10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

R QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006.

OR

£ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to __________.

Commission file number: 0-24611

CFS Bancorp, Inc.

(Exact name of registrant as specified in its charter)

Indiana	35-2042093
(State or other jurisdiction	(I.R.S. Employer
of incorporation or organization)	Identification No.)

707 Ridge Road, Munster, Indiana 46321

(Address of principal executive offices)

(219) 836-5500

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES RNO £

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer £Accelerated filer RNon-accelerated filer £

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES £ NO R

The Registrant had 11,291,012 shares of Common Stock issued and outstanding as of November 3, 2006.

CFS BANCORP, INC.

TABLE OF CONTENTS

		Page
	PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	Condensed Consolidated Statements of Condition	3
	Condensed Consolidated Statements of Income	4
	Condensed Consolidated Statements of Changes in Stockholders' Equity	5
	Condensed Consolidated Statements of Cash Flows	6
	Notes to Condensed Condolidated Financial Statements	7
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	34
Item 4.	Controls and Procedures	37
	PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	37
Item 1A.	Risk Factors	38
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	38
Item 3.	Defaults upon Senior Securities	38
Item 4.	Submission of Matters to a Vote of Security Holders	39
Item 5.	Other Information	39
Item 6.	Exhibits	40
Signature Page		41
Certifications for Principal Executive Officer and Principal Financial Officer
	Exhibit 31.1
	Exhibit 31.2
	Exhibit 32

2

CFS BANCORP, INC.

Condensed Consolidated Statements of Condition

	September 30, 2006			December 31, 2005
		(Unaudited)
	(Dollars in thousands)
Assets
Cash and amounts due from depository institutions	$	16,399		$	17,600
Interest-bearing deposits		15,853			1,785
Federal funds sold		18,102			4,792
Cash and cash equivalents		50,354			24,177
Securities available-for-sale, at fair value		322,770			218,550
Investment in Federal Home Loan Bank stock, at cost		25,455			28,252
Loans receivable		833,010			917,405
Allowance for losses on loans		(10,692	)		(12,939	)
Net loans		822,318			904,466
Interest receivable		7,922			6,142
Office properties and equipment		16,454			15,017
Investment in bank-owned life insurance		35,474			34,889
Prepaid expenses and other assets		10,318			10,031
Goodwill and intangible assets		1,315			1,364
Total assets	$	1,292,380		$	1,242,888
Liabilities and Stockholders’ Equity
Deposits	$	870,830		$	828,635
Borrowed money, net of unamortized deferred premium on early extinguishment of debt		275,051			257,326
Advance payments by borrowers for taxes and insurance		4,393			6,641
Other liabilities		9,084			7,919
Total liabilities		1,159,358			1,100,521
Stockholders’ equity:
Preferred stock, $0.01 par value; 15,000,000 shares authorized		-			-
Common stock, $0.01 par value; 85,000,000 shares authorized; 23,423,306 shares issued; 11,293,170 and 12,005,431 shares outstanding		234			234
Additional paid-in capital		190,692			190,402
Retained earnings		94,101			94,379
Treasury stock, at cost; 12,130,136 and 11,417,875 shares		(147,517	)		(136,229	)
Unallocated common stock held by ESOP		(3,864	)		(4,762	)
Unearned common stock acquired by RRP		-			(111	)
Accumulated other comprehensive loss, net of tax		(624	)		(1,546	)
Total stockholders’ equity		133,022			142,367
Total liabilities and stockholders’ equity	$	1,292,380		$	1,242,888

See accompanying notes.

3

CFS BANCORP, INC.

Condensed Consolidated Statements of Income

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
	(Unaudited)
	(Dollars in thousands, except share and per share data)
Interest income:
Loans	$	14,798		$	15,165		$	45,027		$	44,896
Securities		3,482			1,776			9,123			5,348
Other		625			267			1,674			969
Total interest income		18,905			17,208			55,824			51,213
Interest expense:
Deposits		5,752			3,494			15,309			9,706
Borrowed money		5,300			5,801			15,694			20,340
Total interest expense		11,052			9,295			31,003			30,046
Net interest income		7,853			7,913			24,821			21,167
Provision for losses on loans		413			545			971			1,312
Net interest income after provision for losses on loans		7,440			7,368			23,850			19,855
Non-interest income:
Service charges and other fees		1,730			1,956			5,042			5,592
Commission income		32			159			149			428
Net realized gains (losses) on available-for-sale securities		877			(25	)		750			(113	)
Impairment of available-for-sale securities		-			-			-			(240	)
Net gains (losses) on sale of other assets		(1,339	)		287			(1,291	)		369
Income from bank-owned life insurance		401			409			1,189			1,138
Other income		568			563			1,696			1,558
Total non-interest income		2,269			3,349			7,535			8,732
Non-interest expense:
Compensation and employee benefits		5,092			4,625			15,419			13,751
Net occupancy expense		609			628			1,923			2,055
Data processing		559			646			1,910			1,998
Furniture and equipment expense		548			433			1,516			1,288
Professional fees		319			413			1,083			1,228
Marketing		442			245			1,031			640
Amortization of core deposit intangibles		16			16			49			49
Other general and administrative expenses		1,343			1,192			3,965			3,828
Total non-interest expense		8,928			8,198			26,896			24,837
Income before income taxes		781			2,519			4,489			3,750
Income tax expense		1			632			779			585
Net income	$	780		$	1,887		$	3,710		$	3,165
Per share data:
Basic earnings per share	$	0.07		$	0.16		$	0.33		$	0.27
Diluted earnings per share		0.07			0.16			0.32			0.26
Cash dividends declared per share		0.12			0.12			0.36			0.36
Weighted-average shares outstanding		11,023,626			11,718,907			11,258,651			11,778,729
Weighted-average diluted shares outstanding		11,248,382			11,943,913			11,491,604			12,015,243

See accompanying notes.

4

CFS BANCORP, INC.

Condensed Consolidated Statements of Changes in Stockholders' Equity

	Common Stock		Additional Paid-In Capital			Retained Earnings			Treasury Stock			Unalloc. Common Stock Held By ESOP			Unearned Common Stock Acquired By RRP			Accum. Other Compre-hensive Loss			Total
	(Unaudited)
	(Dollars in thousands, except per share data)
Balance at January 1, 2005	$	234	$	189,991		$	94,904		$	(130,689	)	$	(5,959	)	$	(148	)	$	(422	)	$	147,911
Net income		-		-			3,165			-			-			-			-			3,165
Other comprehensive loss, net of tax: Change in unrealized loss on available- for-sale securities, net of reclassification adjustment																			(821	)		(821	)
Total comprehensive income																						2,344
Purchase of treasury stock		-		-			-			(4,256	)		-			-			-			(4,256	)
Shares earned under ESOP		-		333			-			-			898			-			-			1,231
Amortization of awards under RRP		-		12			-			-			-			37			-			49
Exercise of stock options		-		(255	)		-			727			-			-			-			472
Tax benefit related to stock options exercised		-		134			-			-			-			-			-			134
Dividends declared on common stock ($0.36 per share)		-		-			(4,170	)		-			-			-			-			(4,170	)
Balance at September 30, 2005	$	234	$	190,215		$	93,899		$	(134,218	)	$	(5,061	)	$	(111	)	$	(1,243	)	$	143,715
Balance at January 1, 2006	$	234	$	190,402		$	94,379		$	(136,229	)	$	(4,762	)	$	(111	)	$	(1,546	)	$	142,367
Net income		-		-			3,710			-			-			-			-			3,710
Other comprehensive income, net of tax: Change in unrealized loss on available- for-sale securities, net of reclassification adjustment																			922			922
Total comprehensive income																						4,632
Purchase of treasury stock		-		-			-			(14,705	)		-			-			-			(14,705	)
Shares earned under ESOP		-		424			-			-			898			-			-			1,322
Reclassification of unearned compensation to additional paid-in capital upon the adoption of SFAS 123(R)		-		(111	)		-			-			-			111			-			-
Amortization of awards under RRP		-		48			-			-			-			-			-			48
Exercise of stock options		-		(474	)		-			3,417			-			-			-			2,943
Tax benefit related to stock options exercised		-		403			-			-			-			-			-			403
Dividends declared on common stock ($0.36 per share)		-		-			(3,988	)		-			-			-			-			(3,988	)
Balance at September 30, 2006	$	234	$	190,692		$	94,101		$	(147,517	)	$	(3,864	)	$	-		$	(624	)	$	133,022

See accompanying notes.

5

CFS BANCORP, INC.

Condensed Consolidated Statements of Cash Flows

	Nine Months Ended September 30,
	2006			2005
	(Unaudited)
	(Dollars in thousands)
Operating activities:
Net income	$	3,710		$	3,165
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for losses on loans		971			1,312
Depreciation and amortization		1,130			1,224
Premium amortization on the early extinguishment of debt		7,587			11,581
Net premium amortization on securities available-for-sale		(361	)		690
Impairment of securities available-for-sale		-			240
Benefit for deferred income taxes		(493	)		(1,193	)
Amortization of cost of stock benefit plans		1,370			1,280
Proceeds from sale of loans held-for-sale		7,809			18,599
Origination of loans held-for-sale		(7,664	)		(22,231	)
Net (gain) loss realized on sale of securities		(750	)		113
Dividends received on Federal Home Loan Bank stock		-			(587	)
Net (gain) loss realized on sale of other assets		1,291			(369	)
Net increase in cash surrender value of bank-owned life insurance		(585	)		(1,138	)
(Increase) decrease in prepaid expenses and other assets		(4,873	)		3,713
Increase in other liabilities		4,672			563
Net cash provided by operating activities		13,814			16,962
Investing activities:
Securities:
Proceeds from sales		24,826			49,149
Proceeds from maturities and paydowns		17,064			33,258
Purchases		(140,721	)		(78,615	)
Net loan fundings and principal payments received		66,457			23,766
Proceeds from sales of loans and loan participations		8,754			22,632
Proceeds from sale of real estate owned		4,162			715
Purchases of property and equipment		(2,602	)		(920	)
Disposal of property and equipment		84			467
Net cash provided by (used for) investing activities		(21,976	)		50,452
Financing activities:
Proceeds from exercises of stock options		2,943			472
Tax benefit from exercises of nonqualified stock options		403			134
Dividends paid on common stock		(4,249	)		(4,327	)
Purchase of treasury stock		(14,705	)		(4,256	)
Net increase (decrease) in deposit accounts		42,057			(38,187	)
Net decrease in advance payments by borrowers for taxes and insurance		(2,248	)		(87	)
Net increase in other short-term borrowings		20,322			-
Net decrease in FHLB debt		(10,184	)		(24,172	)
Net cash flows provided by (used for) financing activities		34,339			(70,423	)
Net increase (decrease) in cash and cash equivalents		26,177			(3,009	)
Cash and cash equivalents at beginning of period		24,177			38,094
Cash and cash equivalents at end of period	$	50,354		$	35,085
Cash paid for:
Interest on deposits	$	15,259		$	9,683
Interest on borrowed money		15,735			8,831
Taxes		1,020			-

See accompanying notes.

6

CFS BANCORP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Financial Statements Presentation

The condensed consolidated financial statements of CFS Bancorp, Inc. (including its consolidated subsidiaries, the Company) as of September 30, 2006 and for the nine months ended September 30, 2006 and September 30, 2005 are unaudited; however, the financial information reflects all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations and cash flows of the Company for the interim periods. The financial statements have been prepared in conformity with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.

The results of operations for the nine months ended September 30, 2006 are not necessarily indicative of the results expected for the full year ending December 31, 2006. The accompanying condensed consolidated financial statements do not include information or footnotes necessary for a complete presentation of financial condition, results of operations or cash flows in accordance with U.S. generally accepted accounting principles. The September 30, 2006 condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes for the year ended December 31, 2005 included in the Company’s Annual Report on Form 10-K. The condensed consolidated statement of condition of the Company as of December 31, 2005 has been derived from the audited consolidated statement of condition as of that date.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates, judgments or assumptions that could have a material effect on the carrying value of certain assets and liabilities. These estimates, judgments and assumptions affect the amounts reported in the condensed consolidated financial statements and the disclosures provided. The determination of the allowance for losses on loans and the accounting for income taxes are highly dependent on management’s estimates, judgments and assumptions where changes in those estimates and assumptions could have a significant impact on the financial statements.

Some items in the prior period financial statements were reclassified to conform to the current period’s presentation.

2. Share-Based Compensation

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (SFAS 123(R)). SFAS 123(R) addresses all forms of share-based payment awards, including shares under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. SFAS 123(R) requires all share-based payments to be recognized as expense, based upon their fair values, in the financial statements over the vesting period of the awards. The Company has elected the modified prospective application.

7

During 2005, the Company’s Compensation Committee of the Board of Directors approved the accelerated vesting of all then outstanding unvested stock options (Options) to purchase shares of common stock of the Company. Accordingly, all of the Company’s then outstanding unvested options became vested as of September 30, 2005. The estimated future option expense associated with these options was $1.7 million, net of tax, and would have been required to be recorded in the Company’s income statement in future periods starting upon its adoption of SFAS 123(R) in January 2006. Since the Company accounted for its stock options in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) at the time of acceleration, the Company reported this compensation expense related to the affected options for disclosure purposes only in 2005. Since all of the stock options granted by the Company vested prior to January 1, 2006, the Company did not record any compensation expense related to its stock options for the three or nine months ended September 30, 2006.

Prior to the adoption of SFAS 123(R), unearned compensation related to the Company’s Recognition and Retention Plan (RRP) was classified as a separate component of stockholders’ equity. In accordance with the provisions of SFAS 123(R), on January 1, 2006, the remaining balance of the Company’s unearned common stock related to the RRP was reclassified to additional paid-in capital on the Company’s statement of financial condition.

Also prior to the adoption of SFAS 123(R), the Company accounted for its stock option plans under the recognition and measurement principles of APB 25 and related interpretations. No stock-based employee compensation cost was reflected in net income as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the grant date. Pursuant to SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), pro forma net income and pro forma earnings per share for the three and nine months ended September 30, 2005 are presented in the following table as if the fair value method of accounting for stock-based compensation plans had been utilized.

	Three Months Ended September 30,			Nine Months Ended September 30,
	2005			2005
	(Dollars in thousands except per share data)
Net income (as reported)	$	1,887		$	3,165
Stock-based compensation expense determined using fair value method, net of tax (1)		(1,899	)		(2,176	)
Pro forma net income	$	(12	)	$	989
Basic earnings per share (as reported)	$	0.16		$	0.27
Pro forma basic earnings per share		-			0.08
Diluted earnings per share (as reported)		0.16			0.26
Pro forma diluted earnings per share		-			0.08

(1) A Black-Scholes option pricing model was used to determine the fair values of the options granted.

Stock Options

The Company has stock option plans under which shares of Company common stock are reserved for the grant of both incentive and non-qualified stock options to directors, officers, and employees. The dates the stock options are first exercisable and expire are determined by the

8

Compensation Committee of the Company’s Board of Directors at the time of the grant. The exercise price of the stock options is equal to the fair market value of the common stock on the grant date. All of the Company’s options were fully vested as of December 31, 2005.

The Company did not grant any options during the nine months ended September 30, 2006. On July 25, 2005, the Company granted stock options under its 1998 and 2003 Stock Option Plans to directors, officers and employees of the Company. The number of stock options granted in 2005 totaled 234,945 shares, all of which have an exercise price equal to the fair market value of the Company’s common stock on the day of grant of $13.48. The stock options originally were to vest ratably over five years. Subsequently, on September 30, 2005, the Company accelerated the vesting of all of its outstanding unvested stock options and these stock options became fully vested as of that date. The fair value of the stock options granted in 2005 was estimated using the Black-Scholes option value model with the following assumptions:

Dividend yield	3.6	%
Expected volatility	25.9
Risk-free interest	4.1
Original expected life	6 years

The following table presents the activity related to options under the Company’s stock option plans for the nine months ended September 30, 2006. The number of shares presented are in thousands.

	Number of Shares			Weighted-Average Exercise Price
Options outstanding at January 1, 2006		1,823		$	11.78
Granted		-			-
Exercised		(285	)		10.32
Forfeited		(6	)		13.48
Options outstanding at September 30, 2006		1,532			12.04
Options exercisable at September 30, 2006		1,532			12.04

For stock options outstanding at September 30, 2006, the range of exercise prices was $5.28 to $14.76 and the weighted-average remaining contractual term was 5.19 years.

At September 30, 2006, the aggregate intrinsic value of options outstanding totaled $4.2 million. This value represents the difference between the Company’s closing stock price on the last day of trading for the nine months ended September 30, 2006 and the exercise price multiplied by the number of in-the-money options assuming all option holders had exercised their stock options on September 30, 2006.

The aggregate intrinsic value of options exercised during the nine months ended September 30, 2006 was $1.2 million. The exercise of options during the same period resulted in cash receipts of $2.9 million and a tax benefit of $403,000 that has been recorded as an increase to equity.

The Company reissues treasury shares to satisfy option exercises.

Recognition and Retention Plan

In February 1999, the Company, with shareholder approval, established the RRP, which is a stock-based incentive plan, and a stock option plan. The Bank contributed $7.5 million to

9

the RRP to purchase an aggregate total of 714,150 shares of Company common stock. On April 1, 1999, the Compensation Committee of the Board of Directors granted an aggregate of 707,000 shares under this plan to 92 participants. On April 1, 2003, the Compensation Committee made an additional grant of an aggregate of 21,000 shares to five participants. On April 1, 2004, the remaining 1,050 shares were granted to two participants.

The shares granted in the RRP vest to the participants at the rate of 20% per year. As a result, expense for this plan is being recorded over a 60-month period from the date of grant and is based on the market value of the Company’s stock as of the date of grant. The remaining unamortized cost of the RRP is reflected as a reduction in stockholders’ equity. As of September 30, 2006, the remaining unamortized cost of the RRP totaled $74,000. The cost is expected to be recognized over a period of 1.5 years. The total grant date fair value of shares vested during the nine months ended September 30, 2006 was $48,000.

The following table presents the activity for the RRP for the nine months ended September 30, 2006.

	Number of Shares			Weighted-Average Grant-Date Fair Value
Unvested at December 31, 2005		10,620		$	13.83
Granted		-			-
Vested		(3,505	)		13.83
Forfeited		-			-
Unvested as of September 30, 2006		7,115		$	13.84

3. Other Comprehensive Income

The related income tax effect and reclassification adjustments to the components of other comprehensive income (loss) for the periods indicated are as follows:

	Nine Months Ended September 30,
	2006			2005
	(Dollars in thousands)
Unrealized holding gains (losses) arising during the period:
Unrealized net securities gains (losses)	$	2,229		$	(1,674	)
Related tax (expense) benefit		(846	)		635
Net		1,383			(1,039	)
Less: reclassification adjustment for net gains (losses) realized during the period:
Realized net securities gains (losses)		750			(353	)
Related tax (expense) benefit		(289	)		135
Net		461			(218	)
Total other comprehensive income (loss)	$	922		$	(821	)

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4. Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share for the periods presented:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
	(Dollars in thousands, except per share data)
Net income	$	780	$	1,887	$	3,710	$	3,165
Weighted-average common shares outstanding		11,023,626		11,718,907		11,258,651		11,778,729
Weighted-average common share equivalents (1)		224,756		225,006		232,953		236,514
Weighted-average common shares and common shareequivalents outstanding		11,248,382		11,943,913		11,491,604		12,015,243
Basic earnings per share	$	0.07	$	0.16	$	0.33	$	0.27
Diluted earnings per share		0.07		0.16		0.32		0.26

(1) Assumes exercise of dilutive stock options and also a portion of the unearned awards under the RRP.

For the three months ended September 30, 2006, there were no anti-dilutive options. For the nine months ended September 30, 2006, the Company had 79,000 anti-dilutive options. The Company had 559,000 and 504,000 anti-dilutive options for the three and nine months ended September 30, 2005, respectively. The anti-dilutive options were not included in the above earnings per share calculations.

5. New Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS 109 (FIN 48) which establishes a recognition threshold and measurement for income tax positions recognized in an enterprise’s financial statements in accordance with SFAS 109, Accounting for Income Taxes. FIN 48 also prescribes a two-step evaluation process for tax positions. The first step is recognition and the second is measurement. For recognition, an enterprise judgmentally determines whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of related appeals or litigation processes, based on the technical merits of the position. If the tax position meets the more-likely-than-not recognition threshold, it is measured and recognized in the financial statements as the largest amount of tax benefit that is greater than 50% likely of being realized. If a tax position does not meet the more-likely-than-not recognition threshold, the benefit of that position is not recognized in the financial statements.

Tax positions that meet the more-likely-than-not recognition threshold at the effective date of FIN 48 may be recognized or, continue to be recognized, upon adoption of this Interpretation. The cumulative effect of applying the provisions of FIN 48 shall be reported as an adjustment to the opening balance of retained earnings for that fiscal year. FIN 48 is effective for fiscal years beginning after December 15, 2006. Accordingly, the Company plans to adopt FIN 48 on January 1, 2007. The Company is evaluating the impact of adoption of FIN 48 and is unable, at this time, to quantify the impact, if any, to retained earnings at the time of adoption.

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In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements required under other accounting pronouncements, but does not change existing guidance as to whether or not an instrument is carried at fair value. Additionally, it establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. Earlier application is encouraged provided that the reporting entity has not yet issued financial statements for that fiscal year, including financial statements for an interim period within that fiscal year. The Company does not expect the adoption of SFAS 157 to have a material impact on its financial condition or results of operations.

In September 2006, the U.S. Securities Exchange Commission issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements (SAB 108), which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 is effective for fiscal years ending after November 15, 2006. The Company is currently evaluating the impact, if any, that SAB 108 will have on its financial condition and results of operations.

In October 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132 (R) (SFAS 158) which does not change the amount of net periodic benefit cost included in net income or address the various measurement issues associated with postretirement benefit plan accounting. SFAS 158 requires an entity to recognize in its statement of financial position an asset for a defined benefit postretirement plan’s overfunded status or a liability for a plan’s underfunded status, measure a defined benefit postretirement plan’s assets and obligations that determine its funded status as of the end of the employer’s fiscal year, and recognize changes in the funded status of a defined benefit postretirement plan in comprehensive income in the year in which the changes occur. SFAS 158 is effective for fiscal years ending after December 15, 2006. The Company does not expect the adoption of SFAS 158 to have a significant impact on its financial condition and results of operations since the Company participates in a multi-employer defined benefit pension plan.

Item 2.Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

Certain statements contained in this Form 10-Q, in other filings made by the Company with the U.S. Securities and Exchange Commission (SEC), and in the Company’s press releases or other stockholder communications are forward-looking statements, as that term is defined in U.S. federal securities laws. Generally, these statements relate to business plans or strategies, projections involving anticipated revenues, earnings, profitability or other aspects of operating results or other future developments in the Company’s affairs or the industry in which it conducts business. Forward-looking statements may be identified by reference to a future period or periods or by the use of forward-looking terminology such as “anticipate,” “believe,”

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“expect,” “intend,” “plan,” “estimate,” “would be,” “will,” “intends to,” “project” or similar expressions or the negative thereof.

The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. The Company also advises readers that various factors, including regional and national economic conditions, changes in levels of market interest rates, credit and other risks which are inherent in the Company’s lending and investment activities, legislative changes, changes in the cost of funds, changes in the demand for loan products and financial services, unexpected legal developments, changes in accounting principles, and competitive and regulatory factors, could affect the Company’s financial performance and could cause the Company’s actual results for future periods to differ materially from those anticipated or projected. For further discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements see “Part II. Item 1A. Risk Factors” of this Form 10-Q as well as “Part I. Item 1A. Risk Factors” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. Such forward-looking statements are not guarantees of future performance. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

Overview

The Company’s net income for the third quarter of 2006 was $780,000 compared to $1.9 million for the 2005 period. The Company’s net income for the first nine months of 2006 was $3.7 million compared to $3.2 million for the first nine months of 2005. The Company’s third quarter and year to date 2006 earnings were primarily impacted by higher funding costs, an inverted yield curve, competitive pricing pressures for loans and deposits, continued loan repayments, increases in non-interest expense due to growth initiatives and a loss of $1.3 million on the sale of an other real estate owned asset. The Company realized a gain of $877,000 on the sale of its investment in trust preferred securities which partially offset the aforementioned loss.

Net interest income for the three and nine months ended September 30, 2006 was negatively impacted by the effects of a flat or inverted (negatively sloping) yield curve throughout 2006. A flat or inverted yield curve is where short-term interest rates are at or above medium- to long-term interest rates. The Company’s assets are typically priced using medium- to long-term rates while the Company’s funding sources are typically priced using short-term rates. As a result, the flat or inverted yield curve reduces the interest rate spread between repricing interest-earning assets and repricing interest-bearing liabilities that the Company would otherwise achieve during periods of a positively sloping yield curve. Net interest income benefited from improved weighted-average yields on interest-earning loans and securities and a reduction of $400,000 and $4.0 million, respectively, in the amortization of the deferred premium on the early extinguishment of debt to $2.5 million and $7.6 million, respectively, from the same periods in 2005. These benefits were partially offset by decreases in the weighted-average balance of interest-earning assets due to the Company’s repurchase of shares of its common stock and the repayment of $10.2 million of its Federal Home Loan Bank (FHLB) debt during the nine months ended September 30, 2006 coupled with increases in the cost of deposits.

The Company’s non-interest expense was $8.9 million and $26.9 million, respectively, for the three and nine months ended September 30, 2006 compared to $8.2 million and $24.8

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million, respectively, for the 2005 periods. The Company anticipates further increases in its non-interest expense throughout the remainder of 2006 and into 2007 as it adds additional experienced commercial lenders, increases other credit support staff and makes significant enhancements to its retail sales culture. To support its longer-term growth initiatives, the Company is evaluating several potential sites for future branch expansion within or contiguous to its existing markets in the Southwestern suburbs of Chicago and Northwest Indiana. All of these initiatives are driven by the Company’s strategic focus to grow its relationships by expanding to meet customer’s loan and deposit needs while still providing them with superior customer service.

Critical Accounting Policies

The Company’s condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP), which require the Company to establish various accounting policies. Certain of these accounting policies require management to make estimates, judgments or assumptions that could have a material effect on the carrying value of certain assets and liabilities. The judgments and assumptions used by management are based on historical experience, projected results, internal cash flow modeling techniques and other factors which management believes are reasonable under the circumstances.

The Company’s significant accounting policies are presented in Note 1 to the condensed consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of its Annual Report on Form 10-K for the year ended December 31, 2005. These policies, along with the disclosures presented in the notes to the Company’s unaudited financial statements included in Item 1 of Part I of this Form 10-Q and in this management’s discussion and analysis, provide information on the methodology for the valuation of significant assets and liabilities in the Company’s financial statements. Management views critical accounting policies to be those that are highly dependent on subjective or complex judgments, estimates and assumptions, and where changes in those estimates and assumptions could have a significant impact on the financial statements. Management currently views the determination of the allowance for losses on loans and the accounting for income taxes to be critical accounting policies.

Allowance for Losses on Loans. The Company maintains an allowance for losses on loans at a level management believes is sufficient to absorb credit losses inherent in the loan portfolio. The allowance for losses on loans represents the Company’s estimate of probable incurred losses in the loan portfolio at each statement of condition date and is based on the review of available and relevant information.

One component of the allowance for losses on loans consists of allocations for probable inherent but undetected losses within various pools of loans with similar characteristics pursuant to Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (SFAS 5). This component is based in part on certain loss factors applied to various loan pools as stratified by the Company. In determining the appropriate loss factors for these loan pools, management considers historical charge-offs and recoveries; levels of and trends in delinquencies, impaired loans and other classified loans; concentrations of credit within the commercial loan portfolio; volume and type of lending; and current and anticipated economic conditions.

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The second component of the allowance for losses on loans consists of allocations for probable losses that have been identified related to specific borrowing relationships pursuant to Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (SFAS 114). This component of the allowance for losses on loans consists of expected losses resulting in specific credit allocations for individual loans not considered within the above mentioned loan pools. The analysis on each loan involves a high degree of judgment in estimating the amount of the loss associated with the loan, including the estimation of the amount and timing of future cash flows and collateral values.

Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. The Company assesses the adequacy of the allowance for losses on loans on a quarterly basis and adjusts the allowance for losses on loans by recording a provision for losses on loans in an amount sufficient to maintain the allowance at a level deemed appropriate by management. The evaluation of the adequacy of the allowance for losses on loans is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as future events occur. To the extent that actual outcomes differ from management estimates, an additional provision for losses on loans could be required which could adversely affect earnings or the Company’s financial position in future periods. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the provision for losses on loans for Citizens Financial Bank (the Bank)and the carrying value of its other non-performing loans, based on information available to them at the time of their examinations. Any of these agencies could require the Bank to make additional provisions for losses on loans.

Income Tax Accounting. Income tax expense recorded in the Company’s condensed consolidated statements of income involves management’s interpretation and application of certain accounting pronouncements and federal and state tax codes. As such, the Company has identified income tax accounting as a critical accounting policy. The Company is subject to examination by various regulatory taxing authorities. These agencies may require that changes in the amount of tax expense or valuation allowance be recognized when their interpretations differ from those of management, based on their judgments about information available to them at the time of their examinations. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment of tax liabilities, the impact of which could be significant to the consolidated results of operations and reported earnings. Management believes the tax liabilities are adequately and properly recorded in the Company’s condensed consolidated financial statements.

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Average Balances, Net Interest Income, Yields Earned and Rates Paid

The following tables provide information regarding (i) the Company’s interest income recognized from interest-earning assets and their related average yields; (ii) the amount of interest expense realized on interest-bearing liabilities and their related average rates; (iii) net interest income; (iv) interest rate spread; and (v) net interest margin. Information is based on average daily balances during the periods indicated.

	Three Months Ended September 30,
	2006							2005
	Average Balance		Interest		Average Yield/Cost			Average Balance		Interest		AverageYield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	836,357	$	14,798		7.02	%	$	957,232	$	15,165		6.29	%
Securities (2)		316,459		3,482		4.31	%		200,124		1,776		3.47	%
Other interest-earning assets (3)		49,174		625		5.04	%		35,050		267		3.02	%
Total interest-earning assets		1,201,990		18,905		6.24	%		1,192,406		17,208		5.73	%
Non-interest earning assets		77,422							75,111
Total assets	$	1,279,412						$	1,267,517
Interest-bearing liabilities:
Deposits:
Checking accounts	$	99,450		262		1.05	%	$	111,460		271		0.96	%
Money market accounts		135,766		1,008		2.95	%		123,396		430		1.38	%
Savings accounts		157,105		194		0.49	%		185,668		158		0.34	%
Certificates of deposit		397,482		4,288		4.28	%		342,485		2,635		3.05	%
Total deposits		789,803		5,752		2.89	%		763,009		3,494		1.82	%
Borrowed money:
Other short-term borrowings (4)		24,633		294		4.74	%		2,199		20		3.61	%
FHLB debt (5)(6)		252,908		5,006		7.75	%		285,070		5,781		7.94	%
Total borrowed money		277,541		5,300		7.47	%		287,269		5,801		7.90	%
Total interest-bearing liabilities		1,067,344		11,052		4.11	%		1,050,278		9,295		3.51	%
Non-interest bearing deposits		61,173							55,502
Non-interest bearing liabilities		16,665							16,564
Total liabilities		1,145,182							1,122,344
Stockholders' equity		134,230							145,173
Total liabilities and stockholders' equity	$	1,279,412						$	1,267,517
Net interest-earning assets	$	134,646						$	142,128
Net interest income / interest rate spread			$	7,853		2.13	%			$	7,913		2.22	%
Net interest margin						2.59	%						2.63	%
Ratio of average interest-earning assets to average interest-bearing liabilities						112.62	%						113.53	%

(1) The average balance of loans receivable includes non-performing loans, interest on which is recognized on a cash basis.

(2) Average balances of securities are based on amortized costs.

(3) Includes Federal Home Loan Bank stock, money market accounts, federal funds sold and interest-earning bank deposits.

(4) Includes federal funds purchased and Repo Sweeps.

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(5) The 2006 period includes an average of $262.5 million of contractual FHLB borrowings reduced by an average of $9.6 million of unamortized deferred premium on the early extinguishment of debt. Interest expense on borrowed money includes $2.5 million of amortization of the deferred premium on the early extinguishment of debt. The amortization of the deferred premium increased the average cost of borrowed money as reported to 7.47% compared to an average contractual rate of 3.86%.

(6) The 2005 period includes an average of $305.5 million of contractual FHLB borrowings reduced by an average of $20.4 million of unamortized premium on early extinguishment of debt. Interest expense on borrowings for the 2005 period includes $2.9 million of amortization of the deferred premium on early extinguishment of debt. The amortization of the deferred premium for the 2005 period increased the average cost of borrowed money as reported to 7.90% compared to an average contractual rate of 3.75%.

	Nine Months Ended September 30,
	2006							2005
	Average Balance		Interest		Average Yield/Cost			Average Balance		Interest		Average Yield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	863,874	$	45,027		6.97	%	$	970,883	$	44,896		6.18	%
Securities (2)		283,383		9,123		4.25	%		205,534		5,348		3.43	%
Other interest-earning assets (3)		45,845		1,674		4.88	%		36,109		969		3.59	%
Total interest-earning assets		1,193,102		55,824		6.26	%		1,212,526		51,213		5.65	%
Non-interest earning assets		73,192							75,009
Total assets	$	1,266,294						$	1,287,535
Interest-bearing liabilities:
Deposits:
Checking accounts	$	102,837		773		1.00	%	$	107,602		574		0.71	%
Money market accounts		133,275		2,647		2.66	%		133,861		1,199		1.20	%
Savings accounts		163,261		479		0.39	%		191,587		482		0.34	%
Certificates of deposit		383,416		11,410		3.98	%		349,375		7,451		2.85	%
Total deposits		782,789		15,309		2.61	%		782,425		9,706		1.66	%
Borrowed money:
Other short-term borrowings (4)		12,421		424		4.56	%		1,327		34		3.43	%
FHLB debt (5)(6)		256,152		15,270		7.86	%		288,151		20,306		9.29	%
Total borrowed money		268,573		15,694		7.71	%		289,478		20,340		9.27	%
Total interest-bearing liabilities		1,051,362		31,003		3.94	%		1,071,903		30,046		3.75	%
Non-interest bearing deposits		61,859							51,959
Non-interest bearing liabilities		15,426							17,341
Total liabilities		1,128,647							1,141,203
Stockholders' equity		137,647							146,332
Total liabilities and stockholders' equity	$	1,266,294						$	1,287,535
Net interest-earning assets	$	141,740						$	140,623
Net interest income / interest ratespread			$	24,821		2.32	%			$	21,167		1.90	%
Net interest margin						2.78	%						2.33	%
Ratio of average interest-earning assets to average interest-bearing liabilities						113.48	%						113.12	%

(1) The average balance of loans receivable includes non-performing loans, interest on which is recognized on a cash basis.

(2) Average balances of securities are based on amortized costs.

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(3) Includes Federal Home Loan Bank stock, money market accounts, federal funds sold and interest-earning bank deposits.

(4) Includes federal funds purchased and Repo Sweeps.

(5) The 2006 period includes an average of $268.3 million of contractual FHLB borrowings reduced by an average of $12.1 million of unamortized deferred premium on the early extinguishment of debt. Interest expense on borrowed money includes $7.6 million of amortization of the deferred premium on the early extinguishment of debt. The amortization of the deferred premium increased the average cost of borrowed money as reported to 7.71% compared to an average contractual rate of 3.84%.

(6) The 2005 period includes an average of $312.2 million of contractual FHLB borrowings reduced by an average of $24.0 million of unamortized premium on early extinguishment of debt. Interest expense on borrowings for the 2005 period includes $11.6 million of amortization of the deferred premium on early extinguishment of debt. The amortization of the deferred premium for the 2005 period increased the average cost of borrowed money as reported to 9.27% compared to an average contractual rate of 3.71%.

Rate / Volume Analysis

The following table details the effects of changing rates and volumes on the Company’s net interest income. Information is provided with respect to (i) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume); (ii) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate); and (iii) changes in rate/volume (changes in rate multiplied by changes in volume).

	Three Months Ended September 30,
	2006 compared to 2005
	Increase (decrease) due to
	Rate			Volume			Rate/ Volume			Total Net Increase /(Decrease)
	(Dollars in thousands)
Interest-earning assets:
Loans receivable	$	1,772		$	(1,915	)	$	(224	)	$	(367	)
Securities		426			1,032			248			1,706
Other interest-earning assets		178			108			72			358
Total net change in income on interest-earning assets		2,376			(775	)		96			1,697
Interest-bearing liabilities:
Deposits:
Checking accounts		22			(29	)		(2	)		(9	)
Money market accounts		486			43			49			578
Savings accounts		71			(24	)		(11	)		36
Certificates of deposit		1,060			423			170			1,653
Total deposits		1,639			413			206			2,258
Borrowed money:
Other short-term borrowings		6			204			64			274
FHLB debt		(138	)		(653	)		16			(775	)
Total borrowed money		(132	)		(449	)		80			(501	)
Total net change in expense on interest-bearing liabilities		1,507			(36	)		286			1,757
Net change in net interest income	$	869		$	(739	)	$	(190	)	$	(60	)

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	Nine Months Ended September 30,
	2006 compared to 2005
	Increase (decrease) due to
	Rate			Volume			Rate/ Volume			Total Net Increase / (Decrease)
	(Dollars in thousands)
Interest-earning assets:
Loans receivable	$	5,708		$	(4,948	)	$	(629	)	$	131
Securities		1,269			2,025			481			3,775
Other interest-earning assets		350			261			94			705
Total net change in income on interest-earning assets		7,327			(2,662	)		(54	)		4,611
Interest-bearing liabilities:
Deposits:
Checking accounts		234			(25	)		(10	)		199
Money market accounts		1,459			(5	)		(6	)		1,448
Savings accounts		80			(71	)		(12	)		(3	)
Certificates of deposit		2,946			726			287			3,959
Total deposits		4,719			625			259			5,603
Borrowed money:
Other short-term borrowings		11			285			94			390
FHLB debt		(3,128	)		(2,255	)		347			(5,036	)
Total borrowed money		(3,117	)		(1,970	)		441			(4,646	)
Total net change in expense on interest-bearing liabilities		1,602			(1,345	)		700			957
Net change in net interest income	$	5,725		$	(1,317	)	$	(754	)	$	3,654

Analysis of Statements of Income

Net Interest Income. The Company’s net interest margin for the three months ended September 30, 2006 was 2.59% compared to 2.63% for the 2005 period and net interest income decreased by $60,000 from the 2005 period to $7.9 million. The decrease in net interest income reflected the combined impact of higher funding costs, an inverted yield curve and competitive pricing pressures for loans and deposits. The Company’s net interest margin for the nine months ended September 30, 2006 increased 45 basis points to 2.78% from 2.33% and net interest income for the nine months ended September 30, 2006 increased by $3.7 million or 17.3% from the 2005 period to $24.8 million. The improvements in the Company’s net interest margin and net interest income for the year to date period were primarily a result of an increase in the weighted-average yield on interest-earning assets and a reduction in the amortization of deferred premium on the early extinguishment of debt.

Interest Income. The Company’s interest income increased 9.9% to $18.9 million and 9.0% to $55.8 million, respectively, for the three and nine months ended September 30, 2006 from the comparable 2005 periods. The weighted-average yield on interest-earning assets increased 51 basis points and 61 basis points, respectively, to 6.24% and 6.26%, respectively, for the three and nine months ended 2006 from the comparable 2005 periods. The increases in 2006 were primarily a result of the upward repricing of adjustable-rate loans reflecting higher market rates of interest during the 2006 periods and the reinvestment of loan and securities repayments into additional securities yielding higher interest rates. As of September 30, 2006, the

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Company’s $833.0 million loan portfolio consisted of $209.9 million of variable-rate loans indexed to the Wall Street Journal Prime lending rate and another $371.8 million of variable-rate loans tied to other indices.

The Company’s average interest-earning assets were stable at $1.2 billion for the three months ended September 30, 2006 compared to the 2005 period. For the nine months ended September 30, 2006, average interest-earning assets decreased 1.6% or $19.4 million from the 2005 period, primarily as a result of the Company’s repurchase of its common stock through its buyback program as well as the repayment of its maturing FHLB debt. The decreases in the average balance of interest-earning assets partially mitigated the above mentioned increases in the weighted-average yields on those assets.

Interest Expense. The Company’s total interest expense was $11.1 million and $31.0 million, respectively, for the three and nine months ended September 30, 2006 compared to $9.3 million and $30.0 million, respectively, for the 2005 periods. The Company’s average cost of interest-bearing liabilities increased 60 basis points and 19 basis points, respectively, for the 2006 periods as compared to the same periods in 2005. These increases were primarily the result of the increase in the cost of deposits coupled with an increase in average deposit balances.

Interest expense on interest-bearing deposits was $5.8 million and $15.3 million, respectively, for the three and nine months ended September 30, 2006. The average cost of interest-bearing deposits increased 107 basis points and 95 basis points, respectively, for the three and nine months ended September 30, 2006 from the 2005 periods. The increase in the cost of deposits was due to the upward repricing of money market and certificate of deposit balances and the migration of balances from lower-cost checking and savings accounts to higher-cost money market and certificate of deposit accounts. To mitigate the impact of increasing market rates of interest, the Company continues to focus on growing non-interest bearing deposits and has increased the average balance of those deposits by 10.2% and 19.1%, respectively, for the three and nine months ended September 30, 2006 from the 2005 periods.

As the interest rates offered for existing checking and savings accounts continue to lag interest rates paid for other deposit accounts, the potential remains for a continued, gradual migration of these balances to higher-cost money market and certificates of deposit accounts.

The Company’s total interest expense for the three and nine months ended September 30, 2006 was positively impacted by decreases in interest expense on borrowed money of $501,000 or 8.6% and $4.6 million or 22.8%, respectively, from the 2005 periods. The decreases in interest expense were the result of lower amortization of the deferred premium on the early extinguishment of debt (Premium Amortization) to $2.5 million and $7.6 million, respectively, for the three months and nine months ended September 30, 2006. The Premium Amortization for the comparable 2005 periods was $2.9 million and $11.6 million, respectively.

The Company continues to experience the positive effects of the Company’s 2004 FHLB debt restructuring through the reduction of the amount of FHLB debt outstanding and the contractual interest rates paid; however, the related quarterly Premium Amortization continues to adversely affect the Company’s net interest margin. For the three months ended September 30, 2006 and 2005, the Premium Amortization reduced the net interest margin by 82 basis points and 96 basis points, respectively. The Premium Amortization reduced the net interest margin by 85 basis points and 128 basis points, respectively, for the nine months ended September 30, 2006

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and 2005. The interest expense related to the Premium Amortization is expected to be $2.0 million, $1.4 million, $1.3 million and $1.1 million before taxes in the quarters ended December 31, 2006, March 31, 2007, June 30, 2007 and September 30, 2007, respectively.

Provision for losses on loans. The Company’s provision for losses on loans was $413,000 for the three months ended September 30, 2006 compared to $545,000 for the 2005 period and $971,000 and $1.3 million, respectively, for the nine months ended September 30, 2006 and September 30, 2005 reflecting required changes to the allowance for losses on loans as determined by its quarterly analysis of the adequacy of the allowance for losses on loans. For additional information, see “Changes in Financial Condition - Allowance for Losses on Loans” below in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

Non-interest income. The Company’s non-interest income for the three and nine months ended September 30, 2006 was $2.3 million and $7.5 million, respectively, compared to $3.3 million and $8.7 million, respectively, for the 2005 periods. Non-interest income for the quarter and year to date 2006 periods was impacted by lower service charges and other fees due to decreased overdraft fees during the year as deposit customers are changing their behavior patterns related to overdrafts and fees. Commission income from the Company’s third-party service provider for the sale of investment products was also lower for the 2006 periods as rates offered on certificates of deposit have become more competitive relative to the yields available on non-deposit products.

The Company’s non-interest income for the quarter and year to date 2006 periods was also impacted by a $1.3 million loss on the sale of property that was collateral for an impaired commercial real estate loan which was transferred to other real estate owned during the second quarter of 2006. Partially offsetting the loss on the sale, the Company realized an $877,000 gain on the sale during the third quarter of 2006 of its investment in certain trust preferred securities. The 2005 year to date period included a $240,000 impairment charge on available-for-sale securities due to an impairment on an investment in a Freddie Mac fixed-rate perpetual preferred stock.

Non-interest expense. Non-interest expense was $8.9 million and $26.9 million, respectively, for the three and nine months ended September 30, 2006 compared to $8.2 million and $24.8 million, respectively, for the 2005 periods. The increases from 2005 were primarily the result of increased compensation and employee benefits expense as a result of bringing item processing in-house and staffing for growth coupled with increased pension expense.

The Company’s pension expense totaled $360,000 and $1.1 million, respectively, for the quarter and year to date periods in 2006, up from $200,000 and $420,000, respectively, for the 2005 periods. The increased pension costs are due to higher actuarial estimates for future contributions to the Company’s multi-employer defined benefit plan. The Company anticipates the Pension Protection Act of 2006 (the Act) signed into law in August 2006 will have a material impact on its future pension benefit obligations as the Act mandates accelerated funding requirements for plans that are not fully funded. The Company is currently evaluating the financial impact of the Act and reviewing its options including withdrawing from the multi-employer defined benefit plan.

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In addition, furniture and equipment expense increased for the three and nine months ended September 30, 2006 to $548,000 and $1.5 million, respectively, from the 2005 periods due to the Company’s investment for in-house item processing equipment and other software expenses. Marketing expenses increased for the 2006 periods to $442,000 and $1.0 million, respectively, from the 2005 periods as the Company continued to support growth initiatives through expanded marketing campaigns and brand development.

The Company’s efficiency and core efficiency ratios for the three and nine months ended September 30, 2006 and 2005 are presented in the following table:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
	(Dollars in thousands)
Efficiency ratio:
Non-interest expense	$	8,928		$	8,198		$	26,896		$	24,837
Net interest income plus non-interest income	$	10,122		$	11,262		$	32,356		$	29,899
Efficiency ratio		88.20	%		72.79	%		83.13	%		83.07	%
Core efficiency ratio:
Non-interest expense	$	8,928		$	8,198		$	26,896		$	24,837
Net interest income plus non-interest income	$	10,122		$	11,262		$	32,356		$	29,899
Adjustments:
Net realized (gains) losses on sale of securities available-for-sale		(877	)		25			(750	)		113
Impairment of securities available-for-sale		-			-			-			240
Net realized (gains) losses on sales of other assets		1,339			(287	)		1,291			(369	)
Amortization of deferred premium on the early extinguishment of debt		2,465			2,865			7,587			11,581
Net interest income plus non-interest income - as adjusted	$	13,049		$	13,865		$	40,484		$	41,464
Core efficiency ratio		68.42	%		59.13	%		66.44	%		59.90	%

Management has historically used an efficiency ratio that is a non-GAAP financial measure of operating expense control and operating efficiency. The efficiency ratio is typically defined as the ratio of non-interest expense to the sum of non-interest income and net interest income before the provision for losses on loans. Many financial institutions, in calculating the efficiency ratio, adjust non-interest income (as calculated under GAAP) to exclude certain component elements, such as gains or losses on sales of securities and assets. Management follows this practice to calculate its core efficiency ratio and utilizes this non-GAAP measure in its analysis of the Company’s performance. The core efficiency ratio is different from the GAAP-based efficiency ratio. The GAAP-based measure is calculated using non-interest expense, net interest income before the provision for losses on loans and non-interest income as presented on the condensed consolidated statements of income.

The Company’s core efficiency ratio is calculated as non-interest expense, excluding any prepayment penalties incurred as a result of the early extinguishment of debt, divided by the sum of net interest income before the provision for losses on loans, excluding the deferred premium amortization related to the early extinguishment of debt, and non-interest income, adjusted for

22

gains or losses on the sale of securities and other assets and other-than-temporary impairments. Management believes that the core efficiency ratio enhances investors’ understanding of the Company’s business and performance. The measure is also believed to be useful in understanding the Company’s performance trends and to facilitate comparisons with the performance of others in the financial services industry. Management further believes the presentation of the core efficiency ratio provides useful supplemental information, a clearer understanding of the Company’s financial performance, and better reflects the Company’s core operating activities.

The risks associated with utilizing operating measures (such as the efficiency ratio) are that various persons might disagree as to the appropriateness of items included or excluded in these measures and that other companies might calculate these measures differently. Management of the Company compensates for these limitations by providing detailed reconciliations between GAAP information and its core efficiency ratio.

Income Tax Expense. The Company’s income tax expense for the third quarter of 2006 was $1,000 compared to $632,000 for the 2005 period. The income tax expense for the 2006 year to date period was $779,000 compared to $585,000 for the 2005 period. The change in income tax expense for the 2006 periods is primarily a function of the change in the pre-tax earnings from the comparable 2005 periods. Permanent tax differences, primarily related to the Company’s investment in bank-owned life insurance, and the application of available tax credits continue to have a favorable impact on income tax expense.

Financial Condition

Securities. The Company manages its securities portfolio to adjust balance sheet interest rate sensitivity to insulate net interest income against the impact of changes in market interest rates, to maximize the return on invested funds within acceptable risk guidelines and to meet pledging and liquidity requirements.

The Company adjusts the size and composition of its securities portfolio according to a number of factors including expected loan growth, the interest rate environment and projected liquidity. The amortized cost of the Company’s securities and their fair values were as follows at September 30, 2006 and December 31, 2005:

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	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses				Fair Value
	(Dollars in thousands)
At September 30, 2006:
Government sponsored entity (GSE) securities and commercial paper (1)	$	287,072	$	922	$	(1,486	)	$	286,508
Mortgage-backed securities		21,670		6		(347	)		21,329
Collateralized mortgage obligations		13,611		24		(153	)		13,482
Equity securities		1,386		65		-			1,451
	$	323,739	$	1,017	$	(1,986	)	$	322,770
At December 31, 2005:
Government sponsored entity (GSE) securities (1)	$	167,047	$	94	$	(1,932	)	$	165,209
Mortgage-backed securities		29,927		29		(500	)		29,456
Collateralized mortgage obligations		22,553		7		(222	)		22,338
Trust preferred securities		85		51		-			136
Equity securities		1,386		25		-			1,411
	$	220,998	$	206	$	(2,654	)	$	218,550

(1)At September 30, 2006 and December 31, 2005, the Company held $15.2 million and $12.2 million, respectively, of callable GSE securities.

The Company’s securities portfolio increased over $100.0 million since December 31, 2005 as growth in deposits outpaced loan growth. During the first nine months of 2006, approximately $24.1 million of available-for-sale securities were sold realizing an aggregate net gain on the sales of $750,000.

The Company evaluates all securities for determining if an other-than-temporary impairment (OTTI) exists pursuant to guidelines established in FSP 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments on a quarterly basis, and more frequently when economic conditions warrant any additional evaluations. In evaluating the possible impairment of securities, consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial conditions and near-term prospects of the issuer, and the ability and intent of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, the Company may consider whether the securities are issued by the federal government or its agencies or government sponsored agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. The Company may also evaluate securities for OTTI more frequently when economic or market concerns warrant additional evaluations. If management determines that an investment experienced an OTTI, the loss is recognized in the income statement as a realized loss. Any recoveries related to the value of these securities are recorded as an unrealized gain (as other comprehensive income (loss) in stockholders’ equity) and not recognized in income until the security is ultimately sold.

At September 30, 2006, all securities available-for-sale with a loss position were issued by the federal government, its agencies or GSEs, including the Federal National Mortgage Association and Freddie Mac, and in management’s belief, the unrealized losses as of September

24

30, 2006 were attributable to changes in market interest rates and not the credit quality of the issuers. Management does not believe any of these securities are other-than-temporarily impaired. As of September 30, 2006, the Company has both the intent and ability to hold these impaired securities for a period of time necessary to recover the unrealized losses; however, the Company may from time to time dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds could be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time.

Loans. Loans receivable, net of unearned fees, and the percentage of loans by category are presented in the following table at September 30, 2006 and December 31, 2005:

	September 30, 2006					December 31, 2005
	Amount		Percentage			Amount		Percentage
	(Dollars in thousands)
Commercial and construction loans:
Commercial real estate	$	334,411		40.2	%	$	381,956		41.6	%
Construction and land development		133,108		16.0			136,558		14.9
Commercial and industrial		48,687		5.8			61,956		6.8
Total commercial loans		516,206		62.0			580,470		63.3
Retail loans:
Single-family residential		235,198		28.2			235,359		25.7
Home equity lines of credit		77,594		9.3			96,403		10.5
Other		4,012		0.5			5,173		0.5
Total retail loans		316,804		38.0			336,935		36.7
Total loans receivable, net of unearned fees	$	833,010		100.0	%	$	917,405		100.0	%

Total loans decreased $84.4 million at September 30, 2006 from December 31, 2005. The commercial loan portfolio decreased $64.3 million or 11.1% primarily as a result of the repayment in full of 34 commercial loans totaling $132.6 million during the nine months ended September 30, 2006. Over $36.0 million of these loans were commercial real estate loans that were repaid as a result of the borrowers selling the underlying collateral and over $28.0 million of these loans were repaid as the result of expected pay downs. The Company anticipates that its recently hired experienced commercial lenders will help create additional loan growth that is expected to mitigate the effects of the level of repayments recently experienced.

The retail loan portfolio decreased $20.1 million or 6.0% primarily as a result of a decrease of $18.8 million or 19.5% in home equity lines of credit. The Company’s home equity lines of credit are variable rate loans subject to increased interest rates in a rising rate environment thus causing many borrowers to reduce their outstanding balances through principal repayments or through conversion of all or a portion of their balance to a fixed-rate amortizing loan product. In addition, the Company has reduced its marketing focus on the home equity lines of credit due to the current rate environment.

Allowance for Losses on Loans.The following is a summary of changes in the allowance for losses on loans for the periods presented:

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	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
	(Dollars in thousands)
Balance at beginning of period	$	11,690		$	13,892		$	12,939		$	13,353
Provision for losses on loans		413			545			971			1,312
Charge-offs		(1,473	)		(812	)		(3,457	)		(1,117	)
Recoveries		62			86			239			163
Balance at end of period	$	10,692		$	13,711		$	10,692		$	13,711

At September 30, 2006, the Bank’s allowance for losses on loans totaled $10.7 million, a decrease of $2.2 million from December 31, 2005. The decrease in the allowance for losses on loans is primarily a result of reductions in the estimated SFAS 5 component of the allowance for losses on loans as the Company’s loan portfolio decreased from December 31, 2005 coupled with charge-offs during the first nine months of 2006. Total charge-offs included a $1.0 million charge-off during the third quarter and a $1.7 million charge-off during the second quarter on two previously impaired commercial real estate loans. The charge-offs on these loans equaled the respective impairment allocations and were incurred when the Company transferred each loan at its net realizable value to other real estate owned.

The allowance for losses on loans represented 49.1% and 61.5%, respectively, of the Bank’s non-performing loans and 1.28% and 1.41%, respectively, of its total loans receivable at September 30, 2006 and December 31, 2005. The changes in the ratios are directly related to the charge-offs on the impaired commercial real estate loans discussed above. Management believes the allowance for losses on loans is adequate to absorb credit losses inherent in the loan portfolio at September 30, 2006.

The Company’s impaired loans were as follows at the dates presented:

	September 30, 2006		December 31, 2005
	(Dollars in thousands)
Total impaired loans	$	12,936	$	22,156
Aggregate impairment allocation	$	4,571	$	5,824
Number of impaired loans		7		8

Total impaired loans decreased from December 31, 2005 primarily as a result of a decrease in impaired commercial real estate loans due to the transfer of two impaired loans to other real estate owned. The Company also received repayment of $1.7 million on an impaired commercial real estate loan identified during the second quarter of 2006. These decreases were partially offset by the identification of an impaired construction and land development participation loan during the Company’s third quarter of 2006 analysis of impaired loans. There were no other significant changes to the Company’s impaired loans or the related impairment allocations during the third quarter of 2006.

Non-performing Assets. The following table provides information relating to the Company’s non-performing assets as of the dates indicated. The Company had no loans past due 90 days or more still on interest accrual at either date presented.

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	September 30, 2006			December 31, 2005
	(Dollars in thousands)
Non-accrual loans:
Commercial and construction loans:
Commercial real estate	$	12,314		$	17,492
Construction and land development		4,176			77
Commercial and industrial		718			94
Total commercial and construction loans		17,208			17,663
Retail loans:
Single-family residential		3,817			2,929
Home equity lines of credit		705			429
Other		49			20
Total retail loans		4,571			3,378
Total non-accruing loans		21,779			21,041
Other non-performing assets		579			540
Total non-performing assets	$	22,358		$	21,581
Non-performing assets to total assets		1.73	%		1.74	%
Non-performing loans to total loans		2.61	%		2.29	%

The change in the non-accrual commercial real estate loans from December 31, 2005 included the transfer of two loans to other real estate owned, of which one asset was sold, and the addition of another commercial real estate loan during the third quarter of 2006. The increase in non-performing construction and land development loans was due to the transfer of two loans to non-accrual status during the third quarter of 2006. There were no other significant changes during the third quarter of 2006 related to the Company’s non-performing loans. At September 30, 2006, 38.1% of the Company’s non-performing loans consisted of two impaired commercial real estate loans secured by properties and assets utilized in the hotel industry.

Subsequent to September 30, 2006, one other real estate owned asset comprised of vacant land and held by the Company since March 2004 was sold for approximately $690,000 resulting in an estimated gain of $280,000. The Company will realize the gain during the fourth quarter of 2006.

Deposits and Borrowed Money. The following table identifies the dollar amount and percentage of total deposits in each deposit category offered by the Company at the dates indicated:

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	September 30, 2006					December 31, 2005
	Amount		Percentage			Amount		Percentage
	(Dollars in thousands)
Checking accounts:
Non-interest bearing	$	59,399		6.7	%	$	66,116		8.0	%
Interest-bearing		98,149		11.3			106,938		12.9
Money market accounts		143,297		16.5			121,667		14.7
Savings accounts		152,259		17.5			170,619		20.6
Core deposits		453,104		52.0			465,340		56.2
Certificates of deposit:
Less than $100,000		284,526		32.7			261,977		31.6
$100,000 or greater		133,200		15.3			101,318		12.2
Time deposits		417,726		48.0			363,295		43.8
Total deposits	$	870,830		100.0	%	$	828,635		100.0	%

The Company’s total deposits increased 5.1% to $870.8 million at September 30, 2006 from $828.6 million at December 31, 2005. The $42.2 million increase was primarily the result of an increase of $54.4 million in certificate of deposit accounts which was partially offset by a $12.2 million decrease in core deposits. This decrease in core deposits was caused by disintermediation as depositors sought higher-yielding deposit and investment products.

In conjunction with the Company’s strategy to cultivate new as well as deepen existing deposit relationships with local municipalities and businesses, the Company offers a repurchase sweep agreement (Repo Sweep) account which allows these depositors to earn interest with respect to checking and savings deposit products offered. The depositor’s excess funds are swept from a deposit account and are used to purchase an interest in a pool of multiple securities owned by the Bank. The swept funds are not recorded as deposits by the Company and instead are considered short-term borrowings which provide a lower-cost funding alternative for the Company. At September 30, 2006, the Company had $20.9 million in Repo Sweeps which are not included in the above deposit totals.

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The Company’s borrowed money consisted of the following at the dates indicated:

	September 30, 2006						December 31, 2005
	Weighted- Average Contractual Rate			Amount			Weighted- Average Contractual Rate			Amount
	(Dollars in thousands)
Short-term variable-rate borrowings:
Repo Sweep accounts		4.75	%	$	20,876			3.75	%	$	555
Secured advances from FHLB - Indianapolis:
Maturing in 2006 - fixed-rate		3.43			77,000			3.41			87,000
Maturing in 2007 - fixed-rate		3.65			87,000			3.65			87,000
Maturing in 2008 - fixed-rate		3.89			72,000			3.89			72,000
Maturing in 2009 - fixed-rate		4.09			15,000			4.09			15,000
Maturing in 2014 - fixed-rate (1)		6.71			1,190			6.71			1,209
Maturing in 2018 - fixed-rate (1)		5.54			2,816			5.54			2,816
Maturing in 2019 - fixed-rate (1)		6.31			7,372			6.31			7,537
					262,378						272,562
Less: deferred premium on early extinguishment of debt					(8,203	)					(15,791	)
Net FHLB - Indianapolis advances					254,175						256,771
Total borrowed money				$	275,051					$	257,326
Weighted-average contractual interest rate		3.86	%					3.77	%

(1) These advances are amortizing borrowings and are listed by their contractual maturity.

As previously mentioned, the Company’s Repo Sweep accounts are treated as financings, and the obligations to repurchase securities sold are reflected as borrowed money in the Company’s condensed consolidated statements of condition. The securities underlying these repurchase agreements continue to be reflected as assets of the Company.

At September 30, 2006, the Company had two lines of credit with a maximum of $40.0 million in unsecured overnight federal funds at the federal funds market rate at the time of any borrowing. At September 30, 2006, the Company did not utilize these lines.

At September 30, 2006, the Company also had a $10.0 million revolving line of credit with a maturity date of March 21, 2007. Each borrowing under the line of credit carries an interest rate of either the Wall Street Journal Prime Rate minus 75 basis points or the three month London Interbank Offered Rate, at the Company’s option. The line of credit obtained by the Company is secured by all of the stock of the Bank held by the Company. The Company has not borrowed any funds under this line of credit.

Capital Resources. The Company’s stockholders’ equity at September 30, 2006 was $133.0 million compared to $142.4 million at December 31, 2005. The decrease during the first nine months of 2006 was primarily due to:

•    repurchases of shares of the Company’s common stock during 2006 totaling $14.7 million, and

•    cash dividends declared totaling $4.0 million.

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The following increases in stockholders’ equity during the first nine months of 2006 partially offset the aforementioned decreases:

•    net income of $3.7 million;

•    proceeds from stock option exercises totaling $2.9 million;

•    shares committed to be released under the Company’s Employee Stock Ownership Plan totaling $1.3 million; and

•    decreased accumulated other comprehensive losses of $922,000.

During the nine months ended September 30, 2006, the Company repurchased 997,381 shares of its common stock with an average price of $14.74 per share pursuant to the share repurchase program announced in March 2003, which was completed in June 2006, and the new share repurchase program announced in June 2006 for an additional 600,000 shares. At September 30, 2006, the Company had 258,601 shares remaining to be repurchased under its new share repurchase program. Since its initial public offering, the Company has repurchased an aggregate of 13,114,171 shares of its common stock at an average price of $12.06 per share. For additional information, see “Part II. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.”

At September 30, 2006, the Bank’s regulatory capital was in excess of regulatory requirements set by the Office of Thrift Supervision (OTS). The current requirements and the Bank's actual levels at September 30, 2006 and at December 31, 2005 are provided below:

	Actual					For Capital Adequacy Purposes					To Be Well-Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
As of September 30, 2006:
Risk-based	$	133,974		13.70	%	$	78,210		>8.00	%	$	97,763		>10.00	%
Tangible		123,307		9.58			19,309		>1.50			25,745		>2.00
Core		123,307		9.58			51,490		>4.00			64,362		>5.00
As of December 31, 2005:
Risk-based	$	140,102		13.63	%	$	82,244		>8.00	%	$	102,806		>10.00	%
Tangible		128,884		10.38			18,624		>1.50			24,832		>2.00
Core		128,884		10.38			49,665		>4.00			62,080		>5.00

Liquidity and Commitments

The Company’s liquidity, represented by cash and cash equivalents, is a product of operating, investing and financing activities. The Company’s primary sources of funds have been:

• deposits and Repo Sweeps;

• scheduled payments of amortizing loans and mortgage-backed securities;

• prepayments and maturities of outstanding loans and mortgage-backed securities;

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Table of Contents

• maturities of investment securities and other short-term investments;

• funds provided from operations; and

• borrowings from the FHLB.

Scheduled payments from the amortization of loans, mortgage-backed securities, maturing investment securities and short-term investments are relatively predictable sources of funds, while deposit flows and loan prepayments are greatly influenced by market interest rates, economic conditions and competitive rate offerings.

At September 30, 2006, the Company had cash and cash equivalents of $50.4 million, which was an increase from $24.2 million at December 31, 2005. The increase was mainly the result of:

• significant net repayments of loans totaling $66.5 million;

• proceeds from sales, maturities and paydowns of securities aggregating $41.9 million;

• increases in the balances of Repo Sweeps totaling $20.3 million; and

• increases in the balances of deposit accounts totaling $42.1 million.

The above cash inflows were partially offset by:

•    purchases of available-for-sale securities totaling $140.7 million;

•    repurchases of the Company’s common stock totaling $14.7 million;

•    and repayment of FHLB debt totaling $10.2 million.

The Company uses its sources of funds primarily to meet its ongoing commitments, fund loan commitments, fund maturing certificates of deposit and savings withdrawals, and maintain a securities portfolio. The Company anticipates that it will continue to have sufficient funds to meet its current commitments. During the fourth quarter of 2006, $77.0 million of the Company’s FHLB borrowings will mature. The Company expects to use excess liquidity and maturing securities to repay these borrowings.

The liquidity needs of the parent company, CFS Bancorp, Inc., consist primarily of operating expenses, dividend payments to stockholders and stock repurchases. The primary sources of liquidity are cash and cash equivalents and dividends from the Bank. CFS Bancorp, Inc. also has $10.0 million of available liquidity under a line of credit. Under OTS regulations, without prior approval, the dividends from the Bank are limited to the extent of the Bank’s cumulative earnings for the year plus the net earnings (adjusted by prior distributions) of the prior two calendar years. On a parent company-only basis, for the nine months ended September 30, 2006, the Company received $9.4 million in dividends from the Bank. At September 30, 2006, the parent company had $1.4 million in cash and cash equivalents and $176,000 in securities available-for-sale.

Contractual Obligations.The following table presents significant fixed and determinable contractual obligations to third parties by payment date as of September 30, 2006:

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	Payments Due By Period
	One Year Or Less		Over One Through Three Years		Over Three Through Five Years		Over Five Years		Total
	(Dollars in thousands)
FHLB advances (1)	$	112,250	$	134,554	$	5,634	$	9,940	$	262,378
Repo Sweeps (2)		20,876		-		-		-		20,876
Operating leases		470		345		26		-		841
Dividends payable on common stock		1,355		-		-		-		1,355
	$	134,951	$	134,899	$	5,660	$	9,940	$	285,450

(1) Does not include interest expense at the weighted-average contractual rate of 3.79% for the periods presented.

(2) Does not include interest expense at the weighted-average contractual rate of 4.75% for the periods presented.

See the “Deposits and Borrowed Money” section for further discussion surrounding the Company’s FHLB advances and Repo Sweeps. The Company’s operating lease obligations reflected above include the future minimum rental payments, by year, required under the lease terms for premises and equipment. Many of these leases contain renewal options, and certain leases provide options to purchase the leased property during or at the expiration of the lease period at specific prices.

The Company also has commitments to fund certificates of deposit which are scheduled to mature within one year or less. These deposits totaled $288.2 million at September 30, 2006. Based on historical experience and the fact that these deposits are at current market rates, management believes that a significant portion of the maturing deposits will remain with the Company.

Off-Balance Sheet Obligations. The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the statement of condition. The Company’s exposure to credit loss in the event of non-performance by the third party to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The commitments listed below do not necessarily represent future cash requirements in that these commitments often expire without being drawn upon.

The following table details the amounts and expected maturities of significant commitments at September 30, 2006:

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	One Year or Less		Over One Through Three Years		Over Three Through Five Years		Over Five Years		Total
	(Dollars in thousands)
Commitments to extend credit:
Commercial	$	56,296	$	2,997	$	985	$	327	$	60,605
Retail		16,704		-		-		-		16,704
Commitments to purchase loans:
Commercial		13,638		-		-		-		13,638
Retail		-		-		-		-		-
Commitments to fund unused construction loans		17,898		17,636		11,417		9,084		56,035
Commitments to fund unused lines of credit:
Commercial		13,298		9,536		351		-		23,185
Retail		14,184		709		5		62,859		77,757
Letters of credit		3,498		8,450		529		-		12,477
Credit enhancements		500		9,248		24,557		8,839		43,144
	$	136,016	$	48,576	$	37,844	$	81,109	$	303,545

The Company also had commitments to fund community investments through investments in limited partnerships, which represent future cash outlays for the construction and development of properties for low-income housing, small business real estate, and historic tax credit projects that qualify under the Community Reinvestment Act (CRA). The Company has made commitments to various limited partnerships of $2.6 million to be funded over seven years. The timing and amounts of these commitments are projected based upon the financing arrangements provided in each project’s partnership agreement, and could change due to variances in the construction schedule, project revisions, or the cancellation of the project. These commitments are not included in the commitment table above.

Letters of credit include credit enhancements, which are related to the issuance by municipalities of taxable and nontaxable revenue bonds. The proceeds from the sale of such bonds are loaned to for-profit and not-for-profit companies for economic development projects. In order for the bonds to receive a triple-A rating, which provides for a lower interest rate, the FHLB-Indianapolis (FHLB-IN) issues, in favor of the bond trustee, an Irrevocable Direct Pay Letter of Credit (IDPLOC) for the account of the Bank. Since the Bank, in accordance with the terms and conditions of a Reimbursement Agreement with the FHLB-IN, would be required to reimburse the FHLB-IN for draws against the IDPLOC, these facilities are analyzed, appraised, secured by real estate mortgages, and monitored as if the Bank had funded the project initially.

The Company has not used, and has no current intention of using, any significant off-balance sheet financing arrangements for liquidity purposes. In addition, the Company has not had, and has no current intention to have, any significant transactions, arrangements or other relationships with any unconsolidated, limited purpose entities that could materially affect the

33

Company’s liquidity or capital resources. The Company has not utilized, and has no current intention of utilizing, derivatives or commodity contracts.

Item 3.Quantitative and Qualitative Disclosures about Market Risk

The Bank, like other financial institutions, is subject to interest rate risk (IRR). This risk relates to changes in market interest rates which could adversely affect net interest income or the net portfolio value (NPV) of its assets, liabilities and off-balance sheet contracts. IRR is primarily the result of an imbalance between the price sensitivity of the Bank’s assets and its liabilities. These imbalances can be caused by differences in the maturity, repricing and coupon characteristics of assets and liabilities as well as options (such as loan prepayment options).

The Bank maintains a written Asset/Liability Management Policy that establishes written guidelines for the asset/liability management function, including the management of net interest margin, IRR and liquidity. The Asset/Liability Management Policy falls under the authority of the Company’s Board of Directors who in turn assigns its formulation, revision and administration to the Asset/Liability Committee (ALCO). The ALCO meets monthly and consists of certain senior officers of the Bank and one outside director. The results of the monthly meetings are reported to the Company’s Board of Directors. The primary duties of the ALCO are to develop reports and establish procedures to measure and monitor IRR, verify compliance with Board approved IRR tolerance limits, take appropriate actions to mitigate those risks, monitor and discuss the status and results of implemented strategies and tactics, monitor the Bank’s capital position, review the current and prospective liquidity positions and monitor alternative funding sources. The policy requires management to measure the Bank’s overall IRR exposure using the following measurement techniques: NPV analysis, gap analysis and earnings at risk analysis.

NPV is defined as the net present value of the Bank’s existing assets, liabilities and off-balance sheet contracts. NPV analysis measures the sensitivity of the Bank’s NPV under current interest rates and for a range of hypothetical interest rate scenarios. The hypothetical scenarios are represented by immediate, permanent, parallel movements in interest rates of plus 100, 200 and 300 basis points and minus 100 and 200 basis points. This rate-shock approach is designed primarily to show the ability of the balance sheet to absorb rate shocks on a “theoretical liquidation value” basis. The analysis does not take into account non-rate related issues, which affect equity valuation, such as franchise value or real estate values. This analysis is static and does not consider potential adjustments of strategies by management on a dynamic basis in a volatile rate environment in order to protect or conserve equity values. As such, actual results may vary from the modeled results.

The following table presents, as of June 30, 2006 and December 31, 2005 an analysis of the Bank’s IRR as measured by changes in NPV for immediate, permanent, and parallel shifts in the yield curve in 100 basis point (1%) increments up to 300 basis points and down 200 basis points in accordance with OTS regulations. Information as of September 30, 2006 was not available prior to the filing of this Form 10-Q. The Company does not believe the results as of September 30, 2006 would be significantly different than the results presented as of June 30, 2006.

34

	Net Portfolio Value
	At June 30, 2006								At December 31, 2005
	$ Amount		$ Change			% Change			$ Amount		$ Change			% Change
	(Dollars in thousands)
Assumed change in interest rates (basis points)
+300	$	147,760	$	(28,798	)		(16.3	)%	$	156,592	$	(12,288	)		(7.3	)%
+200		159,182		(17,376	)		(9.8	)		162,507		(6,373	)		(3.8	)
+100		168,931		(7,627	)		(4.3	)		166,875		(2,005	)		(1.2	)
0		176,558		-			-			168,880		-			-
-100		181,601		5,043			(2.9	)		168,938		58			(0.0	)
-200		183,910		(7,352	)		(4.2	)		166,802		(2,078	)		(1.2	)

Gap analysis attempts to measure the relationship of maturing or repricing interest-earning assets and interest-bearing liabilities. Gap is defined as rate-sensitive assets minus rate-sensitive liabilities. A rate-sensitive asset is one that can be repriced to a market rate in a given time frame; a rate-sensitive liability is one that may have its interest rate changed to a market rate during a specified period. Gap analysis expresses gap as a percentage of total interest-earning assets over various time periods to determine whether rate-sensitive assets and liabilities are appropriately matched. In this analysis, maturities of assets and liabilities are adjusted for the estimated impact of embedded options that are contained in certain financial instruments on the Bank's statement of condition. These include prepayment assumptions on real estate loans and mortgage-backed securities, call options embedded in investment securities and put options embedded in certain borrowings. Because of the level of financial instruments with embedded options on the Bank’s statement of condition, certain shortcomings are inherent in using gap analysis to quantify exposure to IRR. With respect to the Bank’s loan portfolio, the Bank may not necessarily be able to predict how borrowers are going to behave as interest rates change. In addition, interest rate changes may impact cash flow on a lag basis or they may lead to future interest rate movements which could result in the expected lives of the Bank’s non-maturing core deposit accounts not being as long-term as the Bank assumes them to be in its gap analysis.

The Bank primarily looks at the cumulative gap at a period of one year when assessing its IRR exposure. Generally, a positive gap or asset sensitive position, where more interest-earning assets are repricing or maturing than interest-bearing liabilities, would tend to result in an increase in net interest income in a period of rising interest rates. Conversely, during a period of falling interest rates, a positive gap would likely result in a reduction in net interest income. The Bank attempts to maintain its one year cumulative gap ratio within a range of negative 20% and positive 20%.

A key assumption which is controlled by the Bank for use in its gap analysis model is the assumed repricing sensitivity of its non-maturing core deposit accounts. The following assumptions were used by the Bank for the repricing of non-maturity core deposit accounts.

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	Percentage of Deposits Repricing In First Year
	September 30, 2006			December 31, 2005
Deposit category:
Business checking accounts		20	%		20	%
Interest checking accounts		20			20
High-yield checking accounts		95			95
Savings accounts		-			20
Money market accounts		50			50

At September 30, 2006, the Bank’s cumulative one-year gap ratio was 8.8% compared to 9.3% at December 31, 2005.

A more refined approach to IRR management than traditional gap analysis is “earnings at risk analysis” or net interest income simulation modeling. Earnings at risk analysis measures the sensitivity of net interest income over a twelve month period to various interest rate movements. The interest rate scenarios are used for analytical purposes and do not necessarily represent management’s view of future market movements. Rather, these scenarios are intended to provide a measure of the degree of volatility interest rate movements may introduce into the Bank’s earnings. The earnings at risk analysis uses the same assumptions as the gap analysis with respect to expected prepayment assumptions, embedded options and expected lives of the Bank’s non-maturing core deposit accounts.

The following table presents the Bank’s projected changes in net interest income over a twelve month period for the various interest rate change (rate shocks) scenarios at September 30, 2006 and December 31, 2005.

	Percentage Change in Net Interest Income Over a Twelve Month Time Period
	September 30, 2006			December 31, 2005
Assumed change in interest rates (basis points):
+200		2.3	%		1.2	%
+100		1.4			0.9
-100		(2.3	)		(3.4	)
-200		(6.1	)		(9.6	)

The earnings at risk analysis suggests the Bank is subject to higher IRR in a falling rate environment than in a rising rate environment. The table above indicates that if interest rates were to move up 200 basis points, net interest income would be expected to increase 2.3% in year one; and if interest rates were to move down 200 basis points, net interest income would be expected to decrease 6.1% in year one. The Bank’s exposure to interest rate risk in a falling rate environment has improved as of September 30, 2006 compared to December 31, 2005 primarily as a result of an increase in shorter-term funding sources.

The Bank manages its IRR position by holding assets on the statement of condition with desired IRR characteristics, implementing certain pricing strategies for loans and deposits and

36

implementing various securities portfolio strategies. The Bank currently plans on continuing to reduce its exposure to falling interest rates by lengthening the duration of its securities portfolio and increasing its core deposit balances. On a quarterly basis, the ALCO reviews the calculations of all IRR measures for compliance with the Board approved tolerance limits. At September 30, 2006, the Bank was in compliance with all of its tolerance limits.

The above IRR analyses include the assets and liabilities of the Bank only. Inclusion of Company-only assets and liabilities would have a non-material impact on the results presented.

Item 4.Controls and Procedures

No change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) or 15(d)-15(f) under the Securities Exchange Act of 1934, as amended (the 1934 Act)) occurred during the third quarter of 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Management evaluated, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of its disclosure controls and procedures (as defined in Rules 13a-15(e) or 15(d)-15(e) under the 1934 Act) as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the 1934 Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations and are operating in an effective manner. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the 1934 Act is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Part II. OTHER INFORMATION

Item 1.Legal Proceedings

Legal Proceedings

The Bank’s suit that was filed against the U.S. government during 1993, Citizens Financial Services, FSB v. United States (Case No. 93-306-C), went to trial in June 2004 in the U.S. Court of Claims. The Bank previously had been granted summary judgment on its breach of contract claim, leaving for trial the issue of damages. The trial concluded in early July 2004. On March 7, 2005, the Court of Claims entered judgment in favor of the Government holding that the Bank was not entitled to recover any damages. The Court of Claims also ruled that the Government is entitled to recover certain minimal costs from the Bank with respect to one claim that the Bank voluntarily dismissed during the proceeding. The Government has indicated that these costs are less than $5,000. The Company filed an appeal on May 17, 2005, Citizens Financial Services, FSB v. United States (Case No. 05-5116) in the U.S. Court of Appeals for the Federal Circuit. Oral argument was held on March 6, 2006. The Bank’s appeal was denied on

37

March 10, 2006 and on April 24, 2006, the Bank subsequently filed a petition for re-hearing of its appeal. The petition was denied on May 17, 2006.  On August 16, 2006, the Bank filed a petition for writ of certiorari with the United States Supreme Court, Citizens Financial Services, FSB, fka Citizens Federal Savings and Loan Association, Petitioner v. United States (Docket No. 06-231) and is awaiting the Court's ruling.

Item 1A.Risk Factors

Information regarding risk factors appears in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Forward Looking Statements,” of Part 1 - Item 2 of this Form 10-Q and in Part 1 - Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. There have been no material changes from the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

Item 2.             Unregistered Sales of Equity Securities and Use of Proceeds

(a) - (b) Not applicable.

(c)The following table presents information related to purchases made by or on behalf of the Company of shares of the Company’s common stock during the indicated periods:

Period	Total Number of Shares Purchased		Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs (1)
July 1-31, 2006		50,863	$	14.76		50,863		495,194
August 1-31, 2006		25,322		14.93		25,322		469,872
September 1-30, 2006		211,271		15.01		211,271		258,601
Total		287,456		14.96		287,456		258,601

(1) The Company publicly announced on June 15, 2006 a repurchase program for 600,000 shares. Prior to July 1, 2006, 53,943 shares had been repurchased under that program. A total of 5,258 shares were purchased in October 2006 under this program.

Item 3.Defaults Upon Senior Securities

(a)None.

(b)Not applicable.

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Item 4.   Submission of Matters to a Vote of Security Holders

(a)Not applicable.

(b)Not applicable.

(c) Not applicable.

(d)Not applicable.

Item 5.          Other Information

(a)None.

(b)None.

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Item 6.            Exhibits

(a)	List of exhibits (filed herewith unless otherwise noted).
3.1	Certificate of Incorporation of CFS Bancorp, Inc. (1)
3.2	Bylaws of CFS Bancorp, Inc. (1)
4.0	Form of Stock Certificate of CFS Bancorp, Inc. (2)
10.1	Employment Agreement entered into between Citizens Financial Bank and Thomas F. Prisby (3)
10.2	Employment Agreement entered into between CFS Bancorp, Inc. and Thomas F. Prisby (3)
10.3	CFS Bancorp, Inc. Amended and Restated 1998 Stock Option Plan (4)
10.4	CFS Bancorp, Inc. Amended and Restated 1998 Recognition and Retention Plan and Trust Agreement (4)
10.5	CFS Bancorp, Inc. 2003 Stock Option Plan (5)
10.6	Employment Agreement entered into between Citizens Financial Bank and Charles V. Cole (3)
10.7	Employment Agreement entered into between Citizens Financial Bank and Thomas L. Darovic (3)
10.8	Employment Agreement entered into between CFS Bancorp, Inc. and Charles V. Cole (3)
10.9	Employment Agreement entered into between CFS Bancorp, Inc. and Thomas L. Darovic (3)
10.10	Employment Agreement entered into between Citizens Financial Services, FSB and Zoran Koricanac (6)
10.11	Employment Agreement entered into between CFS Bancorp, Inc. and Zoran Koricanac (6)
10.12	Amended and Restated Supplemental ESOP Benefit Plan of CFS Bancorp, Inc. and Citizens Financial Services, FSB (6)
10.13	CFS Bancorp, Inc. Directors’ Deferred Compensation Plan (6)
31.1	Rule 13a-14(a) Certification of Chief Executive Officer
31.2	Rule 13a-14(a) Certification of Chief Financial Officer
32.0	Section 1350 Certifications

_____________

(1) Incorporated by reference from the Company's Definitive Proxy Statement from the Annual Meeting of Stockholders filed with the SEC on March 25, 2005.

(2) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

(3) Incorporated by reference from the Company’s Form 8-K filed with the SEC on July 7, 2006.

(4) Incorporated by reference from the Company’s Definitive Proxy Statement for the Annual Meeting of Stockholders filed with the SEC on March 23, 2001.

(5) Incorporated by reference from the Company’s Definitive Proxy Statement for the Annual Meeting of Stockholders filed with the SEC on March 31, 2003.

(6) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

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SIGNATURES

In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

CFS BANCORP, INC.

Date: November 9, 2006	By:	/s/ Thomas F. Prisby
		Thomas F. Prisby, Chairman and
		Chief Executive Officer
Date: November 9, 2006	By:	/s/ Charles V. Cole
		Charles V. Cole, Executive Vice President and
		Chief Financial Officer

41

EX-31.1

Exhibit 31.1

CERTIFICATION

I, Thomas F. Prisby, Chairman of the Board and Chief Executive Officer, certify that:

1. I have reviewed this quarterly report on Form 10-Q of CFS Bancorp, Inc. (Registrant);

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report;

4. The Registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the Registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the Registrant’s internal control over financial reporting that occurred during the Registrant’s most recent fiscal quarter (the Registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and

5. The Registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant’s auditors and the audit committee of Registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant’s internal control over financial reporting.

Date: November 9, 2006	/s/ Thomas F. Prisby
	Thomas F. Prisby
	Chairman of the Board and Chief Executive Officer

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Charles V. Cole, Executive Vice President and Chief Financial Officer certify that:

1. I have reviewed this quarterly report on Form 10-Q of CFS Bancorp, Inc. (Registrant);

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report;

4. The Registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the Registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the Registrant’s internal control over financial reporting that occurred during the Registrant’s most recent fiscal quarter (the Registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and

5. The Registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant’s auditors and the audit committee of Registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant’s internal control over financial reporting.

Date: November 9, 2006	/s/ Charles V. Cole
	Charles V. Cole
	Executive Vice President and Chief Financial Officer

EX-32

Exhibit 32.0

SECTION 1350 CERTIFICATIONS

I, Thomas F. Prisby, Chairman of the Board and Chief Executive Officer, and Charles V. Cole, Executive Vice President and Chief Financial Officer,of CFS Bancorp, Inc. (Company), hereby certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, that:

(1) The Quarterly Report on Form 10-Q of the Company for the three months ended September 30, 2006 (Report) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C 78m(a) or 78o(d), and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date:	November 9, 2006	By:	/s/ Thomas F. Prisby
			Thomas F. Prisby
			Chairman of the Board and Chief Executive Officer
Date:	November 9, 2006	By:	/s/ Charles V. Cole
			Charles V. Cole
			Executive Vice President and Chief Financial Officer

A signed original of this written statement required by Section 906 of the Sarbanes-Oxley Act has been provided to CFS Bancorp, Inc. and will be retained by CFS Bancorp, Inc. and furnished to the Securities and Exchange Commission or its staff upon request.