Edgar Filing: PRINCETON NATIONAL BANCORP INC

Princeton National Bancorp, Inc. Form 10-Q for quarterly period ended 6-30-2009

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2009

Commission File Number 0-20050

PRINCETON NATIONAL BANCORP, INC.

(Exact name of registrant as specified in its charter)


Delaware	36-3210283
(State or other jurisdiction	(I.R.S. Employer Identification No.)
of incorporation or organization)

606 S. Main Street, Princeton, IL 61356

(Address of principal executive offices and Zip Code)

(815) 875-4444

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No o

Indicate by check mark whether the registrant 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 during the preceding twelve months (or for such shorter period that the registrant was required to submit and post such files).

Yes o No o

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


Large accelerated filer		o
Accelerated filer		x
Non-accelerated filer		o
Smaller reporting company		o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

As of July 8, 2009, the registrant had outstanding 3,302,157 shares of its $5 par value common stock.

Page 1 of 41 pages

Part I: FINANCIAL INFORMATION

The unaudited consolidated financial statements of Princeton National Bancorp, Inc. and Subsidiary and management’s discussion and analysis of financial condition and results of operation are presented in the schedules as follows:


	Schedule 1:	Consolidated Balance Sheets
	Schedule 2:	Consolidated Statements of Income
	Schedule 3:	Consolidated Statements of Stockholders’ Equity
	Schedule 4:	Consolidated Statements of Cash Flows
	Schedule 5:	Notes to Consolidated Financial Statements
	Schedule 6:	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Schedule 7:	Controls and Procedures

Part II: OTHER INFORMATION

Item 1A. Risk Factors

The current volatility in economic conditions and the financial markets may adversely affect our industry, business and financial performance. There have been unprecedented disruptions in financial markets in the past nine months, including volatility in asset values and constraints on the availability of credit. In response to these developments, the U.S. government has taken, and may take further, steps designed to stabilize markets generally and strengthen financial institutions in particular. The impact, if any, these financial market events or these governmental actions might have on the Company and its business is still uncertain and cannot be estimated at this time. Item 1A (“Risk Factors”) of the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 discusses some of the principal risks inherent in the Company’s business, including interest rate risks, liquidity risks, credit risks, operational risks, risks from economic or market conditions and general business risks among others. The current upheaval in financial markets has accentuated each of these risks and magnified their potential effect on the Company.

At the same time, there has been a general weakening of the U.S. economy. To the extent these economic developments continue to worsen, and to the extent legislation or regulatory action adversely affects the U.S. economy, the Company’s access to capital or the credit quality of the Company’s loan portfolio, or imposes additional limitations or costs on the Company’s business, there could be an adverse impact on the Company’s costs, credit losses, access to capital or liquidity.

Item 4. Submission of Matters to a Vote of Security Holders

The Annual Meeting of Shareholders of Princeton National Bancorp, Inc. was held on April 28, 2009, for the purpose of electing four directors to serve for a term of three years. Proxies for the meeting were solicited by Management pursuant to Regulation 14A under the Securities Exchange Act of 1934, and there was no solicitation in opposition to Management’s solicitation.

All four of the nominees for director listed in the proxy statement were elected. The results of the vote were as follows:


	Shares Voted “For”		Shares “Withheld”		Abstain

Gretta E. Bieber		2,783,748		119,056		0
Gary C. Bruce		2,762,484		140,320		0
John R. Ernat		2,804,989		97,815		0
Tony J. Sorcic		2,788,517		114,287		0

In addition, the following directors’ terms of office continued after the meeting:


Daryl Becker	Mark Janko	Stephen W. Samet
Sharon L. Covert	Willard Lee	Craig O. Wesner
Donald E. Grubb	Ervin I. Pietsch

Item 6. Exhibits


	31.1	Certification of Tony J. Sorcic required by Rule 13a-14(a).

	31.2	Certification of Todd D. Fanning required by Rule 13a-14(a).

	32.1	Certification of Tony J. Sorcic required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.

	32.2	Certification of Todd D. Fanning required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

PRINCETON NATIONAL BANCORP, INC.


By	/s/ Tony J. Sorcic	By	/s/ Todd D. Fanning
	Tony J. Sorcic		Todd D. Fanning
	President & Chief Executive Officer		Sr. VP & Chief Financial Officer
	July 27, 2009		July 27, 2009

Schedule 1

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)


	June 30, 2009 (unaudited)			December 31, 2008
ASSETS
Cash and due from banks	$	12,741		$	20,163
Interest-bearing deposits with financial institutions		35,929			98

Total cash and cash equivalents		48,670			20,261

Loans held for sale, at lower of cost or market		2,766			2,155

Investment securities:
Available-for-sale, at fair value		317,514			236,883
Held-to-maturity, at amortized cost (fair value of $15,568 and $14,461)		15,186			14,232

Total investment securities		332,700			251,115

Loans:
Loans, net of unearned interest		765,754			790,837
Allowance for loan losses		(6,160	)		(5,064	)

Net loans		759,594			785,773

Premises and equipment, net of accumulated depreciation		28,935			29,297
Land held for sale, at lower of cost or market		2,354			2,354
Federal Reserve and Federal Home Loan Bank stock		4,230			4,211
Bank-owned life insurance		22,072			21,588
Accrued interest receivable		7,840			9,693
Other real estate owned		15,250			2,487
Goodwill		24,521			24,521
Intangible assets, net of accumulated amortization		3,776			4,207
Other assets		5,346			5,468

TOTAL ASSETS	$	1,258,054		$	1,163,130

LIABILITIES
Deposits:
Demand	$	108,952		$	110,559
Interest-bearing demand		289,432			246,714
Savings		67,144			61,089
Time		590,129			543,770

Total deposits		1,055,657			962,132

Borrowings:
Customer repurchase agreements		35,621			35,532
Federal funds purchased		0			6,500
Interest-bearing demand notes issued to the U.S. Treasury		1,516			2,441
Advances from the Federal Home Loan Bank		32,496			32,493
Trust preferred securities		25,000			25,000
Note payable		0			16,050

Total borrowings		94,633			118,016

Other liabilities		9,664			10,511

TOTAL LIABILITIES		1,159,954			1,090,659

STOCKHOLDERS’ EQUITY
Preferred stock, no par value; 100,000 shares authorized; 25,083 shares issued and outstanding at June 30, 2009		24,944			—
Common stock: $5 par value, 7,000,000 shares authorized; 4,478,295 shares issued		22,391			22,391
Common stock warrants		150
Additional paid-in capital		18,395			18,420
Retained earnings		55,597			54,329
Accumulated other comprehensive income, net of taxes		624			1,402
Less: Cost of 1,176,138 and 1,180,254 treasury common shares at June 30, 2009 and December 31, 2008, respectively		(24,001	)		(24,071	)

TOTAL STOCKHOLDERS’ EQUITY		98,100			72,471

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	1,258,054		$	1,163,130

See accompanying notes to unaudited consolidated financial statements

Schedule 2

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(dollars in thousands, except share data)


	For the Three Months Ended June 30				For the Six Months Ended June 30
	2009		2008		2009		2008
Interest income:
Interest and fees on loans	$	11,167	$	11,801	$	22,543	$	24,152
Interest on investment securities:
Taxable		1,920		1,681		3,723		3,297
Non-taxable		1,296		978		2,424		2,041
Interest on federal funds sold		0		4		0		29
Interest on interest-bearing time deposits in other banks		35		9		51		20

Total interest income		14,418		14,473		28,741		29,539

Interest expense:
Interest on deposits		5,103		5,805		10,250		12,479
Interest on borrowings		686		851		1,467		1,789

Total interest expense		5,789		6,656		11,717		14,268

Net interest income		8,629		7,817		17,024		15,271
Provision for loan losses		1,465		450		2,635		818

Net interest income after provision for loan losses		7,164		7,367		14,389		14,453

Non-interest income:
Trust & farm management fees		394		336		708		812
Service charges on deposit accounts		977		1,110		1,953		2,202
Other service charges		508		567		953		1,024
Gain on sales of securities available-for-sale		574		0		761		276
Brokerage fee income		249		208		447		427
Mortgage banking income, net		765		288		876		636
Bank-owned life insurance income		230		206		473		421
Other operating income		34		36		148		106

Total non-interest income		3,731		2,751		6,319		5,904

Non-interest expense:
Salaries and employee benefits		4,113		4,226		8,693		8,623
Occupancy		602		611		1,311		1,290
Equipment expense		763		751		1,536		1,470
Federal insurance assessments		826		84		1,523		168
Intangible assets amortization		208		178		416		357
Data processing		339		302		655		579
Advertising		211		162		408		330
Other real estate expenses, net		419		91		509		122
Other operating expense		1,234		1,104		2,424		2,130

Total non-interest expense		8,715		7,509		17,475		15,069

Income before income taxes		2,180		2,609		3,233		5,288
Income tax expense		282		589		178		1,177

Net income		1,898		2,020		3,055		4,111

Preferred stock dividends		317		—		554		—
Accretion of preferred stock discount		6		—		11		—

Net income available to common stockholders	$	1,575	$	2,020	$	2,490	$	4,111

Per share information:
BASIC net income per common share available to common stockholders		0.48		0.61		0.75		1.25
DILUTED net income per common share available to common stockholders		0.48		0.61		0.75		1.24

Basic weighted average shares outstanding		3,300,161		3,295,998		3,299,119		3,300,030
Diluted weighted average shares outstanding		3,300,586		3,309,084		3,299,634		3,311,735

See accompanying notes to unaudited consolidated financial statements

Schedule 3

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(Unaudited)
(dollars in thousands except per share data)


For the Six Months Ended June 30, 2009	Preferred Stock		Common Stock		Common Stock Warrants		Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss), net of tax effect			Treasury Stock			Total

Balance, January 1, 2009	$	—	$	22,391	$	—	$	18,420		$	54,329		$	1,402		($	24,071	)	$	72,471

Net income											3,055									3,055
Issuance of 25,083 shares of preferred stock and 155,025 common stock warrants, net of expenses		24,933				150		(63	)											25,020
Dividends on preferred stock											(390	)								(390	)
Accretion on preferred stock discount		11									(11	)								—
Sale of 4,116 shares of treasury common stock								(9	)								70			61
Dividends on common stock ($.42 per share)											(1,386	)								(1,386	)
Stock option compensation expense								47												47
Other comprehensive loss, net of $492 tax effect														(778	)					(778	)

Balance, June 30, 2009	$	24,944	$	22,391	$	150	$	18,395		$	55,597		$	624		($	24,001	)	$	98,100

For the Six Months Ended June 30, 2008

Balance, January 1, 2008	$	—	$	22,391	$	—	$	18,275		$	51,279		$	344		($	23,682	)	$	68,607

Net income											4,111									4,111
Purchase of 20,000 shares of treasury common stock																	(554	)		(554	)
Sale of 2,237 shares of treasury common stock								21									39			60
Exercise of stock options and re-issuance of treasury common stock (4,500 shares)								20									77			97
Dividends on common stock ($.56 per share)											(1,851	)								(1,851	)
Stock option compensation expense								42												42
Adjustment to apply EITF 06-4											(579	)								(579	)
Other comprehensive loss, net of $567 tax effect														(897	)					(897	)

Balance, June 30, 2008	$	—	$	22,391	$	—	$	18,358		$	52,960		($	553	)	($	24,120	)	$	69,036

See accompanying notes to unaudited consolidated financial statements


PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY	Schedule 4
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(dollars in thousands)


	For the Six Months Ended June 30
	2009			2008
Operating activities:
Net income	$	3,055		$	4,111
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		1,114			1,123
Provision for loan losses		2,635			818
Amortization of intangible assets and other purchase accounting adjustments, net		417			346
Amortization (accretion) of premiums and discounts on investment securities, net		516			(4	)
Gain on sales of securities available-for-sale, net		(761	)		(276	)
Impairment of mortgage servicing rights		556			0
Compensation expense for vested stock options		47			42
Loss on sales of other real estate owned, net		49			2
Loans originated for sale		(81,492	)		(55,832	)
Proceeds from sales of loans originated for sale		80,881			53,436
Increase (decrease) in accrued interest payable		53			(568	)
Decrease in accrued interest receivable		1,853			2,112
(Increase) decrease in other assets		(1,022	)		736
Decrease in other liabilities		(344	)		(786	)

Net cash provided by operating activities		7,557			5,260

Investing activities:
Proceeds from sales of investment securities available-for-sale		41,310			8,670
Proceeds from maturities of investment securities available-for-sale		38,630			28,679
Purchase of investment securities available-for-sale		(161,550	)		(41,644	)
Proceeds from maturities of investment securities held-to-maturity		1,105			1,130
Purchase of investment securities held-to-maturity		(2,105	)		(1,594	)
Proceeds from sales of other real estate owned		226			736
Net decrease (increase) in loans		10,545			(24,902	)
Purchases of premises and equipment		(752	)		(696	)

Net cash used in investing activities		(72,591	)		(29,621	)

Financing activities:
Net increase in deposits		93,525			12,866
Net (decrease) increase in borrowings		(23,387	)		12,538
Dividends on common stock		(1,386	)		(1,851	)
Dividends on preferred stock		(390	)		—
Purchases of treasury common stock		—			(554	)
Sales of treasury common stock		61			60
Exercise of stock options and issuance of treasury stock		—			97
Proceeds from issuance of preferred stock and common stock warrants, net of expenses		25,020			—

Net cash provided by financing activities		93,443			23,156

Increase (decrease) in cash and cash equivalents		28,409			(1,205	)
Cash and cash equivalents at beginning of period		20,261			27,604

Cash and cash equivalents at June 30	$	48,670		$	26,399



Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	11,664		$	14,836
Income taxes	$	820		$	1,588

Supplemental disclosures of non-cash flow activities:
Loans transferred to other real estate owned	$	13,038		$	756

See accompanying notes to unaudited consolidated financial statements

Schedule 5

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
(Unaudited)

The accompanying unaudited condensed consolidated financial statements reflect all adjustments, which, in the opinion of management, are necessary for a fair presentation of the results of the three-month and six-month periods ended June 30, 2009 and 2008, and all such adjustments are of a normal recurring nature. The 2008 year-end consolidated balance sheet data was derived from audited financial statements, but do not include all disclosures required by generally accepted accounting principles.

The unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information required by accounting principles generally accepted in the United States of America for complete financial statements and related footnote disclosures. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered for a fair presentation of the results for the interim period have been included. For further information, refer to the consolidated financial statements and notes included in the Registrant’s 2008 Annual Report on Form 10-K. Results of operations for interim periods are not necessarily indicative of the results that may be expected for the year. Certain amounts in the 2008 consolidated financial statements have been reclassified to conform to the 2009 presentation.

(1) CAPITAL PURCHASE PROGRAM

On January 23, 2009, the Corporation received $25,083 of equity capital by issuing to the United States Department of Treasury 25,083 shares of the Corporation’s 5.00% Series B Fixed Rate Cumulative Perpetual Preferred Stock, no par value, with a liquidation preference of $1,000 per share and a ten-year warrant to purchase up to 155,025 shares of the Corporation’s common stock, par value $0.01 per share, at an exercise price of $24.27 per share. The proceeds received were allocated to the preferred stock and common stock warrants based on their relative fair values. The resulting discount on the preferred stock is amortized against retained earnings and is reflected in the Corporation’s consolidated statement of income as “Preferred shares dividends”, resulting in additional dilution to the Corporation’s earnings per common share. The warrants are immediately exercisable, in whole or in part, over a term of 10 years. The warrants were included in the Corporation’s diluted average common shares outstanding (subject to anti-dilution). Both the preferred securities and warrants were accounted for as additions to the Corporation’s regulatory Tier 1 and total capital.

The Series B Preferred stock is not mandatorily redeemable and will pay cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. Any redemption requires Federal Reserve approval. The Series B Perpetual Preferred stock ranks senior to the Corporation’s existing authorized Series A Junior Participating Preferred stock.

A company that participates must adopt certain standards for executive compensation, including (a) prohibiting “golden parachute” payments as defined in the Emergency Economic Stabilization Act of 2008 (EESA) to senior Executive Officers; (b) requiring recovery of any compensation paid to senior Executive Officers based on criteria that is later proven to be materially inaccurate; (c) prohibiting incentive compensation that encourages unnecessary and excessive risks that threaten the value of the financial institution; and (d) accept restrictions on the payment of dividends and the repurchase of common stock.

(2) EARNINGS PER SHARE CALCULATION

The following table sets forth the computation of basic and diluted earnings per share for the periods indicated (in thousands, except share data):


	Three Months Ended June 30,				Six Months Ended June 30,
	2009		2008		2009		2008
Numerator:
Net income available to common stockholders	$	1,575	$	2,020	$	2,490	$	4,111

Denominator:
Basic earnings per share-weighted average common shares		3,300,161		3,295,998		3,299,119		3,300,030

Effect of dilutive securities-stock options		425		13,086		515		11,705

Diluted earnings per share-adjusted weighted average common shares		3,300,586		3,309,084		3,299,634		3,311,735

Net income per share available to common stockholders:

Basic	$	0.48	$	0.61	$	0.75	$	1.25
Diluted	$	0.48	$	0.61	$	0.75	$	1.24

The following shares were not considered in computing diluted earnings per share for the three-month and six-month periods ended June 30, 2009 and 2008 because they were anti-dilutive:


	Three and Six Months Ended June 30,
	2009		2008
Stock options to purchase shares of common stock		456,627		279,816

Average dilutive potential common shares associated with common stock warrants		155,025		—

(3) GOODWILL AND INTANGIBLE ASSETS

The balance of goodwill, net of accumulated amortization, totaled $24,521,000 at June 30, 2009 and December 31, 2008. The balance of intangible assets, net of accumulated amortization, totaled $3,776,000 and $4,207,000 at June 30, 2009 and December 31, 2008, respectively.

The Corporation had a goodwill impairment study performed as of March 31, 2009 and December 31, 2008. If the implied fair value of goodwill is lower than its carrying amount, goodwill impairment is indicated and goodwill is written down to its implied fair value. Subsequent increases in goodwill value are not recognized in the financial statements. In the three-month period since the last impairment test, the Corporation’s earnings and stock price have improved. Therefore, there were no impairment indicators which warranted a third party study of goodwill impairment during the second quarter. Accordingly, there was no impairment deemed necessary as of June 30, 2009.

The following table summarizes the Corporation’s intangible assets, which are subject to amortization, as of June 30, 2009 and December 31, 2008:


(in thousands)

	June 30, 2009					December 31, 2008
	Gross Carrying Amount		Accumulated Amortization			Gross Carrying Amount		Accumulated Amortization

Core deposit intangible	$	9,004	$	(5,292	)	$	9,004	$	(4,869	)
Other intangible assets		234		(170	)		234		(162	)
Total	$	9,238	$	(5,462	)	$	9,238	$	(5,031	)

Amortization expense of all intangible assets totaled $416,000 for the six months ended June 30, 2009 and $357,000 for the six months ended June 30, 2008, respectively. The amortization expense of these intangible assets will be approximately $416,000 for the remaining two quarters in 2009.

(4) ORIGINATED MORTGAGE SERVICING RIGHTS

The Corporation has originated mortgage servicing rights which are included in other assets on the consolidated balance sheets. Mortgage servicing rights are amortized in proportion to, and over the period of, estimated net servicing income on a basis similar to the interest method using an accelerated amortization method and are subject to periodic impairment testing. Changes in the carrying value of capitalized mortgage servicing rights are summarized as follows:


(in thousands)

Balance, January 1, 2009	$	2,936
Servicing rights capitalized		719
Amortization of servicing rights		(376	)
Impairment of servicing rights		(556	)
Balance, June 30, 2009	$	2,723

Activity in the valuation allowance for mortgage servicing rights was as follows:


(in thousands)

Balance, January 1, 2009	$	—
Additions		556
Reductions		—
Direct write-downs		—
Balance, June 30, 2009	$	556

The Corporation services loans for others with unpaid principal balances at June 30, 2009 and December 31, 2008 of approximately $341,947,000, and $304,551,000, respectively.

The following table shows the future estimated amortization expense for mortgage servicing rights based on existing balances as of June 30, 2009. The Corporation’s actual amortization expense in any given period may be significantly different from the estimated amounts displayed depending on the amount of additional mortgage servicing rights, changes in mortgage interest rates, estimated prepayment speeds, and market conditions.

Estimated Amortization Expense:


	Amount (in thousands)
For the six months ended December 31, 2009	$	152
For the year ended December 31, 2010		295
For the year ended December 31, 2011		277
For the year ended December 31, 2012		260
For the year ended December 31, 2013		244
For the year ended December 31, 2014		229
Thereafter		1,266

(5) ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

Other comprehensive loss components and the related tax benefit for the six months ended June 30, 2009 and 2008 were as follows:

(in thousands)


	2009			2008

Net unrealized losses on securities available-for-sale	$	(509	)	$	(1,196	)
Less: Reclassification adjustment for realized gains included in income		(761	)		(276	)
		(1,270	)		(1,472	)
Amortization of transition obligation of post retirement health care		0			8

Other comprehensive loss, before tax effect		(1,270	)		(1,464	)

Less: Tax benefit		492			567

Other comprehensive loss	$	(778	)	$	(897	)

The components of accumulated other comprehensive income (loss), included in stockholders’ equity at June 30, 2009 and 2008 are as follows:

(in thousands)


	2009			2008

Net unrealized gains (losses) on securities available-for-sale	$	1,549		$	(351	)
Net unrealized benefit obligations		(530	)		(552	)
		1,019			(903	)

Less: Tax effect		(395	)		350

Net –of-tax amount	$	624		$	(553	)

(6) FEDERAL HOME LOAN BANK STOCK

The Corporation has Federal Home Loan Bank stock totaling $2,373,000 at June 30, 2009 and December 31, 2008. During the third quarter of 2007, the Federal Home Loan Bank of Chicago received a Cease and Desist Order from their regulator, the Federal Housing Finance Board. The Federal Home Loan Bank will continue to provide liquidity and funding through advances, however, the order prohibits capital stock repurchases and redemptions until a time to be determined by the Federal Housing Finance Board and requires their approval for dividends. With regard to dividends, the Federal Home Loan Bank will continue to assess its dividend capacity each quarter and make appropriate request for approval. There were no dividends paid by the Federal Home Loan Bank of Chicago during the first six months of 2009 or during 2008. Management performed an analysis and deemed the investment in Federal Home Loan Bank stock was not other than temporarily impaired as of June 30, 2009 or December 31, 2008.

(7) INVESTMENT SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses, and estimated fair value of available-for-sale and held-to-maturity securities by major security type at June 30, 2009 and December 31, 2008 were as follows:

(in thousands)

June 30, 2009

Amortized
Cost

Gross
Unrealized
Gains

Gross
Unrealized
Losses

Estimated
Fair
Value

Available-for-sale:

United States government agencies

110,557

1,533

(420

)

111,670

State and municipal

115,509

1,768

(2,066

)

115,211

Collateralized mortgage obligations

89,899

1,004

(270

)

90,633

Total

315,965

4,305

(2,756

)

317,514

Held-to-maturity:

State and municipal

15,186

430

(48

)

15,568

Total

331,151

4,735

(2,804

)

333,082

December 31, 2008


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
Available-for-sale:
United States government agencies	$	89,883	$	2,344	$	(29	)	$	92,198
State and municipal		89,776		1,336		(1,384	)		89,728
Collateralized mortgage obligations		54,405		579		(27	)		54,957

Total		234,064		4,259		(1,440	)		236,883
Held-to-maturity:
State and municipal		14,232		294		(65	)		14,461

Total	$	248,296	$	4,553	$	(1,505	)	$	251,344

Maturities of investment securities classified as available-for-sale and held-to-maturity were as follows at June 30, 2009:

(in thousands)


	Amortized Cost		Estimated Fair Value
Available-for-sale:
Due in one year or less	$	1,924	$	1,933
Due after one year through five years		13,025		13,341
Due after five years through ten years		62,326		62,590
Due after ten years		72,283		71,387
		149,558		149,251

Mortgage-backed securities		76,508		77,630
Collateralized mortgage obligations		89,899		90,633
	$	315,965	$	317,514
Held-to-maturity:
Due in one year or less	$	3,611	$	3,625
Due after one year through five years		7,424		7,711
Due after five years through ten years		3,681		3,766
Due after ten years		470		466
	$	15,186	$	15,568

Proceeds from sales of investment securities available-for-sale during the first six months of 2009 were $41,310. Gross gains of $879 and gross losses of $118 were realized on those sales. There were no sales of investment securities classified as held-to-maturity during the six months ended June 30, 2009.

Securities with unrealized losses at June 30, 2009 and December 31, 2008 not recognized in income are as follows:

(in thousands)

2009

Less than 12 Months

12 Months or More

Total

Fair
Value

Gross
Unrealized
Loss

Fair
Value

Gross
Unrealized
Loss

Fair
Value

Gross
Unrealized
Loss

United States Government Agencies

37,884

(420

)

-0-

37,884

(420

)

State and Municipal

61,635

(2,114

)

-0-

61,635

(2,114

)

Collateralized mortgage obligations

26,327

(270

)

-0-

26,327

(270

)

Total temporarily impaired

125,846

(2,804

)

-0-

125,846

(2,804

)


2008	Less than 12 Months					12 Months or More					Total
	Fair Value		Gross Unrealized Loss			Fair Value		Gross Unrealized Loss			Fair Value		Gross Unrealized Loss
United States Government Agencies	$	1,569	$	(19	)	$	461	$	(10	)	$	2,030	$	(29	)
State and Municipal		17,913		(679	)		22,082		(770	)		39,995		(1,449	)
Collateralized mortgage obligations		3,310		(12	)		3,308		(15	)		6,618		(27	)

Total temporarily impaired	$	22,792	$	(710	)	$	25,851	$	(795	)	$	48,643	$	(1,505	)

There are 215 securities in an unrealized loss position in the investment portfolio at June 30, 2009, all due to interest rate changes and not credit events. These unrealized losses are considered temporary and, therefore, have not been recognized into income, because the issuers are of high credit quality and management has the ability and intent to hold for the foreseeable future. The fair value is expected to recover as the investments approach their maturity date or there is a downward shift in interest rates.

The carrying value of securities pledged as collateral, to secure public deposits and for other purposes was $276,786 at June 30, 2009 and $234,525 at December 31, 2008.

(8) FAIR VALUE OF ASSETS AND LIABILITIES

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

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

In accordance with FAS 157, the Corporation groups its financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:


	Level 1	Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

	Level 2	Valuations for assets and liabilities traded in less active dealer or broker markets. Valuations are obtained from third party pricing services for identical or comparable assets or liabilities which use observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets and liabilities.

	Level 3	Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying balance sheet.

Available-for-Sale Securities

The fair value of available-for-sale securities are determined by various valuation methodologies. Where quoted market prices are available in an active market, securities are classified within Level 1. The Corporation has no securities classified within Level 1. If quoted market prices are not available, then fair values are estimated by using pricing models or quoted prices of securities with similar characteristics. Level 2 securities include U.S. Treasury securities, Obligations of U.S. government corporations and agencies, Obligations of states and political subdivisions, mortgage-backed securities and collateralized mortgage obligations. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy. The Corporation has no securities classified within Level 3.

The following table presents the Corporation’s assets that are measured at fair value on a recurring basis and the level within the FAS 157 hierarchy in which the fair value measurements fall as of June 30, 2009 and December 31, 2008 (in thousands):

June 30, 2009


			Fair Value Measurements Using
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Available-for-sale securities	$	317,514	$	0	$	317,514	$	0

December 31, 2008


			Fair Value Measurements Using
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Available-for-sale securities	$	236,883	$	0	$	236,883	$	0

Following is a description of the valuation methodologies used for assets and liabilities measured at fair value on a non-recurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets and liabilities pursuant to the valuation hierarchy.

Impaired Loans

Loans for which it is probable that the Corporation will not collect all principal and interest due according to contractual terms are measured for impairment in accordance with the provisions of Financial Accounting Standard No. 114 (“FAS 114”), Accounting by Creditors for Impairment of a Loan. Allowable methods for estimating fair value include using the fair value of the collateral for collateral dependent loans or, where a loan is determined not to be collateral dependent, using the discounted cash flow method.

If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value. If the impaired loan is determined not to be collateral dependent, then the discounted cash flow method is used. This method requires the impaired loan to be recorded at the present value of expected future cash flows discounted at the loan’s effective interest rate. The effective interest rate of a loan is the contractual interest rate adjusted for any net deferred loan fees or costs, premiums or discount existing at origination or acquisition of the loan. Impaired loans are classified within Level 3 of the fair value hierarchy.

Mortgage Servicing Rights

The fair value used to determine the valuation allowance is estimated using discounted cash flow models. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the hierarchy.

Other Real Estate Owned

Other real estate owned acquired through loan foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined the fair value declines subsequent to foreclosure, a valuation allowance is recorded through non-interest expense. Operating costs associated with the assets after acquisition are also recorded as non-interest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to other non-interest expense. Other real estate owned measured at fair value on a non-recurring basis at June 30, 2009 amounted to $13.9 million.

The following table presents the fair value measurement of assets and liabilities measured at fair value on a nonrecurring basis and the level within the FAS 157 fair value hierarchy in which the fair value measurements fall at June 30, 2009 and December 31, 2008.

June 30, 2009


			Fair Value Measurements Using
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)

Impaired loans	$	3,584	0	0	$	3,584
Mortgage servicing rights		2,723	0	0		2,723
Other real estate owned		13,933	0	0		13,933

December 31, 2008


			Fair Value Measurements Using
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)

Impaired loans	$	2,494	0	0	$	2,494

Statement of Financial Accounting Standards No. 107 (“FAS 107”), “Disclosures about Fair Value of Financial Instruments”, requires all entities to disclose the estimated fair value of their financial instrument assets and liabilities. For the Corporation, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in FAS 107. Many of the Corporation’s financial instruments, however, lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction. It is also the Corporation’s general practice and intent to hold its financial instruments to maturity and to not engage in trading or sales activities except for loans held-for-sale and available-for-sale securities. Therefore, significant estimations and assumptions, as well as present value calculations, were used by the Corporation for the purposes of this disclosure.

Estimated fair values have been determined by the Corporation using the best available data and an estimation methodology suitable for each category of financial instruments. For those loans and deposits with floating interest rates, it is presumed that estimated fair values generally approximate the recorded book balances. The estimation methodologies used, the estimated fair values, and the recorded book balances at June 30, 2009 and December 31, 2008, were as follows:


(in thousands)

	June 30, 2009				December 31, 2008
	Carrying Value		Fair Value		Carrying Value		Fair Value
Financial Assets:

Cash and due from banks	$	12,741	$	12,741	$	20,163	$	20,163
Interest-bearing deposits in financial institutions		35,929		35,929		98		98
Investment securities		332,700		333,082		251,115		251,344
Loans, net, including loans held for sale		762,360		767,363		787,928		793,411
Accrued interest receivable		7,840		7,840		9,693		9,693
Total Financial Assets	$	1,151,550	$	1,156,935	$	1,068,997	$	1,074,709
Financial Liabilities:

Non-interest bearing demand deposits	$	108,952	$	108,952	$	110,559	$	110,559
Interest-bearing deposits		946,705		956,207		851,573		862,165
Borrowings		94,633		108,287		118,016		127,816
Accrued interest payable		4,525		4,525		4,472		4,472
Total Financial Liabilities	$	1,154,815	$	1,177,971	$	1,084,620	$	1,105,012

Unrecognized financial instruments (net of contract amount)

Commitments to originate loans	$	-0-	$	-0-	$	-0-	$	-0-
Lines of credit		-0-		-0-		-0-		-0-

Financial instruments actively traded in a secondary market have been valued using quoted available market prices. Cash and due from banks, interest-bearing time deposits in other banks, federal funds sold, loans held-for-sale and interest receivable are valued at book value, which approximates fair value.

Financial liability instruments with stated maturities have been valued using a present value discounted cash flow analysis with a discount rate approximating current market for similar liabilities. Interest payable is valued at book value, which approximates fair value.

Financial instrument liabilities with no stated maturities have an estimated fair value equal to both the amount payable on demand and the recorded book balance.

The net loan portfolio has been valued using a present value discounted cash flow. The discount rate used in these calculations is the current rate at which similar loans would be made to borrowers with similar credit ratings, same remaining maturities, and assumed prepayment risk.

The fair value of commitments to originate loans is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair values of letters of credit and lines of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties at the reporting date.

Changes in assumptions or estimation methodologies may have a material effect on these estimated fair values.

The Corporation’s remaining assets and liabilities, which are not considered financial instruments, have not been valued differently than has been customary with historical cost accounting. No disclosure of the relationship value of the Corporation’s core deposit base is required by FAS 107.

Fair value estimates are based on existing balance sheet financial instruments, without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, the subsidiary bank has a large fiduciary services department that contributes net fee income annually. The fiduciary services department is not considered a financial instrument, and its value has not been incorporated into the fair value estimates. Other significant assets and liabilities that are not considered financial assets or liabilities include the mortgage banking operation, brokerage network, deferred taxes, premises and equipment, and goodwill. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

Management believes that reasonable comparability between financial institutions may not be likely, due to the wide range of permitted valuation techniques and numerous estimates which must be made, given the absence of active secondary markets for many of the financial instruments. This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values.

(9) INCOME TAXES

A reconciliation of income tax expense at 34 percent of pre-tax income to the Corporation’s actual tax expense (benefit) for the three and six-month periods ended June 30 is shown below:


	Three Months Ended June 30,						Six Months Ended June 30,
	2009			2008			2009			2008
Computed “expected” tax expense	$	741		$	887		$	1,099		$	1,798

Increase (decrease) in income taxes resulting from:
Tax-exempt income		(435	)		(314	)		(814	)		(652	)
State income taxes, net of federal tax benefit		116			171			157			351
Bank-owned life insurance income		(79	)		(68	)		(165	)		(144	)
Other, net		(61	)		(87	)		(99	)		(176	)
	$	282		$	589		$	178		$	1,177

(10) IMPACT OF NEW ACCOUNTING STANDARDS

In December 2007, the FASB issued SFAS No. 141R (FAS 141R), “Business Combinations”, which revises FAS 141 and changes multiple aspects of the accounting for business combinations. Under the guidance in FAS 141R, the acquisition method must be used, which requires the acquirer to recognize most identifiable assets acquired, liabilities assumed, and non-controlling interests in the acquiree at their full fair value on the acquisition date. Goodwill is to be recognized as the excess of the consideration transferred plus the fair value of the non-controlling interest over the fair values of the identifiable net assets acquired. Subsequent changes in the fair value of contingent consideration classified as a liability are to be recognized in earnings, while contingent consideration classified as equity is not to be re-measured. Costs such as transaction costs are to be excluded from acquisition accounting, generally leading to recognizing expense and additionally, restructuring costs that do not meet certain criteria at acquisition date are to be subsequently recognized as post-acquisition costs. FAS 141R is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The implementation of FAS 141R did not have a material impact on the Corporation’s financial position or results of operations.

In December 2007, the FASB issued Statement of Financial Accounting No. 160 (“FAS 160”), “Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51.” The Statement requires that a noncontrolling interest in a subsidiary be reported separately within equity and the amount of consolidated net income specifically attributable to the noncontrolling interest be identified in the consolidated financial statements. It also calls for consistency in the manner of reporting changes in the parent’s ownership interest and requires fair value measurement of any noncontrolling equity investment retained in deconsolidation. FAS 160 became effective for fiscal years beginning after December 15, 2008. The application of FAS 160 did not have a material impact on the Corporation’s consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161 (FAS 161), “Disclosures About Derivative Instruments and Hedging Activities – an amendment of FAS 133”. FAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. FAS 161 is effective for fiscal years beginning after November 15, 2008. The implementation of FAS 161 did not have a material impact on its consolidated financial statements.

In May 2008, the FASB issued Statement of Financial Accounting No. 162 (“FAS 162”), “The Hierarchy of Generally Accepted Accounting Principles.” This Statement identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). This Statement became effective on November 15, 2008. The application of FAS 162 did not have a material impact on the Corporation’s consolidated financial statements.

In January 2009, the FASB issued FSP E 99-20-1, “Amendments to the Impairment and Interest Income Measurement Guidance of EITF Issue No. 99-20”. FSP EITF 99-20-I amends the impairment guidance in EITF Issue No. 99-20 in order to achieve more consistent determination of whether an other-than- temporary impairment (OTTI) has occurred. Prior to the FSP, the impairment model in EITF 99-20 was different from FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. This FSP amended EITF 99-20 to more closely align the OTTI guidance therein to the guidance in Statement No. 115. Retrospective application to a prior interim or annual period is prohibited. The Corporation does not expect the implementation of this FSP to have a material impact on its consolidated financial statements.

In April 2009, the FASB issued three amendments to the fair value measurement, disclosure and other-than-temporary impairment standards:


	•	FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions that are Not Orderly.”

	•	FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments.”

	•	FAS 107 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments.”

FASB Statement of Financial Accounting No. 157 (“FAS 157”), “Fair value Measurements,” defines fair value as the price that would be received to sell the asset or transfer the liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. FAS 157-4 provided additional guidance on identifying circumstances when a transaction may not be considered orderly.

FAS 157-4 provides a list of factors that a reporting entity should evaluate to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity for the asset or liability. When the reporting entity concludes there has been a significant decrease in the volume and level of activity for the asset or liability, further analysis of the information from that market is needed and significant adjustments to the related prices may be necessary to estimate fair value in accordance with FAS 157.

FAS 157-4 clarifies that when there has been a significant decrease in the volume and level of activity for the asset or liability, some transactions may not be orderly. In those situations, the entity must evaluate the weight of evidence to determine whether the transaction is orderly. It also provides a list of circumstances that may indicate that a transaction is not orderly. A transaction price that is not associated with an orderly transaction is given little, if any, weight when estimating fair value.

FAS 115-2 and FAS 124-2 clarifies the interaction of the factors that should be considered when determining whether a debt security is other–than-temporarily impaired. For debt securities, management must assess whether (a) it has the intent to sell the security and (b) it is more likely than not that it will be required to sell the security prior to its anticipated recovery. These steps are done before assessing whether the entity will recover the cost basis of the investment. Previously, this assessment required management to assert it has both the intent and the ability to hold a security for a period of time sufficient to allow for anticipated recovery in fair value to avoid recognizing an other-than-temporary impairment. This change does not affect the need to forecast recovery of the value of the security through either cash flows or market price.

In instances when a determination is made that an other-than-temporary impairment exists but the investor does not intend to sell the debt security and it is not more likely than not that it will be required to sell the debt security prior to its anticipated recovery, FAS 115-2 and FAS 124-2 change the presentation and amount of the other-than-temporary impairment recognized in the income statement. The other-than-temporary impairment is separated into (a) the amount of the total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of the total other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income.

FAS 107-1 and APB 28-1 amends FASB Statement No. 107 (“FAS 107”), “Disclosures about Fair Value of Financial Instruments,” to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. FAS 107-1 also amends APB Opinion No. 28, “Interim Financial Reporting,” to require those disclosures in summarized financial information at interim reporting periods.

All three FASB Staff Positions discussed herein include substantial additional disclosure requirements. The effective date for these new standards is the same: interim and annual reporting periods ending after June 15, 2009. The Corporation adopted these standards at June 30, 2009 and there was not a material impact on its consolidated financial statements.

On May 28, 2009, the FASB issued SFAS No. 165, Subsequent Events (“FAS 165”). Under FAS 165, companies are required to evaluate events and transactions that occur after the balance sheet date but before the date the financial statements are issued, or available to be issued in the case of non-public entities. FAS 165 requires entities to recognize in the financial statements the effect of all events or transactions that provide additional evidence of conditions that existed at the balance sheet date, including the estimates inherent in the financial preparation process. Entities shall not recognize the impact of events or transactions that provide evidence about conditions that did not exist at the balance sheet date but arose after that date. FAS 165 also requires entities to disclose the date through which subsequent events have been evaluated. FAS 165 was effective for interim and annual reporting periods ending after June 15, 2009. The Corporation adopted the provisions of FAS 165 for the quarter ended June 30, 2009, as required, and adoption did not have a material impact on the Corporation’s financial statements taken as a whole.

On June 12, 2009, the FASB issued SFAS No. 166, Accounting for Transfers of Financial Assets (“FAS 166”), and SFAS No.167, Amendments to FASB Interpretation No. 46(R) (“FAS 167”), which change the way entities account for securitizations and special-purpose entities.

FAS 166 is a revision to FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and will require more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. FAS 166 also eliminates the concept of a “qualifying special-purpose entity”, changes the requirements for derecognizing financial assets and requires additional disclosures.

FAS 167 is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance.

Both FAS 166 and FAS 167 will be effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Earlier application is prohibited. The recognition and measurement provisions of FAS 166 shall be applied to transfers that occur on or after the effective date. The Corporation will adopt both FAS 166 and FAS 167 on January 1, 2010, as required. Management has not determined the impact adoption may have on the Corporation’s consolidated financial statements.

On June 29, 2009, the FASB issued Statement of Financial Accounting Standards No. 168 (“FAS 168”) Accounting Standards Codification^TM and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162. FAS 168 establishes the FASB Accounting Standards Codification^TM as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with US GAAP. FAS 168 will be effective for financial statements issued for interim and annual periods ending after September 15, 2009, for most entities. On the effective date, all non-SEC accounting and reporting standards will be superceded. The Corporation will adopt FAS 168 for the quarterly period ended September 30, 2009, as required, and adoption is not expected to have a material impact on the Corporation’s financial statements taken as a whole.

(11) SUBSEQUENT EVENTS

Subsequent events have been evaluated through July 27, 2009, which is the date the financial statements were issued.

Schedule 6

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
For the three and six-month periods ended June 30, 2009 and 2008

The following discussion provides information about Princeton National Bancorp, Inc.’s (“PNBC” or the “Corporation”) financial condition and results of operations for the three and six-month periods ended June 30, 2009 and 2008. This discussion should be read in conjunction with the attached consolidated financial statements and notes thereto. This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as discussions of the Corporation’s pricing and fee trends, credit quality and outlook, liquidity, new business results, expansion plans, anticipated expenses and planned schedules. The Corporation 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 these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Corporation, are identified by use of the words “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project”, or similar expressions. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: the effect of the current severe disruption in financial markets and the United States government programs introduced to restore stability and liquidity, changes in interest rates, general economic conditions and the weakening state of the United States economy, legislative/regulatory changes, 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 loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Corporation’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Further information concerning the Corporation and its business, including a discussion of these and additional factors that could materially affect the Corporation’s financial results, is included in the Corporation’s 2008 Annual Report on Form 10-K under the headings “Item 1. Business” and “Item 1A. Risk Factors.”

CRITICAL ACCOUNTING POLICIES AND USE OF SIGNIFICANT ESTIMATES

The Corporation has established various accounting policies that govern the application of U.S. generally accepted accounting principles in the preparation of the Corporation’s financial statements. The significant accounting policies of the Corporation are described in the footnotes to the consolidated financial statements. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and assumptions, which could have a material impact on the carrying values of assets and liabilities and the results of operations of the Corporation.

Allowance for Loan Losses

The Corporation believes the allowance for loan losses is the critical accounting policy that requires the most significant judgments and assumptions used in the preparation of its consolidated financial statements. We determine probable incurred losses inherent in our loan portfolio and establish an allowance for those losses by considering factors including historical loss rates, expected cash flows and estimated collateral values. In assessing these factors, we use organizational history and experience with credit decisions and related outcomes. The allowance for loan losses represents our best estimate of losses inherent in the existing loan portfolio. The allowance for loan losses is increased by the provision for loan losses charged to expense and reduced by loans charged off, net of recoveries. We evaluate our allowance for loan losses quarterly. If our underlying assumptions later prove to be inaccurate based on subsequent loss evaluations, the allowance for loan losses is adjusted.

We estimate the appropriate level of allowance for loan losses by separately evaluating impaired and non-impaired loans. A specific allowance is assigned to an impaired loan when expected cash flows or collateral do not justify the carrying amount of the loan. The methodology used to assign an allowance to a non-impaired loan is more subjective. Generally, the allowance assigned to non-impaired loans is determined by applying historical loss rates to existing loans with similar risk characteristics, adjusted for qualitative factors including the volume and severity of identified classified loans, changes in economic conditions, changes in credit policies or underwriting standards, and changes in the level of credit risk associated with specific industries and markets. Because the economic and business climate in any given industry or market, and its impact on any given borrower, can change rapidly, the risk profile of the loan portfolio is continually assessed and adjusted when appropriate. Notwithstanding these procedures, there still exists the possibility that our assessment could prove to be significantly incorrect and that an immediate adjustment to the allowance for loan losses would be required.

Other Real Estate Owned

Other real estate owned acquired through loan foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined that fair value declines subsequent to foreclosure, a valuation allowance is recorded through non-interest expense. Operating costs associated with the assets after acquisition are also recorded as non-interest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to other non-interest expense.

Deferred Income Tax Assets/Liabilities

Our net deferred income tax asset arises from differences in the dates that items of income and expense enter into our reported income and taxable income. Deferred tax assets and liabilities are established for these items as they arise. From an accounting standpoint, deferred tax assets are reviewed to determine if they are realizable based on the historical level of our taxable income, estimates of our future taxable income and the reversals of deferred tax liabilities. In most cases, the realization of the deferred tax asset is based on our future profitability. If we were to experience net operating losses for tax purposes in a future period, the realization of our deferred tax assets would be evaluated for a potential valuation reserve.

Additionally, the Corporation reviews its uncertain tax positions annually under FASB Interpretation 48, Accounting for Uncertainty in Income Taxes. An uncertain tax position is recognized as a benefit only if it is “more likely than not’ that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount actually recognized is the largest amount of tax benefit that is greater than 50% likely to be recognized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. A significant amount of judgment is applied to determine both whether the tax position meets the “more likely than not” test as well as to determine the largest amount of tax benefit that is greater than 50% likely to be recognized. Differences between the position taken by management and that of taxing authorities could result in a reduction of a tax benefit or increase to tax liability, which could adversely affect future income tax expense.

Impairment of Goodwill and Intangible Assets

Core deposit and customer relationships, which are intangible assets with a finite life, are recorded on our balance sheets. These intangible assets were capitalized as a result of past acquisitions and are being amortized over their estimated useful lives of up to 15 years. Core deposit intangible assets, with finite lives will be tested for impairment when changes in events or circumstances indicate that its carrying amount may not be recoverable. Core deposit intangible assets were tested for impairment during 2008 and 2007, as part of the goodwill impairment test and no impairment was deemed necessary.

As a result of our acquisition activity, goodwill, an intangible asset with an indefinite life, was reflected on our balance sheet in prior periods. Goodwill is evaluated for impairment annually, unless there are factors present that indicate a potential impairment, in which case, the goodwill impairment test is performed more frequently than annually. Accordingly, as the Corporation’s stock price at March 31, 2009 decreased below book value, a goodwill impairment test was performed and no impairment was deemed necessary (see Note 3 – “Goodwill and Intangible Assets” in the Notes to Consolidated Financial Statements). In the three-month period since the impairment test, the Corporation’s earnings and stock price have improved. Therefore, there were no impairment indicators which warranted a third party study of goodwill impairment during the second quarter. Accordingly, there was no impairment deemed necessary as of June 30, 2009.

Mortgaging Service Rights (MSRs)

MSR fair values are very sensitive to movements in interest rates as expected future net servicing income depends on the projected outstanding principal balances of the underlying loans, which can be greatly reduced by prepayments. Prepayments usually increase when mortgage interest rates decline and decrease when mortgage interest rates rise. For discussion regarding the impairment of MSRs, see Note 4 – “Originated Mortgage Servicing Rights” in the Notes to Consolidated Financial Statements.

Fair Value Measurements

The fair value of a financial instrument is defined as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Corporation estimates the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. When the financial instruments are not actively traded, other observable market inputs, such as quoted prices of securities with similar characteristics, may be used, if available, to determine fair value. When observable market prices do not exist, the Corporation estimates fair value. The Corporation’s valuation methods consider factors such as liquidity and concentration concerns. Other factors such as model assumptions, market dislocations and unexpected correlations can affect estimates of fair value. Imprecision in estimating these factors can impact the amount of revenue or loss recorded.

FASB Statement No. 157, Fair Value Measurements, establishes a framework for measuring the fair value of financial instrument that considers the attributes specific to particular assets or liabilities and establishes a three-level hierarchy for determining fair value based on the transparency of inputs to each valuation as of the fair value measurement date. The three levels are defined as follows:


	Level 1 - quoted prices (unadjusted) for identical assets or liabilities in active markets.

	Level 2 - inputs include quoted prices for similar assets and liabilities in active markets, quoted prices of identical or similar assets or liabilities in markets that are not active, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

	Level 3 - inputs that are unobservable and significant to the fair value measurement.

At the end of each quarter, the Corporation assesses the valuation hierarchy for each asset or liability measured. From time to time, assets or liabilities may be transferred within hierarchy levels due to changes in availability of observable market inputs to measure fair value at the measurement date. Transfers into or out of hierarchy levels are based upon the fair value at the beginning of the reporting period. A more detailed description of the fair values measured at each level of the fair value hierarchy can be found in Note 8- “Fair Value of Assets and Liabilities” in the Notes to Consolidated Financial Statements.

RESULTS OF OPERATIONS

Net income for the second quarter of 2009 was $1,898,000, or basic and diluted earnings per common share of $0.48, as compared to net income of $2,020,000 in the second quarter of 2008, or basic and diluted earnings per common share of $0.61. This represents a decrease of $122,000 (or 6.0%), and $0.13 per basic and diluted common share. The lower net income figure is attributable to an increase in the provision for loan losses and insurance assessments by the FDIC, despite a 16% improvement in net interest income, discussed below. However, the second quarter 2009 results improved 64.2% when compared to the first quarter 2009 results of $1,156,000, or basic and diluted earnings per common share of $0.28. Net income for the first six months of 2009 was $3,055,000 or basic and diluted earnings per common share of $0.75, compared to net income of $4,111,000, or basic earnings per common share of $1.25 (diluted earnings per common share of $1.24) for the first six months of 2008. This represents a decrease of $1,056,000, (25.7%) or $0.50 per basic common share and $0.49 per diluted common share. The lower net income figure is primarily attributed to an increase in the provision for loan losses of $1.8 million and an increase in the amount of federal insurance assessments of $1.4 million. The annualized return on average assets and return on average equity were 0.61% and 7.77%, respectively, for the second quarter of 2009, compared with 0.75% and 11.71% for the second quarter of 2008. For the six-month periods, the annualized return on average assets and return on average equity were 0.51% and 6.51%, respectively for 2009, compared with 0.76% and 11.98%, respectively for 2008.

Net interest income before the provision for loan losses was $8,629,000 for the second quarter of 2009, compared to $7,817,000 for the second quarter of 2008 (an increase of $812,000 or 10.4%). This improvement is a result of an increase in average interest-earning assets of $128.1 million over the past twelve months. For the three months ended June 30, 2009, average interest-earning assets were $1,090.1 million compared to $962.0 million for the three months ended June 30, 2008. The resulting net yield on interest-earning assets (on a fully taxable equivalent basis) decreased to 3.43% in the second quarter of 2009 compared to 3.49% in the second quarter of 2008. Further, the net interest income figure of $8,629,000 for the second quarter of 2009 represents an increase of $550,000 (or 6.8%) over the first quarter of 2009. Net interest income before any provision for loan losses was $17,024,000 for the first six months of 2009, an increase of $1.8 million, or 11.5%, from the $15,271,000 reported for the first six months of 2008. This is attributable to an increase in average interest-earning assets of $107.6 million for the first six months of 2009 as compared to the first six months of 2008, along with the resulting net yield on interest-earning assets (on a fully taxable equivalent basis) increasing to 3.48% in the first half of 2009 from 3.44% in the first half of 2008.

The Corporation’s provision for loan loss expense recorded each quarter is determined by management’s evaluation of the risk characteristics of the loan portfolio. For the second quarter of 2009, PNBC had net charge-offs of $1,169,000, compared to net charge-offs of $189,000 for the second quarter of 2008. For the six-month comparable periods, PNBC had net charge-offs of $1,540,000 in 2009 and net charge-offs of $670,000 in 2008. PNBC recorded a loan loss provision of $1,465,000 in the second quarter of 2009 and $2,635,000 in the first half of 2009 compared to a provision of $450,000 in the second quarter of 2008 and $818,000 in the first half of 2008. The ratio of non-performing loans to total loans at June 30, 2009 is 2.88% compared to 1.95% at June 30, 2008, but has decreased from 4.30% reported on March 31, 2009. The Corporation has no sub-prime loans in the portfolio, nor is there any sub-prime exposure in the investment portfolio.

Non-interest income totaled $3,731,000 for the second quarter of 2009, compared to $2,751,000 in the second quarter of 2008, an increase of $980,000 (or 35.6%). Annualized non-interest income as a percentage of average total assets increased to 1.20% for the second quarter of 2009 from 1.02% for the same period in 2008. The increase was the result of gains on sales of available-for-sale securities of $574,000 and an increase in mortgage banking income of $477,000 (due to refinancing activity). Year-to-date in 2009, non-interest income totaled $6,319,000 compared to $5,904,000 for the first half of 2008, an increase of $415,000 (or 7.0%). The primary reason for the positive change is the additional gains on sales of available-for-sale securities of $485,000, along with an increase in mortgage banking income of $240,000 (or 37.7%) period over period. This increase in mortgage banking income is after the recording of an impairment of mortgage servicing rights recorded during the first quarter of 2009 of $556,000. These increases more than offset decreases in the categories of service charges and trust fees. Annualized non-interest income as a percentage of average total assets decreased from 1.10% for the first six months of 2008, to 1.05% for the same period in 2009.

Total non-interest expense for the second quarter of 2009 was $8,715,000, an increase of $1,206,000 (or 16.1%) from $7,509,000 in the second quarter of 2008. The largest increase was in federal insurance assessments, specifically FDIC premiums, which went up $742,000, or 883.3%. Additionally, the category of other real estate expenses increased by $328,000 (or 360.4%) over the past year. Annualized non-interest expense as a percentage of total average assets increased to 2.81% for the second quarter of 2009, compared to 2.77% for the same period in 2008. Year-to-date non-interest expense for the first half of 2009 was $17,475,000, an increase of $2,406,000 (or 16.0%) from the $15,069,000 for the first half of 2008. Again, the majority of the increase is in the categories of federal insurance assessments which rose $1,355,000 (or 806.5%), and other real estate expenses which increased $387,000 (or 317.2%). Annualized non-interest expense as a percentage of total average assets also increased to 2.90% for the first six months of 2009, compared to 2.80% for the same period in 2008.

INCOME TAXES

Income tax expense totaled $282,000 for the second quarter of 2009, as compared to $589,000 for the second quarter of 2008. The effective tax rate was 12.9% for the three month period ended June 30, 2009 and 22.6% for the three month period ended June 30, 2008. Income tax expense totaled $178,000 for the first six months of 2009, as compared to $1,177,000 for the first six months of 2008. The effective tax rate was 5.5% for the six month period ended June 30, 2009 and 22.3% for the six month period ended June 30, 2008. The lower income tax expense is due to a lower pre-tax income coupled with the effect of tax-exempt investment interest income. For more information on the Corporation’s income taxes see Note 8 – “Income Taxes” in the Notes to Consolidated Financial Statements.

FDIC

On February 27, 2009, the FDIC adopted a final rule modifying the risk-based assessment system and setting initial base assessment rates beginning April 1, 2009, at 12 to 50 basis points and, due to extraordinary circumstances, extended the period of the Restoration Plan to seven years. The Corporation’s assessment, according to the new formula is now 14 basis points. Previously, the quarterly assessment rate was 7 basis points. Accordingly, the new assessment rates increased the Corporation’s quarterly federal insurance expense by approximately $200,000.

On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. The amount of the special assessment for any institution will not exceed 10 basis points times the institution’s assessment base for the second quarter 2009. The special assessment will be collected on September 30, 2009. This assessment equates to a one-time cost of $600,000 and is reflected in the Corporation’s income statement for the six months ended June 30, 2009. An additional special assessment of up to 5 basis points later in 2009 is probable, which would also be approximately $600,000.

ANALYSIS OF FINANCIAL CONDITION

Total assets at June 30, 2009 increased to $1,258,054,000 from $1,163,130,000 at December 31, 2008 (an increase of $94.9 million or 8.2%). Total loan balances decreased by $25.1 million during the six month period to $765.8 million due to a general slow-down in the economy, seasonal pay downs in the agricultural portfolio, and the refinancing of adjustable-rate residential real estate loans into fixed rate products which are sold in the secondary market. Investment balances totaled $332,700,000 at June 30, 2009, compared to $251,115,000 at December 31, 2008 (an increase of $81.6 million or 32.5%), as excess liquidity is invested due to declining loan demand. Total deposits increased to $1,055,657,000 at June 30, 2009 from $962,132,000 at December 31, 2008 (an increase of $93.5 million or 9.7%). Comparing categories of deposits at June 30, 2009 to December 31, 2008, time deposits increased $46.4 million (or 8.5%), interest-bearing demand deposits increased $42.7 million (or 17.3%), savings deposits increased $6.1 million (or 9.9%), and demand deposits decreased $1.6 million (or 1.5%). Borrowings, consisting of customer repurchase agreements, federal funds purchased, notes payable, treasury, tax, and loan (“TT&L”) deposits, and Federal Home Loan Bank advances, decreased from $118,016,000 at December 31, 2008 to $94,633,000 at June 30, 2009 (a decrease of $23.4 million or 19.8%). The majority of this decrease was due to the repayment of the note payable (balance of $16.05 million at December 31, 2008) with proceeds from the sale of preferred stock under the Capital Purchase Program.

CAPITAL PURCHASE PROGRAM

ASSET QUALITY

For the six months ended June 30, 2009, the subsidiary bank charged off $1,640,000 of loans and had recoveries of $100,000, compared to charge-offs of $769,000 and recoveries of $99,000 during the six months ended June 30, 2008. The allowance for loan losses is based on factors that include the overall composition of the loan portfolio, types of loans, underlying collateral, past loss experience, loan delinquencies, substandard and doubtful credits, and such other factors that, in management’s reasonable judgment, warrant consideration. The adequacy of the allowance is monitored monthly. At June 30, 2009, the allowance was $6,160,000, 28.0% of non-performing loans and 0.80% of total loans, compared with $5,064,000, 15.3% of non-performing loans and 0.64% of total loans at December 31, 2008. The increase in the allowance for loan losses as a percentage of total loans is based on the increase in impaired loans in the portfolio (discussed below).

Non-performing loans decreased to $22,021,000 or 2.88% of net loans at June 30, 2009, as compared to $33,038,000 or 4.18% of net loans at December 31, 2008 (see the Other Real Estate Owned section below). At June 30, 2009 non-accrual loans were $21,527,000 compared to $30,383,000 at December 31, 2008. Impaired loans totaled $6,530,000 at June 30, 2009 compared to $3,540,000 at December 31, 2008. The total amount of loans ninety days or more past due and still accruing interest at June 30, 2009 was $494,000 compared to $2,655,000 at December 31, 2008. There was a specific loan loss reserve of $1,530,000 established for impaired loans as of June 30, 2009 compared to a specific loan loss reserve of $818,000 at December 31, 2008. PNBC’s management analyzes the allowance for loan losses monthly and believes the current level of allowance is adequate to meet probable losses as of June 30, 2009.

OTHER REAL ESTATE OWNED

At June 30, 2009, the Corporation had other real estate owned of $15,250,000, an increase of $12.8 million (or 513.2%) since December 31, 2008. Of this increase, $11.0 million represents one commercial loan that was previously listed as a non-performing loan. This loan was originally a participation with a “up-stream” correspondent bank. Based on collateral values, the Corporation made the decision to purchase their interest and continue with foreclosure. The Corporation expects the ultimate resolution of this property to have a positive outcome.

CAPITAL RESOURCES

Federal regulations require all financial institutions to evaluate capital adequacy by the risk-based capital method, which makes capital requirements more sensitive to the differences in the level of risk assets. At June 30, 2009, total risk-based capital of PNBC was 11.46%, compared to 8.30% at December 31, 2008. The Tier 1 capital ratio increased from 6.22% at December 31, 2008, to 7.72% at June 30, 2009. Total stockholders’ equity to total assets at June 30, 2009 increased to 7.80% from 6.23% at December 31, 2008. The increase in these ratios is due to the equity investment received from the U.S. Treasury in the form of Preferred Stock as part of the Capital Purchase Program discussed above.

LIQUIDITY

Liquidity is measured by a financial institution’s ability to raise funds through deposits, borrowed funds, capital, or the sale of assets. Additional sources of liquidity include cash flow from the repayment of loans and the maturity of investment securities. Major uses of cash include the origination of loans and purchase of investment securities. Cash flows provided by financing and operating activities, offset by those used in investing activities, resulted in a net increase in cash and cash equivalents of $28,409,000 from December 31, 2008 to June 30, 2009. This increase was primarily the result of the proceeds received from the issuance of preferred stock, an increase in deposits and a decrease in loans, offset by net purchases of investments and the pay off of the Corporation’s note payable. For more detailed information, see PNBC’s Consolidated Statements of Cash Flows.

FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

The Corporation generates agribusiness, commercial, mortgage and consumer loans to customers located primarily in North Central Illinois. The Corporation’s loans are generally secured by specific items of collateral including real property, consumer assets and business assets. Although the Corporation has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon economic conditions in the agricultural industry.

In the normal course of business to meet the financing needs of its customers, the subsidiary bank is party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the subsidiary bank has in particular classes of financial instruments.

The subsidiary bank’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The subsidiary bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. At June 30, 2009, commitments to extend credit and standby letters of credit were approximately $142,438,000 and $4,552,000 respectively.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The subsidiary bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, by the subsidiary bank upon extension of credit is based on management’s credit evaluation of the counterparty. Collateral held varies, but may include real estate, accounts receivable, inventory, property, plant and equipment, and income-producing properties.

Standby letters of credit are conditional commitments issued by the subsidiary bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. The subsidiary bank secures the standby letters of credit with the same collateral used to secure the loan. The maximum amount of credit that would be extended under standby letters of credit is equal to the off-balance sheet contract amount. The standby letters of credit have terms that expire in one year or less.

LAND HELD FOR SALE

The Corporation owns separate lots in Elburn, Aurora and Somonauk, Illinois that have been removed from the land balance and are now shown on the Corporation’s balance sheet as land held-for-sale, at the lower of cost or market. The land in Elburn, approximately 2 acres, was purchased in 2003 for $930,000 in anticipation of the construction of a branch facility. The land in Aurora, consisting of two lots remaining from the original purchase of fourteen acres in 2004 which was used to construct a branch facility has a cost basis of $1,344,000. The land in Somonauk, acquired in 2005 during the acquisition of FSB Bancorp, Inc., consists of approximately two acres with a cost basis of $80,000.

LEGAL PROCEEDINGS

There are various claims pending against the Corporation’s subsidiary bank, arising in the normal course of business. Management believes, based upon consultation with legal counsel, that liabilities arising from these proceedings, if any, will not be material to the Corporation’s financial position or results of operation.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There has been no material change in market risk since December 31, 2008, as reported in PNBC’s 2008 Annual Report on Form 10-K.

EFFECTS OF INFLATION

The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America and practices within the banking industry which require the measurement of financial condition and operating results in terms of historical dollars, without considering the changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than the effects of general levels of inflation.

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

The following table sets forth (in thousands) details of average balances, interest income and expense, and resulting annualized yields/costs for the Corporation for the periods indicated, reported on a fully taxable equivalent basis, using a tax rate of 34%.



	Six Months Ended, June 30, 2009							Six Months Ended, June 30, 2008
	Average Balance		Interest		Yield/ Cost			Average Balance		Interest		Yield/ Cost
Average Interest-Earning Assets

Interest-bearing deposits	$	47,171	$	51		0.22	%	$	1,672	$	21		2.47	%
Taxable investment securities		161,551		3,723		4.65	%		154,210		3,297		4.30	%
Tax-exempt investment securities		114,108		3,673		6.49	%		77,863		3,091		7.98	%
Federal funds sold		192		0		0.00	%		2,152		29		2.68	%
Net loans		741,320		22,615		6.15	%		720,843		24,188		6.75	%

Total interest-earning assets		1,064,342		30,062		5.70	%		956,740		30,626		6.44	%

Average non-interest earning assets		151,214							124,640

Total average assets	$	1,215,556						$	1,081,380

Average Interest-Bearing Liabilities

Interest-bearing demand deposits	$	261,839		1,569		1.21	%	$	252,805		2,428		1.93	%
Savings deposits		65,198		25		0.08	%		62,152		38		0.12	%
Time deposits		579,251		8,656		3.01	%		488,364		10,013		4.12	%
Interest-bearing demand notes issued to the U.S. Treasury		1,034		0		0.00	%		995		10		2.06	%
Federal funds purchased		512		1		0.39	%		8,009		110		2.77	%
Customer repurchase agreements		32,563		176		1.09	%		36,427		402		2.22	%
Advances from Federal Home Loan Bank		32,494		484		3.00	%		11,046		214		3.89	%
Trust preferred securities		25,000		710		5.73	%		25,000		710		5.71	%
Note payable		4,789		96		4.04	%		14,550		343		4.74	%

Total interest-bearing liabilities		1,002,679		11,717		2.36	%		899,348		14,268		3.19	%

Net yield on average interest-earning assets			$	18,345		3.48	%			$	16,358		3.44	%

Average non-interest-bearing liabilities		118,286							113,031

Average stockholders’ equity		94,591							69,001

Total average liabilities and stockholders’ equity	$	1,215,556						$	1,081,380

The following table reconciles tax-equivalent net interest income (as shown above) to net interest income as reported on the Consolidated Statements of Income.


	For the Six Months Ended June 30,
	2009		2008
Net interest income as stated	$	17,024	$	15,271
Tax equivalent adjustment-investments		1,249		1,051
Tax equivalent adjustment-loans		72		36

Tax equivalent net interest income	$	18,345	$	16,358

Schedule 7. Controls and Procedures


(a)	Disclosure controls and procedures. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2009. Our disclosure controls and procedures are the controls and other procedures that we designed to ensure that we record, process, summarize and report in a timely manner the information we must disclose in reports that we file with or submit to the SEC. Tony J. Sorcic, President and Chief Executive Officer, and Todd D. Fanning, Senior Vice-President and Chief Financial Officer, reviewed and participated in this evaluation. Based on this evaluation, Messrs. Sorcic and Fanning concluded that, as of the date of their evaluation, our disclosure controls were effective.

(b)	Internal controls. There have not been any significant changes in our internal accounting controls or in other factors during the quarter ended June 30, 2009 that could significantly affect those controls.

INDEX TO EXHIBITS


Exhibit Number		Exhibit

31.1	Certification of Tony J. Sorcic required by Rule 13a-14(a).

31.2	Certification of Todd D. Fanning required by Rule 13a-14(a).

32.1	Certification of Tony J. Sorcic required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.

32.2	Certification of Todd D. Fanning required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.