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), Reliance State Bank, formerly known as Randall-Story State Bank (Reliance 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 eleven individuals to assist with financial reporting, human resources, audit, compliance, marketing, technology systems and the coordination of management activities, in addition to 198 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 Company and Banks; (ii) interest on fixed income investments held by the Company and Banks; (iii) fees on trust services provided by those Banks exercising trust powers; (iv) service charges on deposit accounts maintained at the Banks and (v) gain on sale of loans held for sale. The Company's principal expenses are: (i) interest expense on deposit accounts and other borrowings; (ii) provision for loan losses; (iii) salaries and employee benefits; (iv) data processing costs associated with maintaining the Banks' loan and deposit functions; (v) occupancy expenses for maintaining the Banks' facilities; (vi) other real estate owned costs and (vii) Federal Deposit Insurance Corporation ("FDIC") insurance assessments. 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 $3,309,000, or $0.36 per share, for the three months ended June 30, 2012, compared to net income of $3,243,000, or $0.34 per share, for the three months ended June 30, 2011. Total equity capital as of June 30, 2012 totaled $140.0 million or 12.1% of total assets. Total tangible equity capital as of June 30, 2012 totaled $133.0 million or 11.6% of total tangible assets.

The change in quarterly earnings can be primarily attributed to lower provision for loan losses, lower interest expense on deposits and higher interest income on loans, offset in part by an increase in noninterest expense.

Net loan charge-offs for the three months ended June 30. 2012 totaled $9,000, compared to net loan charge-offs of $56,000 for the three months ended June 30, 2011. The provision for loan losses totaled $64,000 and $405,000 for the three months ended June 30, 2012 and 2011, respectively.

The Company had net income of $6,853,000, or $0.74 per share, for the six months ended June 30, 2012, compared to net income of $6,716,000, or $0.71 per share, for the six months ended June 30, 2011.

The change in quarterly earnings can be primarily attributed to lower interest expense on deposits, lower provision for loan losses and higher interest income on loans, offset in part by an increase in noninterest expense.

There were no net charge-offs for the six months ended June 30, 2012, compared to net loan charge-offs of $50,000 for the six months ended June 30, 2011. The provision for loan losses totaled $116,000 and $405,000 for the six months ended June 30, 2012 and 2011, respectively.

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

· Challenges

· Key Performance Indicators and Industry Results

· Critical Accounting Policies

· 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 events or circumstances that may negatively impact the Company's financial condition and results of operations in the future and is attempting to position the Company to best respond to those challenges.

· Interest rates are likely to increase as the economy continues its gradual recovery and the increasing interest rate environment 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 may 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 Banks' 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 compress 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.

· Other real estate owned amounted to $8.7 million and $9.5 million as of June 30, 2012 and December 31, 2011, respectively. Other real estate owned costs amounted to $441,000 and $166,000 for the six months ended June 30, 2012 and 2011, respectively. Management obtains independent appraisals or performs evaluations to determine that these properties are carried at the lower of the new cost basis or fair value less cost to sell. It is at least reasonably possible that change in fair values will occur in the near term and that such changes could have a negative impact on the Company's earnings.

· The Company operates in a highly regulated environment and is subject to extensive regulation, supervision and examination. The compliance burden and impact on the Company's operations and profitability is significant. On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States and, among many other things, establishes the new federal Consumer Finance Protection Bureau ("CFPB"). The CFPB and other federal agencies are continuing to implement many new and significant rules and regulations. At this time, it is difficult to predict the extent to which the Dodd-Frank Act or the resulting rules and regulations will impact the Company's and the Banks' business. Compliance with the new law and regulations are likely to result in additional costs, which could be significant, and could adversely impact the Company's results of operations, financial condition or liquidity. The Company cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that any changes may have on future business and earnings prospects.

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 FDIC and are derived from 7,307 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, 2012                March 31, 2012
                       3 Months       6 Months              3 Months                             Year Ended December 31,
                        Ended          Ended                  Ended                         2011                         2010
                       Company        Company        Company       Industry*       Company       Industry       Company       Industry

Return on assets            1.15 %         1.24 %        1.33 %          1.02 %        1.38 %         0.88 %        1.40 %         0.66 %

Return on equity            9.52 %         9.94 %       10.37 %          9.07 %       10.82 %         7.86 %       10.91 %         5.99 %

Net interest margin         3.38 %         3.39 %        3.41 %          3.52 %        3.60 %         3.60 %        3.74 %         3.76 %

Efficiency ratio           55.34 %        52.88 %       50.34 %         61.67 %       49.80 %        61.37 %       50.12 %        57.22 %

Capital ratio              12.10 %        12.43 %       12.79 %          9.20 %       12.75 %         9.09 %       12.80 %         8.90 %

*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 1.15% and 1.28%, respectively, for the three months ended June 30, 2012 and 2011. The decrease in this ratio in 2012 from the previous period is primarily the result of an increase in average assets.

· 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 9.52% and 10.20%, respectively for the three months ended June 30, 2012 and 2011. The decrease in this ratio in 2012 from the previous period is primarily the result of higher average equity.

· Net Interest Margin

The net interest margin for the three months ended June 30, 2012 and 2011 was 3.38% and 3.63%, respectively. 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. The decrease in this ratio in 2012 is primarily the result of lower market yields on interest earning assets, offset in part by lower market cost of funds on interest bearing liabilities.

· 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 55.34% and 50.40% for the three months ended June 30, 2012 and 2011, respectively. The change in the efficiency ratio in 2012 from the previous period is primarily the result of increased noninterest expense, including non-routine costs as a part of the acquisition, offset in part by higher net interest income.

· 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 2012:

Earnings Rise to Post-Crisis High

FDIC-insured commercial banks and savings institu­tions reported $35.3 billion in net income for first quar­ter 2012. This represents a $6.6 billion (22.9%) improvement over first quarter 2011 results, and is the highest quarterly net income reported by the industry since second quarter 2007. The average return on assets (ROA) rose above the 1% threshold for only the second time since second quarter 2007 (third quarter 2011 ROA was 1.03%). Quarterly net income has now improved year over year for 11 consecutive quar­ters. More than two-thirds of all institutions (67.5%) reported year-over-year improvement in their quarterly earnings, and only 10.3% were unprofit­able, the lowest level since second quarter 2007.

Revenues Receive a Boost from Loan Sales

Net operating revenue (the sum of net interest income and total noninterest income) increased year over year for only the second time in the last five quarters, rising by $5 billion (3.1%). Noninterest income totaled $63 billion, an increase of $4.6 billion (8%) from first quarter 2011. Gains on loan sales were $2.3 billion (132.4%) higher than a year earlier, income resulting from changes in fair values of financial instru­ments was $881 million (38.2%) higher, income from fiduciary activities was up by $413 million (6.2%), and service charges on deposit accounts were $194 million (2.4%) above the level of a year ago. Net interest income was $378 million (0.4%) higher, even though the quarterly average net interest margin declined year over year from 3.66% to 3.52%. Almost two out of every three banks-63.9%-reported year-over-year increases in net operating revenue. In addition to the contribu­tion from increased net operating revenue, first-quarter earnings received a boost from higher realized gains on investment securities and other assets, which were $2 billion more than a year earlier.

Loan-Loss Provisions Continue to Fall

Provisions for loan-and-lease losses fell for a tenth consecutive quarter, declining by $6.6 billion (31.6%) from first quarter 2011 levels. The $14.3 billion that banks set aside in provisions was the small­est quarterly total since second quarter 2007. Slightly fewer than half of all institutions (45.8%) reported lower loss provisions, while fewer than one in three (32%) increased their provisions over first quarter 2011 levels.

Loan Losses Improve in All Major Loan Categories

Loan losses declined from year-ago levels for a seventh consecutive quarter. Net charge-offs (NCOs) totaled $21.8 billion in the first quarter, the lowest quarterly total in four years, and $11.7 billion (34.8%) less than in first quarter 2011. Charge-offs were lower in all major loan categories. The largest year-over-year declines were in credit cards, where NCOs fell by $4.3 billion (37.7%); in real estate construction and land loans, where NCOs were $1.8 billion (60.6%) lower; and in commercial and industrial (C&I) loans, where NCOs declined by $1.5 billion (44.4%).

Noncurrent Loans Decline to Three-Year Low

The amount of loans and leases that were noncur­rent-90 days or more past due or in nonaccrual status-fell for the eighth quarter in a row, declining by $1 billion (0.3%). At $305 billion, noncurrent loans are at their lowest level in three years. Noncur­rent levels declined in most major loan categories; however, noncurrent loans secured by 1-4 family resi­dential real estate properties increased by $7.5 billion (4.1%) as a result of the application of more stringent methodologies for recognizing impairment in junior-lien mortgages, as well as a $10 billion (14.3%) increase in noncurrent rebooked "GNMA loans" that carry federal guarantees.1 Excluding rebooked GNMAs, noncurrent first-lien mortgage balances declined by $7.2 billion (7.2%) during the quarter. Noncurrent real estate construction and land loans declined by $3.7 billion (11.4%), noncurrent C&I loans fell by $1.4 billion (7.9%), and noncurrent loans secured by nonfarm nonresiden­tial real estate properties declined by $1.3 billion (3.2%).

Capital Levels Are at or Near Record Levels

Banks added to their capital in the quarter, as bank equity increased by $18.1 billion (1.2%) and tier 1 leverage capital rose by $15.1 billion (1.2%). Retained earnings contributed $14.3 billion to the increase in capital, up from $13.6 billion in first quarter 2011. Banks paid $21 billion in dividends, an increase of $5.9 billion (38.9%) from a year ago. The aver­age levels of all three regulatory capital ratios rose during the quarter. The average leverage capital ratio matched an all-time high of 9.2% at the end of the quarter, while the average tier 1 risk-based capital ratio set a record of 13.28%. The total risk-based capital ratio rose from 15.31% to 15.52% during the quarter, almost matching the all-time high of 15.53% registered a year ago.

Loan Balances Decline While Other Assets Increase

Total assets of insured institutions increased by only $40.9 billion (0.3%), as total loan and lease balances declined by $56.3 billion (0.8%), and Fed funds sold and securities purchased under resale agreements fell by $13.3 billion (2.9%). Banks' holdings of mortgage-backed securities increased by $84.6 billion (5.1%), while investments in state and municipal securities increased by $7.7 billion (3.5%). Balances due from Federal Reserve Banks increased by $60 billion (8.9%). Loan balances declined in most major categories during the quarter, led by credit cards, which had a seasonal drop of $38.2 billion (5.6%). Closed-end 1-4 family residential real estate loan balances fell by $19.2 billion (1%), home equity lines of credit declined by $13.1 billion (2.2%), and real estate construction and land loans fell by $11.7 billion (4.9%). Small business and farm loan balances declined by $10.8 billion (1.6%). The only major loan categories posting increases in the quarter were C&I loans (up $27.3 billion, or 2%), and auto loans (up $4.5 billion, or 1.5%).

Deposits Continue to Replace Other Liabilities

Deposits in domestic offices increased by only $67.8 billion (0.8%) after rising by more than $200 billion in each of the previous three quarters. In contrast to those quarters, when much of the deposit growth occurred in large-denomination noninterest-bearing accounts, much of the domestic deposit growth in first quarter 2012 consisted of smaller-denomination interest-bearing deposits. Deposits in foreign offices, which had fallen in each of the previous three quarters, increased by $6.9 billion (0.5%). For the sixth consecutive quarter, insured institutions reduced their nondeposit liabilities by $52 billion (2.4%). Federal Home Loan Bank advances fell by $21.7 billion (6.6%), while trading liabilities declined by $25.6 billion (8.2%).

Only 16 Banks Fail in the First Quarter

The number of insured institutions reporting quarterly financial results declined to 7,307, from 7,357 at year-end 2011. Two institutions' financial reports had not been received at the time this publication was prepared. Mergers absorbed 27 institutions during the quarter, while 16 insured institutions failed. This is the smallest number of bank failures in a quarter since fourth quarter 2008, when there were 12 failures. For the second quar­ter in a row, no new reporters were added. In the last five quarters, the only new charters that have been added have been charters created to absorb or liquidate failed banks. The number of insured institutions on the FDIC's "Problem List" declined from 813 to 772 during the quarter, and assets of "problem" banks fell from $319 billion to $292 billion. The number of "problem" institutions has fallen in each of the last four quarters, and is now at its lowest level since year-end 2009.

Critical Accounting Policies

The discussion contained in this Item 2 and other disclosures included within this report are based, in part, on the Company's audited consolidated financial statements. These statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained in these statements is, for the most part, based on the financial effects of transactions and events that have already occurred. However, the preparation of these statements requires management to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses.

The Company's significant accounting policies are described in the "Notes to Consolidated Financial Statements" contained in the Company's Annual Report. Based on its consideration of accounting policies that involve the most complex and subjective estimates and judgments, management has identified its most critical accounting policies to be those related to the allowance for loan losses, valuation of other real estate owned and the assessment of other-than-temporary impairment of certain securities available-for-sale.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses that is treated as an expense and charged against earnings. Loans are charged against the allowance for loan losses when management believes that collectability of the principal is unlikely. The Company has policies and procedures for evaluating the overall credit quality of its loan portfolio, including timely identification of potential problem loans. On a quarterly basis, management reviews the appropriate level for the allowance for loan losses, incorporating a variety of risk considerations, both quantitative and qualitative. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, known information about individual loans and other factors. Qualitative factors include the general economic environment in the Company's market area. To the extent actual results differ from forecasts and management's judgment, the allowance for loan losses may be greater or lesser than future charge-offs. Due to potential changes in conditions, it is at least reasonably possible that change in estimates will occur in the near term and that such changes could be material to the amounts reported in the Company's financial statements.

Other Real Estate Owned

Real estate properties acquired through or in lieu of foreclosure are initially recorded at the fair value less estimated selling cost at the date of foreclosure. Any write-downs based on the asset's fair value at the date of acquisition are charged to the allowance for loan losses. After foreclosure, valuations are periodically performed by management and property held for sale is carried at the lower of the new cost basis or fair value less cost to sell. Impairment losses are measured as the amount by which the carrying amount of a property exceeds its fair value. Costs of significant property improvements are capitalized, whereas costs relating to holding property are expensed. The portion of interest costs relating to development of real estate is capitalized. Independent appraisals or evaluations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to the lower of its cost basis or fair value less cost to sell. These appraisals or evaluations are inherently subjective and require estimates that are susceptible to significant revisions as more information becomes available. Due to potential changes in conditions, it is at least reasonably possible that changes in fair values will occur in the near term and that such changes could materially affect the amounts reported in the Company's financial statements.

Other-Than-Temporary Impairment of Available-for-Sale Securities

Declines in the fair value of securities available-for-sale below their cost that are deemed to be other-than-temporary are generally reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers: (1) the intent to sell the investment securities and the more likely than not requirement that the Company will be required to sell the investment securities prior to recovery; (2) the length of time and the extent to which the fair value has been less than cost; and (3) the financial condition and near-term prospects of the issuer. Due to potential changes in conditions, it is at least reasonably possible that change in management's assessment of other-than-temporary impairment will occur in the near term and that such changes could be material to the amounts reported in the Company's financial statements.

Income Statement Review for the Three Months ended June 30, 2012

The following highlights a comparative discussion of the major components of net income and their impact for the three months ended June 30, 2012 and 2011:

AVERAGE BALANCES AND INTEREST RATES

The following two tables are used to calculate the Company's net interest margin. The first table includes the Company's average assets and the related income to determine the average yield on earning assets. The second table includes the average liabilities and related expense to determine the average rate paid on interest bearing liabilities. The net interest margin is equal to the interest income less the interest expense divided by average earning assets.

                   AVERAGE BALANCE SHEETS AND INTEREST RATES

                                                      Three Months ended June 30,

                                          2012                                          2011

                          Average        Revenue/        Yield/         Average        Revenue/        Yield/
                          balance        expense          rate          balance        expense          rate
. . .