Exhibit 13

2010

ANNUAL REPORT

TO

SHAREHOLDERS

HAWTHORN BANCSHARES, INC.

Lee’s Summit, Missouri

March 30, 2011

Dear Investors:

For 2010, our company reported a net loss available to common shareholders of $5.5 million compared to a net profit of $3.0 million for 2009. On a per share basis, this equates to a net loss of $1.24 per common share.

The net loss for 2010 was driven primarily by expenses related to adjusting our other real estate owned properties to fair value based on current appraisals and increased provision for loan losses to address continued deteriorating asset quality within the existing portfolio (increases in non-accrual loans, charge-offs, and foreclosures) particularly within the real estate construction and real estate mortgage segments of the portfolio. Other real estate expenses (which included impairment valuation write-downs) and loan loss provisions for 2010 increased over 2009 by $8.6 million and $6.9 million, respectively.

It is difficult to overcome such downward pressure on earnings; but the core performance of Hawthorn remains strong and has even improved in recent years due to 2010’s net interest margin increasing to 3.78% from 2009’s margin of 3.50%. I am pleased with our core growth and the work staff has done to enhance margin dollars. Our success in this area has allowed us to absorb the negative financial impact of the recession to a large extent.

With over 30 years of banking experience, I recognize that the sustainability of a bank is centered on asset quality, capital strength and liquidity. Asset quality has been our biggest challenge during the last couple of years. Hawthorn’s level of non-performing loans increased to 6.27% of total loans at year-end 2010, up from 4.27% at year-end 2009 and this is clearly not acceptable. The economic downturn and elevated unemployment rates in our market areas have impaired the ability for some of our customers to make payments in accordance with contractual terms. As such, Hawthorn has taken an active approach to obtain current appraisals so that market valuations can be used in determining probable loan losses. Although I’m disappointed by the increased credit losses and the elevated level of non-performing loans, we are working diligently to limit losses, as well as identify and resolve credit issues in a timely manner. These efforts are evidenced in the increased volume of foreclosures and gross loan charge-offs realized during 2010. Loans taken into foreclosure (other real estate owned) during 2010 totaled $23.7 million and gross charge-offs were $16.2 million during the same period. Comparatively, transfers to other real estate during 2009 totaled $7.0 million and gross charge-offs were $6.8 million.

Hawthorn’s total risk-based capital was 17.05% at year end 2010 and our leverage capital was 11.00% for the same period. As such, Hawthorn is classified as a well-capitalized bank by regulatory definition. We are disappointed that 2010 earnings were not positive; however, lowering the dividend rate and restricting asset growth enabled our capital levels to remain strong. In 2008, we participated in the U.S. Treasury’s Capital Purchase Program (commonly called TARP) which added $30.3 million in additional capital to the company. As of December 31, 2010, inclusion of the TARP funds in Hawthorn’s capital structure increased total risk-based capital from 13.95% to 17.05%. While Hawthorn would continue to exceed regulatory “well-capitalized” levels if the TARP funds were repaid, more evidence supporting an economic recovery is needed before it would be prudent to eliminate the capital cushion provided by the TARP program.

With liquid assets totaling $208 million, Hawthorn has a strong liquidity position.

As I take over the role as chairman and chief executive officer of Hawthorn, I want to emphasize that Hawthorn has a solid future. With strong core earnings, Hawthorn is fundamentally strong and as the economy rebounds, we anticipate loan loss provisions and other real estate expenses will return to pre-recessionary levels.

Sincerely,

David T. Turner
Chairman, Chief Executive Officer,
and President

A WORD CONCERNING FORWARD-LOOKING STATEMENTS

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

•

statements that are not historical in nature, and

•

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

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

•

competitive pressures among financial services companies may increase significantly,

•

changes in the interest rate environment may reduce interest margins,

•

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

•

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

•

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

•

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

•

changes may occur in the securities markets.

     We have described under the caption “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010, and in other reports that we file with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that we have not identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made.

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

Overview

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

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

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

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

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

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

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

SELECTED CONSOLIDATED FINANCIAL DATA

     The following table presents selected consolidated financial information for our Company as of and for each of the years in the five-year period ended December 31, 2010. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements of our Company, including the related notes, presented elsewhere herein.

Income Statement Data

(In thousands, except per share data)		2010				2009				2008				2007				2006
Interest income		$	58,739			$	63,562			$	69,715			$	74,207			$	71,423
Interest expense			15,753				22,974				31,599				37,175				32,766
Net interest income			42,986				40,588				38,116				37,032				38,657
Provision for loan losses			15,255				8,354				8,211				1,154				1,326
Net interest income after provision for loan losses			27,731				32,234				29,905				35,878				37,331
Non-interest income			10,481				10,702				9,294				10,223				8,618
Security gains (losses), net			—				606				3				(2	)			(18	)
Total non-interest income			10,481				11,308				9,297				10,221				8,600
Non-interest expense			44,851				36,730				75,975				35,054				30,148
Income (loss) before income taxes			(6,639	)			6,812				(36,773	)			11,045				15,783
Income tax (benefit) expense			(3,087	)			1,856				(6,146	)			3,245				4,908
Net (loss) income			(3,552	)			4,956				(30,627	)			7,800				10,875
Less: preferred stock dividends			1,513				1,517				50				—				—
and accretion of discount on preferred stock			476				477				16				—				—
Net (loss) income available to common shareholders		$	(5,541	)		$	2,962			$	(30,693	)		$	7,800			$	10,875
Dividends on Common Stock
Declared		$	1,136			$	2,270			$	3,486			$	3,504			$	3,503
Paid			1,385				2,666				3,486				3,504				3,503
Ratio of total dividends declared to net income			N.M.				76.64	%			N.M.				44.92	%			32.21	%
Per Share Data
Basic (loss) earnings per common share		$	(1.24	)		$	0.66			$	(6.83	)		$	1.73			$	2.41
Diluted (loss) earnings per common share			(1.24	)			0.66				(6.83	)			1.71				2.39
Basic weighted average shares of common stock outstanding			4,474,033				4,474,033				4,494,856				4,511,975				4,510,107
Diluted weighted average shares of common stock outstanding			4,474,033				4,474,033				4,494,856				4,551,139				4,544,577

N.M. — not meaningful

(In thousands, except per share data)		2010				2009				2008				2007				2006
Balance Sheet Data (at period end)
Total assets		$	1,200,172			$	1,236,471			$	1,279,699			$	1,195,804			$	1,142,712
Loans			898,472				991,614				1,009,104				911,278				812,312
Investment securities			178,978				152,927				149,401				151,742				183,566
Total deposits			946,663				956,323				955,296				921,257				899,865
Subordinated notes			49,486				49,486				49,486				49,486				49,486
Other borrowed money			66,986				79,317				129,057				77,915				47,368
Common stockholders’ equity			72,647				79,406				78,530				111,199				104,945
Total stockholders’ equity			101,488				107,771				106,418				111,199				104,945
Balance Sheet Data (average balances)
Total assets		$	1,236,841			$	1,258,381			$	1,251,496			$	1,156,500			$	1,146,150
Loans			949,458				1,002,830				963,252				848,771				824,706
Investment securities			165,213				151,907				156,870				171,179				182,902
Total deposits			967,970				977,826				914,218				921,257				899,865
Subordinated notes			49,486				49,486				49,486				49,486				49,486
Other borrowed money			70,456				78,626				124,025				53,626				56,757
Common stockholders’ equity			80,735				79,828				112,307				108,052				100,821
Total stockholders’ equity			109,323				107,938				113,375				108,052				100,821
Key Ratios
Earnings Ratios
(Loss) return on average total assets			(0.29	)%			0.39	%			(2.45	)%			0.67	%			0.95	%
(Loss) return on average common stockholders’ equity			(6.86	)			3.71				(27.33	)			7.22				10.79
Efficiency ratio (3)			83.89				71.61				160.25				74.18				63.80
Asset Quality Ratios
Allowance for loan losses to loans			1.62				1.49				1.26				1.02				1.11
Nonperforming loans to loans (1)			6.27				4.27				2.46				0.67				0.62
Allowance for loan losses to nonperforming loans (1)			25.87				34.94				50.94				152.54				177.95
Nonperforming assets to loans and foreclosed assets (2)			7.71				5.08				3.21				0.92				0.96
Net loan charge-offs to average loans			1.63				0.62				0.50				0.10				0.17
Capital Ratios
Average stockholders’ equity to average total assets			8.84	%			8.58	%			9.06	%			9.34	%			8.80	%
Period-end common stockholders’ equity to period-end assets			6.05				6.42				6.14				9.30				9.18
Period-end stockholders’ equity to period-end assets			8.46				8.72				8.32				9.30				9.18
Total risk-based capital ratio			17.05				16.49				16.01				13.24				13.84
Tier 1 risk-based capital ratio			14.25				14.01				13.55				11.08				11.28
Leverage ratio			11.00				11.35				10.80				9.12				8.77

CRITICAL ACCOUNTING POLICIES

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

Allowance for Loan Losses

     We have identified the accounting policy related to the allowance for loan losses as critical to the understanding of our Company’s results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on our business operations is provided in Note 1 to our Company’s 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.

Income Taxes

     Income taxes are accounted for under the asset / liability method by recognizing the amount of taxes payable or refundable for the current period and deferred tax assets and liabilities for future tax consequences of events that been that have been recognized in an entity’s financial statements or tax returns. Judgment is required in addressing our Company’s future tax consequences of events that have been recognized in our consolidated financial statements or tax returns such as realization of the effects of temporary differences, net operating loss carry forward, and changes in tax laws or interpretations thereof. A valuation allowance is established when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. In this case, our Company would adjust the recorded value of our deferred tax asset, which would result in a direct charge to income tax expense in the period that the determination was made. Given the sensitivity of the Company’s financial performance to changes in net interest margins and increasing reserves associated with loan losses and other real estate owned, sustained negative financial performance could provide sufficient negative evidence to necessitate a deferred tax asset valuation allowance. In addition, our Company is subject to the continuous examination of our tax returns by the Internal Revenue Service and other taxing authorities. Our Company accrues for interest related to income taxes in income tax expense. Total interest expense recognized was $24,000 and $53,000 in 2010 and 2009, respectively. As of December 31, 2010 and 2009, total accrued interest was $31,000 and $94,000, respectively.

Goodwill and Intangible Assets

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

     When facts and circumstances indicate potential impairment of amortizable intangible assets, our Company evaluates the recoverability of the carrying value based upon future cash flows expected to result from the use of the underlying asset and its eventual disposition. If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying value of the underlying asset, the Company recognizes an impairment loss. The impairment loss recognized represents the amount by which the carrying value of the underlying asset exceeds the fair

value of the underlying asset. As a result of the 2008 annual review, our Company determined that goodwill was fully impaired and recorded an impairment charge of $40,323,775, before tax.

Other Real Estate Owned and Repossessed Assets

     Other real estate owned and repossessed assets consist of loan collateral which has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate owned assets are initially recorded as held for sale at the lower of the loan balance or fair value of the collateral less estimated selling costs. Any adjustment is recorded as a charge-off against the allowance for loan losses. The Company relies on external appraisals and assessment of property values by internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. The write-downs are recorded as other real estate expense. The Company establishes a valuation allowance related to other real estate owned on an asset-by-asset basis. The valuation allowance is created during the holding period when the fair value less cost to sell is lower than the “cost” of a parcel of other real estate.

RESULTS OF OPERATIONS ANALYSIS

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

														$ Change								% Change
(Dollars in thousands)		2010				2009				2008				’10-’09				’09-’08				’10-’09				’09-’08
Net interest income		$	42,986			$	40,588			$	38,116			$	2,398			$	2,472				5.9	%			6.5	%
Provision for loan losses			15,255				8,354				8,211				6,901				143				82.6				1.7
Noninterest income			10,481				10,702				9,294				(221	)			1,408				(2.1	)			15.1
Investment securities gains (losses), net			—				606				3				(606	)			603			NM					20,100.0
Noninterest expense			44,851				36,730				75,975				8,121				(39,245	)			22.1				(51.7	)
(Loss) income before income taxes			(6,639	)			6,812				(36,773	)			(13,451	)			43,585				197.5				(118.5	)
Income tax (benefit) expense			(3,087	)			1,856				(6,146	)			(4,943	)			8,002				266.3				(130.2	)
Net (loss) income		$	(3,552	)		$	4,956			$	(30,627	)		$	(8,508	)		$	35,583				171.7	%			(116.2	)%
Less: preferred dividends			1,513				1,517				50				(4	)			1,467				—				—
and accretion of discount			476				477				16				(1	)			461				—				—
Net (loss) income available to common shareholders		$	(5,541	)		$	2,962			$	(30,693	)		$	(8,503	)		$	33,655				287.1	%			(109.7	)%

     Our Company’s consolidated net loss of ($3,552,000) for the year ended December 31, 2010 decreased $8,508,000 compared to net income of $4,956,000 for the year ended December 31, 2009. Our Company recorded preferred stock dividends and accretion on preferred stock of $1,989,000 for the year ended December 31, 2010, resulting in a ($5,541,000) net loss available for common shareholders compared to net income of $2,962,000 for the year ended December 31, 2009. Diluted earnings per share decreased from $0.66 per common share to ($1.24) per common share. Results for the year ended December 31, 2010 were negatively impacted by the $15,255,000 provision for loan losses compared to $8,354,000 for the same time period in 2009. Our Company also recorded a $6,158,000 valuation allowance for other real estate owned during the fourth quarter that significantly increased noninterest expense. For the year ended December 31, 2010, the return on average assets was (0.29)%, the return on average stockholders’ equity was (6.86)%, and the efficiency ratio was 83.9%. Net interest margin increased from 3.50% to 3.78%. Net interest income, on a tax equivalent basis, increased $2,317,000, or 8.0%, from 2009 to 2010.

     Our Company’s consolidated net income of $4,956,000 for the year ended December 31, 2009 increased $35,583,000 compared to a loss of $(30,627,000) for the year ended December 31, 2008. Our Company recorded

preferred stock dividends of $1,994,000 for the year ended December 31, 2009, resulting in $2,962,000 of net income available to common shareholders compared to a net loss of $(30,693,000) for the year ended December 31, 2008. Diluted earnings per share increased from $(6.83) per common share to $0.66 per common share. This $33,655,000 increase from 2008 is primarily due to a one time $40,324,000 ($33,211,000 after tax) goodwill impairment charge to income taken in the fourth quarter of 2008. Excluding this one time goodwill impairment charge, net income available for the common shareholders increased $444,000 from $2,518,000 to $2,962,000. This non-GAAP measure of operating results is discussed more fully below. Our Company did experience substantial real estate refinancing activity in 2009, which contributed additional revenues of approximately $2,001,000. However, this was offset by an industry-wide increase in FDIC insurance assessments. Our Company paid insurance assessments of $2,519,000 during 2009 in comparison to $204,000 during 2008. For the year ended December 31, 2009, the return on average assets was 0.39%, the return on average common shareholders’ equity was 3.71%, and the efficiency ratio was 71.6%. Net interest margin increased from 3.42% to 3.50%. Net interest income, on a tax equivalent basis, increased $2,353,000 or 6.0% from 2008 to 2009.

     Total assets at December 31, 2010 were $1,200,172,000, compared to $1,236,471,000 at December 31, 2009, a decrease of $36,298,000, or 2.9%. On July 1, 2010, our Company distributed a four percent stock dividend for the second consecutive year to common shareholders of record at the close of business May 19, 2010. For all periods presented, share information, including basic and diluted earnings (loss) per share, have been adjusted retroactively to reflect the change.

Comparison of GAAP and Non-GAAP Information

     As a supplement to our U.S. GAAP financial results, our Company has provided non-GAAP operating results for the years ended December 31, 2009 and 2008. Our Company believes that these non-GAAP financial measures are useful because they allow investors to assess, on a consistent basis, our Company’s performance exclusive of items management believes are not indicative of the operations of our Company. Management uses non-GAAP financial measures to evaluate financials results and to establish operational goals. These non-GAAP financial measures should be considered a supplement to, and not a substitute for, financial measures determined in accordance with GAAP. The non-GAAP measures presented below exclude the non-recurring pre-tax charge to write-off our entire goodwill in the fourth quarter of 2008 which is explained in more detail in the “Non-interest Income and Expense” section of this discussion and Note 6 to our Company’s consolidated financial statements.

										$ Change				% Change
(Dollars in thousands)		2009				2008				’09-’08				’09-’08
Non-interest expense (GAAP)		$	36,730			$	75,975			$	(39,245	)			(0.5	)%
Goodwill impairment			—				(40,324	)			40,324				N.M
Non-interest expense (non-GAAP)			36,730				35,651				1,079				3.0
Net (loss) income (GAAP)		$	4,956			$	(30,627	)		$	35,583				(116.2	)%
Goodwill impairment, net of tax effect			—				33,211				(33,211	)			N.M
Less: preferred dividends			1,517				50				1,467				N.M
and accretion of discount			477				16				461				N.M
Net income available to common shareholders (non-GAAP)		$	2,962			$	2,518			$	444				17.6	%
GAAP basis:
Basic earnings (loss) per share		$	0.66			$	(6.83	)		$	7.49				(109.7	)%
Diluted earnings (loss) per share			0.66				(6.83	)			7.49				(109.7	)
Return (loss) on average assets			0.39	%			(2.45	)%
Return (loss) on average common equity			3.71	%			(27.33	)%
Efficiency ratio			71.61	%			160.25	%
Non-GAAP basis:
Basic earnings per share		$	0.66			$	0.56			$	0.10				17.9	%
Diluted earnings per share			0.66				0.56				0.10				17.9
Return on average assets			0.39	%			0.20	%
Return on average common equity			3.71	%			2.24	%
Efficiency ratio			71.61	%			75.20	%

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

     Based on non-GAAP operating results as shown above, our Company’s diluted earnings per common share were $0.66 in 2009 compared to $0.56 in 2008. Consolidated net income for 2009 was $2,962,000, compared to $2,518,000 in 2008. Return on average total assets increased from 0.20% in 2008 to 0.39% in 2009, and return on average common equity decreased from 2.24% in 2008 to 3.71% in 2009. The efficiency ratio was 71.6% in 2009 compared with 75.2% in 2008.

Net Interest Income

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

Average Balance Sheets

     The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the years in the three year period ended December 31, 2010.

(Dollars In thousands)		2010												2009												2008
						Interest				Rate								Interest				Rate								Interest				Rate
		Average				Income/				Earned/				Average				Income/				Earned/				Average				Income/				Earned/
		Balance				Expense(1)				Paid(1)				Balance				Expense(1)				Paid(1)				Balance				Expense(1)				Paid(1)
ASSETS
Loans: (2) (4)
Commercial		$	139,679			$	7,739				5.54	%		$	149,695			$	8,151				5.45	%		$	151,342			$	9,468				6.26	%
Real estate construction - residential			37,954				1,959				5.16				36,630				2,137				5.83				—				—				—
Real estate construction - commercial			75,207				2,904				3.86				64,548				3,610				5.59				—				—				—
Real estate mortgage — residential			221,545				12,672				5.72				222,798				14,197				6.37				223,093				9,560				4.29
Real estate mortgage — commercial			440,285				25,309				5.75				494,703				26,813				5.42				556,343				41,132				7.39
Consumer			34,787				2,626				7.55				34,456				2,606				7.56				32,474				2,606				8.02
Investment in securities: (3)
U.S. treasury			790				15				1.9				—				—				—				—				—				—
Government sponsored enterprises			47,914				1,242				2.59				47,958				1,800				3.75				75,514				3,268				4.33
Asset backed securities			83,237				2,918				3.51				64,133				2,617				4.08				35,326				1,649				4.67
State and municipal			33,272				1,764				5.30				39,816				2,166				5.44				46,030				2,503				5.44
Restricted Investments			6,356				176				2.77				8,817				164				1.86				8,440				316				3.74
Federal funds sold			187				—				—				309				—				—				2,925				60				2.05
Interest bearing deposits in other financial institutions			34,680				86				0.25				18,807				53				0.28				8,738				24				0.27
Total interest earning assets			1,155,893				59,410				5.14				1,182,670				64,314				5.44				1,140,225				70,586				6.19
All other assets			94,802												89,108												121,373
Allowance for loan losses			(13,854	)											(13,397	)											(10,102	)
Total assets		$	1,236,841											$	1,258,381											$	1,251,496
LIABILITIES AND STOCKHOLDERS’ EQUITY
NOW accounts		$	167,303			$	960				0.57	%		$	138,456			$	1,131				0.82	%		$	117,487			$	1,317				1.12	%
Savings			52,605				131				0.25				46,464				139				0.30				44,253				226				0.51
Money market			167,240				1,080				0.65				175,894				1,747				0.99				168,418				3,340				1.98
Time deposits of $100,000 and over			130,493				2,485				1.90				140,502				3,862				2.75				142,713				5,698				3.99
Other time deposits			318,891				7,211				2.26				351,597				10,543				3.00				319,919				12,872				4.02
Total time deposits			836,532				11,867				1.42				852,913				17,422				2.04				792,790				23,453				2.96
Federal funds purchased and securities sold under agreements to repurchase			32,723				75				0.23				33,923				88				0.26				41,633				869				2.09
Subordinated notes			49,486				1,526				3.08				49,486				2,447				4.94				49,486				3,046				6.16
Other borrowed money			70,456				2,285				3.24				78,626				3,017				3.84				124,025				4,231				3.41
Total interest bearing liabilities			989,197				15,753				1.59				1,014,948				22,974				2.26				1,007,934				31,599				3.14
Demand deposits			131,438												124,913												121,428
Other liabilities			6,883												10,582												8,759
Total liabilities			1,127,518												1,150,443												1,138,121
Stockholders’ equity			109,323												107,938												113,375
Total liabilities and stockholders’ equity		$	1,236,841											$	1,258,381											$	1,251,496
Net interest income (FTE)						$	43,657											$	41,340											$	38,987
Net interest spread											3.55	%											3.18	%											3.05	%
Net interest margin											3.78	%											3.50	%											3.42	%

Comparison of Years ended December 31, 2010 and 2009

     Financial results for 2010 compared to 2009 included an increase in net interest income, on a tax equivalent basis, of $2,317,000, or 8.0%. Average interest-earning assets decreased $26,777,000, or 2.3% to $1,155,893,000 at December 31, 2010 compared to $1,182,670,000 at December 31, 2009 and average interest bearing liabilities decreased $25,751,000, or 2.5%, to $989,197,000 at December 31, 2010 compared to $1,014,948,000 at December 31, 2009.

     Average loans outstanding decreased $53,372,000 or 5.3% to $949,458,000 for 2010 compared to $1,002,830,000 for 2009. See the “Lending and Credit Management” section of this discussion for further discussion of changes in the composition of our lending portfolio.

The following is a summary of the changes in average loan balance by major class within our Company’s loan portfolio:

										$				%
										Change				Change
(Dollars in thousands)		2010				2009				’10-’09				’10-’09
Average loans:
Commercial		$	139,679			$	149,695			$	(10,016	)			(6.7	)%
Real estate construction — residential			37,954				42,307				(4,353	)			(10.3	)
Real estate construction — commercial			75,207				74,969				238				0.3
Real estate mortgage — residential			221,545				238,012				(16,467	)			(6.9	)
Real estate mortgage — commercial			440,285				463,391				(23,106	)			(5.0	)
Consumer			34,788				34,456				332				1.0
Total		$	949,458			$	1,002,830			$	(53,372	)			(5.3	)%

     Average investment securities and federal funds sold decreased $13,184,000 or 8.7% to $165,400,000 for 2010 compared to $152,216,000 for 2009. Average interest bearing deposits in other financial institutions increased $15,873,000 to $34,680,000 at December 31, 2010 compared to $18,807,000 at December 31, 2009. See the Liquidity Management section below for further discussion.

     The overall decrease in average interest bearing liabilities was due to a decrease in time deposits and other borrowed money. Average time deposits decreased $16,381,000, or 1.9%, to $836,532,000 at December 31, 2010 compared to $852,913,000 at December 31, 2009. Average other borrowed money decreased $8,170,000 or 10.4% to $70,456,000 for 2010 compared to $78,626,000 for 2009. The decrease in 2010 reflects a net decrease in Federal Home Loan Bank advances.

Comparison of Years ended December 31, 2009 and 2008

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

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

										$				%
										Change				Change
(Dollars in thousands)		2009				2008				’09-’08				’09-’08
Average loans:
Commercial		$	149,694			$	151,342			$	(1,648	)			(1.1	)%
Real estate construction — residential			42,307				68,728				(26,421	)			(38.4	)
Real estate construction — commercial			74,969				80,918				(5,949	)			(7.4	)
Real estate mortgage — residential			238,012				223,093				14,919				6.7
Real estate mortgage — commercial			463,391				406,697				56,694				13.9
Consumer			34,457				32,474				1,983				6.1
Total		$	1,002,830			$	963,252			$	39,578				4.1	%

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

     Average time deposits increased $60,123,000, or 7.6%, to $852,913,000 at December 31, 2009 compared to $792,790,000 at December 31, 2008. The increase was primarily a result of increased public fund deposits. Product specials promoting interest bearing checking accounts and certificate of deposits also contributed to new deposits. Average federal funds purchased and securities sold under agreements to repurchase decreased $7,710,000 or 18.5% to $33,923,000 for 2009 compared to $41,633,000 for 2008. This reflects a $5,387,000 decrease in repurchase agreements for public funds and a $2,323,000 decrease in federal funds purchased from 2008 to 2009. Average other borrowed money decreased $45,399,000 or 36.6% to $78,626,000 for 2009 compared to $124,025,000 for 2008. The decrease in 2009 reflects a net decrease in Federal Home Loan Bank advances.

Rate and volume analysis

     The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, indentifying changes related to volumes and rates for the years ended December 31, 2010, compared to December 31, 2009 and for the years ended December 31, 2009 compared to December 31, 2008. 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.

		2010												2009
						Change due to												Change due to
		Total				Average				Average				Total				Average				Average
(Dollars In thousands)		Change				Volume				Rate				Change				Volume				Rate
Interest income on a fully taxable equivalent basis:
Loans: (1) (3)		$	(4,305	)		$	(3,063	)		$	(1,242	)		$	(5,252	)		$	2,579			$	(7,831	)
Investment securities:
U.S. treasury			15				—				15				—				—				—
Government sponsored entities			(558	)			(2	)			(556	)			(1,468	)			(1,077	)			(391	)
Asset backed securities			301				705				(404	)			968				1,198				(230	)
State and municipal(2)			(402	)			(348	)			(54	)			(337	)			(338	)			1
Restricted Investments			12				(54	)			66				(152	)			13				(165	)
Federal funds sold			—				—				—				(60	)			—				(60	)
Interest bearing deposits in other financial institutions			33				40				(7	)			29				29				—
Total interest income			(4,904	)			(2,722	)			(2,182	)			(6,272	)			2,404				(8,676	)
Interest expense:
NOW accounts			(171	)			207				(378	)			(186	)			210				(396	)
Savings			(8	)			17				(25	)			(87	)			10				(97	)
Money market			(667	)			(82	)			(585	)			(1,593	)			142				(1,735	)
Time deposits of 100,000 and over			(1,377	)			(259	)			(1,118	)			(1,836	)			(87	)			(1,749	)
Other time deposits			(3,332	)			(915	)			(2,417	)			(2,329	)			1,184				(3,513	)
Federal funds purchased and securities sold under agreements to repurchase			(13	)			(3	)			(10	)			(781	)			(136	)			(645	)
Subordinated notes			(921	)			—				(921	)			(599	)			—				(599	)
Other borrowed money			(732	)			(294	)			(438	)			(1,214	)			(1,693	)			479
Total interest expense			(7,221	)			(1,329	)			(5,892	)			(8,625	)			(370	)			(8,255	)
Net interest income on a fully taxable equivalent basis		$	2,317			$	(1,393	)		$	3,710			$	2,353			$	2,774			$	(421	)

     Net interest income on a fully taxable equivalent basis increased $2,317,000, or 5.6%, to $43,657,000 for 2010 compared to $41,340,000 for 2009 and followed a $2,353,000, or 6.0%, increase for 2009 compared to 2008. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased from 3.42% for 2008 to 3.50% for 2009, and increased to 3.78% for 2010. Our Company’s net interest spread increased to 3.55% in 2010 from 3.18% in 2009 and 3.05% in 2008.

     While our Company was able to decrease the rate paid on interest bearing liabilities to 1.59% in 2010 from 3.14% in 2008, this decrease was partially offset by the decrease in the rates earned on interest bearing assets from 6.19% in 2008 to 5.14% in 2010.

Non-interest Income and Expense

Non-interest income for the years ended December 31, 2010, 2009, and 2008 were as follows:

														$ Change								% Change
(Dollars in thousands)		2010				2009				2008				’10-’09				’09-’08				’10-’09				’09-’08
Non-interest Income
Service charges on deposit accounts		$	5,554			$	5,864			$	6,164			$	(310	)		$	(300	)			(5.3	)%			(4.9	)%
Trust department income			803				815				827				(12	)			(12	)			(1.5	)			(1.5	)
Gain on sales of mortgage loans			2,493				2,974				973				(481	)			2,001				(16.2	)			205.7
Other			1,631				1,049				1,330				582				(281	)			55.5				(21.1	)
Total non-interest income		$	10,481			$	10,702			$	9,294			$	(221	)		$	1,408				(2.1	)%			15.1	%
Investment securities gains (losses), net		$	—			$	606			$	3			$	(606	)		$	603				(100.0	)%			NM	%
Non-interest income as a % of total revenue *			19.6	%			20.9	%			19.6	%
Total revenue per full time equivalent employee		$	157.3			$	147.4			$	137.8

Years Ended December 31, 2010 and 2009

     Noninterest income decreased $221,000 or 2.1% to $10,481,000 for 2010 compared to $10,702,000 for 2009. The decrease was primarily the result of a $481,000 decrease in the gains on sales of mortgage loans and a $310,000 decrease in service charges on deposit accounts. Although refinancing activity substantially increased during the last half of 2010, our Company experienced more refinancing activity throughout 2009, impacting both volumes of loans sold and gains recognized. Our Company was servicing $298,325,000 of mortgage loans at December 31, 2010 compared to $269,475,000 at December 31, 2009. The decrease in noninterest income was partially offset by an increase in other income that included a $268,000 refund of prior year’s processing fees and a $227,000 increase in credit card income, of which $167,000 was due to a nonmaterial correction. Our Company recognized $606,000 in gain on sales and calls of debt securities during 2009. Our Company had no sales of debt securities during 2010.

Years Ended December 31, 2009 and 2008

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

Non-interest expense for the years ended December 31, 2010, 2009, and 2008 were as follows:

														$ Change								% Change
(Dollars in thousands)		2010				2009				2008				’10-’09				’09-’08				’10-’09				’09-’08
Non-interest Expense
Salaries		$	13,904			$	13,253			$	14,099			$	651			$	(846	)			4.9	%			(6.0	)%
Employee benefits			3,995				4,204				4,151				(209	)			53				(5.0	)			1.3
Goodwill impairment			—				—				40,324				0				N.M				N.M				N.M
Occupancy expense, net			2,532				2,335				2,440				197				(105	)			8.4				(4.3	)
Furniture and equipment expense			1,997				2,286				2,437				(289	)			(151	)			(12.6	)			(6.2	)
FDIC insurance assessment			1,651				2,519				204				(868	)			2,315				(34.5	)			1,134.8
Legal, examination, and professional fees			1,441				1,222				1,145				219				77				17.9				6.7
Advertising and promotion			1,256				1,272				1,166				(16	)			106				(1.3	)			9.1
Postage, printing, and supplies			1,201				1,168				1,221				33				(53	)			2.8				(4.3	)
Processing expense			3,353				3,420				3,102				(67	)			318				(2.0	)			10.3
Other real estate expense			9,804				1,189				862				8,615				327				724.6				37.9
Other			3,717				3,862				4,824				(145	)			(962	)			(3.8	)			(19.9	)
Total non-interest expense		$	44,851			$	36,730			$	75,975			$	8,121			$	1,079				22.1	%			1.4	%
Efficiency ratio*			83.9	%			71.6	%			75.2	%
Salaries and benefits as a % of total non-interest expense *			39.9	%			47.5	%			51.2	%
Number of full-time equivalent employees			340				348				344

Years Ended December 31, 2010 and 2009

     Noninterest expense increased $8,121,000, or 22.1%, to $44,851,000 for 2010 compared to $36,730,000 for 2009. Other real estate expense increased $8,615,000, or 724.6%, legal, examination, and professional fees increased $219,000, or 17.9%, partially offset by a decrease in Federal Deposit Insurance Corporation (FDIC) insurance assessment of $868,000, or 34.5%. The increase in other real estate expense reflects expenses incurred related to the increase in our Company’s foreclosed property during 2010. $6,158,000 of this expense was incurred during the fourth quarter when our Company recorded a provision to the valuation allowance for other real estate owned based on current appraisals received on two commercial real estate properties. The increase in legal, examination, and professional fees primarily resulted in an increase in accrued expenses representing our Company’s estimated obligation in a suit filed against Hawthorn Bank found in favor of the customer. See Note 17 Commitments and Contingencies for further explanation in the consolidated financial statements. The decrease in the FDIC insurance assessment is a result of a decrease in the estimated expense accrued during 2010 in comparison to 2009 and an increase in special assessments during 2009.

Years Ended December 31, 2009 and 2008

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

Fourth Quarter Results for 2010

     Comparing fourth quarter 2010 to third quarter 2010:

     Our Company’s net loss of ($6,251,000) for the fourth quarter ended December 31, 2010 decreased $7,674,000, compared to net income of $1,423,000 for the third quarter ended September 30, 2010. Net interest income decreased to $10,702,000 from $10,859,000 over the same period. This decrease was primarily the result of a decrease in interest earning assets from $1,146,000 for the third quarter ended September 30, 2010 to $1,132,000 for the fourth quarter ended December 31, 2010.

     The fourth quarter 2010 provision for loan losses of $8,150,000 was $5,700,000 higher than third quarter 2010’s provision of $2,450,000 and was based upon management’s determination of the loan loss reserve required to cover probable losses in the loan portfolio at year-end and as a result of increased nonperforming loans at year-end and receipt of current appraisals.

     Noninterest income of $3,115,000 for fourth quarter 2010 increased $205,000 from third quarter 2010’s noninterest income of $2,910,000. This increase was a result of $268,000 refund of prior year’s processing fees.

     Noninterest expense of $16,035,000 for fourth quarter 2010 increased by $6,670,000 from third quarter 2010’s noninterest expense of $9,365,000. $6,158,000 of this increase was incurred when our Company recorded a provision to the valuation allowance for other real estate owned based on current appraisals received on two commercial real estate properties. In addition, $275,000 of this increase resulted from an increase in accrued expenses for our Company’s estimated obligation in a lawsuit filed against our Bank found in favor of the customer. See Note 17 Commitments and Contingencies in the consolidated financial statements for further explanation.

     Comparing fourth quarter 2010 to fourth quarter 2009:

     Our Company’s net loss of ($6,251,000) for the fourth quarter ended December 31, 2010 decreased $7,039,000, compared to net income of $788,000 for same period in 2009. Net interest income of $10,702,000 increased $97,000 in the fourth quarter of 2010 compared to the fourth quarter of 2009 due to an increase in net interest margin to 3.81% for 2010 compared to 3.66% for the same period of 2009. This increase was partially offset by a decrease in average earning assets of $36,589,000 in the fourth quarter of 2010 compared to the fourth quarter of 2009.

     The fourth quarter 2010 provision for loan losses of $8,150,000 was $4,200,000 more than the fourth quarter 2009 provision of $3,950,000 and was based upon management’s determination of the loan loss reserve required to cover probable losses in the loan portfolio at year-end and as a result of increased nonperforming loans at year-end and receipt of current appraisals.

     Noninterest income of $3,115,000 for fourth quarter 2010 increased by $586,000 from noninterest income of $2,529,000 for fourth quarter 2009. $424,000 of the increase reflects gains on sales of mortgage loans due to increased refinancing activity. Our Company also received a $268,000 refund of prior year’s processing fees during the fourth quarter of 2010.

     Noninterest expense of $16,035,000 for fourth quarter 2010 increased $7,000,000 from fourth quarter 2009 noninterest expense of $9,034,000. $6,158,000 of this increase was incurred when our Company recorded a provision to the valuation allowance for other real estate owned based on current appraisals received on two commercial real estate properties.

Income taxes (benefit)

     Income taxes as a percentage of earnings (loss) before income taxes as reported in the consolidated financial statements were 46.5% for 2010, compared to 27.3% for 2009, and 16.7% for 2008. The increase in the effective tax rate for 2010 in comparison to 2009 is primarily the result of tax exempt income and other tax benefits increasing the overall income tax benefit related to the pre-tax loss. As a result, these calculated tax benefits increase the statutory tax rate in a year where our Company has a pre-tax loss versus a decrease the statutory tax rate in years with positive pre-tax income. The increase in the effective tax rate for 2009 in comparison to 2008 is due to the decrease in 2008 earnings resulting from the goodwill impairment charge. In addition, 2009 tax expense reflects the recognition of tax benefits as a result of the expiration of the statute of limitations on our Company’s 2005 state tax return during the fourth quarter of 2009.

Lending and Credit Management

     Interest earned on the loan portfolio is a primary source of interest income for our Company. Net loans represented 73.7% of total assets as of December 31, 2010 compared to 79.0% as of December 31, 2009.

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

A summary of loans, by major class within our Company’s loan portfolio as of the dates indicated are as follows:

		Balance at December 31,
(In thousands)		2010				2009				2008				2007				2006
		Amount				Amount				Amount				Amount				Amount
Commercial, financial, and agricultural		$	131,382			$	151,399			$	153,386			$	151,488			$	145,697
Real estate construction — residential			31,834				38,841				49,623				—				—
Real estate construction — commercial			56,053				77,937				80,016				147,432				150,891
Real estate mortgage — residential			207,835				232,332				235,834				210,458				182,366
Real estate mortgage — commercial			439,069				453,975				456,696				365,094				296,488
Installment loans to individuals			32,132				36,966				33,404				36,738				36,966
Deferred fees and costs, net			167				164				144				68				(96	)
Total loans		$	898,472			$	991,614			$	1,009,103			$	911,278			$	812,312

     Our Company’s loan portfolio decreased $93,142,000, or 9.4% from 2009 to 2010. This decrease was primarily a result of a decrease in commercial loans of $20,017,000, or 13.2%, a decrease in real estate mortgage — residential loans of $24,498,000, or 10.5%, a decrease in real estate mortgage — commercial loans of $14,907,000, or 3.3%, and a decrease in real estate construction — commercial loans of $21,884,000, or 28.1%. The decrease in commercial loans and real estate mortgage loans primarily reflects the payoff of four large commercial credits and three large real estate mortgage loans. The decrease in individual consumer loans reflects the payoff of one large consumer loan which was secured by a Bank certificate of deposit. Also contributing to the decrease in total loans were gross charge-offs of $16,190,000 and $23,677,000 of assets transferred from loans to other real estate owned and repossessed assets.

     Our Company’s loan portfolio decreased $17,490,000, or 1.7% from 2008 to 2009. This decrease was primarily in our Bank’s commercial and real estate mortgage lending. Commercial loans decreased $1,987,000, or 1.3%, real estate construction loans decreased $12,861,000, or 9.9%, and real estate mortgage loans decreased $6,223,000 or 1.0%, from 2008 to 2009, respectively. Partially offsetting these decreases was an increase in consumer loans of $3,582,000 or 10.7%. During the current down-turn in the economy, management continues to focus on the improvement of asset quality. The decrease in lending activities in the real estate construction market also reflects the slow down in the housing industry and residential construction industry as well as foreclosures on various residential construction properties.

     During the current down-turn in the economy, management continues to focus on the improvement of asset quality. Management has tightened underwriting standards and is focused on lending to credit worthy borrowers with the capacity to service the debts. Where appropriate, management actively works with existing borrowers to modify loan terms and conditions in order to assist the borrowers in servicing their debt obligations to our Company. The decrease in lending activities in the real estate construction market also reflects the slowdown in the housing industry and residential construction industry as well as foreclosures on various residential construction properties. Construction lending will continue to be closely monitored.

     Our Company does not participate in extending credit to sub-prime residential real estate markets. Our Company extends credit to its local community market through traditional real estate mortgage products.

     The contractual maturities of loan categories at December 31, 2010, and the break down of those loans between fixed rate and floating rate loans are as follows:

		Principal Payments Due
						Over One				Over
		One Year				Year Through				Five
		Or Less				Five Years				Years				Total
Commercial, financial, and agricultural		$	86,228			$	42,831			$	2,323			$	131,382
Real estate construction — residential			22,171				9,663				—				31,834
Real estate construction — commercial			45,560				9,496				997				56,053
Real estate mortgage — residential			52,116				95,434				60,284				207,834
Real estate mortgage — commercial			170,156				255,072				13,841				439,069
Installment loans to individuals			13,798				17,943				559				32,300
Total loans net of unearned income		$	390,029			$	430,439			$	78,004			$	898,472
Loans with fixed rates			312,342				378,727				57,036				748,105
Loans with floating rates			77,687				51,712				20,968				150,367
Total loans net of unearned income		$	390,029			$	430,439			$	78,004			$	898,472

     Our Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers, but are not funded until our Company has a non-recourse purchase commitment from the secondary market at a predetermined price. At December 31, 2010 our Company was servicing approximately $298,325,000 of loans sold to the secondary market.

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

     Management along with senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2,000,000 in aggregate and all adversely classified credits identified by management as containing more than usual risk are reviewed. In addition, loans below the above scope are reviewed on a sample basis. On a monthly basis, the senior loan committee reviews and reports to the Board of Directors past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impaired. Management follows the guidance provided in the FASB’s ASC Topic 310, Accounting by Creditors for Impairment of a Loan, in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, allowances are estimated based on the fair value 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 adequate by management for probable losses inherent in the loan portfolio.

Provision and Allowance for Loan Losses

     The provision for loan losses increased $6,901,000 or 82.6% to $15,255,000 for 2010 compared to $8,354,000 for 2009 and followed a $143,000 or 1.7% increase for 2009 compared to 2008.

     The current economy has contributed to the deterioration of collateral values. The economic downturn and elevated unemployment rates in our market area have impaired the ability for certain of our customers to make payments on our loans in accordance with contractual terms. The increase in the provision can be primarily attributed to loan losses for six loan relationships. Five of the commercial real estate relationships have been or are in the process of being resolved through our Company’s foreclosure process. Three of the relationships involve commercial businesses that were unable to survive during the economic downturn. Two of the relationships involve undeveloped development projects which were unable to meet debt service requirements. The last significant loss resulted from a non-owner occupied single and multi-family housing development which was adversely affected by low occupancy rates. During 2010, our Company

realized full or partial charge offs on 346 loans totaling $16,190,000 of which 40% results from the aforementioned six commercial and commercial real estate relationships.

     Our Company has taken an active approach to obtain current appraisals and has adjusted the provision to reflect the amounts management determined necessary to maintain the allowance for loan losses at a level adequate to cover probable losses in the loan portfolio. Due to charge offs taken during 2010, the allowance for loan losses decreased to $14,565,000 or 1.6% of loans outstanding at December 31, 2010 compared to $14,797,000 or 1.5% of loans outstanding at December 31, 2009, and $12,667,000 or 1.3% of loans outstanding at December 31, 2008.

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

										Years Ended December 31,
(Dollars in thousands)		2010				2009				2008				2007				2006
Analysis of allowance for loan losses:
Balance beginning of year		$	14,797			$	12,667			$	9,282			$	9,015			$	9,085
Charge-offs:
Commercial, financial, and agricultural			1,903				1,404				3,571				524				809
Real estate construction — residential			933				1,012				492				—				—
Real estate construction — commercial			4,556				450				189				56				84
Real estate mortgage — residential			4,534				2,673				417				413				—
Real estate mortgage — commercial			3,841				728				115				—				474
Installment loans to individuals			423				534				656				314				484
Total charge-offs			16,190				6,801				5,440				1,307				1,851
Recoveries:
Commercial, financial, and agricultural			153				213				153				141				206
Real estate construction — residential			30				5				34				—				—
Real estate construction — commercial			22				—				1				11				13
Real estate mortgage — residential			228				61				1				96				—
Real estate mortgage — commercial			29				4				80				14				91
Installment loans to individuals			241				294				345				158				145
Total recoveries			703				577				614				420				455
Net charge-offs			15,487				6,224				4,826				887				1,396
Provision for loan losses			15,255				8,354				8,211				1,154				1,326
Balance at end of year		$	14,565			$	14,797			$	12,667			$	9,282			$	9,015
Loans outstanding:
Average		$	949,458			$	1,002,829			$	963,252			$	848,772			$	824,706
End of period			898,472				991,614				1,009,104				911,278				812,312
Allowance for loan losses to loans outstanding:
Average		%	1.53				1.48	%			1.32	%			1.09	%			1.09	%
End of period			1.62				1.49				1.26				1.02				1.11
Net charge-offs to average loans outstanding			1.63				0.62				0.50				0.10				0.17