Edgar Filing: PRINCETON NATIONAL BANCORP INC

pnbc_10q-093011.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended September 30, 2011

Commission File Number: 0-20050

PRINCETON NATIONAL BANCORP, INC.

(Exact name of Registrant as specified in its charter.)

Delaware	36-3210283
(State or other jurisdiction of	(I.R.S. Employer Identification Number)
incorporation or organization)

606 S. Main St.
Princeton, Illinois	61356
(Address of principal executive offices)	(Zip code)

(815) 875-4444

(Registrant’s telephone number, including area code)

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

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

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

Large accelerated filer £	Accelerated filer £	Non-accelerated filer £	Smaller reporting company R

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No R

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class	Outstanding at October 25, 2011
Common, par value $5.00	3,333,890

Part I: FINANCIAL INFORMATION

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

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

Part II: OTHER INFORMATION

Item 1A. Risk Factors

Smaller reporting companies are not required to provide the information required by this item.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

(a)

None.

Item 3. Defaults Upon Senior Securities

As previously disclosed, in the first quarter of 2011, the Corporation elected to defer regularly scheduled quarterly interest payments on its outstanding junior subordinated debentures relating to its trust preferred securities and to suspend quarterly cash dividend payments on its Series B fixed rate, cumulative perpetual preferred stock issued to the U.S. Treasury. Therefore, the Corporation is currently in arrears with the interest payments on the subordinated debentures and dividend payments on the preferred stock, as permitted by the related documentation. As of September 30, 2011, the amounts of the arrearages on the various instruments were as follows: Junior subordinated debentures: $367,000; and, Series B fixed rate, cumulative perpetual preferred stock: $941,000.

Item 4. Reserved.

Item 6. Exhibits

	31.1	Certification of Chief Executive Officer required by Rule 13a-14(a).
	31.2	Certification of Chief Financial Officer required by Rule 13a-14(a).
	32.1	Certification of Chief Executive Officer and Chief Financial Officer required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.
	101.INS**	XBRL Instance
	101.SCH**	XBRL Taxonomy Extension Schema
	101.CAL**	XBRL Taxonomy Extension Calculation
	101.DEF**	XBRL Taxonomy Extension Definition
	101.LAB**	XBRL Taxonomy Extension Labels
	101.PRE**	XBRL Taxonomy Extension Presentation

** XBRL information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.

SIGNATURES

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

PRINCETON NATIONAL BANCORP, INC.

By			By
/s/ Thomas D. Ogaard			/s/ Rodney D. Stickle
Thomas D. Ogaard			Rodney D. Stickle, CPA
President & Chief Executive Officer			Senior Vice President & Chief Financial Officer
November 10, 2011			November 10, 2011

Princeton National Bancorp, Inc.				Schedule 1
Condensed Consolidated Balance Sheets

	September 30,			December 31,
(dollars in thousands except share data)	2011			2010
	(unaudited)
ASSETS
Cash and due from banks	$	18,400		$	12,992
Interest-bearing deposits with financial institutions		65,969			30,888
Total cash and cash equivalents		84,369			43,880

Loans held-for-sale, at lower of cost or market		2,113			5,515

Investment securities:
Available-for-sale, at fair value		254,267			248,752
Held-to-maturity, at amortized cost (fair value of $11,481 and $12,472)		11,344			12,187
Total investment securities		265,611			260,939

Loans:
Loans, net of unearned interest		638,553			704,074
Allowance for loan losses		(16,511	)		(29,726	)
Net loans		622,042			674,348

Premises and equipment, net of accumulated depreciation		25,937			26,901
Land held for sale, at lower of cost or market		2,244			2,244
Federal Reserve Bank and Federal Home Loan Bank stock		4,500			4,498
Bank-owned life insurance		24,103			23,416
Accrued interest receivable		7,179			7,482
Other real estate owned		18,502			20,652
Deferred income taxes		0			10,512
Intangible assets, net of accumulated amortization		2,020			2,531
Other assets		11,163			13,553

TOTAL ASSETS	$	1,069,783		$	1,096,471

LIABILITIES
Deposits:
Demand	$	149,361		$	138,683
Interest-bearing demand		386,348			383,126
Savings		79,635			74,817
Time		323,881			366,335
Total deposits		939,225			962,961

Borrowings:
Customer repurchase agreements		54,262			35,806
Interest-bearing demand notes issued to the U.S. Treasury		1,538			1,753
Advances from the Federal Home Loan Bank		5,000			9,000
Trust preferred securities		25,000			25,000
Total borrowings		85,800			71,559

Other liabilities		5,574			5,090

TOTAL LIABILITIES		1,030,599			1,039,610

STOCKHOLDERS' EQUITY


Preferred stock: no par value, 100,000 shares authorized: 25,083 shares issued and outstanding at September 30, 2011 and December 31, 2010		25,008			24,986
Common stock: $5 par value, 7,000,000 shares authorized: 4,478,295 shares issued at September 30, 2011 and December 31, 2010		22,391			22,391
Common stock warrants		150			150
Surplus		18,221			18,275
Retained earnings (deficit)		(8,448	)		11,589
Accumulated other comprehensive income, net of tax		5,319			3,064
Less: cost of 1,144,405 and 1,152,354 treasury shares at September 30, 2011 and December 31, 2010		(23,457	)		(23,594	)

TOTAL STOCKHOLDERS' EQUITY		39,184			56,861

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY	$	1,069,783		$	1,096,471

See accompanying notes to unaudited condensed consolidated financial statements.

Princeton National Bancorp, Inc.										Schedule 2
Condensed Consolidated Statements of Income (unaudited)

	THREE MONTHS			THREE MONTHS			NINE MONTHS			NINE MONTHS
(dollars in thousands except share data)	ENDED			ENDED			ENDED			ENDED
	September 30, 2011			September 30, 2010			September 30, 2011			September 30, 2010

Interest Income:
Interest and fees on loans	$	7,874		$	9,632		$	24,919		$	30,059
Interest and dividends on investment securities:
Taxable		1,556			1,042			4,663			3,689
Tax-exempt		617			1,336			2,278			4,024
Interest on interest-bearing deposits in other banks		37			32			93			104
Total interest income		10,084			12,042			31,953			37,876

Interest Expense:
Interest on deposits		1,522			2,318			4,894			8,348
Interest on borrowings		197			479			581			1,615
Total interest expense		1,719			2,797			5,475			9,963

Net interest income		8,365			9,245			26,478			27,913

Provision for loan losses		7,975			6,725			17,900			13,300

Net interest income after provision for loan losses		390			2,520			8,578			14,613

Non-interest income:
Fiduciary and farm management fees		256			269			815			850
Service charges on deposit accounts		1,087			1,004			3,032			2,853
Other service charges		565			469			1,391			1,436
Gains on sales of securities available-for-sale		11			0			2,693			722
Brokerage fee income		148			134			494			547
Mortgage servicing rights impairment		(817	)		(333	)		(817	)		(922	)
Mortgage banking income, net		572			694			1,312			1,457
Bank-owned life insurance income		231			227			677			684
Other operating income		36			10			119			68
Total non-interest income		2,089			2,474			9,716			7,695

Non-interest expense:
Salaries and employee benefits		4,659			4,628			13,804			13,494
Occupancy		677			645			1,989			1,978
Equipment expense		754			782			2,316			2,296
Federal insurance assessments		681			603			1,768			1,835
Intangible assets amortization		144			204			513			606
Data processing		301			355			1,016			987
Marketing		151			154			445			536
Other real estate expenses, net		853			446			2,868			1,567
Loan collection expenses		563			104			1,097			492
Write-down of land held-for-sale		0			110			0			110
Other operating expense		1,306			1,016			3,941			3,248
Total non-interest expense		10,089			9,047			29,757			27,149

Loss before income taxes		(7,610	)		(4,053	)		(11,463	)		(4,841	)
Income tax expense (benefit)		11,215			(2,142	)		8,552			(3,609	)

Net loss		(18,825	)		(1,911	)		(20,015	)		(1,232	)

Dividends on preferred shares		0			314			0			941
Dividends in arrears on preferred shares		314			0			941			0
Accretion of preferred stock discount		7			7			22			21

Net loss available to common stockholders	$	(19,146	)	$	(2,232	)	$	(20,978	)	$	(2,194	)

Loss per share available to common stockholders:
Basic net loss per common share available to common stockholders	$	(5.75	)	$	(0.67	)	$	(6.30	)	$	(0.66	)
Diluted net loss per common share available to common stockholders	$	(5.75	)	$	(0.67	)	$	(6.30	)	$	(0.66	)

Basic weighted average shares outstanding		3,330,080			3,313,029			3,328,041			3,309,869
Diluted weighted average shares outstanding		3,330,080			3,313,029			3,328,041			3,309,869

See accompanying notes to unaudited condensed consolidated financial statements.

Princeton National Bancorp, Inc.																		Schedule 3
Condensed Consolidated Statements of Changes in Stockholders' Equity (unaudited)


(dollars in thousands except share data)													Accumulated
													Other
					Common					Retained			Comprehensive
For the Nine Months Ended	Preferred		Common		Stock					Earnings			Income,		Treasury
September 30, 2011	Stock		Stock		Warrants		Surplus			(Deficit)			net of tax effect		Stock			Total


Balance, January 1, 2011	$	24,986	$	22,391	$	150	$	18,275		$	11,589		$	3,064	$	(23,594	)	$	56,861

Net loss											(20,015	)							(20,015	)
Accretion on preferred stock discount		22									(22	)							0
Sale of 7,949 shares of treasury common stock								(104	)							137			33
Amortization of unearned compensation expense								50											50
Other comprehensive income net of $1,425 tax effect														2,255					2,255
Balance, September 30, 2011	$	25,008	$	22,391	$	150	$	18,221		$	(8,448	)	$	5,319	$	(23,457	)	$	39,184

For the Nine Months Ended
September 30, 2010

Balance, January 1, 2010	$	24,958	$	22,391	$	150	$	18,423		$	29,851		$	2,816	$	(23,929	)	$	74,660

Net loss											(1,232	)							(1,232	)
Dividends on preferred stock											(941	)							(941	)
Accretion on preferred stock discount		21									(21	)							0
Sale of 7,028 shares of treasury common stock								(78	)							121			43
Award of 2,000 shares of nonvested common stock out of treasury common stock								(14	)							34			20
Amortization of unearned compensation expense								66											66
Other comprehensive income net of $2,448 tax effect														3,870					3,870
Balance, September 30, 2010	$	24,979	$	22,391	$	150	$	18,397		$	27,657		$	6,686	$	(23,774	)	$	76,486

See accompanying notes to unaudited condensed consolidated financial statements.

Princeton National Bancorp, Inc.				Schedule 4
Condensed Consolidated Statements of Cash Flows (unaudited)

(dollars in thousands)	NINE MONTHS			NINE MONTHS
	ENDED			ENDED
	September 30, 2011			September 30, 2010
Operating activities:
Net loss	$	(20,015	)	$	(1,232	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation		1,422			1,577
Provision for loan losses		17,900			13,300
Deferred income tax benefit		(5,497	)		0
Valuation allowance for deferred tax assets		14,584			0
Amortization of intangible assets and other purchase accounting adjustments, net		513			606
Amortization of premiums and discounts on investment securities, net		1,188			1,178
Gains on sales of securities available-for-sale, net		(2,693	)		(722	)
Impairment of mortgage servicing rights		817			922
Compensation expense for vested stock options		50			66
(Gain) loss on sales and writedowns of other real estate owned, net		1,522			(301	)
Impairment of land held-for-sale		0			110
Loans originated for sale		(47,382	)		(75,740	)
Proceeds from sales of loans originated for sale		50,784			77,948
Decrease in accrued interest payable		(131	)		(1,358	)
Decrease in accrued interest receivable		303			1,315
Increase in other assets		882			444
Increase (decrease) in other liabilities		615			(4,375	)

Net cash provided by operating activities		14,862			13,738

Investing activities:
Proceeds from sales of investment securities available-for-sale		87,041			42,929
Proceeds from maturities of investment securities available-for-sale		15,045			27,107
Purchase of investment securities available-for-sale		(103,035	)		(5,828	)
Proceeds from maturities of investment securities held-to-maturity		1,462			200
Purchase of investment securities held-to-maturity		0			(1,690	)
Purchase of Federal Reserve Bank stock		0			(268	)
Proceeds from sales of other real estate owned		3,643			7,283
Net decrease in loans		31,391			55,789
Purchases of premises and equipment		(458	)		(417	)

Net cash provided by investing activities		35,089			125,105

Financing activities:
Net decrease in deposits		(23,736	)		(115,993	)
Net increase (decrease) in short-term borrowings		14,241			(31,771	)
Dividends paid on preferred stock		0			(941	)
Sales of treasury stock		33			43
Award of nonvested stock from treasury stock		0			20

Net cash used in financing activities		(9,462	)		(148,642	)

Increase (decrease) in cash and cash equivalents		40,489			(9,799	)
Cash and cash equivalents at beginning of period		43,880			71,073

Cash and cash equivalents at end of period	$	84,369		$	61,274


Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest	$	5,607		$	11,319
Income taxes	$	896		$	1,134

Supplemental disclosures of non-cash flow activities:
Loans transferred to other real estate owned	$	3,015		$	7,696

See accompanying notes to unaudited condensed consolidated financial statements.

Schedule 5

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

The accompanying unaudited Condensed Consolidated Financial Statements reflect all adjustments, which, in the opinion of management, are necessary for a fair presentation of the results of the interim periods ended September 30, 2011 and 2010, and all such adjustments are of a normal recurring nature. The 2010 year-end Condensed Consolidated Balance Sheet data was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles.

The unaudited Condensed Consolidated Financial Statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information required by accounting principles generally accepted in the United States of America for complete financial statements and related footnote disclosures. All adjustments are of a normal and recurring nature, except for the adoption of the amendments in Accounting Standards Update No. 2011-02, “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring,” which is described in Note 8 and Note 11 to the Condensed Consolidated Financial Statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered for a fair presentation of the results for the interim period have been included. For further information, refer to the Consolidated Financial Statements and notes included in the Registrant's 2010 Annual Report on Form 10-K. Results of operations for interim periods are not necessarily indicative of the results that may be expected for the year. Certain amounts in the 2010 Consolidated Financial Statements have been reclassified to conform to the 2011 presentation.

NOTE 1 -- CAPITAL PURCHASE PROGRAM

On January 23, 2009, the Corporation received $25,083,000 of equity capital by issuing to the United States Department of Treasury 25,083 shares of the Corporation’s 5.00% Series B Non-voting Cumulative Preferred Stock, par value $0.01 per share, with a liquidation preference of $1,000 per share and a ten-year warrant to purchase up to 155,025 shares of the Corporation’s common stock, par value $5.00 per share, at an exercise price of $24.27 per share. The proceeds received were allocated to the preferred stock and additional paid-in capital based on their relative fair values. The resulting discount on the preferred stock is amortized against retained earnings and is reflected in the Corporation’s Condensed Consolidated Statements of Income as “Dividends on preferred shares,” resulting in additional dilution to the Corporation’s earnings per share. The warrants are exercisable, in whole or in part, over a term of 10 years. The warrants were included in the Corporation’s diluted average common shares outstanding (subject to anti-dilution). Both the preferred securities and warrants were accounted for as additions to the Corporation’s regulatory Tier 1 and total capital.

The Series B Preferred Stock is not mandatorily redeemable and will pay cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. The Corporation can redeem the preferred securities at any time with Federal Reserve approval. The Series B Preferred Stock ranks on equal priority with the Corporation’s currently authorized Series A Preferred Stock.

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

On January 24, 2011, the Corporation notified the U.S. Treasury that it will defer regularly scheduled payments on the Corporation’s 25,083 shares in Series B Preferred Stock. As of September 30, 2011, dividends in arrears on preferred shares, which must be paid prior to the payment of dividends on the common shares, total approximately $941,000.

NOTE 2 -- LOSS PER SHARE

The following table sets forth the computation for basic and diluted loss per share for the periods indicated:

(in thousands, except share data)	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2011			2010			2011			2010

Numerator:
Net loss available to common stockholders	$	(19,146	)	$	(2,232	)	$	(20,978	)	$	(2,194	)

Denominator:
Basic earnings per share - weighted average common shares		3,330,080			3,313,029			3,328,041			3,309,869
Effect of dilutive securities - stock options		-			-			-			-
Diluted earnings per share - adjusted weighted average common shares		3,330,080			3,313,029			3,328,041			3,309,869

Net loss per share available to common stockholders:
Basic	$	(5.75	)	$	(0.67	)	$	(6.30	)	$	(0.66	)
Diluted	$	(5.75	)	$	(0.67	)	$	(6.30	)	$	(0.66	)

The following shares were not considered in computing diluted earnings per share for the three and nine month periods ended September 30, 2011 and 2010 because they were anti-dilutive:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2011		2010		2011		2010

Stock options to purchase shares of common stock		555,277		522,511		555,277		522,511

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

NOTE 3 -- INTANGIBLE ASSETS

The balance of intangible assets, net of accumulated amortization, totaled $2,020,000 and $2,531,000 at September 30, 2011 and December 31, 2010, respectively.

The following table summarizes the Corporation’s intangible assets, which are subject to amortization, as of September 30, 2011 and December 31, 2010:


(in thousands)	September 30, 2011					December 31, 2010
	Gross Carrying		Accumulated			Gross Carrying		Accumulated
	Amount		Amortization			Amount		Amortization

Core deposit intangible	$	9,004	$	(7,025	)	$	9,004	$	(6,522	)
Other acquisition costs		234		(193	)		234		(185	)
Total	$	9,238	$	(7,218	)	$	9,238	$	(6,707	)

Amortization expense of all intangible assets totaled $513,000 and $606,000 for the nine months ended September 30, 2011 and 2010, respectively. The amortization expense of these intangible assets will be approximately $143,000 for the remaining three months of 2011.

NOTE 4 -- ORIGINATED MORTGAGE SERVICING RIGHTS

Mortgage servicing rights, which are included in other assets on the Condensed Consolidated Balance Sheets, are accounted for on an individual loan-by-loan basis. Accordingly, amortization is recorded in proportion to the amount of principal payment received on loans serviced. The mortgage servicing rights are subject to periodic impairment testing. Changes in the carrying value of capitalized mortgage servicing rights are summarized as follows:

(in thousands)

Balance, January 1, 2011	$	3,385
Servicing rights capitalized		413
Amortization of servicing rights		(369	)
Valuation adjustment		(817	)
Balance, September 30, 2011	$	2,612

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

(in thousands)

Balance, January 1, 2011	$	295
Additions		817
Reductions		-
Balance, September 30, 2011	$	1,112

The following table shows the future estimated amortization expense for mortgage servicing rights based on existing balances as of September 30, 2011. The Corporation’s actual amortization expense in any given period may be significantly different from the estimated amounts displayed, depending on the amount of additional mortgage servicing rights, changes in mortgage interest rates, estimated prepayment speeds and market conditions.

Estimated Amortization Expense:

	Amount (in thousands)
For the three months ended December 31, 2011	$	73
For the year ending December 31, 2012		274
For the year ending December 31, 2013		257
For the year ending December 31, 2014		241
For the year ending December 31, 2015		226
For the year ending December 31, 2016		212
Thereafter		1,329

The Corporation services loans for others with unpaid principal balances at September 30, 2011 and December 31, 2010 of approximately $400.4 million and $395.0 million, respectively.

NOTE 5 -- OTHER COMPREHENSIVE INCOME

Other comprehensive income components and related taxes for the nine months ended September 30, 2011 and 2010 were as follows:


(in thousands)	2011			2010

Net unrealized gains on securities available-for-sale	$	6,373		$	7,040
Reclassification adjustment for realized gains included in income		(2,693	)		(722	)
Other comprehensive income, before tax effect		3,680			6,318
Tax expense		1,425			2,448
Other comprehensive income	$	2,255		$	3,870

The components of accumulated other comprehensive income, included in stockholders’ equity at September 30, 2011 and 2010, are as follows:


(in thousands)	2011			2010

Net unrealized gains on securities available-for-sale	$	9,213		$	11,445
Net unrealized benefit obligations		(530	)		(531	)
		8,683			10,914
Tax effect		(3,364	)		(4,228	)
Net-of-tax amount	$	5,319		$	6,686

NOTE 6 -- FEDERAL RESERVE BANK AND FEDERAL HOME LOAN BANK STOCK

The subsidiary bank held $2,373,000 in Federal Home Loan Bank stock at September 30, 2011 and December 31, 2010 and $2,127,000 and $2,125,000 in Federal Reserve Bank stock at September 30, 2011 and December 31, 2010. During the third quarter of 2007, the Federal Home Loan Bank of Chicago received a Cease and Desist Order from their regulator, the Federal Housing Finance Board. The Federal Home Loan Bank will continue to provide liquidity and funding through advances; however, the order prohibits capital stock repurchases until a time to be determined by the Federal Housing Finance Board and requires their approval for dividends. With regard to dividends, the Federal Home Loan Bank of Chicago continues to assess its dividend capacity each quarter and make appropriate request for approval. While there were no dividends paid during 2010, dividends were declared and paid in February, May and August of 2011. Management performed an analysis and deemed the cost-method investment in Federal Home Loan Bank stock was ultimately recoverable.

NOTE 7 -- INVESTMENT SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses and estimated fair value of available-for-sale and held-to-maturity securities by major security type at September 30, 2011 and December 31, 2010 were as follows:

	September 30, 2011
(in thousands)			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Available-for-sale:
United States Government and federal agency and U.S. Government sponsored enterprises (GSEs)	$	80,256	$	1,315	$	(85	)	$	81,486
State and Municipal		89,374		5,429		(61	)		94,742
Collateralized mortgage obligations: GSE residential		75,424		2,615		-			78,039
Total		245,054		9,359		(146	)		254,267
Held-to-maturity:
State and Municipal		11,344		145		(8	)		11,481
Total	$	256,398	$	9,504	$	(154	)	$	265,748

	December 31, 2010
(in thousands)			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Available-for-sale:
United States Government and federal agency and U.S. Government sponsored enterprises (GSEs)	$	77,166	$	1,671	$	(633	)	$	78,204
State and Municipal		113,308		2,730		(384	)		115,654
Collateralized mortgage obligations: GSE residential		52,746		2,148		(0	)		54,894
Total		243,220		6,549		(1,017	)		248,752
Held-to-maturity:
State and Municipal		12,187		309		(24	)		12,472
Total	$	255,407	$	6,858	$	(1,041	)	$	261,224

Securities with unrealized losses at September 30, 2011 and December 31, 2010 not recognized in income are as follows:

						September 30, 2011
(in thousands)	Less Than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses

United States government and federal agency and U.S. government-sponsored entities (GSEs)	$	8,192	$	(85	)	$	0	$	0		$	8,192	$	(85	)
State and municipal		724		(8	)		1,198		(61	)		1,922		(69	)
Temporarily impaired securities	$	8,916	$	(93	)	$	1,198	$	(61	)	$	10,114	$	(154	)

						December 31, 2010
(in thousands)	Less Than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses

United States government and federal agency and U.S. government-sponsored entities (GSEs)	$	26,238	$	(633	)	$	0	$	0		$	26,238	$	(633	)
State and municipal		20,493		(367	)		1,343		(41	)		21,836		(408	)
Temporarily impaired securities	$	46,731	$	(1,000	)	$	1,343	$	(41	)	$	48,074	$	(1,041	)

There are 15 securities in an unrealized loss position in the investment portfolio at September 30, 2011 all due to interest rate changes and not credit events. These unrealized losses are considered temporary and, therefore, have not been recognized into income because the issuers are of high credit quality and management has the intent and ability to hold for the foreseeable future and it is more likely than not that the Corporation will not be required to sell the security before recovery. The fair value is expected to recover as the investments approach their maturity date or there is a downward shift in interest rates.

Maturities of investment securities classified as available-for-sale and held to maturity were as follows at September 30, 2011:

(in thousands)	Adjusted		Fair
	Carrying Value		Value
Available-for-sale:
Due in one year or less	$	1,349	$	1,353
Due after one year through five years		17,612		18,289
Due after five years through ten years		50,699		53,598
Due after ten years		36,381		38,495
		106,041		111,735
Mortgage-backed securities		63,589		64,493
Collateralized mortgage obligations		75,424		78,039
	$	245,054	$	254,267

Held-to-maturity:
Due in one year or less	$	3,644	$	3,665
Due after one year through five years		5,327		5,435
Due after five years through ten years		2,270		2,281
Due after ten years		103		100
	$	11,344	$	11,481

Proceeds from sales of investment securities available-for sale were $87.0 million for the first nine months of 2011 compared to $52.7 million for the year ended December 31, 2010. Net gains were realized of $2,693,000 for the nine months ended September 30, 2011 and $722,000 for the year ended December 31, 2010. The carrying value of securities pledged as collateral to secure public deposits and for other purposes was $220.4 million at September 30, 2011 and $209.5 million at December 31, 2010.

NOTE 8 -- LOANS AND THE ALLOWANCE FOR LOAN LOSSES

The composition of the loan portfolio was as follows:

	September 30,		December 31,
	2011		2010

Commercial	$	61,394	$	138,325

Agricultural		59,881		78,086

Agricultural Real Estate		60,133		46,361
Commercial Real Estate		235,833		205,301
Commercial Real Estate Development		70,944		88,402
Residential Real Estate		100,552		90,869
Total Real Estate		467,462		430,933
Consumer		49,816		56,730
Total	$	638,553	$	704,074

In the third quarter of 2011, the Corporation implemented a loan reporting reclassification in which the segregation of reported loan categories was changed to a collateral focus based on regulatory reporting guidelines from a segregation based on product focus. The primary result of this reclassification in the reported composition of the loan portfolio was a shift of commercial loans that are secured by commercial real estate to be reported as commercial real estate loans rather than commercial loans. Of the $76.9 million decrease in reported commercial loans from December 31, 2010 to September 30, 2011, $53.3 million represented this reclassification to commercial real estate loans, $2.8 million to agricultural real estate loans, and $6.6 million to residential real estate loans. Also impacting this decline in the nine months ended September 30, 2011 was $3.0 million in commercial loan charge-offs and normal loan pay downs. The third quarter 2011 reclassification did not impact the calculation of the allowance for loans losses during the nine months ended September 30, 2011 as the allowance calculation was already based on a collateral focused segregation of the loan portfolio.

At September 30, 2011 and December 31, 2010, the Corporation held $204,441 and $205,301 in commercial real estate loans and $64,980 and $88,402 in commercial real estate development loans, respectively. Generally, these loans are collateralized by the real estate being financed and are expected to be repaid from cash flows or from proceeds of sale of the real estate collateral.

At September 30, 2011 and December 31, 2010, the Corporation held $67,218 and $78,086 in agricultural production loans and $50,765 and $46,361 in agricultural real estate loans, respectively. Generally, these loans are collateralized by the assets of the borrower and are expected to be repaid from cash flows or from proceeds of sale of selected assets of the borrowers.

The Corporation believes that sound loans are a necessary and desirable means of employing funds available for investment. Recognizing the Corporation’s obligations to its depositors and to the communities it serves, authorized personnel are expected to seek to develop and make sound, profitable loans that resources permit and opportunity affords. The Corporation maintains lending policies and procedures designed to focus our lending efforts on the type, location and duration of loans most appropriate for our business model and markets. The Corporation’s principal lending activity is the origination of one-to four-family residential mortgage and commercial real estate loans but also includes agricultural real estate loans, commercial business loans, agribusiness loans, multi-family loans, home equity lines of credits, consumer loans (consisting primarily of automobile loans) and, to a lesser extent, construction loans and land loans. The primary lending market includes the Illinois counties of Bureau, DeKalb, Henry, Kane, Kendall, LaSalle, McHenry and Will, as well as adjacent counties in Illinois. Generally, loans are collateralized by assets, primarily real estate, of the borrowers and guaranteed by individuals. The loans are expected to be repaid from cash flows of the borrowers or from proceeds from the sale of selected assets of the borrowers.

Management reviews and approves the Corporation’s lending policies and procedures on a regular basis. Management regularly (at least quarterly) reviews the allowance for loan losses and reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. Our underwriting standards are designed to encourage relationship banking rather than transactional banking. Relationship banking implies a primary banking relationship with the borrower that includes, at minimum, an active deposit banking relationship in addition to the lending relationship. The integrity and character of the borrower are significant factors in our loan underwriting. Tangible positive or negative evidence of the borrower’s integrity and character are evaluated as a part of loan underwriting. Additional significant underwriting factors beyond location, duration, the sound and profitable cash flow basis underlying the loan and the borrower’s character are the quality of the borrower’s financial history, the liquidity of the underlying collateral and the reliability of the valuation of the underlying collateral.

The Corporation’s policies and loan approval limits are established by the Board of Directors. The loan officers generally have authority to approve secured loans up to $100,000 and unsecured loans or exposures up to $50,000. Managing Officers (those with designated loan approval authority) generally have authority to approve secured loans up to $250,000 and unsecured loans or exposures up to $100,000. The Senior Commercial Banking Officer has authority to approve secured loans up to $750,000 and unsecured loans or exposures up to $250,000. The Chief Credit Officer has authority to approve secured loans up to $1,500,000 and unsecured loans or exposures up to $250,000. In addition, in certain circumstances any two consumer officers may combine their loan authority limits to approve a loan, while only the President and Chief Executive Officer, Chief Credit Officer and Senior Commercial Banking Manager may combine their loan authority limits to approve a commercial loan. The Executive Loan Committee may approve one-to-four family residential mortgage loans up to $2,500,000, commercial real estate loans, multi-family real estate loans and land loans up to $3,500,000, in aggregate, and unsecured loans or exposures up to $1,000,000. All loans above these limits must be approved by the Directors Loan Committee, consisting of the Chairman, the President and Chief Executive Officer and up to three other Board members. At no time will the Corporation originate a loan where a borrower's total borrowing relationship exceeds the Bank’s regulatory lending limit. Loans to related parties, including executive officers and the Corporation’s directors, are reviewed for compliance with regulatory guidelines by the Board of Directors at least annually.

The Corporation’s loan review department conducts periodic independent loan reviews of outstanding loans. The primary objective of the independent loan review function is to ensure the maintenance of a quality loan portfolio and minimize the potential for loan losses. The loan review department is responsible for reviewing a sample of existing loans for compliance with internal policies and procedures. In addition to reviewing loans for compliance, at a minimum, the loan review department analyzes the appropriateness and timeliness of risk grading and problem loan identification by loan officers, the identification of individually impaired loans, the measurement of estimated loan impairment and timeliness of charge-offs, the credit quality, including underwriting and borrower performance, and the overall adequacy of the allowance for loan and lease losses. Beginning in 2011, the Corporation began using a third party service provider to assist with the loan review functions, including the overall assessment of the loan portfolio and the identification of problem loans. Results of these reviews are presented to management and the Directors Loan Committee.

The Corporation’s lending can be summarized into six primary areas; one-to-four family residential mortgage loans, commercial real estate loans and multi-family real estate loans, home equity lines of credits, real estate construction loans, commercial business loans and consumer loans. The primary lending market includes the Illinois counties of Bureau, DeKalb, Henry, Kane, Kendall, LaSalle, McHenry and Will as well as the adjacent counties in Illinois.

One-to-Four Family Residential Mortgage Loans

The Corporation offers one-to-four family residential mortgage loans that conform to Fannie Mae and Freddie Mac underwriting standards (conforming loans) as well as non-conforming loans. In recent years there has been an increased demand for long-term fixed-rate loans, as market rates dropped and remained near historic lows. As a result, the Corporation has sold a substantial portion of fixed-rate one-to-four family residential mortgage loans with terms of 15 years or greater. Generally, the Corporation retains fixed-rate one-to-four family residential mortgage loans with terms of less than 15 years, although this has represented a small percentage of the fixed-rate loans originated in recent years due to the favorable long-term rates for borrower.

As one-to-four family residential mortgage loan underwriting is subject to specific regulations, the Corporation typically underwrites its one-to-four family residential mortgage loans to conform to generally accepted standards. Several factors are considered in underwriting including the value of the underlying real estate and the debt to income and credit history of the borrower. The Corporation has established minimum standards and underwriting guidelines for all residential real estate loan collateral types.

Commercial Real Estate and Multi-Family Real Estate Loans

Commercial real estate mortgage loans are primarily secured by office buildings, owner-occupied businesses, strip mall centers, farms and churches. In underwriting commercial real estate loans and multi-family real estate loans, the Corporation considers a number of factors which include the projected net cash flow to the loan’s debt service requirement, the age and condition of the collateral, the financial resources and income level of the borrower and the borrower’s experience in owning or managing similar properties. Personal guarantees are typically obtained from commercial real estate and multi-family real estate borrowers. In addition, the borrower’s financial information on such loans is monitored on an ongoing basis by requiring periodic financial statement updates. The repayment of these loans is primarily dependent on the cash flows of the underlying property; however, the commercial real estate loan generally must be supported by an adequate underlying collateral value. The performance and the value of the underlying property may be adversely affected by economic factors or geographical and/or industry specific factors. These loans are subject to other industry guidelines that are closely monitored by the Corporation.

Home Equity Lines of Credit

In addition to traditional one-to-four family residential mortgage loans and home equity loans, the Corporation offers home equity lines of credit that are secured by the borrower’s primary or secondary residence. Home equity lines of credit are generally underwritten using the same criteria used to underwrite one-to-four family residential mortgage loans. As home equity line of credit underwriting is subject to specific regulations, the Corporation typically underwrites its home equity lines of credit to conform to widely accepted standards. Several factors are considered in underwriting including the value of the underlying real estate and the debt to income and credit history of the borrower.

Commercial Business Loans

The Corporation originates commercial non-mortgage business (term) loans and adjustable lines of credit. These loans are generally originated to small and medium sized companies in the Corporation’s primary market area. Commercial business loans are generally used for working capital purposes or for acquiring equipment, inventory or furniture, and are primarily secured by business assets other than real estate, such as business equipment and inventory, accounts receivable or stock. The Corporation also offers agriculture loans that are not secured by real estate.

The commercial business loan portfolio consists primarily of secured loans. When making commercial business loans, the Corporation considers the financial statements, lending history and debt service capabilities of the borrower, the projected cash flows of the business and the value of collateral. The cash flows of the underlying borrower, however, may not perform consistent with historical or projected information. Further, the collateral securing the loans may fluctuate in value due to individual economic or other factors. Virtually all of our loans are guaranteed by the principals of the borrower. The Corporation has established minimum standards and underwriting guidelines for all commercial loan types.

Real Estate Construction Loans

The Corporation originates construction loans for one-to-four family residential properties and commercial real estate properties, including multi-family properties. The Corporation generally requires that a commitment for permanent financing be in place prior to closing the construction loan. The repayment of these loans is typically through permanent financing following completion of the construction. Real estate construction loans are inherently more risky than loans on completed properties as the unimproved nature and the financial risks of construction significantly enhance the risks of commercial real estate loans. These loans are closely monitored and subject to other industry guidelines.

Consumer Loans

Consumer loans consist of installment loans to individuals, primarily automotive loans. These loans are centrally underwritten utilizing the borrower’s financial history, including the Fair Isaac Corporation (“FICO”) credit scoring and information as to the underlying collateral. Repayment is expected from the cash flow of the borrower. Consumer loans may be underwritten with terms up to seven years, fully amortized. Unsecured loans are limited to twenty four months. Loan-to-value ratios vary based on the type of collateral. The Corporation has established minimum standards and underwriting guidelines for all consumer loan types.

The following table presents the balance in the allowance for loan losses and the recorded investment in loans based on portfolio segment and impairment method for the nine months ended September 30, 2011:

	Commercial			Agricultural			Agricultural Real Estate		Commercial Real Estate		Commercial Real Estate Development		Residential Real Estate		Consumer		Unallocated		Total
Allowance for Loan Losses
Balance, beginning of period	$	4,435		$	99		$	107	$	6,029	$	15,526	$	1,897	$	1,595	$	38	$	29,726
Provision charged to expense		(403	)		(34	)		374		9,189		4,781		3,548		441		4		17,900
Less: loans charged off		3,029			16			387		9,661		14,270		3,100		1,113		-0-		31,576
Recoveries		32			7			8		250		-0-		8		156		-0-		461
Balance, end of period	$	1,035		$	56		$	102	$	5,807	$	6,037	$	2,353	$	1,079	$	42	$	16,511
Ending Balance: individually evaluated for impairment	$	459		$	-0-		$	-0-	$	1,605	$	3,255	$	1,172	$	237	$	-0-	$	6,728
Ending Balance: collectively evaluated for impairment	$	576		$	56		$	102	$	4,202	$	2,782	$	1,181	$	842	$	42	$	9,783

Loans
Ending Balance	$	61,394		$	59,881		$	60,133	$	235,833	$	70,944	$	100,552	$	49,816	$	-0-	$	638,553
Ending Balance: individually evaluated for impairment	$	2,788		$	-0-		$	3,259	$	38,893	$	34,745	$	12,386	$	1,513	$	-0-	$	93,584
Ending Balance: collectively evaluated for impairment	$	58,606		$	59,881		$	56,874	$	196,940	$	36,199	$	88,166	$	48,303	$	-0-	$	544,969

The following table presents the changes in the allowance for loan losses for the three months ended September 30, 2011:

	Commercial		Agricultural			Agricultural Real Estate		Commercial Real Estate		Commercial Real Estate Development		Residential Real Estate		Consumer		Unallocated		Total
Allowance for Loan Losses
Balance, beginning of period	$	2,331	$	57		$	61	$	5,360	$	8,246	$	1,928	$	1,120	$	26	$	19,129
Provision charged to expense		1,019		(1	)		406		1,563		3,571		1,125		276		16		7,975
Less: loans charged off		2,325		-0-			365		1,366		5,780		701		383		-0-		10,920
Recoveries		10		-0-			-0-		250		-0-		1		66		-0-		327
Balance, end of period	$	1,035	$	56		$	102	$	5,807	$	6,037	$	2,353	$	1,079	$	42	$	16,511

The following table presents the balance in the allowance for loan losses and the recorded investment in loans based on portfolio segment and impairment method as of December 31, 2010:

											Commercial
						Agricultural			Commercial		Real Estate		Residential
	Commercial		Agricultural			Real Estate			Real Estate		Development		Real Estate		Consumer		Unallocated			Total
Allowance for Loan Losses
Balance, beginning of year	$	181	$	129		$	1,181		$	2,661	$	3,022	$	3,419	$	1,059	$	423		$	12,075
Provision charged to expense		9,134		(173	)		(1,054	)		4,828		25,681		745		1,774		(385	)		40,550
Less: loans charged off		4,888		-0-			68			1,460		13,177		2,267		1,306		-0-			23,166
Recoveries		8		143			48			-0-		-0-		-0-		68		-0-			267
Balance, end of year	$	4,435	$	99		$	107		$	6,029	$	15,526	$	1,897	$	1,595	$	38		$	29,726
Ending Balance: individually evaluated for impairment	$	1,004	$	-0-		$	-0-		$	3,425	$	6,906	$	484	$	426	$	-0-		$	12,245
Ending Balance: collectively evaluated for impairment	$	3,431	$	99		$	107		$	2,604	$	8,620	$	1,413	$	1,169	$	38		$	17,481

Loans
Ending Balance	$	138,325	$	78,086		$	46,361		$	205,301	$	88,402	$	90,869	$	56,730	$	-0-		$	704,074
Ending Balance: individually evaluated for impairment	$	2,085	$	-0-		$	-0-		$	18,130	$	18,334	$	3,873	$	734	$	-0-		$	43,156
Ending Balance: collectively evaluated for impairment	$	136,240	$	78,086		$	46,361		$	187,171	$	70,068	$	86,996	$	55,996	$	-0-		$	660,918

Changes in the allowance for loan losses for the nine months ended September 30, 2010 were as follows:

Balance, January 1	$	12,075
Provision for loan losses		13,300
Loans charged off		6,982
Recoveries of loans previously charged off		160
Balance, September 30	$	18,553

Changes in the allowance for loan losses for the three months ended September 30, 2010 were as follows:

Balance, July 1	$	15,975
Provision for loan losses		6,725
Loans charged off		4,193
Recoveries of loans previously charged off		46
Balance, September 30	$	18,553

Management’s opinion as to the ultimate collectability of loans is subject to estimates regarding future cash flows from operations and the value of property, real and personal, pledged as collateral. These estimates are affected by changing economic conditions and the economic prospects of borrowers.

Allowance for Loan Losses

The allowance for loan losses represents an estimate of the amount of losses believed inherent in our loan portfolio at the balance sheet date. The allowance calculation involves a high degree of estimation that management attempts to mitigate through the use of objective historical data where available. Loan losses are charged against the allowance for loan losses when management believes the uncollectability of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Overall, we believe the reserve to be consistent with prior periods and adequate to cover the estimated losses in our loan portfolio as of the reporting date.

The Corporation’s methodology for assessing the appropriateness of the allowance for loan losses consists of two key elements: (1) specific allowances for estimated credit losses on individual loans that are determined to be impaired through the Corporation’s review for identified problem loans; and (2) a general allowance based on estimated credit losses inherent in the remainder of the loan portfolio.

The specific allowance is measured by determining the present value of expected cash flows, the loan’s observable market value, or for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expense. Factors used in identifying a specific problem loan include: (1) the strength of the customer’s personal or business cash flows; (2) the availability of other sources of repayment; (3) the amount due or past due; (4) the type and value of collateral; (5) the strength of the collateral position; (6) the estimated cost to sell the collateral; and (7) the borrower’s effort to cure the delinquency. For loans secured by real estate, the Corporation also considers the extent of any past due and unpaid property taxes applicable to the property serving as collateral on the mortgage.

The Corporation establishes a general allowance for loans that are not deemed impaired to recognize the inherent losses associated with lending activities, but which, unlike the specific allowance, has not been allocated to particular problem assets. The general valuation allowance is determined by segregating the loans by loan category and assigning allowance percentages based on the Corporation’s historical loss experience, delinquency trends and management’s evaluation of the collectability of the loan portfolio. The allowance is then adjusted for significant factors that, in management’s judgment, affect the collectability of the portfolio as of the evaluation date. These significant factors may include: (1) changes in the value of the underlying collateral; (2) management’s assumptions regarding the minimal level of risk for a given loan category; (3) changes in lending policies and procedures, including changes in underwriting standards and charge-off and recovery practices not considered elsewhere in estimating credit losses; (4) changes in international, national, regional and local economics and business conditions, and developments that affect the collectability of the portfolio, including the conditions of various market segments; (5) changes in the nature and volume of the portfolio and in the terms of loans; (6) changes in the experience, ability and depth of the loan officers and other relevant staff; (7) changes in the volume and severity of past due loans, the volume of non-accrual loans and the volume and severity of adversely classified loans; (8) changes in the quality of the loan review system; (9) changes in the value of the underlying collateral for collateral-dependent loans; (10) the existence and effect of any concentrations of credit and changes in the level of such concentrations; and (11) the effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio.

The applied loss factors are evaluated quarterly to ensure their relevance in the current environment.

Although the Corporation’s policy allows for a general valuation allowance on certain smaller-balance, homogenous pools of loans classified as substandard, the Corporation has historically evaluated every loan classified as substandard, regardless of size, for impairment as part of the review for establishing specific allowances. The Corporation’s policy also allows for general valuation allowance on certain smaller-balance, homogenous pools of loans which are loans criticized as special mention or watch. A separate general allowance calculation is made on these loans based on historically measured weakness, and which is no less than twice the percentage of the general allowance calculation on the non-classified loans.

There have been no significant changes to the Corporation’s accounting policies or methodology from the prior periods.

The following tables present the credit risk profile of the Corporation’s loan portfolio based on rating category and payment activity as of September 30, 2011:

Commercial Credit Exposure: Credit Risk Profile by Creditworthiness Category

										Commercial
						Agricultural		Commercial		Real Estate
Risk Rating:		Commercial		Agricultural		Real Estate		Real Estate		Development		Total
	1-2	$	5,162	$	20,594	$	16,944	$	17,394	$	486	$	60,580
	3		27,420		30,193		24,864		87,176		8,471		178,124
	4		20,188		8,070		11,645		54,147		1,568		95,618
	5		1,747		545		2,605		24,235		16,160		45,292
	6		6,772		479		4,075		52,881		37,151		101,358
	7		105		-0-		-0-		-0-		7,108		7,215
Total		$	61,394	$	59,881	$	60,133	$	235,833	$	70,944	$	488,185

Consumer Credit Exposure: Credit Risk Profile by Creditworthiness Category

	Residential
Risk Rating:	Real Estate		Consumer		Total
Pass	$	85,049	$	46,627	$	131,676
Special Mention		1,296		187		1,483
Substandard		14,005		3,002		17,007
Doubtful		202		0		202
Total	$	100,552	$	49,816	$	150,368

The following tables present the credit risk profile of the Corporation’s loan portfolio based on rating category and payment activity as of December 31, 2010:

Commercial Credit Exposure: Credit Risk Profile by Creditworthiness Category

										Commercial
						Agricultural		Commercial		Real Estate
Risk Rating:		Commercial		Agricultural		Real Estate		Real Estate		Development		Total
	1-2	$	3,921	$	12,680	$	5,346	$	5,676	$	52	$	27,675
	3		90,147		41,653		27,742		101,219		13,631		274,392
	4		23,495		17,319		9,195		29,985		8,744		88,738
	5		3,370		2,994		3,385		25,814		22,414		57,977
	6		17,392		3,440		693		42,607		43,561		107,693
	7		-0-		-0-		-0-		-0-		-0-		-0-
Total		$	138,325	$	78,086	$	46,361	$	205,301	$	88,402	$	556,475

Consumer Credit Exposure: Credit Risk Profile by Creditworthiness Category

	Residential
Risk Rating:	Real Estate		Consumer		Total
Pass	$	81,504	$	53,958	$	135,462
Special Mention		314		147		461
Substandard		9,051		2,539		11,590
Doubtful		-0-		86		86
Total	$	90,869	$	56,730	$	147,599

Credit Quality Indicators

The Corporation categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information and current economic trends among other factors. The Corporation analyzes loans individually by classifying the loans according to credit risk. This analysis is performed on all loans at origination. Subsequently, a majority of analyses are reviewed on an annual basis by Risk Management and a third party service provider and rating changes are made as necessary. Interim reviews are performed if borrower circumstances warrant a more timely review.

The Corporation has established a uniform internal risk rating methodology for commercial loans utilizing risk grades from 1 through 7, with 1 being considered “excellent” and 7 being considered “doubtful.” A summary of the general definitions for the risk ratings follows:

Prime Quality: This category includes all obligors whose balance sheet, current position, capitalization, profitability and cash flow have been demonstrated to be consistently of such high quality that the potential for significant disruption in their financial performance is virtually nonexistent. Such borrowers have excellent management in place with depth, well defined and established product lines or services, and operate businesses generally isolated from the normal influences of the business cycle.

2	High Quality: Borrowers assigned this rating are considered above average with high quality and excellent credit standards based on leverage, liquidity and debt coverage ratios, as well as having excellent management in critical areas.

3	Satisfactory “Average” Quality: This category includes borrowers that have average leverage, liquidity and debt service ratios that compare favorably with industry standards.

4	Low Pass: This risk rating includes borrowers that have below average leverage, liquidity and debt service coverage ratios and management that may not be as solid on a historical basis or may compare less favorably with industry standards but are still considered acceptable.

Watch/Special Mention (OAEM): A borrower assigned to this rating category exhibits potential weaknesses or early warning signals that deserve close monitoring by management. If left uncorrected, these potential weaknesses may result in the borrower being unable to meet its financial obligations at some future date.

Substandard: A substandard rating is assigned to a borrower whose credit is inadequately protected by the paying capacity of the borrower, or by the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. These credits are characterized by the distinct possibility that the Corporation will sustain some loss if deficiencies are not corrected.

Doubtful: Borrowers assigned to this rating category have all of the weaknesses inherent in a substandard rating with the added factor that the weaknesses are pronounced to the point where, on the basis of current facts, conditions and values, collection or liquidation in full is highly questionable or improbable. While the possibility of loss is extremely high, the existence of specific pending factors, which may work to the borrower’s advantage, warrants that the estimated loss be deferred until a more exact status can be determined.

The Corporation classifies consumer loans in the risk rating classifications of Pass, Special Mention, Substandard and Doubtful. These classifications generally conform to the risk rating methodology for commercial loans as follows: Pass - risk rating 1 through 4; Special Mention - risk rating 5; Substandard - risk rating 6; Doubtful - risk rating 7.

The accrual of interest on loans is discontinued at the time the loan is 90 days past due unless the credit is well-secured and in process of collection. Past due status is based on contractual terms of the loan. In all cases, loans are placed on non-accrual or charged-off at the earlier date if collection of principal and interest is considered doubtful.

All interest accrued but not collected for loans that are placed on non-accrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

The following table presents the Corporation’s loan portfolio aging analysis as of September 30, 2011:

	30-59 Days		60-89 Days		>90 Days		Total		Total		Total
	Past Due		Past Due		Past Due		Past Due		Current		Loans
Commercial	$	434	$	287	$	1,066	$	1,787	$	57,990	$	59,777
Agricultural		-0-		-0-		-0-		-0-		59,881		59,881
Agricultural Real Estate		-0-		29		-0-		29		56,845		56,874
Commercial Real Estate		3,878		493		1,576		5,947		197,412		203,359
Commercial Real Estate Development		202		-0-		-0-		202		36,191		36,393
Residential Real Estate		577		1,337		-0-		1,914		89,320		91,234
Consumer		540		515		-0-		1,055		47,908		48,963
Non-Accrual		4,408		625		72,676		77,709		4,363		82,072
Total	$	10,039	$	3,286	$	75,318	$	88,643	$	549,910	$	638,553

The following table presents the Corporation’s loan portfolio aging analysis as of December 31, 2010:

	30-59 Days		60-89 Days		>90 Days		Total		Total		Total
	Past Due		Past Due		Past Due		Past Due		Current		Loans
Commercial	$	2,221	$	420	$	222	$	2,863	$	126,621	$	129,484
Agricultural		284		-0-		-0-		284		75,892		76,176
Agricultural Real Estate		249		-0-		-0-		249		45,667		45,916
Commercial Real Estate		3,288		1,324		1,140		5,752		173,890		179,642
Commercial Real Estate Development		669		-0-		-0-		669		50,642		51,311
Residential Real Estate		4,340		1,601		199		6,140		77,970		84,110
Consumer		681		156		-0-		837		55,176		56,013
Non-Accrual		846		8,390		53,393		62,629		18,793		81,422
Total	$	12,578	$	11,891	$	54,954	$	79,423	$	624,651	$	704,074

A loan is considered impaired, in accordance with the impairment accounting guidance (ASC 310-10-35-16), when based on current information and events it is probable the Corporation will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loans and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed.

Impairment is measured on a loan-by-loan basis by either the present value of the expected future cash flows, the loan’s observable market value or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses. Significant restructured loans are considered impaired in determining the adequacy of the allowance for loan losses.

Impaired loans include non-performing loans but also include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection. The Corporation will restructure loans when the borrower demonstrates the inability to comply with the terms of the loan, but can demonstrate the ability to meet acceptable restructured terms. Restructured loans in compliance with modified terms are classified as impaired.

The Corporation actively seeks to reduce its investment in impaired loans. The primary tools to work through impaired loans are settlement with the borrowers or guarantors, foreclosure of the underlying collateral or restructuring.

The following table presents impaired loans as of September 30, 2011:

							Nine Months				Three Months
							Ended				Ended
							Average				Average
			Unpaid				Investment		Interest		Investment		Interest
	Recorded		Principal		Specific		in Impaired		Income		in Impaired		Income
	Balance		Balance		Allowance		Loans		Recognized		Loans		Recognized
With no related allowance recorded:
Commercial	$	2,192	$	2,878	$	-0-	$	6,040	$	41	$	5,965	$	18
Commercial Real Estate		35,268		44,107		-0-		24,086		40	$	30,560	$	27
Commercial Real Estate Development		25,849		39,838		-0-		26,272		74	$	25,740	$	28
Residential Real Estate		8,345		10,291		-0-		6,513		18	$	7,360	$	10
Consumer		1,076		1,192		-0-		538		11	$	867	$	8
With an allowance recorded:
Commercial	$	597	$	845	$	459	$	1,253	$	5	$	2,080	$	3
Commercial Real Estate		6,883		6,883		1,605		12,507		160	$	7,014	$	77
Commercial Real Estate Development		8,896		18,571		3,255		13,702		77	$	11,805	$	4
Residential Real Estate		4,041		4,131		1,172		3,957		28	$	3,783	$	15
Consumer		437		437		237		603		4	$	423	$	1
Total:
Commercial	$	79,685	$	113,122	$	5,319	$	83,858	$	397	$	83,163	$	157
Residential	$	12,386	$	14,422	$	1,172	$	10,470	$	46	$	11,143	$	25
Consumer	$	1,513	$	1,629	$	237	$	1,141	$	15	$	1,290	$	9

The following table presents impaired loans as of December 31, 2010:

							Average
			Unpaid				Investment		Interest
	Recorded		Principal		Specific		in Impaired		Income
	Balance		Balance		Allowance		Loans		Recognized
With no related allowance recorded:
Commercial	$	9,887	$	11,660	$	-0-	$	5,874	$	36
Commercial Real Estate		12,903		13,220		-0-		8,915		480
Commercial Real Estate Development		26,695		36,909		-0-		21,573		225
Residential Real Estate		4,680		5,306		-0-		5,591		96
Consumer		-0-		-0-		-0-		-0-		-0-
With an allowance recorded:
Commercial	$	1,908	$	2,095	$	1,004	$	1,384	$	59
Commercial Real Estate		18,130		18,130		3,425		9,065		77
Commercial Real Estate Development		18,507		18,507		6,906		14,444		428
Residential Real Estate		3,873		3,873		484		3,505		82
Consumer		768		735		426		679		14
Total:
Commercial	$	88,030	$	100,521	$	11,335	$	61,254	$	1,305
Residential	$	8,553	$	9,179	$	484	$	9,096	$	178
Consumer	$	768	$	735	$	426	$	679	$	14

Included in certain loan categories in the impaired loans are troubled debt restructurings, where economic concessions have been granted to borrowers who have experienced financial difficulties that were classified as impaired. These concessions typically result from our loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Troubled debt restructurings are considered impaired at the time of restructuring and typically are returned to accrual status after considering the borrower’s sustained repayment performance, as agreed, for a reasonable period of at least six months, or once the granted concessions have ended or are no longer applicable.

When a loan is modified into a troubled debt restructuring, the Corporation evaluates any possible impairment similar to other impaired loans based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan agreement, and uses the current fair value of the collateral, less selling costs for collateral dependent loans. If the Corporation determines that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance for loan losses. In periods subsequent to modification, the Corporation evaluates all troubled debt restructurings, including those that have payment defaults, for possible impairment and recognizes impairment through the allowance for loan losses.

During the quarter ended September 30, 2011, the Corporation adopted ASU 2011-02, “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.” The amendments in ASU 2011-02 require prospective application of the impairment measurement guidance in ASC 310-10-35 for those receivables newly identified as impaired. As a result of adopting ASU 2011-02, the Corporation reassessed all restructurings that occurred on or after January 1, 2011, the beginning of our current fiscal year, for identification as troubled debt restructurings. The Corporation identified no loans as troubled debt restructurings for which the allowance for loan losses had previously been measured under a general allowance for credit losses methodology. Therefore, there was no additional impact to the allowance for loan losses as a result of the adoption.

The following tables present the recorded balance of troubled debt restructurings as of September 30, 2011 and December 31, 2010:

	September 30, 2011
				Troubled debt restructurings
		Total		performing in accordance				Troubled debt restructurings
		Troubled Debt		with modified terms				not performing in accordance
		Restructurings		Accruing		Nonaccrual		with modified terms

Commercial		$	937	$	0	$		$	937
Agricultural			0		0		0		-
Agricultural Real Estate			0		0		0		-
Commercial Real Estate			14,869		4,842		0		10,027
Commercial Real Estate Development			2,711		45		0		2,666
Residential Real Estate			3,325		2,768		288		269
Consumer			188		145		43		-
Total			22,030		7,800		331		13,899

	December 31, 2010
				Troubled debt restructurings
		Total		performing in accordance				Troubled debt restructurings
		Troubled Debt		with modified terms				not performing in accordance
		Restructurings		Accruing		Nonaccrual		with modified terms

Commercial		$	0	$	0	$	0	$	0
Agricultural			0		0		0		-
Agricultural Real Estate			0		0		0		-
Commercial Real Estate			16,091		6,327		0		9,764
Commercial Real Estate Development			5,293		5,293		0		-
Residential Real Estate			1,570		875		545		150
Consumer			432		320		43		69
Total			23,386		12,815		588		9,983

The following table presents loans modified as troubled debt restructurings during the three and nine month periods ended September 30, 2011:

	Three Months Ended				Nine Months Ended
	Number of		Recorded		Number of		Recorded
	Modifications		Investment		Modifications		Investment
Commercial		0	$	0		1	$	937
Agricultural		0		0		0		0
Agricultural Real Estate		0		0		0		0
Commercial Real Estate		0		0		0		0
Commercial Real Estate Development		0		0		0		0
Residential Real Estate		0		0		10		1,876
Consumer		0		0		0		0
Total		0	$	0		11	$	2,813

During the nine month period ended September 30, 2011, the Corporation modified ten residential real estate loans with a recorded investment of $1,876,000 prior to modification which were deemed troubled debt restructurings. A total of eight modifications totaling $1,480,000 were in conjunction with the Federal Home Affordable Modification program (HAMP). These modifications generally involved a reduction in the contractual interest rate or an adjusted loan amortization schedule. One of the modifications, with a recorded investment of $239,000 was completed outside of the HAMP program and resulted in a reduction of the contractual interest rate and extension of the loan’s maturity date. Also, one of the modifications with a recorded investment of $157,000 was completed to defer principal payment for a period of one year. Of these residential troubled debt restructurings, four were considered to be collateral dependent, and the modifications resulted in the recording of a specific allowance of $227,000, based upon the fair value of the collateral.

In addition, the Corporation modified one commercial loan during the period ended September 30, 2011 which had a recorded investment of $937,000 prior to modification and was deemed a troubled debt restructuring. The Corporation modified the loan payment terms to grant an interest only payment period. Based on the fair value of the collateral, no specific reserve was determined necessary for this loan.

Specific loss allowances are included in the calculation of estimated future loss ratios, which are applied to the various loan portfolios for purposes of estimating future losses. Management considers the level of defaults within the various portfolios when evaluating qualitative adjustments used to determine the adequacy of the allowance for loan losses.

During the nine month period ended September 30, 2011, seven out of a total of thirty-one troubled debt restructuring loans held by the Corporation were either charged down or charged off by a total of $2,774,000. These loans were primarily commercial real estate or commercial real estate development loans. Since these loans were collateral dependent, they were written down to the fair market value of the collateral minus estimated selling costs.

Interest income recognized on impaired loans includes interest accrued and collected on the outstanding balances of accruing impaired loans as well as interest cash collections on non-accruing impaired loans for which the ultimate collectability is not certain.

The following table presents the Corporation’s non-accrual loans at September 30, 2011 and December 31, 2010. This table excludes accruing troubled debt restructurings.

	September 30,		December 31,
	2011		2010
Commercial	$	1,616	$	8,841
Agricultural		0		1,910
Agricultural Real Estate		3,259		444
Commercial Real Estate		32,474		25,659
Commercial Real Estate Development		34,551		37,091
Residential Real Estate		9,318		6,760
Consumer		854		717
Total	$	82,072	$	81,422

NOTE 9 -- FAIR VALUE OF ASSETS AND LIABILITIES

ASC 820, “Fair Value Measurements,” defines the fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

In accordance with ASC 820, the Corporation groups its financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1

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

Level 2

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

Level 3

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

Following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized on the accompanying Condensed Consolidated Balance Sheet.

Available-for-Sale Securities

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

The following table presents the Corporation’s assets that are measured at fair value on a recurring basis and the level within the ASC 820 hierarchy in which the fair value measurements fall as of September 30, 2011 and December 31, 2010 (in thousands):

September 30, 2011	Fair Value Measurements Using
(in thousands)			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Fair Value		(Level 1)		(Level 2)		(Level 3)

Available-for-sale securities
United States Government and federal agency and U.S. Government sponsored enterprises (GSEs)	$	81,486	$	-	$	81,486	$	-
State and Municipal		94,742		-		94,742		-
Collateralized mortgage obligations:		-		-		-		-
GSE Residential		78,039		-		78,039		-
Total	$	254,267	$	-	$	254,267	$	-

December 31, 2010	Fair Value Measurements Using
(in thousands)			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Fair Value		(Level 1)		(Level 2)		(Level 3)

Available-for-sale securities
United States Government and federal agency and U.S. Government sponsored enterprises (GSEs)	$	78,204	$	-	$	78,204	$	-
State and Municipal		115,654		-		115,654		-
Collateralized mortgage obligations:		-		-		-		-
GSE Residential		54,894		-		54,894		-
Total	$	248,752	$	-	$	248,752	$	-

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

Impaired Loans (Collateral Dependent) - Loans for which it is probable that the Corporation will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amount of impairment include estimating the fair value of the collateral for collateral dependent loans.

If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value.

Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method. Fair value adjustments on impaired loans were $51,089 for the nine months ended September 30, 2011, $3,304 for the three months ended September 30, 2011, and $16,040 for the year ended December 31, 2010.

Mortgage Servicing Rights - The fair value used to determine the valuation allowance is estimated using discounted cash flow models. The valuation models incorporate assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. These variables change from quarter to quarter as market conditions and projected interest rates change and may have an adverse impact on the value of the mortgage servicing rights and may result in a reduction to non-interest income. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the hierarchy.

Other Real Estate Owned - Other real estate owned acquired through loan foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate and is classified within Level 3 of the hierarchy. If it is determined the fair value declines subsequent to foreclosure, a valuation allowance is recorded through non-interest expense. Operating costs associated with the assets after acquisition are also recorded as non-interest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to non-interest expense. Fair value adjustments on other real estate owned were $3,032 for the nine months ended September 30, 2011, $3,163 for the three months ended September 30, 2011 and $14,759 for the year ended December 31, 2010.

The following table presents the fair value measurement of assets measured at fair value on a nonrecurring basis and the level within the ASC 820 fair value hierarchy in which the fair value measurements fall at September 30, 2011 and December 31, 2010 (in thousands):

September 30, 2011
(in thousands)			Fair Value Measurements Using
			Quoted Prices in				Significant
			Active Markets for		Significant Other		Unobservable
			Identical Assets		Observable Inputs		Inputs
	Fair Value		(Level 1)		(Level 2)		(Level 3)

Impaired loans (collateral dependent)	$	81,845		-		-	$	81,845
Mortgage servicing rights		2,612		-		-		2,612
Other real estate owned		5,931		-		-		5,931

December 31, 2010
(in thousands)			Fair Value Measurements Using
			Quoted Prices in				Significant
			Active Markets for		Significant Other		Unobservable
			Identical Assets		Observable Inputs		Inputs
	Fair Value		(Level 1)		(Level 2)		(Level 3)

Impaired loans (collateral dependent)	$	30,756		-		-	$	30,756
Mortgage servicing rights		3,385		-		-		3,385
Other real estate owned		2,899		-		-		2,899

ASC 825, "Disclosures about Fair Value of Financial Instruments," requires all entities to disclose the estimated fair value of their financial instrument assets and liabilities. For the Corporation, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in ASC 825. Many of the Corporation's financial instruments, however, lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction. It is also the Corporation's general practice and intent to hold its financial instruments to maturity and to not engage in trading or sales activities except for loans held-for-sale and available-for-sale securities. Therefore, significant estimations and assumptions, as well as present value calculations, are used by the Corporation for the purposes of this disclosure.

Estimated fair values have been determined by the Corporation using the best available data and an estimation methodology suitable for each category of financial instruments. For those loans and deposits with floating interest rates, it is presumed that estimated fair values generally approximate the recorded book balances. The estimation methodologies used, the estimated fair values and the recorded book balances at September 30, 2011 and December 31, 2010, are as follows:

	September 30, 2011				December 31, 2010
	Carrying		Fair		Carrying		Fair
(in thousands)	Value		Value		Value		Value
Financial Assets:

Cash and due from banks	$	18,400	$	18,400	$	12,992	$	12,992
Interest-bearing deposits in financial institutions		65,969		65,969		30,888		30,888
Investment securities		265,611		265,748		260,939		261,224
Loans, net, including loans held for sale		624,155		628,250		679,863		684,438
Accrued interest receivable		7,179		7,179		7,482		7,482
Total financial assets	$	981,314	$	985,546	$	992,164	$	997,024

Financial Liabilities:

Non-interest bearing demand deposits	$	149,361	$	149,361	$	138,683	$	138,683
Interest-bearing deposits		789,864		792,460		824,278		827,266
Borrowings		85,800		85,848		71,559		71,615
Accrued interest payable		1,204		1,204		1,335		1.335
Total financial liabilities	$	1,026,229	$	1,028,873	$	1,035,855	$	1,038,899

Unrecognized financial instruments (net of contract amount)
Commitments to originate loans	$	-	$	-	$	-	$	-
Lines of credit		-		-		-		-
Letters of credit		-		-		-		-

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

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

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

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

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

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

The Corporation's remaining assets and liabilities, which are not considered financial instruments, have not been valued differently than has been customary with historical cost accounting. No disclosure of the relationship value of the Corporation's core deposit base is required by ASC 825.

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

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

NOTE 10 -- INCOME TAXES

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

(in thousands)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2011			2010			2011			2010

Computed "expected" tax benefit	$	(2,587	)	$	(1,265	)	$	(3,897	)	$	(1,533	)

Increase (decrease) in income taxes resulting from:

Tax-exempt income		(197	)		(464	)		(807	)		(1,388	)

State income tax, before valuation allowance, net of federal tax effect		(495	)		(53	)		(1,122	)		(157	)

Bank-owned life insurance income		(79	)		(77	)		(234	)		(236	)

Establishment of valuation allowance for net deferred tax assets		14,584			-			14,584			-

Other, net		(11	)		(283	)		28			(295	)

Actual tax benefit	$	11,215		$	(2,142	)	$	8,552		$	(3,609	)

Under generally accepted accounting principles, income tax benefits and the related tax assets are only allowed to be recognized if they will “more likely than not” be realized. The Corporation did not record a valuation allowance in previous quarters due to the weight of all positive evidence overcoming the negative evidence. However, during the third quarter of 2011, due to the negative evidence of a cumulative loss in the most recent three year period and earnings forecasts revised downward from previous quarters forecasts due to acceleration of provision for loan losses, loan collection and other real estate owned expenses, the Corporation has determined that a valuation allowance against deferred tax assets should be recorded as of September 30, 2011. As a result, as of September 30, 2011, the carrying value of the Corporation’s deferred tax assets has been reduced to zero through the recognition of a $14,584,000 valuation allowance.

NOTE 11 -- IMPACT OF NEW ACCOUNTING STANDARDS

In April 2011, FASB issued ASU No. 2011-02 “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (“TDR”).” ASU No. 2011-02 is intended to provide additional guidance to assist creditors in determining whether a restructuring of a receivable meets the criteria to be considered a troubled debt restructuring. The amendments in this ASU are effective for the first interim or annual period beginning on or after June 15, 2011, and are to be applied retrospectively to the beginning of the annual period of adoption. As a result of applying these amendments, an entity may identify receivables that are newly considered impaired. Early adoption is permitted. The Corporation adopted the methodologies prescribed by this ASU as of July 1, 2011.

In April 2011, FASB issued ASU No. 2011-03 “Reconsideration of Effective Control for Repurchase Agreements.” The amendments in this ASU remove from the assessment of effective control the criterion relating to the transferor’s ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee. The amendments in this ASU also eliminate the requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets. The guidance in this ASU is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The Corporation will adopt the methodologies prescribed by this ASU by the date required and does not anticipate that the ASU will have a material effect on its financial position or results of operations.

In May 2011, FASB issued ASU No. 2011-04 “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The amendments in this ASU generally represent clarifications of Topic 820, but also include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This ASU results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRSs. The amendments in this ASU are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. Early application by public entities is not permitted. The Corporation will adopt the methodologies prescribed by this ASU by the date required and does not anticipate that the ASU will have a material effect on its financial position or results of operations.

In June 2011, FASB issued ASU No. 2011-05 “Amendments to Topic 220, Comprehensive Income.” Under the amendments in this ASU, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments in this ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The amendments in this ASU should be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted, because compliance with the amendments is already permitted. The amendments do not require any transition disclosures. The Corporation intends to adopt the disclosures prescribed by this ASU by the date required.

In September 2011, FASB issued ASU No. 2011-08 “Intangibles – Goodwill and Other.” This ASU provides an entity with the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. If an entity concludes that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, the entity is required to perform the first step of the two-step impairment test. If the carrying amount of the reporting unit exceeds the fair value, then the entity must perform the second step of the two-step evaluation process. This ASU is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011 with early adoption permitted. The Corporation will adopt the methodologies prescribed by this ASU by the date required and does not anticipate that the ASU will have a material effect on its financial position or results of operations.

In September 2011, FASB issued ASU No. 2011-09 “Compensation – Retirement Benefits – Multiemployer Plans: Disclosures about an Employer’s Participation in a Multiemployer Plan.” This ASU requires employers that participate in multiemployer pension plans to provide additional quantitative and qualitative disclosures including: the significant multiemployer plans in which an employer participates, the level of participation in the significant plans including the contribution to the plans and whether the employer’s contributions represent more than five percent of total contributions to the plan by all participants, the funding status of the plans and if a funding improvement plan is pending or implemented and related surcharges on contributions to the plan, and the nature of employer commitments to the plan. This ASU is effective for public entities for annual periods ending after December 15, 2011 with early adoption permitted. The provisions of ASU No. 2011-09 will not have a significant impact on the Corporation’s Condensed Financial Statements.

NOTE 12 -- REGULATORY MATTERS

On September 20, 2011, the Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (the “Consent Order”) with the Office of the Comptroller of the Currency (the “OCC”). Pursuant to the Consent Order, the Bank has agreed to take certain actions and operate in compliance with the Consent Order’s provisions during its term.

Under the terms of the Consent Order, the Bank is required to, among other things: (i) adopt and adhere to a three-year written strategic plan that establishes objectives for the Bank’s overall risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, reduction in non-performing assets and its product development; (ii) adopt and maintain a capital plan; (iii) by December 19, 2011, achieve and thereafter maintain a Tier 1 capital ratio of at least 8% and a total risk-based capital ratio of at least 12%; (iv) seek approval of the OCC prior to paying dividends on its capital stock; (v) develop a program to reduce the Bank’s credit risk; (vi) take certain actions related to credit and collateral exceptions; (vii) reaffirm the Bank’s liquidity risk management program; and (viii) appoint a compliance committee of the Board of Directors to help ensure the Bank’s compliance with the Consent Order. The Bank is also required to submit certain regular reports with respect to the foregoing requirements.

On October 27, 2011, the Corporation entered into a Written Agreement with the Federal Reserve Bank (the “FRB”). Pursuant to the Written Agreement, the Corporation has agreed to take certain actions and operate in compliance with the Written Agreement’s provisions during its term.

Under the terms of the Written Agreement, the Corporation is required to, among other things: (i) serve as a source of strength to the Bank, including taking steps to ensure that the Bank complies with the Consent Order it entered into with the OCC on September 20, 2011, and any other supervisory action taken by the Bank’s federal regulator; (ii) refrain from declaring or paying any dividend, or taking dividends or other payments representing a reduction in the Bank’s capital, each without the prior written consent of the FRB and the Director of the Division of Banking Supervision and Regulation (the “Director”) of the Board of Governors of the Federal Reserve System; (iii) refrain from making any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior approval of the FRB and the Director; (iv) refrain from incurring, increasing, or guaranteeing any debt, and from purchasing or redeeming any shares of its capital stock, each without the prior approval of the FRB; (v) provide the FRB with a written plan to maintain sufficient capital at the Corporation on a consolidated basis; (vi) provide the FRB with a projection of the Corporation’s planned sources and uses of cash; (vii) comply with certain regulatory notice provisions pertaining to the appointment of any new director or senior executive officer, or the changing of responsibilities of any senior executive officer; and (viii) comply with certain regulatory restrictions on indemnification and severance payments. The Corporation is also required to submit certain reports to the FRB with respect to the foregoing requirements.

The Consent Order replaced the previously disclosed formal written agreement entered into by the Bank with the OCC on March 15, 2010. The formal written agreement had set forth the Bank’s commitment to; (i) review and take action as necessary regarding its allowance for loan losses; (ii) improve the Bank’s asset quality through the development of workout plans for criticized assets and the assessment of credit risk; and (iii) revise the Bank’s credit risk rating management information system.

The Bank and the Corporation have taken steps to address the issues raised in the Consent Order, the Written Agreement and the previously disclosed formal written agreement, and intend to fully comply with the requirements set forth in each.

Pursuant to the previously disclosed formal written agreement, the Bank’s Board of Directors has reviewed the adequacy of the allowance for loan losses and established a program for the maintenance of an adequate allowance. The Bank also took immediate action to protect its interest in criticized assets and to adopt individual written workout plans with respect to such assets. A copy of the workout plans is provided to the OCC on a quarterly basis for any criticized asset equal to or exceeding $100,000. The Board of Directors ensures that the Bank’s internal ratings of loan relationships are timely, accurate and consistent with the regulatory credit classification criteria established by the OCC.

In the fourth quarter of 2010, the Bank filled a newly created role of Chief Credit Officer and established a credit administration division to oversee the development, maintenance and monitoring of loan policies and procedures. Other responsibilities of the credit administration division include credit analysis, credit risk management, loan servicing and administration, collections and the special assets group, as well as loan portfolio analysis and the allowance for loan losses. The functions of the special assets group include loss mitigation and workout of non-performing loans, liquidation of non-performing assets and other responsibilities to accelerate and maximize loan recoveries. As part of establishing the new credit administration division and improving internal controls, the Bank’s Chief Credit Officer identified and engaged experienced personnel to fill key roles within credit administration.

In 2010, the internal loan review staff, and the scope of their reviews, was expanded. Considerable progress was achieved in meeting the expanded loan review scope and evaluating and verifying internal loan ratings on a timely basis consistent with credit classification criteria set forth in the Comptroller's Handbook. Loan review grading methodology was refined to ensure that loans with a probability of payment default or well defined weaknesses are graded substandard regardless of mitigating controls which might reduce credit risk. The Directors’ Loan Committee monitored this process with bi-monthly meetings and reviewed loan review reports to ensure compliance with the terms of the agreement.

In March of 2011, the risk management department’s loan review function was restructured, and the majority of the loan review responsibilities were out-sourced to a loan review risk advisory firm. The external loan review services began in April of 2011 and are structured to cover 75% of the loan portfolio annually (excluding residential and consumer loans). The external loan review services are managed by the Loan Review Officer or another designee deemed independent and appropriate within the risk management department with reports made independently to the Directors’ Loan Committee. The Directors’ Loan Committee then reports results to the Bank’s Board of Directors. The outsourcing of the loan review function has assisted management in ensuring the Bank’s internal ratings of commercial credit relationships are timely, accurate and consistent with regulatory credit classification criteria. In addition, this process has contributed in the identification of trends and the assessment of the overall quality of the loan portfolio.

Schedule 6

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

For the nine month periods ended September 30, 2011 and 2010

The following discussion and analysis provides information about Princeton National Bancorp, Inc.'s (“PNBC” or the “Corporation”) financial condition and results of operations for the nine month periods ended September 30, 2011 and 2010. This discussion and analysis should be read in conjunction with the Corporation’s Condensed Consolidated Financial Statements and Notes thereto included in this report. This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as discussions of the Corporation’s pricing and fee trends, credit quality and outlook, liquidity, new business results, expansion plans, anticipated expenses and planned schedules. The Corporation intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Corporation, are identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: the effect of the disruption in financial markets and the United States government programs introduced to restore stability and liquidity, changes in interest rates, general economic conditions and the state of the United States economy, legislative/regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Corporation’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. Further information concerning the Corporation and its business, including a discussion of these and additional factors that could materially affect the Corporation’s financial results, is included in the Corporation’s 2010 Annual Report on Form 10-K under the heading “Item 1. Business.”

CRITICAL ACCOUNTING POLICIES AND USE OF SIGNIFICANT ESTIMATES

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

Allowance for Loan Losses

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

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

Other Real Estate Owned

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

Deferred Income Tax Assets/Liabilities

A net deferred income tax asset arises from differences in the dates that items of income and expense enter into reported income and taxable income. Deferred tax assets and liabilities are established for these items as they arise. From an accounting standpoint, deferred tax assets are reviewed to determine if they are realizable based on the historical level of taxable income, estimates of future taxable income and the reversals of deferred tax liabilities. In most cases, the realization of the deferred tax asset is based on future profitability. Under generally accepted accounting principles, income tax benefits and the related tax assets are only allowed to be recognized if they will “more likely than not” be fully realized.

The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, available tax planning strategies and assessments of the current and future economic and business conditions. The Corporation considers both positive and negative evidence regarding the ultimate realizability of the deferred tax assets, which is largely dependent upon the ability to derive benefits based on future taxable income.

The Corporation did not record a valuation allowance in quarters previous to the third quarter of 2011 due to the weight of all positive evidence overcoming the negative evidence. However, during the third quarter of 2011, due to the negative evidence of a cumulative loss in the most recent three year period and earnings forecasts revised downward from previous quarters forecasts due to acceleration of provision for loan losses, loan collection and other real estate owned expenses, the Corporation has determined that a valuation allowance against deferred tax assets should be recorded as of September 30, 2011. As a result, as of September 30, 2011, the carrying value of the Corporation’s deferred tax assets has been reduced to zero through the recognition of a $14,584,000 valuation allowance.

In each future accounting period, the Corporation will reevaluate whether the current conditions in conjunction with positive and negative evidence support a change in the valuation allowance against deferred tax assets. Any such subsequent reduction in the estimated valuation allowance would lower the amount of income tax expense recognized in the Corporation’s Consolidated Statements of Income in future periods.

Additionally, the Corporation reviews its uncertain tax positions annually under ASC 740-10, “Accounting for Uncertainty in Income Taxes.” An uncertain tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount actually recognized is the largest amount of tax benefit that is greater than 50% likely to be recognized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. A significant amount of judgment is applied to determine both whether the tax position meets the “more likely than not” test as well as to determine the largest amount of tax benefit that is greater than 50% likely to be recognized. Differences between the position taken by management and that of taxing authorities could result in a reduction of a tax benefit or increase to tax liability, which could adversely affect future income tax expense.

Impairment of Intangible Assets

Core deposit and customer relationships, which are intangible assets with a finite life, are recorded on our balance sheets. These intangible assets were capitalized as a result of past acquisitions and are being amortized over their estimated useful lives of up to 15 years. Core deposit intangible assets with finite lives will be tested for impairment when changes in events or circumstances indicate that its carrying amount may not be recoverable. Core deposit intangible assets were tested for impairment during 2011, and no impairment was recognized.

Mortgaging Service Rights (“MSRs”)

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

Fair Value Measurements

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

ASC 820 establishes a framework for measuring the fair value of financial instruments that considers the attributes specific to particular assets or liabilities and establishes a three-level hierarchy for determining fair value based on the transparency of inputs to each valuation as of the fair value measurement date. The three levels are defined as follows:

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

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

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

At the end of each quarter, the Corporation assesses the valuation hierarchy for each asset or liability measured. From time to time, assets or liabilities may be transferred within hierarchy levels due to changes in availability of observable market inputs to measure fair value at the measurement date. Transfers into or out of hierarchy levels are based upon the fair value at the beginning of the reporting period. A more detailed description of the fair values measured at each level of the fair value hierarchy can be found in Note 9 - “Fair Value of Assets and Liabilities” in the Notes to Condensed Consolidated Financial Statements.

RECENT DEVELOPMENTS

Formal Written Agreement with the Comptroller of the Currency

Effective as of March 15, 2010, Citizens First National Bank entered into a formal written agreement (the “Agreement”) with the Office of the Comptroller of the Currency (the “OCC”) that contains provisions to lower nonperforming loan levels and foster improvement in the Bank’s policies and procedures with respect to the Bank’s allowance for loan losses and loan credit risk rating system. The Bank has addressed all of these requirements.

Pursuant to the Agreement, the Bank’s Board of Directors is required to review the adequacy of the Bank’s allowance for loan losses and to establish a program for the maintenance of an adequate allowance. A copy of the Board’s program is required to be submitted to the OCC for review. The program has been completed and is reviewed quarterly by the Board of Directors in order to verify management is maintaining an adequate allowance.

The Bank is also required to take immediate action to protect its interest in criticized assets identified in the Bank’s most recent Report of Examination with the OCC and to adopt individual written workout plans with respect to such assets. A copy of the workout plans is required to be submitted quarterly to the OCC with respect to any criticized asset equal to or exceeding $100,000. Additionally, the Bank is prohibited from extending any additional credit to any borrower whose loan is criticized, unless a majority of the Bank’s Board of Directors (or appropriate committee) has determined that the extension is necessary to promote the best interests of the Bank and such determination is properly recorded.

Under the Agreement, the Board must also ensure that the Bank’s internal ratings of credit relationships are timely, accurate and consistent with the regulatory credit classification criteria set forth in the OCC Handbook and related authority. The board must also ensure that any loan relationship with a high probability of payment default or other well-defined weakness is rated no better than “substandard,” regardless of the existence of certain other mitigating factors that could reduce credit risk.

In 2010, the internal loan review staff, and the scope of their reviews, was expanded. Considerable progress was achieved in meeting the expanded loan review scope and evaluating and verifying internal loan ratings on a timely basis consistent with credit classification criteria set forth in the OCC's Handbook. Loan review grading methodology was refined to ensure that loans with a probability of payment default or well-defined weaknesses are graded “substandard,” regardless of mitigating controls which might reduce credit risk. The Directors’ Loan Committee monitored this process with bi-monthly meetings and reviewed loan review reports to ensure compliance with the terms of the Agreement.

In March of 2011, the risk management department’s loan review function was restructured, and the majority of the loan review responsibilities were outsourced to a loan review risk advisory firm. The external loan review services began in April of 2011 and are structured to cover 75% of the loan portfolio (excluding residential and consumer loans). The external loan review services are managed by the Loan Review Officer, or another designee deemed independent and appropriate within the risk management department, with reports made independently to the Directors’ Loan Committee. The Directors’ Loan Committee then reports results to the Bank’s Board of Directors. The outsourcing of the loan review function has assisted management in ensuring that the Bank’s internal ratings of commercial credit relationships are timely, accurate and consistent with regulatory credit classification criteria. In addition, this process has contributed in the identification of trends and the assessment of the overall quality of the loan portfolio.

In the fourth quarter of 2010, the Corporation filled a newly created role of Chief Credit Officer and established a credit administration division to oversee the development, maintenance and monitoring of loan policies and procedures. Responsibilities of the credit administration division that were created in the fourth quarter of 2010 and the first quarter of 2011 include credit analysis, credit risk management, loan servicing and administration, loan collections and the special assets group, as well as loan portfolio analytics and the maintenance of the allowance for loan losses. The functions of the special assets group include loss mitigation and workout of non-performing loans, liquidation of non-performing assets and other responsibilities to accelerate and maximize loan recoveries. As part of establishing the new credit administration division and improving internal controls, the Bank’s Chief Credit Officer has identified and engaged experienced personnel to fill key roles within credit administration.

In addition to the special assets group, credit risk analytics was created and staffed to facilitate allowance for loan losses calculations, loan portfolio monitoring, migration analysis, concentration analysis and other credit risk analysis. In conjunction with the special assets group, the credit risk analytics position is responsible for ensuring that loan level detail is appropriately maintained relative to problem loan reporting, including current appraisal documentation and the identification of non-accrual loans and loans subject to classification as troubled debt restructurings.

Consent Order with the Comptroller of the Currency

On September 20, 2011, the Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (the “Consent Order”) with the Office of the Comptroller of the Currency (the “OCC”). The Consent Order replaced the previously disclosed formal written agreement entered into by the Bank with the OCC on March 15, 2010. Pursuant to the Consent Order, the Bank has agreed to take certain actions and operate in compliance with the Consent Order’s provisions during its term.

The Bank has taken steps to address the issues raised in the Consent Order and intends to fully comply with the requirements set forth.

Written Agreement with the Federal Reserve Bank

Under the terms of the Written Agreement, the Corporation is required to, among other things: (i) serve as a source of strength to the Bank, including taking steps to ensure that the Bank complies with the Consent Order entered into with the OCC on September 20, 2011, and any other supervisory action taken by the Bank’s federal regulator; (ii) refrain from declaring or paying any dividend, or taking dividends or other payments representing a reduction in the Bank’s capital, each without the prior written consent of the FRB and the Director of the Division of Banking Supervision and Regulation (the “Director”) of the Board of Governors of the Federal Reserve System; (iii) refrain from making any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior approval of the FRB and the Director; (iv) refrain from incurring, increasing or guaranteeing any debt, and from purchasing or redeeming any shares of its capital stock, each without the prior approval of the FRB; (v) provide the FRB with a written plan to maintain sufficient capital at the Corporation on a consolidated basis; (vi) provide the FRB with a projection of the Corporation’s planned sources and uses of cash; (vii) comply with certain regulatory notice provisions pertaining to the appointment of any new director or senior executive officer, or the changing of responsibilities of any senior executive officer; and (viii) comply with certain regulatory restrictions on indemnification and severance payments. The Corporation is also required to submit certain reports to the FRB with respect to the foregoing requirements.

The Corporation has taken steps to address the issues raised in the Written Agreement and intends to fully comply with the requirements set forth.

Other Developments

On January 24, 2011, the Corporation notified the U.S. Treasury that it will defer regularly scheduled payments on the Corporation’s 25,083 shares in Series B Preferred Stock. As of September 30, 2011, “dividends in arrears” on the preferred stock, which must be paid prior to the payment of dividends on common shares, total approximately $941,000.

In April 2011, the Corporation received a Sale Agreement concerning an industrial development property located in the Corporation’s northern region, the carrying value of which represents over 45% of the balance of other real estate owned as of September 30, 2011. The closing of this other real estate owned sale is expected to occur in the fourth quarter of 2011.

RESULTS OF OPERATIONS

Net loss available to common stockholders was $19,146,000 for the third quarter of 2011 compared to net loss available to common stockholders of $2,232,000 for the third quarter of 2010. Basic and diluted loss per common share available to common stockholders for the third quarter of 2011 were $5.75 compared to basic and diluted loss per share of $0.67 for the third quarter of 2010. This represents a decrease of $16,914,000 (757.7%) or $5.08 per basic and diluted common share. The net loss is caused by the recording of a valuation allowance of $14,584,000 for net deferred tax assets, provision for loan losses of $7,975,000 required due to continued collateral de-valuation in troubled real estate markets, increasing costs to carry and manage other real estate owned properties of $853,000, and recognition of impairment on originated mortgage servicing rights of $817,000 created due to the historically low rate environment. The annualized loss on average assets and loss on average equity were 7.06% and 135.49%, respectively, for the third quarter of 2011 compared with 0.79% and 11.28% for the third quarter of 2010.

Net loss available to common stockholders for the first nine months of 2011 was $20,978,000 compared to net loss available to common stockholders of $2,194,000 for the first nine months of 2010. Basic and diluted loss per common share available to common stockholders for the first nine months of 2011 were $6.30 compared to basic and diluted loss per share of $0.66 for the first nine months of 2010. The increase in net loss for the first nine months of 2011 as compared to the first nine months of 2010 is attributed to a $14,584,000 valuation allowance recorded for net deferred tax assets, a $4,600,000 increase in provision for loan losses, a result of continued collateral de-valuation in troubled real estate markets and a $1,300,000 increase in other real estate expenses, net of a $1,971,000 increase in gains on sales of available-for-sale securities. The annualized loss on average assets and loss on average equity were 2.58% and 49.04%, respectively, for the first nine months of 2011 compared with 0.25% and 3.80% for the first nine months of 2010.

Net interest income before the provision for loan losses was $8,365,000 for the third quarter of 2011, compared to $9,245,000 for the third quarter of 2010 (a decrease of $880,000 or 9.5%). The net yield on interest-earning assets (on a fully taxable equivalent basis) decreased by 0.22% to 3.92% in the third quarter of 2011 from 4.14% in the third quarter of 2010, from the impact of a high level of non-accrual loans, a decrease in loans from the lack of sufficient quality loan demand and the historically low rate environment.

Net interest income before the provision for loan losses was $26,478,000 for the first nine months of 2011, compared to $27,913,000 for the first nine months of 2010 (a decrease of $1,435,000 or 5.1%). The net yield on interest-earning assets (on a fully taxable equivalent basis) increased by 0.15% to 4.15% in the first nine months of 2011 from 4.00% for the first nine months of 2010. This increase in the net yield on average interest-earning assets was created from the impact of a high level of non-accrual loans combined with a reduction in the cost of interest-bearing liabilities, primarily time deposits, which decreased from 1.87% for the first nine months of 2010 to 1.22% for the first nine months of 2011.

The Corporation’s provision for loan loss expense recorded each quarter is determined by management’s evaluation of the risk characteristics of the loan portfolio. Net charge-offs increased during the third quarter of 2011 to $10,593,000, compared to net charge-offs of $4,147,000 for the third quarter of 2010. The Corporation recorded a provision for loan loss of $7,975,000 in the third quarter of 2011 compared to a provision of $6,725,000 in the third quarter of 2010. The allowance for loan losses is discussed more fully below.

Net charge-offs increased during the first nine months of 2011 to $31,115,000, compared to net charge-offs of $6,822,000 for the first nine months of 2010. The Corporation recorded a provision for loan loss of $17,900,000 in the first nine months of 2011 compared to a provision of $13,300,000 in the first nine months of 2010.

Non-interest income totaled $2,089,000 in the third quarter of 2011, compared to $2,474,000 in the third quarter of 2010, a decrease of 385,000 or 15.6%. This decrease was primarily due to the recognition of impairment on originated mortgage servicing rights of $817,000 in the third quarter of 2011. Annualized non-interest income as a percentage of total average assets decreased to 0.77% for the third quarter of 2011, from 0.87% for the same period in 2010.

Non-interest income totaled $9,716,000 for the first nine months of 2011, compared to $7,695,000 in the first nine months of 2010, an increase of $2,021,000 or 26.3%. The increase from the prior period is the result of an increase in realization of gains on sales of available-for-sale securities. Securities were sold from the investment portfolio to reduce municipal bond concentration, lower the generation of tax-exempt income, improve the credit position of the municipal portfolio and enhance the efficiency of the overall portfolio via strategic swap opportunities, thereby improving the portfolio’s interest rate risk management structure. There were $2,693,000 in gains on securities sold in 2011, compared to $722,000 during the same period in 2010. In addition, service charges on deposits increased to $3,032,000 in the first nine months of 2011 compared to $2,853,000 during the first nine months of 2010, an increase of $179,000 or 6.3% due primarily to an increase in checking account overdraft fees of $113,000. Annualized non-interest income as a percentage of total average assets increased to 1.20% for the first nine months of 2011, from .92% for the same period in 2010.

Total non-interest expense for the third quarter of 2011 was $10,089,000, an increase of $1,042,000 (or 11.5%) from $9,047,000 in the third quarter of 2010. The primary difference between the two quarters was an increase in expenses related to other real estate owned of $407,000 (or 91.3%) due to updated property valuations and an increase in loan collection expenses of $459,000 (or 441.3%). Annualized non-interest expense as a percentage of total average assets increased to 3.72% for the third quarter of 2011, compared to 3.19% for the same period in 2010.

Total non-interest expense for the first nine months of 2011 was $29,757,000, an increase of $2,608,000 (or 9.6%) from $27,149,000 in the first nine months of 2010. The primary difference between the two periods was an increase in expenses related to other real estate owned of $1,301,000 (or 83.0%) and an increase in loan collection expenses of $605,000 (or 123.0%). Annualized non-interest expense as a percentage of total average assets increased to 3.66% for the first nine months of 2011, compared to 3.11% for the same period in 2010.

INCOME TAXES

The Corporation recorded income tax expense of $8,552,000 for the first nine months of 2011, as compared to an income tax benefit of $3,609,000 for the first nine months of 2010, due primarily to the establishment of a valuation allowance against the Corporation’s deferred tax assets as of September 30, 2011. Under generally accepted accounting principles, income tax benefits and the related tax assets are only allowed to be recognized if they will “more likely than not” be realized.

The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, available tax planning strategies and assessments of the current and future economic and business conditions. The Corporation considered both positive and negative evidence regarding the ultimate realizability of the deferred tax assets, which is largely dependent upon the ability to derive benefits based on future taxable income.

The Corporation did not record a valuation allowance in quarters previous to the third quarter of 2011due to the weight of all positive evidence overcoming the negative evidence. However, during the third quarter of 2011, due to the negative evidence of a cumulative loss in the most recent three year period and earnings forecasts revised downward from previous quarters forecasts due to acceleration of provision for loan losses, loan collection and other real estate owned expenses, the Corporation has determined that a valuation allowance against deferred tax assets should be recorded as of September 30, 2011. As a result, as of September 30, 2011, the carrying value of the Corporation’s deferred tax assets has been reduced to zero through the recognition of a $14,584,000 valuation allowance.

The effective tax rate was 74.6% for the nine-month period ended September 30, 2011 and (74.6%) for the nine-month period ended September 30, 2010. For more information on the Corporation’s income taxes see Note 10 – “Income Taxes” in the Notes to Condensed Consolidated Financial Statements.

FDIC

On September 29, 2009, the Board of Directors of the FDIC adopted a Notice of Proposed Rulemaking (NPR) that would require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC estimated that the total prepaid assessments collected would be approximately $45 billion. The FDIC Board also voted to adopt a uniform three-basis point increase in assessment rates effective on January 1, 2011, and extend the restoration period from seven to eight years.

Under GAAP accounting rules, unlike special assessments, prepaid assessments do not immediately affect bank earnings. Each institution recorded the entire amount of its assessment related to future periods as a prepaid expense (an asset) as of December 31, 2009, the date the payment was made. The Corporation paid an assessment of $6,763,000 for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.

Beginning January 1, 2010, and each quarter thereafter, each institution would record an expense (charge to earnings) for its regular quarterly assessment and an offsetting credit to the prepaid assessment until the asset is exhausted. At September 30, 2011, the Corporation had a remaining prepaid assessment of $2,809,000. This amount is reflected in the category of Other Assets in the Condensed Consolidated Balance Sheets. The Corporation recorded $597,000 of federal insurance assessment expense for the third quarter of 2011 and $522,000 for the third quarter of 2010. Federal insurance assessment expense of $1,500,000 was recorded for the first nine months of 2011, compared to $1,617,000 for the first nine months of 2010.

ANALYSIS OF FINANCIAL CONDITION

Total assets at September 30, 2011 decreased to $1,069,783,000 from $1,096,471,000 at December 31, 2010 (a decrease of $26.7 million or 2.4%). Total loan balances decreased by $65.5 million during the nine month period to $638.6 million, due to the effects of aggressive loan collection and workout efforts relative to problem loans and general decline in the overall demand for new low-risk credit. Investment balances totaled $265,611,000 at September 30, 2011, compared to $260,939,000 at December 31, 2010 (an increase of $4.7 million, or 1.8%). Investment balances have increased slightly as a portion of the Bank’s excess liquidity has been utilized in conservative investments due to the lack of sufficient quality loan demand. Total deposits decreased to $939,225,000 at September 30, 2011 from $962,961,000 at December 31, 2010 (a decrease of $23.7 million or 2.5%). Comparing categories of deposits at September 30, 2011 to December 31, 2010, time deposits decreased $42.5 million (or 11.6%), interest-bearing demand deposits increased $3.2 million (or 0.8%), savings deposits increased $4.8 million (or 6.4%) and demand deposits increased $10.7 million (or 7.7%). Borrowings, consisting of customer repurchase agreements, treasury, tax, and loan (“TT&L”) deposits and Federal Home Loan Bank (“FHLB”) advances, increased from $71,559,000 at December 31, 2010 to $85,800,000 at September 30, 2011 (an increase of $14.2 million or 19.9%). This increase was primarily due to growth in repurchase agreement balances partially offset by the maturity and repayment of a $4,000,000 FHLB advance in the first quarter of 2011.

CAPITAL PURCHASE PROGRAM

On January 23, 2009, the Corporation received $25,083,000 of equity capital by issuing to the United States Department of Treasury 25,083 shares of the Corporation’s 5.00% Series B Non-voting Cumulative Preferred Stock, par value $0.01 per share with a liquidation preference of $1,000 per share and a ten-year warrant to purchase up to 155,025 shares of the Corporation’s common stock, par value $5.00 per share, at an exercise price of $24.27 per share. The proceeds received were allocated to the preferred stock and additional paid-in capital based on their relative fair values. The resulting discount on the preferred stock is amortized against retained earnings and is reflected in the Corporation’s Condensed Consolidated Statements of Income as “Accretion of preferred stock discount,” resulting in additional dilution to the Corporation’s earnings per share. The warrants are exercisable, in whole or in part, over a term of 10 years. The warrants were included in the Corporation’s diluted average common shares outstanding (subject to anti-dilution). Both the preferred securities and warrants were accounted for as additions to the Corporation’s regulatory Tier 1 and total capital.

LOANS

The Corporation’s loan portfolio largely reflects the profile of the communities in which it operates. The Corporation essentially offers four types of loans: commercial, agricultural, real estate and consumer installment. The Corporation has no foreign loans. The following table summarizes the Corporation’s loan portfolio:

	September 30,						December 31,						September 30,
	2011						2010						2010
				% of						% of						% of
	Amount			Total			Amount			Total			Amount			Total
Commercial	$	61,394			9.6	%	$	138,325			19.6	%	$	139,876			19.2	%
Agricultural		59,881			9.4			78,086			11.1			71,738			9.9
Agricultural real estate		60,133			9.4			46,361			6.6			45,825			6.3
Commercial real estate		235,833			36.9			205,301			29.2			206,316			28.3
Commercial real estate development		70,944			11.1			88,402			12.6			105,830			14.5
Residential real estate		100,552			15.7			90,869			12.9			95,936			13.2
Total Real Estate		467,462			73.2			430,933			61.2			453,907			62.3

Consumer		49,816			7.8			56,730			8.1			62,253			8.6
Total loans	$	638,553			100.0	%	$	704,074			100.0	%	$	727,774			100.0	%

Total assets	$	1,069,783					$	1,096,471					$	1,111,227
Loans to total assets		59.7	%					64.2	%					65.5	%

In the third quarter of 2011, the Corporation implemented a loan reporting reclassification in which the segregation of reported loan categories was changed to a collateral focus based on regulatory reporting guidelines from a segregation based on product focus. The primary result of this reclassification in the reported composition of the loan portfolio was a shift of commercial loans that are secured by commercial real estate to be reported as commercial real estate loans rather than commercial loans. Of the $76.9 million decrease in reported commercial loans from December 31, 2010 to September 30, 2011, $53.3 million represented this reclassification to commercial real estate loans, $2.8 million to agricultural real estate loans, and $6.6 million to residential real estate loans. Also impacting this decline in the nine months ended September 30, 2011 was $3.0 million in commercial loan charge-offs and normal loan paydowns. The third quarter 2011 reclassification did not impact the calculation of the allowance for loans losses during the nine months ended September 30, 2011 as the allowance calculation was already based on a collateral focused segregation of the loan portfolio.

Total loans decreased $65,521 (or 9.3%) in the first nine months of 2011. There were no acquisitions in the first nine months of 2011 or in 2010. The decrease reflects the Corporation’s 2011 capital management objectives, as well as the continued dual effects of the present economic environment in which business and consumer borrowers have reduced demand and capacity for new indebtedness and borrower financial deterioration resulting in a higher level of loans charged off and transferred to other real estate owned.

Loans to agricultural operations decreased $18,205 (or 23.3%) in the first nine months of 2011. Short-term agricultural loans are seasonal in nature with paydown from grain sales occurring near the beginning and end of each year. Rapid growth in the bio-fuels industry (primarily ethanol) and rising worldwide food demand continue to influence corn prices. Rising corn prices have influenced soybean prices as the two commodities compete for planted acreage. Corn and soybeans are the two primary crops of the Corporation’s market area. As in 2010, selling prices remain historically strong in 2011, resulting in another year of high profitability for most of the Corporation’s agricultural customers. The balance sheet of local agriculture remains strong, both in terms of equity and liquidity. Agriculture remains the largest single loan industry concentration of the Corporation. The highly experienced agricultural staff continues to effectively manage risk and seek opportunities in this portfolio. Agricultural loans as a percentage of total loans were 9.4% at September 30, 2011, compared to 11.1% at year-end 2010.

Total real estate loans increased $36,529 (or 8.5%) in the first nine months of 2011. Residential real estate loans with fixed rates of more than 7 years are generally sold into the secondary market. The Corporation retains the servicing of sold loans, maintaining the local relationship with customers and generating servicing fee income. With home mortgage rates in 2010 and through the third quarter of 2011 at or near their lowest level in almost 50 years, many borrowers refinanced adjustable rate loans into fixed rate loans that were sold. Total home mortgage closings approximated $57,000 during the first nine months of 2011 and $130,000 in 2010, $45,000 below the record level of $175,000 in 2009.

Consumer installment loans decreased $6,914 (or 12.2%) in the first nine months of 2011. Home equity lending, which continues to reflect reduced consumer demand, comprises over two-thirds of the installment portfolio.

Although the risk of non-payment for any reason exists with respect to all loans, certain other more specific risks are associated with each type of loan. The primary risks associated with commercial loans are quality of the borrower’s management and the impact of national economic factors. Development and construction loans have primary risks associated with demand for housing and other construction projects. As these businesses are capital intensive, when demand for product weakens, revenues are reduced while fixed costs such as debt service remain. With respect to agricultural loans, the primary risks are weather and, like commercial loans, the quality of the borrower’s management. Risks associated with real estate loans include concentrations of loans in a loan type, such as commercial or agricultural, and fluctuating land values. Non-owner occupied commercial real estate loans have risks related to occupancy and lease rates during economic downturns. Consumer loans also have risks associated with concentrations of loans in a single type of loan. Consumer loans additionally carry the risk of a borrower’s unemployment as a result of deteriorating economic conditions. With the exception of agricultural lending, the current economic environment has increased the risk level in the subsidiary bank’s loan portfolio.

The Corporation’s strategy with respect to addressing and managing these types of risks, whether loan demand is weak or strong, is for the subsidiary bank to follow its loan policies and sound underwriting practices, which include: (i) granting loans on a sound and collectible basis; (ii) investing funds profitably for the benefit of the stockholders and the protection of depositors; (iii) serving the legitimate needs of the community and the subsidiary bank’s general market area while obtaining a balance between maximum yield and minimum risk; (iv) ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the loan; (v) administering loan policies through a Directors Loan Committee, an Executive Loan Committee, Chief Credit Officer and officer approvals; (vi) developing and maintaining adequate diversification of the loan portfolio as a whole and of the loans within each loan category and (vii) ensuring that each loan is properly documented and, if appropriate, secured or guaranteed by government agencies, and that insurance coverage is adequate, especially with respect to certain agricultural loans because of the risk of poor weather. In the present difficult economic environment, bank officers and staff actively work with borrowers to achieve the best resolutions possible.

NON-PERFORMING LOANS AND OTHER REAL ESTATE OWNED

Non-performing loans consist of non-accrual loans, loans past due 90 days on which interest is still accruing and loans modified in troubled debt restructurings. Non-performing loans amounted to 14.7% of total loans at September 30, 2011 compared to 13.83% at December 31, 2010. The increase reflects continued stress on the commercial real estate market, primarily from persistent economic issues and their impact on consumer spending and the housing industry. The majority of non-performing loans are in two industries: commercial real estate development and commercial real estate. The Corporation’s exposure to the commercial real estate development industry is primarily in the northern and eastern market areas. Non-performing commercial real estate development loans comprise approximately 37.1% of the Corporation’s total non-performing loans as of September 30, 2011, which is down from 41.3% as of June 30, 2011 and 46.4% as of December 31, 2010. Due to the severe downturn in the housing industry, certain builders and developers have encountered difficulty in servicing their debt, eventually leading to non-performing status. Commercial real estate loans comprise approximately 44.1% of the non-performing total as of September 30, 2011, up from 32.7% and 31.9% as of June 30, 2011 and December 31, 2010, respectively. These loans are generally secured by owner-occupied and leased properties and are located throughout the Corporation’s market area. The Corporation continues to closely monitor these loan relationships for opportunities to accelerate acquisition of property ownership and thereby accelerate eventual resolution. The balance of non-performing loans is comprised primarily of residential real estate and home equity credits. The Corporation has been proactive in obtaining updated appraisals for non-performing loans secured by real estate. As discussed further below, as of September 30, 2011, 91.5% of impaired loans had current third party appraisals. The continued downward pressure on real estate values, particularly development properties, has prompted charge-offs and the recording of specific reserves for potential loss on loans secured by real estate.

Troubled debt restructurings at September 30, 2011 were $22,030 compared to $23,386 at December 31, 2010. These are loans to borrowers that are experiencing varying levels of financial stress but are expected to recover. To assist the borrowers, the Corporation has provided some concession in loan terms, most commonly extending the loan amortization or adjusting the interest rate. In the present economic environment, the vast majority of non-performing loans are secured by real estate. At the time a loan is restructured, the Corporation considers the repayment history of the loan and the value of the collateral. If the principal or interest is due and has remained unpaid for 90 days or more and the loan is not well-secured, the loan is placed on nonaccrual status. If the principal and interest payments are current and the loan is well-secured, the troubled debt restructuring loan continues to accrue interest. Once a loan is placed on nonaccrual status, the borrower is required to make current principal and interest payments based on the modified terms for a period of at least six months before returning the loan to accrual status.

As of September 30, 2011 and December 31, 2010, $8,884 and $14,368, respectively, in troubled debt restructuring loans were on accrual status. When the loan is restructured, the loan officer is required to document the basis for the restructure, obtain current and complete credit and cash flow information and identify a specific repayment plan that would retire the debt. This information is provided to the Credit Analysis department which prepares a thorough credit presentation. The credit presentation includes the modified terms of the loan, a collateral analysis and a cash flow analysis based on the modified terms of the loan. The credit presentation is presented to the Directors’ Loan Committee for approval.

Problem credits are closely monitored by the lending staff, credit administration division and special assets group, which was newly formed in 2010. In addition, beginning in April 2011, external loan review performed by representatives of a loan review risk advisory firm has provided further assistance in identifying problem situations. Loans over 90 days past due are normally either charged off or placed on a non-accrual status. Problem credits have a life cycle in which they either improve or they move through a workout/liquidation process. The workout process often includes reclassification to non-accrual status, unless the loan is well secured and in the process of collection. Collateral securing non-accrual real estate loans that are not resolved by borrowers becomes other real estate owned via foreclosure or receipt of a deed in lieu of foreclosure. The Corporation actively markets other real estate owned properties for sale.

The Corporation formed a special assets group in 2010 to focus on the management of the other real estate owned workout process. Total other real estate owned as of September 30, 2011 was $18,502, down from $20,652 as of December 31, 2010. Over 45% of the September 30, 2011 total is one industrial development property located in the Corporation’s northern region. The Corporation is actively marketing the property by parcel or as a bulk sale. Most of all improvements are complete on the property. Two distribution centers are presently located in the industrial park. Additional roadways may be built depending on how end users choose parcel configuration. Construction of a third distribution center was completed as of June 30, 2011 on a portion of the parcel that was sold in 2010. The selling price per acre was significantly above the Corporation’s carrying value of the property. In April 2011, the Corporation received a Sale Agreement concerning the remaining acres for this industrial development property. The closing of this particular other real estate owned sale is expected to occur in the fourth quarter of 2011.

As with non-performing loans, the Corporation is proactive in obtaining appraisals to support the carrying value of other real estate owned property on the Condensed Consolidated Balance Sheets. The following table provides information on the Corporation’s non-performing loans and other real estate owned as of the periods indicated:

	September 30,			December 31,			September 30,
	2011			2010			2010
Non-accrual	$	68,925		$	72,404		$	73,699
90 days past due and accruing		1,705			1,561			1,438
Troubled debt restructurings		22,030			23,386			7,518

Total non-performing loans	$	92,660		$	97,351		$	82,655

Other real estate owned		18,502			20,652			18,372
Total non-performing assets	$	111,162		$	118,003		$	101,027

Non-performing loans to total loans (net of unearned interest)		14.51	%		13.83	%		11.36	%
Non-performing assets to total assets		10.39	%		10.76	%		9.09	%

Non-performing loans consist of non-accrual loans, loans past due 90 days on which interest is still accruing and troubled debt restructurings. Impaired loans of $93,584, included in the impaired loans table in Note 8 – “Loans and the Allowance for Loan Losses” in the Notes to Condensed Consolidated Financial Statements, include $1,052 in impaired loans which are performing as of September 30, 2011, and therefore are not included in non-performing loans. Performing impaired loans consist of loans for which management has concern regarding the ultimate collectability of full principal and interest under the original terms of the loan agreement due to issues such as borrower payment capacity or collateral coverage. There were no performing impaired loans as of December 31, 2010.

Of the $93,584 in impaired loans at September 30, 2011, the Corporation relied on third party appraisals for $90,790 of the impaired loans. Approximately $85,602 or 91.5% of the impaired loans had current third party appraisals which were relied upon. These appraisals were completed within 12 months of September 30, 2011. The appraisals for the remaining $5,188 in impaired loans in which third party appraisals were obtained had not been updated as the fair value in the last appraisal received and the current estimated value were in significant excess of the outstanding debt for $590 of these loans. The weighted average loan to fair value for the $5,188 was approximately 75%. Collateral values which are not based on current appraisals are discounted 10% to 20% in the collateral evaluation in addition to the already required 12% discount. The initial 12% discount, which was increased in the third quarter from a 10% discount, is due to the anticipated selling costs of the collateral. The additional discount is based on several factors. These factors include the Loan Officer’s review of the collateral and its current condition, the Corporation’s knowledge of the current economic environment in the collateral markets, and the Corporation’s past experience with real estate in the area. The date of the appraisal is also considered in conjunction with the economic environment and the decline in the real estate market since the appraisal was obtained.

The following table provides a loan-to-value ratio distribution for the $5,188 in impaired loans with appraisals over twelve months old as of September 30, 2011:

Loan-to-Value Amount

0 - 50% $ 45

50 - 60% $ 545

60 - 70% $ 261

70 - 80% $ 1,671

80 - 90% $ 2,666

90% + $ -0-

Once a loan is deemed an impaired loan, the Loan Officer or Special Assets officer in conjunction with the credit analysis department in credit administration, completes a Problem Asset Workout Summary, which includes a detailed review of the collateral. Problem Asset Workout Summaries are prepared by the Credit Analysts and Loan Officers, then reviewed by Credit Administration management and utilized in the preparation of the allowance for loan losses calculation. Summaries include a collateral analysis detailing a description of the collateral, the date of the appraisal and the discounts on the collateral. If the discounted collateral is sufficient to cover the outstanding loan balance, no specific valuation allowance is placed on the loan. If the estimated current collateral value is in significant excess of the outstanding debt or the appraisal is less than twelve months old, a new appraisal is not ordered. If the collateral value is not in significant excess of the outstanding debt or the appraisal is over twelve months old, the Loan Officer or Special Assets officer with concurrence of the Chief Credit Officer will determine if a new appraisal should be ordered based on their knowledge of the current market in the collateral’s area. If the Corporation determines that full collection of the principal of the debt owed is not likely, a new appraisal is ordered. If the estimated fair value presented in the new appraisal is less than the outstanding debt, a specific reserve or charge-off is recorded, as appropriate, equal to the difference between the discounted collateral value and the outstanding debt.

The determination of a specific allowance or charge-off is reviewed by the Corporation on a monthly basis. During the nine months ended September 30, 2011, the Corporation recorded partial charge-offs totaling $25,243 on the impaired loans with an outstanding balance of $49,976. The charge-offs were considered warranted as the loans were considered collateral dependent and the discounted collateral value was not sufficient to cover the outstanding debt.

The Corporation requires appraisals on real estate if the loan is over $250,000 or if the collateral is commercial real estate at the time of origination of the loan. If the appraisal is not within one year of the reporting period, the loan officer provides an additional discount on the collateral based on the loan officer’s review of the collateral and its current condition, the Corporation’s knowledge of the current economic environment in the collateral’s market and the Corporation’s past experience with real estate in the area. The date of the appraisal is also considered in conjunction with the economic environment and the decline in the real estate market since the appraisal was obtained. This additional discount is usually 10% to 35%, depending on the type of property and market area. If the loan is below $250,000 and is not commercial real estate, an internal valuation of the collateral may be used, but must be completed by a staff member who has no involvement in the credit decision. Underlying collateral consisting of vehicles, equipment or other assets is valued using information provided by the borrower. The loan officer must confirm the existence of the assets and provide adequate discounts on the value of the collateral when determining its adequacy to cover the loan.

ALLOWANCE FOR POSSIBLE LOAN LOSSES

The allowance shown in the following table represents the allowance available to absorb losses within the entire portfolio:

	September 30,			December 31,			September 30,
	2011			2010			2010
Amount of loans outstanding at end of period (net of unearned interest)	$	638,553		$	704,074		$	727,774
Average amount of loans outstanding for the period (net of unearned interest)	$	677,687		$	687,177		$	756,301
Allowance for loan losses at beginning of period	$	29,726		$	12,075		$	12,075
Charge-offs:
Agricultural		403			68			68
Commercial		26,960			19,525			5,988
Real estate-mortgage		3,100			2,266			616
Installment		1,113			1,307			310

Total charge-offs		31,576			23,166			6,982

Recoveries:
Agricultural		15			-0-			-0-
Commercial		282			45			40
Real estate-mortgage		8			-0-			-0-
Installment		156			222			120

Total recoveries		461			267			160

Net loans charged off		31,115			22,899			6,822
Provision for loan losses		17,900			40,550			13,300

Allowance for loan losses at end of period	$	16,511		$	29,726		$	18,553

Net loans charged off to average loans (annualized)		6.12	%		3.33	%		1.20	%
Allowance for loan losses to non-performing loans		17.82	%		30.53	%		22.44	%
Allowance for loan losses to total loans at end of period (net of unearned interest)		2.59	%		4.22	%		2.55	%

The allowance for loan losses is considered by management to be a critical accounting policy. The allowance for loan losses is increased by provisions charged to operating expense and decreased by charge-offs, net of recoveries. The allowance is based on factors that include the overall composition of the loan portfolio, types of loans, past loss experience, loan delinquencies, potential substandard and doubtful loans and such other factors that, in management’s best judgment, deserve evaluation in estimating possible loan losses. The adequacy of the allowance for loan losses is monitored monthly during the ongoing, systematic review of the loan portfolio by the Credit Risk Analytics staff in Credit Administration, Senior Lending Officers, Chief Credit Officer, Chief Operating Officer, Chief Financial Officer and Chief Executive Officer of the subsidiary bank. The results of these reviews are reported to the Board of Directors of the subsidiary bank on a monthly basis. Monitoring and addressing problem loan situations are primarily the responsibility of the subsidiary bank’s staff, management and its Board of Directors.

More specifically, the Corporation calculates the appropriate level of the allowance for loan losses on a monthly basis using base charge-offs for each loan type, substandard loans and potential losses with respect to specific loans. In addition to management’s assessment of the portfolio, the Corporation and the subsidiary bank are examined periodically by regulatory agencies. Although the regulatory agencies do not determine whether the subsidiary bank’s allowance for loan losses is adequate, such agencies do review the procedures and policies followed by management of the subsidiary bank in establishing the allowance.

Given the current state of the economy, management has assessed the impact of the recession on each category of loans and adjusted historical loss factors for recent economic trends. Management utilizes a twelve quarter history as one component in assessing the probability of inherent future losses, while including additional weighting of the most recent historical data. Given the decline in economic conditions over the past year, management has also increased its allocation to various loan categories for economic factors. Some of the economic factors include the potential for reduced cash flow for commercial operating loans from reduction in sales or increased operating costs, decreased occupancy rates for commercial buildings, reduced levels of home sales for commercial and land developments, reduced values in real estate or other collateral, the decline in and uncertainty regarding grain prices and increased operating costs for farmers, and increased levels of unemployment and bankruptcy impacting consumers’ ability to pay. Each of these economic uncertainties is taken into consideration in developing the appropriate level of reserve.

The Corporation’s allowance for loan losses has two components. The first component is based upon individual review of nonperforming, substandard or other loans identified as a risk for loss and deemed impaired. This includes nonperforming loans, which consist of nonaccrual loans, loans past due over 90 days and troubled debt restructurings, loans designated as impaired as defined by accounting and regulatory guidance and loans evaluated for potential loss on an individual basis.

The second component is based upon expected, but unidentified, losses inherent in our loan portfolio. The second component is determined utilizing the Corporation’s most recent twelve quarter net charge-off history which is then adjusted for qualitative and quantitative factors. These loss reserve factors are reviewed on a quarterly basis by an Allowance Review Committee which is comprised of members of management, including lending, accounting and credit administration. The qualitative and quantitative factors considered include economic conditions, changes in underwriting practices, changes in the value of collateral, changes in the portfolio volume, staff experience, past due and nonaccrual loans, loan review oversight, concentrations of loans and competition.

The allowance for loan losses of $16,511 and $29,726, respectively, was 2.59% and 4.22% of total loans as of September 30, 2011 and December 31, 2010. The Corporation’s net charge-offs as a percentage of loans were 6.12% and 3.33% for the nine months ended September 30, 2011 and year ended December 31, 2010, respectively. The Corporation’s net charge-offs have remained high due to the continued deterioration in the economic environment, especially relative to commercial real estate and commercial real estate development loans in the northern and eastern markets in Grundy, Kane and DuPage counties, but the growth trends in losses and provision are expected to begin to diminish due to the Corporation’s aggressive efforts to identify and resolve problem loans and as signs of economic stabilization begin to appear in the commercial real estate market.

Reduction in the allowance for loan losses recorded for loans collectively evaluated for impairment as reflected in the allowance for loan losses roll-forward table in Note 8 to the Condensed Consolidated Financial Statements ($9,783 and $12,245 as of September 30, 2011 and December 31, 2010, respectively) as a ratio of the ending balance of loans collectively evaluated for impairment ($544,970 and $660,918 as of September 30, 2011 and December 31, 2010, respectively) to 1.80% at September 30, 2011 from 2.65% at December 30, 2010 is primarily the result of the acceleration of loan charge-offs into the third quarter of 2011. This was facilitated by the continued aggressive loan collection and workout efforts of the credit administration department. These ongoing efforts have created acceleration in the identification of troubled loans and recognition of appropriate charge-offs, resulting in the reduction of recorded loan balances to their appropriate carrying value. The Corporation continues to aggressively pursue all practical and legal methods of collection, repossession, disposal and recovery in relation to troubled loans.

During the first nine months of 2011, $31,115 in net loan charge-offs were recorded due to these aggressive loan collection and workout efforts and the receipt of updated appraisals reflecting current deterioration in the collateral value of commercial real estate and commercial real estate development properties primarily in the northern and eastern markets. In estimating the adequacy of the allowance for loan losses, management consistently utilizes a twelve-quarter loan loss history as one component in assessing the probability of inherent future losses, while including higher weighting of the most recent four quarters of data.

The allowance for loan losses as a percentage of non-performing loans has decreased to 17.8% as of September 30, 2011 from 30.5% as of December 31, 2010. The reserve for specifically impaired loans decreased by $2.1 million from the second quarter of 2011. The resulting decrease in the specifically reserved loans is primarily due to the charge-off of $10.9 million in loans that were previously reserved and adding over $5.7 million in new specific provisions, largely due to two commercial real estate development relationships. Also increasing the provision in the third quarter 2011 was an increase in the selling cost discount from 10% to 12%. Charge-offs were taken on credits that were impaired and also collateral dependent and were based on current appraisals. At the end of the current period, the Corporation has an updated appraisal (within twelve months) on the collateral for over 91% of all impaired loans. The Corporation continues to aggressively monitor the collateral values of its impaired loan classifications to assess the need for specific reserves. The allowance for loan losses calculation takes into consideration continuing economic declines and resulting increases in non-performing loans in the quantitative and qualitative factors used to adjust the reserve percentages on loans not specifically reserved for in the calculation.

There were $6,728 in specific loan loss reserves for non-performing loans as of September 30, 2011, compared to $12,245 as of December 31, 2010. Although non-performing loans are trending downward, they remain elevated, and the balance is comprised of loans that management believes will not result in significant additional losses not reserved in the allowance for loan losses as of September 30, 2011. Management considers the allowance for loan losses adequate to meet probable losses as of September 30, 2011.

CAPITAL RESOURCES

Federal regulations require all financial institutions to evaluate capital adequacy by the risk-based capital method, which makes capital requirements more sensitive to the levels of risk inherent in different assets. At September 30, 2011, total risk-based capital of the Corporation was 7.64%, compared to 9.68% at December 31, 2010. The Tier 1 capital ratio decreased to 4.26% at September 30, 2011 from 5.93% at December 31, 2010. Total stockholders' equity to total assets at September 30, 2011 decreased to 3.66% from 5.19% at December 31, 2010.

As reflected in the following table, the Corporation and Bank were considered adequately capitalized under regulatory requirements for the tier one leverage capital ratio and the tier one risk-based capital ratio as of September 30, 2011 and December 31, 2010. The Corporation and the Bank were considered adequately capitalized for the total risk-based capital ratio at December 31, 2010. At September 30, 2011 the Bank was considered adequately capitalized while the Corporation was considered undercapitalized for the total risk-based capital ratio.

	Princeton National Bancorp, Inc.						Citizens First National Bank						Adequately-
	September 30, 2011			December 31, 2010			September 30, 2011			December 31, 2010			Capitalized Thresholds
Carrying Amounts:
Total risk-based capital	$	54,788		$	76,618		$	65,713		$	81,447
Tier 1 risk-based capital	$	45,729		$	66,476		$	56,658		$	71,307
Tier 1 leverage capital	$	45,729		$	66,476		$	56,658		$	71,307

Capital Ratios:
Total risk-based capital		7.64	%		9.68	%		9.17	%		10.29	%		8.00	%
Tier 1 risk-based capital		6.38	%		8.40	%		7.90	%		9.01	%		4.00	%
Tier 1 leverage ratio		4.26	%		5.93	%		5.29	%		6.36	%		4.00	%

Total capital and corresponding capital ratios decreased during the third quarter 2011 due to net operating losses caused by increased provision for loan losses, loan collection and other real estate costs and recognition of a valuation allowance for net deferred tax assets.

LIQUIDITY

Due to internal stress and uncertainty in the financial markets, the Corporation continues conservative liquidity maintenance strategies. The Corporation remains in a stable liquidity position by maintaining minimal reliance on wholesale funding sources combined with strong excess Federal reserves. Interest-bearing deposits with financial institutions, comprised primarily of excess reserve balances held at the Federal Reserve Bank, increased to $66.0 million at September 30, 2011 from $30.9 million at December 31, 2010, an increase of 113.6%. Wholesale funding, consisting of brokered deposits, Federal Home Loan Bank advances and other borrowings, decreased $13.2 million or 49.1% from December 31, 2010 to September 30, 2011 as borrowings from the Federal Home Loan Bank were repaid and brokered deposits were reduced.

Liquidity is measured by a financial institution's ability to raise funds through deposits, borrowed funds, capital or the sale of assets. The Corporation manages its liquidity position with the objective of maintaining sufficient funds to respond to the needs of depositors and borrowers and to take advantage of earnings enhancement opportunities. In addition to the normal inflow of funds from core-deposit growth together with repayments and maturities of loans and investments, the Corporation utilizes other short-term funding sources such as securities sold under agreements to repurchase and the acceptance of short-term deposits from public entities.

The Corporation classifies a significant majority of its securities as available-for-sale, thereby enhancing liquidity. In managing its investment portfolio, the Corporation provides for staggered maturities so that cash flows are a consistent source of liquidity over an appropriate time frame. The Corporation’s liquidity position is further enhanced by loan portfolio principal reduction and interest payments and by the steady stream of loan payment from the Corporation’s retail credit and residential mortgage loan portfolios.

The Corporation is a member of the Federal Home Loan Bank of Chicago (FHLB) and as such has advances from FHLB secured generally by residential mortgage loans with a remaining borrowing capacity of $13.0 million at September 30, 2011.

Cash flows provided by investing and operating activities, offset by those used in financing activities, resulted in a net increase in cash and cash equivalents of $40.5 million from December 31, 2010 to September 30, 2011. This increase was primarily the result of a net decrease in loans. For more detailed information, see the Corporation's Condensed Consolidated Statements of Cash Flows.

FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

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

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

The subsidiary bank's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The subsidiary bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. At September 30, 2011, commitments to extend credit and standby letters of credit were approximately $121.2 million and $1.6 million, respectively.

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

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

LAND HELD FOR SALE

The Corporation owns separate lots in Elburn, Aurora and Somonauk, Illinois that have been removed from the land balance and are now shown on the Corporation’s balance sheet as land held-for-sale, at the lower of cost or market. The land in Elburn, approximately two acres, was purchased in 2003 in anticipation of the construction of a branch facility and has a cost basis of $820,000 at September 30, 2011. The land in Aurora, consisting of two lots remaining from the original purchase of fourteen acres in 2004 which was used to construct a branch facility, has a cost basis of $1,344,000. The land in Somonauk, acquired in 2005 during the acquisition of FSB Bancorp, Inc., consists of approximately two acres with a cost basis of $80,000.

LEGAL PROCEEDINGS

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

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As a smaller reporting company under the U.S. Securities and Exchange Commission’s scaled reporting requirements, the Corporation is not required to include the information required by this item. Accordingly, the information is omitted from this Form 10-Q filing.

EFFECTS OF INFLATION

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

Schedule 7

Controls and Procedures

(a)

Disclosure controls and procedures. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2011. Our disclosure controls and procedures are the controls and other procedures that we designed to ensure that we record, process, summarize and report in a timely manner the information we must disclose in reports that we file with or submit to the SEC. Thomas D. Ogaard, President and Chief Executive Officer, and Rodney D. Stickle, Senior Vice President and Chief Financial Officer, reviewed and participated in this evaluation. Based on this evaluation, management concluded that, as of the date of their evaluation, our disclosure controls were effective.

(b)	Internal controls. There have not been any changes in our internal controls over financial reporting during the quarter ended September 30, 2011 that have materially affected or are reasonably likely to materially affect our internal controls over financial reporting.