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 June 30, 2017

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, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth 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 ¨
Emerging growth company ¨  

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

 

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 August 4, 2017, the registrant had 5,831,210 shares of common stock, par value $1.00 per share, outstanding

 

 

 

 

 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Balance Sheets (unaudited)
(In thousands, except per share data)

 

   June 30,   December 31, 
   2017   2016 
ASSETS          
Cash and due from banks  $20,776   $25,589 
Federal funds sold and other overnight interest-bearing deposits   40,552    1,406 
Cash and cash equivalents   61,328    26,995 
Investment in available-for-sale securities, at fair value   216,353    214,512 
Other investments and securities, at cost   10,798    9,796 
Total investment securities   227,151    224,308 
Loans   1,035,020    974,029 
Allowances for loan losses   (10,545)   (9,886)
Net loans   1,024,475    964,143 
Premises and equipment - net   35,403    35,522 
Mortgage servicing rights   2,766    2,584 
Other real estate and repossessed assets - net   13,356    14,162 
Accrued interest receivable   4,754    5,183 
Cash surrender value - life insurance   2,448    2,409 
Other assets   11,869    11,742 
Total assets  $1,383,550   $1,287,048 
LIABILITIES AND STOCKHOLDERS' EQUITY          
Deposits          
Non-interest bearing demand  $279,634   $235,975 
Savings, interest checking and money market   517,678    468,731 
Time deposits $250,000 and over   56,534    73,523 
Other time deposits   228,841    232,437 
Total deposits   1,082,687    1,010,666 
Federal funds purchased and securities sold under agreements to repurchase   29,118    31,015 
Subordinated notes   49,486    93,392 
Federal Home Loan Bank advances   115,363    49,486 
Accrued interest payable   429    498 
Other liabilities   11,320    10,974 
Total liabilities   1,288,403    1,196,031 
Stockholders’ equity:          
Common stock, $1 par value, authorized 15,000,000 shares; issued 5,822,357 shares, respectively   5,822    5,822 
Surplus   45,665    41,498 
Retained earnings   50,796    51,671 
Accumulated other comprehensive loss, net of tax   (2,874)   (3,801)
Treasury stock; 210,465 and 205,750 shares, at cost   (4,262)   (4,173)
Total stockholders’ equity   95,147    91,017 
Total liabilities and stockholders’ equity  $1,383,550   $1,287,048 

 

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

 

 2

 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income (unaudited) 

         
   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
(In thousands, except per share amounts)  2017   2016   2017   2016 
INTEREST INCOME                    
Interest and fees on loans  $11,671   $10,308   $22,721   $20,295 
Interest on investment securities:                    
Taxable   737    831    1,491    1,769 
Nontaxable   168    119    325    262 
Federal funds sold and                    
other overnight interest-bearing deposits   11    17    60    50 
Dividends on other securities   94    75    184    151 
Total interest income   12,681    11,350    24,781    22,527 
INTEREST EXPENSE                    
Interest on deposits:                    
Savings, interest checking and money market   475    287    864    582 
Time deposit accounts $250,000 and over   99    85    191    153 
Other time deposits   410    383    789    764 
Interest on federal funds purchased and securities sold under agreements to repurchase   27    15    49    39 
Interest on subordinated notes   431    366    840    720 
Interest on Federal Home Loan Bank advances   419    243    741    450 
Total interest expense   1,861    1,379    3,474    2,708 
Net interest income   10,820    9,971    21,307    19,819 
Provision for loan losses   330    425    680    675 
Net interest income after provision for loan losses   10,490    9,546    20,627    19,144 
NON-INTEREST INCOME                    
Service charges and other fees   851    828    1,687    1,662 
Bank card income and fees   663    648    1,277    1,282 
Trust department income   266    265    540    483 
Real estate servicing fees, net   34    (86)   487    (32)
Gain on sale of mortgage loans, net   218    222    374    387 
Gain on sale of investment securities   0    18    0    490 
Other   67    54    141    125 
Total non-interest income   2,099    1,949    4,506    4,397 
NON-INTEREST EXPENSE                    
Salaries and employee benefits   5,352    5,305    10,806    10,655 
Occupancy expense, net   689    673    1,307    1,306 
Furniture and equipment expense   634    439    1,232    850 
Processing, network, and bank card expense   927    840    1,972    1,611 
Legal, examination, and professional fees   317    328    597    662 
FDIC insurance assessment   115    188    216    364 
Advertising and promotion   265    242    503    452 
Postage, printing, and supplies   263    291    495    527 
Real estate foreclosure expense, net   226    42    253    183 
Other   899    1,005    1,656    1,826 
Total non-interest expense   9,687    9,353    19,037    18,436 
Income before income taxes   2,902    2,142    6,096    5,105 
Income tax expense   983    730    2,076    1,695 
Net income   1,919    1,412    4,020    3,410 
Basic earnings per share  $0.33   $0.24   $0.69   $0.58 
Diluted earnings per share  $0.33   $0.24   $0.69   $0.58 

 

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

 

 3

 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income (unaudited)

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
(In thousands)  2017   2016   2017   2016 
Net income  $1,919   $1,412   $4,020   $3,410 
Other comprehensive income, net of tax                    
Investment securities available-for-sale:                    
Unrealized gain on investment securities available-for-sale, net of tax   595    837    900    2,082 
Adjustment for gain on sale of investment securities, net of tax   0    (11)   0    (304)
Defined benefit pension plans:                    
Amortization of prior service cost included in net periodic pension cost, net of tax   13    12    27    24 
Total other comprehensive income   608    838    927    1,802 
Total comprehensive income  $2,527   $2,250   $4,947   $5,212 

 

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

 

 4

 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Statements of Stockholders' Equity (unaudited)

 

               Accumulated       Total 
               Other       Stock - 
   Common       Retained   Comprehensive   Treasury   holders' 
(In thousands)  Stock   Surplus   Earnings   Loss   Stock   Equity 
Balance, December 31, 2015  $5,605   $38,549   $48,700   $(2,018)  $(3,550)  $87,286 
Net income   0    0    3,410    0    0    3,410 
Other comprehensive income   0    0    0    1,802    0    1,802 
Stock based compensation expense   0    11    0    0    0    11 
Purchase of treasury stock   0    0    0    0    (226)   (226)
Stock dividend   0    3,149    (3,149)   0    0    0 
Cash dividends declared, common stock   0    0    (542)   0    0    (542)
Balance, June 30, 2016  $5,605   $41,709   $48,419   $(216)  $(3,776)  $91,741 
                               
Balance, December 31, 2016  $5,822   $41,498   $51,671   $(3,801)  $(4,173)  $91,017 
Net income   0    0    4,020    0    0    4,020 
Other comprehensive income   0    0    0    927    0    927 
Stock based compensation expense   0    2    0    0    0    2 
Purchase of treasury stock   0    0    0    0    (89)   (89)
Stock dividend   0    4,165    (4,165)   0    0    0 
Cash dividends declared, common stock   0    0    (730)   0    0    (730)
Balance, June 30, 2017  $5,822   $45,665   $50,796   $(2,874)  $(4,262)  $95,147 

 

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

 

 5

 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (unaudited)

 

   Six Months Ended June 30, 
(In thousands)  2017   2016 
Cash flows from operating activities:          
Net income  $4,020   $3,410 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for loan losses   680    675 
Depreciation expense   874    962 
Net amortization of investment securities, premiums, and discounts   828    883 
Stock based compensation expense   2    11 
Change in fair value of mortgage servicing rights   (67)   453 
Gain on sale of investment securities   0    (490)
Loss (gain) on sales and dispositions of premises and equipment   1    (6)
Gain on sales and dispositions of other real estate and repossessed assets   (38)   (103)
Provision for other real estate owned   215    76 
Decrease in accrued interest receivable   429    227 
Increase in cash surrender value - life insurance   (39)   (31)
Increase in other assets   (613)   (715)
Decrease in accrued interest payable   (69)   (10)
Increase (decrease) in other liabilities   290    (546)
Origination of mortgage loans for sale   (17,101)   (17,017)
Proceeds from the sale of mortgage loans   16,861    17,520 
Gain on sale of mortgage loans, net   (374)   (387)
Other, net   (47)   (79)
Net cash provided by operating activities   5,852    4,833 
Cash flows from investing activities:          
Net increase in loans   (60,553)   (59,499)
Purchase of available-for-sale debt securities   (21,874)   (76,417)
Proceeds from maturities of available-for-sale debt securities   16,132    24,457 
Proceeds from calls of available-for-sale debt securities   4,525    10,035 
Proceeds from sales of available-for-sale debt securities   0    44,300 
Proceeds from sales of FHLB stock   201    0 
Purchases of FHLB stock   (1,203)   (1,003)
Purchases of premises and equipment   (863)   (592)
Proceeds from sales of premises and equipment   0    6 
Proceeds from sales of other real estate and foreclosed assets   784    2,399 
Net cash used in investing activities   (62,851)   (56,314)
Cash flows from financing activities:          
Net increase in demand deposits   43,659    9,742 
Net increase in interest-bearing transaction accounts   48,947    36,717 
Net (decrease) increase in time deposits   (20,585)   11,585 
Net decrease in federal funds purchased and securities sold under agreements to repurchase   (2,389)   (21,140)
Repayment of FHLB advances and other borrowings   (130,277)   (8,000)
FHLB advances   152,740    32,000 
Purchase of treasury stock   (89)   (226)
Cash dividends paid - common stock   (674)   (542)
Net cash provided by financing activities   91,332    60,136 
Net increase in cash and cash equivalents   34,333    8,655 
Cash and cash equivalents, beginning of period   26,995    28,377 
Cash and cash equivalents, end of period  $61,328   $37,032 

 

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

 

 6

 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (continued) (unaudited)

 

   Six Months Ended  June 30, 
(In thousands)  2017   2016 
Supplemental disclosures of cash flow information:        
Cash paid during the year for:          
Interest  $3,542   $2,718 
Income taxes  $2,185   $1,975 
Noncash investing activities:          
Other real estate and repossessed assets acquired in settlement of loans  $155   $1,634 

 

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, Columbia, Clinton, Warsaw, Springfield, Branson, and the greater Kansas City metropolitan area. 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, 2016.

 

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.

 

Stock Dividend On July 1, 2017, the Company paid a special stock dividend of four percent to shareholders of record at the close of business on June 15, 2017. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

 

The following represents significant new accounting principles adopted in 2017:

 

Stock Compensation The FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, in March 2016, in order to reduce complexity in this area and improve the usefulness of information provided to users. Amendments which will affect public companies include the recognition of excess tax benefits and deficiencies in income tax expense or benefit in the income statement, guidance as to the classification of excess tax benefits on the statement of cash flows, an election to account for award forfeitures as they occur, and the ability to withhold taxes up to the maximum statutory rate in the applicable jurisdictions without triggering liability classification of the award. The Company adopted the ASU on January 1, 2017 and elected to recognize forfeitures as they occur. As allowed by the ASU, the Company’s adoption was prospective, therefore prior periods have not been adjusted. The adoption of the ASU could result in increased volatility to reported income tax expense related to excess tax benefits and tax deficiencies for employee share-based transactions, however, the actual amounts recognized in income tax expense will be dependent on the amount of employee share-based transactions and the stock price at the time of vesting or exercise. The adoption of the ASU did not have a significant effect on the Company’s consolidated financial statements.

 

 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 June 30, 2017 and December 31, 2016 is as follows:

 

   June 30,   December 31, 
(in thousands)  2017   2016 
         
Commercial, financial, and agricultural  $187,251   $182,881 
Real estate construction - residential   20,037    18,907 
Real estate construction - commercial   78,257    55,653 
Real estate mortgage - residential   255,426    259,900 
Real estate mortgage - commercial   461,062    426,470 
Installment and other consumer   32,987    30,218 
Total loans  $1,035,020   $974,029 

 

The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the communities surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson and the greater Kansas City metropolitan area. 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 June 30, 2017, $496.0 million of loans were pledged to the Federal Home Loan Bank as collateral for borrowings and letters of credit.

 

Allowance for Loan Losses

 

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

 

   Three Months Ended June 30, 2017 
   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, &   Construction -   Construction -   Mortgage -   Mortgage -   and Other   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Consumer   allocated   Total 
Balance at beginning of period  $2,360   $99   $579   $2,125   $4,731   $322   $46   $10,262 
Additions:                                        
Provision for loan losses   226    (54)   36    (230)   139    89    124    330 
Deductions:                                        
Loans charged off   32    0    0    62    2    60    0    156 
Less recoveries on loans   (24)   (25)   0    (21)   (14)   (25)   0    (109)
Net loan charge-offs (recoveries)   8    (25)   0    41    (12)   35    0    47 
Balance at end of period  $2,578   $70   $615   $1,854   $4,882   $376   $170   $10,545 
                                         
   Six Months Ended June 30, 2017 
   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, &   Construction -   Construction -   Mortgage -   Mortgage -   and Other   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Consumer   allocated   Total 
Balance at beginning of period  $2,753   $108   $413   $2,385   $3,793    274   $160   $9,886 
Additions:                                        
Provision for loan losses   (157)   (113)   202    (507)   1,084    161    10    680 
Deductions:                                        
Loans charged off   60    0    0    81    16    111    0    268 
Less recoveries on loans   (42)   (75)   0    (57)   (21)   (52)   0    (247)
Net loan charge-offs (recoveries)   18    (75)   0    24    (5)   59    0    21 
Balance at end of period  $2,578   $70   $615   $1,854   $4,882   $376   $170   $10,545 

 

 9

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   Three Months Ended June 30, 2016 
   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, &   Construction -   Construction -   Mortgage -   Mortgage -   and Other   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Consumer   allocated   Total 
Balance at beginning of period  $2,135   $44   $687   $2,273   $3,190   $259   $43   $8,631 
Additions:                                        
Provision for loan losses   817    19    (929)   186    218    61    53    425 
Deductions:                                        
Loans charged off   36    0    0    175    28    67    0    306 
Less recoveries on loans   (80)   0    (491)   (9)   (31)   (31)   0    (642)
Net loan charge-offs (recoveries)   (44)   0    (491)   166    (3)   36    0    (336)
Balance at end of period  $2,996   $63   $249   $2,293   $3,411   $284   $96   $9,392 
                                         
   Six Months Ended June 30, 2016 
   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, &   Construction -   Construction -   Mortgage -   Mortgage -   and Other   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Consumer   allocated   Total 
Balance at beginning of period  $2,153   $59   $644   $2,439   $2,935   $273   $101   $8,604 
Additions:                                        
Provision for loan losses   804    4    (896)   218    495    55    (5)   675 
Deductions:                                        
Loans charged off   138    0    1    381    111    123    0    754 
Less recoveries on loans   (177)   0    (502)   (17)   (92)   (79)   0    (867)
Net loan charge-offs (recoveries)   (39)   0    (501)   364    19    44    0    (113)
Balance at end of period  $2,996   $63   $249   $2,293   $3,411   $284   $96   $9,392 

 

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.

 

Beginning in the first quarter of 2016, the Company began to lengthen its look-back period with the intent to increase such period from three to five years over the next two years. The Company believes that the five-year look-back period, which is consistent with the Company’s practices prior to the start of the economic recession in 2008, provides a representative historical loss period in the current economic environment.

 

The following table provides the balance in the allowance for loan losses at June 30, 2017 and December 31, 2016, and the related loan balance by impairment methodology.

 

 10

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, and   Construction -   Construction -   Mortgage -   Mortgage -   and Other   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Consumer   allocated   Total 
June 30, 2017                                        
Allowance for loan losses:                                        
Individually evaluated for impairment  $393   $0   $7   $450   $264   $11   $0   $1,125 
Collectively evaluated for impairment   2,185    70    608    1,404    4,618    365    170    9,420 
Total  $2,578   $70   $615   $1,854   $4,882   $376   $170   $10,545 
Loans outstanding:                                        
Individually evaluated for impairment  $1,787   $0   $48   $5,787   $2,046   $52   $0   $9,720 
Collectively evaluated for impairment   185,464    20,037    78,209    249,639    459,016    32,935    0    1,025,300 
Total  $187,251   $20,037   $78,257   $255,426   $461,062   $32,987   $0   $1,035,020 
                                         
December 31, 2016                                        
Allowance for loan losses:                                        
Individually evaluated for impairment  $469   $0   $7   $319   $277   $8   $0   $1,080 
Collectively evaluated for impairment   2,284    108    406    2,066    3,516    266    160    8,806 
Total  $2,753   $108   $413   $2,385   $3,793   $274   $160   $9,886 
Loans outstanding:                                        
Individually evaluated for impairment  $1,617   $0   $49   $5,471   $1,918   $89   $0   $9,144 
Collectively evaluated for impairment   181,264    18,907    55,604    254,429    424,552    30,129    0    964,885 
Total  $182,881   $18,907   $55,653   $259,900   $426,470   $30,218   $0   $974,029 

 

Impaired Loans

 

Loans evaluated under ASC 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 individually evaluated for impairment totaled $9.7 million and $9.1 million at June 30, 2017 and December 31, 2016, respectively, and are comprised of loans on non-accrual status and loans which have been classified as troubled debt restructurings (TDRs).

 

The net carrying value of impaired loans is based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. At June 30, 2017 and December 31, 2016, $5.7 million and $4.5 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 June 30, 2017, $1.1 million of the Company’s allowance for loan losses was allocated to impaired loans totaling $9.7 million compared to $1.1 million of the Company's allowance for loan losses allocated to impaired loans totaling approximately $9.1 million at December 31, 2016. Management determined that $1.7 million, or 18%, of total impaired loans required no reserve allocation at June 30, 2017 compared to $2.1 million, or 23%, at December 31, 2016 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

 

The categories of impaired loans at June 30, 2017 and December 31, 2016 are as follows:

 

   June 30,   December 31, 
(in thousands)  2017   2016 
Non-accrual loans  $4,434   $3,429 
Performing TDRs   5,286    5,715 
Total impaired loans  $9,720   $9,144 

 

 11

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The following tables provide additional information about impaired loans at June 30, 2017 and December 31, 2016, 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 
June 30, 2017               
With no related allowance recorded:               
Commercial, financial and agricultural  $587   $751   $0 
Real estate - residential   795    813    0 
Real estate - commercial   366    395    0 
Total  $1,748   $1,959   $0 
With an allowance recorded:               
Commercial, financial and agricultural  $1,200   $1,234   $393 
Real estate - construction commercial   48    55    7 
Real estate - residential   4,992    5,062    450 
Real estate - commercial   1,680    1,767    264 
Installment and other consumer   52    69    11 
Total  $7,972   $8,187   $1,125 
Total impaired loans  $9,720   $10,146   $1,125 

 

       Unpaid     
   Recorded   Principal   Specific 
(in thousands)  Investment   Balance   Reserves 
December 31, 2016               
With no related allowance recorded:               
Commercial, financial and agricultural  $564   $706   $0 
Real estate - residential   1,550    1,557    0 
Total  $2,114   $2,263   $0 
With an allowance recorded:               
Commercial, financial and agricultural  $1,053   $1,078   $469 
Real estate - construction commercial   49    56    7 
Real estate - residential   3,921    3,990    319 
Real estate - commercial   1,918    1,988    277 
Installment and other consumer   89    116    8 
Total  $7,030   $7,228   $1,080 
Total impaired loans  $9,144   $9,491   $1,080 

 

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

 

 12

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   Three Months Ended June 30,   Six Months Ended June 30, 
   2017   2016   2017   2016 
       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  $464   $(1)  $385   $19   $519   $0   $1,014   $29 
Real estate - residential   852    3    1,593    100    912    7    1,738    197 
Real estate - commercial   395    (2)   2,109    63    500    0    2,280    120 
Installment and other consumer   2    0    0    0    31    0    0    0 
Total  $1,713   $0   $4,087   $182   $1,962   $7   $5,032   $346 
With an allowance recorded:                                        
Commercial, financial and agricultural  $1,214   $8   $866   $108   $1,199   $19   $860   $135 
Real estate - construction commercial   48    0    52    0    49    0    64    2 
Real estate - residential   4,790    42    3,442    62    4,595    87    3,977    141 
Real estate - commercial   1,604    14    260    13    1,505    29    560    20 
Installment and other consumer   51    0    114    5    48    0    129    9 
Total  $7,707   $64   $4,734   $188   $7,396   $135   $5,590   $307 
Total impaired loans  $9,420   $64   $8,821   $370   $9,358   $142   $10,622   $653 

 

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 $64,000 and $142,000, for the three months and six months ended June 30, 2017, respectively, compared to $370,000 and $653,000 for the three and six months ended June 30, 2016, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during the periods reported.

 

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 Company’s policy is to discontinue the accrual of interest income on any loan when, in the opinion of management, the ultimate collectability of interest or principal is no longer probable. In general, loans are placed on non-accrual when they become 90 days or more past due. However, management considers many factors before placing a loan on non-accrual, including the delinquency status of the loan, the overall financial condition of the borrower, the progress of management’s collection efforts and the value of the underlying collateral. Non-accrual loans are returned to accrual status when, in the opinion of management, the financial condition of the borrower indicates that the timely collectability of interest and principal is probable and the borrower demonstrates the ability to pay under the terms of the note through a sustained period of repayment performance, which is generally six months.

 

The following table provides aging information for the Company’s past due and non-accrual loans at June 30, 2017 and December 31, 2016.

 

 13

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   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 
June 30, 2017                         
Commercial, Financial, and Agricultural  $185,050   $1,078   $0   $1,123   $187,251 
Real Estate Construction - Residential   20,037    0    0    0    20,037 
Real Estate Construction - Commercial   78,209    0    0    48    78,257 
Real Estate Mortgage - Residential   252,322    600    252    2,252    255,426 
Real Estate Mortgage - Commercial   460,103    0    0    959    461,062 
Installment and Other Consumer   32,767    131    37    52    32,987 
Total  $1,028,488   $1,809   $289   $4,434   $1,035,020 
December 31, 2016                         
Commercial, Financial, and Agricultural  $181,609   $290   $0   $982   $182,881 
Real Estate Construction - Residential   18,681    226    0    0    18,907 
Real Estate Construction - Commercial   55,603    0    0    50    55,653 
Real Estate Mortgage - Residential   254,758    3,200    54    1,888    259,900 
Real Estate Mortgage - Commercial   425,260    790    0    420    426,470 
Installment and Other Consumer   29,920    198    11    89    30,218 
Total  $965,831   $4,704   $65   $3,429   $974,029 

 

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 one or more weaknesses that may result in the deterioration of the repayment exits or the Company’s credit position at some future date. 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. A loan is classified as a troubled debt restructuring (TDR) when a borrower is experiencing financial difficulties that lead to the restructuring of a loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. Loans classified as TDRs which are accruing interest are classified as performing TDRs. Loans classified as TDRs which are not accruing interest are classified as nonperforming TDRs and are included with all other nonaccrual loans for presentation purposes. 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.

 

 14

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The following table presents the risk categories by class at June 30, 2017 and December 31, 2016.

 

(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 June 30, 2017                                   
Watch  $9,266   $1,107   $1,318   $16,879   $46,861   $0   $75,431 
Substandard   1,688    640    97    2,258    736    24    5,443 
Performing TDRs   664    0    0    3,535    1,087    0    5,286 
Non-accrual   1,123    0    48    2,252    959    52    4,434 
Total  $12,741   $1,747   $1,463   $24,924   $49,643   $76   $90,594 
                                    
At December 31, 2016                                   
Watch  $10,295   $665   $1,113   $16,577   $44,611   $0   $73,261 
Substandard   798    640    0    2,159    426    24    4,047 
Performing TDRs   635    0    0    3,582    1,498    0    5,715 
Non-accrual   982    0    50    1,888    420    89    3,429 
Total  $12,710   $1,305   $1,163   $24,206   $46,955   $113   $86,452 

 

Troubled Debt Restructurings

 

At June 30, 2017, loans classified as TDRs totaled $6.3 million, of which $992,000 were classified as nonperforming TDRs and included in non-accrual loans and $5.3 million were classified as performing TDRs. At December 31, 2016, loans classified as TDRs totaled $6.3 million, of which $619,000 were classified as nonperforming TDRs and included in non-accrual loans and $5.7 million were classified as performing TDRs. Both performing and nonperforming TDRs are considered impaired loans. 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 $450,000 and $410,000 related to TDRs were allocated to the allowance for loan losses at June 30, 2017 and December 31, 2016, respectively.

 

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

 

   Six Months Ended June 30, 
   2017   2016 
   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   1   $131   $130    0   $0   $0 
Real estate mortgage - residential   0    0    0    1    78    78 
Real estate mortgage - commercial   1    56    52    0    0    0 
Total   2   $187   $182    1   $78   $78 

 

(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 for the borrower given financial condition such as interest rates below the current market rate, deferring principal payments, and extending maturity dates. There were no loans and two loans meeting the TDR criteria during the three and six months ended June 30, 2017, respectively, compared to no loans and one loan during the three and six months ended June 30, 2016, respectively.

 

The Company considers a TDR to be in default when it is 90 days or more past due under the modified terms, a charge-off occurs, or it is the process of foreclosure. There were no loans modified as a TDR that defaulted during the three months ended June 30, 2017 and 2016, respectively, and within twelve months of their modification date. See Lending and Credit Management section for further information.

 

 15

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(3)Other Real Estate and Repossessed Assets

 

   June 30,   December 31, 
(in thousands)  2017   2016 
Commercial  $761   $809 
Real estate construction - commercial   12,380    12,380 
Real estate mortgage - residential   463    647 
Real estate mortgage - commercial   2,909    3,439 
Repossessed assets   17    16 
Total  $16,530   $17,291 
Less valuation allowance for other real estate owned   (3,174)   (3,129)
Total other real estate and repossessed assets  $13,356   $14,162 

 

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

 

   Three Months Ended June 30,   Six Months Ended June 30, 
   2017   2016   2017   2016 
Balance at beginning of period  $16,669   $18,696   $17,291   $19,225 
Additions   52    892    155    1,634 
Proceeds from sales   (126)   (1,125)   (784)   (2,399)
Charge-offs against the valuation allowance for other real estate owned, net   (53)   (55)   (170)   (101)
Net gain on sales   (12)   54    38    103 
Total other real estate and repossessed assets  $16,530   $18,462   $16,530   $18,462 
Less valuation allowance for other real estate owned   (3,174)   (3,208)   (3,174)   (3,208)
Balance at end of period  $13,356   $15,254   $13,356   $15,254 

 

At June 30, 2017 $100,000 of consumer mortgage loans secured by residential real estate properties were in the process of foreclosure compared to $162,000 at December 31, 2016.

 

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

 

   Three Months Ended June 30,   Six Months Ended June 30, 
(in thousands)  2017   2016   2017   2016 
Balance, beginning of period  $3,044   $3,225   $3,129   $3,233 
Provision for other real estate owned   183    38    215    76 
Charge-offs   (53)   (55)   (170)   (101)
Balance, end of period  $3,174   $3,208   $3,174   $3,208 

 

 16

 

 

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 June 30, 2017 and December 31, 2016 were as follows:

 

   Total             
   Amortized   Gross Unrealized   Fair 
(in thousands)  Cost   Gains   Losses   Value 
June 30, 2017                    
U.S. government and federal agency obligations  $12,945   $0   $(233)  $12,712 
Government sponsored enterprises   37,568    0    (256)   37,312 
Obligations of states and political subdivisions   48,031    261    (298)   47,994 
Mortgage-backed securities:                    
Residential - government agencies   118,491    157    (1,315)   117,333 
Commercial - government agencies   990    12    0    1,002 
Total mortgage-backed securities   119,481    169    (1,315)   118,335 
Total available-for-sale securities  $218,025   $430   $(2,102)  $216,353 
                     
December 31, 2016                    
U.S. government and federal agency obligations  $13,667   $0   $(303)  $13,364 
Government sponsored enterprises   32,786    2    (329)   32,459 
Obligations of states and political subdivisions   42,666    123    (757)   42,032 
Mortgage-backed securities:                    
Residential - government agencies   127,527    124    (1,995)   125,656 
Commercial - government agencies   989    12    0    1,001 
Total mortgage-backed securities   128,516    136    (1,995)   126,657 
Total available-for-sale securities  $217,635   $261   $(3,384)  $214,512 

 

All of the Company’s investment securities are classified as available for sale. Agency bonds and notes, small business administration guaranteed loan certificates (SBA), residential and commercial 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, subordinated debt equity securities, and the Company’s interest in statutory trusts. These securities are reported at cost in other assets in the amount of $10.8 million and $9.8 million as of June 30, 2017 and December 31, 2016, respectively.

 

Debt securities with carrying values aggregating approximately $155.1 million and $167.6 million at June 30, 2017 and December 31, 2016, 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 June 30, 2017, 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.

 

 17

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   Amortized   Fair 
(in thousands)  Cost   Value 
Due in one year or less  $5,781   $5,832 
Due after one year through five years   60,749    60,531 
Due after five years through ten years   26,266    25,956 
Due after ten years   5,748    5,699 
Total   98,544    98,018 
Mortgage-backed securities   119,481    118,335 
Total available-for-sale securities  $218,025   $216,353 

 

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 June 30, 2017 and December 31, 2016 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 June 30, 2017                              
U.S. government and federal agency obligations  $7,788   $(133)  $4,925   $(100)  $12,713   $(233)
Government sponsored enterprises   32,339    (229)   2,473    (27)   34,812    (256)
Obligations of states and political subdivisions   22,886    (264)   1,912    (34)   24,798    (298)
Mortgage-backed securities:                              
Residential - government agencies   77,979    (924)   20,188    (391)   98,167    (1,315)
Total  $140,992   $(1,550)  $29,498   $(552)  $170,490   $(2,102)
                               
(in thousands)                              
At December 31, 2016                              
U.S. government and federal agency obligations  $13,365   $(303)  $0   $0   $13,365   $(303)
Government sponsored enterprises   29,432    (329)   0    0    29,432    (329)
Obligations of states and political subdivisions   32,318    (757)   0    0    32,318    (757)
Mortgage-backed securities:                              
Residential - government agencies   109,772    (1,848)   3,742    (147)   113,514    (1,995)
Total  $184,887   $(3,237)  $3,742   $(147)  $188,629   $(3,384)

 

The total available for sale portfolio consisted of approximately 324 securities at June 30, 2017. The portfolio included 202 securities having an aggregate fair value of $170.5 million that were in a loss position at June 30, 2017. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $29.5 million at fair value. The $2.1 million aggregate unrealized loss included in accumulated other comprehensive income at June 30, 2017 was caused by interest rate fluctuations.

 

The total available for sale portfolio consisted of approximately 298 securities at December 31, 2016. The portfolio included 216 securities having an aggregate fair value of $188.6 million that were in a loss position at December 31, 2016. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer had a fair value of $3.7 million at December 31, 2016. The $3.4 million aggregate unrealized loss included in accumulated other comprehensive income at December 31, 2016 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 June 30, 2017 and December 31, 2016, respectively. In the absence of changes in credit quality of these investments, the fair value is expected to recover on all debt securities as they approach their maturity date or re-pricing date, or if market yields for such investments decline. 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 the Company will be required to sell such investment securities.

 

 18

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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

 

   Three Months Ended June 30,   Six Months Ended June 30, 
(in thousands)  2017   2016   2017   2016 
Gains realized on sales  $0   $18   $0   $490 
Losses realized on sales   0    0    0    0 
Other-than-temporary impairment recognized   0    0    0    0 
Investment securities gains  $0   $18   $0   $490 

 

(5)Intangible Assets

 

Mortgage Servicing Rights

 

At June 30, 2017, the Company was servicing approximately $289.8 million of loans sold to the secondary market compared to $294.4 million at December 31, 2016, and $304.7 million at June 30, 2016. Mortgage loan servicing fees, reported as non-interest income, earned on loans sold were $211,000 and $420,000 for the three and six months ended June 30, 2017, respectively, compared to $211,000 and $421,000 for the three and six months ended June 30, 2016, respectively.

 

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

 

   Three Months Ended June 30,   Six Months Ended June 30, 
(in thousands)  2017   2016   2017   2016 
Balance at beginning of period  $2,877   $2,745   $2,584   $2,847 
Originated mortgage servicing rights   66    63    115    117 
Changes in fair value:                    
Due to change in model inputs and assumptions (1)   (56)   (142)   319    (145)
Other changes in fair value (2)   (121)   (155)   (252)   (308)
Balance at end of period  $2,766   $2,511   $2,766   $2,511 

 

(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 six months ended June 30, 2017 and 2016:

 

   Six Months Ended June 30, 
   2017   2016 
Weighted average constant prepayment rate   9.28%   12.16%
Weighted average note rate   3.86%   3.90%
Weighted average discount rate   9.75%   9.19%
Weighted average expected life (in years)   6.10    5.10 

 

(6)Federal funds purchased and securities sold under agreements to repurchase

 

   June 30,   December 31, 
   2017   2016 
Federal funds purchased  $0   $992 
Repurchase agreements   29,118    30,023 
Total  $29,118   $31,015 

 

 

 19

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The Company offers a sweep account program whereby amounts in excess of an established limit are “swept” from the customer’s demand deposit account on a daily basis into retail repurchase agreements pursuant to individual repurchase agreements between the Company and its customers. Repurchase agreements are agreements to sell securities subject to an obligation to repurchase the same or similar securities. They are accounted for as collateralized financing transactions, not as sales and purchases of the securities portfolio. The securities collateral pledged for the repurchase agreements with customers is maintained by a designated third party custodian. The collateral amounts pledged to repurchase agreements by remaining maturity in the table below are limited to the outstanding balances of the related asset or liability; thus amounts of excess collateral are not shown.

 

Repurchase Agreements  Remaining Contractual Maturity of the Agreements 
   Overnight   Less   Greater     
   and   than   than     
(in thousands)  continuous   90 days   90 days   Total 
At June 30, 2017                    
U.S. government and federal agency obligations  $3,189   $0   $0   $3,189 
Government sponsored enterprises   7,882    0    0    7,882 
Asset-backed securities   18,047    0    0    18,047 
Total  $29,118   $0   $0   $29,118 
                     
At December 31, 2016                    
U.S. government and federal agency obligations  $3,489   $0   $0   $3,489 
Government sponsored enterprises   7,324    0    0    7,324 
Asset-backed securities   19,210    0    0    19,210 
Total  $30,023   $0   $0   $30,023 

 

(7)Income Taxes

 

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 33.9% for the three months ended June 30, 2017 compared to 34.1% for the three months ended June 30, 2016. Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 34.1% for the six months ended June 30, 2017 compared to 33.2% for the six months ended June 30, 2016. The increase in the tax rate for the six months ended June 30, 2017 in comparison to the six months ended June 30, 2016 is primarily due to an immaterial return to provision adjustment made in the first quarter of 2016.

 

The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income of the appropriate character during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, taxable income available in carryback years, and tax planning strategies in making this assessment. With the exception of certain capital losses generated during 2013 and 2014, it is management’s opinion that the Company will more likely than not realize the benefits of these temporary differences as of June 30, 2017 and, therefore, only established a valuation reserve against the Company’s capital loss carry forward. Management arrived at this conclusion 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. As indicated above, the Company generated approximately $219,000 of capital losses during 2013 and 2014 as a result of disposing of certain limited partnership interests. The capital losses will expire between 2018 and 2019, and it is management’s opinion that the Company will not more likely than not generate the capital gain income necessary to utilize the capital loss carry forwards before the capital losses expire. As such, the Company has established an $83,000 valuation reserve against its capital loss carry forward deferred tax asset.

 

(8)Stockholders’ Equity

 

Accumulated Other Comprehensive Loss

 

The following details the change in the components of the Company’s accumulated other comprehensive loss for the six months ended June 30, 2017 and 2016:

 

 20

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   Six months ended June 30, 2017 
       Unrecognized Net   Accumulated 
   Unrealized   Pension and   Other 
   Gain (Loss)   Postretirement   Comprehensive 
(in thousands)  on Securities (1)   Costs (2)   Loss 
Balance at beginning of period  $(1,936)  $(1,865)  $(3,801)
Other comprehensive income, before reclassifications   1,452    45    1,497 
Amounts reclassified from accumulated other comprehensive income (loss)   0    0    0 
Current period other comprehensive income, before tax   1,452    45    1,497 
Income tax expense   (552)   (18)   (570)
Current period other comprehensive income, net of tax   900    27    927 
Balance at end of period  $(1,036)  $(1,838)  $(2,874)
                
   Six months ended June 30, 2016 
       Unrecognized Net   Accumulated 
   Unrealized   Pension and   Other 
   Gain (Loss)   Postretirement   Comprehensive 
(in thousands)  on Securities (1)   Costs (2)   Loss 
Balance at beginning of period  $(591)  $(1,427)  $(2,018)
Other comprehensive income, before reclassifications   3,357    39    3,396 
Amounts reclassified from accumulated other comprehensive income (loss)   (490)   0    (490)
Current period other comprehensive income, before tax   2,867    39    2,906 
Income tax expense   (1,090)   (14)   (1,104)
Current period other comprehensive income, net of tax   1,777    25    1,802 
Balance at end of period  $1,186   $(1,402)  $(216)

 

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

 

(9)Employee Benefit Plans

 

Employee Benefits

 

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

 

   Three Months Ended June 30,   Six Months Ended June 30, 
(in thousands)  2017   2016   2017   2016 
Payroll taxes  $288   $336   $644   $632 
Medical plans   468    487    894    999 
401k match and profit sharing   226    203    476    384 
Pension plan   351    306    703    613 
Other   9    46    25    62 
Total employee benefits  $1,342   $1,378   $2,742   $2,690 

 

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.

 

 21

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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 expects to make a pension contribution in the amount of $1.2 million on September 15, 2017. The minimum required contribution for 2017 is $842,000. Effective July 1, 2017, the Company amended the pension plan to effectuate a “soft freeze” such that no individual hired (or rehired in the case of a former employee) by the Company after June 30, 2017, whether or not such individual is or was a vested member in the plan, will be eligible to be an active member and be entitled to accrue any benefits under the plan. Certain individuals hired by the Company before July 1, 2017 are also not eligible to participate in the plan. Beginning in 2019, the Company anticipates that there may be a small reduction in the overall liability and service cost resulting from the closure of the plan to new entrants.

 

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)  2017   2016 
Service cost - benefits earned during the year  $1,343   $1,179 
Interest costs on projected benefit obligations   1,008    956 
Expected return on plan assets   (1,123)   (1,057)
Expected administrative expenses   88    70 
Amortization of prior service cost   79    79 
Amortization of unrecognized net loss   11    0 
Net periodic pension expense  $1,406   $1,227 
           
Pension expense - three months ended June 30, (actual)  $351   $306 
Pension expense - six months ended June 30, (actual)  $703   $613 

 

(10)Stock Compensation

 

The Company’s stock option plan provides for the grant of options to purchase up to 601,627 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.

 

 22

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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   46,244   $19.33           
Granted   0    0.00           
Exercised   0    0.00           
Forfeited or expired   (26,141)   22.84           
Outstanding, June 30, 2017   20,103   $14.77    1.23   $124,252 
Exercisable, June 30, 2017   18,784   $14.77    1.23   $116,100 

 

Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2017.

 

Total stock-based compensation expense was $1,000 and $2,000 for the three and six months ended June 30, 2017, respectively, compared to $5,000 and $11,000 for the three and six months ended June 30, 2016, respectively. As of June 30, 2017, the total unrecognized compensation expense related to non-vested stock awards was $1,000 and the related weighted average period over which it is expected to be recognized is approximately 0.23 years.

 

(11)Earnings per Share

 

Stock Dividend On July 1, 2017, the Company paid a special stock dividend of 4% to common shareholders of record at the close of business on June 15, 2017. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

 

Basic earnings per share is computed by dividing income available to shareholders by the weighted average number of shares outstanding during the year. Diluted earnings per share gives effect to all dilutive potential 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 June 30,   Six Months Ended June 30, 
(dollars in thousands, except per share data)  2017   2016   2017   2016 
Basic earnings per share:                    
Net income available to shareholders  $1,919   $1,412   $4,020   $3,410 
Basic earnings per share  $0.33   $0.24   $0.69   $0.58 
Diluted earnings per share:                    
Net income available to shareholders  $1,919   $1,412   $4,020   $3,410 
Average shares outstanding   5,838,506    5,871,208    5,839,175    5,874,706 
Effect of dilutive stock options   4,929    0    4,948    0 
Average shares outstanding including dilutive stock options   5,843,435    5,871,208    5,844,123    5,874,706 
Diluted earnings per share  $0.33    0.24    0.69    0.58 

 

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 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.

 

 23

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

Options to purchase 46,244 shares during the three and six months ended June 30, 2016, respectively, 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. There were no anti-dilutive shares for the three and six months ended June 30, 2017.

 

Repurchase Program On August 6, 2015, the Board of Directors authorized a share repurchase plan to purchase through open market transactions $2.0 million market value of the Company’s common stock. As of June 30, 2017, the Company repurchased a total of 48,608 shares of common stock pursuant to the plan at an average price of $15.34 per share, including 4,715 shares of common stock repurchased pursuant to the plan during the six months ended June 30, 2017 at an average price of $19.01 per share. At June 30, 2017, approximately $1.3 million may be used to purchase shares under the plan.

 

The table below shows activity in the outstanding shares of the Company's common stock during the past three years. Shares in the table below are presented on a historical basis and have not been restated for the annual 4% stock dividends.

 

   Number of shares 
   June 30,   December 31,   June 30, 
   2017   2016   2016 
Outstanding, beginning of year   5,616,607    5,441,190    5,441,190 
Issuance of stock:               
4% stock dividend   224,550    217,155    217,155 
Purchase of treasury stock   (4,715)   (41,738)   (15,301)
Outstanding, end of year   5,836,442    5,616,607    5,643,044 

 

Except as noted in the above table, all share and per share amounts in this note have been restated for the 4% common stock dividend distributed July 1, 2017.

 

(12)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 June 30, 2017 and December 31, 2016, 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. 

 

 24

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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.

 

       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) 
June 30, 2017                    
Assets:                    
U.S. government and federal agency obligations  $12,712   $0    12,712   $0 
Government sponsored enterprises   37,312    0    37,312    0 
Obligations of states and political subdivisions   47,994    0    47,994    0 
Mortgage-backed securities   118,335    0    118,335    0 
Mortgage servicing rights   2,766    0    0    2,766 
Total  $219,119   $0   $216,353   $2,766 
                     
December 31, 2016                    
Assets:                    
U.S. government and federal agency obligations  $13,364   $0    13,364   $0 
Government sponsored enterprises   32,459    0    32,459    0 
Obligations of states and political subdivisions   42,032    0    42,032    0 
Mortgage-backed securities   126,657    0    126,657    0 
Mortgage servicing rights   2,584    0    0    2,584 
Total  $217,096   $0   $214,512   $2,584 

 

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

 

 25

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   Fair Value Measurements Using   Fair Value Measurements Using 
   Significant Unobservable Inputs   Significant Unobservable Inputs 
   (Level 3)   (Level 3) 
   Mortgage Servicing Rights   Mortgage Servicing Rights 
(in thousands)  Three Months Ended June 30,   Six Months Ended June 30, 
   2017   2016   2017   2016 
Balance at beginning of period  $2,877   $2,745   $2,584   $2,847 
Total gains or losses (realized/unrealized):                    
Included in earnings   (177)   (297)   67    (453)
Included in other comprehensive income   0    0    0    0 
Purchases   0    0    0    0 
Sales   0    0    0    0 
Issues   66    63    115    117 
Settlements   0    0    0    0 
Balance at end of period  $2,766   $2,511   $2,766   $2,511 

 

The change in valuation of mortgage servicing rights arising from inputs and assumptions decreased $56,000 and increased $319,000 for the three and six months ended June 30, 2017, respectively, compared to decreases of $142,000 and $145,000 for the three and six months ended June 30, 2016, respectively.

 

   Quantitative Information about Level 3 Fair Value Measurements    
   Valuation Technique  Unobservable Inputs  Input Value 
         Six Months Ended June 30, 
         2017   2016 
Mortgage servicing rights  Discounted cash flows  Weighted average constant prepayment rate   9.28%   12.16%
      Weighted average note rate   3.86%   3.90%
      Weighted average discount rate   9.75%   9.19%
      Weighted average expected life (in years)   6.10    5.10 

 

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 June 30, 2017, the Company identified $8.0 million in impaired loans that had specific allowances for losses aggregating $1.1 million. Related to these loans, there was $63,000 and $83,000 in charge-offs recorded during the three and six months ended June 30, 2017, respectively. As of June 30, 2016, the Company identified $4.7 million in impaired loans that had specific allowances for losses aggregating $1.6 million. Related to these loans, there was $208,000 and $768,000 in charge-offs recorded during the three and six months ended June 30, 2016, respectively.

 

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.

 

 26

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

       Fair Value Measurements Using         
       Quoted Prices           Three   Six 
       in Active           Months   Months 
       Markets for   Other   Significant   Ended   Ended 
       Identical   Observable   Unobservable   June 30,   June 30, 
   Total   Assets   Inputs   Inputs   Total Gains   Total Gains 
(in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3)   (Losses)*   (Losses)* 
June 30, 2017                              
Assets:                              
Impaired loans:                              
Commercial, financial, & agricultural  $807   $0   $0   $807   $0   $(1)
Real estate construction - commercial   41    0    0    41    0    0 
Real estate mortgage - residential   4,542    0    0    4,542    (62)   (65)
Real estate mortgage - commercial   1,416    0    0    1,416    0    (4)
Consumer   41    0    0    41    (1)   (13)
Total  $6,847   $0   $0   $6,847   $(63)  $(83)
Other real estate and foreclosed assets  $13,356   $0   $0   $13,356   $(195)  $(180)
                               
June 30, 2016                              
Assets:                              
Impaired loans:                              
Commercial, financial, & agricultural  $723   $0   $0   $723   $0   $(359)
Real estate construction - commercial   44    0    0    44    0    0 
Real estate mortgage - residential   2,047    0    0    2,047    (181)   (216)
Real estate mortgage - commercial   198    0    0    198    (23)   (177)
Consumer   85    0    0    85    (4)   (16)
Total  $3,097   $0   $0   $3,097   $(208)  $(768)
Other real estate and foreclosed assets  $15,254   $0   $0   $15,254   $16   $49 

 

* 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.

 

(13)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.

 

 27

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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.

 

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.

 

 28

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

A summary of the carrying amounts and fair values of the Company’s financial instruments at June 30, 2017 and December 31, 2016 is as follows:

 

           June 30, 2017 
           Fair Value Measurements 
           Quoted Prices         
           in Active       Net 
           Markets for   Other   Significant 
   June 30, 2017   Identical   Observable   Unobservable 
   Carrying   Fair   Assets   Inputs   Inputs 
(in thousands)  Amount   Value   (Level 1)   (Level 2)   (Level 3) 
Assets:                         
Cash and due from banks  $20,776   $20,776   $20,776   $0   $0 
Federal funds sold and overnight interest-bearing deposits   40,552    40,552    40,552    0    0 
Investment in available-for-sale securities   216,353    216,353    0    216,353    0 
Loans, net   1,024,475    1,022,116    0    0    1,022,116 
Investment in FHLB stock   6,151    6,151    0    6,151    0 
Mortgage servicing rights   2,766    2,766    0    0    2,766 
Cash surrender value - life insurance   2,448    2,448    0    2,448    0 
Accrued interest receivable   4,754    4,754    4,754    0    0 
   $1,318,275   $1,315,916   $66,082   $224,952   $1,024,882 
Liabilities:                         
Deposits:                         
Non-interest bearing demand  $279,634   $279,634   $279,634   $0   $0 
Savings, interest checking and money market   517,678    517,678    517,678    0    0 
Time deposits   285,375    285,155    0    0    285,155 
Federal funds purchased and securities sold under agreements to repurchase   29,118    29,118    29,118    0    0 
Subordinated notes   49,486    35,712    0    35,712    0 
Federal Home Loan Bank advances   115,363    115,888    0    115,888    0 
Accrued interest payable   429    429    429    0    0 
   $1,277,083   $1,263,614   $826,859   $151,600   $285,155 

 

 29

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

           December 31, 2016 
           Fair Value Measurements 
           Quoted Prices         
           in Active       Net 
           Markets for   Other   Significant 
   December 31, 2016   Identical   Observable   Unobservable 
   Carrying   Fair   Assets   Inputs   Inputs 
(in thousands)  amount   value   (Level 1)   (Level 2)   (Level 3) 
Assets:                         
Cash and due from banks  $25,589   $25,589   $25,589   $0   $0 
Federal funds sold and overnight interest-bearing deposits   1,406    1,406    1,406    0    0 
Investment in available-for-sale securities   214,512    214,512    0    214,512    0 
Loans, net   964,143    959,929    0    0    959,929 
Investment in FHLB stock   5,149    5,149    0    5,149    0 
Mortgage servicing rights   2,584    2,584    0    0    2,584 
Cash surrender value - life insurance   2,409    2,409    0    2,409    0 
Accrued interest receivable   5,183    5,183    5,183    0    0 
   $1,220,975   $1,216,761   $32,178   $222,070   $962,513 
Liabilities:                         
Deposits:                         
Non-interest bearing demand  $235,975   $235,975   $235,975   $0   $0 
Savings, interest checking and money market   468,731    468,731    468,731    0    0 
Time deposits   305,960    304,334    0    0    304,334 
Federal funds purchased and securities sold under agreements to repurchase   31,015    31,015    31,015    0    0 
Subordinated notes   49,486    33,712    0    33,712    0 
Other borrowings   93,392    93,209    0    93,209    0 
Accrued interest payable   498    498    498    0    0 
   $1,185,057   $1,167,474   $736,219   $126,921   $304,334 

 

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.

 

(14)Repurchase Reserve Liability

 

The Company’s repurchase reserve liability for estimated losses incurred on sold loans was $160,000 at both June 30, 2017 and December 31, 2016. 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. At June 30, 2017, the Company was servicing 2,810 loans sold to the secondary market with a balance of approximately $289.8 million compared to 2,877 loans sold with a balance of approximately $294.4 million at December 31, 2016.

 

 30

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   Three Months Ended June 30,   Six Months Ended June 30, 
(in thousands)  2017   2016   2017   2016 
Balance at beginning of year  $160   $160   $160   $160 
Provision for repurchase liability   0    2    0    2 
Reimbursement of expenses   0    (2)   0    (2)
Balance at end of year  $160   $160   $160   $160 

 

(15)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 June 30, 2017, no amounts have been accrued for any estimated losses for these financial instruments.

 

The contractual amount of off-balance-sheet financial instruments were as follows as of the dates indicated:

 

   June 30,   December 31, 
(in thousands)  2017   2016 
Commitments to extend credit  $220,119   $253,375 
Commitments to originate residential first and second mortgage loans   4,572    2,626 
Standby letters of credit   57,018    2,745 
Total   281,709    258,746 

 

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 June 30, 2017.

 

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.

 

 31

 

 

 

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.

 

We have described under the caption Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, 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

 

Crucial to the Company’s community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, the Company, with $1.4 billion in assets at June 30, 2017, provides a broad range of commercial and personal banking services. The Bank’s specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate, Small Business Administration (SBA) loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include the Missouri communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson, and the greater Kansas City metropolitan area.

 

The Company's primary source of revenue is net interest income derived primarily from lending and deposit taking activities. Much of the Company's business is commercial, commercial real estate development, and residential mortgage lending. The Company's income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancing activity.

 

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.

 

 32

 

 

The Company’s subsidiary 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 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 vehicles, 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.

 

 33

 

 

SELECTED CONSOLIDATED FINANCIAL DATA

 

The following table presents selected consolidated financial information for the Company as of and for each of the three and six months ended June 30, 2017 and 2016, 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   Six Months Ended 
   June 30,   June 30, 
(In thousands, except per share data)  2017   2016   2017   2016 
Per Share Data                    
Basic earnings per share  $0.33   $0.24   $0.69   $0.58 
Diluted earnings per share   0.33    0.24    0.69    0.58 
Dividends paid on common stock   338    271    674    542 
Book value per share             16.29    15.63 
Market price per share             20.95    13.26 
Selected Ratios                    
(Based on average balance sheets)                    
Return on total assets   0.58%   0.46%   0.61%   0.56%
Return on stockholders' equity   8.35%   6.26%   8.65%   7.62%
Stockholders' equity to total assets   7.01%   7.31%   7.06%   7.29%
Efficiency ratio (1)   74.98%   78.46%   73.75%   76.13%
                     
(Based on end-of-period data)                    
Stockholders' equity to assets             6.88%   7.25%
Total risk-based capital ratio             13.47%   14.19%
Tier 1 risk-based capital ratio             11.20%   11.63%
Common equity Tier 1 capital             8.43%   8.73%
Tier 1 leverage ratio (2)             9.77%   9.88%

 

(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)Tier I leverage ratio is calculated by dividing Tier 1 capital by average total consolidated assets.

 

 34

 

 

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 June 30,   Six Months Ended June 30, 
          $   %           $   % 
(In thousands)  2017   2016   Change   Change   2017   2016   Change   Change 
                                 
Net interest income  $10,820   $9,971   $849    8.5%  $21,307   $19,819   $1,488    7.5%
Provision for loan losses   330    425    (95)   (22.4)   680    675    5    0.7 
Noninterest income   2,099    1,949    150    7.7    4,506    4,397    109    2.5 
Noninterest expense   9,687    9,353    334    3.6    19,037    18,436    601    3.3 
Income before income taxes   2,902    2,142    760    35.5    6,096    5,105    991    19.4 
Income tax expense   983    730    253    34.7    2,076    1,695    381    22.5 
Net income  $1,919   $1,412   $507    35.9%  $4,020   $3,410   $610    17.9%

 

Consolidated net income of $1.9 million, or $0.33 per diluted share, for the three months ended June 30, 2017 increased $507,000 compared to $1.4 million, or $0.24 per diluted share, for the three months ended June 30, 2016. For the three months ended June 30, 2017, the return on average assets was 0.58%, the return on average stockholders’ equity was 8.35%, and the efficiency ratio was 74.98%.

 

Consolidated net income increased $610,000 to $4.0 million, or $0.69 per diluted share, for the six months ended June 30, 2017 compared to $3.4 million, or $0.58 per diluted share, for the six months ended June 30, 2016. For the six months ended June 30, 2017, the return on average assets was 0.61%, the return on average stockholders’ equity was 8.65%, and the efficiency ratio was 73.75%.

 

Net interest income was $10.8 million and $21.3 million for the three and six months ended June 30, 2017, respectively, compared to $10.0 million and $19.8 million for the three and six months ended June 30, 2016. The net interest margin (expressed on a fully taxable equivalent basis) increased to 3.50% for the three months ended June 30, 2017, compared to 3.49% for the three months ended June 30, 2016, and decreased to 3.49% for the six months ended June 30, 2017 compared to 3.50% for the six months ended June 30, 2016. These changes are discussed in greater detail under the Average Balance Sheets and Rate and Volume Analysis section below.

 

A $330,000 and $680,000 provision for loan losses was recorded for the three and six months ended June 30, 2017, respectively, compared to a $425,000 and $675,000 provision for the three and six months ended June 30, 2016, respectively.

 

The Company’s net charge-offs were $47,000, or 0.00% of average loans, for the three months ended June 30, 2017 compared to net recoveries of $336,000, or (0.04)% of average loans, for the three months ended June 30, 2016. For the six months ended June 30, 2017, the Company’s net charge-offs were $21,000, or 0.00% of average loans compared to net recoveries of $113,000, or (0.01)% of average loans for the six months ended June 30, 2016.

 

Non-performing loans totaled $10.0 million, or 0.97% of total loans, at June 30, 2017 compared to $9.2 million, or 0.95% of total loans, at December 31, 2016, and $9.5 million, or 1.02% of total loans, at June 30, 2016. These changes are discussed in greater detail under the Lending and Credit Management section below.

 

Non-interest income increased $150,000, or 7.7%, for the three months ended June 30, 2017 compared to the three months ended June 30, 2016, and increased $109,000, or 2.5%, for the six months ended June 30, 2007 compared to the six months ended June 30, 2016. These changes are discussed in greater detail below under Non-interest Income.

 

Non-interest expense increased $334,000, or 3.6%, for the three months ended June 30, 2017 compared to the three months ended June 30, 2016, and increased $601,000, or 3.3%, for the six months ended June 30, 2017 compared to the six months ended June 30, 2017. These changes are discussed in greater detail below under Non-interest Expense.

 

 35

 

 

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 June 30, 2017 and 2016, respectively.

 

 36

 

 

   Three Months Ended June 30, 
(In thousands)  2017   2016 
       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  $190,888   $2,165    4.55%  $154,509   $1,794    4.67%
Real estate construction - residential   20,559    236    4.60    18,207    206    4.55 
Real estate construction - commercial   71,661    798    4.47    42,980    540    5.05 
Real estate mortgage - residential   258,958    2,959    4.58    250,868    2,844    4.56 
Real estate mortgage - commercial   451,185    5,268    4.68    404,141    4,686    4.66 
Consumer   31,801    309    3.90    25,707    288    4.51 
Total loans  $1,025,052   $11,735    4.59%  $896,412   $10,358    4.65%
Investment securities: (3)                              
U.S. government and federal agency obligations  $48,888   $176    1.44%  $40,925   $117    1.15%
Obligations of states and political subdivisions   47,721    266    2.24    28,156    191    2.73 
Mortgage-backed securities   120,012    544    1.82    171,765    700    1.64 
Total investment securities  $216,621   $986    1.83%  $240,846   $1,008    1.68%
Other investments and securities, at cost   10,588    94    3.56    8,544    75    3.53 
Federal funds sold and interest bearing  deposits in other financial institutions   4,795    11    0.92    16,140    18    0.45 
Total interest earning assets  $1,257,056   $12,826    4.09%  $1,161,942   $11,459    3.97%
All other assets   88,361              88,640           
Allowance for loan losses   (10,385)             (8,909)          
Total assets  $1,335,032             $1,241,673           
LIABILITIES AND STOCKHOLDERS' EQUITY                              
NOW accounts  $212,226   $272    0.51%  $205,801   $157    0.31%
Savings   100,985    13    0.05    97,027    12    0.05 
Commercial   1,523    2    0.53    0    0    0.00 
Money market   203,697    188    0.37    181,724    118    0.26 
Time deposits of $250,000 and over   57,095    99    0.70    61,636    85    0.55 
Other time deposits   229,366    410    0.72    235,801    383    0.65 
Total interest bearing deposits  $804,892   $984    0.49%  $781,989   $755    0.39%
Federal funds purchased and securities sold under agreements to repurchase   29,237    27    0.37    36,333    15    0.17 
Subordinated notes   49,486    431    3.49    49,486    366    2.97 
Federal Home Loan Bank Advances   110,124    419    1.53    61,604    243    1.59 
Total borrowings  $188,847   $877    1.86%  $147,423   $624    1.70%
Total interest bearing liabilities  $993,739   $1,861    0.75%  $929,412   $1,379    0.60%
Demand deposits   235,232              212,569           
Other liabilities   11,075              8,902           
Total liabilities   1,240,046              1,150,883           
Stockholders' equity   94,986              90,790           
Total liabilities and stockholders' equity  $1,335,032             $1,241,673           
Net interest income (FTE)        10,965              10,080      
Net interest spread             3.34%             3.37%
Net interest margin             3.50%             3.49%

 

(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 $145,000 and $109,000 for the three months ended June 30, 2017 and 2016, 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.

 

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   Six Months Ended June 30, 
(In thousands)  2017   2016 
       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  $186,741   $4,164    4.50%  $150,746   $3,509    4.68%
Real estate construction - residential   19,936    451    4.56    18,167    414    4.58 
Real estate construction - commercial   68,952    1,518    4.44    39,157    949    4.87 
Real estate mortgage - residential   259,750    5,882    4.57    252,190    5,754    4.59 
Real estate mortgage - commercial   442,219    10,223    4.66    396,282    9,208    4.67 
Consumer   31,022    609    3.96    24,794    562    4.56 
Total loans  $1,008,620   $22,847    4.57%  $881,336   $20,396    4.65%
Investment securities: (3)                              
U.S. government and federal agency obligations  $47,159   $332    1.42%  $52,692   $305    1.16%
Obligations of states and political subdivisions   45,738    516    2.28    29,901    419    2.82 
Mortgage-backed securities   122,154    1,126    1.86    161,195    1,437    1.79 
Total investment securities  $215,051   $1,974    1.85%  $243,788   $2,161    1.78%
Other investments and securities, at cost   10,189    184    3.64    8,291    151    3.66 
Federal funds sold and interest bearing deposits in other financial institutions   13,179    60    0.92    19,226    50    0.52 
Total interest earning assets  $1,247,039   $25,065    4.05%  $1,152,641   $22,758    3.97%
All other assets   89,308              89,571           
Allowance for loan losses   (10,195)             (8,748)          
Total assets  $1,326,152             $1,233,464           
LIABILITIES AND STOCKHOLDERS' EQUITY                              
NOW accounts  $214,140   $504    0.47%  $207,720   $324    0.31%
Savings   100,409    25    0.05    94,627    24    0.05 
Commercial   1,589    4    0.51    0    0    0.00 
Money market   201,709    331    0.33    180,131    234    0.26 
Time deposits of $250,000 and over   60,623    191    0.64    58,779    153    0.52 
Other time deposits   230,759    789    0.69    236,692    764    0.65 
Total interest bearing deposits  $809,229   $1,844    0.46%  $777,949   $1,499    0.39%
Federal funds purchased and securities sold under agreements to repurchase   29,158    49    0.34    42,814    39    0.18 
Subordinated notes   49,486    840    3.42    49,486    720    2.93 
Federal Home Loan Bank Advances   101,399    741    1.47    55,802    450    1.62 
Total borrowings  $180,043   $1,630    1.83%  $148,102   $1,209    1.64%
Total interest bearing liabilities  $989,272   $3,474    0.71%  $926,051   $2,708    0.59%
Demand deposits   232,016              207,833           
Other liabilities   11,198              9,613           
Total liabilities   1,232,486              1,143,497           
Stockholders' equity   93,666              89,967           
Total liabilities and stockholders' equity  $1,326,152             $1,233,464           
Net interest income (FTE)        21,591              20,050      
Net interest spread             3.34%             3.38%
Net interest margin             3.49%             3.50%

 

(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 $284,000 and $231,000 for the six months ended June 30, 2017 and 2016, 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

 

 

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 six months ended June 30, 2017 compared to the three and six months ended June 30, 2016. 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  June 30,   Six Months Ended  June 30, 
   2017 vs. 2016   2017 vs. 2016 
       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  $371   $413   $(42)  $655   $808   $(153)
Real estate construction - residential   30    27    3    37    40    (3)
Real estate construction - commercial   258    325    (67)   569    663    (94)
Real estate mortgage - residential   115    93    22    128    171    (43)
Real estate mortgage - commercial   582    549    33    1,015    1,062    (47)
Consumer   21    62    (41)   47    129    (82)
Investment securities: (3)                              
U.S. government and federal agency obligations   59    26    33    27    (34)   61 
Obligations of states and political subdivisions   75    114    (39)   97    190    (93)
Mortgage-backed securities   (156)   (228)   72    (311)   (358)   47 
Other investments and securities, at cost   19    18    1    33    35    (2)
Federal funds sold and interest bearing deposits in other financial institutions   (7)   (18)   11    10    (19)   29 
Total interest income   1,367    1,381    (14)   2,307    2,687    (380)
Interest expense:                              
NOW accounts   115    5    110    180    10    170 
Savings   1    0    1    1    1    0 
Commercial   2    0    2    4    0    4 
Money market   70    15    55    97    30    67 
Time deposits of $250,000 and over   15    (6)   21    40    5    35 
Other time deposits   26    (10)   36    23    (19)   42 
Federal funds purchased and securities sold under agreements to repurchase   12    (3)   15    10    (15)   25 
Subordinated notes   65    0    65    120    0    120 
Federal Home Loan Bank advances   176    185    (9)   291    337    (46)
Total interest expense   482    186    296    766    349    417 
Net interest income on a fully taxable equivalent basis  $885   $1,195   $(310)  $1,541   $2,338   $(797)

 

(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 $145,000 and $284,000 for the three and six months June 30, 2017, respectively, compared to $109,000 and $231,000 for the three and six months June 30, 2016, 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 June 30, 2017 compared to the three months ended June 30, 2016, reflected an increase in net interest income, on a tax equivalent basis, of $885,000, or 8.78%, and the financial results for the six months ended June 30, 2017 compared to the six months ended June 30, 2016 reflected an increase of $1.5 million, or 7.69%.

 

Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) increased to 3.50% for the three months ended June 30, 2017 compared to 3.49% for the three months ended June 30, 2016, and decreased to 3.49% for the six months ended June 30, 2017 compared to 3.50% for the six months ended June 30, 2016. The increase in net interest income was primarily due to an increase in average loans and the net interest margin has remained relatively unchanged during the periods reported. Due to loan growth and maintaining net interest margin, net interest income has continued to increase.

 

 39

 

 

Average interest-earning assets increased $95.1 million, or 8.19%, to $1.26 billion for the three months ended June 30, 2017 compared to $1.16 billion for the three months ended June 30, 2016, and average interest bearing liabilities increased $64.3 million, or 6.92%, to $993.7 million for the three months ended June 30, 2017 compared to $929.4 million for the three months ended June 30, 2016.

 

Average interest-earning assets increased $94.4 million, or 8.19%, to $1.25 billion for the six months ended June 30, 2017 compared to $1.15 billion for the six months ended June 30, 2016, and average interest bearing liabilities increased $63.2 million, or 6.83%, to $989.3 million for the six months ended June 30, 2017 compared to $926.1 million for the six months ended June 30, 2016.

 

Total interest income (expressed on a fully taxable equivalent basis) was $12.8 million and $25.1 million for the three and six months ended June 30, 2017, respectively, compared to $11.5 million and $22.8 million for the three and six months ended June 30, 2016, respectively. The Company’s rates earned on interest earning assets were 4.09% and 4.05% for the three and six months ended June 30, 2017, respectively, compared to 3.97% for both the three and six months ended June 30, 2016.

 

Interest income on loans increased to $11.7 million and $22.8 million for the three and six months ended June 30, 2017, respectively, compared to $10.4 million and $20.4 million for the three and six months ended June 30, 2016, respectively.

 

Average loans outstanding increased $128.6 million, or 14.4%, to $1.0 billion for the three months ended June 30, 2017 compared to $896.4 million for the three months ended June 30, 2016. The average yield on loans receivable decreased to 4.59% for the three months ended June 30, 2017 compared to 4.65% for the three months ended June 30, 2016.

 

For the six months ended June 30, 2017, average loans outstanding increased $127.3 million, or 14.4%, to $1.0 billion compared to $881.3 million for the six months ended June 30, 2016. The average yield on loans receivable decreased to 4.57% for the six months ended June 30, 2017 compared to 4.65% for the six months ended June 30, 2016. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

 

Total interest expense was to $1.9 million and $3.5 million for the three and six months ended June 30, 2017, respectively, compared to $1.4 million and $2.7 million for the three and six months ended June 30, 2016, respectivley. The Company’s rates paid on interest bearing liabilities was 0.75% and 0.71% for the three and six months ended June 30, 2017, respectively, compared to 0.60% and 0.59% for the three and six months ended June 30, 2016, respectively. See the Liquidity Management section for further discussion.

 

Interest expense on deposits increased to $984,000 and $1.8 million for the three and six months ended June 30, 2017, respectively, compared to $755,000 and $1.5 million for the three and six months ended June 30, 2016, respectively.

 

Average interest bearing deposits increased $22.9 million, or 2.93%, to $804.9 million for the three months ended June 30, 2017 compared to $782.0 million for the three months ended June 30, 2016. The average cost of deposits increased to 0.49% for the three months ended June 30, 2017 compared to 0.39% for the three months ended June 30, 2016.

 

For the six months ended June 30, 2017, average interest bearing deposits increased $31.3 million, or 4.02%, to $809.2 million compared to $778.0 million for the six months ended June 30, 2016. The average cost of deposits increased to 0.46% for the six months ended June 30, 2017 compared to 0.39% for the six months ended June 30, 2016 primarily as a result of higher market interest rates.

 

Interest expense on borrowings increased to $877,000 and $1.6 million for the three and six months ended June 30, 2017, respectively, compared to $624,000 and $1.2 million for the three and six months ended June 30, 2016, respectively.

 

Average borrowings increased $41.4 million, or 28.10%, to $188.8 million for the three months ended June 30, 2017 compared to $147.4 million for the three months ended June 30, 2016. The average cost of borrowings increased to 1.86% for the three months ended June 30, 2017 compared to 1.70% for the three months ended June 30, 2016.

 

For the six months ended June 30, 2017, average borrowings increased $31.9 million, or 21.57%, to $180.0 million for the six months ended June 30, 2017 compared to $148.1 million for the six months ended June 30, 2016. The average cost of borrowings increased to 1.83% for the six months ended June 30, 2017 compared to 1.64% for the six months ended June 30, 2016. See the Liquidity Management section for further discussion.

 

 40

 

 

Non-interest Income and Expense

 

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

 

   Three Months Ended June 30,   Six Months Ended June 30, 
(In thousands)  2017   2016   $
Change
   %
Change
   2017   2016   $
Change
   %
Change
 
Non-interest Income                                        
Service charges and other fees  $851   $828   $23    2.8%  $1,687   $1,662   $25    1.5%
Bank card income and fees   663    648    15    2.3    1,277    1,282    (5)   (0.4)
Trust department income   266    265    1    0.4    540    483    57    11.8 
Real estate servicing fees, net   34    (86)   120    139.5    487    (32)   519    1,621.9 
Gain on sales of mortgage loans, net   218    222    (4)   (1.8)   374    387    (13)   (3.4)
Gain on sale of investment securities   0    18    (18)   (100.0)   0    490    (490)   (100.0)
Other   67    54    13    24.1    141    125    16    12.8 
Total non-interest income  $2,099   $1,949   $150    7.7%  $4,506   $4,397   $109    2.5%
                                         
Non-interest income as a % of total revenue *   16.2%   16.4%             17.5%   18.2%          
Total revenue per full time equivalent employee  $38.8   $35.6             $77.7   $71.8           

 

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

 

Total non-interest income increased $150,000, or 7.7%, to $2.1 million for the quarter ended June 30, 2017 compared to $1.9 million for the quarter ended June 30, 2016, and increased $109,000, or 2.5%, to $4.5 million for the six months ended June 30, 2017 compared to $4.4 million for the six months ended June 30, 2016.

 

Real estate servicing fees, net of the change in valuation of mortgage serving rights increased $120,000 to $34,000 for the quarter ended June 30, 2017 compared to $(86,000) for the quarter ended June 30, 2016, and increased $519,000 to $487,000 for the six months ended June 30, 2017 compared to $(32,000) for the six months ended June 30, 2016. The increases in both periods were primarily due to slower prepayment speeds resulting from a higher rate environment. Mortgage loan servicing fees earned on loans sold were $211,000 for both the quarters ended June 30, 2017 and 2016, and $420,000 for the six months ended June 30, 2017 compared to $421,000 for the six months ended June 30, 2016.

 

The Company was servicing $289.8 million of mortgage loans at June 30, 2017 compared to $294.4 million and $304.7 million at December 31, 2016 and June 30, 2016, respectively.

 

Gain on sales of mortgage loans decreased $4,000 to $218,000 for the quarter ended June 30, 2017 compared to $222,000 for the quarter ended June 30, 2016, and decreased $13,000 to $374,000 for the six months ended June 30, 2017 compared to $387,000 for the six months ended June 30, 2016. The Company sold loans of $9.4 million for the quarter ended June 30, 2017 compared to $10.1 million for the quarter ended June 30, 2016, and $16.2 million for the six months ended June 30, 2017 compared to $17.5 million for the six months ended June 30, 2016.

 

No gain on sale of investment securities was recognized during the three and six months ended June 30, 2017. During the six months ended June 30, 2016 the Company received $44.3 million from proceeds on sales of available-for-sale debt securities and recognized gains of $490,000. This transaction was the result of bond sales and purchases to replace several smaller holdings with fewer, larger investments without materially changing the duration or yield of the investment portfolio.

 

 41

 

 

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

 

   Three Months Ended June 30,   Six Months Ended June 30, 
(In thousands)  2017   2016   $ Change   % Change   2017   2016   $ Change   % Change 
Non-interest Expense                                        
Salaries  $4,010   $3,927   $83    2.1%  $8,064   $7,965   $99    1.2%
Employee benefits   1,342    1,378    (36)   (2.6)   2,742    2,690    52    1.9 
Occupancy expense, net   689    673    16    2.4    1,307    1,306    1    0.1 
Furniture and equipment expense   634    439    195    44.4    1,232    850    382    44.9 
Processing expense, network and bank card expense   927    840    87    10.4    1,972    1,611    361    22.4 
Legal, examination, and professional fees   317    328    (11)   (3.4)   597    662    (65)   (9.8)
FDIC insurance assessment   115    188    (73)   (38.8)   216    364    (148)   (40.7)
Advertising and promotion   265    242    23    9.5    503    452    51    11.3 
Postage, printing, and supplies   263    291    (28)   (9.6)   495    527    (32)   (6.1)
Real estate foreclosure expense, net   226    42    184    438.1    253    183    70    38.3 
Other   899    1,005    (106)   (10.5)   1,656    1,826    (170)   (9.3)
Total non-interest expense  $9,687   $9,353   $334    3.6%  $19,037   $18,436   $601    3.3%
Efficiency ratio *   75.0%   78.5%             73.8%   76.1%          
Salaries and benefits as a % of total non-interest expense   55.2%   56.7%             56.8%   57.8%          
Number of full-time equivalent employees   333    335              332    337           

 

* Efficiency ratio is calculated as non-interest expense as a percent of revenue.

 

Total non-interest expense increased $334,000, or 3.6%, to $9.7 million for the quarter ended June 30, 2017 compared to $9.4 million for the quarter ended June 30, 2016, and increased $601,000, or 3.3%, to $19.0 million for the six months ended June 30, 2017 compared to $18.4 million for the six months ended June 30, 2016.

 

Furniture and equipment expense increased $195,000, or 44.4%, to $634,000 for the quarter ended June 30, 2017 compared to $439,000 for the quarter ended June 30, 2016, and increased $382,000, or 44.9%, to $1.2 million for the six months ended June 30, 2017 compared to $850,000 for the six months ended June 30, 2016. Beginning December 2016, the Company began upgrading its data processing infrastructure to a hosted cloud based network solution. The process included changes in maintenance agreements and service providers.

 

Processing, network, and bank card expense increased $87,000, or 10.4%, to $927,000 for the quarter ended June 30, 2017 compared to $840,000 for the quarter ended June 30, 2016, and increased $361,000, or 22.4%, to $2.0 million for the six months ended June 30, 2017 compared to $1.6 million for the six months ended June 30, 2016. The increase for both periods was primarily due to a corporate wide network upgrade and changes in processing service providers.

 

FDIC insurance assessment decreased $73,000, or 38.8%, to $115,000 for the quarter ended June 30, 2017 compared to $188,000 for the quarter ended June 30, 2016, and decreased $148,000, or 40.7%, to $216,000 for the six months ended June 30, 2017 compared to $364,000 for the six months ended June 30, 2016. In February 2011, the FDIC adopted a rule that requires large institutions to bear the burden of raising the reserve ratio form 1.15% to 1.35% in accordance with the Dodd-Frank Act. The quarter after the reserve ratio reached 1.15%, lower assessment rates, surcharges, and new pricing for small institutions under $10 billion became effective July 1, 2016 and appeared on the December 31, 2016 invoicing. Once the reserve ratio reaches 1.38%, small institutions, such as Hawthorn, will receive credits to offset their contribution to raising the reserve ratio to 1.35%.

 

Real estate foreclosure expense, net increased $184,000, or 438.1%, to $226,000 for the quarter ended June 30, 2017 compared to $42,000 for the quarter ended June 30, 2016, and increased $70,000, or 38.3%, to $253,000 for the six months ended June 30, 2017 compared to $183,000 for the six months ended June 30, 2016. Net losses (gains) recognized on other real estate owned were $190,000 for the quarter ended June 30, 2017 compared to $(26,000) for the quarter ended June 30, 2016, and $171,000 for the six months ended June 30, 2017 compared to $(47,000) for the six months ended June 30, 2016. Expenses to maintain foreclosed properties were $36,000 for the quarter ended June 30, 2017 compared to $68,000 for the quarter ended June 30, 2016, and $82,000 for the six months ended June 30, 2017 compared to $230,000 for the six months ended June 30, 2016. The decrease in expenses period over period was primarily due to sales of foreclosed assets.

 

Other non-interest expense decreased $106,000, or 10.5%, to $899,000 for the quarter ended June 30, 2017 compared to $1.0 million for the quarter ended June 30, 2016, and decreased $170,000, or 9.3%, to $1.7 million for the six months ended June 30, 2017 compared to $1.8 million for the six months ended June 30, 2016. The decrease in both periods was primarily due to a decrease in debit card charge offs due to fraudulent transactions in 2016, a decrease in directors fees, donations, employee training, education, and travel expenses, partially offset by a net loss on the sale of two branch buildings that were in other assets held for sale.

 

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Income taxes

 

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 33.9% for the quarter ended June 30, 2017 compared to 34.1% for the quarter ended June 30, 2016. Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 34.1% for the six months ended June 30, 2017 compared to 33.2% for the six months ended June 30, 2016. The increase in the tax rate for the six months ended June 30, 2017 in comparison to the six months ended June 30, 2016 is primarily due to an immaterial return to provision adjustment made in the first quarter of 2016.

 

Lending and Credit Management

 

Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 74.1% of total assets as of June 30, 2017 compared to 74.9% as of December 31, 2016.

 

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:

 

   June 30,   December 31, 
(In thousands)  2017   2016 
Commercial, financial, and agricultural  $187,251   $182,881 
Real estate construction - residential   20,037    18,907 
Real estate construction - commercial   78,257    55,653 
Real estate mortgage - residential   255,426    259,900 
Real estate mortgage - commercial   461,062    426,470 
Installment loans to individuals   32,987    30,218 
Total loans  $1,035,020   $974,029 
Percent of categories to total loans:          
Commercial, financial, and agricultural   18.1%   18.8%
Real estate construction - residential   1.9    1.9 
Real estate construction - commercial   7.6    5.7 
Real estate mortgage - residential   24.7    26.7 
Real estate mortgage - commercial   44.5    43.8 
Installment loans to individuals   3.2    3.1 
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. During the three and six months ended June 30, 2017, the Company sold approximately $9.4 million and $16.2 million of loans to investors, respectively, compared to $10.1 million and $17.5 million for the three and six months ended June 30, 2016, respectively. At June 30, 2017, the Company was servicing approximately $289.8 million of loans sold to the secondary market compared to $294.4 million at December 31, 2016, and $304.7 million at June 30, 2016.

 

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 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

 

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determines which loans should be considered impaired. Management follows the guidance provided in the FASB’s ASC Topic 310-10-35 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 necessary by management to provide for probable losses inherent in the loan portfolio.

 

Nonperforming Assets

The following table summarizes nonperforming assets at the dates indicated:

 

   June 30,   December 31, 
(In thousands)  2017   2016 
Nonaccrual loans:          
Commercial, financial, and agricultural  $1,123   $982 
Real estate construction - commercial   48    50 
Real estate mortgage - residential   2,252    1,888 
Real estate mortgage - commercial   959    420 
Installment and other consumer   52    89 
Total  $4,434   $3,429 
Loans contractually past - due 90 days or more and still accruing:          
Real estate mortgage - residential  $252   $54 
Installment and other consumer   37    11 
Total  $289   $65 
Performing troubled debt restructurings   5,286    5,715 
Total nonperforming loans   10,009    9,209 
Other real estate owned and repossessed assets   13,356    14,162 
Total nonperforming assets  $23,365   $23,371 
           
Loans  $1,035,020   $974,029 
Allowance for loan losses to loans   1.02%   1.01%
Nonperforming loans to loans   0.97%   0.95%
Allowance for loan losses to nonperforming loans   105.36%   107.35%
Allowance for loan losses to nonperforming loans, excluding performing TDR's   223.27%   282.94%
Nonperforming assets to loans, other real estate owned and repossessed assets   2.23%   2.37%

 

Total nonperforming assets totaled $23.4 million at June 30, 2017 compared to $23.4 million at December 31, 2016. Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing, and TDRs totaled $10.0 million, or 0.97%, of total loans at June 30, 2017 compared to $9.2 million, or 0.95%, of total loans at December 31, 2016. Non-accrual loans included $992,000 and $619,000 of loans classified as TDRs at June 30, 2017 and December 31, 2016, respectively.

 

As of June 30, 2017 and December 31, 2016, approximately $5.4 million and $4.0 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. Management believes the general allowance was sufficient to cover the risks and probable losses related to such loans at June 30, 2017 and December 31, 2016, respectively.

 

Total non-accrual loans at June 30, 2017 increased $1.0 million to $4.4 million compared to $3.4 million at December 31, 2016. This increase primarily consisted of a $903,000 increase in real estate mortgage - commercial loans and real estate mortgage - residential loans, and a $141,000 increase in commercial, financial, and agricultural loans, partially offset by a $37,000 decrease in installment loans.

 

Loans past due 90 days and still accruing interest at June 30, 2017, were $289,000 compared to $65,000 at December 31, 2016. Other real estate and repossessed assets at June 30, 2017 were $13.4 million compared to $14.2 million at December 31, 2016. During the six months ended June 30, 2017, $155,000 of nonaccrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to $1.6 million during the six months ended June 30, 2016.

 

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

 

   June 30, 2017   December 31, 2016 
(In thousands)  Number of
Contracts
   Recorded
Investment
   Specific
Reserves
   Number of
Contracts
   Recorded
Investment
   Specific
Reserves
 
Performing TDRs                              
Commercial, financial and agricultural   8   $664   $29    8   $635   $11 
Real estate mortgage - residential   9    3,535    124    8    3,582    99 
Real estate mortgage - commercial   2    1,087    119    3    1,498    123 
Total performing TDRs   19   $5,286   $272    19   $5,715   $233 
Nonperforming TDRs                              
Commercial, financial and agricultural   1   $65   $-   -   $-   $- 
Real estate mortgage - residential   5    327    56    6    430    58 
Real estate mortgage - commercial   4    600    122    2    189    119 
Total nonperforming TDRs   10   $992   $178    8   $619   $177 
Total TDRs   29   $6,278   $450    27   $6,334   $410 

 

At June 30, 2017, loans classified as TDRs totaled $6.3 million, with $450,000 of specific reserves, of which $992,000 were classified as nonperforming TDRs and $5.3 million were classified as performing TDRs. This compared to $6.3 million of loans classified as TDRs, with $410,000 of specific reserves, of which $619,000 were classified as nonperforming TDRs and $5.7 million were classified as performing TDRs at December 31, 2016. Both performing and nonperforming TDRs are considered impaired loans. 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. The net decrease in total TDRs from December 31, 2016 to June 30, 2017 was primarily due to $232,000 of payments received partially offset by two new TDR’s totaling $187,000.

 

Allowance for Loan Losses and Provision

 

Allowance for Loan Losses

 

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

 

   June 30,   December 31, 
(In thousands)  2017   2016 
Allocation of allowance for loan losses at end of period:          
Commercial, financial, and agricultural  $2,578   $2,753 
Real estate construction - residential   70    108 
Real estate construction - commercial   615    413 
Real estate mortgage - residential   1,854    2,385 
Real estate mortgage - commercial   4,882    3,793 
Installment and other consumer   376    274 
Unallocated   170    160 
Total  $10,545   $9,886 

 

The allowance for loan losses (ALL) was $10.5 million, or 1.02%, of loans outstanding at June 30, 2017 compared to $9.9 million, or 1.01%, of loans outstanding at December 31, 2016, and $9.4 million, or 1.02%, of loans outstanding at June 30, 2016. The ratio of the allowance for loan losses to nonperforming loans, excluding performing TDR’s, was 223.27% at June 30, 2017, compared to 282.94% at December 31, 2016.

 

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

 

   June 30,   December 31, 
(In thousands)  2017   2016 
Allocation of allowance for loan losses:          
Individually evaluated for impairment - specific reserves  $1,125   $1,080 
Collectively evaluated for impairment - general reserves   9,420    8,806 
Total  $10,545   $9,886 

 

 

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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 June 30, 2017, $1.1 million of the Company’s ALL was allocated to impaired loans totaling approximately $9.7 million compared to $1.1 million of the Company’s ALL allocated to impaired loans totaling approximately $9.1 million at December 31, 2016. Management determined that $1.7 million, or 18%, of total impaired loans required no reserve allocation at June 30, 2017 compared to $2.1 million, or 23%, at December 31, 2016 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 loss rates to pools of loans by asset type. 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. Beginning in the first quarter of 2016, the Company began to lengthen its look-back period with the intent to increase such period from three to five years over the next two years. The Company believes that the five-year look-back period, which is consistent with the Company’s practices prior to the start of the economic recession in 2008, provides a representative historical loss period in the current economic environment. These historical loss rates for each risk group are used as the starting point to determine loss rates for measurement purposes. The historical loan loss rates are multiplied by loss emergence periods (LEP) which represent the estimated time period between a borrower first experiencing financial difficulty and the recognition of a loss.

 

The Company’s methodology includes qualitative risk factors that allow management to adjust its estimates of losses based on the most recent information available and to address other limitations in the quantitative component that is based on historical loss rates. Such risk factors are generally reviewed and updated quarterly, as appropriate, and are adjusted to reflect changes in national and local economic conditions and developments, the nature, volume and terms of loans in the portfolio, including changes in volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans, loan concentrations, assessment of trends in collateral values, assessment of changes in the quality of the Company’s internal loan review department, and changes in lending policies and procedures, including underwriting standards and collections, charge-off and recovery practices.

 

The specific and general reserve allocations represent management’s best estimate of probable losses inherent 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.

 

Provision

 

A $330,000 and $680,000 provision was required for the three and six months ended June 30, 2017, respectively, compared to a $425,000 and $675,000 provision for the three and six months ended June 30, 2016, respectively. The Company is using an eighteen quarter look-back period compared to fourteen quarters, as discussed above.

 

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

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
(In thousands)  2017   2016   2017   2016 
Analysis of allowance for loan losses:                    
Balance beginning of period  $10,262   $8,631   $9,886   $8,604 
Charge-offs:                    
Commercial, financial, and agricultural   32    36    60    138 
Real estate construction - commercial   -    -    -    1 
Real estate mortgage - residential   62    175    81    381 
Real estate mortgage - commercial   2    28    16    111 
Installment and other consumer   60    67    111    123 
Total charge-offs   156    306    268    754 
Recoveries:                    
Commercial, financial, and agricultural  $24   $80   $42   $177 
Real estate construction - residential   25    -    75    - 
Real estate construction - commercial   -    491    -    502 
Real estate mortgage - residential   21    9    57    17 
Real estate mortgage - commercial   14    31    21    92 
Installment and other consumer   25    31    52    79 
Total recoveries   109    642    247    867 
Net charge-offs (recoveries)   47    (336)   21    (113)
Provision for loan losses   330    425    680    675 
Balance end of period  $10,545   $9,392   $10,545   $9,392 

 

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Net Loan Charge-offs (Recoveries)

 

The Company’s net loan charge-offs were $47,000, or 0.00%, of average loans for the three months ended June 30, 2017, compared to net loan recoveries of $336,000, or (0.04)%, of average loans for the three months ended June 30, 2016. The decrease in charge-offs quarter over quarter primarily related to a decrease in real estate mortgage residential and commercial loans. The decrease in recoveries quarter over quarter was primarily due to a significant recovery in one real estate construction loan relationship during the quarter ended June 30, 2016.

 

The Company’s net loan charge-offs were $21,000, or 0.00%, of average loans for the six months ended June 30, 2017, compared to net loan recoveries of $113,000, or (0.01)%, of average loans for the six months ended June 30, 2016. The decrease in charge-offs year over year primarily related to a decrease in commercial, financial, and agricultural loans, and a decrease in real estate mortgage residential and commercial loans. The decrease in recoveries year over year was primarily due to a significant recovery in one commercial loan relationship and a recovery in one real estate construction loan relationship during the six months ended June 30, 2016.

 

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.

 

   June 30,   December 31, 
(In thousands)  2017   2016 
Federal funds sold and other overnight interest-bearing deposits  $40,552   $1,406 
Available-for-sale investment securities   216,353    214,512 
Total  $256,905   $215,918 

 

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 $216.4 million at June 30, 2017 and included an unrealized net loss of $1.7 million. The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately $37.5 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 June 30, 2017 and December 31, 2016, the Company’s unpledged securities in the available for sale portfolio totaled approximately $61.3 million and $46.9 million, respectively.

 

Total investment securities pledged for these purposes were as follows:

 

   June 30,   December 31, 
(In thousands)  2017   2016 
Investment securities pledged for the purpose of securing:          
Federal Reserve Bank borrowings  $10,329   $9,211 
Federal funds purchased and securities sold under agreements to repurchase   42,971    43,054 
Other deposits   101,774    115,330 
Total pledged, at fair value  $155,074   $167,595 

 

Liquidity is available from the Company’s base of core customer deposits, defined as demand, interest checking, savings, money market deposit accounts, and time deposits less than $250,000, less all brokered deposits under $250,000. At June 30, 2017, such deposits totaled $979.0 million and represented 90.4% 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 $250,000 and over totaled $103.6 million at June 30, 2017. These accounts are normally considered more volatile and higher costing representing 9.6% of total deposits at June 30, 2017.

 

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Core deposits at June 30, 2017 and December 31, 2016 were as follows:

 

   June 30,   December 31, 
(In thousands)  2017   2016 
Core deposit base:          
Non-interest bearing demand  $279,634   $235,975 
Interest checking   207,521    177,414 
Savings and money market   290,110    276,295 
Other time deposits   201,777    206,088 
Total  $979,042   $895,772 

 

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 June 30, 2017, under agreements with these unaffiliated banks, the Bank may borrow up to $40.0 million in federal funds on an unsecured basis and $18.4 million on a secured basis. There were no federal funds purchased outstanding at June 30, 2017. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company’s investment portfolio. At June 30, 2017, there was $29.1 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 June 30, 2017.

 

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 June 30, 2017, the Bank had $115.4 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 June 30, 2017 and December 31, 2016 were as follows:

 

   June 30,   December 31, 
(In thousands)  2017   2016 
Borrowings:          
Federal funds purchased and securities sold under agreements to repurchase  $29,118   $31,015 
Federal Home Loan Bank advances   115,363    92,900 
Subordinated notes   49,486    49,486 
Other borrowings   -    492 
Total  $193,967   $173,893 

 

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 FHLB establishes a collateral value from which the Company may draw advances against this collateral. This collateral is also used to enable the FHLB to issue letters of credit in favor of public fund depositors of the Company. The Federal Reserve Bank also establishes a collateral value of assets pledged to support borrowings from the discount window. The following table reflects collateral value of assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to the Company as follows:

 

   June 30,   December 31, 
   2017   2016 
(In thousands)  FHLB   Federal
Reserve
Bank
   Federal
Funds
Purchased
Lines
   Total   FHLB   Federal
Reserve
Bank
   Federal
Funds
Purchased
Lines
   Total 
Advance equivalent  $317,288   $10,105   $48,305   $375,698   $314,602   $9,015   $49,020   $372,637 
Letters of credit   (53,000)   0    0    (53,000)   0    0    0    0 
Advances outstanding   (115,363)   0    0    (115,363)   (92,900)   0    (992)   (93,892)
Total available  $148,925   $10,105   $48,305   $207,335   $221,702   $9,015   $48,028   $278,745 

 

At June 30, 2017, loans of $496.0 million were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At June 30, 2017, investments totaling $21.1 million were pledged to secure federal funds purchased lines and borrowing capacity at the Federal Reserve Bank.

 

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Sources and Uses of Funds

 

Cash and cash equivalents were $61.3 million at June 30, 2017 compared to $27.0 million at December 31, 2016. The $34.3 million increase 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 six months ended June 30, 2017. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $5.9 million for the six months ended June 30, 2017.

 

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 $62.9 million. The cash outflow primarily consisted of a $60.6 million increase in loans and $21.9 million purchases of investment securities, partially offset by $20.7 million from maturities and calls of investment securities.

 

Financing activities provided cash of $91.3 million, resulting primarily from a $43.7 million increase in demand deposits, a $48.9 million increase in interest bearing transaction accounts, and a $22.5 million net increase in FHLB advances, partially offset by a $20.6 million decrease in time deposits. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2017.

 

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 $281.7 million in unused loan commitments and standby letters of credit as of June 30, 2017. 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 shareholders. The Company paid cash dividends to its shareholders totaling approximately $674,000 and $542,000 for the six months ended June 30, 2017 and 2016, respectively. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank did not declare or pay dividends to the Company during the six months ended June 30, 2017 and 2016. At June 30, 2017 and December 31, 2016, the Company had cash and cash equivalents totaling $2.3 million and $3.9 million, 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.

 

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 the Company began on January 1, 2015. The Federal Reserve System’s (FRB) capital adequacy guidelines require that bank holding companies maintain a Common Equity Tier 1 risk-based capital ratio equal to at least 4.5% of its risk-weighted assets, a Tier 1 risk-based capital ratio equal to at least 6% of its risk-weighted assets and a total risk-based capital ratio equal to at least 8% of its risk-weighted assets. In addition, bank holding companies generally are required to maintain a Tier 1 leverage ratio of at least 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. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital conservation buffer requirement will be phased in over four years beginning in 2016. On January 1, 2016, the first phase of the requirement went into effect at 0.625% of risk-weighted assets, and the requirement will increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of risk weighted assets on January 1, 2019. Once fully phase in , the capital conservation buffer requirement effectively raises the minimum required risk-based capital ratios to 7% Common Equity Tier 1 Capital, 8.5% Tier 1 Capital and 10.5% Total Capital on a fully phased-in basis.

 

Under the Basel III requirements, at June 30, 2017 and December 31, 2016, the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table as of periods indicated:

 

 49

 

 

                   Well-Capitalized Under 
           Required for Capital   Prompt Corrective Action 
   Actual   Adequacy Purposes   Provision 
(in thousands)  Amount   Ratio   Amount   Ratio   Amount   Ratio 
June 30, 2017                              
Total Capital (to risk-weighted assets):                              
Company  $156,726    13.47%  $93,068    8.00%  $N.A.    N.A.%
Bank   154,226    13.31    92,728    8.00    115,906    10.00 
Tier I Capital (to risk-weighted assets):                              
Company  $130,349    11.20%  $69,801    6.00%  $N.A.    N.A.%
Bank   143,521    12.38    69,544    6.00    92,725    8.00 
Common Equity Tier I Capital (to risk-weighted assets)                              
Company  $98,021    8.43%  $52,351    4.50%  $N.A.    N.A.%
Bank   143,521    12.38    52,158    4.50    75,339    6.50 
Tier I Capital (to adjusted average assets):                              
Company  $130,349    9.77%  $53,356    4.00%  $N.A.    N.A.%
Bank   143,521    10.79    53,198    4.00    66,498    5.00 
                               
(in thousands)                              
December 31, 2016                              
Total Capital (to risk-weighted assets):                              
Company  $152,864    13.88%  $88,125    8.00%  N.A.    N.A.%
Bank   148,304    13.51    87,810    8.00   $109,763    10.00 
Tier I Capital (to risk-weighted assets):                              
Company  $125,779    11.42%  $66,093    6.00%  N.A.    N.A.%
Bank   138,258    12.60    65,858    6.00   $87,810    8.00 
Common Equity Tier I Capital (to risk-weighted assets)                              
Company  $94,818    8.61%  $49,570    4.50%  $N.A.    N.A.%
Bank   138,258    12.60    49,393    4.50    71,346    6.50 
Tier I capital (to adjusted average assets):                              
Company  $125,779    9.87%  $50,998    4.00%  $N.A.    N.A.%
Bank   138,258    10.88    50,810    4.00    63,513    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 June 30, 2017, 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 June 30, 2017. 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.

 

 50

 

 

                       Over     
                       5 Years or     
                       No stated     
(In thousands)  Year 1   Year 2   Year 3   Year 4   Year 5   Maturity   Total 
ASSETS                                   
Investment securities  $37,465   $41,240   $44,969   $30,347   $18,767   $43,565   $216,353 
Federal funds sold and other over-night interest-bearing deposits   40,552    -    -    -    -    -    40,552 
Other investments and securities, at cost   7,798    -    3,000    -    -    -    10,798 
Loans   368,407    166,142    156,756    125,208    116,554    101,953    1,035,020 
Total  $454,222   $207,382   $204,725   $155,555   $135,321   $145,518   $1,302,723 
                                    
LIABILITIES                                   
Savings, interest checking, and money market deposits  $296,949   $-   $220,729   $-   $-   $-   $517,678 
Time deposits   186,638    49,041    23,036    6,868    19,792    -    285,375 
Federal funds purchased and securities sold under agreements to repurchase   29,118    -    -    -    -    -    29,118 
Subordinated notes   49,486    -    -    -    -    -    49,486 
Federal Home Loan Bank advances   41,124    32,000    30,461    7,000    4,778    -    115,363 
Total  $603,315   $81,041   $274,226   $13,868   $24,570   $-   $997,020 
Interest-sensitivity GAP                                   
Periodic GAP  $(149,093)  $126,341   $(69,501)  $141,687   $110,751   $145,518   $305,703 
Cumulative GAP  $(149,093)  $(22,752)  $(92,253)  $49,434   $160,185   $305,703   $305,703 
                                    
Ratio of interest-earning assets to interest-bearing liabilities                                   
Periodic GAP   0.75    2.56    0.75    11.22    5.51     NM     1.31 
Cumulative GAP   0.75    0.97    0.90    1.05    1.16    1.31    1.31 

 

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 June 30, 2017.

 

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 June 30, 2017.  Based upon and as of the date of that evaluation, our principal executive and principal financial officers concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required.  It should be noted that any system of disclosure controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met.  In addition, the design of any system of disclosure controls and procedures is based in part upon assumptions about the likelihood of future events. Because of these and other inherent limitations of any such system, there can be no assurance that any design will always succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

 

There has been no change in our Company's internal control over financial reporting that occurred during the three months ended June 30, 2017 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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Impact of New Accounting Standards

 

Revenue from Contracts with Customers The FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), in May 2014. The ASU supersedes revenue recognition requirements in Topic 605, Revenue Recognition, including most industry-specific revenue recognition guidance in the FASB Accounting Standards Codification. The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance identifies specific steps that entities should apply in order to achieve this principle. The amendments are effective for interim and annual periods beginning January 1, 2018 and must be applied retrospectively.

 

In March 2016, the FASB began to issue targeted guidance to clarify specific implementation issues of ASU 2014-09. The FASB issued ASU 2016-08, Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which provides guidance on determining an entity's role in providing goods and services as a principal versus an agent, and whether it controls each specified good or service before it is transferred to the customer. In April 2016, ASU 2016-10, Identifying Performance Obligations and Licensing, was issued which clarifies the guidance related to whether goods or services are distinct within the contract and therefore are a performance obligation, and clarifies the timing and pattern of revenue recognition for licenses of intellectual property. The effective date and transition requirements of these ASUs are the same as those of ASU 2014-09.

 

In May 2016, the FASB issued ASU 2016-12, Revenue from Contracts with Customers: Narrow-Scope Improvements and Practical Expedients. The amendments in this update address narrow-scope improvements to the accounting guidance on collectability, noncash consideration, and completed contracts at transition. Additionally, the amendments in this Update provide a practical expedient for contract modifications at transition and an accounting policy election related to the presentation of sales taxes and other similar taxes collected from customers. The amendments also included a rescission issued in May 2016, ASU 2016-11, Revenue Recognition and Derivatives and Hedging: Rescission of SEC Guidance Because of ASU 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 Emerging Task Force meeting, and relates to revenue and expense recognition for freight services in process, accounting for shipping and handling fees and costs, and accounting for consideration given by a vendor to a customer.

 

The FASB continues to issue additional ASU’s clarifying the revenue recognition guidance for certain implementation issues. Under the ASU 2014-09 and related amendments, the guidance is effective for periods beginning January 1, 2018 and must be applied retroactively, whether through a full restatement of prior periods or a cumulative adjustment upon adoption of the ASU. The Company is currently evaluating certain non-interest income financial statement line items that contain revenue streams that are in the scope of this update such as service charges and fees, trust department revenue, bank card revenue, and real-estate sales, and expects to adopt the ASU in the first quarter of 2018. Based on preliminary analysis, the Company does not expect the adoption of this ASU to have a significant impact on the Company’s consolidated financial statements; however, the review is ongoing. The Company will continue to evaluate the impact of this accounting guidance, including any additional guidance issued, during the completion of this internal assessment.

 

Debt Instruments The FASB issued ASU 2016-06, Contingent Put and Call Options in Debt Instruments, in March 2016. The ASU clarifies the requirements for assessing whether contingent call (put) options that can accelerate the payment of principal on debt instruments are clearly and closely related to their debt hosts. Under the new guidance, the embedded options should be assessed solely in accordance with a four-step decision sequence, with no additional assessment of whether the triggering event is indexed to interest rates or credit risk. The amendments are effective January 1, 2017 and are not expected to have a significant effect on the Company's consolidated financial statements.

 

Financial Instruments The FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, in January 2016. The amendments require all equity investments to be measured at fair value with changes in the fair value recognized through net income, other than those accounted for under the equity method of accounting or those that result in the consolidation of the investee. Additionally, these amendments require presentation in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk for those liabilities measured at fair value. The amendments also require use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes. These amendments are effective for interim and annual periods beginning January 1, 2018. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements, including potential changes to the Company's note disclosure of the fair value of its loan portfolio.

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The revised accounting guidance will remove all recognition thresholds and will require a company to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the company expects to collect over the instrument's contractual life. It also amends the credit loss measurement guidance for available-for-sale debt securities and beneficial interests in securitized financial assets. This new accounting guidance will be effective for interim and annual reporting periods beginning after December 15, 2019. While the Company generally expects to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, the Company has not determined the magnitude of any such one-time adjustment or the overall impact of the new guidance on the Company’s consolidated financial statements. The Company is continuing to evaluate the impact of the ASU's adoption on the Company's consolidated financial statements.

 

 52

 

 

Leases In February 2016, the FASB issued ASU 2016-02, Leases, in order to increase transparency and comparability by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The ASU primarily affects lessee accounting, which requires the lessee to recognize a right-of-use asset and a liability to make lease payments for those leases classified as operating leases under previous GAAP. For leases with a term of 12 months or less, an election by class of underlying asset not to recognize lease assets and lease liabilities is permitted. The ASU also provides additional guidance as to the definition of a lease, identification of lease components, and sale and leaseback transactions. The amendments in the ASU are effective for interim and annual periods beginning January 1, 2019. The Company continues to evaluate the provision of the new lease standard, but due to the small number of lease agreements, the impact of the adoption is not expected to have a significant effect on the Company's consolidated financial statements.

 

Liabilities The FASB issued ASU 2016-04, Recognition of Breakage for Certain Prepaid Store-Value Products, in March 2016, in order to address current and potential future diversity in practice related to the derecognition of a prepaid store-value product liability. Such products include prepaid gift cards issued on a specific payment network and redeemable at network-accepting merchant locations, prepaid telecommunication cards, and traveler's checks. The amendments require that the portion of the dollar value of prepaid stored-value products that is ultimately unredeemed (that is, the breakage) be accounted for consistent with the breakage guidance for stored-value product transactions provided in ASC Topic 606 - Revenue from Contracts with Customers. These amendments are effective for interim and annual periods beginning January 1, 2018. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements.

 

Statement of Cash Flows The FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, in August 2016, in order to address concerns regarding diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. In particular, this ASU addresses eight specific cash flow issues in an effort to reduce this diversity in practice: (1) debt prepayment or debt extinguishment costs; (2) settlement of zero-coupon bonds; (3) contingent consideration payments made after a business combination; (4) proceeds from the settlement of insurance claims; (5) proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies; (6) distributions received from equity method investees; (7) beneficial interests in securitization transactions; and (8) separately identifiable cash flows and application of the predominance principle. The amendments are effective for annual periods beginning after December 15, 2017, and for interim periods within those annual periods. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements.

 

The FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, in November 2016. The ASU addresses the current diversity in the classification and presentation of changes in restricted cash on the statement of cash flows. The ASU requires that amounts described as restricted cash and restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning and end of period amounts shown on the statement of cash flows. Disclosures are to be provided on the nature of restrictions on cash and cash equivalents. When presented in more than one line item within the statement of financial position, the entity shall disclose the amounts, disaggregated by line item, of cash, cash equivalents, restricted cash, and restricted cash equivalents reported within the statement of financial position. The amendments are effective January 1, 2018 and are not expected to have a significant effect on the Company's consolidated financial statements.

 

Pension The FASB issued ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost in March 2017. Under the new guidance, employers will present the service cost component of the net periodic benefit cost in the same income statement line item (e.g., Salaries and Benefits) as other employee compensation costs arising from services rendered during the period. In addition, only the service cost component will be eligible for capitalization in assets. Employers will present the other components separately (e.g., Other Noninterest Expense) from the line item that includes the service cost. The ASU is effective for interim and annual reporting periods beginning after December 15, 2017. Early adoption is permitted, however, the Company has decided not to early adopt. Employers will apply the guidance on the presentation of the components of net periodic benefit cost in the income statement retrospectively. The guidance limiting the capitalization of net periodic benefit cost in assets to the service cost component will be applied prospectively. The Company expects to utilize the ASU’s practical expedient allowing entities to estimate amounts for comparative periods using the information previously disclosed in their pension and other postretirement benefit plan footnote. The ASU is not expected to have a significant effect on the Company’s Consolidated Financial Statements.

 

 53

 

 

Callable Debt Securities The FASB issued ASU 2017-08, Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities in March 2017. This ASU shortens the amortization period for the premium on certain purchased callable debt securities to the earliest call date. Today, entities generally amortize the premium over the contractual life of the security. The new guidance does not change the accounting for purchased callable debt securities held at a discount; the discount continues to be amortized to maturity. The ASU is effective for interim and annual reporting periods beginning after December 15, 2018 and early adoption is permitted. The guidance calls for a modified retrospective transition approach under which a cumulative-effect adjustment will be made to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the provisions of ASU 2017-08 to determine the potential impact the new standard will have on the Company’s Consolidated Financial Statements.

 

Stock Compensation The FASB issued ASU 2017-09, Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting in May 2017. Under the new guidance an entity may change the terms or conditions of a share-based payment award for many different reasons, and the nature and effect of the change can vary significantly. Modification is currently defined as "a change in any of the terms or conditions of a share-based payment award." The amendments in this ASU provide guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in accordance with Topic 718. The amendments will be effective for interim and annual reporting periods beginning after December 15, 2017. The ASU is not expected to have a significant effect on the Company’s Consolidated Financial Statements.

 

 54

 

 

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  

 

The following table summarizes the purchases made by or on behalf of the Company or certain affiliated purchasers of shares of the Company's common stock during the three months ended June 30, 2017:

 

Period  (a) Total Number of
Shares (or Units)
Purchased
   (b) Average
Price Paid per
Share (or Unit)
   (c) Total Number of Shares
(or Units) Purchased as
Part of Publicly Announced
Plans or Programs
   (d) Maximum Number (or
Approximate Dollar Value)
of Shares (or Units) that
May Yet Be Purchased
Under the Plans or
Programs *
 
April 1-30, 2017   1,461   $18.13    1,461   $1,292,466 
May 1-31, 2017   -   $-    -   $1,292,466 
June 1-30, 2017   1,854   $20.56    1,854   $1,254,354 
Total   3,315   $18.13    3,315   $1,254,354 

 

* On August 6, 2015, the Company announced that its Board of Directors authorized the purchase, through open market transactions, of up to $2,000,000 market value of the Company's common stock. Management was given discretion to determine the number and pricing of the shares to be purchased, as well as, the timing of any such purchases.

 

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).
https://www.sec.gov/Archives/edgar/data/893847/000129993307004833/exhibit1.htm
     
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).
https://www.sec.gov/Archives/edgar/data/893847/000129993309002491/exhibit1.htm
     
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 current report on Form 8-K/A on June 23, 2017 and incorporated herein by reference).
https://www.sec.gov/Archives/edgar/data/893847/000141588917001027/ex4-06232017_100639.htm

 

 55

 

 

31.1   Certificate of the Chief Executive Officer of our Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
31.2   Certificate of the Chief Financial Officer of our Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
32.1   Certificate of the Chief Executive Officer of our Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
     
32.2   Certificate of the Chief Financial Officer of our Company pursuant to 18 U.S.C. Section 1350, as adopted 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).

 

 56

 

 

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
August 14, 2017 David T. Turner, Chairman of the Board and
  Chief Executive Officer (Principal Executive Officer)
   
  /s/ W. Bruce Phelps
August 14, 2017 W. Bruce Phelps, Chief Financial Officer (Principal Financial
  Officer and Principal Accounting Officer)

 

 57

 

 

HAWTHORN BANCSHARES, INC.

 

INDEX TO EXHIBITS

 

June 30, 2017 Form 10-Q

 

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).  https://www.sec.gov/Archives/edgar/data/893847/000129993307004833/exhibit1.htm
     
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).

https://www.sec.gov/Archives/edgar/data/893847/000129993309002491/exhibit1.htm

     
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 current report on Form 8-K/A on June 23, 2017 and incorporated herein by reference).

https://www.sec.gov/Archives/edgar/data/893847/000141588917001027/ex4-06232017_100639.htm

     
31.1   Certificate of the Chief Executive Officer of our Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
31.2   Certificate of the Chief Financial Officer of our Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
32.1   Certificate of the Chief Executive Officer of our Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *
     
32.2   Certificate of the Chief Financial Officer of our Company pursuant to 18 U.S.C. Section 1350, as adopted 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).

 

 

* 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.

 

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