Overview

Ames National Corporation (the "Company") is a bank holding company established in 1975 that owns and operates five bank subsidiaries in central Iowa (the "Banks"). 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 180 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 Banks' 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 $2,574,000, or $0.27 per share, for the three months ended September 30, 2009, compared to net income of $7,000, or $0.00 per share, for the three months ended September 30, 2008. Total equity capital as of September 30, 2009 totaled $112.9 million or 12.8% of total assets.

The Company's earnings for the third quarter increased $2,567,000 from the $7,000 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. For the three months ended September 30, 2008, the Company had other-than-temporary impairments of investment securities of $8,692,000 related to FNMA and FHLMC preferred stock and bonds issued by Lehman Brothers and MGIC Investment Corporation. As of September 30, 2009, the carrying value and fair value of the other-than-temporary impaired securities totaled $856,000. Partially offsetting these improvements was an increase in other real estate owned costs, a decrease in securities gains, an increase in the provision for loan losses and an increase in FDIC insurance assessments. The increase in other real estate costs of $1,039,000 is due primarily to write downs on certain other real estate owned. The increase in the FDIC insurance assessments of $294,000 is due to higher quarterly deposit assessments, which are also expected to negatively impact future operating results if bank failures continue to erode the FDIC insurance fund. In 2009, 106 banks have failed compared to 25 bank failures in 2008.

Net loan charge-offs for the quarter totaled $23,000, compared to net charge-offs of $20,000 in the third quarter of 2008. The provision for loan losses for the third quarter of 2009 totaled $635,000 compared to the provision for loan losses of $74,000 for the same period in 2008 due primarily to specific allowance for loan losses on impaired loans and worsening economic conditions primarily associated with the Company's commercial real estate loans, offset in part by decreases in the outstanding loans.

The Company had net income of $7,424,000, or $0.79 per share, for the nine months ended September 30, 2009, compared to net income of $4,775,000, or $0.51 per share, for the nine months ended September 30, 2008.

The Company's earnings for the nine months ended September 30, 2009 increased $2,649,000 from the $4,775,000 earned a year ago. The higher earnings can be primarily attributed to decreased write downs associated with the other-than-temporary impairment of investment securities. Impairment of securities for the nine months ended September 30, 2009 of $30,000 related to a corporate bond issue of MGIC Investment Corporation. For the nine months ended September 30, 2008, the Company had other-than-temporary impairments of investment securities of $11,248,000 related to FNMA and FHLMC preferred stock and corporate bond issues of Lehman Brothers, American General Finance and MGIC Investment Corporation. The improvement in this area was partially offset by an increase in other real estate owned costs, a decrease in securities gains and higher FDIC insurance assessments. The increase in other real estate costs of $2,133,000 is due primarily to write downs on certain other real estate owned. The increase in the FDIC assessments of $1,242,000 is due primarily to higher quarterly deposit assessment rates and a special assessment for 2009.

Net loan charge-offs for the nine months ended September 30, 2009 totaled $670,000, compared to net charge-offs of $120,000 for the nine months ended September 30, 2008. The increase in the charge-offs was primarily related to a commercial real estate loan. The provision for loan losses for the nine months ended September 30, 2009 totaled $1,191,000 compared to the provision for loan losses of $1,002,000 for the same period in 2008 due primarily to specific allowance for loan losses on impaired loans and worsening economic conditions primarily associated with the Company's commercial real estate loans, offset in part by decreases in the outstanding loans.

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

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 September 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 processes, 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.

? Commercial real estate in the Company's market area may experience declines in fair value. The Company has $12.8 million in other real estate owned as of September 30, 2009. A decline in the fair value of commercial real estate may adversely affect the fair value of the Bank's other real estate owned which could adversely affect results of operations through impairments in the carrying value of other real estate owned.

? 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 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 $4.1 million as of September 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 nine months of 2009 or for the 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 $1.5 million as of September 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 and 2009. This deterioration has contributed to the Company's increased level of non-performing assets. As of September 30, 2009, the Company has impaired loans totaling $4.9 million with four Des Moines area development companies with specific reserves totaling $460,000. The Company has additional credit relationships with real estate developers in the Des Moines. However, these loans may become impaired in the future if economic conditions do not improve or become worse. As of September 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 has focused 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 other real estate owned 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 8,195 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

                       September 30, 2009               June 30, 2009
                      Three           Nine                   Six
                      Months         Months                 Months                              Year Ended December 31,
                      Ended           Ended                 Ended                          2008                         2007
                     Company         Company       Company       Industry *       Company       Industry       Company       Industry

Return on average
assets                    1.17 %         1.14 %        1.12 %           0.04 %        0.74 %         0.12 %        1.30 %         0.81 %

Return on average
equity                    9.38 %         9.26 %        9.20 %           0.38 %        5.89 %         1.24 %        9.89 %         7.75 %

Net interest
margin                    3.75 %         3.80 %        3.83 %           3.43 %        3.94 %         3.18 %        3.39 %         3.29 %

Efficiency ratio         58.25 %        59.75 %       60.57 %          57.07 %       67.40 %        59.02 %       53.71 %        59.37 %

Capital ratio            12.47 %        12.26 %       12.15 %           8.25 %       12.57 %         7.49 %       13.20 %         7.97 %

*Latest available data

Key performances indicators include:

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 1.17% and 0.003%, respectively, for the three month periods ending September 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, offset in part by increased FDIC insurance assessments, increased other real estate owned costs, lower securities gains and a higher provision for loan losses.

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 9.38% and 0.03%, respectively for the three month periods ending September 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, offset in part by increased FDIC insurance assessments, increased other real estate owned costs, lower securities gains and a higher provision for loan losses.

The net interest margin for the three months ended September 30, 2009 was 3.75% compared to 3.99% for the three months ended September 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.

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 58.25% and 135% for the three months ended September 30, 2009 and 2008, respectively. The improvement in the efficiency ratio in 2009 from the previous period is primarily the result of lower write offs of other-than-temporary impairment of investment securities, offset in part by increased FDIC insurance assessments, increased other real estate owned costs, lower securities gains and higher provision for loan losses.

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 second quarter of 2009:

The Industry Posts a Net Loss for the Quarter

Burdened by costs associated with rising levels of troubled loans and falling asset values, FDIC-insured commercial banks and savings institutions reported an aggregate net loss of $3.7 billion in the second quarter of 2009. Increased expenses for bad loans were chiefly responsible for the industry's loss. Insured institutions added $66.9 billion in loan-loss provisions to their reserves during the quarter, an increase of $16.5 billion (32.8%) compared to the second quarter of 2008. Quarterly earnings were also adversely affected by write downs of asset-backed commercial paper, and by higher assessments for deposit insurance. Almost two out of every three institutions (64.4%) reported lower quarterly earnings than a year ago, and more than one in four (28.3%) reported a net loss for the quarter. A year ago, the industry reported a quarterly profit of $4.7 billion, and fewer than one in five institutions (18%) were unprofitable. The average return on assets (ROA) was -0.11%, compared to 0.14% in the second quarter of 2008.

Noninterest Income Grows 10.6% Year-Over-Year

In addition to the $16.5-billion increase in loss provisions, the industry reported a $3.3 billion increase in extraordinary losses and a $1.7 billion (1.7%) year-over-year increase in noninterest expenses. The extraordinary losses stemmed from asset-backed commercial paper write downs, while the increased noninterest expenses primarily reflected higher deposit insurance assessments. These negative factors were partially offset by higher noninterest income (up $6.5 billion, or 10.6%), increased net interest income (up $3.4 billion, or 3.5%), and a $1.5-billion reduction in realized losses on securities and other assets. Gains on asset sales (up $4.5 billion), increased trading revenue (up $4.5 billion), and higher servicing fees (up $3.6 billion) were the largest contributors to the year-over-year improvement in noninterest income.

Margins Improve at a Majority of Institutions

Average net interest margins (NIMs) improved slightly from first quarter levels, as average funding costs fell more rapidly than average asset yields. The average margin increased to 3.48% from 3.39% in the first quarter and 3.37% in the second quarter of 2008. The consecutive-quarter improvement was relatively broad-based: more than half (56.5%) of all institutions reported higher NIMs than in the first quarter. However, the year-over-year improvement was concentrated among larger institutions. Only 45.3% of insured institutions reported year-over-year NIM improvement. Despite the widening in margins, net interest income growth has been limited by recent shrinkage in earning asset portfolios. Interest-earning assets declined by $149.6 billion during the second quarter, following a $163.7 billion decline in the first quarter. In the 12 months ended June 30, the industry's earning assets increased by only $18.3 billion (0.2%).

Net Charge-Off Rate Sets a Quarterly Record

Net charge-offs continued to rise, propelling the quarterly net charge-off rate to a record high. Insured institutions charged-off $48.9 billion in the second quarter, compared to $26.4 billion a year earlier. The annualized net charge-off rate in the second quarter was 2.55%, eclipsing the previous quarterly record of 1.95% reached in the fourth quarter of 2008. The $22.5 billion (85.3%) year-over-year increase in net charge-offs was led by loans to commercial and industrial (C&I) borrowers, which increased by $5.3 billion (165.0%). Net charge-offs of credit card loans were $4.6 billion (84.5%) higher than a year earlier, and the annualized net charge-off rate on credit card loans reached a record 9.95% in the second quarter. Net charge-offs of real estate construction and development loans were up by $4.2 billion (117.0%), and charge-offs of loans secured by 1-4 family residential properties were $4.0 billion (41.1%) higher than a year ago.

Noncurrent Loan Rate Rises to Record Level

The amount of loans and leases that were noncurrent (90 days or more past due or in nonaccrual status) increased for a 13th consecutive quarter, and the percentage of total loans and leases that were noncurrent reached a new record. Noncurrent loans and leases increased by $41.4 billion (14.3%) during the second quarter, led by 1-4 family residential mortgages (up $15.4 billion, or 12.7 %), real estate construction and development loans (up $10.2 billion, or 16.6%), and loans secured by nonfarm nonresidential real estate properties (up $7.1 billion, or 29.2%). Noncurrent home equity loans and junior lien mortgages fell for the first time in three years, declining by $1.7 billion and $1.5 billion, respectively. Noncurrent levels rose in all other major loan categories. Although the increase in total noncurrent loans was almost one-third smaller than the $59.7 billion increase in the first quarter, the average noncurrent rate on all loans and leases rose from 3.76% to 4.35%. This is the highest level for the noncurrent rate in the 26 years that insured institutions have reported noncurrent loan data. On a more positive note, loans that were 30-89 days past due declined by $16.7 billion (10.6%). This is the largest quarterly decline in dollar terms in the 26 years that these data have been reported, and the largest percentage decline since the first quarter of 2004, when 30-89 day past due loans were one-third the current level. The decline in past due loans occurred across all major loan categories, but real estate loans accounted for 83.5% ($13.9 billion) of the total improvement. Restructured loans and leases that were in compliance with their modified terms increased by $13.7 billion (41.6%) at commercial and savings banks that file Call reports, as restructured 1-4 family residential real estate loans rose by $10.2 billion (55.4%).

Institutions Continue to Add to Reserves

The industry's reserves for loan losses increased by $16.8 billion (8.6%) during the second quarter, as loss provisions of $66.9 billion exceeded net charge-offs of $48.9 billion. The ratio of reserves to total loans and leases set another new record, rising from 2.51% to 2.77%. However, the pace of reserve building fell short of the rise in noncurrent loans, and the industry's ratio of reserves to noncurrent loans fell from 66.8% to 63.5%, the lowest level since the third quarter of 1991.

Overall Capital Levels Register Improvement

Equity capital increased by $32.5 billion (2.4%), raising the industry's equity-to-assets ratio from 10.13% to 10.56%, the highest level since March 31, 2007. Average regulatory capital ratios increased as well. The leverage capital ratio increased from 8.02% to 8.25%, while the total risk-based capital ratio rose from 13.42% to 13.76%. However, fewer than half of all institutions reported increases in their regulatory capital ratios. Only 43.2% reported increased leverage capital ratios, and 47.0% had increased total risk-based capital ratios. Insured institutions paid $6.2 billion in dividends in the quarter, about two-thirds less than the $17.7 billion in dividends paid in the second quarter of 2008.

"Problem List" Expands to 15-Year High

The number of insured commercial banks and savings institutions reporting financial results fell to 8,195 in the quarter, down from 8,247 reporters in the . . .