Item 7. Management's Discussion and Analysis of Financial Condition and Results
Operations.
The 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 has two wholly-owned subsidiaries, NorStates Bank (the "Bank") and NorProperties, Inc. ("NorProp"). NorProperties, Inc. was formed during the fourth quarter of 2008 to manage and dispose of the Company's nonperforming assets, including certain of its other real estate owned. The Bank has one wholly-owned subsidiary, Northern States Community Development Corporation ("NSCDC"), which was formed during 2002 to develop and sell one parcel of other real estate owned that was contributed by the Bank in 2002.
The Bank is a commercial banking company that provides traditional banking services to corporate, retail and civic entities in its market as well as mortgage banking services. The Bank defines its market area as northeastern Illinois and southeastern Wisconsin. In addition, the Bank provides trust services.
The Company and its subsidiaries 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 forward-looking statements subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are identifiable by the use of the words "believe", "expect", "intend", "estimate" or similar expressions. The Company cautions readers of this Annual Report that a number of important factors could cause the Company's actual results in 2009 and beyond to differ materially from those expressed in any such forward-looking statements.
OVERVIEW In 2008, like almost all U.S. financial institutions, the Company was impacted by the downturn in the overall economy generally, specifically the residential real estate market. The Company's levels of nonperforming assets substantially increased during 2008 while most of the real estate pledged as collateral for a majority of its loans declined in value. The Company's nonperforming assets more than tripled in 2008 and the Company recorded a provision for loan losses of $13.7 million as compared to only $81,000 in 2007. The worsening economy also caused impairment issues relative to some of the Company's investment securities and the Company recognized impairment losses of $10.5 million on its securities portfolio. The effect of these developments in 2008 was that the Company experienced a net loss of $9.3 million, or $2.26 loss per share as compared to net income of $4.4 million and earnings of $1.05 per share in 2007.
During 2008 the Company continued its efforts to improve its efficiencies and contain costs despite the losses caused by nonperforming loans and securities impairment. Net interest income increased $2.7 million in 2008 compared with 2007 despite the reversal of $1.2 million in loan interest income as nonperforming loans were put on nonaccrual status where income is no longer recognized on those loans. Noninterest expenses remained stable in 2008 with salaries and employee benefits expense declining $518,000 or 6.02% as the Company reduced staff.
The Company's asset levels remained stable during 2008 as compared with 2007. Assets at year-end 2008 were $640.7 million, increasing only $2.6 million from year-end 2007. Loans and leases increased $45.1 million during 2008 while investments in securities declined $50.1 million. Generally, the Company earns higher yields on its loans than on its securities portfolio. The Company's deposits increased $19.9 million during 2008

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while borrowings declined $4.2 million. There was a positive effect on net interest income during 2008 as the volume of loans increased while the rates on deposits decreased.
Noninterest income declined in 2008 by $11.1 million compared with 2007 primarily due to the investment securities impairment losses of $10.5 million in 2008. Other noninterest income from service fees on deposits also declined as retail deposits decreased in 2008.
The Company continued to take steps to contain costs during 2008. Total noninterest expenses increased only $99,000 during 2008 as compared with 2007. The Company reduced its salaries and employee benefits expense by $518,000 in 2008 by reducing staff by 21 employees after carefully reviewing staffing requirements and job functions. Offsetting this decline to other noninterest expenses were increases to occupancy, data processing and audit and other professional expenses. Other operating expenses also increased during 2008 due to increased FDIC insurance premiums and marketing efforts to promote deposit growth.
CRITICAL ACCOUNTING POLICIES Certain critical accounting policies involve estimates and assumptions by management. To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosure provided, and future results could differ. The allowance for loan and lease losses, fair value of financial instruments, valuation of other real estate owned and status of contingencies are particularly subject to change.
The allowance for loan and lease losses is a valuation allowance, for probable incurred credit losses, that is increased by the provision for loan and lease losses and decreased by charge-offs less recoveries. Management estimates the balance for the allowance based on information about specific borrower situations, estimated collateral values and the borrowers' ability to repay the loan. Management also reviews past loan and lease loss experience, the nature and volume of the portfolio, economic conditions and other factors. Allocations of the allowance may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, in management's judgement, should be charged-off. Loan and lease losses are charged against the allowance when management believes the uncollectibility of a loan or lease balance is confirmed.
A loan or lease is impaired when full payment under the loan or lease terms is not expected within the contractual terms of the loan. Impairment is evaluated on an aggregate basis for smaller-balance loans of similar nature such as residential mortgage and consumer loans, and on an individual loan or lease basis for other loans and leases. If a specific loan or lease is determined to be impaired, a portion of the allowance may be specifically allocated to that loan or lease. The specific allocation is calculated at the present value of estimated cash flows using the existing rate of the loan or lease or the fair value of collateral if repayment is expected solely from the collateral.
Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment will be recognized in the period identified.
The core deposit intangible asset arose from the acquisition of First State Bank of Round Lake in January 2004. The core deposit intangible asset was initially measured at fair value and is being amortized over its estimated useful life. This intangible asset is also assessed at least annually for impairment.

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Table 1 - Analysis of Average Balance, Tax Equivalent Yields and Rates 2008 2007 2006 ($ 000s) Average Yield/ Average Yield/ Average Yield/ For the Years Ended December 31, Balance Interest Rate Balance Interest Rate Balance Interest Rate Assets Loans and leases (1)(2)(3) $ 471,483 $ 27,908 5.92 % $ 389,670 $ 27,867 7.15 % $ 389,081 $ 26,958 6.93 % Taxable securities (5) 120,466 6,490 5.36 213,874 9,509 4.43 252,509 8,730 3.39 Securities exempt from federal income taxes (2)(5) 11,046 685 6.15 8,336 472 5.66 6,540 355 5.41 Federal funds sold and other interest earning assets 9,434 112 1.19 15,150 812 5.36 14,610 771 5.28 Interest earning assets (5) 612,429 35,195 5.74 627,030 38,660 6.16 662,740 36,814 5.52 Noninterest earning assets 38,021 41,556 44,452 Average assets (4) (5) $ 650,450 $ 668,586 $ 707,192 Liabilities and stockholders' equity NOW deposits $ 44,813 151 0.34 $ 47,433 357 0.75 $ 52,600 493 0.94 Money market deposits 66,409 1,216 1.83 75,684 2,757 3.64 74,995 2,938 3.92 Savings deposits 61,863 320 0.52 65,323 493 0.75 74,914 724 0.97 Time deposits 258,727 10,081 3.90 251,589 12,112 4.81 280,154 12,341 4.41 Other borrowings 83,100 2,027 2.44 90,452 4,341 4.80 87,271 4,199 4.81 Interest bearing liabilities 514,912 13,795 2.68 530,481 20,060 3.78 569,934 20,695 3.63 Demand deposits 57,386 57,775 58,470 Other noninterest bearing liabilities 7,290 7,953 7,877 Stockholders' equity 70,862 72,377 70,911 Average liabilities and Stockholders' equity $ 650,450 $ 668,586 $ 707,192 Net interest income $ 21,400 $ 18,600 $ 16,119 Net interest spread 3.06 % 2.38 % 1.89 % Net yield on interest earning assets (5) 3.49 % 2.96 % 2.41 % Interest-bearing liabilities to earning assets ratio 84.08 % 84.60 % 86.00 %

(1) Interest income on loans includes loan origination and other fees of $210,000 for 2008, $398,000 for 2007 and $343,000 for 2006.

(2) The financial statement reported interest income is adjusted by the tax equivalent adjustment amount utilizing a 34% rate on federally tax-exempt municipal loans and securities. The tax equivalent adjustment reflected in the above table for municipal loans is approximately $88,000, $78,000 and $61,000 for the years ended 2008, 2007 and 2006. The tax equivalent adjustment reflected in the above table for municipal securities is approximately $233,000, $161,000 and $120,000 for the years ended 2008, 2007 and 2006.

(3) Nonaccrual loans are included in average loans.

(4) Average balances are derived from the average daily balances.

(5) Rate information was calculated based on the average amortized cost for securities. The 2008, 2007 and 2006 average balance information includes an average unrealized
(loss) for taxable securities of ($694,000),
($965,000) and ($4,714,000). The 2008, 2007 and 2006 average balance information includes an average unrealized
(loss) of ($92,000), ($6,000) and ($17,000) for tax-exempt securities. Average taxable securities includes Federal Home Loan Bank (FHLB) and Federal Reserve Bank stock.

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RESULTS OF OPERATIONS - YEARS-ENDED DECEMBER 31, 2008 COMPARED WITH DECEMBER 31, 2007 AND DECEMBER 31, 2007 COMPARED WITH DECEMBER 31, 2006 NET INTEREST INCOME Net interest income is the Company's largest source of income and is defined as the difference between interest income earned on average interest earning assets, such as loans and securities, and interest expense on average interest bearing liabilities, such as deposits and other borrowings. Major factors affecting net interest income are the general level of interest rates, changes to interest rates and the amount and composition of interest earning assets and interest bearing liabilities.
Table 1, "Analysis of Average Balances, Tax Equivalent Yields and Rates", shows a comparison of net interest income, on a fully tax equivalent basis, and average volumes, together with effective yields earned on such assets and rates paid on such funds. The results shown reflect the excess of interest earned on assets over the cost of funds.
The Company's net interest income for 2008, on a fully tax equivalent basis, was $21,400,000 increasing $2,800,000 compared with net interest income for 2007, on a fully tax equivalent basis, of $18,600,000. The major factor causing net interest income to increase in 2008 was loan growth, while rates paid for deposits and borrowings declined. The net interest spread in 2008 was 3.06%, increasing 68 basis points from 2007, as yields on earning assets declined 42 basis points while rates paid on interest bearing liabilities decreased 110 basis points.
Loans are the asset of the Company that, generally, generate the most interest income and earn the highest interest rates for the Company. During 2008, average loan balances were $471.5 million, increasing $81.8 million from 2007's average loan balances of $389.7 million. During 2007, average loan balances increased slightly by $589,000 to $389.7 million from 2006. Loan interest income on a fully tax equivalent basis increased $41,000 in 2008 from 2007 after increasing $909,000 in 2007 from 2006. Table 1 shows that loans earned a yield of 5.92% in 2008 decreasing from 7.15% in 2007 and 6.93% in 2006.
Loan yields fell in 2008 as general interest rates declined in 2008. The prime lending rate stood at 3.25% at year-end 2008 after progressively dropping from 7.25% at year-end 2007 as government policy lowered short-term rates in an effort to foster growth during the economic downturn. The prime lending rate at year-end 2008 was at its lowest level in over 50 years. The Company's loan yields also declined as loans placed on nonaccrual status increased to $36.6 million at year-end 2008 from $10.7 million at year-end 2007. Approximately $1.2 million in loan interest was reversed from loan interest income during 2008 as loans were placed on nonaccrual status.
Table 2, "Analysis of Changes in Interest Income and Expense", shows that loan interest income in 2008 compared with 2007 increased $41,000. The Table shows that the increase of loan interest due to loan balance increases (volume) was largely offset by the decrease to loan interest rates (rate).
Table 1 shows that the Company's taxable securities averaged $120.5 million in 2008 and decreased $93.4 million from $213.9 million in 2007 after declining $38.6 million in 2007 from 2006. As taxable securities matured in 2008, the Company redeployed the funds into higher yielding loans. Taxable securities earned yields of 5.36% in 2008, increasing from yields of 4.43% in 2007 and 3.39% in 2006.
Average levels of tax-exempt securities in 2008, as shown in Table 1, totaled $11.0 million, an increase of $2.7 million over 2007 levels after increasing $1.8 million in 2007 from 2006. Yields on tax-exempt securities also increased in 2008 to 6.15% as compared with yields earned of 5.66% in 2007 and 5.41% in 2006. Although the average tax equivalent yields on the qualified bonds issued by state and political subdivisions were greater than those earned on loans during 2008, the term to maturity of these investments is greater than that on loans. The Company must carefully consider the effect of possible changes to future interest rates when deciding the proper levels of tax exempt securities to carry in its securities portfolio.

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As interest rates declined in 2008, the Company carefully reviewed the rates paid on its deposits and other borrowings, such as repurchase agreements, and was able to reduce its cost of funds. Rates paid on the Company's NOW, money market accounts and savings deposits in 2008 decreased 41, 181 and 23 basis points, respectively, from 2007, continuing a trend as rates on these deposit products had also declined in 2007 compared with 2006. Rates paid on time deposits also declined in 2008 by 91 basis points as compared with 2007 after increasing 40 basis points in 2007 as compared with 2006.
Rates paid on the Company's borrowings in 2008 also declined from 2007 by 236 basis points after remaining constant in 2007 as compared to 2006. The levels of the Company's average borrowings declined $7.4 million during 2008 from 2007 after increasing $3.2 million in 2007 from 2006.
The lower rates offered by the Company caused levels of average interest bearing liabilities to decline by $15.6 million in 2008 as compared with 2007 after showing decreases of $39.5 million in 2007 compared to 2006. To stem the decreases to deposits, the Company may need to increase its interest rates on deposits during 2009.
In comparing 2007 to 2006, net interest income on a fully tax equivalent basis for 2007 increased from 2006 by $2.5 million. The increase in 2007 was due to increases to yields earned on the Company's loans and investment portfolio while rates paid on deposits and borrowings were reduced or contained. The net interest spread in 2007 increased 49 basis points from 2006 as yields on earning assets increased 64 basis points while rates paid on interest bearing liabilities increased only 15 basis points.
It is estimated that short-term interest rates will continue to be at low levels during 2009 as the Federal Reserve continues its attempts to fight the recession.
Many other factors beyond management's control have a significant impact on changes in net interest income from one period to another. Examples of such factors are: (1) credit demands by customers; (2) fiscal and debt management policy of federal and state governments; (3) monetary policy of the Federal Reserve Board; and (4) changes in regulations.

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Table 2 - Analysis of Changes in Interest Income and Expense 2008 2007 Compared Compared to 2007 to 2006 Increase Increase (Decrease) (Decrease) Change Change Change Change ($ 000s) Total Due To Due To Total Due To Due To For the Year Ended December 31 Change Volume Rate Change Volume Rate Interest Income Loans $ 41 $ 5,297 $ (5,256 ) $ 909 $ 41 $ 868 Taxable securities (3,019 ) (4,734 ) 1,715 779 (1,592 ) 2,371 Securities exempt from federal income taxes 213 169 44 117 100 17 Federal funds sold and other (700 ) (229 ) (471 ) 41 29 12 Total interest income (3,465 ) 503 (3,968 ) 1,846 (1,422 ) 3,268 Interest Expense NOW deposits (206 ) (19 ) (187 ) (136 ) (45 ) (91 ) Money market deposits (1,541 ) (305 ) (1,236 ) (181 ) 27 (208 ) Savings deposits (173 ) (25 ) (148 ) (231 ) (85 ) (146 ) Time deposits (2,031 ) 335 (2,366 ) (229 ) (1,319 ) 1,090 Other borrowings (2,314 ) (328 ) (1,986 ) 142 153 (11 ) Total interest expense (6,265 ) (342 ) (5,923 ) (635 ) (1,269 ) 634 Net interest income $ 2,800 $ 845 $ 1,955 $ 2,481 $ (153 ) $ 2,634

Notes:
Rate/volume variances are allocated to the rate variance and the volume variance on an absolute basis.
The financial statements reported interest income is adjusted by the tax equivalent amount utilizing a 34% rate on federally tax-exempt municipal loans and securities. The tax equivalent adjustment reflected in the above table for municipal loans is approximately $88,000, $78,000 and $61,000 for the years ended 2008, 2007 and 2006. The tax equivalent adjustment reflected in the above table for municipal securities is approximately $233,000, $161,000 and $120,000 for the years ended 2008, 2007 and 2006. Table 3 - Securities Available For Sale

2008 2007 2006 ($ 000s) % of Total % of Total % of Total December 31, Amount Portfolio Amount Portfolio Amount Portfolio U.S. Treasury $ 1,024 0.99 % $ 1,005 0.66 % $ 999 0.36 % U.S. government-sponsored entities 1,038 1.01 58,459 38.14 253,252 90.75 States and political subdivisions 11,987 11.62 13,984 9.12 10,513 3.77 Mortgage-backed securities 83,055 80.48 66,393 43.31 1,863 0.67 Other bonds 2,265 2.19 9,808 6.40 9,000 3.22 Equity securities 3,825 3.71 3,628 2.37 3,429 1.23 Total securities available-for-sale $ 103,194 100.00 % $ 153,277 100.00 % $ 279,056 100.00 %

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SECURITIES The Company maintains a securities portfolio to generate earnings, provide liquidity, assist in the management of the Company's tax position, aid in the Company's asset/liability management and accommodate pledging collateral requirements. The Company's policy is that no undue risks be taken with the securities portfolio and that the safety of the securities is the primary and uppermost concern of Company management.
All securities of the Company at December 31, 2008 are classified as available for sale. The carrying values of the securities reflect the fair or market value of the securities. The Company classifies its securities as available for sale to provide flexibility in the event that it may be necessary to sell securities to raise cash for liquidity purposes or to adjust the portfolio for interest rate risk or income tax purposes.
The carrying value of the securities portfolio decreased $50.1 million to $103.2 million at year-end 2008 as compared with $153.3 million at year-end 2007 after declining $125.8 million at year-end 2007 from 2006. In 2008, the Company's securities portfolio declined as the Company used the cash flows from the maturity and call of securities in 2008 to fund loan growth.
The Company changed its mix of securities in 2008 to emulate the mix of securities of the top performing quartiles of its peer group. Table 3 shows the result of this strategy in 2008, reflecting that the biggest changes in 2008 were to U.S. government-sponsored entity securities which decreased while mortgage-backed securities continued to grow.
U.S. government-sponsored entity securities declined $57.4 million to $1.0 million at year-end 2008 compared with 2007 year-end levels. The Company's percentage of U.S. government-sponsored entity securities to the total securities portfolio declined to 1.01% at year-end 2008 as compared with 38.1% at year-end 2007 and 90.8% at year-end 2006. Mortgage-backed securities increased by $16.4 million in 2008 and increased to 80.5% of the entire securities portfolio as compared with 43.3% at year-end 2007 and less than 1.0% at year-end 2006. The mortgage-backed securities are guaranteed by agencies of the U.S. government and as such the mortgages underlying these securities were underwritten to conform to these agencies' standards.
The mix of securities away from U.S. government-sponsored securities is also . . .