Quarterly Report (10-q)

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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 June 30, 2021

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

For the transition period from ______________ to ______________

Commission file number: 0-23636

HAWTHORN BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

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

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

(Address of principal executive offices) (Zip Code)

(573) 761-6100

(Registrant’s telephone number, including area code)

N/A

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

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



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

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

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

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


Large accelerated filer ☐	Accelerated filer ☐	Non-accelerated filer☒

Smaller reporting company ☒	Emerging growth company ☐

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

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

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

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets


	June 30,		December 31,
(In thousands, except per share data)	2021		2020
	(Unaudited)
ASSETS
Cash and due from banks	$	17,920	$	19,235
Federal funds sold and other interest-bearing deposits		58,514		161,128
Cash and cash equivalents		76,434		180,363
Certificates of deposit in other banks		7,165		9,376
Available-for-sale debt securities, at fair value		276,013		198,030
Other investments		6,009		6,353
Total investment securities		282,022		204,383
Loans held for investment		1,293,894		1,286,967
Allowance for loan losses		(18,735)		(18,113)
Net loans		1,275,159		1,268,854
Loans held for sale, at lower of cost or fair value		2,487		5,099
Premises and equipment - net		33,562		34,561
Mortgage servicing rights, at fair value		2,775		2,445
Other real estate owned - net		11,938		12,291
Accrued interest receivable		6,849		6,640
Cash surrender value - life insurance		2,480		2,451
Other assets		8,095		7,268
Total assets	$	1,708,966	$	1,733,731
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Non-interest bearing demand	$	433,288	$	382,492
Savings, interest checking and money market		704,236		723,808
Time deposits $250,000 and over		66,574		91,263
Other time deposits		176,903		186,043
Total deposits		1,381,001		1,383,606
Federal funds purchased and securities sold under agreements to repurchase		32,018		45,154
Federal Home Loan Bank advances and other borrowings		93,554		106,674
Subordinated notes		49,486		49,486
Operating lease liabilities		1,983		2,137
Accrued interest payable		376		837
Other liabilities		14,045		15,248
Total liabilities		1,572,463		1,603,142
Stockholders’ equity:
Common stock, $1 par value, authorized 15,000,000 shares; issued 6,769,322		6,769		6,769
Surplus		64,692		59,307
Retained earnings		72,499		68,935
Accumulated other comprehensive income, net of tax		641		1,528
Treasury stock; 406,846, and 289,214 shares, at cost, respectively		(8,098)		(5,950)
Total stockholders’ equity		136,503		130,589
Total liabilities and stockholders’ equity	$	1,708,966	$	1,733,731

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income (unaudited)


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands, except per share amounts)	2021		2020		2021		2020
INTEREST INCOME
Interest and fees on loans	$	13,885	$	14,536	$	28,864	$	28,958
Interest and fees on loans held for sale		29		50		54		55
Interest on investment securities:
Taxable		711		773		1,378		1,586
Nontaxable		375		173		621		315
Federal funds sold, other interest-bearing deposits, and certificates of deposit in other banks		88		117		190		442
Dividends on other investments		81		72		165		173
Total interest income		15,169		15,721		31,272		31,529
INTEREST EXPENSE
Interest on deposits:
Savings, interest checking and money market		276		290		584		1,237
Time deposit accounts $250,000 and over		146		349		356		762
Time deposits		358		691		820		1,443
Total interest expense on deposits		780		1,330		1,760		3,442
Interest on federal funds purchased and securities sold under agreements to repurchase		26		59		52		96
Interest on Federal Home Loan Bank advances		385		612		781		1,244
Interest on subordinated notes		307		381		617		882
Total interest expense on borrowings		718		1,052		1,450		2,222
Total interest expense		1,498		2,382		3,210		5,664
Net interest income		13,671		13,339		28,062		25,865
Provision for loan losses		400		900		400		4,200
Net interest income after provision for loan losses		13,271		12,439		27,662		21,665
NON-INTEREST INCOME
Service charges and other fees		765		566		1,503		1,364
Bank card income and fees		1,022		812		1,882		1,505
Trust department income		308		279		602		658
Real estate servicing fees, net		351		(16)		424		(103)
Gain on sale of mortgage loans, net		2,042		924		4,511		1,344
Other		101		291		109		379
Total non-interest income		4,589		2,856		9,031		5,147
Investment securities gains, net		—		7		15		6
NON-INTEREST EXPENSE
Salaries and employee benefits		6,955		6,511		14,100		12,633
Occupancy expense, net		719		757		1,490		1,522
Furniture and equipment expense		753		763		1,497		1,514
Processing, network, and bank card expense		1,225		954		2,233		1,929
Legal, examination, and professional fees		385		407		789		774
Advertising and promotion		309		222		552		470
Postage, printing, and supplies		186		193		390		434
Loan expense		229		303		403		427
Other		1,008		1,160		1,966		2,058
Total non-interest expense		11,769		11,270		23,420		21,761
Income before income taxes		6,091		4,032		13,288		5,057
Income tax expense		1,199		750		2,557		907
Net income	$	4,892		3,282	$	10,731	$	4,150
Basic earnings per share	$	0.74	$	0.49	$	1.62	$	0.61
Diluted earnings per share	$	0.74	$	0.49	$	1.62	$	0.61

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (unaudited)


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands)	2021		2020		2021		2020
Net income	$	4,892	$	3,282	$	10,731	$	4,150
Other comprehensive income, net of tax
Investment securities available-for-sale:
Unrealized gains (losses) on investment securities available-for-sale, net of tax		1,748		891		(1,030)		3,072
Adjustment for gains on sale of investment securities, net of tax		—		(4)		(2)		(5)
Defined benefit pension plans:
Amortization of prior service cost included in net periodic pension cost, net of tax		110		31		145		84
Total other comprehensive income (loss)		1,858		918		(887)		3,151
Total comprehensive income	$	6,750	$	4,200	$	9,844	$	7,301

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity (unaudited)



	The three months ended June 30, 2021 and 2020
							Accumulated				Total
							Other				Stock -
	Common				Retained		Comprehensive		Treasury		holders'
(In thousands)	Stock		Surplus		Earnings		Income (Loss)		Stock		Equity
Balance, March 31, 2021	$	6,769	$	59,307	$	73,947	$	(1,217)	$	(8,098)	$	130,708
Net income		—		—		4,892		—		—		4,892
Other comprehensive income		—		—		—		1,858		—		1,858
Stock dividend		—		5,385		(5,385)		—		—		—
Cash dividends declared, common stock ($0.15 per share)		—		—		(955)		—		—		(955)
Balance, June 30, 2021	$	6,769	$	64,692	$	72,499	$	641	$	(8,098)	$	136,503

Balance, March 31, 2020	$	6,520	$	55,727	$	61,708	$	(1,522)	$	(5,763)	$	116,670
Net income		—		—		3,282		—		—		3,282
Other comprehensive income		—		—		—		918		—		918
Purchase of treasury stock		—		—		—		—		(90)		(90)
Stock dividend		—		3,829		(3,829)		—		—		—
Cash dividends declared, common stock ($0.12 per share)		—		—		(749)		—		—		(749)
Balance, June 30, 2020	$	6,520	$	59,556	$	60,412	$	(604)	$	(5,853)	$	120,031

	The six months ended June 30, 2021 and 2020
							Accumulated				Total
							Other				Stock -
	Common				Retained		Comprehensive		Treasury		holders'
(In thousands)	Stock		Surplus		Earnings		Income (Loss)		Stock		Equity

Balance, December 31, 2020	$	6,769	$	59,307	$	68,935	$	1,528	$	(5,950)	$	130,589
Net income		—		—		10,731		—		—		10,731
Other comprehensive loss		—		—		—		(887)		—		(887)
Purchase of treasury stock		—		—		—		—		(2,148)		(2,148)
Stock dividend		—		5,385		(5,385)		—		—		—
Cash dividends declared, common stock ($0.28 per share)		—		—		(1,782)		—		—		(1,782)
Balance, June 30, 2021	$	6,769	$	64,692	$	72,499	$	641	$	(8,098)	$	136,503

Balance, December 31, 2019	$	6,520	$	55,727	$	61,590	$	(3,755)	$	(5,044)	$	115,038
Net income		—		—		4,150		—		—		4,150
Other comprehensive income		—		—		—		3,151		—		3,151
Purchase of treasury stock		—		—		—		—		(809)		(809)
Stock dividend		—		3,829		(3,829)		—		—		—
Cash dividends declared, common stock ($0.24 per share)		—		—		(1,499)		—		—		(1,499)
Balance, June 30, 2020	$	6,520	$	59,556	$	60,412	$	(604)	$	(5,853)	$	120,031

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

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)


	Six Months Ended June 30,
(In thousands)	2021		2020
Cash flows from operating activities:
Net income	$	10,731	$	4,150
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		400		4,200
Depreciation expense		1,155		1,121
Net amortization of investment securities, premiums, and discounts		878		703
Change in fair value of mortgage servicing rights		(38)		525
Investment securities gains, net		(15)		(6)
Losses (gains) on sales and dispositions of premises and equipment		4		(67)
Gain on sales and dispositions of other real estate		(25)		(211)
Provision for other real estate owned		84		12
Decrease in accrued interest receivable		(209)		(1,119)
Increase in cash surrender value - life insurance		(29)		(27)
Decrease (increase) in other assets		387		(14)
Decrease in operating lease liabilities		(154)		(125)
Decrease in accrued interest payable		(461)		(235)
(Decrease) increase in other liabilities		(2,034)		597
Origination of mortgage loans held for sale		(121,386)		(54,987)
Proceeds from the sale of mortgage loans held for sale		128,509		47,718
Gain on sale of mortgage loans, net		(4,511)		(1,344)
Other, net		(292)		(188)
Net cash provided by operating activities		12,994		703
Cash flows from investing activities:
Purchase of certificates of deposit in other banks		(245)		(735)
Proceeds from maturities of certificates of deposit in other banks		2,467		1,235
Net increase in loans		(6,735)		(111,873)
Purchase of available-for-sale debt securities		(114,520)		(54,811)
Proceeds from maturities of available-for-sale debt securities		20,491		26,375
Proceeds from calls of available-for-sale debt securities		13,852		13,185
Proceeds from sales of available-for-sale debt securities		—		1,490
Purchases of FHLB stock		(327)		(1,891)
Proceeds from sales of FHLB stock		684		724
Purchases of premises and equipment		(247)		(799)
Proceeds from sales of premises and equipment		12		135
Proceeds from sales of other real estate and repossessed assets		324		194
Net cash used in investing activities		(84,244)		(126,771)
Cash flows from financing activities:
Net increase in demand deposits		50,796		106,661
Net (decrease) increase in interest-bearing transaction accounts		(19,573)		38,098
Net decrease in time deposits		(33,828)		(3,647)
Net (decrease) increase in federal funds purchased and securities sold under agreements to repurchase		(13,136)		14,925
Repayment of FHLB advances and other borrowings		(13,120)		(40,117)
FHLB advances		—		69,000
Purchase of treasury stock		(2,148)		(809)
Cash dividends paid - common stock		(1,670)		(1,503)
Net cash (used in) provided by financing activities		(32,679)		182,608
Net (decrease) increase in cash and cash equivalents		(103,929)		56,540
Cash and cash equivalents, beginning of period		180,363		78,121
Cash and cash equivalents, end of period	$	76,434	$	134,661
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	3,671	$	5,899
Income taxes	$	4,485	$	—
Noncash investing and financing activities:
Other real estate and repossessed assets acquired in settlement of loans	$	30	$	—

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, St. Louis, and the greater Kansas City metropolitan area. The Company is subject to competition from other financial and nonfinancial institutions providing financial products. Additionally, the Company and its subsidiaries are subject to the regulations of certain regulatory agencies and undergo periodic examinations by those regulatory agencies.

The accompanying unaudited consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and disclosures required by U.S. GAAP for complete financial statements and should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020.

The preparation of the consolidated financial statements includes all adjustments that, in the opinion of management, are necessary in order to make those statements not misleading. Management is required to make estimates and assumptions, including the determination of the allowance for loan losses, real estate acquired in connection with foreclosure or in satisfaction of loans, and fair values of investment securities available-for-sale that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions are subject to many risks and uncertainties, including changes in interest rates and other general economic, business and political conditions, including the effects of the novel coronavirus (COVID-19) pandemic or any resurgence thereof, including its potential effects on the economic environment, our customers and our operations, as well as any changes to federal, state and local government laws, regulations and orders in connection with the pandemic. Actual results could differ from those estimates. The Company’s management has evaluated and did not identify any subsequent events or transactions requiring recognition or disclosure in the consolidated financial statements.

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

Operating, Accounting and Reporting Considerations related to COVID-19

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(2) Loans and Allowance for Loan Losses

Loans

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


	June 30,		December 31,
(in thousands)	2021		2020
Commercial, financial, and agricultural (a)	$	263,511	$	272,918
Real estate construction − residential		35,760		29,692
Real estate construction − commercial		74,788		78,144
Real estate mortgage − residential		267,264		262,339
Real estate mortgage − commercial		628,075		617,133
Installment and other consumer		24,496		26,741
Total loans held for investment	$	1,293,894	$	1,286,967

(a)	Includes $49.6 million and $63.3 million of SBA PPP loans, net as of June 30, 2021 and December 31, 2020, respectively.

The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the Missouri communities surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, St. Louis, and the greater Kansas City metropolitan area. As such, the Bank is susceptible to changes in the economic environment in these communities. The Bank does not have a concentration of credit in any one economic sector. Installment and other consumer loans consist primarily of the financing of automotive vehicles. At June 30, 2021, loans of $537.1 million were pledged to the Federal Home Loan Bank (FHLB) as collateral for borrowings and letters of credit.

Allowance for Loan Losses

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


	Three Months Ended June 30, 2021
	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, &		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
Balance at beginning of period	$	4,676	$	309	$	532	$	2,594	$	9,904	$	245	$	101	$	18,361
Additions:
Provision for loan losses		655		(58)		(37)		(130)		14		38		(82)		400
Deductions:
Loans charged off		28		—		—		4		3		46		—		81
Less recoveries on loans		(33)		—		—		(7)		—		(15)		—		(55)
Net loan charge-offs (recoveries)		(5)		—		—		(3)		3		31		—		26
Balance at end of period	$	5,336	$	251	$	495	$	2,467	$	9,915	$	252	$	19	$	18,735


	Three Months Ended June 30, 2020
	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, &		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
Balance at beginning of period	$	3,623	$	117	$	622	$	2,363	$	8,614	$	351	$	3	$	15,693
Additions:
Provision for loan losses		(32)		22		100		354		435		(26)		47		900
Deductions:
Loans charged off		43		—		—		33		2		39		—		117
Less recoveries on loans		(66)		(32)		—		(27)		(1)		(20)		—		(146)
Net loan charge-offs (recoveries)		(23)		(32)		—		6		1		19		—		(29)

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Balance at end of period

3,614

171

722

2,711

9,048

306

16,622


	Six Months Ended June 30, 2021
	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, &		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
Balance at beginning of period	$	5,121	$	213	$	475	$	2,679	$	9,354	$	264	$	7	$	18,113
Additions:
Provision for loan losses		87		25		20		(384)		587		53		12		400
Deductions:
Loans charged off		55		—		—		3		26		104		—		188
Less recoveries on loans		(183)		(13)		—		(175)		—		(39)		—		(410)
Net loan charge-offs (recoveries)		(128)		(13)		—		(172)		26		65		—		(222)
Balance at end of period	$	5,336	$	251	$	495	$	2,467	$	9,915	$	252	$	19	$	18,735


	Six Months Ended June 30, 2020
	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, &		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
Balance at beginning of period	$	2,918	$	64	$	369	$	2,118	$	6,547	$	381	$	80	$	12,477
Additions:
Provision for loan losses		689		75		353		609		2,522		(18)		(30)		4,200
Deductions:
Loans charged off		84		—		—		52		24		91		—		251
Less recoveries on loans		(91)		(32)		—		(36)		(3)		(34)		—		(196)
Net loan charge-offs (recoveries)		(7)		(32)		—		16		21		57		—		55
Balance at end of period	$	3,614	$	171	$	722	$	2,711	$	9,048	$	306	$	50	$	16,622

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

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

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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

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

Additionally, the funding of $88.4 million and $47.5 million in SBA PPP loans during 2020 and 2021, respectively, required management to assess the methodology that would be adopted in regard to the allowance for loan losses applicable to these loans. As the SBA PPP loans are expected to be mostly paid off in the next six to twelve months and carry a 100% credit guarantee from the SBA, management determined that no allowance for loan losses was deemed necessary for these loans. At June 30, 2021, the net balance of the PPP loans totaled $49.6 million.

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

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)


	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
June 30, 2021
Allowance for loan losses:
Individually evaluated for impairment	$	2,325	$	—	$	16	$	242	$	2,764	$	8	$	—	$	5,355
Collectively evaluated for impairment		3,011		251		479		2,225		7,151		244		19		13,380
Total	$	5,336	$	251	$	495	$	2,467	$	9,915	$	252	$	19	$	18,735
Loans outstanding:
Individually evaluated for impairment	$	7,362	$	—	$	112	$	2,909	$	25,647	$	61	$	—	$	36,091
Collectively evaluated for impairment		256,149		35,760		74,676		264,355		602,428		24,435		—		1,257,803
Total	$	263,511	$	35,760	$	74,788	$	267,264	$	628,075	$	24,496	$	—	$	1,293,894

December 31, 2020
Allowance for loan losses:
Individually evaluated for impairment	$	2,187	$	27	$	28	$	263	$	2,594	$	14	$	—	$	5,113
Collectively evaluated for impairment		2,934		186		447		2,416		6,760		250		7		13,000
Total	$	5,121	$	213	$	475	$	2,679	$	9,354	$	264	$	7	$	18,113
Loans outstanding:
Individually evaluated for impairment	$	7,552	$	192	$	200	$	3,626	$	25,657	$	108	$	—	$	37,335
Collectively evaluated for impairment		265,366		29,500		77,944		258,713		591,476		26,633		—		1,249,632
Total	$	272,918	$	29,692	$	78,144	$	262,339	$	617,133	$	26,741	$	—	$	1,286,967

Impaired Loans

Loans evaluated under Accounting Standards Codification (ASC) 310-10-35 include loans which are individually evaluated for impairment. All other loans are collectively evaluated for impairment under ASC 450-20. Impaired loans individually evaluated for impairment totaled $36.1 million and $37.3 million at June 30, 2021 and December 31, 2020, respectively, and are comprised of loans on non-accrual status and loans which have been classified as troubled debt restructuring (TDRs).

The net carrying value of impaired loans is based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. At June 30, 2021, $31.8 million of impaired loans were evaluated based on the fair value less estimated selling costs of the loans' collateral compared to $32.2 million at December 31, 2020. Once the impairment amount is calculated, a specific reserve allocation is recorded. At June 30, 2021, $5.4 million of the Company’s allowance for loan losses was allocated to impaired loans totaling $36.1 million compared to $5.1 million of the Company’s allowance for loan losses allocated to impaired loans totaling approximately $37.3 million at December 31, 2020. Management determined that $12.4 million, or 34%, of total impaired loans required no reserve allocation at June 30, 2021 compared to $11.9 million, or 32%, at December 31, 2020, primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

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


	June 30,		December 31,
(in thousands)	2021		2020
Non-accrual loans	$	33,783	$	34,559
Performing TDRs		2,308		2,776
Total impaired loans	$	36,091	$	37,335

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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


			Unpaid
	Recorded		Principal		Specific
(in thousands)	Investment		Balance		Reserves
June 30, 2021
With no related allowance recorded:
Commercial, financial and agricultural	$	1,821	$	1,872	$	—
Real estate mortgage − residential		1,153		1,261		—
Real estate mortgage − commercial		9,465		9,483		—
Total	$	12,439	$	12,616	$	—
With an allowance recorded:
Commercial, financial and agricultural	$	5,541	$	5,618	$	2,325
Real estate construction − commercial		112		142		16
Real estate mortgage − residential		1,756		2,191		242
Real estate mortgage − commercial		16,182		16,252		2,764
Installment and other consumer		61		63		8
Total	$	23,652	$	24,266	$	5,355
Total impaired loans	$	36,091	$	36,882	$	5,355


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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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


	Three Months Ended June 30,								Six Months Ended June 30,
	2021				2020				2021				2020
			Interest				Interest				Interest				Interest
	Average		Recognized		Average		Recognized		Average		Recognized		Average		Recognized
	Recorded		For the		Recorded		For the		Recorded		For the		Recorded		For the
(in thousands)	Investment		Period Ended		Investment		Period Ended		Investment		Period Ended		Investment		Period Ended
With no related allowance recorded:
Commercial, financial and agricultural	$	1,826	$	5	$	3,059	$	—	$	1,834	$	13	$	1,370	$	—
Real estate construction − commercial		—		—		528		—		—		—		271		—
Real estate mortgage − residential		1,266		12		2,758		—		1,391		21		1,355		—
Real estate mortgage − commercial		9,459		—		1,448		7		9,458		—		1,178		13
Installment and other consumer		—		—		15		—		—		—		12		—
Total	$	12,551	$	17	$	7,808	$	7	$	12,683	$	34	$	4,186	$	13
With an allowance recorded:
Commercial, financial and agricultural	$	5,553	$	7	$	1,615	$	11	$	5,548	$	13	$	1,195	$	19
Real estate construction − residential		125		—		—		—		158		—		—		—
Real estate construction − commercial		165		—		766		—		182		—		142		—
Real estate mortgage − residential		1,692		4		3,724		8		1,779		11		2,990		28
Real estate mortgage − commercial		16,323		8		540		3		16,189		15		438		6
Installment and other consumer		58		—		147		1		71		3		135		7
Total	$	23,916	$	19	$	6,792	$	23	$	23,927	$	42	$	4,900	$	60
Total impaired loans	$	36,467	$	36	$	14,600	$	30	$	36,610	$	76	$	9,086	$	73

The recorded investment varies from the unpaid principal balance primarily due to partial charge-offs taken resulting from current appraisals received. The amount recognized as interest income on impaired loans continuing to accrue interest, primarily related to TDRs, was $36,000 and $76,000 for the three and six months ended June 30, 2021, respectively, compared to $30,000 and $73,000 for the three and six months ended June 30, 2020, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during the periods reported.

Delinquent and Non-Accrual Loans

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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

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


	Current or				90 Days
	Less Than				Past Due
	30 Days		30 - 89 Days		And Still
(in thousands)	Past Due		Past Due		Accruing		Non-Accrual		Total
June 30, 2021
Commercial, Financial, and Agricultural	$	256,916	$	31	$	—	$	6,564	$	263,511
Real estate construction − residential		35,760		—		—		—		35,760
Real estate construction − commercial		74,612		64		—		112		74,788
Real estate mortgage − residential		265,400		91		—		1,773		267,264
Real estate mortgage − commercial		602,558		204		—		25,313		628,075
Installment and Other Consumer		24,423		47		5		21		24,496
Total	$	1,259,669	$	437	$	5	$	33,783	$	1,293,894
December 31, 2020
Commercial, Financial, and Agricultural	$	265,821	$	380	$	—	$	6,717	$	272,918
Real estate construction − residential		29,500		—		—		192		29,692
Real estate construction − commercial		77,944		—		—		200		78,144
Real estate mortgage − residential		259,688		546		—		2,105		262,339
Real estate mortgage − commercial		591,815		4		—		25,314		617,133
Installment and Other Consumer		26,576		117		17		31		26,741
Total	$	1,251,344	$	1,047	$	17	$	34,559	$	1,286,967

The Company's past due and non-accrual loans at June 30, 2021 and December 31, 2020 do not include $19.2 million and $57.1 million of loans accepting forbearance under the CARES Act, respectively. Their delinquency status will not change through the forbearance period as they are fulfilling the agreement they have made with the Company. Of the total remaining $42.8 million loan modifications under the CARES Act, $23.5 million, are on non-accrual status at June 30, 2021.

Credit Quality

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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

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


	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, &		Construction -		Construction -		Mortgage -		Mortgage -		and other
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		Total
At June 30, 2021
Watch	$	12,544	$	535	$	4,750	$	14,556	$	63,487	$	—	$	95,872
Substandard		628		—		2,670		782		556		—		4,636
Performing TDRs		798		—		—		1,136		334		40		2,308
Non-accrual loans		6,564		—		112		1,773		25,313		21		33,783
Total	$	20,534	$	535	$	7,532	$	18,247	$	89,690	$	61	$	136,599
At December 31, 2020
Watch	$	9,649	$	545	$	10,806	$	15,835	$	66,936	$	—	$	103,771
Substandard		598		—		—		1,002		1,662		—		3,262
Performing TDRs		835		—		—		1,521		343		77		2,776
Non-accrual loans		6,717		192		200		2,105		25,314		31		34,559
Total	$	17,799	$	737	$	11,006	$	20,463	$	94,255	$	108	$	144,368

Troubled Debt Restructurings

At June 30, 2021, loans classified as TDRs totaled $3.1 million, of which $0.8 million were classified as non-performing TDRs and $2.3 million were classified as performing TDRs. At December 31, 2020, loans classified as TDRs totaled $3.7 million, of which $0.9 million were classified as non-performing TDRs and $2.8 million were classified as performing TDRs. Both performing and non-performing TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. Accordingly, specific reserves of $154,000 and $214,000 related to TDRs were allocated to the allowance for loan losses at June 30, 2021 and December 31, 2020, respectively.

Beginning in 2020, the Company began offering short-term loan modification to assist borrowers during the COVID-19 pandemic. These modifications generally meet the criteria of both Section 4013 of the CARES Act and the join interagency statement, and therefore, the Company does not account for such loan modifications as TDRs. At June 30, 2021, $42.8 million, or 3.3% of total loans, remained in some form of a modification. These loan modifications include $11.4 million on interest only, $26.4 million on full deferral and $5.0 million with extended amortization. Of the $26.4 million loan modifications on full deferral, $23.5 million, or 55.0% of the total remaining loan modifications, were determined to be on non-accrual status as of June 30, 2021.

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 June 30,
	2021					2020
	Recorded Investment (1)					Recorded Investment (1)
	Number of	Pre-		Post-		Number of	Pre-		Post-
(in thousands)	Contracts	Modification		Modification		Contracts	Modification		Modification
Troubled Debt Restructurings
Real estate mortgage − residential	—	$	—	$	—	1	$	111	$	119
Total	—	$	—	$	—	1	$	111	$	119


	Six Months Ended June 30,
	2021					2020
	Recorded Investment (1)					Recorded Investment (1)
	Number of	Pre-		Post-		Number of	Pre-		Post-
(in thousands)	Contracts	Modification		Modification		Contracts	Modification		Modification
Troubled Debt Restructurings
Real estate mortgage - residential	—	$	—	$	—	1	$	111	$	119
Installment and other consumer	—		—		—	1		6		5
Total	—	$	—	$	—	2	$	117	$	124

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

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

Loans Held For Sale

The Company designates certain long-term fixed rate personal real estate loans as held for sale, and the Company carries them at the lower of cost or fair value. The loans are primarily sold to Freddie Mac, Fannie Mae, PennyMac, and other various secondary market investors. At June 30, 2021, the carrying amount of these loans was $2.5 million compared to $5.1 million and $9.0 million at December 31, 2020 and June 30, 2020, respectively.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(3) Other Real Estate Acquired in Settlement of Loans


	June 30,		December 31,
(in thousands)	2021		2020
Commercial	$	644	$	920
Real estate construction - commercial		10,986		10,986
Real estate mortgage - residential		124		201
Real estate mortgage - commercial		2,798		2,798
Total	$	14,552	$	14,905
Less valuation allowance for other real estate owned		(2,614)		(2,614)
Total other real estate owned	$	11,938	$	12,291

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


	Three Months Ended June 30,				Six Months Ended June 30,
(in thousands)	2021		2020		2021		2020
Balance at beginning of period	$	14,842	$	15,737	$	14,905	$	15,737
Additions		—		—		30		—
Proceeds from sales		(216)		(194)		(324)		(194)
Charge-offs against the valuation allowance for other real estate owned, net		(84)		—		(84)		—
Donation		—		(266)		—		(266)
Net gain on sales		10		211		25		211
Total other real estate owned	$	14,552	$	15,488	$	14,552	$	15,488
Less valuation allowance for other real estate owned		(2,614)		(2,968)		(2,614)		(2,968)
Balance at end of period	$	11,938	$	12,520	$	11,938	$	12,520

At June 30, 2021, $214,000 of consumer mortgage loans secured by residential real estate properties were in the process of foreclosure compared to $287,000 of consumer mortgage loans at December 31, 2020.

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


	Three Months Ended June 30,				Six Months Ended June 30,
(in thousands)	2021		2020		2021		2020
Balance, beginning of period	$	2,702	$	2,968	$	2,614	$	2,956
Provision (release) for other real estate owned		(4)		—		84		12
Charge-offs		(84)		—		(84)		—
Balance, end of period	$	2,614	$	2,968	$	2,614	$	2,968

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


	Total
	Amortized		Gross Unrealized				Fair
(in thousands)	Cost		Gains		Losses		Value
June 30, 2021
U.S. Treasury	$	3,015	$	19	$	—	$	3,034
U.S. government and federal agency obligations		2,035		33		—		2,068
U.S. government-sponsored enterprises		19,330		261		(96)		19,495
Obligations of states and political subdivisions		104,777		1,652		(184)		106,245
Mortgage-backed securities		133,607		1,665		(634)		134,638
Other debt securities (a)		8,825		464		—		9,289
Bank issued trust preferred securities (a)		1,486		—		(242)		1,244
Total available-for-sale securities	$	273,075	$	4,094	$	(1,156)	$	276,013

December 31, 2020
U.S. Treasury	$	2,772	$	26	$	—	$	2,798
U.S. government and federal agency obligations		11,732		197		—		11,929
U.S. government-sponsored enterprises		22,495		379		—		22,874
Obligations of states and political subdivisions		56,943		1,801		—		58,744
Mortgage-backed securities		88,357		1,809		(54)		90,112
Other debt securities (a)		10,000		358		(14)		10,344
Bank issued trust preferred securities (a)		1,486		—		(257)		1,229
Total available-for-sale securities	$	193,785	$	4,570	$	(325)	$	198,030

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

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

Debt securities with carrying values aggregating approximately $209.5 million and $153.9 million at June 30, 2021 and December 31, 2020, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

The amortized cost and fair value of debt securities classified as available-for-sale at June 30, 2021, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without prepayment penalties.


	Amortized		Fair
(in thousands)	Cost		Value
Due in one year or less	$	4,827	$	4,850
Due after one year through five years		14,407		14,619
Due after five years through ten years		34,713		35,556
Due after ten years		85,521		86,350
Total		139,468		141,375
Mortgage-backed securities		133,607		134,638
Total available-for-sale securities	$	273,075	$	276,013

Other securities

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


	June 30,		December 31,
(in thousands)	2021		2020
Other securities:
FHLB stock	$	5,813	$	6,170
MIB stock		151		151
Equity securities with readily determinable fair values		45		32
Total other investment securities	$	6,009	$	6,353

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2021 and December 31, 2020 were as follows:


	Less than 12 months				12 months or more
									Total		Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
(in thousands)	Value		Losses *		Value		Losses		Value		Losses
At June 30, 2021
U.S. Treasury	$	1,018	$	—	$	—	$	—	$	1,018	$	—
U.S. government-sponsored enterprises		4,904		(96)		—		—		4,904		(96)
Obligations of states and political subdivisions		24,850		(184)		—		—		24,850		(184)
Mortgage-backed securities		54,708		(634)		—		—		54,708		(634)
Bank issued trust preferred securities		—		—		1,244		(242)		1,244		(242)
Total	$	85,480	$	(914)	$	1,244	$	(242)	$	86,724	$	(1,156)

(in thousands)
At December 31, 2020
U.S. Treasury	$	1,015	$	—	$	—	$	—	$	1,015	$	—
Mortgage-backed securities		7,494		(54)		—		—		7,494		(54)
Other debt securities		2,987		(14)		—		—		2,987		(14)
Bank issued trust preferred securities		—		—		1,229		(257)		1,229		(257)
Total	$	11,496	$	(68)	$	1,229	$	(257)	$	12,725	$	(325)

* Amounts less than $1,000 are not reported

The total available-for-sale portfolio consisted of approximately 406 securities at June 30, 2021. The portfolio included 78 securities having an aggregate fair value of $86.7 million that were in a loss position at June 30, 2021. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $1.2 million at fair value at June 30, 2021. The $1.2 million aggregate unrealized loss included in accumulated other comprehensive loss at June 30, 2021 was caused by interest rate fluctuations.

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

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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


	Three Months Ended June 30,				Six Months Ended June 30,
(in thousands)	2021		2020		2021		2020
Investment securities gains, net
Available-for-sale securities:
Gross realized gains	$	—	$	6	$	2	$	6
Gross realized losses		—		—		—		—
Other-than-temporary impairment recognized		—		—		—		—
Other investment securities:
Fair value adjustments, net		—		1		13		—
Investment securities gains, net	$	—	$	7	$	15	$	6

(5) Intangible Assets

Mortgage Servicing Rights

At June 30, 2021, the Company was servicing approximately $286.6 million of loans sold to the secondary market compared to $292.7 million at December 31, 2020, and $273.8 million at June 30, 2020. Mortgage loan servicing fees, reported in real estate servicing fees, net, earned on loans sold were $193,000 and $386,000 for the three and six months ended June 30, 2021, respectively, compared to $234,000 and $422,000 for the three and six months ended June 30, 2020, respectively.

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


	Three Months Ended June 30,				Six Months Ended June 30,
(in thousands)	2021		2020		2021		2020
Balance at beginning of period	$	2,494	$	2,274	$	2,445	$	2,482
Originated mortgage servicing rights		123		121		292		188
Changes in fair value:
Due to changes in model inputs and assumptions (1)		260		(122)		282		(320)
Other changes in fair value (2)		(102)		(128)		(244)		(205)
Total changes in fair value		158		(250)		38		(525)
Balance at end of period	$	2,775	$	2,145	$	2,775	$	2,145

(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 June 30, 2021 and 2020, respectively:


	Six Months Ended June 30,
		2021		2020
Weighted average constant prepayment rate		11.81	%	18.03	%
Weighted average note rate		3.41	%	3.81	%
Weighted average discount rate		8.00	%	7.75	%
Weighted average expected life (in years)		6.0		4.0

(6) Federal funds purchased and securities sold under agreements to repurchase


	June 30,		December 31,
(in thousands)	2021		2020
Federal funds purchased	$	—	$	—
Repurchase agreements		32,018		45,154
Total	$	32,018	$	45,154

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


Repurchase Agreements	Remaining Contractual Maturity of the Agreements
	Overnight		Less		Greater
	and		than		than
(in thousands)	continuous		90 days		90 days		Total
At June 30, 2021
U.S. government-sponsored enterprises	$	6,925	$	—	$	—	$	6,925
Mortgage-backed securities		25,093		—		—		25,093
Total	$	32,018	$	—	$	—	$	32,018

At December 31, 2020
U.S. government and federal agency obligations	$	2,728	$	—	$	—	$	2,728
U.S. government-sponsored enterprises		15,533		—		—		15,533
Mortgage-backed securities		26,893		—		—		26,893
Total	$	45,154	$	—	$	—	$	45,154

(7) Leases

The Company's leases primarily consist of office space and bank branches with remaining lease terms of generally 1 to 10 years. As of June 30, 2021, operating right of use (ROU) assets and liabilities were $2.0 million and $2.0 million,

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

respectively. As of June 30, 2021, the weighted-average remaining lease term on these operating leases is approximately 6.9 years and the weighted-average discount rate used to measure the lease liabilities is approximately 4.0%.

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

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

Operating lease cost, which is comprised of amortization of the ROU asset and the implicit interest accreted on the operating lease liability, is recognized on a straight-line basis over the lease term, and is recorded in net occupancy expense in the consolidated statements of income. The operating lease cost was $95,000 and $196,000 for the three and six months ended June 30, 2021, respectively, compared to $80,000 and $166,000 for the three and six months ended June 30, 2020, respectively.

At adoption of Accounting Standards Update (ASU) 2016-02 on January 1, 2019, lease and non-lease components of new lease agreements are accounted for separately. Lease components include fixed payments including rent, real estate taxes and insurance costs and non-lease components include common-area maintenance costs. Leases with an initial term of 12 months or less are not recorded on the balance sheet; the Company recognizes lease expense for these leases on a straight-line basis over the lease term. Operating lease expense for these leases was $19,000 and $32,000 for the three and six months ended June 30, 2021, respectively, compared to $25,000 and $60,000 for the three and six months ended June 30, 2020, respectively.

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


	Operating
Lease payments due in:	Lease
(in thousands)
2021 (excluding 6 months ended June 30, 2021)	$	182
2022		367
2023		366
2024		258
2025		257
Thereafter		830
Total lease payments		2,260
Less imputed interest		(277)
Total lease liabilities, as reported	$	1,983

(8) Income Taxes

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

months ended June 30, 2021 compared to the three and six months ended June 30, 2020 was primarily attributable to the increase in earnings and an increase in state taxes attributed to elevated earnings. The effective tax rate for each of the three and six months ended June 30, 2021 and 2020, respectively, is lower than the U.S. federal statutory rate of 21% primarily due to tax-free revenues.

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

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

(9) Stockholders’ Equity

Accumulated Other Comprehensive Income (Loss)

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


	Six Months Ended June 30, 2021
					Accumulated
			Unrecognized Net		Other
	Unrealized		Pension and		Comprehensive
	Gains (Losses)		Postretirement		Income
(in thousands)	on Securities (1)		Costs (2)		(Loss)
Balance at beginning of period	$	3,353	$	(1,825)	$	1,528
Other comprehensive income (loss), before reclassifications		(1,305)		184		(1,121)
Amounts reclassified from accumulated other comprehensive income (loss)		(2)		—		(2)
Current period other comprehensive income (loss), before tax		(1,307)		184		(1,123)
Income tax benefit (expense)		275		(39)		236
Current period other comprehensive income (loss), net of tax		(1,032)		145		(887)
Balance at end of period	$	2,321	$	(1,680)	$	641

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)


	Six Months Ended June 30, 2020
					Accumulated
			Unrecognized Net		Other
	Unrealized		Pension and		Comprehensive
	Gains (Losses)		Postretirement		Income
(in thousands)	on Securities (1)		Costs (2)		(Loss)
Balance at beginning of period	$	(23)	$	(3,732)	$	(3,755)
Other comprehensive income, before reclassifications		3,888		107		3,995
Amounts reclassified from accumulated other comprehensive income (loss)		(6)		—		(6)
Current period other comprehensive income, before tax		3,882		107		3,989
Income tax expense		(815)		(23)		(838)
Current period other comprehensive income, net of tax		3,067		84		3,151
Balance at end of period	$	3,044	$	(3,648)	$	(604)

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

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

(10) Employee Benefit Plans

Employee Benefits

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


	Three Months Ended June 30,				Six Months Ended June 30,
(in thousands)	2021		2020		2021		2020
Payroll taxes	$	356	$	336	$	791	$	725
Medical plans		519		497		969		924
401(k) match and profit sharing		444		338		943		644
Periodic pension cost		482		343		898		807
Other		3		5		7		28
Total employee benefits	$	1,804	$	1,519	$	3,608	$	3,128

The Company’s profit-sharing plan includes a matching 401(k) portion, in which the Company matches the first 3% of eligible employee contributions. The Company makes annual contributions for the discretionary portion in an amount up to 6% of income before income taxes and before contributions to the profit-sharing and pension plans for all participants, limited to the maximum amount deductible for federal income tax purposes, for each of the periods shown.

Other Plans

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

The accrued liability relating to the SERP was $1.2 million as of June 30, 2021, and the expense for the three and six months ended June 30, 2021 was $97,000 and $193,000, respectively, compared to $80,000 and $160,000 for the three and six months ended June 30, 2020, respectively, and is recognized over the required service period.

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 eligible employees. Beginning January 1, 2018 and for all retrospective periods presented, the Company adopted the guidance under ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. Under the new guidance, only the service cost component of the net periodic benefit cost is reported in the same income statement line item as salaries and benefits, and the remaining components are reported as other non-interest expense. An employer is required to recognize the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Under the Company’s funding policy for the defined benefit pension plan, contributions are made to a trust as necessary to provide for current service and for any unfunded accrued actuarial liabilities over a reasonable period. To the extent that these requirements are fully covered by assets in the trust, a contribution might not be made in a particular year. The Company made a pension contribution of $1.0 million on March 22, 2021.

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

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

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



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

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

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

participants in the pension plan. The prior service credit is amortized over the average remaining service period to full eligibility for participating employees expected to receive benefits.

(11) Earnings per Share

Stock Dividend

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

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

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


	Three Months Ended June 30,				Six Months Ended June 30,
(dollars in thousands, except per share data)	2021		2020		2021		2020
Basic earnings per share:
Net income available to shareholders	$	4,892	$	3,282	$	10,731	$	4,150
Average shares outstanding		6,616,975		6,740,147		6,617,171		6,752,418
Basic earnings per share	$	0.74	$	0.49	$	1.62	$	0.61
Diluted earnings per share:
Net income available to shareholders	$	4,892	$	3,282	$	10,731	$	4,150
Average shares outstanding		6,616,975		6,740,147		6,617,171		6,752,418
Diluted earnings per share	$	0.74		0.49	$	1.62		0.61

Repurchase Program

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

During the second quarter of 2021, the Company's Board of Directors reauthorized the purchase of up to $5.0 million market value of the Company's common stock under the 2019 authorization. There were no shares repurchased during the second quarter of 2021. As of June 30, 2021, $5.0 million remained available for the repurchase of shares pursuant to the share repurchase authorization.

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(12) Fair Value Measurements

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

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

The fair value hierarchy is as follows:

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

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

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

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

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

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

Available-for-Sale Securities

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

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Mortgage Servicing Rights

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

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)
June 30, 2021
Assets:
U.S. Treasury	$	3,034	$	3,034		—	$	—
U.S. government and federal agency obligations		2,068		—		2,068		—
U.S. government-sponsored enterprises		19,495		—		19,495		—
Obligations of states and political subdivisions		106,245		—		106,245		—
Mortgage-backed securities		134,638		—		134,638		—
Other debt securities		9,289		—		9,289		—
Bank-issued trust preferred securities		1,244		—		1,244		—
Equity securities		45		45		—		—
Mortgage servicing rights		2,775		—		—		2,775
Total	$	278,833	$	3,079	$	272,979	$	2,775

December 31, 2020
Assets:
U.S. Treasury	$	2,798	$	2,798		—	$	—
U.S. government and federal agency obligations		11,929		—		11,929		—
U.S. government-sponsored enterprises		22,874		—		22,874		—
Obligations of states and political subdivisions		58,744		—		58,744		—
Mortgage-backed securities		90,112		—		90,112		—
Other debt securities		10,344		—		10,344		—
Bank-issued trust preferred securities		1,229		—		1,229		—
Equity securities		32		32		—		—
Mortgage servicing rights		2,445		—		—		2,445
Total	$	200,507	$	2,830	$	195,232	$	2,445

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

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


	Fair Value Measurements Using				Fair Value Measurements Using
	(Level 3)				(Level 3)
	Mortgage Servicing Rights				Mortgage Servicing Rights
	Three Months Ended June 30,				Six Months Ended June 30,
(in thousands)	2021		2020		2021		2020
Balance at beginning of period	$	2,494	$	2,274	$	2,445	$	2,482
Total gains or (losses) (realized/unrealized):
Included in earnings		158		(250)		38		(525)
Included in other comprehensive income		—		—		—		—
Purchases		—		—		—		—
Sales		—		—		—		—
Issues		123		121		292		188
Settlements		—		—		—		—
Balance at end of period	$	2,775	$	2,145	$	2,775	$	2,145

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 Non-recurring 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 a senior loan committee. Because many of these inputs are not observable, the measurements are classified as Level 3. As of June 30, 2021, the Company identified $31.8 million in collateral dependent impaired loans that had specific allowances for losses aggregating $5.0 million. Related to these loans, there were $11,000 and $34,000 in charge-offs recorded during the three and six months ended June 30, 2021, respectively. As of June 30, 2020, the Company identified $7.0 million in collateral dependent impaired loans that had specific allowances for losses aggregating $0.4 million. Related to these loans, there were $37,000 and $92,000 in charge-offs recorded during the three and six months ended June 30, 2020, respectively.

Other Real Estate and Foreclosed Assets

Other real estate owned (OREO) and foreclosed assets consisted of loan collateral that has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Subsequent to foreclosure, these assets initially

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

are carried at fair value of the collateral less estimated selling costs. Fair value, when recorded, is generally based upon appraisals by approved, independent state-certified appraisers. Like impaired loans, appraisals on OREO may be discounted based on the Company’s historical knowledge, changes in market conditions from the time of appraisal or other information available. During the holding period, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. Because many of these inputs are not observable, the measurements are classified as Level 3.


			Fair Value Measurements Using
			Quoted Prices
			in Active						Three Months		Six Months
			Markets for		Other		Significant		Ended		Ended
			Identical		Observable		Unobservable		June 30,		June 30,
	Total		Assets		Inputs		Inputs		Total Gains		Total Gains
(in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)		(Losses)*		(Losses)*
June 30, 2021
Assets:
Collateral dependent impaired loans:
Commercial, financial, & agricultural	$	3,976	$	—	$	—	$	3,976	$	—	$	—
Real estate mortgage - residential		359		—		—		359		(3)		(3)
Real estate mortgage - commercial		22,420		—		—		22,420		(2)		(25)
Installment and other consumer		—		—		—		—		(6)		(6)
Total	$	26,755	$	—	$	—	$	26,755	$	(11)	$	(34)
Other real estate and repossessed assets	$	11,938	$	—	$	—	$	11,938	$	14	$	(59)

June 30, 2020
Assets:
Collateral dependent impaired loans:
Commercial, financial, & agricultural	$	2,408	$	—	$	—	$	2,408	$	—	$	—
Real estate construction - commercial		837		—		—		837		—		—
Real estate mortgage - residential		2,031		—		—		2,031		(32)		(51)
Real estate mortgage - commercial		1,304		—		—		1,304		(2)		(24)
Installment and other consumer		11		—		—		11		(3)		(17)
Total	$	6,591	$	—	$	—	$	6,591	$	(37)	$	(92)
Other real estate and repossessed assets	$	12,520	$	—	$	—	$	12,520	$	213	$	199

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

(13) Fair Value of Financial Instruments

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

Loans

Fair values are estimated for portfolios with similar financial characteristics. Loans are segregated by type, such as commercial, real estate, and consumer. Each loan category is further segmented into fixed and variable interest rate categories. The fair value of loans, or exit price, is estimated by using the future value of discounted cash flows

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

using comparable market rates for similar types of loan products and adjusted for market factors. The discount rates used are estimated using comparable market rates for similar types of loan products adjusted to be commensurate with the credit risk, overhead costs, and optionality of such instruments.

Loans Held for Sale

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

Investment Securities

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

Other Investment Securities

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

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

Federal Funds Sold, Cash, and Due from Banks

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

Certificates of Deposit in Other Banks

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

Cash Surrender Value - Life Insurance

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

Accrued Interest Receivable and Payable

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

Deposits

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

Federal funds purchased and Securities Sold under Agreements to Repurchase

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

Subordinated Notes and Other Borrowings

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

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 June 30, 2021 and December 31, 2020 is as follows:


					June 30, 2021
					Fair Value Measurements
						Quoted Prices
					in Active				Net
					Markets for		Other		Significant
	June 30, 2021				Identical		Observable		Unobservable
	Carrying		Fair		Assets		Inputs		Inputs
(in thousands)	amount		value		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and due from banks	$	17,920	$	17,920	$	17,920	$	—	$	—
Federal funds sold and overnight interest-bearing deposits		58,514		58,514		58,514		—		—
Certificates of deposit in other banks		7,165		7,165		7,165		—		—
Available-for-sale securities		276,013		276,013		3,034		272,979		—
Other investment securities		6,009		6,009		45		5,964		—
Loans, net		1,275,159		1,299,656		—		—		1,299,656
Loans held for sale		2,487		2,565		—		—		2,565
Cash surrender value - life insurance		2,480		2,480		—		2,480		—
Accrued interest receivable		6,849		6,849		6,849		—		—
Total	$	1,652,596	$	1,677,171	$	93,527	$	281,423	$	1,302,221
Liabilities:
Deposits:
Non-interest bearing demand	$	433,288	$	433,288	$	433,288	$	—	$	—
Savings, interest checking and money market		704,236		704,236		704,236		—		—
Time deposits		243,477		244,871		—		—		244,871
Federal funds purchased and securities sold under agreements to repurchase		32,018		32,018		32,018		—		—
Federal Home Loan Bank advances and other borrowings		93,554		95,314		—		95,314		—
Subordinated notes		49,486		41,424		—		41,424		—
Accrued interest payable		376		376		376		—		—
Total	$	1,556,435	$	1,551,527	$	1,169,918	$	136,738	$	244,871

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)


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

Off-Balance Sheet Financial Instruments

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

Limitations

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

HAWTHORN BANCSHARES, INC.

AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

(Unaudited)

(14) Commitments and Contingencies

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

The Company’s extent of involvement and maximum potential exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for financial instruments included on its consolidated balance sheets. At June 30, 2021, no amounts have been accrued for any estimated losses for these financial instruments.

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


	June 30,		December 31,
(in thousands)	2021		2020
Commitments to extend credit	$	271,115	$	264,528
Commitments to originate residential first and second mortgage loans		22,488		51,270
Standby letters of credit		3,625		125,800
Total	$	297,228	$	441,598

Commitments

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

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third-party. These standby letters of credit are primarily issued to support contractual obligations of the Company’s customers. The approximate remaining term of standby letters of credit range from one month to five years at June 30, 2021.

Pending Litigation

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

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

Forward-Looking Statements

This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of Hawthorn Bancshares, Inc., and its subsidiaries (collectively, the Company), including, without limitation:

●

statements that are not historical in nature, and

●

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

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

●

competitive pressures among financial services companies may increase significantly,

●

changes in the interest rate environment may reduce interest margins,

●

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

●

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

●

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

●

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

●

changes may occur in the securities markets and,

●

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

We have described under the caption Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020, and in other reports filed with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that have not been identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made. Except as required by law, the Company undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events, or changes in its business, results of operations or financial condition over time.

Overview

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

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

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

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

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

Significant Developments and Transactions

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

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

Effects on Our Market Areas. Our commercial and consumer banking products and services are delivered primarily in Missouri, where individual and governmental responses to the COVID-19 pandemic have led to a broad curtailment of economic activity While positive tailwinds exist, we recognize that our business and consumer customers are experiencing varying degrees of financial distress, which is expected to continue into the third quarter of 2021, especially as new COVID-19 variant infections increase and new health and safety measures are implemented. Commercial activity has improved, but has not returned to the levels existing prior to the outbreak of the pandemic. In addition, the economic pressures and uncertainties related to the COVID-19 pandemic have resulted in changes in consumer spending behaviors,

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

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

The Company continues to lend to qualified consumer and commercial customers. We continue to participate in the SBA’s Small Business Paycheck Protection Program (PPP). As of June 30, 2021, the net balance of the PPP loans totaled $49.6 million.

Beginning in 2020, as provided for by the CARES Act, the Company offered payment modifications to borrowers. At December 31, 2020, these modifications totaled $86.7 million, or 6.7% of total loans. At June 30, 2021, $42.8 million, or 3.3% of total loans, remained in some form of a modification. These loan modifications include $11.4 million on interest only, $26.4 million on full deferral and $5.0 million with extended amortization. As permitted by the CARES Act and other regulatory guidance, the Company has elected to suspend accounting principles generally accepted in the United States of America (U.S. GAAP) and regulatory determinations for loan modifications relating to the COVID-19 pandemic that would otherwise require evaluation as troubled debt restructurings (TDRs). The Company expects most of these modified loans to recover from the pandemic, but uncertainty regarding the short-term and long-term effects of the COVID-19 pandemic remain that may require the Company to downgrade modified loans which may increase our allowance for loan losses, reverse interest income previously recognized but not received, or charge-off modified loans.

CRITICAL ACCOUNTING POLICIES

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

Allowance for Loan Losses

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

SELECTED CONSOLIDATED FINANCIAL DATA

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


Selected Financial Data
	Three Months Ended						Six Months Ended
	June 30,						June 30,
(In thousands, except per share data)		2021			2020			2021			2020
Per Share Data
Basic earnings per share	$	0.74		$	0.49		$	1.62		$	0.61
Diluted earnings per share		0.74			0.49			1.62			0.61
Cash dividends paid on common stock		828			750			1,670			1,503
Book value per share								20.63			17.78
Market price per share								22.93			18.93
Selected Ratios
(Based on average balance sheet data)
Return on total assets		1.14	%		0.81	%		1.26	%		0.53	%
Return on stockholders' equity		14.64	%		11.12	%		16.31	%		7.06	%
Stockholders' equity to total assets		7.76	%		7.24	%		7.70	%		7.51	%
Efficiency ratio (1)		64.45	%		69.59	%		63.14	%		70.17	%
Net interest spread		3.24	%		3.25	%		3.34	%		3.26	%
Net interest margin		3.40	%		3.46	%		3.51	%		3.51	%

(Based on end-of-period data)
Stockholders' equity to assets								7.99	%		7.13	%
Total risk-based capital ratio								14.66	%		14.64	%
Tier 1 risk-based capital ratio								13.20	%		12.76	%
Common equity Tier 1 capital								9.91	%		9.58	%
Tier 1 leverage ratio (2)								10.49	%		9.82	%

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

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

RESULTS OF OPERATIONS ANALYSIS

The Company has prepared all of the consolidated financial information in this report in accordance with U.S. GAAP. In preparing the consolidated financial statements in accordance with U.S. GAAP, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the

date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.


	Three Months Ended June 30,									Six Months Ended June 30,
(In thousands)	2021		2020		$ Change		% Change			2021		2020		$ Change		% Change
Net interest income	$	13,671	$	13,339	$	332		2.5	%	$	28,062	$	25,865	$	2,197		8.5	%
Provision for loan losses		400		900		(500)		(55.6)			400		4,200		(3,800)		(90.5)
Non-interest income		4,589		2,856		1,733		60.7			9,031		5,147		3,884		75.5
Investment securities gains, net		—		7		(7)		(100.0)			15		6		9		150.0
Non-interest expense		11,769		11,270		499		4.4			23,420		21,761		1,659		7.6
Income before income taxes		6,091		4,032		2,059		51.1			13,288		5,057		8,231		162.8
Income tax expense		1,199		750		449		59.9			2,557		907		1,650		181.9
Net income	$	4,892	$	3,282	$	1,610		49.1	%	$	10,731	$	4,150	$	6,581		158.6	%

Consolidated net income of $4.9 million, or $0.74 per diluted share, for the three months ended June 30, 2021 increased $1.6 million compared to $3.3 million, or $0.49 per diluted share, for the three months ended June 30, 2020. For the three months ended June 30, 2021, the return on average assets was 1.14%, the return on average stockholders’ equity was 14.64%, and the efficiency ratio was 64.5%.

Consolidated net income of $10.7 million, or $1.62 per diluted share, for the six months ended June 30, 2021 increased $6.6 million compared to $4.1 million, or $0.61 per diluted share, for the six months ended June 30, 2020. For the six months ended June 30, 2021, the return on average assets was 1.26%, the return on average stockholders’ equity was 16.31%, and the efficiency ratio was 63.1%.

Net interest income was $13.7 million and $28.1 million for the three and six months ended June 30, 2021, respectively, compared to $13.3 million and $25.9 million for the three and six months ended June 30, 2020, respectively. The net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.40% for the three months ended June 30, 2021 compared to 3.46% for the three months ended June 30, 2020, and was consistent at 3.51% for both the six months ended June 30, 2021 and 2020. These changes are discussed in greater detail under the Average Balance Sheet Data and Rate and Volume Analysis section below.

A $0.4 million provision for loan losses was required for both the three and six months ended June 30, 2021 compared to a $0.9 million and $4.2 million provision for the three and six months ended June 30, 2020, respectively. The decreased provision in the three and six months ended June 30, 2021 compared to the three and six months ended June 30, 2020 resulted primarily from the impact of net recoveries and improvement in the economic outlook as the economy begins to recover from the impacts of the COVID-19 pandemic. Criticized loan levels remain elevated when compared to pre-pandemic levels due to the downgrade of loans to borrowers that have been impacted by the COVID-19 pandemic.

The Company’s net loan charge-offs (recoveries) were $26,000 and $(222,000) for the three and six months ended June 30, 2021, respectively, compared to net loan (recoveries) charge-offs of $(29,000) and $55,000 for the three and six months ended June 30, 2020, respectively.

Non-performing loans totaled $33.8 million, or 2.61% of total loans, at June 30, 2021 compared to $34.6 million, or 2.69% of total loans, at December 31, 2020, and $8.9 million, or 0.70% of total loans, at June 30, 2020. These changes are discussed in greater detail under the Lending and Credit Management section below.

Non-interest income increased $1.7 million, or 60.7%, for the three months ended June 30, 2021 compared to the three months ended June 30, 2020, and increased $3.9 million, or 75.5%, for the six months ended June 30, 2021 compared to the six months ended June 30, 2020. These changes are discussed in greater detail under the Non-interest Income and Expense section below.

Non-interest expense increased $0.5 million, or 4.4%, for the three months ended June 30, 2021 compared to the three months ended June 30, 2020, and increased $1.7 million, or 7.6%, for the six months ended June 30, 2021 compared

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

Average Balance Sheet Data

Net interest income is the largest source of revenue resulting from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table presents average balance sheet data, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net

interest margin on a fully taxable equivalent basis for each of the three and six month periods ended June 30, 2021 and 2020, respectively.


	Three Months Ended June 30,
	2021						2020
			Interest		Rate				Interest		Rate
	Average		Income/		Earned/		Average		Income/		Earned/
(In thousands)	Balance		Expense(1)		Paid(1)		Balance		Expense(1)		Paid(1)
ASSETS
Loans: (2) (3)
Commercial	$	256,557	$	2,999	4.69	%	$	280,867	$	3,121	4.47	%
Real estate construction - residential		35,005		427	4.89			25,993		331	5.12
Real estate construction - commercial		77,726		913	4.71			84,824		962	4.56
Real estate mortgage - residential		263,477		2,843	4.33			248,852		2,922	4.72
Real estate mortgage - commercial		618,126		6,620	4.30			586,043		6,992	4.80
Installment and other consumer		24,794		242	3.91			30,071		307	4.11
Total loans	$	1,275,685	$	14,044	4.42	%	$	1,256,650	$	14,635	4.68	%
Loans held for sale	$	4,222	$	29	2.76	%	$	11,513	$	50	1.75	%
Investment securities:
U.S. Treasury	$	3,039	$	8	1.06	%	$	776	$	4	2.07	%
U.S. government and federal agency obligations		22,730		99	1.75			46,981		245	2.10
Obligations of states and political subdivisions		88,153		670	3.05			43,833		318	2.92
Mortgage-backed securities		131,134		416	1.27			100,558		413	1.65
Other debt securities		12,886		158	4.92			6,111		81	5.33
Total investment securities	$	257,942	$	1,351	2.10	%	$	198,259	$	1,061	2.15	%
Other investment securities		6,069		81	5.35			7,421		72	3.90
Federal funds sold and interest bearing deposits in other financial institutions		116,655		88	0.30			99,629		117	0.47
Total interest earning assets	$	1,660,573	$	15,593	3.77	%	$	1,573,472	$	15,935	4.07	%
All other assets		85,077						82,098
Allowance for loan losses		(18,467)						(15,854)
Total assets	$	1,727,183					$	1,639,716
LIABILITIES AND STOCKHOLDERS' EQUITY
NOW accounts	$	227,179	$	134	0.24	%	$	187,559	$	120	0.26	%
Savings		156,944		14	0.04			114,369		10	0.04
Interest checking		41,336		47	0.46			45,996		75	0.66
Money market		281,831		81	0.12			282,722		85	0.12
Time deposits		246,862		504	0.82			304,986		1,040	1.37
Total interest bearing deposits	$	954,152	$	780	0.33	%	$	935,632	$	1,330	0.57	%
Federal funds purchased and securities sold under agreements to repurchase		45,261		26	0.23			39,355		59	0.60
Federal Home Loan Bank advances and other borrowings		94,823		385	1.63			136,983		612	1.80
Subordinated notes		49,486		307	2.49			49,486		381	3.10
Total borrowings	$	189,570	$	718	1.52	%	$	225,824	$	1,052	1.87	%
Total interest bearing liabilities	$	1,143,722	$	1,498	0.53	%	$	1,161,456	$	2,382	0.82	%
Demand deposits		433,879						343,000
Other liabilities		15,582						16,563
Total liabilities		1,593,183						1,521,019
Stockholders' equity		134,000						118,697
Total liabilities and stockholders' equity	$	1,727,183					$	1,639,716
Net interest income (FTE)			$	14,095					$	13,553
Net interest spread					3.24	%					3.25	%
Net interest margin					3.40	%					3.46	%

(1)

Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense, for the three months ended June 30, 2021 and 2020. Such adjustments totaled $424,000 and $214,000 for the three months ended June 30, 2021 and 2020, respectively.

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

(3)	Fees and costs on loans are included in interest income ($0.5 million and $0.4 million of PPP fees were included in commercial loan income for the three months ended June 30, 2021 and 2020, respectively).


	Six Months Ended June 30,
	2021						2020
			Interest		Rate				Interest		Rate
	Average		Income/		Earned/		Average		Income/		Earned/
(In thousands)	Balance		Expense(1)		Paid(1)		Balance		Expense(1)		Paid(1)
ASSETS
Loans: (2) (3)
Commercial	$	257,087	$	7,156	5.61	%	$	239,975	$	5,692	4.77	%
Real estate construction - residential		34,252		822	4.84			24,730		654	5.32
Real estate construction - commercial		78,150		1,791	4.62			85,199		2,070	4.89
Real estate mortgage - residential		261,768		5,684	4.38			249,804		6,064	4.88
Real estate mortgage - commercial		619,991		13,219	4.30			579,588		13,997	4.86
Installment and other consumer		25,390		508	4.03			30,756		652	4.26
Total loans	$	1,276,638	$	29,180	4.61	%	$	1,210,052	$	29,129	4.84	%
Loans held for sale	$	4,858	$	54	2.24	%	$	6,702	$	55	1.65	%
Investment securities:
U.S. Treasury	$	3,023	$	16	1.07	%	$	768	$	7	1.83	%
U.S. government and federal agency obligations		23,473		201	1.73			42,074		440	2.10
Obligations of states and political subdivisions		74,878		1,122	3.02			40,309		589	2.94
Mortgage-backed securities		123,351		798	1.30			102,293		938	1.84
Other debt securities		12,216		301	4.97			5,256		141	5.39
Total investment securities	$	236,941	$	2,438	2.08	%	$	190,700	$	2,115	2.23	%
Other investment securities		6,026		165	5.52			6,837		173	5.09
Federal funds sold and interest bearing deposits in other financial institutions		132,899		190	0.29			90,922		442	0.98
Total interest earning assets	$	1,657,362	$	32,027	3.90	%	$	1,505,213	$	31,914	4.26	%
All other assets		84,905						82,617
Allowance for loan losses		(18,466)						(14,219)
Total assets	$	1,723,801					$	1,573,611
LIABILITIES AND STOCKHOLDERS' EQUITY
NOW accounts	$	229,234	$	272	0.24	%	$	186,601	$	409	0.44	%
Savings		149,879		26	0.04			107,615		32	0.06
Interest checking		51,373		122	0.48			46,646		248	1.07
Money market		280,539		164	0.12			276,621		548	0.40
Time deposits		256,899		1,176	0.92			314,045		2,205	1.41
Total interest bearing deposits	$	967,924	$	1,760	0.37	%	$	931,528	$	3,442	0.74	%
Federal funds purchased and securities sold under agreements to repurchase		43,394		52	0.24			32,822		96	0.59
Federal Home Loan Bank advances and other borrowings		96,479		781	1.63			122,507		1,244	2.04
Subordinated notes		49,486		617	2.51			49,486		882	3.58
Total borrowings	$	189,359	$	1,450	1.54	%	$	204,815	$	2,222	2.18	%
Total interest bearing liabilities	$	1,157,283	$	3,210	0.56	%	$	1,136,343	$	5,664	1.00	%
Demand deposits		416,749						302,122
Other liabilities		17,083						16,998
Total liabilities	$	1,591,115					$	1,455,463
Stockholders' equity		132,686						118,148
Total liabilities and stockholders' equity	$	1,723,801					$	1,573,611
Net interest income (FTE)			$	28,817					$	26,250
Net interest spread					3.34	%					3.26	%
Net interest margin					3.51	%					3.51	%

(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 six months ended June 30, 2021 and 2020. Such adjustments totaled $755,000 and $385,000 for the six months ended June 30, 2021 and 2020, respectively.

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

(3)	Fees and costs on loans are included in interest income ($2.0 million and $0.4 million of PPP fees were included in commercial loan income for the six months ended June 30, 2021 and 2020, respectively).

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 six months ended June 30, 2021 compared to the three and six months ended June 30, 2020, respectively. The change in

interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.


	Three Months Ended June 30,						Six Months Ended June 30,
	2021 vs. 2020						2021 vs. 2020
			Change due to						Change due to
	Total		Average		Average		Total		Average		Average
(In thousands)	Change		Volume		Rate		Change		Volume		Rate
Interest income on a fully taxable equivalent basis: (1)
Loans: (2) (3)
Commercial	$	(122)	$	(279)	$	157	$	1,464	$	427	$	1,037
Real estate construction - residential		96		111		(15)		168		233		(65)
Real estate construction - commercial		(49)		(82)		33		(279)		(165)		(114)
Real estate mortgage - residential		(79)		166		(245)		(380)		280		(660)
Real estate mortgage - commercial		(372)		369		(741)		(778)		933		(1,711)
Installment and other consumer		(65)		(52)		(13)		(144)		(109)		(35)
Loans held for sale		(21)		(42)		21		(1)		(17)		16
Investment securities:
U.S. Treasury		4		7		(3)		9		13		(4)
U.S. government and federal agency obligations		(146)		(110)		(36)		(239)		(170)		(69)
Obligations of states and political subdivisions		352		337		15		533		517		16
Mortgage-backed securities		3		110		(107)		(140)		170		(310)
Other debt securities		77		84		(7)		160		173		(13)
Other investment securities		9		(15)		24		(8)		(22)		14
Federal funds sold and interest bearing deposits in other financial institutions		(29)		18		(47)		(252)		147		(399)
Total interest income	$	(342)	$	622	$	(964)	$	113	$	2,410	$	(2,297)
Interest expense:
NOW accounts		14		24		(10)		(137)		79		(216)
Savings		4		4		—		(6)		10		(16)
Interest checking		(28)		(7)		(21)		(126)		23		(149)
Money market		(4)		—		(4)		(384)		8		(392)
Time deposits		(536)		(172)		(364)		(1,029)		(353)		(676)
Federal funds purchased and securities sold under agreements to repurchase		(33)		8		(41)		(44)		25		(69)
Federal Home Loan Bank advances and other borrowings		(227)		(175)		(52)		(463)		(237)		(226)
Subordinated notes		(74)		—		(74)		(265)		—		(265)
Total interest expense	$	(884)	$	(318)	$	(566)	$	(2,454)	$	(445)	$	(2,009)
Net interest income on a fully taxable equivalent basis	$	542	$	940	$	(398)	$	2,567	$	2,855	$	(288)

(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 six months ended June 30, 2021 and 2020. Such adjustments totaled $424,000 and $755,000 for the three and six months ended June 30, 2021, respectively, compared to $214,000 and $385,000 for the three and six months ended June 30, 2020, respectively.

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

(3)	Fees and costs on loans are included in interest income ($0.5 million and $2.0 million of PPP fees for the three and six months ended June 30, 2021, respectively, compared to $0.4 million for both the three and six months ended June 30, 2020 were included in commercial loan income).

Financial results for the quarter ended June 30, 2021 compared to the quarter ended June 30, 2020 reflected an increase in net interest income, on a tax equivalent basis, of $0.5 million, or 4.0%, and the financial results for the six months ended June 30, 2021 compared to the six months ended June 30, 2020 reflected an increase of $2.6 million, or 9.8%. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.40% for the quarter ended June 30, 2021 compared to 3.46% for the quarter ended June 30, 2020, and remained consistent at 3.51% for both the six months ended June 30, 2021 and 2020, respectively. Net interest income increased primarily due to an increase in average earning assets and a decrease in rates paid on average interest bearing liabilities in both the three and six month comparative periods. Although average earning assets increased for both the three and six

month comparative periods, net interest margin decreased quarter-over-quarter primarily due to a decrease in rates earned, while net interest margin remained consistent for the six months ended June 30, 2021 compared to the six months ended June 30, 2020 primarily due to $2.0 million in PPP income earned in 2021 compared to $0.4 million in 2020.

Average interest-earning assets increased $87.1 million, or 5.5%, to $1.66 billion for the quarter ended June 30, 2021 compared to $1.57 billion for the quarter ended June 30, 2020, and average interest bearing liabilities decreased $17.7 million, or 1.5%, to $1.14 billion for the quarter ended June 30, 2021 compared to $1.16 billion for the quarter ended June 30, 2020.

Average interest-earning assets increased $152.1 million, or 10.1%, to $1.66 billion for the six months ended June 30, 2021 compared to $1.50 billion for the six months ended June 30, 2020, average interest bearing liabilities increased $20.9 million, or 1.8%, to $1.16 billion for the six months ended June 30, 2021 compared to $1.14 billion for the six months ended June 30, 2020.

Total interest income (expressed on a fully taxable equivalent basis) was $15.6 million and $32.0 million for the three and six months ended June 30, 2021, respectively, compared to $15.9 million and $31.9 million for the three and six months ended June 30, 2020, respectively. The Company’s rates earned on interest earning assets were 3.77% and 3.90% for the three and six months ended June 30, 2021, respectively, compared to 4.07% and 4.26% for the three and six months ended June 30, 2020, respectively.

Interest income on loans held for investment was $14.0 million and $29.2 million for the three and six months ended June 30, 2021, respectively, compared to $14.6 million and $29.1 million for the three and six months ended June 30, 2020, respectively.

Average loans outstanding increased $19.0 million, or 1.5%, to $1.28 billion for the quarter ended June 30, 2021 compared to $1.26 billion for the quarter ended June 30, 2020. The average yield on loans decreased to 4.42% for the quarter ended June 30, 2021 compared to 4.68% for the quarter ended June 30, 2020.

Average loans outstanding increased $66.6 million, or 5.5%, to $1.28 billion for the six months ended June 30, 2021 compared to $1.21 billion for the six months ended June 30, 2020. The average yield on loans decreased to 4.61% for the six months ended June 30, 2021 compared to 4.84% for the six months ended June 30, 2020. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

Interest income on available-for-sale securities was $1.4 million and $2.4 million for the three and six months ended June 30, 2021, respectively, compared to $1.1 million and $2.1 million for the three and six months ended June 30, 2020, respectively.

Average securities increased $59.7 million, or 30.1%, to $257.9 million for the quarter ended June 30, 2021 compared to $198.3 million for the quarter ended June 30, 2020. The average yield on securities decreased to 2.10% for the quarter ended June 30, 2021 compared to 2.15% for the quarter ended June 30, 2020.

Average securities increased $46.2 million, or 24.3%, to $236.9 million for the six months ended June 30, 2021 compared to $190.7 million for the six months ended June 30, 2020. The average yield on securities decreased to 2.08% for the six months ended June 30, 2021 compared to 2.23% for the six months ended June 30, 2020. Management plans to continue to grow the investment portfolio based on available liquidity. See the Liquidity Management section for further discussion.

Total interest expense decreased to $1.5 million and $3.2 million for the three and six months ended June 30, 2021, respectively, compared to $2.4 million and $5.7 million for the three and six months ended June 30, 2020, respectively. The Company’s rates paid on interest bearing liabilities were 0.53% and 0.56% for the three and six months ended June 30, 2021, respectively, compared to 0.82% and 1.0% for the three and six months ended June 30, 2020, respectively. See the Liquidity Management section for further discussion.

Interest expense on deposits decreased to $0.8 million and $1.8 million for the three and six months ended June 30, 2021, respectively, compared to $1.3 million and $3.4 million for the three and six months ended June 30, 2020, respectively.

Average interest bearing deposits increased $18.5 million, or 2.0%, to $954.1 million for the quarter ended June 30, 2021 compared to $935.6 million for the quarter ended June 30, 2020. The average cost of deposits decreased to 0.33% for the quarter ended June 30, 2021 compared to 0.57% for the quarter ended June 30, 2020.

Average interest bearing deposits increased $36.4 million, or 3.9%, to $967.9 million for the six months ended June 30, 2021 compared to $931.5 million for the six months ended June 30, 2020. The average cost of deposits decreased to 0.37% for the six months ended June 30, 2021 compared to 0.74% for the six months ended June 30, 2020. Although offering rates remain low in response to lower market interest rates, growth in deposits was positively impacted in part by customers who deposited both economic stimulus payments and PPP loan proceeds.

Interest expense on borrowings was $0.7 million and $1.5 million for the three and six months ended June 30, 2021, respectively, compared to $1.1 million and $2.2 million for the three and six months ended June 30, 2020, respectively.

Average borrowings decreased to $189.6 million for the quarter ended June 30, 2021 compared to $225.8 million for the quarter ended June 30, 2020. The average cost of borrowings decreased to 1.52% for the quarter ended June 30, 2021 compared to 1.87% for the quarter ended June 30, 2020.

Average borrowings decreased to $189.4 million for the six months ended June 30, 2021 compared to $204.8 million for the six months ended June 30, 2020. The average cost of borrowings decreased to 1.54% for the six months ended June 30, 2021 compared to 2.18% for the six months ended June 30, 2020. The decrease in cost of funds primarily resulted from lower market interest rates.

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

Non-interest Income and Expense

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


	Three Months Ended June 30,											Six Months Ended June 30,
(In thousands)	2021			2020			$ Change		% Change			2021			2020			$ Change		% Change
Non-interest income
Service charges and other fees	$	765		$	566		$	199		35.2	%	$	1,503		$	1,364		$	139		10.2	%
Bank card income and fees		1,022			812			210		25.9			1,882			1,505			377		25.0
Trust department income		308			279			29		10.4			602			658			(56)		(8.5)
Real estate servicing fees, net		351			(16)			367		NM			424			(103)			527		(511.7)
Gain on sales of mortgage loans, net		2,042			924			1,118		121.0			4,511			1,344			3,167		235.6
Other		101			291			(190)		(65.3)			109			379			(270)		(71.2)
Total non-interest income	$	4,589		$	2,856		$	1,733		60.7	%	$	9,031		$	5,147		$	3,884		75.5	%
Non-interest income as a % of total revenue *		25.1	%		17.6	%							24.3	%		16.6	%

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

NM = Not meaningful

Total non-interest income increased $1.7 million, or 60.7%, to $4.6 million for the quarter ended June 30, 2021 compared to $2.9 million for the quarter ended June 30, 2020, and increased $3.9 million, or 75.5%, to $9.0 million for the six months ended June 30, 2021 compared to $5.1 million for the six months ended June 30, 2020.

Service charges and fees increased $0.2 million, or 35.2%, to $0.8 million for the quarter ended June 30, 2021 compared to $0.6 million for the quarter ended June 30, 2020, and increased $0.1 million, or 10.2%, to $1.5 million for the six months ended June 30, 2021, compared to $1.4 million for the six months ended June 30, 2020. The Company experienced lower service charge income during 2020 primarily due to a decrease in nonsufficient fund service charges (NSF) collected resulting from both a decrease in volume, in addition to temporary fee waivers for customers related to the COVID-19 pandemic.

Bank Card and Credit card transaction fees increased $0.2 million, or 25.9%, to $1.0 million for the quarter ended June 30, 2021 compared to $0.8 million for the quarter ended June 30, 2020, and increased $0.4 million, or 25.0%, to $1.9 million for the six months ended June 30, 2021, compared to $1.5 million for the six months ended June 30, 2020. The increases were primarily related to increases in debit card usage and interchange fees. As the economy began to recover from the COVID 19 pandemic, the Company began to see an increase in spending due to both stimulus income and a reduction of conservative savings due to the uncertainty of the pandemic.

Real estate servicing fees, net of the change in valuation of mortgage servicing rights (MSRs) increased $0.4 million to $0.4 million for the quarter ended June 30, 2021 compared to $(16,000) for the quarter ended June 30, 2020, and increased $0.5 million to $0.4 million for the six months ended June 30, 2021 compared to $(0.1) million for the six months ended June 30, 2020.

Mortgage loan servicing fees earned on loans sold were $0.2 million and $0.4 million for the three and six months ended June 30, 2021, respectively, compared to $0.2 million and $0.4 million for the three and six months ended June 30, 2020, respectively. The current quarter's MSR valuation increased $0.3 million from the prior linked quarter primarily due to decreased prepayment assumptions. The dramatic drop in market interest rates created an economic incentive for borrowers to refinance their existing home mortgage loans during 2020 that has slowed down in 2021.

The Company was servicing $286.6 million of mortgage loans at June 30, 2021 compared to $292.7 million and $273.8 million at December 31, 2020 and June 30, 2020, respectively.

Gain on sales of mortgage loans increased $1.1 million to $2.0 million for the quarter ended June 30, 2021 compared to $0.9 million for the quarter ended June 30, 2020, and increased $3.2 million to $4.5 million for the six months ended June 30, 2021 compared to $1.3 million for the six months ended June 30, 2020. The Company sold $61.9 million and $128.5 million of loans for the three and six months ended June 30, 2021, respectively, compared to $35.5 million and $47.7 million for the three and six months ended June 30, 2020, respectively. The increase in loans sales is directly attributed to the formation of the mortgage loan group in the fourth quarter of 2019, and significant growth in 2020.

Other Income decreased $0.2 million, or 65.3%, to $0.1 million for the quarter ended June 30, 2021 compared to $0.3 million for the quarter ended June 30, 2020, and decreased $0.3 million, or 71.2%, to $0.1 million for the six months ended June 30, 2021 compared to $0.4 million for the six months ended June 30, 2020. The decreases resulted from a decrease in net gains on sales of other real estate owned and net losses on disposal of fixed assets, and a reduction in rent received on foreclosed properties. In the quarter ended June 30, 2020, the Company sold an out-of-service branch building being held as other real estate owned (OREO) to a non-profit organization. This transaction consisted of a $266,000 donation expense and the Company realized a net gain of $210,000. These decreases were partially offset by an increase in brokerage income.


	Three Months Ended June 30,				Six Months Ended June 30,
(in thousands)	2021		2020		2021		2020
Investment securities gains, net
Available-for-sale securities:
Gross realized gains	$	—	$	6	$	2	$	6
Gross realized losses		—		—		—		—
Other-than-temporary impairment recognized		—		—		—		—
Other investment securities:
Fair value adjustments, net		—		1		13		—
Investment securities gains, net	$	—	$	7	$	15	$	6

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


	Three Months Ended June 30,										Six Months Ended June 30,
(In thousands)	2021			2020			$ Change		% Change		2021			2020			$ Change		% Change
Non-interest expense
Salaries	$	5,151		$	4,992		$	159	3.2	%	$	10,492		$	9,505		$	987	10.4	%
Employee benefits		1,804			1,519			285	18.8			3,608			3,128			480	15.3
Occupancy expense, net		719			757			(38)	(5.0)			1,490			1,522			(32)	(2.1)
Furniture and equipment expense		753			763			(10)	(1.3)			1,497			1,514			(17)	(1.1)
Processing, network and bank card expense		1,225			954			271	28.4			2,233			1,929			304	15.8
Legal, examination, and professional fees		385			407			(22)	(5.4)			789			774			15	1.9
Advertising and promotion		309			222			87	39.2			552			470			82	17.4
Postage, printing, and supplies		186			193			(7)	(3.6)			390			434			(44)	(10.1)
Loan expense		229			303			(74)	(24.4)			403			427			(24)	(5.6)
Other		1,008			1,160			(152)	(13.1)			1,966			2,058			(92)	(4.5)
Total non-interest expense	$	11,769		$	11,270		$	499	4.4	%	$	23,420		$	21,761		$	1,659	7.6	%
Efficiency ratio*		64.5	%		69.6	%						63.1	%		70.2	%
Number of full-time equivalent employees		306			305							306			305

*	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 $0.5 million, or 4.4%, to $11.8 million for the quarter ended June 30, 2021 compared to $11.3 million for the quarter ended June 30, 2020, and increased $1.7 million, or 7.6%, to $23.4 million for the six months ended June 30, 2021 compared to $21.8 million for the six months ended June 30, 2020.

Salaries increased $0.2 million, or 3.2%, to $5.2 million for the quarter ended June 30, 2021 compared to $5.0 million for the quarter ended June 30, 2020, and increased $1.0 million, or 10.4%, to $10.5 million for the six months ended June 30, 2021 compared to $9.5 million for the six months ended June 30, 2020. The increases were primarily due to adding additional personnel to the new mortgage loan department. In addition, annual merit increases average approximately 4.0% each year and were awarded in the first quarter of each year.

Employee benefits increased $0.3 million, or 18.8%, to $1.8 million for the quarter ended June 30, 2021 compared to $1.5 million for the quarter ended June 30, 2020, and increased $0.5 million, or 15.3%, to $3.6 million for the six months ended June 30, 2021 compared to $3.1 million for the six months ended June 30, 2020. The increases were primarily due to an

increase in 401(k) plan contributions, payroll taxes, medical premiums, and pension cost due to lower annual discount rate assumptions compared to the prior year's annual assumptions.

Processing, network, and bank card expense increased $0.3 million, or 28.4%, to $1.2 million for the quarter ended June 30, 2021 compared to $1.0 million for the quarter ended June 30, 2020, and increased $0.3 million, or 15.8%, to $2.2 million for the six months ended June 30, 2021 compared to $1.9 million for the six months ended June 30, 2020. These increases were primarily related to increases in network, processing, and debit card processing expenses, partially offset by decreases in credit card and ATM interchange expenses.

Loan expense decreased $74,000, or 24.4%, to $0.2 million for the quarter ended June 30, 2021 compared to $0.3 million for the quarter ended June 30, 2020, and decreased $24,000, or 5.6%, to $0.4 million for the six months ended June 30, 2021 compared to $0.4 million for the six months ended June 30, 2020. The decreases in loan expense primarily resulted from decreases in commercial and real estate third-party loan expenses. The Company experienced a decrease in commercial loan growth during the three and six months ended June 30, 2021 compared to the three and six months ended June 30, 2020. Also during 2020, the Company experienced significant real estate mortgage refinancing activity and growth in loan volume sold to the secondary market.

Other non-interest expense decreased $0.2 million, or 13.1%, to $1.0 million for the quarter ended June 30, 2021 compared to $1.2 million for the quarter ended June 30, 2020, and decreased $92,000, or 4.5%, to $2.0 million for the six months ended June 30, 2021 compared to $2.1 million for the six months ended June 30, 2020. The decreases were primarily related to a decrease in donations, pension net interest cost, and insurance reserves. In the quarter ended June 30, 2020, the Company sold an out-of-service branch building being held as other real estate owned (OREO) to a non-profit organization. This transaction consisted of a $266,000 donation expense and the Company realized a net gain of $210,000. These decreases were partially offset by an increase in the FDIC assessment expense and software expense due to new mortgage loan software. The increase in the FDIC assessment was due to the Company having received the remaining FDIC assessment credit during the first quarter of 2020 that reduced the overall assessment due in addition to an increase in deposits.

Income taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 19.7% and 19.2% for the three and six months ended June 30, 2021, respectively, compared to 18.6% and 17.9% for the three and six months ended June 30, 2020, respectively. The increase in the effective tax rate for each of the three and six months ended June 30, 2021 compared to the three and six months ended June 30, 2020 was primarily attributable to the increase in earnings and an increase in state taxes attributed to elevated earnings. The effective tax rate for each of the three and six months ended June 30, 2021 and 2020, respectively, is lower than the U.S. federal statutory rate of 21% primarily due to tax-free revenues.

Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 74.6% of total assets as of June 30, 2021 compared to 73.2% as of December 31, 2020.

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

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


	June 30, 2021				December 31, 2020
(In thousands)	Amount		% of Loans		2020		% of Loans
Commercial, financial, and agricultural (a)	$	263,511	20.4	%	$	272,918	21.2	%
Real estate construction − residential		35,760	2.8			29,692	2.3
Real estate construction − commercial		74,788	5.8			78,144	6.1
Real estate mortgage − residential		267,264	20.7			262,339	20.4
Real estate mortgage − commercial		628,075	48.5			617,133	48.0
Installment and other consumer		24,496	1.9			26,741	2.1
Total loans held for investment	$	1,293,894	100.0	%	$	1,286,967	100.0	%

(a)	Includes $49.6 million and $63.3 million of SBA PPP loans, net as of June 30, 2021 and December 31, 2020, respectively.

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

The Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers but are not funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. During the six months ended June 30, 2021, the Company sold approximately $128.5 million of loans to investors compared to $47.7 million for the six months ended June 30, 2020. At June 30, 2021, the Company was servicing approximately $286.6 million of loans sold to the secondary market compared to $292.7 million at December 31, 2020, and $273.8 million at June 30, 2020.

Risk Elements of the Loan Portfolio

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

Non-performing Assets

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


	June 30,			December 31,			June 30,
(In thousands)	2021			2020			2020
Non-accrual loans:
Commercial, financial, and agricultural	$	6,564		$	6,717		$	3,022
Real estate construction − residential		—			192			—
Real estate construction − commercial		112			200			959
Real estate mortgage − residential		1,773			2,105			3,310
Real estate mortgage − commercial		25,313			25,314			1,521
Installment and other consumer		21			31			37
Total	$	33,783		$	34,559		$	8,849
Loans contractually past - due 90 days or more and still accruing:
Real estate mortgage - residential	$	—		$	—		$	51
Installment and other consumer		5			17			7
Total	$	5		$	17		$	58
Total non-performing loans (a)		33,788			34,576			8,907
Other real estate owned and repossessed assets		11,938			12,291			12,520
Total non-performing assets	$	45,726		$	46,867		$	21,427

Loans held for investment	$	1,293,894		$	1,286,967		$	1,280,615
Allowance for loan losses to loans		1.45	%		1.41	%		1.30	%
Non-performing loans to loans (a)		2.61	%		2.69	%		0.70	%
Non-performing assets to loans (b)		3.53	%		3.64	%		1.67	%
Non-performing assets to assets (b)		2.68	%		2.70	%		1.27	%
Allowance for loan losses to non-performing loans		55.45	%		52.39	%		186.62	%

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

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

Total non-performing assets were $45.7 million, or 3.53% of total loans, at June 30, 2021 compared to $46.9 million, or 3.64% of total loans, at December 31, 2020, and $21.4 million, or 1.67% of total loans, at June 30, 2020, respectively.

Total non-accrual loans at June 30, 2021 decreased $0.8 million, or 2.2%, to $33.8 million compared to $34.6 million at December 31, 2020. Loans past due 90 days and still accruing interest at June 30, 2021 were $5,000 compared to $17,000 at December 31, 2020. Other real estate and repossessed assets were $11.9 million and $12.3 million at June 30, 2021 and December 31, 2020, respectively. During the six months ended June 30, 2021, $30,000 of non-accrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to no such loan movements during the six months ended June 30, 2020.

As of June 30, 2021, approximately $6.9 million of loans classified as substandard, which include performing TDRs, and not included in the non-performing asset table, were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms compared to $6.0 million and $5.7 million at December 31, 2020 and June 30, 2020, respectively. Management believes the allowance for loan losses was sufficient to cover the risks and probable losses related to such loans at June 30, 2021 and December 31, 2020, respectively.

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


	June 30, 2021					December 31, 2020
	Number of	Recorded		Specific		Number of	Recorded		Specific
(In thousands)	contracts	Investment		Reserves		contracts	Investment		Reserves
Performing TDRs
Commercial, financial and agricultural	7	$	798	$	36	7	$	835	$	90
Real estate mortgage − residential	5		1,136		46	5		1,521		28
Real estate mortgage − commercial	2		334		7	2		343		7
Installment and other consumer	4		40		5	5		77		10
Total performing TDRs	18	$	2,308	$	94	19	$	2,776	$	135
Non-performing TDRs
Commercial, financial and agricultural *	1	$	—	$	—	1	$	4	$	1
Real estate mortgage − residential	6		748		60	8		895		78
Total non-performing TDRs	7	$	748	$	60	9	$	899	$	79
Total TDRs	25	$	3,056	$	154	28	$	3,675	$	214

* Amounts less than $1,000 are not reported

At June 30, 2021, loans classified as TDRs totaled $3.1 million, with $154,000 of specific reserves compared to $3.7 million of loans classified as TDRs, with $214,000 of specific reserves at December 31, 2020. Non-performing loans, included $0.8 million of loans classified as TDRs at June 30, 2021 compared to $0.9 million at December 31, 2020. Both performing and non-performing TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs if the loan is collateral dependent. The net decrease in total TDRs from December 31, 2020 to June 30, 2021 was primarily due to $620,000 of payments received on TDRs.

Allowance for Loan Losses and Provision

Allowance for Loan Losses

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


	June 30,		December 31,
(In thousands)	2021		2020
Allocation of allowance for loan losses at end of period:
Commercial, financial, and agricultural	$	5,336	$	5,121
Real estate construction − residential		251		213
Real estate construction − commercial		495		475
Real estate mortgage − residential		2,467		2,679
Real estate mortgage − commercial		9,915		9,354
Installment and other consumer		252		264
Unallocated		19		7
Total	$	18,735	$	18,113

The allowance for loan losses (ALL) was $18.7 million, or 1.45% of loans outstanding, at June 30, 2021 compared to $18.1 million, or 1.41%, at December 31, 2020, and $16.6 million, or 1.30% at June 30, 2020. The ratio of the ALL to non-performing loans was 55.45% at June 30, 2021, compared to 52.39% at December 31, 2020, and 186.62% at June 30, 2020.

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


	June 30,		December 31,
(In thousands)	2021		2020
Allocation of allowance for loan losses:
Individually evaluated for impairment − specific reserves	$	5,355	$	5,113
Collectively evaluated for impairment − general reserves		13,380		13,000
Total	$	18,735	$	18,113

The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At June 30, 2021, $5.4 million of the Company’s ALL was allocated to impaired loans totaling approximately $36.1 million compared to $5.1 million of the Company’s ALL allocated to impaired loans totaling approximately $37.3 million at December 31, 2020. Management determined that $12.4 million, or 34%, of total impaired loans required no reserve allocation at June 30, 2021 compared to $11.9 million, or 32%, at December 31, 2020, primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

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

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

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

Provision

resulted primarily from the impact of net recoveries and improvement in the economic outlook as the economy begins to recover from the impacts of the COVID-19 pandemic, which significantly impacted provision in 2020. Criticized loan levels remain elevated when compared to pre-pandemic levels due to the downgrade of loans to borrowers that have been impacted by the COVID-19 pandemic.

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


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands)	2021		2020		2021		2020
Analysis of allowance for loan losses:
Balance beginning of period	$	18,361	$	15,693	$	18,113	$	12,477
Charge-offs:
Commercial, financial, and agricultural		28		43		55		84
Real estate mortgage − residential		4		33		3		52
Real estate mortgage − commercial		3		2		26		24
Installment and other consumer		46		39		104		91
Total charge-offs	$	81	$	117	$	188	$	251
Recoveries:
Commercial, financial, and agricultural	$	33	$	66	$	183	$	91
Real estate construction − residential		—		32		13		32
Real estate mortgage − residential		7		27		175		36
Real estate mortgage − commercial		—		1		—		3
Installment and other consumer		15		20		39		34
Total recoveries	$	55	$	146	$	410	$	196
Net charge-offs (recoveries)		26		(29)		(222)		55
Provision for loan losses		400		900		400		4,200
Balance end of period	$	18,735	$	16,622	$	18,735	$	16,622

Net Loan Charge-offs (recoveries)

The Company’s net charge-offs were $26,000 for the three months ended June 30, 2021 compared to net recoveries of $29,000 for the three months ended June 30, 2020, and net recoveries were $222,000 for the six months ended June 30, 2021 compared to net charge-offs of $55,000 for the six months ended June 30, 2020. During the first quarter of 2021 the Company received commercial and a real estate mortgage recoveries primarily related to two loan relationships

Loans Held For Sale

The Company designates certain long-term fixed rate personal real estate loans as held for sale, and the Company carries them at the lower of cost or fair value. The loans are primarily sold to Freddie Mac, Fannie Mae, and PennyMac and other various secondary market investors. At June 30, 2021, the carrying amount of these loans was $2.5 million compared to $5.1 million at December 31, 2020.

In the fourth quarter of 2019 the Company expanded its current home mortgage loan program to better serve its customers. This expansion began with hiring new mortgage lending personnel and expanding the Bank’s available loan products and upgrading the Company's operating systems. New home loan programs for its customers include: VA loans, designed for military families and veterans; USDA loans for those buying homes in rural communities; and FHA loans, which offer low down payments and flexible underwriting guidelines. In addition, we have added several secondary market investors, allowing us to sell loans on the secondary market versus servicing them at the Company. This provides us with the ability to offer clients more aggressive pricing and at the same time improve the Company's financial return.

Liquidity and Capital Resources

Liquidity Management

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

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

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


	June 30,		December 31,
(In thousands)	2021		2020
Federal funds sold and other interest-bearing deposits	$	58,514	$	161,128
Certificates of deposit in other banks		7,165		9,376
Available-for-sale investment securities		276,013		198,030
Total	$	341,692	$	368,534

Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available-for-sale investment portfolio was $276.0 million at June 30, 2021 and included an unrealized net gain of $2.9 million. The portfolio includes projected maturities and mortgage-backed securities pay-downs of approximately $4.9 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 June 30, 2021 and December 31, 2020, the Company’s unpledged securities in the available-for-sale portfolio totaled approximately $66.6 million and $44.1 million, respectively.

Total investment securities pledged for these purposes were as follows:


	June 30,		December 31,
(In thousands)	2021		2020
Investment securities pledged for the purpose of securing:
Federal Reserve Bank borrowings	$	10,882	$	9,115
Federal funds purchased and securities sold under agreements to repurchase		53,654		59,695
Other deposits		144,918		85,130
Total pledged, at fair value	$	209,454	$	153,940

Liquidity is available from the Company’s base of core customer deposits, defined as demand, interest checking, savings, money market deposit accounts, and time deposits less than $250,000, less all brokered deposits under $250,000. At June 30, 2021, such deposits totaled $1.3 billion and represented 92.9% 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.

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


	June 30,		December 31,
(In thousands)	2021		2020
Core deposit base:
Non-interest bearing demand	$	433,288	$	382,492
Interest checking		252,600		292,375
Savings and money market		421,442		391,248
Other time deposits		175,666		183,072
Total	$	1,282,996	$	1,249,187

Time deposits and certificates of deposit of $250,000 and greater at June 30, 2021 and December 31, 2020 were $66.6 million and $91.3 million, respectively. The Company had brokered deposits totaling $30.2 million and $40.2 million at June 30, 2021 and December 31, 2020, respectively.

Other components of liquidity are the level of borrowings from third-party sources and the availability of future credit. The Company’s outside borrowings are comprised of securities sold under agreements to repurchase, Federal Home Loan Bank advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of June 30, 2021, under agreements with these unaffiliated banks, the Bank may borrow up to $60.0 million in federal funds on an unsecured basis and $10.5 million on a secured basis. There were no federal funds purchased outstanding at June 30, 2021. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company’s investment portfolio. At June 30, 2021, there were $32.0 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 June 30, 2021.

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

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


	June 30,		December 31,
(In thousands)	2021		2020
Borrowings:
Federal funds purchased and securities sold under agreements to repurchase	$	32,018	$	45,154
Federal Home Loan Bank advances		93,540		106,660
Subordinated notes		49,486		49,486
Other borrowings		14		14
Total	$	175,058	$	201,314

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

from the discount window. 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:


	June 30,								December 31,
	2021								2020
					Federal								Federal
					Funds								Funds
			Federal		Purchased						Federal		Purchased
(In thousands)	FHLB		Reserve Bank		Lines		Total		FHLB		Reserve Bank		Lines		Total
Advance equivalent	$	283,148	$	10,498	$	60,000	$	353,646	$	300,633	$	8,898	$	56,835	$	366,366
Letters of credit		(1,000)		—		—		(1,000)		(123,000)		—		—		(123,000)
Advances outstanding		(93,540)		—		—		(93,540)		(106,660)		—		—		(106,660)
Total available	$	188,608	$	10,498	$	60,000	$	259,106	$	70,973	$	8,898	$	56,835	$	136,706

At June 30, 2021, loans of $537.1 million were pledged at the FHLB as collateral for borrowings and letters of credit. At June 30, 2021, investments totaling $10.9 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.

Based upon the above, management believes the Company has more than adequate liquidity, both on balance sheet and through the additional funding capacity with the FHLB, the Federal Reserve Bank and Federal funds purchased lines to meet future anticipated needs in both the short and long-term; this includes accounting for the impact of the COVID-19 pandemic, which is difficult to currently measure. Management believes the most significant impact to the Company’s liquidity position in the short-term may be related to the PPP as loans are expected to be forgiven and depositors may choose to redirect their funds. The longer-term impact on the Company's liquidity from the pandemic will be closely monitored and addressed as needs arise.

The Company also has available additional liquidity having pledged the PPP loans to the FHLB as collateral for available advances.

Sources and Uses of Funds

Cash and cash equivalents were $76.4 million at June 30, 2021 compared to $180.4 million at December 31, 2020. The $103.9 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 six months ended June 30, 2021. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $13.0 million for the six months ended June 30, 2021.

Investing activities consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio used total cash of $84.2 million during the six months ended June 30, 2021. The cash outflow primarily consisted of $114.5 million in purchases of investment securities partially offset by $34.3 million from maturities and calls of investment securities. Management intends to continue to grow the investment portfolio based on available liquidity.

Financing activities used total cash of $32.7 million during the six months ended June 30, 2021, resulting primarily from a $53.4 million decrease in interest-bearing transaction accounts and time deposits, a $13.1 million decrease in securities sold under agreements to repurchase, and a $13.1 million repayment of FHLB advances, partially offset by a $50.8 million increase in demand deposits. The growth in demand deposits was positively impacted by customers who deposited both economic stimulus payments and PPP loan proceeds into demand accounts. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2021.

In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company’s various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company’s liquidity. The Company had $297.2 million in unused loan commitments and standby letters of credit as of June 30, 2021. Although the Company’s current liquidity resources are adequate to fund this commitment level the nature of these commitments is such that the likelihood of such a funding demand is very low.

The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company’s ongoing liquidity needs primarily include funding its operating expenses, paying cash dividends to its shareholders and, to a lesser extent, repurchasing its shares of common stock. The Company paid cash dividends to its shareholders totaling approximately $1.7 million and $1.5 million for the six months ended June 30, 2021 and 2020, respectively. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $4.5 million and $2.5 million in dividends to the Company during the six months ended June 30, 2021 and 2020, respectively. At June 30, 2021 and December 31, 2020, the Company had cash and cash equivalents totaling $1.8 million and $2.0 million, respectively. Subject to declaration by the Company's Board of Directors, the Company expects to continue paying quarterly cash dividends as a part of its current capital allocation strategy. Future dividends will be subject to the determination, declaration and discretion of the Company's Board of Directors and compliance with applicable regulatory capital requirements.

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

Capital Management

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

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

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

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

Financial institutions are categorized as well capitalized or adequately capitalized, based on minimum total risk-based, Tier 1 risk-based, CET1 and Tier 1 leverage ratios. As shown in the table below, the Company’s capital ratios exceeded the regulatory definition of adequately capitalized as of June 30, 2021 and December 31, 2020. Based upon the information in its most recently filed call report, the Bank met the capital ratios necessary to be well capitalized. The regulatory authorities can apply changes in classification of assets and such changes may retroactively subject the Company to changes in capital ratios. Any such change could reduce one or more capital ratios below well-capitalized status. In addition, a change may result in imposition of additional assessments by the FDIC or could result in regulatory actions that could have a material effect on our condition and results of operations. In addition, bank holding companies generally are required to maintain a Tier 1 leverage ratio of at least 4%.

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

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


					Minimum Capital				Required to be
					Required - Basel III				Considered Well-
	Actual				Fully Phased-In				Capitalized
(in thousands)	Amount		Ratio		Amount		Ratio		Amount		Ratio
June 30, 2021
Total Capital (to risk-weighted assets):
Company	$	201,020	14.66	%	$	143,944	10.50	%	$	—	N.A	%
Bank		199,684	14.60			143,562	10.50			136,725	10.00
Tier 1 Capital (to risk-weighted assets):
Company	$	180,936	13.20	%	$	116,526	8.50	%	$	—	N.A	%
Bank		182,572	13.35			116,217	8.50			109,380	8.00
Common Equity Tier 1 Capital (to risk-weighted assets):
Company	$	135,862	9.91	%	$	95,963	7.00	%	$	—	N.A	%
Bank		182,572	13.35			95,708	7.00			88,872	6.50
Tier 1 leverage ratio (to adjusted average assets):
Company	$	180,936	10.49	%	$	68,981	4.00	%	$	—	N.A	%
Bank		182,572	10.63			68,680	4.00			85,850	5.00

December 31, 2020
Total Capital (to risk-weighted assets):
Company	$	193,220	14.97	%	$	135,518	10.50	%	$	—	N.A	%
Bank		191,504	14.87			135,186	10.50			128,748	10.00
Tier 1 Capital (to risk-weighted assets):
Company	$	172,591	13.37	%	$	109,705	8.50	%	$	—	N.A	%
Bank		175,384	13.62			109,436	8.50			102,999	8.00
Common Equity Tier 1 Capital (to risk-weighted assets)
Company	$	129,061	10.00	%	$	90,345	7.00	%	$	—	N.A	%
Bank		175,384	13.62			90,124	7.00			83,686	6.50
Tier 1 leverage ratio:
Company	$	172,591	10.19	%	$	67,724	4.00	%	$	—	N.A	%
Bank		175,384	10.41			67,394	4.00			84,243	5.00

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Asset/Liability and Interest Rate Risk

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

The principal objective of the Company’s asset and liability management function is to evaluate the interest rate risk within the balance sheet and pursue a controlled assumption of interest rate risk while maximizing earnings and preserving adequate levels of liquidity and capital. The asset and liability management function is under the guidance of ALCO with direction from the Board of Directors. The ALCO meets monthly to review, among other things, the sensitivity of the

Company’s assets and liabilities to interest rate changes, local and national market conditions and rates. ALCO also reviews the liquidity, capital, deposit mix, loan mix and investment positions of the Company.

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

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

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


	% Change in projected net interest income
Hypothetical shift in interest rates	June 30,			December 31,
(bps)	2021			2020
200		(1.02)	%		0.73	%
100		(1.36)	%		0.10	%
(100)		(2.38)	%		(1.28)	%
(200)		(3.07)	%		(1.81)	%

The change in the Company’s interest rate risk exposure from December 31, 2020 to June 30, 2021 was primarily due to a lengthening of the Company’s asset repricing schedule. In a rising rate scenario, net interest income decreases 1.02% from the current position as interest income from repricing assets is outweighed by the interest expense from repricing liabilities, predominantly the Company’s variable rate Subordinated Notes. In a decreasing rate scenario, net interest income decreases 3.07% from the current position as assets reprice to lower rates. Management believes the change in projected net interest income from interest rate shifts of up 200 bps and down 200 bps is an acceptable level of interest rate risk.

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

Effects of Inflation

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

Inflation does have an impact on the growth of total assets in the banking industry, often resulting in a need to increase capital at higher than normal rates to maintain an appropriate capital to asset ratio. In the opinion of management, inflation did not have a significant effect on the Company’s operations for the three months ended June 30, 2021.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our Company’s management has evaluated, with the participation of our principal executive and principal financial officers, the effectiveness of our disclosure controls and procedures as defined in Rules 13a – 15(e) or 15d – 15(e) of the Securities Exchange Act of 1934 as of June 30, 2021. Based upon and as of the date of that evaluation, our principal executive and principal financial officers concluded that our disclosure controls and procedures were 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 circumstances.

Changes in Internal Control Over Financial Reporting

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

Impact of New Accounting Standards

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

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

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

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

Item 1A. Risk Factors

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

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


Item 3.	Defaults Upon Senior Securities	None

Item 4.	Mine Safety Disclosures	None

Item 5.	Other Information	None

Item 6.	Exhibits


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

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

August 6, 2021	David T. Turner, Chairman of the Board, President and
	Chief Executive Officer (Principal Executive Officer)

	/s/ Stephen E. Guthrie

August 6, 2021	Stephen E. Guthrie, Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

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