SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

or

[  ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission file Number 0-21292

MERCHANTS AND MANUFACTURERS BANCORPORATION, INC.

19105 West Capitol Drive, Suite 200
Brookfield, Wisconsin 53045

(262) 790-2120

Indicate by check mark whether the Registrant (1) has filed all reports required 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 Exchange Act Rule 12b-2)

Yes [X] No [  ].

As of November 1, 2004, 3,670,145 shares of Common Stock were outstanding.

MERCHANTS AND MANUFACTURERS BANCORPORATION, INC.

FORM 10-Q

INDEX

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Part I. Financial Information

Merchants and Manufacturers Bancorporation, Inc.

See Notes to Unaudited Consolidated Financial Statements.

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Merchants and Manufacturers Bancorporation, Inc.

See notes to unaudited consolidated financial statements.

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Merchants and Manufacturers Bancorporation, Inc. and Subsidiaries

See notes to unaudited consolidated financial statements

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NOTE A — Basis of Presentation

The accompanying unaudited consolidated financial statements include the accounts of Merchants and Manufacturers Bancorporation, Inc. and its wholly owned subsidiaries: Lincoln State Bank, Franklin State Bank, Grafton State Bank, Community Bank Financial, The Reedsburg Bank, Fortress Bank of Westby, Fortress Bank of Cresco, Fortress Bank, Minnesota., Wisconsin State Bank (collectively, the Banks), Merchants Merger Corp., CFG Financial Services, Inc., Merchants New Merger Corp., CFG Mortgage, Inc. and Lincoln Neighborhood Redevelopment Corporation. Lincoln State Bank also includes the accounts of its wholly owned subsidiary, M&M Lincoln Investment Corporation. Grafton State Bank also includes the accounts of its wholly owned subsidiary, GSB Investments, Inc. and Community Bank Financial also includes the accounts of its wholly owned subsidiary, CBOC Investments, Inc. The Reedsburg Bank also includes the accounts of its wholly owned subsidiary, Reedsburg Investments, Inc. Fortress Bank of Westby also includes the accounts of its wholly owned subsidiary, Westby Investment Company, Inc. Wisconsin State Bank also includes the accounts of its wholly owned subsidiary Random Lake Investments, Inc. CFG Financial Services, Inc. also includes the accounts of its wholly owned subsidiaries Community Financial Services, Inc. and Keith C. Winters & Associates. LTD (KCW). All significant intercompany balances and transactions have been eliminated.

The accompanying unaudited condensed consolidated 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. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto included in our Form 10-K for the year ended December 31, 2003.

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 which affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of date of the financial statements, as well as the reported amounts of income and expenses during the reported periods. Actual results could differ from those estimates.

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NOTE B — Earnings Per Share

Presented below are the calculations for basic and diluted earnings per share:

NOTE C — Comprehensive Income

The following table presents our comprehensive income.

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NOTE D — Loans Receivable

In 2004, the Corporation performed an evaluation of the purpose and collateral of each loan. This evaluation resulted in a reallocation of loan dollars between primarily commercial real estate and commercial loans. The following table shows the composition of our loan portfolio on the dates indicated (dollars in thousands):

NOTE E – Stock-Based Compensation Plan

At September 30, 2004 we had a stock-based key officer and employee compensation plan. We account for this plan under the recognitions 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 the income, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of the Financial Accounting Standards Board (FASB) Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

In determining compensation cost using the fair value method prescribed in Statement No. 123, the value of each grant is estimated at the grant date with the following weighted-average assumptions used for grants at September 30, 2004: dividend yield of 1.60%; expected price volatility of 19.74%; blended risk-free interest rates of 3.76%; and expected life of 10 years.

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NOTE F — Recent Acquisitions

On August 12, 2004, we acquired Random Lake Bancorp, Ltd. (“Random Lake”) and its wholly-owned subsidiary, Wisconsin State Bank (“WSB”). The purchase price for Random Lake was $11.5 million including $1.3 million in cash and 334,200 shares of Merchants common stock valued at $10.2 million based on a $30.50 price. At the date of the acquisition Random Lake had assets of $102.3 million, loans of $72.9 million and deposits of $80.0 million. The quarter-to-quarter and year-to-year comparisons are impacted by our completion of the acquisition of Random Lake. The acquisition was accounted for using the purchase method of accounting, and accordingly, the assets and liabilities of Random Lake were recorded at their respective fair values on August 12, 2004 and account balances acquired are included in our financial results.

On November 1, 2003, we acquired Reedsburg Bancorporation, Inc. (“Reedsburg”) and its wholly-owned subsidiary, The Reedsburg Bank. The purchase price for Reedsburg was $36.0 million including $17.8 million in cash and 146,800 shares of Merchants common stock valued at $5.4 million based on the average price over the contractual pricing period. At the date of the acquisition Reedsburg had assets of $141.8 million, loans of $97.2 million and deposits of $120.6 million. The quarter-to-quarter and year-to-year comparisons are impacted by our completion of the acquisition of Reedsburg. The acquisition was accounted for using the purchase method of accounting, and accordingly, the assets and liabilities of Reedsburg were recorded at their respective fair values on November 1, 2003 and account balances acquired are included in our financial results.

NOTE G – Recent Accounting Pronouncements

FIN No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (Revised December 2003): FIN 46 establishes accounting guidance for consolidation of variable interest entities (VIE) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE entity is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a 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. However, subsequent revisions to the interpretation deferred the implementation date of FIN 46 until the first period ending after March 15, 2004.

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The Corporation adopted FIN 46, as revised, in connection with its consolidated financial statements for the quarter ended March 31, 2004. The Corporation has previously formed five statutory trusts (the “Trusts”) to issue an aggregate of $45,000,000 of trust preferred securities. The implementation of FIN 46 required the Corporation to de-consolidate its investment in the Trusts because the Corporation is not the primary beneficiary. There was no impact on stockholders’ equity or net income upon adoption of the standard.

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

On May 6, 2004, the Board of Governors of the Federal Reserve System (the “Board”) issued a Notice of Proposed Rulemaking in which it proposed to allow the continued inclusion of trust preferred securities in the tier 1 capital of bank holding companies, subject to stricter standards. The Board is proposing to limit the aggregate amount of a bank holding company’s cumulative perpetual preferred stock, trust preferred securities and other minority interests to 25% of the company’s core capital elements, net of goodwill. Current regulations do not require the deduction of goodwill. The proposal also provides that amounts of qualifying trust preferred securities and certain minority interests in excess of the 25% limit may be included in tier 2 capital but would be limited, together with subordinated debt and limited-life preferred stock, to 50% of tier 1 capital. The proposal provides a three-year transition period for bank holding companies to meet these quantitative limitations. At this time, it is not possible to predict the impact that this proposal would have on the Company.

The Accounting Standards Executive Committee has issued Statement of Position (SOP) 03-3 “Accounting for Certain Loans or Debt Securities Acquired in a Transfer”. This Statement applies to all loans acquired in a transfer, including those acquired in the acquisition of a bank or a branch, and provides that such loans be accounted for at fair value with no allowance for loan losses, or other valuation allowance, permitted at the time of acquisition. The difference between cash flows expected at the acquisition date and the investment in the loan should be recognized as interest income over the life of the loan. If contractually required payments for principal and interest are less than expected cash flows, this amount should not be recognized as a yield adjustment, a loss accrual, or a valuation allowance. For the Corporation this Statement is effective for calendar year 2005, and early adoption, although permitted, is not planned. No significant impact is expected on the consolidated financial statements at the time of adoption.

At the March 17-18, 2004 Emerging Issues Task Force (“EITF”) meeting, the Task Force reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. EITF 03-1 provides guidance for determining the meaning of “other-than-temporarily impaired” and its application to certain debt and equity securities within the scope of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”) and investments accounted for under the cost method. The guidance set forth in the Statement was originally effective for the Company in the September 30, 2004 consolidated financial statements. However, in September 2004, the effective dates of certain parts of the Statement were delayed. Management is currently assessing the impact of Issue 03-1 on the consolidated financial statements.

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In March 2004, the Financial Accounting Standards Board (“FASB”) issued an Exposure Draft, Share-Base Payment – an amendment of Statements No. 123 and 95. This Statement amends SFAS Statement No. 123, Accounting for Stock-Based Compensation, SFAS Statement No. 95, Statement of Cash Flows, and APB Opinion No. 125, Accounting for Stock Issued to Employees. The objective of the amendment to SFAS No. 123 is to recognize in the financial statements the cost of employee services received in exchange for equity instruments and liabilities incurred as the result of such transactions. The grant-date fair value of stock options would be determined using an option-pricing model, and expense would be recognized over the vesting period. In October 2004, the FASB postponed the effective date of the proposed standard from fiscal years beginning after December 15, 2004 to periods beginning after June 15, 2005. The FASB is expected to issue a final standard by the end of calendar 2004. Management is reviewing the proposed standard to determine the impact on the financial statements.

NOTE H – Commitments and Contingent Liabilities

In the normal course of business, the Corporation is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the consolidated financial statements.

The Corporation is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, financial guarantees, and standby letters of credit. They involve, to varying degrees, elements of credit risk in excess of amounts recognized on the consolidated balance sheets.

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The Corporation’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Corporation uses the same credit policies in making commitments and issuing letters of credit as they do for on-balance-sheet instruments.

Off-balance-sheet financial instruments whose contracts represented credit and/or interest rate risk at September 30, 2004, December 31, 2003 and September 30, 2003, are as follows:

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements and, generally, have terms of one year or less. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds collateral, which may include accounts receivable, inventory, property, equipment, and income-producing properties, supporting those commitments if deemed necessary. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Bank would be required to fund the commitment. The maximum potential amount of future payments the Bank could be required to make is represented by the contractual amount shown in the summary above. If the commitment is funded, the Bank would be entitled to seek recovery from the customer. Credit card commitments are unsecured. At September 30, 2004 no amounts have been recorded as liabilities for the Bank’s potential obligations under these guarantees.

Except for the above-noted commitments to originate loans in the normal course of business, the Corporation and the Banks have not undertaken the use of off-balance-sheet derivative financial instruments for any purpose.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

The Corporation had net income of $1.9 million, or $0.55 per diluted share, for the three months ended September 30, 2004 compared to $2.1 million, or $0.66 per diluted share, for the three months ended September 30, 2003, representing a 8.0% decrease in net income and a 16.6% decrease in diluted earnings per share and net income of $4.8 million, or $1.41 per diluted share, for the nine months ended September 30, 2004 compared to $6.2 million, or $1.94 per diluted share, for the nine months ended September 30, 2003, representing a 21.7% decrease in net income and a 27.3% decrease in diluted earnings per share. The decrease in net income for the current quarter and year-to-date compared to the prior year periods is attributed to a lower net interest margin, a decrease in loan fee revenue due primarily to the industry wide slow down in residential loan refinances, significant costs incurred complying with the Sarbanes-Oxley Act of 2002 and expenses associated with our company-wide “Vision Unlimited” project.

The quarter-to-quarter and year-to-year comparisons are impacted by the Corporation’s completion of the Random Lake acquisition on August 12, 2004. The acquisition was accounted for using the purchase method of accounting, and accordingly, the assets and liabilities of Random Lake were recorded at their respective fair values on August 12, 2004. The Corporation acquired approximately $102.3 million in assets, $72.9 million in loans, $80.0 million in deposits and recognized goodwill and intangible assets of approximately $6.1 million related to the transaction. The quarter-to-quarter and year-to-year comparisons are also impacted by the Corporation’s completion of the Reedsburg acquisition on November 1, 2003. The acquisition was accounted for using the purchase method of accounting, and accordingly, the assets and liabilities of Reedsburg were recorded at their respective fair values on November 1, 2003. The Corporation acquired approximately $141.8 million in assets, $97.2 million in loans, $120.6 million in deposits and recognized goodwill and intangible assets of approximately $19.1 million related to the transaction. The year-to-year comparisons are also impacted by the Corporation’s May 1, 2003 acquisitions of Keith C. Winters & Associates, LTD. (“KCW”), a tax preparation and tax consulting firm with offices located in Franklin, Brookfield and Milwaukee, Wisconsin, and Integrated Financial Services (“IFS”), an insurance agency. The KCW and IFS acquisitions were accounted for using the purchase method of accounting.

2004 continues to be a year of transition for the Corporation. Through a company-wide project called “Vision Unlimited”, the Corporation is in the process of standardizing policies and procedures across the organization and centralizing many operational functions. In addition, the Corporation is converting all of the Banks to a single data processing platform. As of September 30, 2004 five of the six recently acquired banks have been converted to the new system. The Corporation expects these changes will allow it to better manage risk, operate more efficiently and serve customers better. Each of the Banks will continue to keep its name, charter, board of directors and management teams but will transition its human resources from the Bank’s operational activities to customer related activities. Bank employees will have the tools and resources they need to effectively focus on customer service, customer retention and customer prospecting. While the Corporation expects these changes to enhance shareholder value in the long run, a transition of this magnitude involves short-term costs which the Corporation expects will range between $850,000 and $1.0 million before tax in 2004. Through September 30, 2004 we have expended approximately $475,000 relating to this project.

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The Corporation is also facing two other significant challenges in 2004. Like all public companies, we are working towards compliance with the Sarbanes-Oxley Act of 2002. While we are utilizing an outside third party at a significant cost, compliance with Sarbanes-Oxley is largely being accomplished internally through our “Vision Unlimited” project. We originally expected our Sarbanes-Oxley compliance costs would range from $300,000 to $400,000 in 2004. However, based on the review of tasks completed to date, we now expect this expense to amount to range from $400,000 to $500,000. Through September 30, 2004 we have expended approximately $333,000 relating to this project. In addition, like hundreds of other Wisconsin banking organizations, we are in discussion with the Wisconsin Department of Revenue (“WDR”) regarding the tax treatment of our Nevada investment subsidiaries. Nevada does not have an income tax and historically the earnings of these Nevada investment subsidiaries have not been subject to taxation in Wisconsin. We believe that we have complied with private letter rulings the WDR previously issued in connection with the formation and operation of our Nevada investment subsidiaries. However, the effect and intent of these rulings is in question and the WDR may take the position that some or all of the income of our Nevada investment subsidiaries is allocable to their Wisconsin corporate parents and taxable in Wisconsin. The WDR may also take the position that such a reallocation should apply to prior open tax years. The result of these discussions with the WDR could materially increase our future income tax expense and could also result in a significant current year tax charge. As of September 30, 2004 we have not come to an agreement with the WDR and have not accrued for potential future payments to the WDR.

Financial Condition

Total Assets

Total assets increased $177.9 million, or 15.5%, to $1.3 billion at September 30, 2004 compared to $1.1 billion at December 31, 2003. The asset growth can be attributed to both internal growth through loans as well as acquisition growth associated with WSB. At the time of the acquisition, WSB had $102.3 million of assets.

Investment Securities

Available-for-sale investment securities increased $19.6 million, or 12.5%, from $156.6 million at December 31, 2003, to $176.2 million at September 30, 2004. The investment security growth can be attributed to purchases of additional investment securities by the banks as well as acquisition growth associated with WSB. At the time of the acquisition, WSB had $11.5 million of investment securities.

Loans Receivable

Loans receivable, net of allowance for loan losses, increased $148.8 million from $847.9 million at December 31, 2003 compared to $996.8 million at September 30, 2004. The growth in loans can be attributed to the growth in commercial real estate loans that were partially offset by the decrease in commercial business loans and consumer and installment loans as well as acquisition growth associated with the WSB acquisition. At the time of the acquisition, WSB had $72.9 million of loans. Currently, loans receivable consists mainly of commercial loans secured by business assets, real estate and guarantees as well as mortgages secured by residential properties located in our primary market areas. At September 30, 2004 we designated $2.3 million of loans as held for sale.

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Total Deposits and Borrowings

Total deposits increased $86.7 million, or 9.5%, from $911.9 million on December 31, 2003 to $998.6 million on September 30, 2004. The increase in deposits can be attributed to the growth in retail money market accounts and commercial checking accounts currently offered by our subsidiary banks as well as acquisition growth associated with the WSB acquisition. At the time of the acquisition, WSB had $80.0 million of deposits.

Short-term borrowings totaled $56.6 million at September 30, 2004, compared to $34.0 million at December 31, 2003, an increase of 66.3%. Short-term borrowings consist of federal funds borrowed from correspondent banks and repurchase agreements. Long-term debt increased by $40.1 million, or 55.5%, from $72.3 million on December 31, 2003 to $112.5 million on September 30, 2004. Long-term debt consists of Federal Home Loan Bank advances and acquisition notes associated with the Reedsburg transaction.

Subordinated Debentures totaled $46.4 million at September 30, 2004, compared to $36.1 million at December 31, 2003, an increase of 28.6%. We had obligations represented by subordinated debentures at September 30, 2004 totaling $45.0 million with our wholly-owned trusts that were created for the purpose of issuing trust preferred securities. The subordinated debentures were the sole assets of the trusts at September 30, 2004. In accordance with FIN 46, we began deconsolidating the wholly-owned trusts that issued the trust preferred securities in 2004. As a result, these securities no longer are consolidated on our balance sheet. Instead, the subordinated debentures held by the trusts are disclosed on the balance sheet as subordinated debentures.

On September 30, 2004, Merchants and Manufacturers Statutory Trust V, a Connecticut statutory trust wholly owned by the Corporation, issued $10,000,000 of floating rate capital securities to one accredited investor. The Trust used the proceeds from the capital securities to purchase a like amount of floating rate junior subordinated debentures of the Corporation. The capital securities accrue and pay dividends quarterly at a variable rate, reset quarterly, equal to 3-month LIBOR plus 2.05%. The Corporation has fully and unconditionally guaranteed all of the obligations of the Trust. The guarantee covers the quarterly dividends and payments on the liquidation or redemption of the capital securities, but only to the extent of funds held by the Trust. The capital securities are mandatorily redeemable upon maturity of the debentures on September 30, 2034 or earlier as provided in the indenture with respect to the debentures. The Corporation has the right to redeem the debentures on or after September 30, 2009.

Capital Resources

Stockholders’ equity totaled $93.5 million at September 30, 2004, compared to $80.0 million in December 31, 2003, an increase of 16.9%. The component changes in stockholders’ equity consist of net income of $4.8 million, a $189,000 net increase in accumulated other comprehensive income, $272,000 decrease in treasury stock less payments of dividends to shareholders of $1.9 million. We and our banks continue to exceed our regulatory capital requirements.

Under the Federal Reserve Board’s risk-based guidelines, capital is measured against our subsidiary banks’ risk-weighted assets. Our tier 1 capital (common stockholders’ equity less goodwill) to risk-weighted assets was 8.15% at September 30, 2004, above the 4.0% minimum required. Total capital to risk-adjusted assets was 10.47%; also above the 8.0% minimum requirement. The leverage ratio was at 7.19% compared to the 4.0% minimum requirement. According to FDIC capital guidelines, our subsidiary banks are considered to be “well capitalized” as well.

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Nonperforming Assets and Allowance for Losses

Generally a loan is classified as nonaccrual and the accrual of interest on such loan is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectibility of principal or interest. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time and the ultimate collectibility of the total contractual principal and interest is no longer in doubt.

Nonperforming assets are summarized, for the dates indicated, as follows (dollars in thousands):

Nonperforming assets increased by $130,000 from $7.2 million at December 31, 2003 to $7.4 million at September 30, 2004, an increase of 1.8%. Non-accrual loans acquired during the WSB acquisition led to the increase. We believe that any losses on current non-accrual loans balances will be negligible, due to the collateral position in each situation. However, additional charge offs may occur upon sale of the other real estate.

The following table presents changes in the allowance for loan losses (dollars in thousands):

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We believe the allowance for loan losses accounting policy is critical to the portrayal and understanding of our financial condition and results of operations. As such, selection and application of this “critical accounting policy” involves judgments, estimates, and uncertainties that are susceptible to change. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition or results of operations is a reasonable likelihood.

We maintain our allowance for loan losses at a level that management believes will be adequate to absorb probable losses on existing loans based on an evaluation of the collectibility of loans and prior loss experience. We also use a risk rating system to evaluate the adequacy of the allowance for loan losses. With this system, each loan is risk rated between one and ten by the originating loan officer or loan committee, with one being the best case and ten being a loss or the worst case. Historical loan loss reserve factors are multiplied against the balances for each loan type to determine an appropriate level for the allowance for loan losses. Loans with risk ratings between six and nine are monitored much closer by the officers. Control of our loan quality is continually monitored by management and is reviewed by the Board of Directors. We consistently apply our methodology for determining the adequacy of the allowance for loan losses, but may make adjustments to its methodologies and assumptions based on historical information related to charge-offs and management’s evaluation of the current loan portfolio.

The allowance for loan losses is based on estimates, and ultimate losses will vary from current estimates. These estimates are reviewed quarterly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the provision for loan losses. The methodology used to determine the adequacy of the allowance for loan losses for the first nine months of 2004 is consistent with prior periods.

Potential Problem Loans

We utilize an internal asset classification system as a means of reporting problem and potential problem assets. At least quarterly, a watch list is presented to each subsidiary bank’s Board of Directors showing all loans listed as “Watch”, “Special Mention”, “Substandard”, “Doubtful”, and “Loss.” A loan classified as Watch is defined as a loan requiring more than normal management visibility, while still protected by the current net worth and paying capacity of the borrower. Watch loans have one or more deficiencies that require monitoring. A Special Mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan at some future date. An asset is classified Substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard assets include those characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. Assets classified as Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Assets classified as Loss are those considered uncollectible and viewed as non-bankable assets, worthy of charge-off. Assets that do not currently expose us to sufficient risk to warrant classification in one of the aforementioned categories, but possess weaknesses that may or may not be within the control of the customer are deemed to be Management Attention (or equivalent designation at the various subsidiary banks). As of September 30, 2004, loans classified as Watch, Special Mention, Substandard, Doubtful and Loss loans totaled $76.3 million compared to $51.7 million as of December 31, 2003, an increase of $24.6 million or 47.6%. The increase can not be attributed to a deterioration in the quality of the loan portfolio, but a change in the scope of the potential problem loan evaluation from the prior period.

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Our determination as to the classification of our assets and the amount of our valuation allowances is subject to review by the Banks’ primary regulators, which can order the establishment of additional general or specific loss allowances. The FDIC, in conjunction with the other federal banking agencies, has adopted an interagency policy statement on the allowance for loan losses. The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation guidelines. Generally, the policy statement recommends that (i) institutions have effective systems and controls to identify, monitor and address asset quality problems; (ii) management has analyzed all significant factors that affect the collectibility of the portfolio in a reasonable manner; and (iii) management has established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement. We have established an adequate allowance for probable loan losses. We analyze the process regularly, with modifications made if needed, and report those results four times per year to each subsidiary bank’s Board of Directors. However, there can be no assurance that regulators, in reviewing our loan portfolio, will not request us to materially increase our allowance for loan losses at the time. Although management believes that adequate specific and general loan loss allowances have been established, actual losses are dependent upon future events and, as such, further additions to the level of specific and general loan loss allowances may become necessary.

Comparison of Three and Nine Months Ended September 30, 2004 and 2003

Net Interest Income

Net interest income equals the difference between interest earned on assets and the interest paid on liabilities and is a measure of how effectively management has balanced and allocated our interest rate sensitive assets and liabilities as well being the most significant component of earnings. Net interest income on a fully taxable-equivalent basis for the three months ended September 30, 2004 was $11.2 million, an increase of 25.8% from the $8.9 million reported for the same period in 2003, and for nine months ended September 30, 2004 was $31.5 million, an increase of 19.6% from the $26.4 million reported for the same period in 2003. The increase is due partly from revenue resulting from the acquisition of Reedsburg and Wisconsin State Bank as well as the increase in loan and investment volume funded by an increase in deposits and long-term borrowings. Our net interest margin on a fully taxable-equivalent basis was 3.86% and 4.02% for the third quarters of 2004 and 2003, respectively. The continued low interest rate environment, the incremental effect of the acquisitions as well as the increased amortization of purchase accounting premiums associated with our acquisitions resulted in lower margins. The reduction in market interest rates and increased premium amortization during the third quarter caused the average rate on a fully taxable-equivalent basis earned on interest earning assets to decrease from 5.73% for the three months ended September 30, 2003 to 5.59% for the three month period ended September 30, 2004, and from 5.91% for the nine months ended September 30, 2003, to 5.57% for the nine month period ended September 30, 2004.

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The following table presents, for the periods indicated, the total dollar amount of interest income from average interest earning assets and the resultant yields, as well as the interest expense on average interest bearing liabilities, and the resultant costs, expressed both in dollars and rates (dollars in thousands):

AVERAGE BALANCES, INTEREST RATES AND YIELDS

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The following table presents, for the periods indicated, the total dollar amount of interest income from average interest earning assets and the resultant yields, as well as the interest expense on average interest bearing liabilities, and the resultant costs, expressed both in dollars and rates (dollars in thousands):

AVERAGE BALANCES, INTEREST RATES AND YIELDS

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The following table sets forth the effects of changing interest rates and volumes of interest earning assets and interest bearing liabilities on our net interest income. Information is provided with respect to (i) effect on net interest income attributable to changes in volume (changes in volume multiplied by prior rate), (ii) effects on net interest income attributable to changes in rate (changes in rate multiplied by prior volume) and (iii) net change. The net change attributable to the combined impact of volume and rate has been allocated proportionately to the change due to volume and the change due to rate. (dollars in thousands):

VOLUME, RATE AND MIX ANALYSIS OF NET INTEREST INCOME

Provision for Loan Losses

For the three months ended September 30, 2004, the provision for loan losses was $431,000 compared to $372,000 for the same period in 2003. For the nine months ended September 30, 2004, the provision for loan losses was $1.3 million compared to $1.0 million for the same period in 2003. We use a risk-based assessment of our loan portfolio to determine the level of the loan loss allowance. This procedure is based on internal reviews intended to determine the adequacy of the loan loss allowance in view of presently known factors. However, changes in economic conditions in the future financial conditions of borrowers cannot be predicted and may result in increased future provisions to the loan loss allowance.

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Non-Interest Income

Non-interest income for the three months ended September 30, 2004, was $3.2 million compared to $3.1 million for the three months ended September 30, 2003, an increase of $166,000, or 5.5%. Non-interest income for the nine months ended September 30, 2004 was $8.6 million, an increase of $182,000, or 2.17% from the $8.4 million for the nine months ended September 30, 2003. The composition of non-interest income is shown in the following table (dollars in thousands).