HILLS BANCORPORATION The following is management's discussion and analysis of the financial condition ofHills Bancorporation ("Hills Bancorporation" or "the Company") and its banking subsidiaryHills 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 ofthe 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. This includes current concerns related to higher inflation, rising energy prices, theRussia -Ukraine war and supply chain imbalances.
•The effects of recent financial market disruptions and/or an economic recession, and monetary and other governmental actions designed to address such disruptions, including in response to the COVID-19 pandemic.
•The financial strength of the counterparties with which the Company or the Company's customers do business and as to which the Company has investment or financial exposure. •The credit quality and credit agency ratings of the securities in the Company's investment securities portfolio, a deterioration or downgrade of which could lead to recognition of an allowance for credit losses on the affected securities and the recognition of a credit loss. •The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company, including, but not limited to, potential changes inU.S. tax laws and regulations. •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 theBoard of Governors of theFederal 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.
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•The ability of the Company to develop and maintain secure and reliable technology systems.
•The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.
•Consumer spending and saving habits which may change in a manner that affects the Company's business adversely.
•The economic impact of natural disasters, diseases and/or pandemics, including any extended impact from the COVID-19 pandemic, and terrorist attacks and military actions.
•Business combinations and the integration of acquired businesses and assets which may be more difficult or expensive than expected.
•The costs, effects and outcomes of existing or future litigation.
•Changes in accounting policies and practices that may be adopted by state and
federal regulatory agencies and the
•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 theSecurities and Exchange Commission .
Economic Environment
TheU.S. economy continued its recovery during the first quarter of 2022 despite pressures from higher inflation and rising energy prices as well as concerns over theRussia -Ukraine war and the continued economic uncertainty caused by the COVID-19 pandemic. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic and higher energy prices as well as other broader price pressures, and is currently forecast to exceed an annual rate of 7.0 percent in the first quarter of 2022, well above the FRB's target inflation rate. In addition, theRussia -Ukraine war and related events are likely to create additional upward pressure on inflation and weigh on economic activity. As previously discussed, the COVID-19 pandemic has resulted in disruption to business and economic activity. While the Omicron variant took COVID-19 infection rates to a new high inJanuary 2022 , COVID-19 cases declined by the end of the first quarter. However, the duration of the pandemic, including the emergence of new variants, and the ultimate repercussions continue to remain unclear.U.S. Gross Domestic Product ("GDP") is currently forecast to grow at an annual rate in excess of 1.0 percent in the first quarter of 2022, while theU.S. economy added over 450 thousand jobs during the first quarter of 2022 and the total unemployment rate fell to 3.6 percent atMarch 2022 as compared with 3.9 percent atDecember 2021 . InMarch 2022 , the FRB increased short-term interest rates by 25 basis points and indicated that ongoing increases in short-term interest rates will occur in 2022 in order to fight inflation. Although theU.S. economy continued to grow during the first quarter of 2022, the impacts of higher inflation, rising energy prices and theRussia -Ukraine war, in addition to the continuing impact of the COVID-19 pandemic on economic conditions both inthe United States and abroad, have created significant uncertainty about the future economic environment which will continue to evolve and impact our business in future periods. Concerns over interest rate levels, energy prices, domestic and global policy issues, trade policy in theU.S. and geopolitical events, as well as the implications of those events on the markets in general, further add to the global uncertainty. Interest rate levels and energy prices, in combination with global economic conditions, fiscal and monetary policy and the level of regulatory and government scrutiny of financial institutions will continue to impact our results in 2022 and beyond. Each of the developments described above, or any combination of them, could adversely affect our business, financial condition and results of operations. Our credit administration continues to closely monitor and analyze the higher risk segments within the loan portfolio, tracking loan payment deferrals, customer liquidity and providing timely reports to senior management and the board of directors. Based on the Company's capital levels, prudent underwriting policies, loan concentration diversification and our geographic footprint, senior management is cautiously optimistic that the Company is positioned to continue managing the impact of the varied set of risks and uncertainties currently impacting the economy and remain adequately capitalized. However, the Company may be required to make additional loan loss provisions as warranted by the extremely fluid economic condition. Page 51
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Critical Accounting Policies
The Company's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America . The
financial information contained within these financial statements is, to a
significant extent, financial information that is based on approximate measures
of the financial effects of transactions and events that have already occurred.
Based on its consideration of accounting policies that involve the most complex
and subjective decisions and assessments, management has identified its most
critical accounting policies to be those which are related to the allowance for
credit losses.
Allowance for Credit Losses
On
The preparation of financial statements in accordance with the accounting principles generally accepted inthe United States ("U.S. GAAP") requires management to make a number of judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, income and expense in the financial statements. Various elements of our accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain substantial inherent uncertainties. Management has made significant estimates in several areas, including the allowance for credit losses (see Note 5 - Loans and Note 4 - Securities) and the fair value of debt securities (see Note 4 - Securities). We have identified the following accounting policies and estimates that, due to the inherent judgments and assumptions and the potential sensitivity of the financial statements to those judgments and assumptions, are critical to an understanding of our financial statements. We believe that the judgments, estimates and assumptions used in the preparation of the Company's financial statements are appropriate. For a further description of our accounting policies, see Note 1 - Summary of Significant Accounting Policies in the financial statements included in this Form 10-Q. The allowance for credit losses for loans represents management's estimate of all expected credit losses over the expected contractual life of our existing loan portfolio. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the then-existing loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for credit losses in those future periods. We employ a disciplined process and methodology to establish our allowance for credit losses that has two basic components: first, an asset-specific component involving individual loans that do not share risk characteristics with other loans and the measurement of expected credit losses for such individual loans; and second, a pooled component for estimated expected credit losses for pools of loans that share similar risk characteristics. Based upon this methodology, management establishes an asset-specific allowance for loans that do not share risk characteristics with other loans based on the amount of expected credit losses calculated on those loans and charges off amounts determined to be uncollectible. Factors we consider in measuring the extent of expected credit loss include payment status, collateral value, borrower financial condition, guarantor support and the probability of collecting scheduled principal and interest payments when due. When a loan does not share risk characteristics with other loans, we measure expected credit loss as the difference between the amortized cost basis in the loan and the present value of expected future cash flows discounted at the loan's effective interest rate except that, for collateral- dependent loans, credit loss is measured as the difference between the amortized cost basis in the loan and the fair value of the underlying collateral. The fair value of the collateral is adjusted for the estimated cost to sell if repayment or satisfaction of a loan is dependent on the sale (rather than only on the operation) of the collateral. In accordance with our appraisal policy, the fair value of collateral-dependent loans is based upon independent third-party appraisals or on collateral valuations prepared by in-house evaluations. Once a third-party appraisal is greater than one year old, or if its determined that market conditions, changes to the property, changes in intended use of the property or other factors indicate that an appraisal is no longer reliable, we perform an internal collateral valuation to assess whether a change in collateral value requires an additional adjustment to carrying value. When we receive an updated appraisal or collateral valuation, management reassesses the need for adjustments to the loan's expected credit loss measurements and, where appropriate, records an Page 52
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HILLS BANCORPORATION adjustment. If the calculated expected credit loss is determined to be permanent, fixed or nonrecoverable, the credit loss portion of the loan will be charged off against the allowance for credit losses. Loans designated having significantly increased credit risk are generally placed on nonaccrual and remain in that status until all principal and interest payments are current and the prospects for future payments in accordance with the loan agreement are reasonably assured, at which point the loan is returned to accrual status. In estimating the component of the allowance for credit losses for loans that share common risk characteristics, loans are segregated into loan classes. Loans are designated into loan classes based on loans pooled by product types and similar risk characteristics or areas of risk concentration. Credit loss assumptions are estimated using a model that categorizes loan pools based on loan type and purpose. This model calculates an expected life-of-loan loss percentage for each loan category by considering the probability of default using historical life-of-loan analysis periods for agricultural, 1 to 4 family first and junior liens, commercial and consumer segments, and the severity of loss, based on the aggregate net lifetime losses incurred per loan class. The component of the allowance for credit losses for loans that share common risk characteristics also considers factors for each loan class to adjust for differences between the historical period used to calculate historical default and loss severity rates and expected conditions over the remaining lives of the loans in the portfolio related to: •Lending policies and procedures; •International, national, regional and local economic business conditions and developments that affect the collectability of the portfolio, including the condition of various markets; •The nature of the loan portfolio, including the terms of the loans; •The experience, ability and depth of the lending management and other relevant staff; •The volume and severity of past due and adversely classified or graded loans and the volume of nonaccrual loans; •The quality of our loan review and process; •The value of underlying collateral for collateral-dependent loans; •The existence and effect of any concentrations of credit and changes in the level of such concentrations; and •The effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio. Such factors are used to adjust the historical probabilities of default and severity of loss so that they reflect management expectation of future conditions based on a reasonable and supportable forecast. To the extent the lives of the loans in the portfolio extend beyond the period for which a reasonable and supportable forecast can be made, the bank reduces, on a straight-line basis over the remaining life of the loans, the adjustments so that model reverts back to the historical rates of default and severity of loss. The credit loss expense recorded through earnings is the amount necessary to maintain the allowance for credit losses at the amount of expected credit losses inherent within the loans held for investment portfolio. The amount of expense and the corresponding level of allowance for credit losses for loans are based on our evaluation of the collectability of the loan portfolio based on historical loss experience, reasonable and supportable forecasts, and other significant qualitative and quantitative factors. The allowance for credit losses for loans, as reported in our consolidated balance sheet, is adjusted by an expense for credit losses, which is recognized in earnings, and reduced by the charge-off of loan amounts, net of recoveries. For further information on the allowance for credit losses for loans, see Note 1 - Summary of Significant Accounting Policies and Note 5 - Loans in the notes to the financial statements of this Form 10-Q. Page 53
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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 , Marion , and Washington ,
Iowa . At March 31, 2022 , the Bank has nineteen full-service locations.
Net income for the three month period ended March 31, 2022 was $10.65 million
compared to $15.20 million for the same three months of 2021, a decrease of
29.91%. The $4.55 million decrease in net income was caused by a number of
factors. The principal factors in the decrease in net income for the first
three months of 2022 are a credit loss expense of $1.10 million , primarily due
to increased outstanding loan commitments; a decrease in noninterest income of
$1.56 million ; and a decrease in net interest income of $1.05 million .
The Company achieved a return on average assets of 1.09% and a return on average
equity of 10.23% for the twelve months ended March 31, 2022 , compared to the
twelve months ended March 31, 2021 , which were 1.29% and 11.67%, respectively.
The return on average assets and return on average equity for the three months
ended March 31, 2022 were 1.07% and 10.08%, respectively, compared to the three
months ended March 31, 2021 , which were 1.60% and 14.88%, respectively.
Dividends of $1.00 per share were paid in January 2022 to 2,727 shareholders.
The dividend paid in January 2021 was $0.94 per share.
The Company'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 Company achieved a net interest margin on a tax-equivalent
basis of 2.64% for the three months ended March 31, 2022 compared to 2.90% for
the same three months of 2021. Average earning assets were $3.942 billion year
to date in 2022 and $3.734 billion in 2021.
Highlights noted on the balance sheet as of
•Total assets were$4.153 billion , an increase of$108.29 million sinceDecember 31, 2021 . •Cash and cash equivalents were$718.94 million , a decrease of$62.98 million sinceDecember 31, 2021 . A portion of the decrease can be attributed to increased investments inU.S Treasury and mortgage-backed securities of approximately$156.4 million sinceDecember 31, 2021 . Also, cash and cash equivalents included approximately$100 million of temporary public funds. •Net loans were$2.657 billion , an increase of$25.87 million sinceDecember 31, 2021 . The increase is primarily attributable to approximately$15.2 million growth in construction loans and$10.2 million growth in 1-4 family first mortgages sinceDecember 31, 2021 . Loans held for sale decreased$1.01 million sinceDecember 31, 2021 . •Deposits increased$127.59 million sinceDecember 31, 2021 . A portion of the increase can be attributed to increased savings with the current negative economic environment due to the pandemic. Also, deposit growth included approximately$100 million in temporary public funds. Reference is made to Note 7 for a discussion of fair value measurements which relate to methods used by the Company in recording assets and liabilities on its financial statements. Page 54
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Financial Condition
The ongoing fallout from the COVID-19 pandemic, including lingering supply chain
and labor market disruptions, as well as significant inflationary pressures have
created significant uncertainty regarding projecting loan demand throughout
2022. However, outstanding loan commitments continue to be significantly
elevated compared to historical levels.
The following table sets forth the composition of the loan portfolio as of
March 31, 2022 December 31, 2021
Amount Percent Amount Percent
(Amounts In Thousands) (Amounts In Thousands)
Agricultural $ 104,900 3.90 % $ 106,933 4.02 %
Commercial and financial 223,702 8.32 222,002 8.35
Real estate:
Construction, 1 to 4 family residential 87,390 3.25 80,486 3.03
Construction, land development and commercial 135,353 5.04 127,021 4.77
Mortgage, farmland 236,573 8.80 232,744 8.75
Mortgage, 1 to 4 family first liens 919,734 34.22 909,564 34.19
Mortgage, 1 to 4 family junior liens 111,278 4.14 114,342 4.30
Mortgage, multi-family 381,942 14.21 382,792 14.39
Mortgage, commercial 404,769 15.06 401,377 15.09
Loans to individuals 31,568 1.17 32,687 1.23
Obligations of state and political subdivisions 50,397 1.89 50,285 1.88
$ 2,687,606 100.00 % $ 2,660,233 100.00 %
Net unamortized fees and costs 186 299
$ 2,687,792 $ 2,660,532
Less allowance for credit losses 35,850 35,470
$ 2,651,942 $ 2,625,062
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 owning 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, and Staff Accounting Bulletin
No. 119, which aligns the staff's guidance with FASB ASC Topic 326, or CECL, the
Company determines and assigns ratings to loans using factors that include the
following: an assessment of the financial condition of the
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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.
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 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 may be downgraded and the uncollectible amount charged-off or recorded as a specific allowance for losses. The Bank's credit and legal departments undertake a thorough and ongoing analysis to determine if additional specific reserves 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 credit losses as ofMarch 31, 2022 andDecember 31, 2021 by loan category, the percentage of the allowance for each category to the total allowance, and the percentage of all loans in each category to total loans: March 31, 2022 December 31, 2021 % of Total % of Loans to % of Total % of Loans to Amount Allowance Total Loans Amount Allowance Total Loans (In Thousands) (In Thousands) Agricultural $ 2,414 6.73 % 3.90 %$ 2,261 6.37 % 4.02 % Commercial and financial 4,895 13.65 8.32 4,269 12.04 8.35 Real estate: Construction, 1 to 4 family residential 812 2.26 3.25 818 2.31 3.03 Construction, land development and commercial 1,535 4.28 5.04 1,482 4.18 4.77 Mortgage, farmland 3,310 9.23 8.80 3,433 9.68 8.75 Mortgage, 1 to 4 family first liens 8,441 23.56 34.22 8,340 23.52 34.19 Mortgage, 1 to 4 family junior liens 2,997 8.36 4.14 3,158 8.90 4.30 Mortgage, multi-family 3,145 8.77 14.21 3,715 10.47 14.39 Mortgage, commercial 7,089 19.77 15.06 6,783 19.12 15.09 Loans to individuals 769 2.15 1.17 771 2.17 1.23 Obligations of state and political subdivisions 443 1.24 1.89 440 1.24 1.88$ 35,850 100.00 % 100.00 %$ 35,470 100.00 % 100.00 % The allowance for credit losses (ACL) totaled$35.85 million atMarch 31, 2022 compared to the allowance for loan losses under the incurred loss method of$35.47 million atDecember 31, 2021 . The percentage of the allowance to outstanding loans was 1.33% and 1.33% atMarch 31, 2022 andDecember 31, 2021 , 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 the overall amount of loans outstanding. The changes in the ACL in 2022 compared toDecember 31, 2021 is the result of the following factors: improvements in the economic factor forecasts, primarilyIowa unemployment, used in the ACL calculation which resulted in a decrease of$0.54 million ; increase in loan volume which resulted in an increase of$0.42 million ; changes in prepayment and curtailment rates resulting in a decrease of$0.24 million ; increases in historical loss rates resulting in an increase of$0.18 million ; increase in the individually analyzed loans reserve of$0.23 million ; and increases in qualitative factors determined necessary by management which resulted in an increase of$0.33 million . Page 56
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HILLS BANCORPORATION 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 credit 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. Management has determined that the allowance for credit losses was adequate atMarch 31, 2022 , and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for credit losses is based on a comprehensive, 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 credit losses is reviewed and compared to industry data. This review encompasses levels of total collateral-dependent loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs. Investment securities available for sale held by the Company increased by$136.42 million fromDecember 31, 2021 toMarch 31, 2022 . The fair value of securities available for sale was$27.80 million less than the amortized cost of such securities as ofMarch 31, 2022 . AtDecember 31, 2021 , the fair value of the securities available for sale was$1.97 million more than the amortized cost of such securities. Deposits increased$127.59 million in the first three months of 2022 primarily due to the increase in temporary public funds for property taxes. 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$51.60 million as ofMarch 31, 2022 with an average rate of 0.37%. Brokered deposits were$51.59 million as ofDecember 31, 2021 with an average interest rate of 0.36%. As ofMarch 31, 2022 andDecember 31, 2021 , brokered deposits were 1.41% and 1.46% of total deposits, respectively. There were noFederal Home Loan Bank (FHLB) borrowings as ofMarch 31, 2022 andDecember 31, 2021 . The FHLB funding source is considered when loan growth exceeds core deposit increases and the interest rates on funds borrowed from the FHLB are favorable compared to other funding alternatives.
Dividends and Equity
InJanuary 2022 ,Hills Bancorporation paid a dividend of$9.31 million or$1.00 per share. The dividend paid inJanuary 2021 was$0.94 per share. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders' equity as ofMarch 31, 2022 totaled$414.16 million . OnJanuary 1, 2015 , the final rules of theFederal Reserve Board went into effect implementing inthe United States the Basel III regulatory capital reforms from theBasel Committee on Banking Supervision . The final rule also adopted changes to the agencies' regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under the BASEL III rules, the minimum capital ratios are 4% for Tier 1 Leverage Capital Ratio, 4.5% for the Common Equity Tier 1 Capital Ratio, 6% for the Tier 1 Risk-Based Capital Ratio and 8% for the Total Risk-Based Capital Ratio. The Bank elected to use the Community Bank Leverage Ratio (CBLR) framework as provided for in the Economic Growth, Regulatory Relief and Consumer Protection Act. Under the CBLR framework, the Bank is required to maintain a CBLR of greater than 9%. The CARES Act reduced the minimum ratio to 8% beginning in the 2nd quarter of 2020 throughDecember 31, 2020 , increasing to 8.5% for 2021 and returning to 9% beginningJanuary 1, 2022 . As ofMarch 31, 2022 andDecember 31, 2021 , the Company had regulatory capital in excess of theFederal Reserve's minimum and well-capitalized definition requirements. The actual amounts and capital ratios as ofMarch 31, 2022 andDecember 31, 2021 are presented below (amounts in thousands): Page 57
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Actual For Capital Adequacy Purposes
Amount Ratio Ratio
As of March 31, 2022 :
Company:
Community Bank Leverage ratio $ 484,461 11.99 % 9.000 %
Bank:
Community Bank Leverage ratio 485,045 12.01 9.000
Actual For Capital Adequacy Purposes
Amount Ratio Ratio
As of December 31, 2021 :
Company:
Community Bank Leverage ratio $ 484,486 11.80 % 8.50 %
Bank:
Community Bank Leverage ratio 484,429 11.80 8.50
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HILLS BANCORPORATION
Discussion of operations for the three months ended
Net Income Overview Net income decreased$4.55 million for the three months endedMarch 31, 2022 compared to the first three months of 2021. Total net income was$10.65 million in 2022 and$15.20 million in the comparable period in 2021, a decrease of 29.91%. The changes in net income in 2022 from the first three months of 2021 were primarily the result of the following: •Net interest income decreased by$1.05 million , before credit loss expense, attributable in large part to decreased PPP loan fees of$1.88 million compared to the three months endedMarch 31, 2021 . •For the three months endedMarch 31, 2022 , a credit loss expense was recorded totaling$1.10 million . This represents an increase in expense of$4.09 million from the reversal of credit loss reserves of$2.98 million for the three months endedMarch 31, 2021 . •Noninterest income decreased by$1.56 million . •Noninterest expenses decreased by$0.62 million . •Income tax expense decreased by$1.53 million . For the three month period endedMarch 31, 2022 andMarch 31, 2021 basic earnings per share was$1.15 and$1.63 , respectively. Diluted earnings per share was$1.15 for the three months endedMarch 31, 2022 compared to$1.63 for the same period in 2021. The Company's net income for the period was driven primarily by three important factors. The first important factor is credit loss expense recorded under CECL. The majority of the Company's interest-earning assets are in loans outstanding, which amounted to more than$2.657 billion atMarch 31, 2022 . Expected credit loss expense is computed on a quarterly basis and is a result of management's determination of the quality of the loan portfolio. The expense reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers' ability to repay, past loss experience, loan collateral values, the level of collateral-dependent loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management's review of problem and watch loans, including loans with historically higher credit risk. Credit loss expense was$1.10 million in 2022 compared to a reduction of expense of$2.98 million in 2021. The increase in expense when compared to the same period in 2021 is attributable to increases in outstanding loan commitments, loan volume and qualitative factor increases determined by management. The reduction in expense in 2021 was primarily due to the increases to the allowance taken in 2020 in response to the COVID-19 pandemic that were released in 2021. The Company believes that credit loss expense is expected to be dependent on the Company's loan growth, local economic conditions, including, but not limited to, conditions associated with the COVID-19 pandemic and the attendant risks and uncertainties related thereto, and asset quality. The second important factor affecting the Company's net income is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets. Net interest income of$25.18 million for the first three months of 2022 was derived from the Company's$3.942 billion of average earning assets during that period and its tax-equivalent net interest margin of 2.64%. Average earning assets in the three months endedMarch 31, 2021 were$3.734 billion and the tax-equivalent net interest margin was 2.90%. Net interest income for the Company decreased primarily as a result of the continued low interest rates on loans resulting in decreased interest income as well as no PPP fee income in 2022 compared to 2021. The Company expects net interest compression to impact earnings for the foreseeable future due to competition for loans and deposits combined with the low interest rate environment in 2021 and 2020 resulting in decreased net interest income. The Company believes growth in net interest income will be contingent on the growth of the Company's earning assets, increasing yield on loans and the continued interest rate increases by theFederal Reserve Board . The third significant factor affecting the Company's net income is noninterest income, primarily the decrease in net gain on the sale of loans. The net gain on the sale of loans was$0.81 million and$3.00 million for the three months endedMarch 31, 2022 and 2021, respectively, a decrease of 73.00% for the three months endedMarch 31, 2022 compared to the same period in 2021. 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 as well as the current origination and refinancing activity. The volume has been significantly impacted by theFederal Reserve Board's planned increases of the federal funds rate throughout 2022, resulting in a significant decline in the amount of mortgage loan origination and refinance activity. Page 59
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HILLS BANCORPORATION
Net Interest Income
Net interest income decreased for the three months ended March 31, 2022 compared
to the comparable period in 2021. The decrease was primarily attributable to
decreased PPP loan fees of $1.88 million compared to the three months ended
March 31, 2021 . The decrease in interest income was partially offset by the
decrease in interest expense associated with the low rate environment. 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 average volume of earning assets for the period and the
net interest margin. The net interest margin for the first three months of 2022
was 2.64% compared to 2.90% in 2021 for the same period. The measure is shown on
a tax-equivalent basis using a tax rate of 21% 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 2022 compared to the
comparable period in 2021 are shown in the following table:
Increase (Decrease) in Net Interest Income
Change in
Average Change in
Balance Average Rate Volume Changes Rate Changes Net Change
(Amounts in Thousands)
Interest income:
Loans, net $ (29,345) (0.48) % $ (623) $ (2,826) $ (3,449)
Taxable securities 147,728 (0.33) 624 (310) 314
Nontaxable securities 42,142 (0.26) 249 (170) 79
Federal funds sold 47,994 0.09 12 159 171
$ 208,519 $ 262 $ (3,147) $ (2,885)
Interest expense:
Interest-bearing demand deposits $ 143,368 (0.10) % $ (98) $ 279 $ 181
Savings deposits 158,422 (0.05) (61) 139 78
Time deposits (99,389) (0.28) 434 404 838
FHLB borrowings (105,000) (2.82) 741 - 741
Interest-bearing other liabilities (1) (0.10) - - -
$ 97,400 $ 1,016 $ 822 $ 1,838
Change in net interest income $ 1,278 $ (2,325) $ (1,047)
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. 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) 2022 2021
Yield on average interest-earning assets 2.94 % 3.43 %
Rate on average interest-bearing liabilities 0.42 0.70
Net interest spread 2.52 % 2.73 %
Effect of noninterest-bearing funds 0.12 0.17
Net interest margin (tax equivalent interest income divided by average interest-earning assets)
2.64 % 2.90 %
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HILLS BANCORPORATION In pricing loans and deposits, the Bank considers theU.S. Treasury indexes as benchmarks in determining interest rates. TheFederal Open Market Committee met two times during the first three months of 2022. The target rate increased to 0.50% as ofMarch 31, 2022 . Interest rates on loans are generally affected by the target rate since interest rates for theU.S. Treasury market normally increase or decrease when theFederal Reserve Board raises or lowers the federal funds rate. As ofMarch 31, 2022 , the rate indexes for the one, three and five year indexes were 1.63%, 2.45% and 2.42%, respectively. The one year index increased 2,228.72% from 0.07% atMarch 31, 2021 , the three year index increased 600.00% and the five year index increased 163.04%. The three year index was 0.35% and the five year index was 0.92% atMarch 31, 2021 . The targeted federal funds rate was 0.50% atMarch 31, 2022 and 0.25% atMarch 31, 2021 . The Company anticipates short term and long term rates in the indexes to remain consistent throughout 2021. Credit Loss Expense Credit loss expense was$1.10 million for the three months endedMarch 31, 2022 compared to a reduction of expense of$2.98 million in 2021, an increase of expense of$4.09 million . Credit loss expense is the amount necessary to adjust the allowance for credit losses to the level considered by management to appropriately account for the estimated current expected credit losses within the Bank's loan portfolio. The credit loss expense taken to fund the allowance for credit losses is computed on a quarterly basis and is a result of management's determination of the quality of the loan portfolio. The expense reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers' ability to repay, past loss experience, loan collateral values, the level of collateral-dependent loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management's review of problem and watch loans, including loans with historically higher credit risks. Also, under CECL, a significant component in estimating expected credit losses are economic forecasts such asIowa unemployment, all-transactions house price index forIowa andIowa real gross domestic product. The increase in expense when compared to the same period in 2021 is attributable to increases in outstanding loan commitments, loan volume and qualitative factor increases determined by management. The reduction in expense in 2021 was primarily due to the increases to the allowance taken in 2020 in response to the COVID-19 pandemic that were released in 2021. The Company believes that credit loss expense is expected to be dependent on the Company's loan growth, local economic conditions, including, but not limited to, conditions associated with the COVID-19 pandemic and the attendant risks and uncertainties related thereto, and asset quality. The allowance for credit losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the three months endedMarch 31, 2022 and 2021, recoveries were$0.46 million and$0.72 million , respectively; and charge-offs were$0.34 million in 2022 and$0.17 million in 2021. The allowance for credit losses totaled$35.85 million atMarch 31, 2022 compared to$35.47 million as ofDecember 31, 2021 . The allowance represented 1.33% and 1.33% of loans held for investment atMarch 31, 2022 andDecember 31, 2021 .
Noninterest Income
The following table sets forth the various categories of noninterest income for
the three months ended
Three Months Ended March 31,
2022 2021 $ Change % Change
(Amounts in thousands)
Net gain on sale of loans $ 811 $ 3,003 $ (2,192) (72.99) %
Trust fees 3,268 3,013 255 8.46
Service charges and fees 2,880 2,540 340 13.39
Other noninterest income 518 482 36 7.47
$ 7,477 $ 9,038 $ (1,561) (17.27)
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HILLS BANCORPORATION In the three months endedMarch 31, 2022 and 2021, the net gain on sale of loans was$0.81 million and$3.00 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, margin and demand in these types of loans is directly related to the level of interest rates as well as the current origination and refinancing activity. The primary reason for the decrease in 2022 compared to 2021 is the increased mortgage interest rates in the first quarter 2022. 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.
Service charges and fees increased
Other noninterest income categories experienced marginal period-to-period
fluctuations for the three months ended
Noninterest Expenses
The following table sets forth the various categories of noninterest expenses
for the three months ended
Three Months Ended March 31,
2022 2021 $ Change % Change
(Amounts in thousands)
Salaries and employee benefits $ 10,396 $ 10,564 $ (168) (1.59) %
Occupancy 1,132 1,138 (6) (0.53)
Furniture and equipment 1,697 1,983 (286) (14.42)
Office supplies and postage 484 454 30 6.61
Advertising and business development 730 535 195 36.45
Outside services 2,950 3,188 (238) (7.47)
FDIC insurance assessment 281 258 23 8.91
Other noninterest expense 405 579 (174) (30.05)
$ 18,075 $ 18,699 $ (624) (3.34)
Other noninterest expense categories experienced marginal period-to-period
fluctuations for the three months ended
Income Taxes
Federal and state income tax expenses were$2.83 million and$4.36 million for the three months endedMarch 31, 2022 and 2021, respectively. Income taxes as a percentage of income before taxes were 20.97% in 2022 and 22.29% in 2021.
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 16.56% of the Company's total assets atMarch 31, 2022 compared to 13.63% atDecember 31, 2021 . 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 ofMarch 31, 2022 , the Company had no outstanding borrowings from theFederal Home Loan Bank ("FHLB") ofDes 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$864.08 million atMarch 31, 2022 . Page 62
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HILLS BANCORPORATION As additional sources of liquidity, the Company has the ability to borrow up to$10.00 million from theFederal Reserve Bank of Chicago , and has lines of credit with three banks totaling$545.04 million . The borrowings under these credit lines would be secured by the Bank's investment securities. 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 atMarch 31, 2022 .
As of
Contractual Obligations
There have been no material changes with regard to contractual obligations
disclosed in the Company's Form 10-K for the year ended
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HILLS BANCORPORATION
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