Hawthorn Bancshares (HWBK) 10-Q 2021 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

☒   Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2021

OR

☐   Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from ______________ to ______________

Commission file number: 0-23636

HAWTHORN BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Missouri	43-1626350
(State or other jurisdiction of	(I.R.S. Employer Identification No.)
incorporation or organization)

132 East High Street, Box 688, Jefferson City, Missouri 65102

(Address of principal executive offices) (Zip Code)

(573) 761-6100

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report.)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common Stock, $1.00 par value	HWBK	The Nasdaq Stock Market LLC

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

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). ☒ Yes ☐ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ☐	Accelerated filer ☐	Non-accelerated filer☒
Smaller reporting company ☒	Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

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

As of November 4, 2021, the registrant had 6,616,975 shares of common stock, par value $1.00 per share, outstanding.

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

	September 30,		December 31,
(In thousands, except per share data)	2021		2020
	(Unaudited)
ASSETS
Cash and due from banks	$	19,004	$	19,235
Federal funds sold and other interest-bearing deposits		94,262		161,128
Cash and cash equivalents		113,266		180,363
Certificates of deposit in other banks		6,673		9,376
Available-for-sale debt securities, at fair value		278,528		198,030
Other investments		6,015		6,353
Total investment securities		284,543		204,383
Loans held for investment		1,282,820		1,286,967
Allowance for loan losses		(18,929)		(18,113)
Net loans		1,263,891		1,268,854
Loans held for sale, at lower of cost or fair value		4,576		5,099
Premises and equipment - net		33,163		34,561
Mortgage servicing rights, at fair value		2,718		2,445
Other real estate owned - net		11,614		12,291
Accrued interest receivable		7,568		6,640
Cash surrender value - life insurance		2,495		2,451
Other assets		8,145		7,268
Total assets	$	1,738,652	$	1,733,731
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Non-interest bearing demand	$	461,626	$	382,492
Savings, interest checking and money market		693,065		723,808
Time deposits $250,000 and over		77,113		91,263
Other time deposits		179,255		186,043
Total deposits		1,411,059		1,383,606
Federal funds purchased and securities sold under agreements to repurchase		27,443		45,154
Federal Home Loan Bank advances and other borrowings		93,493		106,674
Subordinated notes		49,486		49,486
Operating lease liabilities		1,910		2,137
Accrued interest payable		308		837
Other liabilities		15,859		15,248
Total liabilities		1,599,558		1,603,142
Stockholders’ equity:
Common stock, $1 par value, authorized 15,000,000 shares; issued 7,023,821 and 6,769,322 shares, respectively		7,024		6,769
Surplus		64,437		59,307
Retained earnings		77,303		68,935
Accumulated other comprehensive (loss) income, net of tax		(1,572)		1,528
Treasury stock; 406,846, and 289,214 shares, at cost, respectively		(8,098)		(5,950)
Total stockholders’ equity		139,094		130,589
Total liabilities and stockholders’ equity	$	1,738,652	$	1,733,731

See accompanying notes to the consolidated financial statements (unaudited).

2

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income (unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands, except per share amounts)	2021		2020		2021		2020
INTEREST INCOME
Interest and fees on loans	$	15,448	$	14,777	$	44,311	$	43,735
Interest and fees on loans held for sale		24		41		79		96
Interest on investment securities:
Taxable		680		781		2,058		2,367
Nontaxable		493		173		1,114		489
Federal funds sold, other interest-bearing deposits, and certificates of deposit in other banks		78		111		268		553
Dividends on other investments		81		75		246		247
Total interest income		16,804		15,958		48,076		47,487
INTEREST EXPENSE
Interest on deposits:
Savings, interest checking and money market		280		310		865		1,546
Time deposit accounts $250,000 and over		117		327		473		1,089
Time deposits		320		623		1,139		2,067
Total interest expense on deposits		717		1,260		2,477		4,702
Interest on federal funds purchased and securities sold under agreements to repurchase		19		25		72		121
Interest on Federal Home Loan Bank advances		383		505		1,164		1,749
Interest on subordinated notes		305		326		921		1,208
Total interest expense on borrowings		707		856		2,157		3,078
Total interest expense		1,424		2,116		4,634		7,780
Net interest income		15,380		13,842		43,442		39,707
Provision for loan losses		300		1,200		700		5,400
Net interest income after provision for loan losses		15,080		12,642		42,742		34,307
NON-INTEREST INCOME
Service charges and other fees		782		816		2,285		2,181
Bank card income and fees		1,043		846		2,925		2,351
Trust department income		308		263		910		920
Real estate servicing fees, net		71		54		495		(48)
Gain on sale of mortgage loans, net		1,369		3,026		5,881		4,369
Other		102		114		211		493
Total non-interest income		3,675		5,119		12,707		10,266
Investment securities gains, net		126		12		140		18
NON-INTEREST EXPENSE
Salaries and employee benefits		6,665		6,771		20,765		19,404
Occupancy expense, net		808		781		2,298		2,303
Furniture and equipment expense		787		745		2,284		2,259
Processing, network, and bank card expense		1,288		877		3,521		2,807
Legal, examination, and professional fees		357		381		1,146		1,155
Advertising and promotion		310		316		862		786
Postage, printing, and supplies		218		227		608		661
Loan expense		209		360		612		786
Other		1,026		1,202		2,992		3,260
Total non-interest expense		11,668		11,660		35,088		33,421
Income before income taxes		7,213		6,113		20,501		11,170
Income tax expense		1,417		1,153		3,974		2,060
Net income	$	5,796		4,960	$	16,527	$	9,110
Basic earnings per share	$	0.88	$	0.74	$	2.50	$	1.35
Diluted earnings per share	$	0.88	$	0.74	$	2.50	$	1.35

See accompanying notes to the consolidated financial statements (unaudited).

3

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands)	2021		2020		2021		2020
Net income	$	5,796	$	4,960	$	16,527	$	9,110
Other comprehensive (loss) income, net of tax
Investment securities available-for-sale:
Change in unrealized (losses) gains on investment securities available-for-sale, net of tax		(2,192)		218		(3,222)		3,290
Adjustment for gains on sale of investment securities, net of tax		(93)		(10)		(95)		(15)
Defined benefit pension plans:
Amortization of prior service cost included in net periodic pension cost, net of tax		72		43		217		127
Total other comprehensive (loss) income		(2,213)		251		(3,100)		3,402
Total comprehensive income	$	3,583	$	5,211	$	13,427	$	12,512

See accompanying notes to the consolidated financial statements (unaudited).

4

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity (unaudited)

	The three months ended September 30, 2021 and 2020
							Accumulated				Total
							Other				Stock -
	Common				Retained		Comprehensive		Treasury		holders'
(In thousands)	Stock		Surplus		Earnings		Income (Loss)		Stock		Equity
Balance, June 30, 2021	$	6,769	$	64,692	$	72,499	$	641	$	(8,098)	$	136,503
Net income		0		0		5,796		0		0		5,796
Other comprehensive loss		0		0		0		(2,213)		0		(2,213)
Stock dividend		255		(255)		0		0		0		0
Cash dividends declared, common stock ($0.15 per share)		0		0		(992)		0		0		(992)
Balance, September 30, 2021	$	7,024	$	64,437	$	77,303	$	(1,572)	$	(8,098)	$	139,094
Balance, June 30, 2020	$	6,520	$	59,556	$	60,412	$	(604)	$	(5,853)	$	120,031
Net income		0		0		4,960		0		0		4,960
Other comprehensive income		0		0		0		251		0		251
Purchase of treasury stock		0		0		0		0		(97)		(97)
Stock dividend		249		(249)		0		0		0		0
Cash dividends declared, common stock ($0.12 per share)		0		0		(778)		0		0		(778)
Balance, September 30, 2020	$	6,769	$	59,307	$	64,594	$	(353)	$	(5,950)	$	124,367
	The nine months ended September 30, 2021 and 2020
							Accumulated				Total
							Other				Stock -
	Common				Retained		Comprehensive		Treasury		holders'
(In thousands)	Stock		Surplus		Earnings		Income (Loss)		Stock		Equity
Balance, December 31, 2020	$	6,769	$	59,307	$	68,935	$	1,528	$	(5,950)	$	130,589
Net income		0		0		16,527		0		0		16,527
Other comprehensive loss		0		0		0		(3,100)		0		(3,100)
Purchase of treasury stock		0		0		0		0		(2,148)		(2,148)
Stock dividend		255		5,130		(5,385)		0		0		0
Cash dividends declared, common stock ($0.43 per share)		0		0		(2,774)		0		0		(2,774)
Balance, September 30, 2021	$	7,024	$	64,437	$	77,303	$	(1,572)	$	(8,098)	$	139,094
Balance, December 31, 2019	$	6,520	$	55,727	$	61,590	$	(3,755)	$	(5,044)	$	115,038
Net income		0		0		9,110		0		0		9,110
Other comprehensive income		0		0		0		3,402		0		3,402
Purchase of treasury stock		0		0		0		0		(906)		(906)
Stock dividend		249		3,580		(3,829)		0		0		0
Cash dividends declared, common stock ($0.36 per share)		0		0		(2,277)		0		0		(2,277)
Balance, September 30, 2020	$	6,769	$	59,307	$	64,594	$	(353)	$	(5,950)	$	124,367

See accompanying notes to the consolidated financial statements (unaudited).

5

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)

	Nine Months Ended September 30,
(In thousands)	2021		2020
Cash flows from operating activities:
Net income	$	16,527	$	9,110
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		700		5,400
Depreciation expense		1,727		1,687
Net amortization of investment securities, premiums, and discounts		1,337		1,089
Change in fair value of mortgage servicing rights		86		686
Investment securities gains, net		(140)		(18)
Losses (gains) on sales and dispositions of premises and equipment		8		(87)
Gain on sales and dispositions of other real estate		(25)		(219)
Provision for other real estate owned		97		(3)
Increase in accrued interest receivable		(928)		(1,760)
Increase in cash surrender value - life insurance		(44)		(40)
Decrease in other assets		694		475
Decrease in operating lease liabilities		(227)		(188)
Decrease in accrued interest payable		(529)		(250)
Increase in other liabilities		64		1,986
Origination of mortgage loans held for sale		(161,244)		(136,249)
Proceeds from the sale of mortgage loans held for sale		167,648		133,160
Gain on sale of mortgage loans, net		(5,881)		(4,369)
Other, net		(359)		(531)
Net cash provided by operating activities		19,511		9,879
Cash flows from investing activities:
Purchase of certificates of deposit in other banks		(245)		(735)
Proceeds from maturities of certificates of deposit in other banks		2,957		1,723
Net decrease (increase) in loans		4,121		(110,554)
Purchase of available-for-sale debt securities		(136,686)		(72,050)
Proceeds from maturities of available-for-sale debt securities		30,658		40,096
Proceeds from calls of available-for-sale debt securities		14,685		18,685
Proceeds from sales of available-for-sale debt securities		5,420		4,715
Purchases of FHLB stock		(330)		(1,891)
Proceeds from sales of FHLB stock		688		1,246
Purchases of premises and equipment		(425)		(1,246)
Proceeds from sales of premises and equipment		13		162
Proceeds from sales of other real estate and repossessed assets		747		209
Net cash used in investing activities		(78,397)		(119,640)
Cash flows from financing activities:
Net increase in demand deposits		79,134		111,188
Net (decrease) increase in interest-bearing transaction accounts		(30,743)		51,020
Net decrease in time deposits		(20,938)		(21,977)
Net (decrease) increase in federal funds purchased and securities sold under agreements to repurchase		(17,711)		8,133
Repayment of FHLB advances and other borrowings		(13,181)		(53,176)
FHLB advances		0		69,000
Purchase of treasury stock		(2,148)		(906)
Cash dividends paid - common stock		(2,624)		(2,252)
Net cash (used in) provided by financing activities		(8,211)		161,030
Net (decrease) increase in cash and cash equivalents		(67,097)		51,269
Cash and cash equivalents, beginning of period		180,363		78,121
Cash and cash equivalents, end of period	$	113,266	$	129,390
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	5,163	$	8,029
Income taxes	$	4,729	$	797
Noncash investing and financing activities:
Other real estate and repossessed assets acquired in settlement of loans	$	142	$	73
Stock dividends	$	5,385	$	3,829

See accompanying notes to the consolidated financial statements (unaudited).

6

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(1)   Summary of Significant Accounting Policies

Hawthorn Bancshares, Inc. (the Company) through its subsidiary, Hawthorn Bank (the Bank), provides a broad range of banking services to individual and corporate customers located within the Missouri communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, St. Louis, and the greater Kansas City metropolitan area. 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 accompanying unaudited consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and disclosures required by U.S. GAAP for complete financial statements and should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.

The preparation of the consolidated financial statements includes all adjustments that, in the opinion of management, are necessary in order to make those statements not misleading. Management is required 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. These estimates and assumptions are subject to many risks and uncertainties, including changes in interest rates and other general economic, business and political conditions, including the effects of the novel coronavirus (COVID-19) pandemic or any resurgence thereof, including its potential effects on the economic environment, the Company's customers and operations, as well as any changes to federal, state and local government laws, regulations and orders in connection with the pandemic. 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.

Stock Dividend On July 1, 2021, the Company paid a special stock dividend of 4 percent to shareholders of record at the close of business on June 15, 2021. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

Operating, Accounting and Reporting Considerations related to COVID-19

The COVID-19 pandemic has negatively impacted the global economy, including the United States. In response to this crisis, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed by Congress and signed into law on March 27, 2020. The CARES Act, along with subsequent relief programs, provided substantial funding to fight the COVID-19 pandemic and stimulate the economy by supporting individuals and businesses through loans, grants, tax changes, and other types of relief.  See Note 2 Loans and Leases and the Allowance for Credit Losses for more information.

7

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(2)   Loans and Allowance for Loan Losses

Loans

Major classifications within the Company’s held for investment loan portfolio at September 30, 2021 and December 31, 2020 is as follows:

	September 30,		December 31,
(in thousands)	2021		2020
Commercial, financial, and agricultural (a)	$	232,532	$	272,918
Real estate construction − residential		33,514		29,692
Real estate construction − commercial		72,031		78,144
Real estate mortgage − residential		273,768		262,339
Real estate mortgage − commercial		647,043		617,133
Installment and other consumer		23,932		26,741
Total loans held for investment	$	1,282,820	$	1,286,967

(a) Includes $26.0 million and $63.3 million of SBA PPP loans, net as of September 30, 2021 and December 31, 2020, respectively.

The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the Missouri communities surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, St. Louis, and the greater Kansas City metropolitan area. 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 automotive vehicles. At September 30, 2021, loans of $556.0 million were pledged to the Federal Home Loan Bank (FHLB) as collateral for borrowings and letters of credit.

Allowance for Loan Losses

The following table illustrates the changes in the allowance for loan losses by portfolio segment:

	Three Months Ended September 30, 2021
	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, &		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
Balance at beginning of period	$	5,336	$	251	$	495	$	2,467	$	9,915	$	252	$	19	$	18,735
Additions:
Provision for loan losses		(609)		(16)		(70)		216		780		59		(60)		300
Deductions:
Loans charged off		45		—		—		18		15		78		—		156
Less recoveries on loans		(19)		—		—		(8)		(1)		(22)		—		(50)
Net loan charge-offs (recoveries)		26		—		—		10		14		56		—		106
Balance at end of period	$	4,701	$	235	$	425	$	2,673	$	10,681	$	255	$	(41)	$	18,929

	Three Months Ended September 30, 2020
	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, &		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
Balance at beginning of period	$	3,614	$	171	$	722	$	2,711	$	9,048	$	306	$	50	$	16,622
Additions:
Provision for loan losses		178		49		100		577		218		58		20		1,200
Deductions:
Loans charged off		46		—		—		—		13		42		—		101
Less recoveries on loans		(11)		(13)		—		(4)		—		(15)		—		(43)
Net loan charge-offs (recoveries)		35		(13)		—		(4)		13		27		—		58
Balance at end of period	$	3,757	$	233	$	822	$	3,292	$	9,253	$	337	$	70	$	17,764

8

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

	Nine Months Ended September 30, 2021
	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, &		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
Balance at beginning of period	$	5,121	$	213	$	475	$	2,679	$	9,354	$	264	$	7	$	18,113
Additions:
Provision for loan losses		(522)		9		(50)		(167)		1,368		110		(48)		700
Deductions:														��
Loans charged off		100		—		—		22		42		181		—		345
Less recoveries on loans		(202)		(13)		—		(183)		(1)		(62)		—		(461)
Net loan charge-offs (recoveries)		(102)		(13)		—		(161)		41		119		—		(116)
Balance at end of period	$	4,701	$	235	$	425	$	2,673	$	10,681	$	255	$	(41)	$	18,929

	Nine Months Ended September 30, 2020
	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, &		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
Balance at beginning of period	$	2,918	$	64	$	369	$	2,118	$	6,547	$	381	$	80	$	12,477
Additions:
Provision for loan losses		867		125		453		1,186		2,740		39		(10)		5,400
Deductions:
Loans charged off		130		—		—		52		37		133		—		352
Less recoveries on loans		(102)		(44)		—		(40)		(3)		(50)		—		(239)
Net loan charge-offs (recoveries)		28		(44)		—		12		34		83		—		113
Balance at end of period	$	3,757	$	233	$	822	$	3,292	$	9,253	$	337	$	70	$	17,764

Loans, or portions of loans, are charged off to the extent deemed uncollectible or a loss is confirmed. Loan charge-offs reduce the allowance for loan losses, and recoveries of loans previously charged off are added back to the allowance. 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. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration.

These historical loss rates for each risk group are used as the starting point to determine loss rates for measurement purposes. The historical loan loss rates are multiplied by loss emergence periods (LEP) which represent the estimated time period between a borrower first experiencing financial difficulty and the recognition of a loss. Management's look-back period began with loss history in the first quarter 2012 as the starting point through the current quarter and it will continue to include this starting point going forward. The look-back period will continue to be evaluated and will be adjusted once a sustained loss producing downturn is recognized and found to be representative of historical losses expected for the current portfolio.

The Company’s methodology includes qualitative risk factors that allow management to adjust its estimates of losses based on the most recent information available and to address other limitations in the quantitative component that is based on historical loss rates. Such risk factors are generally reviewed and updated quarterly, as appropriate, and are adjusted to reflect changes in national and local economic conditions and developments, the nature, volume and terms of loans in the portfolio, including changes in volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified or graded loans, loan concentrations, assessment of trends in collateral values,

9

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

assessment of changes in the quality of the Company’s internal loan review department, and changes in lending policies and procedures, including underwriting standards and collections, charge-off and recovery practices.

When the COVID-19 pandemic surfaced in the first quarter of 2020, management reassessed the calculation of the allowance for loan loss by increasing the economic qualitative factor in order to capture the impact on the credit risk present in the loan portfolio given the economic environment that existed at that time. As of the fourth quarter of 2020, management reassessed the qualitative factor and economic indicators. Enough time had passed so that data after the outbreak was available to provide a better interpretation of the impact of the virus on the economy. Management determined that the local market and economy had been able to transition to a functional level while adapting to the new requirements aimed at stopping the spread of the virus and returned to calculating the qualitative adjustment according to the Company's methodology detailed above.

Additionally, the funding of $88.4 million and $47.5 million in SBA PPP loans during 2020 and 2021, respectively, required management to assess the methodology that would be adopted in regard to the allowance for loan losses applicable to these loans. As the SBA PPP loans are expected to be mostly paid off in the next three to six months and carry a 100% credit guarantee from the SBA, management determined that 0 allowance for loan losses was deemed necessary for these loans. At September 30, 2021, the net balance of the PPP loans totaled $26.0 million.

All SBA PPP loans have a 1% interest rate and the Company earns a fee that is based upon a tiered schedule corresponding with the amount of the loan to the borrower, which is deferred and recognized over the life of the loan. The PPP loan may be forgiven by SBA if the borrower meets certain criteria as defined by the CARES Act. The Company reports these loans at their principal amount outstanding, net of unearned income, unamortized deferred loan fee income and loan origination costs. Interest is accrued as earned and loan origination fees and direct costs are deferred and accreted or amortized into interest income, as an adjustment to the yield, over the life of the loan using the level yield method. When a PPP loan is paid off or forgiven by the SBA, the remaining unaccreted or unamortized net origination fees or costs are immediately recognized into income.

10

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The following table illustrates the allowance for loan losses and recorded investment by portfolio segment:

	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, and		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
September 30, 2021
Allowance for loan losses:
Individually evaluated for impairment	$	2,154	$	0	$	14	$	201	$	2,556	$	7	$	0	$	4,932
Collectively evaluated for impairment		2,547		235		411		2,472		8,125		248		(41)		13,997
Total	$	4,701	$	235	$	425	$	2,673	$	10,681	$	255	$	(41)	$	18,929
Loans outstanding:
Individually evaluated for impairment	$	6,565	$	0	$	108	$	2,743	$	25,272	$	58	$	0	$	34,746
Collectively evaluated for impairment		225,967		33,514		71,923		271,025		621,771		23,874		0		1,248,074
Total	$	232,532	$	33,514	$	72,031	$	273,768	$	647,043	$	23,932	$	0	$	1,282,820
December 31, 2020
Allowance for loan losses:
Individually evaluated for impairment	$	2,187	$	27	$	28	$	263	$	2,594	$	14	$	0	$	5,113
Collectively evaluated for impairment		2,934		186		447		2,416		6,760		250		7		13,000
Total	$	5,121	$	213	$	475	$	2,679	$	9,354	$	264	$	7	$	18,113
Loans outstanding:
Individually evaluated for impairment	$	7,552	$	192	$	200	$	3,626	$	25,657	$	108	$	0	$	37,335
Collectively evaluated for impairment		265,366		29,500		77,944		258,713		591,476		26,633		0		1,249,632
Total	$	272,918	$	29,692	$	78,144	$	262,339	$	617,133	$	26,741	$	0	$	1,286,967

Impaired Loans

Loans evaluated under Accounting Standards Codification (ASC) 310-10-35 include loans which are individually evaluated for impairment. All other loans are collectively evaluated for impairment under ASC 450-20. Impaired loans individually evaluated for impairment totaled $34.7 million and $37.3 million at September 30, 2021 and December 31, 2020, respectively, and are comprised of loans on non-accrual status and loans which have been classified as troubled debt restructuring (TDRs).

The net carrying value of impaired loans is based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. At September 30, 2021, $31.2 million of impaired loans were evaluated based on the fair value less estimated selling costs of the loans' collateral compared to $32.2 million at December 31, 2020. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2021, $4.9 million of the Company’s allowance for loan losses was allocated to impaired loans totaling $34.7 million compared to $5.1 million of the Company’s allowance for loan losses allocated to impaired loans totaling approximately $37.3 million at December 31, 2020. Management determined that $11.9 million, or 34%, of total impaired loans required no reserve allocation at September 30, 2021 compared to $11.9 million, or 32%, at December 31, 2020, primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

The categories of impaired loans at September 30, 2021 and December 31, 2020 are as follows:

	September 30,		December 31,
(in thousands)	2021		2020
Non-accrual loans	$	32,835	$	34,559
Performing TDRs		1,911		2,776
Total impaired loans	$	34,746	$	37,335

11

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The following tables provide additional information about impaired loans at September 30, 2021 and December 31, 2020, respectively, segregated between loans for which an allowance has been provided and loans for which no allowance has been provided.

			Unpaid
	Recorded		Principal		Specific
(in thousands)	Investment		Balance		Reserves
September 30, 2021
With no related allowance recorded:
Commercial, financial and agricultural	$	1,451	$	1,500	$	—
Real estate mortgage − residential		1,106		1,219		—
Real estate mortgage − commercial		9,311		9,433		—
Total	$	11,868	$	12,152	$	—
With an allowance recorded:
Commercial, financial and agricultural	$	5,114	$	5,324	$	2,154
Real estate construction − commercial		108		140		14
Real estate mortgage − residential		1,637		2,039		201
Real estate mortgage − commercial		15,961		16,242		2,556
Installment and other consumer		58		60		7
Total	$	22,878	$	23,805	$	4,932
Total impaired loans	$	34,746	$	35,957	$	4,932

			Unpaid
	Recorded		Principal		Specific
(in thousands)	Investment		Balance		Reserves
December 31, 2020
With no related allowance recorded:
Commercial, financial and agricultural	$	1,703	$	1,731	$	—
Real estate mortgage − residential		1,300		1,395		—
Real estate mortgage − commercial		8,943		8,943		—
Total	$	11,946	$	12,069	$	—
With an allowance recorded:
Commercial, financial and agricultural	$	5,849	$	6,180	$	2,187
Real estate construction − residential		192		192		27
Real estate construction − commercial		200		251		28
Real estate mortgage − residential		2,326		2,786		263
Real estate mortgage − commercial		16,714		16,787		2,594
Installment and other consumer		108		112		14
Total	$	25,389	$	26,308	$	5,113
Total impaired loans	$	37,335	$	38,377	$	5,113

12

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The following table presents by class, information related to the average recorded investment and interest income recognized on impaired loans during the periods indicated.

	Three Months Ended September 30,								Nine Months Ended September 30,
	2021				2020				2021				2020
			Interest				Interest				Interest				Interest
	Average		Recognized		Average		Recognized		Average		Recognized		Average		Recognized
	Recorded		For the		Recorded		For the		Recorded		For the		Recorded		For the
(in thousands)	Investment		Period Ended		Investment		Period Ended		Investment		Period Ended		Investment		Period Ended
With no related allowance recorded:
Commercial, financial and agricultural	$	1,517	$	18	$	172	$	128	$	1,703	$	31	$	1,612	$	128
Real estate construction − commercial		0		0		0		0		0		0		179		0
Real estate mortgage − residential		1,131		—		1,414		17		1,238		21		2,101		17
Real estate mortgage − commercial		9,376		—		861		—		9,411		0		870		13
Installment and other consumer		0		0		0		0		0		0		7		0
Total	$	12,024	$	18	$	2,447	$	145	$	12,352	$	52	$	4,769	$	158
With an allowance recorded:
Commercial, financial and agricultural	$	5,295	$	5	$	1,359	$	8	$	5,409	$	19	$	1,237	$	27
Real estate construction − residential		—		—		—		—		63		0		0		0
Real estate construction − commercial		109		—		609		—		139		0		461		0
Real estate mortgage − residential		1,713		16		2,412		—		1,691		26		2,360		36
Real estate mortgage − commercial		16,102		7		1,133		8		16,111		21		984		14
Installment and other consumer		55		—		113		8		63		3		115		7
Total	$	23,274	$	28	$	5,626	$	24	$	23,476	$	69	$	5,157	$	84
Total impaired loans	$	35,298	$	46	$	8,073	$	169	$	35,828	$	121	$	9,926	$	242

The recorded investment varies from the unpaid principal balance primarily due to partial charge-offs taken resulting from current appraisals received. The amount recognized as interest income on impaired loans continuing to accrue interest, primarily related to TDRs, was $46,000 and $121,000 for the three and nine months ended September 30, 2021, respectively, compared to $169,000 and $242,000 for the three and nine months ended September 30, 2020, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during the periods reported.

Delinquent and Non-Accrual Loans

The delinquency status of loans is determined based on the contractual terms of the notes. Borrowers are generally classified as delinquent once payments become 30 days or more past due. The Company’s policy is to discontinue the accrual of interest income on any loan when, in the opinion of management, the ultimate collectability of interest or principal is no longer probable. In general, loans are placed on non-accrual when they become 90 days or more past due. However, management considers many factors before placing a loan on non-accrual, including the delinquency status of the loan, the overall financial condition of the borrower, the progress of management’s collection efforts and the value of the underlying collateral. Subsequent interest payments received on non-accrual loans are applied to principal if any doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis. Non-accrual loans are returned to accrual status when, in the opinion of management, the financial condition of the borrower indicates that the timely collectability of interest and principal is probable and the borrower demonstrates the

13

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

ability to pay under the terms of the note through a sustained period of repayment performance, which is generally six months.

The following table provides aging information for the Company’s past due and non-accrual loans at September 30, 2021 and December 31, 2020.

	Current or				90 Days
	Less Than				Past Due
	30 Days		30 - 89 Days		And Still
(in thousands)	Past Due		Past Due		Accruing		Non-Accrual		Total
September 30, 2021
Commercial, Financial, and Agricultural	$	226,230	$	10	$	0	$	6,292	$	232,532
Real estate construction − residential		33,154		360		0		0		33,514
Real estate construction − commercial		71,923		0		0		108		72,031
Real estate mortgage − residential		272,068		225		0		1,475		273,768
Real estate mortgage − commercial		622,062		41		0		24,940		647,043
Installment and Other Consumer		23,846		66		0		20		23,932
Total	$	1,249,283	$	702	$	0	$	32,835	$	1,282,820
December 31, 2020
Commercial, Financial, and Agricultural	$	265,821	$	380	$	0	$	6,717	$	272,918
Real estate construction − residential		29,500		0		0		192		29,692
Real estate construction − commercial		77,944		0		0		200		78,144
Real estate mortgage − residential		259,688		546		0		2,105		262,339
Real estate mortgage − commercial		591,815	��	4		0		25,314		617,133
Installment and Other Consumer		26,576		117		17		31		26,741
Total	$	1,251,344	$	1,047	$	17	$	34,559	$	1,286,967

The Company's past due and non-accrual loans at September 30, 2021 and December 31, 2020 do not include $11.3 million and $57.1 million of loans accepting forbearance under the CARES Act, respectively. Their delinquency status will not change through the forbearance period as the borrowers are fulfilling the agreements they have made with the Company.

Credit Quality

The Company categorizes loans into risk categories based upon an internal rating system reflecting management’s risk assessment. Loans are placed on watch status when one or more weaknesses are identified that may result in the borrower being unable to meet repayment terms or the Company’s credit position could deteriorate at some future date. Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified may have a well-defined weakness or weaknesses that jeopardize the repayment of the debt. Such loans are characterized by the distinct possibility that the Company may sustain some loss if the deficiencies are not corrected. A loan is classified as a TDR when a borrower is experiencing financial difficulties that lead to the restructuring of a loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. Loans classified as TDRs that are accruing interest are classified as performing TDRs. Loans classified as TDRs that are not accruing interest are classified as non-performing TDRs and are included with all other

14

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

non-accrual loans for presentation purposes. It is the Company’s policy to discontinue the accrual of interest income on loans when management believes that the collection of interest or principal is doubtful.

The following table presents the risk categories by class at September 30, 2021 and December 31, 2020.

	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, &		Construction -		Construction -		Mortgage -		Mortgage -		and other
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		Total
At September 30, 2021
Watch	$	9,169	$	0	$	3,796	$	13,096	$	46,805	$	0	$	72,866
Substandard		101		0		2,671		766		547		0		4,085
Performing TDRs		273		0		0		1,268		332		38		1,911
Non-accrual loans		6,292		0		108		1,475		24,940		20		32,835
Total	$	15,835	$	0	$	6,575	$	16,605	$	72,624	$	58	$	111,697
At December 31, 2020
Watch	$	9,649	$	545	$	10,806	$	15,835	$	66,936	$	0	$	103,771
Substandard		598		0		0		1,002		1,662		0		3,262
Performing TDRs		835		0		0		1,521		343		77		2,776
Non-accrual loans		6,717		192		200		2,105		25,314		31		34,559
Total	$	17,799	$	737	$	11,006	$	20,463	$	94,255	$	108	$	144,368

Troubled Debt Restructurings

At September 30, 2021, loans classified as TDRs totaled $2.5 million, of which $0.6 million were classified as non-performing TDRs and $1.9 million were classified as performing TDRs. At December 31, 2020, loans classified as TDRs totaled $3.7 million, of which $0.9 million were classified as non-performing TDRs and $2.8 million were classified as performing TDRs. Both performing and non-performing TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. Accordingly, specific reserves of $133,000 and $214,000 related to TDRs were allocated to the allowance for loan losses at September 30, 2021 and December 31, 2020, respectively.

Beginning in 2020, the Company began offering short-term loan modifications to assist borrowers during the COVID-19 pandemic. These modifications generally meet the criteria of both Section 4013 of the CARES Act and the join interagency statement on loan modifications and reporting, and therefore, the Company does not account for such loan modifications as TDRs. At September 30, 2021, $11.3 million, or 0.9% of total loans, remained in some form of a modification. These loan modifications include 2 remaining loans on interest only.

15

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AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The following table summarizes loans that were modified as TDRs during the periods indicated.

	Nine Months Ended September 30,
	2021						2020
	Recorded Investment (1)						Recorded Investment (1)
	Number of	Pre-			Post-		Number of	Pre-		Post-
(in thousands)	Contracts	Modification			Modification		Contracts	Modification		Modification
Troubled Debt Restructurings
Real estate mortgage - residential	0	$	0		$	0	1	$	111	$	117
Installment and other consumer	0		0	​		0	1		6		4
Total	0	$	0		$	0	2	$	117	$	121

(1) The amounts reported post-modification are inclusive of all partial pay-downs and charge-offs, and no portion of the debt was forgiven. Loans modified as a TDR that were fully paid down, charged-off or foreclosed upon during the period ended are not reported.

The Company’s portfolio of loans classified as TDRs include concessions for the borrower given their financial condition such as applying interest rates below the current market rate, deferring principal payments, and extending maturity dates. There were 0 loans meeting the TDR criteria that were modified during the three and nine months ended September 30, 2021, respectively, and no loans and 2 loans that were modified during the three and nine months ended September 30, 2020, respectively. The Company considers a TDR to be in default when it is 90 days or more past due under the modified terms, a charge-off occurs, or it is in the process of foreclosure. There were 0 loans modified as a TDR that defaulted during any of the three and nine months ended September 30, 2021, respectively, and 0 loans and 1 loan modified as a TDR that defaulted during the three and nine months ended September 30, 2020, respectively, and within twelve months of their modification date. See Lending and Credit Management section for further information.

Loans Held For Sale

The Company designates certain long-term fixed rate personal real estate loans as held for sale, and the Company carries them at the lower of cost or fair value. The loans are primarily sold to Freddie Mac, Fannie Mae, PennyMac, and other various secondary market investors. At September 30, 2021, the carrying amount of these loans was $4.6 million compared to $5.1 million and $7.9 million at December 31, 2020 and September 30, 2020, respectively.  

(3)   Other Real Estate Acquired in Settlement of Loans

	September 30,		December 31,
(in thousands)	2021		2020
Commercial	$	644	$	920
Real estate construction - commercial		10,094		10,986
Real estate mortgage - residential		235		201
Real estate mortgage - commercial		2,798		2,798
Total	$	13,771	$	14,905
Less valuation allowance for other real estate owned		(2,157)	��	(2,614)
Total other real estate owned	$	11,614	$	12,291

16

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Changes in the net carrying amount of other real estate owned were as follows for the periods indicated:

	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2021		2020		2021		2020
Balance at beginning of period	$	14,552	$	15,488	$	14,905	$	15,737
Additions		112		73		142		73
Proceeds from sales		(423)		(15)		(747)		(209)
Charge-offs against the valuation allowance for other real estate owned, net		(470)		0		(554)		0
Donation		—		—		—		(266)
Net gain on sales		0		8		25		219
Total other real estate owned	$	13,771	$	15,554	$	13,771	$	15,554
Less valuation allowance for other real estate owned		(2,157)		(2,953)		(2,157)		(2,953)
Balance at end of period	$	11,614	$	12,601	$	11,614	$	12,601

At September 30, 2021, $209,000 of consumer mortgage loans secured by residential real estate properties were in the process of foreclosure compared to $287,000 of consumer mortgage loans at December 31, 2020.

Activity in the valuation allowance for other real estate owned was as follows for the periods indicated:

	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2021		2020		2021		2020
Balance, beginning of period	$	2,614	$	2,968	$	2,614	$	2,956
Provision (release) for other real estate owned		13		(15)		97		(3)
Charge-offs		(470)		0		(554)		0
Balance, end of period	$	2,157	$	2,953	$	2,157	$	2,953

17

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AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(4)   Investment Securities

Available for sale securities

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2021 and December 31, 2020 were as follows:

	Total
	Amortized		Gross Unrealized				Fair
(in thousands)	Cost		Gains		Losses		Value
September 30, 2021
U.S. Treasury	$	3,012	$	17	$	0	$	3,029
U.S. government and federal agency obligations		1,316		17		0		1,333
U.S. government-sponsored enterprises		17,497		177		(108)		17,566
Obligations of states and political subdivisions		119,220		1,073		(1,382)		118,911
Mortgage-backed securities		125,126		1,221		(1,334)		125,013
Other debt securities (a)		10,825		570		0		11,395
Bank issued trust preferred securities (a)		1,486		0		(205)		1,281
Total available-for-sale securities	$	278,482	$	3,075	$	(3,029)	$	278,528
December 31, 2020
U.S. Treasury	$	2,772	$	26	$	0	$	2,798
U.S. government and federal agency obligations		11,732		197		0		11,929
U.S. government-sponsored enterprises		22,495		379		0		22,874
Obligations of states and political subdivisions		56,943		1,801		0		58,744
Mortgage-backed securities		88,357		1,809		(54)		90,112
Other debt securities (a)		10,000		358		(14)		10,344
Bank issued trust preferred securities (a)		1,486		0		(257)		1,229
Total available-for-sale securities	$	193,785	$	4,570	$	(325)	$	198,030

(a) Certain hybrid instruments possessing characteristics typically associated with debt obligations.

The Company’s investment securities are classified as available for sale. Agency bonds and notes, SBA guaranteed loan certificates, residential and commercial agency mortgage-backed securities, and agency collateralized mortgage obligations (CMO) include securities issued by the Government National Mortgage Association (GNMA), a U.S. government agency, and the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC), and the Federal Home Loan Bank (FHLB), which are U.S. government-sponsored enterprises.

Debt securities with carrying values aggregating approximately $204.8 million and $153.9 million at September 30, 2021 and December 31, 2020, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.

18

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AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2021, 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
(in thousands)	Cost		Value
Due in one year or less	$	4,776	$	4,798
Due after one year through five years		12,576		12,734
Due after five years through ten years		34,073		34,890
Due after ten years		101,931		101,093
Total		153,356		153,515
Mortgage-backed securities		125,126		125,013
Total available-for-sale securities	$	278,482	$	278,528

Other securities

Other investment securities include equity securities with readily determinable fair values and other investment securities that do not have readily determinable fair values. Investments in FHLB stock, and Midwest Independent Bank (MIB) bankers bank stock, that do not have readily determinable fair values, are required for membership in those organizations.

	September 30,		December 31,
(in thousands)	2021		2020
Other securities:
FHLB stock	$	5,812	$	6,170
MIB stock		151		151
Equity securities with readily determinable fair values		52		32
Total other investment securities	$	6,015	$	6,353

19

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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 September 30, 2021 and December 31, 2020 were as follows:

	Less than 12 months				12 months or more
									Total		Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
(in thousands)	Value		Losses *		Value		Losses		Value		Losses
At September 30, 2021
U.S. Treasury	$	508	$	0	$	0	$	0	$	508	$	0
U.S. government-sponsored enterprises		4,892		(108)		0		0		4,892		(108)
Obligations of states and political subdivisions		62,391		(1,382)		0		0		62,391		(1,382)
Mortgage-backed securities		70,027		(1,324)		1,667		(10)		71,694		(1,334)
Bank issued trust preferred securities		0		0		1,281		(205)		1,281		(205)
Total	$	137,818	$	(2,814)	$	2,948	$	(215)	$	140,766	$	(3,029)
(in thousands)
At December 31, 2020
U.S. Treasury	$	1,015	$	0	$	0	$	0	$	1,015	$	0
Mortgage-backed securities		7,494		(54)		0		0		7,494		(54)
Other debt securities		2,987		(14)		0		0		2,987		(14)
Bank issued trust preferred securities		0		0		1,229		(257)		1,229		(257)
Total	$	11,496	$	(68)	$	1,229	$	(257)	$	12,725	$	(325)

* Amounts less than $1,000 are not reported

The total available-for-sale portfolio consisted of approximately 417 securities at September 30, 2021. The portfolio included 157 securities having an aggregate fair value of $140.8 million that were in a loss position at September 30, 2021. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $2.9 million at fair value at September 30, 2021. The $3.0 million aggregate unrealized loss included in accumulated other comprehensive loss at September 30, 2021 was caused by interest rate fluctuations.

The total available-for-sale portfolio consisted of approximately 308 securities at December 31, 2020. The portfolio included 10 securities having an aggregate fair value of $12.7 million that were in a loss position at December 31, 2020. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $1.2 million at fair value at December 31, 2020. The $325,000 aggregate unrealized loss included in accumulated other comprehensive loss at December 31, 2020 was caused by interest rate fluctuations.

Because the decline in fair value is attributable to changes in interest rates and not credit quality, these investments were not considered other-than-temporarily impaired at September 30, 2021 and December 31, 2020, respectively. In the absence of changes in credit quality of these investments, the fair value is expected to recover on all debt securities as they approach their maturity date or re-pricing date, or if market yields for such investments decline. In addition, the Company does not have the intent to sell these investments over the period of recovery, and it is not more likely than not that the Company will be required to sell such investment securities.

20

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The following table presents the gross realized gains and losses from sales and calls of available-for-sale securities, as well as gains and losses on equity securities from fair value adjustments which have been recognized in earnings:

	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2021		2020		2021		2020
Investment securities gains, net
Available-for-sale securities:
Gross realized gains	$	119	$	21	$	121	$	27
Gross realized losses		0		(8)		—		(8)
Other-than-temporary impairment recognized		0		0		—		—
Other investment securities:
Fair value adjustments, net		7		(1)		19		(1)
Investment securities gains, net	$	126	$	12	$	140	$	18

(5)   Intangible Assets

Mortgage Servicing Rights

At September 30, 2021, the Company was servicing approximately $277.1 million of loans sold to the secondary market compared to $292.7 million at December 31, 2020, and $289.3 million at September 30, 2020. Mortgage loan servicing fees, reported in real estate servicing fees, net, earned on loans sold were $195,000 and $581,000 for the three and nine months ended September 30, 2021, respectively, compared to $216,000 and $638,000 for the three and nine months ended September 30, 2020, respectively.

The table below presents changes in mortgage servicing rights (MSRs) for the periods indicated.

	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2021		2020		2021		2020
Balance at beginning of period	$	2,775	$	2,145	$	2,445	$	2,482
Originated mortgage servicing rights		66		343		359		531
Changes in fair value:
Due to changes in model inputs and assumptions (1)		(13)		(21)		269		(340)
Other changes in fair value (2)		(110)		(140)		(355)		(346)
Total changes in fair value		(123)		(161)		(86)		(686)
Balance at end of period	$	2,718	$	2,327	$	2,718	$	2,327

(1) The change in fair value resulting from changes in valuation inputs or assumptions, reported in real estate servicing fees, net, used in the valuation model reflects the change in discount rates and prepayment speed assumptions primarily due to changes in interest rates.

(2) Other changes in fair value, reported in real estate servicing fees, net, reflect changes due to customer payments and passage of time.

21

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The following key data and assumptions were used in estimating the fair value of the Company’s MSRs as of September 30, 2021 and 2020, respectively:

	Nine Months Ended September 30,
		2021		2020
Weighted average constant prepayment rate		11.41	%	16.89	%
Weighted average note rate		3.38	%	3.67	%
Weighted average discount rate		8.00	%	7.75	%
Weighted average expected life (in years)		6.0		4.7

(6)   Federal Funds Purchased and Securities Sold under Agreements to Repurchase

	September 30,		December 31,
(in thousands)	2021		2020
Federal funds purchased	$	0	$	0
Repurchase agreements		27,443		45,154
Total	$	27,443	$	45,154

The Company offers a sweep account program whereby amounts in excess of an established limit are “swept” from the customer’s demand deposit account on a daily basis into retail repurchase agreements pursuant to individual repurchase agreements between the Company and its customers. Repurchase agreements are agreements to sell securities subject to an obligation to repurchase the same or similar securities. They are accounted for as collateralized financing transactions, not as sales and purchases of the securities portfolio. The securities collateral pledged for the repurchase agreements with customers is maintained by a designated third-party custodian. The collateral amounts pledged to repurchase agreements by remaining maturity in the table below are limited to the outstanding balances of the related asset or liability; thus amounts of excess collateral are not shown.

Repurchase Agreements	Remaining Contractual Maturity of the Agreements
	Overnight		Less		Greater
	and		than		than
(in thousands)	continuous		90 days		90 days		Total
At September 30, 2021
U.S. government-sponsored enterprises	$	1,927	$	0	$	0	$	1,927
Mortgage-backed securities		25,516		0		0		25,516
Total	$	27,443	$	0	$	0	$	27,443
At December 31, 2020
U.S. government and federal agency obligations	$	2,728	$	0	$	0	$	2,728
U.S. government-sponsored enterprises		15,533		0		0		15,533
Mortgage-backed securities		26,893		0		0		26,893
Total	$	45,154	$	0	$	0	$	45,154

22

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(7)   Leases

The Company's leases primarily consist of office space and bank branches with remaining lease terms of generally 1 to 10 years. As of September 30, 2021, operating right of use (ROU) assets and liabilities were $1.9 million and $1.9 million, respectively. As of September 30, 2021, the weighted-average remaining lease term on these operating leases is approximately 6.7 years and the weighted-average discount rate used to measure the lease liabilities is approximately 4.0%.

Operating leases in which the Company is the lessee are recorded as operating lease ROU assets and operating lease liabilities. Currently, the Company does not have any finance leases. The ROU assets are included in premises and equipment, net on the consolidated balance sheets.

Operating lease ROU assets represent the Company's right to use an underlying asset during the lease term and operating lease liabilities represent the Company's obligation to make lease payments arising from the lease. ROU assets and operating lease liabilities are recognized at lease commencement based on the present value of the remaining lease payments using a discount rate that represents the Company's incremental borrowing rate at the lease commencement date.

Operating lease cost, which is comprised of amortization of the ROU asset and the implicit interest accreted on the operating lease liability, is recognized on a straight-line basis over the lease term, and is recorded in net occupancy expense in the consolidated statements of income. The operating lease cost was $93,000 and $289,000 for the three and nine months ended September 30, 2021, respectively, compared to $86,000 and $252,000 for the three and nine months ended September 30, 2020, respectively.

At adoption of Accounting Standards Update (ASU) 2016-02 on January 1, 2019, lease and non-lease components of new lease agreements are accounted for separately. Lease components include fixed payments including rent, real estate taxes and insurance costs and non-lease components include common-area maintenance costs. Leases with an initial term of 12 months or less are not recorded on the balance sheet; the Company recognizes lease expense for these leases on a straight-line basis over the lease term. Operating lease expense for these leases was $24,000 and $56,000 for the three and nine months ended September 30, 2021, respectively, compared to $15,000 and $75,000 for the three and nine months ended September 30, 2020, respectively.

The table below summarizes the maturity of remaining operating lease liabilities:

	Operating
Lease payments due in:	Lease
(in thousands)
2021 (excluding 9 months ended September 30, 2021)	$	91
2022		367
2023		366
2024		258
2025		257
Thereafter		830
Total lease payments		2,169
Less imputed interest		(259)
Total lease liabilities, as reported	$	1,910

23

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(8)   Income Taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 19.7% and 19.4% for the three and nine months ended September 30, 2021, respectively, compared to 18.9% and 18.4% for the three and nine months ended September 30, 2020, respectively. The increase in the effective tax rate for each of the three and nine months ended September 30, 2021 compared to the three and nine months ended September 30, 2020 was primarily attributable to the increase in earnings and an increase in state taxes attributed to elevated earnings. The effective tax rate for each of the three and nine months ended September 30, 2021 and 2020, respectively, is lower than the U.S. federal statutory rate of 21% primarily due to tax-free revenues.

The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income of the appropriate character 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 initiatives in making this assessment. In management's opinion, the Company will more likely than not realize the benefits of its deferred tax assets and, therefore, has not established a valuation allowance against its deferred tax assets as of September 30, 2021. Management arrived at this conclusion based upon the level of historical taxable income and projections for future taxable income of the appropriate character over the periods in which the deferred tax assets are deductible.

The Company follows ASC Topic 740, Income Taxes, which addresses the accounting for uncertain tax positions. For each of the three and nine months ended September 30, 2021 and 2020, respectively, the Company did not have any uncertain tax provisions, and did not record any related tax liabilities.

(9)   Stockholders’ Equity

Accumulated Other Comprehensive Income (Loss)

The following details the change in the components of the Company’s accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2021 and 2020:

	Nine Months Ended September 30, 2021
					Accumulated
			Unrecognized Net		Other
	Unrealized		Pension and		Comprehensive
	Gains (Losses)		Postretirement		Income
(in thousands)	on Securities (1)		Costs (2)		(Loss)
Balance at beginning of period	$	3,353	$	(1,825)	$	1,528
Other comprehensive income (loss), before reclassifications		(4,104)		275		(3,829)
Amounts reclassified from accumulated other comprehensive income (loss)		(95)		—		(95)
Current period other comprehensive income (loss), before tax		(4,199)		275		(3,924)
Income tax benefit (expense)		882		(58)		824
Current period other comprehensive income (loss), net of tax		(3,317)		217		(3,100)
Balance at end of period	$	36	$	(1,608)	$	(1,572)

24

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

	Nine Months Ended September 30, 2020
					Accumulated
			Unrecognized Net		Other
	Unrealized		Pension and		Comprehensive
	Gains (Losses)		Postretirement		Income
(in thousands)	on Securities (1)		Costs (2)		(Loss)
Balance at beginning of period	$	(23)	$	(3,732)	$	(3,755)
Other comprehensive income, before reclassifications		4,165		160		4,325
Amounts reclassified from accumulated other comprehensive income (loss)		(19)		—		(19)
Current period other comprehensive income, before tax		4,146		160		4,306
Income tax expense		(871)		(33)		(904)
Current period other comprehensive income, net of tax		3,275		127		3,402
Balance at end of period	$	3,252	$	(3,605)	$	(353)

(1) The pre-tax amounts reclassified from accumulated other comprehensive income (loss) are included in investment securities gains (losses), net in the consolidated statements of income.

(2) The pre-tax amounts reclassified from accumulated other comprehensive income (loss) are included in the computation of net periodic pension cost.

(10)   Employee Benefit Plans

Employee Benefits

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

	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2021		2020		2021		2020
Payroll taxes	$	310	$	305	$	1,101	$	1,030
Medical plans		436		446		1,405		1,370
401(k) match and profit sharing		513		490		1,456		1,134
Periodic pension cost		449		404		1,347		1,211
Other		3		14		10		42
Total employee benefits	$	1,711	$	1,659	$	5,319	$	4,787

The Company’s profit-sharing plan includes a matching 401(k) portion, in which the Company matches the first 3% of eligible employee contributions. The Company makes annual contributions for the discretionary portion 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 periods shown.

Other Plans

On November 7, 2018, the Board of Directors of the Company adopted a supplemental executive retirement plan (SERP), effective as of January 1, 2018. The SERP provides select employees who satisfy certain eligibility requirements with certain benefits upon retirement, termination of employment or death.

The accrued liability relating to the SERP was $1.2 million as of September 30, 2021, and the expense for the three and nine months ended September 30, 2021 was $97,000 and $290,000, respectively, compared to $80,000 and $240,000 for the three and nine months ended September 30, 2020, respectively, and is recognized over the required service period.  

25

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Pension

The Company provides a noncontributory defined benefit pension plan for all full-time and eligible employees. Beginning January 1, 2018 and for all retrospective periods presented, the Company adopted the guidance under ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. Under the new guidance, only the service cost component of the net periodic benefit cost is reported in the same income statement line item as salaries and benefits, and the remaining components are reported as other non-interest expense. 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 pension contribution of $1.0 million on March 22, 2021.

Effective July 1, 2017, the Company amended the pension plan to effectuate a “soft freeze” such that no individual hired (or rehired in the case of a former employee) by the Company after September 30, 2017, whether or not such individual is or was a vested member in the plan, will be eligible to be an active member and be entitled to accrue any benefits under the plan.

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 periods indicated:

	Nine Months Ended September 30,
(in thousands)	2021		2020
Service cost - benefits earned during the year	$	1,692	$	1,614
Interest costs on projected benefit obligations (a)		1,072		1,127
Expected return on plan assets (a)		(1,843)		(1,598)
Expected administrative expenses		104		110
Amortization of prior service cost (a)		—		50
Amortization of unrecognized net loss (a)		367		164
Net periodic pension cost	$	1,392	$	1,467

(a) The components of net periodic pension cost other than the service cost component are included in other non-interest expense.

Net periodic pension benefit costs include interest costs based on an assumed discount rate, the expected return on plan assets based on actuarially derived market-related values, and the amortization of net actuarial losses. Net periodic postretirement benefit costs include service costs, interest costs based on an assumed discount rate, and the amortization of prior service credits and net actuarial gains. Differences between expected and actual results in each year are included in the net actuarial gain or loss amount, which is recognized in other comprehensive income. The net actuarial gain or loss in excess of a 10% corridor is amortized in net periodic benefit cost over the average remaining service period of active participants in the pension plan. The prior service credit is amortized over the average remaining service period to full

26

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

eligibility for participating employees expected to receive benefits. Currently, there is no prior service cost or net transition (asset)/obligation to be amortized.

(11)   Earnings per Share

Stock Dividend

On July 1, 2021, the Company paid a special stock dividend of 4% to common shareholders of record at the close of business on June 15, 2021. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

Basic earnings per share is computed by dividing income available to shareholders by the weighted average number of shares outstanding during the year. Diluted earnings per share gives effect to all dilutive potential shares that were outstanding during the year.

Presented below is a summary of the components used to calculate basic and diluted earnings per common share, which have been restated for all stock dividends:

	Three Months Ended September 30,				Nine Months Ended September 30,
(dollars in thousands, except per share data)	2021		2020		2021		2020
Basic earnings per share:
Net income available to shareholders	$	5,796	$	4,960	$	16,527	$	9,110
Average shares outstanding		6,616,975		6,737,928		6,617,105		6,747,553
Basic earnings per share	$	0.88	$	0.74	$	2.50	$	1.35
Diluted earnings per share:
Net income available to shareholders	$	5,796	$	4,960	$	16,527	$	9,110
Average shares outstanding		6,616,975		6,737,928		6,617,105		6,747,553
Diluted earnings per share	$	0.88		0.74	$	2.50		1.35

Repurchase Program

In 2019, the Company's Board of Directors authorized the purchase of up to $5.0 million market value of the Company's common stock. Management was given discretion to determine the number and pricing of the shares to be purchased, as well as the timing of any such purchases. The Company repurchased 117,632 shares at an average cost of $18.26 per share totaling $2.1 million during the first quarter of 2021.

During the second quarter of 2021, the Company's Board of Directors reauthorized the purchase of up to $5.0 million market value of the Company's common stock under the 2019 authorization. There were 0 shares repurchased during the third quarter of 2021. As of September 30, 2021, $5.0 million remained available for the repurchase of shares pursuant to the share repurchase authorization.

27

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(12)   Fair Value Measurements

Fair value represents the amount expected to be received to sell an asset or paid to transfer a liability in its principal or most advantageous market in an orderly transaction between market participants at the measurement date.

Depending on the nature of the asset or liability, the Company uses various valuation methodologies and assumptions to estimate fair value. The measurement of fair value under U.S. GAAP uses a hierarchy intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows.

The fair value hierarchy is as follows:

Level 1 – Inputs are unadjusted quoted prices for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and is used to measure fair value whenever available. A contractually binding sales price also provides reliable evidence of fair value.

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.

In accordance with fair value accounting guidance, the Company measures, records, and reports various types of assets and liabilities at fair value on either a recurring or non-recurring basis in the Consolidated Financial Statements. Nonfinancial assets measured at fair value on a non-recurring 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.

Valuation Methods for Assets and Liabilities 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

The fair value measurements of the Company’s investment securities are determined by a third-party pricing service which considers 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. The fair value measurements are subject to independent verification to another pricing source by management each quarter for reasonableness.

Equity securities with readily determinable fair values are recorded at fair value, with changes in fair value reflected in earnings. The Company uses level 1 inputs to value equity securities that are traded in active markets. Equity securities that do not have readily determinable fair values are carried at cost and are periodically assessed for impairment. Equity securities that are not actively traded are classified in level 2.

28

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Mortgage Servicing Rights

The fair value of mortgage servicing rights is based on the discounted value of estimated future cash flows utilizing contractual cash flows, servicing rate, constant prepayment rate, servicing cost, and discount rate factors. Accordingly, the fair value is estimated based on a valuation model that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees. The valuation models estimate the present value of estimated future net servicing income. The Company classifies its servicing rights as Level 3.

			Fair Value Measurements
			Quoted Prices
			in Active
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
(in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)
September 30, 2021
Assets:
U.S. Treasury	$	3,029	$	3,029	$	0	$	0
U.S. government and federal agency obligations		1,333		0		1,333		0
U.S. government-sponsored enterprises		17,566		0		17,566		0
Obligations of states and political subdivisions		118,911		0		118,911		0
Mortgage-backed securities		125,013		0		125,013		0
Other debt securities		11,395		0		11,395		0
Bank-issued trust preferred securities		1,281		0		1,281		0
Equity securities		52		52		0		0
Mortgage servicing rights		2,718		0		0		2,718
Total	$	281,298	$	3,081	$	275,499	$	2,718
December 31, 2020
Assets:
U.S. Treasury	$	2,798	$	2,798	$	0	$	0
U.S. government and federal agency obligations		11,929		0		11,929		0
U.S. government-sponsored enterprises		22,874		0		22,874		0
Obligations of states and political subdivisions		58,744		0		58,744		0
Mortgage-backed securities		90,112		0		90,112		0
Other debt securities		10,344		0		10,344		0
Bank-issued trust preferred securities		1,229		0		1,229		0
Equity securities		32		32		0		0
Mortgage servicing rights		2,445		0		0		2,445
Total	$	200,507	$	2,830	$	195,232	$	2,445

29

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:

	Fair Value Measurements Using				Fair Value Measurements Using
	(Level 3)				(Level 3)
	Mortgage Servicing Rights				Mortgage Servicing Rights
	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2021		2020		2021		2020
Balance at beginning of period	$	2,775	$	2,145	$	2,445	$	2,482
Total gains or (losses) (realized/unrealized):
Included in earnings		(123)		(161)		(86)		(686)
Included in other comprehensive income		0		0		—		—
Purchases		0		0		—		—
Sales		0		0		—		—
Issues		66		343		359		531
Settlements		0		0		—		—
Balance at end of period	$	2,718	$	2,327	$	2,718	$	2,327

Valuation Methods for Assets and Liabilities Measured at Fair Value on a Non-recurring Basis

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

Collateral Dependent Impaired Loans

While the overall loan portfolio is not carried at fair value, the Company periodically records non-recurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans. Non-recurring adjustments also include certain impairment amounts for collateral dependent loans when establishing the allowance for loan losses. Such amounts are generally based on the fair value of the underlying collateral supporting the loan. In determining the value of real estate collateral, the Company relies on external and internal appraisals of property values depending on the size and complexity of the real estate collateral. The Company maintains staff that is trained to perform in-house evaluations and also review third-party appraisal reports for reasonableness. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgments based on the experience and expertise of internal specialists. Values of all loan collateral are regularly reviewed by a senior loan committee. Because many of these inputs are not observable, the measurements are classified as Level 3. As of September 30, 2021, the Company identified $31.2 million in collateral dependent impaired loans that had specific allowances for losses aggregating $4.6 million. Related to these loans, there were $33,000 and $69,000 in charge-offs recorded during the three and nine months ended September 30, 2021, respectively. As of September 30, 2020, the Company identified $2.9 million in collateral dependent impaired loans that had specific allowances for losses aggregating $0.2 million. Related to these loans, there were $36,000 and $129,000 in charge-offs recorded during the three and nine months ended September 30, 2020, respectively.

Other Real Estate and Foreclosed Assets

Other real estate owned (OREO) and foreclosed assets consisted of loan collateral that 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. Subsequent to foreclosure, these assets initially

30

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

are carried at fair value of the collateral less estimated selling costs. Fair value, when recorded, is generally based upon appraisals by approved, independent state-certified appraisers. Like impaired loans, appraisals on OREO may be discounted based on the Company’s historical knowledge, changes in market conditions from the time of appraisal or other information available. During the holding period, 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 Using
			Quoted Prices
			in Active						Three Months		Nine Months
			Markets for		Other		Significant		Ended		Ended
			Identical		Observable		Unobservable		September 30,		September 30,
	Total		Assets		Inputs		Inputs		Total Gains		Total Gains
(in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)		(Losses)*		(Losses)*
September 30, 2021
Assets:
Collateral dependent impaired loans:
Commercial, financial, & agricultural	$	3,960	$	0	$	0	$	3,960	$	0	$	0
Real estate mortgage - residential		324		0		0		324		(18)		(22)
Real estate mortgage - commercial		22,266		0		0		22,266		(15)		(41)
Installment and other consumer		0		0		0		0		0		(6)
Total	$	26,550	$	0	$	0	$	26,550	$	(33)	$	(69)
Other real estate and repossessed assets	$	11,614	$	0	$	0	$	11,614	$	(12)	$	(71)
September 30, 2020
Assets:
Collateral dependent impaired loans:
Commercial, financial, & agricultural	$	308	$	0	$	0	$	308	$	(20)	$	(20)
Real estate construction - commercial		360		0		0		360		0		0
Real estate mortgage - residential		454		0		0		454		0		(52)
Real estate mortgage - commercial		1,635		0		0		1,635		(13)		(37)
Installment and other consumer		0		0		0		0		(3)		(20)
Total	$	2,757	$	0	$	0	$	2,757	$	(36)	$	(129)
Other real estate and repossessed assets	$	12,601	$	0	$	0	$	12,601	$	23	$	222

* Total losses reported for other real estate and foreclosed assets includes charge-offs, valuation write downs, and net losses taken during the periods reported.

(13)   Fair Value of Financial Instruments

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 with similar financial characteristics. Loans are segregated by type, such as commercial, real estate, and consumer. Each loan category is further segmented into fixed and variable interest rate

31

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

categories. The fair value of loans, or exit price, is estimated by using the future value of discounted cash flows using comparable market rates for similar types of loan products and adjusted for market factors. The discount rates used are estimated using comparable market rates for similar types of loan products adjusted to be commensurate with the credit risk, overhead costs, and optionality of such instruments.

Loans Held for Sale

Loans originated and intended to be sold in the secondary market, generally 1-4 family residential mortgage loans, are carried, in aggregate, at the lower of cost or estimated fair value. The estimated fair value measurements of loans held for sale are management's best estimate of fair value, which is primarily based on quoted market prices for similar loans in the secondary market.

Investment Securities

A detailed description of the fair value measurement of the debt instruments in the available-for-sale sections of the investment security portfolio is provided in the Fair Value Measurement section above. A schedule of investment securities by category and maturity is provided in the notes on Investment Securities.

Other Investment Securities

Other investment securities include equity securities with readily determinable fair values and other investment securities that do not have readily determinable fair values. Investments in FHLB stock, and MIB bankers bank stock, that do not have readily determinable fair values, are required for membership in those organizations. Equity securities that are not actively traded are classified in level 2.

Equity securities with readily determinable fair values are recorded at fair value, with changes in fair value reflected in earnings. Equity securities that do not have readily determinable fair values are carried at cost and are periodically assessed for impairment. The Company uses level 1 inputs to value equity securities that are traded in active markets.

Federal Funds Sold, Cash, and Due from Banks

The carrying amounts of short-term federal funds sold, interest earning deposits with banks, and cash and due from banks approximate fair value. Federal funds sold classified as short-term generally mature in 90 days or less.

Certificates of Deposit in Other Banks

Certificates of deposit are other investments made by the Company with other financial institutions that are carried at cost which is equal to fair value.

Cash Surrender Value - Life Insurance

The fair value of Bank-owned life insurance (BOLI) approximates the carrying amount. Upon liquidation of these investments, the Company would receive the cash surrender value which equals the carrying amount.

32

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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.

Federal Funds Purchased and Securities Sold Under Agreements to Repurchase

For Federal funds purchased and securities sold under agreements to repurchase, the carrying amount is a reasonable estimate of fair value, as such instruments reprice in a short time period.

Subordinated Notes and Other Borrowings

The fair value of subordinated notes and other 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.

33

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

A summary of the carrying amounts and fair values of the Company’s financial instruments at September 30, 2021 and December 31, 2020 is as follows:

					September 30, 2021
					Fair Value Measurements
						Quoted Prices
					in Active				Net
					Markets for		Other		Significant
	September 30, 2021				Identical		Observable		Unobservable
	Carrying		Fair		Assets		Inputs		Inputs
(in thousands)	amount		value		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and due from banks	$	19,004	$	19,004	$	19,004	$	0	$	0
Federal funds sold and overnight interest-bearing deposits		94,262		94,262		94,262		0		0
Certificates of deposit in other banks		6,673		6,673		6,673		0		0
Available-for-sale securities		278,528		278,528		3,029		275,499		0
Other investment securities		6,015		6,015		52		5,963		0
Loans, net		1,263,891		1,273,797		0		0		1,273,797
Loans held for sale		4,576		4,663		0		0		4,663
Cash surrender value - life insurance		2,495		2,495		0		2,495		0
Accrued interest receivable		7,568		7,568		7,568		0		0
Total	$	1,683,012	$	1,693,005	$	130,588	$	283,957	$	1,278,460
Liabilities:
Deposits:
Non-interest bearing demand	$	461,626	$	461,626	$	461,626	$	0	$	0
Savings, interest checking and money market		693,065		693,065		693,065		0		0
Time deposits		256,368		257,500		0		0		257,500
Federal funds purchased and securities sold under agreements to repurchase		27,443		27,443		27,443		0		0
Federal Home Loan Bank advances and other borrowings		93,493		94,941		0		94,941		0
Subordinated notes		49,486		42,661		0		42,661		0
Accrued interest payable		308		308		308		0		0
Total	$	1,581,789	$	1,577,544	$	1,182,442	$	137,602	$	257,500

34

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

					December 31, 2020
					Fair Value Measurements
					Quoted Prices
					in Active				Net
					Markets for		Other		Significant
	December 31, 2020				Identical		Observable		Unobservable
	Carrying		Fair		Assets		Inputs		Inputs
(in thousands)	amount		value		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and due from banks	$	19,235	$	19,235	$	19,235	$	0	$	0
Federal funds sold and overnight interest-bearing deposits		161,128		161,128		161,128		0		0
Certificates of deposit in other banks		9,376		9,376		9,376		0		0
Available-for-sale securities		198,030		198,030		2,798		195,232		0
Other investment securities		6,353		6,353		32		6,321		0
Loans, net		1,268,854		1,288,677		0		0		1,288,677
Loans held for sale		5,099		5,279		0		0		5,279
Cash surrender value - life insurance		2,451		2,451		0		2,451		0
Accrued interest receivable		6,640		6,640		6,640		0		0
Total	$	1,677,166	$	1,697,169	$	199,209	$	204,004	$	1,293,956
Liabilities:
Deposits:
Non-interest bearing demand	$	382,492	$	382,492	$	382,492	$	0	$	0
Savings, interest checking and money market		723,808		723,808		723,808		0		0
Time deposits		277,306		279,569		0		0		279,569
Federal funds purchased and securities sold under agreements to repurchase		45,154		45,154		45,154		0		0
Federal Home Loan Bank advances and other borrowings		106,674		110,121		0		110,121		0
Subordinated notes		49,486		40,929		0		40,929		0
Accrued interest payable		837		837		837		0		0
Total	$	1,585,757	$	1,582,910	$	1,152,291	$	151,050	$	279,569

Off-Balance Sheet Financial Instruments

The fair value of commitments to extend credit and standby letters of credit is 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 that are competitive in the markets in which it operates.

Limitations

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.

35

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(14)   Commitments and Contingencies

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 non-performance 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 September 30, 2021, no amounts have been accrued for any estimated losses for these financial instruments.

The contractual amount of off-balance-sheet financial instruments were as follows as of the dates indicated:

	September 30,		December 31,
(in thousands)	2021		2020
Commitments to extend credit	$	354,957	$	264,528
Commitments to originate residential first and second mortgage loans		22,964		51,270
Standby letters of credit		7,542		125,800
Total	$	385,463	$	441,598

Commitments

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. 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 approximate remaining term of standby letters of credit range from one month to five years at September 30, 2021.

Pending Litigation

The Company and its subsidiaries are defendants in various legal actions incidental to the Company’s past and current business activities. Based on the Company’s analysis, and considering the inherent uncertainties associated with litigation, management does not believe that it is reasonably possible that these legal actions will materially adversely affect the Company’s consolidated financial condition or results of operations in the near term. The Company records a loss accrual for all legal matters for which it deems a loss is probable and can be reasonably estimated. Some legal matters, which are at early stages in the legal process, have not yet progressed to the point where a loss is deemed probable or an amount can be estimated.

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Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

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 Hawthorn Bancshares, Inc., and its subsidiaries (collectively, the Company, we, our, or us), 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, plans, hopes 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 the Company’s loan portfolios and adverse economic conditions may necessitate increases to our provisions for loan losses,

● costs or difficulties related to any integration of any business of the Company and its acquisition targets may be greater than expected,

● legislative, regulatory or tax law changes may adversely affect the business in which the Company and its subsidiaries are engaged,

● changes may occur in the securities markets and,

● effects of the COVID-19 pandemic, or any resurgence thereof, or other adverse external events.

We have described under the caption Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020, and in other reports filed 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 have not been 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. Except as required by law, the Company undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events, or changes in its business, results of operations or financial condition over time.

Overview

Crucial to the Company’s community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, Hawthorn Bank (the Bank), the Company, with $1.7 billion in assets at September 30, 2021, provides a broad range of commercial and personal banking services. The Bank’s specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate, Small Business Administration (SBA) loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include the Missouri communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, St. Louis, and the greater Kansas City metropolitan area.

37

The Company’s primary source of revenue is net interest income derived primarily from lending and deposit taking activities. Much of the Company’s business is commercial, commercial real estate development, and residential mortgage lending. The Company’s income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancing activity.

The success of the Company’s growth strategy depends primarily on the ability of the Bank 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. The Company’s financial performance also depends, in part, on its 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 the Company’s growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control.

The 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, the Bank provides trust services.

The deposit accounts of the Bank are insured by the Federal Deposit Insurance Corporation (FDIC) to the extent provided by law. The operations of the Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of the 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. The Company is subject to supervision and examination by the Board of Governors of the Federal Reserve System.

Significant Developments and Transactions

Each item listed below materially affects the comparability of our results of operations for the three and nine months ended September 30, 2021 and 2020, respectively, and our financial condition as of September 30, 2021 and December 31, 2020, and may affect the comparability of financial information we report in future fiscal periods.

Impact of COVID-19. The COVID-19 pandemic and related restrictive measures taken by governments, businesses and individuals caused unprecedented uncertainty, volatility and disruption in financial markets and in governmental, commercial and consumer activity in the United States and globally, including the markets that we serve. Although many of the restrictive measures have been eased during 2020 and 2021, and the U.S. economy has begun to recover and with the availability and distribution of COVID-19 vaccines, the extent of the ultimate impact of the COVID-19 pandemic on the Company’s business remains uncertain and difficult to predict. If the COVID-19 pandemic continues to subside, we anticipate continued improvements in commercial and consumer activity and the U.S. economy. The continuing impact of the COVID-19 pandemic on the Company’s business will depend on a number of factors, including, but not limited to, the scope, severity and duration of any resurgence of the pandemic (including COVID-19 variants), the actions taken to contain the outbreak or any resurgence or mitigate their impacts, the continued supply and distribution of vaccines and the efficacy of those vaccines, the ability of communities to achieve herd immunity, the public’s confidence in the health and safety measures implemented by the Company’s customers, the continuing direct and indirect economic effects of the outbreak and containment measures, and the ability of the Company’s customers to recover from the negative economic impacts of the pandemic as it subsides, all of which are uncertain and cannot be predicted.

Effects on Our Market Areas. Our commercial and consumer banking products and services are delivered primarily in Missouri, where individual and governmental responses to the COVID-19 pandemic led to a broad curtailment of economic activity. While positive tailwinds exist, we recognize that our business and consumer customers are continuing to experience varying degrees of financial distress, which is expected to continue into the fourth quarter of 2021. Commercial activity has improved but has not returned to the levels existing prior to the outbreak of the pandemic. In addition, the economic pressures, materials supply chain disruptions and continuing uncertainties related to the COVID-19 pandemic have resulted in changes in consumer spending behaviors, which has negatively impacted the demand for loans and other

38

services we offer. Our borrowing base includes customers in industries such as hotel/lodging, restaurants, entertainment, retail and commercial real estate, all of which have been significantly impacted by the COVID-19 pandemic. We recognize that these industries take longer to recover as consumers may be hesitant to return to full social interaction or may change their spending habits on a more permanent basis as a result of the pandemic. We continue to monitor these customers closely.

Effects on Our Business. The COVID-19 pandemic and the specific developments referred to above may continue to have a significant impact on our business. In particular, we anticipate that a significant portion of the Bank’s borrowers in the hotel, restaurant, gaming, long-term healthcare and retail industries will continue to endure significant economic distress, which has caused, and may continue to cause them to draw on their existing lines of credit and adversely affect their ability to repay existing indebtedness. These developments, together with economic conditions generally, are also expected to impact our commercial real estate portfolio, particularly with respect to real estate with exposure to these industries, our consumer loan business and loan portfolio, and the value of certain collateral securing our loans.

The Company is an active participant in the SBA’s Small Business Paycheck Protection Programs (PPP), and has been since their inception. As of September 30, 2021, the net balance of the PPP loans totaled $26.0 million.

Beginning in 2020, as provided for by the CARES Act, the Company offered payment modifications to borrowers. At December 31, 2020, these modifications totaled $86.7 million, or 6.7% of total loans. At September 30, 2021, $11.3 million, or 0.9% of total loans, remained in some form of a modification. These loan modifications include two remaining loans on interest only. As permitted by the CARES Act and other regulatory guidance, the Company has elected to suspend accounting principles generally accepted in the United States of America (U.S. GAAP) and regulatory determinations for loan modifications relating to the COVID-19 pandemic that would otherwise require evaluation as troubled debt restructurings (TDRs). The Company expects most of these modified loans to recover from the pandemic, but uncertainty regarding the short-term and long-term effects of the COVID-19 pandemic remain that may require the Company to downgrade modified loans which may increase our allowance for loan losses, reverse interest income previously recognized but not received, or charge-off modified loans.

CRITICAL ACCOUNTING POLICIES

The following accounting policies are considered most critical to the understanding of the 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 the critical accounting policies on the business operations are discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations, where such policies affect the reported and expected financial results.

Allowance for Loan Losses

Management has identified the accounting policy related to the allowance for loan losses as critical to the understanding of the 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. Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on the Company’s business operations is provided in note 1 to the Company’s unaudited consolidated financial statements and is also discussed in the Lending and Credit Management section below. Many of the loans are deemed collateral dependent for purposes of the measurement of the impairment loss, thus the fair value of the underlying collateral and sensitivity of such fair values due to changing market conditions, supply and demand, condition of the collateral and other factors can be volatile over periods of time. Such volatility can have an impact on the financial performance of the Company.

39

SELECTED CONSOLIDATED FINANCIAL DATA

The following table presents selected consolidated financial information for the Company as of and for each of the three and nine months ended September 30, 2021 and 2020, respectively. The selected consolidated financial data should be read in conjunction with the unaudited consolidated financial statements of the Company, including the related notes, presented elsewhere herein.

Selected Financial Data
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(In thousands, except per share data)		2021			2020			2021			2020
Per Share Data
Basic earnings per share	$	0.88		$	0.74		$	2.50		$	1.35
Diluted earnings per share		0.88			0.74			2.50			1.35
Cash dividends paid on common stock		954			749			2,624			2,252
Book value per share								21.02			18.43
Market price per share								23.16			18.21
Selected Ratios
(Based on average balance sheet data)
Return on total assets		1.33	%		1.18	%		1.28	%		0.76	%
Return on stockholders' equity		16.49	%		15.99	%		16.37	%		10.15	%
Stockholders' equity to total assets		8.05	%		7.40	%		7.82	%		7.47	%
Efficiency ratio (1)		61.23	%		61.49	%		62.49	%		66.88	%
Net interest spread		3.62	%		3.30	%		3.43	%		3.27	%
Net interest margin		3.78	%		3.50	%		3.60	%		3.50	%
(Based on end-of-period data)
Stockholders' equity to assets								8.00	%		7.45	%
Total risk-based capital ratio								15.01	%		15.05	%
Tier 1 risk-based capital ratio								13.64	%		13.28	%
Common equity Tier 1 capital								10.26	%		9.97	%
Tier 1 leverage ratio (2)								10.82	%		9.99	%

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

(2) Tier 1 leverage ratio is calculated by dividing Tier 1 capital by average total consolidated assets

RESULTS OF OPERATIONS ANALYSIS

The Company has prepared all of the consolidated financial information in this report in accordance with U.S. GAAP. In preparing the consolidated financial statements in accordance with U.S. GAAP, the 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.

40

	Three Months Ended September 30,									Nine Months Ended September 30,
(In thousands)	2021		2020		$ Change		% Change			2021		2020		$ Change		% Change
Net interest income	$	15,380	$	13,842	$	1,538		11.1	%	$	43,442	$	39,707	$	3,735		9.4	%
Provision for loan losses		300		1,200		(900)		(75.0)			700		5,400		(4,700)		(87.0)
Non-interest income		3,675		5,119		(1,444)		(28.2)			12,707		10,266		2,441		23.8
Investment securities gains, net		126		12		114		950.0			140		18		122		677.8
Non-interest expense		11,668		11,660		8		0.1			35,088		33,421		1,667		5.0
Income before income taxes		7,213		6,113		1,100		18.0			20,501		11,170		9,331		83.5
Income tax expense		1,417		1,153		264		22.9			3,974		2,060		1,914		92.9
Net income	$	5,796	$	4,960	$	836		16.9	%	$	16,527	$	9,110	$	7,417		81.4	%

Consolidated net income of $5.8 million, or $0.88 per diluted share, for the three months ended September 30, 2021 increased $0.8 million compared to $5.0 million, or $0.74 per diluted share, for the three months ended September 30, 2020. For the three months ended September 30, 2021, the return on average assets was 1.33%, the return on average stockholders’ equity was 16.49%, and the efficiency ratio was 61.2%.

Consolidated net income of $16.5 million, or $2.50 per diluted share, for the nine months ended September 30, 2021 increased $7.4 million compared to $9.1 million, or $1.35 per diluted share, for the nine months ended September 30, 2020. For the nine months ended September 30, 2021, the return on average assets was 1.28%, the return on average stockholders’ equity was 16.37%, and the efficiency ratio was 62.5%.

Net interest income was $15.4 million and $43.4 million for the three and nine months ended September 30, 2021, respectively, compared to $13.8 million and $39.7 million for the three and nine months ended September 30, 2020, respectively. The net interest margin (expressed on a fully taxable equivalent basis) increased to 3.78% for the three months ended September 30, 2021 compared to 3.50% for the three months ended September 30, 2020 and increased to 3.60% for the nine months ended September 30, 2021 compared to 3.50% for the nine months ended September 30, 2020. These changes are discussed in greater detail under the Average Balance Sheet Data and Rate and Volume Analysis section below.

A $0.3 million and $0.7 million provision for loan losses was required for the three and nine months ended September 30, 2021 compared to a $1.2 million and $5.4 million provision for the three and nine months ended September 30, 2020, respectively. The decreased provision in the three and nine months ended September 30, 2021 compared to the three and nine months ended September 30, 2020 resulted primarily from the impact of net recoveries and improvement in the economic outlook as the economy begins to recover from the impacts of the COVID-19 pandemic. Criticized loan levels remain elevated when compared to pre-pandemic levels due to the downgrade of loans to borrowers that have been impacted by the COVID-19 pandemic.

The Company’s net loan charge-offs (recoveries) were $106,000 and $(116,000) for the three and nine months ended September 30, 2021, respectively, compared to net loan charge-offs of $58,000 and $113,000 for the three and nine months ended September 30, 2020, respectively.

Non-performing loans totaled $32.8 million, or 2.56% of total loans, at September 30, 2021 compared to $34.6 million, or 2.69% of total loans, at December 31, 2020, and $5.8 million, or 0.45% of total loans, at September 30, 2020. These changes are discussed in greater detail under the Lending and Credit Management section below.

Non-interest income decreased $1.4 million, or 28.2%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, and increased $2.4 million, or 23.8%, for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020. These changes are discussed in greater detail under the Non-interest Income and Expense section below.

Non-interest expense increased $0.08 million, or 0.1%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, and increased $1.7 million, or 5.0%, for the nine months ended September 30,

41

2021 compared to the nine months ended September 30, 2020. These changes are discussed in greater detail under the Non-interest Income and Expense section below.

Average Balance Sheet Data

Net interest income is the largest source of revenue resulting from the 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. The following table presents average balance sheet data, 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 three and nine month periods ended September 30, 2021 and 2020, respectively.

42

	Three Months Ended September 30,
	2021						2020
			Interest		Rate				Interest		Rate
	Average		Income/		Earned/		Average		Income/		Earned/
(In thousands)	Balance		Expense(1)		Paid(1)		Balance		Expense(1)		Paid(1)
ASSETS
Loans: (2) (3)
Commercial	$	247,564	$	4,575	7.33	%	$	291,657	$	3,364	4.59	%
Real estate construction - residential		35,358		453	5.08			26,263		345	5.23
Real estate construction - commercial		75,080		885	4.68			86,056		989	4.57
Real estate mortgage - residential		270,464		2,863	4.20			253,451		2,967	4.66
Real estate mortgage - commercial		633,239		6,590	4.13			588,464		6,959	4.70
Installment and other consumer		24,363		242	3.94			28,691		297	4.12
Total loans	$	1,286,068	$	15,608	4.81	%	$	1,274,582	$	14,921	4.66	%
Loans held for sale	$	3,092	$	24	3.08	%	$	11,573	$	41	1.41	%
Investment securities:
U.S. Treasury	$	3,033	$	4	0.52	%	$	2,808	$	8	1.13	%
U.S. government and federal agency obligations		20,819		75	1.43			39,927		179	1.78
Obligations of states and political subdivisions		114,804		868	3.00			45,609		305	2.60
Mortgage-backed securities		130,658		443	1.35			96,017		411	1.70
Other debt securities		10,609		129	4.82			11,133		152	5.43
Total investment securities	$	279,923	$	1,519	2.15	%	$	195,494	$	1,055	2.15	%
Other investment securities		6,010		81	5.35			6,623		75	4.51
Federal funds sold and interest bearing deposits in other financial institutions		91,654		78	0.34			112,710		111	0.39
Total interest earning assets	$	1,666,747	$	17,310	4.12	%	$	1,600,982	$	16,203	4.03	%
All other assets		83,998						84,068
Allowance for loan losses		(18,801)						(16,727)
Total assets	$	1,731,944					$	1,668,323
LIABILITIES AND STOCKHOLDERS' EQUITY
NOW accounts	$	225,351	$	130	0.23	%	$	198,913	$	124	0.25	%
Savings		161,308		14	0.03			123,405		11	0.04
Interest checking		37,391		45	0.48			53,734		75	0.56
Money market		281,425		91	0.13			281,454		100	0.14
Time deposits		252,732		437	0.69			297,359		950	1.27
Total interest bearing deposits	$	958,207	$	717	0.30	%	$	954,865	$	1,260	0.53	%
Federal funds purchased and securities sold under agreements to repurchase		29,753		19	0.25			36,412		25	0.27
Federal Home Loan Bank advances and other borrowings		93,533		383	1.62			116,977		505	1.72
Subordinated notes		49,486		305	2.45			49,486		326	2.62
Total borrowings	$	172,772	$	707	1.62	%	$	202,875	$	856	1.68	%
Total interest bearing liabilities	$	1,130,979	$	1,424	0.50	%	$	1,157,740	$	2,116	0.73	%
Demand deposits		445,062						368,709
Other liabilities		16,451						18,486
Total liabilities	$	1,592,492					$	1,544,935
Stockholders' equity		139,452						123,388
Total liabilities and stockholders' equity	$	1,731,944					$	1,668,323
Net interest income (FTE)			$	15,886					$	14,087
Net interest spread					3.62	%					3.30	%
Net interest margin					3.78	%					3.50	%

(1) Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense, for the three months ended September 30, 2021 and 2020. Such adjustments totaled $0.5 million and $0.2 million for the three months ended September 30, 2021 and 2020, respectively.

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

(3) Fees and costs on loans are included in interest income ($2.1 million and $0.7 million of PPP fees were included in commercial loan income for the three months ended September 30, 2021 and 2020, respectively).

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	Nine Months Ended September 30,
	2021						2020
			Interest		Rate				Interest		Rate
	Average		Income/		Earned/		Average		Income/		Earned/
(In thousands)	Balance		Expense(1)		Paid(1)		Balance		Expense(1)		Paid(1)
ASSETS
Loans: (2) (3)
Commercial	$	253,878	$	11,732	6.18	%	$	257,328	$	9,055	4.70	%
Real estate construction - residential		34,625		1,274	4.92			25,245		999	5.29
Real estate construction - commercial		77,115		2,676	4.64			85,486		3,059	4.78
Real estate mortgage - residential		264,699		8,546	4.32			251,029		9,031	4.81
Real estate mortgage - commercial		624,455		19,809	4.24			582,568		20,955	4.80
Installment and other consumer		25,044		750	4.00			30,063		950	4.22
Total loans	$	1,279,816	$	44,787	4.68	%	$	1,231,719	$	44,049	4.78	%
Loans held for sale	$	4,263	$	79	2.48	%	$	8,338	$	96	1.54	%
Investment securities:
U.S. Treasury	$	3,026	$	13	0.57	%	$	1,453	$	16	1.47	%
U.S. government and federal agency obligations		22,579		276	1.63			41,353		619	2.00
Obligations of states and political subdivisions		88,333		1,989	3.01			42,088		895	2.84
Mortgage-backed securities		125,814		1,249	1.33			100,186		1,348	1.80
Other debt securities		11,674		430	4.92			7,229		294	5.43
Total investment securities	$	251,426	$	3,957	2.10	%	$	192,309	$	3,172	2.20	%
Other investment securities		6,021		246	5.46			6,765		247	4.88
Federal funds sold and interest bearing deposits in other financial institutions		118,999		268	0.30			98,238		553	0.75
Total interest earning assets	$	1,660,525	$	49,337	3.97	%	$	1,537,369	$	48,117	4.18	%
All other assets		84,600						83,104
Allowance for loan losses		(18,579)						(15,061)
Total assets	$	1,726,546					$	1,605,412
LIABILITIES AND STOCKHOLDERS' EQUITY
NOW accounts	$	227,925	$	402	0.24	%	$	190,734	$	533	0.37	%
Savings		153,730		40	0.03			112,917		43	0.05
Interest checking		46,661		168	0.48			49,026		323	0.88
Money market		280,838		255	0.12			278,244		647	0.31
Time deposits		255,495		1,612	0.84			308,442		3,156	1.37
Total interest bearing deposits	$	964,649	$	2,477	0.34	%	$	939,363	$	4,702	0.67	%
Federal funds purchased and securities sold under agreements to repurchase		38,797		72	0.25			34,028		121	0.48
Federal Home Loan Bank advances and other borrowings		95,486		1,164	1.63			120,650		1,749	1.94
Subordinated notes		49,486		921	2.49			49,486		1,208	3.26
Total borrowings	$	183,769	$	2,157	1.57	%	$	204,164	$	3,078	2.01	%
Total interest bearing liabilities	$	1,148,418	$	4,634	0.54	%	$	1,143,527	$	7,780	0.91	%
Demand deposits		426,290						324,479
Other liabilities		16,871						17,498
Total liabilities	$	1,591,579					$	1,485,504
Stockholders' equity		134,967						119,908
Total liabilities and stockholders' equity	$	1,726,546					$	1,605,412
Net interest income (FTE)			$	44,703					$	40,337
Net interest spread					3.43	%					3.27	%
Net interest margin					3.60	%					3.50	%

(1) Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense, for the nine months ended September 30, 2021 and 2020. Such adjustments totaled $1.3 million and $0.6 million for the nine months ended September 30, 2021 and 2020, respectively.

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

(3) Fees and costs on loans are included in interest income ($4.4 million and $1.2 million of PPP fees were included in commercial loan income for the nine months ended September 30, 2021 and 2020, respectively).

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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, identifying changes related to volumes and rates for the three and nine months ended September 30, 2021 compared to the three and nine months ended September 30, 2020, respectively. 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.

	Three Months Ended September 30,						Nine Months Ended September 30,
	2021 vs. 2020						2021 vs. 2020
			Change due to						Change due to
	Total		Average		Average		Total		Average		Average
(In thousands)	Change		Volume		Rate		Change		Volume		Rate
Interest income on a fully taxable equivalent basis: (1)
Loans: (2) (3)
Commercial	$	1,211	$	(570)	$	1,781	$	2,677	$	(123)	$	2,800
Real estate construction - residential		108		116		(8)		275		349		(74)
Real estate construction - commercial		(104)		(129)		25		(383)		(293)		(90)
Real estate mortgage - residential		(104)		191		(295)		(485)		475		(960)
Real estate mortgage - commercial		(369)		504		(873)		(1,146)		1,440		(2,586)
Installment and other consumer		(55)		(44)		(11)		(200)		(153)		(47)
Loans held for sale		(17)		(44)		27		(17)		(60)		43
Investment securities:
U.S. Treasury		(4)		1		(5)		(3)		10		(13)
U.S. government and federal agency obligations		(104)		(74)		(30)		(343)		(244)		(99)
Obligations of states and political subdivisions		563		518		45		1,094		1,038		56
Mortgage-backed securities		32		128		(96)		(99)		300		(399)
Other debt securities		(23)		(7)		(16)		136		166		(30)
Other investment securities		6		(7)		13		(1)		(29)		28
Federal funds sold and interest bearing deposits in other financial institutions		(33)		(19)		(14)		(285)		99		(384)
Total interest income	$	1,107	$	564	$	543	$	1,220	$	2,975	$	(1,755)
Interest expense:
NOW accounts		6		15		(9)		(131)		91		(222)
Savings		3		3		—		(3)		13		(16)
Interest checking		(30)		(21)		(9)		(155)		(15)		(140)
Money market		(9)		—		(9)		(392)		6		(398)
Time deposits		(513)		(127)		(386)		(1,544)		(478)		(1,066)
Federal funds purchased and securities sold under agreements to repurchase		(6)		(5)		(1)		(49)		15		(64)
Federal Home Loan Bank advances and other borrowings		(122)		(97)		(25)		(585)		(332)		(253)
Subordinated notes		(21)		—		(21)		(287)		—		(287)
Total interest expense	$	(692)	$	(232)	$	(460)	$	(3,146)	$	(700)	$	(2,446)
Net interest income on a fully taxable equivalent basis	$	1,799	$	796	$	1,003	$	4,366	$	3,675	$	691

(1) Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 21%, net of nondeductible interest expense, for the three and nine months ended September 30, 2021 and 2020. Such adjustments totaled $0.5 million and $0.2 million for the three and nine months ended September 30, 2021, respectively, compared to $1.3 million and $0.6 million for the three and nine months ended September 30, 2020, respectively.

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

(3) Fees and costs on loans are included in interest income ($2.1 million and $4.4 million of PPP fees for the three and nine months ended September 30, 2021, respectively, compared to $0.7 million and $1.2 million for the three and nine months ended September 30, 2020 were included in commercial loan income).

45

Financial results for the quarter ended September 30, 2021 compared to the quarter ended September 30, 2020 reflected an increase in net interest income, on a tax equivalent basis, of $1.8 million, or 12.8%, and the financial results for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020 reflected an increase of $4.4 million, or 10.8%. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) increased to 3.78% for the quarter ended September 30, 2021 compared to 3.50% for the quarter ended September 30, 2020 and increased to 3.60% for the nine months ended September 30, 2021 compared to 3.50% for the nine months ended September 30, 2020. Net interest income and net interest margin increased primarily due to an increase in PPP fees and interest income in both the three and nine month comparative periods. The Company earned $2.1 million and $4.4 million in PPP income for the three and nine months ended September 30, 2021, respectively, compared to $0.7 million and $1.2 million for the three and nine months ended September 30, 2020, respectively.  

Average interest-earning assets increased $65.8 million, or 4.1%, to $1.67 billion for the quarter ended September 30, 2021 compared to $1.60 billion for the quarter ended September 30, 2020, and average interest-bearing liabilities decreased $26.8 million, or 2.3%, to $1.13 billion for the quarter ended September 30, 2021 compared to $1.16 billion for the quarter ended September 30, 2020.

Average interest-earning assets increased $123.2 million, or 8.0%, to $1.66 billion for the nine months ended September 30, 2021 compared to $1.54 billion for the nine months ended September 30, 2020, and average interest-bearing liabilities increased $4.9 million, or 0.4%, to $1.15 billion for the nine months ended September 30, 2021 compared to $1.14 billion for the nine months ended September 30, 2020.

Total interest income (expressed on a fully taxable equivalent basis) was $17.3 million and $49.3 million for the three and nine months ended September 30, 2021, respectively, compared to $16.2 million and $48.1 million for the three and nine months ended September 30, 2020, respectively. The Company’s rates earned on interest earning assets were 4.12% and 3.97% for the three and nine months ended September 30, 2021, respectively, compared to 4.03% and 4.18% for the three and nine months ended September 30, 2020, respectively.

Interest income on loans held for investment was $15.6 million and $44.8 million for the three and nine months ended September 30, 2021, respectively, compared to $14.9 million and $44.0 million for the three and nine months ended September 30, 2020, respectively.

Average loans outstanding increased $11.5 million, or 0.9%, to $1.29 billion for the quarter ended September 30, 2021 compared to $1.27 billion for the quarter ended September 30, 2020. The average yield on loans increased to 4.81% for the quarter ended September 30, 2021 compared to 4.66% for the quarter ended September 30, 2020.

Average loans outstanding increased $48.1 million, or 3.9%, to $1.28 billion for the nine months ended September 30, 2021 compared to $1.23 billion for the nine months ended September 30, 2020. The average yield on loans decreased to 4.68% for the nine months ended September 30, 2021 compared to 4.78% for the nine months ended September 30, 2020. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

Interest income on available-for-sale securities was $1.5 million and $4.0 million for the three and nine months ended September 30, 2021, respectively, compared to $1.1 million and $3.2 million for the three and nine months ended September 30, 2020, respectively.

Average securities increased $84.4 million, or 43.2%, to $279.9 million for the quarter ended September 30, 2021 compared to $195.5 million for the quarter ended September 30, 2020. The average yield on securities was consistent at 2.15% for both quarters ended September 30, 2021 and 2020, respectively.

Average securities increased $59.1 million, or 30.7%, to $251.4 million for the nine months ended September 30, 2021 compared to $192.3 million for the nine months ended September 30, 2020. The average yield on securities decreased to 2.10% for the nine months ended September 30, 2021 compared to 2.20% for the nine months ended September 30, 2020.  See the Liquidity Management section for further discussion.

46

Total interest expense decreased to $1.4 million and $4.6 million for the three and nine months ended September 30, 2021, respectively, compared to $2.1 million and $7.8 million for the three and nine months ended September 30, 2020, respectively. The Company’s rates paid on interest bearing liabilities were 0.50% and 0.54% for the three and nine months ended September 30, 2021, respectively, compared to 0.73% and 0.91% for the three and nine months ended September 30, 2020, respectively. See the Liquidity Management section for further discussion.

Interest expense on deposits decreased to $0.7 million and $2.5 million for the three and nine months ended September 30, 2021, respectively, compared to $1.3 million and $4.7 million for the three and nine months ended September 30, 2020, respectively.

Average interest-bearing deposits increased $3.3 million, or 0.4%, to $958.2 million for the quarter ended September 30, 2021 compared to $954.9 million for the quarter ended September 30, 2020. The average cost of deposits decreased to 0.30% for the quarter ended September 30, 2021 compared to 0.53% for the quarter ended September 30, 2020.  

Average interest-bearing deposits increased $25.3 million, or 2.7%, to $964.6 million for the nine months ended September 30, 2021 compared to $939.4 million for the nine months ended September 30, 2020. The average cost of deposits decreased to 0.34% for the nine months ended September 30, 2021 compared to 0.67% for the nine months ended September 30, 2020.

Interest expense on borrowings was $0.7 million and $2.2 million for the three and nine months ended September 30, 2021, respectively, compared to $0.9 million and $3.1 million for the three and nine months ended September 30, 2020, respectively.

Average borrowings decreased to $172.8 million for the quarter ended September 30, 2021 compared to $202.9 million for the quarter ended September 30, 2020. The average cost of borrowings decreased to 1.62% for the quarter ended September 30, 2021 compared to 1.68% for the quarter ended September 30, 2020.

Average borrowings decreased to $183.8 million for the nine months ended September 30, 2021 compared to $204.2 million for the nine months ended September 30, 2020. The average cost of borrowings decreased to 1.57% for the nine months ended September 30, 2021 compared to 2.01% for the nine months ended September 30, 2020. The decrease in cost of funds primarily resulted from lower market interest rates.

The decrease in average borrowings during 2021 compared to 2020 was primarily due to a decrease in FHLB advances. The Company used FHLB advances to fund liquidity needs as refinancing activity increased when rates dropped during the first quarter of 2020. This in turn was offset beginning in April of 2020 when the Company had an increase in liquidity due to participation in the CARES Act economic stimulus programs. The Company experienced significant deposit growth primarily due to stimulus checks, proceeds from PPP loan funding, deferral of income tax payments, and customers holding on to savings due to economic uncertainty, and the Company has been repaying these FHLB advances as they come due since May of 2020. See the Liquidity Management section for further discussion.

47

Non-interest Income and Expense

Non-interest income for the periods indicated was as follows:

	Three Months Ended September 30,											Nine Months Ended September 30,
(In thousands)	2021			2020			$ Change		% Change			2021			2020			$ Change		% Change
Non-interest income
Service charges and other fees	$	782		$	816		$	(34)		(4.2)	%	$	2,285		$	2,181		$	104		4.8	%
Bank card income and fees		1,043			846			197		23.3			2,925			2,351			574		24.4
Trust department income		308			263			45		17.1			910			920			(10)		(1.1)
Real estate servicing fees, net		71			54			17		31.5			495			(48)			543		NM
Gain on sales of mortgage loans, net		1,369			3,026			(1,657)		(54.8)			5,881			4,369			1,512		34.6
Other		102			114			(12)		(10.5)			211			493			(282)		(57.2)
Total non-interest income	$	3,675		$	5,119		$	(1,444)		(28.2)	%	$	12,707		$	10,266		$	2,441		23.8	%
Non-interest income as a % of total revenue *		19.3	%		27.0	%							22.6	%		20.5	%

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

NM = Not meaningful

Total non-interest income decreased $1.4 million, or 28.2%, to $3.7 million for the quarter ended September 30, 2021 compared to $5.1 million for the quarter ended September 30, 2020, and increased $2.4 million, or 23.8%, to $12.7 million for the nine months ended September 30, 2021 compared to $10.3 million for the nine months ended September 30, 2020. The decrease in non-interest income for the quarter end September 30, 2021 compared to the quarter ended September 30, 2020 was primarily due to the decrease in gain on sale of real estate mortgages due to lower volumes of real estate mortgage loans sold as further discussed below.  

Bank Card and Credit card transaction fees increased $0.2 million, or 23.3%, to $1.0 million for the quarter ended September 30, 2021 compared to $0.8 million for the quarter ended September 30, 2020, and increased $0.5 million, or 24.4%, to $2.9 million for the nine months ended September 30, 2021, compared to $2.4 million for the nine months ended September 30, 2020. The increases were primarily related to increases in debit card usage and interchange fees. As the economy began to recover from the COVID 19 pandemic, the Company began to see an increase in spending due to both stimulus income and a reduction of conservative savings due to the uncertainty of the pandemic.

Real estate servicing fees, net of the change in valuation of mortgage servicing rights (MSRs) increased $17,000 to $71,000 for the quarter ended September 30, 2021 compared to $54,000 for the quarter ended September 30, 2020 and increased $543,000 to $495,000 for the nine months ended September 30, 2021 compared to $(48,000) for the nine months ended September 30, 2020.

Mortgage loan servicing fees earned on loans sold were $0.2 million and $0.6 million for the three and nine months ended September 30, 2021, respectively, compared to $0.2 million and $0.6 million for the three and nine months ended September 30, 2020, respectively. The current quarter's MSR valuation decreased $13,000 from the prior linked quarter primarily due to a decrease in the Company's servicing portfolio. The dramatic drop in market interest rates created an economic incentive for borrowers to refinance their existing home mortgage loans during 2020 that has slowed down in 2021.

The Company was servicing $277.1 million of mortgage loans at September 30, 2021 compared to $292.7 million and $289.3 million at December 31, 2020 and September 30, 2020, respectively.

Gain on sales of mortgage loans decreased $1.6 million to $1.4 million for the quarter ended September 30, 2021 compared to $3.0 million for the quarter ended September 30, 2020 and increased $1.5 million to $5.9 million for the nine months ended September 30, 2021 compared to $4.4 million for the nine months ended September 30, 2020. The Company sold $39.1 million and $167.6 million of loans for the three and nine months ended September 30, 2021, respectively, compared to $73.5 million and $133.2 million for the three and nine months ended September 30, 2020, respectively. Loans sold to the secondary market were strong in the first six months but began to slow down in the third quarter of 2021.

48

Other Income decreased $12,000, or 10.5%, to $0.1 million for the quarter ended September 30, 2021 compared to $0.1 million for the quarter ended September 30, 2020, and decreased $0.3 million, or 57.2%, to $0.2 million for the nine months ended September 30, 2021 compared to $0.5 million for the nine months ended September 30, 2020. The decreases primarily resulted from a decrease in net gains on sales of other real estate owned and a decrease in net gains on disposal of fixed assets. In the quarter ended June 30, 2020, the Company sold an out-of-service branch building being held as other real estate owned (OREO) to a non-profit organization. This transaction consisted of a $266,000 donation expense and the Company realized a net gain of $210,000. These decreases were partially offset by an increase in brokerage income and a forfeiture of an OREO escrow deposit.

The following table presents the gross realized gains and losses from sales and calls of available-for-sale securities, as well as gains and losses on equity securities from fair value adjustments which have been recognized in earnings:

	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2021		2020		2021		2020
Investment securities gains, net
Available-for-sale securities:
Gross realized gains	$	119	$	21	$	121	$	27
Gross realized losses		—		(8)		—		(8)
Other-than-temporary impairment recognized		—		—		—		—
Other investment securities:
Fair value adjustments, net		7		(1)		19		(1)
Investment securities gains, net	$	126	$	12	$	140	$	18

Non-interest expense for the periods indicated was as follows:

	Three Months Ended September 30,										Nine Months Ended September 30,
(In thousands)	2021			2020			$ Change		% Change		2021			2020			$ Change		% Change
Non-interest expense
Salaries	$	4,954		$	5,112		$	(158)	(3.1)	%	$	15,446		$	14,617		$	829	5.7	%
Employee benefits		1,711			1,659			52	3.1			5,319			4,787			532	11.1
Occupancy expense, net		808			781			27	3.5			2,298			2,303			(5)	(0.2)
Furniture and equipment expense		787			745			42	5.6			2,284			2,259			25	1.1
Processing, network and bank card expense		1,288			877			411	46.9			3,521			2,807			714	25.4
Legal, examination, and professional fees		357			381			(24)	(6.3)			1,146			1,155			(9)	(0.8)
Advertising and promotion		310			316			(6)	(1.9)			862			786			76	9.7
Postage, printing, and supplies		218			227			(9)	(4.0)			608			661			(53)	(8.0)
Loan expense		209			360			(151)	(41.9)			612			786			(174)	(22.1)
Other		1,026			1,202			(176)	(14.6)			2,992			3,260			(268)	(8.2)
Total non-interest expense	$	11,668		$	11,660		$	8	0.1	%	$	35,088		$	33,421		$	1,667	5.0	%
Efficiency ratio*		61.2	%		61.5	%						62.5	%		66.9	%
Number of full-time equivalent employees		302			301							302			301

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

Total non-interest expense remained consistent at $11.7 million for both the quarters ended September 30, 2021 and 2020, respectively, and increased $1.7 million, or 5.0%, to $35.1 million for the nine months ended September 30, 2021 compared to $33.4 million for the nine months ended September 30, 2020.

Salaries decreased $0.2 million, or 3.1%, to $4.9 million for the quarter ended September 30, 2021 compared to $5.1 million for the quarter ended September 30, 2020 primarily due to reduced commissions due to a decrease in loan originations, and increased $0.8 million, or 5.7%, to $15.4 million for the nine months ended September 30, 2021 compared to $14.6 million for the nine months ended September 30, 2020 primarily due to an increase in commissions paid due to an increase in loan originations. (See Gain on sales of mortgage loans discussion above) In addition, annual merit increases averaged approximately 4.0% each year and were awarded in the first quarter of each year.

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Employee benefits remained consistent at $1.7 million for both the quarters ended September 30, 2021 and 2020, respectively, and increased $0.5 million, or 11.1%, to $5.3 million for the nine months ended September 30, 2021 compared to $4.8 million for the nine months ended September 30, 2020. The increases were primarily due to an increase in 401(k) plan contributions, payroll taxes, medical premiums, and pension cost due to lower annual discount rate assumptions compared to the prior year's annual assumptions.

Processing, network, and bank card expense increased $0.4 million, or 46.9%, to $1.3 million for the quarter ended September 30, 2021 compared to $0.9 million for the quarter ended September 30, 2020, and increased $0.7 million, or 25.4%, to $3.5 million for the nine months ended September 30, 2021 compared to $2.8 million for the nine months ended September 30, 2020. These increases were primarily related to increases in network, processing, and debit card processing expenses, partially offset by decreases in credit card and ATM interchange expenses.

Loan expense decreased $0.2 million, or 41.9%, to $0.2 million for the quarter ended September 30, 2021 compared to $0.4 million for the quarter ended September 30, 2020, and decreased $0.2 million, or 22.1%, to $0.6 million for the nine months ended September 30, 2021 compared to $0.8 million for the nine months ended September 30, 2020. The decreases in loan expense primarily resulted from decreases in commercial and real estate third-party loan expenses. The Company experienced a decrease in commercial loan growth during the three and nine months ended September 30, 2021 compared to the three and nine months ended September 30, 2020. Also during 2020, the Company experienced significant real estate mortgage refinancing activity and growth in loan volume sold to the secondary market.

Other non-interest expense decreased $0.2 million, or 14.6%, to $1.0 million for the quarter ended September 30, 2021 compared to $1.2 million for the quarter ended September 30, 2020, and decreased $0.3 million, or 8.2%, to $3.0 million for the nine months ended September 30, 2021 compared to $3.3 million for the nine months ended September 30, 2020. The decreases were primarily related to a decrease in donations, pension net interest cost, and miscellaneous charged-off items related to teller differences and debit card fraud. In the quarter ended September 30, 2020, the Company sold an out-of-service branch building being held as other real estate owned (OREO) to a non-profit organization. This transaction consisted of a $266,000 donation expense and the Company realized a net gain of $210,000. These decreases were partially offset by an increase in the FDIC assessment expense, deposit product expense, and software expense due to new mortgage loan software.

Income taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 19.7% and 19.4% for the three and nine months ended September 30, 2021, respectively, compared to 18.9% and 18.4% for the three and nine months ended September 30, 2020, respectively. The increase in the effective tax rate for each of the three and nine months ended September 30, 2021 compared to the three and nine months ended September 30, 2020 was primarily attributable to the increase in earnings and an increase in state taxes attributed to elevated earnings. The effective tax rate for each of the three and nine months ended September 30, 2021 and 2020, respectively, is lower than the U.S. federal statutory rate of 21% primarily due to tax-free revenues.

Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 72.7% of total assets as of September 30, 2021 compared to 73.2% as of December 31, 2020.

Lending activities are conducted pursuant to an established loan policy approved by the Bank’s Board of Directors. The Bank’s credit review process is overseen by regional loan committees with established loan approval limits. 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.

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Major classifications within the Company’s held for investment loan portfolio as of the dates indicated is as follows:

	September 30, 2021				December 31, 2020
(In thousands)	Amount		% of Loans		Amount		% of Loans
Commercial, financial, and agricultural (a)	$	232,532	18.1	%	$	272,918	21.2	%
Real estate construction − residential		33,514	2.6			29,692	2.3
Real estate construction − commercial		72,031	5.6			78,144	6.1
Real estate mortgage − residential		273,768	21.3			262,339	20.4
Real estate mortgage − commercial		647,043	50.4			617,133	48.0
Installment and other consumer		23,932	1.9			26,741	2.1
Total loans held for investment	$	1,282,820	100.0	%	$	1,286,967	100.0	%

(a) Includes $26.0 million and $63.3 million of SBA PPP loans, net as of September 30, 2021 and December 31, 2020, respectively.

The Company extends credit to its local community markets through traditional real estate mortgage products. The Company does not participate in extending credit to sub-prime residential real estate markets. The Company does not lend funds for transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Company does not have any interest-earning assets that would have been included in non-accrual, past due, or restructured loans if such assets were loans.

The 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 the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. During the nine months ended September 30, 2021, the Company sold approximately $167.6 million of loans to investors compared to $133.2 million for the nine months ended September 30, 2020. At September 30, 2021, the Company was servicing approximately $277.1 million of loans sold to the secondary market compared to $292.7 million at December 31, 2020, and $289.3 million at September 30, 2020.

Risk Elements of the Loan Portfolio

Management, the senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Loans in excess of $2.0 million in aggregate and all adversely classified credits identified by management are reviewed by the senior loan committee. In addition, all other loans are reviewed on a risk weighted selection process. The senior loan committee reviews and reports to the Board of Directors, at scheduled meetings: 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 which loans should be considered impaired. Management follows the guidance provided in the Financial Accounting Standards Board's (FASB) ASC Topic 310-10-35 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 impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered necessary by management to provide for probable losses inherent in the loan portfolio.

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Non-performing Assets

The following table summarizes non-performing assets at the dates indicated:

	September 30,			December 31,			September 30,
(In thousands)	2021			2020			2020
Non-accrual loans:
Commercial, financial, and agricultural	$	6,292		$	6,717		$	878
Real estate construction − residential		—			192			—
Real estate construction − commercial		108			200			552
Real estate mortgage − residential		1,475			2,105			2,236
Real estate mortgage − commercial		24,940			25,314			1,933
Installment and other consumer		20			31			33
Total	$	32,835		$	34,559		$	5,632
Loans contractually past - due 90 days or more and still accruing:
Real estate mortgage - residential	$	—		$	—		$	175
Installment and other consumer		—			17			8
Total	$	—		$	17		$	183
Total non-performing loans (a)		32,835			34,576			5,815
Other real estate owned and repossessed assets		11,614			12,291			12,601
Total non-performing assets	$	44,449		$	46,867		$	18,416
Loans held for investment	$	1,282,820		$	1,286,967		$	1,279,165
Allowance for loan losses to loans		1.48	%		1.41	%		1.39	%
Non-performing loans to loans (a)		2.56	%		2.69	%		0.45	%
Non-performing assets to loans (b)		3.46	%		3.64	%		1.44	%
Non-performing assets to assets (b)		2.56	%		2.70	%		1.10	%
Allowance for loan losses to non-performing loans		57.65	%		52.39	%		305.49	%

(a) Non-performing loans include loans 90 days past due and accruing, non-accrual loans, and non-performing TDRs included in non-accrual loans and 90 days past due.

(b) Non-performing assets include non-performing loans and other real estate owned and repossessed assets.

Total non-performing assets were $44.4 million, or 3.46% of total loans, at September 30, 2021 compared to $46.9 million, or 3.64% of total loans, at December 31, 2020, and $18.4 million, or 1.44% of total loans, at September 30, 2020, respectively.

Total non-accrual loans at September 30, 2021 decreased $1.7 million, or 5.0%, to $32.8 million compared to $34.6 million at December 31, 2020. There were no loans past due 90 days and still accruing interest at September 30, 2021 compared to $17,000 at December 31, 2020. Other real estate and repossessed assets were $11.6 million and $12.3 million at September 30, 2021 and December 31, 2020, respectively. During the nine months ended September 30, 2021, $142,000 of non-accrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to $73,000 during the nine months ended September 30, 2020.

As of September 30, 2021, approximately $6.0 million of loans classified as substandard, which include performing TDRs, and not included in the non-performing asset table, were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms compared to $6.0 million and $4.7 million at December 31, 2020 and September 30, 2020, respectively. Management believes the allowance for loan losses was sufficient to cover the risks and probable losses related to such loans at September 30, 2021 and December 31, 2020, respectively.

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The following table summarizes the Company’s TDRs at the dates indicated:

	September 30, 2021					December 31, 2020
	Number of	Recorded		Specific		Number of	Recorded		Specific
(In thousands)	contracts	Investment		Reserves		contracts	Investment		Reserves
Performing TDRs
Commercial, financial and agricultural	5	$	273	$	27	7	$	835	$	90
Real estate mortgage − residential	6		1,268		55	5		1,521		28
Real estate mortgage − commercial	2		332		7	2		343		7
Installment and other consumer	4		38		4	5		77		10
Total performing TDRs	17	$	1,911	$	93	19	$	2,776	$	135
Non-performing TDRs
Commercial, financial and agricultural	—	$	—	$	—	1	$	4	$	1
Real estate mortgage − residential	5		624		40	8		895		78
Total non-performing TDRs	5	$	624	$	40	9	$	899	$	79
Total TDRs	22	$	2,535	$	133	28	$	3,675	$	214

At September 30, 2021, loans classified as TDRs totaled $2.5 million, with $133,000 of specific reserves compared to $3.7 million of loans classified as TDRs, with $214,000 of specific reserves at December 31, 2020. Non-performing loans, included $0.6 million of loans classified as TDRs at September 30, 2021 compared to $0.9 million at December 31, 2020. Both performing and non-performing TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs if the loan is collateral dependent. The net decrease in total TDRs from December 31, 2020 to September 30, 2021 was primarily due to $1.2 million of payments received on TDRs.

Allowance for Loan Losses and Provision

Allowance for Loan Losses

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

	September 30,		December 31,
(In thousands)	2021		2020
Allocation of allowance for loan losses at end of period:
Commercial, financial, and agricultural	$	4,701	$	5,121
Real estate construction − residential		235		213
Real estate construction − commercial		425		475
Real estate mortgage − residential		2,673		2,679
Real estate mortgage − commercial		10,681		9,354
Installment and other consumer		255		264
Unallocated		(41)		7
Total	$	18,929	$	18,113

The allowance for loan losses (ALL) was $18.9 million, or 1.48% of loans outstanding, at September 30, 2021 compared to $18.1 million, or 1.41%, at December 31, 2020, and $17.8 million, or 1.39% at September 30, 2020. The ratio of the ALL to non-performing loans was 57.65% at September 30, 2021, compared to 52.39% at December 31, 2020, and 305.49% at September 30, 2020.

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The following table is a summary of the general and specific allocations of the ALL:

	September 30,		December 31,
(In thousands)	2021		2020
Allocation of allowance for loan losses:
Individually evaluated for impairment − specific reserves	$	4,932	$	5,113
Collectively evaluated for impairment − general reserves		13,997		13,000
Total	$	18,929	$	18,113

The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2021, $4.9 million of the Company’s ALL was allocated to impaired loans totaling approximately $34.7 million compared to $5.1 million of the Company’s ALL allocated to impaired loans totaling approximately $37.3 million at December 31, 2020. Management determined that $11.9 million, or 34%, of total impaired loans required no reserve allocation at September 30, 2021 compared to $11.9 million, or 32%, at December 31, 2020, primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

The incurred loss component of the general reserve, or loans collectively evaluated for impairment, is determined by applying loss rates to pools of loans by asset type. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type. The look-back period begins with loss history in the first quarter 2012 as the starting point through the current quarter and it will continue to include this starting point going forward. Management determined that the look-back period should be expanded until a loss producing downturn is recognized. This would be accomplished by allowing the look-back period to shift forward by eliminating the earliest loss period and replenishing it with losses from the most recent period. The look-back period is consistently evaluated for relevance given the current facts and circumstances.

These historical loss rates for each risk group are used as the starting point to determine loss rates for measurement purposes. The historical loan loss rates are multiplied by loss emergence periods (LEP) which represent the estimated time period between a borrower first experiencing financial difficulty and the recognition of a loss.

The Company’s methodology includes qualitative risk factors that allow management to adjust its estimates of losses based on the most recent information available and to address other limitations in the quantitative component that is based on historical loss rates. Such risk factors are generally reviewed and updated quarterly, as appropriate, and are adjusted to reflect changes in national and local economic conditions and developments, the nature, volume and terms of loans in the portfolio, including changes in volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified or graded loans, loan concentrations, assessment of trends in collateral values, assessment of changes in the quality of the Company’s internal loan review department, and changes in lending policies and procedures, including underwriting standards and collections, charge-off and recovery practices.

The specific and general reserve allocations represent management’s best estimate of probable losses inherent in the loan portfolio at the evaluation date. Although the ALL is comprised of specific and general allocations, the entire ALL is available to absorb any credit losses.

The ALL changes from December 31, 2020 to September 30, 2021 primarily resulted from net recovery activity, in addition to organic loan growth. The Company continues to monitor the risks associated with its non-performing loans and the remaining loans modified under the CARES Act.

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Provision

A $0.3 million and $0.7 million provision for loan losses was required for the three and nine months ended September 30, 2021, respectively, compared to a $1.2 million and $5.4 million provision for the three and nine months ended September 30, 2020, respectively. The decreased provision in the three and nine months ended September 30, 2021 compared to the three and nine months ended September 30, 2020 resulted primarily from the impact of net recoveries and improvement in the economic outlook as the economy begins to recover from the impacts of the COVID-19 pandemic, which significantly impacted provision in 2020. Criticized loan levels remain elevated when compared to pre-pandemic levels due to the downgrade of loans to borrowers that have been impacted by the COVID-19 pandemic.

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

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands)	2021		2020		2021		2020
Analysis of allowance for loan losses:
Balance beginning of period	$	18,735	$	16,622	$	18,113	$	12,477
Charge-offs:
Commercial, financial, and agricultural		45		46		100		130
Real estate mortgage − residential		18		—		22		52
Real estate mortgage − commercial		15		13		42		37
Installment and other consumer		78		42		181		133
Total charge-offs	$	156	$	101	$	345	$	352
Recoveries:
Commercial, financial, and agricultural	$	19	$	11	$	202	$	102
Real estate construction − residential		—		13		13		44
Real estate mortgage − residential		8		4		183		40
Real estate mortgage − commercial		1		—		1		3
Installment and other consumer		22		15		62		50
Total recoveries	$	50	$	43	$	461	$	239
Net charge-offs (recoveries)		106		58		(116)		113
Provision for loan losses		300		1,200		700		5,400
Balance end of period	$	18,929	$	17,764	$	18,929	$	17,764

Net Loan Charge-offs (recoveries)

The Company’s net charge-offs were $106,000 for the three months ended September 30, 2021 compared to net charge-offs of $58,000 for the three months ended September 30, 2020, and net recoveries were $116,000 for the nine months ended September 30, 2021 compared to net charge-offs of $113,000 for the nine months ended September 30, 2020. The net recovery for the nine months ended September 30, 2021 was primarily related to a commercial and a real estate mortgage recovery received from two loan relationships in the first quarter of 2021.

Loans Held For Sale

The Company designates certain long-term fixed rate personal real estate loans as held for sale, and the Company carries them at the lower of cost or fair value. The loans are primarily sold to Freddie Mac, Fannie Mae, and PennyMac and other various secondary market investors. At September 30, 2021, the carrying amount of these loans was $4.6 million compared to $5.1 million at December 31, 2020.

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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 these 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 the Company, management prefers to focus on transaction accounts and full service relationships with customers as the primary sources of funding.

The Company’s Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for the 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 the Company’s liquidity.

The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company’s most liquid assets are comprised of available-for-sale investment securities, not including other debt securities, federal funds sold, and excess reserves held at the Federal Reserve.

	September 30,		December 31,
(In thousands)	2021		2020
Federal funds sold and other interest-bearing deposits	$	94,262	$	161,128
Certificates of deposit in other banks		6,673		9,376
Available-for-sale investment securities		278,528		198,030
Total	$	379,463	$	368,534

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 $278.5 million at September 30, 2021 and included an unrealized net gain of $0.05 million. The portfolio includes projected maturities and mortgage-backed securities pay-downs of approximately $4.8 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company’s deposit base.

The Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes as required or permitted by law. At September 30, 2021 and December 31, 2020, the Company’s unpledged securities in the available-for-sale portfolio totaled approximately $73.7 million and $44.1 million, respectively.

Total investment securities pledged for these purposes were as follows:

	September 30,		December 31,
(In thousands)	2021		2020
Investment securities pledged for the purpose of securing:
Federal Reserve Bank borrowings	$	10,755	$	9,115
Federal funds purchased and securities sold under agreements to repurchase		36,207		59,695
Other deposits		157,861		85,130
Total pledged, at fair value	$	204,823	$	153,940

Liquidity is available from the Company’s base of core customer deposits, defined as demand, interest checking, savings, money market deposit accounts, and time deposits less than $250,000, less all brokered deposits under $250,000. At September 30, 2021, such deposits totaled $1.3 billion and represented 93.1% of the Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships.

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Core deposits at September 30, 2021 and December 31, 2020 were as follows:

	September 30,		December 31,
(In thousands)	2021		2020
Core deposit base:
Non-interest bearing demand	$	461,626	$	382,492
Interest checking		249,806		292,375
Savings and money market		423,061		391,248
Other time deposits		178,512		183,072
Total	$	1,313,005	$	1,249,187

Time deposits and certificates of deposit of $250,000 and greater at September 30, 2021 and December 31, 2020 were $77.1 million and $91.3 million, respectively. The Company had brokered deposits totaling $20.2 million and $40.2 million at September 30, 2021 and December 31, 2020, respectively.  

Other components of liquidity are the level of borrowings from third-party sources and the availability of future credit. The Company’s outside borrowings are comprised of securities sold under agreements to repurchase, Federal Home Loan Bank advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of September 30, 2021, under agreements with these unaffiliated banks, the Bank may borrow up to $60.0 million in federal funds on an unsecured basis and $10.3 million on a secured basis. There were no federal funds purchased outstanding at September 30, 2021. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company’s investment portfolio. At September 30, 2021, there were $27.4 million in repurchase agreements. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window, although no such borrowings were outstanding at September 30, 2021.

The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB) and has access to credit products of the FHLB. As of September 30, 2021, the Bank had $93.5 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.

Borrowings outstanding at September 30, 2021 and December 31, 2020 were as follows:

	September 30,		December 31,
(In thousands)	2021		2020
Borrowings:
Federal funds purchased and securities sold under agreements to repurchase	$	27,443	$	45,154
Federal Home Loan Bank advances		93,479		106,660
Subordinated notes		49,486		49,486
Other borrowings		14		14
Total	$	170,422	$	201,314

The 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, the FHLB establishes a collateral value from which the Company may draw advances against this collateral. This collateral is also used to enable the FHLB to issue letters of credit in favor of public fund depositors of the Company. The Federal Reserve Bank also establishes a collateral value of assets pledged to support borrowings from the discount window.

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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 the Company as follows:

	September 30,								December 31,
	2021								2020
					Federal								Federal
					Funds								Funds
			Federal		Purchased						Federal		Purchased
(In thousands)	FHLB		Reserve Bank		Lines		Total		FHLB		Reserve Bank		Lines		Total
Advance equivalent	$	284,161	$	10,301	$	60,000	$	354,462	$	300,633	$	8,898	$	56,835	$	366,366
Letters of credit		(3,000)		—		—		(3,000)		(123,000)		—		—		(123,000)
Advances outstanding		(93,479)		—		—		(93,479)		(106,660)		—		—		(106,660)
Total available	$	187,682	$	10,301	$	60,000	$	257,983	$	70,973	$	8,898	$	56,835	$	136,706

At September 30, 2021, loans of $556.0 million were pledged at the FHLB as collateral for borrowings and letters of credit. At September 30, 2021, investments totaling $10.8 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.

Based upon the above, management believes the Company has more than adequate liquidity, both on balance sheet and through the additional funding capacity with the FHLB, the Federal Reserve Bank and Federal funds purchased lines to meet future anticipated needs in both the short and long-term.

Sources and Uses of Funds

Cash and cash equivalents were $113.3 million at September 30, 2021 compared to $180.4 million at December 31, 2020. The $67.1 million decrease resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the nine months ended September 30, 2021. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $19.5 million for the nine months ended September 30, 2021.

Investing activities consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio used total cash of $78.4 million during the nine months ended September 30, 2021. The cash outflow primarily consisted of $136.7 million in purchases of investment securities partially offset by $50.8 million from maturities and calls and sales of investment securities.

Financing activities used total cash of $8.2 million during the nine months ended September 30, 2021, resulting primarily from a $51.7 million decrease in interest-bearing transaction accounts and time deposits, a $17.7 million decrease in securities sold under agreements to repurchase, and a $13.2 million repayment of FHLB advances, partially offset by a $79.1 million increase in demand deposits. The growth in demand deposits was positively impacted by customers who deposited both economic stimulus payments and PPP loan proceeds into demand accounts. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2021.

In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company’s various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company’s liquidity. The Company had $385.5 million in unused loan commitments and standby letters of credit as of September 30, 2021. Although the Company’s current liquidity resources are adequate to fund this commitment level, the nature of these commitments is such that the likelihood of such a funding demand is very low.

The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company’s ongoing liquidity needs primarily include funding its operating expenses, paying cash dividends to its shareholders and, to a lesser extent, repurchasing its shares of common stock. The Company paid cash

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dividends to its shareholders totaling approximately $2.6 million and $2.3 million for the nine months ended September 30, 2021 and 2020, respectively. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $6.5 million and $2.5 million in dividends to the Company during the nine months ended September 30, 2021 and 2020, respectively. At September 30, 2021 and December 31, 2020, the Company had cash and cash equivalents totaling $2.3 million and $2.0 million, respectively. Subject to declaration by the Company's Board of Directors, the Company expects to continue paying quarterly cash dividends as a part of its current capital allocation strategy. Future dividends will be subject to the determination, declaration and discretion of the Company's Board of Directors and compliance with applicable regulatory capital requirements.

In 2019, the Company's Board of Directors authorized the purchase of up to $5.0 million market value of the Company's common stock. The Company repurchased 117,632 shares at an average cost of $18.26 per share totaling $2.1 million during the first quarter of 2021. During the second quarter of 2021, the Company's Board of Directors reauthorized the purchase of up to $5.0 million market value of the Company's common stock. There were no shares repurchased during the third quarter of 2021. The repurchases under these authorizations may be effectuated in the open market, by block purchase, in privately negotiated transactions, or through other transactions managed by broker-dealers, or any combination thereof. No time limit was set for the completion of these authorized share repurchases.  As of September 30, 2021, $5.0 million remained available for the repurchase of shares pursuant to the share repurchase authorizations. The Company may continue to repurchase shares under its share repurchase authorizations, but the amount and timing of such repurchases will be dependent on a number of factors, including the price of its common stock and other cash flow needs. There is no assurance that the Company will repurchase up to the full amount remaining under its share repurchase authorizations.

Capital Management

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.

The Basel III regulatory capital framework (the "Basel III Capital Rules") adopted by U.S. federal regulatory authorities, among other things, (i) establishes the capital measure called "Common Equity Tier 1" ("CET1"), (ii) specifies that Tier 1 capital consist of CET1 and "Additional Tier 1 Capital" instruments meeting stated requirements, (iii) requires that most deductions/adjustments to regulatory capital measures be made to CET1 and not to other components of capital and (iv) defines the scope of the deductions/adjustments to the capital measures.

Additionally, the Basel III Capital Rules require that the Company maintain a 2.5% capital conservation buffer with respect to each of CET1, Tier 1 and total capital to risk-weighted assets, which provides for capital levels that exceed the minimum risk-based capital adequacy requirements. A financial institution with a conservation buffer of less than the required amount is subject to limitations on capital distributions, including dividend payments and stock repurchases, and certain discretionary bonus payments to executive officers.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of CET1, Tier 1 and total capital to risk-weighted assets, and of Tier 1 capital to average assets, each as defined in the regulations. Management believes, as of September 30, 2021, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

Financial institutions are categorized as well capitalized or adequately capitalized, based on minimum total risk-based, Tier 1 risk-based, CET1 and Tier 1 leverage ratios. As shown in the table below, the Company’s capital ratios exceeded the regulatory definition of adequately capitalized as of September 30, 2021 and December 31, 2020. Based upon the

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information in its most recently filed call report, the Bank met the capital ratios necessary to be well-capitalized. The regulatory authorities can apply changes in classification of assets and such changes may retroactively subject the Company to changes in capital ratios. Any such change could reduce one or more capital ratios below well-capitalized status. In addition, a change may result in imposition of additional assessments by the FDIC or could result in regulatory actions that could have a material effect on our condition and results of operations. In addition, bank holding companies generally are required to maintain a Tier 1 leverage ratio of at least 4%.

Because the Bank had less than $15.0 billion in total consolidated assets as of December 31, 2009, the Company is allowed to continue to classify its trust preferred securities, all of which were issued prior to May 19, 2010, as Tier 1 capital.

Under the Basel III requirements, at September 30, 2021 and December 31, 2020, the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table as of periods indicated:

					Minimum Capital				Required to be
					Required - Basel III				Considered Well-
	Actual				Fully Phased-In				Capitalized
(in thousands)	Amount		Ratio		Amount		Ratio		Amount		Ratio
September 30, 2021
Total Capital (to risk-weighted assets):
Company	$	205,829	15.01	%	$	143,969	10.50	%	$	—	N.A	%
Bank		203,980	14.92			143,540	10.50			136,705	10.00
Tier 1 Capital (to risk-weighted assets):
Company	$	187,031	13.64	%	$	116,546	8.50	%	$	—	N.A	%
Bank		186,868	13.67			116,199	8.50			109,364	8.00
Common Equity Tier 1 Capital (to risk-weighted assets):
Company	$	140,666	10.26	%	$	95,979	7.00	%	$	—	N.A	%
Bank		186,868	13.67			95,694	7.00			88,858	6.50
Tier 1 leverage ratio (to adjusted average assets):
Company	$	187,031	10.82	%	$	69,134	4.00	%	$	—	N.A	%
Bank		186,868	10.86			68,823	4.00			86,028	5.00
December 31, 2020
Total Capital (to risk-weighted assets):
Company	$	193,220	14.97	%	$	135,518	10.50	%	$	—	N.A	%
Bank		191,504	14.87			135,186	10.50			128,748	10.00
Tier 1 Capital (to risk-weighted assets):
Company	$	172,591	13.37	%	$	109,705	8.50	%	$	—	N.A	%
Bank		175,384	13.62			109,436	8.50			102,999	8.00
Common Equity Tier 1 Capital (to risk-weighted assets)
Company	$	129,061	10.00	%	$	90,345	7.00	%	$	—	N.A	%
Bank		175,384	13.62			90,124	7.00			83,686	6.50
Tier 1 leverage ratio:
Company	$	172,591	10.19	%	$	67,724	4.00	%	$	—	N.A	%
Bank		175,384	10.41			67,394	4.00			84,243	5.00

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Asset/Liability and Interest Rate Risk

Management and the Board of Directors are responsible for managing interest rate risk and employing risk management policies that monitor and limit this exposure. Interest rate risk is measured using net interest income simulations and market value of portfolio equity analyses. These analyses use various assumptions, including the nature and timing of interest rate changes, yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, and reinvestment/replacement of asset and liability cash flows.

The principal objective of the Company’s asset and liability management function is to evaluate the interest rate risk within the balance sheet and pursue a controlled assumption of interest rate risk while maximizing earnings and preserving adequate levels of liquidity and capital. The asset and liability management function is under the guidance of ALCO with direction from the Board of Directors. The ALCO meets monthly to review, among other things, the sensitivity of the Company’s assets and liabilities to interest rate changes, local and national market conditions and rates. ALCO also reviews the liquidity, capital, deposit mix, loan mix and investment positions of the Company.

Instantaneous parallel rate shift scenarios are modeled and utilized to evaluate risk and establish exposure limits for acceptable changes in net interest margin. These scenarios, known as rate shocks, simulate an instantaneous change in interest rates and use various assumptions, including, but not limited to, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment and replacement of asset and liability cash flows.

Management analyzes the economic value of equity as a secondary measure of interest rate risk. This is a complementary measure to net interest income where the calculated value is the result of the market value of assets less the market value of liabilities. The economic value of equity is a longer term view of interest rate risk because it measures the present value of the future cash flows. The impact of changes in interest rates on this calculation is analyzed for the risk to our future earnings and is used in conjunction with the analyses on net interest income.

The table below illustrates the impact of an immediate and sustained 200 and 100 basis point increase and a 200 and 100 basis point decrease in interest rates on net interest income based on the interest rate risk model at September 30, 2021 and December 31, 2020.

	% Change in projected net interest income
Hypothetical shift in interest rates	September 30,			December 31,
(bps)	2021			2020
200		1.35	%		0.73	%
100		0.54	%		0.10	%
(100)		(1.96)	%		(1.28)	%
(200)		(3.09)	%		(1.81)	%

The change in the Company’s interest rate risk exposure from December 31, 2020 to September 30, 2021 was primarily due to a reduction in liability funding costs. As liabilities have matured, they have repriced to lower current rates. In addition to lower funding costs, the Bank’s increase in security investments has increased the rate of return on excess funds. This will cause the Company’s balance sheet to remain slightly asset sensitive over the next 12 months, where interest rate increases translate into higher net interest income. Management believes the change in projected net interest income from interest rate shifts of up 200 bps and down 200 bps is an acceptable level of interest rate risk.

Many assumptions are used to calculate the impact of interest rate fluctuations. Actual results may be significantly different than our projections due to several factors, including the timing and frequency of rate changes, market conditions and the shape of the yield curve. The computations of interest rate risk shown above do not include actions that management may undertake to manage the risks in response to anticipated changes in interest rates and actual results may also differ due to any actions taken in response to the changing rates.

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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 the Company’s operations for the three months ended September 30, 2021.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our Company’s management has evaluated, with the participation of our principal executive and principal financial officers, the effectiveness of our disclosure controls and procedures as defined in Rules 13a – 15(e) or 15d – 15(e) of the Securities Exchange Act of 1934 as of September 30, 2021. Based upon and as of the date of that evaluation, our principal executive and principal financial officers concluded that our disclosure controls and procedures were designed, and were effective, to provide reasonable assurance that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required. It should be noted that any system of disclosure controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any system of disclosure controls and procedures is based in part upon assumptions about the likelihood of future events. Because of these and other inherent limitations of any such system, there can be no assurance that any design will always succeed in achieving its stated goals under all circumstances.

Changes in Internal Control Over Financial Reporting

There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) of the Exchange Act) that occurred during the three months ended September 30, 2021 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Impact of New Accounting Standards

Financial Instruments In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (CECL). The revised accounting guidance will remove all recognition thresholds and will require a company to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the company expects to collect over the instrument's contractual life. It also amends the credit loss measurement guidance for available-for-sale debt securities and beneficial interests in securitized financial assets. This new accounting guidance will be effective for interim and annual reporting periods beginning after December 15, 2022. While the Company generally expects to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, the Company has not determined the magnitude of any such one-time adjustment or the overall impact of the new guidance on the Company's consolidated financial statements. The Company has formed a committee and is continuing to evaluate the impact of the ASU's adoption on the Company's consolidated financial statements by assessing different credit risk models. In 2019 and 2020, the Company modeled the various methods prescribed in the ASU against the identified loan segments. The Company will continue to run parallel computations as it continues to evaluate the impact of adoption of this ASU on January 1, 2023.

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Rate Reform In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848) - Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The amendments in this update provide optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting. It provides optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. The amendments in this update are effective for all entities as of March 12, 2020 through December 31, 2022. The Company is currently evaluating the impact of the reference rate reform on the Company’s consolidated financial statements.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

The information required by this Item is set forth in Commitments and Contingencies, Pending Litigation, in our Company’s Notes to Consolidated Financial Statements (unaudited).

Item 1A.  Risk Factors

There has been no material change in risk factors previously disclosed under Part I, Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2020.

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	None
Item 3.	Defaults Upon Senior Securities	None
Item 4.	Mine Safety Disclosures	None
Item 5.	Other Information	None
Item 6.	Exhibits

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Exhibit No.	Description
3.1	Restated Articles of Incorporation of the Company (filed as Exhibit 3.1 to the Company’s current report on Form 8-K on August 9, 2007 and incorporated herein by reference).
3.2	Amended and Restated Bylaws of the Company (filed as Exhibit 3.1 to the Company’s current report on Form 8-K on January 27, 2021 and incorporated herein by reference).
4.1	Specimen certificate representing shares of the Company’s $1.00 par value Common Stock (filed as Exhibit 4.1 to the Company’s current report on Form 8-K/A on June 23, 2017 and incorporated herein by reference).
31.1	Certificate of the Chief Executive Officer of the Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certificate of the Chief Financial Officer of the Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certificate of the Chief Executive Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certificate of the Chief Financial Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS	Inline XBRL Instance Document (the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document).
101.SCH	Inline XBRL Taxonomy Extension Schema Document.
101.CAL	Inline XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF	Inline XBRL Taxonomy Extension Definition Linkbase Document.
101.LAB	Inline XBRL Taxonomy Extension Label Linkbase Document.
101.PRE	Inline XBRL Taxonomy Extension Presentation Linkbase Document.
104	Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101).

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	HAWTHORN BANCSHARES, INC.
Date
	/s/ David T. Turner
November 4, 2021	David T. Turner, Chairman of the Board, President and
	Chief Executive Officer (Principal Executive Officer)
	/s/ Stephen E. Guthrie
November 4, 2021	Stephen E. Guthrie, Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

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