HILLS BANCORPORATION - Annual Report: 2013 (Form 10-K)

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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

HILLS BANCORPORATION

(Exact name of Registrant as specified in its charter)

 

(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:

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 oNo þ

The aggregate market value of the common stock held by non-affiliates of the registrant as of June 30, 2013, based on the most recent sale price of $70.75 per share, and 3,932,430 shares held was $278,219,423.  Common stock held by non-affiliates excludes 800,470 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, 2014 is 4,726,589 shares of no par value common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement dated March 21, 2014 for the Annual Meeting of the Shareholders of the Registrant to be held April 21, 2014 (the Proxy Statement) are incorporated by reference in Part III of this Form 10-K.

 

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HILLS BANCORPORATION

FORM 10-K

TABLE OF CONTENTS

 

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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.  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 $1.513 billion and comprised 82.84% of the Bank’s loan portfolio as of December 31, 2013.  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, 2013, mortgage loans totaled $1.413 billion and comprised 77.39% of the Bank’s loan portfolio.

Residential real estate loans totaled $711.47 million and were 38.95% of the Bank’s loan portfolio as of December 31, 2013.  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.

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Item 1.

Business (Continued)

Commercial real estate loans totaled $315.19 million and were 17.26% of the Bank’s loan portfolio at December 31, 2013.  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 $244.09 million and were 13.37% of the Bank’s loan portfolio at December 31, 2013.  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 $142.69 million and were 7.81% of the Bank’s loan portfolio at December 31, 2013.  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 ten 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, 2013, construction loans for personal residences totaled $30.31 million and were 1.66% of the Bank’s loan portfolio.  Construction loans for land development and commercial projects totaled $69.18 million and were 3.79% of the Bank’s loan portfolio.  In total, construction loans totaled $99.49 million and were 5.45% of the Bank’s loan portfolio as of December 31, 2013.

Commercial and Financial Loans

The Bank’s commercial and financial loan portfolio totaled $166.10 million and comprised 9.10% of the total loan portfolio at December 31, 2013.  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.

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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 $82.14 million and constituted 4.50% of the total loan portfolio at December 31, 2013.  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, 2013, consumer loans totaled $19.82 million and were 1.09% 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 $45.17 million and comprised 2.47% of the Bank’s total loan portfolio at December 31, 2013.

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.

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Item 1.

Business (Continued)

Average Daily Balances

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)

 

Other Information

The Bank’s business is not seasonal.  As of December 31, 2013, the Company had no employees and the Bank had 367 full-time and 54 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.

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Item 1.

Business (Continued)

MARKET AREA

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 102,500.  Johnson County, Iowa has a population of approximately 134,000.  The University of Iowa in Iowa City has approximately 31,100 students and 34,900 full and part-time employees, including 7,500 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 2,300 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 164,100, including approximately 35,600 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 215,500.  The largest employer in the Cedar Rapids area is Rockwell Collins, Inc., manufacturer of communications instruments, with over 9,200 employees.

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 2,500 and Wellman has a population of about 1,400.  The population of Washington County is approximately 21,900.  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 102,500) and Washington, Iowa (population 7,300).  The Bank intends to open an office in Washington, Iowa by March, 2015.

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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.

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, 2013 (most recent date of available data from the FDIC and national credit union websites) is as follows:

(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.

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Item 1.

Business (Continued)

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.

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.

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Item 1.

Business (Continued)

Investments and Activities (Continued) 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 (common stockholder’s 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).  The leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 4%.  Total risk-weighted assets are determined by weighting the assets according to their risk characteristics.

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, 2013, the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements, with a leverage ratio of 12.57%, with total Tier 1 risk-based capital ratio of 16.19% and a total risk-based capital ratio of 17.44%.

In July 2013, the Officer of the Comptroller of the Currency and Board of Governors of the Federal Reserve System adopted a final rule implementing agreements reached by the Basel Committee on Banking Supervision in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems”(BASEL III).   The final rule also adopts changes to the agencies’ regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The rule implements a revised definition of regulatory capital, a new 4.50% common equity tier 1 minimum capital requirement, a 6.00% tier 1 capital requirement, and a tier 1 risk-based capital ratio of 8.00%.   The Company expects to remain categorized as well capitalized under the final rule when it becomes effective on January 1, 2015.

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Item 1.

Business (Continued)

Dividends.  The ability of the Company to pay dividends to its shareholders is dependent upon the earnings and capital adequacy of its subsidiary Bank, which directly impact the ability of the Bank to pay dividends to the Company.  The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in 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 2013, 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.

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 0.62 basis points, or approximately 0.155 basis points per quarter.  These assessments will continue until the FICO bonds mature in 2019.

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Item 1.

Business (Continued)

Capital Requirements.  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, 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, 2013, the Tier 1 risk-based leverage ratio of the Bank was 12.51% 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) which 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.

The actual amounts of risk-based capital and risk-based capital ratios as of December 31, 2013 and the minimum regulatory requirements for the Company and The Bank are presented below (amounts in thousands):

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.

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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, 2013.  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%, $96.58 million of the Bank’s Tier 1 capital of $268.03 million as of December 31, 2013 are available for the payment of dividends to the Company.

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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.

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.

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Item 1.

Business (Continued)

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.

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

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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.

The Bank’s primary markets include the Iowa counties of Johnson, Linn and Washington.  Johnson and Linn Counties have been one of the strongest economic areas in Iowa exhibiting substantial economic growth over the past ten years.  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.  However, 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.  And while the presence of the University of Iowa and its affiliated institutions has a significant favorable impact upon the regional economy, 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.

Although financial markets have stabilized and local as well as global economies have improved, 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.  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.

We may be adversely impacted by recent legislation and potential additional legislation and rulemaking.

The 2008-2009 recession produced a number of new laws that impact financial institutions including the Dodd-Frank Act.  The Dodd-Frank Act established the Consumer Financial Protection Bureau (the “CFPB”) and granted it the broad authority to administer and enforce a new federal regulatory framework of consumer financial regulation.  In particular, the liquidity, capital and stress testing requirements of Basel III and the CFPB could negatively impact operations.  The impact of provisions of the Dodd-Frank Act, regulations to be adopted under the Dodd-Frank Act, and new legislation may negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and adversely impact our financial performance or our stock price.

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Item 1A.

Risk Factors (Continued)

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

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

Our financial condition has not been materially impacted by the deterioration in the credit quality of third parties except as related to borrower credit quality.  As of December 31, 2013, the Company held two investment securities considered to be less than investment grade.  The aggregate fair value of these Ba2 rated bonds is $0.49 million while their amortized cost is $0.50 million, representing an unrealized loss of $0.01 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.

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.

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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, 2013, approximately 82.84% 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.

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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.

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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.

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

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

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

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Item 1A.

Risk Factors (Continued)

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.  The Company, with the assistance of third-party service providers, intends to continue to implement security technology and establish procedures to maintain network security, but there is no assurance that these measures will be successful.  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 a significant negative effect on our reputation.

We are subject to risks associated with negative publicity.

Reputational risk arises from the potential that negative publicity regarding the Company’s business practices, whether true or not, could cause a decline in the customer base, costly litigation, or revenue reductions.  In addition, the Company’s success in maintaining its reputation depends on the ability to adapt to a rapidly changing environment including increasing reliance on social media.

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Item 1B.

Unresolved Staff Comments

None.

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 Bank operates its business from its main office and its 16 full service branches in the Iowa counties of Johnson, Linn and Washington.  The Bank owns its main office complex and 12 of its branch offices.  Four of the Bank’s branches are leased.

The Bank purchased land in Washington, Iowa during the year ended December 31, 2013.  The Bank plans to build a new branch in Washington by March, 2015.

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.

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PART II

Item 5.

Market for the Registrant's Common Equity, Related Stockholder Mattersand Issuer Purchases of Equity Securities

The high and low bid information for the Company’s stock for each quarter of the two most recent fiscal years, as reported by OTC Market Groups, Inc., 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.

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

 

 

(1)

2013 transactions included repurchases by the Company of 19,204 shares of stock under the 2005 Stock Repurchase Program.  2013 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $70.00 to $75.00 per share.

(2)

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.

(3)

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.

 

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 2013, 2012 and 2011 of $5.19 million, $5.00 million and $4.40 million respectively, or $1.10 per share in 2013, $1.05 per share in 2012 and $1.00 per share in 2011.  In January 2014, the Company declared and paid a dividend of $1.15 per share totaling $5.44 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.

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Item 5.

Market for the Registrant's Common Equity, Related Stockholder Mattersand 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 twenty-nine bank holding companies operating principally in the Midwest as selected by MORNINGSTAR. The indexes assume the investment of $100 on December 31, 2008 in Company Common Stock, the NASDAQ Index and the Regional-Southwest Banks Index, with all dividends reinvested.

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Item 5.

Market for the Registrant's Common Equity, Related Stockholder Mattersand Issuer Purchases of Equity Securities (Continued)

The following table sets forth the Company’s equity compensation plan information as of December 31, 2013, all of which relates to stock options issued under stock option plans approved by stockholders of the Company:

 

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 Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2015.  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, 2013:

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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, 2013.  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.

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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 2013 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 financial market disruptions and/or an 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.

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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.

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 2013 was $25.93 million compared to $26.83 million in 2012.  Diluted earnings per share were $5.50 and $5.68 for the years ended December 31, 2013 and 2012, 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, 2013, net interest income on a tax equivalent basis increased by $0.46 million.  In 2013, the Bank achieved a net interest margin of 3.54% compared to 3.60% in 2012, which resulted in $5.76 million decrease in net interest income.  The remaining $6.22 million of increase in net interest income was attributable to growth of $50.66 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.

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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, 2013 included the following:

·	Loans, net of allowance for loan losses and unamortized fees and costs totaling $1.806 billion.

·	Loan growth, net in 2013 of $80.92 million.

·	Deposit growth of $47.33 million in 2013.  Deposits increased to $1.710 billion and included $57.77 million of brokered deposits.

·	Short-term borrowings increased $3.23 million.

·	Stockholders’ equity increased $18.59 million to $243.79 million in 2013, with dividends having been paid in 2013 of $5.19 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 11.13% in 2013 compared to 12.38% in 2012.  The returns for the three previous years, 2011, 2010 and 2009, were 14.96%, 14.61% and 11.01%, respectively.  The Company remains well capitalized as of December 31, 2013 with total risk-based capital at 17.44% and Tier 1 risk-based capital at 16.19%.  The minimum regulatory guidelines are 8% and 4% respectively.  The Company paid a dividend per share of $1.10 in 2013, $1.05 in 2012 and $1.00 in the year ended December 31, 2011.

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

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 losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including economic conditions throughout the Midwest and the state of certain industries.  Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management.  The future impact of the global recession has introduced additional uncertainty into such determinations.  Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position.  Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations.   Although management believes the levels of the allowance for loan losses as of December 31, 2013 and 2012 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

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Item 7.

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

 

Total assets at December 31, 2013 increased $68.08 million, or 3.24%, from the prior year-end.  Asset growth from 2011 to 2012 was $81.42 million and represented a 4.03% increase.  The largest growth in assets occurred in Net Loans, which increased $104.25 million and $35.09 million for the years ended December 31, 2013 and 2012, respectively.  Loans held for sale to the secondary market decreased $23.33 million and increased $3.64 million for the years ended December 31, 2013 and 2012, respectively.  Loans held for investment represent the largest component of the Bank’s earning assets.  Loans held for investment were $1.827 billion and $1.722 billion at December 31, 2013 and 2012, 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 $79.04 million in 2013 and increased $5.90 million in 2012.  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 $106.47 million and $34.05 million in loans to customers for the years ended December 31, 2013 and 2012, respectively.  Net loan originations increased 212.69% in 2013 compared to 2012.  The increase in loan originations in 2013 as compared to 2012 is reflective of improvement in 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 $10.93, $10.44 and $4.08 million as of December 31, 2013, 2012 and 2011, respectively.  The participations purchased were less than one percent of loans held for investment for each of the three years.

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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 2013 or 2012.  Residential real estate loans, including first and junior liens, were $711.47 million, $687.85 million and $682.23 million as of December 31, 2013, 2012 and 2011, respectively.  The dollar total of residential real estate loans increased 3.43% in 2013 and 0.83% in 2012.  Residential real estate loans were 38.95% of the loan portfolio at December 31, 2013, 39.98% at December 31, 2012 and 40.36% at December 31, 2011.  Commercial real estate loans totaled $315.19 million at December 31, 2013, a 0.86% increase over the December 31, 2012 total of $312.51 million.  Commercial real estate loans decreased 1.22% in 2012.  Commercial real estate loans totaled $316.33 million at December 31, 2011.  Commercial real estate loans represented 17.26%, 18.15% and 18.69% of the Company’s loan portfolio as of December 31, 2013, 2012 and 2011, 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 117.05% of Tier 1 capital as of December 31, 2013.

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.

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

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Item 7.

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

The following table shows the principal payments due on loans as of December 31, 2013:

 

(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.

While there has been weakness in the national commercial real estate markets, the Company did not experience the high level of stress or deterioration in its commercial real estate portfolio that has occurred in some other markets.  The sales and building permit trends in the Company’s trade area have followed similar increases as national, regional and state trends.  The increased level of building permits is reflective of the overall economic improvement 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, 2013, 2012 and 2011 and median income information as of December 31, 2012, 2011 and 2010, as December 31, 2013 information is not available as of the date of this report:

 

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.  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.

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Item 7.

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

Total deposits increased by $47.33 million in 2013 of which $16.23 million was from brokered deposits.  Short-term borrowings, which include federal funds purchased and securities sold under agreements to repurchase, increased from $38.78 million to $42.02 million.  Deposits increased by $137.07 million in 2012.  As of June 30, 2013 (latest data available), Johnson County total deposits were $4.256 billion and the Company’s deposits were $1.188 billion, which represent a 27.9% market share.  The Company had nine office locations in Johnson County as of June 30, 2013.  The total banking locations in Johnson County was 57 as of June 30, 2013.  At June 30, 2012, the Company’s deposits were $1.116 billion or a 29.7% market share.  At $5.357 billion as of June 30, 2013, the Linn County deposit market is significantly larger than the Johnson County deposit market of $4.256 billion.  As of June 30, 2013, Linn County had 108 total banking locations.  The six Linn County offices of the Company had deposits of $343.55 million or a 6.4% share of the market.  The Company’s Linn County deposits at June 30, 2012 were $344.53 million and represented a 6.6% market share.  As of June 30, 2013, the Company’s two Washington County offices had deposits of $110.06 million which was 20.5% of the County’s total deposits of $536.63 million.  Washington County had a total of 14 banking locations as of June 30, 2013.  In 2012, the Company’s Washington County deposits were $103.79 million or a 19.9% market share.

Investment securities increased $11.85 million in 2013.  In 2012, investment securities increased by $14.82 million.  The investment portfolio consists of $238.51 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.

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, 2013, 2012, and 2011 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, 2013:

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Item 7.

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

 

As of December 31, 2013, 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.  See Note 2 to the Company’s Consolidated Financial Statements.

During 2013, a major funding source for the growth in loans was the $47.33 million increase in deposits.  In 2012, the major source of funding for the growth in loans was deposit growth of $137.07 million.  Brokered deposits totaled $57.77 million and $41.54 million as of December 31, 2013 and 2012, respectively.  Total advances from the FHLB were $125.00 million at December 31, 2013 and 2012.  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.

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Item 7.

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

The following tables show the amounts of average deposits and average rates paid on such deposits for the years ended December 31, 2013, 2012 and 2011 and the composition of the certificates of deposit issued in denominations in excess of $100,000 as of December 31, 2013, 2012 and 2011:

Stockholders’ equity was $243.79 million at December 31, 2013 compared to $225.20 million at December 31, 2012.  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 $118.84 million and paid shareholders dividends of $22.65 million, or 19.06% of earnings, while still maintaining capital ratios in excess of regulatory requirements.

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, 2013, 2012 and 2011:

 

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Item 7.

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

Net income and diluted earnings per share for the last five years are as presented below:

Net income for 2013 decreased by $0.90 million or 3.36% and diluted earnings per share decreased by 3.17%.  The decrease in net interest margin of 6 basis points accounted for a decrease of $5.76 million in net interest income. The growth in earning assets increased net interest income by $6.22 million.  Other income decreased by $1.56 million, the provision for loan losses increased by $3.98 million and total other expenses decreased by $4.65 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 $68.05 million in 2013 was derived from the Company's $2.000 billion of average earning assets and its net interest margin of 3.54%, compared to $1.950 billion of average earning assets and a 3.60% net interest margin in 2012. The importance of net interest margin is illustrated by the fact that a decrease or an increase in the net interest margin of 10 basis points would result in a $2.00 million decrease or increase in income before taxes.  Net interest margin decreased in 2012 to 3.60% from 3.85% in 2011.  Based on the current interest rate environment, the Company expects continued net interest compression to impact earnings for the foreseeable future.  The Company believes net interest margin in dollars will be contingent on the growth of the Company’s earnings assets.

 

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 $1.832 billion at the end of 2013.  The Company’s allowance for loan losses was $25.55 million at December 31, 2013.  The allowance in 2013 increased in comparison to 2012 due to loan growth of $80.92 million, a decrease in net charge-offs of $1.72 million and an increased provision for loan losses of $3.98 million.  The loan loss provision, which is the amount necessary to adjust the allowance to the level considered appropriate by management, totaled an expense of $1.13 million for 2013, a reduction of expense of $2.85 million for 2012 and $5.66 million of expense for 2011.  Management expects credit quality to remain steady through 2014.  Provision expense is expected to be dependent on the Company’s loan growth through the end of 2014.  (See Note 3 to the Consolidated Financial Statements.)  A detailed discussion is included in the Provision for Loan Losses section below.

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Item 7.

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

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 2013 totaled $204.88 million compared to $328.58 million in 2012 and $187.54 million in 2011, a decrease of 37.65% from 2012 and an increase of 9.24% from 2011.  For the years ended December 31, 2013, 2012 and 2011, the net gain on sale of loans was $1.93, $3.55 and $1.99 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, 2013 was 3.83%.  The average interest rate for the same type of loan was 3.53% for the year ended December 31, 2012.  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, 2013, 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.

Net income for 2012 was $26.83 million, or diluted earnings per share of $5.68.  For 2012, diluted earnings per share decreased by $0.33 per share compared to 2011.  Net interest income decreased $1.30 million for the year ended December 31, 2012 compared to 2011.  This increase in net interest income was due to an increase in average earning assets of $89.55 million in 2012.  Noninterest income increased 12.24% in 2012 to $20.77 million.  Noninterest expense increased from $44.23 million in 2011 to $53.93 million in 2012, or 21.94%. 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 year ended December 31, 2012.

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Item 7.

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

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 2013 to 3.54% and this compares to 3.60% in 2012, 3.85% in 2011, 3.95% in 2010, and 3.55% in 2009.  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.  Interest income and expense for 2013, 2012 and 2011 are indicated on the following table:

 

 

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

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Item 7.

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

Net interest income on a tax-equivalent basis changed in 2013 as follows:

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.

Net interest income on a tax equivalent basis changes for 2012 were as follows: