UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

_____________________________________

FORM 10-K

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

For the fiscal year ended December 31, ~~2011~~2012

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

For the transition period from ______ to ______

_____________________________________

Commission File Number 000 - 19300

NORTHERN STATES FINANCIAL CORPORATION

(Exact name of Registrant as specified in its charter)

Delaware (State of incorporation) 36-3449727 (I.R.S. Employer Identification No.)

Delaware		36-3449727
(State of incorporation)		(I.R.S. Employer Identification No.)

1601 North Lewis Avenue

Waukegan, Illinois 60085

(847) 244-6000

(Address, including zip code, and telephone number, including area code, of principal executive office)

Securities registered pursuant to Section 12(b) of the Act

Common Stock $.40 par value		None
(Title of each class)		(Name of each exchange on which registered)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Exchange Act.

YES £o NO Tx

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act. YES £o NO Tx

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 Tx NO £o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ~~YesT~~ Yesx No £o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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

Large accelerated filer £o Accelerated filer £o Nonaccelerated filer £o Smaller reporting company Tx (Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES £o NO Tx

The aggregate market value of the voting and non-voting common equity held by nonaffiliates of the Registrant is $3,213,222, as of June 30, ~~2011~~2012, based on the last sale price of the Registrant’s common stock on June 30, ~~2011~~2012 of $10.1482 per share. Solely for the purpose of this computation, it has been assumed that executive officers and directors of the Registrant are “affiliates”.

As of February 23, ~~2012~~2013, 4,~~277~~270,755 shares of the Registrant’s common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

A portion of Part III is incorporated by reference from the Registrant’s Proxy Statement for its ~~2012~~2013 Annual Meeting of Stockholders to be held on May 1723, ~~2012~~2013.

TABLE OF CONTENTS

PART I		1	3
~~Item 1.~~	~~Business~~Item 1.	1Business	3
~~Item 1A.~~	~~Risk~~Item ~~Factors~~1A.	13Risk Factors	17
~~Item 1B.~~	~~Unresolved~~Item ~~Staff Comments~~1B.	17Unresolved Staff Comments	22
~~Item 2.~~	~~Properties~~Item 2.	17Properties	22
~~Item 3.~~	~~Legal~~Item ~~Proceedings~~3.	17Legal Proceedings	22
~~Item 4.~~	~~Mine~~Item ~~Safety Disclosures~~4.	18Mine Safety Disclosures	22
PART II		18	23
~~Item 5.~~	~~Market~~Item ~~for the Company’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities~~5.	18Market for the Company’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	23
~~Item 6.~~	~~Selected~~Item ~~Financial Data~~6.	20Selected Financial Data	24
~~Item 7.~~	~~Management’s~~Item ~~Discussion and Analysis of Financial Condition and Results of Operations~~7.	21Management’s Discussion and Analysis of Financial Condition and Results of Operations	25
~~Item 7A.~~	~~Quantitative~~Item ~~and Qualitative Disclosures About Market Risk~~7A.	49Quantitative and Qualitative Disclosures About Market Risk	51
~~Item 8.~~	~~Financial~~Item ~~Statements and Supplementary Data~~8.	52Financial Statements and Supplementary Data	53
~~Item 9.~~	~~Changes~~Item ~~in and Disagreements with Accountants on Accounting and Financial Disclosure~~9.	93Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	95
~~Item 9A.~~	~~Controls~~Item ~~and Procedures~~9A.	93Controls and Procedures	95
~~Item 9B.~~	~~Other~~Item ~~Information~~9B.	95Other Information	97
PART III		95	97
~~Item 10.~~	~~Directors,~~Item ~~Executive Officers and Corporate Governance~~10.	95Directors, Executive Officers and Corporate Governance	97
~~Item 11.~~	~~Executive~~Item ~~Compensation~~11.	96Executive Compensation	97
~~Item 12.~~	~~Security~~Item ~~Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters~~12.	96Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	98
~~Item 13.~~	~~Certain~~Item ~~Relationships and Related Transactions and Director Independence~~13.	96Certain Relationships and Related Transactions and Director Independence	98
~~Item 14.~~	~~Principal~~Item ~~Accountant Fees and Services~~14.	96Principal Accountant Fees and Services	98
PART IV		97	99
~~Item 15.~~	~~Exhibits~~Item ~~and Financial Statement Schedules~~15.	97Exhibits and Financial Statement Schedules	99
~~SIGNATURES~~	SIGNATURES	99	101

~~TABLE~~Table OFof ~~CONTENTS~~Contents

PART I

Item 1.

Business

Cautionary Note About Forward-Looking Statements. Statements contained in this report that are not historical facts may constitute forward-looking statements (within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended), which involve significant risks and uncertainties. Northern States Financial Corporation (the “Company”) cautions readers of this report that a number of important factors could cause the Company'’s actual results subsequent to December 31, ~~2011~~2012 to differ materially from those expressed in forward-looking statements contained in this report. The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of invoking these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by the use of the words "“believe,"” "“expect,"” "“intend,"” "“anticipate,"” "“estimate,"” "“project,"” "“plan,"” or similar expressions. The Company'’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain and actual results may differ from those predicted. The Company undertakes no obligation to update these forward-looking statements in the future unless required to do so under the federal securities laws. Factors that could cause actual results to differ from those predicted and could affect the future prospects of the Company and its subsidiaries include, but are not limited to: the potential for further deterioration in the credit quality of the Company'’s loan and lease portfolios, which may require further increases in its allowance for loan losses; further deterioration in the value of the Company’s other real estate owned; general economic conditions and the economic health of the local real estate market; uncertainty regarding the Company'’s ability to ultimately recover on ~~loan~~loans ~~pools~~ currently on nonaccrual status; the Company’s ability to comply with the provisions of any regulatory enforcement actions, including the Consent Order and the Written Agreement; deterioration of securities investments causing them to be other than temporarily impaired; unanticipated changes in interest rates; legislative/regulatory changes, including the implementation of the Dodd-Frank Act and any changes to regulatory requirements; monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board; the quality or composition of the Company'’s investment portfolios; demand for loan products; deposit flows; competition; demand for financial services in the Company'’s market area; the soundness of other financial institutions; ~~the recent downgrade of the credit rating of the U.S. government by Standard and Poor’s;~~ adverse effects on our operational systems resulting from failures, human error or security breach; and changes in accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating any forward-looking statements.

THE COMPANY

Overview

The Company is a bank holding company organized in 1984 under the laws of the state of Delaware, for the purpose of becoming the parent bank holding company of the Bank of Waukegan. In 1991, the Company acquired First Federal Bank, fsb (“First Federal” or the “Thrift”). In 1998 the Thrift was merged with and into the Bank of Waukegan. On January 5, 2004, Northern States Financial Corporation acquired First State Bank of Round Lake (“First State Bank”). On November 10, 2005, First State Bank was merged with and into the Bank of Waukegan and the name of the merged entity was changed to NorStates Bank (the “Bank”). During 2008, the Company formed the subsidiary NorProperties, Inc. for the purpose of managing and disposing of the Company’s nonperforming assets.

The Company is registered under the Bank Holding Company Act of 1956, as amended, and owns all the outstanding stock of the Bank. At December 31, ~~2011~~2012, the Company had ~~298~~281 registered stockholders of record, 4,~~277~~270,755 shares of Common Stock outstanding, and total consolidated assets of approximately $~~463~~413 million. Aside from the stock of the Bank, stock of NorProperties, Inc. and cash, the Company has no other substantial assets.

As a community-oriented, independent banking organization in Lake County in the State of Illinois, the Company ~~believes~~serves ~~it is well positioned to take advantage of the growth in the~~ communities in Lake County, Illinois and surrounding counties. The Company (or its predecessors) has continuously served the community since 1919 when First Federal was chartered. The Company’s local management, coupled with its long record of service, has allowed it to compete successfully in the banking market. The Bank operates as a traditional community-oriented bank with conveniently located branches and a professional staff.

Neither the Company nor the Bank has material patents, licenses or franchises except the Bank’s charter, which permits it to engage in banking ~~and offer trust~~ services pursuant to applicable law.

~~TABLE~~Table OFof ~~CONTENTS~~Contents

The principal business of the Company, operating through the Bank, consists of traditional retail and commercial banking activities, including attracting deposits and securities sold under repurchase agreements from the general public, making commercial loans, loans secured by residential and commercial real estate, ~~consumer loans,~~ and ~~operating~~consumer ~~mortgage banking and trust businesses~~loans.

The Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports are currently made available free of charge via the Company’s internet website (www.nsfc.net) as soon as practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (the “Commission”).

Subsidiary Operations

NorStates Bank and its predecessor was chartered as a state bank in 1962 and is located in Waukegan, Illinois. Waukegan is located approximately 37 miles north of Chicago, Illinois and has a population of approximately 90,000. At December 31, ~~2011~~2012, NorStates Bank had total assets of approximately $~~463~~413 million, loans and leases of approximately $~~323~~273 million, deposits of approximately $~~398~~359 million and stockholder’s equity of approximately $4130 million. The Bank has a total of eight offices with three branch offices located in Waukegan, one office located in Antioch, Illinois, one office located in Gurnee, Illinois, one office located in Winthrop Harbor, Illinois, one office in Round Lake Beach, Illinois and one office in Round Lake, Illinois.

The Bank provides traditional community banking services to individuals, businesses and local governmental units in northeastern Illinois and southeastern Wisconsin.

The Bank’s full service banking business includes the customary consumer and commercial products and services which banks provide, including the following: demand, savings, and time deposits, securities sold under repurchase agreements and individual retirement accounts; commercial, consumer and real estate lending, including installment loans, home equity loans, lines of credit and overdraft checking; safe deposit operations; ~~trust services;~~ and a variety of additional services tailored to the needs of individual customers, such as the sale of ~~traveler’s checks,~~ money orders, cashier’s checks and foreign currency, direct deposit, and other special services.

Commercial and consumer loans are made to corporations, partnerships and individuals, primarily on a secured basis. Commercial lending focuses on businesses, construction, inventory and real estate. The Bank also makes loans to consumers and ~~commercial customers and~~ originates and services commercial and residential mortgages.

~~The~~Effective September 28, 2012, the Bank’s ~~Trust~~sold ~~Department~~and ~~acts~~transferred asits ~~executor,~~designated ~~administrator,~~trust ~~trustee,~~accounts ~~conservator,~~to ~~guardian~~Thomasville National Bank of Thomasville, ~~custodian~~Georgia. ~~and~~The ~~agent~~Bank ~~and~~recognized ~~also offers~~no ~~investment~~gain ~~services.~~or Atloss ~~December~~on ~~31,~~this ~~2011~~sale, ~~the~~but ~~Trust~~receives ~~Department~~a ~~had~~portion ~~assets~~of ~~under~~revenues ~~management~~from orthe ~~custodial~~trust ~~arrangements~~assets ofand ~~approximately~~any ~~$119~~future ~~million.~~local ~~Its~~trust ~~office~~business that is ~~located~~generated. atThomasville ~~the~~National Bank’s ~~branch~~operates ~~office~~the attrust ~~3233~~business ~~Grand~~through ~~Avenue,~~its ~~Waukegan,~~subsidiary ~~Illinois~~NorStates Wealth Management Company.

During 2002, the Bank formed Northern States Community Development Corporation (“NSCDC”), a wholly-owned subsidiary of the Bank. NSCDC’s assets consist of cash and of other real estate owned. This subsidiary was formed for the purpose of developing and selling a parcel of other real estate owned as part of the City of Waukegan’s lakefront development plans. At December 31, ~~2011~~2012, assets of NSCDC totaled $1.96 million, which includes cash of $2229,000, and the property with a carrying value of $1,~~901~~605,000, and are consolidated into NorStates Bank’s financial statements.

During 2008, the Company formed NorProperties, Inc. (“NorProp”), a wholly-owned subsidiary of the Company. This subsidiary was formed for the purpose of managing and disposing of nonperforming assets of the Company. At December 31, ~~2011~~2012, assets of NorProp totaled $2542,000, which consisted of cash. These assets are consolidated into the Company’s financial statements.

COMPANY OPERATING STRATEGY

Corporate policy, strategy and goals are established by the Board of Directors of the Company. Pursuant to the Company’s philosophy and applicable laws and regulations, the Company also establishes operational and administrative policies for the Bank. Within this framework, the Bank focuses on providing personalized services and quality products to customers to meet the needs of the communities in which it operates, protect capital and liquidity, and work through problem credits.

Table of Contents

As part of its community banking approach, the Company encourages the officers of the Bank to actively participate in community organizations. In addition, within credit and rate of return parameters, the Company attempts to ensure that the Bank meets the credit needs of the community and invests in local municipal securities.

TABLE OF CONTENTS

Lending Activities

General - The Bank provides a wide range of commercial and retail lending services to corporations, partnerships and individuals, including, but not limited to, commercial business loans, commercial and residential real estate construction and mortgage loans, consumer loans, revolving lines of credit and letters of credit. The mortgage banking area originates residential mortgage loans primarily on behalf of other financial institutions that fund and own the loans.

The Bank markets its services to qualified borrowers in both the commercial and consumer sectors. The Bank’s commercial lending officers solicit the business of new companies entering the surrounding market as well as long-standing members of the business community. Through personalized, professional service and competitive pricing, the Bank has historically been successful in attracting new commercial lending customers.

Commercial Loans - The Bank seeks new commercial loans in its market area. The Bank’s lending areas of emphasis include, but are not limited to, loans to manufacturers, building contractors, developers, business services companies and retailers. The Bank provides a wide range of commercial business loans, including lines of credit for working capital purposes and term loans for the acquisition of real estate, equipment and other purposes. Collateral for these loans generally includes accounts receivable, inventory, equipment and real estate. Terms of commercial business loans generally range from one to five years. The primary repayment risk for commercial loans is the failure of the business due to economic or financial factors. In most cases, the Bank collateralizes these loans and/or takes personal guarantees to help ensure repayment.

Mortgage Banking - From 1991 until 1998, the Bank funded conforming long-term residential mortgage loans and sold them in the secondary market with servicing retained. Since 1998, the Bank’s mortgage banking operation originates most residential mortgage loans for a fee on behalf of other financial institutions that fund and own the loans. The Bank does not retain servicing on these originated mortgage loans. The Bank had a portfolio of serviced sold mortgages of approximately $~~902~~675,000 at December 31, ~~2011~~2012.

Consumer Lending - The Bank’s consumer lending department provides all types of consumer loans, primarily home improvement, home equity and auto loans.

Deposit Activities

The Bank offers a wide range of deposit products to individuals, businesses and governmental entities. These include demand, savings, money market, time deposits, securities sold under repurchase agreements and individual retirement accounts.

Trust Activities

~~The~~Effective ~~Bank’s~~September ~~trust~~28, ~~and~~2012, ~~investment~~the ~~services~~Bank ~~department~~sold ~~has~~and ~~been~~transferred ~~providing~~its designated trust ~~services~~accounts to ~~the~~Thomasville ~~community~~National ~~for~~Bank ~~over~~of 25Thomasville, ~~years~~Georgia. AsThe ofBank ~~December~~recognized ~~31,~~no ~~2011,~~gain ~~the~~or ~~Bank~~loss ~~had~~on ~~approximately~~this ~~$119~~sale ~~million~~but receives a portion of revenues from the trust assets ~~under~~and ~~management~~any ~~and~~future ~~provides~~local atrust ~~full~~business ~~complement~~that ofis generated. Thomasville National Bank operates the trust ~~services~~business ~~for~~at ~~individuals~~the Bank’s branch office building at 3233 Grand Avenue, Waukegan, Illinois through its subsidiary NorStates Wealth Management Company. Pursuant to the agreement between the Thomasville National Bank and ~~corporations~~the Bank, Thomasville National Bank has the right to use the “NorStates” name in connection with these trust operations.

The trust department’s focus is in two major areas: (i) investment management for individuals and (ii) administration and investment services for employee benefit plans.

COMPETITION

The ~~Company and the Bank encounter significant competition in all of their activities. The~~ Chicago metropolitan area and suburban Lake County have a high density of financial institutions, many of which are significantly larger and have substantially greater financial resources than the Company and the Bank. ~~Continuing reduction in the effective restrictions on interstate operations of financial institutions has also increased competition.~~ In Lake County, Illinois there are 43 commercial banks and savings institutions with ~~244~~241 offices. The Company and the Bank are subject to intense competition from various financial institutions, including state and national banks, state and federal savings associations, credit unions, certain non-banking consumer lenders, and other companies or firms, including brokerage firms and mortgage brokers that provide similar services in northeastern Illinois. The Bank also competes with Internet-based financial institutions, money market funds and insurance companies.

The primary factors influencing competition for deposits are interest rates, service, and convenience of office locations. The Company competes for loans principally through the range and quality of the services it provides, interest rate and loan fee terms. The Company believes that its long-standing presence in the community and personal service philosophy enhances its ability to compete favorably in attracting and retaining individual and business customers. The Company actively solicits deposit-related clients and competes for deposits by offering customers personal attention, professional service and competitive interest rates.5

3Table of Contents

~~TABLE~~The OFprimary ~~CONTENTS~~factors influencing competition for deposits are interest rates, service and convenience of office locations. The Company competes for loans principally through the range and quality of the services it provides, interest rates and loan terms. The Company believes that its long-standing presence in the community and personal service philosophy enhances its ability to compete favorably in attracting and retaining individual and business customers. The Company actively solicits deposit-related clients and competes for deposits by offering customers personal attention, professional service and competitive interest rates.

EMPLOYEES

The Company and its subsidiaries employed ~~125~~114 full-time equivalent employees as of December 31, ~~2011~~2012. None of the Company’s employees are represented by any collective bargaining group. The Company offers a variety of employee benefits and management considers its employee relations to be good.

GOVERNMENTAL MONETARY POLICY AND ECONOMIC CONDITIONS

The earnings and growth of the Company are affected not only by general economic conditions, but also by the fiscal and monetary policies of the federal government and its agencies. In particular, the Federal Reserve Board regulates monetary policy and interest rates in order to influence general economic conditions, primarily through open-market operations in U.S. government securities, varying the discount rate on bank borrowings, and setting reserve requirements against bank deposits.

These policies have a significant influence on overall growth and distribution of the Company’s loans, investments and deposits, and affect interest rates charged on loans and earned on investments or paid for deposits. The monetary policies of the Federal Reserve Board are expected to continue to substantially affect the operating results of the Bank. The general effect of such policies upon the future business, financial condition and earnings of the Company and the Bank cannot accurately be predicted.

SUPERVISION AND REGULATION

General

Financial institutions and their holding companies are extensively regulated under federal and state laws. As a result, the business, financial condition and prospects of the Company and the Bank can be materially affected not only by management decisions and general economic conditions, but also by applicable statutes and regulations and other regulatory pronouncements and policies promulgated by regulatory agencies with jurisdiction over the Company and the Bank, such as the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”), the Federal Deposit Insurance Corporation (“FDIC”) and the Illinois Department of Financial and Professional Regulation (“IDFPR”). Such statutes, regulations and other pronouncements and policies are primarily intended to protect depositors and the FDIC’s Deposit Insurance Fund (“DIF”), rather than stockholders of banks and bank holding companies. As a company with securities registered under Section 12 of the Securities Exchange Act of 1934 (the “1934 Act”), the Company is also subject to the regulations of the Securities and Exchange Commission (the “SEC”) and the periodic reporting, proxy solicitation and other requirements under the 1934 Act.

The following description of applicable statutes and regulations is not intended to be a complete explanation of such statutes and regulations and their effect on the Company and the Bank and is qualified in its entirety by reference to the actual statutes and regulations. These statutes and regulations may change in the future, and we cannot predict what effect these changes, if made, will have on our operations.

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Recent Developments

Dodd-Frank Act

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act has resulted and will continue to result in dramatic changes across the financial regulatory system, some of which became effective immediately and some of which will not become effective until various future dates. Implementation of the Dodd-Frank Act requires many new rules to be issued by various federal regulatory agencies over the next several years. There will be a significant amount of uncertainty regarding the overall impact of this new law on the financial services industry until final rulemaking is complete. The ultimate impact of this law could have a material adverse impact either on the financial services industry as a whole or on, the Company’s or the Bank’s business, results of operations and financial condition. The Dodd-Frank Act includes provisions addressing capital requirements, deposit insurance assessments, corporate governance and permissible bank activities. In particular, the Dodd-Frank Act includes provisions that, among other things:

4● Direct the federal bank regulatory agencies to review and propose new capital requirements applicable to banking institutions (as discussed in more detail below, such new capital standards have been proposed, but have not been finalized by the regulatory agencies).

~~TABLE~~● OFCentralize ~~CONTENTS~~responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau (the “Bureau”), responsible for implementing, examining, and enforcing compliance with federal consumer financial laws.

·● ~~Direct~~Create the ~~federal~~Financial ~~bank~~Stability ~~regulatory~~Oversight ~~agencies~~Council tothat ~~review~~will ~~and~~recommend ~~propose~~to ~~new~~the ~~capital~~Federal ~~requirements~~Reserve ~~applicable~~Board toincreasingly ~~banking~~strict ~~institutions~~rules ~~(such~~for ~~new~~ capital, ~~standards~~leverage, ~~applicable~~liquidity, torisk ~~the~~management ~~Bank~~and ~~have~~other ~~not~~requirements ~~yet~~as ~~been~~companies ~~established~~grow byin ~~the~~size ~~regulatory~~and ~~agencies)~~complexity.

·● ~~Centralized~~Impose ~~responsibility~~a ~~for~~duty ~~consumer~~on ~~financial~~mortgage ~~protection~~loan byoriginators ~~creating~~to determine a ~~new~~customer’s ~~agency,~~ability to repay the ~~Consumer~~mortgage ~~Financial~~as ~~Protection~~of ~~Bureau~~the (time the ~~“Bureau”)~~loan is extended, ~~responsible~~made ~~for~~more ~~implementing,~~loans ~~examining~~subject to restrictions applicable to higher cost loans and new disclosures, and ~~enforcing~~prohibited ~~compliance~~creditors ~~with~~from ~~federal~~compensating ~~consumer~~mortgage ~~financial~~originators ~~laws~~based upon any loan term other than the size of the loan, thereby prohibiting compensation based on yield spread premiums.

·● ~~Created~~Require ~~the~~financial ~~Financial~~institutions ~~Stability~~to ~~Oversight~~make ~~Council~~a reasonable and good faith determination that ~~will~~borrowers ~~recommend~~have the ability to ~~the~~repay ~~Federal~~loans ~~Reserve~~for ~~Board~~which ~~increasingly~~they ~~strict~~apply. ~~rules~~If ~~for~~a ~~capital,~~financial ~~leverage,~~institution ~~liquidity,~~fails ~~risk~~to ~~management~~make ~~and~~such ~~other~~a ~~requirements~~determination, asa ~~companies~~borrower ~~grow~~can inassert ~~size~~this ~~and~~failure ~~complexity~~as a defense to foreclosure.

·● ~~Included~~Require ~~mortgage~~financial ~~reform~~institutions ~~provisions~~to ~~regarding~~retain a ~~customer’s~~specified ~~ability~~percentage to(5% ~~repay,~~or ~~restricting~~more) ~~variable-rate~~of ~~lending~~certain ~~by requiring that the ability to repay variable~~non-~~rate~~traditional mortgage loans beand ~~determined~~other byassets ~~using~~in the ~~maximum~~event ~~rate~~ that ~~will~~they ~~apply~~seek ~~during the first five years of a variable-rate loan term and making more loans subject~~ to ~~restrictions~~securitize ~~applicable~~such ~~to higher cost loans and new disclosures~~assets. ~~In addition, certain compensation for mortgage brokers based on certain loan terms has been prohibited (e.g. compensation based on yield spread premiums).~~

·● ~~Require~~Change ~~financial~~the ~~institutions~~assessment base for federal deposit insurance from the amount of insured deposits to ~~make~~consolidated aassets ~~reasonable~~less ~~and~~tangible ~~good~~capital, ~~faith~~eliminated ~~determination~~the ~~that~~ceiling ~~borrowers~~on ~~have~~the size of the ~~ability~~DIF, toand ~~repay~~increased ~~loans~~the ~~for~~floor ~~which~~on ~~they~~the ~~apply.~~size Ifof athe ~~financial~~DIF, ~~institution~~which ~~fails~~generally towill ~~make~~require ~~such~~an aincrease ~~determination,~~in athe ~~borrower~~level ~~can~~of ~~assert~~assessments ~~this~~for ~~failure~~institutions aswith aassets ~~defense~~of to$10 ~~foreclosure~~billion or more.

·● ~~Require~~Make ~~financial~~permanent ~~institutions~~the to$250,000 ~~retain~~limit afor ~~specified~~federal ~~percentage~~deposit ~~(5%~~insurance orand ~~more)~~provided ofunlimited ~~certain~~federal ~~non-traditional~~deposit ~~mortgage~~insurance ~~loans~~through ~~and~~December ~~other~~31, ~~assets~~2012 infor ~~the~~noninterest-bearing ~~event~~demand ~~that~~transaction ~~they~~accounts ~~seek~~at toall ~~securitize~~insured ~~such~~depository ~~assets~~institutions.

·● ~~Changed~~Implement ~~the~~corporate ~~assessment~~governance ~~base~~revisions, ~~for~~including ~~federal~~with ~~deposit~~regard ~~insurance from the amount of insured deposits~~ to ~~consolidated~~executive ~~assets less tangible capital~~compensation, ~~eliminate~~say ~~the ceiling~~ on ~~the~~pay ~~size of the DIF~~votes, ~~and~~proxy ~~increase~~access ~~the~~by ~~floor~~shareholders onand ~~the~~clawback ~~size~~policies ~~of the DIF,~~ which ~~generally~~apply ~~will~~to ~~require~~all anpublic ~~increase~~companies, innot ~~the~~just ~~level~~financial ~~of assessments for~~ institutions ~~with assets of $10 billion or more~~.

·● ~~Made~~Repeal ~~permanent~~ the ~~$250,000 limit for~~ federal ~~deposit~~prohibitions ~~insurance~~on ~~and~~the ~~provided~~payment ~~unlimited~~of ~~federal~~interest ~~deposit~~on ~~insurance~~demand ~~through~~deposits, ~~December~~thereby ~~31,~~permitting ~~2012~~depository ~~for~~institutions ~~noninterest-bearing~~to ~~demand~~pay ~~transaction~~interest ~~accounts~~on atbusiness ~~all~~transactions ~~insured~~and ~~depository~~other ~~institutions~~accounts.

·● ~~Implemented~~Amend ~~corporate~~the ~~governance~~Electronic ~~revisions~~Fund Transfer Act to, ~~including~~among ~~with~~other ~~regard~~things, give the Federal Reserve Board the authority to ~~executive~~establish ~~compensation,~~rules ~~say~~regarding oninterchange ~~pay~~fees ~~votes,~~charged ~~proxy~~for ~~access~~electronic debit transactions by ~~shareholders~~payment ~~and~~card ~~clawback~~issuers ~~policies~~having ~~which~~assets ~~apply~~over to$10 ~~all~~billion. ~~public~~The ~~companies~~Federal Reserve Board promulgated rules essentially capping such debit card fees at approximately $0.24 per average debit transaction, ~~not~~representing ~~just~~a ~~financial~~significant decrease from the average debit fee previously charged and received by such institutions.

·● ~~Repealed~~Eliminate the Office of Thrift Supervision (“OTS”) and made the OCC, which is currently the primary federal ~~prohibitions~~regulator onfor national banks, the ~~payment~~primary offederal ~~interest~~regulator onfor ~~demand~~federal ~~deposits~~thrifts. In addition, ~~thereby~~the ~~permitting~~Federal ~~depository~~Reserve ~~institutions~~Board tonow ~~pay~~supervises ~~interest~~and onregulates ~~business~~all ~~transactions~~savings and ~~other~~loan ~~accounts~~holding companies in place of the OTS and the FDIC has assumed the supervisory powers that the OTS previously exercised over state savings associations.

·● ~~Amended~~Limit the ~~Electronic~~hedging ~~Fund~~activities ~~Transfer~~and ~~Act~~private ~~(“EFTA”)~~equity ~~to,~~investments ~~among~~that ~~other~~may ~~things,~~be ~~give~~made ~~the Federal Reserve Board the authority to establish rules regarding interchange fees charged for electronic debit transactions~~ by ~~payment~~various ~~card~~financial issuers having assets over $10 billion. The Federal Reserve Board recently promulgated rules essentially capping such debit card fees at approximately $0.24 per average debit transaction, representing a significant decrease from the average debit fee previously charged and received by such institutions.

· Eliminated the OTS and made the OCC, which is currently the primary federal regulator for national banks, the primary federal regulator for federal thrifts. In addition, the Federal Reserve Board now supervises and regulates all savings and loan holding companies in place of the OTS and the FDIC has assumed the supervisory powers that the OTS previously exercised over state savings associations.7

·Table ~~Limit~~of ~~the~~Contents ~~hedging activities and private equity investments that may be made by various financial institutions.~~

As noted above, the Dodd-Frank Act requires that the federal regulatory agencies draft many new regulations which have implemented or will implement the foregoing provisions as well as other provisions contained in the Dodd-Frank Act, the ultimate impact of which will not be known for some time.

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Bank Holding Company Regulation

The Company is a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”), and subject to supervision and regulation by the Federal Reserve Board. The Bank is an Illinois state-chartered bank subject to supervision and regulation by the IDFPR and the FDIC. Under ~~the BHC Act and the~~ Federal Reserve Board’s regulations, a bank holding company, as well as its banking subsidiaries, is prohibited from engaging in certain tie-in arrangements in connection with an extension of credit or a lease or sale of property, furnishings or services. Accordingly, a bank may not condition a customer’s purchase of one service on the purchase of another service offered by the bank or its holding company or other affiliates, except with respect to traditional banking products. The BHC Act also requires prior Federal Reserve Board approval for, among other things, a bank holding company’s acquisition of direct or indirect control of more than 5% of the voting shares of any bank, substantially all of the assets of any bank or for a merger or consolidation of a bank holding company with another bank holding company.

With limited exceptions, the BHC Act prohibits a bank holding company from acquiring direct or indirect ownership or control of voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or performing services for its authorized subsidiaries. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities that the Federal Reserve Board has determined, by regulation or order, to be so closely related to banking or managing or controlling banks as to be a proper incident thereto, such as owning and operating a savings association, performing functions or activities that may be performed by a trust company, owning a mortgage company, or acting as an investment or financial advisor. The Federal Reserve Board, as a matter of policy, generally requires a bank holding company and its subsidiary bank to be well capitalized and well managed at the time of filing an acquisition application and upon consummation of a proposed acquisition.

The Gramm Leach Bliley Act ~~(the “GLB Act”)~~ permits qualifying holding companies, called “financial holding companies,” to engage in, or to affiliate with companies engaged in, a ~~full~~wider range of financial activities including banking, certain insurance activities (including insurance underwriting and portfolio investing), securities activities and merchant banking activities. A bank holding company’s subsidiary banks must be “well capitalized” and “well managed” and have at least a “satisfactory” Community Reinvestment Act (the “CRA”) rating for the bank holding company to elect, and maintain, status as a financial holding company. The Company is not currently a financial holding company.

Under the Illinois Banking Act ~~(the “IBA”)~~, any acquisition of the Company’s stock that results in a change in control ~~may~~requires ~~require~~ the prior approval of the IDFPR. Under the Change in Bank Control Act, a person may be required to obtain the prior regulatory approval of the Federal Reserve Board before acquiring the power to directly or indirectly control the management, operations or policies of the Company or before acquiring control of 10% or more of any class of our outstanding voting stock.

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Act”) permits a bank holding company that is adequately capitalized and well managed to acquire, with certain limitations and approval, a bank located in a state other than the bank holding company’s home state. The Interstate Act, as amended by the Dodd-Frank Act, also ~~now~~ permits a bank, with the approval of the appropriate Federal and state bank regulatory agencies, to establish a de novo branch in a state other than the bank’s home state if the law of the state in which the branch is to be located would permit establishment of the branch, if the out of state bank were a state bank chartered by such state. In addition, banks having different home states may, under certain circumstances, with approval of the appropriate Federal and state bank regulatory agencies, merge across state lines.

The Illinois Bank Holding Company Act permits Illinois bank holding companies to acquire control of banks in any state and permits bank holding companies whose principal place of business is in another state to acquire control of Illinois banks or bank holding companies, upon satisfactory application to the IDFPR. In reviewing any such application, the IDFPR will review, among other things, compliance by the applicant with the requirements of the CRA and other information designed to determine such banks’ abilities to meet community credit needs.

It is the policy of the Federal Reserve Board that the Company is expected to act as a source of financial and managerial strength to the Bank and to commit resources to support the Bank. The Federal Reserve Board takes the position that in implementing this policy, it may require the Company to provide such support when the Company otherwise would not consider itself able to do so.8

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Pursuant to the Dodd-Frank Act, it is the policy of the Federal Reserve Board that the Company is expected to act as a source of financial and managerial strength to the Bank and to commit resources to support the Bank. The Federal Reserve Board takes the position that in implementing this policy, it may require the Company to provide such support when the Company otherwise would not consider itself able to do so.

As discussed below in more detail, federal and state statutes place certain restrictions and limitations on transactions between banks and their affiliates, which include holding companies. Among other provisions, these laws place restrictions upon:

·● extensions of credit by a bank to its affiliates;

6● the purchase by a bank of assets from its affiliates;

~~TABLE~~● OFthe ~~CONTENTS~~issuance of guarantees, acceptances or letters of credit by a bank on behalf of its affiliates; and

·● ~~the~~investments ~~purchase~~ by a bank in stock or other securities issued by affiliates or acceptance thereof as collateral for an extension of ~~assets~~credit ~~from~~to its affiliates;.

·Under the ~~issuance~~Financial Institutions Reform, Recovery and Enforcement Act of ~~guarantees~~1989, ~~acceptances~~an insured depository institution which is commonly controlled with another insured depository institution shall generally be liable for any loss incurred, or ~~letters~~reasonably anticipated to be incurred, by the FDIC in connection with the default of ~~credit~~such commonly controlled institution, or for any assistance provided by the FDIC to such commonly controlled institution, which is in danger of default. The term “default” is defined to mean the appointment of a ~~bank~~conservator onor ~~behalf~~receiver for such institution. The FDIC maintains discretion to issue a notice of ~~its~~assessment ~~affiliates;~~to ~~and~~the liable institution for the estimated amount of the loss incurred or reasonably anticipated to be incurred by the FDIC.

· investments by a bank in stock or other securities issued by affiliates or acceptance thereof as collateral for an extension of credit to its affiliates.

Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), an insured depository institution which is commonly controlled with another insured depository institution shall generally be liable for any loss incurred, or reasonably anticipated to be incurred, by the FDIC in connection with the default of such commonly controlled institution, or for any assistance provided by the FDIC to such commonly controlled institution, which is in danger of default. The term “default” is defined to mean the appointment of a conservator or receiver for such institution. The FDIC maintains discretion to issue a notice of assessment to the liable institution for the estimated amount of the loss incurred or reasonably anticipated to be incurred by the FDIC.

The Federal Reserve Board issued updated guidance in 2009 regarding a bank holding company’s ability to pay dividends and engage in stock repurchases. Specifically, the updated guidance provides that, as a general matter, a bank holding company should consult with its applicable Federal Reserve Bank and eliminate, defer, or severely limit the payment of dividends if (i) the bank holding company’s net income over the prior four quarters is not sufficient to fully fund the dividends; (ii) the bank holding company’s prospective rate of earnings retention is not consistent with the bank holding company’s capital needs and overall current and prospective financial condition; and (iii) the bank holding company will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. Moreover, a bank holding company should inform the applicable Federal Reserve Bank reasonably in advance of declaring or paying a dividend that exceeds earnings for the relevant period for which the dividend is being paid or that could result in a material adverse change to the organization’s capital structure. Similarly, a bank holding company should apprise the applicable Federal Reserve Bank reasonably in advance of declaring any material increase in its common stock dividend to ensure that it does not raise safety and soundness concerns. The Federal Reserve Board may find that the bank holding company is operating in an unsafe and unsound manner if the bank holding company does not comply with the Federal Reserve Board’s dividend policy and may use its enforcement powers to limit or prohibit the payment of dividends by bank holding companies.

In addition, the Company participated in the U.S. Department of the Treasury’s (“Treasury”) Capital Purchase Program (“CPP”) under its Troubled Asset Relief Program (“TARP”), as described more fully below, which subjects the Company to additional restrictions on dividends. Specifically, as long as any Fixed Rate Cumulative Perpetual Preferred Stock, Series A (“Series A Preferred Stock”) is owned by the Treasury, no dividends may be declared or paid on the Company’s common stock unless dividends on the preferred stock have been paid in full (the Company has not paid dividends on its Series A Preferred Stock since November 2009). Also, Treasury’s consent is required for any increase in the per share dividends on the Company’s common stock above $0.40 per share until the third anniversary of the date of Treasury’s investment, and Treasury’s approval will be required for an increase of more than 3% in dividends ~~after the third anniversary and~~ until the tenth anniversary of the issuance of the Series A Preferred Stock (unless prior to such dates, the preferred stock is redeemed in whole or the Treasury has transferred all of its shares to third parties). After the tenth anniversary, the Company will not be allowed to pay dividends if the Treasury still owns the Series A Preferred Stock.

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The Company’s participation in the TARP CPP also requires it to obtain the prior approval of the Treasury prior to repurchasing shares of its common stock or other capital stock which ranks junior to the Series A Preferred Stock, except that the Company is permitted to redeem or repurchase equity or trust preferred securities under certain circumstances, including to offset dilution related to employee benefit plans in a manner consistent with past practice or pursuant to certain agreements pre-dating participation in the TARP CPP. The requirement to obtain Treasury approval will be in effect until such time as the Company has repurchased all of the shares of Series A Preferred Stock previously issued to the Treasury. After the tenth anniversary of the issuance of Series A Preferred Stock to the Treasury, the Company will not be allowed to repurchase equity or trust preferred securities if the Treasury still owns the preferred stock.

Delaware law also places certain limitations on the ability of the Company to pay dividends. For example, if the capital of the holding company has been diminished to an amount less than the aggregate amount of capital represented by the issued and outstanding stock, a dividend shall not be paid until the deficiency in capital is repaired.

~~The~~Prior ~~Company~~to inthe fourth quarter of 2008, the ~~past~~Company ~~has~~had paid semi-annual cash dividends in June and December to its common stockholders. Following a review of the Company by the Federal Reserve Bank of Chicago (the “Federal Reserve Bank”), the Board of Directors of the Company adopted a Board Resolution dated November 17, 2009 (the “Board Resolution”) whereby the Company agreed to obtain the written approval of the Federal Reserve Bank prior to: (1) paying dividends to its common or preferred stockholders; (2) increasing holding company debt or subordinated debentures issued in conjunction with trust preferred securities obligations; and (3) paying interest on its existing subordinated debentures.

7In November 2009, the Company suspended its dividend payments on the Series A Preferred Stock. At December 31, 2012, the accumulated dividends payable to the Treasury totaled $3.1 million which includes compounding on unpaid dividends at 5.00 percent. The suspension of dividend payments is permissible under the terms of the TARP CPP, but the dividend is a cumulative dividend and failure to pay dividends for six dividend periods gives the holder of the Series A Preferred Stock, currently the Treasury, the contractual right to appoint two (2) directors to the Company’s Board of Directors. At December 31, 2012, the Company had suspended thirteen dividend payments. In December 2012, the Treasury exercised its director appointment rights and appointed one director to the Board of Directors and has the contractual right to appoint one more director. Previously, in January 2011, the Company agreed to allow a Treasury representative to attend its Board of Directors meetings as an observer.

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In November 2009, the Company notified the Treasury of its intent to suspend its dividend payments on the Series A Preferred Stock. The suspension of the dividend has continued through December 31, 2011. At December 31, 2011, the accumulated dividends payable to the Treasury totaled $2.2 million which includes compounding on unpaid dividends at 5.00 percent. The suspension of dividend payments is permissible under the terms of the TARP CPP, but the dividend is a cumulative dividend and failure to pay dividends for six dividend periods gives the holder of the Series A Preferred Stock, currently the Treasury, the contractual right to appoint two (2) directors to the Company’s Board of Directors. At December 31, 2011, the Company had suspended nine dividend payments; however, the Treasury has not yet exercised its director appointment rights. In January 2011, the Company agreed to allow a Treasury representative to attend its Board of Directors meetings as an observer. It is anticipated that this Treasury representative will continue to attend the Company’s board meetings as an observer in 2012.

On March 17, 2011, the Company and the Federal Reserve Bank entered into a Written Agreement. The Written Agreement supersedes the resolution signed by the Board of Directors at the request of the Federal Reserve Bank dated November 17, 2009. The Written Agreement maintains the requirements that the Company obtain the written approval of the Federal Reserve Bank prior to: (1) paying dividends to its common or preferred stockholders; (2) increasing holding company debt or subordinated debentures issued in conjunction with trust preferred securities obligations; and (3) paying interest on its existing subordinated debentures.

On account of the November 2009 Board Resolution, the Company ~~notified~~began ~~the~~deferring ~~trustee~~its ~~that~~regularly ~~holds~~scheduled ~~the~~quarterly ~~Company’s~~interest payments on its junior subordinated debentures relating to its trust preferred securities. ~~that~~The ~~the~~ Company ~~would~~has be$10.3 ~~deferring~~million, ~~its~~at ~~regularly~~an ~~scheduled~~interest ~~quarterly~~rate ~~interest~~of ~~payments~~2.108%, in trust preferred securities at December 31, 2012. The Company has the right to defer the payment of interest on the junior subordinated debentures at any time, for a period not to exceed 20 consecutive quarters without being in default. At year-end 2012, the Company has deferred payment of interest for thirteen consecutive quarters totaling approximately $1.0 million. Thus, unless the Company resumes payment of interest on the trust preferred securities and pays all interest thereon that has been deferred, the Company will default on the trust preferred securities on December 15, 2014. During the deferral period, the Company may not pay any dividends on its common or preferred stock. Accordingly, the Company ~~does~~cannot ~~not~~pay ~~anticipate paying~~ dividends on its common stock ~~for~~until dividends on the ~~foreseeable~~Series ~~future~~A Preferred Stock and interest payments on the trust preferred securities become current.

In addition, pursuant to the terms of the Consent Order entered into by the Bank, the FDIC and the IDFPR discussed below, the Bank cannot pay dividends to the Company without the written approval of the FDIC and the IDFPR. Distributions from the Bank serve as the sole source of dividends that may be paid by the Company.

~~Under~~The Federal Reserve Board has adopted requirements for assessing the capital ~~guidelines,~~adequacy of bank holding companies. Bank holding companies with consolidated assets of more than $500 million are required to ~~maintain~~comply awith ~~minimum~~the ~~Total~~Federal ~~Risk~~Reserve Board’s capital guidelines on risk-~~Based~~based ~~Capital~~capital. ~~Ratio~~Bank ofholding ~~8%,~~companies ofthat ~~which~~are atbelow ~~least~~this 4%threshold ~~must~~and beotherwise inqualify ~~the~~as ~~form~~“small ofbank ~~Tier~~holding 1companies” ~~Capital.~~under ~~The~~applicable ~~minimum~~regulations ~~Leverage~~need ~~Ratio~~not iscomply 3%with ~~for~~the ~~strong~~Federal ~~bank~~Reserve ~~holding~~Board’s ~~companies~~risk-based ~~(those~~capital ~~rated~~guidelines on a ~~composite~~consolidated ~~“1”~~basis ~~under~~but are expected to comply with the Federal Reserve Board’s ~~rating~~Small ~~system)~~Bank ~~and~~Holding 4%Company ~~for~~Policy ~~all~~Statement. ~~other~~Because the Company’s consolidated assets at December 31, 2012 were approximately $413 million, it qualifies as a small bank holding ~~companies.~~company ~~The~~and, as a result, is not required to comply with the Federal Reserve Board’s ~~guidelines~~risk-based ~~provide~~capital ~~that~~requirements. ~~banking~~Instead, ~~organizations~~the ~~experiencing~~Company ~~internal~~must ~~growth~~comply orwith ~~completing~~the ~~acquisitions~~Federal ~~will~~Reserve beBoard’s ~~expected~~Small Bank Holding Company Policy Statement, which requires the Company to maintain ~~strong~~a ~~capital~~certain ~~positions~~debt ~~substantially~~to ~~above~~equity ratio, to maintain its subsidiary bank at the ~~minimum~~well ~~supervisory~~capitalized ~~levels.~~level Asand ofto ~~December~~refrain 31from dividends unless these other criteria are satisfied. The bank regulators, ~~2011~~including the Federal Reserve Board, have proposed new guidelines that would revise and replace the ~~Company~~current ~~had~~bank aholding ~~Total~~company ~~Risk-Based~~capital ~~Capital~~rules ~~Ratio~~consistent ofwith ~~13.10%,~~agreements ofreached ~~which~~by 11the Basel Committee on Banking Supervision (“Basel III”).~~64%~~ ~~was~~However, inuntil the ~~form~~Basel ofIII ~~Tier~~capital 1rules ~~Capital~~are finalized, ~~and~~the aeffect ~~Leverage~~on ~~Ratio~~the ofCompany 7cannot be predicted.~~53%.~~

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Bank Regulation

As noted above, as an Illinois chartered, non-member bank, the Bank is regulated by the FDIC and the IDFPR. These agencies have general supervisory and regulatory authority over the Bank.

Capital Requirements

The FDIC, in conjunction with the other federal bank regulators, has adopted risk-based capital guidelines for state chartered, non-member banks. Under current FDIC regulations, a bank is adequately capitalized if its minimum ratio of qualifying total capital to risk-weighted assets, including certain off-balance sheet items (the “Total Risk-Based Capital Ratio”), is 8%, the minimum ratio of that portion of total capital that is composed of items such as common stock, related additional paid-in capital, retained earnings, certain types of perpetual preferred stock and certain minority interests, less certain intangibles and other assets, including goodwill (“Tier 1 Capital”), to risk-weighted assets (the “Tier 1 Risk-Based Capital Ratio”) is 4% and Tier 1 ~~capital~~Capital divided by adjusted average assets (“Leverage Ratio”) is 4%. Tier 1 Capital must comprise at least 50% of the total capital base of a bank; however, the federal regulatory agencies have stated that in general they expect Tier 1 ~~capital~~Capital to be well in excess of the 50% threshold. The balance of total capital may consist of items such as other preferred stock, certain other instruments, and limited amounts of subordinated debt and the institution’s loan and lease loss allowance. The bank regulators, including the FDIC, have proposed new guidelines that would revise and replace the current bank capital rules consistent with agreements reached by the Basel Committee on Banking Supervision. However, until the Basel III capital rules are finalized, the effect on the Bank cannot be predicted. As of December 31, ~~2011~~2012, the Bank had a Total Risk-Based Capital Ratio of 1312.8611%, a Tier 1 Risk-Based Capital Ratio of 1210.5577% and a Leverage Ratio of 6.67% which was below the Leverage Ratio requirement of the 2013 Consent Order (as discussed below) of 8.2000%.

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Prompt Corrective Action

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) requires federal bank regulatory authorities to take “prompt corrective action” with respect to depository institutions that do not meet minimum capital requirements. FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions may be subject to a variety of actions including limitations on growth and investment activities and are required to submit a capital restoration plan, which must be guaranteed by the institution’s parent company. Institutions that fail to submit an acceptable plan, or significantly undercapitalized institutions, may be subject to a host of more severe regulatory restrictions and measures.

The capital-based prompt corrective action provisions of FDICIA and their implementing regulations apply to FDIC-insured depository institutions. However, federal banking agencies have indicated that, in regulating bank holding companies, the agencies may take appropriate action at the holding company level based on their assessment of the effectiveness of supervisory actions imposed on subsidiary insured depository institutions pursuant to the prompt corrective action provisions of FDICIA.

Federal and state statutes and regulations provide financial institution regulatory agencies with great flexibility to undertake enforcement action against financial institutions, holding companies, or persons regarded as “institution affiliated parties” that fail to comply with regulatory requirements, violate certain laws or regulations or for various other reasons. Institution affiliated parties include controlling shareholders, directors, officers, employees, agents of financial institutions and independent contractors, such as lawyers and accountants, who participate in the conduct of the financial institution’s affairs. Possible enforcement actions include the imposition of a capital plan and capital directive, civil money penalties, consent orders, cease-and-desist orders, conservatorship, receivership or deposit insurance termination.

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Following a joint examination of the Bank by the FDIC and the IDFPR, the Board of Directors of the Bank approved and executed on September 21, 2009, a Memorandum of Understanding (“MOU”) concerning the Bank’s commitment to enhance certain areas of the Bank’s operation, including the implementation of a profit plan and budget with goals and strategies for improving earnings, the creation of a written plan to monitor, improve and lessen risks from the Bank’s substandard assets, the implementation of steps to correct loan administration weaknesses, and the maintenance of an 8% Leverage Ratio.

On April 16, 2010, the Bank ~~then~~ entered into a Consent Order with the FDIC and the IDFPR (the “2010 Consent Order”), which superseded the MOU, pursuant to which the Bank agreed, among other things, to: (1) maintain a Leverage Ratio of at least 8% and a Total Risk-Based Capital Ratio of at least 12%, (2) prohibit the extension of additional credit to any existing borrower with an outstanding classified loan or a loan that has been previously charged-off unless the Board of Directors or a committee thereof determines the loan to be in the best interests of the Bank, (3) adopt written action plans to reduce the Bank’s level of classified assets and delinquent loans and to reduce concentrations of credit identified by the examiners, (4) prohibit dividend payments and (5) adopt a profit plan, a capital contingency plan and a liquidity plan. Because the 2010 Consent Order establishes specific capital amounts to be maintained by the Bank, the Bank will not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the levels of capital set forth in the 2010 Consent Order.

~~Following~~On aJanuary ~~compliance~~14, ~~examination of the Bank performed by the FDIC~~2013, the ~~Board of Directors of the~~ Bank ~~approved~~entered ~~and~~into ~~signed~~ a ~~separate~~new ~~MOU~~Consent onOrder ~~October~~with ~~20, 2010 concerning~~ the ~~Bank’s~~FDIC ~~compliance program~~ and ~~deficiencies identified during~~ the ~~examination~~IDFPR of (the ~~Bank. As~~“2013 aConsent ~~part~~Order”), ofwhich ~~this~~replaced ~~MOU,~~ the ~~Board~~2010 ~~committed~~Consent toOrder. ~~enhance~~The ~~its~~2013 ~~compliance~~Consent ~~management~~Order ~~system,~~requires ~~internal compliance audit program and increase compliance training of~~ the Bank’s, ~~staff.~~among Onother ~~December 29~~things, ~~2011,~~to ~~the~~undertake ~~FDIC terminated~~ the ~~MOU~~ ~~because the Bank improved its compliance management system.~~following:

~~The~~● ~~Bank~~continued ~~continues~~oversight ~~to dedicate significant resources to effectively identify, monitor,~~ and ~~manage~~supervision ~~problem~~by ~~assets~~the ~~and~~Board ~~reduce real estate loan concentrations. In view~~ of ~~these~~Directors ~~matters, the Bank’s ability to improve its financial condition is dependent upon the success~~ of ~~management’s plans to address concerns raised by~~ the ~~bank regulators regarding profitability and asset quality. Management believes they are taking appropriate steps aimed at returning the~~ Bank ~~to profitability~~ and ~~improving asset quality. Management’s success will ultimately be determined by the implementation of~~ its ~~plans~~management, asincluding ~~well~~monitoring ascompliance ~~factors~~with ~~beyond its control, such as~~ the ~~economy~~2013 ~~and~~Consent ~~the local real estate market.~~Order;

●	maintain a Tier 1 Capital to average assets ratio (Leverage Ratio) of at least 8% and a total risk-based capital ratio of at least 12%;

●	provide an updated written capital plan detailing the steps the Bank will take to comply with the minimum capital requirements;

●

charge-off any loans classified as “loss” and prohibit the extension of additional credit to any existing borrower with a loan that has been previously charged-off or classified as “loss”; prohibit the extension of additional credit in excess of $10,000 to any existing borrower with an outstanding loan classified as “substandard,” unless determined by the Board of Directors to be in the best interests of the Bank;

●

continue to maintain, implement and adhere to written plans to reduce the Bank’s risk position for each classified asset and delinquent loan in excess of $1,000,000, and to manage concentrations of credit, including the ongoing measurement, monitoring and the setting of concentration limits commensurate with the Bank’s capital levels and overall risk profile;

●	not declare or pay any dividend without the prior consent of the FDIC and IDFPR;

●	continue to implement its written profit plan and develop a budget that includes the reduction of discretionary expenses and improvement in the Bank’s overall earnings; and

●	not increase its assets by more than 5% during any three-month period without preapproval, and no more than 15% annually.

The Bank continues to dedicate significant resources to effectively identify, monitor and manage problem assets and reduce real estate loan concentrations. In view of these matters, the Bank’s ability to improve its financial condition is dependent upon the success of management’s plans to address concerns raised by the bank regulators regarding profitability and asset quality. Management believes it is taking appropriate steps aimed at returning the Bank to profitability and improving asset quality. Management’s success will ultimately be determined by the implementation of its plans, as well as factors beyond its control, such as the economy and the local real estate market.

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Deposit Insurance; Assessments

~~Under~~The Bank’s deposits are insured up to the ~~Dodd-Frank~~applicable ~~Act~~limits under the DIF. As such, each account owner’s ~~interest bearing~~ deposits are insured up to $250,000 by the FDIC. The DIF is the successor to the Bank Insurance Fund and ~~noninterest~~the ~~bearing~~Savings ~~transaction~~Association Insurance Fund. The FDIC maintains the DIF by assessing depository institutions an insurance premium. Pursuant to the Dodd-Frank Act, the FDIC was required to set a minimum DIF reserve ratio of 1.35% of estimated insured deposits ~~have~~to ~~unlimited~~be ~~coverage~~achieved ~~through~~by ~~December~~September 3130, ~~2012~~2020. The Dodd-Frank Act also eliminated the 1.50% ceiling on the reserve ratio and provides that the FDIC is no longer required to refund amounts in the DIF that exceed 1.50% of insured deposits. Pursuant to the Dodd-Frank Act, the FDIC issued a rule setting a designated reserve ratio at 2.0% of insured deposits. Also, as required by the Dodd-Frank Act, the FDIC calculates an institution’s assessment level based on its total average consolidated assets during the assessment period less average tangible equity (i.e., Tier 1 Capital) as opposed to an institution’s deposit level which was the previous basis for calculating insurance assessments.

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In addition, the FDIC previously adopted the Temporary Liquidity Guarantee Program which included the Debt Guarantee Program (“DGP”), under which the FDIC guarantees certain senior unsecured debt issued by FDIC-insured institutions and their holding companies. Under the DGP, upon a default by an issuer of FDIC-guaranteed debt, the FDIC will continue to make scheduled principal and interest payments on the debt. The unsecured debt must have been issued on or after October 14, 2008 and not later than October 31, 2009, and the guarantee is effective through the earlier of the maturity date (or mandatory conversion date) or December 31, 2012, although the debt may have a maturity date beyond December 31, 2012. The Bank did not issue any guaranteed debt under the DGP.

The Bank’s deposits are insured up to the applicable limits under the DIF. The DIF is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund. The FDIC maintains the DIF by assessing depository institutions an insurance premium. Pursuant to the Dodd-Frank Act, the FDIC was required to set a minimum DIF reserve ratio of 1.35% of estimated insured deposits to be achieved by September 30, 2020. The Dodd-Frank Act also eliminated the 1.50% ceiling on the reserve ratio and provides that the FDIC is no longer required to refund amounts in the DIF that exceed 1.50% of insured deposits. Pursuant to the Dodd-Frank Act, the FDIC recently issued a rule setting a designated reserve ratio at 2.0% of insured deposits. Also, as required by the Dodd-Frank Act, the FDIC will now calculate an institution’s assessment level based on its total average consolidated assets during the assessment period less average tangible equity (i.e., Tier 1 capital) as opposed to an institution’s deposit level which was the previous basis for calculating insurance assessments.

Under the FDIC’s risk-based assessment system, insured institutions are required to pay deposit insurance premiums based on the risk that each institution poses to the DIF. Consistent with previous regulatory guidance, under the Dodd-Frank Act, an institution’s risk to the DIF is measured by its regulatory capital levels, supervisory evaluations and certain other factors. To determine an institution’s assessment rate, the FDIC places each insured depository institution into a risk category. An institution’s assessment rate depends upon the risk category to which it is assigned. The assessment rate is then applied to the institution’s total average consolidated assets during the assessment period less average tangible equity to determine the amount of the assessment.

The FDIC assessment rates range from approximately 2.5 basis points to 3545 basis points (depending on applicable adjustments for unsecured debt and brokered deposits) until such time as the FDIC’s reserve ratio equals 1.15%. Once the FDIC’s reserve ratio reaches 1.15% and the reserve ratio for the immediately prior assessment period is less than 2.0%, the applicable assessment rates may range from 31.5 basis points to 3040 basis points (subject to applicable adjustments for unsecured debt and brokered deposits). If the prior assessment period is equal to or greater than 2.0% and less than 2.5%, the assessment rates may range from 21 basis ~~points~~point to 2838 basis points and if the prior assessment period is greater than 2.5%, the assessment rates may range from 10.5 basis ~~point~~points to 2535 basis points. During 2012, the Bank’s assessment rate was 23 basis points applied to the total of average consolidated assets less average tangible equity.

Deposit insurance may be terminated by the FDIC upon a finding that an institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. Such terminations can only occur, if contested, following judicial review through the federal courts. The Company does not know of any practice, condition or violation that might lead to termination of deposit insurance for the Bank.

In addition to its insurance assessment, each insured financial institution is subject to quarterly debt service assessments (“FICO assessments”) in connection with bonds issued by a government corporation that financed the federal savings and loan bailout of the 1980s. During ~~2011~~2012, the Bank’s FICO assessment totaled $3827,000. These assessments will continue until the FICO bonds are repaid between 2017 and 2019.

Safety and Soundness

The Federal Deposit Insurance Act (“FDIA”), as amended by FDICIA and the Interstate Act require the FDIC, together with the other federal bank regulatory agencies, to prescribe standards of safety and soundness, by regulations or guidelines, relating generally to operations and management, asset growth, asset quality, earnings, stock valuation and compensation. The FDIC and the other federal bank regulatory agencies have adopted a set of guidelines prescribing safety and soundness standards pursuant to FDIA, as amended. The guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. The guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder. In addition, the FDIC has adopted regulations that authorize, but do not require, the FDIC to order an institution that has been given notice by the FDIC that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the FDIC must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized association is subject under the “prompt corrective action” provisions of FDICIA. If an institution fails to comply with such an order, the FDIC may seek to enforce such order in judicial proceedings and to impose civil money penalties. The FDIC and the other federal bank regulatory agencies also have adopted guidelines for asset quality and earnings standards.

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Reserve Requirement

As an insured depository institution, the Bank is subject to Federal Reserve Board regulations requiring depository institutions to maintain reserves against a specified percentage of transaction accounts (primarily NOW and regular checking accounts). Reserves are maintained in the form of vault cash or deposits with the Federal Reserve Bank. The first $1112.54 million of transaction accounts (subject to adjustments by the Federal Reserve Board) are exempted from the reserve requirements. The Federal Reserve Board regulations generally require 3% reserves on the next $5967.51 million of transaction accounts. For transaction accounts totaling over $7179.5 million, Federal Reserve Board regulations require reserves of $12,~~785~~013,000 plus 10% of the amount in excess of $7179.5 million. The Bank is in compliance with the foregoing requirements.

Transactions with Affiliates

Transactions between a state chartered bank and its “affiliates” are subject to quantitative and qualitative restrictions under Sections 23A and 23B of the Federal Reserve Act and the implementing regulations contained in Regulation W. Affiliates of a bank include, among other entities, the bank’s holding company and companies that are under common control with the bank. In general, these restrictions limit the amount of the transactions between a bank and its affiliates, as well as the aggregate amount of transactions between a bank and all of its affiliates, impose collateral requirements in some cases and require transactions with affiliates to be on the same terms comparable to those with unaffiliated entities.

The Dodd-Frank Act also included specific changes to the law related to the definition of “covered transaction” in Sections 23A and 23B and limitations on asset purchases from insiders. With respect to the definition of “covered transaction,” the Dodd-Frank Act now defines that term to include the acceptance of debt obligations issued by an affiliate as collateral for an institution’s loan or extension of credit to another person or company. In addition, a “derivative transaction” with an affiliate is now deemed to be a “covered transaction” to the extent that such a transaction causes an institution or its subsidiary to have a credit exposure to the affiliate. A separate provision of the Dodd-Frank Act states that an insured depository institution may not “purchase an asset from, or sell an asset to” a bank insider (or their related interests) unless (1) the transaction is conducted on market terms between the parties, and (2) if the proposed transaction represents more than 10 percent of the capital stock and surplus of the insured institution, it has been approved in advance by a majority of the institution’s non-interested directors.

Bank Secrecy Act and PATRIOT Act

Under the Bank Secrecy Act (“BSA”), a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report cash transactions involving more than $10,000 to the ~~United States~~ Treasury. In addition, financial institutions are required to file suspicious activity reports for transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect involve illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose.

The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “PATRIOT Act”), which amended the BSA, contains anti-money laundering and financial transparency laws, enhanced information collection tools and enforcement mechanisms for the U.S. government. The PATRIOT Act provisions include the following: standards for verifying customer identity when opening accounts; rules to promote cooperation among financial institutions, regulators and law enforcement; and due diligence requirements for financial institutions that administer, maintain or manage certain bank accounts. The Bank is subject to BSA and PATRIOT Act requirements.

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Community Reinvestment Act

Under the ~~Community Reinvestment Act (“~~CRA”), a financial institution has a continuing and affirmative obligation, consistent with the safe and sound operation of such institution, to serve the “convenience and needs” of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited tofor its particular community. The CRA requires each federal banking agency, in connection with its examination of a financial institution, to assess and assign one of four ratings to the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by the institution, including applications for charters, branches and other deposit facilities, relocations, mergers, consolidations and acquisitions of assets or assumptions of liabilities. The CRA also requires that all institutions make public disclosure of their CRA ratings. The Bank received a “satisfactory” rating on its most recent CRA examination in ~~June~~October ~~2010~~2012.

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In addition to the above, the Bank is subject to many state and federal statutes and regulations that are designed to protect consumers, including the Equal Credit Opportunity Act (Regulation B), the Fair Housing Act, the Truth in Lending Act (Regulation Z), the Truth in Savings Act (Regulation DD), the Real Estate Settlement Procedures Act, the Home Mortgage Disclosure Act (Regulation C) and the Fair and Accurate Credit Transactions Act. Among other things, these statutes and regulations:

·● require lenders to disclose credit terms in meaningful and consistent ways;

·● prohibit discrimination against an applicant in any consumer or business credit transaction;

·● prohibit discrimination in housing-related lending activities;

·● require certain lenders to collect and report applicant and borrower data regarding loans for home purchases or improvement projects;

·● require lenders to provide borrowers with information regarding the nature and cost of real estate settlements;

·● prohibit certain lending practices and limit escrow account amounts with respect to real estate transactions;

·● require financial institutions to implement identity theft prevention programs and measures to protect the confidentiality of consumer financial information; and

·● prescribe possible penalties for violations of the requirements of consumer protection statutes and regulations.

As noted above, the ~~new~~ Bureau ~~will~~ now ~~have~~has authority for amending existing federal consumer compliance regulations and implementing new such regulations. In addition, the Bureau ~~will~~has ~~have~~ the power to examine the compliance of financial institutions with assets in excess of $10 billion with these consumer protection rules. The Bank’s compliance with consumer protection rules will be examined by the FDIC since the Bank does not meet this $10 billion asset level threshold.

Emergency Economic Stabilization Act of 2008; American Recovery and Reinvestment Act of 2009

The Emergency Economic Stabilization Act of 2008 (“EESA”) was signed into law on October 3, 2008. ESSA gave the Treasury broad authority to address the then-current deterioration of the U.S. economy, to implement certain actions to help restore confidence, stability and liquidity to U.S. financial markets, and to encourage financial institutions to increase their lending to clients and to each other. The EESA authorized the Treasury to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies as part of the TARP. The Treasury allocated $250 billion to the voluntary CPP under the TARP. The TARP also included direct purchases or guarantees of troubled assets of certain financial institutions by the U.S. government.

Under the CPP, the Treasury was authorized to purchase preferred stock securities from participating financial institutions in an amount not less than 1% of the institution’s risk-weighted assets and not more than 3% of the institution’s risk-weighted assets or $25 billion, whichever was less. Preferred stock issued pursuant to the CPP qualifies as Tier 1 capital. Preferred stock issuers under the CPP pay a 5% dividend per annum until the fifth year of the investment and 9% per annum thereafter. In addition to the senior preferred stock, participating public financial institutions were required to issue a warrant to Treasury for the purchase of common stock in an amount equal to 15% of the applicable preferred stock investment. Treasury will not exercise any voting rights with respect to the common shares acquired through the exercise of the warrant. Financial institutions participating in the CPP were required to agree to and comply with certain restrictions, including restrictions on dividends and stock redemptions (as discussed above), and executive compensation. Finally, Treasury may unilaterally amend any provision of the CPP to comply with changes in applicable federal statutes.

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~~TABLE~~Under OFthe ~~CONTENTS~~CPP, the Treasury was authorized to purchase preferred stock securities from participating financial institutions in an amount not less than 1% of the institution’s risk-weighted assets and not more than 3% of the institution’s risk-weighted assets or $25 billion, whichever was less. Preferred stock issued pursuant to the CPP qualifies as Tier 1 capital. Preferred stock issuers under the CPP pay a 5% dividend per annum until the fifth year of the investment and 9% per annum thereafter. In addition to the senior preferred stock, participating public financial institutions were required to issue a warrant to Treasury for the purchase of common stock in an amount equal to 15% of the applicable preferred stock investment. Treasury will not exercise any voting rights with respect to the common shares acquired through the exercise of the warrant. Financial institutions participating in the CPP were required to agree to and comply with certain restrictions, including restrictions on dividends and stock redemptions (as discussed above) and executive compensation. Finally, Treasury may unilaterally amend any provision of the CPP to comply with changes in applicable federal statutes.

Pursuant to the terms of the CPP, as modified by the American Recovery and Reinvestment Act of 2009 (“ARRA”), a financial institution may redeem the senior preferred stock if the institution receives approval from its primary federal regulator and the institution gives the preferred stock holder proper notice.

Financial institutions participating in the CPP were also required to modify certain senior executive compensation agreements consistent with EESA to generally prohibit incentive compensation agreements that encourage senior executive officers to take unnecessary and excessive risks. These executive compensation restrictions were then modified by the ARRA and an interim final rule regarding TARP standards for Compensation and Corporate Governance, issued by Treasury and effective on June 15, 2009 (“Interim Final Rule”). Among the executive compensation and corporate governance provisions included in ARRA and the Interim Final Rule, which are applicable to the Company as a result of its participation in the TARP CPP, are the following:

·● an incentive compensation “clawback” provision to cover “senior executive officers” (defined in this instance and below to mean the “named executive officers” for whom compensation disclosure is provided in the company’s proxy statement) and the next 20 most highly compensated employees;

·● a prohibition on certain golden parachute payments to cover any payment related to a departure for any reason (with limited exceptions) made to any senior executive officer and the next five most highly compensated employees;

·● a limitation on incentive compensation paid or accrued to the most highly compensated employee of the financial institution, subject to limited exceptions for pre-existing arrangements set forth in written employment contracts executed on or prior to February 11, 2009, and certain awards of restricted stock, which may not exceed one-third of the individual’s annual compensation, are subject to a two year holding period and cannot be transferred until Treasury’s preferred stock is redeemed (the amount of such stock which may be transferred is based on the amount of TARP CPP preferred stock that is redeemed);

·● a requirement that the Company’s chief executive officer and chief financial officer provide in annual securities filings a written certification of compliance with the executive compensation and corporate governance provisions of the Interim Final Rule;

·● an obligation for the compensation committee of the board of directors to evaluate with the company’s chief risk officer certain compensation plans to ensure that such plans do not encourage unnecessary or excessive risks or the manipulation of reported earnings;

·● a requirement that companies adopt a company-wide policy regarding excessive or luxury expenditures; and

·● a requirement that companies permit a separate, non-binding shareholder vote to approve the compensation of executives.

On February 20, 2009, the Company closed the transaction with Treasury in order to participate in the CPP. The Company issued Series A preferred stock to Treasury equal to $17,211,000 and a warrant to purchase 584,084 shares of common stock at an exercise price of $4.42 per share. As noted above, the Company is subject to the forgoing provisions of the EESA and ARRA.

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Monetary Policy

The earnings of banks and bank holding companies are affected not only by general economic conditions, but also by the policies of various governmental regulatory authorities. In particular, the Federal Reserve Board influences conditions in the money and capital markets, which affect interest rates and growth in bank credit and deposits. Federal Reserve Board monetary policies have had a significant effect on the operating results of banks in the past and this is expected to continue in the future. The general effect, if any, of such policies on future business and earnings of the Company and the Bank cannot be predicted.

Item 1A.

Risk Factors.

Our business, financial condition and results of operations are subject to various risks, including those discussed below, which may affect the value of our common stock. Set forth below are certain risk factors that we believe to be relevant to an understanding of our business. This list should not be considered a comprehensive list of all potential risks and uncertainties. You should also refer to the other information included or incorporated by reference in this Form 10-K, including our consolidated financial statements and related notes for the year ended December 31, ~~2011~~2012.

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If our allowance for loan and lease losses is not sufficient to absorb further losses that may occur in our loan portfolio, our financial condition, results of operations and liquidity could continue to suffer.

The U.S. economy has been in a prolonged recession and slow recovery in recent years, and the local economy in our market remains stressed and volatile. This market turmoil has decreased both our borrowers’ ability to repay their loans and the value of collateral, such as real estate, which secures many of our loans. As ~~a result, the Company’s levels of nonperforming assets substantially increased during 2009, 2010 and 2011.~~ If these economic conditions continue to persist, our loan customers may not be able to repay their loans according to their terms and their collateral may be insufficient to repay the loan. Management makes quarterly provisions to the allowance for loan and lease losses after taking into account specifically impaired loans, historical loss ratios and general economic conditions, among other factors. To the extent the ability of our borrowers to repay their loans worsens, or general economic conditions continue to deteriorate or fail to substantially recover, we may need to continue to ~~substantially~~ increase our allowance, which would have an adverse effect on our results of operations, financial condition and capital.

In addition, our regulators continue to review the adequacy of our allowance and, through the examination process, have authority to compel us to increase our allowance even if we believe it is adequate. We cannot predict whether our regulators will require us to increase our allowance. Although we believe our loan loss allowance is adequate to absorb probable inherent losses in our loan portfolio, the allowance may not be adequate. If our actual loan losses exceed the amount that is anticipated, our earnings could suffer and our capital could be negatively affected. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for discussion of our allowance for loan and lease losses.

Continued adverse conditions in the U.S. economy, and in particular the greater Chicago and suburban Chicago area, could have a material adverse effect on our business and results of operations.

Sustained weakness in the real estate market, reduced business activity, high unemployment, instability in the financial markets, less available credit and lack of confidence in the financial sector, among other factors, have adversely affected the Company and the financial services industry in general over the last ~~three~~several years. A sustained period of high unemployment or further deterioration in national or local business or economic conditions could result in, among other things, a further deterioration in credit quality or reduced demand for credit with a resultant negative effect on the Company’s loan portfolio and allowance for loan and lease losses. Economic factors may also continue to cause increased delinquencies and loan charge-offs, which will negatively affect our results of operations and financial condition.

A large percentage of our loan portfolio is secured by real estate. Current and further deterioration in the commercial real estate and housing market could cause continued increases in delinquencies and nonperforming assets, including loan charge-offs, and further depress our income.

The commercial and residential real estate markets continue to experience ~~extraordinary~~significant challenges. Economic factors have and may continue to cause deterioration to the value of real estate the Company uses to secure a substantial amount of its loans. Moreover, in the Company’s loan portfolio there is a concentration of loans to the hotel industry. ~~The~~ general downturn in hotel occupancy rates has impacted and will continue to negatively impact the borrowers’ ability to repay and consequently affect the Company’s earnings and its allowance for loan and lease losses. The resultant effect of the continued weakness of the economy and the deterioration of our real estate portfolio could result in additional increases in the provision for loan and lease losses, higher delinquencies and additional charge-offs in future periods that may materially affect the Company’s financial condition and results of operations.

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The Company also has a concentration of loans that have payment schedules where only interest is collected until the loan matures. If the value of the collateral securing these loans should decrease, the Bank’s loan to collateral value will decrease to a greater extent than loans that have payment schedules requiring principal reductions.

An inability to raise funds through deposits, borrowings, and the sale or pledging as collateral of loans and other assets could adversely impact our ability to originate loans, invest in securities, meet our expenses or fulfill our other financial obligations.

Liquidity is a measure of whether our cash flows and liquid assets are sufficient to satisfy current and future financial obligations, such as demand for loans, deposit withdrawals and operating costs. Our liquidity position is affected by a number of factors, including the amount of cash and other liquid assets on hand, payment of interest and dividends on debt and equity instruments that we have issued, capital we inject into the Bank and dividends received from the Bank. Continued weakness or worsening of the economy, real estate markets or unemployment levels may deplete our liquid assets. If our liquidity becomes limited, it may have a material adverse effect on our results of operations and financial condition.

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We are required to maintain certain minimum capital ratios by our regulators and any failure to maintain these capital ratios or difficulty raising capital, if required, could result in further enforcement actions against us, and further restrict our ability to originate loans and generate income.

As a banking institution, we are subject to regulations that require us to maintain certain capital ratios, such as the ratio of our Tier 1 ~~capital~~Capital to our risk-based assets. If our regulatory capital ratios decline, as a result of decreases in the value of our loan portfolio or otherwise, we will be required to improve such ratios by either raising additional capital or by disposing of assets. If we choose to dispose of assets, we cannot be certain that we will be able to do so at prices that we believe to be appropriate, and our future operating results could be negatively affected. If we choose to raise additional capital, we may accomplish this by selling additional shares of common stock, or securities convertible into or exchangeable for common stock, which could significantly dilute the ownership percentage of holders of our common stock and cause the market price of our common stock to decline. Events or circumstances in the capital markets generally may increase our capital costs and impair our ability to raise capital at any given time. In addition, our regulators continue to review the adequacy of our capital and, through the examination process, have authority to compel us to increase our capital even if we believe it is adequate. We cannot predict whether our regulators or new regulations will require us to increase our capital.

On ~~April 16~~January14, ~~2010~~2013, the Bank entered into athe ~~joint~~2013 Consent Order with the FDIC and the IDFPR, which replaced the 2010 Consent Order. The 2013 Consent Order imposes certain restrictions on liquidity. It prohibits the payment of any dividends by the Bank to the Company without the prior written consent of both the FDIC and the IDFPR. As of December 31, 2012, the Bank had a Total Risk-Based Capital Ratio of 12.11%, a Tier 1 Risk-Based Capital Ratio of 10.77% and a Leverage Ratio of 6.67% which was below the Leverage Ratio requirement of the 2013 Consent Order of 8.00%. Moreover, because the 2013 Consent Order establishes specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes. As an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC. In addition, other depositors, including some local government entities, may not maintain their deposits at the Bank if the Bank is no longer well capitalized. At year-end December 31, 2011, the Bank had brokered time deposits totaling $11.9 million and public deposits totaling $34.1 million. The Bank has developed a liquidity plan that identifies the sources of liquidity available to meet the Bank’s contingency funding over the next twelve months. Furthermore, the Company has developed and adopted a capital plan pursuant to the requirements of the Written Agreement the Company entered into with the Federal Reserve Bank on March 17, 2011. See “Supervision and Regulation.”

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The new capital rules proposed in June 2012 by the Federal Reserve and the FDIC to implement the Basel III capital guidelines could adversely affect the Company’s capital adequacy and the costs of conducting its business.

Provisions of the Dodd-Frank Act require U.S. banking regulators to consider changes to strengthen minimum capital requirements for financial institutions as part of the overall financial reforms currently in the process of being implemented. On June 7, 2012, the Federal Reserve and other regulators released a notice of proposed rulemaking that would revise and replace the agencies’ current regulatory capital requirements and are intended to align U.S. capital requirements with Basel III international capital standards. To date, the final rules have not been issued. As proposed, these rules may increase the amount of capital required to support our business, especially on a risk-weighted basis, and, therefore, may adversely affect our results of operations and financial condition. Once adopted, these new capital requirements would be phased in over time. Among other things, for bank holding companies with under $15 billion in assets, such as the Company, the ability to treat trust preferred securities as Tier 1 Capital will be phased out over 10 years. The ultimate impact of the implementation of the new capital and liquidity standards to the Company and the Bank will depend upon the final rules. In addition, important questions remain as to how the numerous capital and liquidity mandates of the Dodd–Frank Act will be integrated with the requirements of Basel III.

The Company currently lacks the sources of income and the liquidity to make interest payments on the subordinated debentures associated with its outstanding trust preferred securities, and if this condition continues, the entire amount of deferred interest payments and principal may become due.

Beginning in November 2009, the Company deferred its regularly scheduled quarterly interest payments on its $10.3 million of outstanding junior subordinated debentures relating to its outstanding trust preferred securities. As of December 31, 2012, the Company had deferred 13 quarterly interest payments totaling approximately $1.0 million. The Company has the right to defer the payment of interest on the junior subordinated debentures for a period not to exceed 20 consecutive quarters, or until December 15, 2014, should the deferral of interest continue. If the Company continues to defer interest until that time, then approximately $1.5 million in deferred interest will be due. Unless all of the deferred interest is brought current at that time, the trustee under the indenture may declare the entire outstanding amount of both principal and interest immediately due and payable.

Currently, the Company lacks both the liquid assets to pay the interest on the outstanding junior subordinated debentures and any source of income other than the Bank. Given the restrictions placed upon the Bank by the 2013 Consent Order, the Bank may not be able to provide the Company with dividends in an amount sufficient to pay the deferred interest by December 15, 2014. The Company may have to find a source other than the Bank for these funds, or face defaulting on the subordinated debentures. There can be no assurance that the Company will find such a source of funding.

If the Company does find such a source of funding, the funding may only be available upon onerous terms, such as terms that might substantially dilute the existing shareholders of the Company’s common stock, or the Company’s ownership interest in the Bank. Either of these occurrences could adversely affect the existing shareholders of the Company.

Our business is highly regulated and may be adversely affected by changes in banking laws, regulations, and regulatory practices and enforcement actions.

We are subject to extensive supervision, regulation and examination. This regulatory structure gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies to address not only compliance with applicable laws and regulations (including laws and regulations governing consumer credit, and anti-money laundering and anti-terrorism laws), but also capital adequacy, asset quality and risk, management ability and performance, earnings, liquidity and various other factors. As part of this regulatory structure, we are subject to policies and other guidance developed by the regulatory agencies with respect to capital levels, the timing and amount of dividend payments, the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes.

Under this structure the regulatory agencies have broad discretion to impose restrictions and limitations on our operations if they determine, among other things, that our operations are unsafe or unsound, fail to comply with applicable law or are otherwise inconsistent with laws and regulations or with the supervisory policies of these agencies. This supervisory framework could materially impact the conduct, growth and profitability of our operations. Any failure on our part to comply with current laws, regulations, other regulatory requirements or safe and sound banking practices or concerns about our financial condition, or any related regulatory sanctions or adverse actions against us, could increase our costs or restrict our ability to operate our business and result in damage to our reputation.

The Company’s ongoing participation in the Treasury’s TARP CPP creates additional regulatory oversight and compliance. The TARP regulations place limitations on compensation for executive officers and on dividend payments. These regulations may affect the ability of the Company to recruit and keep management. The regulations pertaining to TARP could affect the Company’s ability to operate in a competitive environment. See “Supervision and Regulation.”

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~~Recently~~Financial ~~enacted financial~~ reform legislation has, among other things, created a new Consumer Financial Protection Bureau and may result in new regulations that tighten capital standards and increase our costs of operations.

OnThe ~~July 21, 2010, the~~ Dodd-Frank ~~Wall Street Reform and Consumer Protection~~ Act, ~~a sweeping financial reform bill, was signed into law. This new law~~ has and will result in a number of new regulations that will impact community banks. The act includes, among other things, provisions allowing the federal bank regulatory agencies to review and establish new capital standards as deemed appropriate, provisions establishing the Consumer Financial Protection Bureau, which ~~will~~has ~~have~~ broad authority to develop and implement rules regarding most consumer financial products; provisions affecting corporate governance and executive compensation at all publicly traded companies; provisions that broaden the base for FDIC insurance assessments and permanently increase FDIC deposit insurance to $250,000; and new restrictions on how mortgage brokers and loan originators may be compensated. These provisions, or any other aspects of current proposed regulatory or legislative changes to laws applicable to the financial industry, if enacted or adopted, may impact the profitability of our business activities or change certain of our business practices, including our ability to offer new products, obtain financing, attract deposits, make loans and achieve satisfactory interest spreads, and could expose us to additional costs, including increased compliance costs. These changes also may require us to invest significant management attention and resources to make any necessary changes to our business in order to comply, and could therefore also materially adversely affect our business, financial condition and results of operations. See “Supervision and Regulation.”

A failure to comply with the terms of the Consent Order, which the Bank entered into with the FDIC and the IDFPR on ~~April 16~~January 14, ~~2010~~2013, and the terms of the Written Agreement, which the Company entered into with the Federal Reserve Bank on March 17, 2011, and any future enforcement actions to which we may become subject, could severely harm our business and financial results.

Any material failure to comply with the provisions of the Consent Order could result in additional enforcement actions by the FDIC and the IDFPR. Likewise, any material failure to comply with the Written Agreement could result in additional enforcement actions against the Company by the Federal Reserve Bank. While the Company and the Bank intend to take such actions as may be necessary to comply with the requirements of the Consent Order and the Written Agreement, there can be no assurance that they will be able to comply fully with the provisions of the Consent Order and the Written Agreement, or that efforts to comply with the Consent Order and the Written Agreement will not have adverse effects on the operations and financial condition of the Company and the Bank.

Changes in interest rates may reduce our net interest income.

Our earnings and profitability depend significantly on our net interest income, which is the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings. Since interest rates can fluctuate in response to general economic conditions and the policies of various governmental and regulatory agencies, including the Reserve Board, our asset-liability management strategy may not be able to prevent changes in interest rates from having a material adverse effect on our results of operations and financial condition.

The expiration of the Dodd-Frank Deposit Insurance Provision at the end of 2012 may have a material impact on deposits and the Company’s funding capabilities.

The FDIC's transaction account guarantee program providing for unlimited insurance on noninterest-bearing demand deposit accounts, which was extended as part of the Dodd-Frank Deposit Insurance Provision, had been in place since 2008 and expired on December 31, 2012. The Bank could experience an outflow of deposits which may impact its funding capabilities and potentially result in an increase in the cost of funds further impairing the Bank’s results of operations.

The soundness of other financial institutions could negatively affect us.

Our ability to engage in routine funding and other transactions could be negatively affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. Defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have in the past led to market-wide liquidity problems and losses of depositor, creditor and counterparty confidence and could lead to losses or defaults by us or by other institutions.

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The loss of certain key personnel could negatively affect our operations.

Our success depends upon the continued service of our senior management team, their relationships with our customers and our ability to attract and retain qualified financial services personnel. Loss of key personnel could negatively impact our results of operations and financial condition through loss of their customer relationships and the potential difficulty promptly replacing officers in this competitive environment.

Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.

We face substantial competition in all phases of our operations from a variety of different competitors. Our profitability depends upon our success in competing in the northeast Illinois and southeast Wisconsin markets. We compete for loans and deposits in our geographic markets with other commercial banks, thrifts, credit unions and brokerage firms operating in the markets we serve. Many of our competitors offer products and services which we do not, and many have substantially greater resources, name recognition and market presence, all of which help to attract business. In addition, larger competitors may be able to price loans and deposits more aggressively than we do. Also, technological advances and the continued growth of internet-based banking and financial services have made it possible for nondepository institutions to offer a variety of products and services competitive with certain areas of our business. Some of the financial institutions and financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on bank holding companies, savings and loan holding companies, federally insured, state-chartered banks, federal savings banks, thrifts and national banks. As a result, these nonbank competitors have certain advantages over us in accessing funding and in providing various products and services.

TABLE OF CONTENTS

Failures of our technology, operational and security systems may adversely affect our operations and our reputation.

We are increasingly depending upon computer and other information technology systems to manage our business. We rely upon information technology systems to process, record and monitor and disseminate information about our operations. In some cases, we depend on third parties to provide or maintain these systems. We are subject to operating risks, including, but not limited to, an interruption or breach in security of information systems, customer or employee fraud and catastrophic failures. If any of our financial, accounting or other data processing systems suffer a cyber attack, fail or have other significant shortcomings, we could be materially adversely affected. Security breaches in our online banking systems could also have an adverse effect on our reputation and could subject us to possible liability. Even if not directed at the Company or the Bank specifically, attacks on other financial institutions could disrupt the overall functioning of the financial system to the detriment of other financial institutions, including the Company and the Bank. Our systems may also be affected by events that are beyond our control, which may include, for example, computer viruses, electrical or telecommunications outages or other damage to our property or assets. Although we take precautions against malfunctions and security breaches, our efforts may not be adequate to prevent problems that could materially adversely affect our business operations.

Table of Contents

Item 1B.

Unresolved Staff Comments.

Not Applicable.

Item 2.

Properties.

The Bank conducts its operations through its main office and seven branches. The Company’s office is located in the main office of the Bank. All offices are owned by the Bank and are located in Lake County, Illinois. The Company believes that its current facilities are adequate for the conduct of its business.

The following table sets forth information relating to each of the Bank’s offices:

~~Main Office: 1601 North Lewis Avenue Waukegan, Illinois 60085~~	~~Trust~~Main ~~Department~~Office: ~~3233~~1601 ~~Grand~~North Lewis Avenue Waukegan, Illinois 60085
~~Branches: 3233 Grand Avenue Waukegan, Illinois 60085~~	~~40220~~Branches: N.3233 ~~Route~~Grand 59Avenue ~~Antioch~~Waukegan, Illinois ~~60002~~60085	40220 N. Route 59 Antioch, Illinois 60002
216 Madison Street Waukegan, Illinois 60085	700 N. Sheridan Road Winthrop Harbor, Illinois 60096
	216 Madison Street	700 N. Sheridan Road
5384 Grand Avenue Gurnee, Illinois 60031	1777 N. Cedar Lake Road Round Lake Beach, Illinois 60073
	Waukegan, Illinois 60085	Winthrop Harbor, Illinois 60096
301 Goodnow Boulevard Round Lake, Illinois 60073
	5384 Grand Avenue	1777 N. Cedar Lake Road
	Gurnee, Illinois 60031	Round Lake Beach, Illinois 60073
	301 Goodnow Boulevard
	Round Lake, Illinois 60073

Item 3.

Legal Proceedings.

Due to the nature of their business, the Company and its subsidiaries are often subject to various legal actions. These legal actions, whether pending or threatened, arise through the normal course of business and are not considered by management to be unusual or material. Management believes that any liabilities arising from these actions or proceedings would not have a material adverse effect on the Company’s business, consolidated results of operations, financial condition or cash flows.

17Item 4. Mine Safety Disclosures.

TABLE OF CONTENTS

Item 4. Mine Safety Disclosures

Not Applicable.

Table of Contents

PART II

Item 5.

Market for the Company’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Stockholder Information - Historically, the Company’s common stock traded on the NASDAQ Capital Market under the ticker symbol “NSFC.” On February 17, 2012, the Company filed a Form 25 with the SEC in connection with its previously announced plans to delist its common stock from The ~~NASDAQ Capital Market, and trading in the~~ Company’s common stock ontrades ~~NASDAQ was suspended~~ on ~~that date. Following~~ the ~~suspension of trading on NASDAQ, the Company’s common stock commenced quotation on the~~ OTC Markets under the ticker symbol “NSFC.” As of February 1523, ~~2012~~2013, there were 6,500,000 common shares authorized; 4,472,255 common shares issued and 4,~~277~~270,755 outstanding; held by approximately ~~298~~281 registered stockholders.

Stock Price Summary - The following schedule details the quarterly high and low sales price of the Company’s common stock for the periods presented:

	2011				2010
	2012				2011
	HIGH		LOW		HIGH		LOW
QUARTER ENDED:
March 31	$	21.4700	$	1.1952	$	42.3947	$	21.8819
June 30		1.6093		1.0055		31.60		21.00
September 30		1.2017		.5665		21.4020		1.5256
December 31		1.5793		.6460		1.9057		1.3564

Cash Dividends

~~The~~Prior to the fourth quarter of 2008, the Company ~~has~~had historically paid semi-annual dividends on its common stock in June and December. However, dividends are declared at the discretion of the Board of Directors, subject to applicable legal and regulatory restrictions~~, and there is no guarantee that the Company will pay dividends in the future~~. OnThe ~~October 21, 2008, the Board of Directors of the~~ Company ~~determined that there would be no cash dividend on December 1, 2008 due to the reduced earnings of the Company in 2008, and the Company~~ did not pay dividends on its common stock infrom 2009, ~~2010~~to ~~and 2011~~date.

In February 2009, the Company sold $17.2 million of preferred stock to the Treasury pursuant to the terms of the TARP CPP. As long as any TARP Series A Preferred Stock issued under the CPP remains outstanding, the terms of the CPP prohibit the Company from increasing semi-annual dividends on its common stock above $0.40 per share without the Treasury’s consent.

In ~~its press release on~~ November ~~10,~~ 2009, ~~announcing its financial results for~~ the ~~third quarter 2009, the~~ Company ~~also~~suspended ~~announced that it notified~~ the ~~Treasury of its intent to suspend the~~ payment of its regular quarterly cash dividends on its TARP Series A Preferred Stock. Under the terms of the TARP Series A Preferred Stock, the Company is required to pay on a quarterly basis a dividend rate of 5% per year for the first five years, after which the dividend rate automatically increases to 9% per year. Dividend payments may be suspended, but the dividend is a cumulative dividend and failure to pay dividends for six dividend periods triggers board appointment rights for the holder of the TARP Series A Preferred Stock. In December 2012, the Treasury exercised its director appointment rights and appointed one director to the Company’s Board of Directors and has the contractual right to appoint one more director. No dividends may be paid on the Company’s common stock until all accrued and unpaid dividends on the preferred stock issued to the Treasury are paid.

In addition, in November 2009 the Company ~~announced~~began ~~that~~deferring itits ~~had~~regularly ~~notified~~scheduled ~~the~~quarterly ~~trustee~~interest ~~that~~payments ~~holds~~on ~~the~~its ~~Company’s~~ junior subordinated debentures relating to its outstanding trust preferred securities ~~that the Company will defer its regularly scheduled quarterly interest payments on the junior subordinated debentures~~. Under the terms of the debentures, the Company is permitted to defer the payment of interest on the junior subordinated debentures at any time, for up to 20 consecutive quarters, without default. Due to the deferral, the trust ~~will~~suspended ~~likewise suspend~~ the declaration and payment of dividends on the trust preferred securities. During the deferral period, the Company may not pay any dividends on its common or preferred stock.

~~Following~~On aMarch ~~review~~17, of2011, the Company byand the Federal Reserve Bank, ~~the~~entered ~~Board~~into ~~of Directors of the Company adopted~~ a ~~Board~~Written ~~Resolution~~Agreement. ~~dated~~Pursuant ~~November~~to ~~17, 2009 concerning~~ the ~~Company’s~~Written ~~conservation~~Agreement, ~~of financial resources. The Board Resolution provides an understanding~~ among ~~the~~other ~~Federal Reserve and the Company~~things, ~~that~~ the Company’s ~~Board~~agreed ofto ~~Directors~~abstain ~~will obtain written approval~~ from ~~the Federal Reserve prior to: (1)~~ paying any dividends, toredeeming ~~common~~any stock or ~~preferred~~incurring ~~stockholders;~~any ~~(2) increasing holding company~~ debt orwithout ~~subordinated~~Federal ~~debentures~~Reserve ~~issued~~Bank inapproval. ~~conjunction~~The ~~with~~Written ~~trust~~Agreement ~~preferred~~superseded ~~securities~~the ~~obligations;~~Board ~~and~~Resolution ~~(3)~~dated ~~paying~~November ~~interest~~17, ~~on its existing subordinated debentures~~2009.

18On January 14, 2013, the Bank entered into the 2013 Consent Order which replaced the 2010 Consent Order dated April 16, 2010, as further described above under “Supervision and Regulation.” The 2013 Consent Order prohibits the payment of any dividends by the Bank to the Company without the prior written consent of both the FDIC and the IDFPR.

~~TABLE OF CONTENTS~~23

OnTable ~~April 16, 2010, the Bank entered into a joint Consent Order with the FDIC and the IDFPR, as further described above under “Supervision and Regulation.” The Consent Order prohibits the payment~~ of ~~any~~Contents ~~dividends by the Bank to the Company without the prior written consent of both the FDIC and the IDFPR.~~

On March 17, 2011, the Company and the Federal Reserve Bank entered into a Written Agreement. Pursuant to the Written Agreement, among other things, the Company has agreed to abstain from paying any dividends, redeeming any stock or incurring any debt without Federal Reserve Bank approval. The written agreement supersedes the Board Resolution dated November 17, 2009.

TABLE OF CONTENTS

Item 6.

Selected Financial Data.

SELECTED CONSOLIDATED FINANCIAL DATA

($ 000s, except per share data)

As of or for the Year Ended December 31,	~~2011~~2012			~~2010~~2011			~~2009~~2010			~~2008~~2009			~~2007~~2008
INCOME STATEMENT DATA:
Interest income	$	2017,~~879~~140		$	2420,~~305~~879		$	2924,~~338~~305		$	3429,~~874~~338		$	3834,~~421~~874
Interest expense		21,~~382~~056			52,~~007~~382			105,~~187~~007			1310,~~795~~187			2013,~~060~~795
Net interest income		1816,~~497~~084			1918,~~298~~497			19,~~151~~298			2119,~~079~~151			1821,~~361~~079
Provision for loan and lease losses		611,~~900~~100			96,~~668~~900			229,~~778~~668			1322,~~663~~778			8113,663
Net interest income after provision for loan and lease losses		114,~~597~~984			911,~~630~~597			(39,~~627~~630	)		7(3,~~416~~627	)		187,~~280~~416
Noninterest income		43,~~109~~490			54,~~657~~109			35,~~784~~657			(63,~~045~~784	)		5(6,~~038~~045	)
Noninterest expense		2221,~~393~~054			2122,~~649~~393			3021,~~153~~649			1630,~~929~~153			16,~~830~~929
(Loss) income before income taxes		(6,687	)		(6,362	)		(29,996	)		(15,558	)		6,488
Income before income taxes		(12,580	)		(6,687	)		(6,362	)		(29,996	)		(15,558	)
Provision for income taxes		0			0			~~5,562~~0			(65,~~285~~562	)		2(6,~~100~~285	)
Net (Loss) income	$	(6,687	)	$	(6,362	)	$	(35,558	)	$	(9,273	)	$	4,388
Net loss		(12,580	)		(6,687	)		(6,362	)		(35,558	)		(9,273	)
Dividends and accretion of preferred stock		1,131			1,074			1,020			854			0
Net loss available to common stockholders	$	(13,711	)	$	(7,761	)	$	(7,382	)	$	(36,412	)	$	(9,273	)
BALANCE SHEET DATA:
Cash, non-interest bearing	$	54,~~313~~971		$	5,~~642~~313		$	105,~~646~~642		$	1410,~~108~~646		$	14,~~273~~108
Investments (1)		~~121~~132,~~461~~141			~~118~~121,~~346~~461			~~158~~118,~~770~~346			~~112~~158,~~711~~770			~~164~~112,~~083~~711
Loans and leases, net		~~303~~252,~~729~~070			~~366~~303,~~453~~729			~~413~~366,~~259~~453			~~470~~413,~~410~~259			~~431~~470,~~128~~410
All other assets		3224,~~487~~090			4132,~~287~~487			3941,~~615~~287			4339,~~490~~615			2843,~~672~~490
Total Assets	$	~~462~~413,~~990~~272		$	~~531~~462,~~728~~990		$	~~622~~531,~~290~~728		$	~~640~~622,~~719~~290		$	~~638~~640,~~156~~719
Deposits	$	~~397~~358,~~631~~594		$	~~446~~397,~~551~~631		$	~~517~~446,~~236~~551		$	~~500~~517,~~821~~236		$	~~480~~500,~~959~~821
Securities sold under repurchase agreements and other borrowings (2)		19,~~455~~262			3519,~~517~~455			4935,~~364~~517			4249,~~574~~364			6642,~~797~~574
Federal Home Loan Bank advances		0			0			0			~~20,000~~0			020,000
Subordinated debentures		10,310			10,310			10,~~000~~310			10,000			10,000
All other liabilities		79,~~055~~173			67,~~065~~055			56,~~389~~065			5,~~710~~389			65,~~946~~710
Stockholder's equity		2815,~~539~~933			3328,~~285~~539			4033,~~301~~285			6140,~~614~~301			7361,~~454~~614
Total Liabilities and Stockholders' Equity	$	~~462~~413,~~990~~272		$	~~531~~462,~~728~~990		$	~~622~~531,~~290~~728		$	~~640~~622,~~719~~290		$	~~638~~640,~~156~~719
		2011			2010			2009			2008			2007
	2012			2011			2010			2009			2008
PER SHARE DATA:
Basic and diluted earnings per share	$	(13.8121	)	$	(1.81	)	$	(81.9481	)	$	(28.2694	)	$	1(2.0526	)
Cash dividends declared		0.00			0.00			0.00			0.4000			0.7240
Book value (at end of year)		2(0.6530	)		32.9565			53.6795			155.1367			1715.5813
SELECTED FINANCIAL AND OTHER RATIOS:
Return on average assets		-12.3186	%		-1.1131	%		-51.5511	%		-15.4355	%		0-1.6643	%
Return on average equity		-2050.5314			-1520.1753			-5315.4917			-1353.0949			6-13.0609
Average stockholders' equity to average assets		65.3771			76.3437			107.3934			10.9039			10.8390
Tax equivalent interest spread		3.7381			3.4873			23.9248			32.0692			23.3806
Tax equivalent net interest income to average earning assets		3.8387			3.6383			3.2263			3.4922			23.9649
Nonperforming assets to total assets		1923.6629			1819.0066			918.7700			79.4477			27.3344
Dividend payout ratio (3)		0.00			0.00			0.00			~~-17~~0.5600			68-17.5556

(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)	Total cash dividends divided by net income.

2024

~~TABLE~~Table OFof ~~CONTENTS~~Contents

Item 7.

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.

OVERVIEW

In ~~2011~~2012, the Company ~~continued~~was ~~to be~~ affected by the ~~downturn~~continued weakness in the economy and the ~~continued~~ decline in general real estate prices. ~~For~~ ~~2011,~~The ~~the~~ Company experienced a net loss available to common stockholders of $613.7 million or $13.8121 loss per share in 2012 as compared ~~with~~to a net loss available to common stockholders of $67.8 million or $1.81 loss per share in 2011 and of $7.4 million or $1.81 loss per share in 2010. asThe 2012 loss was primarily due to the Company’s continued to write -down of nonperforming loans and other real estate owned as a result of declining values of the collateral securing those assets.

The Company’s nonperforming assets remained at high levels as the Company continued to work with its borrowers to find resolution to credit problems. In ~~these~~With ~~difficult~~the ~~economic~~weakened ~~times~~economy, the Company made concessions to borrowers experiencing financial difficulties. These loans were classified as troubled debt restructurings. Nonperforming assets, consisting of nonaccrual loans, loans 90 days past due and still accruing, troubled debt restructurings and other real estate owned acquired through, or in lieu of, foreclosure, totaled $85.4 million, 20.7% of total assets, as compared with $91.0 million at year-end 2011, or 19.7% of total assets, at year-end 2011 asand ~~compared with~~ $95.7 million, or 18.0% of total asset, at year-end 2010.

The Company, in determining its provisions to the allowance for loan losses for ~~2011~~2012, analyzed the collateral values on its collateral dependent impaired loans and discounted cash flows on its cash flow dependent impaired loans. In addition, the Company reviewed past charge-off ~~loan~~ history and economic and internal factors. As a result of this analysis, the Company recognized provisions to the allowance for loan losses totaling $611.91 million during ~~2011~~2012 as compared with $96.79 million during ~~2010~~2011, aan ~~decrease~~increase of $24.82 million. At year-end ~~2011~~2012, the Company’s allowance for loan and lease losses stood at 57.8860% of total loans as compared with 45.7788% at year-end ~~2010~~2011.

Net interest income declined $~~801,000~~2.4 million during ~~2011~~2012 due to decreases in earning assets ~~as the Company continued to write-down nonperforming assets and reposition its balance sheet to preserve capital~~. Although net interest income declined, the Company’s net yield on average earning assets increased to 3.8387% for ~~2011~~2012 as compared with 3.6383% for ~~2010~~2011 as lower interest rates assisted the Company in decreasing its costs of funds. The Company expects these lower interest rate levels to continue in ~~2012~~2013 and into ~~2013~~2014.

The Company’s noninterest income decreased ~~during~~in ~~2011~~2012 by $~~1.5~~619,000 ~~million~~ to $43.~~1million~~5 million. This decrease to noninterest income was primarily due to declines in gains on the sale of securities as the Company recognized ~~only~~no ~~$527,000 in~~ gains in ~~2011~~2012 as compared ~~with~~to $~~2.4~~527,000 ~~million~~ in ~~2010. This~~gains ~~decrease~~ in 2011. Contributing to ~~noninterest~~the ~~income~~decrease ~~was~~in ~~partially~~noninterest ~~offset~~income bywere ~~reductions~~net ~~to other than temporary impairment~~ losses onof ~~securities as the Company recognized only~~ $~~163~~247,000 taken on sales of ~~these~~other ~~impairments~~real inestate ~~2011~~owned as compared with ~~$659,000~~net ingains ~~2010. At~~of ~~year-end 2011~~$17,000 ~~the~~during ~~Company had no securities with other than temporary impairment~~2011.

Noninterest expense for ~~2011~~2012 ~~increased~~decreased $~~744,000~~1.3 million to $2221.41 million as compared with $2122.64 million in ~~2010~~2011 due to cost control measures by management that continued to be implemented in 2012. ~~This~~ ~~increase~~Salaries isexpense ~~primarily~~was ~~the~~$636,000 ~~result~~less ofand ~~increased~~net occupancy and equipment expenses ~~for~~were ~~other~~$282,000 ~~real~~less ~~estate~~in ~~owned~~2012. FDIC insurance expense also declined by $251,000 due to changes to the FDIC assessment base and lower Bank assets. Despite increases to write-downs to other real estate owned ~~which~~of ~~together~~$849,000, ~~totaled~~the ~~$5.3~~cost ~~million~~of inmanaging ~~2011~~and ~~as compared with~~maintaining these properties decreased by $~~4.4~~934,000 ~~million~~as inmanagement ~~2010~~controlled costs and received rental income.

The Company’s ~~asset~~assets ~~levels~~ decreased during ~~2011~~2012 due to a repositioning of its balance sheet. Total assets at year-end ~~2011~~2012 were $~~463~~413.03 million, decreasing $6849.7 million from year-end ~~2010~~2011. Loans and leases decreased $6249.19 million during ~~2011~~2012 of which $4635.17 million of the reduction was due to loan payoffs and receipt of scheduled loan principal payments net of new loans. Also contributing to the decline in loans ~~during 2011~~ were charge offs of nonperforming loans of $69.4 million ~~of nonperforming loans~~ and the transfer of $94.68 million in loans into other real estate owned as properties securing the loans were obtained through, or in lieu of, foreclosure. ~~Loans also decreased due to soft loan demand.~~ Investments in securities decreased $48.70 million during ~~2011~~2012 primarily due to receipt of scheduled principal reductions. The funds received from these reductions were used to provide liquidity and decrease higher cost time deposits.

~~The Company’s investments in overnight federal funds and short-term interest bearing accounts at banks increased $7.8 million at year-end 2011 as compared with year-end 2010.~~25

~~Deposits~~Table ~~decreased $49.0 million during 2011 while borrowings declined $16.1 million. The decrease in deposits was attributable to decreases~~ of ~~$37.5~~Contents million in higher cost nonbrokered time deposits which totaled $140.5 million at year-end 2011 as compared with $178.0 million at year-end 2010. Brokered time deposits were also reduced by $20.3 million which totaled $11.9 million at year-end 2011 as compared with $32.2 million at year-end 2010.

The ~~Consent~~Company’s ~~Order~~investments ~~the Bank entered into with the FDIC and IDFPR during 2010 remained~~ in ~~effect~~interest ~~during~~bearing ~~2011. The~~accounts ~~Consent~~at ~~Order~~banks ~~requires, among other items,~~ increased ~~Bank~~$19.6 ~~Board~~million ~~of Directors oversight, certain minimum capital levels, action plans~~ to ~~reduce and manage its classified assets, and restrictions on the payment of dividends without prior approval from its regulators~~$52. ~~During~~1 ~~2011,~~million ~~the~~at ~~Company~~year-end ~~and~~2012 ~~the~~as ~~Federal~~compared ~~Reserve Bank entered into a Written Agreement requiring that the Company abstain from paying any dividends, adopt a capital plan and provide the Federal Reserve~~ with ~~cash~~$32.5 ~~projections~~million ~~and~~at ~~progress reports. At~~ year-end 2011, as the Company ~~believes~~increased ~~that~~its ~~it and the Bank are addressing the items required by the Written Agreement and Consent Order~~liquidity.

21Deposits decreased $39.0 million during 2012 while borrowings declined $193,000. The decrease in deposits was attributable to maturities of $45.6 million in higher cost time deposits which totaled $106.7 million at year-end 2012 as compared with $152.3 million at year-end 2011.

~~TABLE~~The OF2010 ~~CONTENTS~~Consent Order the Bank entered into with the FDIC and IDFPR remained in effect during 2012 and was replaced by the 2013 Consent Order on January 14, 2013. The 2013 Consent Order requires, among other items, continued Bank Board of Directors oversight, certain minimum capital levels, action plans to reduce and manage its classified assets, and restrictions on the payment of dividends without prior approval from its regulators. During 2011, the Company and the Federal Reserve Bank entered into a Written Agreement requiring that the Company abstain from paying any dividends, adopt a capital plan and provide the Federal Reserve with cash projections and progress reports. At year-end 2012, the Company believes that it and the Bank are addressing the items required by the Written Agreement and Consent Order.

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 valuation allowance for probable incurred credit losses that is increased by the provision for loan and lease losses and decreased by net charge-offs ~~less recoveries~~. Management estimates the balance for the allowance based on information about specific borrower situations, estimated collateral values, discounted cash flows and the borrowers’ ability to repay the loan. Management also reviews past loan and lease loss experience, the nature and volume of the portfolio, environmental and qualitative factors, economic conditions and other factors which may affect the repayment of loans. 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 judgment, 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 within the contractual terms of the loan. 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 may be specifically allocated to that loan or lease. The specific allocation is calculated at the present value of estimated cash flows using the existing rate of the loan or lease or the fair value of collateral if repayment is expected solely from the collateral.

Other real estate owned consists of properties securing nonperforming loans obtained through, or in lieu of, foreclosure and is initially reported at the estimated fair value based on a real estate appraisal or internal evaluation less estimate costs to sell. Other real estate is periodically assessed for impairment and any such impairment is recognized in the current period.

The fair value of securities is based on determinations from a securities broker. On an annual basis these are validated by an independent securities valuation firm. This validation was last done at September 30, ~~2011~~2012 and the differences in fair value were deemed to be immaterial.

There are various contingent liabilities that are not reflected in the financial statements, including claims and legal actions arising against the Company in the ordinary course of business. These matters are not expected to have a material effect on the Company’s operating results or financial condition.

The fair value of financial instruments such as cash and cash equivalents, accrued interest receivable, advances from borrowers for taxes and insurance and accrued interest payable are estimated at carrying value. The estimated fair value for Federal Home Loan Bank stock is equal to the carrying value based on the restricted nature of the stock.

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 was amortized over its estimated useful life. At year-end 2010, the core deposit intangible was fully amortized.26

~~The~~Table ~~assessment~~ of ~~tax~~Contents assets and liabilities involves the use of estimates, assumptions, interpretations and judgment concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. For financial reporting purposes, at year-end 2011 and 2010, a valuation allowance offsets deferred tax assets related to federal and state tax carryforwards and other temporary tax differences. The Company believes that tax assets and liabilities are properly recorded in the consolidated financial statements. See Note 1, “Summary of Significant Accounting Policies” and Note 11, “Income Taxes” of the notes to the consolidated financial statements and the section entitled “Federal and State Income Taxes”.

22The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations and judgment concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. For financial reporting purposes, at year-end 2012, 2011 and 2010, a valuation allowance offsets the deferred tax assets relating to federal and state tax carryforwards and other temporary tax differences. The Company believes that tax assets and liabilities are properly recorded in the consolidated financial statements. See Note 1, “Summary of Significant Accounting Policies”, Note 10, “Income Taxes” of the notes to the consolidated financial statements and the section entitled “Federal and State Income Taxes”.

~~TABLE~~RESULTS OF ~~CONTENTS~~OPERATIONS – YEARS ENDED DECEMBER 31, 2012 COMPARED WITH DECEMBER 31, 2011 AND DECEMBER 31, 2011 COMPARED WITH DECEMBER 31, 2010

Table 1 - Analysis of Average Balances, Tax Equivalent Yields and Rates

($ 000s)

For the Years Ended
December 31,			2011							2010							2009
	Average							Average							Average
	Balance		Interest		Rate			Balance		Interest		Rate			Balance		Interest		Rate
Assets
Loans and leases (1)(2)(3)	$	364,680	$	18,606		5.10	%	$	407,536	$	21,163		5.19	%	$	467,370	$	24,498		5.24	%
Taxable securities (4)		88,007		2,174		2.47			101,029		3,011		3.01			96,094		4,541		4.80
Securities exempt from federal income taxes (2) (4)		3,716		213		5.84			5,142		302		6.04			8,778		541		6.19
Federal funds sold and other interest earning assets		31,759		67		0.21			25,490		43		0.17			32,252		31		0.10
Interest earning assets (4)		488,162		21,060		4.31			539,197		24,519		4.56			604,494		29,611		4.91
Noninterest earning assets		23,534							32,394							35,620
Average assets	$	511,696						$	571,591						$	640,114
Liabilities and stockholders' equity
NOW deposits	$	60,077	$	139		0.23		$	62,701	$	245		0.39		$	50,344	$	273		0.54
Money market deposits		51,352		158		0.31			52,884		276		0.52			62,970		902		1.43
Savings deposits		66,008		37		0.06			63,225		63		0.10			61,483		173		0.28
Time deposits		195,745		1,741		0.89			231,542		3,770		1.63			274,396		7,739		2.82
Other borrowings		34,461		307		0.89			52,270		653		1.25			62,467		1,100		1.76
Interest bearing liabilities		407,643		2,382		0.58			462,622		5,007		1.08			511,660		10,187		1.99
Demand deposits		65,060							60,960							56,389
Other noninterest bearing liabilities		6,415							6,079							5,586
Stockholders' equity		32,578							41,930							66,479
Average liabilities and stockholders' equity	$	511,696						$	571,591						$	640,114
Net interest income			$	18,678						$	19,512						$	19,424
Net interest spread						3.73	%						3.48	%						2.92	%
Net yield on interest earning assets (5)						3.83	%						3.63	%						3.22	%
Interest-bearing liabilities to earning assets ratio						83.51	%						85.80	%						84.64	%

(1) - Interest income on loans includes loan origination and other fees of $73,000 for 2011, $173,000 for 2010 and $119,000 for 2009.

(2) - Tax-exempt income is reflected on a fully tax equivalent basis utilizing a 34 percent on federally tax-exempt municipal loans and securities. The tax equivalent adjustment reflected in the above table for municipal loans is approximately $109,000, $112,000 and $89,000 for the years ended 2011, 2010 and 2009, respectively. The tax equivalent adjustment reflected in the above table for municipal securities is approximately $72,000, $102,000 and $184,000 for the years ended 2011, 2010 and 2009, respectively.

(3) - Non-accrual loans are included in average loans.

(4) - Rate information was calculated on the average amortized cost for securities. The 2011, 2010 and 2009 average balance information includes an average unrealized gain (loss) for taxable securities of ($128,000), $1,092,000 and $1,052,000, respectively. For 2011, 2010 and 2009 average balance information includes an average unrealized gain of $70,000, $140,000 and $45,000, respectively, for tax-exempt securities. Average taxable securities includes Federal Home Loan Bank stock.

TABLE OF CONTENTS

RESULTS OF OPERATIONS – YEARS ENDED DECEMBER 31, 2011 COMPARED WITH DECEMBER 31, 2010 AND DECEMBER 31, 2010 COMPARED WITH DECEMBER 31, 2009

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, on a fully tax equivalent basis, 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 ~~2011~~2012, on a fully tax equivalent basis, was $1816.72 million, decreasing $~~834,000~~2.5 million from $1918.57 million in ~~2010~~2011 after ~~increasing~~decreasing ~~slightly~~ by $88834,000 from ~~2009~~2010. The net interest spread, the difference between rates earned on interest earning assets and paid on deposits and borrowings, in ~~2011~~2012 was 3.7381%, increasing 258 basis points from ~~2010~~2011 after increasing 5625 basis points from ~~2009~~2010. During ~~2011~~2012, the yields on earning assets declined 2519 basis points from ~~2010~~2011 while rates paid on interest bearing liabilities decreased 5027 basis points.

Interest income earned on loans on a fully tax equivalent basis totaled $1815.61 million in ~~2011~~2012, a decrease of $23.65 million as compared with $2118.26 million in ~~2010~~2011 after decreasing $32.36 million from ~~2009. Average rates earned on loans in 2011 were 5.10% as compared with 5.19% in~~ 2010 ~~and 5~~.~~24%~~ inLower ~~2009. Interest~~average ~~rates~~loan ~~remained~~balances ~~at low levels~~ in ~~2011~~2012 ascontributed ~~government policy maintained low short-term rates in an effort~~ to ~~foster economic growth. During 2011, 2010 and 2009,~~ the ~~prime lending rate remained at 3.25%. Loan yields continued to~~ decline inof ~~2011~~interest asincome ~~seasoned~~on loans ~~matured and either paid off or renewed at lower rates~~. ~~Another~~ ~~factor~~Average ~~that lowered average loan rates was the Company's level of nonaccrual~~ loans ~~which~~for ~~totaled~~2012 were $19297.58 million ~~at year-end 2011~~ as compared with $26364.17 million at ~~year-end~~for ~~2010~~2011, ~~and~~a asdecrease ~~compared~~of ~~with~~ $4166.69 million. atLoans ~~year-end~~declined ~~2009. Performing~~due ~~troubled~~to ~~debt~~net ~~restructured~~loan ~~loans~~payoffs, ~~also~~scheduled ~~contributed~~loan toprincipal ~~the~~payments, ~~decline~~loan incharge ~~loan~~offs, ~~yields~~and astransfers ~~these~~of loans ~~totaled~~into ~~$51.7~~other ~~million~~real atestate ~~year-end~~combined ~~2011~~with weak loan demand. Table 2 attributes $~~365,000~~3.4 million of the reduced loan ~~interest~~ income infor ~~2011~~2012 to the lower volume of loan ~~rates~~balances in 2012.

Lower average ~~loan~~rates ~~balances~~earned inon ~~2011~~loans ~~also~~in 2012 contributed to the ~~decline~~lower of interest income~~. Average~~ earned on loans ~~for~~which ~~2011~~declined ~~were~~to ~~$364~~5.706% ~~million~~in 2012 as compared with ~~$407.~~5.10% ~~million~~in ~~for~~2011 ~~2010,~~and a5.19% ~~decrease~~in ~~of $42~~2010.8 ~~million.~~ Table 2 attributes $~~2.2~~160,000 ~~million~~ of the reduced loan interest income ~~for~~in ~~2011~~2012 to ~~the~~ lower ~~volume of~~ loan ~~balances in 2011~~rates.

Table 1 also shows that the Company’s taxable securities averaged $88.0 million in 2011 decreasing $13.0 million from $101.0 million in 2010 after increasing from $96.1 million in 2009. Taxable securities earned yields of 2.47% in 2011 decreasing from yields of 3.01% in 2010 and 4.80% in 2009. Table 3 shows that at year-end 2011, mortgage-backed securities make up 91.5% of total securities and Table 4 shows that these mortgage-backed securities yielded 2.67% at year-end 2011. Management believes that expected yields on the taxable securities for 2012 will remain at these levels.27

~~Average levels of tax-exempt securities in 2011, as shown in~~ Table ~~1, totaled $3.7 million, a decrease~~ of ~~$1.4~~Contents million from 2010 levels after decreasing $3.6 million from 2009. Yields on tax-exempt securities for 2011 decreased 20 basis points to 5.84% from 6.04% in 2010 as compared with 6.19% in 2009. Although the average tax equivalent yields on the qualified bonds issued by state and political subdivisions were greater than those earned on loans during 2011, the term to maturity of these investments is greater. The Company must carefully consider the effect of possible changes to future interest rates when deciding the proper levels of tax exempt securities to carry in its securities portfolio. The Company must also consider its ability to realize tax benefits from tax-exempt securities.

ToTable ~~manage~~1 ~~its liquidity, the Company invests in federal funds sold and other short~~-~~term~~ ~~interest~~Analysis ~~bearing~~of ~~deposits in financial institutions. Federal funds sold are overnight investments that the Company places (sells) to money center banks.~~ Average ~~balances for federal funds sold and other interest earning assets for 2011 were $31.8 million~~Balances, ~~increasing~~Tax ~~$6.3~~Equivalent ~~million~~Yields ~~from 2010 after decreasing $6.8 million from 2009. Rates earned on federal funds sold were 0.21% for 2011 as compared with 0.17% for 2010,~~ and ~~0.10% for 2009.~~Rates

24($ 000s)

~~TABLE~~For OFthe ~~CONTENTS~~Years Ended

Interest expense in 2011 was $2.4 million, decreasing $2.6 million from 2010 after decreasing $5.2 million from 2009. Interest rates remained at low levels during 2011 and the Company’s rates paid on its deposits and other borrowings such as repurchase agreements declined and reduced the Company’s cost of funds to 0.58% as compared with 1.08% for 2010 and 1.99% for 2009. Rates paid on the Company’s money market accounts, savings and time deposits in 2011 declined 21, 4 and 74 basis points, respectively, from 2010. Rates paid on NOW deposits decreased during 2011 by 16 basis points from 2010 after decreasing 15 basis points from 2009.

December 31,	2012							2011							2010
	Average							Average							Average
	Balance		Interest		Rate			Balance		Interest		Rate			Balance		Interest		Rate
Assets
Loans and leases (1)(2)(3)	$	297,801	$	15,062		5.06	%	$	364,680	$	18,606		5.10	%	$	407,536	$	21,163		5.19	%
Taxable securities (5)		81,956		1,961		2.47			88,007		2,174		2.47			101,029		3,011		3.01
Securities exempt from federal income taxes (2) (5)		2,982		176		6.15			3,716		213		5.84			5,142		302		6.04
Federal funds sold and other interest earning assets		39,381		99		0.25			31,759		67		0.21			25,490		43		0.17
Interest earning assets (5)		422,120		17,298		4.12			488,162		21,060		4.31			539,197		24,519		4.56
Noninterest earning assets		17,211							23,534							32,394
Average assets	$	439,331						$	511,696						$	571,591

Liabilities and stockholders' equity
Interest bearing demand deposits	$	62,641	$	91		0.15	%	$	60,077	$	139		0.23	%	$	62,701	$	245		0.39	%
Money market deposits		53,421		61		0.11			51,352		158		0.31			52,884		276		0.52
Savings deposits		70,872		14		0.02			66,008		37		0.06			63,225		63		0.10
Time deposits		121,289		624		0.51			195,745		1,741		0.89			231,542		3,770		1.63
Other borrowings		28,483		266		0.93			34,461		307		0.89			52,270		653		1.25
Interest bearing liabilities		336,706		1,056		0.31			407,643		2,382		0.58			462,622		5,007		1.08
Demand deposits		69,028							65,060							60,960
Other noninterest bearing liabilities		8,506							6,415							6,079
Stockholders' equity		25,091							32,578							41,930
Average liabilities and stockholders' equity	$	439,331						$	511,696						$	571,591

Net interest income			$	16,242						$	18,678						$	19,512

Net interest spread						3.81	%						3.73	%						3.48	%

Net yield on interest earning assets (5)						3.87	%						3.83	%						3.63	%

Interest-bearing liabilities to earning assets ratio						79.77	%						83.51	%						85.80	%

~~Rates~~(1) ~~paid~~- onInterest ~~the~~income ~~Company’s~~on ~~borrowings~~loans inincludes ~~2011~~loan ~~also~~origination ~~declined~~and ~~from~~other ~~2010~~fees ~~by 36 basis points after decreasing 51 basis points from 2009. The levels~~ of ~~the~~$160,000 ~~Company’s~~for ~~average~~2012, ~~borrowings decreased~~ $~~17.8~~73,000 ~~million~~for ~~during~~ 2011 ~~from~~and ~~2010 continuing a trend as borrowings declined~~ $~~10.2~~173,000 ~~million~~for ~~during~~ 2010 ~~from 2009~~.

~~Table~~ (2) ~~attributes~~- ~~$1.9~~Tax-exempt ~~million~~income ofis ~~the~~reflected ~~reduced~~on ~~interest~~a ~~expense~~fully ~~for~~tax ~~2011~~equivalent tobasis ~~the~~utilizing ~~lower~~a ~~rates~~34 ~~paid~~percent on ~~interest~~federally ~~bearing~~tax-exempt ~~liabilities~~municipal inloans ~~2011~~and assecurities. ~~compared~~The ~~with~~tax ~~2010~~equivalent ~~and~~adjustment ~~attributes~~reflected ~~$719,000~~in of the ~~reduced~~above ~~interest~~table ~~expense~~ for ~~2011~~municipal toloans ~~the~~is ~~lower~~approximately ~~volume~~$98,000, of$109,000 ~~interest~~and ~~bearing~~$112,000 ~~liabilities~~for inthe ~~2011~~years asended ~~compared~~2012, ~~with~~2011 and 2010, respectively. ~~Average~~The ~~levels~~tax ofequivalent ~~interest~~adjustment ~~bearing~~reflected ~~liabilities~~in ~~declined~~the ~~$55.0~~above ~~million~~table infor ~~2011~~municipal assecurities ~~compared~~is ~~with~~approximately ~~2010~~$60,000, ~~after~~$72,000 ~~declining~~and $~~49.0~~102,000 ~~million~~for ~~from 2009 as~~ the ~~Company~~years ~~repositioned~~ended ~~its~~2012, ~~balance~~2011 ~~sheet~~and as2010, ~~average loans declined~~respectively.

It(3) is- ~~estimated that short~~Non-~~term~~accrual ~~interest~~loans ~~rates~~are ~~will~~included ~~continue~~in toaverage ~~be at low levels during 2012 as the Federal Reserve continues to balance monetary stimulus while monitoring inflation~~loans.

(4) -

Rate information was calculated on the average amortized cost for securities. The 2012, 2011 and 2010 average balance information includes an average unrealized gain (loss) for taxable securities of $2,564,000, ($128,000) and $1,092,000, respectively. For 2012, 2011 and 2010 average balance information includes an average unrealized gain of $120,000, $70,000 and $140,000, respectively, for tax-exempt securities. Average taxable securities includes Federal Home Loan Bank stock.

Table of Contents

Interest income earned on the Company’s taxable securities decreased $213,000 in 2012 from 2011 after decreasing $837,000 from 2010. The decreased interest income from taxable securities in 2012 was primarily from $6.1 million in decreases in the average taxable securities balances from 2011. As over 91 percent of the Company’s securities are mortgage-backed securities from which the Company receives principal payments monthly, it is expected that the balances of taxable securities will continue to decline in 2013. The yields earned on taxable securities during 2012 of 2.47% remained unchanged from 2011 and are expected to remain approximately the same in 2013.

Average tax-exempt securities in 2012, as shown in Table 1, totaled $3.0 million, a decrease of $734,000 from 2011 levels after decreasing $1.4 million from 2010. Yields on tax-exempt securities for 2012 increased 31 basis points to 6.15% from 5.84% in 2011 as compared with 6.04% in 2010. Although the average tax equivalent yields on the qualified bonds issued by state and political subdivisions were greater than those earned on loans during 2012, the term to maturity of these investments is greater. The Company must carefully consider the effect of possible changes to future interest rates when deciding the proper levels of tax exempt securities to carry in its securities portfolio. The Company must also consider its ability to realize tax benefits from tax-exempt securities.

To manage its liquidity, the Company invests in federal funds sold and other interest earning assets consisting of interest bearing deposits in financial institutions. During 2012, these funds were primarily invested in interest bearing deposits with the Federal Reserve Bank of Chicago and in FDIC insured time deposits issued by financial institutions. Average balances for federal funds sold and other interest earning assets for 2012 were $39.4 million, increasing $7.6 million from 2011 after increasing $6.3 million from 2010. Rates earned on federal funds sold and other interest earning assets were 0.25% for 2012 as compared with 0.21% for 2011, and 0.17% for 2010.

Interest expense in 2012 was $1.1 million, decreasing $1.3 million from 2011 after decreasing $2.6 million from 2010. Interest rates remained at low levels during 2012 and the Company’s rates paid on its interest bearing liabilities, consisting of interest bearing deposits and other borrowings, declined to 0.31% in 2012 as compared with 0.58% for 2011 and 1.08% for 2010. The decline in rates paid in 2012 were primarily due to rates paid on the Company’s time deposits and money market deposits which declined 38 and 20 basis points, respectively.

Table 2 attributes $756,000 of the reduced interest expense for 2012 to the lower rates paid in 2012 as compared with 2011 and attributes $570,000 of the reduced interest expense for 2012 to the lower volume of interest bearing liabilities in 2012 as compared with 2011. Average levels of interest bearing liabilities declined $70.9 million in 2012 as compared with 2011 after declining $55.0 million from 2010. The 2012 decrease was primarily due to decreases to time deposits of $74.5 million as these deposits matured and the Company repositioned its balance sheet.

It is estimated that short-term interest rates will continue to be at low levels during 2013 as the Federal Reserve continues to balance monetary stimulus while monitoring inflation.

Many other factors beyond management’s control have a significant impact on changes in net interest income from one period to another including credit demands by customers, fiscal and debt management policy of federal and state governments, monetary policy of the Federal Reserve Board and changes in regulations.

2529

~~TABLE~~Table OFof ~~CONTENTS~~Contents

Table 2 - Analysis of Changes in Interest Income and Expense

($ 000s)

For the Year Ended December 31	2012 Compared to 2011			~~2011 Compared to 2010~~						2011 Compared to 2010			~~2010 Compared to 2009~~
	Increase (Decrease)			~~Increase (Decrease)~~						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	$	(23,~~557~~544	)	$	(23,~~192~~384	)	$	(~~365~~160	)	$	(32,~~335~~557	)	$	(32,~~109~~192	)	$	(~~226~~365	)
Taxable securities		(~~837~~213	)		(~~330~~216	)		~~(507~~3	)		(~~1,530~~837	)		~~245~~(330	)		(~~1,775~~507	)
Securities exempt from federal income taxes		(8937	)		(8048	)		(911	)		(~~239~~89	)		(~~226~~80	)		(139	)
Federal funds sold and other		2432			1218			1214			1224			(812	)		2012
Total interest income		(3,~~459~~762	)		(23,~~590~~630	)		(~~869~~132	)		(53,~~092~~459	)		(32,~~098~~590	)		(~~1,994~~869	)
Interest Expense
NOW deposits		(106	)		(10	)		(96	)		(28	)		58			(86	)
Interest bearing demand		(48	)		6			(54	)		(106	)		(10	)		(96	)
Money market deposits		(~~118~~97	)		(86	)		(~~110~~103	)		(~~626~~118	)		(~~126~~8	)		(~~500~~110	)
Savings deposits		(2623	)		3			(2926	)		(~~110~~26	)		53			(~~115~~29	)
Time deposits		(21,~~029~~117	)		(~~516~~530	)		(~~1,513~~587	)		(32,~~969~~029	)		(~~1,071~~516	)		(21,~~898~~513	)
Other borrowings		(~~346~~41	)		(~~188~~55	)		~~(158~~14	)		(~~447~~346	)		(~~161~~188	)		(~~286~~158	)
Total interest expense		(21,~~625~~326	)		(~~719~~570	)		(~~1,906~~756	)		(52,~~180~~625	)		(~~1,295~~719	)		(31,~~885~~906	)
Net interest income	$	(~~834~~2,436	)	$	(13,~~871~~060	)	$	~~1,037~~624		$	88(834	)	$	(1,~~803~~871	)	$	1,~~891~~037

Notes:

Rate/volume variances are allocated to the rate variance and the volume variance on an absolute basis.

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 ~~109~~$98,000, $~~112~~109,000 and $89112,000 for the years ended ~~2011~~2012, ~~2010~~2011 and ~~2009~~2010, respectively. The tax equivalent adjustment reflected in the above table for municipal securities is approximately $7260,000, $~~102~~72,000 and $~~184~~102,000 for the years ended 2012, 2011 and 2010, respectively.

~~ended~~NONINTEREST ~~2011, 2010 and 2009, respectively.~~INCOME

26Noninterest income totaled $3.5 million in 2012, decreasing $619,000 compared with $4.1 million in 2011 after decreasing from $5.7 million in 2010. The Company primarily generates noninterest income from service charges and other operating income consisting of miscellaneous fees from loans, safe deposit box rentals and ATM and debit card transactions. It also recognizes as noninterest income gains or losses from sales of securities and other real estate owned and net other than temporary impairment losses on securities.

~~TABLE~~In OFpast ~~CONTENTS~~years, the Company operated a trust department that generated trust income that was included as a component of noninterest income. Effective September 28, 2012, the Bank sold and transferred its designated trust accounts to Thomasville National Bank of Thomasville, Georgia. The Bank recognized no gain or loss on this sale but will receive, in future years, a portion of revenues from these trust assets and any additional local trust business. Thomasville National Bank will operate the trust business through its subsidiary, NorStates Wealth Management Company. The effect of this sale on the Company’s short-term future income is expected to be immaterial as the decreased revenues will be largely offset by decreased operating expenses. The Company expects that future income from this revenue sharing agreement will increase due to Thomasville National Bank’s expertise in the trust business. The Company’s receipt of its share of future trust revenues will be reported as other operating income. As a consequence of this transaction, the Company’s trust income declined $233,000 in 2012 as compared with 2011 and the Company expects that trust income for 2013 will be negligible while other operating income should increase.

Table of Contents

Noninterest income also declined in 2012 due to decreases to gains on sales of securities of $527,000. The Company sold no securities in 2012 compared with 2011 sales of $19.6 million and recognized gains of $527,000. Additionally, during 2012, the Company sold $7.5 million of other real estate owned and recognized $247,000 in losses as compared to 2011 when $10.6 million of other real estate owned was sold at a net gain of $17,000.

Offsetting some of the 2012 decreases to noninterest income were increases to other operating income of $300,000 and decreases to impairment losses on securities of $163,000. Other operating income increased during 2012 primarily due to ATM and debit card income increases of $170,000 and fee income from the sold trust department of $27,000 recognized during the fourth quarter of 2012. The Company recognized no impairment losses on its securities during 2012 as compared with $163,000 in 2011 as the Company wrote down the remaining balances on its Federal National Mortgage Association and Federal Home Loan Mortgage Corporation preferred stock and its Collateral Debt Obligation (“CDOs”) securities.

In comparing noninterest income for 2011 to 2010, these revenues decreased $1.6 million to $4.1 million in 2011 as compared with $5.7 million in 2010. This decrease was due to reductions to net gains on sales of securities of $1.9 million and to lower service fees on deposits of $366,000. During 2011, the Company sold $19.6 million of securities and recognized gains of $527,000 as compared to 2010 when the Company sold $103.3 million of securities and recognized gains of $2.4 million. Service fees on deposits decreased in 2011 as overdraft fee income declined $271,000 and commercial checking account service charges declined $53,000.

Offsetting the decreases to noninterest income in 2011 compared with 2010 were reduced impairment losses on its securities of $496,000. In 2011, the Company had impairment losses on securities of $163,000 as compared with $659,000 in 2010. During 2011, the Company also had net gains on sales of other real estate owned of $17,000 as compared with net losses of $236,000 during 2010.

NONINTEREST EXPENSES

In 2012, total noninterest expenses were $21.1 million, decreasing by $1.3 million, or 6.0%, from 2011. As a percent of average assets, noninterest expenses were 4.79% in 2012, 4.38% in 2011, and 3.79% in 2010.

Salaries and employee benefits expense was $636,000 less in 2012 as the number of full time equivalent employees was reduced to 114 from 125 at year-end 2011 as management chose not to immediately replace departing employees and sold its trust department. Contributing to the decrease in salaries and employee benefits was lower group health insurance premiums negotiated by management for 2012. Net occupancy and equipment expenses declined $282,000 in 2012 as maintenance expenses were reduced by $161,000 from 2011 and utilities expense were reduced by $75,000 as management continued to monitor and control these expenses. Similarly loan and collection and legal expenses declined $177,000 and $125,000, respectively, in 2012. FDIC insurance expense also declined by $251,000 in 2012 due to changes to the FDIC assessment base and the lower assets of the Bank.

Write-downs to other real estate owned increased $849,000 in 2012 as real estate values continued to decline in the local market. Offsetting these increases were reductions to the cost of managing and maintaining these properties by $934,000 as management controlled these costs and received rental income.

Comparing 2011 with 2010, noninterest expenses were $22.4 million in 2011, increasing $744,000 from 2010. The increase was mainly due to expenses relating to nonperforming assets. Other real estate owned expense increased $679,000 during 2011 as real estate taxes and costs to maintain the properties increased. Write-downs of other real estate owned also increased $227,000 as the market prices of these properties declined. Loan and collection expenses increased $581,000 as the Company paid real estate taxes on delinquent mortgage loans in order to maintain the Company’s lien positions.

Offsetting some of the 2011 increases to noninterest expenses were decreases to the amortization of the core deposit intangible asset, FDIC insurance and audit and other professional fees. Amortization of the core deposit intangible asset was reduced by $462,000 during 2011 as the core deposit intangible asset was totally written-down during 2010. FDIC insurance expense decreased $279,000 as the FDIC changed its assessment base from deposits to assets and Bank assets decreased. Audit and other professional expenses decreased $225,000 in 2011 as the Company reduced its use of outside consultants and renegotiated contracts.

Table of Contents

FEDERAL AND STATE INCOME TAXES

The Company recognized no income tax benefit in 2012, 2011 and 2010 despite having operating losses before income taxes of $12.6 million, $6.7 million and $6.4 million, respectively. Per accounting rules, the Company continued to record tax benefits as deferred taxes with a corresponding offset increasing the deferred tax asset valuation allowance without recognizing a tax benefit on the income statement due to uncertainties as to the realization of these benefits. The Company’s tax benefit for 2012, 2011 and 2010 was calculated to be $4.8 million, $4.0 million and $2.6 million, respectively, which increased the deferred tax asset valuation allowance to $25.1 million, $20.3 million and $16.3 million at year-end 2012, 2011 and 2010, respectively.

The Company had no pretax earnings of interest on U.S. Treasury and U.S. government-sponsored entity securities during 2012 as compared with $2,000 and $10,000 in 2011 and 2010, respectively. It is expected that the Company’s nontaxable income for state tax purposes will continue to be negligible in future years until the Company begins to generate state taxable income. Existing state tax credits begin to expire in 2020.

Qualified interest on loans to local political subdivisions and on qualified state and local political subdivision securities are nontaxable for federal income tax purposes. Interest earned on local political subdivisions totaled $116,000 in 2012, $141,000 in 2011 and $200,000 in 2010. The Company purchases qualified state and political subdivision securities from local governmental units in order to assist local communities as well as for tax planning purposes. As the Company did not generate taxable income during 2012, 2011 and 2010, the Company was unable to take full advantage of the interest deductions provided by these securities during 2012, 2011 and 2010. It is expected that nontaxable income for federal income tax purposes from these securities will further decline in 2013.

Table 3 - Securities Available For Sale

($ 000s)

December 31,	~~2011~~2012					~~2010~~2011					~~2009~~2010
			% of					% of					% of
			Total					Total					Total
	Amount		Portfolio			Amount		Portfolio			Amount		Portfolio
U.S. Treasury	$	0		0.00	%	$	~~1,002~~0		10.0900	%	$	1,~~006~~002		01.7509	%
States and political subdivisions		32,~~117~~592		3.5828			3,~~997~~117		43.3658			93,~~641~~997		74.2336
Mortgage-backed securities		7972,~~762~~266		91.5330			8279,~~648~~762		9091.0053			~~118~~82,~~729~~648		8890.9900
Other bonds		0		0.00			200		0.0200			3720		0.0302
Equity securities		4,~~261~~292		45.8942			4,~~163~~261		4.5389			4,~~008~~163		34.0053
Total securities available-for-sale	$	8779,~~140~~150		100.00	%	$	9187,~~830~~140		100.00	%	$	~~133~~91,~~421~~830		100.00	%

SECURITIES

The Company maintains a securities portfolio to provide liquidity, meet pledging requirements, generate a reasonable rate of return, minimize the Bank’s tax liability through the purchase of municipal securities, and minimize risk. The relative amount of securities held in the investment portfolio is determined by the overall asset management plan for the year, long-term trends, tax considerations and earnings potential.

All securities of the Company at December 31, ~~2011~~2012 were classified as available for sale and the carrying values 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, adjust its capital position, alter its interest rate risk profile or make changes for income tax purposes.

The carrying value of the securities portfolio decreased $4.7 million to $87.1 million at year-end 2011 as compared with $91.8 million at year-end 2010 after decreasing $41.6 million from year-end 2009. In 2011 and 2010, the Company used the cash flows generated from maturities, calls and principal payments on securities as well as from securities sales for liquidity purposes and to reposition its balance sheet.32

Table ~~3 shows the Company’s various types~~ of ~~investments~~Contents and the percentage of each type compared to the total portfolio at the past three year-ends. The Company’s investment in mortgage-backed securities as a percentage of the total securities portfolio continued to grow in 2011, increasing to almost 92% of the portfolio as compared with 90% at year-end 2010 and 89% at year-end 2009.

The carrying value of the securities portfolio decreased $8.0 million to $79.1 million at year-end 2012 as compared with $87.1 million at year-end 2011 and $91.8 million at year-end 2010. During 2012, as well as in 2011 and 2010, the Company used the cash flows generated from maturities, calls and principal payments on securities for liquidity purposes and to reposition its balance sheet.

Table 3 shows the Company’s various types of investments and the percentage of each type compared to the total portfolio at the past three year-ends. The Company’s investment in mortgage-backed securities as a percentage of the total securities portfolio was 91 percent at year-end 2012 as compared with 92% at year-end 2011 and 90 percent at year-end 2010.

The Company holds mortgage-backed securities as the yield on this type of security is generally higher than yields on U.S. Treasury notes and on issues of U.S. government-sponsored entities. The mortgage-backed securities are generally low risk as they are either guaranteed by the U.S government or by U.S. government-sponsored entities.

Mortgage-backed securities are also preferred by the Company due to expected payment streams from the mortgages underlying this type of security which provide liquidity. Mortgage-backed securities decreased $7.4 million to $72.3 million at year-end 2012 from $79.7 million at year-end 2011 primarily from the payments received during the year. Although Table 4 shows that the contractual maturities of the mortgage-backed securities are primarily greater than 10 years, the expected average life of these securities at year-end ~~2011~~2012 is approximately 43 years. Mortgage-backed securities are expected to be paid back sooner than their contractual maturity as the mortgages underlying these securities will be reduced due to regular payments, sales of the homes securing the loans and refinancing. At year-end ~~2011~~2012, interest rates remain at historic lows and, if interest rates should increase, the Company may reinvest payments received on these securities to purchase higher yielding interest earning assets.

27In 2011, the Company sold securities for capital management purposes and recognized gains of $527,000 which increased the capital at the Bank and Company. During 2011, the Company sold other bonds consisting of Collateralized Debt Obligations (“CDOs”) and equity securities consisting of Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”) preferred stock that had previously been totally written off and recognized a gain of $250,000 on the bonds and $142,000 on the equity securities. In 2011, the Company also sold $19.6 million of its mortgage-backed securities for $19.7 million at a gain of $135,000 and purchased $19.8 million of other mortgage-backed securities diversifying the underlying collateral of the Company’s mortgage-backed securities portfolio. During 2010, the Company received proceeds of $105.7 million and recognized gains of $2.4 million from the sale of securities.

~~TABLE~~During OF2012, ~~CONTENTS~~the Company recognized no other than temporary impairment losses on its securities. During 2011, the Company recognized $163,000 of other than temporary impairment losses as it wrote down the remaining carrying value of its CDOs and FNMA and FHLMC preferred stock after recognizing $659,000 of impairment losses on these securities in 2010.

~~During~~The ~~2011, the~~ Company ~~also~~pledges ~~used its~~ securities ~~portfolio~~to ~~for~~secure ~~capital~~public ~~management purposes. During the quarter ended June 30~~deposits, ~~2011,~~repurchase ~~equity~~agreements ~~securities consisting of Federal National Mortgage Association (“FNMA”) preferred stock~~ and ~~Federal~~for ~~Home~~other ~~Loan~~purposes ~~Mortgage~~as ~~Corporation~~required ~~(“FHLMC”)~~or ~~preferred~~permitted ~~stock~~by ~~that~~law. ~~had~~At ~~previously~~December ~~been totally written off were sold with the Company recognizing a gain of $142~~31,~~000. During~~ ~~the third quarter of 2011~~2012, the Company ~~sold~~had $1953.6 million of its securities ~~for $19.7 million and recognized a gain of $135~~pledged,~~000. Other~~ ~~mortgage-backed~~or ~~securities were purchased totaling $19~~67.87 ~~million~~percent ~~diversifying the underlying collateral~~ of ~~the~~its ~~Company’s~~total ~~mortgage-backed~~ securities portfolio~~. During~~ ~~the quarter ended December 31, 2011, collateralized debt obligation securities (“CDOs”) classified~~ as ~~other~~compared ~~bonds that had previously been totally written off were sold~~ with ~~the Company recognizing a gain of~~ $~~250,000~~57. ~~The~~0 ~~effect~~million ofor ~~the~~65.5 ~~transactions~~percent ~~was that combined realized gains~~ of ~~$527,000~~its ~~increased~~securities ~~capital~~portfolio at ~~the~~year-end ~~Bank and Company~~2011.

~~During~~Holdings ~~2011,~~of ~~the~~securities ~~Company~~issued ~~recognized~~by ~~other~~states ~~than~~and ~~temporary~~political ~~impairment~~subdivisions ~~losses~~at ~~totaling~~year-end ~~$163~~2012,~~000~~ of which ~~$134,000~~were ~~was~~all ~~due~~federally totax-exempt, ~~additional~~decreased ~~impairment of its CDOs that the Company classified as other bonds and~~ $29525,000 ~~was due~~ to ~~additional~~$2.6 ~~impairment~~from of$3.1 ~~its~~million ~~equity~~at ~~securities~~year-end ~~consisting~~2011. ofAs ~~FNMA~~the ~~and~~Company ~~FHLMC~~lacked ~~preferred~~taxable ~~stock.~~income ~~These~~during ~~impairment~~2012, ~~amounts completely wrote down~~ the ~~remaining~~Company ~~carrying~~was ~~value~~unable onto ~~the~~take ~~CDOs~~full ~~and~~advantage ~~the combined value~~ of the ~~FNMA~~ ~~and~~interest ~~FHLMC~~deductions ~~equity~~provided ~~securities~~by ~~that~~tax-exempt ~~had~~securities ~~carrying~~issued ~~values~~by instates ~~2008,~~and ~~prior~~political tosubdivisions. ~~becoming~~As ~~impaired,~~a result of ~~$11.6~~the ~~million~~lack ~~and~~of ~~$2.1~~taxable ~~million~~income, ~~respectively. During 2011,~~ the ~~CDOs~~Company ~~were~~chose ~~sold~~to ~~for~~let ~~$250,000~~its ~~and~~investment ~~the~~in ~~FNMA~~these ~~and~~types ~~FHLMC~~of ~~preferred~~securities ~~stock~~decrease ~~were~~as ~~sold~~maturities ~~for~~occurred ~~$142,000~~during 2012.

The ~~Company~~maturity ~~pledges~~distribution ~~securities to secure public deposits, repurchase agreements~~ and ~~for~~average ~~other purposes as required or permitted by law. At December 31~~yields, ~~2011,~~on ~~the~~a ~~Company~~fully ~~had~~tax ~~$57.0~~equivalent ~~million of its securities pledged~~basis, ~~or 65.5%~~ of ~~its~~the ~~total~~ securities portfolio asat ~~compared~~December ~~with~~31, ~~$59.0~~2012 ~~million~~is orshown ~~64.2%~~in ofTable ~~its~~4, ~~securities~~“Securities ~~portfolio~~Maturity atSchedule ~~year-end~~& ~~2010~~Yields”.

Holdings of securities issued by states and political subdivisions, of which, at year-end 2011, are all federally tax-exempt, decreased $880,000 to $3.1 from $4.0 million at year-end 2010. 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. As the Company lacked taxable income during 2011, the Company was unable to take full advantage of the interest deductions provided by tax-exempt securities issued by states and political subdivisions. As a result of the lack of taxable income, the Company chose to let its investment in these types of securities decrease as maturities occurred during 2011.33

~~The~~Table ~~maturity distribution and average yields, on a fully tax equivalent basis,~~ of ~~the~~Contents ~~securities portfolio at December 31, 2011 is shown in Table 4, “Securities Maturity Schedule & Yields”.~~

Table 4 - Securities Maturity Schedule & Yields

( $ 000s)

						Greater than					Greater than
						1 yr. and less					5 yrs. and less
	Less than or					than or equal					than or equal					Greater than
Securities available for sale	equal to 1 yr.					to 5 yrs.					to 10 yrs.					10 yrs.					Totals
As of December 31, 2011	Balance		Yield			Balance		Yield			Balance		Yield			Balance		Yield			Balance		Yield
As of December 31, 2012	Balance		Yield			Balance		Yield			Balance		Yield			Balance		Yield			Balance		Yield
States and political subdivisions (1)	$	124		5.8138	%	$	~~525~~545		5.57	%	$	1,~~313~~400		6.4657	%	$	~~1,155~~523		6.2837	%	$	32,~~117~~592		6.1930	%
Mortgage-backed securities (2)		0		0.00			3125		8.00			0		0.00			7972,~~731~~241		2.6769			7972,~~762~~266		2.6769
Equity securities		4,~~261~~292		2.8923			0		0.00			0		0.00			0		0.00			4,~~261~~292		2.8923
Total	$	4,~~385~~416		2.9532	%	$	~~556~~570		5.7187	%	$	1,~~313~~400		6.4657	%	$	8072,~~886~~764		2.72	%	$	8779,~~140~~150		2.8179	%

(1) -

The yield is reflected on a fully tax equivalent basis utilizing a 34% tax rate.

(2) -

Mortgage-backed securities reflect the contractual maturity of the related instrument.

28Table 5 - -Loans and Lease Portfolio

~~TABLE~~( OF$ ~~CONTENTS~~000s)

Table 5 - Loan and Lease Portfolio

As of December 31,	2012			2011			2010			2009			2008

Commercial	$	13,120		$	15,827		$	20,927		$	31,685		$	54,529
Real estate-construction		21,128			28,504			29,776			39,006			57,707
Real estate-mortgage 1-4 family		32,417			35,758			41,228			43,803			47,289
Real estate-mortgage 5+ family		27,787			35,977			44,021			54,986			55,302
Real estate-mortgage commercial		159,729			183,881			223,546			232,634			234,765
Home equity		17,365			21,266			23,392			26,501			26,826
Leases		12			295			442			955			2,352
Installment		1,291			1,476			1,807			2,236			2,745
Total loans and leases		272,849			322,984			385,139			431,806			481,515
Deferred loan fees		(52	)		(271	)		(350	)		(520	)		(703	)
Loans and leases, net of unearned and deferred loan fees		272,797			322,713			384,789			431,286			480,812
Allowance for loan and lease losses		(20,727	)		(18,984	)		(18,336	)		(18,027	)		(10,402	)

Loans and leases, net	$	252,070		$	303,729		$	366,453		$	413,259		$	470,410

($ 000s)

As of December 31,	2011			2010			2009			2008			2007
Commercial	$	15,827		$	20,927		$	31,685		$	54,529		$	55,763
Real estate-construction		28,504			29,776			39,006			57,707			51,024
Real estate-mortgage 1-4 family		35,758			41,228			43,803			47,289			52,541
Real estate-mortgage 5+ family		35,977			44,021			54,986			55,302			53,159
Real estate-mortgage commercial		183,881			223,546			232,634			234,765			190,916
Home equity		21,266			23,392			26,501			26,826			24,604
Leases		295			442			955			2,352			4,723
Installment		1,476			1,807			2,236			2,745			3,435
Total loans and leases		322,984			385,139			431,806			481,515			436,165
Deferred loan fees		(271	)		(350	)		(520	)		(703	)		(431	)
Loans and leases, net of unearned and deferred loan fees		322,713			384,789			431,286			480,812			435,734
Allowance for loan and lease losses		(18,984	)		(18,336	)		(18,027	)		(10,402	)		(4,606	)
Loans and leases, net	$	303,729		$	366,453		$	413,259		$	470,410		$	431,128

Note:

The Company had no foreign loans outstanding at December 31, ~~2011~~2012.

TABLE OF CONTENTS

LOAN AND LEASE PORTFOLIO

The Company’s loan and lease portfolio is the largest interest earning asset of the Company. In ~~2011~~2012, the Company’s loans and leases provided $1815.50 million of interest income, 8887.63% of the interest income generated by the Company. In ~~2010~~2011, interest on loans and leases accounted for 8688.6% of interest income as compared with 8386.2%6 percent in ~~2009~~2010.

For purposes of this discussion, when loans are mentioned it should be understood to include leases unless specified otherwise. As shown in Table 5, “Loan and Lease Portfolio”, loans, net of unearned income and deferred loan fees at December 31, ~~2011~~2012 totaled $~~322~~272.78 million, decreasing $6249.19 million from year-end ~~2010~~2011. At December 31, ~~2010~~2011, loans, net of unearned income and deferred loan fees, totaled $~~384~~322.87 million and decreased $4662.51 million from December 31, ~~2009~~2010. The Company’s lending activities relate mainly to loans to small and mid-sized businesses in the Lake County, Illinois area and adjoining areas in the surrounding counties in northeastern Illinois and southeastern Wisconsin.

Poor economic conditions during 2011 led to lower general loan demand from commercial borrowers. Economic uncertainties, such as falling values of real estate used for collateral, have caused the Company to implement stricter underwriting policies. These factors contributed to the reductions in the Company’s loans during 2011. Also contributing were net loan charge-offs of $6.4 million of nonperforming loans during 2011 and the transfer of $9.6 million in loans into other real estate owned as properties securing nonperforming loans were obtained through, or in lieu of, foreclosure. These conditions are expected to continue in 2012 and the Company expects to see further declines in loan balances.34

AtTable ~~December 31, 2011, over 94%~~ of ~~the~~Contents Company’s loans were secured by real estate. Real estate-mortgage commercial loans are loans secured by properties that are primarily nonresidential properties and include office buildings, hotels, stores, restaurants, warehouses and other commercial purpose properties. Real estate-mortgage commercial loans decreased $39.6 million to $183.9 million at year-end 2011 compared with $223.5 million at year-end 2010 after decreasing $9.1 million as compared with year-end 2009. At year-end 2011, real estate-mortgage commercial loans accounted for 57% of the Company’s total loan portfolio. The Company’s real-estate mortgage commercial loans include hotel industry loans that totaled $47.0 million at year-end 2011 or 15% of total loans, decreasing by $21.5 million from $68.5 million or 18% of total loans at year-end 2010. The hotel industry loans decreased during 2011 as a large hotel loan relationship totaling $14.3 million paid off as it was refinanced by another financial institution.

~~The~~Sustained weakness in local economic conditions continued during 2012 and caused lower general loan demand from commercial borrowers. Economic uncertainties, such as falling values of real estate used for collateral, have caused the Company to implement stricter underwriting policies. These factors contributed to reductions in the Company’s loans ~~secured~~during by2012. ~~1–4~~Also ~~family~~contributing ~~homes~~were ~~declined~~net inloan ~~2011~~charge-offs byof $59.54 million ~~after~~during ~~decreasing~~2012 and the transfer of $24.68 million in ~~2010. The~~loans ~~majority~~into ofother real estate ~~mortgage~~owned ~~1–4~~as ~~family~~properties ~~loans~~securing ~~are~~nonperforming ~~for~~loans ~~commercial~~were ~~purposes~~obtained ~~where~~through, ~~residences~~or ~~are~~in ~~used~~lieu toof, ~~secure these loans~~foreclosure.

At December 31, 2012, 2011 and 2010, over 94 percent of the Company’s ~~had~~loans were secured by real estate. Real estate-mortgage commercial loans are loans secured by ~~residential~~properties ~~units~~that ofare 5primarily ornonresidential ~~more~~properties ~~families~~and ~~totaling~~include office buildings, hotels, stores, restaurants, warehouses and other commercial properties. These loans decreased $3624.02 million, ~~decreasing~~in 2012 to $8159.07 million ~~from~~at ~~December~~year-end ~~31,~~compared ~~2010~~with $183. ~~The~~9 ~~decline~~million ~~was~~at ~~attributable~~year-end to2011 after decreasing $339.16 million ofas compared with year-end 2010. At year-end 2012, these loans ~~being~~accounted ~~charged~~for ~~off~~over ~~and~~58 $6percent of the Company’s total loan portfolio.0 ~~million~~They ofinclude ~~these~~hotel industry loans that ~~were~~totaled ~~transferred~~$45.7 tomillion ~~other~~at ~~real~~year-end ~~estate~~2012 ~~owned~~or ~~during~~17 ~~2011. These~~percent of total loans, ~~had~~which decreased ~~during 2010~~ by $111.03 million asfrom $1047.40 million ofor ~~these~~15 ~~loans~~percent ~~were~~of ~~transferred~~total toloans ~~other~~at ~~real~~year-end ~~estate owned~~2011.

The Company’s ~~retail~~loans ~~lending~~secured ofby ~~combined~~1–4 ~~home~~family ~~equity~~homes ~~and installment loans~~ declined ~~by $2.5 million~~ in ~~2011~~2012 toby $223.73 million ~~compared~~ ~~with 2010~~ after decreasing $35.5 million ~~from~~in ~~2009~~2011. ~~Home~~ ~~equity~~The ~~loans,~~majority ~~a revolving line~~ of ~~credit~~real ~~with~~estate amortgage ~~variable interest rate tied to the prime lending rate totaled $21.3 million at year-end 2011 and, decreased $2.~~1–4 ~~million~~family ~~from~~loans ~~year-end~~are ~~2010. The~~for ~~2011~~commercial ~~and~~purposes ~~2010~~where ~~decreases~~residences ~~primarily~~are ~~resulted~~used ~~from~~as ~~borrowers paying down balances~~collateral.

~~The~~At December 31, 2012, the Company had ~~reductions~~loans secured by residential units of $5 or more families totaling $27.18 million, todecreasing ~~its~~$8.2 ~~commercial~~million ~~loans~~from ~~not~~December ~~secured~~31, by2011. ~~real~~During ~~estate.~~2012, ~~Year-end~~this ~~2011~~decline ~~balances~~was ofattributable ~~these~~to ~~loans were~~scheduled ~~$15.8~~loan ~~million~~payments asand ~~compared~~payoffs. ~~with~~These ~~year-end~~loans ~~2010~~decreased ~~balances~~during of2011 by $208.90 million ~~after~~as ~~declines of~~ $106.80 million inof ~~2010~~these ~~from~~loans ~~2009. The~~were ~~reduction~~transferred to ~~commercial~~other ~~loans~~real ~~came~~estate ~~primarily~~owned ~~from~~and ~~principal~~$3.1 ~~payments~~million were charged off.

~~Lower~~At general loan demand and stricter underwriting during 2011 and 2010 were not only reflected in decreased loan balances but also in decreased unfunded loan commitments and letters of credit at year-end 2011. The Company’s loan commitments totaled $32.2 million at December 31, ~~2011~~2012, ~~declining~~real ~~$4.3~~estate ~~million~~construction ~~from~~loans totaled $3621.51 million atas ~~December~~compared ~~31,~~with ~~2010 after declining~~ $2228.25 million ~~from~~and $5829.78 million at December 31, ~~2009. Standby~~2011 ~~letters~~and ~~of credit issued by the Company also decreased $927~~2010,~~000~~ ~~to $2~~respectively.3 ~~million~~It atis ~~year-end~~expected ~~2011~~that, ~~from~~unless ~~$3.2~~local ~~million~~economic atconditions ~~year-end~~improve, ~~2010~~these ~~after~~loans ~~declining~~will ~~$3.3~~continue ~~million~~to ~~from~~decrease ~~$6.5~~in ~~million at year-end 2009~~2013.

30At December 31, 2012, the Company’s retail lending of combined home equity and installment loans declined by $4.1 million in 2012 to $18.7 million after decreasing $2.5 million from 2010. Home equity loans, a revolving line of credit with a variable interest rate tied to the prime lending rate, totaled $17.4 million at year-end 2012 and decreased $3.9 million from year-end 2011.

~~TABLE~~The OFCompany ~~CONTENTS~~had reductions of $2.7 million in its commercial loans not secured by real estate. Year-end 2012 balances of these loans were $13.1 million as compared with year-end 2011 balances of $15.8 million and year-end 2010 balances of $20.9 million. The reduction to commercial loans came primarily from principal payments.

AtLower ~~December~~general ~~31,~~loan ~~2011,~~demand ~~the~~and ~~Company~~stricter ~~had~~underwriting ~~loans~~during ~~totaling~~2012 ~~$238,000~~and to2011 ~~related~~were ~~parties. Related~~not ~~parties~~only ~~are~~reflected ~~directors~~in ~~and~~decreased ~~officers,~~loan ~~including~~balances ~~their~~but ~~related~~also ~~interests,~~in ofdecreased ~~the~~unfunded loan commitments at year-end 2012. The Company’s orloan ~~its~~commitments ~~subsidiaries~~totaled $28. ~~Commitments~~6 ~~for~~million ~~loans~~at toDecember ~~related~~31, ~~parties~~2012, declining $3.6 million from $32.2 million at ~~year-end~~December 31, 2011 ~~totaled~~after declining $~~247~~4.3 million from $36.5 million at December 31,~~000~~ 2010. ~~Loans~~ ~~and~~Standby ~~commitments~~letters ~~are~~of ~~made~~credit issued by the Company decreased to ~~related~~$1.1 ~~parties~~million at ~~the~~year-end ~~same~~2012 ~~terms~~from ~~and~~$2.3 ~~conditions~~million ~~that~~at ~~are~~year-end ~~available~~2011 toafter ~~the~~declining ~~public~~from $3.2 million at year-end 2010.

~~MATURITY~~At OFDecember ~~LOANS~~31, 2012, the Company had loans totaling $110,000 to related parties. Related parties are directors and officers, including their related interests, of the Company or its subsidiaries. Commitments for loans to related parties at year-end 2012 totaled $99,000. Loans and commitments are made to related parties at the same terms and conditions that are available to the public.

~~Table 6, “Loan Maturity Schedule”, highlights the maturity distribution of the Company's commercial and real estate-construction loan portfolio at year-end 2011.~~35

Table ~~6, shows $8.6 million in construction loans maturing in greater than one year. Loans maturing in greater than one year are for commercial building projects and the construction phase~~ of ~~the~~Contents ~~projects are expected to be completed in less than two years. At that time, the loans will be reclassified as real estate-mortgage commercial loans.~~

~~The~~Table ~~short-term~~6 ~~rate sensitivity of the commercial and real estate~~-~~construction~~ ~~loan~~Loan ~~portfolio~~Maturity ~~to interest rate changes is reflected in the fact that approximately 60.7% of these loans are scheduled to mature within one year.~~ Schedule

Table 6 - Loan Maturity Schedule
($ 000s) As of December 31, 2011	Less than or equal to 1 yr.			Greater Than 1 yr. and less than or equal to 5 yrs.			Greater than 5 yrs.			Totals
Commercial	$	6,981		$	5,790		$	3,056		$	15,827
Real estate-construction		19,907			8,597			0			28,504
Total	$	26,888		$	14,387		$	3,056		$	44,331
Percent of total		60.65	%		32.46	%		6.89	%		100.00	%

($ 000s)

Commercial and construction loans maturing after one year:

As of December 31, 2012	Less than or equal to 1 yr.			Greater than 1 yr. and less than or equal to 5 yrs.			Greater than 5 yrs.			Totals
Commercial	$	6,855		$	3,421		$	2,844		$	13,120
Real estate-construction		17,431			3,697			0			21,128
Total	$	24,286		$	7,118		$	2,844		$	34,248
Percent of total		70.91	%		20.78	%		8.31	%		100.00	%

Fixed Rate	$	14,699
Variable Rate		2,744
Total	$	17,443

Commercial and real estate-construction loans maturing after one year:

Fixed rate	$	7,624
Variable rate		2,338
Total	$	9,962

NONPERFORMING ASSETS

Nonperforming assets consist of nonperforming 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, nonperforming assets at year-end ~~2011~~2012 were $9185.04 million or 20.7% of total assets, decreasing $45.76 million from year-end ~~2010~~2011. During ~~2010~~2011, nonperforming assets ~~increased~~decreased by $344.97 million to $9591.70 million compared with December 31, ~~2009~~2010 levels of $6095.87 million.

Nonperforming loans are: (1) loans accounted for on a nonaccrual basis; (2) accruing loans that are well secured and in the process of collection that are contractually past due ninety days or more as to interest or principal payments; and (3) accruing loans classified as troubled debt restructurings (“TDRs”). Total nonperforming loans at December 31, ~~2011~~2012 were $7173.76 million, increasing $~~326,000~~1.9 million as compared with $71.47 million at December 31, ~~2010~~2011 after ~~increasing~~decreasing $~~29.8~~326,000 ~~million~~ from $4171.64 million at December 31, ~~2009~~2010. Nonperforming loans totaled 2231.20% of total loans at year-end ~~2011~~2012 as compared with 1822.62% of total loans at year-end ~~2010~~2011 as total loans declined during 2012. Although TDRs totaling $52.7 million at December 31, 2012 were considered nonperforming, these loans continue to make payments.

31Accrual of uncollectible income on problem loans inflates income and, if recognized in an untimely fashion, can have a dramatic negative impact on earnings. Any loan meeting one of the following criteria is placed on nonaccrual status and all related interest earned but not collected is reversed at this time:

TABLE OF CONTENTS

Nonaccrual loans and loans 90 days or more past due, still accruing totaled $20.0 million at year-end 2011 decreasing $7.3 million from $27.3 million at year-end 2010. Loans classified as TDRs totaled $51.7 million, a $7.6 million increase from $44.1 million at year-end 2010.

At December 31, 2011, the Company’s nonaccrual loans, loans where interest is no longer earned and where payments received are applied to the principal balance, totaled $19.5 million of which $18.9 million were secured by real estate. The Company had $4.4 million of real estate-construction loans on nonaccrual status at December 31, 2011. Nonaccrual loans secured by mortgages on 1-4 family residences totaled $1.7 million and mortgages on 5 or more family residences totaled $4.0 million. Loans secured by commercial properties on nonaccrual status at year-end 2011 totaled $8.8 million. There was also $548,000 in commercial loans included as nonaccrual loans at year-end 2011.

The Company’s four largest nonaccrual loan relationships at year-end 2011 totaled $14.5 million and accounted for over 70% of the Company’s nonaccrual loans.

A loan relationship secured by commercial real estate totaling $6.8 million at December 31, 2011 was placed on nonaccrual status in 2011 due to inadequate cash flows. The Company is working with the borrower and the Company has allocated $2.9 million of its allowance for loan and lease losses at year-end 2011 to this loan relationship.

Loans totaling $3.9 million, classified as real estate-mortgage 5+ family, secured by condominium buildings were placed on nonaccrual status during 2010 as the borrower experienced cash flow difficulties due to lack of sales. The borrower has been renting the condominium units and the cash flow situation has improved and stabilized. Due to sufficient collateral, there was no allocation of the Company’s allowance for loan and lease losses at year-end 2011 to this loan relationship.

A real estate construction loan of $2.5 million used for the development of lots for residential homes was placed on nonaccrual status during 2009 due to lack of sales. The Company has allocated $1.2 million of its allowance for loan and lease losses at year-end 2011 to this loan relationship.

A $1.2 million real estate construction loan secured by vacant properties was placed on nonaccrual status in 2011. The Company has allocated $84,000 of its allowance for loan and lease losses at year-end 2011 to this loan.

Accrual of uncollectible income on problem loans inflates income and, if recognized in an untimely fashion, can have a dramatic negative impact on earnings. Any loan meeting one of the following criteria is placed on nonaccrual status and all related interest earned but not collected is reversed at that time:

The loan is maintained on a cash basis because of deterioration in the financial condition of the borrower.

The borrower is in bankruptcy and the exposure is not both well secured and in the process of collection.

Full payment of principal or interest is not expected.

The loan has been in default for a period of ninety (90) days or more unless the asset is both well secured and in the process of collection.

Loans meeting any of the criteria above may be exempted from this policy if unanimously agreed upon and duly documented by the Directors Loan Committee. In general, all accrued ~~and earned but not collected~~ interest on an exposure placed on nonaccrual status is charged-off to income. A loan may be returned to accrual status ~~when~~if atthe ~~least~~borrower ~~six~~demonstrates ~~(6)~~repayment ~~months~~performance offor ~~timely~~a ~~payments~~reasonable ~~have~~period ~~been~~prior ~~received~~to the date the loan is returned to accrual status and there is evidence to support ~~the~~that payments will continue. A reasonable period of repayment performance would be a period of at least six months, but may be less depending on the particular circumstances.

~~The Company is attempting to work with nonaccrual borrowers to resolve the issues, but in many cases the Company may have to foreclose on the properties securing these loans.~~36

AtTable December 31, 2011, the Company had $490,000 in nonperforming loans that were 90 days past due and still accruing interest as compared with $1.1 million at year-end 2010 and $30,000 at year-end 2009. These loans were fully secured and in the process of ~~collection.~~Contents

~~Impaired loans at December 31, 2011 totaled $71.2 million as compared with $80.6 million at year-end 2010 and $56.3 million at year-end 2009.~~ The Company ~~considers a loan impaired if it~~ is ~~probable~~attempting ~~that~~to ~~full~~work ~~principal~~with ~~and~~nonaccrual ~~interest~~borrowers ~~will~~to ~~not~~resolve ~~be collected within~~ the ~~contractual~~issues, ~~terms~~but ofin ~~the~~many ~~original~~cases ~~note. Impaired loans and leases are carried at~~ the ~~present~~Company ~~value~~may ofhave ~~expected~~to ~~cash~~foreclose ~~flows~~on ~~discounted at~~ the ~~loan's~~properties ~~effective~~securing ~~interest~~loans ~~rate or at the fair value of the collateral~~ if the ~~loan is collateral dependent. Both nonaccrual and TDR~~ loans are ~~considered~~secured ~~impaired. Although~~by atreal ~~year-end 2011 all impaired loans consisted of nonperforming loans, at year-end 2010, the Company had a total of $10~~estate.~~3 million of performing loans which based on management’s analysis of the borrower's financial condition and estimated future cash flows were reported as impaired loans.~~

32At December 31, 2012, the Company’s nonaccrual loans, loans where interest is no longer earned and where payments received are applied to the principal balance, totaled $19.0 million primarily secured by real estate. Nonaccrual loans secured by commercial properties total $16.6 million at year-end 2012.

~~TABLE~~The OFCompany’s ~~CONTENTS~~three largest nonaccrual loan relationships at year-end 2012 totaled $13.9 million and accounted for over 75% of the Company’s nonaccrual loans.

Loans ~~classified~~totaling ~~as TDRs are included as impaired loans~~$7. ~~Restructuring~~3 ofmillion ~~loans~~secured isby ~~undertaken~~commercial toreal ~~improve~~estate ~~the~~consisting ~~likelihood~~of ~~that~~office ~~the~~space/industrial ~~loan~~park ~~will~~units bewere ~~repaid~~placed inon ~~full~~nonaccrual ~~under~~status ~~the~~during ~~modified~~2012 ~~terms in accordance with a reasonable repayment schedule. All restructured loans are evaluated to determine whether the loans should be reported~~ as ~~a TDR. A loan is a TDR when~~ the ~~Company,~~borrower ~~for~~experienced ~~economic~~cash orflow ~~legal reasons related to the borrower’s financial~~ difficulties, ~~grants~~due ~~a concession~~ to ~~the borrower by modifying or renewing a loan that the Company would not otherwise consider~~vacancies. To ~~make~~The ~~this determination the Bank must determine whether (a) the borrower is experiencing financial difficulties and (b) the~~ Company ~~granted~~has ~~the~~allocated ~~borrower~~$874,000 ~~a concession. This determination requires consideration~~ of ~~all~~its ofallowance ~~the~~for ~~facts~~loan and ~~circumstances~~lease ~~surrounding~~losses ~~the~~to ~~modification. An~~this ~~overall~~loan ~~general~~relationship ~~decline~~and inis ~~the economy or some deterioration~~ in ~~a borrower’s financial condition does not automatically mean~~ the ~~borrower~~process isof ~~experiencing financial difficulties~~foreclosure.

~~Some~~A ofloan ~~the~~relationship ~~factors~~secured ~~reviewed~~by tocommercial ~~determine~~real ~~whether~~estate ~~the~~totaling ~~borrower~~$3.8 ismillion ~~experiencing~~has ~~financial~~been ~~difficulties~~on ~~are:~~nonaccrual 1)status issince ~~the~~2011 ~~borrower~~due ~~currently~~to ininadequate ~~default~~cash onflows. ~~any~~The ofCompany ~~its~~is ~~debts;~~working 2)with ~~has~~ the borrower ~~declared~~and orhas innot ~~the~~foreclosed ~~process~~due ofto ~~declaring~~the ~~bankruptcy;~~current ormarketability 3)of ~~absent~~ the ~~current~~property ~~modification,~~and ~~would~~ the borrower’s ~~more~~continued ~~than~~upkeep ~~likely~~of ~~default~~the property. ~~Factors~~The ~~to consider in determining whether the~~ Company has ~~granted~~allocated ~~a concession include: lowering the interest rate~~$456,000 ~~extending~~of ~~the~~its ~~maturity~~allowance ~~date,~~for ~~forgiving~~loan ~~debt,~~and ~~reducing~~lease ~~accrued~~losses ~~interest~~at oryear-end ~~changing~~2012 ~~the payment~~ to ~~interest~~this ~~only~~loan ~~for an extended period of time~~relationship.

~~For~~A ~~regulatory~~$2.7 ~~purposes,~~million ~~a restructured~~ loan ~~classified~~secured asby acommercial ~~TDR~~real ~~need~~estate ~~not~~consisting ~~continue~~of toa bemotel ~~reported~~and asone ~~such~~additional inproperty ~~calendar~~was ~~years~~placed ~~after~~on ~~the~~nonaccrual ~~year~~status induring ~~which~~2012 ~~the~~due ~~restructuring~~to ~~took~~cash ~~place~~flow ifdifficulties. ~~the~~The ~~loan~~Company ~~yields a market rate and~~ is inworking ~~compliance~~ with the ~~loan’s modified terms~~borrower. In ~~determining~~As ~~whether~~ the ~~rate~~value isof ~~a market rate~~ the ~~Company~~underlying ~~considers~~collateral ~~the~~is ~~riskiness~~greater ofthan the ~~transaction, the structure of the~~ loan, ~~the borrower’s financial condition~~balance, ~~financial support of~~ the ~~guarantor and protection provided by the collateral. The~~ Company ~~also~~has ~~considers~~made ~~rates~~no ~~given~~allocation toof ~~other~~its ~~borrowers~~allowance for ~~similar loans as well as what competitors are offering. To be in compliance with the modified~~ loan ~~terms~~and ~~the~~lease ~~borrower~~losses ~~should demonstrate the ability to repay under the modified terms for a period of~~ at ~~least~~year-end ~~six~~2012 ~~months and evidence~~ to ~~support~~this ~~that~~loan ~~payments will continue~~relationship.

At December 31, ~~2011~~2012, the Company had $511.79 million ofin ~~TDR~~nonperforming loans that were 90 days past due and still accruing interest as compared with $~~44.1~~490,000 ~~million~~ at year-end ~~2010~~2011 and ~~none~~$1.1 million at year-end ~~2009~~2010. ~~This~~ ~~increase~~These isloans ~~indicative~~were offully ~~the~~secured ~~poor~~and ~~economic~~in ~~conditions~~the ~~which~~process ~~have~~of ~~caused~~collection. ~~cash~~The ~~flow~~largest ~~difficulties~~90 ~~for~~days ~~many~~past ~~borrowers. Of~~due ~~these~~and ~~TDR~~still ~~loans~~accruing loan at December 31, ~~2011,~~2012 was a $451.34 million orcommercial ~~over~~mortgage ~~87%~~loan on a hotel in which the Company owns a portion of the total loan. The borrower was seeking to renew the loan and at year-end the participating banks were ~~secured~~in bydiscussions ~~commercial~~with ~~real~~the ~~estate~~borrower.

~~The~~Loans ~~largest~~classified ~~concentration~~as TDRs are considered nonperforming loans as principal and interest will not be collected within the contractual terms of ~~TDRs~~the atoriginal ~~December~~note. ~~31,~~Restructuring ~~2011~~of ~~were~~loans is undertaken to ~~hotels~~improve ~~totaling~~the ~~$33.8~~likelihood ~~million~~that orthe ~~almost~~loan ~~65%~~will ofbe ~~total~~repaid ~~TDRs~~in asfull ~~compared~~under the modified terms in accordance with ~~$28~~a reasonable repayment schedule.2 ~~million~~All atrestructured ~~December~~loans ~~31,~~are ~~2010. The~~evaluated ~~Company~~to ~~entered~~determine ~~into~~whether the loans should be reported as a TDR. A loan ~~modification~~is ~~agreements~~a ~~with~~TDR ~~these~~when ~~borrowers~~the asCompany, for economic or legal reasons related to the ~~hotels~~borrower’s ~~were~~financial ~~affected~~difficulties, grants a concession to the borrower by ~~lower~~modifying ~~occupancy~~or ~~rates~~renewing a loan that ~~negatively~~the ~~impacted~~Company ~~cash~~would ~~flows~~not otherwise consider. At ~~year-end~~To ~~2011,~~make ~~hotel~~this ~~TDRs~~determination ~~were~~the inCompany ~~compliance~~must ~~with~~determine ~~their~~whether ~~modified~~(a) ~~payment~~the ~~schedules.~~borrower ~~The~~is experiencing financial difficulties and (b) the Company ~~has~~granted ~~allocated~~the $5borrower a concession.1 ~~million~~This determination requires consideration of ~~its~~all ~~allowance~~of ~~for~~the ~~loan~~facts and ~~lease~~circumstances ~~losses~~surrounding atthe ~~year-end~~modification. ~~2011~~An tooverall ~~these~~general ~~TDRs~~decline asin ~~compared~~the ~~with~~economy ~~$4.1~~or ~~million~~some atdeterioration ~~year-end~~in ~~2010~~a borrower’s financial condition does not automatically mean the borrower is experiencing financial difficulties.

~~Management~~Some ~~continues~~of the factors reviewed to ~~emphasize~~determine whether the ~~early~~borrower ~~identification~~is ofexperiencing ~~loan-related~~financial ~~problems~~difficulties ~~and~~are: ~~remains~~1) ~~aggressive~~is inthe ~~pursuing~~borrower ~~resolution~~currently ~~strategies. The~~in ~~Company~~default ~~has~~on ~~adopted~~any aof ~~more~~its ~~stringent~~debts; ~~and~~2) ~~disciplined~~has ~~loan~~the ~~underwriting~~borrower ~~policy~~declared or is in ~~regards~~the toprocess ~~relationship~~of ~~size~~declaring ~~and~~bankruptcy; ~~out~~or of3) ~~market~~absent ~~credits. Management~~the iscurrent ~~not~~modification, ~~currently~~would ~~aware~~the ofborrower ~~any~~more ~~other~~than ~~significant~~likely ~~loan,~~default. ~~group~~Factors ofto ~~loans,~~consider orin ~~segment~~determining ofwhether the ~~loan~~Company ~~portfolio~~has ~~not~~granted ~~included~~a inconcession ~~the~~include: ~~discussion~~lowering ~~above~~the asinterest torate, ~~which~~extending ~~there~~the ~~are~~maturity ~~serious~~date, ~~doubts~~forgiving asdebt, toreducing ~~the~~accrued ~~ability~~interest ofor changing the ~~borrower(s)~~payment to ~~comply~~interest ~~with~~only ~~the~~for ~~present~~an ~~loan~~extended ~~payment~~period ~~terms~~of time.

~~Another~~For ~~component~~regulatory ofpurposes, ~~nonperforming~~a ~~assets~~restructured isloan ~~other~~classified ~~real~~as ~~estate~~a ~~owned,~~TDR ~~consisting~~need ofnot ~~assets~~continue ~~acquired~~to ~~through~~be ~~loan~~reported ~~foreclosure~~as orsuch ~~deeds~~in ~~received~~calendar years after the year in ~~lieu~~which ofthe ~~foreclosure. At~~restructuring ~~December~~took ~~31,~~place ~~2011,~~if ~~other~~the ~~real~~loan ~~estate~~yields ~~owned~~a ~~totaled~~market ~~$19.3~~rate ~~million~~and asis ~~compared~~in compliance with ~~$24~~the loan’s modified terms.3 ~~million~~In atdetermining ~~December~~whether 31the rate is a market rate the Company considers the riskiness of the transaction, ~~2010~~the ~~and~~structure ~~$19.2~~of ~~million~~the atloan, ~~December~~the 31borrower’s financial condition, ~~2009~~financial support of the guarantor and protection provided by the collateral. The ~~fair~~Company ~~value~~also ofconsiders rates given to other ~~real~~borrowers ~~estate~~for ~~owned~~similar isloans ~~reviewed~~as bywell ~~management~~as atwhat ~~least~~competitors ~~quarterly~~are tooffering. ~~help~~To ~~ensure~~be in compliance with the ~~reasonableness~~modified ofloan ~~its~~terms ~~carrying~~the ~~value,~~borrower ~~which~~should isnormally ~~lower~~demonstrate ofthe ~~cost~~ability orto repay under the ~~fair~~modified ~~value~~terms ~~less~~for ~~estimated~~a ~~selling~~period ~~costs~~of at least six months and provide evidence to support that payments will continue.

The Company’s total other real estate owned decreased $5.0 million during 2011, to $19.3 million at year-end 2011 as properties were sold for net proceeds of $10.6 million and gains of $17,000 recognized on the sales. Write-downs to other real estate of $4.0 million were also recognized during 2011 due to decreases in real estate values which contributed to the total decrease to other real estate owned. Offsetting a portion of these decreases was $9.6 million in loans transferred into other real estate owned during 2011.37

AtTable ~~year-end 2011, the Company’s other real estate owned consisted~~ of ~~$2.2~~Contents million of vacant land, $1.8 million of 1-4 family residential properties, $6.6 million of 5+ family residences and $8.7 million of commercial real estate properties. The Company is actively seeking to sell these properties.

33At December 31, 2012, the Company had $52.7 million of TDR loans still accruing as compared with $51.7 million at year-end 2011 and $44.1 million at year-end 2010. Poor economic conditions over the past three years have caused cash flow difficulties for many borrowers. The TDR loans at December 31, 2012, were primarily secured by real estate.

~~TABLE~~The OFlargest ~~CONTENTS~~concentration of TDRs at December 31, 2012 were to hotels totaling $19.9 million at December 31, 2012 or nearly 38 percent of total TDRs as compared with $33.8 million at December 31, 2011 and $28.2 million at December 31, 2010. The Company entered into loan modification agreements with these borrowers as the hotels were affected by lower occupancy rates that negatively impacted cash flows. At year-end 2012, all hotel TDRs were in compliance with their modified payment schedules. The Company has allocated $6.1 million of its allowance for loan and lease losses to the hotel TDRs as compared with $5.1 million at year-end 2011 and $4.1 million at year-end 2010.

At December 31, 2012, the Company also has a concentration of TDRs consisting of real estate-construction loans totaling $14.1 million as compared with $2.4 million at December 31, 2011. These TDR real estate-construction loans account for 27 percent of total TDRs at year-end 2012. At year-end 2012, these TDRs were in compliance with their modified payment schedules. The Company has allocated $3.3 million of its allowance for loan and lease losses to these TDRs.

Another way of classifying nonperforming loans is as impaired loans. The Company considers a loan impaired if full principal and interest is not expected to be collected within the contractual terms of the original note. 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 is collateral dependent. Both nonaccrual and TDR loans are considered impaired. At December 31, 2012, impaired loans totaled $71.9 million as compared with $71.2 million at year-end 2011 and $80.6 million at year-end 2010.

Management continues to emphasize the early identification of loan-related problems and remains aggressive in pursuing resolution strategies. The Company has adopted a more stringent and disciplined loan underwriting policy in regards to relationship size and out of market credits. The Company continues to be an active lender for its current customers as well as other qualifying prospective loan customers. 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.

Another component of nonperforming assets is other real estate owned, consisting of assets acquired through loan foreclosure or deeds received in lieu of foreclosure. At December 31, 2012, other real estate owned totaled $11.7 million decreasing $7.6 million from $19.3 million at December 31, 2011. 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.

The Company’s total other real estate owned decreased $7.6 million during 2012, to $11.7 million at year-end, as proceeds of $7.3 million from sales of properties were received with net losses of $247,00. Write-downs to other real estate of $4.9 million were also recognized during 2012 due to decreases in real estate values. Offsetting these decreases was $4.8 million in loans transferred into other real estate owned during 2012.

At year-end 2012, the Company’s other real estate owned consisted of $3.4 million of vacant land, $1.4 million of 1-4 family residential properties, $1.0 million of 5+ family residences and $5.9 million of commercial real estate properties. The Company is actively seeking to sell these properties.

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Table 7 - Nonperforming Assets

($ 000s)

December 31,

~~2011~~2012

~~2010~~2011

~~2009~~2010

~~2008~~2009

~~2007~~2008

Loans and leases:

Nonaccrual status

1918,~~460~~985

2619,~~129~~460

4126,~~589~~129

3641,~~624~~589

1036,~~752~~624

90 days or more past due, still accruing

~~490~~1,931

~~1,141~~490

301,141

~~442~~30

~~1,230~~442

Troubled debt restructurings

5152,~~738~~708

4451,~~092~~738

044,092

Total nonperforming loans and leases

7173,~~688~~624

71,~~362~~688

4171,~~619~~362

3741,~~066~~619

1137,~~982~~066

Other real estate owned

1911,~~342~~744

2419,~~326~~342

1924,~~198~~326

1019,~~575~~198

210,~~857~~575

Total nonperforming assets

9185,~~030~~368

9591,~~688~~030

6095,~~817~~688

4760,~~641~~817

1447,~~839~~641

Nonperforming loans and leases as a percentage of total loans and leases, net of unearned income and deferred loan fees

2226.2198

1822.5521

918.6555

79.7165

27.7571

Nonperforming assets as a percentage of total assets

1920.66

1819.0066

918.7700

79.4477

27.3344

Nonperforming loans and leases as a percentage of the allowance for loan and lease losses

~~377~~355.6221

~~389~~377.1962

~~230~~389.8719

~~356~~230.3487

~~260~~356.1434

Notes:

Loans and leases are placed in nonaccrual status when they are 90 days past due, unless they are ~~well~~fully secured and in the process of collection.

Impaired Loans - At December 31, 2012, 2011, 2010, 2009, ~~2008,~~ and ~~2007~~2008, impaired loans totaled $71,~~198~~854,000, $8071,~~552~~198,000, $5680,~~254~~552,000, $4356,~~756~~254,000, and $1043,~~742~~756,000, respectively, and ~~included~~include nonaccrual and trouble debt restructured loans.

Table of Contents

PROVISION TO THE ALLOWANCE FOR LOAN AND LEASE LOSSES

During ~~2011~~2012, the Company had a provision to the allowance for loan and lease losses (“ALLL”) of $611.91 million, aan ~~decrease~~increase of $24.82 million from $96.79 million during ~~2010~~2011 which decreased from $229.87 million in ~~2009~~2010. The provision for ~~2011~~2012 ~~decreased~~increased due to the ~~stabilization~~continued ofweakness ~~nonperforming~~in real estate values on properties securing impaired loans, ~~decreases~~as towell as increases in the ~~total~~amount ~~loan~~of ~~portfolio~~impaired loans. The ALLL totaled $20.7 million at year-end 2012 as compared with $19.0 million at year-end 2011 and ~~decreases~~$18.3 tomillion ~~impaired~~at ~~loans~~year-end 2010. The ALLL to total loans at year-end ~~2011~~2012 was 57.96% as compared with 45.89% at year-end ~~2010~~2011 and 4.28% at year-end ~~2009~~2010.

The ALLL is a valuation allowance for probable incurred credit losses, increased by the provision for loan and lease losses and decreased by charge-offs net of recoveries. The ALLL represents one of the most significant estimates in the ~~Company~~Bank’s financial ~~statements~~condition. Accordingly, the ~~Company~~Bank endeavors to provide a comprehensive and systematic approach for determining management’s current judgment about the credit quality of the loan portfolio.

At the end of each quarter, or more frequently if warranted, the ~~Company~~Bank analyzes its loan portfolio to determine the level of ALLL needed to be maintained. ~~This~~ Management believes this analysis results in a prudent, conservative ALLL that falls within an acceptable range of estimated credit losses. The ALLL covers estimated credit losses on individually evaluated loans that are determined to be impaired as well as estimated credit losses inherent in the remainder of the loan portfolio.

34Senior management and other lenders review all Watch and Substandard credits to determine if a loan is impaired. A loan is considered impaired if it is probable that full principal and interest will not be collected within the contractual terms of the original note. For loans that are individually evaluated and determined to be impaired, the Bank calculates the amount of impairment based on whether repayment of the loan is dependent on operating cash flow or on the underlying collateral. The decision of which method to use is determined by looking at a number of factors, including the size of the loan and other available information. If the loan is to be repaid primarily from the operating cash flow from the borrower, the impairment analysis calculates the present value of the expected future cash flows discounted at the loan’s effective interest rate and compares the result to the recorded investment. Collateral-dependent loans are measured against the fair value of the collateral less the costs to sell.

~~TABLE~~Management OFfurther ~~CONTENTS~~segregates a component of loans considered to be “high risk” but lacking sufficient weakness to be considered impaired. These loans are assigned a specific percentage allocation, adjusted by environmental and qualitative factors management believes may affect the repayment of these loans.

~~Senior~~The ~~management~~remaining ~~and other lenders review all Watch, Substandard and Nonaccrual credits to determine if a~~ loan portfolio is ~~impaired. For~~segmented ~~loans~~into ~~that~~groups ~~are individually evaluated and determined to be impaired, the Company calculates the amount of impairment~~ based on ~~whether repayment of the~~ loan istypes ~~dependent~~having onsimilar ~~operating~~risk ~~cash flow or on the underlying collateral~~characteristics. ~~The~~ ~~decision~~Estimated ofloan ~~which~~losses ~~method~~for tothese ~~use~~groups isare determined byusing ~~looking~~historical atloss aexperience ~~number~~and ofadjusted ~~factors,~~for ~~primarily~~other ~~the~~environmental ~~source~~and ofqualitative ~~repayment. If~~factors the ~~loan~~Bank isdeems tosignificant bethat ~~repaid~~would ~~primarily~~likely ~~from~~cause ~~the~~estimated ~~operating~~credit ~~cash~~losses ~~flow~~to differ from the ~~borrower, the impairment analysis calculates the present value of the expected future cash flows discounted at the loan~~group’s ~~effective~~historical ~~interest~~loss ~~rate and compares the result to the recorded investment~~experience. ~~Collateral-dependent loans are measured against the fair value of the collateral less the costs to sell.~~

~~During~~Allocations ~~2011,~~of ~~management further refined its methodology for calculating~~ the ~~amount in the~~ ALLL bymay ~~segregating~~be amade ~~component~~for ofspecific loans ~~considered~~and toleases, ~~be “high risk”~~ but ~~lack~~the ~~sufficient~~entire ~~weakness~~allowance tois beavailable ~~considered~~for ~~impaired. These~~any ~~loans~~loan ~~are~~or ~~assigned~~lease athat, ~~specific~~in ~~percentage~~management’s ~~allocation~~judgment, ~~adjusted~~should bybe ~~environmental~~charged-off. Loan and ~~qualitative~~lease ~~factors~~losses ~~management~~are ~~believes~~charged ~~may~~against ~~affect~~ the ~~repayment~~allowance ofwhen ~~these~~management ~~loans. The~~believes ~~impact to~~ the ~~ALLL~~uncollectibility ~~for the creation~~ of ~~this~~a ~~additional~~loan ~~pool~~or oflease ~~loans~~balance ~~was~~is ~~not significant at December 31, 2011~~confirmed.

~~The~~It ~~remaining~~is ~~unimpaired~~the ~~loans~~Company’s ~~not~~policy ~~considered~~to ~~high~~administer ~~risk~~and ~~performing~~pursue ~~loans~~charged-off ~~are~~borrowers ~~segmented~~with ~~into~~the ~~groups~~same ~~based~~diligence onas ~~loan~~other ~~types having similar risk characteristics~~loans. ~~Estimated~~ ~~loan~~Charging ~~losses~~off ~~for~~an ~~these~~exposure ~~groups~~is ~~are determined using~~ an ~~average two~~accounting ~~year~~entry ~~historical loss experience for 2011~~ and ~~2010. This~~does ~~differed~~not ~~from~~affect the ~~one~~ ~~year~~borrower’s ~~historical~~obligation ~~loss~~to ~~experience~~repay ~~used~~the ~~in 2009~~indebtedness. ~~The~~ ~~estimated~~Administration ~~loan~~of ~~losses~~charged-off ~~for~~exposure ~~these~~is ~~groups~~governed ~~are~~by ~~then~~maximization ~~adjusted~~of ~~for~~recoveries, ~~other~~and ~~environmental~~borrowers ~~and~~will ~~qualitative~~be ~~factors~~pursued until, in the ~~Company~~opinion ~~deems~~of ~~significant~~management, ~~which~~future ~~may~~costs ~~affect~~of ~~the~~collection ~~repayment~~exceed ofprobable ~~the~~future ~~loans~~recoveries.

~~Each~~As shown in Table 8, “Analysis of the ~~environmental~~Allowance for Loan and ~~qualitative~~Lease ~~factors~~Losses”, isduring ~~assigned~~2012 athere ~~“high”~~were ornet ~~“low”~~charge-offs ~~risk~~of ~~factor~~$9. ~~This~~4 ~~determination~~million iscompared ~~made~~with by$6.3 ~~senior~~million ~~management~~in ~~based~~2011 onand ~~their~~$9.4 ~~judgment~~million ofin ~~the~~2010. ~~factor’s~~Table ~~overall~~8 ~~impact~~also onindicates the ~~historical~~types ~~loss~~of ~~experience. An~~loans ~~adjustment~~charged-off ~~factor~~and isrecovered ~~then~~for ~~chosen~~the five years from a2008 ~~predetermined~~through ~~range~~2012 ~~based~~as onwell ~~whether~~as each year’s provision. The table shows that the ~~trend~~largest isloan ~~improving,~~charge-offs ~~stable,~~during ~~moderating~~those oryears ~~weakening~~were in 2009.

The Company’s allocation of the ALLL ~~required~~to ~~under~~the ~~each~~various ~~scenario~~loan segments is ~~then~~illustrated ~~summarized~~in Table 9. The allocations of the ALLL to ~~determine~~real ifestate ~~provisions~~construction ~~are~~and ~~needed~~real estate commercial loans at year-end 2012 totaled $16.2 million or 77.9% of the total ALLL.

~~As shown in Table 8, “Analysis of the Allowance for Loan and Lease Losses”, during 2011 there were net charge-offs of $6.3 million compared with $9.4 million in 2010 and $15.2 million in 2009.~~40

~~When~~Table there exists a serious doubt as to the borrower’s ability to fully repay principal or interest, the probable loss is promptly assessed and charged against the ALLL. It is the Bank’s policy to administer and pursue charged-off borrowers with the same diligence as other loans. Charging off an exposure is an accounting entry and does not affect the borrower’s obligation to repay the indebtedness. Administration of ~~charged-off~~Contents ~~exposure is governed by maximization of recoveries, and borrowers will be pursued until, in the opinion of management, future costs of collection exceed probable future recoveries.~~

Table 8 also indicates the types of loans charged-off and recovered for the five years from 2007 through 2011 as well as each year's provision. The table shows that the largest loan charge-offs during those years were in 2009.

The Company's allocation of the ALLL is illustrated in Table 9 and shows that the ALLL allocated to real estate-mortgage commercial loans has been approximately at $12.0 million for year-ends 2011, 2010 and 2009. Table 9 shows $3.1 million allocated to real estate-construction loans at year-end 2011 as compared with $2.8 million at year-end 2010. The allocation for commercial loans at year-end 2011 totaled $792,000 as compared with $1.0 million at year-end 2010. The allocation for real estate-mortgage 5+ family loans at year-end 2011 totaled $1.6 million as compared with $1.0 million at year-end 2010.

It should be noted that negative changes to the collateral value or events that may disrupt the borrowers’ expected cash flows might require additional provisions.

Based upon management'’s analysis, the Company believes that the allowance for loan and lease losses at December 31, ~~2011~~2012 is adequate to cover probable incurred loan losses.

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Table 8 - Analysis of the Allowance for Loan and Lease Losses

($ 000s)

Years ended December 31,	~~2011~~2012			~~2010~~2011			~~2009~~2010			~~2008~~2009			~~2007~~2008
Balance at beginning of year	$	18,~~336~~984		$	18,~~027~~336		$	1018,~~402~~027		$	410,~~606~~402		$	74,~~162~~606
Charge-offs:
Commercial		(~~911~~620	)		(~~361~~911	)		(~~8,487~~361	)		(28,~~788~~487	)		(~~265~~2,788	)
Real estate-construction		(~~326~~3,239	)		(~~1,800~~326	)		(~~465~~1,800	)		(~~1,682~~465	)		(101,682	)
Real estate-mortgage 1-4 family		(~~531~~197	)		(0531	)		(~~546~~0	)		(~~2,045~~546	)		(02,045	)
Real estate-mortgage 5+ family		~~(3,121~~0	)		(~~680~~3,121	)		(6680	)		(06	)		(0	)
Real estate-mortgage commercial		(14,~~326~~669	)		(41,~~919~~326	)		(54,~~278~~919	)		(05,278	)		(~~349~~0	)
Home equity		(~~175~~668	)		(~~1,391~~175	)		(~~500~~1,391	)		(~~1,540~~500	)		(01,540	)
Leases		(0	)		(~~306~~0	)		(~~829~~306	)		(0829	)		(~~2,000~~0	)
Installment		(639	)		(336	)		(2333	)		(6523	)		(6965	)
Total charge-offs		(69,~~396~~432	)		(96,~~490~~396	)		(169,~~134~~490	)		(816,~~120~~134	)		(28,~~693~~120	)
Recoveries
Commercial		5122			~~125~~51			28125			~~216~~28			7216
Real estate-construction		10			01			~~942~~0			0942			0
Real estate-mortgage 1-4 family		721			07			40			334			033
Real estate-mortgage 5+ family		0			0			0			0			0
Real estate-mortgage commercial		8230			082			0			0			340
Home equity		0			0			0			20			02
Leases		0			0			0			0			0
Installment		32			63			76			27			152
Total recoveries		~~144~~75			~~131~~144			~~981~~131			~~253~~981			56253
Net charge-offs		(69,~~252~~357	)		(96,~~359~~252	)		(159,~~153~~359	)		(715,~~867~~153	)		(27,~~637~~867	)
Additions charged to operations		611,~~900~~100			96,~~668~~900			229,~~778~~668			1322,~~663~~778			8113,663
Balance at end of year	$	1820,~~984~~727		$	18,~~336~~984		$	18,~~027~~336		$	1018,~~402~~027		$	410,~~606~~402
Allowance as a % of total loans and leases net of unearned income and deferred loan fees		57.8860	%		45.7788	%		4.1877	%		24.1618	%		12.0616	%
Net charge-offs during the year to average loans and leases outstanding during the year		13.7114	%		21.3071	%		32.2430	%		13.6724	%		01.6867	%

3641

~~TABLE~~Table OFof ~~CONTENTS~~Contents

Table 9 - Allocation of the Allowance for Loan and Lease Losses

($ 000s)

December 31,	~~2011~~2012					~~2010~~2011					~~2009~~2010					~~2008~~2009					~~2007~~2008
			Percent					Percent					Percent					Percent					Percent
			of loans					of loans					of loans					of loans					of loans
	Amount		in each			Amount		in each			Amount		in each			Amount		in each			Amount		in each
			category					category					category					category					category
			to total					to total					to total					to total					to total
			loans					loans					loans					loans					loans
Commercial	$	~~792~~761		4.9081	%	$	~~1,013~~792		54.4390	%	$	~~516~~1,013		75.3443	%	$	~~2,390~~516		117.3234	%	$	12,~~314~~390		1211.7832	%
Real estate-construction		34,~~149~~606		87.8374			23,~~842~~149		78.7383			2,~~591~~842		97.0373			12,~~178~~591		119.9803			~~325~~1,178		11.7098
Real estate-mortgage 1-4 family		~~865~~1,337		11.0788			~~988~~865		1011.7107			~~725~~988		10.1471			~~1,382~~725		910.8214			~~347~~1,382		129.0582
Real estate-mortgage 5+ family		1,~~646~~547		1110.1419			1,~~025~~646		11.4314			~~799~~1,025		1211.7443			~~817~~799		1112.4974			~~322~~817		1211.1949
Real estate-mortgage
Real estate-mortgage commercial		11,575		58.54			12,018		56.93			11,977		58.04			12,138		53.87			4,198		48.76
commercial		12,018		56.93			11,977		58.04			12,138		53.87			4,198		48.76			2,047		43.77
Home equity		878		6.37			500		6.58			468		6.07			1,241		6.14			367		5.57
Home equity		500		6.58			468		6.07			1,241		6.14			367		5.57			148		5.64
Leases		0		0.00			0		0.09			0		0.12			0		0.22			9		0.49
Leases		0		0.09			0		0.12			0		0.22			9		0.49			43		1.08
Installment		23		0.47			14		0.46			23		0.47			17		0.52			61		0.57
Installment		14		0.46			23		0.47			17		0.52			61		0.57			60		0.79
Total	$	20,727		100.00	%	$	18,984		100.00	%	$	18,336		100.00	%	$	18,027		100.00	%	$	10,402		100.00	%
Total	$	18,984		100.00	%	$	18,336		100.00	%	$	18,027		100.00	%	$	10,402		100.00	%	$	4,606		100.00	%

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NONINTEREST INCOME

Noninterest income totaled $4.1 million in 2011, decreasing $1.6 million compared with $5.7 million in 2010. The Company primarily generates noninterest income from service charges and from trust operations. It also recognizes as noninterest income gains or losses from sales of securities and other real estate owned and net other than temporary impairment losses on securities. Other operating income consists of miscellaneous fees from loans, mortgage banking activities, safe deposit box rentals and ATM and debit card transactions.

Noninterest income declined in 2011, primarily as net gains on sales of securities decreased $1.9 million in 2011 to $527,000 as compared with $2.4 million in 2010. During 2011, the Company sold portions of its securities portfolio for capital management purposes as well as to diversify the underlying collateral of its mortgage-backed securities. During 2011, the Company also sold equity securities and other bonds that had been totally written off as being other than temporarily impaired and recognized gains of $392,000. In addition, the Company sold $19.6 million of its mortgage-backed securities for $19.7 million and recognized a gain of $135,000 purchasing other mortgage-backed securities totaling $19.8 million. In 2010, the Company received proceeds of $105.7 million from the sale of securities and recognized gains of $2.4 million. The Company may sell securities during 2012 for capital management or liquidity purposes.

Service fees on deposits declined $366,000 to $1.7 million in 2011 as compared with $2.1 million in 2010. Overdraft fee income declined $271,000 in 2011 as compared with 2010 as the Company experienced the full effect of government regulations limiting overdraft charges due to debit card transactions that became effective during second half of 2010. Commercial checking account service charges also declined in 2011 by $53,000 as the Company limited its exposure from money service business customers.

Offsetting some of these 2011 decreases to noninterest income were reductions to other than temporary impairment losses and to losses on sales of other real estate owned in 2011 as compared with 2010. Other than temporary impairment losses on securities during 2011 decreased $496,000 to only $163,000 as the Company wrote down the remaining balances on its FNMA and FHLMC preferred stock and its CDOs as compared with write-downs of $659,000 during 2010. During 2011, the Company had net gains on sales of other real estate owned of $17,000 as compared with net losses of $236,000 during 2010.

Noninterest income for 2010 totaled $5.7 million, increasing $1.9 million compared with $3.8 million in 2009. This increase primarily resulted from a $2.4 million decline from 2009’s net other than temporary impairment losses on securities, a component of noninterest income. Another factor was decreased losses on the sale of other real estate owned which totaled $236,000 in 2010 as compared with losses of $1.4 million during 2009.

Offsetting these increases to noninterest income were decreases in gains on the sale of securities of $1.5 million in 2010 as compared with 2009. Service fees on deposits also declined $324,000 to $2.1 million in 2010 as compared with $2.4 million in 2009 as overdraft fee income declined $240,000 in 2010 as new government regulations went into effect during the second half of 2010 limiting overdraft charges due to debit card transactions. Checking and NOW account service charges also declined in 2010 by $62,000.

NONINTEREST EXPENSES

In 2011, total noninterest expenses were $22.4 million, increasing by $744,000, or 3.4%, from 2010. As a percent of average assets, noninterest expenses were 4.38% in 2011, 3.79% in 2010, and 4.71% in 2009.

The efficiency ratio, noninterest expenses 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 expenses. The Company’s efficiency ratio was 99.1% in 2011 compared with 86.7% in 2010 and 131.5% in 2009.

The increase of $744,000 to noninterest expenses in 2011 as compared with 2010 was primarily the result of expenses pertaining to the Company’s nonperforming assets increasing $1.5 million from 2010. During 2011, other real estate owned expenses increased $679,000 to $1.3 million as compared with $609,000 during 2010 as real estate taxes and costs to maintain the properties increased. During 2011, the Company also recognized increases of $227,000 in write-downs to the value of other real estate owned which totaled $4.0 million as compared with $3.8 million during 2010. These valuation write-downs were required as the market price of these properties continued to decline in 2011. Loan and collection expenses increased $581,000 during 2011 to $818,000 from $237,000 during 2010 as the Company paid real estate taxes on delinquent mortgage loans in the amount of $526,000 in order to maintain the Company’s lien positions. The Company expects to collect a portion of these real estate tax payments from the borrowers in future years.

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Offsetting some of the 2011 increases to noninterest expenses were decreases to the amortization of the core deposit intangible asset, FDIC insurance and audit and other professional fees. There was a reduction of $462,000 to amortization of core deposit intangible asset during 2011 as the core deposit intangible asset was totally written-down during 2010. FDIC insurance expense decreased $279,000 during 2011 as the FDIC changed its assessment base from deposits to assets. Audit and other professional expenses decreased $279,000 in 2011 as the Company reduced its use of outside consultants and renegotiated auditing costs

Comparing 2010 with 2009, noninterest expenses were $21.6 million in 2010, decreasing $8.5 million from 2009. The decrease of $8.5 million to noninterest expenses was primarily the result of no write-downs of goodwill in 2010 as compared with one-time write-downs of goodwill of $9.5 million in 2009. Also contributing to the decline in noninterest expenses were decreases in salaries and employee benefits of $703,000 in 2010, a 9.1% decrease, as executive salaries were reduced and the number of employees declined. Legal expenses declined by $417,000 during 2010 as litigation involving nonperforming assets decreased. Other operating expenses for 2010 declined $473,000 from 2009 as management worked diligently to control costs.

Offsetting some of the 2010 decreases to noninterest expenses were increases to write-downs to other real estate owned and audit and other professional fees. Write-downs of other real estate owned increased $2.1million to $3.8 million in 2010 as compared with $1.7 million in 2009 due to continued declines in real estate values. Audit and other professional expenses increased $370,000 in 2010 as the Company engaged consultants to assist in meeting the requirements of the Consent Order, Written Agreement and the compliance memorandum of understanding (“MOU”) entered into with the bank regulators.

FEDERAL AND STATE INCOME TAXES

The Company recognized no income tax benefit in 2011 and 2010 despite having an operating loss before income taxes of $6.7 million and $6.4 million, respectively. Per accounting rules, the Company continued to record tax benefits as deferred taxes with a corresponding offset increasing the deferred tax asset valuation allowance without recognizing a tax benefit on the income statement due to uncertainties as to the realization of these benefits. The Company’s tax benefit for 2011 was calculated to be $4.0 million which increased the deferred tax asset valuation allowance to $20.3 million at year-end 2011. In 2010, the Company’s tax benefit was $2.6 million which increased the deferred tax asset valuation allowance to $16.3 million at year-end 2010.

During 2009, the Company recognized income tax expense of $5.6 million on an operating loss before income taxes of $30.0 million. The Company created a deferred tax asset valuation allowance of $13.7 million in 2009 due to uncertainties as to the realization of these benefits. The creation of the deferred tax asset valuation allowance increased 2009 income tax expense by $13.7 million and was a noncash event.

The Company had pretax earnings of interest on U.S. Treasury and U.S. government-sponsored entity securities totaling $2,000, $10,000 and $72,000 in 2011, 2010 and 2009, respectively, which were nontaxable for state income tax purposes as compared with $1.3 million in 2008. The Company has significantly reduced its portfolio of U.S. government-sponsored entity securities from 2008 and as a consequence, interest earned from this source has decreased. This was done as the Company had net operating losses for state tax purposes and was unable to fully realize the benefits from this source of income. It is expected that the Company’s nontaxable income for state tax purposes will continue to be negligible in future years until the Company begins to generate state taxable income. Existing state tax credits begin to expire in 2020.

Qualified interest on loans to local political subdivisions and on qualified state and local political subdivision securities are nontaxable for federal income tax purposes. Interest earned on local political subdivisions, nontaxable for federal income tax purposes, totaled $141,000 in 2011, $200,000 in 2010 and $357,000 in 2009. The Company purchases qualified state and political subdivision securities from local governmental units in order to assist its local communities as well as for tax planning purposes. As the Company did not generate taxable income during 2011, 2010 and 2009, the Company was unable to take full advantage of the interest deductions provided by tax-exempt securities issued by states and political subdivisions. Due to this decrease in taxable income, the Company lowered its investments in these types of securities during 2011, 2010 and 2009 and it is expected that nontaxable income for federal income tax purposes from these securities will further decline in 2012.

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CASH FLOWS AND LIQUIDITY

The statement of cash flows shows the Company’s sources and uses of cash. 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 losses, which are adjusted to a cash basis. Net cash flows from operating activities in 2011 was $6.4 million. This differs from a book loss of $6.7 million primarily due to non cash provisions for loan and lease losses of $6.9 million, write-downs of other real estate owned of $4.0 million and net decreases to other assets of $1.4 million. Net cash flows from operating activities in 2010 was $9.1 million and differs from a book loss of $6.4 million primarily due to non cash provisions for loan and lease losses of $9.7 million, write-downs of other real estate owned of $3.8 million and net decreases to other assets of $2.5 million. Net cash flows from operating activities in 2009 totaled $4.7 million and differs from a book loss of $35.6 million primarily due to the non cash provision for loan losses of $22.8 million, write-down of goodwill of $9.5 million, net deferred tax adjustments of $7.7 million and net impairment losses on securities of $3.1 million.

Cash flows from investing activities come from securities available for sale, loans, other real estate owned and property and equipment transactions. During 2011, the Company had net cash inflows from investing activities of $65.9 million of which $46.3 million was due to decreased loan balances; other real estate owned sold for $10.6 million; and $9.0 million from maturities, calls and payments on securities. Proceeds from the sale of securities of $20.1 million during 2011 were mostly offset by purchases of securities of $19.8 million.

During 2010, the Company had net cash inflows from investing activities of $71.4 million as securities were sold; loan balances decreased; and other real estate owned was sold. The Company had incoming cash flows of $105.7 million from the sale of securities and $27.4 million from maturities, calls and payments on securities which were partially offset by purchases of securities of $89.4 million. The Company had cash inflows from the loan principal reductions of $16.0 million. The Company also received cash in 2010 of $12.1 million from the sale of other real estate owned.

There were net cash outflows of $12.3 million for investing activities during 2009 as the Company used cash of $142.1 million for the purchase of securities during 2009. This outflow of cash was partially offset by incoming cash flows from maturities and sales of securities of $107.5 million, decreases to loans from maturities and payment of loans of $16.2 million and proceeds from the sale of other real estate owned of $6.8 million.

Primary financing activities of the Company that create cash flows are deposits, repurchase agreements, borrowings, payment of dividends, purchase of treasury stock and selling stock. The Company had net outgoing cash flows from financing activities of $64.9 million during 2011. The outgoing cash flows were caused by decreases in deposits of $48.9 million and repurchase agreements of $16.1 million as the Company repositioned its balance sheet.

The Company had net outgoing cash flows from financing activities of $84.3 million during 2010. The outgoing cash flows were caused by decreases in deposits of $70.7 million and repurchase agreements of $13.8 million.

During 2009, the Company had net incoming cash flows from financing activities of $19.9 million. In February 2009, the Company issued preferred stock as it participated in the Treasury Department’s TARP Capital Purchase Program and received $17.2 million in proceeds. The Company also had incoming cash flows during 2009 from increases in deposits of $16.4 million and repurchase agreements of $6.8 million. Partially offsetting the 2009 incoming cash flows were cash outflows of $20.0 million for net repayments on Federal Home Loan Bank advances.

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 depositors wanting to withdraw funds, borrowers’ needs for credit and the Company’s operating needs.

The Company’s liquidity is measured by the ability to raise funds through deposits, borrowed funds, capital, cash flow from the repayment or maturities of loans and securities available for sale and net profits. Liquidity is primarily managed through the growth of deposits and by liquid assets such as cash and due from banks less any reserve requirements, securities available for sale less any pledged securities and federal funds sold. Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities that maintains an acceptable interest rate risk profile while attaining a desired level of profitability. An important part of the overall asset and liability management process is providing adequate liquidity.

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As required by the Consent Order entered into by the Bank with the FDIC and IDFPR on April 16, 2010, Bank management has developed a liquidity plan that identifies the sources of liquid assets available to meet the Bank’s contingency funding over the next twelve months. This liquidity plan looks at the Bank’s ability to meet the cash flow requirements of customers and other operating needs and seeks to manage liquidity to meet these requirements.

The Consent Order also restricts payments of dividends from the Bank to the Company and as such conserves liquidity at the Bank. Dividends from the Bank are needed to fund dividend payments to the Company’s preferred and common stockholders and interest payments on its subordinated debentures. The Written Agreement between the Company and the Federal Reserve Bank dated March 17, 2011, prohibits the Company from paying dividends on its Series A Preferred Stock issued under the TARP Capital Purchase Program. Due to these constraints it is expected that the Company will continue to suspend dividend payments on its Series A Preferred Stock and will not pay any dividends to common stockholders in 2012. Also, the Company will continue to defer interest payments on its subordinated debentures. The dividends payable on the Series A Preferred Stock totaled $2.2 million and the interest payments payable on the subordinated debentures totaled $743,000 at December 31, 2011.

Liquid assets for the Company were $61.2 million at December 31, 2011 as compared with $55.5 million at December 31, 2010. Liquid assets consist of cash and due from banks, federal funds sold, interest bearing deposits in financial institutions with maturities less than 90 days, unpledged securities available for sale less reserve requirements and nominal cash reserves. As part of the liquidity policy, management reviews the Bank’s liquidity ratio daily. The liquidity ratio is the net liquid assets divided by total deposits. At December 31, 2011, this internally calculated ratio at the Bank was 18.2 percent, compared with 14.2 percent at year-end 2010.

In its liquidity plan, the Bank considers federal funds sold, interest bearing deposits in banks and securities available for sale, particularly those of shorter maturities, as principal sources of liquidity. The Company had no federal funds sold at December 31, 2011 as compared with $6.6 million at December 31, 2010. Short-term interest bearing deposits totaled $32.5 million at December 31, 2011 increasing $14.4 million from $18.1 million at December 31, 2010 as the Company earns higher yields on these deposits than on federal funds sold. The Company classifies all of its securities as available for sale, which increases the Company's flexibility to meet liquidity requirements by increasing its repurchase agreement balances or by selling unpledged securities. At year-end 2011, the Company had securities available for sale carried at $87.1 million of which $57.0 million were pledged to secure public deposits and repurchase agreements. Securities available for sale totaled $91.8 million at year-end 2010 of which $59.0 million were pledged.

The liquidity plan also considers the liquidity needed to fund loans net of funds provided by scheduled principal payments, anticipated payoffs and changes in deposit balances.

Liquidity is also available from the scheduled maturities of securities. At December 31, 2011, the Company has $6.2 million of securities that either mature in 2012 or were equity securities that could be sold to provide liquidity. Additional liquidity is made available from anticipated principal payments on the Company’s investments in mortgage-backed securities which the Company estimates will be $9.1 million during 2012 resulting from borrower payments and payoffs on the mortgages underlying these securities.

Another important source of liquidity to the Company is deposits. Under the Consent Order, the Bank must limit its brokered time deposits and is not permitted to pay a rate of interest on deposit products that is more than 75 basis points above the rate applicable to the Bank’s market as determined by the FDIC. The Company anticipates that brokered time deposits, NOW accounts and public deposits may decrease from their current levels due in part to the Bank’s compliance with the Consent Order. The Bank expects that a portion of these deposit reductions will be offset by growth from core deposits to new retail and commercial customers as well as internet advertised wholesale time deposits. The FDIC has recognized that the Bank is operating in a high rate area, which allows the Bank to use local average deposit rates as a basis for setting competitive rates on its deposits. However, it is expected that deposits will continue to decline during the 2012 and liquidity available from this source will be limited.

Additional sources of liquidity to the Company are borrowings and securities sold under repurchase agreements. In its liquidity plan, the Bank considers its line of credit available at the Federal Home Loan Bank of Chicago, which was $15.4 million at December 31, 2011, as a source of liquidity. The Company has pledged loans totaling $28.8 million consisting of 1-4 family and 5+ family real estate mortgages at December 31, 2011 as security for potential borrowings for this line. Securities sold under repurchase agreements amounted to $19.5 million and $35.5 million at December 31, 2011 and 2010, respectively. At December 31, 2011, all repurchase agreements repriced daily as they consisted of an overnight repurchase agreement product.

TABLE OF CONTENTS

DEPOSITS

The Bank provides traditional deposit services to retail, corporate and public entities. These include demand deposit checking accounts, interest bearing demand deposits ("“NOW"”), money market, savings and time deposit accounts. The Company believes that the deposit function solidifies the Bank’s identity to the communities it serves and provides the foundation for future growth.

The Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law by President Barack Obama on July 21, 2010. The Act permanently raised the FDIC insurance coverage to $250,000 per depositor. It also ~~provides~~provided unlimited FDIC insurance coverage of noninterest-bearing transaction accounts through December 31, 2012.

~~Deposits at the Bank were impacted by the Consent Order.~~ Since the Bank is under the 2013 Consent Order, it is considered “adequately capitalized” even if it exceeds the levels of capital set forth in the Order. As such the Bank may not accept or renew brokered deposits without the prior approval of the FDIC. Brokered deposits include deposits with rates of interest that are more than 75 basis points above the ~~rate~~national ~~applicable~~average torate ~~the~~for ~~Bank’s~~various ~~market~~deposit types as determined by the FDIC. The ~~FDIC~~Bank ~~has~~reviews ~~determined that~~ the ~~State~~national ofaverage ~~Illinois~~rates isweekly ~~considered~~to aconfirm ~~high~~that its deposit rate ~~area~~offerings ~~and~~are ~~consequently~~within the ~~Bank~~FDIC ~~is able to offer deposit rates within 75 basis points of its local market average~~parameters.

At year-end ~~2011~~2012, the Bank’s deposits totaled $~~397~~358.6 million, a decrease of $4939.0 million or 119.08% from year-end ~~2010~~2011 ~~deposit of $446.6 million~~ after decreasing $7049.60 million from ~~2009~~2010. Deposits decreased during ~~2011~~2012 as the Company ~~lowered~~reduced its ~~rates~~reliance ~~and~~on ~~repositioned its balance sheet. The decline in deposits was primarily from decreases of $37.5 million to nonbrokered~~ time deposits and ~~$20.3 million to~~ brokered ~~time~~and ~~deposits~~wholesale atcertificates ~~year-end~~of ~~2011 as compared with year-end 2010~~deposit.

~~Retail~~For ~~deposits~~liquidity ~~totaled~~purposes, ~~$271.8~~the ~~million~~Bank atbegan ~~December~~to ~~31,~~accept ~~2010~~wholesale ~~compared~~internet ~~with~~time ~~$279~~deposits in 2010.3 ~~million~~The atrates ~~year-end~~offered ~~2010~~on ~~decreasing~~the ~~$7.5~~internet ~~million. Retail~~time deposits aswere awithin ~~percentage~~the of2013 ~~total~~Consent Order requirements and are generally comparable to rates paid on local deposits. ~~were~~These ~~approximately~~time ~~68%~~deposits decreased $21.1 million to $7.4 million at year-end ~~2011~~2012 as compared with ~~63%~~$28.5 million at year-end ~~2010~~2011 and ~~60%~~$48.6 million at year-end ~~2009~~2010. The Company expects that these deposits will further decrease in 2013.

~~Much~~The ofCompany ~~the~~lowered ~~Bank’s~~its ~~loan~~brokered ~~portfolio~~time isdeposits toby ~~commercial~~$9.9 ~~customers~~million ~~and~~to ~~the~~$2.0 ~~Bank~~million ~~provides~~at ~~these~~year-end ~~customers~~2012 ~~with~~from ~~deposit products. Commercial deposits totaled~~ $5111.49 million at ~~December~~year-end ~~31,~~ 2011, after decreasing from $332.52 million ~~from~~at year-end 2010. ~~The~~At ~~decrease~~year-end is2012, ~~attributable~~the toCompany’s ~~commercial~~brokered ~~depositors~~time ~~needing~~deposits ~~funds~~consisted ~~for~~entirely ~~business~~of ~~purposes~~CDARS ~~due~~time todeposits. ~~the~~The ~~weakened~~Company ~~economy. Contributing~~has tobeen ~~the~~decreasing ~~decline~~its todependence ~~commercial~~on ~~deposit~~brokered ~~balances~~deposits ~~were~~and ~~decreases~~can inno ~~accounts~~longer ~~from~~issue ~~money~~CDARS ~~service~~time ~~businesses~~deposits aswithout the ~~Company~~prior ~~sought~~approval toof ~~limit~~the ~~its~~FDIC. ~~exposure to~~As ~~these~~such, ~~entities. Commercial~~the ~~deposits~~Company asexpects athat ~~percentage~~during of2013 ~~total~~these deposits ~~were~~will ~~approximately~~be ~~13%~~further ~~at year end 2011 compared with12% at year-end 2010 and 11% at year-end 2009~~reduced.

The Bank’s main office and two of its branches are located in the local county seat and the Bank has traditionally had deposit relationships with local public entities. Public deposits have decreased $821,000 to $34.2 million at year-end 2011 as compared with $35.0 million at year-end 2010 after decreasing $21.8 million from $56.8 million at year-end 2009. Public deposit balances often fluctuate based on the municipalities’ needs as well as interest rates paid. The Bank must often pledge securities for its public entity deposits. Under a Consent Order, the Bank is considered “adequately capitalized”. Depending on the municipality and their internal policies, this capital designation of the Bank may contribute to future decreases to public deposits.

During 2011, interest rates were generally at historic lows and the Bank attempted to price its time, savings and money market deposit product rates at the midpoint of local market rates. This strategy was successful as illustrated in Table 1, which shows that time deposit rates in 2011 averaged 0.89%, decreasing 74 basis points from 1.63% in 2010 after decreasing 119 basis points from 2009. The Company’s total cost for interest bearing liabilities averaged 0.58%, decreasing 50 basis points from 1.08% in 2010 after decreasing 91 basis points from 2009.

The Company lowered its brokered time deposits by $20.3 million to $11.9 million from $32.2 million at year-end 2010 after decreasing $62.7 million from $94.9 million at year-end 2009. At year-end 2011, the Company’s brokered time deposits consisted entirely of CDARS time deposits. CDARS time deposits are Bank customer time deposits of $250,000 or greater that allow the depositor to increase their FDIC insurance coverage over the FDIC limits. The Bank trades portions of the customers’ time deposits with other independent financial institutions across the country to accomplish this. The effect is that it allows large time deposit customers to have their entire time deposit balances fully FDIC insured. During the first quarter of 2012, the Bank received the FDIC’s consent to renew or accept new CDARS brokered deposits through May 27, 2012 for certain Bank customers not to exceed $20.0 million.

For liquidity purposes, the Bank began to accept wholesale internet time deposits in 2010. The rates offered on the internet time deposits were within the Consent Order requirements and are generally comparable to rates paid on local deposits. These internet time deposits totaled $28.5 million at year-end 2011 decreasing $20.1 million from $48.6 million at year-end 2010.

~~TABLE~~Table OFof ~~CONTENTS~~Contents

~~Core~~Retail deposits ~~are those retail and commercial demand, NOW, money market and savings accounts that have generally lower interest costs and are considered more stable. Total core deposits at year-end 2011~~ totaled $~~215~~265.02 million ~~increasing~~at ~~$6.5~~December ~~million~~31, or2012 ~~3.1%,~~compared ~~from~~with $~~208~~271.58 million at year-end ~~2010~~2011 ~~after~~ decreasing $86.46 million ~~from $216~~.9 ~~million~~Retail atdeposits ~~year-end~~as ~~2009. Core~~a ~~retail~~percentage ~~and commercial noninterest bearing checking and savings accounts showed increases in 2011~~ of ~~$5.0~~total ~~million~~deposits ~~and~~were ~~$3.1~~approximately ~~million,~~74% ~~respectively. Retail~~at ~~and~~year-end ~~commercial~~2012 ~~NOW~~as ~~and~~compared ~~money~~with ~~market~~68% ~~accounts~~at ~~showed~~year-end ~~decreases in~~ 2011 ~~of $451,000~~ and ~~$1.1~~63% ~~million,~~at ~~respectively~~year-end ~~as interest rates continued to decline on these products~~2010.

~~The~~Much ~~Company~~of ~~had~~the ~~related~~Bank’s ~~party~~loan portfolio is to commercial customers and the Bank provides these customers with deposit products. Commercial deposits, ~~totaling~~excluding wholesale internet time deposits, totaled $249.17 million at December 31, 2012, decreasing $1.7 million from year-end 2011. ~~The~~ Commercial deposits ~~from~~as ~~related~~a ~~parties~~percentage of total deposits were ~~issued~~approximately 14% at ~~the~~year-end ~~same~~2012 ~~terms~~compared ~~and~~with ~~conditions~~13% ~~that~~at ~~were~~year-end ~~offered~~2011 toand ~~other~~12% ~~customers~~at year-end 2010.

The Bank’s main office and two of its branches are located in the local county seat and the Bank has traditionally had deposit relationships with local public entities. Public deposits increased slightly to $34.3 million compared with $34.2 million at year-end 2011 and $35.0 million at year-end 2010. Public deposit balances often fluctuate based on the municipalities’ liquidity needs and the timing of tax collections. The Bank must often pledge securities for its public deposits.

Table 10 - Deposits

($ 000s)

December 31,	~~2011~~2012					~~2010~~2011					~~2009~~2010
			% of					% of					% of
	Amount		Total			Amount		Total			Amount		Total
Demand – noninterest bearing	$	67,955		17.09	%	$	61,341		13.74	%	$	58,001		11.21	%
Demand - noninterest bearing	$	68,323		19.05	%	$	67,955		17.09	%	$	61,341		13.74	%
NOW accounts		58,002		14.59			58,815		13.17			65,302		12.63
Interest bearing demand		60,874		16.98			58,002		14.59			58,815		13.17
Money market accounts		5351,~~185~~680		1314.3841			53,~~056~~185		1113.8838			6053,~~398~~056		11.6888
Savings		6671,~~172~~022		1619.6481			6366,~~137~~172		1416.1464			6163,~~049~~137		1114.8014
Time, $100,000 and over		6942,~~837~~720		1711.5691			9769,~~227~~837		2117.7756			8597,~~253~~227		1621.4877
Time, under $100,000		7061,~~627~~971		17.7628			8070,~~792~~627		1817.0976			9280,~~286~~792		1718.8409
Time, brokered		112,~~853~~004		20.9856			3211,~~183~~853		72.2198			9432,~~947~~183		187.3621
Total deposits	$	~~397~~358,~~631~~594		100.00	%	$	~~446~~397,~~551~~631		100.00	%	$	~~517~~446,~~236~~551		100.00	%

Core deposits are those retail and commercial demand, interest bearing demand, money market and savings accounts that have generally lower interest costs and are considered more stable. Total core deposits at year-end 2012 totaled $220.2 million increasing $5.2 million, or 2.4%, from $215.0 million at year-end 2011 after increasing $6.5 million from $208.5 million at year-end 2010. Most of the 2012 increase to core deposits was from growth in retail savings accounts that increased $4.6 million.

During 2012, interest rates were generally at historic lows and the Bank attempted to price its deposit product rates at the midpoint of local market rates. This strategy was successful as the Company lowered rates paid on its interest bearing liabilities by 27 basis points in 2012 compared to 2011. As illustrated in Table 1, time deposit rates in 2012 averaged 0.51%, decreasing 38 basis points from 0.89% in 2011 after decreasing 74 basis points from 2010. As most time deposits have opened or renewed at lower interest rates, the Company does not expect to see the rates on time deposits decline significantly in 2013.

The Company had related party deposits totaling $7.0 million at December 31, 2012. The deposits from related parties were issued at the same terms and conditions that were offered to other customers.

Table of Contents

Table 11 - Time Deposits, $100,000 and Over Maturity Schedule

($ 000s)

			Greater than		Greater than
			3 mos. and less		6 mos. and less
	Less than or		than or equal		than or equal		Greater than
As of December 31, 2012	equal to 3 mos.		to 6 mos.		to 12 mos.		to 12 mos.		Total

Time deposits, $100,000 and over:
Retail deposits	$	8,720	$	4,951	$	6,063	$	7,810	$	27,544
Corporate deposits		5,974		963		2,700		2,459		12,096
Public fund deposits		1,300		978		802		0		3,080

Total time deposits $100,000 and over	$	15,994	$	6,892	$	9,565	$	10,269	$	42,720

Note:

The Company has no foreign banking offices or deposits.

SECURITIES SOLD UNDER REPURCHASE AGREEMENTS

AND OTHER SHORT-TERM BORROWINGS

Securities sold under repurchase agreements (“repurchase agreements”) provide a source of funds to the Company. Most municipalities, other public entities and some other organizations require that their funds ~~are~~be insured or collateralized. ~~Commercial~~ ~~depositors~~With ~~also find~~ the ~~collateralization~~ending of ~~repurchase~~unlimited ~~agreements~~FDIC ~~attractive~~insurance ascoverage anof ~~alternative~~noninterest-bearing totransaction ~~time~~accounts ~~deposits. Securities~~on ~~sold~~December ~~under~~31, ~~repurchase~~2012, ~~agreements~~the ~~(“repurchase~~collateralization ~~agreements”)~~provided ~~provide~~by arepurchase ~~source~~agreements ofmay ~~funds~~become ~~and~~even domore ~~not~~attractive ~~increase~~to ~~the~~commercial ~~Company’s~~customers ~~reserve~~as ~~requirements~~an ~~with~~alternative ~~the~~to ~~Federal Reserve Bank~~deposits.

~~During~~The ~~2011, the~~ Company ~~sought~~offers ~~to reduce its securities~~ repurchase agreements ~~and~~as ~~other~~an ~~short-term~~overnight ~~borrowings~~product toin ~~lower~~which ~~the~~customers ~~amount~~invest oftheir ~~its~~excess ~~available~~funds ~~for~~or ~~sale~~as ~~securities~~a ~~needing~~term ~~to be pledged for these borrowings~~product. In ~~past~~At ~~years~~year-end 2012, the Company ~~offered~~had $19.3 million in repurchase agreements ascompared awith ~~term~~$19.5 ~~product~~million and an$35.5 ~~overnight~~million ~~product~~at inyear-ends ~~which~~2011 ~~customers~~and ~~would~~2010, ~~invest their excess funds~~respectively. At year-end ~~2011~~2012, ~~all~~repurchase ofagreements ~~the~~consisted ~~Company’s~~of ~~repurchase~~$17.9 ~~agreements~~million ~~were~~in ~~from~~ the overnight product and ~~totaled~~ $191.54 million, ain ~~decrease~~the ofterm ~~$16~~product.0 ~~million from $35.5 million at year-end 2010.~~ At year-end ~~2011~~2012, the Company had repurchase agreements where the securities had a carrying value of $23.50 million as compared with $3923.15 million at year-end ~~2010~~2011.

The Company had no short-term borrowings from the Federal Home Loan Bank of Chicago during 2012 and 2011 with the exception each year of a $1.0 million draw for two days as a contingency test of its line of credit as compared with average Federal Home Loan borrowings of $1. 7 million in 2010. At year-end ~~2011~~2012, the Company had availability of $15.43 million in borrowings from the Federal Home Loan Bank. ~~The~~ During 2012, the Company’s ~~Federal~~pledged ~~Home~~loans ~~Loan~~to Federal Reserve Bank ~~term~~of ~~advance~~Chicago for a line of credit and, while having no short-term borrowings ~~averaged~~outstanding, ~~$1.7~~had ~~million~~availability in ~~2010~~borrowings ~~and~~of $~~10.9~~121,000 ~~million~~at ~~in 2009~~year-end.

Table 1112 - Securities Sold Under Repurchase Agreements

($ 000s)

At or for the Year Ended December 31,	~~2011~~2012			~~2010~~2011			~~2009~~2010
Average daily balance outstanding during the year	$	2418,~~144~~172		$	4024,~~217~~144		$	4140,~~532~~217
Weighted average interest rate during the year		0.3005	%		0.6630	%		10.4366	%
Maximum amount outstanding	$	2921,~~586~~494		$	4629,~~044~~586		$	4946,~~364~~044
Balance at end of year		19,~~455~~262			3519,~~517~~455			4935,~~364~~517
Weighted average interest rate at end of year		0.1702	%		0.4417	%		0.7144	%

TABLE OF CONTENTS

Table 12 - Capital Standards

($ 000s)

As of December 31, 2011:

Qualifying for Tier I Capital:
Common stock	$	1,789
Preferred stock		16,904
Warrants		681
Additional paid-in capital		7,054
Retained earnings		5,489
Treasury stock, at cost		(4,512	)
Trust preferred securities - qualifying portion		9,513
Total Qualifying for Tier I Capital	$	36,918
Qualifying for Tier II Capital:
Total Qualifying tier 1 Capital	$	36,918
Trust preferred securities - qualifying portion		487
Allowance for loan losses - qualifying portion		4,150
Total Qualifying for Tier II Capital	$	41,555
Total Average Net Fourth Quarter Assets	$	489,973

Risked-based Assets	Total		Risked-based
Zero percent risk weighting	$	118,625	$	0
Twenty percent risk weighting		6,812		1,362
Fifty percent risk weighting		65,060		32,530
One hundred percent risk weighting (1)		283,264		283,264
Total Risk-weighted Assets	$	473,761	$	317,156

(1) Includes off-balance sheet items

Minimum Capital Requirements	$		%
Tier I Capital to Net Average Fourth Quarter Assets
Required	$	19,599	4.00	%
Actual		36,918	7.53
Capital to Risk-based Assets:
Tier I:
Required	$	12,686	4.00	%
Actual		36,918	11.64
Tier II:
Required	$	25,373	8.00	%
Actual		41,555	13.10

~~TABLE~~Table OFof ~~CONTENTS~~Contents

Table 13 - Capital Standards

($ 000s)

As of December 31, 2012:

Minimum Capital Requirements	$		%

Tier I Capital to Net Average Fourth Quarter Assets
Required	$	16,884		4.00	%
Actual		19,254		4.56

Capital to Risk-based Assets:
Tier I:
Required	$	10,356		4.00	%
Actual		19,254		7.44
Tier II:
Required	$	20,712		8.00	%
Actual		27,395		10.58

CAPITAL & REGULATORY MATTERS

Capital is important to the Company as it provides a basis for future growth and provides a base to absorb any financial setbacks that might be encountered.

Total stockholders’ equity was $2815.59 million at December 31, ~~2011~~2012, decreasing $412.86 million from year-end ~~2010~~2011. Stockholders’ equity declined due to the Company’s net loss of $612.76 million and accrual for dividends on the preferred stock of $~~938,000~~1.0 ~~for 2011~~million. These declines were partially offset by the $~~2.6~~856,000 ~~million~~ increase to accumulated other comprehensive income relating to the unrealized gain on securities available for sale, net of deferred tax at year-end ~~2011~~2012 and $~~238~~106,000 of accretion ofon the unearned portion of restricted stock awards ~~during 2011~~. The book value of the Company’s outstanding common stock at December 31, 2012 was a negative $0.30. December 31, 2011 book value of common stock was $2.65 per share, ~~compared~~and ~~with~~ $3.95 at December 31, 2010.

Regulatory statutory capital guidelines require that the amount of capital increase with the amount of risk inherent in a company's balance sheet and off-balance sheet exposures. Minimum statutory capital requirements for Tier I ~~capital~~Capital to average assets and Tier I ~~capital~~Capital to risk weighted assets are that they must both be above 4.00%. As shown in Table 1213, at December 31, ~~2011~~2012, the Company’s Tier I ~~capital~~Capital to average assets was at 74.5356% and Tier I ~~capital~~Capital to risk-weighted assets was at 117.6444%~~, both more than 1~~.5 ~~times the amount of statutory capital necessary.~~ The minimum statutory requirement for Tier II ~~capital~~Capital to risk based assets is 8.00%, while the Company’s capital for this ratio was ~~13.~~10.58% ~~or more than 1~~.~~5 times the statutory amount necessary.~~

The Bank’s Tier I1 ~~capital~~Capital to average assets ratio and ~~the~~ total risked-based capital ~~to assets~~ ratio, ~~on a risk adjusted basis,~~ were 86.2067% and 1312.8611%, respectively, atas of December 31, ~~2011,~~2012. ~~above~~The Bank’s Tier 1 Capital to average assets ratio was below the capital levels required by the 2013 Consent Order of 8.00% ~~and~~while the Bank’s total risked-based capital ratio was above the 12.00%, ~~respectively~~level required by the 2013 Consent Order.

Bank regulators, including the Federal Reserve Board have proposed new guidelines that would revise and replace the current bank holding company and bank capital rules consistent with agreements reached by the Basel Committee on Banking Supervision (“Basel III”). However, until the Basel III capital rules are finalized, the effect on the Company and Bank cannot be predicted.

At the Company’s annual meeting of stockholders held on May 21, 2009, the stockholders approved the 2009 Restricted Stock Plan (“Plan”). The goal of the Plan is to promote the Company’s long-term financial success, increase stockholder value and enhance our ability to attract and retain employees and directors. The Plan authorizes the issuance of up to 400,000 shares of the Company’s common stock, in connection with incentive compensation awards which is approximately 10 percent of the Company’s total shares currently issued and outstanding. Shares of the Company’s common stock issued under the Plan as awards may consist of treasury shares or authorized and unissued shares not reserved for any other purpose. Awards under the Plan may be made to directors and employees of both the Company and its subsidiaries and may consist of restricted stock with associated voting rights and the right to receive dividends. Awards may also be issued as restricted stock units not having voting rights or the right to receive dividends until the terms of the award are satisfied and shares of the Company’s common stock are actually issued; however, dividends may be credited to a restricted stock unit award. The terms and conditions of each award is set forth and described in an award agreement between the Company and the participant.

In January 2011, 207,500 shares of restricted stock were issued pursuant to the 2009 Restricted Stock Plan from the Company’s treasury stock. During 2011, employees, who left the Company, forfeited 2,000 shares of restricted stock, which were returned to treasury stock. At year-end 2011, 194,500 shares were available for issuance under the Plan. Of the 80,000 shares issued to directors, 70,000 shares vested immediately during January 2011, while the remaining 10,000 shares vest over a two-year period becoming fully vested in January 2013. A total of 125,500 restricted stock shares granted to employees of the Company will fully vest in January 2013. The expense attributable to the restricted stock awards recognized during 2011 totaled $238,000.

In January 2009, the Company’s stockholders approved an amendment to the Certificate of Incorporation allowing the Company to issue preferred stock in conjunction with the Company’s application in late 2008 with the United States Department of the Treasury (“Treasury Department’) to participate in the TARP Capital Purchase Program. During January 2009, the Company received approval from the Treasury Department for TARP funds in the amount of $17.2 million and these funds were received by the Company in February 2009. These funds provided additional liquidity to the Company and are considered components of Tier I capital. Under the terms of the TARP Capital Purchase Program the Company issued 17,211 shares of preferred stock to the Treasury Department having a dividend of 5.0%. In addition, the Company issued 584,084 stock warrants allowing the Treasury Department to purchase the Company’s common stock at a price of $4.42 per share according to the TARP agreement.

On March 17, 2011, the Company and the Federal Reserve Bank (“Reserve Bank”) entered into a Written Agreement. Pursuant to the Written Agreement, among other things, the Company has agreed to: (i) serve as a source of strength to the Bank; (ii) abstain from paying any dividends, redeeming any stock or incurring any debt without Federal Reserve approval; (iii) adopt a capital plan; (iv) provide the Federal Reserve with cash flow projections on a quarterly basis; (v) notify the Federal Reserve of the proposed addition of any individual to the Board of Directors or the employment of any individual as a senior executive officer of the Company before such addition or employment becomes effective; and (vi) provide progress reports to the Federal Reserve concerning the Company’s compliance with the Written Agreement. Prior to the Written Agreement the Company entered adopted a Board Resolution dated November 17, 2009 which the Written Agreement superseded. The Board Resolution was concerned with the Company’s conservation of financial resources.

~~TABLE~~Table OFof ~~CONTENTS~~Contents

~~Management~~In ~~and~~January ~~the~~2011, ~~Board~~207,500 shares of ~~Directors~~restricted ~~are~~stock ~~committed~~were toissued ~~complying~~pursuant ~~with~~to the ~~terms~~2009 ofRestricted Stock Plan from the ~~Written~~Company’s ~~Agreement,~~treasury stock. During 2012 and ~~have~~2011, ~~already~~employees, ~~taken~~who left the Company, ~~and~~forfeited ~~continue~~9,000 shares of restricted stock which were returned to ~~take~~treasury stock, ~~numerous~~and ~~steps~~80,500 shares of restricted stock issued to ~~address~~directors ~~these~~and ~~matters~~employees vested. ~~The~~ ~~Bank~~Subsequently ~~reports~~on toJanuary 15, 2013, the ~~Federal~~remaining ~~Reserve~~118,000 ~~quarterly~~restricted ~~regarding~~stock ~~its~~shares ~~progress~~vested in ~~complying~~accordance with the ~~provisions~~award ~~included~~agreement. inThe expense attributable to the ~~Written~~restricted ~~Agreement. Compliance~~stock ~~with~~awards ~~the~~totaled ~~terms~~$106,000 ofand ~~the~~$238,000 ~~Written~~during ~~Agreement will~~2012 beand an2011, ~~ongoing~~respectively. ~~priority~~On ~~for~~March ~~management~~7, of2013, the ~~Bank. See~~Company ~~also~~filed ~~Note~~a 22post-~~“Management~~effective ~~Plans”~~amendment to its Registration Statement on Form S-8 to deregister all shares of the ~~condensed~~Company’s ~~consolidated~~common ~~financial~~stock ~~statements~~covered ~~included~~by ~~herein~~the Form S-8 Registration Statement that remained unsold under the Plan.

In ~~response~~January to2009, the ~~Board Resolution the~~ Company’s instockholders ~~November~~approved ~~2009~~an ~~notified~~amendment to the ~~U.S.~~Certificate ~~Treasury~~of ~~Department~~Incorporation ~~(“Treasury”)~~allowing ofthe ~~its~~Company ~~intent~~ to ~~suspend~~issue ~~its~~preferred ~~dividend~~stock ~~payments~~in onconjunction ~~its TARP Series~~with ~~A Preferred Stock. The suspension of~~ the ~~dividend~~Company’s ~~payments~~application isin ~~permissible~~late ~~under~~2008 ~~the~~with ~~terms of~~ the ~~Troubled~~Treasury ~~Asset~~to ~~Relief~~participate ~~Program~~in (“the TARP”) ~~Capital~~CPP. ~~Purchase~~During ~~Program~~January ~~(“CPP”)~~2009, ~~but~~ the ~~dividend~~Company isreceived aapproval ~~cumulative~~from ~~dividend~~the ~~and~~Treasury ~~failure to pay dividends~~ for ~~six~~TARP ~~dividend~~funds ~~periods~~in ~~triggers~~the ~~board~~amount of ~~director~~$17.2 ~~appointment~~million ~~rights~~and ~~for~~these ~~the~~funds ~~holder~~were ofreceived by the ~~Series~~Company Ain ~~Preferred~~February ~~Stock~~2009. AtThese ~~December~~funds ~~31,~~provided ~~2011,~~additional liquidity to the Company ~~had~~and ~~suspended~~are ~~nine~~considered ~~dividend~~components ~~payments;~~of ~~however~~Tier ~~the~~I ~~Treasury~~Capital. ~~Department~~Under ~~has~~the ~~not~~terms ~~yet~~of ~~exercised~~the ~~its~~TARP ~~director~~CPP ~~appointment~~the ~~rights. In~~Company ~~January~~issued ~~2011~~17,211 ~~the~~shares ~~Company~~of ~~agreed~~preferred stock to ~~allow~~the a Treasury ~~Department~~having ~~observer~~a todividend ~~attend its board~~ of ~~directors meetings~~5. ~~While~~0%. ~~dividends~~This ~~are~~rate ~~being~~increases ~~deferred~~to on9.0% ~~the~~in ~~preferred~~February ~~stock~~2014. ~~issued~~In ~~under~~addition, the ~~TARP~~Company ~~Capital~~issued ~~Purchase Program~~584,084 ~~the~~stock ~~Company~~warrants ~~may~~allowing ~~not~~the ~~pay~~Treasury ~~dividends~~to onpurchase ~~its~~the Company’s common stock~~. The~~ ~~Company~~at ~~expects~~a toprice ~~suspend~~of ~~its~~$4.42 ~~tenth~~per ~~dividend~~share ~~payment~~according into ~~February~~the ~~2012~~TARP agreement.

On March 17, 2011, the Company and the Federal Reserve Bank (“Reserve Bank”) entered into a Written Agreement. Pursuant to the Written Agreement, among other things, the Company has agreed to: (i) serve as a source of strength to the Bank; (ii) abstain from paying any dividends, redeeming any stock or incurring any debt without Federal Reserve approval; (iii) adopt a capital plan; (iv) provide the Federal Reserve with cash flow projections on a quarterly basis; (v) notify the Federal Reserve of the proposed addition of any individual to the Board of Directors or the employment of any individual as a senior executive officer of the Company before such addition or employment becomes effective; and (vi) provide progress reports to the Federal Reserve concerning the Company’s compliance with the Written Agreement. Prior to the Written Agreement, the Company entered adopted a Board Resolution dated November 17, 2009 which the Written Agreement superseded. The Board Resolution was concerned with the Company’s conservation of financial resources.

Management and the board of directors are committed to complying with the terms of the Written Agreement, and have already taken, and continue to take, numerous steps to address these matters. The Company reports to the Federal Reserve quarterly regarding its progress in complying with the provisions included in the Written Agreement. Compliance with the terms of the Written Agreement will be an ongoing priority for management of the Company. See also Note 20-“Management Plans” to the condensed consolidated financial statements included herein.

In response to the Board Resolution, the Company in November 2009 notified the Treasury of its intent to suspend its dividend payments on its TARP Series A Preferred Stock. The suspension of the dividend payments is permissible under the terms of the TARP CPP, but the dividend is a cumulative dividend and failure to pay dividends for six dividend periods triggers board of director appointment rights for the holder of the Series A Preferred Stock. At December 31, 2012, the Company had suspended thirteen dividend payments. On December 18, 2012, P. David Kuhl was appointed to the board of directors of the Company pursuant to the terms of the TARP CPP. The appointment was made following the consideration of several candidates proposed by both the Company and Treasury. After consideration of these multiple candidates, the Treasury and Company both agreed that Mr. Kuhl satisfied their respective criteria and that he was therefore best suited to assume the role of a director of the Company. Although not required to do so under the terms of the Series A Preferred Stock, the board of directors of the Company also appointed Mr. Kuhl to the board of directors of the Bank. In January 2011, the Company agreed to allow a Treasury observer to attend its board of directors meetings. However with Mr. Kuhl’s appointment, the Treasury observer attendance has been discontinued and Treasury has the contractual right to appoint one more director. While dividends are being deferred on the preferred stock issued under the TARP CPP, the Company may not pay dividends on its common stock.

In November 2009, the Company notified the trustee that holds the Company’s junior subordinated debentures relating to its trust preferred securities that the Company would be deferring its regularly scheduled quarterly interest payments. The Company has the right to defer the payment of interest on the junior subordinated debentures at any time, for a period not to exceed 20 consecutive quarters. During the deferral period, the Company may not pay any dividends on its common or preferred stock. Accordingly, the Company may not pay dividends on its common stock for the foreseeable future.

On April 16, 2010, the Bank’s Board of Directors, management, the FDIC and the IDFPR entered into a Consent Order. Various items required of the Bank, as agreed to under the Consent Order, are described in Note 21- “Consent Order” in the notes to the condensed consolidated financial statements.

Because the Consent Order establishes specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the levels of capital set forth in the Consent Order. At December 31, 2011, the Bank continued to exceed the capital levels established by the FDIC and the IDFPR in the Consent Order.

As an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC. Brokered deposits also include deposits with rates of interest that are more than 75 basis points above the rate applicable to the Bank’s market as determined by the FDIC. As of December 31, 2011, 3.0 percent of the Bank’s deposits were brokered deposits consisting of CDARS time deposits. During the first quarter of 2012, the Bank received the FDIC’s consent to renew or accept new CDARS brokered deposits through May 27, 2012 for certain Bank customers not to exceed $20.0 million. The Bank has also received a designation by the FDIC that the Bank is operating in a high rate area, which allows the Bank to use local average deposit rates as a basis for setting competitive rates on its deposits.

Any material failure to comply with the provisions of the Consent Order could result in additional enforcement actions by the FDIC as allowed by 12 U.S.C. §1818 and the IDFPR. While the Company intends to take such actions as may be necessary to enable the Bank to comply with the requirements of the Consent Order, there can be no assurance that the Bank will be able to comply fully with the provisions of the Consent Order or that efforts to comply with the Consent Order will not have adverse effects on the operations and financial condition of the Company and the Bank.

Management and the Board of Directors are committed to complying with the terms of the Consent Order, and have already taken, and continue to take, numerous steps to address these matters. The Bank reports to the FDIC and the IDFPR quarterly regarding its progress in complying with the provisions included in the Consent Order. Compliance with the terms of the Consent Order will be an ongoing priority for management of the Bank. See also Note 22-“Management Plans” to the condensed consolidated financial statements included herein.

~~TABLE~~Table OFof ~~CONTENTS~~Contents

InOn ~~July~~April 16, 2010, ~~Congress~~the ~~enacted~~Bank’s ~~regulatory~~board ~~reform~~of ~~legislation~~directors, ~~known~~management, as the ~~Dodd-Frank~~FDIC ~~Wall Street Reform~~ and ~~Consumer Protection Act, which~~ the ~~President~~IDFPR ~~signed~~entered into ~~law~~the on2010 ~~July~~Consent ~~21, 2010~~Order. ~~The~~On ~~Act~~January ~~permanently~~14, ~~raised~~2013, the ~~FDIC~~2010 ~~insurance~~Consent ~~coverage~~Order towas ~~$250,000~~terminated ~~per~~and ~~depositor. Among~~was ~~other~~replaced ~~things,~~by ~~it also~~the ~~provides~~2013 ~~unlimited~~Consent ~~FDIC~~Order. ~~insurance~~Both ~~coverage~~the of2010 ~~noninterest-bearing~~and ~~transaction~~the ~~accounts~~2013 ~~through~~Consent ~~December~~Orders 31require, ~~2012.~~among ~~This~~other ~~new~~items, ~~law~~continued ~~broadly~~Bank ~~affects~~Board ~~the~~of ~~financial~~Directors ~~services~~oversight, ~~industry~~certain byminimum ~~establishing~~capital alevels, ~~framework~~action ~~for~~plans ~~systemic~~to ~~risk~~reduce ~~oversight,~~and ~~creating~~manage aits ~~resolution~~classified ~~authority~~assets, ~~mandating~~and ~~higher~~restrictions ~~capital~~on ~~and~~the ~~liquidity~~payment ~~requirements,~~of ~~requiring~~dividends ~~banks~~without toprior ~~pay~~approval ~~increased~~from ~~fees~~its toregulators. ~~regulatory~~Various ~~agencies~~items ~~and~~required ~~containing~~of ~~numerous~~the ~~other~~Bank, ~~provisions~~as ~~aimed~~agreed atto ~~strengthening~~under the ~~sound~~Consent ~~operation~~Orders, ofare ~~the~~described ~~financial~~in ~~services~~Note ~~sector.~~19 ~~Many~~- ~~aspects~~“Consent ofOrder ~~the~~and ~~law~~Written ~~are~~Agreement” ~~subject~~in tothe ~~further~~notes ~~rulemaking~~to ~~and~~the ~~will~~condensed ~~take~~consolidated ~~effect~~financial ~~over~~statements. ~~several~~The ~~years,~~Company ~~making~~believes that it ~~difficult~~and tothe ~~anticipate~~Bank ~~the~~are ~~overall~~addressing ~~financial~~the ~~impact~~items torequired by the ~~Company~~Consent orOrder ~~across~~and ~~the~~Written ~~industry~~Agreement.

~~Following~~Because athe ~~compliance~~2013 ~~examination~~Consent ofOrder establishes specific capital amounts to be maintained by the Bank, ~~performed~~the byBank may not be considered better than “adequately capitalized” for capital adequacy purposes even if the ~~FDIC,~~Bank exceeds the ~~Board~~levels of ~~Directors~~capital ofset forth in the 2013 Consent Order. The 2013 Consent Order requires the Bank ~~approved~~to ~~and~~maintain ~~signed~~Tier on1 ~~October~~Capital ~~20,~~to ~~2010,~~average assets at a ~~memorandum~~minimum of ~~understanding~~8.00% ~~(“MOU”)~~and ~~concerning~~total ~~the~~risk-based capital ratio at a minimum of 12.00%. The Bank’s ~~compliance~~Tier ~~program~~1 ~~and~~Capital ~~deficiencies~~to ~~identified~~average ~~during~~assets ~~the~~ratio ~~examination~~was of6.67% ~~the~~as ~~Bank. On~~of December 2931, ~~2011~~2012, below the ~~FDIC~~2013 ~~terminated~~Consent ~~the~~Order ~~MOU~~while ~~because~~ the Bank’s ~~improved~~total ~~its~~risked-based ~~compliance~~capital ~~management~~ratio ~~system~~was 12. 11%, above the level required.

Management and the board of directors are committed to complying with the terms of the 2013 Consent Order, and have already taken, and continue to take, numerous steps to address these matters. The Bank reports to the FDIC and the IDFPR quarterly regarding its progress in complying with the provisions included in the 2013 Consent Order. Compliance with the terms of the 2013 Consent Order will be an ongoing priority for management of the Bank. See also Note 20 - “Management Plans” to the condensed consolidated financial statements included herein.

Any material failure to comply with the provisions of the Written Agreement and the 2013 Consent Order could result in additional enforcement actions by the Federal Reserve Bank, the FDIC as allowed by 12 U.S.C. §1818 and the IDFPR. While the Company intends to take such actions as may be necessary to enable the Company and Bank to comply with the requirements of the Written Agreement and the 2013 Consent Order, there can be no assurance that the Company and Bank will be able to comply fully with the provisions or that efforts to comply will not have adverse effects on the operations and financial condition of the Company and the Bank.

In July 2010, Congress enacted regulatory reform legislation known as the Dodd-Frank Wall Street Reform and Consumer Protection Act, which the President signed into law on July 21, 2010. The Act permanently raised the FDIC insurance coverage to $250,000 per depositor. Among other things, it provided unlimited FDIC insurance coverage of noninterest-bearing transaction accounts through December 31, 2012. This law broadly affects the financial services industry by establishing a framework for systemic risk oversight, creating a resolution authority, mandating higher capital and liquidity requirements, requiring banks to pay increased fees to regulatory agencies and containing numerous other provisions aimed at strengthening the sound operation of the financial services sector. Many aspects of the law are subject to further rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact to the Company or across the industry.

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. At year-end ~~2011~~2012, the Company had commitments to make loans of $3228.26 million as compared with $3632.52 million at year-end ~~2010~~2011 and $5836.75 million at year-end ~~2009~~2010. Letters of credit totaled $21.31 million at December 31, ~~2011~~2012 as compared with $3.2.3 million at December 31, ~~2010~~2011 and $63.52 million at December 31, ~~2009~~2010. Many of these commitments expire without being used. Table 1314 presents the Company’s significant fixed and determinable contractual obligations by payment date. The payment amounts in Table 1314 represent those amounts contractually due to the recipient and do not include any unamortized premiums or discounts or similar carrying amount adjustments.

Table 13 - Contractual Obligations, Commitments, Contingent Liabilities and Off-Balance Sheet Arrangements

($ 000s)

As of December 31, 2011	One year or less		Greater than one year and less than or equal to three years		Greater than three years and less than or equal to five years		Greater than five years		Total
Long-term debt
Subordinated debentures	$	0	$	0	$	0	$	10,310	$	10,310
Time deposits		128,802		19,967		3,548		0		152,317
Other contractual obligations
Standby letters of credit		2,283		0		0		0		2,283

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Table 14 - ~~Maturity~~ orContractual ~~Repricing~~Obligations, ofCommitments, ~~Assets~~Contingent Liabilities and ~~Liabilities~~Off-Balance Sheet Arrangements

($ 000s)

			Subject to Repricing Within
			Greater than			Greater than
			Immediate			90 Days			180 Days
			one year and less			three years and
			to			to			to			1 - 3			3 - 5			5 Years
	One year		than or equal			less than or			Greater than
December 31, 2011	Balances		90 Days			180 Days			365 Days			Years			Years			or Greater
As of December 31, 2012	or less		to three years			equal to five years			five years			Total
Assets:
Long-term debt
Interest bearing deposits in financial institutions	$	32,520	$	32,520		$	0		$	0		$	0		$	0		$	0
Subordinated debentures	$	0	$	0		$	0		$	10,310		$	10,310
Securities:
Time deposits		85,225		15,704			5,766			0			106,695
State & political subdivisions		3,117		124			0			0			253			272			2,468
Other contractual obligations
Mortgage-backed securities (1)		79,762		0			0			0			0			31			79,731
Standby letters of credit		1,103		0			0			0			1,103
Equity securities (2)		6,062		6,062			0			0			0			0			0
Loans and leases:
Commercial		15,827		3,638			1,048			2,097			3,429			2,559			3,056
Real estate-construction		28,504		18,268			1,527			3,054			5,575			80			0
Real estate-mortgage 1-4 family		35,758		6,861			1,845			3,690			12,319			5,055			5,988
Real estate-mortgage 5+ family		35,977		7,470			955			1,911			21,598			3,077			966
Real estate-mortgage commercial		183,881		37,834			16,409			32,818			66,754			20,376			9,690
Home equity		21,266		10,031			59			119			10,524			533			0
Leases		295		247			0			0			48			0			0
Installment		1,476		160			100			199			712			277			28
Total Interest Earning Assets	$	444,445	$	123,215		$	21,943		$	43,888		$	121,212		$	32,260		$	101,927
Liabilities:
NOW accounts	$	58,002	$	58,002		$	0		$	0		$	0		$	0		$	0
Money market accounts		53,185		53,185			0			0			0			0			0
Savings		66,172		66,172			0			0			0			0			0
Time deposits, $100,000 and over		69,837		31,945			11,069			13,713			11,194			1,916			0
Time deposits, under $100,000		70,627		25,987			15,717			18,518			8,773			1,632			0
Time deposits, brokered		11,853		8,101			1,252			2,500			0			0			0
Securities sold under repurchase agreements		19,455		19,455			0			0			0			0			0
Subordinated debentures		10,310		10,310			0			0			0			0			0
Total Interest Bearing Liabilities	$	359,441	$	273,157		$	28,038		$	34,731		$	19,967		$	3,548		$	0
Excess Interest Earning Assets (Liabilities)			$	(149,942	)	$	(6,095	)	$	9,157		$	101,245		$	28,712		$	101,927
Cumulative Excess Interest Earning Assets (Liabilities)				(149,942	)		(156,037	)		(146,880	)		(45,635	)		(16,923	)		85,004
Cumulative Interest Rate Sensitivity Ratio (3)				0.45			0.48			0.56			0.87			0.95			1.24

~~Notes:~~CASH FLOWS AND LIQUIDITY

The statement of cash flows shows the Company’s sources and uses of cash. The three major activities of the Company that create cash flows are operating, investing and financing.

For the years 2012, 2011 and 2010, the Company, showed positive cash flows from operating activities as its net losses were adjusted to a cash basis. Net cash flows from operating activities in 2012 were $5.0 million after the net loss of $12.6 million was adjusted for non cash provisions for loan and lease losses of $11.1 million and non cash write-downs of other real estate owned of $4.9 million. During 2011, the Company showed net cash flows from operating activities of $6.4 million after the net loss of $6.7 million was adjusted for non cash provisions for loan and lease losses of $6.9 million, non cash write-downs of other real estate owned of $4.0 million and net decreases to other assets of $1.4 million. Net cash flows from operating activities in 2010 were $9.1 million after the net loss of $6.4 million was adjusted for non cash provisions for loan and lease losses of $9.7 million, non cash write-downs of other real estate owned of $3.8 million and net decreases to other assets of $2.5 million.

Cash flows from investing activities come from securities available for sale, loans, other real estate owned and property and equipment transactions. During 2012, the Company had net cash inflows from investing activities of $47.9 million of which $35.9 million was due to decreased loan balances; other real estate owned sold for $7.3 million; and $9.8 million from maturities, calls and payments on securities. Offsetting a portion of these cash flows were net outflows of $5.4 million in purchases of time deposits in other financial institutions.

During 2011, the Company had net cash inflows from investing activities of $65.9 million of which $46.3 million was due to decreased loan balances; other real estate owned sold for $10.6 million; and $9.0 million from maturities, calls and payments on securities. Proceeds from the sale of securities of $20.1 million during 2011 were mostly offset by purchases of securities of $19.8 million.

There were net cash inflows of $71.4 million during 2010, as the Company received $105.7 million from the sale of securities; $27.4 million from maturities, calls and payments on securities; $16.0 million from decreased loan balances; and $12.1 million from sales of other real estate owned. These inflows were partially offset by purchases of securities of $89.4 million.

Primary financing activities of the Company that can create cash flows are deposits, repurchase agreements, borrowings, payment of dividends, purchase of treasury stock and selling stock. The Company had net outgoing cash flows from financing activities of $39.1 million during 2012 caused by decreases in deposits. During 2011, the Company had net outgoing cash flows from financing activities of $64.9 million caused by decreases in deposits of $48.9 million and repurchase agreements of $16.1 million. During 2010, the Company had net outgoing cash flows from financing activities of $84.3 million caused by decreases in deposits of $70.7 million and repurchase agreements of $13.8 million.

The timing of these cash flows do not always match and the Company must use liquidity management to provide funds to fill the gaps. Liquidity management at the Bank involves the ability to meet the daily cash flow requirements of depositors wanting to withdraw funds, borrowers’ needs for credit and the Company’s operating needs.

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As required by the 2013 Consent Order, Bank management has developed a liquidity plan that identifies the sources of liquid assets available to meet the Bank’s contingency funding over the next twelve months. This liquidity plan looks at the Bank’s ability to meet the cash flow requirements of customers and other operating needs and seeks to manage liquidity to meet these requirements.

The 2013 Consent Order also restricts payments of dividends from the Bank to the Company and as such conserves liquidity at the Bank. Dividends from the Bank are needed to fund dividend payments to the Company’s preferred and common stockholders and interest payments on its subordinated debentures. The Written Agreement between the Company and the Federal Reserve Bank dated March 17, 2011, prohibits the Company from paying dividends on its Series A Preferred Stock issued under the TARP CPP. Due to these constraints it is expected that the Company will continue to suspend dividend payments on its Series A Preferred Stock and will not pay any dividends to common stockholders in 2013. Also, the Company will continue to defer interest payments on its subordinated debentures. The dividends payable on the Series A Preferred Stock totaled $3.1 million and the interest payments payable on the subordinated debentures totaled $1.0 million at December 31, 2012.

Liquid assets for the Company were $70.5 million at December 31, 2012 as compared with $61.2 million at December 31, 2011. Liquid assets consist of cash and due from banks, federal funds sold, interest bearing deposits in financial institutions with maturities less than 90 days and unpledged securities available for sale less nominal cash reserves. As part of the liquidity policy, management reviews the Bank’s liquidity ratio weekly. The liquidity ratio is the net liquid assets divided by total deposits. At December 31, 2012, this internally calculated ratio at the Bank was 21.4 percent, compared with 18.2 percent at year-end 2011.

In its liquidity plan, the Bank considers federal funds sold, interest bearing deposits in banks and securities available for sale, particularly those of shorter maturities, as principal sources of liquidity. The Company had no federal funds sold at December 31, 2012 or December 31, 2011. Short-term interest bearing deposits totaled $47.2 million at December 31, 2012 increasing $14.7 million from $32.5 million at December 31, 2011 as the Company earns higher yields on these deposits than on federal funds sold. The Company classifies all of its securities as available for sale, which increases the Company’s flexibility to meet liquidity requirements by increasing its repurchase agreement balances or by selling unpledged securities. At year-end 2012, the Company had securities available for sale carried at $79.2 million of which $53.6 million were pledged to secure public deposits and repurchase agreements. Securities available for sale totaled $87.1 million at year-end 2011 of which $57.0 million were pledged.

The liquidity plan also considers the liquidity needed to fund loans net of funds provided by scheduled principal payments, anticipated payoffs and changes in deposit balances.

Liquidity is also available from the scheduled maturities of securities and interest bearing deposits in financial institutions with maturities of 90 days or more. At December 31, 2012, the Company has $4.7 million of interest bearing deposits in financial institutions with maturities of 90 days or more that mature in 2013. At December 31, 2012, the Company has $4.4 million of securities that either mature in 2013 or were equity securities that could be sold to provide liquidity. Additional liquidity is made available from anticipated principal payments on the Company’s investments in mortgage-backed securities which the Company estimates will be approximately $12.6 million during 2013 resulting from borrower payments and payoffs on the mortgages underlying these securities.

Another important source of liquidity to the Company is deposits. Under the 2013 Consent Order, the Bank must limit its brokered time deposits and is not permitted to pay a rate of interest on deposit products that is more than 75 basis points above the rate applicable to the Bank’s market as determined by the FDIC. The Company anticipates that brokered and wholesale time deposits may decrease from their current levels due in part to the Bank’s compliance with the 2013 Consent Order. The Bank expects that a portion of these deposit reductions will be offset by growth from core deposits to new retail and commercial customers. However, it is expected that deposits will stabilize during the 2013 and liquidity available from this source will be limited.

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Additional sources of liquidity to the Company are borrowings and securities sold under repurchase agreements. Securities sold under repurchase agreements amounted to $19.3 million and $19.5 million at December 31, 2012 and 2011, respectively. In its liquidity plan, the Bank considers its lines of credit available at the Federal Home Loan Bank of Chicago and the Federal Reserve Bank of Chicago of $15.3 million and $121,000, respectively, at December 31, 2012, as sources of liquidity. The Company has pledged loans totaling $28.1 million consisting of 1-4 family real estate mortgages, 5+ family real estate mortgages and commercial loans at December 31, 2012 as security for potential borrowings for these lines.

Table 15 - Maturity or Repricing of Assets and Liabilities

($ 000s)

			Subject to Repricing Within
December 31, 2012	Balances		Immediate to 90 Days		90 Days to 180 Days		180 Days to 365 Days		1 – 3 Years		3 – 5 Years		5 Years or Greater
Assets:
Interest bearing deposits in financial institutions	$	52,060	$	47,150	$	992	$	3,670	$	248	$	0	$	0
Federal funds sold		0		0		0		0		0		0		0

Securities:
State & political subdivisions		2,592		124		0		0		263		282		1,923
Mortgage-backed securities (1)		72,266		0		0		0		0		25		72,241
Equity securities (2)		5,223		5,223		0		0		0		0		0

Loans and leases:
Commercial		13,120		2,214		1,489		2,978		2,819		776		2,844
Real estate-construction		21,128		10,369		2,348		4,696		1,046		2,669		0
Real estate-mortgage 1-4 family		32,417		7,614		2,011		4,023		6,945		5,553		6,271
Real estate-mortgage 5+ family		27,787		2,900		1,765		3,531		16,319		2,203		1,069
Real estate-mortgage commercial		159,729		61,814		12,566		25,131		32,477		26,908		833
Home equity		17,365		7,073		62		125		9,796		309		0
Leases		12		0		4		8		0		0		0
Installment		1,291		32		98		195		572		394		0

Filing Compare · NORTHERN STATES FINANCIAL CORP /DE/