Unassociated Document
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2008

OR

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

For the transition period from _______ to _______

Commission file number 000-24630

MIDWESTONE FINANCIAL GROUP, INC.
102 South Clinton Street
Iowa City, IA 52240

Registrant’s telephone number: 319-356-5800

(State of Incorporation)
(I.R.S. Employer Identification No.)
Iowa
42-1206172

Indicate by check mark whether the registrant (1) has filed all reports required 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 x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company (as defined in Rule 12b-2 of the Exchange Act).

Large Accelerated Filer o
Accelerated Filer o
Non-accelerated Filer o
Smaller Reporting Company x
    

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

Yes o  No x

As of November 5, 2008, there were 8,646,328 shares of common stock $1 par value outstanding.


PART I — Item 1. Financial Statements

MIDWESTONE FINANCIAL GROUP, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CONDITION

   
September 30,
  
December 31,
  
   
2008
  
2007
  
(dollars in thousands)
  
(unaudited)
      
ASSETS
              
Cash and due from banks
 
$
26,993
  
$
16,294
  
Interest-bearing deposits in banks
   
131
    
84
  
Federal funds sold
   
-
    
17,842
  
Cash and cash equivalents
   
27,124
    
34,220
  
Investment securities:
              
Available for sale at fair value (amortized cost of $284,035 as of September 30, 2008 and $232,446 as of December 31, 2007)
    
279,248
    
235,308
  
Held to maturity (fair value of $8,628 as of September 30, 2008 and $101 as of December 31, 2007)
   
8,468
    
95
  
Loans
   
1,003,752
    
404,263
  
Allowance for loan losses
   
(11,044
)
  
(5,466
)
Net loans
   
992,708
    
398,797
  
Loan pool participations
   
100,915
    
-
  
Premises and equipment, net
    
26,589
    
11,802
  
Accrued interest receivable
   
12,647
    
4,639
  
Goodwill
   
26,955
    
4,356
  
Other intangible assets, net
   
13,543
    
268
  
Bank-owned life insurance
   
17,118
    
8,613
  
Other real estate owned
   
992
    
-
  
Other assets
   
14,708
    
3,885
  
Total assets
 
$
1,521,015
  
$
701,983
  
               
LIABILITIES AND SHAREHOLDERS' EQUITY
              
Deposits:
              
Non-interest bearing demand
 
$
120,153
  
$
66,340
  
Interest-bearing checking
    
378,692
    
135,628
  
Savings
   
58,950
    
79,663
  
Certificates of deposit under $100,000
    
415,684
    
167,045
  
Certificates of deposit $100,000 and over
    
147,337
    
77,939
  
Total deposits
   
1,120,816
    
526,615
  
Federal funds purchased
    
2,250
    
-
  
Securities sold under agreements to repurchase
    
50,692
    
45,997
  
Federal Home Loan Bank advances
   
158,709
    
47,000
  
Notes payable
   
2,111
    
1,742
  
Long-term debt
   
15,654
    
-
  
Accrued interest payable
   
3,908
    
1,734
  
Other liabilities
   
4,675
    
1,503
  
Total liabilities
   
1,358,815
    
624,591
  
               
Shareholders' equity:
              
Common stock, $1 par value; authorized 10,000,000 shares; issued 8,690,398 shares as of September 30, 2008 and 5,165,308 as of December 31, 2007
    
8,690
    
5,165
  
Additional paid-in capital
    
80,747
    
100
  
Treasury Stock at cost, 59,288 shares as of September 30, 2008 and -0- shares as of December 31, 2007
   
(872
)
  
-
  
Retained earnings
    
76,501
    
72,333
  
Accumulated other comprehensive loss
    
(2,866
)
  
(206
)
Total shareholders' equity
    
162,200
    
77,392
  
Total liabilities and shareholders' equity
  
$
1,521,015
  
$
701,983
  

See accompanying notes to consolidated financial statements.
 

PART I — Item 1. Financial Statements, Continued

MIDWESTONE FINANCIAL GROUP, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME


(unaudited)
  
Quarter Ended
  
Nine Months Ended
  
(dollars in thousands, except per share amounts)
  
September 30,
  
September 30,
  
   
2008
  
2007
  
2008
  
2007
  
Interest income:
                          
Interest and fees on loans
 
$
14,842
  
$
7,024
  
$
38,238
  
$
20,563
  
Interest and discount on loan pool participations
   
1,228
   
-
   
3,145
   
-
 
Interest on bank deposits
   
23
   
1
   
26
   
4
 
Interest on federal funds sold
   
70
   
201
   
298
   
396
 
Interest on investment securities:
        
 
              
Available for sale
   
3,130
   
2,563
   
9,059
   
7,543
 
Held to maturity
   
145
   
5
   
248
   
5
 
Total interest income
   
19,438
   
9,794
   
51,014
   
28,511
 
                           
Interest expense:
                          
Interest on deposits:
                          
Interest-bearing checking
   
2,125
   
463
   
3,174
   
1,331
 
Savings
   
109
   
326
   
1,295
   
1,015
 
Certificates of deposit under $100,000
   
3,744
   
2,044
   
9,731
   
5,799
 
Certificates of deposit $100,000 and over
   
474
   
989
   
3,125
   
2,853
 
Total interest expense on deposits
   
6,452
   
3,822
   
17,325
   
10,998
 
Interest on federal funds purchased
   
29
   
2
   
60
   
59
 
Interest on securities sold under agreements to repurchase
    
292
   
541
   
814
   
1,565
 
Interest on Federal Home Loan Bank advances
   
1,528
   
468
   
3,812
   
1,478
 
Interest on notes payable
   
1
   
28
   
110
   
77
 
Interest on long-term debt
   
187
   
-
   
433
   
-
 
Total interest expense
   
8,489
   
4,861
   
22,554
   
14,177
 
Net interest income
   
10,949
   
4,933
   
28,460
   
14,334
 
Provision for loan losses
   
838
   
75
   
1,666
   
425
 
Net interest income after provision for loan losses
   
10,111
   
4,858
   
26,794
   
13,909
 
                           
Noninterest income:
                          
Trust and investment fees
    
1,217
   
839
   
3,290
   
2,667
 
Service charges and fees on deposit accounts
    
1,224
   
555
   
3,068
   
1,526
 
Mortgage origination fees and gains on sales of mortgage loans
    
187
   
318
   
817
   
1,027
 
Other service charges, commissions and fees
    
266
   
529
   
1,648
   
1,340
 
Bank-owned life insurance income
   
121
   
71
   
354
   
232
 
Gain (loss) sale of available for sale securities
   
9
   
-
   
215
   
(299
)
Impairment losses on invesment securities
    
-
   
-
   
(567
)
  
-
 
Total noninterest income
   
3,024
   
2,312
   
8,825
   
6,493
 
                           
Noninterest expense:
                          
Salaries and employee benefits
   
5,815
   
2,749
   
14,918
   
8,161
 
Net occupancy and equipment expense
   
2,234
   
768
   
4,737
   
2,227
 
Professional fees
   
348
   
188
   
927
   
497
 
Data processing expense
   
339
   
363
   
1,253
   
1,074
 
Other operating expense
    
1,818
   
633
   
4,173
   
1,960
 
Loss on disposal of assets
    
400
   
-
   
381
   
-
 
Total noninterest expense
   
10,954
   
4,701
   
26,389
   
13,919
 
Income before income tax expense
   
2,181
   
2,469
   
9,230
   
6,483
 
Income tax expense
   
477
   
638
   
2,288
   
1,666
 
Net income
 
$
1,704
  
$
1,831
  
$
6,942
  
$
4,817
  
                       
Earnings per common share - basic
 
$
0.20
  
$
0.36
  
$
0.90
  
$
0.93
  
Earnings per common share - diluted
 
$
0.20
  
$
0.36
  
$
0.90
  
$
0.93
  
 
See accompanying notes to consolidated financial statements.


PART I — Item 1. Financial Statements, Continued

MIDWESTONE FINANCIAL GROUP, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

                   
Accumulated
      
       
Additional
          
Other
      
(unaudited)
  
Common
  
Paid-in
  
Treasury
  
Retained
  
Comprehensive
      
(in thousands, except per share amounts)
  
Stock
  
Captial
  
Stock
  
Earnings
  
Income (loss)
  
Total
  
                           
Balance at December 31, 2006
  
$
5,176
  
$
14
  
$
-
  
$
69,539
  
$
(1,520
)
$
73,209
  
                                       
Comprehensive income:
                                      
Net income
    
-
    
-
    
-
    
4,817
    
-
    
4,817
  
Unrealized gains arising during the period on securities available for sale, net of tax
    
-
    
-
    
-
    
-
    
(57
)
  
(57
)
Reclassification for realized losses on securities available for sale, net of tax
    
-
    
-
    
-
    
-
    
186
    
186
  
Total comprehensive income
    
-
    
-
    
-
    
4,817
    
129
    
4,946
  
Dividends paid ($0.32 per share)
    
-
    
-
    
-
    
(1,656
)
  
-
    
(1,656
)
Stock options exercised (1,825 shares)
    
2
    
21
    
-
    
-
    
-
    
23
  
Repurchase of 19,605 shares of common stock
    
(19
)
  
(14
)
  
-
    
(497
)
  
-
    
(530
)
                                       
Balance at September 30, 2007
  
$
5,159
  
$
21
  
$
-
  
$
72,203
  
$
(1,391
)
$
75,992
  
                                       
Balance at December 31, 2007
  
$
5,165
  
$
100
  
$
-
  
$
72,333
  
$
(206
)
$
77,392
  
                                       
Comprehensive income:
                                      
Net income
    
-
    
-
    
-
    
6,942
    
-
    
6,942
  
Unrealized losses arising during the period on securities available for sale, net of tax
    
-
    
-
    
-
    
-
    
(2,871
)
  
(2,871
)
Reclassification adjustment for realized gains on securities available for sale, net of tax
    
-
    
-
    
-
    
-
    
211
 
  
211
 
Total comprehensive income
    
-
    
-
    
-
    
6,942
    
(2,660
)
  
4,282
  
Dividends paid ($.15 per share)
                         
(2,641
)
         
(2,641
)
Stock options exercised (5,302 shares)
    
5
    
40
    
11
    
-
    
-
    
56
  
Treasury Stock Purchased
    
-
    
-
    
(883
)
  
-
    
-
    
(883
)
Fractional shares paid out in merger
    
-
      (3
)
  
-
    
-
    
-
    
(3
)
Shares issued in merger (3,519,788 shares)
    
3,520
    
78,245
    
-
    
-
    
-
    
81,765
  
Stock option value allocated to transaction purchase price
    
-
    
2,365
    
-
    
-
    
-
    
2,365
  
Cumulative effect adjustment for postretirement split dollar life insurance benefits
    
-
    
-
    
-
    
(133
)
  
-
    
(133
)
                                       
Balance at September 30, 2008
  
$
8,690
  
$
80,747
  
$
(872
)
$
76,501
  
$
(2,866
)
$
162,200
  

See accompanying notes to consolidated financial statements.


PART I — Item 1. Financial Statements, Continued

MIDWESTONE FINANCIAL GROUP, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)
  
Nine Months Ended
  
(dollars in thousands)
  
September 30,
  
   
2008
  
2007
  
Cash flows from operating activities:
          
Net income
  
$
6,942
  
$
4,817
  
Adjustments to reconcile net income to net cash
              
provided by operating activities: 
              
Depreciation and amortization 
    
1,735
   
993
 
Provision for loan losses 
    
1,666
   
425
 
Deferred income taxes 
    
(247
)
  
-
 
(Gain) loss on sale of available for sale investment securities
      (215
) 
  
299
 
Impairment loss on available for sale investment securities
     567     -  
Loss on sale of premises and equipment  
    
20
   
-
 
Amortization of investment securities and loan premiums 
     509    
-
 
Accretion of investment securities and loan discounts  
     (191
) 
  
-
 
Increase in accrued interest receivable  
    
(1,380
)
  
(1,103
)
(Increase) decrease in other assets  
    
4,159
 
  
(311
)
Decrease in accrued interest payable  
    
(1,771
)
  
-
 
(Decrease) increase in other liabilities  
    
(5,964
)
  
20
 
Net cash provided by operating activities
    
5,830
   
5,140
 
               
Cash flows from investing activities:
              
Investment securities available for sale:
              
Proceeds from sales  
     10,550    
24,472
 
Proceeds from maturities  
     45,190    
51,560
 
Purchases  
     (40,006 )  
(71,603
)
Investment securities held to maturity:
              
Proceeds from maturities  
     1,967    
9
 
Net increase in loans
   
(60,399
)
  
(12,186
)
Net increase in loan pool participations
    
(10,038
)
  
-
 
Purchases of premises and equipment
    
(667
)
  
(455
)
Proceeds from sale of premises and equipment
    
7
       
Increase in other intangible assets
    
(72
)
  
-
 
Net cash acquired in merger
    
20,351
   
-
 
Activity in bank-owned life insurance:
              
Purchases
    
(63
)
  
(68
)
(Increase) in cash value
    
(305
)
  
(232
)
Net cash used in investing activities
    
(33,485
)
  
(8,503
)
               
Cash flows from financing activities:
              
Net increase in deposits
    
7,480
   
6,311
 
Net decrease in federal funds purchased
    
(3,750
)
  
(2,488
)
Net increase in securities sold under agreements to repurchase
    
4,695
   
9,308
 
Proceeds from Federal Home Loan Bank advances
    
45,000
   
19,995
 
Repayment of Federal Home Loan Bank advances
    
(29,404
)
  
(22,515
)
Net increase in notes payable
    
6
   
-
 
Dividends paid
    
(2,641
)
  
(1,656
)
Proceeds from exercise of stock options
    
56
   
23
 
Repurchase of common stock
    
(883
)
  
(530
)
Net cash used in financing activities
    
20,559
   
8,448
 
               
Net increase (decrease) in cash and cash equivalents
    
(7,096
)
  
5,085
 
Cash and cash equivalents at beginning of period
    
34,220
   
17,449
 
Cash and cash equivalents at end of period
  
$
27,124
  
$
22,534
  
           
Supplemental disclosures of cash flow information:
              
Cash paid during the period for:
            
Interest
 
$
24,451
  
$
11,563
  
Income taxes
  
$
4,052
  
$
1,176
  

See accompanying notes to consolidated financial statements.
 

MidWestOne Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

1.
Introductory Note

On March 14, 2008, MidWestOne Financial Group, Inc. merged with and into ISB Financial Corp. in accordance with the Agreement and Plan of Merger dated as of September 11, 2007 (the “Merger”). As a result of the Merger, MidWestOne Financial Group, Inc. (“Former MidWestOne”) ceased to exist as a legal entity and ISB Financial Corp. survived the merger and changed its name to “MidWestOne Financial Group, Inc.” The surviving organization is referred to in this document as the “Company.”

Prior to the merger, ISB Financial Corp’s wholly-owned bank subsidiaries were Iowa State Bank & Trust Co. and First State Bank. Subsequent to the merger, the Company added MidWestOne Bank, MidWestOne Investment Services, Inc. and MidWestOne Insurance Services, Inc. as wholly-owned subsidiaries. On August 9, 2008, the three bank subsidiaries were merged with the resulting bank known as MidWestOne Bank headquartered in Iowa City, IA.

2.
Basis of Presentation

The accompanying consolidated statement of income for the three months ended September 30, 2008 include the accounts and transactions of MidWestOne Financial Group, Inc. (the “Company”) and its wholly-owned subsidiaries MidWestOne Bank and MidWestOne Insurance Services, Inc. The consolidated statement of income for the three months ended September 30, 2007 includes the results of the Company, Iowa State Bank & Trust Co. and First State Bank. The consolidated statements of income and cash flows for the nine months ended September 30, 2008 includes the results of operations for the Company and MidWestOne Bank and MidWestOne Insurance Services from March 15, 2008 through September 30, 2008. The consolidated statements of income and cash flows for the nine months ended September 30, 2007 include the results of operation for the Company, Iowa State Bank & Trust Co. and First State Bank. The consolidated statements of condition as of September 30, 2008 include the accounts and transactions of MidWestOne Financial Group, Inc. (the “Company”) and its wholly-owned subsidiaries, MidWestOne Bank and MidWestOne Insurance Services, Inc, as well as its former wholly-owned subsidiaries Iowa State Bank & Trust Co., First State Bank and MidWestOne Investment Services. The consolidated statements of condition as of December 31, 2007 include the accounts of ISB Financial Corp. and its wholly-owned subsidiaries Iowa State Bank & Trust Co. and First State Bank. All material intercompany balances and transactions have been eliminated in consolidation.

The accompanying consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U. S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. Management believes that the disclosures are adequate to make the information presented not misleading. In the opinion of management, the accompanying consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of September 30, 2008, and the results of operations and cash flows for the three months and the nine months ended September 30, 2008 and 2007.

The results for the three months or the nine months ended September 30, 2008 may not be indicative of results for the year ending December 31, 2008, or for any other period.

3.
Consolidated Statements of Cash Flows

In the consolidated statements of cash flows, cash and cash equivalents include cash and due from banks, interest-bearing deposits in banks, and federal funds sold.

4.
Income Taxes

Federal income tax expense for the three months and the nine months ended September 30, 2008 and 2007 was computed using the consolidated effective federal tax rate. The Company also recognized income tax expense pertaining to state franchise taxes payable individually by the subsidiary banks. The Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109” (“FIN 48”) effective January 1, 2007. The Company did not recognize any increase or decrease for unrecognized tax benefits as a result of the adoption of FIN 48. There were no unrecognized tax benefits or any interest or penalties on any unrecognized tax benefits as of September 30, 2008. 

5.
Earnings Per Common Share

Basic earnings per common share computations are based on the weighted average number of shares of common stock actually outstanding during the period. The weighted average number of shares outstanding for the three months ended September 30, 2008 and 2007 was 8,646,328 and 5,156,927, respectively. The weighted average number of shares outstanding for the nine-month period ended September 30, 2008 and 2007 was 7,707,301 and 5,163,943, respectively. Diluted earnings per share amounts are computed by dividing net income by the weighted average number of shares outstanding and all dilutive potential shares outstanding during the period. The computation of diluted earnings per share used a weighted average diluted number of shares outstanding of 8,646,328 and 5,157,688 for the three months ended September 30, 2008 and 2007, respectively. For the nine months ended September 30, 2008 and 2007, weighted average diluted shares outstanding were 7,707,301 and 5,170,613, respectively. The following table presents the computation of earnings per common share for the respective periods:


   
Three Months Ended
  
Nine months Ended
  
   
September 30,
  
September 30,
  
Earnings per Share Information:
  
2008
  
2007
  
2008
 
2007
 
                   
Weighted average number of shares outstanding during the period
    
8,646,328
    
5,156,927
    
7,707,301
    
5,163,943
  
                           
Weighted average number of shares outstanding during the period including all dilutive potential shares
    
8,646,328
    
5,157,688
    
7,707,301
    
5,170,613
  
                           
Net earnings
  
$
1,704,000
  
$
1,831,000
  
$
6,942,000
  
$
4,817,000
  
                           
Earnings per share - basic
  
$
0.20
  
$
0.36
  
$
0.90
  
$
0.93
  
                           
Earnings per share - diluted
  
$
0.20
  
$
0.36
  
$
0.90
  
$
0.93
  

6.
Split-Dollar Life Insurance

The Company adopted the Emerging Issues Task Force (“EITF”) Issue 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements”, on January 1, 2008. The EITF Issue 06-4 addresses accounting for separate agreements that split life insurance policy benefits between the employer and employee, and requires the employer to recognize a liability for future benefits payable to an employee under these agreements. The effects of adoption must be recognized through either a change in accounting principle through an adjustment to equity or through the retrospective application to all prior periods. Upon adoption, the Company recognized a liability of $133,000 by recording a cumulative effect through shareholders’ equity.

7.
Fair Value Measurements

Effective January 1, 2008, the Company adopted the provisions of SFAS No. 157, “Fair Value Measurements,” for financial assets and liabilities. In accordance with Financial Accounting Standards Board Staff Positions (FSP) No. 157-2, “Effective Date of FASB Statement No. 157,” the Company will delay application of SFAS 157 for non-financial assets and non-financial liabilities until January 1, 2009. These include foreclosed real estate, long-lived assets, goodwill and core deposit premium; which are recorded at fair value only upon impairment. SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements.

SFAS 157 defines 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. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and seller in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

SFAS 157 requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, SFAS 157 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

 
·
Level 1 Inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at measurement date.
 
 
 
·
Level 2 Inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.
 
 
·
Level 3 Inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.
 
A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below. These valuation methodologies were applied to all of the Company’s financial assets and liabilities carried at fair value effective January 1, 2008.

Securities Available for Sale. Investment securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. Included in the securities available for sale are common stock equities, which are reported at fair value using Level 1 inputs.

The following table summarizes financial assets and financial liabilities measured at fair value on a recurring basis as of September 30, 2008, segregated by the level of valuation inputs within the fair value hierarchy utilized to measure fair value:

   
Level 1
Inputs
 
Level 2
Inputs
 
Level 3
Inputs
 
Total
Fair Value
  
Securities available for sale
 
$
2,931
  
$
276,317
  
$
-
  
$
279,248
  
 
Valuation methods for instruments measured at fair value on a nonrecurring basis.

Federal Home Loan Bank Stock. Federal Home Loan Bank Stock carried in other assets represents our carrying value which is approximately equal to fair value. Fair value measurements for these securities are classified as Level 3 based on the undeliverable nature related to credit risk.

Collateral Dependent Impaired Loans. While the overall loan portfolio is not carried at fair value, adjustments are recorded on certain loans to reflect partial write-downs that are based on underlying collateral. In determining the value of real estate collateral, the Company relies on external appraisals and assessment of property values by the Company staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgments based on the experience and expertise of internal specialists. Because many of the inputs are not observable, the measurements are classified as Level 3.

The following table summarizes financial assets and financial liabilities measured at fair value on a non recurring basis as of September 30, 2008, segregated by the level of valuation inputs within the fair value hierarchy utilized to measure fair value.

   
Level 1
Inputs
 
Level 2
Inputs
 
Level 3
Inputs
 
Total
Fair Value
 
Federal Home Loan Bank Stock
  
$
-
  
$
-
  
$
9,073
  
$
9,073
  
Collateral Dependent Impaired Loans
  
$
-
  
$
-
  
$
13,867
  
$
13,867
  
 
8.
Effect of New Financial Accounting Standards
 
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 allows companies to elect fair-value measurement of specified financial instruments and warranty and insurance contracts when an eligible asset or liability is initially recognized or when an event, such as a business combination, triggers a new basis of accounting for that asset or liability. The election, called the “fair value option,” will enable some companies to reduce the volatility in reported earnings caused by measuring related assets and liabilities differently. The election is available for eligible assets or liabilities on a contract-by-contract basis without electing it for identical assets or liabilities under certain restrictions. SFAS No. 159 was effective January 1, 2008. The adoption of SFAS No. 159 did not have an effect on the Company’s financial condition or results of operations.

In December 2007, the FASB issued Statement No. 141 (Revised 2007) “Business Combinations” (“SFAS No. 141R”) and Statement No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51” (“SFAS No. 160”). SFAS No. 141R and SFAS No. 160 require significant changes in the accounting and reporting for business acquisitions and the reporting of a noncontrolling interest in a subsidiary. Among many changes under SFAS No. 141R, an acquirer will record 100% of all assets and liabilities at fair value at the acquisition date with changes possibly recognized in earnings, and acquisition related costs will be expensed rather than capitalized. SFAS No. 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary. Key changes under the standard are that noncontrolling interests in a subsidiary will be reported as part of equity, losses allocated to a noncontrolling interest can result in a deficit balance, and changes in ownership interests that do not result in a change of control are accounted for as equity transactions and upon a loss of control, gain or loss is recognized and the remaining interest is remeasured at fair value on the date control is lost. SFAS No. 141R and SFAS No. 160 apply prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption is not permitted. The Company will adopt these statements on January 1, 2009.
 

In March 2008, the FASB issued Statement No. 161 “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS No. 161”). SFAS No. 161 requires companies with derivative instruments to disclose information that should enable financial-statement users to understand how and why a company uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS No. 133, and how derivative instruments and related hedged items affect a company’s financial position, financial performance and cash flows. SFAS is effective for financial statements issued for fiscal years beginning after November 15, 2008. The Company does not anticipate that the adoption of this statement will have a material effect on its financial condition or results of operation.

In April 2008, the FASB issued FASB Staff Position (FSP) FAS 142-3, “Determination of the Useful Life of Intangible Assets.” This FSP is an amendment of SFAS No. 142, Goodwill and Other Intangible Assets. FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset. The objective of the FSP is to improve the consistency between the useful life of a recognized intangible asset and the period of expected cash flows. This FSP is effective for the Company beginning January 1, 2009. The Company does not expect the adoption of the Statement will have a material impact on its financial condition or results of operations.

In May 2008, the FASB issued Statement No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 162”). SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. It is anticipated that SFAS No. 162 will aid in reducing financial reporting complexity. SFAS No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.” The Company will adopt this statement when it becomes effective. The adoption of this statement is not expected to have a material effect on the financial condition or results of operations.
 
In October 2008, the FASB issued FASB Staff Position No. 157-3 (“FAS 157-3”), “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” which clarifies the application of FAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. This FSP was effective upon issuance, including prior periods for which financial statements have not been issued. The Company adopted this guidance effective September 30, 2008, and the adoption did not have an impact on its financial condition or results of operations.

9.
Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates. A significant estimate that is particularly sensitive to change is the allowance for loan losses.

10.
Business Combinations

On March 14, 2008, the Company and Former MidWestOne completed their merger. Former MidWestOne was the parent company of MidWestOne Bank, MidWestOne Investment Services, Inc. and MidWestOne Insurance Services, Inc. The Company merged with Former MidWestOne in order to create a strong, independent financial services institution headquartered in Iowa that has the increased resources of the combined institution and the potential to achieve greater earnings and balance sheet growth. The Company issued 3,519,788 shares of common stock in exchange for 100% of common stock of Former MidWestOne with a market value of approximately $81.8 million. The Company also issued replacement stock options to the holders of the currently outstanding options of the former MidWestOne in conjunction with the business combination. The fair value of the replacement options is a component of the purchase price. A total of 393,409 replacement options were issued on March 14, 2008, having a fair value of $2.4 million. The Company incurred $1.1 million in transaction costs in the business combination. Former MidWestOne had assets in excess of $760 million and 19 banking offices located in Iowa.

The following is Former MidWestOne’s condensed balance sheet showing the estimated fair values of assets acquired and liabilities assumed as of the date of acquisition. Given the timing of the transaction closing, the purchase price allocation has not been finalized. The Company is in the process of obtaining third-party valuations of certain tangible assets and liabilities, and intangible assets; thus the allocation of the purchase price is subject to refinement. The Company anticipates that the valuations will be finalized in the fourth quarter of 2008.

Condensed Balance Sheet
      
       
Cash & Cash Equivalents
  
$
20,351
  
Investment Securities
    
86,465
  
Loans (net)
    
536,223
  
Loan Pools
    
90,876
  
Other Assets
    
37,603
  
Other Intangible Assets
    
13,507
  
Total Assets
  
$
785,025
  
         
Deposits
  
$
586,721
  
Fed Funds Purchased
    
6,000
  
FHLB Advances
    
96,113
  
Other Borrowed Money
    
1,500
  
Trust Preferred
    
15,683
  
Other Liabilities
    
16,363
  
Total Liabilites
    
722,380
  
         
Net Assets Acquired
    
62,645
  
         
Capitalized Merger Costs
    
1,114
  
         
Value of Shares Issued
    
81,765
  
         
Value of Options Issued
    
2,365
  
         
Goodwill (shares isued to Former MidWestOne
        
shareholders + value of options issued less net assets acquired plus merger costs)
  
$
22,599
  

Assuming the Merger of Former MidWestOne occurred on January 1, 2008, the following summarizes the unaudited pro forma combined operating results for the three months and nine months ended September 30, 2008 and 2007:

   
Nine Months Ended Septmeber 30,
 
(dollars in thousands, except per share)
          
   
2008
  
2007
  
           
Pro forma Interest Income
  
$
57,219
    
66,346
 
Pro forma Interest Expense
    
24,444
   
33,630
 
Pro forma Net Interest Income
    
32,775
   
32,716
 
Pro forma Provision for Loan Losses
    
1,710
   
1,164
 
Pro forma Noninterest Income
    
10,640
   
11,035
 
Pro forma Noninterest Expense
    
30,962
   
30,308
 
Pro forma Income before Tax
    
10,743
   
12,279
 
Pro forma Income Tax
    
3,411
   
3,452
 
Pro forma Net Income
  
$
7,332
    
8,827
 
               
Pro forma earnings per share - basic
  
$
0.84
  
$
0.93
  
               
Proforma earnings per share - diluted
  
$
0.84
  
$
0.93
  
 
 
  
Quarter Ended September 30,
  
(dollars in thousands, except per share)
              
   
2008
  
2007
  
               
Pro forma Interest Income
  
$
19,438
    
21,120
 
Pro forma Interest Expense
    
8,489
   
10,138
 
Pro forma Net Interest Income
    
10,949
   
10,982
 
Pro forma Provision for Loan Losses
    
838
   
329
 
Pro forma Noninterest Income
    
3,024
   
3,716
 
Pro forma Noninterest Expense
    
10,954
   
9,880
 
Pro forma Income before Tax
    
2,181
   
4,489
 
Pro forma Income Tax
    
477
   
1,322
 
Pro forma Net Income
  
$
1,704
    
3,167
 
               
Pro forma earnings per share - basic
  
$
0.20
  
$
0.36
  
               
Proforma earnings per share - diluted
  
$
0.20
  
$
0.36
  
 


PART I — Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

OVERVIEW

The following discussion is provided for the consolidated operations of MidWestOne Financial Group, Inc. (the “Company”), which as of September 30, 2008, includes its wholly-owned banking subsidiary MidWestOne Bank and its insurance subsidiary MidWestOne Insurance Services, Inc. At the close of business on March 14, 2008, ISB Financial Corp. (“ISBF”) and MidWestOne Financial Group, Inc. (“former MidWestOne “) completed a merger-of-equals with ISBF being the surviving entity. Upon consummation of the merger, ISBF adopted the name MidWestOne Financial Group, Inc. At the time of the merger, ISBF had two wholly-owned banking subsidiaries - Iowa State Bank & Trust Co. and First State Bank. At the time of the merger, Former MidWestOne had one bank subsidiary- MidWestOne Bank; an insurance subsidiary - MidWestOne Insurance Services, Inc.; and an investment brokerage subsidiary - MidWestOne Investment Services, Inc. The Company operated the three bank subsidiaries from March 15, 2008 to August 9, 2008, at which time the three banks were merged under the name of MidWestOne Bank. MidWestOne Investment Services has also been merged into the bank subsidiary. The results of operations for the quarter ended September 30, 2008 include the Company and all subsidiaries. The results of operations for the quarter and the nine months ended September 30, 2007 include ISBF and its two bank subsidiaries. The results of operations for the nine months ended September 30, 2008 include ISBF and its two bank subsidiaries for the entire period plus the results of operation for the former MidWestOne subsidiaries from March 15, 2008 through September 30, 2008. The discussion also focuses on the consolidated financial condition of the Company and its subsidiaries as of September 30, 2008 and ISBF and its subsidiaries as of December 31, 2007.

On October 17, 2008, the Company sold its branch location in Wapello, Iowa, to Community Bank of Muscatine, Iowa. Community Bank assumed approximately $8.6 million in deposits. The Company retained the loans associated with the branch and will service them through its branch location in Burlington, Iowa. A premium of 6% of the deposits was received by the Company and will be recognized as income in the fourth quarter of 2008.

Recent Developments

Recent events in the U.S. and global financial markets, including the deterioration of the worldwide credit markets, have created significant challenges for financial institutions such as the Company. Dramatic declines in the housing market during the past year, marked by falling home prices and increasing levels of mortgage foreclosures, have resulted in significant write-downs of asset values by many financial institutions, including government-sponsored entities and major commercial and investment banks. In addition, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers, including other financial institutions, as a result of concern about the stability of the financial markets and the strength of counterparties.

In response to the crises affecting the U.S. banking system and financial markets and attempt to bolster the distressed economy and improve consumer confidence in the financial system, on October 3, 2008, the U.S. Congress passed, and the President signed into law, the Emergency Economic Stabilization Act of 2008 (the “Stabilization Act”). The Stabilization Act authorizes the Secretary of the U.S. Treasury and the Federal Deposit Insurance Corporation (the “FDIC”) to implement various temporary emergency programs designed to strengthen the capital positions of financial institutions and stimulate the availability of credit within the U.S. financial system. Pursuant to the Stabilization Act, the U.S. Treasury will have the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.


On October 14, 2008, the U.S. Treasury announced that it will purchase equity stakes in eligible financial institutions that wish to participate. This program, known as the Capital Purchase Program, allocates $250 billion from the $700 billion authorized by the Stabilization Act to the U.S. Treasury for the purchase of senior preferred shares from qualifying financial institutions. Eligible institutions will be able to sell equity interests to the U.S. Treasury in amounts equal to between 1% and 3% of the institution’s risk-weighted assets. In conjunction with the purchase of preferred stock, the U.S. Treasury will receive warrants to purchase common stock from the participating institutions with an aggregate market price equal to 15% of the preferred investment. Participating financial institutions will be required to adopt the U.S. Treasury’s standards for executive compensation and corporate governance for the period during which the U.S. Treasury holds equity issued under the Capital Purchase Program. Many financial institutions have already announced that they will participate in the Capital Purchase Program. While the Company’s management believes that the Company has sufficient capital to support continued growth, the Company has filed an application to participate in the Capital Purchase Program.

Also on October 14, 2008, using the systemic risk exception to the FDIC Improvement Act of 1991, the U.S. Treasury authorized the FDIC to provide a 100% guarantee of newly-issued senior unsecured debt and deposits in non-interest bearing accounts at FDIC insured institutions. Initially, all eligible financial institutions will automatically be covered under this program, known as the Temporary Liquidity Guarantee Program, without incurring any fees for a period of 30 days. Coverage under the Temporary Liquidity Guarantee Program after the initial 30-day period is available to insured financial institutions at a cost of 75 basis points per annum for senior unsecured debt and 10 basis points per annum for non-interest bearing deposits. After the initial 30-day period, institutions will continue to be covered under the Temporary Liquidity Guarantee Program unless they inform the FDIC that they have decided to opt out of the program. The Company is assessing its participation in the Temporary Liquidity Guarantee Program and anticipates that it will participate in the insurance program covering the non-interest bearing deposits but not participate in the program to guarantee unsecured senior debt.
 
The Stabilization Act also temporarily increases the amount of insurance coverage of deposit accounts held at FDIC-insured depository institutions, including MidWestOne Bank, from $100,000 to $250,000. The increased coverage is effective during the period from October 3, 2008 until December 31, 2009.

It is not clear at this time what impact the Stabilization Act, the Capital Purchase Program, other liquidity and funding initiatives of the Federal Reserve and other agencies that have been previously announced, and any additional programs that may be initiated in the future will have on the Company’s future financial condition and results of operations.


RESULTS OF OPERATIONS

Quarter Ended September 30, 2008
 
Summary

The Company earned net income of $1.7 million for the quarter ended September 30, 2008, compared with $1.8 million for the quarter ended September 30, 2007, a decrease of 7%. Basic and diluted earnings per share for the third quarter of 2008 were $.20 versus $.36 for the third quarter of 2007. The Company’s return on average assets for the third quarter of 2008 was 0.44% compared with a return of 1.07% for the same period in 2007. The Company’s return on average equity was 4.23% for the quarter ended September 30, 2008 versus 9.84% for the quarter ended September 30, 2007. Return on tangible equity was 5.46% for the third quarter of 2008 compared with 10.50% for the same period in 2007.

Net income and earnings per share were lower in the third quarter of 2008 compared with the second quarter of 2008 primarily as the result of nonrecurring events. First, the Company recognized $400,000 of flood loss expense incurred by two of its branch locations. Additionally, the Company reduced the carrying value of a truck stop/convenience store held as other real estate by $500,000 during the third quarter. The reduction in earnings per share related to these losses was $0.08. Net interest income in the third quarter was $423,000 lower compared with second quarter primarily due to reduced income on the Company’s loan pool participations. Noninterest income was also lower in the third quarter due to reduced brokerage and investment service fees and commissions as the recent general decline in stock prices had a large effect on trailing commissions earned. Net income for the quarter ended June 30, 2008 was $3.0 million, or $0.34 basic and diluted earnings per share.

The following table presents selected financial results and measures for the third quarter of 2008 and 2007.

($ amounts in thousands)
  
Quarter Ended September 30,
  
   
2008
  
2007
  
           
Net Income
  
$
1,704
  
$
1,831
  
Average Assets
    
1,532,809
    
681,049
  
Average Shareholders’ Equity
    
160,320
    
73,829
  
Return on Average Assets
    
0.44%
 
  
1.07%
 
Return on Average Equity
    
4.23%
 
  
9.84%
 
Return on Average Tangible Equity
    
5.46%
 
  
10.50%
 
Equity to Assets (end of period)
    
10.66%
 
  
11.14%
 
Tangible Equity to Assets (end of period)
    
8.22%
 
  
10.53%
 


Net Interest Income

Net interest income is computed by subtracting total interest expense from total interest income. Fluctuations in net interest income can result from the changes in the volumes of assets and liabilities as well as changes in interest rates. The Company’s net interest income for the quarter ended September 30, 2008 increased $6.0 million, or 122%, to $10.9 million from $4.9 million from the quarter ended September 30, 2007. Total interest income was $9.6 million greater in the third quarter of 2008 compared with the same period in 2007. Most of the increase in interest income was due to increased interest on loans, which was mainly attributable to increased volumes attributable to the merger. The increase in interest income was offset by increased interest expense on deposits and borrowed funds. Total interest expense for the third quarter of 2008 increased $3.6 million, or 75%, compared with the same period in 2007 due primarily to increased volumes related to the merger. The Company’s net interest margin on a federal tax-equivalent basis for the third quarter of 2008 increased to 3.25% compared with 3.24% in the third quarter of 2007. Net interest margin is a measure of the net return on interest-earning assets and is computed by dividing annualized net interest income by the average of total interest-earning assets for the period. The Company’s overall yield on earning assets declined to 5.67% for the third quarter of 2008 compared with 6.24% for the third quarter of 2007. The rate on interest-bearing liabilities decreased in the third quarter of 2008 to 2.84% compared to 3.58% for the third quarter of 2007.

The following table presents a comparison of the average balance of earning assets, interest-bearing liabilities, interest income and expense, and average yields and costs for the quarter ended September 30, 2008 and 2007. Interest income on tax-exempt securities and loans is reported on a fully tax-equivalent basis assuming a 34% tax rate. Dividing annualized income or expense by the average balances of assets or liabilities results in average yields or costs.
 
   
Three Months ended September 30,
  
(in thousands)
  
2008
  
2007
  
   
Average
Balance
  
Interest
  
Average
Rate
  
Average
Balance
  
Interest
  
Average
Rate
  
Average earning assets:
                                      
Loans
   
997,948
   
14,842
   
5.92
%
  
394,513
   
7,024
   
7.06
%
Loan pool participations
   
92,787
   
1,228
   
5.27
%
  
-
   
-
       
Interest bearing deposits
    
488
   
23
   
18.76
%
  
104
   
1
   
3.81
%
Investment securities:
                                      
Available for sale
   
291,352
   
3,690
   
5.04
%
  
231,092
   
2,863
   
4.92
%
Held to maturity
   
8,342
   
145
   
6.92
%
  
107
   
5
   
18.60
%
Federal funds sold
   
13,369
   
70
   
2.08
%
  
15,924
   
201
   
5.01
%
Total earning assets
   
1,404,286
   
19,998
   
5.67
%
  
641,740
   
10,094
   
6.24
%
                                       
Average interest-bearing liabilities:
                                      
Interest-bearing demand deposits
   
341,023
   
2,125
   
2.48
%
  
204,711
   
463
   
0.90
%
Savings deposits
   
62,937
   
109
   
0.69
%
  
28,066
   
326
   
4.61
%
Certificates of deposit
   
555,027
   
4,218
   
3.02
%
  
214,616
   
3,033
   
5.61
%
Federal funds purchased
   
6,975
   
29
   
1.65
%
  
120
   
2
   
6.63
%
Securities sold under agreements to repurchase
    
51,925
   
292
   
2.24
%
  
49,843
   
541
   
4.31
%
Federal Home Loan Bank advances
   
158,310
   
1,528
   
3.84
%
  
40,656
   
468
   
4.57
%
Notes payable
   
329
   
1
   
1.21
%
  
359
   
28
   
30.94
%
Long-term debt
   
15,463
   
187
   
4.81
%
  
-
   
-
       
Total interest-bearing liabilities
   
1,191,990
   
8,489
   
2.84
%
  
538,371
   
4,861
   
3.58
%
Net interest income
         
11,509
               
5,233
       
Net interest margin
               
3.25
%
              
3.24
%

Interest income and fees on loans increased $7.8 million, or 113%, in the third quarter of 2008 compared to the same period in 2007. Average loans were $603.4 million, or 153% higher in the third quarter of 2008 compared with 2007, which contributed to the growth in interest income. The increase in average loan volume was primarily attributable to the merger. The yield on the Company’s loan portfolio is affected by the amount of nonaccrual loans (which do not earn interest income), the mix of the portfolio (real estate loans generally have a lower overall yield than commercial and agricultural loans), the effects of competition and the interest rate environment on the amounts and volumes of new loan originations, and the mix of variable rate versus fixed rate loans in the Company’s portfolio. During the third quarter of 2008, loan interest income was reduced by $158,000 caused by an increase in loans on non accrual status, affecting the overall yield on the loan portfolio. The average rate on loans decreased from 7.06% in the third quarter of 2007 to 5.92% in third quarter of 2008, primarily due to the overall decline in market interest rates between the periods.

Interest and discount income on loan pool participations was $1.2 million for the third quarter of 2008 compared with $0 for the third quarter of 2007. These loan pool participations are pools of performing, distressed and nonperforming loans purchased at varying discounts from the aggregate outstanding principal amount of the underlying loans. The loan pools are held and serviced by a third-party independent servicing corporation. The Company invests in the pools that are purchased by the servicer from nonaffiliated banking organizations and from the FDIC acting as receiver of failed banks and savings associations. Currently, the Company holds $100.9 million in loan pool participations.


Income is derived from this investment in the form of interest collected and the repayment of the principal in excess of the purchase cost which is herein referred to as “discount recovery.” The loan pool participations were historically a high-yield activity, but this yield has fluctuated from period to period based on the amount of cash collections, discount recovery, and net collection expenses of the servicer in any given period. The income and yield on loan pool participations may vary in future periods due to the volume and discount rate on loan pools purchased.

Interest income on investment securities on a tax-equivalent basis increased $967,000, or 34%, in the third quarter of 2008, compared with the third quarter of 2007 mainly due to higher volume of securities in the portfolio as a result of the merger, as well as a slightly higher yield in 2008. Interest income on investment securities totaled $4.0 million in the third quarter of 2008 compared with $2.9 million for the third quarter of 2007. The average balance of investments in the third quarter of 2008 was $299.7 million compared with $231.2 million in the third quarter of 2007, as a result of the merger. The tax-equivalent yield on the Company’s investment portfolio in the third quarter of 2008 increased to 5.09% from 4.92% in the comparable period of 2007 reflecting reinvestment of maturing securities and purchases of new securities at higher market interest rates.

Interest expense on deposits was $2.6 million, or 69%, greater in the third quarter of 2008 compared with the same period in 2007 mainly due to the increased volume of deposits following the Merger. Offsetting this increase in deposits was a decrease in interest rates paid on deposits as the weighted average rate paid on interest-bearing deposits was 2.68% in the third quarter of 2008 compared with 3.39% in the third quarter of 2007. This decline reflected the reduction in interest rates on deposits throughout the markets. The recent reductions in market interest rates have enabled the Company to substantially reduce the rates it pays on deposit accounts. Average interest-bearing deposits for the third quarter of 2008 were $511.6 million greater compared with the same period in 2007 as a result of the Merger.

Interest expense on borrowed funds was $1.2 million greater in the third quarter of 2008 compared with the same period in 2007. Interest on borrowed funds totaled $1.7 million for the third quarter of 2008. The Company’s average borrowed funds balances were greater in 2008 mainly due to the merger, which resulted in additional interest expense. Lower market interest rates in 2008 helped to offset the higher volume of borrowed funds. Average borrowed funds for the third quarter of 2008 were $133.1 million greater compared to the same period in 2007. The majority of the difference was created through advances by the Federal Home Loan Bank. The weighted average rate paid on borrowed funds decreased to 3.92% in the third quarter of 2008 compared with 4.80% in the third quarter of 2007.

Provision for Loan Losses

The Company recorded a provision for loan losses of $838,000 in the third quarter of 2008 compared with a $75,000 provision in the third quarter of 2007. Net loans charged off in the third quarter of 2008 totaled $409,000 compared with net loans charged off of $231,000 in the third quarter of 2007. The increase in the provision in the third quarter of 2008 compared with the same period in 2007 reflects the increase in net charge-offs as well as a higher level of nonperforming loans and general concerns with the overall economic situation. Management determines an appropriate provision based on its evaluation of the adequacy of the allowance for loan losses in relationship to a continuing review of problem loans, the current economic conditions, actual loss experience and industry trends. Management believed that the allowance for loan losses was adequate based on the inherent risk in the portfolio as of September 30, 2008; however, there is no assurance losses will not exceed the allowance and any growth in the loan portfolio and the uncertainty of the general economy require that management continue to evaluate the adequacy of the allowance for loan losses and make additional provisions in future periods as deemed necessary.


Noninterest Income

Noninterest income results from the charges and fees collected by the Company from its customers for various services performed, miscellaneous other income, and gains (or losses) from the sale of investment securities held in the available for sale category. Total noninterest income was $712,000, or 31%, greater in the third quarter of 2008 compared with the same period in 2007. Most of the change between the periods is due to the merger. Security gains totaled $9,000 in the third quarter of 2008 compared with no gain or loss recognized in the third quarter of 2007. Noninterest income was negatively impacted in the third quarter due to reduced brokerage and investment service fees and commissions as the recent general decline in stock prices had a large effect on trailing commissions earned.

Noninterest Expense

Noninterest expense for the third quarter of 2008 was $11.0 million and included all the costs incurred to operate the Company except for interest expense, the loan loss provision and income taxes. Noninterest expense for the third quarter of 2008 increased $6.3 million over the third quarter of 2007 primarily due to the merger with Former MidWestOne. The Company’s three former subsidiary banks were merged on August 9, 2008, which management anticipates will facilitate the realization of anticipated cost savings into the future. Additional personnel costs associated with the merger of the three bank subsidiaries, including conversion and overtime costs increased noninterest expense for the third quarter of 2008. It is anticipated that personnel costs and other operating expenses will be reduced in future periods following the bank merger. Noninterest expense in the third quarter of 2008 included the recognition of $400,000 of flood loss expense incurred by two of the Company’s branch locations. Additionally, the Company reduced the carrying value of a truck stop/convenience store held as other real estate by $500,000 during the third quarter of 2008. Both the $400,000 flood loss and the $500,000 other real estate charge were included in other operating expense. Management anticipates that future FDIC assessments will be higher as a result of the recent bank closings and due to the increased insurance coverage afforded to depositors.

Income Tax Expense

The Company incurred income tax expense of $477,000 for the third quarter ended September 30, 2008 compared with $638,000 for the same period in 2007. The effective income tax rates as a percentage of income before taxes for the three months ended September 30, 2008 and 2007 were 21.9% and 25.8%, respectively. The effective tax rate varies from the statutory rate due to state taxes and the amount of tax-exempt income on municipal bonds earned during the period. Tax-exempt income on municipal bonds is greater in comparison to previous periods as the market yields on recently purchased bonds has increased and the Company has a higher volume of municipal bonds.

Nine Months Ended September 30, 2008
Summary

The Company earned net income of $6.9 million for the nine months ended September 30, 2008, compared with $4.8 million for the nine months ended September 30, 2007, an increase of 44%. The increase in net income was primarily due to the merger. Basic and diluted earnings per share for the first nine months of 2008 were $0.90 versus $0.93 for the first nine months of 2007. The Company’s return on average assets for the first nine months of 2008 was 0.70% compared with a return of 0.96% for the first nine months of 2007. The Company’s return on average equity was 6.61% for the nine months ended September 30, 2008 versus 8.79% for the nine months ended September 30, 2007. Return on tangible equity was 8.91% for the first nine months of 2008 compared with 9.39% for the same period in 2007.


The following table presents selected financial results and measures for the first nine months of 2008 and 2007.

 
Nine Months Ended September 30,
 
 
 
2008
 
2007
  
           
Net Income
  
$
6,942
  
$
4,817
  
Average Assets*
    
1,322,393
    
673,709
  
Average Shareholders’ Equity*
    
140,297
    
73,234
  
Return on Average Assets
    
0.70%
 
  
0.96%
 
   
6.61%
 
  
8.79%
 
Return on Average Tangible Equity
    
8.91%
 
  
9.39%
 
 
* Note - Averages for the nine months reflect the inclusion of and the increase in average assets and shareholders’ equity resulting from the merger with Former MidWestOne from March 15, 2008 through September 30, 2008.

Net Interest Income

The Company’s net interest income for the nine months ended September 30, 2008 increased $14.1 million, or 99%, to $28.5 million from $14.2 million from the nine months ended September 30, 2007. Total interest income was $22.5 million greater in the first nine months of 2008 compared with the same period in 2007. Most of the increase in interest income was due to increased interest on loans and loan pools, which was mainly attributable to increased volumes of loans and loan pools reflecting the merger. The increase in interest income was offset by increased interest expense on deposits and borrowed funds related to the merger. Total interest expense for the first nine months of 2008 increased $8.4 million, or 59%, compared with the same period in 2007 due primarily to increased volumes. The Company’s net interest margin on a federal tax-equivalent basis for the first nine months of 2008 increased to 3.31% compared with 3.25% for the nine months ended September 30, 2007. The Company’s overall yield on earning assets decreased to 5.83% for the first nine months of 2008 compared with 6.23% for the nine months ended September 30, 2007. The rate on interest-bearing liabilities decreased in the first nine months of 2008 to 2.49% compared to 3.54% for the first nine months of 2007.

The following table presents a comparison of the average balance of earning assets, interest-bearing liabilities, interest income and expense, and average yields and costs for the nine months ended September 30, 2008 and 2007. Interest income on tax-exempt securities and loans is reported on a fully tax-equivalent basis assuming a 34% tax rate. Dividing annualized income or expense by the average balances of assets or liabilities results in average yields or costs. Average balances for the nine months ended September 30, 2008 reflect the additional assets and liabilities of the acquired subsidiaries from March 15, 2008 through September 30, 2008.

   
Nine Months Ended September 30,
 
(in thousands)
 
2008
 
2007
 
 
 
Average
 
 
 
Average
 
Average
 
 
 
Average
 
 
 
Balance
 
Interest
 
Rate
 
Balance
 
Interest
 
Rate
  
Average earning assets:
                                      
Loans
   
828,823
   
38,238
   
6.16
%
  
387,077
   
20,563
   
7.10
%
Loan pool participations
   
65,138
   
3,145
   
6.45
%
  
-
   
-
       
Interest-bearing deposits
   
143
   
26
   
24.24
%
  
108
     -    
0.00
%
Investment securities:
                                      
Available for sale
   
279,660
   
10,165
   
4.86
%
  
238,894
   
8,684
   
4.86
%
Held to maturity
   
6,769
   
248
   
4.89
%
  
110
   
5
   
6.08
%
Federal funds sold
   
14,363
   
298
   
2.77
%
  
9,852
   
396
   
5.37
%
Total earning assets
   
1,194,896
   
52,120
   
5.83
%
  
636,041
   
29,648
   
6.23
%
                                       
Average interest-bearing liabilities:
                                      
Interest-bearing demand deposits
   
334,086
   
3,174
   
1.27
%
  
163,293
   
1,331
   
1.09
%
Savings deposits
   
89,492
   
1,295
   
1.93
%
  
29,132
   
1,015
   
4.66
%
Certificates of deposit
   
557,997
   
12,856
   
3.08
%
  
245,415
   
8,652
   
4.71
%
Federal funds purchased
   
12,041
   
60
   
0.67
%
  
1,395
   
59
   
5.65
%
Securities sold under agreements
    
 
                                
to repurchase
    
50,577
   
814
   
2.15
%
  
50,271
   
1,565
   
4.16
%
Federal Home Loan Bank advances
   
153,914
   
3,812
   
3.31
%
  
43,625
   
1,478
   
4.53
%
Notes payable
   
336
   
110
   
43.78
%
  
1,573
   
77
   
6.54
%
Long-term debt
   
10,382
   
433
   
5.57
%
  
-
   
-
       
Total interest-bearing liabilities
   
1,208,826
   
22,554
   
2.49
%
  
534,704
   
14,177
   
3.54
%
Net interest income
         
29,566
               
15,471
       
Net interest margin
               
3.31
%
              
3.25
%


Interest income and fees on loans increased $17.7 million, or 86%, in the first nine months of 2008 compared to the same period in 2007. Average loans were $441.7 million, or 114% higher in the first nine months of 2008 compared with 2007, which contributed to the growth in interest income. The increase in average loan volume was primarily attributable to the merger. The yield on the Company’s loan portfolio is affected by the amount of nonaccrual loans (which do not earn interest income), the mix of the portfolio (real estate loans generally have a lower overall yield than commercial and agricultural loans), the effects of competition and the interest rate environment on the amounts and volumes of new loan originations, and the mix of variable rate versus fixed rate loans in the Company’s portfolio. The average rate on loans decreased from 7.10% in the first nine months of 2007 to 6.16% in the first nine months of 2008, primarily due to the overall decline in market interest rates between the periods.

Interest and discount income on loan pool participations was $3.15 million for the first nine months of 2008. No interest and discount income was recorded by the Company in the first nine months of 2007. The Company did not have any loan pool participations in 2007.

Interest income on investment securities increased $1.7 million, or 20%, on a tax equivalent basis, in the nine months ended September 30, 2008, compared with the first nine months of 2007 mainly due to higher volume of securities in the portfolio as a result of the merger, as well as a slightly higher yield in 2008. Interest income on investment securities totaled $10.4 million in the first nine months of 2008 compared with $8.7 million for the first nine months of 2007. The average balance of investments in the first half of 2008 was $286.4 million compared with $239.0 million in the first nine months of 2007. The tax-equivalent yield on the Company’s investment portfolio in the first nine months of 2008 remained at 4.86% from the comparable period of 2007.

Interest expense on deposits was $6.3 million, or 56%, greater in the first nine months of 2008 compared with the same period in 2007 mainly due to the increased volume of deposits following the merger. Offsetting this increase in deposit volumes was a decrease in interest rates paid on deposits as the weighted average rate paid on interest-bearing deposits was 2.36% in the first nine months of 2008 compared with 3.36% in the first half of 2007. This decline reflected the reduction in interest rates on deposits throughout the markets. The recent reductions in market interest rates have enabled the Company to substantially reduce the rates it pays on deposit accounts. Average interest-bearing deposits for the first nine months of 2008 were $543.7 million greater compared with the same period in 2007 as a result of the Merger.

Interest expense on borrowed funds was $2.7 million greater in the first nine months of 2008 compared with the same period in 2007. Interest on borrowed funds totaled $4.3 million for the first nine months of 2008. The Company’s average borrowed funds balances were greater in 2008 mainly due to the merger, which resulted in additional interest expense. Lower market interest rates in 2008 helped to offset the higher volume of borrowed funds. Average borrowed funds for the first nine months of 2008 were $119.4 million greater compared to the same period in 2007. The weighted average rate paid on borrowed funds decreased to 3.53% in the first nine months of 2008 compared with 4.60% in the first nine months of 2007.

 
Provision for Loan Losses

The Company recorded a provision for loan losses of $1.67 million in the first nine months of 2008 compared with a $425,000 provision in the first nine months of 2007. The increase in the provision for loan losses is attributable to increased loan charge-offs in 2008, growth in the loan portfolio and higher levels of nonperforming assets reflecting stress in the local and national economy. Net loans charged off in the same period in 2008 totaled $698,000 compared with net charge offs of $102,000 in the same period of 2007. Management determined an appropriate provision based on its evaluation of the adequacy of the allowance for loan losses in relationship to a continuing review of problem loans, the current economic conditions, actual loss experience and industry trends. Management believed that the allowance for loan losses was adequate based on the inherent risk in the portfolio as of September 30, 2008; however, there is no assurance losses will not exceed the allowance and any growth in the loan portfolio and the uncertainty of the general economy require that management continue to evaluate the adequacy of the allowance for loan losses and make additional provisions in future periods as deemed necessary.

Noninterest Income

Noninterest income results from the charges and fees collected by the Company from its customers for various services performed, miscellaneous other income, and gains (or losses) from the sale of investment securities held in the available for sale category. Total noninterest income was $2.33 million, or 36%, greater in the first nine months of 2008 compared with the same period in 2007. Most of the increase between the first nine months of 2008 in comparison to the same period of 2007 was due to the merger. Results for the first nine months of 2008 were affected by a $567,000 write-down of equity securities held in the Company’s investment portfolio that were determined to be an “other than temporary impairment” loss. This write-down was attributable to the decline in the market prices of these stocks, which were below their historical cost. This charge to year-to-date 2008 earnings resulted in a reduction in earnings per share of $0.04 for the nine months ended September 30, 2008.

Noninterest Expense

Noninterest expense for the nine months of 2008 was $26.4 million and included all the costs incurred to operate the Company except for interest expense, the loan loss provision and income taxes. Operating expenses for the subsidiaries of Former MidWestOne were included for the period from March 15, 2008 through September 30, 2008, which is the primary result of the increase from the comparable period. Noninterest expense for the nine months ended September 30, 2008 included the recognition of $400,000 of flood loss expense incurred by two of the Company’s branch locations. Additionally, the Company reduced the carrying value of a truck stop/convenience store held as other real estate by $500,000. It is anticipated that personnel costs and other operating expenses will be reduced in future periods given the merger of its banking subsidiaries in August.

Income Tax Expense

The Company incurred income tax expense of $2.29 million for the nine months ended September 30, 2008 compared with $1.67 million for the nine months ended September 30, 2007. The effective income tax rates as a percentage of income before taxes for the first nine months of 2008 and 2007 were 24.8% and 25.7%, respectively. The effective tax rate varies from the statutory rate due to state taxes and the amount of tax-exempt income on municipal bonds earned during the period. Tax-exempt income on municipal bonds is greater in comparison to previous periods as the market yields on recently purchased bonds has increased and the Company has a higher volume of municipal bonds.


FINANCIAL CONDITION

Total assets as of September 30, 2008 were $1.52 billion compared with $702.0 million as of December 31, 2007, an increase of $818.0 million. The increase reflects the assets contributed by Former MidWestOne in the merger, which was completed on March 14, 2008.

Investment Securities

Investment securities available for sale totaled $279.3 million as of September 30, 2008. This was an increase of $44.0 million from December 31, 2007. The increase in the balance was due primarily to the Merger. Investment securities classified as held to maturity increased to $8.5 million as of September 30, 2008, also as a result of the merger. The investment portfolio consisted mainly of U.S. Government Agency securities, mortgage-backed securities and obligations of states and political subdivisions. The Company holds no Fannie Mae or Freddie Mac common or preferred stock.

During the second quarter of 2008, the Company recognized an other than temporary impairment (“OTTI”) write-down of $567,000 on equity securities held in the available for sale investments category. This write-down was attributable to the decline in the market prices of these stocks, which were below their historical cost.

As of September 30, 2008, the Company holds six different Collateralized Debt Obligations (“CDO’s”) with a purchase cost of approximately $9.7 million. The underlying assets in the CDO’s are primarily pooled trust preferred securities issued by various commercial banks in the United States (approximately 80%) and some insurance companies (approximately 20%). No real estate holding secure these CDO’s. These securities were purchased at various dates between March 2006 and December 2007 and classified as available for sale. As a result of the challenges experienced in the financial markets, the CDO’s have experienced a significant decline in estimated market value. The estimated fair market value of these CDO’s was $4.3 million as of September 30, 2008. In accordance with the provisions of FASB 115, the unrealized losses on the CDO’s was recognized and deducted from the book value and from shareholders’ equity (net of tax effect). Given the magnitude and duration of the loss, a discounted cash flow analysis of the CDO’s was prepared as of September 30, 2008, in accordance with Emerging Issues Task Force 99-20, “Recognition of Interest Income and Impairment on purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transfer in Securitized Financial Assets” to determine if an OTTI was required. The discounted cash flow analysis demonstrated that the value of the securities was substantiated and that no OTTI was required at this time. Management will continue to monitor the values of these CDO’s for purposes of determining OTTI in future periods given the instability in the financial markets and will continue to obtain updated cash flow analysis as required.


Loans

Total loans (excluding loan pool participations) were $1.0 billion as of September 30, 2008, compared with $404.3 million as of December 31, 2007, an increase of $599.5 million. The increase was primarily due to the Merger. As of September 30, 2008 the Company’s loan to deposit ratio was 89.6% compared with a year-end 2007 loan to deposit ratio of 76.3%, reflecting the higher loan to deposit ratio of Former MidWestOne. Management anticipates that the loan to deposit ratio will be reduced in future periods. Prior to the Merger, real estate loans made up a significant portion of each of the Company’s and Former MidWestOne’s loan portfolios. As of September 30, 2008, loans secured by commercial real estate comprised the largest category in the portfolio at approximately 40% of total loans. Residential real estate loans were the next largest category at 28%. Commercial loans made up approximately 20% of the total loan portfolio. Agricultural loans were approximately 8% of the total loan portfolio, with the remaining 4% of the portfolio in consumer loans. All of these percentages relate to our direct loans and do not include loan pool participations. Included in commercial real estate are construction and development loans totaling approximately $97 million, or 10% of total loans.

The Company has minimal direct exposure to subprime mortgages in its loan portfolio. The Company’s loan policy provides a guideline that real estate mortgage borrowers have a Beacon score of 640 or greater. Exceptions to this guideline have been noted but the overall exposure is deemed minimal by management. Mortgages originated by the Company and sold on the secondary market are typically underwritten according to the guidelines of the secondary market investors. These mortgages are on a non-recourse basis, thereby eliminating any subprime exposure.

Loan Pool Participations

As of September 30, 2008, the Company had loan pool participations of $100.9 million. Loan pools are participation interest in performing, sub-performing and non-performing loans that have been purchased from various non-affiliated banking organizations. Former MidWestOne has engaged in this activity since 1988. The loan pool investment balance shown as an asset on the Company’s Statement of Condition represented the discounted purchase cost of the loan pool participations. The Company acquired new loan pool participations totaling $18.6 million during the third quarter of 2008. As of September 30, 2008, the categories of loans by collateral type in the loan pools were commercial real estate - 54%, commercial loans - 13%, agricultural and agricultural real estate - 8%, single-family residential real estate - 13% and other loans - 12%. The Company has minimal exposure in loan pools to consumer real estate subprime credit or to construction and real estate development loans.

The loans in the pools provide some geographic diversification to the Company’s balance sheet. As of September 30, 2008, loans in the southeast portion of the United States represented approximately 40% of the total. The northeast was the next largest area with 33%, central with 22%, southwest had 3% and northwest was 2%. The highest concentration of assets is in Florida at approximately 19% of the basis total, with the next highest state level being Ohio at 10% and then Pennsylvania and New Jersey both at 8%. As of September 30, 2008, approximately 65% of the loans were contractually current or less than 90 days past-due, while 35% were contractually past-due 90 days or more. It should be noted that many of the loans were acquired in a contractually past due status, which is reflected in the discounted purchase price of the loans. Performance status is monitored on a monthly basis. The 35% contractually past-due includes loans in litigation and foreclosed property. As of September 30, 2008, loans in litigation totaled approximately $21.4 million, while foreclosed property was approximately $5.5 million. As of September 30, 2008, the Company’s investment basis in loan pool participations was approximately 54.4% of the “face” amount of the underlying loans.


Goodwill and Other Intangible Assets

Goodwill totaled $27.0 million as of September 30, 2008 and $4.4 million as of December 31, 2007. The increase in goodwill was due to the Merger. As of September 30, 2008 the Company has not finalized the valuation of certain tangible and intangible assets given the timing of the transaction. The Company expects to finalize the valuation in the fourth quarter of 2008; thus the allocation of purchase price is subject to refinement.

Goodwill is subject to impairment testing annually under the provisions of Financial Accounting Standards Board Statement No. 142 (“SFAS 142”). The Company has historically tested goodwill for impairment at the end on the third quarter. Goodwill was determined to not be impaired as of September 30, 2008, and no impairment write-down of goodwill was required. Management will continue to evaluate goodwill for potential impairment given the uncertain business climate and the level of the Company’s stock price relative to book value.

Other intangible assets increased to $13.5 million as of September 30, 2008 as a result of the merger. Amortization of intangible assets is recorded using an accelerated method based on the estimated life of the core deposit intangible. Projections of amortization expense are based on existing asset balances and the remaining useful lives. The following table summarizes the amounts and carrying values of intangible assets as of September 30, 2008 and December 31, 2007.

   
Weighted
  
Gross
      
Unamortized
  
   
Average
  
Carrying
  
Accumulated
  
Intangible
  
   
Useful Life
  
Amount
  
Amortization
  
Assets
  
   
(years)
  
(in thousands)
         
                   
September 30, 2008
                  
Other intangible assets:
                  
Mortgage servicing rights
  
6
 
$
321
    
135
   
186
 
Insurance agency intangible
  
15
 
$
453
    
24
   
429
 
Core deposit premium
  
10
 
$
5,433
    
(140
)
  
5,573
 
Trade name intangible
  
-
  
$
7,040
    
-
   
7,040
 
Customer list intangible
  
15
 
$
330
    
15
   
315
 
Total
        
$
13,577
  
$
34
  
$
13,543
  
                           
December 31, 2007
                          
Other intangible assets:
                          
Mortgage servicing rights
        
$
321
    
88
   
233
 
Insurance agency intangible
        
$
53
    
18
   
35
 
Total
        
$
374
  
$
106
  
$
268
  
 
The following table summarizes future amortization expense of intangible assets. Amortization of intangible assets is recorded using an accelerated method based on the estimated useful lives of the respective intangible assets.
 
   
Mortgage
  
Insurance
  
Core
  
Cutomer
      
   
Servicing
  
Agency
  
Deposit
  
List
      
(in thousands)
  
Rights
  
Intangible
  
Premium
  
Intangible
  
Totals
  
                       
Three months ended December 31, 2008
  
$
20
    
27
   
(62
)
  
8
   
(7
)
                                 
Year ended December 31,
                                
2009
    
166
   
38
   
51
   
28
   
283
 
2010
    
-
   
38
   
303
   
26
   
367
 
2011
    
-
   
38
   
495
   
12
   
545
 
2012
    
-
   
28
   
621
   
24
   
673
 
2013
    
-
   
27