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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 September 30, 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 every Interactive Data File required to be submitted 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 such files). x Yes ¨ No

 

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

 

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨
     
Smaller reporting company x 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 November 8, 2018, the registrant had 6,034,843 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)

 

   September 30,   December 31, 
   2018   2017 
ASSETS          
Cash and due from banks  $16,340   $23,325 
Federal funds sold and other interest-bearing deposits   20,478    39,553 
Cash and cash equivalents   36,818    62,878 
Certificates of deposit in other banks   12,243    3,460 
Available-for-sale debt securities, at fair value   224,562    231,028 
Other securities   5,018    6,551 
Total investment securities   229,580    237,579 
Loans   1,115,765    1,068,432 
Allowances for loan losses   (11,358)   (10,852)
Net loans   1,104,407    1,057,580 
Premises and equipment - net   34,746    34,811 
Mortgage servicing rights   2,871    2,713 
Other real estate owned and repossessed assets - net   13,373    13,182 
Accrued interest receivable   5,984    5,627 
Cash surrender value - life insurance   2,535    2,484 
Other assets   9,107    8,902 
Total assets  $1,451,664   $1,429,216 
LIABILITIES AND STOCKHOLDERS' EQUITY          
Deposits          
Non-interest bearing demand  $257,376   $245,380 
Savings, interest checking and money market   609,216    584,468 
Time deposits $250,000 and over   110,148    63,176 
Other time deposits   205,994    232,788 
Total deposits   1,182,734    1,125,812 
Federal funds purchased and securities sold under agreements to repurchase   32,660    27,560 
Federal Home Loan Bank advances and other borrowings   78,713    121,382 
Subordinated notes   49,486    49,486 
Accrued interest payable   990    554 
Other liabilities   12,209    13,051 
Total liabilities   1,356,792    1,337,845 
Stockholders’ equity:          
Common stock, $1 par value, authorized 15,000,000 shares; issued 6,278,481 and 6,046,907 shares, respectively   6,279    6,047 
Surplus   50,173    45,442 
Retained earnings   52,090    50,595 
Accumulated other comprehensive loss, net of tax   (8,626)   (5,662)
Treasury stock; 243,638 and 248,898 shares, at cost, respectively   (5,044)   (5,051)
Total stockholders’ equity   94,872    91,371 
Total liabilities and stockholders’ equity  $1,451,664   $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   Nine Months Ended 
   September 30,   September 30, 
(In thousands, except per share amounts)  2018   2017   2018   2017 
INTEREST INCOME                    
Interest and fees on loans  $13,252   $11,856   $38,329   $34,577 
Interest on investment securities:                    
Taxable   1,089    785    3,141    2,391 
Nontaxable   146    169    451    494 
Federal funds sold, other interest-bearing deposits, and certificates of deposit in other banks   205    84    500    144 
Dividends on other securities   59    42    162    111 
Total interest income   14,751    12,936    42,583    37,717 
INTEREST EXPENSE                    
Interest on deposits:                    
Savings, interest checking and money market   1,468    682    3,899    1,546 
Time deposit accounts $250,000 and over   391    119    825    309 
Other time deposits   520    463    1,566    1,252 
Interest on federal funds purchased and securities sold under agreements to repurchase   166    29    526    78 
Interest on Federal Home Loan Bank advances   314    440    1,042    1,182 
Interest on subordinated notes   584    450    1,635    1,290 
Total interest expense   3,443    2,183    9,493    5,657 
Net interest income   11,308    10,753    33,090    32,060 
Provision for loan losses   250    555    1,000    1,235 
Net interest income after provision for loan losses   11,058    10,198    32,090    30,825 
NON-INTEREST INCOME                    
Service charges and other fees   942    878    2,760    2,565 
Bank card income and fees   699    664    2,064    1,941 
Trust department income   276    288    867    828 
Real estate servicing fees, net   192    70    574    557 
Gain on sale of mortgage loans, net   205    225    593    599 
Other   10    56    47    197 
Total non-interest income   2,324    2,181    6,905    6,687 
Investment securities gain, net   50    0    256    0 
NON-INTEREST EXPENSE                    
Salaries and employee benefits   5,543    5,502    17,413    16,276 
Occupancy expense, net   749    719    2,162    2,027 
Furniture and equipment expense   785    764    2,104    1,996 
Processing, network, and bank card expense   841    831    2,589    2,803 
Legal, examination, and professional fees   289    331    913    928 
FDIC insurance assessment   181    106    482    322 
Advertising and promotion   297    342    840    845 
Postage, printing, and supplies   256    215    749    690 
Other   947    956    2,821    2,916 
Total non-interest expense   9,888    9,766    30,073    28,803 
Income before income taxes   3,544    2,613    9,178    8,709 
Income tax expense   446    847    1,083    2,923 
Net income   3,098    1,766    8,095    5,786 
Basic earnings per share  $0.51   $0.29   $1.34   $0.95 
Diluted earnings per share  $0.51   $0.29   $1.34   $0.95 

 

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

 

3

 

 

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

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
(In thousands)  2018   2017   2018   2017 
Net income  $3,098   $1,766   $8,095   $5,786 
Other comprehensive income, net of tax                    
Investment securities available-for-sale:                    
Unrealized (loss) gain on investment securities available-for-sale, net of tax   (936)   84    (3,093)   984 
Adjustment for gain on sale of investment securities, net of tax   0    0    0    0 
Defined benefit pension plans:                    
Amortization of prior service cost included in net periodic pension cost, net of tax   44    15    129    42 
Total other comprehensive (loss) income   (892)   99    (2,964)   1,026 
Total comprehensive income  $2,206   $1,865   $5,131   $6,812 

 

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    5,786    0    0    5,786 
Other comprehensive income   0    0    0    1,026    0    1,026 
Stock based compensation expense   0    3    0    0    0    3 
Purchase of treasury stock   0    0    0    0    (623)   (623)
Stock dividend   225    3,940    (4,165)   0    0    0 
Cash dividends declared, common stock   0    0    (1,137)   0    0    (1,137)
Balance, September 30, 2017  $6,047   $45,441   $52,155   $(2,775)  $(4,796)  $96,072 
                               
Balance, December 31, 2017  $6,047   $45,442   $50,595   $(5,662)  $(5,051)  $91,371 
Net income   0    0    8,095    0    0    8,095 
Other comprehensive loss   0    0    0    (2,964)   0    (2,964)
Issuance of stock under equity compensation plan   0    (51)   0    0    186    135 
Purchase of treasury stock   0    0    0    0    (179)   (179)
Stock dividend   232    4,782    (5,014)   0    0    0 
Cash dividends declared, common stock   0    0    (1,586)   0    0    (1,586)
Balance, September 30, 2018  $6,279   $50,173   $52,090   $(8,626)  $(5,044)  $94,872 

 

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

 

5

 

 

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

 

   Nine Months Ended September 30, 
(In thousands)  2018   2017 
Cash flows from operating activities:          
Net income  $8,095   $5,786 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for loan losses   1,000    1,235 
Depreciation expense   1,321    1,399 
Net amortization of investment securities, premiums, and discounts   1,121    1,257 
Stock based compensation expense   0    3 
Change in fair value of mortgage servicing rights   40    72 
Investment securities gain, net   (256)   0 
Loss on sales and dispositions of premises and equipment   3    123 
Gain on sales and dispositions of other real estate and repossessed assets   0    (42)
Provision for other real estate owned   26    243 
(Increase) decrease in accrued interest receivable   (357)   304 
Increase in cash surrender value - life insurance   (51)   (55)
Decrease (increase) in other assets   849    (269)
Increase (decrease) in accrued interest payable   436    (12)
Decrease in other liabilities   (1,038)   (479)
Origination of mortgage loans for sale   (29,197)   (26,446)
Proceeds from the sale of mortgage loans   30,049    26,261 
Gain on sale of mortgage loans, net   (593)   (599)
Other, net   (198)   (162)
Net cash provided by operating activities   11,250    8,619 
Cash flows from investing activities:          
Purchase of certificates of deposit in other banks   (8,783)   0 
Proceeds from maturities of certificates of deposit in other banks   0    1,000 
Net increase in loans   (48,675)   (70,572)
Purchase of available-for-sale debt securities   (102,953)   (32,330)
Proceeds from maturities of available-for-sale debt securities   25,782    24,192 
Proceeds from calls of available-for-sale debt securities   1,685    7,675 
Proceeds from sales of available-for-sale debt securities   77,168    2,656 
Purchases of FHLB stock   (2,367)   (1,203)
Proceeds from sales of FHLB stock   3,903    1,239 
Purchases of premises and equipment   (1,374)   (1,017)
Proceeds from sales of premises and equipment   13    12 
Proceeds from sales of other real estate and foreclosed assets   372    1,001 
Net cash used in investing activities   (55,229)   (67,347)
Cash flows from financing activities:          
Net increase in demand deposits   11,996    23,482 
Net increase in interest-bearing transaction accounts   24,748    70,844 
Net increase in time deposits   20,178    2,968 
Net increase in federal funds purchased and securities sold under agreements to repurchase   5,100    1,048 
Repayment of FHLB advances and other borrowings   (173,619)   (183,132)
FHLB advances   130,950    179,640 
Issuance of stock under equity compensation plan   135    0 
Purchase of treasury stock   (179)   (623)
Cash dividends paid - common stock   (1,390)   (1,067)
Net cash provided by financing activities   17,919    93,160 
Net (decrease) increase in cash and cash equivalents   (26,060)   34,432 
Cash and cash equivalents, beginning of period   62,878    25,995 
Cash and cash equivalents, end of period  $36,818   $60,427 

 

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

 

6

 

 

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

 

   Nine Months Ended September 30, 
(In thousands)  2018   2017 
Supplemental disclosures of cash flow information:          
Cash paid during the year for:          
Interest  $9,058   $5,669 
Income taxes  $50   $2,940 
Noncash investing and financing activities:          
Other real estate and repossessed assets acquired in settlement of loans  $589   $217 
Stock dividends  $5,014   $4,165 

 

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 other than mentioned below.

 

Stock Dividend On July 1, 2018, the Company paid a special stock dividend of four percent to shareholders of record at the close of business on June 15, 2018. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

 

Summary of Recent Transactions and Events On October 18, 2018, Hawthorn Bank, a wholly-owned subsidiary of the Company, announced that it has entered into an agreement to sell its branch located in Branson, Missouri with total deposits of approximately $15 million to Branson Bank in Branson, Missouri. The transaction excludes loans assigned to the branch. The transaction, which is subject to regulatory approval and certain closing conditions, is expected to close during the first quarter of 2019.

 

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 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.

 

8

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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 did not have a significant effect on the Company's consolidated financial statements.

 

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 Stored-Value Products, in March 2016, in order to address current and potential future diversity in practice related to the derecognition of a prepaid stored-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 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. 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 utilizes 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 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 September 30, 2018 and December 31, 2017 is as follows:

 

   September 30,   December 31, 
(in thousands)  2018   2017 
Commercial, financial, and agricultural  $203,485   $192,238 
Real estate construction - residential   30,374    26,492 
Real estate construction - commercial   95,806    98,340 
Real estate mortgage - residential   246,334    246,754 
Real estate mortgage - commercial   506,197    472,455 
Installment and other consumer   33,569    32,153 
Total loans  $1,115,765   $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 September 30, 2018, loans of $498.2 million were pledged to the Federal Home Loan Bank as collateral for borrowings and letters of credit.

 

9

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

Allowance for Loan Losses

 

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

 

   Three Months Ended September 30, 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  $3,943   $201   $905   $2,109   $3,630   $413   $11   $11,212 
Additions:                                        
Provision for loan losses   (420)   26    (159)   255    444    39    65    250 
Deductions:                                        
Loans charged off   75    0    0    32    5    74    0    186 
Less recoveries on loans   (38)   (13)   0    (9)   (2)   (20)   0    (82)
Net loan charge-offs (recoveries)   37    (13)   0    23    3    54    0    104 
Balance at end of period  $3,486   $240   $746   $2,341   $4,071   $398   $76   $11,358 

 

   Nine Months Ended September 30, 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   478    80    (31)   672    (366)   170    (3)   1,000 
Deductions:                                        
Loans charged off   378    48    30    64    34    181    0    735 
Less recoveries on loans   (61)   (38)   0    (44)   (34)   (64)   0    (241)
Net loan charge-offs (recoveries)   317    10    30    20    0    117    0    494 
Balance at end of period  $3,486   $240   $746   $2,341   $4,071   $398   $76   $11,358 

 

   Three Months Ended September 30, 2017 
   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, &   Construction -   Construction -   Mortgage -   Mortgage -   and Other   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Consumer   allocated   Total 
Balance at beginning of period  $2,578   $70   $615   $1,854   $4,882   $376   $170   $10,545 
Additions:                                        
Provision for loan losses   853    64    91    100    (426)   32    (159)   555 
Deductions:                                        
Loans charged off   37    0    0    68    4    56    0    165 
Less recoveries on loans   (12)   (12)   0    (11)   (5)   (25)   0    (65)
Net loan charge-offs (recoveries)   25    (12)   0    57    (1)   31    0    100 
Balance at end of period  $3,406   $146   $706   $1,897   $4,457   $377   $11   $11,000 

 

   Nine Months Ended September 30, 2017 
   Commercial,   Real Estate   Real Estate   Real Estate   Real Estate   Installment         
   Financial, &   Construction -   Construction -   Mortgage -   Mortgage -   and Other   Un-     
(in thousands)  Agricultural   Residential   Commercial   Residential   Commercial   Consumer   allocated   Total 
Balance at beginning of period  $2,753   $108   $413   $2,385   $3,793    274   $160   $9,886 
Additions:                                        
Provision for loan losses   695    (49)   293    (407)   658    194    (149)   1,235 
Deductions:                                        
Loans charged off   97    0    0    149    20    167    0    433 
Less recoveries on loans   (55)   (87)   0    (68)   (26)   (76)   0    (312)
Net loan charge-offs (recoveries)   42    (87)   0    81    (6)   91    0    121 
Balance at end of period  $3,406   $146   $706   $1,897   $4,457   $377   $11   $11,000 

 

10

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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. 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. Beginning with December 31, 2017, the Company has utilized a five-year look-back period.

 

The following table provides the balance in the allowance for loan losses at September 30, 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 
September 30, 2018                                        
Allowance for loan losses:                                        
Individually evaluated for impairment  $381   $0   $0   $657   $166   $21   $0   $1,225 
Collectively evaluated for impairment   3,105    240    746    1,684    3,905    377    76    10,133 
Total  $3,486   $240   $746   $2,341   $4,071   $398   $76   $11,358 
Loans outstanding:                                        
Individually evaluated for impairment  $2,731   $0   $158   $5,145   $1,028   $243   $0   $9,305 
Collectively evaluated for impairment   200,754    30,374    95,648    241,189    505,169    33,326    0    1,106,460 
Total  $203,485   $30,374   $95,806   $246,334   $506,197   $33,569   $0   $1,115,765 
                                         
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 $9.3 million and $10.4 million at September 30, 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 September 30, 2018 and December 31, 2017, $4.2 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 September 30, 2018, $1.2 million of the Company’s allowance for loan losses was allocated to impaired loans totaling $9.3 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 $3.0 million, or 32%, of total impaired loans required no reserve allocation at September 30, 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.

 

11

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The categories of impaired loans at September 30, 2018 and December 31, 2017 are as follows:

 

   September 30,   December 31, 
(in thousands)  2018   2017 
Non-accrual loans  $6,045   $5,672 
Performing TDRs   3,260    4,684 
Total impaired loans  $9,305   $10,356 

 

The following tables provide additional information about impaired loans at September 30, 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 
September 30, 2018               
With no related allowance recorded:               
Commercial, financial and agricultural  $1,570   $1,910   $0 
Real estate - construction commercial   158    183    0 
Real estate - residential   1,142    1,206    0 
Real estate - commercial   119    121    0 
Total  $2,989   $3,420   $0 
With an allowance recorded:               
Commercial, financial and agricultural  $1,161   $1,229   $381 
Real estate - residential   4,003    4,089    657 
Real estate - commercial   909    994    166 
Installment and other consumer   243    269    21 
Total  $6,316   $6,581   $1,225 
Total impaired loans  $9,305   $10,001   $1,225 

 

       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 September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
       Interest       Interest       Interest       Interest 
   Average   Recognized   Average   Recognized   Average   Recognized   Average   Recognized 
   Recorded   For the   Recorded   For the   Recorded   For the   Recorded   For the 
(in thousands)  Investment   Period Ended   Investment   Period Ended   Investment   Period Ended   Investment   Period Ended 
With no related allowance recorded:                                        
Commercial, financial and agricultural  $1,375   $0   $481   $0   $1,334   $1   $478   $0 
Real estate - construction commercial   161    0    0    0    82    0    0    0 
Real estate - residential   1,037    3    341    0    929    9    1,412    0 
Real estate - commercial   120    3    77    3    30    22    221    9 
Installment and other consumer   91    0    0    0    34    0    22    0 
Total  $2,784   $6   $899   $3   $2,409   $32   $2,133   $9 
With an allowance recorded:                                        
Commercial, financial and agricultural  $1,423   $8   $694   $8   $1,507   $23   $1,667   $24 
Real estate - construction residential   0    0    0    0    15    0    0    0 
Real estate - construction commercial   0    0    0    0    24    0    37    0 
Real estate - residential   4,076    25    1,383    33    4,211    71    4,090    121 
Real estate - commercial   1,443    13    597    17    1,649    24    1,772    46 
Installment and other consumer   197    0    56    0    186    1    70    0 
Total  $7,139   $46   $2,730   $58   $7,592   $119   $7,636   $191 
Total impaired loans  $9,923   $52   $3,629   $61   $10,001   $151   $9,769   $200 

 

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 $52,000 and $151,000, for the three months and nine months ended September 30, 2018, respectively compared to $61,000 and $200,000 for the three and nine months ended September 30, 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 nine months.

  

13

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The following table provides aging information for the Company’s past due and non-accrual loans at September 30, 2018 and December 31, 2017.

 

   Current or       90 Days         
   Less Than       Past Due         
   30 Days   30 - 89 Days   And Still         
(in thousands)  Past Due   Past Due   Accruing   Non-Accrual   Total 
September 30, 2018                         
Commercial, Financial, and Agricultural  $200,893   $288   $8   $2,296   $203,485 
Real Estate Construction - Residential   30,374    0    0    0    30,374 
Real Estate Construction - Commercial   95,548    100    0    158    95,806 
Real Estate Mortgage - Residential   242,165    1,189    212    2,768    246,334 
Real Estate Mortgage - Commercial   505,087    513    0    597    506,197 
Installment and Other Consumer   33,111    217    15    226    33,569 
Total  $1,107,178   $2,307   $235   $6,045   $1,115,765 
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 September 30, 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 September 30, 2018                                   
Watch  $7,116   $593   $3,735   $13,114   $35,753   $9   $60,320 
Substandard   57    0    0    1,532    708    5    2,302 
Performing TDRs   434    0    0    2,377    431    18    3,260 
Non-accrual   2,296    0    158    2,768    597    226    6,045 
Total  $9,903   $593   $3,893   $19,791   $37,489   $258   $71,927 
                                    
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 September 30, 2018, loans classified as TDRs totaled $5.4 million, of which $2.2 million were classified as nonperforming TDRs and included in non-accrual loans and $3.2 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 $569,000 and $577,000 related to TDRs were allocated to the allowance for loan losses at September 30, 2018 and December 31, 2017, respectively.

 

15

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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

 

   Three Months Ended September 30, 
   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   2   $353   $353    0   $0   $0 
Real estate mortgage - commercial   0    0    0    1    14    14 
Consumer   1    112    53    0    0    0 
Total   3   $465   $406    1   $14   $14 

 

   Nine Months Ended September 30, 
   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   2   $353   $353    1   $131   $130 
Real estate mortgage - residential   1    75    74    1    14    14 
Real estate mortgage - commercial   0    0    0    1    56    52 
Consumer   5    160    93    0    0    0 
Total   8   $588   $520    3   $201   $196 

 

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

 

The Company’s portfolio of loans classified as TDRs include concessions for the borrower given financial condition such as interest rates below the current market rate, deferring principal payments, and extending maturity dates. There were three loans and eight loans meeting the TDR criteria that were modified during the three and nine months ended September 30, 2018, respectively, compared to one loan and three loans during the three and nine months ended September 30, 2017, respectively.

 

The Company considers a TDR to be in default when it is 90 days or more past due under the modified terms, a charge-off occurs, or it is the process of foreclosure. There were no loans modified as a TDR that defaulted during any of the three and nine months ended September 30, 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 and one commercial real estate loan totaling $366,000 was sold at foreclosure. See Lending and Credit Management section for further information.

 

(3)Other Real Estate and Repossessed Assets

 

   September 30,   December 31, 
(in thousands)  2018   2017 
Commercial  $697   $727 
Real estate construction - residential   179    0 
Real estate construction - commercial   12,101    12,380 
Real estate mortgage - residential   464    382 
Real estate mortgage - commercial   2,934    2,909 
Repossessed assets   0    5 
Total  $16,375   $16,403 
Less valuation allowance for other real estate owned   (3,002)   (3,221)
Total other real estate and repossessed assets  $13,373   $13,182 

 

16

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
Balance at beginning of period  $16,258   $16,530   $16,403   $17,291 
Additions   207    62    589    217 
Proceeds from sales   (68)   (217)   (372)   (1,001)
Charge-offs against the valuation allowance for other real estate owned, net   (20)   0    (245)   (170)
Net gain on sales   (2)   4    0    42 
Total other real estate and repossessed assets  $16,375   $16,379   $16,375   $16,379 
Less valuation allowance for other real estate owned   (3,002)   (3,202)   (3,002)   (3,202)
Balance at end of period  $13,373   $13,177   $13,373   $13,177 

 

At September 30, 2018, $253,000 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 September 30,   Nine Months Ended September 30, 
(in thousands)  2018   2017   2018   2017 
Balance, beginning of period  $3,022   $3,174   $3,221   $3,129 
Provision for other real estate owned   0    28    26    243 
Charge-offs   (20)   0    (245)   (170)
Balance, end of period  $3,002   $3,202   $3,002   $3,202 

 

17

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(4)Investment Securities

 

Available for sale securities

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2018 and December 31, 2017 were as follows:

 

   Total             
   Amortized   Gross Unrealized   Fair 
(in thousands)  Cost   Gains   Losses   Value 
September 30, 2018                    
U.S. Treasury  $1,983   $0   $(67)  $1,916 
U.S. government and federal agency obligations   10,933    0    (459)   10,474 
Government sponsored enterprises   45,777    0    (812)   44,965 
Obligations of states and political subdivisions   41,088    21    (764)   40,345 
Mortgage-backed securities:                    
Residential - government agencies   127,375    41    (4,918)   122,498 
Other debt securities (a)   3,000    0    0    3,000 
Bank issued trust preferred securities (a)   1,486    0    (122)   1,364 
Total available-for-sale securities  $231,642   $62   $(7,142)  $224,562 
                     
December 31, 2017                    
U.S. Treasury  $1,980   $0   $(13)  $1,967 
U.S. government and federal agency obligations   12,341    0    (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 
Other debt securities (a)   3,000    0    0    3,000 
Bank issued trust preferred securities (a)   1,486    0    0    1,486 
Total available-for-sale securities  $234,192   $158   $(3,322)  $231,028 

 

(a) As of January 1, 2018, the Company adopted ASU 2016-01, resulting in reclassification of certain hybrid instruments possessing characteristics typically associated with debt obligations from other securities carried at cost to available for sale securities carried at fair value.

 

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.

 

Debt securities with carrying values aggregating approximately $184.2 million and $181.7 million at September 30, 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 September 30, 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.

 

18

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

   Amortized   Fair 
(in thousands)  Cost   Value 
Due in one year or less  $16,968   $16,846 
Due after one year through five years   65,499    64,046 
Due after five years through ten years   14,151    13,705 
Due after ten years   7,649    7,467 
Total   104,267    102,064 
Mortgage-backed securities   127,375    122,498 
Total available-for-sale securities  $231,642   $224,562 

 

 

Other securities

Other securities include equity securities with readily determinable fair values and other investment securities whose accounting is not addressed in ASU 2016-01 include Federal Home Loan Bank (FHLB) stock, and Midwest Independent Bank (MIB) bankers bank stock, that do not have readily determinable fair values, which are held for debt and regulatory purposes.

 

(in thousands)  September 30, 2018   December 31, 2017 
Other securities:          
FHLB stock  $4,854   $6,390 
MIB stock   151    151 
Equity securities with readily determinable fair values   13    10 
Total other investment securities  $5,018   $6,551 

 

Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 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 September 30, 2018                              
U.S. Treasury  $1,205   $(40)  $711   $(27)  $1,916   $(67)
U.S. government and federal agency obligations   0    0    10,474    (459)   10,474    (459)
Government sponsored enterprises   15,983    (220)   28,983    (592)   44,966    (812)
Obligations of states and political subdivisions   18,265    (182)   17,905    (582)   36,170    (764)
Mortgage-backed securities:                              
Residential - government agencies   31,595    (646)   87,268    (4,272)   118,863    (4,918)
Bank issued trust preferred securities   0    0    1,364    (122)   1,364    (122)
Total  $67,048   $(1,088)  $146,705   $(6,054)  $213,753   $(7,142)
                               
(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 371 securities at September 30, 2018. The portfolio included 344 securities having an aggregate fair value of $213.7 million that were in a loss position at September 30, 2018. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $146.7 million at fair value. The $7.1 million aggregate unrealized loss included in accumulated other comprehensive income at September 30, 2018 was caused by interest rate fluctuations.

 

19

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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 September 30, 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.

 

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

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(in thousands)  2018   2017   2018   2017 
Investment securities gains, net                    
Available for sale securities:                    
Gains realized on sales  $47   $12   $253   $12 
Losses realized on sales   0    (12)   0    (12)
Other securities:                    
Fair value adjustments, net   3    0    3    0 
Investment securities gains, net  $50   $0   $256   $0 

 

Securities gains for the three and nine months ended September 30, 2018 included gains realized from a series of short term sales of U.S. Treasury securities with repurchase agreements in order to generate capital gains to offset capital losses that were to expire during 2018 and 2019.

 

(5)Intangible Assets

 

Mortgage Servicing Rights

 

At September 30, 2018, the Company was servicing approximately $282.9 million of loans sold to the secondary market compared to $285.8 million at December 31, 2017, and $288.7 million at September 30, 2017. Mortgage loan servicing fees, reported in real estate servicing fees, net, earned on loans sold were $201,000 and $614,000 for the three and nine months ended September 30, 2018, respectively, compared to $209,000 and $629,000 for the three and nine months ended September 30, 2017, respectively.

 

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

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(in thousands)  2018   2017   2018   2017 
Balance at beginning of period  $2,813   $2,766   $2,713   $2,584 
Originated mortgage servicing rights   66    61    198    176 
Changes in fair value:                    
Due to change in model inputs and assumptions (1)   70    (30)   203    289 
Other changes in fair value (2)   (78)   (109)   (243)   (361)
Balance at end of period  $2,871   $2,688   $2,871   $2,688 

 

(1)The change in fair value resulting from changes in valuation inputs or assumptions, reported in real estate servicing fees, net, 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, reported in real estate servicing fees, net, reflect changes due to customer payments and passage of time.

 

20

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The following key data and assumptions were used in estimating the fair value of the Company’s MSRs as of September 30, 2018 and 2017, respectively:

 

   Nine Months Ended September 30, 
   2018   2017 
Weighted average constant prepayment rate   9.36%   10.11%
Weighted average note rate   3.92%   3.86%
Weighted average discount rate   10.36%   9.78%
Weighted average expected life (in years)   6.10    5.80 

 

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

 

   September 30,   December 31, 
   2018   2017 
Federal funds purchased  $0   $0 
Repurchase agreements   32,660    27,560 
Total  $32,660   $27,560 

 

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 September 30, 2018                    
U.S. Treasury  $1,442   $0   $0   $1,442 
Government sponsored enterprises   15,698    0    0    15,698 
Asset-backed securities   15,520    0    0    15,520 
Total  $32,660   $0   $0   $32,660 
                     
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 

 

21

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(7)Income Taxes

 

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 12.6% and 11.8% for the three and nine months ended September 30, 2018, respectively, compared to 32.4% and 33.6% for the three and nine months ended September 30, 2017, respectively. As further described below, the decrease in tax rate for the comparative periods is primarily due to a decrease in the federal corporate tax rate, the release of the valuation allowance related to capital losses as a result of the Company’s tax planning initiatives, a pension contribution made during the second quarter of 2018 that was attributable to the 2017 plan year, and the Company’s additional tax planning initiatives.

 

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, (Tax Act). The Company’s tax rate is lower than the federal statutory rate primarily as a result of tax-exempt income, the release of the valuation allowance related to capital loss carryforwards, and a pension contribution made during the second quarter of 2018 that was attributable to the 2017 plan year, 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 Act have been finalized as of September 30, 2018 with the filing of the Company’s 2017 tax return. The finalization of the Tax Act included a $306,000 benefit attributable to the pension contribution discussed above and an $180,000 benefit attributable to various accounting method changes made on the Company’s 2017 tax return. Such adjustments were recorded in the second and third quarters of 2018 respectively, 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 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. In management’s opinion, the Company will more likely than not realize the benefits of its deferred tax assets and, therefore, has not established a valuation allowance against its deferred tax assets as of September 30, 2018. Management arrived at this conclusion based upon the level of historical taxable income and projections for future taxable income of the appropriate character over the periods in which the deferred tax assets are deductible. As indicated above, the Company released a $46,000 valuation allowance against certain capital loss carryforwards during the second quarter of 2018 as a result of the execution of certain tax planning initiatives that generated sufficient capital gain income prior to the expiration of the carryforwards.

 

The Company follows ASC Topic 740, Income Taxes, which addresses the accounting for uncertain tax positions. For each of the three and nine months ended September 30, 2018 and 2017, respectively, the Company did not have any uncertain tax provisions, and did not record any related tax liabilities.

 

22

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

(8)Stockholders’ Equity

 

Accumulated Other Comprehensive Loss

 

The following details the change in the components of the Company’s accumulated other comprehensive loss for the nine months ended September 30, 2018 and 2017:

 

   Nine months ended September 30, 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   (3,915)   164    (3,751)
Amounts reclassified from accumulated other comprehensive (loss) income   0    0    0 
Current period other comprehensive (loss) income, before tax   (3,915)   164    (3,751)
Income tax benefit (expense)   822    (35)   787 
Current period other comprehensive (loss) income, net of tax   (3,093)   129    (2,964)
Balance at end of period  $(5,593)  $(3,033)  $(8,626)

 

   Nine months ended September 30, 2017 
       Unrecognized Net   Accumulated 
   Unrealized   Pension and   Other 
   Gain (Loss)   Postretirement   Comprehensive 
(in thousands)  on Securities (1)   Costs (2)   Loss 
Balance at beginning of period  $(1,936)  $(1,865)  $(3,801)
Other comprehensive income, before reclassifications   1,588    67    1,655 
Amounts reclassified from accumulated other comprehensive income (loss)   0    0    0 
Current period other comprehensive income, before tax   1,588    67    1,655 
Income tax expense   (604)   (25)   (629)
Current period other comprehensive income, net of tax   984    42    1,026 
Balance at end of period  $(952)  $(1,823)  $(2,775)

 

(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 September 30,   Nine Months Ended September 30, 
(in thousands)  2018   2017   2018   2017 
Payroll taxes  $261   $267   $913   $911 
Medical plans   490    595    1,650    1,489 
401k match and profit sharing   261    218    684    694 
Periodic pension cost   470    336    1,280    1,007 
Other   12    17    37    42 
Total employee benefits  $1,494   $1,433   $4,564   $4,143 

 

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.

 

23

 

 

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 made a pension contribution in the amount of $1.8 million in the second quarter of 2018. The 2018 minimum required contribution is $578,000. Effective July 1, 2017, the Company amended the pension plan to effectuate a “soft freeze” such that no individual hired (or rehired in the case of a former employee) by the Company after 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.

 

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  $1,707   $1,343 
Interest costs on projected benefit obligations (a)   1,037    1,009 
Expected return on plan assets (a)   (1,327)   (1,124)
Expected administrative expenses (a)   93    88 
Amortization of prior service cost (a)   79    79 
Amortization of unrecognized net loss (a)   140    11 
Net periodic pension cost  $1,729   $1,406 
           
Net periodic pension cost for the three months ended September 30, (actual)  $470   $336 
Net periodic pension cost for the nine months ended September 30, (actual)  $1,280   $1,007 

 

(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 has one equity compensation plan for its employees pursuant to which options were granted.

 

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, December 31, 2017   20,909   $14.20           
Granted   0    0.00           
Exercised   (20,909)   14.20           
Forfeited or expired   0    0.00           
Outstanding, September 30, 2018   0   $0.00    0.00   $0 
Exercisable, September 30, 2018   0   $0.00    0.00   $0 

 

Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2018.

 

24

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

Total stock-based compensation expense was $0 for the three and nine months ended September 30, 2018 compared to $1,000 and $3,000 for the three and nine months ended September 30, 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. During the third quarter of 2018, the remaining 20,909 options to purchase common shares were exercised at a weighted average price of $14.20 a share.

 

(11)Earnings per Share

 

Stock Dividend On July 1, 2018, the Company paid a special stock dividend of 4% to common shareholders of record at the close of business on June 15, 2018. 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 September 30,   Nine Months Ended September 30, 
(dollars in thousands, except per share data)  2018   2017   2018   2017 
Basic earnings per share:                    
Net income available to shareholders  $3,098   $1,766   $8,095   $5,786 
Average shares outstanding   6,023,269    6,057,399    6,024,317    6,066,253 
Basic earnings per share  $0.51   $0.29   $1.34   $0.95 
Diluted earnings per share:                    
Net income available to shareholders  $3,098   $1,766   $8,095   $5,786 
Average shares outstanding   6,023,269    6,057,399    6,024,317    6,066,253 
Effect of dilutive stock options   6,363    5,784    6,480    5,407 
Average shares outstanding including dilutive stock options   6,029,632    6,063,183    6,030,797    6,071,660 
Diluted earnings per share  $0.51    0.29   $1.34    0.95 

 

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. There were no outstanding stock options for any of the three and nine months ended September 30, 2018 and 2017, respectively, that were omitted from the computation of diluted earnings per share as a result of being considered anti-dilutive.

 

The Company’s share repurchase plan (the plan) expired on September 8, 2018. As of September 30, 2018, the Company had repurchased a total of 95,709 shares of common stock pursuant to the plan at an average price of $17.90 per share, including 8,668 shares of common stock repurchased pursuant to the plan during the nine months ended September 30, 2018 at an average price of $20.63 per share.

 

(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.

 

25

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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. During the nine months ended September 30, 2018 and the year ended 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.

 

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.

 

26

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

       Fair Value Measurements 
       Quoted Prices         
       in Active         
       Markets for   Other   Significant 
       Identical   Observable   Unobservable 
       Assets   Inputs   Inputs 
(in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3) 
September 30, 2018                    
Assets:                    
U.S. Treasury  $1,916   $1,916    0   $0 
U.S. government and federal agency obligations   10,474    0    10,474    0 
Government sponsored enterprises   44,965    0    44,965    0 
Obligations of states and political subdivisions   40,345    0    40,345    0 
Mortgage-backed securities   122,498    0    122,498    0 
Other debt securities   4,364    0    4,364    0 
Equity securities   13    0    13    0 
Mortgage servicing rights   2,871    0    0    2,871 
Total  $227,446   $1,916   $222,659   $2,871 
                     
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 
Other debt securities   4,486    0    4,486    0 
Equity securities   10    0    10    0 
Mortgage servicing rights   2,713    0    0    2,713 
Total  $233,751   $1,967   $229,071   $2,713 

 

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

 

   Fair Value Measurements Using   Fair Value Measurements Using 
   Significant Unobservable Inputs   Significant Unobservable Inputs 
   (Level 3)   (Level 3) 
   Mortgage Servicing Rights   Mortgage Servicing Rights 
(in thousands)  Three Months Ended September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
Balance at beginning of period  $2,813   $2,766   $2,713   $2,584 
Total gains or losses (realized/unrealized):                    
Included in earnings   (8)   (139)   (40)   (72)
Included in other comprehensive income   0    0    0    0 
Purchases   0    0    0    0 
Sales   0    0    0    0 
Issues   66    61    198    176 
Settlements   0    0    0    0 
Balance at end of period  $2,871   $2,688   $2,871   $2,688 

 

27

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

The change in valuation of mortgage servicing rights, arising from inputs and assumptions, decreased $8,000 and $40,000 for the three and nine months ended September 30, 2018, respectively, compared to a decrease of $139,000 and $72,000 for the three and nine months ended September 30, 2017, respectively.

 

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 September 30, 2018, the Company identified $4.2 million in collateral dependent impaired loans that had specific allowances for losses aggregating $891,000. Related to these loans, there was $53,000 and $303,000 in charge-offs recorded during the three and nine months ended September 30, 2018, respectively. As of September 30, 2017, the Company identified $4.4 million in collateral dependent impaired loans that had specific allowances for losses aggregating $1.4 million. Related to these loans, there was $64,000 and $147,000 in charge-offs recorded during the three and nine months ended September 30, 2017, respectively.

 

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.

 

28

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

       Fair Value Measurements Using         
       Quoted Prices           Three   Nine 
       in Active           Months   Months 
       Markets for   Other   Significant   Ended   Ended 
       Identical   Observable   Unobservable   September 30,   September 30, 
   Total   Assets   Inputs   Inputs   Total Gains   Total Gains 
(in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3)   (Losses)*   (Losses)* 
September 30, 2018                              
Assets:                              
Collateral dependent impaired loans:                              
Commercial, financial, & agricultural  $1,549   $0   $0   $1,549   $(21)  $(187)
Real estate construction - commercial   158    0    0    158    0    (27)
Real estate mortgage - residential   1,156    0    0    1,156    (32)   (44)
Real estate mortgage - commercial   399    0    0    399    0    (20)
Consumer   0    0    0    0    0    (25)
Total  $3,262   $0   $0   $3,262   $(53)  $(303)
Other real estate and foreclosed assets  $13,373   $0   $0   $13,373   $(3)  $(29)
                               
September 30, 2017                              
Assets:                              
Collateral dependent impaired loans:                              
Commercial, financial, & agricultural  $1,757   $0   $0   $1,757   $0   $(1)
Real estate mortgage - residential   1,042    0    0    1,042    (57)   (122)
Real estate mortgage - commercial   219    0    0    219    0    (4)
Consumer   0    0    0    0    (7)   (20)
Total  $3,018   $0   $0   $3,018   $(64)  $(147)
Other real estate and foreclosed assets  $13,177   $0   $0   $13,177   $(26)  $(206)

 

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

 

(13)Fair Value of Financial Instruments

 

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate such value:

 

Loans

 

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.

 

29

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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.

 

Cash Surrender Value - Life Insurance

 

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

 

Accrued Interest Receivable and Payable

 

For accrued interest receivable and payable, the carrying amount is a reasonable estimate of fair value because of the short maturity for these financial instruments.

 

Deposits

 

The fair value of deposits with no stated maturity, such as noninterest-bearing demand, NOW accounts, savings, and money market, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

 

Securities Sold under Agreements to Repurchase

 

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.

 

30

 

 

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 September 30, 2018 and December 31, 2017 is as follows:

 

           September 30, 2018 
           Fair Value Measurements 
           Quoted Prices         
           in Active       Net 
           Markets for   Other   Significant 
   September 30, 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  $16,340   $16,340   $16,340   $0   $0 
Federal funds sold and overnight interest-bearing deposits   20,478    20,478    20,478    0    0 
Certificates of deposit in other banks   12,243    12,243    12,243    0    0 
Available for sale securities   224,562    224,562    1,916    222,646    0 
Other securities   5,018    5,018    0    5,018    0 
Loans, net   1,104,407    1,082,384    0    0    1,082,384 
Cash surrender value - life insurance   2,535    2,535    0    2,535    0 
Accrued interest receivable   5,984    5,984    5,984    0    0 
   $1,391,567   $1,369,544   $56,961   $230,199   $1,082,384 
Liabilities:                         
Deposits:                         
Non-interest bearing demand  $257,376   $257,376   $257,376   $0   $0 
Savings, interest checking and money market   609,216    609,216    609,216    0    0 
Time deposits   316,142    312,771    0    0    312,771 
                          
Federal funds purchased and securities sold under agreements to repurchase   32,660    32,660    32,660    0    0 
Federal Home Loan Bank advances and other borrowings   78,713    78,275    0    78,275    0 
Subordinated notes   49,486    45,440    0    45,440    0 
Accrued interest payable   990    990    990    0    0 
   $1,344,583   $1,336,728   $900,242   $123,715   $312,771 

 

31

 

 

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 
Available-for-sale securities   231,028    231,028    1,967    229,061    0 
Other securities   6,551    6,551    0    6,551    0 
Loans, net   1,057,580    1,058,153    0    0    1,058,153 
Cash surrender value - life insurance   2,484    2,484    0    2,484    0 
Accrued interest receivable   5,627    5,627    5,627    0    0 
   $1,369,608   $1,370,181   $73,932   $238,096   $1,058,153 
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)Commitments and Contingencies

 

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

 

The Company’s extent of involvement and maximum potential exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for financial instruments included on its consolidated balance sheets. At September 30, 2018, no amounts have been accrued for any estimated losses for these financial instruments.

 

32

 

 

Hawthorn Bancshares, Inc.
and subsidiaries

 

Notes to the Consolidated Financial Statements

 

(Unaudited)

 

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

 

   September 30,   December 31, 
(in thousands)  2018   2017 
Commitments to extend credit  $233,920   $238,527 
Commitments to originate residential first and second mortgage loans   2,217    1,471 
Standby letters of credit   61,332    74,004 
Total   297,469    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 September 30, 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.

 

(15)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.

 

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 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 current business practices or result in any changes to the Company’s consolidated financial statements.

 

Descriptions of our revenue-generating activities within the scope of this guidance, which are presented in our income statement as components of noninterest income are as follows:

 

Service charges on deposit accounts - represents fees generated from a variety of deposit products and services provided to customers under a day-to-day contract. These fees are recognized on a daily or monthly basis.

 

Bank card income and fees – represents fees, exchange, and other service charge revenue earned from merchant, debit and credit cards that are recognized when the services are rendered or upon completion. These fees are recognized on a daily or monthly basis.

 

Gain on sale of other real estate - represents income recognized at the time of control of a property is transferred to the buyer.

 

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 September 30, 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 nine months ended September 30, 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   Nine Months Ended 
   September 30,   September 30, 
(In thousands, except per share data)  2018   2017   2018   2017 
Per Share Data                    
Basic earnings per share  $0.51   $0.29   $1.34   $0.95 
Diluted earnings per share   0.51    0.29    1.34    0.95 
Cash dividends paid on common stock   579    338    1,390    1,067 
Common stock dividend   5,014    4,165    5,014    4,165 
Book value per share             15.75    15.84 
Market price per share             22.75    19.90 
Selected Ratios                    
(Based on average balance sheets)                    
Return on total assets   0.85%   0.51%   0.75%   0.58%
Return on stockholders' equity   13.02%   7.27%   11.69%   8.18%
Stockholders' equity to total assets   6.50%   7.04%   6.42%   7.06%
Efficiency ratio (1)   72.54%   75.51%   75.19%   74.34%
                     
(Based on end-of-period data)                    
Stockholders' equity to assets             6.54%   6.93%
Total risk-based capital ratio             13.54%   13.42%
Tier 1 risk-based capital ratio             11.31%   11.17%
Common equity Tier 1 capital             8.60%   8.39%
Tier 1 leverage ratio (2)             9.35%   9.62%

 

(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.

 

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RESULTS OF OPERATIONS ANALYSIS

 

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

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(In thousands)  2018   2017   $ Change   % Change   2018   2017   $ Change   % Change 
                                 
Net interest income  $11,308   $10,753   $555    5.2%  $33,090   $32,060   $1,030    3.2%
Provision for loan losses   250    555    (305)   (55.0)   1,000    1,235    (235)   (19.0)
Noninterest income   2,324    2,181    143    6.6    6,905    6,687    218    3.3 
Investment securities gain, net   50    -    50    NM    256    -    256    NM 
Noninterest expense   9,888    9,766    122    1.2    30,073    28,803    1,270    4.4 
Income before income taxes   3,544    2,613    881    33.7    9,178    8,709    213    2.4 
Income tax expense   446    847    (401)   (47.3)   1,083    2,923    (1,840)   (62.9)
Net income  $3,098   $1,766   $1,332    75.4%  $8,095   $5,786   $2,309    39.9%

 

Consolidated net income of $3.1 million, or $0.51 per diluted share, for the three months ended September 30, 2018 increased $1.3 million compared to $1.8 million, or $0.29 per diluted share, for the three months ended September 30, 2017. For the three months ended September 30, 2018, the return on average assets was 0.85%, the return on average stockholders’ equity was 13.02%, and the efficiency ratio was 72.54%.

 

Consolidated net income of $8.1 million, or $1.34 per diluted share, for the nine months ended September 30, 2018 increased $2.3 million compared to $5.8 million, or $0.95 per diluted share, for the nine months ended September 30, 2017. For the nine months ended September 30, 2018, the return on average assets was 0.75%, the return on average stockholders’ equity was 11.69%, and the efficiency ratio was 75.19%.

 

Net interest income was $11.3 million and $33.1 million for the three and nine months ended September 30, 2018, respectively, compared to $10.8 million and $32.1 million for the three and nine months ended September 30, 2017, respectively. The net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.30% for the three months ended September 30, 2018, compared to 3.35% for the three months ended September 30, 2017, and decreased to 3.28% for the nine months ended September 30, 2018 compared to 3.44% for the nine months ended September 30, 2017. These changes are discussed in greater detail under the Average Balance Sheets and Rate and Volume Analysis section below.

 

A $250,000 and $1.0 million provision for loan losses was recorded for the three and nine months ended September 30, 2018, respectively, compared to a $555,000 and $1.2 million provision for the three and nine months ended September 30, 2017, respectively.

 

The Company’s net loan charge-offs were $104,000, or 0.01%, of average loans, and $494,000, or 0.05%, of average loans for the three and nine months ended September 30, 2018, respectively, compared to $100,000, or 0.01%, of average loans, and $121,000, or 0.01%, of average loans for the three and nine months ended September 30, 2017, respectively.

 

Non-performing loans totaled $6.0 million, or 0.54% of total loans, at September 30, 2018 compared to $5.7 million, or 0.53% of total loans, at December 31, 2017, and $6.2 million, or 0.59% of total loans, at September 30, 2017. These changes are discussed in greater detail under the Lending and Credit Management section below.

 

Non-interest income increased $143,000, or 6.6%, for the three months ended September 30, 2018 compared to the three months ended September 30, 2017, and increased $218,000, or 3.3%, for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017. These changes are discussed in greater detail under the Non-interest Income and Expense section below.

 

Investment securities gains, net of $50,000 and $256,000 were recorded for the three and nine months ended September 30, 2018 compared to zero for both the prior comparative periods ending September 30, 2017. Securities gains for the three and nine months ended September 30, 2018 included gains realized from a series of short term sales of U.S. Treasury securities with repurchase agreements in order to generate capital gains to offset capital losses expiring in 2018 and 2019.

 

Non-interest expense increased $122,000, or 1.2%, for the three months ended September 30, 2018 compared to the three months ended September 30, 2017 and increased $1.3 million, or 4.4%, for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017. These changes are discussed in greater detail under the Non-interest Income and Expense section below.

 

Average Balance Sheets

 

Net interest income is the largest source of revenue resulting from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the periods ended September 30, 2018 and 2017, respectively.

 

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   Three Months Ended September 30, 
(In thousands)  2018   2017 
       Interest   Rate       Interest   Rate 
   Average   Income/