HBIA 10-Q Quarterly Report March 31, 2012 | Alphaminr
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HBIA 10-Q Quarter ended March 31, 2012

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10-Q 1 form10-q.htm HILLS BANCORPORATION 10-Q 3-31-12 form10-q.htm

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

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2012

Commission file number: 0-12668

Hills Bancorporation

Incorporated in Iowa
I.R.S. Employer Identification
No. 42-1208067

131 MAIN STREET, HILLS, IOWA 52235

Telephone number: (319) 679-2291

Indicate by checkmark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

[ ü ] Yes  [ ] No

Indicate by checkmark whether the Registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).

[ ü ] Yes  [ ] No

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or smaller reporting company.  See definition of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  _____
Accelerated Filer ü
Non-accelerated filer    _____
Small Reporting Company     ___

Indicate by checkmark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

[ ] Yes  [ ü ] No

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date.

SHARES OUTSTANDING
CLASS
At April 30, 2012
Common Stock, no par value
4,753,977



HILLS BANCORPORATION

Part I
FINANCIAL INFORMATION
Page
Number
Item 1.
Financial Statements
3
4
5
6
7
9
Item 2.
31
Item 3.
46
Item 4.
46
Part II
OTHER INFORMATION
Item 1.
47
Item 1A.
47
Item 2.
47
Item 3.
47
Item 4.
47
Item 5.
47
Item 6.
47
48
49





HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS (Amounts In Thousands, Except Shares)
ASSETS
March 31, 2012 (Unaudited)
December 31, 2011
Cash and cash equivalents
$121,842
$29,291
Investment securities available for sale at fair value (amortized cost March 31, 2012 $204,833; December 31, 2011 $203,312)
211,850
211,367
Stock of Federal Home Loan Bank
10,671
10,728
Loans held for sale
17,595
24,615
Loans, net of allowance for loan losses (March 31, 2012 $28,730; December 31, 2011 $30,150)
1,660,363
1,661,916
Property and equipment, net
31,233
30,321
Tax credit real estate
19,658
20,130
Accrued interest receivable
9,052
8,689
Deferred income taxes, net
8,528
8,531
Other real estate
1,313
1,327
Goodwill
2,500
2,500
Prepaid FDIC insurance
3,641
3,879
Other assets
4,426
5,003
$2,102,672
$2,018,297
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Noninterest-bearing deposits
$221,629
$223,378
Interest-bearing deposits
1,390,427
1,302,099
Total deposits
$1,612,056
$1,525,477
Short-term borrowings
47,010
52,785
Federal Home Loan Bank borrowings
185,000
185,000
Accrued interest payable
1,540
1,625
Other liabilities
19,018
17,155
$1,864,624
$1,782,042
Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)
$28,650
$27,826
STOCKHOLDERS' EQUITY
Capital stock, no par value; authorized 10,000,000 shares; issued March 31, 2012 5,055,021 shares; December 31, 2011 5,051,901 shares
$-
$-
Paid in capital
41,609
41,467
Retained earnings
210,692
207,790
Accumulated other comprehensive income
4,333
4,974
Unearned ESOP shares
(2,017)
(2,017)
Treasury stock at cost (March 31, 2012 301,403 shares; December 31, 2011 292,083 shares)
(16,569)
(15,959)
$238,048
$236,255
Less maximum cash obligation related to ESOP shares
28,650
27,826
$209,398
$208,429
$2,102,672
$2,018,297
See Notes to Consolidated Financial Statements.





HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (Amounts In Thousands, Except Per Share Amounts)
Three Months Ended March 31,
2012
2011
Interest income:
Loans, including fees
$ 21,395 $ 21,365
Investment securities:
Taxable
546 765
Nontaxable
850 859
Federal funds sold
16 32
Total interest income
$ 22,807 $ 23,021
Interest expense:
Deposits
$ 3,574 $ 4,308
Short-term borrowings
34 95
FHLB borrowings
1,990 1,981
Total interest expense
$ 5,598 $ 6,384
Net interest income
$ 17,209 $ 16,637
Provision for loan losses
(560 ) 1,465
Net interest income after provision for loan losses
$ 17,769 $ 15,172
Other income:
Net gain on sale of loans
$ 705 $ 482
Trust fees
1,161 1,089
Service charges and fees
1,873 1,811
Rental revenue on tax credit real estate
394 283
Net gain on sale of other real estate owned and other repossessed assets
296 1
Other noninterest income
584 669
$ 5,013 $ 4,335
Other expenses:
Salaries and employee benefits
$ 5,819 $ 5,550
Occupancy
844 831
Furniture and equipment
1,111 965
Office supplies and postage
379 337
Advertising and business development
436 329
Outside services
1,702 1,726
Rental expenses on tax credit real estate
655 234
FDIC insurance assessment
268 700
Other noninterest expense
413 254
$ 11,627 $ 10,926
Income before income taxes
$ 11,155 $ 8,581
Income taxes
3,255 2,403
Net income
$ 7,900 $ 6,178
Earnings per share:
Basic
$ 1.66 $ 1.40
Diluted
1.66 1.40
See Notes to Consolidated Financial Statements.





HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (Amounts In Thousands)
Three Months Ended March 31,
2012
2011
Net income
$ 7,900 $ 6,178
Other comprehensive (loss) income, before tax:
Unrealized holding (losses) gains arising during the period
(1,034 ) 602
Less:  reclassification adjustments for gains included in net income
(6 ) -
Other comprehensive (loss) income, before tax:
$ (1,040 ) $ 602
Tax benefit (expense) related to other comprehensive income
399 (231 )
Other comprehensive (loss) income, net of tax
$ (641 ) $ 371
Comprehensive income
$ 7,259 $ 6,549



HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited) (Amounts In Thousands, Except Share Amounts)
Paid In Capital
Retained Earnings
Accumulated Other Comprehensive Income (Loss)
Unearned ESOP Shares
Treasury Stock
Maximum Cash Obligation Related To ESOP Shares
Total
Balance, December 31, 2010
$ 14,875 $ 185,412 $ 2,781 $ - $ (11,854 ) $ (24,945 ) $ 166,269
Issuance of 1,071 shares of common stock
33 - - - - - 33
Forfeiture of 151 shares of common stock
(8 ) - - - - - (8 )
Share-based compensation
4 - - - - - 4
Income tax benefit related to share-based compensation
14 - - - - - 14
Change related to ESOP shares
- - - - - (1,066 ) (1,066 )
Net income
- 6,178 - - - - 6,178
Cash dividends ($1.00 per share)
- (4,399 ) - - - - (4,399 )
Purchase of 3,346 shares of common stock
- - - - (202 ) - (202 )
Other comprehensive income
- - 371 - - - 371
Balance, March 31, 2011
$ 14,918 $ 187,191 $ 3,152 $ - $ (12,056 ) $ (26,011 ) $ 167,194
Balance, December 31, 2011
$ 41,467 $ 207,790 $ 4,974 $ (2,017 ) $ (15,959 ) $ (27,826 ) $ 208,429
Issuance of 3,269 shares of common stock
109 - - - - - 109
Forfeiture of 149 shares of common stock
(9 ) - - - - - (9 )
Share-based compensation
4 - - - - - 4
Income tax benefit related to share-based compensation
38 - - - - - 38
Change related to ESOP shares
- - - - - (824 ) (824 )
Net income
- 7,900 - - - - 7,900
Cash dividends ($1.05 per share)
- (4,998 ) - - - - (4,998 )
Purchase of 9,320 shares of common stock
- - - - (610 ) - (610 )
Other comprehensive loss
- - (641 ) - - - (641 )
Balance, March 31, 2012
$ 41,609 $ 210,692 $ 4,333 $ (2,017 ) $ (16,569 ) $ (28,650 ) $ 209,398
See Notes to Consolidated Financial Statements.





HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS ( Unaudited) (Amounts In Thousands)
Three Months Ended March 31,
2012
2011
Cash Flows from Operating Activities
Net income
$ 7,900 $ 6,178
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation
716 621
Provision for loan losses
(560 ) 1,465
Net gain on sale of investment securities
(6 ) -
Share-based compensation
4 4
Forfeiture of common stock
(9 ) (8 )
Compensation expensed through issuance of common stock
21 33
Excess tax benefits from share-based compensation
(38 ) 14
Provision for deferred income taxes
400 (239 )
Net gain on sale of other real estate owned and other repossessed assets
(296 ) (1 )
Increase in accrued interest receivable
(363 ) (780 )
Amortization of discount on investment securities, net
239 230
Decrease in prepaid FDIC insurance
238 603
Decrease (increase) in other assets
615 (77 )
Increase in accrued interest payable and other liabilities
1,778 3,866
Loans originated for sale
(65,004 ) (27,964 )
Proceeds on sales of loans
72,729 37,492
Net gain on sales of loans
(705 ) (482 )
Net cash and cash equivalents provided by operating activities
$ 17,659 $ 20,955
Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale
$ 11,773 $ 9,840
Proceeds from sales of investment securities available for sale
246 -
Purchases of investment securities available for sale
(13,716 ) (17,841 )
Loans made to customers, net of collections
1,635 (16,454 )
Proceeds on sale of other real estate owned and other repossessed assets
788 416
Purchases of property and equipment
(1,628 ) (730 )
Investment in tax credit real estate, net
472 321
Net cash used in investing activities
$ (430 ) $ (24,448 )
Cash Flows from Financing Activities
Net increase in deposits
$ 86,579 $ 69,909
Net (decrease) increase in short-term borrowings
(5,775 ) 1,559
Stock options exercised
88 -
Excess tax benefits related to share-based compensation
38 14
Payments on FHLB borrowings
- (10,000 )
Purchase of treasury stock
(610 ) (202 )
Dividends paid
(4,998 ) (4,399 )
Net cash provided by financing activities
$ 75,322 $ 56,881
(Continued)




HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
Three Months Ended March 31,
2012
2011
Increase in cash and cash equivalents
$ 92,551 $ 53,388
Cash and cash equivalents:
Beginning of year
29,291 62,978
End of period
$ 121,842 $ 116,366
Supplemental Disclosures
Cash payments for:
Interest paid to depositors
$ 3,658 $ 4,446
Interest paid on other obligations
2,024 2,076
Income taxes paid
- 578
Noncash financing activities:
Increase in maximum cash obligation related to ESOP shares
$ 824 $ 1,066
Transfers to other real estate owned
478 609
See Notes to Consolidated Financial Statements.


HILLS BANCORPORATION
(Unaudited)

Note 1.                 Summary of Significant Accounting Policies

Basis of Presentation:

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with instructions for Form 10-Q and Regulation S-X.  These financial statements include all adjustments (consisting of normal recurring accruals) which in the opinion of management are considered necessary for the fair presentation of the financial position and results of operations for the periods shown.  Certain prior year amounts may be reclassified to conform to the current year presentation.  The Company considers that it operates as one business segment, a commercial bank.

Operating results for the three month period ended March 31, 2012 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2012.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the “Company”) for the year ended December 31, 2011 filed with the Securities Exchange Commission on March 9, 2012.

The Company evaluated subsequent events through the filing date of its quarterly report on Form 10-Q with the SEC.

Recently Adopted Accounting Standards:

In April 2011, the FASB issued new standards that revised the determination of when the restructuring of a receivable should be considered a troubled debt restructuring (“TDR”).  The standard provides additional guidance for determining whether the debtor is experiencing financial difficulty.  The new standard became effective for the Company beginning July 1, 2011.  The adoption did not have a material impact on the Company’s financial position.

Also in April 2011, the FASB issued a new standard that changes the assessment of effective control of a transferor when determining whether repurchase agreements are accounted for as a secured borrowing or sale.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.

In May 2011, the FASB issued a new standard that provides guidance about how fair value should be determined where it already is required or permitted under IFRS or U.S. GAAP.  For U.S. GAAP, most of the changes were clarifications of existing guidance or wording changes to align with IFRS.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.  The Company added additional disclosure requirements to Note 6: Fair Value Measurements.

In September 2011, the FASB issued a new standard the permits the Company to make a qualitative assessment of whether it is more likely than not that the fair value of the portion of the Company to which goodwill relates is less than its carrying amount before applying the two-step goodwill impairment test.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.

In June 2011 and December 2011, the FASB issued standards regarding the presentation of comprehensive income in the consolidated financial statements.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.  The Company now presents comprehensive income in a separate statement of comprehensive income.

Recently Issued Accounting Standards:

None.



HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 2.
Earnings Per Share

Basic earnings per share is computed using the weighted average number of actual common shares outstanding during the period.  Diluted earnings per share reflects the potential dilution that would occur from the exercise of common stock options outstanding.  ESOP shares are considered outstanding for this calculation unless unearned.

The computation of basic and diluted earnings per share for the periods presented is as follows:

Three months ended March 31,
2012
2011
Common shares outstanding at the beginning of the period
4,759,818 4,398,337
Weighted average number of net shares issued (redeemed)
(2,175 ) (819 )
Weighted average shares outstanding (basic)
4,757,643 4,397,518
Weighted average of potential dilutive shares
attributable to stock options granted, computed under
the treasury stock method
7,130 11,345
Weighted average number of shares (diluted)
4,764,773 4,408,863
Net income (In Thousands)
$ 7,900 $ 6,178
Earnings per share:
Basic
$ 1.66 $ 1.40
Diluted
$ 1.66 $ 1.40



HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 3.
Other Comprehensive Income

The following table summarizes the changes in the balances of each component of accumulated other comprehensive income (loss) for the three months ended March 31, 2012 and 2011.


Three Months Ended March 31, 2012
Unrealized Gains (Losses) on Securities
Accumulated Other Comprehensive Income (Loss)
Balance December 31, 2011
$ 4,974 $ 4,974
Current period, other comprehensive (loss) income
(641 ) (641 )
Balance March 31, 2012
$ 4,333 $ 4,333


Three Months Ended March 31, 2011
Unrealized Gains (Losses) on Securities
Accumulated Other Comprehensive Income (Loss)
Balance December 31, 2010
$ 2,781 $ 2,781
Current period, other comprehensive income (loss)
371 371
Balance March 31, 2011
$ 3,152 $ 3,152

The following tables show the tax effects allocated to each component of other comprehensive income (loss) for the three months ended March 31, 2012 and 2011 .

Three Months Ended March 31, 2012
Before Tax Amount
Tax (Expense) Benefit
Net of Tax Amount
Unrealized gains on securities:
Unrealized holding (losses) gains arising during period
$ (1,034 ) $ 397 $ (637 )
Less: reclassification adjustment for gains realized in net income
(6 ) 2 (4 )
Other comprehensive (loss) income
$ (1,040 ) $ 399 $ (641 )
Three Months Ended March 31, 2011
Before Tax Amount
Tax (Expense) Benefit
Net of Tax Amount
Unrealized gains on securities:
Unrealized holding gains (losses) arising during period
$ 602 $ (231 ) $ 371
Less: reclassification adjustment for gains realized in net income
- - -
Other comprehensive income (loss)
$ 602 $ (231 ) $ 371




HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 4.
Recent Legislative Developments

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

Note 5.
Loans

The composition of loans is as follows:

March 31, 2012
December 31, 2011
(Amounts In Thousands)
Agricultural
$ 66,461 $ 68,556
Commercial and financial
143,860 143,174
Real estate:
Construction, 1 to 4 family residential
26,367 22,308
Construction, land development and commercial
81,517 84,508
Mortgage, farmland
101,017 99,799
Mortgage, 1 to 4 family first liens
585,146 577,881
Mortgage, 1 to 4 family junior liens
102,055 104,915
Mortgage, multi-family
218,354 222,851
Mortgage, commercial
312,735 316,329
Loans to individuals
19,543 20,598
Obligations of state and political subdivisions
32,038 31,147
$ 1,689,093 $ 1,692,066
Less allowance for loan losses
28,730 30,150
$ 1,660,363 $ 1,661,916





HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three months ended March 31, 2012 were as follows:


Agricultural
Commercial and Financial
Real Estate: Construction and land development
Real Estate: Mortgage, farmland
Real Estate: Mortgage, 1 to 4 family
Real Estate: Mortgage, multi-family and commercial
Other
Total
(Amounts In Thousands)
Allowance for loan losses:
Beginning balance
$ 1,354 $ 6,429 $ 4,994 $ 1,411 $ 9,051 $ 6,150 $ 761 $ 30,150
Charge-offs
- (415 ) (601 ) - (269 ) (211 ) (28 ) (1,524 )
Recoveries
22 360 1 - 125 83 73 664
Provision
(94 ) (341 ) 379 1 (335 ) (112 ) (58 ) (560 )
Ending balance
$ 1,282 $ 6,033 $ 4,773 $ 1,412 $ 8,572 $ 5,910 $ 748 $ 28,730
Ending balance, individually evaluated for impairment
$ - $ 39 $ 3 $ - $ 78 $ 99 $ 1 $ 220
Ending balance, collectively evaluated for impairment
$ 1,282 $ 5,994 $ 4,770 $ 1,412 $ 8,494 $ 5,811 $ 747 $ 28,510
Loans:
Ending balance
$ 66,461 $ 143,860 $ 107,884 $ 101,017 $ 687,201 $ 531,089 $ 51,581 $ 1,689,093
Ending balance, individually evaluated for impairment
- 3,115 2,051 556 4,114 20,581 3 30,420
Ending balance, collectively evaluated for impairment
$ 66,461 $ 140,745 $ 105,833 $ 100,461 $ 683,087 $ 510,508 $ 51,578 $ 1,658,673

Changes in the allowance for loan losses for the three months ended March 31, 2011 were as follows:
Agricultural
Commercial and Financial
Real Estate: Construction and land development
Real Estate: Mortgage, farmland
Real Estate: Mortgage, 1 to 4 family
Real Estate: Mortgage, multi-family and commercial
Other
Total
(Amounts In Thousands)
Allowance for loan losses:
Beginning balance
$ 2,170 $ 6,742 $ 4,394 $ 1,482 $ 7,952 $ 5,657 $ 833 $ 29,230
Charge-offs
- (740 ) (20 ) - (629 ) (50 ) (62 ) (1,501 )
Recoveries
22 259 1 - 240 51 53 626
Provision
(433 ) 511 33 (13 ) 1,277 85 5 1,465
Ending balance
$ 1,759 $ 6,772 $ 4,408 $ 1,469 $ 8,840 $ 5,743 $ 829 $ 29,820
Ending balance, individually evaluated for impairment
$ - $ 69 $ 17 $ 2 $ 89 $ 60 $ - $ 237
Ending balance, collectively evaluated for impairment
$ 1,759 $ 6,703 $ 4,391 $ 1,467 $ 8,751 $ 5,683 $ 829 $ 29,583
Loans:
Ending balance
$ 63,173 $ 141,213 $ 112,486 $ 94,045 $ 638,095 $ 506,089 $ 50,529 $ 1,605,630
Ending balance, individually evaluated for impairment
- 3,566 1,936 227 4,273 16,785 9 26,796
Ending balance, collectively evaluated for impairment
$ 63,173 $ 137,647 $ 110,550 $ 93,818 $ 633,822 $ 489,304 $ 50,520 $ 1,578,834


HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

The following table presents the credit quality indicators by type of loans in each category as of March 31, 2012 and December 31, 2011, respectively (amounts in thousands):

Agricultural
Commercial and Financial
Real Estate: Construction, 1 to 4 family residential
Real Estate: Construction, land development and commercial
March 31, 2012
Grade:
Pass
$ 59,228 $ 115,901 $ 18,530 $ 60,737
Potential Watch
678 3,886 1,809 1,322
Watch
3,819 14,331 3,801 8,609
Substandard
2,736 9,742 2,227 10,849
Total
$ 66,461 $ 143,860 $ 26,367 $ 81,517
Real Estate: Mortgage, farmland
Real Estate: Mortgage, 1 to 4 family first liens
Real Estate: Mortgage, 1 to 4 family junior liens
Real Estate: Mortgage, multi-family
March 31, 2012
Grade:
Pass
$ 92,353 $ 516,744 $ 91,303 $ 177,866
Potential Watch
1,201 19,904 2,840 12,508
Watch
2,478 22,920 4,681 19,587
Substandard
4,985 25,578 3,231 8,393
Total
$ 101,017 $ 585,146 $ 102,055 $ 218,354
Real Estate: Mortgage, commercial
Loans to individuals
Obligations of state and political subdivisions
Total
March 31, 2012
Grade:
Pass
$ 257,732 $ 18,912 $ 31,976 $ 1,441,282
Potential Watch
12,518 142 - 56,808
Watch
31,499 279 62 112,066
Substandard
10,986 210 - 78,937
Total
$ 312,735 $ 19,543 $ 32,038 $ 1,689,093


HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

Agricultural
Commercial and Financial
Real Estate: Construction, 1 to 4 family residential
Real Estate: Construction, land development and commercial
December 31, 2011
Grade:
Pass
$ 60,745 $ 116,234 $ 18,726 $ 60,279
Potential Watch
1,129 5,858 878 5,171
Watch
4,074 11,104 2,374 5,182
Substandard
2,608 9,978 330 13,876
Total
$ 68,556 $ 143,174 $ 22,308 $ 84,508
Real Estate: Mortgage, farmland
Real Estate: Mortgage, 1 to 4 family first liens
Real Estate: Mortgage, 1 to 4 family junior liens
Real Estate: Mortgage, multi-family
December 31, 2011
Grade:
Pass
$ 93,447 $ 511,212 $ 93,761 $ 181,386
Potential Watch
1,393 20,532 3,021 12,561
Watch
2,490 20,706 4,667 19,317
Substandard
2,469 25,431 3,466 9,587
Total
$ 99,799 $ 577,881 $ 104,915 $ 222,851
Real Estate: Mortgage, commercial
Loans to individuals
Obligations of state and political subdivisions
Total
December 31, 2011
Grade:
Pass
$ 259,516 $ 19,914 $ 31,085 $ 1,446,305
Potential Watch
14,401 180 - 65,124
Watch
31,928 290 62 102,194
Substandard
10,484 214 - 78,443
Total
$ 316,329 $ 20,598 $ 31,147 $ 1,692,066

The below are descriptions of the credit quality indicators:

Pass – Pass rated loans are supported by sound payment capacity, are adequately collateralized and have no apparent weaknesses that would affect the full repayment of the loan under the established terms and conditions.

Potential Watch – Potential watch rated loans are supported by adequate payment capacity, are adequately collateralized and are performing according to the established terms and conditions.  However, the loan requires more than average monitoring due to a potential weakness.  The potential watch indicator assists the Company in identifying and monitoring loans for which credit quality could deteriorate.



HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

Watch – Watch rated loans are supported by a marginal payment capacity and may be marginally collateralized.  There are identified weaknesses that if not monitored and corrected may adversely affect the Company’s credit position.  A watch credit would typically have a weakness in one of the general categories (cash flow, collateral position or payment history) but not in all categories.

Substandard – Substandard loans are not adequately supported by the paying capacity of the borrower and may be inadequately collateralized.  These loans have a well-defined weakness or weaknesses.  For these loans, it is more probable than not that the Company could sustain some loss if the deficiency(ies) is not corrected.

Past due loans as of March 31, 2012 and December 31, 2011 were as follows:


90 Days
Total
Accruing Loans
30 - 59 Days
60 - 89 Days
or More
Total Past
Loans
Past Due 90
Past Due
Past Due
Past Due
Due
Current
Receivable
Days or More
(Amounts In Thousands)
March 31, 2012
Agriculture
$ 254 $ - $ - $ 254 $ 66,207 $ 66,461 $ -
Commercial and financial
617 299 574 1,490 142,370 143,860 90
Real estate:
Construction, 1 to 4 family residential
696 - - 696 25,671 26,367 -
Construction, land development and commercial
25 181 242 448 81,069 81,517 14
Mortgage, farmland
- - 556 556 100,461 101,017 -
Mortgage, 1 to 4 family first liens
4,205 449 2,804 7,458 577,688 585,146 2,002
Mortgage, 1 to 4 family junior liens
311 31 307 649 101,406 102,055 30
Mortgage, multi-family
- - 262 262 218,092 218,354 -
Mortgage, commercial
590 183 1,582 2,355 310,380 312,735 624
Loans to individuals
47 19 3 69 19,474 19,543 3
Obligations of state and political subdivisions
- - - - 32,038 32,038 -
$ 6,745 $ 1,162 $ 6,330 $ 14,237 $ 1,674,856 $ 1,689,093 $ 2,763
December 31, 2011:
Agriculture
$ 509 $ - $ 13 $ 522 $ 68,034 $ 68,556 $ 13
Commercial and financial
558 187 849 1,594 141,580 143,174 222
Real estate:
Construction, 1 to 4 family residential
367 - - 367 21,941 22,308 -
Construction, land development and commercial
164 719 327 1,210 83,298 84,508 14
Mortgage, farmland
752 - - 752 99,047 99,799 -
Mortgage, 1 to 4 family first liens
4,042 1,012 3,414 8,468 569,413 577,881 2,673
Mortgage, 1 to 4 family junior liens
454 353 396 1,203 103,712 104,915 105
Mortgage, multi-family
- - 267 267 222,584 222,851 -
Mortgage, commercial
838 755 718 2,311 314,018 316,329 185
Loans to individuals
38 21 - 59 20,539 20,598 -
Obligations of state and political subdivisions
2,834 - - 2,834 28,313 31,147 -
$ 10,556 $ 3,047 $ 5,984 $ 19,587 $ 1,672,479 $ 1,692,066 $ 3,212

The Company does not have a significant amount of loans that are past due less than 90 days where there are serious doubts as to the ability of the borrowers to comply with the loan repayment terms.


HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

The following table summarizes the Company’s impaired loans and non-performing assets at March 31, 2012 and December 31, 2011:

March 31, 2012
December 31, 2011
(Amounts In Thousands)
Non-accrual loans
$ 8,867 $ 7,378
Accruing loans past due 90 days or more (1)
2,763 3,212
TDR loans (2)
18,790 17,889
Total impaired loans
30,420 28,479
Other real estate
1,313 1,327
Non-performing assets (includes impaired loans and other real estate)
31,733 29,806
Loans held for investment
1,689,093 1,692,066
Ratio of allowance for loan losses to loans held for investment
1.70 % 1.78 %
Ratio of allowance for loan losses to impaired loans
94.44 105.87
Ratio of impaired loans to total loans held for investment
1.80 1.68
Ratio of non-performing assets to total assets
1.51 1.48

(1)
There were $0.21 million and $0.26 million of TDR loans included within accruing loans past due 90 days or more as of March 31, 2012 and December 31, 2011.
(2)
Total TDR loans were $22.6 million and $21.4 million as of March 31, 2012 and December 31, 2011, respectively.  Included in the total nonaccrual loans were $3.6 million and $3.2 million of TDR loans as of March 31, 2012 and December 31, 2011.

Certain impaired loan information by loan type at March 31, 2012 and December 31, 2011, was as follows:


March 31, 2012
December 31, 2011
Non-accrual loans
Accruing loans past due 90 days or more
TDR loans
Non-accrual loans
Accruing loans past due 90 days or more
TDR loans
(Amounts In Thousands)
(Amounts In Thousands)
Agriculture
$ - $ - $ - $ - $ 13 $ -
Commercial and financial
1,096 90 1,929 1,286 222 1,109
Real estate:
Construction, 1 to 4 family residential
- - - - - -
Construction, land development and commercial
2,037 14 - 648 14 -
Mortgage, farmland
556 - - 556 - -
Mortgage, 1 to 4 family first liens
1,046 2,002 667 1,141 2,673 541
Mortgage, 1 to 4 family junior liens
276 30 94 291 105 50
Mortgage, multi-family
2,122 - 5,839 2,168 - 5,870
Mortgage, commercial
1,734 624 10,261 1,288 185 10,319
Loans to individuals
- 3 - - - -
$ 8,867 $ 2,763 $ 18,790 $ 7,378 $ 3,212 $ 17,889
Loans 90 days or more past due that are still accruing interest decreased $0.45 million from December 31, 2011 to March 31, 2012 due to an overall reduction in delinquency trends during the first three months of 2012. The average 90 days or more past due loan balance was $92,000 as of March 31, 2012 and $80,000 as of December 31, 2011.  The loans 90 days or more past due and still accruing are believed to be adequately collateralized and the Company expects to collect all principal and interest as contractually due under these loans.


HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

The Company may modify the terms of a loan to maximize the collection of amounts due.  Such a modification is considered a troubled debt restructuring (“TDR”).  In most cases, the modification is either a reduction in interest rate, conversion to interest only payments or an extension of the maturity date.  The borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, so a concessionary modification is granted to the borrower that would otherwise 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.

Below is a summary of information for TDR loans as of March 31, 2012 and December 31, 2011:

March 31, 2012
December 31, 2011
Number
Number
of
Recorded
Commitments
of
Recorded
Commitments
contracts
investment
outstanding
contracts
investment
outstanding
(Amounts In Thousands)
(Amounts In Thousands)
Agriculture
- $ - $ - - $ - $ -
Commercial and financial
10 2,462 36 9 1,802 108
Real estate:
Construction, 1 to 4 family residential
- - - - - -
Construction, land development and commercial
2 333 - 2 335 452
Mortgage, farmland
- - - - - -
Mortgage, 1 to 4 family first liens
7 882 - 7 801 -
Mortgage, 1 to 4 family junior liens
2 94 24 1 50 -
Mortgage, multi-family
4 7,532 - 4 7,597 -
Mortgage, commercial
8 11,271 - 6 10,814 -
Loans to individuals
- - - - - -
33 $ 22,574 $ 60 29 $ 21,399 $ 560

The following is a summary of TDR loans that were modified during the three months ended March 31, 2012:


Three Months Ended March 31, 2012
Number
Pre-modification
Post-modification
of
recorded
recorded
contracts
investment
investment
(Amounts In Thousands)
Commercial and financial
1 $ 926 $ 926
Real estate:
Mortgage, 1 to 4 family junior liens
1 69 54
Mortgage, commercial
2 702 552
4 $ 1,697 $ 1,532


The Company had commitments to lend $0.06 million in additional borrowings to restructured loan customers as of March 31, 2012.  The Company had commitments to lend $0.56 million in additional borrowings to restructured loan customers as of December 31, 2011.  These commitments were in the normal course of business and allowed the borrowers to build pre-sold homes and commercial property, which was expected to increase their overall cash flow.  The additional borrowings were not used to facilitate payments on these loans.



HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

There were $0.21 million and $0.26 million of TDR loans that were in payment default (defined as past due 90 days or more) as of March 31, 2012 and December 31, 2011, respectively.

Information regarding impaired loans as of and for the three months ended March 31, 2012 is as follows:
March 31, 2012
Three Months Ended March 31, 2012
Recorded Investment
Unpaid Principal Balance
Related Allowance
Average Recorded Investment
Interest Income Recognized
With no related allowance recorded:
(Amounts In Thousands)
Agriculture
$ - $ - $ - $ - $ -
Commercial and financial
1,203 2,982 - 1,294 1
Real estate:
Construction, 1 to 4 family residential
- - - - -
Construction, land development and commercial
2,037 2,718 - 2,362 -
Mortgage, farmland
556 556 - 556 -
Mortgage, 1 to 4 family first liens
1,325 1,720 - 1,328 4
Mortgage, 1 to 4 family junior liens
329 645 - 347 1
Mortgage, multi-family
2,122 2,765 - 2,145 -
Mortgage, commercial
2,671 5,151 - 2,773 12
Loans to individuals
- 20 - - -
$ 10,243 $ 16,557 $ - $ 10,805 $ 18
With an allowance recorded:
Agriculture
$ - $ - $ - $ - $ -
Commercial and financial
1,912 1,912 39 1,999 26
Real estate:
Construction, 1 to 4 family residential
- - - - -
Construction, land development and commercial
14 27 3 14 -
Mortgage, farmland
- - - - -
Mortgage, 1 to 4 family first liens
2,389 2,735 76 2,347 31
Mortgage, 1 to 4 family junior liens
71 71 2 75 1
Mortgage, multi-family
5,840 5,840 56 5,855 77
Mortgage, commercial
9,948 10,082 43 9,972 147
Loans to individuals
3 3 1 3 -
$ 20,177 $ 20,670 $ 220 $ 20,265 $ 282
Total:
Agriculture
$ - $ - $ - $ - $ -
Commercial and financial
3,115 4,894 39 3,293 27
Real estate:
Construction, 1 to 4 family residential
- - - - -
Construction, land development and commercial
2,051 2,745 3 2,376 -
Mortgage, farmland
556 556 - 556 -
Mortgage, 1 to 4 family first liens
3,714 4,455 76 3,675 35
Mortgage, 1 to 4 family junior liens
400 716 2 422 2
Mortgage, multi-family
7,962 8,605 56 8,000 77
Mortgage, commercial
12,619 15,233 43 12,745 159
Loans to individuals
3 23 1 3 -
$ 30,420 $ 37,227 $ 220 $ 31,070 $ 300



HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

Information regarding impaired loans as of December 31, 2011 is as follows:

Recorded Investment
Unpaid Principal Balance
Related Allowance
With no related allowance recorded:
(Amounts In Thousands)
Agriculture
$ - $ - $ -
Commercial and financial
793 1,679 -
Real estate:
Construction, 1 to 4 family residential
- - -
Construction, land development and commercial
648 765 -
Mortgage, farmland
556 556 -
Mortgage, 1 to 4 family first liens
1,512 1,905 -
Mortgage, 1 to 4 family junior liens
291 568 -
Mortgage, multi-family
5,148 5,757 -
Mortgage, commercial
1,986 4,305 -
Loans to individuals
- 21 -
$ 10,934 $ 15,556 $ -
With an allowance recorded:
Agriculture
$ 13 $ 13 $ 1
Commercial and financial
1,824 2,954 97
Real estate:
Construction, 1 to 4 family residential
- - -
Construction, land development and commercial
14 27 3
Mortgage, farmland
- - -
Mortgage, 1 to 4 family first liens
2,843 3,187 88
Mortgage, 1 to 4 family junior liens
155 155 5
Mortgage, multi-family
2,890 2,890 29
Mortgage, commercial
9,806 9,806 36
Loans to individuals
- - -
$ 17,545 $ 19,032 $ 259
Total:
Agriculture
$ 13 $ 13 $ 1
Commercial and financial
2,617 4,633 97
Real estate:
Construction, 1 to 4 family residential
- - -
Construction, land development and commercial
662 792 3
Mortgage, farmland
556 556 -
Mortgage, 1 to 4 family first liens
4,355 5,092 88
Mortgage, 1 to 4 family junior liens
446 723 5
Mortgage, multi-family
8,038 8,647 29
Mortgage, commercial
11,792 14,111 36
Loans to individuals
- 21 -
$ 28,479 $ 34,588 $ 259



HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

Impaired loans increased $1.94 million from December 31, 2011 to March 31, 2012.  Impaired loans include any loan that has been placed on nonaccrual status, loans past due 90 days or more and still accruing interest and TDR loans.  Impaired 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.  Impaired loans were 1.80% of loans held for investment as of March 31, 2012 and 1.68% as of December 31, 2011.  The increase in impaired loans is due mainly to an increase in non-accrual loans of $1.49 million from December 31, 2011 to March 31, 2012.  The increase in non-accrual loans is due to additional construction, mortgage and commercial customer relationships classified as nonaccrual.  TDR loans increased $1.18 million from December 31, 2011 to March 31, 2012 as a result of three additional restructured loan relationships.

The Company regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans are impaired in accordance with ASC 310.  If the loans are impaired, the Company determines if a specific allowance is appropriate.  In addition, the Company'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.  Loans that are determined not to be impaired and for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Company allocates a percentage, as determined by management, for a required allowance needed.  The determination of the appropriate percentage begins with historical loss experience factors, which are then adjusted for levels and trends in past due loans, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in restructured loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.

Specific allowances for losses on impaired loans are established if the loan balances exceed the net present value of the relevant future cash flows or the fair value of the relevant collateral based on updated appraisals and/or updated collateral analysis for the properties if the loan is collateral dependent.  The Company recognizes a charge off related to an impaired loan if there is a collateral shortfall or it is unlikely the borrower can make all principal and interest payments as contractually due.

For loans that are collateral dependent, losses are evaluated based on the portion of a loan that exceeds the fair market value of the collateral.  In general, this is the amount that the carrying value of the loan exceeds the related appraised value less estimated costs to sell the collateral.  Generally, it is the Company’s policy not to rely on appraisals that are older than one year prior to the date the impairment is being measured.  The most recent appraisal values may be adjusted if, in the Company’s judgment, experience and other market data indicate that the property’s value, use, condition, exit market or other variable affecting its value may have changed since the appraisal was performed, consistent with the December 2006 joint interagency guidance on the allowance for loan losses.  The charge off or loss adjustment supported by an appraisal is considered the minimum charge off.  Any adjustments made to the appraised value are to provide an additional charge off or specific reserve based on the applicable facts and circumstances.  In instances where there is an estimated decline in value, a specific reserve may be provided or a charge off taken pending confirmation of the amount of the loss from an updated appraisal.  Upon receipt of the new appraisals, an additional specific reserve may be provided or charge off taken based on the appraised value of the collateral.  On average, appraisals are obtained within one month of order.






HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments as of March 31, 2012 are as follows:

March 31, 2012
Carrying Amount
Estimated Fair Value
Readily Available Market Prices(1)
Observable Market Prices(2)
Company Determined Market Prices(3)
(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents
$ 121,842 $ 121,842 $ 121,842 $ - $ -
Investment securities
222,521 222,521 - 222,521 -
Loans held for sale
17,595 17,595 17,595
Loans
Agricultural
65,179 67,073 - - 67,073
Commercial and financial
137,827 136,494 - 3,115 133,379
Real estate:
-
Construction, 1 to 4 family residential
25,187 25,040 - 2,051 22,989
Construction, land development and commercial
77,924 77,528 - 556 76,972
Mortgage, farmland
99,605 102,279 - 3,714 98,565
Mortgage, 1 to 4 family first liens
578,457 595,497 - 400 595,097
Mortgage, 1 to 4 family junior liens
100,172 102,398 - 7,962 94,436
Mortgage, multi-family
216,640 223,813 - 12,619 211,194
Mortgage, commercial
308,538 316,998 - 3 316,995
Loans to individuals
19,197 19,395 - - 19,395
Obligations of state and political subdivisions
31,637 31,689 - - 31,689
Accrued interest receivable
9,052 9,052 - 9,052 -
Total financial instrument assets
$ 2,031,373 $ 2,069,214 $ 121,842 $ 279,588 $ 1,667,784
Financial instrument liabilities:
Deposits
Noninterest-bearing deposits
$ 221,629 $ 221,629 $ - $ 221,629 $ -
Interest-bearing deposits
1,390,427 1,400,656 - 1,400,656 -
Short-term borrowings
47,010 47,010 - 47,010 -
Federal Home Loan Bank borrowings
185,000 198,325 - 198,325 -
Accrued interest payable
1,540 1,540 - 1,540 -
Total financial instrument liabilities
$ 1,845,606 $ 1,869,160 $ - $ 1,869,160 $ -
Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments
$ 291,803 $ - $ - $ - $ -
Letters of credit
11,244 - - - -
Total financial instrument liabilities with off-balance-sheet risk
$ 303,047 $ - $ - $ - $ -

(1)
Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”).
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.



HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

The carrying value and estimated fair values of the Company's financial instruments as of December 31, 2011 are as follows:

December 31, 2011
Carrying Amount
Estimated Fair Value
Readily Available Market Prices(1)
Observable Market Prices(2)
Company Determined Market Prices(3)
(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents
$ 29,291 $ 29,291 $ 29,291 $ - $ -
Investment securities
222,095 222,095 - 222,095 -
Loans held for sale
24,615 24,615 24,615
Loans
Agricultural
67,202 68,306 - - 68,306
Commercial and financial
136,745 135,317 - 2,163 133,154
Real estate:
Construction, 1 to 4 family residential
21,744 22,233 - 472 21,761
Construction, land development and commercial
80,078 79,527 - 331 79,196
Mortgage, farmland
98,388 101,743 - 7,174 94,569
Mortgage, 1 to 4 family first liens
570,844 591,460 - 222 591,238
Mortgage, 1 to 4 family junior liens
102,901 105,872 - 613 105,259
Mortgage, multi-family
220,963 229,779 - 2,297 227,482
Mortgage, commercial
312,067 322,922 - - 322,922
Loans to individuals
20,227 20,542 - - 20,542
Obligations of state and political subdivisions
30,757 30,811 - - 30,811
Accrued interest receivable
8,689 8,689 - 8,689 -
Total financial instrument assets
$ 1,946,606 $ 1,993,202 $ 29,291 $ 268,671 $ 1,695,240
Financial instrument liabilities:
Deposits
Noninterest-bearing deposits
$ 223,378 $ 223,378 $ - $ 223,378 $ -
Interest-bearing deposits
$ 1,302,099 1,309,545 - $ 1,309,545 -
Short-term borrowings
52,785 52,785 - $ 52,785 -
Federal Home Loan Bank borrowings
185,000 199,008 - $ 199,008 -
Accrued interest payable
1,625 1,625 - $ 1,625 -
Total financial instrument liabilities
$ 1,764,887 $ 1,786,341 $ - $ 1,786,341 $ -
Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments
$ 269,687 $ - $ - $ - $ -
Letters of credit
12,016 - - - -
Total financial instrument liabilities with off-balance-sheet risk
$ 281,703 $ - $ - $ - $ -

(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

FASB ASC 820, Fair Value Measurements and Disclosures provides a single definition for fair value, a framework for measuring fair value and expanded disclosures concerning fair value.  Fair value is defined under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.




HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

The Company determines the fair market value of its financial instruments based on the fair value hierarchy established in ASC 820.  There are three levels of inputs that may be used to measure fair value as follows:

Level 1
Quoted prices in active markets for identical assets or liabilities.

Level 2
Observable inputs other than quoted prices included within Level 1.  Observable inputs include the quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active and inputs other than quoted prices that are observable for the asset or liability. Level 2 includes securities purchased from the Federal Home Loan Bank (“FHLB”), Federal Home Loan Mortgage Corporation (“FHLMC”), Federal National Mortgage Association (“FNMA”) and issued by state and political subdivisions.

Level 3
Unobservable inputs supported by little or no market activity for financial instruments.  Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements.  Recent market conditions have led to diminished, and in some cases, non-existent trading in certain of the financial asset classes.  The Company is required to use observable inputs, to the extent available, in the fair value estimation process unless that data results from forced liquidations or distressed sales.  Despite the Company’s best efforts to maximize the use of relevant observable inputs, the current market environment has diminished the observability of trades and assumptions that have historically been available.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value and for estimating fair value for assets or liabilities not recorded at fair value.

ASSETS

Cash and cash equivalents :  The carrying amounts reported in the consolidated balance sheets for cash and short-term instruments approximate their fair values (Level 1).

Investment securities available for sale :  Investment securities available for sale are recorded at fair value on a recurring basis.  Fair value measurement is based upon quoted prices, if available.  If a quoted price is not available, the fair value is obtained from benchmarking the security against similar securities.  All of the Company’s securities are considered Level 2.

The pricing for investment securities is obtained from an independent source.  The Company’s investment securities are low risk and are measured at fair value as Level 2 assets.  There are no Level 1 or Level 3 investment securities owned by the Company.  The Company obtains an understanding of the independent source’s valuation methodologies used to determine fair value by the level of security.  The Company validates assigned fair values on a sample basis using an additional third-party provider pricing service to determine if the fair value measurement is reasonable.  Due to the nature of the Company’s investment portfolio, there is no expectation of significant and unusual fluctuation as fair value changes primarily relate to interest rate changes.  No unusual fluctuations were identified during the three months ended March 31, 2012.  If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.




HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

ASSETS (continued)


Non-marketable equity investments :  Non-marketable equity investments are recorded under the cost or equity method of accounting.  There are generally restrictions on the sale and/or liquidation of these investments, including stock of the Federal Home Loan Bank.  The carrying value of stock of the Federal Home Loan Bank approximates fair value (Level 2).

Loans held for sale :  Loans held for sale are carried at historical cost.  The carrying amount is a reasonable estimate of fair value because of the short time between origination of the loan and its sale on the secondary market (Level 2).

Loans :  The Company does not record loans at fair value on a recurring basis.  For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values (Level 3).  The fair values for other loans are determined using estimated future cash flows, discounted at the interest rates currently being offered for loans with similar terms to borrowers with similar credit quality utilizing an entrance price concept (Level 3).  The Company does record nonrecurring fair value adjustments to loans to reflect (1) partial write-downs that are based on the observable market price or appraised value of the collateral or (2) the full charge-off of the loan carrying value (Level 2).

Foreclosed assets :  Foreclosed assets consist mainly of other real estate owned but may include other types of assets repossessed by the Company.  Foreclosed assets are adjusted to the lower of carrying value or fair value less the cost of disposal upon transfer of the loans to foreclosed assets.   Fair value is generally based upon independent market prices or appraised values of the collateral.  The value of foreclosed assets is evaluated periodically.  Foreclosed assets are classified as Level 2.

Off-balance sheet instruments :  Fair values for outstanding letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing.  The fair value of the outstanding letters of credit is not significant. Unfunded loan commitments are not valued since the loans are generally priced at market at the time of funding (Level 2).

Accrued interest receivable :  The fair value of accrued interest receivable equals the amount receivable due to the current nature of the amounts receivable (Level 2).



HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

LIABILITIES

Deposit liabilities :  Deposit liabilities are carried at historical cost.  The fair value of demand deposits, savings accounts and certain money market account deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.  If the fair value of the fixed maturity certificates of deposit is calculated at less than the carrying amount, the carrying value of these deposits is reported as the fair value (Level 2).

Short-term borrowings :  Short-term borrowings are carried at historical cost and include federal funds purchased and securities sold under agreements to repurchase.  The carrying amount is a reasonable estimate of fair value because of the relatively short time between the origination of the liability and its expected realization (Level 2).

Long-term borrowings :  Long-term borrowings are recorded at historical cost.  The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements (Level 2).

Accrued interest payable :  The fair value of accrued interest payable equals the amount payable due to the current nature of the amounts payable (Level 2).





HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below represents the balances of assets and liabilities measured at fair value on a recurring basis:


March 31, 2012
Readily Available Market Prices(1)
Observable Market Prices(2)
Company Determined Market Prices(3)
Total at Fair Value
(Amounts In Thousands)
Investment securities available for sale
$ - $ 211,850 $ - $ 211,850
Total
$ - $ 211,850 $ - $ 211,850
December 31, 2011
Readily Available Market Prices(1)
Observable Market Prices(2)
Company Determined Market Prices(3)
Total at Fair Value
(Amounts in Thousands)
Investment securities available for sale
$ - $ 211,367 $ - $ 211,367
Total
$ - $ 211,367 $ - $ 211,367

(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

There were no transfers between Levels 1, 2 or 3 during the three months ended March 31, 2012.




HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Company is required to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP.  These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets.  The valuation methodologies used to measure these fair value adjustments are described above.    The following tables present the Company’s assets that are measured at fair value on a nonrecurring basis.


Three Months Ended
March 31, 2012
March 31, 2012
Readily Available Market Prices(1)
Observable Market Prices(2)
Company Determined Market Prices(3)
Total at Fair Value
Total Losses
(Amounts in Thousands)
Loans (4)
Commercial and financial
$ - $ 3,115 $ - $ 3,115 $ 60
Real Estate:
Construction, land development and commercial
- 2,051 - 2,051 563
Mortgage, farmland
- 556 - 556 -
Mortgage, 1 to 4 family first liens
- 3,714 - 3,714 101
Mortgage, 1 to 4 family junior liens
- 400 - 400 -
Mortgage, multi-family
- 7,962 - 7,962 -
Mortgage, commercial
- 12,619 - 12,619 210
Loans to individuals
- 3 - 3 -
Foreclosed assets (5)
- 373 - 373 65
Total
$ - $ 30,793 $ - $ 30,793 $ 999

(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
(4)
Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully-charged off is zero.
(5)
Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.



HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis (continued)

Year Ended
December 31, 2011
December 31, 2011
Readily Available Market Prices(1)
Observable Market Prices(2)
Company Determined Market Prices(3)
Total at Fair Value
Total Losses
(Amounts in Thousands)
Loans (4)
Commercial and financial
$ - $ 2,163 $ - $ 2,163 $ 548
Real Estate:
Construction, land development and commercial
- 472 - 472 30
Mortgage, farmland
- 331 - 331 -
Mortgage, 1 to 4 family first liens
- 7,174 - 7,174 1,205
Mortgage, 1 to 4 family junior liens
- 222 - 222 207
Mortgage, multi-family
- 613 - 613 50
Mortgage, commercial
- 2,297 - 2,297 525
Loans to individuals
- - - - 5
Foreclosed assets (5)
- 286 - 286 198
Total
$ - $ 13,558 $ - $ 13,558 $ 2,768


(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
(4)
Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully-charged off is zero.
(5)
Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

As of March 31, 2012, the $14.95 million of loans recorded at fair value on a nonrecurring basis consisted of the following loan types:  $7.51 million of 1-to-4 family residential loans, $1.97 million of commercial and industrial loans, and $3.14 million of commercial mortgage loans.  The remaining $2.33 million includes loans in the following categories:  construction and land development, agricultural, real estate construction, mortgage – farmland, mortgage – multi-family, and loans to individuals.  The total $14.95 million of loans represents the carrying value of loans partially charged off as it was determined that the fair value of the loan collateral was less than the carrying value.  Of the total $14.95 million, $4.44 million was included in the nonaccrual loan total.  The remaining $10.51 million is accruing interest based on the fact loan payments have been made as contractually agreed.





HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 7.
Stock Repurchase Program

In July of 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”).  This authorization is set to expire on December 31, 2013.  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.  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 and legal factors.  The Company has purchased 301,403 shares of its common stock in privately negotiated transactions from August 1, 2005 through March 31, 2012.  Of these 301,403 shares, 9,320 shares were purchased during the quarter ended March 31, 2012, at an average price per share of $65.53.

Note 8.
Commitments and Contingencies

The Company’s subsidiary, Hills Bank and Trust Company (the “Bank”) is a party to financial instruments with off-balance–sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit, credit card participations and standby letters of credit.  These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.  A summary of the Bank’s commitments at March 31, 2012 and December 31, 2011 is as follows:

March 31, 2012
December 31, 2011
(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans
$ 34,729 $ 35,345
Credit cards
43,775 42,493
Commercial, real estate and home construction
74,431 62,388
Commercial lines and real estate purchase loans
138,868 129,461
Outstanding letters of credit
11,244 12,016


Note 9.
Income Taxes

Federal income tax expense for the three months ended March 31, 2012 and 2011 was computed using the consolidated effective federal tax rate.  The Company also recognized income tax expense pertaining to state franchise taxes payable individually by the subsidiary bank.  The Company files a consolidated tax return for federal purposes and separate tax returns for State of Iowa purposes.  The tax years ended December 31, 2011, 2010 and 2009 remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2011, 2010 and 2009 remain open for examination.  There were no material unrecognized tax benefits at December 31, 2011 and March 31, 2012 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of March 31, 2012, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending March 31, 2013.

Income taxes as a percentage of income before taxes were 29.18% in 2012 and 28.00% in 2011.  The increase in the effective tax rate is due to tax-exempt interest income and income tax credits and the relationship to total income before income taxes.


HILLS BANCORPORATION

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

The following is management’s discussion and analysis of the financial condition of Hills Bancorporation (“Hills Bancorporation” or “the Company”) and its banking subsidiary Hills Bank and Trust Company (“the Bank”) for the dates and periods indicated.  The discussion and analysis should be read in conjunction with the consolidated financial statements and the accompanying footnotes.

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 recent financial market disruptions and the current global economic recession, and monetary and other governmental actions designed to address such disruptions and recession.

·
The financial strength of the counterparties with which the Company or the Company’s customers do business and as to which the Company has investment or financial exposure.

·
The credit quality and credit agency ratings of the securities in the Company’s investment securities portfolio, a deterioration or downgrade of which could lead to other-than-temporary impairment of the affected securities and the recognition of an impairment loss.

·
The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company.

·
The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.

·
The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.

·
The ability of the Company to obtain new customers and to retain existing customers.

·
The timely development and acceptance of products and services, including products and services offered through alternative electronic delivery channels.

·
Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.


HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

·
The ability of the Company to develop and maintain secure and reliable electronic systems.

·
The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.

·
Consumer spending and saving habits which may change in a manner that affects the Company’s business adversely.

·
The economic impact of natural disasters, terrorist attacks and military actions.

·
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.

Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these financial statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company's allowance for loan losses methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including economic conditions throughout the Midwest and the state of certain industries.  Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management.  The future impact of the global recession has introduced additional uncertainty into such determinations.  Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position.  Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations.  Although management believes the levels of the allowance as of March 31, 2012 and December 31, 2011 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.




HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Non-GAAP Financial Measures

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States (“GAAP”).  However, management uses certain non-GAAP measures and ratios to evaluate and measure the Company’s performance.  These measures and ratios include return on average shareholders’ equity and average shareholders’ equity to average total assets.  For each of these measures and ratios, the Company adds to shareholders’ equity the amount in “maximum cash obligation related to ESOP shares”.  Under the ESOP, the Company has certain contingent repurchase obligations to buy back common stock distributed to participants.  This contingent repurchase obligation is reflected in the Company’s financial statements as “maximum cash obligation related to ESOP shares” and, in accordance with GAAP, reduces shareholders’ equity.  The Company believes that it is unlikely that the Company would be required to satisfy its contingent repurchase obligation and therefore believes that adjusting shareholders’ equity by adding “maximum cash obligation related to ESOP shares” to that amount provides a more meaningful view of the applicable measures and ratios.  In addition, management believes that the return on average shareholders’ equity, a financial measure frequently considered to evaluate the performance of bank holding companies, would be significantly overstated.

The following table presents a reconciliation of certain non-GAAP performance measures and ratios used by the Company to the most directly comparable GAAP financial measures for the three months ended March 31, 2012 and the year ended December 31, 2011 (dollars in thousands, except per share data):

March 31, 2012
December 31, 2011
Shareholders' equity (GAAP)
$ 209,398 $ 208,429
Shareholders' equity plus common stock in ESOP subject to contingent repurchase obligation (non-GAAP)
238,048 236,255
Net income (1)
28,499 26,777
Average shareholders' equity (GAAP) (2)
189,506 178,984
Average shareholders' equity plus common stock in ESOP subject to contingent repurchase obligation (2)
216,554 205,370
Return on average shareholders' equity (GAAP) (3)
15.04 % 14.96 %
Return on average shareholders' equity plus common stock in ESOP subject to contingent repurchase obligation (4)
13.16 % 13.04 %


(1)
Calculation based on trailing 12 month figures.
(2)
Calculation based on trailing 12 month average.
(3)
Return on average shareholders’ equity (GAAP) equals net income divided by average shareholders’ equity.  Average shareholders’ equity is calculated using a trailing 12 month average.
(4)
Return on average shareholders’ equity plus common stock in ESOP subject to contingent repurchase obligation (non-GAAP) equals net income divided by average shareholders’ equity plus common stock in ESOP subject to contingent repurchase obligation.  Average shareholders’ equity is calculated using a trailing 12 month average.




HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Overview

This overview highlights selected information and may not contain all of the information that is important to you in understanding our performance during the period.  For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources, and critical accounting estimates, you should carefully read this entire report.

The Company is a holding company engaged in the business of commercial banking.  The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned.  The Bank was formed in Hills, Iowa in 1904.  The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa.  At March 31, 2012, the Bank has seventeen full-service locations. The Company added three additional offices during the three months ended March 31, 2012.  The new office locations are located at the University of Iowa Memorial Union, the University of Iowa Hospitals and Clinics and North Liberty, Iowa.

Net income for the three month period ended March 31, 2012 was $7.90 million compared to $6.18 million for the same three months of 2011, an increase of 27.83%.  The $1.72 million increase in net income was caused by a number of factors.  The principal factors in the increase in net income for the first three months of 2012 are an increase in net interest income of $0.57 million and a decrease in the provision for loan losses of $2.03 million.  In addition, other income increased $0.68 million for the first three months of 2012.  These changes were offset by an increase in other expenses of $0.70 million and an increase in income tax expense of $0.85 million during the 2012 period.

The Company achieved a return on average assets of 1.43% and a return on average equity of 13.16% for the twelve months ended March 31, 2012, compared to the twelve months ended March 31, 2011 which were 1.27% and 12.85%, respectively. Dividends of $1.05 per share were paid in January 2012 to 2,186 shareholders.  The 2011 dividend was $1.00 per share.

The Bank’s net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage. The Bank achieved a net interest margin on a tax-equivalent basis of 3.75% in 2012 compared to 3.82% in 2011.  Average earning assets were $2.022 billion in 2012 and $1.831 billion in 2011.

Highlights noted on the balance sheet as of March 31, 2012 for the Company included the following:

Ÿ
Total assets were $2.103 billion, an increase of $84.38 million since December 31, 2011.
Ÿ
Cash and cash equivalents were $121.84 million, an increase of $92.55 million since December 31, 2011.  The growth in cash and cash equivalents included $70.0 million of temporary public funds.
Ÿ
Net loans were $1.677 billion, a decrease of $8.57 million since December 31, 2011.
Ÿ
Deposit growth of $86.58 million since December 31, 2011.  Deposit growth included $70.0 million of temporary public funds.

Reference is made to Note 6 for a discussion of fair value measurements which relate to methods used by the Company in recording assets and liabilities on its financial statements.




HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Financial Condition

The following table sets forth the composition of the loan portfolio as of March 31, 2012 and December 31, 2011:

March 31, 2012
December 31, 2011
Amount
Percent
Amount
Percent
(Amounts In Thousands)
(Amounts In Thousands)
Agricultural
$ 66,461 3.93 % $ 68,556 4.05 %
Commercial and financial
143,860 8.52 143,174 8.46
Real estate:
Construction, 1 to 4 family residential
26,367 1.56 22,308 1.32
Construction, land development and commercial
81,517 4.83 84,508 4.99
Mortgage, farmland
101,017 5.98 99,799 5.90
Mortgage, 1 to 4 family first liens
585,146 34.64 577,881 34.16
Mortgage, 1 to 4 family junior liens
102,055 6.04 104,915 6.20
Mortgage, multi-family
218,354 12.93 222,851 13.17
Mortgage, commercial
312,735 18.51 316,329 18.69
Loans to individuals
19,543 1.16 20,598 1.22
Obligations of state and political subdivisions
32,038 1.90 31,147 1.84
$ 1,689,093 100.00 % $ 1,692,066 100.00 %
Less allowance for loan losses
28,730 30,150
$ 1,660,363 $ 1,661,916

The Bank has an established formal loan origination policy.  In general, the loan origination policy attempts to reduce the risk of credit loss to the Bank by requiring, among other things, maintenance of minimum loan to value ratios, evidence of appropriate levels of insurance carried by borrowers and documentation of appropriate types and amounts of collateral and sources of expected payment.  The collateral relied upon in the loan origination policy is generally the property being financed by the Bank.  The source of expected payment is generally the income produced from the property being financed.  Personal guarantees are required of individuals owing or controlling at least 20% of the ownership of an entity.  Limited or proportional guarantees may be accepted in circumstances if approved by the Company’s Board of Directors.  Financial information provided by the borrower is verified as considered necessary by reference to tax returns, or audited, reviewed or compiled financial statements.  The Bank does not originate subprime loans.  In order to modify, restructure or otherwise change the terms of a loan, the Bank’s policy is to evaluate each borrower situation individually.  Modifications, restructures, extensions and other changes are done to improve the Bank’s position and to protect the Bank’s capital.  If a borrower is not current with its payments, any additional loans to such borrowers are evaluated on an individual borrower basis.

The Company has not experienced any significant time lapses in recognizing the required provisions for collateral dependent loans, nor has the Company delayed appropriate charge offs.  When an updated appraisal value has been obtained, the Company has used the appraisal amount in determining the appropriate charge off or required reserve.  The Company also evaluates any changes in the financial condition of the borrower and guarantors (if applicable), economic conditions, and the Company’s loss experience with the type of property in question.  Any information utilized in addition to the appraisal is intended to identify additional charge offs or provisions, not to override the appraised value.

In accordance with Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, the Company determines and assigns ratings to loans using factors that include the following: an assessment of the financial condition of the borrower; a realistic determination of the value and adequacy of underlying collateral; the condition of the local economy and the condition of the specific industry of the borrower; an analysis of the levels and trends of loan categories; and a review of delinquent and classified loans.



HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

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 non-accrual status, a charge-off or the establishment of a specific impairment 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 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 the Company determines 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 additional impairment and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize actual losses.

The following table presents the allowance for loan losses on loans by type of loans and the percentage in each category to total loans as of March 31, 2012 and December 31, 2011:

March 31, 2012
December 31, 2011
Amount
% of Total Allowance
% of Loans to Total Loans
Amount
% of Total Allowance
% of Loans to Total Loans
(In Thousands)
(In Thousands)
Agricultural
$ 1,282 4.46 % 3.93 % $ 1,354 4.49 % 4.05 %
Commercial and financial
6,033 21.00 8.52 6,429 21.32 8.46
Real estate:
Construction, 1 to 4 family residential
1,180 4.11 1.56 564 1.87 1.32
Construction, land development and commercial
3,593 12.51 4.83 4,430 14.69 4.99
Mortgage, farmland
1,412 4.91 5.98 1,411 4.68 5.90
Mortgage, 1 to 4 family first liens
6,689 23.28 34.64 7,037 23.34 34.16
Mortgage, 1 to 4 family junior liens
1,883 6.55 6.04 2,014 6.68 6.20
Mortgage, multi-family
1,714 5.97 12.93 1,888 6.26 13.17
Mortgage, commercial
4,196 14.60 18.51 4,262 14.14 18.69
Loans to individuals
347 1.21 1.16 371 1.24 1.22
Obligations of state and political subdivisions
401 1.40 1.90 390 1.29 1.84
$ 28,730 100.00 % 100.00 % $ 30,150 100.00 % 100.00 %

The allowance for loan losses totaled $28.73 million at March 31, 2012 compared to $30.15 million at December 31, 2011.  The percentage of the allowance to outstanding loans was 1.70% and 1.78% at March 31, 2012 and December 31, 2011, respectively.  The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and overall increases in loans outstanding.

The adequacy of the allowance is reviewed quarterly and adjusted as appropriate after consideration has been given to 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. The growth of the loan portfolio and the trends in problem and watch loans are significant elements in the determination of the provision for loan losses.  Quantitative factors include the Company’s historical loss experience, which is then adjusted for levels and trends in past due, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in restructured loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.



HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Management has determined that the allowance for loan losses was appropriate at March 31, 2012, 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 loan losses is based on a comprehensive, well documented, and consistently 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 loan losses is reviewed and compared to industry data. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.

Residential real estate loan products that include features such as loan-to-values in excess of 100% or interest only payments, which expose a borrower to payment increases in excess of changes in the market interest rate, increase the credit risk of a loan.  The Bank has not offered and does not intend to offer this type of loan product.

Investment securities available for sale held by the Company increased by $0.48 million from December 31, 2011 to March 31, 2012.  The fair value of securities available for sale was $7.02 million more than the amortized cost of such securities as of March 31, 2012.  At December 31, 2011, the fair value of the securities available for sale was $8.06 million more than the amortized cost of such securities.  The carrying values of investment securities at March 31, 2012 and December 31, 2011 are summarized in the following table (dollars in thousands):

March 31, 2012
December 31, 2011
Amount
Percent
Amount
Percent
Securities available for sale
Other securities (FHLB, FHLMC and FNMA)
$ 92,211 43.53 % $ 91,936 43.50 %
Obligations of state and political subdivisions
119,639 56.47 119,431 56.50
Total securities available for sale
$ 211,850 100.00 % $ 211,367 100.00 %

Investment securities have been classified in the consolidated balance sheets according to management’s intent.  Available-for-sale securities consist of debt securities not classified as trading or held to maturity.  Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity.  There were no trading or held to maturity securities as of March 31, 2012 or December 31, 2011. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of March 31, 2012 and December 31, 2011 (in thousands):

Amortized Cost
Gross Unrealized Gains
Gross Unrealized (Losses)
Estimated Fair Value
March 31, 2012:
State and political subdivisions
$ 113,975 $ 5,773 $ (109 ) $ 119,639
Other securities (FHLB, FHLMC and FNMA)
90,858 1,389 (36 ) 92,211
Total
$ 204,833 $ 7,162 $ (145 ) $ 211,850
December 31, 2011:
State and political subdivisions
$ 90,353 $ 1,583 $ - $ 91,936
Other securities (FHLB, FHLMC and FNMA)
112,959 6,524 (52 ) 119,431
Total
$ 203,312 $ 8,107 $ (52 ) $ 211,367




HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at March 31, 2012, were as follows (in thousands):

Amortized Cost
Fair Value
Due in one year or less
$ 39,422 $ 39,917
Due after one year through five years
109,121 112,611
Due after five years through ten years
55,628 58,607
Due over ten years
662 715
Total
$ 204,833 $ 211,850


The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2012 and December 31, 2011 (in thousands):


Less than 12 months
12 months or more
Total
March 31, 2012
Unrealized
Unrealized
Unrealized
Description of Securities
#
Fair Value
Loss
%
#
Fair Value
Loss
%
#
Fair Value
Loss
%
State and political subdivisions
17 $ 3,662 $ (82 ) 2.24 % 2 $ 474 $ (27 ) 5.70 % 19 $ 4,136 $ (109 ) 2.64 %
Other securities (FHLB, FHLMC and FNMA)
3 6,020 (36 ) 0.60 % - - - - 3 6,020 (36 ) 0.60 %
Total temporarily impaired securities
20 $ 9,682 $ (118 ) 1.22 % 2 $ 474 $ (27 ) 5.70 % 22 $ 10,156 $ (145 ) 1.43 %
Less than 12 months
12 months or more
Total
December 31, 2011
Unrealized
Unrealized
Unrealized
Description of Securities
#
Fair Value
Loss
%
#
Fair Value
Loss
%
#
Fair Value
Loss
%
State and political subdivisions
2 $ 409 $ (3 ) 0.73 % 2 $ 453 $ (49 ) 10.82 % 4 $ 862 $ (52 ) 6.03 %
Other securities (FHLB, FHLMC and FNMA)
- - - 0.00 % - - - - - - - 0.00 %
Total temporarily impaired securities
2 $ 409 $ (3 ) 0.73 % - $ 453 $ (49 ) 10.82 % 4 $ 862 $ (52 ) 6.03 %

The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are temporary and not other-than-temporary impairments.  The state and political subdivision securities with gross unrealized losses greater than twelve months as of March 31, 2012 included two issues.  The two securities are municipal bonds which are rated B1.  Bonds with a B1 rating are less than investment grade.   The aggregate fair value of these B1 rated bonds is $0.47 million while their amortized cost is $0.50 million, representing an unrealized loss of $0.03 million.  None of the unrealized losses in the above table was due to the deterioration in the credit quality of any of the issues that might result in the non-collection of contractual principal and interest.  The unrealized losses are due to changes in interest rates.  The Company has not recognized any unrealized loss in income because management does not have the intent to sell the securities included in the previous table.  Management has concluded that it is more likely than not that the Company will not be required to sell these securities prior to recovery of the amortized cost basis.



HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Deposit growth was $86.58 million in the first three months of 2012.  The $86.58 million deposit growth included $70.0 million of temporary public funds.  Repurchase agreements decreased $5.78 million in the same period.  In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits are included in total deposits and totaled $35.00 million as of March 31, 2012 with an average rate of 0.70%.  Brokered deposits were $32.12 million as of December 31, 2011 with an average rate of 0.71%.  As of March 31, 2012 and December 31, 2011, brokered deposits were 2.17% and 2.11% of total deposits, respectively.

Dividends and Equity

In January 2012, Hills Bancorporation paid a dividend of $5.00 million or $1.05 per share.  The dividend was $1.00 per share in January 2011.  After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of March 31, 2012 totaled $209.40 million. Under risk-based capital rules, the total amount of Tier 1 risk-based capital was 14.74% and 14.69% as of March 31, 2012 and December 31, 2011, respectively. The Tier 1 risk-based capital was in excess of the required minimum of 8.00%.  Risk-based capital was 16.00% and 15.95% as of March 31, 2012 and December 31, 2011, respectively. As of March 31, 2012, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  There are no conditions or events since that notification that management believes have changed the Company’s category.

Net Income Overview

Net income increased $1.72 million for the quarter ended March 31, 2012 compared to the first quarter of 2011.  Total net income was $7.90 million in 2012 and $6.18 million in the comparable period in 2011, an increase of 27.83%.  The changes in net income in 2012 from the first three months of 2011 were primarily the result of the following:

Ÿ
Net interest income increased by $0.57 million.
Ÿ
The provision for loan losses decreased by $2.03 million.
Ÿ
Other income increased by $0.68 million.
Ÿ
Other expenses increased by $0.70 million.
Ÿ
Income taxes increased $0.85 million.

For the three-month periods ended March 31, 2012 and 2011, basic earnings per share were $1.66 and $1.40, respectively. Diluted earnings per share were $1.66 for the three months ended March 31, 2012 compared to $1.40 for the same period in 2011.




HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Net Income Overview (continued)

Fluctuations in the Company’s net income continue to be driven primarily by three important factors.  The first important factor is the interaction between changes in net interest margin and changes in average earnings assets. Net interest income of $17.2 million for the first three months of 2012 was derived from the Company’s $1.908 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.75%.  Average earning assets in the three months ended March 31, 2011 were $1.831 billion and the tax-equivalent net interest margin was 3.82%. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of 10 basis points to 3.65% would have resulted approximately in a $476,000 decrease in income before income taxes in the three month period ended March 31, 2012. Similarly, an increase in the net interest margin of 10 basis points to 3.85% would have resulted in approximately a $476,000 increase in net interest income before taxes.  Net interest income for the Company increased due to the increase in average earning assets over the same period in 2011.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $1.706 billion at March 31, 2012.  The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio.  The provision 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, the level of impaired 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.  The provision for loan losses was a reduction in expense of $0.56 million in 2012 compared to an expense of $1.47 million in 2011.  The reduction in expense in 2012 is the result of a decrease in the historical loss rates used in the allowance for loan losses calculation.

The third significant factor affecting the Company’s net income is income tax expense.  Federal and state income tax expenses were $3.26 million and $2.40 million for the three months ended March 31, 2012 and 2011, respectively.  Income taxes as a percentage of income before taxes were 29.18% in 2012 and 28.00% in 2011.



HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Net Interest Income

Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities.  The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin.  The net interest margin for the first three months of 2012 was 3.75% compared to 3.82% in 2011 for the same period.  The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable.  The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2012 compared to the comparable period in 2011 are shown in the following table:

Increase (Decrease) in Net Interest Income
Change in Average Balance
Change in Average Rate
Volume Changes
Rate Changes
Net Change
(Amounts in Thousands)
Interest income:
Loans, net
$ 103,857 (0.39 ) % $ 1,640 $ (1,592 ) $ 48
Taxable securities
(6,189 ) (0.66 ) (43 ) (175 ) (218 )
Nontaxable securities
4,863 (0.26 ) 60 (74 ) (14 )
Federal funds sold
(25,404 ) - (17 ) - (17 )
$ 77,127 $ 1,640 $ (1,841 ) $ (201 )
Interest expense:
Interest-bearing demand deposits
$ 39,455 (0.19 ) % $ (34 ) $ 84 $ 50
Savings deposits
10,170 (0.15 ) (7 ) 149 142
Time deposits
(24,211 ) (0.40 ) 100 443 543
Short-term borrowings
(1,628 ) (0.47 ) 2 58 60
FHLB borrowings
(8,172 ) (0.16 ) 63 (72 ) (9 )
$ 15,614 $ 124 $ 662 $ 786
Change in net interest income
$ 1,764 $ (1,179 ) $ 585

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 on a tax-equivalent basis.

A summary of the net interest spread and margin is as follows:

(Tax Equivalent Basis)
2012
2011
Yield on average interest-earning assets
4.92 % 5.23 %
Rate on average interest-bearing liabilities
1.44 1.68
Net interest spread
3.48 % 3.55 %
Effect of noninterest-bearing funds
0.27 0.27
Net interest margin (tax equivalent interest income divided by average interest-earning assets)
3.75 % 3.82 %





HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Net Interest Income (continued)

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates.  The Federal Open Market Committee met two times during the first three months of 2012.  The target rate remains unchanged since December 31, 2008 at 0.25%.  Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate.  As of March 31, 2012, the rate indexes for the one, three and five year indexes were 0.20%, 0.58% and 1.16%, respectively.  The one year index decreased 23.08% from 0.26% at March 31, 2011, the three year index decreased 49.57% and the five year index decreased 44.76%.  The three year index was 1.17% and the five year index was 2.10% at March 31, 2011.  The targeted federal funds rate was 0.25% at March 31, 2012 and 2011.

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.56 million in 2012 compared to an expense of $1.47 million in 2011, a decrease of $2.03 million.  The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management.  The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio.  The provision 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 impaired 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 historical higher credit risks.  The reduction in expense in 2012 is the result of a decrease in the historical loss rates used in the allowance for loan losses calculation.

The allowance for loan losses decreased $1.42 million during the first three months of 2012.  In the first three months of 2012, there was a decrease of $0.44 million due to the volume and composition of loans outstanding and a $0.98 million decrease in the amount allocated to the allowance due to a combination of improvement in credit quality and charge-offs.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented.  For the three months ended March 31, 2012 and 2011, recoveries were $0.66 million and $0.63 million, respectively; and charge-offs were $1.52 million in 2012 and $1.50 million in 2011.  The allowance for loan losses totaled $28.73 million at March 31, 2012 compared to $30.15 million at December 31, 2011.  The allowance represented 1.70% and 1.78% of loans held for investment at March 31, 2012 and December 31, 2011, respectively.




HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended March 31, 2012 and 2011.

Three Months Ended March 31,
2012
2011
$ Change
% Change
(Amounts in thousands)
Net gain on sale of loans
$ 705 $ 482 $ 223 46.27 %
Trust fees
1,161 1,089 72 6.61
Service charges and fees
1,873 1,811 62 3.42
Rental revenue on tax credit real estate
394 283 111 39.22
Net gain on sale of other real estate owned and other repossessed assets
296 1 295
>100.00
Other noninterest income
584 669 (85 ) (12.71 )
$ 5,013 $ 4,335 $ 678

Loans originated for sale in the first three months of 2012 totaled $65.0 million compared to $28.0 million in the same period in 2011, an increase of 132.14%.  In the three months ended March 31, 2012 and 2011, the net gain on sale of loans was $0.71 and $0.48 million, respectively.  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.  The servicing 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 increased $0.07 million in the first three months of 2012 as a result of assets under management increasing from $1.003 billion as of March 31, 2011 to $1.008 billion as of March 31, 2012 due to market conditions and new trust relationships.

Service charges and fees increased $0.06 million in the first three months of 2012 from their level for the comparable period in 2011.  Credit card merchant, debit card and point of sale (POS) pin interchange fees are included in service charges and fees, and that component increased during the same period by $0.09 million due to volume of activity.

The net gain on sale of other real estate owned and other repossessed assets increased $0.30 million to a net gain of $0.30 million for the three months ended March 31, 2012.  The total net gain on sale of other real estate owned for the three months ended March 31, 2012 consisted of a $0.06 million fair market value adjustment on 2 properties within other real estate owned and a $0.36 million net gain on sale of 6 properties.  During the same period in 2011, the gain consisted of a $0.097 million fair market value adjustment on 4 properties within other real estate owned, a $0.099 million gain on sale of 4 properties and a $1,000 loss on sale of 1 property, for a net gain of $1,000.





HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended March 31, 2012 and 2011.

Three Months Ended March 31,
2012
2011
$ Change
% Change
(Amounts in thousands)
Salaries and employee benefits
$ 5,819 $ 5,550 $ 269 4.85 %
Occupancy
844 831 13 1.56
Furniture and equipment
1,111 965 146 15.13
Office supplies and postage
379 337 42 12.46
Advertising and business development
436 329 107 32.52
Outside services
1,702 1,726 (24 ) (1.39 )
Rental expenses on tax credit real estate
655 234 421
>100.00
FDIC insurance assessment
268 700 (432 ) (61.71 )
Other noninterest expense
413 254 159 62.60
$ 11,627 $ 10,926 $ 701

Other expenses of $11.63 million increased $0.70 million for the three months ended March 31, 2012 from the same period in 2011, an increase of 6.42%.  Furniture and equipment expense were $1.11 million for the three months ended March 31, 2012 which represents a $0.15 million increase from the 2011 period.  The negative variance is partially due to an increase of $0.07 million in depreciation for furniture, fixtures and equipment and an increase of $0.06 million in software maintenance contracts.

FDIC insurance assessment expense was $0.27 million for the three months ended March 31, 2012.  This is a decrease of $0.43 million when compared to the same period in 2011.  The decrease in FDIC insurance premium expense is due to the change in the premium calculation base by the FDIC.  Starting in the second quarter of 2011, the assessment is calculated using the assets of the Company less tangible capital resulting in a lower premium expense for the Company.  Previously, the assessment was calculated based on total deposits of the Company.  As of March 31, 2012, the Company has prepaid FDIC insurance of $3.64 million, which represents the FDIC premiums paid by the Bank on December 30, 2009 for the years of 2010, 2011 and 2012.  The prepaid FDIC insurance is being amortized on a quarterly basis as premiums are assessed.  The balance remaining in prepaid FDIC insurance at year ending December 31, 2012 will be refunded to the Company.





HILLS BANCORPORATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Income Taxes

Federal and state income tax expenses were $3.26 million and $2.40 million for the three months ended March 31, 2012 and 2011, respectively.  Income taxes as a percentage of income before taxes were 29.18% in 2012 and 28.00% in 2011.

Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs.  Federal funds sold and investment securities available for sale are readily marketable assets.  Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position.  Investment securities available for sale comprised 10.08% of the Company’s total assets at March 31, 2012, compared to 10.47% at December 31, 2011.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position.  As of March 31, 2012, the Company had borrowed $185 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. Advances are used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk.  The Company had additional borrowing capacity available from the FHLB of approximately $325 million at March 31, 2012.

As additional sources of liquidity, the Company has the ability to borrow up to $10 million from the Federal Reserve Bank of Chicago, and has lines of credit with two banks totaling $142 million. Those two lines of credit require the pledging of investment securities when drawn upon.  The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at March 31, 2012.

As of March 31, 2012, investment securities with a carrying value of $47.01 million were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law.  As of December 31, 2011, investment securities with a carrying value of $52.79 million were pledged.


Contractual Obligations

No significant changes from the 2011 Form 10K.



HILLS BANCORPORATION

Item 3.
Quantitative and Qualitative Disclosures about Market Risk


The Company's primary market risk exposure is to changes in interest rates.  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.  Conversely, 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.

Asset/Liability Management

The Bank maintains an asset/liability committee, which meets at least quarterly to review the Bank’s interest rate sensitivity position and to review various strategies as to interest rate risk management.  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.

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 savings or transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.

Net interest income should decline as interest rates increase, while net interest income should increase as interest rates decline.  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.

Management believes there has been no material change in the Company’s market risk from the information contained in the Company’s Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2011.

Item 4.
Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission.  There have been no changes in the Company’s internal controls over financial reporting during the three months of 2012 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.




HILLS BANCORPORATION
PART II - OTHER INFORMATION
Item 1. Legal Proceedings

No material legal proceedings are pending.

Item 1A. Risk Factors

There have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2011.

Item 2 .                 Unregistered Sales of Equity Securities and Use of Proceeds

The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended March 31, 2012:

Period
Total number of shares purchased
Average price paid per share
Total number of shares purchased as part of publicly announced plans or programs
Maximum number of shares that may yet be purchased under the plans or programs (1)
January 1 to January 31
1,080 $ 64.00 293,163 456,837
February 1 to February 29
1,115 64.00 294,278 455,722
March 1 to March 31
7,125 66.00 301,403 448,597
Total
9,320 $ 65.53 301,403 448,597

(1)  On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”).  This authorization was previously set to expire on December 31, 2009.  At its January 2009 meeting, the Company’s Board of Directors extended the expiration date of the 2005 Stock Repurchase Program to December 31, 2013.  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.

During the first quarter of 2012, the Company issued 269 shares of restricted stock under the 2010 Stock Option and Incentive Plan.  The restricted shares were issued for no cash consideration and will vest over a five-year period from the date of grant.  The issuance of these shares was exempt from the registration requirements of the SEC pursuant to Section 4(2) of the Securities Act of 1933.

Item 3. Defaults upon Senior Securities

Hills Bancorporation has no senior securities.

Item 4. Mine Safety Disclosure

Not applicable

Item 5.
Other Information


Item 6.
Exhibits

3.1 Articles of Incorporation filed as Exhibit 3.1 of Form S-3 restated on May 12, 2011 are incorporated by reference.
3.2                By-laws filed as Exhibit 3.2 of Form S-3 restated on May 12, 2011 are incorporated by reference.
31                 Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
32                 Certifications under Section 906 of the Sarbanes-Oxley Act of 2002




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


HILLS BANCORPORATION
Date: May 9, 2012
By:  /s/ Dwight O. Seegmiller
Dwight O. Seegmiller, Director, President and Chief Executive Officer
Date: May 9, 2012
By:  /s/ James G. Pratt
James G. Pratt, Secretary, Treasurer and Chief Accounting Officer





































QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED MARCH 31, 2012



Exhibit Number
Description
Page Number In The Sequential Numbering System March 31, 2012 Form 10-Q
31
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
50 - 51
32
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
52





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