HAWTHORN BANCSHARES, INC. - Quarter Report: 2015 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2015

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

For the transition period from ______________to______________

Commission File Number: 0-23636

HAWTHORN BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

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

132 East High Street, Box 688, Jefferson City, Missouri 65102

(Address of principal executive offices) (Zip Code)

(573) 761-6100

(Registrant’s telephone number, including area code)

N/A

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

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

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

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

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 August 14, 2015, the registrant had 5,443,344 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)

	June 30,			December 31,
*(In thousands, except per share data)*	2015			2014
ASSETS
Cash and due from banks	$	22,413		$	22,364
Federal funds sold and other overnight interest-bearing deposits		10,922			20,445
Cash and cash equivalents		33,335			42,809
Investment in available-for-sale securities, at fair value		239,487			198,998
Other investments and securities, at cost		7,916			4,722
Total investment securities		247,403			203,720
Loans		863,654			861,213
Allowances for loan losses		(9,986	)		(9,099	)
Net loans		853,668			852,114
Premises and equipment - net		37,006			37,498
Mortgage servicing rights		2,727			2,762
Other real estate and repossessed assets - net		12,516			11,885
Accrued interest receivable		4,642			4,816
Cash surrender value - life insurance		2,319			2,284
Other assets		10,747			11,843
Total assets	$	1,204,363		$	1,169,731
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Non-interest bearing demand	$	206,478		$	207,700
Savings, interest checking and money market		465,253			442,059
Time deposits $100,000 and over		141,776			134,945
Other time deposits		175,359			184,810
Total deposits		988,866			969,514
Federal funds purchased and securities sold under agreements to repurchase		25,842			17,970
Subordinated notes		49,486			49,486
Federal Home Loan Bank advances		47,000			43,000
Accrued interest payable		365			373
Other liabilities		9,015			8,820
Total liabilities		1,120,574			1,089,163
Stockholders’ equity:
Common stock, $1 par value, authorized 15,000,000 shares; issued 5,395,844 shares, respectively		5,396			5,396
Surplus		38,753			35,901
Retained earnings		44,711			44,016
Accumulated other comprehensive loss, net of tax		(1,554	)		(1,228	)
Treasury stock; 161,858 shares, at cost		(3,517	)		(3,517	)
Total stockholders’ equity		83,789			80,568
Total liabilities and stockholders’ equity	$	1,204,363		$	1,169,731

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income (unaudited)

	Three Months Ended				Six Months Ended
	June 30,				June 30,
*(In thousands, except per share amounts)*	2015		2014		2015			2014
INTEREST INCOME
Interest and fees on loans	$	10,104	$	10,048	$	20,177		$	19,913
Interest on investment securities:
Taxable		890		874		1,792			1,755
Nontaxable		172		174		355			363
Federal funds sold and other overnight interest-bearing deposits		8		9		22			18
Dividends on other securities		40		20		66			40
Total interest income		11,214		11,125		22,412			22,089
INTEREST EXPENSE
Interest on deposits:
Savings, interest checking and money market		247		254		497			521
Time deposit accounts $100,000 and over		222		244		431			487
Other time deposits		268		357		562			736
Interest on federal funds purchased and securities sold under agreements to repurchase		9		4		16			9
Interest on subordinated notes		320		315		633			627
Interest on Federal Home Loan Bank advances		164		104		311			208
Total interest expense		1,230		1,278		2,450			2,588
Net interest income		9,984		9,847		19,962			19,501
Provision for loan losses		250		0		250			0
Net interest income after provision for loan losses		9,734		9,847		19,712			19,501
NON-INTEREST INCOME
Service charges and other fees		864		939		1,694			1,830
Bank card income and fees		629		616		1,216			1,159
Trust department income		274		228		478			431
Real estate servicing fees, net		186		22		180			199
Gain on sale of mortgage loans, net		434		257		781			448
Other		74		121		99			202
Total non-interest income		2,461		2,183		4,448			4,269
NON-INTEREST EXPENSE
Salaries and employee benefits		5,175		4,960		10,478			9,991
Occupancy expense, net		717		672		1,380			1,292
Furniture and equipment expense		484		453		915			896
FDIC insurance assessment		258		242		499			480
Legal, examination, and professional fees		339		282		610			508
Advertising and promotion		270		256		507			546
Postage, printing, and supplies		272		280		543			545
Processing, network, and bank card expense		807		791		1,596			1,579
Real estate foreclosure expense and (gains), net		158		172		(23	)		296
Other		787		703		1,470			1,385
Total non-interest expense		9,267		8,811		17,975			17,518
Income before income taxes		2,928		3,219		6,185			6,252
Income tax expense		1,001		1,121		2,120			2,167
Net income		1,927		2,098		4,065			4,085
Basic earnings per share	$	0.35	$	0.39	$	0.75		$	0.75
Diluted earnings per share	$	0.35	$	0.39	$	0.75		$	0.75

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (unaudited)

	Three Months Ended					Six Months Ended
	June 30,					June 30,
*(In thousands)*	2015			2014		2015			2014
Net income	$	1,927		$	2,098	$	4,065		$	4,085
Other comprehensive income, net of tax
Investment securities available-for-sale:
Unrealized (loss) gain on investment securities available-for-sale, net of tax		(860	)		981		(376	)		1,530
Adjustment for gain on sale of investment securities, net of tax		5			0		5			0
Defined benefit pension plans:
Amortization of prior service cost included in net periodic pension cost, net of tax		22			12		45			24
Total other comprehensive (loss) income		(833	)		993		(326	)		1,554
Total comprehensive income	$	1,094		$	3,091	$	3,739		$	5,639

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders' Equity (unaudited)

								Accumulated
								Other						Total
								Comprehensive						Stock -
	Common				Retained			Income			Treasury			holders'
*(In thousands)*	Stock		Surplus		Earnings			(Loss)			Stock			Equity
Balance, December 31, 2013	$	5,195	$	33,385	$	40,086		$	(769	)	$	(3,517	)	$	74,380
Net income		0		0		4,085			0			0			4,085
Other comprehensive income		0		0		0			1,554			0			1,554
Stock dividend		0		2,697		(2,697	)		0			0			0
Stock based compensation expense		0		10		0			0			0			10
Cash dividends declared, common stock		0		0		(504	)		0			0			(504	)
Balance, June 30, 2014	$	5,195	$	36,092	$	40,970		$	785		$	(3,517	)	$	79,525

Balance, December 31, 2014	$	5,396	$	35,901	$	44,016		$	(1,228	)	$	(3,517	)	$	80,568
Net income		0		0		4,065			0			0			4,065
Other comprehensive loss		0		0		0			(326	)		0			(326	)
Stock dividend		0		2,847		(2,847	)		0			0			0
Stock based compensation expense		0		5		0			0			0			5
Cash dividends declared, common stock		0		0		(523	)		0			0			(523	)
Balance, June 30, 2015	$	5,396	$	38,753	$	44,711		$	(1,554	)	$	(3,517	)	$	83,789

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)

	Six Months Ended June 30,
*(In thousands)*	2015			2014
Cash flows from operating activities:
Net income	$	4,065		$	4,085
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation expense		962			867
Net amortization of investment securities, premiums, and discounts		664			543
Stock based compensation expense		5			10
Change in fair value of mortgage servicing rights		262			247
Gain on sale of investment securities		(8	)		0
Gain on sales and dispositions of premises and equipment		(11	)		(39	)
Gain on sales and dispositions of other real estate and repossessed assets		(144	)		(152	)
Provision for other real estate owned		(6	)		174
Decrease in accrued interest receivable		174			248
Increase in cash surrender value -life insurance		(35	)		(38	)
Decrease in other assets		1,344			230
Decrease in accrued interest payable		(8	)		(33	)
Increase in other liabilities		195			1,565
Origination of mortgage loans for sale		(28,950	)		(14,214	)
Proceeds from the sale of mortgage loans		28,904			14,538
Gain on sale of mortgage loans, net		(781	)		(448	)
Other, net		(154	)		(83	)
Net cash provided by operating activities		6,478			7,500
Cash flows from investing activities:
Net increase in loans		(2,244	)		(19,664	)
Purchase of available-for-sale debt securities		(67,583	)		(39,607	)
Proceeds from maturities of available-for-sale debt securities		14,245			12,364
Proceeds from calls of available-for-sale debt securities		10,875			19,500
Proceeds from sales of available-for-sale debt securities		720			0
Proceeds from sales of FHLB stock		120			39
Purchases of FHLB stock		(3,315	)		0
Purchases of premises and equipment		(518	)		(738	)
Proceeds from sales of premises and equipment		11			43
Proceeds from sales of other real estate and foreclosed assets		1,036			3,124
Net cash used in investing activities		(46,653	)		(24,939	)
Cash flows from financing activities:
Net (decrease) increase in demand deposits		(1,222	)		8,789
Net increase in interest-bearing transaction accounts		23,194			29,751
Net decrease in time deposits		(2,620	)		(6,561	)
Net increase (decrease) in federal funds purchased and securities sold under agreements to repurchase		7,872			(8,235	)
Repayment of FHLB advances		(13,000	)		(10,000	)
FHLB advances		17,000			10,000
Cash dividends paid - common stock		(523	)		(504	)
Net cash provided by financing activities		30,701			23,240
Net (decrease) increase in cash and cash equivalents		(9,474	)		5,801
Cash and cash equivalents, beginning of period		42,809			28,439
Cash and cash equivalents, end of period	$	33,335		$	34,240

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (continued) (unaudited)

	Six Months Ended June 30,
*(In thousands)*	2015		2014
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	2,459	$	2,621
Income taxes	$	959	$	1,320
Noncash investing activities:
Other real estate and repossessed assets acquired in settlement of loans	$	1,517	$	305

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

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(1)

Summary of Significant Accounting Policies

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

The accompanying unaudited consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and disclosures required by U.S. GAAP for complete financial statements and should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014. Certain amounts in the 2014 condensed consolidated financial statements have been reclassified to conform to the 2014 condensed consolidated presentation. Such reclassifications have no effect on previously reported net income or stockholders’ equity.

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

Stock Dividend On July 1, 2015, the Company paid a special stock dividend of four percent to shareholders of record at the close of business on June 15, 2015. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

The following represents significant new accounting principles adopted in 2015:

Investments - Equity Method and Joint Ventures

The FASB issued ASU No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects, in January 2014. These amendments allow investors in low income housing tax credit entities to account for the investments using a proportional amortization method, provided that certain conditions are met, and recognize amortization of the investment as a component of income tax expense. In addition, disclosures are required that will enable users to understand the nature of the investments, and the effect of the measurement of the investments and the related tax credits on the investor's financial statements. This ASU was effective January 1, 2015, and the adoption of this pronouncement did not have a significant effect on the Company's consolidated financial statements.

Troubled Debt Restructurings by Creditors

The FASB issued ASU No. 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure, in January 2014. These amendments require companies to disclose the amount of foreclosed residential real estate property held and the recorded investment in consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process according to local requirements of the applicable jurisdiction. The ASU also defines when a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan. This ASU was effective January 1, 2015, and the adoption of this pronouncement did not have a significant effect on the Company's consolidated financial statements.

The FASB issued ASU No. 2014-14, Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure in August 2014. The objective of this update is to reduce diversity in practice by addressing the classification of foreclosed mortgage loans that are fully or partially guaranteed under government programs, including those guaranteed by the FHA and the VA. Some creditors reclassify those loans to real estate consistent with other foreclosed loans that do not have guarantees;

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

others reclassify the loans to other receivables. The amendments in this ASU require that a mortgage loan be derecognized and that a separate other receivable be recognized upon foreclosure if the following conditions are met: (1) The loan has a government guarantee that is not separable from the loan before foreclosure; (2) At the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under that claim; and (3) At the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed. Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. This ASU was effective January 1, 2015, and the adoption of this pronouncement did not have a significant effect on the Company's consolidated financial statements.

(2)

Loans and Allowance for Loan Losses

Loans

A summary of loans, by major class within the Company’s loan portfolio, at June 30, 2015 and December 31, 2014 is as follows:

	June 30,		December 31,
*(in thousands)*	2015		2014
Commercial, financial, and agricultural	$	162,067	$	154,834
Real estate construction - residential		12,088		18,103
Real estate construction - commercial		48,508		48,822
Real estate mortgage - residential		242,095		247,117
Real estate mortgage - commercial		378,398		372,321
Installment and other consumer		20,498		20,016

Total loans	$	863,654	$	861,213

The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the communities surrounding Jefferson City, Columbia, 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 automotive vehicles. At June 30, 2015, loans with a carrying value of $409.7 million, or $341.8 million fair value, were pledged to the 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 during the periods indicated.

	Three Months Ended June 30, 2015
	Commercial,			Real Estate			Real Estate		Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -		Mortgage -			Mortgage -			Loans to			Un-
*(in thousands)*	Agricultural			Residential			Commercial		Residential			Commercial			Individuals			allocated			Total
Balance at beginning of period	$	2,141		$	48		$	374	$	2,709		$	4,115		$	190		$	184		$	9,761
Additions:
Provision for loan losses		1,065			(148	)		45		(284	)		(354	)		66			(140	)		250
Deductions:
Loans charged off		122			0			5		140			8			113			0			388
Less recoveries on loans		(40	)		(117	)		0		(47	)		(117	)		(42	)		0			(363	)
Net loans charged off		82			(117	)		5		93			(109	)		71			0			25
Balance at end of period	$	3,124		$	17		$	414	$	2,332		$	3,870		$	185		$	44		$	9,986

	Six Months Ended June 30, 2015
	Commercial,			Real Estate			Real Estate			Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -			Mortgage -			Mortgage -			Loans to			Un-
*(in thousands)*	Agricultural			Residential			Commercial			Residential			Commercial			Individuals			allocated		Total
Balance at beginning of period	$	1,779		$	171		$	466		$	2,527		$	3,846		$	270		$	40	$	9,099
Additions:
Provision for loan losses		880			(448	)		(47	)		(43	)		(96	)		0			4		250
Deductions:
Loans charged off		150			0			5			211			32			161			0		559
Less recoveries on loans		(615	)		(294	)		0			(59	)		(152	)		(76	)		0		(1,196	)
Net loans (recovered) charged off		(465	)		(294	)		5			152			(120	)		85			0		(637	)
Balance at end of period	$	3,124		$	17		$	414		$	2,332		$	3,870		$	185		$	44	$	9,986

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

	Three Months Ended June 30, 2014
	Commercial,			Real Estate			Real Estate		Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -		Mortgage -			Mortgage -			Loans to			Un-
*(in thousands)*	Agricultural			Residential			Commercial		Residential			Commercial			Individuals			allocated		Total
Balance at beginning of period	$	2,452		$	479		$	550	$	3,090		$	6,019		$	255		$	0	$	12,845
Additions:
Provision for loan losses		(566	)		(65	)		145		(624	)		1,037			64			9		0
Deductions:
Loans charged off		54			0			77		75			705			114			0		1,025
Less recoveries on loans		(111	)		(59	)		0		(14	)		(77	)		(69	)		0		(330	)
Net loans charged off		(57	)		(59	)		77		61			628			45			0		695
Balance at end of period	$	1,943		$	473		$	618	$	2,405		$	6,428		$	274		$	9	$	12,150

	Six Months Ended June 30, 2014
	Commercial,			Real Estate			Real Estate		Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -		Mortgage -			Mortgage -			Loans to			Un-
*(in thousands)*	Agricultural			Residential			Commercial		Residential			Commercial			Individuals			allocated		Total
Balance at beginning of period	$	2,374		$	931		$	631	$	2,959		$	6,523		$	294		$	7	$	13,719
Additions:
Provision for loan losses		(472	)		(458	)		478		(486	)		885			51			2		0
Deductions:
Loans charged off		186			60			491		194			1,073			198			0		2,202
Less recoveries on loans		(227	)		(60	)		0		(126	)		(93	)		(127	)		0		(633	)
Net loans charged off		(41	)		0			491		68			980			71			0		1,569
Balance at end of period	$	1,943		$	473		$	618	$	2,405		$	6,428		$	274		$	9	$	12,150

Loans, or portions of loans, are charged off to the extent deemed uncollectible or a loss is confirmed. Loan charge-offs reduce the allowance for loan losses, and recoveries of loans previously charged off are added back to the allowance. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The following table provides the balance in the allowance for loan losses at June 30, 2015 and December 31, 2014, and the related loan balance by impairment methodology.

	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, and		Construction -		Construction -		Mortgage -		Mortgage -		Loans to		Un-
*(in thousands)*	Agricultural		Residential		Commercial		Residential		Commercial		Individuals		allocated		Total
June 30, 2015
Allowance for loan losses:
Individually evaluated for impairment	$	902	$	0	$	8	$	1,331	$	467	$	17	$	0	$	2,725
Collectively evaluated for impairment		2,222		17		406		1,001		3,403		168		44		7,261
Total	$	3,124	$	17	$	414	$	2,332	$	3,870	$	185	$	44	$	9,986
Loans outstanding:
Individually evaluated for impairment	$	4,425	$	0	$	1,934	$	6,792	$	4,550	$	124	$	0	$	17,825
Collectively evaluated for impairment		157,642		12,088		46,574		235,303		373,848		20,374		0		845,829
Total	$	162,067	$	12,088	$	48,508	$	242,095	$	378,398	$	20,498	$	0	$	863,654

December 31, 2014

Allowance for loan losses:
Individually evaluated for impairment	$	134	$	0	$	0	$	1,343	$	246	$	26	$	0	$	1,749
Collectively evaluated for impairment		1,645		171		466		1,184		3,600		244		40		7,350
Total	$	1,779	$	171	$	466	$	2,527	$	3,846	$	270	$	40	$	9,099
Loans outstanding:
Individually evaluated for impairment	$	7,541	$	1,750	$	2,096	$	7,878	$	16,464	$	234	$	0	$	35,963
Collectively evaluated for impairment		147,293		16,353		46,726		239,239		355,857		19,782		0		825,250
Total	$	154,834	$	18,103	$	48,822	$	247,117	$	372,321	$	20,016	$	0	$	861,213

Impaired Loans

Loans evaluated under ASC 310-10-35 include loans which are individually evaluated for impairment. All other loans are collectively evaluated for impairment under ASC 450-20. Impaired loans individually evaluated for impairment totaled $17.8 million and $36.0 million at June 30, 2015 and December 31, 2014, respectively, and are comprised of loans on non-accrual status and loans which have been classified as troubled debt restructurings (TDRs).

The net carrying value of impaired loans is based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. At June 30, 2015 and December 31, 2014, $14.8 million and $15.6 million, respectively, of impaired loans were evaluated based on the fair value less estimated selling costs of the loan’s collateral. Once the impairment amount is calculated, a specific reserve allocation is recorded. At June 30, 2015, $2.7 million of the Company’s allowance for loan losses was allocated to impaired loans totaling $17.8 million compared to $1.7 million of the Company's allowance for loan losses allocated to impaired loans totaling approximately $36.0 million at December 31, 2014. Management determined that $9.5 million, or 53%, of total impaired loans required no reserve allocation at June 30, 2015 compared to $28.5 million, or 79%, at December 31, 2014 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The categories of impaired loans at June 30, 2015 and December 31, 2014 are as follows:

	June 30,		December 31,
*(in thousands)*	2015		2014
Non-accrual loans	$	11,730	$	18,243
Troubled debt restructurings continuing to accrue interest		6,095		17,720
Total impaired loans	$	17,825	$	35,963

The following tables provide additional information about impaired loans at June 30, 2015 and December 31, 2014, respectively, segregated between loans for which an allowance has been provided and loans for which no allowance has been provided.

			Unpaid
	Recorded		Principal		Specific
*(in thousands)*	Investment		Balance		Reserves
June 30, 2015
With no related allowance recorded:
Commercial, financial and agricultural	$	2,322	$	2,358	$	0
Real estate - construction residential		0		0		0
Real estate - construction commercial		1,879		2,101		0
Real estate - residential		1,816		2,243		0
Real estate - commercial		3,472		3,736		0
Total	$	9,489	$	10,438	$	0
With an allowance recorded:
Commercial, financial and agricultural	$	2,103	$	2,258	$	902
Real estate - construction commercial		55		55		8
Real estate - residential		4,976		5,098		1,331
Real estate - commercial		1,078		1,348		467
Consumer		124		157		17
Total	$	8,336	$	8,916	$	2,725
Total impaired loans	$	17,825	$	19,354	$	2,725

			Unpaid
	Recorded		Principal		Specific
*(in thousands)*	Investment		Balance		Reserves
December 31, 2014
With no related allowance recorded:
Commercial, financial and agricultural	$	6,021	$	6,232	$	0
Real estate - construction residential		1,750		2,259		0
Real estate - construction commercial		2,096		2,319		0
Real estate - residential		3,213		3,270		0
Real estate - commercial		15,409		18,950		0
Consumer		36		36		0
Total	$	28,525	$	33,066	$	0
With an allowance recorded:
Commercial, financial and agricultural	$	1,520	$	1,528	$	134
Real estate - construction residential		0		0		0
Real estate - construction commercial		0		0		0
Real estate - residential		4,665		3,546		1,343
Real estate - commercial		1,055		1,171		246
Consumer		198		237		26
Total	$	7,438	$	6,482	$	1,749
Total impaired loans	$	35,963	$	39,548	$	1,749

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The following table presents by class, information related to the average recorded investment and interest income recognized on impaired loans during the periods indicated.

	Three Months Ended June 30,								Six Months Ended June 30,
	2015				2014				2015				2014
			Interest				Interest				Interest				Interest
	Average		Recognized		Average		Recognized		Average		Recognized		Average		Recognized
	Recorded		For the		Recorded		For the		Recorded		For the		Recorded		For the
*(in thousands)*	Investment		Period Ended		Investment		Period Ended		Investment		Period Ended		Investment		Period Ended
With no related allowance recorded:
Commercial, financial and agricultural	$	2,405	$	8	$	2,663	$	26	$	3,834	$	28	$	2,579	$	47
Real estate - construction residential		0		0		64		0		1,105		0		90		0
Real estate - construction commercial		2,101		0		6,688		0		3,633		0		6,844		0
Real estate - residential		2,246		8		3,281		8		3,328		20		3,091		14
Real estate - commercial		4,081		21		12,614		106		11,383		86		12,212		172
Consumer		0		0		8		0		10		1		16		0
Total	$	10,833	$	37	$	25,318	$	140	$	23,293	$	135	$	24,832	$	233
With an allowance recorded:
Commercial, financial and agricultural	$	2,263	$	7	$	2,103	$	7	$	1,677	$	13	$	2,222	$	15
Real estate - construction residential		0		0		2,260		0		565		0		2,265		0
Real estate - construction commercial		55		0		62		0		14		0		84		0
Real estate - residential		5,224		24		5,215		25		4,865		50		5,347		65
Real estate - commercial		1,360		0		4,904		0		2,056		0		4,749		0
Consumer		160		0		318		0		246		0		330		0
Total	$	9,062	$	31	$	14,862	$	32	$	9,423	$	63	$	14,997	$	80
Total impaired loans	$	19,895	$	68	$	40,180	$	172	$	32,716	$	198	$	39,829	$	313

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 $68,000 and $198,000, for the three months and six months ended June 30, 2015, respectively, compared to $172,000 and $313,000 for the three and six months ended June 30, 2014, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during the periods reported.

Delinquent and Non-Accrual Loans

The delinquency status of loans is determined based on the contractual terms of the notes. Borrowers are generally classified as delinquent once payments become 30 days or more past due. The Company’s policy is to discontinue the accrual of interest income on any loan when, in the opinion of management, the ultimate collectibility of interest or principal is no longer probable. In general, loans are placed on non-accrual when they become 90 days or more past due. However, management considers many factors before placing a loan on non-accrual, including the delinquency status of the loan, the overall financial condition of the borrower, the progress of management’s collection efforts and the value of the underlying collateral. Non-accrual loans are returned to accrual status when, in the opinion of management, the financial condition of the borrower indicates that the timely collectibility of interest and principal is probable and the borrower demonstrates the ability to pay under the terms of the note through a sustained period of repayment performance, which is generally six months.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The following table provides aging information for the Company’s past due and non-accrual loans at June 30, 2015 and December 31, 2014.

	Current or				90 Days
	Less Than				Past Due
	30 Days		30 - 89 Days		And Still
*(in thousands)*	Past Due		Past Due		Accruing		Non-Accrual		Total
June 30, 2015
Commercial, Financial, and Agricultural	$	158,166	$	294	$	24	$	3,583	$	162,067
Real Estate Construction - Residential		12,088		0		0		0		12,088
Real Estate Construction - Commercial		46,574		0		0		1,934		48,508
Real Estate Mortgage - Residential		237,316		1,201		208		3,370		242,095
Real Estate Mortgage - Commercial		375,097		582		0		2,719		378,398
Installment and Other Consumer		20,167		207		0		124		20,498
Total	$	849,408	$	2,284	$	232	$	11,730	$	863,654
December 31, 2014
Commercial, Financial, and Agricultural	$	149,366	$	189	$	0	$	5,279	$	154,834
Real Estate Construction - Residential		16,352		0		0		1,751		18,103
Real Estate Construction - Commercial		46,670		0		56		2,096		48,822
Real Estate Mortgage - Residential		239,469		3,229		0		4,419		247,117
Real Estate Mortgage - Commercial		366,653		1,203		0		4,465		372,321
Installment and Other Consumer		19,551		230		2		233		20,016
Total	$	838,061	$	4,851	$	58	$	18,243	$	861,213

Credit Quality

The Company categorizes loans into risk categories based upon an internal rating system reflecting management’s risk assessment. Loans are placed on watch status when one or more weaknesses that may result in the deterioration of the repayment exits or the Company’s credit position at some future date. Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified may have a well defined weakness or weaknesses that jeopardize the repayment of the debt. Such loans are characterized by the distinct possibility that the Company may sustain some loss if the deficiencies are not corrected. A loan is classified as a troubled debt restructuring (TDR) when a borrower is experiencing financial difficulties that lead to the restructuring of a loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. Loans classified as TDRs which are accruing interest are classified as performing TDRs. Loans classified as TDRs which are not accruing interest are classified as nonperforming TDRs and are included with all other nonaccrual loans for presentation purposes. It is the Company’s policy to discontinue the accrual of interest income on loans when management believes that the collection of interest or principal is doubtful. Loans are placed on non-accrual status when (1) deterioration in the financial condition of the borrower exists for which payment of full principal and interest is not expected, or (2) payment of principal or interest has been in default for a period of 90 days or more and the asset is not both well secured and in the process of collection. Subsequent interest payments received on such loans are applied to principal if any doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The following table presents the risk categories by class at June 30, 2015 and December 31, 2014.

*(in thousands)*	Commercial, Financial, & Agricultural		Real Estate Construction - Residential		Real Estate Construction - Commercial		Real Estate Mortgage - Residential		Real Estate Mortgage - Commercial		Installment and other Consumer		Total

At June 30, 2015
Watch	$	13,492		243	$	4,221	$	27,309	$	27,486	$	243	$	72,994
Substandard		299		1,013		99		2,841		2,762		53		7,067
Performing TDRs		842		0		0		3,422		1,831		0		6,095
Non-accrual		3,583		0		1,934		3,370		2,719		124		11,730
Total	$	18,216	$	1,256	$	6,254	$	36,942	$	34,798	$	420	$	97,886

At December 31, 2014
Watch	$	13,651	$	1,103	$	4,757	$	27,172	$	18,191	$	199	$	65,073
Substandard		926		90		1,211		3,124		4,102		139		9,592
Performing TDRs		2,262		0		0		3,459		11,999		0		17,720
Non-accrual		5,279		1,751		2,096		4,419		4,465		233		18,243
Total	$	22,118	$	2,944	$	8,064	$	38,174	$	38,757	$	571	$	110,628

Troubled Debt Restructurings

At June 30, 2015, loans classified as TDRs totaled $7.7 million, of which $1.6 million were classified as nonperforming TDRs and included in non-accrual loans and $6.1 million were classified as performing TDRs. At December 31, 2014, TDRs totaled $19.3 million, of which $1.6 million were classified as nonperforming TDRs included in non-accrual loans and $17.7 million were classified as performing TDRs. Both performing and nonperforming TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. Accordingly, specific reserves of $1.3 million and $1.0 million related to TDRs were allocated to the allowance for loan losses at June 30, 2015 and December 31, 2014, respectively.

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

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

	Three Months Ended June 30,
	2015						2014
	Recorded Investment (1)						Recorded Investment (1)
*(in thousands)*	Number of Contracts		Pre- Modification		Post- Modification		Number of Contracts		Pre- Modification		Post- Modification
Troubled Debt Restructurings
Commercial, financial and agricultural		0	$	0	$	0		1	$	72	$	72
Real estate mortgage - residential		1		366		355		0		0		0
Real estate mortgage - commercial		1		800		800		0		0		0
Total		2	$	1,166	$	1,155		1	$	72	$	72

	Six Months Ended June 30,
	2015						2014
	Recorded Investment (1)						Recorded Investment (1)
*(in thousands)*	Number of Contracts		Pre- Modification		Post- Modification		Number of Contracts		Pre- Modification		Post- Modification
Troubled Debt Restructurings
Commercial, financial and agricultural		3	$	250	$	240		3	$	244	$	244
Real estate mortgage - residential		3		510		464		1		1,256		1,185
Real estate mortgage - commercial		4		1,273		1,137		0		0		0
Total		10	$	2,033	$	1,841		4	$	1,500	$	1,429

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

The Company’s portfolio of loans classified as TDRs include concessions for the borrower due to deteriorated financial condition such as interest rates below the current market rate, deferring principal payments, and extending maturity dates. During the three months ended June 30, 2015, two loans meeting the TDR criteria were modified compared to one loan during the three months ended June 30, 2014. During the six months ended June 30, 2015, ten loans meeting the TDR criteria were modified compared to four loans during the six months ended June 30, 2014.

Upon default of a TDR, which is considered to be 90 days or more past due under the modified terms, impairment is measured based on the fair value of the underlying collateral less applicable selling costs. The impairment amount is either charged off as a reduction to the allowance for loan losses, provided for as a specific reserve within the allowance for loan losses, or in the process of foreclosure. There were no TDRs that defaulted within twelve months of its modification date during the three and six months ended June 30, 2015 and 2014, respectively.

(3) Other Real Estate and Repossessed Assets

June 30, December 31,

(in thousands) 2015 2014

Real estate construction - residential $ 0 $ 23

Real estate construction - commercial 9,831 9,831

Real estate mortgage - residential 447 417

Real estate mortgage - commercial 5,439 4,831

Repossessed assets 32 38

Total $ 15,749 $ 15,140

Less valuation allowance for other real estate owned (3,233 ) (3,255 )

Total other real estate and repossessed assets $ 12,516 $ 11,885

17

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

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

Three Months Ended June 30, Six Months Ended June 30,

2015 2014 2015 2014

Balance at beginning of period $ 14,984 $ 18,696 $ 15,140 $ 19,542

Additions 914 46 1,517 305

Proceeds from sales (153 ) (2,030 ) (1,036 ) (3,124 )

Charge-offs against the valuation allowance for other real estate owned 0 (1,488 ) (16 ) (1,644 )

Repossessed assets impairment write-downs 0 0 0 0

Net gain on sales 4 7 144 152

Total other real estate and repossessed assets $ 15,749 $ 15,231 $ 15,749 $ 15,231

Less valuation allowance for other real estate owned (3,233 ) (3,205 ) (3,233 ) (3,205 )

Balance at end of period $ 12,516 $ 12,026 $ 12,516 $ 12,026

Net charge-offs against the allowance for loan losses at the time of foreclosure were approximately $51,000 and $50,000 during the three and six months ended June 30, 2015, respectively, compared to $66,000 and $228,000 during the three and six months ended June 30, 2014, respectively.

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

Three Months Ended June 30, Six Months Ended June 30,

(in thousands) 2015 2014 2015 2014

Balance, beginning of period $ 3,233 $ 4,642 $ 3,255 $ 4,675

Provision for other real estate owned 0 51 (6 ) 174

Charge-offs 0 (1,488 ) (16 ) (1,644 )

Balance, end of period $ 3,233 $ 3,205 $ 3,233 $ 3,205

(4) Investment Securities

The amortized cost and fair value of debt securities classified as available-for-sale at June 30, 2015 and December 31, 2014 were as follows:

Gross Gross

Amortized Unrealized Unrealized

(in thousands) Cost Gains Losses Fair value

June 30, 2015

Government sponsored enterprises $ 76,667 $ 287 $ 110 76,844

Asset-backed securities 129,205 746 1,533 128,418

Obligations of states and political subdivisions 33,869 450 94 34,225

Total available-for-sale securities $ 239,741 $ 1,483 $ 1,737 $ 239,487

December 31, 2014

Government sponsored enterprises $ 57,002 $ 240 $ 143 57,099

Asset-backed securities 106,726 855 1,119 106,462

Obligations of states and political subdivisions 34,925 583 71 35,437

Total available-for-sale securities $ 198,653 $ 1,678 $ 1,333 $ 198,998

All of the Company’s investment securities are classified as available for sale. Agency bonds and notes, agency mortgage-backed securities and agency collateralized mortgage obligations (CMO) include securities issued by the Government National

18

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Mortgage Association (GNMA), a U.S. government agency, and the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal Home Loan Bank (FHLB), which are U.S. government-sponsored enterprises.

Other investments and securities primarily consist of Federal Home Loan Bank stock, subordinated debt securities, and the Company’s interest in statutory trusts. These securities are reported at cost in the amount of $7.9 million and $4.7 million as of June 30, 2015 and December 31, 2014, respectively.

Debt securities with carrying values aggregating approximately $181.6 million and $145.5 million at June 30, 2015 and December 31, 2014, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.

The amortized cost and fair value of debt securities classified as available-for-sale at June 30, 2015, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without prepayment penalties.

Amortized Fair

(in thousands) Cost Value

Due in one year or less $ 17,500 $ 17,591

Due after one year through five years 78,174 78,453

Due after five years through ten years 14,023 14,198

Due after ten years 839 827

Total 110,536 111,069

Asset-backed securities 129,205 128,418

Total available-for-sale securities $ 239,741 $ 239,487

Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2015 and December 31, 2014 were as follows:

Less than 12 months 12 months or more Total Total

Fair Unrealized Fair Unrealized Fair Unrealized

(in thousands) Value Losses Value Losses Value Losses

At June 30, 2015

Government sponsored

enterprises $ 30,032 $ (100 ) $ 3,990 $ (10 ) $ 34,022 $ (110 )

Asset-backed securities 48,526 (498 ) 36,908 (1,035 ) 85,434 (1,533 )

Obligations of states and

political subdivisions 8,289 (81 ) 489 (13 ) 8,778 (94 )

Total $ 86,847 $ (679 ) $ 41,387 $ (1,058 ) $ 128,234 $ (1,737 )

(in thousands)

At December 31, 2014

Government sponsored

enterprises $ 2,983 $ (4 ) $ 17,862 $ (139 ) $ 20,845 $ (143 )

Asset-backed securities 10,314 (50 ) 45,445 (1,069 ) 55,759 (1,119 )

Obligations of states and

political subdivisions 3,667 (15 ) 1,942 (56 ) 5,609 (71 )

Total $ 16,964 $ (69 ) $ 65,249 $ (1,264 ) $ 82,213 $ (1,333 )

The total available for sale portfolio consisted of approximately 321 securities at June 30, 2015. The portfolio included 110 securities having an aggregate fair value of $128.2 million that were in a loss position at June 30, 2015. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $41.4 million at fair value. The $1.7

19

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

million aggregate unrealized loss included in accumulated other comprehensive income at June 30, 2015 was caused by interest rate fluctuations.

The total available for sale portfolio consisted of approximately 300 securities at December 31, 2014. The portfolio included 74 securities having an aggregate fair value of $82.2 million that were in a loss position at December 31, 2014. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $65.2 million at fair value. The $1.3 million aggregate unrealized loss included in accumulated other comprehensive income at December 31, 2014 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 June 30, 2015 and December 31, 2014, respectively. In addition, the Company does not have the intent to sell these investments over the period of recovery, and it is not more likely than not that it will be required to sell such investment securities. There have been no investment securities gains and losses which have been recognized in earnings for the three months ended June 30, 2015 and 2014.

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

Three Months Ended June 30, Six Months Ended June 30,

(in thousands) 2015 2014 2015 2014

Gains realized on sales $ 8 $ 0 $ 8 $ 0

Losses realized on sales 0 0 0 0

Other-than-temporary impairment recognized 0 0 0 0

Investment securities gains $ 8 $ 0 $ 8 $ 0

(5) Intangible Assets

Mortgage Servicing Rights

At June 30, 2015, the Company was servicing approximately $312.6 million of loans sold to the secondary market compared to $313.9 million at December 31, 2014, and $315.3 million at June 30, 2014. Mortgage loan servicing fees, reported as non-interest income, earned on loans sold were $228,000 and $442,000 for the three and six months ended June 30, 2015, respectively, compared to $223,000 and $446,000 for the three and six months ended June 30, 2014, respectively.

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

Three Months Ended June 30, Six Months Ended June 30,

(in thousands) 2015 2014 2015 2014

Balance at beginning of period $ 2,662 $ 3,040 $ 2,762 $ 3,036

Originated mortgage servicing rights 107 72 227 122

Changes in fair value:

Due to change in model inputs and assumptions (1) 128 (36 ) 87 70

Other changes in fair value (2) (170 ) (165 ) (349 ) (317 )

Balance at end of period $ 2,727 $ 2,911 $ 2,727 $ 2,911

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

(2) Other changes in fair value reflect changes due to customer payments and passage of time.

20

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The following key data and assumptions were used in estimating the fair value of the Company’s MSRs as of the six months ended June 30, 2015 and 2014:

Six Months Ended June 30,

2015 2014

Weighted average constant prepayment rate 10.66 % 9.69 %

Weighted average note rate 3.92 % 4.00 %

Weighted average discount rate 9.34 % 9.15 %

Weighted average expected life (in years) 5.70 6.00

(6) Income Taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 34.2% for the three months ended June 30, 2015 compared to 34.8% for the three months ended June 30, 2014. Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 34.3% for the six months ended June 30, 2015 compared to 34.7% for the six months ended June 30, 2014

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, taxable income available in carryback years, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these temporary differences at June 30, 2015 and, therefore, did not establish a valuation reserve.

21



Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(7) Stockholders’ Equity

Accumulated Other Comprehensive Income (Loss)

The following details the change in the components of the Company’s accumulated other comprehensive (loss) income for the six months ended June 30, 2015 and 2014:

Six months ended June 30, 2015

Accumulated

Unrecognized Net Other

Unrealized Pension and Comprehensive

Gain (Loss) Postretirement (Loss)

(in thousands) on Securities (1) Costs (2) Income

Balance at beginning of period $ 214 $ (1,442 ) $ (1,228 )

Other comprehensive loss before reclassifications (607 ) 0 (607 )

Amounts reclassified from accumulated other comprehensive income 8 72 80

Current period other comprehensive (loss) income, before tax (599 ) 72 (527 )

Income tax benefit (expense) 228 (27 ) 201

Current period other comprehensive (loss) income, net of tax (371 ) 45 (326 )

Balance at end of period $ (157 ) $ (1,397 ) $ (1,554 )

Six months ended June 30, 2014

Accumulated

Unrecognized Net Other

Unrealized Pension and Comprehensive

Gain (Loss) Postretirement (Loss)

(in thousands) on Securities (1) Costs (2) Income

Balance at beginning of period $ (1,491 ) $ 722 $ (769 )

Other comprehensive income before reclassifications 2,468 0 2,468

Amounts reclassified from accumulated other comprehensive income 0 39 39

Current period other comprehensive income, before tax 2,468 39 2,507

Income tax expense (938 ) (15 ) (953 )

Current period other comprehensive income, net of tax 1,530 24 1,554

Balance at end of period $ 39 $ 746 $ 785

(1) The pre-tax amounts reclassified from accumulated other comprehensive income (loss) are included in gain on sale of investment securities in the consolidated statements of income.

(2) The pre-tax amounts reclassified from accumulated other comprehensive income (loss) are included in the computation of net periodic pension cost.

22

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(8) Employee Benefit Plans

Employee Benefits

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

Three Months Ended June 30, Six Months Ended June 30,

(in thousands) 2015 2014 2015 2014

Payroll taxes $ 270 $ 275 $ 599 $ 568

Medical plans 463 484 971 1,002

401k match and profit sharing 223 176 495 329

Pension plan 348 236 696 472

Other 24 28 43 39

Total employee benefits $ 1,328 $ 1,199 $ 2,804 $ 2,410

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

Pension

The 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 the Company’s funding policy for the defined benefit pension plan, contributions are made to a trust as necessary to provide for current service and for any unfunded accrued actuarial liabilities over a reasonable period. To the extent that these requirements are fully covered by assets in the trust, a contribution might not be made in a particular year. The pension contribution for the 2015 plan year of $716,000 is equal to the minimum annual required contribution and was paid April 15, 2015, which was determined under the pension relief provision of Moving Ahead for Progress in the 21^st Century Act (MAP 21) and Highway and Transportation Funding Act of 2014 (HATFA). Without the pension relief provisions, the minimum required contribution for the 2015 plan year would have been approximately $1,034,000.

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:

Estimated Actual

(in thousands) 2015 2014

Service cost - benefits earned during the year $ 1,325 $ 981

Interest costs on projected benefit obligations 838 732

Expected return on plan assets (957 ) (872 )

Expected administrative expenses 40 40

Amortization of prior service cost 79 79

Amortization of unrecognized net loss 66 0

Net periodic pension expense $ 1,391 $ 960

Pension expense - three months ended June 30, (actual) $ 348 $ 236

Pension expense - six months ended June 30, (actual) $ 696 $ 472

23

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(9) Stock Compensation

The Company’s stock option plan provides for the grant of options to purchase up to 592,168 shares of the Company’s common stock to officers and other key employees of the 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.

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

Weighted

Weighted Average Aggregate

Number average Contractual Intrinsic

of Exercise Term Value

Shares Price (in years) ($000)

Outstanding, beginning of period 100,361 $ 21.56

Granted 0 0.00

Exercised 0 0.00

Forfeited or expired (33,929 ) 21.66

Outstanding, June 30, 2015 66,432 $ 21.51 1.90 $ 0.00

Exercisable, June 30, 2015 57,975 $ 22.32 1.70 $ 0.00

Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2015.

Total stock-based compensation expense was not significant and $5,000 for the three and six months ended June 30, 2015, respectively, compared to $5,000 and $10,000 for the three and six months ended June 30, 2014, respectively. As of June 30, 2015, the total unrecognized compensation expense related to non-vested stock awards was $26,000 and the related weighted average period over which it is expected to be recognized is approximately 1.0 years.

(10) Earnings per Share

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

Three Months Ended June 30, Six Months Ended June 30,

(dollars in thousands, except per share data) 2015 2014 2015 2014

Basic earnings per share:

Net income available to shareholders $ 1,927 $ 2,098 $ 4,065 $ 4,085

Basic earnings per share $ 0.35 $ 0.39 $ 0.75 $ 0.75

Diluted earnings per share:

Net income available to shareholders $ 1,927 $ 2,098 $ 4,065 $ 4,085

Average shares outstanding 5,443,344 5,443,344 5,443,344 5,443,344

Effect of dilutive stock options 0 0 0 0

Average shares outstanding including dilutive stock options 5,443,344 5,443,344 5,443,344 5,443,344

Diluted earnings per share $ 0.35 0.39 $ 0.75 0.75

Under the treasury stock method, outstanding stock options are dilutive when the average market price of the Company’s common stock, when combined with the effect of any unamortized compensation expense, exceeds the option price during the period, except when the Company has a loss from continuing operations available to shareholders. In addition, proceeds from

24

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

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.

Options to purchase 66,432 shares during the three and six months ended June 30, 2015, compared to 101,330 shares during the three and six months ended June 30, 2014 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.

(11) Fair Value Measurements

The Company uses fair value measurements to record fair value adjustments to certain financial and nonfinancial assets and liabilities. The FASB ASC Topic 820, Fair Value Measurements and Disclosures, defines fair value, establishes a framework for the measurement of fair value, and enhances disclosures about fair value measurements. The standard applies whenever other standards require (permit) assets 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 June 30, 2015 and December 31, 2014, 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 the 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 have significantly decreased and on identifying circumstances when a transaction may not be considered orderly.

The 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 the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a recurring basis:

Available-for-Sale Securities

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

25

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Mortgage Servicing Rights

The fair value of mortgage servicing rights is based on the discounted value of estimated future cash flows utilizing contractual cash flows, servicing rate, constant prepayment rate, servicing cost, and discount rate factors. Accordingly, the fair value is estimated based on a valuation model that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees. The valuation models estimate the present value of estimated future net servicing income. The Company classifies its servicing rights as Level 3.

Fair Value Measurements

Quoted Prices

in Active

Markets for Other Significant

Identical Observable Unobservable

Assets Inputs Inputs

(in thousands) Fair Value (Level 1) (Level 2) (Level 3)

June 30, 2015

Assets:

Government sponsored enterprises $ 76,844 $ 0 $ 76,844 $ 0

Asset-backed securities 128,418 0 128,418 0

Obligations of states and political subdivisions 34,225 0 34,225 0

Mortgage servicing rights 2,727 0 0 2,727

Total $ 242,214 $ 0 $ 239,487 $ 2,727

December 31, 2014

Assets:

Government sponsored enterprises $ 57,099 $ 0 57,099 0

Asset-backed securities 106,462 0 106,462 0

Obligations of states and political subdivisions 35,437 0 35,437 0

Mortgage servicing rights 2,762 0 0 2,762

Total $ 201,760 $ 0 $ 198,998 $ 2,762

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

Three Months Ended June 30, Six Months Ended June 30,

(in thousands) 2015 2014 2015 2014

Balance at beginning of period $ 2,662 $ 3,040 $ 2,762 $ 3,036

Total gains or losses (realized/unrealized):

Included in earnings (42 ) (201 ) (262 ) (247 )

Included in other comprehensive income 0 0 0 0

Purchases 0 0 0 0

Sales 0 0 0 0

Issues 107 72 227 122

Settlements 0 0 0 0

Balance at end of period $ 2,727 $ 2,911 $ 2,727 $ 2,911

26

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Total gains (losses) included in earnings attributable to the change in unrealized gains or losses related to assets still held were $128,000 and $87,000 for the three and six months ended June 30, 2015, respectively, compared to $(36,000) and $70,000 for the three and six months ended June 30, 2014, respectively. MSR values have been falling steadily since 2014. The lower values are primarily related to faster prepay speed assumptions, consistent with lower long term interest rates. (See table below) The cost of compliance with new government regulations also has had an impact.

Quantitative Information about Level 3 Fair Value Measurements

Valuation Technique Unobservable Inputs Input Value

Six Months Ended June 30,

2015 2014

Mortgage servicing rights Discounted cash flows Weighted average constant prepayment rate 10.66 % 9.69 %

Weighted average discount rate 9.34 % 9.15 %

Weighted average expected life (in years) 5.70 6.00

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

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

Impaired Loans

The Company does not record loans at fair value on a recurring basis other than loans that are considered impaired. The net carrying value of impaired loans is generally based on fair values of the underlying collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. Once the fair value of the collateral has been determined and any impairment amount calculated, a specific reserve allocation is made. Because many of these inputs are not observable, the measurements are classified as Level 3. As of June 30, 2015, the Company identified $8.3 million in impaired loans that had specific allowances for losses aggregating $2.7 million. Related to these loans, there was $211,000 and $306,000 in charge-offs recorded during the three and six months ended June 30, 2015, respectively. As of June 30, 2014, the Company identified $14.4 million in impaired loans that had specific allowances for losses aggregating $4.3 million. Related to these loans, there was $1.0 million and $2.0 million in charge-offs recorded during the three and six months ended June 30, 2014, respectively.

Other Real Estate and Foreclosed Assets

Other real estate and foreclosed assets consisted of loan collateral that has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate assets are recorded as held for sale initially at the lower of the loan balance or fair value of the collateral less estimated selling costs. The Company relies on 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. Because many of these inputs are not observable, the measurements are classified as Level 3.

27

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Fair Value Measurements Using

Quoted Prices Three Six

in Active Months Months

Markets for Other Significant Ended Ended

Identical Observable Unobservable June 30, June 30,

Total Assets Inputs Inputs Total Gains Total Gains

(in thousands) Fair Value (Level 1) (Level 2) (Level 3) (Losses)* (Losses)*

June 30, 2015

Assets:

Impaired loans:

Commercial, financial, & agricultural $ 1,201 $ 0 $ 0 $ 1,201 $ (21 ) $ (21 )

Real estate construction - residential 0 0 0 0 0 0

Real estate construction - commercial 47 0 0 47 0 0

Real estate mortgage - residential 3,645 0 0 3,645 (135 ) (206 )

Real estate mortgage - commercial 611 0 0 611 (7 ) (30 )

Consumer 107 0 0 107 (48 ) (49 )

Total $ 5,611 $ 0 $ 0 $ 5,611 $ (211 ) $ (306 )

Other real estate and foreclosed assets $ 12,516 $ 0 $ 0 $ 12,516 $ (38 ) $ 190

June 30, 2014

Assets:

Impaired loans:

Commercial, financial, & agricultural $ 1,412 $ 0 $ 0 $ 1,412 $ (19 ) $ (122 )

Real estate construction - residential 1,749 0 0 1,749 0 (60 )

Real estate construction - commercial 39 0 0 39 (77 ) (491 )

Real estate mortgage - residential 3,698 0 0 3,698 (44 ) (138 )

Real estate mortgage - commercial 2,973 0 0 2,973 (704 ) (1,069 )

Consumer 221 0 0 221 (52 ) (70 )

Total $ 10,092 $ 0 $ 0 $ 10,092 $ (896 ) $ (1,950 )

Other real estate and foreclosed assets $ 12,026 $ 0 $ 0 $ 12,026 $ (1,499 ) $ (1,530 )

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

(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.

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.

28

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

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

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

Cash Surrender Value - Life Insurance

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

Accrued Interest Receivable and Payable

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

Deposits

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

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 cashflows. The discount rate is estimated using the rates currently offered for other borrowed money of similar remaining maturities.

29



Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

A summary of the carrying amounts and fair values of the Company’s financial instruments at June 30, 2015 and December 31, 2014 is as follows:

June 30, 2015

Fair Value Measurements

Quoted Prices

in Active Net

Markets for Other Significant

June 30, 2015 Identical Observable Unobservable

Carrying Fair Assets Inputs Inputs

(in thousands) Amount Value (Level 1) (Level 2) (Level 3)

Assets:

Cash and due from banks $ 22,413 $ 22,413 $ 22,413 $ 0 $ 0

Federal funds sold and overnight interest-bearing deposits 10,922 10,922 10,922 0 0

Investment in available-for-sale securities 239,487 239,487 0 239,487 0

Loans, net 853,668 852,497 0 0 852,497

Investment in FHLB stock 3,269 3,269 0 3,269 0

Mortgage servicing rights 2,727 2,727 0 0 2,727

Cash surrender value - life insurance 2,319 2,319 0 2,319 0

Accrued interest receivable 4,642 4,642 4,642 0 0

$ 1,139,447 $ 1,138,276 $ 37,977 $ 245,075 $ 855,224

Liabilities:

Deposits:

Non-interest bearing demand $ 206,478 $ 206,478 $ 206,478 $ 0 $ 0

Savings, interest checking and money market 465,253 465,253 465,253 0 0

Time deposits 317,135 318,305 0 0 318,305

Federal funds purchased and securities sold under agreements to repurchase 25,842 25,842 25,842 0 0

Subordinated notes 49,486 36,177 0 36,177 0

Federal Home Loan Bank advances 47,000 49,612 0 49,612 0

Accrued interest payable 365 365 365 0 0

$ 1,111,559 $ 1,102,032 $ 697,938 $ 85,789 $ 318,305

30

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

December 31, 2014

Fair Value Measurements

Quoted Prices

in Active Net

Markets for Other Significant

December 31, 2014 Identical Observable Unobservable

Carrying Fair Assets Inputs Inputs

(in thousands) amount value (Level 1) (Level 2) (Level 3)

Assets:

Cash and due from banks $ 22,364 $ 22,364 $ 22,364 $ 0 $ 0

Federal funds sold and overnight interest-bearing deposits 20,445 20,445 20,445 0 0

Investment in available-for-sale securities 198,998 198,998 0 198,998 0

Loans, net 852,114 854,062 0 0 854,062

Investment in FHLB stock 3,075 3,075 0 3,075 0

Mortgage servicing rights 2,762 2,762 0 0 2,762

Cash surrender value - life insurance 2,284 2,284 0 2,284 0

Accrued interest receivable 4,816 4,816 4,816 0 0

$ 1,106,858 $ 1,108,806 $ 47,625 $ 204,357 $ 856,824

Liabilities:

Deposits:

Non-interest bearing demand $ 207,700 $ 207,700 $ 207,700 $ 0 $ 0

Savings, interest checking and money market 442,059 442,059 442,059 0 0

Time deposits 319,755 321,041 0 0 321,041

Federal funds purchased and securities sold under agreements to repurchase 17,970 17,970 17,970 0 0

Subordinated notes 49,486 33,371 0 33,371 0

Federal Home Loan Bank advances 43,000 44,396 0 44,396 0

Accrued interest payable 373 373 373 0 0

$ 1,080,343 $ 1,066,910 $ 668,102 $ 77,767 $ 321,041

Off-Balance Sheet Financial Instruments

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

Limitations

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

31

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(13) Repurchase Reserve Liability

The Company’s repurchase reserve liability for estimated losses incurred on sold loans was $160,000 at June 30, 2015 and December 31, 2014, respectively. This liability represents management’s estimate of the potential repurchase or make-whole liability for residential mortgage loans originated for sale that may arise from representation and warranty claims that could relate to a variety of issues, including but not limited to, misrepresentation of facts, appraisal issues, or program requirements that may not meet investor guidelines. At June 30, 2015, the Company was servicing 3,029 loans sold to the secondary market with a balance of approximately $312.6 million compared to 3,057 loans sold with a balance of approximately $313.9 million at December 31, 2014.

(14) Commitments and Contingencies

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

The Company’s extent of involvement and maximum potential exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for financial instruments included on its consolidated balance sheets. At June 30, 2015, no amounts have been accrued for any estimated losses for these financial instruments.

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

June 30, December 31,

(in thousands) 2015 2014

Commitments to extend credit $ 145,732 $ 135,137

Commitments to originate residential first and second mortgage loans 4,393 1,640

Standby letters of credit 1,361 1,621

Total 151,486 138,398

Commitments

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since certain of the commitments and letters of credit are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, furniture and equipment, and real estate.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support contractual obligations of the Company’s customers. The approximate remaining term of standby letters of credit range from one month to five years at June 30, 2015.

Pending Litigation

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

32

Item 2 - Management’s Discussion and Analysis of Financial Condition

And Results of Operations

Forward-Looking Statements

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

· statements that are not historical in nature, and

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

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

· competitive pressures among financial services companies may increase significantly,

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

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

· increases in non-performing assets in the Company’s loan portfolios and adverse economic conditions may necessitate increases to our provisions for loan losses,

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

· legislative or regulatory changes may adversely affect the business in which the Company and its subsidiaries are engaged, and

· changes may occur in the securities markets.

We have described under the caption Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014, and in other reports filed with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that have not been identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made.

Overview

Crucial to the Company’s community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, the Company, with $1.2 billion in assets at June 30, 2015, provides a broad range of commercial and personal banking services. The Bank’s specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate, Small Business (SBA) loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include the communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson, and Lee's Summit, Missouri.

The Company's primary source of revenue is net interest income derived primarily from lending and deposit taking activities. Much of the Company's business is commercial, commercial real estate development, and mortgage lending. The Company's income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancings.

The success of the Company's growth strategy depends primarily on the ability of its banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. The Company's financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and

33

existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of the Company's growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control.

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

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

CRITICAL ACCOUNTING POLICIES

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

Allowance for Loan Losses

Management has identified the accounting policy related to the allowance for loan losses as critical to the understanding of the Company's results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on the Company’s business operations is provided in note 1 to the Company’s unaudited consolidated financial statements and is also discussed in the Lending and Credit Management section below. Many of the loans are deemed collateral dependent for purposes of the measurement of the impairment loss, thus the fair value of the underlying collateral and sensitivity of such fair values due to changing market conditions, supply and demand, condition of the collateral and other factors can be volatile over periods of time. Such volatility can have an impact on the financial performance of the Company.

Other Real Estate and Foreclosed Assets

Other real estate and foreclosed assets consist of loan collateral that has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate assets are initially recorded as held for sale at the fair value of the collateral less estimated selling costs. Any adjustment is recorded as a charge-off against the allowance for loan losses. The Company relies on external appraisals and assessment of property values by 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, net. The Company establishes a valuation allowance related to other real estate owned on an asset-by-asset basis. The valuation allowance is created during the holding period when the fair value less cost to sell is lower than the cost of the property.

34



SELECTED CONSOLIDATED FINANCIAL DATA

The following table presents selected consolidated financial information for the Company as of and for each of the three and six months ended June 30, 2015 and 2014, respectively. The selected consolidated financial data should be read in conjunction with the unaudited consolidated financial statements of the Company, including the related notes, presented elsewhere herein.



Selected Financial Data

Three Months Ended Six Months Ended

June 30, June 30,

(In thousands, except per share data) 2015 2014 2015 2014

Per Share Data

Basic earnings per share $ 0.35 $ 0.39 $ 0.75 $ 0.75

Diluted earnings per share 0.35 0.39 0.75 0.75

Dividends paid on common stock 261 252 523 504

Book value per share 15.39 14.61

Market price per share 14.32 12.04

Selected Ratios

(Based on average balance sheets)

Return on total assets 0.65 % 0.72 % 0.69 % 0.71 %

Return on stockholders' equity 9.21 % 10.83 % 9.89 % 10.75 %

Stockholders' equity to total assets 7.02 % 6.68 % 6.95 % 6.63 %

Efficiency ratio (1) 74.46 % 73.24 % 73.64 % 73.70 %

(Based on end-of-period data)

Stockholders' equity to assets 6.96 % 6.79 %

Total Capital Ratio (to risk weighted assets) 14.87 % 15.55 %

Tier 1 Capital Ratio (to risk weighted assets) 11.82 % 11.85 %

Tier 1 Capital Ratio (to average assets) (2) 9.36 % 9.00 %

Common Equity Tier 1 Capital (to risk weighted assets) (3) 8.82 % NA %

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

(2) Tier I Capital (leverage) Ratio is calculated by dividing Tier 1 capital by average total consolidated assets.

(3) Calculated under Basel III rules, which became effective January 1, 2015.

35

RESULTS OF OPERATIONS ANALYSIS

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

Three Months Ended June 30, Six Months Ended June 30,

(In thousands) 2015 2014 $ Change % Change 2015 2014 $ Change % Change

Net interest income $ 9,984 $ 9,847 $ 137 1.4 % $ 19,962 $ 19,501 $ 461 2.4 %

Provision for loan losses 250 - 250 - 250 - 250 -

Noninterest income 2,461 2,183 278 12.7 4,448 4,269 179 4.2

Noninterest expense 9,267 8,811 456 5.2 17,975 17,518 457 2.6

Income before income taxes 2,928 3,219 (291 ) (9.0 ) 6,185 6,252 (67 ) (1.1 )

Income tax expense 1,001 1,121 (120 ) (10.7 ) 2,120 2,167 (47 ) (2.2 )

Net income $ 1,927 $ 2,098 $ (171 ) (8.2 )% $ 4,065 $ 4,085 $ (20 ) (0.5 )%

Business Events For the seventh consecutive year, on July 1, 2015, the Company distributed a four percent stock dividend to shareholders of record at the close of business on June 15, 2015. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect the stock dividend.

Consolidated net income of $1.9 million, or $0.35 per diluted share, for the three months ended June 30, 2015 decreased $171,000 compared to $2.1 million, or $0.39 per diluted share, for the three months ended June 30, 2014. For the three months ended June 30, 2015, the return on average assets was 0.65%, the return on average stockholders’ equity was 9.21%, and the efficiency ratio was 74.46%.

Consolidated net income was consistent at $4.1 million, or $0.75 per diluted share, for both the six months ended June 30, 2015 and 2014. For the six months ended June 30, 2015, the return on average assets was 0.69%, the return on average stockholders’ equity was 9.89%, and the efficiency ratio was 73.64%.

Net interest income was $10.0 million and $20.0 million for the three and six months ended June 30, 2015, respectively, compared to $9.8 million and $19.5 million for the three and six months ended June 30, 2014, respectively. The net interest margin decreased to 3.63% and 3.67% for the three and six months ended June 30, 2015, respectively, compared to 3.70% and 3.71% for the three and six months ended June 30, 2014, respectively. These changes are discussed in greater detail under the Average Balance Sheets and Rate and Volume Analysis section below.

The provision for loan losses was $250,000 for the three and six months ended June 30, 2015 compared to no provision for the three and six months ended June 30, 2014. The increase over 2014 was primarily due to an increase in specific reserves primarily related to two loan relationships.

The Company’s net charge-offs were $25,000 for the three months ended June 30, 2015 compared to $695,000 for the three months ended June 30, 2014. The Company’s net recoveries were $637,000 for the six months ended June 30, 2015, or (0.07%) of average loans, compared to net charge-offs of $1.6 million, or 0.19% of average loans, for the six months ended June 30, 2014. Non-performing loans totaled $18.1 million, or 2.09% of total loans, at June 30, 2015 compared to $36.0 million, or 4.18% of total loans, at December 31, 2014, and $37.4 million, or 4.36% of total loans, at June 30, 2014. These changes are discussed in greater detail under the Lending and Credit Management section below.

Non-interest income increased $278,000, or 12.7%, for the three months ended June 30, 2015, and increased $179,000, or 4.2%, for the six months ended June 30, 2015 compared to the three and six months ended June 30, 2014, respectively. These changes are discussed in greater detail below under Non-interest Income.

Non-interest expense increased $456,000, or 5.2%, for the three months ended June 30, 2015, and increased $457,000, or 2.6%, for the six months ended June 30, 2015 compared to the three and six months ended June 30, 2014, respectively. These changes are discussed in greater detail below under Non-interest Expense.

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Average Balance Sheets

Net interest income is the largest source of revenue resulting from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the periods ended June 30, 2015 and 2014, respectively.

37

Three Months Ended June 30,

(In thousands) 2015 2014

Interest Rate Interest Rate

Average Income/ Earned/ Average Income/ Earned/

Balance Expense(1) Paid(1) Balance Expense(1) Paid(1)

ASSETS

Loans: (2) (4)

Commercial $ 156,362 $ 1,822 4.67 % $ 144,116 $ 1,733 4.82 %

Real estate construction - residential 13,487 223 6.63 24,131 257 4.27

Real estate construction - commercial 46,483 507 4.37 59,644 639 4.30

Real estate mortgage - residential 247,262 2,873 4.66 230,675 2,770 4.82

Real estate mortgage - commercial 377,636 4,460 4.74 371,450 4,425 4.78

Consumer 20,101 271 5.41 18,734 260 5.57

Total loans $ 861,331 $ 10,156 4.73 % $ 848,750 $ 10,084 4.77 %

Investment securities: (3)

U.S. Treasury $ 0 $ 0 0.00 % $ 154 $ - 0.00 %

Government sponsored enterprises 76,505 267 1.40 69,889 251 1.44

Asset backed securities 130,668 608 1.87 113,163 609 2.16

State and municipal 34,873 273 3.14 32,530 275 3.39

Total investment securities $ 242,046 $ 1,148 1.90 % $ 215,736 $ 1,135 2.11 %

Other investments and securities, at cost 5,616 40 2.86 3,962 20 2.02

Federal funds sold and interest bearing deposits in other financial institutions 9,024 8 0.36 13,612 9 0.27

Total interest earning assets $ 1,118,017 $ 11,352 4.07 % $ 1,082,060 $ 11,248 4.17 %

All other assets 87,922 94,027

Allowance for loan losses (9,939 ) (12,838 )

Total assets $ 1,196,000 $ 1,163,249

LIABILITIES AND

STOCKHOLDERS' EQUITY

NOW accounts $ 209,967 $ 128 0.24 % $ 207,750 $ 142 0.27 %

Savings 89,522 12 0.05 82,992 13 0.06

Money market 170,067 107 0.25 162,756 99 0.24

Time deposits of $100,000 and over 141,881 222 0.63 145,755 244 0.67

Other time deposits 177,627 268 0.61 199,531 357 0.72

Total time deposits $ 789,064 $ 737 0.37 % $ 798,784 $ 855 0.43 %

Federal funds purchased and securities sold under agreements to repurchase 22,565 9 0.16 19,812 4 0.08

Subordinated notes 49,486 320 2.59 49,486 315 2.55

Federal Home Loan Bank Advances 42,242 164 1.56 24,000 104 1.74

Total borrowings $ 114,293 $ 493 1.73 % $ 93,298 $ 423 1.82 %

Total interest bearing liabilities $ 903,357 $ 1,230 0.55 % $ 892,082 $ 1,278 0.57 %

Demand deposits 199,513 187,257

Other liabilities 9,207 6,178

Total liabilities 1,112,077 1,085,517

Stockholders' equity 83,923 77,732

Total liabilities and stockholders' equity $ 1,196,000 $ 1,163,249

Net interest income (FTE) 10,122 9,970

Net interest spread 3.52 % 3.60 %

Net interest margin 3.63 % 3.70 %

(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 $138,000 and $123,000 for the three months ended June 30, 2015 and 2014, respectively.

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

(3) Average balances based on amortized cost.

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

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Six Months Ended June 30,

(In thousands) 2015 2014

Interest Rate Interest Rate

Average Income/ Earned/ Average Income/ Earned/

Balance Expense(1) Paid(1) Balance Expense(1) Paid(1)

ASSETS

Loans: (2) (4)

Commercial $ 152,553 $ 3,656 4.83 % $ 141,104 $ 3,310 4.73 %

Real estate construction - residential 15,573 404 5.23 23,550 495 4.24

Real estate construction - commercial 48,128 1,067 4.47 58,214 1,245 4.31

Real estate mortgage - residential 246,774 5,783 4.73 229,647 5,522 4.85

Real estate mortgage - commercial 376,126 8,840 4.74 373,575 8,880 4.79

Consumer 19,932 530 5.36 19,118 530 5.59

Total loans $ 859,086 $ 20,280 4.76 % $ 845,208 $ 19,982 4.77 %

Investment securities: (3)

U.S. Treasury $ 0 $ 0 0.00 % $ 576 $ 4 1.40 %

Government sponsored enterprises 72,844 511 1.41 68,364 468 1.38

Asset backed securities 126,799 1,250 1.99 111,064 1,258 2.28

State and municipal 35,266 563 3.22 32,874 570 3.50

Total investment securities $ 234,909 $ 2,324 2.00 % $ 212,878 $ 2,300 2.18 %

Other investments and securities, at cost 5,116 66 2.60 4,003 40 2.02

Federal funds sold and interest bearing deposits in other financial institutions 13,429 22 0.33 12,143 18 0.30

Total interest earning assets $ 1,112,540 $ 22,692 4.11 % $ 1,074,232 $ 22,340 4.19 %

All other assets 89,222 95,365

Allowance for loan losses (9,648 ) (13,258 )

Total assets $ 1,192,114 $ 1,156,339

LIABILITIES AND

STOCKHOLDERS' EQUITY

NOW accounts $ 212,777 $ 260 0.25 % $ 208,704 $ 291 0.28 %

Savings 87,533 23 0.05 81,303 33 0.08

Money market 171,303 213 0.25 162,118 197 0.25

Time deposits of $100,000 and over 139,135 432 0.63 144,507 487 0.68

Other time deposits 179,992 562 0.63 201,135 736 0.74

Total time deposits $ 790,740 $ 1,490 0.38 % $ 797,767 $ 1,744 0.44 %

Federal funds purchased and securities sold under agreements to repurchase 20,705 16 0.16 19,606 9 0.09

Subordinated notes 49,486 633 2.58 49,486 627 2.56

Federal Home Loan Bank Advances 41,227 311 1.52 24,580 208 1.71

Total borrowings $ 111,418 $ 960 1.74 % $ 93,672 $ 844 1.82 %

Total interest bearing liabilities $ 902,158 $ 2,450 0.55 % $ 891,439 $ 2,588 0.59 %

Demand deposits 196,937 182,087

Other liabilities 10,161 6,198

Total liabilities 1,109,256 1,079,724

Stockholders' equity 82,858 76,615

Total liabilities and stockholders' equity $ 1,192,114 $ 1,156,339

Net interest income (FTE) 20,242 19,752

Net interest spread 3.56 % 3.60 %

Net interest margin 3.67 % 3.71 %

(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 $280,000 and $251,000 for the six months ended June 30, 2015 and 2014, 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.

39

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 six months ended June 30, 2015 compared to the three and six months ended June 30, 2014. The change in interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.

Three Months Ended June 30, Six Months Ended June 30,

2015 vs. 2014 2015 vs. 2014

       Change due to              Change due to

Total Average Average Total Average Average

(In thousands) Change Volume Rate Change Volume Rate

Interest income on a fully taxable equivalent basis: (1)

Loans: (2) (4)

Commercial $ 89 $ 144 $ (55 ) $ 346 $ 274 $ 72

Real estate construction - residential (34 ) (141 ) 107 (91 ) (191 ) 100

Real estate construction - commercial (132 ) (143 ) 11 (178 ) (223 ) 45

Real estate mortgage - residential 103 195 (92 ) 261 404 (143 )

Real estate mortgage - commercial 35 74 (39 ) (40 ) 61 (101 )

Consumer 11 19 (8 ) 0 23 (23 )

Investment securities: (3)

U.S. Treasury 0 0 0 (4 ) (2 ) (2 )

Government sponsored entities 16 23 (7 ) 43 32 11

Asset backed securities (1 ) 87 (88 ) (8 ) 166 (174 )

State and municipal (2 ) 19 (21 ) (7 ) 39 (46 )

Other investments and securities, at cost 20 10 10 26 13 13

Federal funds sold and interest bearing deposits in other financial institutions (1 ) (4 ) 3 4 2 2

Total interest income 104 283 (179 ) 352 598 (246 )

Interest expense:

NOW accounts (14 ) 2 (16 ) (31 ) 6 (37 )

Savings (1 ) 1 (2 ) (10 ) 3 (13 )

Money market 8 4 4 16 11 5

Time deposits of $100,000 and over (22 ) (6 ) (16 ) (55 ) (18 ) (37 )

Other time deposits (89 ) (36 ) (53 ) (174 ) (72 ) (102 )

Federal funds purchased and securities sold under agreements to repurchase 5 1 4 7 1 6

Subordinated notes 5 0 5 6 0 6

Federal Home Loan Bank advances 60 72 (12 ) 103 128 (25 )

Total interest expense (48 ) 38 (86 ) (138 ) 59 (197 )

Net interest income on a fully taxable equivalent basis $ 152 $ 245 $ (93 ) $ 490 $ 539 $ (49 )

(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 $138,000 and $280,000 for the three and six months June 30, 2015, respectively, compared to $123,000 and $251,000 for the three and six months ended June 30, 2014, respectively.

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

(3) Average balances based on amortized cost.

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

Financial results for the three months ended June 30, 2015 compared to the three months ended June 30, 2014, reflected an increase in net interest income, on a tax equivalent basis, of $152,000, or 1.52%, respectively, and financial results for the six months ended June 30, 2015 compared to the six months ended June 30, 2014 reflected an increase of $490,000, or 2.48%, respectively.

Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.63% for the three months ended June 30, 2015 compared to 3.70% for the three months ended June 30, 2014, respectively, and decreased to 3.67% for the six months ended June 30, 2015 compared to 3.71% for the six months ended June 30, 2014, respectively.

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The increase in net interest income for the three and six months ended June 30, 2015 over the three and six months ended June 30, 2014 was primarily due to an increase in average earning assets and the decrease in the net interest margin was primarily due to a slight contraction in the net interest spread.

Average interest-earning assets increased $36.0 million, or 3.32%, to $1.12 billion for the three months ended June 30, 2015 compared to $1.08 billion for the three months ended June 30, 2014, and average interest bearing liabilities increased $11.3 million, or 1.26%, to $903.4 million for the three months ended June 30, 2015 compared to $892.1 million for the three months ended June 30, 2014.

Average interest-earning assets increased $38.3 million, or 3.57%, to $1.11 billion for the six months ended June 30, 2015 compared to $1.07 billion for the six months ended June 30, 2014, and average interest bearing liabilities increased $10.7 million, or 1.20%, to $902.2 million for the six months ended June 30, 2015 compared to $891.4 million for the six months ended June 30, 2014

Total interest income (expressed on a fully taxable equivalent basis) increased to $11.4 million and $22.7 million for the three and six months ended June 30, 2015, respectively, compared to $11.2 million and $22.3 million for the three and six months ended June 30, 2014, respectively. The Company’s rates earned on interest earning assets were 4.07% and 4.11% for the three and six months ended June 30, 2015, respectively, compared to 4.17% and 4.19% for the three and six months ended June 30, 2014, respectively.

Interest income on loans was $10.2 million and $20.3 million for the three and six months ended June 30, 2015, respectively, compared to $10.1 million and $20.0 million for the three and six months ended June 30, 2014, respectively.

Average loans outstanding increased $12.6 million, or 1.5%, to $861.3 million for the three months ended June 30, 2015 compared to $848.8 million for the three months ended June 30, 2014. The average yield on loans receivable decreased to 4.73% for the three months ended June 30, 2015 compared to 4.77% for the three months ended June 30, 2014

For the six months ended June 30, 2015, average loans outstanding increased $13.9 million, or 1.6%, to $859.1 million compared to $845.2 million for the six months ended June 30, 2014. The average yield on loans receivable decreased to 4.76% for the six months ended June 30, 2015 compared to 4.77% for the six months ended June 30, 2014. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

Total interest expense decreased to $1.2 million and $2.5 million for the three and six months ended June 30, 2015, respectively, compared to $1.3 million and $2.6 million for the three and six months ended June 30, 2014, respectively. The Company’s rates paid on interest bearing liabilities were 0.55% for both the three and six months ended June 30, 2015 compared to 0.57% and 0.59% for the three and six months ended June 30, 2014, respectively. See the Liquidity Management section for further discussion.

Interest expense on deposits decreased to $737,000 and $1.5 million for the three and six months ended June 30, 2015, respectively, compared to $855,000 and $1.7 million for the three and six months ended June 30, 2014, respectively.

Average time deposits decreased $9.7 million, or 1.22%, to $789.1 million for the three months ended June 30, 2015 compared to $798.8 million for the three months ended June 30, 2014. The average cost of deposits decreased to 0.37% for the three months ended June 30, 2015 compared to 0.43% for the three months ended June 30, 2014 primarily as a result of lower market interest rates.

For the six months ended June 30, 2015, average time deposits decreased $7.0 million, or 0.88%, to $790.7 million for the six months ended June 30, 2015 compared to $797.8 million for the six months ended June 30, 2014. The average cost of deposits decreased to 0.38% for the six months ended June 30, 2015 compared to 0.44% for the six months ended June 30, 2014 primarily as a result of lower market interest rates.

Interest expense on borrowings increased to $493,000 and $960,000 for the three and six months ended June 30, 2015, respectively, compared to $423,000 and $844,000 for the three and six months ended June 30, 2014, respectively. Average borrowings increased to $114.3 million and $111.4 million for the three and six months ended June 30, 2015, respectively, compared to $93.3 million and $93.7 million for the three and six months ended June 30, 2014, respectively. See the Liquidity Management section for further discussion.

41

Non-interest Income and Expense

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

Three Months Ended June 30, Six Months Ended June 30,

$ % $ %

(In thousands) 2015 2014 Change Change 2015 2014 Change Change

Non-interest Income

Service charges and other fees $ 864 $ 939 $ (75 ) (8.0 )% $ 1,694 $ 1,830 $ (136 ) (7.4 )%

Bank card income and fees 629 616 13 2.1 1,216 1,159 57 4.9

Trust department income 274 228 46 20.2 478 431 47 10.9

Real estate servicing fees, net 186 22 164 745.5 180 199 (19 ) (9.5 )

Gain on sales of mortgage loans, net 434 257 177 68.9 781 448 333 74.3

Other 74 121 (47 ) (38.8 ) 99 202 (103 ) (51.0 )

Total non-interest income $ 2,461 $ 2,183 $ 278 12.7 % $ 4,448 $ 4,269 $ 179 4.2 %

Non-interest income as a % of total revenue * 19.8 % 18.1 % 18.2 % 18.0 %

Total revenue per full time equivalent employee $ 36.9 $ 35.2 $ 72.4 $ 69.5

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

Total non-interest income increased $278,000, or 12.7%, to $2.5 million for the quarter ended June 30, 2015 compared to $2.2 million for the quarter ended June 30, 2014, and increased $179,000, or 4.2%, to $4.4 million for the six months ended June 30, 2015 compared to $4.3 million for the six months ended June 30, 2014.

Real estate servicing fees, net of the change in the valuation of mortgage servicing rights increased $165,000 to $186,000 for the quarter ended June 30, 2015 compared to $22,000 for the quarter ended June 30, 2014, and decreased $19,000 to $180,000 for the six months ended June 30, 2015 compared to $199,000 for the six months ended June 30, 2014.

Mortgage loan servicing fees earned on loans sold were $228,000 and $442,000 for the three and six months ended June 30, 2015, respectively, compared to $223,000 and $446,000 for the three and six months ended June 30, 2014.

The change in valuation of mortgage servicing rights arising from inputs and assumptions increased $128,000 for the quarter ended June 30, 2015 compared to a $36,000 decrease for the quarter ended June 30, 2014, and increased $87,000 for the six months ended June 30, 2015 compared to a $70,000 increase for the six months ended June 30, 2014. Total realized losses included in earnings attributable to the change in unrealized gains or losses related to assets still held were $(42,000) for the quarter ended June 30, 2015 compared to $(201,000) for the quarter ended June 30, 2014, and $(262,000) for the six months ended June 30, 2015 compared to $(247,000) for the six months ended June 30, 2014. The Company was servicing $312.6 million of mortgage loans at June 30, 2015 compared to $313.9 million and $315.3 million at December 31, 2014 and June 30, 2014, respectively.

Gain on sales of mortgage loans increased $177,000, or 68.9%, to $434,000 for the quarter ended June 30, 2015 compared to $257,000 for the quarter ended June 30, 2014, and increased $333,000, or 74.3%, to $781,000 for the six months ended June 30, 2015 compared to $448,000. The Company sold loans of $16.9 million and $28.9 million for the three and six months ended June 30, 2015, respectively, compared to $8.6 million and $14.5 million for the three and six months ended June 30, 2014, respectively. Refinancing activity during the first six months of 2015 impacting both the volume of loans sold and gains recognized contributed to this increase.

Other income decreased $47,000, or 38.8%, to $74,000 for the quarter ended June 30, 2015 compared to $121,000 for the quarter ended June 30, 2014, and decreased $103,000, or 51.0%, to $99,000 for the six months ended June 30, 2015 compared to $202,000. The decrease in other income primarily related to a decrease in rental income received on other real estate owned during 2014 and an increase in the servicing repurchase liability during the first quarter of 2015 for reimbursement of costs incurred by Freddie Mac related to a foreclosure.

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

Three Months Ended June 30, Six Months Ended June 30,

(In thousands) 2015 2014 $ Change % Change 2015 2014 $ Change % Change

Non-interest Expense

Salaries $ 3,847 $ 3,761 $ 86 2.3 % $ 7,674 $ 7,581 $ 93 1.2 %

Employee benefits 1,328 1,199 129 10.8 2,804 2,410 394 16.3

Occupancy expense, net 717 672 45 6.7 1,380 1,292 88 6.8

Furniture and equipment expense 484 453 31 6.8 915 896 19 2.1

FDIC insurance assessment 258 242 16 6.6 499 480 19 4.0

Legal, examination, and professional fees 339 282 57 20.2 610 508 102 20.1

Advertising and promotion 270 256 14 5.5 507 546 (39 ) (7.1 )

Postage, printing, and supplies 272 280 (8 ) (2.9 ) 543 545 (2 ) (0.4 )

Processing, network, and bank card expense 807 791 16 2.0 1,596 1,579 17 1.1

Real estate foreclosure expense and (gains), net 158 172 (14 ) (8.1 ) (23 ) 296 (319 ) (107.8 )

Other 787 703 84 11.9 1,470 1,385 85 6.1

Total non-interest expense $ 9,267 $ 8,811 $ 456 5.2 % $ 17,975 $ 17,518 $ 457 2.6 %

Efficiency ratio * 74.5 % 73.2 % 73.6 % 73.7 %

Salaries and benefits as a % of total non-interest expense 55.8 % 56.3 % 58.3 % 57.0 %

Number of full-time equivalent employees 337 342 337 342

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

Total non-interest expense increased $456,000, or 5.2%, to $9.3 million for the quarter ended June 30, 2015 compared to $8.8 million for the quarter ended June 30, 2014, and increased $457,000, or 2.6%, to $18.0 million for the six months ended June 30, 2015 compared to $17.5 million for the six months ended June 30, 2014.

Employee benefits increased $129,000, or 10.8%, to $1.3 million for the quarter ended June 30, 2015 compared to $1.2 million for the quarter ended June 30, 2014, and increased $394,000, or 16.3%, to 2.8 million for the six months ended June 30, 2015 compared to $2.4 million for the six months ended June 30, 2014. The increase was primarily due to a $159,000 and $390,000 increase in the 401(k) profit-sharing and pension expenses for the three and six months ended June 30, 2015, respectively.

Legal, examination, and professional fees increased $57,000, or 20.2%, to 339,000 for the quarter ended June 30, 2015 compared to $282,000 for the quarter ended June 30, 2014, and increased $102,000, or 20.1%, to $610,000 for the six months ended June 30, 2015 compared to $508,000 for the six months ended June 30, 2014. The increase for the quarter ended June 30, 2015 over quarter ended June 30, 2014 primarily consisted of an increase in legal fees related to a class action law suit partially offset by a decrease in consulting fees. The increase for the six months ended June 30, 2015 over the six months ended June 30, 2014 primarily consisted of an increase in audit and tax fees and legal fees related to a class action law suit.

Real estate foreclosure expense and (gains), net decreased $14,000, or 8.1%, to $158,000 for the quarter ended June 30, 2015 compared to $172,000 for the quarter ended June 30, 2014, and decreased $319,000, or 107.8%, to $(23,000) for the six months ended June 30, 2015 compared to $296,000 for the six months ended June 30, 2014.

Net gains recognized on other real estate owned were $4,000 and $254,000 for the three and six months ended June 30, 2015 compared to net losses of $44,000 and $21,000 for the three and six months ended June 30, 2014. Expenses to maintain these foreclosed properties were $162,000 and $231,000 for the three and six months ended June 30, 2015 compared to $129,000 and $275,000 for the three and six months ended June 30, 2014. Gains were recognized on two properties sold during the first quarter of 2015 resulting in a net gain for the six months ended June 30, 2015.

Income taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 34.2% for the quarter ended June 30, 2015 compared to 34.8% for the quarter ended June 30, 2014, and 34.3% for the six months ended June 30, 2015 compared to 34.7% for the six months ended June 30, 2014.

Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 70.9% of total assets as of June 30, 2015 compared to 72.9% as of December 31, 2014.

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

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

June 30, December 31,

(In thousands) 2015 2014

Commercial, financial, and agricultural $ 162,067 $ 154,834

Real estate construction - residential 12,088 18,103

Real estate construction - commercial 48,508 48,822

Real estate mortgage - residential 242,095 247,117

Real estate mortgage - commercial 378,398 372,321

Installment loans to individuals 20,498 20,016

Total loans $ 863,654 $ 861,213

Percent of categories to total loans:

Commercial, financial, and agricultural 18.8 % 18.0 %

Real estate construction - residential 1.4 2.1

Real estate construction - commercial 5.6 5.7

Real estate mortgage - residential 28.0 28.7

Real estate mortgage - commercial 43.8 43.2

Installment loans to individuals 2.4 2.3

Total 100.0 % 100.0 %

The Company experienced positive trends in commercial, financial, and agricultural loans, and real estate mortgage commercial loans at June 30, 2015 compared to December 31, 2014, and real estate construction loans and real estate mortgage residential loans saw a slight decrease. At both June 30, 2015 and December 31, 2014, the Company benefited from commercial borrowers being more willing to expand operations, and new calling programs resulted in new customers and expanded loan relationships with existing customers. The Company extends credit to its local community market through traditional real estate mortgage products. The Company does not participate in extending credit to sub-prime residential real estate markets. The Company does not lend funds for the type of transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Company does not have any interest-earning assets that would have been included in nonaccrual, past due, or restructured loans if such assets were loans.

The Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers, but are not funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. During the three months ended June 30, 2015, the Company saw an increase in refinancing activity due to low interest rates and uncertainty of rate increases by the Federal Reserve. The Company sold loans of $16.9 million and $28.9 million for the three and six months ended June 30, 2015, respectively, compared to $8.6 million and $14.5 million for the three and six months ended June 30, 2014, respectively. Refinancing activity during the first six months of 2015 impacting both the volume of loans sold and gains recognized contributed to this increase. At June 30, 2015, the Company was servicing approximately $312.6 million of loans sold to the secondary market compared to $313.9 million at December 31, 2014, and $315.3 million at June 30, 2014.

Risk Elements of the Loan Portfolio

Management, the senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2.0 million in aggregate and all adversely classified credits identified by management are reviewed. In addition, all other loans are reviewed on a sample basis. The senior loan committee reviews and reports to the board of directors, on a monthly basis, past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impaired. Management follows the guidance provided in the FASB’s ASC Topic 310, 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

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maintain the allowance at a level considered adequate by management to provide for probable losses inherent in the loan portfolio.

Nonperforming Assets

The following table summarizes nonperforming assets at the dates indicated:

June 30, December 31,

(In thousands) 2015 2014

Nonaccrual loans:

Commercial, financial, and agricultural $ 3,583 $ 5,279

Real estate construction - residential 0 1,751

Real estate construction - commercial 1,934 2,096

Real estate mortgage - residential 3,370 4,419

Real estate mortgage - commercial 2,719 4,465

Installment loans to individuals 124 233

Total $ 11,730 $ 18,243

Loans contractually past - due 90 days or more and still accruing:

Commercial, financial, and agricultural $ 24 $ 0

Real estate construction - residential 0 0

Real estate construction - commercial 0 56

Real estate mortgage - residential 208 0

Real estate mortgage - commercial 0 0

Installment loans to individuals 0 2

Total $ 232 $ 58

Performing Troubled debt restructurings 6,095 17,720

Total nonperforming loans 18,057 36,021

Other real estate owned and repossessed assets 12,516 11,885

Total nonperforming assets $ 30,573 $ 47,906

Loans $ 863,654 $ 861,213

Allowance for loan losses to loans 1.16 % 1.06 %

Nonperforming loans to loans 2.09 % 4.18 %

Allowance for loan losses to nonperforming loans 55.30 % 25.26 %

Allowance for loan losses to nonperforming loans, excluding performing TDR's 83.48 % 49.72 %

Nonperforming assets to loans,   other real estate owned and foreclosed assets 2.54 % 5.49 %

Total nonperforming assets totaled $30.6 million at June 30, 2015 compared to $47.9 million at December 31, 2014. Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing, and TDRs totaled $18.1 million, or 2.09%, of total loans at June 30, 2015 compared to $36.0 million, or 4.18%, of total loans at December 31, 2014. Non-accrual loans included $1.6 million of loans classified as TDRs at both June 30, 2015 and December 31, 2014.

As of June 30, 2015 and December 31, 2014, approximately $7.1 million and $9.6 million, respectively, of loans classified as substandard, not included in the nonperforming asset table, were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. Even though borrowers are experiencing moderate 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 June 30, 2015 and December 31, 2014, respectively.

Total non-accrual loans at June 30, 2015 decreased $6.5 million to $11.7 million from December 31, 2014. This decrease primarily consisted of a $1.7 million decrease in commercial, financial and agricultural loans, $1.8 million decrease in real estate construction – residential loans, $1.0 million decrease in real estate mortgage - residential loans, and a $1.7 million decrease in real estate mortgage – commercial loans. The decrease in non-accrual loans primarily resulted from the sale of a piece of collateral, transfers of impaired loans to other real estate owned and repossessed assets, and four loan relationships that returned to performing status.

Loans past due 90 days and still accruing interest at June 30, 2015 were $232,000 compared to $58,000 at December 31, 2014. Other real estate and foreclosed assets at June 30, 2015 were $12.5 million compared to $11.9 million at December 31, 2014. During the six months ended June 30, 2015, $1.5 million of nonaccrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to $305,000 during the six months ended June 30, 2014.

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

June 30, 2015 December 31, 2014

(In thousands) Number of
Contracts Recorded
Investment Specific
Reserves Number of
Contracts Recorded
Investment Specific
Reserves

Performing TDRs

Commercial, financial and agricultural 9 $ 842 $ 75 10 $ 2,262 $ 6

Real estate mortgage - residential 8 3,422 884 6 3,459 752

Real estate mortgage - commercial 3 1,831 - 8 11,999 -

Total performing TDRs 20 $ 6,095 $ 959 24 $ 17,720 $ 758

Nonperforming TDRs

Commercial, financial and agricultural 1 $ 56 $ - 2 $ 71 $ -

Real estate mortgage - residential 3 635 120 2 347 140

Real estate mortgage - commercial 5 899 228 3 1,167 10

Total nonperforming TDRs 9 $ 1,590 $ 348 7 $ 1,585 $ 150

Total TDRs 29 $ 7,685 $ 1,307 31 $ 19,305 $ 908

At June 30, 2015, loans classified as TDRs totaled $7.7 million, of which $1.6 million were classified as nonperforming TDRs and included in non-accrual loans and $6.1 million were classified as performing TDRs. At December 31, 2014, TDRs totaled $19.3 million, of which $1.6 million were classified as nonperforming TDRs included in non-accrual loans and $17.7 million were classified as performing TDRs. Both performing and nonperforming TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. Accordingly, specific reserves of $1.3 million and $1.0 million related to TDRs were allocated to the allowance for loan losses at June 30, 2015 and December 31, 2014, respectively. The net decrease in total TDRs from December 31, 2014 to June 30, 2015 was primarily due to $2.0 million additions to TDRs that were offset by $134,000 charged off, approximately $1.3 million of payments received, and $12.2 million from four loan relationships moved to performing loans due to subsequent restructuring at market rates and terms followed by satisfactory payment performance.

Allowance for Loan Losses and Provision

Allowance for Loan Losses

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

June 30, December 31,

(In thousands) 2015 2014

Allocation of allowance for loan losses at end of period:

Commercial, financial, and agricultural $ 3,124 $ 1,779

Real estate construction - residential 17 171

Real estate construction - commercial 414 466

Real estate mortgage - residential 2,332 2,527

Real estate mortgage - commercial 3,870 3,846

Installment loans to individuals 185 270

Unallocated 44 40

Total $ 9,986 $ 9,099

The allowance for loan losses was $10.0 million, or 1.16%, of loans outstanding at June 30, 2015 compared to $9.1 million, or 1.06%, of loans outstanding at December 31, 2014, and $12.1 million, or 1.42%, of loans outstanding at June 30, 2014. The ratio of the allowance for loan losses to nonperforming loans, excluding TDR’s – accruing, was 55.30% at June 30, 2015, compared to 49.72% at December 31, 2014, and 46.30% at June 30, 2014.

Provision

The provision for loan losses was $250,000 for the three and six months ended June 30, 2015 compared to no provision for the three and six months ended June 30, 2014. The increase over 2014 was primarily due to an increase in specific reserves primarily related to two loan relationships.

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

Three Months Ended Six Months Ended

June 30, June 30,

(In thousands) 2015 2014 2015 2014

Analysis of allowance for loan losses:

Balance beginning of period $ 9,761 $ 12,845 $ 9,099 $ 13,719

Charge-offs:

Commercial, financial, and agricultural 122 54 150 186

Real estate construction - residential - - - 60

Real estate construction - commercial 5 77 5 491

Real estate mortgage - residential 140 75 211 194

Real estate mortgage - commercial 8 705 32 1,073

Installment loans to individuals 113 114 161 198

Total charge-offs 388 1,025 559 2,202

Recoveries:

Commercial, financial, and agricultural $ 40 $ 111 $ 615 $ 227

Real estate construction - residential 117 59 294 60

Real estate mortgage - residential 47 14 59 126

Real estate mortgage - commercial 117 77 152 93

Installment loans to individuals 42 69 76 127

Total recoveries 363 330 1,196 633

Net charge-offs 25 695 (637 ) 1,569

Provision for loan losses 250 - 250 -

Balance end of period $ 9,986 $ 12,150 $ 9,986 $ 12,150

Net Loan Charge-offs (Recoveries)

The Company’s net charge-offs were $25,000, 0.00% of average loans, for the quarter ended June 30, 2015 compared to $695,000, or 0.19%, of average loans, for the quarter ended June 30, 2014. As detailed in the table above, in addition to comparable recoveries for the quarter ended June 30, 2015 over the quarter ended June 30, 2014, the decrease in net charge-offs was primarily due to a $697,000 decrease in real estate mortgage – commercial charge-offs.

The Company’s net recoveries were $637,000 for the six months ended June 30, 2015, or (0.07)% of average loans, compared to net charge-offs of $1.6 million, or 0.19% of average loans, for the six months ended June 30, 2014. As detailed in the table above, the Company’s net recoveries for the six months ended June 30, 2015 were primarily due to one loan relationship in commercial loans, and one loan relationship in real estate construction loans. In addition to the recoveries recorded during the six months ended June 30, 2015, the Company also noted a decrease in charge-offs of $1.6 million compared to the six months ended June 30, 2014.

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

June 30, December 31,

(In thousands) 2015 2014

Allocation of allowance for loan losses:

Individually evaluated for impairment - specific reserves $ 2,725 $ 1,749

Collectively evaluated for impairment - general reserves 7,261 7,350

Total $ 9,986 $ 9,099

Specific reserves increased to $2.7 million at June 30, 2015 compared to $1.7 million at December 31, 2014. The increase in reserves from December 31, 2014 primarily occurred in commercial, financial, and agricultural loans, and real estate mortgage commercial loans. The increase in commercial, financial, and agricultural reserves primarily related to one loan relationship due to increased exposure resulting from liquidation of collateral during the current quarter. The increase in real estate mortgage reserves was primarily due to additional reserves required for one loan relationship resulting from the reevaluation of collateral values.

The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At June 30, 2015, $2.7 million of the Company’s allowance for loan losses was allocated to impaired loans totaling approximately $17.8 million compared to $1.7 million of the Company’s allowance for loan losses (ALL) allocated to impaired loans totaling approximately $36.0 million at December 31, 2014. Management determined that $9.5 million, or

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73%, of total impaired loans required no reserve allocation at June 30, 2015 compared to $28.5 million, or 79%, at December 31, 2014 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

The incurred loss component of the general reserve, or loans collectively evaluated for impairment, is determined by applying percentages to pools of loans by asset type. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings, and industry concentration adjusted for certain qualitative factors to reflect current risk characteristics of the portfolio. In addition, the combined historical loan loss rates and qualitative factors are multiplied by loss emergence periods (LEP) which represent the estimated time period between a borrower first experiencing financial difficulty and the recognition of a loss. Management determined that the previous twelve quarters were reflective of the loss characteristics of the Company’s loan portfolio during the recent economic environment. These historical loss rates for each risk group are used as the starting point to determine allowance provisions. The Company’s methodology includes qualitative factors that allow management to adjust its estimates of losses based on the most recent information available. These factors reflect actual changes and anticipated changes such as changes in specific allowances on loans and real estate acquired through foreclosure, any gains and losses on final disposition of real estate acquired through foreclosure, changes in national and local economic conditions and developments, including general economic and business conditions affecting the Company’s key lending areas, credit quality trends, specific industry conditions within portfolio segments, bank regulatory examination results, and findings of the internal loan review department. These risk factors are generally reviewed and updated quarterly, as appropriate.

Loss Emergence Periods While the historical loss rates and qualitative factors (discussed above) provide a good foundation as to the incurred losses in the current portfolio, the portfolio is comprised of very unique loan categories that inherently may need more time to produce a loss than other loan categories (given these unique segments and workout periods). As such, a review of the Company’s LEP is necessary to ensure the ALL estimate is appropriately stated as of the balance sheet date, rather than relying on a singular annualized loss rate based upon the historical charge-off activity. Determination of the LEP allows for loans with effective useful lives other than twelve months, often loans with extended workout periods, to be incorporated into the reserve estimate, given the incurred loss event had occurred prior to the balance sheet date. This approach is consistent with the Interagency ALL Guidance noted above.

The specific and general reserve allocations represent management’s best estimate of probable losses contained in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.

Liquidity and Capital Resources

Liquidity Management

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

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

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

June 30, December 31,

(In thousands) 2015 2014

Federal funds sold and other overnight interest-bearing deposits $ 10,922 $ 20,445

Available-for-sale investment securities 239,487 198,998

Total $ 250,409 $ 219,443

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 $239.5 million at June 30, 2015 and included an unrealized net loss of $254,000. The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately $17.6 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company’s deposit base.

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The Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law. At June 30, 2015 and December 31, 2014, the Company’s unpledged securities in the available for sale portfolio totaled approximately $57.9 million and $53.4 million, respectively.

Total investment securities pledged for these purposes were as follows:

June 30, December 31,

(In thousands) 2015 2014

Investment securities pledged for the purpose of securing:

Federal Reserve Bank borrowings $ 3,500 $ 3,504

Federal funds purchased and securities sold under agreements to repurchase 33,638 26,770

Other deposits 144,494 115,272

Total pledged, at fair value $ 181,632 $ 145,546

Liquidity is available from the Company’s base of core customer deposits, defined as demand, interest checking, savings, and money market deposit accounts. At June 30, 2015, such deposits totaled $671.7 million and represented 67.9% of the Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships. Time deposits and certificates of deposit of $100,000 and over totaled $317.1 million at June 30, 2015. These accounts are normally considered more volatile and higher costing representing 32.1% of total deposits at June 30, 2015.

Core deposits at June 30, 2015 and December 31, 2014 were as follows:

June 30, December 31,

(In thousands) 2015 2014

Core deposit base:

Non-interest bearing demand $ 206,478 $ 207,700

Interest checking 199,774 191,902

Savings and money market 265,479 250,157

Total $ 671,731 $ 649,759

Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. The Company’s outside borrowings are comprised of securities sold under agreements to repurchase, Federal Home Loan Bank advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of June 30, 2015, under agreements with these unaffiliated banks, the Bank may borrow up to $40.0 million in federal funds on an unsecured basis and $7.8 million on a secured basis. There were no federal funds purchased outstanding at June 30, 2015. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company’s investment portfolio. At June 30, 2015, there was $25.8 million in repurchase agreements. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at June 30, 2015.

The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB). As a member of the FHLB, the Bank has access to credit products of the FHLB. As of June 30, 2015, the Bank had $47.0 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.

Borrowings outstanding at June 30, 2015 and December 31, 2014 were as follows:

June 30, December 31,

(In thousands) 2015 2014

Borrowings:

Securities sold under agreements to repurchase $ 25,842 $ 17,970

Federal Home Loan Bank advances 47,000 43,000

Subordinated notes 49,486 49,486

Total $ 122,328 $ 110,456

The Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from these entities. Based on the type and value of collateral pledged, the Company may draw advances against this collateral.

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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 the Company as follows:

June 30, December 31,

2015 2014

(In thousands) FHLB Federal
Reserve
Bank Federal
Funds
Purchased
Lines Total FHLB Federal
Reserve
Bank Federal
Funds
Purchased
Lines Total

Advance equivalent $ 251,676 $ 3,430 $ 44,340 $ 299,446 $ 273,613 $ 3,433 $ 44,340 $ 321,386

Advances outstanding (47,000 ) 0 0 (47,000 ) (43,000 ) 0 0 (43,000 )

Total available $ 204,676 $ 3,430 $ 44,340 $ 252,446 $ 230,613 $ 3,433 $ 44,340 $ 278,386

At June 30, 2015, loans with a market value of $341.8 million were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At June 30, 2015, investments with a market value of $8.6 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.

Sources and Uses of Funds

Cash and cash equivalents were $33.3 million at June 30, 2015 compared to $42.8 million at December 31, 2014. The $9.5 million decrease resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the six months ended June 30, 2015. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $6.5 million for the six months ended June 30, 2015.

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 $46.7 million. The cash outflow primarily consisted of $67.6 million purchases of investment securities, partially offset by $25.1 million proceeds from maturities, calls, and pay-downs of investment securities.

Financing activities provided cash of $30.7 million, resulting primarily from a 23.2 million increase in interest bearing transaction accounts, $7.9 million increase in federal funds purchased and securities sold under agreements to repurchase, and $4.0 million net decrease in FHLB advances, partially offset by $1.2 million decrease in demand deposits, and a $2.6 million decrease in time deposits. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2015.

In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company's various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company's liquidity. The Company had $151.5 million in unused loan commitments and standby letters of credit as of June 30, 2015. Although the Company's current liquidity resources are adequate to fund this commitment level the nature of these commitments is such that the likelihood of such a funding demand is very low.

The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company’s ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its shareholders. The Company paid cash dividends to its shareholders totaling approximately $523,000 and $504,000 for the six months ended June 30, 2015 and 2014, respectively. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $1.0 million in dividends to the Company during the six months ended June 30, 2015. At June 30, 2015 and December 31, 2014, the Company had cash and cash equivalents totaling $795,000 and $1.0 million, respectively.

Capital Management

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

Quantitative measures established by regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital to risk-weighted assets, and of Tier I capital to adjusted-average assets. The Company made a one-time election not to include accumulated other comprehensive

50

income (AOCI) components in regulatory capital. Management believes, as of June 30, 2015 and December 31, 2014, the Company and the Bank each met all capital adequacy requirements.

In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for community banking organizations began January 1, 2015, while larger institutions (generally those with assets of $250 billion or more) must begin compliance on January 1, 2014. The final rules call for the following capital requirements:

· A minimum ratio of common tier 1 capital to risk-weighted assets of 4.5%.

· A minimum ratio of tier 1 capital to risk-weighted assets of 6%.

· A minimum leverage ratio of 4%.

In addition, the final rules establish a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. If a banking organization fails to hold capital above the minimum capital ratios and the capital conservation buffer, it will be subject to certain restrictions on capital distributions and discretionary bonus payments. The phase-in period for the capital conservation and countercyclical capital buffers for all banking organizations will begin on January 1, 2016.

The following table summarizes regulatory capital information as of June 30, 2015 and December 31, 2014 on a consolidated basis and for the Bank, as defined. Regulatory capital ratios for June 30, 2015 were calculated in accordance with the Basel III rules, whereas the December 31, 2014 regulatory ratios were calculated in accordance with Basel I rules.

Well-Capitalized Under

Required for Capital Prompt Corrective Action

Actual Adequacy Purposes Provision

(in thousands) Amount Ratio Amount Ratio Amount Ratio

June 30, 2015

Total Capital (to risk-weighted assets):

Company $ 141,610 14.97 % $ 75,678 8.00 % $ N.A. N.A.

Bank 133,563 14.19 75,313 8.00 94,141 10.00 %

Tier I Capital (to risk-weighted assets):

Company $ 111,859 11.82 % $ 56,758 6.00 % $ N.A. N.A.

Bank 123,417 13.11 56,485 6.00 75,313 8.00 %

Common Equity Tier I Capital (to risk-weighted assets)

Company $ 83,464 8.82 % $ 42,569 4.50 % $ N.A. N.A.

Bank 123,417 13.11 42,363 4.50 61,192 6.50 %

Tier I Capital (to adjusted average assets):

Company $ 111,859 9.36 % $ 47,801 4.00 % $ N.A. N.A.

Bank 123,417 10.44 47,294 4.00 59,118 5.00 %

(in thousands)

December 31, 2014

Total Capital (to risk-weighted assets):

Company $ 138,619 15.78 % $ 70,282 8.00 % N.A. N.A.

Bank 128,311 14.78 69,430 8.00 $ 86,788 10.00 %

Tier I Capital (to risk-weighted assets):

Company $ 108,785 12.38 % $ 35,141 4.00 % N.A. N.A.

Bank 119,212 13.74 34,715 4.00 $ 52,073 6.00 %

Tier I capital (to adjusted average assets):

Company $ 108,785 9.42 % $ 46,197 4.00 % $ N.A. N.A.

Bank 119,212 10.42 45,784 4.00 57,230 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. The Company faces market risk in the form of interest rate risk through transactions other than trading activities. The 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 the 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 the Company feels it has no primary exposure to specific points on the yield curve. For the three months ended June 30, 2015, our Company utilized a 400 basis point immediate and gradual move in interest rates (both upward and downward)

51

applied to both a parallel and proportional yield curve. However, there are no assurances that the change will not be more or less than this estimate.

The following table represents estimated interest rate sensitivity and periodic and cumulative gap positions calculated as of June 30, 2015. Significant assumptions used for this table included: loans will repay at historic repayment rates; certain interest-bearing demand accounts are interest sensitive due to immediate repricing, and fixed maturity deposits will not be withdrawn prior to maturity. A significant variance in actual results from one or more of these assumptions could materially affect the results reflected in the table.

Over

5 Years or

No stated

(In thousands) Year 1 Year 2 Year 3 Year 4 Year 5 Maturity Total

ASSETS

Investment securities $ 28,651 $ 14,501 $ 21,337 $ 22,510 $ 30,136 $ 122,352 $ 239,487

Federal funds sold and other over-night interest-bearing deposits 10,922 - - - - - 10,922

Other restricted investments 7,917 - - - - - 7,917

Loans 325,105 145,808 116,941 118,773 103,370 53,657 863,654

Total $ 372,595 $ 160,309 $ 138,278 $ 141,283 $ 133,506 $ 176,009 $ 1,121,980

LIABILITIES

Savings, interest checking, and money market deposits $ 257,987 $ - $ 207,266 $ - $ - $ - $ 465,253

Time deposits 208,303 62,028 28,091 13,139 5,574 - 317,135

Federal funds purchased and securities sold under agreements to repurchase 25,842 - - - - - 25,842

Subordinated notes 49,486 - - - - - 49,486

Federal Home Loan Bank advances 8,000 3,000 17,000 9,000 10,000 - 47,000

Total $ 549,618 $ 65,028 $ 252,357 $ 22,139 $ 15,574 $ - $ 904,716

Interest-sensitivity GAP

Periodic GAP $ (177,023 ) $ 95,281 $ (114,079 ) $ 119,144 $ 117,932 $ 176,009 $ 217,264

Cumulative GAP $ (177,023 ) $ (81,742 ) $ (195,821 ) $ (76,677 ) $ 41,255 $ 217,264 $ 217,264

Ratio of interest-earning assets to interest-bearing liabilities

Periodic GAP 0.68 2.47 0.55 6.38 8.57 NM 1.24

Cumulative GAP 0.68 0.87 0.77 0.91 1.05 1.24 1.24

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 the Company's operations for the three months ended June 30, 2015.

Item 4. Controls and Procedures

Our Company's management has evaluated, with the participation of our principal executive and principal financial officers, the effectiveness of our disclosure controls and procedures as defined in Rules 13a – 15(e) or 15d – 15(e) of the Securities Exchange Act of 1934 as of June 30, 2015. 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

52

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 June 30, 2015 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Impact of New Accounting Standards

Revenue from Contracts with Customers The FASB issued ASU 2014-09, Revenue from Contracts with Customers, in May 2014. The ASU supersedes revenue recognition requirements in Topic 605, Revenue Recognition, including most industry-specific revenue recognition guidance in the FASB Accounting Standards Codification. The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance identifies specific steps that entities should apply in order to achieve this principle. The amendments are effective for interim and annual periods beginning January 1, 2017 and must be applied retrospectively. The Company is in the process of evaluating the impact of the ASU's adoption on the Company’s consolidated financial statements.

Transfers and Servicing The FASB issued ASU 2014-11, Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures, in June 2014. The amendments require that repurchase-to-maturity transactions and repurchase agreements that are part of financing arrangements be accounted for as secured borrowings. The amendments also require additional disclosures for certain transfers accounted for as sales. The accounting changes and the disclosures on sales are required to be presented in interim and annual periods beginning January 1, 2015. This ASU also requires disclosures about types of collateral, contractual tenor and potential risks for transactions accounted for as secured borrowings. These disclosures are required in interim and annual periods beginning April 1, 2015. The adoption is not expected to have a significant effect on the Company’s consolidated financial statements.

Presentation of Financial Statements - Going Concern Uncertainties. The FASB has issued ASU No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern in August 2014. ASU 2014-15 is intended to define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and to provide related footnote disclosures. Under Generally Accepted Accounting Principles (GAAP), financial statements are prepared under the presumption that the reporting organization will continue to operate as a going concern, except in limited circumstances. Financial reporting under this presumption is commonly referred to as the going concern basis of accounting. The going concern basis of accounting is critical to financial reporting because it establishes the fundamental basis for measuring and classifying assets and liabilities. Currently, GAAP lacks guidance about management’s responsibility to evaluate whether there is substantial doubt about the organization’s ability to continue as a going concern or to provide related footnote disclosures. This ASU provides guidance to an organization’s management, with principles and definitions that are intended to reduce diversity in the timing and content of disclosures that are commonly provided by organizations today in the financial statement footnotes. The amendments are effective for interim and annual periods ending after December 15, 2016. The adoption is not expected to have a significant effect on the Company's consolidated financial statements.

Consolidation The FASB has issued ASU No. 2015-02, Amendments to the Consolidation Analysis. The amendment substantially changes the way reporting entities are required to evaluate whether they should consolidate certain legal entities. All legal entities are subject to reevaluation under the new amendment. Specifically, the amendments modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities (VIEs) or voting interest entities, eliminate the presumption that a general partner should consolidate a limited partnership, and affect the consolidation analysis of reporting entities that are involved with VIEs. The amendments in this update are effective for interim and annual periods beginning after December 15, 2015. Early adoption is permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is currently evaluating the effect that ASU 2015-02 will have on its consolidated financial statements and related disclosures. The adoption is not expected to have a significant effect on the Company’s consolidated financial statements.

53

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

The information required by this Item is set forth in Commitments and Contingencies, 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).

3.2 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).

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)

54

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

August 14, 2015 David T. Turner, Chairman of the Board and

Chief Executive Officer (Principal Executive Officer)

/s/ W. Bruce Phelps

August 14, 2015 W. Bruce Phelps, Chief Financial Officer (Principal Financial

Officer and Principal Accounting Officer)

55

HAWTHORN BANCSHARES, INC.

INDEX TO EXHIBITS

June 30, 2015 Form 10-Q



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).

3.2 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).

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)

*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.

56

	June 30,			December 31,
(in thousands)	2015			2014
Real estate construction - residential	$	0		$	23
Real estate construction - commercial		9,831			9,831
Real estate mortgage - residential		447			417
Real estate mortgage - commercial		5,439			4,831
Repossessed assets		32			38
Total	$	15,749		$	15,140
Less valuation allowance for other real estate owned		(3,233	)		(3,255	)
Total other real estate and repossessed assets	$	12,516		$	11,885

			Gross		Gross
	Amortized		Unrealized		Unrealized
(in thousands)	Cost		Gains		Losses		Fair value
June 30, 2015
Government sponsored enterprises	$	76,667	$	287	$	110		76,844
Asset-backed securities		129,205		746		1,533		128,418
Obligations of states and political subdivisions		33,869		450		94		34,225
Total available-for-sale securities	$	239,741	$	1,483	$	1,737	$	239,487

December 31, 2014
Government sponsored enterprises	$	57,002	$	240	$	143		57,099
Asset-backed securities		106,726		855		1,119		106,462
Obligations of states and political subdivisions		34,925		583		71		35,437
Total available-for-sale securities	$	198,653	$	1,678	$	1,333	$	198,998

	Amortized		Fair
(in thousands)	Cost		Value
Due in one year or less	$	17,500	$	17,591
Due after one year through five years		78,174		78,453
Due after five years through ten years		14,023		14,198
Due after ten years		839		827
Total		110,536		111,069
Asset-backed securities		129,205		128,418
Total available-for-sale securities	$	239,741	$	239,487

	Less than 12 months					12 months or more					Total		Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
*(in thousands)*	Value		Losses			Value		Losses			Value		Losses
At June 30, 2015
Government sponsored
enterprises	$	30,032	$	(100	)	$	3,990	$	(10	)	$	34,022	$	(110	)
Asset-backed securities		48,526		(498	)		36,908		(1,035	)		85,434		(1,533	)
Obligations of states and
political subdivisions		8,289		(81	)		489		(13	)		8,778		(94	)
Total	$	86,847	$	(679	)	$	41,387	$	(1,058	)	$	128,234	$	(1,737	)

*(in thousands)*
At December 31, 2014
Government sponsored
enterprises	$	2,983	$	(4	)	$	17,862	$	(139	)	$	20,845	$	(143	)
Asset-backed securities		10,314		(50	)		45,445		(1,069	)		55,759		(1,119	)
Obligations of states and
political subdivisions		3,667		(15	)		1,942		(56	)		5,609		(71	)
Total	$	16,964	$	(69	)	$	65,249	$	(1,264	)	$	82,213	$	(1,333	)

	Six months ended June 30, 2015
							Accumulated
				Unrecognized Net			Other
	Unrealized			Pension and			Comprehensive
	Gain (Loss)			Postretirement			(Loss)
*(in thousands)*	on Securities (1)			Costs (2)			Income
Balance at beginning of period	$	214		$	(1,442	)	$	(1,228	)
Other comprehensive loss before reclassifications		(607	)		0			(607	)
Amounts reclassified from accumulated other comprehensive income		8			72			80
Current period other comprehensive (loss) income, before tax		(599	)		72			(527	)
Income tax benefit (expense)		228			(27	)		201
Current period other comprehensive (loss) income, net of tax		(371	)		45			(326	)
Balance at end of period	$	(157	)	$	(1,397	)	$	(1,554	)

	Estimated			Actual
*(in thousands)*	2015			2014
Service cost - benefits earned during the year	$	1,325		$	981
Interest costs on projected benefit obligations		838			732
Expected return on plan assets		(957	)		(872	)
Expected administrative expenses		40			40
Amortization of prior service cost		79			79
Amortization of unrecognized net loss		66			0
Net periodic pension expense	$	1,391		$	960

Pension expense - three months ended June 30, (actual)	$	348		$	236
Pension expense - six months ended June 30, (actual)	$	696		$	472

						Weighted
				Weighted		Average		Aggregate
	Number			average		Contractual		Intrinsic
	of			Exercise		Term		Value
	Shares			Price		(in years)		($000)
Outstanding, beginning of period		100,361		$	21.56
Granted		0			0.00
Exercised		0			0.00
Forfeited or expired		(33,929	)		21.66
Outstanding, June 30, 2015		66,432		$	21.51		1.90	$	0.00
Exercisable, June 30, 2015		57,975		$	22.32		1.70	$	0.00

	Three Months Ended June 30,				Six Months Ended June 30,
*(dollars in thousands, except per share data)*	2015		2014		2015		2014
Basic earnings per share:
Net income available to shareholders	$	1,927	$	2,098	$	4,065	$	4,085
Basic earnings per share	$	0.35	$	0.39	$	0.75	$	0.75
Diluted earnings per share:
Net income available to shareholders	$	1,927	$	2,098	$	4,065	$	4,085
Average shares outstanding		5,443,344		5,443,344		5,443,344		5,443,344
Effect of dilutive stock options		0		0		0		0
Average shares outstanding including dilutive stock options		5,443,344		5,443,344		5,443,344		5,443,344
Diluted earnings per share	$	0.35		0.39	$	0.75		0.75

			Fair Value Measurements
			Quoted Prices
			in Active
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
*(in thousands)*	Fair Value		(Level 1)		(Level 2)		(Level 3)
June 30, 2015
Assets:
Government sponsored enterprises	$	76,844	$	0	$	76,844	$	0
Asset-backed securities		128,418		0		128,418		0
Obligations of states and political subdivisions		34,225		0		34,225		0
Mortgage servicing rights		2,727		0		0		2,727
Total	$	242,214	$	0	$	239,487	$	2,727

December 31, 2014
Assets:
Government sponsored enterprises	$	57,099	$	0		57,099		0
Asset-backed securities		106,462		0		106,462		0
Obligations of states and political subdivisions		35,437		0		35,437		0
Mortgage servicing rights		2,762		0		0		2,762
Total	$	201,760	$	0	$	198,998	$	2,762

	Fair Value Measurements Using
	Significant Unobservable Inputs
	(Level 3)
	Mortgage Servicing Rights
	Three Months Ended June 30,						Six Months Ended June 30,
*(in thousands)*	2015			2014			2015			2014
Balance at beginning of period	$	2,662		$	3,040		$	2,762		$	3,036
Total gains or losses (realized/unrealized):
Included in earnings		(42	)		(201	)		(262	)		(247	)
Included in other comprehensive income		0			0			0			0
Purchases		0			0			0			0
Sales		0			0			0			0
Issues		107			72			227			122
Settlements		0			0			0			0
Balance at end of period	$	2,727		$	2,911		$	2,727		$	2,911

	Quantitative Information about Level 3 Fair Value Measurements
	Valuation Technique	Unobservable Inputs	Input Value
			Six Months Ended June 30,
			2015			2014
Mortgage servicing rights	Discounted cash flows	Weighted average constant prepayment rate		10.66	%		9.69	%
		Weighted average discount rate		9.34	%		9.15	%
		Weighted average expected life (in years)		5.70			6.00

	Fair Value Measurements Using
			Quoted Prices						Three			Six
			in Active						Months			Months
			Markets for		Other		Significant		Ended			Ended
			Identical		Observable		Unobservable		June 30,			June 30,
	Total		Assets		Inputs		Inputs		Total Gains			Total Gains
*(in thousands)*	Fair Value		(Level 1)		(Level 2)		(Level 3)		(Losses)*			(Losses)*
June 30, 2015
Assets:
Impaired loans:
Commercial, financial, & agricultural	$	1,201	$	0	$	0	$	1,201	$	(21	)	$	(21	)
Real estate construction - residential		0		0		0		0		0			0
Real estate construction - commercial		47		0		0		47		0			0
Real estate mortgage - residential		3,645		0		0		3,645		(135	)		(206	)
Real estate mortgage - commercial		611		0		0		611		(7	)		(30	)
Consumer		107		0		0		107		(48	)		(49	)
Total	$	5,611	$	0	$	0	$	5,611	$	(211	)	$	(306	)
Other real estate and foreclosed assets	$	12,516	$	0	$	0	$	12,516	$	(38	)	$	190

June 30, 2014
Assets:
Impaired loans:
Commercial, financial, & agricultural	$	1,412	$	0	$	0	$	1,412	$	(19	)	$	(122	)
Real estate construction - residential		1,749		0		0		1,749		0			(60	)
Real estate construction - commercial		39		0		0		39		(77	)		(491	)
Real estate mortgage - residential		3,698		0		0		3,698		(44	)		(138	)
Real estate mortgage - commercial		2,973		0		0		2,973		(704	)		(1,069	)
Consumer		221		0		0		221		(52	)		(70	)
Total	$	10,092	$	0	$	0	$	10,092	$	(896	)	$	(1,950	)
Other real estate and foreclosed assets	$	12,026	$	0	$	0	$	12,026	$	(1,499	)	$	(1,530	)

					December 31, 2014
					Fair Value Measurements
					Quoted Prices
					in Active				Net
					Markets for		Other		Significant
	December 31, 2014				Identical		Observable		Unobservable
	Carrying		Fair		Assets		Inputs		Inputs
*(in thousands)*	amount		value		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and due from banks	$	22,364	$	22,364	$	22,364	$	0	$	0
Federal funds sold and overnight interest-bearing deposits		20,445		20,445		20,445		0		0
Investment in available-for-sale securities		198,998		198,998		0		198,998		0
Loans, net		852,114		854,062		0		0		854,062
Investment in FHLB stock		3,075		3,075		0		3,075		0
Mortgage servicing rights		2,762		2,762		0		0		2,762
Cash surrender value - life insurance		2,284		2,284		0		2,284		0
Accrued interest receivable		4,816		4,816		4,816		0		0
	$	1,106,858	$	1,108,806	$	47,625	$	204,357	$	856,824
Liabilities:
Deposits:
Non-interest bearing demand	$	207,700	$	207,700	$	207,700	$	0	$	0
Savings, interest checking and money market		442,059		442,059		442,059		0		0
Time deposits		319,755		321,041		0		0		321,041
Federal funds purchased and securities sold under agreements to repurchase		17,970		17,970		17,970		0		0
Subordinated notes		49,486		33,371		0		33,371		0
Federal Home Loan Bank advances		43,000		44,396		0		44,396		0
Accrued interest payable		373		373		373		0		0
	$	1,080,343	$	1,066,910	$	668,102	$	77,767	$	321,041

Selected Financial Data
	Three Months Ended						Six Months Ended
	June 30,						June 30,
(In thousands, except per share data)	2015			2014			2015			2014
Per Share Data
Basic earnings per share	$	0.35		$	0.39		$	0.75		$	0.75
Diluted earnings per share		0.35			0.39			0.75			0.75
Dividends paid on common stock		261			252			523			504
Book value per share								15.39			14.61
Market price per share								14.32			12.04
Selected Ratios
*(Based on average balance sheets)*
Return on total assets		0.65	%		0.72	%		0.69	%		0.71	%
Return on stockholders' equity		9.21	%		10.83	%		9.89	%		10.75	%
Stockholders' equity to total assets		7.02	%		6.68	%		6.95	%		6.63	%
Efficiency ratio (1)		74.46	%		73.24	%		73.64	%		73.70	%

*(Based on end-of-period data)*
Stockholders' equity to assets								6.96	%		6.79	%
Total Capital Ratio (to risk weighted assets)								14.87	%		15.55	%
Tier 1 Capital Ratio (to risk weighted assets)								11.82	%		11.85	%
Tier 1 Capital Ratio (to average assets) (2)								9.36	%		9.00	%
Common Equity Tier 1 Capital (to risk weighted assets) (3)								8.82	%		NA	%

	Three Months Ended June 30,									Six Months Ended June 30,
	2015 vs. 2014									2015 vs. 2014
				Change due to									Change due to
	Total			Average			Average			Total			Average			Average
*(In thousands)*	Change			Volume			Rate			Change			Volume			Rate
Interest income on a fully taxable equivalent basis: (1)
Loans: (2) (4)
Commercial	$	89		$	144		$	(55	)	$	346		$	274		$	72
Real estate construction - residential		(34	)		(141	)		107			(91	)		(191	)		100
Real estate construction - commercial		(132	)		(143	)		11			(178	)		(223	)		45
Real estate mortgage - residential		103			195			(92	)		261			404			(143	)
Real estate mortgage - commercial		35			74			(39	)		(40	)		61			(101	)
Consumer		11			19			(8	)		0			23			(23	)
Investment securities: (3)
U.S. Treasury		0			0			0			(4	)		(2	)		(2	)
Government sponsored entities		16			23			(7	)		43			32			11
Asset backed securities		(1	)		87			(88	)		(8	)		166			(174	)
State and municipal		(2	)		19			(21	)		(7	)		39			(46	)
Other investments and securities, at cost		20			10			10			26			13			13
Federal funds sold and interest bearing deposits in other financial institutions		(1	)		(4	)		3			4			2			2
Total interest income		104			283			(179	)		352			598			(246	)
Interest expense:
NOW accounts		(14	)		2			(16	)		(31	)		6			(37	)
Savings		(1	)		1			(2	)		(10	)		3			(13	)
Money market		8			4			4			16			11			5
Time deposits of $100,000 and over		(22	)		(6	)		(16	)		(55	)		(18	)		(37	)
Other time deposits		(89	)		(36	)		(53	)		(174	)		(72	)		(102	)
Federal funds purchased and securities sold under agreements to repurchase		5			1			4			7			1			6
Subordinated notes		5			0			5			6			0			6
Federal Home Loan Bank advances		60			72			(12	)		103			128			(25	)
Total interest expense		(48	)		38			(86	)		(138	)		59			(197	)
Net interest income on a fully taxable equivalent basis	$	152		$	245		$	(93	)	$	490		$	539		$	(49	)

											Well-Capitalized Under
						Required for Capital					Prompt Corrective Action
	Actual					Adequacy Purposes					Provision
*(in thousands)*	Amount		Ratio			Amount		Ratio			Amount		Ratio
June 30, 2015
Total Capital (to risk-weighted assets):
Company	$	141,610		14.97	%	$	75,678		8.00	%	$	N.A.		N.A.
Bank		133,563		14.19			75,313		8.00			94,141		10.00	%
Tier I Capital (to risk-weighted assets):
Company	$	111,859		11.82	%	$	56,758		6.00	%	$	N.A.		N.A.
Bank		123,417		13.11			56,485		6.00			75,313		8.00	%
Common Equity Tier I Capital (to risk-weighted assets)
Company	$	83,464		8.82	%	$	42,569		4.50	%	$	N.A.		N.A.
Bank		123,417		13.11			42,363		4.50			61,192		6.50	%
Tier I Capital (to adjusted average assets):
Company	$	111,859		9.36	%	$	47,801		4.00	%	$	N.A.		N.A.
Bank		123,417		10.44			47,294		4.00			59,118		5.00	%

															Over
															5 Years or
															No stated
*(In thousands)*	Year 1			Year 2			Year 3			Year 4			Year 5		Maturity		Total
ASSETS
Investment securities	$	28,651		$	14,501		$	21,337		$	22,510		$	30,136	$	122,352	$	239,487
Federal funds sold and other over-night interest-bearing deposits		10,922			-			-			-			-		-		10,922
Other restricted investments		7,917			-			-			-			-		-		7,917
Loans		325,105			145,808			116,941			118,773			103,370		53,657		863,654
Total	$	372,595		$	160,309		$	138,278		$	141,283		$	133,506	$	176,009	$	1,121,980

LIABILITIES
Savings, interest checking, and money market deposits	$	257,987		$	-		$	207,266		$	-		$	-	$	-	$	465,253
Time deposits		208,303			62,028			28,091			13,139			5,574		-		317,135
Federal funds purchased and securities sold under agreements to repurchase		25,842			-			-			-			-		-		25,842
Subordinated notes		49,486			-			-			-			-		-		49,486
Federal Home Loan Bank advances		8,000			3,000			17,000			9,000			10,000		-		47,000
Total	$	549,618		$	65,028		$	252,357		$	22,139		$	15,574	$	-	$	904,716
Interest-sensitivity GAP
Periodic GAP	$	(177,023	)	$	95,281		$	(114,079	)	$	119,144		$	117,932	$	176,009	$	217,264
Cumulative GAP	$	(177,023	)	$	(81,742	)	$	(195,821	)	$	(76,677	)	$	41,255	$	217,264	$	217,264

Ratio of interest-earning assets to interest-bearing liabilities
Periodic GAP		0.68			2.47			0.55			6.38			8.57		NM		1.24
Cumulative GAP		0.68			0.87			0.77			0.91			1.05		1.24		1.24

Item 1.	Legal Proceedings

	The information required by this Item is set forth in Commitments and Contingencies, 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).

3.2		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).

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)

Date
	/s/ David T. Turner

August 14, 2015	David T. Turner, Chairman of the Board and
	Chief Executive Officer (Principal Executive Officer)

	/s/ W. Bruce Phelps

August 14, 2015	W. Bruce Phelps, Chief Financial Officer (Principal Financial
	Officer and Principal Accounting Officer)