NORTHERN STATES FINANCIAL CORPORATION
  
 
MANAGEMENT'S DISCUSSION AND ANALYSIS
  
 
  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  
         
 
he following is a discussion and analysis of Northern States Financial Corporation's (the “Company”) financial position and results of operations and should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this report. The Company on November 10, 2005 merged its two wholly owned subsidiaries, the Bank of Waukegan and First State Bank of Round Lake, and named the resulting bank subsidiary NorStates Bank (the “Bank”). The Bank has one wholly owned subsidiary, Northern States Community Development Corporation (“NSCDC”), which was formed during 2002.
The Bank is a commercial bank that provides traditional banking services to corporate, retail and civic entities in their market as well as mortgage banking services. In addition, the Bank provides trust services. NSCDC was set up to develop and sell one parcel of other real estate owned that was contributed by the Bank in 2002.
The Company and its subsidiary are subject to regulation by numerous agencies including the Federal Reserve
   Board, the Federal Deposit Insurance Corporation and the Illinois Department of Financial and Professional Regulation. Among other things, these agencies limit the activities in which the Company and the Bank may engage, the investments and loans that the Bank may fund, and set the amount of reserves against deposits that the subsidiary must maintain.
The statements contained in this management’s discussion and analysis that are not historical facts are forwardlooking statements subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. Forwardlooking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are identifiable by the use of the words “believe”, “expect”, “intend”, “estimate” or similar expressions. The Company cautions readers that a number of important factors could cause the Company’s actual results in 2006 and beyond to differ materially from those expressed in any such forward-looking statements.
 
         
 
OVERVIEW
  
         
  ssets totaled $722.5 million at December 31, 2005, decreasing $27.1 million, or 3.6%, from the previous year-end as a result of a decrease in loans and leases of $42.1 million. As loans and leases decreased, the Company increased its securities available for sale by $14.1 million as compared with year-end 2004 levels. Deposits declined $34.9 million from the previous year-end as deposit levels were not needed to fund the lower loan levels.
The decrease in loans in 2005 resulted from loan repayments outpacing loan growth. During 2005 one borrower paid off $16.3 million in loans by consolidating their borrowings at another financial institution while three other borrowers paid off an additional $11.0 million in loans. The Company has average yearly paydowns of loans of approximately $18 million due to scheduled loan payments. Local loan demand has been down and competition for loans has been fierce. The Company expects to continue to face these same challenges in 2006 and it believes it will be difficult to maintain its loan balance position during 2006.
Net income for 2005 was $2,087,000, or $.49 per share, compared with $4,001,000, or $.93 per share for 2004, a decrease of 47.8 percent. Earnings were impacted unfavorably by a declining net interest margin as well as continued problems with non-performing assets.
Net interest income declined $2,549,000 in 2005 compared with 2004. Interest rates increased in 2005, as evidenced by the prime lending rate ending the year at 7.25% compared to 5.25% on January 1, 2005. Interest rates paid
 
by the Company on its deposits and borrowings in 2005 increased at a greater pace than the rates earned on the Company’s loans and securities.
Interest that the Company earned on its loans and leases was negatively impacted by the decrease in its loan portfolio. Another factor affecting loan interest income was the amount of nonaccrual loans that do not earn interest for the Company due to the deterioration in the financial condition of these borrowers. Nonaccrual loans increased to $21.6 million at year-end 2005 compared with $19.1 million at December 31, 2004.
Yields earned on the Company’s securities portfolio, including Federal Home Loan stock, increased 18 basis points in 2005 as the prime interest rate increased 200 basis points. The reason for the yields on the portfolio increasing only 18 basis points is that in 2005 only 14% of the yearend 2004 portfolio matured and repriced at the increased rates.
Earnings in 2005 were impacted unfavorably by nonperforming assets as the Company made a provision for loan and lease losses of $3,428,000 during 2005 and a $1,067,000 write-down to the value of two motels carried as other real estate owned. The total combined expense during 2005 relating to non-performing assets comes to $4.5 million as compared with the provision to the allowance for loan and lease losses in 2004 of $4.6 million. The Company has been diligently working to reduce its non-performing assets and expects to reduce these assets
 
         
     
NSFC ANNUAL
17
  REPORT 2005