans that
the Company originate and sell. A portion of the loan's book basis is allocated
to mortgage servicing rights which are retained when a loan is sold, based upon
its relative fair value. The fair value of mortgage servicing rights is the
present value of estimated future net cash flows from the servicing relationship
using current market assumptions for prepayments, servicing costs and other
factors. As the loans are repaid and net servicing revenue is earned, mortgage
servicing rights are amortized against servicing revenue. Net servicing rights
are expected to exceed this amortization expense. However, if the actual
prepayment experience exceeds what was originally anticipated, net servicing
revenues may be less than expected and mortgage servicing rights may be
impaired. This impairment would be recorded as a charge to earnings in the
period in which it became impaired.

Core deposit intangibles: Judgment is used in the valuation of other intangible
assets such as core deposit base intangibles. Core deposit base intangibles
assets of $361,000 have been recorded for core deposits (defined as checking,
money market, savings and time deposits) that have been acquired as a result of
a branch acquisition. The core deposit base intangible assets have been recorded
using the assumption in 2003 that they provide a more favorable source of
funding than more expensive wholesale borrowings. An intangible asset has been
recorded for the present value of the difference between the expected interest
expense to be incurred on these deposits and interest expense that would be
expected if these deposits were replaced by wholesale borrowings, over the
expected lives of the core deposits. The Company currently estimates that the
underlying core deposits have lives of seven years. If future analysis shows
these deposits to have a shorter life, then the Company will write down the
asset by expensing the amount that is impaired.

Goodwill: The Company has goodwill assets on the books as a result of two prior
acquisitions. In July 2001, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standard ("SFAS") No. 142, "Goodwill
and Other Intangible Assets." SFAS No. 142 requires that goodwill and intangible
assets with indefinite lives no longer be amortized, but instead tested for
impairment as least annually. SFAS No. 142 requires that intangible assets with
definite useful lives be amortized over their respective estimated useful lives
to their estimated residual values, and be reviewed for impairment in accordance
with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets."

Those tests inherently involve management's judgment as to factors such as an
estimation of the fair value of a reporting unit; screening for potential
impairment and measuring the amount of the impairment. There was no impairment
of goodwill in 2003 or to date in 2004. In the event of goodwill impairment,
that amount would be charged to earnings in the period in which the impairment
is determined.

Income tax accounting: The assessment of tax assets and liabilities involves the
use of estimates, assumptions, interpretations, and judgments concerning certain
accounting pronouncements and federal and state tax codes. There can be no
assurance that future events, such as court decisions or positions of federal
and state taxing authorities, will not differ from management's current
assessment, the impact of which could be significant to the consolidated results
of the Company's operations and reported earnings. The Company believes that
the tax assets and liabilities are adequate and properly recorded in the
consolidated financial statements. The reserve does not include any specific
reserves relative to any position recently taken by the taxing authorities. See
Section on "Results of Operations-Income Taxes."

Results of Operations

For the three months ended June 30, 2004, earnings increased $726,000, or 38.9%,
to $2.6 million from $1.9 million for the second quarter last year. Basic and
fully diluted earnings per share of $0.34 and $0.33, respectively, were reported
for the quarter ended June 30, 2004 compared to $0.25 and $0.24, respectively,
for the same period last year. For the six months ended June 30, 2004, earnings
increased $796,000, or

14

21.6%, to $4.5 million from $3.7 million for the same period in 2003. Basic and
fully diluted earnings per share of $0.59 and $0.58, respectively, were reported
for the six months ended June 30, 2004 compared to $0.49 and $0.48,
respectively, for the same period last year. The increase in net income for both
the three-month and six-month periods included a gain on sale of bank land
totaling $482,000, which was recognized in the second quarter of 2004.

TABLE 1
SUMMARY RESULTS OF OPERATIONS
($ in Thousands, except per share data)

(1) Noninterest expense divided by sum of taxable equivalent net interest
income plus noninterest income, excluding investment securities gains,
net

The increase in net income for the three-month and six-month periods is
primarily due to increased net interest income and a reduction in the provision
for loan losses. This was offset partially by a decrease in other income and an
increase in other expenses.

Net Interest Income

Net interest income is the largest component of the Company's operating income
(net interest income plus other non-interest income) accounting for 76.3% of
total operating income for the three months ended June 30, 2004, as compared to
72.4% for the same period in 2003. Net interest income represents the difference
between interest earned on loans, investments and other interest earning assets
offset by the interest expense attributable to the deposits and the borrowings
that fund such assets. Interest fluctuations together with changes in the volume
and types of earning assets and interest-bearing liabilities combine to affect
total net interest income. This analysis discusses net interest income on a
tax-equivalent basis in order to provide comparability among the various types
of earned interest income. Tax-exempt interest income is adjusted to a level
that reflects such income as if it were fully taxable.

Net interest income on a tax equivalent basis for the three months ended June
30, 2004 increased $1.4 million, or 19.6%, to $8.6 million from $7.2 million
over the comparable period a year ago. During the six months ended June 30,
2004, net interest income increased $2.4 million, or 16.6%, to $16.7 million
from $14.3 million for the comparable period in 2003.

15

Net interest margin is tax-equivalent net interest income expressed as a
percentage of average earning assets. The net interest margin exceeds the
interest rate spread because of the use of non-interest bearing sources of funds
to fund a portion of earning assets. As a result, the level of funds available
without interest cost (demand deposits and equity capital) is an important
component increasing net interest margin.

The net interest margin for the second quarter of 2004 was 3.76%, up 30 basis
points ("bps") from 3.46% for the comparable period in 2003. This comparable
period increase was attributable to a 38 bps increase in interest rate spread
(the net of a 77 bps reduction in the cost of interest-bearing liabilities
offset partially by a 39 bps reduction in the yield on earning assets) and a 7
bps lower contribution from the net free funds. During the six months ended June
30, 2004, the net interest margin was 3.69% compared to 3.49% for the comparable
period in 2003.

Interest rates were relatively stable and historically low, with one interest
rate decrease of 25 bps between the comparable three-months periods. The Federal
funds rate was 1.00% throughout the second quarter of 2004 versus 1.25%
throughout the same period in 2003. The Company had positioned the balance sheet
to be slightly asset sensitive (which means that assets will re-price faster
than liabilities); thus, the prolonged lower interest rate environment favorably
lowered the cost of funding, but also lowered yields on earning assets, putting
pressure on the net interest margin. In late June 2004, the Federal Reserve
Board increased interest rates for the first time in several years. That
increase was followed by a subsequent increase in August 2004. In gradually
increasing interest rate environment, we would continue to anticipate that our
balance sheet would benefit from asset sensitivity over the long term.

For the three months ended June 30, 2004, average-earning assets increased $86.6
million, or 10.4%, when compared to the same period last year. The Company
recorded an increase in average loans of $39.8 million, or 5.8%, for the second
quarter of 2004 compared to the same period a year ago. For the six months ended
June 30, 2004, average-earning assets increased $83.1 million, or 10.0%, when
compared to the same period last year. The Company recorded an increase in
average loans of $36.9 million, or 5.4%, for the six months ended June 30, 2004
compared to the same period a year earlier. Loans have typically resulted in
higher rates of interest income to the Company than have investment securities.

Interest rate spread is the difference between the tax-equivalent rate earned on
average earning assets and the rate paid on average interest-bearing
liabilities. The interest rate spread increased for the quarter ended June 30,
2004 when compared to the same period a year ago. The interest rate spread
increased 38 bps to 3.57% at June 30, 2004 from 3.19% in the same quarter in
2003. While the average yield on earning assets decreased 39 bps during the
period, the average rate paid on interest-bearing liabilities decreased 77 bps
over the same period. For the six months ended June 30, 2004, the interest rate
spread increased 26 bps to 3.50% from 3.24% for the same period a year earlier.
The average yield on earning assets decreased 50 bps during the six-month
period, while the average rate paid on interest-bearing liabilities decreased 76
bps. The reduction in the rates paid on interest-bearing liabilities occurred as
a result of a lower cost of funding from deposits and other wholesale funding
such as federal funds purchased and loans from the Federal Home Loan Bank. We
would not expect that trend to continue in light of the recent Federal Reserve
Board interest rate increases.

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TABLE 2
NET INTEREST INCOME ANALYSIS ON A TAX-EQUIVALENT BASIS
($ In Thousands)

Three months ended June 30,

17

TABLE 3
NET INTEREST INCOME ANALYSIS ON A TAX -EQUIVALENT BASIS
($ In Thousands)

Six months ended June 30,

18

The ratio of average earning assets to average total assets measures
management's ability to employ overall assets for the production of interest
income. This ratio was 91.7% for the first six months of 2004 and 2003,
respectively.

Provision for Loan Losses

The provision for loan losses ("PFLL") is the periodic cost (not less than
quarterly) of providing an allowance for anticipated future loan losses. In any
accounting period, the PFLL is based on the methodology used and management's
evaluation of the loan portfolio, especially non-performing and other potential
problem loans, taking into consideration many factors, including loan growth,
net charge-offs, changes in the composition of the loan portfolio,
delinquencies, management's evaluation of loan quality, general economic factors
and collateral values.

The Company's loan review department performs a risk rating analysis as an
integral part of the review of each loan portfolio. For the commercial and
commercial real estate portfolios, the risk rating analysis includes a grading
system following a standard risk-rating matrix. Based upon this matrix, the
Company determines a risk rating assignment an appropriate measure to each loan
examined. As a result, the Company has provided $1.5 million in PFLL for the
first six months in 2004.

The PFLL for the first half of 2004 at $1.5 million compares to a PFLL of $1.9
million for the first half in 2003. Net loan charge-offs in the first six months
of 2004 were $578,000 compared with net charge-offs of $450,000 for the same
period in 2003. Net charge-offs as a percentage of average loans is a key
measure of asset quality. Net charge-offs to average loans were 0.16% for the
first six months of 2004 compared to 0.13% for the same period in 2003. The
increase in net charge-offs relates primarily to a $200,000 commercial loan
charge-off stemming from a loan to a business services company. This loan had
been previously been allocated a PFLL in the amount of 80% of the loan amount.
During the period, non-accrual loans remained relatively stable, while
restructured loans decreased significantly, primarily as a result of a $2.7
million credit that has improved in asset quality and transferred to a
performing loan status. Management believes that the current provision conforms
to the Company's loan loss reserve policy and is adequate in view of the present
condition of the Company's loan portfolio. However, a decline in the quality of
our loan portfolio, as a result of general economic conditions, factors
affecting particular borrowers or our market area, or otherwise, could affect
the adequacy of the allowance. If there are significant charge-offs against the
allowance, or we otherwise determine that the allowance is inadequate, we will
need to make higher provisions in the future. See "Risk Management and the
Allowance for Loan Losses" below for more information related to non-performing
loans.

Non-Interest Income

Total non-interest income decreased $69,000, or 2.5% to $2.7 million for the
second quarter of 2004 when compared to the second quarter of 2003. For the six
months ended June 30, 2004, total non-interest income

19

was $4.7 million, a decrease of $731,000, or 13.6%, compared to $5.4 million for
the comparable period in 2003. The non-interest income to average assets ratio
was 1.07% for the three months ended June 30, 2004 compared to 1.21% for the
same period in 2003. For the six months ended June 30, 2004, the non-interest
income to average assets ratio was 0.94% compared to 1.20% for the same period
in 2003. The decrease in non-interest income for the three and six month periods
is mainly due to decreases in loan servicing fee income and gains from sales of
loans substantially offset by the gain recognized on the sale of bank land.

TABLE 4
NONINTEREST INCOME
($ in Thousands)

In the second quarter and the first six months of 2004, loan servicing fees and
gains from sales of loans were affected by a slowdown in refinancing activity
throughout the industry due to higher mortgage rates. In comparison, those
periods in 2003 saw high levels of loan refinancing as a result of the
historically low interest rate environment. Loan servicing fees decreased
$318,000 and gains from sales of loans decreased

20

$349,000 between the comparable quarters of 2004 and 2003. For the six months
ended June 30, 2004, loan servicing fees decreased $442,000 and gains from sales
of loans decreased $561,000 compared to the first six months of 2003. The
decrease was driven primarily by secondary mortgage and commercial loan
production (loan production to be sold to the secondary market) and resultant
sales. As interest rates have increased over the quarter, the Company has seen a
decrease in the number of loan applications. Secondary loan production declined
60.1% between the comparable first six-month periods ($31.7 million in the first
half of 2004 versus $81.1 million in the first half of 2003).

For both the three and six month periods, non-interest income included a gain
recognized on the sale of bank land located in the Green Bay market area and
totaled $482,000. The sale of property occurred as a result of a purchase of
19.2 acres by the Department of Transportation to facilitate its highway
expansion efforts. We do not expect the sale to substantially affect operations
at that location.

Financial service income increased $161,000, or 70.6%, as a result of additional
business generated and aided by stronger financial markets performance. Income
from business owned life insurance ("BOLI") amounted to $392,000 for the first
six months of 2004 compared to $336,000 a year earlier. A $13 million purchase
of BOLI made in the second quarter of 2002 and an additional $4 million purchase
made in the second quarter of 2003 impacted those results.

Revenues generated from the operation of Arborview LLC ("Arborview") (a
subsidiary formed in 2002 to manage a community based residential facility and
sold in the first quarter of 2003) as a result of the sale were $0 and $125,000
for the first six months of 2004 and 2003, respectively. The subsidiary was sold
in February 2003 with a gain on sale amounting to $350,000.

Non-Interest Expense

Non-interest expense increased $433,000, or 7.1%, to $6.5 million for the three
months ended June 30, 2004 compared to the same period in 2003 as indicated in
Table 4. For the six months ended June 30, 2004, total non-interest expense
increased $773,000, or 6.4%, to $12.9 million compared to the same period in
2003. The non-interest expense to average assets ratio was 2.61% for the three
months ended June 30, 2004 compared to 2.69% for the same period in 2003. For
the six months ended June 30, 2004, non-interest expense ratio to average assets
was 2.61% compared to 2.70% for the same period in 2003.

Net overhead expense is total non-interest expense less total non-interest
income excluding securities gains. The net overhead expenses to average assets
ratio was 1.54% for the three months ended June 30, 2004 compared to 1.48% for
the same period in 2003. For the six months ended June 30, 2004, the net
overhead expenses to average assets ratio was 1.66% compared to 1.50% for the
similar period in 2003. The efficiency ratio is total non-interest expense as a
percentage of the sum of net-interest income on a fully taxable equivalent basis
and total non-interest income. The efficiency ratio for the three months ended
June 30, 2004 was 57.63% compared to 61.08% for the same period in 2003. For the
six months ended June 30, 2004, the efficiency ratio was 60.23% compared to
61.35% for the same period in 2003. Efficiency ratio for the three and six month
periods ended June 30, 2004 improved as a result of increased net interest
income.

Salaries and employee benefits showed an increase of $299,000, or 8.2%, to $3.9
million for the second quarter of 2004 compared to the same period in 2003. For
the six months ended June 30, 2004, salary and employee benefits expenses
increased $463,000, or 6.3%, to $7.8 million from $7.3 million for the
comparable period in 2003. The number of full-time equivalent employees was 308
as of June 30, 2004 compared to 298 as of June 30, 2003. For the six months
ended June 30, 2004, salary-related expenses increased $284,000, or 5.5%, due
principally to merit increases between the years. Benefit costs, principally for
health insurance and pension costs, represent the remaining increase in
personnel-related costs. The increase in health insurance costs is expected to
continue for the balance of 2004. Management will continue its efforts to
control salaries and employee benefits expense, although increases in these
expenses are likely to continue in future years.

21

TABLE 5
NONINTEREST EXPENSE
($ in Thousands)

Expenses related to the operation of other real estate owned increased $112,000
to $146,000 for the quarter ended June 30, 2004 compared to the same period in
2003. For the six-month period ended June 30, 2004, other real estate owned
expenses increased $134,000 to $271,000 compared to the same period in 2003.
Included in these expenses were net gains taken on the sale of other real estate
owned amounting to $64,000 for the first six months of 2004 compared to net
gains taken on sale of $11,000 for the same period in 2003. In addition, costs
related to the holding of other real estate owned properties increased $257,000
to $405,000 for the first quarter of 2004.

Income Taxes

Income tax expense for the Company for the six months ended June 30, 2004 was
$2.0 million, an increase of $599,000, or 43.9%, compared to the same period in
2003. The higher tax expense in 2004 reflected the Company's increase in before
tax earnings offset partially by a decrease in tax-exempt interest income.

The Company's effective tax rate (income tax expense divided by income before
taxes) was 30.5% for the six months ended June 30, 2004 compared with 27.0% for
the same period in 2003. The effective tax rate of 30.5% consisted of a federal
effective tax rate of 25.9% and Wisconsin State effective tax rate of 4.6%.

Income tax expense recorded in the consolidated statements of income involves
the interpretation and application of certain accounting pronouncements and
federal and state tax codes, and is, therefore, considered a critical accounting
policy. The Company undergoes examination by varying taxing authorities. Such
taxing authorities may require that changes in the amount of income tax or
valuation allowance be recognized when their interpretations differ from those
of management, based on their judgments about information available to them at
the time of their examinations. The Company has not provided any specific
reserves relative to any positions recently taken by State taxing authorities.
See section titled "Critical Accounting Policies."

22

Income tax expense may be affected by developments in the state of Wisconsin.
Like many financial institutions that are located in Wisconsin, a subsidiary of
the Bank located in the state of Nevada holds and manages various investment
securities. Due to that fact that these subsidiaries are out of state, income
from their operations has not been subject to Wisconsin state taxation. Although
the Wisconsin Department of Revenue issued favorable tax rulings regarding
Nevada subsidiaries of Wisconsin financial institutions, the Department
representatives have recently stated that the Department intends to revoke those
rulings and tax some or all these subsidiaries' income, even though there has
been no intervening change in the law. The Department has also implemented a
program for the audit of Wisconsin financial institutions who have formed and
contributed assets to subsidiaries located in Nevada.

The Department sent letters in late July 2004 to financial institutions in
Wisconsin, whether or not they are undergoing an audit, reporting on settlements
involving 17 banks and their out-of-state investment subsidiaries. The letter
provided a summary of currently available settlement parameters. For periods
before 2004, they include: restrictions on the types of subsidiary income
excluded from Wisconsin taxation; assessment of certain back taxes for a limited
period of time; and interest (but not penalties) on any past-due taxes. Going
forward, including 2004, there are similar provisions plus limits on the amount
of subsidiaries' assets as to which their income will be excluded from Wisconsin
tax. Settlement on the terms outlined would result in the Department's
rescission of related prior letter rulings, and would purport to be binding
going forward except for future legislation or change by mutual agreement. By
implication, the Department appears to accept the general proposition that some
out-of-state investment subsidiary income is not subject to Wisconsin taxes.

At this time, the Department has not audited or made an assessment against the
Company's subsidiaries nor has the Company determined how it intends to respond.
The letter did not provide sufficient detail to permit the Company to assess
what effects the acceptance of such a settlement offer might have upon it, and
the Company does not have sufficient information to determine what the
Department's position would be if an assessment were made and the Bank were to
challenge it. The Company intends to seek that information from the Department
and to evaluate the impact of such a settlement after receiving more specific
detail. The Bank's net income would be reduced if there would be an assessment
against it or it determined to settle. The Bank could also incur costs in the
future to address any action taken against it by the Department.

Balance Sheet Analysis

Loans

At June 30, 2004, total loans increased $28.6 million, or 4.1%, to $724.6
million from $696.0 million at December 31, 2003. Growth in the Company's loan
portfolio resulted primarily from an increase in real estate commercial loans to
$411.0 million at June 30, 2004 compared to $387.8 million at December 31, 2003.
Growth in commercial real estate mortgages and commercial loans occurred
principally as a result of the Company's expansion efforts (primarily in the
Green Bay market) and the strong economic growth existing in that market.

The following table reflects the composition (mix) of the loan portfolio
(dollars in thousands):

23

TABLE 6
LOAN PORTFOLIO ANALYSIS
($ in Thousands)

Risk Management and the Allowance for Loan Losses

The loan portfolio is the Company's primary asset subject to credit risk. To
reflect this credit risk, the Company sets aside an allowance or reserve for
credit losses through periodic charges to earnings. These charges are shown in
the Company's consolidated income statement as provision for loan losses. See
"Provision for Loan Losses" above. Credit risk is managed and monitored through
the use of lending standards, a thorough review of potential borrowers, and an
on-going review of payment performance. Asset quality administration, including
early identification of problem loans and timely resolution of problems, further
enhances management of credit risk and minimization of loan losses. All
specifically identifiable and quantifiable losses are immediately charged off
against the allowance. Charged-off loans are subject to periodic review, and
specific efforts are taken to achieve maximum recovery of principal and
interest.

As the following table indicates, the ALL at June 30, 2004 was $13.1 million
compared with $12.2 million at the end of 2003. Loans increased 4.1% from
December 31, 2003 to June 30, 2004, while the allowance as a percent of total
loans increased due to the loan loss provision being higher in comparison to
loan growth for the first six months of 2004. Based on management's analysis of
the loan portfolio risk at June 30, 2004, a provision expense of $1.5 million
was recorded for the six months ended June 30, 2004, a decrease of $426,000 or
22.1% compared to the same period in 2003. Commercial loans represented 73.5% of
the net charge-offs for the first six months of 2004.

24

TABLE 7
ALLOWANCE FOR LOAN LOSSES AND NONPERFORMING ASSETS
($ in thousands)

While management uses available information to recognize losses on loans, future
adjustments to the ALL may be necessary based on changes in economic conditions
and the impact of such change on the Company's borrowers.

Table 8 shows the amount of the ALL allocated for the time periods indicated to
each loan type as described. It also shows the percentage of balances for each
loan type to total loans. Management continues to target and maintain the ALL
equal to the allocation methodology plus an unallocated portion, as determined
by economic conditions on the Company's borrowers. In general, it would be
expected that those types of loans which have historically more loss associated
with them, will have a proportionally larger amount of the allowance allocated
to them than do loans which have less risk.

Consideration for making such allocations is consistent with the factors
discussed above, and all of the factors are subject to change; thus, the
allocation is not necessarily indicative of the loan categories in which future
loan losses will occur. It would also be expected that the amount allocated for
any particular type of loan will increase or decrease proportionately to both
the changes in the loan balances and to increases or decreases in the estimated
loss in loans of that type. In other words, changes in the risk profile of the
various parts of the loan portfolio should be reflected in the allowance
allocated.

25

TABLE 8
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
($ in thousands)

While there exists probable asset quality problems in the loan portfolio,
management believes sufficient reserves have been provided in the ALL to absorb
probable losses in the loan portfolio at June 30, 2004. Ongoing efforts are
being made to collect these loans, and the Company involves the legal process
when necessary to minimize the risk of further deterioration of these loans for
full collection.

While management uses available information to recognize losses on loans, future
adjustments to the ALL may be necessary based on changes in economic conditions
and the impact of such change on the Company's borrowers. As an integral part of
their examination process, various regulatory agencies also review the Company's
ALL. Such agencies may require that changes in the ALL be recognized when their
credit evaluations differ from those of management, based on their judgments
about information available to them at the time of their examination.

Non-Performing Loans, Potential Problem Loans and Other Real Estate

Management encourages early identification of non-accrual and problem loans in
order to minimize the risk of loss. This is accomplished by monitoring and
reviewing credit policies and procedures on a regular basis.

Non-performing loans remain a leading indicator of future loan loss potential.
Non-performing loans are defined as non-accrual loans, guaranteed loans 90 days
or more past due but still accruing, and restructured loans. Additionally,
whenever management becomes aware of facts or circumstances that may adversely
impact on the collection of principal or interest on loans, it is the practice
of management to place such loans on non-accrual status immediately rather than
waiting until the loans become 90 days past due. The accrual of interest income
is discontinued when a loan becomes 90 days past due as to principal or
interest. When interest accruals are discontinued, interest credited to income
is reversed. If collection is in doubt, cash receipts on non-accrual loans are
used to reduce principal rather than recorded as interest income.

Restructuring loans involve the granting of some concession to the borrower
involving a loan modification, such as payment schedule or interest rate
changes.

As indicated in Table 7, non-performing loans at June 30, 2004 were $13.4
million compared to $16.2 million at December 31, 2003. Impacting the decrease
in non-performing loans was a shift, as a result of foreclosure, of
approximately $1.4 million in loans to other real estate owned during 2004.
Non-accrual loans represented $11.1 million of the total non-performing loans.
Real estate non-accrual loans accounted for $10.0 million of the total, of which
$1.8 million was residential real estate and $8.0 million was commercial real
estate, while commercial and industrial non-accrual loans total $1.0 million.
Management believes collateral is sufficient to offset losses in the event
additional legal action would be warranted to collect these non-accrual loans.
Restructured loans were $2.3 million at June 30, 2004 compared with $5.1 million
at year-end 2003. Of the restructured loans at June 30, 2004, approximately $1.6
million consisted of one commercial credit and conditional loan as to which the
Bank has granted various concessions as a result of the borrowers' past cash
flow problems. This loan credit was 61 days past due at June 30, 2004.
Management has allocated a loan loss provision of $1.3 million. This allocation
relates to the commercial

26

credit of $1.6 million, which is the net amount remaining after a loan
charge-off of $2.6 million in 2003. As a result of the cash flow problems of the
debtor, management is continuing to specially monitor this loan on a monthly
basis and is working with the borrower to minimize any additional loss exposure.
If the loan becomes past due greater than 89 days, this loan may be subject to
further charge-off. As a result the ratio of non-performing loans to total loans
at June 30, 2004 was 1.84% compared to 2.33% at end of year 2003. The Company's
ALL was 97.9% of total non-performing loans at June 30, 2004 compared to 75.0%
at end of year 2003.

As indicated in Table 7, non-performing assets (non-performing loans plus other
real estate owned assets) at June 30, 2004 were $16.0 million compared to $18.5
million at December 31, 2003. Other real estate owned, which represents property
that the Company acquired through foreclosure or in satisfaction of debt,
consisted of ten residential and thirteen commercial properties totaling $2.6
million. Other real estate owned at December 31, 2003 totaled $2.3 million and
consisted of nineteen properties.

Potential problem loans are currently performing loans that management believes
may incur difficulties in complying with loan repayment terms. Management's
decision to place loans in this category does not necessarily mean that the
Company expects to take losses on such loans, but that management needs to be
more vigilant in its efforts to oversee the loans and recognize that a higher
degree of risk is associated with these potential problem loans. At June 30,
2004, potential problem loans amounted to $4.2 million compared to a total of
$5.7 million at December 31, 2003. Of the potential problem loans, $3.9 million
of the problem loans stems from one commercial credit experiencing cash flow
concerns. Various commercial loans totaling $300,000 make up the balance of the
total potential problem loans. With the exceptions of the $3.9 million
commercial credit noted above, potential problem loans are not concentrated in a
particular industry but rather cover a diverse range of businesses. Except as
noted above, management does not presently expect significant losses from
credits in the potential problem loan category.

Investment Portfolio

The investment portfolio is intended to provide the Company with adequate
liquidity, flexibility in asset/liability management and, lastly, its earning
potential.

At June 30, 2004, the investment portfolio (which includes investment securities
available for sale and held to maturity) increased $3.6 million, or 1.8%, to
$199.4 million from $195.8 million at December 31, 2003. At June 30, 2004, the
investment portfolio represented 19.8% of total assets compared with 20.1% at
December 31, 2003.

Securities held to maturity and securities available for sale consist of the
following:

TABLE 9
INVESTMENT SECURITY ANALYSIS
At June 30, 2004
($ in Thousands)

27

At December 31, 2003
($ in Thousands)

At June 30, 2004, the contractual maturities of securities held to maturity and
securities available for sale are as follows:

TABLE 10
INVESTMENT PORTFOLIO MATURITY
($ in Thousands)

28

Deposits

Total deposits at June 30, 2004 decreased $3.7 million, or 0.5%, to $780.0
million from $783.3 million at December 31, 2003. Non-interest bearing deposits
at June 30, 2004 decreased $1.4 million, or 1.3%, to $105.3 million from $106.6
million at December 31, 2003. Interest-bearing deposits at June 30, 2004
decreased $2.3 million, or 0.3%, to $674.4 million from $676.7 million at
December 31, 2003. Interest-bearing transaction accounts (NOW deposits)
decreased $2.1 million, primarily in public fund deposits. Savings deposits
decreased $11.8 million, or 5.8%, to $192.5 million at June 30, 2004, when
compared to $204.3 million at December 31, 2003. Time deposits (including time,
$100,000 and over and other time) increased $11.6 million (includes increase of
$25.0 million in time deposits over $100,000), or 3.1%, to $391.7 million at
June 30, 2004, when compared to $380.1 million at December 31, 2003. Brokered
CD's totaled $126.6 million at June 30, 2004 compared to $97.8 million at
December 31, 2003. Time deposits greater than $100,000 and brokered time
deposits were priced within the framework of the Company's rate structure and
did not materially increase the average rates on deposit liabilities. Although
the use of brokered deposits has increased, Management views these as a stable
source of funds, although they are inherently less stable than locally-generated
deposits. If liquidity concerns arose, the Company has alternative sources of
funds such as lines with correspondent banks and borrowing arrangements with
FHLB should the need present itself. Increased competition for consumer deposits
and customer awareness of interest rates continues to limit the Company's core
deposit growth in these types of deposits. Typically, overall deposits for the
first six months tend to decline slightly as a result of the seasonality of the
Company's customer base as customers draw down deposits during the early first
half of the year in anticipation of the summer tourist season.

Emphasis has been, and will continue to be, placed on generating additional core
deposits in 2004 through competitive pricing of deposit products and through the
branch delivery systems that have already been established. The Company will
also attempt to attract and retain core deposit accounts through new product
offerings and quality customer service. The Company also may increase brokered
time deposits during the remainder of the year 2004 as an additional source of
funds to provide for loan growth in the event that core deposit growth goals
would not be accomplished. Under that scenario, the Company will continue to
look at other wholesale sources of funds, if the brokered CD market became
illiquid or more costly in terms of interest rate.

Short Term Borrowings and Other Borrowings

Short-term borrowings at June 30, 2004 consist of federal funds purchased and
securities under agreements to repurchase. Total short-term borrowings at June
30, 2004 increased $10.2 million to $33.6 million from $23.4 million at December
31, 2003. Federal funds purchased increased from $23.3 million at December 31,
2003 to $32.3 million at June 30, 2004 accounting for the balance of the
increase in the balance of short-term borrowings. These have increased as a
result of growth in the loan portfolio coupled with a decrease in core deposits
during the quarter ended June 30, 2004.

Other borrowings consist of term loans with FHLB. These borrowings totaled
$100.2 million at June 30, 2004 compared to $75.1 million at December 31, 2003.

Typically, short-term borrowings and other borrowings increase in order to fund
growth in the loan portfolio. The Company will borrow monies if borrowing is a
less costly form of funding loans compared to the cost of acquiring deposits or
if deposit growth is not sufficient. Additionally, the availability of deposits
also determines the amount of funds the Company needs to borrow in order to fund
loan demand. In the quarter ended June 30, 2004, borrowings were also required
in view of the decrease in deposits. The Company anticipates it will continue to
use wholesale funding sources of this nature, if these borrowings add
incrementally to overall profitability.

29

Long Term Debt

In connection with the issuance of Trust Preferred Securities in 2001 (see
"Capital Resources"), the Company issued long-term subordinated debentures to
Baylake Capital Trust I, a Delaware Business Trust subsidiary of the Company.
The aggregate principal amount of the debentures due 2031, to the trust
subsidiary is $16,597,940. For additional details, please make reference to the
Consolidated Financial Statements and the accompanying footnotes on the
Company's Form 10-K for the year 2003.

Contractual Obligations, Commitments, Off-Balance Sheet Risk, and Contingent
Liabilities

The Company utilizes a variety of financial instruments in the normal course of
business to meet the financial needs of its customers. These financial
instruments include commitments to extend credit, commitments to originate
residential mortgage loans held for sale, commercial letters of credit, standby
letters of credit, and forward commitments to sell residential mortgage loans.
Please refer to the Company's Annual Report on Form 10-K for the year ended
December 31, 2003 for discussion with respect to the Company's quantitative and
qualitative disclosures about its fixed and determinable contractual
obligations. Items disclosed in Form 10-K have not materially changed since that
report was filed.

The following is a summary of our off-balance sheet commitments, all of which
were lending-related commitments, at June 30:

TABLE 11
LENDING RELATED COMMITMENTS
($ in Thousands)

Liquidity

Liquidity management refers to the ability of the Company to ensure that cash is
available in at timely manner to meet loan demand and depositors' needs, and to
service other liabilities as they become due, without undue cost or risk, and
without causing a disruption to normal operating activities. The Company and the
Bank have different liquidity considerations.

The Company's primary sources of funds are dividends from the Bank, investment
income, and net proceeds from borrowings and the offerings of junior
subordinated obligations, in addition to the issuance of its common stock
securities. The Company manages its liquidity position in order to provide funds
necessary to pay dividends to its shareholders. Dividends received from Bank
totaled $2.2 million for the first six months of 2004 and will continue to be
the Company's main source of long-term liquidity. The dividends from the Bank
along with existing cash were sufficient to pay cash dividends to the Company's
shareholders of $3.2 million in the first six months of 2004.

The Bank meets its cash flow needs by having funding sources available to it to
satisfy the credit needs of customers as well as having available funds to
satisfy deposit withdrawal requests. Liquidity at the Bank is derived from
deposit growth, maturing loans, the maturity of the investment portfolio, access
to other funding sources, marketability of certain of its assets; the ability to
use its loan and investment portfolios as collateral for secured borrowings and
strong capital positions.

30

Maturing investments have been a primary source of liquidity at the Bank. For
the six months ended June 30, 2004, principal payments totaling $17.0 million
were received on investments. $24.7 million in investments were purchased in the
first six months of 2004. This resulted in net cash of $7.7 million used in
investing activities for the first six months of 2004. At June 30, 2004, the
carrying or book value of investment securities maturing within one year
amounted to $7.7 million or 3.8% of the total investment securities portfolio.
This compares to 6.1% level for investment securities with one year or less
maturities as of December 31, 2003. Within the investing activities of the
statement of cash flows, sales and maturities of investment securities during
the first six months of 2004 totaled $17.0 million. At June 30, 2004, the
investment portfolio contained $146.9 million of U.S. Treasury and federal
agency backed securities representing 73.7% of the total investment portfolio.
These securities tend to be highly marketable and had a market value below
amortized cost at June 30, 2004 amounting to $1.8 million.

Deposit growth is typically another source of liquidity for the Bank. As a
financing activity reflected in the June 30, 2004 Consolidated Statements of
Cash Flows, deposits decreased and resulted in $3.7 million of cash outflow
during the first six months of 2004. The Company's overall deposit base
decreased 0.5% for the six months ended June 30, 2004. Deposit growth is the
most stable source of liquidity for the Bank, although brokered deposits are
inherently less stable than locally generated core deposits. Affecting liquidity
are core deposit growth levels, certificate of deposit maturity structure and
retention, and characteristics and diversification of wholesale funding sources
affecting the channels by which brokered deposits are acquired. Conversely,
deposit outflow will cause the Bank to develop alternative sources of funds
which may not be as liquid and potentially a more costly alternative.

The scheduled maturity of loans can provide a source of additional liquidity.
The Bank has $226.3 million, or 31.2%, of loans maturing within one year.
Factors affecting liquidity relative to loans are loan origination volumes, loan
prepayment rates and the maturity structure of existing loans. The Bank's
liquidity position is influenced by changes in interest rates, economic
conditions and competition. Conversely, loan demand as a need for liquidity will
cause the Company to acquire other sources of funding which could be harder to
find; therefore more costly to acquire.

Within the classification of short-term borrowings and other borrowings at June
30, 2004, federal funds purchased and securities sold under agreements to
repurchase totaled $33.6 million compared to $23.4 million at the end of 2003.
Federal funds are purchased from various upstream correspondent banks while
securities sold under agreements to repurchase are obtained from a base of
business customers. Borrowings from FHLB, short-term or term, are another source
of funds. They total $100.2 million at June 30, 2004 and $75.1 million at
December 31, 2003.

The Bank's liquidity resources were sufficient in the first six months of 2004
to fund the growth in loans and investments, increase the volume of interest
earning assets and meet other cash needs when necessary.

Management expects that deposit growth will continue to be the primary funding
source of the Bank's liquidity on a long-term basis, along with a stable
earnings base, the resulting cash generated by operating activities, and a
strong capital position. Although federal funds purchased and borrowings from
the FHLB provided funds in the first six months of 2004, management expects
deposit growth to be a reliable funding source in the future as a result of
branch expansion efforts and marketing efforts to attract and retain core
deposits. In addition, Bank may acquire additional brokered deposits as funding
for short-term liquidity needs. Shorter-term liquidity needs will mainly be
derived from growth in short-term borrowings, maturing federal funds sold and
portfolio investments, loan maturities and access to other funding sources.

In assessing liquidity, historical information such as seasonality (loan
demand's affect on liquidity which starts before and during the tourist season
and deposit draw down which affects liquidity shortly before and during the
early part of the tourist season), local economic cycles and the economy in
general are considered along with the current ratios, management goals and the
unique characteristics of the Company. Management believes that, in the current
economic environment, the Company's and the Bank's liquidity position is
adequate. To management's knowledge, there are no known trends nor any known
demands,

31

commitments, events or uncertainties that will result or are reasonably likely
to result in a material increase or decrease in the Bank's or the Company's
liquidity.

Capital Resources

Stockholders' equity at June 30, 2004 increased $627,000 or 0.9% to $70.3
million, compared with $69.6 million at end of year 2003. The increase in
stockholders' equity in 2004 was primarily composed of the retention of earnings
and the exercise of stock options with offsetting decreases to stockholders'
equity from the payment of dividends and the change in unrealized losses on
available for sale securities. Stockholders' equity to assets at June 30, 2004
was 6.98% compared to 7.14% at the end of 2003.

In 2001, the Company formed Baylake Capital Trust I ("the Trust") as a statutory
business trust organized for the sole purpose of issuing trust preferred
securities and investing the proceeds thereof in junior subordinated debentures
of the Company, the sole asset of the Trust. The trust preferred securities
enhanced regulatory capital and added liquidity. The common securities of the
Trust are wholly-owned by the Company. The trust preferred securities and common
securities of the trust represent preferred undivided beneficial interests in
the assets of Baylake Capital Trust I, and the holder of the preferred
securities will be entitled to a preference over the common securities of the
Trust upon an event of default with respect to distributions and amounts payable
on redemption or liquidation. These trust preferred securities are
tax-advantaged issues for the Company that qualify for Tier 1 capital treatment
to the Company. Distributions on these securities are included in interest
expense on guaranteed preferred beneficial interest. The preferred securities
are traded on the American Stock Exchange under the symbol BYL_p.

As of December 31, 2003, the Company deconsolidated the Trust, which had issued
the trust preferred securities (discussed above), and replaced the presentation
of such instruments with the Company's junior subordinated debentures issued to
the Trust. Such presentation reflects adoption of FASB Interpretation No. 46
(FIN 46 R) issued in December 2003.

The Company had $16.6 million of junior subordinated debentures outstanding to
the Trust and the Trust had $16.1 million of trust preferred securities
outstanding at June 30, 2004 and December 31, 2003, respectively. Under
applicable regulatory guidelines, the Trust Preferred Securities qualify as Tier
1 capital up to a maximum of 25% of Tier 1 capital. Any additional portion of
Trust Preferred Securities would qualify as Tier 2 capital. As of June 30, 2004,
all $16.1 million of the Trust Preferred Securities qualify as Tier 1 Capital.

The Company's capital base (before SFAS 115 change) increased primarily due to
the retention of earnings. The Company's dividend reinvestment plan typically
provides capital improvement, as the holders of approximately 23% of Company's
Common Stock participate in the plan.

Cash dividends paid in the first six months of 2004 were $0.28 per share
compared with $0.26 in 2003. The Company provided a 7.7% increase in normal
dividends per share in 2004 over 2003 as a result of earnings for 2004. Total
funds utilized in the payment of dividends was $3.2 million in the first six
months of 2004, as compared to $2.9 million in the corresponding period of 2003.

In 1997, the Company's Board of Directors authorized management, in its
discretion, to repurchase up to 7,000 shares of the Company's common stock each
calendar quarter in the market. The shares repurchased would be used to fill its
needs for the dividend reinvestment program, any future benefit plans, and the
Company's stock purchase plan. Shares repurchased are held as treasury stock and
accordingly, are accounted for as a reduction of stockholders' equity. The
Company repurchased none of its common shares in the first six months of 2004.

The adequacy of the Company's capital is regularly reviewed to ensure that
sufficient capital is available for current and future needs and is in
compliance with regulatory guidelines. The assessment of overall capital
adequacy depends upon a variety of factors, including asset quality, liquidity,
stability of earnings, changing competitive forces, economic conditions in
markets served and strength of management.

32

Management is confident that because of current capital levels and projected
earnings levels, capital levels are more than adequate to meet the ongoing and
future concerns of the Company.

The Federal Reserve Board has established capital adequacy rules which take into
account risk attributable to balance sheet assets and off-balance sheet
activities. All banks and bank holding companies must meet a minimum total
risk-based capital ratio of 8%. Of the 8% required, at least half must be
comprised of core capital elements defined as Tier 1 capital. The federal
banking agencies also have adopted leverage capital guidelines which banking
organizations must meet. Under these guidelines, the most highly rated banking
organizations must meet a leverage ratio of at least 3% Tier 1 capital to
assets, while lower rated banking organizations must maintain a ratio of at
least 4% to 5%. Failure to meet minimum capital requirements can initiate
certain mandatory -and possible additional discretionary- actions by regulators
that, if undertaken, could have a direct material effect on the consolidated
financial statements.

At June 30, 2004 and December 31, 2003, the Company was categorized as "well
capitalized" under the regulatory framework for prompt corrective action. There
are no conditions or events since that notification that management believes
have changed the Company's category.

To be "well capitalized" under the regulatory framework, the Tier 1 capital
ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10%
and the leverage ratio must meet or exceed 5%.

The following table presents the Company's and the Bank's capital ratios as of
June 30, 2004 and December 31, 2003:

TABLE 12
CAPITAL RATIOS
($ in Thousands)

33

Management believes that a strong capital position is necessary to take
advantage of opportunities for profitable expansion of product and market share,
and to provide depositor and investor confidence. The Company's capital level is
strong, but also must be maintained at an appropriate level to provide the
opportunity for an adequate return on the capital employed. Management actively
reviews capital strategies for the Company to ensure that capital levels are
appropriate based on the perceived business risks, further growth opportunities,
industry standards, and regulatory requirements.

Recent Accounting Pronouncements

In January 2003, the FASB issued FASB Interpretations No. 46 ("FIN 46"),
Consolidation of Variable Interest Entities." The objective of this
interpretation is to provide guidance on how to identify a variable interest
entity ("VIE") and determine when the assets, liabilities, non-controlling
interests and results of operations of a VIE need to be included in a company's
consolidated financial statements. A company that holds variable interests in an
entity will need to consolidate the entity if the company's interest in the VIE
is such that the company will absorb a majority of the VIE's expected losses
and/or receive a majority of the entity's expected residual returns, if they
occur. FIN 46 also requires additional disclosures by primary beneficiaries and
other significant variable interest holders. FIN 46 was effective for all VIE's
created after January 31, 2003. However, the FASB had postponed that effective
date to December 31, 2003. In December 2003, the FASB issued a revised FIN 46
(FIN 46 R), which further delayed this effective date until March 31, 2004 for
VIE's created prior to February 1, 2003, except for special purpose entities,
which must adopt either FIN 46 or FIN 46 R as of December 31, 2003. The
requirements of FIN 46 resulted in the deconsolidation of the Company's wholly
owned subsidiary trusts, formed to issue mandatorily redeemable preferred
securities ("trust preferred securities"). The deconsolidation, as of December
31, 2003, results in the recognition of the trust preferred securities as junior
subordinated obligations on the related consolidated statement of financial
condition. The junior subordinated obligations of the trusts also include common
interests, which aggregate $497,940, and are offset by an identical amount
representing the Company's investment and included in other assets. The
provisions of FIN 46 R had no impact on the Company's consolidated statements of
income or cash flows.

On March 9, 2004, the SEC issued Staff Accounting Bulletin No. 105, "Application
of Accounting Principles to Loan Commitments." According to the release, the
fair value of the loan commitment is determined without considering the value of
future cash flows related to servicing the loan, and thus the fair value
represents the value of having to make a loan at what may become a below-market
rate. This guidance is applicable for mortgage loan commitments accounted for as
derivatives and entered into subsequent to March 31, 2004. In management's
opinion, the adoption of Staff Accounting Bulletin No. 105 will not have a
material effect on the Company's consolidated financial statements.

Item 3. Quantitative and Qualitative Disclosure about Market Risk.

The Company's financial performance is affected by, among other factors, credit
risk and interest rate risk. The Company does not use derivatives to mitigate
its interest rate risk or credit risk, relying instead on loan review and its
loan loss reserve.

The Company's earnings are derived from the operations of its direct and
indirect subsidiaries with particular reliance on net interest income,
calculated as the difference between interest earned on loans and investments
and the interest expense paid on deposits and other interest bearing
liabilities, including advances from FHLB and other borrowings. Like other
financial institutions, the Company's interest income and interest expense are
affected by general economic conditions and by the policies of regulatory

34

authorities, including the monetary policies of the Board of Governors of the
Federal Reserve System. Changes in the economic environment may influence, among
other matters, the growth rate of loans and deposits, the quality of the loan
portfolio and loan and deposit pricing. Fluctuations in interest rates are not
predictable or controllable.

As of June 30, 2004, the Company was in compliance with its management policies
with respect to interest rate risk. The Company has not experienced any material
changes to its market risk position since December 31, 2003, as described in the
Company's 2003 Form 10-K Annual Report.

The Company's overall interest rate sensitivity is demonstrated by net interest
income analysis. Net interest income analysis measures the change in net
interest income in the event of hypothetical changes in interest rates. This
analysis assesses the risk of change in net interest income in the event of
sudden and sustained 1.0% to 2.0% increases and decreases in market interest
rates. The table below presents the Company's projected changes in net interest
income for the various rate shock levels at June 30, 2004.

As shown above, at June 30, 2004, the effect of an immediate 200 basis point
increase in interest rates would increase the Company 's net interest income by
$2.6 million or 7.3%. The effect of an immediate 100 basis point reduction in
rates would decrease the Company's net interest income by $1.1 million or 3.0%

Changes in the mix of earning assets and interest-bearing liabilities increased
the Company's asset sensitivity during the past twelve months.

Computations of the prospective effects of hypothetical interest rate changes
are based on numerous assumptions, including the relative levels of market
interest rates and loan prepayments, and should not be relied upon as indicative
of actual results. Actual values may differ from those projections set forth
above, should market conditions vary from the assumptions used in preparing the
analyses. Further, the computations do not contemplate any actions the Company
may undertake in response to changes in interest rates.

Item 4. Controls and Procedures

DISCLOSURES CONTROLS AND PROCEDURES: The Company's management, with the
participation of the Company's Chief Executive Officer and Chief Financial
Officer, has evaluated the effectiveness of the Company's disclosure controls
and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under
the Securities Exchange Act of 1934, as amended (the "Exchange Act") as of June
30, 2004. Based on such evaluation, the Company's Chief Executive Officer and
Chief Financial Officer have concluded that, as of the end of such period, the
Company's disclosure controls and procedures are effective in timely alerting
them to material information relating to the Company's disclosure controls and
procedures to the Company required to be included in this quarterly report on
Form 10-Q.

INTERNAL CONTROL OVER FINANCIAL REPORTING: There have not been any changes in
the Company's internal control over financial reporting (as such term is defined
in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal
quarter to which this report relates that have materially affected, or are
reasonably likely to materially affect, the Company's internal controls
subsequent to the date of such evaluation.

35

Part II - Other Information

Item 1. Legal Proceedings

Baylake and its subsidiaries may be involved from time to time in various
routine legal proceedings incidental to its business. Neither Baylake nor any of
its subsidiaries is currently engaged in any legal proceedings that are expected
to have a material adverse effect on the results of operations or financial
position of Baylake.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

a) The Company's Annual Meeting of Shareholders was held on June 7, 2004.

b) Not applicable

c) The only matter voted upon was the election of four directors for terms
expiring in 2007. The results are as follows:

As a consequence of the Company's staggered board of directors, other directors
remained in office. Directors continuing in office for terms expiring in 2005
are Robert W. Agnew, George Delveaux, Jr., Dee Geurts-Bengtson, and Joseph
Morgan. Directors continuing in office for terms expiring in 2006 are Ronald D.
Berg, Richard A. Braun and William C. Parsons.

Item 5. Other Information

None

36

Item 6. Exhibits and Reports on Form 8-K

(a). The following exhibits are furnished herewith:

(b). Report on Form 8-K:

Baylake Corp. filed a Report on Form 8-K dated June 7, 2004 to report the
results of its annual meeting of shareholders. In addition, a report on Form 8-K
dated May 5, 2004 was submitted under Item 12, Results of Operations and
Financial Condition, reporting Baylake Corp released its earnings for the three
months ended March 31, 2004; that report is not incorporated by reference into
other filings.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

BAYLAKE CORP.
-------------------------------------

Date: August 12, 2004 /s/ Thomas L. Herlache
---------------------- -------------------------------------
Thomas L. Herlache
President (CEO)

Date: August 12, 2004 /s/ Steven D. Jennerjohn
---------------------- -------------------------------------
Steven D. Jennerjohn
Treasurer (CFO)