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HILLS BANCORPORATION - Annual Report: 2012 (Form 10-K)

form10k.htm


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

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2012.
Commission File Number 0-12668
HILLS BANCORPORATION
(Exact name of Registrant as specified in its charter)
Iowa
 
42-1208067
(State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification No.)

131 Main Street, Hills, Iowa 52235
(Address of principal executive offices)

Registrant's telephone number, including area code:  (319) 679-2291
Securities Registered pursuant to Section 12 (b) of the Act:  None
Securities Registered pursuant to Section 12 (g) of the Act:

No par value common stock
Title of Class

Indicate by check mark if the Registrant is well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o No þ

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No þ

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

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).  Yes þ No ­­o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Registrant S-K (§229.405 of this chapter) is not contained herein, and will not be contained to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):
Large accelerated filer o Accelerated filer þ Non-accelerated filer o Smaller Reporting Company o­­

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

The aggregate market value of the common stock held by non-affiliates of the registrant as of June 30, 2012, based on the most recent sale price of $63.90 per share, and 3,858,824 shares held was $246,578,854.  Common stock held by non-affiliates excludes 887,569 shares held by directors, executive officers, and under the Registrant’s Employee Stock Ownership Plan.

The number of shares outstanding of the Registrant's common stock as of February 28, 2013 is 4,739,833 shares of no par value common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement dated March 15, 2013 for the Annual Meeting of the Shareholders of the Registrant to be held April 15, 2013 (the Proxy Statement) are incorporated by reference in Part III of this Form 10-K.
 


 
 

 
 
HILLS BANCORPORATION
FORM 10-K

TABLE OF CONTENTS
 
   
Page
 
PART I
 
Item 1.
3
 
3
 
6
 
7
 
8
 
9
 
16
Item 1A.
29
Item 1B.
34
Item 2.
35
Item 3.
35
Item 4.
35
     
     
 
PART II
 
Item 5.
36
Item 6.
39
Item 7.
40
Item 7A.
61
Item 8.
64
Item 9.
123
Item 9A.
123
Item 9B.
123
     
     
 
PART III
 
Item 10.
124
Item 11.
124
Item 12.
124
Item 13.
124
Item 14.
124
     
 
PART IV
 
Item 15.
125

 
Page 2


PART I

References in this report to “we,” “us,” “our,” “Bank,” or the “Company” or similar terms refer to Hills Bancorporation and its subsidiary.

Item 1.      Business

GENERAL

Hills Bancorporation (the "Company") is a holding company principally engaged, through its subsidiary bank, in the business of banking.  The Company was incorporated December 12, 1982 and all operations are conducted within the state of Iowa.  The Company became owner of 100% of the outstanding stock of Hills Bank and Trust Company, Hills, Iowa (“Hills Bank and Trust” or the “Bank”) as of January 23, 1984 when stockholders of Hills Bank and Trust exchanged their shares for shares of the Company.  Effective July 1, 1996, the Company formed a new subsidiary, Hills Bank, which acquired for cash all the outstanding shares of a bank in Lisbon, Iowa.  Subsequently an office of Hills Bank was opened in Mount Vernon, Iowa, a community that is contiguous to Lisbon.  Effective November 17, 2000, Hills Bank was merged into Hills Bank and Trust.  On September 20, 1996, another subsidiary, Hills Bank Kalona, acquired cash and other assets and assumed the deposits of the Kalona, Iowa office of Boatmen's Bank Iowa, N.A.  Effective October 26, 2001, Hills Bank Kalona was merged into Hills Bank and Trust.

Through its internet website (www.hillsbank.com), the Company makes available the Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, all amendments to those reports, and other filings with the Securities and Exchange Commission, as soon as reasonably practicable after they are filed or furnished.

The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers.  The Bank is actively engaged in all areas of commercial banking, including acceptance of demand, savings and time deposits; making commercial, real estate, agricultural and consumer loans; maintaining night and safe deposit facilities; and performing collection, exchange and other banking services tailored for individual customers.  The Bank administers estates, personal trusts, and pension plans and provides farm management, investment advisory and custodial services for individuals, corporations and nonprofit organizations.  The Bank makes commercial and agricultural loans, real estate loans, automobile, installment and other consumer loans.  In addition, the Bank earns substantial fees from originating mortgages that are sold in the secondary residential real estate market without mortgage servicing rights being retained.

Lending Activities

Real Estate Loans

Real estate loans totaled $1.434 billion and comprised 83.29% of the Bank’s loan portfolio as of December 31, 2012.  The Bank’s real estate loans include construction loans and mortgage loans.

Mortgage Loans.  The Bank offers residential, commercial and agricultural real estate loans.  As of December 31, 2012, mortgage loans totaled $1.329 billion and comprised 77.20% of the Bank’s loan portfolio.

Residential real estate loans totaled $687.85 million and were 39.96% of the Bank’s loan portfolio as of December 31, 2012.  These loans include first and junior liens on 1 to 4 family residences.  The Bank originates 1 to 4 family mortgage loans to individuals and businesses within its trade area.  The Bank sells certain mortgage loans to third parties on the secondary market.  For the loans sold on the secondary market the Bank does not retain any percentage of ownership or servicing rights.  Interest rates for residential real estate mortgages are determined by competitive pricing factors on the secondary market and within the Bank’s trade area.  Collateral for residential real estate mortgages is generally the underlying property.  Generally, repayment of these loans is from monthly principal and interest payments from the borrower’s personal cash flows and liquidity, and collateral values are a function of residential real estate values in the markets that the Bank serves.
 
 
Page 3


Item 1.      Business (Continued)

Commercial real estate loans totaled $312.51 million and were 18.15% of the Bank’s loan portfolio at December 31, 2012.  The Bank originates loans for commercial properties to individuals and businesses within its trade area.  The primary source of repayment is the cash flow generated by the collateral underlying the loan.  The secondary repayment source would be the liquidation of the collateral.  Terms for commercial real estate loans range from one to five years with an amortization period of 25 years or less.  The Bank offers both fixed and variable rate loans for commercial real estate.

Multi-family real estate loans totaled $214.81 million and were 12.48% of the Bank’s loan portfolio at December 31, 2012.  Multi-family real estate loans are made to individuals and businesses in the Bank’s trade area.  These loans are primarily secured by properties such as apartment complexes.  The primary source of repayment is the cash flow generated by the collateral underlying the loan.  The secondary repayment source would be the liquidation of the collateral.  Terms for commercial real estate loans range from one to five years with an amortization period of 25 years or less.  Generally, interest rates for multi-family loans are fixed for the loan term.

Mortgage loans secured by farmland totaled $113.84 million and were 6.61% of the Bank’s loan portfolio at December 31, 2012.  Loans for farmland are made to individuals and businesses within the Bank’s trade area.  The primary source of repayment is the cash flow generated by the collateral underlying the loan.  The secondary repayment source would be the liquidation of the collateral.  Terms for real estate loans secured by farmland range from one to five years with an amortization period of 25 years or less.  Generally, interest rates are fixed for mortgage loans secured by farmland.

Construction Loans.  The Bank offers loans both to individuals that are constructing personal residences and to real estate developers and building contractors for the acquisition of land for development and the construction of homes and commercial properties.  The Bank makes these loans to established borrowers in the Bank’s trade area.  Construction loans generally have a term of one year or less, with interest payable at maturity.  Interest rate arrangements are variable for construction projects.  Generally, collateral for construction loans is the underlying construction project.

As of December 31, 2012, construction loans for personal residences totaled $25.79 million and were 1.50% of the Bank’s loan portfolio.  Construction loans for land development and commercial projects totaled $79.10 million and were 4.59% of the Bank’s loan portfolio.  In total, construction loans totaled $104.89 million and were 6.09% of the Bank’s loan portfolio as of December 31, 2012.

Commercial and Financial Loans

The Bank’s commercial and financial loan portfolio totaled $148.03 million and comprised 8.60% of the total loan portfolio at December 31, 2012.  The Bank’s commercial and financial loans include loans to contractors, retailers and other businesses.  The Bank provides a wide range of business loans, including lines of credit for working capital and operational purposes and term loans for the acquisition of equipment.  Although most loans are made on a secured basis, loans may be made on an unsecured basis where warranted by the overall financial condition of the borrower.  Terms of commercial and financial loans generally range from one to five years.  Interest rates for commercial loans can be fixed or variable.

The Bank’s commercial and financial loans are primarily made based on the reported cash flow of the borrower and secondarily on the underlying collateral provided by the borrower.  The collateral support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of personal guarantees, if applicable.  The primary repayment risks of commercial loans are that the cash flows of the borrower may be unpredictable, and the collateral securing these loans may fluctuate in value.
 
 
Page 4


Item 1.      Business (Continued)

Agricultural Loans

Agricultural loans include loans made to finance agricultural production and other loans to farmers and farming operations.  These loans totaled $76.19 million and constituted 4.43% of the total loan portfolio at December 31, 2012.  Agricultural loans, most of which are secured by crops and machinery, are provided to finance capital improvement and farm operations as well as acquisitions of livestock and machinery.  The ability of the borrower to repay may be affected by many factors outside of the borrower’s control including adverse weather conditions, loss of livestock due to disease or other factors, declines in market prices for agricultural products and the impact of government regulations.  The ultimate repayment of agricultural loans is dependent upon the profitable operation or management of the agricultural entity.  Agricultural loans generally have a term of one year and may have a fixed or variable rate.

Consumer Lending

The Bank offers consumer loans including personal loans and automobile loans.  These consumer loans typically have shorter terms and lower balances.  At December 31, 2012, consumer loans totaled $20.35 million and were 1.18% of the Bank’s total loan portfolio.

Loans to State and Political Subdivisions

Loans to State and Political Subdivisions include only tax-exempt loans.  These loans totaled $43.10 million and comprised 2.50% of the Bank’s total loan portfolio at December 31, 2012.

Deposit Activities

The Bank’s primary funding source for its loan portfolio and other investments consist of the acceptance of demand savings and time deposits.

Other Information

The Bank’s business is not seasonal. As of December 31, 2012, the Company had no employees and the Bank had 364 full-time and 59 part-time employees.

For additional discussion of the impact of the economy on the financial condition and results of operations of the Company, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
 
Page 5

 
Item 1.      Business (Continued)

MARKET AREA

Johnson County and Linn County

The Bank’s trade area includes the Johnson County communities of Iowa City, Coralville, Hills and North Liberty, located near Interstate 80 and Interstate 380 in Eastern Iowa.  These communities have a combined population of approximately 101,600.  Johnson County, Iowa has a population of approximately 132,000.  The University of Iowa in Iowa City has approximately 31,500 students and 33,800 full and part-time employees, including 6,500 employees of The University of Iowa Hospitals and Clinics.

The Bank operates offices in the Linn County, Iowa communities of Lisbon, Marion, Mount Vernon and Cedar Rapids, Iowa.  Lisbon has a population of approximately 2,200 and Mount Vernon, located two miles from Lisbon, has a population of about 4,500.  Both communities are within easy commuting distances to Cedar Rapids and Iowa City, Iowa.  Cedar Rapids has a metropolitan population of approximately 162,500, including approximately 35,300 from adjoining Marion, Iowa and is located approximately 10 miles west of Lisbon, Iowa and approximately 25 miles north of Iowa City on Interstate 380.  The total population of Linn County is approximately 213,300.  The largest employer in the Cedar Rapids area is Rockwell Collins, Inc., manufacturer of communications instruments, with over 9,700 employees.

Other large employers in the Johnson and Linn County areas and their approximate number of employees are as follows (Data source is Corridor Business Journal):

Employer
Type of Business
Employees
Hy-Vee Food Stores
Grocery Stores
         4,100
Cedar Rapids and Linn-Mar School Districts
Education
         3,900
Transamerica
Insurance
         3,600
St. Luke's Hospital
Health Care
         3,600
Heartland Express, Inc.
Trucking
         2,900
Mercy Medical Center
Health Care
         2,900
Wal-Mart Stores, Inc.
Discount Store
         1,800
Iowa City Community School District
Education
         1,700
Kirkwood Community College
Education
         1,600
Pearson Educational Measurement
Information Services - Computers
         1,600
Veteran's Administration Medical Center
Health Care
         1,400
Mercy Iowa City
Health Care
         1,400
ACT, Inc.
Educational Testing Service
         1,300
City of Cedar Rapids
City Government
         1,300
Alliant Energy
Energy
         1,200
Quaker Oats Company
Cereals and Chemicals
         1,100

Washington County

The Bank has offices located in Kalona and Wellman, Iowa, which are in Washington County.  Kalona is located approximately 20 miles south of Iowa City.  Wellman is located approximately 5 miles west of Kalona.  Kalona has a population of approximately 2,400 and Wellman has a population of about 1,400.  The population of Washington County is approximately 21,700.  Both Kalona and Wellman are primarily agricultural communities, but are located within easy driving distance for employment in Iowa City, Coralville and North Liberty (combined population 100,900) and Washington, Iowa (population 7,300).
 
 
Page 6

 
Item 1.      Business (Continued)

COMPETITION

Competition among financial institutions in attracting and retaining deposits and making loans is intense.  Traditionally, the Company’s most direct competition for deposits has come from commercial banks, savings institutions and credit unions doing business in its areas of operation.  Increasingly, the Company has experienced additional competition for deposits from nonbanking sources, such as securities firms, insurance companies, money market mutual funds and financial services subsidiaries of commercial and manufacturing companies.  Competition for loans comes primarily from other commercial banks, savings institutions, consumer finance companies, credit unions, mortgage banking companies, insurance companies and other institutional lenders.  The Company competes primarily on the basis of products offered, customer service and price.  A number of institutions with which the Company competes enjoy the benefits of fewer regulatory constraints and lower cost structures including favorable income tax treatments.  Some have greater assets and capital than the Company does and, thus, are better able to compete on the basis of price than the Company is.  Technological advances, which may diminish the importance of depository institutions and other financial intermediaries in the transfer of funds between parties, could make it more difficult for the Company to compete in the future.

Effective March 13, 2000, securities firms and insurance companies that elect to become financial holding companies were allowed to acquire banks and other financial institutions.  This has increased the number of competitors and intensified the competitive environment in which the Company conducts business.  The increasingly competitive environment is primarily a result of changes in regulations and changes in technology and product delivery systems.  These competitive trends are likely to continue.

The Bank is in direct competition for loans and deposits and financial services with a number of other banks and credit unions in Johnson, Linn and Washington County.  A comparison of the number of office locations and deposits in the three counties as of June, 2012 (most recent date of available data from the FDIC and national credit union websites) is as follows:

   
Johnson County
   
Linn County
   
Washington County
 
   
Offices
   
Deposits (in millions)
   
Offices
   
Deposits (in millions)
   
Offices
   
Deposits (in millions)
 
                                     
Hills Bank and Trust Company
    9     $ 1,116       6     $ 345       2     $ 104  
Branches of largest competing national bank
    7       247       9       758       1       23  
Largest competing independent bank
    7       579       8       553       2       181  
Largest competing credit union (1)
    5       1,221       8       637       1       1  
All other bank and credit union offices
    29       588       76       2,902       7       212  
Total Market in County
    57     $ 3,751       107     $ 5,195       13     $ 521  

 
(1)
Deposit balance of the largest competing credit union in Johnson County includes the credit union’s deposit balance for its entire trade area.  County specific deposit balances for the credit union are unavailable.

Effective July 1, 2004, all limitations on bank office locations of Iowa law were repealed, effectively allowing statewide branching.  Since that date, banks have been allowed to establish an unlimited number of offices in any location in Iowa subject to regulatory approval.  Since July 1, 2007, six new offices have been added in Johnson County and one in Linn County, while the population base has increased by 15,100, or 4.57%, in the two counties in the last five years.  The number of banking offices in Washington County has not increased and its population has remained stable.  The total deposits in the three counties increased $2.18 billion or 30.04%, since July 1, 2007.
 
 
Page 7


Item 1.      Business (Continued)

THE ECONOMY

The Bank’s primary trade territory is Johnson, Linn and Washington Counties, Iowa.  The table that follows shows employment information as of December 31, 2012, regarding the labor force and unemployment levels in the three counties in which the Bank has office locations along with comparable data on the United States and the State of Iowa.

   
Labor Force
   
Unemployed
   
Rate %
 
                   
United States
    155,511,000       12,206,000       7.8 %
State of Iowa
    1,638,500       80,000       4.9 %
Johnson County
    78,700       2,800       3.6 %
Linn County
    118,700       6,300       5.3 %
Washington County
    11,800       500       4.1 %
 
The unemployment rate for the Bank’s prime market area is favorable and the rate historically has been lower than the unemployment rates for both the United States and the State of Iowa.  The unemployment rates in 2011 were 8.5% for the United States, 5.6% for the State of Iowa and 4.2%, 6.0% and 4.9% for Johnson, Linn and Washington Counties, respectively.  As noted within the employment table of large employers in Johnson and Linn County, the University of Iowa’s impact on the local economy is very important in maintaining acceptable employment levels.  The FY 2012-2013 budget for the University of Iowa, including the University of Iowa Hospital and Clinics, is $3.17 billion with state appropriations of approximately $265.74 million, or about 8.4% of the total.  The state appropriations increased from $233.06 million, or about 14.02%, from the FY 2011 – 2012 budget. The University of Iowa Hospitals and Clinics have a FY 2012-2013 budget of $994.56 million with 7.33% coming from State of Iowa appropriations.  The state appropriations for the University of Iowa Hospitals and Clinics decreased from 7.66% in the FY 2011-2012 budget.

It is difficult to predict how the national economic struggles and the budget challenges for the State of Iowa will impact the State of Iowa going forward.  It is unclear what impact the stress of the State budget will continue to have on the University of Iowa and the University of Iowa Hospitals and Clinics.  Johnson and Linn Counties have been one of the strongest economic areas in Iowa and have had substantial economic growth in the past ten years.  The largest segment of the employed population is employed in manufacturing, management, professional or related occupations.

The economies in the counties continue to be enhanced by local Iowa colleges and the University of Iowa.  In addition to providing quality employment, they enroll students who provide economic benefits to the area.  The following table indicates Fall 2012 enrollment.

College
City
 
Enrollment
 
The University of Iowa
Iowa City
    31,498  
Coe College
Cedar Rapids
    1,400  
Cornell College
Mount Vernon
    1,200  
Kirkwood Community College
Cedar Rapids, Iowa City and Washington
    16,661  
Mount Mercy College
Cedar Rapids
    1,810  

 
Page 8


Item 1.      Business (Continued)

The Bank also serves a number of smaller communities in Johnson, Linn and Washington counties that are more dependent upon the agricultural economy, which historically has been affected by commodity prices and weather.  The average price per acre of farm land continues to be an important factor to consider when reviewing the local economy. The average price per acre in Iowa in 2012 was $8,296 compared to $6,708 in 2011, a 23.67% increase.  The range of average land prices in Johnson, Linn and Washington counties is between $8,226 and $9,189 per acre.  The three counties average increase was 17.03% in 2012.  The Bank’s total agricultural loans comprise about 4.43% of the Bank’s total loans.

SUPERVISION AND REGULATION

Financial institutions and their holding companies are extensively regulated under federal and state law. As a result, the growth and earnings performance of the Company can be affected not only by management decisions and general economic conditions but also by the requirements of applicable state and federal statutes and regulations and the policies of various governmental regulatory authorities, including the Iowa Superintendent of Banking (the “Superintendent”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Federal Deposit Insurance Corporation (the “FDIC”), the Internal Revenue Service and state taxing authorities and the Securities and Exchange Commission (the “SEC”).  The effect of applicable statutes, regulations and regulatory policies can be significant and cannot be predicted with a high degree of certainty.

Federal and state laws and regulations generally applicable to financial institutions regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, mergers, consolidations and dividends.  The system of supervision and regulation applicable to the Company and its subsidiary Bank establishes a comprehensive framework for their respective operations and is intended primarily for the protection of the FDIC’s deposit insurance funds and the depositors, rather than the stockholders, of financial institutions.  The enforcement powers available to federal and state banking regulators are substantial and include, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions.

The following is a summary of the material elements of the regulatory framework applicable to the Company and its subsidiary Bank.  It does not describe all of the statutes, regulations and regulatory policies that apply, nor does it restate all of the requirements of the statutes, regulations and regulatory policies that are described.  As such, the following is qualified in its entirety by reference to the applicable statutes, regulations and regulatory policies.  Any change in applicable law, regulations or regulatory policies may have a material effect on the business of the Company and its subsidiary Bank.

Regulation of the Company

General.  The Company, as the sole shareholder of the Bank, is a bank holding company.  As a bank holding company, the Company is registered with, and is subject to regulation by, the Federal Reserve under the Bank Holding Company Act, as amended (the “BHCA”). According to Federal Reserve Board policy, bank/financial holding companies are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary. This support may be required at times when a bank/financial holding company may not be able to provide support. Under the BHCA, the Company is subject to periodic examination by the Federal Reserve.  The Company is also required to file with the Federal Reserve periodic reports of the Company’s operations and such additional information regarding the Company and its subsidiary as the Federal Reserve may require.
 
 
Page 9

 
Item 1.      Business (Continued)

Investments and Activities.  Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after the acquisition, it would own or control more than 5% of the shares of the other bank or bank holding company (unless it already owns or controls the majority of such shares), (ii) acquiring all or substantially all of the assets of another bank or (iii) merging or consolidating with another bank holding company.  Subject to certain conditions (including certain deposit concentration limits established by the BHCA), the Federal Reserve may allow a bank holding company to acquire banks located in any state of the United States without regard to whether the acquisition is prohibited by the law of the state in which the target bank is located.  On approving interstate acquisitions, however, the Federal Reserve is required to give effect to applicable state law limitations on the aggregate amount of deposits that may be held by the acquiring bank holding company and its insured depository institution affiliates in the state in which the target bank is located (provided that those limits do not discriminate against out-of-state depository institutions or their holding companies) and state laws which require that the target bank have been in existence for a minimum period of time (not to exceed five years) before being acquired by an out-of-state bank holding company.

The BHCA also generally prohibits the Company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries.  This general prohibition is subject to a number of exceptions.  The principal exception allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the Federal Reserve to be “so closely related to banking . . . as to be a proper incident thereto.”  Under current regulations of the Federal Reserve, the Company either directly or through non-bank subsidiaries would be permitted to engage in a variety of banking-related businesses, including the operation of a thrift, sales and consumer finance, equipment leasing, the operation of a computer service bureau (including software development) and mortgage banking and brokerage.  The BHCA generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies.

Federal law also prohibits any person from acquiring “control” of a bank holding company without prior notice to the appropriate federal bank regulator.  “Control” is defined in certain cases as the acquisition of 10% or more of the outstanding shares of a bank or a bank holding company depending on the circumstances surrounding the acquisition.

Regulatory Capital Requirements

Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve capital adequacy guidelines.  If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses.

The Federal Reserve’s capital guidelines establish the following minimum regulatory capital requirements for bank holding companies: a risk-based requirement expressed as a percentage of total risk-weighted assets, and a leverage requirement expressed as a percentage of total assets. The risk-based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half of which must be Tier 1 capital.  The leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 4%.

The risk-based and leverage standards described above are minimum requirements.  Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations.  For example, the Federal Reserve’s capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentration of credit, nontraditional activities or securities trading activities.  Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios (i.e., Tier 1 capital less all intangible assets), well above the minimum levels.  Current Federal Reserve minimum requirements for a well-capitalized organization experiencing significant growth are a leverage ratio of 5%, a Tier 1 risk-based capital ratio of 6% and total risk-based capital ratio of 10%.  As of December 31, 2012, the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements, with a leverage ratio of 11.90%, with total Tier 1 risk-based capital ratio of 15.41% and a total risk-based capital ratio of 16.66%.
 
 
Page 10


Item 1.      Business (Continued)

Dividends.  The Iowa Business Corporation Act (“IBCA”) allows the Company to make distributions, including cash dividends, to its shareholders unless, after giving effect to such distributions, either (i) the Company would not be able to pay its debts as they become due in the ordinary course of business or (ii) the Company’s total assets would be less than the sum of its total liabilities plus the amount that would be needed to satisfy preferential shareholder rights, if any, that are superior to the rights of those receiving the distribution.  Additionally, the Federal Reserve has issued a policy statement with regard to the payment of cash dividends by bank holding companies.  The policy statement provides that a bank holding company should not pay cash dividends which exceed its net income or which can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing.  The Federal Reserve also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations.  Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.

Federal Securities Regulation.  The Company’s common stock is registered with the SEC under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Consequently, the Company is subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act.

Regulation of the Bank

General. The Bank is an Iowa-chartered bank, the deposit accounts of which are insured by the FDIC.  As an Iowa-chartered, FDIC insured bank, the Bank is subject to the examination, supervision, reporting and enforcement requirements of the Superintendent of Banking of the State of Iowa (the “Superintendent”), as the chartering authority for Iowa banks, and the FDIC, as the Bank’s primary federal regulator.

Deposit Insurance. The deposits of the Bank are insured up to regulatory limits set by the FDIC, and, accordingly in 2012, were subject to deposit insurance assessments based on the Federal Deposit Insurance Reform Act of 2005, as adopted and effective on April 21, 2006.  The FDIC maintains the Deposit Insurance Fund (“DIF”) by assessing depository institutions an insurance premium (assessment).  The amount assessed to each institution is based on the average total assets of the Company less average tangible equity as well as the degree of risk the institution poses to the DIF.  The FDIC assesses higher rates to those institutions that pose greater risks to the insurance fund.  These assessments included a prepayment of three years of insurance premiums which was paid by the Bank on December 30, 2009.  The prepayment was intended to cover the Bank’s premiums for 2010, 2011 and 2012.

In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation (FICO), a mixed-ownership government corporation established in the 1980’s to recapitalize the Federal Savings and Loan Insurance Corporation.  The current annualized assessment rate is 0.64 basis points, or approximately 0.16 basis points per quarter.  These assessments will continue until the FICO bonds mature in 2019.
 
 
Page 11


Item 1.      Business (Continued)

Capital Requirements.  Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements to maintain reserves against deposits, restrictions on the nature and amount of loans, and restrictions relating to investments, opening of bank offices and other activities of state banks.  Changes in the capital structure of state banks are also approved by the Superintendent.  State banks must have a Tier 1 risk-based leverage ratio of 6.5% plus a fully funded loan loss reserve. In certain instances, the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement on the Bank.  In determining the Tier 1 risk-based leverage ratio, the Superintendent uses total equity capital without unrealized securities gains and the allowance for loan losses less any intangible assets.   At December 31, 2012, the Tier 1 risk-based leverage ratio of the Bank was 11.82% and exceeded the ratio required by the Superintendent.

Capital adequacy for banks took on an added dimension with the establishment of a formal system of prompt corrective action under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).  This system uses bank capital levels to trigger supervisory actions designed to quickly correct banking problems.  Capital adequacy zones are used by the federal banking agencies to trigger these actions.  The ratios and the definition of “adequate capital” are the same as those used by the agencies in their capital adequacy guidelines.

Federal law provides the federal banking regulators of the Bank with broad power to take prompt corrective action to resolve the problems of undercapitalized banking institutions.  The extent of the regulators’ powers depends on whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized,” in each case as defined by regulation.  Under prompt corrective action, banks that are inadequately capitalized face a variety of mandatory and discretionary supervisory actions.  For example, “undercapitalized banks” must restrict asset growth, obtain prior approval for business expansion, and have an approved plan to restore capital.  “Critically undercapitalized banks” must be placed in receivership or conservatorship within 90 days unless some other action would result in lower long-term costs to the deposit insurance fund.

Supervisory Assessments.  All Iowa banks are required to pay supervisory assessments to the Superintendent to fund the Superintendent’s examination and supervision operations.  Effective July 1, 2002, the Superintendent changed the method of computation of the supervisory assessment from billing for each state examination completed based on an hourly rate, to billing on an annual basis based on the assets of the bank, the expected hours needed to conduct examinations of that size bank and an additional amount if more work is required.
 
 
Page 12


Item 1.       Business (Continued)

Community Investment and Consumer Protection Laws.  The Community Reinvestment Act requires insured institutions to offer credit products and take other actions that respond to the credit needs of the community.  Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations.  These laws include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Fair Credit Opportunity Act, the Fair Debt Collection Act and the Home Mortgage Disclosure Act.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) signed by the President on July 21, 2010 posed a significant impact on financial regulations.  The Dodd-Frank Act created an independent regulatory body, the Bureau of Consumer Financial Protection (“Bureau”), with authority and responsibility to set rules and regulations for most consumer protection laws applicable to all banks – large and small - adds another regulator to scrutinize and police financial activities.    Transfer to the Bureau of all consumer financial protection functions for designated laws by the other federal agencies was completed on July 21, 2011.   The Bureau has responsibility for mortgage reform and enforcement, as well as broad new powers over consumer financial activities which could impact what consumer financial services would be available and how they are provided.   The following consumer protection laws are the designated laws that will fall under the Bureau’s rulemaking authority:  the Alternative Mortgage Transactions Parity Act of 1928, the Consumer Leasing Act of 1976, the Electronic Fund Transfer Act, the Equal Credit Opportunity Act, the Fair Credit Billing Act, the Fair Credit Reporting Act subject to certain exclusions, the Fair Debt Collection Practices Act, the Home Owners Protection Act, certain privacy provisions of the Gramm-Leach-Bliley Act, the Home Mortgage Disclosure Act (HMDA), the Home Ownership and Equity Protection Act of 1994, the Real Estate Settlement Procedures Act (RESPA), the S.A.F.E. Mortgage Licensing Act of 2008 (SAFE Act), and the Truth in Lending Act.

The Bureau has issued a Notice regarding the Streamlining of Inherited Regulations.  Suggestions from the public are requested regarding the streamlining of regulations inherited from the other Federal agencies due to the transfer of authority.  The notice also sought suggestions for practical measures that would make complying with the regulations easier.  In addition to the Notice of Streamlining of Inherited Regulations, the Bureau is currently republishing the regulations implementing the consumer financial protection laws.   Issuance of Interim Final Rules for each regulation with a request for public comment provide for technical and conforming changes to reflect the transfer of authority and certain other non-substantive changes to the regulations made by the Dodd-Frank Act.   Review and revision of current financial regulations in conjunction with added new financial service regulations will heighten the regulatory compliance burden and increase litigation risk for the banking industry.

Dividends.  The Iowa Banking Act provides that an Iowa bank may not pay dividends in an amount greater than its undivided profits. The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized.  As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2012.  Notwithstanding the availability of funds for dividends, however, the Superintendent may prohibit the payment of any dividends by the Bank if the Superintendent determines such payment would constitute an unsafe or unsound practice.  The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank.  The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends.  To maintain acceptable capital ratios in the Bank, certain of its retained earnings are not available for the payment of dividends.  To maintain a ratio of total risk-based capital to assets of 8%, $80.02 million of the Bank’s Tier 1 capital of $247.76 million as of December 31, 2012 are available for the payment of dividends to the Company.
 
 
Page 13


Item 1.      Business (Continued)

Insider Transactions.  The Bank is subject to certain restrictions imposed by federal law on extensions of credit to the Company and its subsidiary, on investments in the stock or other securities of the Company and its subsidiary and the acceptance of the stock or other securities of the Company or its subsidiary as collateral for loans.  Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to directors and officers of the Company and its subsidiary, to principal stockholders of the Company, and to “related interests” of such directors, officers and principal stockholders.  In addition, federal law and regulations may affect the terms upon which any person becoming a director or officer of the Company or one of its subsidiaries or a principal stockholder of the Company may obtain credit from banks with which the Bank maintains a correspondent relationship.

Safety and Soundness Standards.  The federal banking agencies have adopted guidelines that establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions.  The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.

In general, the safety and soundness guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals.  If an institution fails to comply with any of the standards set forth in the guidelines, the institution’s primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance.  If an institution fails to submit an acceptable compliance plan, or fails in any material respect to implement a compliance plan that has been accepted by its primary federal regulator, the regulator is required to issue an order directing the institution to cure the deficiency.  Until the deficiency cited in the regulator’s order is cured, the regulator may restrict the institution’s rate of growth, require the institution to increase its capital, restrict the rates the institution pays on deposits or require the institution to take any action the regulator deems appropriate under the circumstances.  Noncompliance with the standards established by the safety and soundness guidelines may also constitute grounds for other enforcement action by the federal banking regulators, including cease and desist orders and civil money penalty assessments.

Branching Authority.  Historically, Iowa’s intrastate branching statutes have been rather restrictive when compared with those of other states.  Effective July 1, 2004, all limitations on bank office locations were repealed, which effectively allowed statewide branching.  Since that date, banks have been allowed to establish an unlimited number of offices in any location in Iowa subject only to regulatory approval.

Under the Riegle-Neal Act, both state and national banks are allowed to establish interstate branch networks through acquisitions of other banks, subject to certain conditions, including certain limitations on the aggregate amount of deposits that may be held by the surviving bank and all of its insured depository institution affiliates.  The establishment of new interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed by the Riegle-Neal Act only if specifically authorized by state law.  The legislation allowed individual states to “opt-out” of certain provisions of the Riegle-Neal Act by enacting appropriate legislation prior to June 1, 1997.  Iowa permits interstate bank mergers, subject to certain restrictions, including a prohibition against interstate mergers involving an Iowa bank that has been in existence and continuous operation for fewer than five years.
 
 
Page 14


Item 1.      Business (Continued)

State Bank Activities.  Under federal law and FDIC regulations, FDIC insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank.  Federal law and FDIC regulations also prohibit FDIC insured state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank or its subsidiary, respectively, unless the Bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity would not pose a significant risk to the deposit insurance fund of which the Bank is a member.  These restrictions have not had, and are not currently expected to have, a material impact on the operations of the Bank.

Financial Privacy.  In accordance with the Gramm-Leach-Bliley Financial Modernization Act of 1999 (the “GLB Act”), federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties.  These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party.  The privacy provisions of the GLB Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.

Anti-Money Laundering Initiatives and the USA Patriot Act.  A major focus of governmental policy on financial institutions has been aimed at combating money laundering and terrorist financing.  The USA PATRIOT Act of 2001 (the “USA Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States.  The U. S. Treasury Department has issued a number of regulations that apply various requirements of the USA Patriot Act to financial institutions such as the Bank.  These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers.  Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution.

Depositor Preference Statute.  In the "liquidation or other resolution" of an institution by any receiver, U.S. federal legislation provides that deposits and certain claims for administrative expenses and employee compensation against the insured depository institution would be afforded a priority over general unsecured claims against that institution, including federal funds and letters of credit.

Government Monetary Policy. The earnings of the Company are affected primarily by general economic conditions and to a lesser extent by the fiscal and monetary policies of the federal government and its agencies, particularly the Federal Reserve.  Its policies influence, to some degree, the volume of bank loans and deposits, and interest rates charged and paid thereon, and thus have an effect on the earnings of the Company's subsidiary Bank.
 
 
Page 15

 
Item 1.      Business (Continued)

CONSOLIDATED STATISTICAL INFORMATION

The following consolidated statistical information reflects selected balances and operations of the Company and the Bank for the periods indicated.

The following tables show (1) average balances of assets, liabilities and stockholders’ equity, (2) interest income and expense on a tax equivalent basis, (3) interest rates and interest differential and (4) changes in interest income and expense.

AVERAGE BALANCES
(Average Daily Basis)

   
Years Ended December 31,
 
   
2012
   
2011
   
2010
 
   
(Amounts In Thousands)
 
ASSETS
                 
Noninterest-bearing cash and cash equivalents
  $ 26,831     $ 24,230     $ 22,075  
Interest-bearing cash and cash equivalents
    52,724       27,679       28,207  
Taxable securities
    101,199       107,541       107,031  
Nontaxable securities
    118,008       110,921       98,753  
Federal funds sold
    18       57       473  
Loans, net
    1,677,642       1,613,844       1,519,344  
Property and equipment, net
    30,986       27,630       26,588  
Other assets
    55,007       57,564       60,230  
    $ 2,062,415     $ 1,969,466     $ 1,862,701  
                         
LIABILITIES AND STOCKHOLDERS' EQUITY
                       
Noninterest-bearing demand deposits
  $ 225,284     $ 205,728     $ 180,851  
Interest-bearing demand deposits
    321,225       274,060       235,380  
Savings deposits
    419,098       394,750       368,517  
Time deposits
    611,260       630,276       634,703  
Short-term borrowings
    46,192       51,391       46,670  
FHLB borrowings
    173,900       187,043       194,651  
Noninterest-bearing other liabilities
    16,608       17,980       15,823  
Interest-bearing other liabilities
    2,805       2,868       2,617  
Redeemable common stock held by Employee Stock Ownership Plan
    29,271       26,386       23,923  
Stockholders' equity
    216,772       178,984       159,566  
    $ 2,062,415     $ 1,969,466     $ 1,862,701  

 
Page 16


Item 1.      Business (Continued)

INTEREST INCOME AND EXPENSE
 
   
Years Ended December 31,
 
   
2012
   
2011
   
2010
 
   
(Amounts In Thousands)
 
                   
Income:
                 
Loans (1)
  $ 84,453     $ 87,655     $ 88,495  
Taxable securities
    1,897       2,797       3,380  
Nontaxable securities (1)
    5,227       5,309       5,067  
Interest-bearing cash and cash equivalents
    134       70       74  
Total interest income
    91,711       95,831       97,016  
                         
Expense:
                       
Interest-bearing demand deposits
    692       714       1,053  
Savings deposits
    989       1,219       2,073  
Time deposits
    12,043       14,055       16,074  
Short-term borrowings
    180       328       451  
FHLB borrowings
    7,583       7,995       8,116  
Interest-bearing other liabilities
    40       50       72  
Total interest expense
    21,527       24,361       27,839  
                         
Net interest income
  $ 70,184     $ 71,470     $ 69,177  

(1) 
Presented on a tax equivalent basis using a rate of 35% for the three years presented.

 
Page 17


Item 1.      Business (Continued)

INTEREST RATES AND INTEREST DIFFERENTIAL

   
Years Ended December 31,
 
   
2012
   
2011
   
2010
 
                   
Average yields:
                 
Loans (1)
    4.99 %     5.39 %     5.81 %
Loans (tax equivalent basis) (1)
    5.02       5.43       5.82  
Taxable securities
    1.87       2.60       3.16  
Nontaxable securities
    2.88       3.11       3.34  
Nontaxable securities (tax equivalent basis)
    4.43       4.79       5.13  
Interest-bearing cash and cash equivalents
    0.25       0.25       0.26  
Federal funds sold
    0.12       0.13       0.07  
Average rates paid:
                       
Interest-bearing demand deposits
    0.21       0.26       0.45  
Savings deposits
    0.24       0.31       0.56  
Time deposits
    1.96       2.23       2.53  
Short-term borrowings
    0.39       0.64       0.97  
FHLB borrowings
    4.29       4.22       4.17  
Interest-bearing other liabilities
    1.43       1.73       2.75  
Yield on average interest-earning assets
    4.69       5.15       5.53  
Rate on average interest-bearing liabilities
    1.36       1.57       1.87  
Net interest spread (2)
    3.33       3.58       3.66  
Net interest margin (3)
    3.60       3.85       3.95  

(1)
Non-accruing loans are not significant and have been included in the average loan balances for purposes of this computation.

(2)
Net interest spread is the difference between the yield on average interest-earning assets and the yield on average interest-paying liabilities stated on a tax equivalent basis using a federal rate of 35% for the three years presented.  The net interest spread decreased 25 basis points in 2012 and decreased 8 basis points in 2011.

(3)
Net interest margin is net interest income, on a tax equivalent basis, divided by average interest-earning assets.  The net interest margin decreased 25 basis points in 2012 and decreased 10 basis points in 2011.    The net interest margin decreased in 2012 due to the continued low rate environment.  The Company was not able to reprice interest-bearing liabilities downward more quickly than the decline in average yields on earning assets.

 
Page 18


Item 1.      Business (Continued)

CHANGES IN INTEREST INCOME AND EXPENSE

   
Changes Due
   
Changes Due
   
Total
 
   
To Volume
   
To Rates
   
Changes
 
   
(Amounts In Thousands)
 
                   
Year ended December 31, 2012:
                 
Change in interest income:
                 
Loans
  $ 3,443     $ (6,644 )   $ (3,201 )
Taxable securities
    (164 )     (736 )     (900 )
Nontaxable securities
    339       (422 )     (83 )
Interest-bearing cash and cash equivalents
    63       1       64  
    $ 3,681     $ (7,801 )   $ (4,120 )
Change in interest expense:
                       
Interest-bearing demand deposits
    (125 )     148       23  
Savings deposits
    (60 )     289       229  
Time deposits
    387       1,626       2,013  
Short-term borrowings
    18       131       149  
FHLB borrowings
    541       (129 )     412  
Interest-bearing other liabilities
    1       7       8  
      762       2,072       2,834  
Change in net interest income
  $ 4,443     $ (5,729 )   $ (1,286 )
                         
Year ended December 31, 2011:
                       
Change in interest income:
                       
Loans
  $ 5,384     $ (6,224 )   $ (840 )
Taxable securities
    20       (603 )     (583 )
Nontaxable securities
    624       (382 )     242  
Interest-bearing cash and cash equivalents
    (1 )     (3 )     (4 )
    $ 6,027     $ (7,212 )   $ (1,185 )
Change in interest expense:
                       
Interest-bearing demand deposits
    (173 )     512       339  
Savings deposits
    (138 )     992       854  
Time deposits
    112       1,907       2,019  
Short-term borrowings
    (49 )     172       123  
FHLB borrowings
    317       (196 )     121  
Interest-bearing other liabilities
    (7 )     29       22  
      62       3,416       3,478  
Change in net interest income
  $ 6,089     $ (3,796 )   $ 2,293  

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 at tax equivalent amounts.
 
 
Page 19


Item 1.      Business (Continued)

LOANS

The following table shows the composition of loans (before deducting the allowance for loan losses) as of December 31 for each of the last five years.  The table does not include loans held for sale to the secondary market.

   
December 31,
 
   
2012
   
2011
   
2010
   
2009
   
2008
 
   
(Amounts In Thousands)
 
                               
Agricultural
  $ 76,190     $ 68,556     $ 65,004     $ 64,598     $ 64,198  
Commercial and financial
    148,034       143,174       141,619       153,997       162,170  
Real estate:
                                       
Construction, 1 to 4 family residential
    25,788       22,308       25,232       25,821       29,343  
Construction, land development and commercial
    79,097       84,508       86,552       95,955       111,006  
Mortgage, farmland
    113,841       99,799       90,448       87,300       83,499  
Mortgage, 1 to 4 family first liens
    583,567       577,318       519,029       469,908       444,209  
Mortgage, 1 to 4 family junior liens
    104,278       104,915       109,036       114,742       117,086  
Mortgage, multi-family
    214,812       222,851       202,630       190,180       180,525  
Mortgage, commercial
    312,506       316,329       302,020       295,070       270,158  
Loans to individuals
    20,350       20,598       23,627       25,405       26,823  
Obligations of state and political subdivisions
    43,102       31,147       24,959       9,745       8,218  
    $ 1,721,565     $ 1,691,503     $ 1,590,156     $ 1,532,721     $ 1,497,235  
Net unamortized fees and costs
    597       563       504       420       265  
    $ 1,722,162     $ 1,692,066     $ 1,590,660     $ 1,533,141     $ 1,497,500  
Less allowance for loan losses
    25,160       30,150       29,230       29,160       27,660  
    $ 1,697,002     $ 1,661,916     $ 1,561,430     $ 1,503,981     $ 1,469,840  

There were no foreign loans outstanding for any of the years presented.

MATURITY DISTRIBUTION OF LOANS

The following table shows the principal payments due on loans as of December 31, 2012:

   
Amount
   
One Year
   
One To
   
Over Five
 
   
Of Loans
   
Or Less (1)
   
Five Years
   
Years
 
   
(Amounts In Thousands)
 
                         
Commercial and Agricultural
  $ 216,277     $ 99,727     $ 101,166     $ 15,384  
Real Estate
    1,441,609       244,856       914,324       282,429  
Other
    63,679       6,889       13,438       43,352  
Totals
  $ 1,721,565     $ 351,472     $ 1,028,928     $ 341,165  
                                 
The types of interest rates applicable to these principal payments are shown below:
 
                                 
Fixed rate
  $ 842,730     $ 127,141     $ 543,550     $ 172,039  
Variable rate
    878,835       224,331       485,378       169,126  
    $ 1,721,565     $ 351,472     $ 1,028,928     $ 341,165  
 
(1)
A significant portion of the commercial loans are due in one year or less.  A significant percentage of the loans will be re-evaluated prior to their maturity and are likely to be extended.
 
 
Page 20

 
Item 1.      Business (Continued)

IMPAIRED LOANS AND NON-PERFORMING ASSETS

The following table summarizes the Company's impaired loans and non-performing assets as of December 31 for each of the years presented:

   
2012
   
2011
   
2010
   
2009
   
2008
 
   
(Amounts In Thousands)
 
                               
Nonaccrual loans
  $ 7,685     $ 7,378     $ 8,246     $ 5,360     $ 1,327  
Accruing loans past due 90 days or more (1)
    2,643       3,212       5,345       7,009       5,049  
Troubled debt restructurings ("TDR loans") (2)
    19,430       17,889       17,957       15,135       4,478  
Total impaired loans
  $ 29,758     $ 28,479     $ 31,548     $ 27,504     $ 10,854  
Other real estate
    746       1,327       2,233       3,227       5,155  
Non-performing assets (includes impaired loans and other real estate)
  $ 30,504     $ 29,806     $ 33,781     $ 30,731     $ 16,009  
Loans held for investment
    1,721,565       1,691,503       1,590,156       1,532,721       1,497,235  
Ratio of allowance for loan losses to loans held for investment
    1.46 %     1.78 %     1.84 %     1.90 %     1.85 %
Ratio of allowance for loan losses to impaired loans
    84.55       105.87       92.65       106.02       254.84  
Ratio of impaired loans to total loans held for investment
    1.73       1.68       1.98       1.79       0.72  
Ratio of non-performing assets to total assets
    1.45       1.48       1.75       1.68       0.90  
 
(1)
There were $0.26 million of TDR loans included within accruing loans past due 90 days or more as of December 31, 2011.  As of December 31, 2012 there were no TDR loans included within accruing loans past due 90 days or more.  The accruing loans past due 90 days or more are still believed to be adequately collateralized.  Loans are placed on nonaccrual status when management believes the collection of future principal and interest is not reasonably assured.

(2)
Total TDR loans were $22.12, $21.40, $22.36, $15.14, and $4.48 million as of December 31, 2012, 2011, 2010, 2009 and 2008, respectively.  Included in the total nonaccrual loans were $2.69, $3.25 and $4.40 million of TDR loans as of December 31, 2012, 2011 and 2010, respectively.

The ratio of allowance for loan losses to impaired loans decreased to 84.55% as of December 31, 2012 compared to 105.87% as of December 31, 2011.  This decrease is due to a decrease in historical loan loss rates used in the allowance for loan losses calculation as of December 31, 2012.

See Note 3 to the Consolidated Financial Statements for additional disclosures on loans.
 
 
Page 21


Item 1.      Business (Continued)

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 if the loan is collateral dependent.

SUMMARY OF LOAN LOSS EXPERIENCE

The following table summarizes the Bank's loan loss experience for the years ended December 31, 2012, 2011 and 2010:
 
   
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
 
                                                 
2012
                                               
Allowance for loan losses:
                                               
Beginning balance
  $ 1,354     $ 6,429     $ 4,994     $ 1,411     $ 9,051     $ 6,150     $ 761     $ 30,150  
Charge-offs
    (12 )     (1,395 )     (1,648 )     -       (1,448 )     (318 )     (205 )   $ (5,026 )
Recoveries
    71       1,583       52       -       521       403       255     $ 2,885  
Provision
    240       (2,044 )     (223 )     335       (36 )     (1,131 )     10       (2,849 )
                                                                 
Ending balance
  $ 1,653     $ 4,573     $ 3,175     $ 1,746     $ 8,088     $ 5,104     $ 821     $ 25,160  
 
   
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
 
                                                 
2011
                                               
Allowance for loan losses:
                                               
Beginning balance
  $ 2,170     $ 6,742     $ 4,394     $ 1,482     $ 7,952     $ 5,657     $ 833     $ 29,230  
Charge-offs
    (81 )     (2,678 )     (549 )     (1 )     (2,892 )     (708 )     (220 )     (7,129 )
Recoveries
    45       896       17       4       934       298       194       2,388  
Provision
    (780 )     1,469       1,132       (74 )     3,057       903       (46 )     5,661  
                                                                 
Ending balance
  $ 1,354     $ 6,429     $ 4,994     $ 1,411     $ 9,051     $ 6,150     $ 761     $ 30,150  

   
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
 
                                                 
2010
                                               
Allowance for loan losses:
                                               
Beginning balance
  $ 2,967     $ 7,090     $ 4,811     $ 1,417     $ 7,484     $ 4,742     $ 649     $ 29,160  
Charge-offs
    (18 )     (3,647 )     (1,202 )     (52 )     (4,343 )     (1,507 )     (423 )     (11,192 )
Recoveries
    248       946       81       44       583       152       283       2,337  
Provision
    (1,027 )     2,353       704       73       4,228       2,270       324       8,925  
                                                                 
Ending balance
  $ 2,170     $ 6,742     $ 4,394     $ 1,482     $ 7,952     $ 5,657     $ 833     $ 29,230  

The ratio of net charge-offs to average net loans outstanding during the years ended December 31, 2012, 2011 and 2010 was 0.13%, 0.29% and 0.58%, respectively.
 
 
Page 22


Item 1.      Business (Continued)

The following table summarizes the Bank's loan loss experience for the years ended December 31, 2009 and 2008:

   
Year Ended December 31,
 
   
2009
   
2008
 
       
             
Balance, beginning
  $ 27,660     $ 19,710  
Charge-offs:
               
Agricultural
    82       99  
Commercial and financial
    5,161       1,359  
Real estate:
               
Construction and land development
    436       62  
Mortgage, farmland
    22       -  
Mortgage, 1 to 4 family
    3,064       2,169  
Mortgage, multi-family and commercial
    2,172       196  
Other
    515       604  
      11,452       4,489  
Recoveries:
               
Agricultural
    20       61  
Commercial and financial
    415       340  
Real estate:
               
Construction and land development
    49       -  
Mortgage, farmland
    1       4  
Mortgage, 1 to 4 family
    236       104  
Mortgage, multi-family and commercial
    7       128  
Other
    277       295  
      1,005       932  
Net charge-offs
    10,447       3,557  
Provision charged to expense (1)
    11,947       11,507  
Balance, ending
  $ 29,160     $ 27,660  
                 
Ratio of net charge-offs during year to average net loans outstanding
    0.71 %     0.25 %
 
(1)
For financial reporting purposes, management reviews the loan portfolio and determines the allowance for loan losses, which represents management’s judgment of the probable losses inherent in the Company’s loan portfolio.  The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management.  The adequacy of the allowance is reviewed quarterly and considers 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.
 
 
Page 23


 
Item 1.      Business (Continued)

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

The Company evaluates the following loans to determine impairment:  1) all nonaccrual and TDR loans, 2) all non-consumer and non 1 to 4 family residential loans with prior charge-offs, 3) all non-consumer and non 1 to 4 family loan relationships classified as substandard and 4) loans with indications of or suspected deteriorating credit quality.

The following table presents the allowance for loan losses by type of loans and the percentage in each category to total loans as of December 31, 2012, 2011, 2010, 2009, and 2008:

   
2012
   
2011
 
               
% of Loans
               
% of Loans
 
   
Amount
   
% of Total Allowance
   
to Total Loans
   
Amount
   
% of Total Allowance
   
to Total Loans
 
   
(In Thousands)
               
(In Thousands)
             
Agricultural
  $ 1,653       6.57 %     4.43 %   $ 1,354       4.49 %     4.05 %
Commercial and financial
    4,573       18.18       8.60       6,429       21.32       8.46  
Real estate:
                                               
Construction, 1 to 4 family residential
    848       3.37       1.50       564       1.87       1.32  
Construction, land development and commercial
    2,327       9.25       4.59       4,430       14.69       4.99  
Mortgage, farmland
    1,746       6.94       6.61       1,411       4.68       5.90  
Mortgage, 1 to 4 family first liens
    6,540       25.99       33.90       7,037       23.34       34.16  
Mortgage, 1 to 4 family junior liens
    1,548       6.15       6.06       2,014       6.68       6.20  
Mortgage, multi-family
    1,840       7.31       12.48       1,888       6.26       13.17  
Mortgage, commercial
    3,264       12.97       18.15       4,262       14.14       18.69  
Loans to individuals
    382       1.52       1.18       371       1.24       1.22  
Obligations of state and political subdivisions
    439       1.75       2.50       390       1.29       1.84  
    $ 25,160       100.00 %     100.00 %   $ 30,150       100.00 %     100.00 %
                                                 
      2010       2009  
Agricultural
  $ 2,170       7.42 %     4.09 %   $ 2,967       10.17 %     4.21 %
Commercial and financial
    6,742       23.07       8.90       7,090       24.31       10.04  
Real estate:
                                               
Construction, 1 to 4 family residential
    752       2.57       1.59       836       2.87       1.68  
Construction, land development and commercial
    3,642       12.46       5.44       3,975       13.63       6.26  
Mortgage, farmland
    1,482       5.07       5.69       1,417       4.86       5.69  
Mortgage, 1 to 4 family first liens
    5,782       19.78       32.66       6,091       20.89       30.68  
Mortgage, 1 to 4 family junior liens
    2,170       7.42       6.85       1,393       4.78       7.49  
Mortgage, multi-family
    1,486       5.09       12.74       1,723       5.91       12.40  
Mortgage, commercial
    4,171       14.27       18.99       3,019       10.36       19.25  
Loans to individuals
    525       1.80       1.48       639       2.19       1.66  
Obligations of state and political subdivisions
    308       1.05       1.57       10       0.03       0.64  
    $ 29,230       100.00 %     100.00 %   $ 29,160       100.00 %     100.00 %
 
   
2008
 
Agricultural
  $ 2,258       8.17 %     4.29 %
Commercial and financial
    5,357       19.37       10.83  
Real estate:
                       
Construction, 1 to 4 family residential
    626       2.26       1.96  
Construction, land development and commercial
    3,986       14.41       7.41  
Mortgage, farmland
    1,210       4.37       5.58  
Mortgage, 1 to 4 family first liens
    6,035       21.82       29.68  
Mortgage, 1 to 4 family junior liens
    1,346       4.87       7.82  
Mortgage, multi-family
    1,569       5.67       12.06  
Mortgage, commercial
    4,642       16.78       18.04  
Loans to individuals
    611       2.21       1.78  
Obligations of state and political subdivisions
    20       0.07       0.55  
    $ 27,660       100.00 %     100.00 %
 
 
Page 24


Item 1.      Business (Continued)

The allowance for loan losses decreased $4.99 million in 2012.  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 the overall amount of loans outstanding.  The reduction in the allowance for 2012 is the result of a decrease in the historical loss rates used in the allowance for loan losses calculation, improvements in asset quality as well as the overall composition of the loan portfolio. For 2012, there was a decrease of $0.91 million due to the volume increase in pass rated loans outstanding of $56.19 million in 2012.  There was also a $4.08 million decrease in the amount allocated to the allowance due to a combination of improvement in credit quality and losses recognized.

Watch loan balances were $98.92 million at December 31, 2012 and $102.19 million at December 31, 2011.  These asset quality changes decreased the provision by $0.66 million based upon the relative mix of watch loans by category.  The $3.27 million decrease in watch loans is related to management’s evaluation of its loan portfolio.  The total decrease of $3.27 million is comprised of approximately $7.04 million in commercial real estate mortgages, $1.33 million in construction land development and commercial real estate, $0.18 million in commercial loans, $2.70 million in agricultural operating loans, $0.63 million in real estate farmland, $0.54 million in construction 1 to 4 family residential and $1.08 million in 1 to 4 family junior mortgages.  The decrease is offset by an increase in the watch classification of $8.62 million for multi-family real estate, $1.02 million for loans to individuals and state and political subdivisions, $0.03 in loans to individuals and $0.56 million in 1 to 4 family residential mortgages.

Substandard loan balances were $50.70 million at December 31, 2012 and $78.44 million at December 31, 2011. These asset quality changes decreased the provision by $3.44 million at December 31, 2012 due to the mix of the substandard loans and reduced balances.    The decrease of $27.74 million in substandard loans at December 31, 2012 includes $7.16 million in multi-family residential mortgages, $2.44 million in commercial loans, $5.05 million of 1 to 4 family residential mortgages, $0.83 million of 1 to 4 family junior mortgages, $10.28 million in construction land development and commercial real estate, $0.06 million in individual loans and $3.87 million in commercial and financial loans.  Those decreases were offset by increases in $0.70 million in construction 1 to 4 family residential real estate loans, $0.22 in agricultural operating loans, and $1.03 million in agricultural real estate loans.

The subprime mortgage banking environment has experienced considerable strain from delinquencies and liquidity pressures.  The increased scrutiny of the subprime lending market and heightened perceptions of the risks associated with bank loan portfolios are factors that have had a negative impact on general market conditions.  The Company’s underwriting standards have been structured to limit exposure to the types of loans that are currently experiencing high foreclosures and loss rates.  Management believes that the Company’s mortgage loan portfolio has minimal exposure to loans generally considered to be subprime loans.

The Company believes that the allowance for loan losses is at a level commensurate with the overall risk exposure of the loan portfolio.  However, if economic conditions do not continue to improve, certain borrowers may experience difficulty and the level of impaired loans, charge-offs and delinquencies could continue to rise and require increases in the provision for loan losses.   The Company will continue to monitor the adequacy of the allowance on a quarterly basis and will consider the impact of economic conditions on the borrowers’ ability to repay, loan collateral values, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition.
 
 
Page 25


Item 1.      Business (Continued)

INVESTMENT SECURITIES

The following tables show the carrying value of the investment securities held by the Bank, including stock of the Federal Home Loan Bank, as of December 31, 2012, 2011, and 2010 and the maturities and weighted average yields of the investment securities, computed on a tax-equivalent basis using a federal tax rate of 35%, as of December 31, 2012:

   
December 31,
 
   
2012
   
2011
   
2010
 
   
(Amounts In Thousands)
 
Carrying value:
                 
Other securities (FHLB, FHLMC and FNMA)
  $ 91,850     $ 91,936     $ 97,836  
Stock of the Federal Home Loan Bank
    8,062       10,728       11,105  
Obligations of state and political subdivisions
    134,332       119,431       107,662  
    $ 234,244     $ 222,095     $ 216,603  
 
   
December 31, 2012
 
         
Weighted
 
   
Carrying
   
Average
 
   
Value
   
Yield
 
   
(Amounts In Thousands)
 
             
Other securities (FHLB, FHLMC and FNMA), maturities:
           
Within 1 year
  $ 20,394       2.40 %
From 1 to 5 years
    64,351       1.04  
From 5 to 10 years
    7,105       0.77  
    $ 91,850          
                 
Stock of the Federal Home Loan Bank
  $ 8,062       3.08 %
                 
Obligations of state and political subdivisions, maturities:
               
Within 1 year
  $ 12,226       4.05 %
From 1 to 5 years
    56,624       4.66  
From 5 to 10 years
    64,952       3.46  
Over 10 years
    530       2.90  
    $ 134,332          
Total
  $ 234,244          

As of December 31, 2012, the Company held no investment securities exceeding 10% of stockholders’ equity, other than securities of the U.S. Government agencies and corporations.  The Company does not hold any investments in FNMA preferred stock, any pooled trust preferred stocks or other preferred stock type investments.
 
 
Page 26


Item 1.      Business (Continued)

DEPOSITS

The following tables show the amounts of average deposits and average rates paid on such deposits for the years ended December 31, 2012, 2011 and 2010 and the composition of the certificates of deposit issued in denominations in excess of $100,000 as of December 31, 2012, 2011 and 2010:

   
December 31,
   
2012
   
Rate
   
2011
   
Rate
   
2010
   
Rate
 
   
(Amounts In Thousands)
Average noninterest-bearing deposits
  $ 225,284       -     $ 205,728       -     $ 180,851       -  
Average interest-bearing demand deposits
    321,225       0.21 %     274,060       0.26 %     235,380       0.45 %
Average savings deposits
    419,098       0.24       394,750       0.31       368,517       0.56  
Average time deposits
    611,260       1.96       630,276       2.23       634,703       2.53  
    $ 1,576,867             $ 1,504,814             $ 1,419,451          
                                                 
Time certificates issued in amounts of $100,000 or more with maturity in:
 
Amount
   
Rate
   
Amount
   
Rate
   
Amount
   
Rate
 
   
(Amounts In Thousands)
3 months or less
  $ 33,920       1.33 %   $ 15,778       1.23 %   $ 37,739       1.89 %
3 through 6 months
    30,928       1.55       18,740       1.86       29,287       2.59  
6 through 12 months
    68,591       1.37       48,302       1.77       38,489       2.34  
Over 12 months
    168,739       2.01       92,099       2.54       76,641       2.71  
    $ 302,178             $ 174,919             $ 182,156          
 
 
Page 27


Item 1.      Business (Continued)

RETURN ON STOCKHOLDERS' EQUITY AND ASSETS

The following table presents the return on average assets, return on average stockholders' equity, the dividend payout ratio and average stockholders’ equity to average assets ratio for the years ended December 31, 2012, 2011 and 2010:

   
2012
   
2011
   
2010
 
                   
Return on average assets
    1.30 %     1.36 %     1.25 %
Return on average stockholders' equity
    12.38       14.96       14.61  
Dividend payout ratio
    18.63       16.42       17.26  
Average stockholders' equity to average assets ratio
    10.51       9.09       8.57  

SHORT-TERM BORROWINGS

The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates of federal funds purchased and securities sold under agreements to repurchase during 2012, 2011 and 2010:

   
2012
   
2011
   
2010
 
   
(Amounts In Thousands)
 
                   
Outstanding balance as of December 31
  $ 38,783     $ 52,785     $ 46,928  
Weighted average interest rate at year end
    0.34 %     0.40 %     0.84 %
Maximum month-end balance
    50,286       77,820       78,145  
Average month-end balance
    46,192       51,391       46,670  
Weighted average interest rate for the year
    0.39 %     0.70 %     1.06 %

FEDERAL HOME LOAN BANK BORROWINGS

The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates of Federal Home Loan Bank borrowings during 2012, 2011 and 2010:

   
2012
   
2011
   
2010
 
   
(Amounts In Thousands)
 
                   
Outstanding balance as of December 31
  $ 125,000     $ 185,000     $ 195,000  
Weighted average interest rate at year end
    4.41 %     4.26 %     4.01 %
Maximum month-end balance
    185,000       195,000       195,000  
Average month-end balance
    173,900       187,043       194,651  
Weighted average interest rate for the year
    4.29 %     4.22 %     4.17 %
 
 
Page 28


Item 1A.   Risk Factors

The performance of our Company is subject to various risks.  We consider the risks described below to be the most significant risks we face, but such risks are not the only risk factors that could affect us.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition or results of operations.  For a discussion of the impact of risks on our financial condition and results of operations in recent years and on forward looking statements contained in this report, reference is made to Item 7 below.

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

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

Despite a recent trend toward stabilization and some limited improvement in some aspects of the local economy, adverse changes in the U.S. economy in recent years led to an increased level of commercial and consumer delinquencies, reduced consumer confidence, decreased market valuations and liquidity, increased market volatility and a widespread reduction of business activity generally.  Although levels of unemployment are decreasing and are not as severe in the Bank’s trade area as in some other parts of the United States, they remain at elevated levels.  The ability of banks and bank holding companies to raise capital or borrow in the debt markets has become more difficult compared to recent years. The resulting economic pressure and lack of confidence in the financial markets may adversely affect our business, our financial condition and our results of operations, as well as the business of our customers.  Foreign or domestic terrorism or geopolitical events could shock commodity and financial markets and prolong or worsen the current economic climate.  A worsening of economic conditions would likely exacerbate the adverse effects of these difficult conditions.

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

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

We are exposed to the risk that third parties that owe us money or other assets will not perform their obligations.  These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons.  Our rights against third parties may not be enforceable in all circumstances.  In addition, deterioration in the credit quality of third parties whose securities or obligations we hold could result in losses and/or adversely affect our ability to use those securities or obligations for liquidity purposes.  We rely on representations of potential borrowers and/or guarantors as to the accuracy and completeness of certain financial information.  Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements or other information that is materially misleading.
 
 
Page 29


Item 1A.   Risk Factors (Continued)

Our financial condition has not been materially impacted by the deterioration in the credit quality of third parties except as related to borrower credit quality.  As of December 31, 2012, the Company held two investment securities considered to be less than investment grade.  The aggregate fair value of these Ba2 rated bonds is $0.48 million while their amortized cost is $0.50 million, representing an unrealized loss of $0.02 million.  Management believes that the allowance for loan losses is adequate to absorb probable losses on any existing loans that may become uncollectible but cannot predict loan losses with certainty and cannot assure that the our allowance for loan losses will prove sufficient to cover actual losses in the future.

Drought or other natural disaster could harm the Company’s business.

The Company’s trade area has experienced moderate to severe drought conditions during 2012.  Drought or other adverse conditions continuing into 2013 may affect our loan portfolio by decreasing agricultural productivity.  The range of impact of a natural disaster cannot be predicted.

Changing interest rates may adversely affect our profits.

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

We experience intense competition for loans and deposits.

Competition among financial institutions in attracting and retaining deposits and making loans is intense.  Traditionally, our most direct competition for deposits has come from commercial banks, savings institutions and credit unions (which don’t pay federal or state income taxes) doing business in our areas of operation.  Increasingly, we have experienced additional competition for deposits from nonbanking sources, such as securities firms, insurance companies, money market mutual funds and corporate and financial services subsidiaries of commercial and manufacturing companies.  Competition for loans comes primarily from other commercial banks, savings institutions, consumer finance companies, credit unions, mortgage banking companies, insurance companies and other institutional lenders.  We compete primarily on the basis of products offered, customer service and price.  A number of institutions with which we compete enjoy the benefits of fewer regulatory constraints and lower cost structures.  Some have greater assets and capital than we do and, thus, are better able to compete on the basis of price than we are.  The increasingly competitive environment is primarily a result of changes in regulation, technology and product delivery systems.  These competitive trends are likely to continue.
 
 
Page 30

 
Item 1A.    Risk Factors (Continued)

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

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

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

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

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

Real estate loans, which constitute a large portion of our loan portfolio, include home equity, commercial, construction and residential loans, and such loans are concentrated in the Bank’s trade area, a small geographic area in Southeast Iowa.  As of December 31, 2012, approximately 83.29% of our loans had real estate as a primary or secondary component of collateral.  The market value of real estate can fluctuate significantly in a short period of time as a result of market conditions in the geographic area in which the real estate is located.  Adverse developments affecting real estate values in our market could increase the credit risk associated with our loan portfolio.  Also, real estate lending typically involves higher loan principal amounts and the repayment of the loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service.  Economic events or governmental regulations outside of the control of the borrower could negatively impact the future cash flow and market values of the affected properties.

If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then we may not be able to realize the amount of security that we anticipated at the time of originating the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results and financial condition.
 
 
Page 31


Item 1A.    Risk Factors (Continued)

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

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

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

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

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

We also originate agricultural operating loans.  As with agricultural real estate loans, the repayment of operating loans is dependent on the successful operation or management of the farm property.  Likewise, agricultural operating loans involve a greater degree of risk than lending on residential properties, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as farm equipment or assets such as livestock or crops.  The primary livestock in our market areas is hogs.  In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.
 
 
Page 32


Item 1A.    Risk Factors (Continued)

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

There has been growth in the national housing market as evidenced by reports of increased levels of new and existing home sales, decreasing inventories of houses on the market, increasing property values, an increase in building permits, and a decrease in the time houses remain on the market.  In past history of real estate growth, some lenders made many adjustable-rate mortgage loans, and lowered their credit standards with respect to mortgage loans and home equity loans.  A subsequent slowdown in the national housing market created uncertainty and liquidity issues relating to the value of such mortgage loans, which caused disruption in credit markets.  Management will continue to monitor that the Bank has maintained appropriate lending standards in times of real estate growth and decline.  No assurance can be given that these conditions will not directly or indirectly affect our operations

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

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

We are subject to risks arising from increases in FDIC insurance premiums.

The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund (the “DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF.  These assessments included a prepayment of three years of insurance premiums which was paid by the Bank on December 30, 2009.  The prepayment was intended to cover the Bank’s premiums for 2010, 2011 and 2012.  The balance remaining in prepaid FDIC insurance after payment of the FDIC assessments for 2012 will be refunded to the Company in June 2013.  The expense for the FDIC insurance will continue to be recorded on a quarterly basis as premiums are assessed.

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

Liquidity is essential to our business, as we must maintain sufficient funds to respond to the needs of depositors and borrowers.  An inability to raise funds through deposits, borrowings, the sale or pledging as collateral of loans and other assets could have a substantial negative effect on our liquidity.  Our access to funding sources in the amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general.  Factors that could negatively affect our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or negative regulatory action against us.  Our ability to borrow could also be impaired by factors that are not specific to us, such as severe disruption of the financial markets or negative news and expectations about the prospects for the financial services industry as a whole, as evidenced by recent turmoil in the domestic and worldwide credit markets.
 
 
Page 33


Item 1A.    Risk Factors (Continued)

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

Our growth strategy relies heavily on our management team, and the unexpected loss of key managers and/or officers may adversely affect our operations.

The Company’s success is dependent on experienced senior management with a strong local community network.  Our ability to retain the current management team and executive officers are key to the successful implementation of our growth strategy.  It is equally important that the Company be able to continue to attract and retain quality and community-focused managers and officers.  The unexpected loss of one of the Company’s key managers and/or officers or the inability to attract qualified personnel could have a negative effect on our operations, financial condition and reputation.

We are subject to risks associated with changes in regulation.

Any changes to state and federal banking laws and regulations may negatively impact our ability to expand services and to increase the value of our business.  We are subject to extensive state and federal regulation, supervision, and legislation that govern almost all aspects of our operations.  These laws may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds.  In addition, the Company’s earnings are affected by the monetary policies of the Board of Governors of the Federal Reserve.  These policies, which include regulating the national supply of bank reserves and bank credit, can have a major effect upon the source and cost of funds and the rates of return earned on loans and investments.  The Federal Reserve influences the size and distribution of bank reserves through its open market operations and changes in cash reserve requirements against member bank deposits.  We cannot predict what effect such Act and any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, but such changes could be materially adverse to our financial performance.

We are subject to risks associated with technological changes and the resources needed to implement the changes

Our industry is susceptible to significant technological changes in the future as there continue to be a high level of new technology driven products and services introduced.  Technological advancement aids the Company in providing customer service and increases efficiency.  Our larger competitors have more resources to invest in technological changes and associated required resources.  As a result they may be able to offer products and services that are more technologically advanced and that may put us at a competitive disadvantage.  Our future will depends on our ability to analyze technological changes to determine the best course of action for our business, customers and shareholders.

We rely heavily on our network security and any system failure or data breach could subject the Company to increased costs as well as reputational risk.

Our operations are dependent on our ability to process financial transactions in a secure manner.  We must ensure that information is properly protected from a variety of threats such as error, fraud, sabotage, terrorism, industrial espionage, privacy violation, service interruption, and natural disaster.  Any activity that jeopardizes our network and the security of the information stored on our network may result in significant cost to the Company and have significant negative effect on our reputation.

Item 1B.    Unresolved Staff Comments

None.
 
 
Page 34


Item 2.      Properties

The Company's office and the main office of the Bank are located at 131 Main Street, Hills, Iowa.  This is a brick building containing approximately 45,000 square feet. A portion of the building was built in 1977, a two-story addition was completed in 1984, and a two-story brick addition was completed in February 2001.  With the completion of the 2001 addition, the entire Bank’s processing and administrative systems were consolidated in Hills, Iowa.

The following table sets forth certain information concerning the branches of the Bank as of December 31, 2012:

   
Approximate
   
Location of Branch
 
Square Feet
 
Status
           
3905 Blairs Ferry Road NE
Cedar Rapids, Iowa
 
13,000
 
Owned
           
240 3rd Avenue SE
Cedar Rapids, Iowa
 
7,000
 
Leased
           
3610 Williams Boulevard SW
Cedar Rapids, Iowa
 
8,200
 
Owned
           
1009 2nd Street
Coralville, Iowa
 
23,000
 
Owned
           
201 South Clinton Street
Iowa City, Iowa
 
5,800
 
Leased
           
1401 South Gilbert Street
Iowa City, Iowa
 
15,400
 
Owned
           
2621 Muscatine Avenue
Iowa City, Iowa
 
5,800
 
Owned
           
Oaknoll Retirement Residence
limited purpose office
Iowa City, Iowa
 
NA
 
NA
           
           
University of Iowa Memorial Union
Iowa City, Iowa
 
500
 
Leased
           
University of Iowa Hospitals and Clinics
Iowa City, Iowa
 
800
 
Leased
           
120 5th Street
Kalona, Iowa
 
6,400
 
Owned
           
103 West Main Street
Lisbon, Iowa
 
3,000
 
Owned
           
800 11th Street
Marion, Iowa
 
8,400
 
Owned
           
720 First Avenue SE
Mount Vernon, Iowa
 
4,200
 
Owned
           
25 Highway 965 North
North Liberty, Iowa
 
2,800
 
Owned
           
590 West Forevergreen Road
North Liberty, Iowa
 
18,600
 
Owned
           
229 8th Avenue
Wellman, Iowa
 
2,400
 
Owned

All of the properties owned by the Bank are free and clear of any mortgages or other encumbrances of any type.  See Note 15 to the Consolidated Financial Statements for minimum future rental commitments for leased properties.

Item 3.       Legal Proceedings

There are no material pending legal proceedings.  Neither the Company nor the Bank holds any properties that are the subject of hazardous waste clean-up investigations.

Item 4.      Mine Safety Disclosures

Not applicable.
 
 
Page 35

 
PART II

Item 5.       Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases Of Equity Securities

As of January 31, 2013, the Company had 2,200 stockholders.  There is no established trading market for the Company's common stock, and the Company's stock is not actively traded.  Our common stock is not listed on the NASDAQ stock market or any other stock exchange.  While there is no established public trading market for our common stock, our shares are currently quoted in the inter-dealer quotation, or “over-the-counter,” marketplace under the trading symbol “HBIA.”  The principal over-the-counter market is operated by OTC Markets Group, Inc. (formerly Pink OTC Markets Inc.), which provides quotes for the Company on its middle tier, the OTCQB.  All OTCQB companies are reporting with the SEC or a U.S. banking regulator, but there are no financial or qualitative standards to be in this tier.
 
The high and low bid information for the Company’s stock for each quarter of the two most recent fiscal years, as reported by The Pink Sheets, is provided below.  The prices indicated reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

   
2012
   
2011
 
   
High
   
Low
   
High
   
Low
 
1st quarter
  $ 64.75     $ 63.00     $ 64.00     $ 63.90  
2nd quarter
    64.50       62.75       65.00       64.00  
3rd quarter
    67.00       63.90       64.00       61.00  
4th quarter
    67.00       65.00       65.00       62.90  

In addition, based on the Company’s stock transfer records and information informally provided to the Company, stock trading transactions have been as follows:

Year
 
Number of Shares Traded
   
Number of Transactions
   
High Selling Price
   
Low Selling Price
   
2012
    51,802       89     $ 70.00     $ 64.00   (1)
2011
    485,425       918     $ 64.00     $ 58.50   (2)
2010
    41,648       60     $ 58.50     $ 53.00   (3)

 
(1)
2012 transactions included repurchases by the Company of 35,982 shares of stock under the 2005 Stock Repurchase Program.  2012 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $64.00 to $70.00 per share.

 
(2)
2011 transactions included repurchases by the Company of 65,901 shares of stock under the 2005 Stock Repurchase Program.  2011 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $58.50 to $64.00 per share. 2011 transactions also include the sale of 412,660 shares of stock through 848 transactions from the 2011 stock offering.

 
(3)
2010 transactions included repurchases by the Company of 29,494 shares of stock under the 2005 Stock Repurchase Program.  2010 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $53.00 to $58.50 per share.

All transactions under the 2005 Stock Repurchase Program were at a price equal to the most recent quarterly independent appraisal of the shares of the Company's common stock.

The Company paid aggregate annual cash dividends in 2012, 2011 and 2010 of $5.00 million, $4.40 million and $4.02 million respectively, or $1.05 per share in 2012, $1.00 per share in 2011 and $0.91 per share in 2010.  In January 2013, the Company declared and paid a dividend of $1.10 per share totaling $5.21 million.  The decision to declare any such cash dividends in the future and the amount thereof rests within the discretion of the Board of Directors and will remain subject to, among other things, certain regulatory restrictions imposed on the payment of dividends by the Bank, and the future earnings, capital requirements and financial condition of the Company.
 
 
Page 36


Item 5.       Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities (Continued)

The following performance graph provides information regarding cumulative, five-year shareholder returns on an indexed basis of the Company's Common Stock compared to the NASDAQ Market Index and the Regional-Southwest Banks Index prepared by MORNINGSTAR of Chicago, IL. The latter index reflects the performance of thirty-one bank holding companies operating principally in the Midwest as selected by MORNINGSTAR. The indexes assume the investment of $100 on December 31, 2007 in Company Common Stock, the NASDAQ Index and the Regional-Southwest Banks Index, with all dividends reinvested.
 

 
Page 37

 
Item 5.      Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities (Continued)

The following table sets forth the Company’s equity compensation plan information as of December 31, 2012, all of which relates to stock options issued under stock option plans approved by stockholders of the Company:
 
Plan Category
 
Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
(a)
   
Weighted-average
exercise price of
outstanding options,
warrants and rights
(b)
   
Number of securities remaining
available for future issuance
under equity compensation
plans [excluding securities
relected in column (a)]
 (c)
 
Equity compensation plans approved by security holders
    17,985     $ 47.62       76,186  
Equity compensation plans not approved by security holders
     -        -        -  
Total
    17,985       47.62       76,186  
 
On July 26, 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”).  The authorization was previously set to expire on December 31, 2013.  In September 2012 the Company’s Board of Directors extended the expiration date of the 2005 Stock Repurchase Program to December 31, 2014.  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 following table sets forth information about the Company’s stock purchases pursuant to the 2005 Stock Repurchase Program for the quarter ended December 31, 2012:

Period in 2012
 
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
 
October 1 to October 31
    0     $ 69.00       318,073       431,927  
November 1 to November 30
    1,142       70.00       319,215       430,785  
December 1 to December 31
    8,850       70.00       328,065       421,935  
Total
    9,992     $ 70.00       328,065       421,935  
 
 
Page 38


Item 6.      Selected Financial Data

CONSOLIDATED FIVE-YEAR STATISTICAL SUMMARY

The following table sets forth certain of our financial and statistical information for each of the years in the five-year period ended December 31, 2012.  This data should be read in conjunction with the consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.

   
2012
   
2011
   
2010
   
2009
   
2008
 
                               
YEAR-END TOTALS (Amounts in Thousands)
                             
Total assets
  $ 2,099,720     $ 2,018,927     $ 1,931,283     $ 1,830,626     $ 1,780,793  
Investment securities
    234,244       222,095       216,603       214,098       214,559  
Loans held for sale
    28,256       24,615       10,390       7,976       8,490  
Loans, net
    1,697,002       1,661,916       1,561,430       1,503,981       1,469,840  
Deposits
    1,662,544       1,525,477       1,480,741       1,347,427       1,237,886  
Federal Home Loan Bank borrowings
    125,000       185,000       195,000       225,000       265,000  
Redeemable common stock
    30,715       27,826       24,945       22,900       23,815  
Stockholders' equity
    225,196       208,429       166,269       151,775       139,362  
                                         
EARNINGS (Amounts in Thousands)
                                       
Interest income
  $ 89,215     $ 93,350     $ 94,987     $ 96,195     $ 97,475  
Interest expense
    21,527       24,361       27,839       37,141       43,481  
Provision for loan losses
    (2,849 )     5,661       8,925       11,947       11,507  
Other income
    20,769       18,504       20,099       18,909       16,670  
Other expenses
    53,931       44,226       45,748       44,813       39,461  
Income taxes
    10,542       10,829       9,258       5,218       5,556  
Net income
    26,833       26,777       23,316       15,985       14,140  
                                         
PER SHARE
                                       
Net income:
                                       
Basic
  $ 5.69     $ 6.02     $ 5.29     $ 3.61     $ 3.16  
Diluted
    5.68       6.01       5.28       3.60       3.15  
Cash dividends
    1.05       1.00       0.91       0.91       0.91  
Book value as of December 31
    47.55       43.79       37.80       34.32       31.38  
Increase (decrease) in book value
                                       
due to:
                                       
ESOP obligation
    (6.48 )     (5.85 )     (5.67 )     (5.18 )     (5.36 )
Accumulated other comprehensive income
    0.84       1.04       0.63       0.95       0.82  
                                         
SELECTED RATIOS
                                       
Return on average assets
    1.30 %     1.36 %     1.25 %     0.88 %     0.83 %
Return on average equity
    12.38       14.96       14.61       11.01       10.42  
Net interest margin
    3.60       3.85       3.95       3.55       3.47  
Average stockholders' equity to average total assets
    10.51       9.09       8.57       7.99       7.98  
Dividend payout ratio
    18.63       16.42       17.26       25.28       28.90  

 
Page 39


Item 7.       Management's Discussion and Analysis of Financial Condition and Results of Operation

The following discussion by management is presented regarding the financial results for Hills Bancorporation (the “Company”) for the dates and periods indicated.  The discussion should be read in conjunction with the “Selected Consolidated Five-Year Statistical Summary” and the consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.

An overview of the year 2012 is presented following the section discussing a special note regarding forward looking statements.

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 electronic delivery channels.
 
 
Page 40


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

·
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.

·
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.

Overview

The Company is a bank holding company engaged, through its wholly-owned subsidiary bank, in the business of commercial banking.  The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”).  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.

The Company’s net income for 2012 was $26.83 million compared to $26.78 million in 2011.  Diluted earnings per share were $5.68 and $6.01 for the years ended December 31, 2012 and 2011, respectively.

The Bank’s net interest income is the largest component of the Bank’s revenue, and it is a function of the average earning assets and the net interest margin percentage.  Net interest margin is the ratio of net interest income to average earning assets.  For the year ended December 31, 2012, net interest income on a tax equivalent basis decreased by $1.29 million.  In 2012, the Bank achieved a net interest margin of 3.60% compared to 3.85% in 2011, which resulted in $5.73 million decrease in net interest income.  The remaining $4.44 million of increase in net interest income was attributable to growth of $89.55 million in the Bank’s average earning assets.

In anticipation of the continuing net interest margin compression in future years, the Bank deleveraged the balance sheet in an effort to benefit net interest margin and mitigate interest rate risk.  The Bank prepaid $60.00 million of Federal Home Loan Bank borrowings during the year ended December 31, 2012.  The Bank incurred a prepayment penalty of $5.93 million recorded as loss on extinguishment of debt.
 
 
Page 41


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

Highlights with respect to items on the Company’s balance sheet as of December 31, 2012 included the following:

·
Loans, net of allowance for loan losses and unamortized fees and costs totaling $1.725 billion.
·
Loan growth, net in 2012 of $38.73 million.
·
Deposit growth of $137.07 million in 2012.  Deposits increased to $1.663 billion and included $41.54 million of brokered deposits.
·
Short-term borrowings decreased $14.00 million.
·
Federal Home Loan Bank borrowings decreased $60.00 million.
·
Stockholders’ equity increased $16.77 million to $225.20 million in 2012, with dividends having been paid in 2012 of $5.00 million.

Reference is made to Note 13 of the Company’s consolidated financial statements for a discussion of fair value measurements which relate to methods used by the Company in recording assets and liabilities on its consolidated financial statements.

The return on average equity was 12.38% in 2012 compared to 14.96% in 2011.  The returns for the three previous years, 2010, 2009 and 2008, were 14.61%, 11.01% and 10.42%, respectively.  The Company remains well capitalized as of December 31, 2012 with total risk-based capital at 16.66% and Tier 1 risk-based capital at 15.41%.  The minimum regulatory guidelines are 8% and 4% respectively.  The Company paid a dividend per share of $1.05 in 2012, $1.00 in 2011 and $0.91 in the year ended December 31, 2010.

A detailed discussion of the financial position and results of operations follows this overview.

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 loss methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan loss 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 December 31, 2012 and 2011 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 42


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

Financial Position

Year End Amounts (Amounts In Thousands)
 
2012
   
2011
   
2010
   
2009
   
2008
 
                               
Total assets
  $ 2,099,720     $ 2,018,297     $ 1,931,283     $ 1,830,626     $ 1,780,793  
Investment securities
    234,244       222,095       216,603       214,098       214,559  
Loans held for sale
    28,256       24,615       10,390       7,976       8,490  
Loans, net
    1,697,002       1,661,916       1,561,430       1,503,981       1,469,840  
Deposits
    1,662,544       1,525,477       1,480,741       1,347,427       1,237,886  
Federal Home Loan Bank borrowings
    125,000       185,000       195,000       225,000       265,000  
Redeemable common stock
    30,715       27,826       24,945       22,900       23,815  
Stockholders' equity
    225,196       208,429       166,269       151,775       139,362  

Total assets at December 31, 2012 increased $81.42 million, or 4.03%, from the prior year-end.  Asset growth from 2010 to 2011 was $87.01 million and represented a 4.51% increase.  The largest growth in assets occurred in Net Loans, which increased $35.09 million and $100.49 million for the years ended December 31, 2012 and 2011, respectively.  Loans held for sale to the secondary market increased $3.64 million and $14.23 million for the years ended December 31, 2012 and 2011, respectively.  Loans held for investment represent the largest component of the Bank’s earning assets.  Loans held for investment were $1.722 billion and $1.692 billion at December 31, 2012 and 2011, respectively.

The local economy that generated increased demand for loans was a significant factor in the trend of increasing net loans in each of the last five years.  The trend of increasing net loans may not be indicative of future performance.

Loans secured by real estate represent the largest increase in loan growth.  These loans increased $5.90 million in 2012 and increased $93.14 million in 2011.  Loans secured by real estate include loans for one-to-four family residential properties, multi-family properties, agricultural real estate and commercial real estate.

On a net basis, the Company originated $34.05 million and $110.36 million in loans to customers for the years ended December 31, 2012 and 2011, respectively.  Net loan originations decreased 69.15% in 2012 compared to 2011.  The decrease in loan originations in 2012 as compared to 2011 is reflective of the overall economic conditions in the Company’s trade area.  The Company does not engage in significant participation activity and does not purchase participations from outside its established trade area.  It is the Company’s policy to purchase or sell participations related to existing customers or to participate in community development activity.  The Company had participations purchased of $10.44, $4.08 and $4.15 million as of December 31, 2012, 2011 and 2010, respectively.  The participations purchased were less than one percent of loans held for investment for each of the three years.
 
 
Page 43


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

The Company did not experience a material change in the composition of its loans held for investment in 2012 or 2011.  Residential real estate loans, including first and junior liens, were $687.85, $682.23 and $628.07 million as of December 31, 2012, 2011 and 2010, respectively.  The dollar total of residential real estate loans increased 0.83% in 2012 and 8.62% in 2011.  Residential real estate loans were 39.98% of the loan portfolio at December 31, 2011, 40.36% at December 31, 2011 and 39.51% at December 31, 2010.  Commercial real estate loans totaled $312.51 million at December 31, 2012, a 1.22% decrease over the December 31, 2011 total of $316.33 million.  Commercial real estate loans increased 4.74% in 2011.  Commercial real estate loans totaled $302.02 million at December 31, 2010.  Commercial real estate loans represented 18.15%, 18.69% and 18.99% of the Company’s loan portfolio as of December 31, 2012, 2011 and 2010, respectively. The Company monitors its commercial real estate level so that it does not have a concentration in that category that exceeds 300% of its capital.  Commercial real estate loan concentration was 125.27% of Tier 1 capital as of December 31, 2012.

Commercial real estate building permit information for 2012 was not available at the time of this report for Johnson County or Linn County. While there has been weakness in the national commercial real estate markets, the Company has not experienced the high level of stress or deterioration in its commercial real estate portfolio that has occurred in some other markets.

The following tables present residential real estate trends in the United States, Midwest, Iowa and the two largest counties in the Company’s trade area.
 
1 to 4 Family Residential Real Estate Sales Statistics
($ values in Thousands)
 
   
2012
   
2011
   
2010
 
                   
United States
                 
- Number of Sales
    4,650,000       4,260,000       4,908,000  
- Average Sales Price
  $ 225,100     $ 214,000     $ 220,000  
                         
Midwest
                       
- Number of Sales
    1,070,000       910,000       1,076,000  
- Average Sales Price
  $ 174,000     $ 166,900     $ 172,500  
                         
Iowa
                       
- Number of Sales
    62,160       55,500       56,300  
- Average Sales Price
  $ 149,950     $ 135,500     $ 140,589  
                         
Johnson County, Iowa
                       
- Number of Sales
    2,640       2,291       2,227  
- Average Sales Price
  $ 185,807     $ 199,513     $ 177,636  
                         
Linn County, Iowa
                       
- Number of Sales
    3,993       3,666       3,867  
- Average Sales Price
  $ 158,560     $ 145,663     $ 155,056  
 
 
Page 44


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)
 
1 to 4 Family Residential Real Estate Building Permits
($ values in Thousands)
 
   
2012
   
2011
   
2010
 
                   
United States
                 
- Number of Permits
    538,920       434,258       456,530  
- Total Value of Permits
  $ 113,096,062     $ 87,805,676     $ 88,986,665  
                         
Midwest
                       
- Number of Permits
    92,317       74,668       79,678  
- Total Value of Permits
  $ 18,887,401     $ 14,636,252     $ 14,780,234  
                         
Iowa
                       
- Number of Permits
    7,672       6,006       6,257  
- Total Value of Permits
  $ 1,450,376     $ 1,135,169     $ 1,089,404  
                         
Johnson County, Iowa
                       
- Number of Permits
    559       414       391  
- Total Value of Permits
  $ 123,913     $ 87,661     $ 83,021  
                         
Linn County, Iowa
                       
- Number of Permits
    624       571       680  
- Total Value of Permits
  $ 73,859     $ 67,704     $ 73,742  
 
Multi-Family Residential Real Estate Building Permits
($ values in Thousands)
 
   
2012
   
2011
   
2010
 
                   
United States
                 
- Number of Permits
    276,592       176,449       130,628  
- Total Value of Permits
  $ 26,177,446     $ 15,831,053     $ 12,020,951  
                         
Midwest
                       
- Number of Permits
    38,300       26,366       20,740  
- Total Value of Permits
  $ 3,399,318     $ 2,051,920     $ 1,876,063  
                         
Iowa
                       
- Number of Permits
    2,320       1,520       1,055  
- Total Value of Permits
  $ 256,361     $ 128,870     $ 101,127  
                         
Johnson County, Iowa
                       
- Number of Permits
    14       12       6  
- Total Value of Permits
  $ 24,774     $ 25,223     $ 10,935  
                         
Linn County, Iowa
                       
- Number of Permits
    4       2       2  
- Total Value of Permits
  $ 667     $ 801     $ 606  
 
 
Page 45


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

The sales and building permit trends in the Company’s trade area have followed similar patterns as national, regional and state trends.  Decreases in housing prices have been less severe in the Company’s trade area as average sales prices have decreased less than national averages.  In addition, average sales prices have been affected by flood-related sales (especially in Linn County, Iowa) and several flood-related housing programs in both Linn and Johnson County.  The increased level of building permits is reflective of the overall activity in the Company’s trade area.

The overall economy in the Company’s trade area, Johnson, Linn and Washington Counties, remains in stable condition with levels of unemployment that remain below national and state levels.  The following table shows unemployment as of December 31, 2012, 2011 and 2010 and median income information as of December 31, 2011, 2010 and 2009, as December 31, 2012 information is not available as of the date of this report:

   
Unemployment Rate %
   
Median Income
 
                                     
   
2012
   
2011
   
2010
   
2011
   
2010
   
2009
 
United States
    7.8 %     8.5 %     9.4 %   $ 50,502     $ 50,046     $ 50,221  
State of Iowa
    4.9 %     5.6 %     6.3 %     49,545       48,031       48,065  
Johnson County
    3.6 %     4.2 %     4.3 %     53,570       51,014       48,955  
Linn County
    5.3 %     6.0 %     6.0 %     55,772       54,806       53,700  
Washington County
    4.1 %     4.9 %     4.9 %     50,559       47,118       49,760  

It is uncertain how the Company’s trade area and Iowa’s economy will recover from the national economic recession.  Competition for quality loans and deposits will continue to be a challenge.  In Johnson and Linn Counties, new banks and credit unions have been opened in the last few years.  Between 2007 and 2012, six new banking locations were added in Johnson County and one was added in Linn County.  The increased competition for both loans and deposits could result in a lower interest rate margin that could result in lower net interest income if the volume of loans and deposits does not increase to offset any such reduction in the interest margin.
 
 
Page 46


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

Total deposits increased by $137.07 million in 2012 of which $9.42 million was from brokered deposits.  Short-term borrowings, which include federal funds purchased and securities sold under agreements to repurchase, decreased from $52.79 million to $38.78 million.  Federal funds purchased decreased $12.41 million and repurchase agreements decreased $1.60 million.  FHLB borrowings decreased from $185.00 million to $125.00 million.  Deposits increased by $44.74 million in 2011.  As of June 30, 2012 (latest data available), Johnson County total deposits were $3.751 billion and the Company’s deposits were $1.116 billion, which represent a 29.7% market share.  The Company had nine office locations in Johnson County as of June 30, 2012.  The total banking locations in Johnson County was 57 as of June 30, 2012.  At June 30, 2011, the Company’s deposits were $1.010 billion or a 31.3% market share.  At $5.195 billion as of June 30, 2012, the Linn County deposit market is significantly larger than the Johnson County deposit market of $3.751 billion.  As of June 30, 2012, Linn County had 107 total banking locations.  The six Linn County offices of the Company had deposits of $344.53 million or a 6.6% share of the market.  The Company’s Linn County deposits at June 30, 2011 were $330.55 million and represented a 7.0% market share.  As of June 30, 2012, the Company’s two Washington County offices had deposits of $103.79 million which was 19.9% of the County’s total deposits of $521.27 million.  Washington County had a total of 13 banking locations as of June 30, 2012.  In 2011, the Company’s Washington County deposits were $96.52 million or an 18.8% market share.

Investment securities increased $14.82 million in 2012. In 2011, investment securities increased by $5.87 million.  The investment portfolio consists of $226.18 million of securities that are stated at fair value, with any unrealized gain or loss, net of income taxes, reported as a separate component of stockholders’ equity.  The securities portfolio, which includes tax exempt securities, is used for liquidity and pledging purposes and to provide a rate of return that is acceptable to management.  See Note 2 to the Company’s Consolidated Financial Statements.

During 2012, the major funding source for the growth in loans was the $137.07 million increase in deposits. In 2011, the major sources of funding for the growth in loans were deposit growth of $44.74 million and $25.83 million received from the stock issuance.  Brokered deposits totaled $41.54 million and $32.12 million as of December 31, 2012 and 2011, respectively.  Total advances from the FHLB were $125.00 million and $185.00 million at December 31, 2012 and 2011, respectively.  It is expected that the FHLB funding source and brokered deposits funding will be considered in the future if loan growth exceeds deposit increases and the interest rates on funds borrowed from the FHLB and interest rates on brokered deposits are favorable compared to other funding alternatives.

Stockholders’ equity was $225.20 million at December 31, 2012 compared to $208.43 million at December 31, 2011.  The Company’s capital resources are discussed in detail in the Liquidity and Capital Resources section.  Over the last five years, the Company has realized cumulative earnings of $107.05 million and paid shareholders dividends of $21.55 million, or 20.13% of earnings, while still maintaining capital ratios in excess of regulatory requirements.
 
 
Page 47

 
Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

Net Income Overview

Net income and diluted earnings per share for the last five years are as presented below:
 
Year
 
Net Income
   
% Increase (Decrease)
   
Earnings Per
Share - Diluted
 
   
(In Thousands)
             
2012
  $ 26,833       0.21 %   $ 5.68  
2011
    26,777       14.84       6.01  
2010
    23,316       45.86       5.28  
2009
    15,985       13.05       3.60  
2008
    14,140       (12.41 )     3.15  

Net income for 2012 increased by $0.06 million or 0.21% and diluted earnings per share decreased by 5.49%.  The decrease in net interest margin of 25 basis points accounted for a decrease of $5.73 million in net interest income. The growth in earning assets increased net interest income by $4.44 million. Other income increased by $2.27 million, the provision for loan losses decreased by $8.51 million and total expenses increased by $9.71 million.

Annual fluctuations in the Company's net income continue to be driven primarily by three generally recurring important factors. The first important factor is net interest margin. Net interest income of $67.69 million in 2012 was derived from the Company's $1.950 billion of average earning assets and its net interest margin of 3.60%, compared to $1.860 billion of average earning assets and a 3.85% net interest margin in 2011. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of 10 basis points to 3.50% would result in a $1.95 million decrease in income before taxes.  Similarly, an increase in the net interest margin of 10 basis points to 3.70% would increase income before taxes by $1.95 million.  Net interest margin decreased in 2011 to 3.85% from 3.95% in 2010.
 
The second significant factor affecting the Company's net income is the provision for loan losses. The majority of the Company's interest-earning assets are in loans outstanding, which amounted to $1.750 billion at the end of 2012. The Company’s allowance for loan losses was $25.16 million at December 31, 2012.  The allowance in 2012 decreased in comparison to 2011 due to loan growth of $36.74 million, a decrease in net charge-offs of $2.14 million and a decreased provision for loan losses of $8.51 million.  The loan loss provision, which is the amount necessary to adjust the allowance to the level considered appropriate by management, totaled a $2.85 million reduction of expense for 2012 and a $5.66 million and $8.93 million of expense for 2011 and 2010, respectively. (See Note 3 to the Consolidated Financial Statements.)  A detailed discussion is included in the Provision for Loan Losses section below.

The amount of mortgage loans sold on the secondary market and the resulting gain or loss is the third factor that can cause fluctuations in net income. Loans originated in 2012 totaled $328.58 million compared to $187.54 million in 2011 and $264.19 million in 2010, an increase of 75.21% from 2011 and an increase of 24.37% from 2010.  For the years ended December 31, 2012, 2011 and 2010, the net gain on sale of loans was $3.55, $1.99 and $3.60 million, respectively.  The sale of loans is influenced by the real estate market and interest rates.  The average interest rate for a 30 year fixed rate loan during the year ended December 31, 2012 was 3.53%.  The average interest rate for the same type of loan was 4.44% for the year ended December 31, 2011.  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.  During the years ended December 31, 2012 and 2011, secondary market rates were favorable resulting in substantial volume of loans sold.  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.  The Company cannot predict the extent to which any future discontinuation of purchases of agency-guaranteed mortgage-backed securities by the Federal Reserve may result in secondary market rates becoming less favorable and a reduction in secondary market activity involving mortgage loans.
 
 
Page 48


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

In addition, the Bank prepaid $60.00 million of Federal Home Loan Bank borrowings during the year ended December 31, 2012 as part of a strategy to utilize the Bank’s liquidity, improve net interest margin and decrease interest rate risk in the future.  As a result, the Bank incurred a one-time prepayment penalty of $5.93 million, which it recorded as loss on extinguishment of debt.  The one-time prepayment had a significant impact on the Company net income for the fiscal year.

Net income for 2011 was $26.78 million, or diluted earnings per share of $6.01.  For 2011, diluted earnings per share increased by $0.73 per share compared to 2010. Net interest income increased $1.84 million for the year ended December 31, 2011 compared to 2010.  This increase in net interest income was due to an increase in average earning assets of $106.23 million in 2011.  Noninterest income decreased 7.94% in 2011 to $18.50 million.  Noninterest expense decreased from $45.75 million in 2010 to $44.23 million in 2011, or 3.32%.

Net Interest Income

Net interest income is the excess of the interest and fees received on interest-earning 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 volume of average earning assets has continued to grow each year, primarily due to new loans.  The net interest margin decreased in 2012 to 3.60% and this compares to 3.85% in 2011, 3.95% in 2010, 3.55% in 2009 and 3.47% in 2008.  The measure is shown on a tax-equivalent basis using a rate of 35% to make the interest earned on taxable and nontaxable assets more comparable.

Net interest income on a tax-equivalent basis changed in 2012 as follows:

   
Change In
   
Change In
   
Increase (Decrease)
 
   
Average
   
Average
   
Volume
   
Rate
   
Net
 
   
Balance
   
Rate
   
Changes
   
Changes
   
Change
 
   
(Amounts In Thousands)
 
Interest income:
                             
Loans, net
  $ 63,798       (0.41 )  %   $ 3,443     $ (6,644 )   $ (3,201 )
Taxable securities
    (6,341 )     (0.73 )     (164 )     (736 )     (900 )
Nontaxable securities
    7,087       (0.36 )     339       (422 )     (83 )
Interest-bearing cash and cash equivalents
    25,045       -       63       1       64  
Federal funds sold
    (39 )     (0.01 )     -       -       -  
    $ 89,550             $ 3,681     $ (7,801 )   $ (4,120 )
Interest expense:
                                       
Interest-bearing demand deposits
  $ 47,165       (0.05 )  %   $ (125 )   $ 148     $ 23  
Savings deposits
    24,348       (0.07 )     (60 )     289       229  
Time deposits
    (19,016 )     (0.27 )     387       1,626       2,013  
Short-term borrowings
    (5,199 )     (0.25 )     18       131       149  
FHLB borrowings
    (13,143 )     0.07       541       (129 )     412  
Interest-bearing other liabilities
    (62 )     (0.25 )     1       7       8  
    $ 34,093             $ 762     $ 2,072     $ 2,834  
Change in net interest income
                  $ 4,443     $ (5,729 )   $ (1,286 )

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.  Interest on nontaxable securities and loans is shown at tax equivalent amounts.
 
 
Page 49

 
Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

Net interest income on a tax equivalent basis changes for 2011 were as follows:

   
Change In
   
Change In
   
Increase (Decrease)
 
   
Average
   
Average
   
Volume
   
Rate
   
Net
 
   
Balance
   
Rate
   
Changes
   
Changes
   
Change
 
   
(Amounts In Thousands)
 
Interest income:
                             
Loans, net
  $ 94,500       (0.39 ) %   $ 5,384     $ (6,224 )   $ (840 )
Taxable securities
    510       (0.56 )     20       (603 )     (583 )
Nontaxable securities
    12,168       (0.34 )     624       (382 )     242  
Interest-bearing cash and cash equivalents
    (528 )     (0.01 )     (1 )     (3 )     (4 )
Federal funds sold
    (416 )     0.06       -       -       -  
    $ 106,234             $ 6,027     $ (7,212 )   $ (1,185 )
Interest expense:
                                       
Interest-bearing demand deposits
  $ 38,680       (0.19 ) %   $ (173 )   $ 512     $ 339  
Savings deposits
    26,233       (0.25 )     (138 )     992       854  
Time deposits
    (4,427 )     (0.30 )     112       1,907       2,019  
Short-term borrowings
    4,721       (0.36 )     (49 )     172       123  
FHLB borrowings
    (7,608 )     0.05       317       (196 )     121  
Interest-bearing other liabilities
    251       (1.02 )     (7 )     29       22  
    $ 57,850             $ 62     $ 3,416     $ 3,478  
Change in net interest income
                  $ 6,089     $ (3,796 )   $ 2,293  

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

(Tax Equivalent Basis)
 
2012
   
2011
   
2010
 
                   
Yield on average interest-earning assets
    4.69 %     5.15 %     5.53 %
Rate on average interest-bearing liabilities
    1.36       1.57       1.87  
Net interest spread
    3.33       3.58       3.66  
Effect of noninterest-bearing funds
    0.27       0.27       0.29  
Net interest margin (tax equivalent interest income divided by average interest-earning assets)
    3.60 %     3.85 %     3.95 %

The net interest margin decreased 25 basis points in 2012 and decreased 10 basis points in 2011.  The net interest spread decreased 25 basis points in 2012 and decreased 8 basis points in 2011.  The decrease in the net interest margin and net interest spread in 2012 are the result of continued low interest rates.  The Company was not able to reprice some assets (particularly loans) more quickly than some liabilities repriced resulting in decreased net interest margin and spread.

During 2012, the Federal Open Market Committee maintained the target rate at 0.25%.  The target rate has remained at 0.25% since December 2008.  Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally correlate to the Federal Reserve Board federal funds rate.  In pricing of loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates.  As of December 31, 2012, the average rate indexes for the one, three and five year indexes were 0.15%, 0.38% and 0.76%, respectively.  The one year index increased 25.00% from December 31, 2011, the three year index decreased 5.00% and the five year index decreased 15.56%.  During 2012 and 2011, the average federal funds rate remained the same at 0.25%.
 
 
Page 50


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

Provision for Loan Losses

The provision for loan losses totaled a reduction in expense of $2.85 million in 2012 and an expense of $5.66 million and $8.93 million for 2011 and 2010, respectively.  Loan charge-offs net of recoveries were $2.14 million in 2012, $4.74 million in 2011 and $8.86 million in 2010.  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 reduction in 2012 is the result of a decrease in the historical loss rates used in the allowance for loan losses calculation as well as improvements in asset quality.

The allowance for loan losses decreased $4.99 million in 2012.  For 2012, there was a decrease of $0.91 million due to the volume increase in pass rated loans outstanding of $56.19 million as well as the composition of new loans added in 2012.  There was an additional decrease of $4.08 million in the amount allocated to the allowance due to a combination of improvement in credit quality and losses recognized.

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 nonaccrual 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 payment 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 we determine that 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 Bank regularly reviews loans in the portfolio and assesses whether the loans are impaired in accordance with ASC 310-10-35, Accounting by Creditors for Impairment of a Loan (formerly FAS 114).  If the loans are impaired, the Bank determines if a specific allowance is appropriate.  In addition, the Bank'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 Bank allocates a percentage, as determined by management, for a required allowance needed.  The determination concerning 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 TDR loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.

 
Page 51


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

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 may recognize a charge off related to an impaired loan when loan balances exceed net present value of cash flows or collateral.

The Company has had very few experiences of repurchasing loans previously sold into the secondary market.  No specific repurchase reserve was considered necessary based on the Company’s historical experience with repurchase activity.

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 TDR 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 December 31, 2012, 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 peers. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.

Other factors that are considered in determining the credit quality of the Company’s loan portfolio are the vacancy rates for both residential and commercial and retail space, current equity the borrower has in the property and overall financial strength of the customer including cash flow to continue to fund loan payments.  The Company also considers the state of the total economy including unemployment levels, vacancy rates of rental units and demand for commercial and retail space.  In most instances, the borrowers have used in their rental projections of income at least a 10% vacancy rate.  As of December 31, 2012, the unemployment levels in Johnson County and Linn County were 3.6% and 5.3%, respectively, compared to 4.2% and 6.0% in December of 2011.  These levels compare favorably to the State of Iowa at 4.9% and the national unemployment level at 7.8% in December 2012 compared to 5.6% and 8.5%, respectively in December 2011.

The residential rental vacancy rates in 2012 in Johnson County, the largest trade area for the Company, were estimated at 3.2% in Iowa City, Coralville and North Liberty and 2.1% in the Cedar Rapids area. The estimated vacancy rates for Iowa City, Coralville and North Liberty was 3.2% and 5.0% in the Cedar Rapids area one year ago.  The State of Iowa vacancy rate is 5.5% and the national rate is 8.7% with the Midwest rate at 9.3%.  These vacancy rates one year ago were 7.0%, 9.4% and 9.7%, respectively.  The Company continues to consider those vacancy rates among other factors in its current evaluation of the real estate portion of its loan portfolio.   Due to the unstable national economic conditions, favorable vacancy rates may not continue in 2013.  Vacancy rates may rise and affect the overall quality of the loan portfolio.

The allowance for loan losses balance is also affected by the charge-offs and recoveries for the periods presented.  For the years ended December 31, 2012, 2011 and 2010, recoveries were $2.89 million, $2.39 million and $2.34 million, respectively; charge-offs were $5.03 million, $7.13 million and $11.19 million in 2012, 2011 and 2010, respectively.

 
Page 52


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

Overall credit quality may deteriorate in 2013.  Such deterioration could cause increases in impaired loans, allowance for loan losses provision expense and net charge-offs.  Management will monitor changing market conditions as a part of its allowance for loan loss methodology.

The allowance for loan losses totaled $26.15 million at December 31, 2012 compared to $30.15 million at December 31, 2011.  The percentage of the allowance to outstanding loans was 1.46% and 1.78% at December 31, 2012 and 2011, respectively.  The percentage decrease was due to loan growth, fewer substandard loans and a decrease in charge-offs.  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 Net Loans outstanding. The Company’s methodology for determining the allowance for loan losses was refined in the third quarter of 2010 to revise and update historical loss percentages applied to loan categories under ASC 450-20.  The refined methodology did not result in a materially different determination of the allowance for loan losses.

Impaired loans increased by $1.28 million from December 31, 2011 to December 31, 2012.  Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans.  Impaired loans also include loans that, based on management’s evaluation of current information and events, the Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement.  The increase in impaired loans is due to an increase in TDR loans of $1.54 million from December 31, 2011 to December 31, 2012 as the result of 16 additional restructured loans.  Most of the impaired loans are secured by real estate and are believed to be adequately collateralized.

The ratio of the allowance for loan losses to impaired loans was 84.55% and 105.87% at December 31, 2012, and 2011, respectively.  This ratio is monitored as a part of the Company’s loan loss methodology.  Charge-offs in 2012 improved due to the stable economic conditions.

The ratio of impaired loans to total gross loans was 1.73% and 1.68% at December 31, 2012 and 2011, respectively. The increase in the 2012 ratio is due to the increase in TDR loans. See discussion of TDR loans in Item 1.  In certain circumstances, 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 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 otherwise would not be considered.  TDR loans accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles.  The Bank’s TDR loans occur on a case-by-case basis in connection with ongoing loan collection processes.

For loans that are collateral dependent, losses are evaluated based on the portion of a loan that exceeds the fair market value of the collateral that can be identified as uncollectible.  In general, this is the amount that the carrying value of the loan exceeds the related appraised value less estimated selling costs.  Generally, it is the Company’s policy not to rely on appraisals that are older than one year prior to the date the impairment is being measured.  The most recent appraisal values may be adjusted if, in the Company’s judgment, experience and other market data indicate that the property’s value, use, condition, exit market or other variable affecting its value may have changed since the appraisal was performed, consistent with the December 2006 joint interagency guidance on the allowance for loan losses.  The charge off or loss adjustment supported by an appraisal is considered the minimum charge off.  Any adjustments made to the appraised value are to provide additional charge off or loss allocations based on the applicable facts and circumstances.  In instances where there is an estimated decline in value, a loss allocation may be provided or a charge off taken pending confirmation of the amount of the loss from an updated appraisal.  Upon receipt of the new appraisals, an additional loss allocation may be provided or charge off taken based on the appraised value of the collateral.  On average, appraisals are obtained within one month of order.
 
 
Page 53


Item 7.       Management's Discussion and Analysis of Financial Condition and Results of Operation (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.

Noninterest Income

The following table sets forth the various categories of noninterest income for the year ended December 31, 2012 and 2011.

   
Year Ended December 31,
   
$ Change
   
% Change
 
   
2012
   
2011
   
2010
      2012/2011       2011/2010       2012/2011       2011/2010  
   
(Amounts in thousands)
                                 
                                                   
Net gain on sale of loans
  $ 3,549     $ 1,986     $ 3,602     $ 1,563     $ (1,616 )     78.70 %     (44.86 ) %
Trust fees
    4,616       4,349       4,026       267       323       6.14       8.02  
Service charges and fees
    7,815       7,579       7,971       236       (392 )     3.11       (4.92 )
Rental revenue on tax credit real estate
    1,587       1,470       1,672       117       (202 )     7.96       (12.08 )
Net gain on sale of other real estate owned and other reposessed assets
    782       653       -       129       653       19.75       100.00  
Other noninterest income
    2,420       2,467       2,828       (47 )     (361 )     (1.91 )     (12.77 )
    $ 20,769     $ 18,504     $ 20,099     $ 2,265     $ (1,595 )                

The noninterest income of the Company was $20.77 million in 2012 compared to $18.50 million in 2011.  The increase of $2.27 million in 2012 was the result of a combination of factors discussed below.  In 2011, the total other income decreased $1.60 million from 2010.

The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly.  The gain was $3.55 million in 2012, $1.99 million in 2011 and $3.60 million in 2010.  The dollar volume of loans sold in 2012 was approximately 175.21% of the volume in 2011 and 124.37% of the activity experienced in 2010.  The volume of activity in these types of loans is directly related to the level of interest rates and the number of new home sales and refinancings. 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.

Trust fees increased $0.27 million to $4.62 million in 2012.  Trust fees increased $0.32 million in 2011.  As of December 31, 2012, the Bank’s Trust Department had $1.121 billion in assets under management compared to $1.025 billion and $979.52 million at December 31, 2011 and 2010, respectively.  Trust fees are based on total assets under management.  The trust assets that are the most volatile are those that are held in common stocks, which amount to approximately 48.8% of assets under management.  In 2012, the Dow Jones Industrial Average increased 7.26%.  The market value of the Dow Jones Industrial Average increased over 5.53% in 2011 and increased over 11.03% in 2010.

The net gain on sale of other real estate owned and other repossessed assets increased $0.13 million to $0.78 million for the year ended December 31, 2012. The total net gain on sale of other real estate owned consisted of a $0.16 million fair market value loss adjustment on 8 properties within other real estate owned and a $0.94 million net gain on sale of 27 properties for a net gain of $0.78 million.  During the same period in 2011, the loss consisted of a $0.20 million fair market value loss adjustment on 13 such properties, a $0.85 million net gain on sale of 39 such properties for a net gain of $0.65 million.  The net gain on sale of other real estate owned increased in 2012 due to the value of such sales coupled with fair value adjustments.

 
Page 54


Item 7.       Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the year ended December 31, 2012 and 2011.

   
Year Ended December 31,
   
$ Change
   
% Change
 
   
2012
   
2011
   
2010
      2012/2011       2011/2010       2012/2011       2011/2010  
   
(Amounts in thousands)
                                 
                                                   
Salaries and employee benefits
  $ 23,793     $ 22,749     $ 22,480     $ 1,044     $ 269       4.59 %     1.20 %
Occupancy
    3,332       3,190       3,163       142       27       4.45       0.85  
Furniture and equipment
    4,573       3,618       4,100       955       (482 )     26.40       (11.76 )
Office supplies and postage
    1,481       1,302       1,368       179       (66 )     13.75       (4.82 )
Advertising and business development
    2,721       2,173       2,058       548       115       25.22       5.59  
Outside services
    6,712       6,656       6,506       56       150       0.84       2.31  
Rental expenses on tax credit real estate
    2,548       1,719       2,517       829       (798 )     48.23       (31.70 )
FDIC insurance assessment
    1,036       1,283       2,074       (247 )     (791 )     (19.25 )     (38.14 )
Loss on extinguishment of debt - Federal Home Loan Bank borrowings
    5,925       -       -       5,925       -       100.00       -  
Net loss on sale of other real estate owned and other repossessed assets
    -       -       6       -       (6 )     -       (100.00 )
Other noninterest expense
    1,810       1,536       1,476       274       60       17.84       4.07  
    $ 53,931     $ 44,226     $ 45,748     $ 9,705     $ (1,522 )                

Total noninterest expenses were $53.93 and $44.23 million for the years ended December 31, 2012 and 2011, respectively. The increase is $9.71 million or 21.94% in 2012 and a decrease of $1.52 million or 3.33% in 2011.

Salaries and employee benefits, the largest component of noninterest expense, increased $1.04 million in 2012, a 4.59% change.  A component of salaries and employee benefits expense is compensation expense related to the officers’ deferred compensation plan and costs associated with restricted common stock awarded to various officers which increased $0.12 million in 2012.  This increase is primarily the result of the change in the appraised value of the Company’s common stock.  As a result of the Company’s program to repurchase up to a total of 750,000 shares of the Company’s common stock, the Company obtains a quarterly independent appraisal of the shares of stock.  The appraised value of the Company’s stock was $70.00 as of December 31, 2012 and $64.00 as of December 31, 2011. Another component of salaries and employee benefits expense is profit sharing plan expense which totaled $1.51 million in 2012.  This expense increased $0.04 million, or 2.60%, from 2011 and includes the Company’s contribution to its ESOP plan.  (See Note 9 to the Consolidated Financial Statements).  The increase is primarily the result of the discretionary contribution that was 9.00% of eligible employee salaries for the years ended December 31, 2012 and 2011.  Salaries and employee benefits expenses increased by $0.76 million in direct salary expense resulting from annual salary adjustments and an increase in accrued real estate lender incentives due to volume and activity.

Furniture and equipment expenses increased $0.96 million in 2012 partially due to the addition of a three new bank branches during 2012.  An additional component of the increase is maintenance contract expense, which increased $0.35 million during the year ended December 31, 2012 as compared to the same period in 2011.

Advertising and business development expense increased $0.55 million from 2011 to 2012. Factors in this increase include the addition of a debit card usage reward program in 2012 which generated of $0.36 million in expenses and an increase in bank provided customer seminars resulting in $0.04 in additional expense.

 
Page 55


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

Noninterest Expenses (Continued)

Outside services expense increased $0.06 million for the year ended December 31, 2012 compared to the same period in 2011.  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. Debit card processing expenses increased $0.09 million due to an increase in the volume of transactions in 2012 compared to 2011.

Rental expenses on tax credit real estate increased $0.83 million in 2012.  The increase is the result of an increase in operating expenses of the tax credit real estate in which the company invests.

FDIC insurance assessment expense was $1.04 million for the year ended December 31, 2012.  This is a decrease of $0.25 million when compared to the same period in 2011.  The decrease in FDIC insurance premium expense is due to the change in the premium calculation base by the FDIC.  At December 31, 2012, the Company had recorded prepaid FDIC insurance of $2.96 million which represents the FDIC premiums paid by the Bank on December 30, 2009 for the years of 2010, 2011 and 2012.  The prepaid FDIC insurance is being amortized on a quarterly basis as premiums are assessed.  The balance remaining in prepaid FDIC insurance at June 30, 2013 after all 2012 assessments have been paid will be refunded to the Company.

In an effort to utilize the Bank’s liquidity, improve net interest margin and decrease interest rate risk in the future the Bank prepaid $60.00 million of Federal Home Loan Bank borrowings during the year ended December 31, 2012.  The Bank incurred a prepayment penalty of $5.93 million recorded as loss on extinguishment of debt.

Other noninterest expense was $1.81 million for the year ended December 31, 2012, an increase of $0.27 million over the same period in 2011.  Other noninterest expense includes fraud losses related to customer credit and debit cards, ATM activity and customer deposit accounts.  This expense increased $0.48 million in 2012 due to increased incidents of unauthorized use of customer credit and debit cards.

Total noninterest expenses were $45.75 million for the year ended December 31, 2010.  The decrease in expenses in 2011 was $1.52 million.  This included an increase of $0.267 million in salaries and benefits, which was the direct result of salary adjustments and restricted stock awards increases due to the increase in the appraised value of the Company stock. Occupancy expense increased $0.27 million due mainly to increases in property tax, depreciation expense and janitorial expense.  Furniture and equipment expense decreased $0.48 million in 2011 when compared to 2010 as a result of the costs related to equipment and software maintenance contracts.  In addition, there was an increase in outside services of $0.15 million.  Outside services include professional fees, courier services and ATM fees.  Attorneys’ fees decreased $0.17 million due to the Company utilizing in-house counsel for credit-related matters.  Credit card, debit card and merchant card processing expenses, along with data processing expenses, increased $0.12 million due to the volume of transactions.  FDIC insurance expense decreased $0.79 million in 2011 due to the change in the premium calculation base.

Income Taxes

Income tax expense was $10.54, $10.83 and $9.26 million for the years ended December 31, 2012, 2011 and 2010, respectively.  Income taxes as a percentage of income before income taxes were 28.21% in 2012, 28.80% in 2011 and 28.42% in 2010.  The amount of tax credits were $1.99, $1.99 and $1.91 million for 2012, 2011 and 2010, respectively.  In 2010, the Company invested in a seventh tax credit property.  Credits related to this new property are approximately $3.0 million and are expected to be recognized over a ten year period starting in 2010.
 
 
Page 56


Item 7.       Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

Impact of Recently Adopted and Issued Accounting Standards and Legislative Developments

Recently Adopted Accounting Standards

In April 2011, the FASB issued new standards that revised the determination of when the restructuring of a receivable should be considered a troubled debt restructuring (“TDR”).  The standard provides additional guidance for determining whether the debtor is experiencing financial difficulty.  The new standard became effective for the Company beginning July 1, 2011.  The adoption did not have a material impact on the Company’s financial position.

Also in April 2011, the FASB issued a new standard that changes the assessment of effective control of a transferor when determining whether repurchase agreements are accounted for as a secured borrowing or sale.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.

In May 2011, the FASB issued a new standard that provides guidance about how fair value should be determined where it already is required or permitted under international financial reporting standards (“IFRS”) or accounting principles generally accepted in the United States (“GAAP”).  For GAAP, most of the changes were clarifications of existing guidance or wording changes to align with IFRS.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.  The Company added additional disclosure requirements to Note 13: Fair Value Measurements.

In September 2011, the FASB issued a new standard that permits the Company to make a qualitative assessment of whether it is more likely than not that the fair value of the portion of the Company to which goodwill relates is less than its carrying amount before applying the two-step goodwill impairment test.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.

In June 2011 and December 2011, the FASB issued standards regarding the presentation of comprehensive income in the consolidated financial statements.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.  The Company now presents comprehensive income in a separate statement of comprehensive income.

Recently Issued Accounting Standards

In July 2012, the FASB issued a new standard which permits an entity to make a qualitative assessment to determine whether it is more likely than not that an indefinite-lived intangible asset, other than goodwill, is impaired.  This accounting standard was subsequently codified into ASC Topic 350.  Under the new standard, if an entity concludes, based on an evaluation of all relevant qualitative factors, that it is not more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount, it will not be required to perform the quantitative impairment test for that asset.  The standard is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted.  The adoption of this standard is not expected to have a material impact on the consolidated financial statements.

 
Page 57


Item 7.       Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

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 1930s.  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.

Effects of Inflation

The consolidated financial statements and the accompanying notes have been prepared in accordance with accounting principles generally accepted in the United States of America.  These principles require the measurement of financial position and operating results in terms of historical dollar amounts without considering the changes in the relative purchasing power of money over time due to inflation.  The impact of inflation is reflected in the increased cost of the Company’s operations.  Unlike industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature.  As a result, interest rates have a more significant impact in the Company’s performance than do the effects of general levels of inflation.  Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services.  In the current economic environment, liquidity and interest rate adjustments are features of the Company’s asset/liability management, which are important to the maintenance of acceptable performance levels.  Item 7A of this Form 10-K contains a more thorough discussion of interest rate risk.  The Company attempts to maintain a balance between monetary assets and monetary liabilities, over time, to offset the potential effects of changing interest rates.

Liquidity and Capital Resources

On an unconsolidated basis, the Company had cash balances of $3.37 million as of December 31, 2012.  In 2012, the Company received dividends of $7.00 million from its subsidiary Bank and used those funds to pay dividends to its stockholders of $5.00 million and to fund purchases of treasury stock under the 2005 Stock Repurchase Program.  The total purchase of treasury stock under the 2005 Stock Repurchase Program totaled $2.44 and $4.11 million for the years ended December 31, 2012 and 2011, respectively.

The Company 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.  The Company sold during 2011 an additional 412,660 shares of the Company’s common stock for $63.00 per share, bolstering capital by $25.83 million after expenses.

The ability of the Company to pay dividends to its shareholders is dependent upon the earnings and capital adequacy of its subsidiary Bank, which affects the Bank’s dividends to the Company.  The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends.  In order to maintain acceptable capital ratios in the subsidiary Bank, certain of its retained earnings are not available for the payment of dividends. Retained earnings available for the payment of dividends to the Company totaled approximately $80.02 million, $66.40 million and $49.86 million as of December 31, 2012, 2011 and 2010, respectively. As of December 31, 2012 and 2011, stockholders' equity, before deducting for the maximum cash obligation related to the ESOP, was $255.91 million and $236.26 million, respectively.  This measure of stockholders’ equity as a percent of total assets was 12.19% at December 31, 2012 and 11.71% at December 31, 2011.  As of December 31, 2012, total equity was 10.73% of assets compared to 10.33% of assets at the prior year end.
 
 
Page 58


Item 7.       Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

The Company and the Bank are subject to the Federal Deposit Insurance Corporation Improvement Act of 1991, and the Bank is subject to Prompt Corrective Action Rules as determined and enforced by the Federal Reserve.  These regulations establish minimum capital requirements that member banks must maintain.

As of December 31, 2012, risk-based capital standards require 8% of risk-weighted assets.  At least half of that 8% must consist of Tier I core capital (common stockholders' equity, non-cumulative perpetual preferred stock and minority interest in the equity accounts of consolidated subsidiaries), and the remainder may be Tier II supplementary capital (perpetual debt, intermediate-term preferred stock, cumulative perpetual, long-term and convertible preferred stock, and loan loss reserve up to a maximum of 1.25% of risk-weighted assets).  Total risk-weighted assets are determined by weighting the assets according to their risk characteristics.  Certain off-balance sheet items (such as standby letters of credit and firm loan commitments) are multiplied by "credit conversion factors" to translate them into balance sheet equivalents before assigning them risk weightings.  Any bank having a capital ratio less than the 8% minimum required level must, within 60 days, submit to the Federal Reserve a plan describing the means and schedule by which the Bank shall achieve the applicable minimum capital ratios.

The Bank is an insured state bank, incorporated under the laws of the state of Iowa.  As such, the Bank is subject to regulation, supervision and periodic examination by the Superintendent of Banking of the State of Iowa (the "Superintendent").  Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements to maintain reserves against deposits, restrictions on the nature and amount of loans which may be made by state banks, and restrictions relating to investments, opening of bank offices and other activities of state banks.  Changes in the capital structure of state banks are also approved by the Superintendent.  State banks must have a Tier 1 risk-based leverage ratio of 6.5% plus a fully funded loan loss reserve.  In certain circumstances, the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement on the Bank.  In determining the Tier 1 risk-based leverage ratio, the Superintendent uses total equity capital without unrealized securities gains and the allowance for loan losses less any intangible assets.  At December 31, 2012, the Tier 1 risk-based leverage ratio of the Bank was 11.82% and exceeded the ratio required by the Superintendent.

The actual amounts of risk-based capital and risk-based capital ratios as of December 31, 2012 and the minimum regulatory requirements for the Company and the Bank are presented below (amounts in thousands):

                     
To Be Well
 
               
For Capital
   
Capitalized Under
 
               
Adequacy
   
Prompt Corrective
 
   
Actual
   
Purposes
   
Action Provisions
 
   
Amount
   
Ratio
   
Ratio
   
Ratio
 
As of December 31, 2012:
                       
Company:
                       
Total risk-based capital
  $ 269,751       16.66 %     8.00 %     10.00 %
Tier 1 risk-based capital
    249,456       15.41       4.00       6.00  
Leverage ratio
    246,456       11.90       4.00       5.00  
Bank:
                               
Total risk-based capital
    268,046       16.56       8.00       10.00  
Tier 1 risk-based capital
    247,757       15.31       4.00       6.00  
Leverage ratio
    247,757       11.82       4.00       5.00  

The Bank is classified as "well capitalized" by FDIC capital guidelines.

 
Page 59


Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

On a consolidated basis, 2012 cash flows from operations provided $25.81 million and net increases in deposits provided $137.07 million.  These cash flows were invested in Net Loans of $34.05 million and $64.17 million in purchases of investment securities.  In addition, $3.09 million was used to purchase property and equipment and leasehold improvements.

The Bank has a contingency funding plan to address liquidity issues in times of crisis.  The primary source of funding will be the Bank’s customer deposit base.  The Bank has established alternative sources of funding available to increase liquidity.  The availability of the funding sources is tested on an annual basis.  The Bank performs quarterly stress testing to determine if the Bank has an appropriate amount of funding sources to address potential liquidity needs. At December 31, 2012, the Bank had total outstanding loan commitments and unused portions of lines of credit totaling $344.12 million (see Note 15 to the Consolidated Financial Statements).  Management believes that its liquidity levels are sufficient at this time, but the Bank may increase its liquidity by limiting the growth of its assets, by selling more loans in the secondary market or selling portions of loans to other banks through participation agreements.  Another liquidity source includes obtaining additional funds from the Federal Home Loan Bank (FHLB).  As of December 31, 2012, the Bank can obtain an additional $379.13 million from the FHLB based on the current real estate mortgage loans held.  In addition, the Bank has arranged $195.58 million of credit lines at three banks.  The borrowings under these credit lines would be secured by the Bank’s investment securities.  Other liquidity sources include a $10.00 million line of credit with the Federal Reserve Bank of Chicago and various sources of brokered deposits.

While the Bank has off-balance sheet commitments to fund additional borrowings of customers, it does not use other off-balance-sheet financial instruments, including interest rate swaps, as part of its asset and liability management. Contractual commitments to fund loans are met from the proceeds of federal funds sold or investment securities and additional borrowings.  Many of the contractual commitments to extend credit will not be funded because they represent the credit limits on credit cards and home equity lines of credits.

As disclosed in Note 15 to the Consolidated Financial Statements, the Company has certain obligations and commitments to make future payments under contracts. The following table summarizes significant contractual obligations and other commitments as of December 31, 2012:

   
Payments Due By Period
 
   
(Amounts In Thousands)
 
                               
         
Less Than
   
One -
   
Three -
   
More Than
 
   
Total
   
One Year
   
Three Years
   
Five Years
   
Five Years
 
Contractual obligations:
                             
Long-term debt obligations
  $ 125,000     $ -     $ -     $ 105,000     $ 20,000  
Operating lease obligations
    1,419       386       548       376       109  
Total contractual obligations:
  $ 126,419     $ 386     $ 548     $ 105,376     $ 20,109  
                                         
Other commitments:
                                       
Lines of credit
  $ 344,120     $ 230,107     $ 89,374     $ 15,075     $ 9,564  
Standby letters of credit
    10,778       10,778       -       -       -  
Total other commitments
  $ 354,898     $ 240,885     $ 89,374     $ 15,075     $ 9,564  

 
Page 60


Item 7.       Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued)

The Bank opened an additional office location in North Liberty, Iowa, in February 2012.  The Bank provides retail and commercial banking services at this location and it serves as the new location of the Bank’s Trust and Wealth Management Department (the “Trust Department”).  The new office location enhances services available at the Trust Department, which is now housed with other traditional banking functions including deposit and loan services provided to the Bank’s retail and commercial customers.  The new office location has 18,600 square feet.  Construction costs for the building were $4.22 million and the Company purchased the land for $1.60 million.  The Bank has not incurred any debt for the construction of the new office.

The Bank has added two additional office leases in Iowa City, Iowa in February and March 2012.  The offices are located at the University of Iowa Memorial Union and the University of Iowa Hospitals and Clinics.  The Bank provides retail and commercial banking services at the new offices. Additional lease detail is disclosed in Note 15.

The Company and the Bank have no material commitments or plans that will materially affect liquidity or capital resources.  Property and equipment may be acquired in cash purchases, or they may be financed if favorable terms are available.

Item 7A.   Quantitative and Qualitative Disclosures About Market Risk

The Company's primary market risk exposure is to changes in interest rates.  Interest rate risk is the risk to current or anticipated earnings or capital arising from movements in interest rates.  Interest rate risk arises from repricing risk, basis risk, yield curve risk and options risk.  Repricing risk is the difference between the timing of rate changes and the timing of cash flows.  Basis risk is the difference from changing rate relationships among different yield curve affecting Bank activities.  Yield curve risk is the difference from changing rate relationships across the spectrum of maturities.  Option risk is the difference resulting from interest-related options imbedded in Bank products.  The Bank’s primary source of interest rate risk exposure arises from repricing risk.  To measure this risk the Bank uses a static gap measurement system that identifies the repricing gaps across the full maturity spectrum of the Bank’s assets and liabilities and an earnings simulation approached.  The gap schedule is known as the interest rate sensitivity report.  The report reflects the repricing characteristics of the Bank’s assets and liabilities.  The report details the calculation of the gap ratio.  This ratio indicated the amount if interest-earning assets repricing within a given period in comparison to the amount of interest-bearing liabilities repricing within the same period of time.  A gap ratio of 1.0 indicates a matched position, in which case the effect on net interest income due to interest rate movements will be minimal.  A gap ratio of less than 1.0 indicates that more liabilities than assets reprice within the time period, and a ratio greater than 1.0 indicates that more assets reprice than liabilities.

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.  Inversely, 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.

The Bank maintains an Asset/Liability Committee, which meets at least quarterly to review the interest rate sensitivity position and to review and develop various strategies for managing interest rate risk within the context of the following factors: 1) capital adequacy, 2) asset/liability mix, 3) economic outlook, 4) market characteristics and 5) the interest rate forecast.  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.  The Bank’s policy is to generally maintain a balance between profitability and interest rate risk.

 
Page 61


Item 7A.   Quantitative and Qualitative Disclosures About Market Risk (Continued)

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 transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.

The table set forth below includes the portion of the balances in interest-bearing checking, savings and money market accounts that management has estimated to mature within one year. The classifications are used because the Bank’s historical data indicates that these have been very stable deposits without much interest rate fluctuation.  Historically, these accounts would not need to be adjusted upward as quickly in a period of rate increases so the interest risk exposure would be less than the re-pricing schedule indicates. The FHLB borrowings are classified based on either their due date or if they are callable on their most likely call date based on the interest rate.

   
Repricing
                                     
   
Maturities
   
Days
   
More Than
       
   
Immediately
      2-30       31-90       91-180       181-365    
One Year
   
Total
 
                                                   
Earning assets:
                                                 
Excess Cash
  $ 23,426       -       -       -       -       -     $ 23,426  
Federal funds sold
    -       -       -       -       -       -       -  
Investment securities
    -       620       5,508       7,207       18,931       201,978       234,244  
Loans
    8,989       174,193       36,915       72,727       113,104       1,344,490       1,750,418  
Total
    32,415       174,813       42,423       79,934       132,035       1,546,468       2,008,088  
Sources of funds:
                                                       
Interest-bearing checking and savings accounts
    85,700       -       -       -       -       717,009       802,709  
Certificates of deposit
    -       20,356       40,627       71,040       104,045       349,794       585,862  
FHLB borrowings
    -       -       -       -       -       125,000       125,000  
Federal funds and repurchase agreements
    38,783       -       -       -       -       -       38,783  
      124,483       20,356       40,627       71,040       104,045       1,191,803       1,552,354  
Other sources, primarily noninterest-bearing
    -       -       -       -       -       273,973       273,973  
Total sources
    124,483       20,356       40,627       71,040       104,045       1,465,776       1,826,327  
Interest Rate Gap
  $ (92,068 )   $ 154,457     $ 1,796     $ 8,894     $ 27,990     $ 80,692     $ 181,761  
                                                         
Cumulative Interest Rate Gap at December 31, 2012
  $ (92,068 )   $ 62,389     $ 64,185     $ 73,079     $ 101,069     $ 181,761          
                                                         
                                                         
Gap Ratio
    0.26       8.59       1.04       1.13       1.27       1.06          
                                                         
Cumulative Gap Ratio
    0.26       1.43       1.35       1.28       1.28       1.10          

 
Page 62


Item 7A.   Quantitative and Qualitative Disclosures About Market Risk (Continued)

Based on the data following, net interest income should decline with instantaneous increases in interest rates while net interest income should increase with instantaneous declines in interest rates.  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.

The following table, which presents principal cash flows and related weighted average interest rates by expected maturity dates, provides information about the Company's loans, investment securities and deposits that are sensitive to changes in interest rates.

   
2013
   
2014
   
2015
   
2016
   
2017
   
Thereafter
   
Total
   
Fair Value
 
   
(Amounts In Thousands)
 
Assets:
                                               
Loans, fixed:
                                               
Balance
  $ 127,141     $ 50,615     $ 99,721     $ 144,528     $ 248,686     $ 172,039     $ 842,730     $ 878,354  
Average interest rate
    4.93 %     5.66 %     5.16 %     4.80 %     4.38 %     4.24 %     4.68 %        
                                                                 
Loans, variable:
                                                               
Balance
  $ 224,331     $ 55,267     $ 84,131     $ 154,178     $ 191,802     $ 169,126     $ 878,835     $ 898,914  
Average interest rate
    4.52 %     6.35 %     5.02 %     4.62 %     4.37 %     4.58 %     4.68 %        
                                                                 
Investments (1):
                                                               
Balance
  $ 40,682     $ 43,270     $ 31,650     $ 26,537     $ 19,518     $ 72,587     $ 234,244     $ 234,244  
Average interest rate
    3.04 %     2.30 %     2.23 %     3.02 %     4.03 %     3.18 %     2.91 %        
                                                                 
Liabilities:
                                                               
Liquid deposits (2):
                                                               
Balance
  $ 802,709     $ -     $ -     $ -     $ -     $ -     $ 802,709     $ 802,712  
Average interest rate
    0.23 %     0.00 %     0.00 %     0.00 %     0.00 %     0.00 %     0.23 %        
                                                                 
Deposits, certificates:
                                                               
Balance
  $ 236,068     $ 137,355     $ 123,171     $ 62,342     $ 26,926     $ -     $ 585,862     $ 594,430  
Average interest rate
    1.44 %     1.69 %     2.22 %     2.49 %     1.78 %     0.00 %     1.96 %        
 
(1)
Includes all available-for-sale investments, federal funds and Federal Home Loan Bank stock.

(2)
Includes NOW and other demand, savings and money market funds.

 
Page 63


Item 8.       Consolidated Financial Statements and Supplementary Data

The consolidated financial statements and supplementary data are included on pages 65 through 133.
 
 
Page 64

 
.3

Report of Independent Registered Public Accounting Firm

Audit Committee, Board of Directors and Stockholders
Hills Bancorporation
Hills, Iowa

We have audited the accompanying consolidated balance sheet of Hills Bancorporation as of December 31, 2012, and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for the year ended December 31, 2012.  The Company’s management is responsible for these financial statements.  Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  Our audit included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation.  We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hills Bancorporation as of December 31, 2012, and the results of its operations and its cash flows for the year ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Hills Bancorporation’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 13, 2013, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/ BKD LLP

Springfield, Missouri
March 13, 2013

 
Page 65



Report of Independent Registered Public Accounting Firm

Audit Committee, Board of Directors and Stockholders
Hills Bancorporation
Hills, Iowa

We have audited Hills Bancorporation’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).  The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting.  Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.  Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.  Our audit also included performing such other procedures as we considered necessary in the circumstances.  We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of reliable financial statements in accordance with accounting principles generally accepted in the United States of America.  Because management’s assessment and our audit were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), our examination of Hills Bancorporation’s internal control over financial reporting included controls over the preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and with the instructions to the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C).  A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company and (3) provide reasonable assurance regarding prevention, or timely detection and correction of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

 
Page 66


Audit Committee, Board of Directors and Stockholders
Hills Bancorporation
Page 2

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Hills Bancorporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Hills Bancorporation and our report dated March 13, 2013, expressed an unqualified opinion.

/s/ BKD LLP

Springfield, Missouri
March 13, 2013

 
Page 67

 
 
2500 Ruan Center
666 Grand Avenue
Des Moines, IA 50309
 
 
 

 
Report of Independent Registered Public Accounting Firm
 
The Board of Directors and Stockholders
Hills Bancorporation:
 
We have audited the accompanying consolidated balance sheet of Hills Bancorporation and subsidiary (the Company) as of December 31, 2011, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the years in the two-year period ended December 31, 2011. These consolidated financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hills Bancorporation and subsidiary as of December 31, 2011, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
 
/s/ KPMG LLP
 
Des Moines, Iowa
March 9, 2012
 
 
Page 68

 
HILLS BANCORPORATION

CONSOLIDATED BALANCE SHEETS
December 31, 2012 and 2011
(Amounts In Thousands, Except Shares)
 
ASSETS
 
2012
   
2011
 
Cash and cash equivalents
  $ 63,582     $ 29,291  
Investment securities available for sale at fair value (amortized cost 2012 $219,777 ; 2011 $203,312) (Notes 1, 2 and 13)
    226,182       211,367  
Stock of Federal Home Loan Bank
    8,062       10,728  
Loans held for sale
    28,256       24,615  
Loans, net of allowance for loan losses (2012 $25,160; 2011 $30,150) (Notes 1, 3, and 12)
    1,697,002       1,661,916  
Property and equipment, net (Note 4)
    30,624       30,321  
Tax credit real estate
    18,745       20,130  
Accrued interest receivable
    7,851       8,689  
Deferred income taxes, net (Note 10)
    7,144       8,531  
Other real estate
    746       1,327  
Goodwill
    2,500       2,500  
Prepaid FDIC insurance
    2,957       3,879  
Other assets
    6,069       5,003  
Total Assets
  $ 2,099,720     $ 2,018,297  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Liabilities
               
Noninterest-bearing deposits
  $ 273,973     $ 223,378  
Interest-bearing deposits (Note 5)
    1,388,571       1,302,099  
Total deposits
    1,662,544       1,525,477  
Short-term borrowings (Note 6)
    38,783       52,785  
Federal Home Loan Bank borrowings (Note 7)
    125,000       185,000  
Accrued interest payable
    1,361       1,625  
Other liabilities
    16,121       17,155  
Total Liabilities
    1,843,809       1,782,042  
Commitments and Contingencies (Notes 9 and 15)
               
                 
Redeemable Common Stock Held By Employee Stock Ownership Plan (ESOP) (Note 9)
    30,715       27,826  
                 
Stockholders' Equity (Note 11)
               
Common stock, no par value; authorized 10,000,000 shares; issued 2012 5,064,383 shares; 2011 5,051,901 shares
    -       -  
Paid in capital
    42,241       41,467  
Retained earnings
    229,625       207,790  
Accumulated other comprehensive income (Note 8)
    3,955       4,974  
Unearned ESOP shares
    (1,513 )     (2,017 )
Treasury stock at cost (2012 328,065 shares; 2011 292,083 shares)
    (18,397 )     (15,959 )
Total Stockholders' Equity
    255,911       236,255  
Less maximum cash obligation related to ESOP shares (Note 9)
    30,715       27,826  
Total Stockholders' Equity Less Maximum Cash Obligations Related To ESOP Shares
    225,196       208,429  
Total Liabilities & Stockholders' Equity
  $ 2,099,720     $ 2,018,297  

See Notes to Consolidated Financial Statements.
 
 
Page 69


HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2012, 2011 and 2010
(Amounts In Thousands, Except Per Share Amounts)

   
2012
   
2011
   
2010
 
Interest income:
                 
Loans, including fees
  $ 83,787     $ 87,032     $ 88,239  
Investment securities:
                       
Taxable
    1,897       2,797       3,380  
Nontaxable
    3,397       3,451       3,294  
Federal funds sold
    134       70       74  
Total interest income
    89,215       93,350       94,987  
Interest expense:
                       
Deposits
    13,724       15,989       19,200  
Short-term borrowings
    220       377       523  
FHLB borrowings
    7,583       7,995       8,116  
Total interest expense
    21,527       24,361       27,839  
Net interest income
    67,688       68,989       67,148  
Provision for loan losses (Note 3)
    (2,849 )     5,661       8,925  
Net interest income after provision for loan losses
    70,537       63,328       58,223  
Noninterest income:
                       
Net gain on sale of loans
    3,549       1,986       3,602  
Trust fees
    4,616       4,349       4,026  
Service charges and fees
    7,815       7,579       7,971  
Rental revenue on tax credit real estate
    1,587       1,470       1,672  
Net gain on sale of other real estate owned and other repossessed assets
    782       653       -  
Other noninterest income
    2,420       2,467       2,828  
      20,769       18,504       20,099  
Noninterest expenses:
                       
Salaries and employee benefits
    23,793       22,749       22,480  
Occupancy
    3,332       3,190       3,163  
Furniture and equipment
    4,573       3,618       4,100  
Office supplies and postage
    1,481       1,302       1,368  
Advertising and business development
    2,721       2,173       2,058  
Outside services
    6,712       6,656       6,506  
Rental expenses on tax credit real estate
    2,548       1,719       2,517  
FDIC insurance assessment
    1,036       1,283       2,074  
Loss on extinguishment of debt - Federal Home Loan Bank borrowings
    5,925       -       -  
Net loss on sale of other real estate owned and other repossessed assets
    -       -       6  
Other noninterest expenses
    1,810       1,536       1,476  
      53,931       44,226       45,748  
Income before income taxes
    37,375       37,606       32,574  
Income taxes (Note 10)
    10,542       10,829       9,258  
Net income
  $ 26,833     $ 26,777     $ 23,316  
                         
Earnings per share:
                       
Basic
  $ 5.69     $ 6.02     $ 5.29  
Diluted
    5.68       6.01       5.28  

See Notes to Consolidated Financial Statements.

 
Page 70

 
HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2012, 2011 and 2010
(Amounts In Thousands)

   
2012
   
2011
   
2010
 
                   
Net income
  $ 26,833     $ 26,777     $ 23,316  
                         
Other comprehensive (loss) income, before tax
                       
Unrealized holding (losses) gains arising during the period
  $ (1,656 )   $ 3,581     $ (2,227 )
Less: reclassification adjustments for realized losses (gains) included in net income
    6       (29 )     (71 )
                         
Other comprehensive (loss) income, before tax
  $ (1,650 )   $ 3,552     $ (2,298 )
                         
Tax benefit (expense) related to other comprehensive income
    631       (1,359 )     879  
                         
Other comprehensive (loss) income, net of tax
  $ (1,019 )   $ 2,193     $ (1,419 )
                         
Comprehensive income
  $ 25,814     $ 28,970     $ 21,897  

See Notes to Consolidated Financial Statements.
 
 
Page 71

 
HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Years Ended December 31, 2012, 2011 and 2010
(Amounts In Thousands, Except Share Data)

                                 
Maximum
       
                                 
Cash
       
               
Accumulated
               
Obligation
       
               
Other
   
Unearned
         
Related
       
   
Paid In
   
Retained
   
Comprehensive
   
ESOP
   
Treasury
   
To ESOP
       
   
Capital
   
Earnings
   
Income (Loss)
   
Shares
   
Stock
   
Shares
   
Total
 
                                           
Balance, December 31, 2009
  $ 14,582     $ 166,120     $ 4,200     $ -     $ (10,227 )   $ (22,900 )   $ 151,775  
Issuance of 6,236 shares of common stock
    197       -       -       -       -       -       197  
Forfeiture of 679 shares of common stock
    (32 )     -       -       -       -       -       (32 )
Share-based compensation
    15       -       -       -       -       -       15  
Income tax benefit related to share-based compensation
    113       -       -       -       -       -       113  
Change related to ESOP shares
    -       -       -       -       -       (2,045 )     (2,045 )
Net income
    -       23,316       -       -       -       -       23,316  
Cash dividends ($.91 per share)
    -       (4,024 )     -       -       -       -       (4,024 )
Purchase of 29,494 shares of common stock
    -       -       -       -       (1,627 )     -       (1,627 )
Other comprehensive loss
    -       -       (1,419 )     -       -       -       (1,419 )
Balance, December 31, 2010
  $ 14,875     $ 185,412     $ 2,781     $ -     $ (11,854 )   $ (24,945 )   $ 166,269  
Issuance of 388,376 shares of common stock
    23,976       -       -       -       -       -       23,976  
Forfeiture of 1,022 shares of common stock
    (54 )     -       -       -       -       -       (54 )
Share-based compensation
    16       -       -       -       -       -       16  
Income tax benefit related to share-based compensation
    132       -       -       -       -       -       132  
Change related to ESOP shares
    -       -       -       -       -       (2,881 )     (2,881 )
Purchase of 40,028 shares under the Employee Stock Ownership Plan
    2,522       -       -       (2,522 )     -       -       -  
Release of 7,314 shares of common stock under the employee stock ownership plan
    -       -       -       505       -       -       505  
Net income
    -       26,777       -       -       -       -       26,777  
Cash dividends ($1.00 per share)
    -       (4,399 )     -       -       -       -       (4,399 )
Purchase of 65,901 shares of common stock
    -       -       -       -       (4,105 )     -       (4,105 )
Other comprehensive income
    -       -       2,193       -       -       -       2,193  
Balance, December 31, 2011
  $ 41,467     $ 207,790     $ 4,974     $ (2,017 )   $ (15,959 )   $ (27,826 )   $ 208,429  
Issuance of 12,825 shares of common stock
    647       -       -       -       -       -       647  
Issuance of 375 shares of common stock
                                                       
under the employee stock purchase plan
    25       -       -       -       -       -       25  
Forfeiture of 718 shares of common stock
    (41 )     -       -       -       -       -       (41 )
Share-based compensation
    20       -       -       -       -       -       20  
Income tax benefit related to share-based compensation
    92       -       -       -       -       -       92  
Change related to ESOP shares
    -       -       -       -       -       (2,889 )     (2,889 )
Release of 8,724 shares of common stock under the employee stock ownership plan
    31       -       -       504       -       -       535  
Net income
    -       26,833       -       -       -       -       26,833  
Cash dividends ($1.05 per share)
    -       (4,998 )     -       -       -       -       (4,998 )
Purchase of 35,892 shares of common stock
    -       -       -       -       (2,438 )     -       (2,438 )
Other comprehensive loss
    -       -       (1,019 )     -       -       -       (1,019 )
Balance, December 31, 2012
  $ 42,241     $ 229,625     $ 3,955     $ (1,513 )   $ (18,397 )   $ (30,715 )   $ 225,196  

See Notes to Consolidated Financial Statements.
 
 
Page 72

 
HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2012, 2011 and 2010
(Amounts In Thousands)

   
2012
   
2011
   
2010
 
Cash Flows from Operating Activities
                 
Net income
  $ 26,833     $ 26,777     $ 23,316  
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
                       
Depreciation
    2,788       2,425       2,568  
Provision for loan losses
    (2,849 )     5,661       8,925  
Net loss (gain) on sale of investment securities
    6       (29 )     (71 )
Share-based compensation
    20       16       15  
Compensation expensed through issuance of common stock
    1,032       921       46  
Excess tax benefits related to share-based compensation
    (92 )     (132 )     (113 )
Forfeiture of common stock
    (41 )     (54 )     (32 )
Provision for deferred income taxes
    2,018       (20 )     (99 )
Net (gain) loss on sale of other real estate owned and other repossessed assets
    (782 )     (653 )     6  
Decrease (increase) in accrued interest receivable
    838       (3 )     991  
Amortization of discount on investment securities, net
    1,027       966       906  
Decrease in prepaid FDIC insurance
    922       1,159       1,909  
(Increase) decrease in other assets
    (975 )     (1,082 )     363  
(Decrease) increase in accrued interest and other liabilities
    (1,298 )     1,380       2,410  
Loans originated for sale
    (328,577 )     (187,536 )     (264,188 )
Proceeds on sales of loans
    328,485       175,297       265,376  
Net gain on sales of loans
    (3,549 )     (1,986 )     (3,602 )
Net cash and cash equivalents provided by operating activities
    25,806       23,107       38,726  
                         
Cash Flows from Investing Activities
                       
Proceeds from maturities of investment securities available for sale
    48,615       45,616       43,658  
Proceeds from sales of investment securities available for sale
    721       529       4,892  
Purchases of investment securities available for sale
    (64,167 )     (49,022 )     (54,188 )
Loans made to customers, net of collections
    (34,052 )     (110,867 )     (69,049 )
Proceeds on sale of other real estate owned and other repossessed assets
    3,178       3,758       3,663  
Purchases of property and equipment
    (3,091 )     (5,940 )     (2,957 )
Income from (investment in) tax credit real estate, net
    1,385       830       (2,183 )
Net cash and cash equivalents used in investing activities
    (47,411 )     (115,096 )     (76,164 )

(Continued)
 
 
Page 73

 
HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2012, 2011 and 2010
(Amounts In Thousands)

   
2012
   
2011
   
2010
 
Cash Flows from Financing Activities
                 
Net increase in deposits
    137,067       44,736       133,314  
Net (decrease) increase in short-term borrowings
    (14,002 )     5,857       (21,606 )
Borrowings from FHLB
    -       -       10,000  
Payments on FHLB borrowings
    (60,000 )     (10,000 )     (40,000 )
Borrowings from FRB
    1       100       100  
Payments on FRB borrowings
    (1 )     (100 )     (100 )
Issuance of common stock, net of costs
    -       25,825       -  
Stock options exercised
    175       256       151  
Excess tax benefits related to share-based compensation
    92       132       113  
Purchase of treasury stock
    (2,438 )     (4,105 )     (1,627 )
Dividends paid
    (4,998 )     (4,399 )     (4,024 )
Net cash and cash equivalents provided by financing activities
    55,896       58,302       76,321  
                         
Increase (decrease) in cash and cash equivalents
  $ 34,291     $ (33,687 )   $ 38,883  
                         
Cash and cash equivalents:
                       
Beginning of year
    29,291       62,978       24,095  
End of year
  $ 63,582     $ 29,291     $ 62,978  
                         
Supplemental Disclosures
                       
Cash payments for:
                       
Interest paid to depositors
  $ 13,988     $ 16,360     $ 19,545  
Interest paid on other obligations
    7,803       8,372       8,567  
Income taxes paid
    9,773       11,225       8,007  
                         
Noncash financing activities:
                       
Increase in maximum cash obligation related to ESOP shares
  $ 2,889     $ 2,881     $ 2,045  
Transfers to other real estate owned
    1,815       2,199       2,675  

See Notes to Consolidated Financial Statements.
 
 
Page 74

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.   Nature of Activities and Significant Accounting Policies

Nature of activities:  Hills Bancorporation (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 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.

The Bank competes with other financial institutions and non-financial institutions providing similar financial products.  Although the loan activity of the Bank is diversified with commercial and agricultural loans, real estate loans, automobile, installment and other consumer loans, the Bank's credit is concentrated in real estate loans.  All of the Company’s operations are considered to be one reportable operating segment.

Accounting estimates:  The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

Certain significant estimates:  The allowance for loan losses, fair values of securities and other financial instruments, and share-based compensation expense involves certain significant estimates made by management.  These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist at December 31, 2012 may change in the near-term future and that the effect could be material to the consolidated financial statements.

Principles of consolidation:  The consolidated financial statements include the accounts of the Company and its subsidiary.  All significant intercompany balances and transactions have been eliminated in consolidation.

Revenue recognition: Interest income on loans and investment securities is recognized on the accrual method. Loan origination fees are recognized when the loans are sold. Trust fees, deposit account service charges and other fees are recognized when the services are provided or when customers use the services.

Cash Equivalents:  The Company considers all investments with original maturities of three months or less to be cash equivalents.  At December 31, 2012 and 2011, cash equivalents consisted primarily of deposits with other banks.

Pursuant to legislation enacted in 2010, the FDIC fully insured all noninterest-bearing transaction accounts beginning December 31, 2010, through December 31, 2012, at all FDIC-insured institutions.  This legislation expired on December 31, 2012.  Beginning January 1, 2013, noninterest-bearing transaction accounts are subject to the $250,000 limit on FDIC insurance per covered institution.

Investment securities:  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 December 31, 2012 and 2011.

Stock of the Federal Home Loan Bank is carried at cost.  The Company has evaluated the stock and determined there is no impairment.

Premiums and discounts on debt securities are amortized or accreted over the period to maturity of those securities.  The method of amortization results in a constant effective yield on those securities (the interest method).  Realized gains and losses on investment securities are included in income, determined on the basis of the cost of the specific securities sold.
 
 
Page 75

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.   Nature of Activities and Significant Accounting Policies (Continued)

Investment securities (continued):  Declines in the fair value of investment securities available for sale (with certain exceptions for debt securities noted below) that are deemed to be other-than-temporary are charged to earnings as a realized loss, and a new cost basis for the securities is established.  In evaluating other-than-temporary impairment, the Company considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term.  Declines in the fair value of debt securities below amortized cost are deemed to be other-than-temporary in circumstances where: (1) the Company has the intent to sell a security; (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis; or (3) the Company does not expect to recover the entire amortized cost basis of the security.  If the Company intends to sell a security or if it is more likely than not that the Company will be required to sell the security before recovery, an other-than-temporary impairment write-down is recognized in earnings equal to the difference between the security’s amortized cost basis and its fair value.  If the Company does not intend to sell the security or it is not more likely than not that the Company will be required to sell the security before recovery, the other-than-temporary impairment write-down is separated into an amount representing credit loss, which is recognized in earnings, and an amount related to all other factors, which is recognized in other comprehensive income.  Realized securities gains or losses on securities sales (using specific identification method) and declines in value judged to be other-than-temporary are included in investment securities gains (losses), net, in the consolidated statements of income.

Loans:  Loans are stated at the amount of unpaid principal, reduced by the allowance for loan losses.  Interest income is accrued on the unpaid balances as earned.

Loans held for sale are stated at the lower of aggregate cost or estimated fair value.  Loans are sold on a non-recourse basis with servicing released and gains and losses are recognized based on the difference between sales proceeds and the carrying value of the loan.  The Company has had very few experiences of repurchasing loans previously sold into the secondary market.  A specific reserve was not considered necessary based on the Company’s historical experience with repurchase activity.

The allowance for loan losses is established through a provision for loan losses charged to expense.  Loans are charged against the allowance when management believes the collectability of principal is unlikely.  The allowance for loan losses is maintained at a level considered adequate to provide for probable losses that can be reasonably anticipated.  The allowance is increased by provisions charged to expense and is reduced by net charge-offs.  The Bank makes continuous reviews of the loan portfolio and considers current economic conditions, historical loss experience, review of specific problem loans and other factors in determining the adequacy of the allowance.  Management classifies loans within the following industry standard categories: watch, substandard and loss.

The policy for charging off loans is consistent throughout all loan categories.  A loan is charged off based on criteria that includes but is not limited to:  delinquency status, financial condition of the entire customer credit line and underlying collateral coverage, economic or external conditions that might impact full repayment of the loan, legal issues, overdrafts, and the customer’s willingness to work with the Company.

Loans are considered impaired when, based on current information and events, it is probable the Bank will not be able to collect all amounts due.  An impaired loan includes any loan that has been placed on nonaccrual status, loans greater than 90 days past due and still accruing and TDR loans.  They also include loans, based on current information and events, that it is likely the Bank will be unable to collect all amounts due according to the contractual terms of the original loan agreement.  The portion of the allowance for loan losses applicable to impaired loans has been computed based on the present value of the estimated future cash flows of interest and principal discounted at the loans effective interest rate or on the fair value of the collateral for collateral dependent loans.  The entire change in present value of expected cash flows of impaired loans or of collateral value is reported as provision expense in the same manner in which impairment initially was recognized or as a reduction in the amount of provision expense that otherwise would be reported.  Interest income on nonaccrual loans is recognized once principal has been recovered.
 
 
Page 76

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.   Nature of Activities and Significant Accounting Policies (Continued)

Loans (continued):  The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to the borrower's ability to meet payments of interest or principal when they become due, which is generally when a loan is 90 days or more past due.  When a loan is placed on nonaccrual status, all previously accrued and unpaid interest is reversed.  Loans are returned to an accrual status when all of the principal and interest amounts contractually due are brought current and repayment of the remaining contractual principal and interest is expected.   A loan may also return to accrual status if additional collateral is received from the borrower and, in the opinion of management, the financial position of the borrower indicates that there is no longer any reasonable doubt as to the collection of the amount contractually due.  Payment received on nonaccrual loans are applied first to principal.  Once principal is recovered, any remaining payments received are applied to interest income.  As of December 31, 2012, none of the Company’s nonaccrual loans were earning on a cash basis.

Nonrefundable loan fees and origination costs are deferred and recognized as a yield adjustment over the life of the related loan.

Troubled debt restructurings (“TDR loans”):  A loan is classified as a troubled debt restructuring when a borrower is experiencing financial difficulties that leads to a restructuring of the loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider.  These concessions may include rate reductions, principal forgiveness, extension of maturity date and other actions intended to minimize potential losses to the Company.  A loan that is modified at a market rate of interest is no longer classified as troubled debt restructuring in the calendar year subsequent to the restructuring if it is in compliance with the modified terms.  Performance prior to the restructuring is considered when assessing whether the borrower can meet the new terms.  At the time of restructuring, the majority of loans included in a troubled debt restructuring are considered nonaccrual loans.  TDR loans are returned to accrual status under the same criteria noted under loans above.

Transfers of financial assets:  Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered.  Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.

Credit related financial instruments:  In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit.  Such financial instruments are recorded when they are funded.

Tax credit real estate:  Tax credit real estate represents two multi-family rental properties, three assisted living rental properties, a multi-tenant rental property for persons with disabilities, and a multi-family senior living rental property all which are affordable housing projects as of December 31, 2012.  The Bank has a 99% limited partnership interest in each limited partnership.  The investment in each was completed after the projects had been developed by the general partner.  The properties are recorded at cost less accumulated depreciation.  The Company evaluates the recoverability of the carrying value on a regular basis.  If the recoverability was determined to be in doubt, a valuation allowance would be established by way of a charge to expense.  Depreciation expense is provided on a straight-line basis over the estimated useful life of the assets.  Expenditures for normal repairs and maintenance are charged to expense as incurred.

The financial condition, results of operations and cash flows of each limited partnership is consolidated in the Company’s consolidated financial statements.  The operations of the properties are not expected to contribute significantly to the Company’s income before income taxes.  However, the properties do contribute in the form of income tax credits, which lowers the Company’s effective tax rate.  Once established, the credits on each property last for ten years and are passed through from the limited partnerships to the Bank and reduces the consolidated federal tax liability of the Company.
 
 
Page 77

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.   Nature of Activities and Significant Accounting Policies (Continued)

Property and equipment:  Property and equipment is stated at cost less accumulated depreciation.  Depreciation is computed using primarily declining-balance methods over the estimated useful lives of 7-40 years for buildings and improvements and 3-10 years for furniture and equipment.

Deferred income taxes:  Deferred income taxes are provided under the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and net operating loss, and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences.  Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some or all of the deferred tax assets will not be realized.  Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.   The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained.  Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized.  Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.  Interest and penalties on unrecognized tax benefits are classified as other noninterest expense.  As of December 31, 2012, the Company had no material unrecognized tax benefits.

Goodwill:  Goodwill represents the excess of cost over the fair value of the net assets acquired, and is not subject to amortization, but requires, at a minimum, annual impairment tests for intangibles that are determined to have an indefinite life.

Prepaid FDIC insurance:  Prepaid FDIC insurance as of December 31, 2012 represents the remaining 13-quarter FDIC premium prepayment paid by the Bank for the years of 2009 through 2012.  The balance remaining in prepaid FDIC insurance after payment of the FDIC assessments for 2012 will be refunded to the Company in June 2013.  The expense for the FDIC insurance will be recorded on a quarterly basis as premiums are assessed.

Other real estate:   Other real estate represents property acquired through foreclosures and settlements of loans.  Property acquired is carried at the lower of the principal amount of the loan outstanding at the time of acquisition, plus any acquisition costs, or the estimated fair value of the property, less disposal costs.  The Bank will obtain updated appraisals to determine the estimated fair value of the property based on the type of collateral securing the loan and the date of the latest appraisal.  Subsequent write downs estimated on the basis of later valuations are charged to net loss on sale of other real estate owned and other repossessed assets.  Net expenses incurred in maintaining such properties are charged to other non-interest expense.

 
Page 78


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.   Nature of Activities and Significant Accounting Policies (Continued)

Earnings per share:   Basic earnings per share is computed using the weighted average number of actual common shares outstanding during the period.  Diluted earnings per share reflects the potential dilution that would occur from the exercise of common stock options outstanding.  ESOP shares are considered outstanding for this calculation unless unearned.  The following table presents calculations of earnings per share:
 
   
Year Ended December 31,
 
   
2012
   
2011
   
2010
 
   
(Amounts In Thousands)
 
Computation of weighted average number of basic and diluted shares:
                 
Common shares outstanding at the beginning of the year
    4,727,104       4,398,337       4,422,274  
Weighted average number of net shares (redeemed) issued
    (11,116 )     52,461       (14,984 )
Weighted average shares outstanding (basic)
    4,715,988       4,450,798       4,407,290  
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method
    5,289       7,724       10,968  
Weighted average number of shares (diluted)
    4,721,277       4,458,522       4,418,258  
                         
Net income (In Thousands)
  $ 26,833     $ 26,777     $ 23,316  
                         
Earnings per share:
                       
Basic
  $ 5.69     $ 6.02     $ 5.29  
Diluted
  $ 5.68     $ 6.01     $ 5.28  

Stock awards and options:   Compensation expense for stock issued through the stock award plan is accounted for using the fair value method prescribed by FASB ASC 718, “Share-Based Payment” (“ASC 718”).  Under this method, compensation expense is measured and recognized for all stock-based awards made to employees and directors based on the fair value of each option as of the date of the grant.

Common stock held by ESOP:  The Company's maximum cash obligation related to these shares is classified outside stockholders' equity because the shares are not readily traded and could be put to the Company for cash.

Trust Department Assets:  Property held for customers in fiduciary or agency capacities is not included in the accompanying balance sheet, as such items are not assets of the Company.

Reclassifications:  Certain reclassifications have been made to the 2011 and 2010 financial statements to conform to the 2012 financial statement presentation.  These reclassifications had no effect on net income.
 
 
Page 79

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2.   Investment Securities

The carrying values of investment securities at December 31, 2012 and December 31, 2011 are summarized in the following table (Amounts in Thousands):
 
   
December 31, 2012
   
December 31, 2011
 
   
Amount
   
Percent
   
Amount
   
Percent
 
Securities available for sale
                       
State and political subdivisions
  $ 134,332       59.39 %   $ 119,431       56.50 %
Other securities (FHLB, FHLMC and FNMA)
    91,850       40.61       91,936       43.50  
                                 
Total securities available for sale
  $ 226,182       100.00 %   $ 211,367       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.  The Company had no securities designated as trading or held to maturity in its portfolio at December 31, 2012 or 2011.  The carrying amount of available-for-sale securities and their approximate fair values were as follows (Amounts in Thousands):

         
Gross
   
Gross
   
Estimated
 
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
   
Cost
   
Gains
   
(Losses)
   
Value
 
       
December 31, 2012:
                       
Other securities (FHLB, FHLMC and FNMA)
  $ 90,929     $ 946     $ (25 )   $ 91,850  
State and political subdivisions
    128,848       5,593       (109 )     134,332  
Total
  $ 219,777     $ 6,539     $ (134 )   $ 226,182  
                                 
December 31, 2011:
                               
Other securities (FHLB, FHLMC and FNMA)
  $ 90,353     $ 1,583     $ -     $ 91,936  
State and political subdivisions
    112,959       6,524       (52 )     119,431  
Total
  $ 203,312     $ 8,107     $ (52 )   $ 211,367  

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at December 31, 2012, were as follows (Amounts in Thousands):

   
Amortized
   
Fair
 
   
Cost
   
Value
 
       
             
Due in one year or less
  $ 32,266     $ 32,620  
Due after one year through five years
    117,695       120,975  
Due after five years through ten years
    69,273       72,057  
Due over ten years
    543       530  
Total
  $ 219,777     $ 226,182  
 
 
Page 80

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2.   Investment Securities (Continued)

As of December 31, 2012, investment securities with a carrying value of $38.78 million were pledged to collateralize short-term borrowings.

Sales proceeds and gross realized gains and losses on available-for-sale securities were as follows (Amounts in Thousands):

   
2012
   
2011
   
2010
 
Sales proceeds
  $ 721     $ 529     $ 4,892  
Gross realized gains
    11       29       99  
Gross realized losses
    (17 )     -       (28 )

The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2012 and 2011 (Amounts in Thousands):
 
   
Less than 12 months
   
12 months or more
   
Total
 
2012
             
Unrealized
                     
Unrealized
                     
Unrealized
       
Description
    #    
Fair Value
   
Loss
   
%
      #    
Fair Value
   
Loss
   
%
      #    
Fair Value
   
Loss
   
%
 
of Securities
                                                                             
                                                                               
Other securities (FHLB, FHLMC and FNMA)
    5     $ 12,865     $ (25 )     0.19 %     -     $ -     $ -       -       5     $ 12,865     $ (25 )     0.19 %
                                                                                                 
State and political subdivisions
    37       7,854       (92 )     1.17 %     2       483       (17 )     3.52 %     39       8,337       (109 )     1.31 %
                                                                                                 
Total temporarily impaired securities
    42     $ 20,719     $ (117 )     0.56 %     2     $ 483     $ (17 )     3.52 %     44     $ 21,202     $ (134 )     0.63 %

   
Less than 12 months
   
12 months or more
   
Total
 
2011
             
Unrealized
                     
Unrealized
                     
Unrealized
       
Description
    #    
Fair Value
   
Loss
   
%
      #    
Fair Value
   
Loss
   
%
      #    
Fair Value
   
Loss
   
%
 
of Securities
                                                                             
                                                                               
Other securities (FHLB, FHLMC and FNMA)
    -     $ -     $ -       0.00 %     -     $ -     $ -       -       -     $ -     $ -       0.00 %
                                                                                                 
State and political subdivisions
    2       409       (3 )     0.73 %     2       453       (49 )     10.82 %     4       862       (52 )     6.03 %
                                                                                                 
Total temporarily impaired securities
    2     $ 409     $ (3 )     0.73 %     2     $ 453     $ (49 )     10.82 %     4     $ 862     $ (52 )     6.03 %

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 12 months as of December 31, 2012 included two issues.  The two securities are municipal bonds rated Ba2.  Bonds with a Ba2 rating are less than investment grade.   The aggregate fair value of these Ba2 rated bonds is $0.48 million while their amortized cost is $0.50 million, representing an unrealized loss of $0.02 million. None of the unrealized losses in the above table was due to the deterioration in the credit quality of any of the issues that might result in the non-collection of contractual principal and interest.  The unrealized losses are due to changes in interest rates.  The Company has not recognized any unrealized loss in income because management does not have the intent to sell the securities included in the previous table.  Management has concluded that it is more likely than not that the Company will not be required to sell these securities prior to recovery of the amortized cost basis.
 
 
Page 81

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans

Classes of loans are as follows:

   
December 31,
 
   
2012
   
2011
 
   
(Amounts In Thousands)
 
             
Agricultural
  $ 76,190     $ 68,556  
Commercial and financial
    148,034       143,174  
Real estate:
               
Construction, 1 to 4 family residential
    25,788       22,308  
Construction, land development and commercial
    79,097       84,508  
Mortgage, farmland
    113,841       99,799  
Mortgage, 1 to 4 family first liens
    583,567       577,318  
Mortgage, 1 to 4 family junior liens
    104,278       104,915  
Mortgage, multi-family
    214,812       222,851  
Mortgage, commercial
    312,506       316,329  
Loans to individuals
    20,350       20,598  
Obligations of state and political subdivisions
    43,102       31,147  
    $ 1,721,565     $ 1,691,503  
Net unamortized fees and costs
    597       563  
    $ 1,722,162     $ 1,692,066  
Less allowance for loan losses
    25,160       30,150  
    $ 1,697,002     $ 1,661,916  
 
 
Page 82

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

Changes in the allowance for loan losses and the allowance for loan loss balance applicable to impaired loans and the related loan balance of impaired loans for the year ended December 31, 2012, 2011 and 2010 are 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
 
                                                 
2012
                                               
Allowance for loan losses:
                                               
Beginning balance
  $ 1,354     $ 6,429     $ 4,994     $ 1,411     $ 9,051     $ 6,150     $ 761     $ 30,150  
Charge-offs
    (12 )     (1,395 )     (1,648 )     -       (1,448 )     (318 )     (205 )   $ (5,026 )
Recoveries
    71       1,583       52       -       521       403       255     $ 2,885  
Provision
    240       (2,044 )     (223 )     335       (36 )     (1,131 )     10       (2,849 )
                                                                 
Ending balance
  $ 1,653     $ 4,573     $ 3,175     $ 1,746     $ 8,088     $ 5,104     $ 821     $ 25,160  
                                                                 
Ending balance, individually evaluated for impairment
    -       22       -       -       90       261       -       373  
                                                                 
Ending balance, collectively evaluated for impairment
    1,653       4,551       3,175       1,746       7,998       4,843       821       24,787  
                                                                 
Loan balances:
                                                               
                                                                 
Ending balance
    76,190       148,034       104,885       113,841       687,845       527,318       63,452       1,721,565  
                                                                 
Ending balance, individually evaluated for impairment
    -       2,152       2,978       806       3,565       20,257       -       29,758  
                                                                 
Ending balance, collectively evaluated for impairment
    76,190       145,882       101,907       113,035       684,280       507,061       63,452       1,691,807  
                                                                 
   
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
 
                                                                 
2011
                                                               
Allowance for loan losses:
                                                               
Beginning balance
  $ 2,170     $ 6,742     $ 4,394     $ 1,482     $ 7,952     $ 5,657     $ 833     $ 29,230  
Charge-offs
    (81 )     (2,678 )     (549 )     (1 )     (2,892 )     (708 )     (220 )     (7,129 )
Recoveries
    45       896       17       4       934       298       194       2,388  
Provision
    (780 )     1,469       1,132       (74 )     3,057       903       (46 )     5,661  
                                                                 
Ending balance
  $ 1,354     $ 6,429     $ 4,994     $ 1,411     $ 9,051     $ 6,150     $ 761     $ 30,150  
                                                                 
Ending balance, individually evaluated for impairment
    1       97       3       -       93       65       -       259  
                                                                 
Ending balance, collectively evaluated for impairment
    1,353       6,332       4,991       1,411       8,958       6,085       761       29,891  
                                                                 
Loan balances:
                                                               
                                                                 
Ending balance
    68,556       143,174       106,816       99,799       682,233       539,180       51,745       1,691,503  
                                                                 
Ending balance, individually evaluated for impairment
    13       2,617       662       556       4,801       19,830       -       28,479  
                                                                 
Ending balance, collectively evaluated for impairment
    68,543       140,557       106,154       99,243       677,432       519,350       51,745       1,663,024  

 
Page 83


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

   
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
 
                                                 
2010
                                               
Allowance for loan losses:
                                               
Beginning balance
  $ 2,967     $ 7,090     $ 4,811     $ 1,417     $ 7,484     $ 4,742     $ 649     $ 29,160  
Charge-offs
    (18 )     (3,647 )     (1,202 )     (52 )     (4,343 )     (1,507 )     (423 )     (11,192 )
Recoveries
    248       946       81       44       583       152       283       2,337  
Provision
    (1,027 )     2,353       704       73       4,228       2,270       324       8,925  
                                                                 
Ending balance
  $ 2,170     $ 6,742     $ 4,394     $ 1,482     $ 7,952     $ 5,657     $ 833     $ 29,230  
                                                                 
Ending balance, individually evaluated for impairment
    21       170       373       32       168       43       3       810  
                                                                 
Ending balance, collectively evaluated for impairment
    2,149       6,572       4,021       1,450       7,784       5,614       830       28,420  
                                                                 
Loans:
                                                               
                                                                 
Ending balance
    65,004       141,619       111,784       90,448       628,065       504,650       48,586       1,590,156  
                                                                 
Ending balance, individually evaluated for impairment
    104       3,692       4,079       147       7,088       16,423       15       31,548  
                                                                 
Ending balance, collectively evaluated for impairment
    64,900       137,927       107,705       90,301       620,977       488,227       48,571       1,558,608  

The Company evaluates the following loans to determine impairment:  1) all nonaccrual and TDR loans, 2) all non consumer and non 1 to 4 family residential loans with prior charge-offs, 3) all non consumer and non 1 to 4 family loan relationships classified as substandard and 4) loans with indications of or suspected deteriorating credit quality.
 
 
Page 84

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

The following table presents the credit quality indicators by type of loans in each category as of December 31, 2012:

   
Agricultural
   
Commercial
and Financial
   
Real Estate: 
Construction, 1 to
4 family residential
   
Real Estate: 
Construction, land
development and
commercial
 
                         
2012
                       
Grade:
                       
Pass
  $ 70,821     $ 123,005     $ 20,698     $ 67,011  
Potential Watch
    1,169       7,996       2,232       4,636  
Watch
    1,376       10,927       1,826       3,855  
Substandard
    2,824       6,106       1,032       3,595  
Total
  $ 76,190     $ 148,034     $ 25,788     $ 79,097  
                                 
   
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
 
                                 
2012
                               
Grade:
                               
Pass
  $ 106,041     $ 517,684     $ 94,219     $ 173,348  
Potential Watch
    2,434       24,240       3,839       11,098  
Watch
    1,863       21,266       3,584       27,936  
Substandard
    3,503       20,377       2,636       2,430  
Total
  $ 113,841     $ 583,567     $ 104,278     $ 214,812  
                                 
   
Real Estate: 
Mortgage,
commercial
   
Loans to
individuals
   
Obligations of state
and political
subdivisions
   
Total
 
                                 
2012
                               
Grade:
                               
Pass
  $ 267,883     $ 19,763     $ 42,022     $ 1,502,495  
Potential Watch
    11,687       118       -       69,449  
Watch
    24,890       318       1,080       98,921  
Substandard
    8,046       151       -       50,700  
Total
  $ 312,506     $ 20,350     $ 43,102     $ 1,721,565  
 
 
Page 85

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

The following table presents the credit quality indicators by type of loans in each category as of December 31, 2011:

   
Agricultural
   
Commercial
and Financial
   
Real Estate: 
Construction, 1 to
4 family residential
   
Real Estate: 
Construction, land
development and
commercial
 
                         
2011
                       
Grade:
                       
Pass
  $ 60,745     $ 116,234     $ 18,726     $ 60,279  
Potential Watch
    1,129       5,858       878       5,171  
Watch
    4,074       11,104       2,374       5,182  
Substandard
    2,608       9,978       330       13,876  
Total
  $ 68,556     $ 143,174     $ 22,308     $ 84,508  
                                 
   
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
 
                                 
2011
                               
Grade:
                               
Pass
  $ 93,447     $ 510,649     $ 93,761     $ 181,386  
Potential Watch
    1,393       20,532       3,021       12,561  
Watch
    2,490       20,706       4,667       19,317  
Substandard
    2,469       25,431       3,466       9,587  
Total
  $ 99,799     $ 577,318     $ 104,915     $ 222,851  
                                 
   
Real Estate: 
Mortgage,
commercial
   
Loans to
individuals
   
Obligations of state
and political
subdivisions
   
Total
 
                                 
2011
                               
Grade:
                               
Pass
  $ 259,516     $ 19,914     $ 31,085     $ 1,445,742  
Potential Watch
    14,401       180       -       65,124  
Watch
    31,928       290       62       102,194  
Substandard
    10,484       214       -       78,443  
Total
  $ 316,329     $ 20,598     $ 31,147     $ 1,691,503  

 
Page 86


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

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.

Watch – Watch rated loans are supported by a marginal payment capacity and are 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.
 
 
Page 87

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

Past due loans as of December 31, 2012 and 2011 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)
 
December 31, 2012:
                                         
Agricultural
  $ 374     $ -     $ -     $ 374     $ 75,816     $ 76,190     $ -  
Commercial and financial
    712       100       100       912       147,122       148,034       10  
Real estate:
                                                       
Construction, 1 to 4 family residential
    -       -       -       -       25,788       25,788       -  
Construction, land development and commercial
    909       15       -       924       78,173       79,097       -  
Mortgage, farmland
    -       -       512       512       113,329       113,841       -  
Mortgage, 1 to 4 family first liens
    5,433       1,579       2,033       9,045       574,522       583,567       1,592  
Mortgage, 1 to 4 family junior liens
    640       43       221       904       103,374       104,278       221  
Mortgage, multi-family
    840       -       845       1,685       213,127       214,812       592  
Mortgage, commercial
    2,060       -       1,415       3,475       309,031       312,506       228  
Loans to individuals
    22       -       -       22       20,328       20,350       -  
Obligations of state and political subdivisions
    -       -       -       -       43,102       43,102       -  
    $ 10,990     $ 1,737     $ 5,126     $ 17,853     $ 1,703,712     $ 1,721,565     $ 2,643  
                                                         
                   
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)
 
December 31, 2011:
                                                       
Agricultural
  $ 509     $ -     $ 13     $ 522     $ 68,034     $ 68,556     $ 13  
Commercial and financial
    558       187       849       1,594       141,580       143,174       222  
Real estate:
                                                       
Construction, 1 to 4 family residential
    367       -       -       367       21,941       22,308       -  
Construction, land development and commercial
    164       719       327       1,210       83,298       84,508       14  
Mortgage, farmland
    752       -       -       752       99,047       99,799       -  
Mortgage, 1 to 4 family first liens
    4,042       1,012       3,414       8,468       568,850       577,318       2,673  
Mortgage, 1 to 4 family junior liens
    454       353       396       1,203       103,712       104,915       105  
Mortgage, multi-family
    -       -       267       267       222,584       222,851       -  
Mortgage, commercial
    838       755       718       2,311       314,018       316,329       185  
Loans to individuals
    38       21       -       59       20,539       20,598       -  
Obligations of state and political subdivisions
    2,834       -       0       2,834       28,313       31,147       -  
    $ 10,556     $ 3,047     $ 5,984     $ 19,587     $ 1,671,916     $ 1,691,503     $ 3,212  

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.

Accruing loans past due 90 days or more decreased $0.57 million from December 31, 2011 to December 31, 2012. Real estate loans make up approximately $7.42 million, or 96.56%, of total nonaccrual loans as of December 31, 2012.  As of December 31, 2012 and 2011, accruing loans past due 90 days or more were 0.15% and 0.19% of total loans, respectively. The average balance of the past due loans also increased in 2012 as compared to 2011.  The average 90 days or more past due loan balance per loan was $0.11 million as of December 31, 2012 compared to $0.08 million as of December 31, 2011.  The loans 90 days or more past due and still accruing are believed to be adequately collateralized.   Loans are placed on nonaccrual status when management believes the collection of future principal and interest is not reasonably assured.
 
 
Page 88

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

Certain impaired loan information by loan type at December 31, 2012 and 2011 was as follows:

   
December 31, 2012
   
December 31, 2011
 
         
Accruing loans
               
Accruing loans
       
   
Nonaccrual
   
past due 90
   
TDR
   
Nonaccrual
   
past due 90
   
TDR
 
   
loans (1)
   
days or more(2)
   
loans
   
loans (1)
   
days or more(2)
   
loans
 
   
(Amounts In Thousands)
   
(Amounts In Thousands)
 
                                     
Agricultural
  $ -     $ -     $ -     $ -     $ 13     $ -  
Commercial and financial
    265       10       1,824       1,286       222       1,109  
Real estate:
                                               
Construction, 1 to 4 family residential
    714       -       -       -       -       -  
Construction, land development and commercial
    2,169       -       95       648       14       -  
Mortgage, farmland
    512       -       294       556       -       -  
Mortgage, 1 to 4 family first liens
    580       1,592       1,065       1,141       2,673       541  
Mortgage, 1 to 4 family junior liens
    17       221       90       291       105       50  
Mortgage, multi-family
    2,027       592       5,739       2,168       -       5,870  
Mortgage, commercial
    1,401       228       10,323       1,288       185       10,319  
Loans to individuals
    -       -       -       -       -       -  
    $ 7,685     $ 2,643     $ 19,430     $ 7,378     $ 3,212     $ 17,889  

(1)
There were $2.69 million and $3.25 million of TDR loans included within nonaccrual loans as of December 31, 2012 and 2011, respectively.
(2)
There were $0.26 million of TDR loans within accruing loans past due 90 days or more as of December 31, 2011.
 
 
Page 89

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

The Company 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.  The borrower is experiencing financial difficulties or is expected to experience financial difficulties in the near-term, so a concessionary modification is granted to the borrower that would otherwise not be considered.  TDR loans accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles.

Below is a summary of information for TDR loans as of December 31, 2012 and 2011:

   
December 31, 2012
 
                   
   
Number of
   
Recorded
   
Commitments
 
   
contracts
   
investment
   
outstanding
 
         
(Dollar Amounts In Thousands)
 
                   
Agricultural
    -     $ -     $ -  
Commercial and financial
    11       1,927       15  
Real estate:
                       
Construction, 1 to 4 family residential
    -       -       -  
Construction, land development and commercial
    3       401       -  
Mortgage, farmland
    1       295       -  
Mortgage, 1 to 4 family first liens
    8       1,277       -  
Mortgage, 1 to 4 family junior liens
    2       90       8  
Mortgage, multi-family
    5       7,364       -  
Mortgage, commercial
    8       10,771       -  
Loans to individuals
    -       -       -  
      38     $ 22,125     $ 23  
                         
   
December 31, 2011
 
                         
   
Number of
   
Recorded
   
Commitments
 
   
contracts
   
investment
   
outstanding
 
           
(Dollar Amounts In Thousands)
 
                         
Agricultural
    -     $ -     $ -  
Commercial and financial
    9       1,802       108  
Real estate:
                       
Construction, 1 to 4 family residential
    -       -       -  
Construction, land development and commercial
    2       335       452  
Mortgage, farmland
    -       -       -  
Mortgage, 1 to 4 family first liens
    7       801       -  
Mortgage, 1 to 4 family junior liens
    1       50       -  
Mortgage, multi-family
    4       7,597       -  
Mortgage, commercial
    6       10,814       -  
Loans to individuals
    -       -       -  
      29     $ 21,399     $ 560  
 
 
Page 90

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

The following is a summary of TDR loans that were modified during the year ended December 31, 2012:

   
December 31, 2012
 
         
Pre-modification
   
Post-modification
 
   
Number of
   
recorded
   
recorded
 
   
Contracts
   
investment
   
investment
 
         
( Dollar Amounts In Thousands)
 
                   
Agricultural
    -     $ -     $ -  
Commercial and financial
    5       1,050       1,050  
Real estate:
                       
Construction, 1 to 4 family residential
    -       -       -  
Construction, land development and commercial
    1       165       95  
Mortgage, farmland
    1       298       298  
Mortgage, 1 to 4 family first liens
    2       460       460  
Mortgage, 1 to 4 family junior liens
    2       107       92  
Mortgage, multi-family
    1       12       12  
Mortgage, commercial
    4       951       801  
Loans to individuals
    -       -       -  
      16     $ 3,043     $ 2,808  

The Bank has commitments to lend additional borrowings to TDR loan customers.  These commitments are in the normal course of business and allow the borrowers to build pre-sold homes and commercial property and which increase their overall cash flow.  The additional borrowings are not used to facilitate payments on these loans.

There were no TDR loans modified during the year that were in payment default (defined as past due 90 days or more) as of December 31, 2012.
 
 
Page 91

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

Information regarding impaired loans as of and for the year ended December 31, 2012 is as follows:

   
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
   
(Amounts in Thousands)
 
2012
                             
With no related allowance recorded:
                             
Agricultural
  $ -     $ -     $ -     $ -     $ -  
Commercial and financial
    364       1,911       -       750       19  
Real estate:
                                       
Construction, 1 to 4 family residential
    714       946       -       1,262       -  
Construction, land development and commercial
    2,264       3,520       -       2,835       7  
Mortgage, farmland
    806       808       -       830       18  
Mortgage, 1 to 4 family first liens
    952       1,332       -       994       24  
Mortgage, 1 to 4 family junior liens
    68       361       -       71       3  
Mortgage, multi-family
    2,027       2,766       -       2,097       -  
Mortgage, commercial
    2,369       5,046       -       2,427       52  
Loans to individuals
    -       20       -       -       -  
    $ 9,564     $ 16,710     $ -     $ 11,266     $ 123  
With an allowance recorded:
                                       
Agricultural
  $ -     $ -     $ -     $ -     $ -  
Commercial and financial
    1,788       1,788       22       1,902       99  
Real estate:
                                       
Construction, 1 to 4 family residential
    -       -       -       -       -  
Construction, land development and commercial
    -       -       -       -       -  
Mortgage, farmland
    -       -       -       -       -  
Mortgage, 1 to 4 family first liens
    2,286       2,487       83       2,284       106  
Mortgage, 1 to 4 family junior liens
    259       259       7       262       16  
Mortgage, multi-family
    6,331       6,331       241       6,399       320  
Mortgage, commercial
    9,530       9,530       20       9,618       568  
Loans to individuals
    -       -       -       -       -  
    $ 20,194     $ 20,395     $ 373     $ 20,465     $ 1,109  
Total:
                                       
Agricultural
  $ -     $ -     $ -     $ -     $ -  
Commercial and financial
    2,152       3,699       22       2,652       118  
Real estate:
                                       
Construction, 1 to 4 family residential
    714       946       -       1,262       -  
Construction, land development and commercial
    2,264       3,520       -       2,835       7  
Mortgage, farmland
    806       808       -       830       18  
Mortgage, 1 to 4 family first liens
    3,238       3,819       83       3,278       130  
Mortgage, 1 to 4 family junior liens
    327       620       7       333       19  
Mortgage, multi-family
    8,358       9,097       241       8,496       320  
Mortgage, commercial
    11,899       14,576       20       12,045       620  
Loans to individuals
    -       20       -       -       -  
    $ 29,758     $ 37,105     $ 373     $ 31,731     $ 1,232  
 
 
Page 92

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

Information regarding impaired loans as of and for the year ended December 31, 2011 is as follows:

   
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
   
(Amounts in Thousands)
 
2011
                             
With no related allowance recorded:
                             
Agricultural
  $ -     $ -     $ -     $ -     $ -  
Commercial and financial
    793       1,679       -       919       -  
Real estate:
                                       
Construction, 1 to 4 family residential
    -       -       -       -       -  
Construction, land development and commercial
    648       765       -       868       -  
Mortgage, farmland
    556       556       -       429       -  
Mortgage, 1 to 4 family first liens
    1,512       1,905       -       1,577       19  
Mortgage, 1 to 4 family junior liens
    291       568       -       290       -  
Mortgage, multi-family
    5,148       5,757       -       4,795       101  
Mortgage, commercial
    1,986       4,305       -       2,125       45  
Loans to individuals
    -       21       -       -       -  
    $ 10,934     $ 15,556     $ -     $ 11,003     $ 165  
With an allowance recorded:
                                       
Agricultural
  $ 13     $ 13     $ 1     $ 13     $ 1  
Commercial and financial
    1,824       2,954       97       2,670       55  
Real estate:
                                       
Construction, 1 to 4 family residential
    -       -       -       -       -  
Construction, land development and commercial
    14       27       3       21       1  
Mortgage, farmland
    -       -       -       -       -  
Mortgage, 1 to 4 family first liens
    2,843       3,187       88       3,071       137  
Mortgage, 1 to 4 family junior liens
    155       155       5       167       7  
Mortgage, multi-family
    2,890       2,890       29       2,914       114  
Mortgage, commercial
    9,806       9,806       36       9,910       429  
Loans to individuals
    -       -       -       -       -  
    $ 17,545     $ 19,032     $ 259     $ 18,766     $ 744  
Total:
                                       
Agricultural
  $ 13     $ 13     $ 1     $ 13     $ 1  
Commercial and financial
    2,617       4,633       97       3,589       55  
Real estate:
                                       
Construction, 1 to 4 family residential
    -       -       -       -       -  
Construction, land development and commercial
    662       792       3       889       1  
Mortgage, farmland
    556       556       -       429       -  
Mortgage, 1 to 4 family first liens
    4,355       5,092       88       4,648       156  
Mortgage, 1 to 4 family junior liens
    446       723       5       457       7  
Mortgage, multi-family
    8,038       8,647       29       7,709       215  
Mortgage, commercial
    11,792       14,111       36       12,035       474  
Loans to individuals
    -       21       -       -       -  
    $ 28,479     $ 34,588     $ 259     $ 29,769     $ 909  

 
Page 93


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

Information regarding impaired loans as of and for the year ended December 31, 2010 is as follows:

   
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
                               
2010
                             
With no related allowance recorded:
                             
Agricultural
  $ -     $ -     $ -     $ -     $ -  
Commercial and financial
    2,301       3,234       -       2,717       -  
Real estate:
                                       
Construction, 1 to 4 family residential
    -       -       -       -       -  
Construction, land development and commercial
    2,118       2,118       -       2,246       98  
Mortgage, farmland
    -       -       -       -       -  
Mortgage, 1 to 4 family first liens
    181       190       -       222       13  
Mortgage, 1 to 4 family junior liens
    -       224       -       -       -  
Mortgage, multi-family
    1,837       1,883       -       1,860       -  
Mortgage, commercial
    485       2,419       -       525       31  
Loans to individuals
    -       -       -       -       -  
    $ 6,922     $ 10,068     $ -     $ 7,570     $ 142  
With an allowance recorded:
                                       
Agricultural
  $ 104     $ 104     $ 21     $ 164     $ 8  
Commercial and financial
    1,391       1,573       172       1,261       58  
Real estate:
                                       
Construction, 1 to 4 family residential
    270       346       54       308       17  
Construction, land development and commercial
    1,691       2,174       319       1,920       10  
Mortgage, farmland
    147       161       32       156       -  
Mortgage, 1 to 4 family first liens
    5,435       6,274       136       5,773       190  
Mortgage, 1 to 4 family junior liens
    1,472       1,482       34       1,492       59  
Mortgage, multi-family
    2,938       2,938       2       2,961       155  
Mortgage, commercial
    11,163       11,243       39       11,273       657  
Loans to individuals
    15       47       1       33       2  
    $ 24,626     $ 26,342     $ 810     $ 25,341     $ 1,156  
Total:
                                       
Agricultural
  $ 104     $ 104     $ 21     $ 164     $ 8  
Commercial and financial
    3,692       4,807       172       3,978       58  
Real estate:
                                       
Construction, 1 to 4 family residential
    270       346       54       308       17  
Construction, land development and commercial
    3,809       4,292       319       4,166       108  
Mortgage, farmland
    147       161       32       156       -  
Mortgage, 1 to 4 family first liens
    5,616       6,464       136       5,995       203  
Mortgage, 1 to 4 family junior liens
    1,472       1,706       34       1,492       59  
Mortgage, multi-family
    4,775       4,821       2       4,821       155  
Mortgage, commercial
    11,648       13,662       39       11,798       688  
Loans to individuals
    15       47       1       33       2  
    $ 31,548     $ 36,410     $ 810     $ 32,911     $ 1,298  
 
 
Page 94

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3.   Loans (Continued)

Impaired loans increased by $1.28 million from December 31, 2011 to December 31, 2012.  Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans.  Impaired loans also include loans that, based on management’s evaluation of current information and events, the Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement.  The increase in impaired loans is due mainly to an increase in TDR loans of $1.54 million from December 31, 2011 to December 31, 2012 as the result of 16 additional restructured loans.

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

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

The Bank regularly reviews loans in the portfolio and assesses whether the loans are impaired in accordance with ASC 310.  If the loans are impaired, the Bank determines if a specific allowance is appropriate.  In addition, the Bank'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 Bank allocates a percentage, as determined by management, for a required allowance needed.  The determination concerning 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 TDR loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.
 
 
Page 95

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 4.   Property and Equipment

The major classes of property and equipment and the total accumulated depreciation are as follows:


   
December 31,
 
   
2012
   
2011
 
   
(Amounts In Thousands)
 
             
Land
  $ 7,580     $ 7,580  
Buildings and improvements
    27,555       27,141  
Furniture and equipment
    25,605       22,986  
      60,740       57,707  
Less accumulated depreciation
    30,116       27,386  
Net
  $ 30,624     $ 30,321  

Note 5.   Interest-Bearing Deposits

A summary of these deposits is as follows:

   
December 31,
 
   
2012
   
2011
 
   
(Amounts In Thousands)
 
             
NOW and other demand
  $ 352,373     $ 291,480  
Savings
    450,336       395,121  
Time, $100,000 and over
    182,403       174,919  
Other time
    403,459       440,579  
    $ 1,388,571     $ 1,302,099  

Brokered deposits totaled $41.54 million and $32.12 million as of December 31, 2012 and 2011, respectively with an average interest rate of 0.70% and 0.71% as of December 31, 2012 and 2011, respectively. As of December 31, 2012, brokered deposits of $29.83 million are included in savings deposits and $11.71 million are included in time deposits.  At December 31, 2011, brokered deposits of $24.58 million were included in savings deposits and $7.54 million were included in time deposits. Brokered time deposits in increments greater than $100,000 as of December 31, 2012 and 2011 were $8.74 million and $4.46 million, respectively.
 
 
Page 96

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 5.   Interest-Bearing Deposits (Continued)

Time deposits have a maturity as follows:

   
December 31,
 
   
2012
   
2011
 
   
(Amounts In Thousands)
 
Due in one year or less
  $ 236,068     $ 292,016  
Due after one year through two years
    137,355       125,431  
Due after two years through three years
    123,171       69,436  
Due after three years through four years
    62,342       73,958  
Due over four years
    26,926       54,657  
    $ 585,862     $ 615,498  

Note 6.   Short-Term Borrowings

The following table sets forth selected information for short-term borrowings (borrowings with a maturity of less than one year):
 
   
December 31,
 
   
2012
   
2011
 
   
(Amounts In Thousands)
 
Federal funds purchased, secured by other securities (FHLB, FHLMC and FNMA)
  $ -     $ 12,406  
Repurchase agreements with customers, renewable daily, interest payable monthly, secured by other securities (FHLB, FHLMC and FNMA)     38,783       40,379  
    $ 38,783     $ 52,785  

The weighted average interest rate on short-term borrowings outstanding as of December 31, 2012 and 2011 was 0.34% and 0.40%, respectively.

Customer repurchase agreements are used by the Bank to acquire funds from customers where the customer is required or desires to have their funds supported by collateral consisting of investment securities.  The repurchase agreement is a commitment to sell these securities to a customer at a certain price and repurchase them at a future date at that same price plus interest accrued at an agreed upon rate.  The Bank uses customer repurchase agreements in its liquidity plan as well as an accommodation to customers.  At December 31, 2012, $38.78 million of securities sold under repurchase agreements with a weighted average interest rate of 0.34%, maturing in 2013, were collateralized by investment securities having an amortized cost of $38.78 million.
 
 
Page 97

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 7. Federal Home Loan Bank Borrowings

As of December 31, 2012 and 2011, the borrowings were as follows:

   
2012
   
2011
 
(Effective interest rates as of December 31, 2012)
 
(Amounts In Thousands)
 
             
Due 2015, 3.70% to 4.56%
  $ -     $ 60,000  
Due 2016, 4.46% to 4.69%
    45,000       45,000  
Due 2017, 4.09% to 4.89%
    60,000       60,000  
Due 2018, 3.65%
    20,000       20,000  
    $ 125,000     $ 185,000  

All of the borrowings are callable by the FHLB with call dates during 2013.  The advances are unlikely to be called unless rates would increase significantly.  The borrowings with the FHLB have prepayment fees associated with them; therefore, the Company cannot prepay without incurring fees.

To participate in the FHLB advance program, the Company is required to have an investment in FHLB stock.  The Company’s investment in FHLB stock was $8.06 million and $10.73 million at December 31, 2012 and 2011, respectively.  Collateral is provided by the Company’s 1 to 4 family mortgage loans totaling $168.75 million at December 31, 2012 and $249.75 million at December 31, 2011.  The Company also has the ability to borrow against commercial real estate and multi-family loans totaling $152.29 million as of December 31, 2012 and $144.37 as of December 31, 2011 and there was $0 borrowed against this collateral as of December 31, 2012 or 2011.

The Bank prepaid $60.00 million of Federal Home Loan Bank borrowings during the year ended December 31, 2012 as part of a strategy to utilize the Bank’s liquidity, improve net interest margin and decrease interest rate risk in the future.  As a result, the Bank incurred a one-time prepayment penalty of $5.93 million, which it recorded as loss on extinguishment of debt.

 
Page 98


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 8.   Other Comprehensive Income

The following table summarizes the changes in the balances of each component of accumulated other comprehensive income (loss) (Amounts in Thousands):

   
December 31, 2012
   
December 31, 2011
   
December 31, 2010
 
   
Unrealized
Gains on
Securities
   
Accumulated
Other
Comprehensive
Income
   
Unrealized
Gains on
Securities
   
Accumulated
Other
Comprehensive
Income
   
Unrealized
Gains on
Securities
   
Accumulated
Other
Comprehensive
Income
 
                                     
Beginning of Year Balance
  $ 4,974     $ 4,974     $ 2,781     $ 2,781     $ 4,200     $ 4,200  
Current period, other comprehensive (loss) income
    (1,019 )     (1,019 )     2,193       2,193       (1,419 )     (1,419 )
End of Year Balance
  $ 3,955     $ 3,955     $ 4,974     $ 4,974     $ 2,781     $ 2,781  

Note 9.   Employee Benefit Plans

The Company’s Board of Directors and its stockholders adopted in April 2012 the Hills Bancorporation Employee Stock Purchase Plan (the “ESPP”).  For each quarterly offering period, eligible employees can elect to contribute from 1% to 15% of his or her compensation.  The purchase price is the lesser of the fair market value on the first day of the offering period or the last day of the offering period.  The maximum dollar amount any one employee can elect to contribute in an offering period is $10,000.  During the year ended December 31, 2012, 375 shares of stock were purchased by employees of the Bank through the ESPP.

The Company has an Employee Stock Ownership Plan (the "ESOP") to which it makes discretionary cash contributions.  The Company's contribution to the ESOP totaled $1.49 million, $1.45 million and $1.56 million for the years ended December 31, 2012, 2011 and 2010, respectively. The 2012 and 2011 discretionary contribution rates were 9% of qualified salaries. The 2010 discretionary contribution rate was 10% of qualified salaries.

During the year ended December 31, 2011, the ESOP purchased an additional 40,028 shares of common stock in the Company with a loan from the Company.  The note payable bears interest at the prime rate subject to a floor of 5.0% with principal and interest payable annually for five consecutive years.  The loan is collateralized by the unreleased shares of stock purchased as well as a certificate of deposit the Company holds at the Bank in the original amount of the note.  The note payable and certificate of deposit are not included in the consolidated balance sheet. There was no interest income or expense recognized in the consolidated statement of income.

As the note payable is repaid by the ESOP, shares are released from collateral and allocated to qualified employees based on the proportion of principal and interest paid in the year to total principal and interest payments anticipated for the life of the loan.  8,724 shares were released in 2012 and 7,314 shares were released in 2011. The shares pledged as collateral are reported as a reduction of stockholder’s equity in the consolidated balance sheet.  As shares are committed to be released from collateral, the Company reports compensation expense equal to the current market price of the shares, and the shares become outstanding for earnings per share computations.  Unallocated shares were 23,990 as of December 31, 2012 and 32,714 as of December 31, 2011. Dividends on allocated ESOP shares are recorded as a reduction of retained earnings.  Dividends on unallocated ESOP shares are used to reduce debt.

 
Page 99


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 9.   Employee Benefit Plans (Continued)

In the event a terminated plan participant desires to sell his or her shares of the Company stock, or for certain employees who elect to diversify their account balances, the Company may be required to purchase the shares from the participant at their fair value.  To the extent that shares of common stock held by the ESOP are not readily traded, a sponsor must reflect the maximum cash obligation related to those securities outside of stockholders' equity.  Effective June 30, 2005, as a result of the Company’s program to repurchase up to a total of 750,000 shares of the Company’s common stock, the Company began obtaining a quarterly independent appraisal of the shares of stock.  Previously, the Company was obtaining an independent appraisal of the shares of stock on an annual basis for the Company’s ESOP.  As of December 31, 2012 and 2011, the shares held by the ESOP, fair value and maximum cash obligation were as follows:

   
2012
   
2011
 
             
Shares held by the ESOP
    438,778       434,775  
Fair value per share
  $ 70.00     $ 64.00  
Maximum cash obligation
  $ 30,715,000     $ 27,826,000  

The Company has a profit-sharing plan with a 401(k) feature, which provides for discretionary annual contributions in amounts to be determined by the Board of Directors.  The Company did not make a profit sharing plan contribution in the years ended December 31, 2012, 2011, and 2010. The Company made matching contributions under its 401(k) plan of $0.14 million in 2012, $0.14 million in 2011, and $0.13 million in 2010 and each such amount is included in salaries and employee benefits.

The Company provides a deferred compensation program for executive officers.  This program allows executive officers to elect to defer a portion of their salaried compensation for payment by the Company at a subsequent date.  The executive officers can defer up to 30% of their base compensation and up to 100% of any bonus into the deferral plan.  Any amount so deferred is credited to the executive officer’s deferred compensation account and converted to units equivalent in value to the fair market value of a share of stock in Hills Bancorporation.  The “stock units” are book entry only and do not represent an actual purchase of stock.  The executive officer’s account is adjusted each year for dividends paid and the change in the market value of Hills Bancorporation stock.  The deferrals and earnings grow tax deferred until withdrawn from the plan.  Earnings credited to the individual’s accounts are recorded as compensation expense when earned.  The deferred compensation liability is recorded in other liabilities and totals $4.37 million and $3.85 million at December 31, 2012 and 2011, respectively.  Expense related to the deferred compensation plan was $0.45 million for 2012, $0.38 million for 2011 and $0.36 million for 2010 and is included in salaries and employee benefits expense.  Expenses related to the deferred compensation plan in 2012 increased from 2011 which is primarily the result of the change in the appraised value of the Company’s common stock during 2012.

The Company also provides a deferred compensation program for its Board of Directors.  Under the plan, each director may elect to defer up to 50% of such director’s cash compensation from retainers and meeting fees for payment by the Company at a subsequent date.  Any amount so deferred is credited to the director’s deferred compensation account and converted to units equivalent in value to the fair market value of a share of stock in Hills Bancorporation.  The “stock units” are book entry only and do not represent an actual purchase of stock.  The director’s account is adjusted each year for dividends paid and the change in the market value of Hills Bancorporation stock.  The deferred compensation liability for the directors’ plan is recorded in other liabilities and totaled $1.99 million and $1.73 million at December 31, 2012 and 2011, respectively. Expense related to the directors’ deferred compensation plan was $0.20 million for 2012, $0.17 million for 2011 and $0.16 million for 2010 and is included in other noninterest expense.  Expenses related to the deferred compensation plan increased from 2011 which is primarily the result of the change in the appraised value of the Company’s common stock during 2012.

 
Page 100


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 9.   Employee Benefit Plans (Continued)

The Company has a Stock Option and Incentive Plan for certain key employees and directors whereby shares of common stock have been reserved for awards in the form of stock options or restricted stock awards. Under the plan, the aggregate number of options and shares granted cannot exceed 94,000 shares. A Stock Option Committee may grant options at prices equal to the fair value of the stock at the date of the grant. Options expire 10 years from the date of the grant. Director options granted on or before December 31, 2006 may be exercised immediately.  Director options granted on or after January 1, 2007, and officers' rights under the plan vest over a five-year period from the date of the grant.

A summary of the stock options is as follows:
 
               
Weighted-Average
   
Aggregate
 
         
Weighted-Average
   
Remaining Contractual
   
Intrinsic Value
 
   
Number of Shares
   
Exercise Price
   
Term (Years)
   
(In Thousands)
 
Balance, December 31, 2009
    33,360       32.88       3.60       1,097  
Granted
    -                          
Exercised
    (5,405 )                        
Balance, December 31, 2010
    27,955       33.83       2.84       946  
Granted
    -                          
Exercised
    (9,115 )                        
Balance, December 31, 2011
    18,840       36.60       2.51       690  
Granted
    5,110                          
Exercised
    (5,965 )                        
Balance, December 31, 2012
    17,985       47.62       4.25       856  
 
The weighted-average fair value of options granted in 2012 was $24.89 per share.  There were 5,110 stock options granted in 2012 and no stock options granted in 2010 or 2011.  The intrinsic value of options exercised in 2012 was $0.23 million.  The intrinsic value of options exercised was $0.26 million for 2011.

The fair value of each option is estimated as of the date of grant using a Black Scholes option pricing model.  The expected lives of options granted incorporate historical employee exercise behavior.  The risk-free rate for periods that coincide with the expected life of the options is based on the ten year interest rate swap rate as published by the Federal Reserve Bank on the date of issuance.  Expected volatility is based on volatility levels of the Company’s peer’s common stock as the Company’s stock has limited trading activity.  Expected dividend yield was based on historical dividend rates. Significant assumptions at date of grant include:

   
October 9, 2012
   
April 24, 2012
   
2011
   
2010
 
                         
Risk-free interest rate
    1.77 %     2.08 %     n/a       n/a  
Expected option life
 
7.5 years
   
7.5 years
      n/a       n/a  
Expected volatility
    39.50 %     39.80 %     n/a       n/a  
Expected dividends
    1.64 %     1.64 %     n/a       n/a  
                                 
 
 
Page 101

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 9.   Employee Benefit Plans (Continued)

Other pertinent information related to the options outstanding at December 31, 2012 is as follows:

Exercise Price
   
Number Outstanding
 
Remaining Contractual Life
 
Number Exercisable
 
                 
  29.33       1,635  
1 month
    1,635  
  33.67       3,000  
12 months
    3,000  
  34.50       2,940  
16 months
    2,940  
  36.25       720  
24 months
    720  
  52.00       4,580  
52 months
    4,580  
  66.00       3,610  
112 months
    -  
  69.00       1,500  
118 months
    -  
          17,985         12,875  

As of December 31, 2012, the outstanding options have a weighted-average exercise price of $47.62 per share and a weighted average remaining contractual term of 4.25 years.  There was $0.11 million in unrecognized compensation cost for stock options granted under the plan as of December 31, 2012.  This cost is expected to be recognized over a weighted-average period of 4.45 years.

As of December 31, 2012, the vested options totaled 12,875 shares with a weighted-average exercise price of $39.97 per share and a weighted-average remaining contractual term of 2.19 years.  There were 4,580 shares that vested in 2012 and no shares that vested in 2011 and 2010.  The fair value of the 4,580 options vested during 2012 was $0.31 million.

As of December 31, 2012, 76,186 shares were available for stock options and awards.  The Compensation and Incentive Stock Committee is also authorized to grant awards of restricted common stock, and it authorized the issuance of 6,885 shares of common stock in 2012, 6,629 shares in 2011 and 831 shares in 2010 to certain employees.  The vesting period for these awards is five years and the Bank amortizes the expense on a straight line basis during the vesting period.  The expense relating to these awards for the years ended December 31, 2012, 2011 and 2010 was $0.17 million, $0.10 million and $0.17 million, respectively.

 
Page 102


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 10.   Income Taxes

Income taxes for the years ended December 31, 2012, 2011 and 2010 are summarized as follows:

   
2012
   
2011
   
2010
 
   
(Amounts In Thousands)
 
                   
Current:
                 
Federal
  $ 6,480     $ 8,895     $ 7,694  
State
    2,045       1,954       1,663  
Deferred:
                       
Federal
    1,822       24       (86 )
State
    195       (44 )     (13 )
    $ 10,542     $ 10,829     $ 9,258  

Temporary differences between the amounts reported in the consolidated financial statements and the tax basis of assets and liabilities result in deferred taxes.  Deferred tax assets and liabilities at December 31, 2012 and 2011 were as follows:

   
December 31,
 
   
2012
   
2011
 
   
(Amounts In Thousands)
 
Deferred income tax assets:
           
Allowance for loan losses
  $ 9,624     $ 11,532  
Deferred compensation
    2,561       2,254  
Accrued expenses
    808       646  
State net operating loss
    482       445  
Gross deferred tax assets
    13,475       14,877  
Valuation allowance
    (482 )     (445 )
Deferred tax asset, net of valuation allowance
    12,993       14,432  
Deferred income tax liabilities:
               
Property and equipment
    2,022       1,710  
Unrealized gains on investment securities
    2,450       3,081  
Goodwill
    624       624  
Other
    753       486  
Gross deferred tax liabilities
    5,849       5,901  
Net deferred income tax assets
  $ 7,144     $ 8,531  

 
Page 103


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 10.   Income Taxes (Continued)

The Company has recorded a deferred tax asset for the future tax benefits of Iowa net operating loss carry-forwards.  The net operating loss carry-forwards are generated by the Company largely from its investment in tax credit real estate properties.  The Company is required to file a separate Iowa tax return and cannot be consolidated with the Bank.  The net operating loss carry-forwards will expire, if not utilized, between 2013 and 2033.  The Company has recorded a valuation allowance to reduce the deferred tax asset attributable to the net operating loss carry-forwards.  At December 31, 2012 and 2011, the Company believes it is more likely than not that the Iowa net operating loss carry-forwards will not be realized.  The increase in net operating loss carry-forward in 2012 compared to 2011 reflects the additional Iowa income tax net operating loss generated during 2012 less any expiring carry-forward.  A valuation allowance related to the remaining deferred tax assets has not been provided because management believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets.

The valuation allowance increased by $37,000 and $3,000 for the years ended December 31, 2012 and 2011, respectively.

The net change in the deferred income taxes for the years ended December 31, 2012, 2011 and 2010 is reflected in the consolidated financial statements as follows:

   
Year Ended December 31,
 
   
2012
   
2011
   
2010
 
   
(Amounts In Thousands)
 
                   
Consolidated statements of income
  $ (2,018 )   $ 20     $ 99  
Consolidated statements of stockholders' equity
    631       (1,359 )     879  
    $ (1,387 )   $ (1,339 )   $ 978  
 
 
Page 104

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 10.   Income Taxes (Continued)

Income tax expense for the years ended December 31, 2012, 2011 and 2010 are less than the amounts computed by applying the maximum effective federal income tax rate to the income before income taxes because of the following items:

   
2012
   
2011
   
2010
 
         
% Of
         
% Of
         
% Of
 
         
Pretax
         
Pretax
         
Pretax
 
   
Amount
   
Income
   
Amount
   
Income
   
Amount
   
Income
 
   
(Amounts In Thousands)
 
                                     
Expected tax expense
  $ 13,081       35.0 %   $ 13,162       35.0 %   $ 11,401       35.0 %
Tax-exempt interest
    (1,622 )     (4.3 )     (1,612 )     (4.3 )     (1,319 )     (4.1 )
Interest expense limitation
    112       0.3       124       0.3       119       0.4  
State income taxes, net of federal income tax benefit
    1,456       3.9       1,242       3.3       1,073       3.3  
Income tax credits
    (2,046 )     (5.5 )     (1,993 )     (5.3 )     (1,909 )     (5.9 )
Other
    (439 )     (1.2 )     (94 )     (0.2 )     (107 )     (0.3 )
    $ 10,542       28.2 %   $ 10,829       28.8 %   $ 9,258       28.4 %

Federal income tax expense for the years ended December 31, 2012, 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.  On January 1, 2007, the Company adopted ASC 740.  The evaluation was performed for those tax years which remain open to audit.  The Company files a consolidated tax return for federal purposes and separate tax returns for the State of Iowa purposes.  The tax years ended December 31, 2012, 2011, 2010 and 2009, remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2012, 2011, 2010 and 2009, remain open for examination.  As a result of the implementation of ASC 740, the Company did not recognize any increase or decrease for unrecognized tax benefits.  There were no material unrecognized tax benefits at December 31, 2012 and December 31, 2011.  No interest or penalties on these unrecognized tax benefits has been recorded.  As of December 31, 2012, the Company does not anticipate any significant increase or decrease in unrecognized tax benefits during the twelve month period ending December 31, 2013.
 
 
Page 105

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11.   Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash Restrictions

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

Quantitative measures established by the regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the tables that follow) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined).  Management believes that, as of December 31, 2012 and 2011, the Company and the Bank met all capital adequacy requirements to which they are subject.

As of December 31, 2012, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table that follows.  There are no conditions or events since that notification that management believes have changed the institution’s category.

The actual amounts and capital ratios as of December 31, 2012 and 2011, with the minimum regulatory requirements for the Company and Bank are presented below (amounts in thousands):

                     
To Be Well
 
               
For Capital
   
Capitalized Under
 
               
Adequacy
   
Prompt Corrective
 
   
Actual
   
Purposes
   
Action Provisions
 
   
Amount
   
Ratio
   
Ratio
   
Ratio
 
As of December 31, 2012:
                       
Company:
                       
Total risk-based capital
  $ 269,751       16.66 %     8.00 %     10.00 %
Tier 1 risk-based capital
    249,456       15.41       4.00       6.00  
Leverage ratio
    249,456       11.90       4.00       5.00  
Bank:
                               
Total risk-based capital
    268,046       16.56       8.00       10.00  
Tier 1 risk-based capital
    247,757       15.31       4.00       6.00  
Leverage ratio
    247,757       11.82       4.00       5.00  

 
Page 106


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11.   Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash Restrictions (Continued)

                     
To Be Well
 
               
For Capital
   
Capitalized Under
 
               
Adequacy
   
Prompt Corrective
 
   
Actual
   
Purposes
   
Action Provisions
 
   
Amount
   
Ratio
   
Ratio
   
Ratio
 
As of December 31, 2011:
                       
Company:
                       
Total risk-based capital
  $ 248,366       15.96 %     8.00 %     10.00 %
Tier 1 risk-based capital
    228,781       14.69       4.00       6.00  
Leverage ratio
    228,781       11.43       4.00       5.00  
Bank:
                               
Total risk-based capital
    247,272       15.87       8.00       10.00  
Tier 1 risk-based capital
    227,669       14.62       4.00       6.00  
Leverage ratio
    227,669       11.38       4.00       5.00  

The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank.  The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends.  To maintain acceptable capital ratios in the Bank, certain of its retained earnings are not available for the payment of dividends.  To maintain a ratio of capital to assets of 8%, retained earnings of $80.02 million as of December 31, 2012 are available for the payment of dividends to the Company.

The Bank is required to maintain reserve balances in cash or with the Federal Reserve Bank.  Reserve balances totaled $54.42 million and $3.58 million as of December 31, 2012 and 2011, respectively.
 
 
Page 107

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 12.   Related Party Transactions

Certain directors of the Company and the Bank and companies with which the directors are affiliated and certain principal officers are customers of, and have banking transactions with, the Bank in the ordinary course of business.  Such indebtedness has been incurred on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons.

The following is an analysis of the changes in the loans to related parties during the years ended December 31, 2012 and 2011:

   
Year Ended December 31,
 
   
2012
   
2011
 
   
(Amounts In Thousands)
 
             
Balance, beginning
  $ 37,318     $ 34,233  
Net decrease due to change in related parties
    (11,654 )     -  
Advances
    27,326       50,234  
Collections
    (29,483 )     (47,149 )
Balance, ending
  $ 23,507     $ 37,318  

Deposits from these related parties totaled $7.21 million and $7.82 million as of December 31, 2012 and 2011, respectively.  Deposits from related parties are accepted subject to the same interest rates and terms as those from nonrelated parties.

 
Page 108


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13.           Fair Value Measurements

The carrying value and estimated fair values of the Company’s financial instruments as of December 31, 2012 are as follows:

   
December 31, 2012
 
   
Carrying
Amount
   
Estimated
Fair Value
   
Readily
Available
Market
Prices(1)
   
Observable
Market
Prices(2)
   
Company
Determined
Market
Prices(3)
 
   
(Amounts In Thousands)
 
Financial instrument assets:
                             
Cash and cash equivalents
  $ 63,582     $ 63,582     $ 63,582     $ -     $ -  
Investment securities
    234,244       234,244       -       234,244       -  
Loans held for sale
    28,256       28,256       -       28,256       -  
Loans
                                       
Agricultural
    74,537       72,605       -       -       72,605  
Commercial and financial
    143,461       138,350       -       -       138,350  
Real estate:
                                       
Construction, 1 to 4 family residential
    24,940       25,516       -       -       25,516  
Construction, land development and commercial
    76,770       78,827       -       -       78,827  
Mortgage, farmland
    112,095       116,751       -       -       116,751  
Mortgage, 1 to 4 family first liens
    577,027       603,442       -       -       603,442  
Mortgage, 1 to 4 family junior liens
    102,730       107,049       -       -       107,049  
Mortgage, multi-family
    212,972       223,295       -       -       223,295  
Mortgage, commercial
    309,242       323,639       -       -       323,639  
Loans to individuals
    19,968       20,148       -       -       20,148  
Obligations of state and political subdivisions
    42,663       42,487       -       -       42,487  
Accrued interest receivable
    7,851       7,851       -       7,851       -  
Total financial instrument assets
  $ 2,030,338     $ 2,086,042     $ 63,582     $ 270,351     $ 1,752,109  
Financial instrument liabilities:
                                       
Deposits
                                       
Noninterest-bearing deposits
  $ 273,973     $ 273,973     $ -     $ 273,973     $ -  
Interest-bearing deposits
    1,388,571       1,400,509       -       1,400,509       -  
Short-term borrowings
    38,783       38,783       -       38,783       -  
Federal Home Loan Bank borrowings
    125,000       136,842       -       136,842       -  
Accrued interest payable
    1,361       1,361       -       1,361       -  
Total financial instrument liabilities
  $ 1,827,688     $ 1,851,468     $ -     $ 1,851,468     $ -  
                                         
   
Face Amount
                                 
Financial instrument with off-balance sheet risk:
                                       
Loan commitments
  $ 344,120     $ -     $ -     $ -     $ -  
Letters of credit
    10,778       -       -       -       -  
Total financial instrument liabilities with off-balance-sheet risk
  $ 354,898     $ -     $ -     $ -     $ -  

 
(1)
Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”).
 
(2)
Considered Level 2 under ASC 820.
 
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
 
 
Page 109


 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13.           Fair Value Measurements (Continued)

The carrying value and estimated fair values of the Company’s financial instruments as of December 31, 2011 are as follows:

   
December 31, 2011
 
   
Carrying
Amount
   
Estimated
Fair Value
   
Readily
Available
Market
Prices(1)
   
Observable
Market
Prices(2)
   
Company
Determined
Market
Prices(3)
 
   
(Amounts In Thousands)
 
Financial instrument assets:
                             
Cash and cash equivalents
  $ 29,291     $ 29,291     $ 29,291     $ -     $ -  
Investment securities
    222,095       222,095       -       222,095       -  
Loans held for sale
    24,615       24,615       -       24,615       -  
Loans
                                       
Agricultural
    67,202       68,306       -       -       68,306  
Commercial and financial
    136,745       135,317       -       -       135,317  
Real estate:
                                       
Construction, 1 to 4 family residential
    21,744       22,233       -       -       22,233  
Construction, land development and commercial
    80,078       79,527       -       -       79,527  
Mortgage, farmland
    98,388       101,743       -       -       101,743  
Mortgage, 1 to 4 family first liens
    570,844       591,460       -       -       591,460  
Mortgage, 1 to 4 family junior liens
    102,901       105,872       -       -       105,872  
Mortgage, multi-family
    220,963       229,779       -       -       229,779  
Mortgage, commercial
    312,067       322,922       -       -       322,922  
Loans to individuals
    20,227       20,542       -       -       20,542  
Obligations of state and political subdivisions
    30,757       30,811       -       -       30,811  
Accrued interest receivable
    8,689       8,689       -       8,689       -  
Total financial instrument assets
  $ 1,946,606     $ 1,993,202     $ 29,291     $ 255,399     $ 1,708,512  
Financial instrument liabilities:
                                       
Deposits
                                       
Noninterest-bearing deposits
  $ 223,378     $ 223,378     $ -     $ 223,378     $ -  
Interest-bearing deposits
    1,302,099       1,309,545       -       1,309,545       -  
Short-term borrowings
    52,785       52,785       -       52,785       -  
Federal Home Loan Bank borrowings
    185,000       199,008       -       199,008       -  
Accrued interest payable
    1,625       1,625       -       1,625       -  
Total financial instrument liabilities
  $ 1,764,887     $ 1,786,341     $ -     $ 1,786,341     $ -  
                                         
   
Face Amount
                                 
Financial instrument with off-balance sheet risk:
                                       
Loan commitments
  $ 269,687     $ -     $ -     $ -     $ -  
Letters of credit
    12,016       -       -       -       -  
Total financial instrument liabilities with off-balance-sheet risk
  $ 281,703     $ -     $ -     $ -     $ -  

 
(1)
Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”).
 
(2)
Considered Level 2 under ASC 820.
 
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

 
Page 110


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13.           Fair Value Measurements (Continued)

Fair value of financial instruments:  FASB ASC 820, Fair Value Measurements and Disclosures (“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
Quoted prices in active markets for identical assets or liabilities.

 
Level 2
Observable inputs other than quoted prices included within Level 1.  Observable inputs include the quoted prices for similar assets or liabilities in markets that are not active and inputs other than quoted prices that are observable for the asset or liability.

 
Level 3
Unobservable inputs supported by little or no market activity for financial instruments.  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.

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.
 
 
Page 111

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13.   Fair Value Measurements (Continued)

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 (Level 1).

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.  All of the Company’s securities are considered Level 2.

The pricing for investment securities is obtained from an independent source.  There are no level 1 or level 3 investment securities owned by the Company.  The Company obtains an understanding of the independent source’s valuation methodologies used to determine fair value by level of security. The Company validates assigned fair values on a sample basis using an additional third-party provider pricing service to determine if the fair value measurement is reasonable.  Due to the nature of our investment portfolio, we do not expect significant and unusual fluctuations as fair value changes primarily relate to interest rate changes.   No unusual fluctuations were identified during the year ended December 31, 2012.   If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.

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 (Level 2).  The market is active for these loans and as a result prices for similar assets are available.

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 (Level 3).  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 (Level 3).  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 (Level 3).  These loans are considered Level 3 as the instruments used to determine fair market value require significant management judgment and estimation.

Foreclosed assets:  The Company does not record foreclosed assets at fair value on a recurring basis.  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.   Fair value is generally based upon independent market prices or appraised values of the collateral, and may include a marketability discount as deemed necessary by management based on its experience with similar types of real estate.  The value of foreclosed assets is evaluated periodically as a nonrecurring fair value adjustment.  Foreclosed assets are classified as Level 3.

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 (Level 2).

Accrued interest receivable:  The fair value of accrued interest receivable equals the amount receivable due to the current nature of the amounts receivable (Level 2).

 
Page 112


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13.   Fair Value Measurements (Continued)

ASSETS (Continued)

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 (Level 2).

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 (Level 2).  Deposit liabilities are classified as Level 2 due to available prices for similar liabilities in the market.

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 (Level 2).  Short-term borrowings are classified as Level 2 due to available prices for similar liabilities in the market.

Federal Home Loan Bank borrowings:  Federal Home Loan Bank borrowings are recorded at historical cost.  The fair values of the Company’s Federal Home Loan Bank borrowings are estimated using discounted cash flow analyses, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements (Level 2).  Federal Home Loan Bank borrowings are classified as Level 2 due to available prices for similar liabilities in the market.

Accrued interest payable:  The fair value of accrued interest payable equals the amount payable due to the current nature of the amounts payable (Level 2).

 
Page 113


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13.   Fair Value Measurements (Continued)

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:

   
December 31, 2012
 
   
Readily Available
Market Prices(1)
   
Observable
Market
Prices(2)
   
Company
Determined
Market
Prices(3)
   
Total at
Fair Value
 
Securities available for sale
 
(Amounts in Thousands)
 
State and political subdivisions
  $ -     $ 134,332     $ -     $ 134,332  
Other securities (FHLB, FHLMC and FNMA)
    -       91,850       -       91,850  
Total
  $ -     $ 226,182     $ -     $ 226,182  
                                 
   
December 31, 2011
 
   
Readily Available
Market Prices(1)
   
Observable
Market
Prices(2)
   
Company
Determined
Market 
Prices(3)
   
Total at
Fair Value
 
Securities available for sale
 
(Amounts in Thousands)
 
State and political subdivisions
  $ -     $ 119,431     $ -     $ 119,431  
Other securities (FHLB, FHLMC and FNMA)
    -       91,936       -       91,936  
Total
  $ -     $ 211,367     $ -     $ 211,367  

 
(1)
Considered Level 1 under ASC 820.
 
(2)
Considered Level 2 under ASC 820.
 
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

There were no transfers between Levels 1, 2 or 3 during the year ended December 31, 2012.
 
 
Page 114

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13.   Fair Value Measurements (Continued)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Company is required to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP.  These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets.  The valuation methodologies used to measure these fair value adjustments are described above.  For assets measured at fair value on a nonrecurring basis in 2012 that were still held on the balance sheet at December 31, 2012, the following table provides the level of valuation assumptions used to determine the adjustment and the carrying value of the related individual assets at year end.

                           
Year Ended
 
   
December 31, 2012
   
December 31, 2012
 
   
Readily
Available
Market
Prices(1)
   
Observable
Market
Prices(2)
   
Company
Determined
Market
Prices(3)
   
Total at Fair Value
   
Total Losses
 
   
(Amounts in Thousands)
       
                               
Loans (4)
                             
Agricultural
  $ -     $ -     $ -     $ -     $ -  
Commercial and financial
    -       -       2,130       2,130       302  
Real Estate:
                                       
Construction, 1 to 4 family residential
    -       -       714       714       -  
Construction, land development and commercial
    -       -       2,264       2,264       1,176  
Mortgage, farmland
    -       -       806       806       -  
Mortgage, 1 to 4 family first liens
    -       -       3,155       3,155       665  
Mortgage, 1 to 4 family junior liens
    -       -       320       320       82  
Mortgage, multi-family
    -       -       8,117       8,117       -  
Mortgage, commercial
    -       -       11,879       11,879       210  
Loans to individuals
    -       -       -       -       12  
Foreclosed assets (5)
    -       -       234       234       164  
Total
  $ -     $ -     $ 29,619     $ 29,619     $ 2,611  

 
(1)
Considered Level 1 under ASC 820.
 
(2)
Considered Level 2 under ASC 820.
 
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
 
(4)
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.
 
(5)
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.

During the year ended December 31, 2012 the Company revised the classification of impaired loans and foreclosed assets from previous filings.  In previous filings, the Company classified impaired loans and foreclosed assets as Level 2 under ASC 820.  The Company revised the classification to Level 3 as the determination of fair value requires significant management judgment or estimation due to the inherent subjectivity of the inputs used to determine value.  The resulting change in presentation does not have a material impact on the Company’s financial position.

 
Page 115


HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13.   Fair Value Measurements (Continued)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis (continued)

                           
Year Ended
 
   
December 31, 2011
   
December 31, 2011
 
   
Readily
Available
Market
Prices(1)
   
Observable
Market
Prices(2)
   
Company
Determined
Market
Prices(3)
   
Total at
Fair Value
   
Total Losses
 
   
(Amounts in Thousands)
       
                               
Loans (4)
                             
Agricultural
  $ -     $ -     $ -     $ -     $ -  
Commercial and financial
    -       -       2,163       2,163       548  
Real Estate:
                                       
Construction, 1 to 4 family residential
    -       -       -       -       -  
Construction, land development and commercial
    -       -       472       472       30  
Mortgage, farmland
    -       -       331       331       -  
Mortgage, 1 to 4 family first liens
    -       -       7,174       7,174       1,205  
Mortgage, 1 to 4 family junior liens
    -       -       222       222       207  
Mortgage, multi-family
    -       -       613       613       50  
Mortgage, commercial
    -       -       2,297       2,297       525  
Loans to individuals
    -       -       -       -       5  
Foreclosed assets (5)
    -       -       286       286       198  
Total
  $ -     $ -     $ 13,558     $ 13,558     $ 2,768  

 
(1)
Considered Level 1 under ASC 820.
 
(2)
Considered Level 2 under ASC 820.
 
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
 
(4)
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.
 
(5)
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.
 
 
Page 116

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 14.   Parent Company Only Financial Information

Following is condensed financial information of the Company (parent company only):

CONDENSED BALANCE SHEETS
December 31, 2012 and 2011
(Amounts In Thousands)

ASSETS
 
2012
   
2011
 
             
Cash and cash equivalents at subsidiary bank
  $ 3,367     $ 2,883  
Investment in subsidiary bank
    254,212       235,142  
Other assets
    1,977       1,983  
Total assets
  $ 259,556     $ 240,008  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
Liabilities
  $ 2,132     $ 1,736  
Redeemable common stock held by ESOP
    30,715       27,826  
Stockholders' equity:
               
Capital stock
    42,241       41,467  
Retained earnings
    229,625       207,790  
Accumulated other comprehensive income
    3,955       4,974  
Treasury stock at cost
    (18,397 )     (15,959 )
      257,424       238,272  
Less maximum cash obligation related to ESOP shares
    30,715       27,826  
Total stockholders' equity
    226,709       210,446  
Total liabilities and stockholders' equity
  $ 259,556     $ 240,008  
 
 
Page 117

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 14.   Parent Company Only Financial Information (Continued)

CONDENSED STATEMENTS OF INCOME
Years Ended December 31, 2012, 2011 and 2010
(Amounts In Thousands)

   
2012
   
2011
   
2010
 
                   
Dividends received from subsidiary
  $ 6,998     $ 7,749     $ 5,375  
Other expenses
    (452 )     (402 )     (377 )
Income before income tax benefit and equity in undistributed income of subsidiary
    6,546       7,347       4,998  
Income tax benefit
    199       141       132  
      6,745       7,488       5,130  
Equity in undistributed income of subsidiary
    20,088       19,289       18,186  
Net income
  $ 26,833     $ 26,777     $ 23,316  
 
 
Page 118

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 14.   Parent Company Only Financial Information (Continued)

CONDENSED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2012, 2011 and 2010
(Amounts In Thousands)

   
2012
   
2011
   
2010
 
Cash flows from operating activities:
                 
Net income
  $ 26,833     $ 26,777     $ 23,316  
Adjustments to reconcile net income to cash and cash equivalents provided by operating activities:
                       
Equity in undistributed income of subsidiary
    (20,088 )     (19,289 )     (18,186 )
Share-based compensation
    20       16       15  
Compensation expensed through issuance of common stock
    528       417       46  
Excess tax benefits related to share-based compensation
    (92 )     (132 )     (113 )
Forfeiture of common stock
    (41 )     (54 )     (32 )
Decrease (increase) in other assets
    97       (239 )     (133 )
Increase in liabilities
    396       224       218  
Net cash and cash equivalents provided by operating activities
    7,653       7,720       5,131  
                         
Cash flows from financing activities:
                       
Stock options exercised
    175       256       151  
Excess tax benefits related to share-based compensation
    92       132       113  
Issuance of common stock, net of costs
    -       25,825       -  
Contribution of capital to subsidiary
    -       (23,303 )     -  
Purchase of treasury stock
    (2,438 )     (4,105 )     (1,627 )
Dividends paid
    (4,998 )     (4,399 )     (4,024 )
Net cash and cash equivalents used by financing activities
    (7,169 )     (5,594 )     (5,387 )
Increase (decrease) in cash and cash equivalents
    484       2,126       (256 )
Cash and cash equivalents:
                       
Beginning of year
    2,883       757       1,013  
Ending of year
  $ 3,367     $ 2,883     $ 757  
 
 
Page 119

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 15.   Commitments and Contingencies

Concentrations of credit risk:  The Bank’s loans, commitments to extend credit, unused lines of credit and outstanding letters of credit have been granted to customers within the Bank's market area.  Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $64.04 million.  The concentrations of credit by type of loan are set forth in Note 3 to the Consolidated Financial Statements.  Outstanding letters of credit were granted primarily to commercial borrowers.  Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the economic conditions in Johnson, Linn and Washington Counties, Iowa.

Contingencies:  In the normal course of business, the Company and Bank are involved in various legal proceedings.  In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the accompanying consolidated financial statements.

Financial instruments with off-balance sheet risk:  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 December 31, 2012 and 2011 is as follows:

   
2012
   
2011
 
   
(Amounts In Thousands)
 
Firm loan commitments and unused portion of lines of credit:
           
Home equity loans
  $ 36,030     $ 35,345  
Credit cards
    44,554       42,493  
Commercial, real estate and home construction
    96,326       62,388  
Commercial lines and real estate purchase loans
    167,210       129,461  
Outstanding letters of credit
    10,778       12,016  
 
 
Page 120

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 15.   Commitments and Contingencies (Continued)

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The Bank evaluates each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the party.  Collateral held varies, but may include accounts receivable, crops, livestock, inventory, property and equipment, residential real estate and income-producing commercial properties.  Credit card participations are the unused portion of the holders' credit limits.  Such amounts represent the maximum amount of additional unsecured borrowings.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements and, generally, have terms of one year, or less.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.  The Bank holds collateral, which may include accounts receivable, inventory, property, equipment, and income-producing properties, supporting those commitments if deemed necessary.  In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Bank would be required to fund the commitment.  The maximum potential amount of future payments the Bank could be required to make is represented by the contractual amount shown in the summary above.  If the commitment is funded the Bank would be entitled to seek recovery from the customer.  At December 31, 2012 and 2011, no amounts have been recorded as liabilities for the Bank’s potential obligations under these guarantees.

Lease commitments: The Company leases certain facilities under operating leases.  The minimum future rental commitments as of December 31, 2012 for all non-cancelable leases relating to Bank premises were as follows:

Year ending December 31:   (Amounts In Thousands)  
2013
   
                  386
 
2014
   
                  304
 
2015
   
                  244
 
2016
   
                  241
 
2017
   
                  135
 
Thereafter
   
                  109
 
    $
1,419
 

Rent expense was $0.31 million, $0.33 million and $0.28 million for the years ended December 31, 2012, 2011 and 2010, respectively.

The Bank added two new offices in 2012.  An office located at the University of Iowa Memorial Union opened in February 2012 and an office located at the University of Iowa Hospitals & Clinics opened in March 2012.  The Bank will provide retail and commercial banking services at the new offices.  The term for both lease agreements is March 1, 2012 to February 28, 2017.
 
 
Page 121

 
HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 16.   Quarterly Results of Operations (unaudited, amounts in thousands, except per share amounts)

   
Quarter Ended
 
   
March
   
June
   
September
   
December
   
Year
 
2012
                             
Interest income
  $ 22,807     $ 22,397     $ 22,256     $ 21,755     $ 89,215  
Interest expense
    5,598       5,574       5,440     $ 4,915       21,527  
Net interest income
  $ 17,209     $ 16,823     $ 16,816     $ 16,840     $ 67,688  
Provision for loan losses
    (560 )     (1,732 )     (608 )     51       (2,849 )
Other income
    5,013       5,180       5,321       5,255       20,769  
Other expense
    11,627       12,132       15,272       14,900       53,931  
Income before income taxes
  $ 11,155     $ 11,603     $ 7,473     $ 7,144       37,375  
Income taxes
    3,255       3,533       1,971       1,783       10,542  
Net income
  $ 7,900     $ 8,070     $ 5,502     $ 5,361     $ 26,833  
                                         
Basic earnings per share
  $ 1.66     $ 1.70     $ 1.16     $ 1.17     $ 5.69  
Diluted earnings per share
    1.66       1.69       1.16       1.17       5.68  
                                         
2011
                                       
Interest income
  $ 23,021     $ 23,366     $ 23,533     $ 23,430     $ 93,350  
Interest expense
    6,384       6,237       5,959       5,781       24,361  
Net interest income
  $ 16,637     $ 17,129     $ 17,574     $ 17,649     $ 68,989  
Provision for loan losses
    1,465       (266 )     1,561       2,901       5,661  
Other income
    4,334       4,329       4,574       5,267       18,504  
Other expense
    10,925       10,270       11,025       12,006       44,226  
Income before income taxes
  $ 8,581     $ 11,454     $ 9,562     $ 8,009       37,606  
Income taxes
    2,403       3,501       2,753       2,172       10,829  
Net income
  $ 6,178     $ 7,953     $ 6,809     $ 5,837     $ 26,777  
                                         
Basic earnings per share
  $ 1.40     $ 1.82     $ 1.55     $ 1.25     $ 6.02  
Diluted earnings per share
    1.40       1.81       1.55       1.25       6.01  
 
 
Page 122

 
PART II

Item 9.   Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A.   Controls and Procedures

Disclosure Controls and Procedures

As of the end of the period covered by this report, 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) and Rule 15d-15(e) under the Securities Exchange Act of 1934).  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective.

There was no change in the Company’s internal control over financial reporting during the most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Management’s Report on Internal Control over Financial Reporting

The Company’s management is responsible for establishing and maintaining an adequate system of internal control over financial reporting (as defined in Rule 13a-15(f) and Rule 15d-15(f) under the Securities Exchange Act of 1934).  Internal control over financial reporting of the Company includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the Company’s consolidated financial statements.  Important features of the Company’s system of internal control over financial reporting include the adoption and implementation of written policies and procedures, careful selection and training of financial management personnel, a continuing management commitment to the integrity of the system and through examinations by an internal audit function that coordinates its activities with the Company’s Independent Registered Public Accounting Firm.

All internal control systems, no matter how well designed, have inherent limitations, including the possibility of human error and the circumvention of overriding controls.  Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation.  Further, because of changes in conditions, the effectiveness of internal control may vary over time.

The Company’s management conducted an evaluation of the effectiveness of the Company’s internal controls over financial reporting as of December 31, 2012.  Management’s assessment is based on the criteria described in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on this assessment, the Company’s management concluded that the Company maintained effective internal control over financial reporting as of December 31, 2012.

The Company’s independent registered public accounting firm, that audited the consolidated financial statements included in this annual report, has issued a report on the Company’s internal control over financial reporting as of December 31, 2012.  Reference is made to the Report of Independent Registered Public Accounting Firm included in this Annual Report.

Item 9B.   Other Information
 
Not applicable
 
 
Page 123

 
PART III

Item 10.   Directors, Executive Officers and Corporate Governance

The information required by Item 10 of Part III is presented under the items entitled “Certain Information Regarding Directors and Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s Definitive Proxy Statement dated March 15, 2013 for the Annual Meeting of Stockholders on April 15, 2013.  Such information is incorporated herein by reference.

The Company has a Code of Ethics in place for the Chief Executive Officer and Chief Financial Officer.  A copy of the Company’s Code of Ethics will be provided free of charge, upon written request to:

Shari DeMaris
Treasurer
Hills Bancorporation
131 Main Street
Hills, Iowa  52235

Item 11.   Executive Compensation

The information required by Item 11 of Part III is presented under the item entitled “Executive Compensation and Benefits” in the Company’s Definitive Proxy Statement dated March 15, 2013 for the Annual Meeting of Stockholders on April 15, 2013.  Such information is incorporated herein by reference.

Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by Item 12 of Part III is presented under the item entitled “Security Ownership of Principal Stockholders and Management” and “Report on Executive Compensation,” in the Company’s Definitive Proxy Statement dated March 15, 2013 for the Annual Meeting of Stockholders on April 15, 2013.  Such information is incorporated herein by reference.

Item 13.   Certain Relationships and Related Transactions, and Director Independence

The information required by Item 13 of Part III is presented under the item entitled “Loans to and Certain Other Transactions with Executive Officers and Directors” in the Company’s Definitive Proxy Statement dated March 15, 2013 for the Annual Meeting of Stockholders on April 15, 2013.  Such information is incorporated herein by reference.

Item 14.   Principal Accounting Fees and Services

Information required by this item is contained in the Company’s Definitive Proxy Statement dated March 15, 2013 for the Annual Meeting of Shareholders on April 15, 2013, under the heading “Independent Registered Public Accounting Firm – Audit and Other Fees,” which section is incorporated herein by this reference.
 
 
Page 124

 
PART IV

Item 15.   Exhibits, Consolidated Financial Statement Schedules
 
       
Form 10-K
(a)
1.
 
Financial Statements
Reference
         
     
Independent registered public accounting firm's report on the financial statements
65-68
     
Consolidated balance sheets as of December 31, 2012 and 2011
69
     
Consolidated statements of income for the years ended December 31, 2012, 2011, and 2010
70
     
Consolidated statements of comprehensive income for the years ended December 31, 2012, 2011 and 2010
71
     
Consolidated statements of stockholders' equity for the years ended December 31, 2012, 2011 and 2010
72
     
Consolidated statements of cash flows for the years ended December 31, 2012, 2011 and 2010
73
     
Notes to consolidated financial statements
75
         
 
2.
 
Financial Statements Schedules
 
         
     
All schedules are omitted because they are not applicable or not required, or because the required information is included in the consolidated financial statements or notes thereto.
 
         
(b)
3.
 
Exhibits
 
         
 
3.1
 
Articles of Incorporation filed as Exhibit 3.1 of Form S-3 restated on May 12, 2011 are incorporated by reference.
 
         
 
3.2
 
By-Laws filed as Exhibit 3 .2 of Form, S-3 restated on May 12, 2011 are incorporated by reference.
 
         
 
10.1
 
Employee Stock Ownership Plan filed as Exhibit 10(a) in Form 10-K for the year ended December 31, 1993 is incorporated by reference.
 
         
 
10.2
 
1995 Deferred Compensation Plans filed as Exhibit 10(c) in Form 10-K for the year ended December 31, 1995 is incorporated by reference.
 
         
 
10.3
 
2010 Stock Option and Incentive Plan filed on Form S-8 dated June 29, 2012 is incorporated by reference.
 
         
 
10.4
 
Employee Stock Purchase Plan filed on Form S-8 dated June 29, 2012 is incorporated by reference.
 
         
 
11
 
Statement Regarding Computation of Basic and Diluted Earnings Per Share. (Note:  Statement included in Note 1 under Item 8 of Part II above)
 
         
 
21
 
Subsidiary of the Registrant is Attached on Page 128.
 
         
 
23.1
 
Consent of Independent Registered Public Accounting Firm is Attached on Page 129. BKD LLP
 
         
 
23.2
 
Consent of Independent Registered Public Accounting Firm is Attached on Page 130. KPMG LLP
 
         
 
31
 
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 on Pages 131-132.
 
         
 
32
 
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002 on Page 133.
 
         
  101 ** The following material from Hills Bancorporation Form 10-K Report for the year ended December 31, 2012, formatted in XBRL: (1) Unaudited Condensed Consolidated Balance Sheets, (2) Unaudited Condensed Consolidated Statements of Income, (3) Unaudited Condensed Consolidated Statements of Comprehensive Income, (4) Unaudited Condensed Consolidated Statement of Changes in Stockholders’ Equity, (5) Unaudited Condensed Consolidated Statements of Cash Flows, and (6) the Notes to Unaudited Condensed Consolidated Financial Statements.  
         
     
**  Users of this data are advised that, pursuant to Rule 406T of Regulation S-T, these intereactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934, and are otherwise not subject to liability under these sections.
 
 
 
Page 125

 
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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:  March 13, 2013
By: /s/Dwight O. Seegmiller
 
Dwight O. Seegmiller, Director, President and Chief Executive Officer
   
Date:  March 13, 2013
By: /s/Shari DeMaris
 
Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
 
 
DIRECTORS OF THE REGISTRANT
   
Date: March 13, 2013
By: /s/Michael S. Donovan
 
Michael S. Donovan, Director
   
Date: March 13, 2013
By: /s/Thomas J. Gill
 
Thomas J. Gill, Director
   
Date: March 13, 2013
By: /s/Michael E. Hodge
 
Michael E. Hodge, Director
   
Date: March 13, 2013
By: /s/Emily A. Hughes
 
Emily A. Hughes, Director
   
Date: March 13, 2013
By: /s/James A. Nowak
 
James A. Nowak, Director
   
Date: March 13, 2013
By: /s/Theodore H. Pacha
 
Theodore H. Pacha, Director
   
Date: March 13, 2013
By: /s/John W. Phelan
 
John W. Phelan, Director
   
Date: March 13, 2013
By: /s/Ann M. Rhodes
 
Ann M. Rhodes, Director
   
Date: March 13, 2013
By: /s/Thomas R. Wiele
 
Thomas R. Wiele, Director
   
Date: March 13, 2013
By: /s/Sheldon E. Yoder
 
Sheldon E. Yoder, Director
 
 
Page 126

 
HILLS BANCORPORATION
ANNUAL REPORT OF FORM 10-K FOR THE
FISCAL YEAR ENDED DECEMBER 31, 2012

   
Page Number
   
In The Sequential
Exhibit
 
Numbering System
Number
Description
For 2012 Form 10-K
     
11
Statement Re Computation of Basic and Diluted Earnings Per Share (Note:  Statement included in Note 1 under Item 8 of Part II above)
 
     
Subsidiary of the Registrant
                          128
     
Consent of Independent Registered Public Accounting Firm, BKD LLP
                          129
     
Consent of Independent Registered Public Accounting Firm, KPMG LLP
                          130
     
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
                          131
     
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
                          132
     
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
                          133
 
 
Page 127