Table of Contents

 

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2008

 

OR

 

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

SECURITIES EXCHANGE ACT OF 1934

 

For transition period from                          to                         

 

Commission file number 005-57237

 

FIRST OTTAWA BANCSHARES, INC.

(Exact name of Registrant as specified in its charter)

 

 

(815) 434-0044

(Registrant’s telephone number,

including area code)

 

Indicate by check mark whether the Registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.                                                                    Yes x   No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

Accelerated filer o

Non-accelerated filer o

Smaller reporting company x

 

Indicate by check mark whether the Registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act) Yes o   No x

 

 

Indicate the number of shares outstanding of each of the Registrant’s classes of common stock as of the latest practicable date:  As of November 13, 2008, the Registrant had outstanding 644,849 shares of common stock, $1.00 par value per share.

 

 

Table of Contents

 

FIRST OTTAWA BANCSHARES, INC.

 

Form 10-Q Quarterly Report

 

Table of Contents

 

PART I

 

Item 1.	Condensed Consolidated Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	24
Item 4.	Controls and Procedures	25
PART II
Item 1.	Legal Proceedings	26
Item 1.A.	Risk Factors	26
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	26
Item 3.	Defaults Upon Senior Securities	26
Item 4.	Submission of Matters to a Vote of Security Holders	26
Item 5.	Other Information	26
Item 6.	Exhibits	26
	Signatures	27

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

 

		(Unaudited) September 30, 2008			December 31, 2007
ASSETS
Cash and cash equivalents		$	28,010		$	16,499
Certificates of deposit		13,914			3,808
Securities available-for-sale		59,571			66,174
Loans, less allowance for loan losses of $1,610 and $1,588		158,543			163,837
Bank premises and equipment, net		7,285			7,517
Interest receivable and other assets		11,408			11,396
Total assets		$	278,731		$	269,231
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities
Deposits
Demand – non-interest-bearing		$	32,868		$	33,710
NOW accounts		66,205			54,963
Money market accounts		39,639			29,884
Savings		22,282			21,954
Time, $100,000 and over		27,329			44,491
Other time		54,651			55,375
Total deposits		242,974			240,377
Other borrowings		6,000			—
Repurchase agreements		2,000			—
Interest payable and other liabilities		2,334			4,248
Total liabilities		253,308			244,625
Commitments and contingent liabilities
Shareholders’ equity
Preferred stock - $1 par value, 20,000 shares Authorized; none issued		—			—
Common stock - $1 par value, 1,000,000 shares authorized and 752,595 issued		753			753
Additional paid-in capital		4,382			4,300
Retained earnings		27,126			26,113
Treasury stock, at cost, 107,746 shares and 105,220 shares		(6,299		)	(6,102		)
Accumulated other comprehensive loss		(539		)	(458		)
Total shareholders’ equity		25,423			24,606
Total liabilities and shareholders’ equity		$	278,731		$	269,231

 

See accompanying notes to condensed consolidated financial statements.

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

 (In thousands, except share and per share data)

(Unaudited)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2008			2007			2008			2007
Interest income
Loans (including fee income)		$	2,659		$	3,060		$	8,289		$	8,942
Securities
Taxable		302			466			1,054			1,493
Exempt from federal income tax		263			208			774			632
Certificates of deposit		151			56			368			132
Federal funds sold		70			213			185			243
Total interest income		3,445			4,003			10,670			11,442
Interest expense
NOW account deposits		134			259			428			745
Money market deposit accounts		134			340			394			1,014
Savings deposits		29			30			89			93
Time deposits		784			981			2,728			2,817
Other borrowings		46			—			126			—
Repurchase agreements		1			—			1			—
Federal funds purchased		—			—			—			100
Total interest expense		1,128			1,610			3,766			4,769
NET INTEREST INCOME		2,317			2,393			6,904			6,673
Provision for loan losses		30			45			90			135
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		2,287			2,348			6,814			6,538
Non-interest income
Service charges on deposit accounts		227			273			646			765
Trust and farm management fee income		135			135			405			405
Gain on loan sales		9			4			54			26
Securities gains (losses)		(8		)	—			20			—
Market value adjustment on derivatives		(80		)	11			(256		)	146
Other income		140			151			489			478
Total non-interest income		423			574			1,358			1,820
Non-interest expenses
Salaries and employee benefits		1,079			1,131			3,262			3,449
Occupancy and equipment expense		339			311			984			941
Data processing expense		111			105			350			293
Supplies		31			23			89			89
Professional fees		95			151			333			396
Amortization of core deposit intangible		40			51			122			153
Other expenses		254			238			845			744
Total non-interest expenses		1,949			2,010			5,985			6,065
INCOME BEFORE INCOME TAXES		761			912			2,187			2,293
Provision for income taxes		188			239			530			537
NET INCOME		$	573		$	673		$	1,657		$	1,756
Earnings per share-basic		$	0.89		$	1.04		$	2.57		$	2.71
Earnings per share-diluted		$	0.89		$	1.04		$	2.56		$	2.70
Dividends per share		$	1.00		$	1.00		$	1.00		$	1.00

 

See accompanying notes to condensed consolidated financial statements.

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

Nine Months ended September 30, 2008 and 2007

(In thousands, except per share data)

(Unaudited)

 

		Common Stock			Additional Paid-In Capital			Retained Earnings			Treasury Stock			Accumulated Other Comprehensive Loss			Total Share- holders’ Equity
Balance at January 1, 2008		$	753		$	4,300		$	26,113		$	(6,102	)	$	(458	)	$	24,606
Net income		—			—			1,657			—			—			1,657
Unrealized net loss on securities available-for-sale, net of reclassi- fications and tax effects		—			—			—			—			(106		)	(106		)
Net gain relating to benefit obligation		—			—			—			—			25			25
Comprehensive income		—			—			—			—			—			1,576
Cash dividends declared ($1 per share)		—			—			(644		)	—			—			(644		)
Stock options vested		—			79			—			—			—			79
Stock options exercised		—			3			—			—			—			3
Purchased 2,526 treasury shares		—			—			—			(197		)	—			(197		)
Balance at September 30, 2008		$	753		$	4,382		$	27,126		$	(6,299	)	$	(539	)	$	25,423
Balance at January 1, 2007		$	750		$	4,103		$	25,644		$	(5,767	)	$	(1,221	)	$	23,509
Net income		—			—			1,756			—			—			1,756
Unrealized net gain on securities available-for-sale, net of reclassifications and tax effects		—			—			—			—			465			465
Comprehensive income																	2,221
Cash dividends declared ($1 per share)		—			—			(649		)	—			—			(649		)
Stock options vested		—			47			—			—			—			47
Stock options exercised		2			92			—			—			—			94
Purchased 1,708 treasury shares		—			—			—			(131		)	—			(131		)
Balance at September 30, 2007		$	752		$	4,242		$	26,751		$	(5,898	)	$	(756	)	$	25,091

 

See accompanying notes to condensed consolidated financial statements.

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine Months ended September 30, 2008 and 2007

(In thousands)

(Unaudited)

 

		2008			2007
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	1,657		$	1,756
Adjustments to reconcile net income to net cash from operating activities
Provision for loan losses		90			135
Depreciation and amortization		494			525
Premium amortization on securities, net		187			286
Derivative valuation adjustment		609			385
Loans originated for sale		(2,596		)	(1,009		)
Proceeds from the sale of loans		2,650			1,035
Gain on loan sales		(54		)	(26		)
(Gain) loss on sales of securities		(20		)	—
Vested stock options		79			47
Change in interest receivable and other assets		(78		)	397
Change in interest payable and other liabilities		(617		)	(335		)
Net cash from operating activities		2,401			3,196
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of securities available-for-sale		4,333			—
Proceeds from maturities of securities		15,783			10,598
Purchases of securities available-for-sale		(13,842		)	(221		)
Proceeds from maturities of certificates of deposit		6,064			1,650
Purchases of certificates of deposit		(16,779		)	(3,082		)
Net change in loans receivable		5,017			(113		)
Proceeds from sale of other real estate owned		200			16
Net property and equipment expenditures		(127		)	(160		)
Net cash from investing activities		649			8,688
CASH FLOWS FROM FINANCING ACTIVITIES
Change in deposits		2,597			1,880
Repayment of other borrowings		(214		)	—
Proceeds from other borrowings		6,214			—
Change in securities sold under agreements to repurchase		2,000			—
Purchase of treasury shares		(197		)	(131		)
Proceeds from exercised options		3			94
Dividends paid		(1,942		)	(1,949		)
Net cash from financing activities		8,461			(106		)
Change in cash and cash equivalents		11,511			11,778
Cash and cash equivalents at beginning of period		16,499			10,644
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	28,010		$	22,422

 

See accompanying notes to condensed consolidated financial statements.

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Table dollars in thousands)

September 30, 2008 and 2007

 

NOTE 1 – BASIS OF PRESENTATION

 

The accounting policies followed in the preparation of the interim condensed consolidated financial statements are consistent with those used in the preparation of annual consolidated financial statements.  The interim condensed consolidated financial statements reflect all normal and recurring adjustments, which are necessary, in the opinion of management, for a fair statement of results for the interim periods presented.  Results for the three months and nine months ended September 30, 2008 are not necessarily indicative of the results that may be expected for the year ended December 31, 2008.

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for the interim financial period and with the instructions to Form 10-Q.  Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s annual report on Form 10-K for 2007 filed with the U.S. Securities and Exchange Commission.  The condensed consolidated balance sheet of the Company as of December 31, 2007 has been derived from the audited consolidated balance sheet as of that date.

 

The Company’s wholly-owned subsidiary, First Ottawa Financial Corporation, sells insurance and investment products.

 

NOTE 2 – EARNINGS PER SHARE

 

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

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2008			2007			2008			2007
Net income (in thousands)		$	573		$	673		$	1,657		$	1,756
Weighted Average Shares outstanding		644,849			648,898			645,418			649,137
Effect of dilutive securities:
Stock options		1,611			979			1,636			933
Shares used to compute diluted earnings per share		646,460			649,877			647,064			650,070

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Table dollars in thousands)

September 30, 2008 and 2007

 

NOTE 2 – EARNINGS PER SHARE (Continued)

 

Earnings per share:

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2008			2007			2008			2007
Basic		$	0.89		$	1.04		$	2.57		$	2.71
Diluted		0.89			1.04			2.56			2.70

 

Anti dilutive shares:

 

Options to purchase 6,314 shares at $70.00 per share, 10,400 shares at $76.00 per share, 10,600 shares at $77.00 per share, and 12,400 shares at $78.13 per share were outstanding at September 30, 2008, but were not included in the computation of diluted earnings per share for the three months ended September 30, 2008 because the options’ exercise price was greater than the average market price of the common shares.

 

NOTE 3 – CAPITAL RATIOS

 

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

 

		September 30, 2008					December 31, 2007
		Amount			Ratio		Amount			Ratio
Total capital (to risk-weighted assets)		$	24,376		13.6	%	$	23,320		12.5	%
Tier I capital (to risk-weighted assets)		22,766			12.7	%	21,732			11.7	%
Tier I capital (to average assets)		22,766			8.3	%	21,732			8.1	%

 

At September 30, 2008, the Company and the Bank were categorized as well capitalized and management is not aware of any conditions or events since the most recent notification that would change the Company’s or Bank’s categories.

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2008 and 2007

 

NOTE 4 - DERIVATIVES

 

The Company uses derivatives to fix future cash flows for interest payments on some of its floating rate certificates of deposit.  In this regard, the Company has entered into an interest rate swap with the Federal Home Loan Bank of Chicago to fix the interest rate on a specific certificate of deposit product.  At September 30, 2008, the Company had $417,000 of certificates of deposit, which mature in 2008 through 2012, in which it pays the Federal Home Loan Bank a weighted average interest rate of 3.08% and will receive an interest rate from the Federal Home Loan Bank based on the appreciation of the S&P 500 Index.  This interest received from the Federal Home Loan Bank will be paid to the customer.  The assets and liabilities in this transaction are being netted and the expense recorded in interest expense on deposits.

 

In addition to the above, the Company also purchased $2.2 million of certificates of deposit, which are included in the certificates of deposit caption on the consolidated balance sheet.  These investments mature in 2008 through 2010.  The investments individually do not exceed $100,000 and are insured by the FDIC.  The initial investment is not at risk, but the return on the investment is based on a calculation of the appreciation in the S&P 500 Index.  The fair value of this embedded derivative is recorded in investment certificates of deposit and the fair value adjustment is included in other income.  At September 30, 2008, the Bank had allocated $337,000 to this asset and recorded valuation losses of $256,000 for the current year.

 

NOTE 5 – DISCLOSURES ABOUT FAIR VALUE OF ASSETS AND LIABILITIES

 

Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157).  FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  FAS 157 has been applied prospectively as of the beginning of the year.

 

FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  FAS 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standard describes three levels of inputs that may be used to measure fair value:

 

Level 1		Quoted prices in active markets for identical assets or liabilities
Level 2		Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in active markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities
Level 3		Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2008 and 2007

 

NOTE 5 – DISCLOSURES ABOUT FAIR VALUE OF ASSETS AND LIABILITIES (Continued)

 

Following is a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.

 

Available-for-sale Securities

 

Where quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy.  Level 1 securities include highly liquid government bonds, and exchange traded equities.  If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows.  Level 2 securities include certain collateralized mortgage and debt obligations, government agency bonds and certain municipal securities.  In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy. The Company currently holds no Level 3 securities.

 

Interest Rate Swap Agreements

 

The fair value is estimated by a third party using inputs that are observable or that can be corroborated by observable market data and, therefore, are classified within Level 2 of the valuation hierarchy

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2008 and 2007

 

NOTE 5 – DISCLOSURES ABOUT FAIR VALUE OF ASSETS AND LIABILITIES (Continued)

 

The following table presents the fair value measurements of assets and liabilities recognized in the accompanying balance sheet measured at fair value on a recurring basis and the level within the FAS 157 fair value hierarchy in which the fair value measurements fall at September 30, 2008:

 

					Fair Value Measurements Using
		Fair Value			Quoted Prices in  Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Available-for-sale securities		$	59,571		$	1,186		$	58,385		$	—
Interest rate swap agreements – investment cds		337			—			337			—
Interest rate swap agreements – customer cds		57			—			57			—

 

NOTE 6 – RECLASSIFICATIONS

 

Certain reclassifications have been made to the December 31, 2007 condensed consolidated financial statements in order to conform to the September 30, 2008 condensed consolidated financial statement presentation.  These reclassifications had no effect on net income.

 

NOTE 7- FUTURE ACCOUNTING PRONOUNCEMENTS

 

In December 2007, the FASB issued SFAS 141 (revised 2007), Business Combinations (SFAS 141R). SFAS 141R established principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. SFAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for business combinations where the acquisition date is on or after fiscal years beginning after December 15, 2008. SFAS 141R is expected to have an impact on the Company’s accounting for any business combinations closing on or after January 1, 2009.

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2008 and 2007

 

NOTE 7- FUTURE ACCOUNTING PRONOUNCEMENTS (Continued)

 

In December 2007, the FASB issued SFAS 160, Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51 (SFAS 160). SFAS 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements and requires retroactive adoption of the presentation and disclosure requirements for existing minority interests. All other requirements of SFAS 160 shall be applied prospectively. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The Company does not anticipate that SFAS 160 will have an impact on its financial results.

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

 

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

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

 

Overview

 

First Ottawa Bancshares, Inc. is the holding company for First National Bank of Ottawa. The Company is headquartered in Ottawa, Illinois and operates four offices in Ottawa, two branches in Streator, a branch in Yorkville, a branch in Morris, and a loan production office in Minooka. The Company continues to explore expansion opportunities within its existing market area and in surrounding areas.

 

The Company’s principal business is conducted by the Bank and consists of a full range of community-based financial services, including commercial and retail banking.  The profitability of the Company’s operations depends primarily on its net interest income, provision for loan losses, other income, and other expenses.  Net interest income is the difference between the income the Company receives on its loan and securities portfolios and its cost of funds, which consists of interest paid on deposits and borrowings.  The provision for loan losses reflects the cost of credit risk in the Company’s loan portfolio.  Other income consists of service charges on deposit accounts, trust and farm management fee income, securities gains (losses), gains (losses) on sales of loans, and other income.  Other expenses include salaries and employee benefits, as well as occupancy and equipment expenses and other non-interest expenses.

 

Net interest income is dependent on the amounts and yields of interest-earning assets as compared to the amounts of and rates on interest-bearing liabilities.  Net interest income is sensitive to changes in market rates of interest and the Company’s asset/liability management procedures in coping with such changes.  The provision for loan losses is dependent upon management’s assessment of the collectibility of the loan portfolio under current economic conditions.

 

The Company’s net income for the nine months ended September 30, 2008, was $1.7 million, or $2.57 per common share, compared to net income of $1.8 million, or $2.71 per common share for the nine months ended September 30, 2007. The Company’s assets at September 30, 2008 were $278.7 million contrasted to $269.2 million at December 31, 2007, an increase of $9.5 million, or 3.5%.

 

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CRITICAL ACCOUNTING POLICIES

 

The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry.  The Company’s significant accounting policies are described in detail in the notes to the Company’s consolidated financial statements for the year ended December 31, 2007. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company’s financial condition and results, and they require management to make estimates that are difficult, subjective, or complex.

 

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

 

The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan’s observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan’s effective interest rate.

 

Regardless of the extent of the Company’s analysis of customer performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors including inherent delays in obtaining information regarding a customer’s financial condition or changes in their unique business conditions, the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of

 

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assumptions utilized to establish allowances for homogenous groups of loans are among other factors. The Company estimates a range of inherent losses related to the existence of these exposures.  The estimates are based upon the Company’s evaluation of risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment.

 

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

 

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

 

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

 

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

 

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

 

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RECENT DEVELOPMENTS

 

Recent events in the U.S. and global financial markets, including the deterioration of the worldwide credit markets, have created significant challenges for financial institutions such as the Company.  Dramatic declines in the housing market during the past year, marked by falling home prices and increasing levels of mortgage foreclosures, have resulted in significant write-downs of asset values by many financial institutions, including government-sponsored entities and major commercial and investment banks.  In addition, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers, including other financial institutions, as a result of concern about the stability of the financial markets and the strength of counterparties.

 

In response to the crises affecting the U.S. banking system and financial markets and attempt to bolster the distressed economy and improve consumer confidence in the financial system, on October 3, 2008, the U.S. Congress passed, and the President signed into law, the Emergency Economic Stabilization Act of 2008 (the “Stabilization Act”).  The Stabilization Act authorizes the Secretary of the U.S. Treasury and the Federal Deposit Insurance Corporation (the “FDIC”) to implement various temporary emergency programs designed to strengthen the capital positions of financial institutions and stimulate the availability of credit within the U.S. financial system.  Pursuant to the Stabilization Act, the U.S. Treasury will have the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.

 

On October 14, 2008, the U.S. Treasury announced that it will purchase equity stakes in eligible financial institutions that wish to participate.  This program, known as the Capital Purchase Program, allocates $250 billion from the $700 billion authorized by the Stabilization Act to the U.S. Treasury for the purchase of senior preferred shares from qualifying financial institutions.  Eligible institutions will be able to sell equity interests to the U.S. Treasury in amounts equal to between 1% and 3% of the institution’s risk-weighted assets.  In conjunction with the purchase of preferred stock, the U.S. Treasury will receive warrants to purchase common stock from the participating institutions with an aggregate market price equal to 15% of the preferred investment.  Participating financial institutions will be required to adopt the U.S. Treasury’s standards for executive compensation and corporate governance for the period during which the U.S. Treasury holds equity issued under the Capital Purchase Program.  Many financial institutions have already announced that they will participate in the Capital Purchase Program.  While the Company’s management believes that the Company has sufficient capital to support its growth, the Company is considering whether or not to participate in the Capital Purchase Program.

 

Also on October 14, 2008, using the systemic risk exception to the FDIC Improvement Act of 1991, the U.S. Treasury authorized the FDIC to provide a 100% guarantee of newly-issued senior unsecured debt and deposits in non-interest bearing accounts at FDIC insured institutions.  Initially, all eligible financial institutions will automatically be covered under this program, known as the Temporary Liquidity Guarantee Program, without incurring any fees

 

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for a period of 30 days.  Coverage under the Temporary Liquidity Guarantee Program after the initial 30-day period is available to insured financial institutions at a cost of 75 basis points per annum for senior unsecured debt and 10 basis points per annum for non-interest bearing deposits.  After the initial 30-day period, institutions will continue to be covered under the Temporary Liquidity Guarantee Program unless they inform the FDIC that they have decided to opt out of the program.  The Company is assessing its participation in the Temporary Liquidity Guarantee Program and anticipates that it will participate in the insurance program covering the non-interest bearing deposits but not participate in the program to guarantee unsecured senior debt.

 

Under the Troubled Asset Auction Program, another initiative based on the authority granted by the Stabilization Act, the U.S. Treasury, through a newly-created Office of Financial Stability, will purchase certain troubled mortgage-related assets from financial institutions in a reverse-auction format.  Troubled assets eligible for purchase by the Office of Financial Stability include residential and commercial mortgages originated on or before March 14, 2008, securities or obligations that are based on such mortgages, and any other financial instrument that the Secretary of the U.S. Treasury determines, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, is necessary to promote financial market stability.  The U.S. Treasury has not issued any definitive guidance regarding this program and the Company’s management has not determined whether or not it will participate.

 

Under the Stabilization Act, the U.S. Treasury is also required to establish a program that will guarantee principal of, and interest on, troubled assets originated or issued prior to March 14, 2008, including mortgage-backed securities.  The program may take any form and may vary by asset class, but it must be voluntary and self-funding.  The U.S. Treasury has the authority to set premiums to reflect the credit risk characteristics of the insured assets.  The U.S. Treasury has solicited requests for comments on how the program should be structured but no program has been implemented to date.  The Stabilization Act also temporarily increases the amount of insurance coverage of deposit accounts held at FDIC-insured depository institutions, including the Bank, from $100,000 to $250,000.  The increased coverage is effective during the period from October 3, 2008 until December 31, 2009.

 

It is not clear at this time what impact the Stabilization Act, the Capital Purchase Program, the Temporary Liquidity Guarantee Program, the Troubled Asset Auction Program, other liquidity and funding initiatives of the Federal Reserve and other agencies that have been previously announced, and any additional programs that may be initiated in the future will have on the Company’s future financial condition and results of operations.

 

The preceding is a summary of recently enacted laws and regulations that could materially impact the Company’s results of operations or financial condition.  This discussion is qualified in its entirety by reference to such laws and regulations and should be read in conjunction with “Supervision and Regulation” discussion contained in the Company’s 2007 Form 10-K.

 

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CONSOLIDATED FINANCIAL CONDITION

 

Total assets at September 30, 2008 were $278.7 million contrasted to $269.2 million at December 31, 2007, an increase of $9.5 million, or 3.5%.  This increase was the result of an increase in cash and cash equivalents and certificates of deposits at other financial institutions. These increases were partially offset by decreases in securities available for sale, loans and interest receivable and other assets. Cash and cash equivalents increased as a result of a $11.5 million increase in cash and due from banks. This increase was funded through decreases in securities available for sale of $6.6 million and deposit growth of $2.6 million from local municipalities as a result of real estate tax collections. Certificates of deposits held for investment purposes increased $10.1 million due to favorable interest rates offered on short term deposits versus bond yields that were available over the same period of time. Loan balances outstanding decreased by $5.3 million due to decreased demand as a result of the contraction in the housing market and it’s impact on the economy, along with pay downs in the portfolio. Other assets remained relatively constant , increasing by $12,000 compared to December 31, 2007.

 

Total liabilities at September 30, 2008 were $253.3 million compared to $244.6 million at December 31, 2007, an increase of $8.7 million, or 3.5%. This increase was primarily the result of an increase in NOW and money market accounts holding public funds.  Deposits increased by $2.6 million, from $240.4 million at December 31, 2007, to $243.0 million at September 30, 2008, primarily due to increases in short term deposits of a local municipality and county funds resulting from real estate tax payments. Other borrowings increased by $6.0 million as a result of Federal Home Loan Bank advances obtained during the first quarter of 2008. Repurchase agreements increased by $2.0 million during the third quarter of 2008. Other liabilities decreased by $1.9 million due to the reduction of dividends payable at year end 2007.

 

Total equity increased to $25.4 million at September 30, 2008 compared to $24.6 million at December 31, 2007. This increase was due primarily to an increase in net income of $1.7 million for the period ended September 30, 2008. Net income was offset by dividends in the amount of $648,000, payable to shareholders in July 2008 that were declared in June 2008.

 

CONSOLIDATED RESULTS OF OPERATIONS

 

Net income for the third quarter of 2008 was $573,000, or $0.89 per share, a 14.9% decrease compared to $673,000, or $1.04 per share, in the third quarter of 2007.  The decrease in net income for the quarter was primarily the result of a decrease in non-interest income of $151,000 and a decrease in net interest income of $76,000. These decreases were partially offset by a decrease in non-interest expense of $61,000. The decrease in income before taxes also resulted in a decrease in the income tax provision of $51,000 for the third quarter compared to prior year.

 

During the nine months ended September 30, 2008, net income was $1.7 million, or $2.57 per share, compared to $1.8 million, or $2.71 per share during the first nine months of 2007.  This 5.6% decrease in net income for the nine month period was primarily due to a decrease in

 

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non-interest income of $462,000, or 25.4%. This decrease was partially offset by an increase in net-interest income of $231,000, and a decrease in non interest expense of $80,000. The decrease in the Company’s pretax income also resulted in a decrease in the tax provision of $7,000.

 

The annualized return on average assets was 0.79% for the nine months ended September 30, 2008, compared to 0.84% in 2007.   The annualized return on average equity decreased to 9.1% for the nine months ended September 30, 2008, from 9.3% in 2007.

 

NET INTEREST INCOME

 

Net interest income decreased by 3.2% to $2.3 million for the three months ended September 30, 2008 as compared to 2007.  Total interest income decreased to $3.5 million for the three months ended September 30, 2008, compared to $4.0 million for the three months ended September 30, 2007.  This change was primarily the result of a decrease in interest income from loans to $2.7 million for the three months ended September 30, 2008 from $3.1 million for the same period a year earlier. This decrease was primarily the result of the decrease in total loans as well as loans repricing downward as interest rates decreased during the first three quarters of 2008. In addition, decreases in interest income from taxable investment securities of $164,000, and interest income on federal funds sold of $143,000, compared to prior year resulted in a change of $558,000 in total interest income. Interest expense decreased to $1.1 million for the three months ended September 30, 2008 from $1.6 million for the same period ended September 30, 2007, a 29.9% decrease. Decreased interest expense was a result of lower rates paid on deposits. The $558,000 decrease in interest income offset the decrease in interest expense for the quarter resulting in a $76,000 decrease in net interest income for the quarter in 2008 compared to prior year.

 

Net interest income for the nine months ended September 30, 2008 was $6.9 million compared to $6.7 million for the same period in 2007. The increase in 2008 was primarily the result of a $1.0 million decrease in interest expense which was partially offset by a $772,000 decrease in interest income compared to prior year. The Company’s net interest margin was 3.73% for the nine months ended September 30, 2008 and 3.59% a year earlier. Loan and securities income is reflected on a fully tax equivalent basis utilizing a 34% rate for municipal securities and tax exempt loans. Net interest income on a fully taxable equivalent basis was $7.1 million for the nine months ending September 30, 2008 and $6.7 million for the same period in 2007. The tax equivalent yield on average earning assets of $254.7 million in 2008 and $250.5 million for the same period in 2007, decreased to 5.70% for the nine months ended September 30, 2008 from 6.13% for the same period ended September 30, 2007, a decrease of 43 basis points. This decrease was offset by a corresponding decrease in the cost of funds to 2.33% from 2.95% paid for the same period ended September 30, 2007, a 62 basis point decrease. These decreases were a result of ongoing repricing of assets and liabilities as they matured in the decreasing rate environment in late 2007 and during the first nine months of 2008.

 

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PROVISION FOR LOAN LOSSES

 

The provision for loan losses was $30,000 during the third quarter of 2008 compared to $45,000 during the third quarter of 2007. Year to date provision for loan loss was $90,000 in 2008 compared to $135,000 in 2007. As of September 30, 2008, the allowance for loan losses totaled $1.6 million, or 1.00% of total loans, which increased from .96% as of December 31, 2007.  Nonaccrual loans decreased from $1.2 million at December 31, 2007 to $982,000 at September 30, 2008. Nonperforming loans, including nonaccrual loans, increased $659,000 to $2.5 million over the same period. As of September 30, 2008, management believed that the Bank was well collateralized on the nonperforming loans as of that date, which significantly reduces the Company’s exposure to losses on the credits.

 

The amounts of the provision and allowance for loan losses are influenced by current economic conditions, actual loss experience, industry trends and other factors, including real estate values in the Company’s market area and management’s assessment of current collection risks within the loan portfolio. While the general economy has shown very little improvement, borrowers may continue to experience difficulty, and the level of non-performing loans, charge-offs, and delinquencies could rise and require increases in the provision. The allowance for loan losses represents management’s estimate of probable incurred losses based on information available as of the date of the financial statements.  The allowance for loan losses is based on management’s evaluation of the collectibility of the loan portfolio, including past loan loss experience, known and inherent risks in the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, and economic conditions.

 

Management has concluded that the allowance for loan losses was adequate at September  30, 2008. However, there can be no assurance that the allowance for loan losses will be adequate to cover all losses.

 

NON-INTEREST INCOME

 

The Company’s non-interest income totaled $423,000 for the three months ended September 30, 2008 compared to $574,000 for the same period in 2007, a decrease of $151,000, or 26.3%. The decrease in non-interest income was primarily due to decreases in service charges on deposit accounts of $46,000, and market value adjustments associated with the derivative portion of Certificates of Deposits held for investment purposes of $186,000. The return on these certificates are based on a calculation of the appreciation or decline in the S&P 500 Index.  The decrease in deposit service charges was a result of decreased volume of daily overdraft charges compared to the prior year.

 

For the nine months ended September 30, 2008, non-interest income decreased by 25.4% or $462,000 to $1.4 million.  Service charges on deposit accounts decreased by $119,000, or 15.6%, due to lower overdraft volume. Market value adjustments associated with the derivative portion of Certificates of Deposits held for investment purposes decreased $402,000, a 275.3% decrease compared to the same period in 2007.  These decreases were partially offset by increased gains on investment securities sold of $28,000 compared to the prior year.  Also, gains

 

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on loan sales to the secondary market increased $20,000 due to increased origination and refinancing volume while other income increased $11,000.

 

NON-INTEREST EXPENSE

 

The Company’s non-interest expense was $2.0 million for the three months ended September 30, 2008 and $2.0 million for the same period in 2007.  Non-interest expense decreased by $61,000 for the three months ended September 30, 2008, compared to 2007. Salaries and benefits, the largest component of non-interest expense, decreased $52,000, or 4.6%, to $1.1 million.  Decreases in amortization of core deposit intangible of $11,000, professional fees expense of $56,000, and salaries and benefits expense of $52,000 were offset by increases in occupancy expense of $28,000 and other expenses of $16,000. Occupancy expense increased due to higher utility and maintenance costs in the current year. Other expenses increased by $16,000 over prior year due to an increase in the Company’s hazard insurance, bank owned life insurance and also increased director fees. In addition, there were nominal increases in supplies expense and data processing expenses.

 

For the nine months ended September 30, 2008, non-interest expense decreased $80,000 to $6.0 million, or -1.3%, compared to the year earlier period.  Salaries and benefits decreased $187,000, or -5.4%, to $3.3 million.  Decreases in amortization of the core deposit intangible of $31,000, and professional fees of $63,000 were partially offset by increased other expense of $101,000, data processing expense of $57,000, and occupancy expense of $43,000. Other expense increased due to insurance expenses, director fees expense, and an increase in losses associated with the sale of other real estate.

 

LIQUIDITY AND CAPITAL RESOURCES

 

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

 

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

 

The Company’s most liquid assets are cash and short-term investments.  The levels of these assets are dependent on the Company’s operating, financing, lending, and investing activities

 

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during any given year.  At September 30, 2008, cash and short-term investments totaled $28.0 million.  The Company has other sources of liquidity if a need for additional funds arises,including securities maturing within one year and the repayment of loans.  The Company may also utilize the sale of securities available-for-sale, federal funds lines of credit from correspondent banks, and borrowings from the Federal Home Loan Bank of Chicago and M&I Marshall & Ilsley Bank.

 

The following table discloses contractual obligations and commercial commitments of the Company as of September 30, 2008:

 

					Less Than 1 Year									After 5 Years
		Total						1 – 3 Years			4 – 5 Years
Lines of credit(1)		$	17,489		$	11,276		$	3,722		$	717		$	1,774
Federal Home Loan Bank advances		6,000			2,000			4,000			—			—
Data processing contract payable		1,113			223			445			445			—
Standby letters of credit(1)		327			327			—			—			—
		$	24,929		$	13,826		$	8,167		$	1,162		$	1,774

 

(1)  Represents amounts committed to customers.

 

IMPACT OF INFLATION AND CHANGING PRICES

 

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

 

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SAFE HARBOR STATEMENT

 

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

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

ITEM 3:      QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Company is a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and is not required to provide the information under this item.

 

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FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARIES

CONTROLS AND PROCEDURES

 

ITEM 4:  CONTROLS AND PROCEDURES

 

As required by Rules 13a-15(b) and 15d-15(b) under the Securities Exchange Act of 1934, management has evaluated, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, the Chief Executive Officer and the Chief Financial Officer concluded the Company’s disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) were effective as of September 30, 2008 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and were effective as of September 30, 2008.  These disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

 

There have been no changes in the Company’s internal controls or disclosure controls or in other factors that have materially affected, or are reasonably likely to materially affect internal controls over financial reporting or disclosure controls.

 

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PART II

ITEM 1.		LEGAL PROCEEDINGS
		There are no material pending legal proceedings to which the Company or its subsidiaries are a party other than ordinary routine litigation incidental to their respective businesses.
ITEM 1.A.		RISK FACTORS
		The Company is a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and is not required to provide the information under this item.
ITEM 2.		UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
		None
ITEM 3.		DEFAULTS UPON SENIOR SECURITIES
		None
ITEM 4.		SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
		None
ITEM 5.		OTHER INFORMATION
		None
ITEM 6.		EXHIBITS
		Exhibits
		31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)
		31.2	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)
		32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
		32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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