Annual Report — Form 10-K Filing Table of Contents
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1: 10-K Annual Report HTML 149K
2: EX-13 Copy of Portions of the Company's Annual Report to HTML 512K Stockholders
3: EX-21 List of Subsidiaries HTML 6K
4: EX-31.1 Section 302 Certification of Chairman of the Board HTML 14K
and President
5: EX-31.2 Section 302 Certification of Vp and Treasurer HTML 14K
6: EX-32 Section 906 Certification HTML 9K
EX-13 — Copy of Portions of the Company’s Annual Report to Stockholders
Net interest income after provision for
loan and lease losses
16,256
17,608
16,574
18,609
17,923
Noninterest income
4,370
4,552
4,050
3,781
3,935
Noninterest expense
18,008
16,623
12,210
11,100
10,270
Income before income taxes
2,618
5,537
8,414
11,290
11,588
Provision for income taxes
531
1,536
2,888
3,779
3,829
Net Income
$
2,087
$
4,001
$
5,526
$
7,511
$
7,759
BALANCE SHEET DATA:
Cash, non-interest bearing
$
23,586
$
20,292
$
18,403
$
16,475
$
18,172
Investments (1)
273,235
262,074
302,497
259,735
231,772
Loans and leases, net
389,884
434,750
353,843
348,426
322,858
All other assets
35,823
32,468
14,876
11,040
14,436
Total Assets
$
722,528
$
749,584
$
689,619
$
635,676
$
587,238
Deposits
$
554,449
$
589,344
$
493,132
$
449,594
$
407,032
Securities sold under repurchase agreements
and other borrowings (2)
73,093
74,764
109,867
97,181
86,170
Federal Home Loan Bank advances
6,500
6,500
6,500
6,500
10,000
Subordinated debentures
10,000
0
0
0
0
All other liabilities
7,734
5,794
4,791
5,809
7,707
Stockholders’ equity
70,752
73,182
75,329
76,592
76,329
Total Liabilities & Stockholders’ Equity
$
722,528
$
749,584
$
689,619
$
635,676
$
587,238
PER SHARE DATA:
Basic and diluted earnings per share
$
0.49
$
0.93
$
1.28
$
1.71
$
1.74
Cash dividends declared
0.62
1.10
1.08
1.06
1.00
Book value (at end of year)
16.47
17.04
17.50
17.75
17.08
SELECTED FINANCIAL AND OTHER RATIOS:
Return on average assets (3)
0.28
%
0.51
%
0.87
%
1.26
%
1.39
%
Return on average equity
2.90
5.44
7.23
9.78
10.33
Average stockholders’ equity to average assets
9.62
9.47
12.01
12.85
13.46
Tax equivalent interest rate spread (3)
2.49
2.88
2.59
2.89
2.60
Tax equivalent net interest income to
average earning assets (3)
2.83
3.08
2.91
3.36
3.46
Non-performing assets to total assets
3.65
3.24
3.40
2.53
3.31
Dividend payout ratio (4)
127.60
118.27
84.15
62.10
57.56
(1)
Includes interest bearing deposits in other financial
institutions, federal funds sold, securities available for sale and
Federal Home Loan Bank and Federal Reserve Bank stock.
(2)
Securities sold under repurchase
agreements and federal funds purchased.
(3)
Reflects
the securities available for sale at amortized cost for average balance calculation.
(4)
Total cash dividends divided by net income.
NSFC ANNUAL 16 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is a discussion and analysis
of Northern States Financial Corporation’s (the
“Company”) financial position and results of
operations and should be read in conjunction with the
consolidated financial statements and notes thereto
appearing elsewhere in this report. The Company on
November 10, 2005 merged its two wholly owned
subsidiaries, the Bank of Waukegan and First State
Bank of Round Lake, and named the resulting bank
subsidiary NorStates Bank (the “Bank”). The Bank has
one wholly owned subsidiary, Northern States
Community Development Corporation (“NSCDC”), which
was formed during 2002.
The Bank is a commercial bank that provides
traditional banking services to corporate, retail and
civic entities in their market as well as mortgage
banking services. In addition, the Bank provides
trust services. NSCDC was set up to develop and sell
one parcel of other real estate owned that was
contributed by the Bank in 2002.
The Company and its subsidiary are subject to
regulation by numerous agencies including the
Federal Reserve Board, the Federal Deposit Insurance Corporation and
the Illinois Department of Financial and Professional
Regulation. Among other things, these agencies limit
the activities in which the Company and the Bank may
engage, the investments and loans that the Bank may
fund, and set the amount of reserves against deposits
that the subsidiary must maintain.
The statements contained in this management’s
discussion and analysis that are not historical facts
are forward-looking statements subject to the safe
harbor created by the Private Securities Litigation
Reform Act of 1995. Forward-looking statements, which
are based on certain assumptions and describe future
plans, strategies and expectations of the Company, are
identifiable by the use of the words “believe”,
“expect”, “intend”, “estimate” or similar
expressions. The Company cautions readers that a
number of important factors could cause the Company’s
actual results in 2006 and beyond to differ
materially from those expressed in any such
forward-looking statements.
OVERVIEW
Assets totaled $722.5 million at December31, 2005, decreasing $27.1 million, or 3.6%, from the
previous year-end as a result of a decrease in loans
and leases of $42.1 million. As loans and leases
decreased, the Company increased its securities
available for sale by $14.1 million as compared with
year-end 2004 levels. Deposits declined $34.9 million
from the previous year-end as deposit levels were not
needed to fund the lower loan levels.
The decrease in loans in 2005 resulted from loan
repayments outpacing loan growth. During 2005 one
borrower paid off $16.3 million in loans by
consolidating their borrowings at another financial
institution while three other borrowers paid off an
additional $11.0 million in loans. The Company has
average yearly paydowns of loans of approximately $18
million due to scheduled loan payments. Local loan
demand has been down and competition for loans has
been fierce. The Company expects to continue to face
these same challenges in 2006 and it believes it will
be difficult to maintain its loan balance position
during 2006.
Net income for 2005 was $2,087,000, or $.49 per
share, compared with $4,001,000, or $.93 per share
for 2004, a decrease of 47.8 percent. Earnings were
impacted unfavorably by a declining net interest
margin as well as continued problems with
non-performing assets.
Net interest income declined $2,549,000 in 2005
compared with 2004. Interest rates increased in 2005,
as evidenced by the prime lending rate ending the
year at 7.25% compared to 5.25% on January 1, 2005.
Interest rates paid by the Company on its deposits and borrowings in
2005 increased at a greater pace than the rates
earned on the Company’s loans and securities.
Interest that the Company earned on its loans and
leases was negatively impacted by the decrease in its
loan portfolio. Another factor affecting loan interest
income was the amount of nonaccrual loans that do not
earn interest for the Company due to the deterioration
in the financial condition of these borrowers.
Nonaccrual loans increased to $21.6 million at
year-end 2005 compared with $19.1 million at December31, 2004.
Yields earned on the Company’s securities
portfolio, including Federal Home Loan stock,
increased 18 basis points in 2005 as the prime
interest rate increased 200 basis points. The reason
for the yields on the portfolio increasing only 18
basis points is that in 2005 only 14% of the year-end
2004 portfolio matured and repriced at the increased
rates.
Earnings in 2005 were impacted unfavorably by
non-performing assets as the Company made a provision
for loan and lease losses of $3,428,000 during 2005
and a $1,067,000 write-down to the value of two
motels carried as other real estate owned. The total
combined expense during 2005 relating to
non-performing assets comes to $4.5 million as
compared with the provision to the allowance for loan
and lease losses in 2004 of $4.6 million. The Company
has been diligently working to reduce its
non-performing assets and expects to reduce these
assets by
NSFC ANNUAL 17 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
OVERVIEW (CONT’D)
$13 million in 2006. The Company also expects the
provision for loan and lease losses to be less in
2006.
Noninterest income for the Company decreased in
2005 by $182,000 while noninterest expense increased
by $1.4 million. Contributing to the increase to
noninterest expense during 2005 was the $1.1 million
write-down of other real estate owned previously mentioned. Audit
and professional fees increased $388,000 in 2005
compared to 2004 due to the Company’s compliance with
the Sarbanes Oxley Act and the outsourcing of the
Company’s internal audit function.
CRITICAL ACCOUNTING POLICIES
Certain critical accounting policies
involve estimates and assumptions by management. To
prepare financial statements in conformity with
accounting principles generally accepted in the
United States of America, management makes estimates
and assumptions based on available information. These
estimates and assumptions affect the amounts reported
in the financial statements and the disclosures
provided, and future results could differ. The
allowance for loan and lease losses is a critical
accounting policy for the Company because management
must make estimates of losses and these estimates are
subject to change. Estimates are also used to
determine the fair value of financial instruments
including the disclosures as to the carrying value of
securities.
The allowance for loan and lease losses is a
valuation allowance for probable incurred credit
losses, that is increased by the provision for loan
and lease losses and decreased by charge-offs less
recoveries. Management estimates the balance for the
allowance based on information about specific
borrower situations, estimated collateral values and
the borrowers’ ability to repay the loan. Management
also reviews past loan and lease loss experience, the
nature and volume of the portfolio, economic
conditions and other factors. Allocations of the
allowance may be made for specific loans and leases,
but the entire allowance is available for any loan or
lease that, in management’s judgement, should be charged-off. Loan and lease losses are
charged against the allowance when management
believes the uncollectibility of a loan or lease
balance is confirmed.
A loan or lease is impaired when full payment
under the loan or lease terms is not expected.
Impairment is evaluated on an aggregate basis for
smaller-balance loans of similar nature such as
residential mortgage and consumer loans, and on an
individual loan or lease basis for other loans and
leases. If a specific loan or lease is determined to
be impaired, a portion of the allowance is
specifically allocated to that loan or lease. The
specific allocation is calculated at the present value of
estimated cash flows using the loan’s or lease’s
existing rate or at the fair value of collateral if
repayment is expected solely from the collateral.
Goodwill results from business acquisitions and
represents the excess of the purchase price over the
fair value of acquired tangible assets and
liabilities and identifiable intangible assets.
Goodwill is assessed at least annually for impairment
and any such impairment will be recognized in the
period identified.
The core deposit intangible asset arose from the
acquisition of First State Bank of Round Lake in
January 2004. The core deposit intangible asset was
initially measured at fair value and is being
amortized over its estimated useful life. This
intangible asset is also assessed at least annually
for impairment.
NSFC ANNUAL 18 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
TABLE 1 — ANALYSIS OF AVERAGE BALANCES, TAX EQUIVALENT YIELDS AND RATES
Securities exempt from
federal income taxes (2) (5)
8,743
437
5.00
10,886
583
5.38
7,639
456
6.19
Federal funds sold and other
interest earning assets
29,973
989
3.30
27,145
328
1.21
8,072
88
1.09
Interest earning assets(5)
698,450
35,271
5.02
730,337
32,382
4.43
612,995
27,201
4.45
Noninterest earning assets
49,314
46,849
23,672
Average assets(4) (5)
$
747,764
$
777,186
$
636,667
Liabilities and
Stockholders’ Equity
NOW deposits
$
58,084
548
0.94
$
64,594
363
0.56
$
48,967
304
0.62
Money market deposits
62,922
1,315
2.09
66,563
636
0.96
51,071
550
1.08
Savings deposits
83,114
896
1.08
83,269
617
0.74
51,371
449
0.87
Time deposits
327,848
10,236
3.12
354,978
7,157
2.02
255,347
6,161
2.41
Other borrowings
75,353
2,377
3.15
64,855
1,086
1.67
99,369
1,939
1.95
Interest bearing liabilities
607,321
15,372
2.53
634,259
9,859
1.55
506,125
9,403
1.86
Demand deposits
61,802
62,820
48,459
Other noninterest
bearing liabilities
6,689
6,510
5,600
Stockholders’ equity
71,952
73,597
76,483
Average liabilities and
stockholders’ equity
$
747,764
$
777,186
$
636,667
Net interest income
$
19,899
$
22,523
$
17,798
Net interest margin
2.49
%
2.88
%
2.59
%
Net yield on interest
earning assets(5)
2.83
%
3.08
%
2.91
%
Interest-bearing liabilities
to earning assets ratio
86.95
%
86.84
%
82.57
%
(1)
— Interest income on loans includes loan origination and other fees of $552 for 2005,
$548 for 2004, and $430 for 2003.
(2)
— The financial statement reported interest income is adjusted by the tax equivalent
adjustment amount utilizing a 34% rate on federally tax-exempt municipal loans and
securities. The tax equivalent adjustment reflected in the above table for municipal loans
is approximately $66, $92 and $39 for the years ended 2005, 2004 and 2003. The tax
equivalent adjustment reflected in the above table for municipal securities is approximately $149, $198 and $155 for 2005, 2004 and 2003.
(3)
— Nonaccrual loans are included in average loans.
(4)
— Average balances are derived from the average daily balances.
(5)
— Rate information was calculated based on the average amortized cost for securities.
The 2005, 2004 and 2003 average balance information includes an average unrealized gain
(loss) for taxable securities of ($4,412), ($1,162) and $841. The 2005, 2004 and 2003
average balance information includes an average unrealized gain of $2, $49 and $270 for
tax-exempt securities. Average taxable securities includes Federal Home Loan Bank (FHLB)
and Federal Reserve Bank stock.
NSFC ANNUAL 19 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
NET INTEREST INCOME
Net interest income is the Company’s largest
source of income and is defined as the difference
between interest income earned on average interest
earning assets, such as loans and securities, and
interest expense on average interest bearing
liabilities, such as deposits and other borrowings.
Major factors affecting net interest income are the
general level of interest rates, changes to interest
rates and the amount and composition of interest
earning assets and interest bearing liabilities.
Table 1, “Analysis of Average Balances, Tax
Equivalent Yields and Rates”, shows a comparison of
net interest income and average volumes, together with
effective yields earned on such assets and rates paid
on such funds. The results shown reflect the excess of
interest earned on assets over the cost of funds.
The Company’s net interest income for 2005, on a
fully tax equivalent basis, was $19,899,000 decreasing
by $2,624,000 compared to net interest income for 2004
of $22,523,000. Net interest income on a fully tax
equivalent basis for 2004 increased from 2003 by
$4,725,000.
The major factors in 2005 affecting net interest
income were the decrease in loans and the increased
levels of nonaccrual loans. Also contributing to the
decline in net interest income was the increased
market interest rates in 2005 and the Company’s
interest rate liability sensitivity position.
Loans are the asset of the Company that generate
the most interest income and earn the highest interest
rates for the Company. Average loan balances for the
Company declined in 2005 by $23.2 million due to a
combination of paydowns of loans and declining loan
demand. Table 2, “Analysis of Changes in Interest
Income and Expense” shows that loan interest income
was affected negatively by $1,307,000 in 2005 as
compared to 2004 due to the decrease in average loan
balances (volume).
Interest income earned on the Company’s average
loans in 2005 was also impacted by the amount of
non-performing nonaccrual loans on which no interest
income was earned. At year-ends 2005 and 2004, loans
classified as nonaccrual were $21.6 million and $19.1
million, respectively. In 2005, loan interest income
was reduced by approximately $1.4 million due to the
levels of nonaccrual loans.
A major factor affecting net interest income
during 2005 was changes in market interest rates that
are generally indicated by the changes in the prime
lending rate. In 2005, the prime rate began the year
at 5.25% and increased .25% eight times until at
year-end it was 7.25%. During 2004, the prime rate
began the year at 4.00% and during the second half of
2004 it increased by .25% five times and ended the
year at 5.25%.
In 2005 the interest rate earned on the Company’s
average interest earning assets was 5.02% as compared
with 4.43% in 2004, an increase of 59 basis points.
Yields on average interest bearing liabilities, in
2005, increased by 98 basis points, outpacing the
increases to rates earned on average earning assets.
At year-end 2004, the Company’s rate sensitivity
position showed that there were $272 million more in
interest bearing liabilities maturing or repricing
during 2005 than interest earning assets. Table 2
shows that net interest income was $1,520,000 less in
2005 as a result of the interest rate changes.
During 2004, net interest income increased mainly
due to increases in loan volume as a result of the
Company’s purchase of First State Bank of Round Lake on
January 5, 2004. Although market interest rates
increased in 2004, the full effect of the rate
increases, especially for time deposits, was not felt
until 2005 as rates started to increase during the
second half of 2004.
It is expected that interest rates will continue
to rise during 2006 as already evidenced by the prime
rate increasing to 7.50% at the end of January 2006.
It is expected that net interest income will continue
to be impacted negatively in 2006. Table 10, “Maturity
or Repricing of Assets and Liabilities”, shows that
the Company has $218,561,000 more of interest bearing
liabilities maturing or repricing in 2006 than
interest earning assets.
Many other factors beyond management’s control
have a significant impact on changes in net interest
income from one period to another. Examples of such
factors are: (1) credit demands by customers; (2)
fiscal and debt management policy of federal and state
governments; (3) monetary policy of the Federal
Reserve Board; and (4) changes in regulations.
NSFC ANNUAL 20 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
TABLE 2 — ANALYSIS OF CHANGES IN INTEREST INCOME AND EXPENSE
($ 000s)
For the Year Ended December 31
2005 Compared to 2004
2004 Compared to 2003
Increase (Decrease)
Increase (Decrease)
Change
Change
Change
Change
Total
Due To
Due To
Total
Due To
Due To
Change
Volume
Rate
Change
Volume
Rate
INTEREST INCOME
Loans
$
2,103
$
(1,307
)
$
3,410
$
3,691
$
4,384
$
(693
)
Taxable securities
271
(190
)
461
1,123
481
642
Securities exempt from
federal income taxes
(146
)
(107
)
(39
)
127
193
(66
)
Federal funds sold
and other
661
38
623
240
230
10
Total interest
income
2,889
(1,566
)
4,455
5,181
5,288
(107
)
INTEREST EXPENSE
NOW deposits
185
(40
)
225
59
90
(31
)
Money market deposits
679
(37
)
716
86
153
(67
)
Savings deposits
279
(1
)
280
168
245
(77
)
Time deposits
3,079
(584
)
3,663
996
2,126
(1,130
)
Other borrowings
1,291
200
1,091
(853
)
(606
)
(247
)
Total interest
expense
5,513
(462
)
5,975
456
2,008
(1,552
)
NET INTEREST INCOME
$
(2,624
)
$
(1,104
)
$
(1,520
)
$
4,725
$
3,280
$
1,445
Rate/volume variances are allocated to the rate variance and the volume variance on an absolute
basis.
The financial statements reported interest income is adjusted by the tax equivalent amount
utilizing a 34% rate on federally tax-exempt municipal loans and securities. The tax equivalent
adjustment reflected in the above table for municipal loans is approximately $66, $92 and $39 for
the years ended 2005, 2004, and 2003. The tax equivalent adjustment reflected in the above table
for municipal securities is approximately $149, $198 and $155 for the years ended 2005, 2004 and
2003.
As of December 31, 2005, the Company had no securities of a single issuer, other than the U.S.
government-sponsored entities, including the Federal Home Loan Bank (FHLB) and the Federal Farm
Credit Bank (FFCB), that exceeded 10% of consolidated stockholders’ equity. Although the Company
holds securities issued by municipalities within various states, no state’s aggregate total
exceeded 10% of consolidated stockholders’ equity.
The Company holds local municipal bonds which, although not rated, are considered low risk
investments.
NSFC ANNUAL 21 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
SECURITIES
The Company maintains a securities portfolio
to generate earnings, provide liquidity, assist in the
management of the Company’s tax position, aid in the
Company’s asset/liability management and accommodate
pledging collateral requirements. The Company’s policy
is that no undue risks be taken with the securities
portfolio and that the safety of the securities is the
primary and utmost concern of management.
All securities of the Company at December 31,2005 are classified as available for sale. The
carrying values of the securities reflect the fair or
market value of the securities. The Company classifies
its securities as available for sale to provide
flexibility in the event that it may be necessary to
sell securities to raise cash for liquidity purposes
or to adjust the portfolio for interest rate risk or
income tax purposes.
The carrying value of the securities portfolio
increased $14.1 million to $265.0 million at year-end
2005 as compared to $250.9 million at year-end 2004
after decreasing $29.5 million at year-end 2004 from
2003. In 2005, the Company’s securities portfolio grew
as decreases in loans created excess funds that were
invested in securities.
The net unrealized loss to the securities
portfolio was $5.7 million at December 31, 2005
compared to a net unrealized loss at December 31, 2004
of $2.7 million reflecting higher bond interest rates
at year-end 2005 compared to year-end 2004. Most of
the net unrealized loss at December 31, 2005 was from
the Company’s U.S. government-sponsored entity
securities, which had a net unrealized loss of $5.6
million. These U.S. government-sponsored entity
securities are of high quality, with the lowest bond
rating being Aaa. The fair value of these securities
is expected to recover as the securities approach
their maturity dates.
At year-end 2005, $187.3 million of the Company’s
U.S. government-sponsored entity securities have call
options. As interest rates are expected to continue to
rise in 2006, it is unlikely that these call options will
be exercised. If interest rates would drop
significantly, these call options would be exercised
causing the average yields on the securities to decline.
The Company sold U.S. government-sponsored entity
securities totaling $6.3 million in 2005 for liquidity
purposes. It recognized a $169,000 loss on the sale of
these securities.
At December 31, 2005, the Company has 95% of its
portfolio in securities issued by the U.S. Treasury
and U.S. government-sponsored entities, as indicated
in Table 3. The Company pledges U.S. Treasury and U.S.
government-sponsored entity securities to secure
public deposits, repurchase agreements and for other
purposes as required or permitted by law. At December31, 2005, the Company had $189.7 million in
U.S. Treasury and U.S. government-sponsored entity
securities pledged, or 72% of its total securities
portfolio.
Holdings of securities issued by states and
political subdivisions, of which over 93% are
tax-exempt, decreased $3.3 million to $7.2 million at
December 31, 2005. According to federal tax law, a
bank is not allowed an interest deduction for the cost
of deposits or borrowings used to fund most tax-exempt
issues acquired after August 7, 1986. Whenever
possible the Company attempts to purchase “bank
qualified” tax-exempt issues from local taxing bodies
in an effort to support the local community,
consistent with the investment standards contained in
the investment policy. In 2005, there were not enough
“bank qualified” tax-exempt issues available for
purchase by the Company to replace those issues that
either matured or were called.
Efforts by the Company to maintain appropriate
liquidity include periodic adjustments to the
securities portfolio, as management considers
necessary, typically accomplished through the maturity
schedule of investments purchased.
The maturity distribution and average yields, on
a fully tax equivalent basis, of the securities
portfolio at December 31, 2005 is shown in Table 4,
“Securities Maturity Schedules & Yields”.
The Company’s loan and lease portfolio is
the largest interest earning asset of the Company. In
2005 the Company’s loans and leases provided $25.7
million of interest income, over 73% of the interest
income generated by the Company.
For purposes of this discussion, when loans are
mentioned it should be taken to include leases unless
specified otherwise. As shown in Table 5, “Loan and
Lease Portfolio”, loans and leases, net of unearned
income and deferred loan fees at December 31, 2005
totaled $400.5 million, decreasing $42.1 million from
year-end 2004. At December 31, 2004, loans totaled
$442.6 million, the highest year-end level in the
Company’s history due primarily to the purchase of
First State Bank in early 2004. Loans in 2004
increased $84.3 million from December 31, 2003.
The Company’s lending activities relate mainly to
loans to small and mid-sized businesses in the Lake
County, Illinois area and the surrounding counties in
northeastern Illinois and southeastern Wisconsin.
Although at December 31, 2005, the loan portfolio
shows $38.1 million in real estate-mortgage 1 — 4
family loans, the majority of these loans are to
commercial borrowers who use their personal residence
to secure their loans. The Company attempts to secure
these commercial purpose loans by real estate whenever
possible. At December 31, 2005, over 81% of the Company’s loans are secured
by real estate and local real estate values have held
up well in 2005.
At December 31, 2005 and 2004, the Company had
$23.9 million and $42.4 million in real
estate-mortgage commercial loans to borrowers in the
hotel industry.
During 2005, the decrease in the loan portfolio
came as one borrower paid off loans totaling $16.3
million when the borrower consolidated and securitized
their loans. Another three borrowers paid down loans
totaling $11.0 million through restructuring or
liquidating their businesses.
Contributing to the lack of loan growth is the
increased competition from larger money center banks
that have found that lending to small and mid-sized
businesses is a lucrative business segment. In 2005,
the Company has restructured its commercial loan area
in order to improve generation of new loan business.
The Company believes that its experienced lenders and
personal service, that is the hallmark of our community bank, will assist in the
challenges presented by increased competition.
Local loan demand is down from previous years.
The increased short-term interest rates as indicated
by the prime lending rate increasing 200 basis points
in 2005 have contributed to lower loan demand.
Commercial loans at year-end 2005 increased $8.0
million to $58.8 million from $50.8 million at
December 31, 2004. The increase in commercial loans
during 2005 came from a $7.9 million participation
purchased from a larger money center bank. Commercial
loans are not secured by real property but may be
secured by leasehold improvements, equipment and
inventory.
The real estate-mortgage 5+ family portfolio was
$29.4 million at year-end 2005 compared with $34.5
million and $25.1 million at year-ends 2004 and 2003.
These loans are secured by apartment buildings which
are quite prevalent in the Company’s lending area due
to the proximity to the Great Lakes Naval base.
Consumer lending is mostly done through home
equity loans. The home equity portfolio is
predominately tied to the prime rate. As the prime
rate increased in 2005 this portfolio declined $3.4
million due to borrowers refinancing their homes as
long-term fixed mortgage rates became more attractive.
As short-term interest rates continue to increase in
2006, home equity loan growth will continue to slow.
The Company has benefited from growth in Lake
County. As development continues westward, the
Company’s branches in the western part of the county,
two of which were acquired in 2004 through the
purchase of First State Bank, will become more
important in the future.
At December 31, 2005, the Company had loans
totaling $2.7 million to related parties. Related
parties are officers of the Company or its
subsidiaries with the title of vice president or
above, and directors of the Company and their related
interests. Commitments for loans to related parties at
year-end 2005 totaled $2.6 million. Loans and
commitments are made to related parties at the same
terms and conditions that are available to the public.
Table 5 shows the year end balance of loans
outstanding by loan purpose for each of the last five
years.
NSFC ANNUAL 24 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
MATURITY OF LOANS
Table 6, “Loan Maturity Schedule”,
highlights the maturity distribution of the Company’s
commercial and real estate-construction loan
portfolio.
Although Table 6, shows $10,060,000 in
construction loans maturing in greater than five
years, these loans are for commercial building
projects and the construction phase of the projects
are expected to be completed in less than two years.
At that time, the loans will be reclassified
as real estate-mortgage loans.
The short-term sensitivity of the commercial and
real estate-construction loan portfolios to interest
rate changes is reflected in the fact that
approximately 54.3% of the loans are scheduled to
mature within one year. Of the remaining loans
maturing beyond one year, 56.0% are variable rate
loans subject to immediate repricing.
Commercial and construction loans maturing after one year:
Fixed rate
$20,412
Variable rate
25,936
Total
$46,348
Real estate-construction loans reflect the contractual maturity of the related note. Due to
anticipated roll-overs of real estate-construction notes, management estimates that the loans will
actually mature between one and five years based upon the related types of construction. Loans that
mature within one year are considered to be variable rate loans as they can be repriced upon
maturity.
NON-PERFORMING ASSETS
Non-performing assets consist of
non-performing loans and leases and other
real estate owned. For purposes of this
discussion, when loans are mentioned it should be taken to include leases unless
specified otherwise. As shown in Table
7, non-performing assets at year-end 2005 were
$26,343,000 increasing $2,067,000 from year-end 2004,
after increasing during 2004 by $860,000 from
December 31, 2003.
Non-performing loans are: (1) loans accounted for
on a nonaccrual basis; and (2) accruing loans in the
process of collection that are contractually past due
ninety days or more as to interest or principal
payment. Total non-performing loans at December31, 2005 were $21.9 million, as compared to $19.5
million at December 31, 2004 and $19.7 million at
December 31, 2003.
At
December 31, 2005, the largest portion of
nonaccrual loans relate to lease pools totaling $9.4
million. The Company has previously disclosed its
involvement in these lease pools that had been
purchased in 2000 and 2001 from Commercial Money
Center (“CMC”). These lease pools are secured by both
the leased equipment as well as surety bonds issued
by ACE/Illinois Union and RLI Insurance Company. The
latest A.M. Best ratings for the sureties are “A+” for
both sureties. These nonaccrual lease pools decreased
$1.9 million from year-end 2004 when the balance was
$11.3 million. In 2005 payments that had previously
been made on these lease pools and held by the
bankruptcy court were released to the Company. The
Company is in the process of attempting to collect on
these leases from the sureties through litigation. In
September 2005, the Company filed Motions for
Judgement on the Pleadings in its CMC litigations
against the sureties. At that time, the court granted
the Motion for Judgement on the Pleadings against
ACE/Illinois Union; however, the Bank’s motion
against the RLI surety was denied. At December31, 2005, ACE/Illinois Union insures the lease pools
that amounted to $5.3 million and RLI acts as the
sureties on lease pools totaling $4.1 million. On
October 31, 2005, the court directed all parties
involved in the CMC litigation to engage in
mediation. Management expects that this litigation
will be resolved in 2006, but no assurance can be
given as to the exact amounts that will be ultimately collected by the Company, if any.
NSFC ANNUAL
25 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
NON-PERFORMING ASSETS (CONT’D)
Also on nonaccrual status is a $4.3 million loan
for a 90-unit condominium construction project which
has been classified as a nonaccrual loan since
December 31, 2003. The Company participated in this
90-unit condominium construction project with other
financial institutions and only has a portion of the
total loan. The construction project experienced
substantial cost overruns and the principal borrowers
declared bankruptcy. The construction project has been
completed and all of the units have been sold, with
the bankruptcy trustee holding the sales proceeds in
escrow. There are disputed mechanic liens of which the
majority are insured by a title company. The
bankruptcy trustee will not release the sales proceeds
from escrow until the disputed mechanic liens are
resolved. The mechanic lien issue is expected to be
concluded during 2006. Management expects to collect
all of the $4.3 million loan balance.
During 2005, the Company placed on nonaccrual
status loans totaling $4.2 million on an entertainment
center that is partially secured by leasehold
improvements and equipment. Also placed on nonaccrual
status in 2005 were loans to one borrower secured by
two local motels that total $3.5 million at year-end
2005. These loans went to nonaccrual status due to
deterioration in the respective borrowers’ financial
condition and failure to make restructured loan
payments.
During 2005, there were some decreases to
nonaccrual loans. Besides the $1.9 million in payments
received on the CMC lease pools, the Company received
funds that paid off one borrower’s nonaccrual loans
that totaled $1.4 million at December 31, 2004. A $1.6
million loan on a motel located near Chicago’s O’Hare
Airport that was on nonaccrual status at December 31,2004 was foreclosed upon and the Company charged off
$487,000 and transferred the remaining balance of $1.1
million to other real estate owned. The Company
participated with other financial institutions on the
loan for this motel and only had a portion of the
original loan and the foreclosed motel property as
well.
Impaired loans at December 31, 2005 totaled $32.1
million. The Company considers a loan impaired if full
principal and interest will not be collected under the
contractual terms of the note. Nonaccrual loans are
included as impaired. Impaired loans and leases are
carried at the present value of expected cash flows
discounted at the loan’s effective interest rate or at
the fair value of the collateral, if the loan or lease
is collateral dependent. Included as impaired loans at
December 31, 2005 are $10.5 million of restructured
loans.
At year-end 2005 the Company’s impaired loans
that are restructured do not appear as non-performing
loans in Table 7. The $10.5 million in restructured
loans represent three loan relationships. Loans
totaling $5.2 million are secured by a strip shopping
center/gas station that has experienced cash flow difficulties due to lower than
expected customer utilization. The second relationship
involves loans secured by a motel totaling $3.8
million that has experienced cash flow problems due to
low room occupancy rates. A third loan relationship
for $1.5 million to a general partnership for
improvements to a motel has also been restructured due
to decreased room occupancy rates. The cash flow
difficulties of these borrowers resulted in their
requesting a reduction in principal loan payments.
These borrowers have made all payments required under
the terms of the restructured loan agreements.
At
December 31, 2005, Table 7 shows that the
Company had $358,000 in loans that were 90 days past
due and still accruing interest compared with $343,000
last year-end. A breakdown of the $358,000 in loans
that were 90 days past due and still accruing interest
at December 31, 2005, shows $160,000 in real
estate-mortgage 1-4 family loans, $112,000 in home
equity loans, $82,000 in real estate-mortgage
commercial loans and $4,000 in consumer loans. These
loans at year-end 2005 were fully secured and in the
process of collection.
Another component of non-performing assets is
other real estate owned, consisting of assets acquired
through loan foreclosure and repossession. At December31, 2005, other real estate owned totaled $4.4 million
as compared with $4.8 million at December 31, 2004.
The fair value of other real estate owned is reviewed
by management at least quarterly to help ensure the
reasonableness of its carrying value, which is lower
of cost or the fair value less estimated selling
costs. During 2005, the Company took a write-down on
two motels held as other real estate owned of $1.1
million that had been carried at $1.5 million at
year-end 2004. The write-down was based primarily on
new appraisals that showed deterioration to the market value. These motels were later sold in 2005 and
the Company realized a gain of $101,000 on the sales.
During 2005, three other properties were transferred
into other real estate owned totaling $1.3 million.
One of these properties transferred to other real
estate owned was a foreclosed motel that the Company’s
share of the fair value was $1.1 million as mentioned
previously. The financial institutions owning this
motel, including the Bank, have this motel up for sale
and it is expected to be sold during 2006.
At year-end 2005, the Company is carrying a
property consisting of a two story office building in
Waukegan, Illinois that is valued at $1.1 million that
had been transferred to other real estate owned in
2004. The Company is in discussions with potential
purchasers who plan to rent the building for a period
of time and then purchase it.
The Company also has a $325,000 restaurant and
vacant land property of $126,000 being carried as
other real estate owned at December 31, 2005. The sale
of the restaurant has been held up due to zoning
problems. The
NSFC ANNUAL 26 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
NON-PERFORMING ASSETS (CONT’D)
Company has a sales contract out on the vacant
property and expects the sale closing to occur during
2006 at no additional loss.
On
December 31,2005, one piece of property
carried at $1.8 million accounted for approximately
40% of the total of other real estate owned. The
property was acquired by the Bank through the receipt
of a deed in lieu of foreclosure in 1987. The parcel
consists of approximately 525,000 square feet of land
overlooking Lake Michigan in Waukegan, Illinois. During
the fourth quarter of 2002 the Bank formed Northern
States Community Development Corporation (“NSCDC”), a
subsidiary of the Bank. NSCDC assets consist of cash
and other real estate owned. This subsidiary was
formed for the purpose of developing and selling this
parcel as part of the City of Waukegan’s lakefront
development plans.
This property is currently undergoing a
brownfield assessment funded by a government grant.
The grant money is to be used for the brownfield
assessment but not for any remediation that may be
needed. The objective of the brownfield assessment is to obtain the
environmental data needed to determine the
appropriate remedial actions, if any, for the property to achieve a “No Further
Remediation Letter” from the Illinois EPA Site
Remediation Program. The end use of property is now
intended to be mixed use residential development
consistent with the City of Waukegan’s lakefront
downtown master plan. The results of the brownfield
assessment are not expected to be available until
later in 2006. Until the results of the brownfield
assessment are known, it is not practicable to
estimate any remediations costs. Thus, no liability
has been recorded for environmental remediation
costs. The carrying value of the property is
supported by a recent appraisal.
Management continues to emphasize the early
identification of loan related problems. Management
is not currently aware of any other significant
loan, group of loans, or segment of the loan portfolio
not included in the discussion above as to which
there are serious doubts as to the ability of the
borrower(s) to comply with the present loan payment
terms.
There were no other interest earning assets at
December 31, 2005 that are required to be disclosed
as non-performing.
Non-performing loans and leases as a
percentage of total loans and leases,
net of unearned income and deferred
loan fees
5.47
%
4.40
%
5.49
%
4.00
%
5.32
%
Non-performing assets as a
percentage of total assets
3.65
3.24
3.41
2.53
3.31
Non-performing loans and leases as a
percentage of the allowance for
loan and lease losses
206.37
249.28
448.32
380.50
455.08
Loans and leases are placed in nonaccrual status when they are 90 days past due, unless they
are fully secured and in the process of collection.
Impaired Loans — At December 31, 2005, 2004, 2003, 2002 and 2001, impaired loans totaled $32,054,
$29,887,$18,152, $13,227 and $3,372 and include nonaccrual loans. Although payments have been made
as agreed on, they are classified as impaired to assist the borrowers in working out deficiencies
in cash flows and collateral that have been noted. At December 31, 2005, there were $10,533 in
loans that were restructured that are not included in Table 7.
NSFC ANNUAL
27 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
PROVISION FOR LOAN AND LEASE LOSSES
A provision is credited to an allowance for
loan and lease losses, which is maintained at a level
considered by management to be adequate to absorb
loan losses. For purposes of this discussion, when
loans are mentioned it should be taken to include
leases unless specified otherwise. The adequacy of
the loan and lease loss allowance is analyzed at
least quarterly. Factors considered in assessing the
adequacy of the allowance include: changes in the
type and volume of the loan portfolio; review of the
larger credits within the Company; historical loss
experience; current economic trends and conditions;
review of the present value of expected cash flows
and fair value of collateral on impaired loans; loan
growth; and other factors management deems
appropriate.
The methodology used by the Company to allocate
the allowance begins by internally rating the risk of
loss on the loans. Poorly rated loans that are
impaired, past due or have known factors making future
payments uncertain are individually reviewed. An
allocation is made for each individual loan based on
the present value of expected cash flows discounted at
the loan’s effective interest rate or on the fair
value of the collateral, if the loan is collateral
dependent. In cases where the present value of
expected cash flows or the fair value of the
collateral is greater than the loan balance, a
specific allocation is not required.
Those loans rated satisfactory have an
allocation made to the allowance using a percentage based on the
5-year average losses on loans of a similar type.
Allocations to the allowance may be adjusted for
economic conditions or trends. In the Company’s
market area, one of the major industries is the
pharmaceutical industry as evidenced by Abbott
Laboratories and Baxter Healthcare. A future major
negative shift in this industry could possibly impact
our loan portfolio and could require additional
allocations of the allowance. In years prior to 2005,
management considered the unallocated portion of the
allowance necessary to allow for inherent subjective
allocations that are needed based on general and more
specific economic factors as well as trends in the
loan portfolio. During 2005, management included the
subjective portion of the allowance as a part of the
allocation process to the respective loan categories.
Management does not deem this process to be a change
in methodology, but rather a refinement in their loan
loss calculation. Management believes that there
would be no change in the balance of the allowance
for loan and lease losses if this approach was used
in all the years presented in Table 9.
During 2005, a provision for loan and lease
losses was made in the amount of $3,428,000 compared
to $4,625,000 in 2004, and $1,030,000 in 2003. Much
of the 2005 provision was allocated to the $4.2
million in loans on an entertainment center that is
partially secured by leasehold improvements and
equipment. These loans on the entertainment center
were placed on nonaccrual status in 2005 and at
December 31, 2005, the Company had $2.2 million of
its allowance for loan and lease losses allocated to
these loans as compared to $530,000 at December 31,2004. The Company also allocated $1.6 million in 2005
to the impaired loans totaling $5.2 million secured
by a strip shopping center/gas station experiencing
cash flow difficulties. Throughout the year
management reviewed the level of provision necessary
to maintain an adequate allowance based on the
methodology outlined above. Management does not
expect levels of non-performing and impaired loans to
rise in 2006, and expects that the provision for loan
and lease losses for 2006 will be less than the
provision amounts in 2005 and 2004.
As shown in Table 8, “Analysis of the Allowance
for Loan and Lease Losses”, during 2005 there were
net charge-offs of $622,000 compared with $2,001,000
in 2004. The biggest charge-off during 2005 was
$487,000 pertaining to the motel near Chicago’s
O’Hare airport that was foreclosed on during 2005.
The Company wrote the loan down to the appraised
value less estimated selling costs when transferring
the loan to other real estate owned.
Table 8 also indicates the types of loans
charged-off and recovered for the five years from
2001 through 2005 as well as each year’s provision.
The table shows that the largest loan charge-offs during those years were
for commercial loans.
The Company’s allocation of the allowance for
loan losses is illustrated in Table 9, “Allocation of
the Allowance for Loan and Lease Losses”. Table 9
shows the amount of $2,409,000 is allocated to
leases. The amount of $2,400,000 is allocated
specifically to the nonaccrual CMC lease pools that
total $9.4 million at year-end 2005.
It should be noted that negative changes to loan
collateral values or events that may disrupt the
borrowers’ expected cash flows might require an
increase to the provision. Larger allocations of the
allowance for loan and lease losses might be required
for those loans affected.
Based upon management’s analysis, the allowance
for loan and lease losses at December 31, 2005, is
adequate to cover probable incurred loan losses.
NSFC ANNUAL 28
REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
TABLE 8 — ANALYSIS OF THE ALLOWANCE FOR LOAN AND LEASE LOSSES
Noninterest income totaled $4,370,000 in 2005, decreasing $182,000 compared to noninterest income
generated in 2004. The Company generates noninterest income from service charges and fees assessed
on deposit accounts, from trust operations and mortgage banking activities. It also generates gains
or losses from sale of securities and other operating income from miscellaneous fees on loans, from
safety deposit box rental and from ATM and debit card transactions. Noninterest income decreased in
2005 mainly from the sale of securities at a loss of $169,000 that was done for liquidity purposes.
In 2005, service fees on deposits decreased by $71,000 due to decreased fees assessed on
commercial checking accounts. Business checking accounts fees are calculated by determining the
costs associated with the account after deducting an earnings credit rate on the balances held in
the account. As short-term interest rates grew in 2005, the earnings credit rate on commercial
checking accounts increased causing fee income on these accounts to decline.
In 2005, the Company sold two motels held as other real estate owned at a gain of $101,000 and
recognized a $10,000 gain from the sale of some vacant lots that had been acquired through
foreclosure. The $111,000 in gains from these sales is included in other operating income.
The Company is expecting to increase retail deposit growth in 2006. It may need to lower
service fees charged on deposit accounts to accomplish this. Fee income derived by offering
financial services to noncustomers is expected to decline in 2006 as compliance with the Patriot
Act and other antiterrorism regulations have made it more difficult to provide these services to
noncustomers.
Comparing 2004 to 2003 showed increases to noninterest income of $502,000 to $4,552,000 in
2004. Much of the increase came from First State Bank that was acquired by the Company on January5, 2004. The acquisition brought additional service fee income on deposits as well as additional
miscellaneous other operating income.
NONINTEREST EXPENSE
In 2005, total noninterest expense was $18.0 million, increasing by $1.4 million from 2004 or 8.3%.
As a percent of average assets, noninterest expense was 2.41%
in 2005 compared to 2.14% in 2004 and 1.92% in 2003.
The efficiency ratio, noninterest expense divided by the sum of net interest income and
noninterest income, is frequently used as an indicator of how well a financial institution manages
its noninterest expense. The Company’s efficiency ratio was 74.9% in 2005, compared to 62.1% in
2004, and 56.4% in 2003. The efficiency ratio increased in 2005 largely due to declines in net
interest income of $2.5 million as well as the $1.4 million increase to noninterest expense.
The biggest factor affecting the increase in noninterest expense in 2005 was the one-time $1.1
million write-down of other real estate owned. Audit and professional fees were also $388,000
greater in 2005 due to management’s compliance with the Sarbanes-Oxley Act and the outsourcing of
much of the internal audit function to third parties. It is expected that audit and professional
fees relating to the Sarbanes-Oxley Act compliance will decrease as the expenses relating to the
initial documentation of the internal controls have been completed.
On November 10, 2005the Company merged the First State Bank into the Bank of Waukegan and
simultaneously changed the name of the Bank of Waukegan to NorStates Bank. This event contributed
to an increase to other operating expenses of $328,000 in 2005 due to marketing efforts relating to
the name change. New forms needed to be ordered for every document at the Bank causing printing
and supplies expense to increase $58,000 in 2005. Some additional expenses relating to the name
change will continue into early 2006.
In 2005, occupancy and equipment expenses increased $104,000. Occupancy and equipment expense
are expected to increase approximately $75,000 in 2006 due to increased depreciation expense as a
full year’s depreciation will be taken for the new signs. The Company also plans to make some
cosmetic updates to its buildings in 2006.
Legal expenses declined significantly in 2005, decreasing $774,000 from 2004’s levels. In 2004
and 2003, much of the legal expenses related to the litigation involving the CMC lease pools which
at that time were in the discovery phase with depositions being taken in many different states.
Although this litigation continued in 2005 the expenses related to it were considerably less.
Comparing 2004 with 2003, noninterest expense increased by $4.4 million to $16.6 million, an
increase of
36.1% from 2003. The largest increases to noninterest expense in 2004 came from the addition
to the Company of First State Bank with 28 employees at year-end 2004 and two branch offices.
Noninterest expense at First State Bank, on a stand-alone basis, was $3.7 million in 2004, which
included $464,000 in core deposit amortization expense.
Data processing expense not connected to First State Bank increased $277,000 in 2004. In April
2004, the Bank of Waukegan outsourced its item processing function to accommodate new check
clearing technologies required to
NSFC ANNUAL 30 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
NONINTEREST EXPENSE (CONT’D)
meet new regulations and allowed the Bank to archive items via imaging technology.
The Company’s audit and professional expenses increased $337,000 in 2004, compared with 2003. The increases were caused by the Sarbanes-Oxley Act
compliance process that began in 2004.
FEDERAL AND STATE INCOME TAXES
For the years ended December 31, 2005, 2004 and 2003, the Company’s provision for federal and state
taxes as a percentage of pretax earnings were 20.3%, 27.7% and 34.3%.
The actual tax rates differ from the statutory rates because the pretax earnings include
amounts of interest on U.S. Treasury and U.S. government-sponsored entity securities, which are
nontaxable for state income tax purposes. Qualified interest on loans to local political
subdivisions and on qualified state and local political subdivision securities are nontaxable for
federal income tax purposes and also lower the actual tax rate compared to the statutory rate. The
Company also receives federal tax credits from its investment in a low/moderate income housing
partnership.
The
tax rate as a percentage of pretax earnings decreased in 2005 as it had in 2004. This
occurred as income before income taxes decreased in 2005 and 2004.
Interest on U.S. Treasury and U.S. government-sponsored entity securities, which are
nontaxable for state income tax purposes, totaled $7.6 million and $7.2 million in 2005 and 2004.
In 2005 and 2004, interest on U.S. Treasury and U.S. government-sponsored entity securities
resulted in the Company having a $367,000 and $178,000 benefit for state income taxes, lowering the
effective tax rate in those years. In addition, interest earned on local political subdivision
securities that are nontaxable for federal income tax purposes was $288,000 in 2005 and $385,000 in
2004 also contributing to the reduction to the 2005 and 2004 tax rates.
NSFC ANNUAL 31 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
TABLE 10 — MATURITY OR REPRICING OF ASSETS AND LIABILITIES
Mortgage-backed securities reflect the time horizon when these financial instruments are
subject to rate change or repricing.
2)
Equity securities includes Federal Home Loan Bank (FHLB) of Chicago stock.
3)
Interest-earning assets divided by interest-bearing liabilities.
This table does not necessarily indicate the impact of general interest rate movements on the
Company’s net interest income because the repricing of certain assets and liabilities is
discretionary and is subject to competition and other pressures. As a result, assets and
liabilities indicated as repricing within the same period may in fact reprice at different times
and at different rate levels.
NSFC ANNUAL 32 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
TABLE 11 — TIME DEPOSITS, $100,000 AND OVER MATURITY SCHEDULE
The Company has no foreign banking offices or deposits.
CASH FLOWS AND LIQUIDITY
The statement of cash flows shows the sources of cash to the Company and what the Company uses the
cash for. The three major activities of the Company that create cash flows are operating, investing
and financing.
Cash flows from operating activities come primarily from net income which is adjusted to a
cash basis. Cash flows in 2005 were above accrual basis income by $4.3 million due to the provision
for loan and lease losses of $3.4 million and the write-down of other real estate owned by $1.1
million. In 2004, operating income cash flows were also above accrual basis income, by $6.0 million
primarily due to provision for loan and lease losses of $4.6 million. Cash flows in 2003 from
operating income were below accrual basis net income by $723,000 due to changes in interest payable
and other liabilities as payments were made in 2003 of interest accrued in 2002. Management expects
ongoing operating activities to continue to be a primary source of cash flow for the Company.
The major cash flow investing activities of the Company are for funding loans and purchasing
securities available for sale. In 2005, there were net cash inflows
from investing activities of $23.3 million as loans were paid down by $40.5 million while cash
outflows were made as net securities were purchased totaling $23.5 million. In 2005, sales of
securities also provided cash inflows of $6.1 million. During 2004 and 2003, the increases the
Company experienced in its loan and leases created outflows of cash of $16.6 million and $9.0
million.
Primary financing activities of the Company that create cash flows are in the areas of
deposits, repurchase agreements, borrowings, payment of dividends and purchase of treasury stock.
Net cash outflows in 2005 for financing activities were $29.3 million.
Cash flows from deposits, repurchase agreements and borrowings are an important source of
funds for the Company’s lending and investing activities. As loans decreased in 2005, deposits were
not needed to fund those loans and there were outgoing cash flows for deposits of $34.9 million.
Total time deposits declined $23.8 million in 2005, which included a $21.2 million decrease in
brokered deposits. NOW accounts also decreased in 2005 by $9.2 million as commercial NOW customers
transferred funds outside of the Bank. During 2004, deposits decreased $3.6 million while in 2003
cash inflows from deposits were $43.5 million.
During 2005, at the holding company level, the Company increased its liquidity by borrowing
$10.0 million through participation in a trust preferred security pooled offering where
subordinated debentures were issued. The subordinated debentures mature in September 2035 and until
September 15, 2010, bear interest at a rate equal to the sum of the product of 50% times the
3-month LIBOR plus 1.80% plus the product of 50% times 6.186%, and thereafter at a rate equal to
the 3-month LIBOR plus 1.80%. The Company contributed $2.0 million of the proceeds from the
offering to the Bank in order to increase the Bank’s capital position.
The Company’s equity capital is in excess of regulatory requirements, as determined on both
risk-based and leverage ratio criteria. Outgoing cash flows for payment of cash dividends were $2.7
million, $4.7 million and $4.7 million in 2005, 2004, and 2003. Dividends per share decreased in
2005 due to the decrease in earnings per share.
The Company purchased no treasury stock in 2005. During 2004, 10,000 shares of treasury stock
were purchased causing a cash outflow of $272,000 as the total number of shares of treasury stock
held by the Company at year-end 2004 totaled 177,150 shares. Cash outflows for treasury stock during 2003 were
$285,000 as 10,000 shares of Northern States Financial Corporation stock were purchased.
The timing of these cash flows do not always match and the Company must use liquidity
management to provide funds to fill the gaps in these timing differences. Liquidity management at
the Bank involves the ability to meet the daily cash flow requirements of the Bank for depositors
NSFC ANNUAL 33 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
CASH FLOWS AND LIQUIDITY (CONT’D)
wanting to withdraw funds and borrowers’ need for credit.
Federal funds sold, interest bearing deposits in banks and securities, particularly those of
shorter maturities, are principal sources of asset liquidity. The Bank classifies all of its
securities as available for sale, which increases the Bank’s flexibility in that it can sell any of
its unpledged securities to meet liquidity requirements. Securities available for sale had a
carrying value of $265.1 million at December 31, 2005 of which $189.7 million were pledged to
secure public deposits and repurchase agreements. During 2005 the Bank sold securities with an
amortized cost of $6.3 million, recognized a $169,000 loss, and received proceeds of $6.1 million
for liquidity purposes.
Federal funds sold at December 31, 2005 were $6.0 million as compared to $8.9 million at
December 31, 2004. The Bank sells excess funds overnight to the money center banks and these funds
provide the Bank with liquidity to fund loans or meet depositor requirements.
At December 31, 2005, the Bank had borrowings from the Federal Home Loan Bank of Chicago of
$6.5 million as compared with year-end 2004 when the Company had $6.5 million in Federal Home Loan
Bank borrowings and $15.0 million of federal funds purchased.
Federal funds purchased are overnight borrowings from the money center banks that the Bank
uses for liquidity purposes. To help ensure the ability to meet its funding needs, including any
unexpected strain on liquidity, the Bank has an unsecured line of credit for $25.0 million in
federal funds from one independent bank.
Another short-term source of funds to the Company consists of securities sold under repurchase
agreements that amounted to $73.1 million at December 31, 2005 that all mature or reprice within
one year. Securities sold under repurchase agreements are offered through either an overnight
repurchase agreement product or a term product with maturities from 7 days to one year.
Brokered deposits are also a source of liquidity for the Company. Brokered deposits are time
deposits placed in the Bank by a broker from depositors outside of the Bank’s geographic area. In
2005, the Company offered the time deposits to brokered depositors at 10 to 15 basis points greater
than the terms and conditions that were offered to local depositors. At December 31, 2005, the
Company had $49.8 million in brokered deposits compared to $71.3 million at year-end 2004.
SECURITIES SOLD UNDER REPURCHASE AGREEMENTS AND OTHER SHORT-TERM BORROWINGS
Securities sold under repurchase agreements (repurchase agreements) and other short-term borrowings
during 2005 have continued to be an alternative to certificates of deposit as a source of funds. At
December 31, 2005, the Company had balances of $73.1 million made up of repurchase agreements.
Most municipalities, other public entities and some other organizations require that their
funds are insured or collateralized as a matter of their policies. Commercial depositors also find
the collateralization of repurchase agreements attractive as an alternative to certificates of
deposits. Repurchase agreements provide a source of funds and do not increase the Company’s reserve
requirements with the Federal Reserve Bank or create an expense relating to FDIC insurance.
Repurchase agreements consequently are less costly to the Company. Management expects to continue
to offer repurchase agreements as an alternative to certificates of deposit in the future.
The Company experienced a $13.3 million increase in its repurchase agreements at year-end 2005
as compared with year-end 2004. As shown in Table 12, average repurchase agreements were $62.8
million during 2005, compared to $56.7 million during 2004, and $89.9 million in 2003. Repurchase
agreements issued to related parties of the Company totaled
$7.5 million at December 31, 2005. The repurchase agreements to related parties were issued at the same terms and conditions that
were offered to other customers.
The Company is able to borrow federal funds purchased from money center banks that the Bank
has correspondent relationships with up to $25.0 million for short periods of time as necessary for
liquidity purposes. During 2005 and 2004, the Company’s borrowings in federal funds purchased
averaged $1.6 million compared to $3.0 million during 2003.
NSFC ANNUAL 34 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
TABLE 12 — SECURITIES SOLD UNDER REPURCHASE AGREEMENTS
As previously disclosed, following a joint examination by the Federal Deposit Insurance Corporation
(“FDIC”) and the Illinois Department of Financial and Professional Regulation (“IDFPR”) the Board
of Directors of the Bank of Waukegan approved and signed on May 17, 2005, a memorandum of
understanding (“MOU”) in connection with certain deficiencies identified during the regulators’
examination of the Bank.
The MOU provides an understanding among the FDIC and the IDFPR and the Bank, that the Bank
will correct certain violations of law, including certain violations regarding the Bank Secrecy
Act, such as the timeliness of
currency transaction reports and the quality of customer identification documentation in
connection with the purchases of money orders, and improve its procedures so as to prevent similar
violations. In addition, the MOU confirms the understanding among the FDIC and the IDFPR and the
Bank, that the Bank will adopt written plans to: (i) lessen the Bank’s risk position with respect
to certain troubled assets; (ii) improve the Bank’s liquidity and lessen its dependence upon
volatile liabilities; (iii) improve earnings; and (iv) restore Tier 1 capital to 8% of the Bank’s
total assets should Tier 1 capital fall below that 8% level. As of December 31, 2005, the Bank’s
Tier 1 capital to total assets ratio was 8.61%. Under the MOU, the FDIC, the IDFPR and the Bank
have also reached an understanding that the Board of Directors will cause a review of the Bank’s
staffing needs with particular emphasis in the area of loan collections and loan administration.
The Bank will report to the FDIC and the IDFPR on a quarterly basis with respect to its progress on
these matters. The Bank believes certain other matters addressed in the MOU have already been
satisfactorily resolved.
At December 31, 2005, the Bank had approximately $4,900,000 in retained earnings available for
dividend declaration without prior regulatory approval.
Management believes that the MOU does not have a material impact on the Company’s operating
results or financial condition and that, unless the Bank fails to adequately address the concerns
of the FDIC and the IDFPR, the MOU will not constrain the Company’s business. Management is
committed to resolving the issues addressed in the MOU as promptly as possible, and had already
taken numerous steps to address the identified deficiencies prior to executing the MOU.
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
The Company has contractual obligations that may not appear on the balance sheet. The largest of
these off-balance sheet obligations is commitments to make loans or extend credit through standby
letters of credit. Many of these commitments expire without being used. The following Table 14
presents the Company’s significant fixed and determinable contractual obligations by payment date.
The payment amounts represent those amounts contractually due to the recipient and do not include
any unamortized premiums or discounts or similar carrying
amount adjustments.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company’s primary market risk exposure is interest rate risk and, to a lesser extent, liquidity
risk. Interest rate risk is the exposure of a banking organization’s financial condition to adverse
movements in interest rates. The Company seeks to achieve consistent growth in net interest income
and net income while managing volatility that arises from shifts in interest rates. The Company’s
Asset and Liability Management Committee (“ALCO”) oversees interest rate risk programs instituted
by management and measurements of interest rate risk to determine that they are within authorized
limits set by the Company’s Board of Directors.
Evaluating a financial institution’s exposure to changes in interest rates includes assessing
both the adequacy of the management process used to control interest rate risk and the
organization’s quantitative level of exposure. When assessing the interest rate risk management
process, the Company seeks to ensure that
appropriate policies, procedures, management information systems and internal controls are in
place to maintain interest rate risk at prudent levels with consistency and continuity. Evaluating
the quantitative level of interest rate risk exposure requires the Company to assess the existing
and potential future effects of changes in interest rates on its consolidated financial condition,
including capital adequacy, earnings, liquidity, and where appropriate, asset quality.
Proper interest rate risk evaluation must include active board of director and senior
management oversight and a comprehensive risk-management process that effectively identifies,
measures, and controls interest rate risk. Several techniques might be used by an institution to
minimize interest rate risk. Such activities fall under the broad definition of asset/liability
management.
One approach used by the Company is to periodically analyze the matching of assets and
liabilities by examining the extent to which such assets and liabilities are “interest rate
sensitive” and by monitoring an institution’s interest rate sensitivity “gap”.
An asset or liability is said to be interest rate sensitive within a specific time period if
it will mature or reprice within that time period. The interest rate sensitivity gap is defined as
the difference between the amount of interest earning assets maturing or repricing within a
specific time period and the amount of interest bearing liabilities maturing or repricing within
that same time period. A gap is considered positive when the amount of interest rate sensitive
assets exceeds the amount of interest rate sensitive liabilities.
A gap is considered negative when the amount of interest rate sensitive liabilities exceeds
the amount of interest rate sensitive assets. During a period of rising interest rates, a negative
gap would tend to adversely affect net interest income while a positive gap would tend to result in
an increase in net interest income. The Company’s gap position is illustrated in Table 10,
“Maturity or Repricing of Assets and Liabilities”.
Rate sensitivity varies with different types of interest earning assets and interest bearing
liabilities. Rate sensitivity on loans tied to the prime rate differs considerably from long-term
investment securities and fixed rate loans. Time deposits are usually more rate sensitive than
savings accounts. Management has portrayed
savings accounts and NOW accounts as immediately repricable in Table 10, because of
management’s ability to change the savings and NOW account interest rate even though market
conditions may allow these rates to remain stable.
Table 11, “Time Deposits, $100,000 and Over Maturity Schedule”, allows one to calculate that
at December 31, 2005, 26.8% of the time deposits $100,000 and over mature after one year, differing
from 4.7% at December 31, 2004. This shows a lengthening of maturities in this type of deposit as
the Company has tried to lower its negative gap position in 2005.
The Company historically has had high levels of time deposits over $100,000. As of December31, 2005, time deposits over $100,000 were 29.9% of total interest bearing liabilities compared to
30.1% in 2004. Table 11 shows at year-end 2005 that there were $52,882,000 or 30.5% of the time
deposits over $100,000 from public depositors. Being located in the county seat, the Company
accepts time deposits over $100,000 from various local governmental units.
At December 31, 2005, approximately 47% of the Company’s loan and lease portfolio float with
the prime rate or are repricable within 90 days, a decrease from 52% at December 31, 2004. This
decrease is from pressure by borrowers requesting fixed rate loans as the prime rate increased 200
basis points in 2005. If interest rates continue to increase in 2006, borrowers will continue to
pressure lenders to make them fixed rate loans so that their loan rate will not rise with perceived
future rate increases. These developments, along with competition, may cause the percentage of
fixed rate loans to increase in 2006.
Securities issued by U.S. government-sponsored entities that reprice within 365 days amount to
$54,725,000 according to Table 10. It should be noted that in Table 10, the repricing of these
securities is based on the maturity date of the investments. At December 31, 2005, $187.3 million
or 75% of the Company’s U.S. government-sponsored entity securities have call options that allow
the issuer to call or payoff the security prior to maturity. It is expected that interest rates
will increase in 2006 and consequently it is expected that few of these securities will be called.
However if interest rates should decline the possibility that these securities will be called
increases.
As Table 10 shows, at December 31, 2005, the Company had a negative gap in the immediate to 90
days time horizon of $129,699,000, with the cumulative excess
NSFC ANNUAL 37 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (CONT’D)
interest earning assets (liabilities) remaining negative through the three-year time horizon. The
Company being liability sensitive would indicate that an increase in interest rates would have a
negative impact on future net interest income.
Another approach used by management to analyze interest rate risk is to periodically evaluate
the “shock” to the base 12 month projected net interest income of an assumed instantaneous decrease
and increase in rates of 1% and 2% using computer simulation. Table 15 shows this analysis at
December 31, 2005 and December 31, 2004. The computer simulation model used to do the interest rate
shocks and calculate the effect on projected net interest income takes into consideration maturity
and repricing schedules of the various assets and liabilities as well as call provisions on the
Company’s securities. Current policy set by the Board of Directors limits exposure to net interest
income from interest rate shocks of plus or minus 2% to plus or minus 10% of the base projected 12
month net interest income.
At December 31, 2005 the forecasted 2006 net interest income decreases $1,062,000 when rates are
shocked upwards 2% while net interest income increases $758,000 for a 2% downward rate shock. This
is indicated by the negative gap position that the Company is in at year-end 2005.
Several ways the Company can manage interest rate risk include: selling existing assets or
repaying certain liabilities and matching repricing periods for new assets and liabilities, for
example, by shortening terms of new loans or securities. At present, the maturity terms of
securities can only be shortened by selling the securities at a loss. In 2007 a majority of the
Company’s investment securities portfolio matures and the Company has the opportunity at that time
to restructure its securities portfolio to decrease the negative gap position it currently
possesses. Financial institutions are also subject to prepayment risk in a falling rate
environment. For example, a debtor may prepay financial assets so that the debtor may refinance
obligations at new, lower rates. Prepayments of assets carrying higher rates reduce the Company’s
interest income and overall asset yields.
TABLE 15 — EFFECT OF INTEREST SHOCKS ON FINANCIAL INSTRUMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Northern States Financial Corporation
Waukegan, Illinois
We have audited the accompanying balance sheets of the NORTHERN STATES FINANCIAL CORPORATION as of
December 31, 2005 and 2004, and the related statements of income, stockholders’ equity, cash flows
and comprehensive income for each of the three years in the period ended December 31, 2005. These
financial statements are the responsibility of the Company’s management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of the NORTHERN STATES FINANCIAL CORPORATION as of December 31,2005 and 2004, and the results of its operations and its cash flows for each of the three years in
the period ended December 31, 2005, in conformity with U.S. generally accepted accounting
principles.
Unrealized
gains (losses) on
securities available for
sale, net of tax
(1,854
)
(1,144
)
(1,854
)
Comprehensive income
$
233
$
2,857
$
3,672
The accompanying notes are an integral part of these consolidated financial statements.
NSFC ANNUAL 43 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation: The consolidated financial statements include the accounts of
Northern States Financial Corporation (“Company”) its wholly owned subsidiary, NorStates Bank
(“Bank”) and NorStates Bank’s majority-owned subsidiary, Northern States Community Development
Corporation (“NSCDC”). NSCDC was formed in 2002 and the Bank contributed a parcel of the other real
estate owned and cash to this entity.
On November 10, 2005, Bank of Waukegan and First State Bank of Round Lake, both wholly owned
subsidiaries of the Company, were merged together. Bank of Waukegan was the resulting Bank from the
merger, under the name NorStates Bank. As discussed in Note 18, the Company acquired First State
Bank of Round Lake on January 5, 2004. Significant intercompany transactions and balances are
eliminated in consolidation.
Nature of Operations: The Company’s and the Bank’s revenues, operating income and assets are
primarily derived from banking activities. Loan customers are mainly located in Lake County,
Illinois and surrounding areas and include a wide range of individuals, businesses and other
organizations. A major portion of loans are secured by various forms of collateral, including real
estate, business assets, consumer property and other items.
Use of Estimates: To prepare financial statements in conformity with accounting principles
generally accepted
in the United States of America, management makes estimates and assumptions based on available
information. These estimates and assumptions affect the amounts reported in the financial
statements and the disclosure provided, and future results could differ. The allowance for loan and
lease losses, fair value of financial instruments and status of contingencies are particularly
subject to change.
Cash Flow Reporting: Cash and cash equivalents are defined as cash and due from banks, federal
funds sold and interest bearing deposits in financial institutions. Net cash flows are reported for
customer loan and deposit transactions, securities sold under repurchase agreements and other
short-term borrowings.
Securities: Securities are classified as available for sale when they might be sold before
maturity. Securities available for sale are carried at fair value, with unrealized holding gains
and losses reported separately as other comprehensive income, net of tax. Restricted securities,
such as Federal Home Loan Bank of Chicago stock and Federal Reserve Bank stock, are carried at
cost.
Gains and losses on sales are determined using the amortized cost of the specific security sold.
Interest income includes amortization of purchase premiums and discounts. Securities are written
down to fair value when a decline in fair value is not temporary.
Declines in fair value of securities below their cost that are other than temporary are
reflected as realized losses. In estimating other-than-temporary losses, management considers: (1)
the length of time and extent that fair value has been less than cost, (2) the financial condition
and near term prospects of the issuer, and (3) the Company’s ability and intent to hold the
security for a period sufficient to allow for any anticipated recovery in fair value.
Loans and Leases: Loans and leases are reported at the principal balance outstanding, net of
deferred loan fees and costs and the allowance for loan losses.
Interest income is reported on the interest method and includes amortization of deferred loan
fees and costs over the loan term. Interest income on mortgage and commercial loans is discontinued
at the time the loan is 90 days delinquent unless the credit is well-secured and in process of
collection. Consumer loans are typically charged-off when they become later than 180 days past due.
In all cases, loans are placed on nonaccrual or charged off if collection of principal or interest
is considered
doubtful.
Interest received on nonaccrual loans is accounted for on the cash-basis or cost-recovery
method, until qualifying for return to actual accrual. Loans are returned to accrual status when
all the principal and interest amounts contractually due are brought current and future payments
are reasonably assured.
Allowance for Loan and Lease Losses: The allowance for loan and lease losses is a valuation
allowance for probable incurred credit losses, increased by the provision for loan and lease losses
and decreased by charge-offs less recoveries. Management estimated the allowance balance required
using past loan and lease loss experience, the nature and volume of the portfolio, information
about specific borrower situations, estimated collateral values, economic conditions and other
factors. Allocations of the allowance may be made for specific loans and leases, but the entire
allowance is available for any loan or lease that, in the management’s judgement, should be
charged-off. Loan and lease losses are charged against the allowance when management believes the
uncollectibility of a loan or lease balance is confirmed.
A loan or lease is impaired when full payment under the loan or lease terms is not expected.
Impairment is evaluated in total for smaller-balance loans of similar nature such as residential
mortgage, consumer and credit card loans, and on an individual loan or lease basis for other loans
and leases.
NSFC ANNUAL 44 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
NOTE 1 (CONT’D)
If a loan or lease is impaired, a portion of the allowance is allocated so that the loan or
lease is reported, net, at the present value of estimated cash flows using the loan’s or lease’s
existing rate or at the fair value of collateral if repayment is expected solely from the
collateral.
Office Building and Equipment: Land is carried at cost. Building and related components are
depreciated using the straight-line method with useful lives ranging from 7 to 40 years. Furniture,
fixtures and equipment are depreciated using the straight-line method with useful lives ranging
from 3 to 10 years.
Other Real Estate: Real estate acquired in settlement of loans is initially reported at
estimated fair value at acquisition. After acquisition, a valuation allowance reduces the reported
amount to the lower of the initial amount or fair value less costs to sell. Expenses, gains and
losses on disposition and changes in the valuation allowance are reported in net loss on other
real estate.
Goodwill and Other Intangible Assets: Goodwill results from prior business acquisitions and
represents the excess of the purchase price over the fair value of acquired tangible assets and
liabilities and identifiable intangible assets. Upon adopting new accounting guidance in 2002, the
Company ceased amortizing goodwill. Goodwill is assessed at least annually for impairment and any
such impairment will be recognized in the period identified.
The core deposit intangible arising from the First State Bank of Round Lake acquisition was
measured at fair value and is being amortized on the straight-line method over seven years.
Long-term Assets: These assets are reviewed for impairment when events indicate their carrying
amount may not be recoverable from future discounted cash flows. If impaired, the assets are
recorded at discounted amounts.
Repurchase Agreements: Substantially all repurchase agreement liabilities represent amounts
advanced by various customers. Securities are pledged to cover these liabilities, which are not
covered by federal deposit insurance.
Employee Benefits: A profit sharing plan covers substantially all employees. Contributions are
expensed annually and are made at the discretion of the Board of Directors. Contributions totaled
$208,000, $264,000 and $241,000 in 2005, 2004 and 2003. The plan allows employees to make voluntary
contributions, although such contributions are not matched by the Company.
Income Taxes: Income tax expense is the sum of the current year income tax due or refundable
and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the
expected future tax consequences of temporary differences between the carrying amounts and tax
basis of assets and liabilities computed using enacted tax rates. A valuation allowance, if needed,
reduces deferred tax assets to the amount expected to be realized.
Fair Value of Financial Instruments: Fair values of financial instruments are estimated using
relevant market information and other assumptions, as more fully disclosed separately. Fair value
estimates involve uncertainties and matters of significant judgement regarding interest rates,
credit risk, prepayments and other factors, especially in the
absence of broad markets for particular items. Changes in assumptions or in market conditions
could significantly affect the estimates. The fair value estimates of on- and off-balance sheet
financial instruments does not include the value of anticipated future business or the values of
assets and liabilities not considered financial instruments.
Loan Commitments and Related Financial Instruments: Financial instruments include off-balance
sheet credit instruments, such as commitments to make loans and commercial letters of credit,
issued to meet customer financing needs. The face amount for these items represents the exposure to
loss, before considering customer collateral or ability to repay. Such financial instruments are
recorded when they are funded.
Earnings per Share: Basic earnings per share is based on weighted average common shares
outstanding.
Comprehensive Income: Comprehensive income consists of net income and other comprehensive
income. Other comprehensive income includes unrealized gains and losses on securities available for
sale, net of deferred tax, which are also recognized as separate components of equity.
Reclassification: Some items in the prior year financial statements were reclassified to
conform to current presentation.
NSFC ANNUAL 45 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
NOTE 2 — SECURITIES
(TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
Year-end securities available for sale were as follows:
Sales of securities available for sale were as follows:
2005
2004
2003
Proceeds
$
6,127
$
0
$
2,005
Gross gains
0
0
5
Gross losses
(169
)
0
0
Contractual maturities of debt securities available for sale at year-end 2005 were as follows.
Securities not due at a single maturity date, primarily mortgage-backed securities, are shown
separately.
Fair
Value
Due in one year or less
$
58,055
Due after one year through five years
197,061
Due after five years through ten years
2,824
Due after ten years
1,129
259,069
Mortgage-backed securities
2,687
Equity securities
3,311
Total
$
265,067
Securities issued by U.S. government-sponsored entities with call options totaled $187,328,000
and $169,215,000 at December 31, 2005 and 2004.
Securities carried at $189,697,000 and $223,038,000 at year-end 2005 and 2004, were pledged to
secure public deposits, repurchase agreements and for other purposes as required or permitted by
law.
As of December 31, 2005, the Company had no securities of a single issuer, other than the U.S.
government-sponsored entities, including the Federal Home Loan Bank (FHLB) and the Federal Farm
Credit Bank (FFCB), that exceeded 10% of stockholders’ equity.
The Company holds securities issued by municipalities within various states with no state’s
aggregate total exceeding 10% of stockholders’ equity.
Securities with unrealized losses at year-end 2005 and 2004 aggregated by investment
category and length of time that individual securities have been in continuous unrealized loss
position at year-end 2005 and 2004 are as follows:
Unrealized losses securities have not been recognized into income because the issuers’
securities are of high credit quality. Management has the intent and ability to hold these
securities for the foreseeable future and the decline in fair value is largely due to increases in
market interest rates. The fair value is expected to recover as the securities approach their
maturity date.
NOTE 3 — LOANS
Year-end loans were as follows:
2005
2004
Commercial
$
58,802
$
50,817
Real estate — construction
42,567
42,872
Real estate — mortgage 1-4 family
38,145
43,270
Real estate — mortgage 5+ family
29,426
34,460
Real estate — mortgage commercial
185,219
216,569
Home equity
31,226
34,607
Leases
10,585
12,550
Installment
5,136
8,329
Total loans
401,106
443,474
Less:
Deferred loan fees
(604
)
(912
)
Loans, net of deferred loan fees
400,502
442,562
Allowance for loan losses
(10,618
)
(7,812
)
Loans and leases, net
$
389,884
$
434,750
NSFC ANNUAL 47 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
NOTE 3 — LOANS (CONT’D)
(TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
Impaired loans were as follows:
2005
2004
2003
Year-end impaired loans and leases with no allowance for loan
and lease losses allocated
$
8,083
$
608
$
0
Year-end impaired loans and leases with allowance for loan
and lease losses allocated
23,971
29,279
18,152
Total impaired loans and leases impaired at year-end
$
32,054
$
29,887
$
18,152
Amount of the allowance allocated to impaired loans and leases
$
7,646
$
5,177
$
1,193
Average of impaired loans and leases during the year
29,285
20,177
14,439
Interest income recognized on impaired loans and leases
during impairment, all on cash basis
941
132
73
Non-performing loans and leases were as follows:
2005
2004
2003
Nonaccrual loans and leases
$
21,554
$
19,131
$
18,174
Loans and leases past due over 90 days
and still accruing interest
358
343
1,476
Total non-performing loans
$
21,912
$
19,474
$
19,650
The Company previously disclosed its involvement in certain lease pools purchased in 2000 and
2001 from Commercial Money Center (“CMC”). These lease pools were secured by both the leased
equipment as well as surety bonds issued by ACE/Illinois Union and RLI Insurance Company. The
latest A. M. Best ratings for these sureties are “A+”. The lease pools are carried on nonaccrual
status and totaled $9.4 million at December 31, 2005. In September 2005, the Company filed Motions
for Judgement on the Pleadings in its CMC litigations against the sureties. At that time, the court
granted the Motion for Judgement on the Pleadings against ACE/Illinois Union; however, the Bank’s
motion against the RLI sureties was denied. ACE/Illinois Union insures the lease pools that
amounted to $5.3 million at December 31, 2005 and RLI acts as the sureties on lease pools totaling
$4.1 million at December 31, 2005. On October 31, 2005, the court directed all parties involved in
the CMC litigation to engage in mediation. No assurance can be given as to the exact amounts that
will be ultimately collected by the Company, if any, as a result of the mediation. At December 31,2005, the Company had $2.4 million of its allowance for loan leases losses allocated to the lease
pools purchased from CMC.
Related party loans were as follows:
2005
Total loans at beginning of year
$
3,668
New loans
1,615
Repayments
(2,718
)
Other changes
135
Total loans at end of year
$
2,700
Real estate-mortgage commercial loans with a carrying value of $23,923,000 and $42,362,000
were made to borrowers in the hotel industry at December 31, 2005 and 2004.
There were no loans held for sale at year-end 2005 and 2004.
(TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
The change in goodwill during the year is as follows:
2005
2004
2003
Balance at beginning of year
$
9,522
$
85
$
85
Acquired goodwill — First
State Bank of Round Lake
0
9,437
0
Impairment
0
0
0
Balance at end of year
$
9,522
$
9,522
$
85
The core deposit intangible asset arising from the First State Bank of Round Lake acquisition
on January 5, 2004 was recorded at $3,246,000. Amortization expense in 2005 was $464,000 and in
2004 was $464,000. The core deposit intangible is being amortized on the straight-line method over
seven years with five years remaining.
Acquired intangible assets were as follows as of year end:
2005
2004
Gross Carrying
Accumulated
Net Carrying
Gross Carrying
Accumulated
Net Carrying
Amount
Amortization
Amount
Amount
Amortization
Amount
Core deposit
intangible
$
3,246
$
928
$
2,318
$
3,246
$
464
$
2,782
At year-end 2005 estimated amortization for each of the next five years were as follows:
2005
2006
$
464
2007
464
2008
464
2009
464
2010
462
NOTE 7 — DEPOSITS
At year-end 2005, stated maturities of time deposits were:
2005
2006
$
221,911
2007
21,422
2008
27,019
2009
10,667
2010
10,358
Total
$
291,377
Related party deposits at year-end 2005 and 2004 totaled $12,114,000 and $11,406,000.
Brokered deposits at year-end 2005 and 2004 totaled $49,758,000 and $71,264,000.
Securities sold under agreements to repurchase are secured by U.S. government agency
securities with a carrying amount of $77,683,000 and $69,112,000 at December 31, 2005 and 2004.
Securities sold under agreements to repurchase are financing arrangements that mature within
one year. At maturity, the securities underlying the agreements are returned to the Company.
Information concerning securities sold under agreements to repurchase is summarized as follows:
2005
2004
Average daily balance during the year
$
62,799
$
56,749
Average interest rate during the year
2.97
%
1.41
%
Maximum month end balance during the year
$
78,981
$
69,734
Weighted average interest rate at year-end
3.80
%
1.89
%
Related party securities sold under repurchase agreements at year-end 2005 and 2004 totaled
$7,480,000 and $18,559,000.
At year-end 2005, there were two customer relationships in which the customer had securities
sold under repurchase agreements that totaled in excess of 10% of equity. One relationship totaled
$23,450,000 and had a weighted average maturity of 103 days. The other relationship totaled
$9,042,000 and had a weighted average maturity of 1 day in an overnight product.
At year-end advances from the Federal Home Loan Bank were as follows at both December 31, 2005
and 2004:
The Banks maintain a collateral pledge agreement with the FHLB covering secured advances
whereby the Bank agrees to retain first mortgage loans with an unpaid principal balance aggregating
no less than 167% of the outstanding secured advance from the FHLB. Additional collateral includes
pledged securities carried at $3,908,000 and holdings of FHLB stock.
Federal funds purchased is a short-term borrowing from a money center bank. At December 31,2005 there were no federal funds purchased and at December 31, 2004 federal funds purchased totaled
$15,000,000.
NOTE 9 — SUBORDINATED DEBENTURES
On September 15, 2005, the Company issued $10 million of trust preferred securities
through Northern States Statutory Trust I. The Company issued $10 million of subordinated
debentures to Northern States Statutory Trust I, which in turn issued $10 million of trust
preferred securities. The subordinated debentures mature in September 2035 and at December 31, 2005
bear interest at a rate of 6.239%. From December 2005 until September 15, 2010, the subordinated
debentures bear interest at a rate equal to the sum of the product of 50% times the 3-month London
Interbank Offered Rate (LIBOR) plus 1.80%, plus the product of 50% times 6.186%, and thereafter at a rate equal to the 3-month LIBOR plus 1.80%. For the
year ended December 31, 2005, interest expense on the subordinated debentures was $178,000. The
Company has the option to defer interest payments on the subordinated debentures at any time for up
to 5 years. The subordinated debentures are redeemable by the Company at any time commencing in
2010 at par.
The $10 million in trust preferred securities is included in Tier I capital (within certain
limitations) under current regulatory guidelines and interpretations. In September 2005, the
Company contributed $2.0 million of the proceeds from the trust preferred securities and related
subordinated debentures to the Bank in order to increase the Bank’s capital.
NSFC ANNUAL 51 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
NOTE 10 — INCOME TAXES
(TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
A summary of federal and state income taxes on operations follows:
2005
2004
2003
Current payable tax:
Federal
$
1,794
$
2,400
$
3,241
State
0
48
224
Deferred tax (benefit)
(1,263
)
(912
)
(577
)
Provision for
income taxes
$
531
$
1,536
$
2,888
The components of deferred tax assets and liabilities at December 31, 2005 and
2004 follow:
2005
2004
Deferred tax assets:
Allowance for loan and lease losses
$
3,929
$
2,785
Deferred compensation and directors’ fees
82
81
Net
operating loss carry forward for state income tax purposes
67
0
Unrealized net loss on securities available for sale
2,204
1,033
Gross deferred tax assets
6,282
3,899
Deferred tax liabilities:
Depreciation
(506
)
(562
)
Federal Home Loan Bank stock dividends
(281
)
(243
)
Deferred loan fees
(256
)
(151
)
Basis difference in acquired assets
(1,148
)
(1,441
)
Other items
(360
)
(205
)
Gross deferred tax liabilities
(2,551
)
(2,602
)
Net deferred tax asset (liability)
$
3,731
$
1,297
No valuation allowance is required for deferred tax assets.
In 2005, the Company generated a net operating loss for state income tax purposes of
approximately $1,400,000, which will be carried forward to reduce future taxable income. The net
operating loss carried forward will expire in 2018 if it is not utilized.
The provision for income taxes differs from that computed at the
statutory federal corporate rates as follows:
2005
2004
2003
Income tax calculated at statutory rate (34%)
$
890
$
1,883
$
2,860
Add (subtract) tax effect of:
Tax-exempt income, net of disallowed interest expense
(125
)
(203
)
(119
)
State income tax, net of federal tax benefit
(242
)
(117
)
94
Tax credits from low income housing investments
(80
)
(80
)
(37
)
Other items, net
88
53
90
Provision for income taxes
$
531
$
1,536
$
2,888
Prior to being merged with the Bank, the former subsidiary, First Federal Bank, fsb qualified
under provisions of the Internal Revenue Code which permitted it to deduct from taxable income a
provision for bad debts which differed from the provision charged to income in the financial
statements. Tax legislation passed in 1996 now requires all thrift institutions to deduct a
provision for bad debts for tax purposes based on actual loss experience. Retained earnings at
December 31, 2005 includes approximately $3,269,000 for which no provision for federal income taxes
has been made. If, in the future, this portion of retained earnings is used for any purpose other
than to absorb bad debt losses, federal income taxes would be imposed at the then prevailing rates.
At December 31, 2005, this would result in approximately $1,269,000 of deferred tax liability.
There are various contingent liabilities that are not reflected in the financial
statements, including claims and legal actions arising in the ordinary course of business. In the
opinion of management, after consultation with legal counsel, the ultimate disposition of these
matters is not expected to have a material effect on financial condition or results of operations.
At year-end 2005 and 2004, reserves of $5,790,000 and $6,802,000 were required as deposits
with the Federal Reserve or as cash on hand. These reserves do not earn interest.
Cash and cash equivalents at December 31, 2005 and 2004 included $17,021,000 and $11,466,000
at the Company’s main correspondent bank, LaSalle National Bank, Chicago, IL.
Some financial instruments are used in the normal course of business to meet the financing
needs of customers and to reduce exposure to interest rate changes. These financial instruments
include commitments to extend credit, standby letters of credit, and financial guarantees. These
involve, to varying degrees, credit and interest-rate risk in excess of the amount reported in the
financial statements.
The same credit policies are used for commitments and conditional obligations as are used for
loans. Collateral or other security is normally required to support financial instruments with
credit risk.
Commitments to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the commitment. 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 used, the commitment does not necessarily
represent future cash requirements. Standby letters of credit and financial guarantees written are
conditional commitments to guarantee a customer’s performance to a third party.
A summary of the notional or contractual amounts of financial instruments with off-balance sheet
risk at year-end follows:
2005
2004
Unused lines of credit and commitments to make loans:
Fixed rate
$
6,892
$
13,578
Variable rate
89,442
100,649
Total
$
96,334
$
114,227
Standby letters of credit
$
5,156
$
4,511
Commitments to make loans at a fixed rate have interest rates ranging primarily from 6.50% to 7.50%
at December 31, 2005.
Commitments to make loans to related parties totaled $2,601,000 and $1,389,000 at December 31, 2005
and 2004.
Other real estate includes a property acquired in 1987 through the receipt of a deed in lieu
of foreclosure. This property is a former commercial/industrial site located overlooking Lake
Michigan in Waukegan, Illinois, with a carrying value of $1,783,000 at December 31, 2005 and 2004. The carrying
value of this property is supported by a current real estate appraisal. Environmental remediation
costs may be incurred in disposing of this property, and the amount of any such costs may depend on
the future use of the property, such as for commercial, residential, or recreational purposes.
There is no requirement to undertake any environmental remediation activities at this time.
Further, there is no pending or threatened litigation regarding the property’s environmental
issues, nor are there any threatened or pending governmental orders, assessments or actions
regarding the same. The property is currently undergoing a brownfield assessment funded by a
government grant. The grant money is to be used for the brownfield assessment but not for any
remediation that may be needed. The objective of the brownfield assessment is to obtain the
environmental data needed to determine the appropriate remedial actions, if any, for the property
to achieve a “No Further Remediation Letter” from the Illinois EPA Site Remediation Program. The
end use of the property is mixed use residential development consistent with the City of Waukegan’s
Lakefront Downtown Master Plan. The results of the brownfield assessment are not expected until
later in 2006. Until the results of the brownfield assessment are known, it is not practicable to
estimate any remediation costs. Thus, no liability has been recorded for environmental remediation
costs.
NSFC ANNUAL 53 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
NOTE 12 — FAIR VALUES OF FINANCIAL INSTRUMENTS
(TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
The following methods and assumptions were used to estimate fair values for financial
instruments. Securities fair values are based on quoted market prices or, if no quotes are
available, on the rate and term of the security and or information about the issuer. For loans,
leases, deposits, securities sold under repurchase agreements and fixed rate FHLB advances, the
fair value is estimated by discounted cash flow analysis using market rates for the estimated life
and credit risk. Fair values for impaired loans are estimated using discounted cash flow analyses
or underlying collateral values, where applicable. Then fair value of off-balance sheet items is
based on the fees or cost that would currently be charged to enter or terminate such arrangements,
and the fair value is not material.
The estimated year-end fair values of financial instruments were:
Estimated
2005
Carrying Value
Fair Value
Financial assets:
Cash and cash equivalents
$
29,668
$
29,668
Securities available for sale
265,067
265,067
Loans and leases, net
389,884
386,276
Federal Home Loan Bank of Chicago stock
2,086
2,086
Accrued interest receivable
3,901
3,901
Financial liabilities:
Deposits
$
(554,449
)
$
(551,444
)
Securities sold under repurchase agreements
(73,093
)
(73,062
)
Federal Home Loan Bank term advances
(6,500
)
(6,356
)
Subordinated debentures
(10,000
)
(10,150
)
Advances from borrowers for taxes and
insurance
(830
)
(830
)
Accrued interest payable
(3,439
)
(3,439
)
Estimated
2004
Carrying Value
Fair Value
Financial assets:
Cash and cash equivalents
$
29,999
$
29,999
Securities available for sale
250,929
250,929
Loans and leases, net
434,750
431,293
Federal Home Loan Bank of Chicago and
Federal Reserve Bank stock
The Company and its subsidiary, NorStates Bank, are subject to regulatory capital
requirements administered by federal banking agencies. Capital adequacy guidelines and prompt
corrective action involve quantitative measures of assets, liabilities, and certain off-balance
sheet items calculated under regulatory accounting practices. Capital amounts and classifications
are also subject to qualitative judgments by regulators about components, risk weighting, and other
factors, and the regulators can lower classifications in certain cases. Failure to meet various
capital requirements can initiate regulatory action that could have a direct material effect on the
financial statements.
The prompt corrective action regulations provide five classifications, including well
capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and
critically undercapitalized, although these terms are not used to represent overall financial
condition. If adequately capitalized, regulatory approval is required to accept brokered deposits.
If undercapitalized, capital distributions are limited, as is asset growth and expansion, and plans
for capital restoration are required.
Actual capital levels and minimum required levels were as follows at December 31, 2005 and 2004:
Minimum Required to
Minimum Required
be Well Capitalized
For Capital
Under Prompt Corrective
Actual
Adequacy Purposes
Action Regulations
Amount
Ratio
Amount
Ratio
Amount
Ratio
2005
Total Capital
(to risk weighted assets)
Consolidated
$
78,539
16.14
%
$
38,936
8.00
%
N/A
NorStates Bank
70,167
14.42
38,915
8.00
$
48,644
10.00
%
Tier I Capital
(to risk weighted assets)
Consolidated
72,399
14.88
19,468
4.00
N/A
NorStates Bank
64,030
13.16
19,458
4.00
29,186
6.00
Tier I Capital
(to average assets)
Consolidated
72,399
9.74
29,733
4.00
N/A
NorStates Bank
64,030
8.61
29,730
4.00
37,163
5.00
2004
Total Capital
(to risk weighted assets)
Consolidated
$
69,300
12.76
%
$
43,452
8.00
%
N/A
Bank of Waukegan
58,499
12.64
36,554
8.00
$
45,692
10.00
%
First State Bank
10,332
11.73
7,044
8.00
8,806
10.00
Tier I Capital
(to risk weighted assets)
Consolidated
62,511
11.51
21,726
4.00
N/A
Bank of Waukegan
52,700
11.39
18,277
4.00
27,415
6.00
First State Bank
9,537
10.83
3,522
4.00
5,283
6.00
Tier I Capital
(to average assets)
Consolidated
62,511
8.03
31,132
4.00
N/A
Bank of Waukegan
52,700
8.41
26,049
4.00
32,562
5.00
First State Bank
9,537
7.86
4,852
4.00
6,066
5.00
NSFC ANNUAL 55 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
NOTE 13 — REGULATORY MATTERS (CONT’D)
(TABLE
AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
The
Company and its subsidiary, NorStates Bank, at year end 2005 were
categorized as well capitalized. Management knows of no circumstances
or events which would change these categorizations.
The Company’s primary source of funds to pay dividends to shareholders is the dividends it
receives from its subsidiary Bank. The Bank is subject to certain restrictions on the amount of
dividends that they may declare without regulatory approval. At December 31, 2005, approximately
$4,900,000 of NorStates Bank’s retained earnings was available for dividend declaration without
prior regulatory approval.
Following a joint examination by the Federal Deposit Insurance Corporation (“FDIC”) and the
Illinois Department of Financial and Professional Regulation (“IDFPR”), the Board of Directors of
the Bank of Waukegan approved and signed on May 17, 2005, a memorandum of understanding (“MOU”) in
connection with certain deficiencies identified during the regulators’ examination of the Bank.
The MOU provides an understanding among the FDIC, the IDFPR and the Bank, that the Bank will
correct certain violations of law, including certain violations regarding the Bank Secrecy Act,
such as the timeliness of currency transaction reports and the quality of customer identification
documentation in connection with the purchases of money orders, and improve its procedures so as to
prevent similar violations. In addition, the MOU confirms the understanding among the FDIC and the
Bank, that the Bank will adopt written plans to: (i) lessen the Bank’s risk position with respect
to certain troubled assets; (ii) improve the Bank’s liquidity and lessen its dependence upon
volatile liabilities; (iii) improve earnings; and (iv) restore Tier 1 capital to 8% of the Bank’s
average assets should Tier 1 capital fall below that 8% level. Under the MOU, the FDIC, the IDFPR
and the Bank have also reached an understanding that the Board of Directors will cause a review of
the Bank’s staffing needs with particular emphasis in the area of loan collections and loan
administration. The Bank will report to the FDIC and the IDFPR on a quarterly basis with respect to
its progress on these matters. The Bank believes certain other matters addressed in the MOU have
already been satisfactorily resolved.
Management believes that the MOU does not have a material impact on the Company’s operating
results or financial condition and that, unless the Bank fails to adequately address the concerns
of the FDIC and the IDFPR, the MOU will not constrain the Company’s business. Management is
committed to resolving the issues addressed in the MOU as promptly as possible, and had already
taken numerous steps to address the identified deficiencies prior to executing the MOU.
NSFC ANNUAL 56 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
NOTE 14 — EARNINGS PER SHARE & STOCKHOLDERS’ EQUITY
Net income was utilized to calculate earnings per share for all years presented. The
weighted average shares utilized in computing earnings per share follow:
2005
2004
2003
Average outstanding common shares
4,295,105
4,302,329
4,305,872
Effect of stock options
0
0
0
Average outstanding shares for
diluted
earnings per share
4,295,105
4,302,329
4,305,872
The Company had a stock-based incentive plan, which terminated prior to 2003. No stock options
or other stock based awards were outstanding in 2005, 2004, or 2003.
In April 2002, the Company announced a stock repurchase program to purchase up to 200,000
shares of its stock. In February 2003, the Company announced an additional stock repurchase plan to
purchase another 200,000 shares once all shares from the initial stock repurchase plan are
purchased. The Company, at year-end 2005, may repurchase 22,850 shares of stock under the April
2002 program and 200,000 shares of stock under the February 2003 program.
NSFC ANNUAL 57 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
NOTE 15 — PARENT COMPANY CONDENSED FINANCIAL STATEMENTS
(TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
Following are condensed parent company financial statements.
Other comprehensive income components and related deferred taxes were as follows:
2005
2004
2003
Unrealized holding gains (losses) on securities available
for sale
$
(3,194
)
$
(1,868
)
$
(3,022
)
Reclassification adjustments for gains and losses recognized
in income
169
0
(5
)
Net unrealized gains (losses)
(3,025
)
(1,868
)
(3,027
)
Tax effect
1,171
724
1,173
Other comprehensive income (loss)
$
(1,854
)
$
(1,144
)
$
(1,854
)
NOTE 17 — QUARTERLY FINANCIAL DATA (UNAUDITED)
Interest
Net Interest
Net
Earnings per Share
2005
Income
Income
Income
Basic and Diluted
First quarter
$
8,582
$
5,616
$
1,025
$
0.24
Second quarter (1)
8,655
5,113
587
0.14
Third quarter (2)
8,780
4,600
135
0.03
Fourth quarter (3)
9,039
4,355
340
0.08
$
35,056
$
19,684
$
2,087
$
0.49
Interest
Net Interest
Net
Earnings per Share
2004
Income
Income
Income
Basic and Diluted
First quarter
$
7,761
$
5,448
$
1,661
$
0.39
Second quarter (4)
7,809
5,419
242
0.06
Third quarter
8,259
5,760
1,389
0.32
Fourth quarter (5)
8,263
5,606
709
0.16
$
32,092
$
22,233
$
4,001
$
0.93
(1)
- During the second quarter 2005, a write-down of other real estate owned occurred in the
amount of $1,067,000 to reflect the decrease in the market value of those properties.
(2)
- During the third quarter 2005, a provision for loan and lease losses in the amount of
$1,700,000 was made primarily due to increased allocations of the allowance for loan and lease
losses to two loan relationships that experienced credit quality issues. These loans had balances
of $10.5 million at September 30, 2005.
(3)
- During the fourth quarter 2005, a provision for loan and lease losses in the amount of
$1,000,000 was made due to deterioration in the valuation of collateral securing troubled loan
relationships and on a loan relationship totaling $4.2 million, the principal borrowers declared
personal bankruptcy.
(4)
- During the second quarter 2004, a provision for loan and lease losses in the amount of
$2,300,000 was made to increase the amount of the allowance for loan and lease losses allocated to
the nonaccrual lease pools that totaled $11.3 million at June 30, 2004.
(5)
- During the fourth quarter 2004, a provision for loan and lease losses in the amount of
$1,575,000 was made due to additional loans being classified as impaired. The allowance for loan
and lease losses allocated to impaired loans and leases was $5.2 million at December 31, 2004, as
compared to approximately $4.0 million at September 30, 2004.
NSFC ANNUAL 59 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
NOTE 18 — ACQUISITION
(TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
On January 5, 2004, the Company acquired the outstanding stock of Round Lake Bankcorp,
Inc., the holding Company for First State Bank of Round Lake (“First State Bank”), for cash in the
amount of $21,408,000 including transaction costs. Round Lake Bankcorp, Inc. was dissolved through
the transaction with First State Bank remaining as a separate subsidiary of the Company in 2004.
The results of First State Bank have been included in the consolidated financial statements since
that date. The Company on November 10, 2005 merged First State Bank into the Bank of Waukegan and
changed the name of the resulting entity to NorStates Bank.
The following table summarizes estimated fair values of the assets acquired and liabilities
assumed at January 5, 2004.
The intangible asset was assigned to core deposits and is being amortized over seven years and
at December 31, 2005, has five years remaining to be amortized. Amortization of intangibles expense
was $464,000 in both 2005 and 2004.
The following table presents pro forma information as if the acquisition had occurred the
beginning of 2003. The pro forma information includes adjustments for the amortization of
intangibles arising from the transaction, depreciation expense on property acquired, interest
expense on deposits acquired, and the related income tax effects. The pro forma financial
information is not necessarily indicative of the results of operations as they would have been had
the transactions been effected on the assumed date.
2003
Net interest income
$
21,536
Net income
6,108
Basic and diluted
earnings per share
$
1.42
NSFC ANNUAL 60 REPORT 2005
NORTHERN STATES FINANCIAL CORPORATION
STOCKHOLDER INFORMATION
Annual Meeting: All stockholders are invited
to attend our annual meeting, which will be held at
4:30 P.M., on Thursday, May 18, 2006 in the lobby of
the NorStates Bank, 1601 N. Lewis Avenue, Waukegan,
Illinois60085.
We look forward to meeting all stockholders and
welcome your questions at the annual meeting. Any
stockholders unable to attend this year’s meeting are
invited to send questions and comments in writing to
Fred Abdula, Chairman of the Board, Chief Executive
Officer and President at Northern States Financial
Corporation.
Form 10-K: Stockholders who wish to obtain a copy
at no charge of Northern States Financial
Corporation’s Form 10-K for the fiscal year ended
December 31, 2005, as filed with the Securities and
Exchange Commission, may do so by writing Thomas M.
Nemeth, Vice President & Treasurer, at Northern States
Financial Corporation.
For Further Information: Stockholders and
prospective investors are welcome to call or write
Northern States Financial Corporation with questions
or requests for additional information. Please direct
inquiries to:
Thomas M. Nemeth
Vice President & Treasurer
Northern States Financial Corporation
1601 N. Lewis Avenue Waukegan, Illinois60085
(847) 244-6000 ext. 269
Transfer Agent, Registrar & Dividend
Disbursements: Stockholders with a change of address
or related inquiries should contact:
American Stock Transfer & Trust Company
59 Maiden Lane New York, NY10038
(800) 937-5449
Quarterly Calendar: The Company operates on a
fiscal year ending December 31. Quarterly results are
announced within 40 days after the end of each
quarter, and audited results are announced within
75-90 days after year-end.
Semi-annual Dividend Dates: Dividends are
expected to be announced and paid on the following
schedule during 2006:
Half
Record Date
Payment Date
First
May 15
June 1
Second
November 15
December 1
Stock Market Information: The common stock of
Northern States Financial Corporation is traded on the
National Association of Securities Dealers Automated
Quotation System (NAS-DAQ Capital Market) under the
ticker symbol NSFC. Stock price quotations are
published weekly in the Chicago Tribune and Chicago
Sun-Times newspapers and, when traded, in The Wall
Street Journal. The stock is commonly listed as
NthnStat.
As of March 20, 2006, there were 6,500,000 common shares authorized; 4,472,255 common shares
issued and 4,295,105 outstanding; held by approximately 363 registered stockholders.
As of February 28, 2006, the following security
firms indicated they were maintaining an inventory of
Northern States Financial Corporation common stock and
are acting as market makers:
Howe Barnes Investments, Inc.
Chicago, Illinois
(800) 800-4693 or (312) 655-2995
Anderson & Strudwick, Inc.
Richmond, Virginia
(800) 767-2424 or (804) 643-2400
Price Summary: The following schedule details our stock’s quarterly high and low bid price:
Cash Dividends: Northern States Financial
Corporation pays semi-annual cash dividends in June
and December. Uninterrupted cash dividends have been
paid since the Company’s formation in 1984. The table
below shows semi-annual cash dividends per share for
the past six years.
