Old Second Bancorp - 10-Q quarterly report FY

Washington, D.C. 20549

FORM 10-Q

Commission File Number 0 -10537

OLD SECOND BANCORP, INC.

(Exact name of Registrant as specified in its charter)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).  Yes  ýNo  o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: As of July 15, 2004, the Registrant had outstanding 6,708,840 shares of common stock, $1.00 par value per share.  On June 16, 2004, the Company declared a 2-for-1 common stock split effected in the form of a one hundred percent stock dividend payable on July 28, 2004, to stockholders of record on July 16, 2004.

OLD SECOND BANCORP, INC.

Form 10-Q Quarterly Report

Table of Contents

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PART I - FINANCIAL INFORMATION

Item 1.  Financial Statements

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share data)

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Income

(In thousands, except share data)

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Six Months Ended June 30, 2004 and 2003

(In thousands)

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

Note 1 – Summary of Significant Accounting Policies

The accounting policies followed in the preparation of interim consolidated financial statements are consistent with those used in the preparation of annual financial information. The interim consolidated financial statements reflect all normal and recurring adjustments, which are necessary, in the opinion of management, for a fair statement of results for the interim period presented.  Results for the period ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.  These interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s 2003 Form 10-K.  Unless otherwise indicated, amounts in the tables contained in these Notes are in thousands.

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts, reported in the consolidated financial statements.

All significant accounting policies are presented in Note 1 to the consolidated financial statements for the year ended December 31, 2003. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined.

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Note 2 – Securities

Securities available for sale are summarized as follows:

Note 3 – Loans

Major classifications of loans were as follows:

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Note 4 – Allowance for Loan Losses

Changes in the allowance for loan losses as of June 30, are summarized as follows:

Note 5 – Deposits

Major classifications of deposits were as follows:

Note 6 – Borrowings

The Company had a $30 million line of credit available with Marshall & Ilsley under which there was an outstanding balance of $500,000 as of June 30, 2004, and also had a $20 million line of credit available with Marshall & Ilsley under which there was an outstanding balance of $500,000 as of December 31, 2003.  A revolving business note dated April 30, 2004 secures the line of credit and is guaranteed by the Company.   The note provides that any outstanding principal will bear interest, at the Company’s option, at the rate of either 1% over the previous month average Federal Reserve targeted rate (federal funds rate) or 0.90% over the adjusted interbank rate, with a minimum interest rate of 2.20%.  This borrowing is for general corporate purposes.

The Company enters into sales of securities under agreements to repurchase (repurchase agreements).  Repurchase agreements may be of varying maturities but are generally under one year.  Underlying securities remain in the Company’s portfolio during the term of the repurchase agreement and are treated as collateral pledged to the customer.  Repurchase agreements generally consisted of U.S. government agencies at June 30, 2004 and December 31, 2003.

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The Company borrowings at the FHLB are limited to the lesser of 35% of total assets or 60% of the book value of certain mortgage loans. In addition, these notes are collateralized by FHLB stock of $5.7 million at June 30, 2004 and $3.7 million at December 31, 2003.

The Company is a Treasury Tax & Loan (TT&L) depository for the Federal Reserve Bank (FRB), and as such, it accepts TT&L deposits. The Company is allowed to hold these deposits for the FRB until they are called. The interest rate is the federal funds rate less 25 basis points. U.S. Treasury Securities with a face value greater than or equal to the amount borrowed are pledged as a condition of holding TT&L deposits. As of June 30, 2004 and December 31, 2003, the TT&L deposits were $1.1 million and $3.1 million, respectively.

At June 30, 2004 and December 31, 2003, total short-term borrowings totaled $124.2 million at a weighted average rate of 1.2% and $154.4 million at a weighted average rate of 1.2%, respectively.   The decrease in short-term borrowings was primarily the result of deposit growth during 2004 that exceeded asset growth. During the six-months ended June 30, 2004, loans and securities grew $113.4 million while deposits grew $184.6 million.

The following table reflects categories of short-term borrowings having average balances during the period greater than 30% of stockholders’ equity of the Company at the end of the period. For the year ended December 31, 2003, securities sold under repurchase agreements met the criteria. For the six months ended June 30, 2004, federal funds sold met the criteria.   Information presented is as of or for the periods indicated:

Note 7–Trust Preferred Debentures

During June 2003, the Company completed its tender offer for shares of its common stock, in which 723,053 shares were repurchased at $42.50 per share.  The total cash payment required to complete the tender offer was approximately $30.7 million, which was funded by the sale of trust preferred securities.  The Company completed the sale of $27.5 million of cumulative trust preferred securities by its subsidiary, Old Second Capital Trust I in June 2003.  An additional $4.1 million of cumulative trust preferred securities was sold in the first week of July 2003.  The costs associated with the tender offer of the cumulative trust preferred securities are being amortized over 30 years using the straight-line method.  Cash distributions on the securities are payable quarterly at an annual rate of 7.80% and are included in interest expense in the consolidated financial statements.

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Note 8– Long-Term Incentive Plan

The Long-Term Incentive Plan (the “Incentive Plan”) currently authorizes the issuance of up to 666,000 shares of the Company’s common stock, including the granting of qualified stock options, nonqualified stock options, restricted stock and stock appreciation rights. Stock based awards may be granted to selected directors and officers or employees at the discretion of the board of directors. The Incentive Plan requires the exercise price of any incentive stock option issued to an employee to be at least equal to the fair market value of Company common stock on the date the option is granted. All stock options are granted for a maximum term of ten years, with vesting occurring during the first three years.

Nonqualified stock options may be granted to directors based on a formula. These options, along with other awards under the Incentive Plan, may be granted subject to a vesting requirement, and would become fully vested upon a merger or change in control of the Company. Since December 31, 1998, there have been no nonqualified stock options, stock appreciation rights, or restricted stock issued under the Incentive Plan.

A summary of activity in the Incentive Plan and options outstanding is included below:

The Company accounts for stock options in accordance with APB No. 25, as allowed under SFAS No. 123.  No expense for stock options is recorded, as the grant price equals the market price of the stock at grant date.  There were no stock options granted in 2004.

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The following pro forma information presents net income and earnings per share had the fair value method of SFAS No. 123 been used to measure compensation cost for stock option plans.

The pro forma effects were computed using option-pricing models with the following assumptions

Note 9 – Earnings Per Share

Earnings per share is included below (share data not in thousands):

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Note 10 – Comprehensive Income

Comprehensive income is included below:

Note 11 – Retirement Plans

The Company has a tax-qualified noncontributory defined benefit retirement plan covering substantially all full-time and regular part-time employees of the Company. Generally, benefits are based on years of service and compensation. Certain participants in the defined benefit plan are also covered by an unfunded supplemental retirement plan. The purpose of the supplemental retirement plan is to extend full retirement benefits to individuals without regard to statutory limitations under tax-qualified plans.

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The Company maintains tax-qualified contributory and non-contributory profit sharing plans covering substantially all full-time and regular part-time employees. The expense of these plans was $764,000 and $817,000 for the six-months ended June 30, 2004 and 2003, respectively.

Note 12 – Subsequent events

On June 16, 2004, the Company declared a 2-for-1 common stock split effected in the form of a one hundred percent stock dividend payable on July 28, 2004, to stockholders of record on July 16, 2004.

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Item 2.   Managements’ Discussion and Analysis of Financial Condition and Results of Operations

Overview

Old Second Bancorp, is a financial services company with its main headquarters located in Aurora, Illinois.  The Company has offices located in Kane, Kendall, DeKalb, DuPage and LaSalle counties in Illinois.  The Company provides financial services through its three subsidiary banks at its twenty-four banking locations.  Old Second Mortgage provides mortgage-banking services at its four offices.  Old Second Financial, Inc. provides insurance products.  The Old Second National Bank of Aurora, the Company’s lead subsidiary bank, also engages in trust operations.

Critical Accounting Policies

Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances.  Some of the facts and circumstances that could affect these judgments include changes in interest rates, in the performance of the economy or in the financial condition of borrowers.  Management has determined that its accounting policies with respect to the allowance for loan losses is the accounting area requiring subjective or complex judgments that is most important to the Company’s financial position and results of operations, and therefore, is its only critical accounting policy.  The Company’s critical accounting policies are discussed in detail in the Annual Report for the year ended December 31, 2003 (incorporated by reference as part of the Company’s 10-K filing) in Note 1 of the Notes to the Consolidated Financial Statements.

Results of Operations

The Company earned $1.71 diluted earnings per share in the first half of 2004, a 17.9% increase over the $1.45 earned in the first half of 2003.  Net income was $11.59 million in the first half of 2004 compared with $10.85 million in the first half of 2003.  This was a 6.82% increase in earnings.  The Company earned $.81 diluted earnings per share in the second quarter of 2004, a 6.75% increase over the $.75 in the second quarter of 2003.  Net income was $5.5 million in the second quarter of 2004, compared with $5.6 million in the second quarter of 2003.  Earnings were impacted in the second quarter by a $1.17 million reserve, net of tax, for the settlement of a damage award.

The return on equity increased to 19.07% in the first half of 2004, from 15.88% for the same period of 2003.   The return on equity was enhanced by the tender offer for common stock related to the issuance of cumulative trust preferred securities in June 2003.  Earnings for the first half of 2004 were enhanced by strong asset growth, the gain on sale of securities, the reduction of the loan loss provision and a decrease in the tax provision.  The return on equity increased to 17.95% in the second quarter of 2004, from 16.18% for the same period of 2003.

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Net Interest Income

Net-interest income increased from $30.3 million in the first half of 2003 to $33.7 million in the first half of 2004, an 11.22% increase. The increase was primarily the result of an increase in interest income on loans of $4.7 million, offset by the increase in interest expense related to the interest paid on the trust preferred debentures of $1.3 million.

Management, in order to evaluate and measure performance, uses certain non-GAAP performance measures and ratios. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures and ratios provide users of the financial information with a more accurate view of the performance of the interest-earning assets and interest-bearing liabilities and of the Company’s operating efficiency for comparison purposes. Other financial holding companies may define or calculate these measures and ratios differently. See the following two tables for supplemental data and the corresponding reconciliation to GAAP financial measures for the six months ended June 30, 2004 and 2003.

Yields on certain asset categories and the net interest margin of the Company and its banking subsidiaries are reviewed on a fully taxable-equivalent basis (“FTE”). In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measure ensures comparability of net interest income arising from both taxable and tax-exempt sources.

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The following table sets forth certain information relating to the Company’s average consolidated balance sheets and reflects the yield on average earning assets and cost of average liabilities for the periods indicated. The rates are determined by dividing the related interest by the average balance of assets or liabilities. Average balances are derived from daily balances.

ANALYSIS OF AVERAGE BALANCES,

TAX EQUIVALENT INTEREST AND RATES

For the six-month periods ended June 30, 2004 and 2003

Notes:             Nonaccrual loans are included in the above stated average balances.

Tax equivalent basis is calculated using a marginal tax rate of 35%.

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Provision for Loan Losses

The Company did not make a provision for loan losses during the first half of 2004 compared to a provision of $1,718,000 during the first half of 2003. The determination by management to maintain the level of the allowance for loan losses at the year-end level was based on a number of factors, including the quality of the loan portfolio and past favorable loan loss experience.  Provisions for loan losses are made to provide for probable and estimable losses inherent in the loan portfolio.  The provision reflects a number of factors, including the size of the loan portfolio, the amount of past due accruing loans (90 days or more), the amount of non-accrual loans and management’s overall view on current credit quality.  Net recoveries for the first half of 2004 were $13,000 compared with net charge-offs of $603,000 in the first half of 2003.  Total loan charge-offs were $215,000 during the first six months of 2004, compared with $959,000 during the first six months of 2003, while recoveries for the same periods were $228,000 and $356,000, respectively.

The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet.

One measure of the adequacy of the allowance for loan losses is the ratio of the allowance to total loans. The allowance for loan losses as a percentage of total loans was 1.28% as of June 30, 2004, compared to 1.39% as of December 31, 2003 and 1.43% as of June 30, 2003.  In management’s judgment, an adequate allowance for estimated losses has been established; however, there can be no assurance that such loss will not exceed the estimated amounts in the future.

Nonperforming loans of $2.4 million as of June 30, 2004, were down from $2.6 million as of December 31, 2003. Nonperforming loans include loans in nonaccrual status, renegotiated loans, and loans past due ninety days or more and still accruing.  Nonaccrual loans decreased from $2.3 million as of December 31, 2003 to $1.6 million as of June 30, 2004.  The allowance for loan losses as a percentage of nonperforming loans was 755.22% at June 30, 2004 as compared to 691.65% as of December 31, 2003.  Asset quality has remained strong, as demonstrated by net charge-offs decreasing from $603,000 in the first half of 2003 to net recoveries of $13,000 in the first half of 2004.

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Past due and nonaccrual loans for the six-month periods ended June 30, 2004 and December 31, 2003 were as follows:

Noninterest Income

Noninterest income was $6.4 million during the second quarter of 2004 and $7.9 million during the second quarter of 2003, a decrease of $1.5 million, or 18.9%.  A decrease in loan originations in the second quarter of 2004 resulted in a decrease in the gain on sale of loans of $1.7 million, or 50.2% and a decrease in secondary mortgage fees of $199,000 or 42.3%.  The decrease in loan originations in the first half of 2004 resulted in a decrease in the gain on sale of loans of $3.6 million, or 55.4% and a decrease in secondary mortgage fees of $454,000 or 49.2% over the first half of 2003.  The first half of 2003 produced an unprecedented volume of mortgage originations while mortgage rates were near historically low levels.  The decrease in loan originations in 2004 was primarily the result of rising mortgage rates during the second half of 2003, which lead to decreased mortgage refinance activity and decreased demand for home mortgages and this has carried over to 2004.  Management does not expect that the high level of gains on sale of loans experienced during 2003 will be repeated during 2004.

During the first half of 2004, increased investment activity resulted in a gain on the sale of securities of $389,000, compared with $39,000 in the first half of 2003.  Service charges on deposits increased $294,000, or 9.08% for the six-month period.  Trust assets under management increased from $746.8 million at June 30, 2003 to $818.5 million at June 30, 2004 resulting in an increase in trust income of  $219,000 or 8.28% for the first half of 2004. Service charges on deposits increased $204,000, or 12.6% for the quarter and $294,000, or 9.1% for the six-month period.

Noninterest Expense

Noninterest expense was $15.2 million during the second quarter of 2004, an increase of $1.3 million, or 9.4%, from $13.9 million in the second quarter of 2003.  Noninterest expense was $29.0 million during the first half of 2004, an increase of $2.0 million, or 7.4%, from $27.0 million in the first half of 2003.  Salaries and benefits, which is the largest component of noninterest expense, decreased in the first six months of 2004 by $493,000, or 2.87% from the first six months of 2003.  Salaries and benefits expense was $8.3 million during the second quarter of 2004, a decrease of $384,000, or 4.43%, from $8.7 million in the second quarter of 2003.  The full-time equivalent number of employees was 546 as of June 30, 2004, as compared with 539 one year earlier.  Increased staffing and merit increases were offset in both periods by decreases in commissions and incentives tied to earnings performance for the mortgage company.

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Employee benefit expenses increased during the second quarter of 2004 by $150,000 from the second quarter of 2003 and increased in the first six months of 2004 by $345,000 from the first six months of 2003.   Employee benefit expenses were also affected by higher employee healthcare insurance and retirement benefits.

Net occupancy and furniture and equipment expenses decreased $97,000, or 4.8% from the second quarter of the of 2003 to the second quarter 2004 and increased $150,000, or 3.8%, from the first half of 2003 to the second half 2004.   As the Company has expanded into and developed new markets, related facility and employee expenses have increased accordingly.  There were two new branch openings in the first six months of 2004.  Other expense, which consists primarily of postage, professional fees and marketing, increased from $5.7 million in the first half of 2003 to $6.3 million in the first half of 2004 related to the expansion into and developing of new markets.

On July 28, 2004, the Company and the plaintiff reached an agreement to settle a jury verdict against a subsidiary of the Company.  Under the terms of the settlement, the Company paid the plaintiff $1.75 million, or $1.17 million, net of tax.

Income Taxes

The Company’s provision for Federal and State of Illinois income taxes was $2.6 million and $3.2 million for the second quarters of 2004 and 2003 respectively and $5.8 million and $6.0 million for the first halves of 2004 and 2003 respectively.  The average effective income tax rates for the second quarters of 2004 and 2003 were 31.7% and 36.3% respectively and 33.3% and 35.7% for the first halves of 2004 and 2003 respectively.   The decrease in the average effective tax rate for 2004 was related to the $1.17 million accrual for litigation, net of $580,000 in taxes, recorded in the second quarter.

Financial Condition

Assets

Total assets reached $2.0 billion at June 30, 2004 for the first time in the Company’s history, an increase of $160.0 million or 8.70% from $1.84 billion at December 31, 2003.

Loans

Total loans were $1.43 billion as of June 30, 2004, an increase of $110.0 million or 8.33% during the six-month period, from $1.32 billion as of December 31, 2003. The largest increases in loan classifications were in real estate construction and real estate residential loans, which increased $55.8 million and $47.8 million, respectively. These changes reflected the continuing loan demand in the markets in which the Company operates.  The loan portfolio generally reflects the profile of the communities in which the Company operates. Because the Company is located in growing areas, real estate lending (including commercial, residential, and construction) is a significant portion of the portfolio. These categories comprised 82.1% of the portfolio as of December 31, 2003 and 84.2% of the portfolio as of June 30, 2004.

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Securities

Securities totaled $418.1 million as of June 30, 2004, an increase of $7.10 million from $411.0 million as of December 31, 2003.  During March 2004, the Company purchased $20 million in bank-owned life insurance (BOLI) that was reported in other assets on the consolidated financial statements. The BOLI purchase was funded by the sale of $20 million of securities, which resulted in a net gain of $629,000.   The net unrealized gains, net of deferred taxes, in the portfolio decreased from a $3.0 million net gain as of December 31, 2003 to a $590,000 net loss as of June 30, 2004.

Deposits and Borrowings

Total deposits were $1.71 billion as of June 30, 2004, an increase of $190.0 million, or 12.5% from $1.52 billion as of December 31, 2003.  Demand deposits increased $15.8 million during the first half of the year from $214.4 million to $230.3 million or 7.37%.  At the same time, savings deposits, which include money market accounts, increased $66.3 million or 9.0% from $737.8 million to $804.1 million.  Time deposits increased $102.5 million from $572.4 million to $674.8 million or 17.9% during the same period.  Given the lower interest rate environment in which retail time deposits were maturing, pricing and sales strategies targeted growth in transactional deposit accounts and customer reinvestment of maturing time deposit balances in longer-term maturities.  Successful selling efforts in these areas resulted in an increase in new account relationships and core funding sources.

Securities sold under repurchase agreements, which are typically of short-term duration, decreased from $47.8 million as of December 31, 2003, to $42.9 million as of June 30, 2004. Other short-term borrowings decreased from $106.0 million to $80.9 million due to a decrease in federal funds purchased of $49.2 million offset by a Federal Home Loan advance of $26.5 million.  The Company is currently maintaining liquid assets and delivering consistent growth in core funding to provide funding for loan growth.

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Capital

The Company and its three subsidiary banks are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines provide for five classifications, the highest of which is well capitalized. The Company and its subsidiary banks were categorized as well capitalized as of June 30, 2004. The accompanying table shows the capital ratios of the Company and Old Second National Bank, the Company’s largest subsidiary bank, as of June 30, 2004.

Capital levels and minimum required levels:

During June 2003, the Company completed its tender offer for shares of its common stock, in which 723,053 shares were repurchased at $42.50 per share.  The total cash payment required to complete the tender offer was approximately $31.6 million, which was funded by the issuance of cumulative trust preferred securities by its subsidiary, Old Second Capital Trust I (Nasdaq:OSBCP).  The costs associated with the tender offer of the cumulative trust preferred securities are being amortized over 30 years using the straight-line method.  Cash distributions on the securities are payable quarterly at an annual rate of 7.80%, and are included in interest expense in the consolidated financial statements.

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Liquidity and Market Risk

Liquidity is the Company’s ability to fund its operations, to meet depositor withdrawals, to provide for customers’ credit needs, to meet maturing obligations and its existing commitments, and to withstand fluctuations in deposit levels.  The liquidity of the Company principally depends on cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and its ability to borrow funds in the money or capital markets.

Net cash outflows from operating activities were $4.2 million in the first half of 2004, compared with net cash inflows of $9.9 million in the first half of 2003. The decrease in cash inflows was related to the increase in accrued interest receivable and other assets of $22.8 million offset by a decrease in accrued interest payable and other liabilities of $5.2 million.  The increase in accrued interest receivable and other assets was directly related to the $20 million purchase of BOLI recorded in other assets. The increase in accrued interest payable and other liabilities were related to the changes in income taxes payable.  Interest received, net of interest paid, was the principal use of operating cash outflows in both periods reported.  Management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows.  Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, so that balance sheet growth is the principal determinant of growth in net interest cash flows.

Net cash outflows from investing activities were $121.4 million in the six months ended June 30, 2004, compared to $108.0 million a year earlier. In the first six months of 2004, securities transactions accounted for a net outflow of $14.4 million, and net change in loans accounted for net outflows of $105.8 million. In the first six months of 2003, securities transactions accounted for a net inflow of $16.3 million, and net change in loans accounted for net outflows of $121.4 million.  Cash outflows for property and equipment were $1.9 million in the first six months of 2004 compared to $3.0 million in the first six months of 2003.

Cash inflows from financing activities included an increase in deposits of $184.6 million and a decrease in repurchase agreements of $5.0 million in the first six months of 2004, offset by a $25.2 million decrease in federal funds purchased and other short-term borrowings.  This compares with a net cash inflow of $83.4 million as a result of an increase in deposits of $93.5 million, and an increase in federal funds purchased and other short-term borrowings of $18.1 million, offset by a reduction to repurchase agreements of $21.3 million during the first six months of 2003.   The issuance of $26.3 million in trust preferred debentures during June 2003 was directly offset by the repurchase of $30.9 million in treasury stock.

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Interest Rate Risk

The impact of movements in general market interest rates on a financial institution’s financial condition, including capital adequacy, earnings, and liquidity, is known as interest rate risk. Interest rate risk is the Company’s primary market risk. As a financial institution, accepting and managing this risk is an inherent aspect of the Company’s business. However, safe and sound management of interest rate risk requires that it be maintained at prudent levels.

The Company analyzes interest rate risk by examining the extent to which assets and liabilities are interest rate sensitive. The interest sensitivity gap is defined as the difference between the amount of interest earning assets maturing or repricing within a specific time period, and the amount of interest-bearing liabilities maturing or repricing within that time period. A gap is considered positive when the amount of interest sensitive assets exceeds the amount of interest sensitive liabilities. A gap is considered negative when the amount of interest sensitive liabilities exceeds the amount of interest sensitive assets. During a period of rising interest rates, a negative gap would tend to result in a decrease in net interest income, while a positive gap would tend to positively affect net interest income. The Company’s policy is to manage the balance sheet so that fluctuations in the net interest margin are minimized, regardless of the level of interest rates.

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The accompanying table does not necessarily indicate the future impact of general interest rate movements on the Company’s net interest income, because the repricing of certain assets and liabilities is discretionary, and is subject to competitive and other pressures. As a result, assets and liabilities indicated as repricing within the same period may in fact reprice at different times and at different rate levels. Assets and liabilities are reported in the earliest time frame in which maturity or repricing may occur. Although securities available for sale are reported in the earliest time frame in which maturity or repricing may occur, these securities may be sold in response to changes in interest rates or liquidity needs.

Expected Maturity of Interest-Earning Assets and Interest-Bearing Liabilities

6/30/2004