HILLS BANCORPORATION - Quarter Report: 2011 September (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 September 30, 2011

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 checkmark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes þ No

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.

	SHARES OUTSTANDING
CLASS	At October 31, 2011

Common Stock, no par value	4,596,458

Page 1

HILLS BANCORPORATION

Index to Form 10-Q

	Part I
	FINANCIAL INFORMATION

		Page
		Number

Item 1.	Financial Statements

	Consolidated balance sheets, September 30, 2011 (unaudited) and December 31, 2010		3
	Consolidated statements of income (unaudited) for three and nine months ended September 30, 2011 and 2010		4
	Consolidated statements of comprehensive income (unaudited) for three and nine months ended September 30, 2011 and 2010		5
	Consolidated statements of stockholders' equity (unaudited) for nine months ended September 30, 2011 and 2010		6
	Consolidated statements of cash flows (unaudited) for nine months ended September 30, 2011 and 2010		7
	Notes to consolidated financial statements		9

Item 2.	Management Discussion and Analysis of Financial Condition and Results of Operations		26

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		42

Item 4.	Controls and Procedures		42

	Part II
	OTHER INFORMATION

Item 1.	Legal proceedings		43

Item 1A.	Risk factors		43

Item 2.	Unregistered sales of equity securities and use of proceeds		43

Item 3.	Defaults upon senior securities		43

Item 4.	Reserved		43

Item 5.	Other information		43

Item 6.	Exhibits		43

Signatures			44

Exhibits Index			45

Page 2

HILLS BANCORPORATION
CONSOLIDATED BALANCE SHEETS
(Amounts In Thousands, Except Shares)

	September 30, 2011
ASSETS	(Unaudited)			December 31, 2010

Cash and cash equivalents	$	27,816		$	62,978
Investment securities available for sale at fair value (amortized cost September 30, 2011 $209,519; December 31, 2010 $200,995)		217,605			205,498
Stock of Federal Home Loan Bank		10,739			11,105
Loans held for sale		22,495			10,390
Loans, net of allowance for loan losses (September 30, 2011 $29,650; December 31, 2010 $29,230)		1,637,673			1,561,430
Property and equipment, net		28,232			26,806
Tax credit real estate		19,994			20,960
Accrued interest receivable		9,386			8,686
Deferred income taxes, net		8,837			9,870
Other real estate		1,978			2,233
Goodwill		2,500			2,500
Prepaid FDIC insurance		4,081			5,038
Other assets		5,044			3,789
	$	1,996,380		$	1,931,283

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	217,325		$	198,791
Interest-bearing deposits		1,307,965			1,281,950
Total deposits	$	1,525,290		$	1,480,741
Short-term borrowings		45,310			46,928
Federal Home Loan Bank borrowings		185,000			195,000
Accrued interest payable		1,617			1,996
Other liabilities		21,976			15,404
	$	1,779,193		$	1,740,069

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	26,747		$	24,945

STOCKHOLDERS' EQUITY
Capital stock, no par value; authorized 10,000,000 shares; issued September 30, 2011 4,800,253 shares; December 31, 2010 4,624,519 shares	$	-		$	-
Paid in capital		25,900			14,875
Retained earnings		201,953			185,412
Accumulated other comprehensive income		4,993			2,781
Treasury stock at cost (September 30, 2011 287,364 shares; December 31, 2010 226,182 shares)		(15,659	)		(11,854	)
	$	217,187		$	191,214
Less maximum cash obligation related to ESOP shares		26,747			24,945
	$	190,440		$	166,269
	$	1,996,380		$	1,931,283

See Notes to Consolidated Financial Statements.

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HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Amounts In Thousands, Except Per Share Amounts)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2011			2010		2011			2010
Interest income:
Loans, including fees	$	21,977		$	22,282	$	65,084		$	66,274
Investment securities:
Taxable		692			814		2,182			2,539
Nontaxable		863			806		2,588			2,458
Federal funds sold		1			9		66			37
Total interest income	$	23,533		$	23,911	$	69,920		$	71,308
Interest expense:
Deposits	$	3,838		$	4,574	$	12,292		$	14,554
Short-term borrowings		109			124		305			387
FHLB borrowings		2,012			2,027		5,983			6,095
Total interest expense	$	5,959		$	6,725	$	18,580		$	21,036
Net interest income	$	17,574		$	17,186	$	51,340		$	50,272
Provision for loan losses		1,561			2,870		2,760			5,788
Net interest income after provision for loan losses	$	16,013		$	14,316	$	48,580		$	44,484
Other income:
Net gain on sale of loans	$	546		$	1,044	$	1,199		$	2,085
Trust fees		1,114			1,004		3,309			3,006
Service charges and fees		1,937			1,985		5,669			6,008
Rental revenue on tax credit real estate		397			403		1,075			1,269
Other noninterest income		580			649		1,985			2,273
	$	4,574		$	5,085	$	13,237		$	14,641
Other expenses:
Salaries and employee benefits	$	5,532		$	5,582	$	16,616		$	16,587
Occupancy		809			835		2,464			2,351
Furniture and equipment		957			1,032		2,739			3,047
Office supplies and postage		308			380		962			1,071
Advertising and business development		402			404		1,178			1,210
Outside services		1,829			1,144		5,052			4,579
Rental expenses on tax credit real estate		648			648		1,530			1,870
FDIC insurance assessment		267			581		1,053			1,626
Net (gain) loss on sale of other real estate owned and other repossessed assets		(119	)		17		(504	)		200
Other noninterest expense		392			305		1,130			1,036
	$	11,025		$	10,928	$	32,220		$	33,577
Income before income taxes	$	9,562		$	8,473	$	29,597		$	25,548
Income taxes		2,753			2,440		8,657			7,409
Net income	$	6,809		$	6,033	$	20,940		$	18,139

Earnings per share:
Basic	$	1.55		$	1.37	$	4.77		$	4.11
Diluted		1.55			1.37		4.76			4.10

See Notes to Consolidated Financial Statements.

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HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(Amounts In Thousands)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010

Net income	$	6,809		$	6,033		$	20,940		$	18,139

Other comprehensive income:
Unrealized holding gains arising during the period	$	1,578		$	1,478		$	3,601		$	1,254
Income tax effect of unrealized gains		(597	)		(555	)		(1,371	)		(463	)
	$	981		$	923		$	2,230		$	791

Less: reclassification adjustments for gains included in net income, net of income taxes		(18	)		(44	)		(18	)		(44	)

Other comprehensive income	$	963		$	879		$	2,212		$	747

Comprehensive income	$	7,772		$	6,912		$	23,152		$	18,886

See Notes to Consolidated Financial Statements.

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HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)
(Amounts In Thousands, Except Share Amounts)

	Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income		Maximum Cash Obligation Related to ESOP Shares			Treasury Stock			Total

Balance, December 31, 2009	$	14,582		$	166,120		$	4,200	$	(22,900	)	$	(10,227	)	$	151,775

Issuance of 652 shares of common stock		26			-			-		-			-			26
Forfeiture of 679 shares of common stock		(32	)		-			-		-			-			(32	)
Share-based compensation		12			-			-		-			-			12
Income tax benefit related to share-based compensation		3			-			-		-			-			3
Change related to ESOP shares		-			-			-		(1,770	)		-			(1,770	)
Net income		-			18,139			-		-			-			18,139
Dividends ($.91 per share)		-			(4,024	)		-		-			-			(4,024	)
Purchase of 25,255 shares of common stock		-			-			-		-			(1,384	)		(1,384	)
Other comprehensive income		-			-			747		-			-			747
Balance, September 30, 2010	$	14,591		$	180,235		$	4,947	$	(24,670	)	$	(11,611	)	$	163,492


Balance, December 31, 2010	$	14,875		$	185,412		$	2,781	$	(24,945	)	$	(11,854	)	$	166,269

Issuance of 176,639 shares of common stock		11,012			-			-		-			-			11,012
Forfeiture of 905 shares of common stock		(48	)		-			-		-			-			(48	)
Share-based compensation		12			-			-		-			-			12
Income tax benefit related to share-based compensation		49			-			-		-			-			49
Change related to ESOP shares		-			-			-		(1,802	)		-			(1,802	)
Net income		-			20,940			-		-			-			20,940
Dividends ($1.00 per share)		-			(4,399	)		-		-			-			(4,399	)
Purchase of 61,182 shares of common stock		-			-			-		-			(3,805	)		(3,805	)
Other comprehensive income		-			-			2,212		-			-			2,212
Balance, September 30, 2011	$	25,900		$	201,953		$	4,993	$	(26,747	)	$	(15,659	)	$	190,440

See Notes to Consolidated Financial Statements.

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HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Amounts In Thousands)

	Nine Months Ended September 30,
	2011			2010
Cash Flows from Operating Activities
Net income	$	20,940		$	18,139
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation		1,862			2,026
Provision for loan losses		2,760			5,788
Net gain on sale of investment securities		(29	)		(71	)
Share-based compensation		12			12
Forfeiture of common stock		(48	)		(32	)
Compensation expensed through issuance of common stock		364			16
Excess tax benefits from share-based compensation		(49	)		(3	)
Provision for deferred income taxes		(338	)		129
Net (gain) loss on sale of other real estate owned and other repossessed assets		(504	)		200
Increase in accrued interest receivable		(700	)		(107	)
Amortization of discount on investment securities, net		723			667
Decrease in prepaid FDIC insurance		957			1,423
(Increase) decrease in other assets		(1,206	)		450
Increase in accrued interest payable and other liabilities		6,193			3,724
Loans originated for sale		(109,364	)		(164,987	)
Proceeds on sales of loans		98,458			163,732
Net gain on sales of loans		(1,199	)		(2,085	)
Net cash and cash equivalents provided by operating activities	$	18,832		$	29,021

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	36,124		$	35,644
Proceeds from sales of investment securities available for sale		529			4,892
Purchases of investment securities available for sale		(45,505	)		(38,800	)
Loans made to customers, net of collections		(80,975	)		(19,227	)
Proceeds on sale of other real estate owned and other repossessed assets		2,731			2,771
Purchases of property and equipment		(3,288	)		(2,213	)
Investment in tax credit real estate, net		966			(2,498	)
Net cash used in investing activities	$	(89,418	)	$	(19,431	)

Cash Flows from Financing Activities
Net increase in deposits	$	44,549		$	86,329
Net decrease in short-term borrowings		(1,618	)		(29,488	)
Issuance of common stock		10,569			-
Stock options exercised		79			10
Excess tax benefits related to share-based compensation		49			3
Borrowings from FHLB		-			10,000
Payments on FHLB borrowings		(10,000	)		(40,000	)
Purchase of treasury stock		(3,805	)		(1,384	)
Dividends paid		(4,399	)		(4,024	)
Net cash provided by financing activities	$	35,424		$	21,446

(Continued)

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HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Continued) (Amounts In Thousands)

	Nine Months Ended September 30,
	2011			2010

(Decrease) increase in cash and cash equivalents	$	(35,162	)	$	31,036

Cash and cash equivalents:
Beginning of year		62,978			24,095
End of period	$	27,816		$	55,131

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	12,671		$	14,878
Interest paid on other obligations		6,288			6,482
Income taxes paid		8,234			5,539

Noncash financing activities:
Increase in maximum cash obligation related to ESOP shares	$	1,802		$	1,770
Transfers to other real estate owned		1,972			2,331

See Notes to Consolidated Financial Statements.

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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 nine month period ended September 30, 2011 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2011. 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, 2010 filed with the Securities Exchange Commission on March 10, 2011.

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 September 30,					Nine months ended September 30,
	2011		2010			2011			2010

Common shares outstanding at the beginning of the period		4,358,392		4,403,452			4,398,337			4,422,274
Weighted average number of net shares issued (redeemed)		23,248		(3,484	)		(11,985	)		(11,320	)
Weighted average shares outstanding (basic)		4,381,640		4,399,968			4,386,352			4,410,954

Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method		10,705		13,266			10,773			13,295
Weighted average number of shares		4,392,345		4,413,234			4,397,125			4,424,249

Net income (In Thousands)	$	6,809	$	6,033		$	20,940		$	18,139

Earnings per share:
Basic	$	1.55	$	1.37		$	4.77		$	4.11
Diluted	$	1.55	$	1.37		$	4.76		$	4.10

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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

On April 5, 2011, the FASB issued ASU No. 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring, which provides additional guidance clarifying when the restructuring of a receivable should be considered a troubled debt restructuring (“TDR”). The ASU provides additional guidance for determining whether the creditor has granted a concession and whether the debtor is experiencing financial difficulty. The ASU also ends the deferral of activity based disclosures about TDRs and public entities will be required to disclose activity based information beginning in the period the ASU is adopted. For the Company, this ASU is effective for interim and annual reporting periods beginning on or after June 15, 2011. The adoption of ASU No. 2011-02 in the third quarter of 2011 did not have a significant impact on the Company’s consolidated financial statements.

As a result of adopting the amendments in ASU No. 2011-02, the Company reassessed all loan modifications that occurred on or after January 1, 2011 for identification as a TDR. The Company did not identify any new TDRs from this assessment.

On May 12, 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. This ASU provides guidance about how fair value should be determined where it already is required or permitted under IFRS or U.S. GAAP. For U.S. GAAP, most of the changes are clarifications of existing guidance or wording changes to align with IFRS. For the Company, this ASU is effective for interim and annual periods beginning after December 15, 2011. The ASU will not have a material impact on the Company’s consolidated financial statements.

In September 2011, the FASB issued ASU No. 2011-08, Testing Goodwill for Impairment. This ASU permits the Company to make a qualitative assessment of whether it is more likely than not that the fair value of the portion of the Company to which goodwill relates is less than its carrying amount before applying the two-step goodwill impairment test. The ASU is intended to simplify how the Company tests goodwill for impairment. For the Company, this ASU is effective for interim and annual periods beginning after December 15, 2011. The ASU will not have a material impact on the Company’s consolidated financial statements.

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 “Dodd-Frank Act”) was signed into law on July 21, 2010. The Dodd-Frank Act represents the most sweeping financial services industry reform since the 1930’s. Generally, the Dodd-Frank Act is effective the day after it was signed into law, but different effective dates apply to specific sections of the Dodd-Frank Act. The Dodd-Frank Act is expected to be fully phased in over twelve years. Among other things, the Dodd-Frank 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 Dodd-Frank 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 Dodd-Frank Act, is available on the Federal Deposit Insurance Corporation website at www.fdic.gov/regulations/reform/index.html.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Loans

The composition of loans is as follows:

	September 30, 2011		December 31, 2010
	(Amounts In Thousands)

Agricultural	$	65,886	$	65,004
Commercial and financial		148,686		141,619
Real estate:
Construction, 1 to 4 family residential		23,862		25,232
Construction, land development and commercial		85,341		86,552
Mortgage, farmland		94,840		90,448
Mortgage, 1 to 4 family first liens		565,668		519,533
Mortgage, 1 to 4 family junior liens		107,019		109,036
Mortgage, multi-family		216,548		202,630
Mortgage, commercial		307,275		302,020
Loans to individuals		20,195		23,627
Tax exempt		32,003		24,959
	$	1,667,323	$	1,590,660
Less allowance for loan losses		29,650		29,230
	$	1,637,673	$	1,561,430

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the nine months ended September 30, 2011 were as follows:

	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi-family and commercial			Other			Total
	(Amounts In Thousands)

Allowance for loan losses:
Beginning balance	$	2,170		$	6,742		$	4,394		$	1,482		$	7,952		$	5,657		$	833		$	29,230
Charge-offs		(81	)		(1,668	)		(238	)		-			(1,766	)		(216	)		(193	)		(4,162	)
Recoveries		34			642			8			-			726			252			160			1,822
Provision		(574	)		1,156			121			(61	)		1,943			204			(29	)		2,760

Ending balance	$	1,549		$	6,872		$	4,285		$	1,421		$	8,855		$	5,897		$	771		$	29,650

Ending balance, individually evaluated for impairment	$	-		$	99		$	-		$	20		$	64		$	88		$	1		$	272

Ending balance, collectively evaluated for impairment	$	1,549		$	6,773		$	4,285		$	1,401		$	8,791		$	5,809		$	770		$	29,378

Loans:

Ending balance	$	65,886		$	148,686		$	109,203		$	94,840		$	672,687		$	523,823		$	52,198		$	1,667,323

Ending balance, individually evaluated for impairment		-			1,497			1,452			1,110			4,387			17,585			3			26,034

Ending balance, collectively evaluated for impairment		65,886			147,189			107,751			93,730			668,300			506,238			52,195			1,641,289

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Loans (continued)

Changes in the allowance for loan losses for the three months ended September 30, 2011 were as follows:

	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi-family and commercial			Other			Total
	(Amounts In Thousands)

Allowance for loan losses:
Beginning balance	$	1,403		$	6,634		$	4,211		$	1,429		$	8,882		$	5,877		$	824		$	29,260
Charge-offs		(81	)		(561	)		(205	)		-			(518	)		(157	)		(44	)		(1,566	)
Recoveries		11			179			1			-			129			32			42			395
Provision		216			620			278			(8	)		362			145			(51	)		1,561

Ending balance	$	1,549		$	6,872		$	4,285		$	1,421		$	8,855		$	5,897		$	771		$	29,650

Changes in the allowance for loan losses for the three and nine months ended September 30, 2010 (amounts in thousands) are as follows:

	Three Months Ended September 30,		Nine Months Ended September 30,
	2010		2010


Balance, beginning	$	28,350	$	29,160
Charge-offs:
Agricultural		1		9
Commercial and financial		1,447		3,268
Real estate:
Construction and land development		307		1,039
Mortgage, farmland		-		39
Mortgage, 1 to 4 family		1,485		2,931
Mortgage, multi-family and commercial		589		1,125
Other		56		263
		3,885		8,674

Recoveries:
Agricultural		225		230
Commercial and financial		306		745
Real estate:
Construction and land development		1		3
Mortgage, farmland		44		44
Mortgage, 1 to 4 family		51		424
Mortgage, multi-family and commercial		32		111
Other		56		219
		715		1,776
Net charge-offs		3,170		6,898
Provision charged to expense		2,870		5,788
Balance, ending	$	28,050	$	28,050

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Loans (continued)

The following table presents the credit quality indicators by type of loans in each category as of September 30, 2011 and December 31, 2010, respectively (amounts in thousands):

	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
September 30, 2011
Grade:
Pass	$	55,146	$	120,727	$	20,563	$	62,556
Potential Watch		3,214		3,886		1,067		4,749
Watch		4,327		14,331		1,922		7,405
Substandard		3,199		9,742		310		10,631
Total	$	65,886	$	148,686	$	23,862	$	85,341

	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi-family
September 30, 2011
Grade:
Pass	$	85,314	$	501,040	$	94,916	$	176,064
Potential Watch		1,661		19,356		3,211		11,544
Watch		2,503		20,985		4,698		18,910
Substandard		5,362		24,287		4,194		10,030
Total	$	94,840	$	565,668	$	107,019	$	216,548

	Real Estate: Mortgage, commercial		Loans to individuals		Tax exempt		Total
September 30, 2011
Grade:
Pass	$	254,374	$	19,545	$	31,936	$	1,422,181
Potential Watch		8,405		187		-		57,280
Watch		36,778		226		67		112,152
Substandard		7,718		237		-		75,710
Total	$	307,275	$	20,195	$	32,003	$	1,667,323

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Loans (continued)

	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
December 31, 2010
Grade:
Pass	$	53,240	$	109,345	$	20,448	$	65,494
Potential Watch		465		2,818		-		3,620
Watch		5,325		16,411		3,967		6,621
Substandard		5,974		13,045		817		10,817
Total	$	65,004	$	141,619	$	25,232	$	86,552

	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi-family
December 31, 2010
Grade:
Pass	$	80,860	$	459,651	$	97,831	$	167,254
Potential Watch		3,453		12,658		3,071		8,808
Watch		2,317		21,330		4,244		14,614
Substandard		3,818		25,894		3,890		11,954
Total	$	90,448	$	519,533	$	109,036	$	202,630

	Real Estate: Mortgage, commercial		Loans to individuals		Tax exempt		Total
December 31, 2010
Grade:
Pass	$	248,805	$	22,669	$	24,887	$	1,350,484
Potential Watch		8,893		261		-		44,047
Watch		36,002		404		72		111,307
Substandard		8,320		293		-		84,822
Total	$	302,020	$	23,627	$	24,959	$	1,590,660

The below are descriptions of the credit quality indicators:

Pass – Pass rated loans are supported by sound payment capacity, are adequately collateralized and have no apparent weaknesses that would affect the full repayment of the loan under the established terms and conditions.

Potential Watch – Potential watch rated loans are supported by adequate payment capacity, are adequately collateralized and are performing according to the established terms and conditions. However, the loan requires more than average monitoring due to a potential weakness. The potential watch indicator assists the Company in identifying and monitoring loans for which credit quality could deteriorate.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Loans (continued)

Watch – Watch rated loans are supported by a marginal payment capacity and may be marginally collateralized. There are identified weaknesses that if not monitored and corrected may adversely affect the Company’s credit position. A watch credit would typically have a weakness in one of the general categories (cash flow, collateral position or payment history) but not in all categories.

Substandard – Substandard loans are not adequately supported by the paying capacity of the borrower and may be inadequately collateralized. These loans have a well defined weakness or weaknesses. For these loans, it is more probable than not that the Company could sustain some loss if the deficiency(ies) is not corrected.

Past due loans as of September 30, 2011 and December 31, 2010 were as follows:

					90 Days						Total		Accruing Loans
	30 - 59 Days		60 - 89 Days		or More		Total Past				Loans		Past Due 90
	Past Due		Past Due		Past Due		Due		Current		Receivable		Days or More
	(Amounts In Thousands)

September 30, 2011
Agriculture	$	224	$	248	$	-	$	472	$	65,414	$	65,886	$	-
Commercial and financial		562		396		751		1,709		146,977		148,686		548
Real estate:
Construction, 1 to 4 family residential		100		-		-		100		23,762		23,862		-
Construction, land development and commercial		1,503		298		758		2,559		82,782		85,341		-
Mortgage, farmland		-		28		969		997		93,843		94,840		969
Mortgage, 1 to 4 family first liens		320		912		3,138		4,370		561,298		565,668		2,039
Mortgage, 1 to 4 family junior liens		533		225		746		1,504		105,515		107,019		475
Mortgage, multi-family		-		317		-		317		216,231		216,548		0
Mortgage, commercial		194		596		513		1,303		305,972		307,275		468
Loans to individuals		51		12		3		66		20,129		20,195		3
Tax exempt		1,440		-		-		1,440		30,563		32,003		-
	$	4,927	$	3,032	$	6,878	$	14,837	$	1,652,486	$	1,667,323	$	4,502

December 31, 2010:
Agriculture	$	77	$	20	$	104	$	201	$	64,803	$	65,004	$	104
Commercial and financial		643		141		1,464		2,248		139,371		141,619		1,045
Real estate:
Construction, 1 to 4 family residential		944		-		271		1,215		24,017		25,232		271
Construction, land development and commercial		5,140		60		1,605		6,805		79,747		86,552		145
Mortgage, farmland		391		-		-		391		90,057		90,448		-
Mortgage, 1 to 4 family first liens		5,620		2,134		4,470		12,224		507,309		519,533		3,053
Mortgage, 1 to 4 family junior liens		843		199		509		1,551		107,485		109,036		483
Mortgage, multi-family		-		-		1,837		1,837		200,793		202,630		-
Mortgage, commercial		1,110		366		230		1,706		300,314		302,020		229
Loans to individuals		38		5		15		58		23,569		23,627		15
Tax exempt		19		-		-		19		24,940		24,959		-
	$	14,825	$	2,925	$	10,505	$	28,255	$	1,562,405	$	1,590,660	$	5,345

The Company does not have a significant amount of loans that are past due less than 90 days where there are serious doubts as to the ability of the borrowers to comply with the loan repayment terms.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Loans (continued)

The following table summarizes the Company’s impaired loans and non-performing assets at September 30, 2011 and December 31, 2010:

	September 30, 2011			December 31, 2010
	(Amounts In Thousands)

Non-accrual loans	$	6,554		$	8,246
Accruing loans past due 90 days or more		4,502			5,345
TDR loans (1)		14,978			17,957
Total impaired loans		26,034			31,548
Other real estate		1,978			2,233
Non-performing assets (includes impaired loans and other real estate)		28,012			33,781
Loans held for investment		1,667,323			1,590,660
Ratio of allowance for loan losses to loans held for investment		1.78	%		1.84	%
Ratio of allowance for loan losses to impaired loans		113.89			92.65
Ratio of impaired loans to total loans held for investment		1.56			1.98
Ratio of non-performing assets to total assets		1.40			1.75

(1)	Total TDR loans were $17.7 million and $22.4 million as of September 30, 2011 and December 31, 2010, respectively. Included in the total TDRloans were $2.7 million and $4.4 million of non-accrual loans as of September 30, 2011 and December 31, 2010.

Certain impaired loan information by loan type at September 30, 2011 and December 31, 2010, was as follows:

	September 30, 2011						December 31, 2010
	Non-accrual loans		Accruing loans past due 90 days or more		Restructured loans		Non-accrual loans		Accruing loans past due 90 days or more		Restructured loans
	(Amounts In Thousands)						(Amounts In Thousands)

Agriculture	$	-	$	-	$	-	$	-	$	104	$	-
Commercial and financial		860		548		90		2,647		1,045		-
Real estate:
Construction, 1 to 4 family residential		-				-		-		271		-
Construction, land development and commercial		1,452		-		-		1,546		145		2,118
Mortgage, farmland		141		969		-		147		-		-
Mortgage, 1 to 4 family first liens		1,528		2,039		73		1,783		3,053		779
Mortgage, 1 to 4 family junior liens		271		475		-		26		483		963
Mortgage, multi-family		1,848		0		5,901		1,837		-		2,938
Mortgage, commercial		454		468		8,914		260		229		11,159
Loans to individuals		-		3		-		-		15		-
	$	6,554	$	4,502	$	14,978	$	8,246	$	5,345	$	17,957

Loans 90 days or more past due that are still accruing interest decreased $800,000 from December 31, 2010 to September 30, 2011 due to an overall reduction in delinquency trends during the first nine months of 2011. The average past due loan balance was $102,000 as of September 30, 2011 and $73,000 as of December 31, 2010. The loans 90 days or more past due and still accruing are believed to be adequately collateralized and the Company expects to collect all principal and interest as contractually due under these loans.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Loans (continued)

The Company may modify the terms of a loan to maximize the collection of amounts due. Such a modification is considered a troubled debt restructuring ("TDR"). In most cases, the modification is either a reduction in interest rate, conversion to interest only payments or an extension of the maturity date. Generally, the borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, so a concessionary modification is granted to the borrower that would otherwise not be considered. TDR loans accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles.

Below is a summary of information for TDR loans as of September 30, 2011 and December 31, 2010:

	September 30, 2011						December 31, 2010
	Number						Number
	of		Recorded		Commitments		of		Recorded		Commitments
	contracts		investment		outstanding		contracts		investment		outstanding
			(Amounts In Thousands)						(Amounts In Thousands)

Agriculture		-	$	-	$	-		-	$	-	$	-
Commercial and financial		3		625		-		2		2,301		155
Real estate:
Construction, 1 to 4 family residential		-		-		-		-		-		1,106
Construction, land development and commercial		-		-		-		4		2,118		2,008
Mortgage, farmland		-		-		-		-		-		-
Mortgage, 1 to 4 family first liens		2		73		-		3		779		-
Mortgage, 1 to 4 family junior liens		2		-		-		4		963		-
Mortgage, multi-family		4		7,652		-		3		4,775		-
Mortgage, commercial		5		9,323		-		5		11,419		-
Loans to individuals		-		-		-		-		-		-
		16	$	17,673	$	-		21	$	22,355	$	3,269

The following is a summary of TDR loans that were modified during the nine months ended September 30, 2011:

	Nine Months Ended September 30, 2011
	Number		Pre-modification		Post-modification
	of		recorded		recorded
	contracts		investment		investment
			(Amounts In Thousands)

Commercial and financial		2	$	251	$	251
Real estate:
Mortgage, commercial		1		157		90
		3	$	408	$	341

There were no loans modified during the three months ended September 30, 2011.

There were no commitments to lend additional borrowings to restructured loan customers as of September 30, 2011. The Company had commitments to lend additional borrowings to restructured loan customers noted above as of December 31, 2010. These commitments were in the normal course of business and allowed the borrowers to build pre-sold homes and commercial property, which was expected to increase their overall cash flow. The additional borrowings were not used to facilitate payments on these loans.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Loans (continued)

There were no TDRs for which there was a payment default (defined as past due 90 days or more) during the three and nine months ended September 30, 2011.

Information regarding impaired loans as of and for the three and nine months ended September 30, 2011 was as follows:

	September 30, 2011				Three Months Ended September 30, 2011						Nine Months Ended September 30, 2011
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:	(Amounts In Thousands)
Agriculture	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Commercial and financial		950		2,527		-		1,445		1		1,895		4
Real estate:
Construction, 1 to 4 family residential		-		-		-		-		-		-		-
Construction, land development and commercial		1,452		1,648		-		1,478		-		1,510		-
Mortgage, farmland		141		161		-		142		-		144		-
Mortgage, 1 to 4 family first liens		1,602		2,048		-		1,641		1		1,758		5
Mortgage, 1 to 4 family junior liens		271		495		-		272		-		272		-
Mortgage, multi-family		1,848		2,180		-		1,868		-		1,842		-
Mortgage, commercial		454		2,481		-		503		4		519		11
Loans to individuals		-		-		-		-		-		-		-
	$	6,718	$	11,540	$	-	$	7,349	$	6	$	7,940	$	20
With an allowance recorded:
Agriculture	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Commercial and financial		547		592		99		562		8		567		26
Real estate:
Construction, 1 to 4 family residential		-		-		-		-		-		-		-
Construction, land development and commercial		-		-		-		-		-		-		-
Mortgage, farmland		969		969		20		969		15		973		44
Mortgage, 1 to 4 family first liens		2,039		2,238		51		2,068		25		2,119		75
Mortgage, 1 to 4 family junior liens		475		475		13		475		7		462		21
Mortgage, multi-family		5,901		5,901		63		5,909		78		5,491		216
Mortgage, commercial		9,382		9,382		25		9,403		141		9,339		415
Loans to individuals		3		3		1		3		-		3		-
	$	19,316	$	19,560	$	272	$	19,389	$	274	$	18,954	$	797
Total:
Agriculture	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Commercial and financial		1,497		3,119		99		2,007		9		2,462		30
Real estate:
Construction, 1 to 4 family residential		-		-		-		-		-		-		-
Construction, land development and commercial		1,452		1,648		-		1,478		-		1,510		-
Mortgage, farmland		1,110		1,130		20		1,111		15		1,117		44
Mortgage, 1 to 4 family first liens		3,641		4,286		51		3,709		26		3,877		80
Mortgage, 1 to 4 family junior liens		746		970		13		747		7		734		21
Mortgage, multi-family		7,749		8,081		63		7,777		78		7,333		216
Mortgage, commercial		9,836		11,863		25		9,906		145		9,858		426
Loans to individuals		3		3		1		3		-		3		-
	$	26,034	$	31,100	$	272	$	26,738	$	280	$	26,894	$	817

Page 18

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Loans (continued)

Information regarding impaired loans as of December 31, 2010 is as follows:

	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:	(Amounts In Thousands)
Agriculture	$	-	$	-	$	-
Commercial and financial		2,301		3,234		-
Real estate:
Construction, 1 to 4 family residential		-		-		-
Construction, land development and commercial		2,118		2,118		-
Mortgage, farmland		-		-		-
Mortgage, 1 to 4 family first liens		181		190		-
Mortgage, 1 to 4 family junior liens		-		224		-
Mortgage, multi-family		1,837		1,883		-
Mortgage, commercial		485		2,419		-
Loans to individuals		-		-		-
	$	6,922	$	10,068	$	-
With an allowance recorded:
Agriculture	$	104	$	104	$	21
Commercial and financial		1,391		1,573		172
Real estate:
Construction, 1 to 4 family residential		270		346		54
Construction, land development and commercial		1,691		2,174		319
Mortgage, farmland		147		161		32
Mortgage, 1 to 4 family first liens		5,435		6,274		136
Mortgage, 1 to 4 family junior liens		1,472		1,482		34
Mortgage, multi-family		2,938		2,938		2
Mortgage, commercial		11,163		11,243		39
Loans to individuals		15		47		1
	$	24,626	$	26,342	$	810
Total:
Agriculture	$	104	$	104	$	21
Commercial and financial		3,692		4,807		172
Real estate:
Construction, 1 to 4 family residential		270		346		54
Construction, land development and commercial		3,809		4,292		319
Mortgage, farmland		147		161		32
Mortgage, 1 to 4 family first liens		5,616		6,464		136
Mortgage, 1 to 4 family junior liens		1,472		1,706		34
Mortgage, multi-family		4,775		4,821		2
Mortgage, commercial		11,648		13,662		39
Loans to individuals		15		47		1
	$	31,548	$	36,410	$	810

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Loans (continued)

Impaired loans decreased $5.5 million from December 31, 2010 to September 30, 2011. Impaired 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. Impaired loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement. Impaired loans were 1.56% of loans held for investment as of September 30, 2011 and 1.98% as of December 31, 2010. The decrease in impaired loans is due mainly to two customer relationships totaling $3.7 million no longer classified as restructured loans. The customers were removed from the classification as the loans were returned to a market rate of interest, all payments have been made as agreed according to the modified loan terms and they are no longer experiencing financial difficulties. Non-accrual loans decreased $1.7 million from December 31, 2010 to September 30, 2011. The reduction in non-accrual loans is due to principal payments received and loans charged off during the nine months ended September 30, 2011. In addition, there was an overall reduction in delinquency trends during the first nine months of 2011.

The Company regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans are impaired in accordance with ASC 310. If the loans are impaired, the Company determines if a specific allowance is appropriate. In addition, the Company's management also reviews and, where determined necessary, provides allowances for particular loans based upon (1) reviews of specific borrowers and (2) management’s assessment of areas that management considers are of higher credit risk, including loans that have been restructured. Loans that are determined not to be impaired and for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Company allocates a percentage, as determined by management, for a required allowance needed. The determination of the appropriate percentage begins with historical loss experience factors, which are then adjusted for levels and trends in past due loans, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in restructured loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.

Specific allowances for losses on impaired loans are established if the loan balances exceed the net present value of the relevant future cash flows or the fair value of the relevant collateral based on updated appraisals and/or updated collateral analysis for the properties if the loan is collateral dependent. The Company recognizes a charge off related to an impaired loan if there is a collateral shortfall or it is unlikely the borrower can make all principal and interest payments as contractually due.

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. In general, this is the amount that the carrying value of the loan exceeds the related appraised value less estimated costs to sell the collateral. 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 an additional charge off or specific reserve based on the applicable facts and circumstances. In instances where there is an estimated decline in value, a specific reserve 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 specific reserve 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.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments under ASC 820, Financial Instruments, as of September 30, 2011 and December 31, 2010 are as follows:

	September 30, 2011				December 31, 2010
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
	(Amounts In Thousands)

Cash and cash equivalents	$	27,816	$	27,816	$	62,978	$	62,978
Investment securities		228,344		228,344		216,603		216,603
Loans		1,660,168		1,705,671		1,571,820		1,578,072
Accrued interest receivable		9,386		9,386		8,686		8,686
Deposits		1,525,290		1,544,653		1,480,741		1,483,116
Short-term borrowings		45,310		45,310		46,928		46,928
Federal Home Loan Bank borrowings		185,000		199,695		195,000		210,093
Accrued interest payable		1,617		1,617		1,996		1,996

	Face Amount				Face Amount
Off-balance sheet instruments:
Loan commitments	$	300,437	$	-	$	281,864	$	-
Letters of credit		12,039		-		11,936		-

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 similar assets or liabilities.

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.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Fair Value Measurements (continued)

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 utilizing an entrance price concept. 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.

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

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

Non-marketable equity investments: Non-marketable equity investments are recorded under the cost or equity method of accounting. There are generally restrictions on the sale and/or liquidation of these investments, including stock of the Federal Home Loan Bank. The carrying value of stock of the Federal Home Loan Bank approximates fair value.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Fair Value Measurements (continued)

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.

Long-term borrowings: Long-term borrowings are recorded at historical cost. The fair values of the Company’s long-term 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.

The Company considered all accounting guidance in its valuation methodologies.

The pricing for investment securities is obtained from an independent source. The Company’s investment securities are measured at fair value as either level 1 or level 2 assets. There are no level 3 investment securities owned by the Company. Due to these factors, the Company reviews prices provided by the independent source on a monthly basis for unusual fluctuations. Due to the nature of our investment portfolio, the Company does not expect significant and unusual fluctuations as fair value changes primarily relate to interest rate changes. No unusual fluctuations were identified during the nine months ended September 30, 2011. If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.

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:

	September 30, 2011
	Level 1		Level 2		Level 3		Total
	(Amounts In Thousands)

Investment securities available for sale	$	98,522	$	119,083	$	-	$	217,605
Total	$	98,522	$	119,083	$	-	$	217,605

	December 31, 2010
	Level 1		Level 2		Level 3		Total
	(Amounts in Thousands)

Investment securities available for sale	$	97,836	$	107,662	$	-	$	205,498
Total	$	97,836	$	107,662	$	-	$	205,498

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Fair Value Measurements (continued)

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 nine months ended September 30, 2011.

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. The following tables present the Company’s assets that are measured at fair value on a nonrecurring basis.

	September 30, 2011
	Level 1		Level 2		Level 3		Total		Three Months Ended September 30, 2011 Total Losses		Nine Months Ended September 30, 2011 Total Losses
	(Amounts In Thousands)

Loans (1)	$	-	$	11,473	$	-	$	11,473	$	597	$	1,374
Foreclosed assets (2)		-		192		-		192		12		136
Total	$	-	$	11,665	$	-	$	11,665	$	609	$	1,510

									Year Ended
	December 31, 2010								December 31, 2010
	Level 1		Level 2		Level 3		Total		Total Losses
	(Amounts in Thousands)

Loans (1)	$	-	$	13,639	$	-	$	13,639	$	4,826
Foreclosed assets (2)		-		762		-		762		505
Total	$	-	$	14,401	$	-	$	14,401	$	5,331

(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 September 30, 2011, the $11.5 million of loans recorded at fair value on a nonrecurring basis consisted of the following loan types: $6.1 million of 1 – 4 family residential loans, $2.4 million of commercial and industrial loans, and $1.1 million of commercial mortgage loans. The remaining $1.9 million includes loans in the following categories: construction and land development, agricultural, real estate construction, mortgage – farmland, mortgage – multi-family, and loans to individuals. The total $11.5 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 $11.5 million, $3.2 million was included in the nonaccrual loan total. The remaining $8.3 million is accruing interest based on the fact loan payments have been made as contractually agreed.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6. 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 and legal factors. The Company has purchased 287,364 shares of its common stock in privately negotiated transactions from August 1, 2005 through September 30, 2011. Of these 287,364 shares, 18,354 shares were purchased during the quarter ended September 30, 2011, at an average price per share of $62.98.

Note 7. 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 September 30, 2011 and December 31, 2010 is as follows:

	September 30, 2011		December 31, 2010
	(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	34,676	$	35,932
Credit cards		43,008		42,369
Commercial, real estate and home construction		83,355		65,035
Commercial lines and real estate purchase loans		139,398		138,528
Outstanding letters of credit		12,039		11,936

Note 8. Income Taxes

Federal income tax expense for the nine months ended September 30, 2011 and 2010 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, 2010, 2009 and 2008 remain subject to examination by the Internal Revenue Service. For state tax purposes, the tax years ended December 31, 2010, 2009 and 2008 remain open for examination. There were no material unrecognized tax benefits at December 31, 2010 and September 30, 2011 and therefore no interest or penalties on unrecognized tax benefits has been recorded. As of September 30, 2011, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending September 30, 2012.

Income taxes as a percentage of income before taxes were 29.25% in 2011 and 29.00% in 2010. 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 has investment or financial exposure.

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

·	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.

·	Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.

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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 develop and maintain secure and reliable electronic systems.

·	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, terrorist attacks and military actions.

·	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.

·	Changes in accounting policies and practices that may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.

·	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 consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these financial 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 losses 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 impaired 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 the state of certain industries. Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. The future impact of the global recession has introduced additional uncertainty into such determinations. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. Size and complexity of individual credits 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 of the Company’s critical accounting policies 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 September 30, 2011 and December 31, 2010 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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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, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa. At September 30, 2011, the Bank has fourteen full-service locations and a trust and wealth management location. The Company is adding an additional office in North Liberty, Iowa, opening in the first quarter of 2012.

Net income for the nine month period ended September 30, 2011 was $20.94 million compared to $18.14 million for the same nine months of 2010, an increase of 15.44%. The $2,801,000 increase in net income was caused by a number of factors. The principal factors in the increase in net income for the first nine months of 2011 are an increase in net interest income of $1,068,000 and a decrease in the provision for loan losses of $3,028,000. In addition, other income decreased $1,404,000 for the first nine months of 2011 and other expenses decreased $1,357,000 during the 2011 period.

The Company achieved a return on average assets of 1.34% and a return on average equity of 13.27% for the twelve months ended September 30, 2011, compared to the twelve months ended September 30, 2010 which were 1.22% and 12.56%, respectively. Dividends of $1.00 per share were paid in January 2011 to 1,726 shareholders. The 2010 dividend was $0.91 per share.

The Bank’s net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage. The Bank achieved a net interest margin on a tax-equivalent basis of 3.85% in 2011 compared to 4.00% in 2010. Average earning assets were $1.849 billion in 2011 and $1.735 billion in 2010.

Highlights noted on the balance sheet as of September 30, 2011 for the Company included the following:

Ÿ	Total assets were $1.996 billion, an increase of $65.10 million since December 31, 2010.

Ÿ	Net loans were $1.660 billion, an increase of $88.35 million since December 31, 2010.

Ÿ	Deposit growth of $44.55 million since December 31, 2010.

Ÿ	Federal Home Loan Bank borrowings decreased $10.0 million since December 31, 2010.

Reference is made to Note 5 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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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Financial Condition

The following table sets forth the composition of the loan portfolio as of September 30, 2011 and December 31, 2010:

	September 30, 2011					December 31, 2010
	Amount		Percent			Amount		Percent
	(Amounts In Thousands)					(Amounts In Thousands)

Agricultural	$	65,886		3.95	%	$	65,004		4.09	%
Commercial and financial		148,686		8.92			141,619		8.90
Real estate:
Construction, 1 to 4 family residential		23,862		1.43			25,232		1.59
Construction, land development and commercial		85,341		5.12			86,552		5.44
Mortgage, farmland		94,840		5.69			90,448		5.69
Mortgage, 1 to 4 family first liens		565,668		33.93			519,533		32.66
Mortgage, 1 to 4 family junior liens		107,019		6.42			109,036		6.85
Mortgage, multi-family		216,548		12.99			202,630		12.74
Mortgage, commercial		307,275		18.43			302,020		18.99
Loans to individuals		20,195		1.20			23,627		1.48
Obligations of state and political subdivisions		32,003		1.92			24,959		1.57
	$	1,667,323		100.00	%	$	1,590,660		100.00	%
Less allowance for loan losses		29,650					29,230
	$	1,637,673				$	1,561,430

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. The collateral relied upon in the loan origination policy is generally the property being financed by the Bank. The source of expected payment is generally the income produced from the property being financed. Personal guarantees are required of individuals owing or controlling at least 20% of the ownership of an entity. Limited or proportional guarantees may be accepted in circumstances if approved by the Company’s Board of Directors. Financial information provided by the borrower is verified as considered necessary by reference to tax returns, or audited, reviewed or compiled financial statements. The Bank does not originate subprime loans. In order to modify, restructure or otherwise change the terms of a loan, the Bank’s policy is to evaluate each borrower situation individually. Modifications, restructures, extensions and other changes are done to improve the Bank’s position and to protect the Bank’s capital. If a borrower is not current with its payments, any additional loans to such borrowers are evaluated on an individual borrower basis.

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.

In accordance with Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, the Company determines and assigns ratings to loans using factors that include the following: an assessment of the financial condition of the borrower; a realistic determination of the value and adequacy of underlying collateral; the condition of the local economy and the condition of the specific industry of the borrower; an analysis of the levels and trends of loan categories; and a review of delinquent and classified loans.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Through the credit risk rating process, loans are reviewed to determine if they are performing in accordance with the original contractual terms. If the borrower has failed to comply with the original contractual terms, further action may be required by the Company, including a downgrade in the credit risk rating, movement to non-accrual status, a charge-off or the establishment of a specific impairment reserve. In the event a collateral shortfall is identified during the credit review process, the Company will work with the borrower for a principal reduction and/or a pledge of additional collateral and/or additional guarantees. In the event that these options are not available, the loan may be subject to a downgrade of the credit risk rating. If the Company determines a loan amount or portion thereof is uncollectible, the loan’s credit risk rating is immediately downgraded and the uncollectible amount is charged-off. The Bank’s credit and legal departments undertake a thorough and ongoing analysis to determine if additional impairment and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize actual losses.

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 September 30, 2011 and December 31, 2010:

	September 30, 2011								December 31, 2010
	Amount		% of Total Allowance			% of Loans to Total Loans			Amount		% of Total Allowance			% of Loans to Total Loans
	(In Thousands)								(In Thousands)
Agricultural	$	1,549		5.22	%		3.95	%	$	2,170		7.42	%		4.09	%
Commercial and financial		6,872		23.18			8.92			6,742		23.07			8.90
Real estate:
Construction, 1 to 4 family residential		584		1.97			1.43			752		2.57			1.59
Construction, land development and commercial		3,701		12.48			5.12			3,642		12.46			5.44
Mortgage, farmland		1,421		4.79			5.69			1,482		5.07			5.69
Mortgage, 1 to 4 family first liens		6,844		23.09			33.93			5,782		19.78			32.66
Mortgage, 1 to 4 family junior liens		2,011		6.78			6.42			2,170		7.42			6.85
Mortgage, multi-family		1,819		6.14			12.99			1,486		5.09			12.74
Mortgage, commercial		4,078		13.75			18.43			4,171		14.27			18.99
Loans to individuals		380		1.28			1.20			525		1.80			1.48
Obligations of state and political subdivisions		391		1.32			1.92			308		1.05			1.57
	$	29,650		100.00	%		100.00	%	$	29,230		100.00	%		100.00	%

The allowance for loan losses totaled $29,650,000 at September 30, 2011 compared to $29,230,000 at December 31, 2010. The percentage of the allowance to outstanding loans was 1.78% and 1.84% at September 30, 2011 and December 31, 2010, respectively. The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and overall increases in loans outstanding.

The adequacy of the allowance is reviewed quarterly and adjusted as appropriate after consideration has been given to 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. The growth of the loan portfolio and the trends in problem and watch loans are significant elements in the determination of the provision for loan losses. Quantitative factors include the Company’s historical loss experience, which is then adjusted for levels and trends in past due, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in restructured loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.

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HILLS BANCORPORATION

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Management has determined that the allowance for loan losses was appropriate at September 30, 2011, and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for loan losses is based on a comprehensive, well documented, and consistently applied analysis of the Company’s loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for loan losses is reviewed and compared to industry data. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.

Residential real estate loan products that include features such as loan-to-values in excess of 100% or interest only payments, 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 intend to offer this type of loan product.

Investment securities available for sale held by the Company increased by $12.1 million from December 31, 2010 to September 30, 2011. The fair value of securities available for sale was $8.1 million more than the amortized cost of such securities as of September 30, 2011. At December 31, 2010, the fair value of the securities available for sale was $4.5 million more than the amortized cost of such securities. The carrying values of investment securities at September 30, 2011 and December 31, 2010 are summarized in the following table (dollars in thousands):

	September 30, 2011					December 31, 2010
	Amount		Percent			Amount		Percent
Securities available for sale
Obligations of state and political subdivisions	$	119,083		54.72	%	$	107,662		52.39	%
Other securities (FHLB, FHLMC and FNMA)		98,522		45.28			97,836		47.61

Total securities available for sale	$	217,605		100.00	%	$	205,498		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 September 30, 2011 or December 31, 2010. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of September 30, 2011 and December 31, 2010 (in thousands):

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

September 30, 2011:
State and political subdivisions	$	113,002	$	6,139	$	(58	)	$	119,083
Other securities (FHLB, FHLMC and FNMA)		96,517		2,005		-			98,522
Total	$	209,519	$	8,144	$	(58	)	$	217,605

December 31, 2010:
State and political subdivisions	$	105,412	$	3,041	$	(791	)	$	107,662
Other securities (FHLB, FHLMC and FNMA)		95,583		2,383		(130	)		97,836
Total	$	200,995	$	5,424	$	(921	)	$	205,498

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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 September 30, 2011, were as follows (in thousands):

	Amortized Cost		Fair Value

Due in one year or less	$	44,158	$	44,876
Due after one year through five years		107,776		111,660
Due after five years through ten years		56,805		60,232
Due over ten years		780		837
Total	$	209,519	$	217,605

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 September 30, 2011 and December 31, 2010 (in thousands):

	Less than 12 months										12 months or more										Total
September 30, 2011
Description of Securities		#	Fair Value		Unrealized Loss			%				#	Fair Value		Unrealized Loss			%				#	Fair Value		Unrealized Loss			%

State and political subdivisions		3	$	426	$	(1	)		0.23	%		4	$	1,097	$	(57	)		5.20	%		7	$	1,523	$	(58	)		3.81	%

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

Total temporarily impaired securities		3	$	426	$	(1	)		0.23	%		4	$	1,097	$	(57	)		5.20	%		7	$	1,523	$	(58	)		3.81	%


	Less than 12 months										12 months or more										Total
December 31, 2010
Description of Securities		#	Fair Value		Unrealized Loss			%				#	Fair Value		Unrealized Loss			%				#	Fair Value		Unrealized Loss			%

State and political subdivisions		103	$	23,374	$	(787	)		3.37	%		1	$	121	$	(4	)		3.31	%		104	$	23,495	$	(791	)		3.37	%

Other securities (FHLB, FHLMC and FNMA)		4		11,137		(130	)		1.17	%		-		-		-			-			4		11,137		(130	)		1.17	%

Total temporarily impaired securities		107	$	34,511	$	(917	)		2.66	%		-	$	121	$	(4	)		3.31	%		108	$	34,632	$	(921	)		2.66	%

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 greater than twelve months as of September 30, 2011 included four issues. Two securities are general obligation bonds rated A3 or better and the remaining two securities are municipal bonds which are rated B1. Bonds with a B1 rating are less than investment grade. The aggregate fair value of these B1 rated bonds is $451,000 while their amortized cost is $503,000, representing an unrealized loss of $52,000. 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 unrealized losses are due to changes in interest rates. The Company has not recognized any unrealized loss in income because management does not have the intent to sell the securities included in the previous table. Management has concluded that it is more likely than not that the Company will not be required to sell these securities prior to recovery of the amortized cost basis.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Deposit growth was $44.5 million in the first nine months of 2011. Repurchase agreements decreased $6.6 million and federal funds borrowed increased $5.0 million in the same period. Federal Home Loan Bank borrowings decreased $10.0 million in the first nine months of 2011. 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 are included in total deposits and totaled $33.3 million as of September 30, 2011 with an average rate of 0.76%. Brokered deposits were $28.8 million as of December 31, 2010 with an average rate of 0.81%. As of September 30, 2011 and December 31, 2010, brokered deposits were 2.18% and 1.94% of total deposits, respectively.

Dividends and Equity

In January 2011, Hills Bancorporation paid a dividend of $4,399,000 or $1.00 per share. The dividend was $0.91 per share in January 2010. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of September 30, 2011 totaled $190.44 million. Under risk-based capital rules, the total amount of Tier 1 risk-based capital was 13.15% and 12.33% as of September 30, 2011 and December 31, 2010, respectively. The Tier 1 risk-based capital was in excess of the required minimum of 8.00%. Risk-based capital was 14.41% and 13.59% as of September 30, 2011 and December 31, 2010, respectively. As of September 30, 2011, 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. Even though the Bank is deemed well capitalized, the Company has filed with the Securities and Exchange Commission on Form S-3 a registration statement for the sale of up to $30 million of the Company’s common stock to further bolster its capital position. The registration statement was declared effective by the Securities and Exchange Commission in August 2011. Through September 30, 2011, the Company has sold 167,766 shares for a total of $10,569,000. The deadline for the offering is November 15, 2011.

Discussion of operations for the nine months ended September 30, 2011 and 2010

Net Income Overview

Net income increased $2,801,000 for the nine months ended September 30, 2011 compared to the first nine months of 2010. Total net income was $20,940,000 in 2011 and $18,139,000 in the comparable period in 2010, an increase of 15.44%. The changes in net income in 2011 from the first nine months of 2010 were primarily the result of the following:

Ÿ	Net interest income increased by $1,068,000.

Ÿ	The provision for loan losses decreased by $3,028,000.

Ÿ	Other income decreased by $1,404,000.

Ÿ	Other expenses decreased by $1,357,000.

Ÿ	Income taxes increased $1,248,000.

For the nine-month periods ended September 30, 2011 and 2010, basic earnings per share were $4.77 and $4.11, respectively. Diluted earnings per share were $4.76 for the nine months ended September 30, 2011 compared to $4.10 for the same period in 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 nine months ended September 30, 2011 and 2010

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 $51.3 million for the first nine months of 2011 was derived from the Company’s $1.849 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.85%. Average earning assets in the nine months ended September 30, 2010 were $1.735 billion and the tax-equivalent net interest margin was 4.00%. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of 10 basis points to 3.75% would have resulted approximately in a $1,382,000 decrease in income before income taxes in the nine month period ended September 30, 2011. Similarly, an increase in the net interest margin of 10 basis points to 3.95% would have resulted in approximately a $1,382,000 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 2010.

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 $1.660 billion at September 30, 2011. 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, the overall composition of the loan portfolio and loan concentrations, the borrowers’ ability to repay, past loss experience, 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 historically higher credit risk. The provision for loan losses was $2,760,000 in 2011 compared to $5,788,000 in 2010.

The third significant factor affecting the Company’s net income is income tax expense. Federal and state income tax expenses were $8,657,000 and $7,409,000 for the nine months ended September 30, 2011 and 2010, respectively. Income taxes as a percentage of income before taxes were 29.25% in 2011 and 29.00% in 2010.

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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 nine months ended September 30, 2011 and 2010

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 nine months of 2011 was 3.85% compared to 4.00% in 2010 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 nine months ended in 2011 compared to the comparable period in 2010 are shown in the following table:

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

	(Amounts in Thousands)

Interest income:
Loans, net	$	84,401			(0.39	) %	$	3,648		$	(4,555	)	$	(907	)
Taxable securities		1,891			(0.49	)		50			(407	)		(357	)
Nontaxable securities		12,792			(0.36	)		495			(295	)		200
Federal funds sold		15,420			(0.01	)		32			(3	)		29
	$	114,504					$	4,225		$	(5,260	)	$	(1,035	)

Interest expense:
Interest-bearing demand deposits	$	43,863			(0.19	) %	$	(150	)	$	377		$	227
Savings deposits		28,792			(0.26	)		(121	)		753			632
Time deposits		2,567			(0.31	)		(49	)		1,452			1,403
Short-term borrowings		7,082			(0.33	)		(64	)		147			83
FHLB borrowings		(6,810	)		0.07			213			(101	)		112
	$	75,494					$	(171	)	$	2,628		$	2,457
Change in net interest income							$	4,054		$	(2,632	)	$	1,422

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. Loan 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)	2011			2010

Yield on average interest-earning assets		5.19	%		5.61	%
Rate on average interest-bearing liabilities		1.60			1.91
Net interest spread		3.59	%		3.70	%
Effect of noninterest-bearing funds		0.26			0.30
Net interest margin (tax equivalent interest income divided by average interest-earning assets)		3.85	%		4.00	%

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Discussion of operations for the nine months ended September 30, 2011 and 2010

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 seven times during the first nine months of 2011. 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 September 30, 2011, the rate indexes for the one, three and five year indexes were 0.13%, 0.42% and 0.96%, respectively. The one year index decreased 51.85% from 0.27% at September 30, 2010, the three year index decreased 34.38% and the five year index decreased 24.41%. The three year index was 0.64% and the five year index was 1.27% at September 30, 2010. The targeted federal funds rate was 0.25% at September 30, 2011 and 2010.

Provision for Loan Losses

The provision for loan losses was $2,760,000 in 2011 compared to $5,788,000 in 2010, a decrease of $3,028,000. The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management. 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, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, 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.

The allowance for loan losses increased $420,000 during the first nine months of 2011. In the first nine months of 2011, there was an increase of $1,026,000 due to the volume and composition of loans outstanding. There was an offsetting $606,000 decrease in the amount allocated to the allowance due to a combination of improvement in credit quality and charge-offs.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the nine months ended September 30, 2011 and 2010, recoveries were $1,822,000 and $1,776,000, respectively; and charge-offs were $4,162,000 in 2011 and $8,674,000 in 2010. The allowance for loan losses totaled $29,650,000 at September 30, 2011 compared to $29,230,000 at December 31, 2010. The allowance represented 1.78% and 1.84% of loans held for investment at September 30, 2011 and December 31, 2010, respectively.

Net Gain on Sale of Loans

Loans originated for sale in the first nine months of 2011 totaled $109.4 million compared to $165.0 million in the same period in 2010, a decrease of 33.70%. In the nine months ended September 30, 2011 and 2010, the net gain on sale of loans was $1,199,000 and $2,085,000, 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.

Other Income

Other income, other than the net gain on sale of loans discussed above, decreased $518,000 for the nine months ended September 30, 2011 from the comparable period in 2010. Trust fees increased $303,000 in the first nine months of 2011 as a result of assets under management increasing from $938.0 million as of September 30, 2010 to $946.8 million as of September 30, 2011 due to market conditions and new trust relationships. Service charges and fees decreased $339,000 in the first nine months of 2011 from their level for the comparable period in 2010. 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 $372,000 due to volume of activity. Overdraft and NSF charges are also included in service charges and fees. This component decreased during the same period by $681,000, or 27.15%, primarily due to regulatory changes effective August 15, 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 nine months ended September 30, 2011 and 2010

Other noninterest income was $1,985,000 for the nine months ended September 30, 2011, a $288,000 decrease from the same period in 2010. Other noninterest income for the nine months ended September 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 period ended September 30, 2011 includes state sales and use tax refunds of $128,000 which were not received in the prior year.

Other Expenses

Other expenses of $32,220,000 decreased $1,357,000 for the nine months ended September 30, 2011 from the same period in 2010, a decrease of 4.04%. Occupancy expenses increased $113,000 for the nine months ended September 30, 2011, which included a $44,000 increase in property taxes and $58,000 increase in janitorial expenses. The increases are related to the office location which opened in 2010. Furniture and equipment expense were $2,739,000 for the nine months ended September 30, 2011 which represents a $308,000 decrease from the 2011 period. The positive variance is due to a decrease of $168,000 in depreciation for furniture, fixtures and equipment and a decrease of $107,000 in software maintenance contracts. The decrease in software maintenance contracts expense is due in part to the completion of a review which resulted in a reduction of $102,000 in accrued use tax. Office supplies and postage expense was $109,000 more for the nine months ended September 30, 2010 as compared to the 2011 period. The 2010 period included postage expenses for additional customer mailings related to regulatory changes for overdraft and NSF charges.

Outside services expense increased $473,000 for the nine months ended September 30, 2011 compared to September 30, 2010. 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 $157,000 due to an increase in the volume of transactions in 2011 compared to 2010. Other professional fees increased $470,000 due to an increase in third party professional fees in the lending, marketing and financial reporting areas during the first nine months of 2011. Attorney fees decreased $145,000 as a result of the Company handling additional legal matters in its internal legal department. Other real estate owned expense decreased $266,000 in the first nine months of 2011. During the first nine months of 2010, the other real estate owned expense increased $390,000 for the payment and accrual of property taxes for other real estate owned.

FDIC insurance assessment expense was $1,053,000 for the nine months ended September 30, 2011. This is a decrease of $573,000 when compared to the same period in 2010. The decrease in FDIC insurance premium expense is due to the change in the premium calculation base by the FDIC. Starting in the second quarter of 2011, the assessment is calculated using the assets of the Company less tangible capital resulting in a lower premium expense for the Company. Previously, the assessment was calculated based on total deposits of the Company. As of September 30, 2011, the Company has prepaid FDIC insurance of $4,081,000, 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.

The net (gain) loss on sale of other real estate owned and other repossessed assets decreased $704,000 to a net gain of $504,000 for the nine months ended September 30, 2011. The total net gain on sale of other real estate owned for the nine months ended September 30, 2011 consisted of a $136,000 fair market value adjustment on 8 properties within other real estate owned, a $660,000 gain on sale of 19 properties and a $20,000 loss on sale of 5 properties, for a net gain of $504,000. During the same period in 2010, the loss consisted of a $404,000 fair market value adjustment on 13 properties within other real estate owned, a $218,000 gain on sale of 17 properties and a $14,000 loss on sale of 3 properties, for a net loss of $200,000.

Income Taxes

Federal and state income tax expenses were $8,657,000 and $7,409,000 for the nine months ended September 30, 2011 and 2010, respectively. Income taxes as a percentage of income before taxes were 29.25% in 2011 and 29.00% in 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 September 30, 2011 and 2010

Net Income

Net income increased to $6,809,000 for the three months ended September 30, 2011 from $6,033,000 for the same period in 2010, an increase of 12.86%. Earnings per share, both basic and diluted, increased for the three months ended September 30, 2011 compared to the same period in 2010. For the three-month period ended September 30, 2011, basic and diluted earnings per share was $1.55. For the three months ended September 30, 2010, basic and diluted earnings per share were $1.37.

Net Interest Income

Net interest income increased for the three month period ended September 30, 2011 by $388,000 from the similar period in 2010. The net interest margin in 2011 was 3.91% compared to 4.04% in 2010. Net interest income changes on a tax-equivalent basis for the three months ended September 30, 2011 and 2010 are as follows:

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

Interest income:
Loans, net	$	104,694			(0.42	) %	$	1,528		$	(1,737	)	$	(209	)
Taxable securities		4,107			(0.55	)		34			(156	)		(122	)
Nontaxable securities		15,398			(0.39	)		197			(109	)		88
Federal funds sold		(11,832	)		(0.07	)		(8	)		-			(8	)
	$	112,367					$	1,751		$	(2,002	)	$	(251	)

Interest expense:
Interest-bearing demand deposits	$	34,168			(0.20	) %	$	(35	)	$	129		$	94
Savings deposits		30,523			(0.26	)		(38	)		251			213
Time deposits		(8,812	)		(0.24	)		54			374			428
Short-term borrowings		22,896			(0.47	)		(32	)		48			16
FHLB borrowings		(10,000	)		0.19			104			(89	)		15
	$	68,775					$	53		$	713		$	766
Change in net interest income							$	1,804		$	(1,289	)	$	515

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)	2011			2010

Yield on average interest-earning assets		5.18	%		5.57	%
Rate on average interest-bearing liabilities		1.53			1.81
Net interest spread		3.65	%		3.76	%
Effect of noninterest-bearing funds		0.26			0.28
Net interest margin (tax equivalent interest income divided by average interest-earning assets)		3.91	%		4.04	%

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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 three months ended September 30, 2011 and 2010

Provision for Loan Losses

The provision for loan losses was $1,561,000 in 2011 compared to $2,870,000 in 2010, a decrease of $1,309,000. The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management. 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, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, 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.

The allowance for loan losses increased $390,000 during the third quarter of 2011. In the third quarter of 2011, there was a increase of $340,000 due to the volume and composition of loans outstanding. There was an additional $50,000 increase in the amount allocated to the allowance due to a combination of improvement in credit quality and charge-offs. For the third quarter of 2010, asset quality changes decreased the allowance for loan losses by $800,000.

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 September 30, 2011 and 2010, recoveries were $394,000 and $715,000, respectively; and charge-offs were $1,566,000 in 2011 and $3,885,000 in 2010. The allowance for loan losses totaled $29,650,000 at September 30, 2011 compared to $28,050,000 at September 30, 2010. The allowance represented 1.78% and 1.82% of loans held for investment at September 30, 2011 and September 30, 2010, respectively.

Other Income

Other income decreased $511,000 to $4,574,000 for the three months ended September 30, 2011 as compared to the same period in 2010. Net gain on sale of loans decreased by $498,000 in the quarter ended September 30, 2011 as compared to the same quarter in 2010 due to a decrease in the volume of loans sold in 2011. Trust fees increased $110,000 in the third quarter of 2011 as a result of the increase in assets under management as noted in the discussion of the results of the nine months ended September 30, 2011.

Service charges and fees decreased $48,000 in the third quarter of 2011 from their level for the comparable period in 2010. 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 $122,000 due to volume of activity. Overdraft and NSF charges are also included in service charges and fees. This component decreased during the same period by $158,000, or 20.09%, due to regulatory changes effective August 15, 2010.

Other noninterest income was $580,000 for the three months ended September 30, 2011, a $69,000 decrease from the same period in 2010. The period ended September 30, 2011 includes a gain on the sale of investment securities available for sale of $29,000 while the same period in 2010 includes a gain of $71,000.

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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 September 30, 2011 and 2010

Other Expenses

Other expenses of $11,025,000 increased $97,000 for the three months ended September 30, 2011 from the same period in 2010, an increase of 0.89%. Salary and employee benefits expense was $5,532,000 for the three months ended September 30, 2011 which was a $50,000 decrease from the same period in 2010. Direct salary expense decreased $79,000, or 1.88%, in the 2011 quarter due to a reduction in bonuses paid to real estate lenders related to loan sales production. Furniture and equipment expense decreased $75,000 for the three months ended September 30, 2011. The positive variance is due to a decrease of $56,000 in depreciation for furniture, fixtures and equipment and an increase of $32,000 in software maintenance contracts. Office supplies and postage expense was $72,000 more for the three months ended September 30, 2010 as compared to the 2011 period. The 2010 period included postage expenses for additional customer mailings related to regulatory changes for overdraft and NSF charges.

Outside services expense increased $685,000 for the three months ended September 30, 2011 compared to September 30, 2010. 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. Other professional fees increased $358,000 due to an increase in third party professional fees in the lending, marketing and financial reporting areas during the three months ended September 30, 2011. Other real estate owned expense increased $166,000 in the third quarter of 2011 as compared to the third quarter of 2010. The increase in expenses is due to the tax liabilities owned on properties in other real estate owned. The Company estimates property taxes related to such properties.

FDIC insurance assessment expense was $267,000 for the three months ended September 30, 2011. This is a decrease of $314,000 when compared to the same period in 2010. The decrease in FDIC insurance premium expense is due to the change in the premium calculation base by the FDIC.

The net (gain) loss on sale of other real estate owned and other repossessed assets decreased $136,000 to a net gain of $119,000 for the three months ended September 30, 2011. The total net gain on sale of other real estate owned for the three months ended September 30, 2011 consisted of a $11,000 fair market value adjustment on 2 properties within other real estate owned, a $144,000 gain on sale of 5 properties and a $14,000 loss on sale of 3 properties, for a net gain of $119,000. During the same period in 2010, the loss consisted of a $137,000 fair market value adjustment on 10 properties within other real estate owned and a $120,000 gain on sale of 8 properties, for a net loss of $17,000.

Income Taxes

Federal and state income tax expenses were $2,753,000 and $2,440,000 for the three months ended September 30, 2011 and 2010, respectively. Income taxes as a percentage of income before taxes were 28.79% in 2011 and 28.80% in 2010.

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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 September 30, 2011, compared to 10.64% at December 31, 2010.

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 September 30, 2011, the Company had borrowed $185 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. The Company repaid $10 million in FHLB borrowings in March 2011. 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 $318 million at September 30, 2011.

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 $164 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 September 30, 2011.

As of September 30, 2011, investment securities with a carrying value of $45,310,000 were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law. As of December 31, 2010, investment securities with a carrying value of $46,928,000 were pledged.

In addition, the Company has filed with the Securities and Exchange Commission on Form S-3 a registration statement for the sale of up to $30 million of the Company’s common stock to further bolster its capital position. The registration statement was declared effective by the Securities and Exchange Commission in August 2011. Through September 30, 2011, the Company has sold 167,766 shares for a total of $10,569,000.

Contractual Obligations

The Bank is adding an additional office location in North Liberty, Iowa, opening in the first quarter of 2012. 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. The new office location will have approximately 18,600 square feet. Construction costs for the building are estimated at $3.9 million and the Company purchased the land for $1.6 million. The Bank will not incur any debt for the construction of the new office.

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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.

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.

Management believes there has been no material change in the Company’s market risk from the information contained in the Company’s Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2010.

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, as of the end of the period covered by this report, 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 nine months of 2011 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

There have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2010.

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 September 30, 2011:

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)
July 1 to July 31		374	$	62.00		269,384		480,616
August 1 to August 31		12,331		63.00		281,715		468,285
September 1 to September 30		5,649		63.00		287,364		462,636
Total		18,354	$	62.98		287,364		462,636

(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.

During the third quarter of 2011, the Company issued 5,472 shares of restricted stock under the 2010 Stock Option and Incentive Plan. The restricted shares were issued for no cash consideration and will vest over a five-year period from the date of grant. The issuance of these shares was exempt from the registration requirements of the SEC pursuant to Section 4(2) of the Securities Act of 1933.

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: November 9, 2011		By: /s/ Dwight O. Seegmiller
		Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date: November 9, 2011		By: /s/ James G. Pratt
		James G. Pratt, Secretary, Treasurer and Chief Accounting Officer

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QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED SEPTEMBER 30, 2011

Exhibit Number	Description	Page Number In The Sequential Numbering System September 30, 2011 Form 10-Q

31.1	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	46

31.2	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	47

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	48

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