Quarterly Report (10-q)

Share Name	Share Symbol	Market	Type
Hawthorn Bancshares Inc	NASDAQ:HWBK	NASDAQ	Common Stock

	Price Change	% Change	Share Price	Bid Price	Offer Price	High Price	Low Price	Open Price	Shares Traded	Last Trade
	-0.04	-0.19%	20.80	20.50	20.85	20.80	20.80	20.80	780	16:03:34

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2018

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

For the transition period from ______________ to ______________

Commission file number: 0-23636

HAWTHORN BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

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

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

(Address of principal executive offices) (Zip Code)

(573) 761-6100

(Registrant's telephone number, including area code)

N/A

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

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. x Yes ¨ No

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

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

Large accelerated filer ¨	Accelerated filer x	Non-accelerated filer ¨

Smaller reporting company x	Emerging growth company ¨

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

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

As of November 8, 2018, the registrant had 6,034,843 shares of common stock, par value $1.00 per share, outstanding

Part I - Financial Information

Item 1. Financial Statements

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets (unaudited)

(In thousands, except per share data)

	September 30,			December 31,
	2018			2017
ASSETS
Cash and due from banks	$	16,340		$	23,325
Federal funds sold and other interest-bearing deposits		20,478			39,553
Cash and cash equivalents		36,818			62,878
Certificates of deposit in other banks		12,243			3,460
Available-for-sale debt securities, at fair value		224,562			231,028
Other securities		5,018			6,551
Total investment securities		229,580			237,579
Loans		1,115,765			1,068,432
Allowances for loan losses		(11,358	)		(10,852	)
Net loans		1,104,407			1,057,580
Premises and equipment - net		34,746			34,811
Mortgage servicing rights		2,871			2,713
Other real estate owned and repossessed assets - net		13,373			13,182
Accrued interest receivable		5,984			5,627
Cash surrender value - life insurance		2,535			2,484
Other assets		9,107			8,902
Total assets	$	1,451,664		$	1,429,216
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Non-interest bearing demand	$	257,376		$	245,380
Savings, interest checking and money market		609,216			584,468
Time deposits $250,000 and over		110,148			63,176
Other time deposits		205,994			232,788
Total deposits		1,182,734			1,125,812
Federal funds purchased and securities sold under agreements to repurchase		32,660			27,560
Federal Home Loan Bank advances and other borrowings		78,713			121,382
Subordinated notes		49,486			49,486
Accrued interest payable		990			554
Other liabilities		12,209			13,051
Total liabilities		1,356,792			1,337,845
Stockholders’ equity:
Common stock, $1 par value, authorized 15,000,000 shares; issued 6,278,481 and 6,046,907 shares, respectively		6,279			6,047
Surplus		50,173			45,442
Retained earnings		52,090			50,595
Accumulated other comprehensive loss, net of tax		(8,626	)		(5,662	)
Treasury stock; 243,638 and 248,898 shares, at cost, respectively		(5,044	)		(5,051	)
Total stockholders’ equity		94,872			91,371
Total liabilities and stockholders’ equity	$	1,451,664		$	1,429,216

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income (unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands, except per share amounts)	2018		2017		2018		2017
INTEREST INCOME
Interest and fees on loans	$	13,252	$	11,856	$	38,329	$	34,577
Interest on investment securities:
Taxable		1,089		785		3,141		2,391
Nontaxable		146		169		451		494
Federal funds sold, other interest-bearing deposits, and certificates of deposit in other banks		205		84		500		144
Dividends on other securities		59		42		162		111
Total interest income		14,751		12,936		42,583		37,717
INTEREST EXPENSE
Interest on deposits:
Savings, interest checking and money market		1,468		682		3,899		1,546
Time deposit accounts $250,000 and over		391		119		825		309
Other time deposits		520		463		1,566		1,252
Interest on federal funds purchased and securities sold under agreements to repurchase		166		29		526		78
Interest on Federal Home Loan Bank advances		314		440		1,042		1,182
Interest on subordinated notes		584		450		1,635		1,290
Total interest expense		3,443		2,183		9,493		5,657
Net interest income		11,308		10,753		33,090		32,060
Provision for loan losses		250		555		1,000		1,235
Net interest income after provision for loan losses		11,058		10,198		32,090		30,825
NON-INTEREST INCOME
Service charges and other fees		942		878		2,760		2,565
Bank card income and fees		699		664		2,064		1,941
Trust department income		276		288		867		828
Real estate servicing fees, net		192		70		574		557
Gain on sale of mortgage loans, net		205		225		593		599
Other		10		56		47		197
Total non-interest income		2,324		2,181		6,905		6,687
Investment securities gain, net		50		0		256		0
NON-INTEREST EXPENSE
Salaries and employee benefits		5,543		5,502		17,413		16,276
Occupancy expense, net		749		719		2,162		2,027
Furniture and equipment expense		785		764		2,104		1,996
Processing, network, and bank card expense		841		831		2,589		2,803
Legal, examination, and professional fees		289		331		913		928
FDIC insurance assessment		181		106		482		322
Advertising and promotion		297		342		840		845
Postage, printing, and supplies		256		215		749		690
Other		947		956		2,821		2,916
Total non-interest expense		9,888		9,766		30,073		28,803
Income before income taxes		3,544		2,613		9,178		8,709
Income tax expense		446		847		1,083		2,923
Net income		3,098		1,766		8,095		5,786
Basic earnings per share	$	0.51	$	0.29	$	1.34	$	0.95
Diluted earnings per share	$	0.51	$	0.29	$	1.34	$	0.95

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (unaudited)

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(In thousands)	2018			2017		2018			2017
Net income	$	3,098		$	1,766	$	8,095		$	5,786
Other comprehensive income, net of tax
Investment securities available-for-sale:
Unrealized (loss) gain on investment securities available-for-sale, net of tax		(936	)		84		(3,093	)		984
Adjustment for gain on sale of investment securities, net of tax		0			0		0			0
Defined benefit pension plans:
Amortization of prior service cost included in net periodic pension cost, net of tax		44			15		129			42
Total other comprehensive (loss) income		(892	)		99		(2,964	)		1,026
Total comprehensive income	$	2,206		$	1,865	$	5,131		$	6,812

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders' Equity (unaudited)

									Accumulated						Total
									Other						Stock -
	Common					Retained			Comprehensive			Treasury			holders'
(In thousands)	Stock		Surplus			Earnings			Loss			Stock			Equity
Balance, December 31, 2016	$	5,822	$	41,498		$	51,671		$	(3,801	)	$	(4,173	)	$	91,017
Net income		0		0			5,786			0			0			5,786
Other comprehensive income		0		0			0			1,026			0			1,026
Stock based compensation expense		0		3			0			0			0			3
Purchase of treasury stock		0		0			0			0			(623	)		(623	)
Stock dividend		225		3,940			(4,165	)		0			0			0
Cash dividends declared, common stock		0		0			(1,137	)		0			0			(1,137	)
Balance, September 30, 2017	$	6,047	$	45,441		$	52,155		$	(2,775	)	$	(4,796	)	$	96,072

Balance, December 31, 2017	$	6,047	$	45,442		$	50,595		$	(5,662	)	$	(5,051	)	$	91,371
Net income		0		0			8,095			0			0			8,095
Other comprehensive loss		0		0			0			(2,964	)		0			(2,964	)
Issuance of stock under equity compensation plan		0		(51	)		0			0			186			135
Purchase of treasury stock		0		0			0			0			(179	)		(179	)
Stock dividend		232		4,782			(5,014	)		0			0			0
Cash dividends declared, common stock		0		0			(1,586	)		0			0			(1,586	)
Balance, September 30, 2018	$	6,279	$	50,173		$	52,090		$	(8,626	)	$	(5,044	)	$	94,872

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)

	Nine Months Ended September 30,
(In thousands)	2018			2017
Cash flows from operating activities:
Net income	$	8,095		$	5,786
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		1,000			1,235
Depreciation expense		1,321			1,399
Net amortization of investment securities, premiums, and discounts		1,121			1,257
Stock based compensation expense		0			3
Change in fair value of mortgage servicing rights		40			72
Investment securities gain, net		(256	)		0
Loss on sales and dispositions of premises and equipment		3			123
Gain on sales and dispositions of other real estate and repossessed assets		0			(42	)
Provision for other real estate owned		26			243
(Increase) decrease in accrued interest receivable		(357	)		304
Increase in cash surrender value - life insurance		(51	)		(55	)
Decrease (increase) in other assets		849			(269	)
Increase (decrease) in accrued interest payable		436			(12	)
Decrease in other liabilities		(1,038	)		(479	)
Origination of mortgage loans for sale		(29,197	)		(26,446	)
Proceeds from the sale of mortgage loans		30,049			26,261
Gain on sale of mortgage loans, net		(593	)		(599	)
Other, net		(198	)		(162	)
Net cash provided by operating activities		11,250			8,619
Cash flows from investing activities:
Purchase of certificates of deposit in other banks		(8,783	)		0
Proceeds from maturities of certificates of deposit in other banks		0			1,000
Net increase in loans		(48,675	)		(70,572	)
Purchase of available-for-sale debt securities		(102,953	)		(32,330	)
Proceeds from maturities of available-for-sale debt securities		25,782			24,192
Proceeds from calls of available-for-sale debt securities		1,685			7,675
Proceeds from sales of available-for-sale debt securities		77,168			2,656
Purchases of FHLB stock		(2,367	)		(1,203	)
Proceeds from sales of FHLB stock		3,903			1,239
Purchases of premises and equipment		(1,374	)		(1,017	)
Proceeds from sales of premises and equipment		13			12
Proceeds from sales of other real estate and foreclosed assets		372			1,001
Net cash used in investing activities		(55,229	)		(67,347	)
Cash flows from financing activities:
Net increase in demand deposits		11,996			23,482
Net increase in interest-bearing transaction accounts		24,748			70,844
Net increase in time deposits		20,178			2,968
Net increase in federal funds purchased and securities sold under agreements to repurchase		5,100			1,048
Repayment of FHLB advances and other borrowings		(173,619	)		(183,132	)
FHLB advances		130,950			179,640
Issuance of stock under equity compensation plan		135			0
Purchase of treasury stock		(179	)		(623	)
Cash dividends paid - common stock		(1,390	)		(1,067	)
Net cash provided by financing activities		17,919			93,160
Net (decrease) increase in cash and cash equivalents		(26,060	)		34,432
Cash and cash equivalents, beginning of period		62,878			25,995
Cash and cash equivalents, end of period	$	36,818		$	60,427

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (continued) (unaudited)

	Nine Months Ended September 30,
(In thousands)	2018		2017
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	9,058	$	5,669
Income taxes	$	50	$	2,940
Noncash investing and financing activities:
Other real estate and repossessed assets acquired in settlement of loans	$	589	$	217
Stock dividends	$	5,014	$	4,165

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

Hawthorn Bancshares, Inc.

and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(1)

Summary of Significant Accounting Policies

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

The accompanying unaudited consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and disclosures required by U.S. GAAP for complete financial statements and should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

The preparation of the consolidated financial statements includes all adjustments that, in the opinion of management, are necessary in order to make those statements not misleading. Management is required to make estimates and assumptions, including the determination of the allowance for loan losses, real estate acquired in connection with foreclosure or in satisfaction of loans, and fair values of investment securities available-for-sale that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company’s management has evaluated and did not identify any subsequent events or transactions requiring recognition or disclosure in the consolidated financial statements other than mentioned below.

Stock Dividend On July 1, 2018, the Company paid a special stock dividend of four percent to shareholders of record at the close of business on June 15, 2018. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

Summary of Recent Transactions and Events On October 18, 2018, Hawthorn Bank, a wholly-owned subsidiary of the Company, announced that it has entered into an agreement to sell its branch located in Branson, Missouri with total deposits of approximately $15 million to Branson Bank in Branson, Missouri. The transaction excludes loans assigned to the branch. The transaction, which is subject to regulatory approval and certain closing conditions, is expected to close during the first quarter of 2019.

The following represents significant new accounting principles adopted in 2018:

Revenue from Contracts with Customers On January 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) and all subsequent ASUs that modified Topic 606. The implementation of the new standard did not have a material impact on the measurement or recognition of revenue; as such, a cumulative effect adjustment to opening retained earnings was not deemed necessary. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period amounts were not adjusted and continue to be reported in accordance with historic accounting under Topic 605.

Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and securities. In addition, certain noninterest income streams such as fees associated with mortgage servicing rights, financial guarantees, derivatives, and certain credit card fees are not in scope of the new guidance. Topic 606 is applicable to noninterest revenue streams such as trust department revenue, service charges and fees, debit card income, ATM surcharge income, and other real estate owned sales. However, the recognition of these revenue streams did not change significantly upon adoption of Topic 606. Noninterest revenue streams within the scope of Topic 606 are discussed in Footnote 16.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Financial Instruments The FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities , in January 2016. The amendments require all equity investments to be measured at fair value with changes in the fair value recognized through net income, other than those accounted for under the equity method of accounting or those that result in the consolidation of the investee. Additionally, these amendments require presentation in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk for those liabilities measured at fair value. The amendments also require use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes. These amendments are effective for interim and annual periods beginning January 1, 2018. The adoption of the ASU did not have a significant effect on the Company's consolidated financial statements.

The FASB issued ASU 2018-04, Investments - Debt Securities (Topic 320) and Regulated Operations (Topic 980) : The amendment in this ASU adds, amends and supersedes various paragraphs that contain SEC guidance in ASC 320, Investments-Debt Securities and ASC 980, Regulated Operations. The amendments in this ASU are effective when a registrant adopts ASU 2016-01, which for the Company was January 1, 2018. This amendment did not have a significant effect on the Company's consolidated financial statements.

Liabilities The FASB issued ASU 2016-04, Recognition of Breakage for Certain Prepaid Stored-Value Products , in March 2016, in order to address current and potential future diversity in practice related to the derecognition of a prepaid stored-value product liability. Such products include prepaid gift cards issued on a specific payment network and redeemable at network-accepting merchant locations, prepaid telecommunication cards, and traveler's checks. The amendments require that the portion of the dollar value of prepaid stored-value products that is ultimately unredeemed (that is, the breakage) be accounted for consistent with the breakage guidance for stored-value product transactions provided in ASC Topic 606 - Revenue from Contracts with Customers. These amendments are effective for interim and annual periods beginning January 1, 2018. The adoption of the ASU did not have a significant effect on the Company's consolidated financial statements.

Pension The FASB issued ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost in March 2017. Under the new guidance, employers will present the service cost component of the net periodic benefit cost in the same income statement line item (e.g., Salaries and Benefits) as other employee compensation costs arising from services rendered during the period. In addition, only the service cost component will be eligible for capitalization in assets. Employers will present the other components separately (e.g., Other Noninterest Expense) from the line item that includes the service cost. The ASU is effective for interim and annual reporting periods beginning after December 15, 2017. Employers will apply the guidance on the presentation of the components of net periodic benefit cost in the income statement retrospectively. The guidance limiting the capitalization of net periodic benefit cost in assets to the service cost component will be applied prospectively. The Company utilizes the ASU’s practical expedient allowing entities to estimate amounts for comparative periods using the information previously disclosed in their pension and other postretirement benefit plan footnote. The adoption of the ASU did not have a significant effect on the Company's consolidated financial statements.

(2)

Loans and Allowance for Loan Losses

Loans

A summary of loans, by major class within the Company’s loan portfolio, at September 30, 2018 and December 31, 2017 is as follows:

	September 30,		December 31,
(in thousands)	2018		2017
Commercial, financial, and agricultural	$	203,485	$	192,238
Real estate construction - residential		30,374		26,492
Real estate construction - commercial		95,806		98,340
Real estate mortgage - residential		246,334		246,754
Real estate mortgage - commercial		506,197		472,455
Installment and other consumer		33,569		32,153
Total loans	$	1,115,765	$	1,068,432

The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the Missouri communities surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson and the greater Kansas City metropolitan area. As such, the Bank is susceptible to changes in the economic environment in these communities. The Bank does not have a concentration of credit in any one economic sector. Installment and other consumer loans consist primarily of the financing of automotive vehicles. At September 30, 2018, loans of $498.2 million were pledged to the Federal Home Loan Bank as collateral for borrowings and letters of credit.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Allowance for Loan Losses

The following is a summary of the allowance for loan losses during the periods indicated.

	Three Months Ended September 30, 2018
	Commercial,			Real Estate			Real Estate			Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -			Mortgage -			Mortgage -			and Other			Un-
(in thousands)	Agricultural			Residential			Commercial			Residential			Commercial			Consumer			allocated		Total
Balance at beginning of period	$	3,943		$	201		$	905		$	2,109		$	3,630		$	413		$	11	$	11,212
Additions:
Provision for loan losses		(420	)		26			(159	)		255			444			39			65		250
Deductions:
Loans charged off		75			0			0			32			5			74			0		186
Less recoveries on loans		(38	)		(13	)		0			(9	)		(2	)		(20	)		0		(82	)
Net loan charge-offs (recoveries)		37			(13	)		0			23			3			54			0		104
Balance at end of period	$	3,486		$	240		$	746		$	2,341		$	4,071		$	398		$	76	$	11,358

	Nine Months Ended September 30, 2018
	Commercial,			Real Estate			Real Estate			Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -			Mortgage -			Mortgage -			and Other			Un-
(in thousands)	Agricultural			Residential			Commercial			Residential			Commercial			Consumer			allocated			Total
Balance at beginning of period	$	3,325		$	170		$	807		$	1,689		$	4,437			345		$	79		$	10,852
Additions:
Provision for loan losses		478			80			(31	)		672			(366	)		170			(3	)		1,000
Deductions:
Loans charged off		378			48			30			64			34			181			0			735
Less recoveries on loans		(61	)		(38	)		0			(44	)		(34	)		(64	)		0			(241	)
Net loan charge-offs (recoveries)		317			10			30			20			0			117			0			494
Balance at end of period	$	3,486		$	240		$	746		$	2,341		$	4,071		$	398		$	76		$	11,358

	Three Months Ended September 30, 2017
	Commercial,			Real Estate			Real Estate		Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -		Mortgage -			Mortgage -			and Other			Un-
(in thousands)	Agricultural			Residential			Commercial		Residential			Commercial			Consumer			allocated			Total
Balance at beginning of period	$	2,578		$	70		$	615	$	1,854		$	4,882		$	376		$	170		$	10,545
Additions:
Provision for loan losses		853			64			91		100			(426	)		32			(159	)		555
Deductions:
Loans charged off		37			0			0		68			4			56			0			165
Less recoveries on loans		(12	)		(12	)		0		(11	)		(5	)		(25	)		0			(65	)
Net loan charge-offs (recoveries)		25			(12	)		0		57			(1	)		31			0			100
Balance at end of period	$	3,406		$	146		$	706	$	1,897		$	4,457		$	377		$	11		$	11,000

	Nine Months Ended September 30, 2017
	Commercial,			Real Estate			Real Estate		Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -		Mortgage -			Mortgage -			and Other			Un-
(in thousands)	Agricultural			Residential			Commercial		Residential			Commercial			Consumer			allocated			Total
Balance at beginning of period	$	2,753		$	108		$	413	$	2,385		$	3,793			274		$	160		$	9,886
Additions:
Provision for loan losses		695			(49	)		293		(407	)		658			194			(149	)		1,235
Deductions:
Loans charged off		97			0			0		149			20			167			0			433
Less recoveries on loans		(55	)		(87	)		0		(68	)		(26	)		(76	)		0			(312	)
Net loan charge-offs (recoveries)		42			(87	)		0		81			(6	)		91			0			121
Balance at end of period	$	3,406		$	146		$	706	$	1,897		$	4,457		$	377		$	11		$	11,000

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Loans, or portions of loans, are charged off to the extent deemed uncollectible or a loss is confirmed. Loan charge-offs reduce the allowance for loan losses, and recoveries of loans previously charged off are added back to the allowance. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration.

Beginning in the first quarter of 2016, the Company began to lengthen its look-back period with the intent to increase such period from three to five years. The Company believes that the five-year look-back period, which is consistent with the Company’s practices prior to the start of the economic recession in 2008, provides a representative historical loss period in the current economic environment. Beginning with December 31, 2017, the Company has utilized a five-year look-back period.

The following table provides the balance in the allowance for loan losses at September 30, 2018 and December 31, 2017, and the related loan balance by impairment methodology.

	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, and		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
September 30, 2018
Allowance for loan losses:
Individually evaluated for impairment	$	381	$	0	$	0	$	657	$	166	$	21	$	0	$	1,225
Collectively evaluated for impairment		3,105		240		746		1,684		3,905		377		76		10,133
Total	$	3,486	$	240	$	746	$	2,341	$	4,071	$	398	$	76	$	11,358
Loans outstanding:
Individually evaluated for impairment	$	2,731	$	0	$	158	$	5,145	$	1,028	$	243	$	0	$	9,305
Collectively evaluated for impairment		200,754		30,374		95,648		241,189		505,169		33,326		0		1,106,460
Total	$	203,485	$	30,374	$	95,806	$	246,334	$	506,197	$	33,569	$	0	$	1,115,765

December 31, 2017
Allowance for loan losses:
Individually evaluated for impairment	$	500	$	0	$	48	$	521	$	243	$	21	$	0	$	1,333
Collectively evaluated for impairment		2,825		170		759		1,168		4,194		324		79		9,519
Total	$	3,325	$	170	$	807	$	1,689	$	4,437	$	345	$	79	$	10,852
Loans outstanding:
Individually evaluated for impairment	$	3,007	$	0	$	97	$	5,072	$	2,004	$	176	$	0	$	10,356
Collectively evaluated for impairment		189,231		26,492		98,243		241,682		470,451		31,977		0		1,058,076
Total	$	192,238	$	26,492	$	98,340	$	246,754	$	472,455	$	32,153	$	0	$	1,068,432

Impaired Loans

Loans evaluated under ASC 310-10-35 include loans which are individually evaluated for impairment. All other loans are collectively evaluated for impairment under ASC 450-20. Impaired loans individually evaluated for impairment totaled $9.3 million and $10.4 million at September 30, 2018 and December 31, 2017, respectively, and are comprised of loans on non-accrual status and loans which have been classified as troubled debt restructurings (TDRs).

The net carrying value of impaired loans is based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. At September 30, 2018 and December 31, 2017, $4.2 million and $4.0 million, respectively, of impaired loans were evaluated based on the fair value less estimated selling costs of the loan’s collateral. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2018, $1.2 million of the Company’s allowance for loan losses was allocated to impaired loans totaling $9.3 million compared to $1.3 million of the Company's allowance for loan losses allocated to impaired loans totaling approximately $10.4 million at December 31, 2017. Management determined that $3.0 million, or 32%, of total impaired loans required no reserve allocation at September 30, 2018 compared to $2.4 million, or 23%, at December 31, 2017, primarily due to adequate collateral values , acceptable payment history and adequate cash flow ability.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The categories of impaired loans at September 30, 2018 and December 31, 2017 are as follows:

	September 30,		December 31,
(in thousands)	2018		2017
Non-accrual loans	$	6,045	$	5,672
Performing TDRs		3,260		4,684
Total impaired loans	$	9,305	$	10,356

The following tables provide additional information about impaired loans at September 30, 2018 and December 31, 2017, respectively, segregated between loans for which an allowance has been provided and loans for which no allowance has been provided.

			Unpaid
	Recorded		Principal		Specific
(in thousands)	Investment		Balance		Reserves
September 30, 2018
With no related allowance recorded:
Commercial, financial and agricultural	$	1,570	$	1,910	$	0
Real estate - construction commercial		158		183		0
Real estate - residential		1,142		1,206		0
Real estate - commercial		119		121		0
Total	$	2,989	$	3,420	$	0
With an allowance recorded:
Commercial, financial and agricultural	$	1,161	$	1,229	$	381
Real estate - residential		4,003		4,089		657
Real estate - commercial		909		994		166
Installment and other consumer		243		269		21
Total	$	6,316	$	6,581	$	1,225
Total impaired loans	$	9,305	$	10,001	$	1,225

			Unpaid
	Recorded		Principal		Specific
(in thousands)	Investment		Balance		Reserves
December 31, 2017
With no related allowance recorded:
Commercial, financial and agricultural	$	1,393	$	1,445	$	0
Real estate - residential		674		688		0
Real estate - commercial		366		395		0
Total	$	2,433	$	2,528	$	0
With an allowance recorded:
Commercial, financial and agricultural	$	1,614	$	1,834	$	500
Real estate - construction commercial		97		97		48
Real estate - residential		4,398		4,500		521
Real estate - commercial		1,638		1,743		243
Consumer		176		196		21
Total	$	7,923	$	8,370	$	1,333
Total impaired loans	$	10,356	$	10,898	$	1,333

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

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

	Three Months Ended September 30,								Nine Months Ended September 30,
	2018				2017				2018				2017
			Interest				Interest				Interest				Interest
	Average		Recognized		Average		Recognized		Average		Recognized		Average		Recognized
	Recorded		For the		Recorded		For the		Recorded		For the		Recorded		For the
(in thousands)	Investment		Period Ended		Investment		Period Ended		Investment		Period Ended		Investment		Period Ended
With no related allowance recorded:
Commercial, financial and agricultural	$	1,375	$	0	$	481	$	0	$	1,334	$	1	$	478	$	0
Real estate - construction commercial		161		0		0		0		82		0		0		0
Real estate - residential		1,037		3		341		0		929		9		1,412		0
Real estate - commercial		120		3		77		3		30		22		221		9
Installment and other consumer		91		0		0		0		34		0		22		0
Total	$	2,784	$	6	$	899	$	3	$	2,409	$	32	$	2,133	$	9
With an allowance recorded:
Commercial, financial and agricultural	$	1,423	$	8	$	694	$	8	$	1,507	$	23	$	1,667	$	24
Real estate - construction residential		0		0		0		0		15		0		0		0
Real estate - construction commercial		0		0		0		0		24		0		37		0
Real estate - residential		4,076		25		1,383		33		4,211		71		4,090		121
Real estate - commercial		1,443		13		597		17		1,649		24		1,772		46
Installment and other consumer		197		0		56		0		186		1		70		0
Total	$	7,139	$	46	$	2,730	$	58	$	7,592	$	119	$	7,636	$	191
Total impaired loans	$	9,923	$	52	$	3,629	$	61	$	10,001	$	151	$	9,769	$	200

The recorded investment varies from the unpaid principal balance primarily due to partial charge-offs taken resulting from current appraisals received. The amount recognized as interest income on impaired loans continuing to accrue interest, primarily related to troubled debt restructurings, was $52,000 and $151,000, for the three months and nine months ended September 30, 2018, respectively compared to $61,000 and $200,000 for the three and nine months ended September 30, 2017, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during the periods reported.

Delinquent and Non-Accrual Loans

The delinquency status of loans is determined based on the contractual terms of the notes. Borrowers are generally classified as delinquent once payments become 30 days or more past due. The Company’s policy is to discontinue the accrual of interest income on any loan when, in the opinion of management, the ultimate collectability of interest or principal is no longer probable. In general, loans are placed on non-accrual when they become 90 days or more past due. However, management considers many factors before placing a loan on non-accrual, including the delinquency status of the loan, the overall financial condition of the borrower, the progress of management’s collection efforts and the value of the underlying collateral. Non-accrual loans are returned to accrual status when, in the opinion of management, the financial condition of the borrower indicates that the timely collectability of interest and principal is probable and the borrower demonstrates the ability to pay under the terms of the note through a sustained period of repayment performance, which is generally nine months.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The following table provides aging information for the Company’s past due and non-accrual loans at September 30, 2018 and December 31, 2017.

	Current or				90 Days
	Less Than				Past Due
	30 Days		30 - 89 Days		And Still
(in thousands)	Past Due		Past Due		Accruing		Non-Accrual		Total
September 30, 2018
Commercial, Financial, and Agricultural	$	200,893	$	288	$	8	$	2,296	$	203,485
Real Estate Construction - Residential		30,374		0		0		0		30,374
Real Estate Construction - Commercial		95,548		100		0		158		95,806
Real Estate Mortgage - Residential		242,165		1,189		212		2,768		246,334
Real Estate Mortgage - Commercial		505,087		513		0		597		506,197
Installment and Other Consumer		33,111		217		15		226		33,569
Total	$	1,107,178	$	2,307	$	235	$	6,045	$	1,115,765
December 31, 2017
Commercial, Financial, and Agricultural	$	189,537	$	192	$	2	$	2,507	$	192,238
Real Estate Construction - Residential		25,930		287		275		0		26,492
Real Estate Construction - Commercial		98,243		0		0		97		98,340
Real Estate Mortgage - Residential		242,597		2,173		28		1,956		246,754
Real Estate Mortgage - Commercial		471,476		43		0		936		472,455
Installment and Other Consumer		31,715		239		23		176		32,153
Total	$	1,059,498	$	2,934	$	328	$	5,672	$	1,068,432

Credit Quality

The Company categorizes loans into risk categories based upon an internal rating system reflecting management’s risk assessment. Loans are placed on watch status when one or more weaknesses that may result in the deterioration of the repayment exits or the Company’s credit position at some future date. Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified may have a well-defined weakness or weaknesses that jeopardize the repayment of the debt. Such loans are characterized by the distinct possibility that the Company may sustain some loss if the deficiencies are not corrected. A loan is classified as a troubled debt restructuring ( TDR) when a borrower is experiencing financial difficulties that lead to the restructuring of a loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. Loans classified as TDRs which are accruing interest are classified as performing TDRs. Loans classified as TDRs which are not accruing interest are classified as nonperforming TDRs and are included with all other nonaccrual loans for presentation purposes. It is the Company’s policy to discontinue the accrual of interest income on loans when management believes that the collection of interest or principal is doubtful. Loans are placed on non-accrual status when (1) deterioration in the financial condition of the borrower exists for which payment of full principal and interest is not expected, or (2) payment of principal or interest has been in default for a period of 90 days or more and the asset is not both well secured and in the process of collection. Subsequent interest payments received on such loans are applied to principal if any doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The following table presents the risk categories by class at September 30, 2018 and December 31, 2017.

(in thousands)	Commercial, Financial, & Agricultural		Real Estate Construction - Residential		Real Estate Construction - Commercial		Real Estate Mortgage - Residential		Real Estate Mortgage - Commercial		Installment and Other Consumer		Total

At September 30, 2018
Watch	$	7,116	$	593	$	3,735	$	13,114	$	35,753	$	9	$	60,320
Substandard		57		0		0		1,532		708		5		2,302
Performing TDRs		434		0		0		2,377		431		18		3,260
Non-accrual		2,296		0		158		2,768		597		226		6,045
Total	$	9,903	$	593	$	3,893	$	19,791	$	37,489	$	258	$	71,927

At December 31, 2017
Watch	$	9,868	$	1,459	$	1,284	$	9,978	$	49,197	$	0	$	71,786
Substandard		658		462		0		2,262		723		16		4,121
Performing TDRs		500		0		0		3,116		1,068		0		4,684
Non-accrual		2,507		0		97		1,956		936		176		5,672
Total	$	13,533	$	1,921	$	1,381	$	17,312	$	51,924	$	192	$	86,263

Troubled Debt Restructurings

At September 30, 2018, loans classified as TDRs totaled $5.4 million, of which $2.2 million were classified as nonperforming TDRs and included in non-accrual loans and $3.2 million were classified as performing TDRs. At December 31, 2017, loans classified as TDRs totaled $6.4 million, of which $1.7 million were classified as nonperforming TDRs and included in non-accrual loans and $4.7 million were classified as performing TDRs. Both performing and nonperforming TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. Accordingly, specific reserves of $569,000 and $577,000 related to TDRs were allocated to the allowance for loan losses at September 30, 2018 and December 31, 2017, respectively.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

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

	Three Months Ended September 30,
	2018						2017
	Recorded Investment (1)						Recorded Investment (1)
(in thousands)	Number of Contracts		Pre- Modification		Post- Modification		Number of Contracts		Pre- Modification		Post- Modification
Troubled Debt Restructurings
Commercial, financial and agricultural		2	$	353	$	353		0	$	0	$	0
Real estate mortgage - commercial		0		0		0		1		14		14
Consumer		1		112		53		0		0		0
Total		3	$	465	$	406		1	$	14	$	14

	Nine Months Ended September 30,
	2018						2017
	Recorded Investment (1)						Recorded Investment (1)
(in thousands)	Number of Contracts		Pre- Modification		Post- Modification		Number of Contracts		Pre- Modification		Post- Modification
Troubled Debt Restructurings
Commercial, financial and agricultural		2	$	353	$	353		1	$	131	$	130
Real estate mortgage - residential		1		75		74		1		14		14
Real estate mortgage - commercial		0		0		0		1		56		52
Consumer		5		160		93		0		0		0
Total		8	$	588	$	520		3	$	201	$	196

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

The Company’s portfolio of loans classified as TDRs include concessions for the borrower given financial condition such as interest rates below the current market rate, deferring principal payments, and extending maturity dates. There were three loans and eight loans meeting the TDR criteria that were modified during the three and nine months ended September 30, 2018, respectively, compared to one loan and three loans during the three and nine months ended September 30, 2017, respectively.

The Company considers a TDR to be in default when it is 90 days or more past due under the modified terms, a charge-off occurs, or it is the process of foreclosure. There were no loans modified as a TDR that defaulted during any of the three and nine months ended September 30, 2018 and 2017, respectively, and within twelve months of their modification date. During 2018, one real estate mortgage loan went to foreclosure totaling $48,000 and one commercial real estate loan totaling $366,000 was sold at foreclosure. See Lending and Credit Management section for further information.

(3)

Other Real Estate and Repossessed Assets

	September 30,			December 31,
(in thousands)	2018			2017
Commercial	$	697		$	727
Real estate construction - residential		179			0
Real estate construction - commercial		12,101			12,380
Real estate mortgage - residential		464			382
Real estate mortgage - commercial		2,934			2,909
Repossessed assets		0			5
Total	$	16,375		$	16,403
Less valuation allowance for other real estate owned		(3,002	)		(3,221	)
Total other real estate and repossessed assets	$	13,373		$	13,182

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
Balance at beginning of period	$	16,258		$	16,530		$	16,403		$	17,291
Additions		207			62			589			217
Proceeds from sales		(68	)		(217	)		(372	)		(1,001	)
Charge-offs against the valuation allowance for other real estate owned, net		(20	)		0			(245	)		(170	)
Net gain on sales		(2	)		4			0			42
Total other real estate and repossessed assets	$	16,375		$	16,379		$	16,375		$	16,379
Less valuation allowance for other real estate owned		(3,002	)		(3,202	)		(3,002	)		(3,202	)
Balance at end of period	$	13,373		$	13,177		$	13,373		$	13,177

At September 30, 2018, $253,000 of consumer mortgage loans secured by residential real estate properties were in the process of foreclosure compared to no loans at December 31, 2017.

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

	Three Months Ended September 30,					Nine Months Ended September 30,
(in thousands)	2018			2017		2018			2017
Balance, beginning of period	$	3,022		$	3,174	$	3,221		$	3,129
Provision for other real estate owned		0			28		26			243
Charge-offs		(20	)		0		(245	)		(170	)
Balance, end of period	$	3,002		$	3,202	$	3,002		$	3,202

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(4)

Investment Securities

Available for sale securities

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2018 and December 31, 2017 were as follows:

	Total
	Amortized		Gross Unrealized					Fair
( in thousands)	Cost		Gains		Losses			Value
September 30, 2018
U.S. Treasury	$	1,983	$	0	$	(67	)	$	1,916
U.S. government and federal agency obligations		10,933		0		(459	)		10,474
Government sponsored enterprises		45,777		0		(812	)		44,965
Obligations of states and political subdivisions		41,088		21		(764	)		40,345
Mortgage-backed securities:
Residential - government agencies		127,375		41		(4,918	)		122,498
Other debt securities (a)		3,000		0		0			3,000
Bank issued trust preferred securities (a)		1,486		0		(122	)		1,364
Total available-for-sale securities	$	231,642	$	62	$	(7,142	)	$	224,562

December 31, 2017
U.S. Treasury	$	1,980	$	0	$	(13	)	$	1,967
U.S. government and federal agency obligations		12,341		0		(268	)		12,073
Government sponsored enterprises		37,321		0		(424	)		36,897
Obligations of states and political subdivisions		47,019		114		(477	)		46,656
Mortgage-backed securities:
Residential - government agencies		131,045		44		(2,140	)		128,949
Other debt securities (a)		3,000		0		0			3,000
Bank issued trust preferred securities (a)		1,486		0		0			1,486
Total available-for-sale securities	$	234,192	$	158	$	(3,322	)	$	231,028

(a) As of January 1, 2018, the Company adopted ASU 2016-01, resulting in reclassification of certain hybrid instruments possessing characteristics typically associated with debt obligations from other securities carried at cost to available for sale securities carried at fair value.

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

Debt securities with carrying values aggregating approximately $184.2 million and $181.7 million at September 30, 2018 and December 31, 2017, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2018, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without prepayment penalties.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

	Amortized		Fair
( in thousands)	Cost		Value
Due in one year or less	$	16,968	$	16,846
Due after one year through five years		65,499		64,046
Due after five years through ten years		14,151		13,705
Due after ten years		7,649		7,467
Total		104,267		102,064
Mortgage-backed securities		127,375		122,498
Total available-for-sale securities	$	231,642	$	224,562

Other securities

Other securities include equity securities with readily determinable fair values and other investment securities whose accounting is not addressed in ASU 2016-01 include Federal Home Loan Bank (FHLB) stock, and Midwest Independent Bank (MIB) bankers bank stock, that do not have readily determinable fair values, which are held for debt and regulatory purposes.

(in thousands)	September 30, 2018		December 31, 2017
Other securities:
FHLB stock	$	4,854	$	6,390
MIB stock		151		151
Equity securities with readily determinable fair values		13		10
Total other investment securities	$	5,018	$	6,551

Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2018 and December 31, 2017 were as follows:

	Less than 12 months					12 months or more					Total		Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(in thousands)	Value		Losses			Value		Losses			Value		Losses
At September 30, 2018
U.S. Treasury	$	1,205	$	(40	)	$	711	$	(27	)	$	1,916	$	(67	)
U.S. government and federal agency obligations		0		0			10,474		(459	)		10,474		(459	)
Government sponsored enterprises		15,983		(220	)		28,983		(592	)		44,966		(812	)
Obligations of states and political subdivisions		18,265		(182	)		17,905		(582	)		36,170		(764	)
Mortgage-backed securities:
Residential - government agencies		31,595		(646	)		87,268		(4,272	)		118,863		(4,918	)
Bank issued trust preferred securities		0		0			1,364		(122	)		1,364		(122	)
Total	$	67,048	$	(1,088	)	$	146,705	$	(6,054	)	$	213,753	$	(7,142	)

(in thousands)
At December 31, 2017
U.S. Treasury	$	1,967	$	(13	)	$	0	$	0		$	1,967	$	(13	)
U.S. government and federal agency obligations		0		0			12,073		(268	)		12,073		(268	)
Government sponsored enterprises		16,471		(119	)		20,426		(305	)		36,897		(424	)
Obligations of states and political subdivisions		22,013		(165	)		12,570		(312	)		34,583		(477	)
Mortgage-backed securities:
Residential - government agencies		52,829		(488	)		69,580		(1,652	)		122,409		(2,140	)
Total	$	93,280	$	(785	)	$	114,649	$	(2,537	)	$	207,929	$	(3,322	)

The total available for sale portfolio consisted of approximately 371 securities at September 30, 2018. The portfolio included 344 securities having an aggregate fair value of $213.7 million that were in a loss position at September 30, 2018. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $146.7 million at fair value. The $7.1 million aggregate unrealized loss included in accumulated other comprehensive income at September 30, 2018 was caused by interest rate fluctuations .

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The total available for sale portfolio consisted of approximately 355 securities at December 31, 2017. The portfolio included 280 securities having an aggregate fair value of $207.9 million that were in a loss position at December 31, 2017. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer had a fair value of $114.6 million at December 31, 2017. The $3.3 million aggregate unrealized loss included in accumulated other comprehensive loss at December 31, 2017 was caused by interest rate fluctuations.

Because the decline in fair value is attributable to changes in interest rates and not credit quality, these investments were not considered other-than-temporarily impaired at September 30, 2018 and December 31, 2017, respectively. In the absence of changes in credit quality of these investments, the fair value is expected to recover on all debt securities as they approach their maturity date or re-pricing date, or if market yields for such investments decline. In addition, the Company does not have the intent to sell these investments over the period of recovery, and it is not more likely than not that the Company will be required to sell such investment securities.

The table presents the components of investment securities gains and losses, which have been recognized in earnings:

	Three Months Ended September 30,					Nine Months Ended September 30,
(in thousands)	2018		2017			2018		2017
Investment securities gains, net
Available for sale securities:
Gains realized on sales	$	47	$	12		$	253	$	12
Losses realized on sales		0		(12	)		0		(12	)
Other securities:
Fair value adjustments, net		3		0			3		0
Investment securities gains, net	$	50	$	0		$	256	$	0

Securities gains for the three and nine months ended September 30, 2018 included gains realized from a series of short term sales of U.S. Treasury securities with repurchase agreements in order to generate capital gains to offset capital losses that were to expire during 2018 and 2019.

(5)

Intangible Assets

Mortgage Servicing Rights

At September 30, 2018, the Company was servicing approximately $282.9 million of loans sold to the secondary market compared to $285.8 million at December 31, 2017, and $288.7 million at September 30, 2017. Mortgage loan servicing fees, reported in real estate servicing fees, net, earned on loans sold were $201,000 and $614,000 for the three and nine months ended September 30, 2018, respectively, compared to $209,000 and $629,000 for the three and nine months ended September 30, 2017, respectively.

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

	Three Months Ended September 30,						Nine Months Ended September 30,
(in thousands)	2018			2017			2018			2017
Balance at beginning of period	$	2,813		$	2,766		$	2,713		$	2,584
Originated mortgage servicing rights		66			61			198			176
Changes in fair value:
Due to change in model inputs and assumptions (1)		70			(30	)		203			289
Other changes in fair value (2)		(78	)		(109	)		(243	)		(361	)
Balance at end of period	$	2,871		$	2,688		$	2,871		$	2,688

(1)

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

(2)

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

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The following key data and assumptions were used in estimating the fair value of the Company’s MSRs as of September 30, 2018 and 2017, respectively:

	Nine Months Ended September 30,
	2018			2017
Weighted average constant prepayment rate		9.36	%		10.11	%
Weighted average note rate		3.92	%		3.86	%
Weighted average discount rate		10.36	%		9.78	%
Weighted average expected life (in years)		6.10			5.80

(6)

Federal funds purchased and securities sold under agreements to repurchase

	September 30,		December 31,
	2018		2017
Federal funds purchased	$	0	$	0
Repurchase agreements		32,660		27,560
Total	$	32,660	$	27,560

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

Repurchase Agreements	Remaining Contractual Maturity of the Agreements
	Overnight		Less		Greater
	and		than		than
(in thousands)	continuous		90 days		90 days		Total
At September 30, 2018
U.S. Treasury	$	1,442	$	0	$	0	$	1,442
Government sponsored enterprises		15,698		0		0		15,698
Asset-backed securities		15,520		0		0		15,520
Total	$	32,660	$	0	$	0	$	32,660

At December 31, 2017
U.S. Treasury	$	1,964	$	0	$	0	$	1,964
U.S. government and federal agency obligations		2,977		0		0		2,977
Government sponsored enterprises		8,382		0		0		8,382
Asset-backed securities		14,237		0		0		14,237
Total	$	27,560	$	0	$	0	$	27,560

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(7)

Income Taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 12.6% and 11.8% for the three and nine months ended September 30, 2018, respectively, compared to 32.4% and 33.6% for the three and nine months ended September 30, 2017, respectively. As further described below, the decrease in tax rate for the comparative periods is primarily due to a decrease in the federal corporate tax rate, the release of the valuation allowance related to capital losses as a result of the Company’s tax planning initiatives, a pension contribution made during the second quarter of 2018 that was attributable to the 2017 plan year, and the Company’s additional tax planning initiatives.

The federal corporate income tax rate declined from 34% to 21% effective January 1, 2018 as a result of the Tax Cuts and Jobs Act, (Tax Act). The Company’s tax rate is lower than the federal statutory rate primarily as a result of tax-exempt income, the release of the valuation allowance related to capital loss carryforwards, and a pension contribution made during the second quarter of 2018 that was attributable to the 2017 plan year, and the Company’s additional tax planning initiatives. The provisional adjustments recorded in the fourth quarter of 2017 related to the enactment of the Tax Act have been finalized as of September 30, 2018 with the filing of the Company’s 2017 tax return. The finalization of the Tax Act included a $306,000 benefit attributable to the pension contribution discussed above and an $180,000 benefit attributable to various accounting method changes made on the Company’s 2017 tax return. Such adjustments were recorded in the second and third quarters of 2018 respectively, within the one-year measurement period provided under Staff Accounting Bulletin No. 118 in regards to the application of FASB’s ASC Topic 740, Income Taxes .

The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income of the appropriate character during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning initiatives in making this assessment. In management’s opinion, the Company will more likely than not realize the benefits of its deferred tax assets and, therefore, has not established a valuation allowance against its deferred tax assets as of September 30, 2018. Management arrived at this conclusion based upon the level of historical taxable income and projections for future taxable income of the appropriate character over the periods in which the deferred tax assets are deductible. As indicated above, the Company released a $46,000 valuation allowance against certain capital loss carryforwards during the second quarter of 2018 as a result of the execution of certain tax planning initiatives that generated sufficient capital gain income prior to the expiration of the carryforwards.

The Company follows ASC Topic 740, Income Taxes, which addresses the accounting for uncertain tax positions . For each of the three and nine months ended September 30, 2018 and 2017, respectively, the Company did not have any uncertain tax provisions, and did not record any related tax liabilities.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(8)

Stockholders’ Equity

Accumulated Other Comprehensive Loss

The following details the change in the components of the Company’s accumulated other comprehensive loss for the nine months ended September 30, 2018 and 2017:

	Nine months ended September 30, 2018
				Unrecognized Net			Accumulated
	Unrealized			Pension and			Other
	Gain (Loss)			Postretirement			Comprehensive
(in thousands)	on Securities (1)			Costs (2)			(Loss) Income
Balance at beginning of period	$	(2,500	)	$	(3,162	)	$	(5,662	)
Other comprehensive (loss) income, before reclassifications		(3,915	)		164			(3,751	)
Amounts reclassified from accumulated other comprehensive (loss) income		0			0			0
Current period other comprehensive (loss) income, before tax		(3,915	)		164			(3,751	)
Income tax benefit (expense)		822			(35	)		787
Current period other comprehensive (loss) income, net of tax		(3,093	)		129			(2,964	)
Balance at end of period	$	(5,593	)	$	(3,033	)	$	(8,626	)

	Nine months ended September 30, 2017
				Unrecognized Net			Accumulated
	Unrealized			Pension and			Other
	Gain (Loss)			Postretirement			Comprehensive
(in thousands)	on Securities (1)			Costs (2)			Loss
Balance at beginning of period	$	(1,936	)	$	(1,865	)	$	(3,801	)
Other comprehensive income, before reclassifications		1,588			67			1,655
Amounts reclassified from accumulated other comprehensive income (loss)		0			0			0
Current period other comprehensive income, before tax		1,588			67			1,655
Income tax expense		(604	)		(25	)		(629	)
Current period other comprehensive income, net of tax		984			42			1,026
Balance at end of period	$	(952	)	$	(1,823	)	$	(2,775	)

(1) The pre-tax amounts reclassified from accumulated other comprehensive loss are included in gain on sale of investment securities in the consolidated statements of income.

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

(9)

Employee Benefit Plans

Employee Benefits

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

	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2018		2017		2018		2017
Payroll taxes	$	261	$	267	$	913	$	911
Medical plans		490		595		1,650		1,489
401k match and profit sharing		261		218		684		694
Periodic pension cost		470		336		1,280		1,007
Other		12		17		37		42
Total employee benefits	$	1,494	$	1,433	$	4,564	$	4,143

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

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Pension

The Company provides a noncontributory defined benefit pension plan for all full-time employees. Beginning January 1, 2018 and for all retrospective periods presented, the Company adopted the guidance under ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost . Under the new guidance, only the service cost component of the net periodic benefit cost is reported in the same income statement line item as salaries and benefits, and the remaining components are reported as other non-interest expense. An employer is required to recognize the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Under the Company’s funding policy for the defined benefit pension plan, contributions are made to a trust as necessary to provide for current service and for any unfunded accrued actuarial liabilities over a reasonable period. To the extent that these requirements are fully covered by assets in the trust, a contribution might not be made in a particular year. The Company made a pension contribution in the amount of $1.8 million in the second quarter of 2018. The 2018 minimum required contribution is $578,000. Effective July 1, 2017, the Company amended the pension plan to effectuate a “soft freeze” such that no individual hired (or rehired in the case of a former employee) by the Company after September 30, 2017, whether or not such individual is or was a vested member in the plan, will be eligible to be an active member and be entitled to accrue any benefits under the plan. Certain individuals hired by the Company before July 1, 2017 are also not eligible to participate in the plan.

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

The following items are components of net pension cost for the periods indicated:

	Pension Benefits
(in thousands)	2018			2017
Service cost - benefits earned during the year	$	1,707		$	1,343
Interest costs on projected benefit obligations (a)		1,037			1,009
Expected return on plan assets (a)		(1,327	)		(1,124	)
Expected administrative expenses (a)		93			88
Amortization of prior service cost (a)		79			79
Amortization of unrecognized net loss (a)		140			11
Net periodic pension cost	$	1,729		$	1,406

Net periodic pension cost for the three months ended September 30, (actual)	$	470		$	336
Net periodic pension cost for the nine months ended September 30, (actual)	$	1,280		$	1,007

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

(10)

Stock Compensation

The Company has one equity compensation plan for its employees pursuant to which options were granted.

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

						Weighted
				Weighted		Average		Aggregate
	Number			average		Contractual		Intrinsic
	of			Exercise		Term		Value
	Shares			Price		(in years)		($000)
Outstanding, December 31, 2017		20,909		$	14.20
Granted		0			0.00
Exercised		(20,909	)		14.20
Forfeited or expired		0			0.00
Outstanding, September 30, 2018		0		$	0.00		0.00	$	0
Exercisable, September 30, 2018		0		$	0.00		0.00	$	0

Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2018.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Total stock-based compensation expense was $0 for the three and nine months ended September 30, 2018 compared to $1,000 and $3,000 for the three and nine months ended September 30, 2017, respectively. As of December 31, 2017, there was no remaining unrecognized compensation expense related to non-vested stock awards. The Plan expired on February 28, 2010, except as to outstanding options under the Plan, and no further options may be granted pursuant to the Plan. During the third quarter of 2018, the remaining 20,909 options to purchase common shares were exercised at a weighted average price of $14.20 a share.

(11)

Earnings per Share

Stock Dividend On July 1, 2018, the Company paid a special stock dividend of 4% to common shareholders of record at the close of business on June 15, 2018. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

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

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

	Three Months Ended September 30,				Nine Months Ended September 30,
(dollars in thousands, except per share data)	2018		2017		2018		2017
Basic earnings per share:
Net income available to shareholders	$	3,098	$	1,766	$	8,095	$	5,786
Average shares outstanding		6,023,269		6,057,399		6,024,317		6,066,253
Basic earnings per share	$	0.51	$	0.29	$	1.34	$	0.95
Diluted earnings per share:
Net income available to shareholders	$	3,098	$	1,766	$	8,095	$	5,786
Average shares outstanding		6,023,269		6,057,399		6,024,317		6,066,253
Effect of dilutive stock options		6,363		5,784		6,480		5,407
Average shares outstanding including dilutive stock options		6,029,632		6,063,183		6,030,797		6,071,660
Diluted earnings per share	$	0.51		0.29	$	1.34		0.95

Under the treasury stock method, outstanding stock options are dilutive when the average market price of the Company’s common stock, when combined with the effect of any unamortized compensation expense, exceeds the option price during the period, except when the Company has a loss from continuing operations available to shareholders. In addition, proceeds from the assumed exercise of dilutive options along with the related tax benefit are assumed to be used to repurchase common shares at the average market price of such stock during the period. There were no outstanding stock options for any of the three and nine months ended September 30, 2018 and 2017, respectively, that were omitted from the computation of diluted earnings per share as a result of being considered anti-dilutive.

The Company’s share repurchase plan (the plan) expired on September 8, 2018. As of September 30, 2018, the Company had repurchased a total of 95,709 shares of common stock pursuant to the plan at an average price of $17.90 per share, including 8,668 shares of common stock repurchased pursuant to the plan during the nine months ended September 30, 2018 at an average price of $20.63 per share.

(12)

Fair Value Measurements

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

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Depending on the nature of the asset or liability, the Company uses various valuation methodologies and assumptions to estimate fair value. The measurement of fair value under US GAAP uses a hierarchy intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows. During the nine months ended September 30, 2018 and the year ended December 31, 2017, respectively, there were no transfers into or out of Levels 1-3.

The fair value hierarchy is as follows:

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

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

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

In accordance with fair value accounting guidance, the Company measures, records, and reports various types of assets and liabilities at fair value on either a recurring or non-recurring basis in the Consolidated Financial Statements. Nonfinancial assets measured at fair value on a nonrecurring basis would include foreclosed real estate, long-lived assets, and core deposit intangible assets, which are reviewed when circumstances or other events indicate that impairment may have occurred.

Valuation Methods for Assets and Labilities Measured at Fair Value on a Recurring Basis

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

Available-for-Sale Securities

The fair value measurements of the Company’s investment securities are determined by a third party pricing service which considers observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. The fair value measurements are subject to independent verification to another pricing source by management each quarter for reasonableness.

Mortgage Servicing Rights

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

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

			Fair Value Measurements
			Quoted Prices
			in Active
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
(in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)
September 30, 2018
Assets:
U.S. Treasury	$	1,916	$	1,916		0	$	0
U.S. government and federal agency obligations		10,474		0		10,474		0
Government sponsored enterprises		44,965		0		44,965		0
Obligations of states and political subdivisions		40,345		0		40,345		0
Mortgage-backed securities		122,498		0		122,498		0
Other debt securities		4,364		0		4,364		0
Equity securities		13		0		13		0
Mortgage servicing rights		2,871		0		0		2,871
Total	$	227,446	$	1,916	$	222,659	$	2,871

December 31, 2017
Assets:
U.S. Treasury	$	1,967	$	1,967		0	$	0
U.S. government and federal agency obligations		12,073		0		12,073		0
Government sponsored enterprises		36,897		0		36,897		0
Obligations of states and political subdivisions		46,656		0		46,656		0
Mortgage-backed securities		128,949		0		128,949		0
Other debt securities		4,486		0		4,486		0
Equity securities		10		0		10		0
Mortgage servicing rights		2,713		0		0		2,713
Total	$	233,751	$	1,967	$	229,071	$	2,713

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

	Fair Value Measurements Using						Fair Value Measurements Using
	Significant Unobservable Inputs						Significant Unobservable Inputs
	(Level 3)						(Level 3)
	Mortgage Servicing Rights						Mortgage Servicing Rights
(in thousands)	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
Balance at beginning of period	$	2,813		$	2,766		$	2,713		$	2,584
Total gains or losses (realized/unrealized):
Included in earnings		(8	)		(139	)		(40	)		(72	)
Included in other comprehensive income		0			0			0			0
Purchases		0			0			0			0
Sales		0			0			0			0
Issues		66			61			198			176
Settlements		0			0			0			0
Balance at end of period	$	2,871		$	2,688		$	2,871		$	2,688

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The change in valuation of mortgage servicing rights, arising from inputs and assumptions, decreased $8,000 and $40,000 for the three and nine months ended September 30, 2018, respectively, compared to a decrease of $139,000 and $72,000 for the three and nine months ended September 30, 2017, respectively.

Valuation methods for Assets and Liabilities measured at fair value on a nonrecurring basis

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

Collateral dependent impaired loans

While the overall loan portfolio is not carried at fair value, the Company periodically records nonrecurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans. Nonrecurring adjustments also include certain impairment amounts for collateral dependent loans when establishing the allowance for loan losses. Such amounts are generally based on the fair value of the underlying collateral supporting the loan. In determining the value of real estate collateral, the Company relies on external and internal appraisals of property values depending on the size and complexity of the real estate collateral. The Company maintains staff that is trained to perform in-house evaluations and also review third party appraisal reports for reasonableness. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgments based on the experience and expertise of internal specialists. Values of all loan collateral are regularly reviewed by senior loan committee. Because many of these inputs are not observable, the measurements are classified as Level 3. As of September 30, 2018, the Company identified $4.2 million in collateral dependent impaired loans that had specific allowances for losses aggregating $891,000. Related to these loans, there was $53,000 and $303,000 in charge-offs recorded during the three and nine months ended September 30, 2018, respectively. As of September 30, 2017, the Company identified $4.4 million in collateral dependent impaired loans that had specific allowances for losses aggregating $1.4 million. Related to these loans, there was $64,000 and $147,000 in charge-offs recorded during the three and nine months ended September 30, 2017, respectively.

Other Real Estate and Foreclosed Assets

Other real estate owned (OREO) and foreclosed assets consisted of loan collateral that has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Subsequent to foreclosure, these assets initially are carried at fair value of the collateral less estimated selling costs. Fair value, when recorded, is generally based upon appraisals by approved, independent state certified appraisers. Like impaired loans, appraisals on OREO may be discounted based on the Company’s historical knowledge, changes in market conditions from the time of appraisal or other information available. During the holding period, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. Because many of these inputs are not observable, the measurements are classified as Level 3.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

			Fair Value Measurements Using
			Quoted Prices						Three			Nine
			in Active						Months			Months
			Markets for		Other		Significant		Ended			Ended
			Identical		Observable		Unobservable		September 30,			September 30,
	Total		Assets		Inputs		Inputs		Total Gains			Total Gains
(in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)		(Losses)*			(Losses)*
September 30, 2018
Assets:
Collateral dependent impaired loans:
Commercial, financial, & agricultural	$	1,549	$	0	$	0	$	1,549	$	(21	)	$	(187	)
Real estate construction - commercial		158		0		0		158		0			(27	)
Real estate mortgage - residential		1,156		0		0		1,156		(32	)		(44	)
Real estate mortgage - commercial		399		0		0		399		0			(20	)
Consumer		0		0		0		0		0			(25	)
Total	$	3,262	$	0	$	0	$	3,262	$	(53	)	$	(303	)
Other real estate and foreclosed assets	$	13,373	$	0	$	0	$	13,373	$	(3	)	$	(29	)

September 30, 2017
Assets:
Collateral dependent impaired loans:
Commercial, financial, & agricultural	$	1,757	$	0	$	0	$	1,757	$	0		$	(1	)
Real estate mortgage - residential		1,042		0		0		1,042		(57	)		(122	)
Real estate mortgage - commercial		219		0		0		219		0			(4	)
Consumer		0		0		0		0		(7	)		(20	)
Total	$	3,018	$	0	$	0	$	3,018	$	(64	)	$	(147	)
Other real estate and foreclosed assets	$	13,177	$	0	$	0	$	13,177	$	(26	)	$	(206	)

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

(13)

Fair Value of Financial Instruments

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

Loans

Fair values are estimated for portfolios with similar financial characteristics. Loans are segregated by type, such as commercial, real estate, and consumer. Each loan category is further segmented into fixed and variable interest rate categories. The fair value of loans is estimated by using the future value of discounted cash flows using comparable market rates for similar types of loan products and adjusted for market factors. The discount rates used are estimated using comparable market rates for similar types of loan products adjusted to be commensurate with the credit risk, overhead costs, and optionality of such instruments.

Investment Securities

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

Federal Home Loan Bank (FHLB) Stock

Ownership of equity securities of FHLB is restricted and there is no established market for their resale. The carrying amount is a reasonable estimate of fair value.

Federal Funds Sold, Cash, and Due from Banks

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

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Certificates of Deposit in other banks

Certificates of deposit are other investments made by the Company with other financial institutions that are carried at cost.

Cash Surrender Value - Life Insurance

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

Accrued Interest Receivable and Payable

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

Deposits

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

Securities Sold under Agreements to Repurchase

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

Subordinated Notes and Other Borrowings

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

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

A summary of the carrying amounts and fair values of the Company’s financial instruments at September 30, 2018 and December 31, 2017 is as follows:

					September 30, 2018
					Fair Value Measurements
					Quoted Prices
					in Active				Net
					Markets for		Other		Significant
	September 30, 2018				Identical		Observable		Unobservable
	Carrying		Fair		Assets		Inputs		Inputs
(in thousands)	amount		value		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and due from banks	$	16,340	$	16,340	$	16,340	$	0	$	0
Federal funds sold and overnight interest-bearing deposits		20,478		20,478		20,478		0		0
Certificates of deposit in other banks		12,243		12,243		12,243		0		0
Available for sale securities		224,562		224,562		1,916		222,646		0
Other securities		5,018		5,018		0		5,018		0
Loans, net		1,104,407		1,082,384		0		0		1,082,384
Cash surrender value - life insurance		2,535		2,535		0		2,535		0
Accrued interest receivable		5,984		5,984		5,984		0		0
	$	1,391,567	$	1,369,544	$	56,961	$	230,199	$	1,082,384
Liabilities:
Deposits:
Non-interest bearing demand	$	257,376	$	257,376	$	257,376	$	0	$	0
Savings, interest checking and money market		609,216		609,216		609,216		0		0
Time deposits		316,142		312,771		0		0		312,771

Federal funds purchased and securities sold under agreements to repurchase		32,660		32,660		32,660		0		0
Federal Home Loan Bank advances and other borrowings		78,713		78,275		0		78,275		0
Subordinated notes		49,486		45,440		0		45,440		0
Accrued interest payable		990		990		990		0		0
	$	1,344,583	$	1,336,728	$	900,242	$	123,715	$	312,771

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

					December 31, 2017
					Fair Value Measurements
					Quoted Prices
					in Active						Net
					Markets for			Other			Significant
	December 31, 2017				Identical			Observable			Unobservable
	Carrying		Fair		Assets		Inputs			Inputs
(in thousands)	amount		value		(Level 1)			(Level 2)			(Level 3)
Assets:
Cash and due from banks	$	23,325	$	23,325	$	23,325		$	0		$	0
Federal funds sold and overnight interest-bearing deposits		39,553		39,553		39,553			0			0
Certificates of deposit in other banks		3,460		3,460		3,460			0			0
Available-for-sale securities		231,028		231,028		1,967			229,061			0
Other securities		6,551		6,551		0			6,551			0
Loans, net		1,057,580		1,058,153		0			0			1,058,153
Cash surrender value - life insurance		2,484		2,484		0			2,484			0
Accrued interest receivable		5,627		5,627		5,627			0			0
	$	1,369,608	$	1,370,181	$	73,932		$	238,096		$	1,058,153
Liabilities:
Deposits:
Non-interest bearing demand	$	245,380	$	245,380	$	245,380		$	0		$	0
Savings, interest checking and money market		584,468		584,468		584,468			0			0
Time deposits		295,964		294,778		0			0			294,778
Federal funds purchased and securities sold under agreements to repurchase		27,560		27,560		27,560			0			0
Federal Home Loan Bank advances and other borrowings		121,382		121,291		0			121,291			0
Subordinated notes		49,486		39,692		0			39,692			0
Accrued interest payable		554		554		554			0			0
	$	1,324,794	$	1,313,723	$	857,962		$	160,983		$	294,778

Off-Balance Sheet Financial Instruments

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

Limitations

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

(14)

Commitments and Contingencies

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

The Company’s extent of involvement and maximum potential exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for financial instruments included on its consolidated balance sheets. At September 30, 2018, no amounts have been accrued for any estimated losses for these financial instruments.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

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

	September 30,		December 31,
(in thousands)	2018		2017
Commitments to extend credit	$	233,920	$	238,527
Commitments to originate residential first and second mortgage loans		2,217		1,471
Standby letters of credit		61,332		74,004
Total		297,469		314,002

Commitments

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

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support contractual obligations of the Company’s customers. The approximate remaining term of standby letters of credit range from one month to five years at September 30, 2018.

Pending Litigation

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

(15)

Revenue Recognition

On January 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) and all subsequent ASUs that modified Topic 606. As stated in Note 1 Summary of Significant Accounting Policies , the implementation of the new standard did not have a material impact on the measurement or recognition of revenue; as such, a cumulative effect adjustment to opening retained earnings was not deemed necessary.

Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and securities. In addition, certain noninterest income streams such as fees associated with mortgage servicing rights, financial guarantees, derivatives, and certain credit card fees are not in the scope of the new guidance. Topic 606 is applicable to noninterest revenue streams such as trust department revenue, service charges and fees, debit card income, ATM surcharge income, and sales of other real estate owned. However, the recognition of these revenue streams did not change current business practices or result in any changes to the Company’s consolidated financial statements.

Descriptions of our revenue-generating activities within the scope of this guidance, which are presented in our income statement as components of noninterest income are as follows:

•

Service charges on deposit accounts - represents fees generated from a variety of deposit products and services provided to customers under a day-to-day contract. These fees are recognized on a daily or monthly basis.

•

Bank card income and fees – represents fees, exchange, and other service charge revenue earned from merchant, debit and credit cards that are recognized when the services are rendered or upon completion. These fees are recognized on a daily or monthly basis.

•

Gain on sale of other real estate - represents income recognized at the time of control of a property is transferred to the buyer.

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

And Results of Operations

Forward-Looking Statements

This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company, Hawthorn Bancshares, Inc., 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 the Company’s 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 the Company and its acquisition targets may be greater than expected,

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

changes may occur in the securities markets.

We have described under the caption Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, and in other reports filed with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that have not been identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made.

Overview

Crucial to the Company’s community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, the Company, with $1.5 billion in assets at September 30, 2018, provides a broad range of commercial and personal banking services. The Bank’s specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate, Small Business Administration (SBA) loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include the Missouri communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson, and the greater Kansas City metropolitan area.

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

The success of the Company's growth strategy depends primarily on the ability of its 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. The Company's financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of the Company's growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control.

The Company’s 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, the Bank provides trust services.

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

CRITICAL ACCOUNTING POLICIES

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

Allowance for Loan Losses

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

SELECTED CONSOLIDATED FINANCIAL DATA

The following table presents selected consolidated financial information for the Company as of and for each of the nine months ended September 30, 2018 and 2017, respectively. The selected consolidated financial data should be read in conjunction with the unaudited consolidated financial statements of the Company, including the related notes, presented elsewhere herein.

Selected Financial Data
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(In thousands, except per share data)	2018			2017			2018			2017
Per Share Data
Basic earnings per share	$	0.51		$	0.29		$	1.34		$	0.95
Diluted earnings per share		0.51			0.29			1.34			0.95
Cash dividends paid on common stock		579			338			1,390			1,067
Common stock dividend		5,014			4,165			5,014			4,165
Book value per share								15.75			15.84
Market price per share								22.75			19.90
Selected Ratios
(Based on average balance sheets)
Return on total assets		0.85	%		0.51	%		0.75	%		0.58	%
Return on stockholders' equity		13.02	%		7.27	%		11.69	%		8.18	%
Stockholders' equity to total assets		6.50	%		7.04	%		6.42	%		7.06	%
Efficiency ratio (1)		72.54	%		75.51	%		75.19	%		74.34	%

(Based on end-of-period data)
Stockholders' equity to assets								6.54	%		6.93	%
Total risk-based capital ratio								13.54	%		13.42	%
Tier 1 risk-based capital ratio								11.31	%		11.17	%
Common equity Tier 1 capital								8.60	%		8.39	%
Tier 1 leverage ratio (2)								9.35	%		9.62	%

(1)

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

(2)

Tier I leverage ratio is calculated by dividing Tier 1 capital by average total consolidated assets.

RESULTS OF OPERATIONS ANALYSIS

The Company has prepared all of the consolidated financial information in this report in accordance with 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, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.

	Three Months Ended September 30,										Nine Months Ended September 30,
(In thousands)	2018		2017		$ Change			% Change			2018		2017		$ Change			% Change

Net interest income	$	11,308	$	10,753	$	555			5.2	%	$	33,090	$	32,060	$	1,030			3.2	%
Provision for loan losses		250		555		(305	)		(55.0	)		1,000		1,235		(235	)		(19.0	)
Noninterest income		2,324		2,181		143			6.6			6,905		6,687		218			3.3
Investment securities gain, net		50		-		50			NM			256		-		256			NM
Noninterest expense		9,888		9,766		122			1.2			30,073		28,803		1,270			4.4
Income before income taxes		3,544		2,613		881			33.7			9,178		8,709		213			2.4
Income tax expense		446		847		(401	)		(47.3	)		1,083		2,923		(1,840	)		(62.9	)
Net income	$	3,098	$	1,766	$	1,332			75.4	%	$	8,095	$	5,786	$	2,309			39.9	%

Consolidated net income of $3.1 million, or $0.51 per diluted share, for the three months ended September 30, 2018 increased $1.3 million compared to $1.8 million, or $0.29 per diluted share, for the three months ended September 30, 2017. For the three months ended September 30, 2018, the return on average assets was 0.85%, the return on average stockholders’ equity was 13.02%, and the efficiency ratio was 72.54%.

Consolidated net income of $8.1 million, or $1.34 per diluted share, for the nine months ended September 30, 2018 increased $2.3 million compared to $5.8 million, or $0.95 per diluted share, for the nine months ended September 30, 2017. For the nine months ended September 30, 2018, the return on average assets was 0.75%, the return on average stockholders’ equity was 11.69%, and the efficiency ratio was 75.19%.

Net interest income was $11.3 million and $33.1 million for the three and nine months ended September 30, 2018, respectively, compared to $10.8 million and $32.1 million for the three and nine months ended September 30, 2017, respectively. The net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.30% for the three months ended September 30, 2018, compared to 3.35% for the three months ended September 30, 2017, and decreased to 3.28% for the nine months ended September 30, 2018 compared to 3.44% for the nine months ended September 30, 2017. These changes are discussed in greater detail under the Average Balance Sheets and Rate and Volume Analysis section below.

A $250,000 and $1.0 million provision for loan losses was recorded for the three and nine months ended September 30, 2018, respectively, compared to a $555,000 and $1.2 million provision for the three and nine months ended September 30, 2017, respectively.

Non-performing loans totaled $6.0 million, or 0.54% of total loans, at September 30, 2018 compared to $5.7 million, or 0.53% of total loans, at December 31, 2017, and $6.2 million, or 0.59% of total loans, at September 30, 2017. These changes are discussed in greater detail under the Lending and Credit Management section below.

Non-interest income increased $143,000, or 6.6%, for the three months ended September 30, 2018 compared to the three months ended September 30, 2017, and increased $218,000, or 3.3%, for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017. These changes are discussed in greater detail under the Non-interest Income and Expense section below.

Investment securities gains, net of $50,000 and $256,000 were recorded for the three and nine months ended September 30, 2018 compared to zero for both the prior comparative periods ending September 30, 2017. Securities gains for the three and nine months ended September 30, 2018 included gains realized from a series of short term sales of U.S. Treasury securities with repurchase agreements in order to generate capital gains to offset capital losses expiring in 2018 and 2019.

Non-interest expense increased $122,000, or 1.2%, for the three months ended September 30, 2018 compared to the three months ended September 30, 2017 and increased $1.3 million, or 4.4%, for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017. These changes are discussed in greater detail under the Non-interest Income and Expense section below.

Average Balance Sheets

Net interest income is the largest source of revenue resulting from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table presents average balance 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 periods ended September 30, 2018 and 2017, respectively.

	Three Months Ended September 30,
(In thousands)	2018								2017
				Interest		Rate						Interest		Rate
	Average			Income/		Earned/			Average			Income/		Earned/
	Balance			Expense(1)		Paid(1)			Balance			Expense(1)		Paid(1)
ASSETS
Loans: (2) (4)
Commercial	$	199,911		$	2,556		5.07	%	$	186,001		$	2,166		4.62	%
Real estate construction - residential		29,444			404		5.44			21,532			253		4.66
Real estate construction - commercial		108,916			1,368		4.98			83,398			952		4.53
Real estate mortgage - residential		246,568			3,020		4.86			252,329			2,938		4.62
Real estate mortgage - commercial		482,800			5,662		4.65			458,684			5,289		4.57
Consumer		33,494			331		3.92			33,852			322		3.77
Total loans	$	1,101,133		$	13,341		4.81	%	$	1,035,796		$	11,920		4.57	%
Investment securities: (3)
U.S. Treasury	$	11,119		$	66		2.36	%	$	0		$	0		0.00	%
U.S. government and federal agency obligations		57,080			259		1.80			49,762			175		1.40
Obligations of states and political subdivisions		40,957			231		2.24			48,359			268		2.20
Mortgage-backed securities		125,976			683		2.15			119,160			533		1.77
Other debt securities		4,485			63		5.57			4,486			59		5.22
Total investment securities	$	239,617		$	1,302		2.16	%	$	221,767		$	1,035		1.85	%
Other securities		4,737			59		4.94			5,713			42		2.92
Federal funds sold and interest bearing deposits in other financial institutions		32,831			205		2.48			27,144			84		1.23
Total interest earning assets	$	1,378,318		$	14,907		4.29	%	$	1,290,420		$	13,081		4.02	%
All other assets		84,359								88,347
Allowance for loan losses		(11,341	)							(10,603	)
Total assets	$	1,451,336							$	1,368,164
LIABILITIES AND
STOCKHOLDERS' EQUITY
NOW accounts	$	204,370		$	513		1.00	%	$	209,704		$	302		0.57	%
Savings		96,548			13		0.05			97,285			12		0.05
Interest checking		3,051			6		0.78			1,450			3		0.82
Money market		312,597			936		1.19			239,742			365		0.60
Time deposits		319,809			911		1.13			290,767			582		0.79
Total interest bearing deposits	$	936,375		$	2,379		1.01	%	$	838,948		$	1,264		0.60	%
Federal funds purchased and securities sold under agreements to repurchase		36,743			166		1.79			29,107			29		0.40
Federal Home Loan advances and other		71,780			314		1.74			100,390			440		1.74
Subordinated notes		49,486			584		4.68			49,486			450		3.61
Total borrowings	$	158,009		$	1,064		2.67	%	$	178,983		$	919		2.04	%
Total interest bearing liabilities	$	1,094,384		$	3,443		1.25	%	$	1,017,931		$	2,183		0.85	%
Demand deposits		250,624								242,262
Other liabilities		11,944								11,627
Total liabilities		1,356,952								1,271,820
Stockholders' equity		94,384								96,344
Total liabilities and stockholders' equity	$	1,451,336							$	1,368,164
Net interest income (FTE)					11,464								10,898
Net interest spread							3.04	%							3.17	%
Net interest margin							3.30	%							3.35	%

(1)

Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21% and 34%, net of nondeductible interest expense for the three months ended September 30, 2018 and 2017 respectively. Such adjustments totaled $156,000 and $145,000 for the three months ended September 30, 2018 and 2017, respectively.

(2)

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

(3)

Average balances based on amortized cost.

(4)

Fees and costs on loans are included in interest income.

	Nine Months Ended September 30,
(In thousands)	2018								2017
				Interest		Rate						Interest		Rate
	Average			Income/		Earned/			Average			Income/		Earned/
	Balance			Expense(1)		Paid(1)			Balance			Expense(1)		Paid(1)
ASSETS
Loans: (2) (4)
Commercial	$	198,074		$	7,362		4.97	%	$	186,492		$	6,456		4.63	%
Real estate construction - residential		29,208			1,135		5.20			20,474			704		4.60
Real estate construction - commercial		104,335			3,774		4.84			73,821			2,470		4.47
Real estate mortgage - residential		247,165			8,846		4.79			257,249			8,819		4.58
Real estate mortgage - commercial		476,724			16,546		4.64			447,767			15,387		4.59
Consumer		32,838			938		3.82			31,975			931		3.89
Total loans	$	1,088,344		$	38,601		4.74	%	$	1,017,778		$	34,767		4.57	%
Investment securities: (3)
U.S. Treasury	$	16,857		$	205		1.63	%	$	0		$	0		0.00	%
U.S. government and federal agency obligations		53,600			690		1.72			48,037			507		1.41
Obligations of states and political subdivisions		42,347			735		2.32			46,621			784		2.25
Mortgage-backed securities		126,092			2,009		2.13			121,145			1,659		1.83
Other debt securities		4,485			184		5.49			4,486			174		5.19
Total investment securities	$	243,381		$	3,823		2.10	%	$	220,289		$	3,124		1.90	%
Other securities		5,042			162		4.30			5,706			111		2.60
Federal funds sold and interest bearing deposits in other financial institutions		32,416			500		2.06			17,885			144		1.08
Total interest earning assets	$	1,369,183		$	43,086		4.21	%	$	1,261,658		$	38,146		4.04	%
All other assets		84,485								88,984
Allowance for loan losses		(11,121	)							(10,332	)
Total assets	$	1,442,547							$	1,340,310
LIABILITIES AND
STOCKHOLDERS' EQUITY
NOW accounts	$	225,376		$	1,604		0.95	%	$	212,645		$	806		0.51	%
Savings		96,024			36		0.05			99,356			37		0.05
Interest checking		2,855			16		0.75			1,542			8		0.69
Money market		290,374			2,242		1.03			214,526			695		0.43
Time deposits		308,243			2,391		1.04			291,175			1,561		0.72
Total interest bearing deposits	$	922,872		$	6,289		0.91	%	$	819,244		$	3,107		0.51	%
Federal funds purchased and securities sold under agreements to repurchase		43,101			526		1.63			29,141			78		0.36
Federal Home Loan advances and other		80,745			1,042		1.73			101,059			1,290		1.71
Subordinated notes		49,486			1,636		4.42			49,486			1,182		3.19
Total borrowings	$	173,332		$	3,204		2.47	%	$	179,686		$	2,550		1.90	%
Total interest bearing liabilities	$	1,096,204		$	9,493		1.16	%	$	998,930		$	5,657		0.76	%
Demand deposits		241,618								235,469
Other liabilities		12,179								11,343
Total liabilities		1,350,001								1,245,742
Stockholders' equity		92,546								94,568
Total liabilities and stockholders' equity	$	1,442,547							$	1,340,310
Net interest income (FTE)					33,593								32,489
Net interest spread							3.05	%							3.28	%
Net interest margin							3.28	%							3.44	%

(1)

Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21% and 34%, net of nondeductible interest expense for the nine months ended September 30, 2018 and 2017 respectively. Such adjustments totaled $503,000 and $429,000 for the nine months ended September 30, 2018 and 2017, respectively.

(2)

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

(3)

Average balances based on amortized cost.

(4)

Fees and costs on loans are included in interest income.

Rate and Volume Analysis

The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates for the three and nine months ended September 30, 2018 compared to the three and nine months ended September 30, 2017. The change in interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.

	Three Months Ended September 30,									Nine Months Ended September 30,
	2018 vs. 2017									2018 vs. 2017
				Change due to									Change due to
	Total			Average			Average			Total			Average			Average
(In thousands)	Change			Volume			Rate			Change			Volume			Rate
Interest income on a fully taxable equivalent basis: (1)
Loans: (2) (4)
Commercial	$	390		$	169		$	221		$	906		$	415		$	491
Real estate construction - residential		151			104			47			431			330			101
Real estate construction - commercial		416			313			103			1,304			1,090			214
Real estate mortgage - residential		82			(68	)		150			27			(353	)		380
Real estate mortgage - commercial		373			282			91			1,159			1,004			155
Consumer		9			(3	)		12			7			25			(18	)
Investment securities: (3)
U.S. Treasury		66			63			3			205			200			5
U.S. government and federal agency obligations		84			29			55			183			63			120
Obligations of states and political subdivisions		(37	)		(42	)		5			(49	)		(74	)		25
Mortgage-backed securities		150			31			119			350			70			280
Other debt securities		4			0			4			10			0			10
Other securities		17			(8	)		25			51			(14	)		65
Federal funds sold and interest bearing deposits in other financial institutions		121			21			100			356			167			189
Total interest income		1,826			891			935			4,940			2,923			2,017
Interest expense:
NOW accounts		211			(8	)		219			798			51			747
Savings		1			0			1			(1	)		(1	)		0
Interest checking		3			0			3			8			7			1
Money market		571			137			434			1,547			315			1,232
Time deposits		329			63			266			830			97			733
Federal funds purchased and securities sold under agreements to repurchase		137			10			127			448			53			395
Federal Home Loan Bank advances and other		(126	)		(125	)		(1	)		(248	)		(262	)		14
Subordinated notes		134			0			134			454			0			454
Total interest expense		1,260			77			1,183			3,836			260			3,576
Net interest income on a fully
taxable equivalent basis	$	566		$	814		$	(248	)	$	1,104		$	2,663		$	(1,559	)

(1)

Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 21%, net of nondeductible interest expense for the three and nine months ended September 30, 2018, respectively, compared to 34% for the three and nine months ended September 30, 2017, respectively. Such adjustments totaled $156,000 and $503,000 for the three months and nine months ended September 30, 2018, respectively, compared to $145,000 and $429,000 for the three and nine months ended September 30, 2017, respectively.

(2)

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

(3)

Average balances based on amortized cost.

(4)

Fees and costs on loans are included in interest income.

Financial results for the quarter ended September 30, 2018 compared to the quarter ended September 30, 2017, reflected an increase in net interest income, on a tax equivalent basis, of $566,000, or 5.19%, and financial results for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 reflected an increase of $1.1 million, or 3.40%. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.30% for the quarter ended September 30, 2018, compared to 3.35% for the quarter ended September 30, 2017, and decreased to 3.28% for the nine months ended September 30, 2018 compared to 3.44% for the nine months ended September 30, 2017. Although net interest income increased primarily due to an increase in average earning assets, net interest margin decreased due to the cost of interest bearing liabilities repricing faster than the rate earned on interest bearing assets in the comparative periods presented.

Average interest-earning assets increased $87.9 million, or 6.81%, to $1.38 billion for the three months ended September 30, 2018 compared to $1.29 billion for the three months ended September 30, 2017, and average interest bearing liabilities increased $76.5 million, or 7.51%, to $1.09 billion for the three months ended September 30, 2018 compared to $1.02 billion for the three months ended September 30, 2017.

Average interest-earning assets increased $107.5 million, or 8.52%, to $1.37 billion for the nine months ended September 30, 2018 compared to $1.26 billion for the nine months ended September 30, 2017, and average interest bearing liabilities increased $97.3 million, or 9.74%, to $1.10 billion for the nine months ended September 30, 2018 compared to $998.9 million for the nine months ended September 30, 2017.

Total interest income (expressed on a fully taxable equivalent basis) was $14.9 million and $43.1 million for the three and nine months ended September 30, 2018, respectively, compared to $13.1 million and $38.1 million for the three and nine months ended September 30, 2017, respectively. The Company’s rates earned on interest earning assets were 4.29% and 4.21% for the three and nine months ended September 30, 2018, respectively, compared to 4.02% and 4.04% for the three and nine months ended September 30, 2017, respectively.

Interest income on loans increased to $13.3 million and $38.6 million for the three and nine months ended September 30, 2018, respectively, compared to $11.9 million and $34.8 million for the three and nine months ended September 30, 2017, respectively.

Average loans outstanding increased $65.3 million, or 6.31%, to $1.10 billion for the three months ended September 30, 2018 compared to $1.04 billion for the three months ended September 30, 2017. The average yield on loans receivable increased to 4.81% for the three months ended September 30, 2018 compared to 4.57% for the three months ended September 30, 2017.

Average loans outstanding increased $70.6 million, or 6.93%, to $1.09 billion for the nine months ended September 30, 2018 compared to $1.02 billion for the nine months ended September 30, 2017. The average yield on loans receivable increased to 4.74% for the nine months ended September 30, 2018 compared to 4.57% for the nine months ended September 30, 2017. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

Total interest expense increased to $3.4 million and $9.5 million for the three and nine months ended September 30, 2018, respectively, compared to $2.2 million and $5.7 million for the three and nine months ended September 30, 2017, respectively. The Company’s rates paid on interest bearing liabilities was 1.25% and 1.16% for the three and nine months ended September 30, 2018, respectively, compared to 0.85% and 0.76% for the three and nine months ended September 30, 2017, respectively. See the Liquidity Management section for further discussion.

Interest expense on deposits increased to $2.4 million and $6.3 million for the three and nine months ended September 30, 2018, respectively, compared to $1.3 million and $3.1 million for the three and nine months ended September 30, 2017, respectively.

Average interest bearing deposits increased $97.4 million, or 11.6%, to $936.3 million for the three months ended September 30, 2018 compared to $838.9 million for the three months ended September 30, 2017. The increase was primarily due to a new money market product that brought in new deposits in addition to new public funds. The average cost of deposits increased to 1.01% for the three months ended September 30, 2018 compared to 0.60% for the three months ended September 30, 2017. The increase was primarily due to the rate paid on the new money market product and generally higher market interest rates quarter over quarter.

Average interest bearing deposits increased $103.6 million, or 12.6%, to $922.8 million for the nine months ended September 30, 2018 compared to $819.2 million for the nine months ended September 30, 2017. The increase was primarily due to a new money market product that brought in new deposits in addition to new public funds. The average cost of deposits increased to 0.91% for the nine months ended September 30, 2018 compared to 0.51% for the nine months ended September 30, 2017. The increase was primarily due to the rate paid on the new money market product and generally higher market interest rates during the current year versus the prior year.

Interest expense on borrowings increased to $1.1 million and $3.2 million for the three and nine months ended September 30, 2018, respectively, compared to $919,000 and $2.6 million for the three and nine months ended September 30, 2017, respectively.

Average borrowings decreased to $158.0 million for the three months ended September 30, 2018 compared to $179.0 million for the three months ended September 30, 2017. The decrease in average borrowings resulted from the repayment of FHLB advances partially offset by an increase in average repurchase agreements due to a tax initiative involving short sales of a U.S. Treasury security funded by repurchase agreements. The average cost of borrowings increased to 2.67% for the three months ended September 30, 2018 compared to 2.04% for the three months ended September 30, 2017. The increase in cost of funds primarily resulted from higher market interest rates and the additional interest cost of the repurchase agreements related to the short sales.

Average borrowings decreased to $173.3 million for the nine months ended September 30, 2018 compared to $179.7 million for the nine months ended September 30, 2017. The decrease in average borrowings resulted from the repayment of FHLB advances partially offset by an increase in average repurchase agreements due to a tax initiative involving short sales of a U.S. Treasury security funded by repurchase agreements. The average cost of borrowings increased to 2.47% for the nine months ended September 30, 2018 compared to 1.90% for the nine months ended September 30, 2017. The increase in cost of funds primarily resulted from higher market interest rates and the additional interest cost of the repurchase agreements related to the short sales. See the Liquidity Management section for further discussion.

Non-interest Income and Expense

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

	Three Months Ended September 30,												Nine Months Ended September 30,
(In thousands)	2018			2017			$ Change			% Change			2018			2017			$ Change			% Change
Non-interest Income
Service charges and other fees	$	942		$	878		$	64			7.3	%	$	2,760		$	2,565		$	195			7.6	%
Bank card income and fees		699			664			35			5.3			2,064			1,941			123			6.3
Trust department income		276			288			(12	)		(4.2	)		867			828			39			4.7
Real estate servicing fees, net		192			70			122			174.3			574			557			17			3.1
Gain on sales of mortgage loans, net		205			225			(20	)		(8.9	)		593			599			(6	)		(1.0	)
Other		10			56			(46	)		(82.1	)		47			197			(150	)		(76.1	)
Total non-interest income	$	2,324		$	2,181		$	143			6.6	%	$	6,905		$	6,687		$	218			3.3	%

Non-interest income as a % of total revenue *		17.0	%		16.9	%								17.3	%		17.3	%

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

Total non-interest income increased $143,000, or 6.6%, to $2.3 million for the quarter ended September 30, 2018 compared to $2.2 million for the quarter ended September 30, 2017, and increased $218,000, or 3.3%, to $6.9 million for the nine months ended September 30, 2018 compared to $6.7 million for the nine months ended September 30, 2017.

Service charges and other fees increased $64,000, or 7.3%, to $942,000 for the quarter ended September 30, 2018 compared to $878,000 for the quarter ended September 30, 2017, and increased $195,000, or 7.6%, to $2.8 million for the nine months ended September 30, 2018 compared to $2.6 million for the nine months ended September 30, 2017. The increases period over period were primarily due to reduced waived service charges and increases in fees and ATM income resulting from deposit growth.

Real estate servicing fees, net of the change in valuation of mortgage serving rights, (MSRs) increased $122,000 to $192,000 for the quarter ended September 30, 2018 compared to $70,000 for the quarter ended September 30, 2017 primarily due to an increase in the change in fair value quarter over quarter. Real estate servicing fees, net of the change in valuation of MSRs increased $17,000 to $574,000 for the nine months ended September 30, 2018 compared to $557,000 for the nine months ended September 30, 2017 primarily due to an increase in the change in fair value year over year. The change in the value of MSRs in both periods presented is primarily the result of market-driven changes in interest rates and prepayment speeds.

Mortgage loan servicing fees earned on loans sold were $201,000 and $614,000 for the three and nine months ended September 30, 2018, respectively, compared to $209,000 and $629,000 for the three and nine months ended September 30, 2017, respectively. The Company was servicing $282.9 million of mortgage loans at September 30, 2018 compared to $285.8 million and $288.7 million at December 31, 2017 and September 30, 2017, respectively.

Gain on sales of mortgage loans decreased $20,000, or 8.9%, to $205,000 for the quarter ended September 30, 2018 compared to $225,000 for the quarter ended September 30, 2017, and decreased $6,000, or 1.0%, to $593,000 for the nine months ended September 30, 2018 compared to $599,000 for the nine months ended September 30, 2017. The decrease period over period was primarily due to a decrease in other loan originating income, partially offset by an increase in loan origination fees and costs. The Company sold loans of $10.3 million and $30.0 million for the three and nine months ended September 30, 2018, respectively, compared to $10.1 and $26.3 million for the three and nine months ended September 30, 2017, respectively.

Other Income decreased $46,000, or 82.1%, to $10,000 for the quarter ended September 30, 2018 compared to $56,000 for the quarter ended September 30, 2017, and decreased $150,000, or 76.1%, to $47,000 for the nine months ended September 30, 2018 compared to $197,000 for the nine months ended September 30, 2017. The decrease period over period was primarily due to a decrease in brokerage income and partially offset by an increase in insurance claim reserve.

Investment securities gains, net for the periods indicated were as follows:

	Three Months Ended September 30,					Nine Months Ended September 30,
(in thousands)	2018		2017			2018		2017
Investment securities gains, net
Available for sale securities:
Gains realized on sales	$	47	$	12		$	253	$	12
Losses realized on sales		0		(12	)		0		(12	)
Other securities:
Fair value adjustments, net		3		0			3		0
Investment securities gains, net	$	50	$	0		$	256	$	0

Securities gains for the three and nine months ended September 30, 2018 included gains realized from a series of short term sales of a U.S. Treasury security with repurchase agreements in order to generate capital gains to offset capital losses that were to expire during 2018 and 2019.

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

	Three Months Ended September 30,												Nine Months Ended September 30,
(In thousands)	2018			2017			$ Change			% Change			2018			2017			$ Change			% Change
Non-interest Expense
Salaries	$	4,049		$	4,069		$	(20	)		(0.5	)%	$	12,849		$	12,133		$	716			5.9	%
Employee benefits		1,494			1,433			61			4.3			4,564			4,143			421			10.2
Occupancy expense, net		749			719			30			4.2			2,162			2,027			135			6.7
Furniture and equipment expense		785			764			21			2.7			2,104			1,996			108			5.4
Processing expense, network and bank card expense		841			831			10			1.2			2,589			2,803			(214	)		(7.6	)
Legal, examination, and professional fees		289			331			(42	)		(12.7	)		913			928			(15	)		(1.6	)
FDIC insurance assessment		181			106			75			70.8			482			322			160			49.7
Advertising and promotion		297			342			(45	)		(13.2	)		840			845			(5	)		(0.6	)
Postage, printing, and supplies		256			215			41			19.1			749			690			59			8.6
Other		947			956			(9	)		(0.9	)		2,821			2,916			(95	)		(3.3	)
Total non-interest expense	$	9,888		$	9,766		$	122			1.2	%	$	30,073		$	28,803		$	1,270			4.4	%
Efficiency ratio *		72.5	%		75.5	%								75.2	%		74.3	%
Number of full-time equivalent employees		299			335

* Efficiency ratio is calculated as non-interest expense as a percent of revenue.

Total revenue includes net interest income and non-interest income.

Total non-interest expense increased $122,000, or 1.2%, to $9.9 million for the quarter ended September 30, 2018 compared to $9.8 million for the quarter ended September 30, 2017, and increased $1.3 million, or 4.4%, to $30.1 million for the nine months ended September 30, 2018 compared to $28.8 million for the nine months ended September 30, 2017.

Salaries decreased $20,000, or 0.5%, to $4.0 million for the quarter ended September 30, 2018 compared to $4.1 million for the quarter ended September 30, 2017, and increased $716,000, or 5.9%, to $12.8 million for the nine months ended September 30, 2018 compared to $12.1 million for the nine months ended September 30, 2017. The decrease quarter over quarter was primarily due to a reduction of thirty-six full-time equivalent employees, the majority of which occurred in the second and third quarter of 2018. The increase year over year was primarily due to a bonus that was paid in February 2018 to all eligible full-time and part-time employees as a result of the expected tax savings from the Tax Act and an average 3% cost of living increase granted in January 2018.

Employee benefits increased $61,000, or 4.3%, to $1.5 million for the quarter ended September 30, 2018 compared to $1.4 million for the quarter ended September 30, 2017, and increased $421,000, or 10.2%, to $4.6 million for the nine months ended September 30, 2018 compared to $4.1 million for the nine months ended September 30, 2017. The increase in both periods presented was primarily due to an increase in pension expense due to lower assumed discount rates. An increase in medical plan premiums effective July 1, 2018 also contributed to the increase year over year.

Processing, network, and bank card expense increased $10,000, or 1.2%, to $841,000 for the quarter ended September 30, 2018 compared to $831,000 for the quarter ended September 30, 2017, and decreased $214,000, or 7.6%, to $2.6 million for the nine months ended September 30, 2018 compared to $2.8 million for the nine months ended September 30, 2017. The increase quarter over quarter was primarily due to an increase in ATM and debit card processing expenses partially offset by a decrease in network and data processing expenses. The decrease for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily due to additional one-time costs associated with a corporate wide network upgrade and changes in processing service providers during 2017. This was partially offset by increased debit card processing expenses during 2018.

Legal, examination, and professional fees decreased $42,000, or 12.7%, to $289,000 for the quarter ended September 30, 2018 compared to $331,000 for the quarter ended September 30, 2017, and decreased $15,000, or 1.6%, to $913,000 for the nine months ended September 30, 2018 compared to $928,000 for the nine months ended September 30, 2017. The decrease quarter over quarter was primarily related to attorney fees incurred in 2017 related to two loan relationships. The decrease for the nine month period year over year was primarily related to a decrease in attorney fees related to settlements received on two loan relationships during 2018, partially offset by an increase in consulting fees related to tax planning initiatives and increased audit fees.

FDIC insurance assessment increased $75,000, or 70.8%, to $181,000 for the quarter ended September 30, 2018 compared to $106,000 for the quarter ended September 30, 2017, and increased $160,000, or 49.7%, to $482,000 for the nine months ended September 30, 2018 compared to $322,000 for the nine months ended September 30, 2017. The increase in both periods presented was primarily due to an increase in the Company’s total assessment base.

Income taxes

The federal corporate income tax rate declined from 34% to 21% effective January 1, 2018 as a result of the Tax Cuts and Jobs Act, (Tax Act). The Company’s tax rate is lower than the federal statutory rate primarily as a result of tax-exempt income, the release of the valuation allowance related to capital loss carryforwards, and a pension contribution made during the second quarter of 2018 that was attributable to the 2017 plan year, and the Company’s additional tax planning initiatives. The provisional adjustments recorded in the fourth quarter of 2017 related to the enactment of the Tax Cuts and Jobs Act have been finalized as of September 30, 2018 with the filing of the Company’s 2017 tax return. The finalization of the Tax Act included a $306,000 benefit attributable to the pension contribution discussed above and an $180,000 benefit attributable to various accounting method changes made on the Company’s 2017 tax return. Such adjustments were recorded in the second and third quarters of 2018 respectively, within the one-year measurement period provided under Staff Accounting Bulletin No. 118 in regards to the application of FASB’s ASC Topic 740, Income Taxes .

Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 76.1% of total assets as of September 30, 2018 compared to 74.0% as of December 31, 2017.

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

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

	September 30,			December 31,
(In thousands)	2018			2017
Commercial, financial, and agricultural	$	203,485		$	192,238
Real estate construction - residential		30,374			26,492
Real estate construction - commercial		95,806			98,340
Real estate mortgage - residential		246,334			246,754
Real estate mortgage - commercial		506,197			472,455
Installment loans to individuals		33,569			32,153
Total loans	$	1,115,765		$	1,068,432
Percent of categories to total loans:
Commercial, financial, and agricultural		18.2	%		18.0	%
Real estate construction - residential		2.7			2.5
Real estate construction - commercial		8.6			9.2
Real estate mortgage - residential		22.1			23.1
Real estate mortgage - commercial		45.4			44.2
Installment loans to individuals		3.0			3.0
Total		100.0	%		100.0	%

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

The Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers, but are not funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. During the three and nine months ended September 30, 2018, the Company sold approximately $10.3 million and $30.0 million of loans to investors, respectively, compared to $10.1 million and $26.3 million for the three and nine months ended September 30, 2017, respectively. At September 30, 2018, the Company was servicing approximately $282.9 million of loans sold to the secondary market compared to $285.8 million at December 31, 2017, and $288.7 million at September 30, 2017.

Risk Elements of the Loan Portfolio

Management, the senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2.0 million in aggregate and all adversely classified credits identified by management are reviewed. In addition, all other loans are reviewed on a sample basis. The senior loan committee reviews and reports to the board of directors, on a monthly basis, 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 310-10-35 in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered necessary by management to provide for probable losses inherent in the loan portfolio.

Non-performing Assets

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

	September 30,			December 31,			September 30,
(In thousands)	2018			2017			2017
Nonaccrual loans:
Commercial, financial, and agricultural	$	2,296		$	2,507		$	3,005
Real estate construction - residential		0			0			0
Real estate construction - commercial		158			97			0
Real estate mortgage - residential		2,768			1,956			2,094
Real estate mortgage - commercial		597			936			943
Installment and other consumer		226			176			168
Total nonaccrual loans including non-performing troubled debt restructurings	$	6,045		$	5,672		$	6,210
Other real estate owned and repossessed assets		13,373			13,182			13,177
Total non-performing assets	$	19,418		$	18,854		$	19,387
Loans contractually past due 90 days or more and still accruing	$	235		$	328		$	178

Loans	$	1,115,765		$	1,068,432		$	1,045,047
Allowance for loan losses to loans		1.02	%		1.02	%		1.02	%
Non-performing loans to loans		0.54	%		0.53	%		0.59	%
Loans past due 90 days or more and still accruing to loans		0.02	%		0.03	%		0.02	%
Non-performing assets to loans and other real estate owned and repossessed assets		1.72	%		1.74	%		1.77	%
Non-performing assets to total assets		1.34	%		1.32	%		1.40	%
Allowance for loan losses to non-performing loans		187.89	%		191.33	%		177.13	%

Non-performing assets consist of nonaccrual loans, TDRs on nonaccrual, and other real estate owned and repossessed assets. Total non-performing assets totaled $19.4 million, or 1.72%, of total loans and other real estate and repossessed assets at September 30, 2018 compared to $18.9 million, or 1.74%, of total loans at December 31, 2017. Non-accrual loans included $2.2 million and $1.7 million of loans classified as TDRs at September 30, 2018 and December 31, 2017, respectively.

Total non-accrual loans at September 30, 2018 increased $373,000, or 7.0%, to $6.0 million compared to $5.7 million at December 31, 2017. This increase primarily consisted of an increase in real estate mortgage - residential loans, partially offset by a decrease in real estate mortgage – commercial loans and commercial, financial, and agricultural loans.

Loans past due 90 days and still accruing interest at September 30, 2018, were $235,000 compared to $328,000 at December 31, 2017. Other real estate and repossessed assets were $13.4 million at September 30, 2018 compared to $13.2 million at December 31, 2017. During the nine months ended September 30, 2018, $589,000 of nonaccrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to $217,000 during the nine months ended September 30, 2017.

As of September 30, 2018 and December 31, 2017, approximately $5.6 million and $8.8 million, respectively, of loans classified as substandard, not included in the non-performing asset table, were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. Substandard loans included $3.2 million and $4.7 million of loans classified as performing TDRs at September 30, 2018 and December 31, 2017, respectively, and is further described in the table below. Management believes the general allowance was sufficient to cover the risks and probable losses related to such loans at September 30, 2018 and December 31, 2017, respectively.

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

	September 30, 2018						December 31, 2017
(In thousands)	Number of Contracts		Recorded Investment		Specific Reserves		Number of Contracts		Recorded Investment		Specific Reserves
Performing TDRs
Commercial, financial and agricultural		5	$	434	$	17		6	$	500	$	20
Real estate mortgage - residential		9		2,377		83		11		3,116		236
Real estate mortgage - commercial		3		431		72		2		1,068		109
Intallment - Consumer		2		18		1		-		-		-
Total performing TDRs		19	$	3,260	$	173		19	$	4,684	$	365
Nonperforming TDRs
Commercial, financial and agricultural		6	$	1,112	$	108		4	$	838	$	41
Real estate mortgage - residential		6		886		209		4		290		61
Real estate mortgage - commercial		1		112		68		4		589		110
Intallment - Consumer		3		75		11		-		-		-
Total nonperforming TDRs		16	$	2,185	$	396		12	$	1,717	$	212
Total TDRs		35	$	5,445	$	569		31	$	6,401	$	577

At September 30, 2018, loans classified as TDRs totaled $5.4 million, with $569,000 of specific reserves, of which $2.2 million were classified as nonperforming TDRs and $3.2 million were classified as performing TDRs. This compared to $6.4 million of loans classified as TDRs, with $577,000 of specific reserves, of which $1.7 million were classified as nonperforming TDRs and $4.7 million were classified as performing TDRs at December 31, 2017. Both performing and nonperforming TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. The net decrease in total TDRs from December 31, 2017 to September 30, 2018 was primarily due to one TDR totaling $48,000 that went to foreclosure and $1.6 million of payments received on TDRs, partially offset by nine new TDRs totaling $520,000.

Allowance for Loan Losses and Provision

Allowance for Loan Losses

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

	September 30,		December 31,
(In thousands)	2018		2017
Allocation of allowance for loan losses at end of period:
Commercial, financial, and agricultural	$	3,486	$	3,325
Real estate construction - residential		240		170
Real estate construction - commercial		746		807
Real estate mortgage - residential		2,341		1,689
Real estate mortgage - commercial		4,071		4,437
Installment and other consumer		398		345
Unallocated		76		79
Total	$	11,358	$	10,852

The allowance for loan losses (ALL) was $11.4 million, or 1.02%, of loans outstanding at September 30, 2018 compared to $10.9 million, or 1.02%, at December 31, 2017, and $11.0 million, or 1.05%, of loans outstanding at September 30, 2017. The ratio of the allowance for loan losses to nonperforming loans was 187.89% at September 30, 2018, compared to 191.33% at December 31, 2017, and 177.13% at September 30, 2017.

The following table is a summary of the general and specific allocations of the allowance for loan losses:

	September 30,		December 31,
(In thousands)	2018		2017
Allocation of allowance for loan losses:
Individually evaluated for impairment - specific reserves	$	1,225	$	1,333
Collectively evaluated for impairment - general reserves		10,133		9,519
Total	$	11,358	$	10,852

The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2018, $1.2 million of the Company’s ALL was allocated to impaired loans totaling approximately $9.3 million compared to $1.3 million of the Company’s ALL allocated to impaired loans totaling approximately $10.4 million at December 31, 2017. Management determined that $3.0 million, or 32%, of total impaired loans required no reserve allocation at September 30, 2018 compared to $2.4 million, or 23%, at December 31, 2017, primarily due to adequate collateral values , acceptable payment history and adequate cash flow ability.

The incurred loss component of the general reserve, or loans collectively evaluated for impairment, is determined by applying loss rates to pools of loans by asset type. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type. Beginning in the first quarter of 2016, the Company began to lengthen its look-back period with the intent to increase such period from three to five years by December 31, 2017. The Company believes that the five-year look-back period, which is consistent with the Company’s practices prior to the start of the economic recession in 2008, provides a representative historical loss period in the current economic environment. These historical loss rates for each risk group are used as the starting point to determine loss rates for measurement purposes. The historical loan loss rates are multiplied by loss emergence periods (LEP) which represent the estimated time period between a borrower first experiencing financial difficulty and the recognition of a loss.

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

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

Provision

A $250,000 and $1.0 million provision was required for the three and nine months ended September 30, 2018, respectively, compared to a $555,000 and $1.2 million provision for the three and nine months ended September 30, 2017. The decrease in both periods reported was primarily due to improved credit quality and economic conditions used in assessing the risk in the portfolio.

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

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands)	2018		2017		2018		2017
Analysis of allowance for loan losses:
Balance beginning of period	$	11,212	$	10,545	$	10,852	$	9,886
Charge-offs:
Commercial, financial, and agricultural		75		37		378		97
Real estate construction - residential		-		-		48		-
Real estate construction - commercial		-		-		30		-
Real estate mortgage - residential		32		68		64		149
Real estate mortgage - commercial		5		4		34		20
Installment and other consumer		74		56		181		167
Total charge-offs		186		165		735		433
Recoveries:
Commercial, financial, and agricultural	$	38	$	12	$	61	$	55
Real estate construction - residential		13		12		38		87
Real estate mortgage - residential		9		11		44		68
Real estate mortgage - commercial		2		5		34		26
Installment and other consumer		20		25		64		76
Total recoveries		82		65		241		312
Net charge-offs		104		100		494		121
Provision for loan losses		250		555		1,000		1,235
Balance end of period	$	11,358	$	11,000	$	11,358	$	11,000

Net Loan Charge-offs

The Company’s net loan charge-offs were $104,000, or 0.01%, of average loans, and $494,000, or 0.05%, of average loans for the three and nine months ended September 30, 2018, respectively, compared to $100,000, or 0.01%, of average loans, and $121,000, or 0.01%, of average loans for the three and nine months ended September 30, 2017, respectively. The increase in charge-offs for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 primarily related to two commercial loan relationships.

Liquidity and Capital Resources

Liquidity Management

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

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

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

	September 30,		December 31,
(In thousands)	2018		2017
Federal funds sold and other overnight interest-bearing deposits	$	20,478	$	39,553
Certificates of deposit in other banks		12,243		3,460
Available-for-sale investment securities		224,562		231,028
Total	$	257,283	$	274,041

Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available-for-sale investment portfolio was $224.6 million at September 30, 2018 and included an unrealized net loss of $7.1 million. The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately $17.4 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company’s deposit base.

The Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law. At September 30, 2018 and December 31, 2017, the Company’s unpledged securities in the available for sale portfolio totaled approximately $35.9 million and $44.8 million, respectively.

Total investment securities pledged for these purposes were as follows:

	September 30,		December 31,
(In thousands)	2018		2017
Investment securities pledged for the purpose of securing:
Federal Reserve Bank borrowings	$	9,509	$	9,570
Federal funds purchased and securities sold under agreements to repurchase		45,073		40,931
Other deposits		129,670		131,197
Total pledged, at fair value	$	184,252	$	181,698

Liquidity is available from the Company’s base of core customer deposits, defined as demand, interest checking, savings, money market deposit accounts, and time deposits less than $250,000, less all brokered deposits under $250,000. At September 30, 2018, such deposits totaled $1.0 billion and represented 88.7% of the Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships. Time deposits and certificates of deposit of $250,000 and over totaled $110.1 million at September 30, 2018. These accounts are normally considered more volatile and higher costing representing 9.3% of total deposits at September 30, 2018.

Core deposits at September 30, 2018 and December 31, 2017 were as follows:

	September 30,		December 31,
(In thousands)	2018		2017
Core deposit base:
Non-interest bearing demand	$	257,376	$	245,380
Interest checking		197,863		229,862
Savings and money market		391,280		345,593
Other time deposits		202,529		230,309
Total	$	1,049,048	$	1,051,144

The total amount of certificates of deposit of $250,000 and greater at September 30, 2018 and December 31, 2017 were $110.1 million and $63.2 million, respectively. The Company had brokered deposits totaling $29.8 million and $9.8 million at September 30, 2018 and December 31, 2017, respectively. Under the Economic Growth, Regulatory Relief, and Consumer Protection Act signed into law in May 2018, certain reciprocal deposits are no longer required to be classified as brokered deposits. As such, prior periods presented have been reclassified to include these reciprocal deposits in the Company’s core deposits and excluded from brokered deposit totals.

Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. The Company’s outside borrowings are comprised of securities sold under agreements to repurchase, Federal Home Loan Bank advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of September 30, 2018, under agreements with these unaffiliated banks, the Bank may borrow up to $50.0 million in federal funds on an unsecured basis and $16.4 million on a secured basis. There were no federal funds purchased outstanding at September 30, 2018. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company’s investment portfolio. At September 30, 2018, there was $32.7 million in repurchase agreements. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at September 30, 2018.

The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB). As a member of the FHLB, the Bank has access to credit products of the FHLB. As of September 30, 2018, the Bank had $78.7 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.

Borrowings outstanding at September 30, 2018 and December 31, 2017 were as follows:

	September 30,		December 31,
(In thousands)	2018		2017
Borrowings:
Federal funds purchased and securities sold under agreements to repurchase	$	32,660	$	27,560
Federal Home Loan Bank advances		78,683		121,352
Subordinated notes		49,486		49,486
Other borrowings		30		30
Total	$	160,859	$	198,428

The Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from these entities. Based on the type and value of collateral pledged, the FHLB establishes a collateral value from which the Company may draw advances against this collateral. This collateral is also used to enable the FHLB to issue letters of credit in favor of public fund depositors of the Company. The Federal Reserve Bank also establishes a collateral value of assets pledged to support borrowings from the discount window. The following table reflects collateral value of assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to the Company as follows:

	September 30,										December 31,
	2018										2017
(In thousands)	FHLB			Federal Reserve Bank		Federal Funds Purchased Lines		Total			FHLB			Federal Reserve Bank		Federal Funds Purchased Lines		Total
Advance equivalent	$	286,706		$	9,267	$	57,137	$	353,110		$	294,081		$	9,364	$	47,825	$	351,270
Letters of credit		(57,750	)		0		0		(57,750	)		(70,000	)		0		0		(70,000	)
Advances outstanding		(78,683	)		0		0		(78,683	)		(121,352	)		0		0		(121,352	)
Total available	$	150,273		$	9,267	$	57,137	$	216,677		$	102,729		$	9,364	$	47,825	$	159,918

At September 30, 2018, loans of $498.2 million were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At September 30, 2018, investments totaling $18.8 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.

Sources and Uses of Funds

Cash and cash equivalents were $36.8 million at September 30, 2018 compared to $62.9 million at December 31, 2017. The $26.1 million decrease resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the nine months ended September 30, 2018. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $11.3 million for the nine months ended September 30, 2018.

Investing activities consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio used total cash of $55.2 million. The cash outflow primarily consisted of $48.7 million increase in loans and $103.0 million purchases of investment securities, partially offset by $104.6 million from maturities, calls, and sales of investment securities.

Financing activities provided cash of $17.9 million, resulting primarily from a $12.0 increase in demand deposits, a $24.7 million increase in interest bearing transaction accounts, a $20.2 million increase in time deposits, and a $5.1 million increase in federal funds purchased and securities sold under agreements to repurchase, partially offset by a net $42.7 million repayment of FHLB advances. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2018.

In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company's various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company's liquidity. The Company had $297.5 million in unused loan commitments and standby letters of credit as of September 30, 2018. Although the Company's current liquidity resources are adequate to fund this commitment level the nature of these commitments is such that the likelihood of such a funding demand is very low.

The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company’s ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its shareholders. The Company paid cash dividends to its shareholders totaling approximately $1.4 million and $1.1 million for the nine months ended September 30, 2018 and 2017, respectively. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $5.0 million and $2.6 million in dividends to the Company during the nine months ended September 30, 2018 and 2017, respectively. At September 30, 2018 and December 31, 2017, the Company had cash and cash equivalents totaling $2.1 million and $1.4 million, respectively.

Capital Management

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

In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for the Company began on January 1, 2015. The Federal Reserve System’s (FRB) capital adequacy guidelines require that bank holding companies maintain a Common Equity Tier 1 risk-based capital ratio equal to at least 4.5% of its risk-weighted assets, a Tier 1 risk-based capital ratio equal to at least 6% of its risk-weighted assets and a total risk-based capital ratio equal to at least 8% of its risk-weighted assets. In addition, bank holding companies generally are required to maintain a Tier 1 leverage ratio of at least 4%.

In addition, the final rules establish a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital conservation buffer requirement will be phased in over four years beginning in 2016. On January 1, 2016, the first phase of the requirement went into effect at 0.625% of risk-weighted assets, and the requirement will increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of risk weighted assets on January 1, 2019. Once fully phased in, the capital conservation buffer requirement effectively raises the minimum required risk-based capital ratios to 7% Common Equity Tier 1 Capital, 8.5% Tier 1 Capital and 10.5% Total Capital on a fully phased-in basis.

Under the Basel III requirements, at September 30, 2018 and December 31, 2017, the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table as of periods indicated:

											Well-Capitalized Under
						Required for Capital					Prompt Corrective Action
	Actual					Adequacy Purposes					Provision
(in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio
September 30, 2018
Total Capital (to risk-weighted assets):
Company	$	162,989		13.54	%	$	96,315		8.00	%	$	N.A.		N.A	%
Bank		159,984		13.32			96,021		8.00			120,027		10.00
Tier I Capital (to risk-weighted assets):
Company	$	136,124		11.31	%	$	72,237		6.00	%	$	N.A.		N.A	%
Bank		148,403		12.36			72,016		6.00			96,021		8.00
Common Equity Tier I Capital (to risk-weighted assets)
Company	$	103,498		8.60	%	$	54,177		4.50	%	$	N.A.		N.A	%
Bank		148,403		12.36			54,012		4.50			78,017		6.50
Tier I Capital (to adjusted average assets):
Company	$	136,124		9.35	%	$	58,264		4.00	%	$	N.A.		N.A	%
Bank		148,403		10.30			57,648		4.00			72,060		5.00
(in thousands)
December 31, 2017
Total Capital (to risk-weighted assets):
Company	$	156,045		12.93	%	$	96,577		8.00	%	$	N.A.		N.A	%
Bank		154,495		12.83			96,326		8.00			120,408		10.00
Tier I Capital (to risk-weighted assets):
Company	$	129,369		10.72	%	$	72,433		6.00	%	$	N.A.		N.A	%
Bank		143,483		11.92			72,245		6.00			96,326		8.00
Common Equity Tier I Capital (to risk-weighted assets)
Company	$	97,033		8.04	%	$	54,325		4.50	%	$	N.A.		N.A	%
Bank		143,483		11.92			54,184		4.50			78,265		6.50
Tier I leverage ratio:
Company	$	129,369		9.33	%	$	55,488		4.00	%	$	N.A.		N.A	%
Bank		143,483		10.38			55,315		4.00			69,144		5.00

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Asset/Liability and Interest Rate Risk

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

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

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

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

The table below illustrates the impact of an immediate and sustained 200 and 100 basis point increase and a 100 basis point decrease in interest rates on net interest income based on the interest rate risk model at September 30, 2018 and December 31, 2017.

	% change in projected net interest income
Hypothetical shift in interest rates (bps)	September 30, 2018			December 31, 2017
200		2.21	%		(3.14	)%
100		3.22	%		(2.05	)%
(100)		5.96	%		1.58	%

The improvement in our interest rate risk exposure from December 31, 2017 to September 30, 2018 was primarily due to higher offering rates for repricing loans at September 30, 2018 and a decrease in short-term maturity borrowings from December 31, 2017.

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

Effects of Inflation

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

Inflation does have an impact on the growth of total assets in the banking industry, often resulting in a need to increase capital at higher than normal rates to maintain an appropriate capital to asset ratio. In the opinion of management, inflation did not have a significant effect on the Company's operations for the nine months ended September 30, 2018.

Item 4. Controls and Procedures

Our Company's management has evaluated, with the participation of our principal executive and principal financial officers, the effectiveness of our disclosure controls and procedures as defined in Rules 13a – 15(e) or 15d – 15(e) of the Securities Exchange Act of 1934 as of September 30, 2018. Based upon and as of the date of that evaluation, our principal executive and principal financial officers concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required. It should be noted that any system of disclosure controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any system of disclosure controls and procedures is based in part upon assumptions about the likelihood of future events. Because of these and other inherent limitations of any such system, there can be no assurance that any design will always succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

There has been no change in our Company's internal control over financial reporting that occurred during the three months ended September 30, 2018 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Impact of New Accounting Standards

Intangibles In August 2018, the FASB issued ASU 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Topic 350-40) Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. This ASU aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). ASU 2018-15 is effective for annual reporting periods beginning after December 15, 2019 and is not expected to have a significant impact on the Company’s consolidated financial statements.

Fair Value Measurement In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820) - Changes to the Disclosure Requirements for Fair Value Measurement. ASU 2018-13 removes the requirement to disclose the amount of and reasons for transfers between Level 1 and Level 2 fair value measurement methodologies, the policy for timing of transfers between levels and the valuation processes for Level 3 fair value measurements. It also adds a requirement to disclose changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period and the range and weighted average of significant unobservable inputs used to develop Level 3 measurements. For certain unobservable inputs, entities may disclose other quantitative information in lieu of the weighted average if the other quantitative information would be a more reasonable and rational method to reflect the distribution of unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company is currently evaluating the impact of the adoption on the Company’s consolidated financial statements and disclosures.

Derivatives and Hedging The FASB issued guidance within ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities (Topic 815) in August 2017. The amendments in ASU 2017-12 to Topic 815, Derivatives and Hedging, are intended to more closely align hedge accounting with companies' risk management strategies, simplify the application of hedge accounting, and increase transparency as to the scope and results of hedging programs. The guidance also amends the presentation and disclosure requirements and changes how companies assess effectiveness. Under the new guidance, public companies will have until the end of the first quarter in which a hedge is designated to perform an initial assessment of a hedge's effectiveness. After initial qualification, the new guidance permits a qualitative effectiveness assessment for certain hedges instead of a quantitative test if the company can reasonably support an expectation of high effectiveness throughout the term of the hedge. Additional disclosures include cumulative basis adjustments for fair value hedges and the effect of hedging on individual income statement line items. The amendments in this Update are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted in any interim period after issuance of the Update. The ASU is not expected to have a significant effect on the Company’s Consolidated Financial Statements.

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

Leases In February 2016, the FASB issued ASU 2016-02, Leases , in order to increase transparency and comparability by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The ASU primarily affects lessee accounting, which requires the lessee to recognize a right-of-use asset and a liability to make lease payments for those leases classified as operating leases under previous GAAP. For leases with a term of 12 months or less, an election by class of underlying asset not to recognize lease assets and lease liabilities is permitted. The ASU also provides additional guidance as to the definition of a lease, identification of lease components, and sale and leaseback transactions. The amendments in the ASU are effective for interim and annual periods beginning January 1, 2019. The Company’s operating leases primarily relate to office space and bank branches. The Company expects to adopt this ASU in the first quarter of 2019. Based on the Company’s current leases, the Company expects to recognize a lease liability and related right-of-use asset on the consolidated balance sheet, and is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated income statement and required disclosures.

PART II - OTHER INFORMATION

Item 1.	Legal Proceedings

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

Item 1A.	Risk Factors	None

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	None

Item 3.	Defaults Upon Senior Securities	None

Item 4.	Mine Safety Disclosures	None

Item 5.	Other Information	None

Item 6.	Exhibits

Exhibit No.		Description
3.1		Restated Articles of Incorporation of the Company (filed as Exhibit 3.1 to the Company's current report on Form 8-K on August 9, 2007 and incorporated herein by reference).
3.2		Amended and Restated Bylaws of the Company (filed as Exhibit 3.1 to the Company's current report on Form 8-K on June 8, 2009 and incorporated herein by reference).
4.1		Specimen certificate representing shares of the Company's $1.00 par value Common Stock (filed as Exhibit 4.1 to the Company's current report on Form 8-K/A on June 23, 2017 and incorporated herein by reference).
31.1		Certificate of the Chief Executive Officer of the Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certificate of the Chief Financial Officer of the Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certificate of the Chief Executive Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certificate of the Chief Financial Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101		Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Changes in Equity, (iv) the Consolidated Statements of Cash Flows and (v) the Notes to Consolidated Financial Statements, tagged as blocks of text and in detail (XBRL).

SIGNATURES

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

	HAWTHORN BANCSHARES, INC.

Date

	/s/ David T. Turner

November 8, 2018	David T. Turner, Chairman of the Board and
	Chief Executive Officer (Principal Executive Officer)

	/s/ W. Bruce Phelps

November 8, 2018	W. Bruce Phelps, Chief Financial Officer (Principal Financial
	Officer and Principal Accounting Officer)

HAWTHORN BANCSHARES, INC.

INDEX TO EXHIBITS

September 30, 2018 Form 10-Q

Exhibit No.		Description
3.1		Restated Articles of Incorporation of our Company (filed as Exhibit 3.1 to the Company's current report on Form 8-K on August 9, 2007 and incorporated herein by reference).
3.2		Amended and Restated Bylaws of the Company (filed as Exhibit 3.1 to the Company's current report on Form 8-K on June 8, 2009 and incorporated herein by reference).
4.1		Specimen certificate representing shares of the Company’s $1.00 par value Common Stock (filed as Exhibit 4.1 to the Company’s current report on Form 8-K/A on June 23, 2017 and incorporated herein by reference).
31.1		Certificate of the Chief Executive Officer of the Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certificate of the Chief Financial Officer of the Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certificate of the Chief Executive Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *
32.2		Certificate of the Chief Financial Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *
101		Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Changes in Equity, (iv) the Consolidated Statements of Cash Flows and (v) the Notes to Consolidated Financial Statements, tagged as blocks of text and in detail (XBRL).

* This information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933, as amended, and Section 18 of the Securities Exchange Act of 1934, as amended.

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HWBK Hawthorn Bancshares Inc