Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2004

Commission File Number 000-30707

First Northern Community Bancorp

(Exact name of registrant as specified in its charter)

195 N. First St., Dixon, CA

(Address of principal executive offices)

95620

(Zip Code)

707-678-3041

(Registrant’s telephone number including area code)

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 Exchange Act).    Yes  x    No  ¨

As of August 5, 2004, there were 3,601,326 shares of Common Stock, no par value, outstanding.

Table of Contents

FIRST NORTHERN COMMUNITY BANCORP

INDEX

2

Table of Contents

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

See notes to unaudited condensed consolidated financial statements.

3

Table of Contents

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share amounts)

See notes to unaudited condensed consolidated financial statements.

4

Table of Contents

Unaudited Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Income

(in thousands, except share amounts)

See notes to unaudited condensed consolidated financial statements.

5

Table of Contents

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

See notes to unaudited condensed consolidated financial statements.

6

Table of Contents

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2004 and December 31, 2003

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 Articles 9 and 10 of Regulation S-X. Accordingly, they do not include all of the information and notes 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. The results of operations for any interim period are not necessarily indicative of results expected for the full year. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in First Northern Community Bancorp’s (the “Company”) Annual Report to shareholders and Form 10-K for the year ended December 31, 2003. All material intercompany balances and transactions have been eliminated in consolidation.

The allowance for loan losses is maintained at levels considered adequate by management to provide for loan losses that can be reasonably anticipated. The allowance is based on management’s assessment of various factors affecting the loan portfolio, including problem loans, economic conditions and loan loss experience, and an overall evaluation of the quality of the underlying collateral. Changes in the allowance for loan losses during the six-month periods ended June 30, 2004 and 2003 and for the year ended December 31, 2003 were as follows (in thousands):

Transfers and servicing of financial assets and extinguishments of liabilities are accounted for and reported based on consistent application of a financial-components approach that focuses on control. Transfers of financial assets that are sales are distinguished from transfers that are secured borrowings. Retained interests (mortgage servicing rights) in loans sold are measured by allocating the previous carrying amount of the transferred assets between the loans sold and retained interest, if any, based on their relative fair value at the date of transfer. Fair values are estimated using discounted cash flows based on a current market interest rate.

The Company recognizes a gain and a related asset for the fair value of the rights to service loans for others when loans are sold. The Company sold substantially all of its conforming long-term residential mortgage loans originated during the six months ended June 30, 2004 for cash proceeds equal to the fair value of the loans.

7

Table of Contents

The recorded value of mortgage servicing rights is included in other assets, and is amortized in proportion to, and over the period of, estimated net servicing revenues. The Company assesses capitalized mortgage servicing rights for impairment based upon the fair value of those rights at each reporting date. For purposes of measuring impairment, the rights are stratified based upon the product type, term and interest rates. Fair value is determined by discounting estimated net future cash flows from mortgage servicing activities using discount rates that approximate current market rates and estimated prepayment rates, among other assumptions. The amount of impairment recognized, if any, is the amount by which the capitalized mortgage servicing rights for a stratum exceeds their fair value. Impairment, if any, is recognized through a valuation allowance for each individual stratum.

At June 30, 2004, the Company had $13,229,000 of mortgage loans held for sale. At June 30, 2004 and December 31, 2003, the Company serviced real estate mortgage loans for others of $104,182,000 and $98,172,000, respectively.

The following table summarizes the Company’s mortgage servicing rights assets as of June 30, 2004 and December 31, 2003.

During the six months ended June 30, 2004, the Company obtained an additional amortizing advance on March 15, 2004, in the amount of $5,625,084, from the Federal Home Loan Bank (FHLB). The advance matures on March 16, 2009, and has a fixed rate of 3.14 percent. The purpose of the advance was to offset the interest risk associated with a loan with similar payment characteristics.

On January 22, 2004, the Board of Directors of the Company declared a 6% stock dividend payable as of March 31, 2004 to shareholders of record as of February 28, 2004. Earnings per share amounts have been adjusted to reflect the effect of the stock dividend.

Earnings Per Share (EPS)

Basic EPS includes no dilution and is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS includes all common stock equivalents (“in-the-money” stock options, warrants and rights, convertible bonds and preferred stock), which reflects the potential dilution of securities that could share in the earnings of an entity.

8

Table of Contents

The following table presents basic and diluted EPS for the three-month and six-month periods ended June 30, 2004 and 2003 (amounts in thousands, except share and earnings per share amounts):

9

Table of Contents

Stock-based employee compensation recognized for all stock options granted after January 1, 2003 is based on the fair value recognition provisions of Statements of Financial Accounting Standards Nos. 123 and 148. For stock options issued prior to January 1, 2003, the Company is using the intrinsic value method, under which compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. The following table illustrates the effect on net income and earnings per share as if the fair value based method had been applied to all outstanding and unvested awards in each period:

10

Table of Contents

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This document contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and subject to the “safe harbor” created by those sections. Forward-looking statements include the information concerning possible or assumed future results of operations of the Company set forth under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements also include statements in which words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” estimate,” “consider” or similar expressions are used, and includes assumptions concerning the Company’s operations, future results and prospects. These forward-looking statements are based upon current expectations and are subject to risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from those set forth in or implied by the forward-looking statements and related assumptions. Some factors that may cause actual results to differ from the forward-looking statements include the following: (i) the effect of changing regional and national economic conditions, including the recent budgetary crisis and continuing fiscal difficulties of the State of California; (ii) uncertainty regarding the economic outlook resulting from the continuing hostilities in Iraq and the war on terrorism, as well as actions taken or to be taken by the United States or other governments as a result of further acts or threats of terrorism; (iii) significant changes in interest rates and prepayment speeds; (iv) credit risks of commercial, agricultural, real estate, consumer and other lending activities; (v) adverse effects of current and future federal and state banking or other laws and regulations or governmental fiscal or monetary policies; (vi) competition in the banking industry; and (vii) other external developments which could materially impact the Company’s operational and financial performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made. For additional information concerning risks and uncertainties related to the Company and its operations, please refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

The following is a discussion and analysis of the significant changes in the Company’s Unaudited Condensed Consolidated Balance Sheets and of the significant changes in income and expenses reported in the Company’s Unaudited Condensed Consolidated Statements of Income and Stockholders’ Equity and Comprehensive Income as of and for the three-month and six-month periods ended June 30, 2004 and 2003 and should be read in conjunction with the Company’s consolidated 2003 financial statements and the notes thereto contained in the Company’s Annual Report to Shareholders and Form 10-K for the year ended December 31, 2003, along with other financial information included in this report.

11

Table of Contents

SUMMARY

The Company recorded net income of $3,008,000 for the six-month period ended June 30, 2004, representing a decrease of $148,000 or 4.7% from net income of $3,156,000 for the same period in 2003.

The decrease in net income for the six-month period ended June 30, 2004 as compared to the same period a year ago resulted primarily from a decrease in net interest income and other operating income which was partially offset by a decrease in provision for loan losses and decreases in other operating expenses.

The Company recorded net income of $1,611,000 for the three-month period ended June 30, 2004, representing an increase of $28,000 or 1.8% from net income of $1,583,000 for the same period in 2003.

The increase in net income for the three-month period ended June 30, 2004 as compared to the same period a year ago resulted primarily from a decrease in provision for loan losses and decreases in other operating expenses which was partially offset by a decrease in net interest income and other operating income.

CHANGES IN FINANCIAL CONDITION

The assets of the Company set forth in the Unaudited Condensed Consolidated Balance Sheets showed a $10,792,000 increase in cash and due from banks, a $4,700,000 decrease in federal funds sold, a $3,462,000 increase in investment securities available-for-sale, a $14,458,000 increase in loans, a $2,557,000 increase in loans held for sale, a $204,000 decrease in premises and equipment, a $571,000 increase in other real estate owned and a $733,000 increase in accrued interest receivable and other assets from December 31, 2003 to June 30, 2004. The increase in cash and due from banks was due to an increase in items in process of collection. The decrease in federal funds sold was due to an increase in sales in investment securities. The increase in investment securities available-for-sale was due to the use of the proceeds from federal funds sold to purchase investment securities. The increase in loans was due to an increase in commercial, agriculture, commercial real estate and construction loans and home equity lines of credit, which was partially offset by a decrease in financed equipment leases and consumer and real estate loans. These fluctuations were due to changes in the demand for certain loan products by the Company’s borrowers. The increase in loans held for sale was in real estate loans and was due, for the most part, to an increase in the origination of loans compared to sales. The Company originated approximately $35,334,000 in residential mortgage loans during the first six months of 2004, which was offset by approximately $33,054,000 in loan sales during this period. The decrease in premises and equipment was due to a reduction in computer hardware and furniture and equipment purchases and continued depreciation. The increase in other real estate owned was due to the foreclosure on real property held as collateral for a loan. The real property was sold on July 7, 2004 for $599,000. The increase in accrued interest receivable and other assets was due to an increase in computer software, cash surrender value of bank-owned life insurance, mortgage servicing asset, and income taxes receivable, which was partially offset by decreases in securities interest receivables and loan interest receivables, prepaid expenses, an increase in housing tax credit amortization expense, and amortized costs on leases.

The liabilities of the Company set forth in the Unaudited Condensed Consolidated Balance Sheets showed an increase in total deposits of $20,206,000 at June 30, 2004 compared to deposit totals for the year ended December 31, 2003. The increase in deposits was due to higher demand, savings, money market and time deposit totals combined with lower interest-bearing transaction deposit totals. The fluctuations were due to cyclical changes in deposit requirements of the Company’s depositors. Federal Home Loan Bank advance (“FHLB advance”) and other borrowings increased $6,049,000 for the six months ended June 30, 2004 compared to the year ended December 31, 2003, due to an additional FHLB advance and an increase in treasury tax and loan note payable. Other liabilities decreased $128,000 from December 31, 2003 to June 30, 2004. The decrease in other liabilities was due to a decrease in accrued interest expense, taxes payable, accrued profit sharing and incentive compensation expenses, which were partially offset by increases in accrued retirement expense and deferred compensation expense.

12

Table of Contents

CHANGES IN RESULTS OF OPERATIONS

Interest Income

The reduction in general market rates decreased the Company’s yields on earning assets. The Federal Open Market Committee increased the federal funds rate by 25 basis points during the twelve-month period ended June 30, 2004. This increase occurred on June 30, 2004.

Interest income on loans for the six-month period ended June 30, 2004 was down 0.3% from the same period in 2003, decreasing from $13,091,000 to $13,052,000 and was up 1.4% for the three-month period ended June 30, 2004 over the same period in 2003, from $6,533,000 to $6,623,000. The decrease from the six-month period ended June 30, 2004 as compared to the same period a year ago was primarily due to a 32 basis point decrease in loan yields which was partially offset by an increase in average loans. The increase over the three-month period ended June 30, 2004 as compared to the same period a year ago was primarily due to a 15 basis point decrease in loan yields which was more than offset by an increase in average loans.

Interest income on federal funds sold for the six-month period ended June 30, 2004 was up 400% from the same period in 2003, increasing from $61,000 to $305,000 and was up 400% for the three-month period ended June 30, 2004 over the same period in 2003, from $32,000 to $160,000. The increase in federal funds income for the six-month period ended June 30, 2004 was primarily due to an increase in average federal funds sold which was partially offset by a 26 basis point decrease in federal funds rates. The increase over the three-month period ended June 30, 2004 as compared to the same period a year ago, was primarily due to an increase in average federal funds sold which was partially offset by a 27 basis point decrease in federal funds rates. The changes in average federal funds sold were the result of the usual seasonality of transaction deposit accounts.

Interest income on investment securities for the six-month period ended June 30, 2004 was down 25.9% from the same period in 2003, decreasing from $1,896,000 to $1,405,000 and was down 23.7% for the three-month period ended June 30, 2004 over the same period in 2003, from $940,000 to $717,000. The decrease from the six-month period ended June 30, 2004 as compared to the same period a year ago was primarily due to a decrease in average securities which was partially offset by a 4 basis point increase in securities yields. The decrease over the three-month period ended June 30, 2004 as compared to the same period a year ago was primarily due to a decrease in average investment securities which was partially offset by a 22 basis point increase in investment securities yields.

Interest Expense

The reduction in general market rates decreased the Company’s cost of funds. The Federal Open Market Committee increased the federal funds rate by 25 basis points during the past twelve months. This increase occurred on June 30, 2004.

Interest expense on deposits and other borrowings for the six-month period ended June 30, 2004 was up 6.4% from the same period in 2003, increasing from $1,536,000 to $1,634,000 and was up 14.8% for the three-month period ended June 30, 2004 over the same period in 2003 from $749,000 to $860,000. The increase in interest expense from the six-month period ended June 30, 2004 was primarily due to increased average interest bearing deposits and an increase in FHLB advance and other borrowings, which was partially offset by a 10 basis point decrease in deposit rates. The increase in interest expense from the three-month period ended June 30, 2004 was primarily due to increased average interest bearing deposits and an increase in FHLB advance and other borrowings, which was partially offset by a 5 basis point decrease in deposit rates.

Provision for Loan Losses

There was a provision for loan losses of $305,000 for the six-month period ended June 30, 2004 compared to a $1,240,000 provision for the same period in 2003. The decrease in the provision was due to a decrease in non-accrual loans. The June 30, 2004 allowance for loan losses of approximately $8,197,000 was 2.09% of total loans (excluding loans held for sale) compared to $7,738,000 or 2.05% of total loans (excluding loans held for sale) at December 31, 2003. The allowance for loan losses is maintained at a level considered adequate by management to provide for possible loan losses.

13

Table of Contents

Other Operating Income

Other operating income was down 39.9% for the six-month period ended June 30, 2004 from the same period in 2003, decreasing from $4,073,000 to $2,450,000. This decrease was primarily due to a decrease in gains on sales of loans, gains on other real estate owned, mortgage brokerage income, and realized gains on available for sale securities, which was partially offset by an increase in service charges on deposit accounts, investment and brokerage services income, loan servicing income, and other miscellaneous income. Decreases in gains on sales of loans and mortgage brokerage income accounted for most of the decrease in other operating income during the six-month period ended June 30, 2004, due to a slowdown in demand for mortgage financing and refinancing activity compared to the same period in 2003. The Company sold approximately $33,054,000 in residential mortgage loans during the six-month period ended June 30, 2004, as compared to $93,717,000 for the same period in 2003. The decrease in other real estate owned income was due to a payment received on a previously owned real estate property during the six-month period ended June 30, 2003 that was not repeated during the same period in 2004. The decrease in realized gains on available for sale securities was due to the sale of a corporate bond that was previously written down due to a decline in value during the six-month period ended June 30, 2003 that was not repeated during the same period in 2004. The increase in service charges on deposit accounts was due to an increase in monthly service charges and other service charges. The increase in loan servicing income was due to an increase in mortgage-servicing income. The increase in investment and brokerage services income was due to an increase in demand for investment and brokerage services. Other miscellaneous income increased for the most part due to an increase in trust income and stand-by letter of credit fees which were offset by a decrease in cash surrender value on bank-owned life insurance policies.

Other operating income was down 37.9% for the three-month period ended June 30, 2004 from the same period in 2003, decreasing from $2,110,000 to $1,310,000. This decrease was primarily due to a decrease in gains on sales of loans, gains on other real estate owned, mortgage brokerage income, loan servicing income, ATM fees and realized gains on available for sale securities, which was partially offset by an increase in service charges on deposit accounts, investment and brokerage services income, and other miscellaneous income. Decreases in gains on sales of loans and mortgage brokerage income accounted for most of the decrease in other operating income during the three-month period ended June 30, 2004, due to a slowdown in demand for mortgage financing and refinancing activity compared to the same period in 2003. The Company sold approximately $22,677,000 in residential mortgage loans during the three-month period ended June 30, 2004, as compared to $48,895,000 for the same period in 2003. The decrease in other real estate owned income was due to a payment received on a previously owned real estate property during the three-month period ended June 30, 2003 that was not repeated during the same period in 2004. The decrease in loan servicing income was due to a decrease in mortgage-servicing income. The decrease in ATM fees was due to lower interchange income associated with a decline in transaction volumes. The decrease in realized gains on available for sale securities was due to the reduction in sales in the three-months ended June 30, 2004 compared to sales in the same period in 2003. The increase in service charges on deposit accounts was due to an increase in overdraft fees, monthly service charges and other service charges. The increase in loan servicing income was due to an increase in mortgage-servicing income. The increase in investment and brokerage services income was due to an increase in demand for investment and brokerage services. Other miscellaneous income increased for the most part due to an increase in trust income, stand-by letter of credit fees, and Visa debit card income which was partially offset by a decrease in interest income on bank-owned life insurance policies.

14

Table of Contents

Other Operating Expenses

Total other operating expenses was down 7.4% for the six-month period ended June 30, 2004 from the same period in 2003, decreasing from $11,509,000 to $10,653,000.

The main reasons for the decrease in other operating expenses in the six-month period ended June 30, 2004 were the following: decreases in salaries and benefits, stationery and supplies, and advertising costs; which were partially offset by increases in occupancy and equipment, data processing expense, and other miscellaneous expense. The decrease in salaries and benefits was due to decreases in the following: commissions for real estate loans; payroll taxes; stock option compensation expense; retirement compensation expense; and profit sharing and incentive compensation provisions due to decreased profits combined with increases in worker’s compensation expense; merit salary increases; group insurance expense; deferred compensation interest expense; and welfare and recreation expense. The decrease in advertising costs was due to reduction in production costs for the Company’s annual report compared to the same period in 2003. The decrease in stationery and supplies was due to a reduction in supply usage. The increase in occupancy and equipment costs was due to increased rent expense, hazard and liability insurance expense, bank-owned vehicle expense, computer hardware depreciation and service contract expense. The increase in data processing costs was due to increased expenses associated with maintaining and monitoring the Company’s data communications network and Internet banking system. The increase in other miscellaneous expense was due to increases in the following: consulting fees; postage; telephone; subscriptions; debit card expenses; public relations; meals and entertainment; membership dues; examination fees; insurance costs; accounting and audit fees; correspondent bank fees; and amortization expense of the investment in unconsolidated subsidiary for the affordable housing tax credit investment; which were partially offset by decreases in miscellaneous loan and lease expense; credit reports; checks purchased; legal fees; contributions; broker fees; messenger service; employee training costs; and sundry losses.

Total other operating expenses was down 7.0% for the three-month period ended June 30, 2004 from the same period in 2003, decreasing from $5,867,000 to $5,456,000.

The main reasons for the decrease in other operating expenses in the three-month period ended June 30, 2004 were the following: decreases in salaries and benefits, stationery and supplies, advertising costs and other miscellaneous expenses which were partially offset by increases in occupancy expense and equipment and data processing expense. The decrease in salaries and benefits was due to decreases in the following: commissions for real estate loans; payroll taxes; welfare and recreation expense; and provision for incentive compensation expenses due to decreased profits combined with increases in worker’s compensation expense; merit salary increases; group insurance; deferred compensation interest expense; stock option compensation expense; and profit sharing provisions. The decrease in advertising costs was due to reduction in production costs for the Company’s annual report compared to the same period in 2003. The decrease in stationery and supplies was due to a reduction in supply usage and printing costs associated with the Company’s annual report compared to the same period in 2003. The decrease in other miscellaneous expense was due to decreases in the following: miscellaneous loan and lease expense; checks purchased; credit reports; meals and entertainment; membership dues; legal fees; broker fees; messenger service; employee training costs; and debit card expenses; which were partially offset by increases in consulting fees; contributions; postage; telephone; subscriptions; public relations; examination fees; insurance costs; accounting and audit fees; and amortization expense of the investment in unconsolidated subsidiary for the affordable housing tax credit investment. The increase in occupancy and equipment costs was due to increased rent expense, bank-owned vehicle expense, computer hardware depreciation and service contract expense. The increase in data processing costs was due to increased expenses associated with maintaining and monitoring the Company’s data communications network and Internet banking system.

Income Taxes

The Company’s tax rate, the Company’s earnings before taxes and the amount of tax relief provided by nontaxable earnings primarily affect the Company’s provision for income taxes. In the six months ended June 30, 2004, the Company’s provision for income taxes decreased from $1,680,000 to $1,612,000 for the same period in 2003. The Company’s effective tax rate for the six months ended June 30, 2004 was 34.9%, compared to 34.7% for the same period in 2003. The increase in the effective tax rate was due to lower nontaxable municipal bond income, which was partially offset by an investment in an affordable housing tax credit in the six months ended June 30, 2004 compared to the same period in 2003. Nontaxable municipal bond income was $311,000 and $368,000 for the six months ended June 30, 2004 and 2003, respectively.

15

Table of Contents

In the three months ended June 30, 2004, the Company’s provision for income taxes increased $37,000 from $846,000 to $883,000 for the same period in 2003. The Bank’s effective tax rate for the three months ended June 30, 2004 was 35.4%, compared to 34.8% for the same period in 2003. The increase in the effective tax rate was due to lower nontaxable municipal bond income in the three months ended June 30, 2004 compared to the same period in 2003, which was partially offset by an investment in an affordable housing tax credit. Nontaxable municipal bond income was $154,000 and $178,000 for the three months ended June 30, 2004 and 2003, respectively.

Off-Balance Sheet Commitments

The following table shows the distribution of the Company’s undisbursed loan commitments at the dates indicated.

Asset Quality

The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans and delinquencies, with particular attention to portfolio dynamics and loan mix. The Company strives to identify loans experiencing difficulty early enough to correct the problems, to record charge-offs promptly based on realistic assessments of current collateral values and to maintain an adequate allowance for loan losses at all times.

It is generally the Company’s policy to discontinue interest accruals once a loan is past due for a period of ninety days as to interest or principal payments. When a loan is placed on non-accrual, interest accruals cease and uncollected accrued interest is reversed and charged against current income. Payments received on non-accrual loans are applied against principal. A loan may only be restored to an accruing basis when it again becomes well secured and in the process of collection or all past due amounts have been collected.

Non-accrual loans amounted to $917,137 at June 30, 2004 and were comprised of four commercial loans totaling $72,776 and three agricultural loans totaling $844,361. At December 31, 2003, non-accrual loans amounted to $3,877,000 and were comprised of six commercial loans totaling $395,000, and nine agricultural loans totaling $3,482,000. At June 30, 2003, non-accrual loans amounted to $8,814,000 and were comprised of twelve commercial loans totaling $5,329,331, ten agricultural loans totaling $3,449,178 and five installment loans totaling $35,278. The decrease in non-accrual loans at June 30, 2004 from the balance at December 31, 2003 was due to four commercial loans for which we received payments and/or were charged off, and eight agricultural loans, six that received payments, one that was partially charged off, and one with the remaining balance transferred to other real estate owned which was subsequently sold. Since June 30, 2004, two of the commercial loans on non-accrual at June 30, 2004 totaling $66,401 have been repaid. Nearly all of the remaining non-accrual loan balances can be attributed to a relationship with one of the Company’s business customers, consisting of 2 agricultural loans which are in the process of collection. These loans did not require a significant increase in loan loss reserves because they were adequately collateralized. The Company’s management believes that nearly $875,608 of the non-accrual loans at June 30, 2004 are adequately collateralized or guaranteed by a governmental entity, and the remaining $41,529 may have some potential loss which management believes is sufficiently covered by the Company’s existing loan loss reserve. See “Allowance for Loan Losses” below for additional information. No assurance can be given that the existing or any additional collateral will be sufficient to secure full recovery of the obligations owed under these loans.

At June 30, 2004, the Company had no loans 90 days past due and still accruing. Such loans amounted to $4,000 at December 31, 2003, and at June 30, 2003, the Company had no loans 90 days past due and still accruing.

16

Table of Contents

Allowance for Loan Losses

The Company’s Allowance for Loan Losses is maintained at a level believed by management to be adequate to provide for loan losses that can be reasonably anticipated. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. The Company makes credit reviews of the loan portfolio and considers current economic conditions, loan loss experience and other factors in determining the adequacy of the reserve balance. The allowance for loan losses is based on estimates and actual losses may vary from current estimates.

The following table summarizes the loan loss experience of the Company for the six-month periods ended June 30, 2004 and 2003, and for the year ended December 31, 2003.

Analysis of the Allowance for Loan Losses

(Dollars in Thousands)

Deposits

Deposits are the Company’s primary source of funds. At June 30, 2004, the Company had the following deposit mix: 33% in savings and MMDA deposits, 24% in time deposits, 12% in interest-bearing transaction deposits and 31% in non-interest-bearing transaction deposits. Non-interest-bearing transaction deposits enhance the Company’s net interest income by lowering its costs of funds.

The Company obtains deposits primarily from the communities it serves. No material portion of its deposits has been obtained from or is dependent on any one person or industry. The Company accepts deposits in excess of $100,000 from customers. These deposits are priced to remain competitive.

17

Table of Contents

Maturities of time certificates of deposits of $100,000 or more outstanding at June 30, 2004 and December 31, 2003 are summarized as follows:

Liquidity and Capital Resources

In order to adequately serve our market area, the Company must maintain adequate liquidity and adequate capital. Liquidity is measured by various ratios, with the most common being the ratio of net loans to deposits (including loans held for sale). This ratio was 76.31% on June 30, 2004. In addition, on June 30, 2004, the Company had the following short-term investments: $66,215,000 in federal funds sold; $7,100,000 in securities due within one year; and $35,400,000 in securities due in one to five years.

To meet unanticipated funding requirements, the Company maintains short-term unsecured lines of credit with other banks totaling $20,700,000.

The Company’s primary source of liquidity on a stand-alone basis is dividends from the Bank. Dividends from the Bank are subject to regulatory restrictions.

As of June 30, 2004, the Bank’s capital ratios exceeded applicable regulatory requirements. The following tables present the capital ratios for the Bank, compared to the standards for well-capitalized depository institutions, as of June 30, 2004 (amounts in thousands except percentage amounts).

Return on Equity and Assets