# First Ottawa Bancshares, Inc.: Form 10-Q for the period ended Mar 31, 2010

- Company: [First Ottawa Bancshares, Inc.](/companies/fotb.md) (CIK 1099668)
- Form: 10-Q
- Filed: 2010-05-14
- Accepted by EDGAR: May 14, 2010, 06:01 ET
- Period: 2010-03-31
- Accession: 0001104659-10-028382
- Inline XBRL: no
- Main document: https://www.sec.gov/Archives/edgar/data/1099668/000110465910028382/a10-5852_110q.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/1099668/000110465910028382/

## Management's discussion and analysis

As filed, 25,005 characters.

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

### Overview

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

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

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

The Company’s net income for the three months ended March 31, 2010, was $308,000, or $.48 per common share, compared to net income of $553,000, or $.86 per common share for the three months ended March 31, 2009. The decrease in net income was due primarily to a decrease in non-interest income. The Company’s net income was further impacted by an increase in non-interest expense.

The Company’s assets at March 31, 2010 were $267.5 million contrasted to $283.7 million at December 31, 2009, a decrease of $16.2 million, or 5.7%.

### CRITICAL ACCOUNTING POLICIES

The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. The Company’s significant accounting policies are described in detail in the notes to the Company’s consolidated financial statements for the year ended December 31, 2009. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The Company’s financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company’s financial condition and results, and they require management to make estimates that are difficult, subjective, or complex.

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

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

Regardless of the extent of the Company’s analysis of customer performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors including inherent delays in obtaining information regarding a customer’s financial condition or changes in their unique business conditions, the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are among other factors. The Company estimates a range of inherent losses related to the existence of these exposures. The estimates are based upon the Company’s evaluation of imprecision risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment.

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

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

Additionally, the Company has purchased certificate of deposits which contain an equity related embedded derivative component. The initial investment in the certificate of deposit is not at risk but the return on the investment is based on appreciation in the S&P 500 Index. Accordingly, the fair value of the embedded derivative is recorded in certificates of deposit and the fair value adjustment is included in other income.

**Stock Compensation**- Grants under the Company’s stock incentive plan are accounted for by applying the fair value method and the use of an option pricing model to estimate the value of the options granted. The stock options are granted with an exercise price equal to the market price at the date of grant. Resulting compensation expense relating to the stock options is measured and recorded based on the estimated value of the options.

**Valuation Measurements-** Valuation methodologies often involve a significant degree of judgment, particularly when there are no observable active markets for the items being valued. Investment securities and derivatives are carried at fair value, as defined in FASB ASC Topic 820, which requires key judgments affecting how fair value for such assets and liabilities is determined. In addition, the outcomes of valuations have a direct bearing on the carrying amounts of goodwill, mortgage servicing rights, and pension and other postretirement benefit obligations. To determine the values of these assets and liabilities, as well as the extent to which related assets may be impaired, management makes assumptions and estimates related to discount rates, asset returns, prepayment rates and other factors. The use of different discount rates or other valuation assumptions could produce significantly different results, which could affect the Company’s results of operations.

**Goodwill-** Under FASB ASC Topic 350, the Company is required to evaluate goodwill for impairment on an annual basis or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The Company has elected to test for goodwill impairment as of December 31 of each year. The Company cannot predict the occurrence of certain future events that might adversely affect the reported value of goodwill. Such events include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the effect of the economic environment on the Company’s customer base, or a material negative change in its relationship with significant customers.

### CONSOLIDATED FINANCIAL CONDITION

Total assets at March 31, 2010 were $267.5 million contrasted to $283.7 million at December 31, 2009, a decrease of $16.2 million, or 5.7%. This decrease in total assets was the result of an $9.2 million decrease in securities available for sale, a $3.6 million decrease in certificates of deposit at other financial institutions, and a $5.9 million decrease in loans due to current economic trends and a decline in demand. These decreases were partially offset by a $2.6 million increase in other assets and a modest increase in loans held for sale. Other assets increased primarily due to an increase in other real estate owned which increased $2.4 million to $4.4 million compared to December 31, 2009. The $16.2 million decrease in total assets resulted in a corresponding decrease of $2.0 million in other borrowings, as a Federal Home Loan Bank advance matured, as well as a $13.8 million decrease in deposits.

Total liabilities at March 31, 2010 were $241.4 million compared to $257.7 million at December 31, 2009, a decrease of $16.3 million, or 6.3%. This decrease in total liabilities was primarily the result of a $9.0 million decrease in interest bearing demand accounts, a $304,000 decrease in time deposit accounts, a $4.3 million decrease in non-interest bearing demand accounts, a $2.0 million decrease in other borrowings, and a $541,000 decrease in other liabilities. Decreases in interest bearing demand accounts were attributable to local municipalities drawing down balances for operations and other seasonal payments. The decrease in other liabilities was primarily due to the payment of dividends in the first quarter. The decrease in interest bearing demand accounts was the result of a temporary reduction in balances of a local municipality.

Total shareholder’s equity was $26.1 million at March 31, 2010 compared to $26.0 million at December 31, 2009. This increase was the result of $308,000 of additional retained earnings from net income for the quarter ended March 31, 2010 and a decrease of $160,000, net of tax, in the valuation of the Company’s investment portfolio.

### CONSOLIDATED RESULTS OF OPERATIONS

Net income for the first quarter of 2010 was $308,000, or $0.48 per share, a 44.3% decrease compared to $553,000, or $0.86 per share, in the first quarter of 2009. The decrease in net income for the quarter was primarily the result of a decrease in non-interest income of $167,000 and a nominal decrease in net interest income of $41,000. These decreases in income were coupled with an increase in non-interest expenses, which were $2.2 million in 2010 compared to $2.1 million in 2009. The provision for income taxes decreased by $96,000 to $53,000 in 2010 as compared to 2009, due to the reduction in pretax income.

The annualized return on average assets was 0.45% in the first quarter of 2010 compared to 0.81% in the first quarter of 2009. The annualized return on average equity decreased to 4.84% in the first quarter of 2010 from 9.23% the first quarter of 2009.

### NET INTEREST INCOME

Net interest income before the provision for loan losses was $2.2 million for the three months ended March 31, 2010, compared to $2.3 million in 2009, a 1.8% decrease. Total interest income decreased $370,000 to $2.9 million for the three months ended March 31, 2010, compared to the same period in 2009. The decrease in total interest income for the three months ended March 31, 2010 reflected a decrease in interest income from loans of $267,000 to $2.2 million, compared to the same period in 2009, a decrease in taxable investment income of $49,000 to $204,000, compared to the same period in 2009, and a decrease in tax exempt investment income of $136,000 to $198,000, compared to the same period in 2009. These decreases were partially offset by an increase in income on certificates of deposit held for investment of $84,000 to $255,000, compared to the same period in 2009. Decreased interest income was a result of decreases in both interest rates on investments and decreased volume of taxable and tax exempt investments and average loans outstanding during the first quarter of 2010. Increased certificates of deposit held for investment was attributable to increases in principal balances of investment certificates of deposit compared to the end of the first quarter of 2009.

The Company’s net interest margin was 3.88% for the three months ended March 31, 2010 compared to 3.92% for the same period in 2009. The yield on average earning assets decreased to 4.92% for the three months ended March 31, 2010 from 5.48% for the same period in 2009, a 56 basis point decrease. This decrease was offset by a similar decrease in the cost of funds from 1.56% to 1.04% paid for the same period ended March 31, 2010, a 52 basis point decrease. The decrease in interest expense was significantly affected by a $245,000 decrease in interest paid on time deposit accounts. This reduction was due to both rate and volume factors.

### PROVISION FOR LOAN LOSSES

The provision for loan losses was $270,000 in the first quarter of each of 2010 and 2009. This consistent provision level, which is high compared to historical periods, was a result of ongoing national and local economic issues, including uncertainties regarding the economic downturn and recovery that could have a negative impact on the ability of borrowers to repay loans during 2010. As of March 31, 2010, the allowance for loan losses totaled $2.3 million, or 1.60% of total loans, which has increased from 1.56% as of December 31, 2009. Nonaccrual loans decreased from $6.8 million at December 31, 2009 to $3.7 million at March 31, 2010. Nonperforming loans, including nonaccrual loans, decreased $3.1 million to $6.3 million over the same period. Management believes that these nonperforming loans are well collateralized, which significantly reduces the Company’s exposure to losses on the credits.

The amounts of the provision and allowance for loan losses are influenced by a number of factors, including current economic conditions, actual loss experience, industry trends and other factors, including real estate values in the Company’s market area and management’s assessment of current collection risks within the loan portfolio. Along with other financial institutions, management shares a concern for the economy for the remainder of 2010. Should the economic climate remain neutral or further deteriorate, borrowers may experience difficulty, and the level of non-performing loans, charge- offs, and delinquencies could rise and require increases in the provision. The allowance for loan losses represents management’s estimate of probable incurred losses based on information available as of the date of the financial statements. The allowance for loan losses is based on management’s evaluation of the collectibility of the loan portfolio, including past loan loss experience, known and inherent risks in the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, and economic conditions.

Management concluded that the allowance for loan losses was adequate at March 31, 2010 to cover probable losses inherent in our loan portfolio. However, there can be no assurance that the allowance for loan losses will be adequate to cover all losses.

### NON-INTEREST INCOME

The Company’s non-interest income totaled $634,000 for the three months ended March 31, 2010 compared to $801,000 for the same period in 2009, a decrease of $167,000 or 20.8%. The decrease in non-interest income was primarily due to a $205,000 decrease in gain on the sale of investment securities to $26,000 in 2010. Gain on loan sales decreased $14,000 to $78,000 in the first quarter of 2010 due to decreased mortgage refinancing activity occurring during the first three months of 2010. Service charges on deposit accounts experienced a nominal decrease of $3,000 to $195,000 for the first quarter 2010 compared to the same period of 2009. These decreases were partially offset by a $55,000 increase in other income, compared to the same period in 2009. This increase in other income resulted from an increase in rental income from other real estate owned, a gain on the sale of other real estate owned, and also from a positive market valuation associated with index powered certificates of deposit held for investment, compared to the same period in 2009.

### NON-INTEREST EXPENSE

The Company’s non-interest expense was $2.2 million for the three months ended March 31, 2010 and $2.1 million for the same period in 2009. Salaries and benefits, the largest component of non-interest expense, increased $29,000, or 2.6%, to $1.2 million. Modest decreases in occupancy and equipment expense of $5,000, and data processing expense of $13,000, were offset by increases in insurance expense of $64,000, other expenses of $54,000, and professional fees of $4,000. Insurance expense increased primarily due to expected increases in FDIC insurance for the current year. Other expenses increased primarily due to increased expenses related to other real estate owned as the amount of repossessed property has increased. In addition, income tax expense decreased $96,000 to $53,000 in 2010 compared to the same period in 2009.

### LIQUIDITY AND CAPITAL RESOURCES

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

Liquidity management is both a daily and long-term responsibility of management. The Company adjusts its investments in liquid assets based upon management’s assessment of (i) expected loan demand, (ii) expected deposit flows, (iii) yields available on interest-earning deposits and securities, and (iv) the objectives of its asset/liability management program. Excess liquid assets are invested generally in interest-earning overnight deposits and short- and intermediate-term United States government and agency obligations. The Company’s most liquid assets are cash and short-term investments. The levels of these assets are dependent on the Company’s operating, financing, lending, and investing activities during any given year. At March 31, 2010, cash and short-term investments totaled $17.7 million. The Company has other sources of liquidity if a need for additional funds arises, including securities maturing within one year and the repayment of loans. The Company may also utilize the sale of securities available-for-sale, federal funds lines of credit from correspondent banks, and borrowings from the Federal Home Loan Bank of Chicago.

The following table discloses contractual obligations and commercial commitments of the Company as of March 31, 2010:

|  | Total | Less Than 1 Year | 1 – 3 Years | 4 – 5 Years | After 5 Years |
| --- | ---: | ---: | ---: | ---: | ---: |
| Lines of credit(1) | $20,820 | $9,959 | $3,510 | $1,727 | $5,624 |
| Federal Home Loan Bank advances | 2,000 | 2,000 | — | — | — |
| Data processing contract payable | 779 | 223 | 445 | 111 | — |
| Standby letters of credit(1) | 506 | 297 | 209 | — | — |
|  | $24,105 | $12,479 | $4,164 | $1,838 | $5,624 |

(1) Represents amounts committed to customers.

### IMPACT OF INFLATION AND CHANGING PRICES

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

### SAFE HARBOR STATEMENT

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

QUANTITATIVE AND QUALITATIVE DISLOSURES ABOUT MARKET RISK

## Market risk

As filed, 176 characters.

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

CONTROLS AND PROCEDURES

## Controls and procedures

As filed, 1,563 characters.

As required by Rules 13a-15(b) and 15d-15(b) under the Securities Exchange Act of 1934, management has evaluated, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, the Chief Executive Officer and the Chief Financial Officer concluded the Company’s disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) were effective as of March 31, 2010 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. These disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

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

Filed May 14, 2010.
Source: SEC EDGAR, the filing index for accession 0001104659-10-028382. Last ingested by Listed: Oct 24, 2026, 15:02 ET. No prices; not investment advice.