Washington, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2003

 

OR

 

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

For transition period from                to               

 

Commission file number 005-57237

 

FIRST OTTAWA BANCSHARES, INC.

(Exact name of Registrant as specified in its charter)

 

 

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 ý  No o

 

Indicate by check mark whether the Registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act)       Yes o  No ý

 

Indicate the number of shares outstanding of each of the Registrant’s classes of common stock as of the latest practicable date:  As of November 13, 2003, the Registrant had outstanding 652,627 shares of common stock, $1.00 par value per share.

 

 

Form 10-Q Quarterly Report

 

Table of Contents

 

PART I
Item 1.	Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
PART II
Item 1.	Legal Proceedings
Item 2.	Changes in Securities and Use of Proceeds
Item 3.	Defaults Upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits and Reports on Form 8-K
Item 7.	Signatures

 

2

 

FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
(Unaudited)

 

		September 30, 2003			December 31, 2002
ASSETS
Cash and cash equivalents		$	8,094		$	8,606
Certificates of deposit		9,373			12,985
Securities available-for-sale		87,066			98,885
Loans held for sale		1,791			1,811
Loans, less allowance for loan losses of $1,123 and $1,167		113,593			108,476
Bank premises and equipment, net		6,365			4,555
Interest receivable and other assets		5,536			5,344
Total assets		$	231,818		$	240,662
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities
Deposits
Demand – non-interest-bearing		$	18,493		$	19,475
NOW accounts		56,290			54,537
Money market accounts		18,158			9,186
Savings		20,395			19,513
Time, $100,000 and over		21,938			23,813
Other time		63,276			67,243
Total deposits		198,550			193,767
Federal funds purchased		2,360			14,700
Securities sold under agreements to repurchase		1,545			1,622
Borrowings		430			652
Interest payable and other liabilities		3,219			4,738
Total liabilities		206,104			215,479
Commitments and contingent liabiliies
Shareholders’ equity
Preferred stock - $1 par value, 20,000 shares Authorized; none issued		—			—
Common stock - $1 par value, 750,000 shares authorized and issued		750			750
Additional paid-in capital		4,004			4,000
Retained earnings		24,727			23,491
Treasury stock, at cost, 97,373 and 93,044 shares		(5,524		)	(5,270		)
Accumulated other comprehensive income		1,757			2,212
Total shareholders’ equity		25,714			25,183
Total liabilities and shareholders’ equity		$	231,818		$	240,662

 

See accompanying notes to condensed consolidated financial statements.

 

3

 

FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except share and per share data)
(Unaudited)

 

		Three Months Ended September  30,						Nine Months Ended September  30,
		2003			2002			2003			2002
Interest income
Loans (including fee income)		$	2,016		$	2,064		$	5,984		$	6,154
Securities
Taxable		814			942			2,562			3,021
Exempt from federal income tax		183			229			569			694
Certificates of deposit		76			76			277			151
Federal funds sold		5			12			5			13
Total interest income		3,094			3,323			9,397			10,033
Interest expense
NOW account deposits		99			94			340			256
Money market deposit accounts		76			33			137			118
Savings deposits		46			79			165			244
Time deposits		769			1,001			2,503			3,234
Repurchase agreements		—			144			8			445
Borrowings		2			28			6			86
Federal funds purchased		20			7			151			44
Total interest expense		1,012			1,386			3,310			4,427
NET INTEREST INCOME		2,082			1,937			6,087			5,606
Provision for loan losses		30			30			90			90
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		2,052			1,907			5,997			5,516
Noninterest income
Service charges on deposit accounts		224			212			607			578
Trust and farm management fee income		114			114			342			342
Gain on loan sales		155			73			648			131
Securities gains(losses), net		1			86			1			87
Other income		120			174			370			485
Total noninterest income		614			659			1,968			1,623
Noninterest expenses
Salaries and employee benefits		964			953			2,986			2,853
Occupancy and equipment expense		250			215			705			625
Data processing expense		115			108			335			331
Supplies		35			28			92			92
Advertising and promotions		18			25			53			74
Professional fees		138			81			291			293
Other expenses		294			275			928			752
Total noninterest expenses		1,814			1,685			5,390			5,020
INCOME BEFORE INCOME TAXES		852			881			2,575			2,119
Provision for income taxes		225			220			682			453
NET INCOME		$	627		$	661		$	1,893		$	1,666
Earnings per share-basic and diluted		$	0.96		$	1.00		$	2.88		$	2.53
Average shares outstanding-basic and diluted		655,151			658,356			656,172			658,356

 

See accompanying notes to condensed consolidated financial statements.

 

4

 

FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
Nine Months ended September 30, 2003 and 2002
(In thousands, except per share data)
(Unaudited)

 

		Common Stock			Additional Paid-In Capital			Retained Earnings			Treasury Stock			Accumulated Other Comprehensive Income (Loss)			Total Share- holders’ Equity
Balance at January 1, 2003		$	750		$	4,000		$	23,491		$	(5,270	)	$	2,212		$	25,183
Net income		—			—			1,893			—			—			1,893
Unrealized net gain on securities available-for-sale, net of reclassi- fications and tax effects		—			—			—			—			(455		)	(455		)
Comprehensive income																	1,666
Cash dividends declared ($1 per share)		—			—			(657		)	—			—			(657		)
Vested options outstanding		—			4			—			—			—			4
Purchase of 4,329 Treasury shares		—			—			—			(254		)	—			(254		)
Balance at September 30, 2003		$	750		$	4,004		$	24,727		$	(5,524	)	$	1,757		$	25,714
Balance at January 1, 2002		$	750		$	4,000		$	23,178		$	(5,196	)	$	175		$	22,907
Net income		—			—			1,666			—			—			1,666
Unrealized net gain on securities available-for-sale, net of reclassi- fications and tax effects		—			—			—			—			1,989			1,989
Comprehensive income																	3,655
Cash dividends declared ($1 per share)		—			—			(658		)	—			—			(658		)
Balance at September 30, 2002		$	750		$	4,000		$	24,186		$	(5,196	)	$	2,164		$	25,904

 

See accompanying notes to condensed consolidated financial statements.

 

5

 

FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months ended September 30, 2003 and 2002
(In thousands)
(Unaudited)

 

		2003			2002
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	1,893		$	1,666
Adjustments to reconcile net income to net cash from operating activities
Change in deferred loan fees		(3		)	(4		)
Provision for loan losses		90			90
Depreciation and amortization		265			225
Premium amortization on securities, net		138			74
Net real estate loans originated for sale		668			703
Gain on loan sales		(648		)	(131		)
Gain on sale/call of securities available-for-sale		(1		)	(87		)
Loss on sale of other real estate owned		13			5
Change in interest receivable and other assets		(206		)	99
Change in interest payable and other liabilities		31			(1,052		)
Net cash from operating activities		2,240			1,588
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of securities available-for-sale		—			7,831
Proceeds from maturities of securities		14,431			12,836
Purchases of securities available-for-sale		(3,438		)	(10,207		)
Proceeds from maturities of certificates of deposit		5,905			—
Purchases of certificates of deposit		(2,293		)	(7,705		)
Change in federal funds sold		—			(5,600		)
Net change in loans receivable		(5,378		)	2,454
Proceeds from sale of other real estate owned		166			70
Property and equipment expenditures		(2,062		)	(1,788		)
Net cash from investing activities		7,331			(2,109		)
CASH FLOWS FROM FINANCING ACTIVITIES
Change in deposits		4,783			20,521
Change in federal funds purchased		(12,340		)	(5,050		)
Change in other borrowings		(222		)	400
Change in securities sold under agreements to repurchase		(77		)	(14,201		)
Purchase of treasury shares		(254		)	—
Dividends paid		(1,973		)	(1,983		)
Net cash from financing activities		(10,083		)	(313		)
Change in cash and cash equivalents		(512		)	(834		)
Cash and cash equivalents at beginning of period		8,606			7,933
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	8,094		$	7,099

 

See accompanying notes to condensed consolidated financial statements.

 

6

 

FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINACIAL STATEMENTS
(Table dollars in thousands)
September 30, 2003 and 2002

 

NOTE 1 – BASIS OF PRESENTATION

 

The accounting policies followed in the preparation of the interim condensed consolidated financial statements are consistent with those used in the preparation of annual consolidated financial statements.  The interim condensed consolidated financial statements reflect all normal and recurring adjustments, which are necessary, in the opinion of management, for a fair statement of results for the interim periods presented.  Results for the three months and nine months ended September 30, 2003 are not necessarily indicative of the results that may be expected for the year ended December 31, 2003.

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for the interim financial period and with the instructions to Form 10-Q.  Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s annual report on Form 10-K for 2002 filed with the U.S. Securities and Exchange Commission.  The condensed consolidated balance sheet of the Company as of December 31, 2002 has been derived from the audited consolidated balance sheet as of that date.

 

During 2001, First Ottawa Bancshares, Inc. (Company) organized a wholly-owned subsidiary, First Ottawa Financial Corporation, to sell insurance and investment products.  There was no significant activity at this subsidiary through September 30, 2003.

 

NOTE 2 – EARNINGS PER SHARE

 

The number of shares used to compute basic and diluted earnings per share were as follows:

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2002			2003			2002
Net income (in thousands)		$	627		$	661		$	1,893		$	1,666
Weighted Average Shares outstanding		655,151			658,356			656,172			658,356
Effect of dilutive securities:
Stock options		—			—			—			—
Shares used to compute diluted earnings per share		655,151			658,356			656,172			658,356
Earnings per share:
Basic		$	0.96		$	1.00		$	2.88		$	2.53
Diluted		0.96			1.00			2.88			2.53

 

7

 

Options to purchase 6,750 shares at September 30, 2003 were not included in the earnings per share calculation as they were anti-dilutive.

 

NOTE 3 – CAPITAL RATIOS

 

At the end of the period,  the Company’s and Bank’s capital ratios were the same and were:

 

		September 30, 2003					December 31, 2002
		Amount			Ratio		Amount			Ratio
Total capital (to risk-weighted assets)		$	24,848		17.4	%	$	23,542		17.5	%
Tier I capital (to risk-weighted assets)		23,724			16.6	%	22,375			16.6	%
Tier I capital (to average assets)		23,724			10.1	%	22,375			9.5	%

 

At Septemebr 30, 2003, the Company and the Bank were categorized as well capitalized and management is not aware of any conditions or events since the most recent notification that would change the Company’s or Bank’s categories.

 

8

 

NOTE 4 - DERIVATIVES

 

The Company uses derivatives to fix future cash flows for interest payments on some of its floating rate certificates of deposit.  In this regard, the Company has entered into an interest rate swap with the Federal Home Loan Bank of Chicago to fix the interest rate on a specific certificate of deposit product.  At Septemebr 30, 2003, the Company had $2.5 million of certificates of deposit, which mature in 2006, 2007, and 2008, in which it pays the Federal Home Loan Bank a weighted average interest rate of 2.94% and will receive an interest rate from the Federal Home Loan Bank based on the appreciation of the S&P 500 Index.  This interest received from the Federal Home Loan Bank will be paid to the customer.  The assets and liabilities in this transaction are being netted and the expense recorded in interest expense on deposits.

 

In addition to the above, the Company also purchased $5.7 million of certificates of deposit, which are included in the certificates of deposit caption on the consolidated balance sheet.  These investments mature throughout 2006, 2007, and 2008.  The investments that individually do not exceed $100,000 are secured by the FDIC.  Investments that do individually exceed $100,000 are guaranteed by a standby letter of credit issued by the Federal Home Loan Bank of Pittsburgh with an interest rate of 0%.  The initial investment is not at risk, but the return on the investment is based on a calculation of the appreciation in the S&P 500 Index.  The fair value of this embedded derivative is recorded in investment certificates of deposit and the fair value adjustment is included in other income.  At September 30, 2003, the  Bank had allocated $567,000 to this asset and recorded a valuation allowance of $297,000, which is classified with the certificates of deposit caption on the consolidated balance sheet.

 

9

 

FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARY
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

 

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

 

The following discussion and analysis is intended as a review of significant factors affecting the financial condition and results of operations of the Company for the periods indicated.  The discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes.  In addition to historical information, the following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties.  The Company’s actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors discussed elsewhere in this report.

 

CRITICAL ACCOUNTING POLICIES

 

The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry.  The Company’s significant accounting policies are described in detail in the notes to the Company’s consolidated financial statements for the year ended December 31, 2002. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company’s financial condition and results, and they require management to make estimates that are difficult, subjective, or complex.

 

Allowance for Credit Losses- The allowance for credit losses provides coverage for probable losses inherent in the Company’s loan portfolio. Management evaluates the adequacy of the allowance for credit losses each quarter based on changes, if any, in underwriting activities, the loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory guidance and economic factors. This evaluation is inherently subjective, as it requires the use of significant management estimates. Many factors can affect management’s estimates of specific and expected losses, including volatility of default probabilities, rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs.

 

The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan’s

 

10

 

observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan’s effective interest rate.

 

Regardless of the extent of the Company’s analysis of customer performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors including inherent delays in obtaining information regarding a customer’s financial condition or changes in their unique business conditions, the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are among other factors. The Company estimates a range of inherent losses related to the existence of these exposures.  The estimates are based upon the Company’s evaluation of imprecision risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment.

 

Mortgage Servicing Rights- Mortgage servicing rights (“MSRs”) associated with loans originated and sold, where servicing is retained, are capitalized and included in other intangible assets in the consolidated balance sheet. The value of the capitalized servicing rights represents the present value of the future servicing fees arising from the right to service loans in the portfolio. Critical accounting policies for MSRs relate to the initial valuation and subsequent impairment tests. The methodology used to determine the valuation of MSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance. Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans. The carrying value of the MSRs is periodically reviewed for impairment based on a determination of fair value. For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates. Impairment, if any, is recognized through a valuation allowance and is recorded as amortization of intangible assets.

 

Derivatives- As a part of the Company’s funding strategy, derivative financial instruments, all of which are interest rate swap arrangements, are used to reduce exposure to changes in interest rates for certain financial instruments.  These derivatives are accounted for by recognizing the fair value of the contracts on the balance sheet.  The valuation of these derivatives is considered critical because carrying assets and liabilities at fair value inherently results in more financial statement volatility.  The fair values and the information used to record valuation adjustments for the interest rate swaps and related deposit products are provided by third parties.

 

Additionally, the Company has purchased certificate of deposits which contain an equity related embedded derivative component.  The initial investment in the certificate of deposit is not at risk but the return on the investment is based on appreciation in the S&P 500 Index.

 

11

 

Accordingly, the fair value of the embedded derivative is recorded at fair value as an adjustment to the certificate of deposit and interest income.

 

Stock Compensation- Grants under the Company’s  stock incentive plan are accounted for under the provisions of Statement of Accounting Standards (SFAS) No. 123, applying the fair value method and the use of an option pricing model to estimate the value of the options granted. The stock options are granted with an exercise price equal to the market price at the date of grant. Resulting compensation expense,  under  the stock options is measured and recorded based on the estimated value of the options.

 

12

 

CONSOLIDATED FINANCIAL CONDITION

 

Total assets at September 30, 2003 were $231.8 million contrasted to $240.7 million at December 31, 2002, a decrease of $8.9 million, or 3.7%.  This decrease was the result of a decrease in  securities available for sale, certificates of deposits at other financial institutions, and modest decreases in cash and cash equivalents and loans held for sale, partially offset by an increase in loans and bank premises and equipment.  Loans increased $5.1 million, primarily due to growth in the commercial and installment loan portfolios which was partially offset by decreases in the residential real estate and agricultural portfolios. The increase in loans was funded by a decrease in securities and certificates of deposits at other financial institutions. Securities available for sale decreased by  $11.8 million while certificates of deposits at other financial institutions decreased by $3.6 million as a result of maturities during the quarter. In addition to a funding source for loans, maturities also were used to pay down federal funds purchased balances. Loans held for sale decreased modestly by $20,000 as customers continued refinancing mortgage loans in reaction to the current rate environment during the first nine months of the year.  Premises and equipment increased by $1.8 million due to capital expenditures on land in Yorkville, Illinois and the construction on a new Morris, Illinois branch facility which opened for business on July 21, 2003.

 

The Company has purchased real estate in Yorkville, Illinois with the intention of establishing a full service branch facility in that community. Construction on the facility is anticipated to commence during the second quarter of 2004, with an expected completion date during the first quarter of 2005.

 

Total liabilities at September 30, 2003 were $206.1 million compared to $215.5 million at December 31, 2002, a decrease of $9.4 million, or 4.4%. This decrease was a result of  a decrease in federal funds purchased, repurchase agreements, other borrowings and other liabilities, partially offset by an increase in deposits.  Deposits increased by $4.8 million,  from $193.8 million at December 31, 2002, to $198.6 million at September 30, 2003, primarily due to increases in local municipality and county funds resulting from real estate tax payments.  Federal funds purchased totaled $2.4 million at September 30, 2003, a $12.3 million decrease from December 31, 2002. Other liabilities decreased by $1.5 million, primarily due to the reduction of dividends payable from $1.3 million as of December 31, 2002, to $0 as of September 30, 2003.  Securities sold under agreements to repurchase decreased $77,000 to $1.5 million as of September 30, 2003.

 

Total equity was $25.7 million at September 30, 2003 compared to $25.2 million at December 31, 2002.  This increase was the result of $1.9 million of additional retained earnings from net income for the period ended September 30, 2003 and a decrease of $455,000, net of tax, in the Company’s investment portfolio due to changing interest rates. The increase in retained earnings was also offset by a $254,000 purchase of Treasury shares and the declaration of dividends payable in July 2003.

 

13

 

CONSOLIDATED RESULTS OF OPERATIONS

 

Net income for the third quarter of 2003 was $627,000, or $0.96 per share, a 5.1% decrease compared to $661,000, or $1.00 per share, in the third quarter of 2002.  The decrease in net income for the quarter was primarily the result of a decrease in non-interest income of $45,000, an increase in non interest expense of $129,000, and a $5,000 increase in the provision for income taxes. These changes were partially offset by an increase in net interest income of $146,000.  This increase in the Company’s non interest expense reflects the additional occupancy expense associated with the opening of a full service branch in Morris, Illinois, along with increased professional expenses related to the pending acquisition of two additional branches located in Streator, Illinois.

 

During the nine months ended September 30, 2003, net income was $1.9 million, or $2.88 per share, compared to $1.7 million, or $2.53 per share during the first nine months of 2002.  This 13.6% increase in net income for the nine month period was primarily due to a $481,000 increase in net interest income, or 8.6%, and an increase in non-interest income of $345,000, or 21.3%. Increases in income were partially offset by an increase in non-interest expense of $370,000, or 7.4%, and an increase in income tax expense of $229,000, or 50.6%. This increase in the Company’s tax provision reflected both an increase in pre-tax income and a migration from tax exempt to taxable investments held in the securities portfolio.

 

The annualized return on average assets was 1.08% for the nine months ended September 30, 2003, compared to .97% in  2002  The annualized return on average equity increased to 10.76% for the nine months ended September 30, 2003, from 9.56% in 2002.

 

NET INTEREST INCOME

 

Net interest income was $2.1 million and $1.9 million for the three months ended September 30, 2003 and 2002.  Total interest income declined to $3.1 million for the three months ended September 30, 2003 from $3.3 million for the same period ended September 30, 2002, a 6.9% decrease.  This decrease was primarily the result of a decrease in interest income from securities to $1.0 million for the three months ended September 30, 2003 from $1.2 million for the same period a year earlier. This decrease was mitigated by a similar decline in interest expense, to $1.0 million for the three months ended September 30, 2003 from $1.4 million for the same period ended September 30, 2002, a 27.0% decrease.

 

Net interest income for the nine months ended September 30, 2003 and 2002 was $6.1 and $5.6 million, respectively. The Company’s net interest margin was 3.77% for the nine months ended September 30, 2003 and 3.57% a year earlier.  The yield on average earning assets decreased to 5.79% for the nine months ended September 30, 2003 from 6.29% for the same period ended September 30, 2002, a decline of 50 basis points.  This decrease was partially offset by a corresponding decrease in the cost of funds to 2.36% from 3.20% paid for the same period ended September 30, 2002, an 84 basis point decline. These decreases were reflective of  the declining rate environment throughout 2002 and the low rate environment which was sustained during  the first nine months of 2003.

 

14

 

PROVISION FOR LOAN LOSSES

 

The provision for loan losses remained constant at $30,000 in the third quarter of 2003 compared to the same period in 2002. As of September 30, 2003, the allowance for loan losses totaled $1.1 million, or .96% of total loans, which is a slight decrease from 1.06% as of December 31, 2002.  Nonaccrual loans increased from $364,000 at December 31, 2002 to $921,000  at September 30, 2003, due primarily to one commercial real estate credit. Nonperforming loans, including nonaccrual loans, decreased $81,000 to $1.0 million over the same period.

 

The amounts of the provision and allowance for loan losses are influenced by current economic conditions, actual loss experience, industry trends and other factors, including real estate values in the Company’s market area and management’s assessment of current collection risks within the loan portfolio. Along with other financial institutions, management shares a concern for the outlook of the economy for the remainder of 2003. Even though there areindications of emerging strength, it is uncertain if this strength is sustainable. If it is not sustainable, borrowers may experience difficulty, and the level of non-performing loans, charge- offs, and delinquencies could rise and require increases in the provision. The allowance for loan losses represents management’s estimate of probable incurred losses based on information available as of the date of the financial statements.  The allowance for loan losses is based on management’s evaluation of the collectibility of the loan portfolio, including past loan loss experience, known and inherent risks in the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, and economic conditions.

 

Management has concluded that the allowance for loan losses is adequate at September  30, 2003. However, there can be no assurance that the allowance for loan losses will be adequate to cover all losses.

 

NONINTEREST INCOME

 

The Company’s noninterest income totaled $614,000 for the three months ended September 30, 2003 compared to $659,000 for the same period in 2002, a decrease of $45,000 or 6.8%. The decrease in noninterest income was primarily due to decreases in gains on securities sold of $85,000  and a decrease in other income from bank owned life insurance of $51,000.  These decreases were partially mitigated by increased mortgage refinancing activity in the low rate environment. Gains on loan sales to the secondary market increased $82,000 to $155,000 in 2003 compared to 2002. Service charges on deposit accounts increased modestly by $12,000, or 5.7%, to $224,000. Trust and farm management fee income remained constant at $114,000 in 2003 compared to the same period in 2002.

 

For the nine months ended September 30, 2003, non-interest income increased by 21.3% or $345,000 to $2.0 million.  Service charges on deposit accounts increased modestly by $29,000, or 5.0%.  Gains on loan sales to the secondary market increased $517,000 due to increased origination and refinancing volume, and other fees and commissions decreased $115,000 due to decreased income related to bank owned life insurance. The increase in gains on sale of loans resulted primarily from the continuing low interest rate environment. While interest rates

 

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remain at historically low levels, management does not anticipate that the level of gains on sale of loans will continue throughout the entire year.

 

NONINTEREST EXPENSE

 

The Company’s noninterest expense was $1.8 million and $1.7 million for the three months ended September 30, 2003 and 2002.  Salaries and benefits, which is the largest component of non-interest expense, increased $11,000, or 1.2%, to $964,000.  Increases in occupancy and equipment expense of $35,000, professional fees of $57,000 and other expenses of $19,000, contributed to the $129,000 increase in noninterest expense for the three month period. Increased salaries and benefits were primarily a result of additional personnel hired to staff the Morris, Illinois facilility, which opened in July 2003. The increase in occupancy and equipment expenses was due primarily to increased depreciation on capital expenditures related to the renovation of the main banking facility and the construction of the Morris, Illinois facility. Increased professional fees were a result of the consulting and legal costs associated with the pending acquisition of two branch facilities in Streator, Illinois.  Increases in other expenses resulted from increased mortgage banking expenses of $23,000,  an increase in director life insurance expense of $27,000, and other expenses related to index powered certificates of deposit of $12,000. These increases were partially offset by decreases in losses on sale of repossessed autos of $22,000,  in addition to decreased credit card portfolio related expenses and merchant expenses of $14,000.

 

For the nine months ended September 30, 2003, noninterest expense increased $370,000 to $5.4 million, or 7.4%, compared to the year earlier period.  Salaries and benefits increased $133,000, or 4.7%, to $3.0 million.  Occupancy and equipment expenses were up $80,000 compared to the prior year, due to construction and capital expenditures and related depreciation expenses. Professional fees, supplies expense, data processing, advertising and promotion expense declined $19,000 in total due to a disciplined approach to controlling costs  Other expenses increased $176,000 primarily due to increases in mortgage banking related expenses, an increase in director life insurance expense and other expenses related to index powered certificates of deposit, which were partially offset by reductions in expenses related to repossessed assets and credit card losses.

 

LIQUIDITY AND CAPITAL RESOURCES

 

The Company’s primary sources of funds are deposits, repurchase agreements, and proceeds from principal and interest payments on loans and securities.  While maturities and scheduled amortization of loans and securities and calls of securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions, and competition.  The Company generally manages the pricing of its deposits to be competitive and to increase core deposit relationships.

 

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Liquidity management is both a daily and long-term responsibility of management.  The Company adjusts its investments in liquid assets based upon management’s assessment of  (i) expected loan demand, (ii) expected deposit flows, (iii) yields available on interest-earning deposits and securities, and (iv) the objectives of its asset/liability management program.  Excess liquid assets are invested generally in interest-earning overnight deposits and short- and intermediate-term U.S. government and agency obligations.

 

The Company’s most liquid assets are cash and short-term investments.  The levels of these assets are dependent on the Company’s operating, financing, lending, and investing activities during any given year.  At September 30, 2003, cash and short-term investments totaled $28.0 million.  The Company has other sources of liquidity if a need for additional funds arises, including securities maturing within one year and the repayment of loans.  The Company may also utilize the sale of securities available-for-sale, federal funds lines of credit from correspondent banks, and borrowings from the Federal Home Loan Bank of Chicago and Bank One.

 

The following table discloses contractual obligations and commercial commitments of the Company as of September 30, 2003:

 

		Total				Less Than 1 Year			1 – 3 Years			4 – 5 Years			After 5 Years
Federal funds purchased		$	2,360			$	2,360		$	—		$	—		$	—
Securities sold under agreements to repurchase		1,545				1,545			—			—			—
Note payable		430				430			—			—			—
		$		4,335		$	4,335		$	—		$	—		$	—

 

		Total Amounts Committed				Less Than 1 Year			1 – 3 Years			4 – 5 Years			Over 5 Years
Lines of credit(1)		$	15,118			$	5,819		$	897		$	1,393		$	7,009
Standby letters of credit(1)		190				190			—			—			—
Other commitments to extend credit(1)		—				—			—			—			—
		$		15,308		$	6,009		$	897		$	1,393		$	7,009

 

(1)  Represents amounts committed to customers.

 

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IMPACT OF INFLATION AND CHANGING PRICES

 

The financial statements and related data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America, which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation.  The primary impact of inflation on the operations of the Company is reflected in increased operating costs.  Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature.  As a result, interest rates, generally, have a more significant impact on a financial institution’s performance than does inflation.  Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

 

RECENT DEVELOPMENTS

 

On July 18, 2003, the Company announced that the Bank entered into a definitive agreement with First Midwest Bancorp, Inc., to purchase the two banking branches of First Midwest Bank located in Streator, Illinois  The transaction will consist of approximately $73.0 million in deposits and approximately $15.0 million in loans as well as the two branch locations in Streator.  The transaction is projected to close in the fourth quarter.

 

SAFE HARBOR STATEMENT

 

This document contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company.  Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions.  Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

 

The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain.  Factors which could have a material adverse effect on the operations and future prospects of the Company and its subsidiaries include, but are not limited to, the following:

•                                         The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company’s assets.

 

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•                                         The economic impact of past and any future terrorist attacks, acts of war or threats thereof and the response of the United States to any such threats and attacks.

 

•                                         The effects of, and changes in, federal, state and local laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters.

 

•                                         The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.

 

•                                         The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.

 

•                                         The inability of the Company to obtain new customers and to retain existing customers.

 

•                                         The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet.

 

•                                         Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.

 

•                                         The ability of the Company to develop and maintain secure and reliable electronic systems.

 

•                                         The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.

 

•                                         Consumer spending and saving habits which may change in a manner that affects the Company’s business adversely.

 

•                                         Business combinations and the integration of acquired businesses which may be more difficult or expensive than expected.

 

•                                         The costs, effects and outcomes of existing or future litigation.

 

•                                         Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.

 

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•                                         The ability of the Company to manage the risks associated with the foregoing as well as anticipated.

 

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.  Additional information concerning the Company and its business, including other factors that could materially affect the Company’s financial results, is included in the Company’s filings with the Securities and Exchange Commission.

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

ITEM 3:      QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Company’s overall interest rate sensitivity is demonstrated by net income analysis and “Gap” analysis.  Net income analysis measures the change in net income in the event of hypothetical changes in interest rates.  This analysis assesses the risk of change in net income in the event of sudden and sustained 2.0% increases and decreases in market interest rates.  The tables below present the Company’s projected changes in annualized net income for the various rate shock levels at September 30, 2003 and September 30, 2002.

 

			2003 Net Income
			Amount			Change			Change
			(Dollars in Thousands)
+200 bp			$	2,477		$	(18	)	(0.7	)%
Base			2,495			—			—
–200 bp			2,336			(159		)	(6.4	)%

 

			2002 Net Income
			Amount			Change			Change
			(Dollars in Thousands)
+200 bp			$	2,286		$	(72	)	(3.1	)%
Base			2,358			—			—
–200 bp			2,414			56			2.4	%

 

As shown above, at September 30, 2003, the effect of an immediate 200 basis point increase in interest rates would decrease the Company’s net income by 0.7% or approximately $18,000.  The effect of an immediate 200 basis point decrease in rates would decrease the Company’s net interest income by 6.4% or approximately $159,000.  However, the Company does not anticipate market interest rates decreasing an additional 200 basis points, so these results may not be acheivable.  Net income sensitivity to a rapidly increasing rate environment has decreased since September 30, 2002.

 

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ITEM 4:      CONTROLS AND PROCEDURES

 

An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended) as of September 30, 2003. Based on that evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls.

 

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PART II

 

ITEM 1.		LEGAL PROCEEDINGS
		There are no material pending legal proceedings to which the Company or its subsidiaries are a party other than ordinary routine litigation incidental to their respective businesses.
ITEM 2.		CHANGES IN SECURITIES
		None
ITEM 3.		DEFAULTS UPON SENIOR SECURITIES
		None
ITEM 4.		SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
		None
ITEM 5.		OTHER INFORMATION
		None
ITEM 6.		EXHIBITS AND REPORTS ON FORM 8-K
		Exhibits
		31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)
		31.2	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)
		32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
		32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
		Reports on Form 8-K
		A report on Form 8-K was filed on July 18, 2003 pursuant to Item 5, which reported, in the form of a press release, that the Corporation’s subsidiary bank, First National Bank of Ottawa, entered into a definitive agreement with First Midwest Bank to purchase two banking branches of First Midwest Bank located in Streator, Illinois.

 

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		A report on Form 8-K was filed on July 25, 2003 pursuant to Item 12, which reported, in the form of a press release, the Corporation’s financial results for the quarter ended June 30, 2003.
		A report on Form 8-K was filed on October 24, 2003 pursuant to Item 12, which reported, in the form of a press release, the Corporation’s financial results for the quarter ended September 30, 2003.

 

 

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.

 

 

	FIRST OTTAWA BANCSHARES, INC.
	(Registrant)
DATE:  November 12, 2003	/S/ JOACHIM J. BROWN
	Joachim J. Brown
	President (Chief Executive Officer)
DATE:  November 12, 2003	/S/ VINCENT G. EASI
	Vincent G. Easi
	Chief Financial Officer

 

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