The following discussion focuses on the consolidated financial condition of Northern States Financial Corporation (the "Company") at June 30, 2009 and the consolidated results of operations for the three and six month periods ended June 30, 2009, compared with the three and six month periods ended June 30, 2008. The purpose of this discussion is to provide a better understanding of the condensed consolidated financial statements of the Company and the operations of its two wholly-owned subsidiaries, NorStates Bank (the "Bank") and NorProperties, Inc. ("NorProp"), and the Bank's wholly-owned subsidiary, Northern States Community Development Corporation ("NSCDC"). This discussion should be read in conjunction with the interim condensed consolidated unaudited financial statements and notes thereto included herein.

Statements contained in this report that are not historical facts may constitute forward-looking statements (within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended), which involve significant risks and uncertainties. The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of invoking these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by the use of the words "believe," "expect," "intend," "anticipate," "estimate," "project," "plan," or similar expressions. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain and actual results may differ from those predicted. The Company undertakes no obligation to update these forward-looking statements in the future. The Company cautions readers of this report that a number of important factors could cause the Company's actual results subsequent to June 30, 2009 to differ materially from those expressed in forward-looking statements. Factors that could cause actual results to differ from those predicted and could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, the potential for further deterioration in the credit quality of the Company's loan and lease portfolios, uncertainty regarding the Company's ability to ultimately recover on loans currently on nonaccrual status, unanticipated changes in interest rates, general economic conditions, increasing regulatory compliance burdens or potential legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the Company's loan or investment portfolios, deposit flows, competition, demand for loan products and financial services in the Company's market area, and changes in accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements.

OVERVIEW

Total assets at June 30, 2009 were $633.3 million, a decrease of $7.4 million, or 1.2 percent, from total assets of $640.7 million at December 31, 2008. Loans totaled $474.0 million at June 30, 2009, a decrease of $6.8 million, or 1.4 percent, from loans of $480.8 million at December 31, 2008. Investment in overnight federal funds sold increased to $30.9 million at June 30, 2009, as compared with $7.5 million, at December 31, 2008, as the Company increased its liquidity levels due in part from the receipt of $17.2 million in proceeds from the issuance of preferred stock under the Treasury Department's TARP Capital Purchase Program on February 20, 2009. These funds increased the Company's capital levels, which exceeded the regulatory minimums for capital adequacy at June 30, 2009.

Deposit totals at June 30, 2009 of $500.7 million remained relatively unchanged from December 31, 2008 deposit levels of $500.8 million. Higher cost time deposits declined $3.1 million from year-end as the Company lowered its levels of wholesale brokered deposits by $14.9 million from year-end levels.

The Company had a loss for the three months ended June 30, 2009 of $11.8 million, or $2.97 per share, compared with a loss of $150,000, or $0.04 per share for the same three months of 2008. The majority of the loss in the second quarter of 2009 was caused by the one-time write-down of $9.5 million of goodwill as weakening financial markets and the faltering economy negatively affected bank stock prices and the Company's earnings. The goodwill write-down was a one-time accounting noncash transaction with no effect on regulatory capital or liquidity and was not tax deductible. Earnings for the quarter ended June 30, 2009, were also negatively impacted by a provision for loan and lease losses of $3.7 million, an impairment charge of $628,000 taken on collateralized debt obligations and a FDIC insurance special assessment of $304,000.

The Company's net interest income, the difference between interest earned on loans and investments and interest paid on deposits and borrowings, decreased 17.8 percent, or $1.0 million, to $4.6 million for the quarter ended June 30, 2009, as compared with $5.6 million for the same quarter of 2008. The decline in net interest income was attributable to nonearning nonaccrual loans that totaled $48.0 million at June 30, 2009 as compared with $18.9 million at June 30, 2008, and increases to lower earning federal funds sold. The net yield on interest earning assets declined to 3.09 percent during the second quarter of 2009 as compared with 3.75 percent during the same quarter of 2008.

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 disclosures provided, and future results could differ. The allowance for loan and lease losses is a critical accounting policy for the Company because management must make estimates of losses and these estimates are subject to change.

The allowance for loan and lease losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan and lease losses and decreased by charge-offs less recoveries. Management estimates the allowance balance required using past loan and lease loss experience, the nature and volume of the portfolio, information about specific borrower situations, estimated collateral values, 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, based on management's judgment, should be charged-off.

Management analyzes the adequacy of the allowance for loan and lease losses at least quarterly. Factors considered in assessing the adequacy of the allowance include: changes in the type and volume of the loan and lease portfolio; review of the larger credits within the Bank; historical loss experience; current economic trends and conditions; review of the present value of expected cash flows or fair value of collateral on impaired loans and leases; portfolio growth; and other factors management deems appropriate. Based on management's analysis, management believes the allowance for loan and lease losses at June 30, 2009 is adequate to cover probable incurred credit losses.

One of the components of the allowance for loan losses is historical loss experience. Due to the increased historical losses during the past year as compared with previous years, the loss percentages based on the recent trailing 12 months has been used as it is believed to be more indicative of current loan loss estimates. This differs from year-end 2008, when a 3-year historic loss average was used and from June 30, 2008, when a 5-year historic loss average was used.

Management specifically analyzes its impaired loans for probable losses. The change in the volume of impaired loans may significantly impact the amount of estimated losses specifically allocated to these loans depending on the adequacy of the loan collateral and the borrowers' ability to repay the loans. As specific allocations are done on a loan-by-loan basis, the amount of the specific allocation is more likely subject to fluctuation than an allocation for a pool of loans based on historical loss trends. The amount of the allocations on nonperforming loans may fluctuate in future periods due to changes in conditions of underlying collateral and changes in the borrowers' ability to repay.

Goodwill resulted 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 was assessed for impairment annually and more often if warranted by circumstances. Any such impairment was recognized in the period identified. Goodwill was analyzed at June 30, 2009 and was found to be impaired in its entirety and was written off in the amount of $9.5 million during the quarter ended June 30, 2009.

Other intangible assets consist of core deposits and acquired customer relationship intangible assets arising from whole bank and branch acquisitions, which is periodically evaluated for impairment. These assets were initially measured at fair value and are being amortized on the straight-line method over their estimated useful life of seven years.

FINANCIAL CONDITION

The Company's federal funds sold at June 30, 2009 increased to $30.9 million compared with $7.5 million at December 31, 2008 as the Company managed its liquidity. The Company's federal funds sold position increased primarily as the result of the receipt of $17.2 million in proceeds from the issuance of preferred stock under the Treasury Department's TARP Capital Purchase Program on February 20, 2009. Loans declined $6.8 million and securities investments declined $8.3 million from year-end 2008. Federal funds sold are excess funds above what is necessary to maintain at the Federal Reserve that the Company lends/sells to other financial institutions on an overnight basis. The Company may also use the funds for its liquidity needs.

The Company's securities available for sale declined $8.3 million to $94.9 million at June 30, 2009 compared with $103.2 million at year-end 2008. The Company, in reviewing its collateralized debt obligations securities, determined and recognized impairment of $628,000 based on its analysis of the creditworthiness of the financial institutions and insurance companies that had issued the debt backing the securities. The amount of securities in the Company's investment portfolio declined as the Company has found it difficult to replace maturing securities with new securities having maturities of less than five years and a sufficient yield. At June 30, 2009, securities totaling $78.4 million were pledged to secure public deposits, repurchase agreements and for other purposes required or permitted by law.

Loans and leases totaled $474.0 million at June 30, 2009, decreasing $6.8 million from $480.8 million at December 31, 2008. The decrease primarily occurred in commercial loans that were not secured by real estate, which declined $10.4 million from year-end 2008. The decrease to total loans was also attributable to the receipt of normal scheduled principal payments as well as lower demand during the quarter due to borrowers' concerns about the continued weakness in the economy. Management is considering various alternatives in order to increase its loan portfolio in the coming quarters.

Approximately 90 percent of the Bank's loan portfolio at June 30, 2009 was secured by real estate. The Company's loans to the hotel industry were $72.1 million at June 30, 2009. Loans totaling $119.3 million at June 30, 2009 were pledged to secure lines of credit from the Federal Reserve Bank of Chicago and the Federal Home Loan Bank of Chicago. Loan commitments have decreased $13.6 million to $69.8 million at June 30, 2009, compared with $83.4 million at December 31, 2008, corresponding with the decline in loan demand during the first half of 2009. Letters of credit also decreased during the six months ended June 30, 2009, to $6.6 million from $7.8 million at year-end. At June 30, 2009, loans to related parties totaled $669,000 and loan commitments and letters of credit issued to related parties were $2.0

million. Loans, loan commitments and letters of credit to related parties are made on the same terms and conditions that are available to the public.

Deposits remained stable at June 30, 2009, totaling $500.7 million as compared with $500.8 million at year-end 2008. The deposit mix changed in that retail and commercial deposits declined $1.9 million and $7.2 million, respectively, while public deposits increased $7.7 million from year-end 2008. The increase in deposits from public entities reflects the cyclical nature of the collection of real estate taxes in June and September of each year. The decline in commercial deposits was attributable to the weakened economy and the need for businesses to draw on their reserves. The decline in retail deposits of $1.9 million was attributable to decreases to higher cost retail time deposits of $8.3 million from year-end 2008. Offsetting much of this decrease to retail time deposits was solid growth to retail core deposits consisting of lower cost checking, NOW, savings and money market accounts that totaled $165.6 million at June 30, 2009, increasing $6.4 million, as compared with $159.2 million at December 31, 2008.

Brokered deposits showed increases of $1.5 million to $100.7 million from $99.2 million at year-end 2008. Brokered time deposits consists of nonlocal time deposits from wholesale brokers that the Company pays a premium of 5 to 10 basis points above its regular time deposit rates and time deposits issued through its CDARs program to local depositors in order to increase customers' FDIC insurance coverage. The higher cost wholesale brokered time deposits decreased $14.9 million while brokered time deposits offered through the CDARs program increased by $16.4 million. The CDARs program provides customers with time deposit balances of $250,000 or greater the ability to increase their FDIC insurance coverage over the FDIC limits because the Bank trades portions of the customers' time deposits with other independent financial institutions across the country.

Securities sold under repurchase agreements decreased by $1.2 million to $41.4 million at June 30, 2009 from $42.6 million at December 31, 2008. The decline in repurchase agreement balances increases the Company's liquidity as it lowers the amount of securities needed to be pledged. Borrowings from Federal Home Loan Bank term advances also decreased $10.0 million from year-end 2008 as the Company used excess liquidity to pay down its borrowings.

During January 2009, the Company's stockholders approved an amendment to the Certificate of Incorporation authorizing the Company to issue preferred stock. This was done in conjunction with the Company's application in late 2008 to the Treasury Department to participate in the TARP Capital Purchase Program as the issuance of preferred stock by the Company was a requirement of the program. During January 2009, the Company received approval from the Treasury Department for the TARP funds in the amount of $17,211,000. Both the Preferred Stock and the Warrants issued in conjunction with the Preferred Stock qualify as Tier 1 capital. During the three months ended June 30, 2009, the Company contributed $16.0 million of these funds to the Bank to further enhance the Bank's capital.

FAIR VALUE MEASUREMENTS

The following tables present information about the Company's securities in its investment portfolio that were measured at fair value on a recurring basis at June 30, 2009, and the valuation techniques used by the Company to determine the fair values.

In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical securities that the Company has the ability to access.

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar securities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related securities.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Company's assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each security.

On an annual basis the Company validates the measurement of the fair values of its securities by sending a listing of its securities to an independent securities valuation firm. This independent securities valuation firm determines the fair values of the Company's securities portfolio that is then compared to the fair value using the methods outlined. When this validation was last done at September 30, 2008, the difference between the fair value reported and the fair value determined by the independent securities valuation firm was considered immaterial.

Disclosures concerning securities measured at fair value are as follows:

                                    TABLE 1

                     NORTHERN STATES FINANCIAL CORPORATION
               ASSETS MEASURED AT FAIR VALUE ON A RECURRING BASIS
                              As of June 30, 2009
                                    ($ 000s)

                                                                      Fair Value Measurements at
                                                                         Reporting Date Using
                                                             Quoted
                                                             Prices
                                                            in Active          Significant
                                                           Markets for            Other          Significant
                                                            Identical          Observable       Unobservable
                                                             Assets              Inputs            Inputs
              Description                   06/30/09        (Level 1)           (Level 2)         (Level 3)
Securities available for sale              $   94,948     $       1,014       $      93,762     $         172

Securities classified within Level 3 consist primarily of collateralized debt obligations ("CDOs"). The CDOs were valued using discounted cash flow models that integrate significant inputs, including prepayment speed, discount and loss rates which are estimated based on projected performance of the specific entities that secure the instruments.

                                    TABLE 2

                     NORTHERN STATES FINANCIAL CORPORATION
         CHANGES IN LEVEL 3 MEASURED AT FAIR VALUE ON A RECURRING BASIS
                              As of June 30, 2009
                                    ($ 000s)

                                                                          Securities
                                                                          Available
                                                                           for Sale
Balance at December 31, 2008                                             $      2,265
Total realized and unrealized gains (losses) included in income                  (628 )
Total unrealized gains (losses) included in other comprehensive income         (1,458 )
Net purchase, sales, calls and maturities                                          (7 )
Net transfer into Level 3                                                           0
Balance at June 30, 2009                                                 $        172

The Company also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets are held to maturity loans that are considered impaired per Financial Accounting Standard
114. The Company has estimated the fair values of the impaired loans using Level 3 inputs, specifically discounted cash flow projections, or, if collateral dependent, the realizable value of the collateral.

                                    TABLE 3

                     NORTHERN STATES FINANCIAL CORPORATION
             ASSETS MEASURED AT FAIR VALUE ON A NON-RECURRING BASIS
                              As of June 30, 2009
                                    ($ 000s)


                                                                              Fair Value Measurements at Reporting Date Using
                                                                Quoted Prices
                                                                  in Active                 Significant
                                                                 Markets for                   Other                       Significant
                                                                  Identical                  Observable                    Unobservable            Total Change
                                                                   Assets                      Inputs                         Inputs              for the period
               Description                     06/30/09           (Level 1)                  (Level 2)                      (Level 3)             ended 06/30/09
Impaired loans accounted for under FAS 114   $     29,064     $               -           $              -           $                 29,064     $        (6,775 )

The following methods and assumptions were used to estimate fair values for financial instruments. Securities fair values are based on quoted market prices, are based on observable inputs, including prices for similar securities in active markets and interest rates and yield curves at commonly quoted intervals, or are based on unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related securities. It is estimated that cash and cash equivalents, accrued interest receivable and accrued interest payable are carried at fair value. For loans and leases, deposits, securities sold under repurchase agreements and fixed rate Federal Home Loan Bank advances, the fair value is estimated by discounted cash flow analysis using market rates for the estimated life and credit. Fair values for impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable. The fair value of off-balance sheet items are based on the fees or costs that would currently be charged to enter or terminate such arrangements and the fair values are not material.

                     NORTHERN STATES FINANCIAL CORPORATION

                                    TABLE 4

                     NORTHERN STATES FINANCIAL CORPORATION
                      FAIR VALUE OF FINANCIAL INSTRUMENTS
                              As of June 30, 2009
                                    ($ 000s)

                                                     Carrying       Estimated
June 30, 2009                                         Value        Fair Value
Financial assets:
  Cash and cash equivalents                         $   45,225     $    45,225
  Securities available for sale                         94,948          94,948
  Loans and leases, net                                459,183         467,942
  Federal Home Loan Bank stock                           1,801           1,801
  Accrued interest receivable                            2,181           2,181

Financial liabilities:
  Deposits                                          $ (500,709 )   $  (504,194 )
  Securities sold under repurchase agreement           (41,397 )       (41,361 )
  Federal Home Loan Bank advances                      (10,000 )        (9,999 )
  Subordinated debentures                              (10,000 )       (10,192 )
  Advances from borrowers for taxes and insurance         (847 )          (847 )
  Accrued interest payable                              (2,101 )        (2,101 )



                                                     Carrying       Estimated
December 31, 2008                                     Value        Fair Value
Financial assets:
  Cash and cash equivalents                         $   21,868     $    21,868
  Securities available for sale                        103,194         103,194
  Loans and leases, net                                470,410         485,206
  Federal Home Loan Bank stock                           1,757           1,757
  Accrued interest receivable                            2,334           2,334

Financial liabilities:
  Deposits                                          $ (500,821 )   $  (505,905 )
  Securities sold under repurchase agreement           (42,574 )       (42,541 )
  Federal Home Loan Bank advances                      (20,000 )       (20,004 )
  Subordinated debentures                              (10,000 )       (10,151 )
  Advances from borrowers for taxes and insurance       (1,011 )        (1,011 )
  Accrued interest payable                              (2,331 )        (2,331 )

CAPITAL RESOURCES

Total stockholders' equity increased $3.1 million to $64.7 million at June 30, 2009, as compared with $61.6 million at year-end 2008. The increase was the result of the receipt of $17.2 million in TARP funds from the Treasury Department on February 20, 2009. In exchange for these funds the Company issued preferred stock and warrants to the Treasury Department. Also increasing capital during the six months ended 2009 was a $1.0 million adjustment due to the adoption of accounting staff positions FSP FAS 115-2 and FSP FAS 124-2 whereby the 2008 impairment write-downs to collateral debt obligations were adjusted to reflect only the credit loss on those securities. During the six months ended June 30, 2009, capital was reduced as the Company recognized losses of $13.3 million. Capital was also reduced by $313,000 during the six months ended June 30, 2009, to account for accrued dividends on the preferred stock for the . . .