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.
Economic and Market Risks
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 over the past ten years. The unemployment rate for 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.
The ongoing COVID-19 pandemic and measures intended to prevent its spread could have a material adverse effect on our business, results of operations and financial condition, and such effects will depend on future developments, which are highly uncertain and are difficult to predict.
In December 2019, a novel coronavirus (COVID-19) was reported in China, and, in March 2020, the World Health Organization declared it a pandemic. On March 12, 2020, the President of the United States declared the COVID-19 outbreak in the United States a national emergency. The COVID-19 pandemic caused significant economic dislocation in the United States as many state and local governments ordered non-essential businesses to close and residents to shelter in place at home, which resulted in an unprecedented slow-down in economic activity and a related increase in unemployment throughout most of 2020 and 2021.
Government response to the COVID-19 pandemic was sweeping, including passage of the Coronavirus Aid, Relief and Economic Security Act (CARES Act) which was signed into law on March 27, 2020 and further legislation was passed in December 2020, the Coronavirus Response and Relief Supplemental Appropriations Act 2021, which extended many provisions in the CARES Act, but there can be no assurance that such steps will be effective or achieve their desired results in a timely fashion. Congress, the Federal Reserve Bank and the other U.S. state and federal financial regulatory agencies have taken actions to mitigate disruptions to economic activity and financial stability resulting from the COVID-19 pandemic. In addition, the federal banking agencies have encouraged financial institutions to prudently work with affected borrowers and passed measures to provide relief from reporting loan classifications due to modifications related to the COVID-19 outbreak.
The broader U.S. and global economies slowly began reopening during the first half of 2021 as vaccines against COVID-19 became widely available. However, labor and supply disruptions resulting from the global pandemic continue, and the emergence of new variants of COVID-19 have created ongoing health and safety concerns that may lead to further disruptions in local, national and global economies.
While significant progress has been made to combat the outbreak of COVID-19, and while it appears that the epidemiological conditions are trending in a positive direction, if there is a resurgence in the virus and any new variants thereof, the Company could experience further adverse effects on its business, financial condition, results of operations and cash flows.
The Company could be subject to any of the following risks, any of which could have a material, adverse effect on our business, financial condition, liquidity, and results of operations:
•demand for our products and services may decline, making it difficult to grow assets and income;
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•decreased consumer confidence and business generally could lead to increased risk of loan delinquencies, problem assets, and foreclosures, resulting in increased charges and reduced income;
•collateral for loans, especially real estate, may decline in value, which could cause loan losses to increase;
•our allowance for credit losses may be insufficient given the significant economic uncertainties created by the pandemic and, as a result, may have to be increased if borrowers experience financial difficulties, which will adversely affect our net income;
•the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us;
•as the result of the decline in the Federal Reserve Board’s target federal funds rate, the yield on our assets may decline to a greater extent than the decline in our cost of interest-bearing liabilities, reducing our net interest margin and spread and reducing net income;
•a material decrease in net income or a net loss over several quarters could result in a decrease in the rate of our quarterly cash dividend;
•we rely on third party vendors for certain services and the unavailability of a critical service due to the COVID-19 outbreak could have an adverse effect on us; and
•Federal Deposit Insurance Corporation premiums may increase if the agency experiences additional resolution costs.
Any one or a combination of the factors identified above could negatively impact our business, financial condition and results of operations and prospects. Even after the COVID-19 outbreak has subsided, the Company may continue to experience materially adverse impacts to our business as a result of the virus’s global economic impact, including the availability of credit, adverse impacts on our liquidity and any recession that has occurred or may occur in the future.
As a participating lender in the Paycheck Protection Program (PPP), the Company and the Bank are subject to additional risks of litigation from the Bank’s customers or other parties regarding the Bank’s processing of loans for the PPP and risks that the Small Business Administration (SBA) may not fund some or all PPP loan guarantees.
Since the opening of the PPP, several other larger banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP and claims related to agent fees. The Company and the Bank may be exposed to the risk of similar litigation from both customers and non-customers that approached the Bank regarding PPP loans. If any such litigation is filed against the Company or the Bank and is not resolved in a manner favorable to the Company or the Bank, it may result in significant financial liability or adversely affect the Company’s reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP related litigation could have a material adverse impact on our business, financial condition and results of operations.
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.
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.
The U.S. government has 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
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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, including changes with the new government administration, but such changes could be materially adverse to our financial performance.
Reduction in the value, or impairment of our investment securities, may impact our earnings and stockholders' equity.
We maintained a balance of $555.90 million, or 13.74% of our assets, in investment securities at December 31, 2021. 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. Available-for-sale (AFS) debt securities in unrealized loss positions are evaluated for impairment related to credit losses at least quarterly. For AFS debt securities, a decline in fair value due to credit loss results in recording an allowance for credit losses to the extent the fair value is less than the amortized cost basis. In assessing whether the impairment of investment securities is due to credit losses, 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.
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.
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.
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Regulatory and Legal Risks
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.
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.
Climate change and related legislative and regulatory initiatives may result in operational changes and expenditures that could significantly impact our business.
The current and anticipated effects of climate change are creating an increasing level of concern for the state of the global environment. As a result, political and social attention to the issue of climate change has increased. In recent years, governments across the world have entered into international agreements to attempt to reduce global temperatures, in part by limiting greenhouse gas emissions. The U.S. Congress, state legislatures and federal and state regulatory agencies have continued to propose and advance numerous legislative and regulatory initiatives seeking to mitigate the effects of climate change. Consumers and businesses may also change their behavior on their own as a result of these concerns. The impact on our customers will likely vary depending on their specific attributes, including reliance on or role in carbon intensive activities. Our efforts to take these risks into account in making lending and other decisions, including by increasing our business with climate-friendly companies, may not be effective in protecting us from the negative impact of new laws and regulations or changes in consumer or business behavior.
Given the lack of empirical data on the credit and other financial risks posed by climate change, it is difficult to predict how climate change may impact our financial condition and operations; however, as a banking organization, the physical effects of climate change may present certain unique risks. For example, weather disasters, shifts in local climates and other disruptions related to climate change may adversely affect the value of real properties securing our loans, which could diminish the value of our loan portfolio. Such events may also cause reductions in regional and local economic activity that may have an adverse effect on our customers, which could limit our ability to raise and invest capital in these areas and communities.
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.
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Credit and Lending Risks
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, 2021, 84.52% 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.
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.
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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.
Capital and Liquidity Risks
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.
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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.
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 credit 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 credit losses will prove sufficient to cover actual losses in the future.
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.
Competitive and Strategic Risks
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.
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.
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Accounting and Tax Risks
Our allowances for credit losses for loans and debt securities may prove inadequate or we may be negatively affected by credit risk exposures. Also, future additions to our allowance for credit losses will reduce our future earnings.
Our business depends on the creditworthiness of our customers. As with most financial institutions, we maintain allowances for credit losses for loans and debt securities to provide for defaults and nonperformance, which represent an estimate of expected losses over the remaining contractual lives of the loan and debt security portfolios. This estimate is the result of our continuing evaluation of specific credit risks and loss experience, current loan and debt security portfolio quality, present economic, political and regulatory conditions, including, but not limited to, the ongoing economic impact of the COVID-19 pandemic and the related uncertainties created thereby, industry concentrations, reasonable and supportable forecasts for future conditions and other factors that may indicate losses. The determination of the appropriate levels of the allowances for loan and debt security credit losses inherently involves a high degree of subjectivity and judgment and requires us to make estimates of current credit risks and future trends, all of which may undergo material changes. Generally, our nonperforming loans and OREO reflect operating difficulties of individual borrowers and weaknesses in the economies of the markets we serve. The allowances may not be adequate to cover actual losses, and future allowance for credit losses could materially and adversely affect our financial condition, results of operations and cash flows.
Our accounting policies and methods are fundamental to how we report our financial condition and results of operations, and we use estimates in determining the fair value of certain of our assets, the expected credit losses related to loans and debt securities, and the amount of other loss contingencies as of the balance sheet date, which estimates are subject to very large uncertainty.
A portion of our assets are carried on the balance sheet at fair value, including debt securities available for sale. Generally, for assets that are reported at fair value, we use quoted market prices or valuation models that utilize observable market data inputs to estimate their fair value as of the balance sheet date. In certain cases, observable market prices and data may not be readily available or their availability may be diminished due to market conditions. We use financial models to value certain of these assets. These models are complex and use asset-specific collateral data and market inputs for interest rates. Although we have processes and procedures in place governing valuation models and their testing and calibration, such assumptions are complex as we must make judgments about the effect of matters that are inherently uncertain. Different assumptions could have resulted in significant changes in valuation, which in turn would have affected earnings or resulted in significant changes in the dollar amount of assets reported on the balance sheet or both.
We may be adversely affected by changes in U.S. tax laws and regulations.
Changes in tax laws at national or state levels could have an effect on the Company’s short-term and long-term earnings. Changes in tax laws could affect the Company’s earnings as well as its customers’ financial positions, or both. Changes in tax laws could also require the revaluation of the Company’s net deferred tax position, which could have a material adverse effect on our results of operations and financial condition.
Operational Risks
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.
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
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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, 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.
The replacement of LIBOR could adversely affect the Company’s revenue or expenses and the value of those assets or obligations.
LIBOR and certain other “benchmarks” are the subject of recent national, international and other regulatory guidance and proposals for reform. These reforms may cause such benchmarks to perform differently than in the past or have other consequences which cannot be predicted. LIBOR is set based on interest information reported by certain banks, which may stop reporting such information after 2021. It is uncertain at this time whether LIBOR will change or cease to exist or the extent to which those entering into financial contracts will transition to any particular benchmark.
While there is no consensus on what rate or rates may become accepted alternatives to LIBOR, a group of large banks, the Alternative Reference Rate Committee or ARRC, selected by the Federal Reserve Bank of New York, started in May 2018 to publish the Secured Overnight Finance Rate or SOFR as an alternative to LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities, given the depth and robustness of the U.S. Treasury repurchase market. At this time, it is impossible to predict whether SOFR will become an accepted alternative to LIBOR.
The market transition away from LIBOR to an alternative reference rate, including SOFR, is complex and could have a range of adverse effects on the Bank’s business, financial condition and results of operations. In particular, any such transition could:
•adversely affect the interest rates paid or received on, and the revenue and expenses associated with, the Bank’s floating rate obligations, loans, deposits, derivatives and other financial instruments tied to LIBOR rates, or other securities or financial arrangements given LIBOR’s role in determining market interest rates globally;
•adversely affect the value of the Bank’s floating rate obligations, loans, deposits, derivatives and other financial instruments tied to LIBOR rates, or other securities or financial arrangements given LIBOR’s role in determining market interest rates globally;
•prompt inquiries or other actions from regulators in respect of the Bank’s preparation and readiness for the replacement of LIBOR with an alternative reference rate;
•result in disputes, litigation or other actions with counterparties regarding the interpretation and enforceability of certain fallback language in LIBOR-based securities; and
•require the transition to or development of appropriate systems and analytics to effectively transition the Bank’s risk management processes from LIBOR-based products to those based on the applicable alternative pricing benchmark, such as SOFR.
The manner and impact of this transition, as well as the effect of these developments on the Bank’s funding costs, loan and investment and trading securities portfolios, asset-liability management, and business, is uncertain.
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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.
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
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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-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.
Risks Related to the Company's Common Stock
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.
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 the Bank. The Bank’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 15 to the Consolidated Financial Statements for minimum future rental commitments for leased properties.
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Item 3. Legal Proceedings
None.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
As of January 31, 2022, the Company had 2,727 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.
High Low High Low
In addition, based on the Company’s stock transfer records and information informally provided to the Company, stock trading transactions have been as follows:
(1)2021 transactions included repurchases by the Company of 55,119 shares of stock under the 2005 Stock Repurchase Program. 2021 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $62.50 to $68.00 per share.
(2)2020 transactions included repurchases by the Company of 133,622 shares of stock under the 2005 Stock Repurchase Program. 2020 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $60.00 to $66.00 per share.
(3)2019 transactions included repurchases by the Company of 89,124 shares of stock under the 2005 Stock Repurchase Program. 2019 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $61.00 to $65.00 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 $70.00 a share. The closing bid for the Company's stock on February 14, 2022 was $67.75 a share as reported by the OTC Markets Group, Inc.
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The Company currently pays an annual dividend on its common stock to stockholders, and it expects to continue to maintain its annual dividend for the foreseeable future periods.
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 prepared by MORNINGSTAR of Chicago, IL and a custom peer group of Midwest community banks. The latter index reflects the performance of bank holding companies operating principally in the Midwest in the following states: Iowa, Illinois, Kansas, Minnesota, Missouri, Nebraska, North Dakota, South Dakota and Wisconsin. The indexes assume the investment of $100 on December 31, 2016 in Company Common Stock, the NASDAQ Index and the Midwest Community Banks Index, with all dividends reinvested.
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.
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The following table sets forth the Company’s equity compensation plan information as of December 31, 2021, all of which relates to stock options issued under stock option plans approved by stockholders of the Company:
Equity compensation plans approved by security holders 13,025 $ 45.92 208,543
Equity compensation plans not approved by security holders — — —
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, 2023. 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, 2021:
Item 6. [Reserved]
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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 consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document. For a discussion on the comparison of results of operations for the years ended December 31, 2020 and 2019, refer to Item 7. “Management's Discussion and Analysis of Financial Condition and Results of Operation” in the Company’s Annual Form 10-K filed with the SEC on March 5, 2021.
An overview of the year 2021 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, including in response to the COVID-19 pandemic.
•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 recognition of an allowance for credit losses on the affected securities and the recognition of a credit 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.
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•The economic impact of natural disasters, diseases and/or pandemics, including any extended impact from the COVID-19 pandemic, and terrorist attacks and military actions.
•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.
COVID-19: Update on Company Action and Ongoing Risks
Our response to COVID-19 continues to be focused on how we can best serve our employees, customers, and communities. We implemented additional safety measures to achieve appropriate social distancing for both customers and employees throughout our locations. We have continued to adjust procedures and restrictions based on local conditions and generally in alignment with guidance from the Centers for Disease Control. Drive-thru services remain available as well as all ATM’s to complete needed transactions. Customers are also able to directly contact our bankers through calling the customer contact center, engaging with a digital banker via the HERE by Hills Bank app, or through Hills Bank Online which is available 24/7.
Lending Assistance
The Bank continues to work with customers to determine how best to serve them, including providing short-term modifications for customers primarily through deferrals of principal only payments for three to six months. Throughout 2020, COVID-19 related payment deferrals provided for customers totaled approximately 14.82% of total loans. As of December 31, 2021 and December 31, 2020, COVID-19 related payment deferrals were approximately 0.12% and 1.20% of total loans, respectively.
The Bank continues to assist customers through this difficult time in the best manner possible by providing $127.10 million of Paycheck Protection Program (PPP) loans through December 31, 2020. With the passage of the Coronavirus Response and Relief Supplemental Appropriations Act 2021 in late December 2020, the Bank provided additional PPP loans in 2021 totaling $58.34 million through December 31, 2021 to further assist our customers. The PPP loans have a two or five year term and earn interest at 1%. Loans funded through the PPP program are fully guaranteed by the U.S. government if certain criteria are met. The Bank believes that the majority of these loans will ultimately be forgiven by the SBA in accordance with the terms of the program. As of December 31, 2021, the Bank has outstanding PPP loan balances of $5.34 million and for the year ended December 31, 2021 has received total forgiveness payments of $140.1 million from the SBA.
Financial Exposures
The COVID-19 pandemic continues to represent an unprecedented challenge to the global economy in general and the financial services sector in particular. However, given the emergence of multiple new and more infectious variants of COVID-19 along with the hesitancy of a significant portion of the U.S. population to become vaccinated, there is still significant uncertainty regarding the overall length of the pandemic and the aggregate impact that it will have on global and regional economies, including uncertainties regarding the potential positive effects of governmental actions taken in response to the pandemic. Our credit administration continues to closely monitor and analyze the higher risk segments within the loan portfolio, tracking loan payment deferrals, customer liquidity and providing timely reports to senior management and the board of directors. Based on the Company’s capital levels, prudent underwriting policies, loan concentration diversification and our geographic footprint, we currently expect to be able to continue to manage the economic risks and uncertainties associated with the pandemic and remain adequately capitalized. However, the Company may be required to make additional loan loss provisions as warranted by the fluid COVID-19 situation.
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
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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 2021 was $48.09 million compared to $38.65 million in 2020 and $45.32 million in 2019. Diluted earnings per share were $5.16, $4.12, and $4.85 for the years ended December 31, 2021, 2020 and 2019, respectively.
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, 2021 and 2020, the Bank achieved a net interest margin of 2.75% and 3.00%, respectively. For the year ended December 31, 2021, net interest income on a tax equivalent basis increased by $2.82 million. In 2021, net interest income increased $1.77 million due to growth of $424.15 million in the Bank's average earning assets and decreases in certficates of deposit and FHLB borrowings as well as increased $1.05 million due to interest rate changes.
Highlights with respect to items on the Company’s balance sheet as of December 31, 2021 included the following:
•Total assets were $4.045 billion, an increase of $262.20 million since December 31, 2020.
•Cash and cash equivalents were $781.92 million, an increase of $207.61 million since December 31, 2020. A substantial portion of the increase can be attributed to increased savings with the current negative economic environment due to the pandemic and equity investors fleeing volatile capital markets in an effort to preserve principal.
•Loans, net of allowance for credit losses and unamortized fees and costs, totaling $2.631 billion, a decrease of $87.18 million since December 31, 2020. The decrease is primarily attributable to the forgiveness of PPP loans totaling a net of $81.16 million for the year ended December 31, 2021. Loans held for sale decreased $38.23 million since December 31, 2020 due to the slowdown in mortgage loan refinance activity later in 2021.
•Tax credit real estate increased by $2.54 million for the year ended December 31, 2021, primarily attributable to a $4.18 million investment in a multi-family affordable housing rental property.
•Deposit growth of $341.43 million in 2021. Deposits increased to $3.534 billion and included $51.59 million of brokered deposits. A substantial portion of the increase can be attributed to increased savings with the current negative economic environment due to the pandemic.
•FHLB borrowings decreased $105.00 million due to prepaying all outstanding FHLB borrowings compared to December 31, 2020.
•Liabilities as of December 31, 2021 include $3.85 million of allowance for credit losses on off-balance sheet credit exposures under CECL compared to zero under the incurred loss model as of December 31, 2020.
•Stockholders’ equity increased $22.37 million to $438.45 million in 2021, with dividends having been paid in 2021 of $8.77 million.
Reference is made to Note 13 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 11.29% in 2021 compared to 9.82% in 2020. The Company remains well-capitalized as of December 31, 2021 with total risk-based capital at 20.24% and Tier 1 risk-based capital at 17.25%. The minimum regulatory guidelines are 8% and 6% respectively. The Company paid a dividend per share of $0.940 in 2021, $0.890 in 2020 and $0.820 in the year ended December 31, 2019.
A detailed discussion of the financial position and results of operations follows this overview.
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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 credit losses.
Allowance for Credit Losses
On January 1, 2021, the Company adopted ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires the allowance for credit losses use the current expected credit loss (CECL) methodology. The following is a discussion of the methodologies used by the Company with the adoption of ASC 326.
ASC 326 CECL Adoption: The preparation of financial statements in accordance with the accounting principles generally accepted in the United States ("U.S. GAAP") requires management to make a number of judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, income and expense in the financial statements. Various elements of our accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain substantial inherent uncertainties. Management has made significant estimates in several areas, including the allowance for credit losses (see Note 3 - Loans and Note 2 - Securities) and the fair value of debt securities (see Note 2 - Securities).
We have identified the following accounting policies and estimates that, due to the inherent judgments and assumptions and the potential sensitivity of the financial statements to those judgments and assumptions, are critical to an understanding of our financial statements. We believe that the judgments, estimates and assumptions used in the preparation of the Company's financial statements are appropriate. For a further description of our accounting policies, see Note 1 - Summary of Significant Accounting Policies in the financial statements included in this Form 10-K.
The allowance for credit losses for loans represents management's estimate of all expected credit losses over the expected contractual life of our existing loan portfolio. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the then-existing loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for credit losses in those future periods.
We employ a disciplined process and methodology to establish our allowance for credit losses that has two basic components: first, an asset-specific component involving individual loans that do not share risk characteristics with other loans and the measurement of expected credit losses for such individual loans; and second, a pooled component for estimated expected credit losses for pools of loans that share similar risk characteristics.
Based upon this methodology, management establishes an asset-specific allowance for loans that do not share risk characteristics with other loans based on the amount of expected credit losses calculated on those loans and charges off amounts determined to be uncollectible. Factors we consider in measuring the extent of expected credit loss include payment status, collateral value, borrower financial condition, guarantor support and the probability of collecting scheduled principal and interest payments when due.
When a loan does not share risk characteristics with other loans, we measure expected credit loss as the difference between the amortized cost basis in the loan and the present value of expected future cash flows discounted at the loan's effective interest rate except that, for collateral- dependent loans, credit loss is measured as the difference between the amortized cost basis in the loan and the fair value of the underlying collateral. The fair value of the collateral is adjusted for the estimated cost to sell if repayment or satisfaction of a loan is dependent on the sale (rather than only on the operation) of the collateral. In accordance with our appraisal policy, the fair value of collateral-dependent loans is based upon independent third-party appraisals or on collateral valuations prepared by in-house evaluations. Once a third-party appraisal is greater than one year old, or if its determined that market conditions, changes to the property, changes in intended use of the property or other factors indicate that an appraisal is no longer reliable, we perform an internal collateral valuation to assess whether a change in collateral value requires an additional adjustment to carrying value. When we receive an updated appraisal or collateral valuation, management reassesses the need for adjustments to the loan's expected credit loss measurements and, where appropriate, records an adjustment. If the calculated expected credit loss is determined to be permanent, fixed or nonrecoverable, the credit loss portion of the loan will be charged off against the allowance for credit losses. Loans designated having significantly increased credit
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risk are generally placed on nonaccrual and remain in that status until all principal and interest payments are current and the prospects for future payments in accordance with the loan agreement are reasonably assured, at which point the loan is returned to accrual status.
In estimating the component of the allowance for credit losses for loans that share common risk characteristics, loans are segregated into loan classes. Loans are designated into loan classes based on loans pooled by product types and similar risk characteristics or areas of risk concentration. Credit loss assumptions are estimated using a model that categorizes loan pools based on loan type and purpose. This model calculates an expected life-of-loan loss percentage for each loan category by considering the probability of default using historical life-of-loan analysis periods for agricultural, 1 to 4 family first and junior liens, commercial and consumer segments, and the severity of loss, based on the aggregate net lifetime losses incurred per loan class.
The component of the allowance for credit losses for loans that share common risk characteristics also considers factors for each loan class to adjust for differences between the historical period used to calculate historical default and loss severity rates and expected conditions over the remaining lives of the loans in the portfolio related to:
•Lending policies and procedures;
•International, national, regional and local economic business conditions and developments that affect the collectability of the portfolio, including the condition of various markets;
•The nature of the loan portfolio, including the terms of the loans;
•The experience, ability and depth of the lending management and other relevant staff;
•The volume and severity of past due and adversely classified or graded loans and the volume of nonaccrual loans;
•The quality of our loan review and process;
•The value of underlying collateral for collateral-dependent loans;
•The existence and effect of any concentrations of credit and changes in the level of such concentrations; and
•The effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio.
Such factors are used to adjust the historical probabilities of default and severity of loss so that they reflect management expectation of future conditions based on a reasonable and supportable forecast. To the extent the lives of the loans in the portfolio extend beyond the period for which a reasonable and supportable forecast can be made, the bank reduces, on a straight-line basis over the remaining life of the loans, the adjustments so that model reverts back to the historical rates of default and severity of loss.
The credit loss expense recorded through earnings is the amount necessary to maintain the allowance for credit losses at the amount of expected credit losses inherent within the loans held for investment portfolio. The amount of expense and the corresponding level of allowance for credit losses for loans are based on our evaluation of the collectability of the loan portfolio based on historical loss experience, reasonable and supportable forecasts, and other significant qualitative and quantitative factors.
The allowance for credit losses for loans, as reported in our consolidated balance sheet, is adjusted by a credit loss expense, which is recognized in earnings, and reduced by the charge-off of loan amounts, net of recoveries. For further information on the allowance for credit losses for loans, see Note 1 - Summary of Significant Accounting Policies and Note 3 - Loans in the notes to the financial statements of this Form 10-K.
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.
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Financial Position
(Amounts In Thousands)
Total assets at December 31, 2021 increased $262.20 million, or 6.93%, from the prior year-end. The largest growth in assets in 2021 occurred in Cash and Cash Equivalents, which increased $207.61 million as of December 31, 2021 compared to December 31, 2020. Net Loans decreased $(48.95) million for the year ended December 31, 2021. Loans held for sale to the secondary market decreased $(38.23) million for the year ended December 31, 2021. Loans held for investment represent the largest component of the Bank’s earning assets. Loans held for investment were $2.661 billion and $2.711 billion at December 31, 2021 and 2020, respectively.
The local economy that generated consistent demand for loans was a significant factor in the trend of increasing net loans in past years. The trend of increasing Net Loans did slow in 2021 and 2020 and may not continue, and as a result, may not be indicative of future performance. The primary reason for the decrease in 2021 was the forgiveness of PPP loans totaling a net of $81.16 million that were provided to customers in response to the COVID-19 pandemic as discussed previously. Without the decrease due to PPP loan forgiveness, loans held for investment increased $30.61 million.
Commercial and financial loans represent a significant portion of the loan growth. These loans increased $16.92 million in 2021 excluding the impact of PPP loans. Construction loans, both 1 to 4 family residential and land development and commercial, had significant growth totaling $24.48 million in 2021. Agricultural loans increased $12.09 million in 2021 though farmland mortgages decreased $14.40 million due to significant competition in the Bank's trade area.
On a net basis, the Company collected $52.02 million in loan payments from customers and the SBA for the year ended December 31, 2021 compared to loan originations of $72.14 million for the year ended December 31, 2020, primarily due to the collections from the forgiveness of PPP loans. 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 $17.18, $19.83 and $15.17 million as of December 31, 2021, 2020 and 2019, 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 2021 or 2020. Residential real estate loans, including first and junior liens, were $1,023.91 million and $1,019.92 million as of December 31, 2021 and 2020, respectively. The dollar total of residential real estate loans increased 0.39% in 2021 and decreased 3.78% in 2020. Residential real estate loans were 38.49% of the loan portfolio at December 31, 2021 and 37.63% at December 31, 2020. Commercial real estate loans totaled $401.38 million at December 31, 2021, a 3.78% decrease over the December 31, 2020 total of $417.14 million. Commercial real estate loans increased 3.72% in 2020. Commercial real estate loans represented 15.09%, 15.39% and 15.24% of the Company’s loan portfolio as of December 31, 2021, 2020 and 2019, 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 155.64% of capital as of December 31, 2021.
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The following table shows the composition of loans (before deducting the allowance for credit 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.
Real estate:
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, 2021:
(Amounts In Thousands)
(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.
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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 and estimated median income information as of December 31, 2021, 2020 and 2019.
Unemployment Rate % Median Income
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 $341.43 million in 2021. Deposits increased by $531.20 million in 2020. As of June 30, 2021 (latest data available from the FDIC), Johnson County total deposits were $11.077 billion and the Company’s deposits were $2.272 billion, which represent a 20.51% market share. The Company had nine office locations in Johnson County as of June 30, 2021. The total banking locations in Johnson County was 48 as of June 30, 2021. At June 30, 2020, the Company’s deposits were $2.060 billion or a 21.71% market share. As of June 30, 2021, Linn County total deposits were $8.580 billion and there were 102 total banking locations in the county. The seven Linn County offices of the Company had deposits of $764 million or a 8.9% share of the market. The Company’s Linn County deposits at June 30, 2020 were $612 million and represented a 7.9% market share. As of June 30, 2021, the Company’s three Washington County offices had deposits of $287 million which was 34.5% of the County’s total deposits of $832 million. Washington County had a total of 14 banking locations as of June 30, 2021. In 2020, the Company’s Washington County deposits were $254 million or a 33.0% 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, 2021, 2020 and 2019 and the composition of the certificates of deposit issued in denominations in excess of $250,000 as of December 31, 2021, 2020 and 2019:
December 31,
(Amounts In Thousands)
Time certificates issued in amounts of $250,000 or more with maturity in:
(Amounts In Thousands)
Portion uninsured $ 40,517
Investment securities increased $139.36 million in 2021. In 2020, investment securities increased by $50.18 million. The investment portfolio consists of $551.35 million of securities that are stated at fair value, with any unrealized gain or loss, net of
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income taxes, 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, 2021, 2020 and 2019 and the maturities and weighted average yields of the investment securities, computed using amortized cost on a tax-equivalent basis using a federal tax rate of 21%, as of December 31, 2021:
December 31,
(Amounts In Thousands)
Carrying value:
Mortgage-backed securities and collateralized mortgage obligations 9,446 — —
CarryingValue WeightedAverageYield
(Amounts In Thousands)
U.S. Treasury
Other securities (FHLB, FHLMC and FNMA), maturities:
Within 1 year $ — — %
From 5 to 10 years — —
Stock of the Federal Home Loan Bank $ 4,546 4.45 %
Obligations of state and political subdivisions, maturities:
Mortgage Backed Securities
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As of December 31, 2021, 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.
During 2021, the major funding source for the growth in loans and other assets was the $341.43 million increase in deposits. In 2020, the major source of funding for the growth in loans was deposit growth of $531.20 million. Brokered deposits totaled $51.59 million and $74.08 million as of December 31, 2021 and 2020, respectively. Total advances from the FHLB were $0.00 million at December 31, 2021 and $105.00 million in 2020. The FHLB funding source is considered when loan growth exceeds core deposit increases and the interest rates on funds borrowed from the FHLB are favorable compared to other funding alternatives.
Stockholders’ equity was $438.45 million at December 31, 2021 compared to $416.08 million at December 31, 2020. 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 $196.88 million and paid shareholders dividends of $38.24 million, or 19.42% 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, 2021, 2020 and 2019:
Average stockholders' equity to average assets ratio 10.70 11.07 12.45
Net Income Overview
Net income and diluted earnings per share for the last three years are as presented below:
Year Net Income % (Decrease) Increase Earnings PerShare - Diluted
(In Thousands)
Net income for 2021 increased by $9.44 million or 24.42% and diluted earnings per share increased by 25.24%. In 2021, net interest income, before credit loss expense, increased by $2.89 million due to the following reasons: 1) decrease in interest income of $6.44 million primarily due to decreases in interest rates and 2) decrease in interest expense of $9.33 million due to interest rate decreases and decreases in the volume of certificates of deposit and FHLB borrowings. Noninterest income increased by $5.13 million, the credit loss expense decreased by $9.87 million and total noninterest expenses increased by $5.71 million.
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Annual fluctuations in the Company's net income are driven primarily by three important factors. The first important factor is net interest margin. Net interest income of $104.46 million in 2021 was derived from the Company's $3.866 billion of average earning assets and its net interest margin of 2.75%, compared to $3.442 billion of average earning assets and a 3.00% net interest margin in 2020. 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 $3.87 million decrease or increase in income before taxes. Net interest income for the Company increased primarily due to the continued low interest rates on interest bearing deposits resulting in decreased interest expense of $9.33 million compared to 2020. $7.34 million of the decrease in interest expense was due to interest rate decreases and $1.99 million was primarily due to volume decreases in certificates of deposit and FHLB borrowings. The Company expects net interest compression to impact earnings for the foreseeable future due to competition for loans and deposits combined with the interest rate decreases by the Federal Reserve Board. The Company believes growth in net interest income will be contingent on the growth of the Company’s earning assets and maintaining yield on loans.
The second significant factor affecting the Company's net income is the credit loss expense recorded under CECL. The majority of the Company's interest-earning assets are in loans outstanding, which amounted to $2.666 billion at the end of 2021. The Company’s allowance for credit losses was $35.47 million at December 31, 2021. Expected credit loss expense is computed on a quarterly basis and is the amount necessary to adjust the allowance for credit losses to the level considered by management to appropriately account for the estimated current expected credit losses within the Bank's loan portfolio. The expense reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers’ ability to repay, past loss experience, loan collateral values, current economic conditions, reasonable and supportable economic forecasts, adjustments for prepayments and curtailments, the level of collateral-dependent loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risk. Credit loss expense was a reduction of expense of $5.51 million in 2021 under CECL compared to an expense of $4.36 million in 2020 and a reduction of expense of $2.88 million in 2019 under the incurred loss model. The decrease is attributable to improvements in the economic factor forecasts, primarily Iowa unemployment in the first quarter 2021, and continued improvement in asset quality, relative to the sizable expense taken for the first half of 2020 from management increases to qualitative factors as a result of the significant economic uncertainties surrounding the pandemic. The Company believes that credit loss expense is expected to be dependent on the Company’s loan growth, local economic conditions, including, but not limited to, conditions associated with the COVID-19 pandemic and the attendant risks and uncertainties related thereto, asset quality and will continue to have potential volatility for the foreseeable future resulting from the uncertainties due to the COVID-19 pandemic.
The third significant factor affecting the Company’s net income is noninterest income, primarily net gain on the sale of loans, services charges and trust fees. The net gain on the sale of loans was $7.59 million and $6.68 million for the years ended December 31, 2021 and 2020, respectively, an increase of 13.63% for the year ended December 31, 2021 compared to the same period in 2020. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates and has been significantly impacted by the Federal Reserve Board's reduction of the federal funds rate to 0.25%, resulting in a significant amount of mortgage loan refinance activity. Services charges and fees were $11.77 million and $10.19 million for the years ended December 31, 2021 and 2020, respectively, an increase of 15.59% for the year ended December 31, 2021 compared to the same period in 2020. This is primarily due to an increase in debit and credit card interchange fees of $1.52 million compared to 2020 with increased usage activity. Trust fees were $13.52 million and $10.28 million for the years ended December 31, 2021 and 2020, respectively, an increase of 31.59% for the year ended December 31, 2021 compared to the same period in 2020. This is primarily driven by the increase in assets under management of $0.37 billion from $2.18 billion as of December 31, 2020 to $2.55 billion as of December 31, 2021 and increased investment transaction activity.
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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 interest-bearing liabilities and the net interest margin. The volume of average earning assets has continued to grow each year, primarily due to excess cash for 2021. The volume of interest-bearing liabilities also grew in 2021 due to growth of interest-bearing demand and savings deposits. The net interest margin was 2.75% in 2021, 3.00% in 2020 and 3.18% in 2019. The measure is shown on a tax-equivalent basis using a rate of 21% for 2021, 2020 and 2019 to make the interest earned on taxable and nontaxable assets more comparable. Interest income and expense for 2021, 2020 and 2019 are indicated on the following table:
Years Ended December 31,
(Amounts In Thousands)
Income:
Interest-bearing cash and cash equivalents 983 945 3,980
Expense:
(1) Presented on a tax equivalent basis using a rate of 21% for 2021, 2020 and 2019. Interest income includes certain loan origination and document preparation fees, which comprise approximately 2.0% of the amounts indicated.
Net interest income on a tax-equivalent basis changed in 2021 as follows:
Change In Change In Increase (Decrease)
AverageBalance AverageRate VolumeChanges RateChanges NetChange
(Amounts In Thousands)
Interest income:
Federal funds sold (19) (0.09) — — —
Interest expense:
Other borrowings (3) (0.46) — — —
Interest-bearing other liabilities — — — — —
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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 changed in 2020 as follows:
Change In Average Balance Change In Average Rate Increase (Decrease)
VolumeChanges RateChanges NetChange
(Amounts In Thousands)
Interest income:
Interest expense:
Other borrowings 1 (1.71) — — —
Interest-bearing other liabilities — — — — —
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A summary of the average yields, average rates paid, net interest spread and margin is as follows:
Years Ended December 31,
Average yields:
Nontaxable securities (tax equivalent basis) 2.31 2.65 2.72
Interest-bearing cash and cash equivalents 0.13 0.26 2.09
Average rates paid:
Interest-bearing demand deposits 0.22 0.48 0.87
Yield on average interest-earning assets 3.20 3.78 4.29
Rate on average interest-bearing liabilities 0.61 1.02 1.42
(1)Non-accruing loans have been included in the average loan balances for purposes of this computation.
(2)Net interest spread is the difference between the yield on average interest-earning assets and the yield on average interest-paying liabilities stated on a tax equivalent basis using a federal rate of 21% for 2021, 2020 and 2019. The net interest spread decreased 17 basis points in 2021 compared to 2020 and the net interest spread decreased 10 basis points compared to 2019.
(3)Net interest margin is net interest income, on a tax equivalent basis, divided by average interest-earning assets. The net interest margin decreased 25 basis points in 2021. The net interest margin decreased 18 basis points in 2020 compared to 2019.
In March 2020, the Federal Open Market Committee decreased the target rate to 0.25%. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally correlate to the Federal Reserve Board federal funds rate. In pricing of loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. As of December 31, 2021, the average rate indexes for the one, three and five year indexes were 0.39%, 0.97% and 1.26%, respectively. The one year index increased 290.00% from December 31, 2020, the three year index increased 470.59% and the five year index increased 250.00%.
CECL Adoption and Allowance for Credit Losses (ACL)
The framework requires that management's estimate reflects credit losses over the full remaining expected life of each credit and considers expected future changes in macroeconomic conditions. The adoption resulted in the recognition on January 1, 2021 of cumulative effect adjustments of $2.75 million related to the ACL for loans and $3.58 million related to the ACL on off-balance sheet credit exposures.
Credit loss expense was a reduction of expense of $5.51 million for the year ended December 31, 2021 compared to an expense of $4.36 million in 2020 under the incurred loss model, a decrease of expense of $9.87 million. The credit loss expense includes expense of $0.27 million related to the ACL on off-balance sheet credit exposures. Credit loss expense is the amount necessary to adjust the allowance for credit losses to the level considered by management to appropriately account for the estimated current expected credit losses within the Bank's loan portfolio. The credit loss expense taken to fund the allowance for credit losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The expense reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of collateral-dependent loans and loans past due ninety days or more. In addition, management considers the credit quality of the
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loans based on management’s review of special mention and substandard loans, including loans with historical higher credit risks. Also, under CECL, a significant component in estimating expected credit losses are economic forecasts such as Iowa unemployment, all-transactions house price index for Iowa and Iowa real GDP. The Company believes that credit loss expense is expected to be dependent on the Company’s loan growth, local economic conditions, including, but not limited to, conditions associated with the COVID-19 pandemic and the attendant risks and uncertainties related thereto, asset quality and will continue to have potential volatility for the foreseeable future resulting from the adoption of CECL and the uncertainties due to the COVID-19 pandemic. The percentage of the allowance to outstanding loans was 1.33% and 1.37% at December 31, 2021 and 2020, respectively. The credit loss expense totaled a reduction of expense of $5.51 million in 2021, an expense of $4.36 million in 2020 and a reduction of expense of $2.88 million in 2019. Loan recoveries net of charge-offs were $1.43 million in 2021, loan charge-offs net of recoveries were $1.05 million in 2020 and loan charge-offs net of recoveries were $1.17 million in 2019. Management has determined that the allowance for credit losses was appropriate at December 31, 2021, and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for credit losses is based on a comprehensive and well-documented applied analysis of the Company’s loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for credit losses is reviewed and compared to industry peers. This review encompasses levels of total nonperforming loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs. However, there is no assurance losses will not exceed the allowance, and any growth in the loan portfolio or uncertainty in the general economy will require that management continue to evaluate the adequacy of the ACL and make additional provisions in future periods as deemed necessary.
Through the credit risk rating process, loans are reviewed to determine if they are performing in accordance with the original contractual terms. If the borrower has failed to comply with the original contractual terms, further action may be required by the Company, including a downgrade in the credit risk rating, movement to nonaccrual status, a charge-off or the establishment of a specific reserve. In the event a collateral shortfall is identified during the credit review process, the Company will work with the borrower for a principal reduction payment and/or a pledge of additional collateral and/or additional guarantees. In the event that these options are not available, the loan may be subject to a downgrade of the credit risk rating. If we determine that a loan amount, or portion thereof, is uncollectible, the loan’s credit risk rating is immediately downgraded and the uncollectible amount is charged-off. The Bank’s credit and legal departments undertake a thorough and ongoing analysis to determine if an additional specific reserve and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize realized loss.
In certain circumstances, the Bank may modify the terms of a loan to maximize the collection of amounts due. In most cases, the modification is either a reduction in interest rate, conversion to interest only payments, deferral of payments or extension of the maturity date. Generally, the borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, so concessionary modification is granted to the borrower that otherwise would not be considered. TDR loans accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles. The Bank’s TDR loans occur on a case-by-case basis in connection with ongoing loan collection processes.
The Bank regularly reviews loans in the portfolio and assesses whether the loans are nonperforming. If the loans are nonperforming, the Bank determines if a specific reserve is appropriate. In addition, the Bank's management also reviews and, where determined necessary, provides allowances for particular loans based upon (1) reviews of specific borrowers and (2) management’s assessment of areas that management considers are of higher credit risk, including loans that have been restructured.
The extent to which collateral secures collateral-dependent loans and changes in the extent to which collateral secures its collateral-dependent loans are described below. Collateral-dependent loans decreased $4.10 million from December 31, 2020 to December 31, 2021. Collateral-dependent loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans. Collateral-dependent loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement. Collateral-dependent loans were 0.63% of loans held for investment as of December 31, 2021 and 0.76% as of December 31, 2020. The decrease in collateral-dependent loans is due to a decrease of $0.55 million in loans with a specific reserve, a decrease in nonaccrual loans of $0.36 million, a decrease in 90 days or more accruing loans of $0.86 million and a decrease in TDR loans of $2.33 million from December 31, 2020 to December 30, 2021. There were no significant changes noted in the extent to which collateral secures collateral-dependent loans. See Note 1 Adoption of New Financial Accounting Standard for further discussion of the allowance for credit losses for loans held for investment. A description of the Bank's credit quality indicators are discussed in Note 3 to the Company's Consolidated Financial Statements.
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The following table summarizes the Company's impaired loans and non-performing assets as of December 31 for each of the years presented:
(Amounts In Thousands)
Other real estate — — — — —
(1)The gross interest income that would have been recorded if the loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination if held for part of the period was $0.46 million in 2021 and $0.66 million in 2020. The amount of interest income on the loans that was included in income was $0.44 million in 2021 and $0.57 million in 2020.
(2)The accruing loans past due 90 days or more are still believed to be adequately collateralized. Loans are placed on nonaccrual status when management believes the collection of future principal and interest is not reasonably assured.
(3)Total TDR loans were $10.20, $13.22, $13.71, $13.38 and $12.09 million as of December 31, 2021, 2020, 2019, 2018 and 2017, respectively. Included in the total nonaccrual loans were $2.28, $2.97, $4.34, $4.84 and $3.62 million of TDR loans as of December 31, 2021, 2020, 2019, 2018 and 2017, respectively.
The ratio of allowance for credit losses to non-performing loans increased to 213.25% as of December 31, 2021 compared to 178.83% as of December 31, 2020. The increase in 2021 is primarily due to the reduction in non-performing loans compared to 2020. The ratio of non-performing loans to total gross loans was 0.63% and 0.76% at December 31, 2021 and 2020, respectively. The decrease in the 2021 ratio is primarily due to the decrease in TDR loans and accruing loans past due 90 days or more.
Other factors that are considered in determining the credit quality of the Company’s loan portfolio are the vacancy rates for both residential and commercial space, current equity the borrower has in the property and overall financial strength of the customer including cash flow to continue to fund loan payments. The Company also considers the state of the total economy including unemployment levels. In most instances, the borrowers have used in their rental projections of income at least a 10% vacancy rate. As of December 31, 2021, the unemployment levels in Johnson County and Linn County were 2.5% and 3.3%, respectively, compared to 2.8% and 3.8% in December of 2020. These levels compare favorably to the State of Iowa at 3.5% and the national unemployment level at 3.9% in December 2021 compared to 3.1% and 6.7%, respectively in December 2020.
The residential rental vacancy rates in 2020 and 2021 in Johnson and Linn County were estimated between 6.0% and 8.0%. The State of Iowa vacancy rate is 7.5% and the national rate is 5.6% with the Midwest rate at 6.5%. These vacancy rates one year ago were 8.5%, 6.5% and 7.8%, respectively. The Company continues to consider those vacancy rates among other factors in its current evaluation of the real estate portion of its loan portfolio. Favorable vacancy rates may not continue in 2021, and vacancy rates may rise and affect the overall quality of the loan portfolio.
See Note 3 to the Company's Consolidated Financial Statements for additional disclosures on loans.
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SUMMARY OF LOAN LOSS EXPERIENCE
The allowance for credit losses balance is also affected by the charge-offs and recoveries for the periods presented. For the years ended December 31, 2021, 2020 and 2019, recoveries were $2.74 million, $1.87 million and $1.80 million, respectively; charge-offs were $1.32 million, $2.92 million and $2.97 million in 2021, 2020 and 2019, respectively.
Overall credit quality may deteriorate in 2022. Such deterioration could cause increases in non-performing loans, allowance for credit losses, credit loss expense and net charge-offs. Management will monitor changing market conditions as a part of its allowance for credit loss methodology. The following table summarizes the Bank's loan loss experience for the years ended December 31 for each of the years presented:
(Amounts In Thousands)
Allowance for credit losses:
(Amounts In Thousands)
Allowance for loan losses:
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(Amounts In Thousands)
Allowance for loan losses:
(Amounts In Thousands)
Allowance for loan losses:
(Amounts In Thousands)
Allowance for loan losses:
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ALLOCATION OF THE ALLOWANCE FOR CREDIT LOSSES
The following table presents the allowance for credit losses by type of loans, the percentage of the allocation for each category to the total allowance and the percentage of all loans in each category to total loans as of December 31, 2021, 2020, 2019, 2018 and 2017:
(In Thousands) (In Thousands)
Real estate:
Real estate:
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Amount % of Total Allowance % of Loansto Total Loans
(In Thousands)
Real estate:
Construction, land development and commercial 1,796 6.11 % 4.46
Obligations of state and political subdivisions 461 1.57 2.34
The Company believes that the allowance for credit losses is at a level commensurate with the overall risk exposure of the loan portfolio. However, if economic conditions deteriorate, certain borrowers may experience difficulty and the level of non-performing loans, charge-offs and delinquencies could rise and require increases in the allowance for credit losses. The Company will continue to monitor the adequacy of the allowance on a quarterly basis and will consider the impact of economic conditions on the borrowers’ ability to repay, loan collateral values, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition.
Noninterest Income
The following table sets forth the various categories of noninterest income for the years ended December 31, 2021, 2020 and 2019.
Year Ended December 31, $ Change % Change
(Amounts in thousands)
The noninterest income of the Company was $33.46 million in 2021 compared to $28.34 million in 2020. The increase of $5.13 million in 2021 was the result of a combination of factors discussed below.
The net gain on the sale of loans was $7.59 million and $6.68 million for the years ended December 31, 2021 and 2020, respectively, an increase of 13.63% for the year ended December 31, 2021 compared to the same period in 2020. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates and has been significantly impacted by the Federal Reserve Board's reduction of the federal funds rate to 0.25%, resulting in a significant amount of mortgage loan refinance activity. The servicing
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of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income.
Trust fees were $13.52 million and $10.28 million for the years ended December 31, 2021 and 2020, respectively, an increase of 31.59% for the year ended December 31, 2021 compared to the same period in 2020. This is primarily driven by the increase in assets under management of $0.37 billion from $2.18 billion as of December 31, 2020 to $2.55 billion as of December 31, 2021 and increased investment transaction activity. The trust assets that are the most volatile are those that are held in common stocks, which amount to approximately 71% of assets under management. In 2021, the Dow Jones Industrial Average increased 18.73%.
Services charges and fees were $11.77 million and $10.19 million for the years ended December 31, 2021 and 2020, respectively, an increase of 15.59% for the year ended December 31, 2021 compared to the same period in 2020. This is primarily due to an increase in debit and credit card interchange fees of $1.52 million compared to 2020 with increased usage activity.
Other noninterest income decreased $0.61 million in 2021 primarily due to the net loss recognized on the tax credit real estate.
Noninterest Expenses
The following table sets forth the various categories of noninterest expenses for the year ended December 31, 2021, 2020 and 2019.
Year Ended December 31, $ Change % Change
(Amounts in thousands)
Total noninterest expenses were $81.34 and $75.63 million for the years ended December 31, 2021 and 2020, respectively. The increase is $5.71 million or 7.55% in 2021 and an increase of $8.37 million or 12.44% in 2020.
Salaries and employee benefits increased $1.84 million in 2021. The increase is primarily the result of annual salary adjustments.
Outside services increased $1.52 million in 2021 compared to 2020 primarily due to increased debit and credit card processing charges with increase usage activity.
Other noninterest expenses increased $2.44 million in 2021 primarily due to $7.69 million in fees incurred from the prepayment of FHLB borrowings compared to $2.53 million of FHLB prepayment fees and $2.68 million of interest rate swap termination fees paid in 2020.
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Income Taxes
Income tax expense was $14.01, $11.28 and $12.55 million for the years ended December 31, 2021, 2020 and 2019, respectively. Income taxes as a percentage of income before income taxes were 22.56% in 2021, 22.59% in 2020 and 21.69% in 2019. The amount of tax credits were $0.48, $0.05 and $0.53 million for 2021, 2020, and 2019, respectively.
Effects of Inflation
The consolidated financial statements and the accompanying notes have been prepared in accordance with accounting principles generally accepted in the United States of America. These principles require the measurement of financial position and operating results in terms of historical dollar amounts without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company’s operations. Nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a more significant impact in the Company’s performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services. Liquidity and interest rate adjustments are features of the Company’s asset/liability management, which are important to the maintenance of acceptable performance levels. Item 7A of this Form 10-K contains a more thorough discussion of interest rate risk. The Company attempts to maintain a balance between monetary assets and monetary liabilities to offset the potential effects of changing interest rates.
Liquidity and Capital Resources
The objective of liquidity management is to ensure the availability of sufficient cash flows to fund operations, to meet depositor withdrawals, to provide for our customers' credit needs and to meet maturing obligations and existing commitments. The Company's principal source of funds is deposits. Other sources include loan principal repayments, proceeds from the maturity and sale of investment securities, federal funds purchased, advances from the FHLB, advances on bank lines of credit, brokered deposit relationships and funds provided by operations. Liquidity management is conducted on both a daily and a long-term basis. Investments in liquid assets are adjusted based on expected loan demand, projected loan and investment securities maturities and payments, expected deposit flows and the objectives set by the Company's asset-liability management, liquidity and contingency funding policies.
As of December 31, 2021, the Company had additional borrowing capacity available from the FHLB of $865.06 million. In addition, the Company had $554.18 million in borrowing capacity available through secured and unsecured lines of credit with correspondent banks. The Company had $0.25 million outstanding under those federal funds lines as of December 31, 2021.
On an unconsolidated basis, the Company had cash balances of $2.18 million as of December 31, 2021. In 2021, the Company received dividends of $12.27 million from its subsidiary Bank and used those funds to pay dividends to its stockholders of $8.77 million and to fund purchases of treasury stock under the 2005 Stock Repurchase Program. The total purchase of treasury stock under the 2005 Stock Repurchase Program totaled $3.57 and $8.55 million for the years ended December 31, 2021 and 2020, respectively.
As of December 31, 2021 and 2020, stockholders' equity, before deducting for the maximum cash obligation related to the ESOP, was $488.46 million and $463.41 million, respectively. This measure of stockholders’ equity as a percent of total assets was 12.08% at December 31, 2021 and 12.26% at December 31, 2020. As of December 31, 2021, total equity, after deducting the maximum cash value related to the ESOP, was 10.84% of assets compared to 11.00% of assets at the prior year end.
The Company and the Bank are subject to the Federal Deposit Insurance Corporation Improvement Act of 1991, and the Bank is subject to Prompt Corrective Action Rules as determined and enforced by the Federal Reserve. These regulations establish minimum capital requirements that member banks must maintain.
The Bank is classified as "well-capitalized" by FDIC capital guidelines. For more information regarding regulatory capital requirements, see the section under Part I, Item 1 to this 10-K captioned “Supervision and Regulation.”
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On a consolidated basis, 2021 cash flows from operations provided $85.07 million, net increases in deposits provided $341.43 million and net collections on loans to customers provided $52.02 million. These cash flows were invested $245.38 million in purchases of investment securities. In addition, $1.46 million was used to purchase property and equipment and leasehold improvements and $4.18 million was used to invest in a tax credit real estate property.
The Bank has a contingency funding plan to address liquidity issues in times of crisis. The primary source of funding will be the Bank’s customer deposit base. The Bank has established alternative sources of funding available to increase liquidity. The availability of the funding sources is tested on an annual basis. The Bank performs quarterly stress testing to determine if the Bank has an appropriate amount of funding sources to address potential liquidity needs. At December 31, 2021, the Bank had total outstanding loan commitments and unused portions of lines of credit totaling $621.50 million (see Note 15 to the Company's Consolidated Financial Statements). Management believes that its liquidity levels are sufficient at this time, but the Bank may increase its liquidity by limiting the growth of its assets, by selling more loans in the secondary market or selling portions of loans to other banks through participation agreements. Another liquidity source includes obtaining additional funds from the Federal Home Loan Bank (FHLB). As of December 31, 2021, the Bank can obtain an additional $865.06 million from the FHLB based on the current real estate mortgage loans held. In addition, the Bank has arranged $544.18 million of credit lines at three banks. The borrowings under these credit lines would be secured by the Bank’s investment securities. Other liquidity sources include a $10.00 million line of credit with the Federal Reserve Bank of Chicago and various sources of brokered deposits.
The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates of Federal Home Loan Bank borrowings during 2021, 2020 and 2019:
(Amounts In Thousands)
Weighted average interest rate at year end 2.82 % 2.93 % 2.93 %
Weighted average interest rate for the year 2.82 % 2.93 % 2.93 %
The Bank has off-balance sheet commitments to fund additional borrowings of customers. Contractual commitments to fund loans are met from the proceeds of federal funds sold or investment securities and additional borrowings. Many of the contractual commitments to extend credit will not be funded because they represent the credit limits on credit cards and home equity lines of credits.
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As disclosed in Note 15 to the Company's Consolidated Financial Statements, the Company has certain obligations and commitments to make future payments under contracts. The following table summarizes significant contractual obligations and other commitments as of December 31, 2021:
Payments Due By Period
(Amounts In Thousands)
Total Less ThanOne Year One -Three Years Three -Five Years More ThanFive Years
Contractual obligations:
Long-term debt obligations $ — $ — $ — $ — $ —
Other commitments:
Standby letters of credit 7,179 7,179 — — —
The Company and the Bank have no additional material commitments or plans that will materially affect liquidity or capital resources. Property and equipment may be acquired in cash purchases, or they may be financed if favorable terms are available.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company's primary market risk exposure is to changes in interest rates. Interest rate risk is the risk to current or anticipated earnings or capital arising from movements in interest rates. Interest rate risk arises from repricing risk, basis risk, yield curve risk and options risk. Repricing risk is the difference between the timing of rate changes and the timing of cash flows. Basis risk is the difference from changing rate relationships among different yield curve affecting Bank activities. Yield curve risk is the difference from changing rate relationships across the spectrum of maturities. Option risk is the difference resulting from interest-related options imbedded in Bank products. The Bank’s primary source of interest rate risk exposure arises from repricing risk. To measure this risk the Bank uses a static gap measurement system that identifies the repricing gaps across the full maturity spectrum of the Bank’s assets and liabilities and an earnings simulation approach. The gap schedule is known as the interest rate sensitivity report. The report reflects the repricing characteristics of the Bank’s assets and liabilities. The report details the calculation of the gap ratio. This ratio indicated the amount of interest-earning assets repricing within a given period in comparison to the amount of interest-bearing liabilities repricing within the same period of time. A gap ratio of 1.0 indicates a matched position, in which case the effect on net interest income due to interest rate movements will be minimal. A gap ratio of less than 1.0 indicates that more liabilities than assets reprice within the time period, and a ratio greater than 1.0 indicates that more assets reprice than liabilities.
The Company's asset/liability management, or its management of interest rate risk, is focused primarily on evaluating and managing net interest income given various risk criteria. Factors beyond the Company's control, such as market interest rates and competition, may also have an impact on the Company's interest income and interest expense. In the absence of other factors, the Company's overall yield on interest-earning assets will increase as will its cost of funds on its interest-bearing liabilities when market interest rates increase over an extended period of time. Inversely, the Company's yields and cost of funds will decrease when market rates decline. The Company is able to manage these swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning assets and interest-bearing liabilities over given periods of time.
The Bank maintains an Asset/Liability Committee, which meets at least quarterly to review the interest rate sensitivity position and to review and develop various strategies for managing interest rate risk within the context of the following factors: 1) capital adequacy, 2) asset/liability mix, 3) economic outlook, 4) market characteristics and 5) the interest rate forecast. In addition, the Bank uses a simulation model to review various assumptions relating to interest rate movement. The model attempts to limit rate risk even if it appears the Bank’s asset and liability maturities are perfectly matched and a favorable interest margin is present. The Bank’s policy is to generally maintain a balance between profitability and interest rate risk.
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The Bank uses derivative financial instruments, when needed, to manage the impact of changes in interest rates on future interest income or interest expense. The Bank is exposed to credit-related losses in the event of nonperformance by the counterparties to these derivative instruments, but believe the risk of these losses has been minimized by entering into the contracts with large, stable financial institutions. The estimated fair market value of these derivative instruments are presented in Note 17 to the Consolidated Financial Statements.
In order to minimize the potential effects of adverse material and prolonged increases or decreases in market interest rates on the Company's operations, management has implemented an asset/liability program designed to mitigate the Company's interest rate sensitivity. The program emphasizes the origination of adjustable rate loans, which are held in the portfolio, the investment of excess cash in short or intermediate term interest-earning assets, and the solicitation of transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.
The table set forth below includes the portion of the balances in interest-bearing checking, savings and money market accounts that management has estimated to mature within one year. The classifications are used because the Bank’s historical data indicates that these have been very stable deposits without much interest rate fluctuation. Historically, these accounts would not need to be adjusted upward as quickly in a period of rate increases so the interest risk exposure would be less than the re-pricing schedule indicates. The FHLB borrowings are classified based on either their due date or if they are callable on their most likely call date based on the interest rate.
Repricing
Maturities Days More Than
(Amounts in Thousands)
Earning assets:
Federal funds sold — — — — — — —
Sources of funds:
FHLB borrowings — — — — — — —
Federal funds and repurchase agreements 249 — — — — — 249
Other sources, primarily noninterest-bearing — — — — — 1,070,804 1,070,804
Interest
Cumulative Interest
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Based on the data following, net interest income should decline with instantaneous increases in interest rates while net interest income should increase with instantaneous declines in interest rates. Generally, during periods of increasing interest rates, the Company's interest rate sensitive liabilities would re-price faster than its interest rate sensitive assets causing a decline in the Company's interest rate spread and margin. This would tend to reduce net interest income because the resulting increase in the Company’s cost of funds would not be immediately offset by an increase in its yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a positive effect on the Company's net interest income.
The following table, which presents principal cash flows and related weighted average interest rates by expected maturity dates, provides information about the Company's loans, investment securities and deposits that are sensitive to changes in interest rates.
(Amounts In Thousands)
Assets:
Loans, fixed:
Loans, variable:
Investments (1):
Liabilities:
Liquid deposits (2):
Average interest rate — % — % — % — % — % — % 0.15 %
Deposits, certificates:
1.11
(1)Includes all available-for-sale investments, federal funds and Federal Home Loan Bank stock.
(2)Includes NOW and other demand, savings and money market funds.
Item 8. Consolidated Financial Statements and Supplementary Data
The consolidated financial statements and supplementary data are included on pages 54 through 118.
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Report of Independent Registered Public Accounting Firm
To the Shareholders, Board of Directors and Audit Committee
Hills Bancorporation
Hills, Iowa
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Hills Bancorporation (the “Company”) as of December 31, 2021 and 2020, the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2021, and the related notes (collectively referred to as the “financial statements”). In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2021 and 2020, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2021, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2021, based on Internal Control-Integrated Framework (2013 edition) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 4, 2022, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Adoption of New Accounting Standard
As discussed in Notes 1 and 3 to the consolidated financial statements, the Company has changed its method of accounting for the allowance for credit losses in 2021 due to the adoption of ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. As discussed below, auditing the Company’s allowance for credit losses, including adoption of the new accounting guidance related to the estimate of allowance for credit losses, was a critical audit matter.
Basis for Opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits.
We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current-period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to an account or disclosure that is material to the financial statements and (2) involved especially challenging, subjective or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the financial statements, taken as a whole,
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and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Allowance for Credit Losses
As discussed in Notes 1 and 3, the Company adopted Topic 326 effective January 1, 2021. The Company uses the discounted cash flow (DCF) method to estimate expected losses for most of the Company’s loan pools that exhibit similar risk characteristics. For each of these loan pools, the Company generates cash flow projections at the instrument level adjusting payment expectations for estimated prepayment speed, curtailments, time to recovery, probability of default and loss given default. The Company uses regression analysis of historical internal and peer data to determine suitable loss drivers when modeling lifetime probability of default and loss given default. The Company’s analysis also determines how expected probability of default and loss given default will react to forecasted levels of the loss drivers. Additional qualitative adjustments are applied for risk factors that are not considered within the modeling process but are relevant in assessing the expected credit losses within the loan pools. Loans that do not share risk characteristics are evaluated on an individual basis. For loans individually evaluated, an allowance is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. The Company applies expected funding percentages to the respective model loss rates to estimate the allowance related to unfunded commitments.
Auditing management’s estimate of the allowances for loan credit losses (ACL) and unfunded commitments involved a high degree of subjectivity due to the complexities of the probability of default and loss given default models and the nature of the qualitative factor adjustments. Management’s qualitative factor adjustments are highly judgmental and had a significant effect on the ACL.
How the Critical Audit Matter was Addressed in the Audit
Our audit procedures related to the ACL and allowance for unfunded commitments included the following procedures, among others:
•Obtained an understanding of the Company’s process for establishing the ACL, including the implementation of models and assumptions and the qualitative factor adjustments of the ACL.
•Obtained an understanding, evaluated the design and tested the operating effectiveness of controls, including information technology, over the reliability and accuracy of data used to calculate and estimate the various components of the ACL including:
◦Loan data completeness and accuracy
◦Grouping of loans by segment
◦Model inputs utilized
◦Approval of model assumptions selected
◦Establishment of qualitative factors
•Tested the mathematical accuracy of the calculation of the ACL
•Tested individual loan files to evaluate the reasonableness of loan credit risk ratings
•Tested the completeness and accuracy of inputs utilized in the calculation of the ACL
•Evaluated the reasonableness of selected loss drivers utilized and loss driver forecasts for each loan segment
•Tested the reasonableness of specific reserves on individually evaluated loans
•Tested estimated funding rate of unfunded loan commitments
•Evaluated the qualitative adjustments, including assessing the reasonableness and basis for adjustments
BKD, LLP
We have served as the Company’s auditor since 2012.
Springfield, Missouri
March 4, 2022
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Report of Independent Registered Public Accounting Firm
To the Shareholders, Board of Directors and Audit Committee
Hills Bancorporation
Hills, Iowa
Opinion on the Internal Control over Financial Reporting
We have audited Hills Bancorporation’s (the “Company”) internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control – Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control – Integrated Framework: (2013) issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated financial statements of the Company and our report dated March 4, 2022, expressed an unqualified opinion.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definitions and Limitations of Internal Control over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of reliable financial statements in accordance with accounting principles generally accepted in the United States of America. Because management’s assessment and our audit also were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), our audit of Hills Bancorporation’s internal control over financial reporting included controls over the preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and with the instructions to the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C). A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention, or timely detection and correction of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
BKD, LLP
Springfield, Missouri
March 4, 2022
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HILLS BANCORPORATION
CONSOLIDATED BALANCE SHEETS
December 31, 2021 and 2020
(Amounts In Thousands, Except Shares)
Stock of Federal Home Loan Bank 4,546 8,172
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Other borrowings, federal funds purchased 249 —
Federal Home Loan Bank borrowings (Note 7) — 105,000
Allowance for credit losses on off-balance sheet credit exposures 3,850 —
Commitments and Contingencies (Notes 9 and 15)
Redeemable Common Stock Held By Employee Stock
Stockholders' Equity (Note 11)
Accumulated other comprehensive gain (Note 8) 1,477 8,782
Less maximum cash obligation related to ESOP shares (Note 9) 50,013 47,329
See Notes to Consolidated Financial Statements.
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HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2021, 2020 and 2019