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EX-32 - EXHIBIT 32 - HILLS BANCORPORATIONex32.htm
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EX-21 - EXHIBIT 21 - HILLS BANCORPORATIONex21.htm


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

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2009.
Commission File Number 0-12668.
HILLS BANCORPORATION
(Exact name of Registrant as specified in its charter)

Iowa
42-1208067
(State or Other Jurisdiction of Incorporation or Organization)
(IRS Employer Identification No.)

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

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

No par value common stock
Title of Class

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

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

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

Indicate by checkmark whether the Registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).  Yes  ¨  No  þ

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

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

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

While it is difficult to determine the market value of shares owned by nonaffiliates (within the meaning of such term under the applicable regulations of the Securities and Exchange Commission), the Registrant estimates that the aggregate market value of the Registrant's common stock held by nonaffiliates on January 31, 2010 (based upon reports of beneficial ownership that approximately 82% of the shares are so owned by nonaffiliates and upon the last independently appraised fair value of the Registrant’s common stock of $53.00 per share) was $192,104,065.

The number of shares outstanding of the Registrant's common stock as of February 28, 2010 is 4,418,500 shares of no par value common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement dated March 19, 2010 for the Annual Meeting of the Shareholders of the Registrant to be held April 19, 2010 (the Proxy Statement) are incorporated by reference in Part III of this Form 10-K.
 


 
Page 1 of 103


HILLS BANCORPORATION
FORM 10-K

TABLE OF CONTENTS

   
Page
     
 
PART I
 
     
Item 1.
3
 
3
 
5
 
6
 
7
 
13
Item 1A.
28
Item 1B.
35
Item 2.
36
Item 3.
37
Item 4.
37
     
     
 
Part II
 
Item 5.
38
Item 6.
41
Item 7.
42
Item 7A.
60
Item 8.
61
Item 9.
99
Item 9A.
99
Item 9B.
100
     
     
 
Part III
 
Item 10.
100
Item 11.
100
Item 12.
100
Item 13.
100
Item 14.
100
     
     
 
Part IV
 
Item 15.
101

 
Page 2 of 103



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

Item 1.
Business

GENERAL

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

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

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

The Bank has an established formal loan origination policy.  In general, the loan origination policy attempts to reduce the risk of credit loss to the Bank by requiring, among other things, maintenance of minimum loan to value ratios, evidence of appropriate levels of insurance carried by borrowers and documentation of appropriate types and amounts of collateral and sources of expected payment.

The Bank’s business is not seasonal, except that loan origination fees are driven by interest rate movements and are higher in a low rate environment due to customer demand.  As of December 31, 2009, the Company had no employees and the Bank had 345 full-time and 90 part-time employees.

 
Page 3 of 103


Item 1.
Business (Continued)

 Johnson County and Linn County

The Bank’s trade area includes the Johnson County communities of Iowa City, Coralville, Hills and North Liberty, located near Interstate 80 and Interstate 380 in Eastern Iowa.  These communities have a combined population of approximately 95,400.  Johnson County, Iowa has a population of approximately 127,000. The University of Iowa in Iowa City has approximately 30,300 students and 33,200 full and part-time employees, including 6,700 employees of The University of Iowa Hospitals and Clinics.

The Bank operates offices in the Linn County, Iowa communities of Lisbon, Marion, Mount Vernon and Cedar Rapids, Iowa.  Lisbon has a population of approximately 2,100 and Mount Vernon, located two miles from Lisbon, has a population of about 4,200.  Both communities are within easy commuting distances to Cedar Rapids and Iowa City, Iowa. Cedar Rapids has a metropolitan population of approximately 158,200, including approximately 31,200 from adjoining Marion, Iowa and is located approximately 10 miles west of Lisbon, Iowa and approximately 25 miles north of Iowa City on Interstate 380.  The total population of Linn County is approximately 209,600.  The largest employer in the Cedar Rapids area is Rockwell Collins, Inc., manufacturer of communications instruments, with about 19,300 employees.

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

Employer
Type of Business
Employees
Cedar Rapids and Linn-Mar School Districts
Education
         3,800
AEGON USA, Inc.
Insurance
         3,700
Heartland Express, Inc.
Trucking
         3,300
Hy-Vee Food Stores
Grocery Stores
         3,100
St. Luke's Hospital
Health Care
         3,100
Mercy Medical Center
Health Care
         2,700
Wal-Mart Stores, Inc.
Discount Store
         1,800
Iowa City Community School District
Education
         1,600
Kirkwood Community College
Education
         1,500
Veteran's Administration Medical Center
Health Care
         1,500
Mercy Iowa City
Health Care
         1,400
Pearson Educational Measurement
Information Services - Computers
         1,400
City of Cedar Rapids
City Government
         1,200
PRC
Telemarketing Services
         1,200
ACT, Inc.
Educational Testing Service
         1,200
Quaker Oats Company
Cereals and Chemicals
         1,100
 
Washington County

The Bank has offices located in Kalona and Wellman, Iowa, which are in Washington County.  Kalona is located approximately 20 miles south of Iowa City.  Wellman is located approximately 5 miles west of Kalona.  Kalona has a population of approximately 2,400 and Wellman has a population of about 1,500.  The population of Washington County is approximately 21,500.  Both Kalona and Wellman are primarily agricultural communities, but are located within easy driving distance for employment in Iowa City, Coralville and North Liberty (combined population 95,000) and Washington, Iowa (population 7,000).

 
Page 4 of 103


Business (Continued)

COMPETITION

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

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

The Bank is in direct competition for loans and deposits and financial services with a number of other banks and credit unions in Johnson, Linn and Washington County.  A comparison of the number of office locations and deposits in the three counties as of June, 2009 (most recent date of available data from the FDIC and national credit union websites) is as follows:

   
Johnson County
   
Linn County
   
Washington County
 
   
Offices
   
Deposits
(in millions)
   
Offices
   
Deposits
(in millions)
   
Offices
   
Deposits
(in millions)
 
                                     
Hills Bank and Trust Company
    6     $ 997       6     $ 272       2     $ 88  
Branches of largest competing national bank
    7       203       9       652       1       23  
Largest competing independent bank
    8       482       8       488       2       166  
Largest competing credit union
    7       658       9       459       1       1  
All other bank and credit union offices
    29       596       79       2,627       7       204  
Total Market in County
    57     $ 2,936       111     $ 4,498       13     $ 482  


Effective July 1, 2004, all limitations on bank office locations of Iowa law were repealed, effectively allowing statewide branching.  Since that date, banks have been allowed to establish an unlimited number of offices in any location in Iowa subject to regulatory approval.  Since July 1, 2006, nine new offices have been added in Johnson County and eleven in Linn County, while the population base has increased by 9,600, or 2.94%, in the two counties in the last three years.  The number of banking offices in Washington County has increased by two while its population has remained stable.  The total deposits in the three counties increased $1.17 billion or 17.51%, since July 1, 2006.

 
Page 5 of 103


Business (Continued)

THE ECONOMY

The Bank’s primary trade territory is Johnson, Linn and Washington Counties, Iowa.  The table that follows shows employment information as of December 31, 2009, regarding the labor force and unemployment levels in the three counties in which the Bank has office locations along with comparable data on the United States and the State of Iowa.

   
Labor Force
   
Unemployed
   
Rate %
 
                   
United States
    153,059,000       15,267,000       10.0 %
State of Iowa
    1,683,800       110,800       6.6 %
Johnson County
    79,900       3,500       4.4 %
Linn County
    121,900       7,800       6.4 %
Washington County
    12,400       700       5.6 %


The unemployment rate for the Bank’s prime market area is favorable and the rate historically has been lower than the unemployment rates for both the United States and the State of Iowa.  The unemployment rates in 2008 were 7.2% for the United States, 4.6% for the State of Iowa and 3.3%, 4.5% and 4.6% for Johnson, Linn and Washington Counties, respectively.  As noted within the employment table of large employers in Johnson and Linn County, the University of Iowa’s impact on the local economy is very important in maintaining acceptable employment levels.  The FY 2009-2010 budget for the University of Iowa, including the University of Iowa Hospital and Clinics, is $2.8 billion with state appropriations of approximately $259 million, or about 9.1% of the total.  The state appropriations decreased from $394 million, or about 14.7%, from the FY 2008 – 2009 budget.  The University of Iowa Hospitals and Clinics have a FY 2009-2010 budget of $859 million with 8.60% coming from State of Iowa appropriations.  The state appropriations for the University of Iowa Hospitals and Clinics increased from 7.40% in the FY 2008-2009 budget.

It is difficult to predict how the national economic struggles will impact the State of Iowa going forward.  The proposed State of Iowa general fund budget for FY 2011 will be $5.3 billion, which is $64 million lower than the FY 2007 general budget.  The lower budget was achieved by continuing the 10% across the board cuts made in the Fall of 2009 for most of the General Fund budget.  These cuts include a hiring freeze, delayed capital purchases and other measures.  The spending cuts are due to reductions in estimates for state revenues over the next two years.  It is unclear what impact the stress of the State budget will continue to have on the University of Iowa and the University of Iowa Hospitals and Clinics.  Johnson and Linn Counties have been one of the strongest economic areas in Iowa and have had substantial economic growth in the past ten years.  The largest segment of the employed population is employed in manufacturing, management, professional or related occupations.

The economies in the counties continue to be enhanced by local Iowa colleges and the University of Iowa.  In addition to providing quality employment, they enroll students who provide economic benefits to the area.  The following table indicates Fall 2009 enrollment.

College
City
Enrollment
The University of Iowa
Iowa City
30,328
Coe College
Cedar Rapids
1,300
Cornell College
Mount Vernon
1,150
Kirkwood Community College
Cedar Rapids, Iowa City and Washington
17,841
Mount Mercy College
Cedar Rapids
1,666

 
Page 6 of 103


Item 1.
Business (Continued)

The Bank also serves a number of smaller communities in Johnson, Linn and Washington counties that are more dependent upon the agricultural economy, which historically has been affected by commodity prices and weather.  The average price per acre of farm land continues to be an important factor to consider when reviewing the local economy.  The average price per acre in Iowa in 2009 was $4,371 compared to $4,468 in 2008, a 2.17% decrease.  The range of average land prices in Johnson, Linn and Washington counties is between $4,734 and $5,201 per acre.  The three counties average decrease was 1.52% in 2009.  The Bank’s total agricultural loans comprise about 4.21% of the Bank’s total loans.

SUPERVISION AND REGULATION

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

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

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

Regulation of the Company

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

 
Page 7 of 103


Item 1.
Business (Continued)

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

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

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

Regulatory Capital Requirements

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

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

The risk-based and leverage standards described above are minimum requirements.  Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations.  For example, the Federal Reserve’s capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentration of credit, nontraditional activities or securities trading activities.  Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios (i.e., Tier 1 capital less all intangible assets), well above the minimum levels.  Current Federal Reserve minimum requirements for a well capitalized organization experiencing significant growth are a leverage ratio of 5%, a Tier 1 risk-based capital ratio of 6% and total risk-based capital ratio of 10%.  As of December 31, 2009, the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements, with a leverage ratio of 9.20%, with total Tier 1 risk-based capital ratio of 11.68% and a total risk-based capital ratio of 12.94%.

 
Page 8 of 103


Item 1.
Business (Continued)

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

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

Regulation of the Bank

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

Deposit Insurance.      The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund (the “DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF.  These assessments have included a special assessment collected on September 30, 2009 and a prepayment of three years of insurance premiums which was paid by the Bank on December 30, 2009.  The prepayment was intended to cover the Bank’s premiums for 2010, 2011 and 2012.  The FDIC has not ruled out additional special assessments in future years.  In addition, a surcharge is paid to the FDIC for participation in the FDIC’s temporary Transaction Account Guarantee Program, which provides full coverage for the Bank’s noninterest-bearing transaction deposit accounts and which will expire on June 30, 2010.  The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating.  Effective January 1, 2007, the FDIC imposed deposit assessment rates based on the risk category of the bank.  Risk Category I is the lowest risk category while Risk Category IV is the highest risk category.

The FDIC has adopted a restoration plan under which it has seven years to restore the reserve ratio of the DIF to 1.15% of insured deposits.  Under this plan, the FDIC made adjustments to its risk-based assessment system which became effective on April 1, 2009, to its assessment rates, and established a special assessment of five basis points on assets minus Tier 1 capital as of June 30, 2009 and collected on September 30, 2009.  In addition, the FDIC imposed a prepayment of three years of insurance premiums which was paid by the Company on December 30, 2009.  The Company’s prepaid FDIC insurance was $6.9 million at December 31, 2009.  The prepayment was intended to cover the Bank’s premiums for 2010, 2011 and 2012.  The FDIC has not ruled out additional special assessments in future years.

In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation (FICO), a mixed-ownership government corporation established to recapitalize a predecessor to the Deposit Insurance Fund.  The current annualized assessment rate is 1.14 basis points, or approximately .285 basis points per quarter.  These assessments will continue until the FICO bonds mature in 2019.

 
Page 9 of 103


Item 1.
Business (Continued)

Capital Requirements.  Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements to maintain reserves against deposits, restrictions on the nature and amount of loans, and restrictions relating to investments, opening of bank offices and other activities of state banks.  Changes in the capital structure of state banks are also approved by the Superintendent.  State banks must have a Tier 1 risk-based leverage ratio of 6.5% plus a fully funded loan loss reserve. In certain instances, the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement on the Bank.  In determining the Tier 1 risk-based leverage ratio, the Superintendent uses total equity capital without unrealized securities gains and the allowance for loan losses less any intangible assets.   At December 31, 2009, the Tier 1 risk-based leverage ratio of the Bank was 9.14% and exceeded the ratio required by the Superintendent.

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

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

Supervisory Assessments.  All Iowa banks are required to pay supervisory assessments to the Superintendent to fund the Superintendent’s examination and supervision operations.  Effective July 1, 2002, the Superintendent changed the method of computation of the supervisory assessment from billing for each state examination completed based on an hourly rate, to billing on an annual basis based on the assets of the bank, the expected hours needed to conduct examinations of that size bank and an additional amount if more work is required.  For fiscal 2009, the Bank’s Iowa supervisory assessment total was $124,996.

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

Dividends.  The Iowa Banking Act provides that an Iowa bank may not pay dividends in an amount greater than its undivided profits.

The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized.  As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2009.  Notwithstanding the availability of funds for dividends, however, the Superintendent may prohibit the payment of any dividends by the Bank if the Superintendent determines such payment would constitute an unsafe or unsound practice.  The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank.  The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends.  To maintain acceptable capital ratios in the Bank, certain of its retained earnings are not available for the payment of dividends.  To maintain a ratio of total risk-based capital to assets of 8%, $38,851,000 of the Bank’s total retained earnings of $166,890,000 as of December 31, 2009 are available for the payment of dividends to the Bank.

 
Page 10 of 103


Item 1.
Business (Continued)

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

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

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

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

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

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

 
Page 11 of 103


Item 1.
Business (Continued)

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

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

 
Page 12 of 103


Item 1.
Business (Continued)

CONSOLIDATED STATISTICAL INFORMATION

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

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

AVERAGE BALANCES
(Average Daily Basis)

   
Years Ended December 31
 
   
2009
   
2008
   
2007
 
   
(Amounts In Thousands)
 
ASSETS
                 
Cash and cash equivalents
  $ 36,138     $ 21,308     $ 22,145  
Taxable securities
    110,883       114,717       114,271  
Nontaxable securities
    99,142       96,771       88,727  
Federal funds sold
    19,440       863       6,527  
Loans, net
    1,479,823       1,406,447       1,305,485  
Property and equipment, net
    24,258       22,208       21,700  
Other assets
    48,681       37,370       31,036  
    $ 1,818,365     $ 1,699,684     $ 1,589,891  
                         
LIABILITIES AND STOCKHOLDERS' EQUITY
                       
Noninterest-bearing demand deposits
  $ 170,627     $ 155,017     $ 137,271  
Interest-bearing demand deposits
    219,545       182,554       157,483  
Savings deposits
    321,208       255,026       261,914  
Time deposits
    643,413       588,691       575,738  
Short-term borrowings
    40,810       84,119       51,880  
FHLB borrowings
    237,556       261,399       248,804  
Other liabilities
    16,605       14,198       11,591  
Redeemable common stock held by
                       
Employee Stock Ownership Plan
    23,357       23,010       21,573  
Stockholders' equity
    145,244       135,670       123,637  
    $ 1,818,365     $ 1,699,684     $ 1,589,891  

 
Page 13 of 103


Item 1.
Business (Continued)

INTEREST INCOME AND EXPENSE
   
Years Ended December 31
 
   
2009
   
2008
   
2007
 
   
(Amounts In Thousands)
 
                   
Income:
                 
Loans (1)
  $ 89,184     $ 89,525     $ 88,937  
Taxable securities
    3,786       4,734       4,706  
Nontaxable securities (1)
    5,187       5,204       4,852  
Federal funds sold
    55       18       325  
Total interest income
    98,212       99,481       98,820  
                         
Expense:
                       
Interest-bearing demand deposits
    1,390       1,571       2,246  
Savings deposits
    3,137       3,397       6,034  
Time deposits
    20,742       23,897       26,997  
Short-term borrowings
    631       1,818       2,151  
FHLB borrowings
    11,241       12,860       12,524  
Total interest expense
    37,141       43,543       49,952  
                         
Net interest income
  $ 61,071     $ 55,938     $ 48,868  

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

 
Page 14 of 103


Item 1.
Business (Continued)

INTEREST RATES AND INTEREST DIFFERENTIAL

   
Years Ended December 31
 
   
2009
   
2008
   
2007
 
                   
Average yields:
                 
Loans (1)
    6.01 %     6.35 %     6.80 %
Loans (tax equivalent basis) (1)
    6.03       6.37       6.81  
Taxable securities
    3.41       4.13       4.12  
Nontaxable securities
    3.40       3.50       3.55  
Nontaxable securities (tax equivalent basis)
    5.23       5.38       5.47  
Federal funds sold
    0.16       2.05       4.98  
Average rates paid:
                       
Interest-bearing demand deposits
    0.63       0.86       1.43  
Savings deposits
    0.98       1.33       2.30  
Time deposits
    3.22       4.06       4.69  
Short-term borrowings
    1.48       2.09       4.15  
FHLB borrowings
    4.73       4.92       5.03  
Yield on average interest-earning assets
    5.69       6.15       6.52  
Rate on average interest-bearing liabilities
    2.52       3.15       3.85  
Net interest spread (2)
    3.17       3.00       2.68  
Net interest margin (3)
    3.55       3.47       3.24  

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

(2)
Net interest spread is the difference between the yield on average interest-earning assets and the yield on average interest-paying liabilities stated on a tax equivalent basis using a federal rate of 35% for the three years presented.  The net interest spread increased 17 basis points in 2009 and increased 32 basis points in 2008.

(3)
Net interest margin is net interest income, on a tax equivalent basis, divided by average interest-earning assets.  The net interest margin increased 8 basis points in 2009 and increased 23 basis points in 2008.    The net interest margin increased in 2009 due to the continued low rate environment.  The Company was able to reprice interest-bearing liabilities downward more quickly that the average yields on earnings assets.

 
Page 15 of 103


Item 1.
Business (Continued)

CHANGES IN INTEREST INCOME AND EXPENSE

   
Changes Due
   
Changes Due
   
Total
 
   
To Volume
   
To Rates
   
Changes
 
   
(Amounts In Thousands)
 
                   
Year ended December 31, 2009:
                 
Change in interest income:
                 
Loans
  $ 4,657     $ (4,998 )   $ (341 )
Taxable securities
    (191 )     (757 )     (948 )
Nontaxable securities
    127       (144 )     (17 )
Federal funds sold
    37       -       37  
    $ 4,630     $ (5,899 )   $ (1,269 )
Change in interest expense:
                       
Interest-bearing demand deposits
    (321 )     502       181  
Savings deposits
    (1,142 )     1,402       260  
Time deposits
    (2,222 )     5,377       3,155  
Short-term borrowings
    912       275       1,187  
FHLB borrowings
    1,206       413       1,619  
      (1,567 )     7,969       6,402  
Change in net interest income
  $ 3,063     $ 2,070     $ 5,133  
                         
Year ended December 31, 2008:
                       
Change in interest income:
                       
Loans
  $ 7,617     $ (7,028 )   $ 589  
Taxable securities
    24       4       28  
Nontaxable securities
    439       (88 )     351  
Federal funds sold
    (307 )     -       (307 )
    $ 7,773     $ (7,112 )   $ 661  
Change in interest expense:
                       
Interest-bearing demand deposits
    (358 )     1,032       674  
Savings deposits
    382       2,256       2,638  
Time deposits
    (607 )     3,707       3,100  
Short-term borrowings
    (1,673 )     2,006       333  
FHLB borrowings
    (671 )     335       (336 )
      (2,927 )     9,336       6,409  
Change in net interest income
  $ 4,846     $ 2,224     $ 7,070  

Rate/volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates.  Loan fees included in interest income are not material.  Interest on nontaxable securities and loans is shown at tax equivalent amounts.

 
Page 16 of 103


Item 1.
Business (Continued)

LOANS

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

   
December 31,
 
   
2009
   
2008
   
2007
   
2006
   
2005
 
   
(Amounts In Thousands)
 
                               
Agricultural
  $ 64,598     $ 64,198     $ 60,004     $ 49,223     $ 43,730  
Commercial and financial
    153,997       162,170       132,070       111,441       86,005  
Real estate:
                                       
Construction, 1 to 4 family residential
    25,821       29,343       33,209       26,266       19,195  
Construction, land development and commercial
    95,955       111,006       89,935       87,933       64,261  
Mortgage, farmland
    87,300       83,499       66,554       53,822       42,554  
Mortgage, 1 to 4 family first liens
    470,328       444,474       423,177       420,642       380,577  
Mortgage, 1 to 4 family junior liens
    114,742       117,086       115,604       111,077       88,952  
Mortgage, multi-family
    190,180       180,525       167,718       166,540       163,070  
Mortgage, commercial
    295,070       270,158       247,749       231,408       230,695  
Loans to individuals
    25,405       26,823       29,069       32,167       32,631  
Obligations of state and political subdivisions
    9,745       8,218       7,220       6,558       5,406  
    $ 1,533,141     $ 1,497,500     $ 1,372,309     $ 1,297,077     $ 1,157,076  
Less allowance for loan losses
    29,160       27,660       19,710       17,850       15,360  
    $ 1,503,981     $ 1,469,840     $ 1,352,599     $ 1,279,227     $ 1,141,716  

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

MATURITY DISTRIBUTION OF LOANS

The following table shows the principal payments due on loans as of December 31, 2009:

   
Amount
Of Loans
   
One Year
Or Less (1)
   
One To
Five Years
   
Over Five
Years
 
   
(Amounts In Thousands)
 
                         
Commercial
  $ 214,704     $ 106,560     $ 100,998     $ 7,146  
Real Estate
    1,282,958       273,646       898,702       110,610  
Other
    35,479       7,149       18,916       9,414  
Totals
  $ 1,533,141     $ 387,355     $ 1,018,616     $ 127,170  
                                 
The types of interest rates applicable to these principal payments are shown below:
                               
                                 
Fixed rate
  $ 759,199     $ 140,825     $ 542,141     $ 76,233  
Variable rate
    773,942       246,530       476,475       50,937  
    $ 1,533,141     $ 387,355     $ 1,018,616     $ 127,170  

(1)
A significant portion of the commercial loans are due in one year or less.  A significant percentage of the loans are re-evaluated prior to their maturity and are likely to be extended.

 
Page 17 of 103


Item 1.
Business (Continued)

NONACCRUAL, PAST DUE, RESTRUCTURED AND NON-PERFORMING LOANS

The following table summarizes the Company's non-accrual, past due, restructured and non-performing loans as of December 31 for each of the years presented:

   
2009
   
2008
   
2007
   
2006
   
2005
 
   
(Amounts In Thousands)
 
                               
Nonaccrual loans
  $ 5,360     $ 2,535     $ 4,948     $ 879     $ 175  
Accruing loans past due 90 days or more
    7,009       5,049       6,019       4,983       1,910  
Restructured loans
    15,135       4,478       -       -       -  
Non-performing (includes non-accrual loans and restructured loans)
    75,265       52,186       39,583       14,681       16,602  
Loans held for investment
    1,533,141       1,497,500       1,372,309       1,297,077       1,157,076  
Ratio of allowance for loan losses to loans held for investment
    1.90 %     1.85 %     1.44 %     1.38 %     1.33 %
Ratio of allowance for loan losses to non-performing loans
    38.74       53.00       49.79       121.59       92.52  

 
Page 18 of 103


Item 1.
Business (Continued)

   
December 31, 2009
   
December 31, 2008
 
   
Non-accrual loans
   
Accruing loans past due 90 days
   
Restructured loans
   
Non-accrual loans
   
Accruing loans past due 90 days
   
Restructured loans
 
   
(Amounts In Thousands)
   
(Amounts In Thousands)
 
                                     
Agriculture
  $ -     $ 8     $ -     $ -     $ -     $ -  
Commercial and financial
    958       280       3,134       661       429       199  
Real estate:
                                               
Construction, 1 to 4 family residential
    -       260       -       1,325       208       1,010  
Construction, land development and commercial
    2,645       1,202       2,442       -       515       3,269  
Mortgage, farmland
    -       172       -       -       -       -  
Mortgage, 1 to 4 family first liens
    1,534       3,528       1,672       549       2,741       -  
Mortgage, 1 to 4 family junior liens
    -       140       613       -       363       -  
Mortgage, multi-family
    -       906       4,867       -       90       -  
Mortgage, commercial
    223       469       2,407       -       605       -  
Loans to individuals
    -       44       -       -       98       -  
    $ 5,360     $ 7,009     $ 15,135     $ 2,535     $ 5,049     $ 4,478  
                                                 
   
December 31, 2007
   
December 31, 2006
 
   
Non-accrual loans
   
Accruing loans past due 90 days
   
Restructured loans
   
Non-accrual loans
   
Accruing loans past due 90 days
   
Restructured loans
 
   
(Amounts In Thousands)
   
(Amounts In Thousands)
 
                                                 
Agriculture
  $ 109     $ 34     $ -     $ 445     $ 25     $ -  
Commercial and financial
    491       795       -       212       307       -  
Real estate:
                                               
Construction, 1 to 4 family residential
    369       -       -       -       506       -  
Construction, land development and commercial
    302       750       -       -       695       -  
Mortgage, farmland
    -       -       -       44       43       -  
Mortgage, 1 to 4 family first liens
    -       3,897       -       -       1,783       -  
Mortgage, 1 to 4 family junior liens
    18       211       -       -       47       -  
Mortgage, multi-family
    -       -       -       -       -       -  
Mortgage, commercial
    3,659       222       -       178       1,157       -  
Loans to individuals
    -       110       -       -       420       -  
    $ 4,948     $ 6,019     $ -     $ 879     $ 4,983     $ -  
                                                 
   
December 31, 2005
                         
   
Non-accrual loans
   
Accruing loans past due 90 days
   
Restructured loans
                         
   
(Amounts In Thousands)
                         
                                                 
Agriculture
  $ -     $ 162     $ -                          
Commercial and financial
    -       166       -                          
Real estate:
                                               
Construction, 1 to 4 family residential
    175       -       -                          
Construction, land development and commercial
    -       -       -                          
Mortgage, farmland
    -       40       -                          
Mortgage, 1 to 4 family first liens
    -       921       -                          
Mortgage, 1 to 4 family junior liens
    -       162       -                          
Mortgage, multi-family
    -       136       -                          
Mortgage, commercial
    -       -       -                          
Loans to individuals
    -       323       -                          
    $ 175     $ 1,910     $ -                          

 
Page 19 of 103


Item 1.
Business (Continued)

Non-performing loans increased by $23.1 million from December 31, 2008 to December 31, 2009.  Non-performing loans include any loan that has been placed on nonaccrual status and restructured loans.  Non-performing loans also include loans that based on management’s evaluation of current information and events, the Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement.  These loans are also considered impaired loans.  The increase in non-performing loans is due to the deterioration of credit quality related to multiple borrowers including five unrelated land development borrowers with aggregate loan balances of $9.4 million, one agricultural production operation with an aggregate loan balance of $4.6 million, four unrelated borrowers with multi-family real estate loans with aggregate balances of $3.7 million and three unrelated borrowers with commercial real estate loans with aggregate balances of $3.1 million.  The remainder of the increase in non-performing loans is related to unrelated borrower relationships of less than $1.0 million and the continued deterioration in economic conditions.  Non-performing loans at December 31, 2009 includes $15.4 million of loans related to the June 2008 floods in the Bank’s trade area.  Most of the non-performing loans are secured by real estate and are believed to be adequately collateralized.

Loans 90 days past due that are still accruing interest increased $2.0 million from December 31, 2008 to December 31, 2009. The average balance of the past due loans also increased during 2009 as compared to 2008.  The average past due loan balance was $95,000 as of December 31, 2009 compared to $90,000 as of December 31, 2008.  The loans 90 days past due and still accruing are believed to be adequately collateralized.   Loans are placed on non-accrual status when management believes the collection of future principal and interest is not reasonably assured.

The Bank regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans are impaired.  If the loans are impaired, the Bank determines if a specific allowance is appropriate.  In addition, the Bank's management also reviews and, where determined necessary, provides allowances based upon (1) reviews of specific borrowers and (2) management’s assessment of areas that management considers are of higher credit risk.  Loans for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Bank allocates a percentage, as determined by management, for a required allowance needed.  The percentage begins with historical loss experience factors, which are then adjusted for levels and trends in past due, charged-off and recovered loans, volume growth, trends in problem and watch loans, current economic factors, and other relevant factors.

The Company does not have a significant amount of loans that are past due less than 90 days where there are serious doubts as to the ability of the borrowers to comply with the loan repayment terms.

The increase in non-accrual loans from December 31, 2008 to December 31, 2009 relates to two borrower relationships that had an aggregate balance of approximately $2.5 million as of December 31, 2009.  Non-accrual loans represent 0.35% of total loans as of December 31, 2009 compared to 0.17% of total loans as of December 31, 2008.  The non-accrual loans are considered to be impaired loans for purposes of reviewing the adequacy of the loan loss reserve.  Interest income was reduced by $391,000, $163,000 and $279,000 for the years ended December 31, 2009, 2008 and 2007, respectively, by the classification of the loans as non-accrual.

Accruing loans past due 90 days or more increased $1.96 million from December 31, 2008 to $7.0 million as of December 31, 2009.  Real estate loans make up approximately $6.7 million, or 95%, of this total.  As of December 31, 2009 and 2008, loans 90 days past due and accruing were 0.46% and 0.34% of total loans, respectively.
 
The Company has no individual borrower or borrowers engaged in the same or similar industry exceeding 10% of total loans.  The Company has no interest-bearing assets, other than loans, that meet the non-accrual, past due, restructured or potential problem loan criteria.

 
Page 20 of 103


Item 1.
Business (Continued)

The Bank restructured loans totaling $11.5 million during 2009.  One customer relationship consisted of seven loans totaling $2.8 million.  The loans currently require interest-only payments at market rates.  The Bank loaned an additional $286,000 to the borrower during 2009 after the completion of the restructuring of the loans.  In addition, the Bank has committed to lend an additional $10,000 to the customer.  Another customer relationship consisted of eleven loans totaling $8.2 million was restructured during 2009.  Since the date of restructure, the Bank would have recorded $139,000 in interest income if the loans had been current in accordance with their original terms.  Instead, the Bank recorded $132,000 of interest income and a loss of interest income of $7,000 due to the restructure of this customer relationship.  The Bank does not have any commitments to lend this customer additional funds.  There were four additional relationships restructured during 2009 totaling $603,000.  Since the date of restructure, the Bank would have recorded $24,000 in interest income if the loans had been current in accordance with their original terms.  Instead, the Bank recorded $23,000 of interest income and a loss of interest income of $1,000 due to the restructure of their customer relationships.  The Bank does not have any commitments to lend these customers additional funds.

The Bank restructured loans totaling $4.5 million during 2008.  These loans related to two customers.  The first 2008 customer relationship consisted of six loans totaling $1.2 million and is flood related.  The Bank would have recorded $63,000 in interest income during the year ended December 31, 2009 related to these loans if the loans had been current in accordance with their original terms.  Instead, the Bank recorded $25,000 of interest for the year ended December 31, 2009, and a loss of interest income of $40,000 due to the restructure of the first borrowing relationship.  After the completion of the restructuring of the loans, the Bank loaned an additional $1,190,000 to the borrower as of December 31, 2009.  In addition, the borrowings are advances on lines of credit with an additional commitment to lend the customer $629,000.  The second 2008 restructured customer relationship consisted of four loans that totaled $3.3 million at the time of the 2008 restructure.  As of December 31, 2009, these loans totaled $2.4 million.  The Bank would have recorded $131,000 in interest income during the twelve months of 2009 related to these loans if the loans had been current in accordance with their original terms.  Instead, the Bank recorded $104,000 of interest for the year ended December 31, 2009, and a loss of interest income of $27,000 due to the restructure of the second borrower relationship.  One of the restructured loans related to the second borrower is a line of credit for $1.4 million.  Currently, the borrower could obtain an additional $732,000 on the line of credit.  After the completion of the restructuring of the loans, the Bank loaned an additional $2.0 million to the borrower as of December 31, 2009.  In addition, the Bank has committed to lend an additional $3,408,000 to the customer through various lines of credit.

Residential real estate loan products that include features such as loan-to-values in excess of 100%, interest only payments or adjustable-rate mortgages, which expose a borrower to payment increases in excess of changes in the market interest rate, increase the credit risk of a loan.  The Bank has not offered and does not offer this type of loan product.

Specific allowances for losses on non-accrual and non-performing loans are established if the loan balances exceed the net present value of the relevant future cash flows or the fair value of the relevant collateral if the loan is collateral dependent.

 
Page 21 of 103


Item 1.
Business (Continued)

SUMMARY OF LOAN LOSS EXPERIENCE

The following table summarizes the Bank's loan loss experience for each of the last five years:

   
Year Ended December 31,
 
   
2009
   
2008
   
2007
   
2006
   
2005
 
   
(Amounts In Thousands)
 
                               
Balance, beginning
  $ 27,660     $ 19,710     $ 17,850     $ 15,360     $ 13,790  
Charge-offs:
                                       
Agricultural
    82       99       343       40       -  
Commercial and financial
    5,161       1,359       1,422       677       802  
Real estate:
                                       
Construction, 1 to 4 family residential
    124       47       45       8       20  
Construction, land development and commercial
    312       15       -       13       30  
Mortgage, farmland
    22       -       58       -       -  
Mortgage, 1 to 4 family first liens
    1,438       1,205       141       128       74  
Mortgage, 1 to 4 family junior liens
    1,626       964       321       308       128  
Mortgage, multi-family
    398       92       -       72       65  
Mortgage, commercial
    1,774       104       57       -       75  
Loans to individuals
    515       604       531       627       981  
      11,452       4,489       2,918       1,873       2,175  
Recoveries:
                                       
Agricultural
    20       61       44       44       47  
Commercial and financial
    415       340       479       643       441  
Real estate:
                                       
Construction, 1 to 4 family residential
    49       -       2       2       -  
Construction, land development and commercial
    -       -       -       -       -  
Mortgage, farmland
    1       4       18       6       1  
Mortgage, 1 to 4 family first liens
    49       25       89       144       -  
Mortgage, 1 to 4 family junior liens
    187       79       130       44       1  
Mortgage, multi-family
    -       95       2       -       7  
Mortgage, commercial
    7       33       58       27       6  
Loans to individuals
    277       295       427       442       1,141  
      1,005       932       1,249       1,352       1,644  
Net charge-offs
    10,447       3,557       1,669       521       531  
Provision charged to expense (1)
    11,947       11,507       3,529       3,011       2,101  
Balance, ending
  $ 29,160     $ 27,660     $ 19,710     $ 17,850     $ 15,360  
                                         
                                         
Ratio of net charge-offs (recoveries)during year to average loans outstanding
    0.71 %     0.25 %     0.13 %     0.04 %     0.05 %

(1)
For financial reporting purposes, management reviews the loan portfolio and determines the allowance for loan losses, which represents management’s judgment of the probable losses inherent in the Company’s loan portfolio.  The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management.  The adequacy of the allowance is reviewed quarterly and considers the impact of economic conditions on the borrowers’ ability to repay, loan collateral values, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition. The growth of the loan portfolio and the trends in problem and watch loans are significant elements in the determination of the provision for loan losses.

 
Page 22 of 103


Item 1.
Business (Continued)

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

The Bank regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans are impaired.  If the loans are impaired, the Bank determines if a specific allowance is appropriate.  In addition, the Bank's management also reviews and, where determined necessary, provides allowances based upon (1) reviews of specific borrowers and (2) management’s assessment of areas that management considers are of higher credit risk.  Loans for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Bank allocates a percentage, as determined by management, for a required allowance needed.  The percentage begins with historical loss experience factors, which are then adjusted for current economic factors.

The following table presents the allowance for loan losses by type of loans and the percentage in each category to total loans as of December 31, 2009, 2008, 2007, 2006 and 2005:

   
2009
   
2008
 
               
% of Loans
               
% of Loans
 
   
Amount
   
% of Total Allowance
   
to Total Loans
   
Amount
   
% of Total Allowance
   
to Total Loans
 
   
(In Thousands)
               
(In Thousands)
             
Agricultural
  $ 2,967       10.17 %     4.21 %   $ 2,258       8.17 %     4.29 %
Commercial and financial
    7,090       24.31       10.04       5,357       19.37       10.83  
Real estate:
                                               
Construction, 1 to 4 family residential
    836       2.87       1.68       626       2.26       1.96  
Construction, land development and commercial
    3,975       13.63       6.26       3,986       14.41       7.41  
Mortgage, farmland
    1,417       4.86       5.69       1,210       4.37       5.58  
Mortgage, 1 to 4 family first liens
    6,091       20.89       30.68       6,035       21.82       29.68  
Mortgage, 1 to 4 family junior liens
    1,393       4.78       7.49       1,346       4.87       7.82  
Mortgage, multi-family
    1,723       5.91       12.40       1,569       5.67       12.06  
Mortgage, commercial
    3,019       10.36       19.25       4,642       16.78       18.04  
Loans to individuals
    639       2.19       1.66       611       2.21       1.78  
Obligations of state and political subdivisions
    10       0.03       0.64       20       0.07       0.55  
    $ 29,160       100.00 %     100.00 %   $ 27,660       100.00 %     100.00 %
 
   
2007
   
2006
 
Agricultural
  $ 1,614       8.19 %     4.37 %   $ 1,509       8.45 %     3.79 %
Commercial and financial
    4,382       22.23       9.62       3,700       20.73       8.59  
Real estate:
                                               
Construction, 1 to 4 family residential
    650       3.30       2.42       475       2.66       2.03  
Construction, land development and commercial
    1,918       9.73       6.55       1,589       8.90       6.78  
Mortgage, farmland
    428       2.17       4.85       332       1.86       4.15  
Mortgage, 1 to 4 family first liens
    4,616       23.42       30.84       4,566       25.58       32.43  
Mortgage, 1 to 4 family junior liens
    1,262       6.40       8.42       1,206       6.75       8.56  
Mortgage, multi-family
    1,466       7.44       12.23       1,433       8.03       12.84  
Mortgage, commercial
    2,563       13.00       18.05       2,245       12.58       17.84  
Loans to individuals
    803       4.08       2.12       788       4.42       2.48  
Obligations of state and political subdivisions
    8       0.04       0.53       7       0.04       0.51  
    $ 19,710       100.00 %     100.00 %   $ 17,850       100.00 %     100.00 %
                                                 
   
2005
                   
Agricultural
  $ 1,528       9.95 %     3.78 %                        
Commercial and financial
    2,701       17.59       7.43                          
Real estate:
                                               
Construction, 1 to 4 family residential
    345       2.25       1.66                          
Construction, land development and commercial
    1,031       6.71       5.55