HAWTHORN BANCSHARES, INC. - Quarter Report: 2011 June (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2011


o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to

Commission File Number: 0-23636

HAWTHORN BANCSHARES, INC.

(Exact name of registrant as specified in its charter)


Missouri		43-1626350
(State or other jurisdiction of		(I.R.S. Employer
of incorporation or organization)		Identification No.)


300 Southwest Longview Boulevard, Lee’s Summit, Missouri		64081
(Address of principal executive offices)		(Zip Code)

(816) 347-8100
(Registrant’s telephone number, including area code)

N/A
(Former name, former address and former fiscal year, if changed since last report.)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). þ Yes o No

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


Large accelerated filer o	Accelerated filer o	Non-accelerated filer þ	Smaller reporting company o
		(Do not check if a smaller reporting company)

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

As of August 15, 2011 the registrant had 4,652,994 shares of common stock, par value $1.00 per share, outstanding

Page 1 of 61 pages

Index to Exhibits located on page 56

TABLE OF CONTENTS


PART I — FINANCIAL INFORMATION
	Item 1. Financial Statements
	Item 3. Quantitative and Qualitative Disclosures about Market Risk
	Item 4. Controls and Procedures
PART II — OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 1A. Risk Factors
	Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
	Item 3. Defaults Upon Senior Securities
	Item 4. (Removed and Reserved)
	Item 5. Other Information
	Item 6. Exhibits
SIGNATURES
EX-31.1
EX-31.2
EX-32.1
EX-32.2
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets (unaudited)


	June 30,			December 31,
	2011			2010

ASSETS

Loans	$	868,798,817		$	898,472,463
Allowances for loan losses		(13,863,050	)		(14,564,867	)

Net loans		854,935,767			883,907,596

Investment in available-for-sale securities, at fair value		219,697,283			178,977,550
Federal funds sold and securities purchased under agreements to resell		171,338			125,815
Cash and due from banks		35,068,582			50,853,985
Premises and equipment — net		37,464,951			36,980,503
Other real estate owned and repossessed assets — net		15,768,518			14,009,017
Accrued interest receivable		5,672,339			5,733,684
Mortgage servicing rights		2,271,915			2,355,990
Intangible assets — net		750,796			977,509
Cash surrender value — life insurance		2,036,197			2,001,965
Other assets		20,869,488			24,248,590


Total assets	$	1,194,707,174		$	1,200,172,204


LIABILITIES AND STOCKHOLDERS’ EQUITY

Deposits:
Non-interest bearing demand	$	148,139,814		$	137,749,571
Savings, interest checking and money market		385,873,185			379,137,539
Time deposits $100,000 and over		132,783,863			124,566,760
Other time deposits		295,275,735			305,208,786


Total deposits		962,072,597			946,662,656

Federal funds purchased and securities sold under agreements to repurchase		28,689,667			30,068,453
Subordinated notes		49,486,000			49,486,000
Other borrowed money		43,656,668			66,985,978
Accrued interest payable		1,690,994			1,491,503
Other liabilities		4,766,987			3,989,303


Total liabilities		1,090,362,913			1,098,683,893

Stockholders’ equity:
Preferred stock, $1,000 par value Authorized and issued 30,255 shares		29,079,479			28,841,242
Common stock, $1 par value Authorized 15,000,000 shares; issued 4,814,852, and 4,635,891 shares, respectively		4,635,891			4,635,891
Surplus		30,420,956			28,928,545
Retained earnings		41,318,862			41,857,302
Accumulated other comprehensive income, net of tax		2,405,891			742,149
Treasury stock; 161,858 shares, at cost		(3,516,818	)		(3,516,818	)


Total stockholders’ equity		104,344,261			101,488,311


Total liabilities and stockholders’ equity	$	1,194,707,174		$	1,200,172,204

See accompanying notes to consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Operations (unaudited)


	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
	2011		2010		2011		2010

INTEREST INCOME
Interest and fees on loans	$	11,991,200	$	13,633,597	$	24,078,842	$	27,052,073
Interest on debt securities:
Taxable		1,342,958		1,118,098		2,497,854		2,182,077
Nontaxable		254,093		294,553		529,901		620,755
Interest on federal funds sold and securities purchased under agreements to resell		25		47		62		83
Interest on interest-bearing deposits		11,695		21,891		32,288		35,522
Dividends on other securities		40,661		34,750		84,361		85,447

Total interest income		13,640,632		15,102,936		27,223,308		29,975,957

INTEREST EXPENSE
Interest on deposits:
Savings, interest checking and money market		447,813		554,453		931,504		1,185,206
Time deposit accounts $100,000 and over		432,649		651,252		895,821		1,362,634
Other time deposit accounts		1,315,987		1,850,082		2,738,789		3,848,733
Interest on federal funds purchased and securities sold under agreements to repurchase		12,628		19,123		25,983		39,663
Interest on subordinated notes		323,016		323,246		725,177		847,546
Interest on other borrowed money		326,008		590,653		642,967		1,267,014

Total interest expense		2,858,101		3,988,809		5,960,241		8,550,796

Net interest income		10,782,531		11,114,127		21,263,067		21,425,161
Provision for loan losses		1,883,334		2,150,000		3,633,336		4,655,000

Net interest income after provision for loan losses		8,899,197		8,964,127		17,629,731		16,770,161

NON-INTEREST INCOME
Service charges on deposit accounts		1,419,272		1,427,202		2,729,763		2,723,290
Trust department income		228,771		200,644		423,866		379,506
Gain on sale of mortgage loans, net		215,996		297,201		462,230		521,774
Other		314,585		524,973		614,845		830,906

Total non-interest income		2,178,624		2,450,020		4,230,704		4,455,476

NON-INTEREST EXPENSE
Salaries and employee benefits		4,333,620		4,550,320		9,010,693		9,207,441
Occupancy expense, net		584,685		604,734		1,223,049		1,226,406
Furniture and equipment expense		509,104		534,611		1,015,783		1,026,650
FDIC insurance assessment		396,266		435,020		875,013		845,198
Legal, examination, and professional fees		307,105		336,033		797,609		583,323
Advertising and promotion		269,700		296,834		501,875		575,023
Postage, printing, and supplies		295,774		286,190		564,481		574,356
Processing expense		812,808		856,495		1,634,885		1,706,860
Other real estate expense		548,436		1,506,291		1,040,869		2,012,746
Other		950,627		913,110		1,721,592		1,692,381

Total non-interest expense		9,008,125		10,319,638		18,385,849		19,450,384

Income before income taxes		2,069,696		1,094,509		3,474,586		1,775,253
Income tax expense		661,202		312,043		1,112,475		499,019

Net income		1,408,494		782,466		2,362,111		1,276,234
Preferred stock dividends		382,390		382,390		752,173		752,173
Accretion of discount on preferred stock		119,118		119,118		238,237		238,237

Net income available to common shareholders	$	906,986	$	280,958	$	1,371,701	$	285,824

Basic earnings per share	$	0.19	$	0.06	$	0.29	$	0.06
Diluted earnings per share	$	0.19	$	0.06	$	0.29	$	0.06

See accompanying notes to consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (unaudited)


										Accumulated					Total
										Other					Stock -
	Preferred		Common				Retained			Comprehensive		Treasury			holders’
	Stock		Stock		Surplus		Earnings			Income		Stock			Equity

Balance, December 31, 2009	$	28,364,768	$	4,463,813	$	26,970,745	$	50,576,551		$	912,224	$	(3,516,818	)	$	107,771,283

Net income		—		—		—		1,276,234			—		—			1,276,234
Change in unrealized gain (loss) on securities:
Unrealized gain on debt securities available-for-sale, net of tax		—		—		—		—			1,145,269		—			1,145,269
Defined benefit pension plans:
Amortization of prior service cost included in net periodic pension cost, net of tax		—		—		—		—			23,982		—			23,982

Total other comprehensive income																1,169,251

Total comprehensive income																2,445,485

Stock based compensation expense		—		—		48,542		—			—		—			48,542
Accretion of preferred stock discount		238,237		—		—		(238,237	)		—		—			—
Stock dividend		—		—		2,042,568		(2,042,568	)		—		—			—
Cash dividends declared, preferred stock								(756,375	)							(756,375	)
Cash dividends declared, common stock		—		—		—		(688,313	)		—		—			(688,313	)

Balance, June 30, 2010	$	28,603,005	$	4,463,813	$	29,061,855	$	48,127,292		$	2,081,475	$	(3,516,818	)	$	108,820,622



Balance, December 31, 2010	$	28,841,242	$	4,635,891	$	28,928,545	$	41,857,302		$	742,149	$	(3,516,818	)	$	101,488,311


Net income		—		—		—		2,362,111			—		—			2,362,111
Change in unrealized gain on securities:
Unrealized gain on debt securities available-for-sale, net of tax		—		—		—		—			1,639,760		—			1,639,760
Defined benefit pension plans:
Amortization of prior service cost included in net periodic pension cost, net of tax		—		—		—		—			23,982		—			23,982

Total other comprehensive income																1,663,742

Total comprehensive income																4,025,853

Stock based compensation expense		—		—		33,877		—			—		—			33,877
Accretion of preferred stock discount		238,237		—		—		(238,237	)		—		—			—
Stock dividend		—		—		1,458,534		(1,458,534	)		—		—			—
Cash dividends declared, preferred stock								(756,376	)							(756,376	)
Cash dividends declared, common stock		—		—		—		(447,404	)		—		—			(447,404	)

Balance, June 30, 2011	$	29,079,479	$	4,635,891	$	30,420,956	$	41,318,862		$	2,405,891	$	(3,516,818	)	$	104,344,261

See accompanying notes to consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)


	Six Months Ended June 30,
	2011			2010

Cash flows from operating activities:
Net income	$	2,362,111		$	1,276,234
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		3,633,336			4,655,000
Depreciation expense		963,122			1,005,026
Net amortization of debt securities, premiums, and discounts		406,130			283,997
Amortization of core deposit intangible assets		226,713			290,425
Stock based compensation expense		33,877			48,542
Loss on sales and dispositions of premises and equipment		667			59,621
Loss on sales and dispositions of other real estate owned and repossessions		258,885			1,234,995
Provision for other real estate owned		440,805			—
Decrease in accrued interest receivable		61,345			692,372
Increase in cash surrender value -life insurance		(34,232	)		(30,156	)
Decrease (increase) in income tax receivable		1,112,475			(803,397	)
Decrease in other assets		277,522			965,928
Increase (decrease) in accrued interest payable		199,491			(141,173	)
Increase in other liabilities		777,683			831,382
Origination of mortgage loans for sale		(23,115,786	)		(29,524,264	)
Proceeds from the sale of mortgage loans		22,336,960			30,046,038
Gain on sale of mortgage loans, net		(462,230	)		(521,774	)
Decrease in net deferred tax asset		15,332			1,346,832
Other, net		23,982			23,982

Net cash provided by operating activities		9,518,188			11,739,610

Cash flows from investing activities:
Net decrease in loans		20,636,247			27,991,681
Purchase of available-for-sale debt securities		(83,043,472	)		(140,268,118	)
Proceeds from maturities of available-for-sale debt securities		19,097,740			98,037,862
Proceeds from calls of available-for-sale debt securities		25,508,000			28,780,100
Proceeds from sales of FHLB stock		1,077,100			595,200
Purchases of premises and equipment		(1,487,479	)		(239,112	)
Proceeds from sales of premises and equipment		34,249			34,528
Proceeds from sales of other real estate owned and repossessions		3,421,481			4,802,109

Net cash (used) provided in investing activities		(14,756,134	)		19,734,250

Cash flows from financing activities:
Net increase (decrease) in demand deposits		10,390,244			(3,512,371	)
Net increase in interest-bearing transaction accounts		6,971,783			38,040,414
Net decrease in time deposits		(1,952,085	)		(19,492,569	)
Net decrease in federal funds purchased and securities sold under agreements to repurchase		(1,378,786	)		(1,476,597	)
Repayment of Federal Home Loan Bank advances		(23,329,310	)		(11,967,528	)
Cash dividends paid — preferred stock		(756,376	)		(756,375	)
Cash dividends paid — common stock		(447,404	)		(946,430	)

Net cash provided by financing activities		(10,501,934	)		(111,456	)

Net (decrease) increase in cash and cash equivalents		(15,739,880	)		31,362,404
Cash and cash equivalents, beginning of period		50,979,800			24,665,695

Cash and cash equivalents, end of period	$	35,239,920		$	56,028,099

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


	Six Months Ended June 30,
	2011		2010

Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	5,760,750	$	8,691,969
Income taxes	$	—	$	200,000
Supplemental schedule of noncash investing and financing activities:
Other real estate and repossessions acquired in settlement of loans	$	5,943,302	$	11,750,040

See accompanying notes to consolidated financial statements.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(1) Basis of Presentation and Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements include all adjustments that, in the opinion of management, are necessary in order to make those statements not misleading. Management is required to make estimates and assumptions, including the determination of the allowance for loan losses, real estate acquired in connection with foreclosure or in satisfaction of loans, and fair values of investment securities available-for-sale that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Our Company’s management has evaluated and did not identify any subsequent events or transactions requiring recognition or disclosure in the consolidated financial statements.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q, do not include all of the information and disclosures required by generally accepted accounting principles for complete financial statements and should be read in conjunction with the consolidated financial statements and related notes filed in our Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

On July 1, 2011, our Company paid a special stock dividend of four percent to common shareholders of record at the close of business on May 12, 2011. For all periods presented, share information, including basic and diluted earnings per share have been adjusted retroactively to reflect this change.

The significant accounting policies followed in the preparation of the quarterly financial statements are disclosed in the 2010 Annual Report on form 10-K.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(2) Loans and Allowance for Loan Losses

A summary of loans, by major class within our Company’s loan portfolio, at June 30, 2011 and December 31, 2010 are as follows:


	June 30,		December 31,
	2011		2010

Commercial, financial, and agricultural	$	127,627,653	$	131,382,467
Real estate construction — residential		28,646,137		31,834,174
Real estate construction — commercial		50,836,737		56,052,910
Real estate mortgage — residential		203,066,932		207,834,488
Real estate mortgage — commercial		428,971,600		439,068,622
Installment and other consumer		29,475,102		32,132,336
Unamortized loan origination fees and costs, net		174,656		167,466


Total loans	$	868,798,817	$	898,472,463

The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the communities of and surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson and Lee’s Summit, Missouri. As such, the Bank is susceptible to changes in the economic environment in these communities. The Bank does not have a concentration of credit in any one economic sector. Installment and other consumer loans consist primarily of the financing of vehicles.

At June 30, 2011, loans of $439,441,000 were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit.

Allowance for loan losses

The following table provides the balance in the allowance for loan losses at June 30, 2011 and December 31, 2010, and the related loan balance by impairment methodology. Loans evaluated under ASC 310-10-35 include loans on non-accrual status, which are individually evaluated for impairment, troubled 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.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

The following is a summary of the allowance for loan losses at or for the three and six months ended June 30, 2011 as follows:


	For the Three Months Ended June 30, 2011
	Commercial,			Real Estate			Real Estate			Real Estate			Real Estate			Installment
	Financial, and			Construction -			Construction -			Mortgage -			Mortgage -			Loans to
(in thousands)	Agricultural			Residential			Commercial			Residential			Commercial			Individuals			Unallocated		Total

Allowance for loan losses:


Balance, beginning of period	$	2,257		$	991		$	1,356		$	3,118		$	3,709		$	223		$	748	$	12,402

Additions:
Provision for loan losses		313			(6	)		(276	)		306			1,264			62			220		1,883

Deductions:
Loans charged off		45			—			—			466			160			138			—		809
Less recoveries on loans		(8	)		(1	)		(250	)		(32	)		(24	)		(72	)		—		(387	)

Net loans charged off		37			(1	)		(250	)		434			136			66			—		422

Balance, end of period	$	2,533		$	986		$	1,330		$	2,990		$	4,837		$	219		$	968	$	13,863


	For the Six Months Ended June 30, 2011
	Commercial,			Real Estate			Real Estate			Real Estate			Real Estate			Installment
	Financial, and			Construction -			Construction -			Mortgage -			Mortgage -			Loans to
(in thousands)	Agricultural			Residential			Commercial			Residential			Commercial			Individuals			Unallocated		Total

Allowance for loan losses:


Balance, beginning of period	$	2,931		$	2,067		$	1,339		$	3,922		$	3,458		$	231		$	617	$	14,565

Additions:
Provision for loan losses		406			404			(259	)		533			2,091			107			351		3,633

Deductions:
Loans charged off		873			1,547			—			1,539			741			247			—		4,947
Less recoveries on loans		(69	)		(62	)		(250	)		(74	)		(29	)		(128	)		—		(612	)

Net loans charged off		804			1,485			(250	)		1,465			712			119			—		4,335

Balance, end of period	$	2,533		$	986		$	1,330		$	2,990		$	4,837		$	219		$	968	$	13,863

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

The tables provide other information regarding the allowance for loan losses and balance by type of allowance methodology at June 30, 2011 and December 31, 2010 as follows:


	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, and		Construction -		Construction -		Mortgage -		Mortgage -		Loans to
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Individuals		Unallocated		Total

June 30, 2011


Allowance for loan losses:

Individually evaluated for impairment	$	1,465	$	45	$	274	$	515	$	3,187	$	—	$	—	$	5,486
Collectively evaluated for impairment		1,068		941		1,056		2,475		1,650		219		968		8,377

Total	$	2,533	$	986	$	1,330	$	2,990	$	4,837	$	219	$	968	$	13,863

Loans outstanding:
Individually evaluated for impairment	$	5,366	$	832	$	10,994	$	6,767	$	31,961	$	—	$	—	$	55,920
Collectively evaluated for impairment		122,261		27,814		39,843		196,300		397,011		29,650		—		812,879

Total	$	127,627	$	28,646	$	50,837	$	203,067	$	428,972	$	29,650	$	—	$	868,799


December 31, 2010


Allowance for loan losses:

Individually evaluated for impairment	$	1,737	$	1,553	$	201	$	1,117	$	1,768	$	—	$	—	$	6,376
Collectively evaluated for impairment		1,194		514		1,138		2,805		1,690		231		617		8,189

Total	$	2,931	$	2,067	$	1,339	$	3,922	$	3,458	$	231	$	617	$	14,565

Loans outstanding:
Individually evaluated for impairment	$	3,660	$	3,586	$	11,783	$	8,040	$	29,076	$	—	$	—	$	56,145
Collectively evaluated for impairment		127,722		28,248		44,270		199,795		409,993		32,299		—		842,327

Total	$	131,382	$	31,834	$	56,053	$	207,835	$	439,069	$	32,299	$	—	$	898,472

Loans, or portions of loans, are charged off to the extent deemed uncollectible. Loan charge-offs reduce the allowance for loan losses, and recoveries of loans 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 streams 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.

Impaired loans

Impaired loans totaled $56,091,828 and $56,270,543 at June 30, 2011 and December 31, 2010 respectively, and are comprised of loans on non-accrual status and loans which have been classified as troubled debt restructurings.

The categories of impaired loans at June 30, 2011 and December 31, 2010 are as follows:


	June 30,		December 31,
	2011		2010

Non-accrual loans	$	49,543,857	$	50,586,887
Troubled debt restructurings continuing to accrue interest		6,547,971		5,683,656

Total impaired loans	$	56,091,828	$	56,270,543

At June 30, 2011, loans classified as trouble debt restructurings (TDR) totaled $23,913,139, of which $17,365,168 were on non-accrual status and $6,547,971 were on accrual status. At December 31, 2010, loans classified as TDR totaled $22,080,431, of which $16,396,775 were on non-accrual status and $5,683,656 was on accrual status. Reserves allocated to troubled debt restructurings were $1,781,000 and $1,359,000 at June 30, 2011 and December 31, 2010, respectively.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Interest income recognized on loans in non-accrual status and contractual interest that would be recorded had the loans performed in accordance with their original contractual terms is as follows:


	Three Months Ended June 30,					Six Months Ended June 30,
	2011		2010			2011		2010

Contractual interest due on non-accrual loans	$	612,472	$	784,350		$	1,218,908	$	1,278,237
Interest income recognized on loans in non-accrual status		32,802		(9,134	)		32,840		4,220

Net reduction in interest income	$	579,670	$	793,484		$	1,186,068	$	1,274,017

The specific reserve component of our Company’s allowance for loan losses at June 30, 2011 and December 31, 2010 was determined by using fair values of the underlying collateral obtained through independent appraisals and internal evaluations, or by discounting the total expected future cash flows. The recorded investment varies from the unpaid principal balance primarily due to partial charge-offs taken resulting from current appraisals received. The amount recognized as interest income on impaired loans continuing to accrue interest, primarily related to troubled debt restructurings, was $71,482 and $318,709 for the six months ended June 30, 2011 and June 30, 2010, respectively. Average recorded investment in impaired loans is calculated on a monthly basis during the period.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

The following table provides additional information about impaired loans at June 30, 2011 and December 31, 2010, respectively, segregated between loans for which an allowance has been provided and loans for which no allowance has been provided:


			Unpaid				Average		Interest Income Recognized
	Recorded		Principal		Related		Recorded		For the Period Ended
	Investment		Balance		Allowance		Investment		Three Months		Six Months

At June 30, 2011
With no related allowance recorded:
Commercial, financial and Agricultural	$	3,063,278	$	3,148,134	$	—	$	2,150,452	$	11,074	$	—
Real estate — construction residential		659,870		824,500		—		1,731,871		—		—
Real estate — construction commercial		8,235,882		9,348,798		—		8,251,242		—		—
Real estate — residential		2,488,885		3,269,889		—		3,429,353		11,698		7,014
Real estate — commercial		12,796,159		14,527,062		—		9,977,051		18,040		—
Consumer		172,191		209,667		—		203,899		1,349		—

Total	$	27,416,265	$	31,328,050	$	—	$	25,743,868	$	42,161	$	7,014

With an allowance recorded:
Commercial, financial and Agricultural	$	2,302,712	$	2,193,991	$	1,465,198	$	1,818,910	$	4,400	$	2,208
Real estate — construction residential		171,982		181,002		45,000		172,315		—		—
Real estate — construction commercial		2,758,396		4,013,396		274,000		2,067,649		—		—
Real estate — residential		4,277,926		4,385,847		514,978		3,998,773		54,472		27,140
Real estate — commercial		19,164,547		19,705,512		3,186,738		17,998,970		3,289		1,648

Total	$	28,675,563	$	30,479,748	$	5,485,914	$	26,056,617	$	62,161	$	30,996

Total impaired loans	$	56,091,828	$	61,807,798	$	5,485,914	$	51,800,485	$	104,322	$	38,010


At December 31, 2010
With no related allowance recorded:
Commercial, financial and Agricultural	$	441,861	$	629,296	$	—
Real estate — construction residential		1,769,622		2,355,936		—
Real estate — construction commercial		8,297,388		9,393,368		—
Real estate — residential		2,463,735		2,950,560		—
Real estate — commercial		12,939,973		14,869,833		—
Consumer		125,858		132,688		—

Total	$	26,038,437	$	30,331,681	$	—

With an allowance recorded:
Commercial, financial and Agricultural	$	3,217,995	$	3,260,009	$	1,737,159
Real estate — construction residential		1,816,276		1,848,593		1,552,406
Real estate — construction commercial		3,485,517		4,740,517		201,147
Real estate — residential		5,576,292		5,669,041		1,117,141
Real estate — commercial		16,136,025		16,215,862		1,767,893

Total	$	30,232,106	$	31,734,022	$	6,375,746

Total impaired loans	$	56,270,543	$	62,065,703	$	6,375,746

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Age Analysis of Past Due and Non-Accrual Loans


	Current or				90 Days
	Less Than				Past Due
	30 Days		30 - 89 Days		And Still
	Past Due		Past Due		Accruing		Non-Accrual		Total

June 30, 2011
Commercial, Financial, and Agricultural	$	123,586,765	$	737,482	$	—	$	3,303,406	$	127,627,653
Real Estate Construction — Residential		27,814,284		—		—		831,853		28,646,137
Real Estate Construction — Commercial		39,833,780		8,679		—		10,994,278		50,836,737
Real Estate Mortgage — Residential		197,059,787		1,391,903		98,631		4,516,611		203,066,932
Real Estate Mortgage — Commercial		398,975,412		270,671		—		29,725,518		428,971,601
Installment and Other Consumer		28,977,502		499,973		91		172,191		29,649,757

Total	$	816,247,530	$	2,908,708	$	98,722	$	49,543,857	$	868,798,817


December 31, 2010
Commercial, Financial, and Agricultural	$	127,315,586	$	534,865	$	—	$	3,532,016	$	131,382,467
Real Estate Construction — Residential		28,200,876		47,400		—		3,585,898		31,834,174
Real Estate Construction — Commercial		45,511,088		474,934		—		10,066,888		56,052,910
Real Estate Mortgage — Residential		199,386,784		2,775,654		—		5,672,050		207,834,488
Real Estate Mortgage — Commercial		409,906,845		1,557,599		—		27,604,178		439,068,622
Installment and Other Consumer		31,784,217		356,812		32,916		125,857		32,299,802

Total	$	842,105,396	$	5,747,264	$	32,916	$	50,586,887	$	898,472,463

The following table provides information about the credit quality of the loan portfolio using our Company’s internal rating system reflecting management’s risk assessment. Loans are placed on watch status when (1) one or more weaknesses which could jeopardize timely liquidation exits; or (2) the margin or liquidity of an asset is sufficiently tenuous that adverse trends could result in a collection problem. Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified may have a well defined weakness or weaknesses that jeopardize the repayment of the debt. Such loans are characterized by the distinct possibility that our Company may sustain some loss if the deficiencies are not corrected. Loans are placed on non-accrual status when (1) deterioration in the financial condition of the borrower exists such that payment of full principal and interest is not expected, or (2) payment of principal or interest has been in default for a period of 90 days or more and the asset is not both well secured and in the process of collection.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)


			Real Estate		Real Estate		Real Estate		Real Estate
			Construction -		Construction -		Mortgage -		Mortgage -		Installment and
	Commercial		Residential		Commercial		Residential		Commercial		other Consumer		Total

At June 30, 2011
Watch	$	22,626,495	$	8,109,338	$	9,392,484	$	13,097,712	$	30,453,623	$	419,571	$	84,099,223
Substandard		4,412,920		829,405		1,991,878		4,163,925		14,582,568		411,775		26,392,471
Non-accrual		3,303,406		831,853		10,994,278		4,516,611		29,725,518		172,191		49,543,857

Total	$	30,342,821	$	9,770,596	$	22,378,640	$	21,778,248	$	74,761,709	$	1,003,537	$	160,035,551


At December 31, 2010
Watch	$	21,981,367	$	7,519,394	$	9,400,584	$	9,184,659	$	35,050,206	$	564,489	$	83,700,699
Substandard		2,840,703		757,637		4,242,934		4,423,219		12,635,163		441,514		25,341,170
Non-accrual		3,532,016		3,585,898		10,066,888		5,672,050		27,604,178		125,857		50,586,887

Total	$	28,354,086	$	11,862,929	$	23,710,406	$	19,279,928	$	75,289,547	$	1,131,860	$	159,628,756

(3)

Real Estate Acquired in Settlement of Loans


	June 30,			December 31,
	2011			2010

Commercial	$	—		$	67,421
Real estate mortgage — construction		12,803,203			13,229,199
Real estate mortgage		9,149,815			6,254,221

Total	$	21,953,018		$	19,550,841
Less valuation allowance for other real estate owned		(6,536,607	)		(6,158,433	)

Total	$	15,416,411		$	13,392,408


Balance at December 31, 2010				$	19,550,841
Additions, net of charge-offs					5,583,613
Proceeds from sales					(3,123,105	)
Net loss on sales					(58,331	)

Total other real estate owned				$	21,953,018
Less valuation allowance for other real estate owned					(6,536,607	)

Balance at June 30, 2011				$	15,416,411

Activity in the valuation allowance for other real estate owned in settlement of loans for the three and six months ended June 30, 2011 and 2010, respectively, is summarized as follows:


	Three Months Ended June 30,					Six Months Ended June 30,
	2011			2010		2011			2010

Balance, beginning of period	$	6,319,098		$	—	$	6,158,433		$	—
Provision for other real estate owned		280,140			—		440,805			—
Charge-offs		(62,631	)		—		(62,631	)		—

Balance, end of period	$	6,536,607		$	—	$	6,536,607		$	—

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(4)

Investment Securities

A summary of investment securities by major category, at fair value, consisted of the following at June 30, 2011 and December 31, 2010.


	June 30,		December 31,
	2011		2010

U.S. treasury	$	2,048,203	$	1,027,891
Government sponsored enterprises		67,212,769		53,341,551
Asset-backed securities		118,939,994		90,176,241
Obligations of states and political subdivisions		31,496,317		34,431,867

Total available for sale securities	$	219,697,283	$	178,977,550

All of our 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 entities and government agencies such as the FHLMC, FNMA and GNMA.

Investment securities which are classified as restricted equity securities primarily consist of Federal Home Loan Bank Stock and our Company’s interest in statutory trusts. These securities are reported at cost in other assets in the amount of $5,064,850 and $6,141,950, as of June 30, 2011 and December 31, 2010, respectively.

The amortized cost and fair value of debt securities classified as available-for-sale at June 30, 2011 and December 31, 2010 are as follows:


			Gross		Gross
	Amortized		unrealized		unrealized
	cost		gains		losses		Fair value

June 30, 2011
U.S Treasury	$	1,999,561	$	48,642	$	—	$	2,048,203
Government sponsored enterprises		66,792,397		524,211		103,839		67,212,769
Asset-backed securities		115,927,700		3,093,068		80,775		118,939,993
Obligations of states and political subdivisions		30,609,854		907,160		20,696		31,496,318

Total available for sale securities	$	215,329,512	$	4,573,081	$	205,310	$	219,697,283


December 31, 2010
U.S Treasury	$	999,823	$	28,068	$	—	$	1,027,891
Government sponsored enterprises		53,516,545		327,051		502,045		53,341,551
Asset-backed securities		88,634,760		1,905,377		363,896		90,176,241
Obligations of states and political subdivisions		34,146,782		555,240		270,155		34,431,867

Total available for sale securities	$	177,297,910	$	2,815,736	$	1,136,096	$	178,977,550

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

The amortized cost and fair value of debt securities classified as available-for-sale at June 30, 2011, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without prepayment penalties.


	Amortized		Fair
	cost		value

Due in one year or less	$	3,794,942	$	3,832,846
Due after one year through five years		75,790,661		76,597,778
Due after five years through ten years		17,310,704		17,771,625
Due after ten years		2,505,505		2,555,041

		99,401,812		100,757,290
Asset-backed securities		115,927,700		118,939,993

Total	$	215,329,512	$	219,697,283

Debt securities with carrying values aggregating approximately $170,372,000 and $148,099,000 at June 30, 2011 and December 31, 2010, respectively, were pledged to secure public fund deposits, federal funds purchased lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve, and for other purposes as required or permitted by law.

Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2011 and December 31, 2010, were as follows:


	Less than 12 months					12 months or more						Total
										Number of
	Fair		Unrealized			Fair		Unrealized		Investment		Fair		Unrealized
At June 30, 2011	Value		Losses			Value		Losses		Positions		Value		Losses

Government sponsored enterprises	$	13,295,901	$	(103,839	)	$	—	$	—		12	$	13,295,901		(103,839	)
Asset-backed securities		10,382,348		(80,775	)		—		—		10		10,382,348	$	(80,775	)
Obligations of states and political subdivisions		1,122,000		(20,696	)		—		—		6		1,122,000		(20,696	)

	$	24,800,249	$	(205,310	)	$	—	$	—		28	$	24,800,249	$	(205,310	)


	Less than 12 months					12 months or more						Total
										Number of
	Fair		Unrealized			Fair		Unrealized		Investment		Fair		Unrealized
At December 31, 2010	Value		Losses			Value		Losses		Positions		Value		Losses

Government sponsored enterprises	$	20,504,526	$	(502,045	)	$	—	$	—		19	$	20,504,526		(502,045	)
Asset-backed securities		21,177,793		(363,896	)		—		—		20		21,177,793	$	(363,896	)
Obligations of states and political subdivisions		8,038,946		(270,155	)		—		—		29		8,038,946		(270,155	)

	$	49,721,265	$	(1,136,096	)	$	—	$	—		68	$	49,721,265	$	(1,136,096	)

Our Company’s available for sale portfolio consisted of approximately 358 securities at June 30, 2011. None of these securities had been in the loss position for 12 months or longer. The $205,000 unrealized loss included in other comprehensive income at June 30, 2011 was caused by interest rate fluctuations. Because the decline in fair value is attributable to changes in interest rates and not credit quality these investments were not considered other-than-temporarily impaired.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Our Company’s available for sale portfolio consisted of approximately 333 securities at December 31, 2010. None of these securities had been in the loss position for 12 months or longer. The $1,136,000 unrealized loss included in other comprehensive income at December 31, 2010 was caused by interest rate fluctuations. Because the decline in fair value is attributable to changes in interest rates and not credit quality these investments were not considered other-than-temporarily impaired.

During the six months ended June 30, 2011 and 2010, there were no proceeds from sales of securities and no components of investment securities gains and losses which have been recognized in earnings.

(5)

Intangible Assets

A summary of other intangible assets at June 30, 2011 and December 31, 2010, respectively is as follows:


	June 30, 2011							December 31, 2010
	Gross							Gross
	Carrying		Accumulated			Net		Carrying		Accumulated			Net
	Amount		Amortization			Amount		Amount		Amortization			Amount

Amortizable intangible assets:
Core deposit intangible	$	4,795,224	$	(4,044,428	)	$	750,796	$	7,060,224	$	(6,082,715	)	$	977,509
Mortgage servicing rights		3,084,915		(813,000	)		2,271,915		3,067,368		(711,378	)		2,355,990

Total intangible assets	$	7,880,139	$	(4,857,428	)	$	3,022,711	$	10,127,592	$	(6,794,093	)	$	3,333,499

Changes in the net carrying amount of other intangible assets for the three months ended June 30, 2011 are as follows:


	Core Deposit			Mortgage
	Intangible			Servicing
	Asset			Rights

Balance at December 31, 2010	$	977,509		$	2,355,990
Additions		—			220,554
Amortization		(226,713	)		(304,629	)

Balance at June 30, 2011	$	750,796		$	2,271,915

Mortgage servicing rights (MSRs) are amortized over the shorter of 7 years or the life of the loan. They are periodically reviewed for impairment and if impairment is indicated, recorded at fair value. At June 30, 2011 and December 31, 2010, no temporary impairment was recognized. The fair value of MSRs is based on the present value of expected cash flows, as further discussed in Fair Value of Financial Instruments. Mortgage loans serviced for others totaled approximately $300,040,000 and $298,325,000 at June 30, 2011 and December 31, 2010, respectively. Included in other noninterest income were real estate servicing fees for the three months ended June 30, 2011 and 2010 of $211,000, and $204,000, respectively, and for the six months ended June 30, 2011 and 2010 of $390,000 and $396,000, respectively.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

The aggregate amortization expense of intangible assets subject to amortization for the three and six months ended June 30, 2011 and 2010 is as follows:


	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
Aggregate amortization expense	2011		2010		2011		2010

Core deposit intangible asset	$	108,687	$	139,906	$	226,713	$	290,425
Mortgage servicing rights		155,390		152,102		304,629		286,976

Our Company’s amortization expense on intangible assets in any given period may be different from the estimated amounts 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 June 30, 2011 for the next five years:


	Core Deposit		Mortgage
	Intangible		Servicing
	Asset		Rights

2011	$	208,050	$	230,000
2012		408,062		435,000
2013		134,684		354,000
2014		—		288,000
2015		—		235,000

(6)

Income Taxes

Our Company follows ASC Topic 740, Income Taxes, which addresses the accounting for uncertain tax positions. At June 30, 2011 and December 31, 2010, our Company had $221,000 of gross unrecognized tax benefits that if recognized would affect the effective tax rate. Our Company believes that during 2011 it is reasonably possible that there would be a reduction of $221,000 in gross unrecognized tax benefits as a result of the lapse of statute of limitations for the 2007 tax year. At June 30, 2011, total interest accrued on unrecognized tax benefits was approximately $40,000. As of June 30, 2011, there were no federal or state income tax examinations in process.

The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not our Company will realize the benefits of these temporary differences at June 30, 2011 and, therefore, has not established a valuation reserve.

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 32.0% and 28.5% for the three months ended June 30, 2011 and 2010, and 32.0% and 28.1% for the six months ended June 30, 2011 and 2010, respectively. The effective tax rate for the three and six months ended June 30, 2011 reflects a decrease in tax-exempt income as a percentage of total taxable income.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(7)

Employee Benefit Plans

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


	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
	2011		2010		2011		2010

Payroll taxes	$	264,350	$	283,673	$	578,879	$	605,640
Medical plans		434,470		393,503		876,789		798,355
401k match		67,414		73,776		135,013		153,788
Pension plan		227,592		216,298		455,185		432,597
Profit-sharing		16,000		—		39,000		72,470
Other		58,405		32,688		99,968		74,016

Total employee benefits	$	1,068,231	$	999,938	$	2,184,834	$	2,136,866

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

Pension

Our Company also provides a noncontributory defined benefit pension plan for all full-time employees. An employer is required to recognize the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Under our Company’s funding policy for the defined benefit pension plan, contributions are made to a trust as necessary to provide for current service and for any unfunded accrued actuarial liabilities over a reasonable period. To the extent that these requirements are fully covered by assets in the trust, a contribution might not be made in a particular year. Our Company made a $554,000 contribution to the defined benefit plan in 2010, and the minimum required contribution for 2011 is estimated to be $997,000. Our Company has contributed $767,000 to the plan for the year.

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


	Estimated			Actual
	2011			2010

Service cost—benefits earned during the year	$	930,691		$	844,178
Interest costs on projected benefit obligations		603,903			556,047
Expected return on plan assets		(702,852	)		(613,982	)
Amortization of prior service cost		78,628			78,628

Net periodic pension expense	$	910,370		$	864,871


Pension expense — three months ended June 30, (actual)	$	227,593		$	216,299

Pension expense — six months ended June 30, (actual)	$	455,185		$	432,597

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(8)

Stock Compensation

Our Company’s stock option plan provides for the grant of options to purchase up to 506,188 shares of our Company’s common stock to officers and other key employees of our 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 10,705 shares that vested immediately.

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


					Weighted
			Weighted		Average		Aggregate
	Number		Average		Contractual		Intrinsic
	of		Exercise		Term		Value
	Shares		Price		(in years)		(000)

Outstanding at January 1, 2011 *		260,466	$	24.44
Granted		—		—
Exercised		—		—
Forfeited		—		—
Expired		—		—


Outstanding at June 30, 2011		260,466	$	24.44		4.0	$	—

Exercisable at June 30, 2011		227,635	$	24.69		3.7	$	—

Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2011.

Total stock-based compensation expense for the three months ended June 30, 2011 and 2010, was $12,000 and $19,000, respectively, and for the six months ended June 30, 2011 and 2010 was $34,000 and $48,000, respectively. As of June 30, 2011, the total unrecognized compensation expense related to non-vested stock awards was $123,000 and the related weighted average period over which it is expected to be recognized is approximately three years.

(9)

Comprehensive Income

Activity in other comprehensive income for the six months ended June 30, 2011 and 2010 is shown in the Consolidated Statements of Stockholders’ Equity and Comprehensive Income. The first component of other comprehensive income is the unrealized holding gains and losses on available for sale securities. Our Company did not have any other-than temporary impairment (OTTI) as required to be reported under current accounting guidance for OTTI on debt securities during the periods reported. Under this guidance, credit-related losses on debt securities with OTTI are recorded in current earnings, while the noncredit- related portion of the overall gain or loss in fair value is recorded in other comprehensive income. The second component of other comprehensive income is pension gains and losses that arise during the period but are not recognized as components of net periodic benefit cost, and corresponding adjustments when these gains and losses are subsequently amortized to net periodic benefit cost.

(10)

Preferred Stock

On December 19, 2008, our 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 is designed to attract broad participation by banking institutions to help stabilize the financial system by encouraging lending. Our Company has used the funds received, as discussed below, to continue to provide loans to its customers and to look for ways to deploy additional funds to benefit the communities in our Company’s market area.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Participation in this program included our Company’s issuance of 30,255 shares of senior preferred stock (with a par value of $1,000 per share) and a ten year warrant to purchase approximately 276,090 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 discount 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. The allocated carrying values of the senior preferred stock and common stock warrant at June 30, 2011 were $29,079,000 and $2,382,000, respectively.

The preferred shares carry a 5% cumulative dividend for the first five years and 9% thereafter if not redeemed. The preferred shares are redeemable after three years at par plus accrued dividends, or before three years if our Company raises Tier 1 capital in an amount equal to the preferred stock issued. The preferred stock generally does not have any voting rights, subject to an exception in the event our Company fails to pay dividends on the preferred stock for six or more quarterly periods, whether or not consecutive. Under such circumstances, the Treasury Department 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 payment. Our Company is prohibited from paying any dividends with respect to shares of common stock unless all accrued and unpaid dividends are paid in full on the senior preferred stock for all past dividend periods. The Treasury Department may also transfer 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 $16.44 per share. The preferred stock and warrant are classified as stockholders’ equity in the consolidated balance sheet and qualify, for regulatory capital purposes, as Tier I capital. For the six months ended June 30, 2011, our Company had declared and paid $756,000 of dividends and amortized $238,000 of accretion of the discount on preferred stock.

(11)

Earnings per Share

Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the year. Diluted earnings per share gives effect to all dilutive potential common shares that were outstanding during the year. The calculations of basic and diluted earnings per share are as follows:

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)


	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
	2011		2010		2011		2010

Basic earnings per common share:
Net income	$	1,408,494	$	782,466	$	2,362,111	$	1,276,234
Less:
Preferred stock dividends		382,390		382,390		752,173		752,173
Accretion of discount on preferred stock		119,118		119,118		238,237		238,237

Net income available to common shareholders	$	906,986	$	280,958	$	1,371,701	$	285,824

Basic earnings per share	$	0.19	$	0.06	$	0.29	$	0.06


Diluted earnings per common share:

Net income	$	1,408,494	$	782,466	$	2,362,111	$	1,276,234
Less:
Preferred stock dividends		382,390		382,390		752,173		752,173
Accretion of discount on preferred stock		119,118		119,118		238,237		238,237

Net income available to common shareholders	$	906,986	$	280,958	$	1,371,701	$	285,824

Average shares outstanding		4,652,994		4,652,994		4,652,994		4,652,994
Effect of dilutive stock options		—		—		—		—

Average shares outstanding including dilutive stock options		4,652,994		4,652,994		4,652,994		4,652,994

Diluted earnings per share	$	0.19	$	0.06	$	0.29	$	0.06

Under the treasury stock method, outstanding stock options are dilutive when the average market price of our Company’s common stock, when combined with the effect of any unamortized compensation expense, exceeds the option price during the period, except when our Company has a loss from continuing operations available to common shareholders. In addition, proceeds from the assumed exercise of dilutive options along with the related tax benefit are assumed to be used to repurchase common shares at the average market price of such stock during the period.

The following options to purchase shares during the three and six months ended June 30, 2011 and 2010, respectively, were not included in the respective computations of diluted earnings per share because the exercise price of the option, when combined with the effect of the unamortized compensation expense, was greater than the average market price of the common shares and were considered anti-dilutive.


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2011		2010		2011		2010

Anti-dilutive shares — option shares		260,466		298,382		260,466		298,382
Anti-dilutive shares — warrant shares		276,090		276,090		276,090		276,090

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(12) Fair Value Measurements

Our Company uses fair value measurements to record fair value adjustments to certain financial and nonfinancial assets and liabilities. The FASB ASC Topic 820, Fair Value Measurements and Disclosures, defines fair value, establishes a framework for the measurement of fair value, and enhances disclosures about fair value measurements. The standard applies whenever other standards require (permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. In this standard, FASB clarified the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. As of the six months ended June 30, 2011 and 2010, there were no transfers into or out of Level 2.

The fair value hierarchy is as follows:

Level 1 — Inputs are unadjusted quoted prices for identical assets or liabilities in active markets.

Level 2 — Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 — Inputs are unobservable inputs for the asset or liability and significant to the fair value. These may be internally developed using our Company’s best information and assumptions that a market participant would consider.

ASC Topic 820 also provides guidance on determining fair value when the volume and level of activity for the asset or liability has significantly decreased and on identifying circumstances when a transaction may not be considered orderly.

Our Company is required to disclose assets and liabilities measured at fair value on a recurring basis separate from those measured at fair value on a nonrecurring basis. Nonfinancial assets measured at fair value on a nonrecurring basis would include foreclosed real estate, long-lived assets, and core deposit intangible assets, which are reviewed when circumstances or other events indicate that impairment may have occurred.

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

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

Available-for-sale securities

Available-for-sale securities are recorded at fair value on a recurring basis. Available-for-sale securities is the only balance sheet category our Company is required, in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP), to carry at fair value on a recurring basis. Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, our Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)


			Fair Value Measurements Using
			Quoted Prices
			in Active
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
Description	Fair Value		(Level 1)		(Level 2)		(Level 3)

June 30, 2011
U.S. treasury	$	2,048,203	$	—	$	2,048,203	$	—
Government sponsored enterprises		67,212,769		—		67,212,769		—
Asset-backed securities		118,939,994		—		118,939,994		—
Obligations of states and political subdivisions		31,496,317		—		31,496,317		—

Total	$	219,697,283			$	219,697,283	$	—

December 31, 2010
U.S. treasury	$	1,027,891	$	—	$	1,027,891	$	—
Government sponsored enterprises		53,341,551		—		53,341,551		—
Asset-backed securities		90,176,241		—		90,176,241		—
Obligations of states and political subdivisions		34,431,867		—		34,431,867		—

Total	$	178,977,550			$	178,977,550	$	—

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

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

Impaired Loans

Our Company does not record loans at fair value on a recurring basis other than loans that are considered impaired. The net carrying value of impaired loans is generally based on fair values of the underlying collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. Once the fair value of the collateral has been determined and any impairment amount calculated, a specific reserve allocation is made. Because many of these inputs are not observable, the measurements are classified as Level 3. As of June 30, 2011, our Company identified $28.7 million in impaired loans that had specific allowances for losses aggregating $5.5 million. Related to these loans, there was $3.8 million in charge-offs recorded during 2011.

Other Real Estate Owned and Repossessed Assets

Other real estate owned and repossessed assets consist of loan collateral which has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate owned 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. Our Company relies on external appraisals and assessment of property values by our internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. Because many of these inputs are not observable, the measurements are classified as Level 3.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)


			Fair Value Measurements Using
			Quoted Prices
			in Active
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs		Total Gains
Description	Fair Value		(Level 1)		(Level 2)		(Level 3)		(Losses)*

June 30, 2011
Impaired loans:
Commercial, financial, & agricultural	$	837,514	$	—	$	—	$	837,514	$	(860,168	)
Real estate construction — residential		126,982		—		—		126,982		(1,493,046	)
Real estate construction — commercial		2,484,396		—		—		2,484,396		—
Real estate mortgage — residential		3,762,948		—		—		3,762,948		(1,161,539	)
Real estate mortgage — commercial		15,977,809		—		—		15,977,809		(315,062	)

Total	$	23,189,649	$	—	$	—	$	23,189,649	$	(3,829,815	)

Other real estate owned and repossessed assets	$	15,768,518	$	—	$	—	$	15,768,518	$	(1,147,963	)

December 31, 2010
Impaired loans:
Commercial, financial, & agricultural	$	1,480,836	$	—	$	—	$	1,480,836	$	(1,634,544	)
Real estate construction — residential		263,870		—		—		263,870		(863,399	)
Real estate construction — commercial		3,284,371		—		—		3,284,371		(4,496,156	)
Real estate mortgage — residential		4,459,151		—		—		4,459,151		(3,971,927	)
Real estate mortgage — commercial		14,368,132		—		—		14,368,132		(3,626,892	)

Total	$	23,856,360	$	—	$	—	$	23,856,360	$	(14,592,918	)

Other real estate owned and repossessed assets	$	14,009,017	$	—	$	—	$	14,009,017	$	(3,528,011	)


*		Total gains (losses) reported for other real estate owned and repossessed assets includes charge offs and net losses taken during the periods reported.

(13) Fair Value of Financial Instruments

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

Loans

The fair value of loans is estimated based on the discounted value of contractual cash flows. The discount rate is estimated using current offering rates applicable to each category of such financial instruments. The net carrying amount of impaired loans is generally based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC Topic 820.

Investment Securities

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

Federal Funds Sold, Cash, and Due from Banks

For federal funds sold, cash, and due from banks, the carrying amount is a reasonable estimate of fair value, as such instruments reprice in a short time period.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Mortgage Servicing Rights

The fair value of mortgage servicing rights is based on the discounted value of contractual cash flows utilizing servicing rate, constant prepayment rate, servicing cost, and discount rate factors.

Accrued Interest Receivable and Payable

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

Deposits

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

Securities Sold under Agreements to Repurchase and Interest-bearing Demand Notes to U.S. Treasury

For securities sold under agreements to repurchase and interest-bearing demand notes to U.S. Treasury, the carrying amount is a reasonable estimate of fair value, as such instruments reprice in a short time period.

Other Borrowings

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

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

A summary of the carrying amounts and fair values of our Company’s financial instruments for the periods stated is as follows:


	June 30, 2011				December 31, 2010
	Carrying		Fair		Carrying		Fair
	amount		value		amount		value

Assets:
Loans	$	854,935,767	$	858,243,000	$	883,907,596	$	889,291,000
Investment in debt securities		219,697,283		219,697,283		178,977,550		178,977,550
Federal fund sold and securities purchased under agreements to resell		171,338		171,338		125,815		125,815
Cash and due from banks		35,068,582		35,068,582		50,853,985		50,853,985
Mortgage servicing rights		2,271,915		2,942,000		2,355,990		3,027,000
Accrued interest receivable		5,672,339		5,672,339		5,733,684		5,733,684

	$	1,117,817,224	$	1,121,794,542	$	1,121,954,620	$	1,128,009,034

Liabilities:
Deposits:
Demand	$	148,139,814	$	148,139,814	$	137,749,571	$	137,749,571
NOW		176,363,696		176,363,696		160,225,356		160,225,356
Savings		61,188,402		61,188,402		54,722,129		54,722,129
Money market		148,321,087		148,321,087		164,190,054		164,190,054
Time		428,059,598		435,753,000		429,775,546		437,996,000
Federal funds purchased and securities sold under agreements to repurchase		28,689,667		28,689,667		30,068,453		30,068,453
Subordinated notes		49,486,000		21,366,000		49,486,000		21,105,000
Other borrowings		43,656,668		45,224,000		66,985,978		69,329,000
Accrued interest payable		1,690,994		1,690,994		1,491,503		1,491,503

	$	1,085,595,926	$	1,066,736,660	$	1,094,694,590	$	1,076,877,066

Off-Balance Sheet Financial Instruments

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

Limitations

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

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(14) Pending Litigation

Our Company and its subsidiaries are defendants in various legal actions incidental to our Company’s past and current business activities. At June 30, 2011 and December 31, 2010, our Company’s consolidated balance sheets included liabilities for these legal actions of $265,000 and $275,000, respectively. Based on our Company’s analysis, and considering the inherent uncertainties associated with litigation, we do not believe that it is reasonably possible that these legal actions will materially adversely affect our Company’s consolidated financial statements or results of operations in the near term.

On November 18, 2010, a suit was filed against Hawthorn Bank in the Circuit Court of Jackson County for the Eastern Division of Missouri by a customer alleging that the fees associated with the Bank’s automated overdraft program in connection with its debit card and ATM cards constitute unlawful 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 Bank has filed for a motion to dismiss the suit. At this early stage of the litigation, it is not possible for management of the Bank to determine the probability of a material adverse outcome or reasonably estimate the amount of any potential loss.

On December 17, 2009, a suit was filed against Hawthorn Bank in Circuit Court of Jackson County for the Eastern Division of Missouri state court by a customer alleging that the Bank had not followed through on its commitment to fund a loan request. A jury found in favor of the customer and as of June 30, 2011 our Company was carrying a liability of $195,000 representing the balance of its estimated obligation. Our Company is currently in the early stages of the appeals process and the probable outcome is presently not determinable.

On May 10, 2011, a suit was filed against Hawthorn Bank in the Circuit Court of Cole County by a customer alleging that the Bank had not properly disclosed information in a sale of foreclosed property. Our Company is carrying a liability of $70,000 representing the balance of its estimated obligation.

Item 2 — Management’s Discussion and Analysis of Financial Condition
And Results of Operations

Forward-Looking Statements

This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of our Company and its subsidiaries, including, without limitation:

	•		statements that are not historical in nature, and

	•		statements preceded by, followed by or that include the words believes, expects, may, will, should, could, anticipates, estimates, intends or similar expressions.

Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

	•		competitive pressures among financial services companies may increase significantly,

	•		changes in the interest rate environment may reduce interest margins,

	•		general economic conditions, either nationally or in Missouri, may be less favorable than expected and may adversely affect the quality of our loans and other assets,

	•		increases in non-performing assets in our loan portfolios and adverse economic conditions may necessitate increases to our provisions for loan losses,

	•		costs or difficulties related to the integration of the business of our Company and its acquisition targets may be greater than expected,

	•		legislative or regulatory changes may adversely affect the business in which our Company and its subsidiaries are engaged, including those discussed below in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and

	•		changes may occur in the securities markets.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, was enacted on July 21, 2010. Provisions of the Act address many issues including, but not limited to, capital, interchange fees, compliance and risk management, debit card overdraft fees, the establishment of a new consumer regulator, healthcare, incentive compensation, expanded disclosures and corporate governance. While many of the new regulations under the Act are expected to primarily impact financial institutions with assets greater than $10 billion, our Company expects these new regulations could reduce our revenues and increase our expenses in the future. Management is currently assessing the impact of the Act and of the regulations anticipated to be promulgated under the Act.

We have described under the caption “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010 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 statements. Other factors that we have not identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made.

Overview

Our Company, Hawthorn Bancshares, Inc., is a community-based, financial institution bank holding company headquartered in Lee’s Summit, Missouri. Our Company was incorporated under the laws of the State of Missouri on October 23, 1992 as Exchange National Bancshares, Inc. and changed its name to Hawthorn Bancshares, Inc. in August 2007. Our Company owns all of the issued and outstanding capital stock of Union State Bancshares, Inc., which in turn owns all of the issued and outstanding capital stock of Hawthorn Bank. Our Company conducts operations primarily through our Bank. Our Bank, a state charted bank, had $1.20 billion in assets at June 30, 2011, and 24 full-service banking offices, including its principal office in Jefferson City, Missouri. Our Bank is committed to providing the most up-to-date financial products and services and delivering these products and services to our market area with superior customer service.

Through our branch network, our Bank 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. We also provide a wide range of lending

services, including real estate, commercial, installment, and other consumer loans. Other financial services that we provide include automatic teller machines, trust services, credit related insurance, and safe deposit boxes. The geographic areas in which we provide our products and services include the communities in and surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson and Lee’s Summit, Missouri. The products and services are offered to customers primarily within these geographical areas.

Our Company’s primary source of revenue is net interest income derived primarily from lending and deposit taking activities. A secondary source of revenue is investment income. Our Company also derives income from trust, brokerage, credit card and mortgage banking activities and service charge income.

CRITICAL ACCOUNTING POLICIES

The following accounting policies are considered most critical to the understanding of our Company’s financial condition and results of operations. These critical accounting policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to our critical accounting policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such polices affect our reported and expected financial results.

Allowance for Loan Losses

We have identified the accounting policy related to the allowance for loan losses as critical to the understanding of our Company’s results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on our business operations is discussed in the Lending and Credit Management section below. Many of the loans are deemed collateral dependent for purposes of the measurement of the impairment loss, thus the fair value of the underlying collateral and sensitivity of such fair values due to changing market conditions, supply and demand, condition of the collateral and other factors can be volatile over periods of time. Such volatility can have an impact on the financial performance of our Company.

Other Real Estate Owned and Repossessed Assets

Other real estate owned and repossessed assets consist of loan collateral which has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate owned assets are initially recorded as held for sale at the lower of the loan balance or fair value of the collateral less estimated selling costs. Any adjustment is recorded as a charge-off against the allowance for loan losses. Our Company relies on external appraisals and assessment of property values by internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. The write-downs are recorded as other real estate expense. Our Company establishes a valuation allowance related to other real estate owned on an asset-by-asset basis. The valuation allowance is created during the holding period when the fair value less cost to sell is lower than the “cost” of a parcel of other real estate.

Valuation of Investment Securities

At the time of purchase, debt securities are classified into one of two categories: available-for-sale or held-to-maturity. Held-to-maturity securities are those securities which our Company has the positive intent and ability to hold until maturity. All debt securities not classified as held-to-maturity are classified as available-for-sale. Our 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 impairment, are reported in other comprehensive income, net of taxes, a component of stockholders’ equity. Securities are periodically evaluated for other-than-temporary impairment in accordance with guidance provided in the FASB ASC Topic 320, Investments — 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 earnings if our Company intends to sell the securities or believes it more likely than not that it will be required to sell the security before the anticipated recovery.

If neither condition is met, but our Company does not expect to recover the amortized cost basis, our Company determines whether a credit loss has occurred, which is then recognized in current earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income.

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 are recognized when earned. Realized gains and losses for securities classified as available-for-sale are included in earnings based on the specific identification method for determining the cost of securities sold.

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 an entity’s financial statements or tax returns. Judgment is required in addressing our Company’s future tax consequences of events that have been recognized in our consolidated financial statements or tax returns such as realization of the effects of temporary differences, net operating loss carry forward, 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, our Company would adjust the recorded value of our deferred tax asset, which would result in a direct charge to income tax expense in the period that the determination was made. Given the sensitivity of our Company’s financial performance to changes in net interest margins and increasing reserves associated with loan losses and other real estate owned, sustained negative financial performance could provide sufficient negative evidence to necessitate a deferred tax asset valuation allowance. In addition, our Company is subject to the continuous examination of our tax returns by the Internal Revenue Service and other taxing authorities. Our Company accrues for interest related to income taxes in income tax expense. Total interest expense recognized was $9,000 and $19,000 as of June 30, 2011 and 2010, respectively. As of June 30, 2011 and December 31, 2010, total accrued interest was $40,000 and $31,000, respectively.

SELECTED CONSOLIDATED FINANCIAL DATA

The following table presents selected consolidated financial information for our Company as of and for each of the three and six months ended June 30, 2011 and 2010, respectively. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements of our Company, including the accompanying notes, presented elsewhere herein.

Selected Financial Data


	Three Months						Six Months
	Ended						Ended
	June 30,						June 30,
(In thousands, except per share data)	2011			2010			2011			2010

Per Share Data

Basic earnings per common share	$	0.19		$	0.06		$	0.29		$	0.06
Diluted earnings per common share		0.19			0.06			0.29			0.06
Dividends paid on preferred stock		378			378			756			756
Amortization of discount on preferred stock		119			119			238			238
Dividends paid on common stock		223			473			447			946
Book value per common share								16.18			17.24
Market price per common share								8.27			11.59

Selected Ratios

*(Based on average balance sheets)*
Return on average total assets		0.47	%		0.25	%		0.40	%		0.21	%
Return on average common stockholders’ equity		4.93	%		1.41	%		3.75	%		0.72	%
Average common stockholders’ equity to average total assets		6.17	%		6.39	%		6.14	%		6.38	%
*(Based on end-of-period data)*
Efficiency ratio (1)		69.51	%		76.08	%		72.12	%		75.15	%
Period-end common stockholders’ equity to period-end assets								6.30	%		6.47	%
Period-end stockholders’ equity to period-end assets								8.73	%		8.78	%
Total risk-based capital ratio								17.54			17.07
Tier 1 risk-based capital ratio								14.76			14.54
Leverage ratio								11.31			11.31


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

RESULTS OF OPERATIONS ANALYSIS

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


	Three months ended										Six months ended
	June 30,										June 30,
(Dollars in thousands)	2011		2010		$ Change			% Change			2011		2010		$ Change			% Change

Net interest income	$	10,782	$	11,114	$	(332	)	$	(3.0	)	$	21,263	$	21,425	$	(162	)	$	(0.8	)%
Provision for loan losses		1,883		2,150		(267	)		(12.4	)		3,633		4,655		(1,022	)		(22.0	)
Noninterest income		2,178		2,450		(272	)		(11.1	)		4,231		4,455		(224	)		(5.0	)
Noninterest expense		9,008		10,320		(1,312	)		(12.7	)		18,386		19,450		(1,064	)		(5.5	)
Income before income taxes		2,069		1,094		975			89.1			3,474		1,775		1,699			95.7

Income tax expense		661		312		349			111.9			1,112		499		613			122.8

Net income	$	1,408	$	782	$	626		$	80.1		$	2,362	$	1,276	$	1,086		$	85.1	%

Less: preferred dividends		382		382		—			—			752		752		—			—
and accretion of discount		119		119		—			—			238		238		—			—

Net income available to common shareholders	$	907	$	281	$	626		$	80.1		$	1,372	$	286	$	1,086		$	85.1	%

Our Company’s consolidated net income of $1,408,000 for the three months ended June 30, 2011 increased $626,000 compared to net income of $782,000 for the three months ended June 30, 2010. Our Company recorded preferred stock dividends and accretion on preferred stock of $501,000 for the three months ended June 30, 2011, resulting in $907,000 of net income available for common shareholders compared to net income of $281,000 for the three months ended June 30, 2010. Diluted earnings per share increased from $0.06 per common share to $0.19 per common share. The provision for loan losses decreased $267,000, or 12.4%, from June 30, 2010 to June 30, 2011 and noninterest expense decreased $1,312,000, or 12.7%. Other real estate expenses and impairment losses incurred on foreclosed properties decreased from $1,506,000 for the three months ended June 30, 2010 to $550,000 for the three months ended June 30, 2011. Our Company’s net interest income, on a tax equivalent basis, decreased $341,000, or 3.0%, to $10,935,000 for the three months ended June 30, 2011 compared to $11,276,000 for the three months ended June 30, 2010 primarily due to a $56,916,000 decrease in average earning assets. The annualized return on average assets was 0.47%, the annualized return on average common stockholders’ equity was 4.93%, and the efficiency ratio was 69.5% for the three months ended June 30, 2011. Net interest margin increased from 3.88% to 3.95%.

Our Company’s consolidated net income of $2,362,000 for the six months ended June 30, 2011 increased $1,086,000 compared to net income of $1,276,000 for the six months ended June 30, 2010. Our Company recorded preferred stock dividends and accretion on preferred stock of $990,000 for the six months ended June 30, 2011, resulting in $1,372,000 of net income available for common shareholders compared to net income of $286,000 for the six months ended June 30, 2010. Diluted earnings per share increased from $0.06 per common share to $0.29 per common share. Our Company’s earnings positively reflected a decrease in other real estate expense and impairment expenses included in noninterest expense from $1,041,000 for the six months ended June 30, 2011 compared to $2,013,000 for the six months ended June 30, 2010. Although the provision for loan losses decreased $1,022,000, or 22.0%, from June 30, 2010 to June 30, 2011, net income continued to be negatively impacted by the higher provisions experienced by our Company during this current economy. Our Company’s net interest income, on a tax equivalent basis, decreased $197,000, or 1.0%, to $21,575,000 for the six months ended June 30, 2011 compared to $21,772,000 for the six months ended June 30, 2010 primarily due to a $56,219,000 decrease in average earning assets. The annualized return on average assets was 0.40%, the annualized return on average common stockholders’ equity was 3.75%, and the efficiency ratio was 72.1% for the six months ended June 30, 2011. Net interest margin increased from 3.74% to 3.90%.

Total assets at June 30, 2011 were $1,194,707,000 compared to $1,200,172,000 at December 31, 2010, a decrease of $5,465,000, or 0.5%. On July 1, 2011, our Company distributed a four percent stock dividend for the second consecutive year to common shareholders of record at the close of business May 12, 2011. For all periods presented, share information, including basic and diluted earnings per share, have been adjusted retroactively to reflect the stock dividend.

Average Balance Sheets

The following tables present average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the three and six month periods ended June 30, 2011 and June 30, 2010.


	The Three Months Ended June 30,
(Dollars In thousands)	2011								2010
				Interest		Rate						Interest		Rate
	Average			Income/		Earned/			Average			Income/		Earned/
	Balance			Expense(1)		Paid(1)			Balance			Expense(1)		Paid(1)

ASSETS
Loans: (2) (4)
Commercial	$	127,749		$	1,754		5.51	%	$	144,193		$	2,016		5.61	%
Real estate construction — residential		29,118			436		6.01			39,211			506		5.18
Real estate construction — commercial		51,659			562		4.36			77,201			774		4.02
Real estate mortgage — residential		202,758			2,898		5.73			229,888			3,223		5.62
Real estate mortgage — commercial		430,919			5,842		5.44			435,181			6,422		5.92
Consumer		30,004			527		7.05			35,876			723		8.08
Investment in securities: (3)
U.S. treasury		1,869			8		1.72			1,000			5		2.01
Government sponsored enterprises		68,494			330		1.93			45,209			312		2.77
Asset backed securities		116,684			994		3.42			84,481			786		3.73
State and municipal		31,266			389		4.99			31,882			441		5.55
Restricted Investments		5,267			41		3.12			6,247			35		2.25
Federal funds sold		165			—		—			145			—		—
Interest bearing deposits in other financial institutions		13,522			12		0.36			35,876			22		0.25

Total interest earning assets		1,109,474			13,793		4.99			1,166,390			15,265		5.25
All other assets		99,251								96,857
Allowance for loan losses		(12,773	)							(13,835	)

Total assets	$	1,195,952							$	1,249,412

LIABILITIES AND STOCKHOLDERS’ EQUITY
NOW accounts	$	184,459		$	258		0.56	%	$	179,887		$	257		0.57	%
Savings		60,502			35		0.23			52,789			32		0.24
Money market		151,436			154		0.41			168,671			265		0.63
Time deposits of $100,000 and over		128,363			433		1.35			131,508			651		1.99
Other time deposits		295,426			1,316		1.79			320,546			1,851		2.32

Total time deposits		820,186			2,196		1.07			853,401			3,056		1.44
Federal funds purchased and securities sold under agreements to repurchase		27,574			13		0.19			33,023			19		0.23
Subordinated notes		49,486			323		2.62			49,486			323		2.62
Other borrowed money		47,984			326		2.73			68,575			591		3.46

Total interest bearing liabilities		945,230			2,858		1.21			1,004,485			3,989		1.59
Demand deposits		142,363								129,448
Other liabilities		5,509								7,145

Total liabilities		1,093,102								1,141,078
Stockholders’ equity		102,850								108,334

Total liabilities and stockholders’ equity	$	1,195,952							$	1,249,412

Net interest income (FTE)				$	10,935							$	11,276

Net interest spread							3.78	%							3.66	%
Net interest margin							3.95	%							3.88	%


(1)		Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 35%, net of nondeductible interest expense. Such adjustments totaled $152,000 and $162,000 for the three months ended June 30, 2011 and 2010, respectively.

(2)		Non-accruing loans are included in the average amounts outstanding.

(3)		Average balances based on amortized cost.

(4)		Fees and costs on loans are included in interest income.


	The Six Months Ended June 30,
(Dollars In thousands)	2011								2010
				Interest		Rate						Interest		Rate
	Average			Income/		Earned/			Average			Income/		Earned/
	Balance			Expense(1)		Paid(1)			Balance			Expense(1)		Paid(1)

ASSETS
Loans: (2) (4)
Commercial	$	128,364		$	3,491		5.48	%	$	146,211		$	4,010		5.53	%
Real estate construction — residential		30,709			853		5.60			38,979			1,015		5.25
Real estate construction — commercial		53,463			1,166		4.40			77,234			1,431		3.74
Real estate mortgage — residential		204,044			5,813		5.75			230,817			6,473		5.66
Real estate mortgage — commercial		431,838			11,950		5.58			441,870			12,766		5.83
Consumer		30,383			1,062		7.05			36,135			1,418		7.91
Investment in securities: (3)
U.S. treasury		1,451			13		1.81			542			5		1.86
Government sponsored enterprises		65,685			679		2.08			45,670			645		2.85
Asset backed securities		108,801			1,784		3.31			80,971			1,505		3.75
State and municipal		32,427			608		3.78			34,294			934		5.49
Restricted Investments		5,546			84		3.05			6,486			85		2.64
Federal funds sold		149			—		—			169			—		—
Interest bearing deposits in other financial institutions		23,721			32		0.27			33,422			36		0.22

Total interest earning assets		1,116,581			27,535		4.97			1,172,800			30,323		5.21
All other assets		99,110								95,365
Allowance for loan losses		(13,670	)							(14,377	)

Total assets	$	1,202,021							$	1,253,788

LIABILITIES AND STOCKHOLDERS’ EQUITY
NOW accounts	$	187,155		$	534		0.58	%	$	178,321		$	533		0.60	%
Savings		58,838			70		0.24			51,047			64		0.25
Money market		154,636			328		0.43			169,081			588		0.70
Time deposits of $100,000 and over		125,909			896		1.44			133,827			1,720		2.59
Other time deposits		298,819			2,738		1.85			323,733			3,491		2.17

Total time deposits		825,357			4,566		1.12			856,009			6,396		1.51
Federal funds purchased and securities sold under agreements to repurchase		28,776			26		0.18			33,377			40		0.24
Subordinated notes		49,486			643		2.62			49,486			848		3.46
Other borrowed money		52,432			725		2.79			73,081			1,267		3.50

Total interest bearing liabilities		956,051			5,960		1.26			1,011,953			8,551		1.70
Demand deposits		138,306								126,290
Other liabilities		4,974								7,108

Total liabilities		1,099,331								1,145,351
Stockholders’ equity		102,690								108,437

Total liabilities and stockholders’ equity	$	1,202,021							$	1,253,788

Net interest income (FTE)				$	21,575							$	21,772

Net interest spread							3.71	%							3.51	%
Net interest margin							3.90	%							3.74	%


(1)		Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 35%, net of nondeductible interest expense. Such adjustments totaled $312,000 and $347,000 for the six months ended June 30, 2011 and 2010, respectively.

(2)		Non-accruing loans are included in the average amounts outstanding.

(3)		Average balances based on amortized cost.

(4)		Fees and costs on loans are included in interest income.

Comparison of the three and six months ended June 30, 2011 and 2010, respectively.

Financial results for the three and six months ended June 30, 2011 compared to the three and six months ended June 30, 2010 included a decrease in net interest income, on a tax equivalent basis, of $341,000, or 3.0%, and $197,000, or 1.0%, respectively. Average interest-earning assets decreased $56,916,000, or 4.9% to $1,109,474,000 for the three months ended June 30, 2011 compared to $1,166,390,000 for the three months ended June 30, 2010 and average interest bearing liabilities decreased $59,255,000, or 5.9%, to $945,230,000 for the three months ended June 30, 2011 compared to $1,004,485,000 for the three months ended June 30, 2010. Average interest-earning assets decreased $56,219,000, or 4.8% to $1,116,581,000 for the six months ended June 30, 2011 compared to $1,172,800,000 for the six months ended June 30, 2010 and average interest bearing liabilities decreased $55,902,000, or 5.5%, to $956,051,000 for the six months ended June 30, 2011 compared to $1,011,953,000 for the six months ended June 30, 2010.

Average loans outstanding decreased $89,343,000 or 9.3% to $872,207,000 for the three months ended June 30, 2011 compared to $961,550,000 for the three months ended June 30, 2010. Average loans outstanding decreased $92,445,000 or 9.5% to $878,801,000 for the six months ended June 30, 2011 compared to $971,246,000 for the six months ended June 30, 2010. See the “Lending and Credit Management” section of this discussion for further discussion of changes in the composition of our lending portfolio.

The following is a summary of the changes in average loan balance by major class within our Company’s loan portfolio:


	Three months ended										Six months ended
	June 30,										June 30,
(Dollars in thousands)	2011		2010		$ Change%			Change			2011		2010		$ Change			%Change

Average loans:
Commercial	$	127,749	$	144,193	$	(16,444	)		(11.4	)%	$	128,364	$	146,211	$	(17,847	)		(12.2	)%
Real estate construction — residential		29,118		39,211		(10,093	)		(25.7	)		30,709		38,979		(8,270	)		(21.2	)
Real estate construction — commercial		51,659		77,201		(25,542	)		(33.1	)		53,463		77,234		(23,771	)		(30.8	)
Real estate mortgage — residential		202,758		229,888		(27,130	)		(11.8	)		204,044		230,817		(26,773	)		(11.6	)
Real estate mortgage — commercial		430,919		435,181		(4,262	)		(1.0	)		431,838		441,870		(10,032	)		(2.3	)
Consumer		30,004		35,876		(5,872	)		(16.4	)		30,383		36,135		(5,752	)		(15.9	)

Total	$	872,207	$	961,550	$	(89,343	)		(9.3	)%	$	878,801	$	971,246	$	(92,445	)		(9.5	)%

Average investment securities and federal funds sold increased $55,761,000 or 34.3% to $218,478,000 for the three months ended June 30, 2011 compared to $162,717,000 for the three months ended June 30, 2010. Average investment securities and federal funds sold increased $46,867,000 or 29.0% to $208,513,000 for the six months ended June 30, 2011 compared to $161,646,000 for the six months ended June 30, 2010.

Average interest bearing deposits in other financial institutions decreased $22,354,000 to $13,522,000 for the three months ended June 30, 2011 compared to $35,876,000 for the three months ended June 30, 2010. Average interest bearing deposits in other financial institutions decreased $9,701,000 to $36,226,000 for the six months ended June 30, 2011 compared to $33,422,000 for the six months ended June 30, 2010. The overall decrease in average interest bearing liabilities was due to a decrease in time deposits and other borrowed money. The decrease in average other borrowed money during 2011 compared to 2010 reflects a net decrease in Federal Home Loan Bank advances. See the Liquidity Management section below for further discussion.

Rate and volume analysis

The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, indentifying changes related to volumes and rates for the three and six months ended June 30, 2011 compared to the three and six months ended June 30, 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.


	Three Months Ended June 30,									Six Months Ended June 30,
	2011 vs. 2010									2011 vs. 2010
				Change due to									Change due to
	Total			Average			Average			Total			Average			Average
(Dollars In thousands)	Change			Volume			Rate			Change			Volume			Rate

Interest income on a fully taxable equivalent basis:
Loans: (1) (3)
Commercial	$	(262	)	$	(226	)	$	(36	)	$	(519	)	$	(485	)	$	(34	)
Real estate construction — residential		(70	)		(143	)		73			(162	)		(226	)		64
Real estate construction — commercial		(212	)		(273	)		61			(265	)		(490	)		225
Real estate mortgage — residential		(325	)		(386	)		61			(660	)		(761	)		101
Real estate mortgage — commercial		(580	)		(62	)		(518	)		(816	)		(286	)		(530	)
Consumer		(196	)		(109	)		(87	)		(356	)		(211	)		(145	)
Investment securities:
U.S. treasury		3			3			—			8			8			—
Government sponsored entities		18			130			(112	)		34			236			(202	)
Asset backed securities		208			279			(71	)		279			472			(193	)
State and municipal(2)		(52	)		(9	)		(43	)		(326	)		(49	)		(277	)
Restricted Investments		6			(6	)		12			(1	)		(13	)		12
Federal funds sold		—			—			—			—			—			—
Interest bearing deposits in other financial institutions		(10	)		(18	)		8			(4	)		(11	)		7

Total interest income		(1,472	)		(820	)		(652	)		(2,788	)		(1,816	)		(972	)

Interest expense:
NOW accounts		1			7			(6	)		1			25			(24	)
Savings		3			5			(2	)		6			10			(4	)
Money market		(111	)		(25	)		(86	)		(260	)		(46	)		(214	)
Time deposits of 100,000 and over		(218	)		(16	)		(202	)		(824	)		(97	)		(727	)
Other time deposits		(535	)		(137	)		(398	)		(753	)		(255	)		(498	)
Federal funds purchased and securities sold under agreements to repurchase		(6	)		(3	)		(3	)		(14	)		(6	)		(8	)
Subordinated notes		—			—			—			(205	)		—			(205	)
Other borrowed money		(265	)		(155	)		(110	)		(542	)		(316	)		(226	)

Total interest expense		(1,131	)		(324	)		(807	)		(2,591	)		(685	)		(1,906	)

Net interest income on a fully taxable equivalent basis	$	(341	)	$	(496	)	$	155		$	(197	)	$	(1,131	)	$	934


(1)		Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 35%, net of nondeductible interest expense. Such adjustments totaled $152,000 and $162,000 for the three months ended June 30, 2011 and 2010, respectively, and $312,000 and $347,000 for the six months ended June 30, 2011 and 2010, respectively.

(2)		Non-accruing loans are included in the average amounts outstanding.

(3)		Fees and costs on loans are included in interest income.

Net interest income on a fully taxable equivalent basis decreased $341,000, or 3.0%, and 197,000, or 1.0%, to $10,935,000 and $21,575,000 for the three and six months ended June 30, 2011, respectively, compared to $11,276,000 and $21,772,000 for the three and six months ended June 30, 2010, respectively. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) increased from 3.88% for the three months ended June 30, 2010 to 3.95% for the three months ended June 30, 2011 and increased from 3.74% to 3.90% for the six months ended June 30, 2010 compared to the six months ended June 30, 2011, respectively. Our Company’s net interest spread increased to 3.78% for the three months ended June 30, 2011 from 3.66% for the three months ended June 30, 2010 and increased to 3.71% for the six months ended June 30, 2011 compared to 3.51% for the six months ended June 30, 2010.

While our Company was able to decrease the rate paid on interest bearing liabilities to 1.21% and 1.26% for the three and six months ended June 30, 2011, respectively, from 1.59% and 1.70% for the three and six months ended June 30, 2010, respectively, these decreases were partially offset by the decrease in the rates earned on interest bearing assets from 5.25% and 5.21% for the three and six months ended June 30, 2010, respectively, to 4.99% and 4.97% for the three and six months ended June 30, 2011, respectively.

Non-interest Income and Expense

Non-interest income for the three and six months ended June 30, 2011 and 2010 were as follows:


	Three Months Ended June 30,												Six Months Ended June 30,
							$			%									$			%
(Dollars in thousands)	2011			2010			Change			Change			2011			2010			Change			Change

Non-interest Income
Service charges on deposit accounts	$	1,419		$	1,427		$	(8	)		(0.6	)%	$	2,730		$	2,723		$	7			0.3	%
Trust department income		229			201			28			13.9			424			379			45			11.9
Gain on sales of mortgage loans, net		216			297			(81	)		(27.3	)		462			522			(60	)		(11.5	)
Other		314			525			(211	)		(40.2	)		615			831			(216	)		(26.0	)

Total non-interest income	$	2,178		$	2,450		$	(272	)		(11.1	)%	$	4,231		$	4,455		$	(224	)		(5.0	)%


Non-interest income as a % of total revenue *		16.8	%		18.1	%								16.6	%		17.2	%
Total revenue per full time equivalent employee	$	38.3		$	38.6								$	75.4		$	73.7


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

Noninterest income decreased $272,000 or 11.1% to $2,178,000 for the three months ended June 30, 2011 compared to $2,450,000 for the three months ended June 30, 2010. The decrease was primarily the result of a $211,000 decrease in other income and an $81,000 decrease in the gains on sales of mortgage loans. Other income decreased primarily due to a $167,000 nonmaterial correction to credit card income during the three months ended June 30, 2010. During the three months ended June 30, 2011, our Company experienced a slight decrease in refinancing activity impacting both the volume of loans sold and gains recognized compared to the three months end June 30, 2010.

Noninterest income decreased $224,000 or 5.0% to $4,231,000 for the six months ended June 30, 2011 compared to $4,455,000 for the six months ended June 30, 2010. The decrease was primarily the result of a $216,000 decrease in other income, a $60,000 decrease in the gains on sales of mortgage loans, partially offset by a $45,000 increase in trust department income. As mentioned above, other income decreased primarily due to a $167,000 nonmaterial correction to credit card income during the three months ended June 30, 2010. Refinancing activity began to decline during the second quarter of 2011 impacting both the volume of loans sold and gains recognized compared to the six months ended June 30, 2010.

Our Company was servicing $300,040,000 of mortgage loans at June 30, 2011 compared to $298,325,000 at December 31, 2010, and $273,237,000 at June 30, 2010. Our Company had no sales of debt securities during the three and six months ended June 30, 2011 and 2010.

Non-interest expense for the three and six months ended June 30, 2011 and 2010 were as follows:


	Three Months Ended June 30,												Six Months Ended June 30,
							$			%									$			%
(Dollars in thousands)	2011			2010			Change			Change			2011			2010			Change			Change

Non-interest Expense
Salaries	$	3,265		$	3,550		$	(285	)		(8.0	)%	$	6,826		$	7,070		$	(244	)		(3.5	)%
Employee benefits		1,068			1,000			68			6.8			2,185			2,137			48			2.2
Occupancy expense, net		585			605			(20	)		(3.3	)		1,223			1,227			(4	)		(0.3	)
Furniture and equipment expense		509			535			(26	)		(4.9	)		1,016			1,027			(11	)		(1.1	)
FDIC insurance assessment		396			435			(39	)		(9.0	)		875			845			30			3.6
Legal, examination, and professional fees		307			336			(29	)		(8.6	)		798			583			215			36.9
Advertising and promotion		270			297			(27	)		(9.1	)		502			575			(73	)		(12.7	)
Postage, printing, and supplies		296			286			10			3.5			564			574			(10	)		(1.7	)
Processing expense		813			857			(44	)		(5.1	)		1,635			1,707			(72	)		(4.2	)
Other real estate expense		548			1,506			(958	)		(63.6	)		1,041			2,013			(972	)		(48.3	)
Other		951			913			38			4.2			1,721			1,692			29			1.7

Total non-interest expense	$	9,008		$	10,320		$	(1,312	)		(12.7	)%	$	18,386		$	19,450		$	(1,064	)		(5.5	)%

Efficiency ratio*		69.5	%		76.1	%								72.1	%		75.2	%
Salaries and benefits as a % of total non-interest expense *		48.1	%		44.1	%								49.0	%		47.3	%
Number of full-time equivalent employees		338			351									338			351

Noninterest expense decreased $1,312,000, or 12.7%, to $9,008,000 for the three months ended June 30, 2011 compared to $10,320,000 for the three months ended June 30, 2010. The decrease primarily resulted from a $958,000, or 63.6%, decrease in other real estate expenses and a $285,000, or 8.0%, decrease in salary expense for the three months ended June 30, 2011. Our Company recorded $1,172,000 in impairment losses on foreclosed property, included in other real estate expenses during the three months ended June 30, 2010. In December of 2010, our company established an allowance for other real estate owned for estimated impaired losses on foreclosed properties. A $280,000 provision for other real estate owned, included in other real estate expense, was recorded for these estimated impaired losses during the three months ended June 30, 2011. Other expenses on foreclosed properties also decreased from $364,000 during the three months ended June 30, 2010 compared to $193,000 during the three months ended June 30, 2011. A decrease in the number of employees and an adjustment to the estimated accrued salary expense during the three months ended June 30, 2011 resulted in a decrease in overall salary expense compared to the three months ended June 30, 2010. Stock option compensation expense, included in salary expense, also decreased $7,000 to $12,000 during the three months ended June 30, 2011 compared to $19,000 during the three months ended June 30, 2010.

Noninterest expense decreased $1,064,000, or 5.5%, to $18,386,000 for the six months ended June 30, 2011 compared to $19,450,000 for the six months ended June 30, 2010. The decrease primarily resulted from a $972,000, or 48.3%, decrease in other real estate expenses, and a $244,000, or 3.5%, decrease in salary expense. This decrease was partially offset by a $215,000, or 36.9%, increase in legal, examination, and professional fees. Our Company recorded $1,235,000 in impairment losses on foreclosed property, included in other real estate expense, during the six months ended June 30, 2010. A $441,000 provision for other real estate owned, included in other real estate expense, was recorded for estimated impaired losses on foreclosed properties during the six months ended June 30, 2011. Other expenses on foreclosed properties also decreased from $710,000 during the six months ended June 30, 2010 compared to $457,000 during the six months ended June 30, 2011. As mentioned above, a decrease in the number of employees and an adjustment to the estimated accrued salary expense during the six months ended June 30, 2011 resulted in a decrease in overall salary expense compared to the six months ended June 30, 2010. Stock option compensation expense, included in salary expense, also decreased $15,000 to $34,000 during the six months ended June 30, 2011 compared to $49,000 during the six months ended June 30, 2010. The increase in legal, examination, and professional fees included a $25,000 increase in legal fees, $47,000 increase in audit fees, and a $149,000 increase in consulting fees. The increase in the legal fees primarily relates to fees incurred on pending litigation. See Note 14 to the condensed consolidated financial statements for further explanation. The increase in audit fees reflects a review of our Company’s loan files for Home Loan Mortgage Act compliance, and the increase in consulting fees was primarily due to a human resource best practices and profitability consulting project.

Income taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements was 32.0% for both the three and six months ended June 30, 2011 compared to 28.1% and 28.5% for the three and six months ended June 30, 2010, respectively. The higher effective tax rate for the three and six months ended June 30, 2011 reflects a decrease in tax-exempt income as a percentage of total taxable income.

Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for our Company. Net loans represented 71.6% of total assets as of June 30, 2011 compared to 73.7% as of December 31, 2010.

Lending activities are conducted pursuant to an established loan policy approved by our Bank’s Board of Directors. The Bank’s credit review process is comprised of a regional loan committee with an established approval limit. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank.

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


	June 30,					December 31,
	2011					2010
(In thousands)	Amount		%			Amount		%
Commercial, financial, and agricultural	$	127,628		14.7	%	$	131,382		14.6	%
Real estate construction — residential		28,646		3.3			31,834		3.5
Real estate construction — commercial		50,837		5.9			56,053		6.2
Real estate mortgage — residential		203,067		23.4			207,835		23.1
Real estate mortgage — commercial		428,972		49.4			439,069		48.9
Installment loans to individuals		29,475		3.3			32,132		3.6
Deferred fees and costs, net		174		—			167		—

Total loans	$	868,799		100.0	%	$	898,472		100	%

Our Company’s loan portfolio decreased $29,674,000, or 3.3% from December 31, 2010 to June 30, 2011, primarily due to repayments, charge-offs and transfers to other real estate owned. During the first six months of 2011 our Company experienced reduced loan demand, thus loan pay-downs and payoffs exceeded new originations. This decrease was seen throughout our Company’s loan portfolio. Gross loans charged-off of $4,947,000 and $5,943,000 of assets transferred from loans to other real estate owned and repossessed assets contributed to this decline.

During the current down-turn in the economy, management continues to focus on the improvement of asset quality. Management has tightened underwriting standards and is focused on lending to credit worthy borrowers with the capacity to service the 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 our Company. The decrease in lending activities in the real estate construction market also reflects the slowdown in the housing industry and residential construction industry as well as foreclosures on various residential construction properties. Construction lending will continue to be closely monitored.

Our Company does not participate in extending credit to sub-prime residential real estate markets. Our Company extends credit to its local community market through traditional real estate mortgage products.

Our Company does not lend funds for the type of transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, our Company does not have any concentrations of loans exceeding 10% of total loans which are not otherwise disclosed in the loan portfolio composition table. Our Company does not have any interest-earning assets which would have been included in nonaccrual, past due, or restructured loans if such assets were loans.

Our Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers, but are not funded until our Company has a non-recourse purchase commitment from the secondary market at a predetermined price. During the first six

months of 2011 our Company sold $22,337,000 of loans to investors. At June 30, 2011 our Company was servicing approximately $300,040,000 of loans sold to the secondary market.

Real estate mortgage loans retained in our Company’s portfolio generally include provisions for rate adjustments at one to three year intervals. Commercial loans and real estate construction loans generally have maturities of less than one year. Installment loans to individuals are primarily fixed rate loans with maturities from one to five years.

Management along with senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2,000,000 in aggregate and all adversely classified credits identified by management as containing more than usual risk are reviewed. In addition, loans below the above scope are reviewed on a sample basis. On a monthly basis, the senior loan committee reviews and reports to the Board of Directors past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impaired. Management follows the guidance provided in the FASB’s ASC Topic 310, Accounting by Creditors for Impairment of a Loan, in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, allowances are estimated based on the fair value as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered adequate by management for probable losses inherent in the loan portfolio.

Provision and Allowance for Loan Losses

The provision for loan losses decreased $267,000 or 12.1% to $1,883,000 for the three months ended June 30, 2011 compared to $2,150,000 for the three months ended June 30, 2010 and decreased $1,022,000 or 22.0% to $3,633,000 for the six months ended June 30, 2011 compared to $4,655,000 for the six months ended June 30, 2010.

The current economy has contributed to the deterioration of collateral values. The economic downturn and elevated unemployment rates in our market area have impaired the ability for certain of our customers to make payments on our loans in accordance with contractual terms.

Our Company has taken an active approach to obtain current appraisals and has adjusted the provision to reflect the amounts management determined necessary to maintain the allowance for loan losses at a level adequate to cover probable losses in the loan portfolio. The allowance for loan losses decreased to $13,863,000 or 1.6% of loans outstanding at June 30, 2011 compared to $14,565,000 or 1.6% of loans outstanding at December 31, 2010. Charge offs taken during the first six months of 2011 and 2010 contributed to the decrease in the allowance for loan losses.

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


	Three Months Ended						Six Months Ended
	June 30,						June 30,
(Dollars in thousands)	2011			2010			2011			2010

Analysis of allowance for loan losses:
Balance beginning of year	$	12,402		$	14,658		$	14,565		$	14,797
Net loan charge-offs:
Commercial, financial, and agricultural		37			612			804			1,104
Real estate construction — residential		(1	)		(22	)		1,485			259
Real estate construction — commercial		(250	)		22			(250	)		101
Real estate mortgage — residential		434			1,591			1,465			3,319
Real estate mortgage — commercial		136			2,319			712			2,337
Installment loans to individuals		66			54			119			100

Total net charge-offs		422			4,576			4,335			7,220

Provision for loan losses		1,883			2,150			3,633			4,655

Balance at June 30,	$	13,863		$	12,232		$	13,863		$	12,232

As shown in the table above, our Company experienced net loan charge-offs of $422,000 for the three months ended June 30, 2011 compared to $4,576,000 for the three months ended June 30, 2010. The $4,154,000 net decrease was primarily due to a $1,157,000 decrease in net charge offs on real estate mortgage — residential properties, and a $2,183,000 decrease in real estate mortgage — commercial properties from June 30, 2010 to June 30, 2011, respectively. The decrease in net charge-offs for the three months ended June 30, 2011 was primarily due to significant write-downs taken during the three months ended June 30, 2010 on foreclosed properties to reflect current collateral values. These write-downs related to two significant loan relationships collateralized by section eight properties. Our Company also received a $250,000 recovery from a judgment on a real estate construction — commercial property during the three months ended June 30, 2011.

As shown in the table above, our Company experienced net loan charge-offs of $4,335,000 for the six months ended June 30, 2011 compared to $7,220,000 for the six months ended June 30, 2010. The $2,885,000 net decrease was primarily due to a $1,854,000 decrease in net charge offs on real estate mortgage — residential properties, and a $1,625,000 decrease in real estate mortgage — commercial properties, partially offset by a $1,226,000 increase in net charge offs on real estate construction — residential properties from June 30, 2010 to June 30, 2011, respectively. As mentioned above, the decrease in net charge-offs for the six months ended June 30, 2011 was primarily due to significant write-downs taken on foreclosed properties to reflect current collateral values during the six months ended June 30, 2010. These write-downs related to two significant loan relationships collateralized by section eight properties. The increase in real estate construction — residential net charge-offs for the six months ended June 30, 2011 was primarily due to charge offs taken on two credits that management had specifically reserved $2,000,000 as of December 31, 2010. Since these two credits were fully reserved as of December 31, 2010, no additional provision for these credits was required during the first six months of 2011, and as a result, total net charge-offs exceeded the provision for loan losses during the six months of 2011. The ratio of annualized total net loan charge-offs to total average loans was 0.49% at June 30, 2011 compared to 1.63% at December 31, 2010.

Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing, and restructured loans totaled $56,191,000 or 6.47% of total loans at June 30, 2011 compared to $56,303,000 or 6.27% of total loans at December 31, 2010.

The following table summarizes our Company’s nonperforming assets at the dates indicated:


	June 30,			December 31,
(Dollars in thousands)	2011			2010

Nonaccrual loans:
Commercial, financial, and agricultural	$	3,303		$	3,532
Real estate construction — residential		832			3,586
Real estate construction — commercial		10,994			10,067
Real estate mortgage — residential		4,517			5,672
Real estate mortgage — commercial		29,726			27,604
Installment loans to individuals		172			126

Total nonaccrual loans		49,544			50,587


Loans contractually past — due 90 days or more and still accruing:
Commercial, financial, and agricultural		—			—
Real estate construction — residential		—			—
Real estate construction — commercial		—			—
Real estate mortgage — residential		98			—
Real estate mortgage — commercial		—			—
Installment loans to individuals		1			33


Total loans contractually past — due 90 days or more and still accruing		99			33

Troubled debt restructurings — accruing		6,548			5,683

Total nonperforming loans		56,191			56,303
Other real estate		15,416			13,393
Repossessions		352			616

Total nonperforming assets	$	71,959		$	70,312


Loans	$	868,799		$	898,472
Allowance for loan losses to loans		1.60	%		1.62	%
Nonperforming loans to loans		6.47	%		6.27	%
Allowance for loan losses to
nonperforming loans		24.67	%		25.87	%
Nonperforming assets to loans and foreclosed assets		8.13	%		7.71	%

It is our Company’s policy to discontinue the accrual of interest income on loans when management believes that the borrower’s financial condition, after consideration of business conditions and collection efforts, is such that the collection of interest is doubtful, or upon which principal or interest has been in default for a period of 90 days or more and the asset is not both well secured and in the process of collection. Subsequent interest payments received on such loans are applied to principal if any doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis. Interest on nonaccrual loans, which would have been recorded under the original terms of the loans, was approximately $1,219,000 and $1,278,000 for the six months ended June 30, 2011 and 2010, respectively. Approximately $33,000 and $4,000 was actually recorded as interest income on such loans for the six months ended June 30, 2011 and 2010, respectively.

Total non-accrual loans at June 30, 2011 decreased $1,043,000 from December 31, 2010. The decrease resulted mainly from a decrease of $2,754,000 and $1,155,000, respectively, in real estate construction — residential and in real estate mortgage — residential non-accrual loans. During the first six months of 2011 our Company charged off three significant loan relationships and is continuing to see an increase in foreclosures. Partially offsetting this decrease was a $2,121,000 increase in Real estate mortgage — commercial nonaccrual loans primarily due to one significant loan relationship.

Loans past due 90 days and still accruing interest increased $66,000 from $33,000 at December 31, 2010 to $99,000 at June 30, 2011. Foreclosed real estate and other repossessions increased $1,759,000 from $14,009,000 at December 31, 2010 to $15,768,000 at June 30, 2011.

The increase in the levels of charge offs has contributed to the decrease in the ratio of allowance for loan losses to nonperforming loans from 25.87% at December 31, 2010 to 24.67% at June 30, 2011. As mentioned previously, management charged off approximately $2,000,000 of loans during the first quarter of 2011 that were fully reserved as of December 31, 2010. As a result, the allowance for loan losses to loans outstanding declined from 1.62% at December 31, 2010 to 1.42% at June 30, 2011.

At June 30, 2011, loans classified as troubled debt restructurings (TDR) totaled $23,913,000, of which $17,365,000 was on non-accrual status and $6,548,000 was on accrual status. At December 31, 2010, loans classified as TDR totaled $22,080,000, of which $16,397,000 was on non-accrual status and $5,683,000 was on accrual status. Our Company has experienced an increase in its loan delinquencies much like the rest of the banking industry as current economic conditions negatively impact our borrowers’ ability to keep their debt payments current.

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


	June 30, 2011						December 31, 2010
	Number of		Recorded		Specific		Number of		Recorded		Specific
(Dollars in thousands)	contracts		Investment		Reserves		contracts		Investment		Reserves

Accruing TDRs
Commercial, financial and agricultural		8	$	2,063	$	121		3	$	128	$	20
Real estate construction — commercial		—		—		—		1		1,716		95
Real estate mortgage — residential		19		2,250		40		20		2,364		82
Real estate mortgage — commercial		3		2,235		—		4		1,475		14

Total		30	$	6,548	$	161		28	$	5,683	$	211


TDRs — Non-accruals
Commercial, financial and agricultural		2	$	89	$	59		5	$	871.00	$	76
Real estate construction — commercial		2		1,183		—		2		1,210		—
Real estate mortgage — residential		10		1,762		135		6		1,092		67
Real estate mortgage — commercial		10		14,331		1,426		5		13,224		1,005

Total		24	$	17,365	$	1,620		18	$	16,397	$	1,148


Total TDRs		54	$	23,913	$	1,781		46	$	22,080	$	1,359

The allowance for loan losses is available to absorb probable loan losses regardless of the category of loans to be charged off. The allowance for loan losses consists of asset-specific reserves, and general reserves based on expected loss estimates and unallocated reserves.

The asset-specific component applies to loans evaluated individually for impairment and is based on management’s best estimate of proceeds from liquidating collateral. The majority of our nonperforming loans are secured by real estate collateral. The actual timing and amount of repayments and the ultimate realizable value of the collateral may differ from management’s estimate.

The expected loss component is determined by applying percentages to pools of loans by asset type. These percentages are determined by using historical loss percentages. These expected loss estimates are sensitive to changes in delinquency status, realizable value of collateral, and other risk factors.

The unallocated portion of the allowance is based on management’s evaluation of conditions that are not directly reflected in the determination of the asset-specific component and the expected loss component discussed above. The evaluation of inherent loss with respect to these qualitative conditions is subject to a higher degree of uncertainty because they may not be identified with specific problem credits or portfolio segments. Conditions evaluated in connection with the unallocated portion of the allowance include general economic and business conditions affecting our key lending areas, credit quality trends (including trends in substandard loans expected to result from existing conditions), collateral values, specific industry conditions within portfolio segments, bank regulatory examination results, and findings of our internal loan review department.

Management believes that based on detailed analysis of each credit risk inherent to our loan portfolio and the value of any associated collateral, that the allowance for loan losses at June 30, 2011 is adequate to cover probable losses.

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 quality and inherent losses. Changes in such estimates could significantly impact the allowance and provision for credit losses. Our Company could experience credit losses that are different from the current estimates made by management.

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


	June 30,		December 31,
(Dollars in thousands)	2011		2010

Allocation of allowance for loan losses at end of period:
Commercial, financial, and agricultural	$	2,533	$	2,931
Real estate construction — residential		986		2,067
Real estate construction — commercial		1,330		1,339
Real estate mortgage — residential		2,990		3,922
Real estate mortgage — commercial		4,837		3,458
Installment loans to individuals		219		231
Unallocated		968		617

Total	$	13,863	$	14,565

Our Company’s allowance for loan losses decreased $702,000 from December 31, 2010 to June 30, 2011. The decline of the allowance for loan losses was primarily seen in the allocation for real estate construction — residential loans and the allocation of commercial, financial, and agricultural loans as they decreased $1,081,000, and $398,000, respectively, resulting from charge offs taken on two loans that were fully reserved for at December 31, 2010. Also contributing to this overall decrease in the allowance was a $932,000 decrease in the real estate mortgage — residential allocation due to a loan that was reserved for at December 31, 2010 was foreclosed on and sold during the first three months of 2011. Partially offsetting this decrease was $1,379,000 increase the allocation of real estate mortgage — commercial loans primarily resulting from two loan relationships.

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


	June 30,		December 31,
(Dollars in thousands)	2011		2010

Allocation of allowance for loan losses:
Specific reserve allocation for impaired loans	$	5,486	$	6,376
General reserve allocation for all other non-impaired loans		8,377		8,189

Total	$	13,863	$	14,565

Management has established procedures that result in specific allowance allocations for any estimated incurred loss. For loans not considered impaired, a general allowance allocation is computed using factors developed over time based on actual loss experience. The specific and general allocations represent management’s best estimate of probable losses contained in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.

The asset-specific reserve component of our allowance for loan losses at June 30, 2011 was determined by using fair values of the underlying collateral through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. The expected loss component of our allowance for loan losses at June 30, 2011 was determined by calculating historical loss percentages for various loan categories over the previous twelve quarters. Management determined that the previous twelve quarters were reflective of the loss characteristics of our Company’s loan portfolio during the recent economic downturn. These historical loss percentages were then applied to the various categories of loans to determine an expected loss requirement for the current portfolio. At June 30, 2011, the asset-specific reserve component decreased $890,000 due to a comparable decrease in the volume of impaired loans as well as the charge-off of two credits during the first quarter of 2011 that management had specifically reserved approximately $2,000,000 as of December 31, 2010. During the same period, the general reserve component increased from $8,189,000 at December 31, 2010 to $8,377,000 at June 30, 2011 due to usage of a historical loss experience reflective of our Company’s loss characteristics.

The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. Once the impairment

amount is calculated, a specific reserve allocation is recorded. At June 30, 2011, $5,486,000 of our Company’s allowance for loan losses was allocated to impaired loans totaling approximately $56,092,000 compared to $6,376,000 of our Company’s allowance for loan losses allocated to impaired loans totaling approximately $56,271,000 at December 31, 2010. Based upon detailed analysis of all impaired loans, management has determined that $27,416,000, or 49%, of impaired loans require no reserve allocation at June 30, 2011 compared to $26,038,000, or 46%, at December 31, 2010.

As of June 30, 2011 and December 31, 2010 approximately $19,845,000 and $19,239,000, respectively, of loans not included in the nonaccrual table above or identified by management as being impaired were classified by management as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. The $606,000 increase in classified loans is the result of several borrowers who have experienced cash flow problems and as well as some deterioration in collateral value. Management believes the general allowance was sufficient to cover the risks and probable losses related to such loans at June 30, 2011 and December 31, 2010.

At June 30, 2011, management determined that $12,895,000 of the $13,863,000 total allowance for loan comprised of the asset-specific and expected loss components and $968,000 was unallocated. This is compared to $13,948,000 of the $14,565,000 total allowance for loan losses allocated to the asset-specific and expected loss components and $617,000 that was unallocated at December 31, 2010. The increase in the portion of the allowance for loan losses related to non asset-specific reserves is the result of management analyzing and assessing this portion of the allowance for loan losses on a detailed level by homogeneous loan categories for loans not considered impaired. Such analysis measured reserve requirements based on historical loss experiences of loans in those individual categories. Such reserve methodology considers the loss experience for certain types of loans and loan grades for the past twelve quarters.

Liquidity and Capital Resources

Liquidity Management

The role of liquidity management is to ensure funds are available to meet depositors’ withdrawal and borrowers’ credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet the demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by our 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.

Our Company’s Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for our Company’s liquidity position and profile. A combination of daily, weekly and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital and exposure to contingent draws on our Company’s liquidity.

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


	June 30,		December 31,
(dollars in thousands)	2011		2010

Federal funds sold	$	171	$	126
Federal Reserve — excess reserves		16,368		29,286
Available for sale investments securities		219,697		178,978

Total	$	236,236	$	208,390

Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available for sale investment portfolio was $219,697,000 at June 30, 2011 and included an unrealized net gain of $4,368,000. The portfolio includes maturities of approximately $8,930,000 over the next twelve months, which offer resources to meet either new loan demand or reductions in our Company’s deposit base.

Our Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchased lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes as required or permitted by law.

At June 30, 2011 and December 31, 2010, total investment securities pledged for these purposes were as follows:


	June 30,		December 31,
(dollars in thousands)	2011		2010

Investment securities pledged for the purpose of securing:
Federal Reserve Bank borrowings	$	2,051	$	3,262
Repurchase agreements		31,065		45,929
Other deposits		137,256		98,908

Total pledged, at fair value	$	170,372	$	148,099

At June 30, 2011 and December 31, 2010, our Company’s unpledged securities in the available for sale portfolio totaled approximately $49,325,000 and $30,879,000, respectively.

Liquidity is also available from our Company’s base of core customer deposits, defined as demand, interest, checking, savings, and money market deposit accounts. At June 30, 2011, such deposits totaled $534,013,000 and represented 55.5% of our Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of our Company through long lasting relationships. Time deposits and certificates of deposit of $100,000 and over totaled $428,060,000 at June 30, 2011. These accounts are normally considered more volatile and higher costing representing 44.5% of total deposits at June 30, 2011.


	June 30,		December 31,
(dollars in thousands)	2011		2010

Core deposit base:
Non-interest bearing demand	$	148,140	$	137,750
Interest checking		176,364		160,225
Savings and money market		209,509		218,912

Total	$	534,013	$	516,887

Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. Our Company’s outside borrowings are comprised of securities sold under agreements to repurchase, FHLB advances, and subordinated notes as follows:


	June 30,		December 31,
(dollars in thousands)	2011		2010

Borrowings:
Securities sold under agreements to repurchase	$	28,689	$	30,068
FHLB advances		43,657		66,986
Subordinated notes		49,486		49,486

Total	$	121,832	$	146,540

Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which our Company maintains approved credit lines. As of June 30, 2011, under agreements with these unaffiliated banks, the Bank may borrow up to $15,650,000 in federal funds on an unsecured basis and $22,153,000 on a secured basis. There were no federal funds purchased outstanding at June 30, 2011. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of our Company’s investment portfolio. At June 30, 2011 there was $28,689,000 in repurchase agreements. Our Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at June 30, 2011. The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB). As a member of the FHLB, the Bank has access to credit products of the FHLB. As of June 30, 2011, the Bank had $43,657,000 in outstanding borrowings with the FHLB. In addition, our Company has $49,486,000 in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.

Our 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, our Company may draw advances against this collateral. The following table reflects the advance equivalent of the assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to our Company at June 30, 2011:


				Federal
(dollars in thousands)	FHLB			Reserve		Other

Advance equivalent	$	263,199		$	2,051	$	25,402
Advances outstanding		(43,657	)		—		—
Letters of credit issued		(206	)		—		—

Total	$	219,336		$	2,051	$	25,402

Sources and Uses of Funds

As our Company sees loan demand decline and overnight borrowing rates remain at historic lows, management has expanded the investment portfolio to keep excess cash minimized. A deposit reclassification program was implemented in January of 2011 that lowered the Federal Reserve account requirement, improving liquidity, and enabling our Company to lower cash balances maintained at the Federal Reserve and invest in higher yielding securities.

Cash and cash equivalents were $35,240,000 at June 30, 2011 compared to $50,980,000 at December 31, 2010. The $15,740,000 decrease resulted from changes in the various cash flows produced by operating, investing, and financing activities of our Company, as shown in the accompanying consolidated statement of cash flows for the six months ended June 30, 2011. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $9,518,000 for the six months ended June 30, 2011.

Investing activities consisting mainly of purchases, sales and maturities of available for sale securities, and changes in the level of the loan portfolio, used total cash of $14,756,000. The cash outflow primarily consisted of $83,043,000 of purchases of investment securities, partially offset by a $20,636,000 decrease in the loan portfolio, $44,606,000 in proceeds from maturities, calls, and pay-downs of investment securities, and $3,421,000 in proceeds from sales of other real estate owned and repossessions.

Financing activities used total cash of $10,502,000, resulting primarily from $23,329,000 of repayments of FHLB advances, a decrease of $1,379,000 of federal funds purchased and securities sold under agreements to repurchase, and a $1,952,000 decrease in time deposits, partially offset by a net $17,362,000 increase in demand deposits and interest-bearing transaction accounts. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2011.

In the normal course of business, our Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through our Company’s various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of our Company’s liquidity. In the section entitled, Commitments, Contractual Obligations, and Off-Balance Sheet Arrangements, below we disclose that our Company had $98,572,000 in unused loan commitments and standby letters of credit as of June 30, 2011. While this commitment level would be difficult to fund given our Company’s current liquidity resources, we know that the nature of these commitments are such that the likelihood of such a funding demand is very low.

Our Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. Our Company’s ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its common and preferred shareholders. During the six months ended June 30, 2011 and 2010, respectively, our Company paid cash dividends to its common and preferred shareholders totaling $1,204,000 and $1,703,000. A large portion of our Company’s liquidity is obtained from the Bank in the form of dividends. For the six months ended June 30, 2011 the Bank declared and paid $1,500,000 to our Company. For the six months ended June 30, 2010, the Bank did not declare or pay dividends. At June 30, 2011 and December 31, 2010, our Company had cash and cash equivalents totaling $11,740,000 and $12,449,000, respectively.

Capital Management

Our Company and our Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on our Company’s consolidated financial statements. Under capital adequacy guidelines, our Company and our Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification of our Company and our Bank are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors.

Quantitative measures established by regulations to ensure capital adequacy require our Company and our Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital to risk-weighted assets, and of Tier I capital to adjusted-average assets. Management believes, as of June 30, 2011 and December 31, 2010, our Company and our Bank each met all capital adequacy requirements to which they were subject.


						Minimum					Well-Capitalized
	Actual					Capital requirements					Capital Requirements
	Amount		Ratio			Amount		Ratio			Amount		Ratio
June 30, 2011 Total capital (to risk-weighted assets):
Company	$	160,674		17.54	%	$	73,282		8.00	%		—		—
Hawthorn Bank		132,415		14.72			71,952		8.00		$	89,940		10.00	%

Tier I capital (to risk-weighted assets):
Company	$	135,177		14.76		$	36,641		4.00	%		—		—
Hawthorn Bank		121,146		13.47			35,976		4.00		$	53,964		6.00	%

Tier I capital (to adjusted average assets):
Company	$	135,177		11.31		$	35,849		3.00	%		—		—
Hawthorn Bank		121,146		10.31			35,249		3.00		$	58,748		5.00	%

December 31, 2010 Total capital (to risk-weighted assets):
Company	$	159,510		17.05	%	$	74,863		8.00	%		—		—
Hawthorn Bank		130,361		14.18			73,548		8.00		$	91,834		10.00	%

Tier I capital (to risk-weighted assets):
Company	$	133,349		14.25		$	37,431		4.00	%		—		—
Hawthorn Bank		118,837		12.93			36,774		4.00		$	55,161		6.00	%

Tier I capital (to adjusted average assets):
Company	$	133,349		11.00		$	36,360		3.00	%		—		—
Hawthorn Bank		118,837		9.99			35,685		3.00		$	59,475		5.00	%

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Sensitivity

Market risk arises from exposure to changes in interest rates and other relevant market rate or price risk. Our Company faces market risk in the form of interest rate risk through transactions other than trading activities. Our Company uses financial modeling techniques to measure interest rate risk. These techniques measure the sensitivity of future earnings due to changing interest rate environments. Guidelines established by our Company’s Asset/Liability Committee and approved by the Board of Directors are used to monitor exposure of earnings at risk. General interest rate movements are used to develop sensitivity as our Company feels it has no primary exposure to specific points on the yield curve. For the three months ended June 30, 2011 our Company utilized a 400 basis point immediate and gradual move in interest rates (both upward and downward) applied to both a parallel and proportional yield curve.

The following table represents estimated interest rate sensitivity and periodic and cumulative gap positions calculated as of June 30, 2011:


													Over
													5 years or
													no stated
(Dollars in thousands)	Year 1			Year 2		Year 3			Year 4		Year 5		Maturity		Total

ASSETS
Investment securities	$	53,745		$	18,480	$	47,317		$	30,095	$	27,083	$	42,977	$	219,697
Interest-bearing deposits		16,719			—		—			—		—		—		16,719
Other restricted investments		5,065			—		—			—		—		—		5,065
Federal funds sold and securities purchased under agreements to resell		171			—		—			—		—		—		171
Loans		488,414			157,598		146,156			24,427		26,425		25,779		868,799

Total	$	564,114		$	176,078	$	193,473		$	54,522	$	53,508	$	68,756	$	1,110,451


LIABILITIES

Savings, Now deposits	$	—		$	—	$	166,119		$	—	$	—	$	—	$	166,119
Rewards checking, Super Now, money market deposits		220,079												—		220,079
Time deposits		286,815			68,387		55,340			7,164		10,028		—		427,734
Federal funds purchased and securities sold under agreements to repurchase		28,690			—		—			—		—		—		28,690
Subordinated notes		49,486			—		—			—		—		—		49,486
Other borrowed money		25,382			8,254		10,021			—		—		—		43,657

Total	$	610,452		$	76,641	$	231,480		$	7,164	$	10,028	$	—	$	935,765


Interest-sensitivity GAP
Periodic GAP	$	(46,338	)	$	99,437	$	(38,007	)	$	47,358	$	43,480	$	68,756	$	174,686

Cumulative GAP	$	(46,338	)	$	53,099	$	15,092		$	62,450	$	105,930	$	174,686	$	174,686


Ratio of interest-earnings assets to interest-bearing liabilities
Periodic GAP		0.92			2.30		0.84			7.61		5.34		NM		1.19
Cumulative GAP		0.92			1.08		1.02			1.07		1.11		1.19		1.19

Effects of Inflation

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

Inflation does have an impact on the growth of total assets in the banking industry, often resulting in a need to increase capital at higher than normal rates to maintain an appropriate capital to asset ratio. In the opinion of management, inflation did not have a significant effect on our Company’s operations for the period ended June 30, 2011.

Item 4. Controls and Procedures

Our Company’s management has evaluated, with the participation of our principal executive and principal financial officers, the effectiveness of our disclosure controls and procedures as defined in Rules 13a — 15(e) or 15d — 15(e) of the Securities Exchange Act of 1934 as of June 30, 2011. Based upon and as of the date of that evaluation, our principal executive and principal financial officers concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required. It should be noted that any system of disclosure controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any system of disclosure controls and procedures is based in part upon assumptions about the likelihood of future events. Because of these and other inherent limitations of any such system, there can be no assurance that any design will always succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

There has been no change in our Company’s internal control over financial reporting that occurred during the period ended June 30, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Impact of New Accounting Standards

In June 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-05, Presentation of Comprehensive Income, which revises the manner in which entities present comprehensive income in their financial statements. The new guidance removes the presentation options in ASC 220 and requires entities to report components of comprehensive income in either a continuous statement of comprehensive income or two separate but consecutive statements. ASU 2011-05 does not change the items that must be reported in other comprehensive income. The amendments of ASU 2011-05 are effective for fiscal years and interim periods within those years, beginning after December 15, 2011, with early adoption permitted. The adoption of ASU 2011-05 is not expected to have a material impact on our Company’s consolidated financial statements.

In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, to substantially converge the guidance in U.S. GAAP and IFRS on fair value measurements and disclosures. The amended guidance changes several aspects of the fair value measurement guidance ASC 820, Fair Value Measurement, and includes several new fair value disclosure requirements. ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011. The adoption of ASU 2011-04 is not expected to have a material impact on our Company’s consolidated financial statements.

In April 2011, the FASB issued ASU 2011-03, Consideration of Effective Control on Repurchase Agreements, which deals with the accounting for repurchase agreements and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. ASU 2011-03 changes the rules for determining when these transactions should be accounted for as financings, as opposed to sales. The guidance in ASU 2011-03 is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The adoption of ASU 2011-03 is not expected to have a material impact on our Company’s consolidated financial statements.

In April 2011, the FASB issued ASU No. 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring. The provisions of ASU No. 2011-02 provide a creditor additional guidance in determining whether a restructuring constitutes a troubled debt restructuring by concluding that both the following conditions exist (1) a creditor has granted a concession, and (2) the borrower is experiencing financial difficulties. A provision in ASU No. 2011-02 also ends the FASB’s deferral of the additional disclosures about troubled debt restructurings as required by ASU No. 2010-20. The provisions of ASU No. 2011-02 will be effective for our Company’s reporting period ending September 30, 2011 and requires retrospective application to all restructurings occurring during 2011 along with additional required disclosures. The adoption of ASU No. 2011-02 is not expected to have a material impact on our Company’s consolidated financial statements.

In July 2010, the FASB issued ASU No. 2010-20 — Receivables (ASC Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. This ASU requires expanded credit risk disclosures intended to provide investors with greater transparency regarding the allowance for credit losses and the credit quality of financing receivables. Under this ASU, companies are required to provide more information about the credit quality of their financing receivables in the disclosures to financial statements, such as aging information, credit quality indicators, changes in the allowance for credit losses, and the nature and extent of troubled debt restructurings and their effect on the allowance for credit losses. Both new and existing disclosures must be disaggregated by portfolio segment or class based on the level of disaggregation that management uses when assessing its allowance for credit losses and managing its credit exposure. The

disclosures as of the end of a reporting period are effective for annual periods ending on or after December 15, 2010. The disclosures about activity that occur during a reporting period are effective for annual reporting periods beginning on or after December 15, 2010. The interim disclosures required by this update are reported in the notes to our Company’s consolidated financial statements.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

The information required by this Item is set forth in Note 14, Pending Litigation, in our Company’s condensed consolidated financial statements.

Item 1A. Risk Factors

None

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults Upon Senior Securities

None

Item 4. (Removed and Reserved)

None

Item 5. Other Information

None


Item 6.		Exhibits


Exhibit No.		Description

3.1		Restated Articles of Incorporation of our Company (filed as Exhibit 3.1 to our Company’s current report on Form 8-K on August 9, 2007 and incorporated herein by reference).

3.1.1		Certificate of Designations of Fixed Rate Cumulative Perpetual Preferred Stock, Series 2008, dated December 17, 2008 (filed as Exhibit 3.1.1 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).

3.2		Amended and Restated Bylaws of our Company (filed as Exhibit 3.1 to our Company’s current report on Form 8-K on June 8, 2009 and incorporated herein by reference).

4.1		Specimen certificate representing shares of our Company’s $1.00 par value common stock (filed as Exhibit 4.1 to our Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1999 (Commission file number 0-23636) and incorporated herein by reference).

4.2		Specimen certificate representing shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series 2008 (filed as Exhibit 4.2 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).

4.3		Warrant to purchase shares of our Company’s $1.00 par value Common Stock, dated December 19, 2008 (filed as Exhibit 4.3 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).

31.1		Certificate of the Chief Executive Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certificate of the Chief Financial Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certificate of the Chief Executive Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certificate of the Chief Financial Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


Exhibit No.		Description

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

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


		HAWTHORN BANCSHARES, INC.

Date

August 15, 2011		/s/ David T. Turner David T. Turner, Chairman of the Board and
		Chief Executive Officer (Principal Executive Officer)

August 15, 2011		/s/ Richard G. Rose Richard G. Rose, Chief Financial Officer (Principal Financial
		Officer and Principal Accounting Officer)

HAWTHORN BANCSHARES, INC.

INDEX TO EXHIBITS

June 30, 2011 Form 10-Q


Exhibit No.	Description	Page No.

3.1	Restated Articles of Incorporation of our Company (filed as Exhibit 3.1 to our Company’s current report on Form 8-K on August 9, 2007 and incorporated herein by reference).		**

3.1.1	Certificate of Designations of Fixed Rate Cumulative Perpetual Preferred Stock, Series 2008, dated December 17, 2008 (filed as Exhibit 3.1.1 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).		**

3.2	Amended and Restated Bylaws of our Company (filed as Exhibit 3.1 to our Company’s current report on Form 8-K on June 8, 2009 and incorporated herein by reference).		**

4.1	Specimen certificate representing shares of our Company’s $1.00 par value common stock (filed as Exhibit 4.1 to our Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1999 (Commission file number 0-23636) and incorporated herein by reference).		**

4.2	Specimen certificate representing shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series 2008 (filed as Exhibit 4.2 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).		**

4.3	Warrant to purchase shares of our Company’s $1.00 par value Common Stock, dated December 19, 2008 (filed as Exhibit 4.3 to our Company’s current report on Form 8-K on December 23, 2008 and incorporated herein by reference).		**

31.1	Certificate of the Chief Executive Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		58

31.2	Certificate of the Chief Financial Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		59

32.1	Certificate of the Chief Executive Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002		60

32.2	Certificate of the Chief Financial Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002		61

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


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

**		Incorporated by reference.