HILLS BANCORPORATION - Quarter Report: 2010 June (Form 10-Q)

form10-q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010

Commission file number: 0-12668

Hills Bancorporation

Incorporated in Iowa

I.R.S. Employer Identification

No. 42-1208067

131 MAIN STREET, HILLS, IOWA 52235

Telephone number: (319) 679-2291

Indicate by checkmark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

þ Yes o No

Indicate by checkmark whether the Registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).

þ Yes o No

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o	Accelerated Filer þ
Non-accelerated filer o	Small Reporting Company o

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

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date.

CLASS		SHARES OUTSTANDING
		At July 31, 2010

Common Stock, no par value		4,400,367

Page 1

HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION

		Page Number


Item 1.	Financial Statements


	Consolidated balance sheets, June 30, 2010 (unaudited) and December 31, 2009		3
	Consolidated statements of income (unaudited) for three and six months ended June 30, 2010 and 2009		4
	Consolidated statements of comprehensive income (loss) (unaudited) for three and six months ended June 30, 2010 and 2009		5
	Consolidated statements of stockholders' equity (unaudited) for six months ended June 30, 2010 and 2009		6
	Consolidated statements of cash flows (unaudited) for six months ended June 30, 2010 and 2009		7 - 8
	Notes to consolidated financial statements		9 - 16

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations		17 - 40

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		40 - 41

Item 4.	Controls and Procedures		41


Part II OTHER INFORMATION

Item 1.	Legal proceedings		42

Item 1A.	Risk factors		42 - 47

Item 2.	Unregistered sales of equity securities and use of proceeds		48

Item 3.	Defaults upon senior securities		48

Item 4.	Reserved		48

Item 5.	Other information		48

Item 6.	Exhibits		48

Signatures			49

Exhibits Index			50

Page 2

Index

HILLS BANCORPORATION

CONSOLIDATED BALANCE SHEETS

(Amounts In Thousands, Except Shares)

	June 30, 2010
ASSETS	(Unaudited)			December 31, 2009

Cash and cash equivalents	$	25,533		$	24,095
Investment securities available for sale at fair value (amortized cost June 30, 2010 $194,363; December 31, 2009 $194,844)		200,852			201,645
Stock of Federal Home Loan Bank		11,119			12,453
Loans held for sale		9,883			7,976
Loans, net of allowance for loan losses (June 30, 2010 $28,350; December 31, 2009 $29,160)		1,513,082			1,503,981
Property and equipment, net		25,764			26,417
Tax credit real estate		21,590			18,777
Accrued interest receivable		9,402			9,677
Deferred income taxes, net		8,894			8,892
Other real estate owned and repossessed assets		3,829			3,227
Goodwill		2,500			2,500
Prepaid FDIC insurance		6,004			6,947
Other assets		3,827			4,039
	$	1,842,279		$	1,830,626

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	181,542		$	184,158
Interest-bearing deposits		1,220,560			1,163,269
Total deposits	$	1,402,102		$	1,347,427
Short-term borrowings		44,212			68,534
Federal Home Loan Bank borrowings		195,000			225,000
Accrued interest payable		2,057			2,341
Other liabilities		17,356			12,649
	$	1,660,727		$	1,655,951

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	23,790		$	22,900

STOCKHOLDERS' EQUITY
Capital stock, no par value; authorized 10,000,000 shares; issued June 30, 2010 4,618,871 shares; December 31, 2009 4,618,962 shares	$	-		$	-
Paid in capital		14,588			14,582
Retained earnings		174,202			166,120
Accumulated other comprehensive income		4,007			4,200
Treasury stock at cost (June 30, 2010 215,419 shares; December 31, 2009 196,688 shares)		(11,245	)		(10,227	)
	$	181,552		$	174,675
Less maximum cash obligation related to ESOP shares		23,790			22,900
	$	157,762		$	151,775
	$	1,842,279		$	1,830,626
See Notes to Consolidated Financial Statements.

Page 3

Index

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Amounts In Thousands, Except Per Share Amounts)

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2010		2009		2010		2009
Interest income:
Loans, including fees	$	22,193	$	22,274	$	43,992	$	44,331
Investment securities:
Taxable		850		948		1,725		1,914
Nontaxable		828		840		1,652		1,681
Federal funds sold		26		13		28		17
Total interest income	$	23,897	$	24,075	$	47,397	$	47,943
Interest expense:
Deposits	$	4,882	$	6,772	$	9,980	$	13,334
Short-term borrowings		120		169		263		402
FHLB borrowings		2,005		2,795		4,068		5,968
Total interest expense	$	7,007	$	9,736	$	14,311	$	19,704
Net interest income	$	16,890	$	14,339	$	33,086	$	28,239
Provision for loan losses		853		3,481		2,918		5,917
Net interest income after provision for loan losses	$	16,037	$	10,858	$	30,168	$	22,322
Other income:
Net gain on sale of loans	$	496	$	1,466	$	1,041	$	2,646
Trust fees		1,042		830		2,002		1,660
Service charges and fees		2,101		1,950		4,023		3,766
Rental revenue on tax credit real estate		404		213		866		521
Other noninterest income		545		590		1,624		1,182
	$	4,588	$	5,049	$	9,556	$	9,775
Other expenses:
Salaries and employee benefits	$	5,563	$	5,544	$	11,005	$	10,745
Occupancy		755		718		1,516		1,491
Furniture and equipment		1,000		892		2,015		1,821
Office supplies and postage		346		350		691		690
Advertising and business development		449		389		806		840
Outside services		1,543		1,480		3,435		2,937
Rental expenses on tax credit real estate		710		187		1,222		600
FDIC insurance assessment		271		1,321		1,045		1,846
Loss on extinguishment of debt - Federal Home Loan Bank borrowings		-		584		-		584
Net loss on sale of other real estate owned and other repossessed assets		42		168		183		632
Other noninterest expense		414		236		731		517
	$	11,093	$	11,869	$	22,649	$	22,703
Income before income taxes	$	9,532	$	4,038	$	17,075	$	9,394
Income taxes		2,811		1,108		4,969		2,475
Net income	$	6,721	$	2,930	$	12,106	$	6,919

Earnings per share:
Basic	$	1.52	$	0.66	$	2.74	$	1.56
Diluted		1.52		0.66		2.73		1.56

See Notes to Consolidated Financial Statements.

Page 4

Index

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited)

(Amounts In Thousands)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2010			2009			2010			2009

Net income	$	6,721		$	2,930		$	12,106		$	6,919

Other comprehensive income (loss):
Unrealized holding gains (losses) arising during the period	$	346		$	(310	)	$	(312	)	$	(314	)
Income tax effect of unrealized gains (losses)		(132	)		119			119			121
Other comprehensive income (loss)	$	214		$	(191	)	$	(193	)	$	(193	)

Comprehensive income	$	6,935		$	2,739		$	11,913		$	6,726

See Notes to Consolidated Financial Statements.

Page 5

Index

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)

(Amounts In Thousands, Except Share Amounts)

										Maximum
										Cash
							Accumulated			Obligation
							Other			Related
	Paid In			Retained			Comprehensive			To ESOP			Treasury
	Capital			Earnings			Income (Loss)			Shares			Stock			Total

Balance, December 31, 2008	$	13,447		$	154,176		$	3,649		$	(23,815	)	$	(8,095	)	$	139,362
Issuance of 1,767 shares of common stock		68			-			-			-			-			68
Forfeiture of 502 shares of common stock		(24	)		-			-			-			-			(24	)
Share-based compensation		8			-			-			-			-			8
Income tax benefit related to share-based compensation		10			-			-			-			-			10
Change related to ESOP shares		-			-			-			1,412			-			1,412
Net income		-			6,919			-			-			-			6,919
Dividends ($.91 per share)		-			(4,041	)		-			-			-			(4,041	)
Purchase of 24,305 shares of common stock		-			-			-			-			(1,311	)		(1,311	)
Other comprehensive loss		-			-			(193	)		-			-			(193	)
Balance, June 30, 2009	$	13,509		$	157,054		$	3,456		$	(22,403	)	$	(9,406	)	$	142,210



Balance, December 31, 2009	$	14,582		$	166,120		$	4,200		$	(22,900	)	$	(10,227	)	$	151,775
Issuance of 302 shares of common stock		16			-			-			-			-			16
Forfeiture of 393 shares of common stock		(18	)		-			-			-			-			(18	)
Share-based compensation		8			-			-			-			-			8
Income tax benefit related to share-based compensation		-			-			-			-			-			-
Change related to ESOP shares		-			-			-			(890	)		-			(890	)
Net income		-			12,106			-			-			-			12,106
Dividends ($.91 per share)		-			(4,024	)		-			-			-			(4,024	)
Purchase of 18,731 shares of common stock		-			-			-			-			(1,018	)		(1,018	)
Other comprehensive loss		-			-			(193	)		-			-			(193	)
Balance, June 30, 2010	$	14,588		$	174,202		$	4,007		$	(23,790	)	$	(11,245	)	$	157,762

See Notes to Consolidated Financial Statements.

Page 6

Index

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Amounts In Thousands)

	Six Months Ended
	June 30,
	2010			2009
Cash Flows from Operating Activities
Net income	$	12,106		$	6,919
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation		1,351			1,203
Provision for loan losses		2,918			5,917
Share-based compensation		8			8
Forfeiture of common stock		(18	)		(24	)
Compensation expensed through issuance of common stock		16			42
Excess tax benefits from share-based compensation		-			(10	)
Provision for deferred income taxes		117			(993	)
Net loss on sale of other real estate owned and other repossessed assets		183			632
Decrease in accrued interest receivable		275			133
Amortization of discount on investment securities, net		432			343
Decrease in prepaid FDIC insurance		943			-
Decrease (increase) in other assets		212			(457	)
Increase in accrued interest and other liabilities		4,423			2,682
Loans originated for sale		(80,489	)		(197,861	)
Proceeds on sales of loans		79,623			199,314
Net gain on sales of loans		(1,041	)		(2,646	)
Net cash and cash equivalents provided by operating activities	$	21,059		$	15,202

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	28,344		$	32,120
Purchases of investment securities available for sale		(26,961	)		(33,484	)
Loans made to customers, net of collections		(14,158	)		2,998
Proceeds on sale of other real estate owned and other repossessed assets		1,354			3,996
Purchases of property and equipment		(698	)		(1,542	)
Investment in tax credit real estate, net		(2,813	)		561
Net cash (used in) provided by investing activities	$	(14,932	)	$	4,649

Cash Flows from Financing Activities
Net increase in deposits	$	54,675		$	119,572
Net decrease in short-term borrowings		(24,322	)		(70,085	)
Stock options exercised		-			26
Excess tax benefits related to share-based compensation		-			10
Borrowings from FHLB		10,000			-
Payments on FHLB borrowings		(40,000	)		(40,000	)
Purchase of treasury stock		(1,018	)		(1,311	)
Dividends paid		(4,024	)		(4,041	)
Net cash (used in) provided by financing activities	$	(4,689	)	$	4,171

(Continued)

Page 7

Index

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued)

(Amounts In Thousands)

	Six Months Ended
	June 30,
	2010		2009

Increase in cash and cash equivalents	$	1,438	$	24,022

Cash and cash equivalents:
Beginning of year		24,095		22,575
End of period	$	25,533	$	46,597

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	10,264	$	13,368
Interest paid on other obligations		4,331		6,350
Income taxes paid		2,874		3,989

Noncash financing activities:
Increase (decrease) in maximum cash obligation related to ESOP shares	$	890	$	(1,412	)
Transfers to other real estate owned		2,139		2,026

See Notes to Consolidated Financial Statements.

Page 8

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1.

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with instructions for Form 10-Q and Regulation S-X. These financial statements include all adjustments (consisting of normal recurring accruals) which in the opinion of management are considered necessary for the fair presentation of the financial position and results of operations for the periods shown. Certain prior year amounts may be reclassified to conform to the current year presentation. The Company considers that it operates as one business segment, a commercial bank.

Operating results for the six month period ended June 30, 2010 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2010. For further information, refer to the consolidated financial statements and footnotes thereto included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the “Company”) for the year ended December 31, 2009 filed with the Securities Exchange Commission on March 10, 2010.

The Company evaluated subsequent events through the filing date of its quarterly report on Form 10-Q with the SEC.

Note 2.

Earnings Per Share

Basic earnings per share amounts are computed by dividing net income (the numerator) by the weighted average number of common shares outstanding (the denominator) during the period. Diluted per share amounts assume the conversion, exercise or issuance of all potential common stock equivalents unless the effect is to reduce the loss or increase the income per common share from continuing operations.

The computation of basic and diluted earnings per share for the periods presented is as follows:

	Three months ended						Six months ended
	June 30,						June 30,
	2010			2009			2010			2009

Common shares outstanding at the beginning of the period		4,416,683			4,430,365			4,422,274			4,440,545
Weighted average number of net shares (redeemed)		(3,200	)		(3,345	)		(5,828	)		(8,099	)
Weighted average shares outstanding (basic)		4,413,483			4,427,020			4,416,446			4,432,446
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method		13,143			15,195			13,236			14,679
Weighted average number of shares		4,426,626			4,442,215			4,429,682			4,447,125

Net income (In Thousands)	$	6,721		$	2,930		$	12,106		$	6,919

Earnings per share:
Basic	$	1.52		$	0.66		$	2.74		$	1.56
Diluted	$	1.52		$	0.66		$	2.73		$	1.56

Page 9

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 3.

Recent Accounting Pronouncements and Recent Legislative Developments

Recent Accounting Pronouncements

In June 2009, the FASB issued FASB ASU No. 2009-16, Accounting for Transfers of Financial Assets – an amendment of FASB ASC 860 (“ASU No. 2009-16”). ASU No. 2009-16 eliminates the concept of a qualified special-purpose entity and its exemption from consolidation in a transferor’s financial statements, establishes conditions for reporting a transfer of a portion of a financial asset as a sale, modifies the financial-asset derecognition criteria, revises how interests retained by the transferor in a sale of financial assets are initially measured, removes the guaranteed mortgage securitization recharacterization provisions and requires additional disclosures. ASU No. 2009-16 is effective for financial statements issued after November 15, 2009. The Company adopted this standard effective on January 1, 2010 and the adoption of ASU No. 2009-16 did not have a significant effect on the Company’s consolidated financial statements.

In June 2009, the FASB issued FASB ASU No. 2009-17, Amendments to FASB ASC 810 (“ASU No. 2009-17”). ASU No. 2009-17 eliminates FASB ASC 810’s exceptions to consolidated qualified special-purpose entities, contains new criteria for determining the primary beneficiary, and increases the frequency of required reassessments to determine whether a company is the primary beneficiary of a variable interest entity (“VIE”). ASU No. 2009-17 also clarifies the characteristics that identify a VIE. In addition, ASU No. 2009-17 contains a new requirement that any term, transaction, or arrangement that does not have a substantive effect on an entity’s status as a VIE, a company’s power over a VIE, or a company’s obligation to absorb losses or its right to receive benefits of an entity must be disregarded in applying the provision of FASB ASC 810. ASU No. 2009-17 is effective for financial statements issued after November 15, 2009. The Company adopted this standard effective on January 1, 2010 and the adoption of ASU No. 2009-17 did not have a significant effect on the Company’s consolidated financial statements.

In January 2010, the FASB issued ASU No. 2010-06, Improving Disclosures about Fair Value Measurements (“ASU No. 2010-06”). ASU No. 2010-06 modifies FASB ASC 820, Fair Value Measurements and Disclosures. ASU No. 2010-06 requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair-value measurements. The FASB also clarified existing fair-value measurement disclosure guidance about the level of disaggregation, inputs, and valuation techniques. ASU No. 2010-06 is effective for financial statements issued for the year beginning after December 15, 2009. The Company adopted this standard effective on January 1, 2010 and the adoption of ASU No. 2010-06 did not have a significant effect on the Company’s consolidated financial statements.

On July 21, 2010, the FASB issued ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which requires significant new disclosures about the allowance for credit losses and the credit quality of financing receivables. The requirements are intended to enhance transparency regarding credit losses and the credit quality of loan and lease receivables. Under this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, impaired financing receivables and nonaccrual status are to be presented by class of financing receivable. Disclosure of the nature and extent, the financial impact and segment information of troubled debt restructurings will also be required. The disclosures are to be presented at the level of disaggregation that management uses when assessing and monitoring the portfolio’s risk and performance. This ASU is effective for interim and annual reporting periods after December 15, 2010. The Company will include these disclosures in the notes to the financial statements beginning in the fourth quarter of 2010.

Page 10

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 3.

Recent Accounting Pronouncements and Recent Legislative Developments (continued)

Recent Legislative Developments

Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Act”) was signed into law on July 21, 2010. The Act represents the most sweeping financial services industry reform since the 1930’s. Generally, the Act is effective the day after it was signed into law, but different effective dates apply to specific sections of the Act. Among other things, the Act may result in added costs of doing business and regulatory compliance burdens and affect competition among financial services entities. Uncertainty exists as to the ultimate impact of many provisions of the Act, which could have a material adverse impact on the financial services industry as a whole and on the Company’s business, results of operations and financial condition. Additional information, including a summary of certain provisions of the Act, is available on the Federal Deposit Insurance Corporation website at www.fdic.gov/regulations/reform/index.html.

Page 11

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4.

Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments under ASC 820, Financial Instruments, as of June 30, 2010 and December 31, 2009 are as follows:

	June 30, 2010				December 31, 2009
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
	(Amounts In Thousands)

Cash and due from banks	$	25,533	$	25,533	$	24,095	$	24,095
Investment securities		211,971		211,971		214,098		214,098
Loans		1,522,965		1,536,189		1,511,957		1,515,351
Accrued interest receivable		9,402		9,402		9,677		9,677
Deposits		1,402,102		1,402,830		1,347,427		1,350,881
Short-term borrowings		44,212		44,212		68,534		68,534
Federal Home Loan Bank borrowings		195,000		211,186		225,000		242,562
Accrued interest payable		2,057		2,057		2,341		2,341


	Face Amount				Face Amount

Off-balance sheet instruments:
Loan commitments	$	276,069	$	-	$	289,927	$	-
Letters of credit		7,430		-		9,724		-

ASC 820 provides a single definition for fair value, a framework for measuring fair value and expanded disclosures concerning fair value. Fair value is defined under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

The Company determines the fair market value of its financial instruments based on the fair value hierarchy established in ASC 820. There are three levels of inputs that may be used to measure fair value as follows:

Level 1

Valuations for assets and liabilities traded in active markets for identical assets or liabilities. Level 1 includes securities purchased from the Federal Home Loan Bank (“FHLB”), Federal Home Loan Mortgage Corporation (“FHLMC”) and Federal National Mortgage Association (“FNMA”) that are traded by dealers or brokers in active markets. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

Level 2

Valuations for assets and liabilities traded in less active dealer or broker markets. Level 2 includes securities issued by state and political subdivisions. Valuations are obtained from third party pricing services for identical or comparable assets or liabilities.

Page 12

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4.

Fair Value Measurements (continued)

Level 3

Valuations for assets and liabilities that are derived from other valuation methodologies, including discounted cash flow models and similar techniques, and not based on market exchange, dealer or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets and liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. The Company does not have any Level 3 assets or liabilities.

It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. Recent market conditions have led to diminished, and in some cases, non-existent trading in certain of the financial asset classes. The Company is required to use observable inputs, to the extent available, in the fair value estimation process unless that data results from forced liquidations or distressed sales. Despite the Company’s best efforts to maximize the use of relevant observable inputs, the current market environment has diminished the observability of trades and assumptions that have historically been available.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value and for estimating fair value for assets or liabilities not recorded at fair value.

ASSETS

Cash and cash equivalents: The carrying amounts reported in the consolidated balance sheets for cash and short-term instruments approximate their fair values.

Investment securities available for sale: Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If a quoted price is not available, the fair value is obtained from benchmarking the security against similar securities. Level 1 securities include securities from the FHLB, FHLMC and FNMA. Level 2 securities include securities issued by state or political subdivisions.

Loans held for sale: Loans held for sale are carried at historical cost. The carrying amount is a reasonable estimate of fair value because of the short time between origination of the loan and its sale on the secondary market.

Loans: The Company does not record loans at fair value on a recurring basis. For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans are determined using estimated future cash flows, discounted at the interest rates currently being offered for loans with similar terms to borrowers with similar credit quality. The Company does record nonrecurring fair value adjustments to loans to reflect (1) partial write-downs that are based on the observable market price or appraised value of the collateral or (2) the full charge-off of the loan carrying value.

Other real estate owned and other repossessed assets: Other real estate owned and other repossessed assets consist mainly of other real estate owned but may include other types of assets repossessed by the Company. Other real estate owned assets are adjusted to the lower of carrying value or fair value less the cost of disposal upon transfer of the loans to other real estate owned. Fair value is generally based upon independent market prices or appraised values of the collateral. The value of other real estate assets is evaluated periodically. Other real estate assets are classified as Level 2.

Off-balance sheet instruments: Fair values for outstanding letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. The fair value of the outstanding letters of credit is not significant. Unfunded loan commitments are not valued since the loans are generally priced at market at the time of funding.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4.

Fair Value Measurements (continued)

Accrued interest receivable: The fair value of accrued interest receivable equals the amount receivable due to the current nature of the amounts receivable.

Stock of Federal Home Loan Bank: There are generally restrictions on the sale and/or liquidation of this investment. The carrying value of stock of the Federal Home Loan Bank approximates fair value.

LIABILITIES

Deposit liabilities: Deposit liabilities are carried at historical cost. The fair value of demand deposits, savings accounts and certain money market account deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. If the fair value of the fixed maturity certificates of deposit is calculated at less than the carrying amount, the carrying value of these deposits is reported as the fair value.

Short-term borrowings: Short-term borrowings are carried at historical cost and include federal funds purchased and securities sold under agreements to repurchase. The carrying amount is a reasonable estimate of fair value because of the relatively short time between the origination of the liability and its expected realization.

Federal Home Loan Bank borrowings: Federal Home Loan Bank borrowings are recorded at historical cost. The fair values of the borrowings are estimated using discounted cash flow analyses, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Accrued interest payable: The fair value of accrued interest payable equals the amount payable due to the current nature of the amounts payable.

Valuation methodologies have not changed during the quarter or six month periods ended June 30, 2010. As noted in the Recent Accounting Pronouncements in Note 3, the Company considered all new accounting guidance in its valuation methodologies. Adoption of the new accounting guidance did not have a significant effect on the Company’s evaluation of the fair value of its financial instruments. Assets and liabilities measured at fair value on a nonrecurring basis are not material to the Company’s consolidated financial statements.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below represents the balances of assets and liabilities measured at fair value on a recurring basis:

	June 30, 2010
	Level 1		Level 2		Level 3		Total
	(Amounts in Thousands)

Investment securities available for sale	$	98,820	$	102,032	$	-	$	200,852
Total	$	98,820	$	102,032	$	-	$	200,852

All securities from the FHLB, FHLMC and FNMA are included in Level 1.

There were no transfers between Levels 1, 2 or 3 during the three and six months ended June 30, 2010.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4.

Fair Value Measurements (continued)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Company is required to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. The valuation methodologies used to measure these fair value adjustments are described above. For assets measured at fair value on a nonrecurring basis in 2010 that were still held on the balance sheet at June 30, 2010, the following table provides the level of valuation assumptions used to determine the adjustment and the carrying value of the related individual assets at quarter end.

									Quarter Ended		Quarter Ended		Six Months Ended
	June 30, 2010								March 31, 2010		June 30, 2010		June 30, 2010
	Level 1		Level 2		Level 3		Total		Total Losses		Total Losses		Total Losses
	(Amounts in Thousands)

Loans (1)	$	-	$	7,328	$	-	$	7,328	$	19	$	1,031	$	1,050
Foreclosed assets (2)		-		728		-		728		144		123		267
Total	$	-	$	8,056	$	-	$	8,056	$	163	$	1,154	$	1,317

(1)	Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully-charged off is zero.

(2)	Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

As of June 30, 2010, the $7.3 million of loans recorded at fair value on a nonrecurring basis consisted of the following loan types: $3.1 million of 1 – 4 family residential loans, $1.1 million of commercial mortgage loans, and $1.4 million of commercial and industrial loans. The remaining $1.7 million was spread over the following categories of loans: agricultural, real estate construction, mortgage – farmland, mortgage – multi-family, and loans to individuals. The total $7.3 million of loans represents the carrying value of loans partially charged off as it was determined that the fair value of the loan collateral was less than the carrying value. Of the total $7.3 million, $1.6 million was included in the nonaccrual loan total. The remaining $5.7 million is accruing interest based on the fact loan payments have been made as contractually agreed.

Note 5. Stock Repurchase Program

In July of 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). This authorization is set to expire on December 31, 2013. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors. The Company has purchased 215,419 shares of its common stock in privately negotiated transactions from August 1, 2005 through June 30, 2010. Of these 215,419 shares, 13,088 shares were purchased during the quarter ended June 30, 2010, at an average price per share of $54.93.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6.

Commitments and Contingencies

The Company’s subsidiary, Hills Bank and Trust Company (the “Bank”) is a party to financial instruments with off-balance–sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, credit card participations and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at June 30, 2010 and December 31, 2009 is as follows:

	June 30, 2010		December 31, 2009
	(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	37,559	$	37,705
Credit card participations		44,135		43,658
Commercial, real estate and home construction		70,228		78,783
Commercial lines and real estate purchase loans		124,147		129,781
Outstanding letters of credit		7,430		9,724

Note 7.

Income Taxes

Federal income tax expense for the six months ended June 30, 2010 and 2009 was computed using the consolidated effective federal tax rate. The Company also recognized income tax expense pertaining to state franchise taxes payable individually by the subsidiary bank. The Company files a consolidated tax return for federal purposes and separate tax returns for State of Iowa purposes. The tax years ended December 31, 2009 and 2008, remain subject to examination by the Internal Revenue Service. For state tax purposes, the tax years ended December 31, 2009, 2008 and 2007, remain open for examination. There were no material unrecognized tax benefits at December 31, 2009 and June 30, 2010 and therefore no interest or penalties on unrecognized tax benefits has been recorded. As of June 30, 2010, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending June 30, 2011.

Income taxes as a percentage of income before taxes were 29.10% in 2010 and 26.35% in 2009. The increase in the effective tax rate is due to tax-exempt interest income and income tax credits and the relationship to total income before income taxes.

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Item 2.

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

The following is management’s discussion and analysis of the financial condition of Hills Bancorporation (“Hills Bancorporation” or “the Company”) and its banking subsidiary Hills Bank and Trust Company (“the Bank”) for the dates and periods indicated. The discussion and analysis should be read in conjunction with the consolidated financial statements and the accompanying footnotes.

Special Note Regarding Forward Looking Statements

This report contains, and future oral and written statements of the Company and its management may contain, forward-looking statements within the meaning of such term in the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Actual results may differ materially from those included in the forward-looking statements. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, the following:

·	The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company’s assets.

—	The effects of recent financial market disruptions and the current global economic recession, and monetary and other governmental actions designed to address such disruptions and recession.

—	The financial strength of the counterparties with which the Company or the Company’s customers do business and as to which the Company had investment or financial exposure.

—	The credit quality and credit agency ratings of the securities in the Company’s investment portfolio, a deterioration or downgrade of which could lead to other-than-temporary impairment of the affected securities and the recognition of impairment loss.

·	The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company. See Note 3 regarding the Dodd-Frank Wall Street Reform and Consumer Protection Act.

·	The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.

·	The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.

·	The ability of the Company to obtain new customers and to retain existing customers.

·	The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet.

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

·	The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.

·	Consumer spending and saving habits which may change in a manner that affects the Company’s business adversely.

·	The economic impact of natural disasters.

·	Business combinations and the integration of acquired businesses and assets which may be more difficult or expensive than expected.

·	The costs, effects and outcomes of existing or future litigation.

·	The ability of the Company to manage the risks associated with the foregoing as well as anticipated.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company’s financial results, is included in the Company’s filings with the Securities and Exchange Commission.

Critical Accounting Policies

The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company's allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including economic conditions throughout the Midwest and in particular, the state of certain industries. Size and complexity of individual loans in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion and analysis should be read in conjunction with the Company's consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management's Discussion and Analysis of Financial Condition and Results of Operations. Although management believes the levels of the allowance as of June 30, 2010 and December 31, 2009 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Overview

This overview highlights selected information and may not contain all of the information that is important to you in understanding our performance during the period. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources, and critical accounting estimates, you should carefully read this entire report.

The Company is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa. At June 30, 2010, the Bank has fourteen full-service locations and a trust and wealth management location.

Net income for the six month period ended June 30, 2010 was $12.11 million compared to $6.92 million for the same six months of 2009, an increase of 74.97%. The $5,187,000 increase in net income was caused by a number of factors. The principal factors in the increase in net income for the first six months of 2010 are an increase in net interest income of $4,847,000 and a decrease in the provision for loan losses of $2,999,000.

The Company achieved a return on average assets of 1.16% and a return on average equity of 12.14% for the twelve months ended June 30, 2010, compared to the twelve months ended June 30, 2009 which were 0.81% and 8.85%, respectively. Dividends of $.91 per share were paid in January 2010 to 1,690 shareholders. The 2010 dividend was the same dividend per share as paid in January 2009.

The Bank’s net interest income is the largest component of revenue and it is primarily a function of the average earnings assets and the net interest margin percentage. The Bank achieved a net interest margin on a tax-equivalent basis of 3.97% in 2010 compared to 3.43% in 2009. Average earning assets were $1.733 billion in 2010 and $1.723 billion in 2009.

Highlights noted on the balance sheet as of June 30, 2010 for the Company included the following:

Ÿ	Total assets were $1.84 billion, an increase of $11.7 million since December 31, 2009.

Ÿ	Net loans were $1.52 billion, an increase of $11.0 million since December 31, 2009.

Ÿ	Deposit growth of $54.68 million since December 31, 2009.

Ÿ	Short-term borrowings decreased $24.32 million since December 31, 2009.

Ÿ	Federal Home Loan Bank borrowings decreased $30.0 million since December 31, 2009.

Reference is made to Note 4 for a discussion of fair value measurements which relate to methods used by the Company in recording assets and liabilities on its financial statements.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Financial Condition

The tables below set forth the composition of the loan portfolio as of June 30, 2010 and December 31, 2009 (dollars in thousands), along with changes in the allowance for loan losses and non-performing loan information:

	June 30, 2010					December 31, 2009
	Amount		Percent			Amount		Percent
	(Amounts In Thousands)					(Amounts In Thousands)

Agricultural	$	64,914		4.21	%	$	64,598		4.21	%
Commercial and financial		148,372		9.62			153,997		10.04
Real estate:
Construction, 1 to 4 family residential		21,877		1.42			25,821		1.68
Construction, land development and commercial		85,830		5.57			95,955		6.26
Mortgage, farmland		81,673		5.30			87,300		5.70
Mortgage, 1 to 4 family first liens		496,741		32.23			470,328		30.68
Mortgage, 1 to 4 family junior liens		114,631		7.44			114,742		7.48
Mortgage, multi-family		193,084		12.53			190,180		12.40
Mortgage, commercial		298,588		19.37			295,070		19.25
Loans to individuals		23,959		1.55			25,405		1.66
Obligations of state and political subdivisions		11,763		0.76			9,745		0.64
	$	1,541,432		100.00	%	$	1,533,141		100.00	%
Less allowance for loan losses		28,350					29,160
	$	1,513,082				$	1,503,981

The Bank has an established formal loan origination policy. In general, the loan origination policy attempts to reduce the risk of credit loss to the Bank by requiring, among other things, maintenance of minimum loan to value ratios, evidence of appropriate levels of insurance carried by borrowers and documentation of appropriate types and amounts of collateral and sources of expected payment. Each customer is evaluated as a part of the Bank’s underwriting process and through periodic reviews. Loan and overall customer credit approval levels are established so that larger borrower relationships are approved through various credit committees. For consumer loans, a third-party credit scoring model is used to help determine eligibility for credit.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Changes in the allowance for loan losses for the periods shown in the following table were as follows:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2010		2009		2010		2009
	(Amounts In Thousands)				(Amounts In Thousands)

Balance, beginning		29,840	$	28,600		29,160	$	27,660
Charge-offs:
Agricultural		-		2		8		2
Commercial and financial		937		1,338		1,821		2,023
Real estate:
Construction, 1 to 4 family residential		20		1		44		1
Construction, land development and commercial		556		125		688		125
Mortgage, farmland		26		-		39		-
Mortgage, 1 to 4 family first liens		644		179		825		528
Mortgage, 1 to 4 family junior liens		384		250		621		613
Mortgage, multi-family		-		-		19		95
Mortgage, commercial		348		186		517		236
Loans to individuals		126		101		207		281
		3,041		2,182		4,789		3,904

Recoveries:
Agricultural		3		3		5		6
Commercial and financial		288		53		439		156
Real estate:
Construction, 1 to 4 family residential		1		-		2		-
Mortgage, farmland		-		-		-		1
Mortgage, 1 to 4 family first liens		228		23		262		38
Mortgage, 1 to 4 family junior liens		61		74		111		110
Mortgage, commercial		48		-		79		-
Loans to individuals		69		78		163		146
		698		231		1,061		457
Net charge-offs		2,343		1,951		3,728		3,447
Provision charged to expense		853		3,481		2,918		5,917
Balance, ending	$	28,350	$	30,130	$	28,350	$	30,130

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Non-performing loan information at June 30, 2010 and December 31, 2009, was as follows:

	June 30, 2010			December 31, 2009
	(Amounts in thousands)

Non-accrual loans	$	5,523		$	5,360
Accruing loans past due 90 days or more		5,030			7,009
Restructured loans		23,982			15,135
Total non-performing loans (1)		34,535			27,504
Other real estate		3,829			3,227
Non-performing assets (includes non-performing loans and other real estate)		38,364			30,731
Loans held for investment		1,541,432			1,533,141
Ratio of allowance for loan losses to loans held for investment		1.84	%		1.90	%
Ratio of allowance for loan losses to non-performing loans		82.09			106.02
Ratio of non-performing loans to total loans held for investment		2.24			1.79
Ratio of non-performing assets to total assets		2.08			1.68

(1) The Company has revised the total of non-performing loans from previous filings. The revised total has decreased by $47,761 as of December 31, 2009. In previous filings, the Company included all loans that were evaluated for potential impairment as part of our quarterly allowance for loan loss calculation in the non-performing loan total. The Company revised the presentation of non-performing loans to include only nonaccrual loans, accruing loans > 90 days past due and restructured loans. The resulting change in the presentation of non-performing loan total does not have any impact on the allowance for loan loss policy, allowance for loan loss calculation or the provision for loan loss for any periods presented. The loans that were removed from the presentation were evaluated for potential impairment. As these loans were not considered impaired, the appropriate allocation was calculated using historical loss rates, as adjusted for qualitative factors. The revised non-performing loan presentation will allow the Company to better compare itself to its appropriate peer group as the revised non-performing loan presentation corresponds with the regulatory definition.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Certain non-performing loan information by loan type at June 30, 2010 and December 31, 2009, was as follows:

	June 30, 2010						December 31, 2009
			Accruing loans						Accruing loans
	Non-accrual		past due		Restructured		Non-accrual		past due		Restructured
	loans		90 days		loans		loans		90 days		loans
	(Amounts In Thousands)						(Amounts In Thousands)

Agriculture	$	-	$	432	$	-	$	-	$	8	$	-
Commercial and financial		579		790		3,220		958		280		3,134
Real estate:
Construction, 1 to 4 family residential		620		-		-		-		260		-
Construction, land development and commercial		944		-		1,805		2,645		1,202		2,442
Mortgage, farmland		-		-		-		-		172		-
Mortgage, 1 to 4 family first liens		1,053		3,406		1,614		1,534		3,528		1,672
Mortgage, 1 to 4 family junior liens		102		218		977		-		140		613
Mortgage, multi-family		1,855		-		4,821		-		906		4,867
Mortgage, commercial		370		179		11,545		223		469		2,407
Loans to individuals		-		5		-		-		44		-
	$	5,523	$	5,030	$	23,982	$	5,360	$	7,009	$	15,135

Non-performing loans increased by $7.03 million from December 31, 2009 to June 30, 2010. Non-performing loans include any loan that has been placed on nonaccrual status, loans past due 90 days or more and still accruing interest and restructured loans. Non-performing loans were 2.24% of loans held for investment as of June 30, 2010 and 1.79% as of December 31, 2009. The increase in non-performing loans is due to the restructure of one large commercial mortgage borrower with an aggregate loan balance of $8.8 million as of June 30, 2010.

Loans 90 days past due that are still accruing interest decreased $2.0 million from December 31, 2009 to June 30, 2010. The average past due loan balance was $75,000 as of June 30, 2010 compared to $95,000 as of December 31, 2009. The loans 90 days past due and still accruing are believed to be adequately collateralized.

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

The Bank restructured loans with an aggregate principal amount totaling $9.3 million during the six months ended June 30, 2010, all of which are considered to be troubled debt restructurings as defined under FASB ASC 310-40. These 2010 restructures related to two customers. The first 2010 customer relationship consisted of five loans totaling approximately $9.0 million. The loans were re-written into two notes using the “Policy Statement on Prudent Commercial Real Estate Loan Workouts” issued by the joint interagency regulators, including the Bank’s main regulator the FDIC, in October 2009. The first note was equal to 80% of the updated 2009 appraised value for the property with a maturity date of five years. The interest rate for the first note of 5.95% is considered a market interest rate by the Company. The second note was for the remaining loan balance with a five year maturity and a below market interest rate of 4.0%. At the time of the restructure, the second note was fully charged off which did not impact the allowance requirement as the Company had already factored this information into the December 31, 2009 allowance for loan loss calculation. The restructure was completed as it allowed the debt that is recorded on the books to be supported by an updated appraisal. The first note has been classified as watch and is accruing interest based on payment history before and after the restructure. There is no interest income recognized on the second note as it is fully charged off. The customer has made monthly payments on all debt owed to the Bank in a timely manner before and after the restructure. Based on this factor, the Bank does not consider there to be any impairment on the remaining debt. Factors that could lead to the removal of the loans from the restructured classification include future improvement of the value of the underlying collateral, the second note returning to a market rate of interest or the loans paying off. The Bank loaned an additional $100,000 to the borrower during 2010 after the completion of the restructuring of the loans. The additional borrowings were not used to facilitate payments on their loans. The Bank has no commitment to lend additional funds to the customer. Since the date of restructure, the Bank would have recorded $232,000 in interest income if the loans had been current in accordance with their original terms. Instead, the Bank recorded $191,000 of interest income and a loss of interest income of $41,000 due to the restructure of this customer relationship. The second 2010 customer relationship consisted of ten loans totaling $358,000. Since the date of restructure, the Bank would have recorded $15,500 in interest income if the loans had been current in accordance with their original terms. Instead, the Bank recorded $4,000 of interest income and a loss of interest income of $11,500 due to the restructure of this customer relationship. The Bank does not have any commitments to lend this customer additional funds.

The Bank restructured loans totaling $11.5 million during the twelve months ended December 31, 2009, all of which were considered to be troubled debt restructurings as defined under FASB ASC 310-40. One customer relationship consisted of seven loans totaling $2.8 million. The customer’s loans were modified to require interest only payments at market rates for approximately 30 months. It is anticipated that the customer will return to principal and interest payments in August 2011. The Bank loaned an additional $286,000 to the borrower during 2009 after the completion of the restructuring of the loans. The new loan was for the purchase of a smaller personal residence which resulted in an overall reduction of borrower debt of approximately $44,000. The customer paid off a mortgage loan on a prior personal residence which exceeded the $286,000 in mortgage debt for the new personal residence. In addition, the Bank has committed to lend an additional $10,000 to the customer to cover minimal personal expenses. At June 30, 2010, after further deterioration of the customer’s financial condition, the customer relationship is non-accrual and is considered impaired. Another customer relationship consisted of eleven loans totaling $8.2 million was restructured during 2009. The borrower was granted a rate concession to 5.25% on approximately $5.2 million of debt until maturity in October 2010 and 5.25% on approximately $3.0 million until maturity in March 2011. Based on the customer’s financial condition, the rate of 5.25% was not considered a market rate by the Company. Since the date of restructure, the Bank would have recorded $363,000 in interest income if the loans had been current in accordance with their original terms. Instead, the Bank recorded $343,000 of interest income and a loss of interest income of $20,000 due to the restructure of this customer relationship. The Bank does not have any commitments to lend this customer additional funds. There were four additional relationships restructured during 2009 totaling $0.5 million. The terms of the restructured amounts included interest only payments for four months, re-amortization of loan payments over 25 years and a rate concession. Since the date of restructure, the Bank would have recorded $23,000 in interest income if the loans had been current in accordance with their original terms. Instead, the Bank recorded $21,000 of interest income and a loss of interest income of $2,000 due to the restructure of their customer relationships. The Bank does not have any commitments to lend these customers additional funds. The payments for all loans restructured during 2009 have been made as agreed. At June 30, 2010, $8.7 million of the total $11.5 million of restructured loans is accruing interest.

Page 24

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

The Bank regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans are impaired. If the loans are impaired, the Bank determines if a specific allowance is appropriate. The Bank evaluates the following loans to determine impairment: 1) all nonaccrual and restructured loans, 2) all non consumer and non 1-4 family residential loans with prior charge-offs, and 3) all non consumer and non 1-4 family loan relationships classified as substandard. Impaired loans include only those loans as to which the Company believes it is probable that it will be unable to collect all amounts due (including principal and interest) according to the contractual terms of the loan agreement. In addition, the Bank's management also reviews and, where determined necessary, provides allowances based upon (1) reviews of specific borrowers and (2) management’s assessment of areas that management considers are of higher credit risk. Loans for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Bank allocates a percentage, as determined by management, for a required allowance needed. The percentage begins with historical loss experience factors, which are then adjusted for levels and trends in past due, charged-off and recovered loans, volume growth, trends in problem and watch loans, current economic factors, and other relevant factors.

For loans that are collateral dependent, losses are evaluated based on the portion of a loan that exceeds the fair market value of the collateral that can be identified as uncollectible. In general, this is the amount that the carrying value of the loan exceeds the related appraised value. Generally, it is the Company’s policy not to rely on appraisals that are older than one year prior to the date the impairment is being measured. The most recent appraisal values may be adjusted if, in the Company’s judgment, experience and other market data indicate that the property’s value, use, condition, exit market or other variable affecting its value may have changed since the appraisal was performed, consistent with the December 2006 joint interagency guidance on the allowance for loan losses. The charge off or loss adjustment supported by an appraisal is considered the minimum charge off. Any adjustments made to the appraised value are to provide additional charge off or loss allocations based on the applicable facts and circumstances. In instances where there is an estimated decline in value, a loss allocation may be provided or a charge off taken pending confirmation of the amount of the loss from an updated appraisal. Upon receipt of the new appraisals, an additional loss allocation may be provided or charge off taken based on the appraised value of the collateral. On average, appraisals are obtained within one month of order.

The Company has not experienced any significant time lapses in recognizing the required provisions for collateral dependent loans, nor has the Company delayed appropriate charge offs. When an updated appraisal value has been obtained, the Company has used the appraisal amount in determining the appropriate charge off or required reserve. The Company also evaluates any changes in the financial condition of the borrower and guarantors (if applicable), economic conditions, and the Company’s loss experience with the type of property in question. Any information utilized in addition to the appraisal is intended to identify additional charge offs or provisions, not to override the appraised value.

For flood-related properties located in Linn County, Iowa, the Company has not used external appraisals to determine the fair market value of collateral. Due to the wide-spread flooding in June 2008, there was a lack of appropriate arms-length transactions to support useful appraisals especially for 1-to-4 family residences. Instead, the Company has utilized assessed values and independent realtor market evaluations on individual properties. The Company believes these tools have been an appropriate measure in estimating the fair market value of such properties in this situation.

Page 25

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

The following table presents the allowance for loan losses on loans by type of loans and the percentage in each category to total loans as of June 30, 2010 and December 31, 2009:

	June 30, 2010								December 31, 2009
			% of			% of					% of			% of
			Total			Loans to					Total			Loans to
	Amount		Allowance			Total Loans			Amount		Allowance			Total Loans
	(In Thousands)								(In Thousands)
Agricultural	$	3,020		10.65	%		4.21		$	2,967		10.17	%		4.21	%
Commercial and financial		6,793		23.96			9.62			7,090		24.31			10.04
Real estate:
Construction, 1 to 4 family residential		683		2.41			1.42			836		2.87			1.68
Construction, land development and commercial		3,011		10.62			5.57			3,975		13.63			6.26
Mortgage, farmland		1,486		5.24			5.30			1,417		4.86			5.69
Mortgage, 1 to 4 family first liens		6,356		22.42			32.23			6,091		20.89			30.68
Mortgage, 1 to 4 family junior liens		1,453		5.13			7.44			1,393		4.78			7.49
Mortgage, multi-family		1,751		6.18			12.53			1,723		5.91			12.40
Mortgage, commercial		3,221		11.36			19.37			3,019		10.36			19.25
Loans to individuals		563		1.98			1.55			639		2.19			1.66
Obligations of state and political subdivisions		13		0.05			0.76			10		0.03			0.64
	$	28,350		100.00	%		100.00	%	$	29,160		100.00	%		100.00	%

The Company believes that the allowance for loan losses is at a level commensurate with the overall risk exposure of the loan portfolio. However, if economic conditions continue to deteriorate, certain borrowers may experience difficulty and the level of nonperforming loans, chargeoffs and delinquencies could continue to rise and require increases in the provision for loan losses. The Company will continue to monitor the adequacy of the allowance on a quarterly basis and will consider the impact of economic conditions on the borrowers’ ability to repay, loan collateral values, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition.

Residential real estate loan products that include features such as loan-to-values in excess of 100%, interest only payments or adjustable-rate mortgages, which expose a borrower to payment increases in excess of changes in the market interest rate, increase the credit risk of a loan. The Bank has not offered and does not offer this type of loan product.

Page 26

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Investment securities available for sale held by the Company decreased by $0.8 million from December 31, 2009 to June 30, 2010. The fair value of securities available for sale was $6.5 million more than the amortized cost of such securities as of June 30, 2010. At December 31, 2009, the fair value of the securities available for sale was $6.8 million more than the amortized cost of such securities. The carrying values of investment securities at June 30, 2010 and December 31, 2009 are summarized in the following table (dollars in thousands):

	June 30, 2010					December 31, 2009
	Amount		Percent			Amount		Percent
Securities available for sale

Obligations of state and political subdivisions	$	102,032		50.80	%	$	102,555		50.86	%

Other securities (FHLB, FHLMC and FNMA)		98,820		49.20			99,090		49.14

Total securities available for sale	$	200,852		100.00	%	$	201,645		100.00	%

Investment securities have been classified in the consolidated balance sheets according to management’s intent. Available-for-sale securities consist of debt securities not classified as trading or held to maturity. Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity. There were no trading or held to maturity securities as of June 30, 2010 or December 31, 2009. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of June 30, 2010 and December 31, 2009 (in thousands):

			Gross		Gross			Estimated
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		(Losses)			Value

June 30, 2010:
Other securities (FHLB, FHLMC and FNMA)	$	95,616	$	3,204	$	-		$	98,820
State and political subdivisions		98,747		3,440		(155	)		102,032
Total	$	194,363	$	6,644	$	(155	)	$	200,852

December 31, 2009:
Other securities (FHLB, FHLMC and FNMA)	$	95,745	$	3,355	$	(10	)	$	99,090
State and political subdivisions		99,099		3,562		(106	)		102,555
Total	$	194,844	$	6,917	$	(116	)	$	201,645

Page 27

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at June 30, 2010, were as follows (in thousands):

	Amortized		Fair
	Cost		Value


Due in one year or less	$	34,528	$	35,073
Due after one year through five years		113,364		117,983
Due after five years through ten years		46,101		47,396
Due over ten years		370		400
Total	$	194,363	$	200,852

The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2010 and December 31, 2009 (in thousands):


	Less than 12 months										12 months or more										Total
June 30, 2010					Unrealized										Unrealized										Unrealized
Description	#		Fair Value		Loss			%			#		Fair Value		Loss			%			#		Fair Value		Loss			%
of Securities

Other securities
(FHLB, FHLMC and FNMA)		-	$	-	$	-			-			-	$	-	$	-			-			-	$	-	$	-			-

State and political subdivisions		39		10,012		(133	)		1.33	%		5		1,014		(22	)		2.17	%		44		11,026		(155	)		1.41	%

Total temporarily impaired securities		39	$	10,012	$	(133	)		1.33	%		5	$	1,014	$	(22	)		2.17	%		44	$	11,026	$	(155	)		1.41	%



	Less than 12 months										12 months or more										Total
December 31, 2009					Unrealized										Unrealized										Unrealized
Description		#	Fair Value		Loss			%				#	Fair Value		Loss			%				#	Fair Value		Loss			%
of Securities

Other securities
(FHLB, FHLMC and FNMA)		1	$	996	$	(10	)		1.00	%		-	$	-	$	-			-			1	$	996	$	(10	)		1.00	%

State and political subdivisions		35		7,929		(106	)		1.34	%		-		-		-			-			35		7,929		(106	)		1.34	%

Total temporarily impaired securities		36	$	8,925	$	(116	)		1.30	%		-	$	-	$	-			-			36	$	8,925	$	(116	)		1.30	%

Page 28

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are temporary and not other-than-temporary impairments. The state and political subdivision securities with gross unrealized losses as of June 30, 2010 included 42 issues which are rated A3 or better, general obligation bonds. Two municipal bonds are rated B1. Bonds with a B1 rating are less than investment grade. The aggregate fair value of these B1 rated bonds is $442,000 while their amortized cost is $507,000, representing an unrealized loss of $65,000. None of the unrealized losses in the above table, was due to the deterioration in the credit quality of any of the issues that might result in the non-collection of contractual principal and interest. The cause of the unrealized losses is due to changes in interest rates. The Company has not recognized any unrealized loss in income because management has the intent and ability to hold the securities until a recovery of fair value or maturity.

Deposit growth was $54.7 million in the first six months of 2010. Repurchase agreements decreased $24.3 million in the same period. Federal Home Loan Bank borrowings decreased $30.0 million in the first six months of 2010. In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits totaled $33.2 million as of June 30, 2010 with an average rate of 1.02%. Brokered deposits were $13.0 million as of December 31, 2009 with an average rate of 2.04%. As of June 30, 2010 and December 31, 2009, brokered deposits were 2.37% and 0.97% of total deposits, respectively.

Dividends and Equity

In January 2010, Hills Bancorporation paid a dividend of $4,024,000 or $.91 per share. The dividend was also $.91 per share in January 2009. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of June 30, 2010 totaled $157.8 million. Under risk-based capital rules, the total amount of tier 1 risk-based capital was 12.36% and 11.68% as of June 30, 2010 and December 31, 2009, respectively. The tier 1 risk-based capital was in excess of the required minimum of 8.00%. Risk-based capital was 13.61% and 12.94% as of June 30, 2010 and December 31, 2009, respectively. As of June 30, 2010, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company’s category.

On October 14, 2008, the FDIC announced its temporary Transaction Account Guarantee Program (“TAGP”), which provides full coverage for noninterest-bearing transaction deposit accounts at FDIC-insured institutions that agree to participate in the TAGP. A 10-basis point surcharge is added to a participating institution’s current insurance assessment in order to fully cover all transaction accounts. The Bank elected to participate in the TAGP and the 10-basis point surcharge totaled $6,708 for the six months ended June 30, 2010. This unlimited insurance coverage is temporary and was originally scheduled to expire on December 31, 2009. On August 26, 2009, the FDIC extended the TAGP through June 30, 2010 and on April 13, 2010 the FDIC extended the TAGP through December 31, 2010. The deposit insurance surcharge was increased from 10 to 25 basis points for institutions electing to continue participation in the TAGP. The Bank elected to continue to participate in the TAGP through December 31, 2010. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“the Act”), which was signed into law on July 21, 2010, extends the expiration date of TAGP through December 31, 2012. The expiration of the TAGP on December 31, 2012 could have an adverse impact on the levels of customer deposits that are sensitive to full FDIC insurance coverage. The Act also permanently increases the deposit insurance coverage to $250,000 and allows depository institutions to pay interest on checking accounts beginning in July 2011.

Page 29

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Discussion of operations for the six months ended June 30, 2010 and 2009

Net Income Overview

Net income increased $5,187,000 for the six months ended June 30, 2010 compared to the first six months of 2009. Total net income was $12,106,000 in 2010 and $6,919,000 in the comparable period in 2009, an increase of 74.97%. The changes in net income in 2010 from the first six months of 2009 were the result of the following:

Ÿ	Net interest income increased by $4,847,000.

Ÿ	The provision for loan losses decreased by $2,999,000.

Ÿ	Net gain on sale of loans decreased by $1,605,000.

Ÿ	Income taxes increased $2,494,000.

For the six-month periods ended June 30, 2010 and 2009, basic earnings per share were $2.74 and $1.56, respectively. Diluted earnings per share were $2.73 for the six months ended June 30, 2010 compared to $1.56 for the same period in 2009.

Fluctuations in the Company’s net income continue to be driven primarily by three important factors. The first important factor is the interaction between changes in net interest margin and changes in average earnings assets. Net interest income of $33.1 million for the first six months of 2010 was derived from the Company’s $1.733 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.97%. Average earning assets in the six months ended June 30, 2009 were $1.723 billion and the tax-equivalent net interest margin was 3.43%. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of 10 basis points to 3.87% would have resulted approximately in an $866,000 decrease in income before income taxes in the six month period ended June 30, 2010. Similarly, an increase in the net interest margin of 10 basis points to 4.07% would have resulted in approximately an $866,000 increase in net interest income before taxes. Net interest income for the Company increased due to the increase in average earning assets over the same period in 2009 and the increase in the net interest margin of 54 basis points.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $1.523 billion at June 30, 2010. The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors including the size of the loan portfolio, loan concentrations, the level of non-performing loans (which includes non-accrual loans, accruing loans past due 90 days or more and restructured loans). The provision for loan losses was $2,918,000 in 2010 compared to $5,917,000 in 2009.

The amount of mortgage loans sold on the secondary market is the third factor that can cause significant fluctuations in net income. Loans originated for sale in the first six months of 2010 totaled $80.5 million compared to $197.9 million in the same period in 2009, a decrease of 59.32%. In the six months ended June 30, 2010 and 2009, the net gain on sale of loans was $1,041,000 and $2,646,000, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income.

Page 30

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Discussion of operations for the six months ended June 30, 2010 and 2009 (continued)

Net Interest Income

Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The net interest margin for the first six months of 2010 was 3.97% compared to 3.43% in 2009 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the six months ended in 2010 compared to the comparable period in 2009 are shown in the following table:

	Change in			Change in			Increase (Decrease) in Net Interest Income
	Average Balance			Average Rate			Volume Changes			Rate Changes			Net Change

	(Amounts in Thousands)

Interest income:
Loans, net	$	31,015			(0.17	) %	$	924		$	(1,240	)	$	(316	)
Taxable securities		(4,572	)		(0.21	)		(35	)		(154	)		(189	)
Nontaxable securities		(649	)		(0.06	)		(17	)		(28	)		(45	)
Federal funds sold		(16,188	)		0.17			11			-			11
	$	9,606					$	883		$	(1,422	)	$	(539	)

Interest expense:
Interest-bearing demand deposits	$	10,748			(0.17	) %	$	(35	)	$	196		$	161
Savings deposits		65,882			(0.53	)		(420	)		1,019			599
Time deposits		(19,483	)		(0.73	)		327			2,267			2,594
Short-term borrowings		278			(0.56	)		2			137			139
FHLB borrowings		(55,810	)		(0.59	)		1,332			568			1,900
	$	1,615					$	1,206		$	4,187		$	5,393
Change in net interest income							$	2,089		$	2,765		$	4,854

Rate/volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates. Loans fees included in interest income are not material. Interest on nontaxable securities and loans is shown on a tax-equivalent basis.

A summary of the net interest spread and margin is as follows:

(Tax Equivalent Basis)	2010			2009

Yield on average interest-earning assets		5.63	%		5.72	%
Rate on average interest-bearing liabilities		1.95			2.70
Net interest spread		3.68	%		3.02	%
Effect of noninterest-bearing funds		0.29			0.41
Net interest margin (tax equivalent interest income divided by average interest-earning assets)		3.97	%		3.43	%

Page 31

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Discussion of operations for the six months ended June 30, 2010 and 2009 (continued)

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. The Federal Open Market Committee met five times during the first six months of 2010. The target rate remains unchanged since December 31, 2008 at 0.25%. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate. As of June 30, 2010, the average rate indexes for the one, three and five year indexes were 0.29%, 1.13% and 1.96%, respectively. The one year index decreased 39.58% from .48% at June 30, 2009, the three year index decreased 34.30% and the five year index decreased 26.32%. The three year index was 1.72% and the five year index was 2.66% at June 30, 2009. The targeted federal funds rate was 0.25% at June 30, 2010 and 2009.

Provision for Loan Losses

The provision for loan losses was $2,918,000 in 2010 compared to $5,917,000 in 2009, a decrease of $2,999,000. The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management. The provision adjustment is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, loan concentrations, the borrowers’ ability to repay, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks.

In the first six months of 2010, problem and watch loans decreased $8.8 million and there was a decrease of $7.0 million in substandard loans in the same period. These asset quality changes decreased the provision by $1.7 million. In the first six months of 2009, problem and watch loans increased $13.9 million while there was an increase of $15.8 million in substandard loans in the same period. These asset quality changes increased the provision by $3.3 million. In the first six months of 2010, loan balances increased $26.6 million which increased the provision for loan losses by $0.9 million. In the first six months of 2009, loan balances declined $37.0 million which decreased the provision for loan losses by $0.9 million.

The allowance for loan losses balance is also affected by the charge-offs, net of recoveries, for the periods presented. For the six months ended June 30, 2010 and 2009, recoveries were $1,061,000 and $457,000, respectively; and charge-offs were $4,789,000 in 2010 and $3,904,000 in 2009. The allowance for loan losses totaled $28,350,000 at June 30, 2010 compared to $29,160,000 at December 31, 2009. The allowance represented 1.84% and 1.90% of loans held for investment at June 30, 2010 and December 31, 2009, respectively. The methodology used in 2010 is consistent with 2009.

Net Gain on Sale of Loans

Loans originated for sale in the first six months of 2010 totaled $80.5 million compared to $197.9 million in the same period in 2009, a decrease of 59.32%. In the six months ended June 30, 2010 and 2009, the net gain on sale of loans was $1,041,000 and $2,646,000, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income.

Page 32

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Discussion of operations for the six months ended June 30, 2010 and 2009 (continued)

Other Income

Other income, other than the net gain on sale of loans discussed above, increased $1,386,000 for the six months ended June 30, 2010 from the prior year. Trust fees increased $342,000 in the first half of 2010 as a result of assets under management increasing from $810.4 million as of June 30, 2009 to $882.2 million as of June 30, 2010 due to market conditions and new trust relationships. Service charges and fees increased $257,000 in the first six months of 2010 from their level for the comparable period in 2009. Credit card merchant, debit card and point of sale (POS) pin interchange fees are included in service charges and fees, and that component increased during the same period by $328,000 due to volume of activity.

Rental revenue on tax credit real estate increased $345,000 in 2010 due to the addition of a tax credit property in the third quarter of 2009 and an additional tax credit property in the second quarter of 2010.

Other noninterest income was $1,624,000 for the six months ended June 30, 2010, a $442,000 increase from the same period in 2009. Other noninterest income for the six months ended June 30, 2010 included insurance proceeds of $425,000 received as a result of a claim filed by the Company in April 2008. The claim pertained to alleged unauthorized activities by a former employee of the Bank in Bank internal accounts that were discovered during 2007. The total loss to the Company was $575,000 which included $559,000 of funds that were misappropriated and $16,000 of fees expensed during the investigation. The Company’s insurance policies covered the loss and expenses but had a deductible of $150,000, resulting in net proceeds of $425,000.

Other Expenses

Other expenses of $22,649,000 decreased $54,000 for the six months ended June 30, 2010 from the same period in 2009. This decrease of 2.38% included an increase of $260,000 in salaries and benefits. A component of salaries and employee benefits expense is compensation expense related to the officers’ deferred compensation plan and costs associated with restricted common stock awarded to various officers which increased $243,000 for the six months ended June 30, 2010 compared to the six months ended June 30, 2009. This increase is primarily the result of the change in the appraised value of the Company’s common stock. As a result of the Company’s program to repurchase up to a total of 750,000 shares of the Company’s common stock, the Company obtains a quarterly independent appraisal of the shares of stock. The final appraisal for each quarter will be completed approximately forty days after each quarter end. The appraised value of the Company’s stock was $55.00 as of June 30, 2010 and $53.00 as of December 31, 2009.

Furniture and equipment expenses increased $194,000 during the six months ended June 30, 2010 as compared to the six months ended June 30, 2009 due mainly to an increase in depreciation and maintenance contracts. Depreciation expense increased $106,000 in the six months ended June 30, 2010 compared to the same period in 2009. The increase is related to the bank building at 3905 Blairs Ferry Road NE in Cedar Rapids being placed into service on January 11, 2010. Maintenance contract expense increased $122,000 in the six months ended June 30, 2010 as compared to the same period in 2009. This increase is due to the increased rates of the contracts and additional software programs purchased by the Company. These increases were offset by a decrease in equipment supplies of $36,000 for the six months ended June 30, 2010 compared to the same period in 2009.

Outside services expense increased $498,000 for the six months ended June 30, 2010 from the same period in 2009. Outside services include professional fees, courier services and ATM fees, and processing charges for the merchant credit card program, retail credit cards and other data processing services. Credit card, debit card and merchant card processing expenses increased $139,000 due to an increase in the volume of transactions in 2010 compared to 2009. Other real estate owned expenses were $475,000 for the six months ended June 30, 2010, an increase of $390,000 over the same period in 2009. The expense includes $362,000 paid for property taxes on other real estate owned properties.

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Discussion of operations for the six months ended June 30, 2010 and 2009 (continued)

Rental expenses on tax credit real estate were $1,222,000 for the six months ended June 30, 2010, an increase of $622,000 from the same period in 2009. This increase is due mainly to the addition of a sixth tax credit property during the third quarter of 2009 and a seventh tax credit property during the second quarter of 2010.

FDIC insurance assessment expense was $1,045,000 for the six months ended June 30, 2010. This is a decrease of $801,000 when compared to the same period in 2009. As of June 30, 2009, the FDIC imposed a five basis point special assessment, which totaled $830,000 on the Bank’s total assets less Tier 1 capital. There was no special assessment imposed during the six months ended June 30, 2010. As of June 30, 2010, the Company recorded prepaid FDIC insurance of $6,004,000, which represents the FDIC premiums paid by the Bank on December 30, 2009 for the years of 2010, 2011 and 2012. The prepaid FDIC insurance is being amortized on a quarterly basis as premiums are assessed.

During the first six months of 2009, the Company pre-paid $40.0 million of FHLB advances incurring an early payment penalty of $584,000. There were no penalties incurred during the first six months of 2010. The $40.0 million in advances consisted of $20.0 million due in June 2009 and $20.0 million due in October 2009, at rates from 5.66% to 6.22%. As a result of the early payment of the FHLB borrowings, the Company’s interest expense on FHLB borrowings decreased. The net impact of the early payment penalty and decreased interest expense was revenue neutral for 2009.

The net loss on sale of other real estate owned and other repossessed assets decreased $449,000 to $183,000 for the six months ended June 30, 2010. The total net loss on sale of other real estate owned for the six months ended June 30, 2010 consisted of a $267,000 fair market value adjustment on eight properties within other real estate owned, a $98,000 gain on sale of 10 properties and a $14,000 loss on sale of 3 properties, for a net loss of $183,000. During the same period in 2009, the loss consisted of a $171,000 fair market value adjustment on two properties within other real estate owned, a $102,000 gain on sale of 5 properties and a $563,000 loss on sale of 10 properties, for a net loss of $632,000. The net loss on sale of other real estate owned increased in 2009 due to the volume of transactions coupled with the reduced levels of new and existing home sales, stagnant to declining property values, a decline in building permits, and an increase in the time houses remain on the market. These factors have led to a reduction in the ultimate sales price of properties versus the carrying value of the property. Also one large commercial property was sold during the six months ended June 30, 2009 at a loss of $345,000. Excluding this large loss and other factors listed above, the net loss on the sale of other real estate owned was comparable during the six months ended June 30, 2010 and 2009.

Other noninterest expense increased $214,000 in the first six months of 2010 to $731,000. This increase is mainly due to expenses related to the deferred compensation plan for the Company’s Board of Directors. This expense increased $108,000 for the first six months of 2010 in comparison to the same period in 2009. This increase is primarily the result of the change in the appraised value of the Company’s common stock. Also, in the six months of 2010, there was a write-off of fixed assets for one bank location of $48,000. In addition to the above two factors, the business continuity expense for the Company increased $32,000 to $59,000 in the first six months of 2010. The increase in expense relates to the Bank utilizing a third party data center in 2010.

Income Taxes

Federal and state income tax expenses were $4,969,000 and $2,475,000 for the six months ended June 30, 2010 and 2009, respectively. Income taxes as a percentage of income before taxes were 29.10% in 2010 and 26.35% in 2009.

The increase in the effective tax rate is due to the relationship of tax-exempt interest income and income tax credits to total income before income taxes.

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Discussion of operations for the three months ended June 30, 2010 and 2009 (continued)

Net Income

Net income increased to $6,721,000 for the three months ended June 30, 2010 from $2,930,000 for the same period in 2009, an increase of 129.39%. Earnings per share, both basic and diluted, increased for the three months ended June 30, 2010 compared to the same period in 2009. For the three-month period ended June 30, 2010, basic and diluted earnings per share were $1.52. For the three months ended June 30, 2009, basic and diluted earnings per share were $0.66.

Net Interest Income

Net interest income increased for the three month period ended June 30, 2010 by $2,551,000 from the similar period in 2009. The net interest margin in 2010 was 3.98% compared to 3.41% in 2009. Net interest income changes on a tax-equivalent basis for the three months ended June 30, 2010 and 2009 are as follows:

	Change in			Change in			Increase (Decrease) in Net Interest Income
	Average Balance			Average Rate			Volume Changes			Rate Changes			Net Change

	(Amounts in Thousands)

Interest income:
Loans, net	$	31,483			(0.17	) %	$	481		$	(547	)	$	(66	)
Taxable securities		(3,463	)		(0.26	)		(13	)		(85	)		(98	)
Nontaxable securities		(562	)		(0.06	)		(7	)		(11	)		(18	)
Federal funds sold		(21,970	)		0.17			13			-			13
	$	5,488					$	474		$	(643	)	$	(169	)

Interest expense:
Interest-bearing demand deposits	$	6,050			(0.17	) %	$	(10	)	$	128		$	118
Savings deposits		60,084			(0.53	)		(186	)		523			337
Time deposits		(29,904	)		(0.73	)		249			1,186			1,435
Short-term borrowings		2,547			(0.60	)		(11	)		60			49
FHLB borrowings		(40,222	)		(0.59	)		478			312			790
	$	(1,445	)				$	520		$	2,209		$	2,729
Change in net interest income							$	994		$	1,566		$	2,560

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Discussion of operations for the three months ended June 30, 2010 and 2009 (continued)

A summary of the net interest spread and margin is as follows:

(Tax Equivalent Basis)	2010			2009

Yield on average interest-earning assets		5.58	%		5.64	%
Rate on average interest-bearing liabilities		1.88			2.62
Net interest spread		3.70	%		3.02	%
Effect of noninterest-bearing funds		0.28			0.39
Net interest margin (tax equivalent interest income divided by average interest-earning assets)		3.98	%		3.41	%

Provision for Loan Losses

The provision for loan losses was $853,000 in 2010 compared to $3,481,000 in 2009, a decrease of $2,628,000. The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management. The provision adjustment is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, loan concentrations, the borrowers’ ability to repay, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks.

In the second quarter of 2010, problem and watch loans decreased $7.7 million and there was a decrease of $14.6 million in substandard loans. These asset quality changes decreased the provision by $1.9 million. In the second quarter of 2009, problem and watch loans increased $15.3 million while there was an increase of $4.3 million in substandard loans in the same period. These asset quality changes increased the provision by $1.8 million. In the second quarter of 2010, loan balances increased $34.7 million which increased the provision for loan losses by $0.4 million. In the second quarter of 2009, loan balances declined $20.9 million which decreased the provision for loan losses by $0.4 million.

The allowance for loan losses balance is also affected by the charge-offs, net of recoveries, for the periods presented. For the three months ended June 30, 2010 and 2009, recoveries were $698,000 and $231,000, respectively; and charge-offs were $3,041,000 in 2010 and $2,182,000 in 2009. The allowance for loan losses totaled $28,350,000 at June 30, 2010 compared to $30,130,000 at June 30, 2009. The allowance represented 1.84% and 2.02% of loans held for investment at June 30, 2010 and June 30, 2009, respectively. The methodology used in 2010 is consistent with 2009.

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Discussion of operations for the three months ended June 30, 2010 and 2009 (continued)

Other Income

Total other income decreased $461,000 to $4,588,000 for the three months ended June 30, 2010 as compared to the same period in 2009. Net gain on sale of loans decreased by $970,000 in the quarter ended June 30, 2010 as compared to the same quarter in 2009 due to a decrease in the volume of loans sold in 2010. Trust fees increased $212,000 in the second quarter of 2010 as a result of assets under management increasing from $810.4 million as of June 30, 2009 to $882.2 million as of June 30, 2010. Service charges and fees increased $151,000 in the three months ended June 30, 2010 from their level for the comparable period in 2009. Credit card merchant, debit card and point of sale (POS) pin interchange fees are included in service charges and fees, and that component increased during the second quarter of 2010 over the second quarter of 2009 by $193,000 due to volume of activity.

Rental revenue on tax credit real estate increased $191,000 during the three months ended June 30, 2010 compared to the same period in 2009 due to the addition of a tax credit property in the third quarter of 2009 and an additional tax credit property in the second quarter 2010.

Other Expenses

Total expenses for the 2010 second quarter compared to the 2009 second quarter decreased $766,000 to $11,093,000.

Furniture and equipment expenses increased $108,000 during the three months ended June 30, 2010 as compared to the three months ended June 30, 2009 due mainly to an increase in depreciation and maintenance contracts. Depreciation expense increased $53,000 in the three months ended June 30, 2010 compared to the same period in 2009. The increase is related to the bank building at 3905 Blairs Ferry Road NE in Cedar Rapids being placed into service on January 11, 2010. Maintenance contract expense increased $60,000 in the three months ended June 30, 2010 as compared to the same period in 2009. This increase is due to the increased rates of the contracts and additional software programs purchased by the Company.

Advertising and business development expense were $449,000 for the three months ended June 30, 2010, a $60,000 increase over the same period in 2009. The increase is related to the timing of office promotions expenses incurred in 2010 when compared to the prior year.

Outside services expense increased $63,000 for the three months ended June 30, 2010 from the same period in 2009. Outside services include professional fees, courier services and ATM fees, and processing charges for the merchant credit card program, retail credit cards and other data processing services. Credit card, debit card and merchant card processing expenses increased $67,000 due to an increase in the volume of transactions in 2010 compared to 2009. Other real estate owned expenses were $61,000 for the three months ended June 30, 2010, an increase of $45,000 over the same period in 2009. The increased expenses are due to the number of properties in other real estate owned in 2010. These increases were offset by a decrease in bill payment expense of $12,000 and a decrease in appraisal fees of $18,000.

Rental expenses on tax credit real estate were $710,000 for the three months ended June 30, 2010, an increase of $523,000 from the same period in 2009. This increase is due mainly to the addition of a sixth tax credit property during the third quarter of 2009 and a seventh tax credit property during the second quarter of 2010.

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Discussion of operations for the three months ended June 30, 2010 and 2009 (continued)

FDIC insurance assessment expense was $271,000 for the three months ended June 30, 2010. This is a decrease of $1,050,000 when compared to the same period in 2009. As of June 30, 2009, the FDIC imposed a five basis point special assessment, which totaled $830,000 on each bank’s total assets less Tier 1 capital. There was no special assessment imposed during the three months ended June 30, 2010. As of June 30, 2010, the Company recorded prepaid FDIC insurance of $6,004,000, which represents the FDIC premiums paid by the Bank on December 30, 2009 for the years of 2010, 2011 and 2012. The prepaid FDIC insurance is being amortized on a quarterly basis as premiums are assessed.

During the three months ended June 30, 2009, the Company pre-paid $40.0 million of FHLB advances incurring an early payment penalty of $584,000. There were no penalties incurred during the three months ended June 30, 2010. The $40.0 million in advances consisted of $20.0 million due in June 2009 and $20.0 million due in October 2009, at rates from 5.66% to 6.22%. As a result of the early payment of the FHLB borrowings, the Company’s interest expense on FHLB borrowings decreased. The net impact of the early payment penalty and decreased interest expense was revenue neutral for 2009.

The net loss on sale of other real estate owned and other repossessed assets decreased $126,000 to $42,000 for the three months ended June 30, 2010. The total net loss on sale of other real estate owned for the second quarter of 2010 consisted of a $123,000 fair market value adjustment on six properties within other real estate owned, a $117,000 gain on sale of six properties and a $36,000 loss on sale of one property, for a net loss of $42,000. During the same period in 2009, the loss consisted of a $171,000 fair market value adjustment on two properties within other real estate owned, a $90,000 gain on sale of 2 properties and a $87,000 loss on sale of 3 properties, for a net loss of $168,000. The net loss on sale of other real estate owned increased in 2009 due to the volume of transactions coupled with the reduced levels of new and existing home sales, stagnant to declining property values, a decline in building permits, and an increase in the time houses remain on the market. These factors have led to a reduction in the ultimate sales price of properties versus the carrying value of the property.

Other noninterest expense increased $178,000 in the second quarter of 2010 to $414,000. This increase is mainly due to expenses related to the deferred compensation plan for the Company’s Board of Directors. This expense increased $103,000 during the second quarter of 2010 in comparison to the same period in 2009. This increase is primarily the result of the change in the appraised value of the Company’s common stock. In addition to the above two factors, the business continuity expense for the Company increased $15,000 to $28,000 in the second quarter of 2010. The increase in expense relates to the Bank utilizing a third party data center in 2010. Other noninterest expense also includes fraud losses related to customer credit and debit cards, ATM activity and customer deposit accounts. This expense increased $34,000 during the three months ended June 30, 2010 as compared to the same period in 2009 due to increased incidents of unauthorized use of customer credit and debit cards.

Income Taxes

Federal and state income tax expenses were $2,811,000 and $1,108,000 for the three months ended June 30, 2010 and 2009, respectively. Income taxes as a percentage of income before taxes were 29.49% in 2010 and 27.44% in 2009.

The increase in the effective tax rate is due to the relationship of tax-exempt interest income and income tax credits to total income before income taxes.

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs. Federal funds sold and investment securities available for sale are readily marketable assets. Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position. Investment securities available for sale comprised 10.90% of the Company’s total assets at June 30, 2010, compared to 11.02% at December 31, 2009.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position. As of June 30, 2010, the Company had borrowed $195.0 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. The Company borrowed $10,000,000 on March 2, 2010 with a due date of March 15, 2011 from the FHLB. The Company repaid $40,000,000 in FHLB borrowings in January 2010. Advances are used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately $222 million at June 30, 2010.

As additional sources of liquidity, the Company has the ability to borrow up to $10 million from the Federal Reserve Bank of Chicago, and has lines of credit with two banks totaling $137.3 million. Those two lines of credit require the pledging of investment securities when drawn upon. The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at June 30, 2010.

As of June 30, 2010, investment securities with a carrying value of $44,212,000 were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law. As of December 31, 2009, investment securities with a carrying value of $68,534,000 were pledged.

Contractual Obligations

The Company plans to add an additional office location in North Liberty, Iowa. It is expected that the Bank will provide retail and commercial banking services at this proposed office and that it also will serve as the new location of the Bank’s Trust and Wealth Management Department (the “Trust Department”). The Trust Department, which currently has 21 employees, was displaced by flooding in June of 2008 from the Iowa City South Gilbert Street office. Since that time the Trust Department has occupied 6,600 square feet of leased office space one half mile south of the proposed new office. The new office location will enhance services available at the Trust Department, which will be housed with other traditional banking functions including deposit and loan services provided to the Bank’s retail and commercial customers. It is expected that the new office location will have approximately 15,000 square feet. Preliminary construction costs for the building are estimated at $2.3 million. The Company will not incur any debt during the construction of the new office.

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Item 2.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (continued)

Contractual Obligations (continued)

Subsequent to the end of the second quarter, on July 13, 2010, the Board of Directors approved a construction management agreement with Hodge Construction for constructions services of a bank building in North Liberty, Iowa. Michael E. Hodge, who is the President and majority owner of Hodge Construction, is a member of the Company’s Board of Directors. The construction management agreement will be based on a percentage of the total cost of the building, which the Company’s management believes is consistent with standard practice in the construction industry. Hodge Construction will not perform any of the construction itself; instead, it will coordinate the competitive bidding of all of the subcontractors and oversee the day-to-day construction activity. The proposed office building is in the early stage of planning, and it is expected that final plans, specifications and costs will not be completed until the end of the third quarter or early in the fourth quarter of 2010. Depending on the planning process, construction may not begin until 2011 and may not be completed before late 2011. Although the construction management contract was not entered into as a result of competitive bidding, the Company’s management believes the expected fee will be similar to the fee other such construction management companies would charge for similar services. Also considered in the decision process was the availability of the desirable location as a result of Director Hodge’s minority ownership interest in the Corridor Commercial Development Company, which is the current owner of the land on which the proposed North Liberty office would be constructed.

The location of the office will be on the Northeast corner of Highway 965 and Forevergreen Road. The Bank has made an offer that has been accepted to purchase four lots totaling 2.36 acres for $1.3 million. The closing date of the land purchase is expected to be August 20, 2010, assuming all contingencies are met. Director Hodge has been a 40% owner of Corridor Commercial Development Company since its formation over ten years ago when the entire development land of 80 acres was purchased. The 4 lots to be purchased by the Company are part of the current development of 7.25 acres consisting of 13 lots. Based on management review of similar commercial sales and current listings of commercial real estate available in the North Liberty and Coralville area, the price to be paid for the four lots is consistent with the market and reflects the stable value of commercial and residential properties in the area.

There are no other material changes in the Company’s contractual obligations from those disclosed in its Annual Report in Form 10-K for the year ended December 31, 2009.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

Market Risk Management

The Company's primary market risk exposure is to changes in interest rates. The Company's asset/liability management, or its management of interest rate risk, is focused primarily on evaluating and managing net interest income given various risk criteria. Factors beyond the Company's control, such as market interest rates and competition, may also have an impact on the Company's interest income and interest expense. In the absence of other factors, the Company's overall yield on interest-earning assets will increase, as will its cost of funds on its interest-bearing liabilities when market interest rates increase over an extended period of time. Conversely, the Company's yields and cost of funds will decrease when market rates decline. The Company is able to manage these swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning assets and interest-bearing liabilities over given periods of time.

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Item 3.

Quantitative and Qualitative Disclosures About Market Risk (continued)

Asset/Liability Management

The Bank maintains an asset/liability committee, which meets at least quarterly to review the Bank’s interest rate sensitivity position and to review various strategies as to interest rate risk management. In addition, the Bank uses a simulation model to review various assumptions relating to interest rate movement. The model attempts to limit rate risk even if it appears the Bank’s asset and liability maturities are perfectly matched and a favorable interest margin is present.

In order to minimize the potential effects of adverse material and prolonged increases or decreases in market interest rates on the Company's operations, management has implemented an asset/liability program designed to mitigate the Company's interest rate sensitivity. The program emphasizes the origination of adjustable rate loans, which are held in the portfolio, the investment of excess cash in short or intermediate term interest-earning assets, and the solicitation of savings or transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.

Net interest income should decline as interest rates increase, while net interest income should increase as interest rates decline. Generally, during periods of increasing interest rates, the Company's interest rate sensitive liabilities would re-price faster than its interest rate sensitive assets causing a decline in the Company's interest rate spread and margin. This would tend to reduce net interest income because the resulting increase in the Company’s cost of funds would not be immediately offset by an increase in its yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a positive effect on the Company's net interest income.

Item 4. Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934,as amended (the “Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls over financial reporting during the first six months of 2010 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

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PART II - OTHER INFORMATION

Item 1.

Legal Proceedings

No material legal proceedings are pending.

Item 1A.

Risk Factors

The Company’s current disclosures concerning risk factors have been revised from the disclosures concerning risk factors set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. The Company has removed risk factors which could apply to any issuer. The revised risk factors are as follows:

The performance of our Company is subject to various risks. We consider the risks described below to be the most significant risks we face, but such risks are not the only risk factors that could affect us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition or results of operations. For a discussion of the impact of risks on our financial condition and results of operations in recent years and on forward looking statements, refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

We may be adversely affected by economic conditions in the local economies in which we conduct our operations, and in the United States in general.

Unfavorable or uncertain economic and market conditions may adversely affect our business and profitability. Our business faces various material risks, including credit risk and the risk that the demand for our products and services will decrease. Decreases in consumer confidence, real estate values, interest rates and investment returns, usually associated with a downturn, could make the types of loans we originate less profitable and could increase our credit risk and litigation expense.

Recent adverse changes in the U.S. economy have led to an increased level of commercial and consumer delinquencies, reduced consumer confidence, decreased market valuations and liquidity, increased market volatility and a widespread reduction of business activity generally. Unemployment has increased significantly. The ability of banks and bank holding companies to raise capital or borrow in the debt markets has become more difficult compared to recent years. The resulting economic pressure and lack of confidence in the financial markets may adversely affect our business, our financial condition and our results of operations, as well as the business of our customers. Foreign or domestic terrorism or geopolitical events could shock commodity and financial markets and prolong or worsen the current recession. A worsening of economic conditions would likely exacerbate the adverse effects of these difficult conditions.

As a result of these conditions, there is a potential for new federal or state laws and regulations regarding lending and funding practices and liquidity standards, and bank regulatory agencies have been and are expected to continue to be very aggressive in responding to concerns and trends identified in examinations, including the issuance of formal or informal enforcement actions or orders. The impact of new legislation in response to these developments may negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and adversely impact our financial performance or our stock price.

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PART II - OTHER INFORMATION

(continued)

Item 1A.

Risk Factors (continued)

Our profitability and liquidity may be adversely affected by deterioration in the credit quality of, or defaults by, third parties who owe us money or other assets.

We are exposed to the risk that third parties that owe us money or other assets will not perform their obligations. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. Our rights against third parties may not be enforceable in all circumstances. In addition, deterioration in the credit quality of third parties whose securities or obligations we hold could result in losses and/or adversely affect our ability to use those securities or obligations for liquidity purposes. We rely on representations of potential borrowers and/or guarantors as to the accuracy and completeness of certain financial information. Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements or other information that is materially misleading.

Our financial condition has not been materially impacted by the deterioration in the credit quality of third parties except as related to borrower credit quality. As of December 31, 2009, the Company held one investment security considered to be less than investment grade. This security had an amortized cost of $193,000 with an unrealized loss of $2,000. Management believes that the allowance for loan losses is adequate to absorb probable losses on any existing loans that may become uncollectible but cannot predict loan losses with certainty and cannot assure that the our allowance for loan losses will prove sufficient to cover actual losses in the future.

Flooding or some other natural disaster and the continuing adverse effects of 2008 flooding could harm the Company’s business.

The severe flooding that occurred in 2008 affected our loan portfolio by damaging properties pledged as collateral and by impairing certain borrowers’ abilities to repay their loans. As a result of the floods, we made a significant provision for loan losses in 2008. The after effects of the floods may continue to affect our loan quality into the future. The severity and duration of the effects of the flooding will depend on a variety of factors that are beyond our control, including the amount and timing of government investment in the area, the pace of rebuilding and economic recovery in Johnson and Linn Counties and the extent to which any property damage is covered by insurance. The effects described above are difficult to accurately predict or quantify at this time. As a result, uncertainties remain regarding the impact the flooding will have on the financial results of the Company. Further, the area in which the Company operates may experience flooding and other natural disasters in the future, and some of those events may have effects similar to those caused by the 2008 flooding.

Changing interest rates may adversely affect our profits.

Our income and cash flows depend to a great extent on the difference between the interest rates earned by us on interest-earning assets such as loans and investment securities and the interest rates paid by us on interest-bearing liabilities such as deposits and borrowings. If interest rates decrease, our net interest income could be negatively affected if interest earned on interest-earning assets, such as loans, mortgage-related securities, and other investment securities, decreases more quickly than interest paid on interest-bearing liabilities, such as deposits and borrowings. This would cause our net income to go down. In addition, if interest rates decline, our loans and investments may be prepaid earlier than expected, which may also lower our income. Rising interest rates may hurt our income because they may reduce the demand for loans and the value of our investment securities. Higher interest rates could adversely affect housing and other sectors of the economy that are interest-rate sensitive. Higher interest rates could cause deterioration in the quality of our loan portfolio. Interest rates are highly sensitive to many factors that are beyond our control, including general economics conditions and monetary policies established by the Federal Reserve Board. Interest rates do and will continue to fluctuate, and we cannot predict future Federal Reserve Board actions or other factors that will cause rates to change.

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HILLS BANCORPORATION

PART II - OTHER INFORMATION

(continued)

Item 1A.

Risk Factors (continued)

We experience intense competition for loans and deposits.

Competition among financial institutions in attracting and retaining deposits and making loans is intense. Traditionally, our most direct competition for deposits has come from commercial banks, savings institutions and credit unions doing business in our areas of operation. Increasingly, we have experienced additional competition for deposits from nonbanking sources, such as securities firms, insurance companies, money market mutual funds and corporate and financial services subsidiaries of commercial and manufacturing companies. Competition for loans comes primarily from other commercial banks, savings institutions, consumer finance companies, credit unions, mortgage banking companies, insurance companies and other institutional lenders. We compete primarily on the basis of products offered, customer service and price. A number of institutions with which we compete enjoy the benefits of fewer regulatory constraints and lower cost structures. Some have greater assets and capital than we do and, thus, are better able to compete on the basis of price than we are. The increasingly competitive environment is primarily a result of changes in regulation and changes in technology and product delivery systems. These competitive trends are likely to continue.

If we do not continue to meet or exceed regulatory capital requirements and maintain our “well-capitalized” status, there could be an adverse effect on the manner in which we do business and on the confidence of our customers in us.

Under regulatory capital adequacy guidelines, we must meet guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items. Failure to meet minimum capital requirements could have a material effect on our financial condition and could subject us to a variety of enforcement actions, as well as certain restrictions on our business. Failure to maintain the status of “well capitalized” under the regulatory framework could adversely affect the confidence that our customers have in us, which can lead to a decline in the demand for or a reduction in the prices that we are able to charge for our products and services. We may at some point need to raise additional capital to maintain our “well capitalized” status. Any capital we obtain may result in the dilution of the interests of existing holders of our common stock. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance. Accordingly, we cannot make assurances of our ability to raise additional capital if needed, or if the terms will be acceptable to us.

Our allowance for loan losses may not be adequate to cover actual losses.

Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and non-performance. Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with its loan portfolio, including the size and composition of the loan portfolio, current economic conditions and concentrations within the portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for loan losses, we will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and, possibly, capital, and may have a material negative effect on our financial condition and results of operations.

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HILLS BANCORPORATION

PART II - OTHER INFORMATION

(continued)

Item 1A.

Risk Factors (continued)

Commercial loans make up a significant portion of our loan portfolio.

Our commercial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Repayment of our commercial loans is often dependent on the cash flows of the borrower, which may be unpredictable. Most often, this collateral is accounts receivable, inventory, machinery or real estate. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. The other types of collateral securing these loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.

Our loan portfolio has a large concentration of real estate loans, which involve risks specific to real estate value.

Real estate lending is a large portion of our loan portfolio and includes home equity, commercial, construction and residential loans and are concentrated in the Bank’s trade area, a small geographic area in Southeast Iowa. As of December 31, 2009, approximately 83% of our loans had real estate as a primary or secondary component of collateral. The market value of real estate can fluctuate significantly in a short period of time as a result of market conditions in the geographic area in which the real estate is located. Adverse developments affecting real estate values in our market could increase the credit risk associated with our loan portfolio. Also, real estate lending typically involves higher loan principal amounts and the repayment of the loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. Economic events or governmental regulations outside of the control of the borrower could negatively impact the future cash flow and market values of the affected properties.

If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then we may not be able to realize the amount of security that we anticipated at the time of originating the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results and financial condition.

Our real estate loans also include construction loans, including land acquisition and development. Construction, land acquisition and development lending involve additional risks because funds are advanced based upon estimates of costs and the estimated value of the completed project. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, commercial construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of the completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project.

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HILLS BANCORPORATION

PART II - OTHER INFORMATION

(continued)

Item 1A.

Risk Factors (continued)

Our agricultural loans may involve a greater degree of risk than other loans, and the ability of the borrower to repay may be affected by many factors outside of the borrower’s control.

Payments on agricultural real estate loans are dependent on the profitable operation or management of the farm property securing the loan. The success of the farm may be affected by many factors outside the control of the borrower, including adverse weather conditions that prevent the planting of a crop or limit crop yields (such as hail, drought and floods), loss of livestock due to disease or other factors, declines in market prices for agricultural products (both domestically and internationally) and the impact of government regulations (including changes in price supports, subsidies and environmental regulations). In addition, many farms are dependent on a limited number of key individuals whose injury or death may significantly affect the successful operation of the farm. If the cash flow from a farming operation is diminished, the borrower’s ability to repay the loan may be impaired. The primary crops in our market areas are corn and soybeans. Accordingly, adverse circumstances affecting these crops could have an adverse effect on our agricultural real estate loan portfolio.

We also originate agricultural operating loans. As with agricultural real estate loans, the repayment of operating loans is dependent on the successful operation or management of the farm property. Likewise, agricultural operating loans involve a greater degree of risk than lending on residential properties, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as farm equipment or assets such as livestock or crops. The primary livestock in our market areas is hogs. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.

A decline in local and national real estate markets may impact our operations and/or financial condition.

There has been a slowdown in the national housing market as evidenced by reports of reduced levels of new and existing home sales, increasing inventories of houses on the market, stagnant to declining property values, a decline in building permits, and an increase in the time houses remain on the market. In recent years, some lenders made many adjustable-rate mortgage loans, lowered their credit standards with respect to mortgage loans and home equity loans, and created collateralized debt obligations which included such mortgage loans. The slowdown in the national housing market created uncertainty and liquidity issues relating to the value of such mortgage loans, which causes disruption in credit markets. The extent to which local real estate mortgage loans have been adversely affected has varied. Although management believes that the Bank has maintained appropriate lending standards and that these trends have yet to materially affect our local economy or our business and profitability, no assurance can be given that these conditions will not directly or indirectly affect our operations. If these conditions continue or worsen, they may result in a decrease in interest income or an adverse impact on our loan losses.

If we are unable to continuously attract deposits and other short-term funding, our financial condition, including our capital ratios, our results of operations and our business prospects could be harmed.

In managing our liquidity, our primary source of short-term funding is customer deposits. Our ability to continue to attract these deposits, and other short-term funding sources, is subject to variability based upon a number of factors, including the relative interest rates we are prepared to pay for these liabilities and the perception of safety of those deposits or short-term obligations relative to alternative short-term investments. The availability and cost of credit in short-term markets depends upon market perceptions of our liquidity and creditworthiness. Our efforts to monitor and manage liquidity risk may not be successful or sufficient to deal with dramatic or unanticipated changes in event-driven reductions in liquidity. In such events, our cost of funds may increase, thereby reducing our net interest revenue, or we may need to dispose of a portion of our investment portfolio, which, depending on market conditions, could result in our realizing a loss or experiencing other adverse consequences.

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HILLS BANCORPORATION

PART II - OTHER INFORMATION

(continued)

Item 1A.

Risk Factors (continued)

We are subject to risks arising from increases in FDIC insurance premiums and the scheduled expiration of the FDIC’s Transaction Account Guarantee Program.

The FDIC has adopted a restoration plan under which it has seven years to restore the reserve ratio of the Deposit Insurance Fund to 1.15% of insured deposits. Under this plan, the FDIC made adjustments to its risk-based assessment system, which became effective on April 1, 2009, to its assessment rates, and established a special assessment of five basis points on assets minus Tier 1 capital as of June 30, 2009 and collected on September 30, 2009. In addition, the FDIC imposed a prepayment of three years of insurance premiums which was paid by the Bank on December 30, 2009. The Bank’s prepaid FDIC insurance was $6.9 million at December 31, 2009. The prepayment was intended to cover the Bank’s premiums for 2010, 2011 and 2012. The FDIC has not ruled out additional special assessments in future years.

On October 14, 2008, the FDIC announced its temporary Transaction Account Guarantee Program (“TAGP”), which provides full coverage for noninterest-bearing transaction deposit accounts at FDIC-insured institutions that agree to participate in the TAGP. A 10-basis point surcharge is added to a participating institution’s current insurance assessment in order to fully cover all transaction accounts. The Bank elected to participate in the TAGP. This unlimited insurance coverage is temporary and was originally scheduled to expire on December 31, 2009. On August 26, 2009, the FDIC extended the TAGP through June 30, 2010 and on April 13, 2010 the FDIC extended the TAGP through December 31, 2010. The deposit insurance surcharge was increased from 10 to 25 basis points for institutions electing to continue participation in the TAGP. The Bank elected to continue to participate in the TAGP through December 31, 2010. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which was signed into law on July 21, 2010, extends the expiration date of TAGP through December 31, 2012. The expiration of the TAGP on December 31, 2012 could have an adverse impact on the levels of customer deposits that are sensitive to full FDIC insurance coverage.

Conditions in the financial markets may limit our access to funding to meet our liquidity needs.

Liquidity is essential to our business, as we must maintain sufficient funds to respond to the needs of depositors and borrowers. An inability to raise funds through deposits, borrowings, the sale or pledging as collateral of loans and other assets could have a substantial negative effect on our liquidity. Our access to funding sources in the amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could negatively affect our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or negative regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as severe disruption of the financial markets or negative news and expectations about the prospects for the financial services industry as a whole, as evidenced by recent turmoil in the domestic and worldwide credit markets.

As a part of our liquidity management, we use a number of funding sources in addition to core deposit growth and repayments and maturities of loans and investments. These sources include brokered certificates of deposit, repurchase agreements, federal funds purchased, lines of credit and Federal Home Loan Bank advances. Negative operating results or changes in industry conditions could lead to an inability to replace these additional funding sources at maturity. Our financial flexibility could be constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our results of operations and financial condition would be negatively affected.

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HILLS BANCORPORATION

PART II - OTHER INFORMATION

(continued)

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended June 30, 2010:

Period	Total number of shares purchased		Average price paid per share		Total number of shares purchased as part of publicly announced plans or programs		Maximum number of shares that may yet be purchased under the plans or programs (1)
April 1 to April 30		711	$	54.00		203,042		546,958
May 1 to May 31		1,277		54.84		204,319		545,681
June 1 to June 30		11,100		55.00		215,419		534,581
Total		13,088	$	54.93		215,419		534,581

(1) On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). This authorization was previously set to expire on December 31, 2009. At its January 2009 meeting, the Company’s Board of Directors extended the expiration date of the 2005 Stock Repurchase Program to December 31, 2013. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.

Item 3.

Defaults upon Senior Securities

Hills Bancorporation has no senior securities.

Item 4.

Reserved

Item 5.

Other Information

None

Item 6.

Exhibits

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002

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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.

HILLS BANCORPORATION


Date: August 6, 2010		By: /s/ Dwight O. Seegmiller
		Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date: August 6, 2010		By: /s/ James G. Pratt
		James G. Pratt, Secretary, Treasurer and Chief Accounting Officer

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HILLS BANCORPORATION

QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED JUNE 30, 2010

		Page Number
		In The Sequential
Exhibit		Numbering System
Number	Description	June 30, 2010 Form 10-Q

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	51- 52

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	53

Page 50