Overview

Ames National Corporation is a bank holding company established in 1975 that owns and operates five bank subsidiaries in central Iowa. The following discussion is provided for the consolidated operations of the Company and its Banks, First National Bank, Ames, Iowa (First National), State Bank & Trust Co. (State Bank), Boone Bank & Trust Co. (Boone Bank), Randall-Story State Bank (Randall-Story Bank) and United Bank & Trust NA (United Bank). The purpose of this discussion is to focus on significant factors affecting the Company's financial condition and results of operations.

The Company does not engage in any material business activities apart from its ownership of the Banks. Products and services offered by the Banks are for commercial and consumer purposes including loans, deposits and trust services. The Banks also offer investment services through a third-party broker dealer. The Company employs twelve individuals to assist with financial reporting, human resources, audit, compliance, marketing, technology systems and the coordination of management activities, in addition to 182 full-time equivalent individuals employed by the Banks.

The Company's primary competitive strategy is to utilize seasoned and competent Bank management and local decision making authority to provide customers with faster response times and more flexibility in the products and services offered. This strategy is viewed as providing an opportunity to increase revenues through creating a competitive advantage over other financial institutions. The Company also strives to remain operationally efficient to provide better profitability while enabling the Company to offer more competitive loan and deposit rates.

The principal sources of Company revenues and cash flow are: (i) interest and fees earned on loans made by the Banks; (ii) securities gains and dividends on equity investments held by the Company and the Banks; (iii) service charges on deposit accounts maintained at the Banks; (iv) interest on fixed income investments held by the Banks; and (v) fees on trust services provided by those Banks exercising trust powers. The Company's principal expenses are: (i) interest expense on deposit accounts and other borrowings; (ii) salaries and employee benefits; (iii) data processing costs associated with maintaining the Bank's loan and deposit functions; and (iv) occupancy expenses for maintaining the Banks' facilities. The largest component contributing to the Company's net income is net interest income, which is the difference between interest earned on earning assets (primarily loans and investments) and interest paid on interest bearing liabilities (primarily deposits and other borrowings). One of management's principal functions is to manage the spread between interest earned on earning assets and interest paid on interest bearing liabilities in an effort to maximize net interest income while maintaining an appropriate level of interest rate risk.

The Company had net income of $2,409,000, or $0.26 per share, for the three months ended June 30, 2009, compared to net income of $1,867,000, or $0.20 per share, for the three months ended June 30, 2008. Total equity capital as of June 30, 2009 totaled $107 million or 12.1% of total assets as of June 30, 2009.

The Company's earnings for the second quarter increased $542,000 from the $1,867,000 earned a year ago. The higher quarterly earnings can be primarily attributed to decreased write downs associated with the other-than-temporary impairment of investment securities and lower provision expense for loan losses. Impairment of securities for the quarter ended June 30, 2009 of $7,000 related to a corporate bond issue of MGIC Investment Corporation. During the same period in 2008, the Company had other-than-temporary impairments of investment securities of $2,328,000 related to FNMA and FHLMC preferred stock and a corporate bond issue of MGIC Investment Corporation. As of June 30, 2009, the carrying value and fair value of the other-than-temporary impaired securities totaled $752,000. Management believes that additional impairment charges may be necessary on investment securities in future quarters if financial and economic conditions do not improve as perceived by bond investors. Partially offsetting these improvements was an increase in other real estate owned costs, a decrease in securities gains and an increase in FDIC insurance assessments. The increase in other real estate costs of $697,000 is due primarily to write downs on certain other real estate owned and other costs associated with the increased volume of other real estate owned. The increase in the FDIC insurance assessments of $509,000 is due to higher quarterly deposit assessment rates and a special assessment for 2009, which are also expected to negatively impact future quarters if bank failures continue to erode the FDIC insurance fund. In 2009, 53 banks have failed compared to 25 bank failures in 2008.

Net loan charge-offs for the quarter totaled $571,000, compared to net charge-offs of $57,000 in the second quarter of 2008. The increase in the charge-offs was primarily related to a commercial real estate loan for which collateral was repossessed in the second quarter of 2009. The provision for loan losses for the second quarter of 2009 totaled $327,000 compared to the provision for loan losses of $819,000 for the same period in 2008 due to higher specific allowance for loan losses on impaired loans, offset in part by a lower general reserve due to a decrease in loan balances.

The Company had net income of $4,850,000, or $0.51 per share, for the six months ended June 30, 2009, compared to net income of $4,768,000, or $0.51 per share, for the six months ended June 30, 2008.

The Company's earnings for the six months ended June 30, 2009 increased $82,000 from the $4,768,000 earned a year ago. While the level of net income remained relatively stable, certain non-interest income and non-interest expense items incurred significant changes. The six month period ending June 30, 2009 had much lower expense associated with the write down of other-than-temporary impairment of investment securities and lower provision expense for loan losses. Impairment of securities for the six months ended June 30, 2009 of $30,000 related to a corporate bond issue of MGIC Investment Corporation. For the six months ended June 30, 2008, the Company had other-than-temporary impairments of investment securities of $2,555,000 related to FNMA and FHLMC preferred stock and a corporate bond issue of MGIC Investment Corporation. The improvement in these areas was partially offset by higher write downs of other real estate owned, a decrease in securities gains and higher FDIC insurance assessments. The increase in other real estate costs of $1,094,000 is due primarily to write downs on certain other real estate owned and other costs associated with the increased volume of other real estate owned. The increase in the FDIC assessments of $948,000 is due primarily to higher quarterly deposit assessment rates and a special assessment for 2009.

Net loan charge-offs for the six months ended June 30, 2009 totaled $647,000, compared to net charge-offs of $101,000 for the six months ended June 30, 2008. The provision for loan losses for the six months ended June 30, 2009 totaled $556,000 compared to the provision for loan losses of $929,000 for the same period in 2008 due to higher specific allowance for loan losses on impaired loans, offset in part by a lower general reserve due to a decrease in loan balances.

The following management discussion and analysis will provide a review of important items relating to:

· Challenges

· Key Performance Indicators and Industry Results

· Income Statement Review

· Balance Sheet Review

· Asset Quality and Credit Risk Management

· Liquidity and Capital Resources

· Forward-Looking Statements and Business Risks

Challenges

Management has identified certain challenges that may negatively impact the Company's revenues in the future and is attempting to position the Company to best respond to those challenges.

· On March 16, 2009, the Office of the Comptroller of the Currency ("OCC") informed the Company's lead bank, First National, of the OCC's decision to establish individual minimum capital ratios for First National in excess of the capital ratios that would otherwise be imposed under applicable regulatory standards. The OCC is requiring First National to maintain, on an ongoing basis, Tier 1 Leverage Capital of 9% of Adjusted Total Assets and Total Risk Based Capital of 11% of Risk-Weighted Assets. As of June 30, 2009, First National exceeded the 9% Tier 1 and 11% Risk Based capital requirements. Failure to maintain the individual minimum capital ratios established by the OCC could result in additional regulatory action against First National.

· On July 16, 2008, First National entered into an informal Memorandum of Understanding with the OCC regarding First National's commercial real estate loan portfolio, including actions to be taken with respect to commercial real estate risk management procedures, credit underwriting and administration, appraisal and evaluation process, problem loan management, credit risk ratings recognition and loan review procedures. Since entering into the Memorandum, management has been actively pursuing the corrective actions required by the Memorandum in an effort to address the deficiencies noted in administration of its commercial real estate loan portfolio.

· The Company and affiliate banks have invested in certain corporate bonds issued by companies whose financial condition may further deteriorate requiring additional impairment charges. Additional impairment charges may be necessary on investment securities in future periods if financial and economic conditions do not improve as perceived by bond investors.

· Banks have historically earned higher levels of net interest income by investing in longer term loans and securities at higher yields and paying lower deposit expense rates on shorter maturity deposits. If the yield curve was to flatten or invert in 2009, the Company's net interest margin may compress and net interest income may be negatively impacted. Historically, management has been able to position the Company's assets and liabilities to earn a satisfactory net interest margin during periods when the yield curve is flat or inverted by appropriately managing credit spreads on loans and maintaining adequate liquidity to provide flexibility in an effort to hold down funding costs. Management would seek to follow a similar approach in dealing with this challenge in 2009.

· While short term interest rates remained at relatively low levels in 2008 and 2009 with an increase in longer term interest rates in 2009, interest rates may eventually increase or the yield curve may change and may present a challenge to the Company. Increases in interest rates may negatively impact the Company's net interest margin if interest expense increases more quickly than interest income. The Company's earning assets (primarily its loan and investment portfolio) have longer maturities than its interest bearing liabilities (primarily deposits and other borrowings); therefore, in a rising interest rate environment, interest expense will increase more quickly than interest income as the interest bearing liabilities reprice more quickly than earning assets. In response to this challenge, the Banks model quarterly the changes in income that would result from various changes in interest rates. Management believes Bank earning assets have the appropriate maturity and repricing characteristics to optimize earnings and the Banks' interest rate risk positions.

· The Company's market in central Iowa has numerous banks, credit unions, and investment and insurance companies competing for similar business opportunities. This competitive environment will continue to put downward pressure on the Banks' net interest margins and thus affect profitability. Strategic planning efforts at the Company and Banks continue to focus on capitalizing on the Banks' strengths in local markets while working to identify opportunities for improvement to gain competitive advantages.

· A substandard performance in the Holding Company's equity portfolio could lead to a reduction in the realized security gains or an other-than-temporary impairment, thereby negatively impacting the Holding Company's earnings. The Holding Company invests capital that may be utilized for future expansion in a portfolio of common stocks with an estimated fair market value of approximately $4.7 million as of June 30, 2009. The Holding Company focuses on stocks that have historically paid dividends in an effort to lessen the negative effects of a bear market. However, this strategy did not prove successful for the first six months of 2009 and for year ended December 31, 2008 as problems in the general economy caused a significant decline in the fair value and dividend rates of the Holding Company's equity portfolio. Unrealized losses in the Holding Company's equity portfolio totaled $2.2 million as of June 30, 2009. This compares to unrealized losses in the Holding Company of $1.2 million as of December 31, 2008.

· The economic conditions for commercial real estate developers in the Des Moines metropolitan area deteriorated in 2008. This deterioration has contributed to the Company's increased level of non-performing assets. During the third quarter of 2008, the Company foreclosed on two real estate properties (other real estate owned) totaling $10.5 million in the Des Moines market. As of June 30, 2009, the Company has impaired loans totaling $5.3 million with six Des Moines area development companies with specific reserves totaling $623,000. The Company has additional credit relationships with real estate developers in the Des Moines area that, presently, have collateral values sufficient to cover loan balances. However, these loans may become impaired in the future if economic conditions do not improve or become worse. As of June 30, 2009, the Company has a limited number of such credits and is actively engaged with the customers to minimize credit risks.

· During 2009, management will be focusing its efforts, in part, on steps necessary to improve the Company's capital position given the ongoing negative developments in the national and local economies and the uncertainty of the timing and improvement of economic conditions. An increased level of capital will enable the Company to better accommodate any impairment losses in the investment portfolio and any provision for loan losses with respect to the Company's commercial real estate loan portfolio that may be recorded during the year due to the asset quality of the Company's investment securities portfolio and commercial real estate loan portfolio.

Key Performance Indicators and Industry Results

Certain key performance indicators for the Company and the industry are presented in the following chart. The industry figures are compiled by the Federal Deposit Insurance Corporation (FDIC) and are derived from 8,246 commercial banks and savings institutions insured by the FDIC. Management reviews these indicators on a quarterly basis for purposes of comparing the Company's performance from quarter to quarter against the industry as a whole.

Selected Indicators for the Company and the Industry

                          June 30, 2009                 March 31, 2009
                     3 Months       6 Months               3 Months                             Year Ended December 31,
                      Ended          Ended                  Ended                          2008                         2007
                     Company        Company        Company       Industry *       Company       Industry       Company       Industry

Return on average
assets                    1.08 %         1.12 %        1.15 %           0.22 %        0.74 %         0.12 %        1.30 %         0.81 %

Return on average
equity                    9.09 %         9.20 %        9.32 %           2.26 %        5.89 %         1.24 %        9.89 %         7.75 %

Net interest
margin                    3.73 %         3.83 %        3.97 %           3.39 %        3.94 %         3.18 %        3.39 %         3.29 %

Efficiency ratio         62.25 %        60.57 %       58.76 %          53.79 %       67.40 %        59.02 %       53.71 %        59.37 %

Capital ratio            11.92 %        12.15 %       12.39 %           8.04 %       12.57 %         7.49 %       13.20 %         7.97 %

*Latest available data

Key performances indicators include:

· Return on Assets

This ratio is calculated by dividing net income by average assets. It is used to measure how effectively the assets of the Company are being utilized in generating income. The Company's annualized return on average assets was 1.08% and 0.85%, respectively, for the three month periods ending June 30, 2009 and 2008. The increase in this ratio in 2009 from the previous period is the result of lower write offs of other-than-temporary impairment of investment securities and lower provision for loan losses, offset in part by increased FDIC insurance assessments, increased other real estate owned costs, lower securities gains and lower net interest income.

· Return on Equity

This ratio is calculated by dividing net income by average equity. It is used to measure the net income or return the Company generated for the shareholders' equity investment in the Company. The Company's return on average equity was 9.09% and 6.70%, respectively for the three month periods ending June 30, 2009 and 2008. The increase in this ratio in 2009 from the previous period is the result of lower write offs of other-than-temporary impairment of investment securities and lower provision for loan losses, offset in part by increased FDIC insurance assessments, increased other real estate owned costs, lower securities gains and lower net interest income.

· Net Interest Margin

The net interest margin for the three months ended June 30, 2009 was 3.73% compared to 3.91% for the three months ended June 30, 2008. The ratio is calculated by dividing net interest income by average earning assets. Earning assets are primarily made up of loans and investments that earn interest. This ratio is used to measure how well the Company is able to maintain interest rates on earning assets above those of interest-bearing liabilities, which is the interest expense paid on deposits and other borrowings. This decrease is primarily the result of lower yields on interest earning assets and a decline in the average loan balances, offset in part by lower cost of funds on deposits and other borrowings. The lower yields and cost of funds were due primarily to lower market interest rates as interest earning assets and interest bearing liabilities are repricing.

· Efficiency Ratio

This ratio is calculated by dividing noninterest expense by net interest income and noninterest income. The ratio is a measure of the Company's ability to manage noninterest expenses. The Company's efficiency ratio was 62.25% and 58.13% for the three months ended June 30, 2009 and 2008, respectively. The increase in the efficiency ratio in 2009 from the previous period is primarily the result of increased FDIC insurance assessments, increased other real estate owned costs, lower securities gains and lower net interest income, offset in part by lower write offs of other-than-temporary impairment of investment securities.

· Capital Ratio

The average capital ratio is calculated by dividing average total equity capital by average total assets. It measures the level of average assets that are funded by shareholders' equity. Given an equal level of risk in the financial condition of two companies, the higher the capital ratio, generally the more financially sound the company. The Company's capital ratio is significantly higher than the industry average.

Industry Results

The FDIC Quarterly Banking Profile reported the following results for the first quarter of 2009:

Highest Earnings in Four Quarters Are 61 Percent Lower than a Year Ago

Sharply higher trading revenues at large banks helped FDIC-insured institutions post an aggregate net profit of $7.6 billion in the first quarter of 2009. Realized gains on securities and other assets at a few large institutions also contributed to the quarter's profits. First quarter earnings were $11.7 billion (60.8%) lower than in the first quarter of 2008 but represented a significant recovery from the $36.9 billion net loss the industry reported in the fourth quarter of 2008. Provisions for loan and lease losses were lower than in the fourth quarter of 2008 but continued to rise on a year-over-year basis. The increase in loss provisions, higher charges for goodwill impairment, and reduced income from securitization activity were the primary causes of the year-over-year decline in industry net income. Evidence of earnings weakness was widespread in the first quarter; more than one out of every five institu­tions (21.6%) reported a net loss, and almost three out of every five (59.3%) reported lower net income than in the first quarter of 2008.

Loss Provisions Continue to Weigh Heavily on Earnings

Insured institutions set aside $60.9 billion in loan loss provisions in the first quarter, an increase of $23.7 billion (63.6%) from the first quarter of 2008. Almost two out of every three insured institutions (65.4%) increased their loss provisions. Goodwill impairment charges and other intangible asset expenses rose to $7.2 billion from $2.8 billion a year earlier. Against these negative factors, total noninterest income contributed $68.3 billion to pretax earnings, a $7.8-billion (12.8%) improvement over the first quarter of 2008. Net interest income was $4.4 billion (4.7%) higher, and realized gains on securities and other assets were up by $1.9 billion (152.6%). The rebound in noninterest income stemmed primarily from higher trading revenue at a few large banks, but gains on loan sales and increased servicing fees also provided a boost to noninterest revenues. Trading revenues were $7.6 billion higher than a year earlier, servicing fees were up by $2.4 billion, and real­ized gains on securities and other assets were $1.9 billion higher. Nevertheless, these positive develop­ments were outweighed by the higher expenses for bad loans and goodwill impairment. The average return on assets (ROA) was 0.22%, less than half the 0.58% registered in the first quarter of 2008 and less than one-fifth the 1.20% ROA the industry enjoyed in the first quarter of 2007.

Lower Funding Costs Lift Large Bank Margins

For the sixth consecutive quarter, falling interest rates caused declines in both average funding costs and aver­age asset yields. The industry's average funding cost fell by more than its average asset yield in the quarter, and the quarterly net interest margin (NIM) improved from fourth quarter 2008 and first quarter 2008 levels. The average NIM in the first quarter was 3.39%, compared to 3.34% in the fourth quarter of 2008 and 3.33% in the first quarter of 2008. This is the highest level for the industry NIM since the second quarter of 2006. However, most of the improvement was concentrated among larger institutions; more than half of all institutions (55.4%) reported lower NIMs compared to a year earlier, and almost two-thirds (66.0%) had lower NIMs than in the fourth quar­ter of 2008. The average NIM at institutions with less than $1 billion in assets fell from 3.66% in the fourth quarter to 3.56%, a 21-year low.

Charge-Offs Continue to Rise in All Major Loan Categories

First-quarter net charge-offs of $37.8 billion were slightly lower than the $38.5 billion the industry charged-off in the fourth quarter of 2008, but they were almost twice as high as the $19.6 billion total in the first quarter of 2008. The year-over-year rise in charge-offs was led by loans to commercial and industrial (C&I) borrowers, where charge-offs increased by $4.2 billion (170%); by credit cards (up $3.4 billion, or 68.9%); by real estate construction loans (up $2.9 billion, or 161.7%); and by closed-end 1-4 family residential real estate loans (up $2.7 billion, or 64.9%). Net charge-offs in all major categories were higher than a year ago. The annualized net charge-off rate on total loans and leases was 1.94%, slightly below the 1.95% rate in the fourth quarter of 2008 that is the highest quarterly net charge-off rate in the 25 years that insured institutions have reported these data. Well over half of all insured institutions (58.3%) reported year-over-year increases in quarterly charge-offs.

Noncurrent Loans Rise by $59.2 Billion

The high level of charge-offs did not stem the growth in noncurrent loans in the first quarter. On the contrary, noncurrent loans and leases increased by $59.2 billion (25.5%), the largest quarterly increase in the three years that noncurrent loans have been rising. The percentage of loans and leases that were noncurrent rose from 2.95% to 3.76% during the quarter; the noncurrent rate is now at the highest level since the second quarter of 1991. The rise in noncurrent loans was led by real estate loans, which accounted for 84% of the overall increase. Noncurrent closed-end 1-4 family residential mortgage loans increased by $26.7 billion (28.1%), while noncurrent real estate construction loans were up by $10.5 billion (20.3%), and noncurrent loans secured by nonfarm nonresidential real estate properties rose by $6.9 billion (40%). All major loan cate­gories experienced rising levels of noncurrent loans, and 58 percent of insured institutions reported increases in their noncurrent loans during the quarter.

Reserve Building Continues

Loss provisions surpassed net charge-offs by $23.1 billion in the first quarter, and the industry's loan loss reserves increased by $20.0 billion (11.5%). The ratio of reserves to total loans rose during the quarter from 2.21% to 2.50%, an all-time high. The previous record level of 2.38% was reached at the end of the first quarter of 1992. Despite the rise in the level of reserves relative to total loans, the indus­try's ratio of reserves to noncurrent loans fell for a 12th consecutive quarter, from 74.8% to 66.5%, the lowest level in 17 years.

Industry Capital Registers Largest Quarterly Increase Since 2004

Total equity capital of insured institutions increased by $82.1 billion in the first quarter, the largest quarterly increase since the third quarter of 2004. The industry's tier one leverage capital increased by a record $69.8 billion (7.0%) during the quar­ter, and the average leverage capital ratio increased from 7.48% to 8.04%. Most of the aggre­gate increase in capital was concentrated among a rela­tively small number of institutions, including some institutions participating in the U.S. Treasury Depart­ment's Troubled Asset Relief Program (TARP). A majority of institutions (55.3%) reported declines in their leverage capital ratios during the quarter. A number of institutions reduced their dividend payments in the first quarter, as the total amount of dividends paid by insured institutions fell by almost half ($6.8 billion) . . .