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Section 1: 10-Q (FORM 10-Q)

 

 

 

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 March 31, 2018

 

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   (I.R.S. Employer Identification No.)
incorporation or organization)    

 

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. (Check one):

 

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨
    (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 May 4, 2018, the registrant had 5,789,341 shares of common stock, par value $1.00 per share, outstanding

 

 

 

 

 

Part I - Financial Information

Item 1. Financial Statements

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets (unaudited)

(In thousands, except per share data)

 

   March 31,   December 31, 
   2018   2017 
ASSETS          
Cash and due from banks  $15,955   $23,325 
Federal funds sold and other interest-bearing deposits   65,449    39,553 
Cash and cash equivalents   81,404    62,878 
Certificates of deposit in other banks   4,812    3,460 
Investment in available-for-sale securities, at fair value   215,720    226,542 
Other investments and securities, at cost   9,725    11,037 
Total investment securities   225,445    237,579 
Loans   1,084,326    1,068,432 
Allowances for loan losses   (10,947)   (10,852)
Net loans   1,073,379    1,057,580 
Premises and equipment - net   34,777    34,811 
Mortgage servicing rights   2,781    2,713 
Other real estate owned and repossessed assets - net   13,239    13,182 
Accrued interest receivable   5,330    5,627 
Cash surrender value - life insurance   2,499    2,484 
Other assets   9,242    8,902 
Total assets  $1,452,908   $1,429,216 
LIABILITIES AND STOCKHOLDERS' EQUITY          
Deposits          
Non-interest bearing demand  $244,834   $245,380 
Savings, interest checking and money market   616,894    584,468 
Time deposits $250,000 and over   84,740    63,176 
Other time deposits   233,912    232,788 
Total deposits   1,180,380    1,125,812 
Federal funds purchased and securities sold          
under agreements to repurchase   34,795    27,560 
Federal Home Loan Bank advances and other borrowings   84,327    121,382 
Subordinated notes   49,486    49,486 
Accrued interest payable   588    554 
Other liabilities   12,061    13,051 
Total liabilities   1,361,637    1,337,845 
Stockholders’ equity:          
Common stock, $1 par value, authorized 15,000,000 shares;          
issued 6,046,907 shares, respectively   6,047    6,047 
Surplus   45,442    45,442 
Retained earnings   52,280    50,595 
Accumulated other comprehensive loss, net of tax   (7,335)   (5,662)
Treasury stock; 254,366 and 248,898 shares, at cost, respectively   (5,163)   (5,051)
Total stockholders’ equity   91,271    91,371 
Total liabilities and stockholders’ equity  $1,452,908   $1,429,216 

 

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

 

 2 

 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income (unaudited)

 

   Three Months Ended 
   March 31, 
(In thousands, except per share amounts)  2018   2017 
INTEREST INCOME          
Interest and fees on loans  $12,223   $11,050 
Interest on investment securities:          
Taxable   947    754 
Nontaxable   158    157 
Federal funds sold, other interest-bearing deposits, and certificates of deposit in other banks   106    48 
Dividends on other securities   110    90 
Total interest income   13,544    12,099 
INTEREST EXPENSE          
Interest on deposits:          
Savings, interest checking and money market   1,084    389 
Time deposits   649    471 
Interest on federal funds purchased and securities sold under agreements to repurchase   171    22 
Interest on Federal Home Loan Bank advances   395    322 
Interest on subordinated notes   491    408 
Total interest expense   2,790    1,612 
Net interest income   10,754    10,487 
Provision for loan losses   300    350 
Net interest income after provision for loan losses   10,454    10,137 
NON-INTEREST INCOME          
Service charges and other fees   876    836 
Bank card income and fees   656    614 
Trust department income   280    274 
Real estate servicing fees, net   221    453 
Gain on sale of mortgage loans, net   146    155 
Other   122    75 
Total non-interest income   2,301    2,407 
NON-INTEREST EXPENSE          
Salaries and employee benefits   6,057    5,438 
Occupancy expense, net   689    619 
Furniture and equipment expense   635    598 
Processing, network, and bank card expense   859    1,045 
Legal, examination, and professional fees   422    280 
FDIC insurance assessment   154    101 
Advertising and promotion   252    239 
Postage, printing, and supplies   268    223 
Other   918    808 
Total non-interest expense   10,254    9,351 
Income before income taxes   2,501    3,193 
Income tax expense   411    1,093 
Net income   2,090    2,100 
Basic earnings per share  $0.36   $0.36 
Diluted earnings per share  $0.36   $0.36 

 

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

 

 3 

 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (unaudited)

 

   Three Months Ended 
   March 31, 
(In thousands)  2018   2017 
Net income  $2,090   $2,100 
Other comprehensive income, net of tax          
Investment securities available-for-sale:          
Unrealized (loss) gain on investment securities available-for-sale, net of tax   (1,715)   306 
Adjustment for gain on sale of investment securities, net of tax   0    0 
Defined benefit pension plans:          
Amortization of prior service cost included in net periodic pension cost, net of tax   42    14 
Total other comprehensive (loss) income   (1,673)   320 
Total comprehensive income  $417   $2,420 

 

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, 2016  $5,822   $41,498   $51,671   $(3,801)  $(4,173)  $91,017 
Net income   0    0    2,100    0    0    2,100 
Other comprehensive income   0    0    0    320    0    320 
Stock based compensation expense   0    1    0    0    0    1 
Purchase of treasury stock   0    0    0    0    (25)   (25)
Cash dividends declared, common stock   0    0    (336)   0    0    (336)
Balance, March 31, 2017  $5,822   $41,499   $53,435   $(3,481)  $(4,198)  $93,077 
                               
Balance, December 31, 2017  $6,047   $45,442   $50,595   $(5,662)  $(5,051)  $91,371 
Net income   0    0    2,090    0    0    2,090 
Other comprehensive loss   0    0    0    (1,673)   0    (1,673)
Purchase of treasury stock   0    0    0    0    (112)   (112)
Cash dividends declared, common stock   0    0    (405)   0    0    (405)
Balance, March 31, 2018  $6,047   $45,442   $52,280   $(7,335)  $(5,163)  $91,271 

 

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

 

 5 

 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)

 

   Three Months Ended March 31, 
(In thousands)  2018   2017 
Cash flows from operating activities:          
Net income  $2,090   $2,100 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for loan losses   300    350 
Depreciation expense   435    473 
Net amortization of investment securities, premiums, and discounts   356    406 
Stock based compensation expense   0    1 
Change in fair value of mortgage servicing rights   (18)   (244)
Gain on sale of investment securities   (98)   0 
(Gain) loss on sales and dispositions of premises and equipment   (13)   1 
Gain on sales and dispositions of other real estate and repossessed assets   (2)   (50)
Provision for other real estate owned   1    32 
Decrease in accrued interest receivable   297    481 
Increase in cash surrender value - life insurance   (15)   (21)
Decrease in other assets   156    58 
Increase (decrease) in accrued interest payable   34    (46)
Decrease in other liabilities   (989)   (742)
Origination of mortgage loans for sale   (7,587)   (7,341)
Proceeds from the sale of mortgage loans   7,587    6,789 
Gain on sale of mortgage loans, net   (146)   (155)
Other, net   (50)   (49)
Net cash provided by operating activities   2,338    2,043 
Cash flows from investing activities:          
Net (increase) decrease in certificates of deposit in other banks   (1,352)   1,000 
Net increase in loans   (16,231)   (35,523)
Purchase of available-for-sale debt securities   (28,134)   (15,346)
Proceeds from maturities of available-for-sale debt securities   9,119    9,750 
Proceeds from calls of available-for-sale debt securities   1,685    4,025 
Proceeds from sales of available-for-sale debt securities   25,723    0 
Purchases of FHLB stock   (1,370)   (263)
Proceeds from sales of FHLB stock   2,682    200 
Purchases of premises and equipment   (401)   (348)
Proceeds from sales of premises and equipment   13    0 
Proceeds from sales of other real estate and foreclosed assets   224    658 
Net cash used in investing activities   (8,042)   (35,847)
Cash flows from financing activities:          
Net (decrease) increase in demand deposits   (546)   3,084 
Net increase in interest-bearing transaction accounts   32,426    50,648 
Net increase (decrease) in time deposits   22,688    (21,394)
Net increase in federal funds purchased and securities sold under agreements to repurchase   7,235    497 
Repayment of FHLB advances and other borrowings   (131,055)   (38,232)
FHLB advances   94,000    36,740 
Purchase of treasury stock   (112)   (25)
Cash dividends paid - common stock   (406)   (336)
Net cash provided by financing activities   24,230    30,982 
Net increase (decrease) in cash and cash equivalents   18,526    (2,822)
Cash and cash equivalents, beginning of period   62,878    25,995 
Cash and cash equivalents, end of period  $81,404   $23,173 

 

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

 

 6 

 

 

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (continued) (unaudited)

 

   Three Months Ended March 31, 
(In thousands)  2018   2017 
Supplemental disclosures of cash flow information:          
Cash paid during the year for:          
Interest  $2,755   $1,658 
Income taxes  $0   $755 
Noncash investing activities:          
Other real estate and repossessed assets acquired in settlement of loans  $278   $103 

 

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 Missouri 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, 2017.

 

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 2018:

 

Revenue from Contracts with Customers On January 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) and all subsequent ASUs that modified Topic 606. The implementation of the new standard did not have a material impact on the measurement or recognition of revenue; as such, a cumulative effect adjustment to opening retained earnings was not deemed necessary. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period amounts were not adjusted and continue to be reported in accordance with historic accounting under Topic 605.

 

Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and securities. In addition, certain noninterest income streams such as fees associated with mortgage servicing rights, financial guarantees, derivatives, and certain credit card fees are also not in scope of the new guidance. Topic 606 is applicable to noninterest revenue streams such as trust department revenue, service charges and fees, debit card income, ATM surcharge income, and other real estate owned sales. However, the recognition of these revenue streams did not change significantly upon adoption of Topic 606. Noninterest revenue streams within the scope of Topic 606 are discussed in Footnote 16.

 

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 adoption of the ASU's 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)

 

The FASB issued ASU 2018-04, Investments - Debt Securities (Topic 320) and Regulated Operations (Topic 980): The amendment in this ASU adds, amends and supersedes various paragraphs that contain SEC guidance in ASC 320, Investments-Debt Securities and ASC 980, Regulated Operations. The amendments in this ASU are effective when a registrant adopts ASU 2016-01, which for the Company was January 1, 2018. This amendment did not 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 adoption of the ASU's did not 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 adoption of the ASU's did not have a significant effect on the Company's consolidated financial statements.

 

(2)Loans and Allowance for Loan Losses

 

Loans

 

A summary of loans, by major class within the Company’s loan portfolio, at March 31, 2018 and December 31, 2017 is as follows:

 

   March 31,   December 31, 
(in thousands)  2018   2017 
Commercial, financial, and agricultural  $190,720   $192,238 
Real estate construction - residential   29,351    26,492 
Real estate construction - commercial   105,345    98,340 
Real estate mortgage - residential   250,131    246,754 
Real estate mortgage - commercial   476,511    472,455 
Installment and other consumer   32,268    32,153 
Total loans  $1,084,326   $1,068,432 

 

The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the Missouri 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 March 31, 2018, loans of $479.4 million were pledged to the Federal Home Loan Bank as collateral for borrowings and letters of credit.

 

Allowance for Loan Losses

 

 9 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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

 

   Three Months Ended March 31, 2018 
   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  $3,325   $170   $807   $1,689   $4,437    345   $79   $10,852 
Additions:                                        
Provision for loan losses   33    106    118    369    (421)   40    55    300 
Deductions:                                        
Loans charged off   110    48    30    20    14    57    0    279 
Less recoveries on loans   (13)   (12)   0    (19)   (6)   (24)   0    (74)
Net loan charge-offs (recoveries)   97    36    30    1    8    33    0    205 
Balance at end of period  $3,261   $240   $895   $2,057   $4,008   $352   $134   $10,947 

 

   Three Months Ended March 31, 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   (384)   (59)   166    (276)   945    72    (114)   350 
Deductions:                                        
Loans charged off   28    0    0    20    14    51    0    113 
Less recoveries on loans   (19)   (50)   0    (36)   (7)   (27)   0    (139)
Net loan charge-offs (recoveries)   9    (50)   0    (16)   7    24    0    (26)
Balance at end of period  $2,360   $99   $579   $2,125   $4,731   $322   $46   $10,262 

 

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. As of December 31, 2017, the Company utilized a five-year look-back period.

 

 10 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The following table provides the balance in the allowance for loan losses at March 31, 2018 and December 31, 2017, and the related loan balance by impairment methodology.

 

   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 
March 31, 2018                                
Allowance for loan losses:                                
Individually evaluated for impairment  $495   $9   $0   $580   $233   $19   $0   $1,336 
Collectively evaluated for impairment   2,766    231    895    1,477    3,775    333    134    9,611 
Total  $3,261   $240   $895   $2,057   $4,008   $352   $134   $10,947 
Loans outstanding:                                        
Individually evaluated for impairment  $2,738   $59   $0   $5,158   $1,978   $160   $0   $10,093 
Collectively evaluated for impairment   187,982    29,292    105,345    244,973    474,533    32,108    0    1,074,233 
Total  $190,720   $29,351   $105,345   $250,131   $476,511   $32,268   $0   $1,084,326 
                                         
December 31, 2017                                        
Allowance for loan losses:                                        
Individually evaluated for impairment  $500   $0   $48   $521   $243   $21   $0   $1,333 
Collectively evaluated for impairment   2,825    170    759    1,168    4,194    324    79    9,519 
Total  $3,325   $170   $807   $1,689   $4,437   $345   $79   $10,852 
Loans outstanding:                                        
Individually evaluated for impairment  $3,007   $0   $97   $5,072   $2,004   $176   $0   $10,356 
Collectively evaluated for impairment   189,231    26,492    98,243    241,682    470,451    31,977    0    1,058,076 
Total  $192,238   $26,492   $98,340   $246,754   $472,455   $32,153   $0   $1,068,432 

 

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 $10.1 million and $10.4 million at March 31, 2018 and December 31, 2017, 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 March 31, 2018 and December 31, 2017, $3.8 million and $4.0 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 March 31, 2018, $1.3 million of the Company’s allowance for loan losses was allocated to impaired loans totaling $10.1 million compared to $1.3 million of the Company's allowance for loan losses allocated to impaired loans totaling approximately $10.4 million at December 31, 2017. Management determined that $2.0 million, or 20%, of total impaired loans required no reserve allocation at March 31, 2018 compared to $2.4 million, or 23%, at December 31, 2017 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

 

The categories of impaired loans at March 31, 2018 and December 31, 2017 are as follows:

 

   March 31,   December 31, 
(in thousands)  2018   2017 
Non-accrual loans  $5,482   $5,672 
Performing TDRs   4,611    4,684 
Total impaired loans  $10,093   $10,356 

 

 11 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The following tables provide additional information about impaired loans at March 31, 2018 and December 31, 2017, 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 
March 31, 2018            
With no related allowance recorded:               
Commercial, financial and agricultural  $1,091   $1,151   $0 
Real estate - residential   908    955    0 
Total  $1,999   $2,106   $0 
With an allowance recorded:               
Commercial, financial and agricultural  $1,647   $1,960   $495 
Real estate - construction residential   59    59    9 
Real estate - residential   4,250    4,344    580 
Real estate - commercial   1,978    2,123    233 
Installment and other consumer   160    179    19 
Total  $8,094   $8,665   $1,336 
Total impaired loans  $10,093   $10,771   $1,336 

 

       Unpaid     
   Recorded   Principal   Specific 
(in thousands)  Investment   Balance   Reserves 
December 31, 2017            
With no related allowance recorded:               
Commercial, financial and agricultural  $1,393   $1,445   $0 
Real estate - residential   674    688    0 
Real estate - commercial   366    395    0 
Total  $2,433   $2,528   $0 
With an allowance recorded:               
Commercial, financial and agricultural  $1,614   $1,834   $500 
Real estate - construction commercial   97    97    48 
Real estate - residential   4,398    4,500    521 
Real estate - commercial   1,638    1,743    243 
Consumer   176    196    21 
Total  $7,923   $8,370   $1,333 
Total impaired loans  $10,356   $10,898   $1,333 

 

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 March 31, 
   2018   2017 
       Interest       Interest 
   Average   Recognized   Average   Recognized 
   Recorded   For the   Recorded   For the 
(in thousands)  Investment   Period Ended   Investment   Period Ended 
With no related allowance recorded:                    
Commercial, financial and agricultural  $906   $0   $555   $1 
Real estate - construction commercial   0    0    0    0 
Real estate - residential   919    3    807    4 
Real estate - commercial   0    0    589    2 
Installment and other consumer   0    0    40    0 
Total  $1,825   $3   $1,991   $7 
With an allowance recorded:                    
Commercial, financial and agricultural  $1,857   $8   $1,192   $11 
Real estate - construction residential   15    0    0    0 
Real estate - construction commercial   0    0    50    0 
Real estate - residential   4,379    32    4,511    43 
Real estate - commercial   2,012    15    1,494    15 
Installment and other consumer   139    0    51    0 
Total  $8,402   $55   $7,298   $69 
Total impaired loans  $10,227   $58   $9,289   $76 

 

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 $58,000 and $76,000, for the three months ended March 31, 2018 and 2017, 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 March 31, 2018 and December 31, 2017.

 

 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 
March 31, 2018                         
Commercial, Financial, and Agricultural  $188,436   $26   $0   $2,258   $190,720 
Real Estate Construction - Residential   29,292    0    0    59    29,351 
Real Estate Construction - Commercial   105,176    169    0    0    105,345 
Real Estate Mortgage - Residential   246,562    1,480    0    2,089    250,131 
Real Estate Mortgage - Commercial   475,349    246    0    916    476,511 
Installment and Other Consumer   31,730    340    38    160    32,268 
Total  $1,076,545   $2,261   $38   $5,482   $1,084,326 
December 31, 2017                         
Commercial, Financial, and Agricultural  $189,537   $192   $2   $2,507   $192,238 
Real Estate Construction - Residential   25,930    287    275    0    26,492 
Real Estate Construction - Commercial   98,243    0    0    97    98,340 
Real Estate Mortgage - Residential   242,597    2,173    28    1,956    246,754 
Real Estate Mortgage - Commercial   471,476    43    0    936    472,455 
Installment and Other Consumer   31,715    239    23    176    32,153 
Total  $1,059,498   $2,934   $328   $5,672   $1,068,432 

 

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 March 31, 2018 and December 31, 2017.

 

(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 March 31, 2018                            
Watch  $9,460   $1,227   $1,291   $8,079   $45,938   $147   $66,142 
Substandard   641    462    0    2,532    725    13    4,373 
Performing TDRs   481    0    0    3,068    1,062    0    4,611 
Non-accrual   2,258    59    0    2,089    916    160    5,482 
Total  $12,840   $1,748   $1,291   $15,768   $48,641   $320   $80,608 
At December 31, 2017                                   
Watch  $9,868   $1,459   $1,284   $9,978   $49,197   $0   $71,786 
Substandard   658    462    0    2,262    723    16    4,121 
Performing TDRs   500    0    0    3,116    1,068    0    4,684 
Non-accrual   2,507    0    97    1,956    936    176    5,672 
Total  $13,533   $1,921   $1,381   $17,312   $51,924   $192   $86,263 

 

Troubled Debt Restructurings

 

At March 31, 2018, loans classified as TDRs totaled $6.3 million, of which $1.7 million were classified as nonperforming TDRs and included in non-accrual loans and $4.6 million were classified as performing TDRs. At December 31, 2017, loans classified as TDRs totaled $6.4 million, of which $1.7 million were classified as nonperforming TDRs and included in non-accrual loans and $4.7 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 $662,000 and $577,000 related to TDRs were allocated to the allowance for loan losses at March 31, 2018 and December 31, 2017, respectively.

 

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

 

   Three Months Ended March 31, 
   2018  2017 
   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   0   $0   $0    1   $131   $131 
Real estate mortgage - commercial   0    0    0    1    56    56 
Total   0   $0   $0    2   $187   $187 

 

(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. During the three months ended March 31, 2018, no loans meeting the TDR criteria was modified compared to two loans during the three months ended March 31, 2017.

 

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 March 31, 2018 and 2017, respectively, and within twelve months of their modification date. During 2018, one real estate mortgage loan went to foreclosure totaling $48,000. 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

 

   March 31,   December 31, 
(in thousands)  2018   2017 
Commercial  $727   $727 
Real estate construction - residential   179    0 
Real estate construction - commercial   12,101    12,380 
Real estate mortgage - residential   348    382 
Real estate mortgage - commercial   2,909    2,909 
Repossessed assets   0    5 
Total  $16,264   $16,403 
Less valuation allowance for other real estate owned   (3,025)   (3,221)
Total other real estate and repossessed assets  $13,239   $13,182 

 

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

 

   Three Months Ended March 31, 
   2018   2017 
Balance at beginning of period  $16,403   $17,291 
Additions   278    103 
Proceeds from sales   (224)   (658)
Charge-offs against the valuation allowance for other real estate owned, net   (195)   (117)
Net gain on sales   2    50 
Total other real estate and repossessed assets  $16,264   $16,669 
Less valuation allowance for other real estate owned   (3,025)   (3,044)
Balance at end of period  $13,239   $13,625 

 

At March 31, 2018, $27,000 of consumer mortgage loans secured by residential real estate properties were in the process of foreclosure compared to no loans at December 31, 2017.

 

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

 

   Three Months Ended March 31, 
(in thousands)  2018   2017 
Balance, beginning of period  $3,221   $3,129 
Provision for other real estate owned   (1)   32 
Charge-offs   (195)   (117)
Balance, end of period  $3,025   $3,044 

 

 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 March 31, 2018 and December 31, 2017 were as follows:

 

   Total             
   Amortized   Gross Unrealized   Fair 
(in thousands)  Cost   Gains   Losses   Value 
March 31, 2018                
U.S. Treasury  $1,981   $0   $(42)  $1,939 
U.S. government and federal agency obligations   11,798         (305)   11,493 
Government sponsored enterprises   38,819    0    (642)   38,177 
Obligations of states and political subdivisions   42,271    42    (709)   41,604 
Mortgage-backed securities:                    
Residential - government agencies   126,186    11    (3,690)   122,507 
Total available-for-sale securities  $221,055   $53   $(5,388)  $215,720 
                     
December 31, 2017                    
U.S. Treasury  $1,980   $0   $(13)  $1,967 
U.S. government and federal agency obligations   12,341         (268)   12,073 
Government sponsored enterprises   37,321    0    (424)   36,897 
Obligations of states and political subdivisions   47,019    114    (477)   46,656 
Mortgage-backed securities:                    
Residential - government agencies   131,045    44    (2,140)   128,949 
Total available-for-sale securities  $229,706   $158   $(3,322)  $226,542 

 

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 the amount of $9.7 million and $11.0 million as of March 31, 2018 and December 31, 2017, respectively.

 

Debt securities with carrying values aggregating approximately $194.3 million and $181.7 million at March 31, 2018 and December 31, 2017, 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 March 31, 2018, 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  $9,928   $9,883 
Due after one year through five years   60,479    59,974 
Due after five years through ten years   21,390    20,344 
Due after ten years   3,072    3,012 
Total   94,869    93,213 
Mortgage-backed securities   126,186    122,507 
Total available-for-sale securities  $221,055   $215,720 

 

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 March 31, 2018 and December 31, 2017 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 March 31, 2018                        
U.S. Treasury  $1,939   $(42)  $0   $0   $1,939   $(42)
U.S. government and federal agency obligations   0    0    11,493    (305)   11,493    (305)
Government sponsored enterprises   14,881    (218)   23,295    (424)   38,176    (642)
Obligations of states and political subdivisions   22,906    (260)   12,379    (449)   35,285    (709)
Mortgage-backed securities:                              
Residential - government agencies   53,183    (1,114)   66,854    (2,576)   120,037    (3,690)
  Total  $92,909   $(1,634)  $114,021   $(3,754)  $206,930   $(5,388)
                               
(in thousands)                              
At December 31, 2017                              
U.S. Treasury  $1,967   $(13)  $0   $0   $1,967   $(13)
U.S. government and federal agency obligations   0    0    12,073    (268)   12,073    (268)
Government sponsored enterprises   16,471    (119)   20,426    (305)   36,897    (424)
Obligations of states and political subdivisions   22,013    (165)   12,570    (312)   34,583    (477)
Mortgage-backed securities:                              
Residential - government agencies   52,829    (488)   69,580    (1,652)   122,409    (2,140)
  Total  $93,280   $(785)  $114,649   $(2,537)  $207,929   $(3,322)

 

The total available for sale portfolio consisted of approximately 341 securities at March 31, 2018. The portfolio included 298 securities having an aggregate fair value of $206.9 million that were in a loss position at March 31, 2018. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $114.0 million at fair value. The $5.4 million aggregate unrealized loss included in accumulated other comprehensive income at March 31, 2018 was caused by interest rate fluctuations.

 

The total available for sale portfolio consisted of approximately 355 securities at December 31, 2017. The portfolio included 280 securities having an aggregate fair value of $207.9 million that were in a loss position at December 31, 2017. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer had a fair value of $114.6 million at December 31, 2017. The $3.3 million aggregate unrealized loss included in accumulated other comprehensive loss at December 31, 2017 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 March 31, 2018 and December 31, 2017, 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 March 31, 
(in thousands)  2018   2017 
Gains realized on sales  $98   $0 
Losses realized on sales   0    0 
Other-than-temporary impairment recognized   0    0 
Investment securities gains  $98   $0 

 

(5)Intangible Assets

 

Mortgage Servicing Rights

 

At March 31, 2018, the Company was servicing approximately $283.1 million of loans sold to the secondary market compared to $285.8 million at December 31, 2017, and $291.0 million at March 31, 2017. Mortgage loan servicing fees, reported as non-interest income, earned on loans sold were $203,000 for the three ended March 31, 2018 compared to $209,000 for the three months ended March 31, 2017, respectively.

 

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

 

   Three Months Ended March 31, 
(in thousands)  2018   2017 
Balance at beginning of period  $2,713   $2,584 
Originated mortgage servicing rights   50    49 
Changes in fair value:          
Due to change in model inputs and assumptions (1)   103    375 
Other changes in fair value (2)   (85)   (131)
Balance at end of period  $2,781   $2,877 

 

(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 three months ended March 31, 2018 and 2017:

 

   Three Months Ended March 31, 
   2018   2017 
Weighted average constant prepayment rate   9.07%   8.29%
Weighted average note rate   3.87%   3.85%
Weighted average discount rate   10.39%   9.72%
Weighted average expected life (in years)   6.20    6.50 

 

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

 

   March 31,   December 31, 
   2018   2017 
Federal funds purchased  $0   $0 
Repurchase agreements   34,795    27,560 
Total  $34,795   $27,560 

 

 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 March 31, 2018                
U.S. Treasury  $1,948   $0   $0   $1,948 
U.S. government and federal agency obligations   2,987    0    0    2,987 
Government sponsored enterprises   9,220    0    0    9,220 
Asset-backed securities   20,640    0    0    20,640 
Total  $34,795   $0   $0   $34,795 
                     
At December 31, 2017                    
U.S. Treasury  $1,964   $0   $0   $1,964 
U.S. government and federal agency obligations   2,977    0    0    2,977 
Government sponsored enterprises   8,382    0    0    8,382 
Asset-backed securities   14,237    0    0    14,237 
Total  $27,560   $0   $0   $27,560 

 

(7)Income Taxes

 

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 16.43% for the three months ended March 31, 2018 compared to 34.2% for the three months ended March 31, 2017. The federal corporate income tax rate declined from 34% to 21% effective January 1, 2018 as a result of the Tax Cuts and Jobs Act. The Company’s tax rate is lower than the federal statutory rate primarily as a result of tax-exempt income. The decrease in tax rate quarter over quarter is primarily due a decrease in the federal corporate tax rate and the Company’s additional tax planning initiatives. The provisional adjustments recorded in the fourth quarter of 2017 related to the enactment of the Tax Cuts and Jobs Act have not been finalized as of March 31, 2018. The Company expects to finalize those adjustments within the one-year measurement period provided under Staff Accounting Bulletin No. 118 in regards to the application of FASB’s ASC Topic 740, Income Taxes. The impact of the Tax Cuts and Jobs Act is expected to require further adjustments in 2018 due to anticipated additional guidance from the U.S. Department of the Treasury, changes in our assumptions, completion of 2017 U.S. tax returns and further information and interpretations that become available.

 

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, and tax planning initiatives 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 March 31, 2018 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 it is more likely than not that the Company will 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 a $46,000 valuation reserve against its capital loss carry forward deferred tax asset.

 

The Company follows ASC Topic 740, Income Taxes, which addresses the accounting for uncertain tax positions. For the three months ended March 31, 2018 and 2017, the Company did not have any uncertain tax provisions.

 

(8)Stockholders’ Equity

 

Accumulated Other Comprehensive Loss

 

 20 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The following details the change in the components of the Company’s accumulated other comprehensive loss for the three months ended March 31, 2018 and 2017:

 

   Three months ended March 31, 2018 
       Unrecognized Net   Accumulated 
   Unrealized   Pension and   Other 
   Gain (Loss)   Postretirement   Comprehensive 
(in thousands)  on Securities (1)   Costs (2)   (Loss) Income 
Balance at beginning of period  $(2,500)  $(3,162)  $(5,662)
Other comprehensive (loss) income, before reclassifications   (2,171)   54    (2,117)
Amounts reclassified from accumulated other comprehensive (loss) income   0    0    0 
Current period other comprehensive (loss) income, before tax   (2,171)   54    (2,117)
Income tax expense (benefit)   456    (12)   444 
Current period other comprehensive (loss) income, net of tax   (1,715)   42    (1,673)
Balance at end of period  $(4,215)  $(3,120)  $(7,335)

 

   Three months ended March 31, 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   493    22    515 
Amounts reclassified from accumulated other comprehensive income (loss)   0    0    0 
Current period other comprehensive income, before tax   493    22    515 
Income tax expense   (187)   (8)   (195)
Current period other comprehensive income, net of tax   306    14    320 
Balance at end of period  $(1,630)  $(1,851)  $(3,481)

 

(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 March 31, 
(in thousands)  2018   2017 
Payroll taxes  $351   $356 
Medical plans   548    426 
401k match and profit sharing   186    250 
Periodic pension cost   405    336 
Other   15    16 
Total employee benefits  $1,505   $1,384 

 

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. Beginning January 1, 2018 and for all retrospective periods presented, the Company adopted the guidance under ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. Under the new guidance only the service cost component of the net periodic benefit cost is reported in the same income statement line item as salaries and benefits, and the remaining components are reported as other non-interest expense. 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 $1.8 million in the second quarter of 2018. The 2018 minimum required contribution is $1.0 million. 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 September 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:

 

   Pension Benefits 
(in thousands)  2018   2017 
Service cost - benefits earned during the year  $1,620   $1,343 
Interest costs on projected benefit obligations (a)   1,033    1,009 
Expected return on plan assets (a)   (1,267)   (1,124)
Expected administrative expenses (a)   93    88 
Amortization of prior service cost (a)   79    79 
Amortization of unrecognized net loss (a)   138    11 
Net periodic pension cost  $1,696   $1,406 
Net periodic pension cost for the three months ended March 31, (actual)  $405   $336 

 

(a) The components of net periodic pension cost other than the service cost component are included in other non-interest expense.

 

(10)Stock Compensation

 

The Company’s has one equity compensation plan for its employees pursuant to which options were granted.

 

 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   20,103   $14.77           
Granted   0    0.00           
Exercised   0    0.00           
Forfeited or expired   0    0.00           
Outstanding, March 31, 2018   20,103   $14.77    0.48   $117,992 
Exercisable, March 31, 2018   20,103   $14.77    0.48   $117,992 

 

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

 

Total stock-based compensation expense was $0 and $1,000 for the three months ended March 31, 2018 and 2017, respectively. As of December 31, 2017, there was no remaining unrecognized compensation expense related to non-vested stock awards. The Plan expired on February 28, 2010, except as to outstanding options under the Plan, and no further options may be granted pursuant to the Plan.

 

(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.

 

Presented below is a summary of the components used to calculate basic and diluted earnings per common share, which have been restated for all stock dividends:

 

   Three Months Ended March 31, 
(dollars in thousands, except per share data)  2018   2017 
Basic earnings per share:        
Net income available to shareholders  $2,090   $2,100 
Basic earnings per share  $0.36   $0.36 
Diluted earnings per share:          
Net income available to shareholders  $2,090   $2,100 
Average shares outstanding   5,797,134    5,839,850 
Effect of dilutive stock options   5,720    4,916 
Average shares outstanding including dilutive stock options   5,802,854    5,844,766 
Diluted earnings per share  $0.36    0.36 

 

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 0 and 21,621 shares during the three months ended March 31, 2018 and 2017, 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.

 

Repurchase Program On August 6, 2015, the Board of Directors authorized a share repurchase plan (the plan) to purchase through open market transactions up to $2.0 million market value of the Company’s common stock. On August 8, 2017, the Board authorized the repurchase of an additional $1.5 million market value of the Company’s common stock. As of March 31, 2018, the Company had repurchased a total of 92,509 shares of common stock pursuant to the plan at an average price of $17.80 per share, including 5,468 shares of common stock repurchased pursuant to the plan during the three months ended March 31, 2018 at an average price of $20.51 per share. At March 31, 2018, approximately $1.8 million remained available for the purchase of shares under the plan. The current plan expires September 8, 2018 unless renewed.

 

(12)Fair Value Measurements

 

Fair value represents the amount expected to be received to sell an asset or paid to transfer a liability in its principal or most advantageous market in an orderly transaction between market participants at the measurement date.

 

Depending on the nature of the asset or liability, the Company uses various valuation methodologies and assumptions to estimate fair value. The measurement of fair value under US GAAP uses a hierarchy intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows. As of March 31, 2018 and December 31, 2017, 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. A quoted price in an active market provides the most reliable evidence of fair value and is used to measure fair value whenever available. A contractually binding sales price also provides reliable evidence of fair value.

 

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.

 

In accordance with fair value accounting guidance, the Company measures, records, and reports various types of assets and liabilities at fair value on either a recurring or non-recurring basis in the Consolidated Financial Statements. Nonfinancial assets measured at fair value on a nonrecurring basis would include foreclosed real estate, long-lived assets, and core deposit intangible assets, which are reviewed when circumstances or other events indicate that impairment may have occurred. 

 

Valuation Methods for Assets and Labilities 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.

 

 24 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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) 
March 31, 2018                    
Assets:                    
U.S. Treasury  $1,939   $1,939    0   $0 
U.S. government and federal agency obligations   11,493    0    11,493    0 
Government sponsored enterprises   38,177    0    38,177    0 
Obligations of states and political subdivisions   41,604    0    41,604    0 
Mortgage-backed securities   122,507    0    122,507    0 
Mortgage servicing rights   2,781    0    0    2,781 
Total  $218,501   $1,939   $213,781   $2,781 
December 31, 2017                    
Assets:                    
U.S. Treasury  $1,967   $1,967    0   $0 
U.S. government and federal agency obligations   12,073    0    12,073    0 
Government sponsored enterprises   36,897    0    36,897    0 
Obligations of states and political subdivisions   46,656    0    46,656    0 
Mortgage-backed securities   128,949    0    128,949    0 
Mortgage servicing rights   2,713    0    0    2,713 
Total  $229,255   $1,967   $224,575   $2,713 

 

 25 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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

 

   Fair Value Measurements Using 
   Significant Unobservable Inputs 
   (Level 3) 
   Mortgage Servicing Rights 
(in thousands)  Three Months Ended March 31, 
   2018   2017 
Balance at beginning of period  $2,713   $2,584 
Total gains or losses (realized/unrealized):          
Included in earnings   18    244 
Included in other comprehensive income   0    0 
Purchases   0    0 
Sales   0    0 
Issues   50    49 
Settlements   0    0 
Balance at end of period  $2,781   $2,877 

 

The change in valuation of mortgage servicing rights arising from inputs and assumptions increased $103,000 and $375,000 for the three months ended March 31, 2018 and 2017, respectively.

 

   Quantitative Information about Level 3 Fair Value Measurements    
   Valuation Technique  Unobservable Inputs  Input Value 
         Three Months Ended March 31, 
         2018   2017 
Mortgage servicing rights   Discounted cash flows  Weighted average constant prepayment rate   9.07%   8.29%
      Weighted average note rate   3.87%   3.85%
      Weighted average discount rate   10.39%   9.72%
      Weighted average expected life (in years)   6.20    6.50 

 

Valuation methods for Assets and Liabilities 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:

 

Collateral dependent impaired loans

 

While the overall loan portfolio is not carried at fair value, the Company periodically records nonrecurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans. Nonrecurring adjustments also include certain impairment amounts for collateral dependent loans when establishing the allowance for loan losses. Such amounts are generally based on the fair value of the underlying collateral supporting the loan. In determining the value of real estate collateral, the Company relies on external and internal appraisals of property values depending on the size and complexity of the real estate collateral. The Company maintains staff that is trained to perform in-house evaluations and also review third party appraisal reports for reasonableness. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgments based on the experience and expertise of internal specialists. Values of all loan collateral are regularly reviewed by senior loan committee. Because many of these inputs are not observable, the measurements are classified as Level 3. As of March 31, 2018, the Company identified $3.8 million in collateral dependent impaired loans that had specific allowances for losses aggregating $952,000. Related to these loans, there was $57,000 in charge-offs recorded during the three months ended March 31, 2018. As of March 31, 2017, the Company identified $2.5 million in collateral dependent impaired loans that had specific allowances for losses aggregating $677,000. Related to these loans, there was $20,000 in charge-offs recorded during the three months ended March 31, 2017.

 

 26 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

Other Real Estate and Foreclosed Assets

 

Other real estate owned (OREO) 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. Subsequent to foreclosure, these assets initially are carried at fair value of the collateral less estimated selling costs. Fair value, when recorded, is generally based upon appraisals by approved, independent state certified appraisers. Like impaired loans, appraisals on OREO may be discounted based on the Company’s historical knowledge, changes in market conditions from the time of appraisal or other information available. During the holding period, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. Because many of these inputs are not observable, the measurements are classified as Level 3.

 

   Fair Value Measurements Using
       Quoted Prices           Three 
       in Active           Months 
       Markets for   Other   Significant   Ended 
       Identical   Observable   Unobservable   March 31, 
   Total   Assets   Inputs   Inputs   Total Gains 
(in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3)   (Losses)* 
March 31, 2018                         
Assets:                         
Collateral dependent impaired loans:                                 
Commercial, financial, & agricultural  $1,369   $0   $0   $1,369   $0 
Real estate construction - commercial   0    0    0    0    (27)
Real estate mortgage - residential   886    0    0    886    0 
Real estate mortgage - commercial   595    0    0    595    (20)
Consumer   0    0    0    0    (10)
Total  $2,850   $0   $0   $2,850   $(57)
Other real estate and foreclosed assets  $13,239   $0   $0   $13,239   $1 
                          
March 31, 2017                         
Assets:                         
Collateral dependent impaired loans:                         
Commercial, financial, & agricultural  $339   $0   $0   $339   $(1)
Real estate mortgage - residential   1,261    0    0    1,261    (3)
Real estate mortgage - commercial   220    0    0    220    (4)
Consumer   0    0    0    0    (12)
Total  $1,820   $0   $0   $1,820   $(20)
Other real estate and foreclosed assets  $13,625   $0   $0   $13,625   $15 

 

* 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:

 

 27 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

Loans

 

Fair values are estimated for portfolios with similar financial characteristics. Loans are segregated by type, such as commercial, real estate, and consumer. Each loan category is further segmented into fixed and variable interest rate categories. The fair value of loans is estimated by using the future value of discounted cash flows using comparable market rates for similar types of loan products and adjusted for market factors. The discount rates used are estimated using comparable market rates for similar types of loan products adjusted to be commensurate with the credit risk, overhead costs, and optionality of such instruments.

 

Investment Securities

 

A detailed description of the fair value measurement of the debt instruments in the available-for-sale sections of the investment security portfolio is provided in the Fair Value Measurement section above. A schedule of investment securities by category and maturity is provided in the notes on Investment Securities.

 

Federal Home Loan Bank (FHLB) Stock

 

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

 

Federal Funds Sold, Cash, and Due from Banks

 

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

 

Certificates of Deposit in other banks

 

Certificates of deposit are other investments made by the Company with other financial institutions that are carried at cost

 

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.

 

 28 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

Securities Sold under Agreements to Repurchase

 

For securities sold under agreements to repurchase, 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 cash-flows. The discount rate is estimated using the rates currently offered for other borrowed money of similar remaining maturities.

 

 29 

 

 

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 March 31, 2018 and December 31, 2017 is as follows:

 

           March 31, 2018 
           Fair Value Measurements 
           Quoted Prices         
           in Active       Net 
           Markets for   Other   Significant 
   March 31, 2018   Identical   Observable   Unobservable 
   Carrying   Fair   Assets   Inputs   Inputs 
(in thousands)  amount   value   (Level 1)   (Level 2)   (Level 3) 
Assets:                         
Cash and due from banks  $15,955   $15,955   $15,955   $0   $0 
Federal funds sold and overnight interest-bearing deposits   65,449    65,449    65,449    0    0 
Certificates of deposit in other banks   4,812    4,812    4,812    0    0 
Investment in available-for-sale securities   215,720    215,720    1,939    213,781    0 
Loans, net   1,073,379    1,055,059    0    0    1,055,059 
Investment in FHLB stock   5,078    5,078    0    5,078    0 
Mortgage servicing rights   2,781    2,781    0    0    2,781 
Cash surrender value - life insurance   2,499    2,499    0    2,499    0 
Accrued interest receivable   5,330    5,330    5,330    0    0 
   $1,391,003   $1,372,683   $93,485   $221,358   $1,057,840 
Liabilities:                         
Deposits:                         
Non-interest bearing demand  $244,834   $244,834   $244,834   $0   $0 
Savings, interest checking and money market   616,894    616,894    616,894    0    0 
Time deposits   318,652    315,994    0    0    315,994 
Federal funds purchased and securities sold under agreements to repurchase   34,795    34,795    34,795    0    0 
Federal Home Loan Bank advances and other borrowings   84,327    83,944    0    83,944    0 
Subordinated notes   49,486    42,166    0    42,166    0 
Accrued interest payable   588    588    588    0    0 
   $1,349,576   $1,339,215   $897,111   $126,110   $315,994 

 

 30 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

           December 31, 2017 
           Fair Value Measurements 
           Quoted Prices         
           in Active       Net 
           Markets for   Other   Significant 
   December 31, 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  $23,325   $23,325   $23,325   $0   $0 
Federal funds sold and overnight interest-bearing deposits   39,553    39,553    39,553    0    0 
Certificates of deposit in other banks   3,460    3,460    3,460    0    0 
Investment in available-for-sale securities   226,542    226,542    1,967    224,575    0 
Loans, net   1,057,580    1,058,153    0    0    1,058,153 
Investment in FHLB stock   6,390    6,390    0    6,390    0 
Mortgage servicing rights   2,713    2,713    0    0    2,713 
Cash surrender value - life insurance   2,484    2,484    0    2,484    0 
Accrued interest receivable   5,627    5,627    5,627    0    0 
   $1,367,674   $1,368,247   $73,932   $233,449   $1,060,866 
Liabilities:                         
Deposits:                         
Non-interest bearing demand  $245,380   $245,380   $245,380   $0   $0 
Savings, interest checking and money market   584,468    584,468    584,468    0    0 
Time deposits   295,964    294,778    0    0    294,778 
Federal funds purchased and securities sold under agreements to repurchase   27,560    27,560    27,560    0    0 
Federal Home Loan Bank advances and other borrowings   121,382    121,291    0    121,291    0 
Subordinated notes   49,486    39,692    0    39,692    0 
Accrued interest payable   554    554    554    0    0 
   $1,324,794   $1,313,723   $857,962   $160,983   $294,778 

 

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 March 31, 2018 and December 31, 2017. 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 March 31, 2018, the Company was servicing 2,743 loans sold to the secondary market with a balance of approximately $283.1 million compared to 2,773 loans sold with a balance of approximately $285.8 million at December 31, 2017.

 31 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   Three Months Ended March 31, 
(in thousands)  2018   2017 
Balance at beginning of year  $160   $160 
Provision for repurchase liability   0    0 
Reimbursement of expenses   0    0 
Balance at end of year  $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 March 31, 2018, 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:

 

   March 31,   December 31, 
(in thousands)  2018   2017 
Commitments to extend credit  $228,595   $238,527 
Commitments to originate residential first and second mortgage loans   3,490    1,471 
Standby letters of credit   76,479    74,004 
Total   308,564    314,002 

 

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 March 31, 2018.

 

Pending Litigation

 

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

 

 32 

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(16)Revenue Recognition

 

On January 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) and all subsequent ASUs that modified Topic 606. As stated in Note 1 Summary of Significant Accounting Policies, the implementation of the new standard did not have a material impact on the measurement or recognition of revenue; as such, a cumulative effect adjustment to opening retained earnings was not deemed necessary. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period amounts were not adjusted and continue to be reported in accordance with our historic accounting under Topic 605.

 

Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and securities. In addition, certain noninterest income streams such as fees associated with mortgage servicing rights, financial guarantees, derivatives, and certain credit card fees are also not in the scope of the new guidance. Topic 606 is applicable to noninterest revenue streams such as trust department revenue, service charges and fees, debit card income, ATM surcharge income, and sales of other real estate owned. However, the recognition of these revenue streams did not change significantly upon adoption of Topic 606. Noninterest revenue streams within the scope of Topic 606 are discussed below.

 

Trust Department Revenue

 

Trust and asset management income is primarily comprised of fees earned from the management and administration of trusts and other customer assets. The Company’s performance obligation is generally satisfied over time and the resulting fees are recognized monthly, based upon the month-end market value of the assets under management and the applicable fee rate. Payment is generally received a few days after month end through a direct charge to customers’ accounts. The Company does not earn performance-based incentives. Optional services such as real estate sales and tax return preparation services are also available to existing trust and asset management customers. The Company’s performance obligation for these transactional-based services is generally satisfied, and related revenue recognized, at a point in time (i.e., as incurred). Payment is received shortly after services are rendered.

 

Service Charges on Deposit Accounts

 

Service charges on deposit accounts consist of account analysis fees (i.e., net fees earned on analyzed business and public checking accounts), monthly service fees, check orders, and other deposit account related fees. The Company’s performance obligation for account analysis fees and monthly service fees is generally satisfied, and the related revenue recognized, over the period in which the service is provided. Check orders and other deposit account related fees are largely transactional based, and therefore, the Company’s performance obligation is satisfied, and related revenue recognized, at a point in time. Payment for service charges on deposit accounts is primarily received immediately or in the following month through a direct charge to customers’ accounts.

 

Fees, Exchange, and Other Service Charges

 

Fees, exchange, and other service charges are primarily comprised of debit and credit card income, ATM fees, merchant services income, and other service charges. Debit and credit card income is primarily comprised of interchange fees earned whenever the Company’s debit and credit cards are processed through card payment networks such as Visa. ATM fees are primarily generated when a Company cardholder uses a non-Company ATM or a non-Company cardholder uses a Company ATM. Merchant services income mainly represents fees charged to merchants to process their debit and credit card transactions, in addition to account management fees. Other service charges include revenue from processing wire transfers, bill pay service, cashier’s checks, and other services. The Company’s performance obligation for fees, exchange, and other service charges are largely satisfied, and related revenue recognized, when the services are rendered or upon completion. Payment is typically received immediately or in the following month.

 

Gains/Losses on Sales of Other Real Estate Owned (OREO)

 

The Company records a gain or loss from the sale of OREO when control of the property transfers to the buyer, which generally occurs at the time of an executed deed. When the Company finances the sale of OREO to the buyer, the Company assesses whether the buyer is committed to perform their obligations under the contract and whether collectability of the transaction price is probable. Once these criteria are met, the OREO asset is derecognized and the gain or loss on sale is recorded upon the transfer of control of the property to the buyer. In determining the gain or loss on the sale, the Company adjusts the transaction price and related gain (loss) on sale if a significant financing component is present. No OREO sales for the three months ended March 31, 2018 and two sales for the three months ended March 31, 2017 were financed by the Bank, which financings were consistent with market terms.

 

 33 

 

 

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, regulatory, or tax law 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, 2017, 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 $1.5 billion in assets at March 31, 2018, 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.

 

 34 

 

 

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.

 

 35 

 

 

SELECTED CONSOLIDATED FINANCIAL DATA

 

The following table presents selected consolidated financial information for the Company as of and for each of the three months ended March 31, 2018 and 2017, 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 
   March 31, 
(In thousands, except per share data)  2018   2017 
Per Share Data          
Basic earnings per share  $0.36   $0.36 
Diluted earnings per share   0.36    0.36 
Dividends paid on common stock   406    336 
Book value per share   15.74    15.94 
Market price per share   20.64    20.29 
Selected Ratios          
(Based on average balance sheets)          
Return on total assets   0.60%   0.65%
Return on stockholders' equity   9.32%   9.23%
Stockholders' equity to total assets   6.41%   7.01%
Efficiency ratio (1)   78.54%   72.52%
           
(Based on end-of-period data)          
Stockholders' equity to assets   6.28%   7.05%
Total risk-based capital ratio   12.87%   13.60%
Tier 1 risk-based capital ratio   10.61%   11.25%
Common equity Tier 1 capital   8.04%   8.47%
Tier 1 leverage ratio (2)   9.17%   9.74%

 

(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.

 

 36 

 

  

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 March 31, 
(In thousands)  2018   2017   $ Change   % Change 
                 
Net interest income  $10,754   $10,487   $267    2.5%
Provision for loan losses   300    350    (50)   (14.3)
Noninterest income   2,301    2,407    (106)   (4.4)
Noninterest expense   10,254    9,351    903    9.7 
Income before                    
income taxes   2,501    3,193    (692)   (21.7)
Income tax expense   411    1,093    (682)   (62.4)
Net income  $2,090   $2,100   $(10)   (0.5)%

 

Consolidated net income of $2.1 million, or $0.36 per diluted share, was consistent for both the three months ended March 31, 2018 and 2017. For the three months ended March 31, 2018, the return on average assets was 0.60%, the return on average stockholders’ equity was 9.32%, and the efficiency ratio was 78.54%.

 

Net interest income was $10.8 million for the three months ended March 31, 2018 compared to $10.5 million for the three months ended March 31, 2017. The net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.29% for the three months ended March 31, 2018, compared to 3.48% for the three months ended March 31, 2017. These changes are discussed in greater detail under the Average Balance Sheets and Rate and Volume Analysis section below.

 

A $300,000 provision for loan losses was recorded for the three months ended March 31, 2018 compared to a $350,000 provision for the three months ended March 31, 2017.

 

The Company’s net charge-offs were $205,000, or 0.02% of average loans, for the three months ended March 31, 2018 compared to net recoveries of $26,000, or 0.00% of average loans, for the three months ended March 31, 2017. Non-performing loans totaled $10.1 million, or 0.93% of total loans, at March 31, 2018 compared to $10.7 million, or 1.00% of total loans, at December 31, 2017, and $9.4 million, or 0.93% of total loans, at March 31, 2017. These changes are discussed in greater detail under the Lending and Credit Management section below.

 

Non-interest income decreased $106,000, or 4.4%, for the three months ended March 31, 2018 compared to the three months ended March 31, 2017. These changes are discussed in greater detail below under Non-interest Income.

 

Non-interest expense increased $903,000, or 9.7%, for the three months ended March 31, 2018 compared to the three months ended March 31, 2017. These changes are discussed in greater detail below under Non-interest Expense.

 

Average Balance Sheets

 

Net interest income is the largest source of revenue resulting from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the periods ended March 31, 2018 and 2017, respectively.

 

 37 

 

 

   Three Months Ended March 31, 
(In thousands)  2018   2017 
       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  $190,698   $2,257    4.80%  $182,548   $2,062    4.58%
Real estate construction - residential   28,470    342    4.87    19,307    215    4.52 
Real estate construction - commercial   101,856    1,172    4.67    66,214    720    4.41 
Real estate mortgage - residential   247,579    2,859    4.68    260,551    2,922    4.55 
Real estate mortgage - commercial   471,927    5,360    4.61    433,152    4,894    4.58 
Consumer   32,342    293    3.67    30,234    300    4.02 
Total loans  $1,072,872   $12,283    4.64%  $992,006   $11,113    4.54%
Investment securities: (3)                              
                               
U.S. Treasury  $17,502   $60    1.39%  $0   $0    0.00%
U.S. government and federal agency obligations   49,399    190    1.56    45,410    156    1.39 
Obligations of states and political subdivisions   44,807    270    2.44    43,733    249    2.31 
Mortgage-backed securities   125,453    680    2.20    124,321    582    1.90 
Total investment securities  $237,161   $1,200    2.05%  $213,464   $987    1.88%
Other investments and securities, at cost   9,910    110    4.50    9,785    90    3.73 
Federal funds sold and interest bearing deposits in other financial institutions   24,573    106    1.75    21,657    48    0.90 
Total interest earning assets  $1,344,516   $13,699    4.13%  $1,236,912   $12,238    4.01%
All other assets   85,116              90,264           
Allowance for loan losses   (10,916)             (10,003)          
Total assets  $1,418,716             $1,317,173           
LIABILITIES AND                              
STOCKHOLDERS' EQUITY                              
NOW accounts  $243,245   $533    0.89%  $216,075   $232    0.44%
Savings   94,356    12    0.05    99,828    12    0.05 
Commercial   1,604    4    1.01    1,655    2    0.49 
Money market   265,994    535    0.82    199,698    143    0.29 
Time deposits   289,970    649    0.91    296,357    471    0.64 
Total interest bearing deposits  $895,169   $1,733    0.79%  $813,613   $860    0.43%
Federal funds purchased and securities sold under agreements to repurchase   43,060    171    1.61    29,078    22    0.31 
Federal Home Loan advances and other   93,041    395    1.72    92,578    322    1.41 
Subordinated notes   49,486    491    4.02    49,486    408    3.34 
Total borrowings  $185,587   $1,057    2.31%  $171,142   $752    1.78%
Total interest bearing liabilities  $1,080,756   $2,790    1.05%  $984,755   $1,612    0.66%
Demand deposits   234,129              228,765           
Other liabilities   12,892              11,322           
Total liabilities   1,327,777              1,224,842           
Stockholders' equity   90,939              92,331           
Total liabilities and stockholders' equity  $1,418,716             $1,317,173           
Net interest income (FTE)        10,909              10,626      
Net interest spread             3.08%             3.35%
Net interest margin             3.29%             3.48%

 

(1)Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21% and 34%, net of nondeductible interest expense for the three months ended March 31, 2018 and 2017 respectively. Such adjustments totaled $155,000 and $139,000 for the three months ended March 31, 2018 and 2017, 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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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 months ended March 31, 2018 compared to the three months ended March 31, 2017. 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  March 31, 
   2018 vs. 2017 
       Change due to 
   Total   Average   Average 
(In thousands)  Change   Volume   Rate 
Interest income on a fully taxable equivalent basis: (1)               
Loans: (2) (4)               
Commercial  $195   $94   $101 
Real estate construction - residential   127    109    18 
Real estate construction - commercial   452    408    44 
Real estate mortgage - residential   (63)   (148)   85 
Real estate mortgage - commercial   466    440    26 
Consumer   (7)   20    (27)
Investment securities: (3)               
U.S. Treasury   60    55    5 
U.S. government and federal agency obligations   34    15    19 
Obligations of states and political subdivisions   21    6    15 
Mortgage-backed securities   98    5    93 
Other investments and securities, at cost   20    1    19 
Federal funds sold and interest bearing deposits in other financial institutions   58    7    51 
Total interest income   1,461    1,012    449 
Interest expense:               
NOW accounts   301    32    269 
Savings   0    (1)   1 
Commercial   2    0    2 
Money market   392    60    332 
Time deposits   178    (10)   188 
Federal funds purchased and securities sold under agreements to repurchase   149    16    133 
Federal Home Loan Bank advances and other   73    2    71 
Subordinated notes   83    0    83 
Total interest expense   1,178    99    1,079 
Net interest income on a fully taxable equivalent basis  $283   $913   $(630)

 

(1)Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 21% and 34%, net of nondeductible interest expense for the three month ended March 31, 2018 and 2017, respectively. Such adjustments totaled $155,000 and $139,000 for the three months ended March 31, 2018 and 2017, 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 March 31, 2018 compared to the three months ended March 31, 2017, reflected an increase in net interest income, on a tax equivalent basis, of $283,000, or 2.66%. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.29% for the three months ended March 31, 2018 compared to 3.48% for the three months ended March 31, 2017. Although net interest income increased primarily due to an increase in average earning assets, net interest margin decreased due to the cost of interest bearing liabilities repriced faster than the rate earned on interest bearing assets.

 

Average interest-earning assets increased $107.6 million, or 8.70%, to $1.34 billion for the three months ended March 31, 2018 compared to $1.24 billion for the three months ended March 31, 2017, and average interest bearing liabilities increased $96.0 million, or 9.75%, to $1.1 million for the three months ended March 31, 2018 compared to $984.8 million for the three months ended March 31, 2017.

 

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Total interest income (expressed on a fully taxable equivalent basis) was $13.7 million for the three months ended March 31, 2018 compared to $12.2 million for the three months ended March 31, 2017. The Company’s rates earned on interest earning assets were 4.13% for the three months ended March 31, 2018 compared to 4.01% for the three months ended March 31, 2017.

 

Interest income on loans increased to $12.3 million for the three months ended March 31, 2018 compared to $11.1 million for the three months ended March 31, 2017.

 

Average loans outstanding increased $80.9 million, or 8.15%, to $1.1 billion for the three months ended March 31, 2018 compared to $992.0 million for the three months ended March 31, 2017. The average yield on loans receivable increased to 4.64% for the three months ended March 31, 2018 compared to 4.54% for the three months ended March 31, 2017. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

 

Total interest expense increased to $2.8 million for the three months ended March 31, 2018 compared to $1.6 million for the three months ended March 31, 2017. The Company’s rates paid on interest bearing liabilities was 1.05% for the three months ended March 31, 2018 compared to 0.66% for the three months ended March 31, 2017. See the Liquidity Management section for further discussion.

 

Interest expense on deposits increased to $1.7 million for the three months ended March 31, 2018 compared to $860,000 for the three months ended March 31, 2017.

 

Average interest bearing deposits increased $81.6 million, or 10.02%, to $895.2 million for the three months ended March 31, 2018 compared to $813.6 million for the three months ended March 31, 2017. The increase was primarily due to a new money market product that brought in new deposits in addition to new public funds. The average cost of deposits increased to 0.79% for the three months ended March 31, 2018 compared to 0.43% for the three months ended March 31, 2017. The increase was primarily due to the rate paid on the new money market product and generally higher market interest rates during the current quarter versus the prior year quarter ended March 31, 2017.

 

Interest expense on borrowings increased to $1.1 million for the three months ended March 31, 2018 compared to $752,000 for the three months ended March 31, 2017. Average borrowings increased to $185.6 million for the three months ended March 31, 2018 compared to $171.1 million for the three months ended March 31, 2017. The primary increase in average borrowings resulted from FHLB advances to fund loan growth and a tax initiative involving a short sale of a U.S. Treasury security funded by a repurchase agreement. The average cost of borrowings increased to 2.31% for the three months ended March 31, 2018 compared to 1.78% for the three months ended March 31, 2017. The increase in cost of funds, primarily resulted from higher interest rates and the additional interest cost of the repurchase agreement related to the short sale. See the Liquidity Management section for further discussion.

 

Non-interest Income and Expense

 

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

 

   Three Months Ended March 31, 
(In thousands)  2018   2017   $ Change   % Change 
Non-interest Income                    
Service charges and other fees  $876   $836   $40    4.8%
Bank card income and fees   656    614    42    6.8 
Trust department income   280    274    6    2.2 
Real estate servicing fees, net   221    453    (232)   (51.2)
Gain on sales of mortgage loans, net   146    155    (9)   (5.8)
Other   122    75    47    62.7 
Total non-interest income  $2,301   $2,407   $(106)   (4.4)%
                     
Non-interest income as a % of total revenue *   17.6%   18.7%          

 

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

 

Total non-interest income decreased $106,000, or 4.4%, to $2.3 million for the three months ended March 31, 2018 compared to $2.4 million for the three months ended March 31, 2017.

 

Real estate servicing fees, net of the change in valuation of mortgage serving rights decreased $232,000 to $221,000 for the three months ended March 31, 2018 compared to $453,000 for the three months ended March 31, 2017 primarily due to a $226,000 decrease in the change in fair value quarter over quarter. This change in value is primarily the result of market-driven changes in interest rates and prepayment speeds.

 

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Mortgage loan servicing fees earned on loans sold were $203,000 for the three months ended March 31, 2018 compared to $209,000 for the three months ended March 31, 2017. The Company was servicing $283.1 million of mortgage loans at March 31, 2018 compared to $285.8 million and $291.0 million at December 31, 2017 and March 31, 2017, respectively.

 

Gain on sales of mortgage loans decreased $9,000, or 5.8%, to $146,000 for the three months ended March 31, 2018 compared to $155,000 for the three months ended March 31, 2017. The decrease quarter over quarter was primarily due to an increase in loan origination costs. The Company sold loans of $7.6 million for the three months ended March 31, 2018 compared to $6.8 million for the three months ended March 31, 2017.

 

Other Income increased $47,000, or 62.7%, to $122,000 for the three months ended March 31, 2018 compared to $75,000 for the three months ended March 31, 2017 primarily due to a gain on the sale of investment securities partially offset by a decrease in brokerage income.

 

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

 

   Three Months Ended March 31, 
(In thousands)  2018   2017   $ Change   % Change 
Non-interest Expense                    
Salaries  $4,552   $4,054   $498    12.3%
Employee benefits   1,505    1,384    121    8.7 
Occupancy expense, net   689    619    70    11.3 
Furniture and equipment expense   635    598    37    6.2 
Processing expense, network and bank card expense   859    1,045    (186)   (17.8)
Legal, examination, and professional fees   422    280    142    50.7 
FDIC insurance assessment   154    101    53    52.5 
Advertising and promotion   252    239    13    5.4 
Postage, printing, and supplies   268    223    45    20.2 
Other   918    808    110    13.6 
Total non-interest expense  $10,254   $9,351   $903    9.7%
Efficiency ratio *   78.5%   72.5%          
Number of full-time equivalent employees   339    333           

 

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

Total revenue includes net interest income and non-interest income.

 

Total non-interest expense increased $903,000, or 9.7%, to $10.3 million for the three months ended March 31, 2018 compared to $9.4 million for the three months ended March 31, 2017.

 

Salaries increased $498,000, or 12.3%, to $4.6 million for the three months ended March 31, 2018 compared to $4.1 million for the three months ended March 31, 2017. The increase was primarily due to a bonus that was paid in February 2018 to all eligible full-time and part-time employees as a result of the expected tax savings from the new tax reform.

 

Employee benefits increased $121,000, or 8.7%, to $1.5 million for the three months ended March 31, 2018 compared to $1.4 million for the three months ended March 31, 2017. The increase was primarily due to an increase in medical plan premiums effective July 1, 2017.

 

Occupancy expense increased $70,000, or 11.3%, to $689,000 for the three months ended March 31, 2018 compared to $619,000 for the three months ended March 31, 2017. The increase was primarily due to increased building repairs and maintenance, utilities, and real estate tax accruals.

 

Processing, network, and bank card expense decreased $186,000, or 17.8%, to $859,000 for the three months ended March 31, 2018 compared to $1.0 million for the three months ended March 31, 2017. The decrease was primarily due to additional one-time costs associated with a corporate wide network upgrade and changes in processing service providers during 2017.

 

Legal, examination, and professional fees increased $142,000, or 50.7%, to $422,000 for the three months ended March 31, 2018 compared to $280,000 for the three months ended March 31, 2017. The increase was primarily related to an increase in consulting fees related to tax planning initiatives and audit fees partially offset by a decrease in legal fees.

 

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FDIC insurance assessment increased $53,000, or 52.5%, to $154,000 for the three months ended March 31, 2018 compared to $101,000 for the three months ended March 31, 2017. The increase is primarily due to an increase in the Company’s total assessment base quarter over quarter.

 

Postage, printing, and supplies increased $45,000, or 20.2%, to $268,000 for the three months ended March 31, 2018 compared to $223,000 for the three months ended March 31, 2017. The increase was primarily due to an increase in stationary and supplies.

 

Other expense increased $110,000, or 13.6%, to $918,000 for the three months ended March 31, 2018 compared to $808,000 for the three months ended March 31, 2017. The increase was primarily due to an increase in loan expense, correspondent bank and deposit fees, and miscellaneous charged off items.

 

Income taxes

 

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 16.4% for the quarter ended March 31, 2018 compared to 34.2% for the quarter ended March 31, 2017. The federal corporate income tax rate declined from 34% to 21% effective January 1, 2018 as a result of the Tax Cuts and Jobs Act. The Company’s tax rate is lower than the federal statutory rate primarily as a result of tax-exempt income. The decrease in tax rate quarter over quarter is primarily due a decrease in the federal corporate tax rate and the Company’s additional tax planning initiatives. The provisional adjustments recorded in the fourth quarter of 2017 related to the enactment of the Tax Cuts and Jobs Act have not been finalized as of March 31, 2018. The Company expects to finalize those adjustments within the one-year measurement period provided under Staff Accounting Bulletin No. 118 in regards to the application of FASB’s ASC Topic 740, Income Taxes. The impact of the Tax Cuts and Jobs Act is expected to require further adjustments in 2018 due to anticipated additional guidance from the U.S. Department of the Treasury, changes in our assumptions, completion of 2017 U.S. tax returns and further information and interpretations that become available.

 

Lending and Credit Management

 

Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 73.9% of total assets as of March 31, 2018 compared to 74.0% as of December 31, 2017.

 

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:

 

   March 31,   December 31, 
(In thousands)  2018   2017 
Commercial, financial, and agricultural  $190,720   $192,238 
Real estate construction - residential   29,351    26,492 
Real estate construction - commercial   105,345    98,340 
Real estate mortgage - residential   250,131    246,754 
Real estate mortgage - commercial   476,511    472,455 
Installment loans to individuals   32,268    32,153 
Total loans  $1,084,326   $1,068,432 
Percent of categories to total loans:          
Commercial, financial, and agricultural   18.1%   18.0%
Real estate construction - residential   2.0    2.5 
Real estate construction - commercial   6.9    9.2 
Real estate mortgage - residential   26.1    23.1 
Real estate mortgage - commercial   43.8    44.2 
Installment loans to individuals   3.1    3.0 
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 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 months ended March 31, 2018, the Company sold approximately $7.6 million of loans to investors compared to $6.8 million for the three months ended March 31, 2017. At March 31, 2018, the Company was servicing approximately $283.1 million of loans sold to the secondary market compared to $285.8 million at December 31, 2017, and $291.0 million at March 31, 2017.

 

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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 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:

 

   March 31,   December 31, 
(In thousands)  2018   2017 
Nonaccrual loans:          
Commercial, financial, and agricultural  $2,258   $2,507 
Real estate construction - residential   59    0 
Real estate construction - commercial   0    97 
Real estate mortgage - residential   2,089    1,956 
Real estate mortgage - commercial   916    936 
Installment and other consumer   160    176 
Total  $5,482   $5,672 
Loans contractually past - due 90 days or more and still accruing:          
Commercial, financial, and agricultural  $0   $2 
Real estate construction - residential   0    275 
Real estate mortgage - residential   0    28 
Installment and other consumer   38    23 
Total  $38   $328 
Performing troubled debt restructurings   4,611    4,684 
Total nonperforming loans   10,131    10,684 
Other real estate owned and repossessed assets   13,239    13,182 
Total nonperforming assets  $23,370   $23,866 
           
Loans  $1,084,326   $1,068,432 
Allowance for loan losses to loans   1.01%   1.02%
Nonperforming loans to loans   0.93%   1.00%
Allowance for loan losses to          
nonperforming loans   108.05%   101.57%
Allowance for loan losses to nonperforming loans, excluding performing TDR's   198.32%   180.87%
Nonperforming assets to loans, other real estate owned and repossessed assets   2.13%   2.21%

 

Total nonperforming assets totaled $23.4 million at March 31, 2018 compared to $23.9 million at December 31, 2017. Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing, and TDRs totaled $10.1 million, or 0.93%, of total loans at March 31, 2018 compared to $10.7 million, or 1.00%, of total loans at December 31, 2017. Non-accrual loans included $1.7 million of loans classified as TDRs at both March 31, 2018 and December 31, 2017, respectively.

 

As of March 31, 2018 and December 31, 2017, approximately $4.4 million and $4.1 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 March 31, 2018 and December 31, 2017, respectively.

 

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Total non-accrual loans at March 31, 2018 decreased $190,000, or 3.3%, to $5.5 million compared to $5.7 million at December 31, 2017. This decrease primarily consisted of a decrease in commercial, financial, and agricultural loans and a decrease in real estate construction – commercial loans, partially offset by an increase in real estate mortgage - residential loans, and real estate construction – residential loans.

 

Loans past due 90 days and still accruing interest at March 31, 2018, were $38,000 compared to $328,000 at December 31, 2017. Other real estate and repossessed assets were $13.2 million at both March 31, 2018 and December 31, 2017. During the three months ended March 31, 2018, $278,000 of nonaccrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to $103,000 during the three months ended March 31, 2017.

 

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

 

   March 31, 2018   December 31, 2017 
(In thousands) 

Number of

Contracts

  

Recorded

Investment

   Specific
Reserves
  

Number of

Contracts

   Recorded
Investment
   Specific
Reserves
 
Performing TDRs                              
Commercial, financial and agricultural   6   $481   $19    6   $500   $20 
Real estate mortgage - residential   11    3,068    269    11    3,116    236 
Real estate mortgage - commercial   2    1,062    72    2    1,068    109 
Total performing TDRs   19   $4,611   $360    19   $4,684   $365 
Nonperforming TDRs                              
Commercial, financial and agricultural   4   $827   $103    4   $838   $41 
Real estate mortgage - residential   3    242    60    4    290    61 
Real estate mortgage - commercial   4    581    139    4    589    110 
Total nonperforming TDRs   11   $1,650   $302    12   $1,717   $212 
Total TDRs   30   $6,261   $662    31   $6,401   $577 

 

At March 31, 2018, loans classified as TDRs totaled $6.3 million, with $662,000 of specific reserves, of which $1.7 million were classified as nonperforming TDRs and $4.6 million were classified as performing TDRs. This compared to $6.4 million of loans classified as TDRs, with $577,000 of specific reserves, of which $1.7 million were classified as nonperforming TDRs and $4.7 million were classified as performing TDRs at December 31, 2017. 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, 2017 to March 31, 2018 was primarily due to one TDR totaling $48,000 that went to foreclosure and $95,000 of payments on TDR’s received.

 

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:

 

   March 31,   December 31, 
(In thousands)  2018   2017 
Allocation of allowance for  loan losses at end of period:          
Commercial, financial, and agricultural  $3,261   $3,325 
Real estate construction - residential   240    170 
Real estate construction - commercial   895    807 
Real estate mortgage - residential   2,057    1,689 
Real estate mortgage - commercial   4,008    4,437 
Installment and other consumer   352    345 
Unallocated   134    79 
Total  $10,947   $10,852 

 

The allowance for loan losses (ALL) was $10.9 million, or 1.01%, of loans outstanding at March 31, 2018 compared to $10.9 million, or 1.02%, at December 31, 2017, and $10.3 million, or 1.02%, of loans outstanding at March 31, 2017. The ratio of the allowance for loan losses to nonperforming loans, excluding performing TDR’s, was 198.32% at March 31, 2018, compared to 180.87% at December 31, 2017.

 

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

 

   March 31,   December 31, 
(In thousands)  2018   2017 
Allocation of allowance for loan losses:          
Individually evaluated for impairment - specific reserves  $1,336   $1,333 
Collectively evaluated for impairment - general reserves   9,611    9,519 
Total  $10,947   $10,852 

  

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 March 31, 2018, $1.3 million of the Company’s ALL was allocated to impaired loans totaling approximately $10.1 million compared to $1.3 million of the Company’s ALL allocated to impaired loans totaling approximately $10.4 million at December 31, 2017. Management determined that $2.0 million, or 20%, of total impaired loans required no reserve allocation at March 31, 2018 compared to $2.4 million, or 23%, at December 31, 2017 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 by December 31, 2017. 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 $300,000 provision was required for the three months ended March 31, 2018 compared to a $350,000 provision for the three months ended March 31, 2017. The decrease was primarily due to loan growth slowing during the current quarter compared to the quarter ended March 31, 2017.

 

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

 

   Three Months Ended 
   March 31, 
(In thousands)  2018   2017 
Analysis of allowance for loan losses:          
Balance beginning of period  $10,852   $9,886 
Charge-offs:          
Commercial, financial, and agricultural   110    28 
Real estate construction - residential   48    - 
Real estate construction - commercial   30    - 
Real estate mortgage - residential   20    20 
Real estate mortgage - commercial   14    14 
Installment and other consumer   57    51 
Total charge-offs   279    113 
Recoveries:          
Commercial, financial, and agricultural  $13   $19 
Real estate construction - residential   12    50 
Real estate mortgage - residential   19    36 
Real estate mortgage - commercial   6    7 
Installment and other consumer   24    27 
Total recoveries   74    139 
Net charge-offs (recoveries)   205    (26)
Provision for loan losses   300    350 
Balance end of period  $10,947   $10,262 

 

Net Loan Charge-offs (Recoveries)

 

The Company’s net loan charge-offs were $205,000, or 0.02%, of average loans for the three months ended March 31, 2018, compared to net loan recoveries of $26,000, or 0.00%, of average loans for the three months ended March 31, 2017. The increase in charge-offs quarter over quarter primarily related to one commercial loan relationship and two real estate construction loans.

 

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.

 

   March 31,   December 31, 
(In thousands)  2018   2017 
Federal funds sold and other overnight interest-bearing deposits  $65,449   $39,553 
Certificates of deposit in other banks   4,812    3,460 
Available-for-sale investment securities   215,720    226,542 
Total  $285,981   $269,555 

 

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 $215.7 million at March 31, 2018 and included an unrealized net loss of $5.3 million. The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately $10.1 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company’s deposit base.

 

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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 March 31, 2018 and December 31, 2017, the Company’s unpledged securities in the available for sale portfolio totaled approximately $21.5 million and $44.8 million, respectively.

 

Total investment securities pledged for these purposes were as follows:

 

   March 31,   December 31, 
(In thousands)  2018   2017 
Investment securities pledged for the purpose of securing:          
Federal Reserve Bank borrowings  $9,002   $9,570 
Federal funds purchased and securities sold under agreements to repurchase   47,728    40,931 
Other deposits   137,538    131,197 
Total pledged, at fair value  $194,268   $181,698 

 

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 March 31, 2018, such deposits totaled $1.0 billion and represented 88.4% 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 $136.4 million at March 31, 2018. These accounts are normally considered more volatile and higher costing representing 11.6% of total deposits at March 31, 2018.

 

Core deposits at March 31, 2018 and December 31, 2017 were as follows:

 

   March 31,   December 31, 
(In thousands)  2018   2017 
Core deposit base:          
Non-interest bearing demand  $244,835   $245,380 
Interest checking   246,008    229,862 
Savings and money market   364,779    345,593 
Other time deposits   188,361    191,563 
Total  $1,043,983   $1,012,398 

 

The total amount of certificates of deposit of $250,000 and greater at March 31, 2018 and December 31, 2017 were $84.7 million and $63.2 million, respectively. The Company had brokered deposits totaling $48.9 million and $48.5 million at March 31, 2018 and December 31, 2017, respectively

 

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 March 31, 2018, under agreements with these unaffiliated banks, the Bank may borrow up to $40.0 million in federal funds on an unsecured basis and $16.2 million on a secured basis. There were no federal funds purchased outstanding at March 31, 2018. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company’s investment portfolio. At March 31, 2018, there was $34.8 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 March 31, 2018.

 

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 March 31, 2018, the Bank had $84.3 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.

 

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Borrowings outstanding at March 31, 2018 and December 31, 2017 were as follows:

 

   March 31,   December 31, 
(In thousands)  2018   2017 
Borrowings:          
Federal funds purchased and securities sold under agreements to repurchase  $34,795   $27,560 
Federal Home Loan Bank advances   84,296    121,352 
Subordinated notes   49,486    49,486 
Other borrowings   31    30 
Total  $168,608   $198,428 

 

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:

 

   March 31,   December 31, 
   2018   2017 
(In thousands)  FHLB   Federal
Reserve
Bank
   Federal
Funds
Purchased
Lines
   Total   FHLB   Federal
Reserve
Bank
   Federal
Funds
Purchased
Lines
   Total 
Advance equivalent  $294,216   $8,796   $47,435   $350,447   $294,081   $9,364   $47,825   $351,270 
Letters of credit   (72,750)   0    0    (72,750)   (70,000)   0    0    (70,000)
Advances outstanding   (84,296)   0    0    (84,296)   (121,352)   0    0    (121,352)
Total available  $137,170   $8,796   $47,435   $193,401   $102,729   $9,364   $47,825   $159,918 

 

At March 31, 2018, loans of $479.4 million were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At March 31, 2018, investments totaling $18.6 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.

 

Sources and Uses of Funds

 

Cash and cash equivalents were $81.4 million at March 31, 2018 compared to $62.9 million at December 31, 2017. The $18.5 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 three months ended March 31, 2018. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $2.3 million for the three months ended March 31, 2018.

 

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 $8.0 million. The cash outflow primarily consisted of $16.2 million increase in loans and $28.1 million purchases of investment securities, partially offset by $36.5 million from maturities, calls, and sales of investment securities.

 

Financing activities provided cash of $24.2 million, resulting primarily from a $32.4 million increase in interest bearing transaction accounts and $22.7 million increase in time deposits, partially offset by a net $37.1 million repayment of FHLB advances. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2018.

 

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 $308.6 million in unused loan commitments and standby letters of credit as of March 31, 2018. 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 $406,000 and $336,000 for the three months ended March 31, 2018 and 2017, respectively. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $1.0 million and $0 in dividends to the Company during the three months ended March 31, 2018 and 2017, respectively. At March 31, 2018 and December 31, 2017, the Company had cash and cash equivalents totaling $1.6 million and $1.4 million, respectively.

 

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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 phased 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 March 31, 2018 and December 31, 2017, 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:

 

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                   Well-Capitalized Under 
           Required for Capital   Prompt Corrective Action 
   Actual   Adequacy Purposes   Provision 
(in thousands)  Amount   Ratio   Amount   Ratio   Amount   Ratio 
March 31, 2018                        
Total Capital (to risk-weighted assets):                              
Company  $157,713    12.87%  $98,069    8.00%  $N.A.    N.A.%
Bank   156,390    12.79    97,794    8.00    122,243    10.00 
Tier I Capital (to risk-weighted assets):                              
Company  $130,070    10.61%  $73,551    6.00%  $N.A.    N.A.%
Bank   145,283    11.80    73,346    6.00    97,794    8.00 
Common Equity Tier I Capital                              
(to risk-weighted assets)                              
Company  $98,606    8.04%  $55,164    4.50%  $N.A.    N.A.%
Bank   145,283    11.88    55,009    4.50    79,458    6.50 
Tier I Capital (to adjusted average assets):                              
Company  $130,070    9.17%  $56,715    4.00%  $N.A.    N.A.%
Bank   145,283    10.37    56,028    4.00    70,035    5.00 
(in thousands)                              
December 31, 2017                              
Total Capital (to risk-weighted assets):                              
Company  $156,045    12.93%  $96,577    8.00%  $N.A.    N.A.%
Bank   154,495    12.83    96,326    8.00    120,408    10.00 
Tier I Capital (to risk-weighted assets):                              
Company  $129,369    10.72%  $72,433    6.00%  $N.A.    N.A.%
Bank   143,483    11.92    72,245    6.00    96,326    8.00 
Common Equity Tier I Capital                              
(to risk-weighted assets)                              
Company  $97,033    8.04%  $54,325    4.50%  $N.A.    N.A.%
Bank   143,483    11.92    54,184    4.50    78,265    6.50 
Tier I leverage ratio:                              
Company  $129,369    9.33%&