-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, JY0Ytb2uIbu1C/gaR/WICARIM21FJi3pNyacfMWyTWjMNzeEd55YgqfBMiTnDugk bW2kY81Usi4YXNZCXksM0w== 0001047469-99-011832.txt : 19990330 0001047469-99-011832.hdr.sgml : 19990330 ACCESSION NUMBER: 0001047469-99-011832 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990329 FILER: COMPANY DATA: COMPANY CONFORMED NAME: NORTHERN STATES FINANCIAL CORP /DE/ CENTRAL INDEX KEY: 0000744485 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 363449727 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-19300 FILM NUMBER: 99575336 BUSINESS ADDRESS: STREET 1: 1601 N LEWIS AVE CITY: WAUKEGAN STATE: IL ZIP: 60085 BUSINESS PHONE: 7082446000 MAIL ADDRESS: STREET 1: 1601 NORTH LEWIS AVENUE CITY: WAUKEGAN STATE: IL ZIP: 60085 10-K405 1 FORM 10-K405 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ------------------------------ FORM 10-K / X / ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______ to ______ ------------------------------ COMMISSION FILE NUMBER 0 - 19300 NORTHERN STATES FINANCIAL CORPORATION (Exact name of Registrant as specified in its charter) Delaware 36-3449727 (State of incorporation) (I.R.S. Employer Identification No.) 1601 North Lewis Avenue Waukegan, Illinois 60085 (847) 244-6000 (Address, including zip code, and telephone number, including area code, of principal executive office) ------------------------------ Securities registered pursuant to Section 12(g) of the Act Name of each exchange on Title of each class which registered --------------------------- ------------------------ Common Stock $.40 par value NASDAQ Small-Cap Market Cover Page 1 of 2 Page 1 of 63 Pages Exhibit Index Appears on Page 21 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. [ X ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X] The aggregate market value of the voting shares held by nonaffiliates of the Registrant is $69,751,065, as of March 19, 1999. Solely for the purpose of this computation, it has been assumed that executive officers and directors of the Registrant are "affiliates" and that the last price known to management was a sale on March 19, 1999, of $23.00 per share. 4,455,435 shares of common stock were outstanding as of March 25, 1999. DOCUMENTS INCORPORATED BY REFERENCE Portions of Parts II and IV are incorporated by reference from the Registrant's 1998 Annual Report to Stockholders; and a portion of Part III is incorporated by reference from the Registrant's Proxy Statement dated March 23, 1999, for the Annual Meeting of Stockholders to be held April 22, 1999. Except for those portions of the 1998 Annual Report incorporated by reference, the Annual Report is not deemed filed as part of this Report. Cover Page 2 of 2 INDEX
PART I PAGE NO. Item 1 Business 4 Item 2 Properties 14 Item 3 Legal Proceedings 14 Item 4 Submission of Matters to a Vote of Security Holders 14 PART II Item 5 Market for the Registrant's Common Stock and Related Stockholder Matters 15 Item 6 Selected Financial Data 15 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 15 Item 7A Quantitative and Qualitative Disclosures about Market Risk 15 Item 8 Financial Statements and Supplementary Data 16 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 16 PART III Item 10 Directors and Executive Officers of the Registrant 17 Item 11 Executive Compensation 17 Item 12 Security Ownership of Certain Beneficial Owners and Management 17 Item 13 Certain Relationships and Related Transactions 17 PART IV Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K 18 Signatures 19
3 PART I Item 1. BUSINESS THE COMPANY OVERVIEW Northern States Financial Corporation (the "Registrant" or the "Company") is a bank holding company organized in 1984 under the laws of Delaware, for the purpose of becoming the parent bank holding company of the Bank of Waukegan (the "Bank"). In 1991, the Registrant acquired First Federal Bank, fsb ("First Federal" or the "Thrift"). On December 17, 1997, the Company's Board of Directors announced that it had approved the merger of its two wholly owned subsidiaries, Bank of Waukegan and First Federal Bank, fsb. The merger became effective April 21, 1998 with the Bank as the surviving entity in the merger. The Registrant is registered under the Bank Holding Company Act of 1956, as amended, and owns all the outstanding stock of the Bank. At December 31, 1998, the Company had 450 registered stockholders of record, 4,453,400 shares of Common Stock outstanding, and total consolidated assets of approximately $486 million. Aside from the stock of the Bank and cash, the Registrant has no other substantial assets. As a large, community-oriented, independent banking organization in the Waukegan-Gurnee area in the State of Illinois, the Company is well positioned to take advantage of the growth in Waukegan-Gurnee and its surrounding communities. The Company has continuously served the community since 1919 when First Federal was chartered; complemented by the Bank when it was chartered in 1962. The Company's local management, coupled with its long record of service, has allowed it to compete successfully in the banking market. The Company operates as a traditional community bank with conveniently located branches and a professional staff. The Registrant and Bank have no material patents, licenses or franchises except the corporate franchises and trademarks which permit them to engage in banking and trust practices pursuant to law. The following table shows loans and deposits of the Bank as of December 31, 1998 (in thousands of dollars): LOANS DEPOSITS ----------------------- $246,209 $355,756 The principal business of the Registrant, operating through the Bank, consists of attracting deposits and securities sold under repurchase agreements from the general public, making commercial loans, loans secured by residential and commercial real estate and consumer loans, and operating a mortgage banking and trust businesses. 4 SUBSIDIARY OPERATIONS The Bank of Waukegan was chartered as a state bank in 1962 and is located in Waukegan, Illinois. Waukegan is located approximately 37 miles north of Chicago, Illinois and has a population of approximately 70,000. At December 31, 1998 the Bank of Waukegan had total assets of approximately $485.7 million, deposits of approximately $356.5 million and stockholder's equity of approximately $64.55 million. The Bank has three banking offices located in Waukegan, one office located in Antioch, Illinois, one office located in Gurnee, Illinois, and one office located in Winthrop Harbor, Illinois. The Bank provides services to individuals, businesses and local governmental units in northeastern Illinois and southeastern Wisconsin. The Bank's full service banking business includes the customary consumer and commercial products and services which banks provide, including the following: demand, savings, and time deposits, securities sold under repurchase agreements and individual retirement accounts; commercial, consumer and real estate lending, including installment loans, student loans, lines of credit and overdraft checking; safe deposit operations; trust services; and a variety of additional services tailored to the needs of individual customers, such as the sale of traveler's checks, money orders, cashier's checks and foreign currency, direct deposit, and other special services. Commercial and consumer loans are made to corporations, partnerships and individuals, primarily on a secured basis. Commercial lending focuses on business, capital, construction, inventory and real estate. The installment loan department of the Bank makes direct and indirect loans to consumers and commercial customers. The mortgage division originates and services commercial and residential mortgages. The Bank's trust department acts as executor, administrator, trustee, conservator, guardian, custodian and agent. At December 31, 1998, the Trust Department had assets under management or custodial arrangements of approximately $214 million. Its office is located in Waukegan, Illinois. COMPANY OPERATING STRATEGY Corporate policy, strategy and goals are established by the Board of Directors of the Company. Pursuant to the Company's philosophy, operational and administrative policies for the Bank are also established by the Company. Within this framework, the Bank focuses on providing personalized services and quality products to customers to meet the needs of the communities in which they operate. 5 As part of its community banking approach, the Company encourages the officers of the Bank to actively participate in community organizations. In addition, within credit and rate of return parameters, the Company attempts to ensure that the Bank meets the credit needs of the community. In addition, the Bank invests in local municipal securities. LENDING ACTIVITIES GENERAL - The Bank provides a range of commercial and retail lending services to corporations, partnerships and individuals, including, but not limited to, commercial business loans, commercial and residential real estate construction and mortgage loans, consumer loans, revolving lines of credit and letters of credit. The installment loan department makes direct and indirect loans to consumers and commercial customers. The mortgage department originates and services commercial and residential mortgages. The Bank's mortgage banking operation takes and processes loan applications that are "table funded" by the institution that ultimately funds and owns the loan. The Bank aggressively markets its services to qualified borrowers in both the commercial and consumer sectors. The Bank's commercial lending officers actively solicit the business of new companies entering the surrounding market as well as long-standing members of the business community. Through personalized professional service and competitive pricing, the Bank has been successful in attracting new commercial lending customers. At the same time, the Bank actively advertises its consumer loan products and continually attempts to make its lending officers more accessible. COMMERCIAL LOANS - The Bank seeks new commercial loans in its market area and much of the increase in these loans in recent years can be attributed to the successful solicitation of new business. The Bank's areas of emphasis include, but are not limited to, loans to manufacturers, building contractors, developers, business services companies and retailers. The Bank provides a wide range of commercial business loans, including lines of credit for working capital purposes and term loans for the acquisition of equipment and other purposes. Collateral for these loans generally includes accounts receivable, inventory, equipment and real estate. Loans may be made on an unsecured basis where warranted by the overall financial condition of the borrower. Terms of commercial business loans generally range from one to five years. The majority of the Bank's commercial business loans have floating interest rates or reprice within one year. The primary repayment risk for commercial loans is the failure of the business due to economic or financial factors. In most cases, the Bank has collateralized these loans and/or taken personal guarantees to help assure repayment. The Bank regularly provides financing to developers who have demonstrated a favorable record of performance for the construction of homes. Sales of these homes have remained very strong in Lake County due to the growth in population. MORTGAGE BANKING - The Bank conducts a mortgage origination operation through its mortgage division. Since 1991, the Bank through the former Thrift began to fund conforming long-term residential mortgage loans and selling them in the secondary market with servicing retained. During 1998, the Bank's mortgage banking operation began taking 6 and processing loan applications that are "table funded" by the institution that ultimately funds and owns the loan. These loans are sold without the Bank retaining servicing. The Bank has a mortgage servicing portfolio of approximately $60.3 million at December 31, 1998. CONSUMER LENDING - The Bank's consumer lending department provides all types of consumer loans including motor vehicle, home improvement, home equity, student loans, unsecured loans and small personal credit lines. TRUST DEPARTMENT - The Bank's trust department has been providing trust services to the community for over 10 years. Currently, the Bank has over $214 million of trust assets under management and provides a full complement of trust services for individuals and corporations including land trust services. To build on the trust department's mainstay of personal trust administration, the trust department's focus is in two major areas: (i) investment management for individuals and (ii) administration and investment services for employee benefit plans. COMPETITION The Registrant and its subsidiary encounter significant competition in all of their activities. The Chicago metropolitan area and suburban Lake County have a high density of financial institutions, many of which are significantly larger and have substantially greater financial resources than the Company and its subsidiary, and all of which are competitors of the Company and its subsidiary to varying degrees. The Registrant and its subsidiary are subject to competition from various financial institutions, including state and national banks, state and federal savings associations, credit unions, certain non-banking consumer lenders, and other companies or firms, including brokerage houses and mortgage brokers, that provide similar services in northeastern Illinois. In total, there are 22 financial institutions which have offices located in the Waukegan-Gurnee area, including the Bank. These financial institutions consist of 9 banks, 6 savings associations and 7 credit unions. The Bank also competes with money funds and with insurance companies with respect to its individual retirement accounts. Competition may increase as a result of the continuing reduction in the effective restrictions on the interstate operations of financial institutions. The Registrant and its subsidiary face additional competition for deposits from short-term money market mutual funds and other corporate and government securities funds. Since the elimination of federal interest rate controls on deposits, the competition from other financial institutions for deposits has increased. The primary factors influencing competition for deposits are interest rates, service, and convenience of office locations. The Company competes for loans principally through the range and quality of the services it provides, interest rate and loan fee terms. The Company believes that its long-standing presence in the community and personal service philosophy 7 enhances its ability to compete favorably in attracting and retaining individual and business customers. The Company actively solicits deposit-related clients and competes for deposits by offering customers personal attention, professional service and competitive interest rates. EMPLOYEES The Registrant and its subsidiary employed 119 full-time and 28 part-time employees as of December 31, 1998. None of the Registrant's employees is represented by any collective bargaining group. The Company offers a variety of employee benefits and management considers its employee relations to be good. GOVERNMENTAL MONETARY POLICY AND ECONOMIC CONDITIONS The earnings and growth of the Company are affected not only by general economic conditions, but also by the fiscal and monetary policies of the federal government and its agencies. In particular, the Federal Reserve Board regulates monetary and credit conditions and interest rates in order to influence general economic conditions, primarily through open-market operations in U.S. Government securities, varying the discount rate on bank borrowings, and setting reserve requirements against bank deposits. These policies have a significant influence on overall growth and distribution of the Company's loans, investments and deposits, and affect interest rates charged on loans and earned on investments or paid for deposits. The monetary policies of the Federal Reserve Board are expected to continue their substantial influence on the operating results of banks. The general effect, if any, of such policies upon the future business and earnings of the Company and its subsidiary cannot accurately be predicted. SUPERVISION AND REGULATION Financial institutions and their holding companies are extensively regulated under federal and state laws. As a result, the business, financial condition and prospects of the Company and the Bank can be materially affected not only by management decisions and general economic conditions, but also by applicable statutes and regulations and other regulatory pronouncements and policies promulgated by regulatory agencies with jurisdiction over the Company and the Bank, such as the Board of Governors of the Federal Reserve System ("FRB"), the Federal Deposit Insurance Corporation ("FDIC") and the Illinois Office of Banks and Real Estate (the "Office"). Such statutes, regulations and other pronouncements 8 and policies are intended to protect depositors and the FDIC's deposit insurance funds, not to protect stockholders. The Company and the Bank are "affiliates" within the meaning of the Federal Reserve Act so that the Bank is subject to certain restrictions with respect to loans to the Company and certain other transactions with the Company or involving its securities. The Company is a bank holding company subject to the Bank Holding Company Act of 1956, as amended (the "Act"), and to regulation by the FRB. The Act limits the activities which may be engaged in by bank holding companies and their nonbank subsidiaries, with certain exceptions, to those so closely related to banking or managing or controlling banks as to be a proper incident thereto. Also, under the Act and the FRB's regulations, a bank holding company, as well as certain of its subsidiaries, are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or provision of any property or services. The Act also prohibits bank holding companies from acquiring substantially all the assets of or owning more than 5% of the voting shares of any bank or nonbanking company, which is not already majority owned, without the prior approval of the FRB. The Reigle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Interstate Act") permits an adequately capitalized and adequately managed bank holding company to acquire, with FRB approval, a bank located in a state other than the bank holding company's home state, without regard to whether the transaction is permitted under any state law, except that a host state may establish by statute the minimum age of its banks (up to a maximum of 5 years) subject to acquisition by out-of-state bank holding companies. The FRB may not approve the acquisition if the applicant bank holding company, upon consummation, would control more that 10% of total U.S. insured depository institution deposits or more than 30% of the host state's total insured depository institution deposits. The Interstate Act also permits a bank, with the approval of the appropriate Federal bank regulatory agency, to establish a de novo branch in a state, other than the bank's home state, in which the bank does not presently maintain a branch if the host state has enacted a law that applies equally to all banks and expressly permits all out-of-state banks to branch de novo into the host state. Banks having different home states may, with approval of the appropriate Federal bank regulatory agency, merge across state lines, unless the home state of a participating bank has opted-out of the Interestate Act prior to June 1, 1997. In addition the Interstate Act permits any bank subsidiary of a bank holding company to receive deposits, renew time deposits, close loans, service loans and receive payments on loans and other obligations as agent for a bank or thrift affiliate, whether such affiliate is located in a different state or in the same state. Illinois law allows the Bank to establish branches anywhere in the state. The Illinois Bank Holding Company Act permits Illinois bank holding companies to acquire control of banks in any state and permits bank holding companies whose principal place of business is in another state to acquire control of Illinois banks or bank holding companies upon satisfactory application to the Office. In reviewing any such application, the Office will review, among other things, compliance by the applicant with the requirements of the Community Reinvestment Act (the "CRA") and other information designed to determine such banks' abilities to meet community credit needs. 9 The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") amended the Act to authorize the FRB to allow bank holding companies to acquire any savings association (whether healthy, failed or failing) and removed "tandem operations" restrictions, which previously prohibited savings associations from being operated in tandem with a bank holding company's other subsidiaries. As a result, bank holding companies now have expanded opportunities to acquire savings associations. Under FIRREA, an insured depository institution which is commonly controlled with another insured depository institution shall generally be liable for any loss incurred, or reasonably anticipated to be incurred, by the FDIC in connection with the default of such commonly controlled institution, or for any assistance provided by the FDIC to such commonly controlled institution, which is in danger of default. The term "default" is defined to mean the appointment of a conservator or receiver for such institution. Such liability is subordinated in right of payment to deposit liabilities, secured obligations, any other general or senior liability and any obligation subordinated to depositors and or other general creditors, other than obligations owed to any affiliate of the depository institution (with certain exceptions) and any obligations to stockholders in such capacity. The Bank is subject to regulation by the FDIC, as well as by the Office. Under the Illinois Banking Act (the "IBA"), the Bank is permitted to declare and pay dividends in amounts up to the amount of its accumulated net profits provided that it shall retain in its additional paid-in capital at least one-tenth of its net profits since the date of the declaration of its most recent previous dividend until such additions to additional paid-in capital, in the aggregate, equal at least the paid-in capital of the Bank. In no event may the Bank, while it continues its banking business, pay dividends in excess of its net profits then on hand (after deductions for losses and bad debts). Under the FDIC's risk-based insurance assessment system, each insured depository institution is placed in one of nine risk categories based on its level of capital and other relevant information. Each insured depository institution's insurance assessment rate is then determined by the risk category in which it has been classified by the FDIC. Under the assessment schedule applicable for the second semi-annual assessment period of 1998 to BIF-insured institutions (such as the Bank), assessment rates ranged from 0% to 0.27% of deposits. In addition, the Bank is subject to "FICO assessments" to repay obligations issued by a federally chartered corporation to provide financing for resolving the thrift crises of the 1980s. The FICO assessment rate applicable to BIF-assessable deposits is limited by law to 20% of the rate applicable to SAIF-assessable deposits. Currently, the FICO assessment rate applicable to BIF-assessable deposits is .0122%, and the rate applicable to SAIF-assessable deposits is .0610%. The Federal bank regulators have adopted risk-based capital guidelines for bank holding companies and banks. The minimum ratio of qualifying total capital to risk-weighted assets, including certain off-balance sheet items (Total Capital Ratio), is 8%, and 10 the minimum ratio of that portion of total capital that is comprised of common stock, related additional paid-in capital, retained earnings, noncumulative perpetual preferred stock, minority interests and, for bank holding companies, a limited amount of qualifying cumulative perpetual preferred stock, less certain intangibles including goodwill (Tier 1 capital), to risk-weighted assets is 4%. The balance of total capital may consist of other preferred stock, certain other instruments, and limited amounts of subordinated debt and the loan and lease loss allowance. The Federal Reserve Board risk-based capital standards contemplate that evaluation of capital adequacy will take account of a wide range of other factors, including overall interest rate exposure; liquidity, funding and market risks; the quality and level of earnings; investment, loan portfolio, and other concentrations of credit; certain risks arising from nontraditional activities; the quality of loans and investments; the effectiveness of loan and investment policies; and management's overall ability to monitor and control financial and operating risks including the risks presented by concentrations of credit and nontraditional activities. In addition, the Federal Reserve has established minimum Leverage Ratio (Tier 1 capital to quarterly average total assets) guidelines for bank holding companies and banks. These guidelines provide for a minimum Leverage Ratio of 3% for bank holding companies and banks that meet certain specified criteria, including having the highest regulatory rating. All other banking organizations are required to maintain a Leverage Ratio of at least 3% plus an additional cushion of 100 to 200 basis points. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the guidelines indicate that the Federal Reserve Board will continue to consider a "Tangible Tier 1 Leverage Ratio" in evaluating proposals for expansion or new activities. The Tangible Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not deducted from Tier 1 capital, to quarterly average total assets. As of December 31, 1998, the Federal Reserve had not advised the Company of any specific minimum Tangible Tier 1 Leverage Ratio applicable to it. At December 31, 1998, the Company had a Tangible Tier 1 Leverage Ratio of 13.69%. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and made revisions to several other federal banking statutes. In general, FDICIA subjects depository institutions to significantly increased regulation and supervision. Among other things, FDICIA requires federal bank regulatory authorities to take "prompt corrective action" with respect to depository institutions that do not meet minimum capital requirements, and imposes certain restrictions upon depository institutions which meet minimum capital requirements but are not "well capitalized" for purposes of FDICIA. FDICIA and the regulations adopted under it establish five capital categories as follows, with the category for any institution determined by the lowest of any of these ratios: 11
TIER 1 TOTAL LEVERAGE RATIO RISKED-BASED RATIO RISKED-BASED RATIO Well Capitalized 5% or above 6% or above 10% or above Adequately Capitalized 4% or above* 4% of above 8% or above Undercapitalized Less than 4% Less than 4% Less than 8% Significantly Undercapitalized Less than 3% Less than 3% Less than 6% RATIO OF TANGIBLE EQUITY TO TOTAL ASSETS Critically Undercapitalized 2% or below
*3% for banks with the highest CAMEL (supervisory) rating. An insured depository institution may be deemed to be in a capital category that is lower than is indicated by its capital ratios if it receives an unsatisfactory rating by its examiners with respect to its assets, management, earnings or liquidity. Under FDICIA, a bank that is not well capitalized is generally prohibited from accepting or renewing brokered deposits and offering interest rates on deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited); in addition, "pass through" insurance coverage may not be available for certain employee benefit accounts. FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to limitations on growth and are required to submit a capital restoration plan, which must be guaranteed by the institution's parent company. Institutions that fail to submit an acceptable plan, or that are significantly undercapitalized, are subject to a host of more drastic regulatory restrictions and measures. The Bank is considered "well capitalized" according to FDICIA guidelines. 12 Federal and state statutes and regulations provide financial institution regulatory agencies with great flexibility to undertake enforcement action against an institution that fails to comply with regulatory requirements, particularly capital requirements. Possible enforcement actions range from the imposition of a capital plan and capital directive to, in the most severe cases, place the institution into conservatorship or receivership or the termination of deposit insurance. FDICIA directs that each federal banking agency prescribe standards for depository institutions or depository institutions' holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses and other standards as they deem appropriate. Many regulations implementing these directives have been adopted by the agencies As a member of the FRB, the Bank is subject to regulations requiring depository institutions to maintain reserves against a specified percentage of transaction accounts (primarily NOW and regular checking). Reserves are maintained in the form of vault cash or non-interest bearing deposits with the FRB. The FRB regulations generally require 3% reserves on the first $47.8 million of transaction accounts; however, the first $4 million of these otherwise reservable balances (subject to adjustments by the FRB) are exempted from the 3% reserve requirement. Net transaction balances over $47.8 million are subject to a reserve requirement of $1,434,000 plus 10% of the amount of the net transaction balances over $47.8 million. The Bank is in compliance with the forgoing requirements. Under the Community Reinvestment Act ("CRA"), a financial institution has a continuing and affirmative obligation, consistent with the safe and sound operation of such institution, to serve the "convenience and needs" of the communities in which they are chartered to do business, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community as long as they are consistent with the CRA. The CRA requires each federal banking agency, in connection with its examination of a financial institution, to assess and assign one of four ratings to the institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by the institution, including applications for charters, branches and other deposit facilities, relocations, mergers, consolidations and acquisitions of assets or assumptions of liabilities. The CRA also requires that all institutions make public disclosure of their CRA ratings. BUSINESS-STATISTICAL DISCLOSURE The information set forth under the caption "Management's Discussion and Analysis of Financial Condition and the Results of Operations" on Pages 10 through 28 of the 1998 Annual Report to Stockholders (filed as Exhibit 13, pages 22 through 40 of this report) is incorporated herein by reference. 13 ITEM 2. PROPERTIES The Bank conducts its operations through its main office and five branches. The Company's office is located in the main office of the Bank. All of such offices are owned by the Bank and are located in Lake County, Illinois. The Bank believes that its current facilities are adequate for the conduct of its business. The following table sets forth information relating to each of such offices: Main Office: Trust Department: 1601 North Lewis Avenue 1601 North Lewis Avenue Waukegan, Illinois 60085 Waukegan, Illinois 60085 Branches: 3233 Grand Avenue 40220 N. Route 59 Waukegan, Illinois 60085 Antioch, Illinois 60002 216 Madison Street 700 N. Sheridan Road Waukegan, Illinois 60085 Winthrop Harbor, Illinois 60096 5384 Grand Avenue Gurnee, Illinois 60031 ITEM 3. LEGAL PROCEEDINGS Due to the nature of their business, the Registrant and its subsidiary are often subject to various legal actions. These legal actions, whether pending or threatened, arise through the normal course of business and are not considered unusual or material. Currently, no material legal procedures are pending which involve the Registrant or the Bank. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable 14 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information set forth under the captions "Stock Market Information"; "Price Summary"; and "Cash Dividends" on Page 50 of the 1998 Annual Report to Stockholders (filed as Exhibit 13, page 62 of this report) is incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA The information set forth under the caption "Selected Consolidated Financial Data" on Page 10 of the 1998 Annual Report to Stockholders (filed as Exhibit 13, page 22 of this report) is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on Pages 10 through 28 of the 1998 Annual Report to Stockholders (filed as Exhibit 13, pages 22 through 40 of this report) is incorporated herein by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information set forth under the caption "Quantitative and Qualitative Disclosures about Market Risk" on Pages 29 through 31 of the 1998 Annual Report to Stockholders (filed as Exhibit 13, pages 41 through 43 of this report) is incorporated herein by reference. 15 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of the Registrant and the Independent Auditors' Report as set forth on the following pages of the 1998 Annual Report to Stockholders (filed as Exhibit 13, to this report) are incorporated herein by reference:
Annual Report to Stockholders Page --------------- Independent Auditors' Report 31 Consolidated Balance Sheets as of December 31, 1998 and 1997 32 Consolidated Statements of Income for the Years ended December 31, 1998, 1997 and 1996 33 Consolidated Statements of Cash Flows for the Years ended December 31, 1998, 1997 and 1996 34 Consolidated Statements of Stockholders' Equity for the Years ended December 31, 1998, 1997 and 1996 35 Consolidated Statements of Comprehensive Income for the Years ended December 31, 1998, 1997 and 1996 35 Notes to the Consolidated Financial Statements 36 Parent Company Only Financial Statements 48
The portions of the 1998 Annual Report to Stockholders which are not specifically incorporated by reference as a part of this Form 10-K are not deemed to be a part of this report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None 16 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS - The information with respect to Directors of the Registrant set forth under the caption "Directors and Executive Management" on pages 2 and 3 of the Registrant's Proxy Statement, dated March 23, 1999, relating to the April 22, 1999 Annual Meeting of Stockholders is incorporated herein by reference. EXECUTIVE OFFICERS - The Company's only executive officers are Mr. Fred Abdula, the President of the Company, and Mr. Kenneth W. Balza, who was the Vice President and Treasurer of the Company at December 31, 1998 and retired from this position in January, 1999. The information with respect to Mr. Abdula and Mr. Balza is set forth under the caption "Directors and Executive Management" on pages 2 and 3 of the Registrant's Proxy Statement, dated March 23, 1999, relating to the April 22, 1999 Annual Meeting of Stockholders and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information set forth under the caption "Executive Compensation" and "Summary Compensation Table" on page 5 of the Registrant's Proxy Statement, dated March 23, 1999, relating to the April 22, 1999 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" on pages 4 and 5 of the Registrant's Proxy Statement, dated March 23, 1999, relating to the April 22, 1999 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the caption "Compensation Committee Interlocks and Insider Participation" on page 9 of the Registrant's Proxy Statement, dated March 23, 1999, relating to the April 22, 1999 Annual Meeting of Stockholders is incorporated herein by reference. 17 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS All financial statements of the Registrant are incorporated herein by reference as set forth under Item 8, Part II of this report on Form 10-K. 2. FINANCIAL STATEMENT SCHEDULES Not applicable 3. EXHIBITS (Numbered in accordance with Item 601 of Regulation S-K) The following exhibits are filed as part of this report: 3-A Articles of Incorporation of the Company, as amended to date. (Filed with Registrant's annual report on Form 10-K for the year ended December 31, 1994 Commission File 0-19300 and incorporated here by reference.) 3-B Bylaws of the Company, as amended to date. (Filed with Registrant's annual report on Form 10-K for the year ended December 31, 1994 Commission File 0-19300 and incorporated here by reference.) 10 1992 Northern States Omnibus Incentive Plan. (Filed with Registrant's annual report on Form 10-K for the year ended December 31, 1994 Commission File 0-19300 and incorporated here by reference.) 11 Statement of Computation of per share earnings. Contained in Notes 1 and 14 to the consolidated financial statements, pages 37 and 47, 1998 Annual Report to Stockholders (filed as Exhibit 13 pages 49 and 59 to this report) is incorporated by reference. 13 Copy of the Company's Annual Report to Stockholders for the year ended December 31, 1998. This exhibit, except for portions thereof that have been specifically incorporated by reference into this report, is furnished for the information of the Commission and shall not be deemed "filed" as part hereof. 21 List of Subsidiaries. (b) REPORTS ON FORM 8-K No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1998. (c) Exhibit List and Index 18 SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized, on this 26th day of March 1999. NORTHERN STATES FINANCIAL CORPORATION (Registrant) Fred Abdula, Chairman of the Board and President /s/ Fred Abdula (Principal Executive Officer) ---------------------------- Thomas M. Nemeth, Vice President and Treasurer (Principal Financial Officer and /s/ Thomas M. Nemeth Principal Accounting Officer) ---------------------------- 19 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Each director of the Registrant, whose signature appears below, hereby appoints Fred Abdula and Thomas M. Nemeth and each of them severally, as his attorney-in-fact, to sign in his name and on his behalf, as a director of the Registrant, and to file with the Commission any and all Amendments to this Report on Form 10-K, on this 26th day of March 1999. Fred Abdula, Director /s/ Fred Abdula ---------------------------- Kenneth W. Balza, Director /s/ Kenneth W. Balza ---------------------------- Jack H. Blumberg, Director /s/ Jack H. Blumberg ---------------------------- Frank Furlan, Director /s/ FRANK FURLAN ---------------------------- Harry S. Gaples, Director /s/ Harry S. Gaples ---------------------------- Laurance A. Guthrie, Director /s/ Laurance A. Guthrie ---------------------------- James A. Hollensteiner, Director /s/ James A. Hollensteiner ---------------------------- Raymond M. Mota, Director /s/ Raymond M. Mota ---------------------------- Helen Rumsa, Director /s/ Helen Rumsa ---------------------------- Frank Ryskiewicz, Director /s/ Frank Ryskiewicz ---------------------------- Henry G. Tewes, Director /s/ Henry G. Tewes ---------------------------- Arthur J. Wagner, Director /s/ Arthur J. Wagner ---------------------------- 20 NORTHERN STATES FINANCIAL CORPORATION AND SUBSIDIARIES FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998 EXHIBIT INDEX Exhibits Page(s) - -------- ------- 3-A Articles of Incorporation of the Company, as amended to date. (Filed with Registrant's annual report on Form 10-K for the year ended December 31, 1994 Commission File 0-19300 and incorporated here by reference.) 3-B Bylaws of the Company, as amended to date. (Filed with Registrant's annual report on Form 10-K for the year ended December 31, 1994 Commission File 0-19300 and incorporated here by reference.) 10 1992 Northern States Omnibus Incentive Plan. (Filed with Registrant's annual report on Form 10-K for the year ended December 31, 1994 Commission File 0-19300 and incorporated here by reference.) 11 Statement of Computation of per share earnings. Contained in Notes 1 and 14 to the consolidated financial statements, pages 37 and 47, 1998 Annual Report to Stockholders (filed as Exhibit 13 to this report) is incorporated by reference. 49 and 59 13 Copy of the Company's Annual Report to Stockholders for the year ended December 31, 1998. This exhibit, except for portions thereof that have been specifically incorporated by reference into this Report, is furnished for the information of the Commission and shall not be deemed "filed" as part hereof. 22 21 List of Subsidiaries. 63 21 EX-13 2 EXHIBIT 13 NORTHERN STATES FINANCIAL CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The Company and its subsidiary are subject to regulation by numerous agencies including the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Illinois Office of Banks and Real Estate. Among other things, these agencies limit the activities in which the Company and the Bank may engage, the investments and loans which the Bank funds, and the reserves against deposits which the Bank must maintain. The statements contained in this management's discussion and analysis that are not historical facts are forward-looking statements subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are identifiable by the use of the words "believe", "expect", "intend", "estimate" or similar expressions. The Company cautions readers of this Annual Report that a number of important factors could cause the Company's actual results in 1999 and beyond to differ materially from those expressed in any such forward-looking statements. TABLE 1 ANALYSIS OF AVERAGE BALANCES, TAX EQUIVALENT YIELDS AND RATES
($ 000's) For the Years Ended December 31, 1998 1997 1996 - ------------------------------- ---------------------------- ------------------------- ---------------------------- Average Average Average Balance Interest Rate Balance Interest Rate Balance Interest Rate ------- -------- ---- ------- -------- ---- ------- -------- ---- ASSETS Loans (1) (2) (3) $242,020 $ 21,903 9.05% $241,019 $ 22,343 9.27% $233,167 $ 22,296 9.56% Taxable securities (5) 167,117 10,263 6.16 132,128 8,411 6.34 124,271 7,663 6.12 Securities exempt from federal income taxes (2) (5) 19,552 1,543 8.18 21,301 1,741 8.38 22,058 1,799 8.36 Interest bearing deposits in financial institutions 428 25 5.84 617 35 5.67 504 28 5.56 Federal funds sold 21,157 1,135 5.36 17,437 965 5.53 13,844 742 5.36 ------- ------ ---- ------- ------ ---- ------- ------ ---- Interest earning assets 450,274 34,869 7.76 412,502 33,495 8.12 393,844 32,528 8.25 Noninterest earning assets 20,823 22,344 25,818 ------- ------ ---- ------- ------ ---- ------- ------ ---- Average assets (4) $471,097 $434,846 $ 419,662 -------- -------- --------- -------- -------- --------- Liabilities and stockholders' equity NOW deposits $ 39,310 1,157 2.94 $ 37,672 1,120 2.97 $ 39,474 1,177 2.98 Money market deposits 42,400 1,656 3.91 41,945 1,672 3.99 44,272 1,792 4.05 Savings deposits 44,067 1,311 2.98 44,458 1,322 2.97 46,828 1,395 2.98 Time deposits 188,365 10,413 5.53 171,149 9,714 5.68 155,378 8,720 5.61 Other borrowings 45,582 2,359 5.18 35,082 1,787 5.09 35,006 1,724 4.92 ------- ------ ---- ------- ------ ---- ------- ------ ---- Interest bearing liabilities 359,724 16,896 4.70 330,306 15,615 4.73 320,958 14,808 4.61 ------- ------ ---- ------- ------ ---- ------- ------ ---- Demand deposits and other noninterest bearing liabilities 48,754 47,453 46,580 Stockholders' equity 62,619 57,087 52,124 ------ ------ ------ Average liabilities and stockholders' equity $471,097 $434,846 $ 419,662 -------- -------- --------- -------- -------- --------- Net interest income $ 17,973 $ 17,880 $ 17,720 -------- -------- --------- -------- -------- --------- Net yield on interest earning assets 3.99% 4.33% 4.50% ----- ----- ----- ----- ----- ----- Interest-bearing liabilities to earning assets ratio 79.89% 80.07% 81.40% ----- ----- ----- ----- ----- -----
(1) - Interest income on loans includes loan origination and other fees of $475 for 1998, $492 for 1997 and $443 for 1996. Average loans include direct lease financing. (2) - Tax-exempt income is reflected on a fully tax equivalent basis utilizing a 34% rate. (3) - Non-accrual loans are included in average loans. (4) - Average balances are derived from the average daily balances. (5) - Rate information was calculated based on the average amortized cost for securities. The 1998, 1997, and 1996, average balance information includes an average valuation allowance for taxable securities of $397, $(526) and $(985). The 1998, 1997 and 1996 average balance information includes an average valuation allowance of $682, $530, and $540 for tax-exempt securities. NSFC ANNUAL 11 REPORT 1998 23 NORTHERN STATES FINANCIAL CORPORATION NET INTEREST INCOME Table 1 shows a comparison of net interest income and average volumes, together with effective yields earned on such assets and rates paid on such funds. The results shown reflect the excess of interest earned on assets over the interest paid for funds. Interest income is the primary source of revenue for the Company. It comprised 92.1% of the Company's total revenues in 1998, 92.4% in 1997 and 90.7% in 1996. Net interest income is the difference between interest income earned on average interest earning assets, such as loans and securities, and interest expense on average interest bearing liabilities, such as deposits and other borrowings. In Table 1, interest income on non-taxable securities and loans has been adjusted to be fully tax equivalent so as to be comparable with rates earned and paid elsewhere. In addition, rates earned on securities are calculated based upon the average amortized cost of the related securities. Several factors affect net interest income, of which one factor is changes in interest rates, which are generally indicated by the changes in the prime lending rate. The prime rate was stable at 8.50% during the first three quarters of 1998 and declined during the fourth quarter to 7.75%. The average weighted prime lending rate in 1998 was 8.36%, a decrease of 8 basis points from 8.44% in 1997, and was 8.27% in 1996. Average rates earned on taxable securities in 1998 declined 18 basis points to 6.16% from 1997 levels after increasing 22 basis points in 1997 from 1996. Rates on federal funds sold in 1998 declined 17 basis points from 1997 after increasing 17 basis points in 1997 from 1996. Another major factor affecting the net interest margin is rates earned on loans. Table 1 shows that rates earned on average loans in 1998 decreased to 9.05% in 1998 from 9.27% in 1997 after declining in 1997 from 9.56% in 1996. The yields on loans during 1998 decreased 22 basis points from 1997 in part as a consequence of the 8 basis points decline of the average prime lending rate in 1998. Another factor impacting the overall decline in loan rates was competitive pressures, which have caused our loan rates to decline and increased the Company's portfolio of fixed rate loans. It is expected that competitive pressures will continue to affect loan pricing in 1999. Loan rates in 1997 declined 29 basis points from 1996, primarily as a result of competition. The average earning asset ratio is another important factor affecting net interest income. The average earning asset ratio is the percentage of average assets that earn interest income to total average assets and an increase in this ratio has a positive effect on net interest income. This percentage has increased for the Company during 1998 to 95.58% compared to 94.86% in 1997 and 93.85% in 1996. As indicated in Table 1, the Company's net interest income rose in 1998 to $17,973,000. Net interest income increased $93,000 in 1998 from 1997. During 1997 net interest income increased $160,000 from 1996. A significant reason for the 1998 increase was that interest earning assets increased $37.8 million while interest bearing liabilities only increased $29.4 million. This is further evidenced in Table 2, which shows that the 1998 increase in net interest income is primarily attributable to changes due to volume. Another factor that influenced net interest income in 1998 was the decrease in the interest rate spread. The interest rate spread is the yield earned on assets less the rates paid on liabilities. The interest rate spread decreased to 3.06% in 1998 as compared to 3.39% in 1997 and 3.64 % in 1996. The Company's average deposit and other borrowing rates were 4.70% in 1998, a slight decrease from 4.73% in 1997, which had increased from 4.61% in 1996. The rates earned on average earning assets during 1998 decreased to 7.76% from 8.12% in 1997, which had declined from 8.25% in 1996. The rates on average earning assets decreased during both years primarily due to competitive pressures on loan rates. Another factor influencing net interest income is the "interest bearing liabilities to earning assets ratio", as shown in Table 1, which indicates how many cents of each dollar of earning assets are funded by an interest bearing liability. As Table 1 indicates, this relationship has declined to 79.89% in 1998 from 80.07% in 1997, which was lower than 1996's percentage of 81.40%. The decline in this ratio has a positive impact on net interest income. The mix of assets and liabilities also affects net interest income. Average loans as a percentage of average earning assets declined to 53.8% in 1998 as compared to 58.4% in 1997 and 59.2% in 1996. As loans as a percentage of earning assets declines a larger percentage of earning assets consists of securities, which normally earn lower yields than loans. In 1998, total average interest bearing deposits increased $18.9 million from 1997 levels while average other borrowings, which consists primarily of repurchase agreement products and term advances from the Federal Home Loan Bank, increased $10.5 million. The 1998 increase in average interest bearing deposits was primarily in time deposits, which increased $17.2 million, while lower cost savings, NOW and money market deposits increased only $1.7 million. The growth in higher costing interest bearing liabilities, such as time deposits and other borrowings, during both 1998 and 1997 has impacted net interest income negatively. Interest rates paid on deposits and charged for loans during 1998 remained comparable with other local financial institutions. Management has lowered time deposits rates during 1998 NSFC ANNUAL 12 REPORT 1998 24 NORTHERN STATES FINANCIAL CORPORATION NET INTEREST INCOME (CONTINUED) by over 100 basis points as general interest rates have declined. The Bank's time deposits remain competitive despite the lower rates. Management expects that the Bank's net interest spread will improve as time deposits mature and reprice at lower rates. In spite of the many non-bank investment products available to our customers today, as well as from other financial institutions, the Company is pleased in its ability to maintain the level of interest bearing liabilities. As Table 1 indicates, the average balances of other borrowings increased $10.5 million in 1998 from 1997. Approximately $7.2 million of this increase was in securities sold under repurchase agreements (repurchase agreements), which the Company continues to offer as an alternative to certificates of deposit. A repurchase agreement is not subject to FDIC insurance and is not subject to reserve requirements, and therefore is less costly to the Company. A repurchase agreement also gives the customer added security for the borrowing in the form of an investment security pledged by the Company. Management expects to continue to offer repurchase agreements as an alternative to certificates of deposit in the future. The remaining $3.3 million increase in the average balance of the other borrowings consists of a $5 million term advance from the Federal Home Loan Bank which the Bank entered into on April 30, 1998, which raised the total advances to $10 million at year-end. Funds provided by these advances have been used to purchase U.S. Government agency securities that have call provisions on the same date that the advances are due to be repaid. Many other factors beyond Management's control can have a significant impact on changes in net interest income from one period to another. Examples of such factors are: (1) credit demands by customers; (2) fiscal and debt management policy of federal and state governments; (3) monetary policy of the Federal Reserve Board; and (4) changes in regulations. The components of the changes in net interest income are shown in Table 2. Table 2 allocates changes in net interest income between amounts attributable to changes in rate and changes in volume for the various categories of interest earning assets and interest bearing liabilities. TABLE 2 ANALYSIS OF CHANGES IN INTEREST INCOME AND EXPENSE
($ 000's) For the Year Ended December 31 1998 Compared to 1997 1997 Compared to 1996 - ------------------------------ ----------------------------------- ------------------------------------- Increase (Decrease) Increase (Decrease) Change Change Change Change Total Due To Due To Total Due To Due To Change Volume Rate Change Volume Rate ------ ------ ---- ------ ------ ---- INTEREST INCOME Loans $ (440) $ 92 $(532) $ 47 $ 737 $(690) Taxable securities 1,852 2,103 (251) 748 463 285 Securities exempt from federal income taxes (198) (156) (42) (58) (63) 5 Interest-bearing deposits in financial institutions (10) (11) 1 7 6 1 Federal funds sold 170 200 (30) 223 198 25 ------- ------- ----- ----- ------- ----- Total interest income 1,374 2,228 (854) 967 1,341 (374) ------- ------- ----- ----- ------- ----- INTEREST EXPENSE NOW deposits 37 48 (11) (57) (54) (3) Money market deposits (16) 18 (34) (120) (93) (27) Savings deposits (11) (12) 1 (73) (70) (3) Time deposits 699 957 (258) 994 894 100 Other borrowings 572 543 29 63 4 59 ------- ------- ----- ----- ------- ----- Total interest expense 1,281 1,554 (273) 807 681 126 ------- ------- ----- ----- ------- ----- NET INTEREST INCOME $ 93 $ 674 $(581) $ 160 $ 660 $(500) ------- ------- ----- ----- ------- ----- ------- ------- ----- ----- ------- -----
Volume/rate variances are allocated to the volume variance and the rate variance on an absolute basis. Tax-exempt income is reflected on a fully tax equivalent basis utilizing a 34% rate. NSFC ANNUAL 13 REPORT 1998 25 NORTHERN STATES FINANCIAL CORPORATION TABLE 3 SECURITIES
($ 000's) December 31, 1998 1997 1996 - ------------ ----------------- ----------------- ----------------- % of Total % of Total % of Total Securities available for sale Amount Portfolio Amount Portfolio Amount Portfolio ------ --------- ------ --------- ------ --------- U.S. Treasury $ 13,109 6.53% $ 14,031 7.77% $ 16,114 10.76% U.S. Government agencies and corporations 152,440 75.89 128,872 71.33 89,604 59.84 States and political subdivisions 23,428 11.67 22,408 12.40 25,482 17.02 Mortgage-backed securities 9,728 4.84 13,123 7.26 16,430 10.97 Equity securities 2,156 1.07 2,238 1.24 2,120 1.41 -------- ------ -------- ------ -------- ------ Total securities available for sale $200,861 100.00% $180,672 100.00% $149,750 100.00% -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ -------- ------
As of December 31, 1998, the Company held no securities of a single issuer, other than the U.S. Treasury and U.S. Government agencies and corporations, including the Federal Home Loan Bank (FHLB), the Federal Home Loan Mortgage Corporation (FHLMC), the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), the Federal Farm Credit Bank (FFCB), and the Student Loan Marketing Association (SLMA), that exceeded 10% of consolidated stockholders' equity. Although the Company holds securities issued by municipalities within the state of Illinois which in the aggregate exceed 10% of consolidated stockholders' equity, none of the holdings from individual municipal issuers exceed this threshold. The Company also holds local municipal bonds which, although not rated, are considered low risk investments. The carrying value of interest bearing balances with banks and federal funds sold consisted of the following at December 31, 1998: First USA Bank, Dallas $ 9,000 LaSalle National Bank, Chicago 3,100 Harris Bank, Chicago 538 Bank of America, Illinois 145 Federal Home Loan Bank, Chicago 100 ------- $12,883 ------- -------
SECURITIES All securities of the Company at December 31, 1998 are classified as available for sale. The Company classifies its securities as available for sale to provide flexibility in the event that it may be necessary to sell securities to raise cash for liquidity purposes or to adjust the portfolio for interest rate risk or income tax purposes. The securities portfolio increased $20.2 million at year-end 1998 from 1997, after an increase of $30.9 million at year-end 1997 from 1996. However, average securities, as shown in Table 1, increased in 1998 from 1997 by $33.2 million. The increase was the result of increased average interest bearing liabilities, of which the excess, after being used to increase our loans, was invested in securities. Holdings of U.S. Treasury securities declined $.9 million at December 31, 1998 compared to December 31, 1997. U.S. Government agency issues increased by $23.5 million, to $152.4 million, at December 31, 1998, from $128.9 million at December 31, 1997. The increase in U.S. Government agency issues is the result of the Company investing in higher yielding agency issues, that may have call provisions, in order to maximize yields on the Company's investment portfolio while helping to minimize state income taxes. As can be seen in Table 3, U.S. Government agency securities increased to 75.9% of the total portfolio at year-end 1998, from 71.3% in 1997 and 59.8% in 1996. Another reason for the growth in U.S. Government agency securities is that the Company attempts to keep at least half its portfolio in U.S. Treasury and U.S. Government agency issues, as indicated for all periods reported in Table 3. This allows the Company to better manage its exposure to changing interest rates, while minimizing credit risk within the portfolio. U.S. Treasury and U.S. Government agency issues comprised over 82% of the total portfolio at December 31, 1998. NSFC ANNUAL 14 REPORT 1998 26 NORTHERN STATES FINANCIAL CORPORATION SECURITIES (CONTINUED) Holdings of securities issued by states and political subdivisions, of which over 90% are tax-exempt, increased by $1.0 million to $23.4 million at December 31, 1998. According to the federal tax law, a bank is not allowed an interest deduction for the cost of deposits or borrowings used to fund most tax-exempt issues acquired after August 7, 1986. The Company has been able to purchase "bank qualified" tax-exempt issues from local taxing bodies to offset the runoff in this portfolio. The Company will continue to buy bonds of local tax-exempt entities, in an effort to support the local community, consistent with the investment standards contained in the investment policy. The Company, at December 31, 1998 has 4.84% of its securities portfolio invested in mortgage-backed securities. Mortgage-backed securities balances at December 31, 1998 were $9.7 million, a decrease of $3.4 million from the previous year, which reflects principal reductions. These principal reductions are made to the mortgage-backed securities as scheduled principal payments are made by borrowers on the mortgages that underlie these securities. The Company's equity securities totaled $2.2 million at December 31, 1998 and consisted of SLMA and FHLB stock. Efforts by the Company to maintain appropriate liquidity include periodic adjustments to the securities portfolio as management considers necessary, typically accomplished through the maturity schedule of investments purchased. The maturity distribution and average yields, on a fully tax equivalent basis, of the securities portfolio at December 31, 1998 is shown in Table 4. TABLE 4 SECURITIES MATURITY SCHEDULE & YIELDS
Greater than 1 yr. Greater than 5 yrs. Securities available for sale Less than or and less than or and less than or Greater ($ 000's) equal to 1 yr. equal to 5 yrs. equal to 10 yrs. than 10 yrs. Totals - ----------------------------- ----------------- ----------------- ------------------ ----------------- ------------------- As of December 31, 1998 Balance Yield Balance Yield Balance Yield Balance Yield Balance Yield - ----------------------------- -------- ------ --------- ----- --------- ------ -------- ------ --------- ------ U.S. Treasury $ 9,078 5.58% $ 4,031 5.54% $ 0 0.00% $ 0 0.00% $ 13,109 5.57% U.S. Government agencies and corporations 7,507 5.45 106,290 5.94 38,643 5.97 0 0.00 152,440 5.92 States and political subdivisions (1) 3,343 7.80 14,328 7.75 5,757 7.57 0 0.00 23,428 7.71 Mortgage-backed securities (2) 332 5.37 1,399 6.19 1,080 7.05 6,917 6.67 9,728 6.60 Equity securities 1,417 6.81 739 5.36 0 0.00 0 0.00 2,156 6.31 ------- ---- -------- ---- ------- ---- ------ ---- -------- ---- Total $21,677 5.95% $126,787 6.13% $45,480 6.20% $6,917 6.67% $200,861 6.15% ------- ---- -------- ---- ------- ---- ------ ---- -------- ---- ------- ---- -------- ---- ------- ---- ------ ---- -------- ----
(1) - The yield is reflected on a fully tax equivalent basis utilizing a 34% tax rate. (2) - Mortgage-backed securities reflect the contractual maturity of the related instrument. NSFC ANNUAL 15 REPORT 1998 27 NORTHERN STATES FINANCIAL CORPORATION TABLE 5 LOAN PORTFOLIO
($ 000's) December 31, 1998 1997 1996 1995 1994 - -------------------------------- --------- --------- --------- --------- --------- Commercial $ 64,043 $ 54,701 $ 50,762 $ 53,886 $ 50,495 Real estate-construction 17,328 26,768 26,905 23,720 21,815 Real estate-mortgage 141,241 138,134 133,566 126,268 122,856 Home equity 15,579 14,722 12,986 11,673 9,974 Installment 8,530 8,544 9,203 10,903 13,069 --------- --------- --------- --------- --------- Total loans 246,721 242,869 233,422 226,450 218,209 Unearned income (99) (154) (240) (370) (592) Deferred loan fees (413) (491) (529) (701) (829) --------- --------- --------- --------- --------- Loans, net of unearned income and deferred loan fees 246,209 242,224 232,653 225,379 216,788 Allowance for loan losses (5,433) (5,430) (4,839) (4,514) (3,965) --------- --------- --------- --------- --------- Loans, net $ 240,776 $ 236,794 $ 227,814 $ 220,865 $ 212,823 --------- --------- --------- --------- --------- --------- --------- --------- --------- ---------
The Company has no foreign loans outstanding at December 31, 1998. LOAN PORTFOLIO Loan growth slowed during 1998 as competition by financial institutions for loans continued. As shown in Table 5, gross loans increased $3,852,000 or 1.6% at year end 1998, following an increase of $9,447,000 or 4.0% in 1997. Table 1 shows that average loans in 1998 were $242,020,000, an increase of only $1,001,000 or .4% over the average loans in 1997. Commercial loans increased $9.3 million to $64 million as of December 31, 1998 after increasing $3.9 million in 1997. The growth in commercial loans in both years reflects the strong local economy. The real estate construction lending portfolio declined $9.4 million during 1998, with balances at December 31, 1998 of $17.3 million compared to $26.7 million for 1997. The reason for the decline is the completion, during 1998, of two projects to construct condominium complexes with the Bank receiving principal reductions of over $9 million. The Company has developed an expertise in construction lending and has developed a portfolio of construction and constructionrelated loans. The construction portfolio consists of loans to residential builders, housing developers, and developers of commercial building projects. The Company recognizes that successful construction lending is dependent upon the successful completion of construction contracts and good management of the construction company. Construction loans are generally made on properties which are under sold contracts. Loans are secured by first lien positions on the real estate and have loan to value ratios between 50% - 75% of appraised value. These loans are usually processed through a title company construction escrow. Terms generally range from six months to three years. The Company attempts to minimize the risk of construction lending by granting credit to established customers and restricting these loans to our market area. The mortgage loan portfolio increased by $3,107,000 at December 31, 1998 as compared to 1997, as shown in Table 5. A large percentage of the mortgages booked were commercial related mortgages that had initially been short term commercial loans or construction loans in which the related projects were completed and transferred to mortgage loans. These commercial mortgages were primarily made at fixed rates with call features after five years. Home equity loans are a product that allows consumers to use the equity in their homes to finance purchases and to get an interest deduction on their tax return. The interest deduction has made this product an attractive alternative to traditional consumer financing and is a product that the Company expects to grow in the future. The home equity portfolio continued to grow during 1998 with balances of approximately $15.6 million at December 31, 1998, an increase of 5.8% from December 31, 1997, which had increased 13.4% from 1996. The Thrift had historically operated a mortgage banking operation whereby mortgage loans were originated and sold, primarily to the Federal Home Loan Mortgage Corporation (FHLMC), the Federal National Mortgage Association (FNMA) and the Illinois Housing Development Authority (IHDA). The Bank has continued this mortgage banking operation since NSFC ANNUAL 16 REPORT 1998 28 NORTHERN STATES FINANCIAL CORPORATION LOAN PORTFOLIO (CONTINUED) the Thrift was merged into the Bank in 1998. In addition, during the second half of 1998, the Bank expanded the mortgage banking operation, which now also takes and processes loan applications that are "table funded" by the institution that ultimately will fund and own the loan, with the Bank receiving a fee. These loans are sold without the Bank retaining servicing. During 1998, $28.5 million in loans were originated by the Bank for sale on the secondary market, of which $24.2 were sold. An additional $16.5 million in loans were processed through "table funding" arrangements during 1998. Mortgage loans originated and held for sale in the secondary market are carried at the lower of cost, net of loan fees collected, or estimated market value in the aggregate. The sale generally occurs approximately three days after funding. Loans held for sale on December 31, 1998 and 1997 were approximately $5,799,000 and $1,338,000 and are classified as real estate mortgage loans. The Bank still services mortgage loans funded and sold previous to its mortgage banking operations expansion in 1998, which generates additional fee income. The unpaid principal balances of these loans at December 31, 1998 and 1997 were $60.3 million and $64.9 million. Installment loans totaled $8.5 million at year-end 1998 and remained unchanged from 1997 levels after decreasing $.7 million during 1997 from 1996. Management has maintained installment loan levels despite lower cost financing alternatives to purchase consumer goods. The Company has a small direct lease financing portfolio, which decreased in 1998 to $987,000. While the Company does not presently solicit leasing business, the Company does occasionally make leases to provide customers with financial alternatives. Table 5 shows the year end balance of loans outstanding by loan purpose for each of the last five years. MATURITY OF LOANS Table 6 highlights the maturity distribution of the Company's loan portfolio, excluding mortgage, home equity and installment loans. The short-term sensitivity of the portfolio to interest rate changes is reflected in the fact that approximately 48.8% of the loans scheduled to mature or subject to rate change occur within one year. Of the remaining loans maturing beyond one year, 55.6% of that total are loans subject to immediate repricing. TABLE 6 LOAN MATURITY SCHEDULE
Greater than ($ 000's) Less than or 1 yr. and less than Greater than As of December 31, 1998 equal to 1 yr. or equal to 5 yrs. 5 yrs. Total - ----------------------- -------------- -------------------- ------------- ---------- Commercial $24,985 $31,568 $ 7,490 $ 64,043 Real estate-construction 14,679 2,527 122 17,328 -------------- -------------------- ------------- ---------- Total $39,664 $34,095 $ 7,612 $ 81,371 -------------- -------------------- ------------- ---------- -------------- -------------------- ------------- ---------- Percent of total 48.75% 41.90% 9.35% 100.00% -------------- -------------------- ------------- ---------- -------------- -------------------- ------------- ---------- Commercial and construction loans maturing after one year: Fixed rate $18,507 Variable rate 23,200 -------------- Total $41,707 -------------- --------------
Real estate-construction loans reflect the contractual maturity of the related note. Due to anticipated roll-overs of real estate-construction notes, management estimates that the loans will actually mature between one and five years based upon the related types of construction. Loans that mature within one year are considered to be variable rate loans as they can be repriced upon maturity. NSFC ANNUAL 17 REPORT 1998 29 NORTHERN STATES FINANCIAL CORPORATION NON-PERFORMING ASSETS Non-performing assets consist of non-performing loans and other real estate owned. Non-performing loans, which include impaired loans, are: (1) loans accounted for on a non-interest accrual basis; (2) accruing loans contractually past due ninety days or more as to interest or principal payment; and (3) loans with terms that have been renegotiated to provide a reduction or deferral of interest or principal because of a deterioration in the financial condition of the borrower. Total nonperforming loans at December 31, 1998 were $4,117,000, increasing from $1,006,000 at December 31, 1997. Impaired loans are included in non-performing loans and totaled $3,515,000 and $754,000 at December 31, 1998 and December 31, 1997. The Bank considers a loan impaired if full principal or interest payments are not anticipated. Impaired loans are carried at the present value of expected cash flows discounted at the loan's effective interest rate or at the fair value of the collateral, if the loan is collateral dependent. At December 31, 1998, approximately 10% of the allowance for loan losses is specifically allocated for impaired loans. Interest income recognized on impaired loans in 1998 was $84,000, which was all cash basis income, compared to $36,000 and $587,000 of income recognized on impaired loans in 1997 and 1996. Other real estate owned includes assets acquired through loan foreclosure and repossession. The carrying value of other real estate owned is reviewed by management at least quarterly to assure the reasonableness of its carrying value, which is lower of cost (fair value at date of foreclosure) or fair value less estimated selling costs. Other real estate owned declined slightly to $2,497,000 at December 31, 1998 from $2,555,000 at December 31, 1997. Loans are placed in nonaccrual status when they are 90 days past due, unless they are fully secured and in the process of collection. At December 31, 1998, the Company had $313,000 in loans that were 90 days past due and still accruing interest. As illustrated in Table 7, total non-performing assets during 1998 increased $3,053,000 from the 1997 levels. Loans on nonaccrual status increased $2,801,000 in 1998 to $3,804,000, from $1,003,000 in 1997. Loans 90 days or more past due and still accruing increased by $310,000 in 1998. The majority of the increase in non-performing assets is a result of one credit in the amount of $3,010,000 that became 90 days past due during 1998 and was placed on nonaccrual status. This credit is secured by a 57,000 square foot office building located in Northbrook, Illinois. During the third quarter of 1998 the Bank became the mortgagee in possession and began managing the building and collecting the rents. Foreclosure proceedings have been instituted and the Bank expects to have title to the building in the first quarter of 1999 when the loan will be transferred to other real estate owned. Management is actively seeking to sell the building and has potential buyers for the building. Management continues to be conservative in placing loans on nonaccrual status. This conservative approach is used to eliminate any unearned interest income which would inflate the Company's earnings. Management will continue its emphasis on the collection of on all nonperforming loans, including the collection of unpaid interest. No loans secured by real estate were foreclosed upon and transferred to other real estate owned during 1998. Other real estate owned decreased $58 thousand at December 31, 1998 from December 31, 1997. During 1998, the Company was able to liquidate a portion of its other real estate owned, realizing sale proceeds of $46 thousand with losses of $2 thousand on the sale. On December 31, 1998, one piece of property accounted for approximately 69.8% of the total of other real estate owned. The property was acquired by the Bank through the receipt of a deed in lieu of foreclosure in 1987. The parcel consists of approximately 525,000 square feet of land situated on Lake Michigan in Waukegan. During 1994, a purchase agreement for the property, along with some neighboring parcels, was negotiated for an amount that satisfies the current carrying value. The option agreement provides for the sale of the property and provides for a fee to be paid to the Bank for the agreement and any 6 month extensions of the agreement. During 1998, all option and extension fees have been received by the Bank at the appropriate time and the agreement remains in force. Conditions necessary to finalize the purchase include approvals from the City of Waukegan and favorable legislative action by the State of Illinois Senate and House of Representatives. It is still uncertain as to when the state legislature will consider such approval of the required legislation. Management continues to emphasize the early identification of loan related problems. Management is not currently aware of any other significant loan, group of loans, or segment of the loan portfolio not included in the discussion above as to which there are serious doubts as to the ability of the borrower( s) to comply with the present loan payment terms. There were no other interest earning assets at December 31, 1998 that would be required to be disclosed as non-performing if such assets were loans. NSFC ANNUAL 18 REPORT 1998 30 NORTHERN STATES FINANCIAL CORPORATION TABLE 7 NON-PERFORMING ASSETS
($ 000's) December 31, 1998 1997 1996 1995 1994 - ------------ ------- ------- ------- ------- ------- LOANS Non-accrual status $ 3,804 $ 1,003 $ 1,108 $ 5,692 $ 4,912 90 days or more past due, still accruing 313 3 58 1,653 2,179 ------- ------- ------- -------- ------- Total non-performing loans 4,117 1,006 1,166 7,345 7,091 Other real estate owned 2,497 2,555 2,846 2,311 2,728 ------- ------- ------- -------- ------- Total non-performing assets $ 6,614 $ 3,561 $ 4,012 $ 9,656 $ 9,819 ------- ------- ------- -------- ------- ------- ------- ------- -------- ------- Non-performing loans as a percentage of total loans, net of unearned income and deferred loan fees 1.67% 0.42% 0.50% 3.24% 3.27% Non-performing assets as a percentage of total assets 1.36 0.78 0.94 2.25 2.39 Non-performing loans as a percentage of the allowance for loan losses 75.78 18.53 24.10 161.74 178.84
Loans are placed in non-accrual status when they are 90 days past due, unless they are fully secured and in the process of collection. Impaired Loans - At December 31, 1998, 1997 and 1996 impaired loans totaled $3,515, $754 and $828 and are included in nonaccrual loans. Potential Problem Loans - At December 31, 1998 there were no other loans classified as problem loans that are not included above. Other Problem Assets - At December 31, 1998, there were no other classified assets other than the loans and other real estate owned shown above. PROVISION FOR LOAN LOSSES A provision is credited to an allowance for loan losses, which is maintained at a level considered by management to be adequate to absorb future loan losses. The adequacy of the loan loss allowance is analyzed at least quarterly. Factors considered in assessing the adequacy of the allowance include: changes in the type and volume of the loan portfolio; review of the larger credits within the Bank; historical loss experience; current economic trends and conditions; review of the present value of expected cash flows and fair value of collateral on impaired loans; loan growth; and other factors management deems appropriate. As mentioned previously, management discounts impaired loans based on expected cash flows or collateral values. A portion of the allowance for loan losses is then allocated to each impaired loan with a calculated collateral shortage. Management during 1998 lowered the loan loss provision to $10,000 from $480,000 in 1997, which was decreased from $1,190,000 in 1996. Throughout the year, management determines the level of provision necessary to maintain an adequate allowance based upon current conditions and outstanding loan volumes. If the level of non-performing assets does not increase significantly during 1999 and the allowance for loan losses remains adequate, management does not expect to increase the loan loss provision for 1999. As shown in Table 8, during 1998 the loan loss provision of $10,000 less net charge-offs of $7,000 increased the allowance for loan losses to $5,433,000. As a result, the allowance for loan losses was 2.2% of gross loans outstanding at December 31, 1998. Table 8 also indicates the types of loans charged-off and recovered for the five years from 1994 through 1998 as well as each year's provision. Because management is not certain as to the full collectibility of the non-performing loans, potential loss exposure has been provided in the Company's allocation of the allowance for loan losses. As illustrated in Table 9, the unallocated portion of the allowance, the portion of the allowance that is not specifically reserved for any particular type of loan, was 38.14% of the total allowance at December 31, 1998 which is a change from 49.76% of the total allowance at December 31, 1997. Based upon management's analysis, the allowance for loan losses at December 31, 1998, is adequate to cover future possible loan losses. NSFC ANNUAL 19 REPORT 1998 31 NORTHERN STATES FINANCIAL CORPORATION TABLE 8 ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
($ 000's) Years Ended December 31, 1998 1997 1996 1995 1994 - ------------------------ ------- ------- ------- ------- ------- Balance at the beginning of year $ 5,430 $ 4,839 $ 4,514 $ 3,965 $ 3,764 ------- ------- ------- ------- ------- Charge-offs: Commercial 0 86 288 145 687 Real estate-construction 0 0 523 334 22 Real estate-mortgage 0 38 125 458 496 Home equity 0 0 20 15 0 Installment 73 85 185 57 110 ------- ------- ------- ------- ------- Total charge-offs 73 209 1,141 1,009 1,315 ------- ------- ------- ------- ------- Recoveries: Commercial 25 33 183 18 9 Real estate-construction 0 0 50 0 0 Real estate-mortgage 0 206 0 0 0 Home equity 0 0 15 0 0 Installment 41 81 28 60 67 ------- ------- ------- ------- ------- Total recoveries 66 320 276 78 76 ------- ------- ------- ------- ------- Net charge-offs (recoveries) 7 (111) 865 931 1,239 ------- ------- ------- ------- ------- Additions charged to operations 10 480 1,190 1,480 1,440 ------- ------- ------- ------- ------- Balance at end of year $ 5,433 $ 5,430 $ 4,839 $ 4,514 $ 3,965 ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- Allowance as a % of total loans, net of unearned income and deferred loan fees 2.21% 2.24% 2.08% 2.00% 1.83% ------- ------- ------- ------- ------- Net charge-offs (recoveries) during the year to average loans outstanding during the year 0.00% -0.05% 0.37% 0.42% 0.58% ------- ------- ------- ------- ------- ------- ------- ------- ------- -------
In addition to management's assessment, loans are examined periodically by federal and state banking authorities. TABLE 9 ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
($ 000's) December 31, 1998 1997 1996 - ------------ ----------------------- ----------------------- --------------------- Percent of Percent of Percent of loans in each loans in each loans in each category to category to category to Amount total loans Amount total loans Amount total loans -------- ----------- ------ ----------- ------ ----------- Commercial $ 1,312 25.96% $ 1,335 22.52% $ 947 21.75% Real estate-construction 1,511 7.02 389 11.02 184 11.53 Real estate-mortgage 480 57.25 931 56.88 796 57.22 Home equity 16 6.31 15 6.06 13 5.56 Installment 42 3.46 58 3.52 45 3.94 Unallocated 2,072 NA 2,702 NA 2,854 NA ------- ------ ------- ------ ------- ------ Total $ 5,433 100.00% $ 5,430 100.00% $ 4,839 100.00% ------- ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- ------
1995 1994 ----------------------- --------------------- Percent of Percent of loans in each loans in each category to category to Amount total loans Amount total loans ------- ----------- ------ ----------- Commercial $ 1,741 23.80% $ 1,468 23.14% Real estate-construction 727 10.47 168 10.00 Real estate-mortgage 632 55.76 803 56.30 Home equity 12 5.16 10 4.57 Installment 87 4.81 116 5.99 Unallocated 1,315 NA 1,400 NA ------- ------ ------- ------ Total $ 4,514 100.00% $ 3,965 100.00% ------- ------ ------- ------ ------- ------ ------- ------
NSFC ANNUAL 20 REPORT 1998 32 NORTHERN STATES FINANCIAL CORPORATION NONINTEREST INCOME Noninterest income increased by $248,000 or 9.2% during 1998 following a decline of $552,000 or 17.0% during 1997. Service fees on deposits declined by $173,000 in 1998. The major portion of this decline was the result of decreased overdraft fee income, which fell $103,000 from 1997, as average customer demand deposit balances increased in 1998. Service charges assessed to deposit accounts, which generally increase as account balances decrease, declined $70,000 in 1998 as average account balances increased from 1997. Trust income increased $40,000 or 6.4% in 1998 from the same period in 1997 due to additional trust business. There were no debt security sales during 1998, 1997 and 1996. The Company did sell one mutual fund in 1996 resulting in a gain of $5,000. Gains on sales of loans increased $162,000 during 1998 as compared to 1997. Volume of mortgage loans originated, funded and then sold on the secondary market increased during 1998 with $24.2 million in loans sold in 1998 as compared to $10.7 million sold in 1997. Much of the increase in the volume of loan sales is the result of the Bank expanding its mortgage banking operation and actively pursuing this line of business during the second half of 1998. Other operating income increased $219,000 or 35% in 1998. The increase is attributable primarily to booking $319,000 in mortgage banking fee income during the second half of 1998. During 1998, $16.5 million in "table funded" mortgage loans were processed by the Bank. The $319,000 consists of the fees earned by the Bank on these "table funded" loans as well as fees for appraisals and credit bureau costs from borrowers of both "table funded" loans and loans originated and funded by the Bank and sold on the secondary mortgage market. Gains on the sale of other real estate owned, a component of other operating income, were $142,000 in 1997 compared to a $2,000 loss during 1998. Comparing 1997 to 1996, noninterest income declined by $552,000. Service fees on deposits declined by $93,000 in 1997. The major portion of this decline was the result of decreased overdraft fee income and service charges assessed on deposits accounts, which fell $31,000 from 1996 as average customer demand deposit balances increased in 1997. Service charge income from automated teller machines (ATMs) decreased $37,000 due to a change in the treatment for credits received when non-customers use our ATMs. Income from trust activities in 1997 increased $102,000 or 19.5% from the same period in 1996 due to increases in the trust fee schedule and additional trust business. Gains on sales of loans declined $38,000 during 1997 as compared to 1996. Volume of loan sales during 1997 remained stable with $10.7 million in loans sold in 1997 as compared to $10.8 million sold in 1996. The decline in gains was the result of competitive pressures which caused the Company to narrow its profit margin on sales of loans in order to maintain sales volume. Other operating income declined $518,000 or 45.3% in 1997. The decrease is attributable to the Company booking $163,000 less in gains from sales of other real estate owned during 1997 than in 1996. Other operating income also declined during 1997 due to the one-time collection during 1996 of back interest and fees on a loan in excess of the amount charged off of $131,000. Prior to September 1, 1998, the Company monitored operating segments in banking and trust. As of September 1, 1998, management also began monitoring mortgage banking as an operating segment. The Company adopted Statement of Financial Accounting Standards No. 131 in 1998 and has disclosed selected operating segment information in the notes to the Consolidated Financial Statements. NONINTEREST EXPENSES In 1998, total noninterest expenses increased by $491,000 to $9,623,000, an increase of 5.38%. Over the last three years total other expenses averaged $9,709,000 as the Company emphasized control of operating expenses. As a percent of average assets, noninterest expense was 2.0% in 1998 compared to 2.1% in 1997 and 2.5% in 1996. The efficiency ratio, noninterest expenses divided by the sum of net interest income and noninterest income, is frequently used as an indicator as to how well a financial institution manages its noninterest expenses. A decreasing ratio is an indication of improving performance. The Company's efficiency ratio was 47.6% in 1998, 46.1% in 1997 and 51.6% in 1996. Compared to its bank holding company peers, the Company's ability to control overhead expenses is one of its operating strengths. Salaries and other employee expenses increased $389,000 in 1998, which was a 7.2% increase over 1997. Salaries for noncommissioned staff increased $200,000 during 1998, or 4.7%, increasing due to yearly pay raises and the addition of four clerical employees to the mortgage banking operation staff, which was expanded during the second half of 1998. Commissions paid to loan originators in the mortgage banking operation were $189,000 during 1998 and are based on a percentage of the gain on loans originated, funded and sold NSFC ANNUAL 21 REPORT 1998 33 NORTHERN STATES FINANCIAL CORPORATION NONINTEREST EXPENSES (CONTINUED) on the secondary market and a percentage of the fees earned on "table funded" loans. Occupancy expenses increased $67,000, or 5.7%, during 1998 as compared to the same period in 1997. During 1998, building and equipment maintenance costs increased $25,000 partially as a result of equipment updates as part of the Company's efforts to address Year 2000 issues. Building and equipment expenditures of $1,338,000 were made during 1998 and depreciation expense increased $22,000 as a result. Building salaries increased during 1998 by $18,000 as additional building staff was added due to the purchase of a new branch. During 1998, the Bank purchased and installed $216,000 of new computer equipment as part of the Company's efforts to address Year 2000 issues. In addition, during the fourth quarter of 1998, the Bank purchased a branch office in the neighboring community of Winthrop Harbor, Illinois, from another financial institution for $1,000,000 and opened the branch there in November, 1998. The Bank did not purchase any assets or liabilities other than the branch building as part of this transaction. With the merging of the Thrift into the Bank, the Bank had two branches within two city blocks of one another. The Bank closed the smaller of the branches during 1998, and the Bank entered into a sales contract with a party who wished to purchase the branch and utilize it for a purpose other than banking. The sale was completed during January, 1999, with a gain on the sale of $74,000. The result of these developments is that the Bank operates six branch locations while expanding its geographic presence. Data processing expense decreased $16,000 or 3.1% during 1998 as compared to the same period in 1997, due to decreased processing expenses resulting from the merger of the Thrift into the Bank. FDIC deposit insurance expense increased in 1998 by $14,000 as compared to 1997. This increase is a result of increases in deposits during 1998. Other real estate owned expenses decreased $64,000 during 1998 compared to the previous year as property taxes on the other real estate owned portfolio declined due to decreases in the assessed valuation of the other real estate owned. The slightly smaller real estate owned portfolio that amounted to $2,497,000 at December 31, 1998 as compared to $2,555,000 at December 31, 1997 also contributed to lower real estate owned expenses. During 1998, other operating expenses increased $101,000 or 5.6% from 1997. Legal expenses increased $153,000 during 1998 resulting from the merger between the two subsidiaries, the five-for-one stock split, the purchase of a branch office and the closing of another branch office. Expenses related to loans and to couriers increased $79,000 and $18,000 during 1998 resulting from the increased mortgage banking volume. Expenses from charged off checking accounts, bad checks and teller differences declined $74,000 during 1998. Expenses relating to correspondent bank accounts were $43,000 less during 1998 as accounts were consolidated as a result of the merger of the two subsidiaries. Directors fees also declined $30,000 during 1998 due to the combination of the two subsidiaries. In 1997, total noninterest expenses declined by $1,240,000 to $9,132,000, a decrease of 11.96% from 1996. Salaries and other employee expenses decreased $70,000 in 1997. The Company continued to experience staff reductions during 1997 due to increased efficiencies. No layoffs of staff occurred during 1997, but as employees left or retired their responsibilities were closely examined by management and delegated to others if possible. Occupancy expenses declined $117,000 or 9% during 1997 as compared to the same period in 1996. A majority of this reduction is a result of decreases in the accrual for property taxes which declined $81,000 during 1997. Management was able to successfully protest and significantly decrease the assessed valuation of the Company's real property. Data processing expense decreased $31,000 or 5.7% during 1997 as compared to the same period in 1996. The Company changed its treatment for credits received for non-customer use of Company owned ATMs, which amounted to increased fees of $37,000 and were applied against data processing expense. FDIC deposit insurance expense fell significantly in 1997 by $745,000 or 91.2% as compared to 1996. During 1996, the Thrift booked a $603,000 one-time FDIC expense due to legislation requiring recapitalization of the FDIC Savings Association Insurance Fund (SAIF). Other real estate owned expenses decreased $83,000 or 37.2% during 1997 compared to the previous year due to decreased balances held in other real estate owned at December 31, 1997, which declined $291,000 from December 31, 1996. Other operating expenses for 1997 declined by $194,000 as compared to 1996. Auditing expenses declined $35,000 from 1996 to 1997 as the internal audit staff took on some of the audit functions that previously were performed by the outside auditors. Loan and collection expenses declined $32,000 in 1997 resulting from the decrease in non-performing loans. Printing expenses declined $32,000 as the Company's loan and customer service areas continued to automate so that forms are printed internally by laser printers as needed, reducing inventories of forms. Business development expenses declined $34,000 during 1997 as greater use of joint advertising of Bank and Thrift products occurred. Expenses relating to correspondent bank accounts were $18,000 less in 1997 as higher balances were maintained and earnings credit allowances were greater, thus reducing this expense. NSFC ANNUAL 22 REPORT 1998 34 NORTHERN STATES FINANCIAL CORPORATION YEAR 2000 The Company, in compliance with the Federal Financial Institutions Examination Council's (FFIEC) guidelines, has established a "Year 2000 Action Plan" in order to deal with risks associated with the new millennium, especially in the area of data processing. As part of the "Year 2000 Action Plan", the Company's Board of Directors is regularly updated as to the Company's ability to deal with the Year 2000 risks. The "Year 2000 Policy and Action Plan" includes the five basic steps or phases recommended by the FFIEC: awareness, assessment, renovation, validation (testing) and implementation. At this time, the Company has completed the awareness and assessment phases of its action plan, and is well underway towards completing the renovation and testing phases. It had been determined during 1997 that both the Company's item processing system and its teller platform system were not Year 2000 compliant and during 1998 the Company purchased and installed new hardware and software for both systems in order to bring them up to Year 2000 standards. The combined cost of these projects was $216,000. Management anticipates the Company will incur $50,000 of additional Year 2000 costs in 1999. The major risk to the Company is that its data systems will inaccurately calculate date related accrual of interest on loans and deposits because of the Year 2000. This would impact customer confidence and Company earnings. Another risk to the Company is that its loan customers' businesses will be impaired by the Year 2000 in such a way that payments will not be made in a timely fashion. During the fourth quarter of 1998, the Company substantially completed a risk assessment of its entire loan portfolio rating each loan customer as to how susceptible the customer's business may be to Year 2000 risks. Those loan customers which were assessed as having a medium to high Year 2000 risk have been contacted to make them aware of possible problems caused by the Year 2000 and to request information as to the borrower's state of preparedness to Year 2000 issues. Information provided by our customers will allow the Company to better determine external risks caused by the Year 2000. The Company continues to monitor and work with these borrowers. The Company has instituted a customer awareness program in which information has been mailed to customers which discusses the Year 2000 problem in general and discloses the Bank's state of preparedness for the Year 2000. Efforts to communicate the Bank's preparedness to customers are expected to continue during 1999 in order to steady customer fears regarding this issue. A majority of the Company's data processing is performed by an outside bank data processing service bureau which has assured the Company that their core products are fully Year 2000 compliant. Our data processing service bureau has provided a "Test Bank" environment in order for tests to be conducted by users to make sure that the system will handle Year 2000 processing. The Bank belongs to a data processing users group that is jointly testing service bureau compliance for the Year 2000. The Company has developed and is refining contingency plans to deal with possible Year 2000 problems. Some strategies are to print, on December 31, 1999, subsidiary trials of loan and deposit applications which would provide balances and accrued interest figures on individual accounts in the event that difficulties occur on January 1, 2000. Another contingency strategy is to print, on December 31, 1999, customer loan and deposit account statements in order to preserve individual account histories if a situation develops. Using these strategies as a focal point, methods of recalculating interest and adjusting customer records are being developed in the event that Year 2000 problems result despite our implementations and testing to avoid them. Although management is confident that the Company has identified all necessary upgrades to its equipment, and budgeted accordingly, no assurance can be made that Year 2000 compliance can be achieved without additional unanticipated expenditures. It is not possible at this time to quantify the estimated future costs due to business disruption caused by vendors, suppliers, customers or even the possible loss of electric power or telephone service; however, such costs could be substantial. As a result of the Year 2000 project, the Company has not had any material delay regarding its information systems projects. FEDERAL AND STATE INCOME TAXES For the years ended December 31, 1998, 1997 and 1996, the Company's provision for federal and state taxes as a percentage of pretax earnings were 31.2%, 31.4% and 29.6%. The actual tax rates differ from the statutory rates because the pretax earnings include significant amounts of interest on United States Government securities, which are nontaxable for state income tax purposes and qualified interest on loans to local political subdivisions and on qualified state and local political subdivision securities, which are nontaxable for federal income tax purposes. NSFC ANNUAL 23 REPORT 1998 35 NORTHERN STATES FINANCIAL CORPORATION TABLE 10 MATURITY OR REPRICING OF ASSETS AND LIABILITIES
----------------------SUBJECT TO REPRICING WITHIN ------------------------------ ($ 000)s IMMEDIATE 91 DAYS 181 DAYS 1 - 3 3 - 5 5 - 10 DECEMBER 31, 1998 BALANCES TO 90 DAYS TO 180 DAYS TO 365 DAYS YEARS YEARS YEARS -------- ---------- ----------- ----------- ----- ----- ------ ASSETS: Interest bearing deposits in financial institutions $ 283 $ 183 $ 0 $ 0 $ 100 $ 0 $ 0 Federal funds sold 12,600 12,600 0 0 0 0 0 Securities: U.S. Treasury 13,109 0 3,020 6,058 4,031 0 0 U.S. Government agencies and corporations 152,440 7,003 0 504 22,427 83,863 38,643 States & political subdivisions 23,428 506 589 2,248 10,554 3,774 5,757 Equity securities 2,156 1,417 0 0 0 739 0 Mortgage-backed securities (1) 9,728 3,306 719 1,676 0 1,400 2,627 Loans: Commercial 64,043 40,091 1,707 4,115 7,428 8,417 2,285 Real estate - construction 17,328 14,370 1,084 1,389 349 14 122 Real estate - mortgage 141,241 37,247 4,489 7,191 28,270 39,892 24,152 Home equity 15,579 15,579 0 0 0 0 0 Installment, net of unearned income 8,431 4,001 560 897 1,915 946 112 Direct lease financing 987 479 50 136 199 123 0 --------- --------- -------- -------- -------- --------- -------- TOTAL INTEREST EARNING ASSETS $ 461,353 $ 136,782 $ 12,218 $ 24,214 $ 75,273 $ 139,168 $ 73,698 --------- --------- -------- -------- -------- --------- -------- --------- --------- -------- -------- -------- --------- -------- Liabilities: NOW accounts $ 39,180 $ 39,180 $ 0 $ 0 $ 0 $ 0 $ 0 Money market accounts 41,003 41,003 0 0 0 0 0 Savings 45,333 45,333 0 0 0 0 0 Time deposits, $100,000 and over 98,338 46,299 18,864 27,647 5,528 0 0 Time deposits, under $100,000 87,827 33,525 19,491 19,715 15,043 47 6 Federal Home Loan Bank term advances 10,000 0 5,000 0 0 0 5,000 Other interest-bearing liabilities 47,990 26,781 2,100 13,109 6,000 0 0 --------- --------- -------- -------- -------- --------- -------- TOTAL INTEREST BEARING LIABILITIES $ 369,671 $ 232,121 $ 45,455 $ 60,471 $ 26,571 $ 47 $ 5,006 --------- --------- -------- -------- -------- --------- -------- --------- --------- -------- -------- -------- --------- -------- EXCESS INTEREST EARNING ASSETS (LIABILITIES) $ (95,339) $ (33,237) $ (36,257) $ 48,702 $ 139,121 $ 68,692 CUMULATIVE EXCESS INTEREST EARNING ASSETS (LIABILITIES) (95,339) (128,576) (164,833) (116,131) 22,990 91,682 CUMULATIVE INTEREST RATE SENSITIVITY RATIO(2) 0.59 0.54 0.51 0.68 1.06 1.25
(1) Mortgage-backed securities reflect the time horizon when these financial instruments are subject to rate change or repricing. (2) Interest earning assets divided by interest bearing liabilities. This table does not necessarily indicate the impact of general interest rate movements on the Company's net interest income because the repricing of certain assets and liabilities is discretionary and is subject to competition and other pressures. As a result, assets and liabilities indicated as repricing within the same period may in fact reprice at different times and at different rate levels. TABLE 11 TIME DEPOSITS $100.00 AND OVER MATURITY SCHEDULE
Greater than Greater than ($ 000's) Less than or 3 mos. & less than 6 mos. & less than Greater than As of December 31, 1998 equal to 3 mos. or equal to 6 mos. or equal to 12 mos. 12 mos. Total - ---------------------------------- --------------- -------------------- ------------------- ------------- -------- Time deposits, $100,000 and over: Retail deposits ............... $13,474 $ 7,803 $ 7,533 $ 4,391 $33,201 Corporate deposits ............ 7,103 2,423 1,521 937 11,984 Public fund deposits .......... 25,722 8,638 18,593 200 53,153 --------------- -------------------- ------------------- ------------- -------- Total ......................... $46,299 $18,864 $27,647 $ 5,528 $98,338 --------------- -------------------- ------------------- ------------- -------- --------------- -------------------- ------------------- ------------- --------
The Company has no foreign banking offices or deposits. NSFC ANNUAL 24 REPORT 1998 36 NORTHERN STATES FINANCIAL CORPORATION LIQUIDITY AND INTEREST RATE SENSITIVITY ANALYSIS The primary functions of asset/liability management are to assure adequate liquidity and maintain an appropriate balance between interest sensitive earning assets and interest bearing liabilities. The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring an institution's interest rate sensitivity "gap." An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest earning assets maturing or repricing within a specific time period and the amount of interest bearing liabilities maturing or repricing within that time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income while a positive gap would tend to adversely affect net interest income. The Company's gap position is illustrated in Table 10. Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers knowing that sufficient funds will be available to meet their credit needs. In addition to federal funds sold and interest bearing deposits in banks, marketable securities, particularly those of shorter maturities, are a principal source of asset liquidity. The Company classifies all of its securities as available for sale which increases its flexibility in that the Company can sell any of its unpledged securities to meet liquidity requirements. Securities available for sale amounted to $200,861,000 at December 31, 1998, representing the entire the securities portfolio. Securities at December 31, 1998 in the amount of $141,158,000 were pledged to secure public deposits and repurchase agreements. During 1998, the Company received an additional term advance from the Federal Home Loan Bank in the amount of $5,000,000, bringing the total of Federal Home Loan Bank term advances up to $10,000,000. The funds provided by these advances have been used to purchase U.S. Government agency securities that have call provisions on the same dates as the advances are due to be repaid. Rate sensitivity varies with different types of interest earning assets and interest bearing liabilities. Federal funds sold on which the rate varies daily and loans tied to the prime rate differ considerably from long-term securities and fixed rate loans. Time deposits over $100,000 are more rate sensitive than savings accounts. Management has portrayed savings accounts as immediately repriceable in Table 10, because of management's ability to change the savings interest rate. Table 11 illustrates the maturity schedule as of December 31, 1998 of the time deposits $100,000 and over portfolio. As shown, 5.6% of the time deposits $100,000 and over mature after a year which differs only slightly from 5.5% at December 31, 1997. The Company historically has a high level of time deposits over $100,000 and securities sold under repurchase agreements and other short term borrowings. As of December 31, 1998, time deposits over $100,000 and repurchase agreements were 35.4% of total interest bearing liabilities, a slight decrease from 36.7% in 1997, and were primarily from existing local public depositors. Being located the county seat, the Company accepts time deposits over $100,000 from various government agencies. At December 31, 1998 approximately 47.3% of the Company's loan and lease portfolio floats with the prime rate or is repriceable within 90 days, a decrease from 51.4% at December 31, 1997. This shift to fixed rate loans is a result of customer demand and competitive pressures. The effect of this shift to fixed rate loans is a lengthening of loan maturities which increases the Bank's negative gap position. As the Table 10 shows, the Company is liability sensitive through the three year time horizon by $116.1 million. This is a change from last year, where the Company was liability sensitive through the three year time horizon by $65.5 million. Although management has attempted during the past year to reduce its liability sensitive gap position, its efforts continued to be restricted by competitive pressures in the area of commercial and commercial real estate loans, which have increased the level of fixed rate loans with intermediate term balloon maturities. The Company has increased the maturity time horizon on its securities by purchasing intermediate term U.S. Government agency securities that have call provisions in order to maximize yields on its securities portfolio. Securities carried at $104.7 million have call options allowing the issuers to redeem the securities prior to the contractual maturity date. Customer preferences and competitive pressures make it difficult for management to reduce the liability gap position. To insure the ability to meet its funding needs, including any unexpected strain on liquidity, the Company has $25 million in federal funds lines of credit from two independent banks. In addition, the Company has the ability to borrow funds, if necessary, directly from the Federal Reserve Bank and the Federal Home Loan Bank approximating $12 million. NSFC ANNUAL 25 REPORT 1998 37 NORTHERN STATES FINANCIAL CORPORATION SECURITIES SOLD UNDER REPURCHASE AGREEMENTS AND OTHER SHORT-TERM BORROWINGS Securities sold under repurchase agreements (repurchase agreements) and other short-term borrowings during 1998 have continued to be an alternative to certificates of deposit as a source of funds. At December 31, 1998, the Company had $47,990,000 of repurchase agreements. Most municipalities, other public entities and some other organizations require that their funds are insured or collateralized as a matter of their policies. Commercial depositors also find the collateralization of repurchase agreements attractive as an alternative to certificates of deposits. Repurchase agreements provide a source of funds and do not increase the Company's reserve requirements with the Federal Reserve Bank or create an expense relating to FDIC insurance. Repurchase agreements consequently are less costly to the Company. Management expects to continue to offer repurchase agreements as an alternative to certificates of deposit in the future. The Company experienced a $9.5 million increase in its repurchase agreements and short term borrowings at year end 1998. Average repurchase agreements during 1998 were $36.2 million compared to $34.2 million during 1997 and $35.0 million during 1996. This data attests to the popularity and the stability of repurchase agreements to the Company. Table 12 provides information as to balances and interest rates pertaining to securities sold under repurchase agreements and other short-term borrowings. TABLE 12 SECURITIES SOLD UNDER REPURCHASE AGREEMENTS AND OTHER SHORT-TERM BORROWINGS
($ 000's) At or for the Year Ended December 31, 1998 1997 1996 - ------------------------------------- -------- -------- ------- Balance at end of year $47,990 $38,504 $36,758 Weighted average interest rate at end of year 4.91% 5.29% 4.93% Maximum amount outstanding $47,990 $39,995 $44,135 Average amount outstanding 36,155 34,176 35,006 Weighted average interest rate 5.11% 5.07% 4.92%
CAPITAL RESOURCES Capital provides the foundation for future growth. Regulatory agencies have developed minimum guidelines by which the adequacy of a financial institution's capital may be evaluated. Northern States' capital ratios exceed these minimum guidelines, both in terms of Tier I capital (stockholders' equity of the Company less intangible assets), and in terms of Tier II capital (Tier I capital plus qualifying long-term debt and the allowance for loan losses). The portion of the allowance for loan losses qualifying as Tier II capital is limited to 1.25% of risk weighted assets. The effect of the unrealized gains (losses) on securities available for sale is excluded from the capital ratio calculations. Regulatory capital guidelines require that the amount of capital increase with the amount of risk inherent in a company's balance sheet and off-balance sheet exposure. Capital requirements in order for the Company to be considered well capitalized are that Tier I capital to average assets must be 5.00% and Tier I capital to risk weighted assets must be 6.00%. The requirements are that Tier II capital must be 10.00% of risk adjusted assets in order for the Company to be considered well capitalized. All of the Company's capital ratios exceed the level required under regulatory guidelines as shown in Table 14. NSFC ANNUAL 26 REPORT 1998 38 NORTHERN STATES FINANCIAL CORPORATION TABLE 13 CAPITAL STANDARDS
($ 000's) As of December 31, 1998 QUALIFYING FOR TIER I CAPITAL: Common stock $ 1,781 Additional paid-in capital 11,336 Retained earnings 51,358 Less - Intangible assets (118) -------- TOTAL QUALIFYING TIER I CAPITAL $ 64,357 -------- --------
($ 000's) As of December 31, 1998 QUALIFYING FOR TIER II CAPITAL: Total Qualifying Tier I Capital $ 64,357 Allowance for loan losses 3,907 -------- Total Qualifying TIER II Capital $ 68,264 -------- -------- TOTAL ASSETS $484,880 -------- --------
($ 000's) As of December 31, 1998 RISK-BASED ASSETS TOTAL RISK-BASED Zero percent risk $ 16,907 $ 0 Twenty percent risk 207,526 41,505 Fifty percent risk 90,517 45,259 One hundred percent risk (1) 225,792 225,792 -------- -------- TOTAL RISK-WEIGHTED ASSETS $540,742 $312,556 -------- -------- -------- --------
($ 000's) As of December 31, 1998 CAPITAL REQUIREMENTS $ % TIER I CAPITAL TO AVERAGE ASSETS: REQUIRED $23,501 5.00% ACTUAL 64,357 13.69 RISK-BASED CAPITAL: Tier I: REQUIRED $18,753 6.00% ACTUAL 64,357 20.59 Tier II: REQUIRED $31,256 10.00% ACTUAL 68,264 21.84
(1) Includes off-balance-sheet items CASH FLOWS Cash flows from operating activities were below accrual basis net income by $4.0 million in 1998. In 1997 cash flows from operating income exceeded net income by $1.8 million and in 1996 cash flows from operating income exceeded net income by $6.2 million. Management expects ongoing operating activities to continue to be a primary source of cash flow for the Company. Deposits increased $7.8 million in 1998. The Company experienced growth in its time deposits over $100,000 from existing local public depositors. Demand-noninterest bearing deposits also grew during 1998 by $2.7 million. Deposits help the Company to maintain an adequate level of cash for the Company's activities. While competition for deposits is expected to remain keen and future deposit growth cannot be predicted with any certainty, the Company plans to continue to actively seek profitable new deposit business. Securities available for sale increased $20.2 million during 1998 and provide increased interest income revenues to the Company. The increase in securities available for sale came from operating activities, an additional term advance of $5.0 million from the Federal Home Loan Bank and increases to deposits. To insure the ability to meet its funding needs, including any unexpected strain on liquidity, the Company has $25 million in federal funds lines of credit from two independent banks. In addition, the Company has the ability to borrow funds, if necessary, directly from the Federal Reserve Bank and the Federal Home Loan Bank approxi- NSFC ANNUAL 27 REPORT 1998 39 NORTHERN STATES FINANCIAL CORPORATION CASH FLOWS (CONTINUED) mating $12 million. The Company has term advances of $10 million from the Federal Home Loan Bank which have been used to purchase U.S. Government agency securities that have call provisions on the same dates as the advances are due to be repaid. Interest earned on the U.S. Government agency securities is used to service the debt to the Federal Home Loan Bank. The Company has no other notes payable or similar debt on its balance sheet. Equity capital is in excess of regulatory requirements, as determined on both risk-based and leverage ratio criteria. Cash dividends as a percentage of net income have ranged from 36.6% in 1998 to 30.4% in 1997 and 29.6% in 1996. During 1998 the Company paid out $1,338,000 for purchases of property and equipment. An expenditures of $1,000,000 was made to purchase the branch office building located in Winthrop Harbor, Illinois. $216,000 was expended to update data processing equipment as part of the Bank's efforts to address Year 2000 issues. The majority of the balance of the 1998 expenditures were for equipment for the new Winthrop Harbor branch. Expenditures during 1997 for building and equipment totaled $217,000, of which $64,000 was for telephone equipment, $76,000 for office remodeling and $77,000 for updating data processing equipment. During 1996 major purchases were a $61,000 outlay for new telephone equipment and $49,000 used to purchase two new ATMs. RECENT ACCOUNTING PRONOUNCEMENTS Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities", was issued by the Financial Accounting Standards Board (FASB) in 1998 and is effective for the Company on January 1, 2000. It requires that all derivatives are recorded at fair value in the balance sheet, with changes to fair value charged or credited to income. If derivatives are documented and effective as hedges, the change in derivative fair value will be offset by an equal change in the fair value of the hedged item. Since the Company has no derivative or hedging activities, adoption of Statement 133 will have no material impact on the Company's consolidated financial statements. SFAS No., 134, "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise", will be effective for fiscal years beginning after December 15, 1998. The statement allows mortgage loans that are securitized to be classified as trading, available for sale, or in certain circumstances, held to maturity. Currently, these must be classified as trading. Since the Company has not securitized mortgage loans, Statement 134 is not expected to affect the Company. American Institute of Certified Public Accountants Statement of Position (SOP) 98-1, effective in 1999, sets the accounting requirement to capitalize costs incurred to develop or obtain software that is to be used solely to meet internal needs. Costs to capitalize are those direct costs incurred after the preliminary project stage, up to the date when all testing has been completed and the software is substantially ready for use. All training costs, research and development costs, costs incurred to convert data, and all other general and administrative costs are expensed as incurred. The capitalized cost of internal use software is to be amortized over its useful life and reviewed for impairment using the criteria in Statement No. 121. SOP 98-1 is not expected to have a material impact on the Company. SOP 98-5, effective in 1999, requires all start up, preopening and organization costs to be expense as incurred. Any such costs previously capitalized for financial reporting purposes must be written off to income at the start of the year. SOP 98-5 is not expected to have a material impact on the Company. NSFC ANNUAL 28 REPORT 1998 40 NORTHERN STATES FINANCIAL CORPORATION QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. Interestrate risk ("IRR") is the exposure of a banking organization's financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and stockholder value, however excessive levels of IRR can pose a significant threat to the Company's earnings and capital base. Accordingly, effective risk management that maintains IRR at prudent levels is essential to the Company's safety and soundness. Evaluating a financial institution's exposure to changes in interest rates includes assessing both the adequacy of the management process used to control IRR and the organization's quantitative level of exposure. When assessing the IRR management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain IRR at prudent levels with consistency and continuity. Evaluating the quantitative level of IRR exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity, and, where appropriate, asset quality. The Federal Reserve Board, together with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, adopted a Joint Agency Policy Statement on Interest Rate Risk, effective June 26, 1996. The policy statement provides guidance to examiners and bankers on sound practices for managing interest rate risk, which will form the basis for ongoing evaluation of the adequacy of interest rate risk management at supervised institutions. The policy statement also outlines fundamental elements of sound management that have been identified in prior Federal Reserve guidance and discusses the importance of these elements in the context of managing interest rate risk. Specifically, the guidance emphasizes the need for active board of directors and senior management oversight and a comprehensive risk management process that effectively identifies, measures, and controls interest rate risk. Several techniques might be used by an institution to minimize interest rate risk. One approach used by the Company is to periodically analyze its assets and liabilities and make future financing and investment decisions based on payment streams, interest rates, contractual maturities, and estimated sensitivity to actual or potential changes in market interest rates. Such activities fall under the broad definition of asset/liability management. The Company's primary asset/liability management technique is the measurement of the Company's asset/liability gap, that is, the difference between the cash flow amounts of interest-sensitive assets and liabilities that will be repriced during a given period. Another tool used by management is to shock the balance sheet by decreasing rates 2% and increasing rates 2% using computer simulation models to show the effect of rate changes on the fair value of the Company. Several ways an institution can manage interest rate risk include: selling existing assets or repaying certain liabilities; matching repricing periods for new assets and liabilities, for example by shortening terms of new loans or investments. Financial institutions are also subject to prepayment risk in falling rate environments. For example, mortgage loans and other financial assets may be prepaid by a debtor so that the debtor may refund its obligations at new, lower rates. Prepayments of assets carrying higher rates reduce the Company's interest income and overall asset yields. A large portion of an institution's liabilities may be short term or due on demand, while most of its assets may be invested in long-term loans or investments. Accordingly, the Company seeks to have in place sources of cash to meet short-term demands. These funds can be obtained by increasing deposits, borrowing, or selling assets. Table 14, provides information about the Company's financial instruments that are sensitive to changes in interest rates as of December 31, 1998 and 1997 based on the information and assumptions set forth in the notes. The Company believes that the assumptions utilized are reasonable. The Company had no derivative financial instruments, or trading portfolio, as of December 31, 1998 and 1997. The expected maturity date values for loans receivable, mortgage-backed securities, and investment securities were calculated by adjusting the instrument's contractual maturity date for expectations of prepayments, as set forth in the notes. Expected maturity for interest bearing core deposits such as NOW, money market and savings accounts are assumed to be 5% each year. With respect to the Company's adjustable rate instruments, expected maturity date values were measured by adjusting the instrument's contractual maturity date for expectations of prepayments, as set forth in the notes. From a risk management perspective, however, the Company believes that repricing dates, as opposed to expected maturity dates, may be a more relevant in analyzing the value of such instruments. Similarly, 52.1% of the Company's investment securities portfolio is comprised of callable securities. Company borrowings consist of securities sold under repurchase agreements and Federal Home Loan Bank term advances and were tabulated by contractual maturity dates without regard to any conversion or repricing dates. Table 15, provides information about the current fair value of the Company's balance sheet. The effects of interest rate shocks of decreasing rates 2% and increasing rates 2% on the fair value of the Company's balance sheet are also shown. The Company's negative gap causes the fair value of the Company's balance sheet to increase by $21.5 million if interest rates immediately dropped 2%. The rate shock of increasing interest rates 2% would cause the fair value of the balance sheet to decline $20.1 million. NSFC ANNUAL 29 REPORT 1998 41 NORTHERN STATES FINANCIAL CORPORATION TABLE 14 - EXPECTED MATURITY DATES OF ON BALANCE SHEET ITEMS
($ 000's) ----------------------------Maturing in------------------------------- As of December 31, 1998 1 Year 2 Years 3 Years 4 Years 5 Years Thereafter - ------------------------------------------------ --------- --------- --------- --------- --------- ---------- INTEREST EARNING ASSETS: Loans (1) (2) Fixed rate $ 23,539 $ 12,282 $ 18,001 $ 24,140 $ 21,407 $ 30,352 Average interest rate 8.48% 8.62% 8.82% 8.44% 8.50% 7.11% Adjustable rate 38,072 15,448 10,279 13,027 6,446 33,728 Average interest rate 8.41% 8.44% 8.25% 8.15% 8.42% 8.20% Securities Fixed rate 20,677 12,225 24,787 36,620 53,155 47,027 Average interest rate 5.95% 6.64% 6.33% 6.14% 5.92% 6.23% Adjustable rate 1,000 0 0 0 0 5,370 Average interest rate 6.15% 0.00% 0.00% 0.00% 0.00% 6.52% Interest-bearing deposits and federal funds sold Fixed rate 0 100 0 0 0 0 Average interest rate 0.00% 7.41% 0.00% 0.00% 0.00% 0.00% Adjustable rate 12,783 0 0 0 0 0 Average interest rate 4.59% 0.00% 0.00% 0.00% 0.00% 0.00% Direct lease financing Fixed rate 665 99 100 123 0 0 Average interest rate 8.13% 8.02% 6.58% 7.44% 0.00% 0.00% --------- --------- --------- --------- --------- ---------- Total $ 96,736 $ 40,154 $ 53,167 $ 73,910 $ 81,008 $116,477 --------- --------- --------- --------- --------- ---------- --------- --------- --------- --------- --------- ---------- INTEREST BEARING LIABILITIES: Interest bearing deposits (3) Balances $171,816 $ 20,469 $ 11,729 $ 5,428 $ 5,112 $ 97,127 Average interest rate 5.00% 5.03% 4.46% 3.08% 3.06% 3.06% Borrowings Balances 46,990 6,000 0 0 0 5,000 Average interest rate 5.00% 4.99% 0.00% 0.00% 0.00% 4.75% --------- --------- --------- --------- --------- ---------- Total $218,806 $ 26,469 $ 11,729 $ 5,428 $ 5,112 $102,127 --------- --------- --------- --------- --------- ---------- --------- --------- --------- --------- --------- ----------
Totals Fair Value --------- ----------- INTEREST EARNING ASSETS: Loans (1) (2) Fixed rate $129,721 $135,604 Average interest rate 8.22% Adjustable rate 117,000 121,062 Average interest rate 8.31% Securities Fixed rate 194,491 194,491 Average interest rate 6.14% Adjustable rate 6,370 6,370 Average interest rate 6.46% Interest-bearing deposits and federal funds sold Fixed rate 100 100 Average interest rate 7.41% Adjustable rate 12,783 12,783 Average interest rate 4.59% Direct lease financing Fixed rate 987 1,001 Average interest rate 7.87% --------- ----------- Total $461,452 $471,411 --------- ----------- --------- ----------- INTEREST BEARING LIABILITIES: Interest bearing deposits (3) Balances $311,681 $312,896 Average interest rate 4.31% Borrowings Balances 57,990 56,472 Average interest rate 4.98% --------- ----------- Total $369,671 $369,368 --------- ----------- --------- -----------
($ 000's) -------------------------------------------Maturing in---------------- As of December 31, 1997 1 Year 2 Years 3 Years 4 Years 5 Years Thereafter - ----------------------- ------ ------- ------- ------- ------- ---------- INTEREST EARNING ASSETS: Loans (1) (2) Fixed rate $ 17,753 $ 10,862 $ 15,771 $ 24,867 $ 16,685 $ 20,776 Average interest rate 8.88% 8.93% 8.98% 9.03% 8.98% 7.86% Adjustable rate 55,486 12,365 13,052 9,012 13,816 32,424 Average interest rate 9.17% 9.27% 9.21% 8.98% 9.29% 9.27% Securities Fixed rate 24,446 19,081 43,344 33,821 33,324 19,625 Average interest rate 6.01% 6.30% 6.50% 6.47% 6.55% 7.33% Adjustable rate 0 0 0 0 0 7,031 Average interest rate 0.00% 0.00% 0.00% 0.00% 0.00% 6.76% Interest bearing deposits and federal funds sold Fixed rate 0 0 100 0 0 0 Average interest rate 0.00% 0.00% 7.30% 0.00% 0.00% 0.00% Adjustable rate 11,306 0 0 0 0 0 Average interest rate 5.57% 0.00% 0.00% 0.00% 0.00% 0.00% Direct lease financing Fixed rate 749 202 67 149 107 0 Average interest rate 7.74% 7.80% 8.74% 7.30% 7.14% 0.00% -------- -------- -------- -------- -------- -------- Total $109,740 $ 42,510 $ 72,334 $ 67,849 $ 63,932 $ 79,856 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- INTEREST BEARING LIABILITIES: Interest bearing deposits (3) Balances $167,753 $ 25,613 $ 10,958 $ 5,128 $ 4,859 $ 92,251 Average interest rate 5.60% 5.46% 4.80% 3.35% 3.34% 3.34% Borrowings Balances 37,504 6,000 0 0 0 0 Average interest rate 5.27% 5.92% 0.00% 0.00% 0.00% 0.00% --------- -------- --------- --------- ---------- --------- Total $205,257 $ 31,613 $ 10,958 $ 5,128 $ 4,859 $ 92,251 --------- -------- --------- --------- ---------- --------- --------- -------- --------- --------- ---------- ---------
Totals Fair Value ------ ---------- INTEREST EARNING ASSETS:> Loans (1) (2) Fixed rate $106,714 $107,151 Average interest rate 8.75% Adjustable rate 136,155 136,155 Average interest rate 9.21% Securities Fixed rate Average interest rate 173,641 173,641 Adjustable rate 6.51% Average interest rate 7,031 7,031 Interest bearing deposits 6.76% and federal funds sold Fixed rate 100 100 Average interest rate 7.30% Adjustable rate 11,306 11,306 Average interest rate 5.57% Direct lease financing Fixed rate 1,274 1,274 Average interest rate 7.70% -------- -------- Total $436,221 $436,658 -------- -------- -------- -------- INTEREST BEARING LIABILITIES: Interest bearing deposits (3) Balances $306,562 $306,958 Average interest rate 4.80% Borrowings Balances 43,504 43,519 Average interest rate 5.36% -------- -------- Total $350,056 $350,477 -------- -------- -------- --------
(1) Does not include net deferred loan fees, unearned income or the allowance for loan losses. (2) For fixed rate loans amortization is based on aggregate payments due. (3) For NOW, money market and savings deposits assumed 5% maturity each year. NSFC ANNUAL 30 REPORT 1998 42 INDEPENDENT AUDITORS' REPORT TABLE 15 - EFFECT OF INTEREST SHOCKS ON FINANCIAL INSTRUMENTS
Fair Value at December 31, 1998 ------------------------------- Down 2% Current Up 2% -------- ------- ----- ASSETS Cash and cash equivalents $ 27,960 $ 27,959 $ 27,958 Interest bearing deposits in financial institutions - maturities over 90 days 101 100 99 Securities available for sale 213,608 200,861 189,199 Loans 259,503 250,721 242,283 Direct lease financing 1,017 1,001 987 Other assets 15,238 15,238 15,238 -------- -------- -------- Total assets $517,427 $495,880 $475,764 -------- -------- -------- -------- -------- -------- FINANCIAL LIABILITIES: Deposits $363,356 $356,971 $350,093 Securities sold under repurchase agreements and other short-term borrowings 47,994 47,990 47,986 Federal Home Loan Bank term advances 9,039 8,482 8,005 Other liabilities 7,062 7,062 7,062 -------- -------- -------- Total liabilities 427,451 420,505 413,146 -------- -------- -------- Total equity 89,976 75,375 62,618 -------- -------- -------- Total liabilities and equity $517,427 $495,880 $475,764 -------- -------- -------- -------- -------- --------
STATEMENT OF MANAGEMENT RESPONSIBILITY Northern States Financial Corporation's management is responsible for the accompanying consolidated financial statements which have been prepared in conformity with generally accepted accounting principles. They are based on our best estimates and judgments. Financial information elsewhere in this annual report is consistent with the data presented in these statements. We acknowledge the integrity and objectivity of published financial data. To this end, we maintain an accounting system and related internal controls which we believe are sufficient in all material respects to provide reasonable assurance that financial records are reliable for preparing financial statements and that assets are safeguarded from loss or unauthorized use. Our independent auditing firm, Crowe, Chizek and Company LLP, provides an objective review as to management's discharge of its responsibilities insofar as they relate to the fairness of reported operating results and the financial condition of the Company. This firm obtains and maintains an understanding of our accounting and financial controls and employs such testing and verification procedures as it deems necessary to arrive at an opinion on the fairness of the consolidated financial statements. The Board of Directors pursues its responsibilities for the accompanying consolidated financial statements through its Audit Committee. The Committee meets periodically with Northern States Financial Corporation's internal auditor and/or independent auditors to review and approve the scope and timing of the internal and external audits and the findings there-from. The Committee recommends to the Board of Directors the engagement of the independent auditors and the auditors have direct access to the Audit Committee. /s/ Fred Abdula FRED ABDULA Chairman of the Board & Chief Executive Officer /s/ Thomas M. Nemeth THOMAS M. NEMETH Vice President & Treasurer INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders Northern States Financial Corporation Waukegan, Illinois We have audited the accompanying consolidated balance sheets of NORTHERN STATES FINANCIAL CORPORATION as of December 31, 1998 and 1997 and the related consolidated statements of income, cash flows, stockholders' equity, and comprehensive income for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based upon our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of NORTHERN STATES FINANCIAL CORPORATION as of December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. CROWE, CHIZEK AND COMPANY LLP Oak Brook, Illinois February 19,1999 NSFC ANNUAL 31 REPORT 1998 43 NORTHERN STATES FINANCIAL CORPORATION CONSOLIDATED BALANCE SHEETS
($ 000's) December 31, 1998 1997 - ------------ ---- ---- ASSETS Cash and due from banks $ 15,176 $ 14,200 Interest-bearing deposits in financial institutions - maturities less than 90 days 183 106 Federal funds sold 12,600 11,200 --------- --------- Total cash and cash equivalents 27,959 25,506 Interest-bearing deposits in financial institutions - maturities over 90 days 100 100 Securities available for sale 200,861 180,672 Loans 246,209 242,224 Less: Allowance for loan losses (5,433) (5,430) --------- --------- Loans, net 240,776 236,794 Direct lease financing 987 1,274 Office buildings and equipment, net 6,647 5,899 Other real estate owned, net of allowance for losses of $552 and $544 2,497 2,555 Accrued interest receivable 4,408 4,308 Other assets 1,686 1,878 --------- --------- Total assets $ 485,921 $ 458,986 --------- --------- --------- --------- LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Deposits Demand - noninterest bearing $ 44,075 $ 41,388 NOW accounts 39,180 36,455 Money market accounts 41,003 38,790 Savings 45,333 43,923 Time, $100,000 and over 98,338 93,469 Time, under $100,000 87,827 93,925 --------- --------- Total deposits 355,756 347,950 Securities sold under repurchase agreements and other short-term borrowings 47,990 38,504 Federal Home Loan Bank term advance 10,000 5,000 Advances from borrowers for taxes and insurance 992 1,166 Accrued interest payable and other liabilities 6,070 6,171 --------- --------- Total liabilities 420,808 398,791 STOCKHOLDERS' EQUITY Common stock 1,781 1,779 Additional paid-in capital 11,336 11,222 Retained earnings 51,358 46,725 Accumulated other comprehensive income, net 638 469 --------- --------- Total stockholders' equity 65,113 60,195 --------- --------- Total liabilities and stockholders' equity $ 485,921 $ 458,986 --------- --------- --------- ---------
The accompanying notes are an integral part of these consolidated financial statements. NSFC ANNUAL 32 REPORT 1998 44 NORTHERN STATES FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME
($ 000's, except per share data) Years Ended December 31, 1998 1997 1996 - ------------------------ ---- ---- ---- Interest income Loans (including fee income) $21,765 $22,199 $22,050 Securities Taxable 10,263 8,411 7,663 Exempt from federal income tax 1,018 1,149 1,188 Interest-bearing deposits in financial institutions 25 35 28 Federal funds sold 1,135 965 742 ------- ------- ------- Total interest income 34,206 32,759 31,671 ------- ------- ------- Interest expense Time deposits 10,413 9,714 8,720 Other deposits 4,124 4,114 4,364 Other borrowings 2,359 1,787 1,724 ------- ------- ------- Total interest expense 16,896 15,615 14,808 ------- ------- ------- Net interest income 17,310 17,144 16,863 Provision for loan losses 10 480 1,190 ------- ------- ------- Net interest income after provision for loan losses 17,300 16,664 15,673 ------- ------- ------- Noninterest income Service fees on deposits 1,091 1,264 1,357 Trust income 665 625 523 Net security gains 0 0 5 Net gains on sales of loans 334 172 210 Other operating income 845 626 1,144 ------- ------- ------- Total noninterest income 2,935 2,687 3,239 ------- ------- ------- Noninterest expenses Salaries and employee benefits 5,796 5,407 5,477 Occupancy and equipment, net 1,251 1,184 1,301 Data processing 495 511 542 FDIC deposit insurance 86 72 817 Other real estate owned 76 140 223 Other operating expenses 1,919 1,818 2,012 ------- ------- ------- Total noninterest expenses 9,623 9,132 10,372 ------- ------- ------- Income before income taxes 10,612 10,219 8,540 Provision for income taxes 3,308 3,209 2,529 ------- ------- ------- Net income $ 7,304 $ 7,010 $ 6,011 ------- ------- ------- ------- ------- ------- Basic earnings per share $ 1.64 $ 1.58 $ 1.35 Diluted earnings per share $ 1.64 $ 1.57 $ 1.35
The accompanying notes are an integral part of these consolidated financial statements. NSFC ANNUAL 33 REPORT 1998 45 NORTHERN STATES FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
($ 000's) Years Ended December 31, 1998 1997 1996 - ------------------------ ---- ---- ---- Cash flows from operating activities Net income $7,304 $7,010 $6,011 Adjustments to reconcile net income to cash from operating activities: Depreciation 590 568 546 Provision for loan losses 10 480 1,190 Provision for losses on other real estate owned 10 21 22 Deferred loan fees (78) (38) (172) Net gains on sales of securities 0 0 (5) Net change in loans held for sale (4,267) (349) 2,863 Net gains on sales of loans (334) (172) (210) Net (gains) losses on sales of other real estate owned 2 (142) (305) Amortization of mortgage servicing rights 65 36 15 Net change in interest receivable (100) (353) 411 Net change in interest payable 260 1,192 342 Net change in other assets 128 742 1,218 Net change in other liabilities (268) (205) 290 ------ ------ ------ Net cash from operating activities 3,322 8,790 12,216 ------ ------ ------ Cash flows from investing activities Proceeds from sales of securities available for sale 0 0 2,675 Proceeds from maturities of securities available for sale 173,014 90,148 90,571 Purchases of securities available for sale (192,926) (120,273) (83,959) Change in loans made to customers 547 (9,151) (17,847) Property and equipment expenditures (1,338) (217) (209) Net change in direct lease financing 287 (275) (377) Proceeds from sales of other real estate owned 46 586 2,180 ------ ------ ------ Net cash from investing activities (20,370) (39,182) (6,966) ------ ------ ------ Cash flows from financing activities Net increase (decrease) in: Deposits 7,806 19,155 1,240 Securities sold under repurchase agreements and other short-term borrowings 9,486 1,746 (6,520) Advances from borrowers for taxes and insurance (174) 145 (260) Federal Home Loan Bank term advance 5,000 5,000 0 Net proceeds from exercise of stock options 54 4 77 Dividends paid (2,671) (2,134) (1,779) ------ ------ ------ Net cash from financing activities 19,501 23,916 (7,242) ------ ------ ------ Net change in cash and cash equivalents 2,453 (6,476) (1,992) Cash and cash equivalents at beginning of year 25,506 31,982 33,974 ------- ------- ------- Cash and cash equivalents at end of year $27,959 $25,506 $31,982 ------- ------- ------- ------- ------- ------- Supplemental disclosures Cash paid during the year for Interest $16,636 $14,423 $14,466 Income taxes 3,234 3,089 2,335 Noncash investing activities Transfers made from loans to other real estate owned 0 174 2,432 Transfers made from tax-exempt loans to securities available for sale, at fair value 0 0 4,700
The accompanying notes are an integral part of these consolidated financial statements. NSFC ANNUAL 34 REPORT 1998 46 NORTHERN STATES FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Accumulated Other Total ($ 000's, except per share data) Common Additional Retained Comprehensive Stockholders' Years Ended December 31, 1998, 1997 and 1996 Stock Paid-In Capital Earnings Income, Net Equity - -------------------------------------------- ------ --------------- -------- ------------------ ------------- Balance, January 1, 1996 $ 1,775 $ 11,123 $ 37,617 $ 490 $ 51,005 Net income 6,011 6,011 Cash dividends ($.40 per share) (1,779) (1,779) Exercise of stock options on 9,210 shares of common stock 4 73 77 Tax benefit from the exercise of stock options 20 20 Unrealized net loss on securities available for sale (499) (499) --------- -------- -------- -------- ------- Balance, December 31, 1996 1,779 11,216 41,849 (9) 54,835 Net income 7,010 7,010 Cash dividends ($.48 per share) (2,134) (2,134) Exercise of stock options on 500 shares of common stock 4 4 Tax benefit from the exercise of stock options 2 2 Unrealized net gain on securities available for sale 478 478 --------- -------- -------- -------- ------- Balance, December 31, 1997 1,779 11,222 46,725 469 60,195 Net income 7,304 7,304 Cash dividends ($.60 per share) (2,671) (2,671) Exercise of stock options on 6,535 shares of common stock 2 52 54 Tax benefit from the exercise of stock options 62 62 Unrealized net gain on securities available for sale 169 169 --------- -------- -------- -------- ------- Balance, December 31, 1998 $ 1,781 $ 11,336 $ 51,358 $ 638 $65,113 --------- -------- -------- -------- ------- --------- -------- -------- -------- -------
The accompanying notes are an integral part of these consolidated financial statements. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
($ 000's) Years ended December 31, 1998 1997 1996 - ------------------------ ---- ---- ---- Net Income $ 7,304 $ 7,010 $ 6,011 Other Comprehensive Income: Unrealized net gains (losses) arising during year on securities available for sale, net of tax 169 478 (499) ------- ------- ------- Comprehensive Income $ 7,473 $ 7,488 $ 5,512 ------- ------- ------- ------- ------- -------
The accompanying notes are an integral part of these consolidated financial statements. NSFC ANNUAL 35 REPORT 1998 47 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998, 1997 & 1996 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include the accounts of Northern States Financial Corporation ("Company") and its wholly owned subsidiary, Bank of Waukegan ("Bank" or "Subsidiary"). All significant intercompany transactions and balances have been eliminated in consolidation. During 1998, the Company received approval from all applicable regulatory agencies to merge First Federal Bank, fsb (the "Thrift") into the Bank. The merger was completed in 1998 and was accounted for as an internal reorganization. Accordingly, the notes to the consolidated financial statements where Bank-only information is presented have been restated to reflect the internal reorganization as if it had occurred on January 1, 1996. Nature of Operations: The Company's and the Bank's revenues, operating income, and assets are primarily from the banking industry. Loan customers are mainly located in Lake County, Illinois and surrounding areas, and include a wide range of individuals, businesses, and other organizations. A major portion of loans are secured by various forms of collateral, including real estate, business assets, consumer property and other items. Use of Estimates: To prepare financial statements in conformity with generally accepted accounting principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The collectibility of loans, fair values of financial instruments, and status of contingencies are particularly subject to change. Cash Flow Reporting: Cash and cash equivalents are defined as cash and due from banks, federal funds sold, and interest-bearing deposits in financial institutions with original maturities under 90 days. Net cash flows are reported for customer loan and deposit transactions, securities sold under agreements to repurchase and other short-term borrowings, and interest bearing deposits in financial institutions with maturities over 90 days. Securities: Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported separately as other comprehensive income, net of tax. Other securities, such as Federal Home Loan Bank stock and Federal Reserve Bank stock, are carried at cost. Securities are written down to fair value when a decline in fair value is not temporary. Gains and losses on sales are determined using the amortized cost of the specific security sold. Interest income includes amortization of purchase premiums and discounts. Loans Held for Sale: Loans held for sale are reported at the lower of cost or market value in the aggregate. Loans: Loans are reported at the principal balance outstanding, net of deferred loan fees and costs and the allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt, typically when payments are past due over 90 days. Payments received on such loans are reported as principal reductions. Allowance for Loan Losses: Because some loans may not be repaid in full, an allowance for loan losses is recorded. Increases to the allowance are recorded by a provision for loan losses charged to expense. Estimating the risk of loss and the amount of loss on any loan is necessarily subjective. Accordingly, the allowance is maintained by management at a level considered adequate to cover possible losses that are currently anticipated based on past loss experience, general economic conditions, information about specific borrower situations, including their financial position and collateral values, and other factors and estimates which are subject to change over time. While management may periodically allocate portions of the allowance for specific problem loan situations, the whole allowance is available for any loan charge-offs that occur. A loan is charged-off by management as a loss when deemed uncollectible, although collection efforts continue and future recoveries may occur. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to provide additions to the allowance based on their judgements at the time of their examinations. Loans are considered impaired if full principal or interest payments are not anticipated. Impaired loans are carried at the present value of expected cash flows discounted at the loan's effective interest rate or at fair value of the collateral if the loan is collateral dependent. A portion of the allowance for loan losses is allocated to impaired loans. Smaller-balance homogeneous loans are evaluated for impairment in total. Such loans include residential first mortgage loans secured by one-to-four family residences, residential construction loans, and automobile, home equity and second mortgage loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. All loans in nonaccrual status and other selected watch list loans are considered impaired. Impaired loans or portions thereof NSFC ANNUAL 36 REPORT 1998 48 (TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA) NORTHERN STATES FINANCIAL CORPORATION NOTE 1 (CONTINUED) are charged off when deemed uncollectible. Increases or decreases in the carrying value of impaired loans are reported as reductions or increases to the provision of loan losses. Office Buildings and Equipment: Asset cost is reported net of accumulated depreciation. Depreciation expense is calculated on the straight-line method over asset useful lives. Other Real Estate: Real estate acquired in settlement of loans is initially reported at estimated fair value at acquisition. After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell. Expenses, gains and losses on disposition, and changes in the valuation allowance are reported in net loss on other real estate. Servicing Rights: The Company has not purchased rights to service loans for others. Servicing rights represent the allocated value of servicing rights retained on loans sold. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates. Any impairment of a grouping is reported as a valuation allowance. Goodwill: Goodwill is the excess of purchase price over identified net assets in business acquisitions. Goodwill is expensed on the straight-line method over 25 years. Goodwill is assessed for impairment based on estimated undiscounted cash flows, and written down if necessary. Long-term Assets: These assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at discounted amounts. Repurchase Agreements: Substantially all repurchase agreement liabilities represent amounts advanced by various customers. Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance. Employee Benefits: A profit sharing plan covers substantially all employees. Contributions are expensed annually and are made at the discretion of the Board of Directors. Contributions totaled $259,000, $260,000 and $255,000 in 1998, 1997 and 1996. The plan allows employees to make voluntary contributions, although such contributions are not matched by the Company. Stock Compensation: Expense for employee compensation under stock option plans is based on Accounting Principles Board Opinion 25, with expense reported only if options are granted below the common stock market price at grant date. Pro forma disclosures of net income and earnings per share are provided as if the fair value method of SFAS No. 123 were used for stock-based compensation instruments awarded after January 1, 1995. Income Taxes: Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. Fair Values of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on and off-balance sheet financial instruments does not include the value of anticipated future business or the values of assets and liabilities not considered financial instruments. Earnings Per Share: Basic earnings per share is based on weighted-average common shares outstanding. Diluted earnings per share further assumes the issuance of any dilutive potential common shares related to outstanding stock options. Comprehensive Income: Comprehensive income consists of net income and other comprehensive income. Other comprehensive income consists of unrealized gains and losses on securities available for sale, net of tax, which are also recognized as separate components of equity. The accounting standard that requires reporting comprehensive income first applies for 1998, with prior information restated to be comparable. Future Accounting Changes: Beginning January 1, 2000, a new accounting standard will require all derivatives to be recorded at fair value. Unless designated as hedges, changes in these fair values will be recorded in the income statement. Fair value changes involving hedges will generally be recorded by offsetting gains and losses on the hedge and on the hedged item, even if the fair value of the hedged item is not otherwise recorded. This is not expected to have a material effect on the Company but the effect will depend on derivative holdings when this standard applies. Operating Segments: Internal financial information is primarily reported and aggregated in three lines of business, banking, trust and mortgage banking. NSFC ANNUAL 37 REPORT 1998 49 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998, 1997 & 1996 NOTE 2 SECURITIES Year end securities available for sale were as follows:
Amortized Gross Unrealized Fair December 31, 1998 Cost Gains Losses Value - ----------------- ----------- ------- ---------- --------- U.S. Treasury $ 13,022 $ 87 $ 0 $ 13,109 U.S. Government agencies and corporations 152,558 208 (326) 152,440 States and political subdivisions 22,693 737 (2) 23,428 Mortgage-backed securities 9,622 106 0 9,728 Equity securities 1,925 242 (11) 2,156 -------- ------ ----- -------- Total $199,820 $1,380 $(339) $200,861 -------- ------ ----- -------- -------- ------ ----- --------
Amortized Gross Unrealized Fair December 31, 1997 Cost Gains Losses Value - ----------------- ----------- ------- ---------- --------- U.S. Treasury $ 14,017 $ 15 $ (1) $ 14,031 U.S. Government agencies and corporations 129,077 45 (250) 128,872 States and political subdivisions 21,712 720 (24) 22,408 Mortgage-backed securities 13,033 137 (47) 13,123 Equity securities 2,069 196 (27) 2,238 -------- ------ ----- -------- Total $179,908 $1,113 $(349) $180,672 -------- ------ ----- -------- -------- ------ ----- --------
Contractual maturities of debt securities available for sale at year-end 1998 were as follows. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.
Amortized Fair ----------------------- Cost Value ----------------------- Due in one year or less $ 19,836 $ 19,928 Due after one year through five years 124,202 124,649 Due after five years through ten years 44,235 44,400 -------- -------- 188,273 188,977 Mortgage-backed securities 9,622 9,728 Equity securities 1,925 2,156 -------- -------- Total $199,820 $200,861 -------- -------- -------- --------
The mortgage pools are issued and guaranteed by the Federal Home Loan Mortgage Corporation (FHLMC), the Government National Mortgage Association (GNMA) or the Federal National Mortgage Association (FNMA). Agency securities with call options totaled $104,748,000 and $77,088,000 at December 31, 1998 and 1997. As of December 31, 1998, the Company held two structured notes with aggregate amortized cost and fair value of $1,499,000. There were no sales of debt securities during 1998, 1997 and 1996. Proceeds from sales of equity securities in 1996 totaled $2,675,000 with a resulting gain of of $5,000. During 1998, 1997 and 1996, the Federal Home Loan Bank of Chicago (FHLB) redeemed 1,441, 220 and 250 shares of its stock with proceeds of $144,000, $22,000 and $25,000 and with no resulting gain or loss. Securities carried at $141,158,000 and $122,419,000 at year-end 1998 and 1997 were pledged to secure public deposits, repurchase agreements and for other purposes as required or permitted by law. NSFC ANNUAL 38 REPORT 1998 50 (TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA) NORTHERN STATES FINANCIAL CORPORATION NOTE 2 SECURITIES (CONTINUED) As of December 31, 1998, the Company had no securities of a single issuer, other than the U.S. Treasury and U.S. Government agencies and corporations, including the FHLB, FHLMC, FNMA, GNMA, the Federal Farm Credit Bank (FFCB), and the Student Loan Marketing Association (SLMA), that exceeded 10% of consolidated stockholders' equity. Although the Company holds securities issued by municipalities with-in the state of Illinois which in aggregate exceed 10% of consolidated stockholders' equity, none of the holdings from individual municipal issuers exceeded this threshold. Interest-bearing balances with banks and federal funds sold consisted of the following at December 31, 1998:
First USA Bank, Dallas $ 9,000 LaSalle National Bank, Chicago 3,100 Harris Bank, Chicago 538 Bank of America, Illinois 145 Federal Home Loan Bank, Chicago 100 ------- Total $12,883 ------- -------
NOTE 3 LOANS
Year-end loans were as follows: 1998 1997 - ------------------------------- --------- ---------- Commercial $ 64,043 $ 54,701 Real estate - construction 17,328 26,768 Real estate - mortgage 141,241 138,134 Home Equity 15,579 14,722 Installment 8,530 8,544 --------- ---------- Total loans 246,721 242,869 Less: Unearned income (99) (154) Deferred loan fees (413) (491) --------- ---------- Loans, net of unearned income and deferred loan fees 246,209 242,224 Allowance for loan losses (5,433) (5,430) --------- ---------- Total loans, net $ 240,776 $ 236,794 --------- ---------- --------- ----------
Impaired loans and nonaccrual were as follows:
1998 1997 1996 ------ ------ ------ Year-end impaired loans with no allowance for loan losses allocated $ 0 $ 0 $ 0 Year-end impaired loans with allowance for loan losses allocated 3,515 754 828 Amount of allowance allocated for impaired loans 544 125 146 Year-end nonaccrual loans, including impaired loans 3,804 1,003 1,108 Average of impaired loans during the year 1,695 776 2,620 Interest income recognized during impairment 84 36 587 Cash-basis interest income recognized on impaired loans 84 36 218
Related party loans were as follows:
1998 ------ Total loans at beginning of year $ 509 New loans 428 Repayments (208) Other changes (294) ------ Total loans at end of year $ 435 ------ ------
Real estate loans with a carrying value of $20,596,000 and $24,807,000 were pledged to secure public deposits at December 31, 1998 and 1997. Loans held for sale at year-end 1998 and 1997 were $5,799,000 and $1,338,000 and are classified as real estate mortgage loans. NSFC ANNUAL 39 REPORT 1998 51 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998, 1997 & 1996 NOTE 4 ALLOWANCES FOR LOAN AND OTHER REAL ESTATE OWNED LOSSES Activity in the allowance for loan losses for the year ended December 31, follows:
1998 1997 1996 -------- -------- -------- Balance at beginning of year $ 5,430 $ 4,839 $ 4,514 Provision charged to operating expense 10 480 1,190 Loans charged off (73) (209) (1,141) Recoveries on loans previously charged-off 66 320 276 -------- -------- -------- Balance at end of year $ 5,433 $ 5,430 $ 4,839 -------- -------- -------- -------- -------- --------
Activity in the allowance for other real estate owned losses for the year ended December 31, follows:
1998 1997 1996 ------ ------ ------ Balance at beginning of year $ 544 $ 532 $ 510 Provision charged to operating expense 10 21 22 Losses on other real estate owned (2) (9) 0 ------ ------ ------ Balance at end of year $ 552 $ 544 $ 532 ------ ------ ------ ------ ------ ------
NOTE 5 OFFICE BUILDINGS AND EQUIPMENT Office buildings and equipment consisted of the following at December 31, 1998 and 1997:
1998 1997 --------- -------- Land $ 1,413 $ 1,300 Office buildings and improvements 8,340 7,428 Furniture and equipment 3,918 3,622 --------- -------- Total cost 13,671 12,350 Accumulated depreciation (7,024) (6,451) --------- -------- Net book value $ 6,647 $ 5,899 --------- -------- --------- --------
Depreciation expense amounted to $590,000 in 1998, $568,000 in 1997 and $546,000 in 1996. NOTE 6 LOAN SERVICING Mortgage loans serviced for others are not reported as assets. These loans totalled $60,288,000 and $64,924,000 at year-end 1998 and 1997. Related escrow deposit balances were $566,000 and $639,000 at year-end 1998 and 1997. Activity for capitalized mortgage servicing rights was as follows for 1998, 1997 and 1996:
1998 1997 1996 ------ ------ ------ Beginning of year $ 120 $ 80 $ 0 Additions 140 76 95 Amortized to expense (65) (36) (15) ------ ------ ------ End of year $ 195 $ 120 $ 80 ------ ------ ------ ------ ------ ------
NSFC ANNUAL 40 REPORT 1998 52 (TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA) NORTHERN STATES FINANCIAL CORPORATION NOTE 7 DEPOSITS At year-end 1998, stated maturities of time deposits were: 1999 $ 165,540 2000 14,507 2001 6,065 2002 and thereafter 53 --------- $ 186,165 --------- ---------
Related party deposits at year-end 1998 and 1997 totaled $11,738,000 and $10,229,000. NOTE 8 BORROWINGS Securities sold under repurchase agreements and other short-term borrowings are financing arrangements. Physical control is maintained for all other securities sold under repurchase agreements. Information concerning securities sold under repurchase agreements is summarized as follows:
- ------------------------------------------------------------------ 1998 1997 - ------------------------------------------------------------------ Average daily balance during the year $36,155 $34,176 Average interest rate during the year 5.11% 5.07% Maximum month end balance during the year $47,990 $38,504
Securities sold under repurchase agreements with directors of the Company and related interests totalled $21,343,000 at December 31, 1998 and have a weighted remaining maturity of 7 months. The Company had fixed rate advances from the FHLB at December 31, 1998 and 1997 as follows:
1998 1997 - -------------------------------------------------------- Maturity Date Interest Rate Balance Balance - -------------------------------------------------------- April 30, 1999 5.90% $5,000 $5,000 February 11, 2008 4.75% 5,000
The Bank maintains a collateral pledge agreement with the FHLB covering secured advances whereby the Bank agrees to retain first mortgage loans with unpaid principal balances aggregating no less than 167% of the outstanding secured advance from the FHLB. NSFC ANNUAL 41 REPORT 1998 53 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998, 1997 & 1996 NOTE 9 INCOME TAXES A summary of federal and state income taxes on operations follows:
- --------------------------------------------------------------- 1998 1997 1996 - --------------------------------------------------------------- Current payable: Federal $3,130 $2,940 $2,184 State 87 262 151 Deferred income tax 91 7 194 ------ ------ ------ Provision for income taxes $3,308 $3,209 $2,529 ------ ------ ------ ------ ------ ------
The components of deferred tax assets and liabilities at December 31, 1998 and 1997 follows:
1998 1997 -------- ------- Deferred tax assets: Allowance for loan and other real estate losses $1,929 $1,922 Deferred loan fees 0 25 Deferred compensation and directors' fees 182 182 Taxable income on nonperforming loans not recorded for book purposes 0 5 ------- ------- Gross deferred tax assets 2,111 2,134 Deferred tax liabilities: Accumulated depreciation (567) (586) Federal Home Loan Bank stock dividend (37) (37) Unrealized net gain on securities available for sale (403) (295) Deferred loan fees (34) 0 Mortgage servicing rights (75) (65) Other items (90) (47) ------- ------- Gross deferred tax liabilities (1,206) (1,030) ------- ------- Net deferred tax asset $ 905 $ 1,104 ------- ------- ------- -------
No valuation allowance is required for deferred tax assets. The provision for income taxes differs from that computed at the statutory federal corporate tax rate as follows:
1998 1997 1996 ------- -------- ------- Income tax calculated at statutory rate (34%) $ 3,608 $ 3,474 $ 2,904 Add (subtract) tax effect of: Tax-exempt income, net of disallowed interest expense (380) (431) (503) State income tax, net of federal tax benefit 71 156 120 Other items, net 9 10 8 ------- ------- ------- Provision for income taxes $ 3,308 $ 3,209 $ 2,529 ------- ------- ------- ------- ------- -------
Prior to being merged with the Bank in 1998, the Thrift qualified under provisions of the Internal Revenue Code which permitted it to deduct from taxable income a provision for bad debts which differs from the provision charged to income in the financial statements. Tax legislation passed in 1996 now requires all thrift institutions to deduct a provision for bad debts for tax purposes based on actual loss experience and recapture the excess bad reserve accumulated in tax years after 1987. These provisions carry forward to the Bank after the merger of the Thrift into the Bank. The NSFC ANNUAL 42 REPORT 1998 54 NORTHERN STATES FINANCIAL CORPORATION NOTE 9 INCOME TAXES (CONTINUED) related amount of deferred tax liability which must be recaptured is not material. Retained earnings at December 31, 1998 includes approximately $3,269,000 for which no provision for federal income taxes has been made. If, in the future, this portion of retained earnings is used for any purpose other than to absorb bad debt losses, federal income taxes would be imposed at the then prevailing rates, resulting in approximately $1,266,000 of deferred tax liability. (TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA) NORTHERN STATES FINANCIAL CORPORATION NOTE 10 - OMNIBUS INCENTIVE PLANS Information about option grants follows:
Number Weighted-average of options exercise price ---------- ---------------- Outstanding, beginning of 1996 35,100 $ 8.33 Exercised in 1996 (9,210) 8.33 ------ Outstanding, end of 1996 25,890 8.32 Exercised in 1997 (500) 8.40 ------ Outstanding, end of 1997 25,390 8.32 Exercised in 1998 (6,535) 8.32 ------ Outstanding, end of 1998 18,855 8.32 ------ ------
The 1992, Omnibus Incentive Plan (the "Plan") authorizes the issuance of up to 375,000 shares of the Company's common stock, including granting of non-qualified stock options, restricted stock and stock appreciation rights. Statement of Financial Accounting Standards No. 123, which became effective for 1996, requires pro forma disclosures for companies that do not adopt its fair value accounting method for stock-based employee compensation. The Company has not granted any stock options since January 1, 1995. Stock options are used to reward directors and employees and provide them with an additional equity interest. Options are issued for 10 year periods and are fully vested when granted. At year-end 1998, options outstanding and exercisable had a weighted average exercise price of $8.32 and a weighted average remaining option life of 3 years. A Committee of the Board of Directors at its discretion may grant stock appreciation rights under the Plan. A stock appreciation right entitles the holder to receive from the Company an amount of cash equal to the excess, if any, of the fair market value of the Company's common stock which is the subject of such grant over the grant price. As of December 31, 1998 and 1997, 14,990 and 16,240 stock appreciation rights were outstanding at the grant price of $8.32 per share. The Company's expense was $25,000, $114,000 and $70,000 in 1998, 1997 and 1996. The stock appreciation rights will expire during 2002. NSFC ANNUAL 43 REPORT 1998 55 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998, 1997 & 1996 NOTE 11 - COMMITMENTS, OFF-BALANCE SHEET RISK, AND CONTINGENCIES There are various contingent liabilities that are not reflected in the financial statements, including claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material effect on the consolidated financial condition or results of operations of the Company. At year-end 1998 and 1997, reserves of $3,165,000 and $2,735,000 were required as deposits with the Federal Reserve Bank or as cash on hand. These reserves do not earn interest. Some financial instruments are used in the normal course of business to meet the financing needs of customers and to reduce exposure to interest rate changes. These financial instruments include commitments to extend credit, standby letters of credit, and financial guarantees. These involve, to varying degrees, credit and interest-rate risk in excess of the amount reported in the financial statements. Exposure to credit loss if the other party does not perform is represented by the contractual amount for commitments to extend credit, standby letters of credit, and financial guarantees written. The same credit policies are used for commitments and conditional obligations as are used for loans. Collateral or other security is normally required to support financial instruments with credit risk. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being used, the commitments do not necessarily represent future cash requirements. Standby letters of credit and financial guarantees written are conditional commitments to guarantee a customer's performance to a third party. A summary of the notional or contractual amounts of financial instruments with off-balance-sheet risk at year-end follows:
1998 1997 ------- ------- Unused lines of credit and commitments to make loans: Fixed rate $19,999 $20,388 Variable rate 60,009 54,339 ------- ------- Total $80,008 $74,727 ------- ------- ------- ------- Standby letters of credit $ 6,598 $ 6,891
Commitments to make loans at a fixed rate have interest rates ranging primarily from 6.00% to 9.00%. NSFC ANNUAL 44 REPORT 1998 56 (TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA) NORTHERN STATES FINANCIAL CORPORATION NOTE 12 - FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate fair values for financial instruments. Securities fair values are based on quoted market prices or, if no quotes are available, on the rate and term of the security and or information about the issuer. For loans or deposits and securities sold under repurchase agreements, the fair value is estimated by discounted cash flow analysis using current market rates for the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable. Fair value of loans held for sale is based on market estimates. The fair value of off-balance-sheet items is based on the fees or cost that would currently be charged to enter or terminate such arrangements, and the fair value is not material. The estimated year-end fair values of financial instruments were:
Carrying Value Estimated 1998 Fair Value - ---- ------------------------ Financial assets: Cash and cash equivalents $ 27,959 $ 27,959 Interest-bearing deposits in financial institutions - maturities over 90 days 100 100 Securities available for sale 200,861 200,861 Loans, net 240,776 250,721 Direct lease financing 987 1,001 Accrued interest receivable 4,408 4,408 Financial liabilities: Deposits $(355,756) $(356,971) Securities sold under repurchase agreements and other short-term borrowings (47,990) (47,990) Federal Home Loan Bank term advances (10,000) 8,482 Advances from borrowers for taxes and insurance (992) (992) Accrued interest payable (3,951) (3,951)
Carrying Value Estimated 1997 Fair Value - ---- ------------------------ Financial assets: Cash and cash equivalents $ 25,506 $ 25,506 Interest-bearing deposits in financial institutions - maturities over 90 days 100 100 Securities available for sale 180,672 180,672 Loans, net 236,794 237,321 Direct lease financing 1,274 1,274 Accrued interest receivable 4,308 4,308 Financial liabilities: Deposits $(347,950) $(348,346) Securities sold under repurchase agreements and other short-term borrowings (38,504) (38,519) Federal Home Loan Bank term advances (5,000) (5,000) Advances from borrowers for taxes and insurance (1,166) (1,166) Accrued interest payable (3,691) (3,691)
NSFC ANNUAL 45 REPORT 1998 57 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998, 1997 & 1996 NOTE 13 - REGULATORY MATTERS The Company and Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized,although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and plans for capital restoration are required. Actual capital levels and minimum required levels were as follows at December 31, 1998 and 1997. The Bank's 1997 information has been restated to reflect the 1998 merger of the Thrift into the Bank.
Minimum Required to Minimum Required be Well Capitalized For Capital Under Prompt Corrective Actual Adequacy Purposes Action Regulations Amount Ratio Amount Ratio Amount Ratio ------------------ --------------------- ------------------------ 1998 Total Capital (to risk weighted assets) Consolidated $68,264 21.84% $25,004 8.00% $31,256 10.00% Bank 67,755 21.69 24,993 8.00 31,241 10.00 Tier I Capital (to risk weighted assets) Consolidated 64,357 20.59 12,502 4.00 18,753 6.00 Bank 63,850 20.44 12,496 4.00 18,745 6.00 Tier I Capital (to average assets) Consolidated 64,357 13.69 18,801 4.00 23,501 5.00 Bank 63,850 13.59 18,795 4.00 23,493 5.00 1997 Total Capital (to risk weighted assets) Consolidated $63,249 21.65% $23,376 8.00% $29,220 10.00% Bank 62,773 21.49 23,365 8.00 29,206 10.00 Tier I Capital (to risk weighted assets) Consolidated 59,597 20.40 11,688 4.00 17,532 6.00 Bank 59,122 20.24 11,682 4.00 17,524 6.00 Tier I Capital (to average assets) Consolidated 59,597 13.71 17,394 4.00 21,742 5.00 Bank 59,122 13.60 17,388 4.00 21,735 5.00
NSFC ANNUAL 46 REPORT 1998 58 (TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA) NORTHERN STATES FINANCIAL CORPORATION NOTE 13 - REGULATORY MATTERS The Company and Bank at year end 1998 and 1997 were categorized as well capitalized. Management knows of no circumstances or events which would change these categorizations. The Company's primary source of funds to pay dividends to shareholders is the dividends it receives from the Bank. The Bank is subject to certain restrictions on the amount of dividends that it may declare without regulatory approval. At December 31, 1998, $9,637,000 of the Bank's retained earnings was available for dividend declaration without prior regulatory approval. NOTE 14 - EARNINGS PER SHARE AND CAPITAL MATTERS Net income was utilized to calculate both basic and diluted earnings per share for all years presented. Information regarding weighted average shares utilized in computing basic and diluted earnings per share is as follows (restated for the five-for-one stock split in 1998):
1998 1997 1996 --------- --------- --------- Average outstanding common shares 4,449,996 4,446,450 4,444,565 Effect of stock options 9,987 9,055 7,320 --------- --------- --------- Average outstanding shares for diluted earnings per share 4,459,983 4,455,505 4,451,885 --------- --------- --------- --------- --------- ---------
On April 23, 1998, the Company's stockholders approved an amendment to the Company's certificate of incorporation to increase the authorized common shares and effect a five-for-one stock split through a reduction in the common stock par value. All prior period earnings per share and dividends per share information has been restated to reflect the five-for-one stock split. Information related to stockholders' equity at December 31, 1998 and 1997 was as follows:
1998 1997 --------- --------- Par value per share $ 0.40 $ 2.00 Authorized shares 6,500,000 1,750,000 Issued and outstanding shares 4,453,400 889,373
NSFC ANNUAL 47 REPORT 1998 59 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998, 1997 & 1996 NOTE 15 - PARENT COMPANY CONDENSED FINANCIAL STATEMENTS Following are condensed parent company financial statements. The 1997 and 1996 information has been restated to reflect the 1998 merger of the Thrift into the Bank. Condensed Balance Sheets
December 31, 1998 1997 - ------------ ---- ---- Assets Cash on deposit at subsidiary bank - noninterest bearing $ 775 $ 874 Interest-bearing deposits in unaffiliated bank 38 36 ------- ------- Total cash and cash equivalents 813 910 Investment in wholly-owned subsidiary Equity in underlying book value of Bank of Waukegan 64,488 59,591 Goodwill, net 118 129 ------- ------- Total investment in subsidiary 64,606 59,720 Other assets 51 108 ------- ------- Total assets $65,470 $60,738 ------- ------- ------- ------- Liabilities and Stockholders' Equity Accounts payable and other liabilities $ 357 $ 543 Stockholders' equity 65,113 60,195 ------- ------- Total liabilities and stockholders' equity $65,470 $60,738 ------- ------- ------- -------
Condensed Statements of Income
Years ended December 31, 1998 1997 1996 - ------------------------ ---- ---- ---- Operating income Dividends from Bank $2,677 $2,124 $1,745 Interest income 2 1 1 ------ ------ ------ Total operating income 2,679 2,125 1,746 Operating expenses 160 218 214 ------ ------ ------ Income before income taxes and equity in undistributed earnings of Bank 2,519 1,907 1,532 Income tax benefit 57 80 78 ------ ------ ------ Income before equity in undistributed earnings of Bank 2,576 1,987 1,610 Equity in undistributed earnings of Bank 4,728 5,023 4,401 ------ ------ ------ Net income $7,304 $7,010 $6,011 ------ ------ ------ ------ ------ ------
Condensed Statements of Cash Flows
Years ended December 31, 1998 1997 1996 - ------------------------ ---- ---- ---- Cash flows from operating activities Net income $ 7,304 $ 7,010 $ 6,011 Adjustments to reconcile net income to net cash from operating activities Equity in undistributed earnings of Bank (4,728) (5,023) (4,401) Goodwill amortization 11 11 10 (Increase) decrease in other assets 77 311 (149) Increase (decrease) in other liabilities (144) (111) 208 ------- ------- ------- Net cash from operating activities 2,520 2,198 1,679 Cash flows from financing activities Exercise of stock options 54 4 77 Dividends paid (2,671) (2,134) (1,779) ------- ------- ------- Net cash from financing activities (2,617) (2,130) (1,702) ------- ------- ------- Increase (decrease) in cash and cash equivalents (97) 68 (23) Cash and cash equivalents at beginning of year 910 842 865 ------- ------- ------- Cash and cash equivalents at end of year $ 813 $ 910 $ 842 ------- ------- ------- ------- ------- -------
NSFC ANNUAL 48 REPORT 1998 60 (TABLE AMOUNTS IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA) NORTHERN STATES FINANCIAL CORPORATION NOTE 16 - OTHER COMPREHENSIVE INCOME Other comprehensive income components and related taxes were as follows:
1998 1997 1996 ---- ---- ---- Unrealized holding gains (losses) on securities available for sale $277 $ 797 $ (833) Less reclassification adjustments for gains later recognized in income 0 0 (5) ---- ----- ----- Net unrealized gains (losses) 277 797 (838) Tax effect (108) (319) 339 ------ ------ -------- Other comprehensive income (loss) $ 169 $ 478 $ (499) ------ ------ -------- ------ ------ --------
NOTE 17 - SEGMENT INFORMATION The operating segments are determined by the products and services offered, primarily distinguished between banking, mortgage banking and trust operations. Loans, investments, and deposits provide the revenues in the banking operation, servicing fees and loan sales provide the revenues in mortgage banking, and trust fees provide the revenues in trust operations. All operations are domestic. Management began evaluating mortgage banking as a separate segment in August, 1998. The accounting policies used are the same as those described in the summary of significant accounting policies. Mortgage banking and trust segment performance is evaluated using fee income net of direct expenses. Income taxes are not allocated to these segments, and selected indirect expenses are allocated. There are no transactions among segments. Substantially all assets are related to the banking segment. Neither mortgage banking nor trust pre-tax net revenues exceeded 10% of total pre-tax income for 1998, 1997 or 1996. Information reported internally for performance assessment follows.
1998 Other Total Banking Segments Segments ------- -------- -------- Net interest income $ 17,310 $ 0 $ 17,310 Provision for loan losses 10 0 10 Other revenue 1,833 1,102 2,935 Other expenses 8,656 967 9,623 -------- ----- -------- Segment profit $ 10,477 $ 135 $ 10,612 -------- ----- -------- -------- ----- -------- 1997 Other Total Banking Segments Segments ------- -------- -------- Net interest income $ 17,144 $ 0 $ 17,144 Provision for loan losses 480 0 480 Other revenue 2,062 625 2,687 Other expenses 8,668 464 9,132 -------- ----- -------- Segment profit $ 10,058 $ 161 $ 10,219 -------- ----- -------- -------- ----- -------- 1996 Other Total Banking Segments Segments -------- -------- -------- Net interest income $ 16,863 $ 0 $ 16,863 Provision for loan losses 1,190 0 1,190 Other revenue 2,716 523 3,239 Other expenses 9,848 524 10,372 -------- ----- -------- Segment profit $8,541 $ (1) $ 8,540 -------- ----- -------- -------- ----- --------
NSFC ANNUAL 49 REPORT 1998 61 NORTHERN STATES FINANCIAL CORPORATION STOCKHOLDER INFORMATION Annual Meeting: All stockholders are invited to attend our annual meeting, which will be held at 4:30 P.M., on Thursday, April 22, 1999 in the lobby of the Bank of Waukegan, 1601 N. Lewis Avenue, Waukegan, Illinois 60085. We look forward to meeting all stockholders and welcome your questions at the annual meeting. Any stockholders unable to attend this year's meeting are invited to send questions and comments in writing to Fred Abdula, Chairman of the Board and Chief Executive Officer, at Northern States Financial Corporation. Form 10-K: Stockholders who wish to obtain a copy at no charge of Northern States Financial Corporation's Form 10-K for the fiscal year ended December 31, 1998, as filed with the Securities and Exchange Commission, may do so by writing Thomas M. Nemeth, Vice President & Treasurer, at Northern States Financial Corporation. For Further Information: Stockholders and prospective investors are welcome to call or write Northern States Financial Corporation with questions or requests for additional information. Please direct inquiries to: Thomas M. Nemeth Vice President & Treasurer Northern States Financial Corporation 1601 N. Lewis Avenue Waukegan, Illinois 60085 (847) 244-6000 ext. 269 Transfer Agent, Registrar & Dividend Disbursements: Stockholders with a change of address or related inquiries should contact: Firstar Bank Milwaukee, NA Investors Services Unit 1555 N. Rivercenter Dr., Suite 301 Milwaukee, Wisconsin 53212 (800) 637-7549 Quarterly Calendar: The Company operates on a fiscal year ending December 31. Quarterly results are announced within 45 days after the end of each quarter, and audited results are announced within 90 days after year end. Semi-annual Dividend Dates: Dividends are expected to be announced and paid on the following schedule during 1999: Half Record Date Payment Date ---- ----------- ------------ First May 17 June 1 Second November 15 December 1 Stock Market Information: The common stock of Northern States Financial Corporation is traded on the National Association of Securities Dealers Automated Quotation System (NASDAQ Small-Cap Market) under the ticker symbol NSFC. Stock price quotations are published daily in the Chicago Tribune and Chicago Sun-Times newspapers and, when traded, in The Wall Street Journal. The stock is commonly listed as NthStat. As of December 31, 1998 there were 6,500,000 common shares authorized; 4,453,400 common shares were outstand-ing, held by approximately 450 registered stockholders. As of February 28, 1999, the following securities firms indi-cated they were maintaining an inventory of Northern States Financial Corporation common stock and are acting as mar-ket makers: Herzog, Heine, Geduld, Inc. Miami, Florida (800) 966-7022 or (305) 932-5880 Howe Barnes Investments, Inc. Chicago, Illinois (800) 800-4693 or (312) 655-2946 Knight Securities, Inc. Jersey City, New Jersey (888) 302-9197 or (212) 336-8861 Price Summary: The following schedule details our stock's quarter ending bid and ask price restated to reflect the five-for- one stock-split which occured in May of 1998.
1998 1997 --------- ---------- BID ASK BID ASK --- --- --- --- Quarter Ended: March 31 $32 $33 5/8 $17 5/8 $18 5/8 June 30 34 1/2 34 3/4 17 3/8 18 3/8 September 30 27 1/4 27 5/8 19 20 December 31 24 5/8 25 23 3/8 26 1/8
1999 ---- BID ASK --- --- For the First Quarter: (through March 1, 1999) $ 22 1/2 $ 22 3/4
Cash Dividends: Northern States Financial Corporation pays semi-annual cash dividends in June and December. Uninterrupted cash dividends have been paid since the Company's formation in 1984 and have been increased each year since then. The table below shows semi-annual cash div-idends per share for the past seven years. Dividends have been restated to reflect the five-for-one stock split which occurred in May of 1998.
June 1 December 1 Total 1994 $ .14 $ .15 $ .29 1995 .16 .17 .33 1996 .19 .21 .40 1997 .23 .25 .48 1998 .28 .32 .60
Independent Auditors Crowe, Chizek and Company LLP Oak Brook, Illinois NSFC ANNUAL 50 REPORT 1998 62 EX-21 3 EXHIBIT 21 EXHIBIT 21. SUBSIDIARIES OF NORTHERN STATES FINANCIAL CORPORATION Bank of Waukegan 1601 N. Lewis Avenue Waukegan, Illinois 60085 State of Incorporation - Illinois A Wholly-Owned Subsidiary of Northern States Financial Corporation 63 EX-27 4 EXHIBIT 27
9 1,000 YEAR DEC-31-1998 JAN-01-1998 DEC-31-1998 15,176 283 12,600 0 200,861 0 0 247,196 5,433 485,921 355,756 47,990 7,062 10,000 0 0 1,781 63,332 485,921 21,765 11,281 1,160 34,206 14,537 16,896 17,310 10 0 9,623 10,612 10,612 0 0 7,304 1.64 1.64 3.99 3,804 313 0 0 5,430 73 66 5,433 3,361 0 2,072
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