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HILLS BANCORPORATION - Quarter Report: 2011 June (Form 10-Q)

form10-q.htm




UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 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 June 30, 2011
   
Common Stock, no par value
 4,358,392
 

 
 
Page 1

 

HILLS BANCORPORATION
Index to Form 10-Q

   
Part I
 
   
FINANCIAL INFORMATION
 
       
     
Page
     
Number
       
Item 1.
 
Financial Statements
 
       
   
3
   
4
   
5
   
6
   
7
   
9
       
Item 2.
 
25
       
Item 3.
 
43
       
Item 4.
   43
       
   
Part II
 
   
OTHER INFORMATION
 
       
Item 1.
 
44
       
Item 1A.
 
44
       
Item 2.
 
44
       
Item 3.
 
44
       
Item 4.
 
44
       
Item 5.
 
44
       
Item 6.
 
44
       
   
45
       
 
46


 
Page 2

 
 
HILLS BANCORPORATION
CONSOLIDATED BALANCE SHEETS
(Amounts In Thousands, Except Shares)
 
             
             
ASSETS
 
June 30, 2011 (Unaudited)
   
December 31, 2010
 
             
Cash and cash equivalents
  $ 25,010     $ 62,978  
Investment securities available for sale at fair value (amortized cost June 30, 2011 $208,556; December 31, 2010 $200,995)
    215,082       205,498  
Stock of Federal Home Loan Bank
    10,757       11,105  
Loans held for sale
    8,191       10,390  
Loans, net of allowance for loan losses (June 30, 2011 $29,260; December 31, 2010 $29,230)
    1,602,768       1,561,430  
Property and equipment, net
    26,879       26,806  
Tax credit real estate
    20,316       20,960  
Accrued interest receivable
    9,232       8,686  
Deferred income taxes, net
    9,267       9,870  
Other real estate
    2,284       2,233  
Goodwill
    2,500       2,500  
Prepaid FDIC insurance
    4,331       5,038  
Other assets
    4,513       3,789  
    $ 1,941,130     $ 1,931,283  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
Liabilities
               
Noninterest-bearing deposits
  $ 195,915     $ 198,791  
Interest-bearing deposits
    1,286,995       1,281,950  
Total deposits
  $ 1,482,910     $ 1,480,741  
Short-term borrowings
    52,023       46,928  
Federal Home Loan Bank borrowings
    185,000       195,000  
Accrued interest payable
    1,823       1,996  
Other liabilities
    19,706       15,404  
    $ 1,741,462     $ 1,740,069  
                 
Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)
  $ 26,289     $ 24,945  
                 
STOCKHOLDERS' EQUITY
               
Capital stock, no par value; authorized 10,000,000 shares; issued June 30, 2011 4,627,402 shares; December 31, 2010 4,624,519 shares
  $ -     $ -  
Paid in capital
    14,997       14,875  
Retained earnings
    195,144       185,412  
Accumulated other comprehensive income
    4,030       2,781  
Treasury stock at cost (June 30, 2011 269,010 shares; December 31, 2010 226,182 shares)
    (14,503 )     (11,854 )
    $ 199,668     $ 191,214  
Less maximum cash obligation related to ESOP shares
    26,289       24,945  
    $ 173,379     $ 166,269  
    $ 1,941,130     $ 1,931,283  
                 
See Notes to Consolidated Financial Statements.
               


 
Page 3

 
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Amounts In Thousands, Except Per Share Amounts)
 
                         
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
Interest income:
                       
  Loans, including fees
  $ 21,742     $ 22,193     $ 43,107     $ 43,992  
  Investment securities:
                               
    Taxable
    725       850       1,490       1,725  
    Nontaxable
    866       828       1,725       1,652  
  Federal funds sold
    33       26       65       28  
    Total interest income
  $ 23,366     $ 23,897     $ 46,387     $ 47,397  
Interest expense:
                               
  Deposits
  $ 4,146     $ 4,882     $ 8,454     $ 9,980  
  Short-term borrowings
    101       120       196       263  
  FHLB borrowings
    1,990       2,005       3,971       4,068  
    Total interest expense
  $ 6,237     $ 7,007     $ 12,621     $ 14,311  
    Net interest income
  $ 17,129     $ 16,890     $ 33,766     $ 33,086  
Provision for loan losses
    (266 )     853       1,199       2,918  
    Net interest income after provision for loan losses
  $ 17,395     $ 16,037     $ 32,567     $ 30,168  
Other income:
                               
  Net gain on sale of loans
  $ 171     $ 496     $ 653     $ 1,041  
  Trust fees
    1,106       1,042       2,195       2,002  
  Service charges and fees
    1,921       2,101       3,732       4,023  
  Rental revenue on tax credit real estate
    395       404       678       866  
  Other noninterest income
    736       545       1,405       1,624  
    $ 4,329     $ 4,588     $ 8,663     $ 9,556  
Other expenses:
                               
  Salaries and employee benefits
  $ 5,534     $ 5,563     $ 11,084     $ 11,005  
  Occupancy
    824       755       1,655       1,516  
  Furniture and equipment
    817       1,000       1,782       2,015  
  Office supplies and postage
    317       346       654       691  
  Advertising and business development
    447       449       776       806  
  Outside services
    1,497       1,543       3,223       3,435  
  Rental expenses on tax credit real estate
    648       710       882       1,222  
  FDIC insurance assessment
    86       271       786       1,045  
  Net (gain) loss on sale of other real estate owned and other repossessed assets
    (384 )     42       (385 )     183  
  Other noninterest expense
    484       414       738       731  
    $ 10,270     $ 11,093     $ 21,195     $ 22,649  
    Income before income taxes
  $ 11,454     $ 9,532     $ 20,035     $ 17,075  
Income taxes
    3,501       2,811       5,904       4,969  
    Net income
  $ 7,953     $ 6,721     $ 14,131     $ 12,106  
                                 
Earnings per share:
                               
Basic
  $ 1.82     $ 1.52     $ 3.22     $ 2.74  
Diluted
    1.81       1.52       3.21       2.73  
                                 
See Notes to Consolidated Financial Statements.
                               


 
Page 4

 
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(Amounts In Thousands)
 
                         
    Three Months Ended June 30,    
Six Months Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Net income
  $ 7,953     $ 6,721     $ 14,131     $ 12,106  
                                 
Other comprehensive income (loss):
                               
  Unrealized holding gains (losses) arising during the period
  $ 1,421     $ 346     $ 2,023     $ (312 )
  Income tax effect of unrealized (gains) losses
    (543 )     (132 )     (774 )     119  
    $ 878     $ 214     $ 1,249     $ (193 )
                                 
Comprehensive income
  $ 8,831     $ 6,935     $ 15,380     $ 11,913  
                                 
See Notes to Consolidated Financial Statements.
                               

 
Page 5

 
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)
(Amounts In Thousands, Except Share Amounts)
 
                                     
   
Paid In Capital
   
Retained Earnings
   
Accumulated Other Comprehensive Income (Loss)
   
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 302 shares of common stock
    16       -       -       -       -       16  
  Forfeiture of 393 shares of common stock
    (18 )     -       -       -       -       (18 )
  Share-based compensation
    8       -       -       -       -       8  
  Income tax benefit related to share-    based compensation
    -       -       -       -       -       -  
  Change related to ESOP shares
    -       -       -       (890 )     -       (890 )
  Net income
    -       12,106       -       -       -       12,106  
  Dividends ($.91 per share)
    -       (4,024 )     -       -       -       (4,024 )
  Purchase of 18,731 shares of common stock
    -       -       -       -       (1,018 )     (1,018 )
  Other comprehensive loss
    -       -       (193 )     -       -       (193 )
Balance, June 30, 2010
  $ 14,588     $ 174,202     $ 4,007     $ (23,790 )   $ (11,245 )   $ 157,762  
                                                 
                                                 
Balance, December 31, 2010
  $ 14,875     $ 185,412     $ 2,781     $ (24,945 )   $ (11,854 )   $ 166,269  
  Issuance of 3,401 shares of common stock
    98       -       -       -       -       98  
  Forfeiture of 518 shares of common stock
    (28 )     -       -       -       -       (28 )
  Share-based compensation
    8       -       -       -       -       8  
  Income tax benefit related to share-
    based compensation
    44       -       -       -       -       44  
  Change related to ESOP shares
    -       -       -       (1,344 )     -       (1,344 )
  Net income
    -       14,131       -       -       -       14,131  
  Dividends ($1.00 per share)
    -       (4,399 )     -       -       -       (4,399 )
  Purchase of 42,828 shares of common stock
    -       -       -       -       (2,649 )     (2,649 )
  Other comprehensive income
    -       -       1,249       -       -       1,249  
Balance, June 30, 2011
  $ 14,997     $ 195,144     $ 4,030     $ (26,289 )   $ (14,503 )   $ 173,379  
                                                 
See Notes to Consolidated Financial Statements.
                                         


 
Page 6

 
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Amounts In Thousands)
 
             
   
Six Months Ended June 30,
 
   
2011
   
2010
 
Cash Flows from Operating Activities
           
  Net income
  $ 14,131     $ 12,106  
  Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
         
    Depreciation
    1,241       1,351  
    Provision for loan losses
    1,199       2,918  
    Share-based compensation
    8       8  
    Forfeiture of common stock
    (28 )     (18 )
    Compensation expensed through issuance of common stock
    19       16  
    Excess tax benefits from share-based compensation
    44       -  
    Provision for deferred income taxes
    (171 )     117  
    Net (gain) loss on sale of other real estate owned and other repossessed assets
    (385 )     183  
    (Increase) decrease in accrued interest receivable
    (546 )     275  
    Amortization of discount on investment securities, net
    468       432  
    Decrease in prepaid FDIC insurance
    707       943  
    (Increase) decrease in other assets
    (768 )     212  
    Increase in accrued interest payable and other liabilities
    4,129       4,423  
    Loans originated for sale
    (48,152 )     (80,489 )
    Proceeds on sales of loans
    51,004       79,623  
    Net gain on sales of loans
    (653 )     (1,041 )
       Net cash and cash equivalents provided by operating activities
  $ 22,247     $ 21,059  
                 
Cash Flows from Investing Activities
               
  Proceeds from maturities of investment securities available for sale
  $ 26,092     $ 28,344  
  Purchases of investment securities available for sale
    (33,773 )     (26,961 )
  Loans made to customers, net of collections
    (44,161 )     (14,158 )
  Proceeds on sale of other real estate owned and other repossessed assets
    1,958       1,354  
  Purchases of property and equipment
    (1,314 )     (698 )
  Investment in tax credit real estate, net
    644       (2,813 )
       Net cash used in investing activities
  $ (50,554 )   $ (14,932 )
                 
Cash Flows from Financing Activities
               
  Net increase in deposits
  $ 2,169     $ 54,675  
  Net increase (decrease) in short-term borrowings
    5,095       (24,322 )
  Stock options exercised
    79       -  
  Excess tax benefits related to share-based compensation
    44       -  
  Borrowings from FHLB
    -       10,000  
  Payments on FHLB borrowings
    (10,000 )     (40,000 )
  Purchase of treasury stock
    (2,649 )     (1,018 )
  Dividends paid
    (4,399 )     (4,024 )
       Net cash used in financing activities
  $ (9,661 )   $ (4,689 )
                 
(Continued)
               

 
Page 7

 
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Continued) (Amounts In Thousands)
 
             
   
Six Months Ended June 30,
 
   
2011
   
2010
 
             
(Decrease) increase in cash and cash equivalents
  $ (37,968 )   $ 1,438  
                 
Cash and cash equivalents:
               
  Beginning of year
    62,978       24,095  
  End of period
  $ 25,010     $ 25,533  
                 
Supplemental Disclosures
               
  Cash payments for:
               
    Interest paid to depositors
  $ 8,627     $ 10,264  
    Interest paid on other obligations
    4,167       4,331  
    Income taxes paid
    4,843       2,874  
                 
  Noncash financing activities:
               
    Increase in maximum cash obligation related to ESOP shares
  $ 1,344     $ 890  
    Transfers to other real estate owned
    1,624       2,139  
                 
See Notes to Consolidated Financial Statements.
               


 
Page 8

 
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

                
 
Note 1.  Basis of Presentation
 
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with instructions for Form 10-Q and Regulation S-X.  These financial statements include all adjustments (consisting of normal recurring accruals) which in the opinion of management are considered necessary for the fair presentation of the financial position and results of operations for the periods shown.  Certain prior year amounts may be reclassified to conform to the current year presentation.  The Company considers that it operates as one business segment, a commercial bank.

Operating results for the six month period ended June 30, 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 June 30,
   
Six months ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Common shares outstanding at the beginning of the period
    4,395,911       4,416,683       4,398,337       4,422,274  
Weighted average number of net shares redeemed
    (16,013 )     (3,200 )     (9,629 )     (5,828 )
    Weighted average shares outstanding (basic)
    4,379,898       4,413,483       4,388,708       4,416,446  
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method
    11,180       13,143       10,638       13,236  
    Weighted average number of shares
    4,391,078       4,426,626       4,399,346       4,429,682  
Net income (In Thousands)
  $ 7,953     $ 6,721     $ 14,131     $ 12,106  
                                 
Earnings per share:
                               
Basic
  $ 1.82     $ 1.52     $ 3.22     $ 2.74  
Diluted
  $ 1.81     $ 1.52     $ 3.21     $ 2.73  

 
Page 9


HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 3.  Recent Accounting Pronouncements and Recent Lesgislative 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 Company is currently evaluating the impact the recently issued guidance will have to the consolidated financial statements.

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 IFRSs.  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.

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.
 
 
 
 
Page 10

 
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
 
Note 4.   Loans

The composition of loans is as follows:
   
June 30, 2011
   
December 31, 2010
 
   
(Amounts In Thousands)
 
             
Agricultural
  $ 60,903     $ 65,004  
Commercial and financial
    143,381       141,619  
Real estate:
               
  Construction, 1 to 4 family residential
    23,645       25,232  
  Construction, land development and commercial
    84,077       86,552  
  Mortgage, farmland
    94,085       90,448  
  Mortgage, 1 to 4 family first liens
    550,427       519,533  
  Mortgage, 1 to 4 family junior liens
    105,469       109,036  
  Mortgage, multi-family
    210,674       202,630  
  Mortgage, commercial
    308,262       302,020  
Loans to individuals
    20,122       23,627  
Tax exempt
    30,983       24,959  
    $ 1,632,028     $ 1,590,660  
Less allowance for loan losses
    29,260       29,230  
    $ 1,602,768     $ 1,561,430  

Changes in the allowance for loan losses and the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the six months ended June 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
  $ 1,759     $ 6,772     $ 4,408     $ 1,469     $ 8,840     $ 5,743     $ 829     $ 29,820  
     Charge-offs
    -       (367 )     (13 )     -       (619 )     (9 )     (87 )     (1,095 )
     Recoveries
    1       204       5       -       358       169       64       801  
     Provision
    (357 )     25       (189 )     (40 )     303       (26 )     18       (266 )
                                                                 
Ending balance
  $ 1,403     $ 6,634     $ 4,211     $ 1,429     $ 8,882     $ 5,877     $ 824     $ 29,260  
                                                                 
Ending balance, individually evaluated for impairment
  $ -     $ 26     $ -     $ 2     $ 69     $ 90     $ -     $ 187  
                                                                 
Ending balance, collectively evaluated for impairment
  $ 1,403     $ 6,608     $ 4,211     $ 1,427     $ 8,813     $ 5,787     $ 824     $ 29,073  
                                                                 
Loans:
                                                               
                                                                 
Ending balance
  $ 60,903     $ 143,381     $ 107,722     $ 94,085     $ 655,896     $ 518,936     $ 51,105     $ 1,632,028  
                                                                 
Ending balance, individually evaluated for impairment
    -       2,066       1,738       227       4,094       17,616       6       25,747  
                                                                 
Ending balance, collectively evaluated for impairment
    60,903       141,315       105,984       93,858       651,802       501,320       51,099       1,606,281  

 
Page 11

 
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 June 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
  $ 1,759     $ 6,772     $ 4,408     $ 1,469     $ 8,840     $ 5,743     $ 829     $ 29,820  
     Charge-offs
    -       (367 )     (13 )     -       (619 )     (9 )     (87 )     (1,095 )
     Recoveries
    1       204       5       -       358       169       64       801  
     Provision
    (357 )     25       (189 )     (40 )     303       (26 )     18       (266 )
                                                                 
Ending balance
  $ 1,403     $ 6,634     $ 4,211     $ 1,429     $ 8,882     $ 5,877     $ 824     $ 29,260  
 
Changes in the allowance for loan losses for the three and six months ended June 30, 2010 (amounts in thousands) are as follows:
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2010
   
2010
 
             
Balance, beginning
  $ 29,840     $ 29,160  
Charge-offs:
               
  Agricultural
    -       8  
  Commercial and financial
    937       1,821  
  Real estate:
               
    Construction and land development
    576       732  
    Mortgage, farmland
    26       39  
    Mortgage, 1 to 4 family
    1,028       1,446  
    Mortgage, multi-family and commercial
    348       536  
  Other
    126       207  
      3,041       4,789  
                 
Recoveries:
               
  Agricultural
    3       5  
  Commercial and financial
    288       439  
  Real estate:
               
    Construction and land development
    1       2  
    Mortgage, farmland
    -       -  
    Mortgage, 1 to 4 family
    289       373  
    Mortgage, multi-family and commercial
    48       79  
  Other
    69       163  
      698       1,061  
  Net charge-offs
    2,343       3,728  
  Provision charged to expense
    853       2,918  
  Balance, ending
  $ 28,350     $ 28,350  

 
 
 
Page 12

 
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 June 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
 
June 30, 2011
                       
Grade:
                       
     Pass
  $ 50,059     $ 114,002     $ 20,803     $ 61,309  
     Potential Watch
    1,166       4,523       -       6,549  
     Watch
    6,904       14,333       2,344       5,159  
     Substandard
    2,774       10,523       498       11,060  
Total
  $ 60,903     $ 143,381     $ 23,645     $ 84,077  
                                 
       
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
 
June 30, 2011
                               
Grade:
                               
     Pass
  $ 84,428     $ 485,193     $ 93,552     $ 169,930  
     Potential Watch
    1,425       17,632       3,461       11,504  
     Watch
    3,307       23,870       4,341       13,875  
     Substandard
    4,925       23,732       4,115       15,365  
Total
  $ 94,085     $ 550,427     $ 105,469     $ 210,674  
                                 
       
Real Estate: 
Mortgage,
commercial
   
Loans to
individuals
   
Tax exempt
   
Total
 
June 30, 2011
                               
Grade:
                               
     Pass
  $ 258,071     $ 19,279     $ 30,916     $ 1,387,542  
     Potential Watch
    9,734       289       -       56,283  
     Watch
    33,888       264       67       108,352  
     Substandard
    6,569       290       -       79,851  
Total
  $ 308,262     $ 20,122     $ 30,983     $ 1,632,028  
                                 

 
Page 13


HILLS BANCORPORATION
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.

 
Page 14


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 June 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)
 
                                           
June 30, 2011
                                         
Agriculture
  $ 132     $ 84     $ -     $ 216     $ 60,687     $ 60,903     $ -  
Commercial and financial
    1,017       212       491       1,720       141,661       143,381       128  
Real estate:
                                                       
  Construction, 1 to 4 family residential
    -       -       -       -       23,645       23,645       -  
  Construction, land development
  and commercial
    901       195       990       2,086       81,991       84,077       -  
  Mortgage, farmland
    175       -       83       258       93,827       94,085       83  
  Mortgage, 1 to 4 family first liens
    802       1,104       3,090       4,996       545,431       550,427       2,256  
  Mortgage, 1 to 4 family junior liens
    348       168       398       914       104,555       105,469       398  
  Mortgage, multi-family
    318       -       53       371       210,303       210,674       53  
  Mortgage, commercial
    244       22       331       597       307,665       308,262       251  
Loans to individuals
    72       7       6       85       20,037       20,122       6  
Tax exempt
    -       -       -       -       30,983       30,983       -  
    $ 4,009     $ 1,792     $ 5,442     $ 11,243     $ 1,620,785     $ 1,632,028     $ 3,175  
                                                         
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.
 
 
Page 15

 
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 June 30, 2011 and December 31, 2010:
 
   
June 30, 2011
   
December 31, 2010
 
   
(Amounts In Thousands)
 
             
Non-accrual loans
  $ 7,535     $ 8,246  
Accruing loans past due 90 days or more
    3,175       5,345  
Restructured loans (1)
    15,037       17,957  
Total impaired loans
    25,747       31,548  
Other real estate
    2,284       2,233  
Non-performing assets (includes impaired loans and other real estate)
    28,031       33,781  
Loans held for investment
    1,632,028       1,590,660  
Ratio of allowance for loan losses to loans held for investment
    1.79 %     1.84 %
Ratio of allowance for loan losses to impaired loans
    113.64       92.65  
Ratio of impaired loans to total loans held for investment
    1.58       1.98  
Ratio of non-performing assets to total assets
    1.44       1.75  
 
(1)  
Total restructured loans were $18.7 million and $22.4 million as of June 30, 2011 and December 31, 2010, respectively.  Included in the total restructured loans were $3.7 million and $4.4 million of non-accrual loans as of June 30, 2011 and December 31, 2010.

Certain impaired loan information by loan type at June 30, 2011 and December 31, 2010, was as follows:
 
   
June 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
    1,847       128       90       2,647       1,045       -  
Real estate:
                                               
  Construction, 1 to 4 family residential
    -       -       -       -       271       -  
  Construction, land development and commercial
    1,738       -       -       1,546       145       2,118  
  Mortgage, farmland
    144       83       -       147       -       -  
  Mortgage, 1 to 4 family first liens
    1,367       2,256       74       1,783       3,053       779  
  Mortgage, 1 to 4 family junior liens
    -       398       -       26       483       963  
  Mortgage, multi-family
    1,887       53       5,918       1,837       -       2,938  
  Mortgage, commercial
    552       251       8,955       260       229       11,159  
Loans to individuals
    -       6       -       -       15       -  
    $ 7,535     $ 3,175     $ 15,037     $ 8,246     $ 5,345     $ 17,957  
                                                 

Loans 90 days or more past due that are still accruing interest decreased $2.2 million from December 31, 2010 to June 30, 2011 due to an overall reduction in delinquency trends during the first six months of 2011. The average past due loan balance was $81,000 as of June 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 Bank expects to collect all principal and interest as contractually due under these loans.
 
 
Page 16

 
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 4.  
Loans (continued)

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

   
June 30, 2011
   
Three Months Ended June 30, 2011
   
Six Months Ended June 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
    1,937       3,394       -       2,367       1       2,387       2  
Real estate:
                                                       
  Construction, 1 to 4 family
  residential
    -       -       -       -       -       -       -  
  Construction, land development
  and commercial
    1,738       2,241       -       1,780       -       1,795       -  
  Mortgage, farmland
    144       161       -       144       -       145       -  
  Mortgage, 1 to 4 family first liens
    1,441       1,774       -       1,482       2       1,503       4  
  Mortgage, 1 to 4 family junior liens
    -       223       -       -       -       -       -  
  Mortgage, multi-family
    1,887       2,191       -       1,862       -       1,862       -  
  Mortgage, commercial
    552       2,494       -       565       4       568       8  
Loans to individuals
    -       -       -       4       -       -       -  
    $ 7,699     $ 12,478     $ -     $ 8,204     $ 7     $ 8,260     $ 14  
With an allowance recorded:
                                                       
Agriculture
  $ -     $ -             $ -     $ -                  
Commercial and financial
    128       191       26       128       2       130       4  
Real estate:
                                                       
  Construction, 1 to 4 family
  residential
    -       -       -       -       -       -       -  
  Construction, land development
  and commercial
    -       -       -       -       -       -       -  
  Mortgage, farmland
    83       83       2       83       1       83       2  
  Mortgage, 1 to 4 family first liens
    2,256       2,608       56       2,351       30       2,359       59  
  Mortgage, 1 to 4 family junior liens
    398       597       13       398       6       398       13  
  Mortgage, multi-family
    5,971       5,971       69       5,542       73       5,553       145  
  Mortgage, commercial
    9,206       9,206       21       9,229       137       9,251       272  
Loans to individuals
    6       6       -       6       -       6       -  
    $ 18,048     $ 18,662     $ 187     $ 17,737     $ 249     $ 17,780     $ 495  
Total:
                                                       
Agriculture
  $ -     $ -     $ -     $ -     $ -     $ -     $ -  
Commercial and financial
    2,065       3,585       26       2,495       3       2,517       6  
Real estate:
                                                       
  Construction, 1 to 4 family
  residential
    -       -       -       -       -       -       -  
  Construction, land development
  and commercial
    1,738       2,241       -       1,780       -       1,795       -  
  Mortgage, farmland
    227       244       2       227       1       228       2  
  Mortgage, 1 to 4 family first liens
    3,697       4,382       56       3,833       32       3,862       63  
  Mortgage, 1 to 4 family junior liens
    398       820       13       398       6       398       13  
  Mortgage, multi-family
    7,858       8,162       69       7,404       73       7,415       145  
  Mortgage, commercial
    9,758       11,700       21       9,794       141       9,819       280  
Loans to individuals
    6       6       -       10       -       6       -  
    $ 25,747     $ 31,140     $ 187     $ 25,941     $ 256     $ 26,040     $ 509  
                                                         
 
 
Page 17

 
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  
 
 
Page 18

 
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 4.  
Loans (continued)

Impaired loans decreased $5.8 million from December 31, 2010 to June 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 1.58% of loans held for investment as of June 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.  In addition, accruing loans past due 90 days or more decreased $2.2 million from December 31, 2010 to June 30, 2011 due to an overall reduction in delinquency trends during the first six 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.  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.

 
 
Page 19


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 June 30, 2011 and December 31, 2010 are as follows:


   
June 30, 2011
         
December 31, 2010
       
   
Carrying Amount
   
Estimated Fair Value
   
Carrying Amount
   
Estimated Fair Value
 
   
(Amounts In Thousands)
 
                         
Cash and cash equivalents
  $ 25,010     $ 25,010     $ 62,978     $ 62,978  
Investment securities
    225,839       225,839       216,603       216,603  
Loans
    1,610,959       1,629,176       1,571,820       1,578,072  
Accrued interest receivable
    9,232       9,232       8,686       8,686  
Deposits
    1,482,910       1,487,882       1,480,741       1,483,116  
Short-term borrowings
    52,023       52,023       46,928       46,928  
Federal Home Loan Bank borrowings
    185,000       200,377       195,000       210,093  
Accrued interest payable
    1,823       1,823       1,996       1,996  
                                 
   
Face Amount
           
Face Amount
         
Off-balance sheet instruments:
                               
  Loan commitments
  $ 289,332     $ -     $ 281,864     $ -  
  Letters of credit
    11,819       -       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.

 
 
Page 20

 
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.
 
 
Page 21

 
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.  Assets and liabilities measured at fair value on a nonrecurring basis are not material to the Company’s consolidated financial statements.

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 six months ended June 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:

   
June 30, 2011
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
   
(Amounts In Thousands)
 
Investment securities available for sale
  $ 101,095     $ 113,987     $ -     $ 215,082  
Total
  $ 101,095     $ 113,987     $ -     $ 215,082  
                                 
                                 
   
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  
 
 
Page 22

 
HILLS BANCORPORATION
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 six months ended June 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.  For assets measured at fair value on a nonrecurring basis in 2011 that were still held on the balance sheet at June 30, 2011, the following table provides the level of valuation assumptions used to determine the adjustment and the carrying value of the related individual assets at quarter end.
 
   
June 30, 2011
                   
   
Level 1
 
Level 2
 
Level 3
 
Total
   
Three Months Ended March 31, 2011 Total Losses
   
Three Months Ended June 30, 2011 Total Losses
   
Six Months Ended June 30, 2011 Total Losses
 
   
(Amounts In Thousands)
 
Loans (1)
  $ -     $ 12,039     $ -     $ 12,039     $ 382     $ 395     $ 777  
Foreclosed assets (2)
    -       235       -       235       97       27       124  
Total
  $ -     $ 12,274     $ -     $ 12,274     $ 479     $ 422     $ 901  
                                                         
 
(1)
Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully-charged off is zero.
(2)
Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

As of June 30, 2011, the $12.0 million of loans recorded at fair value on a nonrecurring basis consisted of the following loan types:  $5.9 million of 1 – 4 family residential loans, $3.1 million of commercial and industrial loans, and $1.2 million of commercial mortgage loans.  The remaining $1.8 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 $12.0 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 $12.0 million, $3.8 million was included in the nonaccrual loan total.  The remaining $8.2 million is accruing interest based on the fact loan payments have been made as contractually agreed.
 

 
Page 23


HILLS BANCORPORATION
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 269,010 shares of its common stock in privately negotiated transactions from August 1, 2005 through June 30, 2011.  Of these 269,010 shares, 39,482 shares were purchased during the quarter ended June 30, 2011, at an average price per share of $61.99.

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 June 30, 2011 and December 31, 2010 is as follows:
 
   
June 30, 2011
   
December 31, 2010
 
   
(Amounts In Thousands)
 
Firm loan commitments and unused portion of lines of credit:
       
  Home equity loans
  $ 35,655     $ 35,932  
  Credit cards
    42,392       42,369  
  Commercial, real estate and home construction
    65,610       65,035  
  Commercial lines and real estate purchase loans
    145,675       138,528  
Outstanding letters of credit
    11,819       11,936  
 
Note 8.  
Income Taxes

Federal income tax expense for the six months ended June 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 June 30, 2011 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of June 30, 2011, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending June 30, 2012.

Income taxes as a percentage of income before taxes were 29.47% in 2011 and 29.10% 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.

 
Page 24

 
HILLS BANCORPORATION

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.

 
 
Page 25

 
HILLS BANCORPORATION

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 June 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.
 
 
Page 26

 
HILLS BANCORPORATION

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

Overview

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

The Company is a holding company engaged in the business of commercial banking.  The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned.  The Bank was formed in Hills, Iowa in 1904.  The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa.  At June 30, 2011, the Bank has fourteen full-service locations and a trust and wealth management location.

Net income for the six month period ended June 30, 2011 was $14.13 million compared to $12.11 million for the same six months of 2010, an increase of 16.73%.  The $2,025,000 increase in net income was caused by a number of factors.  The principal factors in the increase in net income for the first six months of 2011 are an increase in net interest income of $680,000 and a decrease in the provision for loan losses of $1,719,000.  In addition, other income decreased $893,000 for the first six months of 2011 and other expenses decreased $1,454,000 during the 2011 period.

The Company achieved a return on average assets of 1.32% and a return on average equity of 13.20% for the twelve months ended June 30, 2011, compared to the twelve months ended June 30, 2010 which were 1.16% and 12.14%, 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 3.82% in 2011 compared to 3.97% in 2010.  Average earning assets were $1.848 billion in 2011 and $1.733 billion in 2010.

Highlights noted on the balance sheet as of June 30, 2011 for the Company included the following:
 
Ÿ  
Total assets were $1.941 billion, an increase of $9.85 million since December 31, 2010.
Ÿ  
Net loans were $1.611 billion, an increase of $39.14 million since December 31, 2010.
Ÿ  
Deposit growth of $2.17 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.
 
 
 
Page 27

 
HILLS BANCORPORATION

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 June 30, 2011 and December 31, 2010:

   
June 30, 2011
   
December 31, 2010
 
   
Amount
   
Percent
   
Amount
   
Percent
 
   
(Amounts In Thousands)
   
(Amounts In Thousands)
 
Agricultural
  $ 60,903       3.73 %   $ 65,004       4.09 %
Commercial and financial
    143,381       8.79       141,619       8.90  
Real estate:
                               
  Construction, 1 to 4 family residential
    23,645       1.45       25,232       1.59  
  Construction, land development and commercial
    84,077       5.15       86,552       5.44  
  Mortgage, farmland
    94,085       5.76       90,448       5.69  
  Mortgage, 1 to 4 family first liens
    550,427       33.73       519,533       32.66  
  Mortgage, 1 to 4 family junior liens
    105,469       6.46       109,036       6.85  
  Mortgage, multi-family
    210,674       12.91       202,630       12.74  
  Mortgage, commercial
    308,262       18.89       302,020       18.99  
Loans to individuals
    20,122       1.23       23,627       1.48  
Obligations of state and political subdivisions
    30,983       1.90       24,959       1.57  
    $ 1,632,028       100.00 %   $ 1,590,660       100.00 %
Less allowance for loan losses
    29,260               29,230          
    $ 1,602,768             $ 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.

 
Page 28


HILLS BANCORPORATION

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

The Bank may modify the terms of a loan to maximize the collection of amounts due. 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 concessionary modification is granted to the borrower that would otherwise not be considered. Restructured 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.  The Bank restructured loans with an aggregate principal amount totaling $0.3 million and $9.3 million during the six months ended June 30, 2011 and the year ended December 31, 2010, respectively.  All of the loans are considered to be troubled debt restructurings as defined under FASB ASC 310-40.  The $0.3 million restructured during the six months ended June 30, 2011 related to one customer relationship consisting of three loans.  Of the $9.3 million restructured in 2010, $8.8 million related to one customer relationship and consisted of five loans.  The $8.8 million of loans were re-written into two notes using the “Policy Statement on Prudent Commercial Real Estate Loan Workouts” issued by the joint interagency regulators, including the Bank’s main regulator, the FDIC, in October 2009.  The first note was equal to 80% of the updated 2009 appraised value for the property with a maturity date of five years.  The interest rate for the first note is 5.95% and is considered a market interest rate by the Company.  The second note was for the remaining loan balance with a five year maturity and a below market interest rate of 4.0%.  At the time of the restructure, the second note was fully charged off which did not impact the allowance requirement as the Company had already factored this information into the December 31, 2009 allowance for loan loss calculation.  The restructure was completed as it allowed the debt that is recorded on the books to be supported by an updated appraisal.

There were no commitments to lend additional borrowings to restructured loan customers as of June 30, 2011.  The Bank 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 and which increased their overall cash flow.  The additional borrowings were not used to facilitate payments on these loans.

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

   
June 30, 2011
   
December 31, 2010
 
   
Number of
   
Recorded
   
Commitments
   
Number of
   
Recorded
   
Commitments
 
   
contracts
   
investment
   
outstanding
   
contracts
   
investment
   
outstanding
 
    (Amounts In Thousands)     (Amounts In Thousands)  
                                     
Agriculture
    -     $ -     $ -       -     $ -     $ -  
Commercial and financial
    3       1,535       -       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
    1       74       -       3       779       -  
  Mortgage, 1 to 4 family junior liens
    -       -       -       2       963       -  
  Mortgage, multi-family
    4       7,704       -       3       4,775       -  
  Mortgage, commercial
    5       9,426       -       4       11,419       -  
  Loans to individuals
    -       -       -       -       -       -  
      13     $ 18,739     $ -       18     $ 22,355     $ 3,269  
                                                 

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

 
 
Page 29

 
HILLS BANCORPORATION

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

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.

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 June 30, 2011 and December 31, 2010:
 

   
June 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
  $ 1,403       4.80 %     3.73 %   $ 2,170       7.42 %     4.09 %
Commercial and financial
    6,634       22.67       8.79       6,742       23.07       8.90  
Real estate:
                                               
  Construction, 1 to 4 family residential
    590       2.02       1.45       752       2.57       1.59  
  Construction, land development and commercial
    3,621       12.37       5.15       3,642       12.46       5.44  
  Mortgage, farmland
    1,429       4.89       5.76       1,482       5.07       5.69  
  Mortgage, 1 to 4 family first liens
    6,804       23.25       33.73       5,782       19.78       32.66  
  Mortgage, 1 to 4 family junior liens
    2,078       7.10       6.46       2,170       7.42       6.85  
  Mortgage, multi-family
    1,829       6.25       12.91       1,486       5.09       12.74  
  Mortgage, commercial
    4,048       13.84       18.89       4,171       14.27       18.99  
  Loans to individuals
    379       1.29       1.23       525       1.80       1.48  
Obligations of state and political subdivisions
    445       1.52       1.90       308       1.05       1.57  
    $ 29,260       100.00 %     100.00 %   $ 29,230       100.00 %     100.00 %

The allowance for loan losses totaled $29,260,000 at June 30, 2011 compared to $29,230,000 at December 31, 2010.  The percentage of the allowance to outstanding loans was 1.79% and 1.84% at June 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.
 
 
Page 30

 
HILLS BANCORPORATION

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

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.

Management has determined that the allowance for loan losses was appropriate at June 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.

 
 
Page 31

 
HILLS BANCORPORATION

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

Investment securities available for sale held by the Company increased by $9.6 million from December 31, 2010 to June 30, 2011.  The fair value of securities available for sale was $6.5 million more than the amortized cost of such securities as of June 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 June 30, 2011 and December 31, 2010 are summarized in the following table (dollars in thousands):

   
June 30, 2011
   
December 31, 2010
 
   
Amount
   
Percent
   
Amount
   
Percent
 
Securities available for sale
                       
Obligations of state and political subdivisions
  $ 113,987       53.00 %   $ 107,662       52.39 %
Other securities (FHLB, FHLMC and FNMA)
    101,095       47.00       97,836       47.61  
                                 
Total securities available for sale
  $ 215,082       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 June 30, 2011 or December 31, 2010. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of June 30, 2011 and December 31, 2010 (in thousands):
 
   
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized (Losses)
   
Estimated Fair Value
 
June 30, 2011:
                       
  State and political subdivisions
  $ 109,549     $ 4,570     $ (132 )   $ 113,987  
  Other securities (FHLB, FHLMC and FNMA)
    99,007       2,099       (11 )     101,095  
    Total
  $ 208,556     $ 6,669     $ (143 )   $ 215,082  
                                 
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  

 
Page 32

 
HILLS BANCORPORATION

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

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at June 30, 2011, were as follows (in thousands):
 


   
Amortized Cost
   
Fair Value
 
             
Due in one year or less
  $ 43,447     $ 44,155  
Due after one year through five years
    110,607       114,416  
Due after five years through ten years
    53,945       55,932  
Due over ten years
    557       579  
    Total
  $ 208,556     $ 215,082  

The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2011 and December 31, 2010 (in thousands):
 
   
Less than 12 months
   
12 months or more
   
Total
 
June 30, 2011
             
 
                                     
Description of Securities
    #    
Fair Value
   
Unrealized Loss
   
%
      #    
Fair Value
   
Unrealized Loss
   
%
      #    
Fair Value
   
Unrealized Loss
   
%
 
State and political subdivisions
    19     $ 4,621     $ (53 )     1.15 %     4     $ 996     $ (79 )     7.93 %     23     $ 5,617     $ (132 )     2.35 %
Other securities (FHLB, FHLMC and FNMA)
    1       4,480       (11 )     0.25 %     -       -       -       -       1       4,480       (11 )     0.25 %
Total temporarily impaired securities
    20     $ 9,101     $ (64 )     0.70 %     4     $ 996     $ (79 )     7.93 %     24     $ 10,097     $ (143 )     1.42 %
                                                                                                 
                                                                                                 
   
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 June 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 $443,000 while their amortized cost is $504,000, representing an unrealized loss of $61,000.  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 has the intent and ability to hold the securities until a recovery of fair value or maturity.

 
 
Page 33

 
HILLS BANCORPORATION

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

Deposit growth was $2.2 million in the first six months of 2011.  Repurchase agreements decreased $7.3 million and federal funds borrowed increased $12.4 million in the same period.  Federal Home Loan Bank borrowings decreased $10.0 million in the first six 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 $35.4 million as of June 30, 2011 with an average rate of 0.75%.  Brokered deposits were $28.8 million as of December 31, 2010 with an average rate of 0.81%.  As of June 30, 2011 and December 31, 2010, brokered deposits were 2.39% 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 June 30, 2011 totaled $173.4 million. Under risk-based capital rules, the total amount of Tier 1 risk-based capital was 13.05% and 12.33% as of June 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 14.31% and 13.59% as of June 30, 2011 and December 31, 2010, respectively. As of June 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 has not yet been declared effective by the Securities and Exchange Commission.
 
Discussion of operations for the six months ended June 30, 2011 and 2010

Net Income Overview

Net income increased $2,025,000 for the six months ended June 30, 2011 compared to the first six months of 2010.  Total net income was $14,131,000 in 2011 and $12,106,000 in the comparable period in 2010, an increase of 16.73%.  The changes in net income in 2011 from the first six months of 2010 were primarily the result of the following:
 
Ÿ  
Net Interest income increased by $680,000.
Ÿ  
The provision for loan losses decreased by $1,719,000.
Ÿ  
Other income decreased by $893,000.
Ÿ  
Other expenses decreased by $1,454,000.
Ÿ  
Income taxes increased $935,000.

For the six-month periods ended June 30, 2011 and 2010, basic earnings per share were $3.22 and $2.74, respectively. Diluted earnings per share were $3.21 for the six months ended June 30, 2011 compared to $2.73 for the same period in 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 $33.8 million for the first six months of 2011 was derived from the Company’s $1.848 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.82%.  Average earning assets in the six months ended June 30, 2010 were $1.733 billion and the tax-equivalent net interest margin was 3.97%. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of 10 basis points to 3.72% would have resulted approximately in a $916,000 decrease in income before income taxes in the six month period ended June 30, 2011. Similarly, an increase in the net interest margin of 10 basis points to 3.92% would have resulted in approximately a $916,000 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.

 
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HILLS BANCORPORATION

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

Discussion of operations for the six months ended June 30, 2011 and 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 $1.611 billion at June 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 $1,199,000 in 2011 compared to $2,918,000 in 2010.

The third significant factor affecting the Company’s net income is income tax expense.  Federal and state income tax expenses were $5,904,000 and $4,969,000 for the six months ended June 30, 2011 and 2010, respectively.  Income taxes as a percentage of income before taxes were 29.47% in 2011 and 29.10% in 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 six months of 2011 was 3.82% compared to 3.97% 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 six 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
  $ 74,254       (0.37 ) %   $ 2,120     $ (2,818 )   $ (698 )
  Taxable securities
    783       (0.46 )     15       (250 )     (235 )
  Nontaxable securities
    11,490       (0.33 )     298       (186 )     112  
  Federal funds sold
    29,045       -       37       -       37  
    $ 115,572             $ 2,470     $ (3,254 )   $ (784 )
                                         
Interest expense:
                                       
  Interest-bearing demand deposits
  $ 48,710       (0.18 ) %   $ (116 )   $ 249     $ 133  
  Savings deposits
    27,926       (0.26 )     (82 )     501       419  
  Time deposits
    8,256       (0.34 )     (109 )     1,083       974  
  Short-term borrowings
    (826 )     (0.25 )     (36 )     103       67  
  FHLB borrowings
    (5,215 )     0.02       109       (12 )     97  
    $ 78,851             $ (234 )   $ 1,924     $ 1,690  
Change in net interest income
                  $ 2,236     $ (1,330 )   $ 906  

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.


 
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HILLS BANCORPORATION

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

Discussion of operations for the six months ended June 30, 2011 and 2010

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 %     5.63 %
Rate on average interest-bearing liabilities
    1.63       1.95  
Net interest spread
    3.56 %     3.68 %
Effect of noninterest-bearing funds
    0.26       0.29  
Net interest margin (tax equivalent interest income divided by average interest-earning assets)
    3.82 %     3.97 %


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 four times during the first six 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 June 30, 2011, the average rate indexes for the one, three and five year indexes were 0.19%, 0.81% and 1.76%, respectively.  The one year index decreased 40.63% from 0.32% at June 30, 2010, the three year index decreased 19.00% and the five year index decreased 1.68%.  The three year index was 1.00% and the five year index was 1.79% at June 30, 2010.  The targeted federal funds rate was 0.25% at June 30, 2011 and 2010.

Provision for Loan Losses

The provision for loan losses was $1,199,000 in 2011 compared to $2,918,000 in 2010, a decrease of $1,719,000.  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 $30,000 during the first six months of 2011.  In the first six months of 2011, there was an increase of $684,000 due to the volume and composition of loans outstanding.  There was an offsetting $654,000 decrease in the amount allocated to the allowance due to a combination of improvement in credit quality and losses recognized.

The allowance for loan losses balance is also affected by charge-offs, net of recoveries, for the periods presented.  For the six months ended June 30, 2011 and 2010, recoveries were $1,427,000 and $1,061,000, respectively; and charge-offs were $2,596,000 in 2011 and $4,789,000 in 2010.  The allowance for loan losses totaled $29,260,000 at June 30, 2011 compared to $29,230,000 at December 31, 2010.  The allowance represented 1.79% and 1.84% of loans held for investment at June 30, 2011 and December 31, 2010, respectively.

Net Gain on Sale of Loans

Loans originated for sale in the first six months of 2011 totaled $48.2 million compared to $80.5 million in the same period in 2010, a decrease of 40.12%.  In the six months ended June 30, 2011 and 2010, the net gain on sale of loans was $653,000 and $1,041,000, 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.
 
 
 
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HILLS BANCORPORATION

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

Discussion of operations for the six months ended June 30, 2011 and 2010

Other Income

Other income, other than the net gain on sale of loans discussed above, decreased $505,000 for the six months ended June 30, 2011 from the comparable period in 2010.  Trust fees increased $193,000 in the first six months of 2011 as a result of assets under management increasing from $882.2 million as of June 30, 2010 to $1.011 billion as of June 30, 2011 due to market conditions and new trust relationships.  Service charges and fees decreased $291,000 in the first six 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 $250,000 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 $523,000, or 30.38%, due to regulatory changes effective August 15, 2010.
 
 
Other noninterest income was $1,405,000 for the six months ended June 30, 2011, a $219,000 decrease from the same period in 2010.   Other noninterest income for the six months ended June 30, 2010 included insurance proceeds of $425,000 received as a result of a claim filed by the Company in April 2008.  The claim pertained to alleged unauthorized activities by a former employee of the Bank in Bank internal accounts that were discovered during 2007.  The period ended June 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 $21,195,000 decreased $1,454,000 for the six months ended June 30, 2011 from the same period in 2010, a decrease of 6.42%.  Occupancy expenses increased $139,000 for the six months ended June 30, 2011, which included an $89,000 increase in property taxes and $38,000 increase in janitorial expenses.  The increases are related to the office location which opened in 2010. Furniture and equipment expense were $1,782,000 for the six months ended June 30, 2011 which represents a $233,000 decrease from the 2011 period.  The positive variance is due to a decrease of $112,000 in depreciation for furniture, fixtures and equipment and a decrease of $139,000 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.

Outside services expense decreased $212,000 for the six months ended June 30, 2011 compared to June 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 $148,000 due to an increase in the volume of transactions in 2011 compared to 2010.  Other professional fees increased $112,000 due to an increase in third party professional fees in the lending, marketing and financial reporting areas during the first six months of 2011.  Attorney  fees decreased $101,000 as a result of the Company handling additional legal matters in its internal legal department.   Other real estate owned expense decreased $434,000 in the first six months of 2011.  During the first six 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.  The expense for property taxes was less during the 2011 period.

FDIC insurance assessment expense was $786,000 for the six months ended June 30, 2011.  This is a decrease of $259,000 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 June 30, 2011, the Company has prepaid FDIC insurance of $4,331,000, 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.

 
 
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HILLS BANCORPORATION

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

Discussion of operations for the six months ended June 30, 2011 and 2010

The net (gain) loss on sale of other real estate owned and other repossessed assets decreased $568,000 to a net gain of $385,000 for the six months ended June 30, 2011.  The total net gain on sale of other real estate owned for the six months ended June 30, 2011 consisted of a $124,000 fair market value adjustment on 6 properties within other real estate owned, a $516,000 gain on sale of 14 properties and a $7,000 loss on sale of 2 properties, for a net gain of $385,000.  During the same period in 2010, the loss consisted of a $267,000 fair market value adjustment on 8 properties within other real estate owned, a $98,000 gain on sale of 10 properties and a $14,000 loss on sale of 3 properties, for a net loss of $183,000.

Income Taxes

Federal and state income tax expenses were $5,904,000 and $4,969,000 for the six months ended June 30, 2011 and 2010, respectively.  Income taxes as a percentage of income before taxes were 29.47% in 2011 and 29.10% 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 three months ended June 30, 2011 and 2010

Net Income

Net income increased to $7,953,000 for the three months ended June 30, 2011 from $6,721,000 for the same period in 2010, an increase of 18.33%.  Earnings per share, both basic and diluted, increased for the three months ended June 30, 2011 compared to the same period in 2010.  For the three-month period ended June 30, 2011, basic earnings per share was $1.82 and diluted earnings per share was $1.81.  For the three months ended June 30, 2010, basic and diluted earnings per share were $1.52.

Net Interest Income

Net interest income increased for the three month period ended June 30, 2011 by $239,000 from the similar period in 2010.  The net interest margin in 2011 was 3.82% compared to 3.98% in 2010.  Net interest income changes on a tax-equivalent basis for the three months ended June 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
  $ 85,785       (0.41 ) %   $ 1,224     $ (1,575 )   $ (351 )
  Taxable securities
    542       (0.48 )     6       (131 )     (125 )
  Nontaxable securities
    13,209       (0.41 )     171       (113 )     58  
  Federal funds sold
    12,157       -       7       -       7  
    $ 111,693             $ 1,408     $ (1,819 )   $ (411 )
                                         
Interest expense:
                                       
  Interest-bearing demand deposits
  $ 53,431       (0.17 ) %   $ (60 )   $ 130     $ 70  
  Savings deposits
    17,523       (0.27 )     (22 )     267       245  
  Time deposits
    5,570       (0.29 )     (36 )     457       421  
  Short-term borrowings
    7,625       (0.34 )     (21 )     40       19  
  FHLB borrowings
    (10,000 )     0.19       103       (88 )     15  
    $ 74,149             $ (36 )   $ 806     $ 770  
Change in net interest income
                  $ 1,372     $ (1,013 )   $ 359  

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.


 
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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 June 30, 2011 and 2010

A summary of the net interest spread and margin is as follows:
 
(Tax Equivalent Basis)
 
2011
   
2010
 
             
Yield on average interest-earning assets
    5.16 %     5.58 %
Rate on average interest-bearing liabilities
    1.59       1.88  
Net interest spread
    3.57 %     3.70 %
Effect of noninterest-bearing funds
    0.25       0.28  
Net interest margin (tax equivalent interest income divided by average interest-earning assets)
    3.82 %     3.98 %

Provision for Loan Losses

The provision for loan losses was a benefit of $266,000 in 2011 compared to $853,000 in expense in 2010, a decrease of $1,119,000.  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 decreased $560,000 during the second quarter of 2011.  In the second quarter of 2011, there was a decrease of $60,000 due to the volume and composition of loans outstanding.  There was an additional $500,000 decrease in the amount allocated to the allowance due to a combination of improvement in credit quality and losses recognized.

The allowance for loan losses balance is also affected by the charge-offs, net of recoveries, for the periods presented.  For the three months ended June 30, 2011 and 2010, recoveries were $801,000 and $698,000, respectively; and charge-offs were $1,095,000 in 2011 and $3,041,000 in 2010.  The allowance for loan losses totaled $29,260,000 at June 30, 2011 compared to $28,350,000 at June 30, 2010.  The allowance represented 1.79% and 1.84% of loans held for investment at June 30, 2011 and June 30, 2010, respectively.

Other Income

Other income decreased $259,000 to $4,329,000 for the three months ended June 30, 2011 as compared to the same period in 2010.  Net gain on sale of loans decreased by $325,000 in the quarter ended June 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 $64,000 in the second quarter of 2011 as a result of the increase in assets under management as noted in the discussion of the results of the six months ended June 30, 2011.

Service charges and fees decreased $180,000 in the second 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 $120,000 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 $291,000, or 32.28%, due to regulatory changes effective August 15, 2010.

Other noninterest income was $736,000 for the three months ended June 30, 2011, a $191,000 increase from the same period in 2010.  The period ended June 30, 2011 includes state sales and use tax refunds of $128,000 which were not received in the 2010 three month period.
 
 
 
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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 June 30, 2011 and 2010

Other Expenses

Other expenses of $10,270,000 decreased $823,000 for the three months ended June 30, 2011 from the same period in 2010, a decrease of 7.42%.  Occupancy expense increased $69,000 for the three months ended June 30, 2011 which included a $53,000 increase in property taxes and a $19,000 increase in janitorial services.  Furniture and equipment expense decreased $183,000 for the three months ended June 30, 2011.  The positive variance is due to a decrease of $56,000 in depreciation for furniture, fixtures and equipment and a decrease of $117,000 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.

Outside services expense decreased $46,000 for the three months ended June 30, 2011 compared to June 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 $88,000 due to an increase in the volume of transactions in 2011 compared to 2010.  Attorney  fees decreased $91,000 as a result of the Company handling additional legal matters in its internal legal department.   Other real estate owned expense decreased $96,000 in the second quarter of 2011 as compared to the second quarter of 2010.

FDIC insurance assessment expense was $86,000 for the three months ended June 30, 2011.  This is a decrease of $185,000 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 $426,000 to a net gain of $384,000 for the three months ended June 30, 2011.  The total net gain on sale of other real estate owned for the three months ended June 30, 2011 consisted of a $27,000 fair market value adjustment on 2 properties within other real estate owned, a $417,000 gain on sale of 9 properties and a $6,000 loss on sale of 1 property, for a net gain of $384,000.  During the same period in 2010, the loss consisted of a $123,000 fair market value adjustment on 6 properties within other real estate owned, a $117,000 gain on sale of 6 properties and a $36,000 loss on sale of 1 property, for a net loss of $42,000.

Income Taxes

Federal and state income tax expenses were $3,501,000 and $2,811,000 for the three months ended June 30, 2011 and 2010, respectively.  Income taxes as a percentage of income before taxes were 30.57% in 2011 and 29.49% in 2010.

 
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HILLS BANCORPORATION

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 11.08% of the Company’s total assets at June 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 June 30, 2011, the Company had borrowed $185 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. The Company repaid $10,000,000 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 $300 million at June 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 $147 million. Those two lines of credit require the pledging of investment securities when drawn upon.  The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at June 30, 2011.

As of June 30, 2011, investment securities with a carrying value of $52,023,000 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.

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 during the construction of the new office.

 
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HILLS BANCORPORATION

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.

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 six 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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HILLS BANCORPORATION
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 six months ended June 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)
 
April 1 to April 30
    422     $ 61.00       229,950       520,050  
May 1 to May 31
    28,435       61.99       258,385       491,615  
June 1 to June 30
    10,625       62.00       269,010       480,990  
Total
    39,482     $ 61.99       269,010       480,990  

(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.

The Company issued 2,200 shares of unregistered shares of its common stock during the quarter ended June 30, 2011 pursuant to the exercise of options under the 2000 Stock Option and Incentive Plan for an aggregate exercise price of $56,457.  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.  In addition, the Company issued 130 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.
 
 
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 Sections 302 of the Sarbanes-Oxley Act of 2002
32 Certifications under Sections 906 of the Sarbanes-Oxley Act of 2002
 
 
 
Page 44

 
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: July 29, 2011
 
By:  /s/ Dwight O. Seegmiller
   
Dwight O. Seegmiller, Director, President and Chief Executive Officer
     
Date: July 29, 2011
 
By:  /s/ James G. Pratt
   
James G. Pratt, Secretary, Treasurer and Chief Accounting Officer



 
Page 45


HILLS BANCORPORATION
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED JUNE 30, 2011

 
Exhibit Number
 
Description
Page Number In The Sequential
Numbering System June 30, 2011 Form 10-Q
     
3.1
Articles of Incorporation filed as Exhibit 3 of Form 10-K for the year ended December 31, 1993 are incorporated by reference.
     
3.2
By-Laws filed as Exhibit 3 of Form 10-K for the year ended December 31, 1993 are incorporated by reference.
     
31
47 - 48
     
32
                                         49
     
     


 
 
Page 46