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, 2008.

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)	(Zip code)
(219) 836-5500
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required 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 R                      NO £

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

Large accelerated filer £	Accelerated filer R
Non-accelerated filer £ (Do not check if a smaller reporting company)	Smaller reporting company £

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 10,676,483 shares of Common Stock issued and outstanding as of October 29, 2008.

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 Consolidated Financial Statements	8
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	40
Item 4.	Controls and Procedures	43
	PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	43
Item 1A.	Risk Factors	43
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	45
Item 3.	Defaults Upon Senior Securities	45
Item 4.	Submission of Matters to a Vote of Security Holders	45
Item 5.	Other Information	46
Item 6.	Exhibits	46
Signature Page		48
Certifications for Principal Executive Officer and Principal Financial Officer		49

            Exhibit 31.1

           Exhibit 31.2
      Exhibit 32.0

2

CFS BANCORP, INC.

Condensed Consolidated Statements of Condition

	September 30, 2008			December 31, 2007
	(Unaudited)
ASSETS	(Dollars in thousands)
Cash and amounts due from depository institutions	$	16,328		$	25,825
Interest-bearing deposits		6,095			9,744
Federal funds sold		312			3,340
Cash and cash equivalents		22,735			38,909
Securities available-for-sale, at fair value		249,636			224,594
Securities held-to-maturity, at cost		3,500			3,940
Investment in Federal Home Loan Bank stock, at cost		23,944			23,944
Loans receivable		742,298			793,136
Allowance for losses on loans		(8,664	)		(8,026	)
Net loans		733,634			785,110
Interest receivable		4,584			5,505
Other real estate owned		3,347			1,162
Office properties and equipment		19,907			19,326
Investment in bank-owned life insurance		36,435			36,475
Other assets		14,511			10,079
Goodwill and intangible assets		1,185			1,234
Total assets	$	1,113,418		$	1,150,278
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits	$	832,223		$	863,272
Borrowed money		141,146			135,459
Advance payments by borrowers for taxes and insurance		7,009			3,341
Other liabilities		11,939			17,792
Total liabilities		992,317			1,019,864
Commitments and contingencies		–			–
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; 10,676,483 and 10,705,510 shares outstanding		234			234
Additional paid-in capital		189,966			191,162
Retained earnings		91,696			97,029
Treasury stock, at cost; 12,616,732 and 12,583,856 shares		(155,717	)		(154,895	)
Treasury stock held in Rabbi Trust, at cost; 130,091 and 133,940 shares		(1,722	)		(1,766	)
Unallocated common stock held by Employee Stock Ownership Plan		(2,892	)		(3,126	)
Accumulated other comprehensive income (loss), net of tax		(464	)		1,776
Total stockholders’ equity		121,101			130,414
Total liabilities and stockholders’ equity	$	1,113,418		$	1,150,278

See accompanying notes.

3

CFS BANCORP, INC.

Condensed Consolidated Statements of Income

	Three Months Ended September 30,						Nine Months Ended September30,
	2008			2007			2008			2007
	(Unaudited)
	(Dollars in thousands, except share and per share data)
Interest income:
Loans	$	10,739		$	14,362		$	34,823		$	42,818
Securities		3,278			3,036			9,529			10,034
Other		347			468			1,358			2,149
Total interest income		14,364			17,866			45,710			55,001
Interest expense:
Deposits		4,058			6,516			14,300			19,829
Borrowed money		1,399			2,800			5,241			9,460
Total interest expense		5,457			9,316			19,541			29,289
Net interest income		8,907			8,550			26,169			25,712
Provision for losses on loans		1,441			884			9,355			1,197
Net interest income after provision for losses on loans		7,466			7,666			16,814			24,515
Non-interest income:
Service charges and other fees		1,640			1,786			4,544			5,025
Card-based fees		408			382			1,203			1,104
Commission income		88			40			281			107
Security gains (losses), net		(3,470	)		(1	)		(3,983	)		9
Other asset gains, netother assets		11			3			8			13
Income from bank-owned life insurance		349			404			1,129			1,212
Other income		124			228			445			674
Total non-interest income		(850	)		2,842			3,627			8,144
Non-interest expense:
Compensation and employee benefits		4,510			4,343			13,025			14,005
Net occupancy expense		865			766			2,406			2,213
Furniture and equipment expense		562			557			1,656			1,657
Data processing		387			540			1,329			1,669
Professional fees		379			240			865			1,200
Marketing		289			214			675			615
Amortization of core deposit intangibles		16			16			49			49
Other general and administrative expenses		1,667			1,349			4,399			3,953
Total non-interest expense		8,675			8,025			24,404			25,361
Income (loss) before income taxes		(2,059	)		2,483			(3,963	)		7,298
Income tax expense (benefit)		(1,020	)		587			(2,408	)		1,808
Net income (loss)	$	(1,039	)	$	1,896		$	(1,555	)	$	5,490
Per share data:
Basic earnings (loss) per share	$	(0.10	)	$	0.18		$	(0.15	)	$	0.52
Diluted earnings (loss) per share		(0.10	)		0.18			(0.15	)		0.50
Cash dividends declared per share		0.12			0.12			0.36			0.36
Weighted-average shares outstanding		10,269,945			10,460,716			10,315,899			10,591,832
Weighted-average diluted shares outstanding		10,406,919			10,741,093			10,539,043			10,892,853

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			Unallocated Common Stock Held By ESOP			Accum-ulated Other Compre-hensive Income (Loss)			Total
	(Unaudited)
	(Dollars in thousands, except per share data)
Balance at January 1, 2007		$	234	$	190,825		$	94,344		$	(149,735	)	$	(3,564	)	$	(298	)	$	131,806
Net Income			–		–			5,490			–			–			–			5,490
Comprehensive income: Change in unrealized appreciation on available-for-sale securities, net of reclassification and tax			–		–			–			–			–			1,244			1,244
Total comprehensive income			–		–			–			–			–			–			6,734
Purchase of treasury stock			–		–			–			(7,837	)		–			–			(7,837	)
Net purchases of Rabbi Trust shares			–		–			–			(9	)		–			–			(9	)
Shares earned under ESOP			–		168			–			–			360			–			528
Amortization of restricted stock awards			–		48			–			–			–			–			48
Cumulative effect of change in accounting principle upon the adoption of FIN 48			–		–			240			–			–			–			240
Exercise of stock options			–		(161	)		–			1,871			–			–			1,710
Tax benefit related to stock options exercised			–		206			–			–			–			–			206
Dividends declared on common stock ($0.36 per share)			–		–			(3,824	)		–			–			–			(3,824	)
Balance at September 30, 2007		$	234	$	191,086		$	96,250		$	(155,710	)	$	(3,204	)	$	946		$	129,602
Balance at January 1, 2008		$	234	$	191,162		$	97,029		$	(156,661	)	$	(3,126	)	$	1,776		$	130,414
Net loss			–		–			(1,555	)		–			–			–			(1,555	)
Comprehensive loss: Change in unrealized depreciation on available-for-sale securities, net of reclassification and tax			–		–			–			–			–			(2,240	)		(2,240	)
Total comprehensive loss			–		–			–			–			–			–			(3,795	)
Purchase of treasury stock			–		–			–			(2,997	)		–			–			(2,997	)
Net purchases of Rabbi Trust shares			–		–			–			45			–			–			45
Shares earned under ESOP			–		64			–			–			234			–			298
Amortization of award under RRP			–		38			–			–			–			–			38
Forfeiture of RRP award			–		11			–			(11	)		–			–			–
Unearned compensation restricted stock awards			–		(1,555	)		–			1,555			–			–			–
Exercise of stock options			–		200			–			630			–			–			830
Tax benefit related to stock options exercised			–		46			–			–			–			–			46
Dividends declared on common stock ($0.36 per share)			–		–			(3,778	)		–			–			–			(3,778	)
Balance at September 30, 2008		$	234	$	189,966		$	91,696		$	(157,439	)	$	(2,892	)	$	(464	)	$	121,101

See accompanying notes.

5

CFS BANCORP, INC.

Condensed Consolidated Statements of Cash Flows

	Nine Months Ended September 30,
	2008			2007
	(Unaudited)
	(Dollars in thousands)
OPERATING ACTIVITIES
Net income (loss)	$	(1,555	)	$	5,490
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Provision for losses on loans		9,355			1,197
Depreciation and amortization		1,312			1,274
Premium amortization on the early extinguishment of debt		1,246			3,689
Net premium amortization on securities available-for-sale		(871	)		(476	)
Deferred income tax (benefit) expense		(2,746	)		2,204
Tax benefit from exercises of non-qualified stock options		(46	)		(206	)
Amortization of cost of stock benefit plans		336			576
Proceeds from sale of loans held-for-sale		45			8,973
Origination of loans held-for-sale		–			(8,850	)
Securities (gains) losses, net		3,983			(9	)
Other asset gains, net		(8	)		(13	)
Net increase in cash surrender value of bank-owned life insurance		(1,129	)		(1,212	)
Decrease (increase) in other assets		126			(3,226	)
(Decrease) increase in other liabilities		(5,505	)		3,738
Net cash provided by operating activities		4,543			13,149
INVESTING ACTIVITIES
Securities, available-for-sale:
Proceeds from sales		1,992			65,236
Proceeds from maturities and paydowns		55,464			78,884
Purchases		(89,128	)		(75,315	)
Securities, held-to-maturity:
Proceeds from maturities and paydowns		440			–
Net loan fundings and principal payments received		39,944			(32,800	)
Proceeds from sales of loans and loan participations		–			11,988
Proceeds from sale of real estate owned		263			521
Proceeds from bank-owned life insurance		1,169			1,036
Purchases of property and equipment		(1,844	)		(2,605	)
Net cash provided by investing activities		8,300			46,945
FINANCING ACTIVITIES
Proceeds from exercise of stock options		830			1,710
Tax benefit from exercises of non-qualified stock options		46			206
Dividends paid on common stock		(3,895	)		(4,006	)
Purchase of treasury stock		(2,997	)		(7,837	)
Net disposition (purchase) of Rabbi Trust shares		45			(9	)
Net decrease in deposit accounts		(31,155	)		(47,366	)
Net increase in advance payments by borrowers for taxes and insurance		3,668			3,445
Increase (decrease) in short-term borrowings		14,652			(9,559	)
Proceeds from Federal Home Loan Bank debt		75,000			7,000
Repayments of Federal Home Loan Bank debt		(85,211	)		(42,197	)
Net cash flows used for financing activities		(29,017	)		(98,613	)
Decrease in cash and cash equivalents		(16,174	)		(38,519	)
Cash and cash equivalents at beginning of period		38,909			67,167
Cash and cash equivalents at end of period	$	22,735		$	28,648

6

Supplemental disclosures:
Loans transferred to real estate owned	$	2,480	$	1,321
Cash paid for interest on deposits		14,532		19,805
Cash paid for interest on borrowings		4,030		5,850
Cash paid for taxes		800		1,400

See accompanying notes.

7

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, 2008 and for the nine months ended September 30, 2008 and September 30, 2007 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, 2008 are not necessarily indicative of the results expected for the full year ending December 31, 2008.  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, 2008 condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes for the year ended December 31, 2007 included in the Company’s Annual Report on Form 10-K.  The condensed consolidated statement of condition of the Company as of December 31, 2007 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, valuations and impairments of securities and the accounting for income tax expense are highly dependent on management’s estimates, judgments and assumptions where changes in any of those 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. Fair Value Measurements – Adoption of SFAS 157 and SFAS 159

Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) which defines and establishes a framework for measuring fair value, when required or elected, and expands fair value disclosure requirements.  At the same time, the Company also adopted Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115 (SFAS 159) which permits the election of the fair value measurement method for certain financial assets and liabilities.

8

   SFAS 157 establishes a fair value hierarchy that prioritizes the inputs used in valuation techniques, but not the valuation techniques themselves.  The fair value hierarchy is designed to indicate the relative reliability of the fair value measure.  The highest priority is given to quoted prices in active markets and the lowest to unobservable data such as the Company’s internal information.  SFAS 157 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  There are three levels of inputs into the fair value hierarchy (Level 1 being the highest priority and Level 3 being the lowest priority):

Level 1 – Unadjusted quoted prices for identical instruments in active markets;

Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable; and

Level 3 – Instruments whose significant value drivers or assumptions are unobservable and that are significant to the fair value of the assets or liabilities.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The following table sets forth the Company’s financial assets by level within the fair value hierarchy that were measured at fair value on a recurring basis during the third quarter of 2008.

			Fair Value Measurements Using
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Securities available-for-sale	$	249,636	$	–	$	224,786	$	24,850

Securities available-for-sale are measured at fair value on a recurring basis.  Level 2 securities are valued by a third party pricing service commonly used in the banking industry utilizing observable inputs.  The pricing provider utilizes evaluated pricing models that vary based on asset class.  These models incorporate available market information including quoted prices of securities with similar characteristics and, because many fixed-income securities do not trade on a daily basis, apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing.  In addition, model processes, such as an option adjusted spread model is used to develop prepayment and interest rate scenarios for securities with prepayment features.   Changes in the fair market value of the Company’s securities available-for-sale are recorded in other comprehensive income.

Level 3 models are utilized when quoted prices are not available for certain securities or in markets where trading activity has slowed or ceased.  When quoted prices are not available and are not provided by third party pricing services, management judgment is necessary to determine fair value.  As such, fair value is determined using discounted cash flow analysis models, incorporating default rates, estimation of prepayment characteristics and implied volatilities.

9

   The Company determined that Level 3 pricing models should be utilized for valuing its investments in pooled trust preferred securities.  Management determined that an orderly and active market for these securities did not exist based on a significant reduction in trading volume and widening spreads during the third quarter of 2008.  Representations made by the primary dealer of these securities indicated that trading in these securities during the third quarter was limited to distressed sales or liquidations.  During the third quarter, bid/ask spreads on these securities climbed as high as $25.00 from bid/ask spreads of less than $1.00 from when securities were actively traded.

All of the pooled trust preferred securities held by the Company are “Super Senior” and are rated AAA.  Each of the securities held has at least one AAA-rated subordinate tranche and several other subordinate tranches supporting the Company’s “Super Senior” tranches.  Interest payments are current on all of the securities held.  Principal returns are increasingly directed to senior tranches as deferrals and defaults on the underlying collateral increase.  Based on externally produced analysis, the Company estimates that project defaults would need to exceed 75% on the underlying collateral before its principal investment is at risk.

The Company’s internal model estimates expected future cash flows discounted using a rate management believes is representative of current market conditions.  In determining expected cash flows, the Company assumed any defaulted underlying issues will not have any recovery and underlying issues that are currently deferring or in receivership or conservatorship will eventually default and not have any recovery.  In addition, the Company’s internal model estimates cash flows to maturity and assumes no early redemptions of principal due to call options or successful auctions.

The following is a reconciliation of the beginning and ending balances of recurring fair value measurements recognized in the accompanying consolidated statement of condition using Level 3 inputs:

	Available-for-sale Securities
	(Dollars in thousands)
Beginning balance	$	–
Total realized and unrealized gains and losses:		–
Included in net income		–
Included in accumulated other comprehensive income		–
Purchases, issuances and settlements		–
Transfers in and/or out of Level 3		24,850
Ending balance	$	24,850

The following table sets forth the Company’s financial assets by level within the fair value hierarchy that were measured at fair value on a non-recurring basis during the three months ended September 30, 2008.

10

	Fair Value Measurements Using
	Fair Value	Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
	(Dollars in thousands)
Impaired loans	$      29,825	$               –	$               –	$      29,825

Fair value measurements for impaired loans are performed pursuant to Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan, and are measured on a non-recurring basis.  Certain impaired loans were partially charged-off or re-evaluated during the third quarter of 2008.  These impaired loans were carried at fair value as estimated using current and prior appraisals, discounting factors, the borrowers’ financial results, estimated cash flows generated from the property and other factors.  The change in fair value of impaired loans that were valued based upon Level 3 inputs was approximately $2.6 million and $9.5 million, respectively, for the three and nine months ended September 30, 2008.  This loss is not recorded directly as an adjustment to current earnings or comprehensive income, but rather as a component in determining the overall adequacy of the allowance for losses on loans.  These adjustments to the estimated fair value of impaired loans may result in increases or decreases to the provision for losses on loans recorded in current earnings.

The adoption of SFAS 159 permits entities to elect to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis (the Fair Value Option) at specified election dates.  At each subsequent reporting date, an entity is required to report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date.  The objective of the statement is to provide entities with the opportunity to mitigate volatility in earnings caused by measuring related assets and liabilities differently without having to apply complex accounting provisions.

The Company is not currently engaged in any hedging activities and as a result did not elect to measure any financial instruments at fair value under SFAS 159.

3. Earnings Per Share

Amounts reported in earnings per share reflect earnings available to common shareholders for the period divided by the weighted-average number of shares of common stock outstanding during the period, exclusive of unearned ESOP shares and unvested restricted stock shares.  Stock options,  restricted stock and treasury shares held in Rabbi Trust accounts are regarded as common stock equivalents and are considered in the diluted earnings per share calculations to the extent that they would have a dilutive effect if converted to common stock, computed using the “treasury stock” method.

11

	Three Months Ended September 30,					Nine Months Ended September 30,
	2008			2007		2008			2007
	(Dollars in thousands, except per share data)
Net income (loss)	$	(1,039	)	$	1,896	$	(1,555	)	$	5,490
Weighted-average common shares outstanding		10,269,945			10,460,716		10,315,899			10,591,832
Weighted-average common share equivalents		136,974			280,377		223,144			301,021
Weighted-average common shares and common share equivalents outstanding		10,406,919			10,741,093		10,539,043			10,892,853
Basic earnings (loss) per share	$	(0.10	)	$	0.18	$	(0.15	)	$	0.52
Diluted earnings (loss) per share		(0.10	)		0.18		(0.15	)		0.50
Number of anti-dilutive stock options excluded fromthe diluted earnings per share calculation		1,076,000			206,000		498,000			76,000
Weighted-average exercise price of anti-dilutiveoption shares	$	12.38		$	14.65	$	12.99		$	14.66

4. Share-Based Compensation

The Company accounts for its stock options in accordance with 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 service period of the awards.

For additional details on the Company’s share-based compensation plans and related disclosures, see Note 9 to the consolidated financial statements as presented in the Company’s Annual Report on Form 10-K.

Omnibus Equity Incentive Plan

On April 29, 2008, the shareholders of the Company approved at the Annual Meeting the CFS Bancorp, Inc. 2008 Omnibus Equity Incentive Plan (Equity Incentive Plan) which had been approved by the Company’s Board of Directors on March 17, 2008.  In connection with the approval of the Equity Incentive Plan, the Board of Directors froze the CFS Bancorp, Inc. 2003 Stock Option Plan and the CFS Bancorp, Inc. 1998 Recognition and Retention Plan such that no new awards will be made under either of those plans.

The Equity Incentive Plan authorizes the issuance of 270,000 shares of common stock of the Company.  In addition, the 32,000 shares that had not yet been issued under the 2003 Stock Option Plan plus any shares subject to outstanding stock options under the 2003 Stock Option Plan that lapse or are unexercised at the end of the option term will be available for any type of stock-based awards in the future under the Equity Incentive Plan.  Since January 1, 2008, there were a total of 22,500 stock options that lapsed under the 2003 Stock Option Plan, and these shares are eligible for awards under the Equity

12

Incentive Plan.  No more than 25,000 shares will be available for grant during any fiscal year to any one participant and no more than 120,000 shares in the aggregate will be granted in any single year.  At September 30, 2008, 212,574 shares were available for future grants under the Equity Incentive Plan.

Restricted Stock

During the third quarter of 2008, the Compensation Committee of the Board of Directors granted service based awards under the Equity Incentive Plan.  A total of 10,792 shares of restricted stock were granted to Directors and one key employee of the Company.  The Company reissued treasury shares to satisfy the restricted stock awards.

The weighted average fair market value of the restricted stock awards granted in the third quarter of 2008 was $11.70 per share and totaled $126,000.  These restricted stock awards vest 33%, 33% and 34% on May 1, 2010, 2011 and 2012, respectively.  The expense for these awards is being recorded over their requisite service period which is 45 months from the date of grant.  The Company estimates the impact of forfeitures based on its historical experience with previously granted restricted stock and will consider the impact of the forfeitures when determining the amount of expense to record for the restricted stock granted.

The compensation expense related to restricted stock for the three months ended September 30, 2008 and 2007 totaled $37,000 and $12,000, respectively.  The compensation expense for the nine months ended September 30, 2008 and 2007 was $69,000 and $36,000, respectively.  At September 30, 2008, the remaining unamortized cost of the restricted stock awards is reflected as a reduction in additional paid-in capital and totaled $1.6 million.  This cost is expected to be recognized over a weighted-average period of 3.6 years which is subject to the actual number of shares earned and vested.

The following table presents the activity for restricted stock for the nine months ended September 30, 2008.

	Number of Shares			Weighted-Average Grant-Date Fair Value
Unvested at December 31, 2007		2,610		$	13.87
Granted		110,926			14.02
Vested		(2,505	)		13.84
Forfeited		–			–
Unvested as of September 30, 2008		111,031		$	14.02

Stock Options

The Company has stock option plans under which shares of Company common stock were reserved for the grant of both incentive and non-qualified stock options to directors, officers and employees.  These plans were frozen in conjunction with the approval of the Equity Incentive Plan such that no new awards will be made under either of the plans.  The dates the stock options are first exercisable and expire are determined by the 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 at September 30, 2005.

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   The following table presents the activity under the Company’s stock option plans for the nine months ended September 30, 2008.

	Number of Shares			Weighted-Average Exercise Price
Options outstanding at January 1, 2008		1,253,295		$	12.23
Granted		–			–
Exercised		(67,050	)		12.39
Forfeited		(46,000	)		13.62
Options outstanding at September 30, 2008		1,140,245		$	12.16
Options exercisable at September 30, 2008		1,140,245		$	12.16

For stock options outstanding at September 30, 2008, the range of exercise prices was $8.44 to $14.76 and the weighted-average remaining contractual term was 3.4 years.

At September 30, 2008, the aggregate intrinsic value of options outstanding totaled $49,000.  This value represents the difference between the Company’s closing stock price on the last day of trading for the three months ended September 30, 2008 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, 2008.

The aggregate intrinsic value of options exercised during the nine months ended September 30, 2008 and 2007 was $135,000 and $563,000, respectively.  The exercise of options during the nine months ended September 30, 2008 and 2007 resulted in cash receipts of $830,000 and $1.7 million and a tax benefit of $46,000 and $206,000, respectively.

The Company reissues treasury shares to satisfy option exercises.

5. Other Comprehensive Income (Loss)

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,
	2008			2007
	(Dollars in thousands)
Unrealized holding gains (losses) arising during the period:
Unrealized net gains (losses)	$	(7,504	)	$	1,984
Related tax (expense) benefit		2,769			(735	)
Net		(4,735	)		1,249
Less:  reclassification adjustment for net gains (losses) realized during the period:
Realized net gains (losses)		(3,983	)		9
Related tax (expense) benefit		1,488			(4	)
Net		(2,495	)		5
Total other comprehensive income (loss)	$	(2,240	)	$	1,244

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6. Recent Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board (FASB) issued SFAS 141 (revised 2007), Business Combinations (SFAS 141R).  SFAS 141R established principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree.  SFAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  SFAS 141R is effective for business combinations where the acquisition date is on or after fiscal years beginning after December 15, 2008.  SFAS 141R is expected to have an impact on the Company’s accounting for any business combinations closing on or after January 1, 2009.

In December 2007, the FASB issued SFAS 160, Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51 (SFAS 160).  SFAS 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary.  SFAS 160 clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements and requires retroactive adoption of the presentation and disclosure requirements for existing minority interests.  All other requirements of SFAS 160 shall be applied prospectively.  SFAS 160 is effective for fiscal years beginning after December 15, 2008.  The Company does not anticipate that SFAS 160 will have an impact on its financial results.

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,” “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, demand for loan products and financial services, 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

15

“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, 2007.  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

Unprecedented market conditions during the quarter continued to present unforeseen challenges to the Company, the entire financial services sector and the economy in general.  The Company, however, continues to improve its financial results related to its core operations.  Its liquidity, financial flexibility and capital remain strong.

The Bank’s risk-based capital increased to 14.38 % from 13.93% at December 31, 2007 and continues to be in excess of the regulatory requirements to be considered “adequately capitalized” and “well-capitalized” of 8% and 10%, respectively.  At September 30, 2008, the Bank’s risk-based capital was $37.0 million in excess of amounts required by regulatory agencies to be “well-capitalized.”  .

The Bank’s Tier 1 capital also continues to be in excess of the regulatory requirements to be considered “adequately capitalized” and “well-capitalized” of 4% and 5%, respectively.  At September 30, 2008, the Bank’s Tier 1 capital was 10.15% and was $57.2 million in excess of the amounts required by regulatory agencies to be “well-capitalized.”

The Company’s net interest margin expanded 40 basis points to 3.47% for the three months ended September 30, 2008 from 3.07% for the comparable 2007 period and expanded 31 basis points to 3.31% for the nine months ended September 30, 2008 from 3.00% for the comparable 2007 period.  The expansion of the net interest margin resulted from decreases in short-term interest rates which decreased the Company’s cost of deposits and borrowed money.

The financial results of the Company for the third quarter of 2008 were negatively impacted by a $3.5 million other-than-temporary impairment (OTTI) charge on its Fannie Mae and Freddie Mac preferred stock investments and a $1.4 million provision for losses on loans.  As such, the Company reported a net loss for the third quarter of 2008 of $1.0 million or a loss per share of $0.10.  Net income for the third quarter of 2007 was $1.9 million and diluted earnings per share was $0.18.  The OTTI charge and provision for losses on loans reduced net income by $3.1 million and diluted earnings per share by $0.30.  For the nine months ended September 30, 2008, the Company’s net loss was $1.6 million resulting in a loss per share of $0.15 compared to net income of $5.5 million and diluted earnings per share of $0.50 for the 2007 period.

The Company’s provision for losses on loans increased to $1.4 million for the third quarter of 2008 compared to $884,000 for the 2007 period.  The increase reflects increased risks inherent in the loan portfolio in light of deteriorating real estate market conditions and lack of activity in housing and land development.  Net charge-offs for the third quarter of 2008 totaled $3.2 million which included partial charge-offs of $3.0 million related to two impaired loan relationships totaling $9.2 million collateralized by land or commercial real estate which had previously identified impairment reserves of $2.2 million.

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Critical Accounting Policies

The Company’s 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 estimates, 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 consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of the Company’s Annual Report on Form 10-K for December 31, 2007.  These policies, along with the disclosures presented in other financial statement notes and in this management’s discussion and analysis, provide information on the methodology used 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, valuations and impairments of securities 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 management’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 contains allocations for probable inherent but undetected losses within various pools of loans with similar characteristics pursuant to SFAS No. 5, Accounting for Contingencies.  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 portfolios; volume and type of lending; and current and anticipated economic conditions.

The second component of the allowance for losses on loans contains allocations for probable losses that have been identified relating to specific borrowing relationships pursuant to SFAS No. 114.  This component consists of expected losses resulting in specific credit allocations for individual loans not considered within the above mentioned loan pools.  The analysis of 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 when the loan balance or a portion of the loan balance is no longer covered by the paying capacity of the borrower based on an evaluation of available cash resources and collateral value, 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

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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 additional 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 processes, periodically review the allowance for losses on loans for 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.

Securities.  Under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, investment securities must be classified as held-to-maturity, available-for-sale or trading.  Management determines the appropriate classification at the time of purchase.  The classification of securities is significant since it directly impacts the accounting for unrealized gains and losses on securities.  Debt securities are classified as held-to-maturity and carried at amortized cost when management has the positive intent and the Company has the ability to hold the securities to maturity.  Securities not classified as held-to-maturity are classified as available-for-sale and are carried at fair value, with the unrealized holding gains and losses, net of tax, reported in other comprehensive income and do not effect earnings until realized.

The fair values of the Company’s securities are generally determined by reference to quoted prices from reliable independent sources utilizing observable inputs.  Certain of the Company’s fair values of securities are determined using models whose significant value drivers or assumptions are unobservable and are significant to the fair value of the securities.  These models are utilized when quoted prices are not available for certain securities or in markets where trading activity has slowed or ceased.  When quoted prices are not available and are not provided by third party pricing services, management judgment is necessary to determine fair value.  As such, fair value is determined using discounted cash flow analysis models, incorporating default rates, estimation of prepayment characteristics and implied volatilities.

The Company evaluates all securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, for determining if an other-than-temporary impairment (OTTI) exists pursuant to guidelines established in Financial Accounting Standards Board (FASB) Staff Position (FSP) 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.  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’

18

equity) and not recognized in income until the security is ultimately sold.

The Company from time to time may dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds can be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time.

Income Tax Accounting.  Income tax expense recorded in the Company’s 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.  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 consolidated financial statements.

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

The following table provides 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.

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	Three Months Ended September 30,
	2008							2007
	Average Balance		Interest		AverageYield/Cost			Average Balance		Interest		AverageYield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	728,312	$	10,739		5.87	%	$	815,081	$	14,362		6.99	%
Securities (2)		261,574		3,278		4.90			251,463		3,036		4.72
Other interest-earning assets (3)		31,143		347		4.43			39,691		468		4.68
Total interest-earning assets		1,021,029		14,364		5.60			1,106,235		17,866		6.41
Non-interest earning assets		82,098							78,313
Total assets	$	1,103,127						$	1,184,548
Interest-bearing liabilities:
Deposits:
Checking accounts	$	104,159		141		0.54		$	97,737		218		0.88
Money market accounts		181,771		887		1.94			167,068		1,390		3.30
Savings accounts		122,037		140		0.46			139,438		245		0.70
Certificates of deposit		367,993		2,890		3.12			400,990		4,663		4.61
Total deposits		775,960		4,058		2.08			805,233		6,516		3.21
Borrowed money:
Other short-term borrowings (4)		29,140		129		1.76			19,139		200		4.15
FHLB debt (5)(6)		94,118		1,270		5.28			147,153		2,600		6.91
Total borrowed money		123,258		1,399		4.44			166,292		2,800		6.59
Total interest-bearing liabilities		899,218		5,457		2.41			971,525		9,316		3.80
Non-interest bearing deposits		63,418							66,043
Non-interest bearing liabilities		17,298							18,112
Total liabilities		979,934							1,055,680
Stockholders' equity		123,193							128,868
Total liabilities and stockholders' equity	$	1,103,127						$	1,184,548
Net interest-earning assets	$	121,811						$	134,710
Net interest income / interest rate spread			$	8,907		3.19	%			$	8,550		2.61	%
Net interest margin						3.47	%						3.07	%
Ratio of average interest-earning assets to average interest-bearing liabilities						113.55	%						113.87	%

(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 cost.

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

(4) Includes federal funds purchased and repurchase agreements (Repo Sweeps).

(5) The 2008 period includes an average of $94.6 million of contractual FHLB borrowings reduced by an average of $531,000 of unamortized deferred premium on the early extinguishment of debt.  Interest expense on borrowed money includes $270,000 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 4.44% compared to an average contractual rate of 3.54%.

(6) The 2007 period includes an average of $150.2 million of contractual FHLB borrowings reduced by an average of $3.1 million of unamortized deferred premium on the early extinguishment of debt.  Interest expense on borrowed money includes $1.1 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 6.59% compared to an average contractual rate of 3.99%.

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	Nine Months Ended September 30,
	2008							2007
	AverageBalance		Interest		AverageYield/Cost			AverageBalance		Interest		AverageYield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	752,672	$	34,823		6.18	%	$	805,831	$	42,818		7.10	%
Securities (2)		251,608		9,529		4.98			282,244		10,034		4.69
Other interest-earning assets (3)		50,492		1,358		3.59			57,435		2,149		5.00
Total interest-earning assets		1,054,772		45,710		5.79			1,145,510		55,001		6.42
Non-interest earning assets		85,156							77,897
Total assets	$	1,139,928						$	1,223,407
Interest-bearing liabilities:
Deposits:
Checking accounts	$	105,791		498		0.63		$	100,354		729		0.97
Money market accounts		187,363		3,152		2.25			178,252		4,549		3.41
Savings accounts		123,822		465		0.50			145,837		721		0.66
Certificates of deposit		374,514		10,185		3.63			402,156		13,830		4.60
Total deposits		791,490		14,300		2.41			826,599		19,829		3.21
Borrowed money:
Other short-term borrowings (4)		25,323		367		1.94			20,771		655		4.22
FHLB debt (5)(6)		115,575		4,874		5.54			165,940		8,805		7.00
Total borrowed money		140,898		5,241		4.89			186,711		9,460		6.68
Total interest-bearing liabilities		932,388		19,541		2.80			1,013,310		29,289		3.86
Non-interest bearing deposits		62,357							63,438
Non-interest bearing liabilities		16,597							16,723
Total liabilities		1,011,342							1,093,471
Stockholders' equity		128,586							129,936
Total liabilities and stockholders' equity	$	1,139,928						$	1,223,407
Net interest-earning assets	$	122,384						$	132,200
Net interest income / interest rate spread			$	26,169		2.99	%			$	25,712		2.56	%
Net interest margin						3.31	%						3.00	%
Ratio of average interest-earning assets to     average interest-bearing liabilities						113.13	%						113.05	%

(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 cost.

(3) Includes FHLB stock, money market accounts, federal funds sold and interest-earning bank deposits.

(4) Includes federal funds purchased and repurchase agreements (Repo Sweeps).

(5) The 2008 period includes an average of $116.5 million of contractual FHLB borrowings reduced by an average of $929,000 of unamortized deferred premium on the early extinguishment of debt.  Interest expense on borrowed money includes $1.2 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 4.89% compared to an average contractual rate of 3.54%.

(6) The 2007 period includes an average of $170.2 million of contractual FHLB borrowings reduced by an average of $4.3 million of unamortized premium on the early extinguishment of debt.  Interest expense on borrowed money includes $3.7 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 6.68% compared to an average contractual rate of 3.99%.

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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,
	2008 compared to 2007
	Increase (decrease) due to
	Rate			Volume			Rate / Volume			Total Net Increase / (Decrease)
	(Dollars in thousands)
Interest-earning assets:
Loans receivable	$	(2,343	)	$	(1,529	)	$	249		$	(3,623	)
Securities		115			122			5			242
Other interest-earning assets		(26	)		(101	)		6			(121	)
Total net change in income on interest- earning assets		(2,254	)		(1,508	)		260			(3,502	)
Interest-bearing liabilities:
Deposits:
Checking accounts		(85	)		14			(6	)		(77	)
Money market accounts		(574	)		122			(51	)		(503	)
Savings accounts		(85	)		(31	)		11			(105	)
Certificates of deposit		(1,514	)		(384	)		125			(1,773	)
Total deposits		(2,258	)		(279	)		79			(2,458	)
Borrowed money:
Other short-term borrowings		(116	)		105			(60	)		(71	)
FHLB debt		(614	)		(937	)		221			(1,330	)
Total borrowed money		(730	)		(832	)		161			(1,401	)
Total net change in expense on interest- bearing liabilities		(2,988	)		(1,111	)		240			(3,859	)
Net change in net interest income	$	734		$	(397	)	$	20		$	357

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	Nine Months Ended September 30,
	2008 compared to 2007
	Increase (decrease) due to
	Rate			Volume			Rate / Volume			Total Net Increase / (Decrease)
	(Dollars in thousands)
Interest-earning assets:
Loans receivable	$	(5,535	)	$	(2,825	)	$	365		$	(7,995	)
Securities		655			(1,089	)		(71	)		(505	)
Other interest-earning assets		(604	)		(260	)		73			(791	)
Total net change in income on interest- earning assets		(5,484	)		(4,174	)		367			(9,291	)
Interest-bearing liabilities:
Deposits:
Checking accounts		(256	)		39			(14	)		(231	)
Money market accounts		(1,551	)		233			(79	)		(1,397	)
Savings accounts		(173	)		(109	)		26			(256	)
Certificates of deposit		(2,893	)		(951	)		199			(3,645	)
Total deposits		(4,873	)		(788	)		132			(5,529	)
Borrowed money:
Other short-term borrowings		(354	)		144			(78	)		(288	)
FHLB debt		(1,807	)		(2,672	)		548			(3,931	)
Total borrowed money		(2,161	)		(2,528	)		470			(4,219	)
Total net change in expense on interest- bearing liabilities		(7,034	)		(3,316	)		602			(9,748	)
Net change in net interest income	$	1,550		$	(858	)	$	(235	)	$	457

Analysis of Statements of Income

Net Interest Margin.  The Company’s net interest margin for the three months ended September 30, 2008 increased 40 basis points to 3.47% from 3.07% for the comparable 2007 period.  The Company’s net interest margin for the nine months ended September 30, 2008 increased 31 basis points to 3.31% from 3.00% for the comparable period in 2007.  Although the decrease in the prime lending rate from 7.75% to 5.0% since September 2007 has negatively impacted rates earned on interest-earning assets, the Company was able to expand its margin through a decrease in the cost of the Company’s interest-bearing deposit accounts and its short-term borrowings for the 2008 periods.  In addition, interest expense was favorably impacted by the decrease in the amount of interest expense related to the amortization of the deferred premium on the early extinguishment of Federal Home Loan Bank (FHLB) debt.

Interest Income.  The Company’s interest income decreased to $14.4 million for the three months ended September 30, 2008 compared to $17.9 million for the comparable period in 2007.  For the nine months ended September 30, 2008, the Company’s interest income decreased to $45.7 million from $55.0 million for the comparable period in 2007.  The weighted-average yield on interest-earning assets decreased 81 and 63 basis points to 5.60% and 5.79%, respectively, for the three and nine months ended September 30, 2008 when compared to the same periods in 2007.  The decreases were primarily a result of the impact of prime lending rate reductions on adjustable-rate assets, increases in the levels of the Company’s non-performing loans and decreases in the average balances of interest-earning assets.  Interest-earning assets decreased during the 2008 periods as a result of (i) the Company utilizing proceeds from security sales and maturities and other interest-earning assets to fund the repayment of

23

maturing FHLB debt and Company stock repurchases and (ii) the managed run-off of single-service, high-rate certificates and a decrease in the balance of savings accounts as depositors sought higher yields in alternative investment products.

Interest Expense.  The Company’s total interest expense decreased to $5.5 million and $19.5 million, respectively, for the three and nine months ended September 30, 2008 from $9.3 million and $29.3 million, respectively, for the comparable 2007 periods.  The decreases for the 2008 periods were primarily related to decreases in the Company’s cost of funds and in the average balances of interest-bearing liabilities.  The Company’s interest expense on deposits and short-term borrowings was positively impacted by lower interest rates during 2008.

Interest expense on deposit accounts was $4.1 million and $14.3 million, respectively, for the three and nine months ended September 30, 2008.  The average cost of interest-bearing deposits decreased 113 basis points and 80 basis points, respectively, for the three and nine months ended September 30, 2008 from the comparable 2007 periods due to the decrease in general market rates coupled with decreases of 3.6% and 4.2%, respectively, in the average balance of interest-bearing deposits for the three and nine months ended September 30, 2008 which was primarily the result of decreases in the average balance of savings and certificate of deposit accounts.

The Company’s cost of borrowings decreased to 4.44% and 4.89%, respectively, for the three and nine months ended September 30, 2008 from 6.59% and 6.68% for the comparable 2007 periods.  The decreases were primarily the result of decreases in the amortization of the deferred premium on the Company’s early extinguishment of FHLB debt (Premium Amortization) that is included in the Company’s total interest expense on borrowings.  The Premium Amortization adversely impacted the Company’s net interest margin by 11 basis points and 38 basis points, respectively, for the three months ended September 30, 2008 and 2007.  For the nine months ended September 30, 2008 and 2007, the Premium Amortization adversely impacted net interest margin by 38 and 43 basis points, respectively.  The Company’s interest expense on borrowings is detailed in the tables below for the periods indicated.

	Three Months Ended September 30,							Nine Months Ended September 30,
	2008		2007		% Change			2008		2007		% Change
	(Dollars in thousands)
Interest expense on short-term borrowings at contractual rates	$	129	$	200		(35.5	)%	$	367	$	655		(44.0	)%
Interest expense on FHLB borrowings at contractual rates		1,000		1,538		(35.0	)		3,628		5,116		(29.1	)
Amortization of deferred premium		270		1,062		(74.6	)		1,246		3,689		(66.2	)
Total interest expense on borrowings	$	1,399	$	2,800		(50.0	)	$	5,241	$	9,460		(44.6	)

The interest expense related to the premium amortization on the early extinguishment of debt continues to have a smaller impact on the Company’s weighted-average cost of interest-bearing liabilities and is expected to be $206,000, $72,000, $61,000 and $24,000 before taxes in the quarters ending December 31, 2008, March 31, June 30, and September 30, 2009, respectively.

Provision for losses on loans.  The Company’s provision for losses on loans was $1.4 million for the three months ended September 30, 2008 compared to $884,000 for the same period in 2007.  The Company’s provision for losses on loans was $9.4 million compared to $1.2 million, respectively, for

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the nine months ended September 30, 2008 and 2007.  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 following table identifies the changes in non-interest income for the periods presented:

	Three Months Ended September 30,									Nine Months Ended September 30,
	2008			2007			% Change			2008			2007		% Change
	(Dollars in thousands)
Service charges and other fees	$	1,640		$	1,786			(8.2	)%	$	4,544		$	5,025		(9.6	)%
Card-based fees		408			382			6.8			1,203			1,104		9.0
Commission income		88			40			120.0			281			107		162.6
Subtotal fee based revenues		2,136			2,208			(3.3	)		6,028			6,236		(3.3	)
Income from bank-owned life insurance		349			404			(13.6	)		1,129			1,212		(6.8	)
Other income		124			228			(45.6	)		445			674		(34.0	)
Subtotal		2,609			2,840			(8.1	)		7,602			8,122		(6.4	)
Security gains (losses), net		(3,470	)		(1	)	NM				(3,983	)		9	NM
Other asset gains, net		11			3		NM				8			13	NM
Total non-interest income	$	(850	)	$	2,842			(129.9	)%	$	3,627		$	8,144		(55.5	)%

The Company’s service charges and other fees decreased during the 2008 periods from the comparable 2007 periods due to a reduced volume of overdrafts.  Card-based fees increased during the 2008 periods due to increases of 6.0% and 6.7%, respectively, in the number of ATM and debit card transactions from the 2007 periods.  Commission income from the Company’s third-party service provider for the sale of investment products increased due to increased sales volumes of non-deposit products.  Other income decreased during the 2008 periods primarily due to the absence of gains on the sales of one-to-four family mortgage loans to the secondary market because the Company began retaining one-to-four family mortgage loans in its loan portfolio during 2008.  Total non-interest income for the 2008 periods was negatively affected by the other-than-temporary impairment of $3.5 million on the Company’s investment in Fannie Mae and Freddie Mac preferred stock.

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Non-interest expense.  The following table identifies the changes in non-interest expense for the periods presented:

	Three Months Ended September 30,							Nine Months Ended September 30,
	2008		2007		% Change			2008		2007		% Change
	(Dollars in thousands)
Compensation and mandatory benefits	$	3,789	$	3,784		0.1	%	$	11,266	$	12,396		(9.1	)%
Retirement and stock related compensation		365		289		26.3			654		855		(23.5	)
Medical and life benefits		345		250		38.0			1,020		675		51.1
Other employee benefits		11		20		45.0			85		79		7.6
Subtotal compensation and employee benefits		4,510		4,343		3.8			13,025		14,005		(7.0	)
Net occupancy expense		865		766		12.9			2,406		2,213		8.7
Furniture and equipment expense		562		557		0.9			1,656		1,657		0.1
Data processing		387		540		(28.3	)		1,329		1,669		(20.4	)
Professional fees		379		240		57.9			865		1,200		(27.9	)
Marketing		289		214		35.0			675		615		9.8
Other general and administrative expense		1,683		1,365		23.3			4,448		4,002		11.1
Total non-interest expense	$	8,675	$	8,025		8.1	%	$	24,404	$	25,361		(3.8	)%

Compensation and mandatory benefits expense decreased during the nine months ended September 30, 2008 as a result of the reduction in the Company’s full-time-equivalent employees from 360 at December 31, 2006 to 310 at September 30, 2008 and the absence of non-recurring separation costs of $280,000 from the first quarter of 2007.  Retirement and stock related compensation increased during the three month period ended September 30, 2008 due to an increase in pension and ESOP related expenses.  Retirement and stock related expense decreased for the nine month period as a result of the decrease in the Company’s stock price to $9.25 at September 30, 2008 from $11.79 at June 30, 2008 and $14.69 at December 31, 2007 resulting in the quarterly revaluation of 130,091 shares of the Company’s common stock held in Rabbi Trust deferred compensation plans.  The deferred compensation liability under these plans is adjusted with a corresponding charge (or credit) to compensation expense to reflect the changes in the fair value of the amount owed to participant employees.  Medical and Life Benefits increased for the three and nine month periods primarily due to 9.0% and 20.3% increases, respectively, in medical claims.

Data processing charges decreased during the 2008 periods.  The Company renegotiated its core processing agreement during the second quarter of 2008 which reduces base processing expenses approximately 22%.  Professional fees increased for the three months ended September 30, 2008 compared to the same period in 2007 due to increased legal services related to general corporate and employee benefits matters during the quarter.  Professional fees decreased for the nine months ended September 30, 2008 due to the absence of consulting fees associated with the 2007 implementation of the Company’s customer-centric relationship management program and 2007 legal expenses relating to the Bank’s benefits plan, the reduction in its workforce and new SEC proxy disclosure requirements.

The Company’s efficiency ratio for the third quarter of 2008 increased to 107.7% from 70.4% for 2007 period.  The third quarter ratio was negatively impacted by the impairment charge on Fannie Mae and Freddie Mac preferred stock coupled with the increases in non-interest expense as previously discussed.  The Company’s core efficiency ratio was 73.6% for the third quarter of 2008 compared to

26

64.4% for the 2007 period.  The core efficiency ratio was negatively impacted by the increased non-interest expense.  The Company’s efficiency ratio and core efficiency ratios for the nine months ended September 30, 2008 were 81.9% and 69.7%, respectively, compared to 74.9% and 67.6% for the 2007 periods.  The ratios for the nine month period were positively impacted by lower non-interest expense.  The Company’s efficiency and core efficiency ratios for the three and nine months ended September 30, 2008 and 2007 are presented in the following table:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2008			2007			2008			2007
	(Dollars in thousands)
Efficiency ratio:
Non-interest expense	$	8,675		$	8,025		$	24,404		$	25,361
Net interest income plus non-interest income	$	8,057		$	11,392		$	29,796		$	33,856
Efficiency ratio		107.7	%		70.4	%		81.9	%		74.9	%
Core efficiency ratio:
Non-interest expense	$	8,675		$	8,025		$	24,404		$	25,361
Net interest income plus non-interest income	$	8,057		$	11,392		$	29,796		$	33,856
Adjustments:
Security (gains) losses, net		3,470			1			3,983			(9	)
Other asset gains, net		(11	)		(3	)		(8	)		(13	)
Amortization of deferred premium on the early extinguishment of debt		270			1,062			1,246			3,689
Net interest income plus non-interest income – as adjusted	$	11,786		$	12,452		$	35,017		$	37,523
Core efficiency ratio		73.6	%		64.4	%		69.7	%		67.6	%

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 in the consolidated statements of income.

The Company’s core efficiency ratio is calculated as non-interest expense divided by the sum of net interest income before the provision for losses on loans, excluding the Premium Amortization, and non-interest income, adjusted for 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 its 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

27

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 above.

Income Tax Expense.  The Company recognized an income tax benefit for the third quarter of 2008 totaling $1.0 million compared to income tax expense of $587,000 for the 2007 period.  The income tax benefit for the nine months ended September 30, 2008 was $2.4 million compared to income tax expense of $1.8 million for the comparable 2007 period.  The decrease in the tax expense was primarily due to the Company’s pre-tax losses for the 2008 periods when compared to 2007.  Based upon historical taxable income as well as projections of future taxable income, management believes that it is more likely than not that the Company will realize the recorded tax benefit associated with its deferred tax assets.  As a result, no valuation reserve has been recorded.

Changes in Financial Condition

Securities. The Company adjusts the size and composition of its securities portfolio based on a number of dynamic factors.  These factors include expected loan and deposit growth, liquidity and pledging requirements, general economic conditions, the interest rate environment, spread relationships and the level of interest rate risk embedded in the Company’s balance sheet.

At September 30, 2008 and December 31, 2007, the Company had held-to-maturity securities with an amortized cost of $3.5 million and $3.9 million, respectively, invested in state and municipal securities.  The securities had $39,000 and $38,000, respectively, in gross unrecognized holding gains at September 30, 2008 and December 31, 2007.

The amortized cost of the Company’s securities available-for-sale and their fair values were as follows at the dates indicated:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
At September 30, 2008:
Government sponsored entity (GSE) securities	$	104,883	$	2,681	$	–		$	107,564
Mortgage-backed securities		11,141		46		(170	)		11,017
Collateralized mortgage obligations		78,127		625		(808	)		77,944
Commercial mortgage-backed securities		28,127		29		(177	)		27,979
Pooled trust preferred securities		27,807		–		(2,957	)		24,850
Equity securities		282		–		–			282
	$	250,367	$	3,381	$	(4,112	)	$	249,636
At December 31, 2007:
Government sponsored entity (GSE) securities	$	140,301	$	2,859	$	(14	)	$	143,146
Mortgage-backed securities		12,587		15		(39	)		12,563
Collateralized mortgage obligations		56,672		525		(17	)		57,180
Pooled trust preferred securities		8,900		–		–			8,900
Equity securities		3,344		5		(544	)		2,805
	$	221,804	$	3,404	$	(614	)	$	224,594

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As a result of opportunities created during 2008 by market imbalances associated with fears surrounding securities with mortgage related collateral or tied to the mortgage industry, the Company purchased over $6.1 million of agency issued collateralized mortgage obligations; $24.0 million of seasoned AAA-rated senior tranches of collateralized mortgage obligations; and $30.4 million of seasoned, senior, AAA-rated commercial mortgage-backed securities.  The Company also purchased $6.9 million of agency issued mortgage-backed securities and $21.1 million in deeply discounted, AAA-rated, super-senior pooled trust preferred securities during 2008.  The collateralized mortgage obligation portfolio is comprised of AAA-rated securities mainly backed by conventional residential mortgages, with 15-year, fixed-rate loans originated prior to 2005, low historical delinquencies, weighted-average credit scores in excess of 725 and loan-to-values under 50%.

The Company evaluates all securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, to determine if OTTI exists pursuant to guidelines established in FSP 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.  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 book value, 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.  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.

On September 7, 2008, the United States Treasury Department and the Federal Housing Finance Authority placed Fannie Mae and Freddie Mac into conservatorship.  This action caused the market value of the Company’s investment in Fannie Mae and Freddie Mac preferred stocks to decrease to $275,000 at September 30, 2008.  This decrease was determined by management to be other than temporary and resulted in an OTTI charge of $3.5 million for the third quarter of 2008.

At September 30, 2008, the remainder of the Company’s securities available-for-sale with an unrealized loss position was in management’s belief primarily due to differences in market interest rates coupled with an illiquid fixed-income market.  Management does not believe any of these securities are other-than-temporarily impaired.  At September 30, 2008, 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 the dates indicated:

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	September 30, 2008					December 31, 2007
	Amount		% of Total			Amount		% of Total			% Change
	(Dollars in thousands)
Commercial and construction loans:
Commercial real estate	$	330,878		44.6	%	$	328,427		41.4	%		0.7	%
Construction and land development		88,186		11.9			128,584		16.2			(31.4	)
Commercial and industrial		55,367		7.4			60,398		7.6			(8.3	)
Total commercial and construction loans		474,431		63.9			517,409		65.2			(8.3	)
Retail loans:
One-to-four family residential		207,212		27.9			212,598		26.8			(2.5	)
Home equity lines of credit		59,049		8.0			60,326		7.6			(2.1	)
Other		1,606		0.2			2,803		0.4			(42.7	)
Total retail loans		267,867		36.1			275,727		34.8			(2.9	)
Total loans receivable, net of unearned fees	$	742,298		100.0	%	$	793,136		100.0	%		(6.4	)%

At September 30, 2008, the Company’s net loan portfolio included $184.6 million of variable-rate loans indexed to the prime lending rate as listed in the Wall Street Journal and another $275.1 million of variable-rate loans tied to other indices.

The Company’s total loans decreased $50.8 million, or 6.4%, to $742.3 million at September 30, 2008 from $793.1 million at December 31, 2007 primarily due to a $40.4 million, or 31.4%, decrease in construction and land development loans as the Company continues to reduce its exposure in this segment of the loan portfolio.

The Company has experienced increased loan production as a result of the realignment of its Business Banking team.  For the three months ended September 30, 2008, the Company originated $34.6 million of commercial loans, which included $4.2 million of commercial and industrial loans, $10.1 million of owner occupied commercial real estate loans and $20.3 million of other commercial real estate loans.  In addition, the Company originated $23.0 million of commercial lines of credit during the same period.   This activity resulted in an overall increase of $15.3 million in the Company’s commercial and construction loan portfolio since June 30, 2008.  At September 30, 2008, the Company had $56.3 million in the approved but not yet closed commercial loan pipeline, of which, $9.5 million are commercial and industrial and $18.6 million are owner-occupied commercial real estate loans and lines of credit.

The Bank has also invested, on a participating basis, in loans originated by other lenders and loan syndications.  The Bank has historically invested in these types of loans to supplement the direct origination of its commercial and construction loan portfolio.  Based on the Bank’s recent experience with marginal pricing, increased credit risk and decreasing collateral values in this segment, it is reducing its reliance on these types of loans and has not been involved in investing in any new participations or syndications during 2008.  The Company had participations and syndication loans outstanding at September 30, 2008 totaling $41.8 million in construction and land development loans and $34.9 million in loans secured by commercial real estate.  The Bank’s total participations and syndications by state are presented in the table below for the dates indicated.

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	September 30, 2008					December 31, 2007
	Amount		% of Total			Amount		% of Total			% Change
	(Dollars in thousands)
Illinois	$	37,393		47.9	%	$	39,459		47.8	%		(5.2	)%
Ohio		13,965		17.9			15,759		19.1			(11.4	)
Indiana		13,210		16.9			11,361		13.8			16.3
Florida		6,289		8.1			7,375		8.9			(14.7	)
Colorado		4,475		5.7			2,834		3.4			57.9
Texas		1,482		1.9			3,808		4.6			(61.1	)
New York		1,229		1.6			1,957		2.4			(37.2	)
Total participations and syndications	$	78,043		100.0	%	$	82,553		100.0	%		(5.5	)%

The Company’s retail loans have decreased $7.9 million, or 2.9%, to $267.9 million at September 30, 2008 from $275.7 million at December 31, 2007.  The decrease is primarily related to the lack of activity in the housing market due to high levels of inventories and low levels of refinancing.  The Bank was not an active originator of sub-prime or “Alt-A” loans and has never originated option adjustable-rate mortgages or negative amortization loans.

Allowance for Losses on Loans.  The Company maintains the allowance for losses on loans at a level that management believes is sufficient to absorb credit losses inherent in the loan portfolio.  The allowance for losses on loans represents management’s estimate of inherent losses existing in the loan portfolio that are both probable and reasonable to estimate at each balance sheet date and is based on its review of available and relevant information.  While management believes that at September 30, 2008 the allowance for losses on loans was adequate, it is possible that further deterioration in the economy, devaluations of collateral held or requirements from regulatory agencies may require future provisions to the allowance.

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2008			2007			2008			2007
	(Dollars in thousands)
Balance at beginning of period	$	10,403		$	10,624		$	8,026		$	11,184
Provision for losses on loans		1,441			884			9,355			1,197
Charge-offs		(3,246	)		(246	)		(8,833	)		(1,281	)
Recoveries		66			15			116			177
Balance at end of period	$	8,664		$	11,277		$	8,664		$	11,277

	September 30,  2008			December 31, 2007			September 30, 2007
Allowance for losses on loans	$	8,664		$	8,026		$	11,277
Total loans receivable, net of unearned fees		742,298			793,136			820,832
Allowance for losses on loans to total loans		1.17	%		1.01	%		1.37	%
Allowance for losses on loans to non-performing loans		18.13			27.11			34.50

The Company’s allowance for losses on loans was $8.7 million at September 30, 2008, $8.0 million at December 31, 2007 and $11.3 million at September 30, 2007.  The allowance for losses on

31

loans to total loans increased to 1.17% at September 30, 2008 from 1.01% at December 31, 2007 and decreased from 1.37% at September 30, 2007.  The 2008 provision primarily reflects deteriorating market conditions (declines in collateral values) and lack of activity in residential housing and land development.  Net charge-offs for the third quarter of 2008 totaled $3.2 million which included partial charge-offs of $3.0 million on two impaired loan relationships totaling $9.2 million collateralized by land or commercial real estate which had previously identified impairment reserves of $2.2 million.

When management evaluates a non-performing collateral dependent loan and identifies a collateral shortfall, management will charge-off the collateral shortfall.  As a result, the Company is not required to maintain an allowance for losses on loans on these loans as the loan balance has already been written down to its net realizable value (fair value less estimated costs to sell the collateral.)  As such, the ratio of the allowance for losses on loans to total loans, the reserve ratio, and the ratio of the allowance for losses on loans to non-performing loans, the coverage ratio, are lower at September 30, 2008 when compared with December 31, 2007 as a result of $7.2 million of partial charge-offs on $18.3 million of collateral dependent non-performing loans and an increase in the level of non-performing loans.

The following table identifies the Company’s impaired loans and non-accrual loans as of the dates presented.  See the “Non-performing Assets” section in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the detailed classification of the Company’s total non-accrual loans.  During the third quarter of 2008, the Company identified as impaired four construction and land development loans totaling $9.1 million, three of which are to the same borrower totaling $4.2 million and required an impairment reserve of $279,000.  Along with these loans, the Company also identified as impaired two commercial real estate loans totaling $10.4 million, and established impairment reserves of $183,000 in the aggregate.  The increase in impaired loans reflects deteriorating collateral values and worsening economic conditions.  Also during the third quarter of 2008, the Company transferred one previously impaired loan totaling $2.4 million to other real estate owned and received a payoff on a $1.5 million land loan previously identified as impaired.  The Company also recorded partial charge-offs totaling $3.0 million on $18.5 million of identified impaired loans during the third quarter of 2008.

	September 30, 2008		December 31, 2007
	(Dollars in thousands)
Impaired loans:
With a valuation reserve	$	15,791	$	10,190
With no valuation reserve required		27,398		14,441
Total impaired loans		43,189		24,631
Other non-accrual loans		4,610		4,969
Total non-accrual loans	$	47,799	$	29,600
Valuation reserve relating to impaired loans	$	523	$	1,202
Average outstanding impaired loans		28,973		20,675

Non-performing Assets.  The following table provides information relating to the Company’s non-performing assets at the dates presented.  Loans are placed on non-accrual status when, in management’s judgment, the probability of collection of interest is deemed to be insufficient to warrant further accrual.  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, 2008			December 31, 2007
	(Dollars in thousands)
Non-accrual loans:
Commercial and construction loans:
Commercial real estate	$	16,401		$	9,605
Construction and land development		26,982			16,240
Commercial and industrial		330			281
Total commercial and construction loans		43,713			26,126
Retail loans:
One-to-four family residential		3,116			2,706
Home equity lines of credit		964			749
Other		6			19
Total retail loans		4,086			3,474
Total non-accruing loans		47,799			29,600
Other real estate owned, net		3,347			1,162
Total non-performing assets		51,146			30,762
90 days past due and still accruing interest		–			–
Total non-performing assets plus 90 days past due loans still accruing interest	$	51,146		$	30,762
Non-performing assets to total assets		4.59	%		2.67	%
Non-performing loans to total loans		6.44	%		3.73	%

  The Company’s non-performing loans increased $18.2 million to $47.8 million from December 2007 primarily as a result of a $10.7 million increase in non-performing construction and land development loans.  Of the total non-performing loans, the Company previously recorded partial charge-offs totaling $4.2 million which were necessary due to decreases in the related collateral values of these loans.

During the third quarter of 2008, the Company transferred four loans totaling $9.1 million to non-accrual status.  Partially offsetting this increase was the partial charge-off of a non-performing construction and land development loan totaling $1.6 million along with a payoff totaling $1.5 million of a partially charged-off non-accrual loan.  In addition, the Company transferred a $2.4 million non-performing construction and land development loan to other real estate owned.

Non-performing commercial real estate loans increased $6.8 million due to the transfer of three loans totaling $10.8 million to non-accrual status during the third quarter of 2008.  This increase was partially offset by the partial charge-offs totaling $1.5 million of three other non-performing commercial real estate loans.  There were no other significant changes to the Company’s non-performing assets.

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The table below provides the detail for the Company’s non-accrual syndications and purchased participations by state as of the dates indicated.

	September 30, 2008			December 31, 2007			Change
	(Dollars in thousands)
Illinois	$	20,502		$	7,484			173.9	%
Indiana		5,444			–			–
Florida		3,986			2,627			51.7
Texas		–			2,461			(100.0	)
Total non-performing syndications and purchased participations	$	29,932		$	12,572			138.1
Percentage to total non-performing loans		62.6	%		42.5	%
Percentage to total syndications and purchased participations		38.4			15.2

Potential Problem Assets.  The Company’s potential problem assets, defined as loans classified substandard, doubtful, or loss pursuant to the Company’s internal loan grading system that do not meet the definition of a non-performing loan, totaled $6.8 million at September 30, 2008 and $4.4 million at December 31, 2007.  The increase from December 31, 2007 was a result of management downgrading one construction and land development loan totaling $2.8 million to substandard during the second quarter of 2008 due to concerns over the borrowers’ ability to fund the underlying project as originally intended.

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

	September 30, 2008					December 31, 2007
	Amount		% of Total			Amount		% of Total			% Change
	(Dollars in thousands)
Checking accounts:
Non-interest bearing	$	64,596		7.8	%	$	62,306		7.2	%		3.7	%
Interest-bearing		102,215		12.3			107,467		12.5			(4.9	)
Money market accounts		171,492		20.6			171,470		19.9			0.0
Savings accounts		119,238		14.3			127,297		14.7			(6.3	)
Core deposits		457,541		55.0			468,540		54.3			(2.3	)
Certificates of deposit:
Less than $100,000		253,087		30.4			263,134		30.5			(3.8	)
$100,000 or greater		121,595		14.6			131,598		15.2			(7.6	)
Time deposits		374,682		45.0			394,732		45.7			(5.1	)
Total deposits	$	832,223		100.0	%	$	863,272		100.0	%		(3.6	)

Deposits decreased to $832.2 million at September 30, 2008 from $863.3 million at December 31, 2007.  The decrease was primarily a result of a $10.0 million decrease in municipal deposits and a $23.5 million decrease in non-municipal certificates of deposit.  Tightening liquidity in the financial services sector has increased interest rates paid on certificates of deposit and money market accounts and made balances in these types of accounts more vulnerable to above market rates paid by institutions facing liquidity issues.  The Company continues to be disciplined in pricing these deposits.

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  The Company offers specific deposit agreements to local municipalities and other public entities.  The following table identifies the dollar amount of municipal deposits in each deposit category for the dates indicated.

		September 30, 2008					December 31, 2007
		Amount		% of Total			Amount		% of Total			% Change
	(Dollars in thousands)
Checking accounts:
Non-interest bearing		$	767		1.5	%	$	1,028		1.6	%		(25.4	)%
Interest-bearing			7,208		13.7			13,022		20.9			(44.6	)
Money market accounts			24,194		46.1			31,610		50.6			(23.5	)
Core deposits			32,169		61.3			45,660		73.1			(29.5	)
Certificates of deposit			20,335		38.7			16,803		26.9			21.0
Total municipal deposits		$	52,504		100.0	%	$	62,463		100.0	%		(15.9	)%

In addition, the Company offers a repurchase sweep agreement (Repo Sweep) account which allows public entities and other business 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 securities owned by the Bank.  The swept funds are not recorded as deposits by the Bank and instead are classified as other short-term borrowings which generally provide a lower-cost funding alternative for the Company as compared to FHLB advances.  At September 30, 2008, the Company had $19.9 million in Repo Sweeps of which $11.2 million were with municipalities and other public entities.  The Repo Sweeps are included in the below table and are treated as financings, and the obligations to repurchase securities sold are reflected as short-term borrowings.  The securities underlying these Repo Sweeps continue to be reflected as assets of the Company.

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

	September 30, 2008						December 31, 2007
	Weighted- Average Contractual Rate			Amount			Weighted- Average Contractual Rate			Amount
	(Dollars in thousands)
Short-term variable-rate borrowings:
Repo Sweep accounts		1.60	%	$	19,927			3.42	%	$	18,014
Overnight federal funds purchased		2.80			18,740			4.50			6,000
Secured advances from FHLB – Indianapolis:
Maturing in 2008 – fixed-rate		3.93			32,000			3.89			72,000
Maturing in 2009 – fixed-rate		3.99			30,000			3.99			30,000
Maturing in 2010 – fixed-rate		3.22			15,000			–			–
Maturing in 2011 – fixed-rate		3.75			15,000			–			–
Maturing in 2014 – fixed-rate (1)		6.71			1,146			6.71			1,169
Maturing in 2018 – fixed-rate (1)		5.54			2,707			5.54			2,707
Maturing in 2019 – fixed-rate (1)		6.30			7,007			6.31			7,196
					102,860						113,072
Less:  deferred premium on early extinguishment of debt					(381	)					(1,627	)
Net FHLB – Indianapolis advances					102,479						111,445
Total borrowed money				$	141,146					$	135,459
Weighted-average contractual interest rate		3.54	%					4.06	%

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

During the first quarter of 2008, the Company took advantage of a steepening yield curve and market imbalances and borrowed $60.0 million of FHLB debt and invested in higher yielding securities.  Subsequently, the Company has repaid $85.0 million of FHLB debt maturing during 2008 by utilizing its excess liquidity.  During the third quarter of 2008, the Company borrowed an additional $15.0 million of FHLB advances to fund increased loan originations.

At September 30, 2008, the Bank had two lines of credit with a maximum of $30.0 million in unsecured overnight federal funds at the federal funds market rate at the time of any borrowing.  At September 30, 2008, the Bank had an outstanding balance of $18.7 million on these lines at a weighted-average rate of 2.80%.  The maximum amount borrowed pursuant to these lines was $27.0 million and the weighted-average rate paid during the quarter was 2.59%.

At September 30, 2008, the Company also had a $5.0 million revolving line of credit.  Each borrowing under the line of credit carries an interest rate of either the Prime Rate minus 75 basis points or the three month London Interbank Offered Rate, at the Company’s option.  The line of credit was obtained by the Company and 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.  The line of credit matures on March 21, 2009.

Capital Resources.  The Company’s stockholders’ equity at September 30, 2008 was $121.1 million compared to $130.4 million at December 31, 2007.  The decrease was primarily due to:

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• cash dividends declared during 2008 totaling $3.8 million;

• repurchases of shares of the Company’s common stock during 2008 totaling $3.0 million;

• a decrease in accumulated other comprehensive income of $2.2 million; and

• a net loss of $1.6 million.

The Company did not repurchase any of its common stock during the third quarter of 2008.  During the first six months of 2008, the Company repurchased 208,113 shares of its common stock at an average price of $14.40 per share, of which 81,388 were purchased pursuant to the repurchase plan approved in March 2008.  At September 30, 2008, the Company had 448,612 shares remaining to be repurchased under this plan.  Since its initial public offering, the Company has repurchased an aggregate of 14,054,160 shares of its common stock at an average price of $12.23 per share.  For additional information, see “Part II. Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.”

At September 30, 2008, the Bank was deemed to be “well-capitalized” and 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, 2008 and at December 31, 2007 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, 2008:
Total capital to risk-weighted assets	$	121,426		14.38	%	$	67,549	>8.00 %	$	84,436	>10.00 %
Tier 1 (core) capital to risk-weighted assets		112,798		13.36			33,774	>4.00		50,662	>6.00
Tier 1 (core) capital to adjusted total assets		112,798		10.15			44,470	>4.00		55,587	>5.00
Tangible capital to adjusted total assets		112,798		10.15			16,676	>1.50		22,235	>2.00
As of December 31, 2007:
Total capital to risk-weighted assets	$	128,225		13.93	%	$	73,661	>8.00 %	$	92,077	>10.00 %
Tier 1 (core) capital to risk-weighted assets		120,227		13.06			36,831	>4.00		55,246	>6.00
Tier 1 (core) capital to adjusted total assets		120,227		10.50			45,782	>4.00		57,227	>5.00
Tangible capital to adjusted total assets		120,227		10.50			17,168	>1.50		22,891	>2.00

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; 

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

• funds provided from operations; and 

• FHLB borrowings.

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   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.

The Company classifies the majority of its securities as available-for-sale to maintain significant liquidity.  The securities portfolio, federal funds sold and cash and cash equivalents serve as primary sources of liquidity for the Bank.  At September 30, 2008, the Company had cash and cash equivalents of $22.7 million which decreased from $38.9 million at December 31, 2007.  The decrease was mainly the result of:

• purchases of available-for-sale securities totaling $89.1 million;

• decreases in the balance of deposit accounts totaling $31.2 million; and

• net repayment of FHLB debt totaling $10.2 million.

The above cash outflows were partially offset by proceeds from sales, maturities and paydowns of securities aggregating $57.5 million and net repayments of loans totaling $39.9 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.  At September 30, 2008, the Company had two short-term lines of credit available from correspondent banks totaling $30.0 million and additional borrowing capacity from the FHLB of $61.9 million based on current collateral pledged.  The Company had $127.4 million of unencumbered securities available for pledging to the FHLB for additional borrowing capacity.

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 $5.0 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, 2008, the Company received $7.8 million in dividends from the Bank.  At September 30, 2008, the parent company had $4.8 million in cash and cash equivalents.

Contractual Obligations.The following table presents significant fixed and determinable contractual obligations to third parties by payment date as of September 30, 2008:

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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)	$	42,286	$	50,634	$	727	$	9,213	$	102,860
Short-term borrowings (2)		38,667		–		–		–		38,667
Operating leases		515		407		116		–		1,038
Dividends payable on common stock		1,297		–		–		–		1,297
	$	82,765	$	51,041	$	843	$	9,213	$	143,862

(1) Does not include interest expense at the weighted-average contractual rate of 4.05% for the periods presented.

(2) Does not include interest expense at the weighted-average contractual rate of 2.18% for the periods presented.

See the “Deposits and Borrowed Money” section for further discussion surrounding the Company’s FHLB advances.  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 total $327.0 million at September 30, 2008.  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 Bank.

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 following table details the amounts and expected maturities of significant commitments at September 30, 2008:

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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	$	60,496	$	3,443	$	627	$	799	$	65,365
Retail		3,542		–		–		–		3,542
Commitments to purchase loans:
Commercial		200		–		–		–		200
Commitments to fund unused construction loans		10,700		8,246		25		266		19,237
Commitments to fund unused lines of credit:
Commercial		19,832		5,466		120		497		25,915
Retail		11,570		–		250		48,659		60,479
Letters of credit		4,472		1,348		199		3,439		9,458
Credit enhancements		10,850		16,236		–		–		27,086
	$	121,662	$	34,739	$	1,221	$	53,660	$	211,282

The commitments listed above do not necessarily represent future cash requirements, in that these commitments often expire without being drawn upon.  Letters of credit expire at various times through 2018.  Credit enhancements expire at various times through 2010.

The Company also has commitments to fund community investments through investments in various 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.  These commitments include $793,000 to be funded over six 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.

Credit enhancements 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 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 between the FHLB and the Bank, would be required to reimburse the FHLB 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.

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 imbalances between the price sensitivity of the Bank’s assets and its liabilities.  These imbalances can be

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caused by differences in the maturity, repricing and coupon characteristics of various 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).  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 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 NPV 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 valuations, 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, 2008 and December 31, 2007, 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 increments up to 300 basis points and down 100 basis points in accordance with OTS regulations.  Information as of September 30, 2008 was not available prior to the filing of this Form 10-Q.

		Net Portfolio Value
		At June 30, 2008								At December 31, 2007
		$ Amount		$ Change			% Change			$ Amount		$ Change			% Change
		(Dollars in thousands)
Assumed Change in Interest Rates (Basis Points)
	+300	$	137,718	$	(25,792	)		(15.8	)%	$	148,908	$	(18,532	)		(11.1	)%
	+200		147,455		(16,056	)		(9.8	)		158,403		(9,037	)		(5.4	)
	+100		156,293		(7,218	)		(4.4	)		166,898		(542	)		(0.3	)
	0		163,511		–			–			167,440		–			–
	-100		169,297		5,786			3.5			178,059		10,619			6.3

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

41

scenarios are intended to provide a measure of the degree of volatility interest rate movements may introduce into the Bank’s earnings.

A key assumption which is controlled by the Bank for use in its earnings-at-risk analysis 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.

	Percentage of Deposits Maturing In First Year
	September 30, 2008			December 31, 2007
Deposit Category:
Business checking accounts		20	%		20	%
Interest checking accounts		20			20
High-yield checking accounts		95			95
Savings accounts		30			30
Money market accounts		50			50

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, 2008 and December 31, 2007, respectively.

		Percentage Change in Net Interest Income Over a Twelve Month Time Period
		September 30, 2008			December 31, 2007
Assumed Change in Interest Rates  (Basis Points):
	+300		–			(0.8	)%
	+200		0.5	%		–
	+100		0.2			0.3
	-100		(0.9	)		(1.3	)
	-200		(2.3	)		(4.3	)

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 300 basis points, net interest income would be expected to remain stable in year one; and if interest rates were to move down 200 basis points, net interest income would be expected to decrease 2.3% in year one.  The primary causes for the changes in net interest income over the twelve month period were a result of the changes in the composition of the Bank’s assets and liabilities along with changes in interest rates.

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 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, increasing its core deposit balances and replacing fixed-rate borrowings with variable-rate borrowings.  On a quarterly basis, the ALCO reviews the calculations of all IRR measures for compliance with the Board approved tolerance limits.  At September 30, 2008, 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

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Company-only assets and liabilities would not have a 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 Rules 13a-15(f) or 15d-15(f) under the Securities Exchange Act of 1934, as amended) occurred during the quarter ended September 30, 2008 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 Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report.  Based on such 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 Securities Exchange Act of 1934 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.

Part II.            OTHER INFORMATION

Item 1.             Legal Proceedings

           The Company is involved in routine legal proceedings occurring in the ordinary course of its business, which, in the aggregate, are believed to be immaterial to the financial condition of the Company.

Item 1A.          Risk Factors

The following risk factors represent changes and additions to, and should be read in conjunction with “Item 1A.  Risk Factors” contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

The continuation of adverse market conditions in the U.S. economy and the markets in which we operate could adversely impact us.

A continued deterioration of overall market conditions, a continued economic downturn or prolonged economic stagnation in our markets or adverse changes in laws and regulations that impact the banking industry may have a negative impact on our business.  If the strength of the U.S. economy in general and the strength of the economy in areas where we lend (or previously provided real estate financing) continue to decline, this could result in, among other things, a further deterioration in credit quality or a continued reduced demand for credit, including a resultant adverse effect on our loan portfolio and provision for losses on loans.  Negative conditions in the real estate markets where we operate could adversely affect our borrowers’ ability to repay their loans and the value of the underlying collateral.  Real estate values are affected by various factors, including general economic conditions, governmental rules or policies and natural disasters.  These factors may adversely impact our borrowers’ ability to make required payments, which in turn, may negatively impact our financial results.

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Current and further deterioration in the housing market could cause further increases in delinquencies and non-performing assets, including loan charge-offs, and depress our income and growth.

The volume of our one-to-four family residential mortgages and home equity lines of credit (HELOCs) may decrease during economic downturns as a result of, among other things, a decrease in real estate values, an increase in unemployment, a slowdown in housing price appreciation or increases in interest rates.  These factors could reduce our earnings and consequently our financial condition because:

•      the borrowers may not be able to repay their loans;

•      the value of the collateral securing our loans to borrowers may decline further;

•      the quality of our loan portfolio may decline further; and

•      customers may not want or need our products and services.

Any of these scenarios could cause an increase in delinquencies and non-performing assets, require us to charge-off a higher percentage of our loans, increase substantially our provision for losses on loans, or make fewer loans, which would reduce income.

Recent developments affecting the financial markets presently have an unknown effect on our business.

In response to the recent crises affecting the financial markets, the federal government has taken unprecedented steps in an attempt to stabilize and provide liquidity to the U.S. financial markets.

Under the Emergency Economic Stabilization Act of 2008 (“EESA”) and the Troubled Asset Relief Program Capital Purchase Program (“CPP”), the U.S. Treasury will make $250 million of capital available to U.S. financial institutions by purchasing preferred stock in these institutions.  In conjunction with the purchase of preferred stock, the U.S. Treasury will receive warrants to purchase common stock having an aggregate market price equal to 15% of the preferred stock purchased.  Participating financial institutions will be required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds securities issued under the CPP.

In addition, the Federal Deposit Insurance Corporation will temporarily provide a 100% guarantee of the senior unsecured debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest bearing transaction deposit accounts under the Temporary Liquidity Guarantee Program.  Coverage under the Temporary Liquidity Guarantee Program is available for 30 days without charge and thereafter at a cost of 75 basis points per annum for senior unsecured debt and 10 basis points per annum for non-interest bearing transaction deposits.  We are assessing our participation in the CPP and the Temporary Liquidity Guarantee Program but have not made a definitive decision whether or not to participate in either or both programs.  It is not clear at this time whether our decision to participate or not to participate in either the CPP or the Temporary Liquidity Guarantee Program will have an effect on our business.

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We may elect or be compelled to seek additional capital in the future, but that capital may not be available when it is needed.

We are required by our regulatory authorities to maintain adequate levels of capital to support our operations.  In addition, we may elect to raise additional capital to support the growth of our business or to finance acquisitions, if any, or we may elect to raise additional capital for other reasons.  In that regard, a number of financial institutions have recently raised considerable amounts of capital as a result of a deterioration in their results of operations and financial condition arising from the turmoil in the mortgage loan market, deteriorating economic conditions, declines in real estate values and other factors.   Should we elect or be required by regulatory authorities to raise additional capital, we may seek to do so through the issuance of, among other things, our common stock or securities convertible into our common stock, which could dilute your ownership interest in the Company.  Although we remain “well-capitalized” and have not had a deterioration in our liquidity, the future cost and availability of capital may be adversely affected by illiquid credit markets, economic conditions and a number of other factors, many of which are outside of our control.  Accordingly, we cannot assure you of our ability to raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed or on terms acceptable to us, it may have a material adverse effect on our financial condition and results of operations.

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

(a)           Not applicable.

(b)           Not applicable.

                (c)               The Company did not repurchase any shares of its common stock during the quarter ended September 30, 2008 or during October 2008.  Under its repurchase plan publicly announced

on March 20, 20087 for 530,000 shares, the Company has 448,612 shares that may yet be purchased.

Item 3.               Defaults Upon Senior Securities

(a)          None.

(b)          Not applicable.

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

(a)           Not applicable.

(b)           Not applicable.

(c)           Not applicable.

(d)           Not applicable.

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Item 5.                Other Information

None.

Item 6.                Exhibits

(a)	List of exhibits (filed herewith unless otherwise noted).
3.1	Articles of Incorporation of CFS Bancorp, Inc. (1)
3.2	Bylaws of CFS Bancorp, Inc. (2)
4.0	Form of Stock Certificate of CFS Bancorp, Inc. (3)
10.1*	Employment Agreement entered into between Citizens Financial Bank and Thomas F. Prisby (4)
10.2*	Employment Agreement entered into between CFS Bancorp, Inc. and Thomas F. Prisby (4)
10.3*	CFS Bancorp, Inc. Amended and Restated 1998 Stock Option Plan (5)
10.4*	CFS Bancorp, Inc. Amended and Restated 1998 Recognition and Retention Plan and Trust Agreement (5)
10.5*	CFS Bancorp, Inc. 2003 Stock Option Plan (6)
10.6*	Employment Agreement entered into between Citizens Financial Bank and Charles V. Cole (4)
10.7*	Employment Agreement entered into between CFS Bancorp, Inc. and Charles V. Cole (4)
10.8*	Amended and Restated Supplemental ESOP Benefit Plan of CFS Bancorp, Inc. and Citizens Financial Services, FSB (7)
10.9*	CFS Bancorp, Inc. Directors’ Deferred Compensation Plan (8)
10.10*	Separation Agreement entered into between CFS Bancorp, Inc., Citizens Financial Bank and Zoran Koricanac (8)
10.11*	Separation Agreement entered into between CFS Bancorp, Inc., Citizens Financial Bank and Thomas L. Darovic (9)
10.12*	CFS Bancorp, Inc. 2008 Omnibus Equity Incentive Plan (10)
10.13*	Employment Agreement entered into between Citizens Financial Bank and Daryl D. Pomranke (4)
10.14*	Employment Agreement entered into between CFS Bancorp, Inc. and Daryl D. Pomranke (4)
10.15*	CFS Bancorp, Inc. 2008 Cash Incentive Compensation Program (4)
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 Shareholders filed with the SEC on March 25, 2005.

(2) Incorporated by Reference from the Company’s Form 8-K filed on October 25, 2007.

(3) Incorporated by Reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

(4) Incorporated by Reference from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2008.

(5) Incorporated by Reference from the Company’s Definitive Proxy Statement for the Annual

46

Meeting of Shareholders filed with the SEC on March 23, 2001.

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

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

(8) Incorporated by Reference from the Company’s Form 8-K filed on November 16, 2007.

(9) Incorporated by Reference from the Company’s Form 8-K filed on January 3, 2008.

(10) Incorporated by Reference from the Company’s Definitive Proxy Statement from the Annual Meeting of Shareholders filed with the SEC on March 17, 2008.

* Indicates management contract or compensatory plan or arrangement required to be filed as an exhibit to this report.

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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:  October 31, 2008	By:	/s/ Thomas F. Prisby
		Thomas F. Prisby, Chairman of the Board and
		Chief Executive Officer
Date:  October 31, 2008	By:	/s/ Charles V. Cole
		Charles V. Cole, Executive Vice President and
		Chief Financial Officer

48

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: October 31, 2008	/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: October 31, 2008	/s/ Charles V. Cole
	Charles V. Cole
	Executive Vice President and Chief Financial Officer

EX-32.0

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, 2008 (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:	October 31, 2008	By:	/s/ Thomas F. Prisby
			Thomas F. Prisby
			Chairman of the Board and Chief Executive Officer
Date:	October 31, 2008	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.