Hawthorn Bancshares, Inc.
Annual Report 2012

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(DL^9/9 2012 ANNUAL REPORT TO SHAREHOLDERS HAWTHORN BANCSHARES, INC. Jefferson City, Missouri April 1,2013 Dear Investors: Hawthom Bancshares, like the general banking sector, is recovering slowly. Income levels, while positive, have not been restored to pre- recession levels; but I am pleased to report that a recovery, albeit slow, is nonetheless occurring.. For 2012, Hawthom reported a net profit of $2.8 million compared to $2.9 million for 2011. Despite a slightly lower net profit, income available to common shareholders improved for 2012 to Sl.O million compared to $0.9 million for 2011 due to our $12 miUion partial repayment of debt associated with the U.S. Treasury's'Capital Purchase Program (commonly called TARP). On a per share basis, this equates to a net profit of $0.21 per common share for 2012 compared to $0.18 for 2011. Looking at our net interest margin from a historical perspective, net interest income has consistently exceeded $40 million since 2009 while asset levels trended slightly lower. Essentially, Hawthorn's core operations remain sfrong as our net interest margin continues to fare well in comparison to our peers. With the historically low rate environment and growing competition for quahty loans, the entire banking industry is experiencing margin pressure and while Hawthom is experiencing some compression, the margiii for 2012 remained healthy. On a tax equivalent basis, Hawthom's net interest margin for 2012 was 3.83%"compared to 3.92% for 2011 but exceeded our peer group's margin for 2012 of 3.69%. The lower net interest margin for 2012 was primarily the result of reduced eaming asset yields, while the volume of eaming assets remained relatively steady. Non-interest income for 2012 was $9.7 million compared to $9.2 million for 2011. The increase is primarily the result of a $ 1.5 milhon increase in the gain on sales of mortgage loans due to higher real estate refinancing activity experienced during 2012 which was partially offset by a $0.5 million decrease in real estate servicing income related to changes in the fair value of mortgage servicing rights. T^on-interest expense for 2012 was $38.7 million compared to $36.8 million for 2011. The largest contributors to the increase were salary and benefit expenses related to opening a lending center in Liberty, Missouri and additional support staff. Non-performing loans decreased $14.3 million to 4.65% of total loans at December 31, 2012, from 6.37% at December 31; 20fl. During the year, net charge-offs were $7.9 million compared to $12.3 million for 2011. The allowance for loan losses at December 31, 2012 was $14.8 million, or 1.75% of outstanding loans, and 37.7% of non-performing loans compared to December 31, 2011, where the allowance:for loan losses was $13.8 million,:or 1.64% of outstanding loans, and 25.7% of non-performing loans. As we evaluate our loan portfolio, we are not seeing the same level of significant deterioration in our customers' circumstances that we have seen in the recent past. A significant portion of our reserves is allocated to loans of customers who are working through their financial problems but have seen deterioration in the value of their collateral. On May 9, 2012, a $12 million partial repayment was made on the U.S. Treasury's Capital Purchase Program (commonly call TARP) fiinds of $30.3 milhon. Plans are underway to repay without the need to raise additional capital the remaining $18.3 million debt prior to the December 2013 time frame when the interest rate on the TARP funds increases from 5% to 9%. At December 31, 2012, Hawthom's capital measurements exceeded regulatory "well-rnanaged" thresholds despite slight reductions related to the aforementioned $12 million partial repayment. It is ariticipated that the capital le'vfels will continue to exceed'Veil-managed''levels even after repaying the r e ^^ I am certainly not pleased with a 0.24% retum on average assets and a 1.40% retum on average common equity. 'We can, and will, do better! As a shareholder, director and executive officer, I am committed to maintaining strong asset quality, improving eamings performance, sustaining sound and proper capital levels and paying regular di-vidends. I am confident that our Company's 2013 profitability will improve as repayment ofthe Company's debt occurs and fiirther sttengthening in asset quality is achieved. David T. Tumer, Chairman & Chief Executive Officer A WORD CONCERNING 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, Hawthom 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," "estunates," "intends" or shnilar expressions. Forward-looking statements' are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual resuhs may differ materially from those contemplated by the forward-lookmg statements due to, among others, the following factors: • . • "icompetitive 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 loans and other assets, •' increases in non-performing assets in the loan portfolios and adverse economic conditioris may necessitate mcreases to the provisions for loan losses, • costs or difficulties related to the integration ofthe business of the Company and its acquisition targets may be greater than expected, • • < engaged, and legislative or regulatory changes may adversely affect the business in which the Compiany and its subsidiaries are • • " ' • changes may occur in the securities markets. The Dodd;Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, was enacted on My 21, 2010. Provisions ofthe Act address many issues including, but not limited to, capital, interchange fees, comphance and risk management, debit card overdraft fees, the establishment of a new consumer regulator, healthcare, incentive compensation, expanded disclosures and corporate govemance. While many of the new regulations under the Act are expected to primarily impact financial institutions with assets greater than $10 billion, the Company expects these riew regulations could reduce the revenues and increase the expenses in the future. Management is currently assessing the impact ofthe Act and of the regulations anticipated to be promulgated under the Act. We have described under the caption "Risk Factors" in the Annual Report on Form 10-Rfor the year ended December 31, 2012, and in other reports that we file with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statemaits. Other factbrs that we have not identified in this report could also have this effect. You are cautioried not to put undue reliance on any foiward-looking statements, which speak only as of the date they were made. HAWTHORN BANCSHARES, INC. ' '\; MANAGEMENT'S DISCUSSION AND ANALYSIS OF ^ : / ; ; '' CONSOLIDATED FINANCIAL CdNDITlON AND RESULTS OF OPERATIONS Overview ' :.\- • •"•• - • Through the branch network of hs subsidiary bank, the Company provides a broad range of commercial and personal banking services, including certificates of deposit, individual retirement and other time deposit accounts, checking and other demand deposit accounts, interest checking accounts, savings accounts, and money market accounts. The Company also provides a wide range of lending services, ihcliidihg real estate, commercial, installment, and other consumer loans. Other financial services that the Company provides include automated teller machines, tmst services, credit-related insurance, and safe-deposit boxes. The geographic areas in which we provide products and services include the communities in and- surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson and Lee's Summit, Missouri. The Company's primary source of revenue is net interest income derived primarily from lending and deposit taking acti-vities. A secondary source of revenue is investment income. The Company also derives income from trust, brokerage, credit , card and mortgage banking activities and,service charge income. .Much of the Company's business is commercial, commercial real estate development, and mortgage lending: T he Company has experienced soft loan demand in the communhies -within which we operate during the current economic slowdown. The Company's income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancings. . The success of the Company's growth sttategy depends primarily on theability ofthe banking subsidiary t o g e n e r a te an increasing level ofloans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-' interest expenses relative to revenues generated. The Cgmpany's financial performance also depends, in part, on the 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 ofthe Company's growth sfrategy depends on the ability to maintain sufficient regulatory capital levels during periods in, which general economic condhions are unfavorable and despite economic conditions being beyond its conttol. Hawthom Bank (the Bank), 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 frust services. The deposit accounts o f t he 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 ofthe Bank are conducted by representatives o f t he 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 Federal Reserve Board. S E L E C T ED C O N S O L I D A T ED F I N A N C I AL D A TA The following table presents selected consolidated,finaricial information" for the Company as of and for each of the financial-data should be read in conjunction with years in the five-years ended December 3f, 2012. The selected consolidated the Consolidated Financial Statements of the'Company, including the related notes, presented elsewhere herein. Income Statement Data (In thousands, except per share data) Interest income Interest expense Net interest income ProvisionTor loan losses Net interest income after provision for loaii losses Non-interest income Gain on sale of investment securities Total non-interest incoine Non-interest expense Income (loss) before income taxes Income tax expense (benefit) Net income (loss) :..^ Less: preferred stock dividends andaccretion of discount on . prefen-ed stock ., Net income (loss) available to : common shareholders .. .. , . ; ' $ 49,114 $ •- ^ ^ :. 7,905V. : 41,209 •• 8,900 ' 3 2 , 3 09 9,700 26 9,726 38,667 3,368 546 -2,822 1,125 • . 'i' 2012 2011 2010 2009 2008 53,469 $ .. ! 10,853 •"42,616V', 1 1 , 5 23 - ' • ] • • '• 58,739 $ ": 15,753 42,986 63,562,$ ..:22,974:,;^;.: 40,588 ' 8,354 • : 69,715 " •31,093 • '9,200 0 • 9i200 36,845 -^ 3;448 " y' 5 9 1. r.t.;' .o: • •-..:•: 2 , 8 5 7 .' ' 1,513^ " 27,731 10,481,. 0 -10,481 .. ' ,' ' 44,85f • • (6,639) : '"• (3,087). (3,552)-:- 1,513 32,234- ^ •:",'10,702 6 06 ••; , ••' !, " ' ' ^^41,308 >• 36,730 •' 6,812 1,856 4,956 L517 • 477 . " K31,599 '38,116 8,211 • 29,905 9,294 9,297 75,975 (36,773) .(6,146) (30,627) 50 '>> „ . ,: 16 . ;,,,. 659 $ : 1.038 $ - , •• .476 . . • - 8 6 8 $: .;r476 .,, . . . • • ' : :' (5.541) >$: • -; " 9 4 9$ 940 '"'•' ^-''"'' ' 913 $• ' 9 04 1,136$ 1,385 2.962 $ (30^693) ' ' 2 , 2 7 0 $' ' 2;6fe6 . • -•' ' 3,486 ' 3 , 4 8 6 ' '' 33.63% • 105.18% -- NM •• • • 76.64% .. NM _^ ''• ' • '' "• .'' -- 0.21 :$- 0.21 0.-18 $ 0.18 4,839,114 4,839,114 ( f l 5) $ ( f l 5) :> > 4,839,114 ,0.61 $ :0;61 4,839,114 4,839,114 4,839,114 4,839.114 4,839.114 '' (6.31) (6.31) '..,.-' :4,861,'630 ' r'^' 4,861,630:- $ $ Dividends on Common Stock Declared Paid Ratio of total dividends ' declared to net income : P er S h a re D a ta Basic eamings (loss):per common share Diluted eamings (loss) per common share Basic weighted average shares of common stock outstanding Diluted weighted average shares of common stock outstanding NM - not meaningfiil In thousands) 2012 2011 2010 2009 2008 Salance Sheet Data (at year end) Total assets !^ans tavestment securities Total deposits 5ubordinatednotes Federal Home Loan Bank advances [Common stockholders'equity Total stockholders' equity Balance Sheet Data (average balances) Total assets L^ans Investment securities Total deposits Subordinated notes Federal Home Loan Bank advances Common stockholders' equity Total stockholders' equity KeyRatios Earnings Ratios Return (loss) on average total assets Return (loss) on average common stockholders' equity Efficiency ratio (3) Asset Quality Ratios Allowance for loan losses to loans Nonperforming loans to loans (1) Allowance for loan losses to nonperlbrming loans (1) Nonperforming assets to loans and foreclosed assets (2) Net loan charge-offs to average loans Capital Ratios Average stockholders' equity to average total assets Period-end common stockholders' equity to period-end assets Period-end stockholders' equity to period-end assets Total risk-based capital ratio Tier 1 risk-based capital ratio - Leverage ratio , $ $ 1,181,606 846,984' 200,246 991,275 49,486 20,126 74,243 92.220 1,176,384 843,022 220,832 971,767 49,486 27,961 74,245 96,176 0.24 1.40 75.90 $ $ L171,161 '842,931 -^•213,806 958,224 ••• 49,486 28,410 73,258 102J76 1,187,410 ,865,214 209,077 957,965 49,486 42,230 75,390 104,455 ; $ 1,200,172 • 898,472 • -.178,978 946,663- 49,486 66,986 72,647 101,488 $ L236,471 991,614 152,927 956;323 ^ • 49,486 79,317 79,406 107.771 .;v ' $ ' 4,279,699 1,009,104 149,401 955,296 49,486 129,057 78,530 106,418 ( :> $ . 1,236,841 949,457 165,213 . . 967,970 49,486 70,456 80,735 109,323 . $ 1,258,381 1,002,830 $ 151,907^ 977,826.,, 49,486 78,626 79,828 107,938 , 1,251,496 963,252 156,870 914,218 . 49,486 124,025 112,307 113,375 0.24 % (0.29) % 0.39 % (2.45) % 1.15 71.11 (6.86) 83.89 , 3.71 71.61 . (27,33) 160,25 1.75 % 4.65 \ 1.64 %,._ , 6.37 . 1.62 %.- .. 6.27 : 1.49 % 4.27 . .: 1.26 % 2.46 37.70 7.23 0.93 25.73 8T1 1.42 25.87 7.71 1.63 34.94 5.08 0.62 50.94 3.21 0.50 8.18 % , : 8.80 % , 8.84 .%, ,„ 8.58 %. ., 9,06 % ,6.28 7.80 16.83 13.58 10.37 6.26 8.76 18.03 15.16 11.52 6;05 . • ,6.42 8.46 17.05 14.25 11.00 , 8.72 16.49 14.01 11.35 6 . 1 4 "' ,; 8.32 16.01 13.55 ,10.80 , (1) Nonperforming loans consist of nonaccrual loans, troubled debt restructurings, and loans contractually past due 90 days or more and still accruing interest. (2) Nonperforming assets consist of nonperforming loans and foreclosed assets. (3) Efficiency ratio is calculated as non-interest expense as a percentage of revenue. Total revenue includes net interest income and non- interest income. 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 criticalaccounting policies requhe 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 fmancial 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 ofthe Conipany's results of operations, since the apphcation ofthis policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were td change. Further discussion ofthe methodology used in establishing the allowance and the impact ofany associated risks related to these policies on the business operations is provided in Note 1 to the Company's consolidated financial statements and is also discussed in the Lending and Credit Management section below. Many ofthe loans are deemed collatera;! dependent for purposes ofthe measurement ofthe impairment loss, thus the fair value ofthe imderlying 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. Income Taxes Income taxes are accounted for under the asset / liability method by recognizing the amount of taxes payable or refundable for the current period and deferred tax assets and liabilities for future tax consequences of events that have been recognized in the Company's financial statements or tax retums. Judgment is required in addressing the Company's future tax consequences of events that have been recognized in the consolidated financial statements or tax retums such as realization of the effects of temporary differences, net operating loss carry forwards and changes in tax laws or interpretations thereof A valuation allowance is established when ih the judgment of management, it is more likely than not that'such deferred tax assets will not become realizable. In this case, the Company would adjust the recorded value ofthe deferred tax asset, which would result in a direct charge to income tax expense in the period that the determination was made. Likewise, the Company would reverse the valuation allowance when it is expected to realize the deferred tax asset. In addition, the Company is subject to the contmuous examination of its tax retums by the Intemal Revenue Ser-vice and other taxing authorities. The Cbmpariy accrues for penalties and interest related to income taxes in income tax expense. Other Real Estate Owned and Repossessed Assets Other real estate owned and repossessed assets consist of loan collateral that has been repossessed through foreclosure. This collateral comprises of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate owned assets are initially recorded as held for sale at the fair value ofthe collateral less estimated selling costs. Any adjustment is recorded as a charge-off against the allowance for loan losses. The Company relies on external appraisals and assessment of property values by intemal staff In the case of non-real estate collateral, reliance is placed on a variety of sources, including extemal estimates of value and judgment based on experience and expertise of intemal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written dovm to reflect a new cost basis. The write-downs are recorded as other real estate expense. The Company establishes a valuation allowance related to other real estate owned-on an asset-by-asset basis. The valuation allowance is created during the holding period when the fair value less cost to sell is lower than the cost ofthe property. RESULTS OF OPERATIONS ANALYSIS The Company has prepared all ofthe 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 ofassets and liabilities, disclosure of contingent assets aiid habilities at the date ofthe financial statements, and the reported amourits Of revenue and expenses during the reporting period. There can be no assurances that actual results Will not differ from those estirriates. , ' (In thousands) 2012 2011 2010 '12-11 'Il-'IO '12-'ll $ Change ,% Change , 'Il-'IO Net interestincome Provision for loan losses Noninterest income Investment securities gains, net Total noninterest income Noninterest expense Income (loss) before income taxes Income tax expense (benefit) Net income (loss) Less: preferred dividends and accretion of discount Net income (loss) avaUable to common shareholders 3 L .. 41,209$ 8,900 9,700 42,616 $ 11,523 9,200 42,986 $ , 15,255 10,481 : (1,407) $ (2,623) 500 (3-70) (3,732) (1,281) % (3.3) (22.8) 5.4 . ., (0.9) % (24.5) "(12.2) 26 9,726 38,667 - 9,200 36,845 - 10,481 44,851 -: : 26 526 1,822 .i - • • -(1,281) • (8,006) I $ 3,368 546 2.822 $ 1,125 659 3,448 591 2.857 $ 1,513 476 . (6,639) (3,087) (3.552) $ 1,513 476. (80) (45) (35) $ (388) 183 10,087 3,678 6,409 - - NM 5.7 4.9 -2.3, 7.6 (1.2) (25.6) 38.4 % NM. -• (12.2),, (17.9) (151.9) (119.1) (180.4) % - - $ 1,038 $ 868 $ (5,541) $ 170 $ 6,409 19.6 % 115.7 % The Company's consolidated net income of $2,822,000 for the year ended December 3 1, 2012 decreased $35,000 compared to consolidated net income of $2,857,000 for the year ended December 31, 2 0 l l. The Company recorded preferred stock dividends and accretion on preferred stock of $1,784,000 for the year ended December 31, 2012, resulting in $1,038,000 of net income available for common shareholders compared to $868,000 of net income available for common shareholders for the year ended December 3 1, 2 0 11 Diluted eamings per share increased fi-om $0.18 per common share for the year ended December 31, 2011 to $0.21 per common share for the year ended December 31, 2012. On May 9, 2012, the Company redeemed 12,000 ofthe 30,255 shares of preferred stock issued under the U.S. Treasury's CPP program. Related to these shares was an additional $300,000 of accretion that was recognized at the time ofthe redemption. The Company's net interest income, on a tax equivalent basis, decreased $1,466,000, or 3.4%, to $41,759,000 for the year ended December 31, 2012 compared to $43,225,000 for year ended December 31, 2011. This decrease was primarily due to a 9 basis point decrease in the net interest margin from 3.92% for 2 0 11 to 3.83% for 2012 and a year over year decrease in average eaming assets of $15.3 million, or 1.4%. The provision for loan losses decreased $2,623,000, or 22.8%, from the year ended December 3 1, 2011 to December 3 1, 2012 due to reduced levels of nonperforming assets and lower net charge-offs in 2012 compared to 2011. Total noninterest mcome increased $526,000, or 5.7%, for the year ended December 31, 2012 compared to December 31,2011 primarily due to a $1.0 miUion mcrease in gain on sales of mortgage loans partially offset by a $0.5 milhon decrease in mortgage servicing income related to changes in the fair value of mortgage servicing rights. Noninterest expense increased $1,822,000, or 4.9%, from the year ended December 31, 2011 to 2012. Included in this increase was a $1,183,000 increase in salaries and employee benefits and a $400,000 increase in processing expense. The $45,000 decrease in income tax expense includes a $371,000 immaterial correction of a prior period error. For the year ended December 31, 2012, the retum on average assets was 0.24%, the retum on average common stockholders' equity was 1.40%, and the efficiency ratio was 75.9%. The Company's consolidated net income of $2,857,000 for the year ended December 31, 2011 increased $6,409,000 compared to a net loss of ($3,552,000) for the year ended December 31, 2010. The Company recorded preferred stock dividends and accretion on preferred stock of $1,989,000 for the year ended December 31, 2011, resulting in $868,000 of net income available for common shareholders compared to a net loss of ($5,541,000) for the year ended December 3 1, 2010. Diluted eamings per share increased from ($1.15) per common share to $0.18 per common share. The Company's net interest income, on a tax equivalent basis, decreased $432,000, or 1.0%, to $43,225,000 for the year ended December 31, 2011 .7 compared to $43,657,000 for the year ended December 31, 2010 primarily due to a $54.1 million decrease in average eaming assets offset by a 14 basis point improvement in the net interest margin from 3.78% in 2010 to 3.92%.in 2011. The provision for loan losses decreased $3,732,000, or 24.5%, from December 31, 2010 to December 31, 2011 Other real estate expenses and impairment losses incurred on foreclosed properties decreased from. $9,804,000,for the year ended December 31,, 2010 to $2,736,000 for the year ended December 31, 201 i t he Company had recorded a $6,158,000 valuation allowance for otherreal estate owned during the fourth quarter of 2010 that had.significantly increased noninterest expense. The Company's net interest income, on a tax equivalent basis, decreased $432,000, or 1.0%, to $43,225,000 for the year ended December 31, 2011 compared to $43,(557,000 for the year ended December 31,'2010 primarily due to a $54,149,000 decrease in average eaming assets. For the year ended December 31, 2011, the retum on average assets was 0.24%, the return on average common stockholders' equity was 1.15%, and the efficiency ratio was 71.1%. Total assets at December 31, 2012 were $1,181,606,000, compared to $1,171,161,000 at December 31, 2011, an increase of $10,445,000, or.0.9%. On July 1, 2012, the Company distributed ^a four percent stockdividend for the fourth consecutive year to common shareholders of record at the close ofbusiness on June 15, 2012. For all periods presented, share information, including basic and diluted eamings per share, has been adjusted retroactively to reflect the stock dividend: Net Interest Income Net interest income is the largest source of revenue resulting from the Company's lending, investing, borrowing- and deposh 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.' Average Balance Sheets x The following table presents average balance sheets, net interest income, average yields of eaming assets, average costs ofinterest bearing liabihties, net interest spread and net interest margin on a ftilly taxable equivalent basis for' each ofthe- years in the three year period .ended December 31,2012. ;l • (In thousands) ASSETS Loans: (2) (4) Commercial Real estate construction - residential Real estate construction - commercial Real estate mortgage - residential $ 127,035 $ .-21,471- - 43,224 219,045 6,621 1,196 1,872 11,719 Real estate mortgage - commercial 404,462 - 20,856 • Consumer Totalloans Investment securities; (3) U.S. treasury Govemment sponsored entoprises Asset backed securities State and municipal 27,785 $ 843,022$ $ , • 2,048 $ 70,787 113,749 34,248 Total investment securities $ 220,832 $ 4,287 1,798 44,062- 33 998 ' 3,025 1,398 5,454 102 2012 Interest Income/ Average Balance Expensed) Rate Earned/ Paid(l) Average Balance 2011 Interest Income/ Rate Earned/ Exnensed) Paidd) 2010 Interiest Rate Income/ Earned/ Esoensed) Paid(l) Average Balance 5.20 % $ ' 127,572" $ - 6,952 5.45 ./. $ 139,679 $ 5.56 ' , 30,171 1,704 2,255 50,374 r 203,587 '• - 11,619 •423,682 29,828 • 22,884 2,057 5.65 4.48 5.71 5.40 6.90 4.32 5.30 -5.14 •' 6.45 37,954 75,207 •. 7,739' 1,959 2,904 221,545 440,285 34,787 • 12,672 25,309 ' 2,626 5.54../. 5.16 3.86, 5.72 5.75 . 7.55 . 5.60 % 5.21 ./. $ 865,214 $ 47,471 ..• 5.49;./. $ ,949,457 $ . . 53,209 , 1.61 %.$ 1,754 $ 29 1.65 % $ . , f 790 $ 1.41 .2.65 4.07 63,089., 111,859 3,551 ..:3.17 • 32,375 •.,. 1,573 :: 4.86 1,240 > - 1.97 - 47,914 2.46 % $ 209,077 $ 2.37 5,091 117 6,393: 156 3.06 ./. $ 165,213 $ 3.06 15 1,242 2,918 1,764 5,939 1.90 % 2.59 . . 3 . 51 5.30 • 3.59 %, 176 2.77 83,237 33,272 6,356 187 34,680 18,207 46 0.25 22,245 58 $ 1,086,396 $ 49,664 4.56 % $ 1,101,744 $ 54,078 0.26 4.91 % $ 1,155,893 $ 59,410 0.25 5.14 ./. 105,129 (15,141) ,, 99,216 (13,550) - : $..^ 1,176,384 .- - . . - $ 1,187,410 .' 94,802 (13,854) $ 1,236,841 636 - 74 436 1,111 3,715 5,972 • 21 1,381 531 1,933 7,905 •$ 181,422 $ 66,569 - 153,388 129,165 277,337 $ 807,881 $ 23,280 49,486 27,961 $ •$ 100,727 $ 908,608 $ 163,886 7,714 1,080,208 96,176 0.35 % $ 175,347 $ 0.11 •0.28 0.86 1.34 60,582 , 153,672 131,175 291,842 911 125, 608 1,663' 5,124 0.21 0.40 1.27 1.76'- 0.52 % $ 167,303 $ 52,605 167,240 130,493 ' 2,485 1.90 318,891 ' • 7,211 • 2.26 ' 960 131 1,080 0.57 % 0.25 0.65 0.74 % $ 812,618 $ ' 8,431 1.04 % $' 836,532 $ 11,867 1.42 % 0.09- 2.78 1.89 - 27,636 , 49,486 •'• 42,230 1.91 % $ 119,352 $ • 47 1,301 1,074 2,422 0.87 % $ 931,970 $ 10,853 0.17 2.63 2.54 2.03 1.16 % % $ $ • 32,723 • 75 49,486 . •. 1,526 70,456 . 152,665 $ 2,285 3,886 989,197 $ 15,753 0.23 3.08 3.24 2.55 ./. 1.59 % 145,347 5,638 1,082,955 104,455 131,438 6,883 1,127,518 109,323 $ 1,176,384 $ 1,187,410 $ 1,236,841 41,759 43,225 43,657 3.69 % 3.83 % 3.75 3.92 % % . 3.55 % 3.78 % Restricted investments Federal funds sold Interest bearing deposits in other financial institutions Total interest earning assets All other assets Allowance for loan losses Totalassets LIABILITIES AND STOCKHOLDERS' EQUITY NOW accounts Savings Money market Time deposits of $100,000 and over Other time deposits Total time deposits Federal' fimds purchased and securities sold under agreements to repurchase ' • Subordinated notes Federal Home Loan Bank Advances Total borrowings Total interest bearing liabUities Demand deposits Other liabilities Total UabiUties Stockholders' equity Total liabilities and stockholders' equity Net interest income (FTE) Net interest spread Net interest margin (1) Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $550,000, $610,000 and $671,000 for the years ended December 31, 2012, 2011 and 2010, respectively. (2) Non-accruing loans are included in the average amounts outstanding. (3) >i Average balances based on amortized cost. (4) Fees and costs on loans are included in interest income. Comparison of the Years ended December 31, 2012 and 2011 Financial results for the year ended December 31, 2012 compared to the year ended December 31, 2011 reflected a decrease in net interest income, on a tax equivalent basis, of $1,466,000, or 3.4%. Average interest-eammg assets decreased $15,348,000, or 1.4%, to $1,086,396,000 for the year ended December 31, 2012 compared to $1,101,744,000 for the year ended December 31, 2011 and average interest bearing liabilities decreased $23,362,000, or 2.5%, to $908,608,000 fpr the year ended December 31,2012 compared to $931,970,000 for the year ended December 31, 2011. Average loans outstanding decreased $22,192,000 or 2.6% to $843,022,000 for'the year ended December 31, 2012 compared to $865,214,000 for the year ended December 31, 2011. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio. Average investment securities and federal funds sold increased $11,686,000, or 5.6% to $220,880,000 for the year ended December 31, 2012 compared to $209,194,000 for the year ended December 31,2011. Average interest bearing deposits in other financial institutions decreased $4,038,000 to $18,207,000 for the year ended December 31, 2012 compared to $22,245,000 for the year ended December 31, 2011. See the Liquidity Ma«age/ne«? section for further discussion. Average time deposhs decreased $4,737,000, or 0.6%, to $807,881,000 for the year ended December J l, 2012 compared to $812,618,000 for the year ended December 31, 2011. Average borrowings on Federal Home Loan Bank advances decreased $14,269,000 to $27,961,000 for the year ended December 31, 2012 compared to $42,230,000 for the year ended December 31, 2011. See the Z/'^M/WzXy Ma«ageff2e«? section for further discussion. -Comparison of the Years ended December 31,2011 and 2010 Financial results for the year ended December 31, 2011 compared to the year ended December 31, 2010 included a decrease hi net interest income, on a tax equivalent basis, of $432,000, or 1.0%. Average interest-eaming assets decreased $54,149,000, or 4.7% to $1,101,744,000 at December 31, 2011 compared to $1,155,893,000 at December 31, 2010 and average mterest bearing liabilities decreased $57,227,000, or 5.8%, to $931,970,000 at December 31, 2011 compared to $989,197,000 at December 31, 2010. Average loans outstandmg decreased $84,243,000 or 8.9% to $865,214,000 at December 31, 2011 compared to $949,457,000 at December 31, 2010. See the Lending and Credit Management section for further discussion of changes in the composition ofthe lending portfolio. Average investment securities and federal funds sold increased $43,794,000 or 26.5% to $209,194,000 at December 31, 2011 compared to $165,400,000 at December 31, 2010. Average interest bearing deposhs in other financial institutions decreased $12,435,000 to $22,245,000 at December 31, 2011 compared to $34,680,000 at December 31, 2010. See the Z,j^MM(FM?nagemeKf section for fiirther discussion. Average time deposhs decreased $23,914,000 to $812,618,000 at December 31, 2011 compared to $836,532,000 at December 31, 2010. Average borrowings decreased $33,313,000 to $119,352,000 at December 31, 2011 compared to $152,665,000 at December 31, 2010. The decrease in average borrowings primarily reflects a net decrease in Federal Home Loan Bank advances. See the Liquidity Management section for further discussion. 10 Rate and volume analysis The foUowing table summarizes the changes in net interest income on, a fully taxable equivalent basis, by major category ofinterest eaming assets and interest bearing habihties, indentifying changes related to volumes and rates for the years ended December 31; 2012, compared to December 31, 2011 and for the years ended December 31, 2011 compared to December 31, 2010. The change in interest due to the combined rate/volume variance has,been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each. ; 2012 Change due to 2011 Change due to i Total Change Average Volume Average Rate Total Change Average, Volume Average / Rate (302); (23) (71) (752) (1,014) (123) (1) (380) (585) (262) (31) - I : (1)^ (3,545)' (307) . (62) (171) ,. (527) (1,163) . :., . . $ (331) $ (508) (383) : • 100 (2,028) (259) (29) $ (485) (312) 852 (1,014) (136) 4 (242) .' (526),. (175) (54) - (12) (4,414) (276) ' (51) (172) (552) ,(1,408),,;.; , ;, (26) 80 (543). (2,948)- 5 138 . 59 87 (23) - (11) (869) 31 11 (1) (25) (245) (6) - (310). (545) $ " (787), $ (255) (649) (1,053) (2,425) (569) (662). $ (428) (1,062) (1,025) (932) :. (354)' (125) 173 ,413 . (28).,. (1,493) (215)- , 14 (2) 633 (191) (20) - (28) (5,332) (49) (6) (472) (822) (2,087) , 15 339 929 ', (47) (37) (32) (3,296) -,' 45 18 (82) 13 (574) (^1) - (787) (1,378) . . , ' (1)., (341) :, ; (296) = . (144) 17 ' - • 4 (2,036) (94) (24)., . ,, (390), (835) ,. ; (1,513); -: . (17) (225) (424) (3,522) ^ (20) 80 ••. (233) (2,403)i , (28) (225) (1,211) (4,900) (In thousands) Interest income on a fully taxable equivalent basis: (1) Loans: (2) (4) Commercial Real estate construction - residential Real estate construction - comriiercial Real estate mortgage - residential Real estate mortgage - commercial Consumer Investment securities: (3) U.S. treasury Government sponsored entities Asset backed securities State and municipal Restricted investments Federal funds sold Interest bearing deposits in other financial institutions Total interest income Interest expense: NOW accounts Savings Money market Time deposits of $100,000 and over Other time deposits Federal fimds purchased and . , securities sold under agreements to repurchase Subordinated notes Federal Home Loan Bank advarices Total interest expense Net interest income on a fully taxable eanivalent basis $ (1.4661$ (324)$ ; ^ (1.142) S (432) $ (1.918) $ 1.486 (1) Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $550,000, $610,000 and $671,000 for the years ended December 31,2012,2011 and 2010, respectively. (2) Non-accruing loans are included in the average arnounts outstanding. (3) Average balances based on amortized cost. (4) Fees and costs on loans are included in interest income. ' Net interest income on a fully taxable equivalent basis decreased $1,466,000, or 3.4%, to $41,759,000 for the year ended December 31, 2012 compared to $43,225,000 for the year ended December 31, 2011, and followed a $432;000, or 1.0%, decrease for the year ended December 31, 2011 compared to the year ended December 31, 2010. Measured as a percentage of average eaming assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.83% for the year ended December 31, 2012 compared to 3.92% for the year ended December 31, 2011, and increased compared to 3.78% for the 11 year ended December 31,2010. The decrease in net interest income was primarily the result of lower interest uicome eamed on loans due to lower average balances and lower average rates. The Company's net interest spread decreased to 3.69% for the year ended December 31, 2012 from 3.75%'for the year ended December 31, 2011, andincreased compared to 3.55% for the year ended'December 31, 2010. Whhe theCompany was able to decrease the rates paid on mterest bearing liabilities to 0.87% for the year ended December 31, 2012 from 1.16% for the year ended 2011, and 1.59% for the year ended 2010, this decrease was partially offset by the decrease in the rates eamed on interest eaming assets to 4.56% for the year ended December 31, 2012 from 4.91% in 2011, and 5.14% in 2010. Interest expense incurred on deposits and other borrowings decreased $2,948,000 from the year ended December 31, 2012 compared to the year ended December 31, 2011, and decreased $4,900,000 from the year ended December 31, 2011 compared to the year ended December 31, 2010. Effective January 1, 2012, the Company recorded a $368,000 credit to interest expense on time deposits for imputed interest calculated on capitalized interest not accounted for durhig the time period of 2004 through 2011 on the constraction ofthe Company's new bank buildings. This is considered a correction of an immaterial prior period error. Without this credh to interest expense, rates paid on interest bearing liabilities would have been approximately 0.91% for the year ended December 31, 2012. Non-interest Income and Expense Non-interest income for the years ended December 31, 2012, 2011 and 2010 was as follows: (In thousands) N o n - i n t e r e st I n c o me Service c h a r g es on d e p o s it a c c o u n ts T r u st d e p a r t i n e nt i n c o me Gain on s a l es of m o r t g a ge l o a n s, n et Gain on sale of i n v e s t m e nt s e c u r i t i es O t h er T o t al n o n - i n t e r e st i n c o me Non-interest income as a % of total revenue * Total revenue per full time equivalent employee 2 0 12 2 0 11 2 0 10 • 1 2 - ' ll ' I l - ' IO ' 1 2 - ' ll •11 I-'IO $ C h a n ge % C h a n ge $ $ 5,439 893 2,669 26 699 9.726 $. i • 5,566 898 1,649 0 1,087 9,200 $ s 5,554 803 2,493 0 1,631 10,481 $ • •• ( 1 2 7) $ ^ (5) 1,020 26 (388) 526 s $ 12 95 (844) 0 (544) (1.281) % . • (2.3) (0.6) 61.9 NM (35.7) • 5.7 % '.;.. 0.2 % 11.8 (33.9). NM ••(33.4) (12.2) % 19.1 % 17.8 % 19.6 % $ 147.6 $ 153.8 $ 157.3 * Total revenue is calculated as net interest income plus non-interest income. NM - not meaningful '^ . ' " ' ' " ] . ' .% On January I, 2012, the Company opted to measure mortgage servicing rights at fair value as permitted by Accounting Standards Codification (ASC) Topic 860-50 Accounting for Servicing Financial Assets. The election ofthis option resulted in the recognition of a cumulative effect of change m accounting principle of $459,890, which was recorded as an increase to beginning retamed eamings, as further described in Note 6 to the consolidated financial statements.- As siich, effective January 1, 2012, the change in the fair value of mortgage servicing rights is recognized in eamings as other noninterest income for the period in which the change occurs. Years Ended December 31,2012 and 2011 Noninterest income increased $526,000 or 5.7% to $9,726,000 for the year ended December 31, 2012 compared to $9,200,000 for the year ended December 31, 2011. t he increase was primarily the result of a $1,020,000 increase on gam on sales of mortgage loans, net partially offset by a $453,000 decrease in the real estate servicing income recorded in other noninterest income. As a result ofthe changes in fair value during the year ended December 31, 2012, $878,000 was earned in real estate service fees, $122,000 was recorded in real estate servicing income due to changes in model inputs and assumptions, and ($915,000) was recorded due to other changes m fah value resulting from customer payments and passage of time. This is m comparison to the year ended December 31, 2011 in which $863,000 was eamed in real estate servicing fees and $808,000 of MSR amortization was recorded. The Company's loans sold increased from $75,000,000 for the year ended DecemberSl, 2011 to $100,000,000 for the year ended December 31, 2012. As mentioned above, due to low, interest rates, an increase in refinancing activity impacted both the volume ofloans sold and gains recognized. The Company was servicing $310,000,000 of mortgage loans at December 31, 2012 compared to $307,000,000 at December 31, 2011. During 2012, the Company received $790,000 from proceeds on sales of available-for-sale debt securities and recognized a $26,000 gain on sale! 12 Yeiars Ended December 31,2011 and 2010 Nonmterest mcome decreased $1,281,000 or 12.2% to $9,200,000 for 2011 compared to $10,481,000 for 201().:'the decrease was primarily the result of an $844,000 decrease in the gains on sales of mortgage loans and a $544,000 decrease in other income. The Conipany's loans sold decreased from $107,000,000 fOr 2010 to $75,000,000 for 2011, A decrease in refinancing activity impacted both the volume ofloans sold and gains recognized. The Company was servicing $307,000,000 of mortgage loans at December 31, 2011 coriipared to $298,000,000 at December 31, 2010. t he .decrease in other noiimterest income was primarily due to a $268,000 refiind of prior year's processing fees received in 2010 and a $139,000 decrease m credhcardmcomcTheCompanyliadnosalesofdebt secm-itiesdurmg2011 or2010. ,, - Non-interest expense for the years ended December 31, 2012,2011, and 2010 was as follows: ;.,; 2 0 12 2 0 11 2 0 10 ' 1 2 - ' ll • I l - ' IO , ' 1 2 - ' ll •11-UO $ Change % Change (In thousands) N o n - i n t e r e st Eitpense. Salaries Employee benefits O c c u p a n cy e x p e n s e, net F u m i t u re and equiprhent ejqjense FDIC i n s u r a n ce a s s e s s m e nt Legal, exarriination, and p r o f e s s i o n al fees A d v e r t i s i ng aiid promotion • P o s t a g e, printing,iandi. supplies P r o c e s s i ng e x p e n se Other real estate e>q>ense O t h er Total n o n - i n t e r e st e x p e n se Efficiency ratio Salaries and benefits as a % of total n o n - i n t e r e st expense N u m b er of full-time $ ' 14,368 ' 4,797 ; 2 , 5 9 8' $, ' 13,760 .•4,222 2;70t' $ 13,904 3^995 2,532 $ 608 $ •' 1,840 993 2,019 1,107 1,189 1,083 Y' ; 1,332 ' 1,103 1,144 3,593 2,937 4,125 38,667 $ 1,158 3,193 2,736 3,514 36.845 $ ,, 75.9 % 71.1 $ %' 1,997 1^651 1,441 1,256 1,201 3,353 9,804 3,717 44,851 83.9 $ % 49.6 % 48.8 %"'" 39.9 % (144) 227:: 169 ,4.4 % 13.6 (3.8) , 22 (8.9) , ., • „ -, ' , ( 1 . 0 )% ' , ' " •• 5 .7 6.7 1.1 . .(544) J ^ ^ '^ , ; ( 3 2 . 9) , (109) (153) *• (43) (160) (7,068) (203) (8.006) (io;7) • (1.8) (7.6), (i2.2)^;-'' ,'••:, (1.2) • ..r n .5 7.3 17.4 , 4.9 % (3.6) •-•:c(4.8)„ ,> (72.1) :. (5.5) (17.9) % . 575 (103) (179) .0' :,. (114) 0 (143) (20) 0 (14) 400 201 611 1,822 $ , equivalent employees 1 345 , 3 3 7. 340 Totaf noninterest expense increased $1,822,000, or 4.9%, to $38,667,000 for the year ended December 31, 2012 compared to the year ended December 31^ 2011, and decreased $8,006,000, or 17.9%, to $36,845,000 for the year ended December 31, 2011, compared to $44,851,000 forthe year ended December 31, 2010. Salary expense increased $608,00(), pr 4.4%, for the year ended December 31, 2012 compared to the year ended December 31, 2011, and decreased $144,000, or 4.,4%, for the year ended December 31, 2011 compared to the year ended December 31, 2010. The number of full-time equivalent employees increased from 337 at DecemberSl, 2011 to 345 at December 31, !2012 partly due to opening a new lending location in Liberty, Missouri in, May of 2012 as well as hiring additional support personnel in loan operations departments. Employee benefits increased $575,000, or 13.6%, for the year ended December 3.1, 2012 cornpared to the year ended- December 3l, 2011, and increased $227,000, or 5.7%, for the year ended December 31, 2011 compared to the year ended December 31, 2010. The increase in the year ended 2012 oyer 2011 mduded a $95,000 increase in medical insurance premiums, a $68,000 increase in other employee benefits; and a $382,000 increase in esthnated profit sharmg and pension expense accruals.. The increase in the year ended 2011 over 2010 included a $132,000 increase in medical insurance premimhs, a $I5,00() increase in estimated profit sharing and pmsion accruals, and a $88,000 increase in other employee benefits. ; Federal Deposit Insurance Corporation (FDIC) insurance assessment decreased $114,000, or 10.3%, for the year ended December 31, 2012 compared to the year ended December 31, 2011, and decreased $544,000, or 32.9%, for the year ended December 31, 2011 compared to the year ended December 31, 2010. The decrease in FDIC insurance assessments was due to amendments made by the FDIC effective for the third quarter of 2011 to implement revisions to the Federal Deposh Insurance Act made by the Dodd-Frank WaH Sfreet Reform and Consumer Protection Act. The years ending after September 30, 2011 reflect a new assessment base using assets and tier one capital in the assessment calculation. . 13 .' • , ' ended December 31. QQO of piope'^^^'^ , * ^ ' ^ ^ ? f 7 4 T o o S ^ ^ f ° ^ * ' ^ "' $1,068,^41,uw i 7012 provision tor 1 . . ,, for loan losses « f \ ' f 4 %0 decrease mspe^^^^^^ $1,84/., gnaents, . . owned 01'!> ' " - -4 .,cihies. .,. .. - . , - 14 Comparingfourthquarter2012tofourth quarter 2011 The Company's net income available to common shareholders' of $1,90{),000 for the fourth quarter ended Deceniber 31, 2012 increased $3,422,000 compared to a net loss of ($1,522,000) for the fourth quarter ended December 31, 2011. Net mterest income decreased to $10,100,000 from $10,549,000 over the same period. This decrease was primarily the result of a decrease in average mterest eammg assets from $1,081,924,000 for the fourth quarter ended December 31, 2011 to $1,068,741,000 for the fourth quarter ended December 31, 2012. The fourth quarter 2012 provision for loan losses of $1,000,000 was $4,880,000 lower than fbtirth quarter 2 0 l i 's provision of $5,880,000 and was based upon management's determination ofthe loan loss reserve required to cover probable losses in the loan portfolio at year-end. Noninterestdncome of $2,633,000 for fourth quarter 2012 increased $21,000:from fourth quarter 2011's noninterest mcome Of:$2,612,000. This increase was primarily the resuh of gains on sales of mortgage loans that increased $141,000 to $896,000 for the fourth quarter of 2012 from $755,000 in the fourth quarter of 2011. The Company's loanssold were $30,255,000 for three months ended December 31, 2012 compared to $31,491,000 forthe three montiis ended December.31, 2011. Noninterest expense of $8,711,000 for fourth quarter 2012 decreased by $823,000 from fourth quarter 2blt's noninterest expense of $9,534,000. This decrease primarily resulted from a $1,617,000 decrease in other real estate expenses from $1,171,000 for the three months ended December 31, 2011 to $(446,000) for the three months ended December 31,2012, The decrease prirnarily resulted from a $1,699,000 decrease to the provision for. the valuation allowance for other real estate owned. A current appraisal supported a partial recovery of $3,908,000 of a $5,663,000 provision on a commercial real estate construction property taken in 2010. Income taxes , , Income taxes as a percentage of eamings > (loss) before. mcome taxes as reported in the consolidated financial statements were 16.2% for the years ended December 31, 2012 compared to 17.2% for the year ended December 31, 2011, and 46.5%) for the year ended December 31, 2010. Excluding an immaterial correction of a prior period error of $371,000,' and prior, year retum to provision adjustments, income taxes as a percentage of eamings before income taxes were 26.3% in comparison to 17.2% forthe years ended December 31, 2012 and 2011, respectively. Af December 31, 2010, total accrued interest was $31,000 and total interest expense recognized for the year ended December 31, 2010 was $24,000. At December 31, 2011, the Company released $28,000 of interest accrued related to the release of $221,000 of uncertain tax provisions, and as of December 31, 2012, the Company had not recognized any tax liabilities or any interest or penalties in mcome tax expense related to uncertain tax positions. Lending and Credit Management 70.4% of total assets as of December 31,2012 compared to 70.8% as of December 31,2011. Interest eamed on the loan portfolio is a primary source of interest income for the Company. Net loans represented : • Lending activities are conducted pursuant to an established loan policy approved by the Bank's board of directors. The Bank's credit review process comprises of regional loan committees with established loan approval limits. In addition, a senior loan committee reviews all credit relationships in aggregate over anestablished dollar amount. The senior, loan committee theets , weekly and comprises of senior managers ofthe Bank. '.• _ '' A summary ofloans, by major class withm the Company's loan portfolio as ofthe dates indicated is as follows: (In thousands) " 2012 2011 2010 2009 2008 Commercial, financial, and agricultural Real estate constmction - residential Real estate construction - commercial Real estate mortgage - residential Real estate mortgage - commercial Installment loans to individuals , Totalloans , $ ._ $ 130,040- $ 22,177 .43,486 221,223 405,092 24,966 846,984 $ 128,555 $ 30,201 47,697 203,454 402,960 30,063 842.930 S 151,399 $ 38,841 77,937 232,332 453,975 37,130 991.614 S 153,386 $.^^:. 49,623 80,016 235,834 456,696 . 33,548 1.009.103 S 151,488 0 147,432 210,458 365,094 36,806 911,278 15 The Company's loan portfolio increased $4,054,000 from December 31; 2011 to December31, 2012. During the year ended December 31, 2012 there were no significant increases in loan demand. The Company did experience an increase in refinancing during this time period due to low interest rates available for real estate mortgage residential properties. Also, during the first quarter of 2012 approximately $10,000,000 of real estate construction - residential loans were reclassified to real estate mortgage - residential loans due to the completion of the constmction phase. The State's economy as a whole has exhibited recent improvement from the recessionary lows of 2010 and 2011 but continues to be considered weak. State government spending has remained relatively constant over the last year but below pre- recession levels which hurts our cenfral region. Branson, while having good holiday weekends, is still sfruggling. NationaUy, unemployment has improved over the last year but remains high at 7.8% while Missouri's unerhployment rate is better at 6.6%. The stock market has exhibited recent sfrength having set record high levels for the DOw Jones Industiial Average however there is growing concem that theselevels cannot be maintamed unless the economy begins to grow more, than the recent 1.0% - 1.5% quarterly averages. The US FHFA House Price Index fOr December 2012 indicates house prices nationwide have increased 5.5% over the. last four quarters but remainl2.9% below the 2007 peak. For Missouri, the HPI data indicates prices have increased 4.7% over the last foiu- quarters but remain 8.1% below the 2007 peak. The house price index for Jefferson City indicates a year over year price change of 1.76%, Columbia's change was 1.37%, Kansas City declined by 1.25%) and Springfield increased by 0.61%). Borrowing rates have also remained depressed over the last 36 month analysis period. We anticipate moderate improvement in the next several quarters over the 12-quarter analysis period but growth will remain slow and the economy will continue a modest recovery. Management continues to'focus on the improvement of asset quality by tightening underwrhing standards and focusing on lending to credit worthy borrowers with the'capacity to service their debts. Where appropriate, management actively works with existing borrowers to modify loan terms and conditions in order to assist the borrowers in servicing their debt obligations to the Company. ' ' ' The Company extends credit to its local community market through fraditional real estate mortgage products. The Company does not participate in extending credit to sub-prime residential real estate markets. The Company does not lend funds for the type of transactions defined as "highly leveraged" by bank regulatory authorhies or for foreign loans. Additionally, the Company does not have any concenfrations ofloans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Companydoes not have, any interest-eaming assets that would have been included in nonaccrual, past due, or resfructured loans if such assets were loans. s ;» • The confrEictual maturities of loan categories at December 31, 2012, arid the composition of those loans between fixed rate and floating rate loans are as follows: (In thousands) Commercial, financial, and agricultural Real estate construction - residential Real estate construction - commercial Real estate mortgage - residential Real estate mortgage - commercial Installment loans to individuals Total loans net of unearned income Loans with fixed rates Loans with floating rates Total loans net of unearned income $ $ Principal Payments Due Over One Year Through Five Years ' Over Five Years One Year Or Less 80,994 20,954 •31,080 59,979 143,840 10,151 346.998 $ 44,995 1,223 11,972 86,119 246,507 13,657 404.473 $ 4,051 $ 434 75,125 1,4,745 1,158 95.513 $ , Total 130,040 22,177. 43,486 221,223 405,092 24,9,66 846,984 278,050 68,948 346.998 $ 361U59 43,214 404.473 $ 25,6itl 69,872 95.513 $ 664,950^ 182,034 846.984 The Company generally does not retain long-term fixed rate residential mortgage loans in' its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers, but are nof funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. For the year ended December 31, 2012, the Company sold approximately $100,000,000 ofloans to investors compared to $75^000,000 for the year ended-December 31v2011. At December 31, 2012, the Company was servicing approximately $310,000,000 ofloans sold to the secondary market compared to $307,000,000 at December 31, 2010. 16 Real estate mortgage loans retained in the Company's portfolio generaUy include provisions for rate adjustments at one to five year intervals. Commercial loans and real estate consfruction loans generally have maturhies of less than one year. Installment loans to individuals are primarily fixed rate loans with maturities from one to five years. Risk Elements of the Loan Portfolio Management, the senior loan committee, and intemal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2,000,000 in aggregate and all adversely classified credits identified by management are reviewed. In addition, all other loans are reviewed on a sample basis. The senior loan committee reviews and reports to the board of directors, on a monthly basis, past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impafred. Management follows the guidance provided in the FASB's ASC Topic 310, Accounting by Creditors for Impairment of a Loan, in identifying and measurmg loan impafrment. If management determines that h is probable that all amounts due on a loan will not be collected under the original termsof the loan agreement,' the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and mdustry concenfration. Managehient believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered necessary by management to provide for probablelosses inherent in the loan portfoho. Nonperforming Assets The following table summarizes nonperforming assets at the dates indicated: (In thousands) 2011 Nonaccrual loans: 2012 2010 2009 2008 ! Commercial, financial, and agricultural Real estate construction - residential Real estate construction - commercial Real estate mortgage - residential Real estate mortgage - commercial Installment loans to individuals Total ^ Loans contractually past - due 90 days or more and still accruing: Commercial, fmancial, and agricultural Real estate construction - residential Real estate construction - commercial Real estate mortgage - residential Real estate mortgage - commercial Installment loans to individuals Total Troubled debt restructurings - accruing Total nonperforming loans Other real estate owned Repossessions Total nonnerforming assets Loans Allowance for loan losses to loans Nonperforming loans to loans Allowance for loan losses to nonperforming loans Nonperforming assets to loans and foreclosed assets $ ^ '1,335 $ • • : 2,497 7,762 5,330 13,938 219 31,081 $ 2,068 $ 1,147 7,867 4,153 31,000 168 46.403 $ 3,532 $ 3,586 10,067 5,672 27,604 ' 126 50.587.$ ., 2,067 $ 2,678 9,277 ,6;692 13,161 279 34.154 $ • 2,071 .2,775 . 7;572 ,4,345 3,505 • 119 20,387. - • '• , , $• $ 0 $ 0 0 0 0, • , 6$ 8,282 39,369 23,124 468 62.961 $ 0$ 0 8 9 36 5 4 $ -- 0$ Q 0 0 0 33 33 $ 7,217 • 5,683 " 53,674 15,741 ,279 69,694 $ 56,303 13,393 616 70.312 $ 2$ 0 0 0 0 2 $ - 8,191 42,347 8,452 . 39 50,838$ , 140 0, 52, 0 ,547 - 743 3,736 . 24,866 7,828, • :h 32.694 846,984 $ 1.75 % 4.65 % 842,930 $ 1.64 % 6.37 % 898,472 $ 1.62 % 6.27 % 991,614 $ 1.49 % 4.27 % 1,009,103 1.26 % 2.46 •% 37.70 % 25.73 % 25.87 % 34.94 % 50:94 % 7.23 % g.ll % 7.71 % 5.08 % 3.21 % 17 Total nonperforming assets decreased $6,733,000, or 9.7%, from December 31, 2011 to December31, 2012.. As detahed below, this decrease included a decrease of $15,322,000, or 33.0%,-in nonaccrual loans partially offset by incresases of $1,065,000, or 14.8%, in accruing TDR's and $7,572,000, or 47.3%, in other real estate owned and repossessions. Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing, and froubled debt resttiicturings (TDRs) totaled $39,369,000 or 4.65% of total loans at December 31, 2012 compared to $53,674,000 or 6.37% of total loans at December 31,2011. • •- ; ' It is the Company's policy to discontinue the accrual of interest income on loans when management believes that the borrower's financial condition, after consideration ofbusiness conditions and collection^ efforts, is such that the collection of interest is doubtful, or upon.which principal or interest due has been in default for a period of 90 days or more and the asset is not both well secured and in the; process of collection. Subsequent interest payments received on such loans are applied to principal if any doubt exists as to the collectability of such principal; otherwise, such receiptsare recorded as interest income on a cash basis. Interest.on nonaccrual loans, which would have,been recorded under the original terms of the loans, was approximately $1,198,000 and $1,952,000 for,the.years ended December 31, 2012 and 2011, respectively As of December 31, 2012 and 2011, approximately $ 17,556, OCiO and $11,673,000, respectively, ofloans not mcluded m the nonperforming asset taljle were identified as potential problem loans having more than normal risk which raised doubts as to the ability ofthe borrower to comply with present loan repayhieht terms. Even though borrowers are experiencing moderate cash flow problems as well as some deterioration in collateral value. Management believes the general allovvance was sufficient to cover the risks and probable losses related to such loans, at December 31, 2012 and 2011, respectively. Total non-accmal loans at December 31, 2012 decreased $15,322,000 from December 31, 2011. This decrease primarily consisted of a $17,062,000 decrease in real estate mortgage - commercial non-accraal loans. This decrease was partially offset by a $1,350,000 net increase in real estate construction - residential loans, and a $1,177,000 net increase in real estate mortgage - residential non-accrual loans. The overall decrease in nonaccrual loans primarily resulted from the foreclosure of six commercial real estate loans with balances totaling $14,769,000 at December 31, 2011 that had been in nOnaccmal status. The increase in real estate constmction - residential loans, and real estate mortgage residential loans resulted prirnarily from three significant loan relationships with balances totaling $3,336,000 at December 31, 2012 that were put on non-accrual status during the year. At December 31, 2012, real estate mortgage - commercial non-accrual loans made up 45%) of total non-accrual • ^^ loans compared to 67% at December 31,2011. Loans past due 90 days and sthl accrumg interest decreased $48,000 from $54,000 at December 31, 2011 to $6,000 at December 31, 2012. Foreclosed real estate and other repossessions increased $7,572,000 from $16,020,000 at DecemberSl, 2011 to $23,592,000 at December 31, 2012 primarily due to real estate mortgage - commercial foreclosures. During the year ended 2012, $16,869,000 of nonaccrual loans, net of charge-offs taken, moved to foreclosed assets. Real estate values improved during the year and the Company was able to sell several properties v^dth proceeds totaling $8,571,000 that partially offset the additional properties acquired. Also, during the year the Company had recorded a net $713,000 addhional provision to the valuation allowance that included a $3,908,000 recovery as a resuh of a current appraised value. See Note 3 for additional information. The following table summarizes the Company's TDRs at the dates indicated: (In thousands) TDRs - Accrual Commercial, fmancial and agricultural Real estate mortgage- residential Real estate mortgage - commercial Total TDRs - Accrual TDRs - Non-accrual Commercial, financial and agricultural Real estate construction - commercial Real estate mortgage- residential Real estate mortgage - commercial Consumer, Total TDRs - Non-accrual Total TDRs Number of contracts December 31,2012 Recorded Investment Speciflc Reserves Number of contracts December 31, 2011 Recorded Investment Speciflc Reserves '• .. • 12 $ -" 3 6 -^ 21, $,.. . , 2,820' $ 440 • 5,022 8,282. $ 2 .$ 5 9 12 ;•; • 2 .. , 30 $ 51 $ 201 $ 5,693 1,177 6,966 • ' 44 14,081 $ 22,363 $ 18 104 94 ur 309 14 468 142 611 0 1,235 1,544 9 $ 20 3 32 $ 2 $ 8 9 15 0 34 $ 66 $ 2,360 $ 2,416 2,441 7,217 $ • '• 1 ' 20 61 0 181 84 $ . 6,227 1,278 . 17,359 0 24,948 $ 32,165 $ 52 , 321 108 860 0 1,341 1,522 At December 31, 2012, loans classified as TDRs totaled $22,363,000, ofwhich $14,081,000 were on non-accraal status and $8,282,000 were on accrual status. At December 31, 2011, loans classified as TDRs totaled $32,165,000, ofwhich $24,948,000 were on non-accrual status and $7,217,000 were on accrual status. The $9,802,000 decrease from December 31, 2011 consisted primarily of two commercial real estate mortgage nonaccmal loans with balances totaling approximately $8,360,000 at December 31, 2011, that went to foreclosure during the year ended December 31, 2012. These commercial foreclosures consisted of two hotels in the Branson Area and a church in the Lee's Summit area. The church was sold during the fourth quarter of 2012 and the hotels are going to auction during the second quarter of 2013. The decrease in TDRs classified as real estate - mortgage residential accruing loans primarily related to one loan relationship consisting of fourteen loans that were consolidated into one new loan at a market rate meeting ah the qualifications to be removed from the TDR classification. Provision and Allowance for Loan Losses As mentioned above, the Company is continuing to recover from the deterioration of collateral values during the prior and current economic conditions. Current appraisals are being obtained and management has adjusted the provision to reflect the amounts determined necessary to maintain the allowance for loan losses at a level necessary to cover probable losses in the loan portfolio. The allowance for loan losses increased to $14,842,000 or 1.75% ofloans outstanding at December 31, 2012 cornparedto $13,809,000 or 1.64% of loans outstanding at December 31, 2011. The following table summarizes loan loss experience for the years ended as indicated: (In thousands) Analysis of allowance for loan losses: Balance beginning of year Net charge-offs (recoveries): 14,565 $ 13,809$ 2011 2012 $ 2010 14,797$ Commercial, financial, and agricultural Real estate construction - residential Real estate construction - commercial Real estate mortgage - residential Real estate mortgage - commercial Installment loans' to individuals ' Net charge-offs Provision for loan losses Balance end of year Provision 1,599 (67) (23) 819 5,218 321 7,867 8,900 14.842$ 1,964 1,793 262 1,775 6,317 168 12,279 11,523 13.809$ 1,750 903 4,534 4,306 3,812 ' 182 15,487 15,255 14.565$ $ 2009 2008 12,667$ 9,282' 450 . 1,191 , 1,007 • 3,418 458 188 416 35 _ ^ _ _ ^ _ ^ _ ^ _ _ _ _ _ __ •• 3 11 4,826 8,211 12.667 2,612 724 240 6,224 8,354 14.797$ The provision for loan losses decreased to $8,900,000 for the year ended December 31, 2012 compared to $11,523,000 for the year ended December 31, 2011, and $15,255,000 for the year ended Decernber 31,2010. The Company's net loan charge-offs were $7,867,000, or 0.93% of average loans, for the year ended December 31, 2012 compared to net loan charge-offs of $12,279,000, or 1.42% of average loans, for the year ended December 31, 2011, and $15,487,000, or 1.63% of average ioans, for the year ended December 31, 2010. Net charge-offs continued to mclude significant write-downs of approximately $6,700,000 during the year ended December 31,2012 on properties going to foreclosure to reflect declines in current collateral values; Real estate mortgage - commercial net charge-offs represented 66% of total net charge-offs during the year ended Deceniber 31, 2012 and primarily related to three significant commercial loan relationships that went to foreclosure. One of these foreclosures consisted of two hotels in the Branson area for which a $1,745,000 charge off was taken to value the property according to its current appraised value determined during the third quarter of 2012. Although net charge offs have decreased from the year ended December 31, 2010 to the year ended December 31, 2012, the provision for loan losses remains significant due to the level of specific reserves on loans individually evaluated for impairment and the historical loss rate based on the Company's last thirty-six months of charge off experience. Specific reserves were $4,(120,000 at December 31, 2012 compared to $3,748,000 at December 31, 2011, and $6,376,000 at December 31, 2010. 19 Allowance for loan losses The following table is a summary ofthe allocation ofthe allowance for loan losses: (In thousands) Allocation of allowance for loan losses at end of year: Commercial, financial, and agricultural Real estate construction - residential Real estate construction -. commercial Real estate mortgage - residential Real estate mortgage - commercial Installment loans to individuals Unallocated Total Percent of categories to total loans: Commercial, fmancial, and agricultural Real estate construction - residential Real estate construction - commercial Real estate mortgage - residential Real estate mortgage - commercial Installment loans to individuals Total 2012 2011 2010 2009 2008 1,937 .732 1,711.. 3,387 6,834 239 . 2 14.842 • 154 % 2.6 5.1 26.1 47.8 3.0 100.0 % . $ 1,804 1,188 1,562 3,251 5,734 267 .3 13,809 . 15.3 % , 3.6 5.1 24.1 47.8 .. 3.5 100.0 % 2,931 2,067 1,339 3,922 3,458 231 617 14.565 .146 % 3.5 6.2 23.2 48.9' 3.6 100.0 % $ 2,773 348^ 1,740 3,488 4,693 380 1,375 , 14.797 15.3 % 3.9 7.9 23.4 45.8 3.7 100.0 % 1,712 0 2,490 557 6,014. 391 1,503 12,667 15.2 % 49 7.9 234 ' 45.3 , 3.3 100.0 % The Company's allowance for loan losses increased $1,033,000 from December 31, 2011 to December 31, 2012. The overall increase primarily consisted of a $1,100,000 increase in the allocation for real estate mortgage - commercial loans that was partially offset by a $456,000 decrease in real estate consfruction - residential loans. The ratio ofthe allowance for loan losses to nonperforming loans was 37.7% at December 31, 2012 compared to 25.73% at December 31, 2011. The following table is a srunmary of the general and specific allocations of the allowance for loan losses for the years ended as indicated: (In thousands) Allocation of allowance for loan losses: 2008 2011 2010 2009 2012 Individually evaluated for impairment - specific reserves Collectively evaluated for impairment - general reserves ' $ Total _^ 4,020 $ 10,822 14,842 $ 3,748 $ 10,061 13.809 $ 6,376 $ 8,189 14,565 $ 6,415 $ 8,382 14.797 $ 3,837 8,830 12.667 The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals Or intemal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At December 31, 2012, $4,020,000 of the Company's allowance for loan losses was allocated to impaired loans totalmg approximately $39,363,000 compared to $3,748,000 of the Company's allowance for loan losses allocated to impaired loans totaling approximately $53,620,000 at December 31, 2011. Management determined that $14,733,000, or 37%, of total impaired loans required no reserve allocation at December 31, 2012 compared to $23,223,000, or 43%, at December 31, 2011 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability. The incurred loss component ofthe general reserve, or loaris collectively evaluated for impairment, is determined by applying percentages to pools of loans by asset type. Loans not individually evaluated are aggregated based on similar risk characteristics. Historical loss rates for each risk group, which is updated quarterly, are quantified using all recorded loan charge-offs. Management determined that the previous twelve quarters were reflective of the loss characteristics of the Company's loan portfolio during the recent three year economic environment. These historical loss rates for each risk group are used as the starting point to determine allowance provisions. The Company's methodology includes factors that allow management to adjust its estimates of losses based on the most recent information available. The rates are then adjusted to reflect actual changes and anticipated changes such as changes in specific allowances on loans and real estate acquired through foreclosure, any gains and losses on final disposition of real estate acquired through foreclosure, changes in national and local economic conditions and developments, including general economic and business conditions affecting.the Company's key lendmg areas, credit quality trends, specific indusfry conditions within portfolio segments, bank regulatory examination results, 20 and findings of the intemal loan review department These risk factors are generally reviewed and updated quarterly, as appropriate. Prior to 2011, the historical loss percentage for non-impaired loans was based on a blend between indusfry standards and the Company's five year loss experience, and the uiiallocated portion of the allowance was based on management's evaluation of conditions that were not directly refiected in the determination ofthe specific reserve component and the incurred loss component: The specific and general reserve allocations represent management's best estimate of probable losses contained in the loan portfolio at the evaluation date. Although the allowance for loan losses comprises of specific and general aUOcations, the entire allowance is available to absorb any credit losses. Investment Portfolio The Company classifies its debt and equity securities into one of the following two categories: i Held-to-Maturity - includes investments in debt securities that the Company has the positive intent and ability to hold unth maturity. Available-for-Sale - includes investments in debt and equity securities not classified as held to maturity or frading (i.e., investments that the Company has no present plans to sell in the near-term but may be sold m the future under differerit circumstances). The Company's investment portfolio consists of available-for-sale securities. Debt securities classified as held-to-maturity are carried at amortized cost, while debt and equity securities classified as available-for-sale are carried at estimated market value. Unrealized holding gains and losses from available-for-sale securities are excluded from eamings and reported, net of apphcable taxes, as a separate component of stockholders' equity until realized. The Company does not engage in frading activities and accordingly does not have any debt or equity securities classified as trading securities. Historically the Company's practice had been to purchase and hold debt instruments unth maturity unless special circumstances exist. However, since the investment portfolio's major function is to provide liquidity and to balance the Company's interest rate sensitivity position, aU debt securities are classified as available-for-sale. At December 31, 2012, the investment portfolio classified as available-for-sale represented 18.3%) of total consolidated assets. Future levels of held-to-maturity and available-for-sale mvestment securities can be expected to vary depending upon liquidity and interest sensitivity needs as weH as other factors. The following table presents the composition ofthe investment portfolio by major category: (In thousands) U.S. Treasury Govemment sponsored enterprises Asset-backed securhies ObHgations of states and political subdivisions Total available for sale debt securities 2012 2,030 55,180 107,872' 35,164 200.246 2011 $- 2,054 70,314 107,329 34,109 $. 213.806 .$ . $ As of December 31, 2012, the maturity of debt securities in the investment portfolio was as follows: (In thousands) U.S. TreasuT}' Government sponsored enterprises Asset-backed securities(2) States and political subdivisions (3) Total available-for-sale debt $ $ One Year Or Less Over One Through Five Years Over Five Through Ten Years 1,017 $ 590 5,023 2,345 8.975 $ 1,013 $ 52,571 95,995 11,570 161.149 $ - $ 2,019 6,854 19,321 28.194 $ Over Ten Years ,^ - $ 1,928 1.928 $ Total 2,030 55,180 107,872 35,164' 200.246 Weighted Average Yield (1) 1.63 % 1.34 2.69 4.15 2.54 :% Weighted average yield (1) 3.07 %,- 2.38 % 3.34 % 4.67 % 2.54 % 1) Weighted average yield is based on amortized cost. 2) Asset-backed securities have been included using historic repayment speeds. Repayment speeds were determined from actual portfolio experience during the twelve months ended December 31, 2012 calculated separately for each mortgage-backed security. These repayment speeds are not necessarily indicative of future repayment speeds and are subject to change based on changing mortgage interest rates. 21 3) Rates on obligations of states and political subdivisions have been adjusted to fijlIy taxable equivalent rates using the statutory Federal income tax rate of 34%. At December 31, 2012 $105,000 of debt securities classified as available-for-sale in the table above had variable rate provisions with adjustment periods ranging from one week to twelve months. The following non-marketable securities are restricted securities which, lacking a market, are carried at cost. These securities are reported in other assets. At December 31, 2012, $2,278,000 ofthe total included Federal Home Loan Bank (Des Moines) stock held by the Bank in accordance with debt and regulatory requirements. Other non-marketable securities include a $1,486,000 equity investment m the Company's imconsolidated Exchange Statutory Trusts. (See Note 8 to the Company's consolidated financials for further explanation on the Exchange Statutory Trasts.) (In thousands) Federal Home Loan Bank of Des Moines stock Midwest Independent Bank stock Federal Agricultural Mortgage Corporation stock Investment in unconsolidated ttusts Total non-marketable investment securities Liquidity and Capital Resources Liquidity Management 2012 2011 2,278 $ 151 10 1,486 3.925 $ 2,738 151 10 1,486 4.385 The role of liquidity management is to ensure funds are available to meet depositors' withdrawal and borrowers' credit demands while at the same time maximizing profitability. This is accomplished by balancmg changes in demand for funds with changes in the supply of those funds! Liquidity to meet the demands is provided by maturing assets, short-term hquid assets that can be converted to cash-and the abihty to atfract funds from extemal sources, principally depositors. Due to the nature of services offered by the Company, management prefers to focus on- transaction accounts and full service relationships with customers. Management believes it has the ability to increase deposits at any time by offering rates slightly higher than the market rate. The Company's AssefLiability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for the Company's liquidity position and profile. A combination of daily, weekly, and monthly reports provided to management detail the following: intemal hquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital, and exposure to contingent draws on the Company's liquidity. The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company'Srmost liquid assets comprise of available for sale investment securities, federal funds sold, and excess reserves held at the Federal Reserve. Federal funds sold and resale agreements normally have ovemight maturities and are used for general daily liquidity purposes. The fair value ofthe available for sale investment portfolio was $200,246,000 at December 31, 2012 and included an unrealized net gain of $5,353,000. The portfolio includes projected maturities and mortgage backed securities pay-dovras Of approximately $22;850,000 over the next twelve months, which offer resources to meet either new loan demand or reductions m the Company's deposit base. (In thousands) Federal funds sold Federal Reserve Bank - excess reserves Available for sale investment securities Total 2012 2011 $ $ • -$ ,27,857 • 200,246 • 228,103 $ 75 19,997 213,806 233,878 22 TheCompany pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold imder agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law. At December 31, 2012 and 2011, respectively, the Company's unpledged securities in the available for sale portfolio totaled approximately $53,804,000 and $41,359,000, respectively. Total investment securities pledged for these purposes were as follows: (In thousands) Investment securities pledged for the purpose of securing: ' , 2012 2011 Federal Reserve Bank borrowings Repurchase agreements Other deposits Total pledged, at fair value .:''' ': • , . '. $ • ',-' •, .. 2,390 $ •28,888 115,164 146.442 $ 1,819 29,656 1,40,972 172.447 Liquidity is available from the Company's base of core, customer deposits, defined as deniand, iriterest checking, savings, and money market deposit accounts. At Deceriiber 31!, 2012, such deposits totaled $597,973,000 arid represerited 60.3% ofthe Company's total deposits. These core deposits are normally less volatile and are often tied to other products ofthe Company through long lasting relationships. Time deposits and certificates of deposit of $100-000 and over totaleid $393,302,000 at December 31, 2012. These accounts are normally considered more volatile and higher costing representing 39.7% of totaldeposits at December 31, 2012. Core deposits at December 31, 2012 and 2011 were as follows: (In thousands) Core deposit base: Non-interest bearing demand Interest checking Savings and money market Total 2012 2011 192,271 $, 178,121 227,581 597.973 $ 159,187 169,452 215,147 543,786 Other components of liquidity are the level of borrowings from third party sources and the availabihty of future credit; The Company's outside borrowings are comprised of securities sold under agreements to repurchase. Federal Home Loan Bank advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of December 31, 2012, under agreements withlhese imafiFiliated banks, the Bank may borrOw'up to $15,000,000 in federal funds ori an unsecured basis and $5,135,000 on a secured basis. There was no federal ftuids piu-chased outstanding at December 31, 2012. Securities sold under agreemerits to repurchase are generally borrowed overnight and are secured by a portion ofthe Company's investirient portfolio: At December 31, 2012, there was $21,058,000 in repurchase agreements. The Company may periodically borrow additional short- term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at December 31, 2012. The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB). As a member of the FHLB, the Bank has access to credit products of the FHLB. As of December 31, 2012, the Bank had $20,126,000 in outstanding borrowings with the FHLB. In addhion, the Company has $49,486,000 in outstanding subordinated notes issued to wholly-owned grantor frusts, fimded by preferred securities issued by thefrusts. Borrowings outstanding at December 31, 2012 and 2011 were as follows: (In thousands) Borrowings: ' ' ' Securities sold under agreements to repurchase Federal Home Loan Bank advances Subordinated notes Total 23 " ' ' 2012 ' 2011 21,058 20,126 49,486 90.670 $ 24,516 28,410 49,486 102.412 The Company pledges.certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from' these entities. Based on the type and value of collateral pledged, the Company may draw advances against this collateral The following table reflects the advance equivalent ofthe assets pledged,' borrowings, and letters of credit outstariding, in addition to the estimated futm-e funding capacity available to the Company.as follows: (In thousands) Advance equivalent Advances outstariding .Letters of credit issued Total available '$ $ FHLB 290,084 $ (20,126)- 0 269.958 $ 2012 Federal Reserve Bank ' 3,344 0 0 3,344 Federal Funds Purchased Lines $ 16,790 $ 0 0 ' 16:790 S i. 2011 Federal Reserve Bank Federal Funds Purchased Lines $ 2,051 '0 0 J= 2.051 ,25,402 $ . 0 0 25,402 $ Total 290,652' (43,657) (206) 246,789 Total 310,218 (20,126) 0 "290.092 FHLB 263,199 $ (43,657) (206) 219.336 S' $, S At December 31, 2012, loans with a market value of $449,956,000 were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At December 31, 2012, investments with a market value of $5,826,000 were pledged to secure federal ftinds purchase lines and borrowing capacity at the Federal Reserve Bank. Sources and Uses of Funds Cash and cash equivalents were $58,877,000 at December 31, 2012 compared to $43,210,000 at December 31, 2011. The $15,877,000 increase resulted from changes in the various cash flows produced by operating, investing, and financing activities ofthe Company, as shown in the accompanying consolidated statement of cash flows for the year ended December 31, 2012. Cash flow provided from operating activities consists mainly of net income adjusted for certairi non-cash items. Operating activities provided'cash flow of $14,875,000 for the year ended December.31, 2012. Investmg activities consisting mainly of purchases, sales and maturities of available for sale securities, arid changes in the level-of the loan portfolio, used total cash of $6,374,000. The cash outflow primarily consisted of $76,498,000 purchases of investment securhies and a $26,499,000 increase in the loan portfolio. Partially offsetting this increase was $87,905,000 in proceeds from maturities, calls, and pay-downs-of investment securities and $8,571,000 in proceeds from sales of other real estate owned and repossessions' • . . ' ' Financmg activities provided cash of $7^166,000, resulting primarily from a $33,084,000 net increase in demand deposits partially offset by $12,000,000 paid on the redemption of 12,000 shares of preferred stock, an $8,284,000 repayment of Federal Home Bank advances, and a $3,458,000 decrease in federal funds purchased and securities sold under agreements to repurchase. See Note 9 for further discussion. Future short-term liquidity needs arising from daily operations are not expected tp vary significantly during 2013. • In the normal course of business, the Company enters into certain forms of off-balance sheet fransactions, including : unfunded loan commitments and letters of credit. These transactions are managed through the Companj^s various risk management processes: Management considers both on-balance sheet and off-balance sheet fransactions in its evaluation of the Company's liquidity. The Company had $121,407,000 in unused loan commitments and standby letters of; credit as of December 31, 2012. Although the Company's current liquidity resources are adequate to fund this commitment level, we know that the nature of these commitments is such that the likelihood of such a funding demand is very low. The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company's ongoing hquidity needs primarhy include funding its operating expenses and paying cash dividends to its common and preferred shareholders. For the years ended December 31, 2012 and 2011, respectively, the Company paid cash di-vidends to its common and preferred shareholders totaling $2,143,000 and $2,417,000. A large portion of the Company's liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $4,500,000 and $5,000,000 to the Company for each of the years ended December 31,2012 and 2011, respectively At December 31"; 2012 and December 31, 201-lvthe Company had cash and cash equivalents totaling $1,863,000 and $13,282,000, respectively. -; 24 Capital Management The Company and the Bank are subject to various.regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements cari initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if imdertaken, could have a direct material effect on the Company's: consolidated firiancial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that; involve quanthative measures of assets, liabihtiesi and certain off-balance-sheet items as calculated under regulatory accounting practices. The caphal amounts and classification of the Cornpariy and the Bank are subject to qualitative jiidgrrients by the regulators about components, risk-weightings, arid other factors. ; ,; ; Quantitative measures established by regulations to ensure capital adequacy require the Company and. the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital to risk-weighted assets, and of Tierl capitalto adjusted-average assets.. ;;;) -v ; . The Company exceeded all capital adequacy requirements as of Decernber 31, for the years indicated: '.••.-- "•••.,•'• 2012 20li •'••'•,:.^ ''•"••^•'^'•.\.''''' 2010 2009 =.• W e l l- ;'•'•••• ' • ' • C a p i t a l i z ed • R e g u l a t o r y :/ Guidelines '••'• 2008 Risk-based capital ratios: Total capital Tier 1 capital Leverage ratio 16.83 % 13.58 , 10.37 : , 18.03 % 15.16 11.52 , 17.05;% 14.25 .11:00, 16.49 % .14.01 11.35 16.01 % 13.55 10.80 10.00 % 6:00 5.00 Commitments, Contractual Obligations, and Off-Balaiice Sheet Arrangements The required payments of time deposits and other borrowed money, not including interest, at December 31, 2012 are as follows: (In thousands) Time deposits Other borrowed money . Pavments due by Period • . Total $ 393,302 20,126 Less than 1 •, Year $.280,477 10,126 1-3 Years $ 88,702 3-5 Years Overs Years $ 24,123 -'^$;, .- - 10,000 In the normal course ofbusiness, the Company is party to activities that contain credit, market and operational risk that are not reflected in whole or in part in the Company's consolidated financial statements. Such activities include fraditional off- balance sheet credit related financial instruments. The Company provides customers with off-balance sheet credit support through loan commitments and standby letters of credit. Summarized credit-related financial instruments, including both commitments to extend credit and letters of credit at December 31, 2012 are as follows: • (In thousands) Unused loan commitments Standby letters of credit , , - Ainount of Commitment Expiration per Period 1-3 Years $ 13,003 26 Less than lYear $ 90,560 2,944 3 -5 Years $ 4,921 . .. 25 . V: :. • • Total $ 118,412 ' .: .2,995 Overs Years $ 9,928 Since many of the unused commitments are expected to expire or be only partially used, the total amount of commitments in the preceding table does not necessarily represent future cash requirements. 25 Quantitative and Qualitative Disclosures about Market Risk Interest Sensitivity.' . '•.-•.•.,''..'' • . • . . . ' . '• Market risk arises from exposure to changes in iriterest rates ,and ofher relevant market rate or price risk. The. Company faces market risk in fhe form ofinterest rate risk through; tiansactions other than fradirig activities. The'Company uses financial modeling techniqtles to measure interest rate risk. These techniques measure the serisitiyity of future earriirigs due to changirig interest rate environments. Guidelines established by the Conipany's Asset/Liabhity Committee and approved by the board of directors are used to monitor exposiu-e of eamings at risk: General iriteirest rate rriovements are used to develop serisitivity as" the; Company feels-it has no primary exposure fo.specificpoints on the yield curve. At Decerriber 31, 2012, the rate shock scenario models indicated that annual net interest income Couldjcharigebyas much as (22.5)% to 30.3% shouldlnterestrates rise or fall,- respectively, 400 basis points from their current level over a one. year period. However there are no assurances that the change win not be more or less than this estimate. Managernent believes this is;anacceptableleyel of risk. > ;; The following table represents estimatedinterest rate sensitivity and periodic and ciunulafive.gap positions calculated as of December 31, 2012. Significant assumptions used for this table included: loans wih repay at historic repayment rates- certain interest-bearing demand accounts are interest sensitive due to immediate repricing, and fixed maturity deposits will not be withdrawn prior to matiuity. A significant-variance m actual results firiain one or more of these assumptions could materially affect the results reflectedin the table. •' • . ; . - ; . _ - • -• .::•'.";' ; ;• - ; ' • • - (In thousands) ASSETS Investment securities Interest-bearing deposits Other restrictedinvestments Loans Total Y e a r! Year 2 Year 3 Year 4 ; YearS Over 5 Years or No stated Maturity $ • 22,850.'$.^"'^56,723 $• 27,857 . • -3,925 ;•'•;*•;•; ^ . .155,682 . - ' .- ' "411,402 $ .466,034^$^.--212,405.$ -• • . ' . - 50,643 $" ;':31,330^ $ . ' - , 1 3 , 6 4 6 '$ - 25,054 • $• ' . .; - '• , ; •• . , : -• 7. •;., • '; : ? ; • •. , - • • .. 101,646; 152,289 $ 39,727 .. , 71,057 $ 110,375 .124,021 $ 28,152 53,206'. - $' 238,624 280,477 21,058 49,486' 20,126 609,771 $ LIABILITIES Savings, now deposits . Rewards checking, super now, and . money market deposits Time deposits Federal fiinds purchased and securities sold under agreerhents to repurchase Subordihated notes Federal Home Loan Bank advances Total Interest-sensitivity GAP Periodic GAP ••" Cumulative GAP Ratio of interest-eaming assets to interest-bearing liabilities Periodic GAP Cumulative GAP .'. $ $ $ $ 167,077 $ . 65-220 23,482 ,984 12,139 ;: 65,220 $ 190,559 $ 11,984 $ . 1 2 , 1 39 $ . : -. •';;21,058 •:'-:49,486 ...^20,126! ...889,673 . $.-:. (143,737) $ 147,185 ;$ ' (38,270):$ . 59,073 $ 111,882.$ : 53,206 • $• ^^'•189,339 (143,737) $ 3,448 $ (34,822) $ 24,251 $ 136,133 $ 189,339 $ ,, ,.189;339 0.76 0.76 3.26 1.01 0.80 0.96 5.93 1.03 10.22 L15 NM. 1.21 . . 1.21 1.21 ' 26 TdtaH- • 200,246'' ;. 27,857 • vr 3;925;; ; 846,984 1,079,012 .. 167,077 .238,624 ; 393,302; Effects of Inflation The effects of inflation on financial institutions are different from the effects on other commercial enterprises since financial institutions make few significant capital or inventory expenditures, which are directly affected by changing prices. Because bank assets and habilities are virtually ah monetary in nature, mflation does not affect a financial institution as much;as do changes in interest rates. The general level of inflation does underlie the general level of most interest rates, but interest rates do not increase at the rate of inflation as do prices of goods and services. Rather, interest rates react more to changes in the expected rate of inflation and to changes in monetary and fiscal policy. Inflation does have an impact on the growth of total assets in the banking indusfry, often resulting in a need to increase capital at higher than normal rates to maintain an appropriate caphal to asset, ratio. In the opinion of management, mflation did not have a significant effect on the Company's operations for the year ended December 31, 2012. Impact of New Accounting Standards Balance Sheet In December 2011, the FASB issued ASU 201 It 11, Dwc/oiMre^ aboiit Offsetting Assets and Liabilities. The ASU is a joint requirement by the FASB and Intemational Accounting Standards Board to enhance current disclosures and mcrease comparability of GAAP and Intemational Financial Reporting Standards (IFRS) financial statements. Under the ASU, an entity will be required to disclose both gross and net information about insfruments and fransactions eligible for offset in the balance sheet, as well as instruments and fransactions subject to an agreement similar to a master netting agreement. ASU 2013- 01, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities was issued in January 2013, and amended ASU 2011-11 to specifically include only derivatives accounted under Topic 815, repttfchase and reverse purchase agreements, and securities and borrowing and lending fransactions that are either offset or subject to an enforceable master netting arrangement. Both ASUs are effective for annual and interim periods beginning January 1, 2013. Their adoption is not expected to have a significant effect on the Company's financial statements. Other Comprehensive Income In February 2013, the FASB issued ASU No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The amendments of ASU No. 2013-02 require an entity to present, either in the income statement or in the notes, significant amoimts reclassified out of acctunulated other comprehensive income by the respective line items of net income, but only if the amount reclassified is required imder U.S. GAAP td be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety, an entity is requfred to cross-reference to other disclosures that provide additional detah about those amounts. This ASU is effective for armual and interim periods beginning January 1, 2013. Adoption ofthe ASU is not expected to have a significant impact on the Company's consolidated financial statements. 27 CONSOLIDATED FINANCL^L STATEMENTS The following consolidated financial statements ofthe Company and report ofthe Company's independent audhors appear on the pages indicated. , •' • Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets as of December 31, 2012 and 2011 Consolidated Statements of Operations for each of the years ended December 31, 2012, 2011, and 2010 Consolidated Statements of Comprehensive Incorne (Loss) for each of the years ended December 31,2012, 20II, and 2010 Consolidated Statements of Stockholders'Equity for each of the years ended December 31,2012,2011, and 2010 • Consolidated Statements of Cash Flows for each of the years ended December 31, 2012,2011, and 2010 Notes to the Consolidated Financial Statements P a ge , 29 30 31 32 33 34-35 , 36 28. ijt'jtf^'^;-: KPMG LLP Suite 900 10 South Broadway St. Louis, MO 63102-1761 Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders Hawthom Bancshares, Inc.: We have audited the accompanying consolidated balance sheets of Hawthom Bancshares, Inc. and subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity, and cash flows for each ofthe years in the three-year period ended December 3.1, 2012. These consolidated financial statements are the responsibility ofthe Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perfonri the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amoimts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentatiori. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hawd:hom Bancshares, Inc. and subsidiaries as of December :31, 2012 and 2011, and the results of their operations and their cash flows for each ofthe years in the three-year period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the PubUc Company Accounting Oversight Board (United States), Hawthom Bancshares, Inc.'s intemal control oyer financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework, issued by the Committee of Sponsoring Organizations ofthe Treadway Commission, and our report dated April 1, 2013 expressed an unqualified opinion on the effectiveness of Hawthom Bancshares, Inc.'s intemal control over financial reporting. i < ^ H <^ LCT> St. Louis, Missouri April 1,2013 KPMG LLP is a Delaware limited liability partnership, tlie U.S. member firm of KPMG International Cooperative ("KPMG Intemational"), a Swiss entity. 29 HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Consolidated Balance Sheets ASSETS Loans Allowances for loan losses \ Net loans Investment in available-for-sale securities, at fairvalue Federal fiinds sold and securities purchased under agreements to resell Cash and due from banks Premises and equipment - net Other realestate owned and repossessed assets - net Accrued interest receivable Mortgage servicing rights Intangible assets - net Cash surrender value - life insurance Other assets . • . •" ., • . , ' Total assets' LLlBILiriES AND STOCKHOLDERS' EQUITY Deposits;. , ;, Non-interest bearing,demand Savings, interest checking and moneymarket Time deposits $100,000 and over Other time deposits , Total deposits Federalfunds purchased and securities sold under agreements to repurchase ,^ Subordinated notes FederalHome Loan Bankadvances Accrued interest payable Other liabilities -. Total liabilities Stockholders'equity: - $ DecemberSl, 2012 2011 (In thousands, except per share amounts) 846,984 $ (14,842) 832,142 200,246 0 58,877 . 37,021. 23,592 5,190 2,549 135 2,136 19,718. 842,930 (13,809) 829,121 213,806 75 43,135 37,953 16,020 5,341 2,308 543 2,064 20,795 1,181,606 $ 1,171,161 192,271 405,702 120,777 272,525 991,275 21,058 49,486 20,126 909 6,532 159,187 384,599 139,504 274,934 958,224 24,516 49,486 28,410 1,054 6,895 ' 1,089,386 $ 1,068,585 Preferred stock, $0.01 parvalue per share, 1,000,000 shares authorized; ' Issued 18,255 shares tod 30,255 shares, respectively, $1,000 per share liquidation value, net of discount Common stock, $1 parvalue, authorized 15,000,000 shares; Issued 5,000,972 and 4,814,852 shares, respectively Surplus Retained eamings Accumulated othercomprehensive income, net of tax Treasury stock; 161,858 shares, at cost Total stockholders' equity Total liabilities and stockholders' equity See accompanying notes to the consolidated fmancial statements. 17,977 5,001 31,816 39,118 1,825 (3,517) 92,220 1,181,606 $ 29,318 4,815 30,266 40,354 1,340 (3.517) 102,576 1,171,161 30 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Consolidated Statements of Operations (In thousands, except per share amounts) INTEREST INCOME Interest and fees on loans Interest on debt securities: Taxable Nontaxable Interest on federal fluids sold and securities purchased under agreements to resell Interest on interest-bearing deposits Dividends on other securities Total interest income INTEREST EXPENSE Interest on deposits: Savings, interest checking and money market Time deposit accoimts $100,000 and over Other time deposits Interest on federal fiinds purchased and securities sold under agreements to repurchase Interest on subordinated notes Interest on Federal Home Loan Bank advances Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses NON-INTEREST INCOME Service charges on deposit accounts Trust department income Gain on sale of mortgage loans, net Gain on sale of investment securities Other Total non-interest income NON-INTEREST EXPENSE Salaries and employee benefits Occupancy expense, net Fumiture and equipment expense FDIC insurance assessment Legal, examination, and professional fees Advertising and promotion Postage, printing, and supplies Processing expense Other real estate expense, net Other Total non-interest expense Income (loss) before income taxes Income tax expense (benefit) Net income (loss) Preferred stock dividends Accretion of discount on preferred stock Net income (loss) available to common shareholders Basic earnings (loss) per share Diluted earnings (loss) per share See accompanying notes to the consolidated financial statements. $ $ $ 31 Years Ended December 31, 2012 2011 2010 43,957 $ 47,361 $ 53,089 4,100 909 0 46 102 49,114 1,146 1,111 3,715 21 1,381 531 7,905 41,209 8,900 32,309 5,439 893 2,669 26 699 9,726 19,165 2,598 1,840 993 1,189 1,083 1,144 3,593 2,937 4,125 38,667 3,368 546 2,822 1,125 659 1,038 0.21 0.21 $ $ $ 4,864 1,029 1 58 156 53,469 ., . 1,645 1,663 5,123 47 1,301 1,074 10,853 42,616 11,523 31,093 5,566 898 1,649 0 1,087 9,200 17,982 2,701 2,019 1,107 1,332 1,103 1,158 3,193 2,736 3,514 36,845 3,448 591 2,857 1,513 476 868 0.18 0.18 $ $ $ 4,214 1,174 0 86 176 58,739 2,171 2,485 7,211 75 1,526 2,285 15,753 42,986 15,255 27,731 5,554 803 2,493 0 1,631 10,481 17,899 2,532 1,997 1,651 1,441 1,256 1,201 3,353 9;804 . 3,717 44,851 (6,639) (3,087) (3,552) 1,513 476 (5,541) (1.15) (1.15) HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Income (Loss) (In thousands) Net income (loss) Other comprehensive income (loss), net of tax Unrealized (loss) gain on investment securities available-for-sale, net of tax Adjustment for gain on sales of investment securities, net of tax Defined benefit pension plans: Net gain (loss) arising during the year, net of tax Amortization of prior service cost included in net periodic pension cost, net of tax Total other comprehensive income (loss) Total comprehensive income (loss) See accompan5dng notes to the consolidated financial statements. Years Ended December 31, 2011 2010 2012 2,822 $ 2,857 $ (3,552) (123) (16) 547 77 485 3,307 $ 2,380 . (389) . 0 0 (1,830) : ', .. 171. . . ..4g 598 3,455 48 (170) (3,722) 32 HAWTHORN BANCSHARES, INC. AND SUBSIDLVRIES Consolidated Statements of Stockholders'Equity Balance, December 31,2010 28,841 $ (In thousands) Balance, December 31,2009 Net loss Other comprehensive income Stock based compensation expense Accretion of preferred stock discount Stock dividend Cash dividends declared, preferred stock Cash dividends declared, common stock Net income Other comprehensive income Stock based compensation expense Accretion of preferred stock discount Stock dividend Cash dividends declared, preferred stock Cash dividends declared, common stock Balance, December 31,2011 Cumulative effect of change in accounting principle Balance, January 1, 2012 Net income Other comprehensive income Stock based compensation expense Accretion of preferred stock discount Redemption of 12,000 shares of preferred stock Stock dividend Cash dividends declared, preferred stock Cash dividends declared, common stock Balance, December 31, 2012 Preferred Stock Common Stock Surplus Retained Earnings Accumulated Otiier Comprehensive Income Treasury Stock Total stock holders' Equity $ 28,365 $ 4,464 $ 26,971 $ 50,576 $ 912 $ (3,517)$ 107,771 . 0 0 476 0 0 0 0 0 0 477 0 0 0 , • $ 29,318 $ 0 0 0 172 0 . 0 4,636 $ 0 '• 0 0 0 179 0 0 4,815 $ 0 87 0 1,871 0 ' 0 (3,552) 0 0 (476) (2,043) (1,513) (1,135V • 28,929 $ 41,857 $ 0 0 58 0 1,279 0 0 2,857 0 0 (477) (1,458) (1,513) (912), 30,266 $ 40,354 $ (170) 0 ., 0 0 0 0 • 742.$ • 598 0 0 0 0 0 1,340 $ (3,552) (170) ... • 87 0 0 (1,513) (1,135) 0 0 , 0 0 0 0 ':"' (3,517)$ 101,488 0 0' 0, 0 0 0^ 0 : 2,857 598 58 0 0 (1,513) .(912) 102,576 .,^ , ,i ^ (3,517) $ " ' 0 0 0 460 $ 29,318 $ ^4,815 $ 30,266 $ 40,814 $ • 0 1,340 $ 0- (3,517)$ 460 103,036 0 0 659 (12,000) 0 0 0 17,977 $ 0 0 0 0 186 0 0 5,001 $ 0 29 0 0 1,521 0 0 31,816 $ 2,822 0 0 (659) 0 (1,707) ^ (1,203) (949) 39,118 $ 485 ^ 0 0^ ^ 0 0 ' 0 . 2,822 485 - 29 0 • • , 0 0 0 0 1,825 $ 0 0 0 ,0 (3,517)$ . : (12,000) . .0 (1,203) (949) 92,220 See accompanying notes to the consolidated financial statements. 33^ H A W T H O RN B A N C S H A R E S, I N C. A ND S U B S I D I A R I ES Consolidated Statements of Cash Flows (In thousands) Cash flows from operating activities: v Net income (loss) Adjustments to reconcile net income to net cash provided by operating activities: ' : Provision for loan losses Depreciation expense Net amortization of investment securities, premiums, and discounts Amortization of intangible assets Stock based compensation expense Change in fair value of mortgage servicing rights Gain on sale of investment securities (Gain) loss on sales and dispositions of premises and equipment , ^ (Gain) loss on sales and dispositions of other real estate owned ' and repossessions' > ' '. ' ' Provision for other realestate owned Decrease in accrued interest receivable Increase in cash surrender value-Ufe insurance • Decrease in other assets (Increase) decrease in income tax receivable Decrease in accrued interest payable Increase (decrease) in other liabilities Origination of mortgage loans for sale Proceeds from the sale of mortgage loans Gain on sale of mortgage loans, net (Increase) decrease in net deferred tax asset Other, net .'. '• . .. ' Net cash provided by operating activities Cash flows from investing activities: Net (increase) decrease in loans Purchase of available-for-sale debt securities Proceeds from maturities of available-for-sale debt securities Proceeds from calls of available-for-sale debt securities Proceeds from sales of available-for-sale debt securities Proceeds fi-om sales of FHLB stock Pm-chase of FHLB stock Purchases of premises and equipment Proceeds from sales of premises and equipment Proceeds from sales of other real estate owned and repossessions Net cash (used) provided by investing activities Cash flows from financing activities: Net increase in demeind deposits Net increase in interest-bearing transaction accounts Net decrease in time deposits Net decrease in federal funds purchased and securities sold under agreements to repurchase Proceeds from Federal Home Loan Bank advances Repayment of Federal Home Loan Bank advances Redemption of 12,000 shares of preferred stock Cash dividends paid - preferred stock Cash dividends paid - conunon stock Net cash provided (used) by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year See accompanying notes to the consolidated financial statements. 34 Years Ended December 31, 2011 2012 2010 2,822 $ 2,857 $ (3,552) : 8,900 1,858 1,161 408 29 1,331 (26) (79) (317) 713 151 (72) 949 (644) (145) 253 (99,420) 99,797 (2,669) (214) 89 . 14,875 (26,499) (76,498) 42,735 45,170 790 460 .0 (1,375) 272 . 8,571' (6,374) 33,084 21,103 (21,136) (3,458) 0 (8,284) (12,000) (1,203) (940) 7,166 15,667 43,210 58,877 $ 11,523. 1,940 837 1,243 58 • 0 0 (13) ' . •. 15,255 '. 1,964 698 1,360 87 0 0 60 206 1,252 393 (62) . , 252 . ,:-: . .1,008 (437) • (104) (73,272) 74,983 ..^- : (1,649) 462 (645) 20,832 2,311 6,158 892 (72) 1,538 :, (1,328) (946) 30 (104,002) . 106,548 ^ (2,493) (2,299) 11531 . 21,756 32,298 (122,871):: 36,923 54,185 0 1,757 0 (3,393) 47 7,435 6,381 21,438 5,461 (15,337) (5,552) 0 (38,576) 0 (1,513) (904) (34,983) (7,770) 50,980 43,210 $ 53,926 (189,082) 114,899 46,'795 0 1,004 (392) (549) 34 " 9,689 . 36,324 2,732 24,854 (37,246) (6,577) 10,000 (22,331) 0 (1,513) (1,385) (31,466) 26,614 24,666 51,280 H A W T H O RN B A N C S H A R E S, I N C. A ND S U B S I D I A R I ES Consolidated Statements of Cash Flows (continued) (In thousands) Supplemental disclosures of cash flow information:' Cash paid during the year for: Interest Income taxes . : . Supplemental schedule of noncash investing and financing activities: Other real estate and repossessions acquired in settlement of loans See accompanying notes to the consolidated fmancial statements. Years Ended December 31, 2011 2012 2010 8,420 1,591 $ s 11,290 $ 665 $ 16,699 800 .16,869 =.$ . 10,903, $ 23,677 35 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements : December 31, 2012, 2011, and 2010 (1) Summary of Significant Accounting Policies • Havrthom Bancshares, Inc. (the Company) through its subsidiary, ;Hawthbm Bank (the Bank); provides a broad range of banking services to individual and corporate customers located vvithin the commtinities in and;surrolinding Jefferson City, Clinton, Warsaw, Springfield, Branson, and Lee's Surnmit, Missouri. The Company is subjectto Competition fi;om; 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 consolidated financial statenients ofthe Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP).'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; 01" assets and liabilities and disclosure of contingent assets and liabilities at the date ofthe consolidated financial statements and the reported amoimts 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. The significant acpounting policies used by the Company in the preparation ofthe consolidated financial statements are summarized below: Principles of Consolidation In December of 2008 and March of 2010, the Company formed Hawthom Real Estate, LLC, and Real Estate Holdings of Missouri, LLC, respectively (the Real Estate Companies); both are wholly owned subsidiaries of the Company. The consolidated financial statements include the accounts of the Company, Hawthom Bank (the Bank), and the Real Estate Companies. All significant intercompany;accounts and transactions have been eliminated in consolidation. Loans Loans that the Company has the intent and ability to hold for the foreseeable future or maturity are held for investment at their stated unpaid principal balance amount ;less uneamed income and the allowance for loan losses, Income on loans is accrued on a simple-interest basis. Loan origination fees and certain direct costs are deferred and recognized over the life of the loan as an adjustment to yield. Non-Accrual Loans Loans are placed on nonaccrual status when management believes that the borrower's financial condition, after consideration ofbusiness conditions and collection efforts, is such that collection ofinterest is doubtful. Loans that are contractually 90 days past due as to principal and/or interest payments are generally placed on non-accrual, unless they are both well-secured and in the process of collection! Subsequent interest payments received on such loans are applied to principal if doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis. A loan remains on nonaccrual status until the loan is current as to; payment of both principal and interest and/or the borrower demonstrates the ability to pay and remain current. Restructured Loans A modified or restructiared loan is accounted for as a troubled debt restructm-ing (TDR) for any loans in which concessions are made to the borrower for economic or legal reasons that the Company would not. otherwise consider andthe borrower is experiencing financial difficulty. Once a loan has been iclassified as a TDR. it remains a TDR for the life of the.loan. The Company includes all accruing and non-accruing TDRs in the impaired and non-performing asset totals. TDRs are measured for impairment loss by using fair values of the underlying collateral obtained through independent appraisals and intemal evaluations, or by discounting the total expected future cash flows. 36 HAWTHORN BANCSHARES, INC. . AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Impaired Loans . ' ; ' ; - ; . .' A loan is considered impaired when it is probable the Company will be unable to collect, all amounts due, both principal and interest, according fo the contractual terms ofthe loan agreement Included in impaired loans are all non- accrual loans and loans whose terms have been modified in a troubled debt restructuring. Impaired loans are individually evaluated for impairment based on fair values ofthe underlying collateral, obtained through independent appraisals or intemal valuations for a collateral dependent loan, or by discounting the total expected future cash flows. Loans Held for Sale The Bank originates certain loans which are sold in the secondary market. These long-term, fixed rate loans are typically classified as held for sale upon origination based on management's intent to sell. In order to manage the risk associated with such activities, the Company upon locking in an interest rate with the borrower enters into an agreement to sell such loans in the secondary market. Loans held for sale are typically sold with servicing rights retained and without recourse except for normal and custotnary representation and warranty provisions. At December 31, 2012 there were $2,292,000 mortgage loans that were held for sale in comparisonto no loans held for . sale at December 31, 2011. Mortgage loan servicing fees eamed on loans sold are reported as other noninterest income when the related loan payments are collected net of amortization from mortgage servicing rights. Operational costs to service such loans are charged to expense as incurred; Allowance/Provision for Loan Losses The Company maintains an allowance for loan losses to absorb probable loan losses in the Company's loan portfolio. Loans, or portions ofloans, are charged off to the extent deemed uticollectible. Loan charge-offs reduce the allowance for loan losses, and recoveries ofloans previously charged off are added back to the allowance. Provisions for loan losses are charged to income and credited to the allowance in an amount necessary to maintain an appropriate allowance given the risks identified in the portfolio. Once the fair value for a collateral dependent loan has been determined, any impaired amount is typically charged off as a confirmed loss unless the loan has other income streams to support repayment. For impaired loans individually evaluated for impairment, which have other income streams to support repayment, a specific reserve is established for the amount determined to be impaired. The allowance for loan losses consists of a specific reserve component for loans that are individually evaluated for impairment arid an incurred loss component, or general reserves for loans that are collectively evaluated for impairment: based on assigned risk ratings and historical loan loss experience for each loan type. The allowance is based upon management's estimates of probable losses inherent in the loan portfolio. In detertnining the allowance arid the related provision for loan losses, the Company establishes valuation allowances based upon probable losses identified during the review of impaired loans. • Management follows the guidance provided in FASB's ASC Topic 310, Accounting by Creditors for Impairment of a Loan, in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected imderthe original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, arid in conjunction with ciurent economic cotiditions and loss experience, to determine specific reserves as further discussed below. . Loans not individually evaluated are aggregated based oh similar risk characteristics; Historical-loss rates for each risk group, which is updated quarterly, are quantified using all recorded loan charge-offs. Management determined that the previous twelve quarters were refiective ofthe loss characteristics ofthe Company's loan portfolio during the recent three year economic environment. These historical loss rates for each risk group are used as the starting point to determine allowance provisions. The Company's methodology includes factors that allow management to adjust its estimates of losses based on the most recent information available. The rates are then adjusted to reflect actual changes and anticipated changes such as changes in specific allowances on loans and real estate acquired through foreclosure, any gains and losses on final disposition of real estate acquired through foreclosure, changes in national and local 37 . H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 economic conditions and developments, including general economic and business conditions affecting the Company's key Tending areas, credit quality trends, specific industry conditions within portfolio segments, bank regulatory examination resuhs, and findings ofthe intemal loan review department. These risk factors are generally reviewed and updated quarteriy,'as appropriate. The underlying assumptions, estimates and assessments used by management to determine these components are continually evaluated and updated to reflect management's current view of overall economic conditions and relevant factors impacting credit quahty and inherent losses. Changes in such estimates could significantly impact the allowance and provision for credit losses. The Company could experience credit losses that are different from the current estimates made by management. Investment in Debt and Equity Securities At the time of purchase, debt securities are classified into one of two categories:-ayailable-for-sale or held-to-maturity. Held-to-maturity securities are those securities that the Company has the positiye intent and ability to hold until maturity. All debt securities; not .classified as held-to-maturity are-classified as.ayailable-for-sale. The.»Company's securities are classified as available-for-sale and are carried at fair value. Changes in fair value, excluding certain losses associated with other-than-temporary impaimient, are reported in other comprehensive income (loss), net of taxes, as a component, of stockholders' equity. Securities are periodically evaluated for other-than-temporary impairment in accordance with guidance provided in Ae FASB ASC Topic 320, Investinents ^Debt.and Equity Securities. For those securities with other-than-temporary impairment, the entire loss.in fair value: is required to be recognized in current eamings if the Company intends to sell the securities or believes it more likely than not that it will bef equired to sell the security before the anticipated recovery. If neither condition is met, but the Company does not expect to recover the amortized cost basis, the Company determines whether a credit loss has occurred, which is then recognized in current eamings. The amount ofthe total other-than-temporary impairment related to all other factors is recognized in other comprehensive income (loss) net of taxes. Premiums and discounts are amortized using the interest method over the lives of the respective securities, with consideration of historical and estimated prepayment rates for mortgage-backed securities, as an adjustment to yield. Dividend and interest income is recognized when earned. Realized gains and losses for securities: classified as available-for-sale are included in eamings based on the specific identification method for determining the cost of securities sold. Capital Stock of the Federal Home Loan Bank The Bank, as a member ofthe Federal Home Loan Bank System administered by the Federal Housing Finance Board, is required to maintain an investment in the capital stock ofthe Federal Home Loan Bank of Des Moines (FHLB) in an amount equal to 12 basis points ofthe Bank's year-end total assets plus 4.45% of advances from the FHLB to the Bank. These investments are recorded at cost, which represents redemption value... Premises and Equipment : ., Premises and equipment are stated at cost, less accumulated depreciation; Depireciation applicable tb',buildings and improvements and fumiture and equipment is charged to expense using straight-line and accelerated methods over the estimated useful lives ofthe assets. Such lives are estimated to be 5 to 40 years for buildings and improvements and 3 to 15 years for-flimitiu-e and equipment-Maintenance and repairs are charged to expense as.incurred. 38 HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Intangible Assets On January I, 2012, the Company opted to measure mortgage servicing rights at fair value as pennitted by Accounting Standards Codification (ASC) Topic 860-50 Accounting for Servicing Financial Assets. Consistent with ASC 860-50-35-3d, an entity may make an irrevocable decision to subsequently measure a class of servicing assets and servicing liabilities at fair value at the beginning ofany fiscal year. The election ofthis option resulted in the recognition of a cumulative effect of change iri accounting principle of $459,890, net of tax in the amount of $281,868, which was recorded as an increase to beginning retained eamings, as fiirther described in Note 6 to the consolidated fiiiancial statements. As such, effective January 1, 2012, the change in the fair value of mortgage servicing rights is recognized in eamings in the period for which the change occurs. The newly adopted accounting principle is preferable in the circumstances because the fair value measurement method will produce financial information and results more directly aligned with the performance of mortgage servicing rights. Intangible assets that have indefinite useful lives are not amortized, but tested annually for impairment. Intangible assets that have finite usefiil lives, such as core deposit intangibles and mortgage servicing rights, are amortized over their estimated useful lives. Core deposit intangibles are amortized over periods of 7 to 8 years representing their estimated lives using straight line and accelerated methods. During the years ended December 31, 201 Land 2010, mortgage servicing rights (MSRs) were amortized using straight line over the shorter of 7 years or the life ofthe loan. When facts and circumstances indicate potential impairment of amortizable intangible assets, the Comjpany evaluates the recoverability ofthe cairrying value based upon fiiture cash fiows expected to result from the use ofthe underlying asset and its eventual disposition. If the sum ofthe expected ftiture cash flows (undiscounted and without interest charges) is less than the carrying value ofthe imderlying asset, the Compariy recognizes an impairment loss. The impairment loss recognized represents the amount by which the carrying value ofthe underlying asset exceeds the fair value of the imderlying asset. Other Real Estate Owned and Repossessed Assets Other real estate owned and repossessed assets consist of loan collateral that has been repossessed through foreclosure. This collateral comprises of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and constmction equipment. Other real estate owned assets are initially recorded as held for sale at the fair value ofthe collateral less estimated selling costs. Any adjustment is recorded as a charge-off against the allowance for loan losses. The Company relies on extemal appraisals and assessment of property values by intemal staff In the case of non-real estate collateral, rehance is placed on a variety of sources, including extemal estimates of value and judgment based on experience and expertise of intemal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written dovm to reflect a new cost basis. The write-downs are recorded as other real estate expense. The Company establishes a valuation allowance related to other real estate owned on an asset-by-asset basis. The valuation allowance is created diuing the holding period when the fair value less cost to sell is lower than the "cost" of a parcel of other real estate. Pension Plan The Company provides a noncontributory defined benefit pension plan for all full-time employees. The benefits are based on age, years of service and the level of compensation during the employees highest ten years of cornpensation before retirement. Net periodic costs are recognized as employees render the services necessary to eam the retirement benefits. The Company records annual amounts relating to its pension plan based on calculations that incorporate various actuarial and other assumptions including discount rates, mortality, assumed rates of retum, compensation increases and tumover rates. The Company reviews its assumptioris on an annual basis and may make modifications to the assumptions based on current rates and trends when it is appropriate to do so. The Company believes that the 39 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 assumptions utilized in recording its obligations under its plan are reasonable based on its experience and market conditions. The Company follows authoritative guidance included in the FASB ASC Topic 715, Compensation -Retirement Plans under the subtopic Employers' Accounting for Defined Benefit Pension arid Other Postretirement Plans. ASC Topic 715 requires an employer to recognize the overfiinded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its consolidated balance sheet and to recognize changes in the fimded status in the year in w^hich the changes occur through comprehensive incorne. This guidance also requires an employer to measure the fimded status of a plan as of the date of its fiscal year-end, with limited exceptions. Additional disclosures are required to provide users with an understanding of^how investment allocation decisions are made, major categories ofplan assets, and fair value measurement ofplan assets as defined iri ASC Topic 820, Fair Value.Measiirements and Disclosures. ' Income Taxes " Income taxes are accounted for under the asset / liability method by recogriizing the amount oftaxes payable or refuridable for the current period and deferred tax assets and liabilities foi- future tax consequences of events that have been recognized in an entity's financial statements or tax retums. Judgriient is required in addressing the Company's future tax consequences of events that have been recognized in the consolidated'firiancial statements or tax retums such as realization ofthe effects of temporary differences, net operating loss carry forwards and changes in tax laws or interpretations thereof A valuation allowance is established when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. In this case, the Company would adjust the recorded value of thej deferred tax asset, which would result in a direct charge to income tax expense in the period that the determination was made. Likewise, the Company would reverse the valuation allowance when the realization ofthe deferred tax |asset is more likely than not. In addition, the Company is subject to the continuous examination of its tax retums by the Intemal Revenue Service and other taxing authorities. The Company accrues for penalties and interest related to income taxes in income tax expense. At December 31, 2010, total accmed interest was $31,000 and total interest expense recognized for the year ended December 31,2010 was $24,000., At December 31, 2011, the Company released $28^000 ofinterest accraed related to the release of $221,000 of uncertain tax provisions, and as of December 31, 2012; the Company had not recognized any tax liabilities or any interest or penalties in income tax expense related to uncertain tax positions. Trust Department \ \ ' . - -• • • • • • Property held by the Bank in a fiduciary or agency capacity for customers is not included in the accompanying consolidated balance sheets, since such items are not assets ofthe Company. Trast department income is recognized on the accrual basis. I Consolidated Statements of Cash Flows For the purpose ofthe consolidated statements of cash flows, cash and cash equivalents consist of short-term federal funds sold and securities sold or purchased under agreetnents to resell, interest eaming deposits with banks, cash, and due from banks with original maturities of three months or less. Stock-Based Compensation I . - . . • ; _ ' . . .. • ' The Company's, stock-based employee compensation plan is described in Note 11, Stock Compensation. In accordance with FASB ASC Topic 718, Compensation - Stock Compensation, the Company nieasures the cost ofthe stock-based compensation based on the grant-date fair value of the award, recognizing the cost over the requisite service period. The fair value of an award is estimated using the Black-Scholes option-pricing model. The expense recognized is based on an estimation of the number of awards for which the requisite service is expected to be j i 40 . . - HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 rendered, and is included in salaries and employee benefits in the accompanying consolidated statements of operations. The standard also requires that excess tax benefits related to stock option exercises be reflected as financing cash inflows instead of operating cash inflows. Treasury Stock The purchase of the Company's common stock is recorded at cost. Purchases ofthe stock are made both in the open market and through negotiated private purchases based on market prices. At the date of subsequent reissue; the treasury stock account is reduced by the cost associated with such'stock ori a first-in-first-out basis. Comprehensive Income The Company reports comprehensive income (loss) in the consolidated statements of comprehensive income (loss). Reclassifications . Certain prior year information has been reclassified to conform to the current year presentation. The following represents significant new accounting principles adopted in 2012: Repurchase Agreements In April 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-03, Reconsideration of Effective Control for Repurchase Agreements, which deals with the accounting for repurchase agreements and other agreements that both entitle and obligate a transferor to repiirchase or redeem financial assets before their maturity. The provisions of ASU No. 2011-03 modify the criteria for determining when repurchase agreements would be accounted for as a secured borrowing rather than as a sale. Currently, an entity that maintains effective control over transferred financial assets must account for the transfer as a secured borrowing rather than as a sale. ASU No. 2011-03 removes from the assessment of effective confrol the criterion requiring the fransferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the fransferee. The FASB believes that confractual rights and obligations determine effective control and that there does not need to be a requirement to assess the ability to exercise those rights. ASU No. 2011-03 does not change the other existing criteria used in the assessment of effective confrol. The Company adopted the provisions of ASU No. 2011-03 prospectively for fransactions or modifications of existing transactions that occurred on or after January 1, 2012. The Company accounted for all of its repurchase agreements as collateralized financing arrangements prior to the adoption of ASU No. 2011-03 and the adoption had no impact on the Company's consolidated financial statements. Fair Value Measurements h\ May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (IFRSs), to substantially converge the guidance in U.S. GAAP and IFRS on fair value measurements and disclosures. The provisions of ASU No. 2011-04 resuh in a consistent definition of fair value and common requirements for the measurement of and disclosure about fair value between U.S. GAAP and IFRS. The changes to U.S. GAAP as a result of ASU No. 2011-04 are as follows: (1) The concepts of highest and best use and valuation premise are only relevant when measuring the fair value of nonfinancial assets (that is, it does not apply to financial assets or any liabilities); (2) U.S. GAAP currently prohibits application of a blockage factor in valuing financial instruments with quoted prices in active markets. ASU No. 2011-04 extends that prohibition to all fair value measurements; (3) An exception is provided to the basic fair value measurement principles for an entity that holds a group of financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risk that are managed on the.basis ofthe entity's net exposure to either of those risks. This exception allows the entity, if certain criteria are met, to measure the fair value ofthe net asset or liability position in a manner consistent with how market participants would price the net risk position; (4) Aligns the fair value measurement of instruments classified within an entity's shareholders' equity with the guidance for liabilities; and (5) Disclosure requirements have been enhanced for Level 3 fair value measurements to disclose quantitative information about unobservable inputs and assumptions used, to describe the valuation processes used by the entity, and to qualitatively describe the sensitivity of fair value measurements to changes in unobservable inputs and the 41 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 201,1, and 2010 interrelationships between those inputs. In addition, entities must report the level in the fair value hierarchy of items that are not measured at fair value in the statement of condition but whose fair value must be disclosed. The Company adopted the provisions of ASU No. 2011-04 effective January I, 2012. The fair value measurement provisions of ASU No. 2011- 04 had no impact on the Company's consolidated financial statements. See Notes 11 and 12 to the consolidated financial statements for the enhanced disclosures required by ASU No. 2011-04. Other Comprehensive Income In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income, which irevises thej manner in which entities present comprehensive income in their financial statements. The proyisions of ASU No. 2011-05 allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. Under either method, entities are'required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other compreherisive income are presented. ASU No. 2011-05 also elirninates the option tp present the components of other comprehensive income as part of the statement of changes in shareholders' equity but does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU 2011-05 is effective for periods beginning January 1, 2012 and requires refrospective application. ASU No. 2011-05 was effective for the Cbmpany'js interim reporting period beginning on or after January 1, 2012. The Company has chosen to present net income and other comprehensive income in two consecutive statements in the accompanying consolidated financial statements. Stock Dividend On July 1, 2012, the Company paid a special stock dividend of four percent to common shareholders of record at the close of business on June 15, 2012; For all periods presented, share infonnation, including basic and diluted eamings per share, has been adjusted refroactively to refiect this change. (2) Loans and Allowance for Loan Losses Loans ,; ^7 Asummary of loans, by major class within the Company's loanportfolio, at December 31, 2012 and 2011 isas follows: (in thousands) Commercial, financial, and agricultural Real estate construction - residential Real estate constraction - commercial Real estate mortgage - residential Real estate mortgage - commercial Installment and other consumer Total loans r . $ 2012 ' 2011 130,040 $ 22,177 43,486 221,223 405,092 24,966 - 128,555 30,201 47,697 203,454 402,960 30,063 846,984 $ 842,930 The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the communities surroimding Jefferson City, Clinton,'Warsaw, Springfield, Branson and Lee's Summit, Missouri. As such, the Bank is susceptible to changes in the economic environment in these commimities. The Bank does not have a concentration of credit in any one economic sector. Installment and other iibnsumer loans consist primarily ofthe fmancing of vehicles. At December 31, 2012, loans with a carrying value of $457,000,000 "were pledged to the Federal Home Loan Bank as collateral for borrowings and letters of credit. 42 H A W T H O R N 'S ANCSHARESfINC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 The following is a summary ofloans to directors and executive officers or to entities in which such individuals had a beneficial interest of the Company, are summarized as follows: (in thousands) Balance at December 31, 2011 Newloans Amounts collected Balance at December 31, 2012 . ;, • ; . ; .. $ $ 3,161 9,79L (1,937) 11,015 Such loans were made in the nonnal course ofbusiness on substantially the same terms, including interest rates arid collateral requirements, as those prevailing at the same time for comparable fransactions with other persons, and did not involve rnore thanthenormalriskofcollectability or present unfavorable features. . . 43 HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Allowance for loan losses . > The followdng is a summary ofthe allowance for loan losses for the years ended December 31, 2012, 2011, and 2010: (ift thousands) Commercial, Financial, & Agricultural Real Estate Construction - Residential Real Estate Construction - Conimercial Real Estate Mortgage - Residential Real Estate Mortgage - Conimercial Installment Loans to Individuals Un allocated Total Balance at December 31, 2009 . S i,m $ . . 348 $ 1,740 $ 3,488. $ ... 4,693 $ 380 $ W75 $ 14,797: 1,908' ,. ; 2,622.. . ..,. • • 4,133 . Additions: Provision for loan losses Deductions: Loans charged off -, Less recoveries on loans Net loans charged off 1,903 - (153) 1,750 Balance at December 31,2010 S 2,931 $ Additions: Provision for loan losses Deductions: Loans charged off Less recoveries on loans Net loans charged off Balance at December 31,2011 $ Additions; Provision for loan losses Deductions: Loans charged off Less recoveries on loans Net loans charged off 837 2,157 (193) • 1,964 1,804 $ 1,732 1,760 (161) 1,599 , . 933 ' - . (30) 903 2,067 $ 914 1,858 (65) 1,793 1,188 $ (523) 0 (67) (67) 4,740 4,534 (228) 4,306 2,577 3,841 (29)- 3,812" -32 (758) .; .-': 15,254 -•"422 -.., (241) 181 . 0 0 0 •,,,- 16,189 _ . ;-. (703) • 15,486 4,556 (22) 4,534 1,339 $ 3,922 $ 3,458 $ 231 $ 617 $ 14,565 485 512 (250) 262 1,104 1,883 (108) 1,775 8,593 6,420 (103) 6,317 204 376 (208) 168 (614) 11,523 0 0 0 . . 13,206 (927) 12,279 1,562 $ 3,251 $ 5,734 $ 267 $ 3 $ 13,809 126 0 (23) (23) 955 977 (158) 819 6,318 5,466 (248) 5,218 293 586 (265) 321 (1) 0 0 0 ". 8,900 8,789 (922) 7,867 Balance at December 31,2012 $ 1,937 $ 732 $ 1,711 $ 3,387 $ 6,834 .$_ 239 $ 2 $ 14,842 44 H A W T H O R N B A N C S H A R E S, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 The following table provides the balance in the allowance for loan losses at December 31, 2012 and 2011, and the related loan balance by impairment methodology. Loans evaluated under ASC 310-10-35 include loans on non-accraal status, ;which are individually evaluated for impairment, froubled debt restructurings, and other impaired loans deemed to have similar risk characteristics. All other loans are collectively evaluated for impairment under ASC 450-20. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb credit losses. (in thousands) December 31, 2012 Allowance for loan losses: Individually evaluated for impairment Collectively evaluated for impairment Total Loans outstanding; Indi-vidually evaluated for impairment Gollectively evaluated for impairment Total December 31,2011 Allowance for loan losses: Individually evaluated for , impairment Collectively evaluated for impairment Total Loans outstanding: Individually evaluated for impairment Collectively evaluated for impairment Total • Commercial, Financial, and Agricultural Real Estate Construction - Residential Real Estate Construction - Conimercial Real Estate Mortgage - Residential Real Estate Mortgage - Commercial Installment Loans; to Individuals Unallocated Total $ $ 213 $ 1,724 1,937 $ 125 $ 607 732$ 542 $ 1,169 1,711 S 1,069 $ 2,318 3,387 $ 2,071 $ 4,763.. 6,834 $ 0 $ 239 239 $ 0 $ ,,4,020 . 2 . 2,$ 10,822 14,842 4,157 $ ,2,496 : 7,762 5,771 $ 18,959 $ 44 : 0 $ ,,39,189' 125,883 130,040 $ 19,681 22,177 $ 35,724 43,486 $ 215,452 221,223 $ 386,133 405,092 $ 24,922' 24,966 $ 0 0 S .807,795 846,984 239 167 $ 380 653 $ 2,309 1,565 1,804 $ 1,021 1,188 $ 1,182 1,562 $ 2,598 3,251 $ 3,425 5,734 $ 0 $ 267 2 6 7$ 3,748 "10,061 .13,809 3 $ 4,428 1,147 $ 7,867 $ 6,569 33,440 0 $ 0 $ 53,451 , 124,127 128,555 $ 29,054 30,201 $ 39,830 47,697 $ 196,885 203,454 $ 369,520 402,960 $ 30,063 30,063 $ 0, . 789,479 842,930 0 $ Loans, or portions ofloans, are'charged off to the extent deemed uncollectible. Loan charge-offs reduce the allowance for loan losses, and recoveries ofloans previously charged off are added back to the allowance. Once the fair value for a collateral dependent loan has been determined, any impaired amount is typically charged off unless the loan has other income sfreams to support repayment. For impaired loans which have other income streams to support repayment, a specific reserve is established for the amount determined to be impaired. Impairedloans Impaired loans totaled $39,363,000 and $53,620,000 at December 31, 2012 and 2011 respectively, and are comprised ofloans on non-accrual status and loans which have been classified as froubled debt restracturings. The categories of impaired loans at December 31, 2012 and 2011 are as follows: (in thousands) Non-accrual loans Troubled debt restructurings continuing to accrue interest Total impaired loans 2012 2011 31,081 $ 8,282 39,363 $ 46,403 - 7,217 53,620 $ $ 45 HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 The following tables provide additional information about impaired loans at December 31, 2012 and 2011, respectively; segregated between loans for which an allowance has been provided and loans for which no allowance has been provided: (in thousands) ._ At December 31, 2012 Wltli no related allowance recorded: Commercial, financial and agricultural Real estate - construction residential Real estate - construction commercial Real estate - residential Real estate - commercial Consumer Total ^_ With an allowance recorded: Commercial, financial and agricultural Real estate - construction residential Real estate - construction commercial Real estate - residential Real estate - commercial Consumer i Total Total impaired loans At December 31, 2011 Witli no related allowance recorded: Commercial, financial and agricultural Real estate - construction residential Real estate - construction commercial Real estate - residential Real estate - commercial Consumer, Total With an allowance recorded: . Commercial, financial and agricultural Real estate - construction residential Real estate - construction commercial Real estate - residential Real estate - commercial Total Total impaired loans- Recorded Investment Unpaid Principal • Balance f . Related Allowance $ $ $ $ $ , 4;oo9. $ 2,339 2,102 2,393 5,565 186 16,594 $ 898 S 189 6,011 3,999 14,167 44 -•-,,25,308 $ 41,902 $ ,3,625 788 1,756 2,654 21,190 177, 30,190 $ '904 563 6,448 4,265 18,780 30,960 $ 61,150 $ 3,272 -$ 2,307 1,879 1,939 5,162 174 14,733 $ 885 $ 189 5,883 3,832 13,797 44 24,630 $ 39,363 $ 3,546 $ 584 1,459 2,315 15,151 168 23,223 $ 882 563 6,409 4,254 18,289 30,397 $ 53,620 $ 0 0 0 0 0 0 0 213 125 , 542 1,069 2,071 0 4,020 4,020 0 239 167 380 653 2,309 3,748 3,748 46 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements- December 31, 2012, 2011, and 2010 The following table presents by class, information related to the average recorded investment and interest income recognized on impaired loans for the years ended December 31, 2012 and 2011: • - \ (in thousands) With no related allowance recorded: Commercial, financial and agricultural Real estate - construction residential Real estate - construction commercial . Real estate - residential Real estate - commercial Consumer Total With an aUowance recorded: Commercial, financial and agricultural Real estate - construction residential^:..- , Real estate - construction commercial Real estate - residential Real estate - commei-dal Consumer -^ Total Total impaired loans f. r 2012 2011 Average Recorded Investment Interest Recognized Forthe Period Ended Average Recorded Investment Interest Recognized Forthe Period Ended 4,157 : 1,137 1,692 3,169 12,198 170 22,523 $ 7 7 6 - $ -• 189 6,087 2,604 11,271 . 2 20,929 : . 43,452 : 93 : 7 0 50 : 124 ,1 ..275 29 ; 0 0 11 99 0 139 $ 414 : 3,510 : 1,273 3,568 3,596 18,270 190 30,407 : 655 : .. 47 5,805 3,203 12,724 0 :• 22,434 $ 52,841 $ 52- 0 0 26 7 3; 155 17-- 0 0 113 .0 - :0 .130 285 The specific reserve component ofthe Company's allowance for loan losses at December 31, 2012 and 2011 was, determined by using fair values of the imderlying collateral obtained through independent appraisals and intemal evaluations, or by discounting the total expected fiiture cash flows. The recorded investment varies from the unpaid principal balance primarily due to partial charge-offs taken resulting from cunent appraisals received. The amount recognized as interest income on impaired loans continuing to accrue interest, primarily related to troubled debt restructurings, was $275,000 and $155,000, for the years ended December 31, 2012 and 2011, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during, the periods reported, Confractual interest due on loans in non-accraal status was $1,198,000 at December 31, 2012 compared to $1,952,000 at December 31, 2011..Interest income recognized on loans in non-accrual status was $11,000 for the year ended December.31, 2011. During the year ended December 3,1, 2012 there was no significant interest recognized on loans in non-accrual statos. : Delinquent and Non-Accrual Loans The delinquency status ofloans is determined based on the confractual terms ofthe notes. Borrowers are generally classified as delinquent once payments beiiome 30 days or more past due. 47 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 The following table provides aging information for the Company's past due and non-accraal loans at December 31, 2012 and 2011. (in thousands) December 31,2012 Commercial, Financial, and Agricultural Real Estate Construction - Residential Real Estate Construction - Commercial Real Estate Mortgage - Residential Real Estate Mortgage - Commercial Installment and Other Consumer Total December 31,2011 Commercial, Financial, and Agricultoral Real Estate Construction ~ Residential Real Estate Construction - Commercial Real Estate Mortgage - Residential Real Estate Mortgage - Commercial Installment and Other Consumer Total Credit Quality Current or Less Than 3,0;Days PastDue 90 Days Past Due And Still Accruing 30-89 Days Past Due Non-Accrual Total 126,884 19,390 35,117 213,694 390,032 24,221 809,338 126,244 $ . 29,054 39,822 195,779 371,000 29,282 791,181 $ 1,821 290 607 2,199 ,1,122 520 6,559 $ 243 . 0 - 0 3,513 924 612 5,292 0 0 8- 9 36 •54 $ l-,335 $ 2,497 7,762 5,330 13,938 . 219 31,081 2,068 1,1.47; 7,867 4,153 31,000 168 46,403 130,040 22,177 43,486' 221,223 405,092. 24,966- 128,555 30,201 . 47,697 • 203,454 • 402,960 30,063 842,930; The following table provides information about the credit quality ofthe loan portfolio using the Company's intemal rating system reflecting management's risk assessment. Loans are placed on watch status when (I) one or more weaknesses that could jeopardize timely liquidation exits; or (2) the margin or liquidity of an asset is sufficiently tenuous that adverse trends could result in a collection problem. Loans classified as substandard are inadequately protected by the cmrent sound worth and paying capacity ofthe obligor or by the collateral pledged, if any. Loans so classified may have a well defined weakness or. weaknesses that jeopardize the repayment ofthe debt. Such loans are characterized by the distinct possibility that the Company may sustain some loss if the deficiencies are not conected. It is the Company's, policy to discontinue the accrual ofinterest income on loans when management believes that the collection ofinterest or principal is doubtful. Loans are placed on non- accrual status when (1) deterioration in the fmancial condition ofthe borrower exists for which payment of fiillprincipal arid interest is not expected, or (2) payment of principal or interest has been in defauh 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. 48 HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Commercial, Financial, & Agricultural Real Estate Construction - Residential Real Estate Construction - Commercial Real Estate Mortgage- Residential Real Estate Mortgage - Commercial Installment and other Consumer (in thousands) At December 31, 2012 Watch Substandard Non-accrual Total At December 31, 2011 Watch Substandard Non-accrual Total $ - $ 14,814 $ 6,485 1,335 22,634 $ $ $ , -; 22,206 $ 4,142 2,068 28,416 $ 4,580 $ 396 2,497 . 7,473 $ 9,644$ 842 1,147 11,633 $ ; 6,459 $ 2,035 7,762 .16,256 $ 26,063 S 5,472 5,330 36,865 $ 9,338 $ ^^i;i89 7,867 18,394 $ 13,231 $ 4,269 ; 4,153 21,653 $ 29,753 $ 11,027 13,938 . 54,718 $ 24,392 $ 8,004 31,000 63,396 $ Total •' 82,341, ,.j 25,838 31,081 139,260 ' 6 7 2$ • 423, • 219 1,314$ . 557,.$ 444 168 V 1,169$ 79,368 18,890 46,403 144,661 Troubled Debt Restructurings At December 31,2012, loans classified as froubled debt restracturings (TDRs) totaled $22,363,000, ofwhich $14,081,000 was on non-accrual status and $8,282,000 was on accraal status. At December 31, 2011, loans classified as TDRs totaled $32,165,000, ofwhich $24,948,000 was on non-accraal status and $7,217,000 was on accraal status. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected fiiture cash flows discounted at the loan's effective interest rate or the fair value ofthe underlying collateral less applicable selling costs. Accordingly, specific reserves of $1,544,000 and $1,522;000 were allocated to the allowance for loan losses at December 31,2012 and 2011, respectively. The following table summarizes loans that were modified as TDRs during the years ended December 31, 2012 and 2011: (in thousands) Troubled Debt Restructurings Commercial, financial and agricultural Real estate construction - commercial Real' estate mortgage - residential Real estate mortgage - commercial Consumer Total 2012 Recorded Investment (1) 2011 Recorded Investment (1) Number of Contracts Pre Modification Post- Modiflcation Number of Contracts Pre- Modification Post-, Modification 4 S 1 5 2 . 2 14 $ 637 $ 43. 657 645 44 2,026 $ 613 41 657 644 44 1,999 9 $ 8 7 9 0 33 $ 3,500 $ 6,616 1,157 9,553 0 . 20,826 $ 3,486 =6,227 1,010 9,215 0 19,938 (1) The amounts reported post-modification are inclusive of all partial pay-downs and charge-offs, and no portion ofthe debt was forgiven. Loans modified as a TDR that were fiilly paid down, charged-off or foreclosed upon during the period ended are not reported. The Company's portfolio ofloans classified as TDRs include concessions such as interest rates below the current market rate, deferring principal payments, and extending maturity dates. Once a loan becomes a TDR, it will continue to be reported as a TDR until it is ultimately repaid in fiill, charged-off, or the collateral for the loan is foreclosed and sold. The Company considers a loan in TDR status in default when the borrower's payment according to the modified terms is at least 90 days past due or has defaulted due to expiration ofthe loan's maturity date. During the year ended December 31, 2012, fourteen loans meeting the TDR criteria were modified. There was one loan modified as a TDR that defaulted during the year ended December 31, 2012, and vrithin twelve months of their modification date. No loans modified as a TDR during the year ended December 31, 2011 defaulted. 49 HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated-Financial Statements December 31, 2012, 2011, and 2010 (3) Real Estate and Other Assets Acquired in Settlement of Loans • " "; - (in thousands) Commercial Real estate constmction - residential Real estate constraction - commercial Real estate mortgage - residential Real estate mortgage - commercial Repossessed assets Total Less valuation allowance for other real estate owned Total other real estate owned and repossessed assets '• 2012 2011 329 $ 112 13,392 1,227 14,20L 468 29,729 $ (6,137) 23,592 $ 17 307 13,650 2,121 6,623 , . - 279 22,997 (6,977) 16,020 $ $ . : ; •. ;• - • .. : . -- . . .. . .. : . ' . . -. Balance at December 31,2010 Additions Proceeds from sales ; - Charge-offs against: the valuation allowance for other real estate owned Net gain on sales ; . • , • .- -'• Balance at December 31, 2011 Additions Proceeds from sales Charge-offs against the valuation allowance for other real estate owned, net ^ Net gain on sales Total other real estate ovraed and repossessed assets Less valuation allowance for other real estate owned Balance at December 31,2012 , $ ' •' $ 20,168 10,903 (7,435) (433) K206) 22,997 16,869 (8,571) (1,883) 317 29,729 (6,137) 23,592 During the years ended December 31, 2012 and 2011, net charge-offs against the allowance for loan losses at the time of foreclosure were approximately $6,705,000 and $8,248,000, respectively. -' 50 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Activity in the valuation allowance for other real estate owned in settiement ofloans for the years ended December 31, 2012, 2011 and 2010, respectively, is summarized as follows: (in thousands) 2011 2010 2012 • - Balance, beginning of year Provision for other real estate owned Charge-offs Balance, end of year $ 6,977 713 (1,553) 6,137 $ $ 6,158 1,252 _i433i 6,977 S 0 6,158 .0, 6,158 The significant change in the expense provision from the years ended 2010 to 2012, primarily related to one foreclosed commercial real estate constraction property. During the year ended December 31, 2010, tiie Coinpany recorded a $5,663,000 provision and related valuation allowance related to this property reflecting its current appraised value. During the.year ended December 31, 2012, real estate values improved and comparable sales occurred which led to an,increased current,appraised value that allowed the Company to recover $3,908,000 ofthis valuation allowance. This recovery partially offset current year expense provisions for other real estate owned of $4,621,000,primarily atfributable to eight properties where significant write downs were required to reflect current appraised values. These' amounts are reflected" in other real esta;te expense in the consolidated statements of operations. (4) Investment Securities A summary of investment securities by major category, at fair value, consisted ofthe following at December 31, 2012 and 2011, respectively. (in thousands) 2011 2012 ^ - U.S. Treasury Govemment sponsored enterprises Asset-backed securities Obligations of states and political subdivisions Total available for sale securities 2 , 0 3 0$ 55,180 107,872 -^ 35,164 2;054 70,314 107,329' 34,109 '200,246; $ 213,806 All ofthe Company's investment securities are classified as available for sale, as discussed in more detail below. Asset backed securities include agency mortgage-backed securities, which are guaranteed by government sponsored agencies such as the FHLMC, FNMA and GNMA. The Company does not invest in subprune originated mortgage-backed or collateralized debt obligation instraments. '' ' Investment securities that are classified as restticted equity securities primarily consist of Federal Home Loan Bank stock and the Company's interest m statutory trasts. These securities are reported at cost in other assets in the amoimt of $3,925,000 and $4,385,000 as of December 31, 2012 and 2011, respectively. 51 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 The ariiortized cost and fair value of debt securities classified as available-for-sale at December 31, 2012 and 2011 are as follows: (in thousands) December 31,2012 • - U.S. Treasury Govemment sponsored enterprises Asset-backed securities Obhgations of states and political .subdivisions Amortized cost Gross unrealized gains Gross imrealized losses Fair value 2,000 $ 54,327 104,607 30 853 3,276 0 $ 0 II 2,030 55,180 107,872 33,959 . 1,222 17 35,164 Total available for sale securities $ 194,893 •$ 5,381 $ 28 $ 200,246 : • •' . / • • . . ., . • Weighted average yield at end of period 2.54 % December 31, 2011 U.S. Treasury Govemment sponsored enterprises Asset-backed securities Obligations of states and political subdivisions 2,000 $ 69,703 103,806 32,716 54 $ 629 3,547 1,394 Total available for sale securities $ 208,225 $ 5,624 $ Weighted average yield at end ol period 2.89 % 0 $ 18 •24 .2,054 70,314 107,329 I 34,109 43 $ 213,806 The amortized cost and fair value of debt securities classified as available-for-sale at December 31, 2012, by confractual maturity are shown below. Expected maturities may differ from confractual maturities becaiise borrowers have the right to call or prepay obligations with or without prepayment penalties. (in thousands) Due in one year or less Due after one year through five years Due after five years through ten years Due after ten years Total Asset-backed securities Total available for sale securities Amortized cost 3,919 $ 63,985 20,478 1,904 '90,286 104,607 194,893 $ $ $ Fair value 3,951 65,154 21,340 i;929 92,374 107,872 200,246 Debt secm-ities wath carrying values aggregating approximately $146,442,000 and $172,447,000 at December 31, 2012 and 2011, respectively, were pledged to secure public fimds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law. Gross unrealized losses on debt securities and the fair value ofthe related securities, aggregated by investment category and length of time that individual securities have been in a continuous unreahzed loss position, at December 31, 2012 and 2011, were as follows: 52 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 (in thousands) At December 31, 2012 Government sponsored enterprises Asset-backed securities Obligations of states and political subdivisions . Total (in thousands) At December 31,2011 Government sponsored enterprises Asset-backed securities Obligations of states and political subdivisions Total Less than 12 months Fair Value Unrealized Losses 12 months or more Fair Value Unrealized Losses d Tots Fair Value Unrealized Losses $• $ 1,044 4,729 2,114 0 $ (11) (17) 0 $ 0 .. 150 $ 7,887 $ (28) $ 150 $ 0 0 0 0 $ $ . 1,044 4,729 . 2,264 $ 8,037 $. $• $ 13,250 4,591 229 18,070 _$_ $ $ (18) (24) (1) (43) $ 0 $ 0 150 150 $ '$ ' 0 0 13,250 4,591 • $" 0 tL $ 379 18,220 $ 0 (11) ;(i7) (28) • ( 1 ^) (24) (1) (43) The total available for sale portfolio consisted of approximately 380 securities at December 31, 2012. The fiortfolio included 14 securities, having an aggregate fair value of $8,037,000 that were in a loss position at December 31, 2012. Securities identified as temporarily impaired which have been in a loss position for 12 months or longer totaled $150,000 at fair value. The $98 unrealized loss included in other comprehensive income at December 31, 2012 was caused by interest rate fluctuations. The total available for sale portfolio consisted of approximately 365 securities at December 31, 2011. The portfolio included 20 securities, having an aggregate fair value of $ 18,220,000 that were in- a loss position at December 31, 2011. Securities identified as temporarily impaired which have been in a loss position for 12 months or longer totaled $150,000 at fair value. The $294 imrealized loss included in other comprehensive income at December 31, 2011 was caused by interest rate fluctuations. Because the decline in fair value is attributable to changes in interest rates and not credit quahty these investments; were not considered other-than-temporarily impaired at December 31, 2012 and 2011, respectively. The table presents proceeds from sales" of securities aiid the components of investment securities gains and losses which have been recognized in eamings as follows: (in thousands) Proceeds from sales of available for sales securities Gains realized on sales Losses realized on sales Other-than-temporary impairment recognized Investment securities gains 2012 2011 2010 $ $ 790 $ 26 0 0 26 $ 0 $ 0 a 0 0 $ 0 0 0 0 0 53 HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 (5) Premises and Equipment A summary of premises and equipment at December 31,2012 and 2011 is as follows: (in thousands) ' 2012 Land and iand improvements ; Buildings and improvements Furniture and equipment Constmction in progress Total Less accumulated depreciatioii Premises and equipment, net 10,073 $ 34,174 12,250 155 56,652 19,631 37,021 $ $ 2011 10,121 33,652 12,013 ... 277 ' 56,063 18,110 37,953 Depreciation expense for the years ended December 31, 2012, 2011, and 2010 is as follows: (in thousands) - 2012 2011 2010 Depreciation expense $ , 1,858 $ 1,940 $ 1,964 (6) Intangible Assets Core Deposit Intangible Asset' A summary of amortizable intangible assets at December 31, 2012 and 2011 is as follows: (in thousands) _ _ : _^ 2012 ' 2011 Gross Carrying Amount Accumulated Amortization Net Amount Gross Carrying Amount Accumulated Amortization •Net Amount Core deposit intangible $ 4,795 $ . (4,660) $ ... 135 $ 4,795 $ . (4,252) $ 543 The Company's amortization expense on intangible assets in any given period may be different from the estimated amoimts depending upon the acquisition of intangible assets, changes in mortgage interest rates, prepayment rates, and other market conditions. The following table shows the estimated future amortization expense based on existing asset balances and the interest rate environment as of December 31, 2012 for the next five years: ' (in thousands) 2013 2 0 14 2 0 15 2016 2017 • $ . 'h •-• • • 54 : Core Deposit Intangible Asset . ' ;'135 0 Q 0 0 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Changes in the net carrying amount of core deposit intangible assets for the years ended December 31, 2012, 2011, and 2010 is as follows: (in thousands) Balance at beginning of year Additions Amortization Balance at end of year Mortgage Servicing Rights 2012 2011 2010 • $ S 543 $ 0 (408) 135 $ 978 $ 0 (435) . 543 $ . 1,504 0 (526) 978 > On January 1, 2012, the Company opted to measure mortgage servicing rights at fair value as permitted by Accounting Standards Codification (ASC) Topic 860-50, Accounting for Servicing Financial Assets. The election of this option resulted in the recognition of a cumulative effect of change in accounting principle of $459,890, which was recorded as an increase to beginning retained eamings. As such, effective January 1, 2012, changes in the fair value of mortgage servicing rights is recognized in eamings in noninterest income in the period in which the change occurs and no amortization will be recognized on mortgage servicing rights going forward. For the years ended December 31, 2011 and 2010, MSRs were amortized over the shorter of 7 years or the life of the loan and periodically reviewed for impairment. At December 31, 2011 and 2010, no temporary impairment was recognized. At December 31, 2012 and 2011, respectively, the Company serviced mortgage loans for others totaling $310,587,000 and $307,016,000, respectively. Mortgage loan servicing fees eamed on loans sold were $878,000, $863^000, and $927,000 for the years ended DecemberSl, 2012, 2011, and 2010, respectively, and are reported as other noninterest income. The table below presents changes in mortgage servicing rights (MSRs) for the years ended December 31, 2012, 2011, and 2010 as follows: (in thousands) Balance at beginning of year Re-measurement to fair value upon election to measure servicing rights at fair value Originated mortgage servicing rights Changes in fair value: Due to change in model inputs and assumptions (I) Other changes in fair value (2) Amortization Balance at end of year 2012 2011 2010 2,308 .,$ 2,356 $ 2,021 742 830 122 (1,453) 0 . 0 760 ' 0 0 " (808) 0 1,169 0 0 (834) 2,549 $ 2,308 $ 2,356 (1) The change in fair value resulting froin changes in valuation inpiits or assumptions used hi the valuation model reflects the change in discount rates and prepayment speed assumptions primarily due to changes in interest rates. (2) Other changes in fair value reflect changes due to customer payments and passage of time. This also includes a one time adjustment of a $538,000 correction of an immaterial prior period error due to changing from the straight-line amortization method to an accelerated amortization method of accounting for amortizing MSRs in prior years. If the aforementioned was corrected as of December 31, 2011, the balance at the beginning of the period would have been $1,770,000. 55 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 The following key data and assumptions were used in estunating the fair value ofthe Company's mortgage servicing rights as of the years ended December 31, 2012 and 2011: Weighted-Average Constant Prepayment Rate Weighted-Average Note Rate Weighted-Average Discoimt Rate Weighted-Average Confractual Life (in years) (7) Deposits 2012 2011 % % % 18.60 4.22 7.99 20:00 % % % 20.86 4.64 7.99 23.00 - The scheduled maturities of total time deposits as ofthe years ended December 31, 2012 and 2011 are as follows:, (in thousands) Due within: One year Two years Three years Four years Five years Thereafter,- Total 2012 2011 280,477 $ .-, 65,220 23,482 11,984 12,139 0 393,302 $ .266,516 - 93,209 V 34,730 8,811 ,: 11,172 0 414,438 At December 31, 2012 and 2011, the Company had certificates and other time deposits in denominations of $100,000 or more which mature as follows: (in thousands) Due within: Three months or less Over three months through six months Over six months through twelve months Over twelve months Total 2012 2011 - 37,166 $ • 18,690 33,265 31,656 52,274 16,017 32,291 38,922 120,777 $ 139,504 The Federal Reserve-Bank required the Bank to maintain cash or balances of $1,367,000 and $1,335,000 atDecember 31, 2012 and 2011, respectively, to satisfy reserve requirements. Average compensating balances held at correspondent banks were $1,595,000 and $489,000 at December 31, 2012 and 2011, reispectively. The Bank maintains such compensatmg balances with correspondent banks to offset charges for services rendered by those banks. 56 H A W T H O RN BANCSHARES, INC; .: AND SUBSIDL\RIES Notes to the Consolidated Financial Statements; December 31, 2012, 2011, and 2010 (8) Borrowings Federal Funds Purchased and Securities Sold under Agreements to Repurchase (Repurchase Agreements) Information relating to federal fimds purchased and repurchase agreements is as follows: (in thousands) 2012 • Year End Weighted Rate Average Weighted Rate Average Balance Outstanding Maximum Outstanding at any Month End Balance at December 31, Federal fiinds purchased Short-term repurchase agreements 0.0 . 0.1 0.1 412 22,867 345 24,734 Total 2011 Federal fiinds purchased Short-term repurchase agreements \ 0.0 % 0.1 , 0.3 % $ 0.2 ' 2, $ .. 27,634 Total 0 $ 30,227 $ 0 21,058 21,058 0 24,516 '24,516 The securities underlying the agreements to repurchase are under the conttol ofthe Bank. All securities sold under agreements to repurchase are secured by a portion ofthe Bank's investment portfolio. Under agreements with unaffiliated banks, the Bank may borrow federal fimds up to $15,000,000 on an imsecured basis and $5,135,000 on a secured basis at December 31, 2012. Subordinated Notes and Other Borrowings Other borrowings of the Company consisted of the following: (in thousands) 2012 FHLB advances The Bank Borrower Total Bank Subordinated notes The Company Total Company Maturity Date 2013 $ 2014. 2015 2016 2017-18 $ Year End Balance 10,126 . 0 0 0 10,000 20,126 2034 $ 2035 $ 25,774 23,712 49,486 Year End Weighted Rate 2011 Year End Balance Year End Weighted Rate 1.5 % na na na 2.5 % 3.0 % 2.f % $ $ $ _$_ 8,284 10,126 0 0 10,000 28,410 25,774 23,712 49,486 1.6 % 1.5 % na na 2.5 % 3 . 3% •, 2.4 % The Bank is a member ofthe Federal Home Loan Bank of Des Moines (FHLB) and has access to term financing from the FHLB. These borrowings are secured under a blanket agreement which assigns all investment in FHLB stock, as well as mortgage loans equal to 125% to 175% (based on collateral type) ofthe outstanding advance balance, to secure amounts borrowed by the Bank. The outstanding balance of $20,126,000 uicludes $10,000,000 which the FHLB may call for early payment within the next year. Based upon the collateral pledged to the FHLB at December 31, 2012, the Bank could borrow up to an additional $269,958,000 under the agreement. 57 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 On March 17, 2005, Exchange Statiitory Tmst II, a business tiTist, issued $23,000,000 of 30-year floating rate Trust Preferred Securities (TPS) to a TPS Pool. The floating fate is equal to a three-month LIBOR rate plus 1.83% and reprices quarterly (2.14% at December 31, 2012). The TPS can be prepaidWithout penalty at any time after five years from the issuance date. The TPS represent preferred,interests m the frust. The Company invested approximately $712,000 in common interests in the trust and the purchaser in the private placement purchased $23,000,000 in preferred interests. The proceeds were used by the,tmst to purchase from the Company its 30-year deeply subordinated debentures whose terms mirror those stated above for the TPS: The debentures are guaranteed by the Company pursuant to a subordinated guarantee. Disfributions on the TPS are payable quarterly on March 17, June 17, September 17, and December 17 of each year that the TPS are outstanding. The frustee for the TPS holders isU.S. Bank, N;A.. The tioistee does not have the power to take enforcement action in the.event of a defauh.under the TPS for five years from thedate of default. In the event of default, however, the Company would be precluded from paying dividends imtil the defauh is cured. • On March 17, 2004, Exchange Statutory Trust I, a Delaware business trust and subsidiary of the Company issued $25,000,000 of floating TPS to a TPS Pool. The floating rate is equal to the three-month LIBOR rate plus 2.70% and reprices quarterly (3.00% at December 31; 2012). The TPS are-fiilly, irrevocably, and unconditionally guaranteed on a subordinated basis by the Company. The proceeds ofthe TPS were invested in junior subordinated debentures ofthe Company. Distributions on the TPS are payable quarterly on March 17, June 17, September 17, and December 17 of each year that the TPS are outstanding. The-TPS mature on March 17, 2034. That maturity date may be shortened if certain conditions are met. ' The Exchange Statutory Tmsts are not consolidated in the Company's financial statements. Accordingly, the Company does not report the securities issued by the Exchange Stamtory Trusts as liabilities, and instead reports the subordinated notes issued by the Company and held by the Exchange Stamtory Trusts as liabilities. The amount of the subordinated notes as of December 31, 2012 and 2011 was $49,486,000, respectively. The Company has recorded the investments in the common securities issued by the Exchange Statatory Trusts aggregating $1,486,000, and the corresponding obligations under the subordinated notes, as well as the interest income and interest expense on such investments and obligations in its consolidated fmancial statements. (9) Income Taxes The composition of income tax expense (benefit) forthe years ended December 31, 20,12, 2011, and 2010 are as follows: (in thousands) Current: Federal State Total current Deferred: Federal State Total deferred 2012 2011 2010. $ . 651 $ 156 807 (197) . (64)..;, (261) 374 $ (214) 160 386 45 431 (837) 80 (757) (2,091) (239) (2,330) Total income tax expense (benefit) % .. 546 $ .591 $. . (3,087) 58 HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and2010' Applicable income tax (benefit) expense for financial reporting purposes differs from the amount computed by applying the statutory Federal income tax rate for the reasons noted in the table for the years ended December 31, 2012, 2011, and 2010 are as follows: (in thousands) Income (loss) before provision for income tax expense (beneflO Tax at statutory Federal income tax rate Tax-exempt income State income tax, net of Federal tax benefit Release of prior year over acaual Other, net 2012 Amount 2011 Amount 2010 Amount $ .. $ - 3,368 1,145, 34,00 % $ $ (380) (11.27),, 3,448 1,172 (404) . - $ (6,639) 34.00 % $ . ^ (2,257)- 34,00 % (11.72). f. 61 (371) . 91 1.81 : (11,01) 2.70. (111) 0 (3.23) 0.00 (66) (1.91) (445) 6.70 : (105) 0 (280) 1.58 0.00 4,22 Provision for income tax expense (benefit) 546 16.23 % 591 17,14 % (3,087) 46.50 % The components of deferred tax assets and deferred tax liabilities at December 31, 2012 and 2011 are as follows: (in thousands) Deferred tax assets: Allowance for loan losses Impairment of other real estate owned Goodwill Deferred taxes on pension Nonaccraal loan interest Core deposit intangible Pension Deferred compensation Other Total deferred tax assets Deferred tax liabilities: Available-for-sale securities Premises and equipment Mortgage servicing rights Assets held for sale FHLB stock dividend Other Total deferred tax liabilities Net deferred tax asset 2012 2011 : 5,640 $ 2,774 2,483 997 940 - 904 , 450 : 36 449 = 5,248 • ••-' 2,734 .. .2,831 , . 1,380 1,033 883 276 27 549 -• 14,673 $ 14,961 ;,088 $ 958 908 110 100 1 • , . , . .• 4,165 2,177 960 791 109 100 ,. 2 4,139 10,508 $ 10,822 The ultimate realization of deferred tax assets is dependent upon the generation of futare taxable income during the periods in which those temporary differences become deductible. Managemerit considers the scheduled reversal of deferred tax liabilities, projected fiitare taxable income, and tax planning sfrategies in making this assessnient. Based upon the level of historical taxable income and projections for foture taxable income over the periods in which the 59 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 deferred tax assets are-deductible, management believes it is more likely than not the Company will reahze the benefits of these temporary differences at December 31, 2012 and, therefore, did not establish a valuation reserve. At December 31, 2012, the accumulation of prior years' eamings representing tax bad debt deductions ofthe Bank was $2,931,503. If these tax bad debt reserves were charged for losses other than bad debt losses, the Bank would be required to recognize taxable income in the arnount ofthe charge. It is not contemplated that such tax-restticted retained eamings will be used m a marmer that would create federal income tax liabilities. The Company follows ASC Topic 740, Income Taxes, which addresses the accounting for uncertain tax positions. As a result ofthe lapse ofthe statae of limitations for the 2007 tax year, the Company recognized $340,351 of gross unrecognized tax benefits and $30,969 of accrued interest. This resulted in a decrease in the effective tax rate for the year ended December 31, 2011 compared to December 31, 2010. As of December 31, 2012 and 2011, respectively, the Company did not have any uncertain tax provisions. A reconciliation ofthe beginning and ending amount of the unrecognized tax benefits is as follows: Unrecognized tax benefits as of January 1, Gross amounts ofthe increases and decreases in unrecognized tax benefits as a resuk of tax positions taken during prior years Gross amounts ofthe increases and decreases in unrecognized tax benefits as a result of tax positions taken during year The amount of decreases in unrecognized tax benefits relating to settlements with taxing authorities Reductions to unrecognized benefits as a result of a lapse ofthe applicable statute of limitations 2012 0 $ 2011 340,351 ..$ 2010 562,076 0 0 0 0 0 .'-0 ,0 .. . 0 0 . 0 ' (340,351) (221,725) Unrecognized tax benefits as of December 31, 0 $ 0 $, 340;351 (10) Employee Benefit Plans Employee benefits charged to operating expenses are summarized in the table below for the years ended December 31, as indicated. (in thousands) Payroll taxes Medical plans 401k match Pension plan Profit-sharing Other Total employee benefits 2012 2011 2010 ,127 $ ,772 298 ,224 58 318 4,797 $ 1,098 S 1,676 291 907"' 0 250 4,222 $ ' 1,105 1,545 319 '864 0 162 3,995 The Company's profit-sharing plan includes a matching 401k portion, in which the Coinpany rnatches the first 3% of eligible employee confributions. The Company made annual confributions in an amoimt up to 6%) of income, before income taxes-and before confributions 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 confributions. 60 H A W T H O RN BANCSHARES, ING. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Pension The Company provides a nonconfributory defined benefit pension plan for all fall-time employees. An employer is required to recognize the fanded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that fimded status in the year iri which the changes occur through cornprehensive income. Under the Company's fanding policy for the defined benefit pension plan, confributions are made to a tmst as riecessary to provide for current service and for any unfanded accraed actuarial liabilities over a reasonable period. To the extent that these requirements are fally covered by assets in the trast, a contribution might not be made in a'patticular year. The Company made $766,000 of confributions to the defined benefit plan through April 1, 2013, of which $238,000 relates to the 2011 plan year and $528,000 relates to the 2012 plan year. The minimum required corittibution for the 2013 plan year is estimated to be $665,000. The Company has not determined whether it will make any contributions other than the minimum required fimding contiibution for 2013. • < Obligations and Funded Status at December 31 (in thousands) Change in projected benefit obligation: Balance, January 1 Service cost Interest cost Actaarial (gain) loss Benefits paid ' Balance, December 31 Change in plan assets: Fair value, January 1 Actaal gain (loss) return on plan assets Employer conttibution Expenses paid Benefits paid Fair value, December 31 Funded status at end of year Accumulated benefit obligation 2012 2011 14,217;. 1,168 667 (458) (252) 15,342 $ f 0,034 1,193 766" (34) (252) 11,707' $ (3,635) $ ^^=- $ $ . \% .. 12,564 .$ 10,655 931 604 '2,240 ' ( H 3) 14,217 9,296 (54) 1,005 0 (213) •: 10,034 (4,183) 10,762 Components of Net Pension Cost and Other Amounts Recognized in Accumulated Other Comprehensive Income The followdng items are components of net pension cost for the years ended December 31, as indicated: , (in thousands) Service cost—^benefits earned during the year Interest costs on projected benefit obligations Expected return on plan assets Expected administrative expenses Amortization of prior service cost Amortization of imrecognized net loss Net periodic pension expense $ 2012 2011 2010 ,168. $ 668 (776) 40 78 46 1,224 $ 931 $ 604. (706) 0 78 0 907 $ 844 556 (614) 0 78 0 864 61 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December31,2012, 2011, and 2010 Amounts not yet reflected in net periodic benefit cost and included in accumulated other comprehensive income (loss) at December 31, 2012 and 2011 are shovm below, including amoimts recognized in other comprehensive income during the periods. All amounts are shown on a pre-tax basis. •- • • (in thousands) • ' ' Prior service costs' ' Net accumulated actaarial net loss Accumulated other comprehensive loss ' ' :. •-• ' 2012 2011 $ ( 6 0 0) $ ••, (1,849) (2,449) ;(679) (2,777) (3,456) Net periodic benefit cost in excess of cufnulative employer contributions ' •(1,185)- •• ' (727) Net amount recognized at December 31, balance sheet Net gain (loss) arising during period Prior service cost amortization Amortization of net actuarial loss Total reeognized in other comprehensive income (loss) Total recognized in net periodic pension cost and other comprehensive income (loss) $ $• $ $ .(3,634)$; : 88L $ 79 ••• 4 6 '^ 1,006 $ • (4,183) (3,001) 79 0 (2,922) 218 S 3,829 The estimated prior service cost for the defined benefit pension plan that will be amortized froni accumulated other comprehensive income into net periodic cost in 2013 is $79,000. During 2013, $3(),000 is the estimated amount of actuarial loss subject to amortization into net periodic pension cost. Assumptions utilized to determine benefit obligations as of December 31, 2012, 2011 and 2010 and to determine pension expense for the years then ended are as follows: '. Determination of benefit obligation at year end: Discount rate Aimual rate of compensation increase Determination of pension expense for year ended: Discount rate for the service cost Annual rate of compensation increase Expected long-term rate of return on plan assets 2012 2011 4.25% 3.61% 4.75% 3.61% 7.00% 4.75% 4.50% 5.75% 4.50% 7.00% \ 2010 5.75% 4.50% 5.75% 4.50% 7.00% The assumed overall expected long-term rate of retum on pension plan assets used in calculating 2012 pension expense was 7.0%. Determination of the plan's rate of retum is based upon historical retums for equities and fixed income indexes. During the past five years, the Company's plan assets have experienced the following annual retums: 11.4% in 2012, 0.1% in 201,1, l2.4% in 2010, 22.0% in 2009, and (32.6)% in 2008. The rate used in plan calculations may be adjusted by management for current frends in the economic environment. With a fraditional investment mix of over half ofthe plan's investments m equities, the actual retum for any one plan year may fluctaate significantiy with changes in the stock market. Due to a decrease in discount rates used in the actaarial calculation ofplan income, the Company expects to incur $1,144,000 of expense in 2013 compared to $1,224,000 in 2012. 62 HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Plan Assets The investment policy ofthe pension plan is designed for growth in value while minunizirig risk to the overall portfolio. The Company diversifies the assets through investments m domestic and intemational fixed income secitrities and domestic and intemational equity securities. The assets are readily marketable and can be sold to fand benefit payment obligations as they become payable. The Company's long-terrri uivestment target mix for theplaii is 70% equity securities and 30% fixed income. The Company regularly reviews its policies on the investment mix and may make changes depending on economic conditions and perceived investment mix. The fair value ofthe Company's pension plan assets at December 31, 2012 and 2011 by asset category are as follows: Fair Value Measurements [: Quoted Prices in Active Markets for Identical Assets (Levell) Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Fair Value 485 -$ 485 $ 0 $. 4,335 ., 575. 635 1,670 395 . 370 :2,726 416 100 11,707 $ 4,335 575 635 1,670 395 370 0 0 0 0 0 0- 0 0 8,465 $ 2,726 416 too 3,242 $ 1,791 $ 1,791 $ 0 $ 3,821 502 595 1,278 203 198 841 ,653 152 10,034 $ .;,, 3,821 502 595^ 1,278 203 198 0 0 0 8,388 $ 0 0 0./ 0 0 0 841 653 152 1,646 1$ (in thousands) December 31,2012 Cash equivalents. Equity securities: U.S. large-cap (a) U.S. mid-cap (b) U.S. small-cap (c) Intemational (d) Real estate (e) Commodities (f) Fixed income securities: U.S, gov't agency obligations (g) Corporate investment grade (g) Corporate non-investment grade (g) Total December 31,2011 Cash equivalents Equity securities; U.S. large-cap.(a) U.S, mid-cap (b) U,S. small-cap (c) Intemational (d) Real estate (e) Commodities (f) . Fixed income securities: . U,S, gov't agency obligations (g) Corporate investment grade (g) Corporate non-investment grade (g) Total $ (a) This category comprises of low-cost equity index iunds not actively managed that track the, S&P 500. ; .. (b) This category comprises of low-cost equity index fiinds not actively managed that ttack the MSCI U,S, mid-cap 450. (c) This is comprises'of actively managed mutual fiinds, (d) 37% ofthis category is comprised of low-cost equity index funds not actively managed that ttackthe MSCI EAFE. (e) This category comprises of low-cost real estate index exchange traded funds. (t) This category comprises of exchange ttaded fimds investing in agricultural and energy commodities. (g) This category comprises of individual bonds. ,.,. .., ' 63 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 The following fatiu-e benefit payments are expected to be paid: Year (in thousands) 2013 2014 2015 2016 2017 2018 to 2022 (11) Stock Compensation Pension benefits 336 428 452 462 561 3,712 The Company's stock optiori.plan provides for the grant of options to purchase up to 526,435 shares ofthe Company's common stock to officers and other key employees ofthe Company and its subsidiaries. All options have been granted at exercise prices equal to fair value and vest over periods ranging from four to five years, except options.issued in 2008 to acquire 11,133 shares that vested immediately. The following table summarizes the Company's stock option activity: Outstanding, beginning of year Granted Exercised Forfeited Expired dumber of shares December 31 2011 270,835 0 "0 0 (201) 2012 270,634 0 0 0 (55,291) 2010 310,263 $ 0 0 0 (39,428) Weighted average exercise price DecemberSl 2011 23.50 $ 0.00 0.00 0.00 17.96 $ 2012 23.51 0.00 0.00 0.00 18.92 2010 22.29 0.00 0.00 0.00 13.96 Outstanding, end of year 215,343 270,634 270,835 $ 24.68 $ 23.51 $ 23.50 Exercisable, end of year 197,713 242,970 226,100 $ 24.76 $ 23.59 $ 23.58 Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2012. Options outstanding at December 31, 2012 had a weighted average remaining conttactual life of approximately,3.0 years and no intrinsic value. Options outstanding at December 31, 2011 had a remaining conttactual life of approximately 3.5 years arid no intrinsic value. No stock options were granted during the years presented above. Options exercisable at'December 31, 2012 had a weighted average remaining conttactual life of approximately 2.8 years and no intrinsic vaMeT Options' exercisable at December 31, 2011 had a weighted average remaining conttactual life of approximately 3.3 years and no inttinsic value. No stock options were exercised during the years presented above. Total stock-based compensation expense for the years ended December 31, 2012, 2011, and 2010 was $29,000, $58,000, and $87,000, respectively. As of Decernber 31, 2012, the total imrecognized cornpensation expense related to non-vested stock awards was $68,000 and the related weighted average period over which it is expected to be recognized is approximately 2 years. 64 .HAWTHORN.BANCSHARES, INC. • AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 (12) Preferred Stock • On December 19,2008, the Company announced its participation in the U.S. Treasury Department's Capital Purchase Program (CPP), a voluntary program that provides- capital to financially healthy banks. This program was designed to atfract broad participation by banking institutions to help stabilize the financial system by encouraging lending. Participating in this program included the Conipany's issuance of 30,255 shares of senior preferred stock (with,a par value of $ 1,000 per share) and a ten year warrant to purchase approximately 287,133 shares of common stock (see below for additional information) to the U.S. Department of Treasury in exchange for $30,255,000. The proceeds received were allocated between the preferred stock and the common stock warrant based upon their relative fair values. This resulted in the recording of a discoimt on the preferred stock upon issuance that reflects the value allocated to the warrant. The discount on the preferred stock will be accreted over five years, consistent with managements' estimate of the life of the preferred stock. Such accretion will be treated as additional dividends on the preferred stock. On May 9, 2012, the Company redeemed 12,000 shares of preferred stock from the U.S. Department of Treasury by .repaying $12^000,000 ofthe $30,255,000 CPP fands along with $140,000; of accrued arid impaid dividends on the shares redeemed. Related to these shares was an additional $300,000 of accretion that was" recognized at the time of the redemption. The allocated carrying values ofthe senior preferred stock and common stock warrant at December 31, 2012 were $17,977,000.and $2,382,000, respectively. The preferred shares remaining outstanding of 18,255 carry a 5% cumulative dividend through December 2013 and 9% thereafter if not redeemed. The Company intends to redeem the remaining shares by E)ecember 2013. The preferred stock generally does not have any voting rights, subject to an exception in the event the Company fails to pay dividends on the preferred stock for nine or more quarterly periods, whether or riot consecutive. Undersuch circumstances, the Treasury will be entitled to vote to elect two directors to the board until all unpaid dividends have been paid or declared and set apart for paymenf. The Company, is pirohibited from paying any dividends with respect to shares of common stock unless all accmed and impaid dividends are paid in fall on the senior preferred stock for all past dividend periods. The Treasury Department may also fransfer the senior preferred stock to a third party at any time. The common stock warrant is exercisable immediately with a ten year term, in whole or in part, at an exercise price of $15.81 per share. The preferred stock and warrant are classified as stockholders' equity in the consolidated balance sheets and qualify/ for regulatory capital purposes, as Tier I capital. For the year ended December 31, 2012, the Company had declared and paid $1,203,000 of dividends and amortized $659,000 of accretion of the discount on preferred stock. ^ 65 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and'2010 (13) Earnings per Share Basic eamings per share is computed by dividing income available to common shareholders by the weighted average . number of common shares outstanding during the year. Diluted eamings per share' gives effect to all dilutive potential , common shares that were outstandmg during the year.The.calculations of basic and diluted eamings per share are as follows for the.years,indicated: . Basic earnings (loss) per common share: Net income (loss) Less: ' Preferred stock dividends Accretion of discount on preferred stock Net income (loss) available to comnion shareholders Basic earnings Qoss) per share Diluted earnings (loss) per common share: Net income (loss) L e s s: • • . ; • Preferred stock dividends • Accretion of discount on preferred stock Net income (loss) available to ' ; common shareholders Average shares outstanding Effeict of dilutive stock options Average shares outstanding including . dilutive stock options Diluted earnings (loss) per share 2012, 2011 2010 2,821,969 $ • '2,857,270 $ (3,551,740) 1,124,417 659,244 1,512,750 476,474 1,512,750 476,474 1,038,308 $ 0.21 $ 868,046 $ 0.18 $ (5,540,964) 11051 2,821,969 $ 2,857,270 $ (3,551,740) .1,124,417 '• 659,244 $ 1,038,308 '4,839,114 0 1,512,750 476,474 868;046 4,839,114 0 $ •• 1,512,750- 476,474 (5,540,964) 4,839,114 6 • • •• $ 4,839,114 0.21 $ • • •• . 4,839,114 0.18 ; $ -• • 4,839,114 .; (1.15) - $ Under the tteasury stock method, outstandirig stock options are dilutive when the average market price of the Company's common stock, when combined with the effect ofany unamortized compensation expense, exceeds the option price during the period, except when the Company has a loss from continuing operations available to common shareholders. In addition, proceeds from the assumed exercise of dilutive options along wdth the related tax benefit are assumed to be used to repurchase common shares at the ayerage market price of such stock during the period. The following options to purchase shares during the years ended December 31, 2012, 2011 arid 2010 were not included in the respective computations of diluted eamings per share because the exercise price of the option, when combined with the effect ofthe unamortized compensation expense, was greater thari the average market price ofthe common shares and were considered anti-dilutive. Anti-dilutive shares - option shares Anti-dilutive shares - warrant shares Total anti-dilutive shares 2012 ' 2 1 5 , 3 43 287,133 502,476 2011 270,634 287,133 557,767 2010 270,835 287,133 557,968 66 HAWTHORN BANCSHARES, INC. ANDSUBSIDIARIES Notes to the Consolidated {Financial Statements December 31, 2012, 2011, and 2010 (14) Capital Requirements The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements canimitiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken,; could have a direct material effect on: the Company's consohdated financial statements. Under capital adeqiiacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures ofassets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amoimts and classification of the Company and the; Bank are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors. Quantitative measures established by regulations to erisure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital to risk-weighted assets, and of Tier 1 capital to adjusted-average assets. Management believes, as of December 31, 2012 and,2011, the Company and the Bank met all capital .adequacy requirements. As of December 31, 2012, the most recent notification from the regulatory authorities categorized the bank as well- capitalized under the regulatory framework for prompt,corrective action. To be categorized as well-capitalized, the Bank must maintain minimimi total risk-based, Tier I risk-based, arid Tier I leverage ratios as set forth in the table. There are no conditions or events since the notificatioris that management believes have changed the Bank's categories. (in thousands) , , ,. , •." December 3L 2012 Total capital (to risk-vveighted assets): Company Bank Tier I capital (toi risk-weighted assets): Company Bank Tier I capital (to adjusted average assets): ^Company Bank ': , ' '' • .; (in thousands) December 3L 2011 Total capital (to risk-weighted assets): Company Bank Tier I capital (to risk-weighted assets): Company Bank' Tier I capital (to adjusted average assets): Company Bank ,/ ;. , Actual Amount Ratio . -,..; .. Minimuni Capital Requirements Amount Ratio . , Well-Capitalized Capital Requireiiiiehts ' Ratio Amount .•--.;.. r , . "'- ^ .148,889 131,126 . :% .$':-: 16.83,: 15.12 70,75^; . 69,375 •{ 8.00 " 8.00' % .$ ,N.A.-, 86,715: ;' ,.. 'N,A, . . 10,00 % _,,$ 120,138 • 1 2 0 , 2 4 3' .13.58 "13.87 % $..._ , 35,380 ' 34,686' .% 4.00 4.m' " • $ '' N.A.' 52i629 • ' % .., N,A, :;'56,00 "-$ ' 120,138 120,243 10.37 10.60 • %' $ 34,762 34,037- ,' 3.00' 3.00 »/o $ •• .... N.A" ^'' " .'-'kA, i :' 5,00 % 56,729 .$ t59,768-,,: 130,398, 18.03 15.00 % $ ,70,905 , 69,567 •% s 8.00- 8.00 N.A. 86,959 = % N,A, 10,00 \ s 134,35^1. 119,498 as. 16 ' 'l3,74 '% ^ • .: - 35,453 • 34,784' % 4,00' 4.00 $',' N.A, :' 52,175 s 134,391 119,498 % $ 11,52 10,45 34,993 34,309 % .$ 3.00 3;oo N,A, 57,181 % N A, 6,00 % N,A, 5,00 67 H A W T H O RN BANCSHARES^ I NC ANDSUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012,2011, and 2010 (15) Fair Value Measurements The Company uses fair value measurements to record fair value adjustments to certain financial and nonfinancial.assets and liabilities. The FASB ASC Topic 820, Fair Value Measurements and Disclosures, defines fair value, establishes a framework for the measurement:of fair value,.and'enhances disclosures about fair value measurements: The standard applies whenever other standards require (permit) assets lor liabilities to be measured at fair value but does not expand > the use of fair value in,any new circumstances. In' this standard, FASB clarified the principle that fair value should be based on the iassumptions market participants would use wheri pricing the asset or liability. In support ofthis principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. As of December 31, 2012 and 2011, respectively, there were no fransfers into or out of Levels 1-3. ; The fafr value hierarchy is as follows: , Levell -Inputsareunadjustedquotedpricesjfor identical assets or liabilities in active markets, r ; • Level 2 - Inputs other than quoted prices included iri Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabihties in active tnarkets, such as mterest rates andyieldcurvesithat are observable at commonly quoted intervals. : ; .s; -.; . Level 3 - Inputs are unobservable inputs for the asset or lialbility and'significant to the fair value. These may be intemafly developed usirig the Company's best;informatiori and assumptions thaf a tttarket participant would consider. ASC. Topic 820 also provides guidance on determming fair value when the. volume and'level of activity for the asset or „ liability have sigiiificantly^decfeased and on identifying circumstances when a fransaction may not be considered •brderiyv" ' •;; „' r ' •';";. " '. ' — .-, : , . . •• ' :;-• ; The Company is required to disclose assets .and liabilities measured at fair value on a recurring basis separate frorri those measured at fair value on a noru-ecurring basis. Nonfinancial assets measured at fafr value on-a nonrecurring basis would include foreclosed reaf estate, long-lived assets, and core deposit intangible assets, which are reviewed when circumstances or other events indicate that impairriifent may have occurred. - . , Valuation methods for instruments imeasured a:t fair value oil a recurring basis FoUowing is a description ofthe Company's valuation metiiodologies uSed for assets and habilities recorded at fair value on a recurrmg basis: Available-for-sale securities • - - ~; * The fair value measimements of the Company's investment securities are determined by a.third.party pricing ser-vice which considers observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live,frading levels„.frade execution data, market consensus prepayment speeds, credit information and the bond's terms .and conditions, among other things. The fair valiie measurements are subject to indeperident verification tp another pricing source by managetneiit each quarter for reasonableness. Securities classified as available-for-'sale are :- reported at fafr value utilizhig Level 2 uiputs. ..• ' •* ,~ ., • , Mortgage servicing rights'' : '' ' ' f The fair value of mortgage servicing rights is based on the discounted value of estimated fature cash flows utilizmg ' contractual cashflows, servicing rate, constant prepayment rate, servicing cost, and discountf ate factors. Accordingly, tiie fair value is estimated based on a valuation model that calculates the present value of estimated fature net servicing income; The model incorporates assuniptions that market participants use in estimiating fature net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float eamingsrates, and other ancillary mcome, including late fees. The valuation models estimate the present value of estimated fature net servicing income. The Company classifies its servicing rights as Level 3. 68 . HAWTHORN BANCSHARES^ INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 'J Fair Value Measurements (in thousands) December 31, 2012 Assets: - U.S. treasury Govemment sponsored enterprises Asset-backed securities Obligations of states and political subdivisions Mortgage servicing rights Total ' December 31, 2011 -Assets: U.S. treasury Govemment sponsored enterprises Asset-backed securities Obligations of states and political subdi-visions Total Quoted Prices in Active Markets for Identical Assets (Level 1) Fair Value 2,030 $ 55,180 107,872 2,030 0 0 Other Observable Inputs (Levell) Signiflcant Unobservable Inputs (Level 3) 0 55,180 107,872 35,164 0 35,164 :-> 2,549 ^ • 202,795 $ $ . • -• 0 0 - • .2,030 $ 198,216 S ' 0 2,549 ; : 2,549 2,054 $ 70,314 07,329 34,109 213,806 S 2,054 $ 0 $ • ' - • iu 0 0 70,314 107,329 0 0 0 0 , 2,054, $ 34,109 :211,752 .$:, The changes in Level 3 assets and habilities measured at fair value on a recurrmg basis are summarized as follows: (in t h o u s a n d s) Balance at December 31,2011 Transfer imo level 3 Total gains or losses (realized/unrealized): • Included in eamings Included in other comprehensive income . Purchases Sales Issues Settlements Balance at December 31, 2012 -" ' • - ' ' ' . .- Fair Value Measurements Using Significant Unobservable Inputs (Level 3) Mortgage Servicing Rights 0 3,050 (1,331) 0 0 0 830 0 2,549 Total gains for the years ended included hi eamings atfributable to the change in unrealized gains or losses related to assets still held were $2,216,000 and $ 1,705,000 at December 31, 2012 and 2011, respectively. 69 H A W T H O RN BANCSHARES, INC. ANDSUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Quantitative Information about Level 3 Fair Value Measurements Valuation Technique Unobservable Inputs . Mortgage servicing rights , Discounted cash flows Weighted average constant prepayment rate . • Weighted average discount rate ,, - . , . Injput Value 2012 20II 18,60 % 20,86 % 7,99 % 7.99 % Valuation methods for instruments measured at fair value on a nonrecurring basis Following is a description ofthe Company's valuation methodologies used for assets and liabilities recorded at fair value on a nomecurring basis: Impairedloans ' The Company does not record loans at fair value on a recurring basis other than loans that are considered impaired. The net carrying value of impaired loans is generally based on fair values ofthe underlying collateral obtained through indeperident appraisals or intemal. evaluations, or by discounting the total expected fature cash flows. Once the fair value ofthe collateral has been determined and any impairment amount calculated, a specific reserve allocation is made. Because many of these inputs are not observable, the measurements are classified as Level 3. As of December 31, 2012, the Compariy identified $24.6 million in impaired loans that had specific allowances for losses aggregating $4.0 million. Related to these loans, there was $5.2 million in charge-offs recorded during the year ended December 31, 2012. As of December 31, 2011, the Company identified $30.4 million in impafred bans that had specific allowances for losses aggregating $3.7 milhon. Related to these loans, there was $11.3 million in charge-offs recorded during the year ended December 31, 2012. Other Real Estate Owned andRepossessed Assets Other real estate owned and repossessed assets consisted of loan collateral that has been repossessed through foreclosure. This collateral comprises of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and constmction equipment. Other real estate o-wned assets are recorded as held for sale initially at the lower of the loan balance or fair value of the collateral less estimated selling costs. The Company relies on extemal appraisals and assessment of property values by intemal staff, fri the case of non-real estate collateral, reliance is placed on a variety of sources, including extemal estimates of value and judgment based on experience and expertise of intemal specialists. Subsequent to foreclosure, valuatioris 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 measiffements are classified as Level 3. 70 HAWTHORN BANCSHARES, INC. ANDSUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Fair Value Measurements Using Quoted Prices in Active Markets for Identical Assets (Level 1) Total Fair Value other Observable Inputs. (Level 2) Significant Unobservable Inputs ' (Level 3) Total Gains (Losses)* (in thousands) December 31, 2012 Assets: Impaired loans: Cominercial, fmancial, & agricultural $ Real estate construction - residential Real estate construction - commercial Real estate mortgage - residential Real estate mortgage - commercial Consumer Total • • S 672 $ 64 5,341 2,763 .^ 11,726 44 20,610 $ Other real estate owned and repossessed assets $. .:: 23,592 $ •: December 31, 2011 Assets: Impaired loans: Commercial, financial, & agricultural $ Real estate construction - residential Real estate construction - commercial Real estate mortgage - residential Real estate mortgage - commercial Total Other real estate owned and repossessed assets 643 $ 396 6,029 3,601 15,980 ,26,649 $, 16,020 $ 0 $ 0 0 0 0 0 0 $ 0 $ 0 $ 0 0 0 0 0 , S 0 $ 0 0 0 0 0 0 $ 672 $• 64 5,341 2,763 11,726 44 20,610 $ (1,659) 0 0 (83,9) (2,716), 0 (5,214) 0 S . 23,592 $ , •, (4,378) 0 $ 0 0 0 0 643 $ 396 6,029 3,601 15,980 26,649 $ (2,136) (1,557) (279) (1,509) (5,842) (11,323) 16,020 $ (2,112) * Total gains (losses) reported for other real estate owned and repossessed assets includes charge offs, valuation write downs, and net losses taken during the periods reported. (l6) Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate such value: Loans The fair values of loans are estimated by discotmting the expected fature cash flows using the current rates, at which similar loans could be made to borrowers with similar credit ratings and for the same remaining matiuities. The net carrying amount of impaired loans is generally based on the fair values of collateral obtained through independent appraisals or intemal evaluations, or by discounting the total expected fature cash flows. This method of estimating fafr value does not mcorporate the exit-price concept of fair value prescribed by ASC Topic 820. Investment Securities A detailed description ofthe fair value measurement ofthe debt instruments in the available-for-sale sections ofthe 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. 71 H A W T H O RN BANCSHARES, INC. ANDSUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 Federal Home Loan Bank (FHLB) Stock Ownership of equity securities of FHLB is restricted and there is no established market for thefr resale. The carrying amount is a reasonable estunate of fair value. Federal Funds Sold, Cash, and Due from Banks The carrying amounts of short-term federal fands sold and securities purchased under agreements to resell, interest eaming deposits 'with banks, and cash and due from banks approximate fair value. Federal fands sold and securities purchased tmder agreements to resell classified as short-term generally matore in 90 days or less. Mortgage Servicing Rights The fair value of mortgage servicing rights is based on the discounted value of estimated fatare 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 fature net servicing income. The model incorporates assumptions that market participants use in estimating fafare net servicing mcome, including estimates of prepayment speeds, market discount rates, cost to service, float eamings rates, and other ancillary income, including late fees. Cash Surrender Value-Life Insurance The fair value of Bank owned life insurance (BOLI) approximates the carrying amoimt. 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 ofthe short maturity for these financial instmments. Deposits The fair value of deposhs with no stated matiu-ity, 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 contracfaal cash flows. The discount rate is esthnated using the rates currentiy offered for deposits of similar remaining maturities. Securities Sold under Agreements to Repurchase and Interest-bearing Demand Notes to U.S Treasury For securities sold under agreements to repurchase and interest-bearing demand notes to U.S. Treastu-y, the carrying ainount 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 confractual cash flows. The discount rate is estimated usmg the rates currentiy offered for other borrowed money of similar remainmg maturities. 72 HAWTHORN: BANCSHARES, INC.'^ • ANDSUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 A summary ofthe carrying amounts and fair values ofthe Company's financial instruments at December 31, 2012 and 2011 is , as follows: fln thousands) Assets: Loans Investment securities FHLB stock Cash and due from banks Mortgage servicing rights Cash surrender value - life insurance Accrued interest receivable Liabilities: Deposits: Demand NOW Savings Money market Time Federal funds purchased and securities sold under agreements to repurchase Subordinated notes Federal Home Loan Bank advances Accrued interest payable December 31,2012 Fair Value Measurements Quoted Prices in Active Markets for Identical Assets (Level 1) other Observable Inputs (Level 2) Net Significant . Unobservable Inputs (Level 3) 0 $ 0 $ 834,824 2,030 0 58,877 0 5,190 66.097 192,271 178,121 69,997 157,584 0 21,058 0 0 909 1 .0 0 0 2,549 198,216 2,278 0 0 2,136 0 202,630 $ : 837,373 0 0 ,0 0 397,986 0 13,154 20,651 0 December 31,2012 Carrying amount Fair value 832,142 $ 200,246 2,278 58,877 2,549 834,824 $ 200,246 2,278 58,877 2,549 2,136 5,190 2,136 5,190 1,103,418 1,106,100 192,271 178,121 69,997 157,584 393,302 21,058 49,486 20,126 909" 192,271 178,121 69,997 157,584 397,986 21,058 13,154 20,651 909 1,082,854 $ 1.051.731 $ 619,940 $ 33;805 $ 397,986 73 H A W T H O RN BANCSHARES, INC. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 December 31,2011 Fair Value Measurements Quoted Prices in Active Markets for Identical Assets (Level 1) other Observable Inputs (Level 2) Net.. Signiflcant Unobservable Inputs (Level 3) December 31,2011 Carrying amount Fair value 829,121 $ 213,806 2,738 830,077 213,806 2,738 0 $ 2,054 0 0 211,752 2,738 75' 43,135 2,308 2,064 5,341 75 43,135 2,512 2,064 5,341 1,098,588 $ 1,099,748 $ 159,187 169,452' 62,075 153,072 414,438 24,516 49,486 28,410 1,054 159,187 169,452 62,075 153,072 421,687 24,516 22,082 29,525 1,054 75 43,135 0 5,341 50,605 159,187 169,452 62,075 153,072 0 24,516 0 0 1,054 830,077 0 0 0 0 2,512 0 0 0 2,064 0 216,554 $ 832,589 0 0 0 0 421,687 0 0' 0 22,082 29,525 0 (in thousands) Assets: Loans Investment securities FHLB stock Federal fimd sold and securities purchased under agreements to resell Cash and due from banks Mortgage servicing rights Cash surrender value - life insurance Accrued interest receivable Liabilities: Deposits: Demand NOW Savings Money market Time Federal fimds purchased and securities sold under agreements to repurchase Subordinated notes Federal Home Loan Bank advances Accrued interest payable 1,061,690 1,042.650 $ 569,356 $ 51,607 $ 421,687 Off-Balance Sheet Financial Instruments The fair value of commitments to extend credit and standby letters of credit is estimated using the fees ciu-rently charged to enter into similar agreements, taking into accoimt the remainfrig terms ofthe agreements, the likelihood ofthe counterparties drawing on such financial insfruments, 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 instrmnents. Because no market exists for a portion ofthe Company's financial insfruments, fair value estimates are based on judgments regarding fature expected loss experience, current economic conditions, risk characteristics of various financial instmments, 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. 74 H A W T H O RN BANCSHARES, INC. ANDSUBSIDIARIES Notes to the Consolidated Financial Statements December 31, 2012, 2011, and 2010 (17) Commitments and Contingencies The Company issues financial instmments 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 ofthe amoimts 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 fmancial instrament for commitinents to extend credit and standby letters of credit is represented by the confractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for financial instraments included on its consolidated balance sheets. At December 31, 2012, no amounts have been accraed for any estimated losses for these financial instruments. The confractual amotmt of off-balance-sheet financial uistruments as of December 31, 2012 and2011, is as follows: (in thousands) 2012 2011 Commitments to extend credh Standby letters of credit ' $ [ 118,412 $ 2,995 117,171 2,992 r Commitments Commitmerits to extend credit are ajgreeirients to lend to a custoirier as long as there is no violation of any, condition established in the confract. Commitments generally have fixed expfration dates or other termination clauses and may require payment of a fee. Since certain ofthe commitments and letters of credit are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent fature cash requirements, t he 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 accoimts receivable, inventory, fumiture and equipment, and real estate; Standby letters of credit are conditional commitments issued by the CompaSny to guarantee the performance of a customer to a third party. These standby letters of credit are, primarily issued to support confractual obligations ofthe Company's customers. The approximate remaining term of standby letters of credit range from one month to five years at December 31, 2012. 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. On November 18, 2010, a smt was filed against the Company and its subsidiary, the Bank, in the Circuit Court of Jackson County for the Eastem Division of Missouri state court by a customer alleging that the fees associated with the Bank's automated overdraft program in,connection with its debfr card and ATM cards constitute unlawfal interest in violation of Missouri's usury laws. The suit seeks class-action status for Bank customers who have paid overdraft fees on their checking accounts. The suit seeks forfeifare and refand of twice the amoimt of improper overdraft fees assessed and collected. The court has denied the Bank's motion to dismiss the suit. At this stage ofthe litigation, it is not possible for management of the Bank to determine the probability of a material adverse outcome or reasonably estiiriate the amount of any potential loss. On December 17, 2009, a suit was filed against the Bank in Circuit Court of Jackson County for the Eastem Division of Missouri state court by a customer alleging that the Bank had not followed through on its commitment to fand a loan request. A jury found in favor of the customer and awarded $630,000 in damages to the plamtiffs, including $200,000 in 75 H A W T H O RN BANCSHARES, I N C. AND SUBSIDIARIES Notes to the Consolidated Financial Statements December 3 1, 2012,2011, and 2010- punitive damages. The jiuy verdict was upheld at the appellate level. At December 31,..2012, the Company's consolidated balance sheets included reserves for payment ofthe jury award as the Company is awaiting tiie (Court's determmation as to the order in which proceeds will be'applied. After insurance proceeds, the Company's net loss for tiiesejury awards is expected to be approximately $275,000'; ' (18) Condensed Financial Information of the P a r e nt Company Oiily Following are the condensed financial statements of Havvthbm Bancshares, Inc. (Parent only) as of and for the years • > indicated: - . i. . ' Condensed Balance Sheets (in thousands) Assets Cash and due from bank subsidiaries Investment in equity securities Investment in subsidiaries : Premises and equipment Deferred tax asset Other assets Total assets Liabilities and Stocldiolders' Equity Subordinated notes Other liabilities Stockholders' equity Total liabilities and stockholders' equity Condensed Statements of Operations $ December 31, 2012 2011 ,, 1,863 $ • 1,486 139,849. I 1,424 1,022 13,282 1,486 , 140,361 I 1,611 10 145,645 $ 156,751 49,486 $ 3,939 92,220 49,486 4,689 102,576 $ 145,645 $ 156,751 For the Years Ended December 31, 2012 2011 2010 Income Interest and dividends received from subsidiaries Total income Expenses Interest on subordinated notes Other Total expenses Income (loss) before incometax benefit and equity in undisfributed income of stibsidiaries Income tax benefit Equity in undisfributed income (loss) of subsidiaries Net income (loss) $ $ 4,596 4,596 5,192 $ 5,192 , 4,405 4,405,, 1,381 2,889 • 4,270 : 326, 2,257 239 2,822 $ 1,301 2,605 3,906 1,285 1,368 204 '2,857 $ 1,526 2,904 4,430' (25) 1,450 (4,977) (3,552), 76 H A W T H O RN BANCSHARES, INC. ANDSUBSIDIARIES Notes to theConsolidatedFinancial Statements December 31, 2012, 2011, and 2010 2012 2011 2010 2,822 $ •'•2,857- $ f (3^552): I (239) 29 (148) (813) 1,652 :-l,072 1,072 (12,000) (1,203) (940) 2 (204) 58 (274) (89) 2,350 900 900 0 (1,513) (904) " 3 4,977 87 (38) •382 1,859 (K250) (1.250) 0 i(l,513) 1(1,385) (14,143) (2,417) 1(2,898)' (11,419) 13,282 1,863 833 12,449 13,282 $ ! (2,289) 114,738 112,449 Condensed Statements of Cash Flows (in thousands) Cash flows from operating activities: Net income (loss) Adjustments to reconcile net income (loss) to net cash provided, by operating activities: Depreciation Equity in imdistributed (income) losses of subsidiaries - .,^^ . Stock based compensation expense (Increase) decrease in deferred tax asset Other, net •• • ,• ' -.• • ' ••-••---•• ^ Net cash provided by operating activities Cash flows from investing activities: Investment in subsidiary Net cash provided by (used in) investing activities Cash flows from financing activities: Redemption of 12,000 shares of preferred stock Cash dividends paid - preferred stock Cash dividends paid - common, stock Net cash used in financing activities Net (decrease) increase in cash and doe from banks Cash and due from banks at beginning of year Cash and due from banks at end of year 77 HAWTHORN BANCSHARES, INC. ANDSUBSIDIARIES Notesto the Consolidated Financial Statements December 31, 2012,2011, and^20l0v: First quarter Second .... quarter Third quarter - Fourth quarter year to Date 12,646 $ 1,831 10,815 .1,700 1,970 9,480 154 12,297 $ . 12,151 $ ,2,125 , 10,172 1,500 2,443 , 10,098 277 „ , 2,029 10,122 . 4,700 2,680 10,378 • (704) $ 12,020 1,920 10,100 1,000 2,633 . v' .8,711 ,, 819 .49,114 7,905 , 41,209 8,900 ;. 9,726 38,667 546 • 1,451 370 119 962 S 740 296 396 S !V . . %. 48 $' (1,572)$ :228- ... .72- (1,872)'$. , 2,203 231 72 S 2,822 1,125 659 x: 1,900 • •$ \ 1,038 $ 0.21 0.21 $ 0.01 0.01 (0.39) $ :X6:39):.\ $,, 0.39 0.39 0.21 0.21 13,583 3,102 I0,48r 1,750 2,052 9,378 •451 954 , 370 119 $ $ " 13,640 '2,858 "10,782 •" 1,883 2,178 9,008 661 , : •$ 1'3,384 $ . 2,580 10,804 : 2,010 2,358 . 8,925 .711 ...12,862 2,313 10,549 • 5,880 • 2,612 : 9,534 (1,232) ^ . =^^3,469 ,.10,853 "' '42,616 11,523 9,200 36,845 591 . . $. . • : 1,408 382 119 907 465 $ S 0.10 0.10 0.19 0.19 $ .. $ $ 1,516 379 119 1,018 0.21 0.21 • $. , $ $ • . (1,021).^$ 382 119 (1,522) $ 2,857 1,513 476 868 (0.31) $ (0.31) 0.18 0.18 (19) Quarterly Financial Information (Unaudited) .;:.., . (In thousands except per share data) Year Ended December 31,2012 Interest income Interest expense Net interest income < Provision for loan losses Noninterest income Noninterest expense Income tax (benefit) expense Netincoine (liMs) Preferred'stock dividends Accretion of discount on preferred stock * Net income (loss) avajlablejo common stockholders Net income (loss) per share:. Basic eamings (loss) per share Diluted eamings (loss) per share ,, , Year Ended December 31,2011 Interestincome Interest expense Net iiiterest income Provision for loan losses Noniriterest income Noiiinterest expense Income tax (benefit) expense $ S $ $ $ Net iiicome (loss) .; ' • $ ' Preferred stock dividends Accretion of discount on preferred stock Net income (loss) available to common stockholders Net income (loss) per share: Basic eamings (loss) per share Diluted earnings (loss) per share $ $ 78 MARKET PRICE OF AND DIVIDENDS ON EQUITY SECURITIES AND RELATED MATTERS Market Price The Company's common stock trades on Nasdaq's global select market under the stock symboLof "HWBK." The following table sets forth the range of high and low bid prices of the Company's common stock by quarter for each quarter in 2012 and 2011 in which the stock was s v : fraded. ; ,, High Low 2012 First Quarter Second Quarter Third Qiiarter Fourth Quarter 2011 First Quarter Second Quarter Third Quarter. Fourth Quarter ' %• . $ $ $. $ : • $ $ $ - 7.83 $ 9.97 $ 10.38 $ . 9.25 $ ' ' 5 . 73 6.92 .' ,8.45 7.04 , 9.33 $ 8.89 $ 8.50 $ 8.10 $ 8.06 7.29 5.80 5.50 Shares Outstanding. As of Febraary 28, 2013, the Company had issued 5,000,972 shares of common stock, ofwhich 4,839,114 shares were outstanding. The outstanding shares were held of record by approximately 1,425 shareholders. The Company has a warrant outstanding for the purchase of 287,133 shares of common stock. In additiori, the Company has 18,255 shares of cumulative, perpetual preferred stock outstanding. The wartant and preferred shares were issued pursuant to the U.S. Treasury's Capital Purchase Program (or CPP). Dividends The following table sets forth friformation on dividends paid by the Company in 2012 and 2011. Month Paid January, 2012 April, 2012 July, 2012 October, 2012 Total for 2012 January, 2011 April, 2011 July, 2011 October, 2011 Total for 2011 Dividends Per Share 0.05 0.05 0.05 0.05 0.20 0.05 0.05 0.05 0.05 0.20 $ S $ ' $ The board of directors mtends that the Company will continue to pay quarterly dividends. The actual amount of quarterly dividends and the payment, as well as the amount, ofany special dividend ultimately will depend on the payment of sufficient dividends by the subsidiary Bank to the Company. The payment by the Bank of dividends to the 79 Company will-depend upon such factors as the Bank's financial condition,, results of operations and current and anticipated cash needs, including capital requirements. In addition to the above limitations, the Company's ability to pay dividends on its common stock is limited by the Company's participation in the Treasury's Capital Purchase Program (or CPP). If the Company is not current in the payment of quarterly dividends on the Series A preferred stock issued to the U.S. Treasury in CPP, the Company cannot pay dividends on its comfrion stock. Stock Performance Graph . • • ' .. The following performance graph shows a comparison of cumulative total retums for the Company, the Nasdaq Stock Market (U.S. Companies), and a peer mdex of financial instifations havirig total assets of between $1 biUion and $5 billion for the period from December 31, 2007, through December 31, 2012. The cumulative total retum on investment for each ofthe periods for the Company, the Nasdaq Stock Market (U.S. Companies) and the peer index is based on the stock price or mdex at December 31, 2007. The perforinance graph assumes that the value of an investment in the Company's common stock and each index was $100 at December 31, 2007 and that all dividends were reinvested. The information presented in the performance graph is historical in nature and is not intended to represent or guarantee fature retums. Total Return Performance 150 -Hawthorn Bancshares, Inc 125 - -NASDAQ Composite -SNL Bank $1B-$5B 12/31/07 12/31/08 12/31/09 12/31/10 12/31/11 12/31/12 The comparison of cumulative total retums presented in the above graph was plotted using the following index values and common stock price values: Hawthorn Bancshares, Inc. Nasdaq Composite (U.S. Companies) Index of financial 12/31/07 12/31/08 12/31/09 12/31/10 12/31/11 12/31/12 $100.00 $100.00 • -. •- •• $71.61 • $43.35 $41.61 $31.29 $41.32 $60.02 $87.24 $103.08 $102.26 $120.42 institutions ($1 billion to $5 billion) $100.00 .. $82.94 $59.45 ; $67.39 .. $61,46, $75.78 80 DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY Name David T. Tumer Position with The Companv Position with Subsidiary Bank Principal Occupation Chairman, Chief Executive Officer, President and Director Officer, President and Director -Class 111 Chairman, Chief Executive Position with Hawthom Bancshares, Inc. and Hawthom Bank Charles G. Dudenhoeffer, Jr. Director-Class II Philip D. Freeman Director-Class I Director Director Kevin L. Riley Director-Class 111 Director James E. Smith Director-Class 1 Gus S. Wetzel, 11 Director-Class 11 Director Director W. Brace Phelps Chief Financial Officer Senior Vice President and Chief Financial Officer Kathleen L. Bruegenhemke Senior Vice President, Chief Risk Officer and Corporate Secretary Senior Vice President and Chief Risk Officer Retired Owner/Manager, Freeman Mortuary, Jefferson City, Missoiffi Co-owner, Riley Chevrolet, Buick, GMC Cadilac, and Riley Toyota Scion, Jefferson City, Missouri Retired Physician, Wetzel Clinic, Clmton, Missouri Position with Hawthorn Bancshares, Inc. and Hawthom Bank Position with Hawthom Bancshares, Inc. and Hawthom Bank ANNUAL REPORT ON FORM 10-K A copy ofthe Company's Annual Report on Form 10-K for the year ended December 31, 2012, as filed with tiie Securities and Exchange Commission, excluding exhibits, will be fiunished without charge to shareholders entitled to vote at the 2013 annual meeting of shareholders upon written request to Katiileen L. Braegenhemke, Corporate Secretary, Hawthom Bancshares, Inc., 132 East High Sfreet, Jefferson City, Missouri 65101. The Company will provide a copy of any exhibit to the Form 10-K to any such person upon written request and the payment ofthe Company's reasonable expenses in fltmishing such exhibits; 81

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