Company Quick10K Filing
Quick10K
Hills Bancorporation
10-K 2018-12-31 Annual: 2018-12-31
10-Q 2018-09-30 Quarter: 2018-09-30
10-Q 2018-06-30 Quarter: 2018-06-30
10-Q 2018-03-31 Quarter: 2018-03-31
10-K 2017-12-31 Annual: 2017-12-31
10-Q 2017-09-30 Quarter: 2017-09-30
10-Q 2017-06-30 Quarter: 2017-06-30
10-Q 2017-03-31 Quarter: 2017-03-31
10-K 2016-12-31 Annual: 2016-12-31
10-Q 2016-09-30 Quarter: 2016-09-30
10-Q 2016-06-30 Quarter: 2016-06-30
10-Q 2016-03-31 Quarter: 2016-03-31
10-K 2015-12-31 Annual: 2015-12-31
10-Q 2015-09-30 Quarter: 2015-09-30
10-Q 2015-06-30 Quarter: 2015-06-30
10-Q 2015-03-31 Quarter: 2015-03-31
10-K 2014-12-31 Annual: 2014-12-31
10-Q 2014-09-30 Quarter: 2014-09-30
10-Q 2014-06-30 Quarter: 2014-06-30
10-Q 2014-03-31 Quarter: 2014-03-31
10-K 2013-12-31 Annual: 2013-12-31
8-K 2019-04-15 Earnings, Regulation FD, Exhibits
8-K 2019-04-15 Shareholder Vote
8-K 2019-03-20 Amend Bylaw, Exhibits
8-K 2018-04-19 Shareholder Vote
8-K 2018-04-16 Earnings, Regulation FD, Exhibits
8-K 2018-01-12 Other Events
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HBIA 2018-12-31
Part I
Item 1. Business
Item 1A. Risk Factors
Item 1B. Unresolved Staff Comments
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Mine Safety Disclosures
Part II
Item 5. Market for The Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6. Selected Financial Data
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Consolidated Financial Statements and Supplementary Data
Note 1. Nature of Activities and Significant Accounting Policies
Note 2. Investment Securities
Note 3. Loans
Note 4. Property and Equipment
Note 5. Interest - Bearing Deposits
Note 6. Federal Home Loan Bank Borrowings
Note 7. Accumulated Other Comprehensive Income
Note 8. Employee Benefit Plans
Note 9. Income Taxes
Note 10. Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash Restrictions
Note 11. Related Party Transactions
Note 12. Fair Value Measurements
Note 13. Parent Company Only Financial Information
Note 14. Commitments and Contingencies
Note 15. Quarterly Results of Operations (Unaudited, Amounts in Thousands, Except per Share Amounts)
Note 16. Derivative Financial Instruments
Note 17. Subsequent Events
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A. Controls and Procedures
Item 9B. Other Information
Part III
Item 10. Directors, Executive Officers and Corporate Governance
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13. Certain Relationships and Related Transactions, and Director Independence
Item 14. Principal Accounting Fees and Services
Part IV
Item 15. Exhibits, Consolidated Financial Statement Schedules
EX-10.3 ex10_3.htm
EX-10.4 ex10_4.htm
EX-10.5 ex10_5.htm
EX-21 ex2112312018.htm
EX-23.1 ex23_112312018.htm
EX-31.1 ex31_112312018.htm
EX-31.2 ex31_212312018.htm
EX-32 ex3212312018.htm

Hills Bancorporation Earnings 2018-12-31

HBIA 10K Annual Report

Balance SheetIncome StatementCash Flow

10-K 1 hbia2018123110k.htm 10-K Document

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

FORM 10-K
 
ý  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2018.
 
Commission File Number 0-12668
HILLS BANCORPORATION
(Exact name of Registrant as specified in its charter)
Iowa
 
42-1208067
(State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification No.)
 
131 E. Main Street, PO Box 160, Hills, Iowa 52235
(Address of principal executive offices)

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

No par value common stock
Title of Class

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o No þ
 
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ

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

Indicate by checkmark 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 þ No­­ o

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, 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  o
Accelerated Filer                     þ   
Non-accelerated filer    o
Small Reporting Company     o
Emerging Growth Company    o
 

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. o

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

The aggregate market value of the common stock held by non-affiliates of the registrant as of June 30, 2018, based on the most recent sale price of $58.00 per share, and 7,722,910 shares held was $447,928,780.  Common stock held by non-affiliates excludes 1,650,756 shares held by directors, executive officers, and under the Registrant’s Employee Stock Ownership Plan.

The number of shares outstanding of the Registrant's common stock as of February 28, 2019 is 9,387,412 shares of no par value common stock.

DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement dated March 15, 2019 for the Annual Meeting of the Shareholders of the Registrant to be held April 15, 2019 (the Proxy Statement) are incorporated by reference in Part III of this Form 10-K.
 
 
 
 
 



HILLS BANCORPORATION
FORM 10-K

TABLE OF CONTENTS
 
 
PART I
 
Item 1.
 
 
 
 
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
 
 
 
 
PART II
 
Item 5.
Item 6.
Item 7.
Item 7A.
Item 8.
Item 9.
Item 9A.
Item 9B.
 
 
 
 
PART III
 
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
 
 
 
 
PART IV
 
Item 15.




Page 2


PART I

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

Item 1.
Business

GENERAL

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

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

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

Lending Activities

Real Estate Loans

Real estate loans totaled $2.223 billion and comprised 84.59% of the Bank’s loan portfolio as of December 31, 2018.  The Bank’s real estate loans include construction loans and mortgage loans.

Mortgage Loans.  The Bank offers residential, commercial and agricultural real estate loans.  As of December 31, 2018, mortgage loans totaled $2.037 billion and comprised 77.51% of the Bank’s loan portfolio.

Residential real estate loans totaled $1,064.68 million and were 40.51% of the Bank’s loan portfolio as of December 31, 2018.  These loans include first and junior liens on 1 to 4 family residences.  The Bank originates 1 to 4 family mortgage loans to individuals and businesses within its trade area.  The Bank sells certain mortgage loans to third parties on the secondary market.  For the loans sold on the secondary market, the Bank does not retain any percentage of ownership or servicing rights.  Interest rates for residential real estate mortgages are determined by competitive pricing factors on the secondary market and within the Bank’s trade area.  Collateral for residential real estate mortgages is generally the underlying property.  Generally, repayment of these loans is from monthly principal and interest payments from the borrower’s personal cash flows and liquidity, and collateral values are a function of residential real estate values in the markets that the Bank serves.

Commercial real estate loans totaled $383.31 million and were 14.59% of the Bank’s loan portfolio at December 31, 2018.  The Bank originates loans for commercial properties to individuals and businesses within its trade area.  The primary source of repayment is the cash flow generated by the collateral underlying the loan.  The secondary repayment source would be the liquidation of the collateral.  Generally, terms for commercial real estate loans range from one to five years with an amortization period of 25 years or less.  The Bank offers both fixed and variable rate loans for commercial real estate.


Page 3


Multi-family real estate loans totaled $352.43 million and were 13.41% of the Bank’s loan portfolio at December 31, 2018.  Multi-family real estate loans are made to individuals and businesses in the Bank’s trade area.  These loans are primarily secured by properties such as apartment complexes.  The primary source of repayment is the cash flow generated by the collateral underlying the loan.  The secondary repayment source would be the liquidation of the collateral.  Generally, terms for commercial real estate loans range from one to five years with an amortization period of 25 years or less.  Generally, interest rates for multi-family loans are fixed for the loan term.

Mortgage loans secured by farmland totaled $236.45 million and were 9.00% of the Bank’s loan portfolio at December 31, 2018.  Loans for farmland are made to individuals and businesses within the Bank’s trade area.  The primary source of repayment is the cash flow generated by the collateral underlying the loan.  The secondary repayment source would be the liquidation of the collateral.  Terms for real estate loans secured by farmland range from one to ten years with an amortization period of 25 years or less.  Generally, interest rates are fixed for mortgage loans secured by farmland.

Construction Loans.  The Bank offers loans both to individuals that are constructing personal residences and to real estate developers and building contractors for the acquisition of land for development and the construction of homes and commercial properties.  The Bank makes these loans to established borrowers in the Bank’s trade area.  Construction loans generally have a term of one year or less, with interest payable at maturity.  Interest rate arrangements are variable for construction projects.  Generally, collateral for construction loans is the underlying construction project.

As of December 31, 2018, construction loans for personal residences totaled $72.28 million and were 2.75% of the Bank’s loan portfolio.  Construction loans for land development and commercial projects totaled $113.81 million and were 4.33% of the Bank’s loan portfolio.  In total, construction loans totaled $186.09 million and were 7.08% of the Bank’s loan portfolio as of December 31, 2018.

Commercial and Financial Loans

The Bank’s commercial and financial loan portfolio totaled $229.50 million and comprised 8.73% of the total loan portfolio at December 31, 2018.  The Bank’s commercial and financial loans include loans to contractors, retailers and other businesses.  The Bank provides a wide range of business loans, including lines of credit for working capital and operational purposes and term loans for the acquisition of equipment.  Although most loans are made on a secured basis, loans may be made on an unsecured basis where warranted by the overall financial condition of the borrower.  Terms of commercial and financial loans generally range from one to five years.  Interest rates for commercial loans can be fixed or variable.

The Bank’s commercial and financial loans are primarily made based on the reported cash flow of the borrower and secondarily on the underlying collateral provided by the borrower.  The collateral support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of personal guarantees, if applicable.  The primary repayment risks of commercial loans are that the cash flows of the borrower may be unpredictable, and the collateral securing these loans may fluctuate in value.

Agricultural Loans

Agricultural loans include loans made to finance agricultural production and other loans to farmers and farming operations.  These loans totaled $92.67 million and constituted 3.53% of the total loan portfolio at December 31, 2018.  Agricultural loans, most of which are secured by crops and machinery, are provided to finance capital improvement and farm operations as well as acquisitions of livestock and machinery.  The ability of the borrower to repay may be affected by many factors outside of the borrower’s control including adverse weather conditions, loss of livestock due to disease or other factors, declines in market prices for agricultural products and the impact of government regulations.  The ultimate repayment of agricultural loans is dependent upon the profitable operation or management of the agricultural entity.  Agricultural loans generally have a term of one year and may have a fixed or variable rate.

Consumer Lending

The Bank offers consumer loans including personal loans and automobile loans.  These consumer loans typically have shorter terms and lower balances.  At December 31, 2018, consumer loans totaled $30.07 million and were 1.14% of the Bank’s total loan portfolio.


Page 4


Loans to State and Political Subdivisions

Loans to State and Political Subdivisions include only tax-exempt loans. These loans totaled $52.73 million and comprised 2.01% of the Bank’s total loan portfolio at December 31, 2018.

Deposit Activities

The Bank’s primary funding source for its loan portfolio and other investments consist of the acceptance of demand, savings and time deposits.

Average Daily Balances

The following table shows average balances of assets, liabilities and stockholders’ equity:

AVERAGE BALANCES
(Average Daily Basis)
 
Years Ended December 31,
 
2018
 
2017
 
2016
 
(Amounts In Thousands)
ASSETS
 
 
 
 
 
Noninterest-bearing cash and cash equivalents
$
27,914

 
$
27,409

 
$
26,180

Interest-bearing cash and cash equivalents
105,609

 
37,024

 
31,886

Taxable securities
128,128

 
105,059

 
101,187

Nontaxable securities
180,912

 
168,877

 
162,742

Federal funds sold
46

 
71

 
50

Loans, net
2,487,736

 
2,340,606

 
2,159,985

Property and equipment, net
37,766

 
38,139

 
35,225

Other assets
32,178

 
39,175

 
43,558

 
$
3,000,289

 
$
2,756,360

 
$
2,560,813

LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

 
 

Noninterest-bearing demand deposits
$
364,916

 
$
342,640

 
$
312,406

Interest-bearing demand deposits
644,712

 
548,598

 
499,882

Savings deposits
832,772

 
748,862

 
684,283

Time deposits
537,575

 
451,208

 
438,173

Other borrowings
9

 
28,602

 
51,177

FHLB borrowings
228,066

 
268,411

 
231,443

Noninterest-bearing other liabilities
21,773

 
22,226

 
23,177

Interest-bearing other liabilities

 

 
872

Redeemable common stock held by Employee Stock Ownership Plan
46,089

 
42,045

 
39,172

Stockholders' equity
324,377

 
303,768

 
280,228

 
$
3,000,289

 
$
2,756,360

 
$
2,560,813

 
Other Information

The Bank’s business is not seasonal.  As of December 31, 2018, the Company had no employees and the Bank had 424 full-time and 57 part-time employees.

For additional discussion of the impact of the economy on the financial condition and results of operations of the Company, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.


Page 5


MARKET AREA

Johnson County

The Bank’s trade area includes the Johnson County communities of Iowa City, Coralville, Hills and North Liberty, located near Interstate 80 and Interstate 380 in Eastern Iowa.  These communities have a combined population of approximately 119,400.  Johnson County, Iowa has a population of approximately 152,900.  The University of Iowa in Iowa City has approximately 32,900 students and 40,200 full and part-time employees, including 10,000 employees of The University of Iowa Hospitals and Clinics.

Linn County

The Bank operates offices in the Linn County, Iowa communities of Lisbon, Marion, Mount Vernon and Cedar Rapids, Iowa.  Lisbon has a population of approximately 2,200 and Mount Vernon, located two miles from Lisbon, has a population of about 4,600. Both communities are within easy commuting distances to Cedar Rapids and Iowa City, Iowa.  Cedar Rapids has a metropolitan population of approximately 173,800 including approximately 38,800 from adjoining Marion, Iowa and is located approximately 10 miles west of Lisbon, Iowa and 25 miles north of Iowa City on Interstate 380.  The total population of Linn County is approximately 227,000.  The largest employer in the Cedar Rapids area is Collins Aerospace, manufacturer of communications instruments, with approximately 9,000 employees.

Washington County

The Bank has offices located in Kalona, Washington and Wellman, Iowa, which are in Washington County.  Kalona is located approximately 14 miles north of Washington. Wellman is located approximately 5 miles west of Kalona.  Kalona has a population of approximately 2,900, Washington has a population of approximately 7,400 and Wellman has a population of about 1,400.  The population of Washington County is approximately 22,400.  Kalona, Washington and Wellman are primarily agricultural communities, but are located within easy driving distance for employment in Iowa City, Coralville and North Liberty.

COMPETITION

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


Page 6


The Bank is in direct competition for loans and deposits and financial services with a number of other banks and credit unions in Johnson, Linn and Washington County.  A comparison of the number of office locations and deposits in the three counties as of June, 2018 (most recent date of available data from the FDIC and national credit union websites) is as follows:
 
Johnson County
 
Linn County
 
Washington County
 
Offices
 
Deposits
(in millions)
 
Offices
 
Deposits
(in millions)
 
Offices
 
Deposits
(in millions)
Hills Bank and Trust Company
9

 
$
1,772

 
7

 
$
438

 
3

 
$
187

Branches of largest competing national bank
7

 
299

 
8

 
740

 
1

 
22

Largest competing independent bank
7

 
678

 
5

 
971

 
2

 
185

Largest competing credit union (1)
6

 
3,895

 
7

 
950

 
1

 
1

All other bank and credit union offices
23

 
905

 
81

 
3,239

 
8

 
207

Total Market in County
52

 
$
7,549

 
108

 
$
6,338

 
15

 
$
602


(1)
Deposit balance of the largest competing credit union in Johnson County and Linn County includes the credit union’s deposit balance for the entire institution.  County specific deposit balances for the credit union are unavailable.

SUPERVISION AND REGULATION

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

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

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

Regulation of the Company

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


Page 7


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

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

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

Regulatory Capital Requirements.  Bank holding companies are required to maintain minimum levels of capital in accordance with bank regulatory agencies' capital guidelines.  If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses. The guidelines include requirements to maintain certain core capital amounts included as Tier 1 capital at minimum levels relative to total assets (the "Tier 1 Leverage Capital Ratio") and at minimum levels relative to "risk-weighted assets" which is calculated by assigning value to assets, and off balance sheet commitments, based on their risk characteristics (the "Total Risk-Based Capital Ratio"), and to maintain total capital at minimum levels relative to risk-weighted assets (the "Total Risk-Based Capital Ratio").

On January 1, 2015, the final rules of the Federal Reserve Board went into effect implementing in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision. The final rule also adopted changes to the agencies’ regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The rule includes a new Common Equity Tier 1 Capital Ratio, an increased Tier 1 Leverage Capital Ratio and an increased Tier 1 Risk-Based Capital Ratio. Bank holding companies are required to include in Common Equity Tier 1 capital the effects of other comprehensive income adjustments, such as gains and losses on securities held to maturity, that are currently excluded from the definition of Tier 1 capital, but were allowed to make a one-time election not to include those effects. The Company and the Bank meet the well-capitalized requirements under the regulatory framework for prompt corrective action and have made the one-time election to exclude the effects of other comprehensive income adjustments on Tier 1 capital.

Under the BASEL III rules, the minimum capital ratios are 4% for Tier 1 Leverage Capital Ratio, 4.5% for the Common Equity Tier 1 Capital Ratio, 6% for the Tier 1 Risk-Based Capital Ratio and 8% for the Total Risk-Based Capital Ratio. A new capital conservation buffer is being phased in beginning January 1, 2016, at 0.625% of risk-weighted assets and increased each subsequent year by an additional 0.625% until reaching 2.5% on January 1, 2019. As of December 31, 2018, the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements, with a Tier 1 Leverage Capital Ratio of 12.68%, with Common Equity Tier 1 Ratio of 15.93%, with Tier 1 Risk-Based Capital Ratio of 15.93% and Total Risk-Based Capital Ratio of 17.18%.


Page 8


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

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

Regulation of the Bank

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

Deposit Insurance. The deposits of the Bank are insured up to regulatory limits set by the FDIC, and, accordingly in 2018, were subject to deposit insurance assessments based on the Federal Deposit Insurance Reform Act of 2005, as adopted and effective on April 21, 2006.  The FDIC maintains the Deposit Insurance Fund (“DIF”) by assessing depository institutions an insurance premium (assessment).  The amount assessed to each institution is based on the average total assets of the Company less average tangible equity as well as the degree of risk the institution poses to the DIF.  The FDIC assesses higher rates to those institutions that pose greater risks to the insurance fund.

In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation (FICO), a mixed-ownership government corporation established in the 1980’s to recapitalize the Federal Savings and Loan Insurance Corporation.  The current annualized assessment rate is 0.14 basis points, or approximately 0.035 basis points per quarter.  These assessments will continue until the FICO bonds mature in 2019.

Capital Requirements.  The Bank is an insured state bank, incorporated under the laws of the state of Iowa.  As such, the Bank is subject to regulation, supervision and periodic examination by the Superintendent.  Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements to maintain reserves against deposits, restrictions on the nature and amount of loans, and restrictions relating to investments, opening of bank offices and other activities of state banks.  Changes in the capital structure of state banks are also approved by the Superintendent.  State banks must have a Tier 1 risk-based leverage ratio of 6.50% plus a fully-funded loan loss reserve. In certain instances, the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement on the Bank.  In determining the Tier 1 risk-based leverage ratio, the Superintendent uses total equity capital without unrealized securities gains and the allowance for loan losses less any intangible assets.   At December 31, 2018, the Tier 1 risk-based leverage ratio of the Bank was 12.73% and exceeded the ratio required by the Superintendent.

Capital adequacy for banks took on an added dimension with the establishment of a formal system of prompt corrective action under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) which provides the federal banking regulators of the Bank with broad power to take prompt corrective action to resolve the problems of undercapitalized banking institutions.  The extent of the regulators’ powers depends on whether the institution in question is “well-capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized,” in each case as defined by regulation.  Under prompt corrective action, banks that are inadequately capitalized face a variety of mandatory and discretionary supervisory actions.  For example, “undercapitalized banks” must restrict asset growth, obtain prior approval for business expansion, and have an approved plan to restore capital.  “Critically undercapitalized banks” must be placed in receivership or conservatorship within 90 days unless some other action would result in lower long-term costs to the deposit insurance fund.


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The actual amounts of risk-based capital and risk-based capital ratios as of December 31, 2018 and the minimum regulatory requirements for the Company and the Bank are presented below (amounts in thousands):
 
Actual
 
For Capital Adequacy Purposes
 
To Be Well Capitalized Under Prompt Corrective Action Provisions
 
Amount
 
Ratio
 
Ratio
 
Ratio
As of December 31, 2018:
 
 
 
 
 
 
 
Company:
 
 
 
 
 
 
 
Total risk-based capital
$
414,772

 
17.18
%
 
8.00
%
 
10.00
%
Tier 1 risk-based capital
384,502

 
15.93

 
6.00

 
8.00

Tier 1 common equity
384,502

 
15.93

 
4.50

 
6.50

Leverage ratio
384,502

 
12.68

 
4.00

 
5.00

Bank:
 

 
 

 
 

 
 

Total risk-based capital
416,198

 
17.25

 
8.00

 
10.00

Tier 1 risk-based capital
385,943

 
16.00

 
6.00

 
8.00

Tier 1 common equity
385,943

 
16.00

 
4.50

 
6.50

Leverage ratio
385,943

 
12.73

 
4.00

 
5.00


Supervisory Assessments.  All Iowa banks are required to pay supervisory assessments to the Superintendent to fund the Superintendent’s examination and supervision operations.  The method of computation of the supervisory assessment is based on the assets of the bank, the expected hours needed to conduct examinations of that size bank and an additional amount if more work is required.

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

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) posed a significant impact on financial regulations.  The Dodd-Frank Act created an independent regulatory body, the Bureau of Consumer Financial Protection (“Bureau”), with authority and responsibility to set rules and regulations for most consumer protection laws applicable to all banks – large and small - adds another regulator to scrutinize and police financial activities.  The Bureau has responsibility for mortgage reform and enforcement, as well as broad new powers over consumer financial activities which could impact what consumer financial services would be available and how they are provided.   The following consumer protection laws are the designated laws that fall under the Bureau’s rulemaking authority:  the Alternative Mortgage Transactions Parity Act of 1928, the Consumer Leasing Act of 1976, the Electronic Fund Transfer Act, the Equal Credit Opportunity Act, the Fair Credit Billing Act, the Fair Credit Reporting Act subject to certain exclusions, the Fair Debt Collection Practices Act, the Home Owners Protection Act, certain privacy provisions of the Gramm-Leach-Bliley Act, the Home Mortgage Disclosure Act (HMDA), the Home Ownership and Equity Protection Act of 1994, the Real Estate Settlement Procedures Act (RESPA), the S.A.F.E. Mortgage Licensing Act of 2008 (SAFE Act), and the Truth in Lending Act.

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Dividends.  The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank.  The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends. The Iowa Banking Act provides that an Iowa bank may not pay dividends in an amount greater than its undivided profits. The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized.  As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2018.  Notwithstanding the availability of funds for dividends, however, the Superintendent may prohibit the payment of any dividends by the Bank if the Superintendent determines such payment would constitute an unsafe or unsound practice.  To maintain acceptable capital ratios in the Bank, certain of its retained earnings are not available for the payment of dividends.  To maintain a ratio of total risk-based capital to assets of 8%, $192.92 million of the Bank’s Tier 1 capital of $385.94 million as of December 31, 2018, is available for the payment of dividends to the Company. Also, the capital conservation buffer discussed previously could limit the amount of payment of dividends if the Company fails to maintain required capital levels.

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

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

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

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

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

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


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

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

Depositor Preference Statute.  In the "liquidation or other resolution" of an institution by any receiver, U.S. federal legislation provides that deposits and certain claims for administrative expenses and employee compensation against the insured depository institution would be afforded a priority over general unsecured claims against that institution, including federal funds and letters of credit.

Government Monetary Policy. The earnings of the Company are affected primarily by general economic conditions and to a lesser extent by the fiscal and monetary policies of the federal government and its agencies, particularly the Federal Reserve.  Its policies influence, to some degree, the volume of bank loans and deposits, and interest rates charged and paid thereon, and thus have an effect on the earnings of the Company's subsidiary Bank.

Dodd-Frank Wall Street Reform and Consumer Protection Act.  The Dodd-Frank Act was signed into law on July 21, 2010.  The Dodd-Frank Act represents the most sweeping financial services industry reform since the 1930s.  Generally, the Dodd-Frank Act is effective the day after it was signed into law, but different effective dates apply to specific sections of the Dodd-Frank Act.  The Dodd-Frank Act is expected to be fully phased in over twelve years.  Among other things, the Dodd-Frank Act may result in added costs of doing business and regulatory compliance burdens and affect competition among financial services entities.  Uncertainty exists as to the ultimate impact of many provisions of the Dodd-Frank Act, which could have a material adverse impact on the financial services industry as a whole and on the Company’s business, results of operations and financial condition.  Additional information, including a summary of certain provisions of the Dodd-Frank Act, is available on the Federal Deposit Insurance Corporation website at www.fdic.gov/regulations/reform/index.html.

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Item 1A.
Risk Factors

The performance of our Company is subject to various risks.  We consider the risks described below to be the most significant risks we face, but such risks are not the only risk factors that could affect us.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition or results of operations.  For a discussion of the impact of risks on our financial condition and results of operations in recent years and on forward looking statements contained in this report, reference is made to Item 7 below.

We may be adversely affected by economic conditions in the local economies in which we conduct our operations, and in the United States in general.

Our primary market includes the Iowa counties of Johnson, Linn and Washington.  Our market has been one of the strongest economic areas in Iowa exhibiting economic growth over the past ten years.  The unemployment rate for the our prime market area is favorable and the rate historically has been lower than the unemployment rates for both the United States and the State of Iowa.  However, unfavorable or uncertain economic and market conditions may adversely affect our business and profitability.  Our business faces various material risks, including credit risk, liquidity risk and the risk that the demand for our products and services will decrease.  Consumer confidence, real estate values, interest rates and investment returns could make the types of loans we originate less profitable and could increase our credit risk and litigation expense.  And, while the presence of the University of Iowa and its affiliated institutions has a significant favorable impact upon the regional economy, it is unclear what impact the State budget and funding models will have on the University of Iowa and the University of Iowa Hospitals and Clinics.

Changes in U.S. trade policies, such as the implementation of tariffs, and other factors beyond the Company’s control may adversely impact our business, financial condition and results of operations.

Throughout 2018, the U.S. government implemented tariffs on certain products from countries or entities such as Mexico, Canada, China and the European Union. These countries have issued or continue to threaten retaliatory tariffs against products from the United States, including agricultural products. The United States and these countries may impose additional tariffs and retaliatory tariffs in the future. Tariffs, retaliatory tariffs or other trade restrictions on products and materials that our customers import or export, including agricultural products such as soybeans, could cause the prices of our customers’ products to increase which could reduce demand for such products, or reduce our customer margins, and adversely impact their revenues, financial results and ability to service debt. This could adversely affect our financial condition and results of operations. In addition, to the extent changes in the political environment have a negative impact on us or on the markets in which we operate, our business, results of operations and financial condition could be materially and adversely impacted in the future.

We may be adversely impacted by recent legislation and potential additional legislation and rulemaking.

The 2008-2009 recession produced a number of new laws that impact financial institutions including the Dodd-Frank Act.  The Dodd-Frank Act established the Consumer Financial Protection Bureau (the “CFPB”) and granted it the broad authority to administer and enforce a new federal regulatory framework of consumer financial regulation.  Any changes to state and federal banking laws and regulations may adversely impact our ability to expand services and to increase the value of our business.  We are subject to extensive state and federal regulation, supervision, and legislation that govern almost all aspects of our operations.  These laws may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds.  In addition, our earnings are affected by the monetary policies of the Board of Governors of the Federal Reserve.  These policies, which include regulating the national supply of bank reserves and bank credit, may have a major effect upon the source and cost of funds and the rates of return earned on loans and investments.  The Federal Reserve influences the size and distribution of bank reserves through its open market operations and changes in cash reserve requirements against member bank deposits.  We cannot predict what effect such act and any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, but such changes could be materially adverse to our financial performance.

Our profitability and liquidity may be adversely affected by deterioration in the credit quality of, or defaults by, third parties who owe us money or other assets.

We are exposed to the risk that third parties that owe us money or other assets will not fulfill their obligations.  These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons.  Our rights against third parties may not be enforceable in all circumstances.  In addition, deterioration in the credit quality of third parties whose securities or obligations we hold could result in losses and/or adversely affect our ability to use those securities or obligations for liquidity purposes. 


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Our financial condition has not been materially impacted by the deterioration in the credit quality of third parties except as related to borrower credit quality. Management believes that the allowance for loan losses is adequate to absorb probable losses on any existing loans that may become uncollectible but cannot predict loan losses with certainty and cannot assure that our allowance for loan losses will prove sufficient to cover actual losses in the future.

Changing interest rates may adversely affect our profits.

Our income and cash flows depend to a great extent on the difference between the interest rates earned by us on interest-earning assets such as loans and investment securities and the interest rates paid by us on interest-bearing liabilities such as deposits and borrowings.  Our net interest margin will be affected by general economic conditions, fiscal and monetary policies of the federal government, and our ability to respond to changes in such rates. Our assets and liabilities are affected differently by a change in interest rates. An increase or decrease in rates, the length of loan terms or the mix of adjustable and fixed rate loans in our portfolio could have a positive or negative effect on our net income, capital and liquidity. We measure interest rate risk under various rate scenarios and using specific criteria and assumptions. A summary of this process is presented under the heading "Quantitative and Qualitative Disclosures about Market Risk" included under Item 7A of Part II of this Form 10-K. Although we believe our current level of interest rate sensitivity is reasonable and effectively managed, significant fluctuations in interest rates may have an adverse effect on our business, financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions may not fully predict or capture the impact of actual interest rate changes on our financial condition and results of operations.

We experience intense competition for loans and deposits.

Competition in banking and financial services business in our market is highly competitive and is currently undergoing significant change.  Our competitors include local commercial banks, local credit unions, online banks, mortgage companies, finance companies and other non-bank financial services providers. Increasingly, competitors are able to provide integrated financial services over a broad geographic area. Increased competition may result in a decrease in the amounts of loans and deposits, reduced spreads between loan rates and deposit rates or loan terms that are less favorable to us. Competition may also accelerate investments in technology or infrastructure. Any of these results could have a material adverse effect on our ability to grow and remain profitable.

If we do not continue to meet or exceed regulatory capital requirements and maintain our “well-capitalized” status, there could be an adverse effect on the manner in which we do business and on the confidence of our customers in us.

Under regulatory capital adequacy guidelines, we must meet guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items.  Failure to meet minimum capital requirements could have a material effect on our financial condition and could subject us to a variety of enforcement actions, as well as certain restrictions on our business.  Failure to maintain the status of “well-capitalized” under the regulatory framework could adversely affect the confidence that our customers have in us, which may lead to a decline in the demand for or a reduction in the prices that we are able to charge for our products and services. Failure to meet the guidelines could also limit our access to liquidity sources.

Our growth may require us to raise additional capital in the future, but that capital may not be available.

We may at some point need to raise additional capital to maintain our “well-capitalized” status.  Any capital we obtain may result in the dilution of the interests of existing holders of our stock.  Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance.  Accordingly, we cannot make assurances of our ability to raise additional capital if needed, or if the terms will be acceptable to us.

Our allowance for loan losses may not be adequate to cover actual losses.

Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and non-performance.  Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the loan portfolio, current economic conditions and concentrations within the portfolio.  The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes.  Economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses.  In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management.  In addition, if

Page 14


charge-offs in future periods exceed expectations, we will need additional provisions to increase the allowance for loan losses.  Any increases in the allowance for loan losses may result in a decrease in net income and capital, and may have a material adverse effect on our financial condition and results of operations.

In June 2016, the Financial Accounting Standards Board (FASB) issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments," which replaces the current "incurred loss" model for recognizing credit losses with an "expected loss" model referred to as the Current Expected Credit Loss model, or CECL. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the "incurred loss" model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. Moreover, the CECL model may create more volatility in the level of our allowance for loan losses. If we are required to increase our level of allowance for loan losses for any reason, such increase could adversely affect our business, financial condition and results of operations.

The new CECL standard will become effective for us for fiscal years beginning after December 15, 2019 and for interim periods during 2020. We are currently evaluating the impact the CECL model will have on our accounting, but we expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective.

Our loan portfolio has a large concentration of real estate loans, which involve risks specific to real estate value.

Real estate loans, which constitute a large portion of our loan portfolio, include home equity, commercial, construction and residential loans, and such loans are concentrated in the Bank’s trade area.  As of December 31, 2018, 84.59% of our loans had real estate as a primary component of collateral.  The market value of real estate may fluctuate significantly in a short period of time as a result of market conditions in the geographic area in which the real estate is located.  Adverse developments affecting real estate values in our market could increase the credit risk associated with our loan portfolio.  Also, real estate lending typically involves higher loan principal amounts and the repayment of the loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service.  Economic events or governmental regulations outside of the control of the borrower could adversely impact the future cash flow and market values of the affected properties.

If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then we may not be able to realize the amount of security that we anticipated at the time of originating the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results and financial condition.

Our real estate loans also include construction loans, including land acquisition and development.  Construction, land acquisition and development lending involves additional risks because funds are advanced based upon estimates of costs and the estimated value of the completed project.  Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio.  As a result, commercial construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor to repay principal and interest.  If our appraisal of the value of the completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project.

Commercial loans make up a significant portion of our loan portfolio.

Our commercial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower.  Repayment of our commercial loans is often dependent on the cash flows of the borrower, which may be unpredictable.  Most often, this collateral is accounts receivable, inventory, machinery and equipment.  In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.  The other types of collateral securing these loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.


Page 15


There may be issues with environmental law compliance if we take possession of real property that secures a loan.

A significant portion of our loan portfolio is secured by real property. We may foreclose on and take title to certain real property. There is a risk that hazardous substances could be found on the property and we may be liable for remediation costs, personal injury and/or property damage. We may incur substantial expenses to comply with environmental laws which may materially reduce the property's value or limit our ability to dispose of the property. The remediation costs and any other financial liabilities associated with the property could have a material adverse effect on our financial condition and results of operations.

Our agricultural loans may involve a greater degree of risk than other loans, and the ability of the borrower to repay may be affected by many factors outside of the borrower’s control.

Payments on agricultural real estate loans are dependent on the profitable operation or management of the farm property securing the loan.  The success of the farm may be affected by many factors outside the control of the borrower, including adverse weather conditions that prevent the planting of a crop or limit crop yields (such as hail, drought and floods), loss of livestock due to disease or other factors, changes in market prices for agricultural products (both domestically and internationally) and the impact of government regulation (including changes in price supports, subsidies and environmental regulation). In addition, many farms are dependent on a limited number of key individuals whose injury or death may significantly affect the successful operation of the farm.  If the cash flow from a farming operation is diminished, the borrower’s ability to repay the loan may be impaired. The primary crops in our market areas are corn and soybeans.  Accordingly, adverse circumstances affecting these crops could have an adverse effect on our agricultural real estate loan portfolio.

We also originate agricultural operating loans.  As with agricultural real estate loans, the repayment of operating loans is dependent on the successful operation or management of the farm property.  Likewise, agricultural operating loans involve a greater degree of risk than lending on residential properties, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as farm equipment or assets such as livestock or crops.  The primary livestock in our market areas is hogs and turkeys.  In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.

We may be required to repurchase mortgage loans or reimburse investors and others as a result of breaches in contractual representations and warranties.

We sell residential mortgage loans to various parties that purchase mortgage loans for investment. The agreements under which we sell mortgage loans contain various representations and warranties regarding the origination and characteristics of the mortgage loans, including ownership of the loan, compliance with loan criteria set forth in the applicable agreement, validity of the lien securing the loan, absence of delinquent taxes or liens against the property securing the loan, and compliance with applicable origination laws. We may be required to repurchase mortgage loans, indemnify the investor, or reimburse the investor for credit losses incurred on loans in the event of a breach of contractual representations or warranties. The agreements under which we sell mortgage loans require us to deliver various documents to the investor, and we may be obligated to repurchase any mortgage loan as to which the required documents are not delivered or are defective.

We depend on the accuracy and completeness of information about customers and counterparties.

In deciding whether to extend credit or enter into other transactions with customers and counterparties, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements and other financial information. We also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors and accountants if made available. If this information is inaccurate, we may be subject to regulatory action, reputational harm or other adverse effects with respect to the operation of our business, our financial condition and our results of operation.

Growth levels in local and national real estate markets may impact our operations and/or financial condition.

Change in growth in the national housing market as evidenced by reports of levels of new and existing home sales, inventories of houses on the market, property values, building permits, and the time houses remain on the market may indicate increased levels of credit risk.  In past history of real estate growth, some lenders made many adjustable-rate mortgage loans, and lowered their credit standards with respect to mortgage loans and home equity loans.  A subsequent slowdown in the national housing market created uncertainty and liquidity issues relating to the value of such mortgage loans, which caused disruption in credit markets.  Management will continue to monitor that the Bank has maintained appropriate lending standards in times of real estate growth and decline.  No assurance can be given that these conditions will not directly or indirectly affect our operations.


Page 16


If we are unable to continuously attract deposits and other short-term funding, our financial condition and our business prospects could be adversely affected.

In managing our liquidity, our primary source of short-term funding is customer deposits.  Our ability to continue to attract these deposits, and other short-term funding sources, is subject to variability based upon a number of factors, including the relative interest rates we are prepared to pay for these liabilities and the perception of safety of those deposits or short-term obligations relative to alternative short-term investments.  The availability and cost of credit in short-term markets depends upon market perceptions of our liquidity and creditworthiness.  Our efforts to monitor and manage liquidity risk may not be successful or sufficient to deal with dramatic or unanticipated changes in event-driven reductions in liquidity.  In such events, our cost of funds may increase, thereby reducing our net interest revenue, or we may need to dispose of a portion of our investment portfolio, which, depending on market conditions, could result in our realizing a loss or experiencing other adverse consequences.

Conditions in the financial markets may limit our access to funding to meet our liquidity needs.

Liquidity is essential to our business, as we must maintain sufficient funds to respond to the needs of depositors and borrowers.  An inability to raise funds through deposits, borrowings, the sale or pledging as collateral of loans and other assets could have a substantial adverse effect on our liquidity.  Our access to funding sources in the amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general.  Factors that could adversely affect our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us.  Our ability to borrow could also be impaired by factors that are not specific to us, such as severe disruption of the financial markets or adverse news and expectations about the prospects for the financial services industry as a whole.

As a part of our liquidity management, we use a number of funding sources in addition to core deposit growth and repayments and maturities of loans and investments.  These sources include brokered money markets and certificates of deposit, federal funds purchased, lines of credit and Federal Home Loan Bank advances.  Negative operating results or changes in industry conditions could lead to an inability to replace these additional funding sources at maturity.  Our financial flexibility could be constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates.  Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs.  In this case, our results of operations and financial condition would be adversely affected.

Reduction in the value, or impairment of our investment securities, may impact our earnings and stockholders' equity.

We maintained a balance of $331.10 million, or 10.88% of our assets, in investment securities at December 31, 2018. Changes in market interest rates may affect the value of these investment securities, with increasing interest rates generally resulting in a reduction of value. Although the reduction in value from temporary increases in market rates does not affect our income until the security is sold, it does result in an unrealized loss recorded in other comprehensive income that may reduce our stockholders' equity. Further, we periodically test our investment securities for other-than-temporary impairment in value. In assessing whether the impairment of investment securities is other-than-temporary, we consider the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability to retain our investment in the security for a period of time sufficient to allow for any anticipated recovery in fair value.

Our growth strategy relies heavily on our management team, and the unexpected loss of key managers and/or officers may adversely affect our operations.

Our success is dependent on experienced senior management with a strong local community network.  Our ability to retain the current management team is key to the successful implementation of our growth strategy.  It is equally important that we are able to continue to attract and retain quality and community-focused managers and officers.  The unexpected loss of one of our key managers and/or officers or the inability to attract qualified personnel could have an adverse effect on our operations, financial condition and reputation.

We are subject to risks associated with technological changes and the resources needed to implement the changes.

Our industry is susceptible to significant technological changes as there continue to be a high level of new technology driven products and services introduced.  Technological advancement aids us in providing customer service and increases efficiency.  Our national competitors may have more resources to invest in technological changes.  As a result they may be able to offer products and services that are more technologically advanced and that may put us at a competitive disadvantage.  Our future may depend on our ability to analyze technological changes to determine the best course of action for our business, customers and shareholders.

Page 17


We rely heavily on our network security and any system failure or data breach could subject us to increased costs as well as reputational risk.

Our operations are dependent on our ability to process financial transactions in a secure manner.  Failure in or breach of our operational or security systems or infrastructure, or those of our third-party vendors and other service providers, could disrupt our business or the businesses of our customers, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. We must ensure that information is properly protected from a variety of threats such as cyber attacks, error, fraud, sabotage, terrorism, industrial espionage, privacy violation, service interruption, and natural disaster.  These threats arise from numerous sources including human error, fraud on the part of employees or third parties, technological failure, telecommunication outages, and severe weather conditions. Information security risks for financial institutions like us have increased recently in part because of new technologies, the increased use of the internet and telecommunications technologies (including mobile devices and cloud computing) to conduct financial and other business transactions, political activism, and the increased sophistication and activities of organized crime. Although we employ detection and response mechanisms designed to contain and mitigate security incidents, early detection may be thwarted by persistent sophisticated attacks and malware designed to avoid detection.

While we have not been materially impacted by cyber incidents, we have been subject to other intentional cyber incidents from third parties over the last several years, including denial of service attacks which attempt to interrupt service to customers and malicious software attacks on computer systems which attempt to allow unauthorized entrance. We also face risks related to cyber attacks and other security breaches in connection with card transactions that typically involve the transmission of sensitive information regarding our customers through various third parties. Some of these parties have in the past been the target of security breaches and cyber attacks, and because the transactions involve third parties and environments that we do not control or secure, future security breaches or cyber attacks affecting any of these third parties could impact us through no fault of our own, and in some cases we may have exposure and suffer losses for breaches or attacks relating to them. We also rely on numerous other third party service providers to conduct other aspects of our business operations and face similar risks relating to them. While we conduct security assessments on our higher risk third party service providers, we cannot be sure that their information security protocols are sufficient to withstand a cyber attack or other security breach. There can be no assurance that cyber incidents will not occur and they could occur more frequently and on a more significant scale.

We devote significant resources to implement, maintain, monitor and regularly upgrade our systems and networks with measures such as intrusion detection and prevention and firewalls to safeguard critical business applications. The additional cost to the Company of our cyber security monitoring and protection systems and controls includes the cost of hardware and software, third party technology providers, consulting, and legal fees, in addition to the incremental cost of our personnel who focus a substantial portion of their responsibilities on cyber security. In addition, because cyber attacks can change frequently we may be unable to implement effective preventive or proactive measures in time. With the assistance of third-party service providers, we intend to continue to implement security technology and establish procedures to maintain network security, but there is no assurance that these measures will be successful. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities.

Any activity that jeopardizes our network and the security of the information stored thereon may result in significant cost and have a significant adverse effect on our reputation. We maintain insurance coverage that may, subject to policy terms and conditions, cover certain aspects of cyber risks. Such insurance coverage may be insufficient to cover all losses.

Any successful cyber attack or other security breach involving the misappropriation or other unauthorized disclosure of confidential customer information or that compromises our ability to function could severely damage our reputation, erode confidence in the security of our systems, products and services, expose us to the risk of litigation and liability, disrupt our operations and have a material adverse effect on our business. Any successful cyber attack may also subject the Company to regulatory investigations, litigation or enforcement, or require the payment of regulatory fines or penalties or undertaking costly remediation efforts with respect to third parties affected by a cyber security incident, all or any of which could adversely affect the Company’s business, financial condition or results of operations and damage its reputation.

Loss of key third-party vendor relationships or failure of a vendor to protect information of our customers or employees could adversely affect our business or result in losses.

We rely on third-party vendors to provide key components of our business operations such as data processing, recording and monitoring transactions, online and mobile banking interfaces and services, internet connections and network access. While we have performed due diligence procedures in selecting vendors, we do not control their actions. In the event that one or more of our vendors suffers a bankruptcy or otherwise becomes unable to continue to provide products or services, or fails to protect non-

Page 18


public personal information of our customers or employees, we may suffer operational impairments, reputational damage and financial losses. Replacing these third-party vendors could create significant delay and expense. Accordingly, use of such third parties creates an inherent risk to our business operations.

The potential for business interruption exists throughout our organization.

Integral to our performance is the continued efficacy of our technical systems, operational infrastructure, relationships with third parties and the array of personnel involved with bank operations. Failure by any or all of these resources subjects us to risks that may vary in size, scale and scope. This includes, but is not limited to, operational or technical failures, ineffectiveness or exposure due to interruption in third-party support, as well as the loss of key individuals or failure on the part of key individuals to perform properly. These risks are heightened during data system changes or conversions. Although management has established policies and procedures to address such failures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

Our risk management framework may not be effective in mitigating risk and loss.

We maintain an enterprise risk management program that is designed to identify, quantify, monitor, report and control the risks that we face. These include credit, liquidity, market, operational, liquidity, reputational, compliance, strategic, information technology and security, and trust risks. While we assess this program on an ongoing basis, there can be no assurance that its approach and framework for risk management and related controls will effectively mitigate risk and limit losses in our business. If conditions or circumstances arise that expose flaws or gaps in the risk management program or if its controls break down, the performance and value of our business could be adversely affected.

Our internal controls may be ineffective.

We regularly review and update our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well-designed and operated, is based in part on certain assumptions and may provide only reasonable, not absolute, assurances that the objectives of the controls are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, financial condition and results of operation.

We are subject to a variety of litigation or other proceedings, which could adversely affect our business.

We are involved from time to time in a variety of litigation or other proceedings arising out of business or operations. We establish reserves for claims when appropriate under accounting principles generally accepted in the United States of America, but costs often may be incurred in connection with a matter before any reserve has been created. In addition, the actual costs associated with resolving a claim may be substantially higher than amounts that we have reserved. Substantial legal claims could have a detrimental impact on our business, results of operations, and financial condition and may cause reputational harm.

New products and services are essential to remain competitive but may subject us to additional risks.

We consistently attempt to offer new products and services to our customers to remain competitive. There can be risks and uncertainties associated with these new products and services especially if they are newer to market products and services. We may spend significant time and resources in development of new products and services to market to customers. Through our development and implementation process we may incur risks associated with delivery timetables, pricing and profitability, compliance with regulations, effect on internal controls and shifting customer preferences. Failure to successfully manage these risks could have a material effect on our financial condition, result of operations, and business.

Our customers may decide to use non-bank competitors for financial transactions, which could result in loss of business.

Advancement in technology and other changes are increasing the ability for customers to complete financial transactions that have traditionally involved banks through non-bank competitors. Elimination of banks as intermediaries of financial transactions could result in the loss of customer deposits as well as fee income to us.

We are subject to risks associated with negative publicity.

Reputational risk arises from the potential that negative publicity regarding our business practices, whether true or not, could cause a decline in our customer base, costly litigation, or revenue reductions.  In addition, our success in maintaining our reputation depends on the ability to adapt to a rapidly changing environment including increasing reliance on social media.

Page 19


We may be adversely affected by changes in U.S. tax laws and regulations.

The Tax Cuts and Jobs Act was signed into law in December 2017, reforming the U.S. tax code. The legislation includes lowering the federal corporate income tax rate to 21 percent beginning in 2018 from a maximum rate of 35 percent, modifying the U.S. taxation of income earned outside the U.S. and limiting or eliminating various deductions, tax credits and/or other tax preferences. The legislation could negatively impact our customers because it lowers the existing caps on mortgage interest deductions and limits the state and local tax deductions. These changes could make it more difficult for borrowers to make their loan payments and could also negatively impact the housing market, which could adversely affect our business and loan growth.

Our stock is thinly traded.

The average daily trading volume of our common stock is relatively small compared to many public companies. The desired market characteristics of depth, liquidity, and orderliness require the substantial presence of willing buyers and sellers in the marketplace at any given time. In our case, this presence depends on the individual decisions of a relatively small number of investors and general economic and market conditions over which we have no control. Due to the relatively small trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause the stock price to fall more than would be justified by the inherent worth of the Company. Conversely, attempts to purchase a significant amount of our stock could cause the market price to rise above the reasonable inherent worth of the Company.

The stock market can be volatile, and fluctuations in our operating results and other factors could cause our stock price to decline.

The stock market has experienced, and may continue to experience, fluctuations that significantly impact the market prices of securities issued by many companies. Market fluctuations could adversely affect our stock price. These fluctuations have often been unrelated or disproportionate to the operating performance of particular companies. These broad market fluctuations, as well as general economic, systemic, political and market conditions, such as recessions, loss of investor confidence, or interest rate changes, may negatively affect the market price of our common stock. Moreover, our operating results may fluctuate and vary from period to period due to the risk factors set forth herein. As a result, period-to-period comparisons should not be relied upon as an indication of future performance. Our stock price could fluctuate significantly in response to the impact these risk factors have on our operating results or financial position.

There can be no assurances concerning continuing dividend payments.

Our common stockholders are only entitled to receive the dividends declared by our Board of Directors. Although we have historically paid annual dividends on our common stock, there can be no assurances that we will be able to continue to pay regular annual dividends or that any dividends we do declare will be in any particular amount. The primary source of money to pay our dividends comes from dividends paid to the Company by Hills Bank and Trust. Hills Bank and Trust’s ability to pay dividends to the Company is subject to, among other things, its earnings, financial condition and applicable regulations, which in some instances limit the amount that may be paid as dividends.
Item 1B.
Unresolved Staff Comments

None.

Item 2.
Properties

The Company's office and the main office of the Bank are located at 131 E. Main Street, Hills, Iowa.  This is a brick building containing approximately 45,000 square feet. A portion of the building was built in 1977, a two-story addition was completed in 1984, and a two-story brick addition was completed in February 2001.  With the completion of the 2001 addition, the entire Bank’s operations and administrative functions were consolidated in Hills, Iowa.  The Bank operates its business from its main office and its 18 full service branches in the Iowa counties of Johnson, Linn and Washington.  The Bank owns its main office complex and 14 of its branch offices.  Four of the Bank’s branches are leased.

All of the properties owned by the Bank are free and clear of any mortgages or other encumbrances of any type.  See Note 14 to the Consolidated Financial Statements for minimum future rental commitments for leased properties.


Page 20


Item 3.
Legal Proceedings

None.
Item 4.
Mine Safety Disclosures

Not applicable.

PART II

Item 5.
Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

As of January 31, 2019, the Company had 2,481 stockholders.  There is no established trading market for the Company's common stock, and the Company's stock is not actively traded.  Our common stock is not listed on the NASDAQ stock market or any other stock exchange.  While there is no established public trading market for our common stock, our shares are currently quoted in the inter-dealer quotation, or “over-the-counter,” marketplace under the trading symbol “HBIA.”  The principal over-the-counter market is operated by OTC Markets Group, Inc., which provides quotes for the Company on its OTC Pink tier.

The high and low bid information for the Company’s stock for each quarter of the two most recent fiscal years, as reported by OTC Market Groups, Inc., is provided below.  The prices indicated reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

 
2018
2017
 
High
Low
High
Low
1st quarter
$
57.00

$
54.75

$
54.89

$
48.00

2nd quarter
57.50

55.50

54.45

50.50

3rd quarter
59.50

58.00

54.35

52.50

4th quarter
62.99

59.00

54.15

52.60


In addition, based on the Company’s stock transfer records and information informally provided to the Company, stock trading transactions have been as follows:
 
Year
Number of Shares Traded
Number of Transactions
High Selling Price
Low Selling Price
 
2018
157,749

168

$
61.00

$
54.00

(1)
2017
93,095

176

$
54.00

$
48.00

(2)
2016
120,911

191

$
48.00

$
44.50

(3)
 
(1)
2018 transactions included repurchases by the Company of 116,962 shares of stock under the 2005 Stock Repurchase Program.  2018 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $54.00 to $61.00 per share.
(2)
2017 transactions included repurchases by the Company of 46,966 shares of stock under the 2005 Stock Repurchase Program.  2017 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $48.00 to $54.00 per share.
(3)
2016 transactions included repurchases by the Company of 85,362 shares of stock under the 2005 Stock Repurchase Program.  2016 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $44.50 to $48.00 per share.

All transactions under the 2005 Stock Repurchase Program were at a price equal to the most recent quarterly independent appraisal of the shares of the Company's common stock. The most recent independent current quarterly appraisal value of the stock is $62.00 a share. The closing bid for the Company's stock on February 15, 2019 was $60.60 a share as reported by the OTC Markets Group, Inc.

Page 21


The following performance graph provides information regarding cumulative, five-year shareholder returns on an indexed basis of the Company's Common Stock compared to the NASDAQ Market Index and the Regional-Southwest Banks Index prepared by MORNINGSTAR of Chicago, IL. The latter index reflects the performance of twenty-five bank holding companies operating principally in the Midwest as selected by MORNINGSTAR. The indexes assume the investment of $100 on December 31, 2013 in Company Common Stock, the NASDAQ Index and the Regional-Southwest Banks Index, with all dividends reinvested.
hbia201412_chart-20057a04.jpg
 
2013
2014
2015
2016
2017
2018
HILLS BANCORPORATION
$
100.00

$
111.69

$
122.31

$
133.86

$
152.79

$
174.99

REGIONAL-SOUTHWEST BANKS
$
100.00

$
96.65

$
94.07

$
142.32

$
150.05

$
136.78

NASDAQ MARKET INDEX
$
100.00

$
114.75

$
122.74

$
133.62

$
173.22

$
168.30


Note regarding the performance graph: Cumulative five-year Shareholder returns on an indexed basis. The indexes assume the investment of $100 in year with all dividends reinvested.


Page 22


The following table sets forth the Company’s equity compensation plan information as of December 31, 2018, all of which relates to stock options issued under stock option plans approved by stockholders of the Company:
Plan Category
Number of securities to
be issued upon exercise of
outstanding options,
warrants and rights (a)
Weighted-average
exercise price of
outstanding options,
warrants and rights (b)
Number of securities
remaining available for
future issuance under equity
compensation plans
[excluding securities reflected
in column (a)] (c)
Equity compensation plans approved by security holders
9,020

$
33.30

38,125

Equity compensation plans not approved by security holders



Total
9,020

$
33.30

38,125

 
On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 1,500,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”).  The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2020.  The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis.  All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis.  The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.

The following table sets forth information about the Company’s stock purchases pursuant to the 2005 Stock Repurchase Program for the quarter ended December 31, 2018:
Period in 2018
Total number of
shares purchased
Average price paid
per share
Total number of
shares purchased
as part of publicly
announced plans
or programs
Maximum number
of shares that may
yet be purchased
under the plans or
programs
October 1 to October 31
11,190

$
59.50

11,190

381,812

November 1 to November 30
1,664

60.70

1,664

380,148

December 1 to December 31
7,027

60.96

7,027

373,121

Total
19,881

$
60.12

19,881

373,121



Page 23


Item 6.
Selected Financial Data

CONSOLIDATED FIVE-YEAR STATISTICAL SUMMARY

The following table sets forth certain of our financial and statistical information for each of the years in the five-year period ended December 31, 2018.  This data should be read in conjunction with the consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.
 
2018
 
2017
 
2016
 
2015
 
2014
YEAR-END TOTALS (Amounts in Thousands)
 
 
 
 
 
 
 
 
 
Total assets
$
3,042,464

 
$
2,963,360

 
$
2,655,770

 
$
2,493,607

 
$
2,334,318

Investment securities
331,098

 
300,160

 
279,950

 
276,069

 
267,240

Loans held for sale
1,984

 
5,162

 
9,806

 
5,554

 
4,476

Loans, net
2,591,085

 
2,431,165

 
2,251,445

 
2,099,174

 
1,961,369

Deposits
2,421,124

 
2,288,565

 
2,036,312

 
1,890,702

 
1,835,069

Federal Home Loan Bank borrowings
215,000

 
295,000

 
235,000

 
225,000

 
140,000

Redeemable common stock
48,870

 
43,308

 
40,781

 
37,562

 
34,571

Stockholders' equity
334,882

 
311,716

 
289,270

 
272,175

 
255,528

 
 
 
 
 
 
 
 
 
 
EARNINGS (Amounts in Thousands)
 

 
 

 
 

 
 

 
 

Interest income
$
118,797

 
$
105,952

 
$
97,677

 
$
92,167

 
$
86,582

Interest expense
26,323

 
17,972

 
16,087

 
14,967

 
15,037

Provision for loan losses
8,497

 
1,688

 
(1,163
)
 
1,655

 
1,042

Other income
23,818

 
20,818

 
19,995

 
20,802

 
19,356

Other expenses
62,123

 
59,512

 
56,799

 
55,460

 
51,756

Income taxes
8,905

 
19,537

 
14,394

 
12,469

 
11,129

Net income
36,767

 
28,061

 
31,555

 
28,418

 
26,974

Net income before Tax Act (1)
NA
 
32,770

 
NA
 
NA
 
NA
 
 
 
 
 
 
 
 
 
 
PER SHARE
 

 
 

 
 

 
 

 
 

Net income:
 

 
 

 
 

 
 

 
 

Basic
$
3.93

 
$
3.01

 
$
3.40

 
$
3.04

 
$
2.88

Basic before Tax Act (1)
NA
 
3.51

 
NA
 
NA
 
NA
Diluted
3.92

 
3.01

 
3.40

 
3.04

 
2.87

Diluted before Tax Act (1)
NA
 
3.51

 
NA
 
NA
 
NA
Cash dividends
0.750

 
0.700

 
0.650

 
0.625

 
0.575

Book value as of December 31
35.87

 
33.39

 
31.22

 
29.20

 
27.24

Decrease in book value due to:
 
 
 
 
 
 
 
 
 

ESOP obligation
(5.23
)
 
(4.64
)
 
(4.40
)
 
(4.03
)
 
(3.69
)
Accumulated other comprehensive income
(0.35
)
 
(0.26
)
 
(0.36
)
 
(0.13
)
 
(0.05
)
 
 
 
 
 
 
 
 
 
 
SELECTED RATIOS
 
 
 
 
 
 
 
 
 

Return on average assets
1.23
%
 
1.02
%
 
1.23
%
 
1.19
%
 
1.21
%
Return on average assets before Tax Act (1)
NA
 
1.19

 
NA
 
NA
 
NA
Return on average equity
9.92

 
9.24

 
11.26

 
10.79

 
10.83

Return on average equity before Tax Act (1)
NA
 
10.79

 
NA
 
NA
 
NA
Net interest margin
3.25

 
3.43

 
3.43

 
3.50

 
3.49

Average stockholders' equity to average total assets
12.35

 
11.02

 
10.94

 
11.03

 
11.17

Dividend payout ratio
19.05

 
23.11

 
19.20

 
20.60

 
20.09

(1)
Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measures section of this report in Item 7.

Page 24


Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operation

The following discussion by management is presented regarding the financial results for the Company for the dates and periods indicated.  The discussion should be read in conjunction with the “Selected Consolidated Five-Year Statistical Summary” and the consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.

An overview of the year 2018 is presented following the section discussing a special note regarding forward looking statements.

Special Note Regarding Forward Looking Statements

This report contains, and future oral and written statements of the Company and its management may contain, forward-looking statements within the meaning of such term in the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Actual results may differ materially from those included in the forward-looking statements.  Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, the following:

The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company’s assets.
The effects of financial market disruptions and/or an economic recession, and monetary and other governmental actions designed to address such disruptions and recession.
The financial strength of the counterparties with which the Company or the Company’s customers do business and as to which the Company has investment or financial exposure.
The credit quality and credit agency ratings of the securities in the Company’s investment securities portfolio, a deterioration or downgrade of which could lead to other-than-temporary impairment of the affected securities and the recognition of an impairment loss.
The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company.
The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.
The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.
The ability of the Company to obtain new customers and to retain existing customers.
The timely development and acceptance of products and services, including products and services offered through alternative electronic delivery channels.
Technological changes implemented by the Company and by other parties, including third-party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.
The ability of the Company to develop and maintain secure and reliable technology systems.
The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.
Consumer spending and saving habits which may change in a manner that affects the Company’s business adversely.
The economic impact of natural disasters, terrorist attacks and military actions.

Page 25


Business combinations and the integration of acquired businesses and assets which may be more difficult or expensive than expected.
The costs, effects and outcomes of existing or future litigation.
Changes in accounting policies and practices that may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.
The ability of the Company to manage the risks associated with the foregoing as well as anticipated.

These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company’s financial results, is included in the Company’s filings with the Securities and Exchange Commission.

Non-GAAP Financial Measures

This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the Company's presentation of net income without the effect of the Tax Cut and Jobs Act enacted on December 22, 2017 (the "Tax Act"), and the presentation of earnings per share, return on assets and return on equity with the adjusted net income figure. Management believes these Non-GAAP financial measures provide useful information to both management and investors to analyze and evaluate the Company's financial performance. Limitations associated with non-GAAP financial measures include the risks that persons might disagree as to the appropriateness of items included in these measures. These non-GAAP disclosures should not be considered an alternative to the Company's GAAP results. The following table reconciles the non-GAAP financial measures to GAAP.
 
 
Year Ended December 31, 2017
Reconciliation of net income before effect of Tax Act to net income (GAAP):
 
 
Net Income (GAAP)
 
$
28,061

Tax Act related tax expense
 
4,709

Net Income before Tax Act related expense
 
$
32,770

 
 
 
Reconciliation of earnings per share before effect of Tax Act to earnings per share (GAAP):
 
 
Non-GAAP net income reconciled above
 
$
32,770

Weighted average shares outstanding (basic)
 
9,330,003

Earnings Per Share (basic) before effect of Tax Act
 
$
3.51

 
 
 
Weighted average shares outstanding (diluted)
 
9,334,635

Earnings Per Share (diluted) before effect of Tax Act
 
$
3.51

 
 
 
Reconciliation of return on average assets before effect of Tax Act to return on average assets (GAAP):
 
 
Non-GAAP net income reconciled above
 
$
32,770

Average assets
 
2,756,360

Return on average assets before effect of Tax Act
 
1.19
%
 
 
 
Reconciliation of return on average equity after effect of Tax Act to return on average equity (GAAP):
 
 
Non-GAAP net income reconciled above
 
$
32,770

Average equity
 
303,768

Return on average equity before effect of Tax Act
 
10.79
%



Page 26


Overview

The Company is a bank holding company engaged, through its wholly-owned subsidiary bank, in the business of commercial banking.  The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa.  The Bank was formed in Hills, Iowa in 1904.  The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion and Washington, Iowa.

The Company’s net income for 2018 was $36.77 million compared to $28.06 million in 2017. Before the effect of the Tax Act, the Company's net income for 2017 would have been $32.77 million. (1) Diluted earnings per share were $3.92 and $3.01 for the years ended December 31, 2018 and 2017, respectively. Before the effect of the Tax Act, diluted earnings per share would have been $3.51 in 2017. (1) Without the effect of the Tax Act, management estimates the Company's net income for 2018 would have been $30.96 million.

The Tax Act resulted in an approximately $4.7 million charge against net income primarily due to the write down of its deferred tax assets as a result of the Tax Act’s reduction in the base corporate tax rate from 35% to 21%. While the Tax Act negatively impacted earnings for the Company's fiscal year ended December 31, 2017, the lower corporate rate is expected to be a significant ongoing benefit to the Company.

The Bank’s net interest income is the largest component of the Bank’s revenue, and is a function of the average earning assets and the net interest margin percentage.  Net interest margin is the ratio of net interest income to average earning assets.  For the years ended December 31, 2018 and 2017, the Bank achieved a net interest margin of 3.25% and 3.43%, respectively. For the year ended December 31, 2018, net interest income on a tax equivalent basis increased by $3.56 million. In 2018, net interest income increased $7.54 million due to growth of $251.20 million in the Bank's average earning assets and decreased $3.98 million due to interest rate changes.

Highlights with respect to items on the Company’s balance sheet as of December 31, 2018 included the following:

Loans, net of allowance for loan losses and unamortized fees and costs, totaling $2.593 billion.
Net loan growth in 2018 of $159.92 million.
Deposit growth of $132.56 million in 2018.  Deposits increased to $2.421 billion and included $132.46 million of brokered deposits.
FHLB Borrowings decreased $80.00 million.
Stockholders’ equity increased $23.17 million to $334.88 million in 2018, with dividends having been paid in 2018 of $7.00 million.
Reference is made to Note 12 of the Company’s consolidated financial statements for a discussion of fair value measurements which relate to methods used by the Company in recording certain assets and liabilities on its consolidated financial statements.

The return on average equity was 9.92% in 2018 compared to 9.24% in 2017.  The returns for the three previous years, 2016, 2015 and 2014, were 11.26%, 10.79% and 10.83%, respectively. Before the effect of the Tax Act, the Company's 2017 return on average equity would have been 10.79%. (1)  The Company remains well-capitalized as of December 31, 2018 with total risk-based capital at 17.18% and Tier 1 risk-based capital at 15.93%.  The minimum regulatory guidelines are 8% and 6% respectively.  The Company paid a dividend per share of $0.750 in 2018, $0.700 in 2017 and $0.650 in the year ended December 31, 2016.

A detailed discussion of the financial position and results of operations follows this overview.








(1) Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measurement section of this report.


Page 27


Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these financial statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses.

Allowance for Loan Losses

The Company separates its portfolio loans and leases into segments for determining the allowance for loan losses. The Company's portfolio segments includes agricultural, commercial and financial, real estate, loans to individuals and obligations of state and political subdivisions. The Company further separates its portfolio into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. Classes within the real estate portfolio segment includes 1 to 4 family residential construction, land development and commercial construction, farmland, 1 to 4 family first liens, 1 to 4 family junior liens, multi-family and commercial. For an analysis of the Company's allowance for loan losses by portfolio segment and credit risk rating information by class, see Note 3 to the Company's Consolidated Financial Statements.

Loans that exhibit probable or observed credit weaknesses, as well as loans that have been modified in a troubled debt restructuring ("TDR loans"), are subject to individual review for impairment. When individual loans are reviewed for impairment, the Company determines allowances based on management's estimate of the borrower's ability to repay the loan given the availability of the collateral, other sources of cash flow, as well as evaluation of legal options available. Allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the underlying collateral.

Historical loss rates are applied to loans that are not individually reviewed for impairment. A 20 quarter migration analysis performed by management uses loan level attributes to track the movement of loans through the various credit risk rating categories in order to estimate the percentage of historical loss to apply to each specific credit risk rating in each loan category. The credit risk rating system currently utilized for allowance analysis purposes encompasses six categories.

The Company's allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include changes in lending policies and procedures; changes in national and local economic and business conditions; changes in the nature and volume of the loan portfolio; changes in the experience, ability and depth of lending management and staff; changes in the quality of the Bank's loan review system; the existence and effect of concentrations of credit; and the effect of any other identified external factors.

Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position.  As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations.   Although management believes the levels of the allowance for loan losses as of December 31, 2018 and 2017 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.


Page 28


Financial Position
Year End Amounts
2018
 
2017
 
2016
 
2015
 
2014
 
(Amounts In Thousands)
 
 
Total assets
$
3,042,464

 
$
2,963,360

 
$
2,655,770

 
$
2,493,607

 
$
2,334,318

Investment securities
331,098

 
300,160

 
279,950

 
276,069

 
267,240

Loans held for sale
1,984

 
5,162

 
9,806

 
5,554

 
4,476

Loans, net
2,591,085

 
2,431,165

 
2,251,445

 
2,099,174

 
1,961,369

Deposits
2,421,124

 
2,288,565

 
2,036,312

 
1,890,702

 
1,835,069

Federal Home Loan Bank borrowings
215,000

 
295,000

 
235,000

 
225,000

 
140,000

Redeemable common stock
48,870

 
43,308

 
40,781

 
37,562

 
34,571

Stockholders' equity
334,882

 
311,716

 
289,270

 
272,175

 
255,528

 
Total assets at December 31, 2018 increased $79.10 million, or 2.67%, from the prior year-end.  Asset growth from 2016 to 2017 was $307.59 million and represented a 11.58% increase.  The largest growth in assets occurred in Net Loans, which increased $159.92 million and $179.72 million for the years ended December 31, 2018 and 2017, respectively.  Loans held for sale to the secondary market decreased $3.18 million and $4.64 for the years ended December 31, 2018 and 2017, respectively.  Loans held for investment represent the largest component of the Bank’s earning assets.  Loans held for investment were $2.629 billion and $2.461 billion at December 31, 2018 and 2017, respectively.

The local economy that generated consistent demand for loans was a significant factor in the trend of increasing net loans in each of the last five years.  The trend of increasing Net Loans may not continue, and as a result, may not be indicative of future performance.

Loans secured by real estate represent the largest increase in loan growth.  These loans increased $154.56 million in 2018 and increased $156.76 million in 2017.  Loans secured by real estate include loans for 1 to 4 family residential properties, multi-family properties, agricultural real estate, commercial real estate and construction and development.

On a net basis, the Company originated $168.57 million and $181.63 million in loans to customers for the years ended December 31, 2018 and 2017, respectively.  Net loan originations decreased 7.19% in 2018 compared to 2017.  The decrease in net loan originations in 2018 as compared to 2017 is reflective of an increasing interest rate environment.  The Company does not engage in significant participation activity and does not purchase participations from outside its established trade area.  The Company’s policy allows for the purchase or sale of participations related to existing customers or to participate in community development activity.  The Company held participations purchased of $14.03, $14.94 and $13.88 million as of December 31, 2018, 2017 and 2016, respectively.  The participations purchased were less than one percent of loans held for investment for each of the three years.

The Company did not experience a material change in the composition of its loans held for investment in 2018 or 2017.  Residential real estate loans, including first and junior liens, were $1,064.68 million, $975.79 million and $892.87 million as of December 31, 2018, 2017 and 2016, respectively.  The dollar total of residential real estate loans increased 9.11% in 2018 and 9.29% in 2017.  Residential real estate loans were 40.51% of the loan portfolio at December 31, 2018, 39.67% at December 31, 2017 and 39.21% at December 31, 2016.  Commercial real estate loans totaled $383.31 million at December 31, 2018, a 6.12% increase over the December 31, 2017 total of $361.20 million.  Commercial real estate loans increased 8.08% in 2017.  Commercial real estate loans totaled $334.20 million at December 31, 2016.  Commercial real estate loans represented 14.59%, 14.69% and 14.67% of the Company’s loan portfolio as of December 31, 2018, 2017 and 2016, respectively.  The Company monitors its commercial real estate level so that it does not have a concentration in that category that exceeds 300% of its capital.  Commercial real estate loan concentration was 181.94% of capital as of December 31, 2018.


Page 29


The following table shows the composition of loans (before deducting the allowance for loan losses) as of December 31 for each of the last five years.  The table does not include loans held for sale to the secondary market.
 
 
 
 
 
 
 
 
 
 
 
2018
 
2017
 
2016
 
2015
 
2014
 
 
 
 
 
 
 
 
 
 
Agricultural
$
92,673

 
$
88,580

 
$
92,871

 
$
101,588

 
$
97,645

Commercial and financial
229,501

 
218,632

 
192,995

 
184,199

 
174,738

Real estate:


 
 
 
 
 
 
 
 

Construction, 1 to 4 family residential
72,279

 
69,738

 
57,864

 
51,346

 
45,949

Construction, land development and commercial
113,807

 
109,595

 
121,561

 
83,121

 
77,020

Mortgage, farmland
236,454

 
215,286

 
202,340

 
187,856

 
162,503

Mortgage, 1 to 4 family first liens
912,059

 
831,591

 
767,469

 
727,160

 
672,674

Mortgage, 1 to 4 family junior liens
152,625

 
144,200

 
125,400

 
117,873

 
110,284

Mortgage, multi-family
352,434

 
336,810

 
302,831

 
271,974

 
245,213

Mortgage, commercial
383,314

 
361,196

 
334,198

 
323,409

 
321,601

Loans to individuals
30,072

 
26,417

 
25,157

 
24,019

 
21,342

Obligations of state and political subdivisions
52,725

 
57,626

 
54,462

 
52,371

 
55,729

 
$
2,627,943

 
$
2,459,671

 
$
2,277,148

 
$
2,124,916

 
$
1,984,698

Net unamortized fees and costs
952

 
894

 
827

 
768

 
691

 
$
2,628,895

 
$
2,460,565

 
$
2,277,975

 
$
2,125,684

 
$
1,985,389

Less allowance for loan losses
37,810

 
29,400

 
26,530

 
26,510

 
24,020

 
$
2,591,085

 
$
2,431,165

 
$
2,251,445

 
$
2,099,174

 
$
1,961,369


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

The following table shows the principal payments due on loans as of December 31, 2018:
 
Amount
Of Loans
 
Amounts Due in One Year
Or Less (1)
 
Amounts Due in One To
Five Years
 
Amounts Due in Over Five
Years
 
(Amounts In Thousands)
Commercial and Agricultural
$
1,480,463

 
$
422,507

 
$
975,208

 
$
82,748

Real Estate (2)
1,064,217

 
115,092

 
732,507

 
216,618

Other
83,263

 
6,346

 
23,662

 
53,255

Totals
$
2,627,943

 
$
543,945

 
$
1,731,377

 
$
352,621

 
 
 
 
 
 
 
 
The types of interest rates applicable to these principal payments are shown below:
 
 
 
 
 
 
 
 
Fixed rate
$
1,454,297

 
$
389,790

 
$
870,189

 
$
194,318

Variable rate
1,173,646

 
154,155

 
861,188

 
158,303

 
$
2,627,943

 
$
543,945

 
$
1,731,377

 
$
352,621

 
(1)
A significant portion of the commercial loans are due in one year or less.  A significant percentage of the loans will be re-evaluated prior to their maturity and are likely to be extended.
(2)
Commercial, multi-family, construction 1 to 4 family residential, construction land development and commercial, and agricultural real estate loans are reflected in the Commercial and Agricultural total.




Page 30


The overall economy in the Company’s trade area, Johnson, Linn and Washington Counties, remains in stable condition with levels of unemployment below national and state levels.  The following table shows unemployment as of December 31, 2018, 2017 and 2016 and median income information as of December 31, 2017, 2016 and 2015, as December 31, 2018 information is not available as of the date of this report:

 
Unemployment Rate %
 
Median Income
 
2018
 
2017
 
2016
 
2017
 
2016
 
2015
United States
3.9
%
 
4.1
%
 
4.7
%
 
$
60,336

 
$
57,617

 
$
55,775

State of Iowa
2.5
%
 
2.8
%
 
3.6
%
 
58,570

 
56,247

 
54,736

Johnson County
1.7
%
 
2.0
%
 
2.4
%
 
59,965

 
56,808

 
55,700

Linn County
2.7
%
 
3.2
%
 
3.5
%
 
62,702

 
60,989

 
59,322

Washington County
2.2
%
 
2.4
%
 
2.9
%
 
59,157

 
56,864

 
56,390

 
Competition for quality loans and deposits may continue to be a challenge.  The increased competition for both loans and deposits could result in a lower interest rate margin that could result in lower net interest income if the volume of loans and deposits does not increase to offset any such reduction in the interest margin.

Total deposits increased by $132.56 million in 2018.  Deposits increased by $252.25 million in 2017.  As of June 30, 2018 (latest data available from the FDIC), Johnson County total deposits were $7.549 billion and the Company’s deposits were $1.772 billion, which represent a 23.5% market share.  The Company had nine office locations in Johnson County as of June 30, 2018.  The total banking locations in Johnson County was 52 as of June 30, 2018.  At June 30, 2017, the Company’s deposits were $1.526 billion or a 23.00% market share.  As of June 30, 2018, Linn County total deposits were $6.338 billion and there were 108 total banking locations in the county.  The seven Linn County offices of the Company had deposits of $438.41 million or a 6.9% share of the market.  The Company’s Linn County deposits at June 30, 2017 were $401.73 million and represented a 6.5% market share.  As of June 30, 2018, the Company’s three Washington County offices had deposits of $187.30 million which was 31.1% of the County’s total deposits of $601.98 million.  Washington County had a total of 15 banking locations as of June 30, 2018.  In 2017, the Company’s Washington County deposits were $159.78 million or a 27.4% market share.

The following tables show the amounts of the Company's average deposits and average rates paid on such deposits for the years ended December 31, 2018, 2017 and 2016 and the composition of the certificates of deposit issued in denominations in excess of $100,000 as of December 31, 2018, 2017 and 2016:
 
December 31,
 
2018
 
Rate
 
2017
 
Rate
 
2016
 
Rate
 
(Amounts In Thousands)
Average noninterest-bearing deposits
$
364,916

 

 
$
342,640

 

 
$
312,407

 

Average interest-bearing demand deposits
644,712

 
0.63
%
 
548,598

 
0.21
%
 
499,882

 
0.15
%
Average savings deposits
832,772

 
0.75

 
748,862

 
0.34

 
684,283

 
0.23

Average time deposits
537,575

 
1.72

 
451,208

 
1.34

 
438,173

 
1.24

 
$
2,379,975

 
 

 
$
2,091,308

 
 

 
$
1,934,745

 
 


Time certificates issued in amounts of $100,000 or more with maturity in:
 
2018
 
Rate
 
2017
 
Rate
 
2016
 
Rate
 
(Amounts In Thousands)
3 months or less
$
15,536

 
0.85
%
 
$
18,854

 
0.70
%
 
$
34,810

 
0.83
%
3 through 6 months
15,887

 
0.86

 
26,329

 
0.80

 
28,756

 
0.86

6 through 12 months
98,330

 
1.88

 
71,713

 
1.09

 
48,471

 
0.75

Over 12 months
220,972

 
2.11

 
198,662

 
1.74

 
182,797

 
1.49

 
$
350,725

 
 

 
$
315,558

 
 

 
$
294,834

 
 


Investment securities increased $30.94 million in 2018.  In 2017, investment securities increased by $20.21 million.  The investment portfolio consists of $318.93 million of securities that are stated at fair value, with any unrealized gain or loss, net of income taxes,

Page 31


reported as a separate component of stockholders’ equity.  The securities portfolio is used for liquidity and pledging purposes and to provide a rate of return that is acceptable to management.

The following tables show the carrying value of the investment securities held by the Bank, including stock of the Federal Home Loan Bank, as of December 31, 2018, 2017 and 2016 and the maturities and weighted average yields of the investment securities, computed on a tax-equivalent basis using a federal tax rate of 21%, as of December 31, 2018:
 
December 31,
 
2018
 
2017
 
2016
 
(Amounts In Thousands)
Carrying value:
 
 
 
 
 
U.S. Treasury
$
83,155

 
$
54,318

 
$
27,482

Other securities (FHLB, FHLMC and FNMA)
34,871

 
43,959

 
61,660

Stock of the Federal Home Loan Bank
12,172

 
15,005

 
12,413

Obligations of state and political subdivisions
200,900

 
186,878

 
178,395

 
$
331,098

 
$
300,160

 
$
279,950

 
 
December 31, 2018
 
Carrying
Value
 
Weighted
Average
Yield
 
(Amounts In Thousands)
U.S. Treasury
 
 
 
  Within 1 year
$
4,967

 
1.53
%
  From 1 to 5 years
78,188

 
2.27
%
 
$
83,155

 
 
Other securities (FHLB, FHLMC and FNMA), maturities:
 
 
 
Within 1 year
$
19,909

 
1.41
%
From 1 to 5 years
14,962

 
1.23

From 5 to 10 years

 

 
$
34,871

 
 

 
 
 
 
Stock of the Federal Home Loan Bank
$
12,172

 
2.94
%
 
 
 
 
Obligations of state and political subdivisions, maturities:
 

 
 

Within 1 year
$
34,095

 
2.88
%
From 1 to 5 years
87,248

 
2.57

From 5 to 10 years
78,329

 
2.78

Over 10 years
1,228

 
4.49

 
$
200,900

 
 

Total
$
331,098

 
 


As of December 31, 2018, the Company held no investment securities exceeding 10% of stockholders’ equity, other than securities of the U.S. Government agencies and corporations.  The Company does not hold any investments in FNMA preferred stock, any pooled trust preferred stocks or other preferred stock type investments.  See Note 2 to the Company’s Consolidated Financial Statements.


Page 32


During 2018, the major funding source for the growth in loans was the $132.56 million increase in deposits.  In 2017, the major source of funding for the growth in loans was the $60.00 million in additional FHLB Borrowings and deposit growth of $252.25 million.  Brokered deposits totaled $132.46 million and $284.41 million as of December 31, 2018 and 2017, respectively.  Brokered deposits decreased as of December 31, 2018 compared to December 31, 2017 due to passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act which allows reciprocal deposits to be treated as core deposits instead of brokered deposits. As of December 31, 2018, $163.41 million of reciprocal deposits are now treated as core deposits under the Act. Total advances from the FHLB were $215.00 million at December 31, 2018 and $295.00 million in 2017.  It is expected that the FHLB funding source and brokered deposits funding will be considered in the future if loan growth continues to exceed core deposit increases and the interest rates on funds borrowed from the FHLB and interest rates on brokered deposits are favorable compared to other funding alternatives.

Stockholders’ equity was $334.88 million at December 31, 2018 compared to $311.72 million at December 31, 2017.  The Company’s capital resources are discussed in detail in the Liquidity and Capital Resources section.  Over the last five years, the Company has realized cumulative earnings of $151.78 million and paid shareholders dividends of $30.82 million, or 20.31% of earnings, while maintaining capital ratios in excess of regulatory requirements.

The following table presents the return on average assets, return on average stockholders' equity, the dividend payout ratio and average stockholders’ equity to average assets ratio for the years ended December 31, 2018, 2017 and 2016:
 
2018
 
2017
 
2016
Return on average assets
1.23
%
 
1.02
%
 
1.23
%
Return on average assets before Tax Act (1)
NA
 
1.19

 
NA
Return on average stockholders' equity
9.92

 
9.24

 
11.26

Return on average equity before Tax Act (1)
NA
 
10.79

 
NA
Dividend payout ratio
19.05

 
23.11

 
19.20

Average stockholders' equity to average assets ratio
12.35

 
11.02

 
10.94

(1)
Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measures section of this report in Item 7.


Net Income Overview

Net income and diluted earnings per share for the last five years are as presented below:
Year
Net Income
 
% (Decrease) Increase
 
Earnings Per
Share - Diluted
 
(In Thousands)
 
 
 
 
2018
$
36,767

 
31.03
 %
 
$
3.92

2017
28,061

 
(11.07
)
 
3.01

2017 (1)
32,770

 
3.85

 
3.51

2016
31,555

 
11.04

 
3.40

2015
28,418

 
5.35

 
3.04

2014
26,974

 
4.02

 
2.87


(1)
Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measurement section of this report.

Net income for 2018 increased by $8.71 million or 31.03% and diluted earnings per share increased by 30.23%. Without the effect of the Tax Act, net income for 2017 would have increased by $1.22 million or 3.85%. In addition, diluted earnings per share would have increased 3.25%.(1) In 2018, net interest income increased $7.54 million due to growth of $251.20 million in the Bank's average earning assets and decreased $3.98 million due to interest rate changes. Noninterest income increased by $3.00 million, the provision for loan losses increased by $6.81 million and total noninterest expenses increased by $2.61 million.


Page 33


Annual fluctuations in the Company's net income continue to be driven primarily by three generally recurring important factors. The first important factor is net interest margin. Net interest income of $92.47 million in 2018 was derived from the Company's $2.903 billion of average earning assets and its net interest margin of 3.25%, compared to $2.652 billion of average earning assets and a 3.43% net interest margin in 2017. The importance of net interest margin is illustrated by the fact that a decrease or an increase in the net interest margin of 10 basis points would result in a $2.90 million decrease or increase in income before taxes.  Net interest margin in 2016 was 3.43%. Based on the current interest rate environment, the Company expects continued net interest compression to impact earnings for the foreseeable future.  The Company believes net interest margin in dollars will be contingent on the growth of the Company’s earnings assets. Net interest income was also impacted by the increase in interest expense of $8.35 million compared to 2017, primarily driven by interest rate increases which accounted for $7.99 million of the change.

The second significant factor affecting the Company's net income is the provision for loan losses. The majority of the Company's interest-earning assets are in loans outstanding, which amounted to $2.631 billion at the end of 2018.  The Company’s allowance for loan losses was $37.81 million at December 31, 2018.  The allowance in 2018 increased in comparison to 2017 due to an increased provision for loan losses of $6.81 million resulting from a combination of the composition of loan growth, historical loss rates, changes in the composition of loans among the credit risk ratings in 2018 and management's evaluation of qualitative factors given the current and expected deterioration in national and local economic conditions.  The loan loss provision, which is the amount necessary to adjust the allowance to the level considered appropriate by management, totaled an expense of $8.50 million for 2018, an expense of $1.69 million for 2017 and a reduction of expense of $1.16 million for 2016.  The Company may experience some credit quality deterioration in 2019.  Provision expense is expected to be dependent on the Company’s loan growth through the end of 2019. See Note 3 to the Company's Consolidated Financial Statements. A detailed discussion is included in the Provision for Loan Losses section below.

The third significant factor affecting the Company’s net income is income tax expense. Federal and state income tax expenses were $8.91 million and $19.54 million for the years ended December 31, 2018 and 2017, respectively. Income taxes as a percentage of income before taxes were 19.50% in 2018 and 41.05% in 2017. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”). The Tax Act established new tax laws that reduced the U.S. federal corporate income tax rate from 35% to 21% in 2018. Without the effect of the Tax Act, management estimates the Company's net income for 2018 would have been $30.96 million.

Net income for 2017 was $28.06 million, or diluted earnings per share of $3.01.  For 2017, diluted earnings per share decreased by $0.39 per share compared to 2016.  Net interest income increased $6.39 million for the year ended December 31, 2017 compared to 2016.  This increase in net interest income was due to an increase in average earning assets of $195.79 million in 2017.  Noninterest income increased 4.12% in 2017 to $20.82 million.  Noninterest expense increased from $56.80 million in 2016 to $59.51 million in 2017, or 4.78%.


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Net Interest Income

Net interest income is the excess of the interest and fees received on interest-earning assets over the interest paid on the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin.  The volume of average earning assets has continued to grow each year, primarily due to net loan growth.  The net interest margin was 3.25% in 2018, 3.43% in 2017, 3.43% in 2016, 3.50% in 2015, and 3.49% in 2014.  The measure is shown on a tax-equivalent basis using a rate of 21% for 2018 and 35% for 2017 and 2016 to make the interest earned on taxable and nontaxable assets more comparable.  Interest income and expense for 2018, 2017 and 2016 are indicated on the following table: 
 
Years Ended December 31,
 
2018
 
2017
 
2016
 
(Amounts In Thousands)
Income:
 
 
 
 
 
Loans (1)
$
111,172

 
$
101,564

 
$
93,744

Taxable securities
2,759

 
1,709

 
1,471

Nontaxable securities (1)
4,717

 
4,972

 
4,938

Interest-bearing cash and cash equivalents
1,939

 
433

 
163

Total interest income
$
120,587

 
$
108,678

 
$
100,316

Expense:
 

 
 

 
 

Interest-bearing demand deposits
4,056

 
1,172

 
740

Savings deposits
6,208

 
2,532

 
1,577

Time deposits
9,267

 
6,038

 
5,440

Other borrowings

 
184

 
158

FHLB borrowings
6,792

 
8,046

 
8,172

Interest-bearing other liabilities

 

 

Total interest expense
$
26,323

 
$
17,972

 
$
16,087

Net interest income
$
94,264

 
$
90,706

 
$
84,229

 
(1)  Presented on a tax equivalent basis using a rate of 21% for 2018 and 35% for 2017 and 2016.

Net interest income on a tax-equivalent basis changed in 2018 as follows:
 
Change In
 
Change In
 
Increase (Decrease)
 
Average
Balance
 
Average
Rate
 
Volume
Changes
 
Rate
Changes
 
Net
Change
 
(Amounts In Thousands)
Interest income:
 
 
 
 
 
 
 
 
 
Loans, net
$
147,130

 
0.13
 %
 
$
6,369

 
$
3,239

 
$
9,608

Taxable securities
23,069

 
0.50

 
374

 
676

 
1,050

Nontaxable securities
12,035

 
(0.33
)
 
354

 
(609
)
 
(255
)
Interest-bearing cash and cash equivalents
68,585

 
0.67

 
801

 
705

 
1,506

Federal funds sold
(25
)
 
0.99

 

 

 

 
$
250,794

 
 

 
$
7,898

 
$
4,011

 
$
11,909

Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
96,114

 
0.42
 %
 
$
(205
)
 
$
(2,679
)
 
$
(2,884
)
Savings deposits
83,910

 
0.41

 
(389
)
 
(3,288
)
 
(3,677
)
Time deposits
86,367

 
0.38

 
(1,156
)
 
(2,072
)
 
(3,228
)
Other borrowings
(28,593
)
 
2.07

 
184

 

 
184

FHLB borrowings
(40,345
)
 
(0.02
)
 
1,209

 
45

 
1,254

Interest-bearing other liabilities

 

 

 

 

 
$
197,453

 
 

 
$
(357
)
 
$
(7,994
)
 
$
(8,351
)
Change in net interest income
 

 
 

 
$
7,541

 
$
(3,983
)
 
$
3,558


Page 35



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

Net interest income on a tax equivalent basis changes for 2017 were as follows: