Hawthorn Bancshares 10K 2009 Annual report | HWBK Filing

Exhibit 13

2009

ANNUAL REPORT

SHAREHOLDERS

HAWTHORN BANCSHARES, INC.

Lee’s Summit, Missouri

March 15, 2010

Dear Investors:

Hawthorn is very much a part of the communities in which our 24 branches are located and as such, our performance is directly tied to the local economies in which we operate. 2009 proved to be a challenging economic environment for the entire country and more specifically, the banking industry. However, despite significant increases in FDIC insurance costs ($2.3 million over 2008) and a continued larger than normal loan loss provision ($8.4 million for 2009 compared to $8.2 million and $1.2 million for 2008 and 2007, respectively), our core operations remained strong as we realized increases in both net interest income and non-interest income.

As Chairman, I recognize that the sustainability of a bank is centered on 1) asset quality, 2) capital strength and 3) liquidity. At Hawthorn, our credit portfolio has experienced moderate deterioration as evidenced by the spike in non-performing loans of 4.27% of total loans compared to 2.46% for 2008. Despite deterioration in asset quality, the level of problem assets is manageable. Capital levels for Hawthorn continue to far exceed regulatory requirements and even increased during 2009 due to earnings retention and lowering the quarterly common dividend.

The common dividend was reduced to $0.11 per share on July 1, 2009 due to lower earnings. Recognizing the potential long term capital erosion effect of paying out more in dividends than is earned and due to uncertainty in the financial markets, it was prudent to lower the cash dividend. To offset the lower cash dividend, the Board was pleased to declare a 4% stock dividend which provided investors with additional opportunity to directly share in Hawthorn’s growth.

In spite of the impact of the current recession, in 2009 we did have positive earnings and we continued to pay dividends. Many banks in Missouri and across the nation are unable to say this. Net income for 2009 of $5.0 million was greatly improved over 2008’s net loss of $30.6 million which included a $40.3 million non-cash goodwill impairment charge. Exclusive of the impairment charge, the increase over 2008 is primarily attributed to a stronger net interest margin and increased residential refinancing activity. 2009’s net interest margin increased to 3.50% from 3.42% for 2008 which contributed an additional $2.4 million to earnings. Gains from residential refinancing activity contributed an additional $2.0 million for 2009.

I am often asked about management’s plans to continue participation in the U.S. Treasury’s capital purchase program. Your Board of Directors met on several occasions to evaluate the benefits of continuing in the program and after much analysis, management feels it remains practical for Hawthorn to retain higher than normal capital levels to protect shareholder value.

In summary, Hawthorn is a well capitalized, liquid organization which has the ability to endure the challenging operating environment which everyone is experiencing. Your continued support as we move forward to 2010 is much appreciated!

Sincerely,

James E. Smith
Chairman & Chief Executive Officer

A WORD CONCERNING FORWARD-LOOKING STATEMENTS

This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of our Company and its subsidiaries, including, without limitation:

•		statements that are not historical in nature, and

•		statements preceded by, followed by or that include the words “believes,” “expects,” “may,” “will,” “should,” “could,” “anticipates,” “estimates,” “intends” or similar expressions.

Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

•		competitive pressures among financial services companies may increase significantly,

•		changes in the interest rate environment may reduce interest margins,

•		general economic conditions, either nationally or in Missouri, may be less favorable than expected and may adversely affect the quality of our loans and other assets,

•		increases in non-performing assets in our loan portfolios and adverse economic conditions may necessitate increases to our provisions for loan losses,

•		costs or difficulties related to the integration of the business of Hawthorn and its acquisition targets may be greater than expected,

•		legislative or regulatory changes may adversely affect the business in which Hawthorn and its subsidiaries are engaged, and

•		changes may occur in the securities markets.

We have described under the caption “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009, and in other reports that we file with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that we have not identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made.

HAWTHORN BANCSHARES, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Through its branch network, our Company, Hawthorn Bancshares, Inc., provides a broad range of commercial and personal banking services, including certificates of deposit, individual retirement and other time deposit accounts, checking and other demand deposit accounts, interest checking accounts, savings accounts, and money market accounts. We also provide a wide range of lending services, including real estate, commercial, installment, and other consumer loans. Other financial services that we provide include automatic teller machines, trust services, credit related insurance, and safe deposit boxes. The geographic areas in which we provide our products and services include the communities in and surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson and Lee’s Summit, Missouri. The products and services are offered to customers primarily within these geographical areas.

Our Company’s primary source of revenue is net interest income derived primarily from lending and deposit taking activities. A secondary source of revenue is investment income. Our Company also derives income from trust, brokerage, credit card and mortgage banking activities and service charge income.

Much of our Company’s business is commercial, commercial real estate development, and mortgage lending. Our Company has experienced continued strong loan demand in the communities within which we operate even during the current economic slowdown. Our Company’s income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancings.

The successes of our Company’s growth strategy depends primarily on the ability of our banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. Our Company’s financial performance also depends, in part, on our ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of our Company’s growth strategy depends on our ability to maintain sufficient regulatory capital levels during general economic conditions and during economic conditions that are beyond our control.

Our subsidiary Bank is a full service bank conducting a general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial and industrial loans, residential real estate loans, single payment personal loans, installment loans and credit card accounts. In addition, our Bank provides trust services.

The deposit accounts of our Bank are insured by the Federal Deposit Insurance Corporation or “FDIC” to the extent provided by law. The operations of our Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of our Bank are conducted by representatives of the FDIC and the Missouri Division of Finance. Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. Hawthorn Bancshares is subject to supervision and examination by the Federal Reserve Board.

Except as otherwise provided herein, references herein to “Hawthorn” or our “Company” include Hawthorn and its consolidated subsidiaries, and references herein to our “Bank” refers to Hawthorn Bank and its constituent predecessors.

SELECTED CONSOLIDATED FINANCIAL DATA

The following table presents selected consolidated financial information for our Company as of and for each of the years in the five-year period ended December 31, 2009. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements of our Company, including the related notes, presented elsewhere herein.


Income Statement Data

(In thousands, except per share data)	2009			2008			2007			2006			2005

Interest income	$	63,562		$	69,715		$	74,207		$	71,423		$	57,340
Interest expense		22,974			31,599			37,175			32,766			23,673

Net interest income		40,588			38,116			37,032			38,657			33,667
Provision for loan losses		8,354			8,211			1,154			1,326			1,322

Net interest income after provision for loan losses		32,234			29,905			35,878			37,331			32,345

Non-interest income		10,702			9,294			10,223			8,618			7,290
Security gains (losses), net		606			3			(2	)		(18	)		(25	)

Total non-interest income		11,308			9,297			10,221			8,600			7,265
Non-interest expense		36,730			75,975			35,054			30,148			25,368

Income (loss) before income taxes		6,812			(36,773	)		11,045			15,783			14,242
Income taxes (benefit)		1,856			(6,146	)		3,245			4,908			4,327

Net income (loss)		4,956			(30,627	)		7,800			10,875			9,915
Less: preferred stock dividends		1,994			66			—			—			—

Net income available to common shareholders	$	2,962		$	(30,693	)	$	7,800		$	10,875		$	9,915


Dividends on Common Stock

Declared	$	2,270		$	3,486		$	3,504		$	3,503		$	3,503
Paid		2,666			3,486			3,504			3,503			3,378
Ratio of total dividends declared to net income		76.64	%		N.M.			44.92	%		32.21	%		35.33	%

Per Share Data

Basic earnings (loss) per common share	$	0.69		$	(7.10	)	$	1.80		$	2.51		$	2.29
Diluted earnings (loss) per common share		0.69			(7.10	)		1.78			2.49			2.27
Basic weighted average shares of common stock outstanding		4,301,955			4,321,979			4,338,438			4,336,641			4,336,641
Diluted weighted average shares of common stock outstanding		4,301,955			4,321,979			4,376,096			4,369,795			4,363,857


(In thousands, except per share data)	2009			2008			2007			2006			2005

Balance Sheet Data (at period end)
Total assets	$	1,236,471		$	1,279,699		$	1,195,804		$	1,142,712		$	1,126,470
Loans		991,614			1,009,104			911,278			812,312			813,535
Investment securities		152,927			149,401			151,742			183,566			173,389
Total deposits		956,323			955,296			921,257			899,865			881,455
Subordinated notes		49,486			49,486			49,486			49,486			49,486
Other borrowed money		79,317			129,057			77,915			47,368			52,180
Common stockholders’ equity		79,406			78,530			111,199			104,945			96,733
Total stockholders’ equity		107,771			106,418			111,199			104,945			96,733
Balance Sheet Data (average balances)
Total assets	$	1,258,381		$	1,251,496		$	1,156,500		$	1,146,150		$	1,083,746
Loans		1,002,830			963,252			848,771			824,706			743,382
Investment securities		151,907			156,870			171,179			182,902			201,995
Total deposits		977,826			914,218			921,257			899,865			982,360
Subordinated notes		49,486			49,486			49,486			49,486			44,614
Other borrowed money		78,626			124,025			53,626			56,757			48,430
Common stockholders’ equity		79,828			112,307			108,052			100,821			94,663
Total stockholders’ equity		107,938			113,375			108,052			100,821			94,663


Key Ratios

Earnings Ratios
Return (loss) on average total assets		0.39	%		(2.45)	%		0.67	%		0.95	%		0.91	%
Return (loss) on average common stockholders’ equity		3.71			(27.33	)		7.22			10.79			10.47
Efficiency ratio (3)		71.66			160.25			74.18			63.80			61.98

Asset Quality Ratios
Allowance for loan losses to loans		1.49			1.26			1.02			1.11			1.12
Nonperforming loans to loans (1)		4.27			2.46			0.67			0.62			1.11
Allowance for loan losses to nonperforming loans (1)		34.94			50.94			152.54			177.95			100.39
Nonperforming assets to loans and foreclosed assets (2)		5.08			3.21			0.92			0.96			1.30
Net loan charge-offs to average loans		0.62			0.50			0.10			0.17			0.15

Capital Ratios
Average stockholders’ equity to average total assets		8.58	%		9.06	%		9.34	%		8.80	%		8.73	%
Period-end common stockholders’ equity to period-end assets		6.42			6.14			9.30			9.18			8.59
Period-end tangible common stockholders’ equity to period-end tangible assets		6.15			5.89			5.81			5.42			6.07
Period-end stockholders’ equity to period-end assets		8.72			8.32			9.30			9.18			8.59
Total risk-based capital ratio		16.49			16.01			13.24			13.84			12.70
Tier 1 risk-based capital ratio		14.01			13.55			11.08			11.28			9.83
Leverage ratio		11.35			10.80			9.12			8.77			7.88


(1)		Nonperforming loans consist of nonaccrual loans and loans contractually past due 90 days or more and still accruing interest.

(2)		Nonperforming assets consist of nonperforming loans and foreclosed assets.

(3)		Efficiency ratio is calculated as non-interest expense as a percent of revenue. Total revenue includes net interest income and non-interest income.

CRITICAL ACCOUNTING POLICIES

The following accounting policies are considered most critical to the understanding of our Company’s financial condition and results of operations. These critical accounting policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to our critical accounting policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such polices affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 of our consolidated financial statements.

Allowance for Loan Losses

We have identified the accounting policy related to the allowance for loan losses as critical to the understanding of our Company’s results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change. The impact and any associated risks related to these policies on our business operations are discussed in the “Lending and Credit Management” section below.

Income Taxes

Income taxes are accounted for under the asset / liability method by recognizing the amount of taxes payable or refundable for the current period and deferred tax assets and liabilities for future tax consequences of events that been that have been recognized in an entity’s financial statements or tax returns. Judgment is required in addressing our Company’s future tax consequences of events that have been recognized in our consolidated financial statements or tax returns such as realization of the effects of temporary differences, net operating loss carry forward, and changes in tax laws or interpretations thereof. A valuation allowance is established when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. In this case, our Company would adjust the recorded value of our deferred tax asset, which would result in a direct charge to income tax expense in the period that the determination was made. Likewise, our Company would reverse the valuation allowance when the realization of the deferred tax asset is expected. In addition, our Company is subject to the continuous examination of our tax returns by the Internal Revenue Service and other taxing authorities. Our Company accrues for interest related to income taxes in income tax expense. Total interest expense recognized was $53,000 and $77,000 in 2009 and 2008, respectively. As of December 31, 2009 and 2008, total accrued interest was $94,000 and $131,000, respectively.

Goodwill and Intangible Assets

Goodwill and intangible assets that have indefinite useful lives are not amortized, but tested annually for impairment. Intangible assets that have finite useful lives, such as core deposit intangibles and mortgage servicing rights, are amortized over their estimated useful lives. Core deposit intangibles are amortized over periods of 7 to 8 years representing their estimated lives using straight line and accelerated methods. Mortgage servicing rights are amortized over the shorter of 7 years or the life of the loan.

When facts and circumstances indicate potential impairment of amortizable intangible assets, our Company evaluates the recoverability of the carrying value based upon future cash flows expected to result from the use of the underlying asset and its eventual disposition. If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying value of the underlying asset, the Company recognizes an impairment loss. The impairment loss recognized represents the amount by which the carrying value of the underlying asset exceeds the fair value of the underlying asset. As a result of the 2008 annual review, our Company determined that goodwill was fully impaired and recorded an impairment charge of $40,323,775, before tax.

RESULTS OF OPERATIONS ANALYSIS

Our Company has prepared all of the consolidated financial information in this report in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). In preparing the consolidated financial statements in accordance with U.S. GAAP, our Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.


									$ Change						% Change
(Dollars in thousands)	2009		2008			2007			‘09-‘08			‘08-‘07			‘09-‘08			‘08-‘07

Net interest income (loss)	$	40,588	$	38,116		$	37,032		$	2,472		$	1,084			6.5	%		2.9	%
Provision for loan losses		8,354		8,211			1,154			143			7,057			1.7			611.5
Noninterest income		10,702		9,294			10,223			1,408			(929	)		15.1			(9.1	)
Investment securities gains (losses), net		606		3			(2	)		603			5		NM				(250.0	)
Noninterest expense		36,730		75,975			35,054			(39,245	)		40,921			(51.7	)		116.7
Income (loss) before income taxes		6,812		(36,773	)		11,045			43,585			(47,818	)		118.5			(432.9	)

Income taxes (benefit)		1,856		(6,146	)		3,245			8,002			(9,391	)		130.2			(289.4	)

Net income (loss)	$	4,956	$	(30,627	)	$	7,800		$	35,583		$	(38,427	)		116.2	%		(492.7	)%

Less: preferred dividends		1,994		66			—			1,928			66			—			—

Net income (loss) available to common shareholders	$	2,962	$	(30,693	)	$	7,800		$	33,655		$	(38,493	)		109.7	%		(493.5	)%

Our Company’s consolidated net income of $4,956,000 for the year ended December 31, 2009 increased $35,583,000 compared to a loss of $(30,627,000) for the year ended December 31, 2008. Our Company recorded preferred stock dividends of $1,994,000 for the year ended December 31, 2009, resulting in $2,962,000 of net income available to common shareholders, or $0.69 per diluted common share, compared to a net loss of $(30,693,000), or $(7.10) per diluted common share for the year ended December 31, 2008. This $33,655,000 increase from 2008 is primarily due to a one time $40,324,000 ($33,211,000 after tax) goodwill impairment charge to income taken in the fourth quarter of 2008. Excluding this one time goodwill impairment charge, net income available for the common shareholders increased $444,000 from $2,518,000 to $2,962,000. This non-GAAP measure of operating results is discussed more fully below. Our Company did experience substantial real estate refinancing activity in 2009, which contributed additional revenues of approximately $2,001,000. However, this was offset by an industry-wide increase in FDIC insurance assessments. Our Company paid $2,519,000 during 2009 in comparison to $204,000 during 2008. Net interest margin increased 0.08% from 3.42% to 3.50%. Net interest income, on a tax equivalent basis, increased $2,353,000 or 6.0% from 2008 to 2009. Total assets at December 31, 2009 were $1,236,471,000, compared to $1,279,699,000 at December 31, 2008, a decrease of $43,228,000, or 3.4%. The return on average assets was 0.39%, the return on average common shareholders’ equity was 3.71%, and the efficiency ratio was 71.6%.

Our Company’s consolidated net loss of $(30,627,000) for the year ended December 31, 2008 decreased $(38,427,000) compared to net income of $7,800,000 for the year ended December 31, 2007. Our Company recorded preferred stock dividends of $66,000 for the year ended December 31, 2008, resulting in a $(30,693,000) net loss available for common shareholders, or $(7.10) per diluted common share, compared to net income of $7,800,000, or $1.78 per diluted common share for the year ended December 31, 2007. This $38,493,000 decrease from 2007 is a result of a one time $40,324,000 goodwill impairment charge to income. Excluding this one time goodwill impairment charge, $33,211,000 after tax, net income would have been $2,518,000, or $0.58 per diluted common share. This non-GAAP measure of operating results is discussed more fully below. The largest component of the decline in net income was a $8,211,000 provision for loan losses in 2008 compared with a provision of $1,154,000 in 2007. In addition, a lower net interest margin of 3.4% compared to 3.7% at December 31, 2007, was offset by an $114,481,000 increase in average loans increasing net interest income, on a tax equivalent basis, $958,000, or 2.5%, over 2007. Total assets at December 31, 2008 were $1,279,699,000, compared to $1,195,804,000 at December 31, 2007, an increase of $83,895,000, or 7.0%. The return on average assets was (2.45)%, the return on average common shareholders’ equity was (27.33)%, and the efficiency ratio was 160.2%.

Comparison of GAAP and Non-GAAP Information

As a supplement to our U.S. GAAP financial results, our Company has provided non-GAAP operating results for the year ended December 31, 2009. Our Company believes that these non-GAAP financial measures are useful because they allow investors to assess, on a consistent basis, our Company’s performance exclusive of items management believes are not indicative of the operations of our Company. Management uses non-GAAP financial measures to evaluate financials results and to establish operational goals. These non-GAAP financial measures should be considered a supplement to, and not a substitute for, financial measures determined in accordance with GAAP. The non-GAAP measures presented below exclude the non-recurring pre-tax charge to write-off our entire goodwill in the fourth quarter of 2008 which is explained in more detail in the “Non-interest Income and Expense” section of this discussion and Note 8 of the consolidated financial statements.


										$ Change						% Change
(Dollars in thousands)	2009			2008			2007			‘09-‘08			‘08-‘07			‘09-‘08			‘08-‘07

Non-interest expense (GAAP)	$	36,730		$	75,975		$	35,054		$	(39,245	)	$	40,921			(51.7	)%		1.2	%
Goodwill impairment		—			(40,324	)		—			40,324			(40,324	)		N.M			N.M

Non-interest expense (non-GAAP)		36,730			35,651			35,054			1,079			597			3.0			1.7

Net income (loss) (GAAP)	$	4,956		$	(30,627	)	$	7,800		$	35,583		$	(38,427	)		(116.2	)%		(492.7	)%
Goodwill impairment, net of tax effect		—			33,211			—			(33,211	)		33,211			N.M			N.M
Less: preferred dividends		1,994			66			—			1,928			66			N.M			N.M

Net income available to common shareholders (non-GAAP)	$	2,962		$	2,518		$	7,800		$	444		$	(5,282	)		17.6	%		(67.7	)%

GAAP basis:
Basic earnings (loss) per share	$	0.69		$	(7.10	)	$	1.80		$	7.79		$	(8.90	)		(109.7	)%		(494.4	)%
Diluted earnings (loss) per share		0.69			(7.10	)		1.78			7.79			(8.88	)		(109.7	)		(498.9	)
Return (loss) on average assets		0.39	%		(2.45	)%		0.67	%
Return (loss) on average common equity		3.71	%		(27.33	)%		7.22	%
Efficiency ratio		71.66	%		160.25	%		74.18	%
Non-GAAP basis:
Basic earnings per share	$	0.69		$	0.58		$	1.80		$	0.11		$	(1.22	)		19.0	%		(67.8	)%
Diluted earnings per share		0.69			0.58			1.78			0.11			(1.20	)		19.0			(67.4	)
Return on average assets		0.39	%		0.20	%		0.67	%
Return on average common equity		3.71	%		2.24	%		7.22	%
Efficiency ratio		71.66	%		75.20	%		74.18	%

Comparison of years ending 2009 and 2008 Non-GAAP results:

Based on non-GAAP operating results as shown above, our Company’s diluted earnings per common share were $0.69 in 2009 compared to $0.58 in 2008, an increase of 19.0%. Consolidated net income for 2009 was $2,962,000, compared to $2,518,000 in 2008. Return on average total assets increased from 0.20% in 2008 to 0.24% in 2009, and return on average common equity decreased from 2.24% in 2008 to 1.40% in 2009. The efficiency ratio was 71.66% in 2009 compared with 75.20% in 2008.

Comparison of years ending 2008 and 2007 Non-GAAP results:

Based on non-GAAP operating results as shown above, our Company’s diluted earnings per common share were $0.58 in 2008 compared to $1.78 in 2007, a decrease of 67.4%. Consolidated net income for 2008 was $2,518,000, compared to $7,800,000 in 2007. Return on average total assets decreased from 0.67% in 2007 to 0.20% in 2008, and return on average common equity decreased from 7.22% in 2007 to 2.24% in 2008. The efficiency ratio was 75.20% in 2008 compared with 74.18% in 2007.

Net Interest Income

Net interest income is the largest source of revenue resulting from our Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities.

Average Balance Sheets

The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the years in the three year period ended December 31, 2009.


(Dollars In thousands)	2009									2008								2007
					Interest		Rate						Interest		Rate						Interest		Rate
		Average			Income/		Earned/			Average			Income/		Earned/			Average			Income/		Earned/
		Balance			Expense(1)		Paid(1)			Balance			Expense(1)		Paid(1)			Balance			Expense(1)		Paid(1)

ASSETS
Loans: (2) (4)		$	1,002,830		$	57,514		5.74	%	$	963,252		$	62,766		6.52	%	$	848,771		$	65,636		7.73	%
Investment in securities: (3)
Government sponsored enterprises			112,091			4,417		3.94			110,840			4,917		4.44			117,208			5,614		4.79
State and municipal			39,816			2,166		5.44			46,030			2,503		5.44			53,971			2,969		5.50
Restricted Investements			8,817			164		1.86			8,440			316		3.74			5,883			312		5.30
Federal funds sold			309			—		—			2,925			60		2.05			11,313			615		5.44
Interest bearing deposits in other financial institutions			18,807			53		0.28			8,738			24		0.27			1,128			58		5.14

Total interest earning assets			1,182,670			64,314		5.44			1,140,225			70,586		6.19			1,038,274			75,204		7.24
All other assets			89,108								121,373								127,336
Allowance for loan losses			(13,397	)							(10,102	)							(9,110	)

Total assets		$	1,258,381							$	1,251,496							$	1,156,500

LIABILITIES AND STOCKHOLDERS’ EQUITY
NOW accounts		$	138,456		$	1,131		0.82	%	$	117,487		$	1,317		1.12	%	$	110,658		$	1,482		1.34	%
Savings			46,464			139		0.30			44,253			226		0.51			46,634			260		0.56
Money market			175,894			1,747		0.99			168,418			3,340		1.98			159,767			5,668		3.55
Time deposits of $100,000 and over			140,502			3,862		2.75			142,713			5,698		3.99			141,645			7,045		4.97
Other time deposits			351,597			10,543		3.00			319,919			12,872		4.02			318,469			14,826		4.66

Total time deposits			852,913			17,422		2.04			792,790			23,453		2.96			777,173			29,281		3.77
Federal funds purchased and securities sold under agreements to repurchase			33,923			88		0.26			41,633			869		2.09			31,061			1,381		4.45
Interest — bearing demand notes to U.S. Treasury			—			—		—			—			—		—			205			11		5.37
Subordinated notes			49,486			2,447		4.94			49,486			3,046		6.16			49,486			3,617		7.31
Other borrowed money			78,626			3,017		3.84			124,025			4,231		3.41			53,626			2,885		5.38

Total interest bearing liabilities			1,014,948			22,974		2.26			1,007,934			31,599		3.14			911,551			37,175		4.08
Demand deposits			124,913								121,428								126,708
Other liabilities			10,582								8,759								10,189

Total liabilities			1,150,443								1,138,121								1,048,448
Stockholders’ equity			107,938								113,375								108,052

Total liabilities and stockholders’ equity		$	1,258,381							$	1,251,496							$	1,156,500

Net interest income (FTE)					$	41,340							$	38,987							$	38,029

Net interest spread								3.18	%							3.05	%							3.16	%
Net interest margin								3.50	%							3.42	%							3.66	%



(1)		Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 35%, net of nondeductible interest expense. Such adjustments totaled $751,000, $871,000 and $,997,000 for the years ended December 31, 2009, 2008 and 2007, respectively.

(2)		Non-accruing loans are included in the average amounts outstanding.

(3)		Average balances based on amortized cost.

(4)		Fees and costs on loans are included in interest income.

Comparison of Years ended December 31, 2009 and 2008

Financial results for 2009 compared to 2008 included an increase in net interest income, on a tax equivalent basis, of $2,353,000, or 6.0%. Average interest-earning assets increased $42,445,000, or 3.7% to $1,182,670,000 at December 31, 2009 compared to $1,140,225,000 at December 31, 2008 and average interest bearing liabilities increased $7,014,000, or 0.7%, to $1,014,948,000 at December 31, 2009 compared to $1,007,934,000 at December 31, 2008.

Average loans outstanding increased $39,578,000 or 4.1% to $1,002,830,000 for 2009 compared to $963,252,000 for 2008. The following is a summary of the changes in average loan balance by major category:


					$ Change			% Change
(Dollars in thousands)	2009		2008		‘09-‘08			‘09-‘08

Average loans:
Commercial	$	149,694	$	151,342	$	(1,648	)		(1.1	)%
Real estate construction — residential		42,307		68,728		(26,421	)		(38.4	)
Real estate construction — commercial		74,969		80,918		(5,949	)		(7.4	)
Real estate mortgage — residential		238,012		223,093		14,919			6.7
Real estate mortgage — commercial		463,391		406,697		56,694			13.9
Consumer		34,457		32,474		1,983			6.1

Total	$	1,002,830	$	963,252	$	39,578			4.1	%

See the “Lending and Credit Management” section of this discussion for further discussion of changes in the composition of our lending portfolio.

Average investment securities and federal funds sold decreased $7,579,000 or 4.7% to $152,216,000 for 2009 compared to $159,795,000 for 2008. Average interest bearing deposits increased $10,069,000 to $18,807,000 at December 31, 2009 compared to $8,738,000 at December 31, 2008. This increase was a result of changing our Company’s overnight investment of excess funds from federal funds sold to interest bearing reserve balances held at the Federal Reserve Bank.

Average time deposits increased $60,123,000, or 7.6%, to $852,913,000 at December 31, 2009 compared to $792,790,000 at December 31, 2008. The increase was primarily a result of increased public fund deposits. Product specials promoting interest bearing checking accounts and certificate of deposits also contributed to new deposits.

Average federal funds purchased and securities sold under agreements to repurchase decreased $7,710,000 or 18.5% to $33,923,000 for 2009 compared to $41,633,000 for 2008. This reflects a $5,387,000 decrease in repurchase agreements for public funds and a $2,323,000 decrease in federal funds purchased from 2008 to 2009.

Average other borrowed money decreased $45,399,000 or 36.6% to $78,626,000 for 2009 compared to $124,025,000 for 2008. The decrease in 2009 reflects a net decrease in Federal Home Loan Bank advances.

Comparison of Years ended December 31, 2008 and 2007

Financial results for 2008 compared to 2007 included growth in net interest income. Average interest-earning assets increased $101,951,000, or 9.8% to $1,140,225,000 at December 31, 2008 compared to $1,038,274,000 at December 31, 2007. This increase to net interest income was offset by a higher provision for loan loss and an increase to non-interest expense including a goodwill impairment charge of $40,324,000. Net interest income, on a tax equivalent basis, increased $958,000, or 2.5%, reflecting growth in average loan balances.

Average loans outstanding increased $114,481,000 or 13.5% to $963,252,000 for 2008 compared to $848,771,000 for 2007. Average commercial loans outstanding decreased approximately $1,837,000 or 1.2% for 2008 compared to 2007. Average real estate loans outstanding increased approximately $113,555,000 or 17.0% for 2008 compared to 2007. Average consumer loans outstanding decreased approximately $1,032,000 or 3.0% for 2008 compared to 2007. See the “Lending and Credit Management” section of this discussion for further discussion of changes in the composition of our lending portfolio.

Average investment securities and federal funds sold decreased $22,697,000 or 12.4% to $159,795,000 for 2008 compared to $182,492,000 for 2007. The decrease in average investment securities during 2008 and 2007 reflects the use of investment liquidity to fund our Company’s growth in the loan portfolio.

Average interest bearing liabilities increased $96,383,000, or 10.6%, to $1,007,934,000 at December 31, 2008 compared to $911,551,000 at December 31, 2007. Average time deposits increased $15,617,000 or 2.0% to $792,790,000 for 2008 compared to $777,173,000 for 2007. The increase was primarily a result of a marketing campaign during the third quarter designed to attract new deposits and establish new customer relationships.

Average federal funds purchased and securities sold under agreements to repurchase increased $10,572,000 or 34.0% to $41,633,000 for 2008 compared to $31,061,000 for 2007. This reflects an increase in public funds received during 2008 over 2007. Average other borrowed money increased $70,399,000 or132.2% to $124,025,000 for 2008 compared to $53,626,000 for 2007. The increase in 2008 reflects a net increase in Federal Home Loan Bank advances to fund loan growth.

Rate and volume analysis

The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, indentifying changes related to volumes and rates for the years ended December 31, 2009, compared to December 31, 2008 and for the years ended December 31, 2008 compared to December 31, 2007. The change in interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.


	2009										2008
					Change due to									Change due to
		Total			Average			Average			Total			Average			Average
(Dollars In thousands)		Change			Volume			Rate			Change			Volume			Rate

Interest income on a fully taxable equivalent basis:
Loans: (1) (3)		$	(5,252	)	$	2,508		$	(7,760	)	$	(2,870	)	$	8,212		$	(11,082	)
Investment securities:
Government sponsored entities			(500	)		55			(555	)		(697	)		(295	)		(402	)
State and municipal(2)			(337	)		(338	)		1			(466	)		(433	)		(33	)
Restricted Investments			(152	)		13			(165	)		4			112			(108	)
Federal funds sold			(60	)		(28	)		(32	)		(555	)		(302	)		(253	)
Interest bearing deposits in other financial institutions			29			29			—			(34	)		67			(101	)

Total interest income			(6,272	)		2,239			(8,511	)		(4,618	)		7,361			(11,979	)

Interest expense:
NOW accounts			(186	)		211			(397	)		(165	)		88			(253	)
Savings			(87	)		10			(97	)		(34	)		(13	)		(21	)
Money market			(1,593	)		143			(1,736	)		(2,328	)		292			(2,620	)
Time deposits of 100,000 and over			(1,836	)		(88	)		(1,748	)		(1,347	)		53			(1,400	)
Other time deposits			(2,329	)		1,187			(3,516	)		(1,954	)		68			(2,022	)
Federal funds purchased and securities sold under agreements to repurchase			(781	)		(136	)		(645	)		(512	)		373			(885	)
Interest-bearing demand notes to U.S. Treasury			—			—			—			(11	)		(5	)		(6	)
Subordinated notes			(599	)		—			(599	)		(571	)		—			(571	)
Other borrowed money			(1,214	)		(1,695	)		481			1,346			2,708			(1,362	)

Total interest expense			(8,625	)		(368	)		(8,257	)		(5,576	)		3,564			(9,140	)

Net interest income on a fully taxable equivalent basis		$	2,353		$	2,607		$	(254	)	$	958		$	3,797		$	(2,839	)



(1)		Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 35%, net of

		nondeductible interest expense. Such adjustments totaled $751,000, $871,000 and $997,000 for the years ended December 31, 2009, 2008 and 2007, respectively.

(2)		Non-accruing loans are included in the average amounts outstanding.

(3)		Fees and costs on loans are included in interest income.

Net interest income on a fully taxable equivalent basis increased $2,353,000 or 6.0% to $41,340,000 for 2009 compared to $38,987,000 for 2008 and followed a $958,000 or 2.5% increase for 2008 compared to 2007. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased from 3.66% for 2007 to 3.42% for 2008, and increased to 3.50% for 2009. Our Company’s net interest spread increased to 3.18% in 2009 from 3.05% in 2008 and 3.16% in 2007.

While our Company was able to decrease the rate paid on interest bearing liabilities to 2.26% in 2009 from 3.14% in 2008, this decrease was partially offset by the decrease in the rates earned on interest bearing assets from 6.19% in 2008 to 5.44% in 2009.

Provision for loan losses

The provision for loan losses for 2009 was $8,354,000, compared to $8,211,000 for 2008, and $1,154,000 for 2007. Loans charged off, net of recoveries, for 2009 were $6,224,000 compared to $4,826,000 for 2008 and $887,000 for 2007. Approximately $1,191,000 of the 2009 net charge-offs is represented by various commercial loans, $1,457,000 is represented by increased real estate construction losses, $3,336,000 is represented by real estate mortgage loans and approximately $240,000 is represented by various consumer loans.

Further discussion of managements’ methodology related to the allowance and provision for loan losses may be found in the “Lending and Credit Management” section of this report.

Non-interest Income and Expense

Non-interest income for the years ended December 31, 2009, 2008, and 2007 were as follows:


										$ Change						% Change
(Dollars in thousands)	2009			2008			2007			‘09-‘08			‘08-‘07			‘09-‘08			‘08-‘07

Non-interest Income
Service charges on deposit accounts	$	5,864		$	6,164		$	5,707		$	(300	)	$	457			(4.9)	%		8.0	%
Trust department income		815			827			968			(12	)		(141	)		(1.5	)		(14.6	)
Gain on sales of mortgage loans		2,974			973			666			2,001			307			205.7			46.1
Other		1,049			1,330			2,882			(281	)		(1,552	)		(21.1	)		(53.9	)

Total non-interest income	$	10,702		$	9,294		$	10,223		$	1,408		$	(929	)		15.1	%		(9.1	)%

Investment securities gains (losses), net	$	606		$	3		$	(2	)	$	603		$	5		NM %				(250.0	)%

Non-interest income as a % of total revenue *		20.9	%		19.6	%		21.6	%
Total revenue per full time equivalent employee	$	147.4		$	137.8		$	135.4


*		Total revenue is calculated as net interest income plus non-interest income

Years Ended December 31, 2009 and 2008

Noninterest income increased $1,408,000 or 15.1% to $10,702,000 for 2009 compared to $9,294,000 for 2008. The increase was primarily the result of a $2,001,000 increase in the gains on sales of mortgage loans due to increased refinancing activity. Our Company was servicing $269,475,000 of mortgage loans at December 31, 2009 compared to $213,074,000 at December 31, 2008. This increase was partially offset by a $300,000 decrease in service charge income and a $281,000 decrease in other income. The decrease in other income includes an $112,000 increase in 2009 real estate servicing fees offset by a $275,000 increase in amortization of mortgage loan servicing rights, and a $71,000 decrease in brokerage and credit card income. Our Company recognized $606,000 in gain on sales and calls of debt securities during the 2009 compared to $3,000 during 2008.

Years Ended December 31, 2008 and 2007

Noninterest income decreased $929,000 or 9.1% to $9,294,000 for 2008 compared to $10,223,000 for 2007. Service charge income increased $457,000 or 8.0%. Trust department income decreased $141,000 or 14.6%. Mortgage loan servicing fees decreased $206,000 or 21.2%. This decrease in servicing fees was the result of an increase in the amortization of mortgage servicing rights due to increased refinancing of existing mortgage loans.

However, gain on sales of mortgage loans increased $307,000 or 46.2% as a result of increased refinancing activity. Our Company was servicing $213,074,000 of mortgage loans at December 31, 2008 compared to $209,734,000 at December 31, 2007. Our Company recognized $3,000 in gain on sales and calls of debt securities during the 2008 compared to losses of $2,000 during 2007. Other income decreased $1,346,000 or 53.0% to $1,195,000. $1,200,000 of the decrease represents the amount received from the sales of Osage Valley Bank, Bank 10, and Exchange National Bank’s bank charters in 2007 and $254,000 of the decrease reflects recovery of prior years’ legal and collection costs as a result of settlement of a lawsuit in our Company’s favor in 2007.

Non-interest expense for the years ended December 31, 2009, 2008, and 2007 were as follows:


										$ Change						% Change
(Dollars in thousands)	2009			2008			2007			‘09-‘08			‘08-‘07			‘09-‘08			‘08-‘07

Non-interest Expense
Salaries	$	13,253		$	14,099		$	14,261		$	(846	)	$	(162	)		(6.0	)		% (1.1	)%
Employee benefits		4,204			4,151			4,472			53			(321	)		1.3			(7.2	)
Goodwill impairment		—			40,324			—			(40,324	)		N.M			N.M			N.M
Occupancy expense, net		2,335			2,440			2,202			(105	)		238			(4.3	)		10.8
Furniture and equipment expense		2,286			2,437			2,879			(151	)		(442	)		(6.2	)		(15.4	)
FDIC insurance assessment		2,519			204			97			2,315			107			1,134.8			110.3
Legal, examination, and professional fees		1,222			1,145			1,583			77			(438	)		6.7			(27.7	)
Advertising and promotion		1,272			1,166			1,196			106			(30	)		9.1			(2.5	)
Postage, printing, and supplies		1,168			1,221			1,297			(53	)		(76	)		(4.3	)		(5.9	)
Processing expense		3,420			3,102			1,470			318			1,632			10.3			111.0
Other real estate expense		1,189			862			681			327			181			37.9			26.6
Other		3,862			4,824			4,916			(962	)		(92	)		(19.9	)		(1.9	)

Total non-interest expense	$	36,730		$	75,975		$	35,054		$	(39,245	)	$	597			(51.7	)%		1.7	%

Efficiency ratio*		71.6	%		75.2	%		74.2	%
Salaries and benefits as a % of total non-interest expense *		47.5	%		51.2	%		53.4	%
Number of full-time equivalent employees		348			344			349



*		Goodwill impairment not included in ratio calculation

Years Ended December 31, 2009 and 2008

Noninterest expense decreased $39,245,000, or 51.7%, to $36,730,000 for 2009 compared to $75,975,000 for 2008. This decrease is primarily a result of the $40,324,000 goodwill impairment charge taken during the fourth quarter of 2008. Other items such as salary expense decreased $846,000, or 6.0%, FDIC insurance assessment increased $2,315,000, real estate loan expense increased $327,000, or 37.9%, and other expenses decreased $962,000 or 19.9%. The decrease in salary expense includes a $362,000 decrease in salaries, a $393,000 reduction in incentive and deferred compensation expense, and a $101,000 decrease in stock option compensation expense. The increase in the FDIC insurance assessment is a result of higher regular and special assessment rates in effect for the current year as well as the depletion of the Bank’s one-time FDIC assessment credit. The increase in real estate loan expense reflects expenses incurred on the maintenance and preparation to sell the increase in foreclosed properties, including a $67,000 impairment charge on six of the properties. The decrease in other expenses primarily is a result of a $591,000 donation of a large parcel of other real estate owned and an abandoned branch to charitable organizations in 2008, a $100,000 final payment on a contract in 2008, a $89,000 decrease in correspondent bank charges, and a $33,000 decrease in insurance after further consolidating accounts from the 2007 Bank charter merger.

Years Ended December 31, 2008 and 2007

Noninterest expense increased $40,921,000 or 116.7% to $75,975,000 for 2008 compared to $35,054,000 for 2007. $40,324,000 of the increase reflects a goodwill impairment charge taken during the fourth quarter of 2008. Based upon an analysis of the fair value of our Company’s net assets, it was determined that the entire carrying value of goodwill was impaired requiring the impairment charge to earnings. Salaries decreased $162,000 or 1.1%, employee benefits decreased $321,000 or 7.2%, occupancy expense increased $238,000 or 10.8%, furniture and equipment expense decreased $441,000 or 15.3%, legal and professional fees decreased $390,000 or 24.6%, processing expense increased $1,632,000 or 111.0% and donations increased $591,000 or 262.7.9%. The $162,000 decrease in salaries reflects a reduction in incentive compensation expense. The $321,000 decrease in employee benefits primarily represents reductions in profitsharing expense as a result of lower earnings. The $1,632,000 increase in processing expense reflects both the cost of outsourcing our data processing function as well as investment in new technologies including remote deposit capture and document imaging. The $591,000 increase in donations reflects the donation of a large parcel of other real estate owned and an abandoned branch location to charitable organizations.

Income taxes

Income taxes as a percentage of earnings (loss) before income taxes as reported in the consolidated financial statements were 27.3% for 2009 compared to 16.7% for 2008. The increase in the effective tax rate for 2009 in comparison to 2008 is due to the decrease in 2008 earnings resulting from the goodwill impairment charge. In addition, 2009 tax expense reflects the recognition of tax benefits as a result of the expiration of the statute of limitations on our Company’s 2005 state tax return during the fourth quarter of 2009.

Income taxes as a percentage of earnings (loss) before income taxes as reported in the consolidated financial statements were 16.7% for 2008 compared to 29.4% for 2007. The decrease in the effective tax rate for 2008 is due to an increase in non-taxable income as a percentage of total income in the current year and a taxable loss before taxes. In addition, 2008 tax benefit reflects the recognition of tax benefits as a result of the expiration of the statute of limitations on our Company’s 2004 and 2005 federal tax returns during the year. The decrease in 2008 earnings was due to a $40,323,775 goodwill impairment charge in the fourth quarter and an additional $7,056,784 increase in the loan provision in comparison to the year ended 2007. While goodwill impairment is normally a non-tax deductible item, $16,916,000 of our goodwill was related to asset purchases and therefore deductible for book tax purposes.

Fourth Quarter Results for 2009

Comparing fourth quarter 2009 to third quarter 2009:

Our Company’s net income of $788,000 for the fourth quarter ended December 31, 2009 decreased $1,119,000, compared to net income of $1,907,000 for the third quarter ended September 30, 2009. Net interest income of $10,604,000 increased $168,000 from third quarter 2009 due to an increase in net interest margin to 3.66% for the fourth quarter compared to 3.57% for the third quarter.

The fourth quarter 2009 provision for loan losses of $3,950,000 was $2,700,000 higher than third quarter 2009’s provision of $1,250,000 and was based upon management’s determination of the loan loss reserve required to cover probable losses in the loan portfolio at year-end and as a result of increased nonperforming loans at year-end.

Noninterest income of $3,135,000 for fourth quarter 2009 increased $534,000 from third quarter 2009’s noninterest income of $2,601,000. This increase was a result of $600,000 investment gains realized during the fourth quarter.

Noninterest expense of $9,034,000 for fourth quarter 2009 decreased slightly by $6,000 from third quarter 2009’s noninterest expense of $9,040,000.

Comparing fourth quarter 2009 to fourth quarter 2008:

Our Company’s net income of $788,000 for the fourth quarter ended December 31, 2009 increased $35,833,000, compared to net loss of $(35,045,000) for same period in 2008. Net interest income of $10,605,000 increased $1,403,000 in the fourth quarter of 2009 compared to the fourth quarter of 2008 due to an increase in net interest margin to 3.66% for 2009 compared to 3.14% for the same period of 2008.

The fourth quarter 2009 provision for loan losses of $3,950,000 was $311,000 less than the fourth quarter 2008 provision of $4,261,000 and was based upon management’s determination of the loan loss reserve required to cover probable losses in the loan portfolio at year-end and as a result of increased nonperforming loans at year-end.

Noninterest income of $3,135,000 for fourth quarter 2009 increased by $849,000 from noninterest income of $2,286,000 for fourth quarter 2008. $249,000 of the increase reflects gains on sales of mortgage loans due to increased refinancing activity and $600,000 reflects investment gains realized during the fourth quarter.

Noninterest expense of $9,034,000 for fourth quarter 2009 decreased $41,289,000 from fourth quarter 2008 noninterest expense of $50,323,000. The goodwill impairment charge of $40,324,000 represents the majority of the variance between periods.

Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for our Company. Net loans represented 79.0% of total assets as of December 31, 2009 compared to 77.8% as of December 31, 2008.

Lending activities are conducted pursuant to an established loan policy approved by our Bank’s Board of Directors. The Bank’s credit review process is comprised of a regional loan committee with an established approval limit. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank.

The following table shows the composition of the loan portfolio by major category and each category as a percentage of the total portfolio as of the dates indicated.


	Balance at December 31,
(In thousands)	2009					2008					2007					2006					2005
	Amount		%			Amount		%			Amount		%			Amount		%			Amount		%
Commercial, financial and agricultural	$	151,399		15.3	%	$	153,386		15.2	%	$	151,488		16.6	%	$	145,697		17.9	%	$	154,868		19.0	%
Real estate — Construction		116,778		11.8			129,639		12.9			147,432		16.2			150,891		18.6			139,316		17.1
Real estate — Mortgage		686,307		69.2			692,530		68.6			575,552		63.2			478,854		59.0			480,531		59.1
Installment loans to individuals		37,130		3.7			33,548		3.3			36,806		4.0			36,870		4.5			38,820		4.8

Total loans	$	991,614		100.0	%	$	1,009,103		100.0	%	$	911,278		100.0	%	$	812,312		100.0	%	$	813,535		100.0	%

Our Company’s loan portfolio decreased $17,490,000, or 1.7% from 2008 to 2009. This decrease was primarily in our Bank’s commercial and real estate mortgage lending. Commercial loans decreased $1,987,000, or 1.3%, real estate construction loans decreased $12,861,000, or 9.9%, and real estate mortgage loans decreased $6,223,000 or 1.0%, from 2008 to 2009, respectively. Partially offsetting these decreases was an increase in consumer loans of $3,582,000 or 10.7%. During the current down-turn in the economy, management continues to focus on the improvement of asset quality. Management has tightened underwriting standards and is focused on lending to credit worthy borrowers with the capacity to service the debts. The decrease in lending activities in the real estate construction market also reflects the slow down in the housing industry and residential construction industry as well as foreclosures on various residential construction properties. Construction lending will continue to be closely monitored during 2010.

Our Company experienced loan growth of $97,825,000 or 10.7% from 2007 to 2008. This growth was primarily in our Bank’s commercial and real estate mortgage lending. Commercial loans increased $1,898,000 or 1.3% from 2007 to 2008 and real estate mortgage loans increased $116,978,000 or 20.3%. Offsetting these increases were a decrease in real estate construction loans of $17,793,000 or 12.1% and a decrease in individual consumer loans of $3,258,000 or 8.9%. Although management tightened underwriting standards during the 2008, our Company continued to find opportunities to lend to credit worthy borrowers with the capacity to service the debts. This growth was not centered in any one industry, region or borrower and included a fairly diversified portfolio of loans ranging from owner occupied and regional retail properties to include some hospitality properties. Our growth in real estate loans was also partially the result of loans moving from construction to amortizing loans, thus contributing to the decrease in our construction portfolio. In addition, the decrease in lending activities in the real estate construction market also reflects the slow down in the housing industry and residential construction industry as well as foreclosures on various residential construction properties during 2008.

Our Company does not participate in extending credit to sub-prime residential real estate markets. While much publicity has been directed at this market during the past year, our Company extends credit to its local community market through traditional mortgage products.

The contractual maturities of loan categories at December 31, 2009, and the break down of those loans between fixed rate and floating rate loans are as follows:


	Principal Payments Due
			Over One		Over
	One Year		Year Through		Five
	Or Less		Five Years		Years		Total

Commercial, financial, and agricultural	$	99,682	$	49,040	$	2,677	$	151,399
Real estate — construction		116,778		—		—		116,778
Real estate — mortgage		251,525		377,436		57,346		686,307
Installment loans to individuals		14,276		21,810		1,044		37,130

Total loans net of unearned income	$	482,261	$	448,286	$	61,067	$	991,614


Loans with fixed rates		294,260		391,788		14,131		700,179
Loans with floating rates		188,001		56,498		46,936		291,435

Total loans net of unearned income	$	482,261	$	448,286	$	61,067	$	991,614

Our Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers, but are not funded until our Company has a non-recourse purchase commitment from the secondary market at a predetermined price. At December 31, 2009 our Company was servicing approximately $269,475,000 of loans sold to the secondary market.

Mortgage loans retained in our Company’s portfolio generally include provisions for rate adjustments at one to three year intervals. Commercial loans and real estate construction loans generally have maturities of less than one year. Installment loans to individuals are primarily fixed rate loans with maturities from one to five years.

The provision for loan losses is based on management’s evaluation of the loan portfolio in light of national and local economic conditions, changes in the composition and volume of the loan portfolio, changes in the volume of past due and nonaccrual loans, value of underlying collateral and other relevant factors. The allowance for loan losses which is reported as a deduction from loans is available for loan charge-offs. This allowance is increased by the provision charged to expense and is reduced by loan charge-offs net of loan recoveries.

Management along with senior loan committee, and internal loan review, formally reviews all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2,000,000 in aggregate and all adversely classified credits identified by management as containing more than usual risk are reviewed. On a monthly basis, the senior loan committee reviews and reports to the Board of Directors past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines what loans should be considered impaired. Management follows the guidance provided in the FASB ASC Topic 310,Accounting by Creditors for Impairment of a Loan,in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to

be impaired. Once a loan has been identified as impaired, management generally measures impairment based upon the fair value of the underlying collateral. Management believes, but there can be no assurance, that these procedures keep management informed of possible problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered adequate by management for probable losses inherent in the loan portfolio.

Allowance for Loan Losses

The provision for loan losses increased $143,000 or 1.7% to $8,354,000 for 2009 compared to $8,211,000 for 2008 and followed a $7,057,000 or 611.4% increase for 2008 compared to 2007. The provision reflects the amounts management determined necessary to maintain the allowance for loan losses at a level that was adequate to cover probable losses in the loan portfolio. The allowance for loan losses totaled $14,797,000 or 1.5% of loans outstanding at December 31, 2009 compared to $12,667,000 or 1.3% of loans outstanding at December 31, 2008 and $9,282,000 or 1.0% of loans outstanding at December 31, 2007. The allowance for loan losses expressed as a percentage of nonperforming loans was 34.9% at December 31, 2009, 50.9% at December 31, 2008 and 152.5% at December 31, 2007.

The following table summarizes loan loss experience for the years indicated:


	Years Ended December 31,
(Dollars in thousands)	2009			2008			2007			2006			2005

Analysis of allowance for loan losses:
Balance beginning of year	$	12,667		$	9,282		$	9,015		$	9,085		$	7,496
Allowance for loan losses of acuired companies at date of acquisitions		—			—			—			—			1,418
Charge-offs:
Commercial, financial, and agricultural		1,404			3,571			524			809			589
Real estate — construction		1,462			681			56			84			185
Real estate — mortgage		3,401			532			413			474			286
Installment loans to individuals		534			656			314			484			261

Total charge-offs		6,801			5,440			1,307			1,851			1,321

Recoveries:
Commercial, financial, and agricultural		213			153			151			206			40
Real estate — construction		5			35			11			13			—
Real estate — mortgage		65			81			100			91			28
Installment loans to individuals		294			345			158			145			102

Total recoveries		577			614			420			455			170

Net charge-offs		6,224			4,826			887			1,396			1,151
Provision for loan losses		8,354			8,211			1,154			1,326			1,322

Balance at end of year	$	14,797		$	12,667		$	9,282		$	9,015		$	9,085

Loans outstanding:
Average	$	1,002,829		$	963,252		$	848,772		$	824,706		$	743,382
End of period		991,614			1,009,104			911,278			812,312			813,535
Allowance for loan losses to loans outstanding:
Average		1.48	%		1.32	%		1.09	%		1.09	%		1.22	%
End of period		1.49			1.26			1.02			1.11			1.12
Net charge-offs to average loans outstanding		0.62			0.50			0.10			0.17			0.15

The increased provision for loan losses during 2009 and 2008 was the result of an increased level of charged-off loans and an increase in the level of non-performing loans. As shown in the table above, our Company experienced net loan charge-offs of $6,224,000 during 2009 compared to $4,826,000 in 2008 and $887,000 in 2007.

The following table is a summary of the allocation of the allowance for loan losses as of the dates indicated:


	Years Ended December 31,
(Dollars in thousands)	2009		2008			2007			2006			2005

Allocation of allowance for loan losses at end of period:
Commercial, financial, and agricultural	$	2,644	$	1,712		$	3,762		$	3,114		$	2,687
Real estate — construction		3,802		2,490			590			755			764
Real estate — mortgage		6,596		6,571			3,873			3,526			4,138
Installment loans to individuals		380		391			419			529			473
Unallocated		1,375		1,503			638			1,091			1,023

Total	$	14,797	$	12,667		$	9,282		$	9,015		$	9,085

Percent of categories to total loans:
Commercial, financial, and agricultural		15.3		15.2	%		16.6	%		17.9	%		19.0	%
Real estate — construction		11.8		12.9			16.2			18.6			17.1
Real estate — mortgage		69.2		68.6			63.2			59.0			59.1
Installment loans to individuals		3.7		3.3			4.0			4.5			4.8

Total		100.0		100.0			100.0			100.0			100.0

Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due, and restructured loans totaled $42,347,000 or 4.27% of total loans at December 31, 2009 compared to $24,866,000 or 2.46% of total loans at December 31, 2008. The following table summarizes our Company’s nonperforming assets at the dates indicated:


	Years Ended December 31,
(Dollars in thousands)	2009			2008			2007			2006			2005

Nonaccrual loans:
Commercial, financial, and agricultural	$	2,067		$	2,071		$	2,983		$	2,495		$	5,705
Real estate — construction		11,955			10,347			866			1,657			1,760
Real estate — mortgage		19,853			7,850			658			644			1,090
Installment loans to individuals		279			119			32			73			56

Total nonaccrual loans		34,154			20,387			4,539			4,869			8,611

Loans contractually past — due 90 days or more and still accruing:
Commercial, financial, and agricultural		2			140			454			5			238
Real estate — construction		—			52			158			—			—
Real estate — mortgage		—			547			864			170			187
Installment loans to individuals		—			4			70			22			14

Total loans contractually past -due 90 days or more and still accruing		2			743			1,546			197			439
Restructured troubled loans		8,191			3,736			—			—			—

Total nonperforming loans		42,347			24,866			6,085			5,066			9,050
Other real estate		8,452			7,828			2,337			2,720			1,568
Repossessions		39			—			—			15			—

Total nonperforming assets	$	50,838		$	32,694		$	8,422		$	7,801		$	10,618

Loans	$	991,614		$	1,009,103			911,278			812,313			813,535
Allowance for loan losses to loans		1.49	%		1.26	%		1.02	%		1.11	%		1.12	%
Nonperforming loans to loans		4.27	%		2.46	%		0.67	%		0.62	%		1.11	%
Allowance for loan losses to nonperforming loans		34.94	%		50.94	%		152.54	%		177.95	%		100.39	%
Nonperforming assets to loans and foreclosed assets		5.08	%		3.21	%		0.92	%		0.96	%		1.30	%

It is our Company’s policy to discontinue the accrual of interest income on loans when the full collection of principal or interest is in doubt, or when the payment of principal or interest has become contractually 90 days past due unless the obligation is both well secured and in the process of collection. Subsequent interest payments received on such loans are applied to principal if any doubt exists as to the collectibles of such principal; otherwise, such receipts are recorded as interest income. Interest on year-end nonaccrual loans, which would have been recorded under the original terms of the loans, was approximately $1,568,000, $1,522,000 and $745,000 for the years ended December 31, 2009, 2008 and 2007, respectively. Approximately $158,000, $239,000 and $330,000 was actually recorded as interest income on such loans for the year ended December 31, 2009, 2008 and 2007, respectively.

Total non-accrual loans at year end 2009 increased $13,767,000 over 2009. The increase resulted mainly from an increase of $1,608,000 in real estate construction non-accrual loans and an increase of $12,003,000 in real estate mortgage non-accrual loans. The increase primarily represents five commercial customers with balances totaling $18,848,000.

Loans past due 90 days and still accruing interest decreased $741,000 from December 31, 2008 to December 31, 2009. At December 31, 2009, loans classified as trouble debt restructured loans (TDR) totaled $11,233,000, of which $3,042,000 was on non-accrual status and $8,191,000 was on accrual status. At December 31, 2008, loans classified as TDR totaled $3,736,000 were on accrual status. Our Company has experienced an increase in its loan delinquencies much like the rest of the banking industry as current economic conditions negatively impact our borrowers’ ability to keep their debt payments current.

While the ratio of allowance for loan losses to nonperforming loans has decreased from 152.54% at year end 2007 to 50.94% at year end 2008 and to 34.94% at year end 2009, management believes that based on detailed analysis of each nonperforming credit and the value of any associated collateral that the allowance for loan losses at December 31, 2009 is sufficient to cover probable losses in the nonperforming loans.

A loan is considered impaired when it is probable a creditor will be unable to collect all amounts due — both principal and interest — according to the contractual terms of the loan agreement. In addition to nonaccrual loans at December 31, 2009 included in the table above, which were considered impaired, management has identified additional loans totaling approximately $39,713,000 which are not included in the nonaccrual table above but are considered by management to be impaired compared to $9,546,000 in December 31, 2008. $23,950,000 of the $39,713,000 of other impaired loans is represented by three credits. Based upon the value of collateral in excess of these loan balances, management has determined that, although these credits are currently considered impaired, no reserve allocation is required for these credits.

Once a loan has been identified as impaired under ASC Topic 310,Accounting by Creditors for Impairment of a Loan,management generally measures impairment based upon the fair value of the underlying collateral. In general, market prices for loans in our portfolio are not available, and we have found the fair value of the underlying collateral to be more readily available than discounting expected future cash flows to be received. Once a fair value of collateral has been determined and the impairment amount calculated, a specific reserve allocation is made. At December 31, 2009, $6,415,000 of our Company’s allowance for loan losses was allocated to impaired loans totaling approximately $73,867,000. Based upon detailed analysis of all impaired loans, management has determined that of the $73,867,000 of impaired loans $45,572,000 require no reserve allocation due to excess collateral valuations.

As of December 31, 2009 and 2008 approximately $15,944,000 and $13,389,000, respectively, of loans not included in the nonaccrual table above or identified by management as being impaired were classified by management as having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. The $2,555,000 increase in classified loans is the result of several borrowers who have experienced cash flow problems and as well as some deterioration in collateral value. Management elected to allocate non-specific reserves to these credits based upon the inherent risk present. This increase in reserves was the result of our Company’s internal loan review process which assesses credit risk. In addition to the classified list, our Company also maintains an internal loan watch list of loans which for various reasons, not all related to credit quality, management is monitoring more closely than the average loan in the portfolio. Loans may be added to this list for reasons which are temporary and correctable, such as the absence of current financial statements of the borrower, or a deficiency in loan documentation. Other loans are added as soon as any problem is detected which might affect the borrower’s ability to meet the terms of the loan. This could be initiated by the delinquency of a scheduled loan payment, deterioration in the borrower’s financial condition identified in a review of periodic financial statements, a decrease in the value of the collateral securing the loan, or a change in the economic environment within which the borrower operates. Once a loan is placed on our Company’s watch list, its condition

is monitored closely. Any further deterioration in the condition of the loan is evaluated to determine if the loan should be assigned to a higher risk category.

The allowance for loan losses is available to absorb probable loan losses regardless of the category of loan to be charged off. The allowance for loan losses consists of three components: asset-specific reserves, reserves based on expected loss estimates, and unallocated reserves.

The asset-specific component applies to loans evaluated individually for impairment and is based on management’s best estimate of proceeds from liquidating collateral. The actual timing and amount of repayments and the ultimate realizable value of the collateral may differ from management’s estimate.

The expected loss component is generally determined by applying percentages to pools of loans by asset type. These pre-established percentages are based upon standard bank regulatory classification percentages as well as average historical loss percentages. These expected loss estimates are sensitive to changes in delinquency status, realizable value of collateral, and other risk factors.

The unallocated portion of the allowance is based on management’s evaluation of conditions that are not directly reflected in the determination of the asset-specific component and the expected loss component discussed above. The evaluation of inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they may not be identified with specific problem credits or portfolio segments. Conditions evaluated in connection with the unallocated portion of the allowance include general economic and business conditions affecting our key lending areas, credit quality trends (including trends in substandard loans expected to result from existing conditions), collateral values, specific industry conditions within portfolio segments, bank regulatory examination results, and findings of our internal loan review department.

The underlying assumptions, estimates and assessments used by management to determine these components are continually evaluated and updated to reflect management’s current view of overall economic conditions and relevant factors impacting credit quality and inherent losses. Changes in such estimates could significantly impact the allowance and provision for credit losses. Our Company could experience credit losses that are different from the current estimates made by management.

At December 31, 2009, management allocated $13,422,000 of the $14,797,000 total allowance for loan losses to specific loans and loan categories and $1,375,000 was unallocated. Management believes that the December 31, 2009 allowance for loan losses is adequate.

Our Company does not lend funds for the type of transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, our Company does not have any concentrations of loans exceeding 10% of total loans which are not otherwise disclosed in the loan portfolio composition table. Our Company does not have any interest-earning assets which would have been included in nonaccrual, past due, or restructured loans if such assets were loans.

Investment Portfolio

Our Company classifies its debt and equity securities into one of the following two categories:

Held-to-Maturity — includes investments in debt securities which our Company has the positive intent and ability to hold until maturity. Available-for-Sale — includes investments in debt and equity securities not classified as held to maturity or trading (i.e., investments which our Company has no present plans to sell in the near-term but may be sold in the future under different circumstances). Our Company’s investment portfolio consists of available-for-sale securities.

Debt securities classified as held-to-maturity are carried at amortized cost, while debt and equity securities classified as trading or available-for-sale are carried at estimated market value. Unrealized holding gains and losses from available-for-sale securities are excluded from earnings and reported, net of applicable taxes, as a separate component of stockholders’ equity until realized.

Our Company does not engage in trading activities and accordingly does not have any debt or equity securities classified as trading securities. Historically our Company’s practice had been to purchase and hold debt instruments until maturity unless special circumstances exist. However, since the investment portfolio’s major function is to provide liquidity and to balance our Company’s interest rate sensitivity position, certain debt securities are classified as available-for-sale.

At December 31, 2009, debt securities classified as available-for-sale represented 12.4% of total consolidated assets. Future levels of held-to-maturity and available-for-sale investment securities can be expected to vary depending upon liquidity and interest sensitivity needs as well as other factors.

The following table presents the composition of the investment portfolio by major category.


	December 31,
(In thousands)	2009		2008		2007

Government sponsored enterprises	$	44,381	$	55,545	$	87,370
Asset-backed securities		69,435		50,091		10,892
Obligations of states and political subdivisions		39,111		43,765		53,480

Total available for sale debt securities		152,927		149,401		151,742

As of December 31, 2009, the maturity of debt securities in the investment portfolio was as follows:


				Over One			Over Five									Weighted
	One Year			Through			Through			Over						Average
(In thousands)	Or Less			Five Years			Ten Years			Ten Years			Total			Yield (1)

Available-for-Sale

Government sponsored enterprises	$	7,846		$	31,812		$	4,723		$	—		$	44,381			3.34	%
Asset-backed (2)		4,273			61,094			4,068			—			69,435			3.89
States and political subdivisions (3)		3,467			16,855			14,509			4,280			39,111			5.37

Total available-for-sale debt securities	$	15,586		$	109,761		$	23,300		$	4,280		$	152,927			4.11	%


Weighted average yield (1)		4.42	%		3.92	%		4.55	%		5.57	%		5.57	%


(1)		Weighted average yield is based on amortized cost.

(2)		Asset-backed securities have been included using historic repayment speeds. Repayment speeds were determined from actual portfolio experience during the twelve months ended December 31, 2009 calculated separately for each mortgage-backed security. These repayment speeds are not necessarily indicative of future repayment speeds and are subject to change based on changing mortgage interest rates.

(3)		Rates on obligations of states and political subdivisions have been adjusted to fully taxable equivalent rates using the statutory Federal income tax rate of 34%.

At December 31, 2009, $204,000 of debt securities classified as available-for-sale in the table above had variable rate provisions with adjustment periods ranging from one week to twelve months.

The following non-marketable securities are restricted securities which, lacking a market, are carried at cost. These securities are reported in other assets. At December 31, 2009, $5,107,000 of the total included Federal Home Loan Bank (Des Moines) stock held by the Bank in accordance with debt and regulatory requirements. Other non-marketable securities include an $1,486,000 equity investment in our Company’s unconsolidated Trusts.


	December 31,
(In thousands)	2009		2008		2007

Federal Home Loan Bank of Des Moines Stock	$	5,107	$	7,228	$	3,979
Federal Reserve Bank Stock		—		—		—
Midwest Independent Bank Stock		151		151		151
Federal Agricultural Mortgage Corporation		10		10		10
Investment in unconsolidated trusts		1,486		1,486		1,486

Total non-marketable investment securities		6,754		8,875		5,626

Liquidity and Capital Resources

Liquidity Management

The role of liquidity management is to ensure funds are available to meet depositors’ withdrawal and borrowers’ credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet the demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by our Company, management prefers to focus on transaction accounts and full service relationships with customers. Management believes it has the ability to increase deposits at any time by offering rates slightly higher than the market rate.

Our Company’s Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for our Company’s liquidity position and profile. A combination of daily, weekly and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital and exposure to contingent draws on our Company’s liquidity.

Our Company has a number of sources of funds to meet liquidity needs on a daily basis. Our Company’s most liquid assets are comprised of available for sale marketable investment securities, federal funds sold, and securities purchased under agreements to resell, and excess reserves held at the Federal Reserve as follows:


(dollars in thousands)	2009		2008

Liquid assets:
Federal funds sold	$	90	$	104
Federal Reserve — excess reserves		2,216		31,099
Available for sale investments securities		152,927		149,401

Total	$	155,233	$	180,604

Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available for sale investment portfolio was $152,927,000 at December 31, 2009 and included an unrealized net gain of $2,318,000. The portfolio includes maturities of approximately $15,586,000 with an additional $6,472,000 callable over the next twelve months, which offer resources to meet either new loan demand or reductions in our Company’s deposit base. Our Company pledges portions of its investment securities portfolio to secure public fund deposits, securities sold under agreements to repurchase, trust funds, and borrowing capacity at the Federal Reserve Bank.

At December 31, 2009, total investment securities pledged for these purposes were as follows:


(dollars in thousands)	2009

Investment securities pledged for the purpose of securing:
Federal Reserve Bank borrowings	$	3,569
Repurchase agreements		42,835
Other Deposits		85,918

Total pledged, at fair value	$	132,322

At December 31, 2009, our Company’s unpledged securities in the available for sale portfolio totaled approximately $20,604,000.

Liquidity is also available from our Company’s base of core customer deposits, defined as demand, interest, checking, savings, and money market deposit accounts. At December 31, 2009, such deposits totaled $354,284,000 and represented 51.2% of our Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of our Company through long lasting relationships. Time deposits and certificates of deposit of $100,000 and over totaled $467,021,000 at December 31, 2009. These accounts are normally considered more volatile and higher costing representing 48.8% of total deposits at December 31, 2009.


(dollars in thousands)	2009		2008
\| \|
Core deposit base:
Non-interest bearing demand	$	135,018	$	125,245
Interest checking		139,624		123,289
Savings and money market		214,660		219,338

Total	$	489,302	$	467,872

Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. Our Company’s outside borrowings are comprised of securities sold under agreements to repurchase, FHLB advances, and subordinated notes as follows:


(dollars in thousands)	2009		2008

Borrowings:
Federal funds purchased	$	4,980	$	—
Securities sold under agreements to repurchase		31,665		29,139
FHLB advances		79,317		129,057
Subordinated notes		49,486		49,486

Total	$	160,468	$	207,682

Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which our Company maintains approved credit lines. As of December 31, 2009, under agreements with these unaffiliated banks, the Bank may borrow up to $35,000,000 in federal funds on an unsecured basis and $11,713,000 on a secured basis. There was $4,980,000 of federal funds purchased outstanding at December 31, 2009. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of our Company’s investment portfolio. At December 31, 2009 there was $28,595,000 in repurchase agreements and $3,070,000 in a term repurchase agreement due July 2010. Our Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at the year end. The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB). As a member of the FHLB, the Bank has access to credit products of the FHLB. As of December 31, 2009, the Bank had $79,317,000 in outstanding borrowings with the FHLB. In addition, our Company has $49,486,000 in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.

Our Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from these entities. Based on the type and value of collateral pledged, our Company may draw advances against this collateral. The following table reflects collateral value of assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to our Company at December 31, 2009:


	December 31, 2009
				Federal
(dollars in thousands)	FHLB			Reserve		Other

Collateral value pledged	$	292,975		$	3,569	$	10,853
Advances outstanding		(79,317	)		—		—
Letters of credit issued		(100	)		—		—

Total	$	213,558		$	3,569	$	10,853

Sources and Uses of Funds

Cash and cash equivalents were $24,666,000 at December 31, 2009 compared to $53,827,000 at December 31, 2008. The $29,162,000 decrease resulted from changes in the various cash flows produced by operating, investing, and financing activities of our Company, as shown in the accompanying consolidated statement of cash flows for the year ended December 31, 2009. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $9,751,000 during the year ended 2009. Investing activities consisting mainly of purchases, sales and maturities of available for sale securities, and changes in the level of the loan portfolio, provided cash flow of $6,329,000. The cash inflow primarily consisted of a $4,283,000 decrease in the loan portfolio, $151,954,000 in proceeds from maturities, calls, and pay-downs of investment securities, $6,168,000 in proceeds from sales of other real estate owned and repossessions, partially offset by $156,460,000 purchases of investment securities.

Financing activities used total cash of $45,242,000, resulting primarily from a $49,740,000 net repayment of FHLB advances. Partly offsetting this cash outflow was an increase of $7,507,000 of federal funds purchased and securities sold under agreements to repurchase. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2010.

During 2008, liquidity risk became a concern affecting the general banking industry. Because of the uncertainty in the economy, our Company decided to participate in the U.S. Treasury Department’s Capital Purchase Program (CPP), a voluntary program that provides capital to financially healthy banks. During 2009, our Company elected to cease market purchases of treasury stock and preserve its cash and capital position. Cash used for treasury stock purchases, net of cash received in connection with stock programs, and dividend payments were as follows:


(Dollars in thousands)	2009		2008		2007

Purchases of treasury stock	$	—	$	802	$	145
Exercise of stock options		—		—		(100	)
Cash dividends — preferred		1,370		—		—
Cash dividends — common		2,666		3,486		3,504

Total	$	4,036	$	4,288	$	3,549

Our Company’s liquidity depends primarily on the dividends paid to it as the sole shareholder of our subsidiary Bank. As discussed in Note 6 to the consolidated financial statements, the Bank will be required to receive regulatory approval prior to paying dividends to our Company until such time as the Bank’s unappropriated retained earnings balance is restored to a positive balance.

In the normal course of business, our Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through our Company’s various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of our Company’s liquidity. In the section entitled,Commitments, Contractual Obligations, and Off-Balance Sheet Arrangements,below we disclose that our Company has $134,392,000 in unused loan commitments and standby letters of credit as of December 31, 2009. While this commitment level would be difficult to fund given our Company’s current liquidity resources, we know that the nature of these commitments are such that the likelihood of such a funding demand is very low.

Our Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. On December 19, 2008, as part of our Company’s participation in the U.S. Treasury Department’s Capital Purchase Program (CPP), our Company issued 30,255 shares of senior preferred stock and a ten year warrant to purchase approximately 255,260 shares of common stock to the U.S. Department of Treasury in exchange for $30,255,000. SeeNote 15 of Notes to Consolidated Financial Statements.The Company’s ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its common and preferred shareholders. During the years ended December 31, 2009 and 2008, the Company paid cash dividends to its common and preferred shareholders totaling $4,035,000 and $3,486,00. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank must obtain regulatory approval prior to paying dividends to the Company until such time as the unappropriated retained earnings balance is restored to a positive balance. SeeNote 6 of Notes to Consolidated Financial Statements.At December 31, 2009 and 2008, the Company had cash and cash equivalents totaling $14,738,000 and $29,968,000 respectively.

Capital Management

Risk-based capital guidelines for financial institutions were adopted by regulatory authorities effective January 1, 1991. These guidelines are designed to relate regulatory capital requirements to the risk profiles of the specific institutions and to provide more uniform requirements among the various regulators. Our Company is required to maintain a minimum risk-based capital to risk-weighted assets ratio of 8.00%, with at least 4.00% being “Tier 1” capital. In addition, a minimum leverage ratio, Tier 1 capital to adjusted total assets, of 3.00% must be maintained. However, for all but the most highly rated financial institutions, a leverage ratio of 3.00% plus an additional cushion of 100 to 200 basis points is expected.


										Well-Capitalized
										Regulatory
	2009			2008			2007			Guidelines

Risk-based capital ratios:
Total capital		16.49	%		16.01	%		13.24	%		10.00	%
Tier I capital		14.01			13.55			11.08			6.00
Leverage ratio		11.35			10.80			9.12			5.00
Common equtiy/assets		6.42			6.14			9.30
Common dividend payout ratio		90.01		NM				44.92

Commitments, Contractual Obligations, and Off-Balance Sheet Arrangements

The required payments of time deposits and other borrowed money, not including interest, at December 31, 2009 are as follows:


	Payments due by Period
			Less than 1		1-3		3-5		Over 5
(Dollars in thousands)	Total		Year		Years		Years		Years

Time deposits	$	467,021	$	342,750	$	94,601	$	29,584	$	86
Other borrowed money		79,317		22,331		46,860		126		10,000

In the normal course of business, our Company is party to activities that contain credit, market and operational risk that are not reflected in whole or in part in our Company’s consolidated financial statements. Such activities include traditional off-balance sheet credit related financial instruments.

Our Company provides customers with off-balance sheet credit support through loan commitments and standby letters of credit. Summarized credit-related financial instruments, including both commitments to extend credit and letters of credit at December 31, 2009 are as follows:


	Amount of Commitment Expiration per Period
			Less than		1-3		3-5		Over 5
Dollars in thousands)	Total		1 Year		Years		Years		Years

Unused loan commitments	$	131,593	$	105,532	$	14,291	$	4,406	$	7,364
Standby letters of credit		2,800		1,491		609		700		—

Since many of the unused commitments are expected to expire or be only partially used, the total amount of commitments in the preceding table does not necessarily represent future cash requirements.

Quantitative and Qualitative Disclosures About Market Risk

Interest Sensitivity

Our Company’s exposure to market risk is reviewed on a monthly basis by our Company’s Asset/Liability Committee and Board of Directors. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent and that the goal is to identify and minimize those risks. Tools used by our Bank’s management include the

standard gap report subject to different rate shock scenarios. At December 31, 2009, the rate shock scenario models indicated that annual net interest income could change by as much as (18.6)% to 22.3% should interest rates rise or fall within 300 basis points from their current level over a one year period. However there are no assurances that the change will not be more or less than this estimate. Management further believes this is an acceptable level of risk.

The following table represents the estimated interest rate sensitivity and periodic and cumulative gap positions calculated as of December 31, 2009. Significant assumptions used for this table included: loans will repay at historic repayment rates; certain interest-bearing demand accounts are interest sensitive due to immediate repricing, and fixed maturity deposits will not be withdrawn prior to maturity. A significant variance in actual results from one or more of these assumptions could materially affect the results reflected in the table.


															Over
															5 years or
															no stated
(Dollars in thousands)	Year 1			Year 2			Year 3			Year 4			Year 5		Maturity		Total

ASSETS
Investment securities	$	22,058		$	7,443		$	6,265		$	18,232		$	17,288	$	81,641	$	152,927
Interest-bearing deposits		2,570			—			—			—			—		—		2,570
Other restricted investments		6,754																6,754
Federal funds sold and securities purchased under agreements to resell		90			—			—			—			—		—		90
Loans		526,948			155,806			132,588			100,659			41,707		33,906		991,614

Total	$	558,420		$	163,249		$	138,853		$	118,891		$	58,995	$	115,547	$	1,153,955


LIABILITIES

Savings, Now deposits	$	—		$	—		$	123,050		$	—		$	—	$	—	$	123,050
Rewards checking, Super Now, money market deposits		231,313														—		231,313
Time deposits		342,751			74,119			20,482			27,461			2,123		7		466,943
Federal funds purchased and securities sold under agreements to repurchase		36,645			—			—			—			—		—		36,645
Subordinated notes		49,486			—			—			—			—		—		49,486
Other borrowed money		27,343			43,589			8,306			79			—		—		79,317

Total	$	687,538		$	117,708		$	151,838		$	27,540		$	2,123	$	7	$	986,754


Interest-sensitivity GAP
Periodic GAP	$	(129,118	)	$	45,541		$	(12,985	)	$	91,351		$	56,872	$	115,540	$	167,201

Cumulative GAP	$	(129,118	)	$	(83,577	)	$	(96,562	)	$	(5,211	)	$	51,661	$	167,201	$	167,201


Ratio of interest-earnings assets to interest-bearing liabilities
Periodic GAP		0.81			1.39			0.91			4.32			27.79	NM			1.17
Cumulative GAP		0.81			0.90			0.90			0.99			1.05		1.17		1.17

Impact of Recently Issued Accounting Standards

In December 2008, the FASB issued authoritative guidance onEmployers’ Disclosures about Postretirement Benefit Plan Assetswhich was subsequently incorporated into ASC Topic 715Compensation — Retirement Benefits.This guidance became effective for fiscal years ending after December 15, 2009. ASC Topic 715 requires more detailed disclosures regarding defined benefit pension plan assets including investment policies and strategies, major categories of plan assets, valuation techniques used to measure the fair value of plan assets and significant concentrations of risk within plan assets. Upon initial application, the provisions of ASC Topic 715 are not required for earlier periods that are presented for comparative purposes. The disclosures required by ASC Topic 715 are reported in the notes to our Company’s consolidated financial statements.

In April 2009, the FASB issued authoritative guidance for determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly, which

was subsequently incorporated into ASC Topic 820,Fair Value Measurements and Disclosures,and is effective for interim and fiscal years ending after June 15, 2009. This new guidance amends ASC Topic 820 and provides additional guidance for estimating fair value when there is no active market or where the price inputs being used represent distressed sales. Our Company follows the new requirements provided by ASC Topic 820 which did not have a material effect on the consolidated financial statements or the disclosures presented in the consolidated financial statements.

In April 2009, the FASB issued authoritative guidance on recognition and presentation of other-than-temporary impairment, which was subsequently incorporated into ASC Topic 320,Investments — Debt and Equity Securities,which became effective for periods ending after June 15, 2009. This new guidance amends ASC Topic 320 for determining whether an impairment is other than temporary to debt securities and replaces the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert: (a) it does not have the intent to sell the security and (b) it is more likely than not it will not have to sell the security prior to its anticipated recovery. Under this guidance, declines in fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income. Our Company follows the new requirements under ACS Topic 320, which did not have a material effect on the consolidated financial statements or the disclosures presented in the consolidated financial statements.

In May 2009, the FASB issued authoritative guidance for disclosing subsequent events,which was subsequently incorporated into ASC 855,Subsequent Events, andbecame effective for interim and annual periods ending after June 15, 2009.The new guidance amends ASC Topic 855 and incorporates accounting and disclosure requirements related to subsequent events into U.S. Generally Accepted Accounting Principles (GAAP) making management directly responsible for subsequent events account and disclosure. ASC Topic 855 sets forth: (a) the period after the balance sheet date during which management shall evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; (b) the circumstances under which an entity shall recognize events or transactions occurring after the balance sheet date in its financial statements; and (c) the disclosures that an entity shall make about events or transactions that occurred after the balance sheet date. The disclosures required by ASC Topic 855 are reported in the consolidated financial statements and the notes to our Company’s consolidated financial statements.

In June 2009, the FASB issued authoritative guidance on accounting for transfers of financial assets, which was subsequently incorporated into ASC Topic 860,Transfers and Servicing. The new guidance amends ASC Topic 860 and requires more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. The guidance eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets and requires additional disclosures. This is effective for the annual period beginning after November 15, 2009 and for interim periods within the first annual reporting period, and must be applied to transfers occurring on or after the effective date. Management is currently evaluating the provisions of this Topic, which is not expected to have a material effect on the consolidated financial statements or the disclosures presented in the consolidated financial statements.

In June 2009, the FASB issued authoritative guidance which amends how a company determines when a variable interest entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated, and requires additional disclosures about involvement with variable interest entities, any significant changes in risk exposure due to that involvement and how that involvement affects our company’s financial statements. This guidance was subsequently incorporated into ASC Topic 810,Consolidation,and changes how a company determines whether it is required to consolidate an entity based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. The provisions of this Topic are effective for the annual period beginning after November 15, 2009 and for interim periods within the first annual reporting period. Management is currently evaluating the provisions of this Topic, which is not expected to have a material effect on the consolidated financial statements or the disclosures presented in the consolidated financial statements.

Effects of Inflation

The effects of inflation on financial institutions are different from the effects on other commercial enterprises since financial institutions make few significant capital or inventory expenditures which are directly affected by changing prices. Because bank assets and liabilities are virtually all monetary in nature, inflation does not affect a financial institution as much as do changes in interest rates. The general level of inflation does underlie the general level of most interest rates, but interest rates do not increase at the rate of inflation as do prices of goods and services. Rather, interest rates react more to changes in the expected rate of inflation and to changes in monetary and fiscal policy.

Inflation does have an impact on the growth of total assets in the banking industry, often resulting in a need to increase capital at higher than normal rates to maintain an appropriate capital to asset ratio. In the opinion of management, inflation did not have a significant effect on our Company’s operations for the three years ended December 31, 2009.

CONSOLIDATED FINANCIAL STATEMENTS

The following consolidated financial statements of our Company and reports of our Company’s independent auditors appear on the pages indicated.


	Page
Report of Independent Registered Public Accounting Firm		31

Consolidated Balance Sheets as of December 31, 2009 and 2008		32

Consolidated Statements of Operations for each of the years ended December 31, 2009, 2008 and 2007		33

Consolidated Statements of Stockholders’ Equity and Comprehensive Income for each of the years ended December 31, 2009, 2008 and 2007		34-35

Consolidated Statements of Cash Flows for each of the years ended December 31, 2009, 2008 and 2007		36

Notes to Consolidated Financial Statements		37

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
Hawthorn Bancshares, Inc.:

We have audited the accompanying consolidated balance sheets of Hawthorn Bancshares, Inc. and subsidiaries (the Company) as of December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2009. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hawthorn Bancshares, Inc. and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Hawthorn Bancshares, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established inInternal Control – Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 15, 2010 expressed an unqualified opinion on the effectiveness of Hawthorn Bancshares Inc.’s internal control over financial reporting.

/s/ KPMG LLP
St. Louis, Missouri
March 15, 2010

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets


	December 31,
	2009			2008

ASSETS

Loans	$	991,614,007		$	1,009,103,532
Allowances for loan losses		(14,796,549	)		(12,666,546	)

Net loans		976,817,458			996,436,986

Investment in available-for-sale securities, at fair value		152,926,685			149,400,929
Federal funds sold and securities purchased under agreements to resell		89,752			104,393
Cash and due from banks		24,575,943			53,723,075
Premises and equipment — net		38,623,293			39,260,220
Other real estate owned and repossessed assets		8,490,914			7,828,278
Accrued interest receivable		6,625,557			7,476,093
Mortgage servicing rights		2,020,964			1,171,225
Intangible assets — net		1,503,986			2,130,097
Cash surrender value — life insurance		1,929,910			1,852,902
Other assets		22,866,092			20,314,669

Total assets	$	1,236,470,554		$	1,279,698,867

LIABILITIES AND STOCKHOLDERS’ EQUITY

Deposits:
Non-interest bearing demand	$	135,017,639		$	125,245,200
Savings, interest checking and money market		354,284,004			342,626,702
Time deposits $100,000 and over		137,860,435			142,972,489
Other time deposits		329,160,719			344,451,998

Total deposits		956,322,797			955,296,389

Federal funds purchased and securities sold under agreements to repurchase		36,645,434			29,138,623
Subordinated notes		49,486,000			49,486,000
Other borrowed money		79,317,302			129,057,483
Accrued interest payable		2,438,121			3,847,415
Other liabilities		4,489,617			6,454,574

Total liabilities		1,128,699,271			1,173,280,484

Stockholders’ equity:
Preferred stock, $1,000 par value Authorized and issued 30,255 shares		28,364,768			27,888,294
Common stock, $1 par value Authorized 15,000,000 shares; issued 4,463,813 and 4,298,353 shares respectively		4,463,813			4,298,353
Surplus		26,970,745			25,144,323
Retained earnings		50,576,551			51,598,678
Accumulated other comprehensive income, net of tax		912,224			1,005,553
Treasury stock; 161,858 shares, at cost		(3,516,818	)		(3,516,818	)

Total stockholders’ equity		107,771,283			106,418,383

Total liabilities and stockholders’ equity	$	1,236,470,554		$	1,279,698,867

See accompanying notes to consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Operations


	Years ended December 31,
	2009		2008			2007

INTEREST INCOME
Interest and fees on loans	$	57,409,274	$	62,636,558		$	65,533,873
Interest on debt securities:
Taxable		4,495,259		4,989,794			5,702,806
Nontaxable		1,441,418		1,688,871			1,986,171
Interest on federal funds sold and securities purchased under agreements to resell		373		60,550			614,571
Interest on interest-bearing deposits		52,761		23,755			57,963
Dividends on other securities		163,533		315,685			311,723

Total interest income		63,562,618		69,715,213			74,207,107

INTEREST EXPENSE
Interest on deposits:
Savings, interest checking and money market		3,017,488		4,883,042			7,411,043
Time deposit accounts $100,000 and over		3,862,075		5,698,073			7,045,209
Other time deposit accounts		10,542,476		12,871,957			14,825,176
Interest on federal funds purchased and securities sold under agreements to repurchase		88,573		868,528			1,380,328
Interest-bearing demand notes to U.S. Treasury		—		—			10,734
Interest on subordinated notes		2,446,742		3,046,238			3,617,254
Interest on other borrowed money		3,016,872		4,231,062			2,885,119

Total interest expense		22,974,226		31,598,900			37,174,863

Net interest income		40,588,392		38,116,313			37,032,244
Provision for loan losses		8,354,000		8,211,000			1,154,216

Net interest income after provision for loan losses		32,234,392		29,905,313			35,878,028

NON-INTEREST INCOME
Service charges on deposit accounts		5,864,090		6,163,650			5,706,934
Trust department income		814,988		826,546			967,774
Gain on sale of mortgage loans, net		2,973,630		973,095			665,817
Other		1,049,441		1,330,760			2,882,216

Total non-interest income		10,702,149		9,294,051			10,222,741

INVESTMENT SECURITIES GAINS (LOSSES), NET		605,716		2,773			(1,747	)

NON-INTEREST EXPENSE
Salaries and employee benefits		17,457,123		18,250,469			18,733,125
Goodwill impairment		—		40,323,775			—
Occupancy expense, net		2,335,496		2,440,082			2,201,809
Furniture and equipment expense		2,286,014		2,437,558			2,878,810
FDIC insurance assessment		2,518,743		204,131			97,264
Legal, examination, and professional fees		1,221,861		1,144,777			1,582,763
Advertising and promotion		1,272,046		1,165,559			1,196,216
Postage, printing, and supplies		1,168,290		1,220,938			1,296,518
Processing expense		3,419,939		3,101,562			1,470,475
Other real estate expense		1,188,972		862,474			680,832
Other		3,861,896		4,824,133			4,915,995

Total non-interest expense		36,730,380		75,975,458			35,053,807

Income (loss) before income taxes		6,811,877		(36,773,321	)		11,045,215
Less income taxes (benefit)		1,856,120		(6,145,965	)		3,245,239

Net income (loss)		4,955,757		(30,627,356	)		7,799,976
Preferred stock dividends		1,993,426		66,090			—

Net income (loss) available to common shareholders	$	2,962,331	$	(30,693,446	)	$	7,799,976

Basic earnings (loss) per share	$	0.69	$	(7.10	)	$	1.80
Diluted earnings (loss) per share	$	0.69	$	(7.10	)	$	1.78

See accompanying notes to consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss)


										Accumulated						Total
										other						Stock -
	Preferred		Common				Retained			Comprehensive			Treasury			holders’
	Stock		Stock		Surplus		Earnings			Income (Loss)			Stock			Equity

Balance, December 31, 2006	$	—	$	4,298,353	$	22,248,319	$	81,431,713		$	(381,286	)	$	(2,652,509	)	$	104,944,590

Net income		—		—		—		7,799,976			—			—			7,799,976
Change in unrealized gain (loss) on securities:
Unrealized gain on debt and equity securities available-for-sale, net of tax		—		—		—		—			1,403,925			—			1,403,925
Adjustment on sales and calls of debt and equity securities, net of tax		—		—		—		—			1,136			—			1,136
Defined benefit pension plans:
Prior service cost arising during year from plan amendment, net of tax		—		—		—		—			61,701			—			61,701
Net gain arising during year, net of tax		—		—		—		—			234,562			—			234,562
Amortization of prior service cost included in net periodic pension cost, net of tax		—		—		—		—			36,500			—			36,500

Total other comprehensive income (loss)																	1,737,824

Total comprehensive income (loss)																	9,537,800

Stock based compensation expense		—		—		264,881		—			—			—			264,881
Exercise of stock options		—		—		16,991		—			—			83,436			100,427
Treasury stock purchased		—		—		—		—			—			(145,300	)		(145,300	)
Cash dividends declared, $0.84 per share		—		—		—		(3,503,575	)		—			—			(3,503,575	)

Balance, December 31, 2007	$	—	$	4,298,353	$	22,530,191	$	85,728,114		$	1,356,538		$	(2,714,373	)	$	111,198,823

Net loss		—		—		—		(30,627,356	)		—			—			(30,627,356	)
Change in unrealized gain (loss) on securities:
Unrealized gain on debt and equity securities available-for-sale, net of tax		—		—		—		—			1,325,559			—			1,325,559
Adjustment on sales and calls of debt and equity securities, net of tax		—		—		—		—			(1,692	)		—			(1,692	)
Defined benefit pension plans:
Net loss arising during the year, net of tax		—		—		—		—			(1,696,706	)		—			(1,696,706	)
Amortization of prior service cost included in net periodic pension cost, net of tax		—		—		—		—			21,854			—			21,854

Total other comprehensive income (loss)																	(350,985	)

Total comprehensive income (loss)																	(30,978,341	)

Stock based compensation expense		—		—		231,761		—			—			—			231,761
Issuance of 30,255 shares of preferred stock and 245,443 common stock warrants, net of expenses		27,872,629		—		2,382,371		—			—			—			30,255,000
Accretion of preferred stock discount		15,665		—		—		(15,665	)		—			—			—
Treasury stock purchased		—		—		—		—			—			(802,445	)		(802,445	)
Cash dividends declared, $0.84 per share		—		—		—		(3,486,415	)		—			—			(3,486,415	)

Balance, December 31, 2008	$	27,888,294	$	4,298,353	$	25,144,323	$	51,598,678		$	1,005,553		$	(3,516,818	)	$	106,418,383

See accompanying notes to consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) — Continued


										Accumulated						Total
										other						Stock -
	Preferred		Common				Retained			Comprehensive			Treasury			holders’
	Stock		Stock		Surplus		Earnings			Income (Loss)			Stock			Equity

Balance, December 31, 2008	$	27,888,294	$	4,298,353	$	25,144,323	$	51,598,678		$	1,005,553		$	(3,516,818	)	$	106,418,383

Net income		—		—		—		4,955,757			—			—			4,955,757
Change in unrealized gain (loss) on securities:
Unrealized loss on debt and equity securities available-for-sale, net of tax		—		—		—		—			(277,903	)		—			(277,903	)
Adjustment on sales and calls of debt and equity securities, net of tax		—		—		—		—			(369,487	)		—			(369,487	)
Defined benefit pension plans:
Net gain arising during the year, net of tax		—		—		—		—			511,634			—			511,634
Amortization of prior service cost included in net periodic pension cost, net of tax		—		—		—		—			42,427			—			42,427

Total other comprehensive loss																	(93,329	)

Total comprehensive income																	4,862,428

Stock based compensation expense		—		—		130,459		—			—			—			130,459
Accretion of preferred stock discount		476,474		—		—		(476,474	)		—			—			—
Stock dividend		—		165,460		1,695,963		(1,861,423	)		—			—			—
Cash dividends declared, preferred stock								(1,369,879	)								(1,369,879	)
Cash dividends declared, common stock		—		—		—		(2,270,108	)		—			—			(2,270,108	)

Balance, December 31, 2009	$	28,364,768	$	4,463,813	$	26,970,745	$	50,576,551		$	912,224		$	(3,516,818	)	$	107,771,283

See accompanying notes to consolidated financial statements.

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows


	Years ended December 31,
	2009			2008			2007

Cash flows from operating activities:
Net income (loss)	$	4,955,757		$	(30,627,356	)	$	7,799,976
Adjustments to reconcile net income to net cash provided by operating activities:
Goodwill impairment		—			40,323,775			—
Provision for loan losses		8,354,000			8,211,000			1,154,216
Depreciation expense		2,044,257			2,158,740			2,050,122
Net amortization (accretion) of debt securities, premiums, and discounts		524,639			(15,372	)		(46,306	)
Amortization of intangible assets		626,111			701,443			922,337
Stock based compensation expense		130,459			231,761			264,881
Decrease in accrued interest receivable		850,536			1,288,103			9,490
Increase in cash surrender value -life insurance		(77,008	)		(32,370	)		(70,112	)
Increase in other assets		(4,419,959	)		(2,007,842	)		(749,866	)
(Decrease) increase in accrued interest payable		(1,409,294	)		(876,550	)		357,715
(Decrease) increase in other liabilities		(730,764	)		(1,820,022	)		7,232
(Gain) loss on sales of debt securities		(605,716	)		(2,773	)		1,747
Origination of mortgage loans for sale		(150,628,000	)		(54,892,543	)		(39,575,067	)
Proceeds from the sale of mortgage loans		153,601,630			55,865,638			40,240,884
Gain on sale of mortgage loans, net		(2,973,630	)		(973,095	)		(665,817	)
Loss on sales and dispositions of premises and equipment		137,209			49,830			323,752
(Increase) decrease in deferred tax asset		(1,016,107	)		(6,493,604	)		651,591
Other, net		387,035			437,681			710,763

Net cash provided by operating activities		9,751,155			11,526,444			13,387,538

Cash flows from investing activities:
Net decrease (increase) in loans		4,283,403			(115,310,652	)		(103,830,110	)
Purchase of available-for-sale debt securities		(156,459,542	)		(280,670,587	)		(65,747,670	)
Proceeds from maturities of available-for-sale debt securities		115,169,758			212,071,519			66,572,206
Proceeds from calls of available-for-sale debt securities		24,237,200			42,282,640			26,288,700
Proceeds from sales of available-for-sale debt securities		12,546,609			30,920,778			6,910,634
Purchase of FHLB stock		—			(5,040,800	)		(2,015,900	)
Proceeds from sales of FHLB stock		2,121,700			1,791,600			2,597,025
Purchases of premises and equipment		(2,369,890	)		(1,034,021	)		(8,948,850	)
Proceeds from sales of premises and equipment		632,165			51,450			738,287
Proceeds from sales of other real estate owned and repossessions		6,168,067			6,809,258			3,996,405

Net cash provided (used) in investing activities		6,329,470			(108,128,815	)		(73,439,273	)

Cash flows from financing activities:
Net increase (decrease) in demand deposits		9,772,439			(13,110,320	)		(530,363	)
Net increase in interest-bearing transaction accounts		11,657,302			13,405,039			20,348,280
Net (decrease) increase in time deposits		(20,403,333	)		33,744,379			1,574,640
Net increase (decrease) in federal funds purchased and securities sold under agreements to repurchase		7,506,811			3,408,760			(3,730,629	)
Net decrease increase in interest-bearing demand notes to U.S. Treasury		—			—			(1,735,638	)
Proceeds from Federal Home Loan Bank advances		20,145,000			345,300,000			137,000,000
Repayment of Federal Home Loan Bank advances		(69,885,181	)		(294,157,544	)		(106,453,288	)
Proceeds from sale of treasury stock, net of expenses		—			—			100,427
Proceeds from issuance of preferred stock and warrants		—			30,255,000			—
Purchase of treasury stock		—			(802,445	)		(145,300	)
Cash dividends paid — preferred stock		(1,369,879	)		—			—
Cash dividends paid — common stock		(2,665,557	)		(3,486,415	)		(3,503,575	)

Net cash (used) provided by financing activities		(45,242,398	)		114,556,454			42,924,554

Net (decrease) increase in cash and cash equivalents		(29,161,773	)		17,954,083			(17,127,181	)
Cash and cash equivalents, beginning of year		53,827,468			35,873,385			53,000,566

Cash and cash equivalents, end of year	$	24,665,695		$	53,827,468		$	35,873,385


Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	24,383,520		$	32,475,450		$	36,817,148
Income taxes	$	1,487,000		$	2,240,000		$	3,507,000
Supplemental schedule of noncash investing and financing activities:
Other real estate and repossessions acquired in settlement of loans	$	6,982,125		$	12,658,929		$	3,977,012

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

(1)

Summary of Significant Accounting Policies

		Hawthorn Bancshares, Inc. (the Company) provides a broad range of banking services to individual and corporate customers located within the communities in and surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson and Lee’s Summit, Missouri. The Company is subject to competition from other financial and nonfinancial institutions providing financial products. Additionally, the Company and its subsidiaries are subject to the regulations of certain regulatory agencies and undergo periodic examinations by those regulatory agencies.

		The consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles and conform to predominant practices within the banking industry. The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions, including the determination of the allowance for loan losses, real estate acquired in connection with foreclosure or in satisfaction of loans, and fair values of investment securities available-for-sale that affect the reported amounts 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. The Company’s management has evaluated and did not identify any subsequent events or transactions requiring recognition or disclosure in the consolidated financial statements.

		On July 1, 2009, the Company paid a special stock dividend of four percent to common shareholders of record at the close of business on June 15, 2009. For all periods presented, share information, including basic and diluted earnings (loss) per share, have been adjusted retroactively to reflect this change

		In June 2009, the Financial Accounting Standards Board (FASB) issued authoritative guidance on –The FASB Accounting Standards Codification^TM and the Hierarchy of Generally Accepted Accounting Principles.The FASB Accounting Standards Codification^TM, or Codification, became the source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the United States Securities and Exchange Commission, or SEC, under authority of federal securities laws, are also sources of authoritative GAAP for SEC registrants. The Codification superseded all then-existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification became non-authoritative. This is effective for financial statements issued for periods ending after September 15, 2009. The disclosures required by this new guidance are reported in the notes to the Company’s consolidated financial statements.

		The significant accounting policies used by the Company in the preparation of the consolidated financial statements are summarized below:

			*Principles of Consolidation*

			As further described in note 16, during 2007 the Company combined its banking subsidiaries into Hawthorn Bank (the Bank), a wholly owned subsidiary. In December of 2008, the Company formed Hawthorn Real Estate, LLC. (the Real Estate Company), a wholly owned subsidiary of the Company. The consolidated financial statements include the accounts of the Company, the Bank,

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

			and the Real Estate Company. All significant intercompany accounts and transactions have been eliminated in consolidation.

			*Loans*

			Loans are stated at unpaid principal balance amount less unearned income and the allowance for loan losses. Income on loans is accrued on a simple-interest basis.

			Loans are placed on nonaccrual status when management believes that the borrower’s financial condition, after consideration of business conditions and collection efforts, is such that collection of interest is doubtful. Subsequent interest payments received on such loans are applied to principal if doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income. A loan remains on nonaccrual status until the loan is current as to payment of both principal and interest and/or the borrower demonstrates the ability to pay and remain current.

			Loan origination fees and certain direct costs are deferred and recognized over the life of the loan as an adjustment to yield.

			The Bank originates certain loans which are sold in the secondary mortgage market. These long-term, fixed-rate loans are sold on a note-by-note basis. Immediately upon locking in an interest rate, the Company enters into an agreement to sell the mortgage loan without recourse, thereby eliminating the Company’s exposure to interest rate fluctuations. At December 31, 2009 and 2008, $114,000 and $77,000 mortgage loans were held for sale, respectively. Mortgage loan servicing fees earned on loans sold are reported as income when the related loan payments are collected net of mortgage servicing right amortization. Operational costs to service such loans are charged to expense as incurred.

			*Allowance for Loan Losses*

			The allowance for loan losses is increased by provisions charged to expense and is reduced by loan charge-offs, net of recoveries. Management utilizes a systematic, documented approach in determining an adequate allowance for loan losses. Management’s approach, which provides for general and specific valuation allowances, is based on current economic conditions, past losses, collection experience, risk characteristics of the portfolio, assessment of collateral values by obtaining independent appraisals for significant properties, and such other factors, which, in management’s judgment, deserve current recognition in estimating loan losses.

			Management believes the allowance for loan losses is adequate to absorb probable losses in the loan portfolio. While management uses available information to recognize loan losses, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require the Bank to increase the allowance for loan losses based on their judgment about information available to them at the time of their examination.

			A loan is considered impaired when it is probable the Company will be unable to collect all amounts due, both principal and interest, according to the contractual terms of the loan agreement. When measuring impairment, the expected future cash flows of an impaired loan are discounted at

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

			the loan’s effective interest rate. Alternatively, impairment is measured by reference to an observable market price, if one exists, or the fair value of the collateral for a collateral-dependent loan. Regardless of the historical measurement method used, the Company measures impairment based on the fair value of the collateral when foreclosure is probable. Additionally, impairment of a restructured loan is measured by discounting the total expected future cash flows at the loan’s effective rate of interest as stated in the original loan agreement.

			*Investment in Debt and Equity Securities*

			At the time of purchase, debt securities are classified into one of two categories: available-for-sale or held-to-maturity. Held-to-maturity securities are those securities which the Company has the ability and positive intent to hold until maturity. All debt securities not classified as held-to-maturity are classified as available-for-sale. The Company’s securities are classified as available-for-sale and are carried at fair value. Changes in fair value, excluding certain losses associated with other-than-temporary impairment, are reported in other comprehensive income, a component of stockholders’ equity. Securities are periodically evaluated for other-than-temporary impairment in accordance with guidance provided in the FASB ASC Topic 320,Investments –Debt and Equity Securities.For those securities with other-than-temporary impairment, the entire loss in fair value is required to be recognized in current earnings if the Company intends to sell the securities or believes it likely that it will be required to sell the security before the anticipated recovery. If neither condition is met, but the Company does not expect to recover the amortized cost basis, the Company determines whether a credit loss has occurred, which is then recognized in current earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income.

			Premiums and discounts are amortized using the interest method over the lives of the respective securities, with consideration of historical and estimated prepayment rates for mortgage-backed securities, as an adjustment to yield. Dividend and interest income are recognized when earned. Realized gains and losses for securities classified as available-for-sale are included in earnings based on the specific identification method for determining the cost of securities sold.

			*Capital Stock of the Federal Home Loan Bank*

			The Bank, as a member of the Federal Home Loan Bank System administered by the Federal Housing Finance Board, is required to maintain an investment in the capital stock of the Federal Home Loan Bank of Des Moines (FHLB) in an amount equal to 12 basis points of the Bank’s year-end total assets plus 4.45% of advances from the FHLB to the Bank. These investments are recorded at cost, which represents redemption value.

			*Premises and Equipment*

			Premises and equipment are stated at cost, less accumulated depreciation. Depreciation applicable to buildings and improvements and furniture and equipment is charged to expense using straight-line and accelerated methods over the estimated useful lives of the assets. Such lives are estimated to be 5 to 40 years for buildings and improvements and 3 to 15 years for furniture and equipment. Maintenance and repairs are charged to expense as incurred.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

			*Goodwill and Intangible Assets*

			Goodwill and intangible assets that have indefinite useful lives are not amortized, but tested annually for impairment. Intangible assets that have finite useful lives, such as core deposit intangibles and mortgage servicing rights, are amortized over their estimated useful lives. Core deposit intangibles are amortized over periods of 7 to 8 years representing their estimated lives using straight line and accelerated methods. Mortgage servicing rights are amortized over the shorter of 7 years or the life of the loan.

			When facts and circumstances indicate potential impairment of amortizable intangible assets, the Company evaluates the recoverability of the carrying value based upon future cash flows expected to result from the use of the underlying asset and its eventual disposition. If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying value of the underlying asset, the Company recognizes an impairment loss. The impairment loss recognized represents the amount by which the carrying value of the underlying asset exceeds the fair value of the underlying asset. As a result of the 2008 annual review, the Company determined that goodwill was fully impaired and recorded an impairment charge of $40,323,775, before tax.

			*Other Real Estate Owned and Repossessed Assets*

			Other real estate owned and repossessed assets consist of loan collateral which has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate owned assets are recorded as held for sale initially at the lower of the loan balance or fair value of the collateral less estimated selling costs. The Company relies on external appraisals and assessment of property values by internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

			*Pension Plan*

			The Company provides a noncontributory defined benefit pension plan for all full-time employees. The benefits are based on age, years of service and the level of compensation during the employees highest ten years of compensation before retirement. Net periodic costs are recognized as employees render the services necessary to earn the retirement benefits. The Company records annual amounts relating to its pension plan based on calculations that incorporate various actuarial and other assumptions including discount rates, mortality, assumed rates of return, compensation increases and turnover rates. The Company reviews its assumptions on an annual basis and may make modifications to the assumptions based on current rates and trends when it is appropriate to do so. The Company believes that the assumptions utilized in recording its obligations under its plan are reasonable based on its experience and market conditions.

			The Company follows authoritative guidance included in the FASB ASC Topic 715,Compensation –Retirement Plansunder the subtopicEmployers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.ASC Topic 715 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its consolidated balance sheet and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. This guidance also requires an employer to measure the funded status of a plan as of the date of its fiscal year-end, with limited exceptions. Additional disclosures are required to provide users with an understanding of how investment allocation decisions are made, major categories of plan assets, and fair value measurement of plan assets as defined in ASC Topic 820, Fair Value Measurements and Disclosures.

			*Income Taxes*

			Income taxes are accounted for under the asset / liability method by recognizing the amount of taxes payable or refundable for the current period and deferred tax assets and liabilities for future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in addressing the Company’s future tax consequences of events that have been recognized in the consolidated financial statements or tax returns such as realization of the effects of temporary differences, net operating loss carry forward, and changes in tax laws or interpretations thereof. A valuation allowance is established when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. In this case, the Company would adjust the recorded value of our deferred tax asset, which would result in a direct charge to income tax expense in the period that the determination was made. Likewise, the Company would reverse the valuation allowance when the realization of the deferred tax asset is expected. In addition, the Company is subject to the continuous examination of our tax returns by the Internal Revenue Service and other taxing authorities. The Company accrues for interest related to income taxes in income tax expense. Total interest expense recognized was $53,000 and $77,000 in 2009 and 2008, respectively. As of December 31, 2009 and 2008, total accrued interest was $94,000 and $131,000, respectively.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

			*Trust Department*

			Property held by the Bank in fiduciary or agency capacity for customers is not included in the accompanying consolidated balance sheets, since such items are not assets of the Company. Trust department income is recognized on the accrual basis.

			*Consolidated Statements of Cash Flows*

			For the purpose of the consolidated statements of cash flows, cash and cash equivalents consist of federal funds sold and securities sold or purchased under agreements to resell, cash, and due from banks.

			*Stock-Based Compensation*

			The Company’s stock-based employee compensation plan is described in Note 14, Stock Compensation. In accordance with FASB ASC Topic 718,Compensation – Stock Compensation, the Company measures the cost of the stock-based compensation based on the grant-date fair value of the award, recognizing the cost over the requisite service period. The fair value of an award is estimated using the Black-Scholes option-pricing model. The expense recognized is based on an estimation of the number of awards for which the requisite service is expected to be rendered, and is included in salaries and employee benefits in the accompanying consolidated statements of operations. The standard also requires that excess tax benefits related to stock option exercises be reflected as financing cash inflows instead of operating cash inflows.

			*Treasury Stock*

			The purchase of the Company’s common stock is recorded at cost. Purchases of the stock are made both in the open market and through negotiated private purchases based on market prices. At the date of subsequent reissue, the treasury stock account is reduced by the cost associated with such stock on a first-in-first-out basis.

			*Comprehensive Income*

			The Company reports comprehensive income (loss) in the consolidated statements of stockholders’ equity and comprehensive income (loss).

			*Reclassifications*

			Certain prior year information has been reclassified to conform to the current year presentation.

			*Recently Issued Accounting Standards*

			In December 2008, the FASB issued authoritative guidance onEmployers’ Disclosures about Postretirement Benefit Plan Assetswhich was subsequently incorporated into ASC Topic 715Compensation – Retirement Benefits.This guidance became effective for fiscal years ending after December 15, 2009. ASC Topic 715 requires more detailed disclosures regarding defined benefit pension plan assets including investment policies and strategies, major categories of plan assets, valuation techniques used to measure the fair value of plan assets and significant concentrations of risk within plan assets. Upon initial application, the provisions of ASC Topic 715 are not required

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

			for earlier periods that are presented for comparative purposes. The disclosures required by ASC Topic 715 are reported in the notes to the Company’s consolidated financial statements.

			In April 2009, the FASB issued authoritative guidance for determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly, which was subsequently incorporated into ASC Topic 820,Fair Value Measurements and Disclosures,and is effective for interim and fiscal years ending after June 15, 2009. This new guidance amends ASC Topic 820 and provides additional guidance for estimating fair value when there is no active market or where the price inputs being used represent distressed sales. The Company follows the new requirements provided by ASC Topic 820 which did not have a material effect on the consolidated financial statements or the disclosures presented in the consolidated financial statements.

			In April 2009, the FASB issued authoritative guidance on recognition and presentation of other-than-temporary impairment, which was subsequently incorporated into ASC Topic 320,Investments – Debt and Equity Securities, andbecame effective for periods ending after June 15, 2009. This new guidance amends ASC Topic 320 for determining whether an impairment is other than temporary to debt securities and replaces the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert: (a) it does not have the intent to sell the security and (b) it is more likely than not it will not have to sell the security prior to its anticipated recovery. Under this guidance, declines in fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income. The Company follows the new requirements under ACS Topic 320, which did not have a material effect on the consolidated financial statements or the disclosures presented in the consolidated financial statements.

			In May 2009, the FASB issued authoritative guidance for disclosing subsequent events, which was subsequently incorporated into ASC 855,Subsequent Events, andbecame effective for interim and annual periods ending after June 15, 2009.The new guidance amends ASC Topic 855 and incorporates accounting and disclosure requirements related to subsequent events into U.S. Generally Accepted Accounting Principles (GAAP) making management directly responsible for subsequent events account and disclosure. ASC Topic 855 sets forth: (a) the period after the balance sheet date during which management shall evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; (b) the circumstances under which an entity shall recognize events or transactions occurring after the balance sheet date in its financial statements; and (c) the disclosures that an entity shall make about events or transactions that occurred after the balance sheet date. The disclosures required by ASC Topic 855 are reported in the consolidated financial statements and the notes to the Company’s consolidated financial statements.

			In June 2009, the FASB issued authoritative guidance on accounting for transfers of financial assets, which was subsequently incorporated into ASC Topic 860,Transfers and Servicing. The new guidance amends ASC Topic 860 and requires more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

			related to transferred financial assets. The guidance eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets and requires additional disclosures. This is effective for the annual period beginning after November 15, 2009 and for interim periods within the first annual reporting period, and must be applied to transfers occurring on or after the effective date. Management is currently evaluating the provisions of this Topic, which is not expected to have a material effect on the consolidated financial statements or the disclosures presented in the consolidated financial statements.

			In June 2009, the FASB issued authoritative guidance which amends how a company determines when a variable interest entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated, and requires additional disclosures about involvement with variable interest entities, any significant changes in risk exposure due to that involvement and how that involvement affects the company’s financial statements. This guidance was subsequently incorporated into ASC Topic 810,Consolidation,and changes how a company determines whether it is required to consolidate an entity based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. The provisions of this Topic are effective for the annual period beginning after November 15, 2009 and for interim periods within the first annual reporting period. Management is currently evaluating the provisions of this Topic, which is not expected to have a material effect on the consolidated financial statements or the disclosures presented in the consolidated financial statements.

(2)

Loans and Allowance for Loan Losses

A summary of loans, by major classification within the Company’s loan portfolio, at December 31, 2009 and 2008 are as follows:


	2009		2008

Commercial	$	151,399,300	$	153,386,062
Real estate construction — residential		38,840,664		49,623,350
Real estate construction — commercial		77,936,569		80,015,409
Real estate mortgage — residential		232,332,124		238,041,340
Real estate mortgage — commercial		453,975,271		454,488,912
Installment and other consumer		36,966,018		33,404,048
Unamortized loan origination fees and costs, net		164,061		144,411

Total loans	$	991,614,007	$	1,009,103,532

The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the communities surrounding Jefferson City, Clinton, Warsaw, Springfield, Branson and Lee’s Summit, Missouri. As such, the Bank is susceptible to changes in the economic environment in these communities. The Bank does not have a concentration of credit in any one economic sector. Installment and other consumer loans consist primarily of the financing of vehicles.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Following is a summary of activity in 2009 of loans made by the Bank to executive officers and directors or to entities in which such individuals had a beneficial interest. Such loans were made in the normal course of business on substantially the same terms, including interest rates and collateral requirements, as those prevailing at the same time for comparable transactions with other persons, and did not involve more than the normal risk of collectability or present unfavorable features.


Balance at December 31, 2008	$	7,608,022
New loans		1,628,941
Amounts collected		(1,680,038	)

Balance at December 31, 2009	$	7,556,925

The following is a summary of the allowance for loan losses for 2009, 2008 and 2007 is as follows:


	Years Ended December 31,
	2009			2008			2007

Balance, beginning of year	$	12,666,546			9,281,848			9,015,378

Additions:
Provision for loan losses		8,354,000			8,211,000			1,154,216

Deductions:
Loans charged off		6,800,942			5,439,827			1,307,644
Less recoveries on loans		(576,945	)		(613,525	)		(419,898	)

Net loans charged off		6,223,997			4,826,302			887,746

Balance, end of year	$	14,796,549			12,666,546			9,281,848

A summary of impaired loans for 2009, 2008, and 2007 is as follows:


	2009		2008		2007

Loans classified as impaired:
Non-accrual loans	$	34,153,731	$	20,387,859	$	4,538,364
Impaired loans continuing to accrue interest		39,713,014		9,545,914		4,026,976

Total impaired loans	$	73,866,745	$	29,933,773	$	8,565,340


Balance of impaired loans with reserves	$	26,294,560	$	18,482,148	$	8,065,104
Balance of impaired loans without reserves		47,572,185		11,451,625		500,236

Total impaired loans	$	73,866,745	$	29,933,773	$	8,565,340


Reserves for impaired loans	$	6,414,729	$	3,837,419	$	3,256,342
Average balance of impaired loans during the period		39,048,298		20,645,519		8,914,807
Balance of trouble debt restructured loans included in impaired loans		11,233,326		3,736,105		—

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Interest income recognized on non-accrual loans was approximately $158,124, $239,320, and $329,566 for the years ended December 31, 2009, 2008, and 2007, respectively. The gross amount of interest that would have been recognized under the original terms of non-accrual loans was $1,568,271, $1,521,701, and $744,675 for the years ended December 31, 2009, 2008, and 2007, respectively. The amount recognized as interest income on impaired loans continuing to accrue interest was $436,787, $116,521, and $359,229, for the years ended December 31, 2009, 2008, and 2007, respectively.

(3)

Investment in Debt and Equity Securities

The amortized cost and fair value of debt securities classified as available-for-sale at December 31, 2009 and 2008 are as follows:


				Gross		Gross
	Amortized			unrealized		unrealized
	cost			gains		losses		Fair value

December 31, 2009

Government sponsored enterprises	$	44,059,540		$	371,258	$	50,000	$	44,380,798
Asset-backed securities		68,092,852			1,585,774		243,976		69,434,650
Obligations of states and political subdivisions		38,456,246			708,196		53,205		39,111,237

Total available for sale securities	$	150,608,638		$	2,665,228	$	347,181	$	152,926,685


Weighted average yield at end of period		4.11	%


				Gross		Gross
	Amortized			unrealized		unrealized
	cost			gains		losses		Fair value

December 31, 2008

Government sponsored enterprises	$	54,018,436		$	1,526,240	$	—	$	55,544,676
Asset-backed securities		48,801,151			1,292,982		3,148		50,090,985
Obligations of states and political subdivisions		43,201,999			755,091		191,822		43,765,268

Total available for sale securities	$	146,021,586		$	3,574,313	$	194,970	$	149,400,929


Weighted average yield at end of period		4.67	%

Restricted investments in equity securities, reported in other assets, in the amount of $6,753,550 and $8,875,250 as of December 31, 2009 and 2008, respectively, are recorded at cost, and consist primarily of Federal Home Loan Bank Stock and the Company’s interest in the statutory trusts described in Note 10. While some Federal Home Loan Banks have suspended dividends, the Bank is a member of the Federal Home Loan Bank of Des Moines and has continued to receive dividend payments each quarter.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

The amortized cost and fair value of debt securities classified as available-for-sale at December 31, 2009, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without prepayment penalties.


	Amortized		Fair
	cost		value

Due in one year or less	$	11,182,662	$	11,312,689
Due after one year through five years		48,087,053		48,667,242
Due after five years through ten years		18,990,078		19,232,158
Due after ten years		4,255,993		4,279,947

		82,515,786		83,492,036
Asset-backed securities		68,092,852		69,434,649

Total	$	150,608,638	$	152,926,685

Debt securities with carrying values aggregating approximately $132,322,000 and $136,057,000 at December 31, 2009 and 2008, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.


	2009		2008		2007

Proceeds from sales	$	12,546,609	$	30,920,778	$	6,910,634

Gains		605,716		2,733		—
Losses		—		—		(1,747	)

Net gains (losses)	$	605,716	$	2,733	$	(1,747	)

Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2009, were as follows:


	Less than 12 months					12 months or more							Total
											Number of
	Fair		Unrealized			Fair		Unrealized			Investment		Fair		Unrealized
	Value		Losses			Value		Losses			Positions		Value		Losses

Government sponsored enterprises	$	5,943,819	$	(50,000	)	$	—	$	—			6	$	5,943,819		(50,000	)
Asset-backed securities		14,600,160		(243,904	)		20,551		(72	)		15		14,620,711	$	(243,976	)
Obligations of states and political subdivisions		3,576,780		(53,205	)		—		—			14		3,576,780		(53,205	)

	$	24,120,759	$	(347,109	)	$	20,551	$	(72	)		35	$	24,141,310	$	(347,181	)

The $72 unrealized losses included in other comprehensive income at December 31, 2009 on asset-backed securities were caused by interest rate increases. The contractual cash flows of these securities are guaranteed by various government or government sponsored enterprises. It is expected that the securities would not be settled at a price less than the amortized cost of the investment. Because the decline in fair value is attributable to changes in interest rates and not credit quality these investments are not considered

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

other-than-temporarily impaired. As of December 31, 2009, the Company had no other-than-temporary impairment losses.

(4)

Fair Value Measurement

The Company uses fair value measurements to record fair value adjustments to certain financial and nonfinancial assets and liabilities. The FASB ASC Topic 820,Fair Value Measurements and Disclosures,defines fair value, establishes a framework for the measurement of fair value, and enhances disclosures about fair value measurements. The standard applies whenever other standards require (permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. In this standard, FASB clarified the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions.

			The fair value hierarchy is as follows:

			Level 1 – Inputs are unadjusted quoted prices for identical assets or liabilities in active markets.

			Level 2 – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, such as interest rates and yield curves that are observable at commonly quoted intervals.

			Level 3 – Inputs are unobservable inputs for the asset or liability and significant to the fair value. These may be internally developed using the Company’s best information and assumptions that a market participant would consider.

		ASC Topic 820 also provides guidance on determining fair value when the volume and level of activity for the asset or liability has significantly decreased and on identifying circumstances when a transaction may not be considered orderly.

		The Company is required to disclose assets and liabilities measured at fair value on a recurring basis separate from those measured at fair value on a nonrecurring basis. Nonfinancial assets measured at fair value on a nonrecurring basis would include foreclosed real estate, long-lived assets, and core deposit intangible assets, which are reviewed when circumstances or other events indicate that impairment may have occurred.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

		Valuation methods for instruments measured at fair value on a recurring basis

		Following is a description of the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a recurring basis:

		Available-for-sale securities

		Available-for-sale securities are recorded at fair value on a recurring basis. Available-for-sale securities is the only balance sheet category the Company is required, in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP), to carry at fair value on a recurring basis. Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

Fair Value Measurements

At December 31, 2009 Using

Quoted Prices

in Active

Markets for

Other

Significant

Identical

Observable

Unobservable

Fair Value

Assets

Inputs

Description

December 31, 2009

(Level 1)

(Level 2)

(Level 3)

Available-for-Sale Securities

152,926,685

—

152,926,685

—

		Valuation methods for instruments measured at fair value on a nonrecurring basis

		Following is a description of the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a nonrecurring basis:

		Impaired Loans

		The Company does not record loans at fair value on a recurring basis other than loans that are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with the FASB ASC Topic 310,Accounting by Creditors for Impairment of a Loan. Impaired loans for which an allowance is established are generally based on market prices for similar assets determined through independent appraisals, the fair value of the collateral for a collateral-dependent loan, or in the case of trouble debt restructured loans, impairment is measured by discounting the total expected future cash flows. Because many of these inputs are not observable, the measurements are classified as Level 3. As of December 31, 2009, the Company identified $26.2 million in impaired loans that had specific allowances for losses aggregating $6.4 million. Related to these loans, there was $4.2 million in charge-offs recorded during 2009.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Other Real Estate Owned and Repossessed Assets

Other real estate owned and repossessed assets consist of loan collateral which has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate owned assets are recorded as held for sale initially at the lower of the loan balance or fair value of the collateral less estimated selling costs. The Company relies on external appraisals and assessment of property values by our internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. Because many of these inputs are not observable, the measurements are classified as Level 3.


			Fair Value Measurements
			At December 31, 2009 Using
			Quoted Prices
			in Active						The Year
			Markets for		Other		Significant		Ended
	Fair Value		Identical		Observable		Unobservable		Dec. 31, 2009
	December 31,		Assets		Inputs		Inputs		Total Gains
Description	2009		(Level 1)		(Level 2)		(Level 3)		(Losses)

Impaired loans	$	19,879,831	$	—	$	—	$	19,879,831	$	(4,220,285	)
Other real estate owned and repossessed assets	$	8,490,914	$	—	$	—	$	8,490,914	$	(1,367,207	)

(5)

Earnings (loss) per Share


		Basic earnings (loss) per share is computed by dividing income (loss) available to common shareholders by the weighted average number of common shares outstanding during the year. Diluted earnings (loss) per share gives effect to all dilutive potential common shares that were outstanding during the year. The calculations of basic and diluted earnings (loss) per share are as follows:


	2009		2008			2007

Net income (loss), basic and diluted	$	4,955,757	$	(30,627,356	)	$	7,799,976
Less: preferred stock dividends		1,993,426		66,090			—

Net income (loss) available to common shareholders	$	2,962,331	$	(30,693,446	)	$	7,799,976

Average shares outstanding		4,301,955		4,321,979			4,338,438
Effect of dilutive stock options		—		—			37,658

Average shares outstanding including dilutive stock options		4,301,955		4,321,979			4,376,096


Net income (loss) per share, basic	$	0.69	$	(7.10	)	$	1.80
Net income (loss) per share, diluted		0.69		(7.10	)		1.78

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Under the treasury stock method, outstanding stock options are dilutive when the average market price of the Company’s common stock, when combined with the effect of any unamortized compensation expense, exceeds the option price during the period, except when the Company has a loss from continuing operations available to common shareholders. In addition, proceeds from the assumed exercise of dilutive options along with the related tax benefit are assumed to be used to repurchase common shares at the average market price of such stock during the period.

The following options to purchase shares during the fiscal years ended 2009, 2008, and 2007 were not included in the respective computations of diluted earnings (loss) per share because the exercise price of the option, when combined with the effect of the unamortized compensation expense, was greater than the average market price of the common shares and were considered anti-dilutive.

Years Ended December 31,

2009

2008

2007

Anti-dilutive shares

531,226

532,714

214,986


(6)		Capital Requirements

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

Quantitative measures established by regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital to risk-weighted assets, and of Tier I capital to adjusted-average assets. Management believes, as of December 31, 2009 and 2008, the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of December 31, 2009, the most recent notification from the regulatory authorities categorized the bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since the notifications that management believes have changed the Bank’s categories.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

The actual and required capital amounts and ratios for the Company and the Bank as of December 31, 2009 and 2008 are as follows (dollars in thousands):


						Minimum					Well-Capitalized
	Actual					Capital requirements					Capital Requirements
	Amount		Ratio			Amount		Ratio			Amount		Ratio

December 31, 2009
Total capital (to risk-weighted assets):
Company	$	165,969		16.49	%	$	80,502		8.00	%		—		—
Hawthorn Bank		134,673		13.62			79,129		8.00		$	98,911		10.00	%

Tier I capital (to risk-weighted assets):
Company	$	140,974		14.01		$	40,251		4.00	%		—		—
Hawthorn Bank		122,285		12.36			39,564		4.00		$	59,347		6.00	%

Tier I capital (to adjusted average assets):
Company	$	140,974		11.35		$	37,254		3.00	%		—		—
Hawthorn Bank		122,285		10.04			36,556		3.00		$	60,926		5.00	%


						Minimum					Well-Capitalized
	Actual					Capital requirements					Capital Requirements
	Amount		Ratio			Amount		Ratio			Amount		Ratio

December 31, 2008
Total capital (to risk-weighted assets):
Company	$	163,949		16.01	%	$	81,912		8.00	%		—		—
Hawthorn Bank		125,510		12.35			81,310		8.00		$	101,638		10.00	%

Tier I capital (to risk-weighted assets):
Company	$	138,756		13.55		$	40,956		4.00	%		—		—
Hawthorn Bank		113,158		11.13			40,655		4.00		$	60,983		6.00	%

Tier I capital (to adjusted average assets):
Company	$	138,756		10.80		$	38,543		3.00	%		—		—
Hawthorn Bank		113,158		8.82			38,497		3.00		$	64,162		5.00	%

Bank dividends are the principal source of funds for payment of dividends by the Company to it stockholders. The Bank is subject to regulations which require the maintenance of minimum capital requirements. As a result of the 2008 goodwill impairment charge, as described in Note 1, the Bank’s unappropriated retained earnings balance at December 31, 2009 is negative. As a result, the Bank must obtain regulatory approval prior to paying dividends to the Company until such time as the unappropriated retained earnings balance is restored to a positive balance.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

(7)

Premises and Equipment


		A summary of premises and equipment at December 31, 2009 and 2008 is as follows:


	2009		2008

Land and land improvements	$	9,837,854	$	10,136,974
Buildings and improvements		31,220,427		31,460,592
Furniture and equipment		10,734,460		11,096,332
Construction in progress		1,882,773		418,922

Total		53,675,514		53,112,820
Less accumulated depreciation		15,052,221		13,852,600

Net premises and equipment	$	38,623,293	$	39,260,220

Depreciation expense for the past three years is as follows:


	For the Years Ended December 31,
	2009		2008		2007

Depreciation expense	$	2,044,257	$	2,158,740	$	2,050,122

(8)

Goodwill and Other Intangible Assets


		The Company’s goodwill is tested annually for potential impairment. As a result of the 2008 annual review, the Company determined that the goodwill was fully impaired as of December 31, 2008, and recorded an impairment charge of $40,323,775, in the fourth quarter of 2008.

		A summary of other intangible assets at and for the years ended December 31, 2009 and 2008 is as follows:


	For the Years Ended December 31,
			2009							2008
	Gross							Gross
	Carrying		Accumulated			Net		Carrying		Accumulated			Net
	Amount		Amortization			Amount		Amount		Amortization			Amount

Amortizable intangible assets:
Core deposit intangible	$	7,060,224	$	(5,556,238	)	$	1,503,986	$	7,060,224	$	(4,930,127	)	$	2,130,097
Mortgage servicing rights		2,945,019		(924,055	)		2,020,964		2,767,180		(1,595,955	)		1,171,225


Total intangible assets	$	10,005,243	$	(6,480,293	)	$	3,524,950	$	9,827,404	$	(6,526,082	)	$	3,301,322

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Changes in the net carrying amount of other intangible assets for the years ended December 31, 2009 and 2008 are shown in the following table:


	Core Deposit			Mortgage
	Intangible			Servicing
	Asset			Rights

Balance at December 31, 2007	$	2,831,540		$	1,184,868
Additions		—			627,397
Amortization		(701,443	)		(641,040	)

Balance at December 31, 2008		2,130,097			1,171,225
Additions		—			1,765,832
Amortization		(626,111	)		(916,093	)


Balance at December 31, 2009	$	1,503,986		$	2,020,964

Mortgage loans serviced for others totaled approximately $269,475,000 and $213,074,000 at December 31, 2009 and 2008, respectively.

The Company’s amortization expense on intangible assets in any given period may be different from the estimated amounts depending upon the acquisition of intangible assets, changes in mortgage interest rates, prepayment rates and other market conditions. The following table shows the estimated future amortization expense based on existing asset balances and the interest rate environment as of December 31, 2009 for the next five years:


	Core Deposit		Mortgage
	Intangible		Servicing
	Asset		Rights

2010	$	526,477	$	555,000
2011		434,763		429,000
2012		408,062		332,000
2013		134,684		258,000
2014		—		200,000

The aggregate amortization expense of intangible assets subject to amortization for the past three years is as follows:


	For the Years Ended December 31,
Aggregate amortization expense	2009		2008		2007

Core deposit intangible asset	$	626,111	$	701,443	$	922,337
Mortgage servicing rights		916,093		641,040		450,780

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

(9)

Deposits

The scheduled maturities of total time deposits are as follows:


	2009		2008

Due within:
One year	$	342,749,968	$	362,059,020
Two years		74,118,865		62,484,223
Three years		20,481,957		32,505,028
Four years		27,461,147		4,634,125
Five years		2,123,433		25,674,091
Thereafter		85,784		68,000

	$	467,021,154	$	487,424,487

At December 31, 2009 and 2008, our Company had certificates and other time deposits in denominations of $100,000 or more which mature as follows:


	2009		2008

Due within:
Three months or less	$	35,336,996	$	39,041,405
Over three months through six months		30,808,596		27,215,330
Over six months through twelve months		44,787,905		48,556,441
Over twelve months		26,926,938		28,159,313

	$	137,860,435	$	142,972,489

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

(10)

Borrowings

Federal Funds Purchased and Securities Sold Under Agreements to Repurchase (repurchase agreements)

Information relating to federal funds purchased and repurchase agreements is as follows:


	Year End						Average		Maximum
	Weighted			Average			Balance		Outstanding at		Balance at
	Rate			Weighted Rate			Outstanding		any Month End		December 31,

2009
Federal funds purchased		0.9	%		0.9	%	$	1,507,904	$	7,175,000	$	4,980,000
Short-term repurchase agreements		0.2			0.2			32,414,635		32,489,362		31,665,434

Total												36,645,434

2008
Federal funds purchased		—	%		2.8	%	$	3,831,120	$	17,757,000	$	—
Short-term repurchase agreements		0.5			2.0			37,802,343		56,709,965		29,138,623

Total												29,138,623

2007
Federal funds purchased		5.1	%		5.3	%	$	7,041,300	$	14,950,000	$	7,365,000
Short-term repurchase agreements		3.2			4.2			26,806,926		28,704,922		18,364,863

Total												25,729,863

The securities underlying the agreements to repurchase are under the control of the Bank. All securities sold under agreements to repurchase are secured by a portion of the Company’s investment portfolio.

Under agreements with unaffiliated banks, the Bank may borrow federal funds up to $35,000,000 on an unsecured basis and $12,000,000 on a secured basis at December 31, 2009.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Other Borrowings

Other borrowings of the Company consisted of the following at December 31, 2009:


				Year End
		Maturity		Weighted
	Borrower	Date		Rate			Year End Balance

FHLB advances	Subsidiary bank		2010		4.6	%	$	22,331,324
			2011		3.6	%		38,575,989
			2012		1.6	%		8,283,528
			2013		4.1	%		126,461
			2014	na				—
			2015-18		2.5	%		10,000,000

Total								79,317,302


Subordinated notes	The Company		2034		3.0	%		25,774,000
			2035		6.3	%		23,712,000

Total							$	49,486,000

The Bank subsidiary of the Company is a member of the Federal Home Loan Bank of Des Moines (FHLB) and has access to term financing from the FHLB. These borrowings are secured under a blanket agreement which assigns all investment in Federal Home Loan Bank of Des Moines stock, as well as mortgage loans equal to 125% to 175% (based on collateral type) of the outstanding advance balance, to secure amounts borrowed by the Bank. The outstanding balance of $79,317,000 includes $10,000,000 which the FHLB may call for early payment within the next two years. The FHLB has also issued letters of credit totaling $100,000 at December 31, 2009, to secure the Company’s obligations to depositors of public funds.

Based upon the collateral pledged to the Federal Home Loan Bank of Des Moines at December 31, 2009, the Bank could borrow up to an additional $213,558,000 under the agreement.

On March 17, 2005, Exchange Statutory Trust II, a business trust issued $23,000,000 of 30-year floating rate Trust Preferred Securities (TPS) to a TPS Pool. The interest rate on the TPS is a fixed rate at 6.30% until March 17, 2010, at which time it converts to a floating rate equal to a three-month LIBOR rate plus 1.83% and will reprice quarterly. The TPS can be prepaid without penalty at any time after five years from the issuance date.

The TPS represent preferred interests in the trust. The Company invested approximately $712,000 in common interests in the trust and the purchaser in the private placement purchased $23,000,000 in preferred interests. The proceeds were used by the trust to purchase from the Company its 30-year deeply subordinated debentures whose terms mirror those stated above for the TPS. The debentures are guaranteed by the Company pursuant to a subordinated guarantee. Distributions on the TPS are payable quarterly on March 17, June 17, September 17, and December 17 of each year that the TPS are outstanding. The trustee for the TPS holders is U.S. Bank, N.A. The trustee does not have the power to take enforcement action in the event of a default under the TPS for five years from the date of default. In the event of default, however, the Company would be precluded from paying dividends until the default is cured.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

On March 17, 2004, Exchange Statutory Trust I, a Delaware business trust and subsidiary of the Company issued $25,000,000 of floating TPS to a TPS Pool. The floating rate is equal to the three-month LIBOR rate plus 2.70% and reprices quarterly (2.95% at December 31, 2009). The TPS are fully, irrevocably, and unconditionally guaranteed on a subordinated basis by the Company. The proceeds of the TPS were invested in junior subordinated debentures of the Company. Distributions on the TPS are payable quarterly on March 17, June 17, September 17, and December 17 of each year that the TPS are outstanding. The TPS mature on March 17, 2034. That maturity date may be shortened to a date not earlier than March 17, 2009 if certain conditions are met.

The Exchange Statutory Trusts are not consolidated in the Company’s financial statements. Accordingly, the Company does not report the securities issued by the Exchange Statutory Trusts as liabilities, and instead reports the subordinated notes issued by the Company and held by the Exchange Statutory Trusts as liabilities. The amount of the subordinated notes as of December 31, 2009 and 2008 was $49,486,000. The Company has recorded the investments in the common securities issued by the Exchange Statutory Trusts aggregating $1,486,000, and the corresponding obligations under the subordinated notes, as well as the interest income and interest expense on such investments and obligations in its consolidated financial statements.

(11)

Reserve Requirements and Compensating Balances

The Federal Reserve Bank required the Bank to maintain cash or balances of $22,096,000 and $17,962,000 at December 31, 2009 and 2008, respectively, to satisfy reserve requirements.

Average compensating balances held at correspondent banks were $760,000 and $899,000 at December 31, 2009 and 2008, respectively. The Bank maintains such compensating balances with correspondent banks to offset charges for services rendered by those banks.

(12)

Income Taxes

The composition of income tax expense (benefit) for 2009, 2008, and 2007 is as follows:


	2009			2008			2007

Current:
Federal	$	2,131,373		$	1,236,327		$	3,549,527
State		354,072			—			60,297

Total current		2,485,445			1,236,327			3,609,824

Deferred:
Federal		(564,779	)		(6,625,134	)		(364,585	)
State		(64,546	)		(757,158	)		—

Total deferred		(629,325	)		(7,382,292	)		(364,585	)

Total income tax (benefit) expense	$	1,856,120		$	(6,145,965	)	$	3,245,239

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Applicable income tax expense (benefit) for financial reporting purposes differ from the amount computed by applying the statutory Federal income tax rate for the reasons noted in the table below:


	2009						2008						2007
	Amount			%			Amount			%			Amount			%

Income (loss) before provision for income taxes	$	6,811,877					$	(36,773,321	)				$	11,045,215

Tax at statutory Federal income tax rate	$	2,316,038			34.00	%	$	(12,502,929	)		34.00	%	$	3,765,825			34.10	%
Goodwill impairment		—			—			7,112,827			(19.34	)		—			—
Tax-exempt income		(508,002	)		(7.46	)		(570,506	)		(1.55	)		(628,158	)		(5.69	)
State income tax, net of Federal tax benefit		191,087			2.81			—			—			39,796			0.36
Other, net		(143,003	)		(2.10	)		(185,357	)		0.50			67,776			0.61

Provision for income taxes	$	1,856,120			27.25	%	$	(6,145,965	)		16.71	%	$	3,245,239			29.38	%

The components of deferred tax assets and deferred tax liabilities at December 31, 2009 and 2008 are as follows:


	2009		2008

Deferred tax assets:
Allowance for loan losses	$	5,770,654	$	4,939,953
Nonaccrual loan interest		710,918		270,265
Core deposit intangible		804,457		697,040
Goodwill		3,621,401		3,979,134
Deferred compensation		68,543		142,715
Other		795,133		1,105,844

Total deferred tax assets		11,771,106		11,134,951

Deferred tax liabilities:
Premises and equipment		756,632		855,698
Mortgage servicing rights		585,215		176,175
FHLB stock dividend		102,921		102,921
Available-for-sale securities		904,038		1,317,944
Pension		208,839		139,083
Other		16,230		34,895

Total deferred tax liabilities		2,573,875		2,626,716

Net deferred tax asset	$	9,197,231	$	8,508,235

The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these temporary differences at December 31, 2009 and, therefore, has not established a valuation reserve.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

		At December 31, 2009, the accumulation of prior years’ earnings representing tax bad debt deductions of the Bank was $2,931,503. If these tax bad debt reserves were charged for losses other than bad debt losses, the Bank would be required to recognize taxable income in the amount of the charge. It is not contemplated that such tax-restricted retained earnings will be used in a manner that would create federal income tax liabilities.

		On January 1, 2007, the Company adopted the recognition and disclosure provision the FASB Interpretation No. 48, which was subsequently incorporated into ASC Topic 740,Income Taxes,which addresses the accounting for uncertain tax positions.

		At December 31, 2009, the Company had $365,000 of gross unrecognized tax benefits that if recognized would affect the effective tax rate. The Company believes that during 2010 it is reasonably possible that there would be a reduction of $222,000 in gross unrecognized tax benefits as a result of the lapse of statute of limitations for the 2006 tax year.

		At December 31, 2009, total interest was approximately $94,000. A reconciliation of the beginning and ending amount of the unrecognized tax benefits is as follows:


	2009			2008			2007

Unrecognized tax benefits as of January 1,	$	748,942		$	956,577		$	1,015,361
Gross amounts of the increases and decreases in unrecognized tax benefits as a result of tax positions taken during prior years		—			—			(164,793	)
Gross amounts of the increases and decreases in unrecognized tax benefits as a result of tax positions taken during year		—			—			340,351
The amount of decreases in unrecognized tax benefits relating to settlements with taxing authorities		—			—			—
Reductions to unrecognized benefits as a result of a lapse of the applicable statute of limitations		(186,866	)		(207,635	)		(234,342	)

Unrecognized tax benefits as of December 31,	$	562,076		$	748,942		$	956,577

(13)

Employee Benefit Plans

Employee benefits charged to operating expenses are summarized in the table below.


	2009		2008		2007

Payroll taxes	$	1,096,793	$	1,119,073	$	1,399,321
Medical plans		1,494,166		1,466,232		1,245,059
401k match		306,042		294,098		—
Pension plan		890,692		854,407		837,288
Profit-sharing		282,904		205,515		757,561
Other		133,803		211,501		232,929

Total employee benefits	$	4,204,400	$	4,150,826	$	4,472,158

Prior to 2008, the Company provided a non-contributory profit-sharing plan which covered all full-time employees. Beginning in 2008, the Company’s profit-sharing plan was amended to include a matching

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

401k portion, in which the Company matches the first 3% of eligible employee contributions. The Company made annual contributions in an amount up to 6% of income before income taxes and before contributions to the profit-sharing and pension plans for all participants, limited to the maximum amount deductible for Federal income tax purposes, for each of the years shown. In addition, employees were able to make additional tax-deferred contributions.

Pension

The Company also provides a noncontributory defined benefit pension plan for all full-time employees.

An employer is required to recognize the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Under the Company’s funding policy for the defined benefit pension plan, contributions are made to a trust as necessary to provide for current service and for any unfunded accrued actuarial liabilities over a reasonable period. To the extent that these requirements are fully covered by assets in the trust, a contribution might not be made in a particular year. The Company made a $1,000,000 contribution to the defined benefit plan in 2009, and the minimum required contribution for 2010 is estimated to be $864,000. The Company has not determined whether it will make any contributions other than the minimum required funding contribution for 2010.

Obligations and Funded Status At December 31


	2009			2008

Change in projected benefit obligation:
Balance, January 1	$	8,420,847		$	7,293,000
Service cost		850,940			820,401
Interest cost		509,482			452,524
Actuarial loss (gain)		(151,710	)		116,690
Benefits paid		(228,607	)		(261,768	)

Balance, December 31		9,400,952			8,420,847


Change in plan assets:

Fair value, January 1		5,995,985			6,968,205
Actual gain (loss) return on plan assets		1,226,317			(2,210,452	)
Employer contribution		1,000,000			1,500,000
Benefits paid		(228,607	)		(261,768	)

Fair value, December 31		7,993,695			5,995,985


Funded status at end of year	$	(1,407,257	)	$	(2,424,862	)


Accumulated benefit obligation	$	6,918,597		$	6,269,427

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Components of Net Pension Cost and Other Amounts Recognized in Accumulated Other Comprehensive Income

The following items are components of net pension cost for the years ended December 31, 2009, 2008 and 2007:


	2009			2008			2007

Service cost—benefits earned during the year	$	850,940		$	820,401		$	797,675
Interest costs on projected benefit obligations		509,482			452,524			364,406
Expected return on plan assets		(539,283	)		(454,344	)		(385,269	)
Amortization of prior service cost		78,628			78,628			78,628
Amortization of net gains		(9,075	)		(42,802	)		(18,152	)

Net periodic pension expense	$	890,692		$	854,407		$	837,288

Amounts not yet reflected in net periodic benefit cost and included in accumulated other comprehensive income (loss) at December 31, 2009 and 2008 are shown below, including amounts recognized in other comprehensive income during the periods. All amounts are shown on a pre-tax basis.


	2009			2008

Prior service costs	$	(836,068	)	$	(914,696	)
Net accumulated actuarial net loss		(57,326	)		(886,995	)

Accumulated other comprehensive loss		(893,394	)		(1,801,691	)
Cumulative employer contributions in excess of net periodic benefit cost		(513,863	)		(623,171	)

Net amount recognized at December 31, balance sheet	$	(1,407,257	)	$	(2,424,862	)


Net (gain) loss arising during period	$	(838,744	)	$	2,781,486
Prior service cost amortization		(78,628	)		(78,628	)
Amortization of net actuarial gain / (loss)		9,075			42,802

Total recognized in other comprehensive income	$	(908,297	)	$	2,745,660

Total recognized in net periodic pension cost and other comprehensive income	$	(17,605	)	$	3,600,067

The estimated prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into net periodic cost in 2010 is $78,628. For 2010, there is no estimated amount of actuarial gain or loss subject to amortization into net periodic pension cost.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Assumptions utilized to determine benefit obligations as of December 31, 2009, 2008 and 2007 and to determine pension expense for the year then ended are as follows:


	2009			2008			2007

Determination of Benefit obligation at year end:
Discount rate		6.00	%		6.15	%		6.25	%
Annual rate of compensation increase		4.50	%		4.50	%		4.50	%

Determination of Pension expense for year ended:
Discount rate for the service cost		6.00	%		6.25	%		5.50	%
Annual rate of compensation increase		4.50	%		4.50	%		4.50	%
Expected long-term rate of return on plan assets		7.00	%		7.00	%		7.00	%

The assumed overall expected long-term rate of return on pension plan assets used in calculating 2009 pension expense was 7%. Determination of the plan’s rate of return is based upon historical returns for equities and fixed income indexes. During the past five years the Company’s plan assets have experienced the following annual returns: 22.0% in 2009, (32.6)% in 2008, 7.4% in 2007, 14.4% in 2006, and 8.3% in 2005. The rate used in plan calculations may be adjusted by management for current trends in the economic environment. With a traditional investment mix of over half of the plan’s investments in equities, the actual return for any one plan year may fluctuate significantly with changes in the stock market. Due to a decline in the economy and a decrease in discount rates used in the actuarial calculation of plan income, the Company expects to incur $865,000 expense in 2010 compared to $891,000 in 2009.

Plan Assets

The investment policy of the pension plan is designed for growth in value while minimizing risk to the overall portfolio. The Company diversifies the assets through investments in domestic and international fixed income securities and domestic and international equity securities. The assets are readily marketable and can be sold to fund benefit payment obligations as they become payable. The Company’s long-term investment target mix for the plan is 70% equity securities and 30% fixed income. As noted in the table below, cash equivalents were more heavily weighted due to a large contribution at the end of 2008 that was in the process of being invested. The Company regularly reviews its policies on the investment mix and may make changes depending on economic conditions and perceived investment mix.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

The fair value of the Company’s pension plan assets at December 31, 2009 by asset category are as follows:


			Fair Value Measurements
			At December 31, 2009 Using
			Quoted Prices
			in Active
			Markets for		Other		Significant
	Fair Value		Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
Description	2009		(Level 1)		(Level 2)		(Level 3)

Cash equivalents	$	790,415	$	790,415	$	—	$	—
Equity securities:
U.S. large-cap (a)		3,222,262		3,222,262		—		—
U.S. mid-cap (b)		418,330		418,330		—		—
U.S. small-cap (c)		509,926		509,926		—		—
International (d)		1,154,615		1,154,615		—		—
Fixed income securities:
U.S. Govt Agency Obligations (e)		1,123,535		—		1,123,535		—
Corporate investment grade (e)		530,042		—		530,042		—
Corporate non-investment grade (e) (f)		244,570		—		244,570		—

Total	$	7,993,695	$	6,095,548	$	1,898,147	$	—


(a)		This category comprises low-cost equity index funds not actively managed that track the S&P 500.

(b)		This category comprises low-cost equity index funds not actively managed that track the MSCI U.S. mid-cap 450.

(c)		This comprises actively managed mutual funds.

(d)		37% of this category comprises low-cost equity index funds not actively managed that track the MSCI EAFE.

(e)		This category comprise individual bonds.

(f)		24% of this category is comprised of non-rated bonds.

The following future benefit payments are expected to be paid:


Year	Pension benefits

2010	$	270,952
2011		306,759
2012		307,195
2013		313,368
2014		376,464
2015 to 2019		2,122,566

(14)

Stock Compensation

The Company’s stock option plan provides for the grant of options to purchase up to 468,000 shares of the Company’s common stock to officers and other key employees of the Company and its subsidiaries. All options have been granted at exercise prices equal to fair value and vest over periods ranging from four to five years, except 4,821 options issued in 2002, and 9,519 options issued in 2008 to acquire shares that vested immediately.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

The following table summarizes the Company’s stock option activity:


										Weighted average
	Number of shares									exercise price
	December 31									December 31
	2009			2008			2007			2009		2008		2007

Outstanding, beginning of year		277,454			252,644			213,258		$	25.10	$	26.18	$	24.72
Granted		—			39,027			50,016			—		20.20		32.21
Exercised		—			—			(4,835	)		—		—		20.78
Forfeited		(1,488	)		(14,217	)		—			30.22		—		—
Canceled		—			—			(5,795	)		—		30.86		29.07

Outstanding, end of year		275,966			277,454			252,644		$	25.07	$	25.10	$	26.18

Exercisable, end of year		215,712			189,977			145,774		$	24.70	$	24.24	$	22.77

Amounts shown in table have been adjusted for the 4% stock dividend issued on July 1, 2009.

Options outstanding at December 31, 2009 had a weighted average remaining contractual life of approximately five years and no intrinsic value. Options outstanding at December 31, 2008 had a remaining contractual life of approximately six years and an intrinsic value of $35,000. No stock options were granted during 2009.

Options exercisable at December 31, 2009 had a weighted average remaining contractual life of approximately four years and no intrinsic value. Options exercisable at December 31, 2008 had a weighted average remaining contractual life of approximately five years and an intrinsic value of approximately $35,000. During 2007, 4,835 stock options were exercised. No stock options were exercised during 2009 or 2008.

Total stock-based compensation expense for the years ended December 31, 2009, 2008, and 2007 was $130,000, $232,000, and $265,000, respectively. As of December 31, 2009, the total unrecognized compensation expense related to non-vested stock awards was $243,000 and the related weighted average period over which it is expected to be recognized is approximately two years.

The weighted average grant-date fair values of stock options granted during the following years and the weighted average significant assumptions used to determine those fair values, using the Black-Scholes option-pricing model, are as follows:


	2008			2007

Fair value per share at grant date	$	4.53		$	7.13
Significant assumptions:
Risk-free interest rate at grant date		3.14	%		4.49	%
Expected annual rate of quarterly dividends		4.00			2.50
Expected stock price volatility		30			20
Expected life to exercise (years)		6.24			6.25

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

(15)

Preferred Stock

On December 19, 2008, the Company announced its participation in the U.S. Treasury Department’s Capital Purchase Program (CPP) a voluntary program that provides capital to financially healthy banks. This program is designed to attract broad participation by banking institutions to help stabilize the financial system by encouraging lending. The Company has used the funds received, as discussed below, to continue to provide loans to its customers and to look for ways to deploy additional funds to benefit the communities in the Company’s market area.

Participating in this program included the Company’s issuance of 30,255 shares of senior preferred stock (with a par value of $1,000 per share) and a ten year warrant to purchase approximately 255,260 shares of common stock (see below for additional information) to the U.S. Department of Treasury in exchange for $30,255,000. The proceeds received were allocated between the preferred stock and the common stock warrant based upon their relative fair values. This resulted in the recording of a discount on the preferred stock upon issuance that reflects the value allocated to the warrant. The discount on the preferred stock will be accreted over five years, consistent with managements’ estimate of the life of the preferred stock. Such accretion will be treated as additional dividends on the preferred stock. The allocated carrying values of the senior preferred stock and common stock warrant at December 31, 2009 were $28,365,000 and $2,382,000, respectively.

The preferred shares carry a 5% cumulative dividend for the first five years and 9% thereafter if not redeemed. The preferred shares are redeemable after three years at par plus accrued dividends, or before three years if the Company raises Tier 1 capital in an amount equal to the preferred stock issued. The preferred stock generally does not have any voting rights, subject to an exception in the event the Company fails to pay dividends on the preferred stock for six or more quarterly periods, whether or not consecutive. Under such circumstances, the Treasury will be entitled to vote to elect two directors to the board until all unpaid dividends have been paid or declared and set apart for payment. The Company is prohibited from paying any dividends with respect to shares of common stock unless all accrued and unpaid dividends are paid in full on the senior preferred stock for all past dividend periods. The Treasury Department may also transfer the senior preferred stock to a third party at any time.

The common stock warrant is exercisable immediately with a ten year term, in whole or in part, at an exercise price of $17.78 per share.

Assumptions were used in estimating the fair value of common stock warrant on the date of its issuance. The weighted average expected life of the common stock warrant represents the period of time that common stock warrant is expected to be outstanding. The-risk free interest rate is based on the U.S. Treasury yield curve in effect at the time of issuance. The expected volatility is based on the average expected life the warrant. The following assumptions were used in estimating the fair value for the common stock warrant using the Black-Scholes option-pricing model:

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007



Fair value per warrant at issue date	$	7.02
Significant assumptions:
Risk-free interest rate at issue date		2.29	%
Expected stock price volatility		33.9
Expected life to exercise (years)		10.00

The accounting for preferred stock and warrant is classified as stockholders’ equity in the consolidated balance sheet and qualifies, for regulatory capital purposes, as Tier I capital. For the year ended December 31, 2009, the Company had declared $1,516,000 of dividends and amortized $476,000 of accretion of the discount on preferred stock. Through December 31, 2009, the Company had paid dividends in the amount of $1,370,000 on the preferred stock.

As of December 31, 2009, $18,000,000 of the CPP proceeds have been used to capitalize a newly formed subsidiary, Hawthorn Real Estate, LLC, established to hold workout assets purchased from the Company’s subsidiary bank, Hawthorn Bank. Hawthorn Real Estate, LLC. purchased workout loans and other real estate owned properties from the Bank. The $12,255,000 balance of the CPP funds continues to be held in the Company’s interest bearing account at the Bank.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

(16) Condensed Financial Information of the Parent Company Only

Following are the condensed financial statements of Hawthorn Bancshares, Inc. (Parent only) as of and for the years indicated:

Condensed Balance Sheets


	December 31,
	2009		2008

Assets
Cash and due from bank subsidiaries	$	14,737,805	$	29,968,196
Investment in equity securities		1,486,000		1,486,000
Investment in subsidiaries		142,793,737		127,148,243
Premises and equipment		6,103		7,864
Deferred tax asset		238,049		685,440
Other assets		26,034		336,364

Total assets	$	159,287,728	$	159,632,107


Liabilities and Stockholders’ Equity
Subordinated notes	$	49,486,000	$	49,486,000
Other liabilities		2,030,445		3,727,724
Stockholders’ equity		107,771,283		106,418,383

Total liabilities and stockholders’ equity	$	159,287,728	$	159,632,107

Condensed Statements of Operations


	For the Years Ended December 31,
	2009			2008			2007

Revenue
Interest and dividends received from subsidiaries	$	247,842		$	8,188,422		$	8,086,795
Other		—			—			1,308,622

Total revenue		247,842			8,188,422			9,395,417


Expenses
Interest on subordinated notes		2,446,742			3,046,238			3,617,254
Other		3,057,108			3,564,043			3,692,462

Total expenses		5,503,850			6,610,281			7,309,716

(Loss) income before income tax benefit and equity in undistributed income of subsidiaries		(5,256,008	)		1,578,141			2,085,701
Income tax benefit		1,918,880			1,980,100			1,908,564
Equity in undistributed income (loss) of subsidiaries		8,292,885			(34,185,597	)		3,805,711

Net income (loss)	$	4,955,757		$	(30,627,356	)	$	7,799,976

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Condensed Statements of Cash Flows


	2009			2008				2007

Cash flows from operating activities:
Net income (loss)	$	4,955,757		$	(30,627,356	)		$	7,799,976
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation		3,404			5,242				3,276
Equity in undistributed (income) losses of subsidiaries		(8,292,885	)		34,185,596				(3,805,711	)
Stock based compensation expense		130,459			231,761				264,881
Other, net		10,862			(181,859	)			973,726

Net cash (used in) provided by operating activities		(3,192,403	)		3,613,384				5,236,148


Cash flows from investing activities:
							��
Purchase of premise and equipment		(3,052	)		—				(16,382	)
Proceeds from sale premise and equipment		500			—				—
Investment in subsidiary		(8,000,000	)		(10,000,000	)			—

Net cash used in investing activities		(8,002,552	)		(10,000,000	)			(16,382	)


Cash flows from financing activities:

Proceeds from issuance of preferred stock and warrant		—			30,255,000				—
Proceeds from issuance of treasury stock		—			—				100,427
Purchase of treasury stock		—			(802,445	)			(145,300	)
Cash dividends paid — preferred stock		(1,369,879	)		—				—
Cash dividends paid — common stock		(2,665,557	)		(3,486,415	)			(3,503,575	)

Net cash (used in) provided by financing activities		(4,035,436	)		25,966,140				(3,548,448	)


Net increase (decrease) in cash and due from banks		(15,230,391	)		19,579,524				1,671,318

Cash and due from banks at beginning of year		29,968,196			10,388,672				8,717,354

Cash and due from banks at end of year	$	14,737,805		$	29,968,196			$	10,388,672

During 2007, the Company changed the name of Citizen Union State Bank to Hawthorn Bank, and combined Osage Valley Bank, Bank 10 and Exchange National Bank into Hawthorn Bank. Concurrent with each combination, the underlying bank charters were sold to unrelated third parties for cash. Included in other income for 2007 is a gain from the sales of charters aggregating $1,200,000.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

(17)

Disclosures About Financial Instruments


		The Company issues financial instruments with off-balance-sheet risk in the normal course of business of meeting the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments may involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.

		The Company’s extent of involvement and maximum potential exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for financial instruments included on its consolidated balance sheets. At December 31, 2009, no amounts have been accrued for any estimated losses for these financial instruments.

		The contractual amount of off-balance-sheet financial instruments as of December 31, 2009 and 2008 is as follows:


	2009		2008

Commitments to extend credit	$	131,592,651		143,936,230
Standby letters of credit		2,799,828		5,417,161

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Of the total commitments to extend credit at December 31, 2009, approximately $47,625,000 represents fixed-rate loan commitments. Of the total commitments to extend credit at December 31, 2008, approximately $63,584,000 represents fixed-rate loan commitments. Since certain of the commitments and letters of credit are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, furniture and equipment, and real estate.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support contractual obligations of the Company’s customers. The credit risk involved in issuing letters of credit is essentially the same as the risk involved in extending loans to customers. The approximate remaining term of standby letters of credit range from one month to ten years at December 31, 2009.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

A summary of the carrying amounts and fair values of the Company’s financial instruments at December 31, 2009 and 2008 is as follows:


	2009				2008
	Carrying		Fair		Carrying		Fair
	amount		value		amount		value

Assets:
Loans	$	976,817,458	$	984,305,000	$	996,436,986	$	1,000,594,000
Investment in debt securities		152,926,685		152,926,685		149,400,929		149,400,929
Federal fund sold and securities purchased under agreements to resell		89,752		89,752		104,393		104,393
Cash and due from banks		24,575,943		24,575,943		53,723,075		53,723,075
Mortgage servicing rights		2,020,964		2,904,000		1,171,225		2,455,000
Accrued interest receivable		6,625,557		6,625,557		7,476,093		7,476,093

	$	1,163,056,359	$	1,171,426,937	$	1,208,312,701	$	1,213,753,490

Liabilities:
Deposits:
Demand	$	135,017,639	$	135,017,639	$	125,245,200	$	125,245,200
NOW		139,623,577		139,623,577		123,288,896		123,288,896
Savings		47,637,148		47,637,148		43,370,172		43,370,172
Money market		167,023,279		167,023,279		175,967,634		175,967,634
Time		467,021,154		478,011,000		487,424,487		494,427,000
Federal funds purchased and securities sold under agreements to repurchase		36,645,434		36,645,434		29,138,623		29,138,623
Subordinated notes		49,486,000		18,329,000		49,486,000		35,180,000
Other borrowings		79,317,302		80,557,000		129,057,483		130,454,000
Accrued interest payable		2,438,121		2,438,121		3,847,415		3,847,415

	$	1,124,209,654	$	1,105,282,198	$	1,166,825,910	$	1,160,918,940

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate such value:

Loans

Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type, such as real estate, installment and other consumer, commercial, and bankers’ acceptances. Each loan category is further segmented into fixed and adjustable interest rate terms and by performing and nonperforming categories.

The fair value of loans is estimated based on present values using applicable risk-adjusted spreads to the U. S. Treasury curve to approximate current interest rates applicable to each category of such financial instruments. No adjustment was made to the interest rates for changes in credit risk of performing loans where there are no known credit concerns. Management segregates loans in appropriate risk categories. Management believes that the risk factor embedded in the interest rates along with the allowance for loan losses applicable to the performing loan portfolio results in a fair valuation of such loans. The fair values of impaired loans are generally based on market prices for similar assets determined through independent appraisals or discounted values of independent appraisals and brokers’ opinions of value. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC Topic 820.

Investment in Debt and Equity Securities

Fair values are based on quoted market prices or dealer quotes.

Federal Funds Sold, Cash, and Due from Banks

For federal funds sold, cash, and due from banks, the carrying amount is a reasonable estimate of fair value, as such instruments reprice in a short time period.

Mortgage Servicing Rights

The fair value of mortgage servicing rights is based on the discounted value of contractual cash flows utilizing servicing rate, constant prepayment rate, servicing cost, and discount rate factors.

Accrued Interest Receivable and Payable

For accrued interest receivable and payable, the carrying amount is a reasonable estimate of fair value because of the short maturity for these financial instruments.

Deposits

The fair value of deposits with no stated maturity, such as noninterest-bearing demand, NOW accounts, savings, and money market, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

Securities Sold under Agreements to Repurchase and Interest-bearing Demand Notes to U.S. Treasury

For securities sold under agreements to repurchase and interest-bearing demand notes to U.S. Treasury, the carrying amount is a reasonable estimate of fair value, as such instruments reprice in a short time period.

Other Borrowings

The fair value of other borrowings, which include subordinated notes and Federal Home Loan borrowings, is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for other borrowed money of similar remaining maturities.

Commitments to Extend Credit and Standby Letters of Credit

The fair value of commitments to extend credit and standby letters of credit are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the likelihood of the counterparties drawing on such financial instruments, and the present creditworthiness of such counterparties. The Company believes such commitments have been made on terms, which are competitive in the markets in which it operates.

The fair value estimates provided are made at a point in time based on market information and information about the financial instruments. Because no market exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the fair value estimates.

(18) Litigation

Various legal claims have arisen in the normal course of business, which, in the opinion of management of the Company, will not result in any material liability to the Company.

HAWTHORN BANCSHARES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

(19) Quarterly Financial Information

Year Ended December 31, 2009(unaudited)


										Year
	First		Second		Third		Fourth			to
(In thousands except per share data)	quarter		quarter		quarter		quarter			Date

Interest income	$	16,034	$	16,061	$	15,910	$	15,557		$	63,562
Interest expense		6,504		6,043		5,474		4,953			22,974

Net interest income		9,530		10,018		10,436		10,604			40,588
Provision for loan losses		1,750		1,404		1,250		3,950			8,354
Noninterest income		2,765		2,807		2,601		3,135			11,308
Noninterest expense		8,995		9,661		9,040		9,034			36,730
Income taxes		494		555		840		(33	)		1,856

Net income	$	1,056	$	1,205	$	1,907	$	788		$	4,956

Preferred stock dividends		493		502		497		502			1,994
Net income available to common stockholders	$	563	$	703	$	1,410	$	286		$	2,962


Net income per share:
Basic earnings per share	$	0.13	$	0.16	$	0.33	$	0.07		$	0.69
Diluted earnings per share		0.13		0.16		0.33		0.07			0.69

Year Ended December 31, 2008(unaudited)


										Year
	First		Second		Third		Fourth			to
(In thousands except per share data)	quarter		quarter		quarter		quarter			Date

Interest income	$	18,425	$	17,121	$	17,430	$	16,739		$	69,715
Interest expense		8,881		7,605		7,575		7,538			31,599

Net interest income		9,544		9,516		9,855		9,201			38,116
Provision for loan losses		1,650		1,300		1,000		4,261			8,211
Noninterest income		2,368		2,322		2,321		2,286			9,297
Noninterest expense		8,644		8,626		8,382		50,323			75,975
Income taxes (benefit)		531		595		780		(8,052	)		(6,146	)

Net income (loss)	$	1,087	$	1,317	$	2,014	$	(35,045	)	$	(30,627	)

Preferred stock dividends		—		—		—		66			66
Net income (loss) available to common stockholders	$	1,087	$	1,317	$	2,014	$	(35,111	)	$	(30,693	)


Net income (loss) per share — revised for stock dividend:
Basic earnings (loss) per share	$	0.25	$	0.30	$	0.47	$	(8.16	)	$	(7.10	)
Diluted earnings (loss) per share		0.25		0.30		0.47		(8.16	)		(7.10	)

MARKET PRICE OF AND DIVIDENDS ON EQUITY SECURITIES AND RELATED MATTERS

Market Price. Our Company’s common stock trades on Nasdaq’s global select market under the stock symbol of “HWBK.” Prior to our June 2007 name change, our stock symbol was “EXJF”. The following table sets forth the range of high and low bid prices of our Company’s common stock by quarter for each quarter in 2009 and 2008 in which the stock was traded.


2009	High		Low
First Quarter		11.30		11.30
Second Quarter		9.90		9.90
Third Quarter		9.75		9.38
Fourth Quarter		9.65		9.40


2008	High		Low
First Quarter		29.50		23.78
Second Quarter		28.15		23.75
Third Quarter		26.48		19.27
Fourth Quarter		24.39		14.00

Shares Outstanding. As of March 3, 2010, our Company had issued 4,463,813 shares of common stock, of which 4,301,955 shares were outstanding. The outstanding shares were held of record by approximately 1,483 shareholders. In addition to common stock, our Company has 30,255 shares of cumulative, perpetual preferred stock outstanding. The preferred shares were issued pursuant to the U.S. Treasury’s Capital Purchase Program (or CPP).

Dividends. The following table sets forth information on dividends paid by our Company in 2009 and 2008.


	Dividends
Month Paid	Per Share
January, 2009	$	0.21
April, 2009		0.21
July, 2009		0.11
October, 2009		0.11

Total for 2009	$	0.64


January, 2008	$	0.21
April, 2008		0.21
July, 2008		0.21
October, 2008		0.21

Total for 2008	$	0.84

Our Board of Directors intends that our Company will continue to pay quarterly dividends. The actual amount of quarterly dividends and the payment, as well as the amount, of any special dividend ultimately will depend on the payment of sufficient dividends by our subsidiary Bank to our Company. The payment by our Bank of dividends to our Company will depend upon such factors as our Bank’s financial condition, results of operations and current and anticipated cash needs, including capital requirements. As discussed in Note 6 to our consolidated financial statements, the Bank will be required to receive regulatory approval prior to paying dividends to our Company until such time as the Bank’s unappropriated retained earnings balance is restored to a positive balance. In addition to the above limitations, our ability to pay dividends on our common stock is limited by our participation in the Treasury’s Capital Purchase Program (or CPP). Prior to December 19, 2011, unless we have redeemed the Series A preferred stock issued to the U.S. Treasury in the CPP or the U.S. Treasury has transferred the Series A preferred stock to a third party, we must receive the consent of the U.S. Treasury before we can pay quarterly dividends on our common stock of more than $0.20 per share. Furthermore, if we are not current in the payment of quarterly dividends on the Series A preferred stock, we can not pay dividends on our common stock.

Stock Performance Graph. The following performance graph shows a comparison of cumulative total returns for our Company, the Nasdaq Stock Market (U.S. Companies), and a peer index of financial institutions having total assets of between $1 billion and $5 billion for the period from December 31, 2004, through December 31, 2009. The cumulative total return on investment for each of the periods for our Company, the Nasdaq Stock Market (U.S. Companies) and the peer index is based on the stock price or index at January 1, 2004. The performance graph assumes that the value of an investment in our common stock and each index was $100 at December 31, 2004 and that all dividends were reinvested. The information presented in the performance graph is historical in nature and is not intended to represent or guarantee future returns.

The comparison of cumulative total returns presented in the above graph was plotted using the following index values and common stock price values:


	12/31/04		12/31/05		12/31/06		12/31/07		12/31/08		12/31/09
Hawthorn Bancshares, Inc.	$	100.00	$	105.21	$	115.47	$	94.18	$	67.44	$	40.83	��
Nasdaq Composite (U.S. Companies)	$	100.00	$	101.37	$	111.03	$	121.92	$	72.90	$	104.31
Index of financial institutions ($1 billion to $5 billion)	$	100.00	$	98.29	$	113.74	$	82.85	$	68.72	$	49.26

DIRECTORS AND EXECUTIVE OFFICERS OF OUR COMPANY


Name	Position with Our Company	Position with Subsidiary Bank	Principal Occupation
James E. Smith	Chairman, Chief Executive Officer and Director-Class I	Chairman, Chief Executive Officer, and Director of Hawthorn Bank	Position with Hawthorn Bancshares and Hawthorn Bank

David T. Turner	President and Director-Class III	President of East Region and Director of Hawthorn Bank	Position with Hawthorn Bancshares and Hawthorn Bank

Charles G. Dudenhoeffer, Jr.	Director-Class II	Director of Hawthorn Bank	Retired

Philip D. Freeman	Director-Class I	Director of Hawthorn Bank	Owner/Manager, Freeman Mortuary, Jefferson City, Missouri

Kevin L. Riley	Director-Class III	Director of Hawthorn Bank	Co-owner, Riley Chevrolet, Inc. and Riley Toyota, Scion, Cadillac, Inc., Jefferson City, Missouri

Gus S. Wetzel, II	Director-Class II	Director of Hawthorn Bank	Physician, Wetzel Clinic, Clinton, Missouri

Richard G. Rose	Chief Financial Officer	Senior Vice President and Chief Financial Officer of Hawthorn Bank	Position with Hawthorn Bancshares and Hawthorn Bank

Kathleen L. Bruegenhemke	Senior Vice President, Chief Risk Officer and Corporate Secretary	Senior Vice President and Chief Risk Officer	Position with Hawthorn Bancshares and Hawthorn Bank

ANNUAL REPORT ON FORM 10-K

A copy of our Company’s Annual Report on Form 10-K for the year ended December 31, 2009, as filed with the Securities and Exchange Commission, excluding exhibits, will be furnished without charge to shareholders entitled to vote at the 2010 annual meeting of shareholders upon written request to Kathleen L. Bruegenhemke, Secretary, Hawthorn Bancshares, Inc., 132 East High Street, Jefferson City, Missouri 65101. Our Company will provide a copy of any exhibit to the Form 10-K to any such person upon written request and the payment of our Company’s reasonable expenses in furnishing such exhibits.

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. freshman Avg

Hawthorn Bancshares (HWBK) 10-K2009 FY Annual report

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