The net interest margin increased 23 basis points in 2008 and decreased 7 basis points in 2007. The net interest spread increased 32 basis points in 2008 and decreased 13 basis points in 2007. The increase in the net interest margin and net interest spread in 2008 are the result of declining interest rates. The Company is able to reprice some liabilities more quickly than some assets (particularly loans) reprice resulting in increased net interest margin and spread.
The provision for loan losses totaled $11,507,000, $3,529,000 and $3,011,000 for 2008, 2007 and 2006, respectively. Loan charge-offs net of recoveries were $3,557,000 in 2008 and $1,669,000 in 2007 and $521,000 in 2006. The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management. The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks (primarily agricultural and spec real estate construction loans).
The increase in the allowance included an allocation of $375,000 related to watch loans. Watch loans increased by approximately $15.4 million from 2007 to 2008. Approximately $7.1 million of the growth in watch loans is flood-related. The remaining $8.3 million in growth in watch loans is related to management’s evaluation of its loan portfolio and recognition of uncertain economic conditions. The total increase of $15.4 million is comprised of approximately $3.7 million less in commercial real estate mortgages and $3.0 million less for construction loans which are offset by an increase in the watch classification of $3.7 million in agricultural real estate loans, $6.1 million in 1-to-4 family residential mortgages, $10.2 million in multi-family residential mortgages and $2.1 million in commercial loans.
Substandard loan balances were $69.4 million at December 31, 2008 and $48.6 million at December 31, 2007. The increase in allowance related to substandard loans of $6.3 million at December 31, 2008 resulted from several factors. Flood-related loans made up $4.9 million of the increase in substandard loans. In addition, two borrower relationships with an aggregate loan balance of $13.7 million were downgraded to substandard during 2008. The increase of $20.8 million in substandard loans at December 31, 2008 includes $7.9 million in commercial real estate mortgages, $4.1 million in 1-to-4 family residential mortgages, $2.8 million in agricultural real estate mortgages, $1.9 million in agricultural operating loans, $5.5 million in construction loans, $2.8 million in commercial loans and $0.1 million in consumer loans. Those increases were offset by a decrease in multi-family residential mortgages of $4.3 million.
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Item 7. | Management’s Discussion and Analysis of Financial Condition And Results of Operation (Continued) |
Other factors that are considered in determining the credit quality of the Company’s loan portfolio are the vacancy rates for both residential and commercial and retail space, current equity the borrower has in the property and overall financial strength of the customer including cash flow to continue to fund loan payments. The Company also considers the state of the total economy including unemployment levels, vacancy rates of rental units and demand for commercial and retail space. In most instances, the borrowers have used in their rental projections of income at least a 10% vacancy rate. As of December 31, 2008, the unemployment levels in Johnson County and Linn County were 3.3% and 4.6%, respectively, compared to 2.8% and 4.0% in December of 2007. These levels compare favorably to the State of Iowa at 4.5% and the national unemployment level at 7.2%, which were 4.0% and 5.0%, respectively in December, 2007. The residential rental vacancy rates in 2008 in Johnson County, the largest trade area for the Company, were estimated at 5.0% in Iowa City, Coralville and North Liberty and up to 8.0% in the Cedar Rapids area. The estimated vacancy rates for both markets were 5% one year ago. The State of Iowa vacancy rate is 10.9% and the national rate is 9.9% with the Midwest rate at 10.3%. These vacancy rates one year ago were 13.5%, 9.8% and 11.6%, respectively. The Company continues to consider those vacancy rates among other factors in its current evaluation of the real estate portion of its loan portfolio. Due to the unstable national economic conditions, favorable vacancy rates may not continue in 2009. Vacancy rates may rise and affect the overall quality of the loan portfolio.
The amount of problem and watch loans considered in the allowance for loan losses computation increased by approximately $23,700,000 in 2007 and by approximately $19,200,000 from the end of 2005 to 2006. The increase in problem and watch loans for 2007 included $8,600,000 of commercial real estate loans, $5,700,000 in commercial loans, $5,400,000 in construction loans, $3,400,000 in residential mortgages, $1,500,000 in agricultural loans and $700,000 in agricultural real estate loans. Those increases were offset by a reduction of $1,600,000 in problem and watch loans for multi-family residential mortgages contained in the loan portfolio.
The allowance for loan losses balance is also affected by the charge-offs and recoveries for the periods presented. For the years ended December 31, 2008, 2007 and 2006, recoveries were $932,000, $1,249,000, and $1,352,000, respectively; charge-offs were $4,489,000, $2,918,000 and $1,873,000 in 2008, 2007 and 2006, respectively.
Overall credit quality may continue to deteriorate in 2009. Such a deterioration could cause increases in nonperforming loans, allowance for loan loss provision expense and net chargeoffs. Management will monitor changing market conditions as a part of its allowance for loan loss methodology.
The allowance for loan losses totaled $27,660,000 at December 31, 2008 compared to $19,710,000 at December 31, 2007. The percentage of the allowance to outstanding loans was 1.85% and 1.44% at December 31, 2008 and 2007, respectively. The percentage increase was due to loan growth and an increase in the amount of “problem” or “watch” loans as a percentage of total loans outstanding. The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks (primarily agriculture loans and spec real estate construction) and overall increases in Net Loans outstanding. The methodology used in 2008 is consistent with the methodology used in the prior years.
Agricultural loans totaled $64,198,000 and $60,004,000 at December 31, 2008 and 2007, respectively. The level of agriculture loans during the last five years compared to total loans has varied from a high of 4.37% in 2007 to a low of 3.78% in 2005. Management has assessed the risks for agricultural loans to be higher than other loans due to unpredictable commodity prices, the effects of weather on crops and uncertainties regarding government support programs. In particular, loans that are in the swine production segment continue to be of major concern as prices for hogs are subject to severe fluctuations.
Page 47 of 107
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Item 7. | Management’s Discussion and Analysis of Financial Condition And Results of Operation (Continued) |
Non-performing loans increased by $12.6 million from December 31, 2007 to December 31, 2008. Non-performing loans were 3.48% of loans as of December 31, 2008 and 2.88% as of December 31, 2007. Non-performing loans, which are considered impaired, include any loan that has been placed on nonaccrual status. Non-performing loans also include loans that, based on management’s evaluation of current information and events, the Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement. These loans are also considered impaired loans. This increase in non-performing loans is due in part to $5.0 million in flood-related loans. In addition, two large borrower relationships were added to non-performing loans in 2008. The first borrower relationship consists mainly of commercial real estate loans with an aggregate balance of approximately $10.4 million as of December 31, 2008. The second borrower relationship had an aggregate balance of $3.3 million as of December 31, 2008 and relates to residential development in the Company’s market area. These increases of $18.7 million were offset by improvements in various borrower relationships considered non-performing as of December 31, 2007. The Company believes that the allowance for loan losses is at a level commensurate with the overall risk exposure of the loan portfolio. However, if economic conditions continue to deteriorate, certain borrowers may experience additional difficulty and the level of nonperforming loans, chargeoffs and delinquencies could continue to rise and require further increases in the provision for loan losses.
The Company restructured loans totaling $4.5 million during 2008. These loans related to two customers. The first customer relationship consisted of six loans totaling $1.2 million and is flood related. The Company would have recorded $63,000 in interest income during 2008 related to these loans if the loans had been current in accordance with their original terms. There was no interest income related to the restructured loans included in net income for 2008 as the accrued interest on the loans was charged off during the period and the loans are currently on non-accrual status. The Company loaned an additional $137,000 to the borrower in 2008 after the completion of the restructuring of the loans noted above. In addition, the Company has committed to lend an additional $270,000 to the customer. The second restructured customer relationship consisted of four loans totaling $3.3 million. This restructure was completed as of the end of 2008. There was no lost interest income related to this customer relationship. The Company does not have any commitments to lend the customer additional funds.
Other Income
The other income of the Company was $16,670,000 in 2008 compared to $15,984,000 in 2007. The increase of $686,000 in 2008 was the result of a combination of factors discussed below. In 2007, the total other income increased $1,373,000 from 2006.
The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The gain was $1,274,000 in 2008, $934,000 in 2007 and $859,000 in 2006. The dollar volume of loans sold in 2008 was approximately 115% of the volume in 2007 and 126% of the activity experienced in 2006. The fee per loan in 2008 was approximately 24% higher than the fee per loan in 2007. The volume of activity in these types of loans is directly related to the level of interest rates. During portions of 2008, secondary market rates were favorable resulting in the increase in the 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.
Trust fees decreased $11,000 to $3,917,000 in 2008. Trust fees increased $505,000 in 2007. As of December 31, 2008, the Bank’s Trust Department had $784 million in assets under management compared to $963 million and $857 million at December 31, 2007 and 2006, respectively. Trust fees are based on total assets under management. The trust assets that are the most volatile are those that are held in common stocks, which amount to approximately 42.5% of assets under management. In 2008, the Dow Jones Industrial Average decreased 33.8%. The market value of the Dow Jones Industrial Average increased over 6% in 2007 and over 16% in 2006.
Service charges and fees increased $46,000 in 2008 to $7,907,000 from $7,861,000 in 2007. Such charges and fees include fees on deposit accounts and credit card processing fees on merchant accounts. Service fees on deposit accounts decreased $396,000 in 2008 compared to the prior year as a result of diminished results from fee income strategies. Debit card interchange fees increased $226,000 and point of sale (POS) interchange income increased $217,000. These increases were due to volume changes in debit and credit card usage.
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Item 7. | Management’s Discussion and Analysis of Financial Condition And Results of Operation (Continued) |
Rental revenue on tax credit real estate increased $358,000 in 2008 due to the additions of tax credit properties in 2007 and 2008. 2008 includes a full year of income related to the property invested in during 2007 and a partial year of income for the property invested in during 2008.
Other noninterest income was $2,529,000 in 2008 and $2,576,000 in 2007. Included in other noninterest income are amounts related to Visa, Inc. (“Visa”). In the first quarter of 2008, Visa completed its initial public offering (“IPO”). After the redemption, the Company has 4,210 shares of Visa Class B Common Stock which is valued at its carryover basis of $0 on the Company’s balance sheet. The sale of the stock is restricted for the longer of 3 years or until the end of the litigation noted below. The Company received $114,000 in proceeds from the redemption of shares as a part of the IPO and recorded a gain. In addition, during the fourth quarter of 2007, the Company recorded a $50,000 reserve related to the Bank’s contingent liability, as a member of Visa, for the Bank’s portion of settlement payments arising from Visa’s litigation with American Express Company and Discover Financial Services. In conjunction with the IPO, Visa created a litigation escrow which is to be used to pay the litigation settlement payments. As a result, the Company recorded a receivable equal to the $50,000 reserve during the first quarter of 2008. This receivable is recorded as a contra-liability to the reserve. Both the liability and receivable are reflected in other liabilities on the Company’s consolidated financial statements. The economic benefit of the receivable is recorded in other noninterest income. In October 2008, Visa reached a settlement with Discover Financial Services. The Company’s share of the settlement obligation is approximately $33,000 which has been funded through the issuance of additional shares by Visa through the litigation escrow and a reduction in the Class B common stock outstanding.
There was a $170,000 decrease related to official check balance earnings. In 2007, the Company utilized a third-party service provider to issue its official checks. The third party paid interest on the balances required to cover outstanding official checks. In February 2008, the Company changed to an in-house processing system for official checks. Therefore, interest is no longer being earned on the outstanding official check balances.
Service charges and fees increased by $934,000 from 2006 to 2007, resulting in total fees of $7,861,000 in 2007. Service fees on deposit accounts increased $428,000 in 2007 compared to 2006 due to fee income strategies. Service charge income on savings deposits increased $53,000 due to a change in the related fee structure and minimum balance requirements. In addition, debit card interchange fees increased $293,000 and point of sale (POS) interchange income increased $116,000.
Other Expenses
Total other expenses were $39,461,000 and $36,150,000 for the years ended December 31, 2008 and 2007, respectively. The increase is $3,311,000 or 9.16% in 2008 and $1,786,000 or 5.20% in 2007. Salaries and employee benefits, the largest component of non-interest expense, increased $934,000 in 2008, a 4.83% change. This increase includes $906,000 in direct salaries, a 6.25% increase which resulted from annual pay adjustments and additional employees in 2008. The Company had nine additional full time and 11 additional part-time employees in 2008. Another component of salaries and employee benefits expense is profit sharing plan expense which totaled $1,264,000 in 2008. This expense increased $84,000, or 7.12% over 2007 and includes the Company’s contributions to its Profit Sharing and ESOP plans. (See Note 8 to the Consolidated Financial Statements.) The majority of the increase is due to growth in the underlying salary base for eligible employees.
Occupancy expense increased $19,000 with increases of $51,000 in property taxes and $20,000 in rental paid for ATMs. Occupancy expense also includes costs related to building maintenance and upkeep. This expense increased $31,000 in 2008 mainly due to increased snow removal costs incurred during the year. These increase are offset by a reduction in utilities expense of $49,000 and building rent of $29,000. In 2007, building rents included rent paid on a former location which has not been incurred in 2008.
Page 49 of 107
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Item 7. | Management’s Discussion and Analysis of Financial Condition And Results of Operation (Continued) |
In 2008, furniture and equipment expense included depreciation expense of $1,652,000 and $1,265,000 in equipment and software maintenance contracts. These expenses one year ago were $1,670,000 for depreciation and $1,251,000 for the maintenance contracts. These differences in depreciation and maintenance contracts resulted in decreased expenses of $4,000. Phone line lease expense increased $29,000 and equipment repair expense increased $20,000 from 2007 to 2008.
Advertising and business development expense decreased $71,000 from 2007 to 2008. Factors in this decrease included reductions in costs related to core account campaigns of $45,000, newspaper advertising of $29,000 and community gift certificates of $35,000. These cost reductions were offset by additional expenses in 2008 that included $28,000 for customer on-line bill payment expense and $37,000 for credit card reward points based on customer usage volumes.
Outside services increased $311,000 in 2008 to $5,565,000 for the year ended December 31, 2008 compared to the same period in 2007. Outside services include professional fees, courier services and ATM fees, and processing charges for the merchant credit card program, retail credit cards and other data processing services. Professional fees increased $26,000 from 2007 to a total of $1,658,000 for 2008. Attorney’s fees increased $30,000 over 2007 due in part to increased activity related to costs of collection efforts and repossession activity. Credit card, debit card and merchant card processing expenses increased $122,000 due to the volume of transactions in 2008. Data processing expense also increased $79,000 due to a growth in the volume of transactions from 2007 to 2008 and monthly fees for new trust system implemented in 2008 and the teller management system implemented in the third quarter of 2007. Appraisal and abstract fees increased $57,000 from 2007 to 2008 based on loan volume. In addition, the loss on repossessed real estate properties and other repossessed assets increased $85,000 from the same period in 2007. During 2007, thirteen properties were sold at a net gain of approximately $14,000. The twelve properties sold in 2008 were at a net loss of $71,000. Also, other repossessed assets were sold at a loss of $25,000 in 2008.
Rental expenses on tax credit real estate increased $587,000 in 2008 due to the addition of tax credit properties in late 2007 and 2008. 2008 includes a full year of expenses related to the property invested in during 2007 and a partial year of income for the property invested in during 2008.
Flood related expenses were $852,000 in 2008. Included in the flood expenses are a loss of $345,000 on the net book value of property and equipment at two damaged locations. In addition, the Company recorded $507,000 of expenses related to the floods. The expenses include approximately $228,000 for decontaminating, drying and preparing the two flooded offices for remodeling. This expense also includes drying of a limited number of the Company’s records. In addition, the Company incurred $89,000 in expenses related to the evacuation of the two damaged locations. The Company has incurred $98,000 in expenses to operate three temporary locations. This expense includes rent, equipment and supplies. The remaining expense of $92,000 includes various items including meals, sandbagging and other supplies and extra mileage due to road closings and relocation of offices.
Other noninterest expense was $2,202,000 for the year ended December 31, 2008, an increase of $644,000 over the same period in 2007. Other noninterest expense includes fraud losses related to customer credit and debit cards, ATM activity and customer deposit accounts. This expense increased $116,000 in 2007 due to increased incidents of unauthorized use of customer credit and debit cards. Other noninterest expense also includes assessments paid by the Company to the FDIC and State of Iowa. These assessments increased $739,000 in 2008 to a total of $993,000. In 2007, the Company received a one-time assessment credit from the FDIC that offset the assessment expense. There were no assessment credits available in 2008 to offset the assessment expense.
Page 50 of 107
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Item 7. | Management’s Discussion and Analysis of Financial Condition And Results of Operation (Continued) |
Total other expenses were $34,364,000 for the year ended December 31, 2006. The increase in expenses in 2007 was $1,786,000. This included an increase of $885,000 in salaries and benefits, which was the direct result of salary adjustments for 2007. Other expense increases in 2007 include $75,000 in additional profit sharing plan contributions related to the growth in the underlying salary base for eligible employees. Medical expenses included with salaries and benefits increased from $1.5 million to $1.6 million in 2007. Occupancy expense increased $122,000 due to property taxes, utilities and building maintenance. Furniture and equipment expense was $39,000 higher in 2007 when compared to 2006 as a result of the costs related to equipment and software maintenance contracts. In addition, there was an increase in outside services of $366,000. Outside service expense increase included $35,000 in internal audit and loan review fees to third party service providers. Attorneys’ fees increased $49,000 to due in part of increased activity related to costs of collection efforts and repossession volume. Credit card, debit card and merchant card processing expenses, along with data processing expenses, increased $234,000 due to the volume of transactions.
Other noninterest expense was $1,558,000 for the year ended December 31, 2007, an increase of $313,000 over the same period in 2006. The expense related to fraud losses on customer accounts increased $75,000 due to increased incidents of unauthorized use of customer credit and debit cards. Other noninterest expenses also include $243,000 related to unauthorized activities by an employee of the Bank in a Bank internal account.
Income Taxes
Income tax expense was $5,556,000, $7,138,000 and $6,933,000 for the years ended December 31, 2008, 2007 and 2006, respectively. Income taxes as a percentage of income before income taxes were 28.21% in 2008, 30.66% in 2007 and 30.82% in 2006. The amount of tax credits were $706,000, $566,000 and $566,000 for 2008, 2007 and 2006, respectively. In 2008, the Company invested in a fifth tax credit property. Credits related to this new property will be approximately $2.7 million and are expected to be recognized over a fifteen year period starting in 2009.
Page 51 of 107
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Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operation (Continued) |
Impact of Recently Issued Accounting Standards
As of January 1, 2008, the Company adopted FASB Statement No. 157,Fair Value Measurements (“FAS 157”) in its entirety. The Statement provides a single definition of fair value, a framework for measuring fair value and expanded disclosures concerning fair value. Previously, different definitions of fair value were contained in various accounting pronouncements that prescribe fair value as the relevant measure of value. (See Footnotes 1 and 12 to the Company’s consolidated financial statements.)
In February 2007, the FASB issued FASB Statement No. 159,The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115 (“FAS 159”). FAS 159 permits companies to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The objective of FAS 159 is to provide opportunities to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply hedge accounting provisions. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The Statement was effective for financial statements issued for the year beginning after November 15, 2007. As the fair value option was not elected for any financial assets or liabilities, the adoption of this Statement did not have a significant effect on the Company’s consolidated financial statements for 2008.
In November 2007, the SEC issued Staff Accounting Bulletin No. 109,Written Loan Commitments Recorded at Fair Value Through Earnings (“SAB 109”). SAB 109 provides interpretive guidance on the accounting for written loan commitments recorded at fair value through earnings under generally accepted accounting principles. SAB 109 revises and rescinds portions of Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments. The SEC staff belief is that the expected net future cash flows related to the associated servicing of a loan should be included in the measurement of derivative and other written loan commitments that are accounted for at fair value through earnings. SAB 109 was effective for financial statements issued for the year beginning after December 15, 2007. The adoption of SAB 109 did not have a significant effect on the Company’s consolidated financial statements.
In December 2007, the FASB issued FASB Statement No. 141 (revised),Business Combinations (“FAS 141R”). The standard changes the accounting for business combinations including the measurement of acquirer shares issued in consideration for a business combination, the recognition of contingent consideration, the accounting for pre-acquisition gain and loss contingencies, the recognition of capitalized in-process research and development, the accounting for acquisition-related restructuring cost accruals, the treatment of acquisition related transaction costs and the recognition of changes in the acquirer’s income tax valuation allowance. FAS 141R is effective for financial statements issued for the year beginning after December 15, 2008. The adoption of this Statement will not have a significant effect on the Company’s consolidated financial statements.
In December 2007, the FASB issued FASB Statement No. 160,Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (“FAS 160”). The standard changes the accounting for noncontrolling (minority) interests in consolidated financial statements including the requirements to classify noncontrolling interests as a component of consolidated stockholders’ equity, and the elimination of “minority interest” accounting in results of operations with earnings attributable to noncontrolling interests reported as part of consolidated earnings. Additionally, FAS 160 revises the accounting for both increases and decreases in a parent’s controlling ownership interest. FAS 160 is effective for financial statements issued for the year beginning after December 15, 2008. The adoption of this Statement will not have a significant effect on the Company’s consolidated financial statements.
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Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operation (Continued) |
Impact of Recently Issued Accounting Standards (continued)
In January 2008, the SEC issued Staff Accounting Bulletin No. 110, Certain Assumptions Used in Valuation Methods (“SAB 110”) which amends Staff Accounting Bulletin No. 107,Share-Based Payment (“SAB 107”). SAB 110 allows for the continued use, under certain circumstances, of the “simplified” method in developing an estimate of expected term of so-called “plain vanilla” stock options accounted for under FAS 123R. SAB 110 amends SAB 107 to permit the use of the “simplified” method beyond December 31, 2007. The adoption of SAB 110 did not have a significant effect on the Company’s consolidated financial statements.
In March 2008, the FASB issued FASB Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133 (“FAS 161”). The standard requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk related contingent features in derivative agreements. FAS 161 is effective for financial statements issued for the year beginning after November 15, 2008. The adoption of FAS 161 will not have a significant effect on the Company’s consolidated financial statements.
In May 2008, the FASB issued FASB Statement No. 162,The Hierarchy of Generally Accepted Accounting Principles (“FAS 162”). The standard identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements that are presented in conformity with generally accepted accounting principles in the United States of America. FAS 162 will be effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411,The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The adoption of FAS 162 will not have a significant effect on the Company’s consolidated financial statements.
In June 2008, the Emerging Issues Task Force (“EITF”) issued EITF Issue No. 07-5,Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock (“EITF No. 07-5”). EITF No. 07-5 defines when adjustment features within contracts are considered to be equity-indexed. EITF No. 07-5 is effective for financial statements issued for the year beginning after December 15, 2008. The adoption of EITF No. 07-5 will not have a significant effect on the Company’s consolidated financial statements.
In June 2008, the EITF issued EITF Issue No. 08-3,Accounting by Lessees for Maintenance Deposits under Lease Agreements (“EITF No. 08-3”). EITF No. 08-3 states that lessees should account for nonrefundable maintenance deposits as deposit assets if it is probable that maintenance activities will occur and the deposit is therefore realizable. Amounts on deposit that are not probable of being used to fund future maintenance activities should be charged to expense. EITF No. 08-3 is effective for financial statements issued for the year beginning after December 15, 2008. The adoption of EITF No. 08-3 will not have a significant effect on the Company’s consolidated financial statements.
In June 2008, the FASB issued FASB Staff Position FSP EITF 03-6-1,Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (“FSP EITF 03-6-1”). FSP EITF 03-6-1 states that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are participating securities as defined in EITF 03-6,Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings Per Share, and therefore should be included in computing earnings per share using the two-class method. FSP EITF 03-6-1 is effective for financial statements issued for the year beginning after December 15, 2008. The adoption of FSP EITF 03-6-1 will not have a significant effect on the Company’s consolidated financial statements.
In October 2008, the FASB issued FASB Staff Position 157-3,Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (“FSP FAS 157-3”). FSP FAS 157-3 clarifies that application of FAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 was effective upon release and applied to prior periods for which financial statements have not been issued, including periods ending on or before September 30, 2008. The adoption of FSP FAS 157-3 did not have a significant effect on the Company’s consolidated financial statements.
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Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operation (Continued) |
Impact of Recently Issued Accounting Standards (continued)
In December 2008, the FASB issued FASB Staff Position FAS 140-4 and FIN 46(R)-8,Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interest in Variable Interest Entities (“FSP FAS 140-4 and FIN 46(R)-8”). FSP FAS 140-4 and FIN 46(R)-8 amends FASB Statement No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“FAS 140), and FASB Interpretation No. 46 (Revised December 2003),Consolidation of Variable Interest Entities (“FIN 46(R)”). FAS 140 is amended to require public entities to provide additional disclosures about transferors’ continuing involvement with transferred financial assets. FIN 46(R) is amended to require public enterprises to provide additional disclosures about their involvement with variable interest entities. FSP FAS 140-4 and FIN 46(R)-8 is effective for financial statements issued after December 15, 2008. The adoption of FSP FAS 140-4 and FIN 46(R)-8 did not have a significant effect on the Company’s consolidated financial statements.
In January 2009, the FASB issued FASB Staff Position No. EITF 99-20-1,Amendments to the Impairment Guidance of EITF Issue No. 99-20 (“FSP EITF 99-20-1”). FSP EITF 99-20-1 amends EITF Issue No. 99-20,Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets, to achieve more consistent determination of whether an other-than-temporary impairment has occurred. Under FSP EITF 99-20-1, companies must recognize other-than-temporary impairment of beneficial interests in securitized assets if the current information and events indicate it is “possible” that there has been an adverse change in the instrument’s estimated cash flows. Interest income is also required to be based on the same cash flow estimate. FSP EITF 99-20-1 is effective for financial statements issued after December 15, 2008. The adoption of FSP EITF 99-20-1 did not have a significant effect on the Company’s consolidated financial statements.
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Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operation (Continued) |
Interest Rate Sensitivity and Liquidity Analysis
At December 31, 2008, the Company’s interest rate sensitivity report is as follows (amounts in thousands):
| | | | | | | | | | | | | | | | | | | | | | |
| | Repricing
Maturities
Immediately | | Days | | More Than
One Year | | Total | |
|
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| 2-30 | | 31-90 | | 91-180 | | 181-365 |
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Earning assets: | | | | | | | | | | | | | | | | | | | | | | |
Investment securities | | $ | — | | $ | 2,955 | | $ | 7,125 | | $ | 18,370 | | $ | 11,175 | | $ | 174,934 | | $ | 214,559 | |
Loans | | | 7,780 | | | 206,376 | | | 52,509 | | | 69,971 | | | 108,634 | | | 1,060,720 | | | 1,505,990 | |
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Total | | | 7,780 | | | 209,331 | | | 59,634 | | | 88,341 | | | 119,809 | | | 1,235,654 | | | 1,720,549 | |
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Sources of funds: | | | | | | | | | | | | | | | | | | | | | | |
Interest-bearing checking and savings accounts | | | 48,474 | | | — | | | — | | | — | | | — | | | 406,297 | | | 454,771 | |
Certificates of deposit | | | — | | | 26,373 | | | 34,408 | | | 71,797 | | | 224,045 | | | 257,193 | | | 613,816 | |
Other borrowings - FHLB | | | — | | | — | | | — | | | — | | | 40,000 | | | 225,000 | | | 265,000 | |
Federal funds and repurchase agreements | | | 99,937 | | | — | | | — | | | — | | | — | | | — | | | 99,937 | |
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| | | 148,411 | | | 26,373 | | | 34,408 | | | 71,797 | | | 264,045 | | | 888,490 | | | 1,433,524 | |
Other sources, primarily noninterest-bearing | | | — | | | — | | | — | | | — | | | — | | | 169,299 | | | 169,299 | |
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Total sources | | | 148,411 | | | 26,373 | | | 34,408 | | | 71,797 | | | 264,045 | | | 1,057,789 | | | 1,602,823 | |
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Interest Rate Gap | | $ | (140,631 | ) | $ | 182,958 | | $ | 25,226 | | $ | 16,544 | | $ | (144,236 | ) | $ | 177,865 | | $ | 117,726 | |
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Cumulative Interest Rate Gap at December 31, 2008 | | $ | (140,631 | ) | $ | 42,327 | | $ | 67,553 | | $ | 84,097 | | $ | (60,139 | ) | $ | 117,726 | | | | |
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The table set forth above includes the portion of the balances in interest-bearing checking, savings and money market accounts that management has estimated to mature within one year. The classifications are used because the Bank’s historical data indicates that these have been very stable deposits without much interest rate fluctuation. Historically, these accounts would not need to be adjusted upward as quickly in a period of rate increases so the interest risk exposure would be less than the re-pricing schedule indicates. The FHLB borrowings are classified based on either their due date or if they are callable on their most likely call date based on the interest rate.
Page 55 of 107
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Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operation (Continued) |
Effects of Inflation
The consolidated financial statements and the accompanying notes have been prepared in accordance with generally accepted accounting principles. These principles require the measurement of financial position and operating results in terms of historical dollar amounts without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company’s operations. Unlike industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a more significant impact in the Company’s performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services. In the current economic environment, liquidity and interest rate adjustments are features of the Company’s asset/liability management, which are important to the maintenance of acceptable performance levels. The Company attempts to maintain a balance between monetary assets and monetary liabilities, over time, to offset the potential effects of changing interest rates.
Liquidity and Capital Resources
On an unconsolidated basis, the Company had cash balances of $212,000 as of December 31, 2008. In 2008, the Company received dividends of $7,042,000 from its subsidiary Bank and used those funds to pay dividends to its stockholders of $4,086,000 and to fund purchases of treasury stock under the 2005 Stock Repurchase Program.
The ability of the Company to pay dividends to its shareholders is dependent upon the earnings and capital adequacy of its subsidiary Bank, which affects the Bank’s dividends to the Company. The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends. In order to maintain acceptable capital ratios in the subsidiary Bank, certain of its retained earnings are not available for the payment of dividends. Retained earnings available for the payment of dividends to the Company totaled approximately $31,990,000, $32,641,000 and $28,138,000 as of December 31, 2008, 2007 and 2006, respectively. As of December 31, 2008 and 2007, stockholders’ equity, before deducting for the maximum cash obligation related to the ESOP, was $163,177,000 and $152,895,000, respectively. This measure of stockholders’ equity as a percent of total assets was 9.16% at December 31, 2008 and 9.20% at December 31, 2007. As of December 31, 2008, total equity was 7.83% of assets compared to 7.87% of assets at the prior year end.
The Company and the Bank are subject to the Federal Deposit Insurance Corporation Improvement Act of 1991, and the Bank is subject to Prompt Corrective Action Rules as determined and enforced by the Federal Reserve. These regulations establish minimum capital requirements that member banks must maintain.
As of December 31, 2008, risk-based capital standards require 8% of risk-weighted assets. At least half of that 8% must consist of Tier I core capital (common stockholders’ equity, non-cumulative perpetual preferred stock and minority interest in the equity accounts of consolidated subsidiaries), and the remainder may be Tier II supplementary capital (perpetual debt, intermediate-term preferred stock, cumulative perpetual, long-term and convertible preferred stock, and loan loss reserve up to a maximum of 1.25% of risk-weighted assets). Total risk-weighted assets are determined by weighting the assets according to their risk characteristics. Certain off-balance sheet items (such as standby letters of credit and firm loan commitments) are multiplied by “credit conversion factors” to translate them into balance sheet equivalents before assigning them risk weightings. Any bank having a capital ratio less than the 8% minimum required level must, within 60 days, submit to the Federal Reserve a plan describing the means and schedule by which the Bank shall achieve the applicable minimum capital ratios.
Page 56 of 107
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Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operation (Continued) |
The Bank is an insured state bank, incorporated under the laws of the state of Iowa. As such, the Bank is subject to regulation, supervision and periodic examination by the Superintendent of Banking of the State of Iowa (the “Superintendent”). Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements to maintain reserves against deposits, restrictions on the nature and amount of loans which may be made by state banks, and restrictions relating to investments, opening of bank offices and other activities of state banks. Changes in the capital structure of state banks are also approved by the Superintendent. State banks must have a Tier 1 risk-based leverage ratio of 6.5% plus a fully funded loan loss reserve. In certain circumstances, the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement on the Bank. In determining the Tier 1 risk-based leverage ratio, the Superintendent uses total equity capital without unrealized securities gains and the allowance for loan losses less any intangible assets. At December 31, 2008, the Tier 1 risk-based leverage ratio of the Bank was 8.98% and exceeded the ratio required by the Superintendent.
The actual amounts of risk-based capital and risk-based capital ratios as of December 31, 2008 and the minimum regulatory requirements for the Company and the Bank are presented below (amounts in thousands):
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| | Actual | | For Capital
Adequacy
Purposes | | To Be Well
Capitalized Under
Prompt Corrective
Action Provisions | |
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| | Amount | | Ratio | | Ratio | | Ratio | |
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As of December 31, 2008: | | | | | | | | | | | | | |
Company: | | | | | | | | | | | | | |
Total risk-based capital | | $ | 174,402 | | | 12.64 | % | | 8.00 | % | | 10.00 | % |
Tier 1 risk-based capital | | | 157,028 | | | 11.38 | | | 4.00 | | | 6.00 | |
Leverage ratio | | | 157,028 | | | 8.99 | | | 3.00 | | | 5.00 | |
Bank: | | | | | | | | | | | | | |
Total risk-based capital | | | 174,154 | | | 12.63 | | | 8.00 | | | 10.00 | |
Tier 1 risk-based capital | | | 156,795 | | | 11.38 | | | 4.00 | | | 6.00 | |
Leverage ratio | | | 156,795 | | | 8.98 | | | 3.00 | | | 5.00 | |
The Bank is classified as “well capitalized” by FDIC capital guidelines.
On a consolidated basis, 2008 cash flows from operations provided $24,211,000 and net increases in deposits provided $93,960,000. These cash flows were invested in Net Loans of $129,869,000. In addition, $4,968,000 was used to purchase property and equipment and leasehold improvements. Cash flows of $3,262,000 were also used to investment in tax credit real estate properties.
At December 31, 2008, the Bank had total outstanding loan commitments and unused portions of lines of credit totaling $309,305,000 (see Note 14 to the Consolidated Financial Statements). Management believes that its liquidity levels are sufficient at this time, but the Bank may increase its liquidity by limiting the growth of its assets, by selling more loans in the secondary market or selling portions of loans to other banks through participation agreements. It may also obtain additional funds from the Federal Home Loan Bank (FHLB). As of December 31, 2008, the Bank can obtain an additional $189 million from the FHLB based on the current real estate mortgage loans held. In addition, the Bank has arranged $86.5 million of credit lines at three banks. The borrowings under these credit lines would be secured by the Bank’s investment securities.
While the Bank has off-balance sheet commitments to fund additional borrowings of customers, it does not use other off-balance-sheet financial instruments, including interest rate swaps, as part of its asset and liability management. Contractual commitments to fund loans are met from the proceeds of federal funds sold or investment securities and additional borrowings. Many of the contractual commitments to extend credit will not be funded because they represent the credit limits on credit cards and home equity lines of credits.
Page 57 of 107
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Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operation (Continued) |
In 2008, the Bank opted to participate in both programs under the FDIC’s Temporary Liquidity Guarantee Program (“TLGP”). The first program was the Transaction Account Guarantee Program under which, through December 31, 2009, all non-interest bearing transaction accounts are fully guaranteed by the FDIC for the entire amount of the account. Coverage under the Transaction Account Guarantee Program is in addition to and separate from the coverage available under the FDIC’s general deposit insurance rules. The second TLGP program in which the Bank elected to participate was the Debt Guarantee Program. The Debt Guarantee Program guarantees certain newly issued senior, unsecured debt of participating financial institutions. Under the FDIC’s Final Rule adopted on November 21, 2008, certain senior, unsecured debt issued before June 30, 2009, with a maturity of greater than 30 days that matures on or prior to June 30, 2012, is automatically included in the program. The fees associated with this program range from 50 to 100 basis points on an annualized basis and vary according to the maturity of the debt issuance. On February 10, 2009, it was announced that, for an additional premium, the FDIC will extend the Debt Guarantee Program through October 2009. The Company did not have any senior unsecured debt as of December 31, 2008.
In response to the financial crisis affecting the banking system, financial markets, investment banks and other financial institutions, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law. Pursuant to the EESA, the United States Department of the Treasury (the “Treasury”) has the authority to, among other things, make equity investments in certain financial institutions and purchase mortgage-backed and other securities from financial institutions for an aggregate amount of up to $700 billion. The Treasury exercised its authority to make such equity investments by developing the Capital Purchase Program. Under the terms of the Capital Purchase Program as they relate to companies other than S corporations, the Treasury may purchase preferred shares and warrants issued by such companies. Additional preferred shares are issued to the Treasury upon exercise of the Warrants. An investment by the Treasury subjects participants to a number of restrictions, including the need to obtain the Treasury’s consent to increase common stock dividends or repurchase common stock. The Company elected not to apply for the capital available under the Treasury’s Capital Purchase Program. The Company and the Bank are well capitalized with capital ratios that exceed regulatory requirements.
Contractual Obligations and Commitments
As disclosed in Note 14 to the Consolidated Financial Statements, the Company has certain obligations and commitments to make future payments under contracts. The following table summarizes significant contractual obligations and other commitments as of December 31, 2008:
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| | Payments Due By Period | |
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| | (Amounts In Thousands) | |
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| | Total | | Less Than
One Year | | One -
Three Years | | Three -
Five Years | | More Than
Five Years | |
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Contractual obligations: | | | | | | | | | | | | | | | | |
Long-term debt obligations | | $ | 265,000 | | $ | 40,000 | | $ | 40,000 | | $ | — | | $ | 185,000 | |
Operating lease obligations | | | 2,008 | | | 340 | | | 534 | | | 521 | | | 613 | |
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Total contractual obligations: | | $ | 267,008 | | $ | 40,340 | | $ | 40,534 | | $ | 521 | | $ | 185,613 | |
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Other commitments: | | | | | | | | | | | | | | | | |
Lines of credit | | $ | 309,305 | | $ | 237,271 | | $ | 63,229 | | $ | 8,082 | | $ | 723 | |
Standby letters of credit | | | 12,365 | | | 12,365 | | | — | | | — | | | — | |
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Total other commitments | | $ | 321,670 | | $ | 249,636 | | $ | 63,229 | | $ | 8,082 | | $ | 723 | |
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Page 58 of 107
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Item 7A. | Quantitative and Qualitative Disclosures About Market Risk |
Related Party Transactions
The Bank’s primary transactions with related parties are the loan and deposit relationships it maintains with certain principal officers, directors and entities related to these individuals. The Bank makes loans to related parties under substantially the same interest rates, terms and collateral as those prevailing for comparable transactions with unrelated persons. In addition, these parties may maintain deposit account relationships with the Bank that also are on the same terms as with unrelated persons. As of December 31, 2008 and 2007, loan balances to related individuals and businesses totaled $41,210,000 and $38,136,000, respectively. Deposits from these related parties totaled $7,667,000 and $11,416,000 as of December 31, 2008 and 2007, respectively.
Commitments and Trends
The Company and the Bank have no material commitments or plans that will materially affect liquidity or capital resources. Property and equipment may be acquired in cash purchases, or they may be financed if favorable terms are available.
Market Risk Exposures
The Company’s primary market risk exposure is to changes in interest rates. The Company’s asset/liability management, or its management of interest rate risk, is focused primarily on evaluating and managing net interest income given various risk criteria. Factors beyond the Company’s control, such as market interest rates and competition, may also have an impact on the Company’s interest income and interest expense. In the absence of other factors, the Company’s overall yield on interest-earning assets will increase as will its cost of funds on its interest-bearing liabilities when market interest rates increase over an extended period of time. Inversely, the Company’s yields and cost of funds will decrease when market rates decline. The Company is able to manage these swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning assets and interest-bearing liabilities over given periods of time.
The Bank maintains an asset/liability committee, which meets at least quarterly to review the interest rate sensitivity position and to review various strategies as to interest rate risk management. In addition, the Bank uses a simulation model to review various assumptions relating to interest rate movement. The model attempts to limit rate risk even if it appears the Bank’s asset and liability maturities are perfectly matched and a favorable interest margin is present.
In order to minimize the potential effects of adverse material and prolonged increases or decreases in market interest rates on the Company’s operations, management has implemented an asset/liability program designed to mitigate the Company’s interest rate sensitivity. The program emphasizes the origination of adjustable rate loans, which are held in the portfolio, the investment of excess cash in short or intermediate term interest-earning assets, and the solicitation of passbook or transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.
Based on the data following, net interest income should decline with instantaneous increases in interest rates while net interest income should increase with instantaneous declines in interest rates. Generally, during periods of increasing interest rates, the Company’s interest rate sensitive liabilities would re-price faster than its interest rate sensitive assets causing a decline in the Company’s interest rate spread and margin. This would tend to reduce net interest income because the resulting increase in the Company’s cost of funds would not be immediately offset by an increase in its yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a positive effect on the Company’s net interest income.
Page 59 of 107
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Item 7A. | Quantitative and Qualitative Disclosures About Market Risk (Continued) |
The following table, which presents principal cash flows and related weighted average interest rates by expected maturity dates, provides information about the Company’s loans, investment securities and deposits that are sensitive to changes in interest rates.
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| | 2009 | | 2010 | | 2011 | | 2012 | | 2013 | | Thereafter | | Total | | Fair Value | |
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| | (Amounts In Thousands) | |
Assets: | | | | | | | | | | | | | | | | | | | | | | | | | |
Loans, fixed: | | | | | | | | | | | | | | | | | | | | | | | | | |
Balance | | $ | 172,444 | | $ | 81,468 | | $ | 92,954 | | $ | 85,492 | | $ | 247,432 | | $ | 72,012 | | $ | 751,802 | | $ | 833,602 | |
Average interest rate | | | 6.12 | % | | 6.45 | % | | 6.46 | % | | 6.86 | % | | 5.87 | % | | 5.69 | % | | 6.16 | % | | | |
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Loans, variable: | | | | | | | | | | | | | | | | | | | | | | | | | |
Balance | | $ | 246,949 | | $ | 82,898 | | $ | 103,693 | | $ | 63,906 | | $ | 225,650 | | $ | 22,602 | | $ | 745,698 | | $ | 731,923 | |
Average interest rate | | | 4.74 | % | | 6.36 | % | | 6.06 | % | | 6.49 | % | | 5.81 | % | | 5.81 | % | | 5.61 | % | | | |
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Investments (1): | | | | | | | | | | | | | | | | | | | | | | | | | |
Balance | | $ | 54,329 | | $ | 34,505 | | $ | 34,188 | | $ | 31,477 | | $ | 15,533 | | $ | 44,527 | | $ | 214,559 | | $ | 214,559 | |
Average interest rate | | | 4.19 | % | | 4.52 | % | | 4.66 | % | | 4.87 | % | | 4.83 | % | | 5.59 | % | | 4.76 | % | | | |
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Liabilities: | | | | | | | | | | | | | | | | | | | | | | | | | |
Liquid deposits (2): | | | | | | | | | | | | | | | | | | | | | | | | | |
Balance | | $ | 454,771 | | $ | — | | $ | — | | $ | — | | $ | — | | $ | — | | $ | 454,771 | | $ | 454,771 | |
Average interest rate | | | 0.95 | % | | 0.00 | % | | 0.00 | % | | 0.00 | % | | 0.00 | % | | 0.00 | % | | 0.95 | % | | | |
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Deposits, certificates: | | | | | | | | | | | | | | | | | | | | | | | | | |
Balance | | $ | 357,052 | | $ | 165,621 | | $ | 71,179 | | $ | 9,307 | | $ | 10,657 | | $ | — | | $ | 613,816 | | $ | 613,816 | |
Average interest rate | | | 3.32 | % | | 3.96 | % | | 3.99 | % | | 4.05 | % | | 3.86 | % | | 0.00 | % | | 3.59 | % | | | |
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(1) | Includes all available-for-sale investments, federal funds and Federal Home Loan Bank stock. |
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(2) | Includes passbook accounts, NOW accounts, Super NOW accounts and money market funds. |
Page 60 of 107
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Item 8. | Consolidated Financial Statements and Supplementary Data |
The consolidated financial statements and supplementary data are included on Pages 62 through 96.
Page 61 of 107
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| KPMG LLP
2500 Ruan Center
666 Grand Avenue
Des Moines, IA 50309 |
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Hills Bancorporation:
We have audited the accompanying consolidated balance sheets of Hills Bancorporation and subsidiary (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2008. We also have audited Hills Bancorporation’s internal control over financial reporting as of December 31, 2008, based on criteria established inInternal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Hills Bancorporation’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying management’s report on internal control over financial reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall consolidated financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hills Bancorporation and subsidiary as of December 31, 2008 and 2007, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, Hills Bancorporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established inInternal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
/s/ KPMG LLP
March 11, 2009
Page 62 of 107
HILLS BANCORPORATION
CONSOLIDATED BALANCE SHEETS
December 31, 2008 and 2007
(Amounts In Thousands, Except Shares)
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ASSETS | | 2008 | | 2007 | |
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Cash and cash equivalents (Note 10) | | $ | 22,575 | | $ | 32,383 | |
Investment securities available for sale at fair value
(amortized cost 2008 $194,402; 2007 $198,551) (Notes 2 and 6) | | | 200,312 | | | 199,599 | |
Stock of Federal Home Loan Bank | | | 14,247 | | | 14,169 | |
Loans held for sale | | | 8,490 | | | 6,792 | |
Loans, net of allowance for loan losses
(2008 $27,660; 2007 $19,710) (Notes 3, 7 and 11) | | | 1,469,840 | | | 1,352,599 | |
Property and equipment, net (Note 4) | | | 23,606 | | | 21,220 | |
Tax credit real estate | | | 12,065 | | | 8,803 | |
Accrued interest receivable | | | 10,437 | | | 11,391 | |
Deferred income taxes, net (Note 9) | | | 8,959 | | | 7,731 | |
Other real estate | | | 5,155 | | | 473 | |
Goodwill | | | 2,500 | | | 2,500 | |
Other assets | | | 2,607 | | | 3,438 | |
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| | $ | 1,780,793 | | $ | 1,661,098 | |
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LIABILITIES AND STOCKHOLDERS’ EQUITY | | | | | | | |
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Liabilities | | | | | | | |
Noninterest-bearing deposits | | $ | 169,299 | | $ | 154,219 | |
Interest-bearing deposits (Note 5) | | | 1,068,587 | | | 989,707 | |
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Total deposits | | | 1,237,886 | | | 1,143,926 | |
Short-term borrowings (Note 6) | | | 99,937 | | | 87,076 | |
Federal Home Loan Bank borrowings (Note 7) | | | 265,000 | | | 265,348 | |
Accrued interest payable | | | 2,914 | | | 3,227 | |
Other liabilities | | | 11,879 | | | 8,626 | |
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| | | 1,617,616 | | | 1,508,203 | |
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Commitments and Contingencies (Notes 8 and 14) | | | | | | | |
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Redeemable Common Stock Held By Employee Stock Ownership Plan (ESOP) (Note 8) | | | 23,815 | | | 22,205 | |
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Stockholders’ Equity (Note 10) | | | | | | | |
Capital stock, no par value; authorized 10,000,000 shares; issued 2008 4,597,427 shares; 2007 4,583,520 shares | | | — | | | — | |
Paid in capital | | | 13,447 | | | 12,823 | |
Retained earnings | | | 154,176 | | | 144,122 | |
Accumulated other comprehensive income | | | 3,649 | | | 647 | |
Treasury stock at cost (2008 156,882 shares; 2007 93,413 shares) | | | (8,095 | ) | | (4,697 | ) |
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| | | 163,177 | | | 152,895 | |
Less maximum cash obligation related to ESOP shares (Note 8) | | | 23,815 | | | 22,205 | |
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| | | 139,362 | | | 130,690 | |
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| | $ | 1,780,793 | | $ | 1,661,098 | |
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See Notes to Consolidated Financial Statements.
Page 63 of 107
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2008, 2007 and 2006
(Amounts In Thousands, Except Per Share Amounts)
| | | | | | | | | | |
| | 2008 | | 2007 | | 2006 | |
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Interest income: | | | | | | | | | | |
Loans, including fees | | $ | 89,341 | | $ | 88,743 | | $ | 80,240 | |
Investment securities: | | | | | | | | | | |
Taxable | | | 4,734 | | | 4,706 | | | 4,438 | |
Nontaxable | | | 3,382 | | | 3,154 | | | 2,900 | |
Federal funds sold | | | 18 | | | 325 | | | 40 | |
| |
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|
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Total interest income | | | 97,475 | | | 96,928 | | | 87,618 | |
| |
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|
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Interest expense: | | | | | | | | | | |
Deposits | | | 28,865 | | | 35,277 | | | 27,841 | |
Short-term borrowings | | | 1,756 | | | 2,151 | | | 2,801 | |
FHLB borrowings | | | 12,860 | | | 12,524 | | | 11,720 | |
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|
|
|
|
|
|
|
|
|
Total interest expense | | | 43,481 | | | 49,952 | | | 42,362 | |
| |
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|
|
|
|
|
|
|
|
Net interest income | | | 53,994 | | | 46,976 | | | 45,256 | |
Provision for loan losses (Note 3) | | | 11,507 | | | 3,529 | | | 3,011 | |
| |
|
|
|
|
|
|
|
|
|
Net interest income after provision for loan losses | | | 42,487 | | | 43,447 | | | 42,245 | |
| |
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|
|
|
|
|
|
|
Other income: | | | | | | | | | | |
Net gain on sale of loans | | | 1,274 | | | 934 | | | 859 | |
Trust fees | | | 3,917 | | | 3,928 | | | 3,423 | |
Service charges and fees | | | 7,907 | | | 7,861 | | | 6,927 | |
Rental revenue on tax credit real estate | | | 1,043 | | | 685 | | | 781 | |
Other noninterest income | | | 2,529 | | | 2,576 | | | 2,621 | |
| |
|
|
|
|
|
|
|
|
|
| | | 16,670 | | | 15,984 | | | 14,611 | |
| |
|
|
|
|
|
|
|
|
|
Other expenses: | | | | | | | | | | |
Salaries and employee benefits | | | 20,287 | | | 19,353 | | | 18,468 | |
Occupancy | | | 2,363 | | | 2,344 | | | 2,222 | |
Furniture and equipment | | | 3,527 | | | 3,482 | | | 3,443 | |
Office supplies and postage | | | 1,319 | | | 1,329 | | | 1,297 | |
Advertising and business development | | | 1,788 | | | 1,859 | | | 1,843 | |
Outside services | | | 5,565 | | | 5,254 | | | 4,888 | |
Rental expenses on tax credit real estate | | | 1,558 | | | 971 | | | 958 | |
Flood-related expenses | | | 852 | | | — | | | — | |
Other noninterest expenses | | | 2,202 | | | 1,558 | | | 1,245 | |
| |
|
|
|
|
|
|
|
|
|
| | | 39,461 | | | 36,150 | | | 34,364 | |
| |
|
|
|
|
|
|
|
|
|
Income before income taxes | | | 19,696 | | | 23,281 | | | 22,492 | |
Income taxes (Note 9) | | | 5,556 | | | 7,138 | | | 6,933 | |
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|
|
|
|
|
|
|
|
|
Net income | | $ | 14,140 | | $ | 16,143 | | $ | 15,559 | |
| |
|
|
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|
|
|
|
|
|
| | | | | | | | | | |
Earnings per share: | | | | | | | | | | |
Basic | | $ | 3.16 | | $ | 3.59 | | $ | 3.42 | |
Diluted | | | 3.15 | | | 3.57 | | | 3.39 | |
See Notes to Consolidated Financial Statements.
Page 64 of 107
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2008, 2007 and 2006
(Amounts In Thousands)
| | | | | | | | | | |
| | 2008 | | 2007 | | 2006 | |
|
|
|
|
|
|
|
|
|
Net income | | $ | 14,140 | | $ | 16,143 | | $ | 15,559 | |
| | | | | | | | | | |
Other comprehensive income, | | | | | | | | | | |
Unrealized gains on securities: | | | | | | | | | | |
Unrealized holding gains arising during the year, net of income taxes 2008 $1,860; 2007 $1,185; 2006 $320 | | | 3,002 | | | 1,912 | | | 518 | |
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| | | | | | | | | | |
Comprehensive income | | $ | 17,142 | | $ | 18,055 | | $ | 16,077 | |
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See Notes to Consolidated Financial Statements.
Page 65 of 107
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Years Ended December 31, 2008, 2007 and 2006
(Amounts In Thousands, Except Share Amounts)
| | | | | | | | | | | | | | | | | | | |
| | Paid In
Capital | | Retained
Earnings | | Accumulated
Other
Comprehensive
Income (Loss) | | Maximum
Cash
Obligation
Related
To ESOP
Shares | | Treasury
Stock | | Total | |
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| | | | | | | | | | | | | | | | | | | |
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Balance, December 31, 2005 | | $ | 11,970 | | $ | 119,989 | | $ | (1,783 | ) | $ | (20,634 | ) | $ | (63 | ) | $ | 109,479 | |
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|
|
Issuance of 9,715 shares of common stock | | | 346 | | | — | | | — | | | — | | | — | | | 346 | |
Forfeiture of 1,693 shares of common stock | | | (63 | ) | | — | | | — | | | — | | | — | | | (63 | ) |
Share-based compensation | | | 44 | | | | | | | | | | | | | | | 44 | |
Income tax benefit related to share-based compensation | | | 67 | | | — | | | — | | | — | | | — | | | 67 | |
Change related to ESOP shares | | | — | | | — | | | — | | | (306 | ) | | — | | | (306 | ) |
Net income | | | — | | | 15,559 | | | — | | | — | | | — | | | 15,559 | |
Cash dividends ($.81 per share) | | | — | | | (3,696 | ) | | — | | | — | | | — | | | (3,696 | ) |
Purchase of 66,521 shares of common stock | | | — | | | — | | | — | | | — | | | (3,309 | ) | | (3,309 | ) |
Other comprehensive income | | | — | | | — | | | 518 | | | — | | | — | | | 518 | |
| |
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|
|
|
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|
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|
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|
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|
|
Balance, December 31, 2006 | | $ | 12,364 | | $ | 131,852 | | $ | (1,265 | ) | $ | (20,940 | ) | $ | (3,372 | ) | $ | 118,639 | |
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|
|
|
|
|
|
Issuance of 13,030 shares of common stock | | | 326 | | | — | | | — | | | — | | | — | | | 326 | |
Forfeiture of 1,169 shares of common stock | | | (54 | ) | | — | | | — | | | — | | | — | | | (54 | ) |
Share-based compensation | | | 42 | | | — | | | — | | | — | | | — | | | 42 | |
Income tax benefit related to share-based compensation | | | 145 | | | — | | | — | | | — | | | — | | | 145 | |
Change related to ESOP shares | | | — | | | — | | | — | | | (1,265 | ) | | — | | | (1,265 | ) |
Net income | | | — | | | 16,143 | | | — | | | — | | | — | | | 16,143 | |
Cash dividends ($.86 per share) | | | — | | | (3,873 | ) | | — | | | — | | | — | | | (3,873 | ) |
Purchase of 25,492 shares of common stock | | | — | | | — | | | — | | | — | | | (1,325 | ) | | (1,325 | ) |
Other comprehensive income | | | — | | | — | | | 1,912 | | | — | | | — | | | 1,912 | |
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|
|
|
|
|
|
|
|
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|
|
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|
|
|
|
|
|
Balance, December 31, 2007 | | $ | 12,823 | | $ | 144,122 | | $ | 647 | | $ | (22,205 | ) | $ | (4,697 | ) | $ | 130,690 | |
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|
|
|
|
|
|
|
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|
|
|
|
|
|
|
|
Issuance of 15,093 shares of common stock | | | 527 | | | — | | | — | | | — | | | — | | | 527 | |
Forfeiture of 1,186 shares of common stock | | | (51 | ) | | — | | | — | | | — | | | — | | | (51 | ) |
Share-based compensation | | | 21 | | | — | | | — | | | — | | | — | | | 21 | |
Income tax benefit related to share-based compensation | | | 127 | | | — | | | — | | | — | | | — | | | 127 | |
Change related to ESOP shares | | | — | | | — | | | — | | | (1,610 | ) | | — | | | (1,610 | ) |
Net income | | | — | | | 14,140 | | | — | | | — | | | — | | | 14,140 | |
Cash dividends ($.91 per share) | | | — | | | (4,086 | ) | | — | | | — | | | — | | | (4,086 | ) |
Purchase of 63,469 shares of common stock | | | — | | | — | | | — | | | — | | | (3,398 | ) | | (3,398 | ) |
Other comprehensive income | | | — | | | — | | | 3,002 | | | — | | | — | | | 3,002 | |
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance, December 31, 2008 | | $ | 13,447 | | $ | 154,176 | | $ | 3,649 | | $ | (23,815 | ) | $ | (8,095 | ) | $ | 139,362 | |
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|
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
See Notes to Consolidated Financial Statements.
Page 66 of 107
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2008, 2007 and 2006
(Amounts In Thousands)
| | | | | | | | | | |
| | | 2008 | | | 2007 | | | 2006 | |
|
|
|
|
|
|
|
|
|
|
|
Cash Flows from Operating Activities | | | | | | | | | | |
Net income | | $ | 14,140 | | $ | 16,143 | | $ | 15,559 | |
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities: | | | | | | | | | | |
Depreciation | | | 2,237 | | | 2,249 | | | 2,403 | |
Provision for loan losses | | | 11,507 | | | 3,529 | | | 3,011 | |
Share-based compensation | | | 21 | | | 42 | | | 44 | |
Compensation expensed through issuance of common stock | | | 234 | | | 133 | | | 207 | |
Excess tax benefits related to share-based compensation | | | (127 | ) | | (145 | ) | | (67 | ) |
Forfeiture of common stock | | | (51 | ) | | (54 | ) | | (63 | ) |
Provision for deferred income taxes | | | (3,088 | ) | | (1,303 | ) | | (1,114 | ) |
Flood-related loss on disposal of property and equipment | | | 345 | | | — | | | — | |
Net loss (gain) on sale of other real estate owned and other repossessed assets | | | 97 | | | (14 | ) | | 42 | |
Decrease (increase) in accrued interest receivable | | | 954 | | | (1,099 | ) | | (1,673 | ) |
Amortization of discount on investment securities, net | | | 424 | | | 310 | | | 504 | |
(Increase) decrease in other assets | | | (3,724 | ) | | 474 | | | 303 | |
Increase in accrued interest and other liabilities | | | 2,940 | | | 2,049 | | | 379 | |
Loans originated for sale | | | (131,577 | ) | | (114,169 | ) | | (104,286 | ) |
Proceeds on sales of loans | | | 131,153 | | | 112,119 | | | 102,039 | |
Net gain on sales of loans | | | (1,274 | ) | | (934 | ) | | (859 | ) |
| |
|
|
|
|
|
|
|
|
|
Net cash and cash equivalents provided by operating activities | | | 24,211 | | | 19,330 | | | 16,429 | |
| |
|
|
|
|
|
|
|
|
|
| | | | | | | | | | |
Cash Flows from Investing Activities | | | | | | | | | | |
Proceeds from maturities of investment securities: | | | | | | | | | | |
Available for sale | | | 47,473 | | | 36,592 | | | 40,270 | |
Held to maturity | | | — | | | 170 | | | 45 | |
Purchases of investment securities available for sale | | | (43,826 | ) | | (56,758 | ) | | (21,964 | ) |
Loans made to customers, net of collections | | | (129,869 | ) | | (78,030 | ) | | (141,669 | ) |
Proceeds on sale of other real estate owned and other repossessed assets | | | 1,024 | | | 1,143 | | | 1,105 | |
Purchases of property and equipment | | | (4,681 | ) | | (1,408 | ) | | (2,199 | ) |
Purchases of leasehold improvements | | | (287 | ) | | — | | | — | |
Investment in tax credit real estate, net | | | (3,262 | ) | | (1,692 | ) | | 484 | |
| |
|
|
|
|
|
|
|
|
|
Net cash used in investing activities | | | (133,428 | ) | | (99,983 | ) | | (123,928 | ) |
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Page 67 of 107
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2008, 2007 and 2006
(Amounts In Thousands)
| | | | | | | | | | |
| | 2008 | | 2007 | | 2006 | |
|
|
|
|
|
|
|
|
Cash Flows from Financing Activities | | | | | | | | | | |
Net increase in deposits | | | 93,960 | | | 36,517 | | | 70,995 | |
Net increase in short-term borrowings | | | 12,861 | | | 28,013 | | | 24,526 | |
Borrowings from FHLB | | | 20,000 | | | 60,000 | | | 45,000 | |
Payments on FHLB borrowings | | | (20,348 | ) | | (30,031 | ) | | (32,782 | ) |
Borrowings from FRB | | | 1,650 | | | 9,000 | | | — | |
Payments on FRB borrowings | | | (1,650 | ) | | (9,000 | ) | | — | |
Stock options exercised | | | 293 | | | 193 | | | 139 | |
Excess tax benefits related to share-based compensation | | | 127 | | | 145 | | | 67 | |
Purchase of treasury stock | | | (3,398 | ) | | (1,325 | ) | | (3,309 | ) |
Dividends paid | | | (4,086 | ) | | (3,873 | ) | | (3,696 | ) |
| |
|
|
|
|
|
|
|
|
|
Net cash provided by financing activities | | | 99,409 | | | 89,639 | | | 100,940 | |
| |
|
|
|
|
|
|
|
|
|
| | | | | | | | | | |
(Decrease) increase in cash and cash equivalents | | $ | (9,808 | ) | $ | 8,986 | | $ | (6,559 | ) |
| | | | | | | | | | |
Cash and cash equivalents: | | | | | | | | | | |
Beginning of year | | | 32,383 | | | 23,397 | | | 29,956 | |
| |
|
|
|
|
|
|
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|
|
End of year | | $ | 22,575 | | $ | 32,383 | | $ | 23,397 | |
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|
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|
|
| | | | | | | | | | |
Supplemental Disclosures | | | | | | | | | | |
Cash payments for: | | | | | | | | | | |
Interest paid to depositors | | $ | 29,178 | | $ | 35,550 | | $ | 26,654 | |
Interest paid on other obligations | | | 14,616 | | | 14,675 | | | 14,521 | |
Income taxes paid | | | 7,592 | | | 7,877 | | | 8,193 | |
| | | | | | | | | | |
Noncash financing activities: | | | | | | | | | | |
Increase in maximum cash obligation related to ESOP shares | | $ | 1,610 | | $ | 1,265 | | $ | 306 | |
Transfers to other real estate owned | | | 5,756 | | | 850 | | | 912 | |
| | | | | | | | | | |
See Notes to Consolidated Financial Statements. | |
Page 68 of 107
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies
Nature of activities: Hills Bancorporation (the “Company”) is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa.
The Bank competes with other financial institutions and non-financial institutions providing similar financial products. Although the loan activity of the Bank is diversified with commercial and agricultural loans, real estate loans, automobile, installment and other consumer loans, the Bank’s credit is concentrated in real estate loans. All of the Company’s operations are considered to be one reportable operating segment.
Accounting estimates: The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Certain significant estimates: The allowance for loan losses, fair values of securities and other financial instruments, and share-based compensation expense involves certain significant estimates made by management. These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist at December 31, 2008 may change in the near-term future and that the effect could be material to the consolidated financial statements.
Principles of consolidation: The consolidated financial statements include the accounts of the Company and its subsidiary. All significant intercompany balances and transactions have been eliminated in consolidation.
Revenue recognition: Interest income on loans and investment securities is recognized on the accrual method. Loan origination fees are recognized when the loans are sold. Trust fees, deposit account service charges and other fees are recognized when the services are provided or when customers use the services.
Investment securities: Held-to-maturity securities consisted solely of debt securities, which the Company had the positive intent and ability to hold to maturity and were stated at amortized cost. Available-for-sale securities consist of debt securities not classified as trading or held to maturity. Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders’ equity. There were no trading or held to maturity securities as of December 31, 2008 and 2007.
Stock of the Federal Home Loan Bank is carried at cost.
Premiums on debt securities are amortized over the earliest of the call date or the maturity date and discounts on debt securities are accreted over the period to maturity of those securities. The method of amortization results in a constant effective yield on those securities (the interest method). Realized gains and losses on investment securities are included in income, determined on the basis of the cost of the specific securities sold.
Unrealized losses judged to be other than temporary are charged to operations for both securities available for sale and securities held to maturity, and a new cost basis of the securities is established.
Page 69 of 107
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
Loans: Loans are stated at the amount of unpaid principal, reduced by the allowance for loan losses. Interest income is accrued on the unpaid balances as earned.
Loans held for sale are stated at the lower of aggregate cost or estimated fair value. Loans are sold on a non-recourse basis with servicing released and gains and losses are recognized based on the difference between sales proceeds and the carrying value of the loan.
The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance when management believes the collectability of principal is unlikely. The allowance for loan losses is maintained at a level considered adequate to provide for probable losses that can be reasonably anticipated. The allowance is increased by provisions charged to expense and is reduced by net charge-offs. The Bank makes continuous reviews of the loan portfolio and considers current economic conditions, historical loss experience, review of specific problem loans and other factors in determining the adequacy of the allowance. Management classifies loans within the following industry standard categories: watch, substandard and loss.
Loans are considered non-performing when, based on current information and events, it is probable the Bank will not be able to collect all amounts due. A non-performing loan includes any loan that has been placed on nonaccrual status. They also include loans, based on current information and events, that it is likely the Bank will be unable to collect all amounts due according to the contractual terms of the original loan agreement. The portion of the allowance for loan losses applicable to non-performing loans has been computed based on the present value of the estimated future cash flows of interest and principal discounted at the loans effective interest rate or on the fair value of the collateral for collateral dependent loans. The entire change in present value of expected cash flows of non-performing loans or of collateral value is reported as bad debt expense in the same manner in which impairment initially was recognized or as a reduction in the amount of bad debt expense that otherwise would be reported. Interest income on nonaccrual loans is recognized on the cash basis.
The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to the borrower’s ability to meet payments of interest or principal when they become due.
Nonrefundable loan fees and origination costs are deferred and recognized as a yield adjustment over the life of the related loan.
Transfers of financial assets: Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.
Credit related financial instruments: In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded.
Page 70 of 107
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
Tax credit real estate: Tax credit real estate represents two multi-family rental properties, two assisted living rental properties and a multi-tenant rental property for persons with disabilities, all which are affordable housing projects as of December 31, 2008. The Bank has a 99% limited partnership interest in each limited partnership. The investment in each was completed after the projects had been developed by the general partner. The properties are recorded at cost less accumulated depreciation. The Company evaluates the recoverability of the carrying value on a regular basis. If the recoverability was determined to be in doubt, a valuation allowance would be established by way of a charge to expense. Depreciation expense is provided on a straight-line basis over the estimated useful life of the assets. Expenditures for normal repairs and maintenance are charged to expense as incurred.
The financial condition, results of operations and cash flows of each limited partnership is consolidated in the Company’s consolidated financial statements. The operations of the properties are not expected to contribute significantly to the Company’s income before income taxes. However, the properties do contribute in the form of income tax credits, which lowers the Company’s effective tax rate. Once established, the credits on each property last for ten years and are passed through from the limited partnerships to the Bank and reduces the consolidated federal tax liability of the Company.
Property and equipment: Property and equipment is stated at cost less accumulated depreciation. Depreciation is computed using primarily declining-balance methods over the estimated useful lives of 7-40 years for buildings and improvements and 3-10 years for furniture and equipment.
Deferred income taxes: Deferred income taxes are provided under the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and net operating loss, and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Beginning with the adoption of FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes (FIN 48) as of January 1, 2007, the Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. Prior to the adoption of FIN 48, the Company recognized the effect of income tax positions only if such positions were probable of being sustained. Interest and penalties on unrecognized tax benefits are classified as an other noninterest expense. As of December 31, 2008, the Company had no material unrecognized tax benefits.
Goodwill: Goodwill represents the excess of cost over the fair value of the net assets acquired, and is not subject to amortization, but requires, at a minimum, annual impairment tests for intangibles that are determined to have an indefinite life.
Other real estate: Other real estate represents property acquired through foreclosures and settlements of loans. Property acquired is carried at the lower of the principal amount of the loan outstanding at the time of acquisition, plus any acquisition costs, or the estimated fair value of the property, less disposal costs. Subsequent write downs estimated on the basis of later valuations, gains or losses on sales and net expenses incurred in maintaining such properties are charged to other non-interest expense.
Page 71 of 107
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
Earning per share: Basic earnings per share is computed using the weighted average number of actual common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that would occur from the exercise of common stock options outstanding. The following table presents calculations of earnings per share:
| | | | | | | | | | |
| | Year Ended December 31, | |
| | 2008 | | 2007 | | 2006 | |
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|
| | (Amounts In Thousands) | |
Computation of weighted average number of basic and diluted shares: | | | | | | | | | | |
Common shares outstanding at the beginning of the year | | | 4,490,107 | | | 4,503,738 | | | 4,562,237 | |
Weighted average number of net shares issued (redeemed) | | | (22,122 | ) | | (4,158 | ) | | (6,215 | ) |
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Weighted average shares outstanding (basic) | | | 4,467,985 | | | 4,499,580 | | | 4,556,022 | |
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method | | | 15,202 | | | 19,495 | | | 25,581 | |
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Weighted average number of shares (diluted) | | | 4,483,187 | | | 4,519,075 | | | 4,581,603 | |
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Net income (In Thousands) | | $ | 14,140 | | $ | 16,143 | | $ | 15,559 | |
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Earnings per share: | | | | | | | | | | |
Basic | | $ | 3.16 | | $ | 3.59 | | $ | 3.42 | |
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Diluted | | $ | 3.15 | | $ | 3.57 | | $ | 3.39 | |
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Stock awards and options: Compensation expense for stock issued through the stock award plan is accounted for using the fair value method prescribed by Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (FAS 123R). Under this method, compensation expense is measured and recognized for all stock-based awards made to employees and directors based on the fair value of each option as of the date of the grant.
Common stock held by ESOP: The Company’s maximum cash obligation related to these shares is classified outside stockholders’ equity because the shares are not readily traded and could be put to the Company for cash.
Fair value of financial instruments: The Company adopted FASB Statement No. 157,Fair Value Measurements (“FAS 157”), in its entirety on January 1, 2008. FAS 157 provides a single definition for fair value, a framework for measuring fair value and expanded disclosures concerning fair value. Fair value is defined under FAS 157 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.
The Company determines the fair market value of its financial instruments based on the fair value hierarchy established in FAS 157. There are three levels of inputs that may be used to measure fair value as follows:
| | |
| Level 1 | Valuations for assets and liabilities traded in active markets for identical assets or liabilities. Level 1 includes securities purchased from the Federal Home Loan Bank (“FHLB”), Federal Home Loan Mortgage Corporation (“FHLMC”) and Federal National Mortgage Association (“FNMA”) that are traded by dealers or brokers in active markets. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities. |
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| Level 2 | Valuations for assets and liabilities traded in less active dealer or broker markets. Level 2 includes securities issued by state and political subdivisions. Valuations are obtained from third party pricing services for identical or comparable assets or liabilities. |
Page 72 of 107
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
| | |
| Level 3 | Valuations for assets and liabilities that are derived from other valuation methodologies, including discounted cash flow models and similar techniques, and not based on market exchange, dealer or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets and liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. The Company does not have any Level 3 assets or liabilities. |
It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. Recent market conditions have led to diminished, and in some cases, non-existent trading in certain of the financial asset classes. The Company is required to use observable inputs, to the extent available, in the fair value estimation process unless that data results from forced liquidations or distressed sales. Despite the Company’s best efforts to maximize the use of relevant observable inputs, the current market environment has diminished the observability of trades and assumptions that have historically been available.
The following is a description of valuation methodologies used for assets and liabilities recorded at fair value and for estimating fair value for assets or liabilities not recorded at fair value.
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| ASSETS |
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| Cash and cash equivalents: The carrying amounts reported in the consolidated balance sheets for cash and short-term instruments approximate their fair values. |
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| Investment securities available for sale: Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If a quoted price is not available, the fair value is obtained from benchmarking the security against similar securities. Level 1 securities include securities from the FHLB, FHLMC and FNMA. Level 2 securities include securities issued by state or political subdivisions. |
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| Loans held for sale: Loans held for sale are carried at historical cost. The carrying amount is a reasonable estimate of fair value because of the short time between origination of the loan and its sale on the secondary market. |
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| Loans: The Company does not record loans at fair value on a recurring basis. The Company does record nonrecurring fair value adjustments to loans to reflect (1) partial write-downs that are based on the observable market price or appraised value of the collateral or (2) the full charge-off of the loan carrying value. |
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| Foreclosed assets: Foreclosed assets consist mainly of other real estate owned but may include other types of assets repossessed by the Company. Foreclosed assets are adjusted to the lower of carrying value or fair value upon transfer of the loans to foreclosed assets. Fair value is generally based upon independent market prices or appraised values of the collateral. Foreclosed assets are classified as Level 2. |
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| Off-balance sheet instruments: Fair values for outstanding letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of the outstanding letters of credit is not significant. Unfunded loan commitments are not valued since the loans are generally priced at market at the time of funding. |
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| Accrued interest receivable: The fair value of accrued interest receivable equals the amount receivable due to the current nature of the amounts receivable. |
Page 73 of 107
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
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| Non-marketable equity investments: Non-marketable equity investments are recorded under the cost or equity method of accounting. There are generally restrictions on the sale and/or liquidation of these investments, including stock of the Federal Home Loan Bank. The carrying value of stock of the Federal Home Loan Bank approximates fair value. |
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| LIABILITIES |
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| Deposit liabilities: Deposit liabilities are carried at historical cost. The fair value of demand deposits, savings accounts and certain money market account deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. If the fair value of the fixed maturity certificates of deposit is calculated at less than the carrying amount, the carrying value of these deposits is reported as the fair value. |
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| Short-term borrowings: Short-term borrowings are carried at historical cost and include federal funds purchased and securities sold under agreements to repurchase. The carrying amount is a reasonable estimate of fair value because of the relatively short time between the origination of the liability and its expected realization. |
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| Long-term borrowings: Long-term borrowings are recorded at historical cost. The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements. |
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| Accrued interest payable: The fair value of accrued interest payable equals the amount payable due to the current nature of the amounts payable. |
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| Assets and Liabilities Recorded at Fair Value on a Recurring Basis |
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| The table below represents the balances of assets and liabilities measured at fair value on a recurring basis: |
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| | December 31, 2008 | |
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| | Level 1 | | Level 2 | | Level 3 | | Total | |
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| | (Amounts in Thousands) | |
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Investment securities available for sale | | $ | 99,849 | | $ | 100,463 | | $ | — | | $ | 200,312 | |
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Total | | $ | 99,849 | | $ | 100,463 | | $ | — | | $ | 200,312 | |
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Valuation methodologies have not changed during the year ended December 31, 2008.
All securities from the FHLB, FHLMC and FNMA are included in Level 1.
Page 74 of 107
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
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| Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis |
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| The Company is required to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. The valuation methodologies used to measure these fair value adjustments are described above. For assets measured at fair value on a nonrecurring basis in 2008 that were still held on the balance sheet at December 31, 2008, the following table provides the level of valuation assumptions used to determine the adjustment and the carrying value of the related individual assets at year end. |
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| | December 31, 2008 | | Year Ended
December 31, 2008 | |
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| | Level 1 | | Level 2 | | Level 3 | | Total | | Total Losses | |
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| | (Amounts in Thousands) | | | |
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Loans (1) | | $ | — | | $ | 4,850 | | $ | — | | $ | 4,850 | | $ | 1,417 | |
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Total | | $ | — | | $ | 4,850 | | $ | — | | $ | 4,850 | | $ | 1,417 | |
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| (1) | Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully-charged off is zero. |
Reclassifications: Certain prior year amounts may be reclassified to conform to the current year presentation.
Page 75 of 107
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 2. Investment Securities
Investment Securities Available For Sale:
Investment securities have been classified in the consolidated balance sheets according to management’s intent. The Company had no securities designated as trading in its portfolio at December 31, 2008 or 2007. The carrying amount of available-for-sale securities and their approximate fair values were as follows December 31 (in thousands):
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| | Amortized
Cost | | Gross
Unrealized
Gains | | Gross
Unrealized
(Losses) | | Estimated
Fair
Value | |
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December 31, 2008: | | | | | | | | | | | | | |
Other securities (FHLB, FHLMC and FNMA) | | $ | 95,642 | | $ | 4,207 | | $ | — | | $ | 99,849 | |
State and political subdivisions | | | 98,760 | | | 1,774 | | | (71 | ) | | 100,463 | |
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Total | | $ | 194,402 | | $ | 5,981 | | $ | (71 | ) | $ | 200,312 | |
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December 31, 2007: | | | | | | | | | | | | | |
Other securities (FHLB, FHLMC and FNMA) | | $ | 104,041 | | $ | 1,070 | | $ | (146 | ) | $ | 104,965 | |
State and political subdivisions | | | 94,510 | | | 426 | | | (302 | ) | | 94,634 | |
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Total | | $ | 198,551 | | $ | 1,496 | | $ | (448 | ) | $ | 199,599 | |
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The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at December 31, 2008, were as follows (in thousands):
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| | Amortized
Cost | | Fair
Value | |
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Due in one year or less | | $ | 39,644 | | $ | 40,082 | |
Due after one year through five years | | | 111,183 | | | 115,703 | |
Due after five years through ten years | | | 42,661 | | | 43,622 | |
Due over ten years | | | 914 | | | 905 | |
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Total | | $ | 194,402 | | $ | 200,312 | |
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As of December 31, 2008, investment securities with a carrying value of $99,937,000 were pledged to collateralize public deposits, short-term borrowings and for other purposes, as required or permitted by law.
Page 76 of 107
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 2. Investment Securities (Continued)
The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2008 and 2007 (in thousands):
