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EX-32.1 - EX-32.1 - HAWTHORN BANCSHARES, INC.c61157exv32w1.htm
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EX-32.2 - EX-32.2 - HAWTHORN BANCSHARES, INC.c61157exv32w2.htm
EX-31.2 - EX-31.2 - HAWTHORN BANCSHARES, INC.c61157exv31w2.htm
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
     
þ   Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2010
or
     
o   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: 0-23636
HAWTHORN BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
     
Missouri   43-1626350
(State or other jurisdiction of   (I.R.S. Employer
of incorporation or organization)   Identification No.)
300 Southwest Longview Boulevard, Lee’s Summit, Missouri 64081
(Address of principal executive offices) (Zip Code)
(816) 347-8100
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report.)
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. þ Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). o Yes o 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.:
             
Large accelerated filer o   Accelerated filer o   Non-accelerated filer þ   Smaller reporting company o
        (Do not check if a smaller reporting company)    
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No
As of November 9, 2010 the registrant had 4,474,033 shares of common stock, par value $1.00 per share, outstanding.
 
 


 

PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(Unaudited)
                 
    September 30,     December 31,  
    2010     2009  
 
ASSETS
               
Loans
  $ 933,456,302     $ 991,614,007  
Allowances for loan losses
    (13,953,687 )     (14,796,549 )
 
Net loans
    919,502,615       976,817,458  
 
Investment in available-for-sale securities, at fair value
    165,172,611       152,926,685  
Federal funds sold and securities purchased under agreements to resell
    125,820       89,752  
Cash and due from banks
    52,099,695       24,575,943  
Premises and equipment — net
    37,236,395       38,623,293  
Other real estate owned and repossessed assets
    10,012,412       8,490,914  
Accrued interest receivable
    6,020,411       6,625,557  
Mortgage servicing rights
    2,198,887       2,020,964  
Intangible assets — net
    1,095,535       1,503,986  
Cash surrender value — life insurance
    1,979,466       1,929,910  
Other assets
    19,622,328       22,866,092  
 
Total assets
  $ 1,215,066,175     $ 1,236,470,554  
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Deposits:
               
Non-interest bearing demand
  $ 143,143,196     $ 135,017,639  
Savings, interest checking and money market
    363,916,607       354,284,004  
Time deposits $100,000 and over
    127,609,669       137,860,435  
Other time deposits
    315,904,482       329,160,719  
 
Total deposits
    950,573,954       956,322,797  
 
Federal funds purchased and securities sold under agreements to repurchase
    31,460,010       36,645,434  
Subordinated notes
    49,486,000       49,486,000  
Other borrowed money
    67,168,047       79,317,302  
Accrued interest payable
    1,344,701       2,438,121  
Other liabilities
    5,112,064       4,489,617  
 
Total liabilities
    1,105,144,776       1,128,699,271  
 
Stockholders’ equity:
               
Preferred stock, $1,000 par value
               
Authorized and issued 30,255 shares
    28,722,124       28,364,768  
Common stock, $1 par value
               
Authorized 15,000,000 shares; issued 4,635,891 and 4,463,813 shares, respectively
    4,635,891       4,463,813  
Surplus
    28,909,244       26,970,745  
Retained earnings
    48,828,486       50,576,551  
Accumulated other comprehensive income, net of tax
    2,342,472       912,224  
Treasury stock; 161,858 shares, at cost
    (3,516,818 )     (3,516,818 )
 
Total stockholders’ equity
    109,921,399       107,771,283  
 
Total liabilities and stockholders’ equity
  $ 1,215,066,175     $ 1,236,470,554  
 
See accompanying notes to consolidated financial statements.

2


 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
(Unaudited)
                                 
    For the Three Months Ended     For the Nine Months Ended  
    September 30,     September 30,  
    2010     2009     2010     2009  
 
INTEREST INCOME
                               
Interest and fees on loans
  $ 13,234,729     $ 14,340,996     $ 40,286,802     $ 43,332,581  
Interest on debt securities:
                               
Taxable
    1,054,667       1,152,935       3,236,744       3,430,153  
Nontaxable
    273,538       350,839       894,293       1,088,561  
Interest on federal funds sold and securities purchased under agreements to resell
    50       60       133       253  
Interest on interest-bearing deposits
    27,851       11,556       63,373       43,565  
Dividends on other securities
    33,577       53,742       119,024       110,010  
 
Total interest income
    14,624,412       15,910,128       44,600,369       48,005,123  
 
INTEREST EXPENSE
                               
Interest on deposits:
                               
Savings, interest checking and money market
    511,442       693,242       1,696,648       2,390,089  
Time deposit accounts $100,000 and over
    594,334       949,273       1,956,968       3,056,793  
Other time deposit accounts
    1,758,850       2,532,085       5,607,583       8,311,234  
Interest on federal funds purchased and securities sold under agreements to repurchase
    19,690       23,458       59,353       64,028  
Interest on subordinated notes
    353,536       588,554       1,201,082       1,878,657  
Interest on other borrowed money
    527,818       687,535       1,794,832       2,320,481  
 
Total interest expense
    3,765,670       5,474,147       12,316,466       18,021,282  
 
Net interest income
    10,858,742       10,435,981       32,283,903       29,983,841  
Provision for loan losses
    2,450,000       1,250,000       7,105,000       4,404,000  
 
Net interest income after provision for loan losses
    8,408,742       9,185,981       25,178,903       25,579,841  
 
NON-INTEREST INCOME
                               
Service charges on deposit accounts
    1,427,130       1,547,038       4,150,420       4,380,248  
Trust department income
    186,989       237,939       566,495       623,258  
Gain on sale of mortgage loans, net
    1,011,253       489,069       1,533,027       2,437,169  
Other
    284,932       326,560       1,115,838       732,189  
 
Total non-interest income
    2,910,304       2,600,606       7,365,780       8,172,864  
 
NON-INTEREST EXPENSE
                               
Salaries and employee benefits
    4,256,523       4,454,183       13,463,964       13,403,853  
Occupancy expense, net
    654,687       599,555       1,881,093       1,762,990  
Furniture and equipment expense
    472,657       506,469       1,499,307       1,794,400  
FDIC insurance assessment
    442,965       421,690       1,288,163       2,085,472  
Legal, examination, and professional fees
    348,792       311,780       932,115       985,274  
Advertising and promotion
    311,219       301,348       886,242       901,066  
Postage, printing, and supplies
    299,997       271,434       874,353       833,846  
Processing expense
    853,710       845,288       2,560,570       2,538,067  
Other real estate expense
    882,264       239,747       2,895,010       575,008  
Other
    842,703       1,088,245       2,535,084       2,815,972  
 
Total non-interest expense
    9,365,517       9,039,739       28,815,901       27,695,948  
 
Income before income taxes
    1,953,529       2,746,848       3,728,782       6,056,757  
Less income taxes
    531,327       840,070       1,030,346       1,889,060  
 
Net income
    1,422,202       1,906,778       2,698,436       4,167,697  
Preferred stock dividends
    378,187       378,187       1,130,360       1,134,562  
Accretion of discount on preferred stock
    119,119       119,119       357,356       357,356  
 
Net income available to common shareholders
  $ 924,896     $ 1,409,472     $ 1,210,720     $ 2,675,779  
 
Basic earnings per share
  $ 0.21     $ 0.32     $ 0.27     $ 0.60  
Diluted earnings per share
  $ 0.21     $ 0.32     $ 0.27     $ 0.60  
 
See accompanying notes to consolidated financial statements.

3


 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Statements of Changes in Stockholders’ Equity
(Unaudited)
                                                         
                                    Accumulated             Total  
                                    other             Stock -  
    Preferred     Common             Retained     Comprehensive     Treasury     holders’  
    Stock     Stock     Surplus     Earnings     Income (Loss)     Stock     Equity  
 
Balance, December 31, 2009
  $ 28,364,768     $ 4,463,813     $ 26,970,745     $ 50,576,551     $ 912,224     $ (3,516,818 )   $ 107,771,283  
 
Net income
                      2,698,436                   2,698,436  
Change in unrealized gain (loss) on securities:
                                                       
Unrealized gain on debt and equity securities available-for-sale, net of tax
                            1,394,275             1,394,275  
Defined benefit pension plans:
                                                       
Amortization of prior service cost included in net periodic pension cost, net of tax
                            35,973             35,973  
 
                                                     
Total other comprehensive income
                                                    1,430,248  
 
                                                     
Total comprehensive income
                                                    4,128,684  
 
                                                     
Stock based compensation expense
                68,009                         68,009  
Accretion of preferred stock discount
    357,356                   (357,356 )                  
Stock dividend
          172,078       1,870,490       (2,042,568 )                  
Cash dividends declared, preferred stock
                            (1,134,562 )                     (1,134,562 )
Cash dividends declared, common stock
                      (912,015 )                 (912,015 )
 
Balance, September 30, 2010
  $ 28,722,124     $ 4,635,891     $ 28,909,244     $ 48,828,486     $ 2,342,472     $ (3,516,818 )   $ 109,921,399  
 
 
                                                       
 
Balance, December 31, 2008
  $ 27,888,294     $ 4,298,353     $ 25,144,323     $ 51,598,678     $ 1,005,553     $ (3,516,818 )   $ 106,418,383  
 
Net income
                      4,167,697                   4,167,697  
Change in unrealized gain (loss) on securities:
                                                       
Unrealized loss on debt and equity securities available-for-sale, net of tax
                            558,218             558,218  
Defined benefit pension plans:
                                                       
Amortization of prior service cost included in net periodic pension cost, net of tax
                            36,142             36,142  
 
                                                     
Total other comprehensive loss
                                                    594,360  
 
                                                     
Total comprehensive income
                                                    4,762,057  
 
                                                     
Stock based compensation expense
                99,697                         99,697  
Accretion of preferred stock discount
    357,355                   (357,355 )                  
Stock dividend
          165,460       1,695,963       (1,861,423 )                  
Cash dividends declared, preferred stock
                            (991,691 )                     (991,691 )
Cash dividends declared, common stock
                      (1,796,893 )                 (1,796,893 )
 
Balance, September 30, 2009
  $ 28,245,649     $ 4,463,813     $ 26,939,983     $ 50,759,013     $ 1,599,913     $ (3,516,818 )   $ 108,491,553  
 
See accompanying notes to consolidated financial statements.

4


 

Consolidated Statements of Cash Flows (Unaudited)
                 
    Nine months Ended September 30,  
    2010     2009  
 
Cash flows from operating activities:
               
Net income
  $ 2,698,436     $ 4,167,697  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    7,105,000       4,404,000  
Depreciation expense
    1,484,686       1,540,942  
Net amortization of debt securities, premiums, and discounts
    454,671       366,383  
Amortization of intangible assets
    408,451       475,592  
Stock based compensation expense
    68,009       99,697  
Loss on sales and dispositions of premises and equipment
    59,621       147,166  
Other real estate owned impairment charges
    1,595,638       62,535  
Decrease in deferred tax asset, net
    728,912       380,001  
Decrease in accrued interest receivable
    605,146       598,071  
Increase in cash surrender value -life insurance
    (49,556 )     (57,750 )
Decrease in other assets
    578,938       93,894  
Decrease in accrued interest payable
    (1,093,420 )     (1,455,466 )
Increase in other liabilities
    871,960       1,808,432  
Origination of mortgage loans held for sale
    (72,437,349 )     (125,186,177 )
Proceeds from the sale of mortgage loans held for sale
    69,193,376       127,623,346  
Gain on sale of mortgage loans, net
    (1,533,027 )     (2,437,169 )
Other, net
    398,872       371,107  
 
Net cash provided by operating activities
    11,138,364       13,002,301  
 
Cash flows from investing activities:
               
Net decrease in loans
    42,321,380       6,768,359  
Purchase of available-for-sale debt securities
    (154,204,703 )     (110,865,517 )
Proceeds from maturities of available-for-sale debt securities
    105,724,703       83,996,365  
Proceeds from calls of available-for-sale debt securities
    38,065,100       17,805,000  
Proceeds from sales of FHLB stock
    995,600        
Purchases of premises and equipment
    (320,967 )     (420,575 )
Proceeds from sales of premises and equipment
    34,528       582,816  
Proceeds from sales of other real estate owned and repossessions
    9,185,427       1,929,955  
 
Net cash provided (used) by investing activities
    41,801,068       (203,597 )
 
Cash flows from financing activities:
               
Net increase in non-interest-bearing demand deposits
    8,125,557       871,554  
Net increase in savings, interest checking, and money market accounts
    9,632,603       15,278,667  
Net decrease in time deposits
    (23,507,003 )     (3,311,738 )
Net (decrease) increase in federal funds purchased and securities sold under agreements to repurchase
    (5,185,424 )     3,235,954  
Proceeds from other borrowed money
    10,000,000        
Repayment of other borrowed money
    (22,149,255 )     (57,576,317 )
Cash dividends paid — preferred stock
    (1,134,562 )     (991,691 )
Cash dividends paid — common stock
    (1,161,528 )     (2,192,342 )
 
Net cash used by financing activities
    (25,379,612 )     (44,685,913 )
 
Net increase (decrease) in cash and cash equivalents
    27,559,820       (31,887,209 )
Cash and cash equivalents, beginning of year
    24,665,695       53,827,468  
 
Cash and cash equivalents, end of period
  $ 52,225,515     $ 21,940,259  
 
 
               
Supplemental disclosures of cash flow information:
               
Cash paid during the year for:
               
Interest
  $ 13,409,886     $ 19,476,748  
Income taxes
    200,000       390,000  
 
               
Supplemental schedule of noncash investing and financing activities:
               
Other real estate and repossessions acquired in settlement of loans
  $ 12,665,463     $ 5,739,740  
See accompanying notes to consolidated financial statements.

5


 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Basis of Presentation
     The accompanying unaudited condensed consolidated financial statements include all adjustments that, in the opinion of management, are necessary in order to make those statements not misleading. Management is required to make estimates and assumptions, including the determination of the allowance for loan losses, real estate acquired in connection with foreclosure or in satisfaction of loans, and fair values of investment securities available-for-sale that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Operating results for the three and nine-month periods ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010. Our Company’s management has evaluated and did not identify any subsequent events or transactions requiring recognition or disclosure in the consolidated financial statements.
     These unaudited condensed consolidated interim financial statements should be read in conjunction with our Company’s audited consolidated financial statements included in its 2009 Annual Report to Shareholders under the caption Consolidated Financial Statements and incorporated by reference into its Annual Report on Form 10-K for the year ended December 31, 2009 as Exhibit 13.
     The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed and omitted. These financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly our Company’s consolidated financial position as of September 30, 2010, the consolidated statements of operations for the three and nine-month periods ended September 30, 2010 and 2009, and the consolidated statements of cash flows for the nine-month periods ended September 30, 2010 and 2009.
     On July 1, 2010, our Company paid a special stock dividend of four percent to common shareholders of record at the close of business on May 19, 2010. For all periods presented, share information, including basic and diluted earnings per share, have been adjusted retroactively to reflect this change.
Loans and Allowance for Loan Losses
Major classifications in our Company’s loan portfolio at September 30, 2010 and December 31, 2009 are as follows:
                 
    September 30,     December 31,  
    2010     2009  
 
Commercial, financial, and agricultural
  $ 132,919,752     $ 151,399,300  
Real estate construction — residential
    38,229,395       38,840,664  
Real estate construction — commercial
    76,586,537       77,936,569  
Real estate mortgage — residential
    217,802,375       232,332,124  
Real estate mortgage — commercial
    433,930,074       453,975,271  
Installment loans to individuals
    33,821,909       36,966,018  
Unamortized loan origination fees and costs, net
    166,260       164,061  
 
Total loans
  $ 933,456,302     $ 991,614,007  
 
     The Bank grants real estate, commercial, and installment loans to customers located within the communities surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson and Lee’s Summit, Missouri. As such, the Bank is susceptible to changes in the economic environment in these communities. The Bank does not have a concentration of credit in any one economic sector. Installment loans consist primarily of the financing of vehicles.

6


 

     As shown in the above table, our Company’s total loans have declined $58,158,000, or 5.9%, since December 31, 2009. Of this decline $8,466,000 represents loans charged-off and $12,665,000 represents loans that were foreclosed on and moved to other real estate owned and repossessed assets. Of the remaining $37,027,000 decrease, $21,400,000 represents payoffs/paydowns of six large credits.
A summary of impaired loans as of September 30, 2010 and December 31, 2009 is as follows:
                 
    September 30, 2010     December 31, 2009  
 
Loans classified as impaired:
               
Non-accrual loans
  $ 49,847,089     $ 34,153,731  
Impaired loans continuing to accrue interest
    16,635,933       39,713,014  
 
Total impaired loans
  $ 66,483,022     $ 73,866,745  
 
 
               
Balance of impaired loans with reserves
  $ 34,715,944     $ 26,294,560  
Balance of impaired loans without reserves
    31,767,078       47,572,185  
 
Total impaired loans
  $ 66,483,022     $ 73,866,745  
 
 
               
Reserves for impaired loans
  $ 7,797,557     $ 6,414,729  
Average balance of impaired loans during the period
    64,700,592       39,048,298  
Balance of trouble debt restructured loans included in impaired loans
    22,457,385       11,233,326  
 
     The table above shows our Company’s investment in impaired loans at September 30, 2010 and December 31, 2009. These loans consist of loans on non-accrual status and other restructured loans whose terms have been modified and classified as troubled debt restructurings. Although our non-accrual loans significantly increased from $34,153,731 at December 31, 2009 to $49,847,089 at September 30, 2010, total impaired loans decreased $7,383,723. The balance of impaired loans without reserves was 48% of total impaired loans at September 30, 2010 and 64% at December 31, 2009. Management believes the excess value in the collateral was sufficient at September 30, and December 31, and these loans did not require additional reserves.
The following is a summary of the allowance for loan losses for the three and nine-months ended September 30, 2010:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2010     2009     2010     2009  
 
Balance at beginning of period
  $ 12,231,596     $ 13,704,736     $ 14,796,549     $ 12,666,546  
 
Additions:
                               
Provision for loan losses
    2,450,000       1,250,000       7,105,000       4,404,000  
 
Total additions
    2,450,000       1,250,000       7,105,000       4,404,000  
 
Deductions:
                               
Loans charged off
    899,795       1,198,165       8,466,456       3,549,572  
Less recoveries on loans
    (171,886 )     (170,963 )     (518,594 )     (406,560 )
 
Net loans charged off
    727,909       1,027,202       7,947,862       3,143,012  
 
Balance at end of period
  $ 13,953,687     $ 13,927,534     $ 13,953,687     $ 13,927,534  
 

7


 

Investment Securities
A summary of investment securities by major category, at fair value, consisted of the following at September 30, 2010 and December 31, 2009.
                 
    September 30,     December 31,  
    2010     2009  
 
U.S. treasury
  $ 1,040,234     $  
Government sponsored enterprises
    46,898,658       44,380,798  
Asset-backed securities
    85,822,384       69,434,650  
Obligations of states and political subdivisions
    31,411,335       39,111,237  
 
 
Total available for sale securities
  $ 165,172,611     $ 152,926,685  
 
     Most of our Company’s investment securities are classified as available for sale, as discussed in more detail below. Asset backed securities include agency mortgage-backed securities, which are guaranteed by government sponsored agencies such as the FHLMC, FNMA and GNMA. Our Company does not invest in subprime originated mortgage-backed or collateralized debt obligation instruments. Investment securities which are classified as restricted equity securities primarily consist of Federal Home Loan Bank Stock and our Company’s interest in statutory trusts. These securities are reported at cost in other assets in the amount of $6,150,250 and $6,753,550, as of September 30, 2010 and December 31, 2009 respectively.
     The amortized cost and fair value of securities classified as available-for-sale at September 30, 2010 and December 31, 2009 are as follows:
                                 
            Gross     Gross        
    Amortized     unrealized     unrealized        
    cost     gains     losses     Fair value  
 
September 30, 2010
               
U.S. treasury
  $ 999,808     $ 40,426     $     $ 1,040,234  
Government sponsored enterprises
    46,285,100       614,861       1,303       46,898,658  
Asset-backed securities
    82,943,924       2,878,460             85,822,384  
Obligations of states and political subdivisions
    30,340,035       1,073,842       2,542       31,411,335  
 
 
                               
Total available for sale securities
  $ 160,568,867     $ 4,607,589     $ 3,845     $ 165,172,611  
 
 
                               
December 31, 2009
                               
Government sponsored enterprises
  $ 44,059,540     $ 371,258     $ 50,000     $ 44,380,798  
Asset-backed securities
    68,092,852       1,585,774       243,976       69,434,650  
Obligations of states and political subdivisions
    38,456,246       708,196       53,205       39,111,237  
 
 
                               
Total available for sale securities
  $ 150,608,638     $ 2,665,228     $ 347,181     $ 152,926,685  
 

8


 

     The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2010 and December 31, 2009, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without prepayment penalties.
                 
    Amortized     Fair  
    cost     value  
 
Due in one year or less
  $ 3,716,849     $ 3,766,402  
Due after one year through five years
    57,445,491       58,400,399  
Due after five years through ten years
    12,604,036       13,176,191  
Due after ten years
    3,858,567       4,007,235  
 
 
    77,624,943       79,350,227  
Asset-backed securities
    82,943,924       85,822,384  
 
Total available for sale investment securities
  $ 160,568,867     $ 165,172,611  
 
     Debt securities with carrying values aggregating approximately $141,473,000 and $132,322,000 at September 30, 2010 and December 31, 2009, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.
     Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2010 and December 31, 2009, were as follows:
                                                         
    Less than 12 months     12 months or more             Total  
                                    Number of              
    Fair     Unrealized     Fair     Unrealized     Investment     Fair     Unrealized  
    Value     Losses     Value     Losses     Positions     Value     Losses  
 
At September 30, 2010
                         
Government sponsored enterprises
  $ 998,697     $ (1,303 )   $     $       1     $ 998,697     $ (1,303 )
Obligations of states and political subdivisions
    365,173       (2,542 )                 2       365,173       (2,542 )
 
 
  $ 1,363,870     $ (3,845 )   $     $       3     $ 1,363,870     $ (3,845 )
 
                                                         
    Less than 12 months     12 months or more             Total  
                                    Number of              
    Fair     Unrealized     Fair     Unrealized     Investment     Fair     Unrealized  
At December 31, 2009   Value     Losses     Value     Losses     Positions     Value     Losses  
 
Government sponsored enterprises
  $ 5,943,819     $ (50,000 )   $     $       6     $ 5,943,819       (50,000 )
Asset-backed securities
    14,600,160       (243,904 )     20,551       (72 )     15       14,620,711     $ (243,976 )
Obligations of states and political subdivisions
    3,576,780       (53,205 )                 14       3,576,780       (53,205 )
 
 
  $ 24,120,759     $ (347,109 )   $ 20,551     $ (72 )     35     $ 24,141,310     $ (347,181 )
 
     Our Company’s available for sale portfolio consisted of approximately 304 securities at September 30, 2010, of which 3 securities were temporarily impaired. None of these securities have been in the loss position for 12 months or longer. Our Company believes the $4,000 in unrealized losses included in other comprehensive income at September 30, 2010 is attributable to changes in market interest rates and not the credit quality of the issuer and are not considered other-than-temporarily impaired. Our Company does not intend to sell these investments and it is not more likely than not that our Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity.
     Our Company’s available for sale portfolio consisted of approximately 305 securities at December 31, 2009. One of these securities had been in the loss position for 12 months or longer. The $72 unrealized loss included in other comprehensive income at December 31, 2009 on this asset-backed security was caused by interest rate increases. Because the decline in fair value is attributable to changes in interest rates and not credit quality this investment was not

9


 

considered other-than-temporarily impaired. As of September 30, 2010, this security was not in the unrealized loss position.
     During the nine months ended September 30, 2010 and September 30, 2009, there were no proceeds from sales of securities and no components of investment securities gains and losses which have been recognized in earnings.
Intangible Assets
A summary of other intangible assets at September 30, 2010 and December 31, 2009 is as follows:
                                                 
    September 30, 2010     December 31, 2009  
    Gross                     Gross              
    Carrying     Accumulated     Net     Carrying     Accumulated     Net  
    Amount     Amortization     Amount     Amount     Amortization     Amount  
 
Amortizable intangible assets:
                                               
Core deposit intangible
  $ 7,060,224     $ (5,964,689 )   $ 1,095,535     $ 7,060,224     $ (5,556,238 )   $ 1,503,986  
Mortgage servicing rights
    2,880,735       (681,848 )     2,198,887       2,945,019       (924,055 )     2,020,964  
 
 
Total amortizable intangible assets
  $ 9,940,959     $ (6,646,537 )   $ 3,294,422     $ 10,005,243     $ (6,480,293 )   $ 3,524,950  
 
     Changes in the net carrying amount of other intangible assets for the nine months ended September 30, 2010 are as follows:
                 
    Core        
    Deposit     Mortgage  
    Intangible     Servicing  
    Asset     Rights  
 
Balance at December 31, 2009
  $ 1,503,986     $ 2,020,964  
Additions
          772,880  
Amortization
    (408,451 )     (594,957 )
 
Balance at September 30, 2010
  $ 1,095,535     $ 2,198,887  
 
     Mortgage servicing rights (MSRs) are amortized over the shorter of 7 years or the life of the loan. They are periodically reviewed for impairment and if impairment is indicated, recorded at fair value. At September 30, 2010 and December 31, 2009, no temporary impairment was recognized. The fair value of MSRs is based on the present value of expected cash flows, as further discussed in Fair Value of Financial Instruments. Mortgage loans serviced for others totaled approximately $285,888,000 and $269,475,000 at September 30, 2010 and December 31, 2009, respectively. Included in other noninterest income were real estate servicing fees for the nine months ended September 30, 2010 and 2009 of $682,000 and $648,000, respectively.
     Our Company’s amortization expense on intangible assets in any given period may be different from the estimated amounts depending upon the acquisition of intangible assets, changes in mortgage interest rates, prepayment rates and other market conditions. The following table shows the estimated future amortization expense based on existing asset balances and the interest rate environment as of September 30, 2010 and for the next five years:
                 
    Core        
    Deposit     Mortgage  
    Intangible     Servicing  
    Asset     Rights  
 
2010
  $ 118,026     $ 440,000  
2011
    434,763       477,000  
2012
    408,062       363,000  
2013
    134,684       277,000  
2014
          212,000  
2015
          162,000  
 

10


 

     The aggregate amortization expense of intangible assets subject to amortization for the three and nine-month periods ended September 30, 2010 is as follows:
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
Aggregate amortization expense   2010     2009     2010     2009  
 
Core deposit intangible asset
  $ 118,026     $ 150,519     $ 408,451     $ 475,592  
Mortgage servicing rights
    307,981       156,365       594,957       746,682  
 
Income Taxes
     At September 30, 2010 and December 31, 2009, our Company had $562,000 of gross unrecognized tax benefits that if recognized would affect the effective tax rate. Our Company believes that during the next twelve months it is reasonably possible that there would be a reduction of $222,000 in gross unrecognized tax benefits as a result of the lapse of statute of limitations for the 2006 tax year. At September 30, 2010, total interest accrued on unrecognized tax benefits was approximately $59,000. As of September 30, 2010, there were no federal or state income tax examinations in process.
     Our Company recognizes deferred tax assets only to the extent that they are expected to be used to reduce amounts that have been paid or will be paid to tax authorities. Management believes, based on all positive and negative evidence available to it, that the deferred tax asset at September 30, 2010 is more likely-than-not-to be realized, and accordingly, no valuation allowance has been recorded. Future facts and circumstances may require a valuation allowance. Charges to establish a valuation allowance could have a material adverse effect on our results of operations and financial position.
     Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 27.2% for the three months ended September 30, 2010 compared to 30.6% for the three months ended September 30, 2009. Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 27.6% for the nine months ended September 30, 2010 compared to 31.2% for the nine months ended September 30, 2009. The effective tax rate for the three and nine months ended September 30, 2010 reflects the increase in tax-exempt income as a percentage of total taxable income.
Employee Benefit Plans
     Employee benefits charged to operating expenses are summarized for the three and nine-month periods ended September 30, 2010 in the table below.
                                 
    For the Three Months Ended     For the Nine Months Ended  
    September 30,     September 30,  
    2010     2009     2010     2009  
 
Payroll taxes
  $ 257,947     $ 246,232     $ 863,587     $ 855,230  
Medical plans
    372,789       370,113       1,171,144       1,127,477  
401k match
    84,300       81,045       238,088       227,902  
Pension plan
    216,298       229,000       648,895       687,000  
Profit-sharing
    (72,468 )     99,000       2       233,350  
Other
    28,288       28,906       102,304       81,538  
 
 
Total employee benefits
  $ 887,154     $ 1,054,296     $ 3,024,020     $ 3,212,497  
 

11


 

     Our Company provides a noncontributory defined benefit pension plan for all full-time employees. Pension expense for the periods indicated is as follows:
                 
    Estimated     Actual  
    2010     2009  
 
Service cost — benefits earned during the year
  $ 844,178     $ 850,940  
Interest cost on projected benefit obligations
    556,047       509,482  
Expected return on plan assets
    (613,659 )     (539,283 )
Amortization of prior service cost
    78,628       78,628  
Amortization of net gains
          (9,075 )
 
Net periodic pension expense — Annual
  $ 865,194     $ 890,692  
 
 
               
Pension expense — three months ended September 30, (actual)
  $ 216,298     $ 229,000  
 
Pension expense — nine months ended September 30, (actual)
  $ 648,895     $ 687,000  
 
     Our Company made a $1,000,000 contribution to the defined benefit plan in 2009, and the minimum required contribution for 2010 is estimated to be $864,000. Our Company has contributed $554,000 through October 2010.
Stock-Based Compensation
     Our Company’s stock option plan provides for the grant of options to purchase up to 486,720 shares of our Company’s common stock to officers and other key employees of our Company and its subsidiaries. All options have been granted at exercise prices equal to fair value and vest over periods ranging from four to five years, except 10,294 options issued in 2008 that vested immediately.
The following table summarizes our Company’s stock option activity:
                                 
                            Weighted  
            Weighted     Aggregate     Average  
            Average     Intrinsic     Contractual  
            Exercise     Value     Term  
    Options     Price     (000)     (in years)  
 
Outstanding at January 1, 2010*
    286,948     $ 24.11                  
Granted
                           
Exercised
                           
Forfeited
                           
Canceled
                           
 
Outstanding at September 30, 2010
    286,948     $ 24.11     $       4.2  
 
Exercisable at September 30, 2010
    245,617     $ 23.96     $       3.7  
 
 
*   Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2010.
     Total stock-based compensation expense for the three and nine months ended September 30, 2010 and 2009 was $19,000 and $31,000, respectively, and $68,000 and $100,000, respectively. As of September 30, 2010, the total unrecognized compensation expense related to non-vested stock awards was $100,000 and the related weighted average period over which it is expected to be recognized is approximately three years.

12


 

Comprehensive Income
Comprehensive income for the three and nine months ended September 30, 2010 and 2009 is summarized as follows:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2010     2009     2010     2009  
 
Net income
  $ 1,422,202     $ 1,906,778     $ 2,698,436     $ 4,167,697  
Other comprehensive income:
                               
Unrealized gain on securities:
                               
Unrealized gain on debt and equity securities available-for-sale, net of tax
    249,006       808,079       1,394,275       558,218  
Defined benefit pension plan:
                               
Amortization of prior service cost included in net periodic pension cost, net of tax
    11,991       12,052       35,973       36,142  
 
Total other comprehensive income
    260,997       820,131       1,430,248       594,360  
 
Comprehensive income
  $ 1,683,199     $ 2,726,909     $ 4,128,684     $ 4,762,057  
 
Preferred Stock
     On December 19, 2008, our Company announced its participation in the U.S. Treasury Department’s Capital Purchase Program (CPP), a voluntary program that provides capital to financially healthy banks. This program was designed to attract broad participation by banking institutions to help stabilize the financial system by encouraging lending. Our Company has used the funds received, as discussed below, to continue to provide loans to its customers and to look for ways to deploy additional funds to benefit the communities in our Company’s market area.
     Participation in this program included our Company’s issuance of 30,255 shares of senior preferred stock (with a par value of $1,000 per share) and a ten year warrant to purchase approximately 265,471 shares of common stock (see below for additional information) to the U.S. Department of Treasury in exchange for $30,255,000. The proceeds received were allocated between the preferred stock and the common stock warrant based upon their relative fair values. This resulted in the recording of a discount on the preferred stock upon issuance that reflects the value allocated to the warrant. The discount on the preferred stock will be accreted over five years, consistent with management’s estimate of the life of the preferred stock. Such accretion will be treated as additional dividends on the preferred stock. The allocated carrying values of the senior preferred stock and common stock warrants at September 30, 2010 were $28,722,000 and $2,382,000, respectively.
     The preferred shares carry a 5% cumulative dividend for the first five years and 9% thereafter if not redeemed. The preferred shares are redeemable after three years at par plus accrued dividends, or before three years if our Company raises Tier 1 capital in an amount equal to the preferred stock issued. The preferred stock generally does not have any voting rights, subject to an exception in the event our Company fails to pay dividends on the preferred stock for nine or more quarterly periods, whether or not consecutive. Under such circumstances, the Treasury will be entitled to vote to elect two directors to the board until all unpaid dividends have been paid or declared and set apart for payment. Our Company is prohibited from paying any dividends with respect to shares of common stock unless all accrued and unpaid dividends are paid in full on the senior preferred stock for all past dividend periods. The Treasury Department may also transfer the senior preferred stock to a third party at any time.
     The common stock warrant is exercisable immediately with a ten year term, in whole or in part, at an exercise price of $17.10 per share. The preferred stock and warrant are classified as stockholders’ equity in the consolidated balance sheets and qualify, for regulatory capital purposes, as Tier I capital. For the nine months ended September 30, 2010, our Company had declared and paid dividends in the amount of $1,135,000 on the preferred stock.

13


 

Earnings per Share
     Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the three and nine months ending September 30, 2010. Diluted earnings per share gives effect to all dilutive potential common shares that were outstanding during the three and nine months ending September 30, 2010.
          The weighted average common and diluted shares outstanding and earnings per share amounts have been adjusted to give effect to the 4% stock dividend on July 1, 2010. The calculations of basic and diluted earnings per share are as follows:
                                 
    For the Three Months Ended     For the Nine Months Ended  
    September 30,     September 30,  
    2010     2009     2010     2009  
 
Basic income per common share:
                               
Net income
  $ 1,422,202     $ 1,906,778     $ 2,698,436     $ 4,167,697  
Less:
                               
Preferred stock dividends
    378,187       378,187       1,130,360       1,134,562  
Accretion of discount on preferred stock
    119,119       119,119       357,356       357,356  
 
Net income available to common shareholders
  $ 924,896     $ 1,409,472     $ 1,210,720     $ 2,675,779  
 
Basic earnings per share
  $ 0.21     $ 0.32     $ 0.27     $ 0.60  
 
 
                               
Diluted earnings per common share:
                               
 
                               
Net income
  $ 1,422,202     $ 1,906,778     $ 2,698,436     $ 4,167,697  
Less:
                               
Preferred stock dividends
    378,187       378,187       1,130,360       1,134,562  
Accretion of discount on preferred stock
    119,119       119,119       357,356       357,356  
 
Net income available to common shareholders
  $ 924,896     $ 1,409,472     $ 1,210,720     $ 2,675,779  
 
Average shares outstanding
    4,474,033       4,474,033       4,474,033       4,474,033  
Effect of dilutive stock options
                       
 
Average shares outstanding including dilutive stock options
    4,474,033       4,474,033       4,474,033       4,474,033  
 
Diluted earnings per share
  $ 0.21     $ 0.32     $ 0.27     $ 0.60  
 
          Under the treasury stock method, outstanding stock options are dilutive when the average market price of our Company’s common stock, when combined with the effect of any unamortized compensation expense, exceeds the option price during the period, except when our Company has a loss from continuing operations available to common shareholders. In addition, proceeds from the assumed exercise of dilutive options along with the related tax benefit are assumed to be used to repurchase common shares at the average market price of such stock during the period.
          The following options and warrant to purchase shares during the three and nine months ended 2010 and 2009 were not included in the respective computations of diluted earnings per share because the exercise price, when combined with the effect of the unamortized compensation expense, was greater than the average market price of the common shares and were considered anti-dilutive.
                                 
    Three months ended September 30,     Nine months ended September 30,  
    2010     2009     2010     2009  
 
Anti-dilutive shares — option shares
    286,948       286,948       286,948       286,948  
Anti-dilutive shares — warrant shares
    265,471       265,471       265,471       265,471  
 

14


 

Fair Value Measurements
          Our Company uses fair value measurements to record fair value adjustments to certain financial and nonfinancial assets and liabilities. The Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures, defines fair value, establishes a framework for the measurement of fair value, and enhances disclosures about fair value measurements. The standard applies whenever other standards require (permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. In this standard, FASB clarified the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. As of September 30, 2010 and December 31, 2009 there were no transfers into or out of Level 2.
The fair value hierarchy is as follows:
      Level 1 – Inputs are unadjusted quoted prices for identical assets or liabilities in active markets.
 
      Level 2 – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, such as interest rates and yield curves that are observable at commonly quoted intervals.
 
      Level 3 – Inputs are unobservable inputs for the asset or liability and significant to the fair value. These may be internally developed using our Company’s best information and assumptions that a market participant would consider.
ASC Topic 820 also provides guidance on determining fair value when the volume and level of activity for the asset or liability has significantly decreased and on identifying circumstances when a transaction may not be considered orderly.
Our Company is required to disclose assets and liabilities measured at fair value on a recurring basis separate from those measured at fair value on a nonrecurring basis. Nonfinancial assets measured at fair value on a nonrecurring basis would include foreclosed real estate, long-lived assets, and core deposit intangible assets, which are reviewed when circumstances or other events indicate that impairment may have occurred.
          The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate such value:
Valuation methods for instruments measured at fair value on a recurring basis
          Following is a description of our Company’s valuation methodologies used for assets and liabilities recorded at fair value on a recurring basis:
Available-for-sale securities
     Available-for-sale securities are recorded at fair value on a recurring basis. Available-for-sale securities is the only balance sheet category our Company is required, in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP), to carry at fair value on a recurring basis. Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, our Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

15


 

                                 
            Fair Value Measurements  
            At September 30, 2010 Using  
            Quoted Prices              
            in Active              
            Markets for     Other     Significant  
            Identical     Observable     Unobservable  
    Fair Value     Assets     Inputs     Inputs  
Description   September 30, 2010     (Level 1)     (Level 2)     (Level 3)  
 
U.S. treasury
  $ 1,040,234     $     $ 1,040,234     $  
Government sponsored enterprises
    46,898,658             46,898,658        
Asset-backed securities
    85,822,384             85,822,384        
Obligations of states and political subdivisions
    31,411,335             31,411,335        
 
Total
  $ 165,172,611     $     $ 165,172,611     $  
 
                                 
            Fair Value Measurements  
            At December 31, 2009 Using  
            Quoted Prices              
            in Active              
            Markets for     Other     Significant  
            Identical     Observable     Unobservable  
    Fair Value     Assets     Inputs     Inputs  
Description   December 31, 2009     (Level 1)     (Level 2)     (Level 3)  
 
Government sponsored enterprises
  $ 44,380,798     $     $ 44,380,798     $  
Asset-backed securities
    69,434,650             69,434,650        
Obligations of states and political subdivisions
    39,111,237             39,111,237        
 
Total
  $ 152,926,685     $     $ 152,926,685     $  
 
Valuation methods for instruments measured at fair value on a nonrecurring basis
          Following is a description of our Company’s valuation methodologies used for assets and liabilities recorded at fair value on a nonrecurring basis:
Impaired Loans
     Our Company does not record loans at fair value on a recurring basis other than loans that are considered impaired. The fair value of impaired loans are generally based on market prices for loans with similar collateral determined through independent appraisals, the fair value of the collateral for a collateral-dependent loan, or by discounting the total expected future cash flows. Once the fair value of the collateral has been determined and any impairment amount calculated, a specific reserve allocation is made. Because many of these inputs are not observable, the measurements are classified as Level 3. As of September 30, 2010, our Company identified $34.7 million in impaired loans that had specific allowances for losses aggregating $7.8 million. Related to these loans, there was $7.2 million in charge-offs recorded during 2010. As of December 31, 2009, our Company identified $26.3 million in impaired loans that had specific allowances for losses aggregating $6.4 million. Related to these loans, there was $4.2 million in charge-offs recorded during 2009.
Other Real Estate Owned and Repossessed Assets
          Other real estate owned and repossessed assets consist of loan collateral which has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate owned assets are recorded as held for sale initially at the lower of the cost basis or fair value of the collateral less estimated selling costs. Our Company relies on external appraisals and assessment of property values by our internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. Because many of these inputs are not observable, the measurements are classified as Level 3.

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            Fair Value Measurements        
            At September 30, 2010 Using        
            Quoted Prices                     Nine Months  
            in Active                     Ended  
            Markets for     Other     Significant     September 30,  
    Fair Value     Identical     Observable     Unobservable     2010  
    September 30,     Assets     Inputs     Inputs     Total Gains  
Description   2010     (Level 1)     (Level 2)     (Level 3)     (Losses) *  
 
Impaired loans:
                                       
Commercial
  $ 1,094,006     $     $     $ 1,094,006     $ (1,355,716 )
Construction — residential
    1,859,653                   1,859,653       (324,742 )
Construction — commercial
    14,372,565                   14,372,565       (64,000 )
Real estate — residential
    5,129,696                   5,129,696       (3,238,263 )
Real estate — commercial
    4,462,467                   4,462,467       (2,188,893 )
 
Total
  $ 26,918,387     $     $       26,918,387     $ (7,171,614 )
 
Other real estate owned and repossessed assets
  $ 10,012,412     $     $     $ 10,012,412     $ (3,002,454 )
 
 
*   Total gains (losses) include charge offs, valuation write downs, and net losses taken on impaired loans and other real estate owned during the periods reported.
                                         
            Fair Value Measurements        
            At December 31, 2009 Using        
            Quoted Prices                     Year  
            in Active                     Ended  
            Markets for     Other     Significant     December 31,  
    Fair Value     Identical     Observable     Unobservable     2009  
    December 31,     Assets     Inputs     Inputs     Total Gains  
Description   2009     (Level 1)     (Level 2)     (Level 3)     (Losses) *  
 
Impaired loans:
                                       
Commercial
  $ 970,937     $     $     $ 970,937     $ (1,043,465 )
Construction — residential
    1,776,267                   1,776,267       (778,041 )
Construction — commercial
    272,106                   272,106       (160,727 )
Real estate — residential
    7,104,961                   7,104,961       (1,914,530 )
Real estate — commercial
    9,755,560                   9,755,560       (323,522 )
 
Total
  $ 19,879,831     $     $       19,879,831     $ (4,220,285 )
 
Other real estate owned and repossessed assets
  $ 8,490,914     $     $     $ 8,490,914     $ (1,367,207 )
 
 
*   Total gains (losses) include charge offs, valuation write downs, and net losses taken on impaired loans and other real estate owned during the periods reported.
          For both recurring and nonrecurring fair value measurements, there were no transfers between the various levels for the nine months ending September 30, 2010 or the year ended December 31, 2009.
Fair Value of Financial Instruments
          The carrying amounts and estimated fair values of financial instruments held by our Company, in addition to a discussion of the methods used and assumptions made in computing those estimates, are set forth below.
Loans
     The fair value of loans is estimated based on present values using applicable risk-adjusted spreads to the U. S. Treasury curve to approximate current interest rates applicable to each category of such financial instruments. The fair values of impaired loans are generally based on market prices for similar assets determined through independent appraisals or discounted values of independent appraisals and brokers’ opinions of value. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC Topic 820.

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Investment Securities
          A detailed description of the fair value measurement of the debt instruments in the available for sale sections of the investment security portfolio is proved in the Fair Value Measurement section above. A schedule of investment securities by category and maturity is provided in the notes on Investment Securities.
Federal Funds Sold, Cash, and Due from Banks
     For federal funds sold, cash, and due from banks, the carrying amount is a reasonable estimate of fair value, as such instruments reprice in a short time period.
Mortgage Servicing Rights
     The fair value of mortgage servicing rights is calculated by pooling loans into buckets of loans having similar characteristics and performing a present value analysis of future cash flows utilizing the current market rate. The buckets are created based on individual loans characteristics such as loan age, note rate, product type, and the investor remittance schedule.
Accrued Interest Receivable and Payable
     For accrued interest receivable and payable, the carrying amount is a reasonable estimate of fair value because of the short maturity for these financial instruments.
Deposits
     The fair value of deposits with no stated maturity, such as noninterest-bearing demand, NOW accounts, savings, and money market, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
Securities Sold under Agreements to Repurchase and Interest-bearing Demand Notes to U.S. Treasury
     For securities sold under agreements to repurchase and interest-bearing demand notes to U.S. Treasury, the carrying amount is a reasonable estimate of fair value, as such instruments reprice in a short time period.
Other Borrowings
     The fair value of other borrowings, which include subordinated notes and Federal Home Loan borrowings, is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for other borrowed money of similar remaining maturities.

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          A summary of the carrying amounts and fair values of our Company’s financial instruments at September 30, 2010 and December 31, 2009 is as follows:
                                 
    September 30,     December 31,  
    2010     2009  
    Carrying     Fair     Carrying     Fair  
    amount     value     amount     value  
 
Assets:
                               
Loans
  $ 919,502,615     $ 925,518,000     $ 976,817,458     $ 984,305,000  
Investment in debt securities
    165,172,611       165,172,611       152,926,685       152,926,685  
Federal fund sold and securities purchased under agreements to resell
    125,820       125,820       89,752       89,752  
Cash and due from banks
    52,099,695       52,099,695       24,575,943       24,575,943  
Mortgage servicing rights
    2,198,887       3,082,000       2,020,964       2,904,000  
Accrued interest receivable
    6,020,411       6,020,411       6,625,557       6,625,557  
 
 
  $ 1,145,120,039     $ 1,152,018,537     $ 1,163,056,359     $ 1,171,426,937  
 
 
                               
Liabilities:
                               
Deposits:
                               
Demand
  $ 143,143,196     $ 143,143,196     $ 135,017,639     $ 135,017,639  
NOW
    148,709,953       148,709,953       139,623,577       139,623,577  
Savings
    53,502,642       53,502,642       47,637,148       47,637,148  
Money market
    161,704,012       161,704,012       167,023,279       167,023,279  
Time
    443,514,151       453,030,000       467,021,154       478,011,000  
Federal funds purchased and securities sold under agreements to repurchase
    31,460,010       31,460,010       36,645,434       36,645,434  
Subordinated notes
    49,486,000       21,106,000       49,486,000       18,329,000  
Other borrowings
    67,168,047       69,695,000       79,317,302       80,557,000  
Accrued interest payable
    1,344,701       1,344,701       2,438,121       2,438,121  
 
 
  $ 1,100,032,712     $ 1,083,695,514     $ 1,124,209,654     $ 1,105,282,198  
 

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Item 2 - Management’s Discussion and Analysis of Financial Condition
And Results of Operations
Forward-Looking Statements
     This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of our Company and its subsidiaries, including, without limitation:
  statements that are not historical in nature, and
 
  statements preceded by, followed by or that include the words believes, expects, may, will, should, could, anticipates, estimates, intends or similar expressions.
     Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:
  competitive pressures among financial services companies may increase significantly,
 
  changes in the interest rate environment may reduce interest margins,
 
  general economic conditions, either nationally or in Missouri, may be less favorable than expected and may adversely affect the quality of our loans and other assets,
 
  increases in non-performing assets in our loan portfolios and adverse economic conditions may necessitate increases to our provisions for loan losses,
 
  costs or difficulties related to the integration of the business of our Company and its acquisition targets may be greater than expected,
 
  legislative or regulatory changes may adversely affect the business in which our Company and its subsidiaries are engaged, including those discussed below in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and
 
  changes may occur in the securities markets.
     The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, was enacted on July 21, 2010. Provisions of the Act address many issues including, but not limited to, capital, interchange fees, compliance and risk management, debit card overdraft fees, the establishment of a new consumer regulator, healthcare, incentive compensation, expanded disclosures and corporate governance. While many of the new regulations are for financial institutions with assets greater than $10 billion, our Company expects the new regulations to reduce our revenues and increase our expenses in the future. Management is currently assessing the impact of this new regulation.
     We have described under the caption “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009 and in other reports that we file with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that we have not identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made.
Overview
     Our Company, Hawthorn Bancshares, Inc., is a community-based, financial institution bank holding company headquartered in Lee’s Summit, Missouri. Our Company was incorporated under the laws of the State of Missouri on October 23, 1992 as Exchange National Bancshares, Inc. and changed its name to Hawthorn Bancshares, Inc. in August 2007. Our Company owns all of the issued and outstanding capital stock of Union State Bancshares, Inc., which in turn owns all of the issued and outstanding capital stock of Hawthorn Bank. Our Company conducts operations primarily through our Bank. Our Bank, a state charted bank, had $1.22 billion in assets at September 30, 2010, and 24 full-service banking offices, including its principal office in Jefferson City, Missouri. Our Bank is committed to providing the most

20


 

up-to-date financial products and services and delivering these products and services to our market area with superior customer service.
     Through our branch network, our Bank provides a broad range of commercial and personal banking services, including certificates of deposit, individual retirement and other time deposit accounts, checking and other demand deposit accounts, interest checking accounts, savings accounts, and money market accounts. We also provide a wide range of lending services, including real estate, commercial, installment, and other consumer loans. Other financial services that we provide include automatic teller machines, trust services, credit related insurance, and safe deposit boxes. The geographic areas in which we provide our products and services include the communities in and surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson and Lee’s Summit, Missouri. The products and services are offered to customers primarily within these geographical areas.
     Our Company’s primary source of revenue is net interest income derived primarily from lending and deposit taking activities. A secondary source of revenue is investment income. Our Company also derives income from trust, brokerage, credit card and mortgage banking activities and service charge income.
Critical Accounting Policies
     The following accounting policies are considered most critical to the understanding of our Company’s financial condition and results of operations. These critical accounting policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to our critical accounting policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such polices affect our reported and expected financial results.
Allowance for Loan Losses
     We have identified the accounting policy related to the allowance for loan losses as critical to the understanding of our Company’s results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Collateral values and historical loss experience are significant inputs and estimates used to measure losses within the reserve methodology. The impact and any associated risks related to these policies on our business operations are discussed in the “Lending and Credit Management” section below.
Income Taxes
     Income taxes are accounted for under the asset / liability method by recognizing the amount of taxes payable or refundable for the current period and deferred tax assets and liabilities for future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in addressing our Company’s future tax consequences of events that have been recognized in the consolidated financial statements or tax returns such as realization of the effects of temporary differences, net operating loss carry forward, and changes in tax laws or interpretations thereof. A valuation allowance is established when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. In this case, our Company would adjust the recorded value of our deferred tax asset, which would result in a direct charge to income tax expense in the period that the determination was made. Likewise, our Company would reverse the valuation allowance when the realization of the deferred tax asset is expected. In addition, our Company is subject to the continuous examination of our tax returns by the Internal Revenue Service and other taxing authorities. Our Company accrues for interest related to income taxes in income tax expense. A total interest benefit recognized for the nine months ended September 30, 2010 and 2009 was $35,000 and $23,000, respectively. As of September 30, 2010 and December 31, 2009, total accrued interest was $113,000 and $94,000, respectively

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SELECTED CONSOLIDATED FINANCIAL DATA
The following table presents selected consolidated financial information for our Company as of and for each of the three and nine month periods ended September 30, 2010 and September 30, 2009. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements of our Company, including the accompanying notes, presented elsewhere herein.
Selected Financial Data
                                 
    Three Months     Nine Months  
    Ended     Ended  
    September 30,     September 30,  
(In thousands, except per share data)   2010     2009     2010     2009  
 
Per Share Data
                               
 
Basic earnings per common share
  $ 0.21     $ 0.32     $ 0.27     $ 0.60  
Diluted earnings per common share
    0.21       0.32       0.27       0.60  
Dividends paid on preferred stock
    378       378       1,130       1,135  
Amortization of discount on preferred stock
    119       119       357       357  
Dividends paid on common stock
    215       455       1,161       2,192  
Book value per common share
                    18.15       17.94  
Market price common stock
                    10.08       9.75  
 
Selected Ratios
                               
 
(Based on average balance sheets)
                               
Return on average total assets
    0.46 %     0.60 %     0.29 %     0.44 %
Return on average common stockholders’ equity
    4.52 %     7.03 %     2.01 %     4.51 %
Average common stockholders’ equity to average total assets
    6.62 %     6.33 %     6.46 %     6.28 %
(Based on end-of-period data)
                               
Efficiency ratio (1)
    68.02 %     69.35 %     72.68 %     72.59 %
Period-end stockholders’ equity to period-end assets
                    6.68 %     6.47 %
Period-end common stockholders’ equity to period-end assets
                    9.05 %     8.75 %
Total risk-based capital ratio
                    17.47       16.50  
Tier 1 risk-based capital ratio
                    14.94       14.01  
Leverage ratio
                    11.61       11.24  
 
 
(1)   Efficiency ratio is calculated as non-interest expense as a percent of revenue. Total revenue includes net interest and non-interest income.

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Results of Operations
Summary
                                                                 
    Three Months     Nine Months  
    Ended September 30,     Ended September 30,  
(Dollars in thousands)   2010     2009     $ Change     % Change     2010     2009     $ Change     % Change  
 
Net interest income
  $ 10,859     $ 10,436     $ 423       4.1 %   $ 32,284     $ 29,984     $ 2,300       7.7 %
Provision for loan losses
    2,450       1,250       1,200       96.0       7,105       4,404       2,701       61.3  
Noninterest income
    2,910       2,600       310       11.9       7,366       8,173       (807 )     (9.9 )
Noninterest expense
    9,366       9,040       326       3.6       28,816       27,696       1,120       4.0  
Income before income taxes
    1,953       2,746       (793 )     (28.9 )     3,729       6,057       (2,328 )     (38.4 )
 
Income taxes
    531       840       (309 )     (36.8 )     1,031       1,889       (858 )     (45.4 )
 
Net income
  $ 1,422     $ 1,906     $ (484 )     (25.4 )%   $ 2,698     $ 4,168     $ (1,470 )     (35.3 )%
 
Less: preferred dividends
    378       378                       1,130       1,135                  
Less: accretion of discount on preferred stock
    119       119                   357       357              
 
Net income available to common shareholders
  $ 925     $ 1,409     $ (484 )     (34.4 )%   $ 1,211     $ 2,676     $ (1,465 )     (54.7 )%
 
     Our Company’s consolidated net income of $1,422,000 for the three months ended September 30, 2010 decreased $484,000, or 25.4%, compared to the three months ended September 30 2009. Our Company recorded preferred stock dividends and accretion on preferred stock of $497,000 in the three months ended September 30, 2010, resulting in $925,000 of net income available to common shareholders, compared to $1,409,000 for the three months ended September 30, 2009. Diluted earnings per share decreased from $0.32 per common share to $0.21 per common share. Results for the three months ended September 30, 2010 were negatively impacted by the $2,450,000 provision for loan losses compared to $1,250,000 for the same period in 2009. Our Company experienced an increase in real estate refinancing activity during the third quarter of 2010 that partially offset the increase in the provision through increasing gains on sale of mortgage loans. For the three months ended September 30, 2010, the annualized return on average assets was 0.46%, the annualized return on average common shareholders’ equity was 4.52%, and the efficiency ratio was 68.0%. Net interest margin increased from 3.57% to 3.81%. Net interest income, on a tax equivalent basis, increased $394,000 or 3.71% from 2009 to 2010.
     Our Company’s consolidated net income of $2,698,000 for the nine months ended September 30, 2010 decreased $1,470,000, or 35.3%, compared to the nine months ended September 30, 2009. Our Company recorded preferred stock dividends and accretion on preferred stock of $1,487,000 in the first nine months of 2010, resulting in $1,211,000 of net income available to common shareholders, compared to $2,676,000 for the first nine months of 2009. Diluted earnings per share decreased from $0.60 per common share to $0.27 per common share. Results for the nine months ended September 30, 2010 were negatively impacted by the $7,105,000 provision for loan losses compared to $4,404,000 for the same period in 2009. Although real estate refinancing activity substantially increased during the third quarter of 2010, the overall decrease in noninterest income was primarily due to lower gain on sales of mortgage loans during the first nine months of 2010 in comparison to the same time period during 2009. For the nine months September 30, 2010, the annualized return on average assets was 0.29%, the annualized return on average common shareholders’ equity was 2.01%, and the efficiency ratio was 72.7%. Net interest margin increased from 3.44% to 3.77%. Net interest income, on a tax equivalent basis, increased $2,242,000 or 7.3% from 2009 to 2010.
     Total assets at September 30, 2010 were $1,215,066,000, compared to $1,236,470,000 at December 31, 2009, a decrease of $21,404,000, or 1.7%.
Net Interest Income
     Net interest income is the largest source of revenue resulting from our Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities.

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Average Balance Sheets
     The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the three month periods ended September 30, 2010 and 2009, respectively.
                                                 
    Three Months Ended September 30,  
    2010     2009  
            Interest     Rate             Interest     Rate  
    Average     Income/     Earned/     Average     Income/     Earned/  
(dollars in thousands)   Balance     Expense(1)     Paid(1)     Balance     Expense(1)     Paid(1)  
 
ASSETS
                                               
Loans (2)(4)
                                               
Commercial
  $ 136,613     $ 1,929       5.60 %   $ 149,059     $ 2,040       5.43 %
Real estate construction — residential
    38,374       516       5.33       43,026       488       4.50  
Real estate construction — commercial
    76,356       764       3.97       76,115       838       4.37  
Real estate mortgage — residential
    213,774       3,174       5.89       277,626       3,556       5.08  
Real estate mortgage — commercial
    439,261       6,266       5.66       421,172       6,786       6.39  
Consumer
    34,583       615       7.06       35,254       659       7.42  
Investment in securities: (3)
                                               
U.S. Treasury
    1,028       5       1.93                    
Government sponsored enterprises
    49,311       301       2.42       48,915       469       3.80  
Asset backed securities
    83,450       742       3.53       65,858       662       3.99  
State and municipal
    31,489       411       5.18       39,527       536       5.38  
Restricted investments
    6,310       34       2.14       8,875       54       2.41  
Federal funds sold
    183                   262              
Interest bearing deposits in other financial institutions
    36,223       28       0.31       14,288       11       0.31  
 
Total interest earning assets
    1,146,955       14,785       5.11       1,179,977       16,099       5.41  
All other assets
    92,794                       89,610                  
Allowance for loan losses
    (12,654 )                     (13,857 )                
 
Total assets
  $ 1,227,095                     $ 1,255,730                  
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
                                               
NOW accounts
  $ 163,142     $ 226       0.55 %   $ 138,149     $ 268       0.77 %
Savings
    53,128       33       0.25       47,199       35       0.29  
Money market
    165,480       253       0.61       178,719       389       0.86  
Time deposits of
                                               
$100,000 and over
    127,889       595       1.85       141,791       950       2.66  
Other time deposits
    318,075       1,758       2.19       347,783       2,532       2.89  
 
Total time deposits
    827,714       2,865       1.37       853,641       4,174       1.94  
Federal funds purchased and securities sold under agreements to repurchase
    32,149       20       0.25       36,416       23       0.25  
Subordinated notes
    49,486       353       2.83       49,486       589       4.72  
Other borrowed money
    68,644       528       3.05       71,603       688       3.81  
 
Total interest bearing liabilities
    977,993       3,766       1.53       1,011,146       5,474       2.15  
Demand deposits
    133,196                       125,092                  
Other liabilities
    6,028                       11,794                  
 
Total liabilities
    1,117,217                       1,148,032                  
Stockholders’ equity
    109,878                       107,698                  
 
Total liabilities and stockholders’ equity
  $ 1,227,095                     $ 1,255,730                  
 
Net interest income (FTE)
          $ 11,019                     $ 10,625          
 
Net interest spread
                    3.58 %                     3.26 %
Net interest margin
                    3.81 %                     3.57 %
 
 
(1)   Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 35%, net of nondeductible interest expense. Such adjustments totaled $161,000 and $189,000 for the three months ended September 30, 2010 and 2009, respectively.
 
(2)   Non-accruing loans are included in the average amounts outstanding.
 
(3)   Average balances based on amortized cost.
 
(4)   Fees and costs on loans are included in interest income.

24


 

                                                 
    Nine Months Ended September 30,  
    2010     2009  
            Interest     Rate             Interest     Rate  
    Average     Income/     Earned/     Average     Income/     Earned/  
(dollars in thousands)   Balance     Expense(1)     Paid(1)     Balance     Expense(1)     Paid(1)  
 
ASSETS
                                               
Loans (2)(4)
                                               
Commercial
  $ 142,976     $ 5,939       5.55 %   $ 150,876     $ 6,117       5.42 %
Real estate construction — residential
    38,775       1,530       5.28       35,592       1,617       6.07  
Real estate construction — commercial
    76,939       2,195       3.81       59,862       2,703       6.04  
Real estate mortgage — residential
    225,074       9,648       5.73       218,075       10,756       6.59  
Real estate mortgage — commercial
    440,990       19,033       5.77       508,884       20,274       5.33  
Consumer
    35,611       2,033       7.63       33,603       1,937       7.71  
Investment in securities: (3)
                                               
U.S. Treasury
    705       10       1.90                    
Government sponsored enterprises
    46,897       946       2.70       49,133       1,419       3.86  
Asset backed securities
    81,807       2,246       3.67       62,077       1,947       4.19  
State and municipal
    33,349       1,344       5.39       39,725       1,646       5.54  
Restricted investments
    6,427       119       2.48       8,875       110       1.66  
Federal funds sold
    174                   308              
Interest bearing deposits in other financial institutions
    34,366       64       0.25       20,551       44       0.29  
 
Total interest earning assets
    1,164,090       45,107       5.18       1,187,561       48,570       5.47  
All other assets
    94,499                       89,073                  
Allowance for loan losses
    (13,796 )                     (13,303 )                
 
Total assets
  $ 1,244,793                     $ 1,263,331                  
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
                                               
NOW accounts
  $ 173,206     $ 758       0.59 %   $ 139,765     $ 902       0.86 %
Savings
    51,749       97       0.25       45,912       106       0.31  
Money market
    167,867       842       0.67       176,562       1,382       1.05  
Time deposits of
                                               
$100,000 and over
    131,825       1,957       1.98       140,658       3,057       2.91  
Other time deposits
    321,827       5,607       2.33       357,403       8,311       3.11  
 
Total time deposits
    846,474       9,261       1.46       860,300       13,758       2.14  
Federal funds purchased and securities sold under agreements to repurchase
    32,963       59       0.24       32,483       64       0.26  
Subordinated notes
    49,486       1,201       3.24       49,486       1,879       5.08  
Other borrowed money
    71,586       1,795       3.35       79,874       2,320       3.88  
 
Total interest bearing liabilities
    1,000,509       12,316       1.65       1,022,143       18,021       2.36  
Demand deposits
    128,617                       123,206                  
Other liabilities
    6,744                       10,606                  
 
Total liabilities
    1,135,870                       1,155,955                  
Stockholders’ equity
    108,923                       107,376                  
 
Total liabilities and stockholders’ equity
  $ 1,244,793                     $ 1,263,331                  
 
Net interest income (FTE)
          $ 32,791                     $ 30,549          
 
Net interest spread
                    3.53 %                     3.11 %
Net interest margin
                    3.77 %                     3.44 %
 
 
(1)   Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 35%, net of nondeductible interest expense. Such adjustments totaled $507,000 and $565,000 for the nine months ended September 30, 2010 and 2009, respectively.
 
(2)   Non-accruing loans are included in the average amounts outstanding.
 
(3)   Average balances based on amortized cost.
 
(4)   Fees and costs on loans are included in interest income.

25


 

Comparison of the three months ended September 30, 2010 and 2009
     Financial results for the third quarter of 2010 compared to 2009 included an increase in net interest income, on a tax equivalent basis of $394,000, or 3.7%. Average interest-earning assets decreased $33,022,000, or 2.8%, to $1,146,955,000 for the three months ended September 30, 2010 compared to $1,179,977,000 for the three months ended September 30, 2009. Average interest bearing liabilities decreased $33,153,000, or 3.3%, to $977,993,000 for the three months ended September 30, 2010 compared to $1,011,146,000 for the three months ended September 30, 2009.
     Average loans outstanding decreased $63,291,000 or 6.3% to $938,961,000 for the three months ended 2010 compared to $1,002,252,000 for the three months ended September 30, 2009. See the Lending and Credit Management section below for further discussion. The following is a summary of the changes in average loan balance by major category:
                                 
    Three Months Ended September 30,  
(Dollars in thousands)   2010     2009     $ Change     % Change  
 
Average loans:
                               
Commercial
  $ 136,613     $ 149,059     $ (12,446 )     (8.3) %
Real estate construction — residential
    38,374       43,026       (4,652 )     (10.8 )
Real estate construction — commercial
    76,356       76,115       241       0.3  
Real estate mortgage — residential
    213,774       277,626       (63,852 )     (23.0 )
Real estate mortgage — commercial
    439,261       421,172       18,089       4.3  
Consumer
    34,583       35,254       (671 )     (1.9 )
 
Total
  $ 938,961     $ 1,002,252     $ (63,291 )     (6.3) %
 
     Average investment securities and federal funds sold increased $10,899,000, or 7.1%, to $165,461,000 for the three months ended September 30, 2010 compared to $154,562,000 for the three months ended September 30, 2009. Average interest bearing deposits increased $21,935,000 to $36,223,000 for the three months ended September 30, 2010 compared to $14,288,000 for the three months ended September 30, 2009. See the Liquidity Management section below for further discussion.
     The overall decrease in average interest bearing liabilities was due to a decrease in time deposits and Federal funds purchased and securities sold under agreements to repurchase. Average time deposits decreased $25,927,000, or 3.0%, to $827,714,000 for the three months ended September 30, 2010 compared to $853,641,000 for the three months ended September 30, 2009. Average Federal funds purchased and securities sold under agreements to repurchase decreased $4,267,000, or 11.7%, to $32,149,000 for the three months ended September 30, 2010 compared to $36,416,000 for the three months ended September 30, 2009. The decrease primarily reflects a decrease in term repurchase agreement average balances.
Comparison of the nine months ended September 30, 2010 and 2009
     Financial results for the nine months ended September 30, 2010 compared to 2009 included an increase in net interest income, on a tax equivalent basis of $2,242,000, or 7.3%. Average interest-earning assets decreased $23,471,000, or 2.0%, to $1,164,090,000 for the nine months ended September 30, 2010 compared to $1,187,561,000 for the nine months ended September 30, 2009. Average interest bearing liabilities decreased $21,634,000, or 2.1%, to $1,000,509,000 for the nine months ended September 30, 2010 compared to $1,022,143,000 for the nine months ended September 30, 2009.

26


 

     Average loans outstanding decreased $46,527,000 or 4.6% to $960,365,000 for the nine months ended 2010 compared to $1,006,892,000 for the nine months ended September 30, 2009. See the Lending and Credit Management section below for further discussion. The following is a summary of the changes in average loan balance by major category:
                                 
    Nine Months Ended September 30,  
(Dollars in thousands)   2010     2009     $ Change     % Change  
 
Average loans:
                               
Commercial
  $ 142,976     $ 150,876     $ (7,900 )     (5.2) %
Real estate construction — residential
    38,775       35,592       3,183       8.9  
Real estate construction — commercial
    76,939       59,862       17,077       28.5  
Real estate mortgage — residential
    225,074       218,075       6,999       3.2  
Real estate mortgage — commercial
    440,990       508,884       (67,894 )     (13.3 )
Consumer
    35,611       33,603       2,008       6.0  
 
Total
  $ 960,365     $ 1,006,892     $ (46,527 )     (4.6) %
 
     Average investment securities and federal funds sold increased $11,689,000, or 7.7%, to $162,932,000 for the nine months ended September 30, 2010 compared to $151,243,000 for the nine months ended September 30, 2009. Average interest bearing deposits increased $13,815,000 to $34,366,000 for the nine months ended September 30, 2010 compared to $20,551,000 for the nine months ended September 30, 2009. See the Liquidity Management section below for further discussion.
     The overall decrease in average interest bearing liabilities was due to a decrease in time deposits and other borrowed money. Average time deposits decreased $13,826,000, or 1.6%, to $846,474,000 for the nine months ended September 30, 2010 compared to $860,300,000 for the nine months ended September 30, 2009. Average other borrowed money decreased $8,288,000, or 10.4%, to $71,586,000 for 2010 compared to $79,874,000 for 2009. The decrease in 2010 reflects a net decrease in Federal Home Loan Bank advances.

27


 

Rate and volume analysis
     The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates for the three and nine months ended September 30, 2010 compared to the three and nine months ended September 30, 2009. The change in interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.
                                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2010 vs. 2009     2010 vs. 2009  
            Change due to             Change due to  
    Total     Average     Average     Total     Average     Average  
(Dollars In thousands)   Change     Volume     Rate     Change     Volume     Rate  
 
Interest income on a fully taxable equivalent basis:
                                               
Loans: (1) (3)
                                               
Commercial
  $ (111 )   $ (170 )   $ 59     $ (178 )   $ (320 )   $ 142  
Real estate construction — residential
    28       (57 )     85       (87 )     137       (224 )
Real estate construction — commercial
    (74 )     3       (77 )     (508 )     647       (1,155 )
Real estate mortgage — residential
    (382 )     (895 )     513       (1,108 )     336       (1,444 )
Real estate mortgage — commercial
    (520 )     282       (802 )     (1,241 )     (2,844 )     1,603  
Consumer
    (44 )     (13 )     (31 )     96       115       (19 )
Investment securities:
                                               
U.S. Treasury
    5             5       10             10  
Government sponsored entities
    (168 )     4       (172 )     (473 )     (62 )     (411 )
Asset backed securities
    80       163       (83 )     299       564       (265 )
State and municipal(2)
    (125 )     (106 )     (19 )     (302 )     (258 )     (44 )
Restricted investments
    (20 )     (15 )     (5 )     9       (35 )     44  
Federal funds sold
                                   
Interest bearing deposits in other financial institutions
    17       17             20       27       (7 )
 
Total interest income
    (1,314 )     (787 )     (527 )     (3,463 )     (1,693 )     (1,770 )
 
Interest expense:
                                               
NOW accounts
    (42 )     43       (85 )     (144 )     186       (330 )
Savings
    (2 )     4       (6 )     (9 )     12       (21 )
Money market
    (136 )     (27 )     (109 )     (540 )     (65 )     (475 )
Time deposits of 100,000 and over
    (355 )     (86 )     (269 )     (1,100 )     (182 )     (918 )
Other time deposits
    (774 )     (202 )     (572 )     (2,704 )     (768 )     (1,936 )
Federal funds purchased and securities sold under agreements to repurchase
    (3 )     (3 )           (5 )     1       (6 )
Subordinated notes
    (236 )           (236 )     (678 )           (678 )
Other borrowed money
    (160 )     (27 )     (133 )     (525 )     (227 )     (298 )
 
Total interest expense
    (1,708 )     (298 )     (1,410 )     (5,705 )     (1,043 )     (4,662 )
 
Net interest income on a fully taxable equivalent basis
  $ 394     $ (489 )   $ 883     $ 2,242     $ (650 )   $ 2,892  
 
 
(1)   Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 35%, net of nondeductible interest expense. Such adjustments totaled $161,000 and $507,000, and $189,000 and $565,000 for the three and nine months ended September 30, 2010 and 2009, respectively.
 
(2)   Non-accruing loans are included in the average amounts outstanding.
 
(3)   Fees and costs on loans are included in interest income.
     Net interest income on a fully taxable equivalent basis increased $394,000, or 3.7%, to $11,019,000 for the three months ended September 30, 2010 compared to $10,625,000 for the three months ended September 30, 2009. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) increased from 3.57% for the three months ended September 30, 2009 to 3.81% for the three months ended September 30, 2010. This increase is primarily the result of a decrease in average earning liabilities. Our Company’s net interest spread increased from 3.26% during the three months ended September 30, 2009 to 3.58% during the same time period in 2010. While our Company was able to decrease the rate paid on interest bearing liabilities to 1.53% during the three months ended September 30, 2010 from 2.15% during the same time period in 2009, this decrease was partially offset by a decrease in the rates earned on interest bearing assets from 5.41% in 2009 to 5.11% in 2010.

28


 

     Net interest income on a fully taxable equivalent basis increased $2,242,000, or 7.3%, to $32,791,000 for the nine months ended September 30, 2010 compared to $30,549,000 for the nine months ended September 30, 2009. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) increased from 3.44% for the nine months ended September 30, 2009 to 3.77% for the nine months ended September 30, 2010. This increase is primarily the result of a decrease in average earning liabilities. Our Company’s net interest spread increased from 3.11% during the nine months ended September 30, 2009 to 3.53% during the same time period in 2010. While our Company was able to decrease the rate paid on interest bearing liabilities to 1.65% during the nine months ended September 30, 2010 from 2.36% during the same time period in 2009, this decrease was partially offset by a decrease in the rates earned on interest bearing assets from 5.47% in 2009 to 5.18% in 2010.
Non-interest Income and Expense
Non-interest income
                                                                 
    Three Months     Nine Months  
    Ended September 30,     Ended September 30,  
(Dollars in thousands)   2010     2009     $ Change     % Change     2010     2009     $ Change     % Change  
 
Non-interest Income
                                                               
Service charges on deposit
  $ 1,427     $ 1,547     $ (120 )     (7.8 )%     $4,150     $ 4,380     $ (230 )     (5.3) %
Trust department income
    187       238       (51 )     (21.4 )     567       624       (57 )     (9.1 )
Gain on sales of mortgage loans
    1,011       489       522       106.7       1,533       2,437       (904 )     (37.1 )
Other
    285       326       (41 )     (12.6 )     1,116       732       384       52.5  
 
Total non-interest income
  $ 2,910     $ 2,600     $ 310       11.9 %   $ 7,366     $ 8,173     $ (807 )     (9.9) %
 
Non-interest income as a % of total revenue*
    21.1 %     19.9 %                     18.6 %     21.4 %                
Total revenue per full time equivalent employee
  $ 40.1     $ 37.9                     $ 115.6     $ 110.9                  
 
 
*   Total revenue is calculated as net interest income plus non-interest income
Three Months Ended September 30, 2010 and 2009
     Noninterest income for the three months ended September 30, 2010 was $2,910,000 compared to $2,600,000 for the three months ended September 30, 2009, resulting in a $310,000, or 11.9%, increase. The increase was primarily the result of a $522,000 increase in the gains on sales of mortgage loans due to an increase in refinancing activity during the third quarter of 2010 compared to the same time period in 2009.
Nine Months Ended September 30, 2010 and 2009
     Noninterest income for the nine months ended September 30, 2010 was $7,366,000 compared to $8,173,000 for the nine months ended September 30, 2009, resulting in an $807,000, or 9.9%, decrease. Although third quarter experienced a substantial increase in real estate refinancing activity, the decrease in year to date noninterest income was primarily the result of a $904,000 decrease in the gains on sales of mortgage loans in comparison to 2009. Partially offsetting this decrease, other income increased $384,000, or 52.5%, to $1,116,000 compared to the prior period. This was primarily due to a $212,000 increase in credit card income, of which $167,000 was due to a nonmaterial correction and an $186,000 increase in real estate servicing fees.

29


 

Non-interest expense
                                                                 
    Three Months     Nine Months  
    Ended September 30,     Ended September 30,  
(Dollars in thousands)   2010     2009     $ Change     % Change     2010     2009     $ Change     % Change  
                                                                 
Non-interest Expense
                                                               
Salary expense
  $ 3,369     $ 3,400     $ (31 )     (0.9 )%   $ 10,440     $ 10,191     $ 249       2.4 %
Employee benefits
    887       1,054       (167 )     (15.8 )     3,024       3,213       (189 )     (5.9 )
Occupancy expense, net
    655       600       55       9.2       1,881       1,763       118       6.7  
Furniture and equipment expense
    473       507       (34 )     (6.7 )     1,499       1,794       (295 )     (16.4 )
FDIC insurance assessment
    443       422       21       5.0       1,288       2,086       (798 )     (38.3 )
Legal, examination, and professional fees
    349       312       37       11.9       932       985       (53 )     (5.4 )
Advertising and promotion
    311       301       10       3.3       886       901       (15 )     (1.7 )
Postage, printing, and supplies
    300       271       29       10.7       875       834       41       4.9  
Processing expense
    854       845       9       1.1       2,561       2,538       23       0.9  
Other real estate expense
    882       240       642       267.5       2,895       575       2,320       403.5  
Other
    843       1,088       (245 )     (22.5 )     2,535       2,816       (281 )     (10.0 )
                                                                 
Total non-interest expense
  $ 9,366     $ 9,040     $ 326       3.6 %   $ 28,816     $ 27,696     $ 1,120       4.0 %
                                                                 
Efficiency ratio
    68.0 %     69.3 %                     72.7 %     72.6 %                
Salaries and benefits as a % of total non-interest expense
    45.4 %     49.3 %                     46.7 %     48.4 %                
Number of full-time equivalent employees
                                    343       344                  
                                                                 
Three Months Ended September 30, 2010 and 2009
     Noninterest expense for the three months ended September 30, 2010 was $9,366,000 compared to $9,040,000 for the three months ended September 30, 2009 resulting in a $326,000, or 3.6%, increase. Other real estate expense increased $642,000, or 267.5%, partially offset by a decrease in employee benefits of $167,000, or 15.8%, and a decrease in other expenses of $245,000, or 22.5%. The increase in other real estate expense reflects a $644,000 increase in impairment charges and net losses on sales of foreclosed property during the third quarter of 2010 compared to the third quarter of 2009. The decrease in employee benefits expense was primarily due to a $171,000 decrease in our Company’s profit sharing accrual. The decrease in third quarters 2010 other expenses is primarily a result a $178,000 donation of a foreclosed property during September of 2009.
Nine Months Ended September 30, 2010 and 2009
     Noninterest expense for the nine months ended September 30, 2010 was $28,816,000 compared to $27,696,000 for the nine months ended September 30, 2009 resulting in a $1,120,000, or 4.0%, increase. Other real estate expense increased $2,320,000, or 403.5%, partially offset by a decrease in furniture and equipment expenses of $295,000, or 16.4%, and a decrease in Federal Deposit Insurance Corporation (FDIC) insurance assessment of $798,000, or 38.3%. The increase in other real estate expense reflects expenses incurred on the increase in our Company’s foreclosed property during 2010. Impairment charges and net losses on sales of foreclosed property increased $1,849,000 during 2010 compared to 2009. Expenses to maintain and prepare these properties for sale also increased $500,000 during 2010. The decrease in furniture and equipment expense primarily was due to an $186,000 net loss on the sale of one of our Company’s branch buildings in September of 2009. The decrease in the FDIC insurance assessment is a result of a decrease in the estimated expense accrued during 2010 in comparison to 2009 and an increase in special assessments during 2009.
Income Taxes
     Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 27.2% for the three months ended September 30, 2010 compared to 30.6% for the three months ended September 30, 2009. The effective tax rate during the third quarter of 2010 reflects the increase in tax-exempt income as a percentage of total taxable income.

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     Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 27.6% for the nine months ended September 30, 2010 compared to 31.2% for the nine months ended September 30, 2009. The effective tax rate during for the nine months ended September 30, 2010 reflects the increase in tax-exempt income as a percentage of total taxable income.
Lending and Credit Management
     Interest earned on the loan portfolio is a primary source of interest income for our Company. Net loans represented 75.7% of total assets as of September 30, 2010 compared to 79.0% as of December 31, 2009.
     Lending activities are conducted pursuant to an established loan policy approved by our Bank’s Board of Directors. The Bank’s credit review process is comprised of a regional loan committee with an established approval limit. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank.
     The following table shows the composition of the loan portfolio by major category and each category as a percentage of the total portfolio as of the dates indicated.
                                 
    September 30,     December 31,  
(In thousands)   2010     2009  
    Amount     %     Amount     %  
Commercial, financial, and agricultural
  $ 132,920       14.2 %   $ 151,399       15.3 %
Real estate construction — residential
    38,229       4.1       38,841       3.9  
Real estate construction — commercial
    76,587       8.2       77,937       7.9  
Real estate mortgage — residential
    217,802       23.3       232,332       23.4  
Real estate mortgage — commercial
    433,930       46.5       453,975       45.8  
Installment loans to individuals
    33,822       3.6       36,966       3.7  
Deferred fees
    166       0.0       164       0.0  
                                 
Total loans
  $ 933,456       100.0 %   $ 991,614       100.0 %
                                 
     Our Company’s loan portfolio decreased $58,158,000, or 5.9%, from December 31, 2009 to September 30, 2010. This decrease was primarily a result of a decrease in commercial loans of $18,480,000, or 12.2%, a decrease in real estate mortgage — residential loans of $14,530,000, or 6.3%, a decrease in real estate mortgage — commercial loans of $20,045,000, or 4.4%, and a decrease in individual consumer loans of $3,144,000, or 8.5%. The decrease in commercial loans and real estate mortgage loans primarily reflects the payoff of three large commercial credits and two large real estate mortgage loans. The decrease in individual consumer loans reflects the payoff of one large consumer loan which was secured by a Bank certificate of deposit. Also contributing to the decrease in total loans were gross charge-offs of $8,466,000 and $12,665,000 of assets transferred from loans to other real estate owned and repossessed assets. During the current down-turn in the economy, management continues to focus on the improvement of asset quality. Management has tightened underwriting standards and is focused on lending to credit worthy borrowers with the capacity to service the debts. Where appropriate, management actively works with existing borrowers to modify loan terms and conditions in order to assist the borrowers in servicing their debt obligations to our Company. The decrease in lending activities in the real estate construction market also reflects the slow down in the housing industry and residential construction industry as well as foreclosures on various residential construction properties. Construction lending will continue to be closely monitored.
     Our Company does not extend credit to sub-prime residential real estate customers. While much publicity has been directed at this market during recent years, our Company extends credit to its local community market through traditional mortgage products.
     Our Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers, but are not funded until our Company has a non-recourse purchase commitment from the secondary market at a predetermined price. At September 30, 2010 our Company was servicing approximately $285,888,000 of loans sold to the secondary market.

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     Mortgage loans retained in our Company’s portfolio generally include provisions for rate adjustments at one to three year intervals. Commercial loans and real estate construction loans generally have maturities of less than one year. Installment loans to individuals are primarily fixed rate loans with maturities from one to five years.
     Management along with senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2,000,000 in aggregate and all adversely classified credits identified by management as containing more than usual risk are reviewed. In addition, loans below the above scope are reviewed on a sample basis. On a monthly basis, the senior loan committee reviews and reports to the Board of Directors past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impaired. Management follows the guidance provided in the FASB’s ASC Topic 310, Accounting by Creditors for Impairment of a Loan, in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, allowances are estimated based on the fair value as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration. Management believes, but there can be no assurance, that these procedures keep management informed of possible problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered adequate by management for probable losses inherent in the loan portfolio.
Provision and Allowance for Loan Losses
     The provision for loan losses increased $2,701,000 or 61.3% to $7,105,000 for the nine months ended September 30, 2010 compared to $4,404,000 for the nine months ended September 30, 2009. The current economy has contributed to the deterioration of collateral values. Our Company has taken an active approach to obtain current appraisals and has adjusted the provision to reflect the amounts management determined necessary to maintain the allowance for loan losses at a level adequate to cover probable losses in the loan portfolio. However, due to charge offs taken during the first nine months of 2010, the allowance for loan losses decreased to $13,954,000 or 1.5% of loans outstanding at September 30, 2010 compared to $14,797,000 or 1.5% of loans outstanding at December 31, 2009. The allowance for loan losses expressed as a percentage of nonperforming loans was 21.1% at September 30, 2010 and 34.9% at December 31, 2009.
The following table summarizes loan loss experience for the periods indicated:
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
(Dollars in thousands)   2010   2009     2010     2009  
                                 
Provision for loan losses
  $ 2,450     $ 1,250     $ 7,105     $ 4,404  
                                 
Net loan charge-offs:
                               
Commercial, financial, and agricultural
    333       157       1,437       417  
Real estate construction — residential
    (1 )     427       258       988  
Real estate construction — commercial
                101       289  
Real estate mortgage — residential
    306       256       3,625       948  
Real estate mortgage — commercial
    37       115       2,374       321  
Installment loans to individuals
    53       72       153       180  
                                 
Total net loan charge-offs
  $ 728     $ 1,027     $ 7,948     $ 3,143  
                                 
     As shown in the table above, our Company experienced net loan charge-offs of $7,948,000 during the first nine months of 2010 and $3,143,000 during the first nine months of 2009. Net charge offs on commercial, financial, and agricultural loans increased $1,020,000 from September 30, 2009 to September 30, 2010, and was primarily due to three write-downs taken on two loans to reflect current collateral values. Net charge offs on real estate mortgage — residential properties increased $2,677,000 from September 30, 2009 to September 30, 2010 and was primarily due to write-downs taken on foreclosed properties, from two significant customer relationships, to reflect current collateral values. Net charge offs on real estate mortgage — commercial properties increased $2,053,000 from September 30, 2009 to September 30, 2010 and was primarily due to write-downs taken on five loans to reflect current collateral values. The

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ratio of annualized total net loan charge-offs to total average loans was 0.83% at September 30, 2009 compared to 0.31% at September 30, 2010.
     Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing interest, and restructured troubled loans totaled $65,879,000 or 7.06% of total loans at September 30, 2010 compared to $42,347,000 or 4.27% of total loans at December 31, 2009.
The following table summarizes our Company’s nonperforming assets at the dates indicated:
                 
    September 30,     December 31,  
(Dollars in thousands)   2010     2009  
                 
Nonaccrual loans:
               
Commercial, financial, and agricultural
  $ 1,854     $ 2,067  
Real estate construction — residential
    3,086       2,678  
Real estate construction — commercial
    22,580       9,277  
Real estate mortgage — residential
    6,457       6,692  
Real estate mortgage — commercial
    15,769       13,161  
Installment loans to individuals
    101       279  
                 
Total nonaccrual loans
    49,847       34,154  
                 
Loans contractually past — due 90 days or more and still accruing:
               
Commercial, financial, and agricultural
          2  
Real estate mortgage — residential
    73        
Installment loans to individuals
    1        
                 
Total loans contractually past -due 90 days or more and still accruing
    74       2  
Troubled debt restructured loans
    15,958       8,191  
                 
Total nonperforming loans
    65,879       42,347  
Other real estate and repossessions
    10,012       8,491  
                 
Total nonperforming assets
  $ 75,891     $ 50,838  
                 
Loans
  $ 933,456     $ 991,614  
Allowance for loan losses to loans
    1.49 %     1.49 %
Nonperforming loans to loans
    7.06 %     4.27 %
Allowance for loan losses to nonperforming loans
    21.18 %     34.94 %
Nonperforming assets to loans and foreclosed assets
    8.04 %     5.08 %
                 
     It is our Company’s policy to discontinue the accrual of interest income on loans when the full collection of principal or interest is in doubt, or when the payment of principal or interest has become contractually 90 days past due unless the obligation is both well secured and in the process of collection. Subsequent interest payments received on such loans are applied to principal if any doubt exists as to the collectibles of such principal; otherwise, such receipts are recorded as interest income. Interest on nonaccrual loans, which would have been recorded under the original terms of the loans, was approximately $1,874,000 and $1,152,000 for the nine months ended September 30, 2010 and 2009, respectively. Approximately $11,000 and $42,000 was recorded as interest income on such loans for the nine months ended September 30, 2010 and 2009, respectively.
     Total non-accrual loans at September 30, 2010 increased $15,693,000 from December 31, 2009. The increase resulted primarily from an increase of $13,303,000 in real estate construction - commercial non-accrual loans. This increase primarily represents four commercial customers with balances totaling $15,886,000. Although our non-accrual loans significantly increased from $34,154,000 at December 31, 2009 to $49,847,000 at September 30, 2010, total impaired loans decreased $7,384,000.
     Loans past due 90 days and still accruing interest increased $72,000 from December 31, 2009 to September 30, 2010. Foreclosed real estate and other repossessions increased $1,521,000 to $10,012,000. At September 30, 2010, loans classified as troubled debt restructured loans (TDR) totaled $22,457,000, of which $6,499,000 was on non-accrual status and $15,958,000 was on accrual status. At December 31, 2009, loans classified as TDR totaled $11,233,000, of which $3,042,000 was on non-accrual status and $8,191,000 was on accrual status. The increase in TDR loans is primarily reflected by one large hotel credit of $11,091,000.

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     The ratio of nonperforming loans to loans increased from 4.27% at December 31, 2009 to 7.06% at September 30, 2010. Our Company has experienced an increase in its loan delinquencies much like the rest of the banking industry as current economic conditions negatively impact our borrowers’ ability to keep their debt payments current.
     The increase in the levels of charge offs has contributed to the decrease in the ratio of allowance for loan losses to nonperforming loans from 41.11% at September 30, 2009 to 34.94% at December 31, 2009, and to 21.18% at September 30, 2010. Management believes that based on detailed analysis of each nonperforming credit and the value of any associated collateral that the allowance for loan losses at September 30, 2010 is sufficient to cover probable losses in the nonperforming loans.
     The fair value of impaired loans are generally based on market prices for loans with similar collateral determined through independent appraisals, the fair value of the collateral for a collateral-dependent loan, or by discounting the total expected future cash flows. Once the fair value of collateral has been determined and any impairment amount calculated, a specific reserve allocation is made. At September 30, 2010, $7,798,000 of our Company’s allowance for loan losses was allocated to impaired loans totaling approximately $66,483,000 compared to $6,415,000 of our Company’s allowance for loan losses was allocated to impaired loans totaling approximately $73,877,000 at December 31, 2009. Based on detailed analysis of all impaired loans, management has determined that $31,767,000, or 48%, of impaired loans require no reserve allocation at September 30, 2010 compared to $47,572,000, or 64%, at December 31, 2009. Management believes the excess value in the collateral was sufficient at September 30, and December 31, and these loans did not require additional reserves.
     In addition to nonaccrual loans and TDR’s at September 30, 2010 included in the table above, which were considered impaired, management has identified additional loans totaling approximately $678,000 which were not included in the table above but are considered by management to be impaired compared to $31,522,000 at December 31, 2009. Management has allocated $524,000 of reserves for these credits at September 31, 2010.
     As of September 30, 2010 and December 31, 2009 approximately $18,640,000 and $15,944,000, respectively, of loans not included in the table above have been classified by management as having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. The $2,696,000 increase in classified loans is the result of several borrowers who have experienced cash flow problems as well as some deterioration in collateral value. Management elected to allocate non-specific reserves to these credits based upon the inherent risk present.
     The allowance for loan losses is available to absorb probable loan losses regardless of the category of loan to be charged off. The allowance for loan losses consists of asset-specific reserves, and reserves based on expected loss estimates and unallocated reserves.
     The asset-specific component applies to loans evaluated individually for impairment and is based on management’s best estimate of proceeds from liquidating collateral. The actual timing and amount of repayments and the ultimate realizable value of the collateral may differ from management’s estimate.
     The expected loss component is generally determined by applying percentages to pools of loans by asset type. These percentages are determined by using a combination of average historical loss percentages and migration analysis. These expected loss estimates are sensitive to changes in delinquency status, realizable value of collateral, and other risk factors.
     The unallocated portion of the allowance is based on management’s evaluation of conditions that are not directly reflected in the determination of the asset-specific component and the expected loss component discussed above. The evaluation of inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they may not be identified with specific problem credits or portfolio segments. Conditions evaluated in connection with the unallocated portion of the allowance include general economic and business conditions affecting our key lending areas, credit quality trends (including trends in substandard loans expected to result from existing conditions), collateral values, specific industry conditions within portfolio segments, bank regulatory examination results, and findings of our internal loan review department.
     The underlying assumptions, estimates and assessments used by management to determine these components are continually evaluated and updated to reflect management’s current view of overall economic conditions and relevant factors impacting credit quality and inherent losses. Changes in such estimates could significantly impact the allowance and provision for credit losses. Our Company could experience credit losses that are different from the current estimates made by management.

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The following table is a summary of the allocation of the allowance for loan losses as of the dates indicated:
                 
    September 30,     December 31,  
(Dollars in thousands)   2010     2009  
                 
Allocation of allowance for loan losses at end of period:
               
Commercial, financial, and agricultural
  $ 2,123     $ 2,773  
Real estate construction — residential
    995       348  
Real estate construction — commercial
    3,875       1,740  
Real estate mortgage — residential
    2,700       3,488  
Real estate mortgage — commercial
    3,259       4,693  
Installment loans to individuals
    262       380  
Unallocated
    740       1,375  
                 
Total
  $ 13,954     $ 14,797  
                 
     At September 30, 2010, management allocated $13,214,000 of the $13,954,000 total allowance for loan losses to specific loans and loan categories and $740,000 was unallocated. At December 31, 2009, management allocated $13,422,000 of the $14,497,000 total allowance for loan losses to specific loans and loan categories and $1,375,000 was unallocated. The decrease in the portion of the allowance for loan losses related to non asset-specific reserves is the result of management analyzing and assessing this portion of the allowance for loan losses on a more detailed level by homogeneous loan categories for loans not considered impaired. Such analysis measured reserve requirements based on historical loss experiences of loans in those individual categories and therefore provided a more robust reserve methodology. Such reserve methodology considers the loss experience for certain types of loans and loan grades for the past nine quarters. Given the enhancements to the methodology for historical loss experience, the unallocated reserves for certain qualitative factors have been reduced accordingly. Management considers the non asset-specific portion of the allowance for loan losses at September 30, 2010 to be adequate as part of the overall reserves to cover losses in the loan portfolio not identified by specific loss methodologies.
     Our Company does not lend funds for the type of transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, our Company does not have any concentrations of loans exceeding 10% of total loans which are not otherwise disclosed in the loan portfolio composition table. Our Company does not have any interest-earning assets which would have been included in nonaccrual, past due, or restructured loans if such assets were loans.
Financial Condition
     Total assets decreased $21,404,000 or 1.7% to $1,215,066,000 at September 30, 2010 compared to $1,236,470,000 at December 31, 2009. Earning assets at September 30, 2010 were $1,140,114,000 and consisted of 81.9% in loans and 14.5% in available for sale investment securities, compared to 85.9% and 13.3%, respectively at December 31, 2009. Total liabilities decreased $23,554,000 or 2.1% to $1,105,145,000 compared to $1,128,699,000 at December 31, 2009. Stockholders’ equity increased $2,150,000 or 2.0% to $109,921,000 compared to $107,771,000 at December 31, 2009.
     As described in further detail in the “Lending and Credit Management” section above, during the first nine months of 2010, total period end loans decreased $58,158,000 to $933,456,000 at September 30, 2010 compared to $991,614,000 at December 31, 2009. This decrease was primarily the result of an $18,480,000 decrease in commercial loans, an $14,530,000 decrease in real estate - residential loans, a $20,045,000 decrease in real estate — commercial loans, and a $3,144,000 decrease in consumer loans.
     Investment in debt securities classified as available-for-sale, excluding fair value adjustments, increased $9,960,000 or 6.6% to $160,569,000 at September 30, 2010 compared to $150,609,000 at December 31, 2009. The net increase primarily consisted of an increase in mortgage-backed securities of $14,851,000, an increase in federal agency securities of $2,225,000, partially offset by an $8,116,000 reduction in municipal obligations.
     Total deposits decreased $5,749,000 or 0.6% to $950,574,000 at September 30, 2010 compared to $956,323,000 at December 31, 2009. The increase is primarily a result of an decrease in public fund deposits.

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     Federal funds purchased and securities sold under agreements to repurchase decreased $5,185,000 or 14.2% to $31,460,000 at September 30, 2010 compared to $36,645,000 at December 31, 2009. The decrease mostly consisted of a $4,980,000 decrease in federal funds purchased compared to December 31, 2009.
     Other borrowed money decreased $12,149,000 or 15.3% to $67,168,000 at September 30, 2010 compared to $79,317,000 at December 31, 2009. The decrease reflects the net repayment of Federal Home Loan Bank advances.
     Stockholders’ equity increased $2,150,000 or 2.0% to $109,921,000 at September 30, 2010 compared to $107,771,000 at December 31, 2009. The increase in stockholders’ equity reflects net income of $2,698,000 less cash dividends declared of $2,047,000, a $1,394,000 change in unrealized holding gains, net of taxes, on investment in debt securities available-for-sale, $36,000 amortization of prior service cost for defined benefit plan, and a $68,000 increase, net of taxes, related to stock option compensation expense.
Liquidity and Capital Resources
Liquidity Management
     The role of liquidity management is to ensure funds are available to meet depositors’ withdrawal and borrowers’ credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet the demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by our Company, management prefers to focus on transaction accounts and full service relationships with customers. Management believes it has the ability to increase deposits at any time by offering rates slightly higher than the market rate.
     Our Company’s Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for our Company’s liquidity position and profile. A combination of daily, weekly and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital and exposure to contingent draws on our Company’s liquidity. No material changes in our Company’s liquidity or capital resources have occurred since September 30, 2010.
     Our Company has a number of sources of funds to meet liquidity needs on a daily basis. Our Company’s most liquid assets are comprised of available for sale marketable investment securities, federal funds sold, and securities purchased under agreements to resell, and excess reserves held at the Federal Reserve as follows:
                 
    September 30,     December 31,  
(dollars in thousands)   2010     2009  
                 
Liquid assets:
               
Federal funds sold
  $ 126     $ 90  
Federal Reserve — excess reserves
    34,680       2,216  
Available for sale investments securities
    165,173       152,927  
                 
Total
  $ 199,979     $ 155,233  
                 
     Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available for sale investment portfolio was $165,173,000 at September 30, 2010 and included an unrealized net gain of $4,604,000. The portfolio includes maturities of approximately $7,501,000 over the next twelve months, which offer resources to meet either new loan demand or reductions in our Company’s deposit base. Our Company pledges portions of its investment securities portfolio to secure public fund deposits, securities sold under agreements to repurchase, trust funds, and borrowing capacity at the Federal Reserve Bank.

36


 

At September 30, 2010, total investment securities pledged for these purposes were as follows:
         
    September 30,  
(dollars in thousands)   2010  
 
Investment securities pledged for the purpose of securing:
       
Federal Reserve Bank borrowings
  $ 3,306  
Repurchase agreements
    40,589  
Other Deposits
    97,578  
 
Total pledged, at fair value
  $ 141,473  
 
     At September 30, 2010, our Company’s unpledged securities in the available for sale portfolio totaled approximately $23,699,000.
     Liquidity is also available from our Company’s base of core customer deposits, defined as demand, interest checking, savings, and money market deposit accounts. At September 30, 2010, such deposits totaled $507,060,000 and represented 53.3% of our Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of our Company through long lasting relationships. Time deposits and certificates of deposit of $100,000 and over totaled $443,514,000 at September 30, 2010. These accounts are normally considered more volatile and higher costing representing 46.7% of total deposits at September 30, 2010.
                 
    September 30,     December 31,  
(dollars in thousands)   2010     2009  
 
Core deposit base:
               
Non-interest bearing demand
  $ 143,143     $ 135,018  
Interest checking
    148,710       139,624  
Savings and money market
    215,207       214,660  
 
Total
  $ 507,060     $ 489,302  
 
     Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. Our Company’s outside borrowings are comprised of federal funds purchased, securities sold under agreements to repurchase, FHLB advances, and subordinated notes as follows:
                 
    September 30,     December 31,  
(dollars in thousands)   2010     2009  
 
Borrowings:
               
Federal funds purchased
  $     $ 4,980  
Securities sold under agreements to repurchase
    31,460       31,665  
FHLB advances
    67,168       79,317  
Subordinated notes
    49,486       49,486  
 
Total
  $ 148,114     $ 165,448  
 
     Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which our Company maintains approved credit lines. As of September 30, 2010, under agreements with these unaffiliated banks, the Bank may borrow up to $35,684,000 in federal funds on an unsecured basis and $8,905,000 on a secured basis. There were no federal funds purchased outstanding at September 30, 2010. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of our Company’s investment portfolio. At September 30, 2010 there was $31,460,000 in repurchase agreements. Our Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at the current quarter end. The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB). As a member of the FHLB, the Bank has access to credit products of the FHLB. As of September 30, 2010, the Bank had $67,168,000 in outstanding borrowings with the FHLB. In addition, our Company has $49,486,000 in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.

37


 

     Our Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from these entities. Based on the type and value of collateral pledged, our Company may draw advances against this collateral. The following table reflects collateral value of assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to our Company at September 30, 2010:
                         
            September 30, 2010        
(dollars in thousands)   FHLB     Federal Reserve     Other  
 
Collateral value pledged
    $273,909     $ 3,306     $ 7,573  
Letters of Credit
    (96 )                
Advances outstanding
    (67,168 )            
 
Total
  $ 206,645     $ 3,306     $ 7,573  
 
Sources and Uses of Funds
     Cash and cash equivalents were $52,226,000 at September 30, 2010 compared to $24,666,000 at December 31, 2009. The $27,560,000 increase resulted from changes in the various cash flows produced by operating, investing, and financing activities of our Company, as shown in the accompanying consolidated statements of cash flows for the nine months ended September 30, 2010. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $11,138,000 during the first nine months of 2010. Investing activities, consisting mainly of purchases, sales and maturities of available for sale securities, and changes in the level of the loan portfolio, provided cash of $41,801,000. The cash outflow primarily consisted of purchases of $154,205,000 of investment securities offset by a $42,321,000 decrease in the loan portfolio, $143,790,000 in proceeds from maturities, calls, and pay-downs of investment securities, and $9,185,000 in proceeds from sales of other real estate owned and repossessions. Financing activities used total cash of $25,380,000, resulting primarily from $22,149,000 repayments of FHLB advances, $23,507,000 decrease in time deposits, $2,296,000 in dividends paid, and $5,185,000 decrease in federal funds purchased and securities sold under agreements to repurchase, partially offset by a $17,758,000 increase in interest-bearing transaction accounts. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2010.
     During 2008, liquidity risk became a heightened concern affecting the general banking industry. Because of the uncertainty in the economy, our Company decided to participate in the U.S. Treasury Department’s Capital Purchase Program (CPP), a voluntary program that provides capital to financially healthy banks. During 2009, our Company elected to cease market purchases of treasury stock and preserve its cash and capital position.
     In the normal course of business, our Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through our Company’s various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of our Company’s liquidity. Our Company had $116,219,000 in unused loan commitments and standby letters of credit as of September 30, 2010. While this commitment level would be difficult to fund given our Company’s current liquidity resources, we know that the nature of these commitments are such that the likelihood of such a funding demand is very low.
     Our Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. Our Company’s ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its common and preferred shareholders. During the nine months ended September 30, 2010 and 2009, our Company paid cash dividends to its common and preferred shareholders totaling $2,296,000 and $3,184,000, respectively. A large portion of our Company’s liquidity is obtained from the Bank in the form of dividends. For the first nine months ended September 30, 2010, the Bank declared and paid dividends of $2,700,000. At September 30, 2010 and December 31, 2009, our Company had cash and cash equivalents totaling $11,640,000 and $14,738,000 respectively.

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Regulatory Capital
     Our Company and our Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on our Company’s consolidated financial statements. Under capital adequacy guidelines, our Company and our Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification of our Company and our Bank are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors.
     Quantitative measures established by regulations to ensure capital adequacy require our Company and our Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital to risk-weighted assets, and of Tier I capital to adjusted-average assets. Management believes, as of September 30, 2010 and December 31, 2009, our Company and our Bank each meet all capital adequacy requirements to which they are subject.
     The following table summarizes our Company’s risk-based capital and leverage ratios at the dates indicated.
                                                 
                    Minimum     Well-Capitalized  
    Actual     Capital requirements     Capital Requirements  
    Amount     Ratio     Amount     Ratio     Amount     Ratio  
 
September 30, 2010
                                               
Total capital (to risk-weighted assets):
                                               
Company
  $ 166,430       17.47 %   $ 76,233       8.00 %            
Hawthorn Bank
    137,113       14.64       74,908       8.00     $ 93,635       10.00 %
 
Tier I capital (to risk-weighted assets):
                                               
Company
  $ 142,343       14.94     $ 38,117       4.00 %            
Hawthorn Bank
    125,387       13.39       37,454       4.00     $ 56,181       6.00 %
 
Tier I capital (to adjusted average assets):
                                               
Company
  $ 142,343       11.61     $ 36,769       3.00 %            
Hawthorn Bank
    125,387       10.42       36,089       3.00     $ 60,148       5.00 %
 
                                             
 
                                                 
                    Minimum     Well-Capitalized  
    Actual     Capital requirements     Capital Requirements  
    Amount     Ratio     Amount     Ratio     Amount     Ratio  
 
December 31, 2009
                                               
Total capital (to risk-weighted assets):
                                               
Company
  $ 165,969       16.49 %   $ 80,502       8.00 %            
Hawthorn Bank
    134,673       13.62       79,129       8.00     $ 98,911       10.00 %
 
Tier I capital (to risk-weighted assets):
                                               
Company
  $ 140,974       14.01     $ 40,251       4.00 %            
Hawthorn Bank
    122,285       12.36       39,564       4.00     $ 59,347       6.00 %
 
Tier I capital (to adjusted average assets):
                                               
Company
  $ 140,974       11.35     $ 37,254       3.00 %            
Hawthorn Bank
    122,285       10.04       36,556       3.00     $ 60,926       5.00 %
 

39


 

Item 3.   Quantitative and Qualitative Disclosures about Market Risk
     Market risk arises from exposure to changes in interest rates and other relevant market rate or price risk. Our Company faces market risk in the form of interest rate risk through transactions other than trading activities. Our Company uses financial modeling techniques to measure interest rate risk. These techniques measure the sensitivity of future earnings due to changing interest rate environments. Guidelines established by our Company’s Asset/Liability Committee and approved by the Board of Directors are used to monitor exposure of earnings at risk. General interest rate movements are used to develop sensitivity as our Company feels it has no primary exposure to specific points on the yield curve. For the period ended September 30, 2010, our Company utilized a 300 basis point immediate and gradual move in interest rates (both upward and downward) applied to both a parallel and proportional yield curve.
     The following table represents estimated interest rate sensitivity and periodic and cumulative gap positions calculated as of September 30, 2010:
                                                         
                                            Over        
                                            5 years or        
                                            no stated        
(Dollars in thousands)   Year 1     Year 2     Year 3     Year 4     Year 5     Maturity     Total  
 
ASSETS
                                                       
Investment securities
  $ 4,065     $ 3,349     $ 12,621     $ 21,432     $ 19,714     $ 103,992     $ 165,173  
Interest-bearing deposits
    35,209                                     35,209  
Other restricted investments
    6,150                                     6,150  
Federal funds sold and securities purchased under agreements to resell
    126                                     126  
Loans
    479,656       183,927       177,327       44,055       15,188       33,303       933,456  
 
Total
  $ 525,206     $ 187,276     $ 189,948     $ 65,487     $ 34,902     $ 137,295     $ 1,140,114  
 
 
                                                       
LIABILITIES
                                                       
 
                                                       
Savings, Now deposits
  $     $     $ 141,499     $     $       $       $ 141,499  
Rewards checking, Super Now, money market deposits
    222,871                                     222,871  
Time deposits
    325,525       58,962       48,382       4,359       5,833             443,061  
Federal funds purchased and securities sold under agreements to repurchase
    31,460                                     31,460  
Subordinated notes
    49,486                                     49,486  
Other borrowed money
    48,683       293       18,190       2                   67,168  
 
Total
  $ 678,025     $ 59,255     $ 208,071     $ 4,361     $ 5,833     $     $ 955,545  
 
 
                                                       
Interest-sensitivity GAP
                                                       
Periodic GAP
  $ (152,819 )   $ 128,021     $ (18,123 )   $ 61,126     $ 29,069     $ 137,295     $ 184,569  
 
Cumulative GAP
  $ (152,819 )   $ (24,798 )   $ (42,921 )   $ 18,205     $ 47,274     $ 184,569     $ 184,569  
 
 
                                                       
Ratio of interest-earnings assets to interest-bearing liabilities
                                                       
Periodic GAP
    0.77       3.16       0.91       15.02       5.98     NM       1.19  
Cumulative GAP
    0.77       0.97       0.95       1.02       1.05       1.19       1.19  
 

40


 

Item 4.   Controls and Procedures
     Our Company’s management has evaluated, with the participation of our principal executive and principal financial officers, the effectiveness of our disclosure controls and procedures as defined in Rules 13a — 15(e) or 15d — 15(e) of the Securities Exchange Act of 1934 as of September 30, 2010. Based upon and as of the date of that evaluation, our principal executive and principal financial officers concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required. It should be noted that any system of disclosure controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any system of disclosure controls and procedures is based in part upon assumptions about the likelihood of future events. Because of these and other inherent limitations of any such system, there can be no assurance that any design will always succeed in achieving its stated goals under all potential future conditions, regardless of how remote.
     There has been no change in our Company’s internal control over financial reporting that occurred during the fiscal quarter ended September 30, 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Impact of New Accounting Standards
     In January 2010, the FASB issued Accounting Standards Update (ASU) No. 2010-06 which amends ASC Topic 820, Fair Value Measurements and Disclosures. This update will provide more robust disclosures about (1) the different classes of assets and liabilities measured at fair value, (2) the valuation techniques and inputs used, (3) the activity in Level 3 fair value measurements, and (4) the transfers between Levels 1, 2, and 3. This is effective for financial statements issued for interim and annual periods ending after December 15, 2009. The interim disclosures required by this update are reported in the notes to our Company’s consolidated financial statements.
     In February 2010, the FASB issued ASU No. 2010-10 which amends ASC Topic 810, Consolidation. The objective of this update is to defer the effective date of the amendments to the consolidation requirements made by FASB Statement 167 to a reporting entity’s interest in certain types of entities and clarify other aspects of the Statement 167 amendments. As a result of the deferral, a reporting entity will not be required to apply the Statement 167 amendments to the Subtopic 810-10 consolidation requirements to its interest in an entity that meets the criteria to qualify for deferral. However, the amendments in this Update do not defer the disclosure requirements in the Statement 167 amendments to Topic 810. This is effective for financial statements issued for the first annual period beginning after November 15, 2009, and for interim periods with the first annual reporting period. The interim disclosures required by this new update did not have a material effect in the notes to our Company’s consolidated financial statements.
     In July 2010, the FASB issued ASU No. 2010-20 — Receivables (ASC Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. This ASU requires expanded credit risk disclosures intended to provide investors with greater transparency regarding the allowance for credit losses and the credit quality of financing receivables. Under this ASU, companies will be required to provide more information about the credit quality of their financing receivables in the disclosures to financial statements, such as aging information, credit quality indicators, changes in the allowance for credit losses, and the nature and extent of troubled debt restructurings and their effect on the allowance for credit losses. Both new and existing disclosures must be disaggregated by portfolio segment or class based on the level of disaggregation that management uses when assessing its allowance for credit losses and managing its credit exposure. The disclosures as of the end of a reporting period will be effective for interim and annual periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period will be effective for interim and annual reporting periods beginning on or after December 15, 2010. Our Company is currently evaluating the disclosure requirements under this ASU and the impact on our consolidated financial statements and the disclosures presented in our consolidated financial statements.
     In May 2009, the FASB issued SFAS No. 165, Subsequent Events, which was incorporated into ASC Topic 855 Subsequent Events (ASC 855). ASC 855 provides guidance on management’s assessment of subsequent events. The statement is not expected to significantly change practice because its guidance is similar to that in American Institute of Certified Public Accountants Professional Standards U.S. Auditing Standards Section 560, Subsequent Events, with some modifications. This statement became effective for our Company on June 15, 2009. The adoption of this statement did not have a material effect on our financial statements. In February 2010, the FASB issued ASU No. 2010-09 Subsequent Events Amendments to Certain Recognition and Disclosure Requirements, which removed the requirements in ASC 855 for an SEC filer to disclose the date through which subsequent events

41


 

have been evaluated for both issued and revised financial statements. This update became effective upon issuance for our Company and the adoption of this update did not have a material effect on our financial statements
     In June 2009, the FASB issued authoritative guidance on accounting for transfers of financial assets, which was subsequently incorporated into ASC Topic 860, Transfers and Servicing. The new guidance amends ASC Topic 860 and requires more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. The guidance eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets and requires additional disclosures. This became effective for the first annual period beginning after November 15, 2009, and for interim periods within the first annual reporting period, and must be applied to transfers occurring on or after the effective date. Our Company follows the requirements of the new guidance, which did not significantly impact our consolidated financial statements or the disclosures presented in our consolidated financial statements.

42


 

PART II — OTHER INFORMATION
     
Item 1. Legal Proceedings
  None
 
   
Item 1A. Risk Factors
  None
 
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
  None
 
   
Item 3. Defaults Upon Senior Securities
  None
 
   
Item 4. (Removed and Reserved)
  None
 
   
Item 5. Other Information
  None
 
   
Item 6. Exhibits
   
     
Exhibit No.   Description
3.1
  Restated Articles of Incorporation of our Company (filed as Exhibit 3.1 to our Company’s current report on Form 8-K on August 9, 2007 and incorporated herein by reference).
 
   
3.1.1
  Certificate of Designations of Fixed Rate Cumulative Perpetual Preferred Stock, Series 2008, dated December 17, 2008 (filed as Exhibit 3.1.1 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).
 
   
3.2
  Amended and Restated Bylaws of our Company (filed as Exhibit 3.1 to our Company’s current report on Form 8-K on June 8, 2009 and incorporated herein by reference).
 
   
4.1
  Specimen certificate representing shares of our Company’s $1.00 par value common stock (filed as Exhibit 4.1 to our Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1999 (Commission file number 0-23636) and incorporated herein by reference).
 
   
4.2
  Specimen certificate representing shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series 2008 (filed as Exhibit 4.2 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).
 
   
4.3
  Warrant to purchase shares of our Company’s $1.00 par value Common Stock, dated December 19, 2008 (filed as Exhibit 4.3 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).
 
   
31.1
  Certificate of the Chief Executive Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
   
31.2
  Certificate of the Chief Financial Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
   
32.1
  Certificate of the Chief Executive Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
   
32.2
  Certificate of the Chief Financial Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

43


 

SIGNATURES
     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
 
  HAWTHORN BANCSHARES, INC.    
 
       
Date
       
 
  /s/ James E. Smith
 
   
November 9, 2010
  James E. Smith, Chairman of the Board    
 
  and Chief Executive Officer (Principal Executive Officer)    
 
       
 
  /s/ Richard G. Rose
 
   
November 9, 2010
  Richard G. Rose, Chief Financial Officer (Principal Financial    
 
  Officer and Principal Accounting Officer)    

44


 

HAWTHORN BANCSHARES, INC.
INDEX TO EXHIBITS
September 30, 2010 Form 10-Q
             
Exhibit No.   Description     Page No.
3.1
  Restated Articles of Incorporation of our Company (filed as Exhibit 3.1 to our Company’s current report on Form 8-K on August 9, 2007 and incorporated herein by reference).     **  
 
           
3.1.1
  Certificate of Designations of Fixed Rate Cumulative Perpetual Preferred Stock, Series 2008, dated December 17, 2008 (filed as Exhibit 3.1.1 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).     **  
 
           
3.2
  Amended and Restated Bylaws of our Company (filed as Exhibit 3.1 to our Company’s current report on Form 8-K on June 8, 2009 and incorporated herein by reference).     **  
 
           
4.1
  Specimen certificate representing shares of our Company’s $1.00 par value common stock (filed as Exhibit 4.1 to our Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1999 (Commission file number 0-23636) and incorporated herein by reference).     **  
 
           
4.2
  Specimen certificate representing shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series 2008 (filed as Exhibit 4.2 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).     **  
 
           
4.3
  Warrant to purchase shares of our Company’s $1.00 par value Common Stock, dated December 19, 2008 (filed as Exhibit 4.3 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).     **  
 
           
31.1
  Certificate of the Chief Executive Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002     46  
 
           
31.2
  Certificate of the Chief Financial Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002     47  
 
           
32.1
  Certificate of the Chief Executive Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002     48  
 
           
32.2
  Certificate of the Chief Financial Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002     49  
 
**   Incorporated by reference.

45