UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

xQuarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
  For the quarterly period ended September 30, 2014

or

¨Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
  For the transition period from ______________ to______________

 

Commission File Number: 0-23636

 

HAWTHORN BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

 

Missouri   43-1626350

(State or other jurisdiction of

incorporation or organization) 

 

(I.R.S. Employer

Identification No.)

 

132 East High Street, Box 688, Jefferson City, Missouri 65102
(Address of principal executive offices) (Zip Code)

 

(573) 761-6100

(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. x Yes ¨ 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). x Yes ¨ 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 ¨ Accelerated filer ¨
Non-accelerated filer x (Do not check if a smaller reporting company) Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No

 

As of November 14, 2014, the registrant had 5,233,986 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, 
(In thousands, except per share data)  2014   2013 
ASSETS          
Cash and due from banks  $19,681   $27,079 
Federal funds sold and other overnight interest-bearing deposits   5,099    1,360 
Cash and cash equivalents   24,780    28,439 
Investment in available-for-sale securities, at fair value   205,816    205,985 
Other investments and securities, at cost   4,402    4,001 
Total investment securities   210,218    209,986 
Loans   860,985    839,547 
Allowances for loan losses   (12,033)   (13,719)
Net loans   848,952    825,828 
Premises and equipment - net   37,806    38,079 
Mortgage servicing rights   2,867    3,036 
Other real estate and repossessed assets - net   12,438    14,867 
Accrued interest receivable   4,735    4,999 
Cash surrender value - life insurance   2,269    2,213 
Other assets        12,461    12,675 
Total assets       $1,156,526   $1,140,122 
LIABILITIES AND STOCKHOLDERS' EQUITY          
Deposits          
Non-interest bearing demand  $200,280   $187,382 
Savings, interest checking and money market   433,833    419,085 
Time deposits $100,000 and over   139,111    145,957 
Other time deposits   191,481    204,047 
Total deposits      964,705    956,471 
Federal funds purchased and securities sold under agreements to repurchase   19,543    31,084 
Subordinated notes   49,486    49,486 
Federal Home Loan Bank advances   35,000    24,000 
Accrued interest payable   382    426 
Other liabilities      6,889    4,275 
Total liabilities      1,076,005    1,065,742 
Stockholders’ equity:          
Common stock, $1 par value, authorized 15,000,000 shares; issued 5,395,844 and 5,194,537 shares, respectively   5,396    5,195 
Surplus   35,896    33,385 
Retained earnings   42,277    40,086 
Accumulated other comprehensive income (loss), net of tax   469    (769)
Treasury stock; 161,858 shares, at cost   (3,517)   (3,517)
Total stockholders’ equity   80,521    74,380 
Total liabilities and stockholders’ equity  $1,156,526   $1,140,122 

 

See accompanying notes to the consolidated financial statements (unaudited).

 

2
 

  

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income (unaudited)

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
(In thousands, except per share amounts)  2014   2013   2014   2013 
INTEREST INCOME                    
Interest and fees on loans  $10,146   $10,186   $30,059   $31,009 
Interest on investment securities:                    
Taxable   845    873    2,600    2,689 
Nontaxable   180    212    543    641 
Federal funds sold and other overnight interest-bearing deposits   5    6    23    35 
Dividends on other securities   20    21    59    62 
Total interest income   11,196    11,298    33,284    34,436 
INTEREST EXPENSE                    
Interest on deposits:                    
Savings, interest checking and money market   229    238    750    752 
Time deposit accounts $100,000 and over   237    282    723    885 
Other time deposits   331    477    1,067    2,095 
Interest on federal funds purchased and securities sold under agreements to repurchase   5    7    14    17 
Interest on subordinated notes   318    323    945    963 
Interest on Federal Home Loan Bank advances   120    106    328    315 
Total interest expense   1,240    1,433    3,827    5,027 
Net interest income   9,956    9,865    29,457    29,409 
Provision for loan losses   0    0    0    2,000 
Net interest income after provision for loan losses   9,956    9,865    29,457    27,409 
NON-INTEREST INCOME                    
Service charges on deposit accounts   1,381    1,463    3,954    4,213 
Trust department income   211    179    641    598 
Real estate servicing fees, net   86    338    285    760 
Gain on sale of mortgage loans, net   330    175    778    1,515 
Gain on sale of investment securities   0    0    0    554 
Other            305    292    924    903 
Total non-interest income   2,313    2,447    6,582    8,543 
NON-INTEREST EXPENSE                    
Salaries and employee benefits   5,582    4,863    15,573    14,596 
Occupancy expense, net   705    695    1,997    1,973 
Furniture and equipment expense   438    474    1,334    1,438 
FDIC insurance assessment   244    253    724    753 
Legal, examination, and professional fees   341    207    849    727 
Advertising and promotion   305    310    852    907 
Postage, printing, and supplies   268    308    813    854 
Processing expense   758    749    2,278    2,758 
Other real estate expense, net   361    1,265    657    4,437 
Other            897    848    2,340    2,745 
Total non-interest expense   9,899    9,972    27,417    31,188 
Income before income taxes   2,370    2,340    8,622    4,764 
Income tax expense   802    771    2,969    1,519 
Net income        1,568    1,569    5,653    3,245 
Preferred stock dividends and accretion of discount   0    0    0    615 
Net income available to common shareholders  $1,568   $1,569   $5,653   $2,630 
Basic earnings per share  $0.30   $0.30   $1.08   $0.50 
Diluted earnings per share  $0.30   $0.30   $1.08   $0.50 

 

See accompanying notes to the consolidated financial statements (unaudited).

 

3
 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Loss) (unaudited) 

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
(In thousands)  2014   2013   2014   2013 
Net income  $1,568   $1,569   $5,653   $3,245 
Other comprehensive income (loss), net of tax                    
Investment securities available-for-sale:                    
Unrealized gain (loss) on investment securities available-for-sale, net of tax   (328)   (110)   1,202    (3,372)
Adjustment for gain on sale of investment securities, net of tax   0    0    0    (343)
Defined benefit pension plans:                    
Amortization of prior service cost included in net periodic pension cost, net of tax   12    17    36    50 
Total other comprehensive income (loss)   (316)   (93)   1,238    (3,665)
Total comprehensive income (loss)  $1,252   $1,476   $6,891   $(420)

 

See accompanying notes to the consolidated financial statements (unaudited).

 

4
 

  

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders' Equity (unaudited) 

 

                   Accumulated         
                   Other       Total 
                   Comprehensive       Stock - 
   Preferred   Common       Retained   Income   Treasury   holders' 
(In thousands)  Stock   Stock   Surplus   Earnings   (Loss)   Stock   Equity 
Balance, December 31, 2012           $17,977   $5,001   $31,816   $39,118   $1,825   $(3,517)  $92,220 
Net income   0    0    0    3,245    0    0    3,245 
Other comprehensive loss   0    0    0    0    (3,665)   0    (3,665)
Stock based compensation expense   0    0    14    0    0    0    14 
Accretion of preferred stock discount   278    0    0    (278)   0    0    0 
Redemption of 18,255 shares of  preferred stock   (18,255)   0                        (18,255)
Redemption of common stock warrant   0    0    (540)   0    0    0    (540)
Stock dividend   0    194    2,090    (2,284)             0 
Cash dividends declared, preferred stock   0    0    0    (456)   0    0    (456)
Cash dividends declared, common stock   0    0    0    (736)   0    0    (736)
Balance, September 30, 2013           $0   $5,195   $33,380   $38,609   $(1,840)  $(3,517)  $71,827 
                                    
Balance, December 31, 2013  $0   $5,195   $33,385   $40,086   $(769)  $(3,517)  $74,380 
Net income   0    0    0    5,653    0    0    5,653 
Other comprehensive income   0    0    0    0    1,238    0    1,238 
Stock based compensation expense   0    0    15    0    0    0    15 
Stock dividend   0    201    2,496    (2,697)   0    0    0 
Cash dividends declared, common stock   0    0    0    (765)   0    0    (765)
Balance, September 30, 2014  $0   $5,396   $35,896   $42,277   $469   $(3,517)  $80,521 

 

See accompanying notes to the consolidated financial statements (unaudited).

 

5
 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)

 

   Nine Months Ended September 30, 
(In thousands)  2014   2013 
Cash flows from operating activities:          
Net income  $5,653   $3,245 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for loan losses   0    2,000 
Depreciation expense   1,305    1,204 
Net amortization of investment securities, premiums, and discounts   809    981 
Amortization of intangible assets   0    135 
Stock based compensation expense   15    14 
Change in fair value of mortgage servicing rights   386    (86)
Gain on sale of investment securities   0    (554)
(Gain) loss on sales and dispositions of premises and equipment   (41)   2 
(Gain) loss on sales and dispositions of other real estate and repossessed assets   (149)   390 
Provision for other real estate owned   450    3,032 
Decrease in accrued interest receivable   264    234 
Increase in cash surrender value -life insurance   (56)   (56)
(Increase) decrease in other assets   (181)   2,728 
Decrease in accrued interest payable   (44)   (453)
Increase in other liabilities   2,603    2,507 
Origination of mortgage loans for sale   (25,576)   (61,297)
Proceeds from the sale of mortgage loans   25,568    63,452 
Gain on sale of mortgage loans, net   (778)   (1,515)
Other, net   (377)   (394)
Net cash provided by operating activities   9,851    15,569 
Cash flows from investing activities:          
Net (increase) decrease in loans   (24,155)   17,436 
Purchase of available-for-sale debt securities   (41,321)   (76,479)
Proceeds from maturities of available-for-sale debt securities   18,015    28,221 
Proceeds from calls of available-for-sale debt securities   24,605    6,255 
Proceeds from sales of available-for-sale debt securities   0    22,115 
Proceeds from sales of FHLB stock   39    535 
Purchases of FHLB stock   (440)   (612)
Purchases of premises and equipment   (1,181)   (1,787)
Proceeds from sales of premises and equipment   45    0 
Proceeds from sales of other real estate and foreclosed assets   3,945    7,581 
Net cash (used) in provided by investing activities   (20,448)   3,265 
Cash flows from financing activities:          
Net increase (decrease) in demand deposits   12,898    (12,312)
Net increase in interest-bearing transaction accounts   14,748    7,185 
Net decrease in time deposits   (19,412)   (34,670)
Net (decrease) increase in federal funds purchased and securities sold under agreements to repurchase   (11,541)   3,949 
Repayment of FHLB advances   (10,000)   (15,113)
FHLB advances   21,000    19,000 
Redemption of 18,255 shares of preferred stock   0    (18,255)
Warrant redemption   0    (540)
Cash dividends paid - preferred stock   0    (456)
Cash dividends paid - common stock   (755)   (726)
Net cash provided by (used) in financing activities   6,938    (51,938)
Net decrease in cash and cash equivalents   (3,659)   (33,104)
Cash and cash equivalents, beginning of period   28,439    58,877 
Cash and cash equivalents, end of period  $24,780   $25,773 

 

6
 

  

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (continued) (unaudited)

 

   Nine Months Ended September 30, 
(In thousands)  2014   2013 
Supplemental disclosures of cash flow information:        
Cash paid during the year for:          
Interest  $3,872   $5,479 
Income taxes  $1,650   $131 
Noncash investing activities:          
Other real estate and repossessed assets acquired in settlement of loans  $1,817   $3,278 

 

See accompanying notes to the consolidated financial statements (unaudited).

 

7
 

  

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(1)Summary of Significant Accounting Policies

 

Hawthorn Bancshares, Inc. (the Company) through its subsidiary, Hawthorn Bank (the Bank), provides a broad range of banking services to individual and corporate customers located within the communities in and surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson, and Lee’s Summit, Missouri. The Company is subject to competition from other financial and nonfinancial institutions providing financial products. Additionally, the Company and its subsidiaries are subject to the regulations of certain regulatory agencies and undergo periodic examinations by those regulatory agencies.

 

The accompanying unaudited consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and disclosures required by U.S. GAAP for complete financial statements and should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013. Certain amounts in the 2013 condensed consolidated financial statements have been reclassified to conform to the 2014 condensed consolidated presentation. Such reclassifications have no effect on previously reported net income or stockholders’ equity.

 

The preparation of the consolidated financial statements includes 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. Actual results could differ from those estimates. The Company’s management has evaluated and did not identify any subsequent events or transactions requiring recognition or disclosure in the consolidated financial statements.

 

During the three months ended September 30, 2014, the Company’s management discovered employee fraud resulting in the loss of an aggregate $421,000 of cash over an extended period of time. As a result of the discovery, the Company recorded a $136,000 loss in its consolidated financial statements as of September 30, 2014, representing the $421,000 gross loss, net of expected insurance proceeds of $285,000. The Company determined that any adjustments relating to prior-period financial statements were immaterial.

 

Stock Dividend On July 1, 2014, the Company paid a special stock dividend of four percent to shareholders of record at the close of business on June 15, 2014. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

 

Preferred Stock On December 19, 2008, the 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. Participation in this program included the 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 287,133 shares of common stock. On May 9, 2012, the Company redeemed 12,000 of the 30,255 shares of preferred stock issued under the U.S. Treasury’s CPP program, and on May 15, 2013, the remaining 18,255 shares were redeemed.

 

On June 11, 2013, the common stock warrant issued under the U.S. Treasury Department’s CPP program was repurchased by the Company pursuant to a letter agreement between the Treasury and the Company for a total repurchase price of $540,000, or $1.88 per warrant share. The repurchase price was based on the fair market value of the warrant as agreed upon by the Company and the Treasury. The repurchase of the warrant ends the Company’s participation in the U.S. Treasury Department’s CPP.

 

8
 

  

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(2)Loans and Allowance for Loan Losses

 

Loans

 

A summary of loans, by major class within the Company’s loan portfolio, at September 30, 2014 and December 31, 2013 is as follows:

   September 30,   December 31, 
(in thousands)  2014   2013 
         
Commercial, financial, and agricultural  $150,733   $141,845 
Real estate construction - residential   19,935    21,008 
Real estate construction - commercial   62,391    55,076 
Real estate mortgage - residential   234,244    225,630 
Real estate mortgage - commercial   374,909    375,686 
Installment and other consumer   18,773    20,302 
           
Total loans  $860,985   $839,547 

 

The Bank grants real estate, commercial, installment, and other consumer 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 and other consumer loans consist primarily of the financing of automotive vehicles. At September 30, 2014, loans with a carrying value of $373.5 million were pledged to the Federal Home Loan Bank as collateral for borrowings and letters of credit.

 

9
 

  

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

Allowance for Loan Losses

 

The following is a summary of the allowance for loan losses during the periods indicated.

 

 

   Three Months Ended September 30, 2014 
   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, &   Construction -   Construction -   Mortgage -   Mortgage -   Loans to   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Individuals   allocated   Total 
                                 
Balance at beginning of period  $1,943   $473   $618   $2,405   $6,428   $274   $9   $12,150 
Additions:                                        
Provision for loan losses   (188)   (94)   (96)   313    7    38    20    0 
Deductions:                                        
Loans charged off   105    0    0    41    80    71    0    297 
Less recoveries on loans   (55)   0    0    (26)   (67)   (32)   0    (180)
Net loans charged off   50    0    0    15    13    39    0    117 
                                         
Balance at end of period  $1,705   $379   $522   $2,703   $6,422   $273   $29   $12,033 

 

   Nine Months Ended September 30, 2014 
   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, &   Construction -   Construction -   Mortgage -   Mortgage -   Loans to   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Individuals   allocated   Total 
                                 
Balance at beginning of period  $2,374   $931   $631   $2,959   $6,523   $294   $7   $13,719 
Additions:                                        
Provision for loan losses   (660)   (553)   382    (171)   891    89    22    0 
Deductions:                                        
Loans charged off   291    59    491    236    1,152    270    0    2,499 
Less recoveries on loans   (282)   (60)   0    (151)   (160)   (160)   0    (813)
Net loans charged off   9    (1)   491    85    992    110    0    1,686 
                                         
Balance at end of period  $1,705   $379   $522   $2,703   $6,422   $273   $29   $12,033 

 

10
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   Three Months Ended September 30, 2013 
   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, &   Construction -   Construction -   Mortgage -   Mortgage -   Loans to   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Individuals   allocated   Total 
                                 
Balance at beginning of period  $2,119   $932   $2,202   $2,456   $7,415   $233   $1   $15,358 
Additions:                                        
Provision for loan losses   444    32    (216)   4    (294)   25    5    0 
Deductions:                                        
Loans charged off   654    0    135    368    178    91    0    1,426 
Less recoveries on loans   (201)   0    0    (39)   (34)   (48)   0    (322)
Net loans charged off   453    0    135    329    144    43    0    1,104 
                                         
Balance at end of period  $2,110   $964   $1,851   $2,131   $6,977   $215   $6   $14,254 

 

   Nine Months Ended September 30, 2013 
   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, &   Construction -   Construction -   Mortgage -   Mortgage -   Loans to   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Individuals   allocated   Total 
                                 
Balance at beginning of period  $1,937   $732   $1,711   $3,387   $6,834   $239   $2   $14,842 
Additions:                                        
Provision for loan losses   725    351    273    (586)   1,142    91    4    2,000 
Deductions:                                        
Loans charged off   817    119    135    754    1,205    271    0    3,301 
Less recoveries on loans   (265)   0    (2)   (84)   (206)   (156)   0    (713)
Net loans charged off   552    119    133    670    999    115    0    2,588 
                                         
Balance at end of period  $2,110   $964   $1,851   $2,131   $6,977   $215   $6   $14,254 

  

Loans, or portions of loans, are charged off to the extent deemed uncollectible or a loss is confirmed. Loan charge-offs reduce the allowance for loan losses, and recoveries of loans previously charged off are added back to the allowance. 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, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated by risk characteristics 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.

 

11
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The following table provides the balance in the allowance for loan losses at September 30, 2014 and December 31, 2013, and the related loan balance by impairment methodology.

 

   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, and   Construction -   Construction -   Mortgage -   Mortgage -   Loans to   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Individuals   allocated   Total 
                                 
September 30, 2014                                
                                 
Allowance for loan losses:                                
Individually evaluated for impairment  $663   $273   $0   $1,728   $1,942   $55   $0   $4,661 
Collectively evaluated for impairment   1,042    106    522    975    4,480    218    29    7,372 
Total  $1,705   $379   $522   $2,703   $6,422   $273   $29   $12,033 
Loans outstanding:                                        
Individually evaluated for impairment  $4,427   $2,040   $5,679   $8,639   $14,573   $268   $0   $35,626 
Collectively evaluated for impairment   146,306    17,895    56,712    225,605    360,336    18,505    0    825,359 
Total  $150,733   $19,935   $62,391   $234,244   $374,909   $18,773   $0   $860,985 
                                         
December 31, 2013                                        
                                         
Allowance for loan losses:                                        
Individually evaluated for impairment  $721   $392   $304   $1,374   $1,989   $16   $0   $4,796 
Collectively evaluated for impairment   1,653    539    327    1,585    4,534    278    7    8,923 
Total  $2,374   $931   $631   $2,959   $6,523   $294   $7   $13,719 
Loans outstanding:                                        
Individually evaluated for impairment  $4,015   $2,204   $6,615   $6,517   $15,422   $43   $0   $34,816 
Collectively evaluated for impairment   137,830    18,804    48,461    219,113    360,264    20,259    0    804,731 
Total  $141,845   $21,008   $55,076   $225,630   $375,686   $20,302   $0   $839,547 

 

Impaired Loans

 

Loans evaluated under the Financial Accounting Standards Board’s (FASB) Accounting Standards Update (ASU) 310-10-35 include loans which are individually evaluated for impairment. All other loans are collectively evaluated for impairment under ASC 450-20. Impaired loans totaled $35.6 million and $35.1 million at September 30, 2014 and December 31, 2013, respectively, and are comprised of loans on non-accrual status and loans which have been classified as troubled debt restructurings. Total impaired loans of $35.6 million at September 30, 2014 were individually evaluated for impairment compared to $34.8 million of impaired loans individually evaluated for impairment and $259,000 of non-accrual consumer loans that were collectively evaluated for impairment at December 31, 2013. Beginning in 2014, consumer non-accrual loans were included in the individually evaluated impairment calculations.

 

The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. At September 30, 2014 and December 31, 2013, $14.0 million and $21.8 million, respectively, of impaired loans were evaluated based on the fair value less estimated selling costs of the loan’s collateral. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2014, $4.7 million of the Company’s allowance for loan losses was allocated to impaired loans totaling $35.6 million compared to $4.8 million of the Company's allowance for loan losses allocated to impaired loans totaling approximately $35.1 million at December 31, 2013. Management determined that $20.9 million, or 59%, of total impaired loans required no reserve allocation at September 30, 2014 compared to $18.8 million, or 54%, at December 31, 2013 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

 

12
 

  

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The categories of impaired loans at September 30, 2014 and December 31, 2013 are as follows:

 

   September 30,   December 31, 
(in thousands)  2014   2013 
Non-accrual loans  $24,380   $23,680 
Troubled debt restructurings continuing to accrue interest   11,246    11,395 
Total impaired loans  $35,626   $35,075 

 

The following tables provide additional information about impaired loans at September 30, 2014 and December 31, 2013, respectively, segregated between loans for which an allowance has been provided and loans for which no allowance has been provided.

 

       Unpaid     
   Recorded   Principal   Specific 
(in thousands)  Investment   Balance   Reserves 
             
September 30, 2014            
With no related allowance recorded:               
Commercial, financial and agricultural  $2,400   $2,457   $0 
Real estate - construction residential   0    0    0 
Real estate - construction commercial   5,679    6,403    0 
Real estate - residential   3,116    3,568    0 
Real estate - commercial   9,744    11,366    0 
Total  $20,939   $23,794   $0 
With an allowance recorded:               
Commercial, financial and agricultural  $2,027   $2,086   $663 
Real estate - construction residential   2,040    2,260    273 
Real estate - construction commercial   0    0    0 
Real estate - residential   5,523    5,620    1,728 
Real estate - commercial   4,829    5,004    1,942 
Consumer   268    307    55 
Total  $14,687   $15,277   $4,661 
Total impaired loans  $35,626   $39,071   $4,661 

 

13
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

       Unpaid     
   Recorded   Principal   Specific 
(in thousands)  Investment   Balance   Reserves 
             
December 31, 2013               
With no related allowance recorded:               
Commercial, financial and agricultural  $2,467   $2,593   $0 
Real estate - construction residential   44    80    0 
Real estate - construction commercial   6,101    7,148    0 
Real estate - residential   2,121    2,654    0 
Real estate - commercial   7,817    8,056    0 
Consumer   259    282    0 
Total  $18,809   $20,813   $0 
With an allowance recorded:               
Commercial, financial and agricultural  $1,548   $1,607   $721 
Real estate - construction residential   2,160    2,331    392 
Real estate - construction commercial   514    514    304 
Real estate - residential   4,396    4,570    1,374 
Real estate - commercial   7,605    7,925    1,989 
Consumer   43    45    16 
Total  $16,266   $16,992   $4,796 
Total impaired loans  $35,075   $37,805   $4,796 

 

The following table presents by class, information related to the average recorded investment and interest income recognized on impaired loans during the periods indicated.

 

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2014   2013   2014   2013 
       Interest       Interest       Interest       Interest 
   Average   Recognized   Average   Recognized   Average   Recognized   Average   Recognized 
   Recorded   For the   Recorded   For the   Recorded   For the   Recorded   For the 
(in thousands)  Investment   Period Ended   Investment   Period Ended   Investment   Period Ended   Investment   Period Ended 
With no related allowance recorded:                                        
Commercial, financial and agricultural  $2,618   $22   $2,598   $22   $2,592   $69   $2,643   $71 
Real estate - construction residential   16    2    139    0    65    2    242    0 
Real estate - construction commercial   6,524    0    3,459    0    6,737    0    3,803    0 
Real estate - residential   3,941    26    3,168    10    3,374    40    3,179    10 
Real estate - commercial   12,578    84    4,346    29    12,334    255    4,348    86 
Consumer   0    0    202    0    11    0    212    1 
Total  $25,677   $134   $13,912   $61   $25,113   $366   $14,427   $168 
With an allowance recorded:                                        
Commercial, financial and agricultural  $1,940   $4   $1,996   $7   $2,128   $19   $2,031   $34 
Real estate - construction residential   2,260    0    2,272    0    2,263    0    2,273    0 
Real estate - construction commercial   0    0    4,240    0    56    0    4,240    0 
Real estate - residential   5,458    0    2,920    2    5,384    93    2,947    38 
Real estate - commercial   4,587    28    13,210    35    4,695    11    13,524    106 
Consumer   310    11    44    0    324    0    44    0 
Total  $14,555   $43   $24,682   $44   $14,850   $123   $25,059   $178 
Total impaired loans  $40,232   $177   $38,594   $105   $39,963   $489   $39,486   $346 

 

The recorded investment varies from the unpaid principal balance primarily due to partial charge-offs taken resulting from current appraisals received. The amount recognized as interest income on impaired loans continuing to accrue interest, primarily related to troubled debt restructurings, was $134,000 and $366,000 for the three months and nine months ended September 30, 2014, respectively, compared to $61,000 and $168,000 for the three and nine months ended September 30, 2013, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during the periods reported. Contractual interest lost on loans in non-accrual status was $268,000 and $862,000 for the three and nine months ended September 30, 2014, respectively, compared to $269,000 and $929,000 for the three and nine months ended September 30, 2013, respectively.

 

14
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

Delinquent and Non-Accrual Loans

 

The delinquency status of loans is determined based on the contractual terms of the notes. Borrowers are generally classified as delinquent once payments become 30 days or more past due.

 

The following table provides aging information for the Company’s past due and non-accrual loans at September 30, 2014 and December 31, 2013.

 

   Current or       90 Days         
   Less Than       Past Due         
   30 Days   30 - 89 Days   And Still         
(in thousands)  Past Due   Past Due   Accruing   Non-Accrual   Total 
                     
September 30, 2014                         
Commercial, Financial, and Agricultural  $148,276   $421   $0   $2,036   $150,733 
Real Estate Construction - Residential   17,895    0    0    2,040    19,935 
Real Estate Construction - Commercial   56,657    0    56    5,678    62,391 
Real Estate Mortgage - Residential   228,157    864    48    5,175    234,244 
Real Estate Mortgage - Commercial   364,414    1,312    0    9,183    374,909 
Installment and Other Consumer   18,206    298    1    268    18,773 
Total  $833,605   $2,895   $105   $24,380   $860,985 
                          
December 31, 2013                         
Commercial, Financial, and Agricultural  $139,219   $942   $0   $1,684   $141,845 
Real Estate Construction - Residential   18,738    66    0    2,204    21,008 
Real Estate Construction - Commercial   48,230    595    0    6,251    55,076 
Real Estate Mortgage - Residential   217,268    4,068    129    4,165    225,630 
Real Estate Mortgage - Commercial   365,787    725    100    9,074    375,686 
Installment and Other Consumer   19,695    291    14    302    20,302 
Total  $808,937   $6,687   $243   $23,680   $839,547 

 

Credit Quality

 

The Company categorizes loans into risk categories based upon an internal rating system reflecting management’s risk assessment. Loans are placed on watch status when (1) one or more weaknesses that could jeopardize timely liquidation exits; or (2) the margin or liquidity of an asset is sufficiently tenuous that adverse trends could result in a collection problem. Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified may have a well defined weakness or weaknesses that jeopardize the repayment of the debt. Such loans are characterized by the distinct possibility that the Company may sustain some loss if the deficiencies are not corrected. It is the Company's policy to discontinue the accrual of interest income on loans when management believes that the collection of interest or principal is doubtful. Loans are placed on non-accrual status when (1) deterioration in the financial condition of the borrower exists for which payment of full principal and interest is not expected, or (2) payment of principal or interest has been in default for a period of 90 days or more and the asset is not 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 collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis.

 

15
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

  

The following table presents the risk categories by class at September 30, 2014 and December 31, 2013.

  

(in thousands)  Commercial,
Financial, &
Agricultural
   Real Estate
Construction
- Residential
   Real Estate
Construction-
Commercial
   Real Estate
Mortgage -
Residential
   Real Estate
Mortgage -
Commercial
   Installment
and other
Consumer
   Total 
                             
At  September 30, 2014                                   
Watch  $18,254    1,329   $5,027   $25,755   $21,332   $238   $71,935 
Substandard   5,197    91    1,190    7,545    9,965    170    24,158 
Non-accrual   2,036    2,040    5,678    5,175    9,183    268    24,380 
Total  $25,487   $3,460   $11,895   $38,475   $40,480   $676   $120,473 
                                    
At December 31, 2013                                   
Watch  $15,016   $2,007   $6,111   $26,331   $23,662   $388   $73,515 
Substandard   7,553    92    1,403    8,579    14,510    281    32,418 
Non-accrual   1,684    2,204    6,251    4,165    9,074    302    23,680 
Total  $24,253   $4,303   $13,765   $39,075   $47,246   $971   $129,613 

 

Troubled Debt Restructurings

 

At September 30, 2014, loans classified as troubled debt restructurings (TDRs) totaled $20.6 million, of which $9.4 million were on non-accrual status and $11.2 million were on accrual status. At December 31, 2013, TDRs totaled $21.5 million, of which $10.1 million were on non-accrual status and $11.4 million were on accrual status. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. Accordingly, specific reserves of $1.5 million and $2.2 million related to TDRs were allocated to the allowance for loan losses at September 30, 2014 and December 31, 2013, respectively.

 

The following table summarizes loans that were modified as TDRs during the periods indicated.

  

   Nine Months Ended September 30, 
   2014   2013 
   Recorded Investment (1)   Recorded Investment (1) 
(in thousands)  Number
of
Contracts
   Pre-
Modification
   Post-
Modification
   Number of
Contracts
   Pre-
Modification
   Post-
Modification
 
Troubled Debt Restructurings                              
Commercial, financial and agricultural   3   $244   $225    0   $0   $0 
Real estate mortgage - residential   1    1,256    1,171    1    619    481 
Total   4   $1,500   $1,396    1   $619   $481 

 

(1) The amounts reported post-modification are inclusive of all partial pay-downs and charge-offs, and no portion of the debt was forgiven. Loans modified as a TDR that were fully paid down, charged-off or foreclosed upon during the period ended are not reported.

 

The Company’s portfolio of loans classified as TDRs include concessions such as interest rates below the current market rate for the borrower given financial condition, deferring principal payments, and extending maturity dates. Once a loan becomes a TDR, it will continue to be reported as a TDR until it is ultimately repaid in full, charged-off, or the collateral for the loan is foreclosed and sold. The Company considers a loan in TDR status in default when the borrower’s payment according to the modified terms is at least 90 days past due or has defaulted due to expiration of the loan’s maturity date. There were no modified loans that met the TDR criteria during the three months ended September 30, 2014 and 2013. During the nine months ended September 30, 2014, four loans meeting the TDR criteria were modified compared to one loan during the nine months ended September 30, 2013. There were no loans modified as a TDR that defaulted during the three and nine months ended September 30, 2014 and 2013, respectively, and within twelve months of their modification date. See Lending and Credit Management section for further information.

 

16
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

  

(3)Other Real Estate and Repossessed Assets

  

   September 30,   December 31, 
(in thousands)  2014   2013 
Real estate construction - residential  $16   $114 
Real estate construction - commercial   9,831    10,020 
Real estate mortgage - residential   374    830 
Real estate mortgage - commercial   5,498    8,537 
Repossessed assets   1    41 
Total  $15,720   $19,542 
Less valuation allowance for other real estate owned   (3,282)   (4,675)
Total other real estate and repossessed assets  $12,438   $14,867 

 

Changes in the net carrying amount of other real estate and foreclosed assets during the periods indicated were as follows:

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2014   2013   2014   2013 
Balance at beginning of period  $15,231   $21,977   $19,542   $29,729 
Additions   1,512    308    1,817    3,278 
Proceeds from sales   (821)   (1,348)   (3,945)   (7,581)
Charge-offs against the valuation allowance for other real estate owned   (199)   (93)   (1,843)   (4,416)
Repossessed assets impairment write-downs   0    (39)   0    (239)
Net (loss) gain on sales   (3)   (185)   149    (151)
Total other real estate and repossessed assets  $15,720   $20,620   $15,720   $20,620 
Less valuation allowance for other real estate owned   (3,282)   (4,752)   (3,282)   (4,752)
Balance at end of period  $12,438   $15,868   $12,438   $15,868 

 

Net charge-offs against the allowance for loan losses at the time of foreclosure were approximately $51,000 and $280,000 during the three and nine months ended September 30, 2014, respectively, compared to $733,000 and $1.5 million, during the three and nine months ended September 30, 2013, respectively.

 

Activity in the valuation allowance for other real estate owned during the periods indicated was as follows:

 

   Three Months Ended
September 30,
   Nine Months Ended
September 30,
 
(in thousands)  2014   2013   2014   2013 
Balance, beginning of period  $3,205   $3,999   $4,675   $6,137 
Provision for other real estate owned   276    846    450    3,031 
Charge-offs   (199)   (93)   (1,843)   (4,416)
Balance, end of period  $3,282   $4,752   $3,282   $4,752 

 

17
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(4)Investment Securities

 

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2014 and December 31, 2013 were as follows: 

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized     
(in thousands)  Cost   Gains   Losses   Fair value 
September 30, 2014                    
Government sponsored enterprises  $62,069   $241   $259   $62,051 
Asset-backed securities   110,394    833    1,910    109,317 
Obligations of states and political subdivisions   33,819    670    41    34,448 
                     
Total available-for-sale securities  $206,282   $1,744   $2,210   $205,816 
                     
December 31, 2013                    
U.S. Treasury  $1,000   $3   $0   $1,003 
Government sponsored enterprises   61,006    377    767    60,616 
Asset-backed securities   112,747    817    3,191    110,373 
Obligations of states and political subdivisions   33,637    568    212    33,993 
                     
Total available-for-sale securities  $208,390   $1,765   $4,170   $205,985 

 

All of the Company’s investment securities are classified as available for sale. Agency bonds and notes, agency mortgage-backed securities and agency collateralized mortgage obligations (CMO) include securities issued by the Government National Mortgage Association (GNMA), a U.S. government agency, and the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal Home Loan Bank (FHLB), which are U.S. government-sponsored enterprises.

 

Other investments and securities primarily consist of Federal Home Loan Bank stock and the Company’s interest in statutory trusts. These securities are reported at cost in the amount of $4.4 and $4.0 million as of September 30, 2014 and December 31, 2013, respectively.

 

Debt securities with carrying values aggregating approximately $158.3 million and $145.8 million at September 30, 2014 and December 31, 2013, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.

 

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2014, 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 
(in thousands)  Cost   Value 
Due in one year or less  $7,227   $7,307 
Due after one year through five years   61,306    61,589 
Due after five years through ten years   25,884    26,151 
Due after ten years   1,471    1,452 
Total   95,888    96,499 
Asset-backed securities   110,394    109,317 
Total available-for-sale securities  $206,282   $205,816 

 

18
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

  

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, 2014 and December 31, 2013 were as follows:

 

   Less than 12 months   12 months or more   Total   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
(in thousands)  Value   Losses   Value   Losses   Value   Losses 
At September 30, 2014                              
Government sponsored   enterprises  $9,405   $(38)  $19,781   $(221)  $29,186   $(259)
Asset-backed securities   20,915    (170)   48,942    (1,740)   69,857    (1,910)
Obligations of states and   political subdivisions   2,288    (3)   2,578    (38)   4,866    (41)
Total  $32,608   $(211)  $71,301   $(1,999)  $103,909   $(2,210)
                               
(in thousands)                              
At December 31, 2013                              
Government sponsored   enterprises  $25,771   $(767)  $0   $0   $25,771   $(767)
Asset-backed securities   76,048    (2,940)   5,941    (251)   81,989    (3,191)
Obligations of states and   political subdivisions   6,907    (159)   450    (53)   7,357    (212)
Total  $108,726   $(3,866)  $6,391   $(304)  $115,117   $(4,170)

 

The total available for sale portfolio consisted of approximately 301 securities at September 30, 2014. The portfolio included 90 securities having an aggregate fair value of $103.9 million that were in a loss position at September 30, 2014. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $71.3 million at fair value. The $2.2 million aggregate unrealized loss included in accumulated other comprehensive income at September 30, 2014 was caused by interest rate fluctuations.

 

The total available for sale portfolio consisted of approximately 348 securities at December 31, 2013. The portfolio included 96 securities having an aggregate fair value of $115.1 million that were in a loss position at December 31, 2013. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $6.4 million at fair value. The $4.2 million aggregate unrealized loss included in accumulated other comprehensive income at December 31, 2013 was caused by interest rate fluctuations.

 

Because the decline in fair value is attributable to changes in interest rates and not credit quality these investments were not considered other-than-temporarily impaired at September 30, 2014 and December 31, 2013, respectively. In addition, the Company does not have the intent to sell these investments over the period of recovery, and it is not more likely than not that it will be required to sell such investment securities.

 

The table below presents the components of investment securities gains and losses which have been recognized in earnings.

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(in thousands)  2014   2013   2014   2013 
Gains realized on sales  $0   $0   $0   $554 
Losses realized on sales   0    0    0    0 
Other-than-temporary impairment recognized   0    0    0    0 
Investment securities gains  $0   $0   $0   $554 

 

19
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

  

(5)Intangible Assets

 

Core Deposit Intangible Asset

 

Core deposit intangible assets in the amount of $4.8 million were fully amortized as of June 30, 2013. Amortization expense was $135,000 for the nine months ended September 30, 2013.

 

Mortgage Servicing Rights

 

At September 30, 2014, the Company was servicing approximately $314.4 million of loans sold to the secondary market compared to $322.5 million at December 31, 2013, and $323.0 million at September 30, 2013. Mortgage loan servicing fees, reported as non-interest income, earned on loans sold were $226,000 and $672,000 for the three and nine months ended September 30, 2014, respectively, compared to $215,000 and $674,000 for the three and nine months ended September 30, 2013, respectively.

 

The table below presents changes in mortgage servicing rights (MSRs) for the periods indicated.

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(in thousands)  2014   2013   2014   2013 
                 
Balance at beginning of period  $2,911   $2,873   $3,036   $2,549 
Originated mortgage servicing rights   95    83    217    444 
Changes in fair value:                    
Due to change in model inputs and assumptions (1)   27    296    98    677 
Other changes in fair value (2)   (166)   (173)   (484)   (591)
Balance at end of period  $2,867   $3,079   $2,867   $3,079 

 

(1) The change in fair value resulting from changes in valuation inputs or assumptions used in the valuation model reflects the change in discount rates and prepayment speed assumptions primarily due to changes in interest rates.

(2) Other changes in fair value reflect changes due to customer payments and passage of time.

 

The following key data and assumptions were used in estimating the fair value of the Company’s MSRs as of the nine months ended September 30, 2014 and 2013:

 

   Nine Months Ended September 30, 
   2014   2013 
Weighted average constant prepayment rate   10.05%   10.94%
Weighted average note rate   4.00%   4.02%
Weighted average discount rate   9.18%   8.56%
Weighted average expected life (in years)   5.90    5.70 

 

(6)Income Taxes

 

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 33.8% for the three months ended September 30, 2014 compared to 33.0% for the three months ended September 30, 2013. Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 34.4% for the nine months ended September 30, 2014 compared to 31.9% for the nine months ended September 30, 2013.

 

The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these temporary differences at September 30, 2014 and, therefore, did not establish a valuation reserve.

 

20
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

  

(7)Stockholders’ Equity

 

Accumulated Other Comprehensive Income (Loss)

 

The following details the change in the components of the Company’s accumulated other comprehensive income (loss) for the nine months ended September 30, 2014 and 2013:

 

   Nine months ended September 30, 2014 
           Accumulated 
       Unrecognized Net   Other 
   Unrealized   Pension and   Comprehensive 
   Gain (Loss)   Postretirement   (Loss) 
(in thousands)  on Securities (1)   Costs (2)   Income 
Balance at beginning of period  $(1,491)  $722   $(769)
Other comprehensive income, before reclassifications   1,939    0    1,939 
Amounts reclassified from accumulated other comprehensive income   0    59    59 
Current period other comprehensive income, before tax   1,939    59    1,998 
Income tax expense   (737)   (23)   (760)
Current period other comprehensive income, net of tax   1,202    36    1,238 
Balance at end of period  $(289)  $758   $469 

 

   Nine months ended September 30, 2013 
           Accumulated 
       Unrecognized Net   Other 
   Unrealized   Pension and   Comprehensive 
   Gain (Loss)   Postretirement   (Loss) 
(in thousands)  on Securities (1)   Costs (2)   Income 
Balance at beginning of period  $3,266   $(1,441)  $1,825 
Other comprehensive (loss) income, before reclassifications   (5,524)   0    (5,524)
Amounts reclassified from accumulated other comprehensive income   (554)   81    (473)
Current period other comprehensive (loss) income, before tax   (6,078)   81    (5,997)
Income tax benefit (expense)   2,363    (31)   2,332 
Current period other comprehensive (loss) income, net of tax   (3,715)   50    (3,665)
Balance at end of period  $(449)  $(1,391)  $(1,840)

 

(1) The pre-tax amounts reclassified from accumulated other comprehensive income (loss) are included in gain on sale of investment securities in the consolidated statements of income.

(2) The pre-tax amounts reclassified from accumulated other comprehensive income (loss) are included in the computation of net periodic pension cost.

 

21
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(8)Employee Benefit Plans

 

Employee Benefits

 

Employee benefits charged to operating expenses are summarized in the table below for the periods indicated.

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(in thousands)  2014   2013   2014   2013 
Payroll taxes  $272   $266   $840   $832 
Medical plans   510    483    1,512    1,443 
401k match and profit sharing   159    97    488    287 
Pension plan   236    286    708    858 
Other   42    73    81    153 
                     
Total employee benefits  $1,219   $1,205   $3,629   $3,573 

 

The Company’s profit-sharing plan includes a matching 401k portion, in which the Company matches the first 3% of eligible employee contributions. The Company made annual contributions in an amount up to 6% of income before income taxes and before contributions to the profit-sharing and pension plans for all participants, limited to the maximum amount deductible for federal income tax purposes, for each of the periods shown. In addition, employees were able to make additional tax-deferred contributions.

 

Pension

 

The Company provides a noncontributory defined benefit pension plan for all full-time employees. An employer is required to recognize the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Under the Company’s funding policy for the defined benefit pension plan, contributions are made to a trust as necessary to provide for current service and for any unfunded accrued actuarial liabilities over a reasonable period. To the extent that these requirements are fully covered by assets in the trust, a contribution might not be made in a particular year. The Company has made a $725,000 contribution to the defined benefit plan for the current plan year. The minimum required contribution for the 2014 plan year is estimated to be $1.3 million. The Company has not determined whether it will make any contributions other than the minimum required funding contribution for 2014.

 

Components of Net Pension Cost and Other Amounts Recognized in Accumulated Other Comprehensive Income

 

The following items are components of net pension cost for the periods indicated:

 

   Estimated   Actual 
(in thousands)  2014   2013 
Service cost - benefits earned during the year  $981   $1,174 
Interest costs on projected benefit obligations   732    646 
Expected return on plan assets   (887)   (797)
Expected administrative expenses   40    40 
Amortization of prior service cost   79    79 
Amortization of unrecognized net loss   0    31 
Net periodic pension expense  $945   $1,173 
           
Pension expense - three months ended September 30, (actual)  $236   $286 
Pension expense - nine months ended September 30, (actual)  $708   $858 

  

22
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

  

(9)Stock Compensation

 

The Company’s stock option plan provides for the grant of options to purchase up to 569,392 shares of the Company’s common stock to officers and other key employees of the 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.

 

The following table summarizes the Company’s stock option activity:

 

           Weighted     
       Weighted   Average   Aggregate 
   Number   average   Contractual   Intrinsic 
   of   Exercise   Term   Value 
   Shares   Price   (in years)   ($000) 
Outstanding, beginning of period   126,286   $23.21           
Granted   0    0.00           
Exercised   0    0.00           
Forfeited   (9,884)   22.57           
Expired   (18,990)   27.86           
Outstanding, September 30, 2014   97,412   $22.37    2.20   $0.00 
Exercisable, September 30, 2014   86,091   $22.76    2.00   $0.00 

 

Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2014.

  

Total stock-based compensation expense was $5,000 and $15,000 for the three and nine months ended September 30, 2014, respectively, and $7,000 and $14,000 for the three and nine months ended September 30, 2013, respectively. As of September 30, 2014, the total unrecognized compensation expense related to non-vested stock awards was $35,000 and the related weighted average period over which it is expected to be recognized is approximately 1.4 years.

 

23
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(10)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 year. Diluted earnings per share gives effect to all dilutive potential common shares that were outstanding during the year. The calculations of basic and diluted earnings per share are as follows for the periods indicated:

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(dollars in thousands, except per share data)  2014   2013   2014   2013 
Basic earnings per common share:                
Net income  $1,568   $1,569   $5,653   $3,245 
Less:                    
Preferred stock dividends and accretion of discount   0    0    0    615 
Net income available to common shareholders  $1,568   $1,569   $5,653   $2,630 
Basic earnings per share  $0.30   $0.30   $1.08   $0.50 
Diluted earnings per common share:                    
Net income  $1,568   $1,569   $5,653   $3,245 
Less:                    
Preferred stock dividends and accretion of discount   0    0    0    615 
Net income available to common shareholders  $1,568   $1,569   $5,653   $2,630 
Average shares outstanding   5,233,986    5,233,986    5,233,986    5,233,986 
Effect of dilutive stock options   0    0    0    0 
Average shares outstanding including dilutive stock options   5,233,986    5,233,986    5,233,986    5,233,986 
Diluted earnings per share  $0.30    0.30    1.08   $0.50 

 

Under the treasury stock method, outstanding stock options are dilutive when the average market price of the Company’s common stock, when combined with the effect of any unamortized compensation expense, exceeds the option price during the period, except when the 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.

 

Options to purchase 97,412 shares during the three and nine months ended September 30, 2014, and 195,313 shares during the three and nine months ended September 30, 2013 were not included in the respective computations of diluted earnings per share because the exercise price of the option, 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.

 

24
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

   

(11)Fair Value Measurements

 

The Company uses fair value measurements to record fair value adjustments to certain financial and nonfinancial assets and liabilities. The FASB 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, 2014 and December 31, 2013, respectively, there were no transfers into or out of Levels 1-3.

 

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 the 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 have significantly decreased and on identifying circumstances when a transaction may not be considered orderly.

 

The 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. 

 

Valuation Methods for Instruments Measured at Fair Value on a Recurring Basis

 

Following is a description of the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a recurring basis:

 

Available-for-Sale Securities

 

The fair value measurements of the Company’s investment securities are determined by a third party pricing service which considers 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. The fair value measurements are subject to independent verification to another pricing source by management each quarter for reasonableness. Securities classified as available-for-sale are reported at fair value utilizing Level 2 inputs.

 

Mortgage Servicing Rights

 

The fair value of mortgage servicing rights is based on the discounted value of estimated future cash flows utilizing contractual cash flows, servicing rate, constant prepayment rate, servicing cost, and discount rate factors. Accordingly, the fair value is estimated based on a valuation model that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees. The valuation models estimate the present value of estimated future net servicing income. The Company classifies its servicing rights as Level 3.

 

25
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

  

       Fair Value Measurements 
       Quoted Prices         
       in Active         
       Markets for   Other   Significant 
       Identical   Observable   Unobservable 
       Assets   Inputs   Inputs 
(in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3) 
September 30, 2014                    
Assets:                    
Government sponsored enterprises  $62,051   $0   $62,051   $0 
Asset-backed securities   109,317    0    109,317    0 
Obligations of states and political subdivisions   34,448    0    34,448    0 
Mortgage servicing rights   2,867    0    0    2,867 
Total  $208,683   $0   $205,816   $2,867 
                     
December 31, 2013                    
Assets:                    
U.S. Treasury  $1,003   $1,003   $0   $0 
Government sponsored enterprises   60,616    0    60,616    0 
Asset-backed securities   110,373    0    110,373    0 
Obligations of states and political subdivisions   33,993    0    33,993    0 
Mortgage servicing rights   3,036    0    0    3,036 
Total  $209,021   $1,003   $204,982   $3,036 

 

26
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

  

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:

 

   Fair Value Measurements Using 
   Significant Unobservable Inputs 
   (Level 3) 
   Mortgage Servicing Rights 
  Three Months Ended September 30,   Nine Months Ended September 30, 
(in thousands)   2014   2013   2014   2013 
Balance at beginning of period  $2,911   $2,873   $3,036   $2,549 
Total gains or losses (realized/unrealized):                    
Included in earnings   (139)   123    (386)   86 
Included in other comprehensive income   0    0    0    0 
Purchases   0    0    0    0 
Sales   0    0    0    0 
Issues   95    83    217    444 
Settlements   0    0    0    0 
Balance at end of period  $2,867   $3,079   $2,867   $3,079 

  

Total gains included in earnings attributable to the change in unrealized gains or losses related to assets still held were $27,000 and $97,000 for the three and nine months ended September 30, 2014, respectively, and $296,000 and $677,000 for the three and nine months ended September 30, 2013, respectively.

  

   Quantitative Information about Level 3 Fair Value Measurements    
   Valuation Technique  Unobservable Inputs  Input Value 
         Nine Months Ended September 30, 
         2014   2013 
Mortgage servicing rights   Discounted cash flows  Weighted average constant prepayment rate   10.05%   10.94%
      Weighted average discount rate   9.18%   8.56%
      Weighted average expected life (in years)   5.90    5.70 

 

Valuation methods for instruments measured at fair value on a nonrecurring basis

 

Following is a description of the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a nonrecurring basis:

 

Impaired Loans

 

The Company does not record loans at fair value on a recurring basis other than loans that are considered impaired. The net carrying value of impaired loans is generally based on fair values of the underlying collateral obtained through independent appraisals or internal evaluations, 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, 2014, the Company identified $14.7 million in impaired loans that had specific allowances for losses aggregating $4.7 million. Related to these loans, there was $2.1 million in charge-offs recorded during the nine months ended September 30, 2014. As of September 30, 2013, the Company identified $24.0 million in impaired loans that had specific allowances for losses aggregating $4.6 million. Related to these loans, there was $2.5 million in charge-offs recorded during the nine months ended September 30, 2013.

 

27
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

  

Other Real Estate and Foreclosed Assets

 

Other real estate and foreclosed assets consisted of loan collateral that 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 assets are recorded as held for sale initially at the lower of the loan balance or fair value of the collateral less estimated selling costs. The Company relies on external appraisals and assessment of property values by 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.

 

   Fair Value Measurements Using 
       Quoted Prices           Three   Nine 
       in Active           Months   Months 
       Markets for   Other   Significant   Ended   Ended 
       Identical   Observable   Unobservable   September 30,   September 30, 
   Total   Assets   Inputs   Inputs   Total Gains   Total Gains 
(in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3)   (Losses)*   (Losses)* 
September 30, 2014                              
Assets:                              
Impaired loans:                              
Commercial, financial, & agricultural  $1,364   $0   $0   $1,364   $(28)  $(150)
Real estate construction - residential   1,767    0    0    1,767    0    (60)
Real estate construction - commercial   0    0    0    0    0    (491)
Real estate mortgage - residential   3,795    0    0    3,795    (41)   (179)
Real estate mortgage - commercial   2,887    0    0    2,887    (131)   (1,200)
Consumer   213    0    0    213    (4)   (74)
Total  $10,026   $0   $0   $10,026   $(204)  $(2,154)
Other real estate and foreclosed assets  $12,438   $0   $0   $12,438   $(203)  $(1,733)
                               
September 30, 2013                              
Assets:                              
Impaired loans:                              
Commercial, financial, & agricultural  $1,315   $0   $0   $1,315   $(607)  $(692)
Real estate construction - residential   1,902    0    0    1,902    0    (119)
Real estate construction - commercial   3,990    0    0    3,990    0    0 
Real estate mortgage - residential   2,079    0    0    2,079    (81)   (327)
Real estate mortgage - commercial   10,082    0    0    10,082    (376)   (1,363)
Consumer   38    0    0    38    0    0 
Total  $19,406   $0   $0   $19,406   $(1,064)  $(2,501)
Other real estate and foreclosed assets  $15,868   $0   $0   $15,868   $(320)  $(5,006)

 

* Total gains (losses) reported for other real estate and foreclosed assets includes charge-offs, valuation write downs, and net losses taken during the periods reported.

 

28
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(12)Fair Value of Financial Instruments

 

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:

 

Loans

 

The fair values of loans are estimated by discounting the expected future cash flows using the current rates at which similar loans could be made to borrowers with similar credit ratings and for the same remaining maturities. The net carrying amount of impaired loans is generally based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC Topic 820.

 

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 provided 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 Home Loan Bank (FHLB) Stock

 

Ownership of equity securities of FHLB is restricted and there is no established market for their resale. The carrying amount is a reasonable estimate of fair value.

 

Federal Funds Sold, Cash, and Due from Banks

 

The carrying amounts of short-term federal funds sold and securities purchased under agreements to resell, interest earning deposits with banks, and cash and due from banks approximate fair value. Federal funds sold and securities purchased under agreements to resell classified as short-term generally mature in 90 days or less.

 

Mortgage Servicing Rights

 

The fair value of mortgage servicing rights is based on the discounted value of estimated future cash flows utilizing contractual cash flows, servicing rate, constant prepayment rate, servicing cost, and discount rate factors. Accordingly, the fair value is estimated based on a valuation model that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees.

 

Cash Surrender Value - Life Insurance

 

The fair value of Bank owned life insurance (BOLI) approximates the carrying amount. Upon liquidation of these investments, the Company would receive the cash surrender value which equals the carrying amount.

 

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.

 

29
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

  

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.

 

Subordinated Notes and Other Borrowings

 

The fair value of subordinated notes and other borrowings is based on the discounted value of contractual cashflows. The discount rate is estimated using the rates currently offered for other borrowed money of similar remaining maturities.

 

A summary of the carrying amounts and fair values of the Company’s financial instruments at September 30, 2014 and December 31, 2013 is as follows:

 

           September 30, 2014 
           Fair Value Measurements 
           Quoted Prices         
           in Active       Net 
           Markets for   Other   Significant 
   September 30, 2014   Identical   Observable   Unobservable 
   Carrying   Fair   Assets   Inputs   Inputs 
(in thousands)  Amount   Value   (Level 1)   (Level 2)   (Level 3) 
                     
Assets:                         
Cash and due from banks  $19,681   $19,681   $19,681   $0   $0 
Federal funds sold and overnight interest-bearing deposits   5,099    5,099    5,099    0    0 
Investment in available-for-sale securities   205,816    205,816    0    205,816    0 
Loans, net   848,952    850,761    0    0    850,761 
Investment in FHLB stock   2,755    2,755    0    2,755    0 
Mortgage servicing rights   2,867    2,867    0    0    2,867 
Cash surrender value - life insurance   2,269    2,269    0    2,269    0 
Accrued interest receivable   4,735    4,735    4,735    0    0 
   $1,092,174   $1,093,983   $29,515   $210,840   $853,628 
Liabilities:                         
Deposits:                         
Non-interest bearing demand  $200,280   $200,280   $200,280   $0   $0 
Savings, interest checking and money market   433,833    433,833    433,833    0    0 
Time deposits   330,592    332,065    0    0    332,065 
Federal funds purchased and securities sold under agreements to repurchase   19,543    19,543    19,543    0    0 
Subordinated notes   49,486    33,404    0    33,404    0 
Federal Home Loan Bank advances   35,000    36,658    0    36,658    0 
Accrued interest payable   382    382    382    0    0 
   $1,069,116   $1,056,165   $654,038   $70,062   $332,065 

  

30
 

  

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

           December 31, 2013 
           Fair Value Measurements 
           Quoted Prices         
           in Active       Net 
           Markets for   Other   Significant 
   December 31, 2013   Identical   Observable   Unobservable 
   Carrying   Fair   Assets   Inputs   Inputs 
(in thousands)  Amount   Value   (Level 1)   (Level 2)   (Level 3) 
                          
Assets:                         
Cash and due from banks  $27,079   $27,079   $27,079   $0   $0 
Federal funds sold and overnight interest-bearing deposits   1,360    1,360    1,360    0    0 
Investment in available-for-sale securities   205,985    205,985    1,003    204,982    0 
Loans, net   825,828    829,223    0    0    829,223 
Investment in FHLB stock   2,354    2,354    0    2,354    0 
Mortgage servicing rights   3,036    3,036    0    0    3,036 
Cash surrender value - life insurance   2,213    2,213    0    2,213    0 
Accrued interest receivable   4,999    4,999    4,999    0    0 
   $1,072,854   $1,076,249   $34,441   $209,549   $832,259 
Liabilities:                         
Deposits:                         
Non-interest bearing demand  $187,382   $187,382   $187,382   $0   $0 
Savings, interest checking and money market   419,085    419,085    419,085    0    0 
Time deposits   350,004    352,432    0    0    352,432 
Federal funds purchased and securities sold under agreements to repurchase   31,084    31,084    31,084    0    0 
Subordinated notes   49,486    32,048    0    32,048    0 
Federal Home Loan Bank advances   24,000    25,366    0    25,366    0 
Accrued interest payable   426    426    426    0    0 
   $1,061,467   $1,047,823   $637,977   $57,414   $352,432 

 

Off-Balance Sheet Financial Instruments

 

The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the likelihood of the counterparties drawing on such financial instruments, and the present creditworthiness of such counterparties. The Company believes such commitments have been made on terms that are competitive in the markets in which it operates.

 

Limitations

 

The fair value estimates provided are made at a point in time based on market information and information about the financial instruments. Because no market exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the fair value estimates.

 

31
 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(13)Repurchase Reserve Liability

 

The Company’s repurchase reserve liability for estimated losses incurred on sold loans was $160,000 at September 30, 2014. This liability represents management’s estimate of the potential repurchase or make-whole liability for residential mortgage loans originated for sale that may arise from representation and warranty claims that could relate to a variety of issues, including but not limited to, misrepresentation of facts, appraisal issues, or program requirements that may not meet investor guidelines. The Company has not experienced any repurchase losses during the nine months ended September 30, 2014. At September 30, 2014, the Company was servicing 3,058 loans sold to the secondary market with a balance of approximately $314.4 million compared to 3,114 loans sold with a balance of approximately $322.5 million at December 31, 2013.

 

(14)Commitments and Contingencies

 

The Company issues financial instruments with off-balance-sheet risk in the normal course of business of meeting the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments may involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.

 

The Company’s extent of involvement and maximum potential exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for financial instruments included on its consolidated balance sheets. At September 30, 2014, no amounts have been accrued for any estimated losses for these financial instruments.

 

The contractual amount of off-balance-sheet financial instruments as of the periods indicated:

 

   September 30,   December 31, 
(in thousands)  2014   2013 
Commitments to extend credit  $136,921   $117,880 
Commitments to originate residential first and second mortgage loans   2,832    1,852 
Standby letters of credit   1,511    1,826 

 

Commitments

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since certain of the commitments and letters of credit are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, furniture and equipment, and real estate.

 

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support contractual obligations of the Company’s customers. The approximate remaining term of standby letters of credit range from one month to five years at September 30, 2014.

 

Pending Litigation

 

The Company and its subsidiaries are defendants in various legal actions incidental to the Company’s past and current business activities. Based on the Company’s analysis, and considering the inherent uncertainties associated with litigation, management does not believe that it is reasonably possible that these legal actions will materially adversely affect the Company’s consolidated financial condition or results of operations in the near term. The Company records a loss accrual for all legal matters for which it deems a loss is probable and can be reasonably estimated. Some legal matters, which are at early stages in the legal process, have not yet progressed to the point where a loss is deemed probable or an amount can be estimated.

32
 

 

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 the Company, Hawthorn Bancshares, Inc., 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 the Company’s 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 the Company and its acquisition targets may be greater than expected,
·legislative or regulatory changes may adversely affect the business in which the Company and its subsidiaries are engaged, 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 under the Act are expected to primarily impact financial institutions with assets greater than $10 billion, the Company expects these new regulations could reduce revenues and increase expenses in the future. Management is currently assessing the impact of the Act and of the regulations anticipated to be promulgated under the Act.

 

We have described under the caption Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, and in other reports filed 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 have not been 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

 

Through the branch network of its subsidiary bank, the Company, with $1.2 billion in assets at September 30, 2014, 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. The Company also provides a wide range of lending services, including real estate, commercial, installment, and other consumer loans. Other financial services that the Company provides include automated teller machines, trust services, credit-related insurance, and safe-deposit boxes. The geographic areas in which the Company provides products and services include the communities in and surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson, and Lee's Summit, Missouri.

 

The 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. The Company also derives income from trust, brokerage, credit card and mortgage banking activities and service charge income.

 

33
 

  

Much of the Company's business is commercial, commercial real estate development, and mortgage lending. The Company has experienced soft loan demand in the communities within which we operate during the current economic slowdown. The Company's income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancings.

 

The success of the Company's growth strategy depends primarily on the ability of its banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. The Company's financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of the Company's growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control.

 

The Company’s subsidiary bank, Hawthorn Bank (Bank), is a full-service bank conducting a general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial and industrial loans, residential real estate loans, single payment personal loans, installment loans and credit card accounts. In addition, the Bank provides trust services.

 

The deposit accounts of the Bank are insured by the Federal Deposit Insurance Corporation (FDIC) to the extent provided by law. The operations of the Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of the Bank are conducted by representatives of the FDIC and the Missouri Division of Finance. Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. The Company is subject to supervision and examination by the by the Board of Governors of the Federal Reserve System.

 

CRITICAL ACCOUNTING POLICIES

 

The following accounting policies are considered most critical to the understanding of the 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 the critical accounting policies on the business operations are discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations, where such policies affect the reported and expected financial results.

 

Allowance for Loan Losses

 

Management has identified the accounting policy related to the allowance for loan losses as critical to the understanding of the 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. Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on the Company’s business operations is provided in note 1 to the Company’s unaudited consolidated financial statements and is also discussed in the Lending and Credit Management section below. Many of the loans are deemed collateral dependent for purposes of the measurement of the impairment loss, thus the fair value of the underlying collateral and sensitivity of such fair values due to changing market conditions, supply and demand, condition of the collateral and other factors can be volatile over periods of time. Such volatility can have an impact on the financial performance of the Company.

 

Other Real Estate and Foreclosed Assets

 

Other real estate and foreclosed assets consist of loan collateral that 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 assets are initially recorded as held for sale at the fair value of the collateral less estimated selling costs. Any adjustment is recorded as a charge-off against the allowance for loan losses. The Company relies on external appraisals and assessment of property values by 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. The write-downs are recorded as other real estate expense, net. The Company establishes a valuation allowance related to other real estate owned on an asset-by-asset basis. The valuation allowance is created during the holding period when the fair value less cost to sell is lower than the cost of the property.

 

34
 

  

SELECTED CONSOLIDATED FINANCIAL DATA

 

The following table presents selected consolidated financial information for the Company as of and for each of the three and nine months ended September 30, 2014 and 2013, respectively. The selected consolidated financial data should be read in conjunction with the unaudited consolidated financial statements of the Company, including the related notes, presented elsewhere herein.

 

Selected Financial Data                
   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
(In thousands, except per share data)  2014   2013   2014   2013 
Per Share Data                    
Basic earnings per common share  $0.30   $0.30   $1.08   $0.50 
Diluted earnings per common share   0.30    0.30    1.08    0.50 
Dividends paid and accretion of discount on preferred stock   -    -    -    456 
Dividends paid on common stock   252    242    755    726 
Book value per common share             15.38    13.72 
Market price per common share             13.75    13.09 
Selected Ratios                    
(Based on average balance sheets)                    
Return on total assets   0.54%   0.54%   0.65%   0.37%
Return on common stockholders' equity   7.71%   8.68%   9.69%   4.79%
Common stockholders' equity to total assets   6.97%   6.26%   6.74%   7.04%
Efficiency ratio (1)   80.68%   80.99%   76.08%   82.18%
Efficiency ratio (2)   77.74%   72.25%   74.25%   70.44%
                     
(Based on end-of-period data)                    
Common stockholders' equity to assets             6.96%   6.35%
Total risk-based capital ratio             15.68%   15.36%
Tier 1 risk-based capital ratio             12.02%   11.39%
Leverage ratio (3)             9.18%   8.56%

 

(1)Efficiency ratio is calculated as non-interest expense as a percentage of revenue. Total revenue includes net interest income and non-interest income.
(2)Does not include other real estate expense or gain on sale of investment securities.
(3)Leverage ratio is calculated by dividing Tier 1 capital by average total consolidated assets.

 

35
 

  

RESULTS OF OPERATIONS ANALYSIS

 

The Company has prepared all of the consolidated financial information in this report in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). In preparing the consolidated financial statements in accordance with U.S. GAAP, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(In thousands)  2014   2013   $ Change   % Change   2014   2013   $ Change   % Change 
                                 
Net interest income  $9,956   $9,865   $91    0.9%  $29,457   $29,409   $48    0.2%
Provision for loan losses   -    -    -    -    -    2,000    (2,000)   (100.0)
Noninterest income   2,313    2,447    (134)   (5.5)   6,582    8,543    (1,961)   (23.0)
Noninterest expense   9,899    9,972    (73)   (0.7)   27,417    31,188    (3,771)   (12.1)
Income before income taxes   2,370    2,340    30    1.3    8,622    4,764    3,858    81.0 
Income tax expense   802    771    31    4.0    2,969    1,519    1,450    95.5 
Net income  $1,568   $1,569   $(1)   (0.1)%  $5,653   $3,245   $2,408    74.2%
Preferred stock dividends and accretion of discount   -    -    -    -    -    615    (615)   (100.0)
Net income available to common shareholders  $1,568   $1,569   $(1)   (0.1)%  $5,653   $2,630   $3,023    114.9%

 

Business Events On December 19, 2008, the 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. Participation in this program included the 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 287,133 shares of common stock. On May 9, 2012, the Company redeemed 12,000 of the 30,255 shares of preferred stock issued under the U.S. Treasury’s CPP program, and on May 15, 2013, the remaining 18,255 shares were redeemed.

 

On June 11, 2013, the common stock warrant issued under the U.S. Treasury Department’s CPP program was repurchased by the Company pursuant to a letter agreement between the Treasury and the Company for a total repurchase price of $540,000, or $1.88 per warrant share. The repurchase price was based on the fair value of the warrant as agreed upon by the Company and the Treasury. The repurchase of the warrant ends the Company’s participation in the U.S. Treasury Department’s CPP.

 

For the sixth consecutive year, on July 1, 2014, the Company distributed a four percent stock dividend to shareholders of record at the close of business on June 15, 2014. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect the stock dividend.

 

Consolidated net income was $1.6 million for both the three month periods ended September 30, 2014 and 2013. Net income available to common shareholders for both the three month periods ended September 30, 2014 and 2013 was $1.6 million, or $0.30 per diluted common share. For the three months ended September 30, 2014, the return on average assets was 0.54%, the return on average common stockholders’ equity was 7.71%, and the efficiency ratio was 80.68%.

 

For the nine months ended September 30, 2014, consolidated net income was $5.7 million compared to $3.2 million for the nine months ended September 30, 2013. For the nine months ended September 30, 2014, net income available to common shareholders was $5.7 million, or $1.08 per diluted common share, compared to $2.6 million, or $0.50 per diluted common share, for the nine months ended September 30, 2013. For the nine months ended September 30, 2014, the return on average assets was 0.65%, the return on average common stockholders’ equity was 9.69%, and the efficiency ratio was 76.08%.

 

Net interest income was $10.0 million for the three months ended September 30, 2014 compared to $9.9 million for the three months ended September 30, 2013. The net interest margin decreased to 3.71% for the three months ended September 30, 2014, compared to 3.74% for the three months ended September 30, 2013. Net interest income was $29.4 million for both the nine months ended September 30, 2014 and 2013. The net interest margin increased to 3.71% for the nine months ended September 30, 2014, compared to 3.68% for the nine months ended September 30, 2013. During the third quarter of 2013, $23.0 million from a 58 month 6.05% certificate of deposit special matured and approximately $5.7 million was reinvested at current market rates. These changes are discussed in greater detail under the Average Balance Sheets and Rate and Volume Analysis section below.

 

36
 

  

The lower provision for loan losses for the three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013, respectively, was primarily due to decreases in historical loss rates based on the Company’s last thirty-six months of charge-off experience. Net charge-offs for the three months ended September 30, 2014, were $117,000, or 0.05% of average loans (annualized), compared to $1.1 million, or 0.53% of average loans (annualized), for the three months ended September 30, 2013. Net charge-offs for the nine months ended September 30, 2014, were $1.7 million, or 0.27% of average loans (annualized), compared to $2.6 million, or 0.41% of average loans (annualized), for the nine months ended September 30, 2013. Non-performing loans totaled $35.7 million, or 4.15% of total loans, at September 30, 2014 compared to $35.3 million, or 4.21% of total loans, at December 31, 2013, and $36.6 million, or 4.44% of total loan, at September 30, 2013. These changes are discussed in greater detail under the Lending and Credit Management section below.

 

Non-interest income decreased $134,000, or 5.5%, for the three months ended September 30, 2014 and decreased $1.9 million, or 23.0%, for the nine months ended September 30, 2014, compared to the three and nine months ended September 30, 2013, respectively. These changes are discussed in greater detail below under Non-interest Income.

 

Non-interest expense decreased $73,000, or 0.7%, for the three months ended September 30, 2014 and decreased $3.8 million, or 12.1%, for the nine months ended September 30, 2014, respectively, compared to the three and nine months ended September 30, 2013, respectively. These changes are discussed in greater detail below under Non-interest Expense.

 

Average Balance Sheets

 

Net interest income is the largest source of revenue resulting from the 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. 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 periods ended September 30, 2014 and 2013, respectively.

 

37
 

  

   Three Months Ended September 30, 
(In thousands)  2014   2013 
       Interest   Rate       Interest   Rate 
   Average   Income/   Earned/   Average   Income/   Earned/ 
   Balance   Expense(1)   Paid(1)   Balance   Expense(1)   Paid(1) 
ASSETS                              
Loans: (2) (4)                              
Commercial  $146,143   $1,749    4.75%  $140,082   $1,689    4.78%
Real estate construction - residential   21,603    260    4.77    23,679    264    4.42 
Real estate construction - commercial   63,071    657    4.13    47,690    529    4.40 
Real estate mortgage - residential   235,124    2,790    4.71    218,199    2,748    5.00 
Real estate mortgage - commercial   373,138    4,470    4.75    380,216    4,661    4.86 
Consumer   18,683    259    5.50    21,333    319    5.93 
Total loans  $857,762   $10,185    4.71%  $831,199   $10,210    4.87%
Investment securities: (3)                              
U.S. Treasury  $0   $0    0.00%  $1,009   $3    1.18%
Government sponsored enterprises   63,211    229    1.44    64,455    199    1.22 
Asset backed securities   112,350    601    2.12    116,223    660    2.25 
State and municipal   34,195    284    3.30    34,905    328    3.73 
Total investment securities  $209,756   $1,114    2.11%  $216,592   $1,190    2.18%
Other investments and securities, at cost   4,123    20    1.92    4,074    21    2.05 
Federal funds sold and interest bearing deposits in other financial institutions   7,056    5    0.28    8,117    6    0.29 
Total interest earning assets  $1,078,697   $11,324    4.16%  $1,059,982   $11,427    4.28%
All other assets   92,234              100,452           
Allowance for loan losses   (12,180)             (15,423)          
Total assets  $1,158,751             $1,145,011           
LIABILITIES AND                              
STOCKHOLDERS' EQUITY                              
NOW accounts  $195,162   $115    0.23%  $184,912   $118    0.25%
Savings   83,837    12    0.06    76,849    21    0.11 
Money market   164,001    102    0.25    160,865    99    0.24 
Time deposits of $100,000 and over   142,806    237    0.66    153,323    282    0.73 
Other time deposits   194,144    331    0.68    211,971    477    0.89 
Total time deposits  $779,950   $797    0.41%  $787,920   $997    0.50%
Federal funds purchased and securities sold under agreements to repurchase   21,029    5    0.09    22,335    7    0.12 
Subordinated notes   49,486    318    2.55    49,486    323    2.59 
Federal Home Loan Bank Advances   28,043    120    1.70    24,837    106    1.69 
Total borrowings  $98,558   $443    1.78%  $96,658   $436    1.79%
Total interest bearing liabilities  $878,508   $1,240    0.56%  $884,578   $1,433    0.64%
Demand deposits   193,230              180,497           
Other liabilities   6,297              8,209           
Total liabilities   1,078,035              1,073,284           
Stockholders' equity   80,716              71,727           
Total liabilities and stockholders' equity  $1,158,751             $1,145,011           
Net interest income (FTE)        10,084              9,994      
Net interest spread             3.60%             3.64%
Net interest margin             3.71%             3.74%

 

(1)Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $128,000 and $129,000 for the three months ended September 30, 2014 and 2013, 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.

 

38
 

  

   Nine Months Ended September 30, 
(In thousands)  2014   2013 
       Interest   Rate       Interest   Rate 
   Average   Income/   Earned/   Average   Income/   Earned/ 
   Balance   Expense(1)   Paid(1)   Balance   Expense(1)   Paid(1) 
ASSETS                              
Loans: (2) (4)                              
Commercial  $142,802   $5,060    4.74%  $136,321   $4,998    4.90%
Real estate construction - residential   22,894    755    4.41    23,467    790    4.50 
Real estate construction - commercial   59,851    1,902    4.25    46,173    1,653    4.79 
Real estate mortgage - residential   231,493    8,312    4.80    218,226    8,268    5.07 
Real estate mortgage - commercial   373,427    13,351    4.78    388,529    14,364    4.94 
Consumer   18,972    789    5.56    22,863    1,009    5.90 
Total loans  $849,439   $30,169    4.75%  $835,579   $31,082    4.97%
Investment securities: (3)                              
U.S. Treasury  $382   $3    1.05%  $1,503   $17    1.51%
Government sponsored enterprises   66,627    697    1.40    68,147    613    1.20 
Asset backed securities   111,498    1,859    2.23    119,349    2,026    2.27 
State and municipal   33,319    854    3.43    35,168    989    3.76 
Total investment securities  $211,826   $3,413    2.15%  $224,167   $3,645    2.17%
Other investments and securities, at cost   4,044    59    1.95    4,036    62    2.05 
Federal funds sold and interest bearing deposits in other financial institutions   10,428    23    0.29    17,388    35    0.27 
Total interest earning assets  $1,075,737   $33,664    4.18%  $1,081,170   $34,824    4.31%
All other assets   94,310              102,849           
Allowance for loan losses   (12,895)             (15,229)          
Total assets  $1,157,152             $1,168,790           
LIABILITIES AND                              
STOCKHOLDERS' EQUITY                              
NOW accounts  $204,141   $406    0.27%  $195,178   $403    0.28%
Savings   82,157    45    0.07    74,751    59    0.11 
Money market   162,753    299    0.25    159,602    290    0.24 
Time deposits of $100,000 and over   143,934    723    0.67    154,261    886    0.77 
Other time deposits   198,778    1,068    0.72    225,955    2,095    1.24 
Total time deposits  $791,763   $2,541    0.43%  $809,747   $3,733    0.62%
Federal funds purchased and securities sold under agreements to repurchase   20,085    13    0.09    19,997    16    0.11 
Subordinated notes   49,486    945    2.55    49,486    963    2.60 
Federal Home Loan Bank Advances   25,747    328    1.70    23,003    315    1.83 
Total borrowings  $95,318   $1,286    1.80%  $92,486   $1,294    1.87%
Total interest bearing liabilities  $887,081   $3,827    0.58%  $902,233   $5,027    0.74%
Demand deposits   185,843              176,861           
Other liabilities   6,231              7,424           
Total liabilities   1,079,155              1,086,518           
Stockholders' equity   77,997              82,272           
Total liabilities and stockholders' equity  $1,157,152             $1,168,790           
Net interest income (FTE)        29,837              29,797      
Net interest spread             3.60%             3.57%
Net interest margin             3.71%             3.68%

 

(1)Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $380,000 and $388,000 for the nine months ended September 30, 2014 and 2013, 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.

 

39
 

  

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, 2014, respectively, compared to the three and nine months ended September 30, 2013, respectively. 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, 
   2014 vs. 2013   2014 vs. 2013 
       Change due to       Change due to 
   Total   Average   Average   Total   Average   Average 
(In thousands)  Change   Volume   Rate   Change   Volume   Rate 
Interest income on a fully taxable equivalent basis: (1)                              
Loans: (2) (4)                              
Commercial  $60   $73   $(13)  $62   $233   $(171)
Real estate construction - residential   (4)   (24)   20    (35)   (19)   (16)
Real estate construction - commercial   128    162    (34)   249    450    (201)
Real estate mortgage - residential   42    206    (164)   44    489    (445)
Real estate mortgage - commercial   (191)   (86)   (105)   (1,013)   (548)   (465)
Consumer   (60)   (38)   (22)   (220)   (165)   (55)
Investment securities: (3)                              
U.S. Treasury   (3)   (2)   (1)   (14)   (10)   (4)
Government sponsored entities   30    (4)   34    84    (14)   98 
Asset backed securities   (59)   (22)   (37)   (167)   (131)   (36)
State and municipal   (44)   (7)   (37)   (135)   (50)   (85)
Other investments and securities, at cost   (1)   0    (1)   (3)   0    (3)
Federal funds sold and interest bearing deposits in other financial institutions   (1)   (1)   0    (12)   (15)   3 
Total interest income   (103)   257    (360)   (1,160)   220    (1,380)
Interest expense:                              
NOW accounts   (3)   7    (10)   3    19    (16)
Savings   (9)   2    (11)   (14)   6    (20)
Money market   3    2    1    9    6    3 
Time deposits of $100,000 and over   (45)   (18)   (27)   (163)   (56)   (107)
Other time deposits   (146)   (37)   (109)   (1,027)   (228)   (799)
Federal funds purchased and securities                              
sold under agreements to repurchase   (2)   0    (2)   (3)   0    (3)
Subordinated notes   (5)   0    (5)   (18)   0    (18)
Federal Home Loan Bank advances   14    14    0    13    36    (23)
Total interest expense   (193)   (30)   (163)   (1,200)   (217)   (983)
Net interest income on a fully taxable equivalent basis  $90   $287   $(197)  $40   $437   $(397)

 

(1)Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $128,000 and $129,000 for the three months September 30, 2014 and 2013, respectively, and $380,000 and $388,000 for the nine months ended September 30, 2014 and 2013, 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.

 

Financial results for the three months ended September 30, 2014 compared to the three months ended September 30, 2013, reflected an increase in net interest income, on a tax equivalent basis, of $90,000, or 0.90%, and financial results for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, reflected a increase in net interest income, on a tax equivalent basis, of $40,000, or 0.13%. The increase in net interest income for the three and nine months ended September 30, 2014 is primarily due to lower costs of certificates of deposit and borrowings.

 

Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.71% for the three months ended September 30, 2014 compared to 3.74% for the three months ended September 30, 2013, and increased to 3.71% for the nine months ended September 30, 2014 compared to 3.68% for the nine months ended September 30, 2013. Although the volume and yield on average earning assets decreased for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, the increase in the net interest margin was primarily due to lower costs of certificates of deposit. See Interest expense on deposits below for further discussion on lower costs of certificates of deposit.

 

40
 

  

Average interest-earning assets increased $18.7 million, or 1.77%, to $1.08 billion for the three months ended September 30, 2014 compared to $1.06 billion for the three months ended September 30, 2013, and average interest bearing liabilities decreased $6.1 million, or 0.69%, to $878.5 million for the three months ended September 30, 2014 compared to $884.6 million for the three months ended September 30, 2013.

 

Average interest-earning assets decreased $5.4 million, or 0.5%, to $1.07 billion for the nine months ended September 30, 2014 compared to $1.08 billion for the nine months ended September 30, 2013, and average interest bearing liabilities decreased $15.2 million, or 1.68%, to $887.1 million for the nine months ended September 30, 2014 compared to $902.2 million for the nine months ended September 30, 2013.

 

Total interest income (expressed on a fully taxable equivalent basis) decreased to $11.3 million and $33.7 million for the three and nine months ended September 30, 2014, respectively, compared to $11.4 million and $34.8 million for the three and nine months ended September 30, 2013, respectively. The Company’s rates earned on interest earning assets were 4.16% and 4.18% for the three and nine months ended September 30, 2014, respectively, compared to 4.28% and 4.31% for the three and nine months ended September 30, 2013, respectively.

 

Interest income on loans decreased to $10.2 million and $30.2 million for the three and nine months ended September 30, 2014, respectively, compared to $10.2 million and $31.1 million for the three and nine months ended September 30, 2013, respectively.

 

Average loans outstanding increased $26.6 million, or 3.20%, to $857.8 million for the three months ended September 30, 2014 compared to $831.2 million for the three months ended September 30, 2013. The average yield on loans receivable decreased to 4.71% for the three months ended September 30, 2014 compared to 4.87% for the three months ended September 30, 2013 primarily as a result of decreasing market interest rates.

 

Average loans outstanding increased $13.9 million, or 1.66%, to $849.4 million for the nine months ended September 30, 2014 compared to $835.6 million for the nine months ended September 30, 2013. The average yield on loans receivable decreased to 4.75% for the nine months ended September 30, 2014 compared to 4.97% for the nine months ended September 30, 2013 primarily as a result of decreasing market interest rates. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

 

Total interest expense decreased to $1.2 million and $3.8 million for the three and nine months ended September 30, 2014, respectively, compared to $1.4 million and $5.0 million for the three and nine months ended September 30, 2013, respectively. The Company’s rates paid on interest bearing liabilities was 0.56% and 0.58% for the three and nine months ended September 30, 2014, respectively, compared to 0.64% and 0.74% for the three months and nine months ended September 30, 2013, respectively. See the Liquidity Management section for further discussion.

 

Interest expense on deposits decreased to $797,000 and $2.5 million for the three and nine months ended September 30, 2014 compared to $997,000 and $3.7 million for the three and nine months ended September 30, 2013.

 

Average time deposits decreased $8.0 million, or 1.01%, to $779.9 million for the three months ended September 30, 2014 compared to $787.9 million for the three months ended September 30, 2013. The average cost of deposits decreased to 0.41% for the three months ended September 30, 2014 compared to 0.50% for the three months ended September 30, 2013 primarily as a result of lower market interest rates and the maturity of $23.0 million from a 58 month 6.05% certificate of deposit special during the third quarter of 2013.

 

For the nine months ended September 30, 2014, average time deposits decreased $18.0 million, or 2.22%, to $791.8 million for the nine months ended September 30, 2014 compared to $809.7 million for the nine months ended September 30, 2013. The cost of deposits decreased to 0.43% for the nine months ended September 30, 2014 to 0.62% for the nine months ended September 30, 2013.

 

Interest expense on borrowings increased to $443,000 for the three months ended September 30, 2014 compared to $436,000 for the three months ended September 30, 2013, and was $1.3 million for both the nine months ended September 30, 2014 and 2013, respectively. Average borrowings increased to $98.6 million and $95.3 million for the three and nine months ended September 30, 2014, respectively, compared to $96.6 million and $92.5 million for the three and nine months ended September 30, 2013, respectively. See the Liquidity Management section for further discussion.

 

41
 

  

Non-interest Income and Expense

 

Non-interest income for the periods indicated was as follows:

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(In thousands)  2014   2013   $ Change   % Change   2014   2013   $ Change   % Change 
Non-interest Income                                        
Service charges on deposit accounts  $1,381   $1,463   $(82)   (5.6)%  $3,954   $4,213   $(259)   (6.1)%
Trust department income   211    179    32    17.9    641    598    43    7.2 
Real estate servicing fees, net   86    338    (252)   (74.6)   285    760    (475)   (62.5)
Gain on sales of mortgage loans, net   330    175    155    88.6    778    1,515    (737)   (48.6)
Gain on sale of investment securities   0    0    0    NM    0    554    (554)   NM 
Other   305    292    13    4.5    924    903    21    2.3 
Total non-interest income  $2,313   $2,447   $(134)   (5.5)%  $6,582   $8,543   $(1,961)   (23.0)%
                                         
Non-interest income as a % of total revenue *   18.9%   19.9%             18.3%   22.5%          
Total revenue per full time  equivalent employee  $35.7   $35.6             $104.8   $109.7           

* Total revenue is calculated as net interest income plus non-interest income.

    NM - not meaningful

 

Total non-interest income decreased $134,000, or 5.5%, to $2.3 million for the quarter ended September 30, 2014 compared to $2.4 million for the quarter ended September 30, 2013, and decreased $1.9 million, or 23.0%, to $6.6 million for the nine months ended September 30, 2014 compared to $8.5 million for the nine months ended September 30, 2013.

 

Real estate servicing fees, net decreased $252,000, or 74.6%, to $86,000 for the quarter ended September 30, 2014 compared to $338,000 for the quarter ended September 30, 2013, and decreased $475,000, or 62.5%, to $285,000 for the nine months ended September 30, 2014 compared to $760,000 for the nine months ended September 30, 2013. Net real estate servicing fees include mortgage loan servicing fees and the gains or losses due to the change in fair value of MSRs arising from inputs and assumptions. Mortgage loan servicing fees earned on loans sold were $226,000 and $672,000 for the three and nine months ended September 30, 2014, respectively, compared to $215,000 and $674,000 for the three and nine months ended September 30, 2013, respectively. Total net losses recognized related to MSRs due to the change in fair value were $(139,000) and $(386,000) for the three and nine months ended September 30, 2014, respectively, compared to total net gains of $123,000 and $86,000 for the three and nine months ended September 30, 2013, respectively. The Company was servicing $314.4 million of mortgage loans at September 30, 2014 compared to $322.5 million and $323.0 million at December 31, 2013 and September 30, 2013, respectively.

 

Gain on sales of mortgage loans increased $155,000, or 88.6%, to $330,000 for the quarter ended September 30, 2014 compared to $175,000 for the quarter ended September 30, 2013, and decreased $737,000, or 48.6%, to $778,000 for the nine months ended September 30, 2014 compared to $1.5 million for the nine months ended September 30, 2013. The Company sold loans of $11.0 million and $25.6 million for the three months and nine months ended September 30, 2014, respectively, compared to $12.6 million and $63.4 million for the three and nine months ended September 30, 2013, respectively. During the third quarter of 2013 the Company recorded a $150,000 increase in a repurchase reserve liability for estimated losses incurred on sold loans that was included in total gain on sales of mortgage loans, compared to no additional reserve during the three and nine months ended September 30, 2014. (See Repurchase Reserve Liability footnote for further discussion) Refinancing activity impacting both the volume of loans sold and gains recognized continued to be slow during 2014 primarily due to rising interest rates.

 

42
 

  

Non-interest expense for the periods indicated was as follows:

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(In thousands)  2014   2013   $ Change   % Change   2014   2013   $ Change   % Change 
Non-interest Expense                                        
Salaries  $4,363   $3,658   $705    19.3%  $11,944   $11,023   $921    8.4%
Employee benefits   1,219    1,205    14    1.2    3,629    3,573    56    1.6 
Occupancy expense, net   705    695    10    1.4    1,997    1,973    24    1.2 
Furniture and equipment expense   438    474    (36)   (7.6)   1,334    1,438    (104)   (7.2)
FDIC insurance assessment   244    253    (9)   (3.6)   724    753    (29)   (3.9)
Legal, examination, and professional fees   341    207    134    64.7    849    727    122    16.8 
Advertising and promotion   305    310    (5)   (1.6)   852    907    (55)   (6.1)
Postage, printing, and supplies   268    308    (40)   (13.0)   813    854    (41)   (4.8)
Processing expense   758    749    9    1.2    2,278    2,758    (480)   (17.4)
Other real estate expense   361    1,265    (904)   (71.5)   657    4,437    (3,780)   (85.2)
Other   897    848    49    5.8    2,340    2,745    (405)   (14.8)
Total non-interest expense  $9,899   $9,972   $(73)   (0.7)%  $27,417   $31,188   $(3,771)   (12.1)%
Efficiency ratio *   80.7%   81.0%             76.1%   82.2%          
Efficiency ratio ***   77.7    72.3              74.3    70.4           
Salaries and benefits as a % of total non-interest expense   56.4%   48.8%             56.8%   46.8%          
Number of full-time equivalent employees   344    346              344    346           

* Efficiency ratio is calculated as non-interest expense as a percent of revenue. Total revenue includes net interest income and non-interest income.

*** Does not include other real estate expense or gain on sale of investment securities

 

Total non-interest expense decreased $73,000, or 0.70%, to $9.9 million for the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013, and decreased $3.8 million, or 12.1%, to $27.4 million for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013.

 

Salaries increased $705,000, or 19.3%, to $4.4 million for the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013, and increased $921,000, or 8.4%, for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. The increase for both the three and nine months ended September 30, 2014 was primarily due to the accrual of a 2014 incentive program approved by the Board of Directors in the third quarter to be paid out in March of 2015.

 

Legal, examination, and professional fees increased $134,000, or 64.7%, to 341,000 for the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013, and increased $122,000, or 16.8%, for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. The increase for both the three and nine months ended September 30, 2014 over the three and nine months ended September 30, 2013, primarily consisted of an increase in legal fees related to impaired loans, increase in audit and tax fees, and an increase in consulting fees related to strategic planning.

 

Processing expense increased $9,000, or 1.2%, to 758,000 for the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013, and decreased $480,000, or 17.4%, for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. In 2013 a one time consulting fee was incurred to negotiate reduced future core processing expenses. A portion of this fee is being amortized over the new contract period with the Company’s core processing vendor. The overall decrease during the nine months ended is primarily due to contract savings resulting in lower core processing expenses.

 

Other real estate (ORE) expense decreased $904,000, or 71.5%, to $361,000 for the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013, and decreased $3.8 million, or 85.2%, to $657,000 for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. The expense provision for valuation write-downs taken on ORE was $276,000 and $450,000 for the three and nine months ended September 30, 2014, respectively, compared to $846,000 and $3.0 million for the three months and nine months ended September 30, 2013, respectively. The significant expense provision during the first nine months of 2013 primarily related to two hotels located in the Branson area that were sold at auction during the second quarter of 2013. Expenses incurred to maintain foreclosed properties were $87,000 and $362,000 for the three and nine months ended September 30, 2014, respectively, compared to $260,000 and $1.3 million for the three and nine months ended September 30, 2013, respectively. Overall operating costs began to decrease during the third quarter of 2013 due to the sale of the hotels.

 

Other non-interest expense increased $49,000, or 5.8%, to $897,000 for the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013, and decreased $405,000, or 14.8%, to $2.3 million for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. The increase for the three months ended

 

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September 30, 2014 was primarily a result of a $136,000 loss recorded due to employee fraud that management discovered during the third quarter of 2014. (see Item 4. Controls and Procedures for further discussion) This loss was partially offset by reduced levels of credit card dispute charge-offs and loan expenses. The decrease for the nine months ended September 30, 2014 was primarily due to a decrease in core deposit intangible (CDI) asset amortization which became fully amortized in the second quarter of 2013, and a decrease in consumer loan expense primarily related to a $239,000 write-down on repossessed mining equipment during the second quarter of 2013.

 

Income taxes

 

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 33.8% for the quarter ended September 30, 2014 compared to 33.0% for the quarter ended September 30, 2013, and was 34.4% for the nine months ended September 30, 2014 compared to 31.9% for the nine months ended September 30, 2013.

 

Lending and Credit Management

 

Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 73.4% of total assets as of September 30, 2014 compared to 72.4% as of December 31, 2013.

 

Lending activities are conducted pursuant to an established loan policy approved by the Bank’s Board of Directors. The Bank’s credit review process is overseen by regional loan committees with established loan approval limits. 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.

 

A summary of loans, by major class within the Company’s loan portfolio as of the dates indicated is as follows:

 

   September 30,   December 31, 
(In thousands)  2014   2013 
Commercial, financial, and agricultural  $150,733   $141,845 
Real estate construction - residential   19,935    21,008 
Real estate construction - commercial   62,391    55,076 
Real estate mortgage - residential   234,244    225,630 
Real estate mortgage - commercial   374,909    375,686 
Installment loans to individuals   18,773    20,302 
Total loans  $860,985   $839,547 
Percent of categories to total loans:          
Commercial, financial, and agricultural   17.5%   16.9%
Real estate construction - residential   2.3    2.5 
Real estate construction - commercial   7.2    6.6 
Real estate mortgage - residential   27.2    26.9 
Real estate mortgage - commercial   43.5    44.7 
Installment loans to individuals   2.3    2.4 
Total   100.0%   100.0%

 

The Company extends credit to its local community market through traditional real estate mortgage products. The Company does not participate in extending credit to sub-prime residential real estate markets. The Company does not lend funds for the type of transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Company does not have any interest-earning assets that would have been included in nonaccrual, past due, or restructured loans if such assets were loans.

 

The 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 the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. For the nine months ended September 30, 2014, the Company sold approximately $25.6 million of loans to investors compared to $63.4 million for the nine months ended September 30, 2013. At September 30, 2014, the Company was servicing approximately $314.4 million of loans sold to the secondary market compared to $322.5 million at December 31, 2013, and $323.0 million at September 30, 2013.

 

Risk Elements of the Loan Portfolio

 

Management, the 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 $2.0 million in aggregate and all adversely classified credits identified by management are reviewed. In addition, all other loans are reviewed on a sample basis. The

 

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senior loan committee reviews and reports to the board of directors, on a monthly basis, 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, specific reserves are estimated 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 potential 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 to provide for probable losses inherent in the loan portfolio.

 

Nonperforming Assets

 

The following table summarizes nonperforming assets at the dates indicated:

 

   September 30,   December 31, 
(In thousands)  2014   2013 
Nonaccrual loans:          
Commercial, financial, and agricultural  $2,036   $1,684 
Real estate construction - residential   2,040    2,204 
Real estate construction - commercial   5,678    6,251 
Real estate mortgage - residential   5,175    4,165 
Real estate mortgage - commercial   9,183    9,074 
Installment loans to individuals   268    302 
Total  $24,380   $23,680 
           
Loans contractually past - due 90 days or more and still accruing:          
Commercial, financial, and agricultural  $0   $0 
Real estate construction - residential   0    0 
Real estate construction - commercial   56    0 
Real estate mortgage - residential   48    129 
Real estate mortgage - commercial   0    100 
Installment loans to individuals   1    14 
Total  $105   $243 
Troubled debt restructurings - accruing   11,246    11,395 
Total nonperforming loans   35,731    35,318 
Other real estate owned and foreclosed assets   12,438    14,867 
Total nonperforming assets  $48,169   $50,185 
           
Loans  $860,985   $839,547 
Allowance for loan losses to loans   1.40%   1.63%
Nonperforming loans to loans   4.15%   4.21%
Allowance for loan losses to nonperforming loans   33.68%   38.84%
Nonperforming assets to loans, other real estate owned and foreclosed assets   5.51%   5.87%

 

Total nonperforming assets totaled $48.2 million at September 30, 2014 compared to $50.2 million at December 31, 2013. Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing, and TDRs totaled $35.7 million, or 4.15%, of total loans at September 30, 2014 compared to $35.3 million, or 4.21%, of total loans at December 31, 2013. See further discussion below.

 

It is the Company's policy to discontinue the accrual of interest income on loans when management believes that the borrower’s financial condition, after consideration of business conditions and collection efforts, is such that the collection of interest is doubtful, or upon which principal or interest due has been in default for a period of 90 days or more and the asset is not 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 collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis. Contractual interest lost on loans in non-accrual status was $268,000 and $862,000 for the three and nine months ended September 30, 2014, respectively, and $269,000 and $929,000 for the three and nine months ended September 30, 2013, respectively.

 

As of September 30, 2014 and December 31, 2013, approximately $12.9 million and $21.0 million, respectively, of loans classified as substandard, not included in the nonperforming asset table, were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms.

 

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Even though borrowers are experiencing moderate cash flow problems as well as some deterioration in collateral value, management believes the general allowance was sufficient to cover the risks and probable losses related to such loans at September 30, 2014 and December 31, 2013, respectively.

 

Total non-accrual loans at September 30, 2014 increased $700,000 to $24.4 million from December 31, 2013. This increase primarily consisted of a $352,000 increase in commercial, financial and agricultural non-accrual loans and a $1.0 million increase in real estate mortgage - residential non-accrual loans. This increase was partially offset by a $737,000 decrease in real estate construction non-accrual loans. At September 30, 2014 and December 31, 2013, real estate mortgage – commercial non-accrual loans made up 38% of total non-accrual loans for both period ends.

 

Loans past due 90 days and still accruing interest at September 30, 2014 were $105,000 compared to $243,000 at December 31, 2013. Other real estate and foreclosed assets at September 30, 2014 were $12.4 million compared to $14.9 million at December 31, 2013. During the nine months ended September 30, 2014, $1.8 million of nonaccrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets, and a net $450,000 additional provision to the valuation allowance was recorded to reflect current fair values. This is compared to $3.3 million of nonaccrual loans, net of charge-offs taken, that moved to other real estate owned and repossessed assets, and an additional net $3.0 million provision during the nine months ended September 30, 2013. The provision during 2013 primarily related to two hotels located in the Branson area that were sold during the second quarter.

 

The following table summarizes the Company’s TDRs at the dates indicated:

 

   September 30, 2014   December 31, 2013 
(In thousands)  Number of
Contracts
   Recorded
Investment
   Specific
Reserves
   Number of
Contracts
   Recorded
Investment
   Specific
Reserves
 
TDRs - Accrual                              
Commercial, financial and agricultural   11   $2,392   $38    9   $2,331   $101 
Real estate construction - commercial   0    0    0    1    364    0 
Real estate mortgage - residential   7    3,464    826    6    2,352    529 
Real estate mortgage - commercial   6    5,390    0    6    6,348    885 
Total TDRs - Accrual   24   $11,246   $864    22   $11,395   $1,515 
TDRs - Non-accrual                              
Commercial, financial and agricultural   3   $146   $42    2   $88   $8 
Real estate construction - commercial   1    3,742    0    1    3,742    0 
Real estate mortgage - residential   3    369    214    5    639    229 
Real estate mortgage - commercial   5    5,058    371    7    5,572    424 
Consumer   2    43    25    2    43    15 
Total TDRs - Non-accrual   14   $9,358   $652    17   $10,084   $676 
Total TDRs   38   $20,604   $1,516    39   $21,479   $2,191 

 

At September 30, 2014, loans classified as TDRs totaled $20.6 million, of which $9.4 million were on non-accrual status and $11.2 million were on accrual status. At December 31, 2013, loans classified as TDRs totaled $21.5 million, of which $10.1 million were on non-accrual status and $11.4 million were on accrual status. The net decrease in total TDRs from December 31, 2013 was primarily due to $1.6 million additions to TDRs that were offset by $889,000 charged off, and approximately $1.6 million of payments received.

 

Provision and Allowance for Loan Losses

 

As mentioned above, the Company is continuing to recover from the deterioration of collateral values during the prior and current economic conditions. The allowance for loan losses was $12.0 million, or 1.40%, of loans outstanding at September 30, 2014 compared to $13.7 million, or 1.63%, of loans outstanding at December 31, 2013, and $14.3 million, or 1.73%, of loans outstanding at September 30, 2013.

 

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The following table summarizes loan loss experience for the periods indicated:

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
(In thousands)  2014   2013   2014   2013 
Analysis of allowance for loan losses:                    
Balance beginning of period  $12,150   $15,358   $13,719   $14,842 
Charge-offs:                    
Commercial, financial, and agricultural   105    654    291    817 
Real estate construction - residential   -    -    59    119 
Real estate construction - commercial   -    135    491    135 
Real estate mortgage - residential   41    368    236    754 
Real estate mortgage - commercial   80    178    1,152    1,205 
Installment loans to individuals   71    91    270    271 
Total charge-offs   297    1,426    2,499    3,301 
Recoveries:                    
Commercial, financial, and agricultural  $55   $201   $282   $265 
Real estate construction - residential   -    -    60    - 
Real estate construction - commercial   -    -    -    2 
Real estate mortgage - residential   26    39    151    84 
Real estate mortgage - commercial   67    34    160    206 
Installment loans to individuals   32    48    160    156 
Total recoveries   180    322    813    713 
Net charge-offs   117    1,104    1,686    2,588 
Provision for loan losses   -    -    -    2,000 
Balance end of period  $12,033   $14,254   $12,033   $14,254 

 

Loan Charge-offs

 

The Company’s net loan charge-offs were $117,000, or 0.05%, of average loans (annualized) for the three months ended September 30, 2014, compared to net loan charge-offs of $1.1 million, or 0.53%, of average loans (annualized) for the three months ended September 30, 2013. Real estate mortgage charge-offs increased to 41% of total charge-offs during the three months ended September 30, 2014 compared to 38% of total charge-offs during the three months ended September 30, 2013. Commercial, financial, and agricultural charge-offs decreased to 35% of total charge-offs during the three months ended September 30, 2014 compared to 46% of total charge-offs during the three months ended September 30, 2013.

 

The Company’s net loan charge-offs were $1.7 million, or 0.27%, of average loans (annualized) for the nine months ended September 30, 2014 compared to net loan charge-offs of $2.6 million, or 0.41%, of average loans (annualized), for the nine months ended September 30, 2013. Real estate mortgage charge-offs decreased to 55% of total charge-offs during the nine months ended September 30, 2014 compared to 60% of total charge-offs during the nine months ended September 30, 2013. Real estate construction charge-offs increased to 22% of total charge-offs during the nine months ended September 30, 2014 compared to 8% of total charge-offs during the nine months ended September 30, 2013. Commercial, financial, and agricultural charge-offs decreased to 12% of total charge-offs during the nine months ended September 30, 2014 compared to 25% of total charge-offs during the nine months ended September 30, 2013.

 

Provision

 

There was no provision for loan losses during the three and nine months ended September 30, 2014 compared to no provision and $2.0 million for the three and nine months ended September 30, 2013, respectively. Due to decreases in historical loss rates based on the Company’s last thirty-six months of charge-off experience, no provision was required during the nine months ended September 30, 2014.

 

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Allowance for Loan Losses

 

The following table is a summary of the allocation of the allowance for loan losses:

 

   September 30,   December 31, 
(In thousands)  2014   2013 
Allocation of allowance for loan losses at end of period:          
Commercial, financial, and agricultural  $1,705   $2,374 
Real estate construction - residential   379    931 
Real estate construction - commercial   522    631 
Real estate mortgage - residential   2,703    2,959 
Real estate mortgage - commercial   6,422    6,523 
Installment loans to individuals   273    294 
Unallocated   29    7 
Total  $12,033   $13,719 

 

The Company’s allowance for loan losses decreased to $12.0 million at September 30, 2014 compared to $13.7 million at December 31, 2013. The decrease from December 31, 2013 primarily consisted of a $669,000 decrease in commercial, financial, and agricultural loans, a 552,000 decrease in real estate construction - residential loans, and a $256,000 decrease in real estate mortgage – residential loans. The ratio of the allowance for loan losses to nonperforming loans was 33.7% at September 30, 2014, compared to 38.8% at December 31, 2013.

 

The following table is a summary of the general and specific allocations of the allowance for loan losses:

 

   September 30,   December 31, 
(In thousands)  2014   2013 
Allocation of allowance for loan losses:          
Individually evaluated for impairment - specific reserves  $4,661   $4,796 
Collectively evaluated for impairment - general reserves   7,372    8,923 
Total  $12,033   $13,719 

 

The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2014, $4.7 million of the Company’s allowance for loan losses was allocated to impaired loans totaling approximately $35.6 million compared to $4.8 million of the Company's allowance for loan losses allocated to impaired loans totaling approximately $35.1 million at December 31, 2013. Management determined that $20.9 million, or 59%, of total impaired loans required no reserve allocation at September 30, 2014 compared to $18.8 million, or 54%, at December 31, 2013 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

 

The incurred loss component of the general reserve, or loans collectively evaluated for impairment, is determined by applying percentages to pools of loans by asset type. Loans not individually evaluated are aggregated based on similar risk characteristics. Historical loss rates for each risk group, which is updated quarterly, are quantified using all recorded loan charge-offs. Management determined that the previous twelve quarters were reflective of the loss characteristics of the Company’s loan portfolio during the recent economic environment. These historical loss rates for each risk group are used as the starting point to determine allowance provisions. The Company’s methodology includes factors that allow management to adjust its estimates of losses based on the most recent information available. The rates are then adjusted through the use of qualitative risk factors to reflect actual changes and anticipated changes such as changes in specific allowances on loans and real estate acquired through foreclosure, any gains and losses on final disposition of real estate acquired through foreclosure, changes in national and local economic conditions and developments, including general economic and business conditions affecting the Company’s key lending areas, credit quality trends, specific industry conditions within portfolio segments, bank regulatory examination results, and findings of the internal loan review department. These qualitative risk factors are reviewed and updated quarterly, as appropriate.

 

The specific and general reserve allocations represent management’s best estimate of probable losses contained in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.

 

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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 the Company, management prefers to focus on transaction accounts and full service relationships with customers.

 

The Company’s Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for the 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 the Company's liquidity.

 

The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company’s most liquid assets are comprised of available for sale investment securities, federal funds sold, and excess reserves held at the Federal Reserve.

 

   September 30,   December 31, 
(In thousands)  2014   2013 
Federal funds sold and other overnight interest-bearing deposits  $5,099   $1,360 
Available-for-sale investment securities   205,816    205,985 
Total  $210,915   $207,345 

 

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 $205.8 million at September 30, 2014 and included an unrealized net loss of $466,000. The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately $7.7 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company’s deposit base.

 

The Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law. At September 30, 2014 and December 31, 2013, the Company’s unpledged securities in the available for sale portfolio totaled approximately $47.5 million and $60.2 million, respectively.

 

Total investment securities pledged for these purposes were as follows:

 

   September 30,   December 31, 
(In thousands)  2014   2013 
Investment securities pledged for the purpose of securing:          
Federal Reserve Bank borrowings  $3,511   $3,360 
Federal funds purchased and securities sold under agreements to repurchase   22,690    25,149 
Other deposits   132,069    117,283 
Total pledged, at fair value  $158,270   $145,792 

 

Liquidity is available from the Company’s base of core customer deposits, defined as demand, interest checking, savings, and money market deposit accounts. At September 30, 2014, such deposits totaled $634.1 million and represented 65.7% of the Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships. Time deposits and certificates of deposit of $100,000 and over totaled $330.6 million at September 30, 2014. These accounts are normally considered more volatile and higher costing representing 34.3% of total deposits at September 30, 2014.

 

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Core deposits at September 30, 2014 and December 31, 2013 were as follows:

 

   September 30,   December 31, 
(In thousands)  2014   2013 
Core deposit base:          
Non-interest bearing demand  $200,280   $187,382 
Interest checking   184,362    182,103 
Savings and money market   249,471    236,982 
Total  $634,113   $606,467 

 

Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. The Company’s outside borrowings are comprised of securities sold under agreements to repurchase, Federal Home Loan Bank advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of September 30, 2014, under agreements with these unaffiliated banks, the Bank may borrow up to $40.0 million in federal funds on an unsecured basis and $7.8 million on a secured basis. There were no federal funds purchased outstanding at September 30, 2014. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company’s investment portfolio. At September 30, 2014, there was $19.5 million in repurchase agreements. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at September 30, 2014.

 

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, 2014, the Bank had $35.0 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.

 

Borrowings outstanding at September 30, 2014 and December 31, 2013 were as follows:

 

   September 30,   December 31, 
(In thousands)  2014   2013 
Borrowings:          
Securities sold under agreements to repurchase  $19,543   $31,084 
Federal Home Loan Bank advances   35,000    24,000 
Subordinated notes   49,486    49,486 
Total  $104,029   $104,570 

 

The 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, the Company may draw advances against this collateral.

 

The following table reflects the advance equivalent of the assets pledged, borrowings, and letters of credit outstanding in addition to the estimated future funding capacity available to the Company as follows:

 

   September 30,   December 31, 
   2014   2013 
(In thousands)  FHLB   Federal
Reserve
Bank
   Federal
Funds
Purchased
Lines
   Total   FHLB   Federal
Reserve
Bank
   Federal
Funds
Purchased
Lines
   Total 
Advance equivalent  $258,117   $3,441   $44,330   $305,888   $259,221   $3,286   $41,430   $303,937 
Advances outstanding   (35,000)   0    0    (35,000)   (24,000)   0    (13,504)   (37,504)
Total available  $223,117   $3,441   $44,330   $270,888   $235,221   $3,286   $27,926   $266,433 

 

At September 30, 2014, loans with a market value of $366.5 million were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At September 30, 2014, investments with a market value of $8.6 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.

 

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Sources and Uses of Funds

 

Cash and cash equivalents were $24.8 million at September 30, 2014 compared to $28.4 million at December 31, 2013. The $3.6 million decrease resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the nine months ended September 30, 2014. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $9.9 million for the nine months ended September 30, 2014.

 

Investing activities consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio, used total cash of $20.4 million. The cash outflow primarily consisted of $41.3 million purchases of investment securities and a $24.1 million increase the loan portfolio, partially offset by $42.6 million proceeds from maturities, calls, and pay-downs of investment securities and $3.9 million in net proceeds from sales of other real estate and repossessed assets.

 

Financing activities provided cash of $6.9 million, resulting primarily from a 14.7 million increase in interest bearing transaction accounts, a $12.9 million increase in demand deposits, and a $11.0 million net increase in FHLB advances. This was partially offset by a $19.4 million decrease in time deposits and an $11.5 million decrease in federal funds purchased and securities sold under agreements to repurchase. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2014.

 

In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company's various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company's liquidity. The Company had $141.3 million in unused loan commitments and standby letters of credit as of September 30, 2014. Although the Company's current liquidity resources are adequate to fund this commitment level the nature of these commitments is such that the likelihood of such a funding demand is very low.

 

The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company’s ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its common and preferred shareholders. The Company paid cash dividends to its common and preferred shareholders totaling approximately $755,000 and $1.2 million for the nine months ended September 30, 2014 and 2013, respectively. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $2.0 million in dividends to the Company during the nine months ended September 30, 2014. At September 30, 2014 and December 31, 2013, the Company had cash and cash equivalents totaling $753,000 and $450,000, respectively.

 

Capital Management

 

The Company and the 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 the Company’s consolidated financial statements. Under capital adequacy guidelines, the Company and the 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 the Company and the 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 the Company and the 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, 2014 and December 31, 2013, the Company and the Bank each met all capital adequacy requirements.

 

In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for community banking organizations begins January 1, 2015, while larger institutions (generally those with assets of $250 billion or more) must begin compliance on January 1, 2014. The final rules call for the following capital requirements: 

 

·A minimum ratio of common tier 1 capital to risk-weighted assets of 4.5%.
·A minimum ratio of tier 1 capital to risk-weighted assets of 6%.
·A minimum leverage ratio of 4%.

 

In addition, the final rules establish a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. If a banking organization fails to hold capital above the minimum capital ratios and the capital conservation buffer, it will be subject to certain restrictions on capital distributions and discretionary bonus payments. The phase-in period for the capital conservation and countercyclical capital buffers for all banking organizations will begin on January 1, 2016.

 

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Under the proposed rules previously issued by the federal banking agencies, accumulated other comprehensive income (AOCI) would have been included in a banking organization’s common equity tier 1 capital. The final rules allow community banks to make a one-time election not to include these new AOCI components in regulatory capital and instead use the existing treatment under the general risk-based capital rules that excludes most AOCI components from regulatory capital. The opt-out election must be made in the first call report or FR Y-9 series report that is filed after the financial institution becomes subject to the final rule. 

 

The final rules permanently grandfather non-qualifying capital instruments (such as trust preferred securities and cumulative perpetual preferred stock) issued before May 19, 2010 for inclusion in the tier 1 capital of banking organizations with total consolidated assets less than $15 billion as of December 31, 2009 and banking organizations that were mutual holding companies as of May 19, 2010.

 

The Company has assessed the impact of these changes and it does not expect there to be a material impact on the regulatory ratios of the Company and the Bank and on the capital, operations and earnings of the Company and the Bank.

 

The Company exceeded all capital adequacy requirements as of September 30, 2014 and December 31, 2013.

 

       Minimum   Well-Capitalized 
   Actual   Capital Requirements   Capital Requirements 
(in thousands)  Amount   Ratio   Amount   Ratio   Amount   Ratio 
September 30, 2014                              
Total capital (to risk-weighted assets):                              
Company  $138,704    15.68%  $70,783    8.00%  $N.A.    N.A.%
Bank   128,230    14.67    69,922    8.00   87,403    10.00 
Tier I capital (to risk-weighted assets):                              
Company  $106,353    12.02%  $35,392    4.00%  $N.A.    N.A.%
Bank   117,291    13.42    34,961    4.00   52,442    6.00 
Tier I capital (to adjusted average assets):                              
Company  $106,353    9.18%  $34,764    3.00%  $N.A.    N.A.%
Bank   117,291    10.23    34,393    3.00    57,321    5.00 
                               
(in thousands)                              
December 31, 2013                              
Total capital (to risk-weighted assets):                              
Company  $133,638    15.33%  $69,728    8.00%  $N.A.    N.A.%
Bank   122,959    14.29    68,842    8.00   86,052    10.00 
Tier I capital (to risk-weighted assets):                              
Company  $99,398    11.40%  $34,864    4.00%  $N.A.    N.A.%
Bank   112,166    13.03    34,421    4.00   51,631    6.00 
Tier I capital (to adjusted average assets):                              
Company  $99,398    8.80%  $33,876    3.00%  $N.A.    N.A.%
Bank   112,166    10.04    33,517    3.00    55,862    5.00 

  

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Interest Sensitivity

 

Market risk arises from exposure to changes in interest rates and other relevant market rate or price risk. The Company faces market risk in the form of interest rate risk through transactions other than trading activities. The 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 the 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 the Company feels it has no primary exposure to specific points on the yield curve. For the three months ended September 30, 2014, our Company utilized a 400 basis point immediate and gradual move in interest rates (both upward and downward) applied to both a parallel and proportional yield curve. However, there are no assurances that the change will not be more or less than this estimate.

 

The following table represents estimated interest rate sensitivity and periodic and cumulative gap positions calculated as of September 30, 2014. Significant assumptions used for this table included: loans will repay at historic repayment rates; certain interest-bearing demand accounts are interest sensitive due to immediate repricing, and fixed maturity deposits will not be withdrawn prior to maturity. A significant variance in actual results from one or more of these assumptions could materially affect the results reflected in the table.

 

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                       Over     
                       5 Years or     
                       No stated     
(In thousands)  Year 1   Year 2   Year 3   Year 4   Year 5   Maturity   Total 
ASSETS                                   
Investment securities  $17,077   $21,623   $15,125   $22,000   $19,945   $110,046   $205,816 
Federal funds sold and other over-night interest-bearing deposits   5,099    -    -    -    -    -    5,099 
Other restricted investments   4,402    -    -    -    -    -    4,402 
Loans   356,680    126,811    137,092    102,384    99,740    38,278    860,985 
Total  $383,258   $148,434   $152,217   $124,384   $119,685   $148,324   $1,076,302 
                                    
LIABILITIES                                   
Savings, interest checking, and money market deposits  $241,549   $-   $192,284   $-   $-   $-   $433,833 
Time deposits   218,813    53,768    34,754    17,395    5,862    -    330,592 
Federal funds purchased and securities sold under agreements to repurchase   19,543    -    -    -    -    -    19,543 
Subordinated notes   49,486    -    -    -    -    -    49,486 
Federal Home Loan Bank advances   15,000    3,000    5,000    10,000    2,000    -    35,000 
Total  $544,391   $56,768   $232,038   $27,395   $7,862   $-   $868,454 
Interest-sensitivity GAP                                   
Periodic GAP  $(161,133)  $91,666   $(79,821)  $96,989   $111,823   $148,324   $207,848 
Cumulative GAP  $(161,133)  $(69,467)  $(149,288)  $(52,299)  $59,524   $207,848   $207,848 
                                    
Ratio of interest-earning assets to interest-bearing liabilities                                   
Periodic GAP   0.70    2.61    0.66    4.54    15.22    NM    1.24 
Cumulative GAP   0.70    0.88    0.82    0.94    1.07    1.24    1.24 

 

Effects of Inflation

 

The effects of inflation on financial institutions are different from the effects on other commercial enterprises since financial institutions make few significant capital or inventory expenditures, which are directly affected by changing prices. Because bank assets and liabilities are virtually all monetary in nature, inflation does not affect a financial institution as much as do changes in interest rates. The general level of inflation does underlie the general level of most interest rates, but interest rates do not increase at the rate of inflation as do prices of goods and services. Rather, interest rates react more to changes in the expected rate of inflation and to changes in monetary and fiscal policy.

 

Inflation does have an impact on the growth of total assets in the banking industry, often resulting in a need to increase capital at higher than normal rates to maintain an appropriate capital to asset ratio. In the opinion of management, inflation did not have a significant effect on the Company's operations for the three months ended September 30, 2014.

 

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, 2014. 

 

An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended) as of September 30, 2014. Based on that evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that, as of September 30, 2014, the Company’s disclosure controls and procedures were not effective because of the material weakness described below.

 

During the three months ended September 30, 2014, the Company’s management discovered employee fraud resulting in the loss of an aggregate $421,000 of cash over an extended period of time. As a result of the discovery, the Company recorded a $136,000 loss in its consolidated financial statements as of September 30, 2014, representing the $421,000 gross loss, net of expected insurance proceeds of $285,000. The Company determined that any adjustments relating to prior-period financial statements were immaterial.

 

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Management determined that the design and operation of the Company’s controls over the safeguarding of assets, specifically controls related to cash reconcilement and accounting, were not effective to ensure consistent application of established policies and procedures, including those designed to detect or prevent certain unauthorized, fraudulent transactions, and that such deficiency constituted a material weakness in the Company’s internal control over financial reporting. The Company promptly took steps to enhance its cash controls and procedures to remediate such material weakness, including, among other things, the adoption of clarifying revisions to existing policies to aid in their effective implementation, adjustments to the level of precision at which the controls operate, enhancements to the segregation of certain duties, and additional communication from senior management regarding effective application of existing controls and procedures.

 

In addition to these remedial measures, the Company performed a cash count at all of its branches utilizing the enhanced controls and procedures to ensure that cash totals reconciled to its financial statements. Management has discussed these remedial actions with the Audit Committee of the Company’s board of directors and, as of the date of this report, anticipates that these measures will strengthen the Company’s internal control over financial reporting to the extent necessary to remedy the material weakness described above. However, because of the nature of certain of these remedial actions, their operational effectiveness may only be validated over a period of time. Accordingly, their successful implementation will continue to be observed and evaluated before management is able to conclude that the material weakness has been remediated.

 

The Company cannot give assurances that these remedial actions will be successful or that it will not in the future identify further material weaknesses or significant deficiencies in the Company’s internal control over financial reporting that have not been discovered to date. Other than as discussed above, there were no changes in the Company’s internal controls over financial reporting during the quarter ended September 30, 2014 that materially affected or were reasonably likely to materially affect the Company’s internal control over financial reporting.

 

Impact of New Accounting Standards

 

Investments - Equity Method and Joint Ventures The FASB issued ASU No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects, in January 2014. These amendments allow investors in low income housing tax credit entities to account for the investments using a proportional amortization method, provided that certain conditions are met, and recognize amortization of the investment as a component of income tax expense. In addition, disclosures are required that will enable users to understand the nature of the investments, and the effect of the measurement of the investments and the related tax credits on the investor's financial statements. This ASU is effective for interim and annual periods beginning January 1, 2015 and should be applied retrospectively to all periods presented. The adoption is not expected to have a significant effect on the Company's consolidated financial statements.

 

Troubled Debt Restructurings by Creditors

 

The FASB issued ASU No. 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure, in January 2014. These amendments require companies to disclose the amount of foreclosed residential real estate property held and the recorded investment in consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process according to local requirements of the applicable jurisdiction. The ASU also defines when a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan. The amendments are effective for interim and annual periods beginning January 1, 2015. The adoption is not expected to have a significant effect on the Company's consolidated financial statements.

 

The FASB has issued ASU No. 2014-14, Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure in August 2014. The objective of this update is to reduce diversity in practice by addressing the classification of foreclosed mortgage loans that are fully or partially guaranteed under government programs, including those guaranteed by the FHA and the VA. Some creditors reclassify those loans to real estate consistent with other foreclosed loans that do not have guarantees; others reclassify the loans to other receivables. The amendments in this ASU require that a mortgage loan be derecognized and that a separate other receivable be recognized upon foreclosure if the following conditions are met: (1) The loan has a government guarantee that is not separable from the loan before foreclosure; (2) At the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under that claim; and (3) At the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed. Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. The amendments are effective for interim and annual periods beginning after December 15, 2014. The adoption is not expected to have a significant effect on the Company's consolidated financial statements.

 

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Presentation of Financial Statements - Going Concern Uncertainties. The FASB has issued ASU No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern in August 2014. ASU 2014-15 is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. Under Generally Accepted Accounting Principles (GAAP), financial statements are prepared under the presumption that the reporting organization will continue to operate as a going concern, except in limited circumstances. Financial reporting under this presumption is commonly referred to as the going concern basis of accounting. The going concern basis of accounting is critical to financial reporting because it establishes the fundamental basis for measuring and classifying assets and liabilities. Currently, GAAP lacks guidance about management’s responsibility to evaluate whether there is substantial doubt about the organization’s ability to continue as a going concern or to provide related footnote disclosures. This ASU provides guidance to an organization’s management, with principles and definitions that are intended to reduce diversity in the timing and content of disclosures that are commonly provided by organizations today in the financial statement footnotes. The amendments are effective for interim and annual periods ending after December 15, 2016. The adoption is not expected to have a significant effect on the Company's consolidated financial statements.

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PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings

 

The information required by this Item is set forth in Commitments and Contingencies, Pending Litigation, in our Company’s Notes to Consolidated Financial Statements (unaudited).

 

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. Mine Safety Disclosures 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).
     
3.2   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).
     
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
     
101   Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Changes in Equity, (iv) the Consolidated Statements of Cash Flows and (v) the Notes to Consolidated Financial Statements, tagged as blocks of text and in detail (XBRL)

 

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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/ David T. Turner  
     
November 14, 2014 David T. Turner, Chairman of the Board and  
  Chief Executive Officer (Principal Executive Officer)  
     
  /s/ W. Bruce Phelps  
     
November 14, 2014 W. Bruce Phelps, Chief Financial Officer (Principal Financial  
  Officer and Principal Accounting Officer)  

 

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HAWTHORN BANCSHARES, INC.

 

INDEX TO EXHIBITS

 

September 30, 2014 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).   **
         
3.2   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).   **
         
31.1   Certificate of the Chief Executive Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002   59
         
31.2   Certificate of the Chief Financial Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002   60
         
32.1   Certificate of the Chief Executive Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002   61
         
32.2   Certificate of the Chief Financial Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002   62
         
101   Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Changes in Equity, (iv) the Consolidated Statements of Cash Flows and (v) the Notes to Consolidated Financial Statements, tagged as blocks of text and in detail (XBRL)   *

 

 

*As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933, as amended, and Section 18 of the Securities Exchange Act of 1934, as amended.

**Incorporated by reference.

 

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