HAWTHORN BANCSHARES, INC. - Quarter Report: 2012 September (Form 10-Q)

Large accelerated filer

Accelerated filer

Non-accelerated filer

x (Do not check if a smaller reporting company)

Smaller reporting company

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2012

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

For the transition period from to

Commission File Number: 0-23636

HAWTHORN BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Missouri

43-1626350

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

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. x Yes ¨ No

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, 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.:

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

As of November 14, 2012, the registrant had 4,839,114 shares of common stock, par value $1.00 per share, outstanding

Part I - FINANCIAL INFORMATION

Item 1. Financial Statements

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets (unaudited)


	September 30, 2012			December 31, 2011
	*(In thousands, except per share amounts)*
ASSETS
Loans	$	843,098		$	842,930
Allowances for loan losses		(16,920	)		(13,809	)

Net loans		826,178			829,121

Investment in available-for-sale securities, at fair value		216,788			213,806
Federal funds sold and securities purchased under agreements to resell		0			75
Cash and due from banks		20,286			43,135
Premises and equipment - net		37,218			37,953
Other real estate owned and repossessed assets - net		25,195			16,020
Accrued interest receivable		5,467			5,341
Mortgage servicing rights		2,624			2,308
Intangible assets - net		236			543
Cash surrender value - life insurance		2,119			2,064
Other assets		21,180			20,795

Total assets	$	1,157,291		$	1,171,161

LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Non-interest bearing demand	$	165,131		$	159,187
Savings, interest checking and money market		389,632			384,599
Time deposits $100,000 and over		126,685			139,504
Other time deposits		274,962			274,934

Total deposits		956,410			958,224

Federal funds purchased and securities sold under agreements to repurchase		24,109			24,516
Subordinated notes		49,486			49,486
Federal Home Loan Bank advances		28,216			28,410
Accrued interest payable		684			1,054
Other liabilities		7,955			6,895

Total liabilities		1,066,860			1,068,585

Stockholders’ equity:
Preferred stock, $0.01 par value per share, 1,000,000 shares authorized; Issued 18,255 shares and 30,255, respectively, $1,000 per share liquidation value, net of discount		17,905			29,318
Common stock, $1 par value, authorized 15,000,000 shares; Issued 5,000,972 and 4,814,852 shares, respectively		5,001			4,815
Surplus		31,814			30,266
Retained earnings		37,457			40,354
Accumulated other comprehensive income, net of tax		1,771			1,340
Treasury stock; 161,858 shares, at cost		(3,517	)		(3,517	)

Total stockholders’ equity		90,431			102,576

Total liabilities and stockholders’ equity	$	1,157,291		$	1,171,161

See accompanying notes to the unaudited consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income (unaudited)


	For the Three Months Ended September 30,					For the Nine Months Ended September 30,
*(In thousands, except per share amounts)*	2012			2011		2012			2011
INTEREST INCOME
Interest and fees on loans	$	10,881		$	11,852	$	33,068		$	35,930
Interest on debt securities:
Taxable		1,016			1,237		3,216			3,735
Nontaxable		225			250		688			780
Interest on federal funds sold and securities purchased under agreements to resell		0			0		0			1
Interest on interest-bearing deposits		6			8		43			40
Dividends on other securities		23			37		79			121

Total interest income		12,151			13,384		37,094			40,607

INTEREST EXPENSE
Interest on deposits:
Savings, interest checking and money market		265			387		919			1,319
Time deposit accounts $100,000 and over		297			402		1,316			1,298
Other time deposit accounts		979			1,244		2,286			3,983
Interest on federal funds purchased and securities sold under agreements to repurchase		7			13		17			38
Interest on subordinated notes		346			322		1,045			964
Interest on Federal Home Loan Bank advances		135			212		403			938

Total interest expense		2,029			2,580		5,986			8,540

Net interest income		10,122			10,804		31,108			32,067
Provision for loan losses		4,700			2,010		7,900			5,643

Net interest income after provision for loan losses		5,422			8,794		23,208			26,424

NON-INTEREST INCOME
Service charges on deposit accounts		1,360			1,446		4,067			4,176
Trust department income		234			209		670			632
Gain on sale of mortgage loans, net		779			431		1,773			894
Gain on sale of investment securities		26			0		26			0
Other		281			271		557			886

Total non-interest income		2,680			2,357		7,093			6,588

NON-INTEREST EXPENSE
Salaries and employee benefits		4,761			4,505		14,465			13,516
Occupancy expense, net		666			735		1,953			1,958
Furniture and equipment expense		431			467		1,403			1,483
FDIC insurance assessment		249			255		752			1,130
Legal, examination, and professional fees		284			286		880			1,083
Advertising and promotion		288			272		750			774
Postage, printing, and supplies		274			271		817			836
Processing expense		888			787		2,667			2,422
Other real estate expense		1,787			523		3,383			1,564
Other		750			824		2,885			2,545

Total non-interest expense		10,378			8,925		29,955			27,311

(Loss) income before income taxes		(2,276	)		2,226		346			5,701
Income tax (benefit) expense		(704	)		711		(273	)		1,823

Net (loss) income		(1,572	)		1,515		619			3,878
Preferred stock dividends		228			378		894			1,131
Accretion of discount on preferred stock		72			119		587			357

Net (loss) income available to common shareholders	$	(1,872	)	$	1,018	$	(862	)	$	2,390

Basic (loss) earnings per share	$	(0.39	)	$	0.21	$	(0.18	)	$	0.49
Diluted (loss) earnings per share	$	(0.39	)	$	0.21	$	(0.18	)	$	0.49

See accompanying notes to the unaudited consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (unaudited)


	Three Months Ended September 30,					Nine Months Ended September 30,
(dollars in thousands)	2012			2011		2012			2011
Net (loss) income	$	(1,572	)	$	1,515	$	619		$	3,878
Other comprehensive income, net of tax
Unrealized gain on investment securities available-for-sale, net of tax		315			1,003		369			2,642
Adjustment for gain on sales of investment securities		(16	)		0		(16	)		0
Defined benefit pension plans:
Amortization of prior service cost included in net periodic pension cost, net of tax		26			12		78			36

Total other comprehensive income		325			1,015		431			2,678

Total comprehensive (loss) income	$	(1,247	)	$	2,530	$	1,050		$	6,556

See accompanying notes to the unaudited consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity (unaudited)


*(dollars in thousands)*	Preferred Stock			Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income		Treasury Stock			Total Stock - holders’ Equity
Balance, January 1, 2011	$	28,841		$	4,636	$	28,929	$	41,857		$	742	$	(3,517	)	$	101,488

Net income		0			0		0		3,878			0		0			3,878
Other comprehensive income		0			0		0		0			2,678		0			2,678
Stock based compensation expense		0			0		46		0			0		0			46
Accretion of preferred stock discount		357			0		0		(357	)		0		0			0
Stock dividend		0			179		1,279		(1,458	)		0		0			0
Cash dividends declared, preferred stock		0			0		0		(1,135	)		0		0			(1,135	)
Cash dividends declared, common stock		0			0		0		(680	)		0		0			(680	)

Balance, September 30, 2011	$	29,198		$	4,815	$	30,254	$	42,105		$	3,420	$	(3,517	)	$	106,275

Balance, December 31, 2011	$	29,318			4,815		30,266		40,354			1,340		(3,517	)	$	102,576

Cumulative effect of change in accounting principle		0			0		0		460			0		0			460
Balance, January 1, 2012	$	29,318		$	4,815	$	30,266	$	40,814		$	1,340	$	(3,517	)	$	103,036

Net income		0			0		0		619			0		0			619
Other comprehensive income		0			0		0		0			431		0			431
Stock based compensation expense		0			0		27		0			0		0			27
Accretion of preferred stock discount		587			0		0		(587	)		0		0			0
Redemption of 12,000 shares of preferred stock		(12,000	)		0		0		0			0		0			(12,000	)
Stock dividend		0			186		1,521		(1,707	)		0		0			0
Cash dividends declared, preferred stock		0			0		0		(975	)		0		0			(975	)
Cash dividends declared, common stock		0			0		0		(707	)		0		0			(707	)

Balance, September 30, 2012	$	17,905		$	5,001	$	31,814	$	37,457		$	1,771	$	(3,517	)	$	90,431

See accompanying notes to the unaudited consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)


	Nine Months Ended September 30,
(dollars in thousands)	2012			2011
Cash flows from operating activities:
Net income	$	619		$	3,878
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		7,900			5,643
Depreciation expense		1,446			1,443
Net amortization of investment securities, premiums, and discounts		851			620
Amortization of intangible assets		307			331
Stock based compensation expense		27			46
Change in fair value of mortgage servicing rights		985			0
Gain on sale of investment securities		(26	)		0
Gain on sales and dispositions of premises and equipment		(82	)		(13	)
(Gain) loss on sales and dispositions of other real estate owned and repossessions		(220	)		219
Provision for other real estate owned		1,821			661
(Increase) decrease in accrued interest receivable		(126	)		350
Increase in cash surrender value -life insurance		(55	)		(44	)
Decrease in other assets		679			310
(Increase) decrease in income tax receivable		(1,714	)		1,328
Decrease in accrued interest payable		(370	)		(641	)
Increase in other liabilities		823			1,268
Origination of mortgage loans for sale		(67,089	)		(44,356	)
Proceeds from the sale of mortgage loans		68,506			43,785
Gain on sale of mortgage loans, net		(1,773	)		(894	)
Decrease in net deferred tax asset		41			23
Other, net		3			36

Net cash provided by operating activities		12,553			13,993

Cash flows from investing activities:
Net (increase) decrease in loans		(20,929	)		32,623
Purchase of available-for-sale debt securities		(69,305	)		(93,071	)
Proceeds from maturities of available-for-sale debt securities		32,192			26,129
Proceeds from calls of available-for-sale debt securities		33,095			44,184
Proceeds from sales of available-for-sale debt securities		790			0
Proceeds from sales of FHLB stock		100			1,753
Purchases of premises and equipment		(1,155	)		(2,430	)
Proceeds from sales of premises and equipment		269			47
Proceeds from sales of other real estate owned and repossessions		5,553			5,058

Net cash (used) provided by investing activities		(19,390	)		14,293

Cash flows from financing activities:
Net increase in demand deposits		5,944			19,434
Net increase in interest-bearing transaction accounts		5,034			(3,492	)
Net decrease in time deposits		(12,791	)		(9,656	)
Net decrease in federal funds purchased and securities sold under agreements to repurchase		(407	)		(3,871	)
Repayment of Federal Home Loan Bank advances		(194	)		(38,494	)
Redemption of 12,000 shares of preferred stock		(12,000	)		0
Cash dividends paid - preferred stock		(975	)		(1,135	)
Cash dividends paid - common stock		(698	)		(671	)

Net cash used by financing activities		(16,087	)		(37,885	)

Net decrease in cash and cash equivalents		(22,924	)		(9,599	)
Cash and cash equivalents, beginning of period		43,210			50,980

Cash and cash equivalents, end of period	$	20,286		$	41,381

See accompanying notes to the unaudited consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (continued)(unaudited)


	Nine Months Ended September 30,
(dollars in thousands)	2012		2011
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	6,724	$	9,181
Income taxes	$	1,575	$	665
Supplemental schedule of noncash investing and financing activities:
Other real estate and repossessions acquired in settlement of loans	$	16,328	$	9,996

See accompanying notes to unaudited consolidated financial statements.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(1)

Summary of Significant Accounting Policies

Hawthorn Bancshares, Inc. (our Company) through its subsidiary, Hawthorn Bank (the Bank), provides a broad range of banking services to individual and corporate customers located within the communities in and surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson and Lee’s Summit, Missouri. Our Company is subject to competition from other financial and nonfinancial institutions providing financial products. Additionally, our Company and its subsidiaries are subject to the regulations of certain regulatory agencies and undergo periodic examinations by those regulatory agencies.

The accompanying unaudited consolidated financial statements of our Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instruction to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and disclosures required by U.S. GAAP for complete financial statements and should be read in conjunction with the consolidated financial statements and related notes included in our Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

The accompanying unaudited 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 following represents significant new accounting principles adopted in 2012:

Repurchase Agreements In April 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-03, Reconsideration of Effective Control for Repurchase Agreements, which deals with the accounting for repurchase agreements and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. The provisions of ASU No. 2011-03 modify the criteria for determining when repurchase agreements would be accounted for as a secured borrowing rather than as a sale. Currently, an entity that maintains effective control over transferred financial assets must account for the transfer as a secured borrowing rather than as a sale. ASU No. 2011-03 removes from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee. The FASB believes that contractual rights and obligations determine effective control and that there does not need to be a requirement to assess the ability to exercise those rights. ASU No. 2011-03 does not change the other existing criteria used in the assessment of effective control. Our Company adopted the provisions of ASU No. 2011-03 prospectively for transactions or modifications of existing transactions that occurred on or after January 1, 2012. As our Company accounted for all of its repurchase agreements as collateralized financing arrangements prior to the adoption of ASU No. 2011-03, the adoption had no impact on the Company’s consolidated financial statements.

Fair Value Measurements 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 International Financial Reporting Standards (IFRSs), to substantially converge the guidance in U.S. GAAP and IFRS on fair value measurements and disclosures. The provisions of ASU No. 2011-04 result in a consistent definition of fair value and common requirements for the measurement of and disclosure about fair value between U.S. GAAP and IFRS. The changes to U.S. GAAP as a result of ASU No. 2011-04 are as follows: (1) The concepts of highest and best use and

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

valuation premise are only relevant when measuring the fair value of nonfinancial assets (that is, it does not apply to financial assets or any liabilities); (2) U.S. GAAP currently prohibits application of a blockage factor in valuing financial instruments with quoted prices in active markets. ASU No. 2011-04 extends that prohibition to all fair value measurements; (3) An exception is provided to the basic fair value measurement principles for an entity that holds a group of financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risk that are managed on the basis of the entity’s net exposure to either of those risks. This exception allows the entity, if certain criteria are met, to measure the fair value of the net asset or liability position in a manner consistent with how market participants would price the net risk position; (4) Aligns the fair value measurement of instruments classified within an entity’s shareholders’ equity with the guidance for liabilities; and (5) Disclosure requirements have been enhanced for Level 3 fair value measurements to disclose quantitative information about unobservable inputs and assumptions used, to describe the valuation processes used by the entity, and to qualitatively describe the sensitivity of fair value measurements to changes in unobservable inputs and the interrelationships between those inputs. In addition, entities must report the level in the fair value hierarchy of items that are not measured at fair value in the statement of condition but whose fair value must be disclosed. Our Company adopted the provisions of ASU No. 2011-04 effective January 1, 2012. The fair value measurement provisions of ASU No. 2011-04 had no impact on our Company’s consolidated financial statements. See Notes 11 and 12 to the Consolidated Financial Statements for the enhanced disclosures required by ASU No. 2011-04.

Other Comprehensive Income In September 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income, which revises the manner in which entities present comprehensive income in their financial statements. The provisions of ASU No. 2011-05 allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. Under either method, entities are required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. ASU No. 2011-05 also eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity but does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU 2011-05 is effective for periods beginning January 1, 2012 and requires retrospective application. ASU No. 2011-05 was effective for our Company’s interim reporting period beginning on or after January 1, 2012, with retrospective application required.

In December 2011, the FASB issued ASU No. 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. The provisions of ASU No. 2011-12 defer indefinitely the requirement for entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. ASU No. 2011-12, which shares the same effective date as ASU No. 2011-05, does not defer the requirement for entities to present components of comprehensive income in either a single continuous statement of comprehensive income or in two separate but consecutive statements. Our Company adopted the provisions of ASU No. 2011-05 and ASU No. 2011-12 which resulted in a new statement of comprehensive income for the interim period ended September 30, 2012. The adoption of ASU No. 2011-05 and ASU No. 2011-12 had no impact on our Company’s statements of income and condition.

Servicing Financial Assets On January 1, 2012, our Company opted to measure mortgage servicing rights at fair value as permitted by Accounting Standards Codification (ASC)

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Topic 860-50 Accounting for Servicing Financial Assets. Consistent with ASC 860-50-35-3d, an entity may make an irrevocable decision to subsequently measure a class of servicing assets and servicing liabilities at fair value at the beginning of any fiscal year. The election of this option resulted in the recognition of a cumulative effect of change in accounting principle of $459,890, net of tax in the amount of $281,868, which was recorded as an increase to beginning retained earnings, as further described in Note 5 to the consolidated financial statements. As such, effective January 1, 2012, the change in the fair value of mortgage servicing rights are recognized in earnings in the period for which the change occurs. The newly adopted accounting principle is preferable in the circumstances because the fair value measurement method will produce financial information and results more directly aligned with the performance of mortgage servicing rights.

The complete set of significant accounting policies followed in the preparation of the quarterly financial statements are disclosed in the Annual Report on Form 10-K for the year ended December 31, 2011.

Stock Dividend On July 1, 2012, our Company paid a special stock dividend of four percent to common shareholders of record at the close of business on June 15, 2012. For all periods presented, share information, including basic and diluted earnings per share, have been adjusted retroactively to reflect this change.

(2)

Loans and Allowance for Loan Losses

A summary of loans, by major class within our Company’s loan portfolio, at September 30, 2012 and December 31, 2011 are as follows:


(in thousands)	September 30, 2012		December 31, 2011
Commercial, financial, and agricultural	$	124,977	$	128,555
Real estate construction - residential		22,074		30,201
Real estate construction - commercial		44,751		47,697
Real estate mortgage - residential		222,124		203,454
Real estate mortgage - commercial		402,969		402,960
Installment and other consumer		26,006		29,884
Unamortized loan origination fees and costs, net		197		179

Total loans	$	843,098	$	842,930

The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the communities 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 September 30, 2012, loans with a carrying value of $452,000,000 were pledged to Federal Home Loan Bank as collateral for borrowings and letters of credit.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Allowance for loan losses

The following is a summary of the allowance for loan losses for the three and nine months ended September 30, 2012 and 2011:


	For the Three Months Ended September 30, 2012
(in thousands)	Commercial, Financial, and Agricultural			Real Estate Construction - Residential			Real Estate Construction - Commercial		Real Estate Mortgage - Residential			Real Estate Mortgage - Commercial			Installment Loans to Individuals			Unallocated			Total
Balance, beginning of period	$	3,045		$	709		$	1,644	$	3,560		$	6,107		$	232		$	17		$	15,314

Additions:
Provision for loan losses		1,239			(68	)		90		118			3,241			91			(11	)		4,700

Deductions:
Loans charged off		742			0			0		41			2,366			154			0			3,303
Less recoveries on loans		(18	)		0			0		(19	)		(96	)		(76	)		0			(209	)

Net loans charged off		724			0			0		22			2,270			78			0			3,094

Balance, end of period	$	3,560		$	641		$	1,734	$	3,656		$	7,078		$	245		$	6		$	16,920


	For the Nine Months Ended September 30, 2012
(in thousands)	Commercial, Financial, and Agricultural			Real Estate Construction - Residential			Real Estate Construction - Commercial			Real Estate Mortgage - Residential			Real Estate Mortgage - Commercial			Installment Loans to Individuals			Unallocated		Total
Balance, beginning of period	$	1,804		$	1,188		$	1,562		$	3,251		$	5,734		$	267		$	3	$	13,809

Additions:
Provision for loan losses		2,469			(614	)		149			913			4,793			187			3		7,900

Deductions:
Loans charged off		846			0			0			618			3,666			425			0		5,555
Less recoveries on loans		(133	)		(67	)		(23	)		(110	)		(217	)		(216	)		0		(766	)

Net loans charged off		713			(67	)		(23	)		508			3,449			209			0		4,789

Balance, end of period	$	3,560		$	641		$	1,734		$	3,656		$	7,078		$	245		$	6	$	16,920


	For the Three Months Ended September 30, 2011
(in thousands)	Commercial, Financial, and Agricultural		Real Estate Construction - Residential			Real Estate Construction - Commercial		Real Estate Mortgage - Residential			Real Estate Mortgage - Commercial			Installment Loans to Individuals			Unallocated			Total
Balance, beginning of period	$	2,533	$	986		$	1,330	$	2,990		$	4,837		$	219		$	968		$	13,863

Additions:
Provision for loan losses		562		284			490		(9	)		1,550			99			(966	)		2,010

Deductions:
Loans charged off		1,273		311			512		219			884			122			0			3,321
Less recoveries on loans		0		(2	)		0		(27	)		(40	)		(69	)		0			(138	)

Net loans charged off		1,273		309			512		192			844			53			0			3,183

Balance, end of period	$	1,822	$	961		$	1,308	$	2,789		$	5,543		$	265		$	2		$	12,690

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)


	For the Nine Months Ended September 30, 2011
(in thousands)	Commercial, Financial, and Agricultural			Real Estate Construction - Residential			Real Estate Construction - Commercial			Real Estate Mortgage - Residential			Real Estate Mortgage - Commercial			Installment Loans to Individuals			Unallocated			Total
Balance, beginning of period	$	2,931		$	2,067		$	1,339		$	3,922		$	3,458		$	231		$	617		$	14,565

Additions:
Provision for loan losses		968			688			231			524			3,641			206			(615	)		5,643

Deductions:
Loans charged off		2,146			1,858			512			1,758			1,625			369			0			8,268
Less recoveries on loans		(69	)		(64	)		(250	)		(101	)		(69	)		(197	)		0			(750	)

Net loans charged off		2,077			1,794			262			1,657			1,556			172			0			7,518

Balance, end of period	$	1,822		$	961		$	1,308		$	2,789		$	5,543		$	265		$	2		$	12,690

The following table provides the balance in the allowance for loan losses at September 30, 2012 and December 31, 2011, 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.


(in thousands)	Commercial, Financial, and Agricultural		Real Estate Construction - Residential		Real Estate Construction - Commercial		Real Estate Mortgage - Residential		Real Estate Mortgage - Commercial		Installment Loans to Individuals		Unallocated		Total
September 30, 2012
Allowance for loan losses:
Individually evaluated for impairment	$	1,952	$	60	$	553	$	858	$	2,439	$	0	$	0	$	5,862
Collectively evaluated for impairment		1,608		581		1,181		2,798		4,639		245		6		11,058

Total	$	3,560	$	641	$	1,734	$	3,656	$	7,078	$	245	$	6	$	16,920

Loans outstanding:
Individually evaluated for impairment	$	5,676	$	2,540	$	7,890	$	5,307	$	20,585	$	0	$	0	$	41,998
Collectively evaluated for impairment		119,300		19,534		36,861		216,817		382,385		26,203		0		801,100

Total	$	124,976	$	22,074	$	44,751	$	222,124	$	402,970	$	26,203	$	0	$	843,098


December 31, 2011
Allowance for loan losses:
Individually evaluated for impairment	$	239	$	167	$	380	$	653	$	2,309	$	0	$	0	$	3,748
Collectively evaluated for impairment		1,565		1,021		1,182		2,598		3,425		267		3		10,061

Total	$	1,804	$	1,188	$	1,562	$	3,251	$	5,734	$	267	$	3	$	13,809

Loans outstanding:
Individually evaluated for impairment	$	4,428	$	1,147	$	7,867	$	6,569	$	33,440	$	0	$	0	$	53,451
Collectively evaluated for impairment		124,127		29,054		39,830		196,885		369,520		30,063		0		789,479

Total	$	128,555	$	30,201	$	47,697	$	203,454	$	402,960	$	30,063	$	0	$	842,930

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Loans, or portions of loans, are charged off to the extent deemed uncollectible. 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 $42,200,000 and $53,620,000 at September 30, 2012 and December 31, 2011 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 September 30, 2012 and December 31, 2011 are as follows:


(in thousands)	September 30, 2012		December 31, 2011
Non-accrual loans	$	34,233	$	46,403
Troubled debt restructurings continuing to accrue interest		7,967		7,217

Total impaired loans	$	42,200	$	53,620

The following tables provide additional information about impaired loans at September 30, 2012 and December 31, 2011, respectively, segregated between loans for which an allowance has been provided and loans for which no allowance has been provided:


(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
At September 30, 2012
With no related allowance recorded:
Commercial, financial and Agricultural	$	2,849	$	2,955	$	0
Real estate - construction residential		2,350		2,379		0
Real estate - construction commercial		1,879		2,110		0
Real estate - residential		2,138		2,501		0
Real estate - commercial		3,538		3,409		0
Consumer		202		233		0

Total	$	12,956	$	13,587	$	0

With an allowance recorded:
Commercial, financial and Agricultural	$	2,828	$	2,877	$	1,952
Real estate - construction residential		189		189		60
Real estate - construction commercial		6,011		6,115		553
Real estate - residential		3,169		3,324		858
Real estate - commercial		17,047		17,602		2,439

Total	$	29,244	$	30,107	$	5,862

Total impaired loans	$	42,200	$	43,694	$	5,862

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)


(in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
At December 31, 2011
With no related allowance recorded:
Commercial, financial and Agricultural	$	3,546	$	3,625	$	0
Real estate - construction residential		584		788		0
Real estate - construction commercial		1,459		1,756		0
Real estate - residential		2,315		2,654		0
Real estate - commercial		15,151		21,190		0
Consumer		168		177		0

Total	$	23,223	$	30,190	$	0

With an allowance recorded:
Commercial, financial and Agricultural	$	882	$	904	$	239
Real estate - construction residential		563		563		167
Real estate - construction commercial		6,409		6,448		380
Real estate - residential		4,254		4,265		653
Real estate - commercial		18,289		18,780		2,309

Total	$	30,397	$	30,960	$	3,748

Total impaired loans	$	53,620	$	61,150	$	3,748

The following table presents by class, information related to the average recorded investment and interest income recognized on impaired loans for the three and nine months ended September 30, 2012 and 2011:


	For the Three Months Ended September 30,								For the Nine Months Ended September 30,
	2012				2011				2012				2011
(in thousands)	Average Recorded Investment		Interest Recognized For the Period Ended		Average Recorded Investment		Interest Recognized For the Period Ended		Average Recorded Investment		Interest Recognized For the Period Ended		Average Recorded Investment		Interest Recognized For the Period Ended
With no related allowance recorded:
Commercial, financial and Agricultural	$	3,074	$	23	$	3,638	$	19	$	3,315	$	66	$	3,517	$	30
Real estate - construction residential		1,589		0		656		0		737		7		1,488		0
Real estate - construction commercial		1,879		0		8,899		0		1,653		0		9,818		0
Real estate - residential		2,299		5		2,583		7		3,333		47		3,631		19
Real estate - commercial		3,598		28		14,035		23		10,582		87		11,844		41
Consumer		181		0		179		2		162		1		195		3

Total	$	12,620	$	56	$	29,990	$	51	$	19,782	$	208	$	30,493	$	93

With an allowance recorded:
Commercial, financial and Agricultural	$	2,890	$	7	$	963	$	5	$	2,615	$	21	$	661	$	10
Real estate - construction residential		189		0		0		0		189		0		0		0
Real estate - construction commercial		6,192		0		186		0		6,180		0		83		0
Real estate - residential		3,037		4		3,664		28		2,566		11		3,286		83
Real estate - commercial		15,072		2		18,961		2		14,209		1		17,686		5

Total	$	27,380	$	13	$	23,774	$	35	$	25,759	$	33	$	21,716	$	98

Total impaired loans	$	40,000	$	69	$	53,764	$	86	$	45,541	$	241	$	52,209	$	191

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The specific reserve component of our Company’s allowance for loan losses at September 30, 2012 and December 31, 2011 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 $69,000 and $86,000, for the three months ended September 30, 2012 and 2011, respectively, and $241,000 and $191,000 for the nine months ended September 30, 2012 and 2011, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during the periods reported. Contractual interest due on loans in non-accrual status was $966,000 at September 30, 2012 compared to $1,751,000 at September 30, 2011. Interest income recognized on loans in non-accrual status was $8,000 and $41,000 for the three and nine months ended September 30, 2011. During the three and nine months ended September 30, 2012 there was no significant interest collected on loans in non-accrual status. Contractual interest due on non-accrual loans decreased from $1,110,000 at June 30, 2012 to $966,000 at September 30, 2012 due to several significant loans that went to foreclosure during the third quarter of 2012.

Delinquent and Non-Accrual Loans

The delinquency status of loans is determined based on the contractual terms of the notes. Borrowers are generally classified as delinquent once payments become 30 days or more past due. The following table provides aging information for our Company’s past due and non-accrual loans at September 30, 2012 and December 31, 2011.


(in thousands)	Current or Less Than 30 Days Past Due		30 - 89 Days Past Due		90 Days Past Due And Still Accruing		Non-Accrual		Total
September 30, 2012
Commercial, Financial, and Agricultural	$	121,195	$	555	$	0	$	3,227	$	124,977
Real Estate Construction - Residential		19,534		0		0		2,540		22,074
Real Estate Construction - Commercial		36,803		58		0		7,890		44,751
Real Estate Mortgage - Residential		214,390		3,012		0		4,722		222,124
Real Estate Mortgage - Commercial		386,438		879		0		15,652		402,969
Installment and Other Consumer		25,596		400		5		202		26,203

Total	$	803,956	$	4,904	$	5	$	34,233	$	843,098

December 31, 2011
Commercial, Financial, and Agricultural	$	126,244	$	243	$	0	$	2,068	$	128,555
Real Estate Construction - Residential		29,054		0		0		1,147		30,201
Real Estate Construction - Commercial		39,822		0		8		7,867		47,697
Real Estate Mortgage - Residential		195,779		3,513		9		4,153		203,454
Real Estate Mortgage - Commercial		371,000		924		36		31,000		402,960
Installment and Other Consumer		29,282		612		1		168		30,063

Total	$	791,181	$	5,292	$	54	$	46,403	$	842,930

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Credit Quality

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 by the collateral pledged, if any. Loans so classified may have a well defined weakness or weaknesses that jeopardize the repayment of the debt. Such loans are characterized by the distinct possibility that our Company may sustain some loss if the deficiencies are not corrected. It is our Company’s policy to discontinue the accrual of interest income on loans when management believes that the collection of interest or principal is doubtful. Loans are placed on non-accrual status when (1) deterioration in the financial condition of the borrower exists for which payment of full principal and interest is not expected, or (2) payment of principal or interest has been in default for a period of 90 days or more and the asset is not both well secured and in the process of collection. Subsequent interest payments received on such loans are applied to principal if any doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis.


(in thousands)	Commercial		Real Estate Construction - Residential		Real Estate Construction - Commercial		Real Estate Mortgage - Residential		Real Estate Mortgage - Commercial		Installment and other Consumer		Total
At September 30, 2012
Watch	$	21,571	$	4,006	$	7,485	$	24,617	$	27,189	$	648	$	85,516
Substandard		6,051		390		748		4,172		12,358		442		24,161
Non-accrual		3,227		2,540		7,890		4,722		15,652		202		34,233

Total	$	30,849	$	6,936	$	16,123	$	33,511	$	55,199	$	1,292	$	143,910

At December 31, 2011
Watch	$	22,206	$	9,644	$	9,338	$	13,231	$	24,392	$	557	$	79,368
Substandard		4,142		842		1,189		4,269		8,004		444		18,890
Non-accrual		2,068		1,147		7,867		4,153		31,000		168		46,403

Total	$	28,416	$	11,633	$	18,394	$	21,653	$	63,396	$	1,169	$	144,661

Troubled Debt Restructurings

At September 30, 2012, loans classified as troubled debt restructurings (TDRs) totaled $21,711,000, of which $13,744,000 was on non-accrual status and $7,967,000 was on accrual status. At December 31, 2011, loans classified as TDRs totaled $32,165,000, of which $24,948,000 was on non-accrual status and $7,217,000 was on accrual status. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. Accordingly, specific reserves of $1,576,000 and $1,522,000 were allocated to the allowance for loan losses at September 30, 2012 and December 31, 2011, respectively.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The following table summarizes loans that were modified as TDRs during the nine months ended September 30, 2012:


	The Nine Months Ended September 30, 2012
	Recorded Investment (1)
(in thousands)	Number of Contracts		Pre- Modification		Post- Modification
Troubled Debt Restructurings
Commercial, financial and agricultural		3	$	297	$	280
Real estate construction - commercial		1		43		42
Real estate mortgage - commercial		2		644		644

Total		6	$	984	$	966

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

According to guidance provided in ASC subtopic 310-40, Troubled Debt Restructurings by Creditors, a loan restructuring or modification of terms is a TDR if the creditor, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. Our Company’s portfolio of loans classified as TDRs include concessions such as interest rates below the current market rate, deferring principal payments, and extending maturity dates. Once a loan becomes a TDR, it will continue to be reported as a TDR until it is ultimately repaid in full, charged-off, or the collateral for the loan is foreclosed and sold. Our Company considers a loan in TDR status in default when the borrower’s payment according to the modified terms is at least 90 days past due or has defaulted due to expiration of the loan’s maturity date. During the three months ended September 30, 2012 there were no new loans meeting the TDR criteria. During the nine months ended September 30, 2012, six loans meeting the TDR criteria were modified. There were no loans modified as a TDR that defaulted during the three and nine months ended September 30, 2012, and within twelve months of their modification date.

(3)

Real Estate Acquired in Settlement of Loans


(in thousands)	September 30, 2012			December 31, 2011
Commercial	$	329		$	17
Real estate construction - residential		112			307
Real estate construction - commercial		13,407			13,650
Real estate mortgage - residential		1,586			2,121
Real estate mortgage - commercial		16,444			6,623

Total	$	31,878		$	22,718
Less valuation allowance for other real estate owned		(7,480	)		(6,977	)

Total	$	24,398		$	15,741

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)


Balance at December 31, 2011	$	22,718

Additions		15,585
Proceeds from sales		(5,323	)
Charge-offs against the valuation allowance for other real estate owned		(1,318	)
Net gain on sales		216

Total other real estate owned	$	31,878
Less valuation allowance for other real estate owned		(7,480	)

Balance at September 30, 2012	$	24,398

During the three and nine months ended September 30, 2012, net charge-offs against the allowance for loan losses at the time of foreclosure were approximately $2,401,000 and $4,141,000, respectively.

Activity in the valuation allowance for other real estate owned in settlement of loans for the three months and nine months ended September 30, 2012 and 2011, respectively, is summarized as follows:


(in thousands)	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Balance, beginning of period	$	7,474		$	6,537		$	6,977		$	6,158
Provision for other real estate owned		1,081			220			1,821			661
Charge-offs		(1,075	)		(127	)		(1,318	)		(189	)

Balance, end of period	$	7,480		$	6,630		$	7,480		$	6,630

(4)

Investment Securities

A summary of investment securities by major category, at fair value, consisted of the following at September 30, 2012 and December 31, 2011.


(in thousands)	September 30, 2012		December 31, 2011
U.S. treasury	$	2,036	$	2,054
Government sponsored enterprises		66,327		70,314
Asset-backed securities		113,207		107,329
Obligations of states and political subdivisions		35,218		34,109

Total available for sale securities	$	216,788	$	213,806

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 agencies such as the FHLMC, FNMA and GNMA. Our Company does not invest in subprime originated mortgage-backed or collateralized debt obligation instruments.

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 $4,285,000 and $4,385,000, as of September 30, 2012 and December 31, 2011 respectively.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2012 and December 31, 2011 are as follows:


(in thousands)	Amortized cost		Gross unrealized gains		Gross unrealized losses		Fair value
September 30, 2012

U.S. Treasury	$	2,000	$	36	$	0	$	2,036
Government sponsored enterprises		65,400		927		0		66,327
Asset-backed securities		109,340		3,873		7		113,206
Obligations of states and political subdivisions		33,887		1,337		5		35,219

Total available for sale securities	$	210,627	$	6,173	$	12	$	216,788


(in thousands)	Amortized cost		Gross unrealized gains		Gross unrealized losses		Fair value
December 31, 2011

U.S. Treasury	$	2,000	$	54	$	0	$	2,054
Government sponsored enterprises		69,703		629		18		70,314
Asset-backed securities		103,806		3,547		24		107,329
Obligations of states and political subdivisions		32,716		1,394		1		34,109

Total available for sale securities	$	208,225	$	5,624	$	43	$	213,806

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2012, 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.


(in thousands)	Amortized cost		Fair value
Due in one year or less	$	3,459	$	3,484
Due after one year through five years		74,943		76,232
Due after five years through ten years		22,022		22,966
Due after ten years		863		900

		101,287		103,582
Asset-backed securities		109,340		113,206

Total	$	210,627	$	216,788

Debt securities with carrying values aggregating approximately $167,592,000 and $172,447,000 at September 30, 2012 and December 31, 2011, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.

Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2012 and December 31, 2011, were as follows:

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)


	Less than 12 months					12 months or more						Total
(in thousands)	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses		Number of Investment Positions		Fair Value		Unrealized Losses
At September 30, 2012
Asset-backed securities	$	5,257	$	(7	)	$	0	$	0		5	$	5,257	$	(7	)
Obligations of states and political subdivisions		2,189		(5	)		150		0		7		2,339		(5	)

	$	7,446	$	(12	)	$	150	$	0		12	$	7,596	$	(12	)


	Less than 12 months					12 months or more						Total
(in thousands)	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses		Number of Investment Positions		Fair Value		Unrealized Losses
At December 31, 2011
Government sponsored enterprises	$	13,250	$	(18	)	$	0	$	0		13	$	13,250	$	(18	)
Asset-backed securities		4,591		(24	)		0		0		5		4,591		(24	)
Obligations of states and political subdivisions		229		(1	)		150		0		2		379		(1	)

	$	18,070	$	(43	)	$	150	$	0		20	$	18,220	$	(43	)

Our Company’s available for sale portfolio consisted of approximately 390 securities at September 30, 2012. One of these securities with an unrealized loss of $164 had been in the loss position for 12 months or longer. The unrealized loss included in other comprehensive income at September 30, 2012 was caused by interest rate fluctuations. Our Company’s available for sale portfolio consisted of approximately 365 securities at December 31, 2011. One of these securities with an unrealized loss of $294 had been in the loss position for 12 months or longer. The unrealized loss included in other comprehensive income at December 31, 2011 was caused by interest rate fluctuations. Because the decline in fair value is attributable to changes in interest rates and not credit quality these investments were not considered other-than-temporarily impaired at September 30, 2012 and December 31, 2011, respectively.

During the three and nine months ended September 30, 2012, there was a $26,000 realized gain from sales of securities recognized in earnings. During the three and nine months ended September 30, 2011, there were no proceeds from sales of securities and no components of investment securities gains and losses which have been recognized in earnings.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(5)

Intangible Assets

Core Deposit Intangible Asset

A summary of amortizable intangible assets at September 30, 2012 and December 31, 2011 is as follows:


	September 30, 2012							December 31, 2011
(in thousands)	Gross Carrying Amount		Accumulated Amortization			Net Amount		Gross Carrying Amount		Accumulated Amortization			Net Amount
Core deposit intangible	$	4,795	$	(4,559	)	$	236	$	4,795	$	(4,252	)	$	543

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 September 30, 2012 for the next five years:


(in thousands)	Core Deposit Intangible Asset
2012	$	101
2013		135
2014		—
2015		—
2016		—
2017		—

Changes in the net carrying amount of core deposit intangible assets in the table below for the periods indicated were as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
(in thousands)	2012			2011			2012			2011
Balance at beginning of period	$	337		$	751		$	543		$	978

Additions		0			0			0			0
Amortization		(101	)		(104	)		(307	)		(331	)

Balance at end of period	$	236		$	647		$	236		$	647

Mortgage Servicing Rights

On January 1, 2012, our Company opted to measure mortgage servicing rights at fair value as permitted by Accounting Standards Codification (ASC) Topic 860-50 Accounting for Servicing Financial Assets. The election of this option resulted in the recognition of a cumulative effect of change in accounting principle of $460,000, which was recorded as an increase to beginning retained earnings. As such, effective January 1, 2012, changes in the fair value of mortgage servicing rights are recognized in earnings in noninterest income in the period in which the change occurs and no amortization will be recognized on mortgage servicing rights going forward.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

At September 30, 2012 and December 31, 2011, our Company serviced mortgage loans for others totaling $306,926,000 and $307,016,000, respectively.

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


(in thousands)	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Balance at beginning of period	$	2,666		$	2,272		$	2,308		$	2,356

Re-measurement to fair value upon election to measure servicing rights at fair value		0			0			742			0
Originated mortgage servicing rights		231			215			559			436
Changes in fair value:
Due to change in model inputs and assumptions (1)		96			0			372			0
Other changes in fair value (2)		(369	)		0			(1,357	)		0
Amortization		0			(221	)		0			(526	)

Balance at end of period	$	2,624		$	2,266		$	2,624		$	2,266

(1)

The change in fair value resulting from changes in valuation inputs or assumptions used in valuation model primarily reflects the change in discount rates and prepayment speed assumptions primarily due to changes in interest rates.

(2)

Other changes in fair value reflect changes due to customer payments and passage of time. This also includes a one time adjustment of a $538,000 correction of an immaterial prior period error due to changing from the straight-line amortization method to an accelerated amortization method of accounting for amortizing MSRs in prior years. If the aforementioned was corrected as of December 31, 2011, the balance at the beginning of the period would have been $1,770,000.

The following key data and assumptions were used in estimating the fair value of our Company’s mortgage servicing rights as of the date indicated:


	September 30, 2012
Weighted-Average Constant Prepayment Rate		16.32	%
Weighted-Average Contractual Life (in years)		20.00
Weighted-Average Note Rate		4.38	%
Weighted-Average Discount Rate		8.01	%

(6)

Income Taxes

Income taxes as a percentage of earnings (loss) before income taxes as reported in the consolidated financial statements were (78.9)% for the nine months ended September 30, 2012 compared to 32.0% for the nine months ended September 30, 2011. Excluding an immaterial correction of a prior period error of $371,000, and prior year return to provision adjustments, income taxes as a percentage of earnings before income taxes were 18.9% in comparison to 32.0% for the nine months ended September 30, 2012 and 2011, respectively.

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

likely than not our Company will realize the benefits of these temporary differences at September 30, 2012 and, therefore, has not established a valuation reserve.

(7)

Employee Benefit Plans

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


(in thousands)	For the Three Months Ended September 30,					For the Nine Months Ended September 30,
	2012			2011		2012		2011
Payroll taxes	$	278		$	264	$	857	$	843
Medical plans		448			401		1,346		1,278
401k match		70			79		218		214
Pension plan		330			228		990		683
Profit-sharing		(100	)		30		58		101
Other		69			37		242		137

Total employee benefits	$	1,095		$	1,039	$	3,711	$	3,256

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 periods shown. In addition, employees were able to make additional tax-deferred contributions.

Pension

Our Company provides a noncontributory defined benefit pension plan for all full-time employees. An employer is required to recognize the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Under 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 $766,000 of contributions to the defined benefit plan through November 14, 2012, of which $238,000 relates to the 2011 plan year and $528,000 relates to the 2012 plan year. The minimum required contribution for the 2012 plan year is estimated to be $1,048,000. Our Company has not determined whether it will make any contributions other than the minimum required funding contribution for 2012.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Components of Net Pension Cost and Other Amounts Recognized in Accumulated Other Comprehensive Income

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


(in thousands)	Estimated 2012			Actual 2011
Service cost - benefits earned during the year	$	1,202		$	930
Interest costs on projected benefit obligations		667			604
Expected return on plan assets		(721	)		(706	)
Amortization of prior service cost		79			79
Amortization of unrecognized net loss		93			0

Net periodic pension expense	$	1,320		$	907

Pension expense - three months ended September 30, (actual)	$	330		$	228
Pension expense - nine months ended September 30, (actual)	$	990		$	683

(8)

Stock Compensation

Our Company’s stock option plan provides for the grant of options to purchase up to 526,435 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 11,133 shares that vested immediately.

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


	Number of Shares			Weighted Average Exercise Price		Weighted Average Contractual Term (in years)		Aggregate Intrinsic Value (000)
Outstanding at January 1, 2012 *		270,634		$	23.51
Granted		0			0
Exercised		0			0
Forfeited		0			0
Expired		(55,291	)		18.92

Outstanding at September 30, 2012		215,343		$	24.68		3.3	$	0

Exercisable at September 30, 2012		197,713		$	24.76		3.1	$	0

Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2012.

Total stock-based compensation expense for the three months ended September 30, 2012 and 2011 was $7,000 and $12,000, respectively, and for the nine months ended September 30, 2012 and 2011 was $27,000 and $46,000, respectively. As of September 30, 2012, the total unrecognized compensation expense related to non-vested stock awards was $71,000 and the related weighted average period over which it is expected to be recognized is approximately two years.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(9)

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 was designed to attract broad participation by banking institutions to help stabilize the financial system by encouraging lending.

Participating 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 287,133 shares of common stock (see below for additional information) to the U.S. Department of Treasury in exchange for $30,255,000. The proceeds received were allocated between the preferred stock and the common stock warrant based upon their relative fair values. This resulted in the recording of a 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. On May 9, 2012, our Company redeemed 12,000 shares of preferred stock from the U.S. Department of Treasury by repaying $12,000,000 of the $30,255,000 CPP funds along with $140,000 of accrued and unpaid dividends on the shares redeemed. Related to these shares was an additional $300,000 of accretion that was recognized at the time of the redemption. The allocated carrying values of the senior preferred stock and common stock warrant at September 30, 2012 were $17,905,000 and $2,382,000, respectively.

The 18,255 preferred shares remaining outstanding carry a 5% cumulative dividend through December 2013 and 9% thereafter if not redeemed. Our Company intends to redeem the remaining shares by December 2013. 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 nine or more quarterly periods, whether or not consecutive. Under such circumstances, the Treasury will be entitled to vote to elect two directors to the board until all unpaid dividends have been paid or declared and set apart for 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 $15.81 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 nine months ended September 30, 2012, our Company had declared and paid $975,000 of dividends and amortized $587,000 of accretion of the discount on preferred stock.

(10)

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 for the periods indicated:

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)


	For the Three Months Ended September 30,					For the Nine Months Ended September 30,
	2012			2011		2012			2011
Basic (loss) earnings per common share:
Net (loss) income	$	(1,571,541	)	$	1,515,639	$	619,225		$	3,877,750
Less:
Preferred stock dividends		228,188			378,187		893,694			1,130,360
Accretion of discount on preferred stock		71,873			119,119		587,372			357,356

Net (loss) income available to common shareholders	$	(1,871,602	)	$	1,018,333	$	(861,841	)	$	2,390,034

Basic (loss) earnings per share	$	(0.39	)	$	0.21	$	(0.18	)	$	0.49

Diluted (loss) earnings per common share:
Net (loss) income	$	(1,571,541	)	$	1,515,639	$	619,225		$	3,877,750
Less:
Preferred stock dividends		228,188			378,187		893,694			1,130,360
Accretion of discount on preferred stock		71,873			119,119		587,372			357,356

Net (loss) income available to common shareholders	$	(1,871,602	)	$	1,018,333	$	(861,841	)	$	2,390,034

Average shares outstanding		4,839,114			4,839,114		4,839,114			4,839,114
Effect of dilutive stock options		0			0		0			0

Average shares outstanding including dilutive stock options		4,839,114			4,839,114		4,839,114			4,839,114

Diluted (loss) earnings per share	$	(0.39	)	$	0.21	$	(0.18	)	$	0.49

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 nine months ended September 30, 2012 and 2011 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 September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Anti-dilutive shares - option shares		215,343		270,835		215,343		270,835
Anti-dilutive shares - warrant shares		287,133		287,133		287,133		287,133

Total anit-dilutive shares		502,476		557,968		502,476		557,968

(11)

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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 September 30, 2012 and December 31, 2011, respectively, there were no transfers into or out of Levels 1-3.

The fair value hierarchy is as follows:

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

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

Level 3 - Inputs are unobservable inputs for the asset or liability and significant to the fair value. These may be internally developed using 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

The fair value measurements of our Company’s investment securities are determined by a third party pricing service which considers observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. The fair value measurements are subject to independent verification to another pricing source by management each quarter for reasonableness. Securities classified as available for sale are reported at fair value utilizing Level 2 inputs.

Mortgage servicing rights

The fair value of mortgage servicing rights is based on the discounted value of estimated future cash flows utilizing contractual cash flows, servicing rate, constant prepayment rate, servicing cost, and discount rate factors. Accordingly, the fair value is estimated based on a valuation model which calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income,

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

including late fees. The valuation models estimate the present value of estimated future net servicing income. Our Company classifies its servicing rights as Level 3.


	Fair Value Measurements
(in thousands)	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
September 30, 2012
Assets:
U.S. treasury	$	2,036	$	2,036	$	0	$	0
Government sponsored enterprises		66,327		0		66,327		0
Asset-backed securities		113,206		0		113,206		0
Obligations of states and political subdivisions		35,219		0		35,219		0
Mortgage servicing rights		2,624		0		0		2,624

Total	$	219,412	$	2,036	$	214,752	$	2,624

December 31, 2011
Assets:
U.S. treasury	$	2,054		2,054		0		0
Government sponsored enterprises		70,314		0		70,314		0
Asset-backed securities		107,329		0		107,329		0
Obligations of states and political subdivisions		34,109		0		34,109		0

Total	$	213,806	$	2,054	$	211,752	$	0

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


	Fair Value Measurements Using Significant Unobservable Inputs (Level 3) Mortgage Servicing Rights
(in thousands)	Three Months Ended September 30, 2012			Nine Months Ended September 30, 2012
Balance at beginning of period	$	2,666		$	2,512
Total gains or losses (realized/unrealized):
Included in earnings		(42	)		112
Included in other comprehensive income		0			0

Balance at end of period	$	2,624		$	2,624

Total gains or losses for the three and nine months included in earnings attributable to the change in unrealized gains or losses relating to assets still held at September 30, 2012	$	96		$	372

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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 September 30, 2012, our Company identified $29.2 million in impaired loans that had specific allowances for losses aggregating $5.9 million. Related to these loans, there was $2.9 million in charge-offs recorded during the nine months ended September 30, 2012.

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 the Consolidated Financial Statements

(Unaudited)


	Fair Value Measurements Using
(in thousands)	Total Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Gains (Losses)*
September 30, 2012
Assets:
Impaired loans:
Commercial, financial, & agricultural	$	876	$	0	$	0	$	876	$	(791	)
Real estate construction - residential		130		0		0		130		0
Real estate construction - commercial		5,458		0		0		5,458		0
Real estate mortgage - residential		2,311		0		0		2,311		(564	)
Real estate mortgage - commercial		14,607		0		0		14,607		(1,547	)

Total	$	23,382	$	0	$	0	$	23,382	$	(2,902	)

Other real estate owned and repossessed assets	$	25,195	$	0	$	0	$	25,195	$	(3,186	)

December 31, 2011
Assets:
Impaired loans:
Commercial, financial, & agricultural	$	643	$	—	$	—	$	643	$	(2,136	)
Real estate construction - residential		396		—		—		396		(1,557	)
Real estate construction - commercial		6,029		—		—		6,029		(279	)
Real estate mortgage - residential		3,601		—		—		3,601		(1,509	)
Real estate mortgage - commercial		15,980		—		—		15,980		(5,842	)

Total	$	26,649	$	—	$	—	$	26,649	$	(11,323	)

Other real estate owned and repossessed assets	$	16,020	$	—	$	—	$	16,020	$	(2,112	)

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

(12)

Fair Value of Financial Instruments

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

Loans

The fair values of loans are estimated by discounting the expected future cash flows using the current rates at which similar loans could be made to borrowers with similar credit ratings and for the same remaining maturities. The net carrying amount of impaired loans is generally based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC Topic 820.

Investment Securities

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Federal Home Loan Bank (FHLB) Stock

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

Federal Funds Sold, Cash, and Due from Banks

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

Mortgage Servicing Rights

Cash Surrender Value - Life Insurance

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

Accrued Interest Receivable and Payable

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

Deposits

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

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

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

Subordinated Notes and Other Borrowings

The fair value of subordinated notes and other borrowings is based on the discounted value of contractual 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 the Consolidated Financial Statements

(Unaudited)

A summary of the carrying amounts and fair values of our Company’s financial instruments at September 30, 2012 and December 31, 2011 is as follows:


					September 30, 2012 Fair Value Measurements
	September 30, 2012				Quoted Prices in Active Markets for Identical		Other Observable		Net Significant Unobservable		December 31, 2011
(in thousands)	Carrying amount		Fair value		Assets (Level 1)		Inputs (Level 2)		Inputs (Level 3)		Carrying amount		Fair value
Assets:
Loans	$	826,178	$	830,401	$	0	$	0	$	830,401	$	829,121	$	830,077
Investment securities		216,788		216,788		2,036		214,752		0		213,806		213,806
FHLB stock		2,638		2,638		0		2,638		0		2,738		2,738
Federal fund sold and securities purchased under agreements to resell		0		0		0		0		0		75		75
Cash and due from banks		20,286		20,286		20,286		0		0		43,134		43,134
Mortgage servicing rights		2,624		2,624		0		0		2,624		2,309		2,512
Cash surrender value - life insurance		2,119		2,119		0		2,119		0		2,064		2,064
Accrued interest receivable		5,467		5,467		5,467		0		0		5,341		5,341

	$	1,076,100	$	1,080,323	$	27,789	$	219,509	$	833,025	$	1,098,588	$	1,099,747

Liabilities:
Deposits:
Demand	$	165,131	$	165,131	$	165,131	$	0	$	0	$	159,187	$	159,187
NOW		168,240		168,240		168,240		0		0		169,452		169,452
Savings		67,065		67,065		67,065		0		0		62,075		62,075
Money market		154,327		154,327		154,327		0		0		153,072		153,072
Time		401,647		407,083		0		0		407,083		414,438		421,687
Federal funds purchased and securities sold under agreements to repurchase		24,109		24,109		24,109		0		0		24,516		24,516
Subordinated notes		49,486		28,636		0		28,636		0		49,486		22,082
Federal Home Loan Bank advances		28,216		28,819		0		28,819		0		28,410		29,525
Accrued interest payable		684		684		684		0		0		1,054		1,054

	$	1,058,905	$	1,044,094	$	579,556	$	57,455	$	407,083	$	1,061,690	$	1,042,650

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 the Consolidated Financial Statements

(Unaudited)

(13)

Pending Litigation

Our Company and its subsidiaries are defendants in various legal actions incidental to our Company’s past and current business activities. At September 30, 2012 and December 31, 2011, our Company’s consolidated balance sheets included liabilities for these legal actions of $200,000, respectively. Based on our Company’s analysis, and considering the inherent uncertainties associated with litigation, management does not believe that it is reasonably possible that these legal actions will materially adversely affect our Company’s consolidated financial statements or results of operations in the near term.

On November 18, 2010, a suit was filed against our Company and its subsidiary, the Bank, in the Circuit Court of Jackson County for the Eastern Division of Missouri state court 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 suit seeks forfeiture and refund of twice the amount of improper overdraft fees assessed and collected. The court has denied the Bank’s 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 the 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 awarded $630,000 in damages to the plaintiffs, including $200,000 in punitive damages. After hearing post-judgment motions, the trial court struck the punitive damage award and entered an amended judgment for a total of $510,000 against the Bank. As of September 30, 2012, our Company carried a liability of $200,000 with respect to this matter. Our Company is in the appeals process and the probable outcome is presently not determinable.

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, 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, 2011, 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

Through the branch network of its subsidiary bank, our Company, Hawthorn Bancshares, Inc., 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.

Much of our Company’s business is commercial, commercial real estate development, and mortgage lending. Our Company has experienced soft loan demand in the communities within which we operate during the current economic slowdown. Our Company’s income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancings.

The successes of our Company’s growth strategy depends primarily on the ability of our banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. Our Company’s financial performance also depends, in part, on our ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of our Company’s growth strategy depends on our ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond our control.

Our subsidiary Bank is a full service bank conducting a general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial and industrial loans, residential real estate loans, single payment personal loans, installment loans and credit card accounts. In addition, our Bank provides trust services.

The deposit accounts of our Bank are insured by the Federal Deposit Insurance Corporation or “FDIC” to the extent provided by law. The operations of our Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of our Bank are conducted by representatives of the FDIC and the Missouri Division of Finance. Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. Hawthorn Bancshares is subject to supervision and examination by the Federal Reserve Board.

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 policies 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 provided in Note 1 to our Company’s consolidated financial statements and is also discussed in the Lending and Credit Management section below. Many of the loans are deemed collateral dependent for purposes of the measurement of the impairment loss, thus the fair value of the underlying collateral and sensitivity of such fair values due to changing market conditions, supply and demand, condition of the collateral and other factors can be volatile over periods of time. Such volatility can have an impact on the financial performance of our Company.

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 the consolidated financial statements or tax returns such as realization of the effects of temporary differences, net operating loss carry forwards and changes in tax laws or interpretations thereof. A valuation allowance is established when 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. Likewise, our Company would reverse the valuation allowance when we expect to realize the deferred tax asset. 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 penalties and interest related to income taxes in income tax expense.

Other Real Estate Owned and Repossessed Assets

Other real estate owned and repossessed assets consist of loan collateral 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.

SELECTED CONSOLIDATED FINANCIAL DATA

The following table presents selected consolidated financial information for our Company as of and for each of the three and nine months ended September 30, 2012 and 2011, 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 Ended September 30,						Nine Months Ended September 30,
(In thousands, except per share data)	2012			2011			2012			2011
Per Share Data
Basic (loss) earnings per common share	$	(0.39	)	$	0.21		$	(0.18	)	$	0.49
Diluted (loss) earnings per common share		(0.39	)		0.21			(0.18	)		0.49
Dividends paid on preferred stock		229			378			975			1,135
Accretion of discount on preferred stock		72			119			587			357
Dividends paid on common stock		233			224			698			671
Book value per common share								14.99			16.57
Market price per common share								8.84			7.25

Selected Ratios
*(Based on average balance sheets)*
Return on average total assets		-0.54	%		0.51	%		0.07	%		0.43	%
Return on average common stockholders’ equity		-9.95	%		5.29	%		-1.54	%		4.28	%
Average common stockholders’ equity to average total assets		6.41	%		6.48	%		6.31	%		6.25	%
*(Based on end-of-period data)*
Efficiency ratio (1)		81.07	%		67.81	%		78.41	%		70.65	%
Period-end common stockholders’ equity to period-end assets								6.27	%		6.59	%
Period-end stockholders’ equity to period-end assets								7.81	%		9.09	%
Total risk-based capital ratio								16.71	%		18.02	%
Tier 1 risk-based capital ratio								13.36	%		15.24	%
Leverage ratio								10.09	%		11.60	%

(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 September 30,											Nine months ended September 30,
(Dollars in thousands)	2012			2011		$ Change			% Change			2012			2011		$ Change			% Change
Net interest income	$	10,122		$	10,804	$	(682	)		(6.3	)%	$	31,108		$	32,067	$	(959	)		(3.0	)%
Provision for loan losses		4,700			2,010		2,690			133.8			7,900			5,643		2,257			40.0
Noninterest income		2,680			2,357		323			13.7			7,093			6,588		505			7.7
Noninterest expense		10,378			8,925		1,453			16.3			29,955			27,311		2,644			9.7

(Loss) income before income taxes		(2,276	)		2,226		(4,502	)		(202.2	)		346			5,701		(5,355	)		(93.9	)

Income tax (benefit) expense		(704	)		711		(1,415	)		(199.0	)		(273	)		1,823		(2,096	)		(115.0	)

Net (loss) income	$	(1,572	)	$	1,515	$	(3,087	)		(203.8	)%	$	619		$	3,878	$	(3,259	)		(84.0	)%

Less: preferred dividends and		228			378		(150	)		(39.7	)		894			1,131		(237	)		(21.0	)
accretion of discount		72			119		(47	)		(39.5	)		587			357		230			64.4

Net (loss) income available to common shareholders	$	(1,872	)	$	1,018	$	(2,890	)		(283.9	)%	$	(862	)	$	2,390	$	(3,252	)		(136.1	)%

Our Company’s consolidated net loss of $1,572,000 for the three months ended September 30, 2012 decreased $3,087,000 compared to consolidated net income of $1,515,000 for the three months ended September 30, 2011. Our Company recorded preferred stock dividends and accretion on preferred stock of $300,000 for the three months ended September 30, 2012, resulting in a $1,872,000 net loss available for common shareholders compared to net income available for common shareholders of $1,018,000 for the three months ended September 30, 2011. Diluted earnings (loss) per share decreased from $0.21 per common share for the three months ended September 30, 2011 to $(0.39) per common share for the three months ended September 30, 2012. The provision for loan losses increased $2,690,000, or 133.8%, from September 30, 2011 to September 30, 2012. Our Company’s net interest income, on a tax equivalent basis, decreased $694,000, or 6.3%, to $10,259,000 for the three months ended September 30, 2012 compared to $10,953,000 for the three months ended September 30, 2011. For the three months ended September 30, 2012, the return on average assets was (0.54)%, the return on average common stockholders’ equity was (9.95)%, and the efficiency ratio was 81.1%. Net interest margin decreased from 3.98% to 3.80% from the three months ended September 30, 2011 to 2012, respectively.

Our Company’s consolidated net income of $619,000 for the nine months ended September 30, 2012 decreased $3,259,000 compared to consolidated net income of $3,878,000 for the nine months ended September 30, 2011. Our Company recorded preferred stock dividends and accretion on preferred stock of $1,481,000 for the nine months ended September 30, 2012, resulting a $862,000 net loss available for common shareholders compared to net income available for common shareholders of $2,390,000 for the nine months ended September 30, 2011. Diluted earnings (loss) per share decreased from $0.49 per common share for the nine months ended September 30, 2011 to $(0.18) per common share for the nine months ended September 30, 2012. The provision for loan losses increased $2,257,000, or 40.0%, from the nine months ended September 30, 2011 to September 30, 2012, respectively. On May 9, 2012, our Company redeemed 12,000 of the 30,255 shares of preferred stock issued under the U.S. Treasury’s CPP program. Related to these shares was an additional $300,000 of accretion that was recognized at the time of the redemption. Our Company’s net interest income, on a tax equivalent basis, decreased $1,004,000, or 3.09%, to $31,524,000 for the nine months ended September 30, 2012 compared to $32,528,000 for the nine months ended September 30, 2011. The $2,096,000 decrease in income tax expense includes a $371,000 immaterial correction of a prior period error. For

the nine months ended September 30, 2012, the return on average assets was 0.07%, the return on average common stockholders’ equity was (1.54)%, and the efficiency ratio was 78.4%. Net interest margin decreased from 3.92% to 3.84% from the nine months ended September 30, 2011 to 2012, respectively.

Total assets at September 30, 2012 were $1,157,291,000, compared to $1,171,161,000 at December 31, 2011, a decrease of $13,870,000, or 1.2%. On July 1, 2012, our Company distributed a four percent stock dividend for the third consecutive year to common shareholders of record at the close of business June 15, 2012. For all periods presented, share information, including basic and diluted earnings per share, have been adjusted retroactively to reflect the stock dividend.

Net Interest Income

Net interest income is the largest source of revenue resulting from our Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities.

Average Balance Sheets

The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the three and nine month periods ended September 30, 2012 and September 30, 2011, respectively.


	Three Months Ended September 30,
	2012								2011
(Dollars In thousands)	Average Balance			Interest Income/ Expense (1)		Rate Earned/ Paid (1)			Average Balance			Interest Income/ Expense (1)		Rate Earned/ Paid (1)
ASSETS
Loans: (2) (4)
Commercial	$	126,092		$	1,620		5.11	%	$	126,997		$	1,747		5.46	%
Real estate construction - residential		21,087			225		4.24			28,923			416		5.71
Real estate construction - commercial		43,697			463		4.22			48,366			547		4.49
Real estate mortgage - residential		221,191			2,842		5.11			203,070			2,951		5.77
Real estate mortgage - commercial		401,649			5,311		5.26			421,830			5,710		5.37
Consumer		27,474			448		6.49			29,620			508		6.80

Total loans	$	841,190		$	10,909		5.16	%	$	858,806		$	11,879		5.49	%

Investment securities: (3)
U.S. treasury	$	2,041		$	8		1.56	%	$	2,049		$	8		1.55	%
Government sponsored enterprises		69,656			231		1.32			62,397			298		1.89
Asset backed securities		118,773			765		2.56			117,698			920		3.10
State and municipal		34,790			346		3.96			31,541			383		4.82

Total investment securities	$	225,260		$	1,350		2.38	%	$	213,685		$	1,609		2.99	%

Restricted Investments	$	4,287		$	23		2.13	%	$	4,899		$	37		3.00	%
Federal funds sold		46			—		—			96			—		—
Interest bearing deposits in other financial institutions		4,066			6		0.59			14,887			8		0.21

Total interest earning assets	$	1,074,849		$	12,288		4.55	%	$	1,092,373		$	13,533		4.92	%

All other assets		108,898								98,812
Allowance for loan losses		(15,471	)							(13,521	)

Total assets	$	1,168,276							$	1,177,664

LIABILITIES AND
STOCKHOLDERS’ EQUITY
NOW accounts	$	176,904		$	136		0.31	%	$	168,779		$	212		0.50	%
Savings		67,162			18		0.11			61,912			30		0.19
Money market		152,488			111		0.29			151,082			145		0.38
Time deposits of $100,000 and over		127,565			297		0.93			135,945			403		1.18
Other time deposits		278,305			980		1.40			289,058			1,243		1.71

Total time deposits	$	802,424		$	1,542		0.76	%	$	806,776		$	2,033		1.00	%

Federal funds purchased and securities sold under agreements to repurchase		24,170			7		0.12			25,861			13		0.20
Subordinated notes		49,486			346		2.78			49,486			322		2.58
Federal Home Loan Bank advances		28,258			134		1.89			35,933			212		2.37

Total borrowings	$	101,914		$	487		1.90	%	$	111,280		$	547		1.95	%

Total interest bearing liabilities	$	904,338		$	2,029		0.89	%	$	918,056		$	2,580		1.12	%

Demand deposits		163,538								148,339
Other liabilities		7,697								5,864

Total liabilities		1,075,573								1,072,259
Stockholders’ equity		92,703								105,405

Total liabilities and stockholders’ equity	$	1,168,276							$	1,177,664

Net interest income (FTE)				$	10,259							$	10,953

Net interest spread							3.66	%							3.80	%
Net interest margin							3.80	%							3.98	%

(1)	Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $137,000 and $149,000 for the three months ended September 30, 2012 and 2011, 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.


	Nine Months Ended September 30,
	2012								2011
(Dollars In thousands)	Average Balance			Interest Income/ Expense (1)		Rate Earned/ Paid (1)			Average Balance			Interest Income/ Expense (1)		Rate Earned/ Paid (1)
ASSETS
Loans: (2) (4)
Commercial	$	127,634		$	4,913		5.13	%	$	127,904		$	5,238		5.48	%
Real estate construction - residential		21,058			928		5.87			30,107			1,269		5.64
Real estate construction - commercial		42,967			1,382		4.28			51,745			1,713		4.43
Real estate mortgage - residential		217,919			8,841		5.40			203,716			8,763		5.75
Real estate mortgage - commercial		404,826			15,709		5.17			428,465			17,460		5.45
Consumer		28,176			1,374		6.50			30,126			1,571		6.97

Total Loans	$	842,580		$	33,147		5.24	%	$	872,063		$	36,014		5.52	%

Investment securities: (3)
U.S. treasury	$	2,053		$	24		1.56	%	$	1,652		$	21		1.70	%
Government sponsored enterprises		73,771			796		1.44			64,577			977		2.02
Asset backed securities		115,227			2,363		2.73			111,799			2,704		3.23
State and municipal		34,092			1,058		4.13			32,128			1,191		4.96

Total Investment securities	$	225,143		$	4,241		2.51	%	$	210,156		$	4,893		3.11	%

Restricted investments	$	4,308		$	79		2.44	%	$	5,328		$	121		3.04	%
Federal funds sold		65			—		—			131			—		—
Interest bearing deposits in other financial institutions		20,229			42		0.28			20,744			40		0.26

Total interest earning assets	$	1,092,325		$	37,509		4.57	%	$	1,108,422		$	41,068		4.95	%

All other assets		104,223								99,110
Allowance for loan losses		(14,707	)							(13,620	)

Total assets	$	1,181,841							$	1,193,912

LIABILITIES AND
STOCKHOLDERS’ EQUITY
NOW accounts	$	186,933		$	529		0.38	%	$	180,963		$	745		0.55	%
Savings		65,862			56		0.11			59,874			100		0.22
Money market		152,090			334		0.29			153,438			473		0.41
Time deposits of $100,000 and over		130,887			833		0.85			129,291			1,297		1.34
Other time deposits		278,305			2,769		1.33			295,529			3,984		1.80

Total time deposits	$	814,077		$	4,521		0.74	%	$	819,095		$	6,599		1.08	%

Federal funds purchased and securities sold under agreements to repurchase		23,271			17		0.10			27,794			39		0.19
Subordinated notes		49,486			1,045		2.81			49,486			964		2.60
Federal Home Loan Bank advances		28,323			402		1.89			46,872			938		2.68

Total borrowings	$	101,080		$	1,464		1.96	%	$	124,152		$	1,941		2.09	%

Total interest bearing liabilities	$	915,157		$	5,985		0.87	%	$	943,247		$	8,540		1.21	%

Demand deposits		160,765								141,687
Other liabilities		8,086								5,273

Total liabilities		1,084,008								1,090,207
Stockholders’ equity		97,833								103,605

Total liabilities and stockholders’ equity	$	1,181,841							$	1,193,812

Net interest income (FTE)				$	31,524							$	32,528

Net interest spread							3.70	%							3.74	%
Net interest margin							3.84	%							3.92	%

(1)	Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $416,000 and $461,000 for the nine months ended September 30, 2012 and 2011, 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 nine months ended September 30, 2012 and 2011, respectively.

Financial results for the three months ended September 30, 2012 compared to the three months ended September 30, 2011 reflected a decrease in net interest income, on a tax equivalent basis, of $694,000, or 6.3%. Average interest-earning assets decreased $17,524,000, or 1.6%, to $1,074,849,000 for the three months ended September 30, 2012 compared to $1,092,373,000 for the three months ended September 30, 2011 and average interest bearing liabilities decreased $13,718,000, or 1.5%, to $904,338,000 for the three months ended September 30, 2012 compared to $918,056,000 for the three months ended September 30, 2011.

Average loans outstanding decreased $17,616,000, or 2.1%, to $841,190,000 for the three months ended September 30, 2012 compared to $858,806,000 for the three months ended September 30, 2011. See the Lending and Credit Management section for further discussion of changes in the composition of our lending portfolio. Average investment securities and federal funds sold increased $11,525,000, or 5.4%, to $225,306,000 for the three months ended September 30, 2012 compared to $213,781,000 for the three months ended September 30, 2011. Average interest bearing deposits in other financial institutions decreased $10,821,000 to $4,066,000 for the three months ended September 30, 2012 compared to $14,887,000 for the three months ended September 30, 2011. See the Liquidity Management section for further discussion.

Average time deposits decreased $4,352,000 to $802,424,000 for the three months ended September 30, 2012 compared to $806,776,000 for the three months ended September 30, 2011. Average borrowings on Federal Home Loan Bank advances decreased $7,675,000 to $28,258,000 for the three months ended September 30, 2012 compared to $35,933,000 for the three months ended September 30, 2011. See the Liquidity Management section for further discussion.

Financial results for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011 reflected a decrease in net interest income, on a tax equivalent basis, of $1,004,000, or 3.1%. Average interest-earning assets decreased $16,097,000, or 1.4%, to $1,092,325,000 for the nine months ended September 30, 2012 compared to $1,108,422,000 for the nine months ended September 30, 2011 and average interest bearing liabilities decreased $28,090,000, or 3.0%, to $915,157,000 for the nine months ended September 30, 2012 compared to $943,247,000 for the nine months ended September 30, 2011.

Average loans outstanding decreased $29,483,000 or 3.0% to $842,580,000 for the nine months ended September 30, 2012 compared to $872,063,000 for the nine months ended September 30, 2011. See the Lending and Credit Management section for further discussion of changes in the composition of our lending portfolio. Average investment securities and federal funds sold increased $14,921,000, or 7.1% to $225,208,000 for the nine months ended September 30, 2012 compared to $210,287,000 for the nine months ended September 30, 2011. Average interest bearing deposits in other financial institutions decreased $515,000 to $20,229,000 for the nine months ended September 30, 2012 compared to $20,744,000 for the nine months ended September 30, 2011. See the Liquidity Management section for further discussion.

Average time deposits decreased $5,018,000 to $814,077,000 for the nine months ended September 30, 2012 compared to $819,095,000 for the nine months ended September 30, 2011. Average borrowings on Federal Home Loan Bank advances decreased $18,549,000 to $28,323,000 for the nine months ended September 30, 2012 compared to $46,872,000 for the nine months ended September 30, 2011. See the Liquidity Management section 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, identifying changes related to volumes and rates for the three and nine months ended September 30, 2012, compared to the three and nine months ended September 30, 2011. 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 September 30, 2012 vs. 2011									Nine Months Ended September 30, 2012 vs. 2011
				Change due to									Change due to
(Dollars In thousands)	Total Change			Average Volume			Average Rate			Total Change			Average Volume			Average Rate
Interest income on a fully taxable equivalent basis:
Loans: (1) (3)
Commercial	$	(127	)	$	(12	)	$	(115	)	$	(325	)	$	(11	)	$	(314	)
Real estate construction - residential		(191	)		(98	)		(93	)		(341	)		(396	)		55
Real estate construction - commercial		(84	)		(51	)		(33	)		(331	)		(284	)		(47	)
Real estate mortgage - residential		(103	)		250			(353	)		84			592			(508	)
Real estate mortgage - commercial		(405	)		(269	)		(136	)		(1,757	)		(938	)		(819	)
Consumer		(60	)		(36	)		(24	)		(197	)		(99	)		(98	)

Investment securities:
U.S. treasury		—			—			—			3			5			(2	)
Government sponsored entities		(67	)		32			(99	)		(181	)		126			(307	)
Asset backed securities		(155	)		8			(163	)		(341	)		81			(422	)
State and municipal (2)		(37	)		36			(73	)		(133	)		70			(203	)

Restricted investments		(14	)		(5	)		(9	)		(42	)		(21	)		(21	)
Federal funds sold		—			—			—			—			—			—
Interest bearing deposits in other financial institutions		(2	)		(9	)		7			2			(1	)		3

Total interest income		(1,245	)		(154	)		(1,091	)		(3,559	)		(876	)		(2,683	)

Interest expense:
NOW accounts		(76	)		10			(86	)		(216	)		24			(240	)
Savings		(12	)		3			(15	)		(44	)		9			(53	)
Money market		(34	)		1			(35	)		(139	)		(4	)		(135	)
Time deposits of $100,000 and over		(106	)		(24	)		(82	)		(464	)		16			(480	)
Other time deposits		(263	)		(45	)		(218	)		(1,215	)		(221	)		(994	)
Federal funds purchased and securities sold under agreements to repurchase		(6	)		(1	)		(5	)		(22	)		(5	)		(17	)
Subordinated notes		24			—			24			81			—			81
Federal Home Loan Bank advances		(78	)		(40	)		(38	)		(536	)		(309	)		(227	)

Total interest expense		(551	)		(96	)		(455	)		(2,555	)		(490	)		(2,065	)

Net interest income on a fully taxable equivalent basis	$	(694	)	$	(58	)	$	(636	)	$	(1,004	)	$	(386	)	$	(618	)

(1)

Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $137,000 and $149,000 for the three months ended September 30, 2012 and 2011, respectively, and $416,000 and $461,000 for the nine months ended September 30, 2012 and 2011, 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 $694,000, or 6.3%, to $10,259,000 for the three months ended September 30, 2012 compared to $10,935,000 for the three months ended September 30, 2011. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.80% for the three months ended September 30, 2012 from 3.98% for the three months ended September 30, 2011. The decrease in net interest income was primarily the result of lower interest income earned on loans due to lower average balances and lower average rates. Our Company’s net interest spread decreased to 3.66% for the three months ended September 30, 2012 from 3.80% for the three months ended September 30, 2011. The rates earned on interest earning assets decreased from 4.92% for the three months ended September 30, 2011 to 4.55% for the three months ended September 30, 2012. Partially offsetting this decrease in rates earned was a decrease in interest expense incurred on deposits and other borrowings. Our Company’s rates paid on interest bearing liabilities decreased to 0.89% for the three months ended September 30, 2012 compared to 1.12% for the three months ended September 30, 2011.

Net interest income on a fully taxable equivalent basis decreased $1,004,000, or 3.1%, to $31,524,000 for the nine months ended September 30, 2012 compared to $32,528,000 for the nine months ended September 30, 2011. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.84% for the nine months ended September 30, 2012 from 3.92% for the nine months ended September 30, 2011. The decrease in net interest income was primarily the result of lower interest income earned on loans due to lower average balances and lower average rates. Our Company’s net interest spread decreased to 3.70% for the nine months ended September 30, 2012 from 3.74% for the nine months ended September 30, 2011. Rates earned on interest earning assets decreased from 4.95% for the nine months ended September 30, 2011 to 4.57% for the nine months ended September 30, 2012, while rates paid on interest bearing liabilities decreased to 0.87% for the nine months ended September 30, 2012 compared to 1.21% for the nine months ended September 30, 2011. For the nine months ended September 30, 2012, interest expense incurred on deposits and other borrowings decreased $2,555,000 from the nine months ended September 30, 2011. Effective January 1, 2012, our Company recorded a $368,000 credit to interest expense on time deposits for imputed interest calculated on capitalized interest not accounted for during the time period of 2004 through 2011 on the construction of our Company’s new bank buildings. This is considered a correction of an immaterial prior period error. Without this credit to interest expense, rates paid on interest bearing liabilities would have been approximately 0.92% for the nine months ended September 30, 2012.

Non-interest Income and Expense

Non-interest income for the three and nine months ended September 30, 2012 and 2011 were as follows:


	Three Months Ended September 30,												Nine Months Ended September 30,
(Dollars in thousands)	2012			2011			$ Change			% Change			2012			2011			$ Change			% Change
Non-interest Income
Service charges on deposit accounts	$	1,360		$	1,446		$	(86	)	$	(5.9	)%	$	4,067		$	4,176		$	(109	)	$	(2.6	)%
Trust department income		234			209			25			12.0			670			633			37			5.8
Gain on sales of mortgage loans		779			431			348			80.7			1,773			894			879			98.3
Gain on sale of investment securities		26			0			26			NM			26			0			26			NM
Other		281			271			10			3.7			557			885			(328	)		(37.1	)

Total non-interest income	$	2,680		$	2,357		$	323		$	13.7	%	$	7,093		$	6,588		$	505		$	7.7	%

Non-interest income as a
% of total revenue *		20.9	%		17.9	%								18.6	%		17.0	%
Total revenue per full time equivalent employee	$	36.6		$	39.6								$	109.1		$	116.4

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

On January 1, 2012, our Company opted to measure mortgage servicing rights at fair value as permitted by Accounting Standards Codification (ASC) Topic 860-50 Accounting for Servicing Financial Assets. The election of this option resulted in the recognition of a cumulative effect of change in accounting principle of $459,890, which was recorded as an increase to beginning retained earnings, as further described in Note 5 to the consolidated financial statements. As such, effective January 1, 2012, the change in the fair value of mortgage servicing rights is recognized in earnings as other noninterest income for the period in which the change occurs.

Noninterest income increased $323,000 or 13.7% to $2,680,000 for the three months ended September 30, 2012 compared to $2,357,000 for the three months ended September 30, 2011. The increase was primarily the result of a $348,000 increase in the gains on sales of mortgage loans. Our Company’s loans sold increased from $22,000,000 for the three months ended September 30, 2011 to $27,000,000 for the three months ended September 30, 2012. Due to low interest rates, an increase in refinancing activity impacted both the volume of loans sold and gains recognized.

Noninterest income increased $505,000 or 7.7% to $7,093,000 for the nine months ended September 30, 2012 compared to $6,588,000 for the nine months ended September 30, 2011. The increase was primarily the result of a $879,000 increase on gains on sales of mortgage loans partially offset by a $452,000 decrease in the real estate servicing income recorded in other noninterest income. As a result of the changes in fair value during the first nine months of

2012, $637,000 was earned in real estate service fees, $372,000 was recorded in real estate servicing income due to changes in model inputs and assumptions, and ($1,357,000) was recorded due to other changes in fair value resulting from customer payments and passage of time. This is in comparison to the nine months ended September 30, 2011 in which $630,000 was earned in real estate servicing fees and $526,000 of MSR amortization was recorded. Our Company’s loans sold increased from $44,000,000 for the nine months ended September 30, 2011 to $69,000,000 for the nine months ended September 30, 2012. As mentioned above, due to low interest rates, an increase in refinancing activity impacted both the volume of loans sold and gains recognized. Our Company was servicing $307,000,000 of mortgage loans at September 30, 2012 compared to $302,000,000 at September 30, 2011.

Non-interest expense for the three and nine months ended September 30, 2012 and 2011 were as follows:


	Three Months Ended September 30,												Nine Months Ended September 30,
(Dollars in thousands)	2012			2011			$ Change			% Change			2012		2011			$ Change			% Change
Non-interest Expense
Salaries	$	3,666		$	3,466		$	200			5.8	%	$	10,754	$	10,260		$	494			4.8	%
Employee benefits		1,095			1,039			56			5.4			3,711		3,256			455			14.0
Occupancy expense, net		666			735			(69	)		(9.4	)		1,953		1,958			(5	)		(0.3	)
Furniture and equipment expense		431			468			(37	)		(7.9	)		1,403		1,483			(80	)		(5.4	)
FDIC insurance assessment		249			254			(5	)		(2.0	)		752		1,130			(378	)		(33.5	)
Legal, examination, and professional fees		284			286			(2	)		(0.7	)		880		1,083			(203	)		(18.7	)
Advertising and promotion		288			272			16			5.9			750		774			(24	)		(3.1	)
Postage, printing, and supplies		274			271			3			1.1			817		836			(19	)		(2.3	)
Processing expense		888			787			101			12.8			2,667		2,422			245			10.1
Other real estate expense		1,787			524			1,263			241.0			3,383		1,564			1,819			116.3
Other		750			823			(73	)		(8.9	)		2,885		2,545			340			13.4

Total non-interest expense	$	10,378		$	8,925		$	1,453			16.3	%	$	29,955	$	27,311		$	2,644			9.7	%

Efficiency ratio		81.1	%		67.8	%								78.4		%70.7	%
Salaries and benefits as a % of total non-interest expense		45.9	%		50.5	%								48.3		%49.5	%
Number of full-time equivalent employees		350			332									350		332

Total noninterest expense increased $1,453,000, or 16.3%, to $10,378,000 for the three months ended September 30, 2012 compared to $8,925,000 for the three months ended September 30, 2011. For the nine months ended September 30, 2012, total noninterest expense increased $2,644,000, or 9.7%, to $29,955,000 compared to $27,311,000 for the nine months ended September 30, 2011.

Salary expense increased $200,000, or 5.8%, to $3,666,000 for the three months ended September 30, 2012 compared to the prior year quarter, and increased $494,000, or 4.8%, to $10,754,000 for the nine months ended September 30, 2012 compared to the same period last year. The number of full-time equivalent employees increased from 332 at September 30, 2011 to 350 at September 30, 2012 partly due to opening a new lending location in Liberty, Missouri in May of 2012 as well as additional support personnel in our loan operations departments.

Employee benefits increased $56,000, or 5.4%, for the three months ended September 30, 2012 compared to the three months ended September 30, 2011, and increased $455,000, or 14.0%, for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. The quarterly increase included a $47,000 increase in medical insurance premiums, and a $32,000 increase in other employee benefits, partially offset by a $37,000 decrease in estimated profit sharing and pension accrual. The increase for the nine months end September 30, 2012 included increases of $268,000 in estimated profit sharing and pension accrual, $105,000 in other employee benefits, and $68,000 in medical insurance premiums.

Federal Deposit Insurance Corporation (FDIC) insurance assessment decreased $6,000, or 2.4%, for the three months ended September 30, 2012 compared to the three months ended September 30, 2011, and decreased $378,000, or 33.5%, for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. The decrease in FDIC insurance

assessments was due to amendments made by the FDIC effective for the third quarter of 2011 to implement revisions to the Federal Deposit Insurance Act made by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The quarters ending after September 30, 2011 reflect a new assessment base using assets and tier one capital in the assessment calculation.

Legal, examination, and professional expenses decreased $2,000, or 0.7%, for the three months ended September 30, 2012 compared to prior year quarter, and decreased $203,000, or 18.7%, for the nine months ended September 30, 2012 compared to the prior year to date period primarily as a result of a decrease in consulting fees due to a human resource best practices and profitability-consulting project completed during 2011.

Other real estate expense increased $1,264,000, or 241.7%, to $1,787,000 for the three months ended September 30, 2012 compared to the three months ended September 30, 2011, and increased $1,819,000, or 116.3%, to $3,383,000 for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. The current quarter increase was primarily due to a $1,081,000 expense provision for other real estate owned compared to $220,000 for the prior year quarter. Expenses incurred to maintain foreclosed properties during the current quarter also increased $467,000 compared to the prior year quarter. During the nine months ended September 30, 2012, the provision for other real estate owned was $1,821,000 compared to $661,000 for the prior year to date period and expenses incurred to maintain foreclosed properties increased $792,000 in comparison to those for the nine months ended September 30, 2011. The increase in other real estate expenses was primarily due to increased operating costs of recently acquired foreclosed properties.

Other noninterest expense decreased $74,000, or 9.0%, for the three months ended September 30, 2012 compared to the three months ended September 30, 2011. The $340,000 year to date increase over the prior year was primarily due to $309,000 of property donations to charitable organizations during the current year that were in other real estate owned.

Income taxes

Income taxes as a percentage of earnings (loss) before income taxes as reported in the consolidated financial statements were 30.9% for the three months ended September 30, 2012 compared to 31.9% for the three months ended September 30, 2011, and were (78.9)% for the nine months ended September 30, 2012 compared to 32.0% for the nine months ended September 30, 2011. Excluding an immaterial correction of a prior period error of $371,000, and prior year return to provision adjustments, income taxes as a percentage of earnings before income taxes were 18.9% in comparison to 32.0% for the nine months ended September 30, 2012 and 2011, respectively. As of December 31, 2011, our Company released $28,000 of interest accrued related to the release of $221,000 of uncertain tax provisions. As of September 30, 2012, our Company had not recognized any tax liabilities or any interest or penalties in income tax expense related to uncertain tax positions.

Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for our Company. Net loans represented 71.4% of total assets as of September 30, 2012 compared to 70.8% as of December 31, 2011, and 71.6% as of September 30, 2011.

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 is as follows:


(In thousands)	September 30, 2012		December 31, 2011
Commercial, financial, and agricultural	$	124,977	$	128,555
Real estate construction - residential		22,074		30,201
Real estate construction - commercial		44,751		47,697
Real estate mortgage - residential		222,124		203,454
Real estate mortgage - commercial		402,969		402,960
Installment loans to individuals		26,006		29,884
Deferred fees and costs, net		197		179

Total loans	$	843,098	$	842,930

Our Company’s loan portfolio increased $168,000 from December 31, 2011 to September 30, 2012. During the nine months ended September 30, 2012 there were no significant increases in loan demand. Our Company did experience an increase in refinancing during this time period due to low interest rates available for real estate mortgage residential properties. Also, during the first quarter of 2012 approximately $10,000,000 of real estate construction - residential loans were reclassified to real estate mortgage - residential loans due to the completion of the construction phase.

The economy for the state of Missouri as a whole continues to be considered weak. Our Company anticipates several more quarters of slow growth and a very tight economy. As the State continues to look for places to balance its budget, our Company believes the economy in our central market could be impacted. The economy in the southern half of our Company’s market area has been impacted by a tornado that struck the Branson area. Currently, the Branson area is experiencing good holiday weekends, but its economy is still struggling. Significant fluctuations in the stock market show little indication that the economy will stabilize and rebound soon. Although unemployment rates remain elevated, employment levels in our Company’s market area have remained steady during the nine months ended September 30, 2012. Borrowing rates have also remained at all time lows during our Company’s thirty-six month analysis period. Management continues to focus on the improvement of asset quality by tightening underwriting standards and focusing on lending to credit worthy borrowers with the capacity to service their debts. Where appropriate, management actively works with existing borrowers to modify loan terms and conditions in order to assist the borrowers in servicing their debt obligations to our Company. The U.S. FHFA House Price Index for July 2012 indicates house prices nationwide to be 16.4% below the April 2007 peak and 11.2% below that peak in Missouri. Our Company’s market area compares favorably to other regions in the nation with increases over the last four quarters as much as 1.2% while nationally the index declined 0.6%.

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

ended September 30, 2012 our Company sold $68,000,000 of loans to investors. At September 30, 2012, our Company was servicing approximately $307,000,000 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 five 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 the senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2,000,000 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, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered necessary by management to provide for probable losses inherent in the loan portfolio.

Nonperforming Assets

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


(Dollars in thousands)	September 30, 2012			December 31, 2011
Nonaccrual loans:
Commercial, financial, and agricultural	$	3,227		$	2,068
Real estate construction - residential		2,540			1,147
Real estate construction - commercial		7,890			7,867
Real estate mortgage - residential		4,722			4,153
Real estate mortgage - commercial		15,652			31,000
Installment loans to individuals		202			168

Total nonaccrual loans		34,233			46,403

Loans contractually past - due 90 days or more and still accruing:
Commercial, financial, and agricultural		—			—
Real estate construction - residential		—			—
Real estate construction - commercial		—			8
Real estate mortgage - residential		—			9
Real estate mortgage - commercial		—			36
Installment loans to individuals		5			1

Total loans contractually past - due 90 days or more and still accruing		5			54
Troubled debt restructurings - accruing		7,967			7,217

Total nonperforming loans		42,205			53,674
Other real estate		24,398			15,741
Repossessions		797			279

Total nonperforming assets	$	67,400		$	69,694

Loans	$	843,098		$	842,930
Allowance for loan losses to loans		2.01	%		1.64	%
Nonperforming loans to loans		5.00	%		6.37	%
Allowance for loan losses to nonperforming loans		40.09	%		25.73	%
Nonperforming assets to loans and foreclosed assets		7.76	%		8.11	%

Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing, and restructured loans totaled $42,205,000 or 5.00% of total loans at September 30, 2012 compared to $53,674,000 or 6.37% of total loans at December 31, 2011.

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 $966,000 and $1,792,000 for nine months ended September 30, 2012 and 2011, respectively.

As of September 30, 2012 and December 31, 2011, approximately $16,194,000 and $11,673,000, respectively, of loans not included in the nonperforming asset table were identified 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. Borrowers are continuing to experience cash flow problems 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 September 30, 2012 and December 31, 2011.

Total non-accrual loans at September 30, 2012 decreased $12,170,000 from December 31, 2011. This decrease primarily consisted of a $15,347,000 decrease in real estate mortgage - commercial non-accrual loans. This decrease was partially offset by a $1,159,000 net increase in commercial, financial and agricultural non-accrual loans and a $1,393,000 net increase in

real estate construction - residential loans. The overall decrease in nonaccrual loans primarily resulted from the foreclosure of five loans with balances totaling $13,470,000 at December 31, 2011 that had been in nonaccrual status. The increase in commercial, financial and agricultural non-accrual loans resulted primarily from one significant loan relationship with a balance totaling $1,279,000 at September 30, 2012 that was put on non-accrual status during the first three months of 2012. The increase in real estate construction - residential loans resulted primarily from one significant loan relationship with a balance totaling $2,259,000 at September 30, 2012 that was put on non-accrual status during the third quarter of 2012. At September 30, 2012, real estate mortgage - commercial non-accrual loans made up 46% of total non-accrual loans compared to 67% at December 31, 2011.

Loans past due 90 days and still accruing interest decreased $49,000 from $54,000 at December 31, 2011 to $5,000 at September 30, 2012. Foreclosed real estate and other repossessions increased $9,175,000 from $16,020,000 at December 31, 2011 to $25,195,000 at September 30, 2012 primarily due to real estate mortgage - commercial foreclosures.

At September 30, 2012, loans classified as troubled debt restructurings (TDRs) totaled $21,711,000, of which $13,744,000 were on non-accrual status and $7,967,000 were on accrual status. At December 31, 2011, loans classified as TDRs totaled $32,165,000, of which $24,948,000 were on non-accrual status and $7,217,000 were on accrual status. The $10,454,000 decrease from December 31, 2011 consisted primarily of two loans with balances totaling approximately $8,200,000 that went to foreclosure during the nine months ended September 30, 2012.

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


(Dollars in thousands)	September 30, 2012						December 31, 2011
TDRs - Accrual	Number of contracts		Recorded Investment		Specific Reserves		Number of contracts		Recorded Investment		Specific Reserves
Commercial, financial and agricultural		11	$	2,449	$	104		9	$	2,360	$	120
Real estate mortgage - residential		5		585		124		20		2,416		61
Real estate mortgage - commercial		6		4,933		129		3		2,441		—

Total		22	$	7,967	$	357		32	$	7,217	$	181


	September 30, 2012						December 31, 2011
TDRs - Non-accrual	Number of contracts		Recorded Investment		Specific Reserves		Number of contracts		Recorded Investment		Specific Reserves
Commercial, financial and agricultural		2	$	209	$	14		2	$	84	$	52
Real estate construction - commercial		5		5,816		480		8		6,227		321
Real estate mortgage - residential		6		739		203		9		1,278		108
Real estate mortgage - commercial		12		6,980		522		15		17,359		860

Total		25	$	13,744	$	1,219		34	$	24,948	$	1,341

Total TDRs		47	$	21,711	$	1,576		66	$	32,165	$	1,522

Provision and Allowance for Loan Losses

As mentioned above, the economy continues to contribute 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 necessary to cover probable losses in the loan portfolio. The allowance for loan losses increased to $16,920,000 or 2.0% of loans outstanding at September 30, 2012 compared to $12,690,000 or 1.5% of loans outstanding at September 30, 2011.

The following table summarizes loan loss experience for the three and nine months ended as indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
(Dollars in thousands)	2012		2011		2012			2011
Analysis of allowance for loan losses:
Balance beginning of period	$	15,314	$	13,863	$	13,809		$	14,565
Net charge-offs:
Commercial, financial, and agricultural		724		1,273		713			2,077
Real estate construction - residential		—		309		(67	)		1,794
Real estate construction - commercial		—		512		(23	)		262
Real estate mortgage - residential		22		192		508			1,657
Real estate mortgage - commercial		2,270		844		3,449			1,556
Installment loans to individuals		78		53		209			172

Net charge-offs		3,094		3,183		4,789			7,518
Provision for loan losses		4,700		2,010		7,900			5,643

Balance at end of period	$	16,920	$	12,690	$	16,920		$	12,690

The provision for loan losses increased $2,690,000 to $4,700,000 for the three months ended September 30, 2012 compared to $2,010,000 for the three months end September 30, 2011, and increased $2,257,000, or 40.0%, to $7,900,000 for the nine months ended September 30, 2012 compared to $5,643,000 for the nine months ended September 30, 2011. Although net charge offs decreased $2,729,000 during the nine months ended September 30, 2012 in comparison to the nine months ended September 30, 2011, the provision for loan losses remains significant due to the level of specific reserves and the historical loss rate based on our Company’s last thirty-six months of charge off experience. Specific reserves on impaired loans were $5,862,000 at September 30, 2012 in comparison to $3,933,000 at September 30, 2011.

Our Company’s net loan charge-offs were $3,094,000, or 0.37% of average loans, for the three months ended September 30, 2012. In comparison, net loan charge-offs were $3,183,000, or 0.37% of average loans, for the three months ended September 30, 2011. Real estate mortgage - commercial net charge-offs represented 73% of the current quarter’s net charge-offs and primarily related to one loan relationship that went to foreclosure during the third quarter of 2012.

Our Company’s net loan charge-offs were $4,789,000, or 0.57% of average loans, for the nine months ended September 30, 2012 compared to net loan charge-offs of $7,518,000, or 0.86% of average loans, for the nine months ended September 30, 2011. Net charge-offs continued to include significant write-downs of approximately $4,000,000 during the nine months ended September 30, 2012 on properties going to foreclosure to reflect current collateral values. Real estate mortgage - commercial net charge-offs represented 72% of total net charge-offs during the nine months ended September 30, 2012 and primarily related to three significant commercial loan relationships that went to foreclosure. One of these foreclosures consisted of two hotels in the Branson area for which a $1,745,000 charge off was taken to value the property according to its current appraisal received during the third quarter of 2012.

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 incurred loss estimates and unallocated reserves.

The asset-specific reserve component applies to loans evaluated individually for impairment and is primarily 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 incurred loss component of the general reserve is determined by applying percentages to pools of loans by asset type. These percentages are determined by using historical loss percentages. These incurred 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 incurred 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 September 30, 2012 is a reasonable estimate of probable losses incurred at that date.

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:


(Dollars in thousands)	September 30, 2012			December 31, 2011
Allocation of allowance for loan losses at end of period:
Commercial, financial, and agricultural	$	3,560		$	1,804
Real estate construction - residential		641			1,188
Real estate construction - commercial		1,734			1,562
Real estate mortgage - residential		3,656			3,251
Real estate mortgage - commercial		7,078			5,734
Installment loans to individuals		245			267
Unallocated		6			3

Total	$	16,920		$	13,809

Percent of categories to total loans:
Commercial, financial, and agricultural		14.8	%		15.3	%
Real estate construction - residential		2.6			3.6
Real estate construction - commercial		5.3			5.7
Real estate mortgage - residential		26.3			24.1
Real estate mortgage - commercial		47.8			47.8
Installment loans to individuals		3.2			3.5

Total		100.0	%		100.0	%

Our Company’s allowance for loan losses increased $3,111,000 from December 31, 2011 to September 30, 2012. The overall increase primarily consisted of a $1,756,000 increase in the allocation for commercial, financial, and agricultural loans, and a $1,344,000 increase in the allocation for real estate mortgage - commercial loans. The ratio of the allowance for loan losses to nonperforming loans was 40.09% at September 30, 2012 compared to 25.73% at December 31, 2011.

At September 30, 2012, management determined that $16,914,000 of the $16,920,000 total allowance for loan losses represented asset-specific and incurred loss components and $6,000 was unallocated. This compares to $13,806,000 of the $13,809,000 total allowance for loan losses allocated to asset-specific and incurred loss components and $3,000 that was unallocated at December 31, 2011. Management’s analysis of assessing the general reserve portion of the allowance for loan losses on a detailed level by homogeneous loan categories for loans not considered impaired measures reserve requirements based on historical loss experiences for these certain types of loans and loan grades for the past twelve quarters.

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


(Dollars in thousands)	September 30, 2012		December 31, 2011
Allocation of allowance for loan losses:
Specific reserve allocation for impaired loans	$	5,862	$	3,747
General reserve allocation for all other non-impaired loans		11,058		10,062

Total	$	16,920	$	13,809

The asset-specific reserve component of our allowance for loan losses at September 30, 2012 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 general reserve component of our allowance for loan losses at September 30, 2012 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. Management realizes there are inherent weaknesses in relying solely on historical loss percentages and also considers qualitative factors in determining the allowance for loan losses. Internal factors management considers consist of underwriting standards, nature and volume of loans, lending staff experience, volume and severity of delinquencies and classified loans, loan review quality, value of underlying collateral, and concentrations of credit. Management also considers external factors such as economic conditions, market segments, regulatory and legal considerations, and competition. During the third quarter of 2011, management elected to further refine the methodology by distributing the previous quarter’s unallocated reserve throughout the call report classes of loans by adding qualitative adjustments in addition to the historical loss rate applied to determine the expected probable loss requirement for the current portfolio. 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 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 September 30, 2012, $5,862,000 of our Company’s allowance for loan losses was allocated to impaired loans totaling approximately $42,200,000 compared to $3,747,000 of our Company’s allowance for loan losses allocated to impaired loans totaling approximately $53,619,000 at December 31, 2011. Based upon detailed analysis of all impaired loans, management has determined that $12,956,000, or 31%, of impaired loans required no reserve allocation at September 30, 2012 compared to $23,223,000, or 43%, at December 31, 2011.

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.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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 excess reserves held at the Federal Reserve as follows:


(dollars in thousands)	September 30, 2012		December 31, 2011
Federal funds sold	$	—	$	75
Federal Reserve - excess reserves		440		19,997
Available for sale investment securities		216,788		213,806

Total	$	217,228	$	233,878

Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available for sale investment portfolio was $216,788,000 at September 30, 2012 and included an unrealized net gain of $6,160,000. The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately $25,518,000 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 purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law.

At September 30, 2012 total investment securities pledged for these purposes were as follows:


(dollars in thousands)	September 30, 2012		December 31, 2011
Investment securities pledged for the purpose of securing:
Federal Reserve Bank borrowings	$	3,443	$	1,819
Repurchase agreements		28,841		29,656
Other deposits		135,308		140,972

Total pledged, at fair value	$	167,592	$	172,447

At September 30, 2012 and December 31, 2011, our Company’s unpledged securities in the available for sale portfolio totaled approximately $49,196,000 and $41,359,000, respectively.

Liquidity is available from our Company’s base of core customer deposits, defined as demand, interest, checking, savings, and money market deposit accounts. At September 30, 2012, such deposits totaled $554,763,000 and represented 58.0% 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 $401,647,000 at September 30, 2012. These accounts are normally considered more volatile and higher costing representing 42.0% of total deposits at September 30, 2012.


(dollars in thousands)	September 30, 2012		December 31, 2011
Core deposit base:
Non-interest bearing demand	$	165,131	$	159,187
Interest checking		168,240		169,452
Savings and money market		221,392		215,147

Total	$	554,763	$	543,786

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:


(dollars in thousands)	September 30, 2012		December 31, 2011
Borrowings:
Securities sold under agreements to repurchase	$	24,109	$	24,516
FHLB advances		28,216		28,410
Subordinated notes		49,486		49,486

Total	$	101,811	$	102,412

Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which our Company maintains approved credit lines. As of September 30, 2012, under agreements with these unaffiliated banks, the Bank may borrow up to $15,000,000 in federal funds on an unsecured basis and $23,772,000 on a secured basis. There were $345,000 of federal funds purchased outstanding at September 30, 2012. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of our Company’s investment portfolio. At September 30, 2012 there was $24,109,000 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 September 30, 2012. The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB). As a member of the FHLB, the Bank has access to credit products of the FHLB. As of September 30, 2012, the Bank had $28,216,000 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 as follows:


	September 30, 2012								December 31, 2011
(dollars in thousands)	FHLB			Federal Reserve Bank		Federal Funds Purchased Lines			FHLB			Federal Reserve Bank		Federal Funds Purchased Lines
Advance equivalent	$	272,973		$	3,352	$	35,765		$	263,199		$	2,051	$	25,402
Advances outstanding		(28,216	)		—		(345	)		(43,657	)		—		—
Letters of credit issued		—			—		—			(206	)		—		—

Total available	$	244,757		$	3,352	$	35,420		$	219,336		$	2,051	$	25,402

At September 30, 2012, loans with a market value of $445,458,000 were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At September 30, 2012, investments with a market value of $29,133,000 were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.

Sources and Uses of Funds

Cash and cash equivalents were $20,286,000 at September 30, 2012 compared to $43,210,000 at December 31, 2011. The $22,924,000 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 nine months ended

September 30, 2012. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $12,553,000 for the nine months ended September 30, 2012.

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 $19,390,000. The cash outflow primarily consisted of $69,305,000 purchases of investment securities and a $20,929,000 increase in the loan portfolio. Partially offsetting this increase was $66,077,000 in proceeds from maturities, calls, and pay-downs of investment securities and $5,553,000 in proceeds from sales of other real estate owned and repossessions

Financing activities used cash of $16,087,000, resulting primarily from a $7,757,000 net decrease in time deposits and interest-bearing transaction accounts and $12,000,000 paid on the redemption of 12,000 shares of preferred stock. See Note 9 for further discussion. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during the remainder of 2012.

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. Our Company had $142,393,000 in unused loan commitments and standby letters of credit as of September 30, 2012. Although our Company’s current liquidity resources are adequate to fund this commitment level, 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. For the nine months ended September 30, 2012 and 2011, respectively, our Company paid cash dividends to its common and preferred shareholders totaling $1,673,000 and $1,806,000. A large portion of our Company’s liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $3,000,000 to our Company for each of the nine months ended September 30, 2012 and 2011, respectively. At September 30, 2012 and December 31, 2011, our Company had cash and cash equivalents totaling $2,125,000 and $13,282,000, respectively.

Capital Management

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

Quantitative measures established by regulations to ensure capital adequacy require our Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital to risk-weighted assets, and of Tier I capital to adjusted-average assets. Management believes, as of September 30, 2012 and December 31, 2011, our Company and the Bank each met all capital adequacy requirements to which they are subject.

The actual and required capital amounts and ratios for our Company and the Bank as of September 30, 2012 and December 31, 2011 follows:


	Actual					Minimum Capital requirements					Well-Capitalized Capital Requirements
(dollars in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio
September 30, 2012
Total capital (to risk-weighted assets):
Company	$	147,258		16.71	%	$	70,493		8.00	%		—		—
Hawthorn Bank		130,499		15.08			69,226		8.00		$	86,532		10.00	%

Tier I capital (to risk-weighted assets):
Company	$	117,714		13.36	%	$	35,246		4.00	%		—		—
Hawthorn Bank		119,613		13.82			34,613		4.00		$	51,919		6.00	%

Tier I capital (to adjusted average assets):
Company	$	117,714		10.09	%	$	34,993		3.00	%		—		—
Hawthorn Bank		119,613		10.46			34,299		3.00		$	57,166		5.00	%


December 31, 2011
Total capital (to risk-weighted assets):
Company	$	159,768		18.03	%	$	70,905		8.00	%		—		—
Hawthorn Bank		130,398		15.00			69,567		8.00		$	86,959		10.00	%

Tier I capital (to risk-weighted assets):
Company	$	134,391		15.16	%	$	35,453		4.00	%		—		—
Hawthorn Bank		119,498		13.74			34,784		4.00		$	52,175		6.00	%

Tier I capital (to adjusted average assets):
Company	$	134,391		11.52	%	$	34,993		3.00	%		—		—
Hawthorn Bank		119,498		10.45			34,309		3.00		$	57,181		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 and nine months ended September 30, 2012 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 September 30, 2012:


(Dollars in thousands)	Year 1			Year 2			Year 3			Year 4		Year 5		Over 5 years or no stated Maturity		Total
ASSETS
Investment securities	$	25,518		$	61,365		$	53,761		$	31,717	$	20,166	$	24,261	$	216,788
Interest-bearing deposits		457			—			—			—		—		—		457
Other restricted investments		4,285			—			—			—		—		—		4,285
Loans		419,640			152,022			117,176			39,552		89,668		25,040		843,098

Total	$	449,900		$	213,387		$	170,937		$	71,269	$	109,834	$	49,301	$	1,064,628


LIABILITIES

Savings, Now deposits	$	—		$	—		$	160,961		$	—	$	—	$	—	$	160,961
Rewards checking, Super Now, money market deposits		228,671													—		228,671
Time deposits		284,579			66,314			27,182			11,484		12,088		—		401,647
Federal funds purchased and securities sold under agreements to repurchase		24,109			—			—			—		—		—		24,109
Subordinated notes		49,486			—			—			—		—		—		49,486
Federal Home Loan Bank advances		28,205			11			—			—		—		—		28,216

Total	$	615,050		$	66,325		$	188,143		$	11,484	$	12,088	$	—	$	893,090


Interest-sensitivity GAP
Periodic GAP	$	(165,150	)	$	147,062		$	(17,206	)	$	59,785	$	97,746	$	49,301	$	171,538

Cumulative GAP	$	(165,150	)	$	(18,088	)	$	(35,294	)	$	24,491	$	122,237	$	171,538	$	171,538


Ratio of interest-earning assets to interest-bearing liabilities
Periodic GAP		0.73			3.22			0.91			6.21		9.09		NM		1.19
Cumulative GAP		0.73			0.97			0.96			1.03		1.14		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 three and nine months ended September 30, 2012.

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 September 30, 2012. Based upon and as of the date of that evaluation, our principal executive and principal financial officers concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required. It should be noted that any system of

disclosure controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any system of disclosure controls and procedures is based in part upon assumptions about the likelihood of future events. Because of these and other inherent limitations of any such system, there can be no assurance that any design will always succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

There has been no change in our Company’s internal control over financial reporting that occurred during the three months ended September 30, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Impact of New Accounting Standards

Balance Sheet In December 2011, the FASB issued ASU No. 2011-11, Disclosures about Offsetting Assets and Liabilities, amending ASC Topic 210. The objective of this update is to provide enhanced disclosures that will enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position. This includes the effects or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities within the scope of this update. These amendments are effective for annual periods beginning on or after January 1, 2013, and interim periods within those annual periods and retrospectively require disclosures for all comparative periods presented. The adoption of ASU 2011-11 is not expected to have a material impact on 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 13, Pending Litigation, in our Company’s Notes to Consolidated Financial Statements (unaudited).

Item 1A.	Risk Factors	None

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	None

Item 3.	Defaults Upon Senior Securities	None

Item 4.	Mine Safety Disclosures	None

Item 5.	Other Information	None

Item 6.	Exhibits


Exhibit No.		Description

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

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

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


				/s/ David T. Turner
November 14, 2012				David T. Turner, Chairman of the Board and
				Chief Executive Officer (Principal Executive Officer)

				/s/ W. Bruce Phelps
November 14, 2012				W. Bruce Phelps, Chief Financial Officer (Principal Financial
				Officer and Principal Accounting Officer)

HAWTHORN BANCSHARES, INC.

INDEX TO EXHIBITS

September 30, 2012 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	63

31.2	Certificate of the Chief Financial Officer of our Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	64

32.1	Certificate of the Chief Executive Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	65

32.2	Certificate of the Chief Financial Officer of our Company pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	66



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.